Bank regulators insist on feeding the systemic risk of credit ratings, even after it became tragically evident.

Sir, Kate Allen writes “Funds that allocate capital based on instruments’ investment grades and index weighting may look as if they are playing it safe but they are, in fact, taking a gamble, creating towers of risk, any floor of which could prove unstable… do not look to the canaries in the financial markets’ coal mines to sound an early warning. By the time the downgrades come, it will be too late” “Tail Risk” February 28.

Indeed by the “time issuers’ credit ratings were downgraded, [banks] were already staring the worst-case scenario in the face.

Basel II’s standardized risk weights for the risk weighted bank capital requirements:

AAA to AA rated = 20%; allowed leverage 62.5 times to 1.

Below BB- rated = 150%; allowed leverage 8.3 times to 1

Absolute lunacy! With the same risk weight banks would anyway build up much more exposure to what they ex ante perceived as very safe, than against what they perceived as very risky.

As is, that regulation dooms our bank systems to especially large crisis, resulting from especially large exposures, to what is perceived as especially safe, against especially little capital. 

Allen observes: “An investment structure that is revealed to have done a bad job only when disaster arrives, as in the financial crisis”. Unfortunately no. Bank regulators blamed the credit rating agencies, and not themselves for betting too much on these, and so that so faulty regulations that should have been eliminated with a big “Sorry!” is still very well active. 

PS. In FT January 2003: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds. Friends, please consider that the world is tough enough as it is.”

PS. At World Bank: April 2003: "Market or authorities have decided to delegate the evaluation of risk into the hands of much fewer players such as the credit rating agencies. This will, almost by definition, introduce systemic risks in the market"

@PerKurowski