To base bank regulations on that ex ante perceived risks reflects the ex post possible dangers, is pure an unabridged naïve over-optimism

Sir, Martin Wolf writes “Over-optimism is the natural precursor of excessive risk-taking, asset price bubbles and then financial and economic crises.” “A bit of fear is exactly what markets need” February 14.

Indeed, and what is more a naïve “Over-optimism” than bank regulator’s risk weighted capital requirements for banks, based on ex ante perceived risks reflect the ex post possibilities?

Wolf writes of “the hope that those who manage systemically significant financial institutions remain scarred by the crisis and are managing risks more prudently than before”. Why should they? The incentives provided by the risk weighted capital requirements for banks still distort the allocation of credit. In this context “prudently” means more banks assets going to perceived, decreed or concocted safe-havens, some of which, as a consequence, are doomed to be dangerously overpopulated. 

Wolf admonishes, “If a policy [quantitative easing] designed to stabilise our economies destabilises finance, the answer has to be even more radical reform of the latter.”

I would argue that the “quantitative easing” was not correctly designed to help the economy, precisely because it ignored the regulatory distortions that impeded the economy to, by way of bank credit, use that liquidity efficiently.

Wolf correctly states “It is immoral and ultimately impossible to sacrifice the welfare of the bulk of the people in order to placate the gods of the financial markets”. But I ask, is that not what is being done by allowing banks to obtain higher expected risk adjusted returns on equity when financing the safer present, than when financing the “riskier” future our grandchildren need to be financed?

Again, I dare Martin Wolf to explain why he believes regulators are correct in wanting banks to hold more capital against what, by being perceived as risky, has been made innocous to the bank system, than against what, precisely because it is perceived as safe, is so much more dangerous?

Bank regulators have the right to be fearful, but they should fear more what is perceived safe than what is perceived risky.

PS. Here a brief aide memoire on the major mistakes with the risk weighted capital requirements

@PerKurowski

Why is real fear of credit risks not as transitory as fear of terrorism?

Sir, Tim Harford writes about when recalling a flight taken after “watching the Twin Towers of the World Trade Center collapse on television”, he was “in a state of mortal fear”, but how that fear seems so foolish to him now. And that’s because “each year an American citizen has a one in 9,000 chance of dying in a motor vehicle accident, and… Even in 2001, the chance of an American being killed by a terrorist was less than one in 100,000”, “Nothing to fear but fear itself?” November 14.

Harford then argues: “Perhaps the true impact of terrorism is psychological… The terrorists’ best hope lies in provoking and overreaction. Too often they succeed”

Absolutely. And the question then is: What terrorism impacted our current bank regulators into believing so much that those who are perceived a risky credits cause more damage to our banks, than those who perceived as safe can turn out to be very risky?

The worst part of that belief is that seemingly it is not as transitory as Harford argues fear to more normal terrorism to be. Today, years after the explosion of what was considered safe by regulators, like AAA rated securities and loans to Greece, we still have much higher capital requirements for banks against what is perceived as risky than against what is perceived as safe.

@PerKurowski ©

Prudence is ok. But prudence on top of prudence is very dangerous too!

Sir, William Rhodes holds that “Without prudence as a value we are all at risk” August 8. Absolutely, that is only as long as we are prudent when being prudent. Let me give you the mother of examples about what I mean.

Bankers already looked at credit risks when deciding interest rates, amounts of exposure and other terms of their financial assets. And they did so in a quite risk adverse way; if we remember Mark Twain’s saying “A banker lends you the umbrella when the sun shines and wants it back when it looks like it is going to rain”.

But then came the regulators and, in the name of their prudence, set also the capital requirements for banks based on the same perceived credit risks… something which suddenly allowed banks to earn much higher risk-adjusted returns on equity when lending to “The Infallible” than when lending to “The Risky”… and which of course resulted in distorting the allocation of bank credit in the real economy.

And so if we begin loading prudence on top of prudence, especially on top of the same prudence, that is when we enter into that Roosevelt territory of having nothing to fear as much as fear itself.

These nanny regulators from Basel, who basically force bankers to eat broccoli when they eat spinach and reward them with ice cream when eating chocolate cake, have now turned our economies into obese monsters, with none of the muscles provided by credits to the risky medium and small businesses entrepreneurs and start ups.

Start by controlling the blind runaway fear shown by the bank regulators

Sir, Alan Greenspan is absolutely right in that “Fear undermines America’s recovery” October 7. But instead of complaining about market fear and market risk-premiums, he should attack what really caused the crisis and so much stand against us getting out of it, namely that stupidly blind fear that bank regulators showed, when they ordered banks to have 5 times as much capital when lending to small businesses and entrepreneurs, than when lending or investing to anything related to a triple-A rating.

That is the blind runaway fear that first must be controlled.