Bank loans

Ex-ante: Not-riskyEx-post: Not-risky

“As expected”

Ex-ante: RiskyEx-post: Risky

Risk premium collected

Ex-ante: Not-riskyEx-post: Risky

Danger Zone!!!

Ex-ante: RiskyEx-post: Not-risky

“Great news”

The Risk Weights of Basel IICLAIMS ON SOVEREIGNS

Credit Rating Risk Weight Capital Required Allowed Leverage

AAA to AA 0% 0.0% Infinity

A+ to A 20% 1.6% 62.5 to 1

BBB+ to BBB- 50% 4.0% 25 to 1

BB+ to B- 100% 8.0% 12.5 to 1

Below B- 150% 12.0% 8.3 to 1

Unrated 100% 8.0% 12.5 to 1

CLAIMS ON CORPORATES

Credit Rating Risk Weight Capital Required Allowed Leverage

AAA to AA 20% 1.6% 62.5 to 1

A+ to A 50% 4.0% 25 to 1

BBB+ to B- 100% 8.0% 12.5 to 1

Below B- 150% 12.0% 8.3 to 1

Unrated 100% 8.0% 12.5 to 1

http://www.bis.org/publ/bcbs118b.pdf

Basel II’s “perceived-risk” discriminationBasel II’s “perceived-risk” discrimination

AAA Rated Not Rated

a. Expected Default Losses (after additional research) 0.02% 1.50%

b. Transaction and further credit investigation costs 0.02% 1.50%

c. Desired Risk Adjusted Margin (“Mark Twain”) 1.00% 1.50%

d. Required Interest Rate Spread 1.04% 4.50%

e. Basic Capital Requirement 8.00% 8.00%

f. Basic Bank Leverage 12.5 to 1 12.5 to 1

g. Basic Expected Return on Equity (c*f) 12.50% 18.75%

h. BASEL II’s Risk-Weight (RW) 20.00% 100.00%

i. Capital Requirement Adjusted for Risk-Weights (e*h) 1.60% 8.00%

j. Risk-Weigh Adjusted Bank Leverage 62.5 to 1 12.5 to 1

k. Estimated Cost of External Funds 4.00% 4.00%

l. Additional external funds per unit of loan 6.40% 0.00%

m. Additional costs of external funds ((k*l)*Δj) 12.80% 0.00%

n. Risk-Weight Adjusted Expected Return On Equity ((c*j)-m) 49.70% 18.75%

Possible Outcomes:

a. Additional R.O.E. Banks provided by BASEL II 37.20%

b. Or: Potential Lower Interest Spread Offered 0.60%

c. Or: Required Higher Interest Spread to Compensate 2.98%

perkurowski@gmail.com http://www.subprimeregulations.blogspot.com/