Tuesday, December 9, 2014

Bank regulators originated and institutionalized a “market imperfection”, causing less equality in opportunities

In presence of financial market imperfections, implying that the ability to invest of different individuals depends on their income or wealth level. If this is the case, poor individuals may not be able to afford worthwhile investments… In turn, under-investment by the poor implies that aggregate output would be lower than in the case of perfect financial markets (5). We will refer to this view, first formalized by Galor and Zeira (1993, 1998), as the “human capital accumulation” theory. (6)

(5) With perfect financial markets, all individuals would invest in the same (optimal) amount of capital, equalizing the marginal returns of investment to the interest rate. This occurs as complete markets allow poor individuals, whose initial wealth would not allow reaching the optimal amount of investment, to borrow from the rich (infra-marginal gains from trade). If, on the contrary, financial markets are not available, and the returns to individual investment projects are decreasing, under-investment by the poor implies that aggregate output would be lower, a loss which would in general increase in the degree of wealth heterogeneity (see e.g. Benabou, 1996; Aghion et al, 1999).

(6) Aghion and Bolton (1997) and Piketty (1997) explicitly modeled the supply side of the credit market, explaining imperfections based on moral-hazard (e.g. problems of input verifiability) or enforcement problems stemming from contract incompleteness (e.g. due to output verifiability). Moral-hazard would occur, for example, with limited liability (i.e. when a borrower's repayment to his lenders cannot be greater than his wealth); if the probability of success of the project depends on a (costly) effort exerted by the borrower, her incentives to exert efforts would be lower the larger the fraction of externally financed investment. Thus the interest rate on the loan will be an increasing function of its size (i.e. higher for the poorer).

And that provides me with a new opportunity to try to draw the attention to how bank regulators, during the last couple of decades, have originated and institutionalized a truly odious and discriminatory capital market imperfection.

The Basel Committee for Banking Supervision imposed credit-risk-weighted capital (equity) requirements for banks which are much much lower for assets perceived as “absolutely safe” than for assets perceived as “risky”.

And, of course, what is perceived as “absolutely safe”, correlates much more with wealth than what is perceived as risky.

And, of course, what is perceived as “absolutely safe”, correlates much more with what already exists (history) than with the riskier future.

And that allows banks to make much much higher risk adjusted returns on equity when lending to those perceived as safe (like the "infallible sovereigns", the AAAristocracy and the housing sector) than what they can obtain when financing "the risky".

And, as a consequence, small businesses and entrepreneurs, those creators of jobs that will allow mortgages and utilities to be serviced, have no longer fair access to bank credit.

And, as a consequence banks, no longer finance the future, they mostly refinance the past.

And in short, that is how our economies are stalling, while inequality is growing.

“A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926