July 13, 2012

What was “not-risky” turned into risky because it was allowed to earn too high returns on bank equity.

Sir, I much appreciate Martin Wolf mentioning that I have reminded him regularly that “crises occur when what was thought to be low risk turns out to be very high risk”, arguing that “For this reason, unweighted leverage matters”, “Seven ways to clean up our banking ‘cesspit’” July 13. 

This is true, but what I have mostly tried to remind and explain to everyone, with less success, is about the dangerous distortion regulatory risk-weighting produces. 

For instance, Robert Jenkins, Member of the Financial Policy Committee, Bank of England, in a recent speech said: “The successful investor is not interested in promises of short-term return on equity; he is interested in achieving attractive risk-adjusted returns. The higher the perceived risk, the higher the return required. The lower the perceived risk, the lower the return expected. Capital will flow with either combination but its price will be different” 

What Mr. Jenkins, has not fully realized yet is that when regulators decide to allow banks to leverage their equity much more when something is perceived as risky than when something is perceived as not risky, they completely distort the system, producing the opposite; the higher the perceived risk the lower return on equity and the lower risk the higher the return. 

And this distortion is sheer lunacy, as it assassinates the risk-taking a society needs in order to move forward; and also dooms our banks to end up gasping for profits and capital on some beach that was perceived as very safe, but was not, when it became overcrowded