Basel I, II, and III are all examples of pure unabridged regulatory statism

In July 1988 the G10 approved the Basel Accord. For its risk weighted bank capital requirements it assigned the following risk weights:

0% to claims on central governments and central banks denominated in national currency and funded in that currency. 

100% to claims on the private sector.

That means banks can leverage much more whatever net margin a sovereign borrower offers than what it can leverage loans like to entrepreneurs. That means banks will find it easier to earn high risk adjusted returns on their equity lending to the sovereign than for instance when lending to entrepreneurs. That means it will lend too much at too low rates to the sovereign and too little at too high rates to entrepreneurs.

In other words Basel I introduced pure and unabridged statism into our bank regulations. 

Basel II of June 2004 in its Standardized Risk Weight, for the same credit ratings, also set lower risk weights for claims on sovereigns than for claims on corporates.

In a letter published by FT November 2004 I asked: “How many Basel propositions will it take before they start realizing the damage they are doing by favoring so much bank lending to the public sector. In some developing countries, access to credit for the private sector is all but gone, and the banks are up to the hilt in public credits.”

And the European Commission, I do not know when, to top it up, assigned a Sovereign Debt Privilege of a 0% risk weight to all Eurozone sovereigns, even when these de facto do not take on debt in a national printable currency.

And, to top it up, the ECB launched its Quantitative Easing programs, QEs, purchasing European sovereign debts.

At the end of the day, the difference between the interest rates on sovereign debt that would exist in the absence of regulatory subsidies and central bank purchases, and the current ultra low or even negative rates, is just a non-transparent tax, paid by those who save. Financial communism

And all this began one year before the fall of the Berlin Wall

J’Accuse[d] the Basel Committee for Banking Supervision (BCBS) a thousands times, but I am no Émile Zola and there’s no L’Aurore

J’Accuse the Basel Committee of setting up our bank systems to especially large crises, caused by especially large exposures to something perceived as especially safe, which later turns into being especially risky, while held against especially little capital.

My letter to the Financial Stability Board

J’Accuse the Basel Committee for distorting the allocation of bank credit to the real economy by favoring the sovereign and the safer present, AAA rated and residential mortgages, while discriminating against the riskier future, SMEs and entrepreneurs.

My letter to the International Monetary Fund

A question to the Fed: When in 1988 bank regulators assigned America’s public debt a 0.00% risk weight, its debt was about $2.6 trillion, now it is around $22 trillion and still has a 0.00% risk weight. When do you think it should increase to 0.01%?

What if taking down our bank systems was/is an evil masterful plan for winter to come?

Tweets on "What if taking down our bank systems was/is an evil masterful plan for winter to come?"

The poison used is that of basing bank capital requirements on ex ante perceived risks, more risk more capital, less risk much less capital.

That way banks were given incentives to build up the largest exposures to what is ex ante perceived by bankers as safe, something which, as we know, in the long run, when ex post some of it turns out very risky, is what always take bank systems down.

For that they made sure no one considered making the risks conditional on how bankers perceive the risks.

And that hurdle cleared, some very few human fallible credit rating agencies were given an enormous influence in determining what is risky and what is safe.

And taking advantage of some statists or that few noticed, sovereigns were assigned a 0% risk weight, while citizens 100%. That guaranteed government bureaucrats got too much of that credit they’re not personally responsible, and e.g. the entrepreneurs too little.

And to make the plan even more poisonous some European authorities were convinced to also assign to all Eurozone sovereigns a 0% risk weight, and this even though these all take up loans in a currency that is not their domestic printable one.

And because banks were allowed to leverage much more with “safe” residential mortgages than with loans to “risky” small and medium businesses, houses prices went up faster than availability of jobs, and houses morphed from homes into investment assets

And finally, by means of bailouts, Tarps, QE’s, fiscal deficit, ultra low interest rates and other concoctions, enormous amounts of financial stimuli was poured on that weak structure… and so the evil now just sit back and wait for winter to come

http://theaaa-bomb.blogspot.com

PS. My letter to the Financial Stability Board

What would have happened if, since Basel I, 1988, there had just been one 8% bank capital requirement for all assets?

The “safe” sovereigns would not have seen their borrowings subsidized by the “risky” SMEs and entrepreneurs lesser access to bank credit. 

Sovereigns like Greece would never have been able to run up such large debts on such low initial interest rates.

House financing would not have been so much available at artificial low rates so house prices would be lower.

Much more financing would have gone to those “risky” SMEs and entrepreneurs who could create the jobs the house owners need in order to repay mortgages and service utilities, and that so many young need in order not having to live in the basements of their parents’ houses.

Some other crisis could have resulted, but the catastrophic sized one with the AAA rated securities collateralized with mortgages to the subprime sector, would never have happened.

Central banks would not have needed to kick the crisis can down the road with trillions of QEs… that are still out there on the road menacing to run back on us.

Central banks would not have needed to kick the crisis can down the road with ultra low interest rates that are creating havoc on all pension plans.

The world would not have served up the table with so much for the populists to munch on.

The saddest part though is that now, ten years after those assets that caused the big crisis correlated completely with those assets that required banks to hold the least capital, regulators still apply risk weighted capital requirements. I guess, as Upton Sinclair Jr. said, “it is difficult to get a man to understand something when his salary depends upon his not understanding it.”

Ten years ago ECB decided to ignore the benefits of a hard landing and go for kicking the can down the road

In August 2006, when we were already hearing worrisome comments about complex securities linked to mortgages, I wrote a letter to FT titled “The Long Term Benefits of a Hard Landing”. At that moment I had not yet been censored by FT and so they published it.

One year later, when panic about the AAA rated securities backed with mortgages to the subprime sector impacted the financial markets, ECB (and the Fed earlier) decided to ignore that option and go for the politically more convenient short-termish option of kicking the can down the road, with QEs and ultralow interest rates.

It could have worked, if only what had caused the crisis and what hindered the stimuli to flow in the correct directions had been removed. But no, the regulators refused to admit their mistake with the risk weighted capital requirements.

And so here we are, a full decade later, still allowing banks to multiply the net margins obtained more when it relates to assets perceived, decreed or concocted as safe, than with assets perceived as risky, and so obtain higher expected risk adjusted returns on their equity financing the safe than financing the risky.

In a historic analogy, regulators still believe the sun to be circling around the earth; in this case that what is perceived as risky is more dangerous to the banking system than what is perceived as safe.

As a result “safe” sovereigns, AAArisktocracy and residential houses still dangerously get way too much bank credit, while “risky” SMEs and entrepreneurs, way too little to keep our economies dynamic.

Every day we allow regulators like Mario Draghi to regulate based on a flawed theory, the worse for all of us.

But what are we to do when there are so many vested interests in shutting up this the mother of all bank regulation mistakes?

Capital requirements for banks should be ex ante perceived risks neutral.

Professor Steve Hanke writes: “The calculated risk that a financial institution takes is best understood by the institution itself, not the government or any outside party” “Let Banks Manage Risks, Not Regulators” Forbes July 30, 2017.

I agree: For about 600 years banks use to run their banks as if each dollar invested in any asset was worth the same. Not any longer, since Basel I, 1988 and Basel II, 2004 some assets produce net margins that regulators allow them to leveraged much more than other. That meant that banks would find it easier to obtain higher risk adjusted returns on equity on some assets, those perceived ex ante as safe, than on other, those perceived as risky.

That of course distorted dangerously the allocation of bank credit to the real economy. The 2007-08 problems resulting mainly from excessive exposures to AAA rated securities and sovereigns, as well as the mediocre response to ultra large stimulus like QEs and minimal interest rates should suffice to prove it.

And I disagree: Because bank regulators should consider the risks that banks are not able to manage the risks they perceive, or that some unexpected events can put the system in danger. But since that has absolutely nothing to do with ex ante perceived risks per se, the capital requirements should be risk-perceived neutral, like for instance solely a leverage ratio. 

Besides, if regulators insist in risk weighing, only to show off some regulatory sophistication, so as to be known as important experts, then they should never forget that what really poses dangers to the banks system is what is perceived safe and never ever what is ex ante perceived very risky.

Could a hostile power create bank regulations capable of destroying our Western financial system? It would seem so :-(

David Bookstaber in his “The End of Theory”, 2017 refers to the following question:

“If you were a hostile foreign power, how could you disrupt or destroy the U.S. financial system? That is how do you create a crisis?

Well one way to do it begins, as does any strategic offensive, with the right timing. Wait until the system exposes a vulnerability. Maybe that is when it’s filled with leverage, and when assets become shaky.”

Then Bookstaber suggests: “create a fire sale by pressing down prices to trigger forced selling…freeze funding by destroying confidence… maybe pull out your money from some institutions with some drama… and to make money, short the market before you start pushing things off the cliff”

That is Bookstaber’s interesting tale on what “turned the vulnerabilities of 2006 and 2007 into the crisis of 2008, and nearly destroyed our system.” “And we didn’t need an enemy power; we did it all by ourselves.

But what if it all had started with a hostile foreign power taking over bank regulations in order to create the vulnerabilities?

I mean like telling banks they could hold 1.6% in capital or less, meaning a 62.5 to 1 or more leverage, against assets with an AAA rating (like some fatal MBS) or against sovereigns, like Greece. That would give banks the chance to earn fabulous expected risk adjusted margins on those assets, and therefore build up huge exposures to these against very little capital (equity).

I ask, because that was exactly what the Basel Committee for Banking Supervision did with its Basel II of 2004.

And to top it up their AAA-bomb was so powerful that, because it discriminates against the access to bank credit of “the risky”, like SMEs and entrepreneurs, the economy would find it almost impossible to recover on its own; and the crisis-can had to be kicked further and further down the road, with Tarps, QEs, fiscal deficits and silly low interest rates? 

http://theaaa-bomb.blogspot.com

A safer banking system compared to our current dangerously misregulated one with so many systemic risks on steroids

What is a safer banking system?

One in which thousand banks compete and those not able to do so fail as fast as possible, before some major damage has been done, while even, as John Kenneth Galbraith explained, often leaving something good in their wake. 

What is a dangerous banking system?

One were all banks are explicitly or implicitly supported, by taxpayers, as long as they follow one standard mode that includes living wills, stress tests, risk models, credit ratings, standardized risk weights... all potential sources of dangerous systemic risks.

A bank system in which whenever there is a major problem, the can gets kicked down the road with QEs and there is no cleaning up, and banks just get bigger and bigger.

One that make it more plausible that the banks will all come crashing down on us, at the same time, with excessive exposures to something ex ante perceived safe that ex-post turned out risky, and therefore the banks holding especially little capital.

But you don’t worry; the regulators have it all under control with their Dodd-Frank’s Orderly Liquidation Authority (OLA). “Orderly”? Really?

So that is why when I hear about banks “cheating” with their risk models I am not too upset, since that at least introduces some diversity. 

Also that cheating stops, at least for a while, the Basel Committee regulators from imposing their loony standardized risk weights of 20% for what has an AAA rating, and so therefore could be utterly dangerous to the system; and one of 150% for the innocuous below BB- rated that bankers don’t like to touch with a ten feet pole.

How did we end up here? That is where you are bound to end up if you allow some statist technocrats, full of hubris, to gather in a mutual admiration club, and there engage into some intellectually degenerating incestuous groupthink.

Statist? What would you otherwise call those who assign a 0% risk weight to the Sovereign and one of 100% to the citizen?

And it is all so purposeless and useless!

Purposeless? “A ship in harbor is safe, but that is not what ships are for”, John A Shedd

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

In essence it means that while waiting for all banks to succumb because of lack of oxygen in the last overpopulated safe-haven available, banks will no longer finance the "riskier" future our grandchildren need is financed, but only refinance the "safer" present and past.

In April 2003, as an Executive Director of the World Bank I argued: "A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind."

PS. FDIC... please don't go there!

Note: For your info, before 1988, we had about 600 years of banking without risk weighted capital requirements for banks distorting the allocation of bank credit to the real economy.

PS. The best of the Financial Choice Act is a not distorting, not systemic risks creating, 10% capital requirement for all assets. Its worst? That this is not applied to all banks.

PS. If I were a regulator: Bank capital requirements = 3% for bankers' ineptitude + 7% for unexpected events = 10% on all assets = Financial Choice Act
 

3 questions on IMF’s Global Financial Stability Report’s, “Where Are the U.S. Corporate Sector’s Vulnerabilities?”

That section, on page 9 states:

“The corporate sector has tended to favor debt financing, with $7.8 trillion in debt and other liabilities added since 2010. Bank lending to the corporate sector has continued to recover and could well rise further in response to more favorable market valuations. In contrast, equity finance has traditionally been outstripped by share buybacks and has recently leveled off. A drop in the cost of equity capital may stimulate equity financing, but it could coincide with higher corporate debt—particularly if additional share buybacks are financed through debt.” 

That begs three questions: 

First: How much of the recent increase in the stock markets is the result of buybacks; that which helps earnings per share to get a sort of artificial boost; that which results in less equity controlling the corporations? 

Second: Do the recent stock-market prices increases duly reflect the increase riskiness derived from much higher corporate debts? 

Third: Have Central Banks therefore, with their low interests rate policies, de facto, dangerously lowered the capital (equity) requirements of corporations? 

On the first two questions I have no answers, though just having to ask them should suffice to at least raise some eyebrows. 

On the third the IMF clearly seems to respond, “Yes!” when on that same page, under the subtitle “High Leverage Combined with Tighter Borrowing Conditions Could Affect Financial Stability” it writes: 

“As leverage has risen, so too has the proportion of income devoted to debt servicing, notwithstanding low benchmark borrowing costs. Although the absolute level of debt servicing as a proportion of income is low relative to what it was during the global financial crisis, the 4 percentage point rise has brought it to its highest level since 2010, which leaves firms vulnerable to tighter borrowing conditions. The average interest coverage ratio—a measure of the ability for current earnings to cover interest expenses— has fallen sharply over the past two years. Earnings have dropped to less than six times interest expense, close to the weakest multiple since the onset of the global financial crisis.” 

Holy Moly! And interest rates have not yet returned to something more "normal"; and the Fed's balance sheet is still so huge it leaves little space for any future QE assistance...and not to speak of the already too large public debts. 

My intuition tells me that if we do not develop something along the lines of a Universal Basic Income, fast, we will not be able to counter sufficiently upcoming recessions and huge unemployment so as to keep truly horrendous populists away.

Really, how on earth can we have left so much power in so few so intellectually incestuous hands?

Why has IMF kept silence on what was done to banks in 1988?

What happened?

Before 1988, for about 600 years, bank exposures were a function of the by bankers ex-ante perceived risks (bpr), risk premiums (rp) meaning interest rates, and bankers’ risk tolerance (brt) 

Pre 1988 bank exposures =ƒ(bpr, rp, brt)

Bank credit was then allocated to what produced banks the highest expected risk adjusted return on equity

But 1998, with the Basel Accord, risk weighted capital requirements were introduced. With that bank exposures became a function of the: by bankers ex-ante perceived risks (bpr), risk premiums (rp), bankers’ risk tolerance (brt), and regulatory capital requirements (rcc), this last itself a function of the by regulators ex-ante perceived (or decreed) risks (rpr) and the regulator’s risk tolerance (rrt)

After 1988 bank exposures = ƒ(bpr, rp, brt, rccƒ(rpr, rrt))

Bank credit was thereafter allocated to what produced banks the highest expected risk/capital-requirement adjusted return on equity

And of course banking changed dramatically, and the allocation of bank credit to the real economy became hugely distorted.

With Basel II of 2004, which introduced risk weighting within the private sector, and made the process much dependent on credit ratings, the distortions and the systemic risks were dramatically increased.

Fundamental mistakes:

1. Although hard to believe, bank regulators never defined what the purpose of banks is before regulating these. “A ship in harbor is safe, but that is not what ships are for.” John A Shedd, 1850-1926

2. Although hard to believe, as the purported reason was to make banks safer, the regulators never researched what had caused bank crisis in the past; namely unexpected events, criminal doings and what was ex ante perceived as very safe but that ex post turned out very risky. What is perceived as very risky is, precisely because of that perception, what is least dangerous to the system. “May God defend me from my friends, I can defend myself from my enemies” Voltaire

3. Any risk, even if perfectly perceived, causes the wrong actions if excessively considered; and here the regulators doubled down on ex ante perceived risks.

4. Ignoring risk-taking is the oxygen of development. For banks to take risks, albeit in smaller amounts on “risky” SMEs and entrepreneurs, is absolutely vital for the economy to move forward, in order not to stall and fall. Where would we be had these regulations been in place during the previous 600 years? In April 2003 as an Executive Director of the World Bank I stated: “The Basel Committee dictate norms for the banking industry… there is a clear need for an external observer of stature to assure that there is an adequate equilibrium between risk-avoidance and the risk- taking needed to sustain growth.” In fact the risk of excessive risk aversion was the theme of my first ever Op-Ed. 

5. Little understanding of systemic risks: In January 2003 I wrote in Financial Times: “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.”

6. Little understanding of fragility: In April 2003, as an ED of the World Bank I stated: “A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind.”

7. Little understanding of pro-cyclicality: When times are good, credit-risks seem low, so the risk-weighted capital requirements allow banks to expand more than they should; and when times are bad, the credit risk are naturally perceived higher, and so the capital requirements force banks to contract credit, precisely when less bank credit austerity is needed.

8. Macro-imprudence: Prudential regulation helps failed banks to fail expediently. Macro-imprudent regulation impedes failed banks from failing… which builds uphuge mountains of combustible materials waiting for a Big Bang.

9. Overreliance on data and models: In October 2004 in a formal statement at the World Bank I warned: “Much of the world’s financial markets are currently being dangerously overstretched through an exaggerated reliance on intrinsically weak financial models that are based on very short series of statistical evidence and very doubtful volatility assumptions.”

Consequences:

Statism: Basel Accord’s risk weights of 0% for “The (infallible) Sovereign” and 100% for “We the (risky) People” introduced runaway statism. Since then the proxies for risk-free rates have been subsidized. We have no idea what the current low interest rates on much sovereign debt would be if government bureaucracy bank borrowings were affected by a risk-weight similar to SMEs’. De facto those risk-weights imply that regulators believe public bureaucrats know better what to do with bank credit, than the private sector.

Crisis resulting from dangerous overpopulation of “safe” havens: The first crisis, that of 2008, resulted from excessive exposures to AAA rated securities (Basel II risk weight 20% = allowed leverage 62 to 1), sovereigns like Greece, and residential housing (Basel II risk weight 35% = allowed leverage 32 to 1)  

Stagnation: Banks have stopped financing the riskier future and basically keep to refinancing the safer past and present. As an example banks finance much more “safe” basements where jobless kids can stay with their parents, than the SMEs that could create the jobs that could allow the kids afford to also become parents. In short this regulation keeps Keynes' animal spirits caged.

Stimulus waste: Since credit will not flow were they could most be needed, much of the stimuli fiscal deficits, quantitative easing and low interest could produce, is wasted.

More inequality: The result of making it harder and more expensive for the “risky” weaker to access opportunities of bank credit for productive purposes.

Too Big Too Fail: Clearly minimalistic capital requirements, for so many assets, has served as a potent growth hormone for the TBTF banks.

Over indebtedness: By allowing ridiculously low capital requirements for assets perceived as safe, the regulators allowed banks to leverage too much their equity and the support they received from society (taxpayers). That facilitated the current generation to extract more borrowing capacity to sustain its own consumption than any other previous generation. That has left little borrowing capacity over for the future generations.

What to do?

To accept the problem exists!

To know neither Hollywood nor Bollywood, would allow new movies on the same theme to be produced by directors and scriptwriters responsible for such box-office flops as Basel I-II-III.

To understand that bank capital requirements would be better if based on ex-post risks of models based on ex-ante risk perceptions.

To know that if you absolutely must distort, it is better to do so based on some useful social purpose, like based on job-creation and environmental-sustainability ratings.

To understand that getting our banks and our economies out of the Basel mess is a very delicate process, which does not permit an ounce more of that technocrats’ hubris that caused it all.

IMF, will you keep on being silent on this?

Per Kurowski

PS. Here is an updated list of the many mistakes with risk weighing.