In banking, too much simplicity is dangerous

In his Financial Times editorial, Standard Chartered's chief executive, Peter Sands, puts forth a robust argument for why relying on too much simplicity in the form of bank capital requirements is dangerous for taxpayer wealth.

Simply, these capital requirements, whether specified as a leverage ratio or a risk-weighted ratio or a combination of the two, don't present a true picture of the risk that each bank is actually taking.

Regular readers know that the only way for market participants to assess the risk of each bank is if each bank discloses on an ongoing basis its current asset, liability and off-balance sheet exposure details.  It is only with this information, that market participants have the data they need to actually assess each bank's risk.

As shown by our current financial crisis, when market participants cannot assess the risk the banks are taking, bad things happen to taxpayer wealth.  Specifically, policymakers and financial regulators find it irresistible to reach into the taxpayers' back pocket to bailout the banks and ensure the uninterrupted flow of bonuses to the bankers.

How can people trust banks using their own models when they are so opaque and produce such different results?

Only requiring banks to provide transparency eliminates this problem.

When market participants have access to the exposure detail data, market participants can use their own models to assess each of the banks.

This concern underpins the enthusiasm for the leverage ratio, and why some advocate a return to the so-called “standardised approach”. 

Under this approach, there are no sophisticated models – simply standard risk-weightings for different categories of asset that all banks have to apply. This gives the appearance of comparability, but it is entirely illusory. 

Massive differences in risk profile are simply smoothed out by very crude assumptions. 

Like the leverage ratio, it assumes lending to a start-up and an established multinational are equivalent risks, and takes no account of collateral. Indeed, imposing the standardised approach amounts to imposing a very poor model we know is wrong.

With transparency, the massive differences in risk profile are not smoothed out by very crude assumptions.

In fact. the massive differences in risk profile are exposed for all to see.

The standardised approach and leverage ratio share two characteristics. 

First, they simplify a complex reality. But the allure of simplicity should be resisted if the simplification so dangerously distorts and obscures the real picture. 

Your humble blogger agrees with Mr. Sands that the allure of the simplicity of capital ratios as a measure of bank solvency is a simplification that dangerously distorts and obscures the real picture.

Capital ratios are a form of regulatory opacity.

It is only with transparency into the underlying exposure details that a real picture of the risk each bank is taking can be seen.

Second, they narrow the difference in regulatory approach between risky and safe assets, creating perverse and powerful incentives for banks to run higher risk portfolios....

Your humble blogger agrees with Mr. Sands that capital ratios allow bankers to operate behind a veil of opacity and take on far more risk in their portfolios.

It is only with transparency into the underlying exposure details that market discipline can be exerted on the banks to restrain their risk taking.

The fact that different institutions give apparently similar assets different risk weightings is a real problem, and it has created a serious credibility gap. 

Some of the differences between model results are good, reflecting real variations in intrinsic risks and in the effectiveness of different banks’ risk-management approaches.

When each bank is required to disclose its current exposure details, the market gets to see which banks are being overly aggressive and which banks are being conservative in the management of their risks.