October 29, 2012

Ex-ante and ex-post perceived risks are not the same - belts or braces not both.

Sir, in “A belt-and-braces approach to banks” October 29, you write that regulators are too reliant on risk-weighted capital ratios and clearly your ego is not strong enough to admit that this problem is part of what I have been writing to you about for years, and which you decided just to ignore. 

You quote well Andrew Haldane´s arguments against complexity, one that I have also opposed on the grounds that markets, bankers and regulators have not understood what they were up to. 

But, you still fail to grasp the most fundamental objections to the use of capital based on perceived risk, that is of course unless you have understood it but want to play innocent. 

The problem is that perceived risk of default is cleared for by banks and markets by means of interest rates, amounts at exposure and other contract terms. Therefore all what risk-weighting for determining the capital of bank achieves is to allow for much higher bank returns on equity when lending to “The Infallible” and much lower returns on equity when lending to “The Risky”. 

And that my friends, completely distorts the economic efficient resource allocation function that banks are supposed to perform on behalf of the society. 

You want capital requirements for banks that could possibly distort less? Well then you might need to force banks to charge the same interest rate to everyone. So, no! It is not belt and braces, it is belt or braces. And I prefer the belt of one and the same capital requirement for all assets of the banks, a leverage ratio. 

But then you hold that “a leverage ratio encourages loading up on the riskiest assets available, which offer higher returns for the same capital”. No that argument is not applicable! Because for that you are looking at the ex-post determined risks, not the ex-ante perceived risks. 

Again I dare you, find me a bank crisis that has resulted from excessive bank lending to what was ex-ante perceived as risky. 

PS. Since you are little by little entering into somewhat dangerous terrain, at least in a moral sense, you might want to brush up on concepts like journalistic ethics and or journalistic plagiarism. Not only do I have comments received on these issues by many of your journalists, but other important persons have over the years also received copies of my letters to you, and, of course, on this blog.