June 14, 2016

Please help save us from regulators applying their standardized risk models to all banks… that would be the end

Sir, Martin Sandbu, in “Free Lunch: The bank, the fox and the henhouse”, June 13, discusses the issue that “Rules for banks’ capital cannot rely on their own models of risk

Sandbu writes: “non-initiated may be surprised to know that [some] banks were [and are] permitted to decide how risky their assets were — which determines their capital requirements under rules that set safe capital thresholds as ratios of “risk-weighted assets”. To the extent banks perceive capital requirements as a burden, that creates an incentive for them to engineer risk assessments that minimize that burden.”

And so clearly when “The Basel Committee on Banking Supervision, which recommends global standards for national banking authorities, proposes to replace banks’ internal models of riskiness with external standardized models” this sounds very logic to many.

But the non initiated are not aware either of that, with Basel II, the regulators already gave a set of standardized risk weights to be used by all banks deemed not sophisticated (or big enough) to run their own risk models.

And Sir, it behooves us to fully understand what regulators did, before we dare to hand over to them one iota of more power.

Unbelievable, Basel II derived the risk weights, those that determine the capital requirements, from the ex ante perceived risk of the assets per se, and not from the risk these assets can pose to the banks or the bank system.

And therefore we have that assets rated below BB-, speculative and worse, those assets to which banks would never ever create excessive exposures to, got a risk weight of 150%, while assets rated AAA to AA, those to which banks could easily get to be dangerously exposed, these got a risk weight of only 20%.

So Sir, is there any good reason for us to welcome the same regulators to start working on a Basel IV?

As a minimum minimorum, before Basel IV work begins, we must require regulators to clearly specify what is the purpose of the banks, something they never did before they regulated. I say this because with the distortions produced with Basel I, Basel II and Basel III, they clearly evidenced, they do not give a damn about whether banks allocate credit efficiently to the real economy.

The only useful risk model is that which understands that bank capital is to be there against unexpected events, not against expected credit risks. For example, capital could be 8 percent against all assets.

But perhaps banks do need more capital, like 10 percent, because now we also have to guard them against the “unexpected” reality of regulators being capable of such an immense hubris, they can just push on without a clue about what they’re doing.

PS. To top it up... their risk-weights were portfolio invariant

@PerKurowski ©