Tuesday, September 20, 2016

Luckily credit rating agencies got it wrong and put a temporary stop on it. Otherwise we would have been much worse off

Few can really evidence having warned so much against the use of credit rating agencies in bank regulations, as I can. So I believe that should give me the right to dare to opine that the fact that the credit rating agencies got it wrong, was and is not the worst part of the current bank regulation horror story.

As for examples of the first, in January 2003 the Financial Times published a letter in which I wrote: “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, as an Executive Director of the World Bank, in April 2003, at its Board I formally stated: “Ages ago, when information was less available and moved at a slower pace, the market consisted of a myriad of individual agents acting on limited information basis. Nowadays, when information is just too voluminous and fast to handle, market or authorities have decided to delegate the evaluation of it into the hands of much fewer players such as the credit rating agencies. This will, almost by definition, introduce systemic risks in the market and we are already able to discern some of the victims, although they are just tips of the icebergs.”

And of course, when then the credit rating agencies later messed it up, and got it so amazingly wrong with the AAA rated securities backed with truly lousy mortgages to the subprime sector, it was a real disaster. But, I tell you, it could have been much worse, like if they had rated correctly for a much longer period.

The reason for that lies in the malignant error of the Basel Committee’s risk weighted capital requirements for banks; more ex ante perceived credit risk more capital – less risk less capital.

Perceived credit risk is the risk most cleared for by banks; they do so by means of interest rate risk premiums and size of exposures. And so when regulators decided to clear for exactly the same risk, now in the capital, that perceived credit risk got to be excessively considered. And any risk, no matter how correctly it is perceived, if it is excessively considered, will cause the wrong actions.

For instance banks were (and are) allowed to leverage much more when financing the purchase of residential houses, or when investing in AAA rated securities backed with mortgages, “The Safe”, than what they are allowed to leverage when lending to the core of the bank credit needing part of the economy, the SMEs and entrepreneurs, those who help create the new generation of jobs, “The Risky”.

And that has resulted in that banks earn much higher expected risk adjusted returns on The Safe than on The Risky; which results banks will finance much more The Safe than The Risky.

So, had it gone on (oops it still goes on) we will all end up in houses with no more houses to be built, and without that new generation of jobs that could help us, or foremost our children and grandchildren, to service mortgages and pay utilities.

So let’s be thankful the credit rating agencies got it wrong, but, please, let us also correct for the regulators' mistakes. Thinking on my grandchildren, I would in fact prefer lower capital requirements for banks when financing unrated SMEs and entrepreneurs than when financing the purchase of a house.

But how did this happen and how could it have been avoided.

Well perhaps it would have been nice if the regulators, before regulating the banks ,had defined their purpose. Then perhaps John A. Sheed’s “A ship in harbor is safe, but that is not what ships are for”, could have come to their mind.

And also it would have been nice if the regulators had done some empirical research on what causes bank crisis; and then they would have discovered that never ever excessive exposures to what is perceived as risky; and then they might have thought of Voltaire’s “May God defend me from my friends [AAA rated]: I can defend myself from my enemies [the unrated]