January 22, 2014

The distortive risk weighted capital requirements for banks will haunt Ben Bernanke and Martin Wolf

Sir, Martin Wolf writes that contemporary “banks are constrained not by reserves but by their perception of risk and rewards of additional lending”, “Model of a modern central banker” January 22.

That is indeed so, but Wolf forgot to include that banks are also constrained by capital requirements, and by how the regulators’ perceptions of risks are transmitted by means of the risk-weighting of these.

When Wolf comments “An active an enterprising financial system creates risk, often by raising leverage dramatically in good times” he is ignoring the fact that the extreme high bank leverages of now, are actually leverages that were and are authorized by the regulators… and since banking itself is much about leveraging, banks must go to where they can earn the highest-risk adjusted returns on equity… which is usually where the capital requirements are the smallest.

And that created the distortions which not only produced the crisis when allowing investment banks and European banks to leverage immensely on AAA rated securities, and “infallible sovereigns”, but it also hindered the liquidity provided by for instance quantitative easing from reaching those who could do the most with it… like the medium and small businesses, entrepreneurs and start-ups. 

Ben Bernanke has most certainly done good things as a central banker, and Martin Wolf has definitely written great pieces as a journalist, but I do believe that history will hold their silence about this source of distortion seriously against them… and this even if they plead ignorance about it.

PS. Sir, just to let you know, I am not copying Martin Wolf with this, as he has asked me not to send him any more comments related to the capital requirements for banks, as he understands it all… at least so he thinks.