Thursday, July 13, 2017

With Basel II, how many times could banks multiply net risk adjusted margins, so as to obtain their returns on equity?

The expected pretax return on equity for banks is the amount of net risk adjusted margins they earn over the capital they need to hold.

For instance if banks had to hold the 8% basic capital requirement defined in Basel II, they could leverage (multiply) those net risk adjusted margins 12.5 times. And so if a bank wanted to earn a 20% pre tax ROE, it would need to collect an average net risk adjusted margin of 1.6% (20%/12.5) on assets equivalent to 12.5 times its capital.

Clearly, the more banks can leverage (multiply) those net risk adjusted margins, the higher the expected return on its equity, or the lower do those margins need to be.

For instance if banks had to hold only 1.6% in capital they would be able to leverage (multiply) those net risk adjusted margins 62.5 times. And so if banks wanted to earn the same 20% pre tax ROE as before, they would need to collect an average net risk adjusted margin of only 0.32% (20%/12.5) on assets equivalent to 62.5 times its capital. If the bank was abled to collect the same 1.6% average net risk adjusted margins, then its expected ROE would be a whopping 100%. 

The problem (for us) though, of Basel II, is that it, based on credit ratings, risk adjusted the capital requirements. And so, according to Basel II’s standardized risk weights, the banks were allowed to multiply their net risk adjusted margins the following way: 

AAA to AA = Unlimited
A+ to A = 62.5 times
BBB+ to BBB- 25 times
BB+ to B- = 12.5 times
Below B- = 8.3 times
Unrated = 12.5 times

AAA to AA = 62.5 times
A+ to A = 25 times
BBB+ to BB- = 12.5 times
Below BB- = 8.3 times
Unrated = 12.5 times

Residential mortgages = 35.7 times

Anyone who does not immediately understand how this distorts the allocation of bank credit; in favour of those who can have their net margin offers multiplied more by banks; and against those who have these multiplied less, does not understand finance, or has a vested interest in not wanting to understand it.

Can there be any question that these regulations pushed banks overboard with exposures to AAA rated securities and loans to sovereigns, like to Greece?

But, someone might say, this is all in order to make banks safer. Bullshit! There has never ever been a major bank crisis resulting from excessive exposures to something perceived as risky when placed on banks’ balance sheets.

Of course with Basel III, which has a leverage ratio that is not risk depended, the differences in the times net risk adjusted margins can be multiplied are smaller, but that does not mean for one second that the Basel discrimination keeps on being kicking and alive.

God help our young… God help our Western civilization. These idiotic risk-adverse regulators are hindering banks from financing our young ones’ riskier future, and have banks only refinancing their parents’ (and their regulators’) safer present and past. 

Risk-taking is the oxygen of development. God make us daring!

Bank regulators, the Basel Committee, FSB, and other, insist on putting systemic risk on ever-larger doses of steroids

What was the biggest systemic risk we used to refer ages ago? That which Mark Twain described with “The bankers are those who want to lend you an umbrella when the sun shines and take it away as soon as it looks like it is going to rain”. In other words that bankers could be too risk adverse, and therefore not be allocating credit efficiently to the real economy. 

But what did regulators do with their risk weighted capital requirements for banks? They told banks to lend out even more the umbrella when the sun shines. 

I have written on bank regulations for a long time, not as a regulator, but as a consultant that has walked up and down on Main Street helping corporations of all types to access that bank credit that seems so impossible or so expensive when one is perceived as risky. 

And as an Executive Director of the World Bank 2002-2004 I also raised my voice on many related issues. You can read some of my public opinions here

Today I was made aware of a paper from the International Institute for Applied Systems Analysis, IIASA, authored by Sebastian Poledna, Olaf Bochmann, Stefan Thurner and that is said to suggest: “smart transaction taxes based on the level of systemic risk” 

Holy Moly, when will they ever learn? All intrusions that tilt regulations in favor of something or someone become, immediately, a new source of systemic risk? 

And the more and the better you are in guarding against some identified systemic risk, the higher you are climbing up the very dangerous mountain. 

In April 2003, when commenting on the World Bank's Strategic Framework 04-06 I held: "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." 

Everywhere I look I see more and more sources of systemic risks in our banking system. Like which? 

Continuing to rely on too few human fallible and capturable credit rating agencies. 
Continuing to use risk weighted capital requirements that distort for no good reason at all. 
Liquidity requirements that can only increase the distortions. 
Forcing the use of standardized risk weights, which imposes a single set of criteria on too many. 
Regulators now wanting to assure that banks all apply similar approved risk models. 
The stress tests of the stresses that are a la mode. 
Living wills. 
And of course that pure ideological interference that have statist regulators assigning a 0% risk weight to sovereign and a 100% to citizens. 

All in all, in terms of creating dangerous systemic risks, hubris filled bank regulators are the undisputable champions. 

The main cause for all this is that our bank regulators seem to find it more glamorous to concern themselves with trying to be better bankers, than with being better regulators. 

Regulators, let the banks be banks, perceive the risks and manage the risks. The faster a bank fails if its bankers cannot be good bankers, the better for all. Your responsibility is solely related to what to do when banks fail to be good banks. Please?

And regulators always remember these two rules of thumb: 

1. The safer something is perceived to be, the more dangerous to the system it gets; and the riskier it is perceived, the less dangerous for the system it becomes. 

2. All good risk management must begin by clearly identifying what risk can we not afford not to take. In banking the risk banks take when allocating credit to the real economy is precisely that kind of risks we cannot afford them not to take. 

So when can we get bank regulators humble enough to understand their role is to regulate banks against risks they themselves cannot understand? Please?

Monday, July 10, 2017

Could a hostile power create bank regulations capable of destroying our Western financial system? It would seem so :-(

David Bookstaber in his “The End of Theory”, 2017 refers to the following question:

“If you were a hostile foreign power, how could you disrupt or destroy the U.S. financial system? That is how do you create a crisis?

Well one way to do it begins, as does any strategic offensive, with the right timing. Wait until the system exposes a vulnerability. Maybe that is when it’s filled with leverage, and when assets become shaky.”

Then Bookstaber suggests: “create a fire sale by pressing down prices to trigger forced selling…freeze funding by destroying confidence… maybe pull out your money from some institutions with some drama… and to make money, short the market before you start pushing things off the cliff”

That is Bookstaber’s interesting tale on what “turned the vulnerabilities of 2006 and 2007 into the crisis of 2008, and nearly destroyed our system.” “And we didn’t need an enemy power; we did it all by ourselves.

But what if it all had started with a hostile foreign power taking over bank regulations in order to create the vulnerabilities?

I mean like telling banks they could hold 1.6% in capital or less, meaning a 62.5 to 1 or more leverage, against assets with an AAA rating (like some fatal MBS) or against sovereigns, like Greece. That would give banks the chance to earn fabulous expected risk adjusted margins on those assets, and therefore build up huge exposures to these against very little capital (equity).

I ask, because that was exactly what the Basel Committee for Banking Supervision did with its Basel II of 2004.

And to top it up their AAA-bomb was so powerful that, because it discriminates against the access to bank credit of “the risky”, like SMEs and entrepreneurs, the economy would find it almost impossible to recover on its own; and the crisis-can had to be kicked further and further down the road, with Tarps, QEs, fiscal deficits and silly low interest rates? 

Sunday, July 9, 2017

What if traffic regulators, to make your town safe, limited motorcycles to 8 mph but allowed cars to speed at 62 mph?

The fatality rate per 100 million vehicle miles traveled in cars is 1.14
The fatality rate per 100 million vehicle miles traveled in motorcycles is 21.45

That could indicate that in terms of risks measured and expressed as credit ratings, the cars should be rated AAA, and motorcycles below BB-.

But in 2011, in the US, 4,612 persons died in motorcycle accidents.
And in 2011, in the US, 32,479 persons died in vehicle accidents.

That explains the differences between ex-ante perceived risk and the ex-post dangers conditioned by the ex-ante perceptions. Cars are more dangerous to the society than motorcycles, in much because the latter are perceived as much riskier.

But what did bank regulators do in Basel II, 2004?

By weighting for ex-ante perceived risks their basic capital requirement of 8%, they allowed banks to leverage 62.5 times to 1 when AAA-ratings were present, and 8.3 times in the case of below BB- ratings.

So, what if traffic regulators, in order to make your hometown safe, limited motorcycles to 8 mph but allowed cars to speed at 62 mph?

Do you see why I argue that current bank regulators in the Basel Committee and in the Financial Stability Board have no idea about what they are doing?

But it is even worse. We need SMEs and entrepreneurs to access bank credit in order to generate future opportunities for our kids. Unfortunately, since when starting out these usually have to drive more risky motorcycles than safe cars, our future real economy gets also slapped in the face. 

An 8% capital requirement translates into a 12.5 to 1 leverage. Why can’t our regulators allow banks to speed through our economy at 12.5mph, independently of whether they go by cars or motorcycles?

Friday, July 7, 2017

How the Western civilization is being lost because of regulatory induced risk aversion.

Mark Twain has been attributed opining that bankers lend you the umbrella when the sun shines and want it back as soon as it looks it could rain.

And never ever has there been a bank crisis caused by excessive exposures to something perceived as risky when placed on banks’ balance sheets.

But that did not stop scared lack of testosterone bank nannies to also require banks to hold more equity when lending to the risky than when lending to the “safe”.

So what happened? 

As banks earned much higher risk adjusted returns on the safe they could not resist the AAA rated securities backed with mortgages to the subprime sector, or sovereigns like Greece. And so a typical bank crisis, that of excessive exposures to what was ex-ante perceived as safe but that ex post turned out very risky ensued. 

In this case the crisis was made specifically worse, by means of the lower equity banks had been authorized to maintain. For example in the case of the AAA rated securities, Basel II, because of the standardized risk weights, banks were required to only hold 1.6% in capital, meaning an authorized leverage of 62.5 to 1. 

But much worse, since banks of course find it harder to earn higher risk adjusted ROEs on more capital, they have abandoned lending to risky SMEs and entrepreneurs, those who open up new roads on the margins of our economy, and so of course slower economic growth results.

Lack of testosterone, risk aversion, is not a fundamental value of the Western civilization. On the contrary in churches we sometimes sang, or at least used to sing, “God make us daring!


Tuesday, July 4, 2017

Can you have a neutral interest rate when bank regulations are not neutral?

That theoretical interest rate that neither pushes nor restrains the economy from its natural rhythm of growth, is called the neutral interest rate, and is of course the subject of much interest by central bankers.

But what these bankers never discuss, who knows why, is what happens to this neutral interest rate, if bank regulations are not neutral.

Current risk weighted capital requirements for banks which allow banks to earn higher risk adjusted returns on equity with what is perceived, decreed or concocted as safe, than with what is perceived as risky, are clearly not neutral.

They push bank credit to the “safe” areas and away from the “risky” and that distortion must have a real cost for the economy.

Just for a starter, since the risk-weight assigned to the sovereign is 0%, all those “risky” SMEs and entrepreneurs who will not get credit or need to pay more for it, only because of these regulations that are biased against them, are paying a regulatory tax that is directly subsidizing lower interest rates for the government.

As I have argued many times before… we do not have real risk-free rates, we have subsidized risk-free interest rates.

Monday, July 3, 2017

FSB reports: “G20 reforms are building a safer, simpler, fairer financial system”. What a triple lie!

FSB reports to G20 Leaders on progress in financial regulatory reforms, and it starts with: G20 reforms are building a safer, simpler, fairer financial system

“Safer”? Major bank crises do not result from excessive exposures against what is perceived risky, but always from unexpected events or excessive exposures to what was ex ante perceived, decreed or concocted as safe, but that, ex post, turned out to be very risky.

In the FSB video they say “A safe banking system needs enough capital to absorb unexpected losses” and so my question is: So why require capital based on expected risks?

“Simpler”? Don’t be ridicule! Just have a look at the Basel Committee’s absurdly obscure Minimum capital requirements for market risk” of January 2016, and on its consultative document for a "simplification" of July 2017.

The FSB video does not really even dare to explain the "simpler" factor.

“Fairer”? Forget it! The discrimination in the access to bank credit in favor of those perceived, decreed or concocted as safe, like the Sovereigns and the AAA-risktocracy is still alive and kicking; just like that one against “the risky”, the SMEs and entrepreneurs. It is an inequality driver.

No wonder the FSB video has the comments disabled.

G20 you want to understand what is wrong with current bank regulations? Start here!

Saturday, July 1, 2017

ECB Working Paper 2079, as is standard, also suffers from confusing ex ante perceived risks with ex post realities.

Jonathan Acosta Smith, Michael Grill, Jan Hannes Lang have produced a paper titled “The leverage ratio, risk-taking and bank stability”, ECB Working Paper 2079, June 2017, which analyzes the non-risk based leverage ratio (LR) that has been introduced in Basel III to work alongside the risk-based capital framework.

I quote: “The main concern relates to the risk-insensitivity of the LR: assets with the same nominal value but of different riskiness are treated equally and face the same capital that an LR has a skewed impact, binding only for those banks with a large share of low risk-weighted assets on their balance sheets, this move away from a solely risk-based capital requirement may induce these banks to increase their risk-taking; potentially offsetting any benefits from requiring them to hold more capital.” 

Unfortunately this paper suffers from the usual and tragic mistake of confusing ex ante perceived risks with ex post realities.

Basel Committee bank regulators acted like bankers and not like regulators, when they got fixated on the risk of the assets of the banks, and not on the risk those assets posed for the banking system. Had they done some empirical research on what caused previous bank crises, they would have seen that what was ex ante perceived as risky never played a mayor role.

As is Basel II’s risk weighted capital requirements allow banks to earn higher risk adjusted returns on equity with assets ex ante perceived (decreed or concocted) as safe, than with assets perceived as risky. That results in banks building up dangerous exposures, against little capital, to assets that though ex ante perceived were perceived as very safe, could ex post turn out very risky. E.g. the AAA rated securities backed with mortgages to the subprime sector.

The clearest way I have found to illustrate the regulator’s fundamental error is by referencing Basel II’s standardized risk weights:

It allocates a meager 20% risk weight to corporates "dangerously" rated AAA to AA, while assigning a 150% risk weight to the "innocuous" below BB- rated, that which banks would never touch with a ten feet pole.

And, with their risk weighting the regulators, with serious consequences, are also distorting the allocation of bank credit to the real economy. Since the introduction of Basel II, millions of “risky” SMEs and entrepreneurs have not been able to access bank credit, or have had to pay extra compensatory interest charges, precisely because of this pillar.

Bank capital requirements should not be based on what is perceived but on the possibilities that the perceptions are wrong, that the perceptions are right but not adequately managed or that unexpected events could happen. 

In this respect I am all for one single capital requirement for all assets (including of course sovereign loans).

So does the introduction of the leverage ratio partly fulfill what I want? Unfortunately not! The more a leverage ratio translates into banks finding it difficult to meet regulatory bank capital requirements, the more will the risk-weighted requirements distort on the margin. I often refer this to the Drowning Pool simile.

Friday, June 30, 2017

Task Force on Climate Related Financial Disclosures is clueless about the allocation of resources to the economy.

The Task Force on Climate Related Financial Disclosures begins the summary of its “Final TCFD Recommendations Report” with: 

“One of the essential functions of financial markets is to price risk to support informed, efficient capital-allocation decisions. Accurate and timely disclosure of current and past operating and financial results is fundamental to this function, but it is increasingly important to understand the governance and risk management context in which financial results are achieved. The financial crisis of 2007-2008 was an important reminder of the repercussions that weak corporate governance and risk management practices can have on asset values. This has resulted in increased demand for transparency from organizations on their governance structures, strategies, and risk management practices. Without the right information, investors and others may incorrectly price or value assets, leading to a misallocation of capital.”

Efficient credit and capital allocation to the real economy is indeed the most essential function of financial markets, but let me here inform TCFD that bank regulators, like the Basel Committee and the Financial Stability Board gave zero importance to that. Had they done so, they would never ever have come up with the risk weighted capital requirements for banks, which make that impossible. 

“The financial crisis of 2007-2008 was an important reminder of the repercussions that weak corporate governance and risk management practices can have on asset values”

No! It was an important but ignored reminder of what dangers lie in allowing regulators to regulate within a mutual admiration club breeding intellectual incest. 

When you allow banks to leverage more their equity with what is ex ante perceived, decreed or concocted as safe, so that banks can earn higher risk adjusted returns on equity on what’s “safe”, then you will end up, sooner or later, with dangerous excessive bank exposures, against little capital, to what’s “safe”, like AAA rated securities backed with mortgages to the subprime sector and loans to sovereigns like Greece, but that ex post can turn out to be very risky.

Who the hell authorized regulators to direct (distort) the allocation of bank credit that way?

Listen up Mark Carney, Michael Bloomberg and you other! Any risk, even if perfectly perceived, if excessively considered, causes the wrong actions. Let banks be banks!

Let me end this comment by just asking: How many profiteering climate-change consultants will now banks have to employ in order to fulfill what is requested by this report?

Want some more detailed objections to the idiotic current bank regulations? Here!

Wednesday, June 21, 2017

A challenge: Can you spot the lunacy in the Basel Committee’s risk weighted capital requirements for banks?

These are the facts established by Basel II in 2004.

1. Very safe AAA to AA rated = 20% risk weight = 1.6% capital requirement = 62.5 times to 1 allowed leverage.

2. Very risky below BB- rated = 150% risk weight = 12% capital requirement = 8.3 times to 1 allowed leverage.

So what’s crazy with that?

Let me give you a clue! 

What can create those kinds of excessive bank exposures that could bring down a bank system?

Monday, June 19, 2017

Mr Watson IBM, besides helping wine growers, when are you going to tell bank regulators they’re so wrong?

Bank regulators, thinking they are so smart, assigned a meager 20% risk weight for what is rated AAA to AA, and a whopping 150% to what is rated below BB-.

That allows banks to hold much less capital against assets rated AAA to AA than against assets rated below BB-.

Now you tell me Watson, what is more dangerous to our banking system, that rated AAA to AA, that because is perceived as so safe could lead to the dangerous build-up of excessive bank exposures, or that which because it is rated below BB- bankers wont touch with a ten feet pole?

So, when are you going to offer to help the bank regulators? They sure need it! We sure need it!

Wednesday, June 14, 2017

Sadly the Basel Committee did not perform a Gedankenexperimente before regulating banks.

I just read about "Gedankenexperimente" in The Economist of June 10, 2017 "Quantum mechanics and relativity theory: Does one thing lead to another?

So, if the Basel Committee had done a Gedankenexperimente before regulating banks, then, if also applying Werner Heisenberg's uncertainty principle, they would have understood that the better current risks are perceived and the more you want banks to go for what is now safe, the riskier the future becomes.

First, because risk taking is the oxygen of development and a better future is built at least as much upon failures than upon successes. 

Second because what would be perceived as safe in the present would then get too much access to bank credit and thereby at one point in the future become very risky.

And so the regulators would have realized that with their risk weighted capital requirements for banks, they would be setting up the bank system for the worst kind of explosion imaginable, namely huge exposures to something very safe, turning very risky, against little capital, and with a real economy that has gone soft. 

PS. July 2011 I wrote twice to the Financial Times about Basel Committee’s regulations and Heisenberg’s uncertainty principle but, since I have been censored by FT, the editor was not interested. 

Tuesday, June 13, 2017

What causes the “motivated reasoning” that keeps Basel bank regulators from admitting their mother of all mistakes?

The Basel Committee for Banking Supervision developed, as a pillar of their regulations, the risk-weighted capital requirements for banks. 

They should never have done that because that completely ignored the fact that these would distort the allocation of credit to the real economy. 

But, when doing so, they also committed the mother of all regulatory mistakes, namely the following:

They set the risk weights based on the risk of the assets and not on the risks the assets represented for the bank system.

That for instance is why, in their standardized risk weights of Basel II, regulators assigned a meager 20% risk weight to what is AAA to AA rated, something which precisely because of such good rating, could lead to the build-up of dangerously large exposures; and a whopping 150% risk weight, to what is rated below BB-, and which is therefore of course rarely touched by bankers, not even with a ten-feet pole.

In other words regulators took the ex-ante risks to be the ex-post risks.

But it has been absolutely impossible to get anyone related to those regulations to admit such thing. And many of those who should have no reason to not divulge that mistake, like specialized journalists and finance professors, have also kept mum on it.

The Economist, June 10, 2017 writes on: “How to be wrong: To err is human. Society is suffering from an inability to acknowledge as much”. It refers there to a “framework for thinking about…[why] people frequently disregard information that conflicts with their view of the world”, elaborated by Roland Benabou and Jean Tirole.

The framework holds that: “Because beliefs… are treasured in their own right, new information that challenges them is unwelcome. People often engage in “motivated reasoning”. [This can be caused by]: “‘Strategic ignorance’… when a believer avoids information offering conflicting evidence.” or “In ‘reality denial’ troubling evidence is rationalized away”, or “in ‘self-signaling’, the believer creates his own tools to interpret the facts in the way he wants”

So Mr Roland Benabou and Mr Jean Tirole, I here ask you. Was, is, any of the three causes for “motivated ignorance” you mention, absent in this case of the Basel Committee’s so mistaken risk-weighted capital requirements for banks?

And also when illustrious Martin Wolf publicly acknowledges, without doubting the correctness of it, that “As Per Kurowski, a former executive director of the World Bank, reminds me regularly, crises occur when what was thought to be low risk turns out to be very high risk", Why is Wolf still not capable to understand how 180 degrees-off the risk weighted capital requirements are?

And about that society is suffering from this mistake there can be no doubt.

If you want even a more detailed explanation on The Mistake go here.

And if Econ Journal Watch wants to attract some confessions then help me ask these questions 

Thursday, June 8, 2017

A safer banking system compared to our current dangerously misregulated one with so many systemic risks on steroids

What is a safer banking system?

One in which thousand banks compete and those not able to do so fail as fast as possible, before some major damage has been done, while even, as John Kenneth Galbraith explained, often leaving something good in their wake. 

What is a dangerous banking system?

One were all banks are explicitly or implicitly supported, by taxpayers, as long as they follow one standard mode that includes living wills, stress tests, risk models, credit ratings, standardized risk weights... all potential sources of dangerous systemic risks.

A bank system in which whenever there is a major problem, the can gets kicked down the road with QEs and there is no cleaning up, and banks just get bigger and bigger.

One that make it more plausible that the banks will all come crashing down on us, at the same time, with excessive exposures to something ex ante perceived safe that ex-post turned out risky, and therefore the banks holding especially little capital.

But you don’t worry; the regulators have it all under control with their Dodd-Frank’s Orderly Liquidation Authority (OLA). “Orderly”? Really?

So that is why when I hear about banks “cheating” with their risk models I am not too upset, since that at least introduces some diversity. 

Also that cheating stops, at least for a while, the Basel Committee regulators from imposing their loony standardized risk weights of 20% for what has an AAA rating, and so therefore could be utterly dangerous to the system; and one of 150% for the innocuous below BB- rated that bankers don’t like to touch with a ten feet pole.

How did we end up here? That is where you are bound to end up if you allow some statist technocrats, full of hubris, to gather in a mutual admiration club, and there engage into some intellectually degenerating incestuous groupthink.

Statist? What would you otherwise call those who assign a 0% risk weight to the Sovereign and one of 100% to the citizen?

And it is all so purposeless and useless!

Purposeless? “A ship in harbor is safe, but that is not what ships are for”, John A Shedd

Useless? “May God defend me from my friends, I can defend myself from my enemies”, Voltaire

In essence it means that while waiting for all banks to succumb because of lack of oxygen in the last overpopulated safe-haven available, banks will no longer finance the "riskier" future our grandchildren need is financed, but only refinance the "safer" present and past.

In April 2003, as an Executive Director of the World Bank I argued: "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."

PS. FDIC... please don't go there!

Note: For your info, before 1988, we had about 600 years of banking without risk weighted capital requirements for banks distorting the allocation of bank credit to the real economy.

PS. The best of the Financial Choice Act is a not distorting, not systemic risks creating, 10% capital requirement for all assets. Its worst? That this is not applied to all banks.

PS. If I were a regulator: Bank capital requirements = 3% for bankers' ineptitude + 7% for unexpected events = 10% on all assets = Financial Choice Act