March 29, 2016

The risk weighted capital requirements for banks, put the “Minsky moments” on steroids.

Sir, you write “A period of stability leads to rising investment, financed by borrowing, which drives up asset prices until cash flows generated by those assets can no longer support the debt taken on to buy them. Eventually there is what has been dubbed the “Minsky moment”: a dash for the exits as asset prices plunge. After the bubble bursts, the debt burden remains and can depress activity for a long time. “The challenge posed by oil’s ‘Minsky moment’” March 29.

But the regulators, with Basel II, told banks “If you think that something is safe then you can hold less capital against it”. And, in their Standardized Approach to Credit Risk, the regulators allocated the basic capital requirement of 8 percent according to the following risk weights: zero percent for loans to AAA-rated sovereigns; 20 percent on loans to the AAArisktocracy, 35 percent risk weight on the finance of residential mortgages; and 100 percent risk weight on exposures to unrated citizens.

And that translated into banks could leverage equity unlimited times when lending to AAA rated sovereigns; 62.5 times to 1 when lending to the AAArisktocracy, 35.7 times when financing residential housing 35.7, and only 12.5 times to 1 when lending to the unrated citizens.

And of course that allowed banks to earn different risk adjusted returns on equity not based on what the market offered, but much more based on what the regulators dictated.

And since “Minsky moments” never occur in areas ex ante perceived as risky but always in what is perceived as safe, that is of course equivalent to putting the “Minsky moments” on steroids.

You also end with: “As Minsky argued, booms and busts are endemic to capitalism. Sensible policy strives not to abolish the cycle but to mitigate its effects.”

But the risk weighted capital requirements signifies banks will have especially little capital precisely when the busts occur. And that has nothing to do with “mitigating” its effects, just the opposite.

Sir, I must have written to you and your colleagues well over 2.000 letters trying to explain the dangerous distortions caused by the risk-weighted capital requirements for banks, but apparently it has not yet been understood.

Sir, between us in petit committee, although I understand that it probably has to do with you wanting to sound sophisticated, I do not think you have earned the right of referring to Minsky into your editorials.

PS. This is not a critique directed solely to you Sir. For example, out there, the less many seem to understand what is really going on with our banks, the more they express concerns about “derivatives”, only because that word sounds so delightfully sophisticated.