Monday, September 13, 2010

The new Basle rules would not hamper economies even if we ignore the beneficial effects of reducing the chance of another credit crunch.

The most popular and naïve assumption (an assumption which is even made in the Basel III reports) is that higher lending costs hamper economies. Though the Basle reports claim the benefits from a reduced chance of another credit crunch will override the “hamper” effect.

The idea that those tighter requirements represent a cost is based on the assumption that any old increase in lending is good, because, er, any old investment is good.

Well, there is actually an OPTIMUM amount of investment.

Now is the amount of investment currently optimum? No, it’s not. It’s actually more than optimum because maturity transformation lets borrowers borrow at lower rates than they otherwise would. And more stringent capital requirements effectively reduces the extent of maturity transformation. For more on this see here, (point No 1 in particular).

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