July 01, 2009

The too few credit rating agencies opinions to follow are a larger source of systemic risk than the “too big to fail”

Sir, with respect to the “too big to fail” at a workshop on risk management in the World Bank in 2003 I told the financial regulators that “knowing that the larger they are the harder they fall on us, if I were a regulator, I would be thinking on a progressive tax on size” I can therefore evidence having stood up against the big while they were still believed invincible and few dared to do so. 

That said it is clear that this crisis, though it did hit some of the big especially bad, was not caused by these banks but by the “too few credit rating agencies opinions to follow” that were imposed on the system by the financial regulators. 

But as we can read from Martin Wolf’s “The cautious approach to fixing banks will not work” July 1, slowly and surely we are getting to the truth. Martin Wolf now informs us that the median leverage of commercial banks in Europe in 2007 was 45 to 1 and of course it is “insane”, anyone knows that, so the real question becomes why did not anyone, including Martin Wolf, say so? 

The answer lies in the risk weighting of the assets that was done and in this aspect Wolf still has something to learn. When he says “the required bank capital must also not be risk-weighted on the basis of bank models, which are not to be trusted” he blithely ignores that the bank models has little to do with that because the essential parts of the risk-weighting is derived from the arbitrarily rules on minimum capital requirements concocted by the regulators and from the opinions of the appointed supreme risk surveyors.

PS. Incentives matter. The escape valves of risk weighted bank capital (equity) requirements, cause banks’ risk models to be more about equity-minimizing/leverage-maximizing, than about analyzing bank assets’ true risks. That’s life!