Friday, March 31, 2017

The Basel Committee for Banking Supervision has doomed our banking system to fail in its purpose, and to crash.

The Basel Committee (and national bank regulators) allows banks to hold less capital against assets perceived or decreed as safe, like loans to sovereigns, to what has an AAA rating or residential mortgages, than against assets perceived as risky, like loans to SMEs and entrepreneurs. 

That means banks can leverage more their equity with “safe” assets than with “risky” assets.

That means banks can earn higher risk adjusted returns on equity on “safe” assets than on “risky” assets.

That means banks will acquire too many safe assets and too little risky assets.

But, you might ask, is that not great? The answer is, NO! 

It guarantees that the real economy will be negated the risk-taking necessary for it to keep on moving forward so as not to stall and fall. 

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

And it guarantees that, sooner or later, (like in 2007-08 with AAA rated securities and Greece) banks will end up holding, against too little capital, too much of an asset ex ante perceived as safe, but that ex-post turns out to be very risky. 

May God defend me from my friends, I can defend myself from my enemies” Voltaire

And of course that meant that bank regulators decreed inequality.

Thursday, March 30, 2017

BoE: Regulations make banks value what’s “risky” riskier than what it is, and what’s “safe” safer than what it is.

I refer to “The art of the deal: what can Nobel-winning contract theory teach us about regulating banks?” by Caterina Lepore, Caspar Siegert, Quynh-Anh Vo published on BoE’s Bank Underground blog.

It states “Capital Structure: Banks can finance their assets via debt, equity, hybrid securities or a mix of them. Changes in banks’ capital structure may have big impacts on their market capitalisation and are usually under close watch of regulators.”

As many do, that recognizes that differences in capital structure impacts market capitalization and profits. But again, as most can’t, the authors cannot take that intellectual step to understand that different capital structures, ordained for different assets, by means of risk weighted capital requirements for banks, distort the allocation of credit to the real economy.

Since banks do look at perceived risks when deciding on size of exposures and risk premiums, to have regulators also make these ex ante perceived risks influence the capital requirements, one is effectively doubling down on whatever ‘information asymmetries’ might exist in the perception of risks.

That de facto means that current regulations make banks value what’s “risky” riskier than what it is, and what’s “safe” safer than what it is… and seemingly no one, not even BoE, cares a damn.

The author’s also write: “Because banks are better informed about their own risks, institutions allowed to determine risks using their own models, under the internal ratings-based (IRB) approach, may have incentives to under-estimate risks.”

Of course they have incentives to under-estimate risks, as that would generate lower capital requirements, as that would allow for higher leverage of equity, as that would increase the expected risk adjusted returns on equity. 

To understand how naïve regulators have behaved, let us just indicate that it is similar to allowing Volkswagen to do their own carbon emission testing in their own laboratories.

But, don’t get me wrong, this does not mean for a second bank regulators do it better with their standard risk weights. Just as an example those private sector assets rated AAA to AA and that could because of their perceived safety really cause a major bank crisis if those perceptions turn out to be wrong ex-post were assigned in Basel II a risk weight of 20%, while the totally innocuous below BB- rated carry a risk weight of 150%. 

The authors suggest: “In the real world where banks can both undertake excessive risks and underreport such risks, as recognized by the current capital framework, a combination of risk-weighted capital requirement and a non-risk-based leverage ratio might indeed be optimal.”

The fact is that the higher a “non-risk-based leverage ratio” might be, the more can the “risk-weighted capital requirement” distort on the margin. I invite you to think of the movie “The drowning pool”

Professors Oliver Hart’s and Bengt Holmström’s contributions to contract theory can indeed be “helpful in regulating banks!” But, let us not kid ourselves, current bank regulatory mistakes are so basic, these need no new theories in order to be corrected, just pure common sense.

Here are my most urgent questions on bank regulations. These seemingly belong to those that should not be asked, much less answered.


Monday, March 20, 2017

How many YYYs at XXX believe the below BB- rated more dangerous to a bank system than the AAA rated?

I ask because the bank regulators in the Basel Committee clearly do believe that.

In 2004, with Basel II they assigned a 150% risk weight to what is rated below BB-, something to which banks would never ever create dangerous exposures to; and a meager 20% to what is AAA rated, something which, if wrong ex-post, is precisely the stuff bank crises are made of.

And I am a bit concerned seeing that no one is out questioning the regulators about this.

I have tried to ask them questions, but I am not a University, an important media or a sufficiently important personality

Would they answer me if I were ZZZ?

Here is a question to all of you who have read Charles P. Kindleberger’s emblematic “Manias, Panics and Crashes”

In that book, a History of Financial Crises, (6 editions!) did you find something whatsoever that would in the least indicate to you, that current risk-weighted capital requirements for banks could bring stability to our banking system?

I haven’t, much the contrary!

This non-portfolio adjusted risk weighted regulation would only seem to feed more into speculative bubbles… when times are good, a lot seems good, and so a lot gets bank credit… until something gets too much bank credit... and is not so good any longer. 

And if so many crises were caused by unexpected events... how can you settle on regulating based on expected risks?

Could it be that current bank regulators never ever read this book? 

Could it be that regulators never even looked for what has caused bank crises before regulating these? 

Yes, apparently, amazingly, that’s how it seems.

If in doubt just reflect that in Basel II of 2004, the regulators awarded a risk weight of only 20% to that so dangerous for the banking system as what’s rated AAAs, and slammed a 150% risk weight on the so really innocuous below BB- rated, that which would never ever attract excessive bank exposures.

If you happen upon a bank regulator ask him these questions and see him cringe

Sunday, March 19, 2017

Banks, regulators and sovereigns, colluded to introduce, statism, risk aversion and complacency.

It's hard to pinpoint the exact meaning of complacency, especially as that sentiment could have different origins. I am not really sure what it means to Tyler Cowen, but to me, complacency, is quite often only a more comfortable and somewhat hypocritical expression of a “Please don’t rock the boat” wish.

I now quote extensively from Tyler Cowen’s “The complacent class” (page 13)

One thing most Americans agree on it politics–for all the complaining about the bank bailouts–is that there should be more guaranteed and very safe assets. The Federal Reserve Bank of Richmond has estimated that 61 percent of all private-sector financial liabilities are guaranteed by the federal government, either explicitly or implicitly. As recently as 1999, this figure was below 50 percent. We’re also more and more willing to hold government-supplied, risk free assets, even if they offer very small or zero yields… Plenty of commentators suggest that something about this isn’t right, but again the push to fix it is extraordinarily weak, especially since that would mean someone somewhere would have to take significant financial losses.


There is a Zeitgeist and a cultural shift well under way, so far under way in fact that it probably needs to play itself out before we can be cured of it. The America economy is less productivity and dynamic, Americans challenge fundamental ideas less, we move around less and change our lives less, and we are all the more determined to hold on to what we have, dig in, and hope (in vain) that, in this growing stagnation, nothing possibly can disturb our sense of calm.”



Is it really so as Cowen seems to argue, that the Home of the Brave, that which has developed based on considerable doses of risk-taking by risk-takers, now comes to this complacency on its own... or was it entrapped?

I argue the latter. One way or another, regulators managed to sell to a financially naïve political sector the concept that it was possible for bank regulators, or for the more sophisticated banks’ risk models to determine real-risks, and so introduced risk-weighted capital requirements… topping it up by putting aside all considerations as to whether this could distort the allocation of credit to the real economy.

In 1988 America induced and signed up on the Basel Accord, Basel I. That ruled that for the capital requirements banks needed to hold, the risk weight of the sovereign was to be zero percent, 0%; for mortgages to the residential housing 55%; and for loans to We the People 100%.

In 2004, with Basel II, the risk-weight for residential mortgages was reduced to 35%; We the People were also split up in “the safe”, the AAA rated, the AAArisktocracy with a risk weight of 20%; passing through a risk-weight of 100% for those not rated ordinary citizens; and topping it out at 150% for those rated below BB-.

What did this mean? First that regulating technocrats, sent out the falsely tranquilizing message to the market of “Don’t worry, banks are now risk-weighted”. Second, that statists told banks: “We scratch your back and you scratch ours… the State guarantees you, and you lend to the State as cheap as possible”. 

Of course that immediately resulted in that banks would search out any assets that were decreed, perceived or concocted as safe; as with these banks could leverage more and therefore obtain higher risk adjusted returns on equity… which much explains the much increased appetite for “safe assets”, in America and Europe.

Of course that meant that the sovereign would by artifice receive much more bank credit, at much lower rates than usual; making a joke of that “risk-free-rate” used in finance. 

Of course that immediately resulted in that banks would avoid all assets officially perceived as “risky”, like loans to SMEs and entrepreneurs, as with these banks could leverage much less and therefore obtain lower expected risk adjusted returns on equity… which of course affected the productivity and the dynamism of the real economy, in America and Europe.

Of course that meant banks would prefer financing the construction of the “safe” basements were young unemployed can live with their parents than the riskier future that could create the jobs they need… which reduces mobility as more and more get to be chained to houses with artificially high prices.

And a truly sad part of all these induced statism and risk aversion is that it does not lead to any more bank stability, much the contrary. Major bank crises are caused by unexpected events (e.g. devaluations), criminal behavior (e.g. loans to affiliate) and excessive exposures to what was ex ante perceived as very safe but that ex post turns out to be very risky, among others because being perceived as very safe often causes it to receive too much bank credit.

What caused the 2007-08 crisis? Excessive exposures to what was perceived or decreed as safe as AAA rated securities and sovereigns like Greece.

What has caused stagnation thereafter? Lack of lending to SMEs and entrepreneurs, those best equipped to open up new paths.

Where banks in on this? Answer would banks like being able to earn the highest risk adjusted returns on equity when holding what they perceived as the safest? Of course they would, that sounds like bankers’ wet dreams come true.

I find “The Complacent Class” to be a fun and very useful book, and it could help get very important and needed debates going. That said I would like to see Tyler Cowen substantially updating the second edition of it, by including that dangerous risk aversion and complacency imposed on banks and on America (and Europe) by its regulators.

Thursday, March 16, 2017

If Basel’s capital requirements for banks were gender or race weighted, would the world have been so silent?

We now have risk weighted capital requirements for banks, more risk more capital, which clearly discriminates against the access to bank credit of those perceived as risky. That even when what is perceived as risky has never ever caused a major bank crisis; in terms of risk perceptions, that dishonor has always fallen on those ex ante perceived as very safe.

And so SMEs and entrepreneurs have much less access to bank credit, that is unless they are willing to pay much higher risk premiums. And so our economies are provided with much less of that oxygen that risk-taking signifies to its development.

And yet the world keeps mum on it.

I wonder what hullaballoo it would raise if instead those capital requirements were gender or race based?

I ask because when it comes down to odious discrimination it all seems the same. 

Dr Andreas Dombret your Basel I, II and III will be discovered as a truly ugly piece of Ramsey statue.

I will quote from Dr Andreas Dombret speech “Basel III - goal within sigh” delivered at the Bundesbank symposium on "Banking supervision in dialogue", Frankfurt am Main, 15 March 2017. 

The Member of the Executive Board of the Deutsche Bundesbank stated:

“The statue of Ramses is not only a work of art; it is also testament to the highest quality of craftsmanship, which is one major reason it has survived for three thousand years. Figuratively speaking, this is how we, too, must approach the Basel reform package. It’s not just about developing uniform, consistent rules – risk sensitivity is another of our guiding principles. During the negotiations, we will therefore call for higher risk to go hand in hand with higher capital requirements.”

Dr. Dombret if you and your regulatory technocrat buddies keep on insisting that what is perceived as risky is the stuff major bank crises are made of, your Basel regulations will doom the banks and the real economy.

You state “The equity ratio of German banks and savings banks has risen by more than half a percentage point to currently 16.2% since September last year, which was due primarily to the reduction in risk-weighted assets”, and I ask: How do you know that the reduction in risk-weighted assets did not affect those assets your banks most need to hold for your real economy not to stall and fall? 

Dr. Dombret, if you read this comment please answer these following questions, if you dare!

If bank regulations had been privatized, how much would a Basel Committee Ltd have paid in fines for 2007-08 crisis?

I ask, because in courts it would have been quite easy to demonstrate that the banking sectors excessive exposures, to for instance AAA rated securities backed with mortgages to the subprime sector in the US, or in loans to a sovereign like Greece, those which caused the crisis, were the direct result of the risk weighted capital requirements for banks.

By strangely awarding lower risk weights to what was perceived as safe, which translated into lower capital requirements, the banks could leverage their equity with exposures to the “safe” many times more than with exposures to what was perceived as risky, like loans to SMEs.

As an example the risk weight for the AAAs was 20%, for sovereigns it hovered between 0 and 20% (Greece) and for SMEs 100%. That meant banks could leverage their equity 62.5 times with AAAs, unlimited to 62.5 times with sovereigns, but only 12.5 times with SMEs. That meant banks would earn much higher expected risk adjusted returns on equity on AAAs and sovereigns than on SMEs. 

I mentioned above, “strangely awarding”, because any regulator who knows what he is doing, would have gone back to analyze what causes bank crisis. Doing so he would have discovered that excessive exposures to what were ex ante perceived as risky never ever occur, (ask Mark Twain). All crises result from either unexpected events (devaluations), criminal behavior (loans to affiliates) or excessive exposures to something ex ante perceived very safe but that ex post turned out to be very risky.

So if society had brought this in front of a court, how much would Basel Committee Ltd have been fined? Clearly so much that it would have been out of business; so much more than what happened to Arthur Andersen when it was brought down for failing in its auditing of Enron.

And all that before all those “risky” SMEs, those who as a result of these regulations had their access to bank credit impaired, would have sued Basel Committee Ltd for the loss of their lifetime opportunities. 

But what has happened to the regulators responsible for the Basel Committee for Banking Supervision? Nothing, zilch, zero, nada, in fact many of them have been promoted.

And anyone knows what has happened to those emission controllers that were cheated by Volkswagen? Nothing? Perhaps there is a real case for privatizing regulations and controls, that way we could at least have some accountability.

PS. In the case of the larger more “sophisticated” banks the Basel Committee even went as far as allowing these to use their own models to calculate capital requirements, something like allowing Volkswagen to calculate their own carbon emissions.


Wednesday, March 8, 2017

“You’re crazy!” That’s what John K. Galbraith would have said; about Basel’s risk weighted capital requirements for banks

I quote from John Kenneth Galbraith’s “Money: Whence it came where it went” 1975.

“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] 

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.”

[But that] 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.”

So, on behalf of "the men of wisdom", in came the Basel Committee for Banking Supervision. With Basel I 1988, and Basel II 2004, it told bankers that even when they already consider perceived risk when setting interest rates and deciding on the amount of exposures, they also had to consider the perceived risks for how much capital their banks needed to hold.

In other words bank regulators ordered the banking system to double down on ex ante perceived, (decreed or concocted) risks.

For a while, while bankers were exploiting all the opportunities of being able to mind-boggling leverage their equity with what was thought safe (a banker’s wet dream come true) all seemed fine and dandy. 

The immense growth of bank credit (later followed up with QEs) injected tremendous amount of liquidity into the economy… all until some safe havens, like AAA rated securities and Greece, in 2007/08 became dangerously overpopulated and burst.

One should think the “men of wisdom” would have updated their wisdom, but no!

“The risky”, like SMEs and entrepreneurs, still have to compete with “The Safe” for access to bank credit while carrying the burden of generating larger capital requirements for the banks… while “the safe” havens run the risk of being dangerously overpopulated.

I have no doubt John Kenneth Galbraith, if alive, would say: “You’re crazy!”

My 1997 Puritanism in banking

Sunday, March 5, 2017

Here is one mystery in current bank regulations that regulators refuse to reveal to us.

That which has an AAA rating, meaning it is perceived as very safe, will of course have much access to bank credit, and be required to pay very low risk premiums. If those ratings then turn out to be wrong, sometimes precisely because since it was considered very safe too much credit was given to it, individual banks, and the bank system, face a very serious problem.

That which has a below a BB- rating, meaning it is perceived as extremely risky, has access to much less credit and, when it gets it, will be by paying much higher risk premiums. If those ratings turn out to be even worse, some individual bank might have a smaller problem, but the bank system as such, would face no problems at all.

But, an here is the mystery, bank regulators, with their Basel II, in June 2004, for the purpose of setting the capital requirements for banks, set a 20% risk weight for the AAA rated and 150% for what is below BB-.

Why so? If "safe" could be dangerous and "risky" is innocuous, could it not really be the other way around?

And that, since regulators refuse to explain it, is now, soon 13 years later, still a mystery to us