Darrell Duffie of Stanford may not realize it, but his defense of risk weightings on Bloomberg yesterday is really an argument for bigness in banking institutions. Duffie’s logic proceeds thusly: 1)Tossing out risk-weightings,as some regulators are now suggesting, would simply induce banks to reach for yield and thus court disaster. 2) Unfortunately, regulators tend to misappraise asset riskiness and have a particular weakness for sovereign debt.3) So when risk weightings are used, lenders often all pile into a relatively narrow range of “safe” assets. 4) When those assets blow up, everyone goes down together.See the problem? The professor gets at a solution:
An improved approach would recognize that, other things being equal, banks are likely to invest more heavily in assets with lower risk weights. This “piling on” can cause even a safe asset class to endanger a bank. Research I did . . . shows that it is relatively difficult for an adequately capitalized bank to fail from many small, high-risk loans unless they have a tendency to go bad at the same time. Given a failure, the culprit is relatively likely to be losses on very large loans to borrowers that had been judged safe. During the subprime crisis and the euro area’s sovereign-debt crisis, large loans with very low risk weights quickly became life-threatening. [Emph. added]I would translate “have a tendency to go bad at the same time” as “non-diversified” or, if I want to come off as wonkish,“correlated.” As Duffie notes, it’s safer for a bank to hold a diverse portfolio of higher-risk assets than it is to hold a monolithic portfolio of“low-risk” assets. The best way for a bank to weather a credit storm, then,would seem to be to ensure it is engaged in a wide variety of businesses, both lending- and non-lending related. Things like investment banking, payment processing, credit card lending, and mortgage servicing say. A broad geographical reach might also help!The model institution I’m describing sounds a lot more like, for example, JPMorgan Chase than First Bank of Paducah or, for that matter, Countrywide, does it not? This is one reason why the recent re-regulation of the banking industry is such a disaster: it artificially limits the businesses banks can engage in. The Durbin amendment puts a ceiling on debit-card fees. The Volcker Rule severely limits trading. In the end, banks will be less diversified rather than more so. And as Duffie’s work shows,that’s not a good thing for the financial system.What do you think? Let me know!