November 27, 2015

What blocks Martin Wolf from understanding risk-weighted capital requirements for banks is a dangerous distortion?

Sir, I refer to Martin Wolf’s “The fantasy of Britain as ‘most prosperous economy’” November 27. Of course it is a fantasy! There is an obstacle to that. Though in truth, that is an obstacle for most economies becoming or remaining prosperous. And I refer of course to the risk-weighted capital requirements for banks.

Our society lends the banks a lot of explicit and implicit support. And then regulators, on behalf of the society, now allow banks to leverage that support many times more on their equity for assets perceived as safe from a credit point of view than for assets perceived as risky.

And, since being perceived as safe from a credit point of view, has not one iota to do with whether that credit is more important for the real economy than a credit awarded to someone perceived as risky, the result is pure distorting credit-risk aversion.

The problem is that too many are incapable to understand how dangerous those distortions are. For instance Martin Wolf, with respect to these capital requirements once explained to me: “there is no coercion: if the risks are high, [banks] should not, in their own interest, make the loans. Nor is it the case that risk weighting prevented banks from lending to small enterprises. The reason that they did not (and do not) do so is that it IS ACTUALLY risky to do so, relative to the perceived return.”

It is there, right in front of him, and yet he does not see it. If banks could leverage as much when lending to these “actually risky” than what they are allowed to do when lending to “the safe”, then their perceived risk adjusted return on equity would be much higher and they might indeed lend to the risky.

But no! That leverage advantage is only awarded to “The Safe”, those who already get lower interests, those who already get much larger loans, those who when they turn out ex-post to be risky, are precisely those who cause major bank crisis.

@PerKurowski ©