July 20, 2012

The pro-cyclical tsunami machinery

Sir, Sir Samuel Brittan starts his “An ancient Greek approach to modern economics” July 20, taking about cycles and ends it with the need for “removing distortions at the micro level”. He might be interested in the following macro micro distortion that is taking economic cyclicality to unimaginable levels. 

A European bank was authorized to lend to Greece holding only 1.6 percent in capital, which meant being able to leverage Greece’s risk-adjusted margins 62.5 times, and so it did, but, unfortunately, so did too many other banks, and Greece went bust. 

And now, when the bank has lost all its capital, it is required to hold many times more capital if lending to Greece, and so the European bank has no other choice but to lend to Germany, as so must all other banks do, something which does not require it to hold any capital. In fact, if lending only to the infallibles, then the bank would not even need shareholders, and could retain all bank profits for bankers’ bonuses. 

If this bank regulation is not a machine for creating a tsunami of pro-cyclicality, what is?