Should we not expect the Fed to do something if they hear they are distorting the allocation of bank credit?

I refer to the letter from Managed Funds Association to the Board of Governors of the Federal Reserve System titled “Supplemental Comments in Response to Federal Reserve Staff Questions on Managed Funds Association Regulatory Priorities”

In it, discussing “the flow-through impacts of the supplementary leverage ratio (SLR) on the buy- side’s use of centrally cleared derivatives” MFA comments: 

“At present the SLR is having a more direct impact on banks… [there are] cases in which certain banks have exited the clearing business altogether,or have reduced client clearing services.

Of course, banking organizations allocate capital to business lines based on expected returns. As such, an organization will use its balance sheet to fund businesses that can meet return-on-equity (“ROE”) targets given the amount of capital required to be held against the activities of each business.”

That is a crystal clear explanation (or confession) that bank’s business lines ROE targets are adjusted by “the amount of capital required to be held against the activities of each business.”

So therefore it should be crystal clear that whatever is ex ante perceived, decreed or can be concocted as safe, currently, because of the risk weighted capital requirements for banks, can easier meet the ROE targets of banks than what is perceived as risky.

So therefore it should be crystal clear the “safe” financing of house purchases, sovereigns and AAA rated securities, will stand too much better chances to meet the ROE targets of banks than the financing of “risky” entrepreneurs or SMEs.

So therefore it should be crystal clear that house purchases, sovereigns and AAA rated securities will obtain much easier credit, and that entrepreneurs or SMEs will see their difficulties to access credit only be increased.

Damn that distortion!

By giving banks the incentives to further increase, against especially little capital, the exposures to what being perceived as “safe” always represent the detonators, they set bank crisis on steroids.

By giving banks the incentives to further reduce the exposures to what’s “risky”, that dooms the economies to stagnation.

And as usual, most probably the Board of Governors of the Federal Reserve System won’t care one iota about that, as they until now see as their only bank regulatory role, that of keeping the banks as safe mattresses into which to stash away cash… and never concern themselves whether these mattresses might be infested by the lice of dangerous uselessness.

Patrick McHenry, next time ask Fed’s Janet Yellen about the legality of risk weighted capital requirements for banks

Patrick McHenry (R-North Carolina) asked Fed chair Janet Yellen about the Fed's legal authority to  implement negative rates… And seemingly it is a bit unclear. 

But he should also have asked:

Is it really legal for the Fed to support bank regulations that require banks to hold more capital against loans to The Risky than against loans to The Safe?

I ask since that allows banks to leverage more their equity and the support we gve them when lending to The Safe than when lending to The Risky.

And that allows banks to earn higher expected risk adjusted returns on equity when lending to The Safe than when lending to The Risky 

And therefore that favors the access to bank credit of those perceived as safe, and thereby discriminates against the fair access to bank credit of those perceived as risky.

Are not The Risky already discriminated enough by the sole fact they are perceived as risky and therefore receive less and more expensive credit?

Does not the real economy suffer when the allocation of bank credit is distorted this way?

Has this not introduce a regulatory risk aversion in The Home of the Brave?

And how does this make banks more stable? Are not the big bank crises always detonated by something perceived as very safe that later turn out very risky?

If I were a Senator a Congressman or a Governor of a US state, here is what I would ask the Fed and the FDIC.

Why on earth can a state-chartered bank, or any other bank for that matter, operating in my state, be allowed to lend to well-rated corporations elsewhere, or to sovereign governments, holding less equity than when lending to our own local SMEs and entrepreneurs? 

I mean that does not sound right. That sounds like a regulatory tax on my “risky” borrowers, those who already get less credit and pay higher risk premiums, and a regulatory subsidy to strange “safe” borrowers, those who already get larger loans at cheaper rates.

If I were a bank regulator, the last thing I do, would be to regulate against the fair access to bank credit of "the risky" of my own hometown.

Fed Chair Janet Yellen has not been briefed on the real implications of current risk-weighted capital requirements for banks.

I refer to Fed Chair Janet L. Yellen speech At the 2014 Michel Camdessus Central Banking Lecture, International Monetary Fund, Washington, D.C. July 2, 2014 on Monetary Policy and Financial Stability.

From it I deduct that she has not yet been fully briefed about the real implications of the pillar of current bank regulations namely the risk-weighted capital requirements for banks.

I will illustrate this with two examples:

First Yellen states: “A smoothly operating financial system promotes the efficient allocation of saving and investment, facilitating economic growth and employment. A strong labor market contributes to healthy household and business balance sheets, thereby contributing to financial stability. And price stability contributes not only to the efficient allocation of resources in the real economy, but also to reduced uncertainty and efficient pricing in financial markets, which in turn supports financial stability.”

Absolutely, the problem though is that by means of risk-weighing the capital banks are required to hold, you allow banks to earn different risk-adjusted returns on equity something which stops in the tracks any possibility of efficiently allocating bank credit in ways that permit sturdy economic growth. In essence current requirements, by allowing banks to earn more on the “absolutely safe” it has stopped banks to lend sufficiently to the risky, like medium and small businesses, entrepreneurs and start-ups. And, an economy with insufficient risk-taking, is doomed to recede.

But also, from the perspective of financial stability the current risk weights are completely wrong, since never ever do big bank crises erupt from too much bank exposure to what is ex ante considered risky, they always result from too much bank exposures to what ex ante is considered absolutely safe, but that ex post turns out very risky.

Second Yellen states: “Tools that build resilience aim to make the financial system better able to withstand unexpected adverse developments. For example, requirements to hold sufficient loss-absorbing capital make financial institutions more resilient in the face of unexpected losses.”

Absolutely, the problem though is that the current risk weights have nothing to do with unexpected losses, and all to do with the expected losses derived from the perceived credit risks which are already cleared for in interest rates, size of exposures and other contractual terms.

And the consequence of that is that expected losses get cleared for twice, while the unexpected losses are not considered, and huge distortions ensue.

In the remote possibility that Janet Yellen would read this, let me end here by assuring her that if banks had had to hold the same capital against any asset, for instance the basic Basel II's 8 percent, something else might have happened… but not the current crisis.

PS. Here is a link to a fuller list of the Basel II mistakes.

Janet Yellen why are bank capital requirements based on credit ratings and not on job creation ratings?

Bank lending to small businesses has never had anything to do with causing the latest or any other financial crises for that matter; and risk-weighted capital requirements for banks makes it impossible for “the risky” small businesses to access bank credit in a fair way… 

Now knowing that, as Federal Reserve Chair Janet L. Yellen must know, how can you give a speech such as that delivered at the National Small Business Week Event at the U.S. Chamber of Commerce in May 2014?

She speaks much of the importance of job creation. Indeed, if I had been invited and allowed to make a question, that one would be… why do you base capital requirements for banks on perceived credit risk ratings and not on job creation ratings?

Regulators, please, your only problems with banks begin when their risk models stop to function.

Now we read that “Under rules being implemented by the Federal Reserve and the Office of the Comptroller of the Currency, the biggest U.S. banks will use their own models for judging their riskiness.”

Are they nuts? 

Bank regulators should have no problems whatsoever when banks own internal models which determine the “expected losses” function well.

The regulators only serious problems begin when these models do no function well... and “unexpected losses” result.

And so, frankly, it seems utterly absurd to allow for regulations which are based on trusting the bank models to function well.

And in this case, trusting primarily those banks which because of their systemic significance most can hurt if their risk models do not work... is like doubling up on the mistake.

If anything, trust the small banks which, if and when they fail, do not hurt us as much.