The silly doubling down on ex ante perceived risks is killing the Western economies... and not so softly

The interest rates, the size of the exposures and all other terms of assets that banks put on their balance sheet, are a function of their ex ante perceived risks, like those reflected in credit ratings.

But current bank regulations also determines that the capital (equity) banks are required to hold against those assets, are also to be a function of risk weights determined from ex ante perceived risk, like those of credit ratings.

And that fundamental mistake of doubling down on the same ex ante perceived risks, like those in credit ratings, potentiating risk aversion, is killing the western economies as we knew them... and not so softly.

Trusting excessively ex ante perceived risks, regulators have allowed banks to hold much much less capital against assets perceived ex ante as “absolutely safe”, than against assets perceived as risky. And that resulted in that banks earn much much higher risk adjusted returns on equity on “The Infallible”, like exposures to sovereigns, housing sector and the AAAristocracy, than on The Risky, like medium and small businesses, entrepreneurs and start ups.

And that means that banks have dangerously leveraged up much too much on The Infallible and, equally dangerously, much too little on The Risky.

And so when one of “The Infallible” ex post turns out to belong to “The Risky”, as always happens sooner or later, often precisely because it has had too much access to bank credit, then the banks stand there naked with almost no capital.

And so “The Risky”, those who on the margins of the real economy most need and should have access to bank credit, in order to help our economies to move forward, they will not get it.

In essence this all means that banks will not help to finance the western economies future, but only help to refinance its past.

Senator Patrick Moynihan is quoted with saying “There are some mistakes it takes a PhD to make”. Unfortunately most of us equally seem to believe “There are mistakes, so dumb, these just cannot be made by a PhD”.

We baby-boomers extract as much equity as possible from the risk-taking our parents allowed banks to take, while refusing now to allow banks to take the risks our grandchildren need.