Tuesday, June 22, 2010

Lord Turner, please help save the world from our financial regulators´ regulatory exuberance!

In June 2010, during a conference given by Adair Turner at the Brookings Institute, I asked the following: 

1:20:07 MR. KAROFSKY: Pere Karofsky (In the transcripts that's me) from the Voice of Noise Foundation (You can also hear it in the audio).

"Big companies in consolidated sectors, like BP in oil, tend to have much better credit ratings than those participating in developing markets like wind energy. Do you really think the banks will perform better their societal capital allocation role if regulators allow them to have much lower capital requirements when lending to the consolidated sectors than when lending to the developing? Do you think we can reach a meaningful financial regulatory reform without opening up the discussion on the issue of risk in development? I mean to combat the regulatory exuberance of the Basel Committee."

1:26:08 To that Lord Turner responded: "The point about lending to large companies development, I'm not sure. I'm trying to think about that. I mean we try to develop risk weights which are truly related to the underlying risks. And the fact is that on the whole lending to small and medium enterprises does show up as having both a higher expected loss but also a greater variance of loss. And, of course, capital is there to absorb unexpected loss or either variance of loss rather than the expected loss. I think, therefore, it's quite difficult for us to be as regulators, skewing the risk weights to achieve, as it were, developmental goals. There are some developmental goals, for instance, in a renewable energy, which I'm very committed to wearing one of my other hats on climate change, where I do think you may need to do, you know, in a straight public subsidy rather than believing that we can do it through the indirect mechanism of the risk weights. So I may have misunderstood your question, but I'm sort of cautious of the sort of the leap to introducing developmental roles into -- I think we, as regulators, have to focus simply on how risky actually is it?"

I replied (not authorized, perhaps even rudely) the following: 1:27:19 

"But you do do make all regulatory discrimination based on credit risk and that risk is just one of the many risk we face".

My prime conclusion of it all was that when Lord Turner states "capital is there to absorb unexpected loss, or either variance of loss rather than the expected loss" he does not understand the sillines of estimating unexpected loss using expected loss. The safer something is perceived de facto de larger its potential to deliver unexpected losses. And he also does not understand the purposelessness of weighing capital requirements based on one of the only risks banks have already cleared for, by means of risk premiums and the size of the exposure

And on June 22, 2010 I sent Lord Turner the following letter:

Dear Lord Turner.

In November 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 at the end will cause the collapse of the last standing bank in the world.”

There has never ever been a major or systemic bank crisis that has resulted from the banks being involved with what ex-ante was perceived as risky; they all resulted from lending and investing in what ex-ante was considered as not risky, given the returns offered. 

But then came the Basel Committee regulators and, to top it up, lowered the capital requirements for what ex-ante is perceived by the credit rating agencies as having lower risks, which of course increased the banks’ expected ex-ante returns from pursuing these “low risk” opportunities. 

And now, when two years after an explosion that resulted from so many banks following the minuscule capital requirements when investing in securities collateralized with subprime mortgages; and there is a bank explosion awaiting round the corner because of the minuscule capital requirements when lending to well rated fancy sovereigns, like Greece; they keep on applying the same regulatory paradigm of risk-weighted assets, we can only deduct that our financial regulators simply do not get it, not even ex-post.

Please, Lord Turner, help save the world from our financial regulators´ regulatory exuberance!

Per Kurowski
A former Executive Director of the World Bank (2002-2004)

I received and answer but since its states "This communication and any attachments contains information which is confidential and may be subject to legal privilege" I refrain from making it known unless I am duly authorized.

But I then answered:

Dear Lord Turner

Yes, we met yesterday at Brookings... and it is not only that “our ability to know ex ante what is low and high risk is clearly limited and we have undoubtedly placed too much faith in apparently sophisticated but conceptually flawed VAR type approaches” but that, ex-post, the most benign risk for the society, might be the risk of default on which the regulators concentrate exclusively.

Think about the horror or a world without defaults and with corporations and banks becoming larger and larger. What about the risks of our banks not performing efficiently their role in allocating capitals?

By the way, lending to Greece and BP required the banks to have only 1.6 percent in capital.

Per Kurowski

To that I received no answer.