Wednesday, September 26, 2012

One reasonable and one very stupid efficient resource allocation methods for the banks

If banks need to hold for instance 8 percent of equity against any asset, they will allocate their funds in accordance to what assets produce the largest risk-adjusted returns on that equity. 

If banks, on the contrary, as is the case with Basel II, need to hold 8 percent of equity against assets perceived as “risky”, being able to leverage their equity 12.5 to 1, but can hold other assets deemed as “not risky” with only 1.6 percent in capital, and in that case being able to leverage their equity 62.5 times to 1, they will allocate their funds in accordance to whatever assets produce the largest risk adjusted return on the particular bank equity which regulators have decided should be held for the different assets. 

And only fools could believe that both systems have a chance to perform a resource allocation that is effective for the economy. The current method is a resource allocation completely distorted by the regulators own risk perceptions. 

We can be certain that if these capital requirements, which favor what is perceived as “not-risky” and discriminate against what is perceived as “risky” remain, this will guarantee us flabby economies, lack of jobs, and set our countries on a downward slope which condemns us to perish in some dangerously overpopulated safe-haven.