Regulators forced banks into what’s perceived safe, thereby forcing the usually most risk adverse into what’s perceived risky.

Sir, Robin Wigglesworth writes “Many investors such as pension funds and insurers [are] pushed towards the only other option: venturing into the riskier corners of the bond market, such as fragile countries, heavily indebted companies and exotic, financially engineered instruments. These are securities they would normally shun — or at least demand a much higher return to buy.” “Negative yields force investors to snap up riskier debt” August 16.

As an example he mentions “Victoria a UK-based company that issued a €330m five-year bond that drew more than €1bn of orders [because] the relatively high 5.25 per cent yield it offered, helped investors swallow misgivings over its leverage.”

Clearly liquidity injections, like central banks’ huge QEs, has helped to move interest rates much lower everywhere, but, as I see it, much, or perhaps most of what Wigglesworth refers to is the direct consequence of the risk weighted capital requirements for banks.

That regulations allowed banks to leverage much more their capital with what’s perceived (decreed or concocted) as safe, than with what’s perceived as risky, which meant that banks can more easily obtain higher risk adjusted returns on equity with the safe than with the risky… and those incentives were as effective as ordering the banks what to do. That made banks substitute their savvy loan officers, precisely those who would be evaluating and lending to a Victoria, with equity minimizing financial engineers.

As a result the interest rates charged to the safe… little by little forced those who did not posses savvy loan officers to take up the role of banks.

Will it stop there? Not necessarily. Banks, and their regulators, are now slowly waking up to the fact that the margins that the regulation benefited “safes” offer, are not enough for banks to survive as banks. 

But how to get out of that mess will not be easy. Solely as an example, when in 1988 bank regulators assigned America’s public debt a 0.00% risk weight, its debt was about $2.6 trillion, now it is around $22 trillion and still has a 0.00% risk weight. How do you believe markets would react if it increased to 0.01%? 

@PerKurowski