Clearing for perceived risk vs. discriminating based on perceived risk.

If making good down payments house buyers normally had more and cheaper access to bank credit than an entrepreneurs wanting loan for risky ventures.

But when regulators, with their risk weighted bank capital requirements decreed that banks needed to hold less capital against residential mortgages than against unsecured loans to entrepreneurs; which meant that banks could leverage much more their equity with residential mortgages than with unsecured loans to entrepreneurs; which meant that with the same risk adjusted interest than before banks could earn higher risk adjusted returns on equity with residential mortgages than with unsecured loans to entrepreneurs, the regulators de facto discriminated the access to bank credit in favor of house buyers and against entrepreneurs.

So there’s a world of difference between banks clearing for perceived credit risk and the regulators discriminating the access to bank credit based on perceived credit risk.

With their discrimination regulators decreed inequality

With their 0% risk weighted sovereign and 100% risk weighted citizens regulators decreed that the sovereign has more rights to more and cheaper access to bank credit than citizens.

And, at the end of the day it's all for nothing. That discrimination only sets up our banks to especially large bank crises, caused by especially large exposures to something ex ante perceived, decreed or concocted as especially safe, and which ex post turns into being especially risky, while being held against especially little capital.

A letter to the Financial Stability Board

A letter to the IMF titled: "The risk weights are to access to credit, what tariffs are to trade, only more pernicious."

My 4 tweets on the access to bank credit war

1. Way too much discussions on whether bank capital requirements should be 4%, 8%, 15%, 20% or whatever, and way to little about the fact that different capital requirements for different assets, dangerously distorts the allocation of bank credit.

2. The risk weights in the risk weighted capital requirements for banks are de facto tariffs on the access to bank credit. Sovereigns 0%, AAA rated 20%, residential mortgages 35%, unrated citizens 100%, below BB- corporates 150%.

3. So why do all those who tear their clothes about trade protectionism, keep silence about the access to bank credit protectionism imposed by “the safe” on “the risky”, and which can have even much more serious implications for the world economy.

4. As is it guarantees especially large bank crises from especially big exposures to what’s perceived as especially safe, against especially little capital.

As is, by favoring credit to the “safer” present over the “riskier” future it guarantees stagnation.

http://subprimeregulations.blogspot.com/2019/03/my-letter-to-financial-stability-board.html

PS. It has caused houses to morph from being homes into being investment assets.

PS. More than a trade war it is actually this access to bank credit war that is most likely to bring the euro and then EU down.

PS. 0% risk weights will turn sovereign into spoiled filthy rich brats that will end up defaulting.

PS. Are these reasons not enough cause for impeaching the current bank regulators?

My tweet comments on Stephen Cecchetti's and Kim Schoenholtz's "The financial crisis, ten years on", Vox August 2017

"The financial crisis, ten years on"

Does a crisis start when the bomb is armed, the fuse is lit, the explosion occurs, or when the explosion is noted? http://voxeu.org/article/financial-crisis-ten-years#

In 2003 FT published a letter I wrote about the systemic risk of giving credit rating agencies so much power https://teawithft.blogspot.com/2003/01/credit-ratings-for-developing-nations.html

In 2004 the fuse was lit when Basel II authorized banks to leverage 62.5 times with what was rated AAA http://voxeu.org/debates/commentaries/impose-higher-bank-capital-requirements-what-has-best-credit-ratings

In August 2006 clearly the bomb had already exploded https://teawithft.blogspot.com/2006/08/long-term-benefits-of-hard-landing.html

Unfortunately it was not until July 2007 credit rating agencies woke up and in August that the fan started to spread out the shit.

Capital requirements for banks should be ex ante perceived risks neutral.

Professor Steve Hanke writes: “The calculated risk that a financial institution takes is best understood by the institution itself, not the government or any outside party” “Let Banks Manage Risks, Not Regulators” Forbes July 30, 2017.

I agree: For about 600 years banks use to run their banks as if each dollar invested in any asset was worth the same. Not any longer, since Basel I, 1988 and Basel II, 2004 some assets produce net margins that regulators allow them to leveraged much more than other. That meant that banks would find it easier to obtain higher risk adjusted returns on equity on some assets, those perceived ex ante as safe, than on other, those perceived as risky.

That of course distorted dangerously the allocation of bank credit to the real economy. The 2007-08 problems resulting mainly from excessive exposures to AAA rated securities and sovereigns, as well as the mediocre response to ultra large stimulus like QEs and minimal interest rates should suffice to prove it.

And I disagree: Because bank regulators should consider the risks that banks are not able to manage the risks they perceive, or that some unexpected events can put the system in danger. But since that has absolutely nothing to do with ex ante perceived risks per se, the capital requirements should be risk-perceived neutral, like for instance solely a leverage ratio. 

Besides, if regulators insist in risk weighing, only to show off some regulatory sophistication, so as to be known as important experts, then they should never forget that what really poses dangers to the banks system is what is perceived safe and never ever what is ex ante perceived very risky.

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
 

Here is one mystery in current bank regulations that regulators refuse to reveal to us.

That which has an AAA rating, meaning it is perceived as very safe, will of course have much access to bank credit, and be required to pay very low risk premiums. If those ratings then turn out to be wrong, sometimes precisely because since it was considered very safe too much credit was given to it, individual banks, and the bank system, face a very serious problem.

That which has a below a BB- rating, meaning it is perceived as extremely risky, has access to much less credit and, when it gets it, will be by paying much higher risk premiums. If those ratings turn out to be even worse, some individual bank might have a smaller problem, but the bank system as such, would face no problems at all.

But, an here is the mystery, bank regulators, with their Basel II, in June 2004, for the purpose of setting the capital requirements for banks, set a 20% risk weight for the AAA rated and 150% for what is below BB-.

Why so? If "safe" could be dangerous and "risky" is innocuous, could it not really be the other way around?

And that, since regulators refuse to explain it, is now, soon 13 years later, still a mystery to us

PS. Questions regulators refuse to answer

Do bank regulators, now with “output floor” based on their standardized risk weights, keep on making fun of us?

A 75-percent output floor signifies that no matter which outcome the bank’s internal calculation yields, the risk weight that determines the capital required, can’t be more than 25 percent lower than the standardized risk weighting method designed by the regulators.

So let’s see what that really means. 

For the standard method’s 0% risk weighted sovereign, unless some bank’s internal calculation comes up with a negative risk, it will still mean 0%.

For the standard method’s 20% risk weighted private asset, it means the weight cannot be less than 15%.

For the standard method’s 35% risk weighted residential mortgage, it means that weight cannot be less than 26.25%.

For the standard method’s 100% risk weighted private asset without a credit rating, like loans to SMEs, it means that the risk weight cannot be less than 75%.

Really? Are bank’s internal models worse than your standardized weights? Do you really think the Medici’s would have assigned a risk weight of 0% to the Sovereign?

There’s absolutely nothing wrong with allowing banks to use their own risk models in order to try to minimize their cost of capital, but that regulators concoct a set of ex ante perceived standardized risk weights in order to determine how much capital banks should have in order to be able to confront, not perceived risks, but uncertainty, is just as crazy as it gets.

Here some questions bank regulators refuse to answer, something that should make us all nervous. They really might not have a clue about what they are doing.

Stefan Ingves, years after Basel Committee’s failure, you all have still no idea about how to regulate banks.

On December 2, 2016 Stefan Ingves, the Chairman of the Basel Committee gave a Keynote speech at the second Conference on Banking Development, Stability and Sustainability, titled “Finalising Basel III: Coherence, calibration and complexity” 

In it Ingves stated: “an area of further research which would be welcome relates to how we should think about the capital benefits of allowing banks to use internally modelled approaches, and therefore the appropriate calibration of capital floors to such models. What are the pre-conditions for such models to produce better outcomes than, say, simpler standardised approaches? And to whom do the benefits of improved modelling accrue? If a bank using a model can lower its capital requirements by, say, 30%, what are the financial stability and real economy benefits of such an approach? To what extent do the benefits of modelling accrue to lower-risk borrowers as opposed to the parties being compensated for developing and using the models?”

That is clear evidence that the Basel Committee still, soon ten years after the crisis, their failure, has no idea about what it is doing. It should concern us all. 

Here’s one example on of how the Basel Committee’s has totally confused ex ante risks with ex post risks. In their Basel II standardized risk weights the weight assigned to AAA assets is 20% while the weight of a highly speculative below BB- rated assets was set at 150%. 

I ask: What has much greater chance of taking the banking system down, excessive exposures to something ex ante believed very safe or excessive exposures to something believed very risky? The answer should be clear. Never ever have bank crises resulted from excessive exposures to something believe risky when placed on the balance sheet; these have always resulted from unexpected events (like devaluations), criminal behavior or excessive exposures to something perceived ex ante as very safe but that ex post turned out to be very risky. 

The truth is that the Basel Committee told banks: “Go out and leverage your capital more than with assets that are safe”. And so when disaster happens, like with AAA rated securities, banks stand there more naked than ever.

Of course, the other side of that coin is, “Do not go and lend to what is risky”. So banks dangerously for the real economy stopped lending to SMEs and entrepreneurs… something that is never considered when stress testing.

To top it up, like vulgar statist activists, they set a risk weight of 0% for the Sovereign and one of 100% for We the People; which translates into a belief that government bureaucrats can use bank credit more efficiently than the private sector… something which of course created the excessive indebtedness of Greece and other.

One final comment, the regulators naivety is boundless: “to whom do the benefits of improved modeling accrue? asks Ingves” Clearly there is no understanding of that bankers will, as is almost their duty, always look to minimize capital if so allowed, in order to obtain the highest expected risk adjusted returns on equity. 

When fake regulators supervise banks; totally unsupervised banks is much better.

PS. Must one go on a hunger strike to have the Basel Committee on Banking Supervision answer some very basic questions? 

Perhaps I did not understand all Professor Lawrence Summers answered me at IMF, but he might have understood less of what I asked/argued.

In the IMF’s Annual Research Conference at the end of Professor Lawrence Summers' Mundell Fleming Lecture I had a chance the pose a question (1:18:25)

Here is the short explanation for my question:

Suppose banks believe that a 10% return on equity to shareholder’s resulting from lending to the sovereign is, in terms of risk, equivalent to a 25% return derived from a diversified portfolio of loans to SMEs.

Then if banks held on average 10% in equity, meaning a leverage of 10 to 1, banks would have to earn about 1% in net margins on sovereigns and on average 2.5% to SMEs to produce those desired ROEs.

But, then suppose that banks were told by regulators that though they must hold the usual 10% of equity against SME loans, they were now allowed to lend to the sovereign holding only 5% in equity, meaning an authorized 20 to 1 leverage. Then banks could produce that 10% ROE on equity by obtaining only a .5% net margin on sovereign loans. That would clearly but downward pressure on the interest rates paid on public debt.

And in 1988, with the Basel Accord, the regulators decided that the risk weight for the sovereign was 0% and that of SMEs 100%... meaning banks were allowed to leverage equity immensely more with public debt than with loans to the private sector.

My question: Professor Summers, today you showed a graph that showed the risk free rate going down over the last 30 years, the risk free rate based on the proxy of public debt of course. And Lord Turner also recently showed that same trend. And it started around 1989/90. Can that not have anything to do with the very clear evidence that in 1988 the Basel Accord decided that for purposes of the risk weighted capital requirements for banks, the risk weight of the public sector, of the sovereign was 0%, and the risk weight for us, we the people, 100% 

Professor Summers' answer: Could it have anything to do with it? Yes it could have something to do with it. 

Notice that your explanation is in the category of Ricardo Caballero’s explanation. Its in the category of something has happened that has shifted the relative demand for government bonds versus other things.

And my argument is that, if that were true, what you would expect to see as the major counterpart to the decline in government rates is a major increase in risk premiums. And the fact is that I think is closer to right, a better first approximation I believe, to assume that risk premiums have been relative constant, or not long term trending, and that real rates have declined, than it is to believe that risk premiums have been long term trending.

And therefore I prefer the saving and investment based explanations, rather than the asset specific explanations of the kind that Ricardo adduces, or of the kind you suggest.

My afterthoughts: 

How is it possible to hold that such in favor of the public sector distorting bank regulations, would not have “shifted the relative demand for government bonds versus other things”?

How is it possible, like Professor Summer does, to use the “artificially low public sector debt rates”, as a justification of putting more financial resources in hands of government bureaucrats, to build infrastructure, than in the hands of the private sector’s SMEs and entrepreneurs?

PS. The day after, I got a much more straightforward answer from Mr. Olivier Blanchard.
PS. Here’s my recent, 2019, comments sent to the Financial Stability Board
PS. Here’s my recent, 2019, letter sent to the IMF

Professor Summers, fixing potholes using 0% public debt will not fix America. Don’t put the cart before the horse.

Professor Larry Summers, and many others with him, promote the idea that the government in America (and other governments too) should take advantage of the extraordinarily low interest rates on public debt, in order to finance new infrastructure and the maintenance of old.

Briefly their calculation is as follows: If government takes on debt at 0% and invest it in infrastructure projects that renders a 5% economic return, then the government, with a 30% tax on that, will have earned a net 1.5%... and we can all live happily ever-after.

NO! First, even if the government nominally pays 0% on its debt, that does not mean that debt has a zero cost. To begin with we should have to add the cost of all those giving up (cheated out of) some long term decent earnings on their saving, in order to finance the government for free. But, even more importantly, those zero or low rates are not free and clear market rates, but rates that are non-transparently subsidized by regulations.

In 1988, with the Basel Accord, Basel I; for the purpose of calculating the risk weighted capital requirements for banks, the regulators decided that the risk-weight for the sovereign was 0%, while that of We the People was 100%. And those risk-weights are still in full force.

I cannot say how much of the low interest rates on public debts are explained by this regulatory distortion, but it sure has to be quite a lot.

I have lately seen Professor Summers, and Lord Adair Turner, showing these rates trending down for the last 30 years. Unfortunately for reasons that are beyond my grasp, they have not been able to see a connection between this and 1988’s bank regulations.

But I do know that piece of egregious regulation, introduced such distortions in the allocation of bank credit that, worldwide, millions of SMEs and entrepreneurs have been negated the opportunities   provided by access to bank credit. That is a real huge cost that should be added to the nominal 0% rate. In other words the rates on public debt are the nominal rates, plus the economic and human costs of the distortions.

Since because of this regulatory risk aversion (even in the Home of the Brave) the economies are stalling and falling. So in this respect one could argue that in reality, never ever before have the interest rates on public debt been as high.

Which also leads me to my second objection, that of “infrastructure projects rendering a 5% economic return”. The final real return of any infrastructure project is a function of how it meets the needs of the economy, and of the state of the economy. If regulatory distortions impede the growth of the economy, those infrastructure projects, even if perfectly carried out, even if financed at 0%, might really turn out to provide a negative return.

Professor Summer, let us, very carefully, get rid of those regulatory distortions so that the banks of America, and those of the world, can return to the normality that was so rudely interrupted by regulatory hubris and statism in 1988. That would allow infrastructure to be financed by governments out of real economic growth, something that would then certainly even justify having to pay much higher nominal interest rates than now.

Please don’t put the cart before the horse! Don’t refuse “the risky” the opportunities to access bank credit only because they are risky. Our economies were all built on risk-taking, even when some of it was not adequately reasoned.

To lay on regulatory risk aversion on top of bankers natural risk-aversion, is an insult to intelligence and human wisdom.

God make us daring!

Since bank regulators in 1988 decreed sovereign debt to be risk free, the market has not set the risk-free rates

In the discussion by Lawrence Summers and Adair Turner on secular stagnation in the Institute of New Economic Thinking INET, on October 28, I extract the following:

15:25 Lord Adair Turner

“The longer we have the slow growth and sub-target inflation, the more you have to think that there is something secular is at work. And the thing that makes me pretty sure that Larry is right in his hypothesis that something secular is at work, is to look at the 30, not the 10 year trend, but the 30 year trend, in real risk-free interest rates. 

Take UK’s 10 year yields on real index linked gilts. 

Take an average for each five year period, from 86-90, 91 to 95 and so six of those 5 year periods until the last

And the sequence is 3.8%; 3.6; 2.5%; 1.9%; 1.2%; minus 0.6%, and the value is now minus 1.5%. 

When you see a trend like that you begin to think that there may be something secular, petty strong, about that; with a dramatic fall even before the 2008 crisis, so you can’t put all this down to central bank intervention, quantitative easing.

So we seem to have entered a world where savings and investments only balance at very low or negative real interest rates. And of course those very low interests rates themselves, played a role in stimulating the excessive private credit growth which landed us with the debt overhang. 

But despite this those low interest we have low growth and below target inflation, and so it is vital we try work why is this… 

17:58 Well logically, the long term decline in real interest rates must mean that we have faced over the last 30 year either:

an increase in the ex ante desired aggregate global saving rate 

or a decline in the ex ante desired or intended global investment rate 

or a mix of both.”

Lord Adair Turner, the former chairman of the Financial Service Authority, FSA (2008-2013), and therefore supposedly a technocrat well versed in bank regulations, had not a word to say about: 

That extraordinary moment when, after about 600 years of “one for all and all for one” capital in banking, in 1988, with the Basel Accord, Basel I, regulators introduced risk weighted capital requirements for banks and, to that purpose, set the risk weight for the sovereign at 0%, while the risk weight for We the People was set at 100%.

That of course signified an extraordinary regulatory subsidy of sovereign debt, that had to set the UK’s 10 year yields on real index linked gilts, on a negative path.

From that moment on, since the regulators had decreed sovereign debt to be risk free, we can no longer really hold the market, using public debt as a proxy, can provide a reliable risk free rate estimate.

For now those artificially decreed risk-free rates can only go down and down and down… until BOOM!

The low “real” public debt interests might be the highest real rates ever, in that these regulations also make banks finance less the riskier, like SMEs and entrepreneurs, those who could provide us with our future incomes, and therefore governments with its future tax revenues.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

PS. Please do not categorize misregulation as deregulation. 

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

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

Evidence that demonstrates, without any reasonable doubt, we have landed us some very feeble-minded bank regulators

What are the chances banks build up huge exposures to those rated prime, AAA to AA, and which could be dangerous to the bank system, if these, ex post, turn out to have been worthy of a much lower rating? Big!

What are the chances banks build up dangerously large exposures to those rated “highly speculative “ and worse below BB-? None! 

And yet the regulators, for the purposes of determining the capital requirements for banks, in Basel II, assigned to the AAA to AA rated, a risk weight of 20%, and to the below BB- rated, a risk weight of 150%.

And to top it up, the risk weights are portfolio invariant.

Do we really need more evidence that the Basel Committee regulators and those affiliated to it are cuckoo?

They behave like nannies telling the children “Stay away from the ugly and foul smelling, and embrace the nice gents bringing you candy”, and so dangerously distort the allocation of bank credit to the real economy.

Voltaire to the Basel Committee: “May God defend me from my friends [AAA rated]: I can defend myself from my enemies [BB- rated]”

Here is a brief memo that further explains their idiocy.