Wednesday, March 8, 2017

“You’re crazy!” That’s what John K. Galbraith would have said; about Basel’s risk weighted capital requirements for banks

I quote from John Kenneth Galbraith’s “Money: Whence it came where it went” 1975.

“For the new parts of the country [USA’s West]… there was the right to create banks at will and therewith the notes and deposits that resulted from their loans…[if] the bank failed…someone was left holding the worthless notes… but some borrowers from this bank were now in business...[jobs created] 

The function of credit in a simple society is, in fact, remarkably egalitarian. It allows the man with energy and no money to participate in the economy more or less on a par with the man who has capital of his own. And the more casual the conditions under which credit is granted and hence the more impecunious those accommodated, the more egalitarian credit is… Bad banks, unlike good, loaned to the poor risk, which is another name for the poor man.”

[But that] was an arrangement which reputable bankers and merchants in the East viewed with extreme distaste… Men of economic wisdom, then as later expressing the views of the reputable business community, spoke of the anarchy of unstable banking… The men of wisdom missed the point. The anarchy served the frontier far better than a more orderly system that kept a tight hand on credit would have done…. what is called sound economics is very often what mirrors the needs of the respectfully affluent.”

So, on behalf of "the men of wisdom", in came the Basel Committee for Banking Supervision. With Basel I 1988, and Basel II 2004, it told bankers that even when they already consider perceived risk when setting interest rates and deciding on the amount of exposures, they also had to consider the perceived risks for how much capital their banks needed to hold.

In other words bank regulators ordered the banking system to double down on ex ante perceived, (decreed or concocted) risks.

For a while, while bankers were exploiting all the opportunities of being able to mind-boggling leverage their equity with what was thought safe (a banker’s wet dream come true) all seemed fine and dandy. 

The immense growth of bank credit (later followed up with QEs) injected tremendous amount of liquidity into the economy… all until some safe havens, like AAA rated securities and Greece, in 2007/08 became dangerously overpopulated and burst.

One should think the “men of wisdom” would have updated their wisdom, but no!

“The risky”, like SMEs and entrepreneurs, still have to compete with “The Safe” for access to bank credit while carrying the burden of generating larger capital requirements for the banks… while “the safe” havens run the risk of being dangerously overpopulated.

I have no doubt John Kenneth Galbraith, if alive, would say: “You’re crazy!”

My 1997 Puritanism in banking