December 30, 2012

The incredibly skewed bank exposure in favor of “The Infallible” and against “The Risky” is the Achilles’ heel of the real economy.

Sir, the regulatory standing order for the banks, especially when faced as they are with great scarcity of capital, is to stock up on “The Infallible” assets and get rid of “The Risky”, those for which they are required to hold much more capital. And that is becoming even more imperative when Basel III will impose liquidity requirements based on perceived risk. 

This is what creates the largest distortions in the financial market and so I keep being amazed by how for instance John Authers can write a “Message from Memphis gives a bonds perspective” December 29, completely ignoring the Basel regulations perspective. 

If, as in pre-Basel days, all bank assets generated the same requirements, the current markets would be dramatically different which just comes to show how loony it is to have placed us in the hands of some bank regulators who have no idea of what damage to the real economy they are doing with their silly risk-weights. 

Authers writes “many holders regard Treasuries as truly risk-free [and] this anomaly looks particularly dangerous.” Of course it is dangerous, but by now he should know that no market participants regards the Treasuries as risk-free as the regulators do, like when in Basel II they assigned these a zero risk-weight, and which meant there was no limit on how much banks could leverage their equity if stocking up on these assets.