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!

“The Parade of the Bankers’ New Clothes Continues: 28 Flawed Claims Debunked” by Anat Admati and Martin Hellwig

I refer here to their revised document of July 6 2014

As I have argued before the authors present a better description than most of the problems of current bank regulations.

Unfortunately, though they correctly identify that relying capital requirements that are risk-weighted is a flawed concept, they do not yet identify the most serious problem with doing so, namely that it dramatically distorts the allocation of bank credit to the real economy.

Since the perceived risks, like for instance those reflected in credit ratings, are already cleared for by means of interest rates, size of exposure and other contract terms, to also clear for the same perceptions of risks in the capital, signifies a double consideration of risk perceptions… and any risk perception, even if absolutely correct, will lead to the wrong conclusions if excessively considered.

In this particular case that signifies that banks will be able to earn much higher risk adjusted returns on equity on assets considered “absolutely safe” than on assets considered “risky”… and that in its turn means that banks will not serve in a fair way the credit needs of those who might most be need in access to it, like medium and small businesses, entrepreneurs and start-ups.

And the main reason for why we ended up with these bad regulations was that nowhere did bank regulators define the purpose of those entities they were regulating.

Another objection to risk-weighing not clearly identified by the authors, is that what regulators really need to consider when setting the capital requirements is not the expected risks or losses, but the unexpected risk and losses. And the Basel Committee, in a document where they explained the methodology of the risk-weighing explicitly stated that, since unexpected risks are hard to measure, they would use the expected risks in substitution of the not-expected… something which of course does not make any sense at all.

The same explicatory document from the Basel Committee on Basel II’s risk weights also states that the capital requirements are portfolio invariant, meaning that they do not consider the risk of over concentrating in what is perceived as safe, nor the benefits of diversifying in what is perceived as risky. And the argument to do so, amazingly, is that otherwise it would be too difficult for regulators to manage the system.

In summary one can say that regulators concentrated on the risks of the assets of the banks, and not on the risk of the banks… which is of course not the same.

Also any empirical study would have shown that bank crises always result from excessive exposures to something perceived as safe... and never from excessive exposures to something perceived as risky. 

Finally, and though there are some other issues I slightly disagree on, let me here conclude with reference to their remarks on:

"Flawed Claim 13: There is not enough equity around for banks to be funding with 30% equity."

"Flawed Claim 14: Because banks cannot raise equity, they will have to shrink if equity requirements are increased, and this will be bad for the economy."

"Flawed Claim 15: Increasing equity requirements would harm economic growth."

I agree with the authors those are mostly flawed claims, but primarily so from the point of view of a static analysis.

But unfortunately, the road from where our banks now find themselves, to where they propose and many would love the banks to be in terms of equity, makes for a very difficult journey.

In my opinion in order to speed up the travelling, before our young  run the risk of becoming a lost generation, will for instance perhaps require awarding special tax exemptions, in order to make those equity increases feasible over a not too long time span…. because we might in fact be talking about at least a trillion dollars of new equity.

And of course, meanwhile, make all fines payable in voting shares.

Please... again...more important than more bank capital is less distorting bank capital requirements.

My issue with the Anat R. Admati, Peter M. de Marzo, Martin Hellwig and Paul Pfleiderer, October 2013, paper.

The authors referenced have published a revised paper titled “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Socially Expensive”. I agree with much… except for…

The author states on page 9: “Another issue we do not elaborate on here is the current use of risk weights to determine the size of asset base against which equity is measured. As discussed in Brealey (2006) Hellwig 2010, and Admati and Hellwig (2013) this system is complex, easily manipulated and it can lead to distortions in the lending and investment decisions of banks.”

And that issue is too important to be set aside in the context of any discussion of bank equity, and what is said also leaves dangerous space for doubts. I have argued for years that risk weights, which effectively determine the capital requirements for banks against different exposures, even if not manipulated, do distort the allocation of bank credit in the real economy... and there should be no doubts about that.

If there is anything that with respect to the banking system has put our western economies on a downward slippery slope, that is not so much the problem of banks having too low capital requirements, but the issue of allowing banks to earn much much higher risk-adjusted returns on their equity on what is perceived as “absolutely safe”, than on what is perceived as “risky”. 

That guarantees the dangerous overpopulation of the “absolute safe havens”, and that the “risky-bays” our economies need to be visited in order to move forward… will be dangerously underexplored.

“The Infallible”, those with extremely low risk weights, 20% or less, comprise the infallible sovereigns, the AAAristocracy and the housing sector.

“The Risky”, those with 100% or higher risk weights, count among its ranks, medium and small businesses, entrepreneurs and start-ups.

That has made it more profitable for the banking sector, on risk adjusted terms, for instance to finance the houses where we are to live in, than to finance the job creation that will allow us to pay for the utilities.

That has made it more profitable for the banking sector, on risk adjusted terms, for instance to finance the King Johns of the world, than to finance the Robin Hoods and their friends.

The regulator (the neo-Sheriff of Nottingham) amazingly ignored (unless it was on purpose) that the ex ante perceived risks he considers in order to define the capital required (the denominator), are cleared for by banks and markets by means of interest rates, size of exposure, duration and other terms (the numerator). 

And so the regulator screwed up the whole risk price equation and caused banks to overdose on perceived risks… and funnily, if not so tragic, some still call all this a market failure 

The regulator, amazingly, instead of analyzing as a regulator why banks fail, analyzed, like if he was a banker, why the clients of the banks fail… and that, of course…c’est pas la meme chose.

On page 59 the authors write: “The use of risk-weighted assets for capital regulation is based on the idea that the riskiness of the asset should in principle guide regulators on how much of an equity cushion they should require” 

And that is precisely what is so nutty with the whole concept. The risk for the regulator is the bank, not its assets, and the prime risk for the bank is getting the risk-weights wrong.

In fact, for the regulators to really cover their real risk, capital requirements for banks should be higher for what is perceived as “absolutely safe” than for what is perceived as risky.

And, amazingly, the academic world, basically keeps mum on this almost criminal regulatory failure.

Please, can someone of you help to explain it all to the finance ministers around the world, to Congressmen, to all those who, naturally, do not understand one iota of the Basel Committee’s mumbo-jumbo

Worse than truck being allowed high speeds, is that different speeds are allowed.

Anat Admati in “The Compelling Case for Stronger and More Effective Leverage Regulation in Banking” October 14, 2013, refers to “The speeding analogy” which appeared in hers and Martin Hellwig’s splendid book "The Bankers' new clothes"

“Imagine that trucks were allowed to drive faster than all other cars on the road even though they are the most dangerous. Further suppose that the trucking companies and the drivers are rewarded the faster they are able to make a delivery, benefit from subsidized insurance, and have a special safety system that protects the driver in case of accidents and explosions. The companies might produce narratives suggesting that their deliveries are essential and that the fast delivery is important for economic growth. They and others might produce models suggesting possible “tradeoffs” associated with a lower speed limit for the trucks. Whereas there probably are tradeoffs associated with trucks driving too slowly, it is clear that they are irrelevant, and there are no tradeoffs, when choosing between 90 miles per hour and 50 miles per hour for a truck carrying dangerous cargo in a residential neighborhood”

Yes, Admati is right in her analogy.

What guarantees mayhem more than a generally allowed high speed is, as I have argued for years, to allow different vehicles, based on safety ratings, to drive at different speeds (risk-weights) on the same streets. Sooner or later those safety ratings, will either be captured by interested speeders, or simply be wrong; and besides these loony traffic regulations will make it more difficult for doctors, fire trucks and other vital essentials to arrive in time.

But no, Admati is very wrong in her analogy when she mentions: “Imagine that trucks were allowed to drive faster than all other cars on the road even though they are the most dangerous.”

That is because what's perceived as “most dangerous”, the risky, the trucks, is what currently in banking must transit at the slowest speeds, the lowest allowed bank leverages; while those perceived as the safest, like sovereigns, residential mortgages and AAA rated securities, are those allowed to go through our residential neighborhoods at the highest speeds, the highest allowed leverages.

I do understand, it is hard to internalize that, at least when it comes to banking, that which is perceived as safe is so much more dangerous to the system than that which is perceived as risky. Sadly way too many missed their lectures on conditional probabilities. 

I've used a very similar though quite distinct analogy on my blog.

All this is of course why I give much more importance to eliminating the risk-weighting of the capital requirements for banks, than just increasing the basic capital required. In fact the more capital banks are asked to increase the capital means that, while that is being taken cared off, the worse will be the effective discrimination against those who, even though they in fact pose the least de facto risks for the banks, are been castigated with the highest risk weights. Remember "The drowning pool"

The Basel Committee seems to be drowning in in-house surrealism. Put it out of its misery

Risk weighted capital requirements are insane, since the perceived risks they are based on, are already been cleared for in interest rates, amounts of exposure and other terms. 

And not only am I saying it. Anat Admati and Martin Hellwig recently wrote “the studies that support the Basel III proposals are based on flawed models and their quantitative results are meaningless. For example, they assume that the required return on equity is independent of risk”.

And now the Basel III reformers are introducing a simple, transparent, non-risk based leverage ratio of 3 percent to act as a credible supplementary measure to the risk-based capital requirements.

And they argue they do that to “reinforce the risk-based requirements with a simple, non-risk-based "backstop" measure.” “reinforce”? They’ve got to be joking. "Supplementary" as they say,  perhaps somewhat, though the fact remains that capital requirements will still be based on perceived risk and therefore still favor “The Infallible” those already favored by banks and markets, and discriminate against “The Risky” those already discriminated against by banks and markets.

And read this! “Implementation of the leverage ratio requirement has begun with bank-level reporting to supervisors of the leverage ratio and its components from 1 January 2013, and will proceed with public disclosure starting 1 January 2015.” And which means that before January 1st 2013 we the public, will not have the right to know how really leveraged our banks are.

The Basel Committee seems to be drowning in in-house surrealism, and some ministers or central bankers should show some mercy and put it out of its misery

Why can´t a sequestration begin cutting where it could be most productive?

REVISED “The Bankers´ New Clothes”, by Anat Admati and Martin Hellwig, is a very good, and therefore [not] a dangerous book

Anat Admati and Martin Hellwig in their “The Bankers´ New Clothes” write the following about risk-weighted assets: 

“The risk-weighting approach gives the impression of being scientific”. 

“The risk-weighting approach is extremely complex and has many unintended consequences that harm the financial system. It allows banks to reduce their equity by concentrating on investments that the regulations treats as safe.” 

“The official approach to the regulation of bank equity, enshrined in the different Basel agreements is unsatisfactory… the complex attempts in this regulation to fine tune-equity requirements – for example, by relying on risk measurements and weights- are deeply flawed and create many distortions, among them a bias against traditional business lending.” 

And yet the authors when then writing “Whatever the merits of stating equity requirements relative risk-weighted assets may be in theory”, evidence they cannot or dare not free themselves entirely from believing there is something valuable in risk-weighting.

But no! There are no merits to risk-weighting, even in theory. It is just a big dumb regulatory mistake! Clearing in the capital requirements for perceived risks already cleared for on the assets side with risk premiums, amounts of exposure and other terms, just dooms banks to overdose on perceived risks, like those expressed in credit ratings, and at the same time effectively hinders the banks from performing an effective resource allocation which is so important for the society. 

The authors write “The idea behind risk-weighting is that if the assets banks hold are less risky, less equity may be needed for a bank to absorb potential losses”. What regulatory lunacy is that? If banks believe they hold less risky assets they will hold these at much lower risk-premiums, for much larger amounts, and on much more generous terms. Come on, does that sound like something which could merit banks holding less capital?

And because of their lingering doubts, what Anat Admati and Martin Hellwig propose in their book, is not so much the need of eliminating the distortion of the risk-weights, but the need for more capital. And that is why, especially as I considered it a very good book, and it includes so much of what I have argued over the last decade, I must also call it a very dangerous book.

Let me explain: If the capital requirements for a bank were zero, then risk-weights would not discriminate nor distort. It is the higher the capital requirements are, than the larger will the discrimination and the distortion the risk-weights produce. 

The authors argue: “Requiring that bank’s equity be at least on the order of 20-30 percent of their total assets would make the financial system substantially safer and healthier” Can you imagine what distortions that would cause if something like the current risk-weights are kept? 

No! and especially since I look at the banks not as separate entities in Mars, but a part of the real economy on Earth, I bet that a Basel II, 8 percent capital requirement that came with absolutely no risk-weighting, would make the financial system and the real economy substantially safer and healthier, and sturdier, than a 20-30 percent capital where regulators remain thinking of themselves as risk-managers of the world. 

And here is a previous comment on the same book

DISCLAIMER: I have just exchanged opinions with Anat Admati and she holds that contrary to what I interpreted the book makes clear that they completely oppose the pillar of Basel bank regulations, namely risk-weighted capital requirements based on perceived risk. Great! I wonder where this now leaves the Basel Committee and the Financial Stability Board, as risk-weighting is their Pillar, pride and joy.

Clearly this is a big support for the bank bill being introduced by Senators Sherrod Brown, Democrat of Ohio, and David Vitter, Republican of Louisiana. Go Brown-Vitter! Screw Basel! Enough is enough!

Its what’s safe that’s risky!

Dear finance professors of the world, can you please help me?

Before the Basel Committee regulations’ era, banks cleared for (ex-ante) perceived risk, that information which for instance is to be found in credit ratings, by means of interest rate (risk-premiums), the size of the exposure, and other contractual terms; let us call that “in the numerator”. 

But Basel II, and now Basel III, instruct the banks to also clear, I would call it re-clear, for exactly the same (ex-ante risk) perceived risk, credit ratings, “in the denominator”, by means of different capital requirements, more risk more capital, less risk less capital. 

That is just plain crazy. Allowing banks to leverage many times more when lending to what is perceived as “safe” than when lending to what is perceived as “risky”, allows the banks a much higher expected risk-adjusted return on equity when lending to “The Infallible” than when lending to “The Risky”. That distorts and makes it impossible for banks to allocate resources efficiently.

Recently Anat Admati and Martin Hellwig published an excellent “The Bankers’ New Clothes” 2013, though I think “The Regulators’ New Clothes” would have been a better title. But, in one passage they write “Whatever merits of stating equity requirements relative to risk-weighted assets may be in theory, in practice…” 

And, dear finance professors, my problem is that I have not been able to find anything yet that I would include within the “Whatever merits”. 

Besides the so fuzzy “more risk more capital, less risk less capital, it sounds logical”, do you have any idea why the regulators did that? If not, can you help me asking around? 

I mean, it is no minor thing that our whole banking system seems to be driven by a loony double consideration of perceived risks.

I mean it is no minor thing that our bank regulators have decided to favor “The Infallible” those already favored by the market and bankers and thereby discriminate against “The Risky”, like all our small businesses and entrepreneurs.