How many YYYs at XXX believe the below BB- rated more dangerous to a bank system than the AAA rated?

I ask because the bank regulators in the Basel Committee clearly do believe that.

In 2004, with Basel II they assigned a 150% risk weight to what is rated below BB-, something to which banks would never ever create dangerous exposures to; and a meager 20% to what is AAA rated, something which, if wrong ex-post, is precisely the stuff bank crises are made of.

And I am a bit concerned seeing that no one is out questioning the regulators about this.

I have tried to ask them questions, but I am not a University, an important media or a sufficiently important personality

Would they answer me if I were ZZZ?

Houston we’ve got a huge problem. Bank regulators and other experts don’t get it!

With Basel II, banks were authorized to leverage their defined equity:

Unlimited times when lending to AAA to AA rated sovereigns
62.5 times to 1 when lending to the AAA to AA corporates, the AAArisktocracy
35.7 times to 1 when financing residential housing
And only 12.5 times to 1 when lending to unrated citizens SMEs and entrepreneurs

And that of course allowed banks to earn quite different expected risk adjusted returns on equity not based on what the market offered, but based on what the regulators dictated.

And regulators, finance professors, FT editors and journalists, and many other experts simply do not understand that this distorts the allocation of bank credit to the real economy.

What are we to do?

The curious border between what finance professors can understand, and what they cannot understand

If with regulations you allow banks to leverage much more their equity, and all the support these receives from society, with assets type A than with asset type B, then banks will be able to obtain higher expected risk adjusted returns on equity with assets A than with assets B. 

That finance professors can understand.

And the above will cause the banks to exclusively hold assets A, unless assets B offers these a much higher risk adjusted return than what would have been the case in the absence of such regulations.

That finance professors can understand.

And that clearly signifies a distortion in the allocation of bank credit. 

And that finance professors can understand.

But if you just substitute “safe assets” for assets “type A”, and “risky assets”, like loans to SMEs and entrepreneurs, for assets “type B”, then suddenly finance professors no longer understand.

And that I know because no one of them is protesting the distortions in the allocation of credit produced by the risk weighted capital requirements for banks. 

Strange eh?

What behavioral theory explains that?

The role of journalists is to be curious. So why aren’t those who cover bank regulations curious? Are they scared?

Even though credit risks were already cleared for banks by means of interest rates and size of exposures, regulators introduced in the 1980s risk weighted capital requirements for banks. These indicated banks needed to hold more capital against assets perceived as risky than against assets perceived as safe. That allowed banks to leverage more with assets perceived as safe than with assets perceived as risky resulting in that banks earned higher expected risk adjusted returns on equity on assets perceived as safe than on assets perceived as risky.

Where not regulators aware of that this introduced serious distortions in the allocation of bank credit to the real economy? And if so, who authorized them to do such a thing?

In Basel I, for the purpose of calculating the risk weighted capital requirements for banks the risk-weight of the sovereigns was set at zero percent while the risk-weight of the private sector that provides the sovereign its strength was set at 100 percent. 

How come? Would this not mean that the access of sovereigns to bank credit would be subsidized by the private sector's loss of access?

In 2004 Basel II set the risk in the private sector at 20 percent for what was rated ‘prime’ AAA to AA; 100 percent for what was unrated, and 150 percent for what was rated ‘highly speculative’ below BB- rated.

This meant that bank regulators considered ‘highly speculative’ below BB- rated to be much more dangerous to banks and the bank system than ‘prime’ AAA to AA rated.

How could expert regulators believe such a thing?

Bank capital is to cover for unexpected losses, and that the regulators acknowledge. 

How then could regulators believe they could use ex-ante perceived expected credit losses to generate an estimate for the unexpected? And to top it up, by definition the safer something is perceived, the larger its potential to cause unexpected losses. And if so should not the capital requirements be 180 degrees in the opposite direction, higher for what is perceived as safe than for what is perceived as risky?

And there are many more questions on this issue a curious reporter should be able to make… but they don’t ask… why? Are they scared for something?

Tenured finance professors, with their indifference, are some of the villains who let us down.

Karthik Ramanna, an associate professor at Harvard Business School writes : “Narrower interests that would otherwise find themselves straining to shape political outcomes often prevail unchallenged. Somewhat perversely, we may well be better off when politics is a bazaar of ideas and incentives.

Consider the technical regulations that govern capital markets — whether banks have as much capital as they say they do…We might think these regulations are somehow self-evident, derived from fundamental laws of economics. In reality, they are largely social constructs, reflecting expert opinions and political necessities…. I call these regulatory processes thin political markets because they seldom attract wide public participation. On any specific rule-making issue, there are usually a handful of business executives … who are truly experts on the subject. They also have the greatest stakes in the outcome. They meet with regulators in genteel isolation, obligingly offering direction for regulation. The rules of the game that emerge reflect their interests.

But there are no manifest villains here. Executives get involved when they understand an issue, and it matters to them. When they participate, they rarely face serious opposition. Those who might oppose them are sometimes not even aware of the regulatory proceedings. What arises in aggregate is a system of rules that looks as if it was produced by a quilt of special interests. Society as a whole bears the costs of this subtle”  "Ruling From the Shadows" New York Times,  November 21, 2015.

No, that is unacceptable! What the heck do we have tenured academicians for, if not to question what is going on in the real world?

In 1988 the Basel Accord introduced risk weighted capital requirements for banks and decided, amazingly, that the risk weights for sovereigns (meaning governments) was to be zero percent, while that of the private sector (meaning citizens) was to be 100 percent.

And in 2004, with Basel II, they also divided the private sector into groups carrying risk weights of 20, 50 100 and 150 percent.

And of course that utterly distorted the allocation of bank credit to the real economy.

And where were the tenured finance professors to question this? As far as I know they were nowhere to be seen. In fact they are still mostly nowhere to be seen.

“There are no manifest villains here”? I could easily make a case for most academicians in finance being the indifferent villains. They truly are letting the society down.

Revoke their tenures!