September 22, 2017

Why would some not participate in needed societal risk taking, but have right to unimpeachably safe liquid assets?

Martin Wolf writes: “The most important purpose of money is to serve as a safe source of purchasing power in an uncertain world.”, "Why banking remains far too undercapitalised for comfort" September 22. 

I am not sure that means to allocate bank credit efficiently to the real economy, but if it does then I agree.

But that purpose was absolutely absent from regulators’ minds when, because of an insane risk aversion, they decided to allow banks leverage much more the capital required by regulations when lending to “the safe”, than when lending to “the risky”.

The result was henceforth that banks would be able to earn higher risk adjusted returns on equity while lending to the safe than when lending to the risky. That, which allowed bankers to realize some wet dreams and big bonuses, completely hindered banks from fulfilling their purpose.

We read: banks “remain highly undercapitalised, relative to the risks they bear.” That is a misleading statement. Banks remain highly undercapitalized relative to the risks of the assets considered by regulators to be safe, is a more correct way to describe the reality.

Wolf holds: “This system is designed to fail” Of course it is. To allow banks to hold less capital against those assets that have always provoked major bank crises, namely those ex ante perceived as safe, cannot but result in making the failures even more dangerous.

The truth is that current bank regulators are too inept for comfort.

Wolf also refers to all “these proposals try to separate the risk-taking from the public’s holdings of unimpeachably safe liquid assets”

To me such proposals are the product of obnoxious social/financial engineering mindsets.

Unless we limit it to perhaps the value of one year’s median salary, why on earth should the public have the right to unimpeachably safe liquid assets… and why on earth should it not have the right, and the duty, to participate in the risk taking a society needs to move forward?

And just the expectation of “unimpeachably safe liquid assets” introduces a huge systemic error.

To follow that recipe, in an economy depressed by lack of risk taking, would have the remaining risk takers end up with all the negative interests earned by the risk avoiders… talk about putting inequality on steroids and feeding lines to populists.

No way Martin Wolf, that is not the way my western world got to where it is… that is not the road I want my world to take for my grandchildren.

Am I opposed to higher bank equity? Of course no, though I do not feel that much more than ten percent is needed… as long as it is ten percent for all… sovereigns, AAA rated and housing finance included.

To require 20%, a leverage of five to one, while leaving in place any kind of risk weighting adjustments, could just worsen current distortions.

PS. Wolf refers to Mervin Kings book “The end of alchemy” but that book had nothing to say about “the alchemy of risk-weighting” to which he now refers to, and about which I have written hundreds of letters to him over the years.