Free markets were set up to go bad, because of bad bank regulations.

John Thornhill writes: “The global financial crisis of 2008 exploded the ideology that markets always deliver the goods” “Three game-changing ideas to shape the post-pandemic world” Life and Arts, May 30.

Sir, that is the problem, because that is exactly what all those against free markets want us to believe. 

The 2008 crisis resulted from huge exposures to securities collateralized with mortgages to the subprime sector in the USA, turning out risky. 

And those huge exposures were a direct result of: Regulators allowing European banks and US investment banks to hold these securities, if these were rated AAA to AA, which they were, against only 1.6% in capital; meaning banks could leverage their equity an amazing 62.5 times. 

Securitization, just like making sausages, is the most profitable when you pack the worst and are able to sell it of as the best. If you can sell someone a $300.000 mortgage at 11 percent for 30 years, which was a typical mortgage to the subprime sector, and then package it in a security that you could get rated a AAA to AA, so that someone would want to buy it if it offered a six percent return, then you would pocket an immediate profit of $210.000. 

The combination of those two temptations proved irresistible.

‪#Oxfordlitfest‪ ‬An opportunity to see if Martin Wolf has overcome his intuitions with respect to bank regulations

"More-perceived-risk-more-bank-equity and less-risk-less-equity", sounds so utterly logical, that perhaps intuition kills understanding… or, in Daniel Kahneman’s terms, that System 1, the fast intuitive and emotional one, is so convinced it has done its part, so as not to allow System 2, the slower more deliberative and more logical thinking process, to kick in.

For instance Martin Wolf, in July 2012 wrote: “Per Kurowski, a former executive director of the World Bank, reminds me regularly, crises occur when what was thought to be low risk turns out to be very high risk.” 

Yet Wolf has not been able to take it from there and deduct that, if so, and as all empirical evidence supports, then those bank equity requirements should perhaps be 180 degrees the opposite.

Sir, what on earth has a regulator to do with the perceived risks of bank assets, when what he should be exclusively concerned with, is with how bankers perceive those risks and manage these?

Our banks currently are like in a car with two steering wheels; the first one controlled by bankers, and the second by regulators who are responding, simultaneously, to basically the same risks the banker sees. And so of course we must crash either because banks embrace excessively what seems safe, or because of an excessive aversion to what seems risky.

Perhaps ‪Oxfordlitfest‪ would provide an opportunity to see if Martin Wolf has finally managed to engage System 2, by asking him: 

Mr. Wolf: If bank crises usually result from excessive exposures to something which ex ante has seemed safe but that ex post turned out to be risky: Why are equity requirements for banks lower for what is perceived as risky than for what is perceived as safe?

Mr. Wolf: Give us one single bank crisis resulting from an excessive exposure to something that was perceived as risky, when banks put that asset on their balance sheet.