September 17, 2018

Tier one capital ratios is a game invented by regulators for banks to play.

Sir, Jonathan Ford mentions “An average tier one capital ratio of 8 per cent —. An accounting measure of their soundness, it meant banks could lose that proportion of the value of their risk-weighted assets before their loss-absorbing capital was spent.” “Financial fragility lurks behind a confident façade” September 17.

No, not really-really so. Let us, just for the example suppose that a bank carries only very “safe” corporate assets rated AAA to AA assigned by the regulators a risk weight of 20%. Based on the Basel II basic capital requirement of 8%, that meant it needed to hold only 1.6% in capital against those assets. That would give the bank a tier one ratio of 8%... but how much could it afford to lose on its assets that had been risk weighted before its capital was completely gone? Not 8%, but 1.6%.

The risk-weighted assets only give a correct indication if the perceived risk reflected are correct and if bankers will manage those perceived risks correctly. What are the chances of that? Quite slim, especially when banks have all the incentives to minimize equity they are holding, something that makes it easier for them to maximize the return on equity to their shareholder (and of course the bankers’ own bonuses)

In other words, the Basel Committee tier-one bank capital ratio, based on risk-weighted assets, as if risks were known, is just devious and dangerous false information that feeds a false sense of security. Nothing of what accountancy can misreport beats that. Worse, by distorting the allocation of credit, much more than concealing realities, it changes realities… on a global scale.