Fed: The biggest stress resulting from banks might be their misallocation of bank credit to the real economy.

The Federal Reserve System’s(Fed) Dodd-Frank Act Stress Tests.

Banks are not there just to make profits for their shareholders, or to be safe places where to stash away money… they are there to perform the social function of allocating as efficiently as possible bank credits to the real economy. That’s the only logical reason why taxpayers could be willing to lend them support.

In this respect any stress-test that does not include looking at assets banks have on their balance sheet from more than credit risk perspective, is an utterly incomplete test.

For instance taxpayers should be able to do know how much unsecured bank credit has gone to SMEs and entrepreneurs, and how that lending has evolved over the last 3 decades.

Four things the next Fed chair should absolutely know, and that the candidates most probably don’t know, yet.

The Fact: Current capital requirements for banks are much much lower for exposures to the “infallible sovereigns” and the AAAristocracy, than for exposures to small and medium businesses, entrepreneurs and start-ups.

The next Fed chair, whoever it is, should know that such different capital requirements for banks, based on perceived risks already cleared for by other means, produce different expected risk-adjusted returns on bank equity, and therefore completely distorts the process of allocating bank credit in the real economy, making it unreal.

The next Fed chair, whoever it is, should know that a financial transmission mechanism, when distorted as described above, stands no chance of producing a sturdy economic growth or generate sustainable employment. And, as a result, any quantitative easing becomes just a big waste.

The next Fed chair, whoever it is, should know that lower capital requirements for banks for what is perceived as “absolutely safe” than for what is perceived as “risky”, do not make any sense from a bank safety point of view. This is so because only exposures of the first kind can grow large enough to take the system down. And also because, when something ex-ante perceived as absolutely safe, ex-post turns out to be risky, as will happen sooner or later, then regulators will find the bank there with little or no capital at all.

The next Fed chair, whoever it is, should know that since banks need to hold much less capital when lending to the “infallible sovereign” than when lending to “risky” citizens, this translates into a subsidy of government borrowings, which means that current Treasury rates are not comparable to historical rates. In other words, the usual proxy for the risk-free rate is subsidized and distorted.

My objection to “An Explanatory Note on the Basel II IRB Risk Weight Functions”, July 2005, Bank of International Settlements

The document referred to in the title describes how the Basel II risk-weights came about. I have two major concerns with what it states and one immense with what it ignores: 

First, it describe one important simplification needed in order to allow a practical implementation of a rating based capital allocation, namely that “The model should be portfolio invariant, i.e. the capital required for any given loan should only depend on the risk of that loan and must not depend on the portfolio it is added to…. . 

The simplification is justified with “A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules” by Michael B. Gordy a senior economist at the Board of Governors of the Federal Reserve System, October 22, 2002. 

And so it states “As a result the Revised Framework was calibrated to well diversified banks… If a bank failed at this, supervisors would have to take action under the supervisory review process” 

And that places an immense supervision burden on a body often not sufficiently equipped for it, and worse still, a body that had been sold a feeling that, with the rating based risk-weights, it had already solved the problem forever. 

Second it states: “Losses above expected levels are usually referred to as Unexpected Losses (UL) - institutions know they will occur now and then, but they cannot know in advance their timing or severity. Interest rates, including risk premia, charged on credit exposures may absorb some components of unexpected losses, but the market will not support prices sufficient to cover all unexpected losses. Capital is needed to cover the risks of such peak losses, and therefore it has a loss-absorbing function.” 

That is indeed correct, but that does not mean one can go ahead assuming that these risk premiums are covering zero of the unexpected losses, or that the market will “not support prices sufficient” the same over the whole range of perceived risks. In fact given basic bankers risk-aversion, I would make a case that where the markets do not support the prices correctly, is mostly for whatever is perceived as “absolutely safe”, and that, for the “risky”, it might overprice it instead.

Also if one must use credit rating information which is already available for the bankers to see, then instead of basing it on what the ratings indicate, one should base it on how bankers usually act when observing those ratings. Then they would have seen that bank crises never ever occur because of excessive exposures to "The Risky" but always from excessive exposures to "The Infallible".

Sincerely to use the expected as a proxy of the unexpected is as nutty as can be. The more safe an asset might seem the more room there is for bad unexpected events. The riskier an asset might seem the less the room for bad unexpected events.

And then finally, what the document completely ignores, is that the setting of differential risk-weights, by allowing banks to leverage risk and transaction cost adjusted margins immensely more for what is perceived as “absolutely safe”, introduces a very dangerous bias and distortion against what is considered as “risky”. 

And I just do not understand how that came to happen. Though banks do use risk-models to estimate appropriate capital levels, when looking for capital, they do not make separate share issues based on perceived risks, indeed, as all capital has usually to cover for all risks. 

In fact by allowing banks to hold much less capital against what is perceived as “safe” than against what is perceived as “risky”, regulators are in fact allowing for speculative profits, not on what is “risky” but on what is safe… and that turning the world upside down cannot be healthy. What about the efficient resource allocation function of our banks? With their risk weights the regulators are de facto telling us that those perceived as safe use bank credit more efficiently than those perceived as risky... and that we all know is not so.

And I must ask again: If banks are induced to make more profit on what is perceived as safe than on what is perceived as risky… then what is left for us… and for our orphans and widows?