01 April 2013

Avinash Persaud: Leave risk to hedge fund and equity investors

Michael Pettis’s call for more reckless bankers is a needed jolt to a debate on financial regulation that is fast becoming a competition to see who can demand more capital and less risk at financial institutions. But Prof Pettis’s Schumpeterian vision of small banks engaged in ruinous competition, while tempting to those who dislike government intervention, is equally one-dimensional.

Prof Pettis is right to point out that an economy cannot grow without risk-takers. But he is in danger of conflating banking with the financial sector. Major risk-takers should be equity and hedge fund investors, where there is the explicit contract that you risk losing your shirt in return for better returns than are on offer at the bank, and pension funds and life insurers that can more safely diversify risks across time than banks with their short-term deposits.

In the bank credit economy, deposits need to considered to be equivalent to cash. Bankers should take risks only to the extent allowed by their ability to diversify their exposure to different borrowers with collateral that is easy to sell. Because of the systemic role of confidence in bank deposits, reckless bankers, in small banks as well as large banks, do far more damage than overly optimistic equity investors...

Ten years ago, writing in the FT, I warned of the systemic risks contained in the Basel II accord on banking regulation (“Banks put themselves at risk in Basel”, Comment, October 17). Today, the systemic danger lies in Solvency II, which limits the ability of non-bank investors to hold risks that are appropriate for them – just as the banks are being forced to shed them.

Full letter (FT subscription required)

Article by Michael Pettis, Why the world needs reckless bankers, 25.3.13 (FT subscription required)

© Financial Times