16 tweet-sized fundamental mistakes with regulatory credit-risk weighted capital requirements for banks… and counting

The regulators are regulating the banks without having defined the purpose of the banks. 

Regulators ignored that banks need and should allocate credit efficiently to the real economy.

Regulators ignore that for the society, what is not on the balance sheet of banks, could be as important as what is.

To allow bank equity to be leveraged with net margins of assets differently, distorts the allocation of bank credit.

The scarcer the bank capital is, the greater the distortions produced by the risk weighted capital requirements.

Bank capital is to cover for unexpected losses, yet regulators base the requirements on expected credit risks.

The safer something is perceived the greater is its potential for unexpected losses.

The risk of a bank has little to do with perceived risk of assets, and much to do with how the bank manages risks.

Banks clear for credit risk with interest rates and exposures, so to also do in the capital double-counts that risk.

Any perfectly perceived risk causes the wrong actions if the risk is excessively considered.

The standard risk weights that determine the capital requirements for banks are, amazingly, portfolio invariant.

The undue importance given to few information sources, credit rating agencies, introduced a serious systemic risk.

That imposing similar and specific regulations on any system stiffens it and increases its fragility was ignored.

Any regulatory constraint that can be gamed will be gamed and benefit the worst gamers in detriment of lesser gamers.

A risk weight of zero percent for the sovereign, and of 100 percent for the private sector, is pure unabridged statism.

Impeding “the risky” to have fair access to bank credit blocks opportunities and thereby increases inequality

Consequences: Too much bank credit against too little capital to whatever is perceived or can be construed as being safe, and too little credit to what is perceived as risky. In other words banks that do not finance the “risky” future, but only refinance the “safer” past.

Questions: Of these mistakes how many have been sufficiently debated and corrected? How many of the responsible for these mistakes have been held accountable?

Excuse me Stefan Ingves. Are you a raving statist? Are you a raving communist?

In 1988, with the Basel Accord, Basel I, the bank regulators of the all important G10 decided that, for the purpose of defining the capital requirements of banks, the risk weight for the sovereign, meaning the government, was to be zero percent, while the risk weight for the private sector, meaning the citizens, was set at 100 percent. What a lunacy!

Mr Stefan Ingves, Chairman of the Basel Committee on Banking Supervision and Governor of the Sveriges Riksbank, in remarks made on May 5, 2015 to the 8th Meeting of the Regional Consultative Group for Europe, had this to say about “Sovereign risk”

“A discussion of the risk-weighted capital framework would not be complete without a discussion of the Committee's work on sovereign risk - a topic which is clearly of relevance to Europe. At its meeting earlier this year, the Group of Central Bank Governors and Heads of Supervision - the Basel Committee's oversight body - agreed to initiate a review of the existing regulatory treatment of sovereign risk, including potential policy options.

In many cases sovereign exposures are in fact relatively low credit risk assets and also highly liquid. 

Yes, they do receive a lower capital charge than other asset classes, but this is generally warranted. But - and this is an important but - I think we can all agree that there is no such thing as a risk-free asset. When we talk about this issue we talk about "sovereign-risk" - not about "sovereign risk-free"

For this reason the Committee will consider potential policy options related to the existing treatment of sovereign risk. It is important to note that this review will be conducted in a careful, holistic and gradual manner.”

Let me here concentrate on “Yes, sovereigns exposures do receive a lower capital charge than other asset classes, but this is generally warranted.”

Mr. Stefan Ingves, why is that generally warranted?

If sovereigns exposures receive a lower capital charge than other assets that means banks will be able to leverage more their equity and the support they receive from society when lending to the sovereign than when lending to the private sector, meaning to the citizens. 

And that of course means banks will be able to earn higher expected risk adjusted returns on equity when lending to sovereigns than when lending to the private sector, meaning to the citizens.

And that of course means banks will tend to favor lending to the sovereigns than to the private sector, meaning the citizens.

And the only possible rational explanations for that must be if you believe government bureaucrats more able than citizens to use bank credit.

Do you Stefan Ingves believe that? Are you a raving statist? Are you a raving communist?

Who has ever heard about a zero percent risk free sovereign? They even tell you in your face that they have an inflation target, so as to pay you off with money worth less and, if that does not suffice, that they will then increase your taxes to service their debt.

Mr Stefan Ingves, Chairman of the Basel Committee. Basel III contains the same major design flaw of Basel I & II

Mr Stefan Ingves, Chairman of the Basel Committee and Governor of Sveriges Riksbank in a recent speech has likened Basel II to the Swedish warship Vasa that sank “after sailing only 1,300 metres, on 10 August 1628”… because “the Vasa was well constructed but incorrectly proportioned”.

Ingves states that Basel II “looked impressive on paper. In the Committee's quest for greater risk sensitivity, Basel II introduced the role of internally modelled approaches for credit risk and operational risk and expanded the role of models for market risk.

But things did not work out precisely according to plan. The financial crisis highlighted a number of shortcomings with the banking system and the regulatory framework, including:

• too much leverage, with insufficient high-quality capital funding banks' assets;

• excessive credit growth, fuelled in part by weak underwriting standards and an underpricing of credit and liquidity risk;

• a high degree of systemic risk, interconnectedness among financial institutions and common exposures to similar shocks;

• inadequate capital buffers to mitigate the inherent procyclicality of financial markets and maintain lending to the real economy in times of stress; and

• insufficient liquidity buffers and excessive exposure to liquidity risk. This was in terms of both direct and indirect liquidity risk (for example, through the shadow banking system).”

And according to Ingves now: “The Basel III framework seeks to address the weaknesses I mentioned and provides the foundation for a resilient banking system”.

First, any regulator who approved of capital requirements that allowed banks to leverage their equity 60 times to 1 or more, should be ashamed of speaking of “too much leverage”, “excessive credit growth” and “inadequate capital buffers” as “shortcomings with the banking system and the regulatory framework”. It is not about “shortcomings” it is about a monstrous definite flaw in bank regulations that caused the financial crisis. 

And since Mr. Ingves and his colleagues have apparently yet not understood the basic design flaw of Basel I and II, Basel III will also sink.

The number one problem is that regulators have never defined what was the purpose of banks. Had they done so, they would have had to include that of allocating bank credit efficiently to the real economy. And, had they spelled out that purpose, then they would not have been able to use credit-risk weighted capital requirements for banks. 

Allowing banks to leverage their equity and the support they receive from society differently, based on credit risks, results in banks being able to earn higher risk adjusted returns on equity on some assets than on others. Because that did of course totally distorts the allocation of bank credit.

And then Ingves says: “In addition, another important lesson is that the quest for perfection - or in this case, ever-more precision in measuring risk - can be illusory. Spending years on developing a "perfect" risk-sensitive framework may not deliver the results we would hope for. Instead, having in place multiple regulatory constraints provide more safeguards against the risk of a defect in any single element of the framework.”

Once again he evidences not having understood the real problem. It is not about the precision in measuring the risk. Since banks already clear for risks with interest rates and size of exposures, forcing them to re-clear for the same risk in the capital, means that credit risk will be excessively considered. And any risk, even if perfectly perceived, causes the wrong actions, if excessively considered.

And then Ingves says: “Instead, having in place multiple regulatory constraints provides more safeguards against the risk of a defect in any single element of the framework.”

And once again he shows he does not get it. Banks are to hold capital against unexpected losses, and unexpected losses cannot be derived from expected risks. The most that can be said in that respect is that the safer an asset is perceived to be the bigger is its potential to deliver unexpected losses.

Mr Ingves concludes with “The Committee's ongoing policy reforms are grounded in trying to balance the simplicity, risk sensitivity and comparability of the risk-weighted framework.”

No! We, and especially the generations to follow us need a banking system that believes in the future. Capital requirements based on credit risk gives banks the incentives to stay away from financing the “risky” future and to keep solely refinancing the “safer” past. God make us daring!

May I humbly suggest a different course?

For a start the same basic capital requirement for all assets, like 8 percent, to cover for unexpected losses, like those for instance that can be caused by regulators not knowing what they are doing, cyber attacks, or an asteroid hitting earth. Of course one would have to design a very careful course for taking banks from here to there since it is fraught with a lot of dangers for the banks and the real economy.

Then and even when it is arrogant and dangerous to interfere in any way with the market, if you must, why not make some capital requirements for banks based on purpose weights, like for instance the SDGs? In such a case we would allow banks to earn a little higher risk adjusted returns on equity when they are doing something that society might want them to do, and not like now, just when they avoid credit risks.

Would the bank system become unstable because of that? Not at all, major bank crisis have never resulted from excessive bank exposure to assets that were perceived as risky when they were put on the balance sheet… they have always resulted from excessive exposures to something wrongly believed to be safe… or to something that was a safe haven but became dangerously overpopulated.

PS. Ingves states with relation to Basel II: "Six years were spent on developing this new framework. Hundreds were involved - central bankers, regulators and supervisors, not to mention the untold bankers, academics and others who commented on the Committee's proposals. Perhaps the equivalent of 40 acres of timber were consumed in the form of internal BCBS papers, consultation papers and responses received by stakeholders!" No! At the end of the day, it was something brought out by the members of a very small mutual admiration club.

PS. Mr Ingves. I recently suggested Mario Draghi he should take a sabbatical year in order to study the mistakes of current Basel bank regulations. You should too!

Tenured finance professors, with their indifference, are some of the villains who let us down.

Karthik Ramanna, an associate professor at Harvard Business School writes : “Narrower interests that would otherwise find themselves straining to shape political outcomes often prevail unchallenged. Somewhat perversely, we may well be better off when politics is a bazaar of ideas and incentives.

Consider the technical regulations that govern capital markets — whether banks have as much capital as they say they do…We might think these regulations are somehow self-evident, derived from fundamental laws of economics. In reality, they are largely social constructs, reflecting expert opinions and political necessities…. I call these regulatory processes thin political markets because they seldom attract wide public participation. On any specific rule-making issue, there are usually a handful of business executives … who are truly experts on the subject. They also have the greatest stakes in the outcome. They meet with regulators in genteel isolation, obligingly offering direction for regulation. The rules of the game that emerge reflect their interests.

But there are no manifest villains here. Executives get involved when they understand an issue, and it matters to them. When they participate, they rarely face serious opposition. Those who might oppose them are sometimes not even aware of the regulatory proceedings. What arises in aggregate is a system of rules that looks as if it was produced by a quilt of special interests. Society as a whole bears the costs of this subtle”  "Ruling From the Shadows" New York Times,  November 21, 2015.

No, that is unacceptable! What the heck do we have tenured academicians for, if not to question what is going on in the real world?

In 1988 the Basel Accord introduced risk weighted capital requirements for banks and decided, amazingly, that the risk weights for sovereigns (meaning governments) was to be zero percent, while that of the private sector (meaning citizens) was to be 100 percent.

And in 2004, with Basel II, they also divided the private sector into groups carrying risk weights of 20, 50 100 and 150 percent.

And of course that utterly distorted the allocation of bank credit to the real economy.

And where were the tenured finance professors to question this? As far as I know they were nowhere to be seen. In fact they are still mostly nowhere to be seen.

“There are no manifest villains here”? I could easily make a case for most academicians in finance being the indifferent villains. They truly are letting the society down.

Revoke their tenures!

Mr Mario Draghi. For Europe’s good, why not take a sabbatical year and do all it takes for you to understand the RWCR?

The citations below are extracted from the speech “Cross-border markets and common governance” delivered by Mario Draghi, President of the ECB, during the Bank of England Open Forum, London, 11 November 2015.

These evidence that the former Chair of the Financial Stability Board, does yet not understand what caused the current crisis, namely the distortion in banks assets allocation to the real economy produced of Basel II’s risk weighted capital requirements for banks (RWCR); more ex ante perceived risk, more capital – less risk, less capital.

Draghi: “To reap the benefits of openness, markets require appropriate governance. Indeed, a market stipulates not just the freedom to take part in the market, but also the means to protect that freedom. That means the confidence that contracts entered into will be enforced. It means the assurance that the rules of fair competition will be upheld, that property rights will be respected, that standards and codes will be applied properly. It means, in short, the Rule of Law.”

Mr. Draghi: The RWCR violated directly the rules of fair competition in the markets for bank credits. These allow banks to earn higher risk adjusted returns on equity on assets perceived as safe than on assets perceived as risky. As a consequence those perceived as safe and who already pay lower interest rates and have access to more bank credit are, because of the RWCR, treated even better, in direct detriment to the fair access to bank credit of those perceived as risky. And negating the risky fair access to bank credit is a prime inequality driver. 

Draghi: “For financial markets this is especially important given their inherent fragility. If rules and standards are not effectively applied, it can produce information asymmetries and other destabilising forces which, in turn, lead to sudden reversals of confidence in the market. We have seen in the past how markets have run ahead of regulation leaving them vulnerable to such dynamics.”

Mr. Draghi: Those RWCR produced gigantic information asymmetries and destabilising forces. Go back and read all the specialized newspaper that spoke of well capitalized banks, like of a 10 to 1 leverage, without understanding that this was based on risk-weighted assets and that their real leverage was often 50 to 1.

Draghi: “Here is one illustration: during the crisis, the market for securitised assets was all but destroyed by a collapse of confidence. Lack of oversight allowed excesses to be committed and market abuse to take place” 

Mr. Draghi. The fact that Basel II of June 2004 allowed banks to hold those securities against only 1.6 percent in capital if they achieved an AAA to AA rating; which means an almost unimaginable allowed leverage of 62.5 to 1, provided the incentives for excesses and market abuse to be committed. Before that there had been mortgages to the subprime sector for many decades, without these causing any problems.

Draghi: “Securities that were previously deemed safe, certainly with some measure of complacency and too much blind confidence, turned out to be very unsafe indeed, and imparted significant losses on their holders.”

Mr. Draghi: Securities or loans "that were previously [ex ante] deemed safe, certainly with some measure of complacency and too much blind confidence, and turn out [ex post] to be very unsafe” is precisely the stuff all major bank crises in history are made of. Show us one bank asset that was perceived as risky when it was placed on the balance sheets and that amounted to such an importance that it caused a major bank crisis? There is none! 

Draghi: “What is also unfortunate is that the subsequent attempts to re-regulate that market have threatened to undermine the parts that are beneficial to many. There was too much opacity as to the nature of the assets underpinning asset-backed securities, too damaging a breakdown of confidence in the integrity of those who packaged and sold them. And the immediate temptation of regulators was to impose punishing capital charges on holdings of asset-backed securities, independent of their individual characteristics, mixing the wheat with the chaff.”

Mr. Draghi. Regulators should not substitute for the markets. Let the market value the individual characteristics of the wheat and the chaff. At this moment all the stimulus to the economy are being dangerously wasted because regulators have decided, with their risk weights to treat the “risky” SMEs and entrepreneurs as chaff, and not as the nutrient and for the economy indispensable wheat they represent. 

Mr. Draghi the capital of banks is to cover for unexpected losses, and that is something explicitly accepted by the regulators. And so here follows some basics in risk management you and your colleagues could benefit from knowing:

It does not make any sense setting what is to cover for the unexpected based on expected credit losses already cleared for.

The RWCR doubled up on credit risk; and any risk, even if perfectly perceived, results in the wrong actions if excessively considered.

The regulators concerned themselves with the risks of bank assets while their worry should have exclusively been on how banks manage the risks of those assets.

You allowed big banks to decide on the capital required by using risk models. That was like telling your kids they can pick anything they want from a menu of ice-cream chocolate cake, spinach and broccoli. Is that a market?

The safer something is perceived the greater its potential to deliver unexpected losses.

Motorcycles are riskier than cars, but car accidents cause more deaths than motorcycle accidents.

It is not by telling banks to avoid risks that we can live up to that holy intergenerational bond Edmund Burke spoke of.

Mr Mario Draghi. For the good of Europe, why do you not take a sabbatical year to reflect on this? You said you were willing to do all it takes.

Hopefully Mr Draghi you would end up understanding that the biggest systemic risks for banks are always imbedded in the assets perceived as the safest or so safe that all must have them; and that excessive risk aversion is about the riskiest there is for the economy...

According to Winston Churchill I am clearly a fanatic “one who can't change his mind and won't change the subject.”

Yes! I have over the last 18 years written more than 3.000 comments, articles, blog-posts, and letters to the editor, about how flawed I know the portfolio invariant credit risk weighted capital requirements for banks are. And I won’t change my mind or change the subject. And so in Winston Churchill’s words I am a fanatic… I would say a really obsessive fanatic.

But, on the other hand, the silence on this problem by thousand of experts is equivalent to billions of comments, articles, blog-posts and letters to the editor from the opposite side; and so I am not sure about who is more obsessively fanatic, they or little me.

And of course, when compared to those statist regulators who came up with that crazy surreal nonsense of a zero percent risk weighting for the sovereign and a 100 percent risk weighting of those citizens the sovereign depends upon, I am just fanatic obsessive chicken shit.

Failed bank regulators cuddled up for comfort in the bosom of Her Majesty’s “Why did no one see this coming?”

IEA, I refer to your Discussion Paper No. 65 “Britain’s Baker’s dozen of disasters” and specifically No. 13 “2000-2008: The Gordon Brown bubble”

It starts by quoting HM The Queen at London School of Economics, November 2008 asking with respect to the financial crisis “Why did no one see this coming?”

What a marvelous question, for failed regulators. It allows all of them to hide as a group, avoiding thereby any personal responsibility.

But of course some of us saw it coming! 

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 its collapse”

In January 2003, in a letter published in the Financial Times I 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 in October 2004, as an Executive Director of the World Bank I formally stated: “We believe that much of the world’s financial markets are currently being dangerously overstretched through an exaggerated reliance on intrinsically weak financial models that are based on very short series of statistical evidence and very doubtful volatility assumptions.”

In 1988, with the Basel Accord, Basel I, bank regulators set a zero percent risk weight for sovereigns and a 100 percent risk weight for the private sector. A zero risk weight for governments that in your face set inflation targets that mean you will be repaid with less worth money, or that mention that in need they will have to raise taxes, is truly a surreal concept. With it, obviously statist regulators implicitly told the world that government bureaucrats make more efficient use of bank credit than the private sector.

And in June 2004, with Basel II, they introduced different risk weights for the private sector. These were 20, 50, 100 and 150 percent, depending on the credit rating. Since the basic capital requirement was 8 percent, that meant that in order to buy a $100 asset, banks had to put down $1.6, $4, $8 or $12 of their own capital, depending on the credit rating.

The fundamental errors committed by the regulators were/are mind-blowing.

Bank capital is to cover for unexpected losses and they designed the capital requirements based on the perceived credit risk losses that were already being cleared for by the banks by mean of risk premiums and size of exposures. 

That caused a double consideration of ex ante perceived credit risk and any risk, even if perfectly perceived, results in wrong actions if excessively considered.

It also ignored the simple fact that the safer something is perceived, by definition, the larger is its potential to deliver an unexpected shock.

In fact regulators regulated the banks without even defining the purpose of the banks, like that of allocating bank credit efficiently to the real economy.

And so that allowed banks to leverage much more their equity on assets perceived as safe than on assets perceived as risky; which allowed banks to earn much higher risk adjusted returns on equity on assets perceived as safe, or made to be perceived as safe, than on assets perceived as risky, like lending to small business and entrepreneurs. And that of course distorted the allocation of bank credit to the real economy. 

It caused the creation of dangerous excessive exposures to something ex ante perceived as safe but that ex post turn out risky, precisely the stuff major bank crises are made of: like AAA rated securities and Greece. This time aggravated by the fact that since the assets were perceived as safe, banks needed to hold very little capital. 

And it introduced a credit risk aversion that impedes our banks to help us live up to our commitment towards the next generations. Risk taking is the oxygen of any development. Without it the economy stalls and falls.

And the distortion this portfolio invariant credit-risk weighted capital requirements produces in the allocation of bank credit, is an issue that is not yet even discussed. The regulators are trying to hide their mistake imposing a not risk weighted leverage ratio but, by still keeping the risk weighted part, the distortion are well alive and kicking. If only in their stress testing of banks they would also look at what is not on the balance sheets but should be there. 

Why do nations fail? When they care more about what they already have than about what they can get! God make us daring!

And no one of the regulators responsible for the mess seems to have been held accountable… in fact most of them seem to have been promoted.

Here is the best and the worst of macro-prudential bank regulation. Guess which one we got?

The best macro-prudential bank regulation that exists is: “Do not interfere in their allocation of credit but, make sure banks go belly-up as soon as they find themselves belly-up” 

Quite the opposite of today which is: “Let’s interfere as much as possible, like for instance with our portfolio invariant credit-risk weighted capital requirements for banks,” which is a potent growth hormone of too big to fail banks, and also potently distorts the allocation of bank credit, and then, with QEs and other concoctions: "Let's cover up fast we can how stupid we as regulators have been”

In 2003, as an Executive Director of the World Bank I told regulators that had gathered to talk about Basel II the following: "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."

You need not to be an Einstein to know that current bank regulations are procyclical.

Jon Cunliffe, Deputy Governor for Financial Stability of the Bank of England spoke on November 15, 2015 about “The outlook for countercyclical macro prudential policy”

He began with: “It is an interesting experiment to think what Einstein might have accomplished had he chosen the world of economics rather than physics. Would he have brought to our world the same brilliant simplicity and achieved the same lasting change in our understanding?”

I have no idea what Einstein would have done in such case but I am absolutely certain about what he would not have done.

He would not have set up pro-cyclical credit risk weighted capital requirements for banks, those which are lower for what is perceived as safe than for what is perceived as risky; those which allow banks to leverage more with what is perceived as safe than what is perceived as risky; those which therefore allow banks to earn higher risk-adjusted returns on what is perceived as safe than on what is perceived as risky; those which therefore in Mark Twain’s supposed words make bankers lend you the umbrella even faster than usual when the sun is out and take it away even faster than usual when it looks like it is going to rain.

When times are rosy and so much can seem safe, then banks need to hold little capital and so when times get bad, and so much seems risky, then banks, on top of their difficulties must also come up with additional capital or shed assets. No Mr Cunliffe Einstein would never have done a stupid thing like that.

Einstein would also have understood that the safer an asset is perceived the larger is its potential to deliver those unexpected losses that bank equity is to serve as a buffer against. To set capital requirements based on the ex ante expected credit losses is as dumb as it gets.

And Einstein would of course, before regulating the banks have asked: “What is the purpose of banks?” And when stress-testing banks, besides looking at what is on their balance sheets, Einstein would also have looked at what is not and perhaps should be.

But come to think of it… you should not be an Einstein to get all this!

With respect to developing countercyclical macro prudential policy Cunliffe expresses “I have some sympathy of the ‘don’t do it at all’ approach.

Yes Mr. Cunlifee. The regulators have done more than enough damage as is. Just eliminate the re-clearing in the capital of the perceived credit risk that has already been cleared for with interest rates and the size of the exposure. Don’t you understand that any risk, even though perfectly perceived, leads to the wrong actions if excessively considered?

A letter in Washington Post: Reverse-mortgaging the future

Reverse-mortgaging the future

The reverse mortgage on the economy the baby boomers allowed will forever shame their intellectual elite.

In 1988, the Basel Capital Accord introduced the concept of credit-risk-weighted capital requirements for banks. More risk, more capital — less risk, less capital. That allowed banks to leverage more, and therefore to earn higher risk-adjusted returns on equity when lending to the safe as opposed to the risky.

As a result, it also imposed a de facto reverse mortgage on the economy, which extracted the value it already contained, as banks focused more on refinancing the safer past than the riskier future.

And that also meant we refused those coming after us the risk-taking that brought us here and, in such a way, we baby boomers — or at least our elite — allowed the intergenerational holy bond that Edmund Burke wrote about to be violated. That is something the good we might have done in the 1960s will never be able to excuse.

PS. The capacity to borrow at a reasonable cost is a very valuable strategic sovereign asset. It should not be squandered away by the generation in turn only to benefit its members, or with some non-productive investments.

A letter in The Washington Post 

Here other of my letters in the Washington Post on this issue:
September 6, 2007: Factors in the Financial Storm
June 20, 2008: An Aspect of the Bubble
December 27, 2009: Another 'worst': Faulty bank regulation

January 6, 2012: Handcuffed by a triple-A rating
May 1, 2013: An American approach to banking
December 23, 2014: Let the market rule on risky trades
August 9, 2016: Banks, regulators and risk
April 16, 2017: When banks play it too safe 

July 11, 2018: There is another tariff war that is being dangerously ignored. 

December 30, 2018: Affordable homes or investment assets?

Thomas Hoenig of the FDIC, please indicate your colleagues, the right non-Taliban way of regulating banks.

In a speech of November 5, Thomas Hoenig, the Vice Chairman of the FDIC in a speech titled "Post-Crisis Risks and Bank Equity Capital", spelled out correctly and clearly the problem with current bank regulations.

Hoenig stated: “Global banks are not as well capitalized as some within the industry would have you believe. The fact is they remain highly leveraged and highly complicated, and should one fail, it would have systemic, destabilizing consequences. There are two different ways to address these concerns. One would require detailed rules to control firms' behaviors, structure their balance sheets, and direct their activities…

The other way to promote stability would be to simply demand more equity capital to enable banking firms to better withstand a crisis, while allowing them to run their businesses with less government direction.

The first option would require regulators to predict what activities and investments might cause future crises. It also would require them to calibrate rules in a manner that wouldn't give rise to subsequent crises. In other words, regulators would have to successfully anticipate the source of future crises, which as you know could arise from a number of activities, but mostly likely will come from something we fail to predict.

The second approach is based on equity capital and thus would not require such extraordinary insight from regulators. By design, it acknowledges that regulators cannot predict events and it ensures a safer system because well capitalized institutions are better able to withstand shocks and survive crises. Using simple leverage measures instead of risk-based capital measures eliminates relying on the best guesses of financial regulators to guide decisions.” End of quote.

Since the safer something is perceived the larger the potential for it to deliver an unexpected shock, it is of course only the second approach that can be the valid one… and the only thing we would pray for, is for that very careful attitude and steady hand required for getting us from here to there, without making it all so much worse.

Mr. Hoenig. Show your colleagues very carefully the right very careful way! There are more than enough regulatory Taliban out there.

Just asking for 20-30 percent capital requirements for banks is just playing for the galleries.

PS. Personally I would gladly settle for a goal of 8-12% of capital against all assets thereby getting rid of the worst part of current regulations, namely how the risk-weighing distorts the allocation of bank credit. How to get there? I have my ideas and the one I most like is inspired by how Chile capitalized their banks in 1985.

#BoEOpenForum: What a great opportunity to make questions that have bothered me for over a decade, but which are never responded

The Bank of England announced: “Send your thoughts and ideas by email to: OpenForum@bankofengland.co.uk We will publish as much of this material as we can.”

And so I did, and they replied: “Thank you for your e-mail regarding the Open Forum on Building Real Markets for the Good of the People. We welcome your interest in the event, which is due to take place on 11 November 2015 at the Guildhall, London.”

Below is what I sent… have you seen any answer?

Bank of England, how can you justify the pillar of current bank regulations that have emanated under the Basel Accord, the credit-risk weighted capital requirements for banks? More ex ante perceived credit risk, more capital (meaning mostly equity) – less risk, less capital.

1. Banks already consider credit risks when setting risk premiums and deciding on the size of their exposures. And so, considering that same credit risk again, when setting the capital requirements, causes credit risks to be excessively considered. Don’t we all know that any risk perfectly perceived results in the wrong actions, if excessively considered?

2. Why do regulators concern themselves with the risk of banks’ assets when they should really be concerned with how the banks manage those risks? Motorcycles are indeed riskier than cars, but many more die in car than in motorcycle accidents.

3. This regulation allows banks to leverage more with what is perceived as safe than with what is perceived as risky; meaning that banks will be able to earn higher expected risk adjusted returns on equity when lending to what is safe than when lending to what is perceived as risky; resulting in that banks will lend too much to what is perceived as safe, and too little to what is perceived as risky… like to SMEs and entrepreneurs.

4. And this means in essence that banks will be prone to stay away from financing the riskier future, and keep to refinancing the safer past. How come regulators did not define the purpose of banks, like allocating credit efficiently to the economy before settling for these capital requirements? Is being a safe mattress in which to stack away or savings, the reason why society supports the banks? That does not sound right. If regulators cannot resist the temptations to distort, why not do so based on the SDGs?

5. Besides, if capital requirements are primarily to serve as a buffer against unexpected losses, something regulators have explicitly accepted, how on earth can one justify these to be based on expected credit losses? Is it not really so that the safer something is perceived, the greatest is its potential to deliver unexpected shocks?

6. And all that credit risk aversion for what? Is it not so that no major bank crisis ever, has resulted from excessive financial exposure to assets perceived as risky when booked? Have these not always resulted from excessive financial exposures to what was wrongly considered as very safe assets when booked? What empirical data gathering about the ex post causes of bank failures and bank crises did bank regulators do, before settling for these capital requirements that are based solely on ex ante perceived credit risks?

7. And those capital requirements have seeded all type of confusion in the market. That can clearly be evidenced with the number of time specialized media, and even financial officer of high status, have made historical comparisons between the non-risk weighted capital of banks in the past and this modern credit risk-weighted concoction. Do you really think risk-weighted capital requirements allow for any sort of reasonable comparison between banks?

8. And why do you accept the increasing complexity that, with the exceptions of those who make a living out of it, serve no one well? From about 30 pages in Basel I to what there is now. And add to that massive local regulatory documentation. And how come you can sit back and not scream when subject to intellectual waterboarding, by for instance the European Commission’s decreeing “a supporting factor equal to 0,7619 to allow credit institutions to increase lending to SMEs.”?

9. Besides, the regulators set the risk weight for sovereigns much lower than for any other borrowers…. zero percent sovereigns -100 percent private sector! Some could justify that arguing that sovereigns can print money and are therefore always able to repay. But does that not ignore that sovereigns quite often end up repaying with printed money worth much less; or requiring extra taxpayer assistance. And does not that, which makes it easier for governments to borrow, imply regulators believe government bureaucrats can use bank credit more efficiently than the private sector? Are current bank regulators allowed to act as statist activists?

10. And with the above referenced regulatory favoring of that sovereign debt that is usually used as reference for the risk free rate, do we now not have a subsidized free rate that is impossible to interpret?

11. We are here thanks to the risk-taking of generations before us. Are we morally allowed to accept risk adverse regulations that negates next coming generations the risk-taking they deserve and need? Does that not break that holy intergenerational bond Edmund Burke spoke about? God make us daring!

12. And odiously discriminating in favor of The Safe, and therefore against The Risky, and thereby negating many the opportunities of betterment, is that not the surest way to increase inequalities?

13. Leverage ratios that do not depend on credit risk, are now being imposed on banks; and this undoubtedly creates extra capital scarcity. Just like when crossing a desert you sacrifice those who most consume scarce water reserves that makes on the margin the credit risk weights even more distortionary. Do regulators ignore how pro-cyclical these regulations are?

14. Though I have many other similar observations, let me just finalize here by asking: Why is it that a person like me, who has more than enough professional and academic background to be making these questions, who has proven like very few having alerted to the dangers of current bank regulations, even while being an Executive Director of the World Bank (2002-04); who has formulated thousands of questions on this issue during more than a decade, in all type of venues, has not been able to receive any sort of clear answers?

Friends, 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 its collapse”. We have already experienced one AAA-bomb exploding, but our regulators keep taking us down that same crazy road. BoE could you please help us stop them?

Yours truly,

Per Kurowski

PS. Mark Twain has been attributed with saying that the bankers are those who want to lend you the umbrella when the sun shines and want to take it away when it is raining. Dear BoE, what is to be gained by making bankers want to lend you the umbrella even more when the sun shines, and take it away even more when it looks like it is going to rain?

PS. If you need references of me here is what I can document having written early:

http://subprimeregulations.blogspot.com/2004/11/some-of-my-early-public-opinions-on.html

And since then you can find my many thousands comments in:

http://subprimeregulations.blogspot.com

http://teawithft.blogspot.com/search/label/subprime%20banking%20regulations

http://financefordevelopment.blogspot.com

Current bank regulators have no moral right to address the misconduct of other in the financial sector.

The Financial Stability Board (FSB) published November 6 a progress report for the G20 on the FSB’s work on addressing misconduct in the financial sector. The progress report on the Measures to reduce misconduct risk sets out details about the FSB-coordinated work to address misconduct in the financial sector and the timeline for the actions.

For many years argued that the bank regulators themselves carried out the most serious misconduct in the financial sector.

With their portfolio invariant credit-risk weighted capital requirements for banks, imposed without the slightest evidence of having empirically studied why bank crises occur, and without defining what is the purpose of banks, they manipulated the world’s bank credit markets with serious consequences for millions.

Compared to that, the manipulation of of example the Libor rate, although clearly not to be excused in any way, is simply peanuts.

When we consider the millions of SMEs and entrepreneurs who have been impeded fair access to bank credit, and the loss of job creation for the coming generations that must have resulted from that; and the trillions of public bailout/stimulus debts hanging over us, the regulators should better retire in shame than preach about the misconduct of others.