NCPA - National Center for Policy Analysis

Why Savers Prefer Low Yield Instruments

April 16, 2013

Across the globe, and particularly in America, savers have been attracted to long-term instruments with low yields. The preference of these low yield instruments is the result of financial regulation on capital allocation, says Arnold Kling, a member of the Financial Markets Working Group at the Mercatus Center.

  • The Basel Capital Accord was an international agreement that since the late 1980s has guided financial regulators in applying capital standards to banks based on risk.
  • The accord established international standards that leveled the playing field and ensured that capital would not automatically move to a country with the friendliest regulatory environment.
  • The accord also established risk-based capital standards as a result of the savings and loan crisis and the Latin American debt crisis.

While the accord was not binding, most countries voluntarily abided by its goals. Basel established different risk weights to different assets.

  • Government debt instruments were given a risk weight of zero, meaning that they required no capital.
  • Government mortgages like those guaranteed by Fannie Mae and Freddie Mac carried low risk weights and thus gave these instruments an enormous advantage in the market that eventually resulted in the housing crisis of 2007.
  • Mortgage-backed securities grew from $17 billion in 1980 to $604 billion in 1990 to $1,283 billion in 2000.

Under Basel, U.S. regulators issued a 2000 rule requiring banks to hold capital for securities sold that they were responsible for in the event of a default. At the same time, Wall Street firms and large banks were now able to have their mortgage-backed securities ranked as low risk if they received an AAA or AA rating from a rating agency, which they did.

  • The result was the financial crisis of 2008, which occurred when the huge influx of mortgage-backed securities collapsed as subprime mortgages began to default.
  • The risk of these instruments was artificially inflated, which demonstrated the inability of risk-based capital (RBC) standards to curb risk-taking behaviors.
  • Researchers have found that RBC standards do not actually lower risk-taking and are less effective than simple capital ratios.

Despite evidence suggesting that a simple capital ratio works, the risk-based model is still being employed. This is particularly concerning with regard to sovereign debt, which is still considered a zero risk instrument. Risky national balance sheets suggest otherwise. Risk-based regulations are the reason why investors are shying away from productive higher yield investments.

Source: Arnold King, "Regulating Risk," The American, April 11, 2013.


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