Sunday, November 30, 2014

No Martin Wolf, arrogance and stupidity were (and are) the real sins of bank regulators.

Martin Wolf in his recent book “The shifts and the shocks – What we’ve learned-and have still to learn-from the financial crisis” writes: “Regulators made errors of omission and commission:

Sins of omission are the result of excessively permissive regulations and supervision: they occur when regulators choose to ignore either gross malfeasance or excessive risk taking,

Sins of commission arise when regulators and lawmakers encourage financial institutions to take risks for political reasons.”

And Wolf holds that “Behind all this was the assumption that self-interest would, via Adam Smith’s invisible hand, ensure a stable, dynamic and efficient system… The application of these naïve ideas proved extraordinarily dangerous.

No! Mr. Martin Wolf. 

The first sin was the sin of arrogance by which regulators thought themselves capable to be the risk managers for the world and started to allocate credit risk weights that determined the capital (equity) requirements for banks.

And the second sin was stupidity, which took on two major expressions:

The first one not understanding that allowing different capital requirements against different assets would allow banks to earn different risk-adjusted returns on assets, and that had to distort the allocation of bank credit to the real economy.

The second, not being able to understand that the real dangers for the banking system do not loom among what was perceived as “risky”, but always among what is perceived as absolutely safe.

And the saddest part is that now, so many years after the outburst of the crisis, we have a book written by one of the mot influential columnists, which does not even mention these problems.

And it is not like no one has told Martin Wolf about this. For instance in July 2012, he himself writes: “Per Kurowski, a former executive director of the World Bank, reminds me regularly, crises occur when what was thought to be low risk turns out to be very high risk.”

And then there are more than hundred of letters over the years to him on this issue, many of which have been discussed in the interchange of emails.

And NO! Mr Martin Wolf. No one who could interfere in the allocation of bank credit like the regulators did, can be said to sincerely believe in the "invisible hand".

PS. Wolf touches on the fact of the safe being risky, by on page 252 writing: “the disaster came from what banks wrongly thought to be safe.” Yet he clearly does not understand its real meaning as he explains it as: “Risk-weighting is extremely unreliable, because the samples from which the weights are derived are always to small or irrelevant.” 

Apparently Wolf cannot come to grips with the notion that even perfect risk weights, can generate dangerous distortions, both for the economy and for the banks. That is so because if that perceived risk has already been cleared for, and so for to clear it again (now in the capital of banks) makes that perception to become over-considered. What if the risk aversion of one nannie was added to the risk aversion of other nannies? Would the kid ever be let out of his house?