My Favorite Regulatory Critic, And My Complicated Risk-Weighting Scheme

One of the blogs I admire is Tea With FT by Per Kurowski. He is tireless and single-minded in his criticism of financial regulators, to a degree rarely seen in the blogging world, on any subject.

His strongest critique – and most striking in its simplicity and common sense – is of the current system of ‘risk weights’ (=charging financial institutions different amounts of capital for assets deemed to be in different risk categories). It is based on the seemingly iconoclastic and counterintuitive, but I think ultimately incontrovertible, observation that assets that everyone already thinks are risky aren’t the ones that cause widespread problems. Assets believed risky already get discounted by the market, in the thing we call the ‘price’, and by having more risk-averse buyers shy away from them.

The assets that cause widespread problems are those that everyone thinks are safe. So, charging lower ‘risk weights’ for perceived-safe assets is idiotic. The risk-averse don’t need any extra incentive or leverage to be induced to park their capital in perceive-safe assets, by definition; more to the point, telling everyone that in effect they can gorge themselves on perceived-safe assets is precisely what you would expect to set the financial system up for a big crash – unless one could somehow have a foolproof way of identifying assets that really are 100% safe. Which would be hubris. Not that that prevents Basel from trying.

This critique meshes perfectly well with my critique of the stupid idea to use rating agency reviews of assets (I know they are technically called ‘ratings’ but I call them reviews, for reasons better explained in that link) as part of official regulation of them. As Kurowski complains, the ‘Basel’ consensus is based on the notion that (what some rating agency calls) a “AAA” asset has very low risk, thus should be given less risk weight. This automatically leads to an incentive to repackage “AAA” assets out of sub-AAA assets. In other words, to take assets in a perceived-risky category and convert them into a non-risky category, so that the risk regulators will penalize them less, and more people can buy them.

The point is that the moment you even set up different ‘risk weights’ for different assets, you automatically create the incentive for this sort of regulatory arbitrage. You are asking for CDOs, in other words. Thus anyone who (1) thinks CDOs were a bad thing and shouldn’t have been created and had a hand in creating The Financial Crisis™ should be (2) against variable ‘risk weights’ and (3) against basing any regulations on rating-agency ratings. To be (1) but not (2) and (3) either bespeaks ignorance or lack of understanding of the products in question.

The interesting thing is that nobody seems to have a good reason for weighting “AAA” assets at 20%, etc.; it springs a sort of tacit, shared-consensus risk framework that everybody accepts but nobody questions (besides Per Kurowski). In Sonic Charmer’s ideal regulatory environment, all assets would have a risk weight of “1″. It would be a very complicated calculation. What’s the capital usage of this asset? 1 times the asset!

Think of all the spreadsheet columns saved….

Certainly in my Regulatory Eden, any utterance issued by “Basel” or the “Basel Committee” or whoever the hell they are would be ignored, as they have already proven their incompetence beyond a shadow of a doubt. So why aren’t they discredited? My theory is that it has a lot to do with being associated the word “Basel”. To most people, who don’t know where/what “Basel” is really any more than I do, terms like “Basel” and “Basel Committee” and “Basel II” probably connote little more than “some classy European city, so there’s probably classy old dudes in suits listening to translators on earphones (like at the UN) who probably know what they’re talking about”.

I suspect none of these stupid risk regulations would have gotten any mileage whatsoever if the committee had instead been headquartered in, like, Nashville Tennessee. “We welcome and vow to be compliant with not just the letter but the spirit of Nasvhille III” just doesn’t have quite the same ring to it.

Just a theory.

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