Pity the Basel Committee’s small leverage ratio; it sure has to carry a lot of risks on its back.

Sir, with interest rates and size of exposure the expected credit risk is the risk most cleared for by banks. Yet bank regulators also wanted to clear for it, and imposed their expected credit-risk weighted capital requirements. That left out of consideration, at least until Basel III, all other risks, like for instance that of cyber attacks to which Gillian Tett refers to in “Hackers target the weakest links in the financial chain”. May 20.

I say “until Basel III”, because now banks are by force of a leverage ratio, to hold at least 3% of capital against all exposures to cover for any risk.

But the Financial Stability Board has also “Task Force on Climate-related Financial Disclosures” which reminds us of risks from climate change.

And then there are the risks of demographic changes; the risk that the economies do not react to stimulus; the risks that credit risks have not been correctly perceived; the risk of war; the risk of epidemics, negative interest rates, deflation… and a never-ending list of risks of expected or unexpected losses. 

And you know I have repeatedly called for banks to also hold some capital against the risk regulators have no idea about what they’re doing, a risk that has morphed into a frightening reality.

But what’s the enticement for banks to cover for these types of risks when they can leverage as much as they currently do? Very little… in the same vein that the bonuses you can pay out to bank managers, when little bank capital is required, can be very big.

What do I propose? The abandonment of all dumb credit risk weighted capital requirements, and move towards a leverage ratio of 8 to 12%. That should increase the importance of the shareholders vis-à-vis management. And that should help to generate more interest among shareholders into making sure better risk avoidance or risk preparedness takes place.

The process of implementing those changes must though be very carefully designed, so as not to worsen the current capital scarcity driven bank credit austerity.

PS. The fact Basel Committee argued that “a simple leverage ratio framework is critical and complementary to the risk-based capital framework” was already a confession of not knowing what they were doing, but that notitia criminis was foolishly ignored. 

@PerKurowski ©