Thursday, August 8, 2013

Four things the next Fed chair should absolutely know, and that the candidates most probably don’t know, yet.

The Fact: Current capital requirements for banks are much much lower for exposures to the “infallible sovereigns” and the AAAristocracy, than for exposures to small and medium businesses, entrepreneurs and start-ups.

The next Fed chair, whoever it is, should know that such different capital requirements for banks, based on perceived risks already cleared for by other means, produce different expected risk-adjusted returns on bank equity, and therefore completely distorts the process of allocating bank credit in the real economy, making it unreal.

The next Fed chair, whoever it is, should know that a financial transmission mechanism, when distorted as described above, stands no chance of producing a sturdy economic growth or generate sustainable employment. And, as a result, any quantitative easing becomes just a big waste.

The next Fed chair, whoever it is, should know that lower capital requirements for banks for what is perceived as “absolutely safe” than for what is perceived as “risky”, do not make any sense from a bank safety point of view. This is so because only exposures of the first kind can grow large enough to take the system down. And also because, when something ex-ante perceived as absolutely safe, ex-post turns out to be risky, as will happen sooner or later, then regulators will find the bank there with little or no capital at all.

The next Fed chair, whoever it is, should know that since banks need to hold much less capital when lending to the “infallible sovereign” than when lending to “risky” citizens, this translates into a subsidy of government borrowings, which means that current Treasury rates are not comparable to historical rates. In other words, the usual proxy for the risk-free rate is subsidized and distorted.