August 06, 2013

Do not help banks play the liquidity card trying to avoid higher leverage ratios

Sir, Daniel Schäfer begins his “Fix the contradictory rules pushing banks to be riskier”, of August 6, with the question “Can regulations make banks less safe?” And the answer is: Absolutely!

The current crisis was entirely the consequence of bank regulations, primarily Basel II, which allowed banks to hold extremely little capital/equity when lending to or investing in what was perceived as absolutely safe; which meant that banks could earn amazingly high expected risk-adjusted returns on equity when lending to or investing in what was perceived as absolutely safe; which meant that banks went overboard lending to or investing in what was perceived as absolutely safe, like to “infallible sovereigns” and the AAAristocracy; and which finally meant that when the problems arose, like with loans to Greece or with investments in securities collateralized with lousily awarded mortgages to the subprime sector, the banks stood there completely naked without any capital/equity.

The leverage ratio is a tool now used to correct somewhat for the above described miss-regulation, and some banks simply do not like it since it requires them to hold more capital/equity.

From reading Schäfer’s article, it is clear some banks are playing the liquidity card in trying to avoid the threat of even higher leverage ratios, as those proposed for example by Thomas Hoenig of FDIC. I hope the regulators, and the press, do not fall for this dirty trick.

Liquidity for banks was usually provided by the central bank’s discount window, and all it took for the bank in order to access that window, was to have good assets, of basically any kind. The underlying problem with Basel III liquidity requirements, is that is does nothing to solve the problems of Basel II, but layers on new regulations which are also basically based on ex ante perceived risks, on top of the old capital requirements, and thereby distorts and confuses even more.

Schäfer also writes banks will now as a consequence of adjusting to leverage ratios have zillions less in government bonds and deposits in other banks, but the real question is, why should banks have zillions in this type of investments? And what about all the absolutely essential loans to “The Risky”, like the small and medium businesses and entrepreneurs that are not given precisely because of the absence of a non-discriminatory and all encompassing leverage ratio? That to me sounds like a much more important issue, in order to make the real economy less risky, and which is really the best way of making our banking system less risky.