What would have happened if, since Basel I, 1988, there had just been one 8% bank capital requirement for all assets?

The “safe” sovereigns would not have seen their borrowings subsidized by the “risky” SMEs and entrepreneurs lesser access to bank credit. 

Sovereigns like Greece would never have been able to run up such large debts on such low initial interest rates.

House financing would not have been so much available at artificial low rates so house prices would be lower.

Much more financing would have gone to those “risky” SMEs and entrepreneurs who could create the jobs the house owners need in order to repay mortgages and service utilities, and that so many young need in order not having to live in the basements of their parents’ houses.

Some other crisis could have resulted, but the catastrophic sized one with the AAA rated securities collateralized with mortgages to the subprime sector, would never have happened.

Central banks would not have needed to kick the crisis can down the road with trillions of QEs… that are still out there on the road menacing to run back on us.

Central banks would not have needed to kick the crisis can down the road with ultra low interest rates that are creating havoc on all pension plans.

The world would not have served up the table with so much for the populists to munch on.

The saddest part though is that now, ten years after those assets that caused the big crisis correlated completely with those assets that required banks to hold the least capital, regulators still apply risk weighted capital requirements. I guess, as Upton Sinclair Jr. said, “it is difficult to get a man to understand something when his salary depends upon his not understanding it.”

Ten years ago ECB decided to ignore the benefits of a hard landing and go for kicking the can down the road

In August 2006, when we were already hearing worrisome comments about complex securities linked to mortgages, I wrote a letter to FT titled “The Long Term Benefits of a Hard Landing”. At that moment I had not yet been censored by FT and so they published it.

One year later, when panic about the AAA rated securities backed with mortgages to the subprime sector impacted the financial markets, ECB (and the Fed earlier) decided to ignore that option and go for the politically more convenient short-termish option of kicking the can down the road, with QEs and ultralow interest rates.

It could have worked, if only what had caused the crisis and what hindered the stimuli to flow in the correct directions had been removed. But no, the regulators refused to admit their mistake with the risk weighted capital requirements.

And so here we are, a full decade later, still allowing banks to multiply the net margins obtained more when it relates to assets perceived, decreed or concocted as safe, than with assets perceived as risky, and so obtain higher expected risk adjusted returns on their equity financing the safe than financing the risky.

In a historic analogy, regulators still believe the sun to be circling around the earth; in this case that what is perceived as risky is more dangerous to the banking system than what is perceived as safe.

As a result “safe” sovereigns, AAArisktocracy and residential houses still dangerously get way too much bank credit, while “risky” SMEs and entrepreneurs, way too little to keep our economies dynamic.

Every day we allow regulators like Mario Draghi to regulate based on a flawed theory, the worse for all of us.

But what are we to do when there are so many vested interests in shutting up this the mother of all bank regulation mistakes?

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”

Here is the succinct but complete explanation of the subprime crisis. One, which apparently should not be told.

Here's a prologue, on the 10th anniversary of the Lehman Brothers collapse: In 2006 in a letter to the Financial Times I argued for the long-term benefits of a hard landing. The Fed and ECB decided to kick the can forward and upwards, which could have worked; better at least, had they removed the distortions that created the crisis. 

Just four factors explains it all, or at least 99.99%.

Securitization: The profits for those involved in securitization are a function of the betterment in risk perceptions and the duration of the underlying debts being securitized. The worse we put in the sausage – and the better it looks - the more money for us. Packaging a $300.000, 11%, 30 year mortgage, and selling it off for US$ 510.000 yielding 6% produces and immediate profit of $210.000 for those involved in the process. (Those who are being securitized do not participate in the profits)

Credit ratings: Too much power to measure risks was concentrated in the hands of some very few human fallible credit rating agencies.

Borrowers: As always there were many financially uneducated borrowers with needs and big dreams that were easy prey for strongly motivated salesmen, of the sort that can sell a lousy time-share to a very sophisticated banker. 

Capital requirements for banks. Basel II, June 2004, brought down the risk weight for residential mortgages from 50% to 35%. Additionally, it set a risk weight of only 20% for whatever was rated AAA to AA. The latter, given a basic 8%, translated into an effective 1.6% capital requirement, which meant bank equity could be leveraged 62.5 times to 1.

Clearly the temptations became too much to resist for all involved.

The banks, like the Europeans, thinking that if they could make a 1% net margin they could obtain returns on equity of over 60% per year, went nuts demanding more and more of these securities; and the mortgage producers and packagers were more than happy to oblige, signing up lousier and lousier mortgages and increasing the pressure on credit rating agencies. The US investment banks, like Lehman Brothers, also participated, courtesy of the SEC.

Of course it had to end bad... and it did!

Can you image what would have happened if the craze had gone on one or two years more?

I have explained all the above in many shapes or form, for much more than a decade. Unfortunately it is an explanation that is not allowed to move forward, because it would put some serious question marks about the sanity of some of the big bank regulators.

Might I need to go on a hunger strike to get some answers from the Basel Committee and the Financial Stability Board?

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

PS. And here are some of my early opinions on these regulations, some of them while being an Executive Director at the World Bank, 2002-04

PS. Here’s my recent, 2019, comments sent to the Financial Stability Board

PS. Here’s my recent, 2019, letter sent to the IMF

PS. And here is a very humble home-made youtube comment on it all, from 2010

Greenspan never understood the distortions in credit allocation the risk weighted capital requirements for banks caused

Fed chairman Alan Greenspan in January 2004 said: “There are several developments, however, that I find worrisome…The first is that yield spreads continue to fall. As yield spreads fall, we are in effect getting an incremental increase in risk-taking that is adding strength to the economic expansion. And when we get down to the rate levels at which everybody is reaching for yield, at some point the process stops and untoward things happen. The trouble is, we don’t know what will happen except that at these low rate levels there is a clear potential for huge declines in the prices of debt obligations such as Baa-rated or junk bonds.”

This is clear evidence Greenspan did not understand much of the distortions produced by the risk weighted capital requirements for banks.

The reality was that as “yield spreads continue to fall” banks reached out for those yields with which they could most leverage their equity with; not “Baa-rated or junk bonds” but AAA rated securities.

Bonds perceived ex ante as junk never ever signify a danger to the bank systems

Here is an aide mémoire

A letter in Washington Post: Factors in the Financial Storm

Factors in the Financial Storm

David Ignatius, in his Sept. 2 op-ed, "The Real Causes of the Financial Storm," failed to mention the two lead actors in the financial mess we find ourselves in: the credit rating agencies, whose AAA ratings turned what should have remained a local problem involving some subprime lenders into a global financial storm; and, of course, the bank regulators who against all wisdom enabled the credit rating agencies to foist what they consider to be only their First Amendment-enabled opinions upon the markets.

In May 2003, as one of the 24 executive directors of the World Bank, and probably only because of that, I was invited to make some comments during a workshop arranged by the World Bank for bank regulators on assessing, managing and supervising financial risk. Along with offering some suggestions, I told the regulators, "I simply cannot understand how a world that preaches the value of the invisible hand of millions of market agents can then go out and delegate so much regulatory power to a limited number of human and very fallible credit rating agencies. This sure must be setting us up for the mother of all systemic errors."

I never got invited to comment again.

Published in the Washington Post.

Here other of my letters in the Washington Post on this issue:
June 20, 2008: An Aspect of the Bubble
December 27, 2009: Another 'worst': Faulty bank regulation

January 6, 2012: Handcuffed by a triple-A rating
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?