To make banks safer, stop allowing besserwisser regulators distort the allocation of credit.

Sir, Martin Wolf writes: “147 individual national banking crises occurred between 1970 and 2011. These crises … were colossally expensive, in terms of lost output, increased public debt and, not least, political credibility” “Why the Swiss should vote for ‘Vollgeld’” June 7.

Sir, in the years before those crises, did the economy grow in the same way? No one seems to be interested in the quality of the booms, as they are all too fixated on the damages of the busts. John Kenneth Galbraith, in his “ Money: Whence it came, where it went” (1975) wrote: “Banks opened and closed doors and bankruptcies were frequent, but as a consequence of agile and flexible credit policies, even the banks that failed left a wake of development in their passing.”

Wolf writes: “it is often easiest for banks to justify lending more just when they should lend less, because lending creates credit booms and asset-price bubbles, notably in property.” But Wolf, probably being one of those “insiders” Yanis Varoufakis refers to in his “Adults in the room”, refuses to point out how regulators, by allowing banks to leverage much more with “safe” residential mortgages, than for instance with loans to “risky” entrepreneurs, helped feed the property bubble.

The regulators, when interfering with their capital requirements for banks based on the ex ante perceived risks that would usually be cleared for solely by the market, obfuscate market signals, and thereby distort the allocation of bank credit making the economy weaker and the bank system riskier… and there is no way around that! 

PS. Does an ordinary British citizen know, for instance, that their bank regulators allows banks to hold much less capital against loans to Germany than against loans to British entrepreneurs? Sir, don’t you think they have a right to know that? Or is it a case of the risk-weights that shall not be named?

@PerKurowski

Loss aversion has bank regulators looking too much at the cost of the crisis, while ignoring the benefits of the whole boom-bust cycle.

Sir, Tim Harford writes: The concept of “loss aversion” developed by Daniel Kahneman and Amos Tversky…showed that we tend to find a modest loss roughly twice as painful as an equivalent gain… Those who were forced to evaluate and decide at a slow pace were… not intimidated by short-term fluctuations… less likely to witness losses.”, “The languid pleasures of slow investing” February 10.

That is precisely what happens when bank regulators go into action during a crisis; they just look at the losses, and completely ignore what good might have been achieved during the whole boom-bust credit cycle.

And that is why our regulators in the Basel Committee, panicking, imposed risk weighted capital requirements for banks, which pushes debt that relies more on existing servicing capacity, like financing “safe” houses, than debt that hopes to generate new revenue streams, like loans to “risky” entrepreneurs.

And we all know there’s little future in that!

Harford ends with: writes: “Perhaps we slow investors should adopt a mascot. I suggest the sloth” Indeed, and let us send a stuffed one to Basel.

An aide-mémoire on the major mistakes with the risk based capital requirements

@PerKurowski

Low interest rates cause buy-backs, meaning less equity controlling assets and higher leverages. How will it play out?

Sir, you write: “the relationship between rates and the valuations of assets such as stocks is not simple. Ironically, if there is a bubble in stocks right now, excessive faith in and misunderstanding of the power of low rates might be a contributing factor. Central bankers keen to avoid crashes might explain this more clearly.” “Central bankers cannot blow bubbles alone” May 6.

In a sort of veiled way, IMF in its Global Financial Stability Report’s, “Where Are the U.S. Corporate Sector’s Vulnerabilities?” reports on this, when it states:

“The corporate sector has tended to favor debt financing, with $7.8 trillion in debt and other liabilities added since 2010. Bank lending to the corporate sector has continued to recover and could well rise further in response to more favorable market valuations. In contrast, equity finance has traditionally been outstripped by share buybacks and has recently leveled off. A drop in the cost of equity capital may stimulate equity financing, but it could coincide with higher corporate debt—particularly if additional share buybacks are financed through debt.”

That begs three questions:

First: How much of the recent increase in the stock markets is the result of buybacks; that which helps earnings per share to get a sort of artificial boost; that which results in less equity controlling the corporations?

Second: Do the recent stock-market prices increases duly reflect the increase riskiness derived from much higher corporate debts? 

Third: Have Central Banks therefore, with their low interests rate policies, dangerously lowered the capital (equity) requirements of corporations?

On the first two questions I have no answers, though just having to ask them should suffice to at least raise some eyebrows.

On the third the IMF seems to clearly respond, “Yes!” when on that same page, under the subtitle “High Leverage Combined with Tighter Borrowing Conditions Could Affect Financial Stability” it writes:

“As leverage has risen, so too has the proportion of income devoted to debt servicing, notwithstanding low benchmark borrowing costs. Although the absolute level of debt servicing as a proportion of income is low relative to what it was during the global financial crisis, the 4 percentage point rise has brought it to its highest level since 2010, which leaves firms vulnerable to tighter borrowing conditions. The average interest coverage ratio—a measure of the ability for current earnings to cover interest expenses— has fallen sharply over the past two years. Earnings have dropped to less than six times interest expense, close to the weakest multiple since the onset of the global financial crisis.”

Holy Moly! And interest rates have not yet returned to something more "normal"; and the Fed's balance sheet is still so huge it leaves little space for any future QE assistance...and not to speak of the already too large public debts. 

How will this all play out? I don’t know. Perhaps I’d better, like most, stick my head in the sand.

@PerKurowski

The risk weighted capital requirements for banks, put the “Minsky moments” on steroids.

Sir, you write “A period of stability leads to rising investment, financed by borrowing, which drives up asset prices until cash flows generated by those assets can no longer support the debt taken on to buy them. Eventually there is what has been dubbed the “Minsky moment”: a dash for the exits as asset prices plunge. After the bubble bursts, the debt burden remains and can depress activity for a long time. “The challenge posed by oil’s ‘Minsky moment’” March 29.

But the regulators, with Basel II, told banks “If you think that something is safe then you can hold less capital against it”. And, in their Standardized Approach to Credit Risk, the regulators allocated the basic capital requirement of 8 percent according to the following risk weights: zero percent for loans to AAA-rated sovereigns; 20 percent on loans to the AAArisktocracy, 35 percent risk weight on the finance of residential mortgages; and 100 percent risk weight on exposures to unrated citizens.

And that translated into banks could leverage equity unlimited times when lending to AAA rated sovereigns; 62.5 times to 1 when lending to the AAArisktocracy, 35.7 times when financing residential housing 35.7, and only 12.5 times to 1 when lending to the unrated citizens.

And of course that allowed banks to earn different risk adjusted returns on equity not based on what the market offered, but much more based on what the regulators dictated.

And since “Minsky moments” never occur in areas ex ante perceived as risky but always in what is perceived as safe, that is of course equivalent to putting the “Minsky moments” on steroids.

You also end with: “As Minsky argued, booms and busts are endemic to capitalism. Sensible policy strives not to abolish the cycle but to mitigate its effects.”

But the risk weighted capital requirements signifies banks will have especially little capital precisely when the busts occur. And that has nothing to do with “mitigating” its effects, just the opposite.

Sir, I must have written to you and your colleagues well over 2.000 letters trying to explain the dangerous distortions caused by the risk-weighted capital requirements for banks, but apparently it has not yet been understood.

Sir, between us in petit committee, although I understand that it probably has to do with you wanting to sound sophisticated, I do not think you have earned the right of referring to Minsky into your editorials.

PS. This is not a critique directed solely to you Sir. For example, out there, the less many seem to understand what is really going on with our banks, the more they express concerns about “derivatives”, only because that word sounds so delightfully sophisticated.