Streetwise Professor

May 27, 2010

Isn’t It Interesting?

Filed under: Economics,Financial crisis,Politics — The Professor @ 8:41 pm

Isn’t it interesting that the current mortal threat to the stability of the world financial system isn’t the dreaded “D” word–derivatives–but plain jane government debt?  Isn’t it interesting that the major force behind the last crisis–mortgage debt–and the major force behind this one–sovereign debt–received very favorable capital treatment for banks?; both were considered eminently safe, and banks had to hold very little capital against them.  What’s more, given the favorable treatment, banks loaded up with them by the gross.  Therefore, mightn’t one conclude that perverse bank capital rules are a major systemic risk?  Shouldn’t this raise concerns that centralized price setting mechanisms–such as centrally determined capital requirements–are not going to save us from the next crisis, but create it?

It is inevitable that such a mechanism will underprice some risks; that this will induce financial institutions to overinvest in those instruments; and that as a result, they are likely to be the source of a financial “surprise” that wreaks havoc.

And isn’t it interesting that the capital rules gave very favorable treatment to politically favored instruments–mortgage debt/real estate, and government debt?

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