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:

“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.”

Now 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 is how a portfolio is 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 perceived as risky turns up even more risky; or when something perceived safe turns up risky?

Evidence that demonstrates, without any reasonable doubt, we have landed us some very feeble-minded bank regulators

What are the chances banks build up huge exposures to those rated prime, AAA to AA, and which could be dangerous to the bank system, if these, ex post, turn out to have been worthy of a much lower rating? Big!

What are the chances banks build up dangerously large exposures to those rated “highly speculative “ and worse below BB-? None! 

And yet the regulators, for the purposes of determining the capital requirements for banks, in Basel II, assigned to the AAA to AA rated, a risk weight of 20%, and to the below BB- rated, a risk weight of 150%.

And to top it up, the risk weights are portfolio invariant.

Do we really need more evidence that the Basel Committee regulators and those affiliated to it are cuckoo?

They behave like nannies telling the children “Stay away from the ugly and foul smelling, and embrace the nice gents bringing you candy”, and so dangerously distort the allocation of bank credit to the real economy.

Voltaire to the Basel Committee: “May God defend me from my friends [AAA rated]: I can defend myself from my enemies [BB- rated]”

Here is a brief memo that further explains their idiocy.

My bank regulator went to Basel, and all he brought me was this lousy credit risk weighted capital requirements

I sent my bank regulator to learn with the big boys in the Basel Committee for Banking Supervision about how to regulate banks. Among what he was supposed to pick up was an idea of how much capital he should require banks to hold, primarily against any unexpected losses.

He could have come back with capital requirements that considered all type of events that unexpectedly could blow a hole in a banks solvency like: cyber-attacks, a weather event with disastrous consequences, a major earthquake, the central banks or even the regulators themselves not knowing what to do, inflation suddenly popping up, crazy governments (I am from Venezuela), a set of important companies suddenly turning up engaged in some hanky panky, Systemic Important Financial Institutions (SIFIs) going belly up, internal or external fraud, a major loss from an authorized or unauthorized position in a speculative trading, unexpected consequences from new regulations and thousand of other things… BUT NO all he brought me was this silly risk weighted capital requirements based on expected credit risks, about the only risks banks are supposed to really take care of on their own.

If only it had been based on the risk that banks were not able to manage expected credit risk, then I could have accepted it… but that had of course nothing to do with the credit risk per se, in fact usually it is what is perceived as safe that could pose the biggest dangers for a bank. 

And, to top it up, these credit risk based capital requirements were portfolio invariant, meaning independent of the size of the exposures, only because otherwise it would be too hard for him and his regulating colleagues to handle.

And, to top it up, these credit risk based capital requirements also smuggled in the absurd statist notion that sovereigns were infallible, de facto implying government bureaucrats knew better what to do with bank credit than "the risky" SMEs and entrepreneurs.

And to top it up, during his whole stay with the Basel Committee, and during his study visits to the Financial Stability Board and the IMF, not one single word was said about the societal purpose of banks.

And, so these credit risk based capital requirements guarantees to dangerously distort the allocation of bank credit to the real economy... which they did, look at how much credit Greece got... which they do, look at how little credit SMEs get.

And so these credit risk based capital requirements now guarantee that the next time a bank crisis results from excessive exposures to something that was erroneously perceived as very safe, which is precisely the stuff major bank crisis are made of, then banks will stand there with their pants down and no capital to cover themselves up with.

No! I will surely never ever send my bank regulator to Basel again.

Bank regulators… dare to answer this single question

There are literally thousand of risks, especially many unexpected risks, which could bring our banking system down.

And so why on earth did you regulators base your capital requirements for banks, those which are to cover especially for unexpected risks, solely on the ex ante perceived credit risk, that which is basically the only risk already cleared for by banks, by means of interests risk premiums and the size of their exposures?

And, to top it up, you made those capital requirements portfolio invariant… as if diversification has no meaning?

If anything, should you not have based it on the risks that bankers were not able to clear for those perceived risks?

Since that dangerously distorts the allocation of bank credit to the real economy, do we not deserve a clear-cut answer on that?

I have been asking this for over a decade, and you have not even wanted to acknowledge my question. Does that not tell you something?

Suppose a dictator decided on bank regulations.

What if in a country there was a dictator who told banks: I will allow you to leverage much more your equity, so that you can earn much higher risk adjusted returns on your equity and on the implicit support our taxpayers give your banks, that is as long as you lend to the government, meaning to me, your infallible sovereign, to my friends and courtesans, the AAArisktocracy, and stay away from lending to those perceived as risky, like our quite vulgar SMEs and entrepreneurs.

Would you not be upset? Especially considering that it is precisely SMEs and entrepreneurs who most need to have fair access to bank credit in order to help the real economy to move forward and not to stall and fall.

Would you not be upset? Especially considering that de facto means the dictator believes the government, or the AAArisktocracy, can use bank credit more efficiently than what SMEs and entrepreneurs can?

Would you not be upset? Especially considering that never ever do major bank crises result from excessive bank lending to those perceived as risky, these always result from excessive lending to those who were erroneously perceived as safe.

For your information, the Basel Committee, and the Financial Stability Board, with their portfolio invariant credit risk weighted capital requirements for banks, dictated precisely that... for the whole world. And the world so submissively, says nothing about it.

The amazing Achilles heels of the Basel Committee’s bank regulations

1. The unexpected losses (UL) are derived from the expected Probabilities of default (PD) adjusted with an arbitrary "Loss Given Default" factor. 

I cite directly from “An Explanatory Note on the Basel II IRB Risk Weight Functions” July 2005

“It was decided… to require banks to hold capital against Unexpected Losses (UL) only. However, in order to preserve a prudent level of overall funds, banks have to demonstrate that they build adequate provisions against Expected Losses” (Page 7)

"Under the implementation of the Asymptotic Single Risk Factor (ASRF) model used for Basel II, the sum of UL and EL for an exposure (i.e. its conditional expected loss) is equal to the product of a conditional PD and a “downturn” Loss Given Default (LGD) [a parameter that reflects adverse economic scenarios]. As discussed earlier, the conditional PD is derived by means of a supervisory mapping function that depends on the exposure’s average PD." (Page 4)

What does this mean? 

First, that the risk weights have nothing to do with the risk premiums banks charge. 

Second, the real dangerous unexpected losses in banking are most certainly inverse to the expected probabilities of default. The higher the expected losses the lower can we expect the probable size of the bank exposure to be… meaning, the safer an asset is perceived to be, the higher the possibilities of something really dangerous unexpected happening. In short this all does not make any sense.

Third, that this would not have been so serious if there had been an adjustment for portfolio risk, since most probably what is perceived as safe commands larger exposures...

but then, to top it up:

2. The risk weights are portfolio invariant... Holy Moly!

I cite directly from “An Explanatory Note on the Basel II IRB Risk Weight Functions” July 2005 (page 4) 

“The Basel risk weight functions used for the derivation of supervisory capital charges for Unexpected Losses (UL) are based on a specific model developed by the Basel Committee on Banking Supervision (cf. Gordy, 2003). The model specification was subject to an important restriction in order to fit supervisory needs: 

The model should be portfolio invariant, i.e. the capital required for any given loan should only depend on the risk of that loan and must not depend on the portfolio it is added to. This characteristic has been deemed vital in order to make the new IRB framework applicable to a wider range of countries and institutions. Taking into account the actual portfolio composition when determining capital for each loan - as is done in more advanced credit portfolio models - would have been a too complex task for most banks and supervisors alike. The desire for portfolio invariance, however, makes recognition of institution-specific diversification effects within the framework difficult: diversification effects would depend on how well a new loan fits into an existing portfolio. 

As a result the Revised Framework was calibrated to well diversified banks. Where a bank deviates from this ideal it is expected to address this under Pillar 2 of the framework. If a bank failed at this, supervisors would have to take action under the supervisory review process (pillar 2)."

What does this mean? 

That the benefits of diversification are completely ignored... that the risk weights have nothing to do with the size of the exposure… all because to consider diversification, that “would have been a too complex task for most banks and supervisors alike”, and so “the Revised Framework was calibrated to well diversified banks.” 

But, if a bank fail to be well diversified, then the supervisors, those who have just been deemed as not being able to understand what diversification is, shall address the problem under Pillar 2 of the framework, the “Supervisory Review Process.” Basel II (page 158) 

And if all that does not sound like sheer Kafkaesque lunacy, you tell me. 

As a result we then have portfolio invariant credit-risk-based equity requirements, which allow banks to hold less equity against safe assets than against risky assets, even though all major bank crises in history have never ever resulted from excessive exposures to what was perceived as risky, but always from excessive exposures to what ex ante was perceived as safe.

And that led to much lower equity requirements for what ex ante is perceived safe than for what is perceived risky.

And that caused banks to be able to leverage much more their equity, and the support society gives them, with assets ex ante perceived as safe than with assets perceived as risky.

And that caused banks to be able to generate much higher risk adjusted returns on equity with assets ex ante perceived as safe than with assets perceived as risky.

And that meant that banks would lend too much and at too easy terms to those perceived as safe, like to "infallible sovereigns" and the AAArisktocracy, and too little in relative too harsh terms, to those perceived as risky, like to SMEs and entrepreneurs.

And that means that though the standardized risk weighted capital requirements were “calibrated to well diversified banks”, its mere existence guarantees badly diversified banks.   

With bank regulators like these… who need enemies?

And please read the Explanatory Note and consider what a regular subordinated regulator would dare to opine about it :-)

PS. But the sophisticated (meaning large) banks can do whatever they like: In the inexplicable “Explanatory Note on the Basel II IRB Risk Weight Functions” we also read: “It should be noted that the choice of the ASRF (Asymptotic Single Risk Factor model) for use in the Basel risk weight functions does by no means express any preference of the Basel Committee towards one model over others… Banks are encouraged to use whatever credit risk models fit best for their internal risk measurement and risk management needs.” So seemingly all their nonsense needs not to be applied to large and sophisticated banks, only to the small. That said we must ask though, is there a risk model out there that allows banks to leverage more than 62.5 times with a corporate asset only because it has been AAA rated?

PS. Risk of cyber-attack weighted equity requirements for banks make much more sense than the credit-risk weighted

The sad tale about the rookie instructors in the Basel Committee's bank driving school

More perceived credit risk more bank equity… less perceived credit risk less bank equity. Does that not sound logical? It does, and that is precisely why intuition manages to overtake understanding.

Let me try to explain it all with the help of the following image of a two driving wheel car sometimes used by driving schools.

Suppose the driving student is an expert driver, let’s call him a banker, and the driving instructors  is  a rookie who does not know even how to drive well on his own, let’s call him the regulator.

And let us also suppose that the car came with a manufacturing defect, namely the instructor's driving wheel not overriding the student's... and nobody at the driving school cared to check for that.

And now they are out on the street. The banker sees a credit risk danger, and averts it by turning his driving wheel, taking on small exposures and setting the risk premiums high so as to compensate for the added risk.. all as one should normally drive. 

But, seeing the same perceived credit risk, the scared rookie regulator also turns his driving wheel, that of equity requirements. The result will be a dangerous over-reaction to perceived credit risks… either too much steering the car into safety or too much steering it away from the risks that are natural when driving.

You might argue the regulator has accelerating and breaking pedals too he could use. Not so! In this case the regulators of the Basel Committee stated that, making the driving also depend on the speed, was much too complicated for them, and so the driving lessons were to be “portfolio invariant”.

And with bankers already hating velocity where risks seem high… they now do almost no lending at all to “risky” SMEs and entrepreneurs, to those who are those most in need of fair access to bank credit.

And with bankers loving to speed when it seems safe, they crash, where they usually crash, someplace seemingly “very safe”. Unfortunately, now the crashes causes much more tragedy because, when driving around in AAA rated securities, sovereigns like Greece, real estate in Spain and similar "safe"terrains, they are now allowed to drive with little use of safety belts, bank equity.

And here we are biting our nails, thinking about what still lies waiting for us around ultra-safe corners.

Where were Joseph Stiglitz and Paul Krugman when the Basel Committee decided to odiously discriminate against "the risky"?

We have Nobel Prize winners complaining, over and over again, about how de-regulated bankers messed up the world, without saying one iota about how it really was, with regulators who with their portfolio invariant credit risk-weighted equity requirements for banks, are all to blame for that.

Those bank regulators odiously discriminated in favor of those who already have more access to bank credit, namely the “infallible sovereigns” and the AAArisktocracy. 

Those regulators odiously discriminated against the fair access to bank credit of those we most need to have access to bank credit, like the "risky" small businesses and entrepreneurs. 

Many correctly argue that bankers should have to give back much of their bonuses, if in the medium and long term what they did did not work out alright. In the same vein there should perhaps be a claw-back clause on Nobel Prizes.

What did we in the Western world do, to deserve getting saddled with so dumb bank regulations/regulators?

The pillar of current bank regulations issued by the Basel Committee for Banking Supervision is “the risk weighted capital requirements for banks”.

For those interested, a more accurate name would be “the portfolio invariant credit-risk-weighted equity requirements for banks”

In essence it signifies that the more the ex ante the perceived credit risk is, the more equity banks need to hold.

That does not make any sense! It is never what the perceived credit risk is that constitutes any real risk for a bank and much less for a banking system. It is only how wrong banks could have perceived the risks to be, which represents the real risk.

If something is perceived as safe and turns out risky, everything is ok.

If something is perceived as risky but turns out to be less risky, then that is only good news.

If something perceived as risky turns out to be even more risky, then that is bad, but at least in that case one can suppose the balance sheet exposures to be lower, and that the bank has been receiving higher risk premiums that partly compensate.

But, if something perceived as safe turns out ex post to be risky, that is where the real dangers lie.

And so we can only conclude in that: the safer a bank asset may seem the more dangerous it becomes… and which is 180 degrees opposite of what current regulators think.

And that mistake also stops the banks from financing precisely those our society most need to be financed, in order to move forward, namely "the risky" small businesses and entrepreneurs.

What did we do to deserve that?

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."

Scene 1

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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?

“The Parade of the Bankers’ New Clothes Continues: 28 Flawed Claims Debunked” by Anat Admati and Martin Hellwig

I refer here to their revised document of July 6 2014

As I have argued before the authors present a better description than most of the problems of current bank regulations.

Unfortunately, though they correctly identify that relying capital requirements that are risk-weighted is a flawed concept, they do not yet identify the most serious problem with doing so, namely that it dramatically distorts the allocation of bank credit to the real economy.

Since the perceived risks, like for instance those reflected in credit ratings, are already cleared for by means of interest rates, size of exposure and other contract terms, to also clear for the same perceptions of risks in the capital, signifies a double consideration of risk perceptions… and any risk perception, even if absolutely correct, will lead to the wrong conclusions if excessively considered.

In this particular case that signifies that banks will be able to earn much higher risk adjusted returns on equity on assets considered “absolutely safe” than on assets considered “risky”… and that in its turn means that banks will not serve in a fair way the credit needs of those who might most be need in access to it, like medium and small businesses, entrepreneurs and start-ups.

And the main reason for why we ended up with these bad regulations was that nowhere did bank regulators define the purpose of those entities they were regulating.

Another objection to risk-weighing not clearly identified by the authors, is that what regulators really need to consider when setting the capital requirements is not the expected risks or losses, but the unexpected risk and losses. And the Basel Committee, in a document where they explained the methodology of the risk-weighing explicitly stated that, since unexpected risks are hard to measure, they would use the expected risks in substitution of the not-expected… something which of course does not make any sense at all.

The same explicatory document from the Basel Committee on Basel II’s risk weights also states that the capital requirements are portfolio invariant, meaning that they do not consider the risk of over concentrating in what is perceived as safe, nor the benefits of diversifying in what is perceived as risky. And the argument to do so, amazingly, is that otherwise it would be too difficult for regulators to manage the system.

In summary one can say that regulators concentrated on the risks of the assets of the banks, and not on the risk of the banks… which is of course not the same.

Also any empirical study would have shown that bank crises always result from excessive exposures to something perceived as safe... and never from excessive exposures to something perceived as risky. 

Finally, and though there are some other issues I slightly disagree on, let me here conclude with reference to their remarks on:

"Flawed Claim 13: There is not enough equity around for banks to be funding with 30% equity."

"Flawed Claim 14: Because banks cannot raise equity, they will have to shrink if equity requirements are increased, and this will be bad for the economy."

"Flawed Claim 15: Increasing equity requirements would harm economic growth."

I agree with the authors those are mostly flawed claims, but primarily so from the point of view of a static analysis.

But unfortunately, the road from where our banks now find themselves, to where they propose and many would love the banks to be in terms of equity, makes for a very difficult journey.

In my opinion in order to speed up the travelling, before our young  run the risk of becoming a lost generation, will for instance perhaps require awarding special tax exemptions, in order to make those equity increases feasible over a not too long time span…. because we might in fact be talking about at least a trillion dollars of new equity.

And of course, meanwhile, make all fines payable in voting shares.

Please... again...more important than more bank capital is less distorting bank capital requirements.

A simple question, on bank regulations, to Basel Committee, Financial Stability Board, FED, ECB, FDIC, PRA and other

Do you really believe that those “unexpected losses” which could destabilize the banking system, should be estimated based on the estimations of “expected losses”? 

I ask that because that is what you have, in my opinion irresponsibly so, bet our whole banking system on... in fact even bet the health of our real economy on.

The capital requirements for banks should primarily cover for any unexpected losses, as any expected losses should primarily be covered by bankers knowing what they are doing. But, by your own confessions you have based the unexpected losses on the perceived risk of expected losses, like those contained in a credit rating. And that leads to the expected losses to be counted twice, while the unexpected losses are not considered at all.

And to top it up your current capital requirements for banks are, again by your own confessions, “portfolio invariant”, which means that the benefits of asset diversification among “the risky” or the dangers of excessive concentration of assets to something perceived as “absolutely safe” are not considered at all.

What you have done allow the banks to earn much higher risk-adjusted returns on capital when lending to The Infallible than when lending to The Risky, and this seriously distorts the allocation of bank credit in the real economy, with tragic implications for its future health.

And all for nothing, because you should know that what can cause the unexpected losses that can really bring a banking system down, are really to be found among what is perceived to generate the lowest expected losses.

What can I say regulators? That you have no idea of what you are up to? Frankly, I can’t find any other explanation.

You have a lot of explaining to do all that unemployed youth that you might turn into a lost generation. 

You fill pages after pages with talk about prudential regulations, but let me remind you of that the first rule of prudence is to cause not even larger damages! And that you have done.

An alternative "Abstract" for my paper

The expected losses of a bank should normally be covered by its operations. The capital requirements are imposed by regulators primarily to cover for the “unexpected losses”.

But the risk-weighted capital requirements of Basel II and III have nothing to do with “unexpected losses” and all to do with a double counting of “expected losses”.

In fact an “Explanatory note of the risk weights function” July 2005, clearly spells out that: 

Because “Taking into account the actual portfolio composition when determining capital for each loan - as is done in more advanced credit portfolio models - would have been a too complex task for most banks and supervisors alike… The model [is] portfolio invariant and so the capital required for any given loan does only depend on the risk of that loan and must not depend on the portfolio it is added to”

In other words, a bank portfolio with extremely dangerous concentrations in what ex ante is perceived as “absolutely safe” will be deemed much safer than an extremely well diversified portfolio of assets perceived as “risky”.

And the note explains: “In the context of regulatory capital allocation, portfolio invariant allocation schemes are also called ratings-based. This notion stems from the fact that, by portfolio invariance, obligor specific attributes like probability of default, loss given default and exposure at default suffice to determine the capital charges of credit instruments. If banks apply such a model type, they use exactly the same risk parameters for expected losses (EL) and unexpected losses (UL), namely probability of default (PD), loss given default (LGD) and exposure at default (EAD).”

And so in fact there is never a provisioning for unexpected losses, but only a double provisioning for expected losses. 

The net result of these capital requirements are then that banks will be earn a much higher “perceived risk” adjusted return on equity when lending to those perceived as “safe” than when lending to those perceived as “risky”. And that causes a huge regulatory discrimination in favor of those perceived as “absolutely safe” and against those perceived as “risky”.

And all this the Basel Committee has done even admitting to that “intuition tells that low PD borrowers (safer) have, so to speak, more “potential” and more room for down-gradings than high PD (riskier) borrowers”. 

But, instead of considering this larger unexpected loss potential in the capital requirements, they postpone any adjustments to the moment of when a downgrading occurs, completely ignoring that a downgrading is nothing but the unexpected increase of expected losses.

This regulatory mistake, by pushing excessive bank credit to what was perceived as “absolutely safe” caused the current crisis, and by not allowing for sufficient bank credit to flow to the "risky", impedes us from getting out of the crisis.

PS. The current version of the paper