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

ECB’s Peter Praet, seemingly solidary with deep-rooted pessimists, has no moral right to speak out against pessimism.

Claire Jones reports that Peter Praet, the member of the ECB’s top-ranking executive board responsible for economics said: “what worries me the most is that you have a sort of longer-term growth pessimism filtering through to expectations, and authorities in general have to be very attentive to this”, “ECB warns of ‘pessimism’ threat” November 18.

Frankly, are not capital requirements for banks based on perceived credit risks, and which are designed to make banks avoid taking risks on the “risky” and limiting themselves to financing the “absolutely safe”, an expression of profound pessimism? Of course it is. Optimism is equivalent to let’s go for it, even if its risky. And that is what Europe needs.

But, the problem Praet might have is that it must be difficult to discuss the distortions in credit allocation that that bank regulation causes, if your boss, Mario Draghi, as the previous chairman of the Financial Stability Board, is one of the most responsible for it.

My answer to Praet would be: You have to decide whether the future of your children and grandchildren is more important than yours. It is as easy (and as hard) as that!