Here a simple as can be one-minute explanation of the distortions produced by the risk weighted bank capital requirements in the allocation of credit to the real economy.

For 600 years, before the Basel Accord of 1988, banks, with an eye to their overall portfolio, allocated their assets depending on the perceived risk adjusted return these were to produce.

For instance if a safe asset at a 4% interest rate and a risky asset a 7% interest were both producing a 1% net risk adjusted return acceptable to the banks, they could pick either one or both. If banks were allowed (by markets or regulators) to leverage their assets 10 times, that would produce them a 10% risk adjusted return on equity.

But the introduction of the risk weighted bank capital requirements changed all that.

Let us suppose that banks were now allowed to leverage 30 times their equity with safe assets but still only 10 times with risky assets.

That with the previous numbers though risky assets would still produce a 10% risk adjusted return on equity, the safe assets now delivered 30%.

And so either the risky had to be charged 9% instead of 7%, so as to deliver the 3% risk adjusted return that, with a 10 times allowed leverage would earn banks a 30% risk adjusted return on equity, something that naturally made the risky even riskier; or the safe could be charged a 2% interest rate instead of 4%, and still deliver a 10% risk adjusted return on equity.

What happened? The risky, like unsecured loans to entrepreneurs, were abandoned by banks, while the safe, like sovereigns, residential mortgages and AAA rated, were much more embraced by banks, who even offered these lower interest rates than in the past.

And the risk-free rate became a subsidized risk-free rate.

“A ship in harbor is safe, but that is not what ships are for.” John A. Shedd. But the Basel Committee for Banking Supervision is causing banks to dangerously overpopulate safe harbors, while leaving the riskier oceans to other investors and small time savers.

And the savvy loan officers were substituted by creative bank equity minimizing financial engineers

The risk weights in the risk weighted bank capital requirements are to access to credit, what tariffs are to trade, only more pernicious.

https://subprimeregulations.blogspot.com/2016/09/if-ever-allowed-following-would-be-my.html

If the Basel Committee had only been asked these four simple questions about its risk weighted capital requirements for banks?

1. What? Do you really know what the real risks for banks are? If you do, why are you not bankers?

2. What? Don’t you see that allowing banks to leverage differently with different assets will lead to a new not market set of risk adjusted returns on equity. Are you not at all concerned this could dangerously distort the allocation of credit to the real economy?

3. What? Do you think that what’s perceived risky by bankers that which they adjust by means of lower exposures and higher risk premiums, is more dangerous to the bank system than what they perceive as safe?

4. What? A 0% risk weight of sovereigns? That could only be explained by their capacity to print currency in order to get out of debt. But is that not also one of their worst possible misbehaviors?

How much sufferings and how many unrealized dreams would not have been avoided?

And now, 30 years after that faulty regulation was introduced with the Basel Accord in 1988, these questions are still waiting for an answer.

PS. Here a list of some of the horrendous mistakes of the risk weighted capital requirements

Fed, during the last 15 years what were the capital requirements for a US bank when lending to Puerto Rico?

The single most important reason for which Greece’s debt levels got so out of whack was that the European bank regulators, out of misunderstood solidarity, also gave Greece, for purposes of capital requirements for banks a 0% risk weight. 

That of course allowed banks to leverage much more loans to Greece than loans let us say to an unrated European SME, which of course allowed banks to earn higher risk adjusted returns on equity lending to Greece than lending to an unrated European SME. (The Greek citizens now suffering have not held those regulators accountable for that lunacy)

Now we read: “The Puerto Rico debt, a result of generations of mismanagement, was enabled by Wall Street, which was enticed by the fact it was tax free everywhere in the U.S. and risky enough to provide rich yields.” “Trump Suggests Puerto Rico’s Debt May Need to Be ‘Wiped Out’” Justin Sink, Bloomberg, October 3.

“Mismanagement?” With respect to debt it takes as a minimum two to tango, the borrower and the creditor; and since distorting risk weighted capital requirements were introduced, the regulators also participate in that dance. 

So my immediate info request to the Fed would be: Over the last 15 years, so that we have some pre 2007-08 crisis figures too, can you show us precisely the evolution of how much capital American banks were required to hold when lending to Puerto Rico?

Who knows, Puerto Rican citizens might want to sue the Fed for stimulating an excessive lending/borrowing to Puerto Rico.

PS. It would also be interesting to know how much banks were required to hold against a loan to an unrated SME in Puerto Rico. To compare those requirements would allow us to establish whether there was some statist regulatory favoritism of the Puerto Rico government. 

The Riskiness of Country Risk

An Unsustainable Debt Sustainability 

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

Can you have a neutral interest rate when bank regulations are not neutral?

That theoretical interest rate that neither pushes nor restrains the economy from its natural rhythm of growth, is called the neutral interest rate, and is of course the subject of much interest by central bankers.

But what these bankers never discuss, who knows why, is what happens to this neutral interest rate, if bank regulations are not neutral.

Current risk weighted capital requirements for banks which allow banks to earn higher risk adjusted returns on equity with what is perceived, decreed or concocted as safe, than with what is perceived as risky, are clearly not neutral.

They push bank credit to the “safe” areas and away from the “risky” and that distortion must have a real cost for the economy.

Just for a starter, since the risk-weight assigned to the sovereign is 0%, all those “risky” SMEs and entrepreneurs who will not get credit or need to pay more for it, only because of these regulations that are biased against them, are paying a regulatory tax that is directly subsidizing lower interest rates for the government.

As I have argued many times before… we do not have real risk-free rates, we have subsidized risk-free interest rates.

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.

Why such hullabaloo about Trump’s at view of everyone conflicts of interest, while ignoring the bank’s hidden ones?

We all know that Trump is going to be subject to so much scrutiny that his “conflicts of interest” might even suffer. 

But on the large banks’ outrageous conflicts of interest, namely being able to use their own models to partially determine the capital they need to hold, on that everyone keeps mum. Why?

The lower the risk is calculated, the lower is the capital requirements, the higher is the allowed leverage, and so the better are the banks perspectives on obtaining high risk adjusted returns on equity. If that’s not a mother of a conflict of interest what is?

With risk weighted capital requirements, Basel Committee’s regulators fed the banking system brutish misinformation

If you have $100.000 to invest you might invest more and at a lower interest rate in what you perceive as safe, as compared to how you would invest in what you perceive as risky. But, even so, you would never ever think of your $1 invested in what you perceive as safe, to be any different than the $1 you have invested in what you perceive as risky. 

That is not the current case with banks. With the risk weighed capital requirements for banks, they have been told that $1 invested in what is perceived as safe, is worth much more than $1 invested in what’s is perceived as risky. That because regulators allow banks to leverage the former $1 much more than the latter; which means that $1 invested in what is ex ante perceived, decreed or concocted as safe, produce the banks a much higher expected risk-adjusted return on equity, than $1 invested in what is ex ante perceived or decreed as risky.

For instance Basel II, with its 8% basic capital requirement set a 20% risk weight for AAA rated private assets and 100% risk weights for unrated SMEs. That allow banks to leverage their equity, and the support they received from society 62.5 times with AAA rated assets and only 12.5 to 1 with loans to SMEs. That resulted into that for a bank to lend to a SME, as compared to lending to an AAA rated borrower, carried the cost of 50 times lesser leverage opportunities.

That signified that banks, in order to keep shareholders happy with high risk adjusted returns, and management bonuses high, had to keep to what was perceived as safe and abandon lending to what was perceived as risky.

So banks no longer finance the “riskier” future, they only refinance the “safer” past.

So banks are dangerously overpopulating safe havens and, for the real economy, dangerously underexploring riskier bays.

So banks are gladly financing those “safe” basements where jobless kids can live with their parents, and not those “risky” SMEs that stand a chance to create the jobs that could allow the kids to afford to become parents too. 

Damn those regulators who manipulated and still are manipulating the allocation of bank credit this way. They should be shamed and banned forever.

If ever allowed, the following would be my brief testimony about what caused the 2008 bank crisis

The following, if I am ever allowed to give it, as so many would not like to hear it, would be my brief testimony on what caused the 2008 bank crisis 

Sir, as I have learned to understand it, the 2008 crisis resulted from a combination of 3 factors.

The first were some very minimal capital requirements for some assets that had been approved, starting in 1988 with Basel I, for sovereigns and the financing of residential housing; and made extensive in Basel II of 2004 to private sectors assets with good credit ratings.

These allowed banks then to earn much higher expected risk adjusted returns on equity on some assets than on other, which introduced a serious distortion. After Basel II the allowed bank equity leverages were almost limitless when lending to “sound” (or friendly) sovereigns; 36 times to 1 when financing residential housing; and over 60 to 1 with private sector assets rated AAA to AA. Just the signature, on some type of guarantee by an AAA rated, like AIG, also allowed an operation to become leveraged over 60 times to 1. 

The second was Basel II’ extensive conditioning of the capital requirements for banks to the decisions of some very few (3) human fallible credit rating agencies. As I so many times warned about (in a letter published in FT January 2003 and even clearer in a written statement at the World Bank) this introduced a very serious systemic risk.

The third factor is a malignant element present in the otherwise beneficial process of securitization. The profits of that process are a function of how much implied and perceived risk-reduction takes place. To securitize something safe to something safer does not yield great returns for the securitization process. Neither does to securitize something risky into something less risky. 

What produces BIG profits is to securitize something really risky, and sell it off as something really safe. Like awarding really lousy subprime mortgages and packaging them in securities that could achieve an AAA rating. A 11%, 30 years, $300.000 mortgage, packaged into a security rated AAA and sold at a 6 percent yield, can be sold for $510.000, and provide those involved in the process an instantaneous profit of $210.000

With those facts it should be easy to understand the explosiveness of mixing the temptations of limitless, 36, and more than 60 to 1 allowed bank equity leverages providing huge expected risk adjusted ROEs; with subjecting the risk-assesment too much to the criteria of too few; with the huge profit margins when securitizing something very risky into something “very safe”. Here follows some indicative consequences:

As far as I have been able to gather, over a period of about 2 years, over a trillion dollars of the much larger production of subprime mortgages dressed up in AAA-AA ratings, ended up only in Europe. Add to that all the American investment banks’ holdings of this shady product.

To that we should also add Europe’s own problems with mortgages, like those in Spain derived in much by an excessive use of “teaser interest rates”, low the first years and then shooting up with vengeance.

And sovereigns like Greece, would never have been able to take on so much debt if banks (especially those in the Eurozone) would not have been able to leverage their equity so much with these loans.

Without those consequences there would have been no 2008 crisis, and that is an absolute fact.

The problem though with this explanation is that many, especially bank regulators, especially bank bashers, especially equity minimizing bankers, especially inattentive finance academicians, especially faulty besserwissers (those who love the sophisticated taste of words like "derivatives"), they all do not like this explanation, so it is not even discussed.

The real question though is: Who is the guiltiest party, those who fell for the temptations, or those who allowed the creation of the temptations?

I mean how far can you go blaming the children from eating some of that deliciously looking chocolate cake you left on the table, at their reach?

PS. Please do not categorize misregulation as deregulation. 

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

PS. And here is my letter to the Financial Stability Board that was officially received. Will it be answered?

Today I got to be 65, and so I give myself a list of some of my ramblings on bank regulations, in no special order.

The current pillar of bank regulations “more-perceived-risk-more-equity and less perceived risk less equity” is absolutely wrong, but might intuitively seem too correct so as to allow Daniel Kahneman’s System 2 even to begin its deliberation.

Today banks compete to obtain higher returns on equity more by reducing the equity needed that by identifying those who pay the highest risk adjusted margins.

Today the dollar in net risk adjusted margin paid by those perceived “safe” is worth more to the bank than that same dollar paid by “the risky”.

If you have regulators that do not understand that different equity requirements affects the risk-adjusted returns on equity of assets, which dangerously distorts the allocation of bank credit to the real economy…then you’ve got to change your bank regulators… urgently.

If you have regulators that do not understand that the perceived risk of bank assets does not matter since what is important is how the banks manage those perceptions of risk…then you’ve got to change your bank regulators… urgently.

If you have regulators that do not even look at the empirical evidence of what has caused all major bank crisis, never something perceived ex ante as risky, always something erroneously perceived ex ante as safe...then you’ve got to change your bank regulators… urgently.

If you have regulators who cannot manage the differences between ex ante perceived risks and ex post realities, and so can understand that what really poses dangers for the banking system at large are assets perceived as “safe”… then you’ve got to change your bank regulators… urgently.

If you have regulators who regulate banks without clearly defining their purpose… then you’ve got to change your bank regulators… urgently... because then the current ones would only be freaking dangerous vigilantes. 

If you have regulators who believe they have the right to odiously discriminate against the fair access to bank credit of those perceived as "risky", SMEs, entrepreneurs and start-ups… then you’ve got to change your bank regulators… urgently.

If you have regulators who believe they have the right to specially favor the fair access to bank credit of those perceived as "safe" sovereigns and members of the AAArisktocracy… then you’ve got to change your bank regulators… urgently.

If you have regulators who set the weights for capital (equity) requirements for banks when lending to government at 0%, and at 100% when lending to SMEs, which means that banks will lend more and at lower relative rates to the government than to the SMEs… that means de facto they believe that government bureaucrats are more productive using bank credit than SMEs… and then you’ve got to change your bank regulators… urgently... because then the current ones would only be freaking dangerous communists. 

Had regulators thought abut the “what are banks for?”, they would have known that banks are to allocate credit efficiently to the real economy, and they would never have concocted those highly distortionary credit-risk weighted equity requirements for banks.

A different take on the previous, is that the first step of any good risk management, is to clearly identify the risks you cannot afford not to take.

Few things are as risky as an excessive risk aversion.

Why is so much discussed about excessive risk-taking… and so little about excessive risk aversion?

Risk taking is the oxygen of development and we owe it to our kids and grandchildren that banks take risks with reasoned audacity. Nothing as dangerous, as excessive risk avoidance. God make us daring!

Our grandchildren will damn current bank regulators for denying them the risk-taking needed for them to find decent jobs.

Banks do not finance the risky future anymore they just refinance the safer past.

  

Bank regulators recommended banks an investment strategy fitting old retirees with short life expectancies and completely ignored the need of our young ones.

The best macro-prudential regulations is one of micro-prudential regulations that help banks to fail… fast… not the current micro-prudential regulation, which only helps to create too big to fail banks.

Mini-bank-equity requirements are the best growth hormones for the too big to fail banks.

Perfect information makes everyone to stay in bed… why bother, there’s not going to be any real profits? Blissful ignorance and imperfect information is a great driver of the economy.

Don’t ever allow a failed regulator to get away with the “this was a Black Swan, a totally unexpected event, a completely unforeseen consequence” excuse.

If a regulator tells you that the risk-weight of a sovereign is 0% but the risk weight of the citizens of that sovereign is 100%, then the regulators is not a regulator, only a communist.

If the Home of the Brave were really the Land of the Free, would they have allowed the current risk aversion in bank regulations?

With an Equal Credit Opportunity Act (Regulation B) how come regulators are allowed to discriminate against somebody’s access to bank credit only because he is perceived as risky from a credit point of view?

How can a Governor allow that his state chartered banks can lend, for instance to Germany, against much less equity that when lending to a local entrepreneur? 

Hold your bank regulators accountable. If they fail like they did with Basel II, do not promote them, and much less allow them to design Basel III. Neither Hollywood nor Bollywood would never ever do a stupid thing like that, after a mega box-office-flop.

Do not allow regulators to regulate within the confinement of a mutual admiration club. That only guarantees degenerative groupthink.

Without regulators and regulations, how many banks, like those in Europe, would have been allowed to leverage their equity 30 to 50 times to 1? ¡Zero¡ 

When you regulate, remember that every rule carries in it the seeds of being a systemic risk that can explode as a truly dangerous systemic error.

If your Homeland Security cannot visualize that bad distortive bank regulations could be even more dangerous than a full fledge terrorist attack… then you’ve got to refresh your Homeland Security

If you have progressives who do not understand how higher bank equity requirements when lending to those perceived as risky kills opportunities and drives inequality, then you better get yourself some new progressives.

If you have some free-market defenders that do not see how regulators, with their credit risk weighted equity requirements for banks, impose capital controls on where bank credit should go, and accept to talk about a de-regulated market, then you better get yourself some new liberals.

Finance professor’s in university that do not care about such “vulgar” issues as bank regulations and how these can influence the economy should be send to a boot-camp for a refresher. There they could for instance learn that the risk-free rate they are using is currently a subsidized risk free rate.

Anyone talking about de-regulation when we are in fact facing one of the most intrusive and distortive regulations ever… has been brainwashed.

While current regulatory distortions exists the QEs are just a waste, since these only help to increase the value of the existing assets… sometimes by even reducing what there is… like with the buybacks of shares.

“The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause the collapse of our banks.”

The whole regulatory framework coming out of the Basel Committee for Banking Supervision might possibly put a lid on development finance, as a result of being more biased in favor of safety of deposits as compared to the need for growth.

“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”

But... being too right is too bad for your own voice

Unless blessed with eternal ignorance, how can bank regulators live with themselves knowing what they are doing?

How naïve and infantile is it not to believe that what is perceived as risky is what is really risky?

PS. I will be editing and adding on to this points whenever I remember any other of my ramblings.

What are we to do with immoral and dumb dumb bank regulators?

Current bank regulators, with the Basel Accord of 1988, and further with their Basel II in 2004, decided to concoct and impose credit-risk weighted requirements for banks…more-risk-more-equity and less risk-less-equity.

That results in that bank can leverage more, and therefore obtain higher risk adjusted returns on their equity, and on the implicit and explicit support of taxpayers, when lending to “the safe” than when lending to “the risky”.

That constitutes a regulatory bias in favor of those who already are favored by bankers because they are perceived as safe, which results in an immoral and odious discrimination against “the risky”, those who are already naturally discriminated against by bankers.

And it is dumb because that distorts the allocation of bank credit to that real economy on which our pensions, our children and grandchildren’s future, and even our banks long-term safety depends upon.

And it is also dumb because never ever have major bank crisis resulted from excessive exposures to what was ex ante perceived as risky, these have all resulted from excessive exposures to what was ex ante perceived as safe but that ex post turned out to be very risky.

So what are we to do with these immoral and dumb dumb bank regulators? The Basel Committee and the Financial Stability Board, they don't even acknowledge that there is a problem.

PS. By the way, what are regulators really doing when they assign a zero risk weight to the government and a 100 percent risk weight to an unrated citizen? Does that not give out a very strong stench of communism?

On risk-taking, retirement accounts, and lousy bank regulations.

What would have happened with anyone’s retirement plan if, when a young professional and starting to save, his instructions would have included paying his investment manager much higher commissions on returns produced by safe investments, than on returns produced by riskier investments. 

There is no doubt that in such circumstances, his investment manager would have played it overly safe, and he, the beneficiary, would probably have had to retire on a very meager income.

But, by means of their credit-risk weighted equity requirements, which allow banks to earn much higher risk adjusted returns on their equity when lending to something “safe”, than when lending to something “risky”, the regulators are instructing the banks to act in precisely this way.

Whether we like it or not, banks have a very important role to play as investment managers for our economies. And the reason we taxpayers implicitly agree to support banks, is not for them to avoid risks, but to, with reasoned audacity, take intelligent risks on our behalf. 

And so, even if we have to pay banks high commissions, we need them to act much more like aggressive growth funds taking risks but looking to produce for us investors better returns; and for our economies sturdier growth; and for our young better good future employment opportunities.

So let's get these regulators out of our way!

What I would be tempted to say to Mario Draghi of the ECB, if I were Yanis Varoufakis of Greece

Mr. Mario Draghi.

You were the chairman of the Financial Stability Board for some years. In this respect, and especially since we have never heard you say otherwise, you were in full agreement with current bank regulations.

These regulations allowed any European bank to leverage much more when lending to the Government of Greece, or to other sovereigns, than when doing any other type of lending in Europe. For instance, Basel II restricted banks to leverage their equity to not more than 12 to 1 when lending to any unrated small business or entrepreneur in Europe, while allowing a leverage of more than 60 to 1 when lending to our government.

And so bankers became too interested in tempting our government with credit; and sadly our government-officials/politicians were unable to resist the sirens, and got too much into debt; and those Greek small businesses or entrepreneurs, those who with their activities are to generate the fiscal income needed to pay for our government’s expenses, they have had their fair access to bank credit severely curtailed.

And so I hold that you, Mario Draghi, are directly co-responsible for Greece’s current tragic predicaments.

Therefore, please allow me to speak with somebody else in the ECB.

PS. What is not included in the Memorandum on Economic and Financial Policies.

PS. Mr. Yanis Varoufakis, ask your own Greek bank regulators the following:

"Why on earth should a bank, operating in Greece, be allowed to lend to well-rated corporations elsewhere, or to sovereign governments, holding less equity than when lending to Greek SMEs and entrepreneurs?

I mean that does not sound right. That sound like a regulatory tax on our “risky” borrowers and a regulatory subsidy to strange “safe” borrowers."

Western world, it behooves you to understand the following about current bank regulations, and to do something about it.

Banks are currently allowed to hold much less equity against assets perceived as safe than against assets perceived as risky.

That means that banks are allowed to leverage their equity much more with assets perceived as safe than with assets perceived as risky.

That means bank currently obtain much higher risk adjusted returns on equity with assets perceived as safe than with assets perceived as risky.

And that, compared to equity requirements which do not discriminate based on ex ante perceived credit risks, means that banks will lend too much at too low rates to what is perceived as safe, and too little at relative too high rates to what is perceived as risky.

And the supposedly “safe” are sovereigns, basically considered as infallible, the members of the AAArisktocracy, and the housing sector.

And the supposedly “risky” are for instance all those SMEs and entrepreneurs we so much depend on for our economies to move forward, so as not to stall and fall.

And all for nothing! Major bank crises result always from to large exposures to what is erroneously perceived ex ante as safe, and never ever from too large exposure to what is perceived as “risky”.

And the distortions this regulation has created is destroying the Western world that has become what it is, not by risk avoidance, but by the reasoned and sometimes the unreasonable risk taking of our forefathers.

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

How did this monstrous regulatory mistake happen?

First and foremost because regulators concerned themselves with the risk of the assets of banks, which is what bankers should be concerned with, and not with the risk that bankers are unable to manage the perceived risks, or the risk perceptions being faulty, and which is what regulators should be concerned with.

Second by allowing the regulations to take place in a small mutual admiration club of “experts” with no accountability.

Third, by allowing ideology to infiltrate bank regulations to such an extent so as to make it possible for regulators to declare some sovereigns to be infallible, to have a zero risk weight.

Fourth by the fact we live in a world that finds it difficult to imagine, or does not want to recognize, the possibility of experts being so utterly wrong. 

How can we correct for it? Not easy, but it will clearly not happen by allowing the failed regulators to keep on regulating.

And please do not ask bankers to correct it. For them, being able to earn the highest risk-adjusted returns on equity by lending to the “safe”, is a dream come true. 

In 1999, in an Op-Ed I wrote: “The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause the collapse of our banks”

That AAA-bomb detonated in 2007-08 and its poisonous radiation is still killing our economies. For those coming after us… please do something! 

@PerKurowski

A former Executive of the World Bank (2002-2004)

http://teawithft.blogspot.com

http://subprimeregulations.blogspot.com/

http://financefordevelopment.blogspot.com

http://www.theaaa-bomb.blogspot.com

http://bombaaaa.blogspot.com

PS. Any editing suggestion that could make the explanation more understandable is appreciated on perkurowski@gmail.com

Scene 5 on the crazy reality lived while “Banking in times of the Basel Committee”

Jr. Credit Officer Martin: “Sir, I am not sure AIG deserves its AAA rating, and we keep somewhat important exposures to it. May I take a couple of our officers and assign them to do a little credit worthiness research on their own?”

Bank President Wally: “Have you gone raving mad? Do you know what that would cost? And who is going to pay us for that? The credit rating agencies have access to privileged information that AIG would never ever dream of giving to you, much less if they got hold of that you questioned their AAA rating...  So forget it! If the Base Committee and the Financial Stability Board considers that being able to get an AAA rating from a credit rating agencies merits us to being able to leverage our equity more than 60 times to 1, then those ratings must be good enough for us”

Jr. Credit Officer Martin: “But Sir?”

Bank President Wally: “No! No I do not want to hear any more buts from you! Have you no idea what the low, almost non-existent equity requirements for anything related to a good credit rating, the AAArisktocracy, has to do with the extremely high returns on equity our shareholders obtain... or with the fairly decent bonuses we get?”

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Scene 4 on the crazy reality lived while “Banking in times of the Basel Committee”

Jr. Credit Officer Martin: "Sir, do you not think that our exposure to Greece is way too big and risky? You know we only earn a 0.7 percent in margin on it and you know that country is so crazy it has an official retirement age of 50."

Bank President Wally: "Of course I do Martin. But since the Basel Committee allows us to leverage our equity with loans to Greece 60 times or more, tell me: how do you expect me to explain to our board we should withhold from a lending to Greece that produces us more than 42 percent in annual returns on equity?

And Martin, don't forget the bonuses we get... while nothing happens to Greece!"

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Here’s a crazy real life scene from “Banking in times of the Basel Committee”

Jr. Credit Officer Martin: “But Sir, I believe that borrower to be riskier than what the credit rating agencies and we perceive” 

Bank President Wally: “That might be Martin, but that possible extra risk is more than compensated by the fact that having to hold less equity against it, produces us anyhow a higher risk adjusted return on equity than many of our other loans… and so you better keep that perception to yourself… don’t forget our bonuses”

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Is telling banks “make your profits where it’s safe and stay away from what’s risky” an un-American act of cowardice?

I have heard many comments indicating as an “un-American act of cowardice”, that Sony cancelled the release of “The Interview”, after North Korean government hackers penetrated the studio's computers and threatened to attack theaters that showed the movie. 

I will not get into that but I would though take this opportunity to pop a question of my own on that epithet.

Currently regulations allow banks to hold much less capital (meaning equity) against assets perceived as absolutely safe than against assets perceived as risky; which allows banks to leverage their equity much more against assets perceived as absolutely safe than against assets perceived as risky; which of course means that banks will make much higher risk-adjusted returns on equity on assets perceived as absolutely safe than on assets perceived as risky… and which effectively means regulators are telling the banks “Go and make your profits where it is safe and stay away from the risky”. 

With that are not regulators inciting the banks in the Land of the Free and the Home of the Brave to commit un-American acts of cowardice?

Reviving Economic Growth: A Cato Online Forum: My unsolicited opinion

Question: If you could wave a magic wand and make one or two policy or institutional changes to brighten the U.S. economy’s long-term growth prospects, what would you change and why?

My answer:

Anyone who thinks the US would have become what it is by allowing banks to earn much higher risk-adjusted returns on equity when financing what was perceived as absolutely safe than what was perceive as risky... raise his hand.

I say this because current credit-risk-weighted capital (equity) requirements for banks, allow banks to hold government debt and loans to the AAAristocracy against much less equity than when financing “risky” small businesses and entrepreneurs, and so that is de facto what you get.

And since risk taking is the essence of development, “the home of the brave” will go down if you continue to impose on your banks such regulatory risk-aversion.

Have you lately asked your friend the banker how much equity he needs to have in order to give a loan to an unrated fellow American citizen, compared to what he needs to have when lending to his government? Do that! And then you will begin to understand how much communism is creeping in on “the land of the free.”

You are already giving your banks a lot of support, so don’t also give them easy money allowing high returns leveraging on the safe… make them sweat their returns lending also to the risky... because that is how you build, or keep a nation great.

And so friends, if you want to have growth, get rid, urgently, of that distorting regulatory nonsense; which by the way does not make your banks safer, as never ever are major bank crisis the result of excessive exposures to what is perceived as risky… these always result from excessive exposure to something that was wrongly thought as absolutely safe.

What to do when even describing it, an eminence like Martin Wolf is yet unable to see The Great Bank Distortion?

On page 251 of his “The shifts and the shocks” Martin Wolf writes: 

“But [bank] shareholders should only be interested in their risk adjusted returns. If taking on more risk does not raise risk-adjusted returns, shareholders should flee.”

But let me now give you the fuller version of what he writes:

So: "If taking on more risk [like lending to small businesses and entrepreneurs] “does not raise risk-adjusted returns, [because when doing so bank regulators require banks to hold more equity] “shareholders should flee”.

The result: No bank credit to “risky” small businesses and entrepreneurs.

And the other side of the coin would be: "If taking on less risk, like lending to the infallible sovereigns, the housing sector or to members of the AAAristocracy, does raise risk-adjusted returns, because when doing so bank regulators allow banks to hold much less equity, shareholders will love it.

The result: Too much bank credit to the infallible sovereigns, the housing sector and members of the AAAristocracy.

And Martin Wolf, on page 243 concludes that: “Risk-weighted assets can play a secondary role. That way one would have a ‘belt and braces’ approach: a strong leverage ratio, plus a risk–weighted capital ratio as a back-up.

And that he does because on page 251 he argues: “Risk-weighting is extremely unreliable, because the samples from which the weights are derived are always too small or irrelevant”. 

Wolf simply does not understand the dangerous distortion produced by risk weighting... even if the risk-weights are perfect. If perfect they would be perfectly cleared for in the interest rates, the size of bank exposures and all other contractual terms. To also clear for these perfect risk-weights in the capital, signifying a double counting of the perfect risk weights, is just sheer regulatory lunacy. 

“A ship in harbor is safe, but that is not what ships are for”, wrote John Augustus Shedd (1850-1926),.And that goes for our banks too.

And precisely because we all want our ships, or our banks, to sail as safe as possible to the ports we want them to sail to… the last think we should do… is what bank regulators, thinking themselves with 'fatal conceit' capable of being risk managers to the world did… namely to start tinkering with risk weights with their compasses. 

And so no Martin Wolf, not even as a back-up is there a role for credit risk weighted bank capital.

And if we really get down to what Wolf writes on page 252: "the disaster came from what banks wrongly thought to be safe", and which by the way is what all empirical evidence would point at as the usual suspect of causing bank disasters, then the capital requirements should be totally opposite; larger for what is perceived as absolutely safe and lower for what is perceived as risky.

In short, the number one "Macro-prudential Policy" that needs to be implemented, is to get rid of the current batch of distorting bank regulators. But, for that to happen, it is helpful that eminences, like Martin Wolf, also understands what is going on.