My brevissimus criticism lecture on the Basel Committee’s bank regulations

Students. 

Let’s refer to two types of bank assets, those perceived as safe, e.g., government debt and residential mortgages; and those perceived as risky, e.g., loans to small businesses and entrepreneurs.

Let’s also assume all these assets, whether the Safe or the Risky, are offering perfect risk adjusted interest rates.

Before the Basel Committee regulations, the banks, with a general look to the safety of their whole portfolio, would have given all of these assets, whether safe or risky, a quite similar consideration.

But, when the Basel Committee imposed risk weighted bank capital requirements, more capital/equity for what’s perceived as risky than for what’s perceived (or decreed) as safe, that all changed.

Because banks can now leverage their capital/equity much more with what’s “safe”, the risk adjusted interest rates offered by the Safe, produce them higher risk adjusted returns on their equity, than the risk adjusted interest rates offered by the Risky.

That dramatically distorted the allocation of bank credit. 

The Safe now get too much credit, often at rates lower than what their correct risk adjusted interest rate would demand. As a consequence, excessive bank exposures are construed, turning the Safe effectively into risky and very dangerous to the stability of bank systems. (Have you ever heard of a dangerous asset bubble built-up with assets perceived as risky?)

The Risky now get too little credit and, whatever they get, is at interest rates higher than what their correct risk adjusted interest rates would merit. As a consequence, the Risky become riskier, and too little risk-taking, the oxygen of all development, takes place, something which, of course, weakens the economy.

Why would regulators do this? As Paul Volcker (valiantly) confessed “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”

Students, one big problem is that the Academia seem not to care one iota about it, so this might have been your only chance to hear this explanation. 

Why should you care? Having banks give much priority to refinancing the safer present than financing the riskier future, cannot be in your best interests.