Joseph Stiglitz: Until the world rids itself of distortionary bank regulations, The Great Malaise will continue.

Professor Joseph Stiglitz, in Project Syndicate and Social Europe, January 2016 writes “Why The Great Malaise Of The World Economy Continues In 2016”

And in it Stiglitz states: “While our banks are back to a reasonable state of health, they have demonstrated that they are not fit to fulfill their purpose. They excel in exploitation and market manipulation; but they have failed in their essential function of intermediation. Between long-term savers (for example, sovereign wealth funds and those saving for retirement) and long-term investment in infrastructure stands our short-sighted and dysfunctional financial sector.

“Short-sighted and dysfunctional financial sector”? Of course, how could it not be, when regulators impose odiously discriminating capita requirements for banks based on credit risk. That allows banks to leverage their equity much more with assets perceived or deemed to be "safe" (AAA rated) than with assets perceived as risky (SMEs); and which means banks make higher expected risk adjusted returns on equity with “safe” assets than with “risky” assets. That completely distorts the allocation of bank credit to the real economy. 

Why can a Professor Stiglitz scream out against market manipulation of banks and simultaneously keep total silence on the so much worse bank credit manipulations by regulators?

Why can a Professor Stiglitz scream out against fiscal austerity and simultaneously keep total silence on the so much worse bank credit austerity that is hitting the “risky” borrowers in the market, like SMEs and entrepreneurs.

Why can a Professor Stiglitz scream out against inequality and simultaneously keep total silence on that inequality driver capital requirements for banks based on credit risk signify?

Why cannot a Professor Stiglitz understand that if you want banks to “match long-term savings to long term needs” you are better off with capital requirements based on long term needs and not on short-termish credit risks?

Professor Stiglitz then opines “The obstacles the global economy faces are not rooted in economics, but in politics and ideology.”

Absolutely! When Stiglitz wants government bureaucrats to take advantage of that ultra low interests that in much result from favoring bank regulations, in order to finance new projects, he shows he is clearly rooted in politics and ideology. His being “Long live the technocrats and their technocratic approaches! They can do no wrong!”

I guess Professor Stiglitz was thrilled with the Basel Accord of 1988 that, for purposes of bank capital requirements, set the risk weight of sovereigns at zero percent and the risk weight of the private sector at 100 percent.

Do we really want to bet our economies on government bureaucrats using bank credit better than SMEs and entrepreneurs?

Those who protest government austerity the loudest are frequently those who most want to force banks to increase their capital. Let us analyze the implications of that position:

If governments are not going to be austere and spend more, and consequentially run deficits, it is only natural governments will need to take on more debt.

If banks are forced to hold more capital then, while the banks find more capital and adjust their business models to those new realities, there is going to be quite a lot of austerity when it comes to the supply of bank credit to the economy.

Since current capital requirements for banks are lower when lending to the government than when lending to the private sector, that will generate a bank credit squeeze on the private sector, affecting most especially those against which loans banks needs to hold more equity, like the SMEs and the entrepreneurs.

The only way to bridge the contradiction between government austerity being something bad for the economy, and bank credit austerity something good for the economy, is of course by believing that government bureaucrats can use bank credit more efficiently than SMEs and entrepreneurs. And that friends, is a truly doubtful proposition on which to bet the future of our economies.

Citizens, it behooves us to unite much more than what government bureaucrats/technocrats unite.

In the case of banks, the Modigliani-Miller Theorem is absolutely inapplicable

James Kwak of the Baseline Scenario, in a post titled: “More Misinformation about Banking Regulation” while discussing the effects of increased capital requirements writes:

“The Modigliani-Miller Theorem…says that a firm’s capital structure — the amount of equity it has relative to debt — doesn’t matter: in the case of the hypothetical bank, if you increase equity and reduce debt, after the reduced debt payments, there is just enough cash left over to compensate the larger number of shareholders at the lower rate that they are now willing to accept.

Now, the assumptions of Modigliani-Miller don’t hold in the real world, but the main reason they don’t hold is the tax subsidy for debt…

Since the cost of capital doesn’t change with capital requirements (except, again, because of the tax subsidy for debt), the amount of bank lending doesn’t change either.” 

Oops… that is in itself some misinformation! 

For banks, besides tax considerations, the Modigliani-Miller Theorem is absolutely inapplicable; since it does not consider the value of the support society (taxpayers) explicitly or implicitly give the holders of bank debt. If a bank has 100% equity then all risk falls on the shareholder and the societal support is 0. If a bank has 5% equity and 95% debt then society contributes a lot to the party.

Frankly, like in Europe, where some banks were leveraged about 50 to 1, and rates on bank deposits are still low, who on earth can one even dream to bring the Modigliani-Miller Theorem into the analysis?

And the fluctuating societal support, is one of the main reasons behind the argument I have been making for over a decade, about how credit-risk adjusted capital requirements for banks distort the allocation of credit. Regulators are telling the banks: If you lend to what is perceived as safe, like to the AAArisktocracy, then you are allowed to hold less capital, meaning leveraging more, meaning you will receive more societal (taxpayer) backing, than if you lend to a risky SME. 

And so of course, if you increase capital requirements which reduces the leverage, banks will get less taxpayer support… ergo lend less and at higher interest costs. Would that be bad for the economy? Of course it would keep billions out of the economy (it already happens) especially while business models are adjusted and bank capital increased. But that austerity J (less societal support spending) though it would hurt would not necessarily be bad… what is really bad for the economy are the different capital requirements for different assets… since that stops bank credit from being allocated efficiently.

Take away all deposit guarantees and all bailout assistance, and then the Modigliani-Miller Theorem, subject to tax considerations would be more applicable to banks.

Is the Independent Evaluation Office (IEO) of the International Monetary Fund (IMF) independent enough?

In October 2014, the Independent Evaluation Office of the International Monetary Fund presents a report titled: “IMF responses to the financial and economic crisis: An IEO Assessment”

And it does not mention what I am convinced is the primary cause of the 2007-08 crisis; and also what most obstructs our way out of it. 

I refer to the Basel Committee for Banking Supervision’s credit-risk-weighted capital/equity requirements for banks.

These allowed banks to hold assets perceived as “absolutely safe” against extremely small capital (equity) requirements, which translated into extremely high leverages of equity (62.5 times to 1 and more). 

That allowed banks to earn much higher expected risk-adjusted returns on equity when lending to what was perceived as “absolutely safe” than when lending to what was perceived as “risky”, which translated, naturally, into dangerously high exposures to what was perceived as absolutely safe”.

And any simple observation of the crisis makes clear the direct relation that existed between bank assets in problem, and bank assets with low risk-weights. For instance: i. AAA rated securities backed with mortgages to the subprime sector in the US. ii. Real estate backed financing, like that in Spain. iii. Loans to “infallible sovereigns”, like to Greece.

And we have not been able to get out of that crisis because banks still need to hold much more equity when lending to what is perceived as “risky”, like to medium and small businesses, entrepreneurs and start-ups… and that has of course impeded the liquidity provided by central banks to reach where it is needed the most.

And this regulatory risk aversion that so much distorts the allocation of bank credit to the real economy, and is dooming our economies to stall and fall, is not even part of the IMF discussions on what to do.

And so those criticizing IMF for “austerity” are not addressing the worst one of these, namely the risk-taking austerity regulatory virus that has invaded our banks... slaying the animal spirit of our economies.

And so how do you think I feel about IEO. I have to doubt its real independency… I must suspect it is also into the pockets of a groupthink incapable of understanding, or not daring to consider the possibility that bank regulators could have been so utterly mistaken. Not daring to lay the blame for the crisis more on regulators than on the bankers.

Is there a point at which a Nobel Prize must be recalled so as to avoid reputational and other damages?

How much can Nobel Prize winners be allowed to ignore facts relevant to what they are discussing?

Facts: 

1. The pillar of current bank regulations is the risk-weighted capital requirements for banks. 

2. These because regulators cannot differentiate between ex ante and ex post risks, allow banks to leverage their shareholder´s capital much higher when lending to “the infallible” than when lending to “the risky”. 

3. And that results in that banks can earn much higher risk-adjusted returns on their equity when lending to “the infallible” than when lending to the risky.

4. And that distorts and makes it impossible for medium and small businesses, entrepreneurs and start-ups to have access to bank credit in fair market conditions.

5. And that makes it impossible for the liquidity or stimulus provided by quantitative easing (QEs), fiscal deficits or low interest rates, to reach what needs most to be reached.

6. And all that for no good reason at all since bank crises are never ever the result of excessive exposures to what is ex ante perceived as risky.

And so when time and time again I read that a Nobel Prize winner asks for more economic stimulus and less austerity, without the slightest reference to the need of removing that huge regulatory boulder that stands in the way of job creation and sturdy economic growth, I can´t help but to ask… is there a point at which a Nobel Prize must be recalled so as to avoid reputational damage?

Of course I do understand the difficulties for the Committee for the Prize in Economic Sciences in Memory of Alfred Nobel. That prize was endowed by the Swedish central bank… and the current president of Sveriges Riksbank, Stefan Ingves, is also the current chairman of the Basel Committee, the committee responsible for creating the regulatory boulder that stands in our way... and that is a huge reputational risk in itself.

How dangerous it can be when reputational risks intertwine so much... in mutual admiration clubs.

  

The risk in not running the risk of the risky

The current crisis detonated because of investments in assets of the safest type, houses and mortgages; in the safest country, the US; and in the safest type of zero-risk instruments, triple-A rated, that turned out bad. Even so the immense majority of financial experts, even Nobel Prize winners, explain the crisis as the result of “excessive risk-taking”. They are wrong; the crisis is clearly the result of an extremely misguided excessive risk-aversion.

Looking to help the large international banks to compete better with the smaller local banks, and wanting also to avert a new bank crisis, the regulators from some developed countries got together behind closed doors in Basel and came up with what they thought was the brilliant idea of determining the capital requirements for the banks, based on how the credit rating agencies rated a loosely defined default risk of borrowers and securities.

We are not talking about something insignificant. According to the regulations known as Basel II and that apply or at least inspire most banking regulations in the world, in order to lend funds to a corporation that does not have a credit rating a bank is required to hold 8 percent in capital, but, if lending to someone rated AAA it is only required to have 1.6 percent. As you understand, these regulations, approved in June 2004, started a wild chase after the AAAs… and here we find ourselves where the global losses in what was supposed to be risk-free exceed many times what has been lost in what was considered to be more risky… among others because what is perceived as risky by itself always inspires more care.

This regulatory system is still applicable, causing immense hardships in the world economy. In tandem with how the ratings of borrowers worsen the banks need to obtain more capital and since bank equity is scarce, they try to obtain it freeing themselves from clients for whom because these have even worse credit ratings, they are required to hold even more capital. With that all bank clientele that is perceived as more risky, but that is just as or even more important to the economy, is exposed to additional pressures, just when they least need it.

Companies that are presenting difficulties and have to restructure their liabilities are among those most affected by these puritan and intrusive regulatory inventions. Clearly if the difficulties of a borrower seem to be unsurpassable the best things to do, for all, is to speedily cut it off from credit, but, if after having analyzed it, the decision is taken to help it out, it does not make any sense making it even more difficult for it, like by imposing higher capital requirements on its creditor banks. It should be just the opposite, not only because these companies need to be treated with delicacy, but also since normally, they have been more scrutinized than the majority of firms that show themselves off as representing zero risk.

It is natural that creditors would charge more or less for a loan in accordance with how they perceive the risk but… on account of what does a regulator arbitrarily intrude in the decision? Is by any chance a job in a company rated B- less important than a job in a company rated AAA?

Risk is the oxygen of all development and in this respect regulations oriented to conserve what has been developed because it is more likely to be perceived as less risky, are unacceptable. Less risky for whom? For the world? How naïve! There is nothing so risky for the world than to refuse to run the risk of the risky.

The triple-A ratings have, in only about four years, without leaving much development in its wake, taken over the precipice more capital than all that lent by the World Bank and the International Monetary Fund since their creation sixty years ago. I have for years debated and fought these regulations from Basel, in the World Bank, in the United Nations and on the web… while others lose their time and our oil revenues in such absolute irrelevancies as a Banco del Sur.

Translated from El Universal, July 23, 2009