July 23, 2014

A bank’s expected failure going from once in 1000, to once in 200 years, does not sound like an impressive improvement :-)

Sir, Gina Chon refers to Steve Strongin, head of Goldman’s investment research division stating: “In the past the mean time for the failure of a well-capitalized bank was 41 years… Now, with increased capital standards and stress tests scrutinizing how banks would withstand a crisis, it is estimated to be about 200 years”, “Dodd-Frank rules blamed for curbing growth” July 23.

To help you understand what an unbelievable scenario for bullshit that represents, let me mention that in the Explanatory Note on the Basel II IRB Risk Weight Functions of July 2005, the confidence level is described as “fixed at 99.9%, i.e. an institution is expected to suffer losses that exceed its level of tier 1 and tier 2 capital on average once in a thousand years. This confidence level might seem rather high. However, Tier 2 does not have the loss absorbing capacity of Tier 1. The high confidence level was also chosen to protect against estimation errors that might inevitably occur from banks’ internal Probability of Default (PD), Loss Given Default (LGD) and Exposure at Default (EAD) estimation, as well as other model uncertainties.”

Chon mentions “A senior Obama administration official said banks had overreacted and argued that a person with a high credit score should be able to obtain a mortgage on decent terms, which was not happening at many banks”. That official should ask regulators to explain that the system in place is first the banks reacting to perceived credit risks with interest rates, size of exposures and other terms… and then having the regulators, for good measure, to also react to the same perceived credit risks by means of setting the capital the bank needs to hold against assets… and, of course, reacting twice to the same risk, must cause an overreaction.

In this respect the Dodd-Frank Act cannot be much blamed for curbing growth that is unless you feel, like I do, that in the home of the brave, that Act should have prohibited the odious system of risk weighing the capital requirements of banks, something which negates the fair access to bank credit to for instance all SMEs.