The economic impact of a “too big to fail" bank's” failure is monstrous, even if it had 100% equity.

Sir, I refer to Martin Wolf’s “‘Too big to fail’ is too big to ignore” April 16.

Wolf, like many, questions whether a 5 percent leverage ratio, and which translated into layman terms signifies a 19 to 1 debt to equity ratio, can be enough. Of course it is not!

That said the fact remains that if a monstrously big bank fails, in terms of its overall economic impact, whether it has 100% equity or 100% debt, is sort of marginal… wealth destroyed is wealth destroyed no matter how its financed. Clearly, the distribution of a loss matters but, for instance, would the world be sustainably better off, if it the one percenter’s lost all they had?

And so, out of three recommendations the IMF makes, just like Wolf I think the most important is to “reduce the probabilities of distress”.

And how is that done? As you well know in my opinion that requires committing to the dustbin of bad memories, the risk-weighing of capital requirements for banks.

The risk-weighing means that banks earn different risk-adjusted returns on equity on different assets, and this distorts all common sense out of the overall important credit allocation function of the banks.

Even worse, the current system guarantees that banks will have especially little capital when they encounter those icebergs which have always sunk bank systems, when cruising in waters perceived as “absolutely safe”.

And, here is a reminder. It does not matter whether the too big to fail banks allocates 100% correctly its resources, if the rest of the banking system doesn’t, since that way, the well behaved too big to fail, will anyhow go down, sooner or later, because there is no such thing as a stable banking system in a lousy and unstable real economy.

What current regulators do not understand is that making the banks safe begins by not distorting the allocation of credit, which they do!

The real losses of a banks, except perhaps for interest rates mismatch, do not occur on the liabilities and equity side of the balance, but on the asset side  

PS. With relation to the subsidies of TBTF banks there is some inconsistency, as some could argue that a subsidy could be necessary to keep these from failing. And even if labeled TBTF, banks are little or not subsidized at all by the markets, could that not be an indication of how fallible markets believe their rescuers to be?

PS. Sir, just to let you know, I am not copying Martin Wolf with this, as he has asked me not to send him any more comments related to the capital requirements for banks, as he understands it all… at least so he thinks.

Banks need to be made more useful, meaning less distorted when allocating credit to the real economy

Sir, I refer to your “Banks should be made more solid” April 12.

Like you I welcome the introduction of the “leverage ratio” which will require banks to hold capital against assets, independently of perceived risk. And like you I am astonished banks could argue that a 5% leverage ratio, which in essence translates into an authorized 19 to 1 debt equity ratio, is too much for them… of course, arguing that a 3% leverage ratio, a 32 to 1 debt equity ratio is too much, blows anyone´s mind.

But, unfortunately, the regulators, as tyrannical experts, unable to admit to their mistakes, intend to keep in place a layer of risk-weighted capital requirements, and so the regulatory distortions will only continue.

I believe that much better for all, would be to make certain that a leverage ratio really applies to all assets, and abolish to just being bad memories, those risk-weighted capital requirements which only serve to amplify the negative consequences of insufficiently, and of excessively, perceived risks.

Of course, in the long term, once the real economy has recovered, regulators should try for banks to reach an 8% leverage ratio, that which is equivalent to the capital requirements established in Basel II for a 100% risk weighted asset.

As an aide memoire, the dangers the distortions in credit allocation produced by risk weighting are:

For the stability of the banking system, as it produces larger exposures than what should ordinarily exist, to what is erroneously perceived as “safe”, and then, when the real ex post risk reveals itself, banks stand there with less safety capital than what they ordinarily would have.

For the real economy, by causing many borrowers who are not perceived as that safe but who would ordinarily merit having access to bank credit, in competitive terms, to be denied it.

A mystic crusade against debt?

Sir, there is too much debt because debt has been given huge fiscal incentives; that banks have in some circumstances been authorized to have extraordinarily high leverages; that consumer debt pushers have been able to act freely with an impudence that any drug dealer or casino owner would kill for; and that markets followed faulty risk rating signals that indicated some borrowers were risk-free no matter how much debt they contracted.

And there is nothing “mystic” with that, as the almost embarrassing manifest of Nassim Nicholas Taleb and Mark Spitznagel “Time to tackle the real evil: too much debt” July 14 would seem to indicate. The authors call for economic demystification by calling for a mystic crusade against debt.

I have professionally been involved with many debt to equity conversion operations and of course they are often very useful but let´s face it, at the end of the day, a loss is a loss is a loss, whether you are holding debt or equity, just that the latter usually allows you to bluff yourself a little longer.