The short and true story of the financial crisis

This crisis originated in what are supposedly very safe assets, houses and mortgages, in what is supposedly the strongest and financially safest country, the USA, and in what are supposedly the absolute safest instruments, the triple-A rated. When we then hear even Nobel Prize winners talking about excessive-risk taking, it should be clear to all of us that something very serious has happened to risk. It happened in Basel.

The Basel Committee on Banking Supervision, in their irrational fear of bank defaults, while forcing the banks to have 8 percent of equity when lending to “risky” small companies or entrepreneurs, completely ignored the fact that bank crisis originate only where ex-ante risks are perceived as low, and allowed the banks to hold only 1.6 percent in capital when investing in triple-A rated securities, like those backed with lousily awarded mortgages to the subprime sector, or when lending to sovereigns rated A+ to A like Greece, and which implied allowing the banks to leverage 62.5 to 1, 

Of course, needing less capital when doing business with the “less risky”, made the profitability of bank business with the “less risky” shoot up to the skies, and so the banks forgot all the small businesses and entrepreneurs, and gorged up anything that had a good rating on it… until they choked on the triple-As and the Greeces of the world.

God make us daring!

Asking about Propositum Bancos could help the Basel Committee break the Confundus spell.

Surely the Basel Committee must know by now that no matter how poorly defined their basic capital requirement for banks of 8% of the assets was in Basel II, this was not what caused many banks to hold insufficient capital. That was entirely the consequence of those so faulty risk-weights applied, those which for instance when investing in triple-A rated securities such as those collateralized with lousily awarded mortgages to the subprime sector, or lending to countries like Greece and Ireland, allowed banks to hold only 20% of the 8%, 1.6%, and therefore being able to leverage their capital 62.5 times to 1.

The basic mistake that caused Basel II to be so shamefully inappropriate was that the Basel Committee explicitly ignored the fact that perceived risk of default is already cleared for in the market by means of the risk premiums charged and so making a difference for it in the capital requirements accounts twice for the same risk. And that leads to making access for those perceived as less risky even easier and cheaper, creating the perfect storm conditions as bank crisis only occur because of excessive investments or lending to what is ex-ante perceived as not risky; and causes that those who already have difficulties accessing bank credit at a reasonable rate, like the small business and entrepreneurs, will find it even harder and more onerous to do so.

But the Basel Committee, instead of tackling the fundamental weakness of Basel II, the risk-weights, is in Basel III working on important but yet marginal issues. Clearly the lower but much stricter and cleared defined basic capital requirement of 7 percent announced is an improvement, but, its final effectiveness depends 100% on correcting the issue of the risk-weights... and which basically means throwing them out completely.

And that is why we get so nervous when according to re-“Calibrating regulatory minimum capital requirements and capital buffers: a top-down approach” October 2010 we read of how the Basel Committee tries to capture empirical knowledge by analyzing the “Return on Risk-Weighted Assets” completely ignoring that risk-weighted assets when weighted with their risk weights have no real meaning at all.

Clearly the Basel Committee has fallen under that spell identified by J.K. Rowling as “Confundus” (causes the victim to become confused, befuddled) and the first order of day must be to break it. How can it be achieved? First, we need to get rid of those regulators in the Basel Committee who are way beyond any salvage; and then we must awake the rest by asking the magical question “Propositum Bancos”… what is the purpose of the banks?

Of course too many banks should not fail by not being able to maintain sufficient capital to survive throughout a significant sector-wide downturn, but that is more of a minimum requirement, a restriction, and not at all a purpose. If we, after their huge failure, are to allow the Basel Committee on Banking Supervision to keep on regulating globally the banks, the least they should tell us is what they think the purpose of the banks is, and we should be able to agree on that.

Does the devil reside in Basel?

The following is a verse of a Swedish psalm (244).

“God, from your house, our refuge, you call us, out to a world where many risks await us.

As one with your world, you want us to live. God make us daring!”

“God make us daring!” expresses extraordinarily well the need that society has of risk-taking, in order to move forward, so as not to start rotting.

Unfortunately that is a need that our current global bank regulators, the Basel Committee, has not the least understanding of. They give banks huge incentives to operate in areas where risks are perceived as low, as if bankers would not do enough of that of their own will, and punish banks when entering areas where risks are perceived as high, as if bankers would not, on their own will, mostly avoid those.

The regulatory risk-adverseness is clearly evidenced by that banks, when lending to a small business or an entrepreneur, are now required to hold FIVE TIMES as much capital than when lending to a triple-A rated entrepreneur. That signifies that although the banks already compensate for perceived risk of default by charging different risk premiums, they have now to discriminate twice on that perception having to charge different premiums with relation to capital requirements.

As a result small businesses or entrepreneurs have their access to bank credit curtailed and their borrowings made much more onerous than needed, while those perceived as less risky have more access and cheaper access to bank credit than what they would otherwise have.

As a result we are suffering a huge financial crisis that has precisely resulted from what is always the cause of bank crisis, excessive investments and lending to what ex-ante is perceived as having a low risk of default, because, of course, no financial nor bank crisis has ever resulted from excessive investments and lending to what ex-ante is perceived as having a high risk of default.

We need to stop this regulatory nonsense that is killing the vitality of our economies. There is nothing as so risky long term as turning into cowards unwilling to run risks… and the Basel Committee has no right or reason for tempting the world into believing that development and growth can take place in a park with only safe attractions, only because the regulators are so childishly frightened of their so innocent and even indispensable default monsters. Scary is a world without defaults!

What about the risk of billions of young people around the globe not finding jobs? That is a real risk to write home about!

Let us never forget that the door to enter into a better and more sustainable, and more job-rich future, might only be found by taking the craziest risks in the middle of the craziest boom… that’s life… that’s development.

Honestly, the current risk weighted capital requirements for banks, are an insolence to the memory our risk-taking forefathers.

Scary indeed!

Over 90 percent of the direct explanation of this crisis is to be found in the more than two trillions lost over a very short period of time, in triple-A rated securities collateralized by lousily awarded mortgages in the subprime sector. The marketability of these securities, and of the value of an AIG´s triple-A ratings, had been so extremely, almost obnoxiously, increased by the Basel Committee when they, in June 2004, with Basel II, allowed the banks to invest in these securities requiring only a 1.6 percent of a quiet loosely defined capital, signifying that the banks could leverage their equity over 60 times, signifying that if a bank expected to made a .5 percent margin on a triple-A rated securities they could make over 30 percent of return on their equity.

I just saw the “Inside Job” the film about “The Global economic crisis of 2008 cost ten millions of people their savings, their jobs, and their home. This is how it happened”. The movie is promoted as “Scarier than anything Wes Craven and John Carpenter have ever made”

Covering in a good and expensive production almost all under the sun, like money laundering by Riggs bank for Pinochet, academicians writing papers without disclosing that they have been paid to do so, the role of prostitutes and cocaine in finance, as well as most of the other actors we have seen related to this crisis over the last couple of years, the movie does not mention, not even once, the Basel Committee and it brethren the Financial Stability Board; just like the recent over 2.000 pages of financial reform approved by the US Congress does not mention them either.

Since the Basel Committee and the Financial Stability Board are now preparing Basel III, that is indeed as scary as it gets!

Mary and Richard Corliss of the Time opine “If you´re not ENRAGED by the end of the movie, you weren´t paying attention”. I paid much attention and by the end of the movie I was also enraged AT the movie.

The financial crisis: What went wrong and what to do… in the eyes of an interested and concerned citizen observer.

In explaining the current financial crisis there are some very few pieces that allow for a quite clear image of the final puzzle and are obviously needed in order to find the best way to avoid repeating the same mistake… and so that we could at least give some new mistakes a chance to show what they´re worth.

1st piece: The Basel Committee had decided that the only risk it needed to consider with respect to the banking system was the risk that banks lent or invested in operations that could default. All other risks related to whether banks fulfilled adequately their capital allocation responsibilities, were taken off the table.

2nd piece: The Basel Committee because of its hysterical aversion of risk turned a blind eye to the fact that all bank crisis have resulted from excessive lending or investment in what was perceived ex-ante as having a low risk of default and never from excessive lending or investment in what ex-ante was perceived as having a high risk of default.

3rd piece: The Basel Committee, when determining the risk-weights by which it arbitrarily discriminated on the risk of default, amazingly ignored the fact that the market and the banks already clear for risks by the risk premiums they charge in interest rates, and so ex-ante perceived low risk was twice benefitted while ex-ante perceived higher risk were twice punished.

4th piece: The regulators naively ignored that the oligopoly of risk surveyors they empowered, the credit rating agencies, where human fallible and could also be captured. There has been a lot of comments with respect to the excessive trust placed by banks and markets in general in the “opinions” of the credit rating agencies but, if there is anyone that has showed the way for such excessive trust, that is of course the Basel Committee itself.

5th piece: On June 26 2004 the G10 substituted the 30 pages long Basel I adopted in 1988 with the 251 pages long Basel II, which allowed a bank to hold only 1.6 percent of fairly loosely defined capital (8 percent basic capital requirement multiplied by its 20 percent risk-weight) when lending or investing in anything related to a private triple-A rated client or security; which signified that a bank could leverage its equity on those operations to 62.5 to 1; which signified that if a bank expected to make a margin of .5 percent on a triple-A rated operation, it could expect a return on its capital of 31.25 percent a year.

6th piece: The primary and really only detonator of this crisis were the over two trillion dollars from all over the world invested and lost in triple-A rated securities collateralized with very badly awarded mortgages to the subprime sector. The market, as markets do, in response to a really mindboggling acceleration in demand after mid 2004 for triple-A rated securities, and because almost by definition real triple-A financial operations are extremely scarce, resorted to fabricate and supply fake Potemkin-triple-A ratings.

What are the first conclusions we should draw when seeing the image these six pieces create?

1st conclusion: If we are going to have global regulators, which we will need, it absolutely behooves us to make sure those regulators are chosen from an extremely diversified pool of talents, since the least we need is to allow for creation of incestuous mutual admiration clubs… like the Basel Committee is. We need urgently to change at least 80 percent of the professionals involved with the Basel Committee and guarantee the existence of multidisciplinary professional participation. Think of it, if the challenge of global climate change is placed into the hands of something like the current Basel Committee, we are all toast, before it even begins to heat up!

2nd conclusion: Before regulating the banks we need to define what the purpose of banks is. As just mattresses to stash away cash, mattresses might be better. For this the world, but especially the submerging countries, need to reconsider completely the issue of what is the necessary risk-taking a society must be willing to absorb in order to move forward.

3rd conclusion: Throw away the capital requirements for banks based on ex-ante perceived risk of default as fast as possible. As long as small businesses and entrepreneurs are discriminated to such an extent that banks need to hold 5 TIMES as much capital when lending to them when compared to when lending to triple-A rated clients, there is no sustainable way out of this crisis nor sufficient job creation.

4th conclusion: We also need all to work ourselves out of that amazing regulatory bias in favor of big governments represented by the fact that when banks lend to a triple-A rated sovereign, they need zero capital; a distortion that among others hinders us from seeing the real interest rates on public debt.

The mystery of the unconnected dots!

We have two outstanding pieces of evidence that can help us understand the current financial crisis and therefore help us to avoid repeating the same mistake… and so we could at least give new mistakes a chance to show what they are worth.

The first evidence is the really mindboggling acceleration in demand after mid 2004 for securities rated triple-A and which led to over two trillion dollars from all over the world to be invested and lost in securities which were collateralized with very badly awarded mortgages to the subprime sector.

The second evidence is represented by two dates and one piece of bank regulations:

On April 28, 2004 in an Open Meeting the SEC discussed "Alternative Net Capital Requirements for Broker-Dealers that are Part of Consolidated Supervised Facilities and Supervised Investment Bank Holding Companies" and in both cases it was approved that the respective parties “would be required periodically to provide [their respective] Commission with consolidated computations of allowable capital and risk allowances (or other capital assessment) consistent with the Basel Standards." In other words, that day, the SEC, almost explicitly, delegated some of its fundamental functions to the Basel Committee.

On June 26 2004 the G10 substituted the 30 pages long Basel I adopted in 1988 with the 251 pages long Basel II.

And Basel II, required for instance a bank to hold if it wanted to invest in triple-A rated private securities only 1.6 percent of fairly loosely defined capital, signifying that the bank was there allowed to leverage a quite loosely defined capital 62.5 to 1, signifying that if a Bank bought a triple-A rated security on which it expected to make a margin of .5 percent that it could expect a return on its capital of 31.25 percent a year. Needless to say the banks went berserk demanding triple-A rated securities. And since there were not sufficient real triple-A securities, the market, as markets do, supplied them with fake Potemkin-triple-A ratings.

It should not be difficult to connect the dots for anyone who wants to connect the dots and so the big lingering question about this crisis and its explanation remains… why do so very few experts want to connect the dots? A real mystery!

What do I, Per Kurowski, want with respect to the current bank regulations?

I want the current capital requirements for banks based on perceived risk of default concocted by the Basel Committee to be thrown out forever.

Why do I want that?

1st because these capital requirements ignore that the risk of default, as perceived, among other by the credit rating agencies, is already taken care of by the risk premiums charged by the markets and the banks, and so we end double counting for the same perceived default risk; which causes those who already are benefitted by lower interest rates, because they are perceived as having a low risk of return, to be additionally benefitted by having to provide a return on less capital; and punishes additionally those who already have to pay higher interest rates because they are perceived as “risky”, by means of having to provide a satisfactory return on more bank capital.

2nd because the more we strengthen the basic capital requirements like for instance going from a very wishy-washy 8 percent in Basel II to a more solid composed 7 percent in Basel III the more damage will the discrimination produced by the risk-weights cause.

3rd because the risk of default compared to many other risks we face, like climate change or a world with billions of young people with no jobs, is really a minor and almost innocent risk that is an integral part of an operating market, something which becomes even more apparent if we think about the possibilities of markets without defaults and which, of course, could only end up with the mother of the mother of all the too-big-to-fail banks.

4th because it is always dangerous to identify and empower a risk-assessment oligopoly of credit rating agencies, which will leverage whatever mistakes they make on their own or because they are captured.

5th because in order to go forward and not stagnate and fade away humanity always needs a hefty dose of risk-taking, and you can therefore not allow that the banks turn solely into mattresses, where to stash away your savings. To accept sending your children away to war where they could die but at the same time arbitrarily make it harder for young entrepreneurs to access the capital he feels he needs to take himself, and us, forward, does not seem like a reasonably balances proposition.

Why would they want to give it to me?

1st since the regulators have recently been reminded of the fact that all monstrous financial and bank crisis always occur because of excessive investments in what is perceived as not risky, the triple-A rated of each time, and never because of excessive investments or lending to like what is considered as not risky, that should get them thinking. Don’t you think so?

2nd because it is obvious that we need to give small businesses and entrepreneurs, of any age, more fair access to bank credit if they are going to have a chance to make something useful out of all that cash thrown on the economy by fiscal spending and quantitative easing. For your information, right now, the banks when lending to small businesses or entrepreneurs, because their Basel decreed risk-weight is 100 percent, need to have 5 TIMES as much capital than when lending to a triple-A rated client whose Basel decreed risk-weight are merely 20 percent.

And would that be all?

Absolutely not! If we are going to have global regulators, which we will need, it absolutely behooves us to make sure those regulators are chosen from an extremely diversified pool of talents, since the least we need is to allow for creation of incestuous mutual admiration clubs… like the Basel Committee is. Think of it, if the challenge of global climate change is placed into the hands of something like the current Basel Committee, we are all toast.

Are these extravagant wishes?

I don’t think so. Do you?

Capital requirements for banks based on job creation, makes more sense than those based on risk of default.

And there they are again, the G20, now in South Korea, lost for words, but yet babbling.

If I were to be given one minute of voice there, I would ask all of them to throw away the capital requirements based on the risk of default, because the risk of default is already being priced in the interest rates of the market, so there’s no need to discriminate through bank regulations against the unrated small businesses and other “risky” elements.

And, if the government official could just not resist meddling with the markets, then I would suggest them to impose capital requirements for banks based on the job creation potential of the borrower… more jobs less capital less jobs more capital… I mean, is not to help create job a primary function of banks?

But, of course, history has recently taught us that we need to be very careful with the job-creation-rating-agencies we empower.

Members of the Basel Committee consider yourselves insulted and challenged

The Basel Committee of Banking Supervision, that extremely important global regulatory agency, instructed the credit rating agencies to set up their warnings sign of perceived risk of default, ordered the banks to follow these signs, and then proceeded to calibrate the capital requirements of banks as if the banks did not see them. Somewhat like setting up traffic-lights all over town and synchronizing them under the assumption that drivers are blind.

Of course, if the regulators wanted to calibrate adequately for the default risk of any bank exposure to any credit rating, they could only do so by taking into account how the banks would react to those credit ratings…as well as considering the banks’ relative exposure to the different credit ratings. If a bank lends only to triple-A rated clients then its systemic danger, is only represented by its triple-A rated clients.

Since perceived risk is cleared in the market through the interest rates charged, this has signified that the relative profitability for the banks of lending to what is perceived as not risky, like what has a triple-A rating, increased dramatically, while the relative profitability for the banks of lending to what is perceived as more risky, like unrated small business and entrepreneurs, decreased.

Knowing as we should know that no bank crisis has ever resulted from excessive lending to what is perceived risky and that they have all resulted from excessive investments to what is perceived ex-ante as not risky, applying the Basel Committee’s current regulatory paradigm of capital requirements based on risk results clearly in counterfactual and stupid regulations. Also, since the most important role of commercial banks is to help satisfy the financial needs of those who are perceived as more risky and have not yet access to the capital markets, the odious discrimination against these clients (who are already paying much higher interest rates into the capital of banks) is doubly stupid.

If by any chance the issue of regulating on climate change would fall in the lap of an entity like the Basel Committee… we would all be toast.

For over a decade, even as an Executive Director of the World Bank 2002-2004 and always under my own name and indicating my email, I have presented many arguments against the current central regulatory paradigm use by the Basel Committee, that of capital requirements based on perceived risk of default, and called it stupid, stupid, stupid!

And by the way, if the regulators absolutely have an existential need to calibrate for risks, what is so particularly risky with defaults? Is not the risk of not creating jobs or the risk of increased un-sustainability worse? Does not just to think of a world without defaults make you shiver?

Having said that, not once, in all these years, has anyone identified as having anything to do with the Basel Committee ever denied my accusations, presented any counter-argument, or shown the least willingness to discuss the issue. Is it not strange? Could it really be that little me is right and these so expert experts are so utterly wrong? I dare them to prove me wrong!

In October 2010, during the annual meetings of the International Monetary Fund I publicly asked “Right now, when a bank lends money to a small business or an entrepreneur it needs to put up 5 TIMES more capital than when lending to a triple-A rated clients. When is the IMF to speak out against such odious discrimination that affects development and job creation, for no good particular reason since bank and financial crisis have never occurred because of excessive investments or lending to clients perceived as risky?” Dominique Strauss-Kahn, IMF’s Managing Director, answered in no uncertain terms that “capital requirement discrimination has no reason to be”, and so it seems that there are also other who agree with that the Basel Committee stands there completely naked without a functional regulatory paradigm.

In this moment when an extremely serious financial crisis affects the world and when the Basel Committee is digging us even deeper in the hole they placed us in, would we all not feel more comfortable if the Basel Committee at least agreed to a public debate on what I criticize?

Therefore…members and professionals of the Basel Committee consider yourselves slapped on the face with a glove and dared to accept the challenge. Wear with dignity your cones of shame!

Want a more detailed explanation? Listen to this home made video
http://subprimeregulations.blogspot.com/2010/09/the-financial-crisis-simple-why-and.html

Per Kurowski   @Per Kurowski

PS. I appreciate any help I could get in provoking the Basel Committee to respond to this challenge

PS. Risk taking is the oxygen of any development. God Make Us Daring!

PS. Has the Basel Committee just suffered the Nut Island effect? 

PS. US Congress, what are you up to? Over 2.000 pages of financial reform and you do not even mention once the Basel Committee which has so messed up the capital requirements of your banks.

PS. A small numeric example: If banks were allowed to leverage only 12.5 to 1 when lending to triple-A rated clients, which is what they were allowed to leverage when lending to small businesses under Basel II, then if they made a .5% margin, they would obtain return on capital of 6.25% lending to AAAs, decent but nothing to write home about, less pay bonuses on. But since they were allowed to leverage 62.5 to 1 they could, with the same .5% margin then make a return of capital of 31.25%. No wonder banks stampeded wanting the AAAs!

PS. A visitor from outer space, observing that banks are required to have 8% of equity when lending to a small businesses, but zero% when lending to a triple-A rated sovereign as the US, would he be at fault thinking he had landed on a communistic planet? With such an arbitrary discrimination in favor of the public sector, do you really know the real market interest rates on public debt?

PS. Since I am no regulator, or a PhD with published research on the subject, here are some of my early opinions on these regulations, which should evidence that I am far from being  very few pieces just another Monday morning quarterback:

http://subprimeregulations.blogspot.com/
http://financefordevelopment.blogspot.com/
http://baselcommittee.blogspot.com/
http://teawithft.blogspot.com/search/label/subprime%20banking%20regulations
http://www.theaaa-bomb.blogspot.com/

God make us daring!

A Swedish psalm 288 Text: F Kaan 1968 B G Hallqvist 1970

Gud, från ditt hus, vår tillflykt, du oss kallar
ut i en värld där stora risker väntar.
Ett med din värld, så vill du vi skall leva.
Gud, gör oss djärva!

“God, from your house, our refuge, you call us
out to a world where many risks await us.
As one with your world, you want us to live.

God make us daring!”

“God make us daring!” That is indeed a prayer that the regulators in the Basel Committee for Banking Supervision do not even begin to understand the need for.

The Parable of Talents

Pope John Paul II also reminded us that Jesus Christ invited the Apostle to "put out into the deep" for a catch: "Duc in Altum". That is something regulators should remember when, with their risk weighted capital requirements, they want our banks to fish only from “safe” shores

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

And all for nothing! At the end of the day the current risk-weighted capital requirements for banks guarantees 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.

Here is a letter to the Financial Stability Board

Here is a letter to the IMF

Here is an aide-mémoire on what is so wrong with the current risk weighted capital requirements for banks.

PS. In Italy deaths from coronavirus COVID19 are only 0.25% for those under 40 years of age. YES, we older need to take care, but it is those under 40 years who will for the longest bear the brunt of the economic costs of overreacting... Just in case I am now, April 2020, weeks away from 70.

Excuse me… what calibration?

During a recent conference titled “Financial Reform: What´s next” I had the opportunity to ask one of the Keynote speakers Mr. Donald Kohn the former Vice Chairman of the Federal Reserve the following:

Current bank regulations ordained by the Basel Committee require the banks to hold 8 percent in capital when lending to unrated small businesses and entrepreneurs while allowing the bank to invest in US government debt against zero capital. When looking at the interest rates in the market, how much do you think they are distorted by these discriminatory regulations?

His answer: “If the calibration is done right there are no distortions.” The session ended there and I had no chance to ask him: Sir, what calibration?

That which solely considers the risk of default, as perceived by the credit rating agencies, and that should at least consider the defaults of bank operations after the banks are given the credit rating information, and that should at least consider that those who are perceived as riskier pay higher risk premiums that goes into bank capital.

Why not a calibration based on different criteria, since the current calibration would sort of indicate that lending the funds to the government is infinitely more efficient for the society than lending them to small businesses and entrepreneurs… and that sounds not about right?

I am aghast at the thought that a financial super-expert can even think that if they are only well calibrated, the capital requirements for banks that discriminate among borrowers based on the risk of default as perceived by some few credit rating agencies, they will not distort… mostly because that can only mean the regulators will now proceed to dig us even deeper in the hole they placed us in.

What are we to do with the Financial Stability Board?

The Financial Stability Board (FSB) reported from their meeting in Seoul on October 20 ahead of the G20 Summit in Seoul and endorsed principles for reducing reliance on credit rating agency (CRA) ratings as follows:

“The goal of the principles is to reduce the cliff effects from CRA ratings that can amplify procyclicality and cause systemic disruption. The principles call on authorities to do this through:

Removing or replacing references to CRA ratings in laws and regulations, wherever possible, with suitable alternative standards of creditworthiness assessment;

Expecting that banks, market participants and institutional investors make their own credit assessments, and not rely solely or mechanistically on CRA ratings.”

Since FSB does not even mention the risk-weights we can only assume FSB feels that all what went wrong was the excessive reliance on the credit ratings. They have no clue. What went really wrong was the way the regulators arbitrarily assigned to the different credit ratings the different risk-weights which determined the capital requirements for banks… like the 20% risk-weight for any lending to private entities rated triple-A or 0% risk weight on any lending to sovereigns rated triple-A.

In other words the FSB is unable or unwilling to understand that the credit rating agencies could have been totally wrong and yet they would never have produces the damage they did with their faulty ratings, had they not been so incredible endorsed by the bank regulators.

And neither does FSB understand that their regulatory favors to what is perceived as having a low risk of default, amounts only to an odious discrimination of what is perceived as having a higher risk of default, and all for no real purpose at all, since we all know that what is perceived as risky does never carry the potential to turn into a systemic danger.

And so friends what are we to do with the thick-as-a-brick Financial Stability Board?

With their “Risk-Weights” it is the regulator who is taking the load off the books of the banks

With reference to all being written about that “distasteful” behavior of banks of putting much of their exposure off the books, you should perhaps consider the following:

When the regulators used (and use) a risk-weight of only 20% to reflect the risk-weighted value on the books of banks, of for instance lousily awarded mortgages to the subprime sector that manage to hustle up a triple-A rating, it was (is) the regulator who is taking 80% off the balance sheet(books)of the banks.

When the regulators used (and use) a risk-weight of only 0% to reflect the risk-weighted value on the books of banks of loans to a sovereign rated triple-A, like the US or UK, it was (is) the regulator who is taking 100% off the balance sheet(books)of the banks.

Sincerely, I doubt the banks could have managed that kind of disappearance acts on their own.

Sort of like Basel Committee shocked!

The Basel Committee on Banking Supervision is guilty of gross negligence

I have since 1997 been criticizing the regulatory paradigm of capital requirements for banks based on ex-ante perceived risks and applied by the regulators of the Basel Committee, primarily because I felt these would only confuse the market when it cleared for default risks by means of its risk premiums and that there were systemic dangers in forcing the opinions of the credit rating agencies too much on the banks.

Since all past financial and bank crisis have resulted from excessive investments in what ex-ante was perceived as low risk, I also saw these requirements of more-risk-more-capital, less-risk-less-capital, to be absolutely counterfactual.

As I frequently spoke out about the previously in very clear and harsh words, and never received a response, I simply assumed the Basel Committee regulators to be lost for words and incapable of assuming their responsibility; or just plain thick-as-a-brick.

Unfortunately, now I must also accuse them of gross negligence, as I have only recently been able to internalize to its full extent that when the regulators calculated their risk-weights, they never considered the fact that the riskier pay much higher premiums, and which, when repaid, as it most often is, goes directly to the capital of the banks.

In “An Explanatory Note on the Basel II IRB Risk-Weight Functions", July 2005 prepared by the Basel Committee on Banking Supervision we read: “Interest rates, including risk premia, charged on credit exposures may absorb some components of unexpected losses, but the market will not support prices sufficient to cover all unexpected losses.” That would prove the regulators decided to completely ignore the markets… with premeditation.

This is exactly like if the insurance regulators required the insurance companies to post higher capital when insuring the health of persons who represent higher health-risks, without accounting for the fact that these persons will be obliged, precisely therefore, to pay much higher insurance premiums.

How negligent can one be? This negligence resulted in an odious regulatory discrimination of those perceived as “risky”, like the many small unrated businesses or entrepreneurs who, as a result did not get access to bank credit or had to pay much more than the market premiums for it. It also directly provoked the current crisis by creating the incentives that made the banks stampede after AAA-ratings, until they took the world over the subprime cliff.

I do not know whether or where you can present an accusation against the Basel Committee for gross negligence, but I do know that all its members should be forced to parade down the major streets of many capitals in the world, wearing their cone of shame.

Did really the Basel Committee dare to ignore the markets completely? 100%?

Since 1997 I have been speaking out against the regulatory paradigm of capital requirements for banks based on ex-ante perceived risks applied by the Basel Committee and I have never really been able to figure out what went on in the minds of the regulators to come up with such an idea that, though sounding so logical, more-risk-more-capital less-risk-less-capital, is so utterly faulty and counterfactual, since bank crisis never ever occur form excessive investments in what ex-ante is perceived as risky- when in fact it is just the opposite.

My main suspicion derived from the fact that I have never seen the Basel Committee define a purpose for the banks, and, not doing that, led of course to the wrong regulations.

But lately I am starting to get an inkling that an even more astonishing possibility lies behind it all.

Could it really be that regulators completely ignored what “the riskier”, when paying higher interest rates than for instance those rated triple-A, contributed to bank equity?

Currently a bank lending to a triple-A rated company needs 1.6 percent of capital which allows for a 62.5 to 1 leverage, but when lending to an unrated small business it needs 8 percent of capital and is therefore limited to a 12.5 to 1 leverage.

Let us assume that the margin before credit losses on a loan to a triple-A rated company is .4% and that of a loan to an unrated entrepreneur, 4%. In that case triple-A rated companies provide the banks of a before credit losses return on equity of 25 percent (.4*62.5) while the loans to an unrated small business would result in before credit losses return on equity of 50 percent.

But what if both types of loans could be made with a 62.5 to 1 leverage? Then the unrated small businesses would provide a before credit losses return on equity of 250 percent (4*62.5) in which case we would ask... why regulators feel they are safer with banks lending to triple-A rated clients for a 25 percent margin before credit losses than lending to small unrated businesses that provide a 250 percent margin before credit losses? Do regulators really believe that the bankers are so bad at analyzing credits to small businesses so they are better of just following the ratings of the credit rating agencies?

If both types of loans were made with a 14.5 to 1 leverage? Then the triple-A rated clients would provide the banks with only 5 percent before credit losses return on equity (.4*12.5) and of course then the banker would have a better incentive to try to do a good job lending to small businesses as they are supposed to do.

Please read from The Basel Committee on Banking Supervision the document “An Explanatory Note on the Basel II IRB Risk-Weight Functions", July 2005.

In it we find “Interest rates, including risk premia, charged on credit exposures may absorb some components of unexpected losses, but the market will not support prices sufficient to cover all unexpected losses.”

That leads us to suspect that the Basel Committee completely ignored all the differences in interest rates that the market charges based on perceived risk… something like saying “the market is absolutely and totally useless and so we need to impose our own risk-weights, independently of what it does". Is this what they understand as de-regulation? What hubris! Help!

The Basel Committee on Banking Supervision has only a completely wrong and harmful tool in its toolbox.

Capital requirements based on the perceived risk of default as perceived by credit rating agencies or bank’s own internal risk analysis, is the most important tool in the toolbox of the Basel Committee for Banking Supervision.

The higher the perceived risk the higher the capital requirement, and the lower the perceived risk the lower the capital requirements. It all sounds so extremely logical. Unfortunately as all bank and financial crisis have exclusively originated from excessive investments in what has been perceived ex-ante as having a low risk; and none from excessive investments I what has perceived ex-ante as having high risk, this regulatory tool is totally counterfactual; and therefore totally counterproductive, as this crisis in triple-A rated territory clearly evidences.

And it is even worse than that. As that tool discriminates precisely against the type of clients banks are supposed to help the most, the small businesses and entrepreneurs who have little alternative access to finance, it harms the economy and job creation.

Day by day more get to be aware of this problem, and I had the chance to take it to the forefront by making questions in three of the events during the annual meetings of the International Monetary Fund and the World Bank, October 8-11, 2010

The problem though is that seem they do not yet know what to do about it… and so they try to ignore it and whistle in the dark. In one of the final seminars “The financial sector: navigating the road ahead, where there was no Q. & A. opportunity the basic problem with the capital requirements based on risk was not even mentioned, though the additional layers of confusion currently contemplated, such as capital requirements for liquidity risks, for systemic risk and for cyclicality risks were. Can there be something more pro-cyclical than helping the triple-A rated?

It is truly amazing to see how difficult it is for so many to extract themselves from the regulatory paradigm, or almost regulatory voodooism that has entrapped them. The only truly invisible hand at work was… that of the scheming banking regulators messing around with risk-weights under the table.

Below are the three events that I referred to, and where I asked my question.

The Civil Society Town-Hall Meeting

In the video you can find my question in minute 47.28, Dominique Strauss-Kahn’s answer in minute 1.01.08, and Robert Zoellick’s answer in minute 1.16.32

http://www.imf.org/external/mmedia/view.aspx?vid=628246206001

Structural Reforms: Effective Strategies for Growth and Jobs

Here my first and second question can be seen from minute 1.14.25 on.

http://www.imf.org/external/am/mmedia/view.aspx?vid=629575645001

Accelerating Financial Inclusion–Delivering Innovative Solutions

My question (not the best sound quality, but it is a similar question) can be found in minute 1.04.03 on

http://www.imf.org/external/am/mmedia/view.aspx?vid=629531170001

If the IMF and the World Bank bites the Basel Committee, that should be news.

Capital requirements for banks that discriminate based on ex-ante perceived risk of default, with higher requirements when risks are perceived as higher and lower when risks are perceived as lower, is about the only tool in the Basel Committee for Banking Supervision’s toolbox. This single tool is completely inadequate, even outright dumb, on two counts:

First, it is totally counterfactual as all the financial and bank crisis have always originated from excessive investments in what ex-ante is perceived as having a low risk of default and no crisis has ever originated from excessive investments in what is perceived as risky. The perception of being risky is as big a weight as it comes and does not need to be supported by additional arbitrary risk-weights imposed by regulators. Risk premiums reflected in higher interest rates that goes directly to the capital of the banks are more than sufficient risk-weights. If anything we might need regulatory risk-weights to make up for the risk of the ex-ante perceptions of low risk turn out to be false.

Second, these capital requirements unduly and odiously discriminate against those perceived as having higher risk like the small business and entrepreneurs, and who happen to be precisely those whose financial needs the society has the largest interest in that the banks help to satisfy.

That a Mr. Kurowski voices the above arguments over and over again is of no importance, but, when these arguments begin to find an echo in the World Bank and the IMF… which would mean that these two institutions would be the one calling out that “The Basel Committee has no clothes” then one could presume they get to be newsworthy.

Below is the link to the video where you can find the questions I made during a Civil Society Town-Hall meeting (minute 47.28) and Dominique Strauss-Kahn’s answer (minute 1.01.08) and Robert Zoellick’s answer (minute 1.16.32)

http://www.imf.org/external/mmedia/view.aspx?vid=628246206001

Today I had a great day

For someone who since 1997 has been opposing the regulatory paradigm used by the Basel Committee for Banking Supervision, even as an Executive Director of the World Bank 2002-2004, today was a great day.

As a member of Civil Society, whatever that now means, at a Civil Society Town-hall Meeting during the 2010 Annual Meetings, I had the opportunity to pose a question to Dominique Strauss-Kahn, the Managing Director of the International Monetary Fund, and to Robert B. Zoellick, the President of the World Bank:

My question: (minute 47:35) “Right now, when a bank lends money to a small business or an entrepreneur it needs to put up 5 TIMES more capital than when lending to a triple-A rated clients. When is the World Bank and the IMF speak out against such odious discrimination that affects development and job creation, for no good particular reason since bank and financial crisis have never occurred because of excessive investments or lending to clients perceived as risky?”

Dominique Strauss-Kahn's answer: (minute 1:01:05) "Well, the question about requirements, a couple of requirements for banks. You know, it's a very technical question and a very difficult one, but the way you asked the question, which is why there any kind of discrimination against SMEs is an interesting way of looking at that. In fact, there is no reason to have any kind of discrimination. The right thing for the Bank is to know whether or not their borrower is reliable, but you can be as reliable being a small enterprise than not reliable when you're a big company. So this kind of systematic discrimination has, in our view, no reason to be.

Robert B. Zoellick's answer: (minute 1:16:30) "On the new rules for global finance, you asked when would speak up on the bank capital. I've been doing so for two years. It's all over the website, because I started with trade finance, knowing that field pretty well. Pascal Lamy, the head of the WTO, and I have led a campaign that said you're going to make it harder for trade finance for developing countries if you have higher capital levels for doing trade finance. So we've pressed very hard on that issue. You get an advanced notice, because tomorrow morning I'll be doing a PowerPoint briefing of all the Governors, and what I'll be mentioning is that for developing countries as a whole, we are seeing foreign direct investment go up, access to bond markets go up, but a net negative inflow of banks, in part, because I think of some of the capital standards and other regulatory issues."

The question that now floats around there out in the open, is what the Basel Committee on Banking Supervision, the supreme global regulatory authority, has to say about that, because bank capital requirement discriminations based on perceived risks is precisely the heart and soul of their regulatory paradigm… without that they have nothing!

The video of the meeting

Is it really possible that the Basel Committee bank regulators did not think of this?

When a bank client, perceived as more risky, like for instance your average small business or entrepreneur, is requested to pay for instance 5 percent or more on their loans than what a triple-A rated client pays, where do you think that 5 percent or more goes to when it gets repaid? The answer is to bank equity of course. That is what we could call the market´s risk-weights.

And when a regulator decides that a triple-A rated client generates only a 1.4 percent capital requirement for the bank (the Basel III 7 percent, adjusted by the risk-weight of 20 percent), while your average risky small business or entrepreneur generates a capital requirement of 7 percent, where do you think the about 2 percent in additional interest that your average small business or entrepreneur has to pay the bank in order to make up for the bank´s opportunity costs goes? The answer is to bank equity of course. This is what we call the regulator´s risk weights.

And so we have a world where, out of the blue, the Basel Committee decided that all our small businesses and entrepreneurs, those whom we should be most interested that our banks finance, well they have to run with under the weight of two different sets of risk-weights.

What kind of handicap officer is thia Basel Committee, taking off weights from those who have been running nicely and putting weights on those who have not run as good or are debutants? I would say that handicap officer is completely nuts or he has completely misunderstood his role.

The best way to end the markets’ addiction to the credit rating agencies is to end the regulator´s obsession with the credit rating agencies.

To reform financial regulations we need to reform in depth the Basel Committee.

In May 2003, as an Executive Director of the World Bank, I told those many present at a risk management workshop for regulators the following with respect to the role of the Credit Rating Agencies. “I simply cannot understand how a world that preaches the value of the invisible hand of millions of market agents can then go out and delegate so much regulatory power to a limited number of human and very fallible credit-rating agencies. This sure must be setting us up for the mother of all systemic errors.” And this I repeated over and over again, even in the press.

Now the IMF is finally admitting “Policy makers should continue their efforts to reduce their own reliance on credit ratings, and wherever possible remove or replace references to ratings in laws and regulations, and in central bank collateral policies”

That is good, better late than never. But the real question has to be why on earth it had to take a financial crisis of monstrous proportions to reach a conclusion that should have been apparent to any regulator from the very beginning.

I saw it happen and I know why it happened. As I wrote in a letter published in the Financial Times in November 2004, it was the result of the whole debate about bank regulations being sequestered by the members of a small mutual admiration club.

If there is now something even more important than rectifying the faulty financial regulations, that is to break up the Basel Committee and make absolutely sure it represents a much more diversified group of thinkers. That would have at least guaranteed that the basic question of what the purpose of the banks should be would have been put in the forefront before regulating them. Current regulations do not contain one word about that.

Besides me there were not too many but still plenty of experts who raised the question of whether the credit rating agencies should have such a prominent role. These persons should participate in designing and putting in place the needed reforms. It is simply unacceptable that these reforms with huge global implications are implemented exclusively by Monday morning quarterbacks.

Are you ok with a 71.4 to 1 leverage for banks?

Basel III now tells us that the basic capital requirement for banks is not any longer going to be the 8 percent of wishy-washy made up capital of Basel II, but a more real and solid 7 percent. Good news!

But unfortunately Basel III completely ignores mentioning the risk-weights, though these were the real source of the problems with Basel II.

And so now with Basel III, since the risk-weight for operations with triple-A rated securities is still 20%, the “more real and solid” equity required is 1.4 percent; the new authorized leverage for banks when investing in exactly the same type of securities that set of the current crisis, is 71.4 to 1.

Are you really ok with this?

The bare-naked Basel Committee

The innocent child´s "But he isn't wearing anything at all!" in “The Emperor’s new clothes” tale by Hans Christian Andersen, would not have been written today, since modern emperors and their spin doctors are much too savvy to let an innocent voice get due attention.

As a sort of innocent child I have been clamoring for a long time that the Basel Committee on Banking Regulations, no matter their standing as the great global expert on these matters, is bare-naked and completely wrong… so wrong that they are in fact the primary cause of the current crisis… but the Basel Committee just ignores me.

In this respect I am searching for a voice stronger than mine who could pose some simple questions to the Basel Committee and have them answered. A Senator of the US concerned with that the banks in the land of the free and the home of the brave are not really free and are instructed to be coward, could be a perfect such voice.

Question 1: All major bank and financial crisis in the world have, without exceptions, resulted from excessive investments in what was ex-ante perceived as not risky but that ex-post turned out to be risky; and no crisis has never ever resulted from excessive investments in what was perceived as risky. In this respect, guys, what are your fundaments for creating regulations that give banks extra-incentives to lend or invest in what ex-ante is perceived as not risky; and thereby create extra disincentives for the banks to lend or invest in what is perceived as risky?

Question 2: In the whole set of bank regulations that has emanated from the Basel Committee over the last two decades, there is not one single word about the purpose of the banks. Guys, is not defining the purpose of the entity you are to regulate the basic required element for any successful regulation?

Question 3: Banks are allowed to lend to triple-A rated governments, like the US, with no capital at all, but are required to post 8 percent in capital when lending to any small business or entrepreneur. Guys, are you communist?

Question 4: Inducing the banks to follow too much the opinion of some few credit rating agencies must increase the risk that when these agents go wrong the banks will go dramatically and exponentially wrong. Guys why on earth would you do a dumb thing like this?

Question 5: Guys, when you have by the results been proven absolutely wrong are you not supposed to pause and perhaps even hit the reset button? Why then are you now forging ahead and perhaps digging us deeper in the hole we are in by now so arrogantly even trying to control for economic cycles?

Question 6: Guys, since even hedge funds rarely manage to leverage more than 15 to 1, would the banks without you explicitly allowing them to do so, even contemplate to leverage themselves 40 to 1?

Question 7: What was going on in your minds guys authorizing banks during the last five years to lend to a country like Greece or investing in triple-A rated securities, leveraging 62.5 to 1, and thereby converting for instance a .5 percent margins in an astonishing 31.25% return on equity… precisely that sort of returns that giant bonuses and too-big-to-fail banks are made of?

Question 8: It is evident that given the scarcity of bank capital, the small businesses and entrepreneurs, and who might be able to develop the next generation of jobs, are being crowded out from bank credits by your regulations are. Guys, why do you find that acceptable? Especially considering that these clients are supposed to be the banks´ most natural clients; and that they have nothing to do with creating a systemic crisis.

Question 9: Guys in the Basel Committee, who are you, how do you get appointed, who sets and pay your salaries?

There are of course many more questions, but for a starter these would do.

Is there any free and brave Senator fed up with being Razzle Dazzle Razzle Bazzled willing to make them? I sincerely hope so the whole world needs it… urgently!

My letter to the Independent Commission on Banking in UK

You’ve all been “Razzle Dazzle 'em, Razzle Bazzle 'em”… Get out of that trance!

Sir,

The regulatory paradigm on which the Basel Committee stands will quite soon be discovered as one of the biggest regulatory failures ever, and all the experts will be looking for ways how to disassociate from them.

This is so because those regulations are primarily based on requiring the banks to have more capital when risk are perceived as high while allowing for much lower capital when risks are perceived as low, even though all financial and bank crisis in history have occurred from excessive investments in what is perceived as having low risk.

Only what is perceived as having a low risk can grow into systemic risk. A high perceived risk always takes care of itself and does never grow to be a systemic threat.

The regulators fixated themselves so much on stopping a bank from failing, that they ignored the system. Besides, who would like to live in a world where banks did not fail?

Currently small businesses and entrepreneurs, only because of the arbitrary, regressive and discriminatory capital requirements, need to pay the banks 2 percent more per year in order to provide the banks with the same return on capital that a loan or an investment to a triple-A rated client yields them. And this on top of the higher interests the small businesses and entrepreneurs anyway have to pay. Crazy!

I invite you to a brief lesson on how bank regulators have become so fixated on seeing the gorilla in the room that they completely lost track of the ball. http://bit.ly/c66DLp

Per Kurowski

A former Executive Director at the World Bank (2002-2004)

Basel Committee, what are you, a naïve regulator, a terminator, a communist or just plain stupid?

All financial and bank crisis have resulted from excessive investments or loans where the risk of default was perceived as low. If so what are you doing dramatically lowering the capital requirements for banks when they invest or lend to what is perceived as safe?

One of the primary purposes of banks is tending to the financial needs of those small businesses and entrepreneurs who might be the source for the future generation of decent jobs, but are yet too small for the capital markets. If so why are you making it less attractive for banks to do just that by, in relative terms, placing much higher capital requirements on whom naturally must be perceived as riskier? Is not being perceived as riskier a heavy weight by itself? Do these clients not have to pay higher interest rates anyhow?

A banker’s most important mission is to learn to analyze a client and find ways of how to safely satisfy his credit needs. If so why are you implicitly ordering all bankers just to follow the opinions of some few credit rating agencies?

An absolute perfect credit rating, guarantees an exact pricing, and therefore provides no special profits to any side of the operation. Special profits, for one side or another, do only arise from incorrect perceptions of risk. If so, why are you creating risk information oligopolies which, when captured, can only leverage incorrect risk perceptions into a systemic risk?

Current financial regulations requires a bank to hold 100% of the standard Basel II or Basel III capital requirement when lending to a small business or entrepreneur, but allows it to hold zero percent of that same standard Basel II or Basel III capital requirement when lending to a triple-A rated sovereign like that of the USA. If so could not a visitor from outer space, looking solely at the financial regulations, simply conclude that planet earth is communistic?

In order to regulate banks, one would naturally assume the need of establishing a purpose for the banks. The Basel Committee does no such thing!

Titling the comment as I do, am I to harsh with the Basel Committee? I don’t think so!

In 1999 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”; and as an Executive Director at the World Bank I did all I could to warn about what I was certain was doomed to happen. But I was blithely ignored by this small group of regulators who were just too cozy in their little mutual admiration club.

Well the AAA-bomb finally exploded and the Basel Committee does still not take any questions from outside their own circle, which now includes the Financial Stability Board. And now they are only giving us their “Razzle Dazzle 'em, Bazzle III 'em” treatment. That is inacceptable for a world that is and will be going through much suffering, precisely because of the Basel Committee.

The Basel Committee’s lousy Maginot Line

It is impossible not to see now that the financial regulators in the Basel Committee, trying to fend off a bank and a financial crisis, constructed an incredibly faulty Maginot Line.

It was built with lousy materials, like arbitrary risk-weights and humanly fallible credit rating opinions.

And it was built on the absolutely wrong frontier, for two reasons:

First, it was build where the risk are perceived high, and where therefore no bank or financial crisis has ever occurred, because all those who make a living there, precisely because they are risky, can never grow into a systemic risk. Is being perceived as risky not more than a sufficient risk-weight?

Second it was built where it fends of precisely those clients whose financial needs we most expect our banks to attend, namely those of small businesses and entrepreneurs, those who could provide us our next generation of decent jobs and who have no alternative access to capital markets.

Now with their Basel III the Basel Committee insists on rebuilding with the same faulty materials on the same wrong place and it would seem that we are allowing them to do so.

I am trying to stop them… are you going to help me or do you prefer to swim in the tranquil waters of automatic solidarity with those who are supposed to know better?

The implicit stupidity of the current Basel regulations could, seeing the damage these are provoking, represent an economic crime against humanity!

We are all being subject to a “Razzle Dazzle 'em, Bazzle III 'em” scheme

In Basel III, as in Basel II, the capital requirements are set “in relation to risk-weighted assets (RWAs)” even though it was the risk weights which proved to be most wrong.

It was a low risk weight of only 20% which generated a capital requirement of only 1.6 percent (.08 x .2) allowing banks to leverage 62.5 times to 1, which drove the banks to stampede after the triple-A rated securities collateralized with lousily awarded mortgages to the subprime sector.

Also if a bank lends to a small business then it needs 8 percent in capital but if it instead lends that money to the government of a sovereign rated AAA to AA then the bank needs no capital for the risk-weighted assets since the weight is 0%... lunacy!

Since the risk weights have not been modified at all in Basel III, let me assure you that the Basel Committee still has no idea about what they are doing. Frightening!

Basel III does mention that “These capital requirements are supplemented by a non-risk-based leverage ratio that will serve as a backstop to the risk-based measures described” but since that supplement seemingly will be small and what really counts are the marginal capital requirements for different assets Basel III does not provide a solution.

The Basel Committee is still so fixated with looking at the gorilla called “perceived risk” so as to completely lose track of the ball.

No financial or bank crisis has ever occurred from something ex-ante perceived as risky they have all resulted, no exceptions, from excessive lending or investment in something perceived as not risky.

Basel III still constitutes an arbitrary and regressive discrimination of small businesses and entrepreneurs whose needs we in fact most want our banks to attend. With the same risk-weight discriminations, the higher the capital requirements are, the higher the real effective discrimination.

Banks were authorized by the Basel Committee to lend to Greece leveraging 62.5 to 1! Now even after being sunk, we are still in the hands of exactly the same banks with exactly the same regulators following exactly the same fundamentally faulty regulatory paradigm… Help!

Give 'em the old Razzle Dazzle, Razzle Bazzle 'em,

Show 'em the first rate sorceror you are

Long as you keep 'em way off balance

How can they spot you've got no talent

Razzle Dazzle 'em, Bazzle III 'em,

And they'll make you a star!

The financial crisis: The simple why and what to do?

When I talk about an authorized leverage of "64.5 to 1" the real figure is "62.5 to 1". Since there could be some debate on whether I was trying to see if you were following me, catch you sleeping, or because I did not use a calculator I made a mistake... be my guest and pick any explanation you choose, it won´t matter anyhow for the conclusions… and I will not repeat the class just because of that.

The six questions the Financial Regulatory Establishment refuses to answer.

1.- Knowing as we know that all bank or financial crisis have had their origin in excessive investments in what was ex-ante is perceived as having no risk... can you please explain the rationale behind a regulatory system that by means of allowing much lower capital requirements when lending or investing in anything is related to triple-A rated operations, provides the banks further incentives to accumulate excesses in what ex-ante is perceived as having lower risks?

2.- Knowing as we know that a perfect credit rating, though providing some useful information for capital allocation, provides none of the two sides in a operation with any real profit, something which only wrong risk appreciations can do, the wronger the larger the profits for the side that benefits... what is the rationale behind empowering the credit rating agencies with asymmetrical risk information oligopolies which dramatically increases the financial system´s exposure to catastrophic systemic risk?

3.- What is the rationale of a regulatory system where if the bank lends to an unrated small business or entrepreneur it needs to have 8 percent in capital but, if it instead lends to the government of an AAA rated sovereign, like the USA, so that government bureaucrats lend or give stimulus to the unrated small businesses and entrepreneurs, the banks need to hold zero capital? Is this not plain pro too-obese-to-succeed government regulation? What do the interest rates on public debt really signal with this type of regulations interfering?

4.- If a bank was required to have the same capital when lending to a country with a credit rating like that of Greece before year end 2009, as when lending to a small unrated businesses, then it could leverage itself 12.5 to 1. If it then made a spread of .5 percent when lending to a Greece it would obtain a return on capital of 6.25percent per year. But since the banks were allowed to do the above with only 1.6 percent in capital they could leverage their capital 62.5 to 1 and earn 31.25 percent on capital. Is this not exactly the stuff from which unbelievable bonuses are made of? Is this not exactly the growth hormones that results in too-big-to-fail banks?

5.- How come when regulating the banks the Basel Committee does not establish what is the purpose of banks? Is that not a pre-requisite for adequate regulation? When you regulate traffic it is to facilitate the traffic between two points... not to guarantee that the road will never need maintenance. Do the regulators really aspire for a world where there are no bank defaults? I shiver at the thought!

6.- Institutionally and given that the world will be in need of more global regulations, how is the oversight of the Basel Committee and the Financial Stability Board managed? To whom are they transparently accountable? I ask this because for instance if we had delegated the solving of global warming into a global institution that made mistakes like those made in the regulation of banks... there´s no question we would all be toast.

The questions at the IMF blog

What a flabby pillar!

When the credit ratings are perfect, borrowers pay the exact interest rate and lenders earn the exact interest rate and so there is no profit for anyone.

Therefore the implicit profit driver in any operation using credit ratings is for these to be off as much as possible.

That is when you can sell a badly awarded mortgage of $300.000 at 11% for 30 years for $510.000 because when packed in a triple-A rated security you could convince someone 6% was a great rate.

And so I ask… how on earth could the regulators use as a pillar of their regulations the assumption that the credit ratings were to be right and people would trade without a profit motive? Seems to me like a very a flabby pillar!

What do the financial regulations say about the mental capacity of the regulators, and ours?

1st Quadrangle: Excessive lending to those who are perceived as having a low risk of default:

2nd Quadrangle: Excessive lending to those who are perceived as having a high risk of default:

3rd Quadrangle: Insufficient lending to those who are perceived as having a low risk of default:

4th Quadrangle: Insufficient lending to those who are perceived as having a high risk of default:

Let us analyze which role each quadrangle plays in causing a financial crisis.

By far, the most likely and perhaps even exclusive cause of a financial crisis is found in the first quadrangle that of excessive investments to what was perceived ex-ante as not being risky.

Next, insomuch as it could cause a problematic lack of economic development, we could mention quadrangle 4 that of insufficient investments to those representing an ex-ante higher risk of default.

Quadrangle 3 that of insufficient lending to those who are perceived as having a low risk of default is quite unlikely to occur.

Finally, what really never ever causes a financial crisis, as it goes against the coward nature of capitals and bankers, is quadrangle 2 represented by an excessive lending to those who are perceived as having a high risk of default.

If we then observe how the current regulators have imposed very low capital requirements, zero to 1.6 percent on the quadrangles represented by those being perceived ex-ante as having a low risk of default, and a much higher though quite reasonable 8 percent on the quadrangles represented by those who ex-ante are perceived as having a high risk of default, what does this say about the mental clarity of the current regulators?

I can only conclude in tha they are thick as a brick! And so are we, allowing these regulators to play out, totally unsupervised their bedroom fantasies of a world without any bank failures.

What on earth are we to do with a world where no banks fail when doing their jobs and we all might fail because banks are not doing their job?

Q. Where do bankers' bonuses come from?

A. From huge bank profits of course.

Q. Where do then huge bank profits come from?

A. From lending using little own capital and from trading faulty risk assessments.

Q. Can you please explain?

A. Of course!

Lending: If a bank had to keep 8 percent of capital when lending to triple-A rated borrowers, the same as when lending to a small business, and which implies a leverage of 12.5 to 1, then if the margin on that lending was .5 it would earn a profit of 6.25%, decent but nothing to write home about. But, when courtesy of the regulators they are allowed to hold only 1.6 percent in capital, and which implies a leverage of 62.5 to 1percent, then the margin on lending to triple-A clients have the potential to increase to 31.25 percent a year (.5 x 62.5), meaning that type of stuff that real big bonuses are made of.

Trading: The profits from trading a paper with an absolute perfect credit rating are nil. But the profits from selling a paper that is much riskier than their credit rating indicates, or buying a paper that is much less risky than their credit rating indicates, those can be huge. A risky 11%, 30 years, $300.000 mortgage, sold as what it is could be worth even less than $300.000. But, sold as part of a triple-A security believed to merit a return of only 6%, it is worth $510.000, resulting in an immediate profit of $210.000…meaning that kind of stuff that real big bonuses are made of.

Conclusion: If you think bank profits and bankers´ bonuses are excessive, then you need to focus much more on where the stuff is generated and much less on how it gets distributed.

¿Reguladores tapados?

Por cuanto ni la mejor regulación bancaria del mundo serviría para algo dentro de un entorno económico tan absurdo como el nuestro, lo siguiente no es un tema muy relevante para Venezuela. No obstante habiendo desde 1997 criticado las regulaciones bancarias globales surgidas del Comité de Basilea, de vez en cuando necesito retomar el tema.

El pilar fundamental y casi único de las regulaciones de Basilea, son unos requerimientos de capital que se basan en el riesgo del no pago, tal como este riesgo sea percibido por las agencias calificadoras de crédito. No obstante que eso pueda sonar lógico, a más riesgo más capital, considero a tales requerimientos un absurdo. Permítame explicar.

Primero. Por cuanto los capitales y los banqueros en esencia son cobardes, jamás en la historia ha ocurrido una crisis financiera o bancaria que se haya derivado de un exceso de préstamos o inversiones en algo que a priori se haya considerado como riesgoso. Todas las crisis bancarias y financieras, sin exclusión y hasta casi por definición, han resultado del exceso de préstamos o inversiones en lo que a priori se ha considerado no tener riesgo alguno.

En tal sentido, incentivar a los bancos a prestar o invertir más en lo que a priori se percibe como de menor riesgo va en contrasentido a lo que la historia nos indica… por lo que me permito creer que los reguladores allá en Basilea, o están metidos en un club de mutua admiración con una discusión incestuosa degenerante o son simplemente unos tapados.

Segundo. Por cuanto quienes se perciben como de poco riesgo casi siempre tienen acceso a los mercados de capitales, son las pequeñas y medianas empresas, las que sin duda son más riesgosas, quienes de verdad más necesitan de los bancos para satisfacer sus necesidades financieras.

En tal sentido, el dificultarle a los bancos, en términos relativos, el prestar o invertir dinero justamente a quienes más los necesitan; siendo además estos clientes los más probables proveedores de los empleos decentes del mañana, carece totalmente de sentido… por lo que me permito creer que los reguladores allá en Basilea, o están metidos en una discusión en un club de mutua admiración con una discusión incestuosa degenerante o son simplemente unos tapados.

Tercero. Veamos lo que actualmente rige en muchos países. Si un banco desea efectuar un préstamo a una pequeña y mediana empresa entonces se le requiere tener 8 por ciento de capital. Pero si ese banco le presta al gobierno de uno de los soberanos clasificados como AAA, para que sus burócratas le hagan los préstamos a las pequeñas y medianas empresas de su agrado, entonces el banco no necesita de capital alguno.

En tal sentido, hay vemos que un socialismo incompetente del siglo XXI, no es una exclusividad venezolana. Hasta Dalí se queda chiquito en surrealismo comparado con lo que inventan los reguladores bancarios del Comité de Basilea. Ya causaron su primera crisis global con esa estampida en busca de los triple-A que provocaron. Falta ver lo que nos harán la próxima.

La semana pasada, en una competencia donde el G20 anda pescando soluciones para ver cómo el sector privado financia más y mejor a la pequeña y mediana empresa, presenté una propuesta dirigida a corregir parte de lo que he criticado. Si les interesa, pueden ver cómo me irá en mi pelea contra el establishment regulador global, en la página web de www.changemakers.com/en-us/SME-Finance 

We’re in big trouble with these financial regulators!

I have just read the “Interim Report: Assessing the macroeconomic impact of the transition to stronger capital and liquidity requirements” produced by the Macroeconomic Assessment Group established by the Financial Stability Board and the Basel Committee on Banking Supervision.” August 2010.

By far the most prominent feature of the current bank regulations is that it discriminates the capital requirements for the banks based on the perceived risk of default, and therefore for instance allows a bank to leverage up their capital 62.5 times to 1 when lending or investing to triple-A rated clients while only permitting them to leverage up 12.5 to 1 when lending to unrated small businesses and entrepreneurs.

If a triple A rated client presented the banks with a margin of .5 percent then had it been regulated like when the bank lent to the small business, it would have produced the bank a return of 6.25 percent, decent but nothing to write home about. Instead because of the regulators’ inexplicable largess it could obtain a return of 31.25 percent a year. No wonder our banks disappeared in the AAA swamps and our small businesses and entrepreneurs, whom we depend so much for our next generation of decent jobs are ignored.

Since the existence of the discrimination which obviously must have macroeconomic impact, is not even mentioned as a problem, much less studied, I assume the document to be basically worthless, as it clearly reflects that those who wrote it know little about banking and care even less about its purpose.

Basically it is the same authors, or type of authors who, in “An Explanatory Note on the Basel II IRB Risk Weight Functions” of July 2005, produced a prime candidate for the mother of all bullshit papers ever, where they assured us that “The confidence level is fixed at 99.9%, i.e. an institution is expected to suffer losses that exceed its level of tier 1 and tier 2 capital on average once in a thousand years.”

Indeed, we’re in big trouble with these financial regulators!