Saturday, September 29, 2012

Houston, we’ve got a problem: The IMF is lost in space.

Even though the report mentions “the banks’ likely increase in their allocation to safer but low-yielding assets to accommodate regulatory requirements” it completely fails to understand the distortions that precisely this causes in the economy. In fact, the word distortion does not even appear in the report. 

And, if there is anything current regulations have done, that is to distort the economic efficient resource allocation so much, by favoring banks holding assets that ex-ante are perceived as “not-risky”, against banks holding assets that ex-ante are perceived as “risky”. 

Basel II allowed a bank to leverage its equity 62.5 to 1, if the asset had an AAA rating, but only 12.5 to 1, if it was unrated. And which means that the profitability for banks, their return on equity, when holding “not-risky” assets, becomes much higher than when holding “risky” assets, like loans to small businesses and entrepreneurs. And, if this is not hugely distortive, I do not know what is. 

Distortive, and utterly useless… since we know that no major bank crisis ever, has resulted from banks holding excessive assets that, when acquired, were perceived as “risky”, these have all resulted, no exceptions, from banks holding excessive assets that, when acquired, were perceived as "absolutely not-risky".

IMF does a lot of empirical research, but the research they have completely failed to do, is to run a simple regression between all the current problem assets, and the fact that these were ex-ante perceived as “not-risky”, and so therefore the banks were allowed to hold much less bank equity. That should have given them a clue.

And so, about five years after the beginning of the crisis, the IMF does yet not understand why a crisis that was doomed to happen, because of plain dumb regulations, happened. 

The Independent Evaluation Officer of the IMF (IEO) in their report “IMF Performance in the Run-Up to the Financial and Economic Crisis: IMF Surveillance in 2004-07” of 2011 wrote: 

“The IMF’s ability to correctly identify the mounting risks was hindered by a high degree of groupthink, intellectual capture, a general mindset that a major financial crisis in large advanced economies was unlikely, and inadequate analytical approaches. Weak internal governance, lack of incentives to work across units and raise contrarian views, and a review process that did not “connect the dots” or ensure follow-up also played an important role, while political constraints may have also had some impact.” 

It would sure seem that no one in IMF read that report. What a shame!

PS. And by the way Houston we've got another serious problem too