February 05, 2018

Banks now invest based on the risk-adjusted yields of assets adjusted for allowed leverages; that distorts the allocation of credit to the real economy.

Sir, Lawrence Summers, when writing about the challenges Jay Powell will face as Fed chairman mentions “Even with very low interest rates, the normal level of private saving consistently and substantially exceeds the normal level of private investment in the US” “Powell’s challenge at the Fed” February 5.

Not too long ago, markets, banks included, invested based on the risk adjusted yields they perceived the assets were offering. Some more sophisticated investors also looked to maximize the risk adjusted yield of their whole portfolio.

But, then in 1988 with Basel I, and especially in 2004 with Basel II, the regulators introduced risk based capital requirements for banks. As a consequence, banks now invest based on the risk-adjusted yields adjusted for the leverage allowed that they perceive the assets offer. As banks are allowed to leverage more with safe assets, which helps to increase their expected return on equity, they now invest more than usual, and at lower rates than usual, in “safe” assets like loans to sovereigns, AAA rated and mortgages. And of course, banks also invest less than usual, and at even higher rates than usual, in loans to the “risky” like entrepreneurs and SMEs.

That has helped to push the “risk free” down, and also explains much of the lowering of the neutral rate. Since the regulators now de facto block the channel of banks to the “risky” part of the economy, there is a lot of private investment that simply is not taking place any longer.

It is sad and worrisome that neither the leaving Fed chairman, Janet Yellen, nor the arriving one, Jay Powell (nor Professor Summers for that matter) can apparently give a clear direct and coherent answer to the very straight forward questions of: “Why do regulators want banks to hold more capital against what’s been made innocous by being perceived as risky, than against what’s dangerous because it’s perceived as safe? Does that not set us up for slow growth and too-big-to-manage crises?