Saturday, January 19, 2013

In 2007, the Fed did not understand how markets were distorted by bank regulations. Do they now?

In the recently released transcript of a Conference Call of the Federal Open Market Committee on  August 10, 2007, on page 9, discussing the emerging financial crisis, we can read the President of the Federal Reserve Bank of Richmond, Mr Jeffrey M. Lacker declare the following: 

“Credit spreads are beyond our ability to peg or influence, and I don’t think we should go down the road of trying to do so” 

Amazing, there was no awareness of that by setting different capital requirements for banks, the bank regulators were already distorting the market appetite for different exposures and thereby the credit spreads. 

Seemingly they had no understanding that by requiring banks to hold only 1.6 percent in capital against securities rated AAA to AA, which implies an authorized bank equity leverage of 62.5 to 1 they had dramatically wetted the markets appetite for these securities. 

I wonder if they have ever discussed how much higher the interest rates on US Treasuries would be if banks had to hold as much capital against that asset, than what they need to hold when for instance lending to “risky” small businesses and entrepreneurs? 

I guess the Fed does not want to hear the truth, that with these regulations the regulators were artificially lowering, or subsidizing, the “risk-free” rate of the world.

Sincerely, in finance, manipulating something like the Libor rate, is chicken shit compared to unwittingly manipulating the risk-free-rate