July 30, 2014

Mr. John Kay, there is a vital document you must read, in order to understand what is happening.

Sir, it is very hard to understand John Kay´s “Why there is never such a thing as a single true and fair view”, July 30, unless you begin with the premise that Kay does not understand the background or the implications of what he writes either.

For instance Kay says: “If banks had large portfolios of uncorrelated loans, it might make sense to value that portfolio at 99p in the pound: but, as financial institutions discovered yet again in 2008, the outcomes of a portfolio are generally closely correlated”.

Indeed… but Mr. Kay should know by now that bank portfolios had no chance in hell to be uncorrelated, as they had to forcibly be closely correlated to what was perceived as absolutely safe, because of the risk-weighted capital requirements for banks.

How really sad it is that a knowledgeable and influential man like John Kay does not find the time to read the most important document that pertains to current bank regulations, namely the Basel Committee’s “An Explanatory Note on the Basel II IRB (internal ratings-based) Risk Weight Functions” of 2005.

Had he read it he would see that in that document the Basel Committee confesses that the risk-weighted capital requirements are “portfolio invariant”… for the extremely poor reason that because otherwise, bank regulators would not be able to handle the equations.

Holy moly!