September 2, 1986 was the tragic night when Paul A. Volcker, in London, gave in to (insane) European bank regulators.

Paul A. Volcker in “Keeping at it” penned together with Christine Harper writes on bank regulations and capital requirements the following:

"The travails of First Pennsylvania and Continental Illinois, the massive threat posed by the Latin American crisis, and the obvious strain on the capital of thrift institutions had an impact on thinking over time, but strong action was competitively (and politically) stalled by the absence of an international consensus.

An approach toward dealing with that problem was taken by the G-10 central banking group meeting under the auspices of the Bank for International Settlements (BIS) headquartered in Basel, Switzerland. A new Basel Committee would assess existing standards and practices in a search for an analytic understanding.

Progress was slow… 

The US practice had been to asses capital adequacy by using a simple “leverage ratio”-in other words, the bank’s total assets based compared with the margin of capital available to absorb any losses on those assets. (Historically, before, the 1931 banking collapse, a ten percent ratio was considered normal)

The Europeans, as a group, firmly insisted upon a “risk-based” approach, seemingly more sophisticated because it calculated assets based on how risky they seemed to be. They felt it was common sense that certain kind of assets –certainly including domestic government bonds but also home mortgages and other sovereign debt- shouldn’t require much if any capital. Commercial loans, by contrast, would have strict and high capital requirements, whatever the credit rating might be.

Both approaches could claim to have strengths. Each had weaknesses. How to solve the impasse?

At the end of a European tour in September in 1986, I planned to stop in London for an informal dinner with the Bank of England’s then governor Robin Leigh-Pemberton. In that comfortable setting without a lot of forethought, I suggested to him that if it was necessary to reach agreement, I’d try to sell the risk-based approach to my US colleagues.

Over time, the inherent problems with the risk-based approach became apparent. The assets assigned the lowest risk, for which capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages. Ironically, losses on those two types of assets would fuel the global crisis in 2008 and a subsequent European crisis in 2011."

Insane? Yes! 

How can one believe that what bankers perceive as risky is more dangerous to bank systems than what bankers perceive as safe? 

Should it not be clear that dooms our bank system to especially severe crises, resulting from excessive exposures the what ex ante is perceived as especially safe, but that  ex post might not be, against especially little capital?

These self-nominated besserwisser experts had (have) just not the faintest understanding of conditional probabilities.

September 2? From here

This September 2016, there will be 30 years since regulators, scared of the climb, declared our economies should peak

In Steven Solomon’s "The Confidence Game" (1995) we read: 

"On September 2, 1986, the fine cutlery was laid once again at the Bank of England governor’s official residence at New Change… The occasion was an impromptu visit from Paul Volcker… When the Fed chairman sat down with Governor Robin Leigh-Pemberton and three senior BoE officials, the topic he raised was bank capital…

At dinner the governor’s hopes had been modest: to find areas of sufficient convergence of goals and regulatory concepts to achieve separate but parallel upgrading moves… 

Yet the momentum it galvanized… produced an unanticipated breakthrough of a fully articulated, common bank capital adequacy regime for the United States and United Kingdom. This in turn catalyzed one of the 1980’s most remarkable achievements – the first worldwide protocol on the definitions, framework, and minimum standards for the capital adequacy of international active banks…

They literally wiped the blackboard clean, then explored designing a new risk-weighted capital adequacy for both countries… 

It included… a five-category framework of risk-weighted assets… It required banks to hold the full capital standard against against the highest-risk loans, half the standard for the second riskiest category, a quarter for the middle category, and so on to zero capital for assets, such as government securities, without meaningful risk of credit default.” End of quote.

And that suddenly meant that banks were able to leverage equity much more with what was perceived, or deemed by regulators, as safe, than with what was perceived as risky.

And that of course meant banks would earn higher expected risk-adjusted rates of return on equity on what was perceived as safe than on what was perceived as risky.

And that meant banks would stop lending to the risky future and just keep to refinancing the safer past.

The bank regulators, scared of more climbing, had then declared that the Western Civilization had reached its peak. No more risk-taking!

The Basel Committee for Banking Supervision, with the Basel Accord of 1988, concocted Basel I and in 2004 Basel II... and they are now in Basel III... and it has all been going down down ever since. The liquidity injected byTarps, QEs and fiscal deficits, and which generate temporary illusions of growth, obesity, cannot reach those who could best produce sturdy growth, the "risky" SMEs and entrepreneurs.

September 2, 1986 was fatal for Western World’s economies. Its banks would be told not to finance the riskier future.

In Charles Goodhart’s “The Basel Committee on Banking Supervision: A History of the early years 1974-1997” 2012, Cambridge Press Goodman (p.167) refers to Steven Solomon’s The Confidence Game (1995), and we read:

On September 2, 1986, the fine cutlery was laid once again at the Bank of England governor’s official residence at New Change… The occasion was an impromptu visit from Paul Volcker… When the Fed chairman sat down with Governor Robin Leigh-Pemberton and three senior BoE officials, the topic he raised was bank capital…

At dinner the governor’s hopes had been modest: to find areas of sufficient convergence of goals and regulatory concepts to achieve separate but parallel upgrading moves… 

Yet the momentum it galvanized… produced an unanticipated breakthrough of a fully articulated, common bank capital adequacy regime for the United States and United Kingdom. This in turn catalyzed one of the 1980’s most remarkable achievements – the first worldwide protocol on the definitions, framework, and minimum standards for the capital adequacy of international active banks…

They literally wiped the blackboard clean, then explored designing a new risk-weighted capital adequacy for both countries… 

It included… a five-category framework of risk-weighted assets… It required banks to hold the full capital standard against against the highest-risk loans, half the standard for the second riskiest category, a quarter for the middle category, and so on to zero capital for assets, such as government securities, without meaningful risk of credit default.”

And that, as far as I am concerned, could be the opening scene for a Mission Impossible or Bond movie, describing the actions of terrorists wanting to destroy the world’s economies. 

Of course it was just dumb arrogant technocrats going abour their business of solely thinking about how banks could avoid failure, without giving even the slightest consideration to the possibility that when doing so they could dangerously distort the allocation of bank credit to the real economy.

The buckets with riskweights of 100%, 50% 25% 0%, and if the capital standard was set to 8 percent meant that a bank would be able to leverage its equity, and the implicit support of society, 12.5, 25, 50 and ∞ times to one respectively with the assets in each bucket.

That meant banks would earn higher risk adjusted returns on equity on assets in those buckets they could leverage more. And that meant that the net of risk margins offered by The Risky to the banks were worth less than the same margins offered by The Safe.

And what was also clear to these “statist conspirators”, was that the risk weight for the private sector would be 100% while that of their governments would be zero.

All in all that night the diners decided the Western World had had enough of risktaking and so the banks should stop giving credit to the riskier future and concentrate on refinancing the safer past.

You might argue that regulators did not force banks to do anything, but that would be to ignore that out there in the real world any bank that earns less risk adjusted returns on equity than other banks will, sooner or later, be eaten up.

And the baby conceived that night was born 21 months later in November 1988 and named the Basel Accord or Basel I. And that baby grew up to be a real monster in 2004, when it turned into Basel II.

And because of this financial terrorism act, millions of small loans to SMEs and entreprenuers that would otherwise have been awarded have now been denied. 

And with that the possibility of creating the new jobs that could substitute for the disappearing ones were greatly diminished.

And by so denying those in lack of capital the opportunities to access bank credit, inequality got a strong boost.

And, ridicously, all for nothing, since major bank crises never ever result from excessive exposures to what is ex ante perceived as risky.