We need to eliminate the range of authorized bank leverages.
The heart, lungs and brains of the current banking regulations that have all emanated from Basel are primarily represented in the minimum capital requirements for banks.
If a bank lends to a sovereign country that is rated AAA it can have as much leverage it wants, there are no limits. If a bank lends to a corporation rated AAA or AA- it is authorized by the regulators to have a 62 to 1 leverage. If it lends to a corporation that is not rated or one that has only received a BB- the banks are authorized to leverage their capital 12 or 8 times respectively.
As seen these requirements allow the banks to move on an astonishing wide range of authorized bank equity leverages, from limitless to 8 times, depending exclusively on something vaguely identified as “risk of default” and as measured by some few thereto empowered credit rating agencies.
The above, like some of us knew and warned about, and the regulators chose to ignore, detonated the mother of all the booms in the market of regulatory arbitrage and drowned the world in a tsunami of systemic risk.
The risks for the financial world of what is perceived as not-risky are more than the risks of what is perceived as risky. Not only because capitals are more naturally drawn to what is less risky and so these investments will always represent a higher volume of the global exposures but also because what is perceived as more risky usually gets more careful scrutiny.
Does this mean we should impose higher capital requirements on what is perceived as less risky than for what is perceived as more risky? Of course not, but we would do well not continue with a system that introduces a regulatory bias in the area of risks and let the markets, and especially the banks, be freer to render their own judgements with relation to the risks instead of concentrating so much of their attention on how others perceive the risks.
Let us therefore, over time, in such a way as not to worsen the current scarcity of bank equity, eliminate differentiating bank capital requirements based on default risks and go back to a standard of perhaps 12 to 1 leverage for normal times, allowing a 14 to 1 when the markets are depressed like now, and imposing for instance a 10 to 1 when credit markets seem to be overheated.
Besides eliminating sources of regulatory arbitrage doing so would also eliminate the de-facto tax on risk that the current minimum capital requirements imply, and that we who consider risk-taking to be the oxygen of development so profoundly dislike.
Also if there is one thing we should know by now that is that one of the principal fundamental for the creation Basel Committee, namely that of avoiding regulatory arbitrage among different regulators, was absolutely and totally flawed. What we know now, though some of us knew it all the time, is that the world would have been better off had its banks been able to arbitrage among many varied regulators instead of being induced to arbitrate just one set of regulations. Long live diversity!