Banks should allocate credit based on risk-adjusted return on equity, and not on regulatory required equity

Banks used to allocate bank credit (interest rates and amount of exposure) according to what produced them the highest risk adjusted return per dollar of equity. Since some borrowers, like SMEs and entrepreneurs, are more dependent on banks for credit than others, that might not have been absolutely perfect in terms of allocating bank credit to the needs of the real economy, but at least it was fair and unbiased.

That was before the Basel Accord introduced their outright odious capital requirements based on credit risk. Now banks allocate their credit according to what produces them the highest risk adjusted return per dollar of required equity. Obviously that is totally biased and completely unfair.

Since those borrowers perceived a safe have been additionally benefited by generating lower capital requirements, it is almost impossible for the risky to compete for bank credit.

The resulting distortion in the allocation of bank credit to the real economy is mind boggling.

It is amazing the number of experts who think that even though banks already clear for perceived credit risks, by means of interest rates and size of exposures, that in order to be certain they have done that, it is better the regulators require banks to clear again for that same perceived credit risks, this time in the capital

It is amazing the number of experts who do not understand that even if you have an absolutely perfect perceived credit risk, you will get it wrong if you give that credit risk perception more weight than it should have.

It is amazing the number of experts who do not understand that: more risk more capital- less risk less capital will cause banks to create dangerous excessive exposures to "the safe" and equally dangerous (for the real economy) underexposures to "the risky".

It is amazing the number of experts who are statist or communists, since otherwise there is no way to argue a zero percent risk weight for sovereigns, and a 100 percent risk weight for the private sector.

Here is but a short list of those experts: Mario Draghi, Stefan Ingves, Mark Carney, Ben Bernanke, Jaime Caruana, Lord Turner, Martin Wolf and most of FT, Alan Greenspan, seemingly all those in the IMF, Basel Committee, Financial Stability Board, European Commission, BoE, Fed, FDIC, ECB

To be in the company of fools might make you a less lonely fool, never a lesser fool.

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.

Current bank regulations present two absolute inexplicable lunacies, which can only be justified if you are a communist

Starting 1988, with the G10 Basel Accord of which the US is a signatory, bank regulators, in Basel I, for the purposes of establishing how much capital (equity) banks need to hold against assets, declared the following credit-risk-weights: Government Zero percent; citizens, or their SMEs, 100 percent.

Knowing that only the citizens are the real back up of any government, and that governments can be very creative dishonoring their debt, for instance by means of inflation… that is an absolute inexplicable lunacy... unless you’re a communist of course.

Worse yet. Those risk weights cause banks to lend more and at lower relative rates to the government than to the citizens and to their SMEs. And that would imply that government bureaucrats are more productive using bank credit than the citizens, or their SMEs.

In other words, the credit-risk-weights de facto simultaneously translates into bank-credit-productivity-weights of 100% for government bureaucrats and zero percent for citizens, or for their SMEs. 

And so the question lingers is the Basel Committee a tool for communists to infiltrate the financial system of the free world? It would certainly seem so.

Here: The confessions of an ideologue.

PS. Here my letter to the Financial Stability Board