November 21, 2012

“Misunderstanding Financial Crises”... Indeed Professor Gorton

Sir, Gary Gorton a Professor of financial economics at Yale, and consultant for over ten years to AIG Financial Products writes “Banking must not be left to lurk in the shadows”, November 21, in which he concludes with “we know now… privately created bank money is subject to runs in the absence of government regulation”. 

"Absence of government regulation”, what does the Professor mean?” Does he not understand that there never ever have been such intrusive and distortive regulations as when regulators took upon themselves to play the risk managers of the world, and ordered risk-weights to be applied when calculating the effective capital banks needed to hold against individual assets? 

Does the consulting Professor not know that the sole reason for AIG getting into trouble selling an extraordinarily excessive amount of credit default swaps, was that bank regulations allowed banks who bought such product, when issued by an AAA rated entity, like AIG was, to hold that asset against only 1.6 percent of capital, a mindboggling authorized leverage of over 60 to 1? 

In his recent book, “Misunderstanding Financial Crises”, Professor Gorton briefly refers to “risk-based capital requirements” in the context of forcing “banks with low capital ratios to increase them”. He is wrong. What the risk weights mostly produced was a reduction of the capital banks had to hold. Basel II, required 8 percent in capital, but, when a risk-weight of 20 percent was present, like when lending to Greece, banks needed to hold only a meager 1.6 percent in capital. Clearly when the Professor writes “The commercial banks that failed in the recent crisis held on average more capital than Basel III required” is because he is not really ware of how the risk-weights weighted. 

But what really gets me up in arms is when a Yale Professor in finance, several years after this crisis has started, can write in a book:”There is no evidence that links capital to bank failure”. 

Professor Gorton should know that the correlation between all bank assets that ran into troubles and caused the current crisis, with the fact that banks were allowed to hold these assets against extraordinarily little capital, and therefore allowed the banks to earn extraordinarily high expected risk-adjusted returns on capital on these assets, was 1. And I guarantee the Professor there was causality involved. 

Yes Professor Gorton, I agree that regulators should have looked to the history of financial crisis. If they had done so they would have noted that these are never ever caused by excessive exposures to “The Risky” these are always the result, no exclusions, of excessive exposures to “The Infallible”.