December 23, 2017

Imposing on banks risk aversion more suitable to older than younger, regulators violated Edmund Burke’s holy intergenerational social contract

Vanessa Houlder when writing about Richard Thaler’s ‘nudge’ theory and how our hatred of losses affects risk taking mentions: “Investing in a portfolio tilted towards equities makes sense for the young, although — given that share prices can drop dramatically — the proportion should be reduced as people near retirement, according to Thaler.” “Be lazy, the first rule of investing” December 23.

Sir, that refers precisely to something on which I have written to you hundred of letters over the years.

Regulators, with their risk-weighted capital requirements, by allowing banks to hold less capital against what is perceived as “safe”, like mortgages, than against what is perceived as “risky”, like loans to entrepreneurs, they allow banks to earn higher risk adjusted returns on what’s perceived safe than on what’s perceived risky.

With it regulators top up the natural risk aversion of bankers with their own one, and by there doom banks to primarily work in the interest of the older and against those of the young. That, phrased in Edmund Burke’s terms, is a shameful breach of the holy intergenerational social contract that should guide our lives. How our society has managed to turn a blind eye on this makes me, a grandfather, very disappointed and sad.

But all that risk aversion is also so totally useless. Major bank crisis never ever result from excessive exposures to what has ex ante been perceived as risky; but always because of unexpected events or excessive exposures to what was perceived, decreed or concocted as safe but then turned out to be risky, like AAA rated securities backed by mortgages awarded to the subprime sector and loans to sovereigns like Greece.

PS. It would be great if Vanessa Houlder could ask Richard Thaler why he thinks regulators want banks to hold more capital against what perceived as risky is made innocous than against what is perceived as safe is therefore intrinsically more dangerous? My own explanation is that they mistook the ex ante perceived risk of bank assets for being the ex post risks for banks.