Thursday, January 24, 2013

The subsidized risk-free rate

A theoretical rate, and a major benchmark in the world of finance, is the one which is known as the "risk free rate". Of course, since nothing is completely free of risk, it is normal, as an approximation, to use as that the interest rate which country perceived to have the strongest economies need to pay in order to service their debt, for example the United States. 

But I argue that this "risk free rate" has been consciously or unconsciously (I pray for the latter) manipulated by the Basel Committee on Banking Supervision, the Committee which seeks to be the manager of all world’s banking risks. 

This committee came up with, and the imposed, capital requirements for banks which depend on the risk of the various assets, primarily as perceived by the credit rating agencies and to whom they outsourced much credit analysis. 

When doing so the committee completely ignored, consciously or without thinking (I pray for the latter) that the perceived risks were already considered by banks when setting the interest rates, the amount of the loans and all other terms, let us say of the numerator. Consequently, when the regulators decided the same perception of risks also needed to be reflected in the capital, let us say in the denominator, they condemned the entire banking system to overdose on perceived risk. 

And that has meant that all those who are perceived as being more risky, be they countries, companies or citizens, have to pay higher interest rates and receive smaller loans, than what would have been the case in the absence of these regulations. 

And so also that all who are perceived as less risky, like “solid” sovereigns and corporations with high credit ratings, will pay much lower interest rates and receive many more and larger loans, than what would have been the case in the absence of these regulations. 

And the above distorted and dislocated world economies more than you could believe. Not only did it encourage a dangerous overcrowding of all safe-havens, but also by dangerously ignoring that risk-taking is the oxygen of any development, and that the "absolutely not risky "of today, were almost always the "risky" of yesterday. 

And this means that the "risk free rate" which we today observe in the market, is actually the "risk-free rate less the value of the Basel Committee’s regulatory subsidy”. 

And this means that the flight instruments which the markets and the central banks in the world use, simply do not give correct readings. 

How is this possible? "One has to belong to the intelligentsia to believe things like that: no ordinary man would be such a fool" George Orwell, Notes on Nationalism, 1945. 

Or, as Patrick Moynihan would have explained it: "There are some mistakes it takes a Ph.D. to make”