Saturday, January 9, 2016

How come Nobel Prize winning economists do not understand how regulators distort the allocation of bank credit?

Capital is invested in banks by shareholders looking to obtain the best risk adjusted returns on their equity.

Before current regulators concocted the credit risk weighted capital requirements for banks, the banks, without any sort of discriminations, gave credit to whoever offered them the highest risk adjusted margins.

But now, because of those requirements, more credit risk more capital – less risk less capital, banks can leverage their equity much more with what is perceived as safe than with what is perceived as risky; and can thereby earn much higher risk adjusted returns on equity when lending to the perceived safe than when lending to what is perceived as risky.

And of course, favoring the AAA rated and sovereigns, negates the fair access to bank credit to those perceived as risky, like SMEs and entrepreneurs, and so helps to weaken the economies and to increase the existing inequalities.

Just look at this: Basel II of June 2004 set the risk weight for AAA rated at 20 percent and allowed banks to leverage their equity over 60 times. But for unrated corporations the risk weight was set at 100 percent and in this case banks could only leverage about 12 times.

And all distortion for nothing, since absolutely all major bank crisis result from excessive exposures to something that ex ante was perceived as safe but that ex post turned out to be very risky.

But you read the comments on the 2007-08 crises by Nobel Prize winning research economists, like those of Joseph Stiglitz and Paul Krugman, and it is clear they have no idea about how the regulatory incentives distorted the allocation of bank credit. Unless they shut up for other reasons, like ideological ones, it would seem clear they never had the benefits of a decent Econ 101.

As for me, I strongly feel the Nobel Prize Committee, when the winners use the Nobel Prize reputation to opine in areas totally strange to them, should have the right to revoke Nobel Prizes, and ask for the prize money to be repaid.