March 05, 2015

Bank regulators caused lenders to also argue borrowers’ creditworthiness. Not so smart!

Sir I refer to Frank Partnoy’ “The Fed’s magic tricks will not make risk disappear” March 5.

In it Partnoy to that “complex rules create incentives for banks to… hide risks”, and he is perhaps more right than he knows.

For instance, what did we have before Basel Committee´s credit risk weighted equity requirements? We hade the banks interested in arguing the credit risk of the borrowers, so to be able to charge them higher interest rates; and the borrowers interested in proving they were very creditworthy safe, so to get larger loans at lower rates.

This of course created a certain tension that could only benefit a regulator… and helped foster an efficient allocation of bank credit.

What do we have now? We now have bankers and borrowers on the same side. Now the banker also wants to convince the regulator that the borrower is very creditworthy, so as to be able to hold less equity when lending to it, and thereby generate higher risk-adjusted returns on its equity. That cannot be helpful for a regulator, and can only lead to an inefficient allocation of bank credit. Not so smart!

The most extreme example of the previous is the alliance between banks and sovereigns. That one is based on: “I the sovereign lend you the bank my full support; and in return you the bank lend me the sovereign a lot of money; and to facilitate all that we both assume that I am an infallible sovereign, and represent no credit risk whatsoever, and so therefore, you banker, need to hold no equity when lending to me.

So Sir, when it comes to gaming regulations, the regulators, who work for governments, they also know how to game regulations, in order to take care of themselves, by taking care of their bosses’ wishes.

PS. How do you fire a regulatory mandarin who sucks up to his boss so much that he defines him to be an infallible sovereign?