April 28, 2015

Basing equity requirements for banks based on cuckoo-calls, could be better than using current risk weights

Sir, Satyajit Das writes “Where assets are not adjusted for relative risk, banks are encouraged to increase risk without having to hold additional capital”, “Rules to cut bank risk work in theory but not necessarily in practice”, April 28.

Wrong! Adjusted to relative risk has all to do with expected risks, with unexpected losses, those that bankers should be able to manage or have to fail, fast. Capital requirements should create a shield against the unexpected, something which definitely does not include the expected risks that banks are already clearing for.

For instance, if the probability of a cuckoo calling out more than x times during x month was 8 percent, then that percentage or required equity applied to all bank assets would make more sense that current risk-weights.

As is banks are not taking sufficient risk on what is perceived as risky, like lending to SMEs, but taking excessive risks on what is perceived as “safe”, like lending to the sovereigns or to the AAArisktocracy

The cuckoos in the forest would serve us better than the cuckoos in the Basel Committee.