Thursday, October 1, 2009

Free us from imprudent risk-aversion

There is no reason to believe the world would be better if financial regulators provided extra incentives to those who, perceived as having a lower default risk, are already favoured by lower interest rates, or punish further those who, perceived as more risky, are already punished by higher interest rates. In fact, the opposite is probably true.

According to the bank regulations of the Basel Committee, the global standard-setters for much of the world, if a bank lends to an unrated corporation then it must hold 8 per cent in equity, but when lending to an AAA rated client only 1.6 per cent will suffice. Given the high cost of bank equity, the difference between 8 and 1.6 per cent, a 400 per cent increase, entails substantial costs that increase the premiums on risk and confuse the market’s risk allocation mechanisms. The capital requirements for lending to governments, however, and I hope you are seated, is quite often zero per cent.

The debate over the current financial crisis ignores what really hit us. We still hear the most influential experts, Nobel Prize winners included, repeat the mantra of “excessive risk-taking”. How can they be blind? This crisis did not arise as a result of financing “risky projects”, but from financing the safest of assets, houses and mortgages, in the supposedly safest of countries, the US, and using instruments rated AAA, which are supposed to carry no risk.

This crisis resulted from some misguided and imprudent risk-aversion policies put in place by regulators employing capital requirements for banks based on risk and the empowerment of the credit rating agencies, which, with their rating signals, caused herds of capital to stampede over a subprime precipice.

If we do not want to understand and accept this, how are we supposed to move out of this crisis and into a better future, something which, as history has proved, always requires prudent and sometimes even a dose of imprudent risk-taking?

I have been writing about this issue for a long time, to little or no avail, as the financial regulatory system is founded upon an almost unbreakable paradigm created by regulators who are not interested in the larger scheme of things. Instead, they concentrate furiously on trying to live out their fantasies of a world without any bank failure — as if a world without bank failures has anything to do with a better world. Actually, the more frequent bank failures are, the smaller the risk of a systemic crisis like the current one.

If you need evidence for the above, read the 347 pages of the bank regulations known as Basel II. You will not find a single phrase that has anything to do with establishing the purpose for our banks. Regulators, when regulating, should you not start by doing just that?

In January 2003 the Financial Times published a letter in which I wrote: “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.” The most important part to understand, and the hardest one to accept, is that the systemic errors for the world at large would occur even if the credit rating agencies had got their ratings absolutely right.

Between 2002 and 2004, as an executive director at the World Bank, I did what I could to remind the development bank that risk is the oxygen of all development, but I was never really heard. The World Bank, forced to harmonise with Mr. Stability, the IMF, had been effectively silenced.

Today, when there are renewed puritan screams against “risks” I hope that the World Bank finally comes to grips with its role and turns into a champion of prudent risk-taking. The world needs it. Just as an intellectual exercise, think how much better off our children and grandchildren could be, had the trillions that were wasted on a useless housing boom in the US been lost instead financing projects which adapt for and mitigate climate change?

Dear baby-boomers, there is a world that needs a whole lot of risk-taking in order to stand a chance of a better future — a world which does not want to lay down and die in tranquillity just yet.