I’ve enjoyed reading Anat Admati and Martin Hellwig’s recent book, The Bankers’ New Clothes, which explains a ton of things extremely well, including:

Differentiating between what’s “good for banks” (i.e. bankers) versus what’s good for the public, and how, through unnecessary complexity and shittons of lobbying money, the “good for bankers” case is made much more often and much more vehemently, that, when there’s a guaranteed backstop for a loan, the person taking out the loan has incentive to take on more risk, and that there are two different definitions of “big returns” depending on the context: one means big in absolute value (where -30% is bigger than -10%), the other mean big as in more positive (where -10% is bigger than -30%). Believe it or not, this ambiguity could be (at least metaphorically) taken as a cause of confusion when bankers talk to the public, in the following sense. Namely, when the expected return on an investment is, say, 3%, it makes sense for bankers to lever up their bets so they get “bigger returns” in the first sense, especially since there’s essentially no down side for them (a -30% return doesn’t affect them personally, a 30% return means a huge bonus). From the perspective of the public, they’d like to see the banks go for the “bigger return” in the second sense, so avoid the -30% scenario altogether, via restrained risk-taking.

Admati and Hellwig’s suggestion is to raise capital requirements to much higher levels than we currently have.

Here’s the thing though, and it’s really a question for you readers. How do derivatives show up on the balance sheet exactly, and what prevents me from building a derivative that avoids adding to my capital requirement but which adds risk to my portfolio?

I’ve been getting a lot of different information from people about whether this is possible, or will be possible once Basel III is implemented, but I haven’t reached anyone yet who is actually expert enough to make a definitive claim one way or the other.

It’s one thing if you’re talking about government interest rate swaps, but how do CDS’s, for example, get treated in terms of capital requirements? Is there an implicit probability of default used for accounting purposes? In that case, since such instruments are famously incredibly fat-tailed (i.e. the probability of default looks miniscule until it doesn’t), wouldn’t that encourage everyone to invest extremely heavily in instruments that don’t move their capital ratios much but take on outrageous risks? The devil’s in the detail here.