April 12, 2015

Blind to effects of risk weighted equity requirements for banks, Summers-Bernanke do not understand what’s happening

Sir, Wolfgang Münchau refers to discrepancies between Lawrence Summers and Ben Bernanke about the deep causes of the economic slowdown, “Macroeconomists need new tools to challenge consensus”, April13.

Both Summers and Bernanke, like most or perhaps all other famous economists, Münchau included, fail to consider the dramatic consequences of the new bank regulations that came into effect in the early 1990s with Basel I, and which really exploded with Basel II in 2004.

Before the advent of risk-weighted equity requirements, banks could be leveraged differently. But, whatever their leverage was at a particular moment, it was de facto applied to all bank assets, independently of their respective credit risk. That meant banks evaluated credits solely on the basis of the risk-adjusted net margins these were expected to produce; since those margins would contribute in the same way to generate the returns on bank equity. Those were the days of relative fair-access for all to bank credit.

When credit-risk-weighted equity requirements were introduced this resulted in that the risk-adjusted margins produced different risk-adjusted returns on equity, depending on how many times regulators allowed these to be leveraged. And that marked the beginning of the current ear of unfair access to bank credit. Those perceived as “safe” would have better risk-adjusted access to bank credit than those perceived as “risky”.

In practical terms those perceived as “safe” would get too much ban credit at too easy terms, while those perceived as “risky” would get too little bank credit at relatively too harsh terms. 

And of course this dramatically distorted the allocation of bank credit to the real economy and has made many traditional macroeconomic assumption irrelevant. 

And of course any economist unaware of the Great Distortion, or not wanting or daring to consider its implications, has no idea of what is really going on.