“Relax” or “tighten” has little to do with better regulation of US’s banks. Revise, correct and simplify, is what it should all be about.

Sir, I refer to Hal Scott’s and Lisa Donner’s discussion “Head to head: Should the US relax regulation on its big banks?” March 2.

Hal Scott writes: “There is empirical evidence that higher bank capital requirements cut lending and economic growth. A recent Fed paper concludes that a 1 percentage point rise in capital ratios could reduce the level of long-run gross domestic product growth by 7.4 basis points.”

And Lisa Donner writes: “Increased capital requirements lower the return on equity and, by extension, the bonuses linked to it. The desire of a small number of very wealthy people to become still richer should not drive public policy.”

They both, obviously each one from to the point of view of their respective agendas are correct in recognizing that capital requirements have clear effects. But then, as is unfortunately the current norm, they both ignore the problem of the distortions in the allocation of credit that different capital requirements produce.

And, if there is any problem in current bank regulations that needs to be tackled, that is getting rid of those distortions. If there is one analysis needed that is whether the bank’s balance sheets correspond with the best interests of our economies. The answer would be “NO!”

Scott asks: “Do we really want banks to hold enough capital to survive events that have no US historical precedent? If such an extreme economic event did occur, would any amount of capital be enough to withstand the panic it could trigger?”

Ok, agree, but then why should we want our banks to keep especially little capital when such events occur? Like when 20% risk weighted AAA rated securities exploded?

Scott, mentioning stress tests that depend on secret government financial models to predict bank losses argues: “avoid ‘model monoculture’ in which every bank adapts its holdings in order to pass the tests and they all end up holding assets the government model favors. A diversity of bank strategies is preferable given that risks are hard to predict.”

Absolutely and that is why, April 2003, as an Executive Director of the World Bank I held "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."

The stress tests, by focusing too much on the risk flavor of the day, as I have written to you before, are in themselves huge sources of systemic risk.

Scott informs “The living wills process requires banks with more than $50bn in assets to hold minimum amounts of “safe” assets; currently this stockpile totals more than $4tn in government debt”

Holy moly, $4tn is close to 20% of all US public debt. Is there really no interest for trying to figure out where real rates on US government debt would be if banks were not given the 0% risk-weight incentives for these debts, or, alternatively, be forced by statist regulators to hold lots of it?

Donner argues: “There is no fundamental trade-off between sound regulation of the financial system and shared prosperity. Quite the opposite. Even as tighter bank capital and liquidity requirements were phased in after the crisis, bank credit to the private sector has surged to new heights as a percentage of global output.”

But really, is that credit surge an efficient one? Are banks financing enough the “riskier” future, or are they mostly writing reverse mortgages on our “safer” present economy? 

Sir, what kind of crazy model could hold that economic growth is the result of banks being able to earn their highest risk adjusted return on equity on what is perceived, decreed or concocted as “safe”, and so avoid lending to “risky” entrepreneurs? 

@PerKurowski

The most important risk with banks will most probably be totally ignored again in the stress tests

Sir, Ben McLannahan reports on the Federal Reserve stress tests of the biggest US banks “designed to assess whether banks have enough loss-absorbing capital to keep trading through a shock to the system similar to the collapse of investment bank Lehman Brothers in 2008.” “US banks face tougher stress tests” February 22.

Again those tests will probably totally ignore the biggest risk with banks, that of these not allocating credit efficiently to the real economy.

In Yuval Noah Harari’s “Sapiens: A brief history of humankind” we read:

Over the last few years, [central]-banks and governments have been frenziedly printing money. Everybody is terrified that the current economic crisis may stop the growth of the economy. So they are creating trillions of dollars, euros and yens out of thin air, pumping cheap credit into the system, and hoping that the scientists, technicians and engineers will manage to come up with something really big, before the bubble bursts…

Everything depends on the people in the labs. New discoveries in fields such as biotechnology and nanotechnology could create entire new industries, whose profits could back the trillions of make believe money that the banks and governments have created since 2008. If the labs do not fulfill these expectations before the bubble bursts, we are heading towards very rough times.

And substitute there “the real economy with its SMEs and entrepreneurs” for “the labs”. 

Since banks are allowed to leverage their equity, and the support they receive from the society, many times more with assets perceived as safe than with assets perceived as risky; and banks therefore earn higher expected risk adjusted returns on equity on assets perceived as safe than on assets perceived as risky, banks have no incentives to lend to “risky” SMEs and entrepreneurs. And much less so when most banks suffer a scarcity of capital.

And central bankers should dare to ask themselves: How many millions of small bank loans to SMEs and entrepreneurs, has the Basel Committee’s regulations impeded?

And so any sensible stress test of banks should not only consider what is on banks’ balance sheets but also what is absent.

And regulators should opine on whether banks are fulfilling their number one social purpose, which is that of allocating credit efficiently to the real economy.

But because banks no longer finance the risky future, and only refinance the safer past, that might be just to stressful for the great distorters.

@PerKurowski ©

The Federal Reserve failed by submitting banks to an incomplete stress test.

Sir I refer to Tom Braithwaite, Ben McLannahan and Barney Jopson’s report on the recent stress tests performed by the Federal Reserve ad that that have given the US banks a clean bill of health, “European banks fail US stress tests”, March 12.

It is the Federal Reserve who has really failed the test by only testing for the assets banks have on their balance sheet, and not for the assets that should have been there. In other words, one thing is for banks to have sufficient equity for what they are doing, and another quite different sufficient equity for what they should be doing, if complying with their societal purpose of efficient credit allocation.

Banks have been made dysfunctional by the introduction of distorting credit-risk weighted equity requirements which favors assets perceived as “safe” As a result of this, banks in America (and in Europe) are not giving “risky” SMEs and entrepreneurs a fair and sufficient access to bank credit. For the banks to become functional again all differences in equity requirements against assets need to be eliminated. And to make room for such a leveling, basically all banks must increase their equity.

Our young, in order to have jobs and a decent future, need banks to take risks on “risky” small businesses and entrepreneurs. How many of these borrowers will now not be able to get credit, only because of the dividends and the buy-backs of shares the Federal Reserve’s incomplete stress tests stimulate?

@PerKurowski

Higher capital will soon turn into banks’ new competitive edge.

Sir I refer to Tracy Alloway’s and Patrick Jenkins’ “US banks face strict leverage proposals” July 10.

At this moment, when warning signs stating “bank creditors, caveat emptor, you won’t be bailed out like before” are being put up all over the world, starting in Cyprus, banks have to be truly insane not knowing they have to substantially raise their capital.

In this respect, though some dumb US banks are complaining that their regulators, are setting too high capital requirements for them, these might turn out to be a blessing in disguise… and perhaps soon all will understand that those even higher ratios favored by FDIC’s Martin Gruenberg and foremost Thomas Hoenig, make all sense in the world.

Just wait until the recent decision of the Basel Committee about having to publish the leverage ratio comes into effect. Then there is a lot of bank-running that is going to be happening from those banks leveraged over 30 to 1 to those banks leveraged 10 to 1, and this no matter the riskiness of the underlying assets.

Frankly, European banks should beware

Après Martin Wolf, le deluge!

Sir, Martin Wolf opines “A stronger recovery from a steeper plunge is hardly a better outcome than a slower recovery from a milder plunge” and follows it up with “The great achievement of policy was to limit the severity of the post crisis recession”, “A slow convalescence under Obama” October 11. 

From it one can only get the sensation that what he wishes for is a sort of “get me a couple of years more at hospital hooked up to life support, and, perhaps, after that, I don´t mind”. In other words an Après Wolf, le deluge. 

Wolf completely ignores the cleansing effect that a contraction produces. Since all that has been achieved is kicking the can down the road, no real term contraction has been avoided, and fat and flabbiness, are substituting for muscles and sturdiness day by day. 

Again Mr. Wolf, the US did not have a real estate bubble. What it had was its real estate values increased by means of the triple-A bubble which resulted from regulators allowing banks to hold assets so rated against extremely little capital. That has now morphed into banks holding sovereign assets against extremely little capital which, in somewhat colloquial terms, amounts to … just the same shit! 

And the reason for it all, are the so distorting financial regulations which, by allowing banks to hold much less capital when lending to “The Infallible” than when lending to “The Risky”, allow banks to earn immensely higher risk-adjusted returns on equity when lending to “The Infallible” than when lending to “The Risky”. 

And why are US banks seemingly better than European? Easy, Europe applied that principle much more… it even allowed banks to lend to Greece against only 1.6 percent in wishy-washy capital. 

PS. In respect to this letter I would like to refer to a letter I wrote in response to one of your editorials, and which you published before I fell out of favor with you.