Sunday, December 22, 2013

Trying to understand the how come of the so loony bank regulations, by reading Daniel Kahneman’s “Thinking, Fast and Slow” 2011.

I hold that the current risk-weighted capital requirements for banks, more risk more capital, less risk much less capital, is sheer regulatory lunacy.

Fact: These are based on perceived risks which have already been cleared for by banks in interest rates, size of exposure, duration and other terms (the numerator). And so, re-clearing for the same perceived risks in the capital (the denominator) causes the risk price equation to go haywire. 

And that allows banks to earn much higher risk-adjusted returns on equity when lending to what is perceived as “safe” than on what is perceived as “risky”, making it thereby impossible for banks to efficiently allocate bank credit in the real economy. It instills an additional dose of unproductive risk-aversion in the banking system.

And it also guarantees that when something ex ante perceived as "absolutely safe", turns out ex post to be very risky, precisely the stuff all bank crises are made off, that banks will then stand there naked with no capital.

And so, how could regulators be so dumb? How could it be that so long after the 2007-08 crises exploded, this truly monstrous regulatory mistake is not even discussed?

Here, I will try to get to the answer to those questions by reading Nobel Prize winner Daniel Kahneman’s “Thinking, fast and slow” Farrar Straus and Giroux, 2011. I begin in “Part 3 Overconfidence”

But first I need to start with expressing one reservation with respect to the following which Professor Kahneman writes there in Chapter 19:

“I have heard too many people who ‘knew well before it happened that the 2008 financial crisis was inevitable’. This sentence contains a highly objectionable word, which should be removed from our vocabulary in discussions of major events. The word is, of course, knew. … [that] language implies that the world is more knowable than it is.”

In the sense that could be construed as a “nobody knew”, and could like the Black Swan story serve as an excuse for the regulators for not doing their job, I must strongly object to it, as we then will not hold them sufficiently accountable for their mistakes.

Professor Kahneman refers to an “outcome bias [that] makes it almost impossible to evaluate a decision properly – in terms of the beliefs that were reasonable when the decision was made… Actions that seem prudent in foresight can look irresponsibly negligent in hindsight.” 

Yes, but what when an action that should have been declared irresponsibly negligent in hindsight, survives as if nothing has happened? In our case the Basel III is just some tweaking of Basel II… and it hangs on to the risk-weighted capital requirements... as if nothing has happened.

Of course I had no idea that the crisis would happen in 2008, or where it would finally explode, but there could be no doubt that assigning so much regulatory importance to the already known and cleared for credit ratings, introduced a systemic risk that had to explode, somewhere somehow, sooner or later. 

In January 2003, while I was an Executive Director at the World Bank, Financial Times published a letter in which I wrote: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors to be propagated at modern speeds”.

But now back to the how comes of this post.

The first Great Explainer I find, chapter 20 is “The illusion of validity”. Professor Kahneman writes about how a good coherent story triumphs the absence and the quality of evidence… and, in this case, what could initially sound a more coherent story than “more perceived risk more bank capital (equity), less perceived risk less capital”?

In reality since all bank crisis have originated from excessive exposures to what was perceived as "absolutely safe", and none from excessive exposures to something perceived ex ante as “risky”, the truth is that, if anything, the capital requirements for banks should be higher for what is perceived as absolutely safe than for what is perceived as risky… but, Professor Kahneman, how the hell do you sell that storyline?

Another Great Explainer, chapter 20: “The illusion of validity and skill… supported by a powerful professional culture…. We know that people can maintain an unshakable faith in any proposition, however absurd, when they are sustained by a community of like-minded believers”.

Indeed that is when regulators are allowed to assemble in a mutual admiration club… like the one I protested in another letter in the Financial Times in November 2004.

(December 24, 2013) And in chapter 21 in “intuitions vs. formulas” we read how, when there is “a significant degree of uncertainty and unpredictability” then, in terms of explicatory powers, “the accuracy of experts was matched or exceeded by simple algorithms”. One possible explanation for that, provided by Paul Mehl, is that experts “try to be clever” and “feel they can overrule the formula because they have additional information”. And some examples of powerful algorithms are provided like the five variables rule developed by Dr. Virginia Apgar to determine whether a new born baby was in distress.

But this chapter does really not provide me with much explanation with respect to the regulations I object. This is first because I feel that in this case we are not really in the presence of real experts who possess the minimum intuitions required, and secondly the formula itself, the risk-weighting, is just a very bad formula.

How can I explain it? Perhaps saying that an expert bank regulator should have started by defining a purpose for the banks, and then analyzing the risks and whys and consequences of a banks failing while pursuing that purpose, and not, as has been done by just analyzing the risks of the clients of a bank failing, and which of course is far from being the same.

But yes “do not try to be too clever” is always a good recommendation for any regulator, and yes, that our current bank regulators start from the premise of them being very clever, is hard to doubt. The 30 pages of Basel I are by means of Basel III and Dodd-Frank Act, evolving into ten thousand of pages of regulations.

And yes I bet one formula, one single capital requirement for any type of bank asset, is a superior formula… and so do not tell me I harbor a “hostility to algorithms”. What I really do feel hostility against, is for regulators to dig us even deeper into the hole where they have placed us.

(December 25, 2013) Chapter 22: “Expert intuition: when can we trust it?” Professor Kanehman holds that an expert’s intuition can only be trusted if the area of expertise in question contains “an environment that is sufficiently regular to be predictable”, and if the experts have had “an opportunity to learn these regularities through prolonged practice”

Considering bank regulations not only as firefighting but within a complete framework of how banks help to finance the growth and the strengthening of the real economy, in other words the mystery of development, the answer must of course be a rotund NO! There is just too much involved for it to be predictable.

But even in the case of bank regulation designed only to stop bank failures we would have to answer with an equally rotund NO!, the question of whether regulators in the Basel Committee and the Financial Stability Board had sufficient expertise. 

Kahneman writes: “The acquisition of expertise in complex tasks such as… firefighting is intricate and slow because expertise in a domain is not a single skill but rather a collection of miniskills”, and I sincerely doubt that persons such as Stefan Ingves, Mark Carney, Mario Draghi, Ben Bernanke have had many specific experiences of bank failures which they have managed and even more importantly understood.

In short this chapter only reinforces the concerns I referred to in an Op-Ed which I wrote in 1999: “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 collapse”

If Professor Kahneman was asked whether it was reasonable and wise to vest so much regulatory power over our banks in the hands of some few “experts”, I suspect he would express serious doubts.

December 26. 2013. Chapter 23. “Irrational perseverance” “sunk-cost fallacy” Professor Kahneman recounts an experience: “If pressed further I would have admitted that we had started the project on faulty premises and we should at least consider the option of declaring defeat and going home. But nobody pressed me…..we had already invested a great deal of effort… It would have been embarrassing for us… I can best describe our state as a form of lethargy – an unwillingness to think about what had happened. So we carried on."

And this describes a lot of why, after the clearly evident failures of Basel II, we now have basically the same failed regulators, using basically the same “risk-weighted capital” script, producing, directing and acting in a Basel III, as if nothing has happened. Neither Hollywood nor Bollywood would be so dumb, so as to follow up a huge box-office flop without major revisions. 

December 31, Chapter 24. Professor Kahneman refers to an extremely interesting idea suggested by Gary Klein to combat dangerous overconfidence, “The premortem”… “Imagine that we are a year into the future. We implemented the plan as it now exists. The outcome was a disaster. Please take 5 to 10 minutes to write a brief history of that disaster” “The main virtue of the premortem is that it legitimizes doubts” Otherwise “public doubts about the wisdom of the planned move are gradually suppressed and eventually come to be treated 

If regulators had done that with Basel II…can you imagine if someone in his premortem had written that the crisis was a direct result of clearing for the same risk twice, which would cause banks earning higher risk adjusted returns on equity on what was perceived as absolutely safe, which distorted the allocation of bank credit to the real economy?

Can you imagine if someone in his premorten had written…”And there stood all the banks in the world, on with all that exposure to that AAA rated, against almost no capital… and the unexpected happened”?

Can you imagine if someone had written…”And since therefore no bank financed “the risky”, those who help to build the future, the real economy was placed in a death-spiral that brought the banks down.

As is, the faults with the risk-weighted capital requirements are not even recognized in the postmortem

(January 4, 2014) Chapter 17, “Regression to the mean”

The expected losses of a bank should normally be covered by its operations. It is to cover the “unexpected losses” for which regulators primarily require banks to hold capital.

And the Basel Committee has defined that the capital requirements for banks should be higher for what is considered “risky” than for what is considered as “absolutely safe”. 

That has always sounded wrong to me, as it is in the sector of the “absolutely safe” that the most unpleasant unexpected events roam.

In fact if something is considered 100% risky there should be 0% unexpected losses, but if something is considered 0% risky, the unexpected losses could be 100%. 

And why current bank regulators, even when faced with a crisis derived from unexpected losses in what was considered “absolutely safe” do not even want to discuss my arguments, has always been a mystery to me.

But reading chapter 17 it occurs to me that one explanation is that regulators do simply not understood the meaning of regression to the mean, and the fact that the timing of any unexpected result should not be perfectly correlated with, for instance, recent credit ratings. 

And that might be explained by “our mind is strongly biased towards casual explanations”, and what is more casual than “risky is risky and safe is safe and there´s no more to that!” 

(January 15, 2014) Chapter 31, Risk Policies, “Broad or Narrow?” Professor Kahneman writes.

“These attitudes make you willing to pay a premium to obtain a sure gain rather than to face a gamble, and also willing to pay a premium (in expected value) to avoid a sure loss”.

Could that translate into… bank regulators were willing to pay a premium to make sure banks did not fail, and were also willing to pay a premium to avoid a sure bank failure?

If so could that be the reason for which regulators failed to identify the benefits of bank failures, namely just that they were willing to take risks?

I am not sure. Perhaps they did so in a subconscious way. But, consciously?, I am sure they were and are not even aware of what they are doing with their excessive risk aversion... that of banks must not fail.

How different our world would be if regulators had set as an objective, for instance… in order to insure that sufficient risk taking is taking place 1-2 percent of the banks should fail yearly.

And I will keep on commenting here...

The more I think of it I come to the conclusion that “more-risk-more-equity / less-risk-less-equity”, is such a powerful System 1 intuition that it stops System 2 deliberations rights in its tracks and does not allow these to even begin.




PS. Today, March 27, 2024, I tweeted /X
"So sad to hear about Daniel Kahneman passing away.
May he rest in peace.
I never met him and he surely never knew of me.
He was a truly valuable source of inspiration."