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

Banking before and after 1988

For about 600 years, before 1988, the exposures of banks to assets were a function of the by bankers ex-ante perceived risks (bpr), the risk premiums (rp), and bankers’ risk tolerance (brt) 

Pre 1988 Bank exposures = f (bpr, rp, brt)

Bank capital (equity) followed the rule of "One for all and all for one".

After 1998, Basel Accord, soon 30 years, with the introduction of the risk weighed capital requirements, the exposures of banks to assets are a function of the by bankers ex-ante perceived risks (bpr), the risk premiums (rp), bankers’ risk tolerance (brt), and regulatory capital requirements (rcc), this last itself a function of the by regulators ex-ante perceived (or decreed) risks (rpr) and the regulators' risk tolerance (rrt)

After 1988 Bank exposures = f (bpr, rp, brt, rcc=f (rpr, rrt))

Anyone thinking banking remained the same after 1988 is either naïve or dumb.

Anyone thinking the allocation of bank credit to the real economy was not distorted by this, is dumb.

Anyone thinking that distorting bank credit to the real economy is not something very risky, is either ignorant or a populist technocrat suffering from excessive hubris.

Anyone thinking that distorting bank exposures this way make banks safer, is an ignoramus who has no idea about what bank crises are made of: namely unexpected events, criminal doings and what was ex ante perceived as very safe but that ex post turned out very risky.

Anyone thinking this does not promote inequality has no idea of what the opportunity to bank credit does to fight it 

PS. With respect to the perceived risks, both the bankers’ and the regulators, let me remind you that any risk, even if perfectly perceived, causes the wrong actions if excessively considered; something here done by design.

Luckily credit rating agencies got it wrong and put a temporary stop on it. Otherwise we would have been much worse off

Few can really evidence having warned so much against the use of credit rating agencies in bank regulations, as I can. So I believe that should give me the right to dare to opine that the fact that the credit rating agencies got it wrong, was and is not the worst part of the current bank regulation horror story.

As for examples of the first, in January 2003 the Financial Times published a letter in which I wrote: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds. Friends, as it is, the world is tough enough.”

And, as an Executive Director of the World Bank, in April 2003, at its Board I formally stated: “Ages ago, when information was less available and moved at a slower pace, the market consisted of a myriad of individual agents acting on limited information basis. Nowadays, when information is just too voluminous and fast to handle, market or authorities have decided to delegate the evaluation of it into the hands of much fewer players such as the credit rating agencies. This will, almost by definition, introduce systemic risks in the market and we are already able to discern some of the victims, although they are just tips of the icebergs.”

And of course, when then the credit rating agencies later messed it up, and got it so amazingly wrong with the AAA rated securities backed with truly lousy mortgages to the subprime sector, it was a real disaster. But, I tell you, it could have been much worse, like if they had rated correctly for a much longer period.

The reason for that lies in the malignant error of the Basel Committee’s risk weighted capital requirements for banks; more ex ante perceived credit risk more capital – less risk less capital.

Perceived credit risk is the risk most cleared for by banks; they do so by means of interest rate risk premiums and size of exposures. And so when regulators decided to clear for exactly the same risk, now in the capital, that perceived credit risk got to be excessively considered. And any risk, no matter how correctly it is perceived, if it is excessively considered, will cause the wrong actions.

For instance banks were (and are) allowed to leverage much more when financing the purchase of residential houses, or when investing in AAA rated securities backed with mortgages, “The Safe”, than what they are allowed to leverage when lending to the core of the bank credit needing part of the economy, the SMEs and entrepreneurs, those who help create the new generation of jobs, “The Risky”.

And that has resulted in that banks earn much higher expected risk adjusted returns on The Safe than on The Risky; which results banks will finance much more The Safe than The Risky.

So, had it gone on (oops it still goes on) we will all end up in houses with no more houses to be built, and without that new generation of jobs that could help us, or foremost our children and grandchildren, to service mortgages and pay utilities.

So let’s be thankful the credit rating agencies got it wrong, but, please, let us also correct for the regulators' mistakes. Thinking on my grandchildren, I would in fact prefer lower capital requirements for banks when financing unrated SMEs and entrepreneurs than when financing the purchase of a house.

But how did this happen and how could it have been avoided.

Well perhaps it would have been nice if the regulators, before regulating the banks ,had defined their purpose. Then perhaps John A. Sheed’s “A ship in harbor is safe, but that is not what ships are for”, could have come to their mind.

And also it would have been nice if the regulators had done some empirical research on what causes bank crisis; and then they would have discovered that never ever excessive exposures to what is perceived as risky; and then they might have thought of Voltaire’s “May God defend me from my friends [AAA rated]: I can defend myself from my enemies [the unrated]”

Basel Committee and you other scheming dumb regulators, “Thanks, Great Job! Next time please keep out of our banks.”

A bank would ordinarily require lower risk premiums for the purchase of a house by someone willing to make an important down payment, and who showed sufficient income to be able to service the mortgage, than the risk premium the bank would require for riskier ventures, like that of lending to SMEs or entrepreneurs... those who though risky, could best help us to create the next generation of decent jobs.

But now, ever since regulators allowed banks to leverage more their equity with “safe” housing loans than with loans to The Risky, that meant the risk premiums offered in the market for housing loans suddenly got to be worth much more in terms of risk adjusted returns on bank equity, than those offered by The Risky. 

The consequence? More loans to housing, and much less loans to SMEs and entrepreneurs than would ordinarily have been the case without this distortion. 

And so now we are doomed to live unsafely in our safe houses, because of the lack of jobs we need in order to repay mortgages and utility bills.

Thanks regulators! Great Job! Next time please keep out of our banks.

Governments, your prime responsibility is to profoundly distrust your own technocrats, and to block these from dangerously meddling with our real economies.

http://subprimeregulations.blogspot.com/2016/02/the-governments-must-stop-their.html

Bank regulators… dare to answer this single question

There are literally thousand of risks, especially many unexpected risks, which could bring our banking system down.

And so why on earth did you regulators base your capital requirements for banks, those which are to cover especially for unexpected risks, solely on the ex ante perceived credit risk, that which is basically the only risk already cleared for by banks, by means of interests risk premiums and the size of their exposures?

And, to top it up, you made those capital requirements portfolio invariant… as if diversification has no meaning?

If anything, should you not have based it on the risks that bankers were not able to clear for those perceived risks?

Since that dangerously distorts the allocation of bank credit to the real economy, do we not deserve a clear-cut answer on that?

I have been asking this for over a decade, and you have not even wanted to acknowledge my question. Does that not tell you something?

Our banks… a bad road leading from nowhere to nowhere!

A road can be extremely well constructed but lead from nowhere to nowhere. That is why it so extraordinary that we allow the global regulators in the Basel Committee to regulate our banks without defining a purpose for our banks. That said, since the Basel Committee proved that it was not even good at regulating basic road engineering, we now have a bad road coming from nowhere and leading to nowhere.

Let me explain why besides lacking a purpose, the regulations of our banks are so lousy.

The only risk the regulators considered in order to set the capital requirements for the banks in Basel II was the risk of default of their clients, mostly as this was perceived by the credit rating agencies. The higher the perceived risks, the higher were the capital requirements and vice versa.

The above though sounding logical completely ignored that the market already arbitrages for the information provided by the credit rating agencies about risk of defaults, by means of adjusting the risk-premiums it applies. Therefore, the unforeseen but should have been foreseen results of these capital requirements based on risk, was to dramatically increase the risk-adjusted return on bank capital when lending to anything perceived as “not-risky”, while making it, in relative terms, dramatically much less attractive to finance anything officially perceived as “risky” and that for its same adjusted risk premium requires more bank capital.

No wonder that the banks stampeded into the triple-A rated waters where, since real triple-As are and will always be extremely scarce or non-existent, the market had provided some Potemkin triple-A ratings.

The only real Black Swan event that caused this crisis was that amazingly inept regulators got hold of the Basel Committee… and the most amazing thing is that they are still there!