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

Knowingly or unwittingly, I believe and pray for the latter, current bank regulators are saboteurs of the economy

There has never ever been an economy that has grown strong and sturdy based on risk-aversion… they have always done so based sometimes on pure unabridged crazy risk-taking and other times with reasoned audacity… but that is what have kept them moving forward without stalling and falling.

Therefore when regulators imposed credit-risk weighted capital (equity) requirements for banks; which allow banks to earn much much higher risk adjusted returns on equity on what is ex ante officially perceived as absolutely safe, like “infallible sovereigns”, housing sector and members of the AAAristocracy, than on what is perceived as “risky”, like the medium and small businesses, entrepreneurs and start-ups… then they, de facto, sabotaged the economy.

So who wants to be known in the history as one of the saboteurs who brought down our economies?

For your information, secular stagnation, deflation, mediocre economy and other similar creatures out there, are direct descendants of risk aversion.

The bank regulatory establishment, Basel Committee, Fed, ECB, FDIC, BoE, FSB, IMF (and FT) believes this… do you?

Bankers should be able by means of interest rates, amounts of exposure and other terms be able to clear for any perceived credit risks, such as those expressed in credit ratings. And if they cannot do so, then clearly the faster they refrain from banking the better for all.

But regulators, though they should in fact be making sure that banks had some reserves for unexpected events, which obviously has nothing to do whatsoever with ex ante perceived credit risks, decided that the capital (equity) that banks needed to hold, was also to be based on exactly the same perceived credit risks.

And this led to the perceived credit risks being considered twice, which has caused banks to lend too much at too low rates to what is for the time being considered ex ante as “absolutely safe”, like to “infallible sovereigns”, housing finance and the AAAristocracy; and nothing or way too little, at too high risk adjusted interest rates, to what is for the time being officially considered as “risky”, like medium and small companies, entrepreneurs and start-ups.

And of course that is not smart, actually it is quite dumb, something which the too much lending against too little capital to Greece, to real estate in Spain, or investments in AAA rated securities backed with mortgages to the subprime sector in the US, and which caused the current crisis, can attest to.

And of course that is not smart, actually it is quite dumb, as all those tough “risky” risk-takers that we need to get going when the going gets tough, have now no fair access to bank credit.

And of course those who will bear the brunt of the costs of this what I refer to as a malignant regulatory concoction, are all the young who not only will face larger tax bills in the future but also the perspective of much less jobs.

But no! The regulatory establishment, which seemingly includes those penning in FT, have circled the wagons, and refuse to even acknowledge, less answer, the questions this little howling Indian has been throwing at them over the years.

And not that this little Indian is unqualified to ask… much the contrary, he belongs to those who in very clear terms, long before the crisis, warned that something was completely wrong. For a starter he held that those regulators were regulating banks, without even mentioning their purpose.

“A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926.

And to which today I would add that a ship in harbor is really not safe at all, if the harbor, no matter how safe it seems, becomes dangerously overcrowded.

So, do you want to join those within the circled wagons, or do you want to help this little Indian holding those regulators accountable for what they have done?

Bank regulators hate me when I ask this simple question. They refuse to answer it. They can’t! That’s the real problem!

The Question: Sir, current risk weighted capital requirements for banks are based on the perceptions of risk by credit rating agencies and bankers. But if bankers and credit rating agencies perceive the risks correctly there should be no major problems. So why are not the capital requirements for banks based instead on the credit risks not being correctly perceived by bankers and credit agencies?

As is, the perceived risks are now, besides being cleared for in the interest rate charged by the banks and in the amount of exposure accepted,also cleared, for a second time, in the required bank capital (equity). And that has created the distortions that make the banks lend dangerously much to what is perceived as “absolutely safe”, and dangerously little to what is perceived as “risky”, like to medium and small businesses, entrepreneurs and start ups.

As is, the risk with risk weighted capital requirements for banks is much greater than the risks which are being weighted! Got it?

I suspect the whole mess results from the fact that when regulators were given an explanation similar to that which appears in “The Basel Committee on Banking Supervision´sExplanatory Note on the Basel II IRB Risk Weight Functions of July 2005”… they did not understand one iota of it, but did not want to admit that in front of their equally befuddled colleagues. In other words, could it be the weak egos of expert bank regulators which provoked this financial crisis?

A subsequent problem is of course that too few are capable of daring to think that globally renowned experts can be so utterly wrong… and so they do not dare to help me to ask The Question.

Friends, we have to put a stop to the lack of accountability of those working in Committees which decisions have global implications. Can you imagine what could happen to the earth if similar weak egos are placed in charge of a Global Warming Supervision Committee in Basel?

PS. Here is a current summary of why I know the risk weighted capital requirements for banks, is utter and dangerous nonsense.

My list of the biggest X mistakes of risk-weighted capital requirements for banks, which regulators (and FT) ignores

For the time being, and in no particular order… 

1. The risk-weights are portfolio invariant, which means these do not reflect the dangers of excessive concentration or the benefits of diversification. The main explanation for the why of this is, amazingly, that otherwise it would have been too difficult for regulators to manage.

2. The risk-weights are based on the expected risk which is already being cleared for by bankers, by means of interest rates, size of exposure and other contractual terms; and not based on the unexpected risks, that which should really be the concern of regulators.

3. The risk-weights with their consequential different capital requirements for different assets allow banks to earn higher risk-adjusted returns on its equity on assets classified as "safe" than on assets deemed "risky", something which hugely distorts the allocation of bank credit in the real economy.

4. One thing is the risk for the banks of the expected risks of their assets… and another completely different the risk for regulators of the banks not perceiving the expected risk correctly.

5. The less the number of those officially appointed to perceive credit risks, like the human fallible credit rating agencies, the larger the consequences of a magnificent risk-perception imperfection.

6. The only reason for which regulators can set higher capital requirements for banks when lending to “the infallible” than when lending to “the risky” is that they did not do any empirical research on what always causes bank crises, namely excessive exposures to something ex-ante considered "absolutely safe" but that ex-post turned out not to be.

7. To believe that the risks of huge loans to an infallible sovereign are greater than many small loans to that sovereigns subjects, is about as crazy as it gets… unless of course you are a communist.

8. Emphasizing the avoidance of short term perceived credit risks, without considering the benefit that loans to "the risky" might bring to the sturdiness of the real economy, causes banks to concentrate on financing the safer past and to avoid financing the riskier future… which is something our children will pay dearly for.

9. Ridiculously small capital requirements, 4%, 2.8%, 1.6% and even 0% constitute of course the best growth-hormones for the “too-big-to-fail” banks.

10. Diminishing the importance of bank capital allows for outrageous bankers’ bonuses.

11. Of course underlying all of the problems of Basel II is that there is not a word to be found in all the Basel Committee’s regulations about what is the real purpose of the banks. No wonder!

12. To ignore the consequences of all the distortions in the allocation of credit to the real economy the risk-weighing has and will cause, is sheer lunacy!

PS. This post will be continuously revised.

Basel Committee for Banking Supervision and the Financial Stability Board take notice: Anyone who imposes regulations that can be gamed is the wrongdoer’s best friend

This financial crisis did not disprove the efficient market hypothesis.

One of the most mentioned aspects about the current bank crisis is that in much it was a consequence of Alan Greenspan believing blindly in the efficient markets hypothesis, a hypothesis that became so thoroughly discredited.

Sorry… what efficient markets? With respect to the allocation of bank credit, the markets were completely distorted by the risk-weighted capital requirements, and so that hypothesis had no chance to be proven or disproven.

The capital requirements were and are much lower for what is perceived as absolutely safe, than for what is perceived as risky, and so the risk-adjusted returns on bank equity are much higher on assets perceived as absolutely safe than on assets perceived as safe.

In terms of the equity markets this would be something similar to the government multiplying the profits of investors, by paying them bonuses or similar subsidies, whenever they invested in shares with low volatility and not in shares with high volatility. Do you really think that would allow for an efficient market hypothesis to work free at its leisure?

I am not saying that the markets behave efficiently all the time but that, this time at least, it was clearly not the fault of markets, but the fault of dumb regulators.

PS. These comments were inspired by reading Chapter 1, "Primordial Seeds" in James Owen Weatherall's "The Physics of Wall Street" and which contains a fascinating description of the origins of the hypothesis and of its first and almost forgotten originator Louis Bachelier.

PS. I should acknowledge Tim Harford's arguments that though not the same do point in the same direction.

Mr. Alan Greenspan… tell us the story… why were your legitimate concerns waived… what really happened?

In 1998, celebrating the tenth anniversary of the Basel Accord Alan Greenspan gave a speech titled “The Role of Capital in Optimal Banking Supervision and Regulation”, FRBNY Economic Policy Review/October 1998”. Three comments stand out:

First: “It is argued that the heightened complexity of these large bank’s risk-taking activities, along with the expanding scope of regulatory arbitrage, may cause capital ratios as calculated under the existing rules to become increasingly misleading. I, too, share these concerns”

And there was Greenspan only referring to the measly 30 pages of Basel I… and so how on earth, with this type of miss-feelings, can we now have arrived to our tens of thousands of pages of Basel III and Dodd-Frank Act?

Second: “regulatory capital arbitrage… is not costless and therefore not without implications for resource allocation. Interestingly, one reason that the formal capital standards do not include many risk buckets is that regulators did not want to influence how banks make resource allocation. Ironically, the one-size-fits-all standard does just that, by forcing the banks into expending effort to negate the capital requirement, or to exploit it, whenever there is a significant disparity between the relatively arbitrary standard and internal, economic capital requirements.” 

And so here if the implications for resource allocation (of bank credit in the real economy) is considered as an issue… how on earth did they go from some risk-weights depending of the category of assets, to something even so much distortive for resource allocation as risk weights depending on credit ratings?

Third: “For internal purposes, these large institutions attempt explicitly to quantify their credit, market and operating risks, by estimating loss probabilities distribution for various risk positions. Enough economic, as distinct from regulatory, capital is then allocated to each risk position to satisfy the institution’s own standard for insolvency probability.”

And so what happened to the distinction between economic and regulatory capital? Is it not so that a regulator´s real problem begins when the economic capital is miscalculated by the banks? If so, why the hell would he then want to calculate regulatory capital as it was economic capital?

No I am sorry… Alan Greenspan… as well as his successor Ben Bernanke… and of course all the other regulators like those in the Basel Committee and the Financial Stability Board… they will have a lot of explanation to do… when history finally catches up on them.

And I would certainly not want to be in their shoes. “Daddy why was grandfather so dumb? … It is because of his stupid regulatory risk aversion that banks stopped financing the future and only refinanced the past, and which is why I and my friends now do not have jobs.”

All dollars (or Pounds, or Euros) should be equal!

The efficient market hypothesis, and the capacity of free markets to allocate efficiently financial resources have, as a consequence of the recent financial crisis, been seriously questioned. There is absolutely no cause for that.

In a free market all dollars pursuing assets are equal, and so the prices reflect the markets appreciations of returns, risks, and other factors… and so in essence, all assets will produce equivalent all included risk-adjusted returns. Like any bet on the roulette.

But then came bank regulators, with their risk-weighted capital requirements, more risk more capital, less risk less capital, and determined that some dollars, those being lent to what was perceived as “absolutely safe” were worth much more because these could be leveraged by banks much much more, than the dollars lent to what was perceived as “risky”. Like doubling the roulette payout when playing it safe, like betting on a color.

And of course that made it impossible for the markets to function. It would be like pricing assets in dollars Euros and Pounds, simultaneously without informing the markets of which currency was used. In fact, since bank capital when in “risk-free” land could sometimes be leveraged about 40 times more than when in “risky” land, the currencies used are perhaps more like dollars, pesos and yen. 

And so a dollar going to someone “risky” is for the banks worth de facto much much less than a dollar going to the AAAristocracy. Talk about financial exclusion! Talk about increasing inequality gaps!

Discriminating against risk-taking, in the "Home of the Brave"... you´ve got to be kidding!

Please regulators, allow a dollar to be a dollar for everyone! So that markets will work again!

PS. By the way who authorized all that?

Basel Committee, Financial Stability Board, please do not make fun of us, or bullshit yourselves

Here is a document, which in 2005 explains why bank regulators like Mario Draghi, Lord Turner, Alan Greenspan, Mark Carney, Stefan Ingves, Michel Barnier and many other, and commentators like Martin Wolf, decided to give their full backing, in 2004, to Basel II capital requirements based on perceived risk.

It says: “This paper purely focuses on explaining the Basel II risk weight formulas in a non-technical way by describing the economic foundations as well as the underlying mathematical model and its input parameters”… and so unfortunately “By its very nature this means that this document cannot describe the full depth of the Basel Committee’s thinking as it developed the IRB framework”… but luckily for us “For further, more technical reading, references to background papers are provided.” 

Is someone trying to make fun of us? 

The document details: 

“The model should be portfolio invariant, i.e. the capital required for any given loan should only depend on the risk of that loan and must not depend on the portfolio it is added to. This characteristic has been deemed vital in order to make the new IRB framework applicable to a wider range of countries and institutions. 

Taking into account the actual portfolio composition when determining capital for each loan - as is done in more advanced credit portfolio models - would have been a too complex task for most banks and supervisors alike. The desire for portfolio invariance, however, makes recognition of institution-specific diversification effects within the framework difficult: diversification effects would depend on how well a new loan fits into an existing portfolio. 

As a result the Revised Framework was calibrated to well diversified banks. Where a bank deviates from this ideal it is expected to address this under Pillar 2 of the framework. If a bank failed at this, supervisors would have to take action under the supervisory review process (pillar 2).” 

And so that means to tell us our and all other bank supervisors around the globe who have adopted Basel II are up to this? 

Bullshit!

PS. Who wrote it?

PS. Please help me ask the question that debunks all this Basel II nonsense.

Houston, we’ve got another problem: Our central bankers’ are flying blind

In February of 2011, Alan Greenspan gave the keynote address during an event at the Brookings Institution on “Reforming the Mortgage Market”. He ended his speech by expressing that he really would like to know what the real mortgage rates would be in the US, without any of those many distortions which affect it.

I got no chance to question him in public but at the end of the event I managed to ask him: 

“Mr. Greenspan, would you likewise not want to know what the most important interest rate in the market, the interest rate on US Treasuries would be without distortions?” 

He looked at me and asked “What do you mean?” I told him: “I mean that interest rate which would result if banks were required to hold as much capital when lending to the US Treasury as they are when lending to a US citizen, a small businesses or entrepreneurs.” I felt for a moment Greenspan nervously doubting, but then he answered “Yes, I would!” 

And that is one of the sad facts today. Central banks, in the US and Europe, are basically flying blind, because they have not the faintest idea about what their real Treasury rates would be without the regulatory subsidies in favor of public borrowings they have introduced. 

And then we hear so much nonsense about this being a great time for public indebtedness because rates are so low… Rates low? Has no one factored in all the opportunity costs for the economy and job creation of all those small businesses and entrepreneurs who did, and do still not have access to bank credit in competitive terms? 

PS. So, Houston, we sure have got ourselves another serious problem.

PS. Might someone at long last be waking up?