BANKTHINK

A Decade of Perverse Incentives, Spawned by Basel Risk-Weighting

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Ten years ago today, unelected bureaucrats from the Group of 10 decided for the Western World economies to call it quits, and adopted Basel II.

Let me explain what I mean by "calling it quits." The pillar of Basel II was risk-weighted capital requirements for banks, which allowed them to hold much less capital when lending to credits perceived as absolutely safe than when lending to those seen as risky. The fundamental arbiters of riskiness in this model were the credit rating agencies.

Those perceived risks were already being cleared for banks by means of interest rates, amounts of exposure and other terms. Now banks could expect to earn much higher risk-adjusted returns on equity by lending to the “infallible” sovereigns, the housing sector and the AAAristocracy, than lending to the risky small and midsize businesses, entrepreneurs and startups. From that moment on, when allocating credit, banks would no longer finance the risky future, but restrict themselves to refinancing the safer past.

It took very few years for the banks to consequentially lend much too much to what was ex ante perceived as safe, like Greece, the real estate sector in Spain, or AAA-rated securities backed by U.S. subprime mortgages. All of which brought us the North Atlantic Financial Crisis.

And of course since that fateful day our “risky" prospects, those who we in fact most needed to have fair access to bank credit, have seen less and less of it. Especially when banks were left with too little capital, after so many of those "safe" credits, against which the banks held little capital, actually failed.

When nations stop taking risks, they stall and fall, like a bicycle that does not move forward.

And here we are 10 years later, and the problem of the distortion in bank credit allocation that the risk-weighted capital requirements produce has not even begun to be discussed.

And as a consequence all liquidity injected by central banks, with their quantitative easing, and by governments, with their deficits, turned into a diet based solely on "safe" carbs and fats and no proteins. We now see no muscular growth but only some obese economic expansion.

Like true baby boomers, our current bank regulators have been reacting to their own short-term monsters, without even establishing whether there is any causality between bank exposures to those ex ante perceived as risky and bank crises.

Per Kurowski was an executive director at the World Bank from 2002 to 2004.

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Comments (4)
Admitting that politically inspired distortions caused the financial crisis represents an existential threat to today's political class. Expect more of the same.
Posted by kvillani | Thursday, June 26 2014 at 2:26PM ET
The unintended consequences of regulatory fiat end up in a tangled mess. Has this ever been more apparent than now? Yes, there is a cost to less regulation. However the costs(intended and unintended) of increased regulation are often greater, particularly when you factor in opportunity costs. What ever happened to the concept of an honest cost/benefit analysis for government regulation? As the author points out, the costs are almost always borne by the masses with very little benefit to show for it.
Posted by tk101 | Thursday, June 26 2014 at 3:41PM ET
The unintended consequences of regulatory fiat end up in a tangled mess. Has this ever been more apparent than now? Yes, there is a cost to less regulation. However the costs(intended and unintended) of increased regulation are often greater, particularly when you factor in opportunity costs. What ever happened to the concept of an honest cost/benefit analysis for government regulation? As the author points out, the costs are almost always borne by the masses with very little benefit to show for it.
Posted by tk101 | Thursday, June 26 2014 at 3:41PM ET
The author makes a strong case for much more accountability for the work of the Basel Committee. Too often, its global proposals are revered as if they were treaties, when they are much thinner than that, often ill-suited to U.S. financial conditions and the regulatory structure (the Liquidity Coverage Ratio regime is an excellent and current example).

His case is a lot weaker when it comes to assuming that there is little or no place for risk-weighting in regulatory practice. Basel II (far from implemented in the U.S.) reveals the shortcomings of regulatory models, but it does not prove the lack of value in risk weighting. The models have errors and limitations, but we know that risk-blind measures--like leverage ratios--that assume all risks are the same, are by wrong by design. What is evolving in capital regulation is a system of risk weighting for risks that can be identified and efficiently measured, and leverage ratio for those that cannot be. Good supervision would use both tools in appropriate measure.
Posted by WayneAbernathy | Thursday, June 26 2014 at 4:44PM ET
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