Has the Basel Committee calibrated the risk weighted bank capital requirements to a mirage… to an illusion... to a dream?

Definition: A well-diversified portfolio: one that includes a variety of securities so that the weight of any security is small. The risk of a well-diversified portfolio closely approximates the systematic risk of the overall market, and the unsystematic risk of each security has been diversified out of the portfolio.

The following is extracted from “An Explanatory Note on the Basel II IRB Risk Weight Functions”, published by the Basel Committee on Banking Supervision in July 2005, and available in the Bank of International Settlements BIS web site.

"The current risk weighted bank capital requirements are portfolio invariant; meaning the capital required for any given loan depend on the perceived risk of that loan and does not depend on the portfolio it is added to. This is so because; taking into account the actual portfolio composition when determining capital for each loan - as is done in more advanced credit portfolio models - would have been a too complex task for most banks and supervisors alike.”

The desire for portfolio invariance, however, makes recognition of institution-specific diversification effects within the framework difficult: diversification effects would depend on how well a new loan fits into an existing portfolio. As a result, the Revised Framework was calibrated to well diversified banks. If a bank fails at this, supervisors would have to take action under the supervisory review process (Pillar 2). "

So, just for a starter here are four questions.

1. With risk weighted capital requirements banks can leverage more with what's perceived or decreed as safe than with what's perceived as risky. Does that not introduce distortions in the allocation of credit, that impede the existence of that well diversified portfolio on which the Revised Framework was calibrated? 

2. What is here a “well-diversified”-bank-portfolio? One where regulators ex ante decide how much exposures bank should have to each type of assets; or one where a free and unincumbered market have banks allocating credit, as best as possible, based on their perceived risk adjusted returns, on the one and only bank capital/equity required against all assets?

3. Supervisors for which: “Taking into account the actual portfolio composition when determining capital for each loan - has been deemed a too complex task”, why should they suddenly be able to better do so in “the supervisory review process” Pillar 2?

4. Can anyone name any bank that has or has ever had a well-diversified portfolio as defined above? If not have the Basel Committee's risk weights been calibrated to a mirage, to a dream?

And to top it up: Calibrated to the risk perceived the morning after a crisis, not to the risks of the building up of too large dangerous exposures… to what’s perceived as safe.

Why did not anyone of the responsible for these regulations object? John Kenneth Galbraith provides an explanation: “If one is pretending to knowledge, one does not have, one cannot ask for explanations to support possible objections” 

PS. Here's a 2015 post on this issue.

PS. Here's my 2019 letter to the Financial Stability Board - FSB

PS. Here's a post in which, with the example of the recent SVB crisis, I try to explain some difficulties of banks and their supervisors in applying the Supervisory Review Process – Basel Pillar 2.

PS. I asked #AI ChatGPT – OpenAI: Could you help recalibrate bank capital requirements risk weights, so as to make these more portfolio variant? Sadly, it is not ready to do so... yet.

Here, there is good money to be earned, by just explaining the risk weighted capital requirements for banks to me.

I will pay a US$ cash bonus to the first who manage to extract clear answers from any regulator on two questions that have had me intrigued for a way too long time… so much that many tell me I am obsessive about… which of course I am.

I start with US$ 100 for each one of the answers and increase it by U$10 each month... for some time

US$100 to the first who gets a clear answer from a regulator on: Why do you want banks to hold more capital against what, by being perceived as risky has been made quite innocous, than against what, because it is perceived as safe, is much more dangerous? 

http://perkurowski.blogspot.com/2016/04/here-are-17-reasons-for-why-i-believe.html

And also US$100 to the first who gets a clear answer from a regulator on: Why are banks allowed to leverage much more when financing homes, than when financing the entrepreneurs who could help create jobs needed to pay utilities and service the mortgages?

https://perkurowski.blogspot.com/2018/01/many-of-our-young-will-be-without-jobs.html