January 21, 2015

Martin Wolf: How risky to the banking system can a borrower perceived as risky really be?

Sir, I refer to Martin Wolf’s “Chronic economic and political ills defy easy cure” January 21.

Of course! It is impossible to cure current problems if you are not even able to acknowledge, how the current credit risk weighted equity requirements for banks distort the allocation of credit to the real economy.

Wolf writes: “The leverage — ratio of assets to equity — of many large global banks is about 25 to 1, which is bound to make them vulnerable…  Moreover the lack of transparency of [bank’s] balance sheets remains daunting. In a complex global financial system, the ability of participants to understand balance sheets is limited. This tends to generate cycles of overwhelming risk-affection followed by panic-induced aversion. The low real returns on safe assets tend to exacerbate the intensity of the affection and so the extent of the aversion.”

But, if you know that 25 to 1 leveraged equity strapped banks must hold much more equity against assets perceived as risky, than against assets perceived as “absolutely safe”, like sovereigns and the AAArisktocracy, then it should not be hard to understand that instead, it is the following which happens: 

Overwhelming exposures to what is perceived, or made to be perceived as absolutely not risky, are created; followed by panic-induced realizations that something of what was perceived ex ante as absolutely safe turned out to be not so safe, and ate up what little bank equity there was; which causes a rush to add more exposure to what is perceived as absolutely safe. And round and round we go, until all our banks end up holding the last remaining “absolutely safe” asset… whichever that happens to be.

If Martin Wolf wants to makes really good use of his stay in Davos, and is not afraid to ruffle some feathers, including his own, he should walk around and ask as many he can: How risky to the banking system can a borrower perceived as risky really be?