September 27, 2012

A question from a humble reader to any of FT’s brilliant economists, on how banks assist in an efficient economic resource allocation.

Sir, undoubtedly FT must be interested in the banks assisting in allocating resources in an efficient way. In this respect, I would humbly request that you ask some of your great economists, like for instance Martin Wolf and John Kay, to answer the following: 

Let us suppose a bank with only two types of clients, those perceived as fairly “risky” and those perceived as “absolutely not risky” 

And then let us suppose there are two different types of capital requirements for banks methods: 

The first, let us call it the pre-Basel method, which requires the bank to hold 8 percent in capital against any loans to any of their clients. 

The second, let us call it the Basel method, requires the banks to hold 8 percent in equity for loans to those considered “risky”, but only 1.6 percent against loans to the “absolutely not-risky” 

I ask this because it would seem to me that, in the first case, banks would allocate their funds in accordance to what produces the largest risk-adjusted return to them on their equity, but, in the second, they would allocate their funds in accordance to whatever produces the largest risk adjusted return equity for the particular bank equity which regulators have decided should be held for that particular  asset… and, frankly, both methods can’t be correct from an economic efficient resource allocation perspective 

I, as you must be aware of by now, believe that the “Basel method” seriously distorts the resource allocation process, by dramatically increasing the possibilities of returns on bank equity for what is officially perceived as not-risky... and thereby dooming our economies, which for instance need their "risky" small businesses and entrepreneurs to have access to bank credit in competitive terms.  

But, since FT’s economists have absolutely refused to concern themselves with this issue during so many years, no matter how many letters I sent them, that could indicate that they know something that I, also an economist, do not know. Please, help me, what class did I miss?

PS. In case it is easier for your economists to understand what I am talking about with numbers, here are some very simple. 

Suppose that the banks would, during pre-Basel method days, have set the interest rates in such a way that the loans to the “risky” and to the “absolutely not risky” produced an expected risk adjusted margins of 1 percent. This would then have provided the banks with an expected 12.5 percent return on its equity (1/.08) on any of the loans. 

But, with the Basel method, and using the previous set interest rates, though the expected return on equity for lending to the “risky” would remain the same 12.5 percent, the expected return on lending to the “absolutely not risky” would now be a mindboggling 62.5 percent a year (1/.016). 

That would of course mean that banks could lower, by much, the interest rate charged to the “absolutely not risky”, or needed to increase, by much, the interest rate charged to the “risky” in order to provide them with the same return their equity as the "not-risky". Whatever, but, pas la même allocation de ressources.