Lord Adair Turner’s awakening as a bank regulator has at least begun, and that’s good news.

In June 2010, during a conference given by Adair Turner at the Brookings Institute, I asked him the following: 

"Big companies in consolidated sectors, like BP in oil, tend to have much better credit ratings than those participating in developing markets, like wind energy. Do you really think the banks will perform better their societal capital allocation role if regulators allow them to have much lower capital requirements when lending to the consolidated sectors than when lending to the developing? Do you think we can reach a meaningful financial regulatory reform without opening up the discussion on the issue of risk in development?"

Lord Turner responded: "The point about lending to large companies development, I'm not sure. I'm trying to think about that. I mean we try to develop risk weights, which are truly related to the underlying risks. And the fact is that on the whole, lending to small and medium enterprises does show up as having both a higher expected loss but also a greater variance of loss. And, of course, capital is there to absorb unexpected loss or either variance of loss rather than the expected loss. I think, therefore, it's quite difficult for us to be as regulators, skewing the risk weights to achieve, as it were, developmental goals. There are some developmental goals, for instance, in a renewable energy, which I'm very committed to wearing one of my other hats on climate change, where I do think you may need to do, you know, in a straight public subsidy rather than believing that we can do it through the indirect mechanism of the risk weights. So I may have misunderstood your question, but I'm sort of cautious of the sort of the leap to introducing developmental roles into -- I thinks we, as regulators, have to focus simply on how risky actually is it?"

Lord Turner did not understand what I was referring to, and what was wrong:

Lord Turner: “we try to develop risk weights which are truly related to the underlying risks”. No! The real underlying risk with banks is not the risk of their assets, but how banks manage the perceived risks of their assets.

Lord Turner: “capital is there to absorb unexpected loss or either variance of loss rather than the expected loss”

Yes “capital is there to absorb unexpected loss”, and that is why it is so ridiculous to base the capital requirements for banks on something expected, like the perceived credit risks.

Now Lord Turner in his recent book, “Between Debt and the Devil”, though he still evidences he does not understand the distortions in the allocation of bank credit to the real economy the risk weighted capital requirements produce, he seems to become more flexible about using other criteria. From the “I think we, as regulators, have to focus simply on how risky actually is it” he now states: “We need to manage the quantity and influence the allocation of credit bank create… Capital requirements against specific categories of lending should ideally reflect their different potential impact of financial and macroeconomic stability. 

Though Turner has not yet reached as far as banks actually having a social purpose more important than that of just not failing, like financing job creation and the sustainability of our planet, this is a good and welcome start. And I say so especially because Lord Turner’s awakening might reflect what hopefully might be going on in other regulators' minds.

Lord Turner even though he gets it that “it is rational for banks to maximize their own leverage, increasing the returns on equity”, still fails to understand how allowing different leverages, much higher for safe assets than for risky, make banks finance more than usual what is perceived as safe, and much less than usual what is perceived as risky… which is precisely why banks finance so much houses and so little the SMEs and entrepreneurs, those that help create the jobs needed to pay mortgages and utilities.

Lord Turner also mentions in his book the issue of inequality. For the hopefully revised and corrected sequel to his book, I would suggest he thinks about the following quote from John Kenneth Galbraith’s “Money: Whence it came where it went” 1975. 

“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 clearly Galbraith was referring to credit to producers and not to consumers. 

And of course I wish Lord Turner, like so many other, stops referring to the financial crisis as a result of free markets running amok. Free markets would never ever have authorized banks to leverage over 60 to 1 when investing in AAA rated securities, or when lending to Greece. Markets were not free. Banks were not deregulated. Banks were utterly misregulated.

PS. Cross your fingers. There might be something there that wasn't there before :-)

This is the mumbo jumbo that the Basel Committee bet our whole western world banking system on. Shame on it!

Here is the document which describes the risk-weight functions of Basel II

An Explanatory Note on the Basel II IRB Risk Weight Functions, Bank for International Settlements, July 2005

And these are the 3 papers referenced therein:

A risk-factor model foundation for ratings-based bank capital rules, by Michael B. Gordy, October 2002

Robert C Merton, On the pricing of corporate debt: The risk structure of interest rates. 1974, Journal of Finance 29, 449 - 470. 

Oldrich Vasicek, O. (2002) Loan portfolio value. RISK, December 2002, 160 - 162

All put together, does not make any sense!

And on that the Basel Committee, and the Financial Stability Board bet our whole western world banking system. Shame on it! How could they?

And that same crazy risk-weighing function is still part of Basel III

I wonder who wrote that “Explanatory Note”. “The confidence level is fixed at 99.9%, i.e. an institution is expected to suffer losses that exceed its level of tier 1 and tier 2 capital on average once in a thousand years”. That must indeed be the Bank Regulator’s real New Clothes.

Come on Mario Draghi, Adair Turner, Mark Carney, Stefan Ingves, Michel Barnier, or anyone else involved with bank regulations... have a go at explaining it to us! I bet you do not understand it either... but your egos stop you from recognizing that.

Bank Regulator! How dare you distort the markets this way! Look at what you’ve done! And you’re not even sorry. Shame on you!

Arrogant regulatory busybodies thought they could stop bank crisis forever, by setting capital requirements for banks based on perceived risk. The higher the perceived risk, the higher the capital needed to be, and the lower the perceived risk, the lower the capital.

And, in doing so, the regulators completely ignored the fact that banks and markets already clear for risk by means of interest rates, amounts exposed and contractual terms. And as a result banks could earn much higher returns on equity when financing what was officially perceived as “not-risky” than when financing what was officially perceived as “risky”, like our small unrated businesses and entrepreneurs.

And we are not talking about minor differences. Basel II required banks to hold 8 percent in capital when lending to small businesses, which meant banks could leverage 12.5 to 1, but allowed banks to hold only 1.6 percent in equity against a private asset rated AAA, (or a loan to Greece) allowing the banks to leverage a mindboggling 62.5 to 1. Five times less bank equity!

And the result is that these regulations added immense regulatory bias in favor of what is perceived as not risky, on top of the natural bias that already existed in their favor, and, consequentially, added immense regulatory bias against what is perceived as “risky”, on top of the natural bias that already existed against the risky.

And all this the regulators did without ever bothering to ask themselves the question of…what is the purpose of the banks?

And all this the regulators did without ever bothering to reflect on the fact that all bank crises ever have occurred because of excessive exposures to what was erroneously perceived ex ante as “not risky” and never because of excessive exposures to what was ex-ante correctly perceived as risky.

And as a consequence here we find us mired in a deep crisis with obese bank exposures to what was ex-ante perceived as “not risky” and anorexic banks exposures to what was considered “risky”.

And, of course, by maintaining the same fundamental capital requirement discrimination based on ex-ante perceived risk, there is no way we can work ourselves out of a crisis, in which our economies are turning flabbier and flabbier by the second.

Regulators, don’t you know that nations develop by generously allowing for daring opportunities, and fail and fall when turning stingy and coward?

What would the US Supreme Court opine about bank regulations which discriminate against The Risky and favor The Infallible?

No! Shame on you bank regulators! Who gave you the right to distort our economy this way? And shame on you too financial journalists who keep silencing this, not daring to question the regulating establishment.

Occupy Wall Street? Occupy RBS? No! Occupy the Basel Committee! Hell, occupy FSA and the Dodd-Frank Act too!

I have not read yet in full FSA’s report on the failure of RBS, but I know what it does not include, the admittance of the fundamental mistake committed by the bank regulators, because that mistake is kept, alive and kicking, in Basel III.

Simplified, if the cost of funds for RBS was 2 percent; if it wanted to earn a 1.5 percent margin; if the cost of analyzing the credit worthiness of a small business in the UK was 1 percent; and if the risk that this borrower would default was perceived as 3 percent, then RBS would charge the small business in the UK an interest of 7.5 percent.

And if the cost of funds for RBS was the same 2 percent; if it wanted to earn the same 1.5 percent margin; if the cost of analyzing the credit worthiness of Greece was zero, because that is paid by Greece to the credit rating agencies to do; and if the risk that Greece would default was perceived as 1 percent, then RBS would charge Greece an interest of 4.5 percent.

If RBS bank was required to have about 8 percent in capital against any loan, and could therefore leverage its capital about 12 times, RBS could then expect to earn 18 percent on its capital when lending to a small business in the UK or when lending to Greece.

But that was before the bank regulators of the Basel Committee, and FSA, intervened and messed it all up.

Because the bank regulators, ignoring the empirical evidence that bank crisis never occur because of excessive exposures to what was considered risky but only because of excessive exposures to what was considered as absolutely not risky, with their Basel II, told RBS: “You RBS, if you lend to a “risky” small business in the UK you must have 8 percent in capital, but, if you lend to an infallible Greece or anyone else similarly risk-free, you only need to have 1.6 percent in capital”.

And because that 1.6 percent allowed for a leverage of more than 60 times when lending to Greece, RBS, though it still could earn a decent 18 percent on its capital when lending to a small business in the UK, suddenly RBS could expect to earn 90 percent on its capital when lending to Greece or similar. Hell, RBS could even afford to lower the interest rate it charged Greece and still earn more when lending to Greece than when lending to a small business in the UK.

And of course RBS, as did all banks in the Western world, started running to the officially perceived safe-havens of Greece, Italy, Spain, triple-A rated securities and other, where they could earn much more on their equity; and of course the governments of the safe-havens could not resist the temptations of cheap and abundant loans, and all these safe-havens became dangerously overcrowded… while the small business in the UK found it harder and much more expensive to access any bank credit… and while the too big to fail banks grew even bigger.

And, many years into a crisis that has the Western World in a freefall, this issue is not even discussed, and the same failed bank regulators are allowed to work on Basel III, using the same failed loony and distorting ex-ante perceived risk of default based capital requirement discrimination principle.

And when Adair Turner, the Chairman of FSA, in the report on the failure of RBS now states “These prudential regulations have been changed radically since the crisis, with the internationally agreed Basel III standards” he is not referring to this problem.

And this problem has been known, for a long time, just as an example the Financial Times published two letters of mine that clearly warned about what was going to happen. In January 2003, “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds” and, in October 2004, “Our bank supervisors in Basel are unwittingly controlling the capital flows in the world. How many Basel propositions it will take before they start realizing the damage they are doing by favoring so much bank lending to the public sector (sovereigns)?

And I have even explained much of the problem personally to Lord Adair Turner, quite some time ago.

Occupy Wall Street? Occupy RBS? No! Occupy Basel! Hell, occupy FSA and the Dodd-Frank Act too!

Lord Turner, please help save the world from our financial regulators´ regulatory exuberance!

In June 2010, during a conference given by Adair Turner at the Brookings Institute, I asked the following: 

1:20:07 MR. KAROFSKY: Pere Karofsky (In the transcripts that's me) from the Voice of Noise Foundation (You can also hear it in the audio).

"Big companies in consolidated sectors, like BP in oil, tend to have much better credit ratings than those participating in developing markets like wind energy. Do you really think the banks will perform better their societal capital allocation role if regulators allow them to have much lower capital requirements when lending to the consolidated sectors than when lending to the developing? Do you think we can reach a meaningful financial regulatory reform without opening up the discussion on the issue of risk in development? I mean to combat the regulatory exuberance of the Basel Committee."

1:26:08 To that Lord Turner responded: "The point about lending to large companies development, I'm not sure. I'm trying to think about that. I mean we try to develop risk weights which are truly related to the underlying risks. And the fact is that on the whole lending to small and medium enterprises does show up as having both a higher expected loss but also a greater variance of loss. And, of course, capital is there to absorb unexpected loss or either variance of loss rather than the expected loss. I think, therefore, it's quite difficult for us to be as regulators, skewing the risk weights to achieve, as it were, developmental goals. There are some developmental goals, for instance, in a renewable energy, which I'm very committed to wearing one of my other hats on climate change, where I do think you may need to do, you know, in a straight public subsidy rather than believing that we can do it through the indirect mechanism of the risk weights. So I may have misunderstood your question, but I'm sort of cautious of the sort of the leap to introducing developmental roles into -- I think we, as regulators, have to focus simply on how risky actually is it?"

I replied (not authorized, perhaps even rudely) the following: 1:27:19 

"But you do do make all regulatory discrimination based on credit risk and that risk is just one of the many risk we face".

My prime conclusion of it all was that when Lord Turner states "capital is there to absorb unexpected loss, or either variance of loss rather than the expected loss" he does not understand the sillines of estimating unexpected loss using expected loss. The safer something is perceived de facto de larger its potential to deliver unexpected losses. And he also does not understand the purposelessness of weighing capital requirements based on one of the only risks banks have already cleared for, by means of risk premiums and the size of the exposure

And on June 22, 2010 I sent Lord Turner the following letter:

Dear Lord Turner.

In November 1999 I wrote: “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 at the end will cause the collapse of the last standing bank in the world.”

There has never ever been a major or systemic bank crisis that has resulted from the banks being involved with what ex-ante was perceived as risky; they all resulted from lending and investing in what ex-ante was considered as not risky, given the returns offered. 

But then came the Basel Committee regulators and, to top it up, lowered the capital requirements for what ex-ante is perceived by the credit rating agencies as having lower risks, which of course increased the banks’ expected ex-ante returns from pursuing these “low risk” opportunities. 

And now, when two years after an explosion that resulted from so many banks following the minuscule capital requirements when investing in securities collateralized with subprime mortgages; and there is a bank explosion awaiting round the corner because of the minuscule capital requirements when lending to well rated fancy sovereigns, like Greece; they keep on applying the same regulatory paradigm of risk-weighted assets, we can only deduct that our financial regulators simply do not get it, not even ex-post.

Please, Lord Turner, help save the world from our financial regulators´ regulatory exuberance!

Regards

Per Kurowski

A former Executive Director of the World Bank (2002-2004)

I received and answer but since its states "This communication and any attachments contains information which is confidential and may be subject to legal privilege" I refrain from making it known unless I am duly authorized.

But I then answered:

Dear Lord Turner

Yes, we met yesterday at Brookings... and it is not only that “our ability to know ex ante what is low and high risk is clearly limited and we have undoubtedly placed too much faith in apparently sophisticated but conceptually flawed VAR type approaches” but that, ex-post, the most benign risk for the society, might be the risk of default on which the regulators concentrate exclusively.

Think about the horror or a world without defaults and with corporations and banks becoming larger and larger. What about the risks of our banks not performing efficiently their role in allocating capitals?

By the way, lending to Greece and BP required the banks to have only 1.6 percent in capital.

Regards

Per Kurowski

To that I received no answer.