Can you have a neutral interest rate when bank regulations are not neutral?

That theoretical interest rate that neither pushes nor restrains the economy from its natural rhythm of growth, is called the neutral interest rate, and is of course the subject of much interest by central bankers.

But what these bankers never discuss, who knows why, is what happens to this neutral interest rate, if bank regulations are not neutral.

Current risk weighted capital requirements for banks which allow banks to earn higher risk adjusted returns on equity with what is perceived, decreed or concocted as safe, than with what is perceived as risky, are clearly not neutral.

They push bank credit to the “safe” areas and away from the “risky” and that distortion must have a real cost for the economy.

Just for a starter, since the risk-weight assigned to the sovereign is 0%, all those “risky” SMEs and entrepreneurs who will not get credit or need to pay more for it, only because of these regulations that are biased against them, are paying a regulatory tax that is directly subsidizing lower interest rates for the government.

As I have argued many times before… we do not have real risk-free rates, we have subsidized risk-free interest rates.

IMF: The “I scratch your back if you scratch my back” crony statism deal between sovereigns and banks, must stop.

In 1988, with the Basel Accord, Basel I, for the purpose of capital requirements for banks, regulators assigned to the sovereigns a risk weight of 0%, while citizens got one of 100%.

That meant banks would be able to leverage more their capital when lending to sovereigns than when lending to citizens. 

That meant banks would be able to earn higher expected risk adjusted returns on equity when lending to sovereigns than when lending to citizens. 

That meant that banks would lend more and at lower rates than usual to sovereigns and in relative terms less and at higher rates than usual to citizens.

That de facto established the Sovereign-Bank Nexus. I Sovereign help to guarantee you banks, and you help to finance me abundantly and cheap.

IMF, in its Global Financial Stability Report 2017, page 36 and 37 have a section titled “The Sovereign-Bank Nexus could reemerge”. It correctly spells out how banks can be affected by difficulties of sovereigns and how sovereigns can be affected by difficulties of banks. 

But it makes absolutely no reference to the regulatory support of the Sovereign-Bank Nexus previously described. Why?

That runaway statism must stop!

IMF, Basel Committee for Banking Supervision: Don’t tell me you do not know who did the Eurozone in?

PS. November 2016 Olivier Blanchard agreed on that there was a need to research the distortions produced by these regulations. Has that started?

FSB’s Mark Carney is no one to lecture us on inequality, lack of opportunities and intergenerational divide

Mark Carney, the Governor of the Bank of England, in a speech titled “The Spectre of Monetarism” December 5, 2016 said: 

“For both income and wealth, some of the most significant shifts have happened across generations. A typical millennial earned £8,000 less during their twenties than their predecessors. Since 2007, those over 60 have seen their incomes rise at five times the rate of the population as a whole. Moreover, rising real house prices between the mid-1990s and the late 2000s have created a growing disparity between older homeowners and younger renters...  At the same time as these intergenerational divides are emerging, evidence suggests that equality of opportunity in the UK remains disturbingly low, potentially reinforcing cultural and economic divides.”

But Mark Carney is also the current Chairman of G20’s Financial Stability Board and, as such, one of the primarily responsible for current bank regulations… the pillar of which is the risk weighted capital requirements for banks.

That piece of regulation decrees inequality resulting from negating “the risky”, like SMEs and entrepreneurs fair access to bank credit. 

That piece of regulation favors the financing of “safe” basements where jobless kids can stay with their parents over “riskier” ventures that could provide the kids in the future the jobs, so that they had a chance to become responsible parents too.

That piece of regulations is a violation of that holy intergenerational bond Edmund Burke spoke about.

Carney also said: “Higher uncertainty has contributed to what psychologists call an affect heuristic amongst households, businesses and investors. Put simply, long after the original trigger becomes remote, perceptions endure, affecting risk perceptions and economic behaviour. Just like those who lived through the Great Depression, people appear more cautious about the future and more reluctant to take irreversible decisions. That means less willingness to put capital to work and, ultimately, lower growth.”

If any have suffered form “affect heuristic” that is the bank regulators. Mixing up ex ante perceptions with ex post possibilities, these decided on “more risk more capital – less risk less capital”, without: defining the purpose of banks “A ship in harbor is safe, but that is not what ships are for.” John A Shedd; or looking at what has caused bank crises in the past “May God defend me from my friends, I can defend myself from my enemies” Voltaire

Mark Carney also said “For two-and-a-half centuries, the prices of government bonds and the prices of equities tended to move together: the typical bull market entails rising equity prices and falling bond yields, with the reverse in bear markets. Since the mid-2000s, however, this pattern has reversed and bond yields have tended to fall along with equity prices”.

He is not able to connect that to the fact the risk weight given to sovereign debt is 0%, as compared to one of 100% for We the People… and that capital scarce banks therefore shed “riskier” assets in favor of public debt. As statist, Carney also ignores the fact that regulation has subsidized public borrowings, paid of course by negating credit opportunities to SMEs and entrepreneurs.

Must one go on a hunger strike in order to get some contestability from the Basel Committee or the Financial Stability Board?

Perhaps I did not understand all Professor Lawrence Summers answered me at IMF, but he might have understood less of what I asked/argued.

In the IMF’s Annual Research Conference at the end of Professor Lawrence Summers' Mundell Fleming Lecture I had a chance the pose a question (1:18:25)

Here is the short explanation for my question:

Suppose banks believe that a 10% return on equity to shareholder’s resulting from lending to the sovereign is, in terms of risk, equivalent to a 25% return derived from a diversified portfolio of loans to SMEs.

Then if banks held on average 10% in equity, meaning a leverage of 10 to 1, banks would have to earn about 1% in net margins on sovereigns and on average 2.5% to SMEs to produce those desired ROEs.

But, then suppose that banks were told by regulators that though they must hold the usual 10% of equity against SME loans, they were now allowed to lend to the sovereign holding only 5% in equity, meaning an authorized 20 to 1 leverage. Then banks could produce that 10% ROE on equity by obtaining only a .5% net margin on sovereign loans. That would clearly but downward pressure on the interest rates paid on public debt.

And in 1988, with the Basel Accord, the regulators decided that the risk weight for the sovereign was 0% and that of SMEs 100%... meaning banks were allowed to leverage equity immensely more with public debt than with loans to the private sector.

My question: Professor Summers, today you showed a graph that showed the risk free rate going down over the last 30 years, the risk free rate based on the proxy of public debt of course. And Lord Turner also recently showed that same trend. And it started around 1989/90. Can that not have anything to do with the very clear evidence that in 1988 the Basel Accord decided that for purposes of the risk weighted capital requirements for banks, the risk weight of the public sector, of the sovereign was 0%, and the risk weight for us, we the people, 100% 

Professor Summers' answer: Could it have anything to do with it? Yes it could have something to do with it. 

Notice that your explanation is in the category of Ricardo Caballero’s explanation. Its in the category of something has happened that has shifted the relative demand for government bonds versus other things.

And my argument is that, if that were true, what you would expect to see as the major counterpart to the decline in government rates is a major increase in risk premiums. And the fact is that I think is closer to right, a better first approximation I believe, to assume that risk premiums have been relative constant, or not long term trending, and that real rates have declined, than it is to believe that risk premiums have been long term trending.

And therefore I prefer the saving and investment based explanations, rather than the asset specific explanations of the kind that Ricardo adduces, or of the kind you suggest.

My afterthoughts: 

How is it possible to hold that such in favor of the public sector distorting bank regulations, would not have “shifted the relative demand for government bonds versus other things”?

How is it possible, like Professor Summer does, to use the “artificially low public sector debt rates”, as a justification of putting more financial resources in hands of government bureaucrats, to build infrastructure, than in the hands of the private sector’s SMEs and entrepreneurs?

PS. The day after, I got a much more straightforward answer from Mr. Olivier Blanchard.
PS. Here’s my recent, 2019, comments sent to the Financial Stability Board
PS. Here’s my recent, 2019, letter sent to the IMF

Bank regulations also flatter the fiscal accounts... too much

Claudio Boro, in a very useful and interesting presentation at IMF’s “Rethinking Macro Policy II” forum, mentioned the concept of how financial cycles, during their peak, could so dangerously be flattering the fiscal accounts. 

Indeed, but perhaps what flatters the fiscal accounts even more, are bank regulations, like Basel II, which so extremely flattering assigns a 0 to 20 percent risk-weights to "infallible" sovereigns, allowing the banks to lend to these against zero to 1.6 percent in capital which translates into a mindboggling 62.5 to 1 and up to infinity authorized leverage. 

That translates into much lower borrowing rates for the sovereign (mostly paid by higher borrowing rates for the rest) and as a by product produces what I term as subsidized proxies of risk-free rates.

My comments for IMF's revision of its "Code of Good Practices on Fiscal Transparency"

Washington, February 4, 2013

International Monetary Fund

Dear Sirs,

You hold that “Fiscal transparency – defined as the clarity, reliability, timeliness, and relevance of public fiscal reporting and the openness to the public of government’s fiscal policy-making process - is a critical element of effective fiscal policymaking and risk management. Without comprehensive, reliable and timely fiscal information, governments cannot understand the fiscal risks they face or make good budget decisions. If citizens don’t have access to this information, they cannot hold governments accountable for those decisions.”

And the IMF, now seeking comments for the revision of its Code of Good Practices on Fiscal Transparency and related instruments specifically asks:

“Does the Code adequately address all of the most important aspects of fiscal transparency? What practices should be dropped? What practices should be added? Which practices should be updated to reflect recent developments in fiscal reporting standards and practices or the lessons learned from the crisis?”

In this respect I would submit that any “Good Practice on Fiscal Transparency” should also look to identify the presence of any hidden subsidies and or taxes that might affect government’s fiscal affairs, and, if possible, provide estimates as to their significance.

Specifically I refer to the fact that current bank regulations require banks to hold much more capital against assets perceived as risky, like loans to small businesses and entrepreneurs, than for assets perceived as “absolutely safe”, like loans to “infallible sovereigns”.

This translates into that a bank can leverage its equity man y time more the dollars paid by “the infallible sovereign” in risk-adjusted interests, than the same risk-adjusted dollars paid by “the risky”.

That translates directly into a regulatory subsidy of the government’s bank borrowings, paid by “the risky bank borrowers” by means of higher interest rates, and paid by the society at large by means of the opportunity cost that might be present in allowing the public sector to borrow much easier and much cheaper than the “risky” private sector, than what would have been the case in the absence of this regulations.

That translates into giving banks incentives to dangerously overpopulated safe-havens, and equally dangerous for the real economy, under explore some more risky but perhaps more productive bays; something which of course introduces a distortion that makes it impossible for banks to perform their utterly important function of allocating economic resources efficiently.

That also translates into that one of the most important theoretical rates there is in finance, the risk-free rate, usually approximated by the rate to the “most infallible sovereign” is a subsidized rate and which of course makes it impossible for the government and the markets, to know where the real risk free rate is. In other words one of the fundamental instruments needed to navigate the economy gives wrong readings.

Since there are also sovereigns who are deemed not so infallible and so against their borrowings banks are required to hold more capital, this also translates into an effective global capital control that helps to channel funds away from what is ex-ante perceived as risky into what is ex ante perceived as infallible. In other words these capital controls only help to increase the existing gaps between “the risky developing” and the “infallible developed”.

In conclusion I ask of the IMF to try to estimate all the fiscal effects of what is described above, or to respond publicly why in IMF’s opinion my arguments might be wrong, or plain irrelevant.

Sincerely,

Per Kurowski

A former Executive Director at the World Bank (2002-2004)

The subsidized risk-free rate

A theoretical rate, and a major benchmark in the world of finance, is the one which is known as the "risk free rate". Of course, since nothing is completely free of risk, it is normal, as an approximation, to use as that the interest rate which country perceived to have the strongest economies need to pay in order to service their debt, for example the United States. 

But I argue that this "risk free rate" has been consciously or unconsciously (I pray for the latter) manipulated by the Basel Committee on Banking Supervision, the Committee which seeks to be the manager of all world’s banking risks. 

This committee came up with, and the imposed, capital requirements for banks which depend on the risk of the various assets, primarily as perceived by the credit rating agencies and to whom they outsourced much credit analysis. 

When doing so the committee completely ignored, consciously or without thinking (I pray for the latter) that the perceived risks were already considered by banks when setting the interest rates, the amount of the loans and all other terms, let us say of the numerator. Consequently, when the regulators decided the same perception of risks also needed to be reflected in the capital, let us say in the denominator, they condemned the entire banking system to overdose on perceived risk. 

And that has meant that all those who are perceived as being more risky, be they countries, companies or citizens, have to pay higher interest rates and receive smaller loans, than what would have been the case in the absence of these regulations. 

And so also that all who are perceived as less risky, like “solid” sovereigns and corporations with high credit ratings, will pay much lower interest rates and receive many more and larger loans, than what would have been the case in the absence of these regulations. 

And the above distorted and dislocated world economies more than you could believe. Not only did it encourage a dangerous overcrowding of all safe-havens, but also by dangerously ignoring that risk-taking is the oxygen of any development, and that the "absolutely not risky "of today, were almost always the "risky" of yesterday. 

And this means that the "risk free rate" which we today observe in the market, is actually the "risk-free rate less the value of the Basel Committee’s regulatory subsidy”. 

And this means that the flight instruments which the markets and the central banks in the world use, simply do not give correct readings. 

How is this possible? "One has to belong to the intelligentsia to believe things like that: no ordinary man would be such a fool" George Orwell, Notes on Nationalism, 1945. 

Or, as Patrick Moynihan would have explained it: "There are some mistakes it takes a Ph.D. to make”

Translated from El Universal 

Here in Spanish http://bombaaaa.blogspot.com/2013/01/la-subsidiada-tasa-libre-de-riesgo.html

PS. https://subprimeregulations.blogspot.com/2015/07/the-financial-stability-board-makes.html
PS. https://subprimeregulations.blogspot.com/2016/10/since-bank-regulators-in-1988-decreed.html
PS. https://subprimeregulations.blogspot.com/2016/11/olivier-blanchard-agrees-there-is-need.html

PS. http://perkurowski.blogspot.com/2019/09/financial-communism.html

In 2007, the Fed did not understand how markets were distorted by bank regulations. Do they now?

In the recently released transcript of a Conference Call of the Federal Open Market Committee on  August 10, 2007, on page 9, discussing the emerging financial crisis, we can read the President of the Federal Reserve Bank of Richmond, Mr Jeffrey M. Lacker declare the following: 

“Credit spreads are beyond our ability to peg or influence, and I don’t think we should go down the road of trying to do so” 

Amazing, there was no awareness of that by setting different capital requirements for banks, the bank regulators were already distorting the market appetite for different exposures and thereby the credit spreads. 

Seemingly they had no understanding that by requiring banks to hold only 1.6 percent in capital against securities rated AAA to AA, which implies an authorized bank equity leverage of 62.5 to 1 they had dramatically wetted the markets appetite for these securities. 

I wonder if they have ever discussed how much higher the interest rates on US Treasuries would be if banks had to hold as much capital against that asset, than what they need to hold when for instance lending to “risky” small businesses and entrepreneurs? 

I guess the Fed does not want to hear the truth, that with these regulations the regulators were artificially lowering, or subsidizing, the “risk-free” rate of the world.

Sincerely, in finance, manipulating something like the Libor rate, is chicken shit compared to unwittingly manipulating the risk-free-rate

Houston, we’ve got another problem: Our central bankers’ are flying blind

In February of 2011, Alan Greenspan gave the keynote address during an event at the Brookings Institution on “Reforming the Mortgage Market”. He ended his speech by expressing that he really would like to know what the real mortgage rates would be in the US, without any of those many distortions which affect it.

I got no chance to question him in public but at the end of the event I managed to ask him: 

“Mr. Greenspan, would you likewise not want to know what the most important interest rate in the market, the interest rate on US Treasuries would be without distortions?” 

He looked at me and asked “What do you mean?” I told him: “I mean that interest rate which would result if banks were required to hold as much capital when lending to the US Treasury as they are when lending to a US citizen, a small businesses or entrepreneurs.” I felt for a moment Greenspan nervously doubting, but then he answered “Yes, I would!” 

And that is one of the sad facts today. Central banks, in the US and Europe, are basically flying blind, because they have not the faintest idea about what their real Treasury rates would be without the regulatory subsidies in favor of public borrowings they have introduced. 

And then we hear so much nonsense about this being a great time for public indebtedness because rates are so low… Rates low? Has no one factored in all the opportunity costs for the economy and job creation of all those small businesses and entrepreneurs who did, and do still not have access to bank credit in competitive terms? 

PS. So, Houston, we sure have got ourselves another serious problem.

PS. Might someone at long last be waking up?