July 19, 2016

To save the banks the regulators must admit their huge mistakes, and rectify these urgently and intelligently

Sir, Philippe Bodereau, the global head of financial research at Pimco writes: “To prevent… equity volatility [to] temporarily destabilise a large institution the European Central Bank must convince the equity market that rates will not go deeper into negative territory, capital requirements will not spiral higher in perpetuity and regulators will not move the goalposts on asset quality again.” “European banks’ crisis of earnings cries out for a quick Italian job” July 19.

I disagree because that is at best a very temporary solution. The banks and their shareholders in general, though specially the European, cry out for a real explanation of what is happening, and so that they can regain the trust in the future of banking.

This because the truth is that the current risk weighted capital requirements, those which allow banks to leverage their equity and the societal support they receive more with what is perceived as safe than with what is perceived as risky, are entirely unsustainable, for two reasons.

First, though they might allow banks to earn high risk adjusted returns on equity on what’s safe for quite some time, in the long run they will cause banks to dangerously overpopulate “safe” havens, which is precisely the stuff major bank crises are made of.

Second, as they impede the “risky”, like SMEs and entrepreneurs, to access sufficiently bank credit, the real economy will begin to suffer, and there is not a chance banks can expect to survive with a real economy in tatters.

Substituting a significant leverage ratio for the risk weighting, would eliminate the distortions.

That said it has to be done intelligently, so that the economy does not suffer an excessive credit squeeze. One way could be allowing banks to hold the capital originally required on all their current assets and have the new ones apply solely to any new assets.

Since that would, on the margin, reduce the demand of banks for safe assets such as loan to sovereigns, that would, on its own, help to avoid getting deeper and deeper into negative territory.

I would also suggest European finance ministers to look at Chile’s intelligent way of extricating its banks from very similar difficulties in 1981-1983

@PerKurowski ©