In order to try to shed light on what I find so utterly disturbing with current bank regulations, let me then try use the example of an imaginary weekly-televised game among bankers, in which the contestants has to pick one of two boxes.
Box1 contains one 3 year $1 million loan to someone very safe at a very low interest rate.
Box2 contains one hundred 3 year ten thousand $ loans to many riskier borrowers but at much higher interest rates.
Which box would the banker contestant pick?
If he could analyze the second box in detail, the answer would clearly depend on if those higher interest rates seemed sufficient to cover the increased risk.
If the risk adjusted value at the end of the 3 years seemed the same for both boxes, or Box 2 produced only a slightly higher value, the ordinary risk adverse banker would surely go for “safe” Box1. Otherwise he would, he should, pick “risky” Box2, because that is precisely what bankers do… or at least did.
But that was not how bank regulators wanted that game to be played.
Considering bankers were not risk adverse enough, they wanted the contestants to pick Box 1 many times more and avoid Box2 much more; and to that effect they introduced risk weighted capital requirements.
That rule meant that if the banker picked “risky” Box2, while waiting for the 3 years result, he had to hold more capital (equity) than if he picked “safe” Box1.
As a result bankers would, from that moment on, prefer Box1 to Box2 much more; with what should have been expected consequences.
First to keep the game show going, many more boxes of the “safe” Box 1 type were needed, something that also meant the producers had to offer lower interest rates on the “safe” loans.
And in order to keep the audience interested, so that a Box2 had also a chance to be selected, the game show host also had to make sure to compensate the additional capital required, with still higher interest rates on the loans in Box 2; something which de facto made these loans even riskier.
What was the end result? Too many loans and too low rates were given to the “safe” and too few or at too high rates were given to the “risky”
For the bank system and for the real economy this was a disaster. Bankers would choke on “safe” loans to sovereigns, AAA rated borrowers or mortgages (causing crisis type 2007-8); and the economy would suffer from the “risky” SMEs or entrepreneurs lack of access to competitively priced credit (causing low growth).
Are we to appreciate these regulators interference? I don’t!
@PerKurowski
Source:
http://teawithft.blogspot.com/2017/10/how-great-bankers-game-show-got-to-be.html
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