Ms. Elizabeth Warren, the banking system is rigged; foremost in favor of the State and banks, and against the young.

Senator Elizabeth Warren, in remarks given to AFL-CIO council on November 10, while trying to explain what lay behind the election of Donald Trump as president said: “Working families across this country are deeply frustrated about an economy and a government that doesn’t work for them. Exit polling on Tuesday found that 72 percent of voters believe that, quote, ‘the American economy is rigged to advantage the rich and powerful.’ The polls also made clear that the economy was the top issue on voters’ minds. Americans are angry with a federal government that works for the rich and powerful and that leaves everyone else in the dirt.”

Yes, the American economy is rigged, but at least with respect to the bank system, not exactly in the way most believe it is. I explain.

For the purposes of setting the capital requirements for banks, regulators, the Basel Committee, have decided, among others, on the following risk weights:

The sovereign (the central government and its bureaucrats) = 0%

Those rated AAA to AA (the AAArisktocracy) = 20%

Houses = 35%

The not rated, like citizen’s and SMEs = 100%

Those rated as extremely risky, like below BB-, = 150%

A lower risk weight results in having to hold less capital (equity); 

That means bank can leverage their equity more; 

That results in banks earning higher risk adjusted returns on equity; 

That therefore means banks will lend much more to what has a low capital requirements; 

In this case that means banks will lend much more than they would otherwise have done, to what is perceived, decreed or concocted as safe; and much less than the would otherwise have done to what is ex ante perceived as risky.

And so Yes! The banking system is rigged.

First and foremost, rigged in favor of the State; suggesting that when government bureaucrats use bank credit they do so much more efficiently, and generate much less risk, than if similar credit is used by the private sector/We the People.

Then rigged in favour of the banks; because being allowed to make the highest risk adjusted returns on equity on what is perceived as safe, must be a dream come true for all those bankers, described by Mark Twain, as wanting to lend you the umbrella when the sun was out, and wanting it back as soon it looked it could rain

Rigged in favor of the AAArisktocracy; by believing that a few human fallible credit rating agencies will always get it right, and that credit ratings, based on an ex ante very low risk perception, guarantees a very low ex post risk.

Rigged in favour of those buying houses, for instance basements were unemployed youth can live with their parents.

It is rigged against We the (risky) People

It is rigged against SMEs and entrepreneurs; negating the “risky” credit opportunities, it is a major driver of inequality.

It is foremost rigged against the young; because it makes banks refinance more their parents “safer” past and present, than their “riskier” future.

And all that risk aversion... in the Home of the Brave. America would never ever have become what it is, with this senseless bank regulation. Risk-taking is the oxygen of all development. 

God make us daring!

Dr Raghuram Rajan the color of the credit risk weighted capital requirement for banks policy is INTENSE RED

Dr Raghuram Rajan: in “Towards rules of the monetary game” a speech delivered in New Delhi March 12, 2016 during the conference" Advancing Asia: Investing for the Future" said: 

“To use a driving analogy, polices that are generally seen to have few adverse spillovers, and are even to be encouraged by the global community should be rated Green, policies that should be used temporarily and with care could be rated Orange, and policies that should be avoided at all times could be rated Red.” 

And I have a simple question for Dr Rajan: 

What color, Green, Orange or Red would he give the policy of the risk weighted capital requirements for banks? 

That which allows banks to hold much less capital against what is perceived ex ante as safe than against what is perceived as risky. 

That which therefore allows banks to leverage more their equity with what is perceived ex ante as safe than with what is perceived as risky.

That which therefore allows banks to earn higher risk adjusted returns on equity on what is perceived ex ante as safe than on what is perceived as risky.

That which therefore cause banks to create excessive and dangerous exposures to what is ex ante perceived as safe and insufficient exposures to what is perceived as risky. 

That which in real terms means causing the banks to extract the most refinancing much more the safer past abandoning their social responsibility of assisting in the financing of the riskier future. 

That which “has led to the debt overhang” that which makes it more difficult for “new technologies and new markets [to] come to the rescue” 

Dr Rajan asks and answers: 

“Why is there so much of a political need for growth in industrial countries? 

One reason is the need to fulfill government commitments such as debt and social security entitlements. 

Another reason is that growth is necessary for inter-generational equity, especially because the young, who are most benefited from job creation, are the generations that will be working to pay off commitments to older generations. 

A third reason is that, within country, long periods of below par growth can lead the unemployed to become unemployable.” 

Dr Raghuram Rajan, using your driving analogy the color of the policy of risk weighted capital requirement for banks is INTENSE RED, especially for developing countries like India.

PS. Here is the document I presented at the High-level Dialogue on Financing for Developing at the United Nations, New York, October 2007, and titled “Are the bank regulations coming from Basle good for development?” It was also reproduced in The Icfai University Journal of Banking Law Vol. VI No.4, India, October 2008

There is only one 100 percent sure cause for the financial crisis 2007/08, and it is discussed less than 0.01 percent

The crisis exploded because of excessive exposures to AAA rated securities, real estate (Spain), loan to sovereigns (Greece) and short-term loans to banks (Iceland). They all one thing in common, namely that banks were required by regulators to hold very very little capital against these assets, and so banks could leverage very very much their equity with these assets, meaning that banks could expect to earn very very high risk adjusted returns on equity for these assets.

Had banks been required to hold the same level of capital against all assets, other crisis could have happened, but not one as large as the one in 2007/08.

So how much have you read about the problems related to the distortions produced by the risk weighted capital requirements in the allocation of credit to the real economy? Probably nothing!

Why? There are many explanations to that but, one of the most important, is that there is much more political interest in blaming bad bankers than laying it on good regulators.

Is this a problem? 

Yes, those regulations are still in place and so could still lead banks to create similar dangerously large exposures to something perceived or deemed safe. 

And since that still favors The Safe over The Risky, those who could most help us get our economies moving again, the SMEs and the entrepreneurs, have a lousy access to bank credit.

Right now banks are not financing the risky future, they are just refinancing the safer past, that which might soon turn risky, because of excessive financing.

PS. Here is a more extensive aide memoire on the mistakes in the risk weighted capital requirements for banks.

The regulators distort the allocation of bank credit to the real economy.

Regulators have imposed credit risk weighted capital requirements for banks… more perceived risk, more capital – less perceived risk, less capital. 

That allow banks to leverage more their equity and the support they receive from society like for instance deposit insurance guarantees when lending to The Safe than when lending to The Risky. 

That means banks earn higher expected risk adjusted returns on equity when lending to The Safe than when lending to The Risky.

And so banks will lend more and on easier terms to The Safe, and less and on relatively harsher terms to The Risky. 

And too much lending in too easy terms against too little capital to what is ex ante perceived as safe, but that ex post can turn out risky, is precisely the stuff major bank crises are made of.

And too little lending and on too harsh relative terms to what is ex ante perceived as risky, like to SMEs and entrepreneurs, is precisely the stuff that hinders sturdy economic growth.

Banks no longer finance the riskier future they only refinance the safer past... and our young are going to pay dearly for it.

Why do not Wall Street Journal’s reporters pose THE QUESTION at WEF in Davos 2016?

I refer to Wall Street’s World Economic Forum “Outlook 2016”, January 20, 2016.

Like for instance when Lingling Wei and John Hilsenrath write “Global Economy Loses Steam” The Wall Street Journal, January 20, 2016.

How on earth could not the Global Economy lose steam with regulators who, in an effort to make banks safer, have decided banks should be allowed to earn much higher risk adjusted returns on equity when lending to what is ex ante perceived or deemed to be safe, like to “infallible sovereigns”, AAArisktocracy or housing, than when lending to “risky” SMEs and entrepreneurs. That is the direct result of the risk weighted capital requirements.

“The future is here. It just needs a big push”, writes Christopher Mims. Indeed but why not start by removing the hurdles? As is, with this regulatory credit risk aversion, banks are no longer financing the riskier future they are only refinancing the safer past.

And all that distortion for no good reason, since major bank crisis never result from excessive exposures to something ex ante perceived as risky, but always from too big exposure to what has turned out to be erroneously perceived as safe.

What a shame that, with so many good journalists present in Davos, no one makes THE QUESTION

PS. Another version of THE QUESTION

@PerKurowski ©