Friday, April 3, 2020

What if golf, roulette or horse-racing, had fallen into the hands of a Basel Committee?

What would have happened to golf, if its handicap system had fallen into hands as those of the Basel Committee who designed the risk weighted bank capital requirements?

What would have happened to casinos, if odds settings, like for roulette, had fallen into hands as those of the Basel Committee who designed the risk weighted bank capital requirements?

What would have happened to horse racing, if the handicapping of horses with weights had fallen into hands as those of the Basel Committee who designed the risk weighted bank capital requirements?

Thursday, March 12, 2020

The Basel Committee for Banking Supervision’s bank regulations vs. mine.

A tweet to: @IMFNews, @WorldBank, @BIS_org @federalreserve, @ecb @bankofengland @riksbanken @bankofcanada
"Should you allow the Basel Committee to keep on regulating banks as it seems fit, or should you not at least listen to other proposals?

Bank capital requirements used to be set as a percentage of all assets, something which to some extent covered both EXPECTED credit risks, AND UNEXPECTED risks like major sudden downgrading of credit ratings, or a coronavirus.

BUT: Basel Committee introduced risk weighted bank capital requirements SOLELY BASED ON the EXPECTED credit risk. It also assumes that what is perceived as risky will cause larger credit losses than what regulators perceive or decreed as safe, or bankers perceive or concoct as safe. 

The different capital requirements, which allows banks to leverage their equity differently with different assets, dangerously distort the allocation of bank credit, endangering our financial system and weakening the real economy.

The Basel Committee also decreed a statist 0% risk weight for sovereign debts denominated in its domestic currency, based on the notion that sovereigns can always print itself out of any problem, something which clearly ignores the possibility of inflation, but, de facto, also implies that bureaucrats/politicians know better what to do with bank credit they are not personally responsible for, than for instance entrepreneurs, something which is more than doubtful.

Basel Committee's motto: Prepare for the best, for what's expected, and, since we do not know anything about it, ignore the unexpected 

I propose we go back to how banks were regulated before the Basel Committee, with an immense display of hubris, thought they knew all about risks; which means one single capital requirements against all assets; 10%-15%, to cover for the EXPECTED credit risk losses and for the UNEXPECTED losses resulting from wrong perceptions of credit risk, like 2008’s AAA rated securities or from any other unexpected risk, like COVID-19.

My one the same for all assets' capital requirement, would not distort the allocation of credit to the real economy.

My motto: Prepare for the worst, the unexpected, because the expected has always a way to take care of itself.


PS. My letter to the Financial Stability Board
PS. A continuously growing list of the risk weighted bank capital requirements mistakes

Friday, March 6, 2020

“The raison d’être of macroprudential policy is to ensure the financial system supports the economy.” Mark Carney left out: “EFFICIENTLY”.


“The raison d’être of macroprudential policy is to ensure the financial system supports the economy.”

Yes, but absolutely not in the way of how a brochure at the Bank of England’s museum, explaining quantitative easing, states it, by: “Putting more money into our economy to boost spending

Our financial system should support our economy by allocating financial resources as efficiently as possible… and that, with current risk weighted bank capital requirements is something it definitely does not achieve. For example:

Assigning a risk weight of 0% to the sovereign’s debt and one of 100% to the citizen’s debts de facto implies that a bureaucrat knows better what to do with a credit for which’s repayment he is not personally responsible for than for example and entrepreneur. And that sort of veiled communism has failed here, there and everywhere.

Assigning a risk weight of 0% to residential mortgages and one of 100% to debts of unrated entrepreneurs’, de facto implies that financing the purchase of a house is more important than financing those who could help create the jobs needed to be able to service utilities and repay mortgages… something which I hope everyone understands is not so. It caused houses to morph from being affordable homes into being risky investment assets.

Assigning a risk weight of 20% to corporate AAA rated debt and one of 150% to corporate debt rated below BB-, de facto implies that the former, besides being able to obtain much more credit and at much lower rates, also deserves even better terms… and that is plainly an immoral discrimination… and besides an utterly stupid one. Anyone who believes that the excessive bank exposures that could cause profound bank crises are built up more with assets rated below BB- than with assets rated AAA, has never ever left his desk and walked on Main-Street.

Soon the history on banking will include: Between 1988 and 202x, believe it or not, banks were regulated by experts using risk weighted bank capital requirements based on that what was perceived as risky, was more dangerous to our bank system than what was perceived as safe


Monday, March 2, 2020

Central banks and regulators should not be allowed to discriminate in favor of asset owners or those perceived or decreed as safe.

Again, I visited the Bank of England’s museum.


Into my hands came a brochure titled “Quantitative easing explained: Putting more money into our economy to boost spending” It reads:


A direct cash injection: The Bank creates new money to buy assets from private sector institution’

Purchases of financial assets push up their price, as demand for those assets increases and corporate credit markets unblocked

Total wealth increases when higher asset prices make some people wealthier either directly or, for example, through pension funds.

My comment: “some people” this is a clear recognition that quantitative easing helps more those who own assets than those who don’t. Central banks should not be allowed to carry out such under the table non transparent discrimination.

The cost of borrowing reduces as higher asset prices mean lower yields, making it cheaper for households and businesses to finance spending.

My comment: Because of risk weighted bank capital requirements the benefits of any “lower yields” are primarily transmitted to those perceived or decreed as safe, for example, the sovereign and the beneficiaries of residential mortgages. 

More money means private sector institutions receive cash which they can spend on goods and services or other financial assets. Banks end up with more reserves as well as the money deposited with them.

Increased reserves mean banks can increase their lending to households and businesses, making it easier to finance spending.

My comment: Again, because of risk weighted bank capital requirements, banks increases in lending will primarily benefit those perceived or decreed as safe, for example, the sovereign and the beneficiaries of residential mortgages. 

My conclusion: Central banks should not be allowed to carry out such here confessed under the table non transparent discrimination in favor of those who own assets and those who generate lower capital requirements for banks. The combination of quantitative easing with the main transmission channel for monetary policy, bank credit, being distorted by risk weighted bank capital requirements has de facto introduced communism/crony capitalism into the financial sector.


Saturday, January 11, 2020

Paul Volcker valiantly accepted that the risk weighted bank capital requirements he helped to promote had serious problems.

In his 2018 autobiography “Keeping at It” Paul Volcker wrote:

“The US practice had been to assess capital requirements by using a simple “leverage” ratio-in other words, the bank’s total assets compared with the margin of capital available to absorb any losses on those assets. (Historically, before the 1931 banking collapse, a 10 percent ratio was considered normal.) 

The Europeans, as a group, firmly insisted upon a “risk based” approach, seemingly more sophisticated because it calculated assets based on how risky they seemed to be. They felt it was common sense that certain kinds of assets-certainly including domestic government bonds but also home mortgages and other sovereign debt-shouldn’t require much if any capital. Commercial loans, by contrast, would have strict and high capital requirements, whatever the credit rating might be.

Both approaches could claim to have strengths. Each had weaknesses. How to resolve the impasse?...

The Fed and the Bank of England came to a bilateral understanding, announced in early 1987… It became known as the “Basel Agreement” …

Over time, the inherent problems with the risk weighted bank capital-based approach became apparent. The assets assigned the lowest risk, for which capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages. Ironically, losses on those two types of assets would fuel the global crisis in 2008 and a subsequent European crisis in 2011. The American “overall leverage” approach had a disadvantage as well in the eyes of shareholders and executives focused on return on capital; it seemed to discourage holdings of the safest assets, in particular low-return US government securities.

Thursday, December 19, 2019

What would Hyman Minsky say if able to observe how his financial instability moments were put on steroids by bank regulators?

On Minsky moments

In many cases even trying to regulate banks runs the risk of giving the impression that by means of strict regulations, the risks have disappeared. History is full of examples of where the State, by meddling to avoid damages, caused infinite larger damages”

Old agricultural traditions of burning a little each year, thereby getting rid of some of the combustible materials, was much wiser than no burning at all, which only guarantees disaster and scorched earth, when fire finally breaks out, as it does, sooner or later. Therefore a regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises.”

Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds”

The Basel Committee’s credit risk weighted bank capital requirements cause our banks to be dangerously overexposed to what’s expected, and to be woefully unprepared for the unexpected. 

Current risk weighted bank capital requirements guarantee especially large bank crises, caused by especially large exposures to what’s perceived as especially safe but might not be, and is held against especially little capital.

"A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind."

Sunday, December 15, 2019

Since they believe it to be safer, regulators want banks to finance house purchases much more than job creating entrepreneurs. Doesn’t anyone of them have grandchildren?

Let us suppose that in a world without risk weighted capital requirements, like the world of banking was for around 600 years before 1988’s Basel Accord, a world with one single capital requirement against all bank assets, for instance 8%.

Let us also suppose that in that world banks would view residential mortgages at 5% interest rate to be, when adjusted to perceived credit risks, equivalent to 9% interest rate on loans to entrepreneurs, and that, for both these assets, their expected risk adjusted net margin was 1%.

In that case, since banks could leverage 12.5 times their equity (100/8) the expected risk adjusted return on equity, on both these assets, would be 12.5%

How many residential mortgages and how many loans to entrepreneurs were given in such a world? I have no idea but adjusted for their perceived credit risk, it was clear both house buyers and entrepreneurs competed equally for credit. 

But then came the Basel Committee with its risk weighted bank capital requirements, and for instance in its 2004 Basel II, assigned a risk weight of 35% to residential mortgages and 100% for loans to unrated entrepreneurs. 

That, for Basel’s basic capital requirement of 8%, meant banks needed to hold 2.8% in capital against residential mortgages and 8% against loans to entrepreneurs.

This in turn meant banks could in the case of loans to entrepreneurs still leverage 12.5 times but now, with residential mortgages, they could leverage almost 36 times (100/2.8). 

And in this case, with the same as expected risk adjusted margin of 1%, banks could still earn12.5% in expected risk adjusted return on equity, but residential mortgages now offered them the possibility of earning a whooping 36% in expected risk adjusted return on equity.

Clearly house buyers were much favored since banker would offer residential mortgages much more and even contemplate some interest rate reductions, while the entrepreneurs had their access to credit much curtailed that is unless they offered to pay higher interest rates.

So what does all this result in? Houses morphing from affordable home into being risky investment assets, while at the same time much less of those job opportunities that entrepreneurs might have helped to create for us and our descendants.

Thinking of our grandchildren’s future is this kind of bank regulations acceptable? Absolutely not! “A ship in harbor is safe, but that is not what ships are for.” John A. Shedd.

PS. Much worse statist regulators assigned 0% risk weights on loans to the sovereign, which de facto implied government bureaucrats to use credit for which they are not personally responsible for much better, than for instance entrepreneurs.

Tuesday, December 10, 2019

Here a simple as can be one-minute explanation of the distortions produced by the risk weighted bank capital requirements in the allocation of credit to the real economy.

For 600 years, before the Basel Accord of 1988, banks, with an eye to their overall portfolio, allocated their assets/credits depending on the perceived risk adjusted return these were to produce.

For instance, if a safe AAA to AA rated asset at 4% interest rate and a riskier asset rated BBB+ to BB- a 7% interest were, in the mind of the banker, both producing an acceptable 1% net risk adjusted return, he could pick either one or both. If banks were allowed (by markets or regulators) to leverage their assets 12.5 times, that would produce the bank a 12.5% risk adjusted return on equity.

But the introduction of the risk weighted bank capital requirements changed all that.

Basel II, 2004, standardized risk weights banks assigned a risk weight of 20% to AAA to AA rated assets, and 100% BBB+ to BB- rated assets.

That based on a basic capital requirement of 8% translated into a 1.6% capital requirement for AAA to AA rated assets, and 8% for BBB+ to BB- rated assets.

That mean banks could leverage AAA to AA rated assets 62.5 times, while only 12.5 times with BBB+ to BB- rated assets.

So, with the same previous 1% net risk adjusted return AAA to AA rated assets would now yield a 62.5% risk adjusted return on equity while the BBB+ to BB- rated assets would keep on yielding a 12.5% risk adjusted return on equity.

And so either the BBB+ to BB- rated risky had to be charged 12% instead of 7%, so as to deliver the 5% risk adjusted return that, with a 12.5 times allowed leverage would earn banks a 62.5% risk adjusted return on equity, something which naturally made the risky even riskier; or the AAA to AA rated could be charged a lower 3.2 % interest rate instead of 4%, and still deliver a 12.5% risk adjusted return on equity.

What happened? The risky, like unsecured loans to entrepreneurs, were abandoned by banks, or had to pay much higher interest rates, while the safe, like sovereigns, residential mortgages and AAA rated, were much more embraced by banks, and even offered lower interest rates than in the past.

This is the distortion in the allocation of bank credit to the real economy that the regulators have caused. Is that good? Absolutely not! It promotes excessive credit to what’s perceived or decreed safe, and insufficient to what’s perceived as risky. 

And since risk taking is the oxygen of all development, with it, regulators have doomed our real economy and financial sector to suffer from lack of muscles, severe obesity and osteoporosis.

A ship in harbor is safe, but that is not what ships are for.” John A. Shedd. But the Basel Committee for Banking Supervision is causing banks to dangerously overpopulate safe harbors, while leaving the riskier oceans to other investors and small time savers.

And the savvy loan officers were substituted by creative bank equity minimizing financial engineers

And the risk-free rate became a subsidized risk-free rate.


Saturday, December 7, 2019

Tombstones

Here rests a bank regulator who all his life believed that what bankers perceived as risky was more dangerous to our bank systems than what bankers perceived as safe. 
May his soul rest in peace.

Here rests a bank regulator who based the risk weighted bank capital requirements on bankers perceiving risk correctly, and not on that they could be wrong.
May his soul rest in peace.

Here rests a regulator who missed his lectures on conditional probabilities, and therefore did not set the risk weighted capital requirements conditioned on how bankers respond to perceived credit risks.
May his soul rest in peace.

Here rests a regulator who even though bankers respond to perceived credit risks, with size of exposures and risk adjusted interest rates, also wanted bank capital to double up on that same perceived risk
May his soul rest in peace.

Here rests a bank regulator who never understood the systemic risks he introduced into banking, by for instance assigning so much power to credit rating agencies, or his stress-tests of the stresses a la mode.
May his soul rest in peace.

Here rests a bank regulator who for the risk weighted bank capital requirements agreed with risk weights of 20% for dangerous AAA rated and 150% for innocous below BB- rated
May his soul rest in peace.

“A ship in harbor is safe, but that is not what ships are for.” John A. Shedd.
Here rests a bank regulator who caused banks to dangerously overpopulate safe harbors, and sent other investors and small time savers out on the risky oceans. 
May his soul rest in peace.

Here rests a bank regulator who by favoring banks to finance the "safer" present and to stay away from the "riskier" future, blocked millions of entrepreneurs' access to bank credit and with it risk-taking… the oxygen of all development
May his soul rest in peace.

Here rests a statist bank regulator who believed a government bureaucrat knows better (Risk Weight 0%) what to do with credit he’s not personally responsible for, than an entrepreneur or SME (RW 100%)
May his soul rest in peace.

Here rests a bank regulator who for risk weighted bank capital requirements agreed with a low 35% risk weight to residential mortgages, which caused houses to morph from affordable homes to risky investment assets.
May his soul rest in peace.

Here rests a bank regulator with a Ph.D. who proved right Daniel Patrick Moynihan, who supposedly held “There are some mistakes only Ph.Ds. can make.
May his soul rest in peace.

Here lies a central banker who injected huge amounts of liquidity without understanding how risk weighted bank capital requirements distorted the allocation of credit
May his soul rest in peace.

Here lies a financial journalist who scared stiff he would never be invited to important conferences, never questioned the risk weighted bank capital requirements. 
May his soul rest in peace.

Here lies an ordinary citizen who wanting so much to believe it true, swallowed lock stock and barrel the regulatory technocrats' populism imbedded in the risk weighted bank capital requirements
May his soul rest in peace.

Here rests a regulator who helped guarantee especially large bank crises, caused by especially large exposures to what’s perceived especially safe and might not be, and is held against especially little capital
May his soul rest...

Here rests a regulator who assisted by his central bank colleagues, helped set horrible Minsky moments on steroids
May his soul rest...

Tuesday, December 3, 2019

My tweets on “How the Basel Committee doomed our bank systems and our economies”

The Basel Committee doomed our bank systems and our economies.
For around 600 years risk adverse bankers had, not always successfully, tried to do their best to clear for perceived credit risks, by means of risk adjusted interest rates and the size of bank exposures. 

When what bankers had perceived as risky turned out to be even more risky, since the exposures were generally quite small, it hurt but banks could manage. 
When what bankers perceived as safe turned out to be risky, since the exposures were then very large, big crises often ensued. 

But then, starting in 1988 with Basel I, and really exploding in 2004 with Basel II, risk adverse regulators decided they also wanted to clear for those same perceived credit risks, and to that effect introduced risk weighted bank capital requirements.

In the softest words I can muster, that was extremely dumb. As bank supervisors they should be almost exclusively concerned with bankers not perceiving the credit risks correctly. Instead they bet our bank systems on that bankers would perceive credit risks correctly.

Banks everywhere were then taken out of the hands of savvy loan officers, and placed in the hands of creative equity minimizing financial engineers, who then ably marketed the nonsense that more bank capital hindered bank lending and was therefore bad for the real economy 

The 2008 crisis caused by AAA rated securities backed with mortgages to the US subprime sector, with which European banks and US investment banks were allowed to leverage 62.5 times with these, should have loudly reminded them about the dangers of the “safe”. 

But regulators refused to admit their mistake and kept risk weighting in Basel III.
The result is an ever increasing dangerous overcrowding of “safe harbors” and the abandonment of the “riskier oceans.
“A ship in harbor is safe, but that is not what ships are for.” John A. Shedd.

And those who used to populated safe harbors, like insurance companies, pension funds, personal saving accounts and other, have been expelled to the risky oceans, confronting loans to leveraged corporates, emerging markets and others for which they're less prepared than bankers

To sum it up, risk-weighted bank capital requirements guarantees especially large crises, resulting from especially large exposures to what’s perceived especially safe, and is held against especially little capital. 
Let’s get rid of these regulators… now!

And not only are they dangerously bad regulators… by decreeing risk weights of 0% for the sovereign and 100% for the citizens, they also evidence being dangerous statist/communist regulators.



Saturday, October 19, 2019

My tweets to IMF and World Bank on risks and bank regulations during their Annual Meetings 2019

@IMFNews @WorldBank #IMFmeetings #WBGMeetings
The world needs the IMF and World Bank to hold a continuous and intensive back and forth debate, a give and take, on risk-taking. 
“A ship in harbor is safe, but that is not what ships are for.” John A. Shedd.

The World Bank, as the world’s premier development bank should always make clear that risk taking is oxygen needed for moving forward.
And the IMF, as guardian of the world’s financial stability, is responsible for that risk taking not getting out of hands. 

That debate has sadly not been forthcoming.
That resulted in the acceptance of the credit risk weighted bank capital requirements. 
That introduced a regulatory risk aversion, dangerous both for the financial stability and for economic growth.

For financial stability, by creating excessive bank exposures to what’s perceived, decreed or concocted as especially safe, against especially little capital.
For the economy, by reducing the “risky” but vital SMEs’ and entrepreneurs’ access to bank credit.

A synchronized financialization: 
"A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind."

A synchronized disaster:
“Perceiving risks wrong: What happens when markets misprice risk?”
Wrong question! When markets see risks, it stays away 
Correct question! “Perceiving safety wrong: What happens when markets (and regulators) misprice safety?

Thursday, September 26, 2019

Some tweets on macro-imprudent policies

I tweeted this to BIS in response to a speech by Mario Draghi, President of the European Central Bank and Chair of the European Systemic Risk Board, titled "Macroprudential policy in Europe" delivered September 26, 2019

Regulators have based their risk weighted bank capital requirements on that what’s perceived as risky is more dangerous to our bank systems than what is perceived, decreed or concocted as safe. That puts bank crises on steroids.

The risk weighted bank capital requirements are as procyclical it can get. Getting rid of these is the best countercyclical measure.

The 0% capital requirements assigned to all Eurozone sovereigns’ debts, even when these are not denominated in their own printable fiat currency. This WILL blow up the Euro and perhaps, sadly, the EU too.

Wednesday, August 28, 2019

Basel I, II, and III are all examples of pure unabridged regulatory statism

In July 1988 the G10 approved the Basel Accord. For its risk weighted bank capital requirements it assigned the following risk weights:

0% to claims on central governments and central banks denominated in national currency and funded in that currency. 

100% to claims on the private sector.

That means banks can leverage much more whatever net margin a sovereign borrower offers than what it can leverage loans like to entrepreneurs. That means banks will find it easier to earn high risk adjusted returns on their equity lending to the sovereign than for instance when lending to entrepreneurs. That means it will lend too much at too low rates to the sovereign and too little at too high rates to entrepreneurs.

In other words Basel I introduced pure and unabridged statism into our bank regulations. 

Basel II of June 2004 in its Standardized Risk Weight, for the same credit ratings, also set lower risk weights for claims on sovereigns than for claims on corporates.

In a letter published by FT November 2004 I asked: “How many Basel propositions will it take before they start realizing the damage they are doing by favoring so much bank lending to the public sector. In some developing countries, access to credit for the private sector is all but gone, and the banks are up to the hilt in public credits.”

And the European Commission, I do not know when, to top it up, assigned a Sovereign Debt Privilege of a 0% risk weight to all Eurozone sovereigns, even when these de facto do not take on debt in a national printable currency.

And, to top it up, the ECB launched its Quantitative Easing programs, QEs, purchasing European sovereign debts.

At the end of the day, the difference between the interest rates on sovereign debt that would exist in the absence of regulatory subsidies and central bank purchases, and the current ultra low or even negative rates, is just a non-transparent tax, paid by those who save. Financial communism

Monday, August 19, 2019

J’Accuse[d] the Basel Committee for Banking Supervision (BCBS) a thousands times, but I am no Émile Zola and there’s no L’Aurore

J’Accuse the Basel Committee of setting up our bank systems to especially large crises, caused by especially large exposures to something perceived as especially safe, which later turns into being especially risky, while held against especially little capital.


J’Accuse the Basel Committee for distorting the allocation of bank credit to the real economy by favoring the sovereign and the safer present, AAA rated and residential mortgages, while discriminating against the riskier future, SMEs and entrepreneurs.

My letter to the International Monetary Fund

A question to the Fed: When in 1988 bank regulators assigned America’s public debt a 0.00% risk weight, its debt was about $2.6 trillion, now it is around $22 trillion and still has a 0.00% risk weight. When do you think it should increase to 0.01%?

Saturday, August 17, 2019

Clearing for perceived risk vs. discriminating based on perceived risk.

If making good down payments house buyers normally had more and cheaper access to bank credit than an entrepreneurs wanting loan for risky ventures.

But when regulators, with their risk weighted bank capital requirements decreed that banks needed to hold less capital against residential mortgages than against unsecured loans to entrepreneurs; which meant that banks could leverage much more their equity with residential mortgages than with unsecured loans to entrepreneurs; which meant that with the same risk adjusted interest than before banks could earn higher risk adjusted returns on equity with residential mortgages than with unsecured loans to entrepreneurs, the regulators de facto discriminated the access to bank credit in favor of house buyers and against entrepreneurs.

So there’s a world of difference between banks clearing for perceived credit risk and the regulators discriminating the access to bank credit based on perceived credit risk.

With their discrimination regulators decreed inequality


And, at the end of the day it's all for nothing. That discrimination only sets up our banks to especially large bank crises, caused by especially large exposures to something ex ante perceived, decreed or concocted as especially safe, and which ex post turns into being especially risky, while being held against especially little capital.


A letter to the IMF titled: "The risk weights are to access to credit, what tariffs are to trade, only more pernicious."

Friday, August 9, 2019

“I am not sure about 'subsidised' sovereign. Since sovereign is ultimate safety net for entire financial system… the term is I'll suited.”

My answer:

Yes a sovereign, if we ignore inflation and the possibility of being repaid in worthless money, the sovereign represents no risk if it takes on debt denominated in a currency it can print. Which by the way is not the case with the sovereigns in the Eurozone.

But let us assume that in the open market the required risk/cost/inflation adjusted net return for a sovereign in .5% and for the risky SMEs 3%

Then if banks, as it used to be for almost 600 years, had to hold one single capital against the risks of its whole portfolio, and the authorities, or in their absence the markets, allowed banks to leverage 12 times then the risk/cost/inflation adjusted required expected return on equity would be 6% for sovereigns and 36% for SMEs.

BUT, since banks are now allowed to leverage immensely more with safe sovereigns, let us say 40 times and only 12 times with SMEs, the now distorted risk/cost/inflation adjusted expected ROEs are 20% for sovereigns and still 36% for SMEs. So now banks can offer to lower the interest rates to sovereigns and still obtain the risk/cost/inflation adjusted required expected return on equity of 6% for sovereigns, ergo the subsidized sovereign.

OR, since banks could now earn a risk/cost/inflation adjusted expected ROEs of 20% on sovereign debt, then in terms of comparable risk adjustments it would have to earn more than 36% on SMEs, or not lend to them at all, ergo that subsidy to the sovereign, is paid by others who find their access to bank credit made more difficult and expensive as a consequence of the risk weighted bank capital requirements. 

PS. Is there no sovereign risk present when some current rates are negative and central banks work like crazy to produce 2% inflation? 

PS. If you go back in time and start taking about risk-free sovereigns to bankers who sometimes had their head chopped off or were been burned when trying to collect from the sovereigns, they would think you were crazy.

Saturday, July 20, 2019

The before and after the risk weighted bank capital adequacy ratio (RWCR)

The risk weighted bank capital requirements were introduced in 1988 by means of the Basel Accord, Basel I, and were much further developed in 2004, with Basel II. RWCR survives in Basel III.

Before RWCR banks, for their return on equity, leaned on savvy bank loan officers to obtain the highest risk adjusted net margins. A net margin of 1.5% when leveraged 10 times on their equity, would produce a 15% ROE. All wanting access to bank credit, whether perceived as safe or risky, competed equally with their risk adjusted net margin offers.

After the introduction of RWCR though banks, for their return on equity, still leaned somewhat on bank loan officers obtaining the highest ROE depended more on equity minimizing financial engineers. A risk adjusted net margin of 1%, when leveraged 20 times on equity, produces a 20% ROE. The risk adjusted net margin offers of those perceived or decreed as safe, which could be leveraged many times more, were now worth much more than those offered by the risky.

And what are the consequences?

The RWCR by favoring the financing of the “safer present” like sovereigns, residential mortgages and what’s AAA rated over the financing of the “riskier future, like entrepreneurs, leads to a more obese and less muscular economy.

All that RWCR really guarantees is especially large bank crisis, caused by especially large exposures to something perceived or decreed as especially safe, and that turn out to be especially risky, while being held against especially little bank capital. 

So what went wrong? Simply that regulators based their capital requirements on the same perceived risks that bankers already consider when they make their lending decisions, and not on the conditional probabilities of what bankers do when they perceive risks.

Any risk, even if perfectly perceived, will lead to the wrong actions, if excessively considered.

Thursday, July 18, 2019

Why are regulators allowed to introduce odious and dangerous discrimination in the access to bank credit?

Banks used to apportion their credit between those perceived as risky, and those perceived as safe, based on (1) the risk adjusted interest rates and (2) their own portfolio considerations.

But that was before the Basel Committee for Banking Supervision’s credit risk weighted capital requirements.

Now banks apportion credit between those perceived as risky and those perceived as safe, based on (1) the risk-adjusted interest rates (2) the times their bank equity can be leveraged with those risk-adjusted interest rates and (3) hopefully, since those risk weighted capital requirements are explicitly portfolio invariant, their own portfolio considerations.

That means the risk adjusted interest rates “the safe” now can offer in order to access bank credit have been lowered, while the risk adjusted interest rates “the risky” have to offer in order to access bank credit have been increased.

That has leveraged whatever natural discrimination in access to bank credit there was against the “riskier” in favor of the “safer”.

That dangerously distorts the access to bank credit in favor of the “safer” present, like sovereigns, house purchases and the AAA rated and against the “riskier” future, like entrepreneurs; which means that our banks have no other social purpose to fulfill than being safe mattresses into which stash away our savings.

And all so useless because the only thing these regulations guarantee, is especially large bank crisis, caused by especially large exposures to something perceived or decreed as especially safe, and that turn out to be especially risky, while being held against especially little bank capital. 

Wednesday, July 17, 2019

What if taking down our bank systems was/is an evil masterful plan for winter to come?

Tweets on "What if taking down our bank systems was/is an evil masterful plan for winter to come?"
The poison used is that of basing bank capital requirements on ex ante perceived risks, more risk more capital, less risk much less capital.

That way banks were given incentives to build up the largest exposures to what is ex ante perceived by bankers as safe, something which, as we know, in the long run, when ex post some of it turns out very risky, is what always take bank systems down.

For that they made sure no one considered making the risks conditional on how bankers perceive the risks.
And that hurdle cleared, some very few human fallible credit rating agencies were given an enormous influence in determining what is risky and what is safe.

And taking advantage of some statists or that few noticed, sovereigns were assigned a 0% risk weight, while citizens 100%. That guaranteed government bureaucrats got too much of that credit they’re not personally responsible, and e.g. the entrepreneurs too little.

And to make the plan even more poisonous some European authorities were convinced to also assign to all Eurozone sovereigns a 0% risk weight, and this even though these all take up loans in a currency that is not their domestic printable one.

And because banks were allowed to leverage much more with “safe” residential mortgages than with loans to “risky” small and medium businesses, houses prices went up faster than availability of jobs, and houses morphed from homes into investment assets

And finally, by means of bailouts, Tarps, QE’s, fiscal deficit, ultra low interest rates and other concoctions, enormous amounts of financial stimuli was poured on that weak structure… and so the evil now just sit back and wait for winter to come

Friday, July 5, 2019

Risk weights are to access to credit what protectionist tariffs are to trade, only more pernicious.

A letter to the Executive Directors and Staff of the International Monetary Fund.

For decades now IMF has helped to spread around all developing countries the pillar of the Basel Committee’s bank regulations; the risk weighted capital requirements for banks.

Since risk taking is in essence the oxygen of any development, that piece of regulation is fundamentally flawed, especially for developing countries.

How do risk weighted capital requirements alter the incentives for banks? 

If banks hold the same capital against their whole portfolio, as they used do until some three decades ago, then with an eye on their overall portfolio and funding structure, banks lend in accordance to what produces them the highest risk adjusted interest rate; which would also provide them with the highest risk adjusted return on equity.

But, when different assets have different capital requirements, obtaining the highest risk adjusted return on equity will depend on how many times the risk adjusted interest rate for any specific loan or asset will depend on how many times it can be leveraged. The higher the allowed leverage is, the easier it is to obtain a high ROE; which means that “safe” highly leveregable loans could be competitive at lower risk adjusted interest rates than before, while “risky” lower leveregable loans would require paying higher risk adjusted interest rates. 

In essence the introduction of that regulation has caused banks to substitute savvy loan officers with equity minimizing engineers.

How do risk weighted capital requirements distort the allocation of bank credit?

The regulators based their decision on how much banks were allowed to leverage their capital with for the different assets, solely on the perceptions of credit risk. It never explicitly had one iota to do with banks fulfilling their obligation of allocating credit efficiently to the real economy.

So the introduction of that regulation simply distorts the allocation of bank credit; in favor of “the safer present” and against “the riskier future”. 


Specifically, a credit that is perceived as risky but that is directly related to helping reach a Sustainable Development Goal is much less favored by bankers, and now by bank regulators too, than a credit, perceived as safe, but which purpose could in fact be harmful to any SDG.

Specifically, safe credits for the purchase of houses are much more favored over credits to risky entrepreneurs, those who could create the jobs that would allow the income needed to service the mortgages and pay the utilities. 

Specifically, assigning lower risk weights to the sovereign than to citizens de implies de facto a statist belief that bureaucrats know better what to do with bank credit, than entrepreneurs who put their name on the line.

In other words these risk weight are to access to credit what tariffs are to trade, only much more pernicious. 

Do risk weighted capital requirements make our banks system safer?

If that regulation made the financial system safer there would at least be a favorable tradeoff. But it doesn’t, much the contrary. Too much easy credit can turn what is safe into something risky, like for instance morphing houses from being affordable homes into investment assets. 

The 2007/2008-bank crisis would never have happened or, if so, remotely had been of the same scale had regulators, for their risk weights, instead of perceived credit risk risks, used the probabilities of banks investing conditioned on how credit risks were perceived.

Many Eurozone sovereigns would not face current high levels of indebtedness had not EU authorities decreed a Sovereign Debt Privilege and assigned it a 0% risk weight, this even though they take on debt denominated in a currency that de facto is not their domestic printable one.

And so, at the end of the day, this regulation only guarantees especially large bank crisis, caused by especially large exposures to what was perceived (or decreed) as especially safe, which end up being especially risky, and are held against especially little capital.

Risk weighted capital requirements and inequality.

John Kenneth Galbraith wrote: “The function of credit in a simple society is, in fact, remarkably egalitarian. It allows the man with energy and no money to participate in the economy more or less on a par with the man who has capital of his own. And the more casual the conditions under which credit is granted and hence the more impecunious those accommodated, the more egalitarian credit is… the poor risk… is another name for the poor man.” “Money: Whence it came where it went” 1975.

So I ask, how many millions of SMEs and entrepreneurs have not been given the opportunity to advance with credits over the last 25 years as a direct result of it?

IMF, please, wake up!

Should banks not be regulated? 

Of course these need to be regulated! I am only reminding everyone of the fact that the damage dumb bank regulators can cause when meddling without taking enough care, by far surpasses anything the free market can do. A free market would never have knowingly allowed banks to leverage 62.5 times their equity like regulators did, only because some very few human fallible credit rating agencies had assigned an AAA to AA rating to some securities backed with mortgages to the US subprime sector. 

A simple leverage ratio between 10 to 15% for all banks assets would be a much mote effective regulation than all those thousands of pages that currently exist.

And please, please, please, stop talking about "deregulation" in the presence of such an awful and intrusive mis-regulation. The regulators imposed the worst kind of capital controls.

Of course, just in case, all problems here referred to, are clearly applicable to developed economies too.

PS. “The inherent problems with the risk weighted bank capital-based approach is that the assets assigned the lowest risk, for which capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages”, “Keeping At It” 2018, Paul Volcker

PS. My recent letter to the Financial Stability Board

PS. An ever growing aide memoire on Basel Committee’s many mistakes.

PS. Because it would also create distortions I am not proposing it, but would not risk weighted bank capital requirements based on SDGs ratings at least show more purpose for our banks? And, in the case of sovereigns, besides credit ratings, do we citizens not also need ethic ratings?

PS.Are Basel bank regulations good for development?” a document presented at the High-level Dialogue on Financing for Developing at the United Nations, New York, October 2007.
Sincerely,

Per Kurowski

@PerKurowski