October 01, 2009

Please free us from imprudent risk-aversion and give us some prudent risk-taking.

Published in FT's / Martin Wolf's Economist Forum October 1, 2009

There is not one single reason to believe the world would be a better place because our financial regulators provide additional incentives to those who, perceived as having a lower risk of default, are already favored by lower interest rates, or punish further those who, perceived as more risky, are already punished by higher interest rates. In fact the opposite is most likely truer.

According to the bank regulations of the Basel Committee, the global standards setters for much of the world, if a bank lends to an unrated corporation then it must hold 8 percent in equity but, if lending to an AAA rated client, then only 1.6 percent will suffice. The difference between 1.6 and 8 percent, 400 percent, given the high costs of bank equity, carries a substantial cost that increases the premiums on risk; something which also confuses the markets risk allocation mechanism. And, by the way, you better sit down; the capital requirement for lending to governments is quite often zero!

The debate of the current financial crisis ignores what really hit us. We still hear the most influential experts, Nobel Prize winners included, repeating over and over again the mantra of “excessive risk-taking”. How can they be so blind? This crisis did not detonate from financing “risky projects”, but from financing the safest of assets, houses and mortgages, in the supposedly safest of countries, the US, and using instruments rated AAA, which are supposed to carry no risk. 

This crisis resulted from some misguided and imprudent risk-aversion policies put in place by regulators by means of capital requirements for banks based on risk and the empowerment of the credit rating agencies, and who with their rating signs caused herds of capital to stampede over a subprime precipice. If we do not want to understand and accept this, how are we supposed to move out of this crisis and into a better future, something which, as human history has proved again and again, always requires prudent and sometimes even a dose of imprudent risk-taking?

I have been writing about this issue for a long time, to little or no avail, since the current financial regulatory system is founded upon an almost unbreakable paradigm created by regulators who are not at all interested in the big-scheme of things but who furiously concentrate on trying to live out their own small bedroom fantasies, that of a world without any bank failure... and as if a world without bank failures has to do with a better world. Actually, the more frequent bank failures are, the smaller the risk of a systemic crisis like the current. 

If you need evidence for the above, read the 347 pages of the bank regulations known as Basel II, where you will not find a single phrase that has anything to do with establishing the purpose for our banks. Regulators, when regulating, should you not start by doing just that?

In January 2003 the Financial Times published a letter were I wrote “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds.” But, even though it were the mistakes of the credit rating agencies which detonated the crisis, and which were doomed to happen, the most important part to understand, and the hardest one to accept, is that the systemic errors for the world at large would occur even if the credit rating agencies had got their ratings absolutely right. 

Between 2002 and 2004, as an Executive Director at the World Bank, I did what I could to remind this development bank that risk is the oxygen of all development, but I was never really heard. The World Bank, forced to harmonize with Mr. Stability, the IMF, had been effectively silenced. Today, when there are renewed puritan screams against “risks” I hope that the World Bank finally comes to grip with its role and turns into a Champion of prudent risk-taking. The world needs it. Just as an intellectual exercise think of how much better off our children and grandchildren could be, had the trillions that were wasted on a useless housing boom in the US, been lost instead financing projects which adapt and mitigate for climate change?

As a note, in terms familiar to the development community, current financial regulations, by favouring the “lower-risk” that resides more easily in the rich and developed countries, and castigating the “higher-risk” more prone to be part of the poor and the developing world, helps to increase the inequalities and therefore the world’s Gini coefficient.

Dear baby-boomers, there is a world out there that needs a whole lot of risk-taking in order to stand a chance of a better future; a world which does not want to lay down and die in tranquility, just yet.

PS January 2016: What already exists is usually perceived as safer than what is to come; and so regulators have de facto imposed higher capital requirements for banks when financing the future than when refinancing the past.