IMF, the darkest corner, is where Basel II’s mistake with risk-weighted capital requirements for banks is hidden.
In “Where Danger Lurks” Finance & Development, IMF, September 2014 Olivier Blanchard writes: “The recent financial crisis has taught us to pay attention to dark corners, where the economy can malfunction badly”
Indeed but what is most dangerous is that the darkest corner which brought on this crisis, regulatory stupidity, is not even acknowledged… probably because many of the frontline responsible feel, rightly so, that their own jobs could be at stake... or it upsets other agendas.
Blanchard: “economists recognized that bank regulatory constraints, such as the minimum amount of capital (essentially a bank’s net worth; that is, its ability to absorb losses) institutions had to hold, could force banks to react more sharply to decreases than to increases in their capital”
… which only leaves us with the question of why bank regulators were not told of this.
Blanchard: “The Great Moderation had fooled not only macroeconomists. Financial institutions and regulators also underestimated risks. The result was a financial structure that was increasingly exposed to potential shocks.”
Nonsense! It was not underestimation of risks which caused the crisis but the hubris of regulators who thought they could play risk managers for the world with their “risk-weighted capital requirements for banks”; and did not care one iota about how allowing banks to earn much much higher risk-adjusted returns on equity on exposures which, ex ante, from a credit risk point of view were considered as absolutely safe than on exposures considered the same way as risky, would distort the allocation of bank credit.
And here we are, years after the crisis, and the dark corner of the distortion of bank credit allocation is not even being discussed… and that dark corner of bank regulations is still well alive and kicking in Basel III.
Blanchard writes: “So-called diabolical loops developed between public and private debt: weak governments weakened banks that held government bonds in their portfolios; weakened banks needed more capital, which often had to come from public funds, weakening governments.”
But he does not mention that diabolical, I would dare say communistic styled sovereign debt favoring, which occurs when banks need not to hold zero or very little capital, when lending to sovereigns/governments, when compared to what they need to hold when lending to a citizen.
And Blanchard when writing about the too small effect of fiscal profligacy, massing quantitative easing and low interest has had in the growth of the real economy and the generation of jobs, he seems to be wanting to keep his reader in a dark corner, not noticing that current bank regulations stop bank credit from going to where it should… namely to all those tough daring risky risk-takers we need to get going when the times are tough.
What a shame that IMF has allowed the Basel Committee for Banking Supervision to act as if the stability of banks is more important than the state of the economy. As evidence of this, let me here remind the IMF, again, that in all Basel I, II, III regulations, there is not a word about what is the purpose of banks.
“A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926.
There is one central Basel Committee paper that explains the risk weights used by Basel II. I wish Olivier Blanchard would read it, and try to explain it to us.
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