January 05, 2017

Risk weighted capital requirements for banks, is a false solution that is destroying the western world

Sir, Martin Wolf writes: “By succumbing to the lure of false solutions, born of disillusion and rage, the west might even destroy the intellectual and institutional pillars on which the postwar global economic and political order has rested.”, “The march to world disorder” January 6.

Again Wolf prefers to ignore the perhaps most destructive false solution that has affected us.

Before 1988, bank credit, except for when criminal activity was involved, was allocated to what produced banks the highest expected risk adjusted return on equity.

But then, in order to make our banks safer, the regulators, with Basel I 1988 and Basel II 2004, imposed portfolio invariant risk weighted capital requirements for banks. Bank credit was thereafter allocated to what produced banks the highest expected risk and capital-requirement adjusted return on equity.

For a starter with risk weights of 0% for the Sovereign, and 100% for We the People, it introduced runaway regulatory statism, just while communism was disintegrating,

It also caused a dangerous risk aversion, which has bankers no longer financing the riskier future but only refinancing the safer past and present, something which of course is a driver of inequality.

How could it have happened? Six major factors stand out.

First, although hard to believe, bank regulators never defined what the purpose of banks is before regulating these. “A ship in harbor is safe, but that is not what ships are for.” John A Shedd, 1850-1926

Second, equally hard to believe, the regulators never researched what had caused bank crisis in the past; namely unexpected events, criminal doings and what were ex ante perceived as very safe but that ex post turned out very risky. What is perceived as very risky is, precisely because of that perception, what is least dangerous to the system. “May God defend me from my friends, I can defend myself from my enemies” Voltaire

Third, regulators completely missed out on that any risk, even if perfectly perceived, causes the wrong actions, if excessively considered, and doubled down on the ex ante perceived risks.

Fifth, not understanding that, as regulators, they could be introducing serious systemic risks.

Sixth, a general Groupthink, that which results from allowing experts to isolate themselves in a mutual admiration club.

The saddest part of the history though is how after so much evident failure, and evident waste of stimulus like QEs, the risk weighted capital requirements for banks is still discussed as part of a solution. To that we have many silencers, like you Sir and like Martin Wolf to thank for.

Sir, where would the western world have been if since Medici banks had used risk weighted capital requirements for banks