Thursday, March 3, 2016

September 2, 1986 was fatal for Western World’s economies. Its banks would be told not to finance the riskier future.

In Charles Goodhart’s “The Basel Committee on Banking Supervision: A History of the early years 1974-1997” 2012, Cambridge Press Goodman (p.167) refers to Steven Solomon’s The Confidence Game (1995), and 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…

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 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.”

And that, as far as I am concerned, could be the opening scene for a Mission Impossible or Bond movie, describing the actions of terrorists wanting to destroy the world’s economies. 

Of course it was just dumb arrogant technocrats going abour their business of solely thinking about how banks could avoid failure, without giving even the slightest consideration to the possibility that when doing so they could dangerously distort the allocation of bank credit to the real economy.

The buckets with riskweights of 100%, 50% 25% 0%, and if the capital standard was set to 8 percent meant that a bank would be able to leverage its equity, and the implicit support of society, 12.5, 25, 50 and ∞ times to one respectively with the assets in each bucket.

That meant banks would earn higher risk adjusted returns on equity on assets in those buckets they could leverage more. And that meant that the net of risk margins offered by The Risky to the banks were worth less than the same margins offered by The Safe.

And what was also clear to these “statist conspirators”, was that the risk weight for the private sector would be 100% while that of their governments would be zero.

All in all that night the diners decided the Western World had had enough of risktaking and so the banks should stop giving credit to the riskier future and concentrate on refinancing the safer past.

You might argue that regulators did not force banks to do anything, but that would be to ignore that out there in the real world any bank that earns less risk adjusted returns on equity than other banks will, sooner or later, be eaten up.

And the baby conceived that night was born 21 months later in November 1988 and named the Basel Accord or Basel I. And that baby grew up to be a real monster in 2004, when it turned into Basel II.

And because of this financial terrorism act, millions of small loans to SMEs and entreprenuers that would otherwise have been awarded have now been denied. 

And with that the possibility of creating the new jobs that could substitute for the disappearing ones were greatly diminished.

And by so denying those in lack of capital the opportunities to access bank credit, inequality got a strong boost.

And, ridicously, all for nothing, since major bank crises never ever result from excessive exposures to what is ex ante perceived as risky.