July 20, 2011

It was naïve bank regulators who never contemplated the possibility of the credit ratings being wrong.

Sir, bank regulators, not me, told banks that if they lent to sovereigns such as Greece, and could obtain a 0.4 percent risk and cost of transaction adjusted margin, then they would be able to earn 25 percent on their capital, because since they were only required to post 1.6 percent capital against that lending they could leverage 62.5 to 1. A small business or entrepreneur, since lending to them required 8 percent in capital, which allowed for a leverage of only 12.5 to 1, would have to pay 2 percent in risk and cost of transaction adjusted margin to the bank in order to provide the bank the same return on equity Greece did… for some time. Could there be any doubt of why banks went overboard lending to sovereigns, like Greece. 

John Kay, in “American lessons in how to run a single currency” July 20, answering “Why were interest rate spreads in Europe so small?” writes that “Many participants simply did not care about default possibilities”. That is not precisely right. The correct answer is that bank regulators did not care about the possibilities of the credit ratings being wrong, and therefore ordered no reserve contingencies for that event, which should of course have been expected to occur, sooner or later. In other words we had scandaliciously dumb bank regulators, but the worst, is that they are still allowed to regulate as if credit ratings can never be wrong.

I invite to see the loony bank regulations explained in an apolitical red and blue!