Europe, the safety of your banks, though important, is only a subset of the safety of your real economy.

Sir, Wolfgang Münchau writes: “The wisest course of action is to appeal to those who are concerned about Europe’s declining influence, and who are open minded enough up to see the casual link between narrow-minded national economic dogmatism, poor economic performance, and declining geopolitical influence”, “Divisions behind a continent’s declining influence” September 15.

Indeed! But how hard it is for most to understand that possibly the narrow-minded national economic dogmatism that most causes poor economic performance, is the credit risk weighted capital requirements for banks

Not many decades ago, in Europe and elsewhere, banks decided what amount of credit to award to borrowers based on who offered to pay them the highest interest rates adjusted of course for perceived credit risk. And for the purposes of those decisions, the capital cost for the banks were the same for all borrowers. And that helped banks to allocate credit in the real economy to those who could produce the highest economic returns.

But then in July 1988 some besserwisser busybodies, in something know as the Basel Committee on Banking Supervision decided that banks needed to hold much less capital (equity) for some assets, because these were perceived as safe. 

And that meant of course that the banks would earn much higher credit risk adjusted returns on what was perceived as safe than on what was perceived as risky… and so the allocation of bank credit was not any longer based on who produced the highest return, but on who produced the highest return on capital (equity) adjusted for risk weights.

Simplified, initially safe assets were defined as: loans to (good) sovereigns, with a risk weight of 0 to 20%; “loans fully secured by mortgage on residential property that is or will be occupied by the borrower or that is rented” with a risk weight of 50%; and all other assets were given a risk weight of 100%.

In June 2004, with Basel II, all those other assets were awarded risk-weights between 20 and 150% depending on their credit ratings. And in Basel III the risk weighted capital requirements survive, though there is a minimum capital floor for the total of all assets, the leverage ratio.

And so, of course, banks are not longer allocating bank credit efficiently. In essence they are giving much too little credit to what is perceived as risky, which means financing too little future, while giving much too much credit to what is perceived as “absolutely safe” which in essence means mostly refinancing the past, and, under such circumstances it should be clear that Europe cannot go anywhere else but down.

Münchau correctly states: “It is only when you take a global view that you can spot what is wrong”. How sad then he is unable to take that global view which clearly indicates that the safety of banks, though important, is only a subset of the safety and sturdiness of the economy.

“A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926