How can banks price risks correctly when regulators interfere and alter the payouts?

Sir, Gillian Tett writes: “If you peer into the weeds of global finance, you will see peculiarities sprouting all over the place… there is [a] pessimistic explanation: years of ultra-loose monetary policy have made investors so complacent that they are mis-pricing risk.” “Markets appear calm but are behaving abnormally” June 22.

Years of ultra-loose monetary policy, QEs or asset purchase program have indeed distorted the markets so there has to be much mis-pricing going on. But that’s not all.

The expected winnings (the dividends or payouts times the odds of winning) is exactly the same for all possible bets in a game of roulette. This is why roulette functions as a game. The credit markets with all the signals read and emitted, by all its many participants, givers and takers, continuously work towards equal payouts. And achieving these is what an efficient credit allocation is all about. 

But what if someone altered the payouts in roulette, like the regulators, with their risk-weighted capital requirements for banks did in the market of bank credit, how long would roulette survive as game?

Sir, just remember the 0% risk weight assigned by European central bankers to Greece. Those allowed banks immense leveraging and see such ROE payout possibilities that it went overboard lending to Greece; just in the same way Greece went overboard borrowing too much. 

And what about mispricing the risk of securities with a 20% risk weight in Basel II, which allowed banks to leverage 62.5 times only because some human fallible rating agencies had assigned these an AAA to AA rating? Frankly, is not the current bunch of bank regulators the mother of all mispricers ever?

So, to blame the investors, markets, banks for mispricing risks while blithely ignoring the regulatory (and other) distortions that exists is irresponsible; and could only be understood in terms of wanting to favour bank regulators… something which you hold in your motto you do not. 

Sir, let’s get rid of as many distortions as possible, so as to let investors, markets, and our banks stand a decent chance to do a good job allocating credit. The future of our grandchildren depends on it.

For a starter, and though the road there is full of difficulties, we must get back to one single capital requirement (8-15%) for banks, so that these can leverage the same against absolutely all assets.

@PerKurowski

Just wait until the music stops playing the low interest rate tango building up corporate balance sheet leverage

Sir, John Plender, when discussing IMF’s latest Global Financial Stability Report writes: “Low yields, compressed spreads, abundant financing and the relatively high cost of equity capital, it observes, have encouraged a build-up of financial balance sheet leverage as corporations have bought back equity and raised debt levels…Rising debt has been accompanied by worsening credit quality and elevated default risk.” “Beware the curse of buybacks that destroy shareholder value” October 31

Clearly this is another music that keeps bankers dancing, even when they know they shouldn’t, not for their own or for the economy’s sake.

In July 2014, commenting on an article by Camilla Hall on this subject I wrote: “Ask any old retired banker what was his first question to a prospective borrower and you would most probably hear him say: “What do you intend to do with the money if I lend it to you?” The banker would not have liked to hear “To pay a dividend or buy back some shares”.

Not any longer. Now his first priority is to think about how he can construe the operation in such a way as to minimize the capital needed, so that he could max out leverage too… and pay dividends and buy-back shares too.

But why should we assume only bankers are to behave responsibly? It takes two to tango. The regulators, with their risk weighted capital requirements clearly indicate they do not care one iota about the purpose of banks, and the central bankers, they just keep on kicking the crisis can down the road with QEs and low interest rates.

https://teawithft.blogspot.com/2017/05/low-interest-rates-cause-buy-backs.html

@PerKurowski

Old banking: “What do you intend to do with the money?” New banking: “How do I minimize the capital the bank needs to hold?

Sir, Camilla Hall quotes a bank officer in that “loan growth [in the US] doesn't seem to be driven by the underpinning of an economic recovery” and then she reports that “much of the corporate lending is going to fund payouts to shareholders, finance acquisitions and fuel the domestic energy boom”, “US banks cautious over growing levels of lending” July 9.

Ask any old retired banker what his first question to a prospective borrower would be and you would most probably hear him say: “What do you intend to do with the money if we lend it to you?”, and the banker, as Camilla Hall writes, would not have liked to hear “To pay a dividend or buy back some shares”.

What is the first question a banker nowadays makes? Most probably “How can I structure this loan so that the bank needs to hold the least capital against it?”

And I ask you FT… what do you believe leads to healthier banks and a sturdier economy, the old or the new banking?