Mr. Stefan Ingves… I do seriously disagree with your “risk-based capital adequacy ratios”, and I dare you to debate it.

Mr. Stefan Ingves the Chairman of the Basel Committee on Banking Supervision delivered a speech titled “Banking on Leverage" during a High-Level Meeting on Banking Supervision, held Auckland, New Zealand, 25-27 February 2014.

In it Ingves stated: “Risk-based capital adequacy ratios have been the cornerstone of the Basel framework since it was introduced 25 years ago. Capital adequacy ratios measure the extent to which a bank has sufficient capital relative to the risk of its business activities. They are based on a simple principle: that a bank that takes higher risks should have higher capital to compensate. Of course, there are plenty of challenges in measuring risk -- something I will come back to shortly -- but I have yet to meet anyone who seriously disagrees with that simple principle.”

Well I am one who seriously disagrees with that principle… and I dare him to meet me and debate the issue.

A bank, when taking risks, high or low, should compensate for any probable expected losses, by means of interest rates (risk premiums), the size of the exposure, and other terms, like the duration of the loans and guarantees.

And, if the banker does his job well, and adjusts adequately to the risk, then capital has absolutely no role to play in that. And, if the banker does not know how to do his job well, and does not adjust adequately to the risks, then he should fail, the sooner the better for all, so that the bank accumulates as little combustible mistakes as possible.

But a bank regulator, like the Basel Committee, cannot and should not, entirely trust that all risks are being duly perceived by the bankers because, as we all know, there are such things as hidden risks and unexpected losses.

But any hidden risks and unexpected losses cannot be approximated by means of the perceived risks and the expected losses… in fact it is what is perceived as absolutely safe, what is expected to produce the smallest losses, and which therefore can lead to very high bank exposures, which always produce the most dangerous unexpected losses which pose a threat, not only to an individual bank, but to the whole banking system.

And so bank regulators should not require banks to have higher capital to compensate for higher perceived risk, as they do now, but require banks to have a reasonable level of capital in defense of what is not perceived… and since they can not presume to know about the hidden risks of unexpected losses, then they have no other alternative than to set one single capital requirements for all assets, independent of their perceived risks.

To have an idea of how much current risk based capital requirements miss the target, if anything, one could even make an empirical case for setting the capital requirements slightly higher for what is perceived as "absolutely safe" than for what is seen as "risky".   

And that would also eliminate a great source of distortion. The current capital requirements, more perceived risk more capital, less perceived risk less capital, translates into allowing banks to earn much higher risk-adjusted returns on equity on assets deemed as safe, than on assets deemed as risky… and that makes it impossible for banks to perform their function of allocating efficiently bank credit to the real economy.

Basel Committee, Financial Stability Board, know that Your risk-based capital ratios are stopping the banks to finance the risks our future needs to be financed, and only have banks refinancing the safer past. Our young, who now because of your regulations might end up being a lost generation, will hold You all accountable.

As I see it… anyone who allowed banks to leverage 62.5 to 1 on assets, only because these had an AAA rating… or allowed banks to lend to the “infallible sovereigns” against no capital at all, like the Basel Committee allowed for in Basel II, is just not fit to be a regulator. Capisce Mr. Ingves?

PS. Stefan Ingves also states that “The world's largest listed non-financial companies fund their assets around 50:50 with debt and equity. In banking, a more common ratio is 95:5” Let it be clear that 95:5 is 19 to 1 debt to equity… never ever, in the history of banking before the Basel Committee’s risk based capital ratios, have banks remotely been allowed to leverage this much, knowingly.

In the hands of self righteous, arrogant, dumb and unsupervised bank regulators, Europe is doomed.

Let there be no doubt. Basel II did the eurozone in, but, Basel III, is fundamentally still a perceived risk-based bank regulatory regime. All its new concoctions, like Leverage Ratio, Liquidity Coverage Ratio and Net Stable Funding Ratio are, admittedly, only backstops, supplements or complements.

And this means that banks will still be allowed to hold much less capital against loans to “The Infallible”, like to sovereigns, the housing sector and the AAAristocracy, than against loans to “The Risky”, like to medium and small businesses, entrepreneurs and start-ups.

And that means, of course, banks will be making much higher expected risk-adjusted returns on equity when lending to The Infallible than when lending to The Risky.

And that means, of course, banks will not lend to the future, only refinance the past.

And that means, of course, Europe will not risk exploring sufficiently the new adventurous bays it needs in order to sustain a movement forward, and to create sturdy jobs for its youth, and will therefore die, gasping for oxygen, in dangerously overpopulated safe havens.

Europe, I cry for you. You have no idea of what you have gotten yourself into. Your banking system has been overtaken by what must be the stupidest risk-averse mentality, incapable of understanding the simple fact that what is perceived, ex ante, as “risky”, has never ever caused a major bank crisis, only what has been erroneously perceived as absolutely safe do that.

Europe, for your own sake, rid yourself of the false Pharisees in the Basel Committee for Banking Supervision and in the Financial Stability Board, as fast as you can!

God make us daring!

Comments on Basel Committee's “The regulatory framework: balancing risk sensitivity, simplicity and comparability” of July 8, 2013

Basel Committee for Banking Supervision

Sir,

These are comments made in reference to your July 8, 2013 consultation document “The regulatory framework: balancing risk sensitivity, simplicity and comparability”

I would like to begin by clearly stating that for a long time I have completely objected the capital requirements for banks based on ex ante perceived credit risks. I consider these capital requirements to be totally insane and much responsible for causing the current bank crisis, as well as for impeding us getting out of it.

And to that effect I enclose a short opinion recently published in the Journal of Regulation and Risk - North Asia, Volume V Issue II Summer 2013. The “Mistake” that shall not be named

That said I would also like, just as an example of what I criticize, refer to the following in the document.

“73. For example, in increasing ex ante risk sensitivity and expanding risk coverage, the framework has progressively sought greater alignment of regulatory capital with economic capital. This approach is implicitly premised on the suitability of economic capital as an appropriate measure for regulatory purposes. But the relationship between economic capital and regulatory capital may need reexamination in the light of the recent shift in the focus of regulation and supervision from ensuring the soundness of individual institutions to, additionally, safeguarding the stability of the banking system.”

First, what are you saying? That “safeguarding the stability of the banking system” was not understood to be the role of the Basel Committee for Banking Supervision before? Do those who appointed you really agree with that statement?

Second, your regulatory capital based on ex ante perceived credit risk, even in the case of an individual bank, is an utterly incomplete reflection of economic capital, since it does not consider facts like the size of the exposures, meaning the portfolio diversification/concentration, or the duration of those exposures, for instance the interest rate risk.

And then let me briefly and partially answer some of your specific questions

Q1. Does the current framework, with its reliance on the risk-based capital at its core, appropriately balance the objectives set out in paragraph 29?

No! The core of the current framework, risk-based capital is completely wrong.

For instance, when in 29 you write “These ideas should be assessed against the primary aims of the capital adequacy framework: that is, the capital adequacy framework should…. take into account the effects of capital requirements on banks' risk-taking incentives, eg when faced with regulatory constraints on their capital (and therefore the size of their balance sheet), to seek higher-risk assets as a means of boosting expected returns”, you do not seem to comprehend the real problem.

The fact is that banks, “when faced with regulatory constraints on their capital”, primarily seek assets which have a low capital requirement, in order to boost expected risk-adjusted returns on equity

Q2. Are there other objectives that should be considered in reviewing the international capital adequacy framework?

Yes, like the little matter of the purpose of the banks; like that the capital adequacy framework should not be allowed to distort the bank credit allocation to the real economy. 

Q3. To what extent does the current capital framework strike the right balance between simplicity, comparability and risk sensitivity, given the costs and benefits that greater risk sensitivity brings?

To no degree at all, especially since the “greater risk sensitivity it brings” is only a quite arrogant ex-ante presumption.

Q4. Which of the potential ideas outlined in Section 5 offer the greatest potential benefit in terms of improving the balance between the simplicity, comparability and risk sensitivity of the capital adequacy framework?

In my opinion, a simple leverage ratio of 8 to 10 percent, complemented by a reporting requirement which includes; a report of risk adjusted leverage based on standardized risk-weights, and issued strictly for approximate comparative purposes; and some additional information on its portfolio diversification and duration, and that can be helpful for the market to get a sense of the risk structure of the bank.

The transition to such a reality though would have to be managed with a lot of intelligence in order not to make things worse.

Q5. Are there other ideas and approaches that the Committee should consider?

Yes!

How did Basel I, II and III evolve? How can we make sure that the serious mistakes in them and that I attribute to incestuous group-think within a mutual admiration club, are not repeated?

There is a need for a critical mass of qualified creditors in the market who know they will not be bailed out automatically from a bank problem.

Who authorized the Basel Committee to act as a risk-manager of our banks and the world?

If you want to do it right, you need to work with a whole set of new regulators who have no vested interest in defending what has been done in the past… remember, neither Hollywood nor Bollywood would ever dream of entrusting a Basel III to those responsible for Basel II flop.

Am I to harsh and impolite in my criticism? Considering the suffering and the millions of unemployed youth resulting directly from your faulty regulations, I do not think so.

Sincerely

Per Kurowski

http://subprimeregulations.blogspot.com/

Rockville, Maryland, USA

PS. If you want to download the whole journal from which my opinion was extracted you can go tohttp://www.scribd.com/doc/149858219/Journal-of-Regulation-Risk-North-Asia-Volume-V-Issue-II-Summer-2013

Weighing the risk of a bank’s clients is not the same as weighing the risks of the bank.

If bank regulators are concerned, like for instance now with uncleared derivatives, it is one thing for them to order the bank to increase the capital it holds against all not risk weighted assets, let us say from 6 to 6.2 percent, and quite another, to target specific assets with a higher capital requirements. The first adjusts the capital to the overall risk level of that banks activity, the second just distorts and discriminates against what the regulator perceives is risky. 

“An nescis, mi fili, quantilla prudentia mundus regatur?” Axel Oxenstierna, 1583 – 1654

Helping the Financial Times’ experts to understand the distortions produced by risk-weighted capital requirements for banks

Since I do not belong to any Academic Community, or special sphere of influence, or mutual adoration club, I have very little voice, even when noisy, even when being an Executive Director of the World Bank, 2002-2004. 

So, in this respect I decided long ago to try to use the Financial Times as my channel to express my absolute rejection of bank regulations coming out from the Basel Committee. If for instance a Martin Wolf got to understand my arguments, he would be much more effective communicating these to the world than little me. 

What I had not counted on, were the immense difficulties in making the FT experts understand what I was talking about, even now after more than eight hundred letters on the subject. But, I am insistent, and I will manage to do so, one day. 

And so here below is another attempt to explain, in the simplest possible terms, so that perhaps even FT experts could understand, if they wanted to, the distortions produced by the risk-weighted capital requirements for banks, and which represent the pillar of Basel II and III regulations.

If for instance a German bank, lent to Greece as one of “The semi-Infallible” Greece was rated just a couple of years ago then, according to Basel II, if it could earn doing so a 1 percent net after perceived risk and cost, then it could earn 62.5 percent on its equity. But, if instead lent to a small German or Greek unrated business and earn the same net margin then it could only achieve 12.5 percent on equity. Does this make any sense to FT? Sincerely I cannot think so. And yet, what am I suppose to think?

And so the result is a world with dangerous obese bank exposures to “The Infallible”, and for us equally dangerous anorexic exposure to “The Risky”, and all aggravated by the fact that even the most infallible safe-haven can become extremely dangerous, if overpopulated. 

Capisce FT, or do I need to explain it again?

PS. Me, London, banks,regulators, lions, pussycats and FT’s pink