Are Regulators Encouraging a Financial Bubble?

November 24 2015

It is interesting to see how legislation such as the Basel accords, designed to limit the risk of a banking crisis, in reality only shifts the risk. How is it possible that regulators are actually encouraging risk, rather than reducing it? 

How Solvency Is Normally Calculated

A bank’s capital, or that of your own (net worth), equals its assets minus outstanding liabilities. 

Example:

  • If your total assets are worth €100.000, and you have debts equaling €80.000, then your equity equals €20.000. This means that your equity ratio (your equity relative to total assets) equals 20%.

But a bank’s equity ratio is calculated differently (!).

This is because supervisors have introduced something called 'risk weighted assets.'

How a Bank’s Equity Ratio Is Calculated

What do they mean by 'risk weighted assets?'

Essentially, regulators are saying that they are better (than banks) at judging to what extent assets are 'risk-free,' or risky. And because 'that is the truth, and nothing but the truth,' banks do not have to include these so-called risk-free investments when calculating their equity ratios. 

Example:

  • Bank X has assets equaling €100 million, €90 million of debts, and therefore €10 million of equity. According to our standard calculation method, its equity ratio equals 10%.  
  • But, the regulator says: “Of your €100m in assets, half is invested in Greek government bonds. And since we tell you they are risk free, they do not have to be included in your calculation.”
  • Bank X therefore has €50m assets that are not risk-free, and €10m of equity. That is why, according to regulators, the equity ratio of Bank X is not 10%, but 20%!

This story is not made up, nor has it been exaggerated. This is how things work in practice.

Next to risky assets (which have a full weight of 100% in the calculation), and 'risk-free' assets (not counted at all), there are also assets that fall somewhere along the continuum (somewhere between zero and hundred percent).   

The problem with regulatory frameworks such as Basel II and Basel III is that regulators decide, for banks, which assets are safe and which are not. This leads to a concentration of risk in the banking sector on a scale we haven’t seen before. If it turns out the regulators are not infallible after all (as they are also people, not all-knowing gods), then we are faced with an enormous problem. In essence, they have reformed the banking sector, as bankers are now forced to follow the instructions of a centralized institute that decides what is good or bad.

I am not saying anything new: for example, within the IMF there is a lot of debate on what assets have to be included in the calculations, and to what extent (percentage wise).  They also discuss to what risks this sort of centralized regulatory mania may lead. 

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