Tuesday, May 16, 2017

Why are excessive bank exposures to what’s perceived safe considered as excessive risk-taking when disaster strikes?


In terms of risk perceptions there are four basic possible outcomes:

1. What was perceived as safe and that turned out safe.

2. What was perceived as safe but that turned out risky. 

3. What was perceived as risky and that turned out risky.

4. What was perceived as risky but that turned out safe.

Of these outcomes only number 2 is truly dangerous for the bank systems, as it is only with assets perceived as safe that banks in general build up those large exposures that could spell disaster if they turn out to be risky.

So any sensible bank regulator should care more about what the banks ex ante perceive as safe than with what they perceive as risky.

That they did not! With their risk weighted capital requirements, more perceived risk more capital – less risk less capital, the regulators guaranteed that when crisis broke out bank would be standing there especially naked in terms of capital. 

One problem is that when exposures to something considered as safe turn out risky, which indicates a mistake has been made, too many have incentives to erase from everyones memory that fact of it having been perceived as safe.

Just look at the last 2007/08 crisis. Even though it was 100% the result of excessive exposures to something perceived as very safe (AAA rated MBS), or to something decreed by regulators as very safe (sovereigns, Greece) 99.99% of all explanations for that crisis put it down to excessive risk-taking.

For Europe that miss-definition of the origin of the crisis, impedes it to find the way out of it. That only opens up ample room for northern and southern Europe to blame each other instead.

The truth is that Europe could disintegrate because of bank regulators doing all they can to avoid being blamed for their mistakes.

Sunday, May 7, 2017

The insidious credit distorting risk weighted bank capital requirements’ tax, crosses the Laffer Curve at point zero

The Laffer Curve indicates at what rate, a tax will produce less tax revenues for the government.

For purposes of setting the capital requirements for banks in 1988 (Basel Accord) the regulators introduced the risk weighing of banks’ assets. And they decided that loans to the sovereign carried a 0% risk weight, while loans to the citizens (SMEs and entrepreneurs) 100%. 

That means banks need to hold less capital (meaning equity) against loans to the sovereign (meaning government) than against loans to citizens.

That means banks can leverage more their equity with the market risk adjusted interest rates for loans to the sovereign than with the market risk adjusted interest rates for loans to the citizens; which means sovereign will have more and cheaper access to bank loans, a regulatory subsidy, paid by lesser and more expensive access to bank credit for the private sector, a regulatory tax.

That de facto signifies that regulators believe government bureaucrats can make better use of bank credit than the private sector, something that is not true. 

As a consequence of this regulatory distortion, bank credit will not be allocated efficiently to the economy; and so the economy will grow less; and so the tax intake will be smaller; and so the Laffer curve has immediately been crossed. 

Of course, if the current generation does not care about falling tax revenues being compensated with higher debts to be repaid by grandchildren, then this is a moot issue.

PS. Of course all other favoring, like a 20% risk weight for the AAA-risktocracy and 35% for residential housing also to misallocate credit... and thereby cause less ordinary tax revenues. 

PS. Of course, sadly, nothing is gained in term of stability, as never ever do major bank crisis result from excessive exposures to something perceived risky. These results from excessive exposures to something perceived safe, like sovereigns like Greece, like AAA rated securities.