February 25, 2013

The children in the Basel Committee and Financial Stability Board, they indeed need adult supervision

Sir, you hold that “Washington needs adult supervision” February 25. You might be right, but as far as I am concerned what Washington most needs, Republicans and Democrats alike, as indeed also Europe most need, is to make sure that there is some adult supervision of what their bank regulators are up to. 

Read the two most important documents where the Basel Committee describes the theory behind different capital requirements for banks based on risk and how those risk-weights are calculated. 

From these you will see that in no place did these regulators consider the possibility that by allowing banks to leverage their equity immensely more with the risk-adjust returns on exposures perceived as “safe” than for exposures perceived as “risky”, they could completely distort the financial markets. And, if that is not childish, what is? 

PS. Here are the documents I refer to: 

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

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.