December 12, 2014

Capital (equity) requirements for banks, to be correct, need to be based on the perceived credit risks being incorrect.

Sir, the risk weights in Basel II for an AAA to AA rated sovereign was zero percent; the risk weight for a corporate rated AAA to AA was 20 percent; and the risk weight for an unrated corporate, like a small business was 100 percent… and they still are in Basel III

And so it would be interesting to know where Tom Braithwaite got “the risk weights, which obliges the banks to hold more capital against the riskiest assets, were also made tougher” from, “Fed’s push for safety test the business model at US banks”, December 12.

The only real important difference between Basel II and Basel III has been the introduction of the leverage ratio, which is not risk-weighted.

Unfortunately putting the pressure on banks with the leverage ratio to increase their capital (equity) while keeping the risk-weighting in place only means those weighted as “risky” are being more discriminated against that ever.

And Braithwaite writes: The international Basel II rules required banks to hold 2 percent of common equity against risk-weighted assets. The new Base III standards announced in 2010 requires a 7 percent capital ratio by 2019”.

There are of course differences but, since Basel II established “The total capital ratio to risk weighted assets must be no lower than 8%”, while Basel III states that “Total Capital (Tier 1 plus Tier 2 Capital) must be at least 8% of risk-weighted assets at all time”, and so Braithwaite is in my opinion quite shamelessly glossing up differences that really are not that big.

And though Braithwaite correctly states “Adding more equity depresses ROE and makes it more challenging to satisfy investors” he forgets to include the caveat: [those investors who do not appreciate the commensurate reduction in risk].

Nor does Braithwaite seem able to extrapolate from the above that lending to those borrowers against who the banks are forced to hold more equity, will depress ROE the most… and so unfortunately he does not understand how that distorts the allocation of bank credit.

Sir, again, if the perceived risks were correct, banks would need no capital… and any bank in then problem should just be out of business. And that is why it is so utterly silly to have capital requirements for banks based on these perceived risk being correct.

PS. Do I imply then that those experts in the Basel Committee and the Financial Stability Board and other prominent bank regulators are completely wrong? Yes, 180 degrees!