April 27, 2018

Bank regulators, get rid of risk weighted capital requirements, so that savvy loan officers mean more for banks’ ROE’s, than creative equity minimizers.

Sir, Gillian Tett referring to IMF’s recent warnings about the risks of overheating in risky loan and bonds markets; like “The proportion of US loans with a rating of single B or below (ie risky) rose from 25 per cent in 2007 to 65 per cent last year. And a stunning 75 per cent of all 2017 institutional loans were “covenant lite” writes: “it is possible — and highly probable — that non-banks are taking bigger risks, since they have less historical expertise than banks, and thinner capital buffers.” “The US has picked the wrong time to ease up on banks” April 27.

Yes, with risk weighted capital requirements banks ROE’s began to depend more on maximizing leverage, and so banks sent home many savvy loan officers and hired creative equity minimizers instead. As a result someone else had to serve “the risky”. 

But then Tett warns “Trump-era regulators” with a “it is foolish to be encouraging risky lending right now”. Wrong! It is always foolish to encourage risky lending. 

What Tett does not understand is that “risky lending” has nothing to do with a borrower being risky, and all to do with whether the lending to those perceived risky or those perceived safe, is done in such a way, with adequate exposures and risk premiums, so that the resulting bank portfolio is well balanced. 

The current extremely risky bank lending is the result of way too large exposures, at way too low risk premiums, to what is perceived, decreed or can be concocted as safe; and way too little exposures, at way too high risk premiums, to anything perceived as risky.

What regulators really should do, is to get rid of the risk-weighted capital requirements for banks. Then bank loan officers, those that could also show the non-banks the way would return, for the benefit of both the banks and the real economy.

Why do many bankers hate such possibility? Because high leverage, meaning little equity to serve, is the main driver of their outlandish bonuses.