Finance & Development, June 2010, Volume 47, Number 2

THE current regulatory paradigm based on arbitrary risk weights lowers the capital requirements for banks when lending to what ex ante is perceived by the credit rating agencies as having lower risk of default, and, as a direct consequence, increases the banks’ expected ex ante returns from pursuing these “low-risk” opportunities.

But since there has never ever been a major or systemic bank crisis that has resulted from banks being involved with anything that ex ante was perceived as risky—and they have all resulted from lending and investing in what ex ante was considered as not risky—we can only conclude that those regulations are outright stupid since they only reinforce the real risk.

Even the infamous Dutch tulips would, in their own bubble time, have earned these AAA ratings, and if the same set of circumstances and regulations had been in place, the lower capital requirements would have made that boom and bust even worse.

It would seem that the regulators thought the credit rating agencies possessed some extraterrestrial sensorial abilities that other humans did not. One must be truly desperate for safety to believe such nonsense.

But that was not all the regulators did. They also imposed on our banks solely their particular concern, the risk of default, a risk that when compared to the many other risks we confront as humans is in fact quite a benign risk; the triple-A rated BP suffices as evidence of that.

It is always better to fail when taking real and worthy risks than to fail when taking useless Potemkin risks!

Per Kurowski
A former Executive Director of the World Bank (2002-2004)