April 16, 2014

The economic impact of a “too big to fail" bank's” failure is monstrous, even if it had 100% equity.

Sir, I refer to Martin Wolf’s “‘Too big to fail’ is too big to ignore” April 16.

Wolf, like many, questions whether a 5 percent leverage ratio, and which translated into layman terms signifies a 19 to 1 debt to equity ratio, can be enough. Of course it is not!

That said the fact remains that if a monstrously big bank fails, in terms of its overall economic impact, whether it has 100% equity or 100% debt, is sort of marginal… wealth destroyed is wealth destroyed no matter how its financed. Clearly, the distribution of a loss matters but, for instance, would the world be sustainably better off, if it the one percenter’s lost all they had?

And so, out of three recommendations the IMF makes, just like Wolf I think the most important is to “reduce the probabilities of distress”.

And how is that done? As you well know in my opinion that requires committing to the dustbin of bad memories, the risk-weighing of capital requirements for banks.

The risk-weighing means that banks earn different risk-adjusted returns on equity on different assets, and this distorts all common sense out of the overall important credit allocation function of the banks.

Even worse, the current system guarantees that banks will have especially little capital when they encounter those icebergs which have always sunk bank systems, when cruising in waters perceived as “absolutely safe”.

And, here is a reminder. It does not matter whether the too big to fail banks allocates 100% correctly its resources, if the rest of the banking system doesn’t, since that way, the well behaved too big to fail, will anyhow go down, sooner or later, because there is no such thing as a stable banking system in a lousy and unstable real economy.

What current regulators do not understand is that making the banks safe begins by not distorting the allocation of credit, which they do!

The real losses of a banks, except perhaps for interest rates mismatch, do not occur on the liabilities and equity side of the balance, but on the asset side  

PS. With relation to the subsidies of TBTF banks there is some inconsistency, as some could argue that a subsidy could be necessary to keep these from failing. And even if labeled TBTF, banks are little or not subsidized at all by the markets, could that not be an indication of how fallible markets believe their rescuers to be?

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.