Karen Petrou  memorand  to Federal Financial Analytics clients Fannie Mae – what happens when governments use capital rules for political ends.

TO: Federal Financial Analytics Clients

FROM: Karen Shaw Petrou

DATE: October 2, 2015

Do governmental edicts erase risk? The U.S. thought so and supported residential mortgages by jiggering the risk-based capital rules, first for S&Ls and then even more disastrously for Fannie Mae and Freddie Mac. Now, the European Union will see if setting regulatory-capital standards for social purposes works any better for them. Although my hope is that fixing the EU’s capital books will spark lending, my forecast is that it won’t and my fear is that resulting distortions will have long-term, systemic impact akin to those in the U.S. If governments want spending for the public good, great – just do it directly or with express guarantees, not hidden subsidies to private financial-services firms.

Stuck in an economic rut, some in the fractured EU want to advance a Capital Markets Union that overrides national rules and create non-bank financing channels for corporate and infrastructure growth. Nice thought – the EU’s financial infrastructure resembles that of the Articles of Confederation. Not so nice in execution, though. Among other problematic provisions, the EU plan includes fixing the risk-based capital weightings for credit obligations based not on risk, but rather on social or, less charitably, political purpose.

The risk-based capital rewrites would cover asset-backed securities (ABS), with the EU thinking it can skirt the catastrophe visited on the globe via an ABS class – mortgage-backed securities – by limiting favorable capital requirements only for simple and transparent ABS. What makes the EU’s blessed ABS any better than the U.S.’s – Fannie Mae and Freddie Mac MBS couldn’t have been simpler – can only be an act of faith that the EU will get this right, chastened by hard experience.

Risk-based capital rules are already a crap-shoot – that’s why folks have come to love leverage despite its devastating impact on low-risk assets like excess reserves. The more governments cut risk weightings to meet social needs, the more corrupt the rules despite the virtuous purposes to which favorable standards may well be put. As a result, finagled risk weightings not only directly raise new systemic-risk specters, but also so undermine the construct of risk-based capital as to force policy-makers into a leverage regime with unintended and adverse consequences all its own. See a recent FedFin paper on custody banks and cash deposits as a case in point.

Governments are governments because they are supposed to be able to exert their will for the public good without resort to under-handed calls on private capital. If governments in fact can’t support economic growth and infrastructure improvement, then the problem isn’t buried in the risk-based capital weightings.

Governments have several proven avenues for realizing the public good without perverting private markets. These include direct spending – i.e., that for infrastructure improvements, affordable housing, and the like. Another option is to provide backstop that encourages private capital to flow into social-welfare spending. With guarantees and similar explicit backstops, the government pays markets to offset the cost of undue risk or market opacity.

The trick with these backstops is not figuring out how to offset private risk; rather, it’s constraining the guarantee tightly enough to ensure that it buttresses the public good without unduly enriching private capital. Still, even if guarantees go too far, they are at least explicit and budgeted for taxpayer purposes – a sharp contrast to the hidden subsidies embedded in capital regulation that are fixed to substitute for direct expenditures politicians are too cowardly to request.

However, express government support does share one downside with risk-based capital fiddles: both distort markets to subsidize one or another politically-favored objective at the cost of all the others left to the vagaries of merciless private financial markets. Housing finance and infrastructure improvements aren’t the only public goods out there, although they suck up almost every subsidized dollar and risk-based capital preference. Another one I think at least as pressing is funding biomedical research to counter diseases that kill, cripple, and cost. I’ve developed one way to encourage the flow of private capital for biomedical research with a limited federal guarantee. Getting Congress to advance it is challenging because all too many guarantees have turned into subsidies. Maybe I should have thought of proposing a discounted risk-weight for bank loans and insurance investments in biomedical projects. So much for trying the high road – hey there, EU, how about subsidizing investment in biomedical research under the risk-based capital table?

Fannie Mae
Fannie Mae