The figure contains most of the mostly untold truth of what led us to this crisis, namely the incredible relaxation of the capital requirements that resulted from Basel I and especially Basel II (1994) when the regulators decided that the credit rating agencies were capable of identifying what was risky and what was not.
The capital requirements for banks were brought down from a traditional range of 8-12 percent for any type of assets to an unbelievable low 1.6 percent when related to operations with private sector AAA ratings or even zero percent for the case of the sovereign AAAs. These lowering of capital requirements released a tremendous lending power of the banks, and which created havoc in the capital allocation mechanism of the markets and caused a stampede into safe-havens that, as a consequence, became overcrowded and extremely dangerous AAA havens.
It is an untold story as comes clear from the following paragraph that appears on the same side of the report and that pertains to one of “the competing and not necessarily contradictory explanations” for the crisis. It reads: “An excessive loosening of regulatory oversight. The reduction of regulatory barriers to speculation and excessive reliance on self regulation of the banking sector in industrial countries generated and failed to curb excessive risk taking by financial institutions.”
And I ask how can one speak about excessive reliance on self regulation of the banking sector, when the risk analysis that determines the adequacy of bank capital is outsourced to some few human fallible credit rating agencies?
Yes, ex-post it might seem as excessive risk-taking, but ex-ante it was most clearly a result of an excessive trust in the credit rating agencies capabilities of identifying what is not risky, as if risks are perfectly identifiable and quantifiable.
What is now much weighing down the road to recovery is the need to rebuild those real bank equity ratios that were consumed by the supposedly risk free AAAs and which, from figure 2.1, seems to be extraordinarily large amounts.
But, we also need to correct the most basic fault of the current paradigm of our financial regulations, namely that the regulators, on top of those benefits that coward capitals already assigns to what is perceived having low risk, felt they had to lay another layer of benefits in terms of low capital requirements for banks. What has the risk of bank defaults and the risk of credit defaults have to do with the general risks of human growth and development? Very little I would say.
Accepting that risk is the oxygen of any development and correcting the current regulatory bias against risk-taking, could only help development, whenever, wherever and in whatever form it occurs.
The World Bank, as the world´s premier development bank has as its prime responsibility to help the world at large to achieve a better understanding of what risk really signifies so that it is able to enter into a more rational relationship with risk.