Tuesday, September 2, 2014

In “The land of the brave” banks are given incentives to avoid “The Risky” and to stock up on “The Infallible”

I refer to Kevin Dowd’s “Math Gone Mad”, Policy Analysis of the Cato Institute, September 2014

Dowd’s conclusion “The solution to these problems is legislation to prohibit risk modeling by financial regulators and establish a simple conservative capital standard for banks based on reliable capital ratios instead of unreliable models”, is completely in line with which I have been arguing for more than a decade, except for that I would use the word “sensible” instead of reliable… since reliability is good to have, but it cannot be the final objective of our banks.

“A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926

I agree of course with all the examples Dowd gives about how the credit allocation to the real economy is distorted by regulations, but I would make even clearer the fact that what can most help to bring stability banks is a sturdy economy… and current credit risk-weighting of capital has only managed to introduce, in the land of the brave, a senseless risk-aversion… which will only weaken it… which will only reduce its chances of creating the next generation of jobs our youth needs

But also, current regulations are based on a principle that sounds so very logical, “more-risk-more-capital and less-risk-less-capital”, so too few take time needed to think about it; and regulators are so unwilling to admit mistakes that would show them not having been marginally wrong, but 180-degrees wrong. And, in this respect, the paper might be strengthened by some additional arguments, and by providing some idea on how to motivate and facilitate the legislator to act.

The first is that if banks’ individual risk management is correct, then regulators have nothing to fear. Their problem begins when the banks’ risk management fails. For instance, regulators have no special reason to concern themselves with the credit-worthiness of the clients of the banks’, as their concern should be the creditworthiness of the bank, which is by far not the same. A bank with a well-diversified exposure to many risky borrowers might be immensely safer than a bank with a few large exposures to those perceived as absolutely safe. One of the unbelievable surreal failings with the current risk-weighted capital requirements is that, by the regulators own admission, these are portfolio invariant.

Also it is precisely the fact that the risk-weights used for the capital requirements clear for precisely the same risks already cleared for by the banks, through interest rates and size of exposures, which originates the most severe distortions. As a result banks now earn much higher risk adjusted returns on equity when lending to The Infallible than when lending to The Risky. The regulators, also by their own admission, have used expected losses as a substitute for the unexpected losses, and this represents of course one amazing intellectual regulatory mistake.

I have, even as an Executive Director of the World Bank objected to these regulations, long before Basel II was approved. And I have tried to extract answers from the regulators by all means possible, with very little luck. Therefore, as a tool to begin breaking down the wall, I would suggest legislators request from regulators the answer to some very simple questions, which would evidence how crazy it all is…but they should brace themselves because, once one finds out how incredibly wrong current bank regulations are… it is truly scary. And I would also request from regulators that when they stress test banks balance sheets, they also take notice of what is not any longer on banks’ balance sheets… since that is a part of a stress test of the economy at large.

And, one of the most important lessons to extract from it all this is the… “How could it happen?” and so that never again a small group of unelected bureaucrats will get the chance to influence global markets in this way, with no real accountability. I have often said that if the world would allow a Basel Committee on Climate Change to decide what to do in this way… then earth would most definitely be toast.

Finally when Dowd suggests “a minimum capital ratio of 15 percent” (I could do with even less) the most important part is how to get from here to there, a journey costing at least a trillion dollars only in the US and that poses many dangers, and that perhaps requires a full change of the regulatory team… since we know that Hollywood would never ever authorize those responsible for a monumental box-office flop like Basel II, to follow up with a Basel III production, using the same scriptwriters.

PS. As curiosa let me mention that the Dodd-Frank Act, in all its many pages, does not even mention the Basel Committee’s regulations to which the US is a signatory.