Comments on IMF Global Financial Stability Report October 2014 Chapter III: Risk Taking by Banks: The role of Governance and Executive Pay

MY CONCLUSION: Without bank regulations, especially the credit risk weighted capital (equity) requirements, there would not have been a financial crisis like the current, nor would there have been any reason for the IMF to write this chapter. And IMF should have the guts to rise to the occasion and state that truth... the world needs it.

Here: Chapter III: Risk Taking by Banks: The role of Governance and Executive Pay

General comments:

Though I have naturally no objections to the call for better governance of banks, or for more constrain and rationality on their executive pay, I object to the relative importance assigned to those issues in terms of causing the current financial crisis… as this will help to divert the attention from those who most need to be held accountable… namely bank regulators.

And that because I am totally convinced that the distorting regulatory incentives present in the risk-weighted capital requirements for banks were the most important cause of the crisis and for the difficulties of our economies to be placed on the road of finding sturdy growth. 

And also, specifically relevant to this chapter, because those regulations dramatically eroded the importance of bank capital (equity) and bank shareholders, and thereby left the road open for bank management to appropriate for itself, much more of the financial results.

Comments on the Summary:

Text: “There is broad consensus that excessive risk taking by banks contributed to the global financial crisis.”

Comment: A broad consensus does not necessarily represent the truth. In this case it is important to remember that absolutely all of the excessive risk taking that showed up on the balance sheets of banks, were related to excessive exposures against which regulators allowed minimum capital requirements, as a consequence of these assets being ex ante perceived as absolutely safe from a credit point of view.

Text: “Equally important were lapses in the regulatory framework that failed to prevent such risk taking. Reforms are under way to further strengthen the regulatory framework, realign incentives, and foster prudent behavior by bankers.”

Comment: To be effective and avoid unintended consequences, such reforms must be based on a thorough understanding of what drives risk taking in banks. The distortions in the bank’s portfolios, and in the allocation of credit to the real economy produced by the risk-weighted capital requirements, have not been sufficiently acknowledged and discussed so as to expect these will be eliminated in a rational way. I hold this because even though there are many calls for more bank equity, and some who correctly suggest the full elimination of risk-weighting, the transition of the banks from here to there implies serious risks, for the banks and for the real economy.

Comments on: Box 3.5. Regulation and Risk-Taking Incentives: Basel I to III 

Text: “Basel I (1988) introduced uniform, risk- sensitive minimum capital standards at the international level… credit risk was divided into five buckets, ranging from zero percent to 100 percent depending on the riskiness of the underlying asset.”

Comment: “depending on the riskiness of the underlying asset” is not a correct way to phrase it. More precisely it depended on the ex ante risk preferences of regulators and general ex ante credit risk perceptions, both which does not necessarily have anything to do with the ex post realities.

Text: "Although Basel I was hailed for incorporating risk into the calculation of capital requirements and was regarded as a big step forward, it was also criticized for not taking into account hedging, diversification, and differences in risk-management techniques. It also did not take into account other types of risk, particularly market risk."

Comment: Basel II (and Basel III) are still essentially “portfolio invariant” and has therefore not corrected for not taking into account diversification. One loan of $1 billion to one “absolutely safe” borrower requires the bank to hold only a fraction of the capital needed against 1.000 $1 million loans to “the risky”. And though coverage for liquidity risk has been included in Basel III, as it also build on ex ante perceptions, it could also be aggravating the distortions.

Text: "Advances in technology and risk-management techniques allowed banks to develop their own internal capital allocation models in the 1990s, which enabled them to align the amount of risk they undertook on a loan with the overall goals of the bank (internal risk tolerance). 

For example, Basel I placed all commercial loans into the 8 percent capital category. In contrast, internal model calculations led to capital allocations on commercial loans that varied from 1 to 30 percent, depending on the loan’s estimated risk. It was hence argued that although Basel I was a step in the right direction, it was not sufficiently risk sensitive and could result in arbitrage: if capital regulation was binding, a lack of risk sensitivity encouraged banks to shift toward the riskiest activity within each category.

The Market Risk Amendment (1996) and Basel II (2005) were introduced to address these shortcomings, allowing internal models for market and credit risk, respectively. These measures allowed banks to use internal models to more finely differentiate risks of individual loans. Risk could now be differentiated not only between but also within loan categories."

Comment: And the consequence of that, which should have been expected by the regulators, was that instead of taking diversified risks on what was perceived as “risky”, banks took on extreme and dangerously leveraged exposures to what was and is ex ante perceived as “absolutely safe”

Text: “The regulations were designed to induce banks to invest more in risk-management and modeling technology by providing capital relief— the standardized approaches were calibrated to be more conservative than risk-sensitive internal models.”

Comment: “the standardized approach” calibrations were the result of a complete absurdity that in my opinion no one understood but no one dared to question. I dare anyone to read the explanation provided by the Basel Committee and then he might understand better the horrible truth behind the “risk-weighing” which sounds so comforting and rational. 

Specifically I strongly suggest all development and finance ministers to query their regulators on the Explanatory Note on the Basel II IRB Risk-Weight Functions issued by the Basel Committee.

Text: “Before these changes were introduced, banks’ internal risk models (and other risk-management functions) were designed to measure risk accurately. However, after the Market Risk Amendment and Basel II, subject to regulatory approval, models became a key input in determining capital requirements, generating a competing objective of using models to minimize measured risk to minimize capital requirements.”

Comment: Is not minimizing capital requirements a natural and essential way for banks to compete in capital markets, especially when risk-weighing of assets made everything less transparent to the market? That regulators did not foresee that risk-weighted capital requirements would lead to overall much lower bank capital is mind-blowing.

Text: “These incentives may have contributed to the global financial crisis, during which banks, particularly large banks, were found to hold insufficient capital. Since the crisis, Basel III has raised the capital requirements for banks, and work is ongoing to better capture risk.”

Comment: “These incentives may have contributed to the global financial crisis”, may count as one of the understatements of the century. Those incentives caused the global financial crisis… suffice to see the total correlation between “bank assets in trouble” and “low capital requirements”.

Final comments: 

The regulators never defined what is the purpose of the banks, and therefore they never cared, nor care, one iota about how banks allocated credit to the real economy. “A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926.

The regulators fixated on the expected ex ante perceived risk of the assets of the banks, something which is already clear for by means of interest rates and exposures, instead of focusing on the unexpected risks of the banks… pas le meme chose. Amazingly, by their own confession, they substituted expected risks for unexpected risks.

And the above allows banks to earn much higher risk adjusted returns on equity on assets perceived as "absolutely safe" than on assets perceived as "risky", something which introduces a monstrous distortion in the allocation of bank credit to the real economy.

And because of this regulatory distortion much or even perhaps most of current fiscal and monetary support systems of the real economy is wasted, only because regulations do not allow bank credit to go to where it is needed the most.

As a grandfather, extremely concerned about the future of my grandchildren, I hold that the current regulators, and whose extreme hubris made them believe they could be risk managers for all our banks, deserve to be sent home... in shame. Were we to regulate for climate change the way banks have been and are regulated, our planet will be toast!

PS. In 1999 in an Op-Ed I wrote “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 our banks” And the Big Bang happened! And yet seven years after the explosion, the world seems not to have noticed the Basel Bomb... and the IMF has a lot of responsibility for that.

PS. As the IMF is now taking up the issue of inequality, it should be reminded that the odious discrimination  against fair access to bank credit of "the risky", is one prime driver of inequality.