Banking regulatory flaws

Supervisory efforts to rein in banking solvency show an appalling record in times of hectic trade, as the last financial bubble proved beyond any doubt. Central bankers were ready to buy the misguided consensus of a self-propelled never-ending expansion likely to shelve forever the slightest hint of a crisis.

After all, most economists readily endorsed the dream of an unchallenged growth buttressed by a miraculously increasing productivity and innovation. Applying recklessly this principle to the financial system led to wild bets on its capacity to stretch beyond any reasonable limit its leverage, keeping the capital base at abnormally low levels. After all, paying attention to solvency seemed close to an idle endeavour when yearly benefits increased at such a breath-taking pace.

Attention was focused on moderating the huge money pile-up, fearing its long term effect on inflation. Even so, as liquidity trap claimed its first victims, the FED was faced with the conflicting interests of preserving the merry-go-round bonanza against the odds of fuelling the monetary run. It chose the easy way to pump extra liquidity in a bold attempt to cut short any further disruption. A wrong bet as the ensuing banking collapses showed. The ECB took the opposite view markedly increasing interest rates in the very eve of a liquidity crash.

The crisis exposed to such a blatant extent the supervisory shortcomings that witnessing a brisk U turn in regulation came as no surprise.

Full priority in forcing banks to fill in their coffers with fat own resources, stood as the obvious answer. Building up successive layers of hefty readily-available money cushions seemed to offer enough comfort to distressed central bankers. No one paid attention to the price to pay in terms of potential credit crunch and lower growth. Worse than that, no one bothered to thoroughly review how risk is ascertained by banks.

The old models of internal appraisal enshrined in Basel II have remained largely unchanged. Sharper rules for the trading book and sovereign exposure are indeed a welcome novelty. But the way to gauge the critical credit risk has failed being improved in any significant way.

Does it make sense to steeply increase the capital ratio when the reference term, namely the weighted average of total risk, can be misleading? Current Value at Risk being applied by leading banks to their balance sheet stands as the maximum one-day loss expected at a 99% confidence interval, taking into account a two-year record. In short, the loss reckoned being exceeded only two or three days per year. What happens should market risks suddenly sky-rocket driven by a severe turbulence? What happens should open positions prove unable to be hedged within one business day? The answer is that banks might run in severe trouble and taxpayers are likely to foot the bill.

Adequate ex-ante coverage of potential non-performing portfolio, plus a thorough scrutiny on banking trading and risk concentration, stands as the only effective way to prevent excessive exposure.

It does require a closer involvement by supervisory authorities, encroaching on banks free run of their business. But, at the end of the day, this grass-root policy proves more efficient than leaving to internal modelling the fate of financial stability. Using statistical confidence intervals can only be regarded as an appropriate rule of conduct for professional gamblers.