Charles Goodhart also pointed out the stupidity of risk weighted capital requirements for banks based on ex ante perceived risks… also with no luck!

In the very last page (540) of Charles Goodhart’s “The Basel Committee on Banking Supervision: A history of the Early Years, 1947-1997” of 2011 we read the following:

“Capital is supposed to be a buffer against unexpected loss: In so far as capital is required against unexpected loss, since expected loss should be handled by appropriate interest margins, the use of credit ratings as a guide to risk weights for capital adequacy requirements (CARs) is wrong and inconsistent, since these give a measure of expected loss. What is needed instead is a measure of the uncertainty of such losses, the second moment rather than the first.

If capital risk weights had been based, as they should logically have been, on the uncertainty attending future losses, rather than their expected modal performance, the financial system might have avoided much of the worst disasters of the 2007/08 financial crisis.

It remains surprisingly difficult to persuade regulators of this simple point.”

But to that Goodhart adds “It does however, get recognized from time to time”… though the examples he then indicates, are not so clear.

In the Epilogue (page 581) Goodhart list some of the failings of the BCBS’s regulations:

1. The lack of any theoretical basis.

2. The focus on the individual institution, rather that the system

3. The failure to reach an accord on liquidity;

4. The lack of empirical analysis;

5. The unwillingness to discuss either sanctions or crisis resolution, and so on.

That clearly adds up to a total regulatory failure... no wonder they don't want to discuss sanctions. 

But, unfortunately as I see it, Charles Goodhart, though absolutely right, is only scratching the surface. What is most dangerously ignored are the distortions in the allocation of bank credit to the real economy that these risk weighted capital requirements for banks cause.

Here is my own, also ignored, current brief aide memoire on the major mistakes with the risk weighted capital requirements

September 2, 1986 was fatal for Western World’s economies. Its banks would be told not to finance the riskier future.

In Charles Goodhart’s “The Basel Committee on Banking Supervision: A History of the early years 1974-1997” 2012, Cambridge Press Goodman (p.167) refers to Steven Solomon’s The Confidence Game (1995), and we read:

On September 2, 1986, the fine cutlery was laid once again at the Bank of England governor’s official residence at New Change… The occasion was an impromptu visit from Paul Volcker… When the Fed chairman sat down with Governor Robin Leigh-Pemberton and three senior BoE officials, the topic he raised was bank capital…

At dinner the governor’s hopes had been modest: to find areas of sufficient convergence of goals and regulatory concepts to achieve separate but parallel upgrading moves… 

Yet the momentum it galvanized… produced an unanticipated breakthrough of a fully articulated, common bank capital adequacy regime for the United States and United Kingdom. This in turn catalyzed one of the 1980’s most remarkable achievements – the first worldwide protocol on the definitions, framework, and minimum standards for the capital adequacy of international active banks…

They literally wiped the blackboard clean, then explored designing a new risk-weighted capital adequacy for both countries… 

It included… a five-category framework of risk-weighted assets… It required banks to hold the full capital standard against against the highest-risk loans, half the standard for the second riskiest category, a quarter for the middle category, and so on to zero capital for assets, such as government securities, without meaningful risk of credit default.”

And that, as far as I am concerned, could be the opening scene for a Mission Impossible or Bond movie, describing the actions of terrorists wanting to destroy the world’s economies. 

Of course it was just dumb arrogant technocrats going abour their business of solely thinking about how banks could avoid failure, without giving even the slightest consideration to the possibility that when doing so they could dangerously distort the allocation of bank credit to the real economy.

The buckets with riskweights of 100%, 50% 25% 0%, and if the capital standard was set to 8 percent meant that a bank would be able to leverage its equity, and the implicit support of society, 12.5, 25, 50 and ∞ times to one respectively with the assets in each bucket.

That meant banks would earn higher risk adjusted returns on equity on assets in those buckets they could leverage more. And that meant that the net of risk margins offered by The Risky to the banks were worth less than the same margins offered by The Safe.

And what was also clear to these “statist conspirators”, was that the risk weight for the private sector would be 100% while that of their governments would be zero.

All in all that night the diners decided the Western World had had enough of risktaking and so the banks should stop giving credit to the riskier future and concentrate on refinancing the safer past.

You might argue that regulators did not force banks to do anything, but that would be to ignore that out there in the real world any bank that earns less risk adjusted returns on equity than other banks will, sooner or later, be eaten up.

And the baby conceived that night was born 21 months later in November 1988 and named the Basel Accord or Basel I. And that baby grew up to be a real monster in 2004, when it turned into Basel II.

And because of this financial terrorism act, millions of small loans to SMEs and entreprenuers that would otherwise have been awarded have now been denied. 

And with that the possibility of creating the new jobs that could substitute for the disappearing ones were greatly diminished.

And by so denying those in lack of capital the opportunities to access bank credit, inequality got a strong boost.

And, ridicously, all for nothing, since major bank crises never ever result from excessive exposures to what is ex ante perceived as risky.

What would the Founding Fathers have to say about risk weighted bank capital/equity requirements with decreed weights: 0% Federal Government – 100% We the People?

Looking to level the playing field for banks to compete, regulators unleveled real economies’ access to bank credit

I refer to Charles Goodhart’s “The Basel Committee on BankingSupervision: A History of the early years 1974-1997” 2012, Cambridge Press.

Goodhart frequently mentions the importance given by bank regulators “towards preserving and, where necessary, enhancing national prudential standards and towards removing competitive inequalities arising from different regulatory requirements” (p.175)

But since the need for an efficient allocation of bank credit to the real economy was never in any way shape or form on the regulators’ agenda, while doing so they came up with risk weighted capital requirements for banks; which guaranteed unleveling the playing-field for all bank borrowers, by favoring the “safe” in detriment of the “risky”.

Goodman (p.195) writes “the risk weights to be applied to the various groups of assets were ad-hoc and broad-brush, based on subjective (and political judgement), not on any empirical studies. Their application soon led to serious distortions in bank bank asset portfolios that undermined Basel I. There was little or no discussion at the time about the impact that the Accord might or should have on bank behavior. The need was just to achieve the two desiderata: higher capital ratios and a level playing field” (p.195) 

And since the need for an efficient allocation of bank credit to the real economy was never, in any way shape or form part of the regulators’ agenda, they came up with risk weighted capital requirements for banks; which guaranteed and unlevel-playing-field for all bank borrowers, by favoring the “safe” in detriment of the “risky”. And with respect to the health and growth of the real economy, that was as imprudent as imprudent can be.

Goodman opines “any simple approach would tend to put into common groupings (or ‘buckets’) assets/liabilities that were in many respects dissimilar, thereby leading to anomalies, distortions and ‘gaming’” (p.158). I do not agree. It was the existence of different buckets, which received different capital requirements treatments, that led to distortions and gaming. Any assets might have arrived to a specific bucket by means of gaming, but once in that bucket, within that bucket, there were no further distortions as the risk weights were all the same.

In an undisturbed real economy, there is only one bucket, in which all have to live and fight for survival.

I found some qualified support for one of my ignored arguments against current credit risk weighted capital requirements for banks.

In Charles Goodhart’s “The Basel Committee on Banking Supervision: A History of the early years 1974-1997" I just discovered, tucked away in a small note right before the Epilogue and with no reference in the index, the following about “unexpected losses”

“In so far as capital is required against unexpected loss, since expected loss should be handled by appropriate rate margins, the use of credit ratings as a guide to risk weights for Capital Adequacy Requirement’s is wrong and inconsistent, since these give a measure of expected credit loss… If capital requirements had been based, as they logically should have been, on the uncertainty attending future losses, rather than their expected modal performance, the financial system might have avoided much of the worst disasters of the 2007/2008 financial crisis”

That is what I have argued of years. Does the fact that somebody knew it, and said it, and yet it was ignored not clearly reflect that something smells very rotten in the Basel Committee for Banking Supervision?

How on earth do we allow our banking system to be in the hands of such irresponsible regulatory charlatans? Have they not done enough damage as is?

And of course, this is but one of many regulatory mistakes/sins they have committed 

PS. On the specific issue of expected risks substituting for unexpected risks, I have written around 50 letters to the Financial Times, but they have all been ignored. Perhaps when now raised by one with much better standing than me, it will at long last be brought into the debate.

PS. For instance in 2001 the Fed, FDIC and OCC 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 nonsense what is?

Basel global bank regulations: What blocked timely warnings from even being heard and much less considered?

Charles Goodhart has written “The Basel Committee on Banking Supervision: A History of the Early Years 1974-1997, 2011” For someone like me who became slightly aware of the existence of the Basel Committee in 1997 and who as an Executive Director of the World Bank 2002-04 questioned much of what it was up to, it is an extraordinary interesting book and I will comment it frequently… jumping all over it.

Close to the end, page 578, Goodhart writes. “The regulatory process itself is likely to exacerbate internal self-reinforcing dynamics… by introducing a single set of international standards, it tends towards making more banks behave in the same way at the same time (Alexander, Eatwell, Persaud and Reoch 2007). Thus it adds to the likelihood of crowded trades forcing major and sudden price readjustments”.

Precisely, in April 2003, a time during which Basel II was discussed, when commenting on the World Bank’s Strategic Framework 2004-06, I formally warned:

“Ages ago, when information was less available and moved at a slower pace, the market consisted of a myriad of individual agents acting on limited information basis. Nowadays, when information is just too voluminous and fast to handle, market or authorities have decided to delegate the evaluation of it into the hands of much fewer players such as the credit rating agencies. This will, almost by definition, introduce systemic risks in the market and we are already able to discern some of the victims, although they are just the tip of an iceberg. Once again, perhaps only the World Bank has the sufficient world standing to act in this issue. 

A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind. Who could really defend the value of diversity, if not The World Bank?"

How do such comments become so totally ignored? Was it because I did not belong to any mutual admiration network of experts?

A question about the Wolfson Economic Prize

A £250,000 Wolfson Economics Prize competition has now been announced for the best answer to the following question: If member states leave the European Economic and Monetary Union, what is the best way for the economic process to be managed to provide the soundest foundation for the future growth and prosperity of the current membership? 

And, what if one believes no member state should have to leave the eurozone, because even though the eurozone undoubtedly presents many challenges, this crisis was primarily the result of bad banking regulations, and not of the eurozone? 

Let me explain. The only way the current imbalances could have resulted in building up the humongous European sovereign debt burdens, carried primarily by banks, was that the regulators allowed the banks to hold these exposures against zero or very little equity. This caused the banks to be willing to lend too much, at artificially low interest rates. 

If that is the case, at this moment, when some of the European sovereigns are rated as “riskier”, and therefore banks are required to hold more capital when lending to these, the possibilities are either that these debtors will find it much harder to work themselves out of any excessive debt position, and or, that the remaining safe-sovereign-havens also end up dangerously overcrowded. 

It is bad enough that bankers lent the umbrella to the European sovereigns when the sun was shining and now they want it back when it rains, for the regulators to do exactly the same. 

What solutions do I envision?

Perhaps a general and substantial haircut on all outstanding European sovereign debt, Germany included, which would allow the stronger countries to help out more in getting the eurozone economy going… and, of course, a total reversal, over a period of time, of the current capital requirements for banks based on ex-ante perceived risk of default, and which will go down in history as the mother of all failed and truly stupid bank regulation Maginot lines.

I have now received an answer to my query, it is: “The question stands as framed”

Unfortunately, it seems that the possibility of a solution that does not mean someone being expelled from the eurozone, is not acceptable.

We golfers can count ourselves lucky golf is not regulated by a Basel Committee

Current bank regulations:

Those perceived as safe, who therefore have easier access to credit, lower bank capital requirements. 

Those perceived as risky, who therefore have less access to credit, higher bank capital requirements. 

"I play with friends, but we don't play friendly games." Ben Hogan 

In reference to the recent published history of the Basel Committee of Banking Supervision (early years 1974-1997) by Charles Goodhart, I must say that we golf players, who enjoy a handicap system that allows us bad players to play against the good ones, should feel very lucky that system did not fall in the hands of something like a Basel Committee of Golf Supervision. 

Had that happened and had that Committee followed the same mentality as the BCBS, we could have ended up with a system that allows good players extra strokes and takes away strokes from the bad, which, in essence is what the current capital requirements for banks based on ex-ante perceived risk do. 

The end result of such a system would be to little by little weed out all bad players until only the best one was left standing, victorious, but with no friend to play with.

Likewise current bank regulations are little by little eliminating the access to bank credit to those perceived as “risky” and concentrating it in lesser and lesser borrowers perceived as not-risky. 

In this respect, having weeded out all “risky” small businesses and entrepreneurs and now doing the same to sovereigns, like falling domino pieces, the US dollar might end up as the last absolute-risk-free-borrower-standing, but what’s the use of that if he then has no friend to play an "unfriendly" game with?

PS. Here´s a video that explains a fraction of the stupidity of our bank regulations, in an apolitical red and blue! http://bit.ly/mQIHoi