Mark Carney: Would the Magna Carta include risk-weights like these: King John 0%, AAA-risktocracy 20% and Englishmen 100%?

With the Basel Accord of 1988 (signed one year before the Berlin wall fall) bank regulators assigned a 0% risk weight for loans to the sovereign and 100% to the private sector. Some years later, 2004, with Basel II, they reduced the risk-weight for loans to those in the private sector rated AAA to AA to 20%, and leaving the unrated with their 100%.

That introduced a considerable regulatory subsidy for the bank borrowings of the infallible sovereign (government bureaucrats) and for those of the private sector deemed almost infallible. And that taxed severely the fair access to bank credit, of those deemed as risky, like SMEs and entrepreneurs.

Reading Mark Carney’s interesting: “From Lincoln to Lothbury - Magna Carta and the Bank of England” I felt like asking him what he would think the Magna Carta would have to say about these risk-weights.

Scene 3 of the crazy reality lived while “Banking in times of the Basel Committee”

Jr. Credit Officer Martin: "Sir Bank President, do you not think that, no matter how safe it looks, this 100 million of exposure to Mr. Absolutely safe, must be a hundred times more risky for the bank, than all those half million exposures to the more risky, and from which we anyhow get much higher risk premiums?"

Bank President Wally: "Dear Martin, I know it sounds sort of crazy that the Basel Committee, in a portfolio invariant way, requires us to hold only a fraction of equity when lending to Mr. Absolutely safe, when compared to what we must have when lending to “The Risky”…. you might be right… but who are we to doubt those experts in the Basel Committee and the Financial Stability Board? 

Besides, as your mentor and friend, I strongly suggest you keep your concerns hushed up. As you surely must know much of the returns to our shareholders, and the size of our bonuses, depend on those ultralow equity requirements allowed when doing “ultra-safe” business."

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Bank regulators originated and institutionalized a “market imperfection”, causing less equality in opportunities

The OECD has just released: OECD Social, Employment and Migration Working Papers No. 163, titled “Trends in income inequality and its impact on economic growth”, authored by Federico Cingano. On page 9 it states the following:

“In presence of financial market imperfections, implying that the ability to invest of different individuals depends on their income or wealth level. If this is the case, poor individuals may not be able to afford worthwhile investments… In turn, under-investment by the poor implies that aggregate output would be lower than in the case of perfect financial markets (5). We will refer to this view, first formalized by Galor and Zeira (1993, 1998), as the “human capital accumulation” theory. (6)

(5) With perfect financial markets, all individuals would invest in the same (optimal) amount of capital, equalizing the marginal returns of investment to the interest rate. This occurs as complete markets allow poor individuals, whose initial wealth would not allow reaching the optimal amount of investment, to borrow from the rich (infra-marginal gains from trade). If, on the contrary, financial markets are not available, and the returns to individual investment projects are decreasing, under-investment by the poor implies that aggregate output would be lower, a loss which would in general increase in the degree of wealth heterogeneity (see e.g. Benabou, 1996; Aghion et al, 1999).

(6) Aghion and Bolton (1997) and Piketty (1997) explicitly modeled the supply side of the credit market, explaining imperfections based on moral-hazard (e.g. problems of input verifiability) or enforcement problems stemming from contract incompleteness (e.g. due to output verifiability). Moral-hazard would occur, for example, with limited liability (i.e. when a borrower's repayment to his lenders cannot be greater than his wealth); if the probability of success of the project depends on a (costly) effort exerted by the borrower, her incentives to exert efforts would be lower the larger the fraction of externally financed investment. Thus the interest rate on the loan will be an increasing function of its size (i.e. higher for the poorer).”

And that provides me with a new opportunity to try to draw the attention to how bank regulators, during the last couple of decades, have originated and institutionalized a truly odious and discriminatory capital market imperfection.

The Basel Committee for Banking Supervision imposed credit-risk-weighted capital (equity) requirements for banks which are much much lower for assets perceived as “absolutely safe” than for assets perceived as “risky”.

And, of course, what is perceived as “absolutely safe”, correlates much more with wealth than what is perceived as risky.

And, of course, what is perceived as “absolutely safe”, correlates much more with what already exists (history) than with the riskier future.

And that allows banks to make much much higher risk adjusted returns on equity when lending to those perceived as safe (like the "infallible sovereigns", the AAAristocracy and the housing sector) than what they can obtain when financing "the risky".

And, as a consequence, small businesses and entrepreneurs, those creators of jobs that will allow mortgages and utilities to be serviced, have no longer fair access to bank credit.

And, as a consequence banks, no longer finance the future, they mostly refinance the past.

And in short, that is how our economies are stalling, while inequality is growing.

“A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926

Should not the taxman also create incentives to avoid stupid risk-taking like the Basel Committee does?

The Basel Committee allows banks to earn much higher risk-adjusted returns on their equity when lending to “the infallible” than when lending to “the risky”. And that is done by means of the portfolio invariant bank equity requirements based on perceived credit risk. 

And seemingly most of the world, if it does not ignore that, finds that regulatory risk-aversion which I find so dangerous, to be a swell idea (at least those in FT).

Now if these anti-risk supporters truly believe in the powers of these incentives, why do they not propose their taxmen to design similar policies?

For instance they should propose that dividends and capital gains from investments in absolutely safe companies should be taxed at a higher rate than those deriving from investments in risky companies. That should do it, eh?

Paul Krugman, don’t be in such denial, if we are ever to get out of this depression, we must rid our banks of regulatory repression

On Sunday October 4, 2014 Paul Krugman writes in the International New York Times “Depression denial syndrome”, in relation to his favorite theme of lambasting those who cannot see what he can see, in this case Bill Gross, on that being in a “liquidity trap”, the world needs basically unlimited amounts of fiscal and monetary stimulus. 

Well if Krugman can so can I, and so let me lambast all those who like Krugman cannot see what I have seen, for soon two decades now, namely the odious regulatory repression which, by favoring the financing of the “infallible sovereigns’, the housing sector and the AAAristrocracy, keeps all those perceived ex ante as “The Risky” from having fair access to bank credit.

Krugman writes in an “economy awash in desired saving with no place to go… government borrowing doesn’t compete with private demand because the private sector doesn’t compete want to spend”. That proves he ignores, on purpose or unwittingly, the fact that banks need to hold much much more of that currently so scare bank capital (equity) when lending to The Infallible than when lending to medium and small businesses, entrepreneurs and start-ups.

In short, Paul Krugman, don’t be in such denial, if we are ever to get out of this depression, we must rid our banks of the regulatory repression imposed on them by unconscious regulators.

On the externalities of the Basel Committee´s bank regulations

Those perceived as belonging to The Infallible, like the sovereigns, the members of the AAAristocracy and the housing sector, benefit from very positive externalities derived from bank regulations, since because banks need to hold very little, almost no capital at all when lending to them, they get much larger loans at much lower rates.

Those perceived as belonging to The Risky, like medium and small businesses, entrepreneurs and startups, are hit with the costs of very negative externalities derived from bank regulations, since because banks need to hold much more capital when lending to them than when lending to the former, they need to make up for that competitive disadvantage when accessing bank credit, and so they get much smaller loans, at much higher rates, or no loans at all.

Those in society who are old, and whose only concern is the short term stability of the banks, in other words those who gladly sign up on the après nous le deluge objective, benefit from positive externalities, as short term, banks are expected to be safer.

Those in society who are young, and whose future wellbeing depends much on banks financing without distortions the real economy, so that the economy has a chance to grow sturdy and generate jobs, are hit with the costs of very negative externalities derived from bank regulations, because the differences in capital requirements based on credit risks alone, introduce a very dangerous and distortive risk aversion.

And we all suffer the very negative externality of having bank regulators who seemingly do not understand, and do not care one iota, about what externalities their regulations cause.

And in this respect we also suffer the externalities of a financial press much too much in awe of regulators so as to dare to call their bluff.

And in this respect we also suffer the externalities caused by political agendas that need to blame it all on the banks, markets and deregulations, and which cannot accept the possibility of regulators and bad regulations being responsible for the disasters.

The Basel Committee’s and the Financial Stability Board’s Credo

We believe that banks should give larger loans, on lower interest rates and on softer terms than usual, to those who are ex ante perceived as “absolutely safe”, like the infallible sovereigns and the AAA-ristocracy; and that they should give smaller loans, at higher interest rates and on harsher terms than usual, to those who are ex ante perceived as risky, like medium and small businesses, entrepreneurs and start-ups… so that we can go home and sleep calmly.

Since that could expose us to accusations of being discriminatory, we believe that the risk-weighted capital requirements for banks, by which we allow banks to earn higher risk-adjusted returns on equity when lending to the “absolutely safe” than when lending to “the risky”, is the least transparent and therefore the most effective regulatory pillar by which we can reach our objectives.

And, to those who might criticize us we say… we believe it is not our role to guarantee an efficient allocation of bank credit so that the economy grows sturdy and stays healthy… that is definitely somebody else’s business.

How come XXX, who graduated as a financial expert from YYY, did not know this?

Anyone with some basic financial knowledge must know that banks allocate their portfolio to what produces them the highest risk-adjusted return on their equity; and that constitutes in its turn the best possible (or least bad) way of allocating bank resources to the real economy.

What I cannot for my life figure out is how come a financial professional does not understand that if bank regulators allow banks to hold much less shareholder’s capital against some assets, for instance those perceived as “safe”, than against other assets, for instance those perceived as “risky”, then the banks will earn higher risk adjusted returns on “safe” assets than on “risky” assets, which will distort the allocation of bank credit, and guarantee that the banks will hold too much “safe” assets and too little “risky” assets.

And of course when banks hold “too much” of a “safe” asset, then that asset could turn into a very risky asset for the banks. This is by the way something empirically well established. Never ever has a major bank crisis resulted from excessive exposures to what was perceived ex ante as “risky”, these have all, no exceptions, resulted from excessive exposures to what was ex ante, erroneously perceived as safe... like AAA-rated securities, Greece, etc.

And of course holding “too little” of the “risky” assets, like of loans to medium and small businesses, entrepreneurs and start ups, is very bad for the real economy which thrives on risk-taking, and is therefore, in the medium term, something also very risky for the banks.

How come all those reputable tenured finance professors in so reputable universities did not care one iota about the allocation of bank credit in the real economy was being so completely distorted by the risk-weighted capital requirements for banks? 

If asked by Janet Yellen about risk-weighted bank capital requirements, how would Margaret Thatcher have answered?

Although I am sure Janet Yellen fulfills all the formal qualifications, I really do not know sufficient about her so as to be able to provide any credible input as to her chances of doing a good job as the new Chair of the Fed. What I am sure of though, is that Yellen will need to show a type of Margaret Thatcher type of character strength, if she is going to be able to stand a chance against what is to come.

And in this respect I would also have liked, if Janet Yellen had been able to pose the following question to Margaret Thatcher:

By requiring banks to hold much more capital against what is perceived as risky than against what is perceived as absolutely safe, banks earn higher risk-adjusted returns on equity when lending to The Infallible Sovereign and to the AAAristocracy than when lending to The Risky. This causes of course banks to lend less than what they would ordinarily do, and more expensively so, to all “risky” medium and small businesses, entrepreneurs and start ups. Margaret do you think this is sane? Do you think this makes our banks safer? Do you think this helps the economy to grow muscular and sturdy?

And though certainly uttered in some much better way than what my poor British English allows me, I can almost hear Margaret Thatcher answering something as follows:

“No Dear Janet, that is as insane as it comes. We the western world did not become what we are by foolishly telling risk-adverse bankers to avoid taking risks, or by allowing bankers to binge profitably on what we for now, in shortsighted blissful ignorance, believe to be absolutely safe.”

Europe’s unemployed youth, is a result of expulsing testosterone from its banking system. Is it accident or terrorism?

To call banks cuddling up excessively in loans to the Infallible Sovereign and the AAAristocracy, an excessive risk-taking which results from too high testosterone levels, is ludicrous. That is just cowardly hiding away, guided by computer models, in havens officially denominated as absolutely safe.

The risk-taking which requires true banking testosterone is the lending to medium and small businesses, entrepreneurs and start ups.

Unfortunately bank regulators, by means of allowing for far less capital when lending “to the safe than when lending to “the risky”, guaranteed that the expected risk-adjusted returns on bank equity when lending to the former were much much higher than when lending to the latter. 

And, as any economist knows, equity goes to where the highest returns are offered. And so bankers possessing true testosterone, were all made redundant. And since the safe jobs of tomorrow need the risk-taking of today, and “the risky” got and get no loans, the European youth ended up without jobs… or even the prospective of jobs.

I have always thought this regulatory calamity was an accident resulting from allowing some very few regulators to engage in intellectual incest, in some small mutual admiration club where it is prohibited by rules to call out any member as being at fault.

But now, since more than five years after the detonation of the bomb that was armed in 2004 with Basel II, the issue of the distortion these capital requirements produce in the allocation of bank credit in the real economy is not yet even discussed, reluctantly, because I am no conspirator theories freak, forces me to admit the possibility of terrorism.

And frankly what is the difference between injecting bankers with a testosterone killing virus, and doing so with a mumbo jumbo bank regulation no one really understands?

Poor European youth… they are not yet aware that unless they expulse the current bank regulators from the Basel Committee and the Financial Stability Board, for being dumb or terrorists, they live in an economy that is going down, down, down.

All dollars (or Pounds, or Euros) should be equal!

The efficient market hypothesis, and the capacity of free markets to allocate efficiently financial resources have, as a consequence of the recent financial crisis, been seriously questioned. There is absolutely no cause for that.

In a free market all dollars pursuing assets are equal, and so the prices reflect the markets appreciations of returns, risks, and other factors… and so in essence, all assets will produce equivalent all included risk-adjusted returns. Like any bet on the roulette.

But then came bank regulators, with their risk-weighted capital requirements, more risk more capital, less risk less capital, and determined that some dollars, those being lent to what was perceived as “absolutely safe” were worth much more because these could be leveraged by banks much much more, than the dollars lent to what was perceived as “risky”. Like doubling the roulette payout when playing it safe, like betting on a color.

And of course that made it impossible for the markets to function. It would be like pricing assets in dollars Euros and Pounds, simultaneously without informing the markets of which currency was used. In fact, since bank capital when in “risk-free” land could sometimes be leveraged about 40 times more than when in “risky” land, the currencies used are perhaps more like dollars, pesos and yen. 

And so a dollar going to someone “risky” is for the banks worth de facto much much less than a dollar going to the AAAristocracy. Talk about financial exclusion! Talk about increasing inequality gaps!

Discriminating against risk-taking, in the "Home of the Brave"... you´ve got to be kidding!

Please regulators, allow a dollar to be a dollar for everyone! So that markets will work again!

PS. By the way who authorized all that?

Why the Bank of England, BoE, like most other bank regulators, is pissing outside the pot.

I invite you to read the Bank of England publication “Bank capital and liquidity”

It states: “It is the role of bank prudential regulation to ensure the safety and soundness of banks, for example by ensuring that they have sufficient capital and liquidity resources to avoid a disruption to the critical services that banks provide to the economy.”

But, if that comes with avoiding that those in the real economy who most need and deserve access to bank credit, do not get it, only because they are perceived as more “risky”, then the regulators are most definitively pissing outside the pot.

The regulator divides here the balance sheet of the bank in 3 categories: Cash and Guilts, Safer loans, and Riskier loans.

If then, as they do, they allow banks to hold much much less capital against Guilts and Safer loans than against Riskier loans, that simply means that banks will be earning much much higher expected risk adjusted return on Guilts and Safer loans, that on Riskier loans.

And that means that “The Infallible” will have even more access to bank credits, which could turn these into risky, and make it very dangerous for the banks, while “The Risky” will get even less access to bank credit and make it very dangerous for the real economy.

“The Infallible” are the sovereigns, the housing sector and the AAAristocracy. “The Risky” are medium and small businesses, entrepreneurs and start-ups.

“The World Development Report 2014 - Risk and Opportunity”, seems to completely ignore what is dumb and dangerous with Basel Committee´s risk adverse bank regulations

In its introduction, Jim Yong Kim, the president of the World Bank, expresses his “hope that the WDR-2014 will lead to risk management policies that allow us to minimize the danger of future crisis and to seize every opportunity for development.”

Sir, though WDR 2014 will surely contribute importantly in many ways and in many areas, unfortunately, with respect to the "Financial Sector", it does little, or even nothing, to help to achieve those goals. This is so because it seems to completely ignore the absolutely mistaken principles of current bank regulations being disseminated around the world. With their dumb and dangerous risk-aversion, these regulations attempt directly against development and stability. More than manage risks, those regulations have generated enormous risks.

More than 10 years ago, April 2003, when commenting on The World Bank’s Strategic Framework 2004-06, in a written statement which I delivered as an Executive Director of the World Bank, I opined the following: 

"The Basel Committee dictates norms for the banking industry that might be of extreme importance for the world’s economic development. In its drive to impose more supervision and reduce vulnerabilities, 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. The World Bank seems to be the only suitable existing organization to assume such a role."

Unfortunately, the World Bank, or any other institution, did not assume such a role, and as a consequence we have landed ourselves with the most dumb and dangerous bank regulations possible.

Before explaining it, let me, just as a reference for why I deserve being listened to, point to a similar statement at the Board on October 19, 2004, and in which I so correctly and timely warned: 

“We believe that much of the world’s financial markets are currently being dangerously overstretched though an exaggerated reliance on intrinsically weak financial models that are based on very short series of statistical evidence and very doubtful volatility assumptions.”

The pillar of the Basel Committee’s bank regulations, is capital requirements for banks based on ex ante perceived risks of borrowers. These allow banks to hold much much less capital against assets perceived as “absolutely safe”, “The Infallible”, than against assets perceived as belonging to “The Risky”. A more capable regulator, would be much more concerned about what bankers do with the risks they perceive, and with what happens when those ex ante perceptions, turn out, ex post, to have been wrong.

And those risk-weighted capital requirements result directly in that banks are able to earn much much higher risk adjusted returns on equity, when lending to some sovereigns, housing or the AAArisktocracy, than when lending to the medium and small businesses, entrepreneurs and start-ups. Something like rewarding children with chocolate cake when they eat ice cream, and punishing them with spinach when they eat broccoli... and declaring being surprised when kids turn out obese. And it is all like drastically changing the payouts on roulette bets, and believing the game of roulette will remain the same. 

And since the assessments of safeness and riskiness were to be done by very few human fallible credit rating agencies, on January 2003, in a letter published in the Financial Times, I also warned:

"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." 

And so those regulations doomed of course the banks to, sooner or later, create excessive and dangerous bank exposures to something that would have erroneously been considered as “absolutely safe”; like AAA rated securities backed with lousily awarded mortgages to the subprime sector, banks in Ireland, real estate in Spain, and sovereigns, like Greece. And doomed the banks to have especially little capital when the biggest disasters struck. It even did the eurozone in. Just a little empirical research on what causes bank crises, would have concluded that... never ever, those ex ante perceived as risky.

And, of course, that also doomed those who though “risky”, are the true dynamos of the real economy, and the best possible creators of the next generation of sturdy jobs, and who are those most in need of bank credit, to have their competitive access to bank credit severely curtailed. And that has effectively placed the economy in a shutdown mode… and whatever movement we might detect in it, might have to do with the sad fact that it is heading down down, on a very slippery slope.

And this truly odious regulatory discrimination is only helping to increase the gap between the past, the developed, the haves, and the future, the developing, the have nots. In other words it excludes more than it includes. WDR-2014 writes: “All too often risk management strategies prove ineffective (or introduce other risks) because they are not coordinated among all relevant policy stake holders”. Indeed! And I ask… who consulted bank regulations with “The Risky” borrowers?

But not one word about all that in WDR-2014!

The WDR-2014 does state though: “Stability. The Achilles’ heel of the financial system is its propensity for crisis”. And that is wrong! Its Achilles’ heel is the propensity to try to delay the crises. May 2003, at the World Bank in a workshop on bank regulations, I told those present: 

“A regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises.” 

And the WDR-2014 does propose creating a "National Risk Board", "an integrated, permanent risk management agency that deals with multiple risks." That might have some advantages, but it also reminds me of why, in November 1999, I had to write in an Op Ed:

"The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause its total collapse"

Jim Yong Kim also writes: “This year’s WDR cautions that the greatest risk may be taking no risk at all”. And he is absolutely correct. But, unfortunately, the great institution he presides, the world’s premier development bank, seems not to fully understand that risk-taking is in fact the oxygen of development.

And, therefore, the World Bank has done nothing to stop the members of the Basel Committee, and of the Financial Stability Board, those who with so much hubris believe themselves capable of being the financial risk-managers of the world, from applying their so truly risky risk-adverse bank regulations.

Let me end by reminding you that these regulators, those who after the Basel II flop are still allowed to work on Basel III (neither Hollywood nor Bollywood would be so dumb), were the real enablers of our current bank crisis. If in doubt, just ask yourselves whether the market, in the absence of any bank regulations, would have allowed banks to leverage 50 to 1?

God make us daring! We need bankers capable of reasoned audacity! World Bank, step up to your duties!

Per Kurowski

PS. IMF is also completely disoriented by current bank regulations. They have for instance no idea of what would be the real market interest rates on public debt, for instance in the US, if banks needed to hold the same amount of capital against it, as they are required to hold against a loan to a citizen.

PS. I hear you. "Per, how can this be?" Well, Patrick Moynihan said “there are mistakes only PhDs can make; and George Orwell that “one has to belong to the intelligentsia to believe things like that: no ordinary man could be such a fool.” But I personally think, this is the typical thing to happen, when the wish of not criticizing colleagues in ones networks, crosses the path of those not wanting to admit they do not understand one thing of the mumbo jumbo that is being said.

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

We need “The Risky” to access bank credit, competitively, especially in bad times, as “The Infallible” alone cannot pull us out of anything

If a bank charges a 3 percent risk premium to set of small and medium businesses, entrepreneurs and start-ups borrowers, then it is reserving for sustaining losses of about 30 percent on 10 percent of these borrowers, something which, as bankers do not give loans were they think they are going to lose, is a hell of a great reserve.

But, the higher risk premiums paid by “The Risky” was something completely disregarded by the regulators when setting those capital requirements for banks based on perceived risk and that so much favor bank lending to “The Infallible”, in essence sovereigns, housing and the AAAristocracy.

You see, our current set of bank regulators, they do not care one iota about the fact that their capital requirements utterly distorts the allocation of bank credit in the real economy, and in which, it is really the access to bank credit of “The Risky”, in competitive terms, what most needs to be assured.

You see our current bank regulators care only about the banks, and that is why they are so damn bad bank regulators.

You see our current bank regulators are so scared shit about all ex ante “risk”, they fail to understand that, ex post, only “The Infallible” cause major bank disasters.

There is nothing as risky for the banks, and for us, as not taking a risk on “The Risky” of the real economy.

God make us daring!

Why is the President of the World Bank not informed about consequences of risk-weighted capital requirements for banks?

In Russia, September 6, 2013, Jim Yong Kim, the President of the World Bank Group, said the following in his statement issued at the end of the G20 summit.

“The G20 has pledged to achieve strong, sustainable, balanced and inclusive growth, and creating more and higher-quality jobs.”

Mr. Jim Yong Kim. As long as bank regulators allow banks to hold much much less capital when lending to "The Infallible", like some sovereigns, housing or the AAAristocracy; than what they are required to hold when lending to “The Risky”, like medium and small businesses, entrepreneurs and start-ups; and which means the banks will earn much much higher risk-adjusted returns on their equity when lending to the former than when lending to the latter... "strong, sustainable, balanced and inclusive growth" able to create more and higher-quality jobs” will just not happen. 

The odious and dangerous discrimination of "The Risky" does only increase, not reduce, the gap between those perceived as safe, the past, the developed, the haves, and those perceived as “risky”, the future, the developing, the have nots.

And the truly sad thing is that no one in the world’s premier development bank wants to inform its president about it.

Mr. Jim Yong Kim. I assure you, risk-taking is the oxygen of development. God make us daring!

Per Kurowski

A former Executive Director of the World Bank, 2002-2004

What if Mark Twain knew about the capital requirements for banks in Basel I, II and III, based on ex ante perceived risks?

If Mark Twain resurrected, and read about what our current bank regulator came up with, in terms of capital requirements based on perceived risk, which allow the banks to earn much much higher risk-adjusted returns on equity when lending to “The Infallible”, than when lending to “The Risky”, he would need to expand on his opinion on bankers, to something like what follows:

“A bank regulator is one who likes the banker to lend out the umbrella when the sun shines, even more than what a banker likes to do that, truly amazing; and one who wants the banker to take that umbrella back when there is the slightest indication it could rain, even faster than what the banker would like to do, equally truly amazing.”

David A. Stockman’s “The Great Deformation” did not include what is perhaps the greatest deformation.

David A. Stockman’s The Great Deformation is a truly great book, except for the fact that sadly it misses out on what in my mind constitutes the greatest deformation… namely allowing for much much lower capital (equity) requirements for banks on exposures that are considered as “absolutely safe”, than what they are required to hold for exposures considered as “risky”.

That allows the banks to grow so as to end up as Too Big To Fail, and to earn much higher risk-adjusted returns when lending to “The Infallible”, than when lending to “The Risky”.

And that distorts completely the way credit is allocated within the real economy, so that too much at too low interest rates of it goes to the "The Infallible", like the sovereign and the AAAristocracy (or AAArisktocracy) and too little to at too high interest to "The Risky", like medium and small businesses, entrepreneurs and star-ups.

And that effectively increases the de-facto risk-adverseness of banks, in the home of the brave, and in all other countries were these truly lamentable regulations are applied. And if that is not a deformation, what is?

Stockman does not mention that because of Basel II, approved in June 2004, and what SEC approved for US investment banks, April 2004, the European banks and the US investment banks could hold AAA rated securities, or lend against these securities, holding only 1.6 percent in capital, meaning leveraging their equity a mind-boggling 62.5 times to 1. 

And a result, though Stockman, in Chapter 20, “How the Fed brought the gambling mania to America’s neighborhoods”, explains splendidly the tragedy of how extremely bad mortgages were awarded to the subprime and other sectors in the US, and then packaged into dubious AAA rated securities sold all over the world, he misses out completely on the main reason for why the world demanded these securities and all other “supper-safies” so much, that it completely lost its common sense.

Let me assure everyone that if the banks had needed to hold the 8 percent they have to hold when lending to their “risky” citizen, then the current US subprime, Greek sovereign, Spanish real estate, Cyprus' banks, and similar tragedies, would not have happened. It is as easy as that… which of course does not make it any easier to swallow.

I hope that in the next edition of “The Great Deformation” David Stockman at least rewrites his chapter 20 so as to include these considerations. It would be a shame not to do so in such a good book.

And I need to repeat it again: A nation were banks need to hold 8 percent in capital when lending to the citizens, but are allowed to lend to their government against zero capital, is a deformed nation.

PS. The risk weights of 0% for the Sovereign, 20% for the AAArisktocracy and 100% for We the People, is anathema to America.

God make us daring!

Community bankers in order to defend themselves should start by defending their more typical borrowers.

There is no reason on earth why banks should need to hold larger capital requirements when lending to those perceived as “risky”, namely the medium and small businesses, the entrepreneurs and the start-ups, that when lending to “The Infallible”, the AAAristocracy. That only discriminates against the borrowers more typical of the community banks… which besides have never ever caused a major bank crisis. Only the false “absolutely safes” have.

Community bankers need to realize that no matter how much they might like low capital requirements, in the long run these, when based on risk perceptions, will always favor the larger banks, which have more readily access to the “absolutely safe”, or can more readily access the tools needed to construe “absolutely safe” images.

The condensed dark truth about the risk weighting in current Basel bank regulations

Before the current risk-weighted capital requirements for banks, the risk adjusted returns on bank equity were basically the same for all loans, and the ex ante perceived risk was cleared for in interest rates, amount of exposure, duration and other contractual terms.

But with the introduction of risk weighted capital requirements for banks, which re-cleared for the same ex ante perceived risk, in the way of less-risk much-less-capital, more-risk more-capital, the expected risk adjusted returns on bank equity are now much much higher when lending to “The Infallible” than when lending to “The Risky”.

And that results in that banks will lend, even more than usual, at even lower rates than usual, to sovereigns, housing and the AAAristocracy; and even less than usual, at even higher rates than usual, to medium and small businesses, the entrepreneurs and start-ups.

Of course there is an initial economic high when all that fresh bank credit flows to “The Infallible”, I call it economic froth, but, after that, the real economy will been going down, down, down, because, if “The Risky”, namely the medium and small businesses, the entrepreneurs and the start-ups, do not get access to credit in competitive terms, then there is nowhere else the real economy can head.

Mamma Mia! The Basel bank regulations are 180° wrong!

The Basel II roulette manipulation

Poor Pakistan! Another developing country being held back by the Basel Committee

I read that “In order to further strengthen the capital related rules the State Bank of Pakistan (SBP) has decided to implement the Basel III reforms issued by the Basel Committee on Banking Supervision”

It is impossible for me to understand how a developing nation can adopt a bank regulatory framework which has, as its prime pillar, capital requirements which favor bank lending to The Infallible those already favored from being perceived as absolutely safe, and discriminate against The Risky, those already being discriminated against because they are perceived as risky.

If a developed and rich country, like France, wants to call it quits and not risk anything more, and accepts Basel II or III, and decide to castrate their banks, although that will not serve their real economy well, or save them from bank crises, that is their business… but, Pakistan?

In 2007 at the High-level Dialogue on Financing for Developing at the United Nations, I presented a document in titled “Are bank regulations coming from Basel good for development?" Unfortunately it received no attention, as the discussions which followed there were basically only focused on promoting, not development, but political agendas.

And little has changed since those meetings. For instance, even Professor Joseph Stiglitz, who chaired the Commission of Experts of the President of the United Nations General Assembly on Reforms of the International Monetary and Financial System, and who recently published a thick book titled "The Price of Inequality: How Today’s Divided Society Endangers Our Future" has still not understood how the risk-weighting of the capital requirements odiously favors bank lending to “The Infallible”, the haves, the old, the past, the AAAristocracy, those already favored by banks and markets, and thereby discriminates against “The Risky”, the not haves, the young, the future, those already discriminated against by banks and markets.

Developing nations, you need all your banks to exercise reasoned audacity and not to just follow the risk aversion instructions given by some overly anxious and nervous nannies, who have not even defined the purpose of the banks they regulate.