Friday, January 27, 2017

Dear Mr Kurowski, here is our answer to your doubts. Sincerely, the experts in Basel Committee, FSB and affiliates

(I dreamt I got this letter from our bank regulators in response to my questions.)

Dear Mr Kurowski

It does not matter whether the risky already get less credit and pay higher interest rates, they must get even less credit and pay even higher interests… because they are risky. Don’t you get that!

It does not matter whether the safe already get more credit and pay lower interest rates, they must get even more credit and pay even lower interests… because they are safe. Don’t you get that!

It does not matter that the risky have never caused a major bank crisis. Risky is risky and that’s that! 

It does not matter that there could be too large exposures to what’s perceived safe but could in act not be; which could cause a huge crisis. Safe is safe and that’s that.

Yes, yes we understand, (we think) that our risk weighted capital requirements might introduce some serious credit austerity for the risky, like SMEs and entrepreneurs, and that this could affect the economic growth of the real economy. But that’s not our problem. Our sole concern is to keep banks safe. 

For economic growth there are infrastructure projects, like bridges, to be undertaken by the Sovereign taking advantage of the exceptionally low rates it is awarded, because it is really and truly safe. If we can’t trust the Sovereign who are we to trust? The citizens?

Oh, that the 2007-08 crisis was caused primarily because of too much investment in securities rated AAA that was supposed to be super-safe? Yes, but now we are imposing huge fines on those credit rating agencies, so they should have learned their lessons, and all will be fine and dandy. Trust us Mr Kurowski. We are after all, as you know, the experts. 

PS. For your own good stop writing those letters about us to the Financial Times. How many now, around 2500? You’re crazy! Don’t you see FT doesn’t care?

Yours sincerely,

Names withheld (by me)… out of delicacy

PS. Friends, as you can see, our bank regulators remain as captured as ever in their cognitive bias, poor us.

Monday, January 23, 2017

Has history known a worse and more dangerous case of confirmation bias than that of current bank regulators?

Confirmation bias, also called confirmatory bias or myside bias,[is the tendency to search for, interpret, favor, and recall information in a way that confirms one's preexisting beliefs or hypotheses, while giving disproportionately less consideration to alternative possibilities. It is a type of cognitive bias and a systematic error of inductive reasoning. People display this bias when they gather or remember information selectively, or when they interpret it in a biased way. The effect is stronger for emotionally charged issues and for deeply entrenched beliefs. People also tend to interpret ambiguous evidence as supporting their existing position. Biased search, interpretation and memory have been invoked to explain attitude polarization (when a disagreement becomes more extreme even though the different parties are exposed to the same evidence), belief perseverance (when beliefs persist after the evidence for them is shown to be false), the irrational primacy effect (a greater reliance on information encountered early in a series) and illusory correlation (when people falsely perceive an association between two events or situations).

A series of experiments in the 1960s suggested that people are biased toward confirming their existing beliefs. Later work reinterpreted these results as a tendency to test ideas in a one-sided way, focusing on one possibility and ignoring alternatives. In certain situations, this tendency can bias people's conclusions. Explanations for the observed biases include wishful thinking and the limited human capacity to process information. Another explanation is that people show confirmation bias because they are weighing up the costs of being wrong, rather than investigating in a neutral, scientific way.

Confirmation biases contribute to overconfidence in personal beliefs and can maintain or strengthen beliefs in the face of contrary evidence. Poor decisions due to these biases have been found in political and organizational contexts:

The Basel Committee for Banking Supervision's and other bank regulator's confirmation bias. 

Regulators think, as they should, as it is, that what is rated below BB- is much more riskier than what is rated AAA. 

But when deciding on the risk weights to be used for the capital requirements of banks in Basel II of 2004, the regulators directly extrapolated from these beliefs and assigned 20% to the AAA rated and 150% to the below BB-. That is probably one of the most dangerous cases of confirmation bias in history.  Regulator should not have looked at the risk of the assets but at the risk of the assets to the banks, which is not the same thing.

The truth is that precisely because the below BB- is perceived as very risky, that makes it much less risky for the banks; while the AAA rated which is perceived as very safe, precisely because of such perceptions, is what could lead to those dangerously high bank exposures that can cause a huge bank crisis if the ex-post reality turns out to be different.

We are in 2017 and the regulators, because of "belief perseverance", have still not discovered their own confirmation bias… and that even after the mother of all evidences, represented by the AAA rated securities backed with mortgages to the subprime sector turning out to be so very risky.

That this was the fault of credit rating agencies is hugely irrelevant. The better the ratings are, the more confidence is deposited in these, and so the worse do the doomsday scenarios become.

Does anyone know a worse case of confirmation bias?

The dangers? First of course that banks will get caught with their pants down, little capital, precisely when one big exposure might get hit. But second, it introduced a senseless risk aversion that have banks no longer financing the riskier future but only refinancing the “safer” past and present… so our economies are stalling and falling.

PS. Are you still unsure of this? Then try to get the regulators to answer you these questions

PS. In this case it is not only regulators who suffer from “belief perseverance”. Prestigious and influential economists like Martin Wolf, even when being told that the safer is riskier and the riskier is safer, can’t get a grip on the issue.

Saturday, January 14, 2017

Reflections on Terracotta Warriors, credit ratings, and capital requirements for banks

I read in Latin American Herald Tribune of January 14, 2017: “A Chinese state-run newspaper reported that armed with clubs authorities destroyed a museum with 40 fake Terracotta Warriors that tricked numerous tourists and prompted some complaints”

Oh I can already hear it! “Tom, you see, I told you those terracotta soldier boys they took us to see seemed fake. Why did you not listen to me? Why did we have to show those photos to Nancy and George? Do you think we could now sue the Chinese tourism authorities for those terra-whatever being fakes, or at least for disclosing those as fakes after the fact?

My head started to spin too. Some years ago I bought some small Terracotta Warriors in China. Because of their size and pricing, I always thought these to be absolute fakes. No problema! But are these now exposed to being crushed by some Chinese regulator? Might someone over there have a copyright on these that has been infringed?

Come to think of it, do we not need some Chinese Terracotta Authenticity rating agencies? 

Perhaps, but, if those rating agency fall for the temptations to be most certainly offered to them by shady Terracotta Warrior suppliers, hey we’re talking China here, could we ask our government to sue these agencies? 

I mean like the US has done with Moody’s and S&P with respect to their worse than lousy rating processes that produced totally unworthy AAAs for some of the securities backed with mortgages to the subprime sector in the US.

But then again, if these terracotta rating agencies mislead us, would we see some of the money from the fines, or would that only go to those who, to begin with, excessively empowered the rating agencies? 

And should then regulators in China request the vendors of Terracota Warriors to hold more capital, against the risk of being sued, the faker the rating shows its product to be; somewhat like what is being done with banks and their risk weighted capital requirements?

I would not think so. I would have bought my Terracota Warriors even if rated very fake; since the price was right.

Of course, the real problem, like in the case of the AAA rated securities, would be an AAA rated Terracota Warrior, and for which partly because of that rating, billions had been paid for at an auction, if it then later proves to be fake.

Does this mean that the better a Terracota Warrior would be rated, the more capital should the suppliers hold? Yes! Precisely! That’s what fundamentally current bank regulators got wrong.

The safer an asset is ex ante perceived, decreed concocted or rated, the riskier it could be ex post. They completely ignored Voltaire’s “May God defend me from my friends, I can defend myself from my enemies

Thursday, January 12, 2017

The SEC Regulatory Accountability Act is even more needed for the case of Fed / FDIC bank regulations

The SEC Regulatory Accountability Act, sponsored by Financial Services Committee member Rep. Ann Wagner (R-MO), passed 243-184.

Jeb Hensarling (R-TX), the Chairman of the Financial Services Committee explained it: 

“Ill-advised laws like the Dodd-Frank Act empower unelected, unaccountable bureaucrats to callously hand down crushing regulations without adequately considering what impact those regulations have on jobs…The true cost of Washington red tape includes the jobs not created, the small businesses not started and the dreams of our children not fulfilled.”

Now under the bill, before issuing a regulation the SEC will be required to:
identify the nature and source of the problem its proposed regulation is meant to address;
utilize the SEC’s Chief Economist to assess the costs and benefits of a proposed regulation to ensure the benefits justify the costs;
identify and assess available alternatives; and
ensure that any regulations are consistent and written in plain language.

Further, the legislation requires the SEC to engage in a retrospective review of its regulations every five years and conduct post-adoption impact assessments of major rules.

What great news! Not a moment too soon. Now the Financial Services Committee needs to, as fast as possible, issue a similar bill with respect to the regulations applied by the Fed and FDIC to the banks… because in their case they never even defined the purpose of banks before regulating these.

The current risk weighted capital requirements for banks are totally senseless.

Not only has regulators no business regulating based on perceived risks already cleared for by banks, as they should primarily require some capital reserves to face uncertainties, but these regulations also cause banks to no longer finance the “riskier” future but mainly refinance the “safer” present and past, at great costs for the real economy and for future generations.

Here are some questions I have not been able to have regulators to answer; perhaps the Financial Service Committee needs not to go on a hunger strike to manage that.

Bank regulators should be forced to see “Hell on Wheels” and read John Kenneth Galbraith’s “Money: Whence It Came, Where It Went”

In the TV series Hell on Wheels, its main character, Cullen Bohannon, when asked to testify before the US Senate about all the obvious corruption of Thomas ‘Doc’ Durant, someone absolutely not Bohannon’s friend, someone absolutely not one having been sanctimonious or behaved according to any social norms, repeats, over and over again, to the great chagrin of his interrogators: “The Transcontinental railroad could not have been built without Thomas Durant

And John Kenneth Galbraith wrote in his “Money: Whence it came where it went” 1975 the following: “For the new parts of the country [USA’s West]… there was the right to create banks at will and therewith the notes and deposits that resulted from their loans…[if] the bank failed…someone was left holding the worthless notes… but some borrowers from this bank were now in business...[jobs created]

It was an arrangement which reputable bankers and merchants in the East viewed with extreme distaste… Men of economic wisdom, then as later expressing the views of the reputable business community, spoke of the anarchy of unstable banking… The men of wisdom missed the point. The anarchy served the frontier far better than a more orderly system that kept a tight hand on credit would have done…. what is called sound economics is very often what mirrors the needs of the respectfully affluent.”

And Galbraith also opined in his book that: “The function of credit in a simple society is, in fact, remarkably egalitarian. It allows the man with energy and no money to participate in the economy more or less on a par with the man who has capital of his own. And the more casual the conditions under which credit is granted and hence the more impecunious those accommodated, the more egalitarian credit is… Bad banks, unlike good, loaned to the poor risk, which is another name for the poor man.”

Therefore I cannot but conclude in that bank regulators should be forced to see “Hell on Wheels” and read John Kenneth Galbraith’s “Money: Whence It Came, Where It Went”. That in order to, hopefully, be able realize that with their risk weighted capital requirements for banks, these will not finance the risky future, but only refinance the safer past and present and, as a result, the economy will stall and fall. 

To add insult to the injury, bank regulators are doing all this in the belief that bank crises result from excessive exposures to what is perceived as risky, which is utter nonsense. Bank crises have always, and will always, result from uncertainties; that which includes unexpected events, like devaluations earthquakes and regulators not knowing what they are doing, criminal behavior and excessive exposures to something ex ante perceived as safe but that ex post turned out to be very risky.

“If you see something, say something”. Someone should run to the Homeland Security of the Home of the Brave and denounce that, most probably, unwittingly; some serious terrorism is taking place by means of dangerously risk adverse faulty bank regulations.

Do bank regulators, now with “output floor” based on their standardized risk weights, keep on making fun of us?

A 75-percent output floor signifies that no matter which outcome the bank’s internal calculation yields, the risk weight that determines the capital required, can’t be more than 25 percent lower than the standardized risk weighting method designed by the regulators.

So let’s see what that really means. 

For the standard method’s 0% risk weighted sovereign, unless some bank’s internal calculation comes up with a negative risk, it will still mean 0%.

For the standard method’s 20% risk weighted private asset, it means the weight cannot be less than 15%.

For the standard method’s 35% risk weighted residential mortgage, it means that weight cannot be less than 26.25%.

For the standard method’s 100% risk weighted private asset without a credit rating, like loans to SMEs, it means that the risk weight cannot be less than 75%.

Really? Are bank’s internal models worse than your standardized weights? Do you really think the Medici’s would have assigned a risk weight of 0% to the Sovereign?

There’s absolutely nothing wrong with allowing banks to use their own risk models in order to try to minimize their cost of capital, but that regulators concoct a set of ex ante perceived standardized risk weights in order to determine how much capital banks should have in order to be able to confront, not perceived risks, but uncertainty, is just as crazy as it gets.

Here some questions bank regulators refuse to answer, something that should make us all nervous. They really might not have a clue about what they are doing.

Sunday, January 8, 2017

Economist Andrew Haldane. At least when acting as a bank regulator, you are admitting the wrong error you committed

Chief economist of Bank of England Andrew Haldane says “his profession must adapt to regain the trust of the public, claiming narrow models ignored ‘irrational behaviour’” “Chief economist of Bank of England admits errors in Brexit forecasting” The Guardian, January 5, 2017.

Hold it Mr Haldane! What you and other economists ignored. when acting as regulators, was that banks would, as always, behave perfectly rational, and lend to what they expected would yield them the highest risk adjusted returns on equity.

That is what you failed to understand when allowing banks to hold less capital against what was perceived, decreed or concocted as safe. That meant banks could leverage more, and so earn higher expected risk adjusted returns on equity, when lending to the “safe”. 

That distortion in the allocation of bank credit to the real economy, resulted in that banks end up lending too much at too low interest rates to the “safe”… which could be risky for the banks; and to little and too expensive to “risky” SMEs and entrepreneurs which is very dangerous for the economy.