What if traffic regulators, to make your town safe, limited motorcycles to 8 mph but allowed cars to speed at 62 mph?

The fatality rate per 100 million vehicle miles traveled in cars is 1.14

The fatality rate per 100 million vehicle miles traveled in motorcycles is 21.45

That could indicate that in terms of risks measured and expressed as credit ratings, the cars should be rated AAA, and motorcycles below BB-.

But in 2011, in the US, 4,612 persons died in motorcycle accidents.

And in 2011, in the US, 32,479 persons died in vehicle accidents.

That explains the differences between ex-ante perceived risk and the ex-post dangers conditioned by the ex-ante perceptions. Cars are more dangerous to the society than motorcycles, in much because the latter are perceived as much riskier.

But what did bank regulators do in Basel II, 2004?

By weighting for ex-ante perceived risks their basic capital requirement of 8%, they allowed banks to leverage 62.5 times to 1 when AAA-ratings were present, and 8.3 times in the case of below BB- ratings.

So, what if traffic regulators, in order to make your hometown safe, limited motorcycles to 8 mph but allowed cars to speed at 62 mph?

Do you see why I argue that current bank regulators in the Basel Committee and in the Financial Stability Board have no idea about what they are doing?

But it is even worse. We need SMEs and entrepreneurs to access bank credit in order to generate future opportunities for our kids. Unfortunately, since when starting out these usually have to drive more risky motorcycles than safe cars, our future real economy gets also slapped in the face. 

An 8% capital requirement translates into a 12.5 to 1 leverage. Why can’t our regulators allow banks to speed through our economy at 12.5mph, independently of whether they go by cars or motorcycles?

PS: Here is a more detailed explanation of the mother of all regulatory mistakes.

Regulators looking after the same risks bankers look at

Should not a consultant group like McKinsey, if it sees-something dangerous for the society, have to say something?

During many years I have been wondering why consultants, like those in McKinsey, have not spoken out against the risk-weighted capital requirements for banks.

I do understand that McKinsey must have many bank clients who just love the idea of being able to earn higher-risk adjusted returns on equity with assets deemed as safe than with assets deemed as risky.

But any financial consultant should also be able to understand that, in the medium or long term, that will cause banks to dangerously overpopulate safe-havens; just as he must understand that the resulting under-exploration of the risky-bays, like SMEs and entrepreneurs, poses great dangers for the sustainability of the economy. 

Or is it that McKinsey, like the Basel Committee does not understand the difference between risk and uncertainty?

Now I just read two new articles published by McKinsey. One “The future of bank risk management” by Philipp Härle, Andras Havas, and Hamid Samandari; and the other “Poorer than their parents? A new perspective on income inequality” by Richard Dobbs, Anu Madgavkar, James Manyika, Jonathan Woetzel, Jacques Bughin, Eric Labaye, and Pranav Kashyap.

None of these touch even remotely on the fact that current regulatory risk-aversion, distorts the allocation of bank credit to the real economy; and that the regulatory discrimination against those perceived as “risky”, cannot but increase inequality.

On its website McKinsey tells us: “Social Impact: We help address societal challenges” Again, why does it not address this super societal challenge? 

“A ship in harbor is safe, but that is not what ships are for.” John A Shedd, 1850-1926 

God make us daring!

Here is a brief summary of some of the monstrous mistakes in current bank regulations.

Are some consulting companies, e.g. McKinsey & Co. Too-Big-To-Think?

A book, “No ordinary Disruption”, which I paid for, arrived with my mail today. The authors are Richard Dobbs, James Manyika, Jonathan Woetzel all belong to McKinsey Global Institute, the economics and business research arm of the management-consulting firm McKinsey & Co

From its introduction “An intuition reset” I quote:

“Dramatic changes come from nowhere, and then from everywhere… The fortunes of industries, companies, products, technologies, and eve countries and cities rise and fall overnight and in completely unpredictable ways.”

That is true but it makes me ask: Where was McKinsey & Co when bank regulators decided that their capital [equity) requirements for banks, those that are expected to cover for unexpected losses, were to be based on the predictable expected losses derived from the ex ante perceived credit risks?

Why on earth should banks need capital against perceived credit risks, when what is perceived cannot really be what is that dangerous? 

Or is it that McKinsey does not understand the difference between risk and uncertainty?

And the McKinsey authors identifying their “Four great disruptive forces” list: (1) the locus of economic dynamism shifting to emerging markets like China; (2) the impact of technology; (3) demographics; (4) “The final disruptive force is the degree to which the world is much more connected through trade and through movements in capital, people, and information. 

But they leave out that monstrous source of disruptive force that can emanate at any moment from sheer regulatory stupidities with global reach. Why? 

And I ask this because I am convinced that McKinsey & Co., somewhere deep in its bowels, must have known that: allowing banks to hold so little equity against some assets, only because these were perceived as safe, had to end in tears; and that allowing for different capital requirements for different assets, based on perceived credit risk already cleared for, had to dangerously distort the allocation of bank credit to the real economy.

The authors present us with the management imperative for the coming decade, namely: “To realize that much of what we thought we knew about the how the world works is wrong.”... 

Wrong! That’s no excuse, McKinsey & Co. involved in so many areas should have known that when regulating banks you must do two things: First define what’s the purpose of banks, something which was not done; and second analyze what caused bank crises in the past… and it sure was not what was perceived as risky but always what was ex ante perceived as safe but that ex-pots turned out risky.

So if there is a management imperative for the next decade that should be: To realize why so much we think about how the world should work could turn out to be so fundamentally wrong; and how to avoid to become a silly mutual admiration club prone to groupthink.

When a consulting group is no longer able to freely question what’s going on, to freely be able to call the bluff of what’s dumb, then it will have grown too big. It will be weighed down by too many conflicts of interests of all nature; which hinders it from speaking or even thinking the truth… and finally, very sadly, it will end up as a highly paid endorser of stupidities.

When a consulting group with global reach reaches a point of too much importance, then it also becomes a dangerous source of systemic risks.

So do we now need capital requirements for banks based on the size of the consultant group they use? J