It takes two to tango, and it takes two to play the game of bank capital requirements

Sir, I refer to “On Wall Street Truth must be told about bank cap­ital rules plans” Sheila Bair, FT September 2, 2023.

Way back, before 1988, when there was one bank capital/equity requirement against all assets, a leverage ratio, the game bankers played was easier than Ludo. It was all about hiding some assets away from their balance sheet, and of finding more capital on it than what they really had.

After 1988, with the introduction of the Basel Committee’s risk weighted bank capital requirements, Basel I, and especially with Basel II which assigned so much importance to credit rating agencies, the game became dramatically more complicated. Out went the type of old time basically loan officer bankers, and in came the dangerously creative banking financial engineers. A game much more like chess has ensued. 

The steps in this Bank Capital Requirements are becoming ever more complicated. If you doubt it just consider that though Basel I had 30 pages, the recent Fed FDIC OCC July 2023 request for just comments on proposed rules to strengthen capital requirements for large banks has 1.087 pages.

Sheila Bair, expressing a con­cern about the complexity of current pro­pos­als ends with “Hopefully, reg­u­lat­ors will find ways to sim­plify the rules and make them more understandable to the pub­lic.”

Sir, from my thousands of letters to you over the last two decades, you know I would like the bank capital requirements to become a game of Ludo again. I might have given you hundred arguments for scrapping the risk weighted capital requirement, Please let me just list here the most fundamental ones.

Lower risk weights for government debt de facto imply that bureaucrats and politicians know better what to do with credit for which repayment they’re not personally responsible for than e.g., small businesses and entrepreneurs. (Long term US treasuries still have a 0% risk weight) I strongly object to that. Sir, don’t you?

Lower capital requirements against residential mortgages de facto imply that financing houses is more important for the economy than lending to small businesses and entrepreneurs. I object to that. Sir, don’t you?

Basing the risk weights on perceived risk and not conditioned to how bankers perceive risks; and on that what’s perceived as risky is more dangerous to bank systems than what’s perceived as safe is clear evidence that the regulators work from their desk and have never walked on main-street. Just think of Mark Twain supposedly saying: “A banker is a fellow who wants to lend you the umbrella when the sun shines and wants it back when it rains”, and then consider the risk weights of 20% for AAA to AA rated assets and 150% for the below BB- rated ones. It’s sheer hubristic lunacy. Sir, don’t you agree?

And honestly, in an uncertain world where so many unexpected events can become dangerous, how on earth, even with “a thoughtful multi year pro­cess” can regulators still base their capital requirements so much on the certainty of perceived risk? In “Against the Gods” Peter L. Bernstein writes that the boundary between the modern times and the past is the mastery of risk, since for those who believe that everything was in God’s hands, risk management, probability, and statistics, must have seemed quite irrelevant. Sir, today, I cannot but speculate on whether we, when managing risk, have not left out God’s hand just a little bit too much.

Finally, as I have tweeted or X-ed repeatedly: “When times are good, and bank capital buffers should be built-up, regulators allow banks to hold little equity, pay dividends and do buybacks so, when times turn bad, banks stand naked, when we need them the most, when the hardest to raise new bank equity.”

https://twitter.com/PerKurowski/status/1688901715989282816?s=20 

PS. Sheila Bair writes about “massive mort­gage defaults dur­ing the fin­an­cial crisis”. Let’s not ignore that crisis was caused not really by mortgages but by the AAA to AA rated securities backed with mortgages to the subprime sector and which therefore were assigned a mind-blowing low 20% risk weight.

@PerKurowski

“Age of Easy Money” ignored the risk weighted bank capital/equity requirements.

I’m stunned. 1:54 hours of a very interesting “Age of Easy Money”, that does contain one single reference to the credit risk weighted bank/equity requirements which distorted the allocation of bank credit and allowed bureaucrats and asset owners, to live on Easy Street.

James Jacoby: With all due respect, I wonder if you could be a little bit more explicit with me. What will the Fed own when it comes to the vulnerability of the system?

Neel Kashkari: Well, I reject the thesis. I actually don't think it's been the Fed's monetary policy that has led to these vulnerabilities. I think it's been incomplete regulatory policy that has led to these vulnerabilities.

My comment: Central banks’ monetary policies, e.g., liquidity injections, have to pass many corianders/strainers before reaching the economy. The most important one, bank credit allocation. Think of risk weighted bank capital requirements as one of these.

Then think of central bankers not caring about the fact that coriander/strainer contains different sized holes. Larger for “safe” government debt, residential mortgages and AAA rated assets; smaller for “risky” loans to small businesses and entrepreneurs. 

Sheila Bair: The entire business community has had a taste of bailouts. I fear that now, the Fed stepping in, not just to bail out Wall Street, but the entire corporate America, is starting to be embedded into people's thinking. People talk about the survival of capitalism, but this is the biggest threat to capitalism. In good times, when anybody can make money, you reap those profits. In bad times, the Fed just keeps stepping in. You have this never-ending ratchet up. The markets never correct.

James Jacoby: It's like a no-lose casino.

Sheila Bair: It is. It is a no-lose casino. That's exactly right

My comment: No! Its more of a doomed casino. In a roulette table, the payouts are all a direct function of the probabilities of any one of the outcomes. E.g., black or red, 50% chance, a payout of 1 plus the bet; any single number, a payout of 35 plus the bet. Imagine then that a casino regulator arguing that the gamblers should be saved from losing too much, decreed that the pay out on “safe” bets, e.g., black or red, should double. The casino would be doomed.

That’s what the perceived credit risk weighted bank capital requirements do. These allow banks to leverage much more their equity, increasing the payout, with assets perceived (or decreed, or concocted) as safe than with assets perceived as risky.

James Jacoby: Was there a concern at the White House that the Fed was running the economy too hot for too long?

Brian Deese: That is a question that I will institutionally not answer.

James Jacoby: Why?

Brian Deese: Because one of the hallmarks of our system is the independence of monetary policymaking.

My comment: Independence? Hah! Here follows the confession that seemingly shall not be heard.

“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… The American “overall leverage” approach had a disadvantage as well in the eyes of shareholders and executives focused on return on capital; it seemed to discourage holdings of the safest assets, in particular low-return US government securities." Paul Volcker in “Keeping at it” 2018.

My questions, to all: 

Where would the market’s “risk-free” interest rates be, if not allowing banks to earn higher risk adjusted returns on government debt? 

Would government debt (government spendings) have become as large, if not allowing banks to earn higher risk adjusted returns on government debt? 

Where would house prices be if not allowing banks to earn higher risk adjusted returns on residential mortgages?

Christopher Leonard: The financial system globally has been built around extremely low, ultra-low interest rates for 10 years.

My comment: And around bank regulations based on that what’s perceived (or decreed or concocted as safe) is more dangerous to our bank systems than what’s perceived as risky. What would Mark Twain have opined about that?

Mohamed El-Erian: In 2022, we've had this very unusual situation whereby you've made double-digit losses on both risky assets, stocks, and risk-free assets, U.S. Treasuries. That's not supposed to happen.

My question: Should it suffice for regulators to argue that what’s safe is not supposed to become risky?

Mohamed El-Erian: A big issue for retirement plans, pension systems, because no matter how well you diversified your portfolio, there was no risk mitigation in it at all.

My question: How much of current bank regulations that so much favors the refinancing the “safer” present, over the financing of the “riskier” future (a reverse mortgage) have also seeped through to contaminate retirement plans and pension systems? 

Nouriel Roubini: We have had literally a few decades of ever-increasing bubbles that have been fed and supported by central banks. And not only have we had bubbles, but we've had bubbles that have been fed by excessive leverage, excessive private and public borrowing and excessive risk-taking.

My comment: All of that, except “excessive risk-taking”. What happened was the buildup of excessive exposures to assets that were perceived, decreed or concocted as safe.

Rana Foroohar, Associate editor, Financial Times: When interest rates start to rise and the tide pulls out, as Warren Buffet would say—

Charles Duhigg: The New York Times: You don't know who's swimming naked—

My comment: With bank capital/equity requirements mostly based on perceived credit risks, not misperceived risks or unexpected events, e.g., covid, war, inflation, one should know banks will stand there naked, just when they’re needed the most, just when its hardest to raise bank equity.

James Jacoby: So I guess the question though is how much disruption in the financial markets are you willing to tolerate now that they're adjusting to this new interest rate environment, after more than a decade of zero rates?

Neel Kashkari:

We live in a market economy.

My comment: “A market economy”, with risk weighted bank capital requirements and Quantitative Easing? Sorry you have not the faintest idea of what a market economy is. Have you ever left your desk and walked on Main-street?

James Jacoby: Are you basically saying that we should be preparing right now? That there would be a bursting of this massive credit bubble?

Jim Millstein: It's happening right in front of us. It may—It's happening right now.

My opinion: Yes! What can be done? Not a full plan, but here's a start:

1. Zero dividends, buy-backs and big bonuses, before banks have ten percent in capital against ALL assets.

2. Debt to equity conversion should be one of the most important resolution tools.

Female newsreader: In breaking news, a U.S. Federal Reserve has bailed out the Silicon Valley Bank, which had collapsed over the weekend.

Joe Biden: There are important questions of how these banks got into the circumstance in the first place.

My comment: SVB was holding a high number of Treasury and other government bonds — amounting to more than half of its assets. Mr. President dare to ask its regulators: How much capital/equity/skin-in-the game, did SVB's shareholders need to hold against that?

James Jacoby: How do you think we’ll look back at this era of easy money?

Steven Pearlstein: Unfortunately, I think we may look back on it as something of a golden era, because cheap and free money, without consequences, is great. But in other ways, we will think about it as a lesson for the future, which is that it was a mistake.

My comment: Yes, and those after us will recognize it as a violent violation of that social intergenerational contract Edmund Burke spoke about. 

Mohamed El-Erian: I think that we're going to look back on this era as being totally exceptional historically, and one where we didn't fulfill its potential. We lost sight of something critical: We lost sight of how we grow our economy in a sustainable and inclusive fashion.

My comment: Absolutely, and all because bank regulators focused solely on the safety of banks and totally ignored what their real purpose is; way more important than safe mattresses in which to stash away cash.

Christopher Leonard: When you have a society with the middle struggling and the rich realizing almost unimaginable gains, it starts to corrode the civic foundation. People start to feel like this cliche you hear all the time: that the system is rigged.

My comment: It is rigged. The more creditworthy have always paid lower risk adjusted interest rates than the less creditworthy, and that's as it should be. But credit risk weighted bank capital/equity requirements, have also decreed the less creditworthy to be less worthy of credit. And that's not how it should be.

Mohamed El-Erian: This is a political problem.

My comment: Absolutely. It was all about empowering a Bureaucracy Autocracy.

Bank capital requirements with decreed risk weights; 0% Federal Government – 100% We the People. What would America’s Founding Fathers have opined on that?

@PerKurowski In all this, where do I come from?

Can members of a mutual admiration club really tell each other the truth?

I refer to “The progress, pitfalls and persistent challenges of recent regulatory reform” by Sheila C. Bair, former FDIC Chair, and Ricardo R. Delfin, former Executive Director, Systemic Risk Council. It appears in “A force for good: how enlightened finance can restore faith in capitalism” edited by John G. Taft, 2015. 

I agree with many of the recommendations put forward, such as the need for less regulatory complexity, and of a system that could allow for the orderly liquidation of large complex financial institutions. 

But the authors also refer to “the Financial Stability Oversight Council (FSOC), an interagency body made up of the heads of the federal financial regulatory agencies, state regulatory representatives, an independent insurance representative and the head of the new Office of Financial Research. The FSCO is tasked with identifying potentially systemic risks…”

And here I must ask: Is FSCO structured in such a way as to be able to identify systemic risks arising from bad regulations?

Since the inception of the Basel Accord in 1988, the pillar of banking regulations has been credit-risk-weighted equity requirements for banks. These basically translate into offering banks better risk-adjusted returns on equity on what is perceived as safe, than on what is perceived as risky. By this the regulators approved to pay the managers of one of the societies most important retirement accounts, what is generated by means of bank credit, higher commissions for whatever returns coming from activities perceived as safe, or defined by regulators as safe, than from activities perceived as risky. That guarantees an excessive risk aversion that will lead to few jobs and very low retirement incomes for the whole of society.

And if that is not a monstrous systemic risk that has been embedded in current bank regulations what is? I doubt an FSCO, as just another member of the regulator’s mutual admiration club, can do anything about it.

But I might be wrong. Perhaps some “state regulatory representatives” will suddenly ask: Why on earth do our state chartered banks need to hold more equity when lending to our local SMEs and entrepreneurs than when lending to some distant borrowers?