August 17, 2014

Friend-of-the-bank’s-owner ratings would be more useful than credit ratings when setting capital requirements for some banks.

Sir I refer to James Crabtree´s lunch with Raghuram Rajan, “Everyone expects you to be a prophet” August 16.

In his famous speech at Jackson Hole 2005 Raghuram Rajan said: “Something as intimate as credit risk is now being traded with strangers. In fact the same way as parent are asked ‘Do you know where your children are?’, bankers nowadays are asked ‘Do you know where your risks are held’”?

That was a somewhat incomplete observation because just as many parents would have answered “with their nannies”, bankers would then need to answer “in the hands of very few human fallible credit rating agencies”, because that was what Basel II approved in June 2004, instructed banks to do.

And of course, as was doomed to happen (see my letter in FT January 2003), soon thereafter some AAA ratings awarded to some securities guaranteed with mortgages to the subprime sector, became the nail in the coffer of those financial markets which even Rajan at that time called to be “in extremely healthy shape”.

And Rajan also concluded his speech admonishing regulators to allow “markets to signal the winners and losers” without reflecting that when it comes to the allocation of bank credit the risk-weighted capital requirements for banks are precisely distorting those market signals.

And I say all this because when now Rajan is quoted saying “Central bankers have had enormous responsibilities thrust on them to compensate, essentially for the failings of the political system”, he and we should not forget that central bankers, in their close nexus to bank regulations, also hold enormous responsibilities for the current failings of the banking system.

But I also say this because when I read Rajan complaining about “Many businesses groups treat public sector banks as their equity kitty”, and which of course is the same as the problem of private owners of banks also treating these as their equity kitty, it occurred to me that friends-of-the-bank’s-owner ratings could prove to be more useful than credit ratings when setting the banks´ capital requirements.

PS. Afterthought. Should not owner-controlled-banks and management-controlled-banks merit different regulations?