February 07, 2015

Thanks to credit risk weighted equity requirements, borrowers and banks now share the objective of fooling regulators.

Sir, Tracy Alloway refers to the transformation of unsafe loans into super-duper “safe” ones “eBonds that strip out risk would be financial alchemy at its oddest” February 7. She misses out on what I would hold to be the most important incentive for such process.

Borrowers have of course always been interested in selling themselves to the banks as having a very low credit risk, in order to negotiate lower risk premiums.

And bankers used always to be very interested in questioning the creditworthiness of borrowers, in order to obtain higher risk premiums.

And that struggle helped to allocate bank credit efficiently to the real economy.

But then came regulators with their credit-risk-weighted equity requirements for banks and changed the priorities for the banks.

Now more important for the risk adjusted return on bank equity than the negotiation of risk premiums with borrowers, is dressing up the credit operation in such a way so as to make it seem as safe as possible, so as to allow the highest possible leverage of bank equity.

In other words regulators, instead of fully exploiting the tensions between borrowers and lenders, managed to align both of these with the objective of fooling them. Not too bright doings Basel Committee!