August 19, 2017

Tim Harford do not compare hurricane Katrina to our 2007/08-bank crisis. The first was nature the second was manmade

Sir, Tim Harford with respect to the global financial crisis, and referring to the fact that Hurricane Ivan of 2004 should have better prepared New Orleans for Katrina in 2005 asks: “even if we had clearly seen the crisis coming, would it have made a difference?” “Mental bias leaves us unprepared for disaster” August 19.

That is indeed a question, but a more precise one would be: “If we had clearly understood why a crisis had to come, would it have made a difference?”

Here is my simplified version of that issue.

Suppose a SME offered to pay the bank 6.5% in interest rate, which the bank saw as 2% for it’s cost of funds, 3% for the risk of the SME and 1.5% in net risk adjusted margin. Suppose also an AAA rated offering to pay 3.5% in interests, which the bank sees again as 2% for it’s cost of funds, 0.5% in risk premium and so therefore yielding a resulting risk adjusting net margin of 1%.

In all those more than 600 years of banking before the risk weighted capital requirements were introduced, bankers would lend to whom offered the largest risk adjusted net margin perceived, in the previous case to the SME.

But, after Basel II banks could leverage the SME’s offer 12.5 times, which would produce the bank an expected ROE of 18.75%, while the AAA rated could be leveraged 62.5 times, yielding an expected ROE of 62.5%.

Then of course the banks would naturally have to lend to the AAA rated, as not doing so would actually be ignoring their fiduciary responsibility to their shareholders.

So here is the real question. If that distortion in the allocation of bank credit had been duly understood, would it have made a difference? My answer would be a qualified “Yes!” That because, as a minimum minimorum, regulators would have understood that since their capital requirements were (loony) portfolio invariant, they would have to be especially careful with excessive growth of “safe” investments... like those AAA rated securities. 

Harford writes: “10 years on, senior Federal Reserve official Stanley Fischer is having to warn against ‘extremely dangerous and extremely short-sighted’ efforts to dismantle financial regulations.”

Sir, I warn instead against not dismantling entirely those financial regulations that caused the crisis… and that now keep sending all QE and low interest stimuli down unproductive roads.

PS. And not to speak about the 0% risk weighing of sovereigns, that which caused the excessive bank exposures to for instance Greece.