Risk weights are to access to credit what protectionist tariffs are to trade, only more pernicious.

A letter to the Executive Directors and Staff of the International Monetary Fund.

For decades now IMF has helped to spread around all developing countries the pillar of the Basel Committee’s bank regulations; the risk weighted capital requirements for banks.

Since risk taking is in essence the oxygen of any development, that piece of regulation is fundamentally flawed, especially for developing countries.

How do risk weighted capital requirements alter the incentives for banks? 

If banks hold the same capital against their whole portfolio, as they used do until some three decades ago, then with an eye on their overall portfolio and funding structure, banks lend in accordance to what produces them the highest risk adjusted interest rate; which would also provide them with the highest risk adjusted return on equity.

But, when different assets have different capital requirements, obtaining the highest risk adjusted return on equity will depend on how many times the risk adjusted interest rate for any specific loan or asset will depend on how many times it can be leveraged. The higher the allowed leverage is, the easier it is to obtain a high ROE; which means that “safe” highly leveregable loans could be competitive at lower risk adjusted interest rates than before, while “risky” lower leveregable loans would require paying higher risk adjusted interest rates. 

In essence the introduction of that regulation has caused banks to substitute savvy loan officers with equity minimizing engineers.

How do risk weighted capital requirements distort the allocation of bank credit?

The regulators based their decision on how much banks were allowed to leverage their capital with for the different assets, solely on the perceptions of credit risk. It never explicitly had one iota to do with banks fulfilling their obligation of allocating credit efficiently to the real economy.

So the introduction of that regulation simply distorts the allocation of bank credit; in favor of “the safer present” and against “the riskier future”. 

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

Specifically, a credit that is perceived as risky but that is directly related to helping reach a Sustainable Development Goal is much less favored by bankers, and now by bank regulators too, than a credit, perceived as safe, but which purpose could in fact be harmful to any SDG.

Specifically, safe credits for the purchase of houses are much more favored over credits to risky entrepreneurs, those who could create the jobs that would allow the income needed to service the mortgages and pay the utilities. 

Specifically, assigning lower risk weights to the sovereign than to citizens de implies de facto a statist belief that bureaucrats know better what to do with bank credit, than entrepreneurs who put their name on the line.

In other words these risk weight are to access to credit what tariffs are to trade, only much more pernicious. 

Do risk weighted capital requirements make our banks system safer?

If that regulation made the financial system safer there would at least be a favorable tradeoff. But it doesn’t, much the contrary. Too much easy credit can turn what is safe into something risky, like for instance morphing houses from being affordable homes into investment assets. 

The 2007/2008-bank crisis would never have happened or, if so, remotely had been of the same scale had regulators, for their risk weights, instead of perceived credit risk risks, used the probabilities of banks investing conditioned on how credit risks were perceived.

Many Eurozone sovereigns would not face current high levels of indebtedness had not EU authorities decreed a Sovereign Debt Privilege and assigned it a 0% risk weight, this even though they take on debt denominated in a currency that de facto is not their domestic printable one.

And so, at the end of the day, this regulation only guarantees especially large bank crisis, caused by especially large exposures to what was perceived (or decreed) as especially safe, which end up being especially risky, and are held against especially little capital.

Risk weighted capital requirements and inequality.

John Kenneth Galbraith wrote: “The function of credit in a simple society is, in fact, remarkably egalitarian. It allows the man with energy and no money to participate in the economy more or less on a par with the man who has capital of his own. And the more casual the conditions under which credit is granted and hence the more impecunious those accommodated, the more egalitarian credit is… the poor risk… is another name for the poor man.” “Money: Whence it came where it went” 1975.

So I ask, how many millions of SMEs and entrepreneurs have not been given the opportunity to advance with credits over the last 25 years as a direct result of it?

IMF, please, wake up!

Should banks not be regulated? 

Of course these need to be regulated! I am only reminding everyone of the fact that the damage dumb bank regulators can cause when meddling without taking enough care, by far surpasses anything the free market can do. A free market would never have knowingly allowed banks to leverage 62.5 times their equity like regulators did, only because some very few human fallible credit rating agencies had assigned an AAA to AA rating to some securities backed with mortgages to the US subprime sector. 

A simple leverage ratio between 10 to 15% for all banks assets would be a much mote effective regulation than all those thousands of pages that currently exist.

And please, please, please, stop talking about "deregulation" in the presence of such an awful and intrusive mis-regulation. The regulators imposed the worst kind of capital controls.

Of course, just in case, all problems here referred to, are clearly applicable to developed economies too.

PS. My recent letter to the Financial Stability Board

PS. Because it would also create distortions I am not proposing it, but would not risk weighted bank capital requirements based on SDGs ratings at least show more purpose for our banks? And, in the case of sovereigns, besides credit ratings, do we citizens not also need ethic ratings?

PS. “Are Basel bank regulations good for development?” a document presented at the High-level Dialogue on Financing for Developing at the United Nations, New York, October 2007.

Sincerely,

Per Kurowski

@PerKurowski

What I as a former Executive Director of the World Bank pray that any new President of it understands

I was an Executive Director at the World Bank from November 2002 until October 2004. During that time the Basel Committee's Basel II bank regulations were being discussed. It was approved in June 2004. 

I was against the basic principles of those regulations that had begun with the Basel Accord of 1988, Basel I. That should be clear from Op-Eds I had published earlier, transcripts of my statements at the WB Board, and in the letters that I wrote and FT published during that time. Here is a brief summary of all that 

Since then I haven't changed my mind... the risk weighted capital requirements for banks, which are a pillar of those bank regulations, is almost unimaginable bad.

I pray the next president of the world’s premier development bank, whoever he is, and wherever he comes from, at least, as a minimum minimorum, understands:

First, that risk-taking is the oxygen of any development, and therefore the regulators’ risk adverse risk weighted capital requirements, will distort against banks taking the risks that help to push our economies forward. “A ship in harbor is safe, but that is not what ships are for.”, John A Shedd.

Second, that what’s perceived as risky is much less dangerous to our bank systems than what’s perceived as safe, and so that these regulations doom us to especially large bank crises, because of especially large exposures to what is especially perceived (or decreed) as safe, against especially little capital.

Do you not agree that mine is a quite reasonable wish?

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

@PerKurowski

Should our nannie state tax all risk-taking at higher rates, as current bank regulators do?

Motorcycles, in terms of deaths per miles driven, are much riskier than cars. Should society therefore levy a special risk tax to compensate it for the unnecessary early death of its members? (Even though we know more people die in car than motorcycle accidents) 

Since sport injuries have a cost for the society should we tax sports based on their injury rates? For instance applying a 10 percent risk tax on cricket and one of only 1 percent on croquet (pesky squirrels).

If one assumes that the risks involved with any activity are not adequately perceived or considered, one could of course construe a case for those taxes. But, should we dare to assume risks are not already perceived and cleared for if we therefore could end up with a very risky too risk adverse society?

And I ask all this because taxing risk-taking is exactly what current regulators do with their risk weighted capital requirements for banks.

They now require banks to hold more capital against what is already perceived as riskier (motorcycles) than against what is perceived as safe (cars). This translates into banks having much higher possibility of maximizing their returns on equity with what is “safe” than with what is “risky”; which de facto is a tax on “the risky”.

Consequences? Banks build up dangerously large exposures to what is perceived, decreed, or concocted as safe, like sovereigns, AAArisktocracy and mortgages; and to small exposures, or even no exposure at all to what is perceived as risky, like SMEs and entrepreneurs.

Clearly if the risks are already perceived and considered by bankers, in the size of the exposure and the interest rates charged, to then also have the capital reflect the perceived risks, cause these risks to be excessively considered; resulting in an excessively risk-adverse banking system.

Just consider that already, partly because of the higher risk perceptions, many more people die in car than in motorcycle accidents. 

Think of a society where no one drives motorcycles or plays cricket because the risk-taxes are too high, and all keep to cars and crocket. Is that the kind of society that will be strong enough to survive? Is that what we want?

I am sorry but there is no more figurative way to express it. The Basel Committee for Banking Regulations and their affiliated regulators have effectively castrated our banking system. Will that make us safer? Of course not! 

Our banks will dangerously overpopulate safe-havens; in which they will die from lack of oxygen.

Our economies are going to dwindle into nothing, when denied the oxygen of risk-taking necessary for all development.

Friends, we must urgently get rid of these dangerously inept bank nannies.

Sadly the Basel Committee did not perform a Gedankenexperimente before regulating banks.

I just read about "Gedankenexperimente" in The Economist of June 10, 2017 "Quantum mechanics and relativity theory: Does one thing lead to another?" 

So, if the Basel Committee had done a Gedankenexperimente before regulating banks, then, if also applying Werner Heisenberg's uncertainty principle, they would have understood that the better current risks are perceived and the more you want banks to go for what is now safe, the riskier the future becomes.

First, because risk taking is the oxygen of development and a better future is built at least as much upon failures than upon successes. 

Second because what would be perceived as safe in the present would then get too much access to bank credit and thereby at one point in the future become very risky.

And so the regulators would have realized that with their risk weighted capital requirements for banks, they would be setting up the bank system for the worst kind of explosion imaginable, namely huge exposures to something very safe, turning very risky, against little capital, and with a real economy that has gone soft. 

PS. July 2011 I wrote twice to the Financial Times about Basel Committee’s regulations and Heisenberg’s uncertainty principle but, since I have been censored by FT, the editor was not interested. 

http://teawithft.blogspot.com/2011/07/bank-regulators-should-read-up-on.html

http://teawithft.blogspot.com/2011/07/arbiters-under-fire-should-be-bank.html

Why are excessive bank exposures to what’s perceived safe considered as excessive risk-taking when disaster strikes?

In terms of risk perceptions there are four basic possible outcomes:

1. What was perceived as safe and that turned out safe.

2. What was perceived as safe but that turned out risky. 

3. What was perceived as risky and that turned out risky.

4. What was perceived as risky but that turned out safe.

Of these outcomes only number 2 is truly dangerous for the bank systems, as it is only with assets perceived as safe that banks in general build up those large exposures that could spell disaster if they turn out to be risky.

So any sensible bank regulator should care more about what the banks ex ante perceive as safe than with what they perceive as risky.

That they did not! With their risk weighted capital requirements, more perceived risk more capital – less risk less capital, the regulators guaranteed that when crisis broke out bank would be standing there especially naked in terms of capital. 

One problem is that when exposures to something considered as safe turn out risky, which indicates a mistake has been made, too many have incentives to erase from everyones memory that fact of it having been perceived as safe.

Just look at the last 2007/08 crisis. Even though it was 100% the result of excessive exposures to something perceived as very safe (AAA rated MBS), or to something decreed by regulators as very safe (sovereigns, Greece) 99.99% of all explanations for that crisis put it down to excessive risk-taking.

For Europe that miss-definition of the origin of the crisis, impedes it to find the way out of it. That only opens up ample room for northern and southern Europe to blame each other instead.

The truth is that Europe could disintegrate because of bank regulators doing all they can to avoid being blamed for their mistakes.

It is prudent for our banks to take risks on the not so creditworthy, especially if these are up to something worthy

In a recent article in the Financial Times a bank was mentioned to be “an exemplar of prudence…[because] The target loan loss ratio is zero; [and] low loan losses, in turn, allow the bank to offer competitively priced loans and personalized service to creditworthy customers.”

To me that points clearly to what’s wrong with banks nowadays. “A target loan loss ratio of zero”… might allow “to offer competitively priced to creditworthy customers” but it will clearly not offer sufficient opportunities of credit to the not so creditworthy, those which includes too many risky SMEs and entrepreneurs, but also that could help provide the proteins the economy needs to move forward, in order not to stall and fall.

And the real truth is that, in the medium and long term, the creditworthy could benefit much more by banks taking much more risks on the not creditworthy, especially if these seem to be up to something worthy, than by they just getting low priced loans.

And if to the “zero loss loan target” you then add the distortion in the allocation of bank credit caused by the risk weighted capital requirements for banks, you might get a feel for why our economies seem to stagnate. 

Those regulations require the banks to hold more equity when lending to someone perceived risky, than when lending to someone perceived safe. And so that results in banks earning higher expected risk adjusted returns on equity when lending to someone perceived, decreed or concocted as safe, than when lending to someone perceived as risky. And that signifies that, around the world, millions of “risky” SMEs and entrepreneurs are not given the opportunity they might deserve and we might need for them to get.

As is, the banking system no longer finances the “riskier” future but only refinances the “safer” past, and that is as imprudent as can be, at least for our grandchildren.

Those bankers who with reasoned audacity take chances on the future are good servants of the society. Those who only maximize return on equity by diminishing the required capital and avoiding risks are, in the best of cases, absolutely boring.

And don’t get me wrong; I do not want to endanger our banking system, it is just the opposite. The forgotten truth is that major bank crises never ever result from banks building up excessive exposures to what ex ante is perceived as risky, it is not in the nature of bankers, as Mark Twain explained in terms of sun, rain and umbrellas.

The big crises always result from unexpected event of because of excessive exposures to something erroneously considered as safe.

PS. With their risk weighted capital requirements the regulators decreed inequality.

Dare answer this question, and then dare reflect on current bank regulations, and then dare do something about it.

An AAA rating signifies a “prime” asset and assets rated below BB- signify, at their best as “highly speculative”

So here is the question: 

What might be more dangerous to the banking system, too much exposure to AAA rated assets, or too much exposure to below BB- rated assets?

Which is your answer? Here's a hint: “May God defend me from my friends, I can defend myself from my enemies” Voltaire

If you reply as I do, that of course banks would never-ever build up excessive and dangerous to something rated below BB-, and that this is much more likely to happen with AAA rated assets, then I dare you to reflect on the following:

Your regulators, for the purpose of deciding the capital requirements for banks, assigned a risk-weight of 150% for assets rated below BB-, and a risk-weight of only 20% to AAA rated assets.

Does that sound like the regulators know what they are doing?

If you answer “Yes!” go back to sleep, but if by any chance you answer “No!, then you must know you have a very important assignment in front of you, that is, if you care about the future economic perspectives of your children and grandchildren.

And this is just an appetizer on all the Basel Committee for Banking Supervision’s idiotic mistakes.

PS. What legal consequences should a bank regulator face if, informed of a serious mistake, he does nothing to correct it?

There are risks and risks. Bank regulators promote the worst and avoid the best.

We now read “US federal regulators this week proposed new pay rules intended to limit excessive risk-taking”

And so its time again to understand there are different “excessive risk-taking”.

One “excessive risk-taking”, is that of creating dangerously large exposures to what is perceived, decreed or concocted as safe. Those exposures currently require very little bank capital. That was the “excessive risk taking” that caused the 2007-08 crisis; AAA rated securities, residential housing finance and sovereigns like Greece.

Another different “excessive risk-taking” is taking risks on the risky, like on SMEs and entrepreneurs. These risks, because they currently generate much higher capital requirements, are risks not sufficiently taken by the banks, and the economy suffers from that.

Do regulators really know what “excessive risk-taking” they want to limit? I seriously doubt it. The “more-risk less-pay” and the “less-risk more-pay” is just the typical kind of intervention that brings on unexpected consequences.

More-risk more-capital less-pay. Less-risk less-capital more-pay. Friends with these regulations we will soon all end up suffocating because of lack of oxygen in some over-populated safe haven!

And our children, they will be without jobs. Because with this regulatory silliness banks do not finance the riskier future any longer, they just refinance the for the short time being safer past.

In short, any senseless risk aversion, whether in bank regulations or elsewhere, condemn our economies and nations to fizzle out.

Regulators told banks: "Extract all value you can from the safer past, and forget about the riskier future." And so here we stand.

Nancy Birdsall in “Middle-Class Heroes”, Foreign Affairs March/April 2016 writes:

“The fear is that the new middle class will be hit hard if it turns out that global growth was built too much on easy credit and commodity booms and too little on the productivity gains that raise incomes and living standards for everyone”

That is precisely what happened, and the awful consequences of it are already to be seen.

When bank regulators decided on risk weighted capital requirements for banks, they allowed banks to leverage their equity, and the support they received from society, much more with assets perceived or deemed as safe than with assets perceived as risky.

And that meant that banks would earn much higher expected risk adjusted returns on equity with “safe” assets than with “risky” assets.

And what is the biggest source of safeness? What we already know it, what is already here, what comes from the past. 

And what is the biggest source of riskiness? What we still do not know, what is not here, what still lies in the future.

And so banks were given the incentives to refinance the safe past, like placing reverse mortages on what had already been achieved; and to forget to finance the riskier future.

And that is destroying not only the current middle class but, much worse yet, the of our young ones, who need a great dose of risk-taking in order to have a chance for a better future.

World Bank, the credit risk weighted capital requirements for banks promote financial instability and exclusion

May 9-13, 2016 the World Bank will hold “The 13th Overview Course on Financial Issues: Promoting Stable and Inclusive Financial Systems”

And I wonder if they are still going to ignore the distortions produced by the credit risk weighted capital requirements for banks; more risk, more capital – less risk less capital.

These capital requirements allow banks to leverage more with “the safe” than with “the risky”; which means banks will earn higher risk adjusted returns on equity lending to “the safe” than when lending to “the risky”; which means banks will lend too much to “the safe” and too little to “the risky”. And that will:

Promote financial instability since all major bank crisis have always resulted from excessive exposures to something ex ante perceived as safe but that ex post resulted risky.… in this case aggravated by the fact that banks against that hold especially little capital.

Promote exclusion, as it odiously discriminates against the risky… like SMEs and entrepreneurs.

I quote John Kenneth Galbraith from “Money: Whence it came where it went” 1975. “The function of credit in a simple society is, in fact, remarkably egalitarian. It allows the man with energy and no money to participate in the economy more or less on a par with the man who has capital of his own. And the more casual the conditions under which credit is granted and hence the more impecunious those accommodated, the more egalitarian credit is… Bad banks, unlike good, loaned to the poor risk, which is another name for the poor man.”

And when will the World Bank, the world’s premier development bank remind the world of that risk-taking is the oxygen of any development.

Again I quote John Kenneth Galbraith from “Money: Whence it came where it went” 1975. “For the new parts of the country [USA’s West]… there was the right to create banks at will and therewith the notes and deposits that resulted from their loans…[if] the bank failed…someone was left holding the worthless notes… but some borrowers from this bank were now in business...[jobs created]... It was an arrangement which reputable bankers and merchants in the East viewed with extreme distaste… Men of economic wisdom, then as later expressing the views of the reputable business community, spoke of the anarchy of unstable banking… The men of wisdom missed the point. The anarchy served the frontier far better than a more orderly system that kept a tight hand on credit would have done…. what is called sound economics is very often what mirrors the needs of the respectfully affluent.”

In March 2003, as an Executive Director of the World Bank I gave the following formal statement on this:

http://subprimeregulations.blogspot.com/2003/03/financial-sector-assessments-program.html

And soon 12 years later, I am still waiting L

My sincere Christmas wish: That our bank regulators wake up and understand what they are doing to our children.

On December 24, 1941, in Washington DC, Winston Churchill ended his Christmas speech to war torn England with: “By our sacrifice and daring, [our] children shall not be robbed of their inheritance or denied their right to live in a free and decent world.”

I absolutely do not pretend being something like Winston Churchill but, here in Washington, on December 24, 2015, 74 years later, I assure you all that: By us not daring to allow our banks to dare, we are robbing our children of their inheritance and denying their right to live in a free and decent world.

I pray our bank regulators in 2016 wake up to understand how much their credit risk weighted capital requirements for banks, distort the allocation of bank credit to the real economy.

By allowing banks to earn higher risk adjusted returns on what is perceived as safe than on what is perceived as risky banks do not any longer finance the riskier future but only keep to refinancing the safer past.

In essence we are placing a reverse mortgage on our economies, which will extract its value, without allowing the risk taking needed for something new to take its place.

Is the problem with our bank regulators a lack of testosterone?

We have read a lot about excessive testosterone levels producing excessive risk taking, for instance in banks. But, could a deficiency of testosterone equally produce an excessive risk aversion.

Let me explain. Even though the credit risks perceived by bankers are already cleared for by means of the size of the exposure and risk premiums, current bank regulators imposed on banks higher capital requirements for what is perceived as risky than for what is perceived as safe. 

And the above is like adding up the risk aversion of two nannies before deciding what the children can do; and so of course the children are not allowed to do much; and so of course banks will lend too much to the “safe” and too little to the “risky”… and so of course there is a monstrous distortion of the allocation of bank credit to the real economy.

To top it up, it does not serve any stability purpose, since all major bank crises have always resulted from excessive exposures to what was erroneously considered “safe” and never ever to something correctly perceived as risky.

This, being so scared of what is perceived as risky and so little suspicious of what is perceived as safe, is so loony that perhaps it points to a hormonal imbalance. Could it be that current bank regulators have a serious lack of testosterone?

I, as many others, suffer from too much risk aversion, and so I could be suffering from that lack of testosterone too. But, in me, that deficiency presents no major problem, except perhaps for my kids who might therefore not inherit what they could inherit. But, when the testosterone deficiency is present in those who regulate our banks, then we are talking about that kind of systemic illnesses that can even bring a Western world down on its knees.

God make us daring!

PS. Again. If you lend too much to what is perceived as risky and too little to what is perceived as safe, then it might be because of excessive testosterone… why then can if you lend too much too what is perceived as safe, and too little to what is perceived as risky, not be a lack of testosterone?

Dumb bank regulators clearly evidence we need artificial intelligence, at least as a backup

Banks fail because: they cannot perceive the risks correctly, they cannot manage the correctly perceived risks correctly, or suddenly something truly bad an unexpected happens… like the economy falling to pieces.

So if banks should be required to hold equity, in order to build up a buffer before they need help from taxpayers, those equity requirements should be based on: the credit risks not being correctly perceived, the bankers not being able to manage perceived risks, and something truly not expected happening, like an asteroid hitting their borrowers.

But, the Basel Committee for Banking Supervision, based its equity requirements for banks on the ex ante credit risks being correctly perceived… and that is nothing but loony... seemingly they all missed the lecture on conditional probabilities.

Besides they regulate banks in thousand of pages, without defining what the purpose of banks is… and that is nothing but absolutely irresponsible.

Any artificial intelligence worthy of its name would have made two simple questions.

What is the purpose of banks?

What has caused major bank crisis?

And how different and better the world would then have been. We could surely have had other type of problems, but definitively not the current crisis, caused by excessive lending to what was ex ante perceived as safe; nor the current lousy economy, caused by the lack of lending to those perceived as “risky”, like the SMEs, precisely the tough we need to get going when the going gets tough.

Our grandchildren will damn current bank regulators, for not allowing banks to take the risks their future needs.

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