More on the art of Risk-Weighted Assessments

In a system where Commercial Banks have the ability to create money out of thin air, the question of what determines where that money ends up is clearly going to be absolutely critical.

Attempts to regulate money creation by Banks are essentially based on trying to restrict their assets to capital ratios. With the  Basel III system, introduced in 2010,  banks are supposed to hold 4.5% of common equity (up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel II) of "risk-weighted assets".

By setting the rules for assessing the risk levels associated with particular loans, regulatory authorities can potentially guide the way that banks use their money creation powers. Since they are required to keep the ratio between risk-weighted assets and capital under control, they will clearly be paying attention to where they put their newly created money. Assets with low risk-weightings will obviously be more attractive options.

So, what numbers do banks actually used for determining "Risk-weighted assets"? In July 2013, the Bank for International Settlements published a 57-page document called  "Analysis of risk-weighted assets for credit risk in the banking book".  On page 18, you can find the following chart that shows the ranges of RWA values for four sectors.

Loans to the corporate sector were rated at around 50%, retail loans at around 25%, loans to other banks at 17.5%, and loans to sovereign governments at around 4%. Clearly lending to governments is seen as a very risk-free venture. It's hardly surprising that banks will be happy to create lots of new money (debt) for governements. And hardly surprising that the 27 EU countries collectively owe €11 trillion to the banking system.

On page 21, there is a graph showing the distribution of exposure according to the various classifications used by ratings agencies.


As you can see, nearly 80% of exposure to sovereign debt was considered to by AAA or AA. But for corporate lending, most lending is made to corporations rated BB.

The whole idea that you can control the way new money is pumped into the economy using these sorts of rules seems absurd. For obvious reasons, commercial banks will create money in the form of loans if and only if they think that they will make a profit.

Surely, there must be a better way. Imagine a system in which commercial banks don't get to create money at all. Where debt-free money can be created by central banks and injected into the economy when and where it is needed.

In such a system, none of this regulatory rules would be needed, and the entire Basel III system could be scrapped entirely. Banks would simply take deposits from savers, and lend them where they thought there would be a reasonable return.  If they screw up, then they, and the savers would lose their investments.  Banks that do a good job would get rewarded by having more people saving their spare cash with them.

It would be a much safer world than the current one in which Commercial Banks can end up creating hundreds of billions of new money, taking massive risks, and requiring tax payer bailouts when they mess up.