June 26, 2010

Financial Times would you mind?

Sir would you mind much if I explained to FT’s sophisticated readers why it is not so much whether the capital requirements for banks are high or low that matters, but more so the way they discriminate among assets based on default risk-weights?

Let us suppose that banks, with no special regulations, would be willing to lend at .5% over their own cost of funds to those who are rated triple-A, and with a 4% spread to more risky small businesses.

If the banks were obliged to hold 8 percent against any asset, which means they can have a leverage of 12.5 to 1 (100/8) then their net results on capital, before credit losses, when lending to the AAAs would be 6.25% (.5x12.5); and 50% (4x12.5) when lending to the small businesses. With such a difference the banks would do their utmost trying to lend well to the small businesses… as there are clearly no major bonuses to be derived from lending to the AAAs.

But when the regulators allow, as they do, the bank to hold only 1.6 percent in capital when lending to AAA rated clients, which implies a leverage of 62.5 to one (100/1.6), then the expected net result on capital for the banks when lending to AAAs, before credit losses, becomes a whopping 31.25% (.5x62.5).

And of course, a bank, and bankers, being able to make 31.25% before credit losses when lending to no risk-AAAs, would be crazy going after the much more difficult 50% margin before credit losses available when lending to the riskier small businesses and entrepreneurs.

And this is how the risk-adverse regulators pushed our banks into the so dangerous “risk-free-AAA-land” while blithely ignoring that no bank or financial failure has ever occurred because of something perceived as risky, they were all the result from something perceived as not risky; and while ignoring that what we most want out of our banks is precisely that they be good in nurturing with credit those small businesses that might grow up to be the AAAs of tomorrow.

And this is really why we find ourselves in a crisis of monumental proportions, never ever before had our regulators dared to be so publicly wimpy so as to ask the banks to so excessively embrace what was, ex-ante, perceived as having no risk.

By the way, who gave the regulators the right to discriminate solely based on perceived default risks? The small businesses, in order to have a chance to access credit, are as a direct consequence of these capital requirements forced by the regulators to pay much more for their loans... as simple as that! Do not forget that whatever little capital the banks currently have, it is mostly because of those perceived as being risky.