A tweet thread on rational and irrational expectations

Rational expectations of something being risky, simply makes most stay away from it.

Irrational expectations of something being risky, though certainly not presenting a danger to our bank systems, might sadly means lost opportunities to grow the real economy.

Rational expectations of something being safe, does of course not hurt the economy nor the banking system.

Irrational expectations of something being safe can easily bring down our bank system, and our real economy with it.

But with their risk weighted capital bank requirements, much lower for what was perceived ex ante as safe, than for what was perceived as risky, the Basel Committee bank regulators, de facto, irrationally based it all on rational expectations.

http://subprimeregulations.blogspot.com/2018/08/risk-weighted-capital-requirements-for.html

PS. A tweet on tail risks

Did regulators, when developing the fundamentally wrong risk weighted capital requirements for banks, suffer some kind of “perception controlled hallucination” or any other psychological disorder?

In 1988, with the Basel Accord, Basel I, the Basel Committee for Banking Supervision introduced the use of risk-weighted capital requirements for banks. That scheme was further much expanded in 2004 with Basel II.

In essence that meant that banks had to hold more capital against what is (ex ante) perceived as risky than against what is perceived as safe. 

The stated goal of this regulation, was and is to avoid the failure of banks that can put the economy in jeopardy and that could cause big loses for depositors or big costs for tax payers derived from official rescue interventions.

Nothing wrong with that intention, except for what they did and what they ignored when developing these risk-weighted capital requirements.

What did they do? 

They looked at the risk of the assets just like bankers do, and not at the risk that bankers might be perceiving the risks wrong, or acting wrongly to risks well perceived. 

What’s the worst case scenario about risks perceived wrong? Clearly that something ex ante perceived as very safe turns out ex post as very risky. The opposite, something perceived as very risky turning out very safe should obviously not bother anyone… except of course the borrower who had to pay too high risk premiums.

What did they ignore? 

First that all major bank crises have resulted from, criminal behavior, unexpected events or excessive exposures to something ex ante perceived as safe but that ex post turned out to be very risky. “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain.” Mark Twain. The mistake can perhaps be illustrated by the fact that regulators, in their standardized risk weights of 2004, assigned a 150% to the below BB- rated, that which bankers won’t touch with a teen feet pole, but a meager 20% to what is AAA to AA rated.

Second, that these risk weighted capital requirements, which allowed banks to leverage more with what was perceived safe, would have banks earning higher expected risk adjusted returns with what was perceived safe, which would naturally increase the risk of some perceived safe havens become dangerously overpopulated, against especially little capital. In a Roulette in a casino,  2 to 1 and 36 to 1 are equivalent winnings paid out to those playing it “safe” on color or those playing it “risky” on a number. If the winning for those same bets were for example 3 to 1 and 30 to 1, that would break the bank and sink the casino.

Third, that the real economy, in order to move forward depends much on risky entrepreneurs and small and medium enterprises (SMEs) having access to bank credit. “A ship in harbor is safe, but that is not what ships are for.” John A Shedd.

I do not think it is prudent to distort the allocation of bank credit to the real economy, so I would favor one single capital requirement against all assets, but if I absolutely had to distort in this way, then my risk weighting would have to be 180 degrees in the opposite direction, higher perceived risk-lower capital, lower perceived risk-higher capital. 

It was 30 years when this monumental mistake was initiated, and for all practical purposes it is not yet even discussed… so the stickiness of that mistake has proven to be equally monumental.

Friends, is it something in “Predictive Processing” that could explain this so fundamental mistake in our current bank regulation, and its stickiness?

And more importantly still, in what way can “Predictive Processing” help us to avoid this type of extremely costly mistakes.

Here a brief aide memoire on the major mistakes with the risk weighted capital requirements

@PerKurowski

Economist Andrew Haldane. At least when acting as a bank regulator, you are admitting the wrong error you committed

Chief economist of Bank of England Andrew Haldane says “his profession must adapt to regain the trust of the public, claiming narrow models ignored ‘irrational behaviour’” “Chief economist of Bank of England admits errors in Brexit forecasting” The Guardian, January 5, 2017.

Hold it Mr Haldane! What you and other economists ignored. when acting as regulators, was that banks would, as always, behave perfectly rational, and lend to what they expected would yield them the highest risk adjusted returns on equity.

That is what you failed to understand when allowing banks to hold less capital against what was perceived, decreed or concocted as safe. That meant banks could leverage more, and so earn higher expected risk adjusted returns on equity, when lending to the “safe”. 

That distortion in the allocation of bank credit to the real economy, resulted in that banks end up lending too much at too low interest rates to the “safe”… which could be risky for the banks; and to little and too expensive to “risky” SMEs and entrepreneurs which is very dangerous for the economy.

Come on Mr. Haldane I dare you to answer the following verybasic questions.

Regulatory risk-weights: The sovereign = Zero percent and We the (risky) People = 100%. In America?

I am not an American, and I am not well versed on its Constitution,  but there's one issue which has for a long time been a mystery to me. 

How on earth could America, in 1988, as a signatory of the Basel Accord, accept that for the purpose of setting capital requirements for banks, the risk-weight for the sovereign, meaning the government, was going to be zero percent, while the risk-weight for the citizen, meaning We The People was set at 100%; and all without a major discussion?

I know that “sovereigns” currently means the government but, from reading for instance Randy E. Barnett’s “Our Republican Constitution”, one could have expected some debate about something that is akin to risk weighing the King with an "infallible" 0%, and his subservients with a "risky" 100%.

Barnett's book states that Justice James Wilson, in the Chisholm v. Georgia case of 1793, opined that “To the Constitution of the United States the term Sovereign is totally unknown…and if the term sovereign is to be used at all, it should refer to the individual people”. And the book also frequently refers to the importance of the required consent of the people, which of course is also a thorny issue. 

And, since those risk-weights effectively permit banks to leverage their equity much more when lending to the sovereign, than when lending to the citizen; banks will earn higher risk adjusted returns when lending to the sovereign than when lending to the citizens; and so banks will de facto, sooner or later, lend much too much to the sovereign and much too little to the citizens… and I can simply not fathom how citizens, be they individual or majority, could give their consent to something like that.

De-facto those risk weights signify that regulators believe that government bureaucrats can make better use of bank credit than citizens… it is statism running amok.

But it became even worse. In 2004, in Basel II, regulators also made a distinction between those private who had great credit ratings, like AAA to AA, and who received a 20% risk-weight, and for instance those who had no ratings, and who kept their 100% risk weight. That to creates a sort of AAA-risktocracy that does not square well with the Constitution’s “No Title of Nobility shall be granted by the United States.

But even without entering into constitutional issues, there is even a current law that seems to prohibit this type of discrimination, but that is not applied to bank regulations. And I refer to the Equal Credit Opportunity Act: “Regulation B”.

So in the land in which its Declaration of Independence states: “We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness.”, I just must ask: How could regulators dare to decree such regulatory inequality?

And to top it up, the current risk-weighted capital requirements for banks, more ex ante perceived risk more capital – less risk less capital, are arbitrary and irrational. And that because no major bank crises have ever result from the build up of excessive dangerous bank exposures to something perceived as risky, that has always happened with something, erroneously, perceived as very safe. If you want to understand how really crazy these bank regulations are, here is a brief memo.

And frankly what would a Governor answer to this question: Why can our banks leverage their equity lending more to a foreign sovereign or a foreigner with a high credit rating, than when lending to us, the local SMEs and entrepreneurs?

No! America would never have become what it is, had it had this type of risk averse discriminatory bank regulations before.

And by the way the Dodd Frank Act, in all its 848 pages, surrealistically, does not mention the Basel Committee nor the Basel Accord, not even once.

Have the risk weights used in current bank regulations really been approved by the US Congress, in accordance to the Constitution?

PS. In his book Professor Barnett defends Federalism from the perspective of making diversity more possible. That rhymes well with what I stated at the World Bank as an Executive Director 2002-04: "A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind”