April 20, 2011

If you are short on capital you naturally go where less of it is needed.

Sir, John Plender in “Why the rush by UK banks into property needs watching” April 20, asks “Why the enthusiasm for an asset class that has been a graveyard for lenders in countless busts?” The simple answer is that going there they are allowed to have less capital than when lending to those officially considered more risky, like the small businesses and entrepreneurs.

Plender also quotes Adrian Blundell-Wignall of the OECD arguing “that the Basel risk weighting formulas are based on a mathematical model that does not penalize portfolio concentration”. That is indeed correct, but much more important is to notice that those risk-weights encouraged excessive concentrations… and even the safest of havens can become overcrowded.

What the “mathematical model” (big words to describe nonsense) used by Basel calculating the risk-weights left out was the fact that the banks were already looking at credit ratings when setting their risk premiums and corresponding interest rates. It might seem a small mistake but it has created thousands times more losses than when a technical confusion derived from simultaneously applying metric and English measures made the Mars Climate Orbiter spaceship miss Mars.