May 26, 2010

It was the financial regulator who upset the delicate balance between grasshoppers and ants.

Sir Martin Wolf ends “The grasshoppers and the ants – a contemporary fable” May 26, as all fables should end, namely with a moral, in this case being “If you want to accumulate enduring wealth, do not lend to grasshoppers”. Now since that moral cannot in any way classify as a new moral, the question that begs an answer is how come it was so utterly ignored. Let me explain why.

Our financial regulators, fed up with so many bank failures, got together in something they named the Basel Committee and there, in an incestuous petit committee, decided that it did not any longer really matter whether the banks were lending to grasshoppers or ants, as long as they were lending to those who were most certain to repay. And, in order to make sure that their new regulations were duly carried out they empowered some few human fallible credit rating agencies to decide who were most likely to repay… and created monstrously huge incentives for the banks, in terms of ridiculously low capital requirements, to lend to those deemed absolutely safe by the risk-commissars.

And the risk-commissars, grateful for the opportunity to perform a very profitable service, set out by rating their masters, the most reputable sovereigns, as having no risks… crowning them with their AAAs. And then all sort of crazy things started to happen and which brought total confusion to the markets.

The banks began leveraging up lending to sovereigns and other “risk-free” client, and though this should have resulted in the credit ratings of the banks being cut, the risk commissars measured the willingness of sovereigns to assist the banks if need be, and deeming it to be good kept the ratings of the banks; which then could further lend to super-safe-grasshoppers and super-safe-ants alike. But, unfortunately, since there is a natural scarcity of super-safes, as a good regulator should have known, and there was such an extraordinarily demand for these, the market, being what it is, began supplying some fake subprime super-safes... until the forgery was discovered, much too late.

But, meanwhile, since the lending to all of the small ants, those who in their beginnings of course pose higher risk of default were kept under the thumb of much more conservative capital requirements, it also upset the very delicate world balance between grasshoppers and ants, ending in the current disaster of having too many grasshoppers per ant.