Basel Committee and other bank regulators beware, there's "A hole in the bucket."

To understand what bank regulators have been doing, ever since the 2008 Global Financial Crisis made them aware everything with their risk weighted bank capital requirements was all not fine and dandy, there's nothing like listening to Odetta & Harry Belafonte singing.

The hole was caused by current bank capital/equity requirements, when based on that what’s perceived as risky is more dangerous to bank systems than what’s perceived as safe.

https://teawithft.blogspot.com/2021/05/the-parable-of-talents-is-currently.html

https://teawithft.blogspot.com/2012/10/theres-hole-in-bank-bucket-dear-andy.html

The Bank of England’s Museum’ explanation of “credit risk” keeps mum on how BoE, as a regulator, helped to mess it all up

Yesterday I visited the Bank of England’s Museum, and there I read the following on "What is credit risk?":

“Banks have ways of reducing credit risk. When you apply for a loan, the lender will look at what’s known as the five C’s: credit history, capacity, collateral, capital and conditions.

Credit history, also known as character, is basically your track record for repaying debts.

Capacity refers to your ability to repay a loan by looking at your job stability and your debt compared to your income, known as the debt-to-income ratio.

If you can’t pay back your secured loan, the lender will seize an asset such as your house or car as collateral.

Would you still be able to pay your loan if you lost your job? To know, the lender looks at any savings, investments and other assets you might own to determine how much capital you have.

Finally, the purpose – or conditions – of the loan can affect whether someone wants to lend you money or not.

The bank’s assessment determines how much interest they’ll charge you. If you are seen as a risky customer, for example by having a bad credit history, your loan will be more expensive.”

Yes that belongs in a museum!

That is how it used to be, before 1988, before overly creative and full of hubris regulators ,with Basel I, imposed risk weighted capital requirements on banks.

After that, and especially after 2004 Basel II, the banks must also consider how much capital (equity) the regulators require it to have against that loan... as that will determine their final risk adjusted expected return on equity.

I did not find a single word in the BoE museum about how these risk weighted capital requirements for banks distort the allocation of bank credit to the real economy.

I did not find a single word in the BoE museum about the fact that absolutely all assets that caused the 2007/08 crisis, had one single thing in common, namely very low capital requirements, that because these assets were perceived (residential mortgages), decreed (sovereigns) or concocted (AAA rated securities) as very safe. 

I can only conclude that the Bank of England is engaging in covering up their own fatal mistakes. Let us pray that at least internally they admit and learn from these.

I saw there that Bank of England is also presenting itself as the “Knowledge Bank”. When in 2002-04, as an Executive Director of the World Bank, I heard the same promo I begged WB to try being a “Wisdom Bank” instead, or at least a “Common Sense” bank.

PS. There was also a video at the museum that explained the vital role of the banks. It stated:

“Banks need to manage risks, and they monitor their lending carefully, spreading the risk among many loans to different sectors.”

Yes that also belongs in a museum!

That is how a portfolio should be managed… but the risk weighted capital requirements for banks were explicitly made “portfolio invariant” because to have these being “portfolio variant” presented too many complications for the regulator.

“Banks need enough capital to provide a strong basis for their lending in case things go wrong.” 

Indeed but the question remains when does a bank need the most of capital, when something ex ante perceived as risky, ex post turns up as even more risky; or when something ex ante perceived as safe, ex post turns up risky?

Charles Goodhart also pointed out the stupidity of risk weighted capital requirements for banks based on ex ante perceived risks… also with no luck!

In the very last page (540) of Charles Goodhart’s “The Basel Committee on Banking Supervision: A history of the Early Years, 1947-1997” of 2011 we read the following:

“Capital is supposed to be a buffer against unexpected loss: In so far as capital is required against unexpected loss, since expected loss should be handled by appropriate interest margins, the use of credit ratings as a guide to risk weights for capital adequacy requirements (CARs) is wrong and inconsistent, since these give a measure of expected loss. What is needed instead is a measure of the uncertainty of such losses, the second moment rather than the first.

If capital risk weights had been based, as they should logically have been, on the uncertainty attending future losses, rather than their expected modal performance, the financial system might have avoided much of the worst disasters of the 2007/08 financial crisis.

It remains surprisingly difficult to persuade regulators of this simple point.”

But to that Goodhart adds “It does however, get recognized from time to time”… though the examples he then indicates, are not so clear.

In the Epilogue (page 581) Goodhart list some of the failings of the BCBS’s regulations:

1. The lack of any theoretical basis.

2. The focus on the individual institution, rather that the system

3. The failure to reach an accord on liquidity;

4. The lack of empirical analysis;

5. The unwillingness to discuss either sanctions or crisis resolution, and so on.

That clearly adds up to a total regulatory failure... no wonder they don't want to discuss sanctions. 

But, unfortunately as I see it, Charles Goodhart, though absolutely right, is only scratching the surface. What is most dangerously ignored are the distortions in the allocation of bank credit to the real economy that these risk weighted capital requirements for banks cause.

Here is my own, also ignored, current brief aide memoire on the major mistakes with the risk weighted capital requirements

10 years after, the problem is not that some are forgetting bank regulations, but that most never learned about these.

1. Allowing banks to leverage their equity more with The Safe, like with Sovereigns and AAA rated, than with The Risky, like with SMEs, allows banks to earn higher risk-adjusted returns on their equity with The Safe than with The Risky. 

2. That distorts the allocation of bank credit to the real economy causing banks to lend too much to The Safe and too little to The Risky.

3. And all for nothing because all major bank crisis have resulted from excessive exposures to what was perceived as belonging to The Safe, and never ever from exposures to something perceived as belonging to The Risky when placed on bank's balance sheets. 

Since risk weighted capital requirements for banks are still used, we are still on the same route to new similar failures.

 

Here is much more on this

My voice and noise on the regulatory reform of banks

As I am just a citizen working on his own I would appreciate any comment or editing suggestion and which you can send to my email perkurowski@gmail.com

My voice and noise on the regulatory reform of banks

Introduction

It is we the people who are supposed to be able to invest our savings in low-risk-operations. It is them the bankers, those who are supposed to be the professionals, whom we should count on to identify those risky risk-taking entrepreneurs most capable of restoring fiscally sustainable growth and create decent jobs, and then take the risk of lending to them.

Why then has the regulator been so set on having the banks avoiding ordinary banking risks, and have instead create incentives for our banks to finance those already rated AAA and who should not even need the help of a bank? In truth, the AAAs should be the almost exclusive territory of widows and orphans.
The bank regulatory framework which emanated from Basel and which promoted a highly imprudent risk-aversion in our banks, instead of a prudent risk-taking, represents a failure of immense proportions and it needs to be stopped, right now.

The following are some suggestions on that route and I call on anyone who knows the value of living in a “land of braves” to help to stop the arbitrary taxes on risks imposed on our banks by the Basel wimps.

We should temporarily lower the capital requirements for what is perceived as high risk.

The first, and basically only pillar of the Basel regulations, the minimum capital requirements, establishes that when a bank has an asset that carries an AAA rating it is required to hold 1.6 percent equity while, if it lends to an unrated entrepreneur it needs 8 percent. The difference of 6.4 percent, especially when bank equity is scarce and expensive, represents effectively a high and totally arbitrary regulatory tax on perceived risk; and which has to be added on to what the market already charges in premiums for risk.
Therefore and while we are increasing the extraordinary low capital requirements for the “low-risk” operations, which have proven to be so dangerous, we must, in order to avoid that "high-risk" borrowers are unduly crowded out from bank lending, substantially reduce the capital requirements for all those operations that are deemed more risky, in essence those rated BB+ or below. As an initial level I suggest 4 percent.This is real counter-cyclicality.

Once the banks have achieved a level of 4 percent (tier-one) capital for all of their assets (including government) and once out of the woods of this crisis, we must rebuild the capital base of the banks to a level ranging between 8 and 12 percent, for all assets, government included, cash excepted, a level that could fluctuate depending on where we find ourselves in the economic cycle.

Can the banks currently handle a 4 percent in capital requirements when lending to a risky entrepreneur? Yes, I am absolutely sure that a shell-shocked banking sector will behave prudently with what is perceived as “high-risk”. In fact since what normally produces certain carelessness are those loans and investments perceived as being less-risky, one could build a case for arguing that it is the “lower-risks” that should have higher capital requirements.

Since I am aware that the above sounds somewhat strange in the midst of the knee-jerk rule tightening reactions that a crisis always produces let me remind you that the first wave of bank losses sustained in this crisis from lending or investing in what required 8 percent of capital were only a fraction of those first wave losses sustained in “safe” 1.6 percent endeavors.

By the way, arguing in the first place that the losses that arose in connections to the safest assets, houses and mortgages, in the safest of the countries, the USA; and in the safest instruments, rated AAA, has anything to do with excessive risk-taking, seems to me somehow to include a dose of intellectual dishonesty.

Suppose a person entered a modern building and took an elevator that was supposed to be duly checked and then died in an accident because some inspectors did not do their job… would you call that excessive risk-taking? Of course not!

Purpose of the banks

The 347 pages of Basel II regulations contains not one single phrase, much less a paragraph that has anything to do with establishing the purpose of our banks.

Therefore we must require from the bank regulators to define the purpose for our banks, because without doing so, how can they regulate and how can we be sure they are taking the banks to where we want them to go? Let me below give you a hint

What’s in it for humanity for the banks to finance the AAA rated? Nothing! The real or fake AAAs are already more than strong enough, and so who we really need for our banks to support are those with BB+ or below ratings in order for these to have the chance of becoming the real AAAs of tomorrow. What the banks are supposed to do is to help society to evaluate the BB+ or below rated in order to generate new winners, while creating the lowest possible contingency risks for having to bail out the depositors if the banks fail in their mission.

Governments

Currently when a bank lends or invests in paper of the government there are no capital requirements. This amounts to an outright discrimination in favor of the government and against the citizen. I do not see how see how this could have been in the minds of any founding fathers.

Over a period of time we should reach a point where the capital requirements for banks when lending to the government, are the same to those when lending to an ordinary unrated citizen.

Credit rating agencies.

In January 2003 the Financial Times published a letter I wrote that included
“Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds”

And of course if we insist on blindly following the opinions of the credit rating agencies, as has been the case, we are sooner or later doomed to be back to the point where this crisis started.

But, what need is there to have the credit rating agencies pointing out the directions with 100 percent accuracy, if we should not be going to the place we are going? None! We cannot afford to channel scarce funds, by means of very low capital requirements for what is perceived as “low-risk”… into financing something, if that something is useless… like perhaps building a huge inventory of coffins. at zero percent interest rates.

And so, referring to the previous point, we should not waste a single second by reforming the credit rating agencies, when by reforming what really needs to be reformed, namely eliminating the regulations that discriminate based on risk of defaults, the problem of humanly faulty credit rating agencies will be solved on its own.

"Too big to fail."

In February 2000, in the Daily Journal of Caracas, in an article title “Kafka and global banking” I wrote:

"… thank God we still have several banks to work with". Imagine if we would have had to discuss the issue with an official of the One and Only World Bank (OOWB). Without a doubt this would present us with a future full of horrendous Kafkaesque possibilities. With every day that passes we have fewer and fewer banking institutions worldwide with which to work. This trend has been marketed as one of the seven wonders of globalization.”

Also in May 2003 in a risk management workshop for regulators at the World Bank I held:

“There is a thesis that holds that the old agricultural traditions of burning a little each year, thereby getting rid of some of the combustible materials, was much wiser than today’s no burning at all, that only allows for the buildup of more incendiary materials, thereby guaranteeing disaster and scorched earth, when fire finally breaks out, as it does, sooner or later.

Therefore 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.

Knowing that the larger they are, the harder they fall, if I were regulator, I would be thinking about a progressive tax on size.”

But, having said all that, I equally believe firmly in that we are not well served by rushing to solve this particular problem, especially while we have much more urgent matters at hand, such as getting out of the woods.

And neither should we break up large banks while we still have regulations in place that breed and support large banks… does that not seem logical?

If there is one alternative that should definitely be explored is that of using a Non Operating Holding Company (NOHC) under which to separate the different activities of the typical huge bank of today and which I have seen proposed by OECD in their "The Financial Crisis: Reform and Exit Stategies". I find this route to be a very sensible and not too traumatic alternative and, if it would prove not to be working, we would at least already have it cut up in more digestible pieces.

Therefore my suggestion on the "Too Big To Fail" issue would be to give the largest banks some basic separation guidelines and ask them to come back for a proposal on how they would wish to set up their NOHC, if so required, and then take it from there.

On derivatives

Just get a central clearing house for anything that seems to taking on the form of a mass market and let all the rest be, stating of course, very loud and very clear, your caveat emptor and your caveat venditor.
Derivatives which cover real original risks are never as dangerous as derivatives designed to exploit arbitrary differences of a regulatory system.

The reason is that in real derivatives, for each seller taking the risk of being a seller, you always find a buyer taking the same sized opposite risk as a buyer… and all they have to do is being sure that the other counterpart has the means to pay out if he has to.

But, when derivatives are entered into in order to exploit a regulatory arbitrage, you find sellers and buyers more like partners eagerly sharing a free prize, and which often means they will let down their guards somewhat on each other´s respective counterparty risk.

Example: If a bank has an exposure to a an A- client then it needs a 4 percent equity but if it bought a CDS from a AAA rated insurance company (AIG) then it can get away with only 1.6 percent of capital. The saved difference of the costs of 2.4 percent of expensive bank equity, and which of course has nothing to do with real risks, can then be shared between a bank and an AIG.

When and if, as is here proposed, one eliminates the differences in capital requirements for banks based on risk, there are no longer incentives for this type of bastard derivatives…problem solved!

Systemic Risk

How are those who came up with the minimum capital requirements and enforced the use of credit rating, and thereby introduced so much systemic risk in the financial system, now going to control for systemic risk? They now mostly take systemic risk means to be institutions that are so large and important so as to create a risk for the system… that is just one of many systemic risks.

Bailouts

One thing is to bail out depositors for some fixed amount. But to think about the possibility of bailing out institutions because they might constitute a systemic risk is a totally different ballgame. That could be an open checkbook to disaster. As a government you should never want to have a pre-authorization to bailout a financial institution because then you are supposed to do so, or at least it is harder to say no.

We must measure and act during the full cycle.

If we are going to get the best out of our banks we have to stop measuring them only at their worst. We need to look at the full boom bust cycle since there are some busts where all the pains of a crisis are more than compensated with all achieved during the preceding boom, while at the same time there could also be booms that are so unproductive booms that no lack of a crisis pays for them.

Final Note:

I have been a financial advisor all my life never a regulator but when I started hearing about what the Basel Committee was up to I had to raise my voice. The surprise of my life is that still, two years into the crisis, the issue of the dangerous arbitrary risk aversion the Basel regulations were introducing in our financial system is not yet even discussed

Here is the link to the very first article I wrote on the subject in 1997
http://subprimeregulations.blogspot.com/1997/06/puritanism-in-banking.html

If you want to see more you can find it in: http://www.subprimeregulations.blogspot.com/
or in http://financefordevelopment.blogspot.com/
and in the more than 330 letters that I sent to the Financial Times on this issue and that can all be found in http://teawithft.blogspot.com/ searching under the label of subprime banking regulations.

And you can also find a fun conspiracy theory of it all in: http://www.theaaa-bomb.blogspot.com/

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