Here I’m going to argue that Basel-defined risk-weighted assets, a key component of banking regulation, may be partly responsible for recent business cycles.
Readers might have already noticed my aversion to risk-weighted assets (RWAs), which I view as abominations for various reasons. They are defined by Basel accords and used in regulatory capital ratios. Basel I (published in 1988 and enforced from 1992) had fixed weights by asset class. For example, corporate loans and mortgages would be weighted respectively 100% and 50%, whereas OECD sovereign debt would be weighted 0%. If a bank had USD100bn of total assets, applying risk-weights could, depending on the lending mix of the bank, lead to total RWAs of anything between USD20bn to USD90bn. Regulators would then take the capital of the bank as defined by Basel (‘Tier 1’ capital, total capital…) and calculate the regulatory capital ratio of the bank: Tier 1 capital/RWAs. Basel regulation required this ratio to be above 4%.
Basel II (published in 2004 and progressively implemented afterwards) introduced some flexibility: the ‘Standardised method’ was similar to Basel I’s fixed weights with more granularity (due to the reliance on external credit ratings), while the various ‘Internal Ratings Based’ methods allowed banks to calculate their own risk-weight based on their internal risk management models (‘certified’ by regulators…).
This system is perverse. Banks are profit-maximising institutions that answer to their shareholders. Shareholders on the other hand have a minimal threshold under which they would not invest in a company: the cost of capital, or required return on capital. As a result, return on equity (ROE) has to at least cover the cost of capital. If it doesn’t, economic losses ensue and investors would have been better off investing in lower yielding but lower risk assets in the first place. But Basel accords basically dictate banks how much capital they need to hold. Therefore banks have an incentive in trying to ‘manage’ capital in order to boost ROE. Under Basel, this means pilling in some particular asset classes.
Let’s make very rough calculations to illustrate the point under a Basel II Standardised approach: a pure commercial bank (i.e. no trading activity) has a choice between lending to SMEs (option 1) or to individuals purchasing homes (option 2). The bank has EUR1bn in Tier 1 capital available and wishes to maximise returns while keeping to the minimum of 4% Tier 1 ratio. We also assume that external funding (deposits, wholesale…) is available and that the marginal increase in interest expense is always lower than the marginal increase in interest income.
- Option 1: Given the 100% risk-weight on SME lending, the bank could lend EUR25bn (25bn x 100% x 4% = 1bn), at an interest rate of 7% (say), equalling EUR1.75bn in interest income.
- Option 2: Mortgage lending, at a 35% risk-weight, allows the same bank to lend a total of EUR71.4bn (71.4bn x 35% x 4% = 1bn) for EUR1bn in capital, at an interest rate of 3% (say), equalling EUR2.14bn in interest income.
The bank is clearly incentivised to invest its funding base in mortgages to maximise returns. In practice, large banks that are under the IRB method can push mortgage risk-weights to as low as barely above 10%, and corporate risk-weights to below 50%. As a result, banks are involuntarily pushed by regulators to game RWAs. The lower RWAs, the lower capital the bank needs, the higher its ROE and the happier the regulators. Banks call this ‘capital optimisation’.
Consequently, does it come as a surprise that low-risk weighted asset classes were exactly the ones experiencing bubbles in pre-crisis years? Oh sorry, you don’t know which asset classes were lowly rated… Here they are: real estate, securitisation, OECD sovereign debt. Yep, that’s right. Regulatory incentives that create crises. And the new Basel III regime does pretty much nothing to change the incentivised economic distortions introduced by its predecessors.
Yesterday, Fitch, the rating agency, published a study of lending and RWAs among Europe’s largest banks (press release is available here, full report here but requires free subscription). And, what a surprise, corporate lending is going…down, while mortgage lending and credit exposures to sovereigns are going…up (see charts below). The trend is even exacerbated as banks are under pressure from regulators to boost regulatory capitalisation and from shareholders to improve ROE. And this study only covers IRB banks. My guess is that the situation is even more extreme for Standardised method banks that cannot lower their RWAs.
The ‘funny’ thing is: not a single regulator or central banker seems to get it. As a result, we keep seeing ill-founded central banks schemes aiming at giving SME lending a boost, like the Funding for Lending Scheme launched by the Bank of England in 2012, which provided banks with cheap funding. Yes, you guessed it: SME lending continued its downward trend and the scheme provided mortgage lending a boost.
Should the situation ‘only’ prevent corporates to borrow funds, bad economic consequences would follow but remain limited. Economic growth would suffer but no particular crisis would ensue. The problem is: Basel and RWAs force a massive misallocation of capital towards a few asset classes, resulting in bubbles and large economic crises when the crash occurs.
The Mises and Hayek Austrian business cycle theory emphasises the distortion in the structure of relative prices that emanates from central banks lowering the nominal interest rate below the natural rate of interest as represented by economic agents’ intertemporal preferences, resulting in monetary disequilibrium (excess supply of money). The consequent increase in money supply flows in the economy through one (or a few) entry points, increasing the demand in those sectors, pushing up their prices and artificially (and unsustainably) increasing their return on investment.
I argue here that due to Basel’s RWAs distortions, central banks could even be excluded from the picture altogether: banks are naturally incentivised to channel funds towards particular sectors at the expense of others. Correspondingly, the supply of loanable funds increases above equilibrium in the favoured sectors (hence lowering the nominal interest rate and bringing about an unsustainable boom) but reduces in the disfavoured ones. There can be no aggregate overinvestment during the process, but bad investments (i.e. malinvestments) are undertaken: the investment mix changes as a result of an incentivised flow of lending, rather than as a result of economic agents’ present and future demand. Eventually, the mismatch between expected demand and actual demand appears, malinvestments are revealed, losses materialise and the economy crashes. Central banks inflation worsen the process through the mechanism described by the Austrians.
I am not sure that regulators had in mind a process to facilitate boom and bust cycles when they designed Basel rules. The result is quite ‘ironic’ though: regulations developed to enhance the stability of the financial sector end up being one of the very sources of its instability.
RWA-based ABCT Series:
- Banks’ risk-weighted assets as a source of malinvestments, booms and busts
- Banks’ RWAs as a source of malinvestments – Update
- Banks’ RWAs as a source of malinvestments – A graphical experiment
- Banks’ RWAs as a source of malinvestments – Some recent empirical evidence
- A new regulatory-driven housing bubble?
Quite a long post… Here I’m going to have to get to the heart of my theoretical economic beliefs. I’ll try to keep it simple and as short as I can though. I will argue that there are many risks to investors going forward due to distortions in interest rates.
I wasn’t surprised yesterday when I read the two following FT articles. The first one tells how leveraged buyouts (LBOs) in the US have boomed recently, with leverage reaching the height of the pre-crisis boom of 5.3 times EBITDA, some even reaching 7.5 times EBITDA. This means that the private equity funds that acquired those firms used debt equivalent to 5 times earnings before depreciation, interest and taxes of the targets to fund the acquisitions. It is a lot. What is usually considered a highly leveraged LBO is around 4 times EBITDA and higher.
The second FT article talks about the fact that hedge funds are struggling to achieve high returns due to the size of the industry. Institutional investors have piled in hedge funds expecting higher returns than what traditional investments yield at the moment.
Earlier this year, we have seen many investors also piling in junk bonds, offering some of the lowest non-investment grade yields on record (despite the economy still not being in great shape and spreads over US treasuries not being at their lowest level ever). What’s going on?
Many people won’t agree with that, but to me, it looks like central banks’ monetary policies (low interest rates, quantitative easing, LTRO, OMT…) are lowering interest rates below their so-called ‘natural rates’. What is the natural rate of interest? It was the Swedish economist Knut Wicksell who came up with this term, highlighting to him the equivalent of the equilibrium free-market rate of interest in a barter world. Wicksell defined the natural rate in those terms in his 1898 book Interest and Prices, chapter 8:
“There is a certain rate of interest on loans which is neutral in respect to commodity prices, and tends neither to raise nor to lower them. This is necessarily the same as the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of real capital goods. It comes to much the same thing to describe it as the current value of the natural rate of interest on capital.” (emphasis his)
We can interpret it as the equilibrium interest rate that would exist under free market conditions, with no external interferences such as central banks’ monetary policies and governments’ interest-lowering schemes. In such conditions, intertemporal preferences between savers and borrowers are matched. This natural rate is in opposition to the ‘money rate of interest’, or the actual interest rate prevalent in a money and credit economy. The system is near equilibrium when the natural and the money rates coincide.
At the moment, some people such as Scott Sumner would argue that the natural rate of interest is below zero, justifying massive cash injection in the economy in order to lower the money rate of interest (= nominal interest rate). For him, the evidence is that nominal GDP has been allowed to fall below trend during the crisis and hasn’t recovered since then. While I agree that there was a case for an increase in the quantity of money to counteract a higher demand for money in the earlier stages of the crisis, I don’t believe this is now necessary. (I also believe that ‘trend’ is a very imperfect indicator on which to base policies. NGDP growth trend changed several times since World War 2 and can also be impacted over fairly long periods by unsustainable booms).
But it does continue. There have now been several rounds of QE in the US and monetary easing in Europe, Japan and China, to name a few. So the current situation looks like a sign that the money rate of interest has been pushed below the natural rate for quite some time. While nominal interest rates have been low for a while, real interest rates are now even lower (or even negative). And real interest rates are what investors care about, as it represents the actual gain over cost of life inflation. This has the consequence of pushing investors toward higher-yielding asset classes (hedge funds, private equity, junk bonds, emerging market equities…), in order to generate the returns they normally get on lower-risk assets.
But there is no inflation, you’re going to tell me. True, inflation as measured by CPI has also been relatively low for a while. Is CPI the right measure though? Asset prices (from real estate to equities and bonds) are not reflected in it despite arguably representing a form of inflation. Remember what Wicksell said: “There is a certain rate of interest on loans which is neutral in respect to commodity prices, and tends neither to raise nor to lower them.” Well… It’s clearly not what’s happening now. Even excluding asset classes, CPI may even not accurately reflect goods’ prices inflation. Would investors really need to search for yield if the cost of life actually declined or remained stable?
Does it mean that asset prices should always remain stable at the natural rate? Not at all, and there can be good reasons why asset prices move (real supply shocks for example). But what we can now witness in financial markets look more like malinvestments than anything else. Malinvestments represent bad allocation of capital to investments that would not be profitable under natural rate of interest conditions. As the discount rate on those investments decline in line with the nominal interest rate, they suddenly look attractive from a risk-reward point of view. But what if the discount rate is wrong in the first place? And what if future cash flows are also artificially boosted by low rates? This is a variation of the original Austrian business cycle theory, first developed by Ludwig von Mises and F.A. Hayek early 20th century, and which originally focused on the effects of a distorted interest rate on the structure of production.
Another indication – more scientific than my previous observation – that the money rate may well be below the natural rate, has been devised by a former colleague of mine. Thomas Aubrey published a very interesting book in 2012, Profiting from Monetary Policy, in which he underlines his own calculation of what he calls the ‘Wicksellian differential’ (the difference between the natural and the money rates of interest). He uses estimates of the return on capital and the cost of capital in order to calculate the differential (according to neoclassical economic theory, the real interest rate should equal the marginal product of capital in equilibrium conditions – not everybody agrees though). Using those assumptions, it does look like we have been in a new credit boom since 2010 as you can see from the charts here:
Where does this lead us? Every unsustainable boom has to end at some point. It is likely that as soon as nominal interest rates start rising above a certain level, mark to market losses and worse, outright defaults, will force investors to mark down their holdings of malinvestments. We’ve already recently seen the impact on emerging markets of a mere talk of reducing the pace of quantitative easing.
What could be the consequences? Banks don’t place their liquidity in such risky assets, but might well be exposed to clients that do (many banks provide so-called leveraged loans for instance). Such impact on banks should be relatively limited though, given current regulatory constraints and deleveraging. In turn, this should limit the damage to credit creation and reduce the risk of another monetary contraction through the money multiplier. However, and it is a big question mark, banks might be exposed to companies (and households) under life support from low interest rates. This is more likely to be the case in some countries than others (I’ll let you guess which ones). When rates rise, loan impairment charges may rise quite a lot in those countries.
Private losses (through various types of investment funds and not subject to the money multiplier) may well be large though, negatively affecting private investments for some time afterwards. If you were thinking that the economy was naturally recovering at the moment, you might give it a second thought… Investors, beware, timing will be crucial.
First chart: Wall Street Journal; Second chart: Credit Capital Advisory
I like Baron Adair Turner of Ecchinswell (Lord Turner for short). Every time he speaks about the financial system, I can hear enough misconceptions and misunderstandings to give me enough material to write several posts. By the way, he used to be Chairman of the UK’s Financial Services Authority, the former UK financial regulator, between end-2008 and early 2013. I have attended a couple of his conferences in the past.
Lord Turner has a particular quality: he is quite good at figuring out the symptoms of a crisis, but always seems to mistake those symptoms for the underlying disease. As a result, he comes up with misguided remedies that are usually very interventionist and with the potential to make things worse. So you’ll probably hear of him relatively often on this blog.
A couple of weeks ago, he published an article called…”The Failure of Free-Market Finance”… As you can guess, I couldn’t miss the opportunity to review it. Well… I was disappointed. Not because he doesn’t make any mistake, but simply because he does not seem to actually justify the title of his article.
Overall, he is right than an excess of debt is partly a reason for the crisis, and that current mainstream economic theory does not factor in leverage (or not enough) and wrongly considers a low and stable inflation as enough/necessary to ensure economic and financial stability. But he never explains how this debt level builds up over time (to be fair, he does explain it in other articles and presentations, but once again, without ever digging enough in order to reach the root cause. Probably more on this later).
I find it quite ironic that someone who promotes a strong state control of the financial sector, like Turner, quotes Friedrich Hayek. My guess is that he needs to reread Hayek. As Hayek never mentioned over-investments as the cause of the economic cycle, but malinvestments (roughly, investments wrongly directed towards less than profitable-enough activities) (although over-investments could arguably be linked to the theory). And Hayek would certainly never have promoted state control, which he saw as the root cause of crises.
Photograph: Alastair Grant/AP