Anat Admati explains the financial crisis better than most, but does still not get to the real heart of it.

I refer to Promarket.org and Evonomics.com where Stanford professor Anat Admati discusses her paper“It Takes a Village of Media, Business, Policy, and Academic Experts to Maintain a Dangerous Financial System” May 2016.

In it she explains how a mix of distorted incentives, ignorance, confusion, and lack of accountability contributes to the persistence of a dangerous and poorly regulated financial system.

Here some quotes and comments:

1. “Admati draws a contrast with aviation. Although tens of thousands of airplanes take off and land, often in crowded skies, busy airports, and within short time spans, crashes are remarkably rare. Everyone involved in aviation collaborates to maintain high safety standards”

PK. The main explanation for that is that everything in aviation is considered risky… and there are no aviation regulators giving anyone the excuse of “at this point you can relax”.

2. “When they seek profits banks effectively compete to endanger their depositors and the public. An analogy would be subsidizing trucks to drive at reckless speed even as slower driving would cause fewer accidents.”

PK. Of course allowing reckless speeds, like no limit at all when lending to Greece, and 62.5 times when AAA to AA ratings are present, must cause serious crashes.

But, the worst part of it all is that banks are not allowed to drive all assets at the same speed. As a consequence, being paid on delivery, banks will not go to where they must go slower, like the leverage speed limits that apply when lending to entrepreneurs, and will therefore not perform their vital function of allocating credit efficiently to the economy. The words “the purpose of banks is” are sadly nowhere to be seen in bank regulations.

3. “Politicians, find implicit guarantees attractive because they are an ‘invisible form of subsidy’ that appear free because they do not show up on budgets, as the costs associated are ultimately paid for by the citizenry.”

PK. At this moment the statist regulators and politicians find those “implicit guarantees” especially attractive because of its quid-pro-quo component. “We scratch your back with implicit guarantees and you scratch ours something for which we in 1988, with the Basel Accord assigned to the sovereign a 0% risk weight, and one of 100% to the citizen” And ever since the “good and friendly” sovereigns have had access to subsidized credit… and the regulators have now painted themselves into a corner. 

4. “Credit rating agencies, “private watchdogs,” have conflicted interests because they derive revenues from regulated companies as well as sometimes from regulators.”

PK. Yes but notwithstanding that, even if the credit rating agencies have behaved totally independent, there can be little doubt that assigning so much decision power to some few human fallible credit rating agencies would introduce the mother of all systemic risks.

And besides, since bankers already consider risks perceived when deciding on size of exposures and risk premiums to charge, to have perceived risks also reflected in the capital requirements, violates the “Kurowski dixit” rule: “Risks, even when perfectly perceived, leads to the wrong actions, if excessively considered.” 

5. “I had expected academics and policy makers to engage and care about whether what they were saying and doing was appropriate, particularly since they often know more than the public about the issues and are entrusted to protect the public”

PK. So had I. They, Anat Admati included, are still not able to explain to regulators about conditional probabilities. And so regulators keep on regulating based on the perceived risk of assets and not based on the risk of assets based on how these are perceived.

In terms of airplanes they regulate based on how the pilots perceive the risks and not based on that the pilots could perceive the wrong risks or act incorrectly when facing the correct risks.

6. “Lawmakers are rarely held accountable for the harmful effect of implicit guarantees combined with poor regulations.”

PK. Yes not one single regulators have been forced to parade down 5thAvenue wearing a dunce cap. On the contrary many of them have been promoted and are still regulating without even considering the possibility they have been mistaken all the time.

PS. Even though Daniel Moynihan is supposed to have opined: “There are some mistakes it takes a Ph.D. to make”, the challenges still remain for the PhDs about what to do with the opinions of the lowlier graduates, like with just an MBA. Do we dare to quote him?

Here my very early opinions on this issue

Here some letters Washington Post have published

And here my soon 2.800 letters to the Financial Times on this. Am I obsessed? Sure, but so are they ignoring my arguments.

And finally here a humble home-made youtube https://youtu.be/TUdKhm6_a8Y

Failed bank regulators cuddled up for comfort in the bosom of Her Majesty’s “Why did no one see this coming?”

IEA, I refer to your Discussion Paper No. 65 “Britain’s Baker’s dozen of disasters” and specifically No. 13 “2000-2008: The Gordon Brown bubble”

It starts by quoting HM The Queen at London School of Economics, November 2008 asking with respect to the financial crisis “Why did no one see this coming?”

What a marvelous question, for failed regulators. It allows all of them to hide as a group, avoiding thereby any personal responsibility.

But of course some of us saw it coming! 

In 1999 in an Op-Ed I wrote “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 collapse”

In January 2003, in a letter published in the Financial Times I 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 in October 2004, as an Executive Director of the World Bank I formally stated: “We believe that much of the world’s financial markets are currently being dangerously overstretched through an exaggerated reliance on intrinsically weak financial models that are based on very short series of statistical evidence and very doubtful volatility assumptions.”

In 1988, with the Basel Accord, Basel I, bank regulators set a zero percent risk weight for sovereigns and a 100 percent risk weight for the private sector. A zero risk weight for governments that in your face set inflation targets that mean you will be repaid with less worth money, or that mention that in need they will have to raise taxes, is truly a surreal concept. With it, obviously statist regulators implicitly told the world that government bureaucrats make more efficient use of bank credit than the private sector.

And in June 2004, with Basel II, they introduced different risk weights for the private sector. These were 20, 50, 100 and 150 percent, depending on the credit rating. Since the basic capital requirement was 8 percent, that meant that in order to buy a $100 asset, banks had to put down $1.6, $4, $8 or $12 of their own capital, depending on the credit rating.

The fundamental errors committed by the regulators were/are mind-blowing.

Bank capital is to cover for unexpected losses and they designed the capital requirements based on the perceived credit risk losses that were already being cleared for by the banks by mean of risk premiums and size of exposures. 

That caused a double consideration of ex ante perceived credit risk and any risk, even if perfectly perceived, results in wrong actions if excessively considered.

It also ignored the simple fact that the safer something is perceived, by definition, the larger is its potential to deliver an unexpected shock.

In fact regulators regulated the banks without even defining the purpose of the banks, like that of allocating bank credit efficiently to the real economy.

And so that allowed banks to leverage much more their equity on assets perceived as safe than on assets perceived as risky; which allowed banks to earn much higher risk adjusted returns on equity on assets perceived as safe, or made to be perceived as safe, than on assets perceived as risky, like lending to small business and entrepreneurs. And that of course distorted the allocation of bank credit to the real economy. 

It caused the creation of dangerous excessive exposures to something ex ante perceived as safe but that ex post turn out risky, precisely the stuff major bank crises are made of: like AAA rated securities and Greece. This time aggravated by the fact that since the assets were perceived as safe, banks needed to hold very little capital. 

And it introduced a credit risk aversion that impedes our banks to help us live up to our commitment towards the next generations. Risk taking is the oxygen of any development. Without it the economy stalls and falls.

And the distortion this portfolio invariant credit-risk weighted capital requirements produces in the allocation of bank credit, is an issue that is not yet even discussed. The regulators are trying to hide their mistake imposing a not risk weighted leverage ratio but, by still keeping the risk weighted part, the distortion are well alive and kicking. If only in their stress testing of banks they would also look at what is not on the balance sheets but should be there. 

Why do nations fail? When they care more about what they already have than about what they can get! God make us daring!

And no one of the regulators responsible for the mess seems to have been held accountable… in fact most of them seem to have been promoted.

The importance of being ignored… by for instance the Basel Committee, the IMF and the Financial Times

The pillar of current bank regulations is risk weighted capital requirements for banks; or more exactly portfolio invariant credit risk-weighted equity requirements for banks. It signifies banks are allowed to hold much less equity against assets perceived as safe, than against assets perceived as risky.

Though intuitively it might sound extremely correct, it is extremely flawed, primarily for three reasons:

First, it just doesn’t make any sense from the perspective of making the banking system safe, since all major bank crises have resulted from excessive exposure to something perceived as safe but that ex post turned out not to be; and none from excessive exposures to something ex ante perceived as risky.

Second, allowing banks to leverage their equity, and the support the society lends them, differently, depending on perceived credit risk already cleared for by other means, introduces a tremendous distortion in the allocation of bank credit to the real economy.

Third, by discriminating the access to bank credit against those who by being perceived as risky are already naturally discriminated against, it kills equal opportunities and thereby fosters inequality.

I have voiced my furious objections to that regulation, for way over a decade, to no avail.

The indifference with which my arguments have been met, by the Basel Committee, the Financial Stability Board, the IMF, the Fed, the Bank of England and all other institutions related to bank regulations; plus that of medias such as the Financial Times, has undoubtedly been a source of frustration. And worst has it been when I am told that my questioning is obsessive, something which I have never negated, but when I have always felt that the way they have ignored this issue shows even more obsessiveness.

But, little by little, I have started to appreciate the fact that being ignored, has added a much more important aspect to my criticism. Had regulators accepted and corrected for their mistakes immediately, that would have undoubtedly been good. But at the same time that would also perhaps have shed less light on the importance issue of how little contestability and accountability there exists in institutions ruled by a self-appointed technocrats.

And so, when the world wakes up to the horrendous implications of this regulatory risk aversion, it might hopefully also be able to wake up and correct for the horrible regulatory procedures... and for the sort of bias in favor of regulators that many in the media show.

Then perhaps the SMEs and entrepreneurs could get a real hearing about their difficulties to access bank credit in Basel, in Davos or in Washington during the Spring or Annual Meetings of the IMF and the World Bank. 

When will regulators ever learn? The risks to banks are not the same as the risks banks pose to us.

Banks need to perceive the risks of their assets, and to manage these correctly. And, if they are unable to do so, then it is good riddance.

We instead need for banks to perceive their risks and manage these sufficiently well, so that to avoid major overspills to us by having to pay for bailouts or other means; and also, primarily, we need them to allocate their credit efficiently to the real economy.

Unfortunately, current regulators, with their credit-risk weighted equity requirements for banks, focus mainly on the risks of the assets of banks, acting as if they were bankers, and are therefore not regulating on behalf of our needs and interests.

Bankers love it, no doubt about it. As a result they earn higher risk-adjusted returns on their equity on what is perceived as safe than on what is perceived as risky. It is banker’s dream come true.

And in this respect we can say the current score is “Banker’s needs 2 – Our needs 0”

When will we as a society show sufficient character and responsibility to stand up to the “experts" in the Basel Committee, and in the Financial Stability Board, so as to hold them really accountable?