How do you regulate a regulator’s algorithm?

Sir, I refer to your opinion “Want to regulate ‘the algorithm’? It won’t be easy” Washington Post December 3, 2021, in which you discuss the thorny issue of how to regulate social media in general and Facebook in particular.

Regulators, like the Federal Reserve, de facto also use an algorithm, the risk weighted bank capital requirements. This one determines how much capital/equity banks need to hold and, by its incentive of allowing more or less leverage of bank capital, influences how credit is allocated to the economy.

Let me list a few of too many worrisome aspects of that algorithm:

That what’s perceived as risky is more dangerous to bank systems than what’s perceived as safe

That bureaucrats know better what to do with taxpayer’s credit than e.g.., entrepreneurs with theirs.

That banks should refinance much more our “safer” present than finance our children’s and grandchildren’s’ “riskier” future.

That residential mortgages should be prioritized over small business loans.

How did we get there? My briefest answer: Groupthink by deskbound members of a mutual admiration club. Anyone who has walked on main-streets would e.g., understand that the real risks are conditioned to how risks are perceived, signifying assets can become very risky by the sole fact of being perceived very safe.

John A. Shedd, in “Salt from my attic” 1928 wrote: “A ship in harbor is safe, but that is not what ships are for”. Sir, I submit that goes for banks too. Try to ask current regulators about the purpose of our banks.

PS. IBM, we need our bank regulators to be helped by your Watson.

PS. Rachel Siegel wrote on December 3 “Biden’s pledge to bring ‘new diversity’ to Federal Reserve to soon be tested” I just hope the true meaning of diversity is really understood.

Any risk, even if perfectly perceived, causes the wrong answer to it, if excessively considered.

Any risk, even if perfectly perceived, causes the wrong action, if excessively considered.

“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” Mark Twain (supposedly)

And Mark Twain is right in that bankers, in general are risk adverse and, when they accept taking some, it is usually in small amounts and against high risk premiums.

And, for around 600 years, bank credit was allocated, usually with a view on the portfolio, based on risk adjusted net interest rates.

But then, in 1988 with Basel I, the Basel Committee introduced (I would say ‘concocted’ is a more precise term) the concept of risk weighted bank capital requirements, based on exactly the same credit risk aversion.

With that the regulators ignored that any risk, even if perfectly perceived, causes the wrong answer to it, if excessively considered.

If Twain was alive he could just as well be writing: “A bank regulator is a fellow that allow banks to hold little capital when the sun is shining, so that banks can pay lots of dividends and buy back lots of stock, but wants banks to hold much more capital, the moment it starts to rain”

And, since then, bank credit is allocated based on risk adjusted returns on equity and, of course, the higher the allowed leverage is the easier it is to obtain a higher return on equity.

John A. Shedd (1859 – 1928) wrote “A ship in harbor is safe, but that is not what ships are for”. And that should also apply to banks. Unfortunately, these capital requirements guarantee that banks stay in safe harbors, running the risk of dangerously overcrowding these, and stay away from the risky oceans, and most certainly not lending enough to those “risky” entrepreneurs and SMEs on which our real economies so much depend.

In his book “Money: Whence it came, where it went” (1975), John Kenneth Galbraith wrote “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”

By doubling up on credit risk, the regulators made it so much more difficult for banks to fulfill such important societal function.

And it’s all so much worse. With their much lower bank capital requirements on loans to governments than on loans to citizens, statist/communist/ fascist regulators de facto imply bureaucrats/politicians know better what to do with credit for which repayment they’re not personally responsible for, than e.g. entrepreneurs.

And it is all so stupid. There’s never ever been a major bank crisis caused by the buildup of excessive exposures to what’s perceived as risky, those exposures have always been built up with assets perceived as safe.

The regulators, by basing most of their pro-cyclical bank capital requirements on perceived credit risks; not on misperceived credit risks, or unexpected dangers, like a pandemic, guaranteed all banks now stand there with their pants down. Basel Committee, Good Job!

My 2019 letter to the Financial Stability Board. Received and never answered 

And the Academia, scared of the Banking Inquisition’s High Priests, have kept silence, for decades

Risk-taking is the oxygen of all human development: God make us daring!

Did regulators, when developing the fundamentally wrong risk weighted capital requirements for banks, suffer some kind of “perception controlled hallucination” or any other psychological disorder?

In 1988, with the Basel Accord, Basel I, the Basel Committee for Banking Supervision introduced the use of risk-weighted capital requirements for banks. That scheme was further much expanded in 2004 with Basel II.

In essence that meant that banks had to hold more capital against what is (ex ante) perceived as risky than against what is perceived as safe. 

The stated goal of this regulation, was and is to avoid the failure of banks that can put the economy in jeopardy and that could cause big loses for depositors or big costs for tax payers derived from official rescue interventions.

Nothing wrong with that intention, except for what they did and what they ignored when developing these risk-weighted capital requirements.

What did they do? 

They looked at the risk of the assets just like bankers do, and not at the risk that bankers might be perceiving the risks wrong, or acting wrongly to risks well perceived. 

What’s the worst case scenario about risks perceived wrong? Clearly that something ex ante perceived as very safe turns out ex post as very risky. The opposite, something perceived as very risky turning out very safe should obviously not bother anyone… except of course the borrower who had to pay too high risk premiums.

What did they ignore? 

First that all major bank crises have resulted from, criminal behavior, unexpected events or excessive exposures to something ex ante perceived as safe but that ex post turned out to be very risky. “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain.” Mark Twain. The mistake can perhaps be illustrated by the fact that regulators, in their standardized risk weights of 2004, assigned a 150% to the below BB- rated, that which bankers won’t touch with a teen feet pole, but a meager 20% to what is AAA to AA rated.

Second, that these risk weighted capital requirements, which allowed banks to leverage more with what was perceived safe, would have banks earning higher expected risk adjusted returns with what was perceived safe, which would naturally increase the risk of some perceived safe havens become dangerously overpopulated, against especially little capital. In a Roulette in a casino,  2 to 1 and 36 to 1 are equivalent winnings paid out to those playing it “safe” on color or those playing it “risky” on a number. If the winning for those same bets were for example 3 to 1 and 30 to 1, that would break the bank and sink the casino.

Third, that the real economy, in order to move forward depends much on risky entrepreneurs and small and medium enterprises (SMEs) having access to bank credit. “A ship in harbor is safe, but that is not what ships are for.” John A Shedd.

I do not think it is prudent to distort the allocation of bank credit to the real economy, so I would favor one single capital requirement against all assets, but if I absolutely had to distort in this way, then my risk weighting would have to be 180 degrees in the opposite direction, higher perceived risk-lower capital, lower perceived risk-higher capital. 

It was 30 years when this monumental mistake was initiated, and for all practical purposes it is not yet even discussed… so the stickiness of that mistake has proven to be equally monumental.

Friends, is it something in “Predictive Processing” that could explain this so fundamental mistake in our current bank regulation, and its stickiness?

And more importantly still, in what way can “Predictive Processing” help us to avoid this type of extremely costly mistakes.

Here a brief aide memoire on the major mistakes with the risk weighted capital requirements

@PerKurowski

Should not science matter to bank regulators, at least a little?

I ask because though I am no scientist, far from it, have never really understood Einstein’s relativity theory, I know that if I were asked to regulate banks there would be two basic questions I would have to ask:

First, what is the purpose of our banks? Quite early someone would have mentioned John A Shedd’s “A ship in harbor is safe, but that is not what ships are for” and I would have ascertained that purpose to be, to allocate credit to the real economy, carefully but efficiently. 

Second, what has caused major bank crises? a. Unexpected events, like devaluations, b. criminal behavior, like lending to affiliates; and c. dangerously large exposures to something ex ante perceived as very safe but that ex post turned out to be very risky. Surely someone would have also cited Voltaire’s “May God defend me from my friends, I can defend myself from my enemies” as a reminder that what is perceived as risky is, precisely because of that perception, quite innocuous.

After that initial mini research, the last thing I would have come up with is the current risk weighted capital requirements, more risk more capital – less risk less capital, that which distorts the allocation of bank credit, for no stability purpose at all... much the contrary.

So again… should not science matter to bank regulators, at least a little?

PS. My 2019 letter to the Financial Stability Board

The Basel Committee for Banking Supervision has doomed our banking system to fail in its purpose, and to crash.

The Basel Committee (and national bank regulators) allows banks to hold less capital against assets perceived or decreed as safe, like loans to sovereigns, to what has an AAA rating or residential mortgages, than against assets perceived as risky, like loans to SMEs and entrepreneurs. 

That means banks can leverage more their equity with “safe” assets than with “risky” assets.

That means banks can earn higher risk adjusted returns on equity on “safe” assets than on “risky” assets.

That means banks will acquire too many safe assets and too little risky assets.

But, you might ask, is that not great? The answer is, NO! 

It guarantees that the real economy will be negated the risk-taking necessary for it to keep on moving forward so as not to stall and fall. 

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

And it guarantees that, sooner or later, (like in 2007-08 with AAA rated securities and Greece) banks will end up holding, against too little capital, too much of an asset ex ante perceived as safe, but that ex-post turns out to be very risky. 

And that (dangerously) overpopulated the “safe” harbors (and reduced the returns one could obtain there) and so, all small savers who tried to build-up their pension funds, had to take to the risky waters they know so little about. 

“May God defend me from my friends, I can defend myself from my enemies” Voltaire

And of course that meant that bank regulators decreed inequality.

PS. My 2019 letter to the Financial Stability Board

The Basel Committee, FSB and other bank regulators know dangerously little about risks. Why? Here it is!

What many perceive as very safe can lead to the build up of very large exposures that could threaten the bank system.

What many perceive as very risky never leads to the build up such large exposures that it could threaten the bank system.

Yet the Basel Committee, in Basel II of 2004, assigned a risk weight of only 20% to what rated AAA to AA and therefore so dangerous to the banking system, and one of 150% to what is rated below BB- and therefore so innocuous to the banking system.

The Basel Committee has refused to explain why they did so, and the only document purported to explain it, is pure GroupThink mumbo jumbo.

Additionally, risk weighted capital requirements for banks allow banks to leverage their equity differently with different assets, which produces quite different expected risk adjusted returns on equity than would have been the case in the absence of such regulations, and therefore this dramatically distorts the allocation of bank credit to the real economy. It introduced rampant risk aversion that have our banks no longer financing the riskier future, only refinancing the safer past.

Additionally, without obtaining due permission, the Basel Committee assigned a risk weight of 0% to a set of friendly sovereigns and 100% for the We the People of such sovereigns. This introduced rampant statism. As if government bureaucrats could use bank credit better than the private sector.

I have tried by all means possible to get explanations from the Basel Committee, even by using their formal consultation procedures, but all to no avail.

Please, you in the media who have more access to bank regulators ask them: Why do you think the below BB- rated are more dangerous to the bank system than the AAA rated?

Have you never heard of Voltaire’s “May God defend me from my friends, I can defend myself from my enemies”?

We also have John A Shedd (1850-1926) with his: “A ship in harbor is safe, but that is not what ships are for.”

With respect to that the Basel Committee is not only not allowing our banks to sail to explore riskier but perhaps more profitable bays, but it is also assuring to turn safe havens into overpopulated death traps. 

For our children and grandchildren’s case, help me to get rid of those dangerously incapable regulators.

P.S. Like during the Oscar it seems that at the Basel Committee there was also a mix-up of envelopes, in this case of those containing the names of what is the most and the least risky for our bank system. The saddest fact is that at the Oscar they got it fast, 2 minutes and 30 seconds, but in Basel they have yet to discover it after more than a decade.

Must one go on a hunger strike to have the Basel Committee or FSB answer some very basic questions?

Before regulating banks did you ever define their purpose? I know we all want them to be safe but, as John Augustus Shedd said: “A ship in harbor is safe, but that is not what ships are for.” 

By allowing for different capital requirements based on ex ante perceived risks of assets, banks will be able to leverage their equity (and the support given by authorities) differently, which will cause quite different expected risk adjusted returns for different assets, than would have been the case in the absence of this regulation. Were you never concerned about how this would distort the allocation of bank credit to the real economy? 

Since ex ante perceived risk were already considered by bankers when deciding on the amounts of exposures and interest rates, when you decided that the perceived risk was also going to determine capital requirements, you doubled up on perceived risk. Don’t you know that any risk, even if perfectly perceived, causes the wrong actions if excessively considered? 

In the case of larger and more “sophisticated” banks, you allowed these to use their own internal risk models to determine capital requirements. (Something like allowing Volkswagen to calculate their own emissions) Was it not naïve of you to believe banks would not naturally aim for lower capital requirements, in order to increase their expected risk adjusted returns on equity?

What’s perceived as safe can be leveraged into being utterly dangerous, only because of that perception; while what’s perceived as risky is automatically less dangerous, precisely because of that perception. Or as Voltaire said: “May God defend me from my friends, I can defend myself from my enemies”. In this respect can you explain the logic behind your standardized Basel II risk weights of 20% for what is AAA to AA rated, and 150% for what is rated below BB-? 

In the same vein what empirical research did you carry out to determine that what is perceived ex ante as risky has caused major bank crises? I ask because as far as I know these have always been caused by unexpected event, like natural disasters or devaluations, by fraudulent criminal behavior, or by excessive exposures to what ex ante was considered as safe but that ex post turned out to be very risky. 

In other words since bank capital is there for the unexpected, is it not dumb to require it based on the expected?

A risk weight of 0% for the sovereign, and 100% for We the People clearly implies you regulators all believe government bureaucrats make better use of bank credit than the private sector. Are you really such statists? Did you never consider that such dramatic rearrangement of economic power needed approval by for instance a Congress or a Parliament… or even a referendum? 

Finally do you really believe that with such risk adverse regulations, layered on top of banker’s own risk aversion, our economies would have developed as they did? Don't you see that banks are no longer financing the riskier future but only refinancing the "safer" present and past? Don't you see this decrees inequality?

PS. FT’s / Financial Times Establishment, notwithstanding my soon 2.500 letters to it on “subprime bank regulations” has also steadfastly refused to help me get answers to these questions.

PS. And here is one evidence of that I have posed my objections during formal consultations by the Basel Committee

PS. And I dreamt I got this letter with their answers!

PS. And I am 100% for the 10% on all assets capital requirement for small banks in the Financial Choice Act. I just hope it was applied to all banks, foremost the biggest, as these need it the most, as we need these to be better capitalized the most.

Why I distrust governments so much, and about which the World Bank and IMF could do a lot.

Sir, as a Venezuelan, I of course distrust completely any government that thinks it can manage, on behalf of its people, 97% of the country’s exports, better than what each citizen could manage his per capita share of the net revenues from those exports. 

But the following comment has to do with a completely different issue and that applies to many more countries than my own, namely: I entirely distrust governments that can allow bank regulators to do what they have done... Here's a short summary of it:

Without defining the purpose of the banks, in a way with which governments and We the People could agree on, the regulators decided that the only role of banks was not to fail. To be a safe mattress in which you could stash away cash. For instance, how they allocated credit to the real economy, did not matter. “A ship in harbor is safe, but that is not what ships are for.” John A Shedd, 1850-1926

Then in order to keep banks from failing, without absolutely no empirical research on what makes banks and bank systems fail, they proceeded to impose credit risk weighted capital requirements on banks. More ex ante perceived risk more capital – less risk less capital.

Sheer lunacy! This seriously distorted the allocation of bank credit to the real economy, overpopulating “safe” havens like AAA rated securities and sovereigns like Greece, and for the real economy dangerously underexploring risky but perhaps productive bays, like SMEs.

These regulations, since implemented, have certainly hindered millions of SMEs and entreprenuers to have access to credit who otherwise would have been awarded by banks. No wonder QEs, fiscal deficits and low interests, fail to stimulate the economy.  Now banks finance “safe” basements where jobless kids can live with their parents, but not the risky SMEs, those that could create the jobs that could allow the kids to also become parents themselves.

And all for no good stability purpose at all. Just an example, the risk-weight for the dangerous AAA to AA rated corporate was set to 20%, while that for the absolutely innocuous below BB- rated was determined to be 150%. Motorcycles are clearly riskier than cars, which is why, having the choice of transport, so many more people die in car accidents. “May God defend me from my friends, I can defend myself from my enemies” Voltaire.

To top it up with these regulations the bank regulators helped to decree inequality

So World Bank and IMF, could I at least trust you to take up this with all finance ministers present during the meetings in October 2016? I have asked it of you many times before, but until now, nothing, zilch, nada.

PS. Here is a link to a somewhat expanded description of the horrors of the Basel Committee’s risk weighted capital requirements for banks.

Per Kurowski

@PerKurowski

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

http://subprimeregulations.blogspot.com

http://perkurowski.blogspot.com

Luckily credit rating agencies got it wrong and put a temporary stop on it. Otherwise we would have been much worse off

Few can really evidence having warned so much against the use of credit rating agencies in bank regulations, as I can. So I believe that should give me the right to dare to opine that the fact that the credit rating agencies got it wrong, was and is not the worst part of the current bank regulation horror story.

As for examples of the first, in January 2003 the Financial Times published a letter in which 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. Friends, as it is, the world is tough enough.”

And, as an Executive Director of the World Bank, in April 2003, at its Board I formally stated: “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 tips of the icebergs.”

And of course, when then the credit rating agencies later messed it up, and got it so amazingly wrong with the AAA rated securities backed with truly lousy mortgages to the subprime sector, it was a real disaster. But, I tell you, it could have been much worse, like if they had rated correctly for a much longer period.

The reason for that lies in the malignant error of the Basel Committee’s risk weighted capital requirements for banks; more ex ante perceived credit risk more capital – less risk less capital.

Perceived credit risk is the risk most cleared for by banks; they do so by means of interest rate risk premiums and size of exposures. And so when regulators decided to clear for exactly the same risk, now in the capital, that perceived credit risk got to be excessively considered. And any risk, no matter how correctly it is perceived, if it is excessively considered, will cause the wrong actions.

For instance banks were (and are) allowed to leverage much more when financing the purchase of residential houses, or when investing in AAA rated securities backed with mortgages, “The Safe”, than what they are allowed to leverage when lending to the core of the bank credit needing part of the economy, the SMEs and entrepreneurs, those who help create the new generation of jobs, “The Risky”.

And that has resulted in that banks earn much higher expected risk adjusted returns on The Safe than on The Risky; which results banks will finance much more The Safe than The Risky.

So, had it gone on (oops it still goes on) we will all end up in houses with no more houses to be built, and without that new generation of jobs that could help us, or foremost our children and grandchildren, to service mortgages and pay utilities.

So let’s be thankful the credit rating agencies got it wrong, but, please, let us also correct for the regulators' mistakes. Thinking on my grandchildren, I would in fact prefer lower capital requirements for banks when financing unrated SMEs and entrepreneurs than when financing the purchase of a house.

But how did this happen and how could it have been avoided.

Well perhaps it would have been nice if the regulators, before regulating the banks ,had defined their purpose. Then perhaps John A. Sheed’s “A ship in harbor is safe, but that is not what ships are for”, could have come to their mind.

And also it would have been nice if the regulators had done some empirical research on what causes bank crisis; and then they would have discovered that never ever excessive exposures to what is perceived as risky; and then they might have thought of Voltaire’s “May God defend me from my friends [AAA rated]: I can defend myself from my enemies [the unrated]”

Dumb G20 ministers reiterated in Hangzhou their support of the inept Basel Committee on Banking Supervision (BCBS)

We read in the “G20 Leaders’ Communique Hangzhou Summit”

“We reiterate our support for the work by the Basel Committee on Banking Supervision (BCBS) to finalize the Basel III framework by the end of 2016, without further significantly increasing overall capital requirements across the banking sector, while promoting a level playing field”

Clearly the Ministers did not dare to ask the regulators some minimum minimorum questions like:

What do you believe is the purpose of banks? Should it not have something to do with what like John A Shedd opined: “A ship in harbor is safe, but that is not what ships are for” 

If the purpose of the banks includes that of allocating credit efficiently to the real economy, why then do you distort that with risk weighted capital requirements for banks?

Can you indicate us one single bank crisis derived from excessive exposures to what was perceived as risky when incorporated to the balance sheets of banks? Voltaire said “May God defend me from my friends. I can defend myself from my enemies”. 

So, could that lack of questioning by the ministers be explained by John Kenneth Galbraith’s “If one is pretending to knowledge one does not have, one cannot ask for explanations to support possible objections”?

Frankly, neither Hollywood nor Bollywood, would insist in supporting the work of someone producing such Basel I-II flop, as the 2007/08 crisis and the thereafter continued stagnation evidences.

PS. Here is a short aide memoire on some of the monstrous regulatory mistakes

Mervyn King’s book “The end of alchemy” is dangerously incomplete and excessively praised

Mervin King, former governor of the Bank of England begins his book “The end of alchemy” by citing from “The Rock” by TS Elliot, 1934. 

The endless cycle of idea and action,

Endless invention, endless experiment,

Brings knowledge of motion, but not of stillness; 

Knowledge of speech, but not of silence; 

Where is the wisdom we have lost in knowledge? 

Where is the knowledge we have lost in information? 

From a formal statement, delivered in March 2003, as an Executive Director of the World Bank, let me extract the following: 

“In this otherwise very complete Global Development Finance 2003, there is no mention about the issue of the growing role of the Independent Credit Rating Agencies, and the systemic risks that might so be induced, when they are called to intervene and direct more and more the world’s capital flows.

With respect to Basel, we would also like to point out that the document does not analyze at all a very fundamental risk for the whole issue of Development Finance, being it that the whole regulatory framework coming out of the BCBS might possibly put a lid on development finance, as a result of being more biased in favor of safety of deposits as compared to the need for growth.

As the financial sector grows ever more sophisticated, making it less and less transparent and more difficult to understand for ordinary human beings, like us EDs, it is of extreme importance that the World Bank remains prudently skeptical and vigilant, and not be carried away by the glamour of sophistication. In this particular sense, we truly believe that the World Bank has a role to play that is much more important than providing knowledge per-se and that is the role of looking on how to supply the wisdom-of-last-resort.”

And some weeks later in another formal statement I insisted in my arguments and added:

“We truly have to find a way of helping the Knowledge Bank to try to evolve into something more of a Wisdom Bank, or, to put it more humbly, at least a Common Sense Bank.

Basel is getting to be a big rulebook (this was said by the Bank). And, to tell you the truth, the sole chance the world has of avoiding the risk that Bank Regulators in Basel, accounting standard boards, and credit-rating agencies will introduce serious and fatal systemic risks into the world, is by having an entity like the World Bank stand up to them—instead of rather fatalistically accepting their dictates and duly harmonizing with the International Monetary Fund”

Unfortunately though I expressed my reasoned concerns, timely, in a globally important and relevant institution, these fell on deaf ears and were unable to stop crazy Basel II from being approved in June 2004.

And that is the reason why I believe I have earned all the right to openly consider “The End of Alchemy” a very dangerously incomplete book that, equally dangerous, is being excessively praised. 

Mervyn King dedicates his book to his “four grandchildren because it is their generation who will have to develop new ways of thinking about macroeconomics and to redesign our system of money and banking if another global financial crisis is to be prevented."

While I equally dedicate, to my for the time being only two grandchildren, the fight against bank regulators who, fixated on turning the banks into safe mattresses where to stash away savings, did and do not give any consideration to the importance of banks allocating credit efficiently to the real economy, so that the economy can move forward and not stall and fall over us all.

Kings book, in 370 pages, except perhaps when discussing the “Chicago Plan” of banks’ holding 100 percent liquid reserves against deposits, and the configuration of “wide banks” financed with equity and long term debt, does not really discuss the allocation of bank credit to the real economy. That function which to me, represents the fundamental social purpose of banks. That allocation which has now been impeded by mindboggling stupid risk-weighted requirements, those which dangerously favor credit for what is perceived, decreed or concocted as safe, sovereigns, the AAArisktocracy and residential house financing over credit to those perceived as risky, like SMEs and entrepreneurs.

King's book, in 370 pages, does not mention the fact that allowing banks to hold less capital against assets perceived, decreed or concocted as safe, allows banks to earn higher expected risk adjusted returns on equity on these assets than on those perceived as risky.

But King writes “The people who designed those risk weights did so after careful thought and an evaluation of past experience”. Nonsense, they analyzed the perceived risks of bank assets, not the risk of those assets that have created bank crises.

And King follows that with “They simply did not imagine how risky mortgage lending and the sovereign debt of countries such as Greece would become during the crisis”. That clearly evidences that King does not yet understand the role the assignment of low risk weights as zero percent to sovereigns, 35 % to residential mortgages and 20% to AAA rated securities, played in helping create the dangerous excessive bank exposures to these categories.

And King follows that with: “Rather than lambast the regulators for not anticipating those events, it is more sensible to recognize that the pretense that it is possible to calibrate risk weights is an illusion” And I just have to ask, should we not lambast regulators more with the latter, as it proves their excessive hubris?

And King follows that with: “The need for banks to use equity to absorb losses is most important in precisely those circumstances where something wholly unexpected occurs” Right, that is precisely why setting capital requirement that are to cover of the unexpected based on expected credit risks, the risk most cleared for by the banks is so loony.

But at least King there concludes in that “A simple leverage ratio is a more robust measure for regulatory purposes. Good for him! Though clearly he does that only from the perspective of making banks safer, without any thought about the need for less distortions produced in the credit allocation.

In terms of TS Eliot, when it comes to making the bank system safer: 

Knowledge could, as it did, set the risk weights, based the ex ante perceptions of it. 

Wisdom would only set these based on their ex post possibilities of creating havoc. 

Knowledge can get you get started immediately on the avoidance of risks. 

Wisdom would first have you to identify, which risks you cannot afford not to take.

Where King is absolutely right is when he opines, “Regulation has become extraordinarily complex, and in ways that do not go the heart of the problem of alchemy… By encouraging a culture in which compliance with detailed regulations is a defense against a charge of wrong doing, bankers and regulators have colluded in a self-defeating spiral of complexity”

But then a much better title of the book would have been “How do we stop bank regulators from doubling down on alchemy”.

Current regulations only make banks refinance the safer past. For King’s grandchildren, and for mine, let us pray they can soon take on again their vital role in financing the riskier future.

The major mistake with current bank regulations, one that has not been rectified yet, is that the regulators never defined the purpose of banks before regulating these. In this respect, let me stop, for now, by quoting John A Shedd “A ship in harbor is safe, but that is not what ships are for.”

What to do when even describing it, an eminence like Martin Wolf is yet unable to see The Great Bank Distortion?

On page 251 of his “The shifts and the shocks” Martin Wolf writes: 

“But [bank] shareholders should only be interested in their risk adjusted returns. If taking on more risk does not raise risk-adjusted returns, shareholders should flee.”

But let me now give you the fuller version of what he writes:

So: "If taking on more risk [like lending to small businesses and entrepreneurs] “does not raise risk-adjusted returns, [because when doing so bank regulators require banks to hold more equity] “shareholders should flee”.

The result: No bank credit to “risky” small businesses and entrepreneurs.

And the other side of the coin would be: "If taking on less risk, like lending to the infallible sovereigns, the housing sector or to members of the AAAristocracy, does raise risk-adjusted returns, because when doing so bank regulators allow banks to hold much less equity, shareholders will love it.

The result: Too much bank credit to the infallible sovereigns, the housing sector and members of the AAAristocracy.

And Martin Wolf, on page 243 concludes that: “Risk-weighted assets can play a secondary role. That way one would have a ‘belt and braces’ approach: a strong leverage ratio, plus a risk–weighted capital ratio as a back-up.

And that he does because on page 251 he argues: “Risk-weighting is extremely unreliable, because the samples from which the weights are derived are always too small or irrelevant”. 

Wolf simply does not understand the dangerous distortion produced by risk weighting... even if the risk-weights are perfect. If perfect they would be perfectly cleared for in the interest rates, the size of bank exposures and all other contractual terms. To also clear for these perfect risk-weights in the capital, signifying a double counting of the perfect risk weights, is just sheer regulatory lunacy. 

“A ship in harbor is safe, but that is not what ships are for”, wrote John Augustus Shedd (1850-1926),.And that goes for our banks too.

And precisely because we all want our ships, or our banks, to sail as safe as possible to the ports we want them to sail to… the last think we should do… is what bank regulators, thinking themselves with 'fatal conceit' capable of being risk managers to the world did… namely to start tinkering with risk weights with their compasses. 

And so no Martin Wolf, not even as a back-up is there a role for credit risk weighted bank capital.

And if we really get down to what Wolf writes on page 252: "the disaster came from what banks wrongly thought to be safe", and which by the way is what all empirical evidence would point at as the usual suspect of causing bank disasters, then the capital requirements should be totally opposite; larger for what is perceived as absolutely safe and lower for what is perceived as risky.

In short, the number one "Macro-prudential Policy" that needs to be implemented, is to get rid of the current batch of distorting bank regulators. But, for that to happen, it is helpful that eminences, like Martin Wolf, also understands what is going on.

I am sure that for Europe’s young unemployed, all 123 European banks failed EBA’s and ECB’s stress tests… dramatically.

So now the European Banking Authority (EBA) has announce the stress test of 123 European banks… and we are informed that 12 failed. Bullshit! They all have failed. 

For instance, ECB's Vitor Constancio says “the vast majority of banks proved resilient”… and I just have to ask him… What’s good about a resilient bank that completely fails to intermediate credit correctly? ... or, as John Augustus Shedd (1850-1926) so well phrased it: “A ship in harbor is safe, but that is not what ships are for.”

It is not what’s on the balance sheets of the banks of Europe that should most concern us… it is what has been condemned by bank regulators from being on the balance sheets of banks in Europe that should really make us tremble… namely all the loans to medium and small businesses, entrepreneurs and start-ups. 

And that so extremely risky prohibition to take risks, that which has effectively castrated European banks, was imposed by the regulators, by means of their so tragically unwise credit risk weighted capital (meaning equity) requirements for banks.

And, to top it up, that will not make our banks safer in the long term... since there have never ever been major bank crises which have detonated because of excessive exposures to what, ex ante, was perceived as risky, as these have always resulted from excessive bank exposures (against too little bank equity) to what was, ex ante, perceived as absolutely safe.

NOTE: I am a happy husband, father and grandfather, with no scandalous past. 

I have a long and quite successful carrier as a financial and strategic private and public sector consultant and, in 2002-2004, I was an Executive Director at the World Bank. 

I have studied in Sigtuna SHL Sweden, Lund University, IESA Caracas, London Business School and London School of Economics. 

Since 1997 I have published over 800 Op-Eds in some of the most important newspapers in Venezuela. 

I have had many letters and articles on banking regulations published around the world. And few can claim having warned in such precise terms about the impending banking disasters as I did between 1997 and 2007. 

And I stake all my professional reputation, and the loving trust my family has shown me over the years, on the fact that current bank regulators of the Basel Committee, and of the Financial Stability Board, have been wrong. Not a pardonable 15 degrees wrong, but an unpardonable 180 degrees totally wrong.

More than "The Voice" and "American Idol" we need a TV competition to elect better bank regulators.

There I was trying to dry my hands wringing them in some tepid air blowing from the round hole of an appliance, thinking about how much more efficient the flat whole hand reaching drier was, when suddenly I thought… if I were a bank regulator I would at least give Dyson’s engineering group a call to see what they would think I should do….

And from there my mind wandered of into thinking about how monumentally important banks are too our economy… and about how monumentally crazy we have been allowing some very few untested bureaucrats, who we know very little about, to draw up the regulations that defines much of the functioning of our banks all around the world…

And into thinking that the least we could have done was to set up a public competition to search for the best bank regulations, similar to that which awarded Brunelleschi the right to build the dome of the cathedral in Florence.

And into thinking that such competition should be televised, perhaps ‘The Regulator’, so as to better ascertain that the interests of all stakeholders in banks were represented, not just those bankers who just think of banks as profit making machines, and not just those risk adverse nannies who think of banks solely in terms of more sophisticated places to stash away money than mattresses…

And finally into sadly reflecting on that in such a competition, the Basel II and Basel III bank regulation drawings would not make it into the final 12, probably not even pass the early qualification round…

I could imagine the judges asking the members of the Basel Committee.

“Do you really believe ordinary bankers to be so dumb, so you must require them to hold 5 times as much capital (equity) when they lend to someone they know has a BBB+ to a BB- rating, or no rating at all, than when they lend to someone they know has an AAA to AA rating?

Or, are you really so dumb to believe bankers when they argue they should be allowed to hold only a fifth of capital when lending to someone who has an AAA to AA rating, than what they are required to hold when lending to someone with a BBB+ to BB- rating, or no rating at all? 

Don’t you know bankers already adjust to differences in credit ratings by means of interest rates and the size of exposure they are willing to take, for you to also require these to adjust the capital they need to hold… 5 times?

Don't you think this would utterly distort the allocation of bank credit to the real economy… with those having BBB+ to BB- ratings, or no ratings at all, getting much too little bank credit, and those with AAA to AA ratings getting much too much bank credit?”

And here, I could imagine the experts of the Basel Committee and their family members of the Financial Stability Board, becoming quite teary-eyed.

And I could hear the judges concluding: “There is no chance someone would want regulations which, in the name of what at best could seem like short term bank stability, discriminates against those who we in fact most need to have access to bank credit, the “risky”, like middle and small businesses, entrepreneurs and start-ups, those who might get us the next generation of jobs, favoring an AAAristocracy.”

And then I could hear another contestant auditioning: 

“We must of course start with asking ourselves what is the purpose of our banks and in this respect I suggest we remember John Augustus Shedd’s ‘A ship in harbor is safe, but that is not what ships are for’’’. 

And I could hear and see in front of me the judges standing up and enthusiastically applauding. 

And so I concluded…let a 1.000 regulation proposal’s bloom! And let us hope the final regulations can infuse our bankers with reasoned audacity, and not disable them with an extreme aversion to credit risk. Enough of this insane de-testosterone-mania! We send our kids to war but we don't allow our banks to take the risks we need them to take?

IMF, the darkest corner, is where Basel II’s mistake with risk-weighted capital requirements for banks is hidden.

In “Where Danger Lurks” Finance & Development, IMF, September 2014 Olivier Blanchard writes: “The recent financial crisis has taught us to pay attention to dark corners, where the economy can malfunction badly”

Indeed but what is most dangerous is that the darkest corner which brought on this crisis, regulatory stupidity, is not even acknowledged… probably because many of the frontline responsible feel, rightly so, that their own jobs could be at stake... or it upsets other agendas.

Blanchard: “economists recognized that bank regulatory constraints, such as the minimum amount of capital (essentially a bank’s net worth; that is, its ability to absorb losses) institutions had to hold, could force banks to react more sharply to decreases than to increases in their capital”

… which only leaves us with the question of why bank regulators were not told of this.

Blanchard: “The Great Moderation had fooled not only macroeconomists. Financial institutions and regulators also underestimated risks. The result was a financial structure that was increasingly exposed to potential shocks.” 

Nonsense! It was not underestimation of risks which caused the crisis but the hubris of regulators who thought they could play risk managers for the world with their “risk-weighted capital requirements for banks”; and did not care one iota about how allowing banks to earn much much higher risk-adjusted returns on equity on exposures which, ex ante, from a credit risk point of view were considered as absolutely safe than on exposures considered the same way as risky, would distort the allocation of bank credit.

And here we are, years after the crisis, and the dark corner of the distortion of bank credit allocation is not even being discussed… and that dark corner of bank regulations is still well alive and kicking in Basel III. 

Blanchard writes: “So-called diabolical loops developed between public and private debt: weak governments weakened banks that held government bonds in their portfolios; weakened banks needed more capital, which often had to come from public funds, weakening governments.” 

But he does not mention that diabolical, I would dare say communistic styled sovereign debt favoring, which occurs when banks need not to hold zero or very little capital, when lending to sovereigns/governments, when compared to what they need to hold when lending to a citizen.

And Blanchard when writing about the too small effect of fiscal profligacy, massing quantitative easing and low interest has had in the growth of the real economy and the generation of jobs, he seems to be wanting to keep his reader in a dark corner, not noticing that current bank regulations stop bank credit from going to where it should… namely to all those tough daring risky risk-takers we need to get going when the times are tough.

What a shame that IMF has allowed the Basel Committee for Banking Supervision to act as if the stability of banks is more important than the state of the economy. As evidence of this, let me here remind the IMF, again, that in all Basel I, II, III regulations, there is not a word about what is the purpose of banks.

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

There is one central Basel Committee paper that explains the risk weights used by Basel II. I wish Olivier Blanchard would read it, and try to explain it to us.

Meanwhile, I here offer you the shortcut of a more extensive terminology