April 07, 2011

If you account for perfect information twice, you are valuing it imperfectly

Sir, suppose you have perfect credit information… what should you use it for? To set the interest rates you will charge, or to set the capital reserve you should have? If you use that perfect information twice you are valuing it imperfectly. That is the fundamental flaw with the main pillar of the Basel Committee regulations. Because it makes for the same risk information to be accounted for twice, it introduced a totally unwarranted bias in favor of what is officially perceived as “not risky” against what is officially perceived as “risky”.

Unless someone orders that the same interest rate should apply to all borrowers, which I am of course not proposing, then the only valid conclusion is that we must have one sole capital requirement for all lending.

By the way this does not exclude the possibility that the banks need to report what exposure they have to the different official credit risk categories, so as to provide the market a better way to gauge the risk taking of the bank. What happened now, with risk-weighted capital ratios, was that the banks could take on much more risk than what the market (and the regulators) really saw.