April 22, 2009

The regulators changed the odds at the casino... surreptitiously

John Kay in “How economics lost sight of the real world” April 22, writes that “grossly imperfect information have led us to where we are today” and he is more right than he knows.

On June 26, 2004 Ministers and central bankers from the G10 endorsed the publication of the International Convergence of Capital Measurement and Capital Standards: a Revised Framework. Those regulations authorized banks to have a leverage of 62.5 to 1 if they lent to corporations to which human fallible credit rating agencies had awarded AAA-ratings. With that the regulators send out the message, loud and clear, that risks could be measured with much more preciseness than previously thought possible and that there were agents capable of doing so.

And the regulators also naively ignored that the measurement of risks would itself alter the realities of risks, and so those regulations amounted to something like fooling around with the odds at the casino without informing the players. Markets that wanted to play it safe, on black or red, were unknowingly lured into placing their bets on a number.

Those regulations contained in sum the most dysfunctional financial regulatory innovation in history and no one said a word. Shame on the tenured professors, the think-tanks, the press and all the others the society counts on to keep it informed.