Lawmaker: Mr. Bank Regulator, is it not so that banks and markets look at the perceived risk of default of any borrower, including the information contained in credit ratings, in order to set the interest rate, the amounts and all other terms of the credit?
Regulator: Yes, that is correct.
Lawmaker: Is it not so that currently the equity capital requirements for banks are based mostly on those same perceived risks, and that banks are required to hold less capital when the perceived risk is low than when it is high?
Regulator: Yes, those capital requirements are in fact the pillar, and the joy and pride, of us bank regulators.
Lawmaker: Is it no so that if you can earn a risk-adjusted margin on less equity, you make a greater return on equity?
Regulator: Yes, and of course the opposite is true too.
Lawmaker: So this signifies that bank lending that is perceived as safe produces a much higher risk-adjusted return on equity than lending that is perceived as risky?
Regulator: If you phrase it that way, yes.
Lawmaker: How would you phrase it?
Regulator: I'm not sure. I would have to come back on that.
Lawmaker: Now, if you provided banks with higher risk-adjusted returns on equity when lending to what was perceived as riskless, could you not have expected banks to lend too much to whatever was officially perceived as absolutely riskless?
Regulator: Yes, perhaps.
Lawmaker: And could you for the same reason not have expected the banks to lend too little to what was officially perceived as risky?
Regulator: Yes, perhaps.
Lawmaker: And so as a result we have a monstrous crisis threatening the West. A crisis that detonated because of obese bank exposure to what was perceived as not risky, like the triple-A rated securities backed with lousily underwritten subprime mortgages, or infallible sovereigns like Greece. And all aggravated by a truly anorexic exposure to what is perceived as risky, like small businesses and entrepreneurs, those who could help us to create the next generation of jobs. Would this be a fair description?
Regulator: Hmm, perhaps.
Lawmaker [imitating regulator]: Hmm … if we played on a golf club where they took away strokes from bad players like me and gave it to good players, like perhaps you are … that golf club would not last for long, since soon there would be no one left to play with the best player. Would you agree?
Regulator: Yes, absolutely… but I do not see the connection.
Lawmaker: Is it not so that there has never, ever been a major bank crisis that has resulted from excessive exposures to what was considered risky, and that these have always resulted from excessive exposures to what was perceived as not risky? If so, would that not suggest a need for higher capital requirements for banks when the perceived risk is low instead?
Regulator: Can I come back to you on that? I don't have the data available.
Lawmaker: What, in your own words, is the purpose of bank regulations?
Regulator: To stop banks from failing and, if they fail, to assure that they have a sufficient buffer of capital so that taxpayers will not be left holding the bag for too much.
Lawmaker: Well clearly, if that was the purpose, your regulations did not work. But I was referring more to what banks are expected to do for society. Is there, for instance, any mission statement for banks that hints at helping a risk-adverse society with channeling capital to small businesses and entrepreneurs?
Regulator: Not really that I am aware of.
Lawmaker: So you tell us you regulate banks without defining their complete purpose? Is that not a bit like regulating and supervising the construction of a road, without caring about from where it comes and to where it goes, or about who will travel on it?
Regulator: Yes, but that was sort of our job description.
Lawmaker: So if we now can so clearly connect these capital requirements for banks and the crisis, what are you proposing we use instead?
Regulator: We are not sure, but for the time being the use of capital requirements based on perceived risk remain firmly in place, for instance in Basel III.
Lawmaker: Sincerely, would you find it out of place if the current regulators, after this incredible failure, instead of rewriting regulations, were sent home and paraded down Fifth Avenue wearing dunce caps?
Regulator: Yes… Sir… we did nothing wrong… the whole world, even the Members of Congress could see what we were doing, it was all there on our websites.
Lawmaker: On second thought, tarring and feathering sounds much more appropriate. This hearing is adjourned. [Bangs gavel] Oh wait – one more thing: Occupy the Basel Committee and other bank regulators!
Per Kurowski was an executive director at the World Bank from 2002 to 2004. He writes the Subprime Regulations blog from Rockville, Md.