Bank regulators, the Basel Committee, FSB, and other, insist on putting systemic risk on ever-larger doses of steroids

What was the biggest systemic risk we used to refer ages ago? That which Mark Twain described with “The bankers are those who want to lend you an umbrella when the sun shines and take it away as soon as it looks like it is going to rain”. In other words that bankers could be too risk adverse, and therefore not be allocating credit efficiently to the real economy. 

But what did regulators do with their risk weighted capital requirements for banks? They told banks to lend out even more the umbrella when the sun shines. 

I have written on bank regulations for a long time, not as a regulator, but as a consultant that has walked up and down on Main Street helping corporations of all types to access that bank credit that seems so impossible or so expensive when one is perceived as risky. 

And as an Executive Director of the World Bank 2002-2004 I also raised my voice on many related issues. You can read some of my public opinions here. 

Today I was made aware of a paper from the International Institute for Applied Systems Analysis, IIASA, authored by Sebastian Poledna, Olaf Bochmann, Stefan Thurner and that is said to suggest: “smart transaction taxes based on the level of systemic risk” 

Holy Moly, when will they ever learn? All intrusions that tilt regulations in favor of something or someone become, immediately, a new source of systemic risk? 

And the more and the better you are in guarding against some identified systemic risk, the higher you are climbing up the very dangerous mountain. 

In April 2003, when commenting on the World Bank's Strategic Framework 04-06 I held: "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." 

Everywhere I look I see more and more sources of systemic risks in our banking system. Like which? 

Continuing to rely on too few human fallible and capturable credit rating agencies. 

Continuing to use risk weighted capital requirements that distort for no good reason at all. 

Liquidity requirements that can only increase the distortions. 

Forcing the use of standardized risk weights, which imposes a single set of criteria on too many. 

Regulators now wanting to assure that banks all apply similar approved risk models. 

The stress tests of the stresses that are a la mode. 

Living wills. 

And of course that pure ideological interference that have statist regulators assigning a 0% risk weight to sovereign and a 100% to citizens. 

All in all, in terms of creating dangerous systemic risks, hubris filled bank regulators are the undisputable champions. 

The main cause for all this is that our bank regulators seem to find it more glamorous to concern themselves with trying to be better bankers, than with being better regulators. 

Regulators, let the banks be banks, perceive the risks and manage the risks. The faster a bank fails if its bankers cannot be good bankers, the better for all. Your responsibility is solely related to what to do when banks fail to be good banks. Please?

And regulators always remember these two rules of thumb: 

1. The safer something is perceived to be, the more dangerous to the system it gets; and the riskier it is perceived, the less dangerous for the system it becomes. 

2. All good risk management must begin by clearly identifying what risk can we not afford not to take. In banking the risk banks take when allocating credit to the real economy is precisely that kind of risks we cannot afford them not to take. 

So when can we get bank regulators humble enough to understand their role is to regulate banks against risks they themselves cannot understand? Please?

A safer banking system compared to our current dangerously misregulated one with so many systemic risks on steroids

What is a safer banking system?

One in which thousand banks compete and those not able to do so fail as fast as possible, before some major damage has been done, while even, as John Kenneth Galbraith explained, often leaving something good in their wake. 

What is a dangerous banking system?

One were all banks are explicitly or implicitly supported, by taxpayers, as long as they follow one standard mode that includes living wills, stress tests, risk models, credit ratings, standardized risk weights... all potential sources of dangerous systemic risks.

A bank system in which whenever there is a major problem, the can gets kicked down the road with QEs and there is no cleaning up, and banks just get bigger and bigger.

One that make it more plausible that the banks will all come crashing down on us, at the same time, with excessive exposures to something ex ante perceived safe that ex-post turned out risky, and therefore the banks holding especially little capital.

But you don’t worry; the regulators have it all under control with their Dodd-Frank’s Orderly Liquidation Authority (OLA). “Orderly”? Really?

So that is why when I hear about banks “cheating” with their risk models I am not too upset, since that at least introduces some diversity. 

Also that cheating stops, at least for a while, the Basel Committee regulators from imposing their loony standardized risk weights of 20% for what has an AAA rating, and so therefore could be utterly dangerous to the system; and one of 150% for the innocuous below BB- rated that bankers don’t like to touch with a ten feet pole.

How did we end up here? That is where you are bound to end up if you allow some statist technocrats, full of hubris, to gather in a mutual admiration club, and there engage into some intellectually degenerating incestuous groupthink.

Statist? What would you otherwise call those who assign a 0% risk weight to the Sovereign and one of 100% to the citizen?

And it is all so purposeless and useless!

Purposeless? “A ship in harbor is safe, but that is not what ships are for”, John A Shedd

Useless? “May God defend me from my friends, I can defend myself from my enemies”, Voltaire

In essence it means that while waiting for all banks to succumb because of lack of oxygen in the last overpopulated safe-haven available, banks will no longer finance the "riskier" future our grandchildren need is financed, but only refinance the "safer" present and past.

In April 2003, as an Executive Director of the World Bank I argued: "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."

PS. FDIC... please don't go there!

Note: For your info, before 1988, we had about 600 years of banking without risk weighted capital requirements for banks distorting the allocation of bank credit to the real economy.

PS. The best of the Financial Choice Act is a not distorting, not systemic risks creating, 10% capital requirement for all assets. Its worst? That this is not applied to all banks.

PS. If I were a regulator: Bank capital requirements = 3% for bankers' ineptitude + 7% for unexpected events = 10% on all assets = Financial Choice Act
 

FDIC, don’t go there! The more similar living wills, stress tests & risk models are, the greater the systemic risks

I just received the FDICs “Supervisory Guidance on Model Risk Management"

It really scares me to read how concerned FDIC still is with how bankers’ develop and use their risk models, among these those for determining capital and reserve adequacy.

I just don’t get it! Let bankers do their job, which is to develop all the models they can that will facilitate their job as bankers, the best they can. And the more crazily diverse these risk models are, the better, as the less is their systemic risk.

FDIC should concern itself exclusively with the what if the bankers of some banks are not good enough when modeling.

And the same goes for living wills and stress tests. Force each bank to present what they think about that, and leave it like that.

In January 2003, while an ED of the World Bank, in a letter published by the Financial Times I argued: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds”

And in April 2003, commenting on the World Bank's Strategic Framework 04-06 I wrote: "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."

I still hold all that to be true… now more than ever!

FDIC, please, they are the bankers and you are the regulator (and insurer), don’t confuse the roles!

FDIC, please, don't insist on being a better banker than the bankers, just be their regulator!

Must one go on a hunger strike to have the Basel Committee or FSB answer some very basic questions?

Before regulating banks did you ever define their purpose? I know we all want them to be safe but, as John Augustus Shedd said: “A ship in harbor is safe, but that is not what ships are for.” 

By allowing for different capital requirements based on ex ante perceived risks of assets, banks will be able to leverage their equity (and the support given by authorities) differently, which will cause quite different expected risk adjusted returns for different assets, than would have been the case in the absence of this regulation. Were you never concerned about how this would distort the allocation of bank credit to the real economy? 

Since ex ante perceived risk were already considered by bankers when deciding on the amounts of exposures and interest rates, when you decided that the perceived risk was also going to determine capital requirements, you doubled up on perceived risk. Don’t you know that any risk, even if perfectly perceived, causes the wrong actions if excessively considered? 

In the case of larger and more “sophisticated” banks, you allowed these to use their own internal risk models to determine capital requirements. (Something like allowing Volkswagen to calculate their own emissions) Was it not naïve of you to believe banks would not naturally aim for lower capital requirements, in order to increase their expected risk adjusted returns on equity?

What’s perceived as safe can be leveraged into being utterly dangerous, only because of that perception; while what’s perceived as risky is automatically less dangerous, precisely because of that perception. Or as Voltaire said: “May God defend me from my friends, I can defend myself from my enemies”. In this respect can you explain the logic behind your standardized Basel II risk weights of 20% for what is AAA to AA rated, and 150% for what is rated below BB-? 

In the same vein what empirical research did you carry out to determine that what is perceived ex ante as risky has caused major bank crises? I ask because as far as I know these have always been caused by unexpected event, like natural disasters or devaluations, by fraudulent criminal behavior, or by excessive exposures to what ex ante was considered as safe but that ex post turned out to be very risky. 

In other words since bank capital is there for the unexpected, is it not dumb to require it based on the expected?

A risk weight of 0% for the sovereign, and 100% for We the People clearly implies you regulators all believe government bureaucrats make better use of bank credit than the private sector. Are you really such statists? Did you never consider that such dramatic rearrangement of economic power needed approval by for instance a Congress or a Parliament… or even a referendum? 

Finally do you really believe that with such risk adverse regulations, layered on top of banker’s own risk aversion, our economies would have developed as they did? Don't you see that banks are no longer financing the riskier future but only refinancing the "safer" present and past? Don't you see this decrees inequality?

PS. FT’s / Financial Times Establishment, notwithstanding my soon 2.500 letters to it on “subprime bank regulations” has also steadfastly refused to help me get answers to these questions.

PS. And here is one evidence of that I have posed my objections during formal consultations by the Basel Committee

PS. And I dreamt I got this letter with their answers!

PS. And I am 100% for the 10% on all assets capital requirement for small banks in the Financial Choice Act. I just hope it was applied to all banks, foremost the biggest, as these need it the most, as we need these to be better capitalized the most.

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?

12 years after Basel II, ECB sees faults in risk weighted capital requirements for banks, but still doesn’t get it

ECB has published a document titled “The limits of model-based regulation” ECB Working Paper 1928, July 2016. In it the authors find that risk-weighted capital requirements based on sophisticated models applied by big banks, are basically dangerous and worthless.

Of course that regulation is worthless, it does not serve any useful purpose, and only increases the probabilities of financial instability.

But from its “Non-technical summary” it is harrowing to see that they still do not fully understand why these risk weighted capital requirements are dangerous; not only for the big banks with their models, but also for the smaller that apply the standard approach risk weights declared by the Basel Committee; and also, primarily, for the real economy.

For a starter it declares: “In recent decades, policy makers around the world have concentrated their efforts on designing a regulatory framework that increases the safety of individual institutions as well as the stability of the financial system as a whole.”

And so the first observation is: Who gave policy makers the right to concentrate on designing a regulatory framework that completely ignores whether the allocation of bank credit to the real economy is efficient or not? Is the real economy to serve banks or are the banks to serve the real economy? “A ship in harbor is safe, but that is not what ships are for.” John A Shedd, 1850-1926 

Then it states: “an important innovation has been the introduction of complex, model-based capital regulation that was meant to promote the adoption of stronger risk management practices by financial intermediaries, and ultimately to increase the stability of the banking system”... “banks that opted for the introduction of the model-based approach experienced a reduction in capital charges and consequently increased their lending by about 9 percent relative to banks that remained under the traditional [standard risk weights] approach”... “Back-of-the-envelope calculations (abstracting from risk-based pricing of the cost of capital) suggest that underreporting of PDs allowed banks to increase their return on equity by up to 16.7 percent”

How come regulators believed the adoption of “stronger risk management practices by financial intermediaries” would trump the maximization by banks of their risk-adjusted returns on equity? This is like given children a book with indication of calories and expecting them to stay away from the chocolate cake. Worse, in the case of the big banks applying their internal models, it was like allowing the children to calculate on their own the calories of the chocolate cake they desire. How mind-boggling naive are regulators allowed to be?

From the conclusion “Certainly, one would expect less of a downward bias in risk estimates if model outputs were generated by the regulator and not the banks themselves” one could believe the authors favor the standard approach risk weighting. 

Of course that is better than the sophisticated modelling by the big banks, which only guarantees Too Big To Fail Banks. But the all the principal faulty characteristics of the whole risk weighting process remain intact even then... and are still ignored:

Like why basing capital on ex ante perceived credit risks, when all major bank crises have resulted either from unexpected events or excessive exposures to what was ex ante perceived as safe?

Like why if banks by the size of the exposures and interest rates already clear for perceived risk, should they also be cleared for in the capital? Do not regulators understand that any risk, even if perfectly perceived, leads to the wrong actions if excessively considered?

Earlier, on the same issue

And like so many other whys?

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

PS. No matter what explanatory mumbo jumbo regulators gave us, Paul Volcker valiantly confessed: “The assets assigned the lowest risk, for which bank capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages”

Below my original post:

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

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

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

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

What does this mean? 

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

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

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

but then, to top it up:

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

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

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

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

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

What does this mean? 

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

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

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

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

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

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

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

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

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

With bank regulators like these… who need enemies?

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

P.S. And the Mumbo Jumbo goes on and on and on

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

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

P.S. My 2019 letter to the Financial Stability Board FSB

Regulators, please, your only problems with banks begin when their risk models stop to function.

Now we read that “Under rules being implemented by the Federal Reserve and the Office of the Comptroller of the Currency, the biggest U.S. banks will use their own models for judging their riskiness.”

Are they nuts? 

Bank regulators should have no problems whatsoever when banks own internal models which determine the “expected losses” function well.

The regulators only serious problems begin when these models do no function well... and “unexpected losses” result.

And so, frankly, it seems utterly absurd to allow for regulations which are based on trusting the bank models to function well.

And in this case, trusting primarily those banks which because of their systemic significance most can hurt if their risk models do not work... is like doubling up on the mistake.

If anything, trust the small banks which, if and when they fail, do not hurt us as much.

You the Basel Committee, and you the Financial Stability Board, are you really as smart as you think you are?

Even though you, as bank regulators, never have problems with bank’s risk models that function and credit ratings that are correct, and only have problems when bank’s risk models malfunction and credit ratings prove incorrect, with your capital requirements based on ex-ante perceived risk, you decided to bet all our banking system on bank’s risk models functioning perfect and the credit ratings being perfectly correct… was that such a smart move guys? 

Even though you, as a bank regulators, must have known that except for when outright fraud is  present, all major bank crisis, no exceptions, have resulted from excessive bank exposures to what was perceived as absolutely safe, and none from excessive exposures created to something ex-ante perceived as risky, you decided that the bank needed to hold much more capital when investing or lending to something risky than when investing or lending to something perceived as absolutely safe… was that such a smart move guys? 

Even though you, as bank regulators, must have known about Mark Twain’s accurate description of a banker as the fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain” and that this was often a hinder for those that though perceived as risky are often on the margin the most important players of the real economy decided to give the bankers even further incentives to lend while it is sunny and to withdraw their credit even faster at the slightest indication that it could possibly rain…. was that such a smart move guys? 

What can I say but to quote Axel Oxenstierna: (1583–1654) “An nescis, mi fili, quantilla prudentia mundus regatur?”, “Do you not know, my son, with how little wisdom the world is governed?”, “¿No sabes, hijo mio, con que poca sabiduría el mundo esta gobernado?”, “Vet du inte, min son, med hur litet förstånd världen styrs?” 

In March 2003, while being an Executive Director at the World Bank (2002-2004) and when discussing the implications of Basel II bank regulations I stated: “As the financial sector grows ever more sophisticated, making it less and less transparent and more difficult to understand for ordinary human beings, like EDs, it is of extreme importance that the World Bank remains prudently skeptical and vigilant, and not be carried away by the glamour of sophistication. In this particular sense, we truly believe that the World Bank has a role to play that is much more important than providing knowledge per-se and that is the role of looking on how to supply some of the wisdom-of-last-resort.”

Unfortunately, the whole world is, in dumb open-mouthed amazement, suffocating under the weight of too much knowledge that no one finds time to reflect upon. 

Can we please ask for a time out in order to discuss these quite loony and dangerous Basel bank regulations from scratch? I ask this because when now adding your Basel III liquidity requirements, also based on the ex-ante perceived risk, you seem intent on digging us further down in the hole were you have placed our economies.