Tuesday, June 23, 2015
The IMF keeps on ignoring one of the prime causes for manmade inequality... the risk adverse bank regulations
In June 2015 the IMF made public a paper titled “Causes and Consequences of Income Inequality: A Global Perspective”. It was prepared by Era Dabla-Norris, Kalpana Kochhar, Frantisek Ricka, Nujin Suphaphiphat, and Evridiki Tsounta (with contributions from Preya Sharma and Veronique Salins) and authorized for distribution by Siddharh Tiwari.
Once again, one of the fundamental manmade and artificial drivers of inequality is not mentioned. I refer to the credit-risk-weighted capital requirements for banks which allow banks to earn much higher risk-adjusted returns on equity, when lending to what is perceived or made to be perceived as “safe”, than to what is perceived as “risky”, like to SMEs and entrepreneurs.
That regulation kills opportunities and impedes banks from financing the future, dedicating them mostly to refinancing the past. Of course that promotes inequality.
Also there is no mention about the bailouts directed to safeguard the value of existing assets, which also promotes inequality, as it does not do remotely as much for those who have no assets.
In the final remarks the paper states: “The promotion of credit without sufficient regard for financial stability, however, can result in crises, as evidenced by the subprime mortgage crisis in the United States, with disproportionately adverse effects on the poor and the middle class. Moreover, it illustrates the broader point that deep social issues cannot be resolved purely with an infusion of credit. Policies thus need to strike a balance between fostering prudence stability, and inclusion, while encouraging innovation and creativity.”
In my opinion that is a serious misstatement of financial history. Mortgages to the subprime sector never represented major problems, until Basel II regulations in June 2004 allowed banks to hold securities against only 1.6 percent in capital, meaning allowed leverage of more than 60 to 1, as long as they were rated AAA to AA. That, as should have been expected, set of a frantic demand for, and an ensuing production of, AAA-AA rated securities. In January 2003 in FT I had written: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds”
I hold that credit risk weighted capital requirements for banks seriously distort the allocation of bank credit to the real economy. The World Bank in its Global Development Finance 2003, “Striving for Stability in Development Finance” already hinted at the distortion, since under the topic of Basel II it stated:
“risk weights would be set for a bank’s exposure to sovereigns, corporations, and other banks based on ratings from major credit-rating agencies… the new methods of assessing the minimum-capital requirement is expected to have important implications for emerging-market economies, principally because capital charges for credit risks will be explicitly linked to indicators of credit quality… the regulatory capital requirements would be significantly higher in the case of non-investment grade emerging borrowers than under Basel I", plus finally “The current proposal places project loans in a higher risk category than corporate loans”
Unfortunately it seems this type of criticism was off-limit as it has since then been silenced.