Wednesday, July 29, 2015

Sir Jon Cunliffe. Tiberius would have regulated banks much better than the Basel Committee.

I hereby reference a speech titled “Macroprudential policy: from Tiberius to Crockett and beyond” given on July 28 by Sir Jon Cunliffe, Deputy Governor Financial Stability, Member of the Monetary Policy Committee, Member of the Financial Policy Committee and Member of the Prudential Regulation Authority Board 

Sir Cunliffe writes: “the underlying prudential standards – the reserves of capital and liquid assets that individual banks and other firms need to hold to enable them to withstand bad times – should be set not simply in relation to the risks in the individual firm, but also to reflect the importance of the firm to the financial system and the cost to the economy as a whole if the system fails”

Indeed but it was precisely there, when defining the risks of an individual firm, that regulators completely lost it:

Instead of considering the risks of unexpected losses, and the risk that banks would not be able to clear for the perceived risks, the regulators based “the reserves of capital and liquid assets that individual banks and other firms need to hold to enable them to withstand bad times” on the expected losses derived from the perceived credit risks… the only risks that were already being cleared for by banks by means of size of exposure and risk premiums…

And, as the regulator should have known, any risk even when perfectly perceived is wrongly managed if excessively considered. And that completely distorted the allocation of bank credit to the real economy.

If you’re a kid and your parents assign two nannies to care for you, you can still live a fairly ordinary childhood if the average of your two nannies’ risk aversion is applied. But, if their two risk aversions are added up, you stand no chance, then you better forget about having a childhood.

Sir Cunliffe writes: “The financial system does not simply respond to the economic cycle, growing as the economy grows and vice versa. It also feeds on its own exuberance in good times and on its fear in bad times which can in turn drive the real economy to extremes, as we have witnessed in recent years. The underlying causes of this phenomenon are interactions, feedback loops and amplifiers that exist within the financial system that can act as turbo chargers in both directions”

Precisely and perceived credit risks, credit ratings are main feedback loops and amplifiers that exist within the financial system. In January 2003 in a letter published in FT I wrote: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds. Friends, please consider that the world is tough enough as it is.”

Sir Cunliffe writes: “recognition that what distinguishes ‘macroprudential’ from ‘microprudential’ and from ‘macroeconomic’ is its objective of financial system stability rather than the instruments it deploys.” 

Let me spell it out more directly: The best macro-prudential regulations is one of micro-prudential regulations that help banks to fail… fast… not the current micro-prudential regulation, which only helps to create too big to fail banks.

Sir Cunliffe so correctly writes: “The financial system plays a crucial role in a modern economy directing resources to where they can be most productive and can generate the greatest return. When the dynamics of the system itself distort incentives and judgments of risk and return, there can be a huge misallocation of resources in the economy. And when the bubble bursts and the economy has to adjust, a damaged financial system cannot guide the necessary reallocation of resources – indeed, as we have witnessed, it can slow it down.”

How unfortunate then that Sir Cunliffe, and his regulatory colleagues, cannot get themselves to understand that the pillar of their regulations, the portfolio invariant credit risk weighted capital requirements, is in fact the greatest source of distortion in the allocation of bank credit of them all. It guarantees the dangerous overpopulation of safe havens, as well as the equally dangerous lack of exploration of the riskier but perhaps much more productive bays.

Sir Cunliffe begins his speech by saying “Historians still argue about the exact causes of the financial crash of AD 33 that rocked the Roman Empire.” 

I guarantee him that historians will soon know perfectly well what caused the financial crash of 2008, and why it is taking so much time for the world to get out of it. And they will not be kind on the current batch of regulators. Without being clear about the crash of AD 33, they will have no doubt about that Tiberius would have known better than the Basel Committee.

Tiberius would have picked bank regulators who would have tried to understand why banks fail... not why bank clients fail. 

Tiberius would have picked bank regulators who would have known that the biggest risk for the banking system is that of not allocating bank credit efficiently to the real economy... as no bank can  remain safe while standing in the midst of the rubbles of a destroyed economy.