Monday, April 30, 2018

Which business cycle would you prefer?

There is one business cycle during which the capital requirements for banks against all assets are the same. 

And so banks offer, the risky and the safe, credit based on the size of exposure and the net margin adjusted for risk. 

Sooner or later because of unforeseen events, criminal behavior, or excessive exposures to what was ex ante perceived as safe but that ex post turned out risky, there will be a bank crisis, everyone will hurt, and the economy will suffer a set back. 

Hopefully, usually, the net economic gain, since this business cycle started, will anyhow be positive.


Now there is another business cycle, like the current one, during which the capital requirements for banks are risk-weighted… more ex ante perceived risk more capital – less ex ante perceived risk less capital.

And so banks then offer, the risky and the safe, credit based on the size of exposure the net margin adjusted for risk and the allowed leverage resulting from the capital that is required.

Sooner or later because of unforeseen events, criminal behavior, or excessive exposures to what was ex ante perceived as safe but that ex post turned out risky, there will be a bank crisis, and everyone will hurt. 

But this crisis could be so much worse because the exposures to what is perceived as safe, those which therefore contain more dangerous fatter tail risks, will be so much higher, and will be held against especially little capital. 

And because most credit financed the safer present, creating a reverse mortgage on it, and way too little financed the risky future, the economy might suffer a set back that puts it much worse off than when this business cycle got started.


Unfortunately the difference in the business cycles bank regulations can cause, is rarely discussed.