Monday, March 7, 2016

Here is the explanation for the genesis of the financial crisis of 2007-08 and of the secular stagnation since.

Getting the clue from Charles Goodhart’s “The Basel Committee on Banking Supervision: A History of the Early Years 1974-1997”, in Steven Solomon's “The Confidence Game” we read:

“On September 2, 1986, the fine cutlery was laid once again at the Bank of England governor’s official residence at New Change… The occasion was an impromptu visit from Paul Volcker… When the Fed chairman sat down with Governor Robin Leigh-Pemberton and three senior BoE officials, the topic he raised was bank capital…

Adequate capital – the bank’s buffer against bankrupting loss- was the keystone of a central banker’s mission to uphold financial system safety and soundness. It was the banks’ capital inadequacy that made LDC (Less Developed Countries) over-indebtedness so grave a threat; upgrading U.S. bank capital was Volcker’s strategy to extricate the world financial system from that crisis. 

At dinner the governor’s hopes had been modest: to find areas of sufficient convergence of goals and regulatory concepts to achieve separate but parallel upgrading moves… 

Yet the momentum it galvanized… produced an unanticipated breakthrough of a fully articulated, common bank capital adequacy regime for the United States and United Kingdom. This in turn catalyzed one of the 1980’s most remarkable achievements – the first worldwide protocol on the definitions, framework, and minimum standards for the capital adequacy of international active banks…

They literally wiped the blackboard clean, then explored designing a new risk-weighted capital adequacy for both countries… 

It included… a five-category framework of risk-weighted assets… It required banks to hold the full capital standard against the highest-risk loans, half the standard for the second riskiest category, a quarter for the middle category, and so on to zero capital for assets, such as government securities, without meaningful risk of credit default.”

But then in Alexis Rieffel’s “Restructuring Sovereign Debt”,‪ Brookings Institution Press, 2003 we also read:

“Countries don’t go bankrupt” seems to be the most frequently repeated sound bite associated with the broad subject of sovereign debt workouts. It is everywhere. Former Citibank chairman Walter Wriston is usually cited as the originator of the quip [An Op Ed in New York Times 1982]. This is almost certainly wrong. It was considered conventional wisdom in the international financial community at least a decade earlier”

And there you have it! The regulators completely confused ex ante perceived risks with ex-post realities. The LDC crisis did not result from banks taking large ex ante perceived risks.

And so what resulted? The pillar of current bank regulations, the risk weighted capital requirements for banks. More ex ante perceived risk more capital - less risk less capital.

Which allowed banks to leverage more with The Safe than with The Risky.

Which allowed banks to earn higher risk adjusted returns on equity with The Safe than with The Risky.

Which made banks lend more against less capital to The Safe… like AAA rated securities and sovereigns like Greece. Hence the Financial Crisis!

And which make banks lend less to The Risky, like SMEs and entreprenuers. Hence Secular Stagnation!

Which make banks finance more the basements in which kids can live with parents, than the jobs they need.

PS. Here is an aide memoire on the final monstrous mistakes of such risk weighted capital requirements.