How can you hold governments accountable, while their borrowings are being non-transparently subsidized?

Sir, Aveek Bhattacharya discusses various options to improve the productivity and effectiveness of public spending. “A future case for the ‘retro’ policy of public sector reform” FT February 18, 2022.

He fails to mention: Current bank capital requirements are much lower for loans to the government than for other assets. This translates into banks being able leverage much more their capital – and so making it easier for them to earn higher risk adjusted returns on equity when lending to the government than when lending to the citizens. That, which de facto implies bureaucrats know better what to do with credit they’re not personally responsible for than e.g., small businesses, turns into a subsidy of the interest rates government has to pay on its debts. Top it up with that the quantitative easing carried out by central banks is almost all through purchases of sovereign debt, and then dare think of what sovereign rates would be in the absence of such distortions.

Sir, if you really want to make your government more accountable, have them at least know what their real borrowing costs are.

Sir, in a letter you published in 2004, soon two decades ago I asked “How many Basel propositions will it take before regulators start realizing the damage, they are doing by favoring so much bank lending to the public sector?” Do you think this only applied to developing nations? If so, please open your eyes.

@PerKurowski

Tim Harford, non-transparent taxes disguised in clothes of bank regulations, is that not statist sadism?

Sir, I refer to Tim Harford’s discussion of taxes from the perspective of economists, “The pillar of tax wisdom”, November 21.

If companies could like governments print money so as to repay their debts with money worth less, or if companies, like governments do when they increase taxes, could when in need force shareholders and strangers to pay in additional equity to help repay its debts, then companies could be as “good-credits” as governments.

In 1988, the overall important G10, with the Basel Accord, sprang the risk weighted capital requirements for banks on the world. In it bank regulators amazingly decreed the risk weight of the sovereign, meaning the government, was to be zero percent, while that of the private sector was set at 100 percent.

From that moment on, banks of G10 would be able to leverage their equity more with loans to the sovereign than when lending to the private sector. And that meant banks would earn higher expected risk adjusted returns on equity when lending to the government than when lending to the “risky” private sector. Of course, implicitly it also meant that regulators believe that governments could use bank credit more efficiently than the private sector. In other words an expression of statist sadism!

That translated into a non-transparent subsidy for the government, just another different type of tax revenue, payable by all the extra interest rates or lesser access to bank credit the private sector would have as a result of it.

How much would that tax be? It is hard to say but, if we consider that the most important part of its cost is the foregone opportunities of fair access of bank credit to SMEs and entrepreneurs, then we could be talking about some truly mindboggling amounts.

Sir, would you ask Tim Harford whether he, as an economist, has any opinion about taxes disguised as regulations?

PS. That subsidy also implies that the usual proxy for risk-free rates, like US Treasury, now indicates a subsidized risk free rate

​Per Kurowski

Economist

@PerKurowski ©

Show steel and lower the capital requirements for banks when lending to the risky, or the economy will collapse

Sir I refer to Avinash Persaud’s “Show steel and raise rates or the financial system will fracture” August 25.

Though I do not disagree with what Persaud writes, I would argue that before the rates are increased, we should get rid of the credit risk weighted capital requirements for banks. These artificially lower the interest rates on what is perceived as safe, and artificially increase the relative interest rates paid by those perceived as risky... like SMEs and entrepreneurs.

By getting such distortions out of the way, it would be so much easier for the real economy to adjust to any interest rate adjustment. By leaving these in place, the distortions in bank credit allocation could be dramatically amplified when adjusting the rates.

I hear you: “Kurowski are you crazy? Lowering the capital requirements for banks on risky assets?”

Why not? “Risky” assets present much less risks of unexpected losses than those perceived as absolutely safe… and are not unexpected losses the prime reason for which banks are required to hold equity?

@PerKurowski

Martin Wolf: Sovereigns = 0% risk weight; citizens = 100%. Are not regulations relevant to sovereign bond markets?

Sir, Martin Wolf discusses lengthily the history and possible future of the current low yields of sovereign bonds, “The wary retreat of the bond bulls”, May 20.

Surprisingly, or perhaps not so surprisingly, Wolf fails to even mention the absolutely extraordinary development that took place with the signing of the Basel Accord in 1988. In that accord, regulators, decided unilaterally and with no explanations given, that for purposes of the equity banks needed to hold, the sovereigns were assigned a risk weight of zero percent, while the citizens, those who really constitutes the backing of a sovereign, were risk-weighted with 100 percent.

That of course meant that those interest rates which were used as proxies for the risk-free rate, became subsidized risk-free rates and are not at all comparable to what existed before 1988.

That of course meant that banks would earn immensely higher risk-adjusted returns on equity when lending to the sovereign than when lending to the risky.

In November 2004 in a letter published in FT I wrote: “Our bank supervisors in Basel are unwittingly controlling the capital flows in the world. How many Basel propositions it will take before they start realizing the damage they are doing by favoring so much bank lending to the public sector (sovereigns)?” More than a decade later I still ask the same question and many still prefer to ignore that.

@PerKurowski

The ultra-low interest rates might not reflect real market rates but only mumbo jumbo rates.

Sir, we are giving banks permission to load up their balance sheets with a lot of sovereign and highly rated corporate debt against much less capital than what they need to have for holding “riskier” assets, and we think this has nothing to do with current low and even negative rates for the “safe” assets.

We have our central banks buying up, at no personal cost for central bankers such amazing quantities of sovereign debt the markets run out of it... and we still think we can talk about market rates? And, of course the rates we see are the marginal rates and not the average rates. It would be interesting to know at what rate sovereigns could refinance all of their debt in truly genuine markets.

Sir, when I saw the title of Gillian Tett’s “An ultra-low interest rate show that could run and run” March 13, I got enthusiastic, as I thought she would approach the issue as an anthropologists. That she would try to explain how come people could accept lending their in many cases hard earned savings, for instance to Germany at .25 percent for ten years… even when their central banks announce their determination of achieving the target of 2 percent inflation. As a minimum it sounds like freely giving away 17.5 percent of their money to the government. Or perhaps real people do not do such things others do it for them.

But unfortunately, at least for now, Ms. Tett took refuge in the discussion of swaps, basis points and other technicalities. We eagerly wait for the anthropologist to get working at it.

PS. For all of you financial experts using US Treasury as the “risk-free rate” remember that is now a subsidized risk-free rate. 

@PerKurowski

Today’s “risk-free-rates”, are not real risk free rates but subsidized risk free rates!

Sir, I refer to Amin Rajan’s “Portfolio theory has hypnotised asset managers” January 19.

Rajan, referring to Pascal Blanqué’s book “Essays in Positive Investment Management” writes:

“In practice, from 1999 to 2009, US 10-year Treasury bonds not only outperformed risky assets such as equities, their actual returns were also well above the expected ones. In fact, government bonds have violated every tenet of conventional investment wisdom over the past 30 years…

So what is the solution? The author is at pains to point out that there is no silver bullet. Our current knowledge of how markets operate is very limited. There is a crying need for more research and debate.”

Sir, when markets finally get to understand that the interest rates sovereigns are paying, is not just a consequence of their perceived “infallibility”, but also a result of them having awarded themselves regulatory subsidies… it might be too late… and all hell might break loose.

Here is the story. In the early 90s with Basel I, and then with Basel II, and currently with Basel III, banks need to hold very little or no equity at all when lending to the sovereigns, especially when compared to what they are required to hold when lending to “risky” citizens.

And that means: the more problem loans eats up bank equity; and the more regulators require banks to hold more equity; and even the more bank are fined (which eats into their equity)… the more will the banks de facto be forced to hold sovereigns.

Current US Treasury bond rates, those usually used as “risk-free-rates”, are not real risk free rates but subsidized free rates!

IMF, Mme. Lagarde, Martin Wolf: Get it! Bank regulators have prescribed the “new mediocrity”.

Sir, I refer to Martin Wolf’s “How to do better than the new mediocrity” October 15.

Wolf writes: “It is important not to exaggerate the story of slowdown in the world economy. Yet it is also vital to avoid a progressive downward slide in growth. To address this risk it is necessary to launch well-crafted reforms in both emerging and high-income economies...”

Current capital requirements for banks direct banks to hold assets, not based on their pure economic returns, but based on those higher risk adjusted equity returns they can obtain by adjusting to the ex ante perceived credit risks, those which have already been cleared for in interest rates and size of exposure. And that IMF, Martin Wolf and so many others cannot understand that excessive credit-risk aversion can only lead to mediocrity, is a real mystery to me.

And so the number one reform the world needs is to abandon all credit risk weighing when setting the capital (equity) requirements for banks.

That would unfortunately not be an easy task because, while bank credit redirects itself to serve the needs of the real economy and not the wishes of the Basel Committee; and while banks are made to have stronger capital (equity) levels, it is important to make certain that the overall liquidity provided by banks does not shrink and become a recessionary factor.

In the absence of such reform, “more public investment in infrastructure” capitalizing on regulatory subsidies that makes public debt less expensive that it would otherwise be, and like what the IMF and Martin Wolf with so much gusto propose, could make it all so much worse… and, of course, so much more mediocre.

Lawrence Summers, if you tell governments there’s abundance, you guarantee your grandchildren much scarcity.

Sir, I refer Lawrence Summers’ “Why public investment really is a free lunch” October 7 and in which he writes: “Most notably, the IMF asserts that properly designed infrastructure investment will reduce rather than increase government debt burdens. Public infrastructure investments can pay for themselves.”

I must ask, what is so notably about that? Though of course, jumping from that to the conclusion expressed in the title, which throws indispensible criteria of scarcity of resources out the window, seems indeed notable and horribly so. 

That would certainly guarantee the construction of not properly designed, too expensive and not really useful infrastructures… which would clearly negate his: “So infrastructure investment actually makes it possible to reduce burdens on future generations”.

Summers, quite similarly to what Martin Wolf does when he also preaches for public infrastructure investments, bases much of his argument on: “Real [public] interest costs, that is interest costs less inflation, are below 1 per cent in the US and much of the industrialised world over horizons of up to 30 years.” That is, by a long shot, not necessarily true.

We have no idea of what would be the real interest rates on sovereign debt, were regulators, as they should, eliminate that distorting regulation which establishes that banks need to hold much more capital (equity) when lending to a citizen or an SME, than when lending to what they have deemed as infallible sovereigns.

And, were these interest rates to change, someone would pay enormously, whether the government meaning taxpayers, or all those pension funds which will find the public debt they are holding worthless.

IMF must be very careful when sending out messages of this nature, as there are too many out there who when offered a hand, grab the whole arm… plus a leg or two.

QEs were wasted by dangerously overcrowding safe-havens while leaving risky but valuable bays unexplored

Sir, Martin Wolf explores if quantitative easing “An unconventional tool” has worked” October 6. He fends off much criticism of QE with arguments that could make a savvy defense lawyer blush, namely that it should not be accused of weaknesses and risks that it shares with other monetary policies.

My continuous criticism of QE, and that Wolf ignores, is that if QE is done in conjunction with the current credit risk-weighted capital requirements for banks, it will help the safe havens to become dangerously overcrowded, while “the risky” bays, those the economy most need, will remain totally and even more dangerously unexplored.

Wolf mentions the possibility of a “helicopter drop”, retrospectively, but, for that to happen, the QE liquidity would have to be soaked up and returned without the existence of the silly guidance mechanism used by bank regulators.

There can’t be any sturdy economic growth in sending our banks to occupy the terrain where orphans, widows and pension funds used to roam, in order to wait for money to drop on them.

Which also leaves us with one question about the civilian casualties of QE. Where do risk-adverse savers save when what is “most-safe”, pays interest rates below the risk-free rate, as a result of sovereign debt being subsidized by the fact that banks do not have to hold much or any capital against it?

How do you price bank credit for sustainable growth having to consider both risk profiles and capital requirements?

Sir, Axel Merk writes “sustainable growth comes from pricing credit correctly according to the risk profile of the borrowers, not merely cheap credit”, “The missing fear factor will return to haunt Yellen”, July 10.

Absolutely… but how do banks do that when they also must price credit according to the capital requirements ordained by the regulators for different borrowers? Impossible!

And Merk also refers to that “Forward-looking indicators, such as the yield curve, are less reliable as the Fed itself has actively managed those gauges”. Yes and here also by means of the risk-weighted capital requirements for banks, which being the smallest or even zero for “infallible” sovereign debts, has helped to convert treasury bills and bonds into a proxy of a subsidized risk-free rate.

Mr. Richard Madigan would you not like to know the real not subsidized US bond based risk-free rate?

Sir, Richard Madigan, chief investment officer at JPMorgan Private Bank writes “US bond markets leads all markets because they act as the risk-free rate for all risk-assets”, “Rate rises will come despise lower bond yield”, June .

I would love to ask Mr. Madigan the same question I asked Mr. Alan Greenspan some years ago namely… would you not like to know the real US bond based free-rate, without that regulatory distortion resulting from allowing banks to hold US bonds against so much less capital than what they need to hold when lending to citizens, and which in effect makes it therefore a subsidized free-rate?

Mr. Greenspan after hesitating for some moments advanced a "Yes".

To measure the real costs of bank credit look at those 100 percent risk weighted. The sovereigns are subsidized

Sir, when Peter Spiegel writes about Italian and Spanish borrowing costs are at the lowest levels since the euro´s launch, I presume he refers to the borrowing costs of the sovereign Italy and Spain. I say this because I am sure of that if he went down to the poorer quarters where the Italian and Spanish small businesses and entrepreneurs hang out, he would, at least in relative terms, find a quite different reality, “The eurozone won the war – now it must win the peace” May 17.

One of the current problems is being able to separate the effects from real lower risk appreciations of sovereigns, from the subsidies that much lower bank capital requirements when lending to them imply. In these days of extreme bank capital scarcity the low rates paid by sovereigns might hide the fact that other borrowers have to pay higher rates or do not get access to bank credit at all.

As I see it the eurozone has won no war… it has not yet even discovered who one of the real enemies is, namely that absurd and dangerous risk aversion introduced by its bank regulators. Real peace in Europe, besides other requires throwing away the whole concept of risk weighted bank capital requirements.

FT, don’t scare or bullshit us, with that September and October labor data is indispensable for the Fed to know what to do.

Sir, Robin Harding reports that “Experts fear loss of October data could influence tapering policy” October 5. Boy if that is what we depend on for the Federal Reserve to act correctly, we are, as the somewhat vulgar expression goes, most certainly up shit creek without a paddle.

He also quotes an expert saying “It’s like flying blind”. Come on, the Fed is flying truly blind by not knowing what would be the real interest rates on public debt, net of the subsidies implicit in bank regulations which allow banks to lend to the public sector against much less capital than when lending to citizens. Compared to that blindness the labor data would be, also in a somewhat vulgar expression, chicken shit.

That the Fed, not having a clue about what to do, would naturally like to have that data in order to explain itself, well that is a quite different proposition.

By George, it looks like Ms. Tett finally got it!

Sir, Gillian Tett in “Fasten your seat belts tightly for a turbulent QE exit”, June 21, makes a reference to the Fed piloting the plane “in a thick financial fog, with incomplete data dials and a volatile market compass”.

I have not read anything of that sort previously from Ms. Tett but, if she is referring to the fact that given the banks are required to hold so much more capital when lending to ordinary mortal “risky” citizens than when lending to the “infallible sovereign”, and that this translates into a regulatory subsidy of US Treasury rates, which completely impedes to know what the real undisturbed Treasury rates are, then by George it looks like she’s finally got it!

More than the public borrowing rate trapped at zero, it is the banks that are trapped into public lending

Sir, I refer to the “Austerity is hurting. But is it working?” debate, April 27.

The Yes camp, represented by Chris Giles advances by far the strongest argument by just stating the fact that with respect to “finances to fight crises or wars. Advanced economies had leeway in 2008; they do not now”.

The No camp, represented by Robin Harding, echoing Martin Wolf, refers again to the boost that fiscal policy could give the economy “when interest rates are trapped at zero”. Again no consideration is given to the fact that the infallible sovereign rate is “trapped” at zero in much by capital requirements for banks that are extremely biased in favor of public borrowings. And again no consideration is given to the fact that the “risky”, like the small and medium businesses and entrepreneurs, therefore need to pay banks exaggerated risk premiums in order to provide the banks with the same return on their equity; that is if they even can get the banks to take notice of them.

If the No camp would try to figure out what would happen if for instance bank were required to hold 8 percent on all assets, including sovereigns, then perhaps they would understand that more than the public interest rate trapped at zero, it is the banks that are trapped into public lending.

And if you do not think there is something wrong with that, you've got to be communists.