It is prudent for our banks to take risks on the not so creditworthy, especially if these are up to something worthy

In a recent article in the Financial Times a bank was mentioned to be “an exemplar of prudence…[because] The target loan loss ratio is zero; [and] low loan losses, in turn, allow the bank to offer competitively priced loans and personalized service to creditworthy customers.”

To me that points clearly to what’s wrong with banks nowadays. “A target loan loss ratio of zero”… might allow “to offer competitively priced to creditworthy customers” but it will clearly not offer sufficient opportunities of credit to the not so creditworthy, those which includes too many risky SMEs and entrepreneurs, but also that could help provide the proteins the economy needs to move forward, in order not to stall and fall.

And the real truth is that, in the medium and long term, the creditworthy could benefit much more by banks taking much more risks on the not creditworthy, especially if these seem to be up to something worthy, than by they just getting low priced loans.

And if to the “zero loss loan target” you then add the distortion in the allocation of bank credit caused by the risk weighted capital requirements for banks, you might get a feel for why our economies seem to stagnate. 

Those regulations require the banks to hold more equity when lending to someone perceived risky, than when lending to someone perceived safe. And so that results in banks earning higher expected risk adjusted returns on equity when lending to someone perceived, decreed or concocted as safe, than when lending to someone perceived as risky. And that signifies that, around the world, millions of “risky” SMEs and entrepreneurs are not given the opportunity they might deserve and we might need for them to get.

As is, the banking system no longer finances the “riskier” future but only refinances the “safer” past, and that is as imprudent as can be, at least for our grandchildren.

Those bankers who with reasoned audacity take chances on the future are good servants of the society. Those who only maximize return on equity by diminishing the required capital and avoiding risks are, in the best of cases, absolutely boring.

And don’t get me wrong; I do not want to endanger our banking system, it is just the opposite. The forgotten truth is that major bank crises never ever result from banks building up excessive exposures to what ex ante is perceived as risky, it is not in the nature of bankers, as Mark Twain explained in terms of sun, rain and umbrellas.

The big crises always result from unexpected event of because of excessive exposures to something erroneously considered as safe.

PS. With their risk weighted capital requirements the regulators decreed inequality.

The deforestation of the economy leads to flooding and to its dangerous desertification

Through “Learning with dogs” I was recently made aware of an article by George Monbiot, titled “Drowning in Money”, written on the subject of “The hidden and remarkable story of why devastating floods keep happening”, published in The Guardian, 14th January 2014. 

It refers to “a major research programme, which produced the following astonishing results: water sinks into the soil under the trees at 67 times the rate at which it sinks into the soil under the grass. The roots of the trees provide channels down which the water flows, deep into the ground. The soil there becomes a sponge, a reservoir which sucks up water then releases it slowly. In the pastures, by contrast, the small sharp hooves of the sheep puddle the ground, making it almost impermeable: a hard pan off which the rain gushes.

And, writes Monbiot: “here we start to approach the nub of the problem – there is an unbreakable rule laid down by the Common Agricultural Policy. If you want to receive your single farm payment – by the far biggest component of farm subsidies – that land has to be free from what it calls ‘unwanted vegetation’ Land covered by trees is not eligible. The subsidy rules have enforced the mass clearance of vegetation from the hills.” And, consequently, there is much dangerous flooding.

I immediately identified with the problem. For more than 15 years I have argued that medium and small businesses, entrepreneurs and start ups, constitute the most important root system that allows the economy to grow muscular, and not just obese. 

But, the regulators in the Basel Committee, with their utterly senseless risk-weighted capital requirements for banks, denied fair access to bank credit to these vital trees of the economy, only because these are perceived as risky. The consequence is that the economy turns into a paved parking lot where most rain just flows out to the sea without nurturing the economy. And it also guarantees that, when any AAA-rated levee breaks, true disaster will ensue.

Banks are there to fulfill an extremely important function of efficiently allocating credit in the real economy, and not simply to survive. But that was of no importance for regulators who, so fixated on keeping banks from failing, are not even considered the need for pruning.

In UK the Prudential Regulation Authority (PRA) is responsible for the supervision of banks, and its role is defined in terms promoting the safety and soundness of these. There is not one single reference to promoting the safety and soundness of the real economy, though nothing can be so dangerous for the long term prospects of an economy than an excess of prudence. 

If the UK, like most other economies, wants to avoid being dragged down in the death spiral of excessive risk aversion, it better starts thinking more in terms of an authority that understands the need for trees, perhaps about a Reasoned Audacity Regulation Authority.

“Reasoned Audacity”

There, in “Berthe Morisot, or, reasoned audacity”, a book published by the Denis and Annie Rouart Foundation and the Marmottan Monet Museum (2005), is where I first saw the term “reasoned audacity”. And it took the breath out of  me, as did, of course, Edouard Manet’s portrait of his sister in law. 

Yes, absolutely, that´s it, I said to myself. If I was a regulator, “reasoned audacity” is what I would try to inspire the banks with, and not with the dysfunctional unreasonable risk-aversion current regulators are imposing, with their mindless capital requirements for banks based on perceived risks.

God make us daring!