September 26, 2009

There is a not so secret “low-risk” leverage-enrichment facility in Basel.

Sir excuse me if I insist on it but after some hundreds of letters to you, I am still looking for the words that could help FT understand what was really the origin of the current financial crisis and why we will not be able to get out of it without getting rid of a paradigm that has chained our financial regulators, that of having the capital requirements of our banks depend on risk-weights.

Henny Sender in “Washington is the cheerleader but sentiment remains fragile” September 26, quotes a private equity executive saying “CDO´s destroyed prudent lending in America. It was like a nuclear bomb to good lenders”. What does prudent lending mean? Shying away from risks? No! Prudent lending means investing according to your risk tolerance and getting the right reward for it. In this respect prudent lending should have its own financial returns and not returns derived from arbitrarily set lower capital requirements.

What is the worth of one dollar invested in an operation perceived as having a higher risk? One dollar! What is the worth of one dollar invested in an operation perceived as having a lower risk? Also one dollar! Then how on earth can anyone sustain that a dollar lent to a BBB+ to BB- rated corporation is worth one dollar, while a dollar lent to an AAA to AA- rated one only represent 20 cents? Well this is exactly what the regulators did with their capital requirements for banks based on default risks and as assessed by human fallible credit rating agencies.

When a bank invests $1.000bn dollars in anything related to an AAA then that is subject to an arbitrary risk-weight of 20% and so the “risk-weighted assets” are reported as only $200bn, leading to low reported bank leverages, and which after a short while fooled even the designers.

And this is what has been produced in the not so secret “low-risk” leverage-enrichment facility in Basel and that has been proven to be so explosive and that I have been describing in

Sir it is so unimaginably risky to fool around with risk. Please consider that even if all the credit ratings had been absolutely precise, the world could still go so very wrong, as nobody in his sane mind will hold that the world’s future lies so much in areas perceived as having low financial default risks, that the investment in these areas have to be given especial incentives.

Friends, we need to urgently rid ourselves of regulators that can only dream about a world without bank defaults and put in their place regulators that dream of a better world, and who know that in order to reach such a world you have to learn to embrace risk… in a prudent way.

The world has had more than enough with this imprudent prudence!