January 20, 2011

It is not the capital requirements that are wrong it is the risk-weights that have gone bananas

Sir, Anat Admati asks for higher equity requirements for banks “Force banks to put America´s first”, January 20. She is correct about that goal but wring about how to reach it. The reason why banks have too little capital is not that the basic capital requirements are low; but that the arbitrary risk-weights which the regulators playing risk-managers assign to those risks perceived as low are obnoxiously low… especially when considering that it is precisely what is considered to have a low risk which poses the highest systemic risk. A society will not disappear because of the risk their children will turn all into risky bungee jumpers, but it could disappear because of the risk that they all pick the wrong subject to specialize in at the risk-free university.

The basic capital requirement under Basel II was 8 percent… but the risk-weight for lending to Irish banks or Greece, for instance, was only 20% which effectively diluted the previous decent 8 percent to an indecent 1.6 percent.