Higher bank capital ratios without eliminating distortions based on perceived risks, would make banks riskier

Sir, John Plender refers both to the draft legislation advanced by US senators David Vitter and Sherrod Brown, and to Anad Admati’s and Martin Hellwig’s “The bankers’ New Clothes”, in order to point out that “Support is growing for higher bank capital ratios”, May 8.

Plender unfortunately entirely misses what is most important. Many have asked for higher capital requirements but, what sets those he references apart from many others is that they also want to do away with the pillar, and the pride and joy of Basel regulations, namely that the capital requirements are to be based on perceived risk.

Let me ask Plender. Today, according to Basel II, a bank can hold some zero risk weighted sovereign assets against zero capital, while giving a loan to a business requires it to hold 8 percent of it in capital. If tomorrow the risk-weights for some sovereign would remain zero, but banks were instead required to hold 30 percent against a loan to a business, would the distortions be smaller or larger?