Monday, October 27, 2014

The Basel Committee's Bank Stability Decree (scary eh?)

WE THE BANK REGULATORS we believe that even though those who are perceived as risky, like the medium and small businesses, the entrepreneurs and start-ups, already have to pay higher risk premiums and get smaller loans than those perceived as absolutely safe, that does not suffice in order to keep our banks safe. 

And so we, the Basel Committee for Banking Supervision, with the full support of the Financial Stability Board, in order to guarantee the stability of all our banks, and so that these do not pose a threat to our economies, decree the following: 

To make absolutely sure banks do not lend to the risky, we allow banks to hold much much less capital (meaning equity) against exposures to the infallible, like good sovereigns, housing finance and members of the AAAristocracy.

Brief explanation: That should permit banks to obtain much much higher risk adjusted returns on their equity when lending to the infallible than when lending to the risky and, being bankers greedy, that should take care of it! And so sorry if that kills equal opportunities and drives inequality, but, as they say, you can't have the cake and eat it too.

Note: To those wondering about how this regulation might distort the allocation of bank credit to the real economy, perhaps so much that in the medium and long term it could even cause great dangers for the stability of banks, we remind them that is of no concern to us bank regulators… and besides… après nous le deluge!

(My own ps. to bank regulators: Never forget that risk-taking, and blissful-ignorance, are two prime drivers of economic growth and development and that, without these, our world will stall and fall.)

Sunday, October 26, 2014

I am sure that for Europe’s young unemployed, all 123 European banks failed EBA’s and ECB’s stress tests… dramatically.

So now the European Banking Authority (EBA) has announce the stress test of 123 European banks… and we are informed that 12 failed. Bullshit! They all have failed. 

For instance, ECB's Vitor Constancio says “the vast majority of banks proved resilient”… and I just have to ask him… What’s good about a resilient bank that completely fails to intermediate credit correctly? ... or, as John Augustus Shedd (1850-1926) so well phrased it: “A ship in harbor is safe, but that is not what ships are for.”

It is not what’s on the balance sheets of the banks of Europe that should most concern us… it is what has been condemned by bank regulators from being on the balance sheets of banks in Europe that should really make us tremble… namely all the loans to medium and small businesses, entrepreneurs and start-ups. 

And that so extremely risky prohibition to take risks, that which has effectively castrated European banks, was imposed by the regulators, by means of their so tragically unwise credit risk weighted capital (meaning equity) requirements for banks.

And, to top it up, that will not make our banks safer in the long term... since there have never ever been major bank crises which have detonated because of excessive exposures to what, ex ante, was perceived as risky, as these have always resulted from excessive bank exposures (against too little bank equity) to what was, ex ante, perceived as absolutely safe.

NOTE: I am a happy husband, father and grandfather, with no scandalous past. 

I have a long and quite successful carrier as a financial and strategic private and public sector consultant and, in 2002-2004, I was an Executive Director at the World Bank. 

I have studied in Sigtuna SHL Sweden, Lund University, IESA Caracas, London Business School and London School of Economics. 

Since 1997 I have published over 800 Op-Eds in some of the most important newspapers in Venezuela. 

I have had many letters and articles on banking regulations published around the world. And few can claim having warned in such precise terms about the impending banking disasters as I did between 1997 and 2007. 

And I stake all my professional reputation, and the loving trust my family has shown me over the years, on the fact that current bank regulators of the Basel Committee, and of the Financial Stability Board, have been wrong. Not a pardonable 15 degrees wrong, but an unpardonable 180 degrees totally wrong.

What "market triumphalism" are you referring to Professor Michael Sandel?

Michael Sandel, in “The Art of Theory Interview” refers to: 

“a tendency, over the past three decades, of economics to crowd out politics. This has been an age of market triumphalism. We’ve come to the assumption that markets are the primary instruments for achieving the public good.”

And that is a much distorted, and quite often a very interested version of what is actually happening.

Over the last few decade banks, instead of allocating their credit based on adjusting to the perceptions of credit risk, by means of the interest rates (risk premiums), and the size of their exposures, have also had to adjust those credits to capital requirements (meaning equity requirements), and that are also based on the same ex ante perceived credit risks.

“More risk more equity – less risk much less equity” has translated into banks earning much higher risk adjusted returns on equity when lending to “the infallible” than when lending to “the risky”. 

For instance, a bank, according to Basel II, when lending to an infallible sovereign, can hold zero equity but, when lending to a citizen, it has to have 8 percent of equity.

That means banks can leverage their equity 12.5 times to 1 lending to citizens while not even the sky is the limit when lending to their sovereign. 

Professor Sandel, what on earth has that do with "market triumphalism"? It has all to do with an obnoxious non-transparent triumph of government powers.

And the credit risk aversion introduced by bank regulators, effectively blocks "the risky" from having fair access to bank credit, and thereby impedes equal opportunities and promotes inequality.

Is this all a conspiracy of some mighty self declared "infallible", against us their declared "risky" citizens?

It looks like we honest citizens again need to take refuge in a Sherwood Forest, in this case among the trees making a living in the world of shadow-banking. Hell, they are now even trying to convert our Robin Hood into a Sherif of Nottingham tax-collector for King George.

Saturday, October 18, 2014

Janet Yellen, are you really so unaware you are also one of the equal opportunities killers?

“Owning a business is risky, and most new businesses close within a few years. But research shows that business ownership is associated with higher levels of economic mobility. However, it appears that it has become harder to start and build businesses. The pace of new business creation has gradually declined over the past couple of decades, and the number of new firms declined sharply from 2006 through 2009… One reason to be concerned about the apparent decline in new business formation is that it may serve to depress the pace of productivity, real wage growth, and employment. Another reason is that a slowdown in business formation may threaten what I believe likely has been a significant source of economic opportunity for many families below the very top in income and wealth.” 

Unbelievable! Janet Yellen, even though she is extremely connected to bank regulations, seems not to have the faintest idea of how these effectively block the creation of new businesses, by unfairly discriminating the access to bank credit of those who are perceived as risky… like new businesses. 

Janet Yellen (and others at the Fed), let me explain it for you: 

The pillar of current bank regulations is credit risk weighted capital (equity) requirements for banks… more-perceived-credit-risk more equity – less-perceived-credit-risk less equity. 

And that translates into banks being allowed to earn much much higher risk adjusted returns on equity when lending to the “absolutely safe” than when lending to the risky” 

And that translates directly into that those who are perceived as “risky”, like new businesses, and who, precisely because they are perceived as “risky”, already have to pay higher interests and have lesser access to bank credit, will then have to pay up twice for that perception…and so will then need to pay even higher interests and then get even less access to bank credit. 

And that is odious discrimination, a great driver of inequality… and a killer of the equal opportunities the poor so much need in order to progress. 

And of course, let us not even think of what the Fed’s QE’s have done in terms of un-leveling the playing fields. The fact is that had it not been for how the financial crisis management favored foremost those who had most, Thomas Piketty’s "Capital in the Twenty-First Century”, would have remained a manuscript. 

And Janet Yellen thinks: “it is appropriate to ask whether this trend [of widening inequality] is compatible with values rooted in our nation's history, among them the high value Americans have traditionally placed on equality of opportunity.” 

Frankly to hear someone who favors regulatory risk-aversion, daring to speak about American values, in the “home of the brave”, in the land built up on the risk-taking of their daring immigrants… is sad.

PS. To me it is amazing how bank regulators in America can so blitehly ignore the Equal Credit Opportunity Act (Regulation B)

Thursday, October 16, 2014

How could our bank regulators have fallen for our bankers’ so childish and selfish arguments?

We all know Mark Twain’s saying about bankers wanting to lend you the umbrella when the sun shines and wanting it back as soon as it looks like it is going to rain. Of course bankers are risk-adverse… aren’t most of us?

But suddenly bankers discovered that bank regulators were even more risk-adverse than they were (most probably because that is a pre-requisite to become a regulator) and decided to exploit that.

And so they went to the Basel Committee, the Financial Stability Board, the Fed, and for good measure to the IMF, and argued the following:

"You know taking risks tempts us very much, because doing so we can earn those higher returns on equity that make our shareholders happy and keep us in our jobs. But that can, unfortunately, turn out very bad for us… and, consequentially, very bad for you, since then many could rightly argue you are not performing your duties as regulators.

And so here is what we propose: If you allow us to hold much lower equity for what is ex ante perceived as absolutely safe, from a credit point of view, than what we must hold against what is perceived as risky, then we will be able to earn much higher risk-adjusted return on equity on what is absolutely safe… and so we do not need to go to where it seems risky... and so we, and you ,will all be able to live our happy risk-free ever after."

In essence that was like some children convincing their parents that they should be rewarded with ice cream if they ate up the chocolate cake, and punished with having to eat spinach if they dared to eat up their broccoli.

And since bank regulators fell for it, now banks have dangerously overpopulated “safe havens” like the infallible sovereigns (Greece), the AAAristocracy (securities collateralized with mortgages to the subprime sector) or real estate (Spain)… and have equally or even more dangerously, left “risky” bays unexplored, by withholding credit to medium and small businesses, entrepreneurs and start-ups.

Just like if the children had been able to convince their parents, they would now be obese after gorging on fats and carb, and not having any of those fibers, proteins and vitamins they like much less.

And the Western World, built among others upon a lot of risk-taking by banks, is now stalling and falling… and no one seems too concern about this regulatory risk-aversion.

And, because of the less importance of equity, and therefore of shareholders, the bankers also, by means of the bonuses they award themselves, been able to stay with a much larger share of the profits.

So, now you tell me, who has been the dumb and dumber of all this? The bank regulators… or we who trusted them blindly?

Tuesday, October 14, 2014

Why Europe should be scared having the ECB, under Mario Draghi, being the supervisor of its 120 most significant banks.


Because Mario Draghi, as the former chairman of the Financial Stability Board either likes it, or has not understood that: 

If you allow banks to have much lower capital (equity) when holding, from a credit risk point of view only, "absolutely safe" assets than when holding "risky" assets; then you allow banks to earn much higher risk adjusted returns on equity on assets perceived as “absolutely safe” than on assets perceived as “risky”… and then banks will lend too much at too low interests to those perceived as “absolutely safe”, and too little at too high interests to those perceived as “risky”, namely the medium and small businesses, the entrepreneurs and start-ups…namely, as they say, those tough risky risk-takers Europe most needs to get going when the going gets tough.

And, for more clarity, because Mario Draghi is not capable to understand that secular stagnation, deflation, mediocre economy and all similar obnoxious creatures, are direct descendants of silly risk aversion.

And, for more clarity, because Mario Draghi does not understand that Europe was built up with risk-taking and that, without it, it will fall and stall.

Just look now at the ECB doing all its expensive “Comprehensive Assessment of all significant banks in the euro area by the ECB”, and worrying exclusively about not finding anything risky on bank’s balance sheets, and not one iota about all those loans that should be there, had it not been for this sissy and odious discrimination against what is ex ante perceived as risky. 

As you see Europe, Mario Draghi is really dangerous for your future. And especially so if you are young and about to run the risk of belonging to a lost generation.

Now if you are a European just concerned with making it a couples of months, or perhaps some few years more down the line, because you subscribe to the philosophy of “après nous le deluge”, then keep Mario Draghi, because then he really is your man.

PS. Europe, keep an eye open on Stefan Ingves, the chair of the Basel Committee, and on Mark Carney, the current chair of the Financial Stability Board... they are just as dangerous.

Monday, October 13, 2014

Bank regulators regulate based on the safety needs of the very old, and not on the risk-taking needs of the young.

On October 13 2014, in the International New York Times, Mary Williams Walsh, in “No smoke no mirrors” analyses comprehensibly the pension plan in the Netherlands.

And therein she writes that, after seeing what the financial crisis had done to the pension accounts: “Dutch young people found their voice. No matter their employment sector, they could see that their pension money was commingled with retirees’ money…[and] they realized that they and the retirees had fundamentally opposing interests. The young people were eager to keep taking investment risk, to take advantage of their long time horizon. But the retirees now wanted absolute safety, which meant investing in risk-free, cashlike assets. If all the money remained pooled, young people said, the aggressive investment returns they wanted would be diluted by the pittance that cashlike assets pay.”

Mary Williams Walsh describes precisely what should be the objection of all young people around the world to current bank regulations, but that the young, unfortunately, have not yet discovered.

The pillar of current bank regulations, is credit risk-weighted capital (equity) requirements for banks… in short more perceived credit risk more equity, less perceived risk less equity. 

And that causes banks to be able to earn much higher risk adjusted returns on assets perceived as “absolutely safe” than on assets perceived as “risky”… which leads banks to not financing the riskier future, but only to refinancing the safer past.

And given that risk-taking, not risk aversion, is what took the western world economies to become what they are, without it, they are bound to stall and fall.

And if that is not dumb short-termish regulations, which might perhaps benefit some of those baby-boomers sooner to pass away, but certainly hurt the young who risk becoming a lost generation, I do not know what is.

It would be great if the young Dutch kids also opened their eyes on this issue, and started a revolt against the banks being all castrated.

“A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926

Secular stagnation, deflation, mediocre economy and all similar obnoxious creatures, are direct descendants of silly risk aversion.

Banks need to be regulated more in the interests of the advancees than in the interest of the retirees.

Mario Draghi, Stefan Ingves, Mark Carney, Jaime Caruana and other bank regulators, you should be ashamed

Thanks to theirs and other regulators’ credit risk weighted capital requirement for banks, the risks your banks now take, are that of dangerously excessive exposures to what’s deemed as “absolutely safe”; not the true risk-taking the economy needs; and, as a consequence, Europe, which was constructed upon true risk-taking, is now stalling and falling… and its youth condemned to be a lost generation.

You young Europeans, if you want to have a chance of a better world, or a least of a not too much worse world, then go tell your regulators to immediately stop basing their capital requirements for banks on some purposeless credit risk ratings, those which are already considered by banks; and to use instead creation-of-jobs-to-young-people ratings, sustainability of planet earth ratings, and, when lending to sovereigns, ethics and good governance ratings.

Tell them that they should know that secular stagnation, deflation, mediocre economy and all similar obnoxious creatures, are direct descendants of excessive risk aversion

Before blaming any regulatory capture on bankers, look first to the parents of central bankers and regulators.

That is because the regulatory capture could very well begin with some overly sissy parents, whose risk-adverseness causes the risk aversion in their kids which makes them natural candidates to be central bankers and regulators.

And then their grown-up equally scared kids, prohibit banks from engaging in natural market risk-taking, like lending to entrepreneurs and start-ups. 

And that risk-adverseness takes the strength out of the real economy, and, at the end, only causes banks to take truly dangerously excessive risks on what regulators, with amazing hubris, consider themselves to be capable to deem as “absolutely safe”… like the infallible sovereigns (Greece), the AAAristocracy (securities collateralized with mortgages to the subprime sector) or real estate (Spain).

Sunday, October 12, 2014

“Too defined and too encompassing to go wrong regulations” is riskier than “Too big to fail banks”

Mark Carney the Chairman of the Financial Stability Board, in his Statement delivered to the International Monetary and Financial Committee Washington, DC, 11 October 2014, makes no reference whatsoever to the distortions credit risk-weighted capital requirements have in the allocation of bank credit to the real economy. 

And so Carney at least, evidences he has not learned anything from this crisis, or that he absolutely agrees with the idea of banks dangerously overpopulating safe havens and withholding completely from exploring any riskier though perhaps of us more productive bays. 

As you can read, still not one single word about the purpose of our banks… banks just standing there, without any other purpose, seems perfectly all-right to him. 

“A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926

Mark Carney also refers to the fact that one of the goals of the Basel Committee is to set out its plan to address excessive variability in risk-weighted asset calculations. He seems still not able to understand that, the lack of variability in risk-weighted asset calculations, by leveraging the consequences of errors made in their calculations, is also a possible horrendous source of systemic risk.

Really how can someone worrying about too big to fail banks, simultaneously preach a one set of can’t go wrong regulations? What’s the difference between too big to fail banks and too defined to go wrong regulations?

In short Mark Carney, and the rest of regulators out there, have not been able to understand that even if their risk-weights are based on perfect risk perceptions, applying these to bank capital requirements is wrong, because these “perfect” risk perceptions should already be cleared for banks in the interest rates, in the size of the exposures and in the other terms that apply.

Mark Carney…and you other regulators out there… stop being so stubborn… you should not concern yourselves with the risk of bank assets, which is the concern of bankers. You instead must concern yourselves with the fact that the banks could perhaps not manage those risks… something that, as they say here in Paris, is pas la meme chose. 

You regulators you do not solve anything for us managing the risks of banks because you yourself then become our largest systemic risk with banks… and, I am sorry, but, I at least, see absolutely no reason to trust some central bankers to know what risks should or should not be taken out there in the real world, for my grandchildren to have a great future. And much less so when you all, with your Basel II, have already proven yourself to be huge failures.

Sincerely I find your hubris of believing yourself capable of being the risk managers of the world quite disgusting. 

Look around you… I would hold that capital requirements based on potential of job creation ratings, sustainability of planet earth ratings, and good governance and ethics ratings of governments, though distorting, would do so in a better directions than your credit ratings, which in fact promotes inequality and exclusion.

Saturday, October 11, 2014

World Bank and IMF, is the stability of banks really a good growth (or stability) strategy?

The most important “New Growth Strategy” that has been put in effect by global authorities during the last decades, is the one based on the notion that as long as our banks are stable, the economy will grow and everything will be fine and dandy.

And, in order to foster that stability of the banks, the Basel Committee for Banking Supervision designed a system of ex ante perceived credit-risks weighted capital (equity) requirements, which translates into: more-risk-more-equity, less-risk-less-equity. 

And that allows banks to be able to earn much much higher risk-adjusted returns on equity when lending to “the infallible” than when lending to “the risky”.

And, of course, the result was just as could have been expected… huge exposures to the infallibles, like to AAA rated securities (subprime mortgages USA), sovereigns (like Greece) and real estate (Spain)… and no exposures at all to the risky, like to medium and small businesses, entrepreneurs and start ups.

So how has that strategy worked? I would dare say “quite lousily”… but I might be wrong… because I see most of you feel like it is ok for those responsible for Basel I and Basel II, to now have a go at Basel III, that is if they are not to take up even higher responsibilities, like that of chairing the ECB.

I have always thought that risk taking was the oxygen of development, and that secular stagnation, deflation, mediocre economy, unemployment, underemployment, managed depression and all similar obnoxious creatures, were all direct descendants of risk aversion. But, then again I might be wrong, especially considering that the world’s premier development bank, has not objected one iota to that artificial regulatory risk aversion 

Looking back at history I have also always thought that what really posed dangers to the stability of banks, was what is perceived ex ante as absolutely safe. That because there is were the real dangerously large exposures could be found, never among the risky, But, then again I might be wrong, especially considering that the world’s premier financial stability agent, has not objected one iota to that structure of incentives for the allocation of the portfolios of banks.

It will be very interested to hear what renowned experts like Andreu Mas-Collel, Dani Rodrik, Philippe Aghion, Arvind Subramanian, Ivan Rossignol will have to say about that when, on October 14, they discuss in Washington: “New Growth Strategies: Delivering on Their Promise?” Sorry I can't be there (well not that sorry, since I will be in Paris :-))

PS. And, while you’re at it, if you can spare a second, give a thought to whether the risk-weighted bank capital requirements are helpful in order to decrease inequality or financial exclusion… or if perhaps they may serve as drivers of that.

PS. And, while you’re at it, if you can spare a second, give a thought to whether injecting some purpose into bank capital requirements could do some good, like instead of using credit ratings, using perhaps potential of job creation ratings, sustainability of planet earth ratings, and good governance and ethics ratings of governments.

Friday, October 10, 2014

Yes Mme. Lagarde. It matters much where banks are going, and they’re being directed in the wrong direction.

Yes Mme. Lagarde. It matters much where banks are going, and they’re heading the wrong way.

Christine Lagarde Managing Director, International Monetary Fund in “The IMF at 70: Making the Right Choices—Yesterday, Today, and Tomorrow” during The IMF/World Bank Annual Meetings, Washington, D.C. October 10, 2014, states: “It matters where we want to go in order to decide which way we go.”

Indeed it matters. And that is why I ask Christine Lagarde to use her influence to ask bank regulators: where do they want our banks to go.

I say this because in all their regulations there is not on single word about the destiny of the banks, in terms of the purpose of our banks. 

And that is of course why they have allowed themselves to impose on banks “credit-risk weighted capital requirements for banks”, which introduces a sissy silly risk aversion in the banking system and which completely distorts the allocation of bank credit to the real economy.

When Mme. Lagarde presents to us a choice between stability and fragility, that is a perfect opportunity to remind all of you that the search for stability can itself produce that stiffness, brittleness and lack of flexibility, that can lead to real monstrous fragility.

When Mme. Lagarde presents to us a choice between acceleration and stagnation that is not really a choice, since the lack of acceleration, moving forward, taking risks, will make the economy stall and fall, sooner or later.

And finally when Mme. Lagarde presents to us the choice between solidarity and seclusion, I would just note that, though there is a saying that goes “better alone than in bad company”, whenever you build a wall, you cannot be absolutely sure you end up on the right side of it.

IMF, and World Bank you have an important and urgent role to perform in holding bank regulators accountable for what they have done and are doing… please do not shy away from it.

And also never forget that secular stagnation, deflation, mediocre economy, unemployment, underemployment, managed depression and all similar obnoxious creatures, are all direct descendants of risk aversion.

A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926

Wednesday, October 8, 2014

Knowingly or unwittingly, I believe and pray for the latter, current bank regulators are saboteurs of the economy

There has never ever been an economy that has grown strong and sturdy based on risk-aversion… they have always done so based sometimes on pure unabridged crazy risk-taking and other times with reasoned audacity… but that is what have kept them moving forward without stalling and falling.

Therefore when regulators imposed credit-risk weighted capital (equity) requirements for banks; which allow banks to earn much much higher risk adjusted returns on equity on what is ex ante officially perceived as absolutely safe, like “infallible sovereigns”, housing sector and members of the AAAristocracy, than on what is perceived as “risky”, like the medium and small businesses, entrepreneurs and start-ups… then they, de facto, sabotaged the economy.

So who wants to be known in the history as one of the saboteurs who brought down our economies?

For your information, secular stagnation, deflation, mediocre economy and other similar creatures out there, are direct descendants of risk aversion.

Tuesday, October 7, 2014

IMF, Christine Lagarde, “the new mediocre” was ordained by risk adverse bank regulators.

Christine Lagarde speaks about “the new mediocre the state of the global economy—and the risk that the world could get stuck for some time with a ‘mediocre’ level of growth”; and of that we need a mix of bolder policies to inject a ‘new momentum that can overcome this ‘new mediocre’ that clouds the future.

The “New Mediocre” is the direct result of a growing risk adversity, most clearly illustrated by the credit-risk-weighted capital (equity) requirements for banks that for no good reason at all, distorts the allocation of bank credit, by allowing banks to earn much much higher risk-adjusted returns on equity on exposures ex ante perceived as “absolutely safe” than on exposures perceived as “risky”… since risk-taking is the oxygen of any development such risk-aversion can only lead to our economies stalling and falling, and where “mediocrity” is only a benign intermediate point.

How the IMF and others have allowed bank regulators to regulate banks without even defining the purpose of the banks, and caring exclusively about the banks and not about the allocation of bank credit to the real economy, is just incomprehensible to me.

Two times during civil society round-tables (do not ask me what civil society means) I have asked Christine Lagarde about the odious discriminatory regulations that impedes “the risky” to have fair access to bank credit, two times she has answered as she could be understanding, two times she has clearly not.

This year I will not be present at the IMF/World Bank annual meetings in Washington... (I have better things to do in her Paris :-))... but I sure hope, and pray for, that when she speaks of the “need of bolder policies”, she will understand that for that it might very well suffice with getting rid of silly and dangerous credit-risk-adverse bank regulations.

PS. Christine Lagarde, let me be even clearer still. Secular stagnation, deflation, mediocre economy, unemployment and all similar creatures, are direct descendants of silly risk aversion.

PS. Comments on IMF Global Financial Stability Report October 2014 Chapter III: Risk Taking by Banks: The role of Governance and Executive Pay

Monday, October 6, 2014

Comments on IMF Global Financial Stability Report October 2014 Chapter III: Risk Taking by Banks: The role of Governance and Executive Pay

MY CONCLUSION: Without bank regulations, especially the credit risk weighted capital (equity) requirements, there would not have been a financial crisis like the current, nor would there have been any reason for the IMF to write this chapter. And IMF should have the guts to rise to the occasion and state that truth... the world needs it.

Here: Chapter III: Risk Taking by Banks: The role of Governance and Executive Pay

General comments:

Though I have naturally no objections to the call for better governance of banks, or for more constrain and rationality on their executive pay, I object to the relative importance assigned to those issues in terms of causing the current financial crisis… as this will help to divert the attention from those who most need to be held accountable… namely bank regulators.

And that because I am totally convinced that the distorting regulatory incentives present in the risk-weighted capital requirements for banks were the most important cause of the crisis and for the difficulties of our economies to be placed on the road of finding sturdy growth. 

And also, specifically relevant to this chapter, because those regulations dramatically eroded the importance of bank capital (equity) and bank shareholders, and thereby left the road open for bank management to appropriate for itself, much more of the financial results.

Comments on the Summary:

Text: “There is broad consensus that excessive risk taking by banks contributed to the global financial crisis.”

Comment: A broad consensus does not necessarily represent the truth. In this case it is important to remember that absolutely all of the excessive risk taking that showed up on the balance sheets of banks, were related to excessive exposures against which regulators allowed minimum capital requirements, as a consequence of these assets being ex ante perceived as absolutely safe from a credit point of view.

Text: “Equally important were lapses in the regulatory framework that failed to prevent such risk taking. Reforms are under way to further strengthen the regulatory framework, realign incentives, and foster prudent behavior by bankers.”

Comment: To be effective and avoid unintended consequences, such reforms must be based on a thorough understanding of what drives risk taking in banks. The distortions in the bank’s portfolios, and in the allocation of credit to the real economy produced by the risk-weighted capital requirements, have not been sufficiently acknowledged and discussed so as to expect these will be eliminated in a rational way. I hold this because even though there are many calls for more bank equity, and some who correctly suggest the full elimination of risk-weighting, the transition of the banks from here to there implies serious risks, for the banks and for the real economy.

Comments on: Box 3.5. Regulation and Risk-Taking Incentives: Basel I to III 

Text: “Basel I (1988) introduced uniform, risk- sensitive minimum capital standards at the international level… credit risk was divided into five buckets, ranging from zero percent to 100 percent depending on the riskiness of the underlying asset.”

Comment: “depending on the riskiness of the underlying asset” is not a correct way to phrase it. More precisely it depended on the ex ante risk preferences of regulators and general ex ante credit risk perceptions, both which does not necessarily have anything to do with the ex post realities.

Text: "Although Basel I was hailed for incorporating risk into the calculation of capital requirements and was regarded as a big step forward, it was also criticized for not taking into account hedging, diversification, and differences in risk-management techniques. It also did not take into account other types of risk, particularly market risk."

Comment: Basel II (and Basel III) are still essentially “portfolio invariant” and has therefore not corrected for not taking into account diversification. One loan of $1 billion to one “absolutely safe” borrower requires the bank to hold only a fraction of the capital needed against 1.000 $1 million loans to “the risky”. And though coverage for liquidity risk has been included in Basel III, as it also build on ex ante perceptions, it could also be aggravating the distortions.
Text: "Advances in technology and risk-management techniques allowed banks to develop their own internal capital allocation models in the 1990s, which enabled them to align the amount of risk they undertook on a loan with the overall goals of the bank (internal risk tolerance). 

For example, Basel I placed all commercial loans into the 8 percent capital category. In contrast, internal model calculations led to capital allocations on commercial loans that varied from 1 to 30 percent, depending on the loan’s estimated risk. It was hence argued that although Basel I was a step in the right direction, it was not sufficiently risk sensitive and could result in arbitrage: if capital regulation was binding, a lack of risk sensitivity encouraged banks to shift toward the riskiest activity within each category.

The Market Risk Amendment (1996) and Basel II (2005) were introduced to address these shortcomings, allowing internal models for market and credit risk, respectively. These measures allowed banks to use internal models to more finely differentiate risks of individual loans. Risk could now be differentiated not only between but also within loan categories."

Comment: And the consequence of that, which should have been expected by the regulators, was that instead of taking diversified risks on what was perceived as “risky”, banks took on extreme and dangerously leveraged exposures to what was and is ex ante perceived as “absolutely safe”

Text: “The regulations were designed to induce banks to invest more in risk-management and modeling technology by providing capital relief— the standardized approaches were calibrated to be more conservative than risk-sensitive internal models.”

Comment: “the standardized approach” calibrations were the result of a complete absurdity that in my opinion no one understood but no one dared to question. I dare anyone to read the explanation provided by the Basel Committee and then he might understand better the horrible truth behind the “risk-weighing” which sounds so comforting and rational. 

Specifically I strongly suggest all development and finance ministers to query their regulators on the Explanatory Note on the Basel II IRB Risk-Weight Functions issued by the Basel Committee.

Text: “Before these changes were introduced, banks’ internal risk models (and other risk-management functions) were designed to measure risk accurately. However, after the Market Risk Amendment and Basel II, subject to regulatory approval, models became a key input in determining capital requirements, generating a competing objective of using models to minimize measured risk to minimize capital requirements.”

Comment: Is not minimizing capital requirements a natural and essential way for banks to compete in capital markets, especially when risk-weighing of assets made everything less transparent to the market? That regulators did not foresee that risk-weighted capital requirements would lead to overall much lower bank capital is mind-blowing.

Text: “These incentives may have contributed to the global financial crisis, during which banks, particularly large banks, were found to hold insufficient capital. Since the crisis, Basel III has raised the capital requirements for banks, and work is ongoing to better capture risk.”

Comment: “These incentives may have contributed to the global financial crisis”, may count as one of the understatements of the century. Those incentives caused the global financial crisis… suffice to see the total correlation between “bank assets in trouble” and “low capital requirements”.

Final comments: 

The regulators never defined what is the purpose of the banks, and therefore they never cared, nor care, one iota about how banks allocated credit to the real economy. “A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926.

The regulators fixated on the expected ex ante perceived risk of the assets of the banks, something which is already clear for by means of interest rates and exposures, instead of focusing on the unexpected risks of the banks… pas le meme chose. Amazingly, by their own confession, they substituted expected risks for unexpected risks.

And the above allows banks to earn much higher risk adjusted returns on equity on assets perceived as "absolutely safe" than on assets perceived as "risky", something which introduces a monstrous distortion in the allocation of bank credit to the real economy.

And because of this regulatory distortion much or even perhaps most of current fiscal and monetary support systems of the real economy is wasted, only because regulations do not allow bank credit to go to where it is needed the most.

As a grandfather, extremely concerned about the future of my grandchildren, I hold that the current regulators, and whose extreme hubris made them believe they could be risk managers for all our banks, deserve to be sent home... in shame. Were we to regulate for climate change the way banks have been and are regulated, our planet will be toast!

PS. In 1999 in an Op-Ed I wrote “The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause the collapse of our banks” And the Big Bang happened! And yet seven years after the explosion, the world seems not to have noticed the Basel Bomb... and the IMF has a lot of responsibility for that.

PS. As the IMF is now taking up the issue of inequality, it should be reminded that the odious discrimination  against fair access to bank credit of "the risky", is one prime driver of inequality.