Saturday, July 30, 2016
The Economist refers to Hyman Minsky’s important “financial instability hypothesis”, but concludes that it “would be a stretch to see that hypothesis becoming a new foundation for economic theory, “Minsky’s moment” July 30, 2016
That might be, but it should become an essential foundation of financial regulations because, by ignoring it, with the risk weighted capital requirements for banks, the regulators set the “boom that can sow the seeds of busts” on steroids.
Normally, without distortions, bank credit should be allocated to whoever offers the highest perceived risk adjusted rate. That of course might quite often not be true, because “a safe” can be riskier or safer than what it is perceived; just llke “a risky, could equally be safer or riskier.
But, when regulators decided banks needed to hold less capital against what was perceived, decreed or concocted as safe, than against what was perceived as risky, they dramatically distorted the allocation of bank credit to the real economy.
Suddenly the booms of what was perceived as safe got a tremendous boost, as banks could earn higher risk adjusted rates there; all while “the risky” saw their access to bank credit severely curtailed.
We only need to go the crisis of 2007-08 to see that what caused it, was all which had very low capital requirements because it was perceived as safe when placed on the bank’s balance sheets.
And of course, the power of those regulatory steroids, was further strengthen by the fact that so much decision power, over deciding what was safe and what was risky, was placed in the hands of some very few human fallible credit rating agencies.
PS. I was just a consultant from a developing country who happened to end up on the Board of the World Bank as an Executive Director, and so I can of course not aspire, by far, to receive the same attention as Hyman Minsky, but you might anyhow be interested in what were my very early opinions on these issues
PS. And here is my most recent aide memoire on what is monstrously wrong with Basel Committee’s regulations.