De riskvägda bankkapitalkraven borde åtminstone ha baserats på betingade sannolikheter. Det var de/är de inte.

Här några tweets om P (A / B)

I sannolikhetsteori är betingat sannolikhet sannolikheten för att en händelse (A) inträffar (som att banker lånar för mycket till någon säker), med tanke på att en annan händelse (B) har inträffat (att bankirerna hade uppfattat denne någon som mycket säker).

I sannolikhetsteori är betingat sannolikhet sannolikheten för att en händelse (A) inträffar (som att  banker lånar för mycket till någon riskabel), med tanke på att en annan händelse (B) har inträffat (att bankirerna hade uppfattat denne någon som mycket riskabel).

Ingen tillsynsmyndighet som vet något om betingad sannolikhet skulle aldrig ha tilldelat, med tanke på riskvägda bankkapitalkrav, en låg riskvikt på bara 20% till de bedömda som mycket säkra AAA, och en hög 150% till de bedömda som mycket riskabla lägre än BB-

PS. Mitt brev till Financial Stability Board

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.

Mercatus Center, in order to reframe financial regulations, you must dig in much deeper into the current mistakes.

I refer to “Reframing Financial Regulation: Enhancing Stability  and Protecting Consumers” 2016, by the Mercatus Center at George Mason University, and edited by Hester Peirce & Benjamin Klutskey.

The book includes many wise suggestions but, since it does not seem to capture how incredibly faulty current regulations really are, it has gaps that make it more difficult to understand how sensitive the financial system, primarily banks, and the real economy as such, is to the process of implementing a “reframing”.

For brevity and because my main reservations with current financial regulations have to do with the issue therein discussed, I will limit my comments to Chapter 1: Risk-Based Capital Rules by Arnold Kling.

The author writes: “Risk-based capital rules dramatically affect the rate of return banks earn from holding different type of assets. Regardless of the intent of these rules they strongly influence capital allocation in the economy.”

That is correct, although referring to the ex-ante expected risk adjusted returns on equity would be more precise.

Then the author states: “They substitute even crude regulatory judgment for individual bank discretion and market mechanism”. 

That is not entirely correct. The real problem is that since banks already clear for ex ante perceived risks, when setting interest rates and the amount of their exposures, that regulators also use basically the same ex ante risk perceptions for determining the capital requirements, means that “ex-ante perceived risks”, will be doubly considered. What regulators missed entirely, is that any risk, even if perfectly perceived, will cause the wrong actions, if excessively considered.

The book identifies partly what the distortion in the allocation of bank credit could do to the safety of banks, but what it most misses to comment on, is what the risk weights actually calculated and used, really meant and mean to the allocation of bank credit to the real economy. 

For instance Basel I, 1988, applied to the United States, set the risk weight of 0 percent for US Treasuries; 20 percent for claims to for instance local governments; 50 percent when financing residential properties and revenue bonds; and 100 percent all other claims on private obligors.

0% risk weight for the sovereign? If that’s not in runaway statism what is? De facto it implies that regulators consider government bureaucrats will give better use to bank credit than the private sector.

In 2001 the Federal Reserve Board, the Office of the Comptroller of the Currency and the FDIC set the following risk weight depending on credit rating; AAA to AA 20 percent; A 50%; BBB (the lowest investment grade) 100 percent; and BB (below investment grade) 200%.

If that’s not runaway stupidity what is? The regulators really seem to have thought (and think) that assets perceived as extremely risky, are more dangerous to the bank system than assets perceived as safe. As if they never heard of Mark Twain’s “A banker lends you the umbrella when the sun shines and wants it back when it looks it could rain”; as if they never heard of Voltaire’s “May God defend me from my friends, I can defend myself from my enemies”. 

Worse though, they never gave any consideration to the possibility that millions of “risky” 100% weighted SMEs and entrepreneurs, so vital to the sturdy growth of the real economy, would see their credit applications negated only because of this. 

Mercatus Center, any reframing of current financial regulations that is not based on a full understanding of how statists and stupid current regulations are, will not be able to adequately deliver what we, especially the young, so urgently need.

For instance all those propositions of increasing the capital requirements for banks with higher leverage ratios but that would keep of the risk weighting in place fail to understand that the bigger the capital squeeze the more will the risk weighing distort the allocation of bank credit to the real economy. (Think of “The Drowning Pool”)

For instance to avoid imposing on the real economy the bank credit austerity that would result in the initial stages of capital increases the grandfathering of old capital requirements for existing assets until these are disposed would be a must.

Mercatus Center, you have clout that I as a citizen have not! Do all us a favor and request straight answers from the regulators on some very basic questions.

Stefan Ingves, years after Basel Committee’s failure, you all have still no idea about how to regulate banks.

On December 2, 2016 Stefan Ingves, the Chairman of the Basel Committee gave a Keynote speech at the second Conference on Banking Development, Stability and Sustainability, titled “Finalising Basel III: Coherence, calibration and complexity” 

In it Ingves stated: “an area of further research which would be welcome relates to how we should think about the capital benefits of allowing banks to use internally modelled approaches, and therefore the appropriate calibration of capital floors to such models. What are the pre-conditions for such models to produce better outcomes than, say, simpler standardised approaches? And to whom do the benefits of improved modelling accrue? If a bank using a model can lower its capital requirements by, say, 30%, what are the financial stability and real economy benefits of such an approach? To what extent do the benefits of modelling accrue to lower-risk borrowers as opposed to the parties being compensated for developing and using the models?”

That is clear evidence that the Basel Committee still, soon ten years after the crisis, their failure, has no idea about what it is doing. It should concern us all. 

Here’s one example on of how the Basel Committee’s has totally confused ex ante risks with ex post risks. In their Basel II standardized risk weights the weight assigned to AAA assets is 20% while the weight of a highly speculative below BB- rated assets was set at 150%. 

I ask: What has much greater chance of taking the banking system down, excessive exposures to something ex ante believed very safe or excessive exposures to something believed very risky? The answer should be clear. Never ever have bank crises resulted from excessive exposures to something believe risky when placed on the balance sheet; these have always resulted from unexpected events (like devaluations), criminal behavior or excessive exposures to something perceived ex ante as very safe but that ex post turned out to be very risky. 

The truth is that the Basel Committee told banks: “Go out and leverage your capital more than with assets that are safe”. And so when disaster happens, like with AAA rated securities, banks stand there more naked than ever.

Of course, the other side of that coin is, “Do not go and lend to what is risky”. So banks dangerously for the real economy stopped lending to SMEs and entrepreneurs… something that is never considered when stress testing.

To top it up, like vulgar statist activists, they set a risk weight of 0% for the Sovereign and one of 100% for We the People; which translates into a belief that government bureaucrats can use bank credit more efficiently than the private sector… something which of course created the excessive indebtedness of Greece and other.

One final comment, the regulators naivety is boundless: “to whom do the benefits of improved modeling accrue? asks Ingves” Clearly there is no understanding of that bankers will, as is almost their duty, always look to minimize capital if so allowed, in order to obtain the highest expected risk adjusted returns on equity. 

When fake regulators supervise banks; totally unsupervised banks is much better.

PS. Must one go on a hunger strike to have the Basel Committee on Banking Supervision answer some very basic questions? 

The lousier the sand turned into "gold", the more profitable is securitization… for the securitizers.

What can you earn by packaging a lot of AA rated instruments (like good 30 years fixed rate mortgages) into a security rated AAA? Very little, basically it is not even worth the effort.

But if you package something rated BB- or below into a security that gets an AAA rating, then there is a fortune to be shared, by all except, those who signed the original BB- obligations.

Securitization has been defended on the ground that it provides more financing to those who otherwise cannot afford it. That is 99% a lie. It provides much financing to those who cannot afford it, in order to benefit the originators, the packagers and the intermediaries.

Here’s the real deal! If you convinced risky and broke Joe to take a $300.000 mortgage at 11 percent for 30 years and then, with more than a little help from the credit rating agencies, you could convince risk-adverse Fred that this mortgage, repackaged in a securitized version, and rated AAA, was so safe that a six percent return was quite adequate, then you could sell Fred the mortgage for $510.000. This would allow you and your partners in the set-up, to pocket an immediate tidy profit of $210.000

But if you think that’s all with securitization looking to turn sand into gold, just you wait.

If an AA rated instrument is packaged into a security that gets an AAA rating it means nothing in terms of risk-weighted capital requirements for banks but, if a BB+ rated or an unrated instrument is packaged into a security that gets an AA rating, then the risk weight diminishes from 100 percent to 20 percent. And that, in terms of Basel II, meant that banks instead of having to hold 8 percent in capital against that instrument, were then only required to hold a meager 1.6 percent in capital. Meaning that instead of leveraging their equity 12.5 times to 1 they could leverage it a mind-blowing 62.5 times to 1.

PS. Should not those securitizing these mortgages, share the benefits with those being securitized? A 50% sharing in the example above, would allow the debtor $105.000 to help repay the mortgage. That would perhaps turn that subprime mortgage to earn a real AAA rating.

Banks regulators believe what’s rated AAA, is more dangerous to the banking system than what’s rated below BB-… Really?

Bank regulators, when trying to make our banks safe, decided that the risk weight for AAA rated assets, a rating described as “prime”, was to be 20%. That, since the basic capital requirement in Basel II was 8 percent, meant that banks needed to hold 1.6 percent in capital (equity) against those assets; and could leverage their equity 62.5 times to 1 with these assets. 

For assets rated below BB_ though, ratings described as moving from “highly speculative”, through “extremely speculative” and up to “default imminent”, the risk weight was set at 150 percent. And that, with Basel II’s basic 8 percent, meant that banks needed to hold 12 percent in capital against such assets, and which allowed banks to only leverage about 8.4 times to 1.

But let me ask all of you. What do you think can create those kind of excessive exposures that could endanger the stability of our banking system; exposures to what ex ante was thought to be AAA but that ex post surprised banks by being very risky, or exposures to what was rated below BB- and actually turned out to be very risky?

I hear you… so what did we do to deserve such bad bank regulators?

Reporters, this question could evidence whether bank regulators know what they are doing.

The Basel Committee decided that in order to make banks safe, these need to hold more capital (equity) against assets perceived as safe from a credit risk point of view than against assets perceived as risky. 

For instance in Basel II a private sector asset rated AAA to AA carried a 20 percent risk weight while an asset rated below BB- had a 150 percent risk weight. That meant banks needed to hold 7.5 times more capital against a below BB- rated asset than against a AAA to AA rated asset.

Allowing banks to leverage their equity differently based on credit risks obviously distorts the allocation of bank credit to the real economy, something that by itself could also be very dangerous for the safety of banks.

And so, the only way those risk weighted capital requirements for banks could be justified, would be if they really made banks safer.

But ask any bank regulator, like Stefan Ingves, the current Chair of the Basel Committee the following:

Sir, would you be so kind so as to provide us with one example of a major bank crisis that has resulted from excessive bank exposures to assets that were perceived as risky when placed on the balance sheet of banks.

If they cannot answer, should that not be a sufficient indication that they might have no idea about what they are doing?

I mean I can think of many instances were bankers were lulled into a false sense of security by good credit ratings, but I cannot for my life imagine bankers building up excessive exposures to something rated below BB-. Can you?

Another letter in The Washington Post: Handcuffed by a triple-A rating

Handcuffed by a triple-A rating

The headline on Mohamed El-Erian's Jan. 1 op-ed asked, "Who will save the triple-A rating?" This makes for a good opportunity to remind everyone that the United States, and the Western world, did not become what they are by sticking to the super-safe. They did it by allowing their risk-takers to take risks. A triple-A credit rating is a result, not a precondition.

If the United States is going to lose its triple-A rating because it is taking the kind of risks that are necessary to make the wheels of its development move forward, creating jobs for our grandchildren, that should be welcome. But if it is going to continue the current pattern, set out by loony bank regulators, of blindly avoiding perceived default risks and dangerously overcrowding the safe havens, then it is lost.

The expert financiers worrying about a triple-A rating are also navel-gazing. Much more important than a triple-A for the United States is the fact that this country is, by far, the foremost military power in the world. Lose that supremacy and all hell breaks loose. Keep it and a BBB rating could do.

Washington Post
Here other of my letters in the Washington Post on this issue:
September 6, 2007: Factors in the Financial Storm
June 20, 2008: An Aspect of the Bubble
December 27, 2009: Another 'worst': Faulty bank regulation
May 1, 2013: An American approach to banking
December 23, 2014: Let the market rule on risky trades
November 11, 2015: Reverse-mortgaging the future
August 9, 2016: Banks, regulators and risk
April 16, 2017: When banks play it too safe 

July 11, 2018: There is another tariff war that is being dangerously ignored.

December 30, 2018: Affordable homes or investment assets?

Has the US Congress delegated to the Basel Committee the settings of capital requirements for banks?

Can anyone explain why the Basel Committee is not mentioned even once in the 1336 pages long reform bill presented to the US Senate or in the 1776 pages long H.R. 4173 financial regulatory Act approved by the House of Representatives?

Has the US Congress delegated into the Basel Committee the settings of capital requirements for banks? If so is the US citizen aware of it?

For instance is Congress unaware of that the SEC when it on April 28, 2004 allowed the US investment banks to substantially increase their leverage, it did so explicitly stating that “the consolidated computations of allowable capital and risk allowances [be] prepared in a form that is consistent with the Basel Standards”.

Don’t they know that if there is anything that has guided the evolution of the current financial regulations, those that I have for so long sustained doomed the world to exactly the type of crisis we now have, that is the Basel Committee. Basel’s AAA-bomb was ignited on June 26 2004, when the G10 countries, which includes the US endorsed the revised capital framework for banks known as the Basel II standards.

Financial Stability Forum, please, show some courage to tell it as it is.

“Addressing procyclicality in the financial system is an essential component of strengthening the macroprudential orientation of regulatory and supervisory frameworks.” [and so there is a need to] “mitigate mechanisms that amplify procyclicality in both good and bad times”. That is part of what the Financial Stability Forum recommends in their report of 2 April 2009.

Indeed it sounds a so very impressive and technically solid conclusion? Yet it completely ignores that the prime reason why we find ourselves in the current predicament has much less to do with prociclicality in good times or bad times and much more with some good old fashioned plain vanilla type plain bad investment judgments. What had the world to do, whether in good or bad times, investing in securities collateralized by awfully bad awarded mortgages to the subprime sector in the USA? Would we be so deep in this mess had not the credit rating agencies awarded AAA to such securities? Of course not!

It is a shame that the Financial Stability Forum does not have in it to openly accept the fact that the whole risk based minimum capital requirements for banks idea imposed by Basel is fundamentally flawed, in so many ways. They only accept it in a veiled way when they recommend a “supplementary non-risk based measure to contain bank leverage”.

The lack of forthrightness serves no purpose and can only supply further confusion. Let me here just spell out two of the arguments I have been making.

The current minimum capital requirements are based on requiring less capital for investments that are perceived as being of lower risk while in fact, in a cumulative way, what most signifies a truly systemic risk for the world, lies exclusively in the realms of the investments that are perceived and sold as being of a low risk. In other words systemically the world at large does never enter B- land it goes like a herd to where it is told the AAAs live. The problem was not so much that the world went to play at the casino, the real problem was that the tables were rigged, one way or another.

In the current minimum capital requirements dictated by Basel a loan by a bank to a corporation rated AAA by a human fallible credit rating agencies requires only $1.60 for each $100 lent, equivalent to a 62.5 to 1 leverage and this obviously has much more to do with regulators losing their marbles than with times being good or bad.

This financial and economic crisis will cause more misery in the world than most if not perhaps all wars. Do you really not think the world merits the truth and nothing but the truth?