Why has IMF kept silence on what was done to banks in 1988?
What happened?
Before
1988, for about 600 years, bank exposures were a function of the by bankers ex-ante
perceived risks (bpr), risk premiums (rp) meaning interest rates, and bankers’
risk tolerance (brt)
Pre
1988 bank exposures =ƒ(bpr, rp, brt)
Bank
credit was then allocated to what produced banks the highest expected risk
adjusted interest rate return on equity
But
1988, with the Basel Accord, risk weighted capital requirements were
introduced. With that bank exposures became a function of the: by bankers ex-ante
perceived risks (bpr), risk premiums (rp), bankers’ risk tolerance (brt), and
regulatory capital requirements (rcc), this last itself a function of the by
regulators ex-ante perceived (or decreed) risks (rpr) and the regulator’s risk
tolerance (rrt)
After
1988 bank exposures = ƒ(bpr, rp, brt, rccƒ(rpr, rrt))
Bank
credit was thereafter allocated to what produced banks the highest expected risk and capital-requirement adjusted return on equity
And
of course banking changed dramatically, and the allocation of bank credit to
the real economy became hugely distorted.
With
Basel II of 2004, which introduced risk weighting within the private sector,
and made the process much dependent on credit ratings, the distortions and the
systemic risks were dramatically increased.
Fundamental mistakes:
1.
Although hard to believe, bank regulators never defined what the purpose of
banks is before regulating these. “A
ship in harbor is safe, but that is not what ships are for.” John A Shedd, 1850-1926
2.
Although hard to believe, as the purported reason was to make banks safer, the
regulators never researched what had caused bank crisis in the past; namely
unexpected events, criminal doings and what was ex ante perceived as very safe
but that ex post turned out very risky. What is perceived as very risky is,
precisely because of that perception, what is least dangerous to the system. “May God defend me
from my friends, I can defend myself from my enemies” Voltaire
3.
Any risk, even if perfectly perceived, causes the wrong actions if excessively
considered; and here the regulators doubled down on ex ante perceived risks.
4. Ignoring risk-taking is the oxygen of development. For banks to take risks, albeit in smaller amounts on “risky” SMEs and entrepreneurs, is absolutely vital for the economy to move forward, in order not to stall and fall. Where would we be had these regulations been in place during the previous 600 years? In April 2003 as an Executive Director of the World Bank I stated: “The Basel Committee dictate norms for the banking industry… there is a clear need for an external observer of stature to assure that there is an adequate equilibrium between risk-avoidance and the risk- taking needed to sustain growth.” In fact the risk of excessive risk aversion was the theme of my first ever Op-Ed.
5. Little understanding of systemic risks: In January 2003 I wrote in Financial Times: “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.”
5. Little understanding of systemic risks: In January 2003 I wrote in Financial Times: “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.”
6. Little understanding of
fragility: In April 2003, as an ED of the World Bank I stated: “A mixture of thousand solutions, many of them
inadequate, may lead to a flexible world that can bend with the storms. A world
obsessed with Best Practices may calcify its structure and break with any small
wind.”
7. Little understanding of
pro-cyclicality: When times are good, credit-risks seem low, so
the risk-weighted capital requirements allow banks to expand more than they
should; and when times are bad, the credit risk are naturally perceived higher,
and so the capital requirements force banks to contract credit, precisely when
less bank credit austerity is needed.
8. Macro-imprudence: Prudential regulation helps failed banks to fail expediently.
Macro-imprudent regulation impedes failed banks from failing… which builds uphuge mountains of combustible materials waiting for a Big Bang.
9. Overreliance on data and models:
In October 2004 in a formal statement at the World Bank I warned: “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.”
Consequences:
Statism: Basel
Accord’s risk weights of 0% for “The (infallible) Sovereign” and 100% for “We
the (risky) People” introduced runaway statism. Since then the proxies for
risk-free rates have been subsidized. We have no idea what the current low
interest rates on much sovereign debt would be if government bureaucracy bank
borrowings were affected by a risk-weight similar to SMEs’. De facto those risk-weights imply that regulators believe public bureaucrats know better what to do with bank credit, than the
private sector.
Crisis resulting from dangerous
overpopulation of “safe” havens: The first crisis, that of 2008,
resulted from excessive exposures to AAA rated securities (Basel II risk weight
20% = allowed leverage 62 to 1), sovereigns like Greece, and residential
housing (Basel II risk weight 35% = allowed leverage 32 to 1)
Stagnation:
Banks have stopped financing the riskier future and basically keep to
refinancing the safer past and present. As an example banks finance much more
“safe” basements where jobless kids can stay with their parents, than the SMEs
that could create the jobs that could allow the kids afford to also become
parents. In short this regulation keeps Keynes'
animal spirits caged.
Stimulus waste: Since credit will not flow were they could
most be needed, much of the stimuli fiscal deficits, quantitative easing and
low interest could produce, is wasted.
More inequality:
The result of making it harder and more expensive for the “risky” weaker to
access opportunities of bank credit for productive purposes.
Too Big Too Fail: Clearly minimalistic capital requirements, for so many assets, has served as a potent growth hormone for the TBTF banks.
Too Big Too Fail: Clearly minimalistic capital requirements, for so many assets, has served as a potent growth hormone for the TBTF banks.
Over indebtedness: By allowing
ridiculously low capital requirements for assets perceived as safe, the
regulators allowed banks to leverage too much their equity and the support they
received from society (taxpayers). That facilitated the current generation to
extract more borrowing capacity to sustain its own consumption than any other
previous generation. That has left little borrowing capacity over for the
future generations.
What to do?
To accept the problem exists!
To
know neither Hollywood nor Bollywood, would allow new movies on the same theme
to be produced by directors and scriptwriters responsible for such box-office
flops as Basel I-II-III.
To understand that bank capital requirements would be better if
based on ex-post risks of models based on ex-ante risk perceptions.
To know that if you absolutely must distort, it is better to do
so based on some useful social purpose, like based on job-creation and
environmental-sustainability ratings.
To
understand that getting our banks and our economies out of the Basel mess is a
very delicate process, which does not permit an ounce more of that technocrats’
hubris that caused it all.
IMF, will you keep on being silent on this?
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