Thursday, November 10, 2011

Who did the eurozone in?

There are of course many suspicious characters to blame for the eurozone’s pains, not the least the fact that it was created without any strong fiscal root system.

In November 1998, in an Op-Ed titled “Burning the bridges in Europe”, which title had to do with the fact there no escape-route from the euro had been considered. I also wrote there: “That the European countries will subordinate their political desires to the whims of a common Central Bank that may be theirs but really isn’t, is not a certainty. Exchange rates, while not perfect, are escape valves. By eliminating this valve, European countries must make their economic adjustments in real terms. This makes these adjustments much more explosive.”

But, there is one huge piece of evidence that is ignored by most of those trying to explain the current troubles. That evidence is the “risk-weights”, the smoking-gun which we find in the hands of the butlers in charge of regulating the banks, and who have their quarters in the Basel Committee for Banking Supervision. Yes, it was some butlers who did the eurozone in! 

The bank butlers, naturally concerned about the safety of the banks, imposed a basic bank capital requirement of 8 percent; applicable for instance when banks lent to European small unrated businesses. In this case that limited the leverage of bank equity to a reasonable 12.5 times to one. 

But, when banks lent to a sovereign, with credit ratings such as those Greece-Portugal-Italy-Spain had during the buildup of their huge mountains of debt, the bank butlers, because this lending seemed so safe to them, and perhaps because they also wanted to be extra friendly with the governments who appointed them, they applied a “risk-weight” of only 20 percent. And that translated into an amazingly meager capital requirement of 1.6 percent; and which allowed the banks to leverage their capital when lending to the infallible a mind-blowing 62.5 times. 

The result was that if a bank lent to a small business and made a risk-and-cost-adjusted-margin of 1 percent, it could earn 12.5 percent a year, not much to write home about. But, if instead it earned that same risk-and-cost-adjusted-margin lending to a Greece, it could then earn 62.5 percent on your bank equity… and that, as you can understand, is really the stuff of which huge bank bonuses are made of, and also the hormones that cause banks to grow into too-big-to-fail. 

And, as should have been expected, the banks went bananas lending to “safe” sovereigns. With such incentives, who wouldn’t? Just the same way they went bananas buying those AAA rated securities that were collateralized with lousily awarded mortgages to the subprime sector, and to which the bank-regulating-butlers also applied the risk-weight of 20 percent. And of course the governments also went the way of the banana-republics, and borrowed excessively. What politicians could have resisted such temptations? 

And it was these generous financing conditions, and all the ensuing loans, which helped to hide all the misalignments and disequilibrium within the eurozone… until it was too late. 

Now how could these bank-regulating-butlers do a criminally stupid thing like that? The main reasons were: the bank butlers only concerned themselves trying to make the banks safe, and did not care one iota about who the banks were lending to and for what purpose; they ignored that banks were already discriminating based on perceived risks so what they were doing was to impose an additional layer of risk-perception-discrimination; they completely forgot that no bank crisis in history has ever resulted from an excessive exposure to what was considered as “risky”, but that these have always been the consequence of excessive exposures to what, at the moment when the loans were placed on the banks balance sheet, was considered to be absolutely “not-risky”. 

Also, when the bank-regulating-butlers decided to outsource much of the risk-perception function to some few credit-risk-rating-butlers, two additional mistakes were made. First, they completely forgot that what they needed to concern themselves with was not with the credit ratings being right, but with the possibility of these being wrong; and second, that what they needed most needed to look at was not so much the significance of the credit ratings meant, but how the bankers would act and react to these. 

And the consequences of these regulatory failure in the eurozone, are worsening by the day, or by the nanosecond… because these bank capital requirements have the banks jumping from the last ex-ante-officially-perceived-no-risk-sovereign now turned risky, to the next ex-ante-officially-perceived-no-risk-sovereign about-to-turn risky … all while bank equity is going more and more into the red… and becoming more and more scarce. 

What could be done? One solution could be that of declaring a ten year new capital requirement moratorium on all current bank exposures; allowing the banks to run new lending with whatever new capital they can raise, while imposing an equal 8 percent capital requirement on any bank business, no risk-weighting. If there’s an exception, that should be on lending to small businesses and entrepreneurs, in which case they could require, for instance, only 6 percent of capital, because these borrowers do not pose any systemic risk, and also because of: when the going gets to be risky, all of us risk-adverse need the “risky” risk-takers to get going. 

But that requires of course a complete new set of bank-regulating-butlers… as the current should not even be issued any letters of recommendations. Let’s face it, after such a horrendous flop as Basel II, neither Hollywood nor Bollywood, would ever dream of allowing the same producers and directors to do a Basel III, and much less with only small script changes and the same actors.

The saddest part is that many of those in charge of helping Europe to get out of the current mess that they helped to create, might be busying themselves more with dusting off their own fingerprints.

If there is any place that deserves an occupation... that is Basel!

PS. Years later I learned that all this was just so much worse, as EU authorities had assigned a 0% risk weight to Greece. Unbelievable!  And then EU authorities put the whole blame for that on Greece and did not even consider paying for the cost of their own mistake. Is that a way to build a union? No way Jose.