June 26, 2015

To think credit-risk weighted capital requirements for banks are compatible with efficient flow of credit is loony.

Sir, Martin Wolf, in reference to “the financial crises that hit western economies in 2007” writes: “This is the fourth most costly fiscal event of the past 225 years… Mismanaged finance imposes fiscal costs that are not far short of world wars.” “Indispensable banks need a sturdy ringfence” June 26.

Wolf, as most other, is fixated on the “event”, on the explosion of the financial crisis. By doing so he fails to give sufficient attention to the build-up of pressures that caused the explosion, namely the misallocation of bank credit.

What set up the crisis of 2007? Regulatory distortion. Regulators allowed that which was perceived as safe to be financed against less bank equity; thereby permitting banks to obtain higher risk adjusted returns on equity on those assets; therefore causing too large exposures to what was perceived as safe.

From this perspective the “fiscal costs” Wolf refers to, could be seen as the reversal of fiscal income that should never have been earned… e.g. property taxes on properties artificially valued too high.

The number one priority for any bank regulator, long before thinking about ring-fencing and similar “safety” devices, is to make sure the allocation of bank credit to the real economy is not distorted. To look for banks to be able to survive in shining armor in the midst of the rubbles of a destroyed economy is just insane.

The Independent Commission on Banking, of which Wolf was a member, listed among its objectives in its Report (The Vickers Report) to “efficiently channelling savings to productive investments”; and yet it recommended “Ring-fenced banks with a ratio of risk-weighted assets (RWAs) to UK GDP of 3% or more should be required to have an equity-to-RWAs ratio of at least 10%. ”

The members of the ICB, and other regulators too of course, believing that credit risk-weighted capital requirements is in any way compatible with maintaining the efficient flow of credit to the economy, simply evidence they do not know what they are doing.

For the umpteenth time: Banks, primarily by means of risk premiums and size of exposures, already clear for perceived credit risks. To require banks to also adjust for perceived risk in their equity guarantees the system to malfunction. That which is perceived as “safe” will get too much credit at too low rates… that which is perceived as “risky” will get too little credit, or no credit at all, at too high relative rates.

If anything the risks to be considered is the risk of banks being able to manage the credit risks they perceive.

Bank equity requirements should foremost be a buffer against unexpected losses, and unexpected losses has nothing, zilch, zero to do with perceived risks… except perhaps that the higher the perceived risks are… the less room there is for unexpected losses.

Sir, more than anything we need to get regulators who know what they are doing, and who are much humbler about their own capacities.