Saturday, December 22, 2012

The Basel II Roulette Manipulation

Because of what they perceive as reckless speculative risk-taking by banks, many refer to banking as a casino. And so let us think of the alternative loans and investments a bank can make, as the alternative bets on a roulette table.

On it there were for instance “Safe Bets”, black or red, with a payout of 1 plus the bet; “Intermediate bets”, columns, with a payout of 2 plus the bet; and “Risky Bets”, any single number, with a payout of 35 plus the bet. All bets had of course a similar expected value of return, the same risk-adjusted return, though in the case of the roulette, a somewhat negative one, because the House always wins when the zero or double zero comes up, the House Edge. In banking, good credit and investment analysis, is expected to provide positive yields, even for the "zero" and "double zero".

But imagine then that a Basel Committee for Roulette Supervision suddenly got too concerned with that some players were making too many risky plays, and losing all their money, very fast, and that this was something for which they felt that, as a regulatory authority, they could be blamed for, and so decided to do something about it.

And so they decreed their Basel Roulette II Regulations and by which, in order to keep the players playing longer and not losing it all so fast, they allowed the payout for “Safe Bets” to be five times higher, 5 plus the bet, the payout for “Intermediate Bets” double the current, 4 plus the bet, while the payout for “Risky Bets” would remain the same, 35 plus the bet. 

And so what do you think would happen? Just what had to happen! Every player ran to make “Safe Bets”, and now and again, just for kicks, perhaps an “Intermediate Bet”, but they all stayed away from “Risky Bets”, since these just did not make sense any longer.

And the players got so excited with their profits, and bet more than ever, and so when suddenly the zero or double zero appeared, as had to happen, sooner or later, they lost fortunes, and really got wiped out, more than ever, and to such an extent that the casino even had to pay for their taxi ride home. 

Before current Basel bank regulations, all bank lending or investment alternatives produced basically the same expected risk and cost of transaction adjusted returns on equity; because that is what a free competitive market and banking mostly produces. But this was precisely what The Basel Committee for Banking Supervision changed when, with their Basel II, they imposed different risk-weights to determine the capital requirements for banks for different assets.

For instance, when lending to “The Infallible”, like “solid sovereigns” and what is triple-A rated, the banks had to hold only 1.6 percent in capital, and so were allowed to leverage their equity 62.5 times to 1. And that is FIVE times as much allowed leverage than when lending to “The Risky”, like small businesses and entrepreneurs, and where banks had to hold 8 percent in capital and therefore could only leverage their bank equity 12.5 to 1. And for “The Intermediate”, in a similar fashion, a doubling of the pay-out ratio, to 25 to 1 was authorized. 

This absolutely loony manipulation of the odds of banking; and which obviously not only guaranteed that when disaster struck the banks would be standing there naked without any capital; also made it impossible for the banks to perform with any sort of efficiency their vital role of allocating economic resources. 

And the most crazy thing is that soon five years after the disaster occurred, this manipulation of the odds of banking is not even being discussed, and the regulators with Basel III are even adding on liquidity requirements based on perceived risk, which can only have a similar effect of improving the expected risk-adjusted returns from lending to “The Infallible” instead of lending to “The Risky” 

And instead of discussing this monstrous and odious odd manipulation that favors those already favored, "The Infallible", and discriminate against those already discriminated against “The Risky” the world, and the specialized press, like Financial Times, keep themselves busy with the clearly illegal, but immensely less relevant “Libor Affair”.

Poor us! These banking regulations are castrating our banks, making them sing is falsetto by accumulating more and more on their balance sheets exposure to the safe-havens perceived as not yet too dangerously overpopulated; while avoiding like the plague exposure to the more risky but probably more productive bays where our young could find the next generation of jobs they so urgently need.

PS. And it would be so comic, if not so tragic, that absolutely most experts, including Nobel Prize winners, keep on referring to the crisis as a result of excessive risk-taking by banks, and which is of little assistance when trying to explain that what all banks were doing, was betting excessively on boring safe bets, red or black, and this only because of bad regulations… rien ne va plus.