30 years after the introduction of risk weighted capital requirements for banks, the European Commission's Action Plan, finally spills the beans on that these can distort the allocation of bank credit, for a good (or for a bad) purpose.

The European Commission's Action Plan for a greener and cleaner economy, of March 8, 2018 includes the following statement:

“Incorporating sustainability in prudential requirements: banks and insurance companies are an important source of external finance for the European economy. The Commission will explore the feasibility of recalibrating capital requirements for banks (the so-called green supporting factor) for sustainable investments, when it is justified from a risk perspective, while ensuring that financial stability is safeguarded.”

To my knowledge this is the first time in 30 years, since the introduction in 1988 of risk weighted capital requirements for banks, that an official entity has recognized that by distorting the allocation of bank credit, in favor or against something, regulators can make banks serve a purpose different from safeguarding financial stability.

PS. Sadly though not even “safeguarding financial stability” was well served as all this regulation did was to doom banks to dangerously overpopulate safe-havens holding especially little capital

PS. In October 2013 I discussed this issue on my "Our-piead-a-terre blog"

PS. And on Earth Day 2015 I made a proposal exactly like what the EC will now study, namely to base the capital requirements for banks based on the Sustainable Development Goals SDGs, which of course include environmental sustainability.

@PerKurowski

Banking before and after 1988

For about 600 years, before 1988, the exposures of banks to assets were a function of the by bankers ex-ante perceived risks (bpr), the risk premiums (rp), and bankers’ risk tolerance (brt) 

Pre 1988 Bank exposures = f (bpr, rp, brt)

Bank capital (equity) followed the rule of "One for all and all for one".

After 1998, Basel Accord, soon 30 years, with the introduction of the risk weighed capital requirements, the exposures of banks to assets are a function of the by bankers ex-ante perceived risks (bpr), the 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 regulators' risk tolerance (rrt)

After 1988 Bank exposures = f (bpr, rp, brt, rcc=f (rpr, rrt))

Anyone thinking banking remained the same after 1988 is either naïve or dumb.

Anyone thinking the allocation of bank credit to the real economy was not distorted by this, is dumb.

Anyone thinking that distorting bank credit to the real economy is not something very risky, is either ignorant or a populist technocrat suffering from excessive hubris.

Anyone thinking that distorting bank exposures this way make banks safer, is an ignoramus who has no idea about what bank crises are made of: namely unexpected events, criminal doings and what was ex ante perceived as very safe but that ex post turned out very risky.

Anyone thinking this does not promote inequality has no idea of what the opportunity to bank credit does to fight it 

PS. With respect to the perceived risks, both the bankers’ and the regulators, let me remind you that any risk, even if perfectly perceived, causes the wrong actions if excessively considered; something here done by design.

Just before the Berlin Wall fell, communists, statists, dictators and those who benefit from crony statism, gave the liberal capitalistic free-market world the finger.

The Confession that, seemingly, shall not be acknowledged:

“The assets assigned the lowest risk, for which capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages. The American 'overall leverage' approach had a disadvantage as well in the eyes of shareholders and executives focused on return on capital; it seemed to discourage holdings of the safest assets, in particular low-return US government securities." Paul A. Volcker, “Keeping at it” 2018.

In 1988, just before the fall of the Berlin Wall in 1989, some communists/statists hacked into the free market capitalist world’s bank regulations. By means of Basel I, and for the purpose of determining the capital requirements for banks, they arranged so that the risk weight for lending to OECD sovereigns was zero percent, the risk weight for lending secured with houses 50 percent, while the risk weight for lending to the private sector was set at 100 percent.

Since the basic capital requirement was set at 8 percent that meant that banks could leverage their capital unlimited times when lending to their sovereign, 25 times (100/4) when financing the purchase of houses and 12.5 times to 1 (100/8) when lending to the private sector, to the citizens.

That doomed bank to lend too much to the governments and too much to the housing sector, and basically to abandon the traditional role of banks, namely to provide credit for the private sector, like to SMEs and entrepreneurs. Of course those from the private sector that were exploiting crony statism, they just loved it. 

That de facto reflected the belief that government bureaucrats, the autocratic bureaucracy, know better what to do with bank credit for which repayment they are not personally responsible for, than for instance e.g., small businesses and entrepreneurs.

And that in turn doomed the liberal free-market and capitalistic economies of the western world.

In a letter published by Financial Times in 2004 I wrote: "Our bank supervisors in Basel are unwittingly controlling the capital flows in the world. How many Basel propositions will it take before they start realizing the damage they are doing by favoring so much bank lending to the public sector?”

That the world is suffering under the thumb of neo-liberalism? That is just sad fake-news cover up invented by statists/communists.

How much public debt would have been avoided, or at least priced correctly if banks, when lending to the sovereign, needed to hold that same 8% they were required to hold when lending to the citizens?

Please, for the good of our grandchildren, it might already be too late for our children, help me tear down that wall the Basel Committee built… urgently … Greece was just the tip of the iceberg!

P.S. On that day, all around the world, Bureaucracy Autocracies were empowered. 

P.S. On that day, financial communism was decreed 

P.S. When 1988 regulators assigned America’s debt a 0.00% risk weight, its debt was $2.6 trillion, 50% GDP, now on route to $28 trillion, about 100% GDP, and it still has a 0.00% risk weight. When do you think that weight should increase to 0.001%?

P.S. Are those regulations in accordance with what the Founding Fathers expressed in the US Constitution?

PS. November 2023, there's 34 years since the world went from “Tear Down that Wall” to the “Build Up that Wall” for 34 years.

P.S. If Basel I had been imposed four decades earlier:

Would now John F. Kennedy have wanted to deliver his 1963 “Ich bin ein Berliner” speech?

If the Berlin Wall was still up, would now Ronald Reagan, if still with us, have needed to tell Putin “Tear down this wall!”?

PS. Here is an aide memoire on the mistakes in the risk weighted capital requirements for bank made so much worse with the introduction of Basel II in 2004.

A letter to the Financial Stability Board

A letter to the IMF titled: "The risk weights are to access to credit, what tariffs are to trade, only more pernicious."

I’ve recently enrolled ChatGPT - OpenAI to assist me in the fight against regulatory communism/fascism.

Here a letter the Washington Post published in August 2023 and that refers to Paul Volcker’s valiant courageous and honorable confession on what happened 1988.

Greece was taken down by loony statist technocrats or by hard line communists, acting as bank regulators.

More than six years ago, in jest, but also in all seriousness, I set up a blog named AAA-bomb. In it I recounted the actions of “Carlos Molotov Pavlov, a central planner who to avenge his loss of a cushy job in the Soviet entered the bank regulatory system in Basel and managed to create, seed and detonate an AAA-bomb in the heart of the capitalist Empire”

Already in 1999 in a Op-Ed I had written: “The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause the collapse of our banks”.

The AAA-Bomb, which had been invented in 1988 with the Basel Accord, Basel I, and that had been further refined in 2004, Basel II, was the credit-risk-weighted capital requirements for banks.

While these required banks to hold 8 percent in capital when lending to any unrated SME in Europe, these allowed banks, in accordance to how Greece was then rated, to lend to the government of Greece against only 1.6 percent in capital. So banks could leverage their equity, and the support they received from taxpayers, over 60 times lending to Greece, compared to only about 12 times to 1 when lending to, for instance, a German or a Greek SME.

Implicitly those capital requirements meant that regulators believed government bureaucrats were capable of using bank credit more efficiently than the private sector.

And of course that had to mean sovereigns were going to become over-indebted… and Greece was just one of the AAA-bomb's first casualties.

PS. Citizens beware of the Basel Committee's bureaucrats/technocrats bearing gifts to government bureaucrats/technocrats.

PS. Reality was even worse since European Commission felt that the Greece sovereign, even though it could not print euros on its own and independent of credit ratings, should also be 0% risk weighted, which meant European banks could lend to Greece holding no capital (equity) at all. And then they left Greece to pay for all of that mistake.