March 02, 2018

“Relax” or “tighten” has little to do with better regulation of US’s banks. Revise, correct and simplify, is what it should all be about.

Sir, I refer to Hal Scott’s and Lisa Donner’s discussion “Head to head: Should the US relax regulation on its big banks?” March 2.

Hal Scott writes: “There is empirical evidence that higher bank capital requirements cut lending and economic growth. A recent Fed paper concludes that a 1 percentage point rise in capital ratios could reduce the level of long-run gross domestic product growth by 7.4 basis points.”

And Lisa Donner writes: “Increased capital requirements lower the return on equity and, by extension, the bonuses linked to it. The desire of a small number of very wealthy people to become still richer should not drive public policy.”

They both, obviously each one from to the point of view of their respective agendas are correct in recognizing that capital requirements have clear effects. But then, as is unfortunately the current norm, they both ignore the problem of the distortions in the allocation of credit that different capital requirements produce.

And, if there is any problem in current bank regulations that needs to be tackled, that is getting rid of those distortions. If there is one analysis needed that is whether the bank’s balance sheets correspond with the best interests of our economies. The answer would be “NO!”

Scott asks: “Do we really want banks to hold enough capital to survive events that have no US historical precedent? If such an extreme economic event did occur, would any amount of capital be enough to withstand the panic it could trigger?”

Ok, agree, but then why should we want our banks to keep especially little capital when such events occur? Like when 20% risk weighted AAA rated securities exploded?

Scott, mentioning stress tests that depend on secret government financial models to predict bank losses argues: “avoid ‘model monoculture’ in which every bank adapts its holdings in order to pass the tests and they all end up holding assets the government model favors. A diversity of bank strategies is preferable given that risks are hard to predict.”

Absolutely and that is why, April 2003, as an Executive Director of the World Bank I held "A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind."

The stress tests, by focusing too much on the risk flavor of the day, as I have written to you before, are in themselves huge sources of systemic risk.

Scott informs “The living wills process requires banks with more than $50bn in assets to hold minimum amounts of “safe” assets; currently this stockpile totals more than $4tn in government debt”

Holy moly, $4tn is close to 20% of all US public debt. Is there really no interest for trying to figure out where real rates on US government debt would be if banks were not given the 0% risk-weight incentives for these debts, or, alternatively, be forced by statist regulators to hold lots of it?

Donner argues: “There is no fundamental trade-off between sound regulation of the financial system and shared prosperity. Quite the opposite. Even as tighter bank capital and liquidity requirements were phased in after the crisis, bank credit to the private sector has surged to new heights as a percentage of global output.”

But really, is that credit surge an efficient one? Are banks financing enough the “riskier” future, or are they mostly writing reverse mortgages on our “safer” present economy? 

Sir, what kind of crazy model could hold that economic growth is the result of banks being able to earn their highest risk adjusted return on equity on what is perceived, decreed or concocted as “safe”, and so avoid lending to “risky” entrepreneurs?