Saturday, November 12, 2016
In the IMF’s Annual Research Conference at the end of Professor Lawrence Summers' Mundell Fleming Lecture I had a chance the pose a question (1:18:25)
Here is the short explanation for my question:
Suppose banks believe that a 10% return on equity to shareholder’s resulting from lending to the sovereign is, in terms of risk, equivalent to a 25% return derived from a diversified portfolio of loans to SMEs.
Then if banks held on average 10% in equity, meaning a leverage of 10 to 1, banks would have to earn about 1% in net margins on sovereigns and on average 2.5% to SMEs to produce those desired ROEs.
But, then suppose that banks were told by regulators that though they must hold the usual 10% of equity against SME loans, they were now allowed to lend to the sovereign holding only 5% in equity, meaning an authorized 20 to 1 leverage. Then banks could produce that 10% ROE on equity by obtaining only a .5% net margin on sovereign loans. That would clearly but downward pressure on the interest rates paid on public debt.
And in 1988, with the Basel Accord, the regulators decided that the risk weight for the sovereign was 0% and that of SMEs 100... meaning banks were allowed to leverage equity immensely more with public debt than with loans to the private sector.
My question: Professor Summers, today you showed a graph that showed the risk free rate going down over the last 30 years, the risk free rate based on the proxy of public debt of course. And Lord Turner also recently showed that same trend. And it started around 1989/90. Can that not have anything to do with the very clear evidence that in 1988 the Basel Accord decided that for purposes of the risk weighted capital requirements for banks, the risk weight of the public sector, of the sovereign was 0%, and the risk weight for us, we the people, 100%
Professor Summers' answer: Could it have anything to do with it? Yes it could have something to do with it.
Notice that your explanation is in the category of Ricardo Caballero’s explanation. Its in the category of something has happened that has shifted the relative demand for government bonds versus other things.
And my argument is that, if that were true, what you would expect to see as the major counterpart to the decline in government rates is a major increase in risk premiums. And the fact is that I think is closer to right, a better first approximation I believe, to assume that risk premiums have been relative constant, or not long term trending, and that real rates have declined, than it is to believe that risk premiums have been long term trending.
And therefore I prefer the saving and investment based explanations, rather than the asset specific explanations of the kind that Ricardo adduces, or of the kind you suggest.
How is it possible to hold that such in favor of the public sector distorting bank regulations, would not have “shifted the relative demand for government bonds versus other things”?
How is it possible, like Professor Summer does, to use the “artificially low public sector debt rates”, as a justification of putting more financial resources in hands of government bureaucrats, to build infrastructure, than in the hands of the private sector’s SMEs and entrepreneurs?
PS. The day after, I got a much more straightforward answer from Mr. Olivier Blanchard.