“I am not sure about 'subsidised' sovereign. Since sovereign is ultimate safety net for entire financial system… the term is I'll suited.”

My answer:

Yes a sovereign, if we ignore inflation and the possibility of being repaid in worthless money, the sovereign represents no risk if it takes on debt denominated in a currency it can print. Which by the way is not the case with the sovereigns in the Eurozone.

But let us assume that in the open market the required risk/cost/inflation adjusted net return for a sovereign in .5% and for the risky SMEs 3%

Then if banks, as it used to be for almost 600 years, had to hold one single capital against the risks of its whole portfolio, and the authorities, or in their absence the markets, allowed banks to leverage 12 times then the risk/cost/inflation adjusted required expected return on equity would be 6% for sovereigns and 36% for SMEs.

BUT, since banks are now allowed to leverage immensely more with safe sovereigns, let us say 40 times and only 12 times with SMEs, the now distorted risk/cost/inflation adjusted expected ROEs are 20% for sovereigns and still 36% for SMEs. So now banks can offer to lower the interest rates to sovereigns and still obtain the risk/cost/inflation adjusted required expected return on equity of 6% for sovereigns, ergo the subsidized sovereign.

OR, since banks could now earn a risk/cost/inflation adjusted expected ROEs of 20% on sovereign debt, then in terms of comparable risk adjustments it would have to earn more than 36% on SMEs, or not lend to them at all, ergo that subsidy to the sovereign, is paid by others who find their access to bank credit made more difficult and expensive as a consequence of the risk weighted bank capital requirements. 

PS. Is there no sovereign risk present when some current rates are negative and central banks work like crazy to produce 2% inflation? 

PS. If you go back in time and start taking about risk-free sovereigns to bankers who sometimes had their head chopped off or were been burned when trying to collect from the sovereigns, they would think you were crazy.

The before and after the risk weighted bank capital adequacy ratio (RWCR)

The risk weighted bank capital requirements were introduced in 1988 by means of the Basel Accord, Basel I, and were much further developed in 2004, with Basel II. RWCR survives in Basel III.

Before RWCR banks, for their return on equity, leaned on savvy bank loan officers to obtain the highest risk adjusted net margins. A net margin of 1.5% when leveraged 10 times on their equity, would produce a 15% ROE. All wanting access to bank credit, whether perceived as safe or risky, competed equally with their risk adjusted net margin offers.

After the introduction of RWCR though banks, for their return on equity, still leaned somewhat on bank loan officers obtaining the highest ROE depended more on equity minimizing financial engineers. A risk adjusted net margin of 1%, when leveraged 20 times on equity, produces a 20% ROE. The risk adjusted net margin offers of those perceived or decreed as safe, which could be leveraged many times more, were now worth much more than those offered by the risky.

And what are the consequences?

The RWCR by favoring the financing of the “safer present” like sovereigns, residential mortgages and what’s AAA rated over the financing of the “riskier future, like entrepreneurs, leads to a more obese and less muscular economy.

All that RWCR really guarantees is especially large bank crisis, caused by especially large exposures to something perceived or decreed as especially safe, and that turn out to be especially risky, while being held against especially little bank capital. 

So what went wrong? Simply that regulators based their capital requirements on the same perceived risks that bankers already consider when they make their lending decisions, and not on the conditional probabilities of what bankers do when they perceive risks.

Any risk, even if perfectly perceived, will lead to the wrong actions, if excessively considered.

My letter to the Financial Stability Board

Our modern statist rulers insidiously debase our currencies with their decreed zero-risk weighting of sovereigns

Lawrence W. Reed in “Did You Know about the Great Hyperinflation of the 17th Century?” FEE August 2017, quotes Nicolaus Copernicus (1473–1543) with: “The greatest and most forbidding mistake has to be when a ruler tries to make a profit from the minting of coins by introducing and circulating new coins with an inferior weight and fineness, alongside the originals, and claims that they are of equal value”

And Reed notes: “Desperate to raise cash and secure material for war, many of the German states in 1618 resorted to the debasement of coinage. They clipped and they melted. At first, they adulterated their own coin but then discovered that they could do the same to that of their neighbors too.”

Our modern governments use much more refined and insidious debasement methods. In order they say to make our banks safe, regulators came up with the risk weighted capital requirements which assigned to the sovereign a risk weight of 0%... yes, you read it well, zero percent.

That means that banks are able to leverage any little net margin obtained on public debt, into great returns on equity. That means that banks will be offering to hold a lot of public debt at low rates which will help to confound all the rest of investors into believing the markets believe that debt to be intrinsically safe.

That also means banks are going to absorb much more of the governments injections of liquidity than would otherwise have been the case.

One day buyers of public debts of these by regulators decreed ultra-safe sovereigns, are going to wake up.

When that happens all bets are off. Interest rates on public debt will shoot up, repaying governments will inject liquidity that will be impossible to drain… and economic realities will be hyper-inflation/hyper-recession messy.

When will that happen? Who knows, in Europe governments have already recruited insurance companies to also operate under a scheme similar to the banks’ Basel I, II and III, and which has quite cynically been named Solvency II.

Why is this all unsustainable? Any system, in which government bureaucrats can, without being responsible for its repayment, have easier access to other peoples’ money than for instance the 100% risk weighted SMEs and entrepreneurs, simply cannot end well.

PS. I often hear the argument that if sovereigns borrow in their own currency they represent indeed a zero risk because they will always be able to repay. Wow they’ve got to be kidding! True repayment does only happen when done with purchase power that has not been diluted by inflation.

PS. Here is a current summary of why I know the risk weighted capital requirements for banks, is utter and dangerous nonsense.

With Basel II, how many times could banks multiply net risk adjusted margins, so as to obtain their returns on equity?

The expected pretax return on equity for banks is the amount of net risk adjusted margins they earn over the capital they need to hold.

For instance if banks had to hold the 8% basic capital requirement defined in Basel II, they could leverage (multiply) those net risk adjusted margins 12.5 times. And so if a bank wanted to earn a 20% pre tax ROE, it would need to collect an average net risk adjusted margin of 1.6% (20%/12.5) on assets equivalent to 12.5 times its capital.

Clearly, the more banks can leverage (multiply) those net risk adjusted margins, the higher the expected return on its equity, or the lower do those margins need to be.

For instance if banks had to hold only 1.6% in capital they would be able to leverage (multiply) those net risk adjusted margins 62.5 times. And so if banks wanted to earn the same 20% pre tax ROE as before, they would need to collect an average net risk adjusted margin of only 0.32% (20%/12.5) on assets equivalent to 62.5 times its capital. If the bank was abled to collect the same 1.6% average net risk adjusted margins, then its expected ROE would be a whopping 100%. 

The problem (for us) though, of Basel II, is that it, based on credit ratings, risk adjusted the capital requirements. And so, according to Basel II’s standardized risk weights, the banks were allowed to multiply their net risk adjusted margins the following way: 

SOVEREIGNS:

AAA to AA = Unlimited

A+ to A = 62.5 times

BBB+ to BBB- 25 times

BB+ to B- = 12.5 times

Below B- = 8.3 times

Unrated = 12.5 times

CORPORATES:

AAA to AA = 62.5 times

A+ to A = 25 times

BBB+ to BB- = 12.5 times

Below BB- = 8.3 times

Unrated = 12.5 times

Residential mortgages = 35.7 times

Anyone who does not immediately understand how this distorts the allocation of bank credit; in favour of those who can have their net margin offers multiplied more by banks; and against those who have these multiplied less, does not understand finance, or has a vested interest in not wanting to understand it.

Can there be any question that these regulations pushed banks overboard with exposures to AAA rated securities and loans to sovereigns, like to Greece?

But, someone might say, this is all in order to make banks safer. Bullshit! There has never ever been a major bank crisis resulting from excessive exposures to something perceived as risky when placed on banks’ balance sheets.

Of course with Basel III, which has a leverage ratio that is not risk depended, the differences in the times net risk adjusted margins can be multiplied are smaller, but that does not mean for one second that the Basel discrimination keeps on being kicking and alive.

God help our young… God help our Western civilization. These idiotic risk-adverse regulators are hindering banks from financing our young ones’ riskier future, and have banks only refinancing their parents’ (and their regulators’) safer present and past. 

Risk-taking is the oxygen of development. God make us daring!

Banks and regulators don’t care about our economy

Banks, regulators and risk

The Aug. 5 Economy & Business article “What happens when lines blur between banks, regulators” referred to several issues and conflicts of importance between banks and regulators but did not mention the prime point of agreement between all regulators and all banks: None of these actors cares about the state of the real economy.

Banks love to earn high-risk adjusted returns on equity when lending to something perceived as absolutely safe, so they love when regulators allow them to hold much less equity when lending to something perceived, decreed or concocted as safe.

Regulators love it when banks avoid taking risks, so they are more than happy to allow banks to hold much less equity when lending to something ex-ante perceived by them as safe, and therefore allow banks to earn much higher risk-adjusted returns on equity when staying away from the risky.

Our problem, though, is that we need for our banks to lend to the risky, such as small and medium-size enterprises and entrepreneurs, to keep our economy moving forward.

Regulators have never defined the purpose of the banks, so they do not care about whether these banks allocate credit efficiently to our real economy.

Per Kurowski, Rockville

The writer was an executive director at the World Bank from 2002 to 2004.

A letter in the Washington Post

Why was the most important obstacle for small businesses accessing bank credit not even mentioned in 2012 JOBS Act?

Bank regulators consider small unrated businesses to be much more dangerous to the banking system and to financial stability, than well-rated corporations.

That is an extremely flimsy and wrong proposition, based on absolutely nothing! 

And that is why, with Basel II, for the purpose of defining the risk weighted capital requirements for banks, regulators assigned a risk weight of 100 percent for the small unrated businesses and one of only 20 for AAA to AA rated corporations.

And that translated into banks being allowed to hold much less capital against “the safe” assets than against “the risky assets; which meant banks could leverage more their equity lending to the safe than lending to the risky; which meant banks earn higher expected risk adjusted returns on equity when lending to the safe than when lending to the risky.

And that represents the most significant cause for small-unrated businesses not having fair access to bank credit.

And not a single word about that obstacle, and the need to remove it, was mentioned in the Jumpstart Our Business Startups (JOBS) Act of 2012. 

And amazingly, the issue of the distortions in the allocation of bank credit to the real economy that credit risk aversion causes in the Home of the Brave, is still not even being discussed.

William C Dudley, Fed New York, does still not understand how risk-weighted capital requirements for banks distort

On March 31, 2016 William C Dudley of the Federal Reserve Bank of New York, gave a speech titled “The role of the Federal Reserve – lessons from financial crises” 

There are many issues I do not agree with in that discourse but let me here concentrate on “lessons from financial crisis”. 

Mr Dudley stated: “The crisis showed that the regulatory community did not fully grasp the vulnerability of the financial system. In particular, critical financial institutions were not resilient enough to cope with large scale disruptions without assistance, and problems in one institution quickly spread to others.”

Not a word about how the risk-weighted capital requirements for banks; which permit banks to leverage more on what is perceived, or has been decreed, or has been concocted as safe, than with what is perceived as risky; which means banks earn higher risk adjusted returns on equity on what is "safe" than on what is “risky”; which means banks will lend too much to what is “safe”, like sovereigns and the AAArisktocracy, and too little to what is “risky”, like SMEs and entrepreneurs.

And anyone who has still not understood the dangers that distortion of the allocation of bank credit poses to the banks, and to the real economy, doest not have what it takes to work on bank regulations.

The main lesson here is: It was the regulators who, by allowing banks to hold less capital against precisely the stuff that all major bank crisis are made of, namely what is ex ante perceived as safe, made the banking sector more vulnerable.

Who is willing to rein in the bank regulatory abuses on Basel Committee Street?

The Basel Committee for Banking Supervision introduced credit risk weighted capital (equity) requirements for banks: more risk more capital – less risk less capital.

That allowed banks to leverage their equity much more when lending to that perceived or deemed safe, like to the AAArisktocracy or Infallible Sovereigns, than when lending to those perceived risky, like SMEs and entrepreneurs.

That allowed banks to earn much higher risk-adjusted returns on equity when lending to the safe than when lending to the risky… sort of realizing bankers' wet dreams.

And that means banks build up dangerous excessive financial exposures to what is perceived as safe, against very little capital, precisely the stuff major bank crises are made off.

And that means banks will mostly refinance the safer past than finance the riskier future, negating thereby the young the opportunities their elder benefitted from in the past.

And, in a nutshell, that guarantees growing inequalities and weakening economies.

Damn the Basel Committee, their associates and all other who maintain interested silence on this de facto regulatory crime against humanity, that I sincerely believe was committed unwittingly.

Where did this disaster, which could even be defined as an unwitting economic crime against humanity, originate? There are many factors, and here are some of those I feel are most relevant. 

Regulators never defined the purpose of the banks and, if you regulate without doing that, then anything could happen. 

Regulators though knowing that banks capital is to be there to help cover for unexpected losses, got confused and used the expected credit risks to estimate the unexpected. 

Regulators simply ignored that what is perceived as safe has by definition a greater potential to deliver unexpected losses than what is perceived as risky. 

Regulators concerned themselves with the perceived risks of bank assets, instead of with the risk of how bankers would manage those perceived risks. 

Regulators simply did not do some empirical research on what causes major bank crises and where therefore not able to manage the differences between ex ante perceptions and ex post realities 

Etc. etc. etc.

Shame on the Basel Committee, their associates and all other who keep mum on this.

How come Nobel Prize winning economists do not understand how regulators distort the allocation of bank credit?

Capital is invested in banks by shareholders looking to obtain the best risk adjusted returns on their equity.

Before current regulators concocted the credit risk weighted capital requirements for banks, the banks, without any sort of discriminations, gave credit to whoever offered them the highest risk adjusted margins.

But now, because of those requirements, more credit risk more capital – less risk less capital, banks can leverage their equity much more with what is perceived as safe than with what is perceived as risky; and can thereby earn much higher risk adjusted returns on equity when lending to the perceived safe than when lending to what is perceived as risky.

And of course, favoring the AAA rated and sovereigns, negates the fair access to bank credit to those perceived as risky, like SMEs and entrepreneurs, and so helps to weaken the economies and to increase the existing inequalities.

Just look at this: Basel II of June 2004 set the risk weight for AAA rated at 20 percent and allowed banks to leverage their equity over 60 times. But for unrated corporations the risk weight was set at 100 percent and in this case banks could only leverage about 12 times.

And all distortion for nothing, since absolutely all major bank crisis result from excessive exposures to something that ex ante was perceived as safe but that ex post turned out to be very risky.

But you read the comments on the 2007-08 crises by Nobel Prize winning research economists, like those of Joseph Stiglitz and Paul Krugman, and it is clear they have no idea about how the regulatory incentives distorted the allocation of bank credit. Unless they shut up for other reasons, like ideological ones, it would seem clear they never had the benefits of a decent Econ 101.

As for me, I strongly feel the Nobel Prize Committee, when the winners use the Nobel Prize reputation to opine in areas totally strange to them, should have the right to revoke Nobel Prizes, and ask for the prize money to be repaid.

World Bank, the credit risk weighted capital requirements for banks promote financial instability and exclusion

May 9-13, 2016 the World Bank will hold “The 13th Overview Course on Financial Issues: Promoting Stable and Inclusive Financial Systems”

And I wonder if they are still going to ignore the distortions produced by the credit risk weighted capital requirements for banks; more risk, more capital – less risk less capital.

These capital requirements allow banks to leverage more with “the safe” than with “the risky”; which means banks will earn higher risk adjusted returns on equity lending to “the safe” than when lending to “the risky”; which means banks will lend too much to “the safe” and too little to “the risky”. And that will:

Promote financial instability since all major bank crisis have always resulted from excessive exposures to something ex ante perceived as safe but that ex post resulted risky.… in this case aggravated by the fact that banks against that hold especially little capital.

Promote exclusion, as it odiously discriminates against the risky… like SMEs and entrepreneurs.

I quote John Kenneth Galbraith from “Money: Whence it came where it went” 1975. “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… Bad banks, unlike good, loaned to the poor risk, which is another name for the poor man.”

And when will the World Bank, the world’s premier development bank remind the world of that risk-taking is the oxygen of any development.

Again I quote John Kenneth Galbraith from “Money: Whence it came where it went” 1975. “For the new parts of the country [USA’s West]… there was the right to create banks at will and therewith the notes and deposits that resulted from their loans…[if] the bank failed…someone was left holding the worthless notes… but some borrowers from this bank were now in business...[jobs created]... It was an arrangement which reputable bankers and merchants in the East viewed with extreme distaste… Men of economic wisdom, then as later expressing the views of the reputable business community, spoke of the anarchy of unstable banking… The men of wisdom missed the point. The anarchy served the frontier far better than a more orderly system that kept a tight hand on credit would have done…. what is called sound economics is very often what mirrors the needs of the respectfully affluent.”

In March 2003, as an Executive Director of the World Bank I gave the following formal statement on this:

http://subprimeregulations.blogspot.com/2003/03/financial-sector-assessments-program.html

And soon 12 years later, I am still waiting L

Understand what originated the bank crisis and what stops the economies from recovering in 157 words

Bank regulators told our credit risk adverse banks: 

“If you take on Safe assets, we will allow you to leverage your equity and the support you receive from the society more than 60 to 1 times but, if Risky assets then you cannot leverage more than 12 to 1.” 

And that of course meant banks would be earning much higher risk adjusted returns on equity on assets perceived or made out to be Safe, than on “Risky” assets. 

It was like telling children: “If you eat up your ice cream then you can have chocolate cake too but, if you eat spinach, then you must eat broccoli too. 

And so banks built up excessive dangerous financial exposures to “Safe” assets, like AAA rated securities and loans to Greece, which detonated the crisis. 

And so banks are reluctant to hold Risky assets, like loans to SMEs and entrepreneurs, which makes it impossible to get out of the crisis.” 

And, amazingly, most describe what happened and is happening with our banks in terms of deregulated entities and failed markets.

I have not seen “The Big Short” but I am sure it comes up short explaining what happened. If not, I will apologize.

This is the film "The Big Short"

And this is my short explanation of the subprime crisis.

In June 2004 the Basel Committee, with Basel II, decided that any bank that held securities rated AAA to AA (or lent to investors guaranteed with such securities) needed to hold only a meager 1.6 percent in capital (equity) against these. That meant banks could leverage their equity (and the support they received from society) with the expected risk adjusted profit margin of these securities, a mindboggling 62.5 times to 1.

For instance, if banks thought they could earn a reasonable 1 percent expected risk adjusted return on such securities, then they would be expecting to earn a 62.5 percent yearly return on their equity.

Basel II regulations applied to the European banks and, due to a decision taken by the Security Exchange Commission in April 2004, also to American investment banks.

This mother of all incentives set up the mother of all demands for AAA to AA rated securities collateralized with mortgages to the subprime sector.

And it was really not the “good” mortgages that the intermediaries were most after in order to package. The worse they were, meaning the higher interest rates they carried, the larger their profits.

Let me explain the deal! If you convinced risky and broke Joe to take a $300.000 mortgage at 11 percent for 30 years and then, with a little help from your friends the credit rating agencies, you could convince risk-adverse Fred the banker that this mortgage, repackaged in a securitized version, and rated AAA, was so safe that a six percent return was quite adequate, then you could sell Fred that mortgage for $510.000. This would allow you and your partners in the set-up, to pocket a tidy profit of $210.000

I am almost sure that “The Big Short” is based on the growing overabundance of these lousy mortgages packaged in highly rated securities... but not on the cause for their overabundance.

I heard in the film trailer "The banks' got greedy"... but in fact there was and is no rational market in the world, that has the strength to say NO! to the kind of temptations offered by the regulators.

And this is tragic. If the truth does not come out, and there is plentiful of interests in the truth not coming out, for instance among all bank regulators, then we have missed a very good opportunity to learn that we should not leave the regulations of our banks in the hand of a small mutual admiration club of experts.

For a starter, current regulators have not yet even defined the purpose of our banks before regulating these. Is that not criminally stupid?

Professor Richard Thaler, do not give lousy regulatory Econs, the excuse of only having misbehaved cause they are Humans

Professor Richard Thaler opens his great and fun ”Misbehaving” with ”Virtually no economists (Econs) saw the financial crisis of 2007-08 coming” and then explains that it all has much to do with human behavior (Humans).

But hold it there Professor, plain lousy Econs should not be given the easy way out justifying it all with them only having misbehaved because they are Humans.

That a bank crisis had to explode, sooner or later, was perfectly predictable. 

It used to be that each dollar in net risk adjusted margin paid by those perceived as safe and those perceived as risky was worth the same.

But with the introduction of credit-risk weighted capital requirements for banks that changed.

For instance in Basel II, the net risk adjusted margin dollars paid by those rated AAA to AA were worth 62.5 equity leverages (ELs), while the dollars paid by unrated borrowers, for instance SMEs, were only worth 12.5 ELs.

And so of course banks would sooner or later have too much assets against little capital in what was perceived as safe, and too little assets exposure against decent capital in what was perceived as risky.

And any econ, with his Optimization +Equilibrium = Economics should be able to tell you that.

The problem with the regulators in the Basel Committee for Banking Supervision, the Financial Stability Board and the IMF is that they were plain lousy Econs

Basel II data for calculating the Els:

AAA-AA rated had a 20% risk-weight which times Basel II’s basic capita requirement of 8% results in a specific 1.6 capital requirement meaning bank equity could be leveraged 62.5 times to 1. 

Unrated borrowers had a 100% risk-weight which times Basel II’s basic capita requirement of 8% results in a specific 8% capital requirement, meaning bank equity can then be leveraged 12.5 times to 1. 

PS. I just remembered I made a similar argument to Professor Thaler backin 2008

Banks should allocate credit based on risk-adjusted return on equity, and not on regulatory required equity

Banks used to allocate bank credit (interest rates and amount of exposure) according to what produced them the highest risk adjusted return per dollar of equity. Since some borrowers, like SMEs and entrepreneurs, are more dependent on banks for credit than others, that might not have been absolutely perfect in terms of allocating bank credit to the needs of the real economy, but at least it was fair and unbiased.

That was before the Basel Accord introduced their outright odious capital requirements based on credit risk. Now banks allocate their credit according to what produces them the highest risk adjusted return per dollar of required equity. Obviously that is totally biased and completely unfair.

Since those borrowers perceived a safe have been additionally benefited by generating lower capital requirements, it is almost impossible for the risky to compete for bank credit.

The resulting distortion in the allocation of bank credit to the real economy is mind boggling.

It is amazing the number of experts who think that even though banks already clear for perceived credit risks, by means of interest rates and size of exposures, that in order to be certain they have done that, it is better the regulators require banks to clear again for that same perceived credit risks, this time in the capital

It is amazing the number of experts who do not understand that even if you have an absolutely perfect perceived credit risk, you will get it wrong if you give that credit risk perception more weight than it should have.

It is amazing the number of experts who do not understand that: more risk more capital- less risk less capital will cause banks to create dangerous excessive exposures to "the safe" and equally dangerous (for the real economy) underexposures to "the risky".

It is amazing the number of experts who are statist or communists, since otherwise there is no way to argue a zero percent risk weight for sovereigns, and a 100 percent risk weight for the private sector.

Here is but a short list of those experts: Mario Draghi, Stefan Ingves, Mark Carney, Ben Bernanke, Jaime Caruana, Lord Turner, Martin Wolf and most of FT, Alan Greenspan, seemingly all those in the IMF, Basel Committee, Financial Stability Board, European Commission, BoE, Fed, FDIC, ECB

To be in the company of fools might make you a less lonely fool, never a lesser fool.

Are bank regulators violating human rights with their perceived-credit-risk obsession?

It is not only the suffering bank regulators have caused, and cause, but also that their regulations, especially in Europe, amounts to intellectual torture… pure waterboarding. Listen to this:

Bank regulators ask (instructs) the credit rating agencies: “Go out there and do a perfect credit rating job”.

And logically the banks will consider those perfect credit ratings in order to set their interest rates, and decide on the amount of their exposure to the credit risks indicated by those ratings.

But then the regulators also require the banks to hold capital (equity), based on the same perfect credit ratings.

That is because even though regulators knew that capital is to be required against unexpected losses, since they faced difficulties in calculating the unexpected, they decided to base it on the expected credit losses.

And, if you give an excessive consideration to a perfect credit rating, then of course the resulting credit decision will be wrong.

And so now, for these capital requirements to be able to allocate bank credit correctly to the real economy, the credit ratings need to be adequately wrong. What is perceived as safe must be much safer, and what is perceived as risky must be much riskier.

And of course, who has ever heard of a major bank crisis that resulted from banks lending too much to what they perceived as risky?

And with this dangerous regulatory nonsense: more perceived credit risk more capital – less perceived credit risk less capital, regulators allow banks to leverage their equity (and the support they receive from taxpayers) much more when lending to The Safe than when lending to The Risky; and which meant banks earn higher risk-adjusted returns on equity when lending to The Safe than when lending to The Risky; which means banks will lend too much to The Safe and too little to The Risky.

And so a monstrous financial crisis resulted… as always, from excessive financial exposures to what was perceived a safe, but in this case aggravated by the fact that banks, thanks to the regulators, stood there naked with especially little capital to cover themselves up with. And the resulting human sufferings are huge.

And so our banking system, because of its regulators' obsessive credit-risk aversion, also negates the future generations that kind of risk taking that helped the current one to be where it is. And so the resulting human sufferings will be huge.

And because now, years later, some regulators discovered that their risk weights might have impeded the fair access to bank credit of the “risky” SMEs… they now, magnanimously, decided that: “Capital charges for exposures to SMEs should be reduced through the application of a supporting factor equal to 0,7619 to allow credit institutions to increase lending to SMEs.”… 0,7619? Why not 0,7618? Why not 0,0001? At least for the small and micro, those with less than 50 employees… when have excessive bank loans to these “risky” ever created a financial crisis?

Please Basel Committee, please Financial Stability Board, and please European Commission, no more waterboarding… I can’t stand it more… my head, and my heart, hurts… what do you want me to do? What do you want me to confess?

On risk-taking, retirement accounts, and lousy bank regulations.

What would have happened with anyone’s retirement plan if, when a young professional and starting to save, his instructions would have included paying his investment manager much higher commissions on returns produced by safe investments, than on returns produced by riskier investments. 

There is no doubt that in such circumstances, his investment manager would have played it overly safe, and he, the beneficiary, would probably have had to retire on a very meager income.

But, by means of their credit-risk weighted equity requirements, which allow banks to earn much higher risk adjusted returns on their equity when lending to something “safe”, than when lending to something “risky”, the regulators are instructing the banks to act in precisely this way.

Whether we like it or not, banks have a very important role to play as investment managers for our economies. And the reason we taxpayers implicitly agree to support banks, is not for them to avoid risks, but to, with reasoned audacity, take intelligent risks on our behalf. 

And so, even if we have to pay banks high commissions, we need them to act much more like aggressive growth funds taking risks but looking to produce for us investors better returns; and for our economies sturdier growth; and for our young better good future employment opportunities.

So let's get these regulators out of our way!

Are these the bank regulators the world needs?

We central bank bureaucrats, we think government bureaucrats are much better at deciding whereto the savings of a society should be allocated, than what private bankers, SMEs and entrepreneurs are. 

And therefore we as bank regulators, government bureaucrats ourselves, have decided to launch the Basel Accord, that which allows banks to hold no equity when lending to the government but requires these to hold 8 percent in equity against any loan to the private sector.

This way we guarantee that whatever net margin our governments, our employers, pay our banks can be infinitely leveraged, so as to be able to produce the banks much higher risk adjusted returns on equity, than whatever returns banks can obtain when lending in fair terms to the private sector.

But of course, our only motivation, is to make banks safer :-)

Down with risky privates! Long live the infallible sovereigns! Government bureaucrats of the World unite!

July 1988: The Basel Capital Accord

PS. One of the benefits with this Accord is that all the subsidies our governments, our employers, are going to receive by having preferential access to bank credit, will not be identified as a tax. Another one is of course that markets will be seen perceiving us as much less risky than usual, which is good. Here among us, in our petit mutual admiration club, we often talk about “the subsidized risk-free rate”.

PS. Warning: We need though to be careful and not overdo it and suddenly have our governments pay negative interest rates on its debts; since then the citizens might begin to suspect not all smells right in the Kingdom.