Crush RWAs to end secular stagnation?
Some BIS researchers very recently published this piece of research demonstrating that the growth of the financial sector was linked to lower productivity in the economy. MCK in FT Alphaville commented on it and reached the wrong conclusion (the title of his post is ‘Crush the financial sector, end the great stagnation?’, though he could be forgiven given that the BIS paper itself is titled ‘Why does financial sector growth crowd out real economic growth?’).
I have attempted in previous posts to explain why Basel risk-weighted assets (RWAs) were the root cause of the misallocation of bank credit and hence the misallocation of capital in the economy prior to the financial crisis: in order to optimise return on equity, bankers were incentivised by RWAs to allocate a growing share of available loanable funds to the real estate sector, creating an unsustainable boom. I also speculated that, consequently, fewer financial resources were hence available for sectors that were penalised by regulatory-defined high RWAs (i.e. business lending), and that this could be one of the main causes of the so-called ‘secular stagnation’.
I have also regularly criticized governments’ and central banks’ schemes such as FLS and TLTRO when they were announced, as they could simply not address the fundamental problem that Basel had introduced a few decades earlier.
I have recently pointed out that new studies seem to highlight that, indeed, real estate lending had overtaken business lending for the first time in the past 150 years exactly after Basel 1 was put in place at the end of the 1980s, and that the growth of business lending had been lower since then. (Same chart again. Yes it is that important)
This new BIS study is remarkably linked, although its authors don’t seem to have noticed. This is what they conclude:
In our model, we first show how an exogenous increase in financial sector growth can reduce total factor productivity growth. This is a consequence of the fact that financial sector growth benefits disproportionately high collateral/low productivity projects. This mechanism reflects the fact that periods of high financial sector growth often coincide with the strong development in sectors like construction, where returns on projects are relatively easy to pledge as collateral but productivity (growth) is relatively low. […]
First, at the aggregate level, financial sector growth is negatively correlated with total factor productivity growth. Second, this negative correlation arises both because financial sector growth disproportionately benefits to low productivity/high collateral sectors and because there is an externality that creates a possible misallocation of skilled labour.
Replace some of the terms above with RWAs and you get the right picture. What those researchers miss is that the growth of the financial sector has been similar in previous periods over the past 150 years, with no decline in secular growth rate and productivity. However, what changed since the 1980s is the allocation of this growth. And the dataset this BIS piece examines only starts…in 1980. Their conclusion that high collateral industries would attract a higher share of lending is also coherent with my views, as higher lending collateralisation reduces the required capital buffer than banks need to maintain.
MCK is right when he declares that
the growth of the financial sector has been concentrated in mortgage lending, which means that more lending usually just leads to more building. That’s a problem for aggregate productivity, since the construction industry is one of the few that has consistently gotten less productive over time. For example, Spain had no productivity growth between 1998 and 2007, a period when 20 per cent of all the net job growth can be attributed to the building sector.
But his conclusion that regulation needs to force the banking industry to get smaller is off the mark. Getting rid of the incentives created by RWAs, and the resulting unproductive misallocations, is what is needed.