Saturday, 14 March 2015

Bank regulators think risk can be made to vanish.

Bank regulators (aka zombies whose brains are controlled by banksters) have a way of making risk vanish. Assuming they’ve got this right, they deserve a Nobel Prize. Their amazing “risk removal” trick goes like this.

Suppose a bank is funded entirely by equity. The return demanded by shareholders is composed essentially of two elements. First there’s the fact that shareholders (like bond-holders or those putting money in term accounts) sacrifice current consumption so that someone else CAN CONSUME. That is, shareholders lend to those borrowing from banks, and as is normal, lenders require some reward or return for that sacrifice.

Second, shareholders require a reward or return to reflect the risk they take: the value of their shares may decline – perhaps even to nothing.

Enter debt, stage left.

Now suppose the bank decides to fund itself say 50% by shares and 50% by debt (in the form of bonds or deposits). According to regulators (aka zombies), the TOTAL cost of funding the bank declines because equity is inherently expensive, so if you use less equity, the total cost of funding the bank declines.

Now this is amazing. Assuming to keep things simple that the bank’s total assets and liabilities remain constant, then the total amount loaned by savers to borrowers (intermediated by the bank) remains constant. So there should be no change in the TOTAL return demanded by bank funders stemming from that source.

As to RISK, that is also unaltered. Reason is that the risk run by a bank is determined entirely by the nature of its loans and investments. E.g. a bank specialising in NINJA mortgages clearly runs a bigger risk than one specialising in more standard mortgages. And there is no reason to think that because a bank replaces some shareholders with debt-holders that the nature of its loans and investments changes.

But (to repeat) according to regulators (aka zombies) bank capital is inherently expensive, thus replacing shareholders with bond-holders or depositors reduces the total cost of funding the bank.

Amazing: the total charge made for covering risk has been reduced even though total risk has remained unaltered. Evidently risk has vanished. I’m amazed.

Well actually I’m not: the truth is that bank capital is not inherently more expensive than other types of bank funding, debt in particular. But banks go to HUGE LENGTHS to persuade all and sundry (zombies included) that bank capital IS INDEED expensive, and that propaganda effort pays off: that is, zombies then believe that bank capital is expensive.

The fact that that belief involves a blatant nonsense, i.e. that risk can be made to vanish, doesn’t matter: banks know that zombies will never notice the nonsense.

Cut your insurance costs by not insuring!

Also the above nonsense isn't quite the full picture and for the following reasons.

It’s virtually impossible for a bank funded entirely by equity to go insolvent. Thus the risk involved in running the bank is fully covered so to speak.

However, if the bank is largely funded by debt, it’s much more likely that the bank DOES GO insolvent. In which case, of course, the risk of running the bank is not fully covered. At least the bank is not insured against closure or collapse.

It’s a bit like house insurance. There’s a fantastically clever way of cutting the cost of insuring your house or car: don’t insure them, or don’t FULLY insure them.

So in addition to the above points about risk, it looks like bank regulators and politicians have also fallen for the latter bank insurer’s snake oil trick.

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