Optimism? No! Use of credit risk weighted capital requirements for banks reflects a severe pessimism about the future

Had banks not held excessive financial exposures related to AAA rated securities backed with mortgages to the subprime sector, or to loans to sovereigns like Greece, the greatest bank crisis of our times would not have happened… and there can be no doubt about that.

Those excessive financial exposures, to assets that were ex ante perceived or deemed as safe, should have been an expected consequence of allowing banks to earn much much higher risk adjusted returns on equity on these assets, than what they could earn for instance on “risky” loans to SMEs and entrepreneurs.

That resulted from regulators allowing banks to hold much much less capital (equity) against “The Safe” than against “The Risky”; by which banks could leverage their equity many many times more with supposedly safe assets than with supposedly risky ones.

And the cost of the greatest bank crisis of our times is still underestimated and is still growing, because it does not include the cost of all those growth opportunities the world, as a consequence, missed and misses by not lending to “risky” SMEs and entrepreneurs.

Favoring with regulations what’s safe over what’s risky, something that also promotes inequality can only be the result of a deeply ingrained risk adverse pessimism. Therefore, while these faulty regulations are still in place, referring to a feeling of optimism about the future is a contradiction in terms.

The economy is, by going for the “safe” carbohydrates, growing obese. A muscular growth requires the intake of “risky” proteins.

Banks are no longer financing the riskier future they are just refinancing the safer past.

How come the Home of the Brave (and Europe) that became what it is because of its willingness to take risks, has accepted this senseless regulatory risk aversion?

Bank capital should cover unexpected losses but what is perceived as safe, has always a greater potential of delivering these than what is perceived as risky and therefore avoided.

How come those most guilty for the greatest bank crisis of our times have not been named, much less held accountable?

If the US stops distorting the allocation of bank credit to the real economy… does Europe dare to be left behind?

For 6.000 (out of 6.400) traditional US banks those that hold, effectively, zero trading assets or liabilities; no derivative positions other than interest rate swaps and foreign exchange derivatives; and whose total notional value of all their derivatives exposures - including cleared and non-cleared derivatives - is less than $3 billion...

Thomas M. Hoenig, the Vice Chairman of the FDIC is proposing the following:

“A bank should have a ratio of GAAP equity-to-assets of at least 10 percent. The substantial majority of [US] community banks already have equity-to-asset ratios of 10 percent or higher, and the number is in reach for those that do not.”

“Exempting traditional banks from all Basel capital standards and associated capital amount calculations and risk-weighted asset calculations.”

If approved, that would effectively mean the US begins to distance itself from the pillar of Basel Committees bank regulations, the credit-risk-weighted capital requirements.

Since those capital requirements odiously discriminate against the fair access to bank credit of borrowers deemed “risky”; and thereby distorts bank credit allocation, that would mean that most US banks would be able to return to real lending to the real economy.

Does Europe dare to be left behind in such development?

PS. Its about time the US suspended such regulatory discrimination, which should never have been allowed, according to the Equal Credit Opportunity Act (Regulation B)

If I were a Senator a Congressman or a Governor of a US state, here is what I would ask the Fed and the FDIC.

Why on earth can a state-chartered bank, or any other bank for that matter, operating in my state, be allowed to lend to well-rated corporations elsewhere, or to sovereign governments, holding less equity than when lending to our own local SMEs and entrepreneurs? 

I mean that does not sound right. That sounds like a regulatory tax on my “risky” borrowers, those who already get less credit and pay higher risk premiums, and a regulatory subsidy to strange “safe” borrowers, those who already get larger loans at cheaper rates.

If I were a bank regulator, the last thing I do, would be to regulate against the fair access to bank credit of "the risky" of my own hometown.

Scene 6 on the crazy reality lived while “Banking in times of the Basel Committee”

Jr. Credit Officer Martin: “But Sir, how can we put this 30 years, 11 percent, lousily awarded mortgage into a security that aspires an AAA rating?” 

Bank President Wally: “Easy, let me explain it to you Martin. To put a proper AAA quality mortgage, with a proper interest rate into that security, would be absolutely useless, as it would generate no profits for us. But, if we put that very bad mortgage you refer to in a security, and manage to get an AAA rating for it, then we can resell it as earning solely a six percent return… and that would mean an instant profit to be share among us all of $210.000. Irresistible eh?” 

Jr. Credit Officer Martin: “But Sir, would not the bankers find out how bad these AAA rated securities were?” 

Bank President Wally: “Dear Martin, when you are allowed, by your regulator, to leverage your equity more than 60 times, only because an AAA to AA rating is present, and which means that if you believe you can make a 1 percent margin means you expect a 60 percent return on your equity, you do not make a lot of questions. You see, if the ratings only go down to the range of A+ to A, then banks can only leverage those securities less than 25 times. Imagine from more than 60 to less than 25!...

In fact Martin, it is the European banks and our US investment banks who are demanding these AAA securities so much that frankly we have to cut corners… don’t forget that we are a service company… and we do what our clients wants us to do... hi-hi-hi!”

Scene 1

Scene 2

Scene 3

Scene 4

Scene 5

Reviving Economic Growth: A Cato Online Forum: My unsolicited opinion

Question: If you could wave a magic wand and make one or two policy or institutional changes to brighten the U.S. economy’s long-term growth prospects, what would you change and why?

My answer:

Anyone who thinks the US would have become what it is by allowing banks to earn much higher risk-adjusted returns on equity when financing what was perceived as absolutely safe than what was perceive as risky... raise his hand.

I say this because current credit-risk-weighted capital (equity) requirements for banks, allow banks to hold government debt and loans to the AAAristocracy against much less equity than when financing “risky” small businesses and entrepreneurs, and so that is de facto what you get.

And since risk taking is the essence of development, “the home of the brave” will go down if you continue to impose on your banks such regulatory risk-aversion.

Have you lately asked your friend the banker how much equity he needs to have in order to give a loan to an unrated fellow American citizen, compared to what he needs to have when lending to his government? Do that! And then you will begin to understand how much communism is creeping in on “the land of the free.”

You are already giving your banks a lot of support, so don’t also give them easy money allowing high returns leveraging on the safe… make them sweat their returns lending also to the risky... because that is how you build, or keep a nation great.

And so friends, if you want to have growth, get rid, urgently, of that distorting regulatory nonsense; which by the way does not make your banks safer, as never ever are major bank crisis the result of excessive exposures to what is perceived as risky… these always result from excessive exposure to something that was wrongly thought as absolutely safe.

Is America, the land of the brave living within the land of the sissy, or vice-versa?

I just finished seeing Zero Dark Thirty, which refers to all that US risk-taking needed in order to kill Osama Bin Laden, something quite compatible with the “land of the brave”. 

But then I compare that to all that sissy and dumb risk-aversion implicit in bank regulations which pay banks extra returns on equity, for lending to “The Infallible”, no matter how useless, and not when lending to “The Risky”, no matter how important, and I wonder how all that can coexist within one same country. There just has to be some immense disconnect. 

Is America, USA, the land of the brave living within the land of the sissy, or vice-versa?

Good morning, Your Honor. May I approach the bench, to do a sort of defense of Standard and Poor’s, pro bono?

There are many reports which indicate that the US department of justice is expected to file a civil lawsuit against Standard & Poor’s for the issuing of overly rosy credit ratings with respect of some collateralized debt obligations. 

If I was allowed to defend S&P, pro bono, without of course implying that any outright illegalities committed by it should not be punished, I would state the following: 

Your honor: Credit rating agencies have been around for a long time issuance opinions which are certainly quite often very wrong, by being very rosy or by painting a too dark picture. Doing the first investors and lenders might lose out in favor of borrowers, doing the latter borrowers might lose out in favor of investors or lenders. C’est la vie. 

But one thing I am absolutely sure of is that, had the bank regulators not assigned so much importance and so much credibility to some human fallible rating agencies, like by allowing banks to hold AAA to AA rated securities against only 1.6 percent in capital, and which translates into a mindboggling approved leverage of bank capital of 62.5 to 1 times, we would not be standing here. 

There would have not been the kind of pressures exerted on credit rating agencies to produce these AAA to AA ratings, and if produced there would not have been the same outrageous demand for these securities, and the consequences would not have been something to write home about. 

And so, if you ask me, the credit rating agencies broke the window, but the bank regulators, placed the stone in their hands. 

Your honor, in evidence of what I am saying I introduce here a letter I wrote in January 2003, and which was published by the Financial Times. It states: “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” 

Also, in April 2003, in a formal written statement delivered as an Executive Director of the World Bank I held: “Ages ago, when information was less available and moved at a slower pace, the market consisted of a myriad of individual agents acting on a limited information basis. Nowadays, when information is just too voluminous and fast to handle, market or authorities have decided to delegate the evaluation of it into the hands of much fewer players such as credit rating agencies. This will, almost by definition, introduce systemic risks in the market and we are already able to discern some of the victims, although they are just the tip of an iceberg.” 

And in May 2003 in an Op-Ed I also wrote “In a world that preaches the worth of the invisible hands of the market, with its millions of mini-regulators we find it so strange that the Basel Committee delegate, without any protest, so much responsibility in the hand of so very few and so very fallible credit rating agencies” 

Your honor, unfortunately the bank regulators did not want to listen, just as they still do not want to do. If you find Standard and Poor’s guilty of misdoings, something which you might do, I beg of you not to ignore those who unwittingly, but with extreme arrogance, set us up to all this disaster.

Members of the Basel Committee consider yourselves insulted and challenged

The Basel Committee of Banking Supervision, that extremely important global regulatory agency, instructed the credit rating agencies to set up their warnings sign of perceived risk of default, ordered the banks to follow these signs, and then proceeded to calibrate the capital requirements of banks as if the banks did not see them. Somewhat like setting up traffic-lights all over town and synchronizing them under the assumption that drivers are blind.

Of course, if the regulators wanted to calibrate adequately for the default risk of any bank exposure to any credit rating, they could only do so by taking into account how the banks would react to those credit ratings…as well as considering the banks’ relative exposure to the different credit ratings. If a bank lends only to triple-A rated clients then its systemic danger, is only represented by its triple-A rated clients.

Since perceived risk is cleared in the market through the interest rates charged, this has signified that the relative profitability for the banks of lending to what is perceived as not risky, like what has a triple-A rating, increased dramatically, while the relative profitability for the banks of lending to what is perceived as more risky, like unrated small business and entrepreneurs, decreased.

Knowing as we should know that no bank crisis has ever resulted from excessive lending to what is perceived risky and that they have all resulted from excessive investments to what is perceived ex-ante as not risky, applying the Basel Committee’s current regulatory paradigm of capital requirements based on risk results clearly in counterfactual and stupid regulations. Also, since the most important role of commercial banks is to help satisfy the financial needs of those who are perceived as more risky and have not yet access to the capital markets, the odious discrimination against these clients (who are already paying much higher interest rates into the capital of banks) is doubly stupid.

If by any chance the issue of regulating on climate change would fall in the lap of an entity like the Basel Committee… we would all be toast.

For over a decade, even as an Executive Director of the World Bank 2002-2004 and always under my own name and indicating my email, I have presented many arguments against the current central regulatory paradigm use by the Basel Committee, that of capital requirements based on perceived risk of default, and called it stupid, stupid, stupid!

And by the way, if the regulators absolutely have an existential need to calibrate for risks, what is so particularly risky with defaults? Is not the risk of not creating jobs or the risk of increased un-sustainability worse? Does not just to think of a world without defaults make you shiver?

Having said that, not once, in all these years, has anyone identified as having anything to do with the Basel Committee ever denied my accusations, presented any counter-argument, or shown the least willingness to discuss the issue. Is it not strange? Could it really be that little me is right and these so expert experts are so utterly wrong? I dare them to prove me wrong!

In October 2010, during the annual meetings of the International Monetary Fund I publicly asked “Right now, when a bank lends money to a small business or an entrepreneur it needs to put up 5 TIMES more capital than when lending to a triple-A rated clients. When is the IMF to speak out against such odious discrimination that affects development and job creation, for no good particular reason since bank and financial crisis have never occurred because of excessive investments or lending to clients perceived as risky?” Dominique Strauss-Kahn, IMF’s Managing Director, answered in no uncertain terms that “capital requirement discrimination has no reason to be”, and so it seems that there are also other who agree with that the Basel Committee stands there completely naked without a functional regulatory paradigm.

In this moment when an extremely serious financial crisis affects the world and when the Basel Committee is digging us even deeper in the hole they placed us in, would we all not feel more comfortable if the Basel Committee at least agreed to a public debate on what I criticize?

Therefore…members and professionals of the Basel Committee consider yourselves slapped on the face with a glove and dared to accept the challenge. Wear with dignity your cones of shame!

Want a more detailed explanation? Listen to this home made video
http://subprimeregulations.blogspot.com/2010/09/the-financial-crisis-simple-why-and.html

Per Kurowski   @Per Kurowski

PS. I appreciate any help I could get in provoking the Basel Committee to respond to this challenge

PS. Risk taking is the oxygen of any development. God Make Us Daring!

PS. Has the Basel Committee just suffered the Nut Island effect? 

PS. US Congress, what are you up to? Over 2.000 pages of financial reform and you do not even mention once the Basel Committee which has so messed up the capital requirements of your banks.

PS. A small numeric example: If banks were allowed to leverage only 12.5 to 1 when lending to triple-A rated clients, which is what they were allowed to leverage when lending to small businesses under Basel II, then if they made a .5% margin, they would obtain return on capital of 6.25% lending to AAAs, decent but nothing to write home about, less pay bonuses on. But since they were allowed to leverage 62.5 to 1 they could, with the same .5% margin then make a return of capital of 31.25%. No wonder banks stampeded wanting the AAAs!

PS. A visitor from outer space, observing that banks are required to have 8% of equity when lending to a small businesses, but zero% when lending to a triple-A rated sovereign as the US, would he be at fault thinking he had landed on a communistic planet? With such an arbitrary discrimination in favor of the public sector, do you really know the real market interest rates on public debt?

PS. Since I am no regulator, or a PhD with published research on the subject, here are some of my early opinions on these regulations, which should evidence that I am far from being  very few pieces just another Monday morning quarterback:

http://subprimeregulations.blogspot.com/
http://financefordevelopment.blogspot.com/
http://baselcommittee.blogspot.com/
http://teawithft.blogspot.com/search/label/subprime%20banking%20regulations
http://www.theaaa-bomb.blogspot.com/