Sunday, November 1, 2015

Banks should allocate credit based on risk-adjusted return on equity, and not on regulatory required equity

Banks used to allocate bank credit (interest rates and amount of exposure) according to what produced them the highest risk adjusted return per dollar of equity. Since some borrowers, like SMEs and entrepreneurs, are more dependent on banks for credit than others, that might not have been absolutely perfect in terms of allocating bank credit to the needs of the real economy, but at least it was fair and unbiased.

That was before the Basel Accord introduced their outright odious capital requirements based on credit risk. Now banks allocate their credit according to what produces them the highest risk adjusted return per dollar of required equity. Obviously that is totally biased and completely unfair.

Since those borrowers perceived a safe have been additionally benefited by generating lower capital requirements, it is almost impossible for the risky to compete for bank credit.

The resulting distortion in the allocation of bank credit to the real economy is mind boggling.

It is amazing the number of experts who think that even though banks already clear for perceived credit risks, by means of interest rates and size of exposures, that in order to be certain they have done that, it is better the regulators require banks to clear again for that same perceived credit risks, this time in the capital

It is amazing the number of experts who do not understand that even if you have an absolutely perfect perceived credit risk, you will get it wrong if you give that credit risk perception more weight than it should have.

It is amazing the number of experts who do not understand that: more risk more capital- less risk less capital will cause banks to create dangerous excessive exposures to "the safe" and equally dangerous (for the real economy) underexposures to "the risky".

It is amazing the number of experts who are statist or communists, since otherwise there is no way to argue a zero percent risk weight for sovereigns, and a 100 percent risk weight for the private sector.

Here is but a short list of those experts: Mario Draghi, Stefan Ingves, Mark Carney, Ben Bernanke, Jaime Caruana, Lord Turner, Martin Wolf and most of FT, Alan Greenspan, seemingly all those in the IMF, Basel Committee, Financial Stability Board, European Commission, BoE, Fed, FDIC, ECB

To be in the company of fools might make you a less lonely fool, never a lesser fool.