Jeffrey Friedman on the Greek Tragedy

Incentives matter, spencer.

N. has it exactly right. Without the regulation, banks wouldn’t have overweighted sovereign debt so much. The regulation effectively subsidized the purchase of debt by requiring no capital outlay, while taxing the purchase of other securities. This artificially lowered the risk premium on Greek (and all gov’t) debt, making it easier for Greece to borrow. Without Basel, banks undoubtedly would be more diversified and could take advantage of the benefits of that diversification in times like these.

Is it really freedom when a government bureaucrat tells your company how you can use your money?

You can use your money on X amount of securitized mortgages but only X/2 amount of unsecuritized mortgages and X/4 amount of commerical loans and infinite amount on government debt.

This conformal regulation that affects all banks forces all banks to take on similar asset allocations (more asset-backed securities versus unsecuritized assets versus commercial loans). This leads to an over-pricing of asset-backed securities versus those other financial instruments…and, eventually, investors begin questioning why are banks holding so many asset-backed securities and government debt despite the fundamentals. They pull their money out and banks have to unravel some of their positions and they don’t have the capital to do it.

The Basel rules ignore one basic concept…risk changes based on the asset’s price. It is not a static value.

Once again we have an example of what happens when the political process attempts to rewrite the laws of economics. And once again the politicans will try to find a private sector fall guy to pin the blame for the politican’s failures.

There may yet be the day when we accept that if the government is trying to insert their view into private matters we will quickly replace those politicans with the note that they are not allowed to play in areas where they simply do not understand the rules.

Will the new financial regulatory agency recognize this type of “systemic risk?”

@spencer

Crazy Basel II requirements are only one side of the equation. The other side is pervasive deposit insurance.

What is happening is that governments are giving the banks a nice easy guarantee and castrating them when the banks actually come calling.

Without deposit insurance, bank customers would be forced to evaluate the financial health of banks themselves and they would probably do a much better job (overall) than some random room full of bureaucrats with nothing at stake.

Prakhar Goel: I disagree.

I doubt that the average Joe bank customer has any idea about the soundness of his bank’s balance sheet, even in uninsured accounts. This goes doubly true when the bank has off-balance sheet activity. In addition, due to the high transaction costs involved with switching banks, I doubt that competition between banks would be very effective.

Only when things got really bad would people rush to the bank, leading to bank runs. Just look at the 1920s: uncompetitive, uninsured banks, until the end of the decade which was mired by bank runs.

On the contrary, I would expect regulators to have a better idea about the soundness of banks. It is their job after all, and regulatory agencies tend to hire people experienced in risk management. Case-in-point: If you were to grab an average bank customer with an account at, say, Citibank, and an average safety & soundness regulator, who do you expect would have a better idea of Citibank’s balance sheet and risk exposure?

@N — yes, incentives matter.

However, while Basel risk measures are meant to limit systematic risks due to banks, the whole reason for having non-state-owned banks is for them to make intelligent, purely profit-motivated credit decisions, with the expectation that some, because they will make unfortunate credit decisions in pursuit of profit, must fail.

Blaming a bank’s failure on its having leveraged too hard against the lender of last resort (miscalibration of systemic risk) is simply saying that banks are not performing their social function, and so are useless — blood-sucking appendages to the central banks. Not what the original poster intended, I’m sure. Is that your meaning?

(BTW, Greece has NOT actually defaulted on its debt, nor is there enough of it at risk that it could suffice to drive more than a tiny fraction of otherwise-well-capitalized banks to extinction.)

” no bank capital need be used to buy a government bond.”

Incredible! Does that just apply to EU bonds, or can a German bank really buy as many Zimbabwean bonds as it wants?

Wasn’t this Long-Term Capital Management’s downfall— heavily buying Russian govt. bonds with massive leverage? I don’t see why European banks haven’t done the same. I wonder if they’re also allowed to buy derivatives on governmetn bonds.

Before I read the post, I had another idea, perhaps relevant but much less so. If an American bank were to buy Greek bonds, it wouldn’t succeed in getting a bailout for Greece. A German bank will. Thus, the German bank is the highest-value holder.

The highest value except, perhaps, for the German government, which could ahve bought the Greek bonds, swallowed the loss, and avoided having to incur the even greater expense of bailing out Greece to protect the German banks.

(cross posted at http://rasmusen.dreamhosters.com/b/2010/02/why-european-banks-own-greek-govt-bonds/)