October 16, 2009

Is Jacques de Larosière befuddled or just lobbying?

Sir Jacques de Larosière´s “Financial regulators must take care over capital” October 16, is either a perfect example of how trapped the regulators are in their own groupthink, or a simple lobbying effort on behalf of some European banks.

Larosière starts by rightly declaring “History shows that economic recovery essentially depends on the existence of a strong and risk-taking financial system” but then speaks out in favour of higher capital requirements for banks the higher the risks as “it is the quality of the assets of a bank that matters more than its leverage”; and writes that “imposing a non-risk based leverage ratio could entail serious negative, albeit unintended consequences.”

Well the market already charges for risk though interest spreads and so any additional risk-adjustment, for instance by means of different capital requirements, amounts to an arbitrary intervention by the regulators in favour of what they might consider low risk and quality, but which might have absolutely nothing to do with what the economy really needs.

If we want an example of how “serious negative, albeit unintended consequences” that regulatory mingling with risks could have, it suffices to look at the current crisis with its low capital requirements for the huge exposures to “non-risk” AAA rated operations. And besides, the “quality” of a financial asset is not a function of risk, but a function of its risk-reward relation.

If we are to have banks capable of taking the risks the economy needs to recover, then the first thing we need is for the regulators to stop from arbitrarily interfering with the risk allocation mechanisms of the market. If this signifies special transition problems for the European banks, as Larosière indicates it could, let us solve that by other means than defending and conserving the worst element of our current financial regulations.