Which business cycle would you prefer?

There is one business cycle during which the capital requirements for banks against all assets are the same. 

And so banks offer, the risky and the safe, credit based on the size of exposure and the net margin adjusted for risk. 

Sooner or later because of unforeseen events, criminal behavior, or excessive exposures to what was ex ante perceived as safe but that ex post turned out risky, there will be a bank crisis, everyone will hurt, and the economy will suffer a set back. 

Hopefully, usually, the net economic gain, since this business cycle started, will anyhow be positive.

Now there is another business cycle, like the current one, during which the capital requirements for banks are risk-weighted… more ex ante perceived risk more capital – less ex ante perceived risk less capital.

And so banks then offer, the risky and the safe, credit based on the size of exposure the net margin adjusted for risk and the allowed leverage resulting from the capital that is required.

Sooner or later because of unforeseen events, criminal behavior, or excessive exposures to what was ex ante perceived as safe but that ex post turned out risky, there will be a bank crisis, and everyone will hurt. 

But this crisis could be so much worse because the exposures to what is perceived as safe, those which therefore contain more dangerous fatter tail risks, will be so much higher, and will be held against especially little capital. 

And because most credit financed the safer present, creating a reverse mortgage on it, and way too little financed the risky future, the economy might suffer a set back that puts it much worse off than when this business cycle got started.

Unfortunately the difference in the business cycles bank regulations can cause, is rarely discussed.

The almost 600 year long history of banks changed dramatically, for the worse, in 1988, with the Basel Accord.

If we use the Medici Bank as the first bank, it was established in 1397. From there on, until 1988, a bank’s capital (equity) followed the simple “one for all and all for one” principle. 

Then with the Basel Accord, Basel I, the regulators introduced risk weighted capital requirements for the banks. More ex ante perceived risk more capital – less risk less capital. That had serious and non-transparent consequences for the borrowers, for the economy, for bank stability and for the balance between the government and We the People.

It promoted inequality among the borrowers:

The ex ante perceived “risky” borrowers, those who precisely because of those perceptions, already got less credit and had to pay higher interest rates, now also had to face the costs of generating higher capital requirements for banks; while the ex ante perceived “sage” borrowers, those who precisely because of those perceptions, already got more credit and had to pay lower interest rates, now also received the subsidy of generating lower capital requirements for banks.

It stopped the economy to move forward, so it stalls and falls

Banks, because of the higher leverage allowed with assets perceived as safe, obtained higher expected risk adjusted returns on equity when financing, the “safe” than when financing the “risky”, like SMEs. The new regulations stopped banks from financing the riskier future and mostly dedicate themselves to refinance the safer past and present. They now finance safe basements where jobless kids can live with parents, but not the SMEs that could get the kids jobs.

It destabilized the bank system.

By assigning ultra low capital requirements for what was perceived as safe it caused the dangerous overpopulation of “safe havens”, like the AAA rated securities built-up with lousy mortgages to the subprime sector… and against very little capital.

It brought in statism thru the bathroom window.

Risk weights of 0% for the Sovereign and 100% for We the People, expresses unabridged statism in that it, de facto, implies regulators think government bureaucrats are able to use bank credit better than SMEs and entrepreneurs.

Just try to imagine what the Médicis would have said about assigning a 0% risk weight to the Sovereign?

PS. Here's a more extensive aide memoire on some of the monstrosities of such regulations

William C Dudley, Fed New York, does still not understand how risk-weighted capital requirements for banks distort

On March 31, 2016 William C Dudley of the Federal Reserve Bank of New York, gave a speech titled “The role of the Federal Reserve – lessons from financial crises” 

There are many issues I do not agree with in that discourse but let me here concentrate on “lessons from financial crisis”. 

Mr Dudley stated: “The crisis showed that the regulatory community did not fully grasp the vulnerability of the financial system. In particular, critical financial institutions were not resilient enough to cope with large scale disruptions without assistance, and problems in one institution quickly spread to others.”

Not a word about how the risk-weighted capital requirements for banks; which permit banks to leverage more on what is perceived, or has been decreed, or has been concocted as safe, than with what is perceived as risky; which means banks earn higher risk adjusted returns on equity on what is "safe" than on what is “risky”; which means banks will lend too much to what is “safe”, like sovereigns and the AAArisktocracy, and too little to what is “risky”, like SMEs and entrepreneurs.

And anyone who has still not understood the dangers that distortion of the allocation of bank credit poses to the banks, and to the real economy, doest not have what it takes to work on bank regulations.

The main lesson here is: It was the regulators who, by allowing banks to hold less capital against precisely the stuff that all major bank crisis are made of, namely what is ex ante perceived as safe, made the banking sector more vulnerable.

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.

Fed: The biggest stress resulting from banks might be their misallocation of bank credit to the real economy.

The Federal Reserve System’s(Fed) Dodd-Frank Act Stress Tests.

Banks are not there just to make profits for their shareholders, or to be safe places where to stash away money… they are there to perform the social function of allocating as efficiently as possible bank credits to the real economy. That’s the only logical reason why taxpayers could be willing to lend them support.

In this respect any stress-test that does not include looking at assets banks have on their balance sheet from more than credit risk perspective, is an utterly incomplete test.

For instance taxpayers should be able to do know how much unsecured bank credit has gone to SMEs and entrepreneurs, and how that lending has evolved over the last 3 decades.