July 16, 2013

With capital requirements based on a perceived risk already cleared for, do not banks overdose on perceptions?

Sir, Tim Adams, in a letter on July 16 that comments your editorial “In praise of bank leverage ratios” (July 11) writes that “Given the lessons of the crisis, it would be unwise to rely on a measure that does not take into account the riskiness of banking assets…. Let’s focus on strengthening the existing framework and avoid incentivising firms to shift to the riskiest assets, which could only sow the seeds of another crisis.”

I do not understand. What crisis did Mr. Adams see, and what lessons did he learned? I say this because the crisis I saw was 100 percent the result of incentivizing banks to move excessively to the “safest assets”, those which allowed banks to hold the least capital, those which allowed the banks to earn the highest expected risk-adjusted returns on their equity.

Banks already take the ex ante perceived risk into account when setting interest rates, deciding the amount of the exposure, and defining any other term, and so why should banks also consider exactly the same perceived risk in their capital. Does that not guarantee that banks will overdose on ex-ante perceived risk?

I have posed that last question to the regulators for many years, and never received an answer. Maybe the President and CEO of the Institute of International Finance, Washington, DC, US could help me and the regulators providing an answer?