Did regulators, when developing the fundamentally wrong risk weighted capital requirements for banks, suffer some kind of “perception controlled hallucination” or any other psychological disorder?

In 1988, with the Basel Accord, Basel I, the Basel Committee for Banking Supervision introduced the use of risk-weighted capital requirements for banks. That scheme was further much expanded in 2004 with Basel II.

In essence that meant that banks had to hold more capital against what is (ex ante) perceived as risky than against what is perceived as safe. 

The stated goal of this regulation, was and is to avoid the failure of banks that can put the economy in jeopardy and that could cause big loses for depositors or big costs for tax payers derived from official rescue interventions.

Nothing wrong with that intention, except for what they did and what they ignored when developing these risk-weighted capital requirements.

What did they do? 

They looked at the risk of the assets just like bankers do, and not at the risk that bankers might be perceiving the risks wrong, or acting wrongly to risks well perceived. 

What’s the worst case scenario about risks perceived wrong? Clearly that something ex ante perceived as very safe turns out ex post as very risky. The opposite, something perceived as very risky turning out very safe should obviously not bother anyone… except of course the borrower who had to pay too high risk premiums.

What did they ignore? 

First that all major bank crises have resulted from, criminal behavior, unexpected events or excessive exposures to something ex ante perceived as safe but that ex post turned out to be very risky. “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain.” Mark Twain. The mistake can perhaps be illustrated by the fact that regulators, in their standardized risk weights of 2004, assigned a 150% to the below BB- rated, that which bankers won’t touch with a teen feet pole, but a meager 20% to what is AAA to AA rated.

Second, that these risk weighted capital requirements, which allowed banks to leverage more with what was perceived safe, would have banks earning higher expected risk adjusted returns with what was perceived safe, which would naturally increase the risk of some perceived safe havens become dangerously overpopulated, against especially little capital. In a Roulette in a casino,  2 to 1 and 36 to 1 are equivalent winnings paid out to those playing it “safe” on color or those playing it “risky” on a number. If the winning for those same bets were for example 3 to 1 and 30 to 1, that would break the bank and sink the casino.

Third, that the real economy, in order to move forward depends much on risky entrepreneurs and small and medium enterprises (SMEs) having access to bank credit. “A ship in harbor is safe, but that is not what ships are for.” John A Shedd.

I do not think it is prudent to distort the allocation of bank credit to the real economy, so I would favor one single capital requirement against all assets, but if I absolutely had to distort in this way, then my risk weighting would have to be 180 degrees in the opposite direction, higher perceived risk-lower capital, lower perceived risk-higher capital. 

It was 30 years when this monumental mistake was initiated, and for all practical purposes it is not yet even discussed… so the stickiness of that mistake has proven to be equally monumental.

Friends, is it something in “Predictive Processing” that could explain this so fundamental mistake in our current bank regulation, and its stickiness?

And more importantly still, in what way can “Predictive Processing” help us to avoid this type of extremely costly mistakes.

Here a brief aide memoire on the major mistakes with the risk weighted capital requirements

@PerKurowski

All dollars (or Pounds, or Euros) should be equal!

The efficient market hypothesis, and the capacity of free markets to allocate efficiently financial resources have, as a consequence of the recent financial crisis, been seriously questioned. There is absolutely no cause for that.

In a free market all dollars pursuing assets are equal, and so the prices reflect the markets appreciations of returns, risks, and other factors… and so in essence, all assets will produce equivalent all included risk-adjusted returns. Like any bet on the roulette.

But then came bank regulators, with their risk-weighted capital requirements, more risk more capital, less risk less capital, and determined that some dollars, those being lent to what was perceived as “absolutely safe” were worth much more because these could be leveraged by banks much much more, than the dollars lent to what was perceived as “risky”. Like doubling the roulette payout when playing it safe, like betting on a color.

And of course that made it impossible for the markets to function. It would be like pricing assets in dollars Euros and Pounds, simultaneously without informing the markets of which currency was used. In fact, since bank capital when in “risk-free” land could sometimes be leveraged about 40 times more than when in “risky” land, the currencies used are perhaps more like dollars, pesos and yen. 

And so a dollar going to someone “risky” is for the banks worth de facto much much less than a dollar going to the AAAristocracy. Talk about financial exclusion! Talk about increasing inequality gaps!

Discriminating against risk-taking, in the "Home of the Brave"... you´ve got to be kidding!

Please regulators, allow a dollar to be a dollar for everyone! So that markets will work again!

PS. By the way who authorized all that?

The Basel II Roulette Manipulation

Because of what they perceive as reckless speculative risk-taking by banks, many refer to banking as a casino. And so let us think of the alternative loans and investments a bank can make, as the alternative bets on a roulette table.

On it there were for instance “Safe Bets”, black or red, with a payout of 1 plus the bet; “Intermediate bets”, columns, with a payout of 2 plus the bet; and “Risky Bets”, any single number, with a payout of 35 plus the bet. All bets had of course a similar expected value of return, the same risk-adjusted return, though in the case of the roulette, a somewhat negative one, because the House always wins when the zero or double zero comes up, the House Edge. In banking, good credit and investment analysis, is expected to provide positive yields, even for the "zero" and "double zero".

But imagine then that a Basel Committee for Roulette Supervision suddenly got too concerned with that some players were making too many risky plays, and losing all their money, very fast, and that this was something for which they felt that, as a regulatory authority, they could be blamed for, and so decided to do something about it.

And so they decreed their Basel Roulette II Regulations and by which, in order to keep the players playing longer and not losing it all so fast, they allowed the payout for “Safe Bets” to be five times higher, 5 plus the bet, the payout for “Intermediate Bets” double the current, 4 plus the bet, while the payout for “Risky Bets” would remain the same, 35 plus the bet. 

And so what do you think would happen? Just what had to happen! Every player ran to make “Safe Bets”, and now and again, just for kicks, perhaps an “Intermediate Bet”, but they all stayed away from “Risky Bets”, since these just did not make sense any longer.

And the players got so excited with their profits, and bet more than ever, and so when suddenly the zero or double zero appeared, as had to happen, sooner or later, they lost fortunes, and really got wiped out, more than ever, and to such an extent that the casino even had to pay for their taxi ride home. 

Before current Basel bank regulations, all bank lending or investment alternatives produced basically the same expected risk and cost of transaction adjusted returns on equity; because that is what a free competitive market and banking mostly produces. But this was precisely what The Basel Committee for Banking Supervision changed when, with their Basel II, they imposed different risk-weights to determine the capital requirements for banks for different assets.

For instance, when lending to “The Infallible”, like “solid sovereigns” and what is triple-A rated, the banks had to hold only 1.6 percent in capital, and so were allowed to leverage their equity 62.5 times to 1. And that is FIVE times as much allowed leverage than when lending to “The Risky”, like small businesses and entrepreneurs, and where banks had to hold 8 percent in capital and therefore could only leverage their bank equity 12.5 to 1. And for “The Intermediate”, in a similar fashion, a doubling of the pay-out ratio, to 25 to 1 was authorized. 

This absolutely loony manipulation of the odds of banking; and which obviously not only guaranteed that when disaster struck the banks would be standing there naked without any capital; also made it impossible for the banks to perform with any sort of efficiency their vital role of allocating economic resources. 

And the most crazy thing is that soon five years after the disaster occurred, this manipulation of the odds of banking is not even being discussed, and the regulators with Basel III are even adding on liquidity requirements based on perceived risk, which can only have a similar effect of improving the expected risk-adjusted returns from lending to “The Infallible” instead of lending to “The Risky” 

And instead of discussing this monstrous and odious odd manipulation that favors those already favored, "The Infallible", and discriminate against those already discriminated against “The Risky” the world, and the specialized press, like Financial Times, keep themselves busy with the clearly illegal, but immensely less relevant “Libor Affair”.

Poor us! These banking regulations are castrating our banks, making them sing is falsetto by accumulating more and more on their balance sheets exposure to the safe-havens perceived as not yet too dangerously overpopulated; while avoiding like the plague exposure to the more risky but probably more productive bays where our young could find the next generation of jobs they so urgently need.

PS. And it would be so comic, if not so tragic, that absolutely most experts, including Nobel Prize winners, keep on referring to the crisis as a result of excessive risk-taking by banks, and which is of little assistance when trying to explain that what all banks were doing, was betting excessively on boring safe bets, red or black, and this only because of bad regulations… rien ne va plus.