October 25, 2017

Martin Wolf insists on turning a blind eye to the Financial Instability AAA-Bomb armed by the Basel Committee

Sir, Martin Wolf writes: “it has to be possible for the financial system to cope with changes in asset prices without blowing up the world economy… An essential part of achieving this is deleveraging and in other ways strengthening intermediaries, notably banks.” “Central banks alone cannot stabilise finance” October 25.

What did the Basel Committee for Banking Supervision do, for instance with Basel II?

They assigned risk weights of 0% for AAA rated sovereigns, 20% for AAA rated private sector, 35% for residential mortgages and 100% for the unrated private sector.

That, with a basic capital requirement of 8%, translated into banks being able to leverage their capital (equity): limitless with AAA rated sovereigns, 62.5 times with AAA rated private sector, 35.7 times with residential mortgages and 12.5 times with the unrated private sector.

Major bank crisis never ever result from excessive lending to what is perceived as risky. These, with the exception for when some major unforeseen events occur, always result from excessive exposures (credit bubbles) to what is ex ante perceived as safe, but that ex post turns out to be very risky, often precisely because too much credit has been given to it.

So considering that this regulation implies telling banks to go to where for the system it is the most dangerous, while holding the least capital, it must truly be classified as a bomb against financial stability. In 2009, in sad jest, I set up a blog titled The AAA-Bomb.

And oh if the only thing that bomb produced was financial instability. But no, it also produces economic weakness, by negating the “risky” the access to credit they need in order to keep the economy going forward. We finance much more the building of safe basements in which our jobless children can live, than those “risky” who could have a better chance to provide them with the jobs they need to move to their own upstairs.

And don’t tell us that if a bank can leverage much more with the “safe”, and thereby obtain much higher expected returns on equity with the “safe” than with the “risky”, it will keep on bothering with lending to SMEs or entrepreneurs. Of course it won’t. The risk weighted capital requirements for banks have turned our savvy know-your-client loan officers into dumb equity minimizers.

With respect to “deleveraging and in other ways strengthening intermediaries, notably banks” Wolf now opines “That has indeed happened, but not, in my view, nearly enough.”

Well of course not! How could that be, when even Martin Wolf himself has played a great role in silencing the existence of that bomb… that about which I have written to him more than 400 letters and to FT in general more than 2.500.

Finally Martin Wolf writes about “the failure of governments to address the many frailties that still lead to financial excess. The central banks did their job. Unfortunately, almost nobody else has done theirs”

What? Look at the major role central bankers like Paul Volcker, Mario Draghi, Jaime Caruana, Mark Carney, Stefan Ingves and many other have had or have in the area of banking regulations. They, by ignoring the distortions in the allocation of bank credit to the real economy these regulations caused, have wasted most of the stimulus they have been injecting with their quantitative easing and low interest rates.

Sir, since getting rid of the risk weighted capital requirements for banks is not even mentioned here by Wolf, and you yourself can be considered a partner in the silencing of me, I guess this letter will also be added to the silenced ones… but of which I of course keep a record… here on the web.

PS. Come to think of it, should not central bankers even recuse themselves when it comes to bank regulations?

PS. Truly, FT's lack of curiosity amazes me

PS. Sir, click if you want an aide mémoire on the mistakes