Who nudged regulators into using stupid and dangerous risk-weighted capital requirements for banks? The bankers?
Banks not capable of perceiving risks correctly, or not adjusting to perceived risks correctly, with size of exposure and adequate risk-premiums, should fail as fast as possible.
Banks capable of perceiving risks correctly, and to adjust to these correctly with size of exposure and adequate risk-premiums, would in fact not need to hold any capital.
Unfortunately, since banks could belong to the first group, and there is also the risk of unexpected events that could affect even the best of banks, regulators need to require banks to hold some capital.
Curiously, unfortunately, bank regulators, with the Basel Accord of 1988 introduced risk weighted capital requirements. These spelled out more risk more capital, less risk less capital.
Though at first sight that might all sound quite logical, in terms of searching for more financial stability it makes no sense whatsoever, as what’s perceived as risky poses by just that fact alone less danger to the banks. It is what is perceived as safe than can cause banks to create excessive exposures, which if these later turn out risky could put a whole bank system in danger.
To top it up it the risk weighting translates into allowing banks to leverage differently different assets, thereby producing different risk adjusted returns on equity than what would have been the case in the absence of this regulations, and so it introduced a serious distortion in the allocation of bank credit that is affecting the real economy.
Who could have nudged regulators to do so? Since being able to earn the highest risk adjusted returns on equity on what is perceived as safe sounds like a wet dream come true for bankers, I have my suspicions.
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