Friday, July 7, 2017

How the Western civilization is being lost because of regulatory induced risk aversion.

Mark Twain has been attributed opining that bankers lend you the umbrella when the sun shines and want it back as soon as it looks it could rain.

And never ever has there been a bank crisis caused by excessive exposures to something perceived as risky when placed on banks’ balance sheets.

But that did not stop scared lack of testosterone bank nannies to also require banks to hold more equity when lending to the risky than when lending to the “safe”.

So what happened? 

As banks earned much higher risk adjusted returns on the safe they could not resist the AAA rated securities backed with mortgages to the subprime sector, or sovereigns like Greece. And so a typical bank crisis, that of excessive exposures to what was ex-ante perceived as safe but that ex post turned out very risky ensued. 

In this case the crisis was made specifically worse, by means of the lower equity banks had been authorized to maintain. For example in the case of the AAA rated securities, Basel II, because of the standardized risk weights, banks were required to only hold 1.6% in capital, meaning an authorized leverage of 62.5 to 1. 

But much worse, since banks of course find it harder to earn higher risk adjusted ROEs on more capital, they have abandoned lending to risky SMEs and entrepreneurs, those who open up new roads on the margins of our economy, and so of course slower economic growth results.

Lack of testosterone, risk aversion, is not a fundamental value of the Western civilization. On the contrary in churches we sometimes sang, or at least used to sing, “God make us daring!