April 21, 2014

When banks earn higher risk adjusted returns on equity financing houses than financing the creation of jobs… something is wrong.

Sir, Congressman John Delaney writes “A significant contributor to the financial crisis was the governments mispricing of risk” “A pragmatic plan to free the mortgage market from Washington” April 21.

That is not exactly so. First, it is never the role of the government to correctly price risks, but to insure there are sufficient defenses for when the market and banks fail to correctly price risk… in other words, to care more for the unexpected than about the expected. And, while doing so, it is also definitely not the role of the government to distort the markets… something which unfortunately it has been doing lately.

With those risk-weighted capital requirements that have been so much in vogue lately among regulators, by allowing banks to hold much less capital against what is perceived as “safe”, which does not mean it will be safe, than against what is perceived as “risky”, which does not mean it has to be risky, regulators have allowed banks to earn higher returns on equity when lending to the safe than when lending to the risky… and of course that distorts. For instance it allows banks to earn more financing the houses than financing the riskier creation of jobs needed to pay for those houses.

When Congressman Delaney so correctly writes to remove “the harmful distortion that government involvement causes” I just wish he knew more about the mother of all regulatory distortions.