My tweet comments on Stephen Cecchetti's and Kim Schoenholtz's "The financial crisis, ten years on", Vox August 2017

"The financial crisis, ten years on"

Does a crisis start when the bomb is armed, the fuse is lit, the explosion occurs, or when the explosion is noted? http://voxeu.org/article/financial-crisis-ten-years#

In 2003 FT published a letter I wrote about the systemic risk of giving credit rating agencies so much power https://teawithft.blogspot.com/2003/01/credit-ratings-for-developing-nations.html

In 2004 the fuse was lit when Basel II authorized banks to leverage 62.5 times with what was rated AAA

https://subprimeregulations.blogspot.com/2010/06/impose-higher-bank-capital-requirements.html

 

In August 2006 clearly the bomb had already exploded https://teawithft.blogspot.com/2006/08/long-term-benefits-of-hard-landing.html

Unfortunately it was not until July 2007 credit rating agencies woke up and in August that the fan started to spread out the shit.

AI Watson, would you ever feed robobankers those algorithms current bank regulators feed human bankers?

The normal real world rules banks had to follow for about 600 years before 1988, in order to become and remain successful bankers, was to while carefully considering their portfolio, to lend or invest in whatever they perceived would produce them the highest risk adjusted returns on equity. One dollar of equity lost in an operation perceived as risky would hurt just as much as a dollar lost in an operation perceived as safe. 

And even though bankers in general suffered from a risk aversion bias, expressed well by Mark Twain’s “a banker is one to lend you the umbrella when the sun shines and wanting it back when it seems it could rain”, that obviously served our economies well. 

As John Kenneth Galbraith argued, even when in some cases “Banks opened and closed doors and bankruptcies were frequent, as a consequence of agile and flexible credit policies, the failed banks left a wake of development in their passing.”

But then came the Basel Committee for Banking Supervision, and out of the blue decided to assume bankers did not perceive risks; and so came up with their risk weighted capital requirements. These instructed banks, with no consideration to their portfolio, to hold more capital (equity) against what is perceived risky and less against what is perceived safe.

As an example of their crazy regulatory algorithm, it suffices to mention they assigned a risk weight of 20% for the so dangerously AAA rated while one of 150% to the so innocous below BB- rated.

As a consequence of this bankers had to morph from being mainly risk perceivers into also having to be capital (equity) minimizers. Being able to leverage more the “safe “ than the “risky” allowed them to obtain higher risk adjusted returns on equity lending with the safe than with the risky.

As a consequence we have already suffered major bank crisis resulting from excessive exposures to what was erroneously perceived, decreed or concocted as safe, like AAA rates securities and sovereigns like Greece.

As a consequence of not enough lending to the “risky”, like SMEs and entrepreneurs, development is coming to a halt.

Since regulators refuse to listen to little me, I can’t wait for IBM’s Watson developing lending and investment algorithms for robobankers. These would help show bank current regulators how dangerously wrong they are.

Watson would understand that with current distortions banks go wrong even if they perceive the risks absolutely correct.

Watson would understand that what is perceived risky ex ante becomes by that fact alone less dangerous ex post; and that what is perceived safe ex ante becomes by that fact alone more dangerous ex post.

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

Regulator Watson, in contrast to the Basel Committee, would not be looking in the same direction the bankers look

PS. Here on the regulators' confirmation bias

PS. Here my letter to the Financial Stability Board

PS. How do you regulate a regulators' algorithm?

How the Western civilization is being lost because of regulatory induced risk aversion.

Mark Twain has been attributed opining that bankers lend you the umbrella when the sun shines and want it back as soon as it looks it could rain.

And never ever has there been a bank crisis caused by excessive exposures to something perceived as risky when placed on banks’ balance sheets.

But that did not stop scared lack of testosterone bank nannies to also require banks to hold more equity when lending to the risky than when lending to the “safe”.

So what happened? 

As banks earned much higher risk adjusted returns on the safe they could not resist the AAA rated securities backed with mortgages to the subprime sector, or sovereigns like Greece. And so a typical bank crisis, that of excessive exposures to what was ex-ante perceived as safe but that ex post turned out very risky ensued. 

In this case the crisis was made specifically worse, by means of the lower equity banks had been authorized to maintain. For example in the case of the AAA rated securities, Basel II, because of the standardized risk weights, banks were required to only hold 1.6% in capital, meaning an authorized leverage of 62.5 to 1. 

But much worse, since banks of course find it harder to earn higher risk adjusted ROEs on more capital, they have abandoned lending to risky SMEs and entrepreneurs, those who open up new roads on the margins of our economy, and so of course slower economic growth results.

Lack of testosterone, risk aversion, is not a fundamental value of the Western civilization. On the contrary in churches we sometimes sang, or at least used to sing, “God make us daring!”

@PerKurowski

Lawrence Summers, like most, is still blinded by the fairy tale of the risk-weighted capital requirements for banks

I refer to Professor Lawrence Summers “Five suggestions for avoiding another banking collapse” of May 21, 2017

In it Summers clearly evidences he has not yet woken up to the fact that the whole notion of the risk weighted capital requirements of banks is pure and unabridged nonsense… a regulatory fairytale. He still actually believes that risk weighting has anything to do with real risk weighting of the risks to our bank system.  In fact bad-luck risk weighted capital requirements might better cover for the unexpected risk in banking. And so here I explain it again, for the umpteenth time.

The current risk weighting is based on the ex ante perceived risk of bank assets, and NOT on the possibility of that those assets could ex post be risky for the banks and for the bank system

That is for example why regulators in Basel II assigned to what was perceived as AAA rated and that because of such perception of safety could lead to a build up of dangerously excessive exposures, a tiny 20% risk weight; while to the below BB- rated, so innocuous because the banks would never voluntarily create large exposures to it, they assigned a whamming 150%.

Rule: If bankers are not capable of managing perceived risks, then zero capital might be the best requirement, because the faster they would fold.

Truth: A bank system can collapse because of unexpected events (like devaluations), major financial fraud, and when assets ex ante perceived as very safe suddenly turn out ex post as very risky. None of these risks is covered by the Basel Committees’ risk weighted capital requirements.

Summers writes: “there is distressingly little evidence in favor of the proposition that banks that are measured as better capitalized by their regulators are less likely to fail than other banks.” That might be true but only to believe that the measuring of the “measured as better capitalized” is correct, is absurd. Too much reputable research has taken the historical not “risk weighted” capital to asset ratios to be the same as the current capital to risk-weighted asset ratios, which is comparing apples to oranges.

Summers explains: “Our paper examines a comprehensive suite of volatility measures including actual volatility, volatility implied by option pricing, beta, credit default spreads, preferred stock yields and earnings price ratios… none [of which] suggest a major reduction in leverage for the largest US financial institutions, large global institutions or midsize domestic institutions.” I just ask, Professor, amongst so much glamorous sophistications, did you examine the gross not risk weighted assets to capital ratio? That would have probably sufficed.

Summers recommends, “First, it is essential to take a dynamic view of capital” Absolutely! But Professor, do you not believe that a real dynamic view would have to take into account what the shape of the future real economy would be if regulators insist in distorting with their risk weighing the allocation of bank credit to the real economy? For instance should a real stress test not also look at what is not on banks’ balance sheets… like for instance to see if vital risky loans to SMEs and entrepreneurs are too inexistent?

Summers recommends: “banks should not be permitted to take excessive risks or treat customers unfairly in order to raise their franchise value.” Indeed, but what about by means of current risk weighting unfairly allowing those perceived, decreed (sovereigns) or concocted as safer, to have much better access to bank credit than usual than those perceived as risky? Does that not foster more inequality?

Summers very correctly write: “it is high time we move beyond a sterile debate between more and less regulation. No one who is reasonable can doubt that inadequate regulation contributed to what happened in 2008 or suppose that market discipline is sufficient to contain excessive risk-taking in the financial industry” But that requires understanding and accepting that the risk weighting, which so favored what was AAA rated and sovereigns was “the inadequate regulation”. Moreover, as Einstein said, “No problem can be solved from the same level of consciousness that created it”, that requires us to completely change all our current regulators and start from scratch. 

SO NO! Professor Lawrence Summers, with respect to bank regulations, may I respectfully suggest you either wake up or shut up!

PS. And that goes for most of you others bank regulation experts out there.

PS. This is not the first way I have told Professor Summers he does not get it.

PS. Here is a set of questions current bank regulators do not dare to answer.

Why are excessive bank exposures to what’s perceived safe considered as excessive risk-taking when disaster strikes?

In terms of risk perceptions there are four basic possible outcomes:

1. What was perceived as safe and that turned out safe.

2. What was perceived as safe but that turned out risky. 

3. What was perceived as risky and that turned out risky.

4. What was perceived as risky but that turned out safe.

Of these outcomes only number 2 is truly dangerous for the bank systems, as it is only with assets perceived as safe that banks in general build up those large exposures that could spell disaster if they turn out to be risky.

So any sensible bank regulator should care more about what the banks ex ante perceive as safe than with what they perceive as risky.

That they did not! With their risk weighted capital requirements, more perceived risk more capital – less risk less capital, the regulators guaranteed that when crisis broke out bank would be standing there especially naked in terms of capital. 

One problem is that when exposures to something considered as safe turn out risky, which indicates a mistake has been made, too many have incentives to erase from everyones memory that fact of it having been perceived as safe.

Just look at the last 2007/08 crisis. Even though it was 100% the result of excessive exposures to something perceived as very safe (AAA rated MBS), or to something decreed by regulators as very safe (sovereigns, Greece) 99.99% of all explanations for that crisis put it down to excessive risk-taking.

For Europe that miss-definition of the origin of the crisis, impedes it to find the way out of it. That only opens up ample room for northern and southern Europe to blame each other instead.

The truth is that Europe could disintegrate because of bank regulators doing all they can to avoid being blamed for their mistakes.

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.

Willful (or naive) blindness of epical proportions, reigns in the world of the Basel Committe’s bank regulations

Note: The following comments have been inspired by beginning to read Margaret Hefferman’s “Willful Blindness”

To agree with bank regulations for which the regulators have not even defined the purpose of the banks they regulate… is that not an act of willful (or naive) blindness?

To agree with bank regulations that look to hinder banks to hold assets ex ante perceived as risky, when these kinds of assets have never created a bank crisis… is that not an act of willful (or naive) blindness?

To agree with bank regulations based on perceived credit risks, when obviously what matter are unexpected events or not perceived credit risks… is that not an act of willful (or naive) blindness?

To believe that you could place so much decision power into the hands of some few human fallibe credit rating agencies, without intriducing a systemic risk of gigantic proportions… is that not an act of willful (or naive) blindness?

Not seeing that allowing banks to leverage their equity, and the support they receive from society differently, with different assets, will produce a serious distortion in the allocation of bank credit to the real economy… is that not an act of willful (or naive) blindness?

Not seeing that curtailing the access to bank credit of the risky, more than it is already curtailed increases inequality… is that not an act of willful (or naive) blindness?

Not seeing that future generations will be affected by denying them the risk-taking that brought current generation to where its at… is that not an act of willful (or naive) blindness?

Not understanding that banks, if allowed to use their own risk models to set their capital requirements will lower these so as to maximize their expected risk adjusted returns on equity… is that not an act of willful (or naive) blindness?

Believing that some Basel I and II regulators who were totally surprised by the 2007/08 crisis have it in them to fix it with a Basel III… is that not an act of willful (or naive) blindness?

To believe that a 2007/08 crisis and the following stagnation can be cured by just throwing QEs, fiscal deficits and low interest rates at it… is that not an act of willful (or naive) blindness?

And the list of questions related to current bank regulations that gives ground to believing willful acts of blindness takes place goes on and on and on… and I might add some with time after finishing the book that inspired this. 

PS to Financial Times: To receive thousands of letters on these problems from someone that has been showned right on many letters previously published… is that not an act of willful (not naive) blindness?

Bank regulations put Minsky’s “financial instability hypothesis” on steroids, boosting its speed towards “the moment”.

The Economist refers to Hyman Minsky’s important “financial instability hypothesis”, but concludes that it “would be a stretch to see that hypothesis becoming a new foundation for economic theory, “Minsky’s moment” July 30, 2016

That might be, but it should become an essential foundation of financial regulations because, by ignoring it, with the risk weighted capital requirements for banks, the regulators set the “boom that can sow the seeds of busts” on steroids.

Normally, without distortions, bank credit should be allocated to whoever offers the highest perceived risk adjusted rate. That of course might quite often not be true, because “a safe” can be riskier or safer than what it is perceived; just llke “a risky, could equally be safer or riskier.

But, when regulators decided banks needed to hold less capital against what was perceived, decreed or concocted as safe, than against what was perceived as risky, they dramatically distorted the allocation of bank credit to the real economy.

Suddenly the booms of what was perceived as safe got a tremendous boost, as banks could earn higher risk adjusted rates there; all while “the risky” saw their access to bank credit severely curtailed.

We only need to go the crisis of 2007-08 to see that what caused it, was all which had very low capital requirements because it was perceived as safe when placed on the bank’s balance sheets.

And of course, the power of those regulatory steroids, was further strengthen by the fact that so much decision power, over deciding what was safe and what was risky, was placed in the hands of some very few human fallible credit rating agencies.

PS. I was just a consultant from a developing country who happened to end up on the Board of the World Bank as an Executive Director, and so I can of course not aspire, by far, to receive the same attention as Hyman Minsky, but you might anyhow be interested in what were my very early opinions on these issues

PS. And here is my most recent aide memoire on what is monstrously wrong with Basel Committee’s regulations.

@PerKurowski ©

The regulatory powers of our bank regulators need to be urgently regulated, at least those of the Basel Committee.

What do you think the world would have said if the Basel Committee had informed it that it would regulate the banks, without considering the purpose of the banks? 

What do you think the world had said if the Basel Committee had informed that in order to make the banks safer, they were going to distort the allocation of credit to the real economy?

What do you think the world would have said if the Basel Committee had informed it that even though all major bank crises have always resulted from excessive exposures to something ex ante erroneously perceived as safe, they would allow for especially low capital requirements against bank exposures to what ex ante was perceived as safe.

What do you think the world would have said if the Basel Committee had informed it that even though the society considered that banks giving credit to SMEs and entrepreneurs was very important, they would saddle the banks with especially large capital requirements on account of those “risky” being risky.

What do you think the world would have said if the Basel Committee had informed it that it was going to assign a zero risk weight to sovereigns and a 100 percent risk weight to the citizens, and which indicated their belief that government employees could make better use of other people’s money than private citizens could use theirs. 

What do you think the world would have said if the Basel Committee had informed it that even though banks already cleared for credit risks with interest rates and size of exposure they would also require banks to clear for that same risk in the capital; and that even though any risk that is excessively considered leads to the wrong actions even if perfectly perceived.

What do you think the world would have said if the Basel Committee had informed it that because they could not estimate the unexpected losses that bank capital is primarily to cover for, they would use expected credit risks as a proxy for the unexpected.

What do we think about that even when the 2007-08 clearly evidenced the failure of the regulators, they go on as if nothing, using the same regulatory principles? I just know that neither Hollywood nor Bollywood would ever have permitted those creating the box-office flop of Basel II, to go on working on Basel III.

Sincerely, are we really sure all these regulators in the Basel Committee, and in the Financial Stability Board, are just not some Chauncey Gardiner characters?

There is only one 100 percent sure cause for the financial crisis 2007/08, and it is discussed less than 0.01 percent

The crisis exploded because of excessive exposures to AAA rated securities, real estate (Spain), loan to sovereigns (Greece) and short-term loans to banks (Iceland). They all one thing in common, namely that banks were required by regulators to hold very very little capital against these assets, and so banks could leverage very very much their equity with these assets, meaning that banks could expect to earn very very high risk adjusted returns on equity for these assets.

Had banks been required to hold the same level of capital against all assets, other crisis could have happened, but not one as large as the one in 2007/08.

So how much have you read about the problems related to the distortions produced by the risk weighted capital requirements in the allocation of credit to the real economy? Probably nothing!

Why? There are many explanations to that but, one of the most important, is that there is much more political interest in blaming bad bankers than laying it on good regulators.

Is this a problem? 

Yes, those regulations are still in place and so could still lead banks to create similar dangerously large exposures to something perceived or deemed safe. 

And since that still favors The Safe over The Risky, those who could most help us get our economies moving again, the SMEs and the entrepreneurs, have a lousy access to bank credit.

Right now banks are not financing the risky future, they are just refinancing the safer past, that which might soon turn risky, because of excessive financing.

PS. Here is a more extensive aide memoire on the mistakes in the risk weighted capital requirements for banks.