Bank regulators would do well reading up on Shakespeare (and on conditional probabilities)

Sir, Robin Wigglesworth writing about risk and leverage quotes Shakespeare in Romeo and Juliet, “These violent delights have violent ends”, and argues “It is a phrase investors in the riskier slices of the loans market should bear in mind.” “Investors should beware leveraged loan delights that risk violent ends” August 25.

Sir, we would all have benefitted if our bank regulators had known their Shakespeare better. Then they might have been more careful with falling so head over heels in love with what looks delightfully safe.

The Basel Committee, Basel II, 2004, for their standardized approach risk weights for bank capital requirements, assigned a risk weight of 20% to what was AAA to AA rated, and one of 150% to what is below BB- rated. 

That meant, with a basic requirement of 8%, that banks needed to hold 1.6% in capital against what was AAA to AA rated and 12% against what is rated below BB-.

That meant that banks were allowed to leverage 62.5 times if only a human fallible rating agencies awarded an asset an AAA to AA rating, and only 8.3 times if it had a below BB- rating.

That meant that banks fell for the violent delights of the AAA to AA rated, which of course caused the violent ends we saw in 2007/08.

Sadly, from what it looks like, our current regulators might not have it in them to understand what Shakespeare meant, just as they have no idea about the meaning of conditional probabilities… if they could they might be able to understand that what is ex ante perceived as risky is really not that dangerous.

@PerKurowski

Regulators like FSB’s Draghi, placed heavy weights, on what central bankers like ECB’s Draghi, now want banks to carry.

Sir, I refer to Patrick Jenkin’s “Question hangs over Draghi’s latest salvo on lending” September 8.

In it, with respect to the ECB purchase of asset backed securities, planned in order to free up banks’ balance sheets” so that banks lend more to business, Jenkins writes: “Selling the highest quality, least risky tranches… still leaves the issuing banks with the lower-grade portion of the securitization”.

But though Jenkins refers to the obstacle of rules on capital, he does not make clear that it is precisely those “lower-grade” tranches of the ABSs, and the lending to business, which is by far what is most affected by those capital rules and which, by the way, are not really “post crisis” rules but Basel II rules.

The irony is that Mario Draghi, when during many years the chairman of the Financial Stability Board, supported the very nonsensical credit risk weighted capital requirements for banks; those which now impedes him as chairman of the European Central Bank, to perform his duties. And of course, he does not want anyone now to notice how dumb he has been, since that would lead many to ask, “If so, why on earth was he promoted?” 

What a Shakespearian tragicomedy!