This financial crisis did not disprove the efficient market hypothesis.

One of the most mentioned aspects about the current bank crisis is that in much it was a consequence of Alan Greenspan believing blindly in the efficient markets hypothesis, a hypothesis that became so thoroughly discredited.

Sorry… what efficient markets? With respect to the allocation of bank credit, the markets were completely distorted by the risk-weighted capital requirements, and so that hypothesis had no chance to be proven or disproven.

The capital requirements were and are much lower for what is perceived as absolutely safe, than for what is perceived as risky, and so the risk-adjusted returns on bank equity are much higher on assets perceived as absolutely safe than on assets perceived as safe.

In terms of the equity markets this would be something similar to the government multiplying the profits of investors, by paying them bonuses or similar subsidies, whenever they invested in shares with low volatility and not in shares with high volatility. Do you really think that would allow for an efficient market hypothesis to work free at its leisure?

I am not saying that the markets behave efficiently all the time but that, this time at least, it was clearly not the fault of markets, but the fault of dumb regulators.

PS. These comments were inspired by reading Chapter 1, "Primordial Seeds" in James Owen Weatherall's "The Physics of Wall Street" and which contains a fascinating description of the origins of the hypothesis and of its first and almost forgotten originator Louis Bachelier.

PS. I should acknowledge Tim Harford's arguments that though not the same do point in the same direction.

Could Thomas Piketty´s tax on 1% wealth, be a Trojan horse for Chrystia Freeland’s 0.01% Plutocrats to capture more wealth?

Today I heard at the World Bank Chrystia Freeland speak about her book “Plutocrats”... that I am now reading.

I asked her two question and some other remained unasked

First: Does the book analyze in any sort of depth, how much of Plutocrats wealth accumulation can be explained by intellectual property rights, patents? I ask this because I have argued that it is not good for capitalism, that the usually ample profits obtained under the protection of a patent (or the power of an extravagant market share) should be taxed at the same rate, than those more meager profits allowed by having to compete naked and unprotected in the market. And so the capital accumulation of “the protected” will be higher than that of “the unprotected”… with dire results in the long term.

Second: Since wealth accumulation by the Plutocrats are so often traced to market anomalies, known as rent-seeking and crony relations, could Thomas Piketty´s tax on the wealthy 1%, which he proposes in "Capital", be a Trojan horse for your 0.01% Plutocrats to increase the size of the cake that they are masters capturing?

One questions I did not have time to ask is… if you actually go after the wealth of the 1%, or even better that of the 0.01%, what would happen to their assets… who would be able to buy these? What would happen to the value of a $500 million Picasso? If it is the government, for instance by printing money, then we should be real careful because, as a Venezuelan, a country where 98% of all its exports goes straight into government coffers, I can guarantee you that government Plutocrats are much worse than the private Plutocrats who, at least for the time being, do not control all other powers.

The other question… or comment, will come later, in due time…because there is much which I do not agree with, in Freeland’s chapter on “Rent-seeking on Wall Street and in The City” and about which she already knows some. Basically it has to do with my vehement objection to the fact, so much ignored, that bank regulator’s pathological risk aversion, had them allowing banks to earn higher risk-adjusted returns on equity when lending to “the safe” than when lending to “the risky”. 

I do agree with her though that the Canadian bank regulator showed himself to be much wiser, by setting the capital requirements for banks more based on “the unexpected” than on “the expected”… that risk which should be taken care of directly by the banks.

PS. What a coincidence! Chrystia Freeland is the representative in the Canadian Parliament of where my Canadian grandchild lives. I informed Freeland that when my grandchild reached voting age, she could try to get her vote… and I would not object. Meanwhile, hands off, she is my constituency.

Who are the rent extractors and who the rent payers of current bank regulations?

The pillar of current bank regulations is capital requirements for banks based on perceived risk, a.k.a. risk-weights. The more risk the more capital the much less “risk” the much less capital. 

That means that the rent extractors are:

1. The bankers, whose dream of making high equity return on what is perceived as “absolutely safe” has come through… that is of course until they discover the ex ante perceptions were, ex post, wrong.

2. "The Infallible": the "sovereigns, the housing sector and the AAAristocracy; namely those who will have much more access, in much better terms, to bank credit.

And that means that the rent squeezed payers are:

1. "The Risky”: medium and small businesses, entrepreneurs and star ups, namely those who will have much less access and in much worse terms, to bank credit.

2. And of course all the unemployed youth who will find their possibilities in life to gain access to decent and sturdy jobs much reduced by this senseless regulatory risk aversion.

Imagine what much good some more “daring” bank regulations could do for the real economy.

Currently capital requirements for banks are much lower for exposures to what is perceived as “absolutely safe” than for what is perceived as “risky”. It may sound logical, but it is not.

That only helps banks to earn, for no good reason, much higher risk-adjusted returns on equity when lending to what is perceived as absolutely safe, than when lending to what is perceived as risky. And that only guarantees that when something ex ante perceived as absolutely safe, ex-post turns out to be absolutely risky, that banks will stand there holding humongous failed exposures against little or no capital.

Imagine instead if the capital requirements for banks were slightly lower for what is perceived as risky than for what is perceived as absolutely safe.

That would give the banks and all their extraordinary smart number crunchers the incentives to actively go out and look for opportunities in lending to the small and medium businesses, the entrepreneurs, the start-ups. Can you imagine what that could do to the dynamism of our real economy and the creation of jobs?

Yes I hear you “But would that not increase the risk for the banking system?” No! on two counts.

First, let us not forget we are talking here about exposures to what is perceived as “risky”, meaning Mark Twain’s banker unwillingly lending out the umbrella when it rains, and not about the truly potentially dangerous exposures to what is perceived as absolutely safe, meaning Mark Twain’s banker eagerly lending out the umbrella when the sun shines.

Second, let us not forget that there is nothing better to keep a banking system safe, than a healthy and sturdy real economy, and that no banks could survive, no matter how safe, if the real economy really comes tumbling down.

Friends, do not our young unemployed youngsters deserve some more daring bank regulations?

I sure think so.

What is the Basel Committee’s Stefan Ingves now saying, “risk-adjusted (regulatory) returns”?

Stefan Ingves, the Chairman of the Basel Committee in “Where to next? Priorities and themes for the Basel”, a speech delivered on March 12, in page 5 of transcripts, says: 

“The major reforms…that have been developed by the Committee…intended to generate a more resilient financial system, in which higher levels of capital and liquidity are held, and in which risk is appropriately managed and priced. This will obviously have consequences for the costs of financial intermediation, although studies undertaken suggest that this cost is both relatively small, and considerably outweighed by the benefits of increased financial stability. 

Nevertheless ... The Committee is mindful of two potential consequences from the programme of reforms. 

While a degree of deleveraging and increased risk premia are intended consequences of the reforms, there is always a danger that some unintended consequences may arise… 

A second potential consequence relates to the incentives that may arise as the banking sector adapts to the reforms by moving into those businesses where risk-adjusted (regulatory) returns are greatest. This reshaping of banking (either within bank balance sheets or outside the regulated banking system) needs to be monitored on an ongoing basis…” 

What Mr Ingves? “risk-adjusted (regulatory) returns”? This is the first time I read the Basel Committee admitting it is (hopefully unwittingly) distorting the markets, and thereby making it impossible for the banks to efficiently allocate economic resources.

It is not about banks arbitraging opportunities between bank balance sheets or outside the regulated banking system, something quite frequently discussed, but about arbitrating “within bank balances”. 

And so it is not about risk-adjusted bank returns, appropriately managed and priced, something perfectly natural, but about “risk-adjusted (regulatory) returns”. 

In other words, it is about the Basel Committee deciding about where banks can obtain higher or lower returns. 

In other words, as I have argued for a decade, it is not about the credits our banks give out being guided by the markets invisible hand, but by the Basel Committees invisible (and unaccountable) hand. 

Who the hell authorized you Basel Committee bureaucrats to do that? 

And then, “... studies undertaken suggest that this cost is both relatively small”. 

Basel Committee, I dare you to show those studies… If you think, like in Basel II, that authorizing banks to leverage 62.5 times to 1 when lending to a AAA rated client but only 12.5 to 1 when it is an unrated “risky” borrower, has only “relative small” effects on the interest rate that the unrated “risky” borrower has to pay in order to make up for the discrimination, you simply have no idea what you are talking about. 

And then “…this cost [is] considerably outweighed by the benefits of increased financial stability” 

Basel Committee, please, don’t mock us, what stability?