Sunday, August 29, 2010
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!
Saturday, August 21, 2010
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?
Friday, August 20, 2010
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.
Thursday, August 19, 2010
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
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!
Saturday, August 14, 2010
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.
Saturday, August 7, 2010
Never has there been a financial or bank crisis that has originated from too much investments or lending to what was perceived as being risky… capitals and bankers are much too coward for that.
All financial or bank crisis have always originated from lending or investing too much in what was wrongly perceived as not risky… even Dutch tulips would certainly have had an AAA rating.
So when therefore we see how regulators were fooled into giving bankers special incentives for investing or lending to what is perceived as not being risky, by means of allowing in those circumstances the banks to have specially low capital requirements, we can only conclude that the regulators in the Basel Committee are thick as a brick… just like we are when we allow those same regulators to keep on regulating.
If the handicap officials on a racetrack took of the weights from the best horses and placed these on the weakest… would they be allowed to remain as handicap officials? I don’t think so!