January 09, 2019

The world’s banking systems are dangerously fragile, courtesy of inept and statist regulators.

Sir, Martin Wolf writes: “Should we be concerned about the state of the world economy? Yes: it always makes sense to be concerned. That does not mean something is sure to go badly wrong in the near future… It is the political and policy instability, combined with the exhaustion of safe options for credit expansion, that would make handling even a limited and natural short-term slowdown potentially so tricky.” “Why the world economy feels so fragile” January 9.

Sir, as you know because of the thousands of letter I have obsessively written to you on this subject, which you have equally obsessively ignored, I am absolutely sure something has been going very badly for a long time, and will explode… perhaps the sooner the better.

In April 2003, as an Executive Director of the World Bank, in a board meeting I said, "A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind."

Likewise, a world obsessed with allowing banks to leverage their capital immensely only because something is perceived or decreed as safe, is doomed to overload what’s “safe” way too much with debt, while, relative to that, financing what’s “risky” way too little. That will sure exhaust, sooner or later, any "safe options for credit expansion". That makes for a hell of a fragile bank system. 

Wolf writes, “The long-term credit cycle reached its denouement in the disastrous financial crisis of 2007-08.” 

That crisis was solely caused by excessive exposures to what was perceived as safe, mortgages to residences and AAA rated securities, against which investment banks in the US and all banks in Europe had to hold little capital. Did regulators wake up and change their risk weighted capital requirements, which are so idiotically based on the idea that what’s perceive as risky is more dangerous to our banking system than what’s perceived as safe? No! No real denouement there.

And then Greece exploded in 2009, and the fact that statist EU authorities had assigned all Eurozone sovereigns a risk weight of 0%, which allowed EU banks to lend to Greece against no capital requirement at all, which clearly doomed the not so well managed Greece to excessive indebtedness, does not even appear listed among the causes for its tragedy. No denouement there either. EU sovereigns are still risk-weighted 0%.

Sir, just look at houses. Easy financing made available by very low capital requirements turned what used to be homes into investment assets. All this while entrepreneurs, those who could create the jobs so that house owners can afford to service their mortgages and pay the utilities, were denied credit or charged higher interest rates, because of higher bank capital requirements. Just you wait till that easy financing stream stops and too many house owners wish to convert their houses into main-street-purchase capacity again. It's going to be hell.