The risk weighted bank capital requirements had a real purpose... quite different from making our banks safe

"I have been sitting here for most of these five days without being able to detect a single formula or word indicating that growth and credits are also a function of bank regulations"

I've often complained about the lack of purpose of the current bank regulations… until I finally understood that the risk weighted bank capital requirements decreed weights of 0% government - 100% citizens, revealed their real purpose, the empowerment of Bureaucracy Autocracies.

And don't take my word for it. Paul Volcker valiantly confessed: “Assets for which bank capital requirements were nonexistent, were what had the most political support; sovereign credits. A ‘leverage ratio’ discouraged holdings of low-return government securities”

What would America’s Founding Fathers opine about bank capital/equity requirements with decreed risk weights: 0% Federal Government and 100% We the People?

Financial Communism

In America, in the Home of the Brave, in democracy, how can this have been going on, for over three decades?

“Assets assigned the lowest risk [in 1988], for which bank capital requirements were therefore nonexistent or low, were what had the most political support: sovereign credits & home mortgages… A ‘leverage ratio’ discouraged holdings of low-return government securities” Paul Volcker “Keeping at It” 2018.

That de facto means banks can leverage more their capital/equity with government debt and residential mortgages than with loans to small businesses and entrepreneurs. 

That de facto means banks can easier earn risk adjusted returns on capital/equity with government debt and residential mortgages than with loans to small businesses and entrepreneurs.

That de facto means banks have been given incentives to hold more government debt and residential mortgages than when holding loans to small businesses and entrepreneurs.

That de facto means banks will hold government debt and residential mortgages against much lower risk adjusted interest rates than those charged on loans to small businesses and entrepreneurs.

That de facto implies bureaucrats know better what to do with bank credit for which repayment they’re not personally responsible for than small businesses and entrepreneurs with theirs.

That de facto implies residential mortgages are more important than loans to those who can create the jobs and incomes, by which make down-payments, repay mortgages, service utilities & live.

In America, in the Home of the Brave, in democracy, how can this have been happening, for over three decades, and no one objects?

What would its Founding Fathers have said?

Two questions to America’s economists, and one for its lawyers.

Bear with me.

Let me start with two passages from John Kenneth Galbraith’s “Money: Whence it came where it went” 1975.

First: “For the new parts of the country [USA’s West] … there was the right to create banks at will and therewith the notes and deposits that resulted from their loans…[if] the bank failed…someone was left holding the worthless notes… but some borrowers from this bank were now in business... [jobs created]

It was an arrangement which reputable bankers and merchants in the East viewed with extreme distaste… Men of economic wisdom, then as later expressing the views of the reputable business community, spoke of the anarchy of unstable banking… The men of wisdom missed the point. The anarchy served the frontier far better than a more orderly system that kept a tight hand on credit would have done…. what is called sound economics is very often what mirrors the needs of the respectfully affluent.”

Second: “The function of credit in a simple society is, in fact, remarkably egalitarian. It allows the man with energy and no money to participate in the economy more or less on a par with the man who has capital of his own. And the more casual the conditions under which credit is granted and hence the more impecunious those accommodated, the more egalitarian credit is… Bad banks, unlike good, loaned to the poor risk, which is another name for the poor man.”

Then, in Steven Solomon's “The Confidence Game” we read:

“On September 2, 1986, the fine cutlery was laid once again at the Bank of England governor’s official residence at New Change… The occasion was an impromptu visit from Paul Volcker… When the Fed chairman sat down with Governor Robin Leigh-Pemberton and three senior BoE officials, the topic he raised was bank capital…” 

Finally in his autobiography “Keeping at it” of 2018, penned together with Christine Harper, Paul Volcker wrote:

“The assets assigned the lowest risk, for which capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages. Ironically, losses on those two types of assets would fuel the global crisis in 2008 and a subsequent European crisis in 2011. The American “overall leverage” approach had a disadvantage as well in the eyes of shareholders and executives focused on return on capital; it seemed to discourage holdings of the safest assets, in particular low-return US government securities."

Thanks!

So, now let me ask America’s economists two questions:

If since its Founding Fathers’ days America’s banks had been regulated so as to finance much more the government and residential mortgages than loans to its small businesses and entrepreneurs, would America be where it is now? 

Knowing that all those excessive bank exposures that have set on major bank crises were always built-up with what was ex ante perceived as very safe, what true precautionary purpose do these regulations serve?

And one question to America’s lawyers:

The risk weighted bank capital requirements with decreed weights of 0% Federal Government 100% - We the People, do they really conform with what 's wanted in the U.S. Constitution?

Where do I come from? 

At the World Bank “Let us not forget that the other side of the Basel [Committee’s regulatory risk weighted capital requirements] coin might be many, many developing opportunities in credit foregone”

As one of the Christian Western World? God make us daring!

As one having a strong opinion? My letter to the Financial Stability Board.

25 years on the issue. My first Op-Ed ever, began with what this post does.

To help moor (my) inflationary expectations, get rid of what facilitates it.

Paul Volcker, in his autography “Keeping at it”, penned together with Christine Harper in 2018, wrote: “The assets assigned the lowest risk [in 1988], for which capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages… The American ‘overall leverage’ approach had a disadvantage as well in the eyes of shareholders and executives focused on return on capital; it seemed to discourage holdings of the safest assets, in particular low-return US government securities."

Washington Post, in reference to your “Do not underestimate inflation” November 11 let me assure you that, just as lower bank capital requirements against residential mortgages fuels house prices; lower bank capital requirements against Treasuries, by artificially lowering the interest rate on these, sooner or later, are bound to facilitate those excessive injections of liquidity that fuels inflation.

I’m not an expert on the US Constitution, I’m not even an American citizen, but I cannot understand how Section 8’s "The Congress shall have the power to borrow Money on the credit of the United States" could be read as to include the assistance of a Federal Reserve quantitative easing; and bank capital requirements with risk weights: 0% the Federal Government, 100% We the People.

If I had a chance to be heard by the Fed, here’s a Basel IV I would suggest

PS. Fight inflation, from bottom up! Injecting liquidity while banks obtain higher risk adjusted returns on equity with Treasuries & residential mortgages (carbs) than with loans to small businesses & entrepreneurs (proteins), that favors demand over supply, something which can only help to inflate inflation.

PS. To top it up, are we really sure that the inflation that's pursued is the inflation that matters?

@PerKurowski

Five sad musings on the current bank regulations autocratically dictated by central bankers.

It is so hard for me to muster enough interest about central bankers’ monetary policies, while they make these so ineffective by imposing regulations that dangerously distort the allocation of bank credit.

“Credit risk weighted bank capital (equity) requirements” 

translates as 

“Worthy of credit allowed bank capital (equity) leverages”

Their lower bank capital requirements when lending to the government than when lending to citizens, de facto implies bureaucrats know better what to do with credit they’re not personally responsible for than e.g. entrepreneurs... and so are more worthy of it.

Their lower bank capital requirements for banks when financing the central government than when financing local governments, de facto implies federal bureaucrats know much better what to do with credit than local bureaucrats... and so are more worthy of it.

Their lower bank capital requirements for banks when financing residential mortgages, de facto implies that those buying a house are more important for the economy than, e.g. small businesses and entrepreneurs... and so are more worthy of it.

Their lower bank capital requirements for banks when financing the “safer” present than when financing the “riskier” future, de facto implies placing a reverse mortgage on the current economy and giving up on our grandchildren’s future.

And all that for nothing. Those excessive bank exposures that could be dangerous to our bank systems are always built-up with assets perceived or decreed as safe, and never ever with assets perceived as risky.

It’s despairing to see a Federal Reserve not understanding how these bank shareholders’ capital (equity) requirements distort the interest rates e.g., the risk-free rate.

Is all this in accordance to the U.S. Constitution? 

A letter to the IMF: The risk weights are to access to credit what tariffs are to trade... only more pernicious. 

A 2023 AI comment from ChatGPT on this issue:

A 2025 AI comment from Grok on this issue:

Regulatory risk-weights: The sovereign = Zero percent and We the (risky) People = 100%. In America?

I am not an American, and I am not well versed on its Constitution,  but there's one issue which has for a long time been a mystery to me. 

How on earth could America, in 1988, as a signatory of the Basel Accord, accept that for the purpose of setting capital requirements for banks, the risk-weight for the sovereign, meaning the government, was going to be zero percent, while the risk-weight for the citizen, meaning We The People was set at 100%; and all without a major discussion?

I know that “sovereigns” currently means the government but, from reading for instance Randy E. Barnett’s “Our Republican Constitution”, one could have expected some debate about something that is akin to risk weighing the King with an "infallible" 0%, and his subservients with a "risky" 100%.

Barnett's book states that Justice James Wilson, in the Chisholm v. Georgia case of 1793, opined that “To the Constitution of the United States the term Sovereign is totally unknown…and if the term sovereign is to be used at all, it should refer to the individual people”. And the book also frequently refers to the importance of the required consent of the people, which of course is also a thorny issue. 

And, since those risk-weights effectively permit banks to leverage their equity much more when lending to the sovereign, than when lending to the citizen; banks will earn higher risk adjusted returns when lending to the sovereign than when lending to the citizens; and so banks will de facto, sooner or later, lend much too much to the sovereign and much too little to the citizens… and I can simply not fathom how citizens, be they individual or majority, could give their consent to something like that.

De-facto those risk weights signify that regulators believe that government bureaucrats can make better use of bank credit than citizens… it is statism running amok.

But it became even worse. In 2004, in Basel II, regulators also made a distinction between those private who had great credit ratings, like AAA to AA, and who received a 20% risk-weight, and for instance those who had no ratings, and who kept their 100% risk weight. That to creates a sort of AAA-risktocracy that does not square well with the Constitution’s “No Title of Nobility shall be granted by the United States.

But even without entering into constitutional issues, there is even a current law that seems to prohibit this type of discrimination, but that is not applied to bank regulations. And I refer to the Equal Credit Opportunity Act: “Regulation B”.

So in the land in which its Declaration of Independence states: “We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness.”, I just must ask: How could regulators dare to decree such regulatory inequality?

And to top it up, the current risk-weighted capital requirements for banks, more ex ante perceived risk more capital – less risk less capital, are arbitrary and irrational. And that because no major bank crises have ever result from the build up of excessive dangerous bank exposures to something perceived as risky, that has always happened with something, erroneously, perceived as very safe. If you want to understand how really crazy these bank regulations are, here is a brief memo.

And frankly what would a Governor answer to this question: Why can our banks leverage their equity lending more to a foreign sovereign or a foreigner with a high credit rating, than when lending to us, the local SMEs and entrepreneurs?

No! America would never have become what it is, had it had this type of risk averse discriminatory bank regulations before.

And by the way the Dodd Frank Act, in all its 848 pages, surrealistically, does not mention the Basel Committee nor the Basel Accord, not even once.

Have the risk weights used in current bank regulations really been approved by the US Congress, in accordance to the Constitution?

PS. In his book Professor Barnett defends Federalism from the perspective of making diversity more possible. That rhymes well with what I stated at the World Bank as an Executive Director 2002-04: "A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind”

Financial regulations, if wrong, could destroy the economy of a nation, and is therefore an issue of utmost importance for national security.

Suppose military regulations which implicitly stated that those who avoided taking direct risks when fighting the enemy, for instance by using drones, had much better possibilities to advance in the ranks than those who dared to risk hand to hand combat. Would this not impact negatively, at least in the long term, the strength of the Home of the Brave?

And should bank regulators not have to consider the dangers of introducing distortions in credit allocation, which might weaken the economy and thereby weaken the defense of the nation?

In 1988, the G10, a group which includes United States, decided to introduce risk-weighted capital requirements for banks; where “risk” means credit risk, and “capital” means bank equity. As a consequence, those bank assets with a low risk-weight require banks to hold less equity than those assets with a high risk-weight.

The initial big risk-weight differentiation, in 1992 with Basel I, was that loans to the central governments of the OECD nations had a cero risk-weight, while loans to the private sector carried a 100 percent risk-weight. In 2004, with Basel II, many more risk buckets were added and in the private sector the risk-weights were set from 20 to 150 percent.

And it all sounds like prudent bank regulations… more-risk-more-equity - less-risk-less-equity. But, unfortunately, bank regulators, I pray unwittingly, did not notice that by doing that, they were introducing an extremely dangerous distortion of how bank credit was allocated to the real economy.

It signified that the equity of a bank, to which we have to add the value of the support a society and taxpayers lend the banks, could be leveraged many times more for assets with a low risk weight, than with assets with a high risk-weight. 

And that meant banks could earn much higher risk adjusted returns on equity on assets that carry a low risk-weight than on assets with a high risk-weight.

Just for a starter it meant that regulators effectively instructed banks to allocate more credit to the central government than to the private sector… implying thereby of course that a government bureaucrat has more capacity to allocate financial resources efficiently to the real economy than a private agent, like a SME or an entrepreneur

And anyone who thinks this regulatory risk aversion will not affect the strength of the USA’s economy, has no idea about how the USA got to be strong

And to top it up, it is all for nothing, since all major bank crises have always resulted from too big exposures to something that was perceived as “safe” that turned out risky, and never ever from excessive bank exposures to something perceived as risky.

Really; are the risk weighted bank capital requirements with decreed weights: 0% Federal Government, 100% We the People, in accordance to the US Constitution?

 

@PerKurowski

A message sometime ago to Homeland Security

A letter on the issue of defense in the Washington Post

A Financial AAAristocracy… in the US?

Bank regulators, who knows based on what right, created a financial aristocracy. It is composed by “The Noble Infallible” borrowers, like “The Noble AAAs”, and “The Noble Systemic Important Financial Institutions”, technically known as “The Noble SIFI’s” or, in more vulgar terms, “The Noble Too-Big-To-Fail banks”, “The Noble TBTF”.

When compared to the commons, like any unrated borrower, “The Risky”, like small businesses and entrepreneurs, and to smaller banks, like community banks, also known as “systemic un-important financial institutions”, the Financial Aristocracy has been endowed with immense privileges.

Just as an example, according to the Basel II orders, a bank can lend to a “Noble AAA” holding only 1.6 percent in capital, while if lending to any lowly member of ‘The Risky”, it needs to hold 8 percent in capital, five times as much!

The previous signifies of course that every dollar paid in risk adjusted interest rates by a Noble AAA represents five times in return on bank equity that the same risk-adjusted dollar in interests paid by the unrated "risky" commoner.

Of course to keep their rulers happy, bank regulators also named these as “The Absolute Infallible” and which, again according to the rulings of Basel II, signified that banks needed to hold no capital at all when lending to the Supreme Sovereign.

I can understand perhaps how this appointments of a Financial Aristocracy, or more precise yet an AAArisktocracy might have slipped through in Europe, but, in America, where its Constitution establishes: “No Title of Nobility shall be granted by the United States”... how on earth did that happen?

And though the United States in June 2004 formally committed to implementing the Basel II bank regulations; and though the SEC in April 2004 delegated supervision decisions to the Basel Committee,  there is surrealistically enough not one single mention of these regulations, or of the Basel Committee for Banking Supervision, in the 848 pages of the Dodd-Frank Act. And this though that Act makes reference to foreign organizations like the Extractive Industry Transparency Review (EITI). It would seem like someone somewhere, has been playing some dirty tricks on someone.

And, by the way, discriminating against risk-taking, in a land which became what it is thanks to risk-taking, in “the land of the brave”… You’ve got to be kidding!