Friday, November 26, 2010

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.

Saturday, November 20, 2010

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.

Wednesday, November 17, 2010

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.

Tuesday, November 16, 2010

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.

Monday, November 15, 2010

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.

Sunday, November 14, 2010

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?

Thursday, November 11, 2010

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.