May 19, 2010

Where did the regulators get their risk weights from?

Sir John Kay extends “A royal invitation to raise the debate on finance” May 19. Knowing that the value of those commissions lies primarily in how the questions are phrased, since quite often the questions are too general or too many, which tends to obscure the answers, let me suggest one single line of question.

Current capital requirements for banks were established at 8 percent, adjusted for risk-weights. A loan to a small business is risk-weighted at 100%, and the bank needs to hold 8 percent in capital when lending to it. But since a loan to a corporation rated AAA, or to a country like Greece, which until quite recently was rated A, would be risk-weighted at 20% and so then only 1.6 percent in capital would suffice when lending.

So ask the commission… where did the regulators get those 100% or 20% risk-weights from?

We know that the Basel Committee has published for example “An Explanatory Note on the Basel II IRB Risk Weight Functions” but reading the paper only reinforces the urgent need of introducing outsiders to this close circle of regulatory insiders, who are now circling their wagons defending themselves, so successfully that they allowed to dig us even deeper in the hole they placed us in.

The Explanatory Note, prepared in July 2005, states that the risk-weights were developed with a “confidence level of 99.9%, meaning a bank is expected to suffer losses that their capital on average once in a thousand years” How come that confidence level did not last for two years? Who authorized that confidence level? I for one know perfectly well that, if the world would regulate their banks under the assumption that they would fail only once every thousand years… it might as well be dead and buried.