August 19, 2015

One inequality is so bad for growth that it should enter the Guinness Book of Records.

Sir, Chris Giles discusses the point of view of OECD and IMF with respect to the relations between inequality and economic growth, “Inequality is unjust — it is not bad for growth”, August 19.

Giles correctly writes: “Vigorously promoting competition…simultaneously boosted efficiency and fairness” and “attacking vested interests and the economic rents that allow the fortunate few to gain at the expense of others is a fruitful avenue for policy.”

But Giles, sadly, finds again no reason to mention the access to bank credit, one of the most fundamental ingredients of any pro-growth and pro-equality agenda, and how bank regulations completely distorted it. Here follows a short recap:

The basic capital requirement banks had to hold against assets in Basel II of June 2004 was 8 percent.

The risk weight for an AAA to AA rated sovereign (which means money managed by government bureaucrats) was 0%, so that the effective capital requirement was 0%, so banks could leverage infinitely when lending to such governments.

The risk weight for an AAA to AA rated private sector borrower (the AAArisktocracy) was 20% so that the effective capital requirement was 1.6%, so banks could leverage more than 60 to 1 when lending to this AAArisktocracy

The risk weight for a borrower without a credit rating was 100%, so that the effective capital requirement was 1.6%, so banks could only leverage 12.5 times to 1 when lending to for instance SMEs and entrepreneurs.

That meant that banks could leverage their equity and the implicit support they receive from taxpayers immensely more lending to “The Safe” than when lending to “The Risky”.

That meant that banks could earn much higher risk-adjusted returns on their equity when lending to “The Safe” than when lending to “The Risky”.

That meant banks would lend more and at lower relative rates to “The Safe” and less at higher relative rates to “The Risky” thereby curtailing the opportunities of those who have not yet made it.

And that had banks dangerously overpopulating supposedly safe-havens like the AAA rated securities backed with mortgages to the subprime sector and Greece; which caused the very bad for growth financial crisis; while simultaneously, equally bad for growth, negating the fair access to bank credit, the opportunity, to those tough we need to get going, most especially when the going gets tough.

The number one reform that needs to take place, for growth and equality to have a fair chance, is to get rid of the credit-risk weighted capital requirements for banks; and this even if it requires to temporarily lower the basic capital requirement for banks.

However the problem with that is that it would require all experts of OECD, IMF and all other having anything to do with bank regulations to explain, the why of this distortion in the allocation of credit to the real economy… and the why of their utterly long silence on it…

And of course, on the silencing part, FT and the likes of Chris Giles, are also among those having some explaining to do.

PS. Basel III, by tightening general capital requirements for banks has, on the margin, even increased some of the distortion the credit-risk weighting cause.