In banking, the worst worse case scenario by far, is something perceived as very safe turning out to be very risky
Sir, Tim Harford writes “We don’t think about worst-case scenarios in the right way.” “To help us think sensibly about it, Gary Klein has argued for conducting ‘pre-mortems’ — or hypothetical postmortems. Before embarking on a project, imagine receiving a message from the future: the project failed, and spectacularly. Now ask yourself: why? Risks and snares will quickly suggest themselves — often risks that can be anticipated and prevented.” “We need to be better at predicting bad outcomes” September 21.
Indeed and what would that pre-mortem suggest as the worst-case scenario for banks regulated by means of risk weighted bank capital requirements?
1. That what was perceived as risky turned out to be risky? No bankers already knew it was risky and, if they anyhow took a chance on it, that would be with a small exposure and a high risk-adjusted interest rate.
2. That what was perceived as risky turned out to be safe? Of course not! What great news, perhaps the bank had helped a successful entrepreneur.
3. That what was perceived as safe turned out to be safe? Of course not!
4. That what was perceived as safe turned out to be risky? Holy Moly! Like those AAA rated securities.
So since that “hypothetical postmortem” was not done, the risk weighted bank capital requirements, besides seriously distorting the allocation of credit to the real economy, also produce especially large exposures to what’s perceived or decreed as especially safe, and is held against especially little capital, risking thereby especially big crises… Good job regulators!
@PerKurowski
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