Basel III - sense and sensitivity”? No! Much more “senseless and insensitivity”

I refer to the speech titled “Basel III - sense and sensitivity” on January 29, 2018 by Ms Sabine Lautenschläger, Member of the Executive Board of the European Central Bank and Vice-Chair of the Supervisory Board of the European Central Bank.

“Senseless and insensitive” is how I would define it. It evidences that regulators have still no idea about what they are doing with their risk weighted capital requirements for banks.

Ms Lautenschläger said: With Basel III we have not thrown risk sensitivity overboard. And why would we? Risk sensitivity helps align capital requirements with actual levels of risk and supports an efficient capital allocation. It prevents arbitrage and risk shifting. And risk-sensitive rules promote sound risk management.

“Risk sensitivity helps align capital requirements with actual levels of risk and supports an efficient capital allocation” No! The ex ante perceived risk of assets is, in a not distorted market aligned to the capital by means of the size of exposure and the risk premium charged. Considering the perceived risk in the capital too, means doubling down on perceived risks; and any risk, even if perfectly perceived, if excessively considered causes the wrong actions.

“It prevents arbitrage” No! It stimulates arbitrage. Bankers have morphed from being diligent loan officers into too diligent equity minimizers. 

“It prevents risk shifting.” No! It shifts the risks from assets perceived as risky to risky excessive exposures to assets perceived as safe.

“It promote sound risk management” No! With banks that compete by offering high returns on equity, allowing some assets to have lower capital requirements than other, makes that impossible.

Ms Lautenschläger said: “for residential mortgages, the input floor increases from three basis points to five basis points. Five basis points correspond to a once-in-2,000 years default rate! Is such a floor really too conservative?”

The “once-in-2000 years default rate on residential mortgages!” could be a good estimate on risks… if there were no distortions. But, if banks are allowed to leverage more their capital with residential mortgages and therefore earn higher expected risk adjusted returns on residential mortgages then banks will, as a natural result of the incentive, invest too much and at too low risk premiums in residential mortgages… possibly pushing forward major defaults from a “once-in-2000 years default” to one "just around the corner". That is senseless! Motorcycles are riskier than cars, but what would happen if traffic regulators therefore allowed cars to speed much faster?

I guess Basel Committee regulators have never thought on how much of their lower capital requirement subsidies are reflected in higher house prices?

Then to answer: “Does this mean that Basel III is the perfect standard - the philosopher's stone of banking regulation? Ms Lautenschläger considers “What impact will the final Basel III package have on banks - and on their business models and their capital?”

Again, not a word about how all their regulations impacts the allocation of bank credit to the real economy… as if that did not matter… that is insensitivity!

Our banks are now financing too much the “safer” present and too little the “riskier” future our children and grandchildren need and deserve to be financed.

PS. In 2015 I commented another speech by Ms Lautenschläger on the issue of “trust in banks”.

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

If a banker, I would ask: Is our bank being fooled by Basel regulators to dangerously overcrowd safe havens?

Gentlemen,

We are allowed to hold less capital against what is ex ante perceived (decreed or concocted to be safe than against what I perceived to be risky.

That, when compared to if we had to hold the same capital against any asset now permit us to expect higher risk adjusted returns on equity for what is perceived as safe than on what is perceived as risky.

To be able to earn more ROE on the safe than on the risky sounds wonderful, but it has its costs: 

First we might be willing to accept risk adjusted rates from “the safe” than might be lower than what would be the case in an undistorted market.

Second, to compensate for the above, we might be requiring “the risky”, like SMEs and entrepreneurs to pay us higher risk adjusted rates than what they would have to pay us in the case of an undistorted market, and that means we might lose out on some interesting business or otherwise make “the risky” riskier. 

If it was only our bank that had access to this regulatory distortion, then we might benefit without rocking the boat, but the fact is that the whole banking system is doing the same, and so the distortions in the allocation of bank credit to the real economy are huge.

So friends, it is clear that if we go on following the directives of our bank regulators, and basically only keep to refinancing the safer past, we are doomed to end up, sooner or later, gasping for oxygen in an overpopulated safe haven. 

And by abandoning the financing of the riskier future, we are also neglecting our duties to the real economy, and our children and grandchildren might, should, hold us accountable for that.

So what are we to do? What can we do? 

May I suggest we look into the possibility of ignoring the different capital requirements and, based of course on a sound bank diversification and portfolio management, begin, without discrimination, to look at the risk premiums offered by all, risky and safe, on an equal dollar to dollar basis.

Or, as our famous colleague Mr. George Banks once suggested, we could all go and fly a kite!

When will bank regulators stop making bankers’ wet dreams come true and do more for the beautiful dreams of our young?

What is a banker’s wet dream? Presumably to earn a lot of return on equity while not having to take risks. And the regulators granted that dream by allowing banks to have especially little capital against assets perceived as safe. Little capital means high leverage, and which means high-expected risk adjusted returns on equity. So banks just refinance the "safer" past.

What could our young ones dream of? To find decent jobs that allows them to form families and earn sufficiently to maintain these well. And that we know requires a lot of SMEs and entrepreneurs to open up new roads and ways to jobs in the real economy. But these dreams are denied by the regulators when requiring banks to hold more capital when lending to the “risky” than when lending to the safe. More capital means lower leverage, and which means lower expected risk adjusted returns on equity. So banks do not finance the "riskier" future.

And the current nightmare is that regulators are not even aware of what their credit risk aversion is doing. “A ship in harbor is safe, but that is not what ships are for.” John A Shedd

And the current nightmare is that regulators are not even aware that for the banking system, what’s perceived as safe, is the only that can generate those dangerous excessive exposures that bring on crises.  “May God defend me from my friends [what’s safe]: I can defend myself from my enemies [what’s risky]” Voltaire

Here is an aide-mémoire that explains some incredible mistakes in the risk weighted capital requirements for banks, the pillar of current regulations.

Decreed 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… Bad banks, unlike good, loaned to the poor risk, which is another name for the poor man.” “Money: Whence it came where it went” 1975.

And that pro-egalitarian function had to face that natural risk aversion of bankers supposedly described by Mark Twain with “A banker is a fellow who wants to lend you the umbrella when the sun shines and wants it back when it rains”.

But since “poor risks” could always offer to pay higher risk premiums than the “safe”, and a dollar paid in interest was a dollar whoever paid it, the “poor risks” of yesterday, frequently got the opportunities for bank credit that in many cases transformed these into the safe of today. 

No longer. Bank regulators, wanting nothing but safer banks, decided since the early 1990s that the natural risk aversion of bankers was insufficient, and decreed risk weighted capital requirements for banks.

With it banks are required to hold more capital (equity) against assets perceived as risky than against those perceived as safe; which meant banks are able to leverage equity less with loans to those perceived as risky than with loans to those perceived as safe; which meant banks earn lower expected risk adjusted returns on equity lending to the risky than lending to the safe; which means that dollars paid in net risk adjusted margins on loans by the risky do not any longer have the same value than the same dollars paid by the safe; which means that no longer have the “risky poor” fair access to bank credit, while that of the “safe rich” is de facto subsidized. 

And this is what I mean with “Decreed Inequality”. 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? That would never have resulted in a free market with unregulated banks. And it sadly also means that banks no longer finance the “riskier future” but only refinance the “safer past”.

And in terms of “safer banks” it was and is all for nothing, as major bank crises never ever result from excessive exposures to something perceived ex ante as risky. The 2007/2008-bank crisis would never have happened or, if so, remotely had been of the same scale had banks not been regulated. A free market would never have knowingly allowed banks to leverage 30 to 50 times their equity like regulators did.

Do I think banks should not be regulated? Absolutely not! I am only reminding everyone of the fact that the damage dumb bank regulators can cause with their meddling, by far surpasses anything the free market can do.

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.

Note: I expressed concerns about the distortions that capital requirements based on perceived risks could cause in my very first Op-ed, back in 1997.

PS. Through the bathroom window of the Basel Committee for Banking Supervision, and by decreeing the risk weight of the sovereign to be zero percent, while that of the private sector was set at 100 percent, the regulators also smuggled in horrendous statism. 

P.S. Here is a link to a more detailed aide memoire on the horrible mistakes of risk-weighing the capital requirements

PS. Then on top of it all they top it up with QEs and other stimulus that primarily benefit those who already own assets.

PS. Here is a letter on this issue the Washington Post published 

And here is my 2019 letter to the Financial Stability Board

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.

Is there anything more shortsighted short termism than credit risk weighted capital requirements for banks?

More ex ante perceived credit risk requires more capital – less ex ante perceived credit risk allows much less capital… that is the pillar of current bank regulations.

And that allows banks to leverage much more when lending to The Safe than when lending to The Risky; which means banks can earn much higher expected risk-adjusted returns on equity when lending to The Safe than when lending to The Risky.

And so banks do not any longer finance the riskier future, but keep to refinancing the safer past. If that is not short termism, what is?