Thursday, February 25, 2016

The curious border between what finance professors can understand, and what they cannot understand

If with regulations you allow banks to leverage much more their equity, and all the support these receives from society, with assets type A than with asset type B, then banks will be able to obtain higher expected risk adjusted returns on equity with assets A than with assets B. 

That finance professors can understand.

And the above will cause the banks to exclusively hold assets A, unless assets B offers these a much higher risk adjusted return than what would have been the case in the absence of such regulations.

That finance professors can understand.

And that clearly signifies a distortion in the allocation of bank credit. 

And that finance professors can understand.

But if you just substitute “safe assets” for assets “type A”, and “risky assets”, like loans to SMEs and entrepreneurs, for assets “type B”, then suddenly finance professors no longer understand.

And that I know because no one of them is protesting the distortions in the allocation of credit produced by the risk weighted capital requirements for banks. 

Strange eh?

What behavioral theory explains that?