IMF, the Basel Committee’s procyclical risk weighted capital requirements puts financial cycles, global or local, on steroids

This year’s IMF Jacques Polak Annual Research Conference on November 2–3 is titled “The Global Financial Cycle.” 

It aims to bring together contributions by leading experts on the topic—from both within and outside the IMF—to improve the “understanding of a range of issues, including the causes and consequences of the global financial cycle, the transmission channels of global financial shocks, and the role of domestic policies in dampening the impact of global shocks.”

I wonder if, again, for the umpteenth time, the distortions produced by risk weighted capital requirements in the allocation of credit to the real economy will be ignored.

The following is the comment I posted on the IMF Blog

Risk weighted capital requirements, more risk more capital – less risk less capital, allows banks to earn much higher risk adjusted returns on equity with what is perceived decreed or concocted as safe, than on what is perceived as risky. 

That pushes more than ordinary the financial pursuit of “the safe” and the avoidance of “the risky”.

That de facto puts financial cycles, whether global or local, on steroids.

Will this comment be considered? I have not seen much action on the one I made last year.

PS. I have now read all the papers presented in the conference and the only one that makes somewhat of a reference to risk weighted capital requirements, is “Global financial cycles and risk premiums?” authored by Oscar Jorda, Moritz Schularick, Alan M. Taylor and Felix Ward, October 2017

It includes “If banks hold foreign assets on their balance sheets and mark them to market, price changes can synchronize the risk appetite and the trading behavior of banks around the world. For instance, if Federal Reserve policy affects U.S. equity prices, falling asset prices in the U.S. decrease (risk-weighted)-asset-capital ratios of U.S. as well as international banks, which start to cut down their risk-taking in sync with U.S. banks.

If no large risk-neutral player steps in to compensate for the lower risk taking of the leverage-constrained intermediaries, risk-spreads will increase.”

But as one can see that is how financial cycles or event affect “(risk-weighted)-asset-capital ratios”, but not how these risk weighted capital requirements affect the financial cycles.

For instance Greece would never ever have been able to obtain so much debt had it not been for the ridiculous low capital requirements on that debt.

Olivier Blanchard agrees there is a need for more research on whether bank regulations have distorted

In the IMF’s Annual Research Conference during the final Economic Forum: Policy challenge after the Great Recession I had the chance to pose Olivier Blanchard a question session of Professor Lawrence Summers Mundell Fleming Lecture I had a chance the pose a question (1:01:10)

My Question: 

I might insist here briefly on a point: Why do you say that interest rates on public debt are low, when they are based on so much of regulatory subsidies? Add to the zero low rates of the public debt, all those costs that comes from not giving SMEs and entrepreneurs, millions of them, the chances for credit, only as a result of the distortions produced by risk weighted capital requirements for banks.

Olivier Blanchard answer: 

This is a theme that you have explored over the years. You are absolutely right that the answer is: if the very low safe rates is due to distortions, then the first order of business, should be to eliminate the distortions.

That’s true, if your right, of regulations, but it may be true of the lack of social insurance in some countries which leads people to basically be willing to save enormous amounts that they should not be saving, it could also be true because of missing markets. 

For all this reason you are absolutely right, step zero in what I say, lets make sure that we have removed all the distortions which we can, which affect r (rates), so we have the right r. I take your point.

My afterthoughts: 

I sure appreciate Olivier Blanchard's acceptance of the relevance of my concerns, its been a long trip. In 2004 in a letter published by the Financial Times I wrote “How many Basel propositions will it take before they start realizing the damage they are doing by favoring so much bank lending to the public sector?" 

And I hope the research on it starts now, not only by the IMF. It is long overdue. In fact the possible distortions should have been analyzed before these regulations were imposed.

PS. The day earlier I had posed Professor Lawrence Summers a similar question

PS. Here’s my recent, 2019, comments sent to the Financial Stability Board

PS. Here’s my recent, 2019, letter sent to the IMF

 

To the moral hazard of government guarantees, you should add any regulatory distortion hazard.

Because of current risk weighted capital requirements for banks, banks are allowed to leverage any government guarantees more with assets ex ante perceived, decreed or concocted as safe, than with assets ex ante perceived as risky.

So when government guarantees are awarded when this regulation is imposed on banks, something which clearly distorts the allocation of bank credit to the real economy, then you have to increase the moral hazard with the regulatory distortion hazard.

Professor Summers, fixing potholes using 0% public debt will not fix America. Don’t put the cart before the horse.

Professor Larry Summers, and many others with him, promote the idea that the government in America (and other governments too) should take advantage of the extraordinarily low interest rates on public debt, in order to finance new infrastructure and the maintenance of old.

Briefly their calculation is as follows: If government takes on debt at 0% and invest it in infrastructure projects that renders a 5% economic return, then the government, with a 30% tax on that, will have earned a net 1.5%... and we can all live happily ever-after.

NO! First, even if the government nominally pays 0% on its debt, that does not mean that debt has a zero cost. To begin with we should have to add the cost of all those giving up (cheated out of) some long term decent earnings on their saving, in order to finance the government for free. But, even more importantly, those zero or low rates are not free and clear market rates, but rates that are non-transparently subsidized by regulations.

In 1988, with the Basel Accord, Basel I; for the purpose of calculating the risk weighted capital requirements for banks, the regulators decided that the risk-weight for the sovereign was 0%, while that of We the People was 100%. And those risk-weights are still in full force.

I cannot say how much of the low interest rates on public debts are explained by this regulatory distortion, but it sure has to be quite a lot.

I have lately seen Professor Summers, and Lord Adair Turner, showing these rates trending down for the last 30 years. Unfortunately for reasons that are beyond my grasp, they have not been able to see a connection between this and 1988’s bank regulations.

But I do know that piece of egregious regulation, introduced such distortions in the allocation of bank credit that, worldwide, millions of SMEs and entrepreneurs have been negated the opportunities   provided by access to bank credit. That is a real huge cost that should be added to the nominal 0% rate. In other words the rates on public debt are the nominal rates, plus the economic and human costs of the distortions.

Since because of this regulatory risk aversion (even in the Home of the Brave) the economies are stalling and falling. So in this respect one could argue that in reality, never ever before have the interest rates on public debt been as high.

Which also leads me to my second objection, that of “infrastructure projects rendering a 5% economic return”. The final real return of any infrastructure project is a function of how it meets the needs of the economy, and of the state of the economy. If regulatory distortions impede the growth of the economy, those infrastructure projects, even if perfectly carried out, even if financed at 0%, might really turn out to provide a negative return.

Professor Summer, let us, very carefully, get rid of those regulatory distortions so that the banks of America, and those of the world, can return to the normality that was so rudely interrupted by regulatory hubris and statism in 1988. That would allow infrastructure to be financed by governments out of real economic growth, something that would then certainly even justify having to pay much higher nominal interest rates than now.

Please don’t put the cart before the horse! Don’t refuse “the risky” the opportunities to access bank credit only because they are risky. Our economies were all built on risk-taking, even when some of it was not adequately reasoned.

To lay on regulatory risk aversion on top of bankers natural risk-aversion, is an insult to intelligence and human wisdom.

God make us daring!

All economic research that has not controlled for the distortions produced by bank regulations could be worthless.

In 1988 with the Basel Accord the concept of risk-weighted capital requirements for banks was introduced. The first decision: Zero percent risk weight for sovereigns and 100 percent for private sector.

In June 2004 Basel II introduced risk weights for the private sector of 20 percent for the AAA-AA rated, 50 percent for the A+ to A rated, 150 percent risk weight for those rated below BB-, and 100 percent for all others.

That meant that the risk-adjusted returns on banks equity would not only depend on the risks of the assets, but also on the regulatory capital requirements for those assets.

Therefore, all economic research that should but that has not controlled for the serious distortions in the allocation of bank credit to the real economy these regulations produce, could be worthless.