February 24, 2010

Bank regulators need a better understanding of risk

Sir Martin Wolf holds that “The world economy has no easy way out of the mire” February 24. Who could argue with that... except perhaps in terms of it being an understatement.

Wolf holds that, ceteris paribus, we will not get out of the crisis unharmed and that either through a bigger financial crisis in the future or the “the fiscal rope” running out we will ultimately have a “sovereign debt crisis”. No doubt he is right. And as the only possibility for avoiding collapse he argues, quite correct again, having the world to grow out of its debt overhang.

But what I have not been able to convince Martin Wolf about, no matter hundreds of letters is that to grow out of the debt overhang we need a completely different paradigm with respect of how we regulate our banks. The current one, based exclusively on risk-avoidance, will not take us anywhere and on the contrary will just help to reinforce the dangerous fairytales that there are enough safe-havens and AAAs to go around for all, and that it is in safe havens you can generate real growth.

Martin Wolf quotes William White former chief economist of the Bank of International Settlements referencing “the explosion of the balance sheet of the financial sector and increase in its exposure to risk” as one of the imbalances that led to this crisis.

If our bank regulators were more capable of performing what Arthur Koestler labelled as bisociation they would have long ago discovered the irony in that the explosion of the balance sheet and the exposure to risk that occurred and failed was almost all in supposedly risk-free AAA rated operations.