In yesterday’s ‘FT’, it was suggested that the US Federal Reserve is considering forcing US banks to operate much higher capital ratios. The idea is to reduce the risk of a banking crisis. Critics say such action may increase the risk of prolonged economic downturn.

It all boils down the perceived riskiness of different assets. A bank with lots of high risk debt on its balance sheet needs more capital under Basel III rules. A bank with low risk debt, such as US government bonds, does not need so much. The Fed is looking at changing this.

The ‘FT’ put it this way: “The move is being considered amid growing scepticism about the Basel III capital accords, which impose higher capital requirements on banks around the world but allow them to vary the amount depending on the riskiness of individual assets. Officials are concerned that some banks are gaming the system.”

But, and this is the more interesting point, the ‘FT’ also said: “However, critics of a higher leverage ratio argue that it is a blunt tool that makes no distinction between safe securities, such as US Treasuries, and risky assets such as leveraged loans, and could result in banks taking on more risk.”  See: Fed weighs tighter cap on bank leverage 

So there you have it, the Fed tries to reduce risk, and in the process may be creating more risk.

But then again, is that not the point? Regulators do have this problem seeing beyond the end of their nose. They try to reduce risk, for example by enforcing higher capital rules, and in the process risk prolonging the recession, which in turn leads to bank losses, and may force banks to impose even higher capital reserves.

Isn’t the whole point of QE to try to urge investors and banks to take more risk; to buy more risky assets?

The big error of the growth years was to see mortgage security as low risk, when in fact applied out across the economy it was high risk.

The truth is that the creation of wealth relies on risk. The more risky loans banks make to innovators, the less risk of a major economic crisis.

If changes to bank capital rules mean banks take on more risk, in the sense that they back innovation, then that should be applauded and so should the Fed.

© Investment & Business News 2013