Tuesday, March 15, 2016

John D. Turner’s “Banking in Crisis” truly evidences a mind-blowing "Regulations in Crisis"

Turner writes: “If the rationale of bank regulation is to prevent banks from risk shifting and the banking system from collapsing, then the Basel approach to capital regulation failed dramatically”

That might seem like a correct statement but it is not. The true rationale of bank regulations is to assure banks serve their social and economic purpose of allocating bank credit to the real economy, without of course incurring excessive risks that could lead to the collapse of the banking system.

And in this respect the Basel approach, as it completely ignored that purpose of banks, and even went so far as to de-facto base its prime pillar, the risk-weighted capital requirements, on distorting the allocation of credit, fails even more dramatically.

Turner writes: "One reason for this failure was regulatory arbitrage… whereby capital regulations perversely incentivized banks to become riskier”

Absolutely wrong! The capital regulations perversely incentivized banks to create dangerous large exposures to what was perceived or deemed to be safe”

Turner writes: "Indeed, much bank lending to the residential-property market could have been partially due to the regulatory arbitrage because such lending had a 50 percent weighting in a Basel risk-weighted asset calculation, compared to 100 per cent for a commercial loan”

What regulatory arbitrage? Regulator set the weights that allowed banks to leverage twice as much on residential-property market loans than on commercial loans. Banks did not arbitrage, they did what they were instructed.

Turner writes: "To increase their return on equity, banks engaged in ’cherry-picking’ by shifting the composition of their loan portfolios towards riskier credits.”

What? In order to increase their expected risk-adjusted returns on equity they shifted the composition of their loan portfolios towards those credits that perceived or deemed as safer, allowed them to hold less capital. That is NOT ’cherry-picking’, that is something healthy banks are supposed to do to remain healthy, or does Turner believe it is good banks should on purpose try to lower their risk-adjusted returns on equity?

Of course with this type of regulations, there was much vested interest in hiding the risks. The pressures on the credit rating agencies to provide Potemkin AAA ratings were immense.

No! This current bunch of regulators, trying to avoid their own mental monsters, confusing ex ante risk with ex post realities, have distorted all common sense out of the allocation of bank credit. And so now banks no longer finance the riskier future they just keep on refinancing the for the time being safer past.

Our children and grandchildren will pay for their hubris.

The risk-weighted capital requirements clear in the capital for risks that have already been cleared for by means of risk premiums and size of exposures. And any perceived risk, even if perfectly perceived, if excessively considered, guarantees wrong actions.

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

And regulators also forgot that even the safest harbors could turn into dangerous traps, if excessively populated.

We must completely clean the bank regulatory slate, which of course begins with retiring all current regulators who are suffering from the credit risk adverse Basel frame of mind.

PS. All the discussion here were limited to pages 195-199 of John D. Turner's "Banking in Crisis