February 07, 2018

We humans search for risk-adjusted yields. So did banks, but they now search for risk-adjusted yields adjusted to allowed leverage

Sir, let me comment on three paragraphs in John Plender’s “The global economy looks solid but there are worrying signs” February 7.

First: “there are grounds for concern about a credit cycle in which risk is clearly being mispriced. This is partly a product of the enduring search for yield. When almost every asset class looks expensive, investors tend to respond by taking on more risk”

Ever since risk weighted capital requirements were introduced, banks do not more search for yield, but instead search for yield adjusted by allowed leverage, and so risk has been mispriced.

Second: “A further hint of a return to normality is the reappearance of volatility after a long period in which it has been conspicuously absent — helpful if you worry that low volatility encourages complacency and makes the financial system more vulnerable to crises.”

And why should we not there worry, in precisely the same way, that what is perceived as safe encourages complacency and makes the financial system more vulnerable to crises?

Third: “Applying a higher discount rate to the liabilities while enjoying an uplift in the value of the assets is the answer in today’s low interest world to the pension fund manager’s prayer.”

The so many times repeated opinion that all pension funds should be able to obtain a real return of 5 to 7% annually, is one of the most harmful financial misinformation ever.