The Minsky "displacement" that caused the ongoing crisis, was the credit risk weighted capital requirements for banks.

I cite from Charles P. Kindleberger’s “Manias, Panics and Crashes” 1978.

“Financial crisis are associated with the peaks of business cycles… the culmination of a period of expansion.

According to Hyman Minsky, events leading up to a crisis start with a ‘displacement’ some exogenous, outside shock to the macroeconomic system. The nature of this displacement varies from one speculative boom to another. It may be the outbreak or end of a war, a bumper harvest or crop failure, the widespread adoption of an invention with pervasive effects – canals, railroads, the automobile – some political event or surprising financial success, or a debt conversion that precipitously lower interest rates. But whatever the source of the displacement, if it is sufficiently large and pervasive, it will alter the economic outlook by changing profit opportunities in at least one important sector of the economy. Displacement brings opportunities for profit in some new or existing lines, and closes out others… a boom is under way.

In Minsky’s model, the boom is fed by an expansion of bank credit which enlarges the total money supply… Bank credit is, or at least has been, notoriously unstable and the Minsky model is based squarely on that fact.” End of quote

In 1999 in a Op-Ed in 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 will cause the collapse of our banks” 

And I have no doubt that the systemic error, the Minsky displacement that brought on the credit expansion that resulted in the financial crisis of 2007-08, was the introduction by regulators of credit risk weighted capital requirements for banks.

That facilitated a tremendous credit expansion by allowing banks to hold absolute minimum equity against assets perceived as safe. We are talking about zero percent when lending to sovereigns (Basel I 1988) to 1.6 percent when lending to the private sector rated AAA to AA (Basel II 2004).

And allowing for such minimum equity, while still lending the banking sector much implicit and explicit government support, made possible immense leverages and thereby immense risk-adjusted returns on bank equity on assets perceived as safe, while closing out the fair access to bank credit for all those perceived as “risky”, like the SMEs.

And today, soon a decade later, that “displacement” which completely distorted the allocation of bank credit to the real economy has not even been acknowledged much less corrected.

PS. Read Charles P. Kindleberger’s “Manias, Panics and Crashes” and you will not find one evidence that supports current credit risk weighted capital requirements for banks… unless perhaps they are 180 degrees the opposite: higher for what is perceived as safe and lower for what is perceived as risky.

PS. In the Wikipedia on Hyman Minsky, I do not agree with how Paul McCulley translates the Minsky's hypothesis to the subprime mortgage crisis ignoring the minimum bank capital requirements associated with the AAA rated securities backed with mortgages to the subprime sector.

Western world, it behooves you to understand the following about current bank regulations, and to do something about it.

Banks are currently allowed to hold much less equity against assets perceived as safe than against assets perceived as risky.

That means that banks are allowed to leverage their equity much more with assets perceived as safe than with assets perceived as risky.

That means bank currently obtain much higher risk adjusted returns on equity with assets perceived as safe than with assets perceived as risky.

And that, compared to equity requirements which do not discriminate based on ex ante perceived credit risks, means that banks will lend too much at too low rates to what is perceived as safe, and too little at relative too high rates to what is perceived as risky.

And the supposedly “safe” are sovereigns, basically considered as infallible, the members of the AAArisktocracy, and the housing sector.

And the supposedly “risky” are for instance all those SMEs and entrepreneurs we so much depend on for our economies to move forward, so as not to stall and fall.

And all for nothing! Major bank crises result always from to large exposures to what is erroneously perceived ex ante as safe, and never ever from too large exposure to what is perceived as “risky”.

And the distortions this regulation has created is destroying the Western world that has become what it is, not by risk avoidance, but by the reasoned and sometimes the unreasonable risk taking of our forefathers.

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

How did this monstrous regulatory mistake happen?

First and foremost because regulators concerned themselves with the risk of the assets of banks, which is what bankers should be concerned with, and not with the risk that bankers are unable to manage the perceived risks, or the risk perceptions being faulty, and which is what regulators should be concerned with.

Second by allowing the regulations to take place in a small mutual admiration club of “experts” with no accountability.

Third, by allowing ideology to infiltrate bank regulations to such an extent so as to make it possible for regulators to declare some sovereigns to be infallible, to have a zero risk weight.

Fourth by the fact we live in a world that finds it difficult to imagine, or does not want to recognize, the possibility of experts being so utterly wrong. 

How can we correct for it? Not easy, but it will clearly not happen by allowing the failed regulators to keep on regulating.

And please do not ask bankers to correct it. For them, being able to earn the highest risk-adjusted returns on equity by lending to the “safe”, is a dream come true. 

In 1999, in an Op-Ed 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 will cause the collapse of our banks”

That AAA-bomb detonated in 2007-08 and its poisonous radiation is still killing our economies. For those coming after us… please do something! 

@PerKurowski

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

http://teawithft.blogspot.com

http://subprimeregulations.blogspot.com/

http://financefordevelopment.blogspot.com

http://www.theaaa-bomb.blogspot.com

http://bombaaaa.blogspot.com

PS. Any editing suggestion that could make the explanation more understandable is appreciated on perkurowski@gmail.com

My letter in May 2012 to Anders Borg, the Minister of Finance in Sweden

Anders,

I am the Venezuelan born Sweden educated former World Bank Executive Director you met for a brief moment during the recent World Bank meetings. Let me refresh your mind about what I told you.

The capital requirements for banks based on ex-ante perceived risks, more risk more capital and less risk less capital are senseless, for many reasons.

Not only has no major bank crisis ever occurred as a result of excessive bank lending to what is perceived as risky, they have always resulted from excessive bank lending to what was perceived as absolutely not risky and turn out to be risky… even the Dutch Tulips would have been AAA rated before their crash.

Also these capital requirements discriminate against the sparkplugs of any economic growth, namely the “risky” small businesses and entrepreneurs.

Risk is the oxygen of economic growth and also what provides our banks with the Lebensraum that allows them to grow sturdy… Build them up on excessive risk-avoidance and you are building yourself an AAA-bomb ready to explode.

I invite you to see a brief video where I explain part of my arguments and, on that same blog, you will find much more.

http://subprimeregulations.blogspot.com/2011/04/basels-monstrous-regulatory-mistake.html

As a small reference as to why perhaps you should hear me out just the following examples:

In November 1999 in an Op-Ed in the Daily Journal of Caracas 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 will cause the collapse, of the only remaining bank in the world”

In January 2003, in a letter published by the Financial Times I wrote: “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”

In October 2004, in a written statement delivered as an ED at the World Bank Board I opined: “We believe that much of the world’s financial markets are currently being dangerously overstretched through an exaggerated reliance on intrinsically weak financial models that are based on very short series of statistical evidence and very doubtful volatility assumptions”

Regards

Per

God make us daring! Gud gör oss djärva!

PS. A couple of days later I was advised by the Ministry of Finance that my letter had been forwarded to the political advisor Hanna Schönning... and that was all folks!

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.

About the SEC, the human factor, and laughing

A couple of days ago, our SEC reported that their pension fund had also been the victim of a fraudulent stock-managing firm, and that they had lost a lot of money.

I also read recently about the Mars Climate Orbiter spaceship that, after having required an investment of 125 million dollars, had to be declared as a total loss due to a technical confusion derived from simultaneously applying metric and English measures.

If what happened to NASA or what happened to our SEC is of any mutual comfort to them, I don’t care, but what I do hope is that they have learned a bit more about humility.

I bring this opinion to the table since I recently heard that our SEC was now establishing higher capital requirements for stockbroker firms, arguing that “. . . the weak have to merge to remain. We have to get rid of the rotten apples so that we can renew the trust in the system.” As I read it, it establishes a very dangerous relationship between weak and rotten. In fact, the financially weakest stockbroker in the system could be providing the most honest services while the big ones, just because of their size, can also bring down the whole world. It has always surprised me how the financial regulatory authorities, while preaching the value of diversification, act in favor of concentration.

The SEC should not substitute the need for capital in place of the need for ethics, nor should it allow that fraudulent behavior hides amid the anonymity of huge firms. In this respect, let us not forget that the risk of social sanctions should be one of the most fundamental tools in controlling financial activities.

If there is a relation between weakness and a rotten apple, it could really be in the SEC itself, since, though they frequently complain about the lack of resources, that doesn’t stop them from transmitting institutional messages about how well they are fulfilling their responsibilities. Perhaps the best thing that the SEC could do is to stop all their actions that are creating a false sense of security in the investor, acknowledging the absence of any supervisory capacity, and instead stamp each share prospectus with a big “BUYERS BEWARE.”

We read an article in Newsweek (“Giving Big Blue a Shiner, November 1999), about the surprising 20% drop in value that IBM shares had suffered in just one day. It also states that this drop was not in any way the result of any especially surprising event. The purported lesson of the article was “To teach not to take too seriously the investigative capacity of Wall Street and to remember to laugh next time you hear that the stock-market is a rational place where the big investors know what they are doing.” I would also like to suggest remembering to laugh next time a regulator presumptuously assures you he is doing his job.

And last I want to comment on another risk of regulations. Reading about accidents in nuclear reactors in Japan and about the risks of proliferation of nuclear weapons there is no doubt that the fears of a nuclear Big Bang are being renewed.

That said, 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 will cause the collapse of the OWB (the only bank in the world) or of the last financial dinosaur that survives at that moment.


Currently market forces favors the larger the entity is, be it banks, law firms, auditing firms, brokers, etc. Perhaps one of the things that the authorities could do, in order to diversify risks, is to create a tax on size.

Here the version in Spanish: