January 04, 2013

The Western world dominance resulted from risk-taking. It’s stalling and falling is the result of regulatory risk-aversion.

Sir, Sir Samuel Brittan writes about “The long foreshadowed decline of western dominance” January 4.

The management of an investment portfolio always starts by ascertaining the clients risk tolerance: whether low (conservative), moderate or high (aggressive); and defining the portfolios primary investment objectives: conservation of capital, income generation, long-term capital growth or speculative capital gain. And for those most risk adverse, the investment mandates might be described in the following terms:

Risk Tolerance: Low (Conservative). The client’s principal objective is to conserve their investment by reducing the risk of loss of capital and thus volatility of portfolio. They are aware that capital risk can never be eliminated entirely, and that this type of investment will probably be subject to inflation risk. Typically, low risk strategies will comprise predominantly sovereign bonds and cash management investments, although the client may also be willing to accept some increased capital risk, for example through investment in other asset classes with higher yields and /or capital growth potential.

Primary Investment Objectives: Conservation of capital. To seek to minimize the probability of loss to principal over time by investing in relatively liquid instruments with limited price fluctuations. The client wishes to be in a position to realize the capital of his investment at any time. Products that protect notional at maturity but that may be worth less that the notional prior to maturity will not be suitable for clients with conservation of capital as their primary.

Sir Samuel Brittan knows very well that, in the long run, such risk adverse investment mandate, is doomed to dwindle the value of the portfolio into nothing.

And Sir Samuel Brittan must also know that the western world had become what it was, thanks to a lot of aggressive risk-taking searching for long term capital growth and speculative capital gains. And in its churches we could hear “God make us daring!”

But then suddenly, in June 2004, out of the blue, authorized by who knows who, the Basel Committee for Banking Supervision instructed the banks of Europe and America, with Basel II, to follow a low risk and capital conservation investment strategy. And those instructions were given by means of allowing banks to leverage immensely more their equity with exposures to “The Infallible” than with exposures to “The Risky”. And of course that zapped completely the vitality of the western economies.

I can hear the standard objection: “What do you mean Kurowski? The banks collapsed because they took on excessive risks, not because of too little risks” And again I must clarify: No! The banks took on excessive exposures to what was officially deemed as absolutely not risky, and that is an entirely different matter than taking risks. Absolutely every asset that has created the current bank problems were assets considered absolutely safe and assets and which required the banks to hold only 1.6 percent in capital or less.

And so friends, if we do not restore urgently the capacity of our banks to finance what is risky we, in the Western world, are also doomed to dwindle into nothing. And Basel III does nothing of that sort, on the contrary it also introduces liquidity requirements based on perceived risk.