How come we ended up with stupid portfolio invariant risk weighted bank capital requirements?

Which are based on:

That those excessive exposures that can really be dangerous to our bank systems are build up with assets perceived as risky and not with assets perceived as safe.

That the bureaucrats/politicians/apparatchiks know better what to do with credit they’re not personally responsible for than e.g., entrepreneurs

That so much of bank capital requirements can depend on the evaluation performed by some very few human fallible credit rating agencies.

That substituting risk adjusted returns on equity for risk adjusted interest rates, would not seriously distort the allocation of bank credit.

Well here is the seed “A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules"

And here is Basel Committee’s “An Explanatory Note on the Basel II IRB Risk Weight Functions"

Though Paul A. Volcker, in his autography “Keeping at it”, valiantly confessed “The assets assigned the lowest risk, for which capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages”

And here my explanations:

All bank regulators faced/face a furious attack mounted by dangerously creative capital minimizing / leverage maximizing financial engineers, who, getting rid of traditional loan officers, those with their “know your client” and their “what are you going to use the money for?”, managed to capture the banks. (And, since less capital means less dividends, they can also pay themselves larger bonuses.)

Hubris! “We regulators, we know so much about risks so we will impose risk weighted capital requirements on banks, something which will make our financial system safer” Yep, what’s risky is risky, what’s safe is safe. What is there not to like with such an offer? And the world, for the umpteenth time, again fell for demagogues, populists, Monday morning quarterbacks and those who find it so delightful to impress us rolling off their tongues sophisticated words like derivatives.

In a world full of mutual admiration clubs, like the Basel Committee and Academia in general, you do not ask questions that can imply criticism of any of your colleagues or superiors, “C’est pas comme il faut», nor, if you are a high shot financial journalist, do you risk not being invited to Davos or IMF meetings.

"It is difficult to get a man to understand something, when his salary depends upon his not understanding it!" Upton Sinclair

Clearly there are many more jobs with ever growing thousands of pages of regulations than with just a one liner: “Banks shall have one capital requirement (8%-15%) against all assets”. And so, instead of getting rid of the extremely procyclical credit risk weighted capital requirements, they designed new insufficient countercyclical ones.

“The time spent on any item of the agenda will be in inverse proportion to the sum involved." Parkinson’s law

Since bank regulators must have heard of (supposedly) Mark Twain’s “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it looks to rain” it is clear they all missed their lectures on conditional probabilities.

“There are some mistakes it takes a Ph.D. to make”, Daniel Moynihan.

“One has to belong to the intelligentsia to believe things like that: no ordinary man could be such a fool”, George Orwell, in Notes on Nationalism

And so now: 

“A ship in harbor is safe, but that is not what ships are for” John A. Shedd, something that should apply to banks too. Sadly, dangerously our bank systems, banks are overpopulating safe harbors and, equally dangerous for our economy, underexploring risky waters. 

“What gets us into trouble is not what we don't know. It's what we know for sure that just ain't so.” Mark Twain

And since current bank capital requirements are mostly based on the expected credit risks banks should clear for on their own; not on misperceived credit risks, like 2008’s AAA rated MBS, or unexpected dangers, like COVID-19, now banks stand there with their pants down.

Let us pray 2021 will not be too hurtful.

PS. Might “availability heuristic” “availability bias” help explain these loony risk weighted bank capital requirements?

My 2009 video on the 62.5 times to 1 authorized leverage

My 2019 letter to the Financial Stability Board

My 2019 letter to the Executive Directors and Staff of the International Monetary Fund

I’ve never been a regulator, but on the issue, neither am I a new arrival.

And the regulators’ mumbo jumbo, shows no sign it will stop.

Current bank regulation, more risk more capital - less risk less capital, is something as fake and dumb as it gets.

1. Even though the most important function of banks is to allocate credit efficiently to the real economy, let’s forget that and concentrate solely on banks becoming super safe mattresses in which we can store our savings.

So let us not worry about banks being able to leverage more their equity and the support we give them on what is perceived as safe than on what is perceived as risky; which obviously means banks will be able to earn higher expected risk adjusted returns on equity on what is perceived as safe than on what is perceived as risky; which obviously means banks will lend too much to what is perceived as safe and too little to what is perceived as risky.

2. Even though that reduces the opportunities of those coming from behind to access bank credit, and therefore basically decrees more inequality, let’s also forget about that.

3. Even though the distortion will cause banks to finance less the risky that our young need in order for them to have jobs and a workable economy, let us forget about that and go for short term safety, we baby-boomers aren’t that young, are we?

4. Even though all banking crisis have resulted from unexpected events, like natural disasters and devaluations, from criminal activity and from excessive exposures to something ex ante perceived as safe but that ex post turned out to be very risky, let us ignore that and require banks to hold more capital when holding assets perceived as risky. 

5. Even though we know that banks will do their utmost to lower their capital requirements so as to obtain higher returns on assets, let us allow the big banks to run their own risk models, as they will love us for that and make our yearly visits to Davos so much more agreeable.

6. Even though it is clear that our economies would never have developed the same had these regulations been in place before, let us ignore that, in order as regulators to feel more tranquil.

7. Even though the distortion will cause banks to finance less the risky SMEs and entrepreneurs that our young need to be financed in order for them to have jobs and a workable economy, let us forget about that and go for short term safety, we baby-boomers aren’t that young, are we?

8. Even though 0% risk weight for the Sovereign and 100% for We the People gives away that we believe government bureaucrats know better how to use bank credit than the private sector, let’s stand firm on it. We are true statists, aren’t we?

9. Even though Greece and AAA rated securities, and the ensuing stagnation, and the ensuing waste of so much stimulus has proved us so very wrong, let us ignore that, since otherwise we could lose our jobs.

10. There is probably not a clearer evidence that current bank regulators have no clue about they are doing that Basel II's risk weights. These assign 20% to the dangerous AAA to AA rated while sticking the so innocuous below BB- rated with 150%.

PS. I have tried for over a decade to get some answers from regulators to some very basic questions, unfortunately in that area the technocrats are seemingly following a strict Zero Contestability policy.

Let us tell the story of the Basel Committee’s risk weighted capital requirements for banks this way:

This happened during a meeting of the Basel Committee for Banking Supervision

Q. Colleagues, how on earth can we stop banks from failing? 

A. Well they must avoid taking risks?

Q. Absolutely! But how do we stop them from taking risks?

A. Perhaps by giving them great incentives to make their profits where it is safe?

Q. Sounds great! Any idea how?

A. Well we could allow them to leverage their capital much more when lending to what is safe than when lending to what is risky.

Q. How would that help?

A. Well then the banks could obtain higher risk adjusted rates of return when lending to what is safe than when lending to what is risky.

Q. But, could that not distort the allocation of credit to the real economy?

A. Oh that is not our problem. We're just here to make banks safe. 

Q. But, what if something perceived as safe turns out to be risky?

A. Don’t be so negative. We'll deal with that later if it ever happens.

Q. But could not someone argue we're introducing a regulatory discrimination against The Risky?

A. Who cares? The sovereigns will be more than happy if we give it a zero percent risk weighting. The banks, making their best profits on what is safe, will only have their wettest wet dreams realized. And, the risky, the SMEs and entrepreneurs, they have no voice… hey they are not even invited to the World Economic Forum at Davos… there we only meet the AAArisktocracy.

Q. Dear colleague, you have convinced all of us… let us go for it. By the way, what's your name?

A. Chauncey Gardiner, Sir

Mario Draghi and his colleagues might all just be Chauncey Gardiners too :-( 

Why do not Wall Street Journal’s reporters pose THE QUESTION at WEF in Davos 2016?

I refer to Wall Street’s World Economic Forum “Outlook 2016”, January 20, 2016.

Like for instance when Lingling Wei and John Hilsenrath write “Global Economy Loses Steam” The Wall Street Journal, January 20, 2016.

How on earth could not the Global Economy lose steam with regulators who, in an effort to make banks safer, have decided banks should be allowed to earn much higher risk adjusted returns on equity when lending to what is ex ante perceived or deemed to be safe, like to “infallible sovereigns”, AAArisktocracy or housing, than when lending to “risky” SMEs and entrepreneurs. That is the direct result of the risk weighted capital requirements.

“The future is here. It just needs a big push”, writes Christopher Mims. Indeed but why not start by removing the hurdles? As is, with this regulatory credit risk aversion, banks are no longer financing the riskier future they are only refinancing the safer past.

And all that distortion for no good reason, since major bank crisis never result from excessive exposures to something ex ante perceived as risky, but always from too big exposure to what has turned out to be erroneously perceived as safe.

What a shame that, with so many good journalists present in Davos, no one makes THE QUESTION

PS. Another version of THE QUESTION

@PerKurowski ©

If we are going to give bankers new real clothes, let’s make really sure they fit our children’s needs

I have frequently commented on statements or writings of Anat Admati. I have done so mostly because I find reasons to think she understands better than many the problems with current bank regulations, and so therefore I am especially frustrated when I see her being somewhat imprecise.

Here I refer to Admati’s comments at the Finance and Society INET Conference May 6, 2015 “Making Financial Regulations Work for Society”

1. Admati writes: “What we are tricked into tolerating, even subsidizing, is the equivalent of allowing trucks full of dangerous chemicals to drive at 120 mph in residential neighborhoods (and having trouble actually measuring actual speed), which burns lots of fuel, harms the engine and risks explosions.”

That is indeed a good description of the risks of a blow-up of the banking system… but it needs clarifications in order not to create confusion… in order to correct the system.

Banks are currently allowed to drive at 120 mph or faster only if they are thought not to carry anything dangerous, like if they carry a cargo of loans to sovereigns or AAArisktocrats, if they carry a load that is perceived as risky, like loans to SMEs and entrepreneurs, then they must drive at much lower speeds. That is what the credit-risk-weighted equity requirements do.

The problem with that is twofold. First, since the drivers are paid based on how fast they complete the journey (returns on equity) they only carry “safe” cargo, which constitutes an odious discrimination against all those who need the transport of “risky” cargo. And second, that it does not make any traffic-safety-sense, because all major crashes have always occurred precisely when the drivers think they are carrying something safe and therefore speed too much.

2. Then Admati writes: “harm from finance is abstract and spread out. Connecting the harm to individual wrongdoing or recklessness is hard to establish. Courts might work for fraud, but you can't take someone to court for designing bad regulations.”

I believe you can. If somebody had designed regulations that discriminate based on race and gender they could be taken to court… at least so that those regulations were immediately suspended. Here the regulators are layering on artificial discrimination against the fair access to bank credit of those perceived as risky, precisely those who are already naturally discriminated against by bankers. There is an Equal Opportunity Act in the US, Regulation B, the problem is that no one is applying to what regulators concoct.

3. And Admati writes: “Goldman Sachs CEO was wrong when he said banking is ‘god's work.’ Creating and enforcing good financial regulation is god's work.” No way Jose! Neither Goldman Sachs CEO nor regulators can do God’s work. 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”.

4. Admati also gives some ideas of how to proceed: “First, increasing the pay of regulators may reduce revolving door incentives. Second, effective regulators might be industry veterans who are not inclined to go back. Third, we must try to reduce the role of money in politics.”

Yes... but totally insufficient! In terms of fixing current bank regulations there are three things that I find to be much more important. 

The first is to define a purpose for the banks that is agreeable to the society as a whole. In all thousand of pages of regulations, there is not a single word about what banks are supposed to do… and I ask: how on earth can you regulate what you do not know what it is to do?

The second to close up the mutual small admiration club bank regulators have turned themselves into. Sovereigns and AAArisktocrats might have access to regulators at the IMF or Davos… but risky borrowers are never invited.

The third is to fully understand the need of risk-taking. If nothing is done on that, rest assure, our grandchildren will damn the Basel Committee and the Financial Stability Board, for denying them the risk-taking of banks their economies need.

The parable of talents

God make us daring!

Those in Davos might be famous and rich but, as the elite the world needs, they surely don't cut it.

Dumb bank regulators that should be concerned with the possibilities of banks perceiving credit risks wrongly, decided instead to introduce equity requirements for banks based on ex ante perceived credit risks.

And simplistically they applied a more-risk-more-equity and less-risk-less-equity rule, ignoring that a real bank system crisis only results from when something ex ante perceived as absolutely safe, turns out ex post to be very risky.

And that caused banks to lend excessively to some infallible sovereigns, the AAArisktocracy and real estate, which brought on the current crisis 

And that keeps us from getting out of the crisis, since those tough risky risk taking small businesses and entrepreneurs we need to get going when the going gets tough, are denied fair access to bank credit by equity starved banks. 

And this fundamental problematic was not even part of the agenda discussed in Davos 2015. I must say, they might be very famous and rich, but as the financial elite the world needs, those in Davos 2015, they sure don't cut it.

PS. Is there a record of all those who, since 1971, have assisted the WEF meetings in Davos?

“The empires of the future are the empires of the mind”, said Winston Churchill, and sadly we’re losing ours.

A Western world that, without questioning, allows its regulators to require banks to hold more equity when lending to those perceived as risky, than when lending to those perceived as safe, is showing serious evidence of losing its mind.

Not only are those perceived as “risky” not really risky for the banking system; it is those perceived as "absolutely safe" which can be; but that also impedes our banks from allocation credit efficiently to the real economy.

It is only daring and reasoned audacity that can keep us moving forward, so as not to stall and fall. Have we become so risk-adverse so as to blind ourselves to the real risks of avoiding taking the risks we must take?

Carney first stop supporting risk-weighted equity requirements for banks, those that discriminate against “the risky”.

“We have had to start reinvesting in social capital to rebuild trust in the system” holds Mark Carney… the Chairman of the Financial Stability Board.

Mr. Carney, before you have a right talk about social capital, you should stop supporting those antisocial distorting credit-risk-weighted equity requirements for banks, which so odiously discriminate against the fair access to bank credit of those perceived as “risky”… those whose small diversified bank borrowings anyhow never ever constitute a real risk to the banking system.

Boston Consulting Group, a consultant who does not dare to speak a truth that might hurt, is no real consultant.

Boston Consulting Group wrote a reasonably good paper about the need to finance the Next-Generation Companies, and which it presented at the World Economic Forum in Davos in 2013 

Unfortunately, the paper fails to identify that, courtesy of excessively sissy bank regulators, we now have capital requirements for banks which favor “The Infallible” and thereby discriminate “The Risky”, and which of course means favoring the past, those who have already made it, and therefore discriminating against the Next-Generation Companies. 

How come the Boston Consulting Company does not raise that issue? Would it be because doing so would reveal bank regulators for the fools they are? 

As I see it a consultant who does not dare to speak a truth that might hurt, is no real consultant.

A good consultant should always try to block group-think, not nurture it.