Monday, February 16, 2015

Western world, it behooves you to understand the following about current bank regulations, and to do something about it.

Banks are currently allowed to hold much less equity against assets perceived as safe than against assets perceived as risky.

That means that banks are allowed to leverage their equity much more with assets perceived as safe than with assets perceived as risky.

That means bank currently obtain much higher risk adjusted returns on equity with assets perceived as safe than with assets perceived as risky.

And that, compared to equity requirements which do not discriminate based on ex ante perceived credit risks, means that banks will lend too much at too low rates to what is perceived as safe, and too little at relative too high rates to what is perceived as risky.

And the supposedly “safe” are sovereigns, basically considered as infallible, the members of the AAArisktocracy, and the housing sector.

And the supposedly “risky” are for instance all those SMEs and entrepreneurs we so much depend on for our economies to move forward, so as not to stall and fall.

And all for nothing! Major bank crises result always from to large exposures to what is erroneously perceived ex ante as safe, and never ever from too large exposure to what is perceived as “risky”.

And the distortions this regulation has created is destroying the Western world that has become what it is, not by risk avoidance, but by the reasoned and sometimes the unreasonable risk taking of our forefathers.

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

How did this monstrous regulatory mistake happen?

First and foremost because regulators concerned themselves with the risk of the assets of banks, which is what bankers should be concerned with, and not with the risk that bankers are unable to manage the perceived risks, or the risk perceptions being faulty, and which is what regulators should be concerned with.

Second by allowing the regulations to take place in a small mutual admiration club of “experts” with no accountability.

Third, by allowing ideology to infiltrate bank regulations to such an extent so as to make it possible for regulators to declare some sovereigns to be infallible, to have a zero risk weight.

Fourth by the fact we live in a world that finds it difficult to imagine, or does not want to recognize, the possibility of experts being so utterly wrong. 

How can we correct for it? Not easy, but it will clearly not happen by allowing the failed regulators to keep on regulating.

And please do not ask bankers to correct it. For them, being able to earn the highest risk-adjusted returns on equity by lending to the “safe”, is a dream come true. 

In 1999, in an Op-Ed I wrote: “The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause the collapse of our banks”

That AAA-bomb detonated in 2007-08 and its poisonous radiation is still killing our economies. For those coming after us… please do something! 

A former Executive of the World Bank (2002-2004)

PS. Any editing suggestion that could make the explanation more understandable is appreciated on