January 13, 2014

Risk weighted capital requirements for banks should be based on unexpected losses. They are not!

Sir, a bank should be free to calculate his own capital requirements in any which way he likes, and these will be almost entirely be based on expected losses. But a regulator should set the capital requirements based on the “unexpected losses” as these are those that should really be of his concern, but they do not.

Explicitly, for reasons of simplicity, the Basel Committee sets the capital requirements for banks that are there to cover for unexpected losses based on the same risk perceptions used to estimate the expected losses. And, to top it up, these capital requirements are also, explicitly, portfolio invariant… which means that the benefits of diversification is not accounted for, nor are the dangers of any asset concentration.

What a miserable state of affair of our bank regulatory system, if the implications of simple facts like that, cannot even be discussed.

In “Banks win concessions from Basel on leverage” January 13, Sam Fleming and Gina Chon report that if relying on a non-risk weighted capital requirement, such as the leverage ratio, that would tempt banks “to take on riskier loans to earn higher returns”. But again there is no discussion about the wisdom of allowing banks, by means of risk-weights to be able to earn higher risk-adjusted returns on safer loans, and which leaves hanging in the air the question of… who is then going to finance “the risky” medium and small businesses entrepreneurs and start ups?

That one can allow a Mario Draghi to mention “The leverage ratio is an important backstop to the risk-based capital regime”, without anyone asking him, the European Central Bank President, about the distortions in the allocation of bank credit to the real economy risk-weighting produces, is clear evidence that something is rotten in the Union of Europe.