July 14, 2010

The baby-boomers called out “Stop the World, until we get off”… too early.

Sir Martin Wolf painting the horrifying dimensions of the crisis that still lay ahead of us references a paper from 2005 by Raghuram Rajan titled “Has financial development made the world riskier?” “Three years on, fault line threaten the world economy.” July 14.

Though that paper is indeed excellent, especially when treating the subject of how bankers could or would respond erroneously to remuneration incentives, it does not really touch on the even more important issue of the very wrong turn taken at a regulatory crossroad which got us here.

When bank regulators in the early 90’s decided to impose a system of handicap weights based on the perceived risk of default, they basically ordered the world to a halt... “Let us not risk what we got!” Everything big and already established and which therefore already had better access to credit was given an additional boost from causing lower capital requirements for the banks, while anything small and new and which therefore already had more difficulties in getting bank credit, got even more restrained by causing higher capital requirements in relative terms.

Basel II, in 2004, was the ultimate refinement of this “Stop the World, until we get off.” In it, a credit to an unrated client requires the bank to hold 8 percent in capital while any bank operation with an AAA rated client only requires the backing of 1.6 percent.

Unfortunately for the too early out baby-boomers, the finance world immediately went after the extraordinary source of profit that the margin between the official credit rating agency ratings issued and the underlying true reality allowed for. The greater the differences in those margins, like when between AAAs and subprime, the greater the profits. Indeed, one of the much ignored aspects in the current discussions is that an absolute perfect credit rating, leads to no financial intermediation profits at all.

If we are to find ourselves a way of this mess, with or without the baby-boomers, we must understand much better were we come from.