Regulators told banks: "Extract all value you can from the safer past, and forget about the riskier future." And so here we stand.

Nancy Birdsall in “Middle-Class Heroes”, Foreign Affairs March/April 2016 writes:

“The fear is that the new middle class will be hit hard if it turns out that global growth was built too much on easy credit and commodity booms and too little on the productivity gains that raise incomes and living standards for everyone”

That is precisely what happened, and the awful consequences of it are already to be seen.

When bank regulators decided on risk weighted capital requirements for banks, they allowed banks to leverage their equity, and the support they received from society, much more with assets perceived or deemed as safe than with assets perceived as risky.

And that meant that banks would earn much higher expected risk adjusted returns on equity with “safe” assets than with “risky” assets.

And what is the biggest source of safeness? What we already know it, what is already here, what comes from the past. 

And what is the biggest source of riskiness? What we still do not know, what is not here, what still lies in the future.

And so banks were given the incentives to refinance the safe past, like placing reverse mortages on what had already been achieved; and to forget to finance the riskier future.

And that is destroying not only the current middle class but, much worse yet, the of our young ones, who need a great dose of risk-taking in order to have a chance for a better future.

Bank regulators cause price of credit for the safe to be lower than usual than that of the risky. It costs us a lot!

Lawrence H. Summers writes about “the concept of secular stagnation, first put forward by the economist Alvin Hansen in the 1930s. The economies of the industrial world, in this view, suffer from an imbalance resulting from an increasing propensity to save and a decreasing propensity to invest. [And that] it is natural to suppose that interest rates – the price of money- adjust to balance the supply of savings and the demand for investment in an economy” “The Age of Secular Stagnation” Foreign Affairs March/April 2016.

But the intermediation between savings and investment, when carried out by banks, has now been distorted by the fact that banks are allowed to earn higher risk adjusted returns on equity when holding “safe” assets, than when holding “risky” assets? That is the de facto result of the risk weighted capital requirement for banks.

And so now the difference in the price of bank money for the safe, and the price of money for the risky, will be much larger than what would be the case without these regulations. And, consequentially, the demand for investment of the safe will be larger than that in an undistorted equilibrium, and the demand for investment of the risky, much lower.

One way to explain it is with houses and jobs. As is, the financing of houses has been considered much safer by regulators than the financing of job creation through “risky” SMEs and entrepreneurs. And so society is, faster than little by little, getting stuck with too many houses and too few jobs.

@PerKurowski ©