My response to the G-20 SME Finance Challenge

Friends,

The Group of 20 and Ashoka’s Changemakers, with support from the Rockefeller Foundation, launched the G-20 SME Finance Challenge, where competitors are to submit proposals on solutions or projects for how public finance can unlock private finance to small and medium enterprise on a sustainable and scalable basis. 

The goal is to identify catalytic and well-targeted public interventions to unlock private finance for SMEs. Maximizing leverage of scarce public resources is at the core of the Challenge.

The following is my proposal:

The taking of risks is the oxygen of any development!

We need to eliminate the regressive discrimination of SMEs caused by imposing different capital requirements on banks based on perceived risk of default. Its primary reason is that risk of default of a debtor is a natural, manageable and secondary degree risk that banks and society need to take. As a bonus it also corrects a huge regulatory error that only increases the possibilities of systemic disasters.”

Here follows some of the questions and answer given on the entry form:

What makes your innovative solution unique? 

It rejects completely the first pillar of the current regulatory paradigm developed by the Basel Committee, that of construing “safer” banks by means of discriminating precisely against those whom, because of their limited access to capital markets, the banks should most help with their lending, the SMEs. 

To discriminate against the more “risky” while favoring those who because of their good credit ratings most likely already have access to the capital markets, is nonsensical. 

It is like the handicap officials on a racetrack taking off weights from the stronger horses and placing them on the weaker. It could only have been thought up by regulatory zealots who, shortsightedly, have only the immediate safeness of the banks on their minds and care little or nothing about development and banks’ real long term purpose. 

If you consider how unelected officials are influencing in a quite non-transparent way how global finances operate, I also hope this proposal helps to open up a much needed debate on regulatory transparency.

How does your proposed innovation leverage public intervention in catalyzing private SME finance?

If a bank was required to hold the same capital requirement when lending to a triple-A rated company than it has to hold when lending to an SME, namely 8 percent, it could leverage its capital 12.5 times to 1. If the bank then made a margin of .5 percent when lending to the triple-A rated, it would obtain a total return on capital of 6.25 percent. 

But, since the regulators allow the banks to hold only 1.6 percent in capital when lending to the triple-A rated, and so that they could therefore leverage themselves 62.5 to 1, the total capital return on this lending for the banks becomes instead 31.25 percent. 

To make up for that difference of 25% of regulatory advantage awarded to the triple-A lending (31.25-6.25), and be able to compete for access to bank credit, the SMEs therefore need to pay an additional interest rate of 2 percent (25/12.5), on top of the higher risk premiums they are anyhow charged with because of their higher perceived and real risk. 

Leveling the playing field, by eliminating this arbitrary regressive and discriminatory regulatory tax on risk that affects many of those accessing bank credits, is the most important public intervention needed in order to catalyze private SME financing. 

As an important bonus it would also remove the regulatory incentives which caused the stampede after triple-As in the market and thereby originated the current crisis. 

What barriers does your proposed solution address? Describe how so? 

SMEs are more prone to be considered as risky. Therefore the elimination of the current regulatory de-facto tax on the perceived risk of default will help to decrease the disincentives for the banks to serve these clients; or, in other words, it will increase the competitiveness of SMEs in their race against all those perceived to represent lesser risk for access to bank credits.

In the same vein the natural higher transaction costs for financial intermediaries to lend to SME’s would cease to be further compounded by the costs derived from higher discriminatory capital requirements. 

Additionally it would help to fight the excessive asymmetrical empowerment of the credit rating agencies as credit information providers, and thereby help to reestablish banking as a truly accountable profession that is not induced to rely robotically on a general type of GPS guidance system. In other words, it will provide an opportunity for bankers to be bankers again.

Provide empirical evidence of your proposed solution’s success/impact at present: 

This should be superfluous. The genesis of the current financial crisis was the stampede after the incentivized and open to capture triple-A ratings; and which since there were naturally not enough of these AAAs to satisfy the demand, being the AAAs in many ways only fidgets of imagination, this led the markets to provide some Potemkin ratings instead. 

It suffices to know that since capital and bankers are by nature coward, the world would have even been better off, if totally opposite capital requirements had been imposed on the banks, meaning capital requirements which progressively discriminated against those who represent lesser perceived risk. In such a case there would have been less rush after AAAs, while the lending to “the risky” would never have occurred in volumes that could systemically endanger the system.

All banks crisis in history have always resulted from excessive lending to what is perceived ex-ante as not being risky and no bank crisis has ever occurred because of excessive lending to anything perceived ex-ante as risky. Do you need more empirical evidence than that?

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 indeed the AAA-bomb exploded.

How many firms do you expect to reach?

All SMEs, most of them are not even rated.

What is the volume of private SME finance you aim to catalyze? 

The current capital requirements stimulated trillions of dollars to finance triple-A rated securities collateralized with badly awarded subprime mortgages in the US. I would be satisfied if it could help to catalyze just a decent fraction of that amount in new lending to the SMEs.

What time frame will be required to reach these targets? 

The market lost their trillions in about three years, from mid 2004 until mid 2007. The speed of the proposed adjustment should be further studied carefully monitored in order to avoid any problems in the middle of an economic crisis. 

I envisage the possibility of an immediate reduction of the maximum capital requirements for banks on all lending from 8 percent to 4 percent and then, over a period of 4 to 6 years elevating it to a 8-10 percent capital requirement, on any lending to all type of private borrowers. 

The adjustment of the capital requirements for public debt, and which for triple-As currently amazingly requires no capital at all, could take longer time though. Where would interest rates on public debt be without this arbitrary and non-transparent regulatory subsidy?

Does your innovation seek to have an impact on public policy?

Yes it looks precisely to correct an utterly wrong public policy.

What might prevent your innovative solution from succeeding?

From success, nothing! Though from being implemented, the difficulties with thick-as-a-brick regulators who are unable to break free from their current regulatory paradigm and who have a vested interest of remaining in total control of their own mutual admiration club.

Tell us about the social impact of your innovation. 

Since among the small SMEs we probably have our best chance of finding our next generation of decent jobs, the social impact of this innovative regulatory stepping back cannot be overstated. 

How many SMEs are there and how many more could there be if regulators did not discriminate against them? That is the number of SMEs that will benefit!

Demonstrate how your proposed solution has the capacity to graduate from dependence on public finance. What is the time frame? 

Currently if a bank lends to a SME it is required to have 8 percent in capital but, if it lends to an A-rated government so that this government in its turn can lend or give stimulus to a SME, then it needs zero capital. Could there be a more direct way of decreasing the dependence on public finance…immediately?

Please tell us if your proposed solution aims to scale up through a high growth sector, expand immediately to multiple sectors, and/or scale up geographically.

Absolutely, it aims to be applied to all the countries which have fallen in the current Basel Committee risk-adverseness trap. The fact that many emerging countries did not suffer so much from these regulations has a lot to do with the absence in these countries of AAA rated clients.

Please tell us what kind of partnerships, if any, could be critical to the greater success and sustainability of your innovation. 

We need a complete new crew of bank regulators with diverse backgrounds and able to break out from the current paradigm. 

We also need legislators that dare to face the problem. The final statement of the recent G20 meeting in Toronto mentions the Basel Committee on Banking Supervision 11 times and the Financial Stability Board (FSB) 27 times. But, in the 2319 pages of the Financial Regulatory Reform approved by the US Congress, those entities are not mentioned even once. Such disconnect is unmanageable!

In these days many, including Nobel-prize winners, speak about the excessive risk-taking of banks, while turning a blind eye to the fact that the crisis originated entirely in triple-A operations and so that we could just as well speak about an excessive and regulatory induced risk adverseness. I acknowledge though that this proposal is indeed noisy and difficult to move forward… and so a decided support from sturdy and eager group of changemakers is of course much needed and also much appreciated.

Friends, as you know I have been shouting about this issue for years, to very little avail, since most prefer either not to criticize the regulatory establishment or, for their own piece of mind, to think the regulatory establishment incapable of being as thick-as-a-brick as I hold them to be. In this respect, as you can understand, I very much look forward to the comments from the qualified jurors and commentators… some of whom might have some conflicts of interest on this issue.

By the way, since I am not a PhD, not a financial operator, not a banker and not a bank regulator, and just in case you should think that my criticism, as often happens, is facilitated by a lack of deeper knowledge on the subject, let me just copy below one example of the many formal and informal statements that I gave at the board of the World Bank as an Executive Director (1 of 24) on the subject. In October 2004 I wrote:

“We believe that much of the world’s financial markets are currently being dangerously overstretched through an exaggerated reliance on intrinsically weak financial models that are based on very short series of statistical evidence and very doubtful volatility assumptions.”

Who knows, perhaps after this proposal even the World Bank will invite me to discuss my objections to Basel regulations. Last time I did so, in May 2003, what little I then told them, sort of sent me off to their own Siberia.

Regards,

Per