Thursday, March 26, 2015

Financial regulations, if wrong, could destroy the economy of a nation, and is therefore an issue of utmost importance for national security.

Suppose military regulations which implicitly stated that those who avoided taking direct risks when fighting the enemy, for instance by using drones, had much better possibilities to advance in the ranks than those who dared to risk hand to hand combat. Would this not impact negatively, at least in the long term, the strength of the Home of the Brave?

And should bank regulators not have to consider the dangers of introducing distortions in credit allocation, which might weaken the economy and thereby weaken the defense of the nation?

In 1988, the G10, a group which includes United States, decided to introduce risk-weighted capital requirements for banks; where “risk” means credit risk, and “capital” means bank equity. As a consequence, those bank assets with a low risk-weight require banks to hold less equity than those assets with a high risk-weight.

The initial big risk-weight differentiation, in 1992 with Basel I, was that loans to the central governments of the OECD nations had a cero risk-weight, while loans to the private sector carried a 100 percent risk-weight. In 2004, with Basel II, many more risk buckets were added and in the private sector the risk-weights were set from 20 to 150 percent.

And it all sounds like prudent bank regulations… more-risk-more-equity - less-risk-less-equity. But, unfortunately, bank regulators, I pray unwittingly, did not notice that by doing that, they were introducing an extremely dangerous distortion of how bank credit was allocated to the real economy.

It signified that the equity of a bank, to which we have to add the value of the support a society and taxpayers lend the banks, could be leveraged many times more for assets with a low risk weight, than with assets with a high risk-weight. 

And that meant banks could earn much higher risk adjusted returns on equity on assets that carry a low risk-weight than on assets with a high risk-weight.

Just for a starter it meant that regulators effectively instructed banks to allocate more credit to the central government than to the private sector… implying thereby of course that a government bureaucrat has more capacity to allocate financial resources efficiently to the real economy than a private agent, like a SME or an entrepreneur

And anyone who thinks this regulatory risk aversion will not affect the strength of the USA’s economy, has no idea about how the USA got to be strong

And to top it up, it is all for nothing, since all major bank crises have always resulted from too big exposures to something that was perceived as “safe” that turned out risky, and never ever from excessive bank exposures to something perceived as risky.