Bank regulators would do well reading up on Shakespeare (and on conditional probabilities)

Sir, Robin Wigglesworth writing about risk and leverage quotes Shakespeare in Romeo and Juliet, “These violent delights have violent ends”, and argues “It is a phrase investors in the riskier slices of the loans market should bear in mind.” “Investors should beware leveraged loan delights that risk violent ends” August 25.

Sir, we would all have benefitted if our bank regulators had known their Shakespeare better. Then they might have been more careful with falling so head over heels in love with what looks delightfully safe.

The Basel Committee, Basel II, 2004, for their standardized approach risk weights for bank capital requirements, assigned a risk weight of 20% to what was AAA to AA rated, and one of 150% to what is below BB- rated. 

That meant, with a basic requirement of 8%, that banks needed to hold 1.6% in capital against what was AAA to AA rated and 12% against what is rated below BB-.

That meant that banks were allowed to leverage 62.5 times if only a human fallible rating agencies awarded an asset an AAA to AA rating, and only 8.3 times if it had a below BB- rating.

That meant that banks fell for the violent delights of the AAA to AA rated, which of course caused the violent ends we saw in 2007/08.

Sadly, from what it looks like, our current regulators might not have it in them to understand what Shakespeare meant, just as they have no idea about the meaning of conditional probabilities… if they could they might be able to understand that what is ex ante perceived as risky is really not that dangerous.

@PerKurowski