April 29, 2018

Even perfectly perceived risks, if excessively considered, cause wrong reactions

Sir, John Authers writes that John Locke…when asked if we have an idea of the substance behind our perceptions, answered that we have “no such clear idea at all, and therefore signify nothing by the word substance, but only an uncertain supposition of we know not what”. “Economic reality is hard to fathom after years of distortion” April 28.

And then Authers argues: “Uncertainty is nothing new, particularly about the future. But it is rare for the present to be so hard to perceive as it is now. After a decade of desperate monetary measures to stave off the Great Recession, there is also a reluctance to believe what the markets are telling us, as their signals are distorted.”

At least when it comes to banks and their allocation of credit to the real economy, the signals are indeed extremely distorted, all as a result of the risk weighted capital requirements.

Bankers perceived credit risks and cleared for these by means of the size of the exposure they accepted and the risk premiums they demanded. But then came regulators and ordered that precisely those same perceived risks, should also be cleared for with the capital requirements.

With that they just ignoredthat any risk, even if perfectly perceived, leads to the wrong actions, if excessively considered.

As a result there are now way too high exposures, at too low risk premiums, to what is perceived as safe (and which therefore contains the fattest dangerous tail risks) and too little exposures, at too high risk premiums, to what is perceived as risky, like entrepreneurs.