World Bank, "Knowledge Bank”, why have you shut out the voice of a former Executive Director who clearly and timely warned about bad bank regulations?

From November 2002 through October 2004, I was one of the 24 Executive Directors (EDs) on the Board of the World Bank. And those were the years when bank regulations known as Basel II and which were approved in June 2004 were much discussed. And I was totally set against these.

Already in November 1999 in an Op-Ed titled “The SEC, the human factor, and laughing” I had written “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, of the only remaining bank in the world”

In February 2000, in an Op-Ed titled “Kafka and global markets" I warned about the following risks with global bank regulations:

1. A diminished diversification of risk: No matter what bank regulators can invent to guarantee the diversification of risks in each individual bank, there is no doubt in my mind that less institutions means less baskets in which to put one’s eggs. One often reads that during the first four years of the 1930’s decade in the U.S.A., a total of 9,000 banks went under. One can easily ask what would have happened to the U.S.A. if there had been only one big bank at that time.

2. The risk of regulation: In the past there were many countries and many forms of regulation. Today, norms and regulation are haughtily put into place that transcend borders and are applicable worldwide without considering that the after effects of any mistake could be explosive.

3. Excessive similitude: By trying to insure that all banks adopt the same rules and norms as established in Basel, we are also pushing them into coming ever closer and closer to each other in their way of conducting business. Unfortunately, however, nor are all countries the same, nor are all economies alike. This means that some countries and economies necessarily will end up with banking systems that do not adapt to their individual needs.

4. The cost of global assistance: When Venezuela’s banking system went down the drain, there is no doubt that the cost of the crisis was paid integrally by the country itself. In today’s world, when we see that a series of international banks are investing in our country’s institutions, I often wonder what will happen when one of these behemoths runs into serious trouble in its own country. Will we have to pay for our part of the crisis, less than our part of the crisis or more than our part of the crisis?

In July 2002, firmly believing that risk-taking is the oxygen of development I was especially critic of Basel Bank regulations when applied in a developing country, as this quote, from an Op-Ed titled “Our economic policies suffer an inferiority complex” shows: “Our country has adopted, without blinking an eye, the regulations coming out of the Basel Committee, that are more appropriate for the banking sector of a developed country than for ours. There is nothing wrong being a developing country, the bad is only to believe that by just adopting different postures, one could reach a different degree of maturity… just like the little girl who borrows mother´s lipstick in order to feel big.”

And in September 2002, in an Op-Ed titled “The riskiness of country risk” I wrote the following: “If they underestimate the risk of a given country, the latter will most assuredly be inundated with fresh loans and will be leveraged to the hilt. The result will be a serious wave of adjustments sometime down the line. If on the contrary, they exaggerate the country’s risk level, it can only result in a reduction in the market value of the national debt, increasing interest expense and making access to international financial markets difficult. The initial mistake will unfortunately turn out to be true, a self-fulfilling prophecy.”

And so, even though I had never been a regulator, or a full-fledged banker, you can understand what was in my mind when I took up my duties as an ED. And, through my full two years I did as much as I could to express, in all shapes of forms, what I felt was wrong with the regulatory paradigm imposed by the Basel Committee for Banking Supervision.

Most of my more technical objections were expressed in the Audit Committee of the World Bank, of which I was a member, certainly the most vociferous one. I have no formal records of these meetings but any other ED member of that Committee or the WB staff who assisted should be able to attest my constant warnings about “counter-party risks” and about the AAA-bomb that was doomed to explode in the midst of our banking system. (I never knew specifically what AAA rating would explode, where and when, but I was certain one would)

But outside of that Committee I also spoke out and on this many records exist:

In January 2003 I finished a letter that the Financial Times published with “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds”

In March 2003 in a formal statement at the Board commenting the Global Development Finance 2003 report I wrote as example:

“In this otherwise very complete report there is no mention about the issue of the growing role of the Independent Credit Rating Agencies, and the systemic risks that might so be induced, when they are called to intervene and direct more and more the world’s capital flows. 

It is not a small issue. Today many insurance companies and pension funds are already limited by the credit ratings for their investments and, for banks we are only told things will get worse. 

The sole fact that emerging countries, when affected by lower credit ratings, face additional difficulties to access investors with availability of long term financing, forces them into more short term arrangements which, compounded by the much higher rates charged, almost guarantee a crisis, once the snowball starts rolling. 

The document does not analyze at all a very fundamental risk for the whole issue of Development Finance, being it that the whole regulatory framework coming out of the BCBS might possibly put a lid on development finance, as a result of being more biased in favor of safety of deposits as compared to the need for growth. 

As the financial sector grows ever more sophisticated, making it less and less transparent and more difficult to understand for ordinary human beings, like EDs, it is of extreme importance that the World Bank remains prudently skeptical and vigilant, and not be carried away by the glamour of sophistication. In this particular sense, we truly believe that the World Bank has a role to play that is much more important than providing knowledge per-se and that is the role of looking on how to supply the wisdom-of-last-resort.”

And also In March 2003 in a verbal statement as an ED at the board on the Financial Sector Assessment Program I urged the following: “Basel is getting to be a big rule book,” and, to tell you the truth, the sole chance the world has of avoiding the risk that Bank Regulators in Basel, accounting standard boards, and credit-rating agencies will introduce serious and fatal systemic risks into the world is by having an entity like the World Bank stand up to them—instead of rather fatalistically accepting their dictates and duly harmonizing with the International Monetary Fund.” 

In April 2003, discussing the World Bank’s Strategic Framework 2004-2006, I again urged: “Basel dictates norms for the banking industry that might be of extreme importance for the world’s economic development. In Basel’s drive to impose more supervision and reduce vulnerabilities, there is a clear need for an external observer of stature to assure that there is an adequate equilibrium between risk-avoidance and the risk-taking needed to sustain growth. Once again, the World Bank seems to be the only suitable existing organization to assume such a role."

In May 2003, in comments made at a workshop for regulators at the World Bank: I said among others: “A regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises. Knowing that “the larger they are, the harder they fall,” if I were regulator, I would be thinking about a progressive tax on size”. Please, if you can read my comments in their entirety

Also in May 2003, in an Op-Ed on Basel bank regulations I warned: “In a world that preaches the worth of the invisible hands of the market, with its millions of mini-regulators, we find it so strange that the Basel Committee delegates, without protest heard, so much responsibility in the hand of so very few and human-fallible credit rating agencies… Perhaps we need to include a label that states: Warning, excessive banking regulations from the Basel Committee can be very dangerous for the development of your country”

And in October 2004, in a written formal statement delivered as an ED at the Board of the World Bank I wrote: “Phrases such as “absolute risk-free arbitrage income opportunities” should be banned in our Knowledge Bank. We believe that much of the world’s financial markets are currently being dangerously overstretched though an exaggerated reliance on intrinsically weak financial models that are based on very short series of statistical evidence and very doubtful volatility assumptions.”

And then finally, in November 2004, having just concluded my term as an ED, in a letter published by the Financial Times I wrote: “Our bank supervisors in Basel are unwittingly controlling the capital flows in the world. How many Basel propositions it will take before they start realizing the damage they are doing by favoring so much bank lending to the public sector (sovereigns)? In some developing countries, access to credit for the private sector is all but gone, and the banks are up to the hilt in public credits. Please, help us get some diversity of thinking to Basel urgently; at the moment it is just a mutual admiration club of firefighters”

Sincerely, how many can like me document having timely warned about the impending AAA-bomb that exploded in 2007?

And now eight years have gone by since I ended my term as an ED of the World Bank. During these years I studied more in depth the Basel bank regulations, something which as an ED I never had time to do, and what I found has just shocked me more. These regulations are utterly dangerous. 

I even passed the exams needed to be a licensed real estate and mortgage broker (in Maryland) so as to better understand what happened with the AAA rated subprime debacle. That only confirmed to me my suspicions that what was most to blame were the faulty bank regulations.

Over the years I have refined my arguments keeping active two blogs on the issue; Subprime Regulations and Tea With FT. These blogs jointly have until now received about 140.000 hits, which is not bad for blogs on boring bank regulations which on top of it all do not accept comments, as I have no time to answer these. I had picked out the Financial Times as a channel to give my small voice more volume, but unfortunately I must have trampled on someones ego there or they just do not understand. I have though not given up on FT

And there are even some youtube videos floating around where I try to find the words that will allow me to shatter the current regulatory paradigm that has proved resistant beyond belief.

Given my interest in the issue of bank regulations I also tried, in-numerous times, to qualify for a staff job at the World Bank in the area of financial regulations, but I never made it even to a short-list. I guess c’est la vie!

But what I must confess really upsets or saddens me, especially since the World Bank has a great meaning to me, and I absolutely feel the World Bank should be in the forefront of explaining to the world the importance of risk-taking for development, is that over the years I have assisted to countless conferences at the World Bank on the issue of bank regulations, having had to listen mostly to the same invited speakers over and over again, and never have I been given an opportunity to address directly the World Bank staff with my arguments. 

In that respect I have been strictly limited to some interventions in the Q. and A. sessions of such conferences and a 5 minute chance to speak in one of the Civil Society sessions during spring and fall meetings, and this was only the courtesy of a civil society.

And so of course I feel have earned the right to wonder… how comes a “Knowledge Bank”, like the World Bank, can shut out so completely the voice of some who has inside its own walls shown to know and to timely warn?

The Independent Evaluation Officer of the IMF (IEO) in their report “IMF Performance in the Run-Up to the Financial and Economic Crisis: IMF Surveillance in 2004-07” of 2011 wrote: 

“The IMF’s ability to correctly identify the mounting risks was hindered by a high degree of groupthink, intellectual capture, a general mindset that a major financial crisis in large advanced economies was unlikely, and inadequate analytical approaches. Weak internal governance, lack of incentives to work across units and raise contrarian views, and a review process that did not “connect the dots” or ensure follow-up also played an important role, while political constraints may have also had some impact.”

Although the many research and articles published by the World Bank points at some incestuous relations, in the case of the World Bank more than groupthink I attribute its failings in discussing bank regulations to group-deafness, most of that resulting from that horrendous “harmonization agreement” signed with the IMF.

And now ten years later than the Global Development Financial Report 2003 that I commented on above, I find that the Global Development Financial Report 2013 only quite meekly comments on the role of “The State as Regulator and Supervisor”, timidly putting forward: “A key challenge of regulations is to better align private incentives with public interest without taxing or subsidizing private risk-taking”; but without getting into what taxes and what subsidies they really refer to.

Well let me give you a very brief summary on what the regulators did in very simple terms.

By allowing the banks to hold much less capital when lending or investing in the “absolutely not risky”, The Infallible”, than when lending to “The Risky”, the small businesses and entrepreneurs, they allowed the banks to obtain much higher risk-adjusted return on equity when financing "The Infallible" than when financing "The Risky". And that translates into a huge regulatory subsidy to "The Infallible" and therefore a huge regulatory tax on "The Risky".

And that: 

Guarantees that bank exposures to The Infallible, those who always are the origin of bank crises when their infallibility fails will be higher than ever.

Guarantees that the gap between The Infallible and The Risky will only widen

Guarantees that the safe-havens will become dangerously overpopulated

Guarantees that small businesses and entrepreneurs, will not have an equal opportunity accessing bank credit, and so will therefore not be able to help out as much creating jobs.

World Bank, why have you not yet used your huge voice to ask bank regulators to clearly define the purpose of banks before they regulate these?

It has also been sad for me to see that otherwise splendid "World Development Report 2013: Jobs" not including a word about what I most feel is absolutely necessary to create the next generation of jobs, namely abandoning the unreasonable risk-adverseness that is embedded in the Basel bank regulations.

Really, what is the use of Executive Directors, if their recommendations and warnings can be so blithely ignored by a World Bank that proudly has referred to itself as "The Knowledge Bank"?