“The empires of the future are the empires of the mind”, said Winston Churchill, and sadly we’re losing ours.

A Western world that, without questioning, allows its regulators to require banks to hold more equity when lending to those perceived as risky, than when lending to those perceived as safe, is showing serious evidence of losing its mind.

Not only are those perceived as “risky” not really risky for the banking system; it is those perceived as "absolutely safe" which can be; but that also impedes our banks from allocation credit efficiently to the real economy.

It is only daring and reasoned audacity that can keep us moving forward, so as not to stall and fall. Have we become so risk-adverse so as to blind ourselves to the real risks of avoiding taking the risks we must take?

The Basel Committee, the Financial Stability Board and “The Parable of the Talents” Matthew 25:14-30

The governments, on behalf of us citizens, us taxpayers, support the banks in times of troubles, for instance by the Fed acting as a lender of last resort. And that can cost us citizens, us taxpayers, a lot.

But that risk of supporting the banks is not acceptable only in order to produce special profits to bank shareholders, or just to have the banks serve as a mattress where to safely stash away our money. It is accepted exclusively so that banks, by means of efficiently allocating bank credit, could help us to drive our economies forward.

And that willingness to support-the-banks-risk is, for its management, placed into the hands of bank regulators, like the Basel Committee and the Financial Stability Board.

But these regulators decided (on their own) that banks’ primary purpose was to avoid risks… something loony because that by itself would negate the reason for supporting the banks.

And so they concocted credit risk weighted equity requirements that made banks earn much higher risk-adjusted returns on equity when lending to those perceived as "absolutely safe", than when lending to "the risky".

And that regulatory risk aversion, besides stopping banks from lending to the risky, like to small businesses; also made banks lend excessively to what ex ante was perceived as absolutely safe, but that ex post turned out to be very risky, like AAA rated securities and Greece.

And that all resulted in a crisis that caused immense costs… this time without having generated sufficient and reasonable compensation in terms of creating sturdy economic growth.

And those risk adverse regulations now block our way out of the crisis... and might doom our young to become a lost generation.

And today in mass we were reminded of “The Parable of the Talents: Matthew 25:14-30, and of which I extract the following: 

14 “It will be like a man going on a journey, who called his servants and entrusted his wealth to them. 15 To one he gave five bags of gold, to another two bags, and to another one bag, each according to his ability. Then he went on his journey… 

24 “Then the man who had received one bag of gold came. ‘Master,’ he said, ‘I knew that you are a hard man, harvesting where you have not sown and gathering where you have not scattered seed. 25 So I was afraid and went out and hid your gold in the ground. See, here is what belongs to you.’

26 “His master replied, ‘You wicked, lazy servant! So you knew that I harvest where I have not sown and gather where I have not scattered seed? 27 Well then, you should have put my money on deposit with the bankers, so that when I returned I would have received it back with interest. 28 “‘So take the bag of gold from him and give it to the one who has ten bags. 29 For whoever has will be given more, and they will have an abundance. Whoever does not have, even what they have will be taken from them. 30 And throw that worthless servant outside, into the darkness, where there will be weeping and gnashing of teeth.’

And in the sermon we later heard abut the dangers of caution and of playing it safe; and about the security that comes from risk-taking.

And there was a reference to Erikson’s Theory… with its Generativity that includes reaching out to others in ways that give to and guide the next generation, and a commitment which extends beyond self; versus Stagnation with its placing own comfort and security above challenge and sacrifice, and its self-centered, self- indulgent, and self-absorbed.

And we prayed for “courage so that we can walk in the way of the Lord”… and of course I was reminded of “God make us daring!”

And so I naturally identified with the “Master” in wanting to throw those “wicked lazy” bank regulators “outside, into the darkness, where there will be weeping and gnashing of teeth”

US Congress, you are the legislators, so who of you ordered the banks in the home of the brave to become credit risk adverse?

Fact: Banks give larger loans, charging lower interest rates and allowing for leaner terms to those perceived as absolutely safe, than when lending to those perceived as risky. And that so much, that your Mark Twain described bankers as those who lend you the umbrella when the sun shines but want it back as soon as it seems it might rain.

Fact: Your regulators now allow banks to hold much less capital for what from a credit risk perspective is perceived as “absolutely safe” than against what is perceived as “risky”.

Fact: And that means banks can leverage their equity much more when lending to those perceived as “absolutely safe” than when lending to those perceived as “risky”.

Fact: And that means banks will earn much higher expected risk adjusted returns on their equity when lending to those perceived as “absolutely safe” than when lending to those perceived as “risky”.

Fact: And that means banks will lend almost exclusively to those perceived as “absolutely safe”, and basically nothing at all to those perceived as “risky”.

Fact: And that seems as far away as can be for the home of the brave which became a great land of the free primarily because of risk-takers… as few risk adverse crossed the ocean to reach its coasts.

And so the question: Who of you US legislators ordered the banks in the home of the brave to become even more risk adverse than what Mark Twain held these to be?

And legislators, if you are somewhat confused by these comments, may I suggest you invite your bank regulators to an open hearing to explain their main scripture, “The Basel Committee on Banking Supervision´s Explanatory Note on the Basel II IRB Risk Weight Functions of July 2005” to you. 

But then you might really going to be scared.

PS. Here is an updated list on the many mistakes with risk weighted capital requirements

Europe’s unemployed youth, is a result of expulsing testosterone from its banking system. Is it accident or terrorism?

To call banks cuddling up excessively in loans to the Infallible Sovereign and the AAAristocracy, an excessive risk-taking which results from too high testosterone levels, is ludicrous. That is just cowardly hiding away, guided by computer models, in havens officially denominated as absolutely safe.

The risk-taking which requires true banking testosterone is the lending to medium and small businesses, entrepreneurs and start ups.

Unfortunately bank regulators, by means of allowing for far less capital when lending “to the safe than when lending to “the risky”, guaranteed that the expected risk-adjusted returns on bank equity when lending to the former were much much higher than when lending to the latter. 

And, as any economist knows, equity goes to where the highest returns are offered. And so bankers possessing true testosterone, were all made redundant. And since the safe jobs of tomorrow need the risk-taking of today, and “the risky” got and get no loans, the European youth ended up without jobs… or even the prospective of jobs.

I have always thought this regulatory calamity was an accident resulting from allowing some very few regulators to engage in intellectual incest, in some small mutual admiration club where it is prohibited by rules to call out any member as being at fault.

But now, since more than five years after the detonation of the bomb that was armed in 2004 with Basel II, the issue of the distortion these capital requirements produce in the allocation of bank credit in the real economy is not yet even discussed, reluctantly, because I am no conspirator theories freak, forces me to admit the possibility of terrorism.

And frankly what is the difference between injecting bankers with a testosterone killing virus, and doing so with a mumbo jumbo bank regulation no one really understands?

Poor European youth… they are not yet aware that unless they expulse the current bank regulators from the Basel Committee and the Financial Stability Board, for being dumb or terrorists, they live in an economy that is going down, down, down.

Do bank regulators suffer from damage in the ventromedial prefrontal cortex?

All major bank crises originate not from too much lending to what is perceived as risky, that never happens, but from too much lending to something perceived as absolutely not risky but that later becomes very risky, and this often because too much has been lent to it. This is a fact, and regulators, financial journalists and other experts know it. 

And yet, bank regulators set up capital requirements for banks that were much higher when the perceived risk were higher than when the perceived risk were lower, and thereby generated the incentives for too much lending to the latter… as a result of that since banks were allowed to leverage their equity more when doing so, banks could obtain a higher return on their equity when lending to what was officially deemed as absolutely not risky. 

And that not only caused the current crisis but it also keeps us from digging ourselves out of it, as it discriminates against all the “risky” small businesses and entrepreneurs we need to help us. 

And no matter how much I have written about it, the regulatory nannies don’t seem to get it, and keep on digging us, deeper and deeper, into what I have called “L’economia castrata”, that which so dangerously discriminates against what seems as “risky”. Why is this so? 

Well Malcolm Gladwell, in his book “Blink”, 2005, wrote that those who suffer from damage in the ventromedial prefrontal cortex, “can be highly intelligent and functional, but they lack judgment”, and that it “causes a disconnect between what you know and what you do”. Could that be it?

Capital requirements for banks, according to any behavioral finance, should NOT be based on perceived risk, but on what banks do with any perceived risk.

But, whatever it does, Europe first needs to put the sparkplugs back into its economic engine.

Those sparkplugs, the risk-takers, the “risky” small business and entrepreneurs, were forcedly removed by the regulators when they decided to base the capital requirements for banks on the perceived risks of default, as if those perceptions were not already discriminated for sufficiently by the banks. 

What these regulations delivered, as should have been expected, are dangerous obese bank exposures to what is officially perceived as not-risky, and, for us and economic growth, equally dangerous anorexic exposures to what is officially perceived as “risky”. 

But, unfortunately, what does Mario Draghi of ECB and his fellow failed regulators know about sparkplugs?

Homeland Security, bad bank regulations could be used as a lethal weapon of terrorism

Mark Twain is attributed having said: “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain” and yes, we all know that bankers are characteristically risk-adverse. 

What then if someone somewhere concocted a biochemical agent that made the bankers even more risk-adverse, perhaps a testosterone reducer... a de-testosteroner. Would that not be classified as an act of terrorism, even if the chemist proved there was absolutely no bad intention?

But that is what effectively bank regulators did, when they allowed banks to have much less capital  (equity) when lending or investing in what was officially perceived as "absolutely safe", than the capital (equity) they were required to hold against any asset officially perceived as risky.

That allowed banks to earn higher risk-adjusted returns on equity when lending to "the infallible" than when lending to "the risky", something which introduced the mother of all distortions in how bank credit was allocated to the real economy.

As should have been expected, the result was a crisis that destroyed the economy of the US; by dangerously overcrowding the perceived safe-havens, like triple-A rated securities and infallible sovereigns (Greece); and by causing the equally dangerous underexposure to what is perceived as being risky, like in lending to small businesses and entrepreneurs. 

Honestly, is the willingness of the banks to take risks not a matter of national security for the Home Of The Brave?

Why do we so easily accept the distractionary explanation that the current crisis was caused by excessive risk-taking when so clearly all the serious losses have been in what was officially considered as the safest type of bank lending and investment?

PS. Here is a current summary of why I know the risk weighted capital requirements for banks to be dangerous nonsense.

Who on earth authorized the Basel Committee to do more than regulate or supervise banks?

The Basel Committee for Banking Supervision, whose recommendations the USA has committed to follow, has decided that when a bank lends to the government it requires zero capital but that when it lends to a small businesses or entrepreneur, it needs 8 percent of generously defined bank capital (Basel II), or 7 percent of more strictly defined bank capital (Basel III).

In doing so the Basel Committee is doing much more than regulating and supervising banks, it is de-facto introducing a monstrous, almost communistic, pro-government bias into the world’s financial system, as well as an unexplained risk-adverseness that could easily jeopardize the creation of the next generation of decent jobs. 

Besides it is utterly stupid because never ever has a bank crisis originated because of excessive lending to those who like small businesses or entrepreneurs are perceived as more risky, and therefore already pay higher interest rates, which goes into the capital accounts of the banks.

Who on earth authorized the Basel Committee to do what they do and which, by the way, sounds so un-American?

Crazy bank regulations explained in red and blue

How sad bank regulators didn’t listen to Pope John Paul II

The Basel Committee for Banking Supervision, and other assorted bank regulators, decided to increase the risk-adverseness of banks by imposing on them capital requirements based on officially perceived risk, among other as perceived by some few officially appointed risk-perceivers, the credit rating agencies.

And, naturally, if when doing so one favors the financing of houses, public debt and whatever has managed to temporarily hustle up a good credit rating, and discriminate against all of what is officially perceived as “risky”, like small businesses and entrepreneurs, one will, naturally, end up with a lot of houses, dangerously excessive lending to what is triple-A rated, a huge public debt, and very few jobs which, to create, requires a lot of risk-taking.

How sad the regulators did not listen to Pope John Paul II when he said “Do not be afraid. Do not be satisfied with mediocrity. Put out into the deep and let down your nets for a catch.”

Does the devil reside in Basel?

The following is a verse of a Swedish psalm (244).

“God, from your house, our refuge, you call us, out to a world where many risks await us.

As one with your world, you want us to live. God make us daring!”

“God make us daring!” expresses extraordinarily well the need that society has of risk-taking, in order to move forward, so as not to start rotting.

Unfortunately that is a need that our current global bank regulators, the Basel Committee, has not the least understanding of. They give banks huge incentives to operate in areas where risks are perceived as low, as if bankers would not do enough of that of their own will, and punish banks when entering areas where risks are perceived as high, as if bankers would not, on their own will, mostly avoid those.

The regulatory risk-adverseness is clearly evidenced by that banks, when lending to a small business or an entrepreneur, are now required to hold FIVE TIMES as much capital than when lending to a triple-A rated entrepreneur. That signifies that although the banks already compensate for perceived risk of default by charging different risk premiums, they have now to discriminate twice on that perception having to charge different premiums with relation to capital requirements.

As a result small businesses or entrepreneurs have their access to bank credit curtailed and their borrowings made much more onerous than needed, while those perceived as less risky have more access and cheaper access to bank credit than what they would otherwise have.

As a result we are suffering a huge financial crisis that has precisely resulted from what is always the cause of bank crisis, excessive investments and lending to what ex-ante is perceived as having a low risk of default, because, of course, no financial nor bank crisis has ever resulted from excessive investments and lending to what ex-ante is perceived as having a high risk of default.

We need to stop this regulatory nonsense that is killing the vitality of our economies. There is nothing as so risky long term as turning into cowards unwilling to run risks… and the Basel Committee has no right or reason for tempting the world into believing that development and growth can take place in a park with only safe attractions, only because the regulators are so childishly frightened of their so innocent and even indispensable default monsters. Scary is a world without defaults!

What about the risk of billions of young people around the globe not finding jobs? That is a real risk to write home about!

Let us never forget that the door to enter into a better and more sustainable, and more job-rich future, might only be found by taking the craziest risks in the middle of the craziest boom… that’s life… that’s development.

Honestly, the current risk weighted capital requirements for banks, are an insolence to the memory our risk-taking forefathers.

The UN Conference Crisis & Development June 2009 - My Dissapointments

UN Conference Crisis & Development June 2009 Disappointments
Uploaded by PerKurowski. - News videos from around the world.

0:30 Millennium Development Goals

2:00 Risk weighted capital requirements for banks 

5:08 Polarization

6:25 Migrants in the world

62.5 to 1!

The regulators they authorized a leverage of 62.5 to 1!

Uploaded by PerKurowski

The risks of following the wimps from Basel

Stating that “poor credit-rating practices” have brought on the current crisis is part of what brought us here, because the fact is that the better the credit-rating practices, the more we risk following the practitioners into the wilderness.

The minimum capital requirements for banks based on credit rating of risks, introduces an formal regulatory risk adversion against “risks of default” that will set us up to all other type of much more dangerous risks.

Who dares to tell me that avoiding default risks is all financing is about?

From now on are the bailouts we going to see only to be the result of faultily measured risks and not of those risks that society incurs to move it forward?

Currently our biggest problem is that most have completely bought the silly one track-mind agenda of our financial regulators… the Basel wimps!

Financial regulation is much too serious to be left in the hands of the members of the mutual admiration club of financial regulators.

If we are going to waste taxpayer’s money let us at least assure the crisis has been worth it. Never in life have I seen such a useless crisis than the current one that has only produced millions of people to move in into their homes only to be evicted a couple of months and many tears later.

My questions to the World Bank/IMF - Spring Meetings 2008

Risk is the oxygen of development!

It is absurd to believe that the US and other countries would have reached development without bank failures. When the Basel Committee imposes on the banks minimum capital requirements based solely on default risks, this signifies putting a tax on risk-taking, something which in itself carries serious risks. The real risk is not banks defaulting; the real risk is banks not helping the society in its growth and development. Not having a hangover (bank-crisis) might just be the result of not going to the party!

We need to stop focusing solely on the hangovers and begin measuring the results of the whole cycle, party and hangover, boom and bust! The South Korean boom that went bust in 1997-1998 seems to have been much more productive for South Korea than what the current boom-bust cycle seems to have been for the United States.

All over the world there is more than sufficient evidence that taxing risks has only stimulated the financing of anything that can be construed as risk free, like public sector and securitized consumer financing; and penalized the finance of more risky ventures like decent job creation. Is it time for capital requirements based on units of default risk per decent job created?

When is the World Bank as a development bank to speak up on this issue on which they have been silent in the name of “harmonization” with the IMF?

When are we to stop digging in the hole we’re in?

The detonator of our current financial turmoil were the badly awarded mortgages to the subprime sector and that morphed into prime rated securities with the help of the credit rating agencies appointed as risk surveyors for the world by the bank regulators.

If we survive this one and since it is “human to err” we know that if we keep empowering the credit rating agencies to direct the financial flows in the world, it is certain that at some time in the future we will follow them over even more dangerous precipices.

Note: I have just read the Financial Stability Forum brotherhood’s report on Enhancing Market and Institutional Resilience and while including some very common sense recommendations with respect to better liquidity management and “reliable operational infrastructure”; and some spirited words about more supervision and oversight (the blind leading the blind); with respect to the concerns expressed above, bottom line is that they recommend we should deepen the taxes on risks and make certain that the credit rating agencies behave better and get to be more knowledgeable… so that we are more willing to follow them where we, sooner or later, do not and should not want to go.

Do micro-credit institutions make too much use of “predatory ratings”?

Any group of debtors that is charged a higher interest rate because it is considered a higher credit risk is composed by those spending their money servicing a debt that they will finally default on, and those who should have in fact deserved a lower interest rate. Are there any real winners among them?

Who is out there talking about that the extensive use of ratings signifies something like a regressive tax for the poor? Who is out there informing the poorly rated about how very dearly they are paying for their loans? Who is out there analyzing the murdering impact that credit ratings have in chipping away at the minimum levels of solidarity that any society needs to keeps itself a society?

If there is a minimum of things that needs to be done in the world of micro credits that is to focus more on transparent system of incentives that: 1. Stimulates and rewards good group behavior and returns to the compliant borrowers some of the “extraordinary” margins earned. 2. Spreads out the costs of those who cannot make it over a much wider group of debtors.

And, by the way, this applies just the same to the financing of mortgages to the subprime sector.

Why we cannot leave bank regulators to regulate on their own!

Nout Wellink the Chairman of the Basel Committee on Banking Supervision declared in the Financial Time on April 10 2008 that “Basel II is sophisticated and sorely needed”; and it is a splendid confirmation of why we cannot leave the traditional bank regulators regulating banks on their own. The just are digging ourselves deeper in the hole we are in!

Of course there is nothing wrong with sophistication as long as it does not take away from our understanding of what is going on, which it will be the end result, which makes further mockery of market transparency; and as long as it does not create new artificial market advantages, which it will by favoring the big banks and the continuation of our craze of putting ever more eggs into fewer basket; and as long as it does not create new systemic risks, which it will as long as “to err is human” applies, just like it applied in the case of the credit rating agencies.

But, what I most object to is that “there will be greater differentiation in the capital requirements for high risk and low risk exposure”. Who on earth told the bank regulators that the only role of banks was to avoid failing and that for that purpose you had to create an additional regulatory bias against risks, more than the natural bias against risk that already exists in the market? No, we do not need the banks to increasingly finance only securitized consumers and public sectors around the world just because that could be construed as having a lower risk of default. To do so could lead the world to default. If we are going to use default risk as a basis, then we better design the minimum capital requirements in terms of units of risk per decent job created.

Basel, please give us back our old known risks!

Are the bank regulations coming from Basle good for development?

The document that I presented at the High-level Dialogue on Financing for Developing at the United Nations, New York, October 2007, as a member of New Rules for Global Finance.

ARE THE BASEL BANK REGULATIONS GOOD FOR DEVELOPMENT?

1. It is very sad when a developed nation decides making risk-adverseness the primary goal of their banking system and places itself voluntarily on a downward slope, since risk taking is an integral part of its economic vitality, but it is a real tragedy when developing countries copycats that and falls into the trap of calling it quits.

2. In his book “Money: Whence it came, where it went” (1975), John Kenneth Galbraith speculates on the fact that one of the basic fundamentals of the accelerated growth experienced in the western and south-western parts of the United States during the past century was the existence of an aggressive banking sector working in a relatively unregulated environment. Banks opened and closed doors and bankruptcies were frequent, but as a consequence of agile and flexible credit policies, even the banks that failed left a wake of development in their passing.

3. Few things can be so relevant to the financing of development as the regulations that are being applied to commercial banks. Unfortunately, as the world has been quite infatuated with the banking regulations emanating from Basel ; as they seemingly kept the bank crisis at bay so efficiently –although some of us believe they seemed more destined to stop the small tremors than to help to avoid the big quakes, or what in recent Alan Greenspan terminology would amount to a lack of "benevolent turbulence"– there has been no room to question the basic principles of the regulations, much less so from the perspective of developing countries that "needed" to be "saved" from their recurring bank crises.

4. As a former Executive Director at the World Bank (2002-2004) who tried to voice this issue frequently, among others at an ECOSOC-Bretton Woods-WTO meeting at the UN in April 2004, I can testify to the difficulties.

5. Some specific problems, such as the possible reinforcement of the pro-cyclicality of bank lending, and some specifics of the Basel II reforms such as its high costs, which could give the larger banks a comparative advantage, have been recorded as discussed, though resulting in nothing special of practical consequence. We should also comment that it is a bit surrealistic to debate the Basel II reforms without ever having entered into and much less exhausted the discussions on the fundamental principles imbedded in Basel I, which clearly contain the genesis of a series of factors that could affect the financing of development.

6. The recent financial turmoil that has cast some serious shadows on some of the Basel operational methods, for instance the high reliance on credit rating agencies, can perhaps now provide us with the opportunity to ask and debate "Are the bank regulations coming out from Basel truly compatible with the best interests of developing countries?" It is in this vein that we would like to start by raising the following issues:

Current regulatory arbitrage favors risk adverseness

7. The bank regulations that come out from Basel are almost exclusively against-risks-at-any-cost driven and so they completely ignore the other two major functions of banking systems, namely to help generate growth and to distribute opportunities.[1] The fact that in a developing society there are some risks more worthy to take than others is completely ignored in the minimum capital requirements ordained by Basel. The argument that "a stable banking system is critical to the long-term growth of an economy" is repeated like a mantra with no consideration of the stage of development and circle of growth in which a country finds itself.

8. Credits deemed to have a low default or collection risk will intrinsically always have the advantage of being better perceived and therefore being charged lower interest rates, precisely because they are lower risk. But, the minimum capital requirements of the Basel regulations, by additionally rewarding "low risk" with the cost saving benefits resulting from lower capital requirements, are unduly leveraging the attractiveness of "low risk" when compared to "higher risk" financing.

9. Allow us to illustrate this central argument in a very simplified way. Under the current Basel I Standardized Approach, a low risk corporate loan (rated AAA to AA-) requires a bank to hold only 20% of the basic 8% capital requirement, meaning 1.6 in units of capital, while a much riskier loan (rated below BB-) requires it to hold 150% of the basic 8%, meaning 12 units of capital. If the current cost of capital for the bank is 15%, then the bank's carrying cost for the low risk credit is 0.24% (8%*20%*15%) while the bank's carrying cost for the high risk credit is 1.80% (8%.150%*15%), thereby producing an additional cost of 1.56% that must be added on to the normal spread that the market already requires from a high risk compared to a low risk loan in a free market.

10. The extra Basel spread on risk makes it more difficult for higher risk borrowing needs to have access to credit from the commercial banks. In a developed country this might not be so serious because there are other alternative sources, but in a developing economy this is fatal, as the commercial banks frequently represent the only formal and supervised source of finance.

11. And of course the Basel effect does not limit itself to the extra carrying cost. From the perspective of the balance sheet we see that each unit of bank capital can sustain 62.5 units of low risk lending but only 8.3 units of high risk lending, and since bank capital itself is more scarce in a developing country, this also induces channeling of local savings increasingly towards the low risk side of the economy.

12. In Basel II, while the "Internal Ratings-Based Approach" provides a much more refined instrument for assessing risks it creates even more bias against risk, much the same as a health insurance scheme is able to offer more differentiated rates the more they know or think they know about the expected health prospects of their clients. We should not ignore that the finance of development requires the current generation to be willing to share in the risks of the future so as to help the society and coming generations to progress. In this respect the Basel risk adverseness could be described as a baby-boomer generation's invention to assure that their savings are there when they need them, with little consideration to what might come after.

13. By adding on a new layer of sophistication and digging deeper in the hole created by Basel I, Basel II will ironically increase the possibilities of new systemic risks and make the fight against the risks targeted by the Basel Committee even more difficult. This particular problem lies outside the context of this paper but for those interested we refer to the Statement number 160 of the Shadow Financial Regulatory Committee, March 2000,[2] where they propose instead the more logical route of harnessing more market discipline by using subordinated debt to make capital requirements more risk sensitive.

14. We are by no means implying that the risks in lending should be taken lightly, but since development normally does not make a living in the land of low risks, much the contrary, this regulatory arbitrage of overly benefiting risk adverseness, and adding on costs, is very costly for development. In short, Basel provides economic signals for maintaining the status quo rather than fostering development.

15. In this respect, and since the current Basel II proposals do contain much that could stimulate the banks to better quantify and manage risk, an alternative that could perhaps provide some of the benefits with less regulatory-ordered bias would be to require a flat percentage of assets as the capital requirement for the banks but forcing them to report to the market a Basel-calculated minimum capital, thereby allowing the market participants, investors or depositors, to price in their views on the differences between these two figures. Going this route would also diminish the quite dangerous possibility that the markets begin to believe that the Basel minimum capital requirements constitute a perfect risk equalization machine among banks with totally different risk structures.

16. As much of the risk management used by Basel is based on the analysis of old data, so as to establish loss probabilities, we also need to acknowledge the fact that a desired future does not stand on past statistical data, much less in the case of developing countries where that past statistical data refers precisely to what should be avoided in the future, and bears little relevance to what needs to be done.

17. But again we wish to make absolutely clear that this is NOT a proposal to abolish the Basel minimum capital requirements outright, but rather to study its other social costs in order to contain these or develop alternative methods that better balance the different societal objectives for the banks.

Current regulatory arbitrage leads to risk hiding

18. An excessive anti-risk bias will naturally stimulate risk hiding. Let us not forget that the need for assets to be qualified as more or less risky is exactly the reason why the credit rating agencies were so much empowered that now we also have the credit rating agencies bias risk, which already helped to create the sub-prime mortgages debacle.

19. One of the dangers for a developing country, where regulatory weaknesses might be more easily exploitable, is that the banks deviate all assets that in their opinion carry a lower capital requirement than what the regulator-credit rating agencies order into other formal or informal places of the market, while loading up their balance sheet with assets for which the risk/capital allocation seems a bargain; giving new meaning to the Thomas Gresham's principle that states that "bad money drives out good money.”

20. The mentioned risks are clearly not limited to developing countries and we can find a discussion of it in the context of developed countries in a speech of Alan Greenspan on "The Role of Capital in Optimal Banking Supervision and Regulation"[3] in 1998.

Excessive empowerment of new participants

21. Credit rating agencies. The Basel I Standardized Approach regulations led to the credit-rating agencies substituting for some of the traditional in-house credit analyst departments in local banks which, for better or for worse, had allowed credit analysis to be more colored by local factors. This has affected the whole credit environment, and the recent drive towards "development banks" and the establishing of the micro credit institutions can be seen in great part as efforts to satisfy needs created by the Basel inspired bank regulations.

22. It is indeed very difficult for developing countries to understand how authorities that have frequently preached to them the value of the invisible hand of millions of market agents can then go out and delegate so much regulatory power to a limited number of human and very fallible credit-rating agencies, especially as this must surely be setting us up for very serious new systemic errors.

23. Powers to the Supervisors. The Basel II "Internal Ratings-Based Approach" returns much of the credit analysis to the banks themselves, where it belongs, but in doing so it generates a series of new hands-on activities for bank supervisors who will need to consent, concur, approve and what have you, and which can only create new sources of distortions. In this respect suffice it to read the book by James R. Barth, Gerard Caprio, Jr. and Ross Levine, "Rethinking Bank Regulations: Till Angels Govern" [4] to reflect on the possible consequences.

We need much more research

24. When looking at how consumer credit is growing fast in so many developing countries, mainly because it can be more easily packaged (or camouflaged) as a low risk operation while traditional entrepreneurial credits barely skimp along, it would be natural to ask whether this could not be the direct result of the Basel regulations.

25. Could Basel be hindering development finance? What are the consequences of regulatory arbitrated risk adverseness? Is Basel introducing a bias in favor of public sector finance? Could the paradox of the increasing net outward financial flows from developing to developed countries be in any way related to these regulations?

26. These are all vital questions but there seems to be no ongoing research to try to understand how global financial flows have been affected by the Basel regulations and by the use of the credit rating agencies. The topic seems almost taboo, but given the importance of banking regulations for the financing of development, we would urge giving more priority to the research of these issues.

Who is the lender of last resort?

27. One concern, much aggravated by the new Basel II regulations, is that the world might have been irrevocably placed on a route that leads it to end up with just a couple of big international banks. In such a case, if one of these banks that have captured a very large share of local deposits in a developing country runs into problems, who is the real lender of last resort? Is the European Central Bank, for instance, willing to furnish Latin American countries with at least a letter of intent to provide support if a European-owned bank runs into problems while working in Latin America? Clearly there is an urgent need for close international collaboration on this matter.

28. The issue of a possible tendency to have fewer banks, which would seem to imply that damages caused by an individual bank default could grow as a result of upping the ante, also raises the question of why this is not considered by Basel. If the Basel risk assessment methodology favors a diversification in the portfolio of a particular bank, then shouldn’t society, and the lender of last resort, also apply this criteria to their own portfolio of banks? Is there not a need for an additional capital requirement based on the individual bank's market share?

What can be done?
29. There are no easy answers, but to discuss these problems openly and candidly is as good a start as any, and so therefore these questions and issues need to be brought to the forefront of the discussions, like for example:

30. Can and should the minimum capital requirements be supplemented or complemented in such a way as to neutralize the risk adverseness of current regulation by, for instance, providing an adjustment for credits destined to create jobs? If the bank regulators of the world insist on imposing the criteria of the credit rating agencies, should we development agents request the presence of our development rating agencies and distribution of opportunities rating agencies?

31. Instead of using the differences in the perceived risks of the credits to determine the formal capital requirements an alternative is to apply an equal percentage to all the assets of the bank but then having the banks to report something similar to a Basle risk valuation as an additional transparent information reference. Although this approach looks to incorporate a more holistic market view than the strictly risk related “subordinated debt route suggested by the Shadow Financial Regulatory Committee, there is nothing that stops it from being complementary to the former.

32. Some could argue that to rely on the markets is impossible in developing countries where markets are deemed to be non-existent or weak but the other side of that coin is that that constitutes precisely the reason for having to rely on whatever little market there is.

Who is debating?
33. Put together the chefs from many different countries and you might get a quite varied menu, but gather the brain-surgeons and there is not going to be a great deal of diversity in their opinions. One of the main problems in discussing the Basel issue, and more so of being able to introduce any changes, is the current lock-hold that central bankers and bank supervisors have on the debate. Sometimes it is argued that if developing countries are better represented in Basel, they will be better able to voice their development concerns, but if this representation of diversity is only to happen by convening experts from all around the world that profess the same principles and have the same mindset, then no matter where they come from, this will be a dead-end street.

34. The numerous comments made by Basel officials about the importance of not rushing the implementation of Basel II, would seem to indicate that experts from developing countries feel the pressure to be recognized as being just as up-to-date and risk-adverse as their peers in developed countries. This syndrome, that costs many developing countries dearly in many of their WTO negotiations, needs to be controlled by assuring the presence of professionals that have other interests beside bank regulations.

35. The World Bank, as a development institution, should have played a much more counterbalancing role in this debate, but unfortunately it has been often silenced in the name of the need to "harmonize" with the IMF. Likewise, the Financial Stability Forum is also, by its sheer composition and mission, too closely related to the Basel bank regulations to provide for an independent perspective, much less represent the special needs of developing countries. Therefore the introduction of independent development voices in the debate is absolutely crucial, and perhaps this could be arranged through a G77 or a G24 effort.

36. As evidence for the lack of inclusion of other points of view different from risk avoidance, let us just refer to the Policy Conclusion in the Report of the Secretary General on the International Financial System and Development dated July 6, 2007, where "surveillance" appears seven times and except for one reference to the development of the financial sector there is not a single word about development itself.

37. For the record, let us state that although we have made the above comments from the perspective of "finance for development," most of the criticism put forward is just as applicable to developed countries. In this respect it is interesting to note that in the United States there has been some serious questioning of whether those regulations are not too uniform as to be applicable to all of their banks.

38. To conclude, we wish to insist that no society can survive by simply maximizing risk avoidance; future generations will pay dearly for this current run to safety. So therefore, more than placing our trust in the banks’ financial standing, we need to trust in what the banks do. Let us make certain our bank regulations help us to do just that.

[1] http://www.bis.org/publ/bcbs107.htm

[2] http://www.aei.org/publications/pubID.16542/pub_detail.asp

[3] Federal Reserve Bank of New York Economic Policy Review of October 1998.

[4] Cambridge University Press, 2006

This document was also reproduced in The Icfai University Journal of Banking Law Vol. VI No.4 October 2008