August 06, 2018

To really understand the 2007-08 crisis, it is the ex ante perceived risks that should be used, and not the ex post understood risks

Sir, Martin Sandbu, when reviewing Ashoka Mody’s “EuroTragedy: A drama in nine acts" writes: “Mody nails the biggest policy error of them all: the insistence that euro member states could not default on their own debt, or allow their banks to default on senior bondholders.” “A crisis made worse by poor policy choices” August 6.

That refers indeed to a great ex-post crisis policy error, but not to the biggest error of all, that which caused the crisis, namely the ex ante policy of the regulators, for the purpose of their risk weighted capital requirements for banks, assigning all EU sovereigns, Greece included, a 0% risk weight.

Mody (on page 168) includes the following: “If, for example, €100 of bank assets generate a return of €1, then a bank with €10 of equity earns a 10 percent return for its equity investors, but a bank with only €5 of equity earns a 20 percent return.” Though not entirely exact (because it might be slightly more difficult to generate that €1 with less capital) it shows clearly Mody understand the effect on returns on equity of different leverages.

But what Mody, and I would say at least 99.9% of the Euro crisis commentators do not get, or do not want to see, or do not dare to name, is that allowing banks different leverages for different assets, based on different perceived, decreed (or sometimes concocted) risks, distorts the allocation of bank credit to the real economy. In the case of the Euro, the two shining examples are: the huge exposures to securities backed with mortgages to the US subprime sector that, because they got an AAA to AA rating, could be leveraged 62.5 times; and the exposures to sovereigns, like Greece.

Sir, let us be clear, there is no doubt whatsoever that, had for instance German and French banks have to hold as much capital/equity against Greece that they had to hold against loans to German and French entrepreneurs, then they would never ever have lent Greece remotely as much.

The other mistake that Mody in his otherwise excellent book makes, and which is one that at least 99% of the crisis commentators also make, is that they fall into the Monday-morning-quarterback trap of considering ex post realized risks, as being the ex ante perceivable risks. Mody refers in the book to that George Orwell might have written about narrating history “not as it happened, but as it ought to have happened” In this case the risk referred to, are not the risks that were seen but the risks, we now know, that should have been seen.

Sir, Ashoka Mody’ EuroTragedy has so much going for it that it merits to be rewritten. Just reflect on what it means for the Greek citizens having to pay the largest share of sacrifices, for a mistake committed by European technocrats.

PS. Mody goes into the details of the demise of “the smallest of Wall Street’s five top tier investment banks” Bear Stearns. It “was an accident waiting to happen… it had borrowed $35 for every dollar of capital it held”. Had Mody added the fact that Bear Stearns had been duly authorized by the SEC to leverage this much and even more, the recounting of the events would have been different.