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Rejoice in unintended consequences

Rejoice in unintended consequences

Risk-weightings encourage cross-border flows into unproductive assets 

by Bruce Packard in Berlin

Mon 7 Oct 2013

Organisations that lobby on behalf of the banking industry always seem to be warning of the ‘unintended consequences’ of regulation.

Such an approach implies that unintended consequences are always negative and intended consequences are always positive. But in complex systems it is rarely possible to do ‘just one thing.' A single action can have many effects.

We need to consider that there may be some beneficial, unintended effects of new regulation. One example is the newly-fashionable leverage ratio. This ‘new’ leverage ratio is not really new at all: risk-weighting of assets has been around since the mid-1980s. Before then, regulation tended to focus on total assets, liquidity and reserve ratios. The Basel Committee is clearly re-thinking the risk-weighting methodology, and some of the perverse incentives it encourages. This is the intended consequence and seems to be a move in the right direction.

The Association for Financial Markets in Europe argues that one unintended consequence is that the leverage ratio is harsher on universal banks than broker-dealers and therefore should be dropped. Other bank management and lobbying organisations warn that if an instrument as blunt as a leverage ratio is introduced, it will reduce credit supply to the ‘real economy.'

In fact, the opposite is likely to occur. Assets with low risk-weightings under the Basel Accord fall into two broad categories: retail mortgages and government debt. Assets with higher risk-weightings are corporate and small and medium-sized enterprise (SME) loans. The introduction of a simple leverage ratio could restrict cross-border flows of interbank funding towards retail mortgages and government bonds, and instead encourage more lending to SMEs.

SMEs provide the bulk of non-public sector employment in most economies. But these smaller companies may lack the economies of scale that large listed corporations enjoy, and therefore generate less revenue per employee.

SME lending is far more productive than purely lending against property assets or government obligations.

Most losses in the financial crisis have come from mortgages and government debt, while SMEs, despite having a higher risk-weighting, have not been the cause of systemic risk.

Assume Basel I never happened. As faster-growing countries exported their cheap goods, cross-border trade surpluses would still have built up. Let us suppose that the surplus was reinvested by banks in the form of higher SME and corporation sector exposure, as opposed to government debt, mortgages and other so-called AAA rated securities. Rather than unproductive property speculation and government, China and the oil-rich nations of the Middle East would have (through the global banking system) been financing productivity capacity in deficit countries.

Similarly, instead of the consequences under which low risk-weightings encouraged German Landesbanken to fund a Greek government which could not collect enough taxes to pay its public sector obligations, the cross-border flow of capital would have been into the Greek SME and corporate sector.

In the three decades since risk-weighting has been introduced, more banking systems have collapsed than in any previous comparable period. Loan losses in Japan, the Nordic countries, Thailand, Malaysia, Indonesia, Mexico (twice), Brazil, Argentina, Iceland, Ireland, the US & UK have ranged from 10% to 50% of assets, according to Charles Kindleberger.

One feature of these credit bubbles was the over-indebtedness of a large group of either mortgage borrowers or government borrowers. It is no coincidence that these groups are also weighted as low risks under the Basel framework. Risk-weightings encourage cross-border flows of wholesale bank funds into unproductive assets, which increase a country’s external indebtedness much more rapidly than the economy can grow.

Encouraging cross-border flows of money away from unproductive areas into more productive uses is not the intended consequence of the leverage ratio. The intended consequence of a leverage ratio is to prevent catastrophic bank failures.

Risk-weighted capital ratios simply did not work as they were supposed to. This is demonstrated by the failure of banks with relatively high tier 1 capital ratios, such as: Northern Rock (reported tier 1 ratio 11.3% June 2007); Bradford and Bingley (reported tier 1 ratio 9.9% June 2008); HBOS (reported tier 1 ratio 8.6%) and Lehman Brothers (reported tier 1 ratio 10.7%). At the time, these ratios were all among the highest in the western banking sector.

Lobbying organisations that defend the status quo are not acting in the interest either of preventing future banking crises or of stimulating loans to productive enterprises.

Bruce Packard, former Analyst at Seymour Pierce, is a member of the OMFIF Advisory Board.

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