Risk-weighted capital requirements for banks favoring the sovereign, artificially lowers the neutral/risk-free rate

Sir, Chris Giles writes: One “fundamental problem in central banking is that estimates of the neutral rate of interest — seen as the long-term rate of interest that balances people’s desire to save and invest with their desire to borrow and spend — appear to have fallen persistently across the world.” “FT Big Read. IMF Meetings: Setting policy in the dark” October 12.

That has an explanation:

Banks are allowed by the regulators to hold less capital against loans to the government (sovereign) than against loans to the private sector.

That means that banks are allowed to leverage more with loans to the government than with loans to the private sector.

That means that banks can earn higher risk-adjusted returns on equity with loans to the government than with loans to the private sector.

That means that banks, when compared to what they would have done in the absence of these distortive regulations, lend more to the government and less to the private sector; especially to the “riskier” part of it, like unrated SMEs or entrepreneurs.

That means there is a downward pressure on the interest rate on loans to the government, and, since these signify for the most a reference of the risk-free rate, that pulls all rates down from what should be their ordinary level.

And when that regulatory pulling down of rates is topped up with central banks with their QEs loads of government debt, the drop in the “risk-free” floor rate becomes truly important.

Sir, IMF and central bankers have been blind for a very long time to the distortions produced by the risk weighted capital requirements for banks.

Now and again they seem close to understanding it, like last November during IMF Research conference, but then they lose themselves again.

I guess, as Upton Sinclair Jr. said, “it is difficult to get a man to understand something when his salary depends upon his not understanding it.”

Now the real problem for me with central bankers goes way beyond this issue of the neutral interest rate.

My problem is that central bankers never resolved anything, they just kicked the 2007-08 crisis can forward, and basically left in place the distortions that produced it. So therefore a new crisis, could be an augmented one, just lurks around the corner. Great job guys!

And of course, with respect to central bankers pursuing an inflation marker, like in a greyhound race these pursue an artificial hare, I can’t but agree with Daniel Tarullo’s “Essentially you are setting policy on things you don’t know and can’t measure and then reasoning after the fact”.

@PerKurowski