A question about the Wolfson Economic Prize

A £250,000 Wolfson Economics Prize competition has now been announced for the best answer to the following question: If member states leave the European Economic and Monetary Union, what is the best way for the economic process to be managed to provide the soundest foundation for the future growth and prosperity of the current membership? 

And, what if one believes no member state should have to leave the eurozone, because even though the eurozone undoubtedly presents many challenges, this crisis was primarily the result of bad banking regulations, and not of the eurozone? 

Let me explain. The only way the current imbalances could have resulted in building up the humongous European sovereign debt burdens, carried primarily by banks, was that the regulators allowed the banks to hold these exposures against zero or very little equity. This caused the banks to be willing to lend too much, at artificially low interest rates. 

If that is the case, at this moment, when some of the European sovereigns are rated as “riskier”, and therefore banks are required to hold more capital when lending to these, the possibilities are either that these debtors will find it much harder to work themselves out of any excessive debt position, and or, that the remaining safe-sovereign-havens also end up dangerously overcrowded. 

It is bad enough that bankers lent the umbrella to the European sovereigns when the sun was shining and now they want it back when it rains, for the regulators to do exactly the same. 

What solutions do I envision?

Perhaps a general and substantial haircut on all outstanding European sovereign debt, Germany included, which would allow the stronger countries to help out more in getting the eurozone economy going… and, of course, a total reversal, over a period of time, of the current capital requirements for banks based on ex-ante perceived risk of default, and which will go down in history as the mother of all failed and truly stupid bank regulation Maginot lines.

I have now received an answer to my query, it is: “The question stands as framed”

Unfortunately, it seems that the possibility of a solution that does not mean someone being expelled from the eurozone, is not acceptable.

Occupy Wall Street? Occupy RBS? No! Occupy the Basel Committee! Hell, occupy FSA and the Dodd-Frank Act too!

I have not read yet in full FSA’s report on the failure of RBS, but I know what it does not include, the admittance of the fundamental mistake committed by the bank regulators, because that mistake is kept, alive and kicking, in Basel III.

Simplified, if the cost of funds for RBS was 2 percent; if it wanted to earn a 1.5 percent margin; if the cost of analyzing the credit worthiness of a small business in the UK was 1 percent; and if the risk that this borrower would default was perceived as 3 percent, then RBS would charge the small business in the UK an interest of 7.5 percent.

And if the cost of funds for RBS was the same 2 percent; if it wanted to earn the same 1.5 percent margin; if the cost of analyzing the credit worthiness of Greece was zero, because that is paid by Greece to the credit rating agencies to do; and if the risk that Greece would default was perceived as 1 percent, then RBS would charge Greece an interest of 4.5 percent.

If RBS bank was required to have about 8 percent in capital against any loan, and could therefore leverage its capital about 12 times, RBS could then expect to earn 18 percent on its capital when lending to a small business in the UK or when lending to Greece.

But that was before the bank regulators of the Basel Committee, and FSA, intervened and messed it all up.

Because the bank regulators, ignoring the empirical evidence that bank crisis never occur because of excessive exposures to what was considered risky but only because of excessive exposures to what was considered as absolutely not risky, with their Basel II, told RBS: “You RBS, if you lend to a “risky” small business in the UK you must have 8 percent in capital, but, if you lend to an infallible Greece or anyone else similarly risk-free, you only need to have 1.6 percent in capital”.

And because that 1.6 percent allowed for a leverage of more than 60 times when lending to Greece, RBS, though it still could earn a decent 18 percent on its capital when lending to a small business in the UK, suddenly RBS could expect to earn 90 percent on its capital when lending to Greece or similar. Hell, RBS could even afford to lower the interest rate it charged Greece and still earn more when lending to Greece than when lending to a small business in the UK.

And of course RBS, as did all banks in the Western world, started running to the officially perceived safe-havens of Greece, Italy, Spain, triple-A rated securities and other, where they could earn much more on their equity; and of course the governments of the safe-havens could not resist the temptations of cheap and abundant loans, and all these safe-havens became dangerously overcrowded… while the small business in the UK found it harder and much more expensive to access any bank credit… and while the too big to fail banks grew even bigger.

And, many years into a crisis that has the Western World in a freefall, this issue is not even discussed, and the same failed bank regulators are allowed to work on Basel III, using the same failed loony and distorting ex-ante perceived risk of default based capital requirement discrimination principle.

And when Adair Turner, the Chairman of FSA, in the report on the failure of RBS now states “These prudential regulations have been changed radically since the crisis, with the internationally agreed Basel III standards” he is not referring to this problem.

And this problem has been known, for a long time, just as an example the Financial Times published two letters of mine that clearly warned about what was going to happen. In January 2003, “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” and, in October 2004, “Our bank supervisors in Basel are unwittingly controlling the capital flows in the world. How many Basel propositions it will take before they start realizing the damage they are doing by favoring so much bank lending to the public sector (sovereigns)?

And I have even explained much of the problem personally to Lord Adair Turner, quite some time ago.

Occupy Wall Street? Occupy RBS? No! Occupy Basel! Hell, occupy FSA and the Dodd-Frank Act too!