September 11, 2017

Bank regulators need Business Education… perhaps Finance professors too… if not, they sure need History Education

Sir I refer to your special magazine “FT: Business Education”, September 11, 2017.

If you were a banker, of that type that until 1988 (Basel I) existed for about 600 years, you would, in order to obtain the highest risk adjusted return on equity, and while keeping a close eye on your whole portfolio, lend money to whoever offered you the highest risk adjusted interest rate… of course as long as all your other costs were covered.

If for instance you had to hold 10% capital, perhaps so that your depositors or regulators felt safe, then your expected return of equity would be the average of those net risk adjusted interest rates times 10 (100%/10%)… this before taxes of course.

If an SME or an entrepreneur offered the bank a perceived risk adjusted net margin of 1.25% while an AAA rated only offered 0.75%, the banker would in that case naturally prefer giving the riskier borrower the loan... though probably it would be a much smaller loan.

Sir, do you agree with that? No? Why?

Because when bank regulators introduced risk adjusted equity requirements, they completely changed banking. Since then the risk adjusted net margins borrowers offered, have to be multiplied, by the times these margins can be leveraged on equity.

For instance Basel II, 2004, with a basic 8% bank capital requirement, assigned a risk weight of 20% to any private sector exposure rated AAA, which meant banks needed to hold 1.6% (8%*20%) against these exposures, which meant they could leverage equity 62.5 times (100%/1.6%).

That same Basel II assigned to for instance an unrated SME or entrepreneur, a risk weight of 100%, meaning a capital requirement of 8%, meaning banks could leverage only 12.5 times their equity with this type of loans.

So now what happened? The AAA’s 0.75% net risk adjusted margin offer would become almost a 47% expected risk adjusted return on equity, while the riskier’s 1.25% would only represent about a 16% expected risk adjusted return on equity. Therefore the bank would now by much prefer the AAA rated… Bye-bye SMEs and entrepreneurs.

To earn the highest perceived risk adjusted ROE on the safest, must clearly be a wet dream come true for most bankers; well topped up by the fact that requiring so little capital from their shareholders when lending to the “safe”, left much more profits over for their bonuses.

Did not regulators know their risk weighted capital requirements would distort in this way the allocation of bank credit to the real economy? Seemingly not and that is why I suggest they should go and get some basic business education… after the professors who did not see this have also gone back to the most basic basics.

That because, if regulators did know about the distortion they would cause, then they have no idea of history… or worse, they are financial terrorists. That because no major bank crisis have never ever resulted from excessive exposures to what is ex ante perceived as risky; these have always, no exceptions, resulted from excessive exposures to what was ex ante perceived, and never ever from what was ex ante perceived as risky.

Sir, come to think of it you and most of your collaborators, perhaps all, should also go back to a business education 101.