Lender of Last Resort – You!

Date:        17 April, 14
By:            Frank Gue, B.Sc., MBA, P.Eng., 2252 Joyce St., Burlington, ON L7R 2B5, 905 634 9538
To:            Editors, The Economist, London, UK
Re:           “Leviathan of last resort” April 12 issue
 

Dear Editors:

 
It is encouraging that regulators are re-learning the importance of leverage, but discouraging that relentless pressure from the financial industry is (apparently with some success) pushing the ratios back down.
 
Capital ratios are a form of group insurance, with the important members of the group, in this case, comprising a relatively small number of big banks, with the government as the re-insurer.  Unfortunately this is probably too small a group, individually accounting for too large a balance sheet, to assure the hoped-for performance, in an emergency, of the group.
 
In proportion to the size of the risk, a 3% or 5% ratio is totally inadequate; Canada barely squeaked through with ratios varying from 7% to 10%, of which most was of good quality.  “Quality” brings up the vexatious subject of weighting formulae with their infinite potential for gaming of the system.  Is it not past time that a more rigorous definition of “quality” be adopted?  One such definition, which would calm many of the anxious, unwilling lenders and might reopen their wallets, would exclude commercial and financial paper and pyramidal schemes such as securitization (and magnetic dots!) from “reserves”.  Such a definition would admit only tangible, saleable assets such as property, especially productive property such as mines, factories, and farms.  
 
True, this would create enormous disruption in the capital markets; but, arguably, it is time for creative destruction of a system that has become a haven for clever people designing clever (but fragile) games with names like “derivatives” and “high frequency trading”.  Finance, far from enabling productive enterprise, which was once its function, now simply enables finance to finance finance.  E.g., close to 100% of current market traffic is now exclusively financial in nature; and it is a serious question whether the textbook “efficient allocation of resources” objective is being served whatsoever.
 
Concerning Bagehot’s “sting in the tail”, the logic in the common assumption that the taxpayer must be the lender of last resort escapes most taxpayers entirely.  As one writer put it, after explaining the process of money creation, don’t look for any logic in taxpayer bailouts; there isn’t any.
 
Cheers,
 
F.
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