Europe beware, you´ve got yourself a very sad bunch of systemic risk experts reviewing the systemic risks of your banking system.

In the so posh sounding European Systemic Risk Board’s Advisory Scientific Committee´s report titled “Is Europe overbanked?” dated June 2014, we read:

“Large banks were able to increase their leverage - and therefore their return on equity (unadjusted for risk) – while complying with risk-based regulatory ratios”

And that is not correct... the lower risk weights in the risk-weighted capital requirements for banks, translates into allowing banks to hold much less capital against assets perceived as “absolutely safe”, which signifies that banks can leverage their equity much more with assets perceived as “absolutely safe”, and therefore earn much higher expected RISK-ADJUSTED returns on equity when lending to “The Infallible” than when lending to “The Risky.”

And this has made a true mockery of the report´s: “Financial development can also foster growth by allocating capital more efficiently, channeling resources to better projects and thus boosting total productivity”

Current risk weighted capital requirements signify that resources will be transferred in function of ex-ante perceived credit risks, which has of course not one iota to do with guaranteeing the transfer of these resources to better projects that can boost total productivity.

And in this respect, as I have been arguing for more than a decade, the risk weighted capital requirements represents the largest possible systemic risk to our banks and to our economies... as it basically prohibits much of the risk-taking necessary for our economies to move forward and for our descendants to have a future. 

As an example January 2003 in a letter published by FT I wrote “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. Friend, please consider that the world is tough enough as it is.”

And yet, now soon 7 years after the crisis broke out, that systemic risk has not even been identified by those who allow themselves to be called experts in systemic risk. How come?

The report refers to “some reason, such as badly designed prudential regulation” in order to get to “banks’ rapid expansion into loans secured against residential real estate”

And yet the report does not mention the truly bad design of the prudential regulations that resulted from assigning very low risk weights against loans secured against residential real estate… which meant that banks could leverage much more their equity when giving loans secured against residential rate… which of course meant that banks would earn much higher than normal relative risk adjusted returns on equity on loans secured against residential real estate… which of course led to an explosion of bank loans secured against residential real estate.

And the report asks “Why has overbanking occurred?” and advances the explanation of “deposit insurance schemes may themselves generate moral hazard. Capital requirements can often be circumvented by banks, especially the largest ones, which have greater capacity to engage in risk-weight manipulation”

Circumvented? Hell no! The regulators allowed banks to hold only 1.6 percent in capital against securities rated AAA which meant authorizing a mindboggling leverage of 62.5 to 1… does as a bank really need to circumvent that? No! What they might need though, is to find some AAA ratings issued by the friendly and human fallible credit rating agencies. 

And let us not even go to the area of bank lending to the “Infallible Sovereigns” where no equity is required and the sky is the limit for bank leverage. In November 2004 FT published a letter in which I asked “How many Basel propositions will it take before they start realizing the damage they are doing by favoring so much bank lending to the public sector (sovereigns)?”

And so I must conclude in a: “Europe, beware, you´ve got yourself a very sad bunch of systemic risk experts reviewing the systemic risks of your banking system”

Am I to harsh in my criticism? Absolutely! If this was the first time I criticized. But, considering I have been asking the regulators my questions for more than a decade, all over the web and in hundreds of conferences, and they have never ever dared to give me a straight answer (with one incredible exception) and much less have dared debate me on these issues… I do not feel I am too harsh or too impolite in any way shape or form. 

On the contrary, I feel it is my responsibility to shame them in all the ways I can, so that no regulator dares to act ever again with so much hubris, believing he can be the risk manager for the world.

To finalize… may I kindly suggest these systemic risk experts that their so impressive list of 130 documents referenced does not include the most basic and important document required to understand the mumbo jumbo of financial regulators namely the Basel Committee on Banking Supervision´s Explanatory Note on the Basel II IRB Risk WeightFunctions of July 2005. That this document, has clearly not been reviewed by those preparing the report, is by itself something impossible to understand, unless of course they want to avoid shaming some members in a mutual admiration club.

Mr. Alan Greenspan… tell us the story… why were your legitimate concerns waived… what really happened?

In 1998, celebrating the tenth anniversary of the Basel Accord Alan Greenspan gave a speech titled “The Role of Capital in Optimal Banking Supervision and Regulation”, FRBNY Economic Policy Review/October 1998”. Three comments stand out:

First: “It is argued that the heightened complexity of these large bank’s risk-taking activities, along with the expanding scope of regulatory arbitrage, may cause capital ratios as calculated under the existing rules to become increasingly misleading. I, too, share these concerns”

And there was Greenspan only referring to the measly 30 pages of Basel I… and so how on earth, with this type of miss-feelings, can we now have arrived to our tens of thousands of pages of Basel III and Dodd-Frank Act?

Second: “regulatory capital arbitrage… is not costless and therefore not without implications for resource allocation. Interestingly, one reason that the formal capital standards do not include many risk buckets is that regulators did not want to influence how banks make resource allocation. Ironically, the one-size-fits-all standard does just that, by forcing the banks into expending effort to negate the capital requirement, or to exploit it, whenever there is a significant disparity between the relatively arbitrary standard and internal, economic capital requirements.” 

And so here if the implications for resource allocation (of bank credit in the real economy) is considered as an issue… how on earth did they go from some risk-weights depending of the category of assets, to something even so much distortive for resource allocation as risk weights depending on credit ratings?

Third: “For internal purposes, these large institutions attempt explicitly to quantify their credit, market and operating risks, by estimating loss probabilities distribution for various risk positions. Enough economic, as distinct from regulatory, capital is then allocated to each risk position to satisfy the institution’s own standard for insolvency probability.”

And so what happened to the distinction between economic and regulatory capital? Is it not so that a regulator´s real problem begins when the economic capital is miscalculated by the banks? If so, why the hell would he then want to calculate regulatory capital as it was economic capital?

No I am sorry… Alan Greenspan… as well as his successor Ben Bernanke… and of course all the other regulators like those in the Basel Committee and the Financial Stability Board… they will have a lot of explanation to do… when history finally catches up on them.

And I would certainly not want to be in their shoes. “Daddy why was grandfather so dumb? … It is because of his stupid regulatory risk aversion that banks stopped financing the future and only refinanced the past, and which is why I and my friends now do not have jobs.”

There is plentiful of vested interest in hiding a major bank regulatory stupidity.

In my country Venezuela, during many decades, the interest rate charged by banks was fixed by the government, and was the same for all borrowers, independently of the risk that each one of them was perceived to represent. Under such circumstances, a system of capital requirements for banks based on perceived risks, more-risk-more-capital less-risk-less-capital, makes sense. 

But, when banks already clear for perceived risks, by means of interest rates, amounts of exposure and other contractual terms, then re-clearing for the same perception in the capital requirements, makes absolutely no sense. 

And yet capital requirements based on perceived risks, is the pillar of the Basel Committee’s bank regulations. How on earth could this have happened? Why was, and is, this never questioned? 

The unhappy Barings’ Bank trader Nick Leeson writes in his memoirs: “And they never dared ask me any basic questions, since they were afraid of looking stupid about not understanding futures and options.” And if we add that most or perhaps all of the discussion on bank regulations take place in a mutual admiration club, where one does not harshly question colleagues, do I need to explain more? 

The current capital requirements for banks allow banks to earn immensely higher expected risk adjusted returns on equity when lending to “The Infallible” than when lending to “The Risky” and this creates a distortion that makes it impossible for banks to allocate economic resources efficiently. 

It dooms the banks to end up, sooner or later, with extremely high exposures to something wrongly perceived as safe and little capital to back it up with. Like in AAA rated securities backed with lousily awarded mortgages or in loans to Greece. 

It also dooms those actors within the real economy who are perceived as “risky”, like small businesses and entrepreneurs, to have less and more expensive access to bank credit. 

On the web site of Nick Leeson we find the question: “How could one trader bring down the Barings banking empire that had funded the Napoleonic Wars?”

And we could just the same ask: How could an idea so stupid it will bring down all the economies of the Western World find approval among experts? 

Well think about all banks regulators, all academicians, all ministry of finance bureaucrats, all central bankers, all finance journalists, all “financial crisis 2007-08 experts” and so many more who have not said a word questioning these loony capital requirements, and you will understand that there is huge amount of vested interest in banding together to silence this most embarrassing truth. 

But, the truth needs to come out, and the responsible need to be held accountable, so as to help us out of the current crisis, and so to make it less possible that a small group of expert global regulators will again be allowed to mess it all up this much. 

How can we help? Easy, ask any potential silencer to explain to you the rationale behind capital requirements, beyond what that fuzzy “more-risk-more-capital less-risk-less-capital, it sounds logical” provides. 

If he can’t, then tell him “So I should assume you do not understand it? ... And send me his name. 

If you would ever get an answer that makes sense, please send it to me, and if correct, I would as they say, have to eat my hat and much humble pie.

Basel Committee, stop giving our banks your capital requirements suppositories.

Banks, before the Basel era, cleared for perceived risk, that which for instance is to be found in credit ratings, by taking caplets containing the interest rate (risk-premiums), the size of the exposure and other contractual terms. 

But Basel II, and now Basel III, ordered the banks to also clear for exactly the same perceived risk, credit ratings, by means of a suppositories containing capital requirements, more risk more capital, less risk less capital. 

That double dosage against “perceived risk” allow banks to leverage many times more their equity when lending to what is perceived as “safe” than when lending to what is perceived as “risky”, and that allows the banks a much higher expected risk-adjusted return on equity when lending to “The Infallible” than when lending to “The Risky”. 

And that distorts and makes it impossible for banks to allocate economic resources efficiently. 

Our current bank regulators are dangerous fools.

Bank regulators foolishly allow banks to hold much less capital against assets which are perceived as “safe” than when holding assets perceived as “risky”. 

That means that bank regulators foolishly allow banks to leverage their capital many times more when holding assets which are perceived as “safe” than when holding assets perceived as “risky”. 

And that means that bank regulators foolishly allow banks to earn a much higher expected risk-adjusted return on equity when holding assets perceived as “safe” than when holding assets perceived as “risky”. 

And I say “foolishly” because with that bank regulators introduce a distortion that makes it absolutely impossible for banks to perform their vital social function of allocating resources efficiently. 

And I say “foolishly” because that guarantees that when something ex-ante perceived as safe, ex post turns out to be risky, bank exposures to it will be huge, and the bank capital to cover for it totally insufficient. 

And I hold our current bank regulators to be dangerous fools, because they don´t even understand the harm their capital requirements based on perceived risk of Basel II does to our banking system and that it caused the current crisis; and because they now want to dig us even deeper down into the hole with Basel III adding liquidity requirements which are also based on perceived risk. 

A bank is there to take intelligent risks on behalf of the risk-adverse society, and not to be treated as just another widow or orphan by some dumb overanxious nannies.

A perfect depiction of our bank regulators… looking out in the same direction of bankers for what is perceived as risky, forgetting that in banking, as in so much other, what is really risky is what is considered absolutely safe. (Thanks "Learning from dogs" for the heads up for the photo)

My comments for IMF's revision of its "Code of Good Practices on Fiscal Transparency"

Washington, February 4, 2013

International Monetary Fund

Dear Sirs,

You hold that “Fiscal transparency – defined as the clarity, reliability, timeliness, and relevance of public fiscal reporting and the openness to the public of government’s fiscal policy-making process - is a critical element of effective fiscal policymaking and risk management. Without comprehensive, reliable and timely fiscal information, governments cannot understand the fiscal risks they face or make good budget decisions. If citizens don’t have access to this information, they cannot hold governments accountable for those decisions.”

And the IMF, now seeking comments for the revision of its Code of Good Practices on Fiscal Transparency and related instruments specifically asks:

“Does the Code adequately address all of the most important aspects of fiscal transparency? What practices should be dropped? What practices should be added? Which practices should be updated to reflect recent developments in fiscal reporting standards and practices or the lessons learned from the crisis?”

In this respect I would submit that any “Good Practice on Fiscal Transparency” should also look to identify the presence of any hidden subsidies and or taxes that might affect government’s fiscal affairs, and, if possible, provide estimates as to their significance.

Specifically I refer to the fact that current bank regulations require banks to hold much more capital against assets perceived as risky, like loans to small businesses and entrepreneurs, than for assets perceived as “absolutely safe”, like loans to “infallible sovereigns”.

This translates into that a bank can leverage its equity man y time more the dollars paid by “the infallible sovereign” in risk-adjusted interests, than the same risk-adjusted dollars paid by “the risky”.

That translates directly into a regulatory subsidy of the government’s bank borrowings, paid by “the risky bank borrowers” by means of higher interest rates, and paid by the society at large by means of the opportunity cost that might be present in allowing the public sector to borrow much easier and much cheaper than the “risky” private sector, than what would have been the case in the absence of this regulations.

That translates into giving banks incentives to dangerously overpopulated safe-havens, and equally dangerous for the real economy, under explore some more risky but perhaps more productive bays; something which of course introduces a distortion that makes it impossible for banks to perform their utterly important function of allocating economic resources efficiently.

That also translates into that one of the most important theoretical rates there is in finance, the risk-free rate, usually approximated by the rate to the “most infallible sovereign” is a subsidized rate and which of course makes it impossible for the government and the markets, to know where the real risk free rate is. In other words one of the fundamental instruments needed to navigate the economy gives wrong readings.

Since there are also sovereigns who are deemed not so infallible and so against their borrowings banks are required to hold more capital, this also translates into an effective global capital control that helps to channel funds away from what is ex-ante perceived as risky into what is ex ante perceived as infallible. In other words these capital controls only help to increase the existing gaps between “the risky developing” and the “infallible developed”.

In conclusion I ask of the IMF to try to estimate all the fiscal effects of what is described above, or to respond publicly why in IMF’s opinion my arguments might be wrong, or plain irrelevant.

Sincerely,

Per Kurowski

A former Executive Director at the World Bank (2002-2004)

If I was the FDIC, I would ask bank regulators two questions

If I was the Federal Deposit Insurance Corporation, mandated to insure depositors for when banks fail, I would not lose one minute of sleep concerning myself with bank assets perceived as “risky”, but I would certainly toss and turn all night, thinking about assets that are perceived as “absolutely safe” and might not be. 

“The Risky” assets those take care of most of my risks on their own, by means of lower bank exposures, higher interest rate premiums and tougher contract terms. 

It is always “The Infallible” assets which represent the really expensive dangers to me, since if these assets, as sometimes happens, ex-post turn out to be very risky, then the bank exposures are usually enormous, the earned risk premiums much too low, and the contracting terms much too lax. 

And so, if I was the FDIC, I would ask the current bank regulators about what they are thinking when they allow banks to hold so much less capital against “The Infallible” than against “The Risky”. 

And since if I was the FDIC, and therefore also responsible for “promoting sound public policies … in the nation's financial system”, I would also ask the regulators whether allowing banks to leverage their equity much more when lending to “The Infallible” than when lending to “The Risky”, does not introduce distortions that make it impossible for the banks to assign resources in the real economy, with any type of efficiency.

In short, if I was FDIC, current capital requirements based on perceived risk would be completely unacceptable.

Immoral, useless and outright dangerous; what more do you need to repel Basel bank regulations?

The fundamental pillar of the Basel Committee's bank regulations is capital requirements with risk-weights based on ex-ante perceived risk.

The way those capital requirements favor the access to bank credit of “The Infallible”, those already favored by markets and banks, and discriminate against that of “The Risky”, those already discriminated against by banks and markets… is immoral.

Those capital requirements are also useless, because they give banks incentives to stay away from taking manageable risks on “The Risky”, those who never ever caused a major bank crisis, and to instead take unmanageable risk on “The Infallible”, those who always have been the origin of all bank crises.

Those capital requirements are also outright dangerous, as these completely hinder the banks from performing an efficient economic resource allocation.

What more do you need to repel them?

How on earth have German bank regulators avoided being blamed for bad German bank lending to Greece?

If German banks had only two clients, German small businesses and Greece, and where required to hold 8 percent in equity, 12.5 to 1 leverage, they would lend their funds to whoever produced the highest risk-adjusted return on that 8 percent equity. 

But if German regulators told the German banks that though in the case of the German small businesses they still needed to hold 8 percent of equity, in the case of Greece, only because regulators considered Greece to be safe given its ratings, German banks had only to hold 1.6 percent of equity, allowing them 62.5 to 1 leverage… who do you think German banks would lend to? 

It is amazing how German bank regulators have avoided to be held accountable for what happened. That same question holds of course for the bank regulators of most other countries.

One reasonable and one very stupid efficient resource allocation methods for the banks

If banks need to hold for instance 8 percent of equity against any asset, they will allocate their funds in accordance to what assets produce the largest risk-adjusted returns on that equity. 

If banks, on the contrary, as is the case with Basel II, need to hold 8 percent of equity against assets perceived as “risky”, being able to leverage their equity 12.5 to 1, but can hold other assets deemed as “not risky” with only 1.6 percent in capital, and in that case being able to leverage their equity 62.5 times to 1, they will allocate their funds in accordance to whatever assets produce the largest risk adjusted return on the particular bank equity which regulators have decided should be held for the different assets. 

And only fools could believe that both systems have a chance to perform a resource allocation that is effective for the economy. The current method is a resource allocation completely distorted by the regulators own risk perceptions. 

We can be certain that if these capital requirements, which favor what is perceived as “not-risky” and discriminate against what is perceived as “risky” remain, this will guarantee us flabby economies, lack of jobs, and set our countries on a downward slope which condemns us to perish in some dangerously overpopulated safe-haven.