How does the Law of Unanticipated Consequences apply to risk weighted bank capital requirements?
There’s Murphy’s Law type unanticipated consequences: “What Can Go Wrong, Will Go Wrong”; and there are perverse effects that result in the opposite of what was intended.
And then there is Robert K. Merton’s, Law of Unanticipated Consequences. This one identifies five principle causes of unanticipated consequences:
Ignorance, making it impossible to anticipate everything, thereby leading to incomplete analysis.
Ignorance? Yes, but much spiced up with that abundant hubris that made regulators believe that they, from their desks, and with the help of some few human fallible credit rating agencies, could get a grip on what the risks for bank systems are.
Errors in analysis of the problem or following habits that worked in the past but may not apply to the current situation.
Errors? Many but perhaps none worse than the following:
1. Risk weights 0% the government and 100% citizens, as if bureaucrats know better what to do with credit for which repayment they're not personally responsible for than e.g., small businesses and entrepreneurs.
2. Fixating on the perceived credit risks and not on the risks conditioned to how the credit risks are perceived.
3. Ignoring how dangerously procyclical these bank capital requirements would be.
Immediate interests overriding long-term interests.
Immediate interests? Absolutely, and perhaps none as clear as that valiantly but sadly so late confessed one by Paul Volcker “The assets assigned the lowest risk, for which bank capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages.”
Basic values which may require or prohibit certain actions even if the long-term result might be unfavourable.
Basic values? Can’t think of anyone except of course that “it’s not come-il-faut to question your colleagues”, and which tends to prevail in all mutual admiration clubs defending the jobs of their members.
Self-defeating prophecy, or, the fear of some consequence which drives people to find solutions before the problem occurs, thus the non-occurrence of the problem is not anticipated.
Self-defeating prophecy? Perhaps, in terms of listening too much to Monday Morning Quarterback besserwisser prophets. The morning after a crisis they describe in detail the risky assets. What they never mention before the crisis, is with what "safe" assets those dangerous bank exposures are being built-up with.
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