Mr. Martin Wolf think he´s understood the problem with risk-weighted bank capital. He has not!

Sir, Martin Wolf in “Two cheers for Britain´s banking reform plans” June 15, states that rejecting a general rise in bank equity “makes almost everything depend on risk-weighted capital: a fallible, even intellectually fraudulent, concept, as the Independent Commission on Banking´s final report”. And so one could think Mr. Wolf has now finally understood the problem with risk-weighted bank capital. Unfortunately, not yet! 

The ICB report states: “Risk-weighting has merit in principle but inevitable imperfections in practice. For example, the low risk weights attributed to some sovereign bonds have clearly been inconsistent with the market’s view of the likelihood of their default. So there is a strong case for capping total (un-weighted) leverage too, as a backstop.” And this basically means that ICB thinks the problem with the risk-weights is that these could be wrong. But that´s not it, it is much more intellectually fraudulent than that! 

The use of the risk-weights based on perceived risk is wrong even if the weights are perfect, even if they are consistent with the market views, because these perceived risks have already been cleared for by the banks (by means of the interest rate, amount exposed and other terms) and so forcing that risk perception to also affect the capital of a bank, dooms the banks to overdose on perceived risks. 

If you really want to have correct risk-weights for bank capital then these would have to be calculated based on how bankers react to perceived risks. And then, at least according to Mark Twain´s “a banker lends you the umbrella when sun shines and wants it back when it rains”, you might find instead a need for higher capital requirements for banks when the perceived risk of default of the borrower is low than for when the perceived risk is high.