First, about risk aversion. My point is not about the level of risk premiums. You can implement any level of risk premium you think is correct and still have expected profitability as the selection criterion. My point is that because banks don’t have an upside, they will select on something other than expected profitability. This other criterion is inferior to expected profitability, exactly because it does not factor in an upside. For any level of risk premium you want, it will still be biased.

Second, my point is not a critique against banks, at least not directly. I think banks should worry primarily about credit risk (and if they had been better at it, we wouldn’t be having this discussion), instead my point is that a cost of the current situation is that we get a different kind of selection process.

Third, I guess I could have formulated this a bit clearer. I did not mean to say that low productivity makes you a better credit risk, only that banks will have very weak incentives to include productivity in their rationing decisions. So they are quite likely to provide credit to a low productivity firm with a low credit risk, and let a higher productivity firm with a higher credit risk go under (or be severely constrained).

Hmmm…. not so clear to me. Gold and commodities are screaming inflation, bonds and housing are saying deflation, add some regime uncertainty. Risk aversion seems like exactly the right strategy.

Perhaps you mean you think another enviornment where banks can take greater risks is healthier. If so, then I agree. However, I believe that a large reduction in the currently existing risk is what gets us to that better place. If this is true, then the banks current risk aversion is healthy in the sense that it moves us in the direction of the place we want to be.

“large, established, low-productivity, low-debt, tangible-capital firms represent a somewhat lower credit risk”

I am not sure why low-productivity makes you a lower credit risk. Perhaps large, established, low-debt, tangible-capital makes you low-productivity. But, this doesn’t seem correct either.