We humans search for risk-adjusted yields. So did banks, but they now search for risk-adjusted yields adjusted to allowed leverage

Sir, let me comment on three paragraphs in John Plender’s “The global economy looks solid but there are worrying signs” February 7.

First: “there are grounds for concern about a credit cycle in which risk is clearly being mispriced. This is partly a product of the enduring search for yield. When almost every asset class looks expensive, investors tend to respond by taking on more risk”

Ever since risk weighted capital requirements were introduced, banks do not more search for yield, but instead search for yield adjusted by allowed leverage, and so risk has been mispriced.

Second: “A further hint of a return to normality is the reappearance of volatility after a long period in which it has been conspicuously absent — helpful if you worry that low volatility encourages complacency and makes the financial system more vulnerable to crises.”

And why should we not there worry, in precisely the same way, that what is perceived as safe encourages complacency and makes the financial system more vulnerable to crises?

Third: “Applying a higher discount rate to the liabilities while enjoying an uplift in the value of the assets is the answer in today’s low interest world to the pension fund manager’s prayer.”

The so many times repeated opinion that all pension funds should be able to obtain a real return of 5 to 7% annually, is one of the most harmful financial misinformation ever.

@PerKurowski

Ex ante expected real rates of return and ex post real rates of return are apples and oranges

Gillian Tett referring to “The Rate of Return on Everything, 1870-2015” authored by Oscar Jorda, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick and Alan Taylor writes: “real rates are very low today compared with the peacetime years in the 20th century. But real returns on bonds and bills were much lower during the first and second world wars, tumbling to about minus 4 per cent (compared with 3 per cent for bonds in 2015, and zero for bills).” "Take the very long view on asset prices", December 22.

Sir, we cannot know the ex post real rates of return for bonds yet, and it must be very hard to gauge the ex ante expected real rates of return during the first and second world. Therefore it is not clear to me whether Ms. Tett refers in both cases to ex ante expected real rates or to ex post finally obtained real rates? If not she is comparing apples to oranges. Frankly, no matter how high patriotic willingness to contribute with war efforts could stimulate lending to it, I truly doubt investors accepted ex ante a minus 4 per cent real rate offer… so they must have expected a much lower inflation rate.

Sir, there is a lot of confusing ex post with ex ante going on. For instance, the Basel Committee regulators, when setting their risk weighted capital requirements for banks, used the ex ante perceived risk of bank assets as proxies for the ex post risks to banks… a horrible mistake that distorted the allocation of bank credit and that has not been corrected during soon 30 years.

PS. And now having read the paper I must also observe that risk free rates, and rates of returns on what is considered by regulators a safe assets, like houses, must be separated into those before the risk weighted capital requirement for banks and those thereafter, since the regulatory subsidy to the “safe” again makes apples and oranges of these.

@PerKurowski

Negative interests make you need deflation to balance your social security plans.

Sir, you mention that “José Viñals, a senior IMF official, has warned that negative rates could become more damaging for society the longer they persist, undermining the viability of life insurers, pensions and savings vehicles.” “Negative rates may be nearing a political limit” April 11.

Of course it does that. More than a decade ago, as an Executive Director of the World Bank I frequently objected to all those documents on Social Security System Reforms that assumed pension funds to obtain real rates of return I felt were unrealistically high for the long term. And to achieve those returns in an environment of negative interests, how much deflation might you need? Clearly, negative interests do not lead to something good.

You write: “Opponents of negative rates need to spell out the alternatives”. But Sir, that is precisely what I have done, in those hundreds of letters that you for whatever internal reasons decided to silence.

And so here it comes again. You mention that negative interests are — “intended to encourage… banks to lend more to the real economy”. But it is not only a question of more lending but also of correct lending. And the risk weighted capital requirements for banks impede these to allocate credit efficiently to the real economy.

How? Again: by allowing banks to leverage more on “safe” assets than on “risky”, the expected risk adjusted returns for safe assets will be higher than those of risky assets, and so banks will lend too much to “the safe” and too little to “the risky”.

And so in order for negative interests, QEs or any other monetary concoction to work, that regulatory distortion needs to be eliminated. Capisci?

@PerKurowski ©