The regulatory distortion that shall not be understood… or at least not be named
My twitter thread.
The regulatory distortion that shall not be understood… or at least not be named.
After the operational costs and the perceived credit risks have been cleared for with higher or lower cost/risk adjusted interest rates, we get the expected risk adjusted return of a bank asset.
If a bank asset produces an expected risk adjusted return of 1 percent, then, if the capital requirement is 8 percent, it can be leveraged 12.5 times and it will produce an expected risk adjusted return on bank equity of 12.5 percent.
But if a bank asset produces an expected risk adjusted return of 1 percent, and the capital requirement is only 2.8 percent, it can be leveraged 35 times, and it will produce an expected risk adjusted return on bank equity of 35 percent.
So, exactly the same expected risk adjusted return on assets, if deemed “safe” by regulators, e.g., residential mortgages, could produce almost three times the expected risk adjusted return on bank equity than if regulators deem it “risky”, e.g., loans to small businesses.
The consequence?
For the bank system, dangerously too many residential mortgages, most at lower than their correct risk-adjusted interest rates, and, for the economy, dangerously too few loans to small businesses, most at higher than their correct risk-adjusted interest rates.
Those perceived less creditworthy and who always got less credit and paid higher rates were, with this, also declared less worthy of credit. Does that promote or decrease inequality?
And since banks are subject to capital requirements mostly based on perceived credit risks, not misperceived risks or unexpected events, e.g., pandemic or war, they will now stand there naked, just when we surely need them the most.
Basel Committee… Good Job!
And what if the bank capital requirement is much lower and the allowed leverage much higher for government debt, Treasuries?
Well then, the regulators are really empowering the Bureaucracy Autocracy with loads of credit at ultra-low rates… and this even before the QEs.
And don’t just take my word for it.
“Assets for which bank capital requirements were nonexistent, were what had most political support: sovereign credits. A simple ‘leverage ratio’ discouraged holdings of low-return government securities” Paul Volcker
Posts
