December 05, 2012

“We should not be starting from here” has no real meaning if you do not know where “here” is.

Sir, John Plender writes about “the question of how banks can be encouraged to play restore a wider role in restoring economic growth” and states “There is no doubt that part of the problem lies in the inadequate cushion of capital”, “Welcome to Japanese-style financial crisis management” November 5. 

But he does not analyze the why of that inadequate cushion of capital, and therefore does not really understand that the misallocation of credit is not a “growing potential” but already a de-facto reality. 

Let me see if I can get him to understand. It is not that difficult. The banks do not have adequate capital not because something risky went wrong but because something ex-ante perceived as absolutely safe, and for which the regulators allowed banks to hold very little capital, ex-post turned out to be very risky, among other reasons, precisely because banks lent too much to “The Infallible” 

If bank or markets set the required risk adjusted returns for loans perfectly, these will be made wrong if regulators allow those perfect risk-adjusted returns to be leveraged differently and therefore provide higher risk-adjusted returns on bank equity for lending to “The Infallible” than when lending to “The Risky” and this distorts complete the resource allocation function of the banks.

Is this so difficult to understand? Apparently, since no one in FT is able (or allowed) to recognize the distortions produced. Plender ends with the old Irish joke “We should not be starting from here”, but the sad fact is that he does not even really know where “here” is.