The most important risk with banks will most probably be totally ignored again in the stress tests

Sir, Ben McLannahan reports on the Federal Reserve stress tests of the biggest US banks “designed to assess whether banks have enough loss-absorbing capital to keep trading through a shock to the system similar to the collapse of investment bank Lehman Brothers in 2008.” “US banks face tougher stress tests” February 22.

Again those tests will probably totally ignore the biggest risk with banks, that of these not allocating credit efficiently to the real economy.

In Yuval Noah Harari’s “Sapiens: A brief history of humankind” we read:

Over the last few years, [central]-banks and governments have been frenziedly printing money. Everybody is terrified that the current economic crisis may stop the growth of the economy. So they are creating trillions of dollars, euros and yens out of thin air, pumping cheap credit into the system, and hoping that the scientists, technicians and engineers will manage to come up with something really big, before the bubble bursts…

Everything depends on the people in the labs. New discoveries in fields such as biotechnology and nanotechnology could create entire new industries, whose profits could back the trillions of make believe money that the banks and governments have created since 2008. If the labs do not fulfill these expectations before the bubble bursts, we are heading towards very rough times.

And substitute there “the real economy with its SMEs and entrepreneurs” for “the labs”. 

Since banks are allowed to leverage their equity, and the support they receive from the society, many times more with assets perceived as safe than with assets perceived as risky; and banks therefore earn higher expected risk adjusted returns on equity on assets perceived as safe than on assets perceived as risky, banks have no incentives to lend to “risky” SMEs and entrepreneurs. And much less so when most banks suffer a scarcity of capital.

And central bankers should dare to ask themselves: How many millions of small bank loans to SMEs and entrepreneurs, has the Basel Committee’s regulations impeded?

And so any sensible stress test of banks should not only consider what is on banks’ balance sheets but also what is absent.

And regulators should opine on whether banks are fulfilling their number one social purpose, which is that of allocating credit efficiently to the real economy.

But because banks no longer finance the risky future, and only refinance the safer past, that might be just to stressful for the great distorters.

@PerKurowski ©