Why is it good for all to allocate their risk premiums adjusted investments according to the needs of their portfolio… except for banks?

Sir, Jonathan Wheatley writes:“Here’s a mystery: if emerging market debt as an asset class has had such a torrid time this year, why has it not suffered more outflows?” And to answer it he quotes Paul Greer, portfolio manager at Fidelity International: “People will look at what they are getting in the rest of the world, and they’ll say you know what? We’re getting paid for the risks.” “EM bonds resilient as investors are well rewarded for risks” November 2.

That which sounds so perfectly logical, is not what the banks can do, since the risk weighted capital requirements take no consideration whatsoever of the risk premiums banks can obtain. 

To top it up, these weights are formally portfolio invariant. Since you might think that because I am obsessively against that regulation I will give a biased version of it, let me extract verbatim the following from the horse's mouth, “An Explanatory Note on the Basel II IRB (internal ratings-based) Risk Weight Functions” 

“The model [is] portfolio invariant and so the capital required for any given loan does only depend on the risk of that loan and must not depend on the portfolio it is added to.”

And the reason given for that mindboggling simplification is: “This characteristic has been deemed vital in order to make the new IRB framework applicable to a wider range of countries and institutions. Taking into account the actual portfolio composition when determining capital for each loan - as is done in more advanced credit portfolio models - would have been a too complex task for most banks and supervisors alike.”

Besides the disastrous effect in our economy the distortion in the allocation of credit, credit risk-weighted capital requirements produce, is to guarantee especially large exposures, to what’s perceived as especially safe, against especially little capital, which dooms or bank system to especially severe crises, like that in 2008.

And this has been going on during 30 years and no one is allowed to ask regulators: Why do you believe that what’s perceived as risky is more dangerous to our bank system than what’s perceived as safe?

Clearly that is seemingly one of those questions that shall not be asked.

@PerKurowski

Current risk weighted capital requirements for banks are a stand out example of “garbage in garbage out”

Sir, when discussing artificial intelligence and “how much power should be ceded to the machines” you mention: First. “the need to overcome limitations in machine learning techniques”; Second. “garbage in, garbage out…the need for better quality control”; and Third. “the need to develop a clear and transparent governance structure for AI”, “The paradox in ceding powers of decision to AI” December 30.

Sir, human intelligence is quite often in need of all that too.

When bank regulators used intrinsic risks of bank assets as inputs for developing their risk weighted capital requirement, they could not produce anything but garbage out. What they should have used is unexpected events or the risk those assets could pose to our bank system, namely the risk that bankers would not be able to adequately manage perceived risks.

And little evidences the need for a transparent governance structure for human intelligence too, as current regulators refusal to answer the very basic questions: “Why do you require banks to hold more capital against assets made innocous by being perceived as risky than against assets becoming dangerous by being perceived as safe?”.

Humans must also also overcome some technical limitations: An Explanatory Note by the Basel Committee on the Basel II IRB (internal ratings-based) Risk Weight Functions” expresses: “The model [is] portfolio invariant and so the capital required for any given loan does only depend on the risk of that loan and must not depend on the portfolio it is added to.”

And the explicit reason for that mindboggling simplification is: “This characteristic has been deemed vital in order to make the new IRB framework applicable to a wider range of countries and institutions. Taking into account the actual portfolio composition when determining capital for each loan - as is done in more advanced credit portfolio models - would have been a too complex task for most banks and supervisors alike.”

Sir, finally, I would add a fourth requirement, namely to make sure artificial intelligence is kept free from that excessive hubris and besserwisserism that too often affect humans. Like that which kept regulators from even having to define the purpose or banks before regulating these,

@PerKurowski

A philosopher’s questions to the Basel Committee on capital requirements for banks and unexpected-losses.

Sir, Alain de Botton makes "The good case for putting philosophers into company boardrooms”. January 2.

In that respect I would hold that philosophers are also urgently needed elsewhere, like in the Basel Committee for Banking Supervision. Let me explain.

In “An Explanatory Note on the Basel II Internal Rating Based (IRB) Risk Weight Functions” July 2005 we read:

“The model [is] portfolio invariant and so the capital required for any given loan does only depend on the risk of that loan and must not depend on the portfolio it is added to.”

And the explicit reason for that simplification is:

“This characteristic has been deemed vital in order to make the new IRB framework applicable to a wider range of countries and institutions. Taking into account the actual portfolio composition when determining capital for each loan - as is done in more advanced credit portfolio models - would have been a too complex task for most banks and supervisors alike.”

And this leads to:

“In the context of regulatory capital allocation, portfolio invariant allocation schemes are also called ratings-based. This notion stems from the fact that, by portfolio invariance, obligor specific attributes like probability of default, loss given default and exposure at default suffice to determine the capital charges of credit instruments. If banks apply such a model type, they use exactly the same risk parameters for expected losses (EL) and unexpected losses (UL), namely probability of default (PD), loss given default (LGD) and exposure at default (EAD).”

And so, if the Basel Committee had included a philosopher in their team, he might very well have asked the following disturbing and possibly game-changing question.

“Friends, I read here you have decided, primary for reasons of expediency, to make the capital requirements for banks, those that should cover for “unexpected losses”, dependent on the same risk perceptions used to estimate the “expected losses”.

Does that not signify that banks could overdose on perceptions about expected risks, without you regulators doing what you should do about considering the unexpected losses?”

Does that not signify you would be discriminating against “The Risky” those who are already discriminated against because of expected losses, by making them also bear the largest regulatory burden for unexpected losses?