“The World Development Report 2014 - Risk and Opportunity”, seems to completely ignore what is dumb and dangerous with Basel Committee´s risk adverse bank regulations

In its introduction, Jim Yong Kim, the president of the World Bank, expresses his “hope that the WDR-2014 will lead to risk management policies that allow us to minimize the danger of future crisis and to seize every opportunity for development.”

Sir, though WDR 2014 will surely contribute importantly in many ways and in many areas, unfortunately, with respect to the "Financial Sector", it does little, or even nothing, to help to achieve those goals. This is so because it seems to completely ignore the absolutely mistaken principles of current bank regulations being disseminated around the world. With their dumb and dangerous risk-aversion, these regulations attempt directly against development and stability. More than manage risks, those regulations have generated enormous risks.

More than 10 years ago, April 2003, when commenting on The World Bank’s Strategic Framework 2004-06, in a written statement which I delivered as an Executive Director of the World Bank, I opined the following: 

"The Basel Committee dictates norms for the banking industry that might be of extreme importance for the world’s economic development. In its 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. The World Bank seems to be the only suitable existing organization to assume such a role."

Unfortunately, the World Bank, or any other institution, did not assume such a role, and as a consequence we have landed ourselves with the most dumb and dangerous bank regulations possible.

Before explaining it, let me, just as a reference for why I deserve being listened to, point to a similar statement at the Board on October 19, 2004, and in which I so correctly and timely warned: 

“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.”

The pillar of the Basel Committee’s bank regulations, is capital requirements for banks based on ex ante perceived risks of borrowers. These allow banks to hold much much less capital against assets perceived as “absolutely safe”, “The Infallible”, than against assets perceived as belonging to “The Risky”. A more capable regulator, would be much more concerned about what bankers do with the risks they perceive, and with what happens when those ex ante perceptions, turn out, ex post, to have been wrong.

And those risk-weighted capital requirements result directly in that banks are able to earn much much higher risk adjusted returns on equity, when lending to some sovereigns, housing or the AAArisktocracy, than when lending to the medium and small businesses, entrepreneurs and start-ups. Something like rewarding children with chocolate cake when they eat ice cream, and punishing them with spinach when they eat broccoli... and declaring being surprised when kids turn out obese. And it is all like drastically changing the payouts on roulette bets, and believing the game of roulette will remain the same. 

And since the assessments of safeness and riskiness were to be done by very few human fallible credit rating agencies, on January 2003, in a letter published in the Financial Times, I also warned:

"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. Friends, as it is, the world is tough enough." 

And so those regulations doomed of course the banks to, sooner or later, create excessive and dangerous bank exposures to something that would have erroneously been considered as “absolutely safe”; like AAA rated securities backed with lousily awarded mortgages to the subprime sector, banks in Ireland, real estate in Spain, and sovereigns, like Greece. And doomed the banks to have especially little capital when the biggest disasters struck. It even did the eurozone in. Just a little empirical research on what causes bank crises, would have concluded that... never ever, those ex ante perceived as risky.

And, of course, that also doomed those who though “risky”, are the true dynamos of the real economy, and the best possible creators of the next generation of sturdy jobs, and who are those most in need of bank credit, to have their competitive access to bank credit severely curtailed. And that has effectively placed the economy in a shutdown mode… and whatever movement we might detect in it, might have to do with the sad fact that it is heading down down, on a very slippery slope.

And this truly odious regulatory discrimination is only helping to increase the gap between the past, the developed, the haves, and the future, the developing, the have nots. In other words it excludes more than it includes. WDR-2014 writes: “All too often risk management strategies prove ineffective (or introduce other risks) because they are not coordinated among all relevant policy stake holders”. Indeed! And I ask… who consulted bank regulations with “The Risky” borrowers?

But not one word about all that in WDR-2014!

The WDR-2014 does state though: “Stability. The Achilles’ heel of the financial system is its propensity for crisis”. And that is wrong! Its Achilles’ heel is the propensity to try to delay the crises. May 2003, at the World Bank in a workshop on bank regulations, I told those present: 

“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.” 

And the WDR-2014 does propose creating a "National Risk Board", "an integrated, permanent risk management agency that deals with multiple risks." That might have some advantages, but it also reminds me of why, in November 1999, I had to write in an Op Ed:

"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 its total collapse"

Jim Yong Kim also writes: “This year’s WDR cautions that the greatest risk may be taking no risk at all”. And he is absolutely correct. But, unfortunately, the great institution he presides, the world’s premier development bank, seems not to fully understand that risk-taking is in fact the oxygen of development.

And, therefore, the World Bank has done nothing to stop the members of the Basel Committee, and of the Financial Stability Board, those who with so much hubris believe themselves capable of being the financial risk-managers of the world, from applying their so truly risky risk-adverse bank regulations.

Let me end by reminding you that these regulators, those who after the Basel II flop are still allowed to work on Basel III (neither Hollywood nor Bollywood would be so dumb), were the real enablers of our current bank crisis. If in doubt, just ask yourselves whether the market, in the absence of any bank regulations, would have allowed banks to leverage 50 to 1?

God make us daring! We need bankers capable of reasoned audacity! World Bank, step up to your duties!

Per Kurowski

PS. IMF is also completely disoriented by current bank regulations. They have for instance no idea of what would be the real market interest rates on public debt, for instance in the US, if banks needed to hold the same amount of capital against it, as they are required to hold against a loan to a citizen.

PS. I hear you. "Per, how can this be?" Well, Patrick Moynihan said “there are mistakes only PhDs can make; and George Orwell that “one has to belong to the intelligentsia to believe things like that: no ordinary man could be such a fool.” But I personally think, this is the typical thing to happen, when the wish of not criticizing colleagues in ones networks, crosses the path of those not wanting to admit they do not understand one thing of the mumbo jumbo that is being said.

PS. Here is a current summary of why I know the risk weighted capital requirements for banks are utter and dangerous nonsense.