Banks’ RWAs as a source of malinvestments – Update

Following a couple of comments I received on my RWA-based Austrian business cycle theory (ABCT) post, I’d like to clarify a few points:

• In the original ABCT, one cannot figure out where malinvestments will appear following an increase in the money supply not matched by an increase in the demand for money, apart from the fact that they are likely to be in producer goods industries rather than in consumer goods industries, due to the artificial lengthening of the structure of production. The mechanism involved is the Cantillon effect: the first firms to receive the new money will see their purchasing/investing power increase at the expense of the rest. We cannot really foresee where the new spending/investments will be directed though but what is certain is that the original structure of relative prices between goods in the economy will be modified as a result.

• In the RWA-based theory the Cantillon effect is ‘limited’: new funds are effectively channelled towards a few specific sectors that benefit from regulatory advantages (lower capital requirements for banks). It is thus possible to foresee which sectors could boom first and where some of the malinvestments could emerge. This does not mean that all malinvestments will show up in those sectors. Other related sectors could also boom as a result. And the increasing wealth effects of the people concerned could also reflect on unrelated sectors…

• Securitisation also makes it a lot more difficult to follow the channelling effect: asset-backed securities were lowly weighted under Basel 2 (under both Standardised and IRB methods) if they obtained a good credit rating. As a result, some corporate lending got a boost from the measure and this would typically replicate the exact process of the original ABCT. Risk-weights were tightened under latest Basel rules though.

• In the RWA-based ABCT, there is no increase in the money supply as assumption. Interest rates are lowered for some sectors (increasing related prices) and raised for others (depressing related prices) as a result of funding rebalancing through banks’ optimisation of capital. Consequences could be less catastrophic than an actual increase in money supply though (although I have no evidence of that). But there is always increase in the money supply at the same time anyway! 🙂

Today in an SNL article (membership required), I found out that the UK government is becoming increasingly frustrated about the lack of SME lending in the country. Hold your breath:

After years of frustration in its attempts to induce banks to extend more credit to small and medium-sized enterprises, the U.K. government has reached the perhaps surprising conclusion that bankers may simply lack the skills they need to lend.

RWAs? Capital requirements guys? No? It must be the skills! To be so clueless is both sad and hilarious.

RWA-based ABCT Series:

1. Banks’ risk-weighted assets as a source of malinvestments, booms and busts
2. Banks’ RWAs as a source of malinvestments – Update
3. Banks’ RWAs as a source of malinvestments – A graphical experiment
4. Banks’ RWAs as a source of malinvestments – Some recent empirical evidence
5. A new regulatory-driven housing bubble?