Re: Clouds Seen in Regulators’ Crystal Ball for Banks
Modeling of bank credit risk based upon empirical analysis of past events is an inappropriate tool for predicting future bank crises. Austrian business cycle theory, which requires no such empirical analysis, explains that once the central bank expands bank credit by driving the interest rate below its natural level, the subsequent boom must be followed by a bust. Empirically based “Agent-based modeling”, which assumes that a “shock on a vulnerability of the financial system” is the root cause of the crisis, ignores this more fundamental cause. Even if regulators were successful in earlier identification of excessive leverage in a particular segment of the market, the damage has been done. Shutting off credit to one market segment will merely cause the excessive credit to flow to other market segments. The resulting continuous series of smaller, sector specific crises would be no better than a general crisis that occurs less often. If regulators wish to prevent a bust, they should tell the central bank to refrain from initiating the boom.