Note: Tett writes: “So how respond? Regulators could bolster capital reserves”. Here, in order to further avoid the source of so much confusion, let me begin by explaining that regulatory “capital” refers to bank equity – the skin in the game of shareholders or of holders of subordinated debt - contingent convertible bonds (Cocos /AT1 bonds).
Introduction:
The world has been duped/lulled into a false sense of security by the use of risk weighted assets (RWA) as a real and valid measure of banks' risk exposure. E.g., the interest rate risk in the banking book IRRBB, the duration risk of SVB’s long-term government bonds is not included among the weighted risks.
It analyzed two options: “The regulatory treatments of IRRBB within the standardized Pillar 1 approach, namely the Risk Weighted Minimum Capital [Equity] Requirements; or with an enhanced Pillar 2 approach, meaning the Supervisory Review Process subject to guidance set out in the 2004 Principles for the management and supervision of interest rate risk.
The Committee noted the industry’s feedback on the feasibility of a Pillar 1 approach to IRRBB, in particular the complexities involved in formulating a standardized measure of IRRBB which would be both sufficiently accurate and risk-sensitive to allow it to act as a means of setting regulatory capital [equity] requirements. It therefore concluded that the heterogeneous nature of IRRBB would be more appropriately captured in Pillar 2.
What did that mean?
That the risk weighted bank equity requirements, e.g., decreed 0% risk weight of government debt, on the margin, where it most means when deciding to do something that might require more equity, remained unaltered.
That whatever consideration of interest rate risks, were to be discussed between the supervisors and banks’ risk managers.
That placed these petit committee participants between a rock and a hard place.
The risk weighted bank capital (meaning equity) requirements have caused the banks’ risk models to be used much more for equity-minimizing/leverage-maximizing, than for analyzing bank assets’ true risks. So, what bank risk manager would currently want to address his Board of Directors with: “Our model, because of too many assets we have perceived as safe could turn out risky, indicates that you have to raise a substantial amount of equity”?
What supervisors/examiners, would dare to suggest to the Basel Committee that it’s time for it to increase the Pillar 1 risk weights, e.g., the 0% of government debt, at least for the long-term portion, and by that force their superiors to handle a truly hot potato?
There’s where banks and regulators find themselves now. If by means of Pillar 1 or Pillar 2 the capital/equity requirements are increased for long term government debt, we will have to face a new dimension in the already abundant distortions of the allocation of bank credit.
Here on I will mention some aspects Gillian Tett seems to have missed in her article. If I am wrong sorry… but as Martin Wolf rightly mentioned once, I am obsessed with this issue.
Tett holds “Fractional banking works brilliantly well in normal conditions, recycling funds into growth-boosting loans and bonds”. The “brilliantly well” might be a slight exaggeration but current regulations have clearly impeded banks to work reasonably well.
And don’t take my words for it. Just
listen carefully to Paul Volcker’s valiant confession (one that seemingly belongs to the confessions that shall not be heard). “Assets assigned the lowest risk, for which bank capital requirements were therefore nonexistent or low, were what had the most political support: sovereign credits and home mortgages… A ‘leverage ratio’ discouraged holdings of low-return government securities”
Would SVB hold these bonds if it was required to hold as much equity against Treasuries than against e.g, loans to small businesses?
Growth boosting? I classify sovereign credits and home mortgages as “demand-carbs” and e.g., loans to small businesses and entrepreneurs as “supply-proteins”. If it is going to boost growth, that will be an obese one.
Tett, when arguing “with SVB: its Achilles heel was its portfolio of long-term Treasury bonds that are supposed to be the safest asset of all; so much so that regulators have encouraged (if not forced) banks to buy them” quotes Jamie Dimon correctly explaining “ironically banks were incented to own very safe government securities because they were considered highly liquid by regulators and carried very low capital [meaning equity] requirements” (i) But Tett then writes: “Rules to fix the last crisis — and create “safety” — sometimes create new risks.”
And there she’s wrong. No new risk rules, just the same ones all over again! Though “bankers told [her] in 2008 that one reason why the dangers around repackaged subprime mortgage loans were ignored was that these instruments had supposedly safe triple-A credit ratings — so risk managers paid scant attention”, the reality was that US investment banks, like Lehman Brothers, and European banks could at that time, thanks to Basel II, leverage their equity a mindboggling 62.5 times to one.
What’s the fundamental problem? That although most correctly, as any Monday morning quarterback would, identifies what’s risky the morning after a bank crisis, they do not reflect on that the large exposures that cause bank crises, are always built up with what’s perceived as safe.
And, if there’s a real dangerous Achille’s heel threatening our bank systems, that’s precisely the risk weighted bank equity requirements based on that what’s perceived as risky is more dangerous to bank systems than what’s perceived as safe.
Tett writes, “think of the crowd panic in the streets of London during the South Sea Bubble of 1720”. But why the panic? Because the South Sea investments they thought were very safe, suddenly appeared to be very risky. Has a “Bubble” ever been blown up with what’s perceived as risky?
In summary. If there’s any real lesson to be learned, it is the following. Bankers react to perceived risk with risk weighted interest rates. Bank regulators decided to also react to the same perceived risk with their bank equity requirement. Any risk, even if perfectly perceived, if excessively considered, will cause the wrong reactions.
Our current bank regulators never heard of Mark Twain’s “A banker is a fellow who wants to lend you the umbrella when the sun shines and wants it back when it rains”. (Supposedly) and, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so”
Our current bank regulators also missed their lectures on conditional probabilities… namely what’s the risk conditioned to the risk being perceived?
How can Gillian Tett, chair of the FT’s editorial board and US editor-at-large, and all the rest in FT help to correct the current regulatory failures?
By always clearly differentiating between the risk-taking taking risks; and the risk-taking by building up risky large exposures to what’s perceived safe.
Also, FT could help me, a grandfather, explain to regulators that bank regulations that favor much more the refinancing of the “safer” present than that of the “riskier” future is, a violation of that holy intergenerational social contract Edmund Burke spoke about.
(i) Jamie Dimon, why did it take you more than three decades to explain that?
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