July 21, 2018

To tell us “What really went wrong in the 2008 financial crisis” might require more distance to the events

Martin Wolf reviewing Adam Tooze’ “Crashed: How a Decade of Financial Crisis Changed the World” refers to the author’s question of “How do huge risks build up that are little understood and barely controllable?” “What really went wrong in the 2008 financial crisis?” July 18.

May I suggests as one cause, the nonsensical ideas that can be developed through incestuous groupthink in mutual admiration clubs of great importance, such as bank regulators gathering around with their colleagues of the central banks in the Basel Committee for Banking Supervision.

Wolf writes: “The crisis marked the end of the dominant consensus in favour of economic and financial liberalisation” 

Not so! The end in “favour of economic and financial liberalisation” happened much earlier when the regulating besserwissers decided they knew enough about making our bank systems safer, so as to allow themselves to distort the allocation of bank credit.

In 1988, the regulators, with the Basel Accord, Basel I, surprisingly, with none or very few questioning them, decided that what’s perceived as risky was more dangerous to our bank system than what’s perceived as safe, and proceeded to apply such nonsense with their risk weighted capital requirements for banks. More risk, more capital – less risk, less capital. 

That meant that banks could then leverage more their regulatory capital (equity) with “the safe” than with “the risky”; which translated into banks earning higher expected risk-adjusted returns on equity with “the safe” than with “the risky”. That would of course from thereon distort the allocation of bank credit more than usual in favor of the safe and in disfavor of “the risky”.

That of course ignored the fact that what is perceived as risky has historically proven much less dangerous to the bank system than that which is perceived as safe. 

Basel I, which already included much fiction, like assigning a 0% risk weight to sovereigns and 100% to citizens, was bad enough but then, in 2004, with Basel II, the regulators really outdid themselves allowing for instance banks to leverage 62.5 times their capital with assets that had an AAA to AA rating, issued by human fallible rating agencies was present.

We have already paid dearly for that stupidity, as can be evidenced by the fact that absolutely all assets that detonated the 2007/08 crisis had in common generating especially low capital requirements for banks, because these were perceived (houses), decreed (Greece) or concocted (AAA rated securities) as safe.

I have ordered it but of course I have not read Adam Tozze’s book yet. When I do I will find out if it makes any reference to this. If not, I might just have to wait for other historians who are more distant from the events.