Tombstones

Here rests a bank regulator who all his life believed that what bankers perceived as risky was more dangerous to our bank systems than what bankers perceived as safe. 

May his soul rest in peace.

Here rests a bank regulator who based the risk weighted bank capital requirements on bankers perceiving risk correctly, and not on that they could be wrong.

May his soul rest in peace.

Here rests a regulator who missed his lectures on conditional probabilities, and therefore did not set the risk weighted capital requirements conditioned on how bankers respond to perceived credit risks.

May his soul rest in peace.

Here rests a regulator who even though bankers respond to perceived credit risks, with size of exposures and risk adjusted interest rates, also wanted bank capital to double up on that same perceived risk

May his soul rest in peace.

Here rests a bank regulator who never understood the systemic risks he introduced into banking, by for instance assigning so much power to credit rating agencies, or his stress-tests of the stresses a la mode.

May his soul rest in peace.

Here rests a bank regulator who for the risk weighted bank capital requirements agreed with risk weights of 20% for dangerous AAA rated and 150% for innocous below BB- rated

May his soul rest in peace.

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

Here rests a bank regulator who caused banks to dangerously overpopulate safe harbors, and sent other investors and small time savers out on the risky oceans. 

May his soul rest in peace.

Here rests a bank regulator who by favoring banks to finance the "safer" present and to stay away from the "riskier" future, blocked millions of entrepreneurs' access to bank credit and with it risk-taking… the oxygen of all development

May his soul rest in peace.

Here rests a statist bank regulator who believed a government bureaucrat knows better (Risk Weight 0%) what to do with credit he’s not personally responsible for, than an entrepreneur or SME (RW 100%)

May his soul rest in peace.

Here rests a bank regulator who for risk weighted bank capital requirements agreed with a low 35% risk weight to residential mortgages, which caused houses to morph from affordable homes to risky investment assets.

May his soul rest in peace.

Here rests a bank regulator with a Ph.D. who proved right Daniel Patrick Moynihan, who supposedly held “There are some mistakes only Ph.Ds. can make.

May his soul rest in peace.

Here lies a central banker who injected huge amounts of liquidity without understanding how risk weighted bank capital requirements distorted the allocation of credit

May his soul rest in peace.

Here lies a financial journalist who scared stiff he would never be invited to important conferences, never questioned the risk weighted bank capital requirements. 

May his soul rest in peace.

Here lies an ordinary citizen who wanting so much to believe it true, swallowed lock stock and barrel the regulatory technocrats' populism imbedded in the risk weighted bank capital requirements

May his soul rest in peace.

Here rests a regulator who helped guarantee especially large bank crises, caused by especially large exposures to what’s perceived especially safe and might not be, and is held against especially little capital

May his soul rest...

PS. A summary of The Basel Committee for Banking Supervision's mistakes

My letter to the Financial Stability Board was received.

http://www.fsb.org/wp-content/uploads/Per-Kurowski.pdf

From: Per Kurowski

Sent: 18 March 2019 19:16

To: Financial Stability Board (FSB)

Subject: SME financing evaluation

I have not found sufficient strength to sit down and formally write up my comments, because I feel I would just be like a heliocentric Galileo writing to a geocentric Inquisition.

The Basel Committee’s standardized risk weights are based on the presumption that what is ex ante perceived as risky is more dangerous to our bank system.

And I hold a totally contrarian opinion. I believe that what is perceived a safe when placed on banks balance sheets to be much more dangerous to our bank system ex post than what is perceived ex ante as risky; and this especially so if those “safe” assets go hand in hand with lower capital requirements, meaning higher leverages, meaning higher risk adjusted returns on equity for what is perceived safe than for what is perceived as risky.

The following Basel II risk weights are signs of total lunacy or an absolute lack of understanding of the concept of conditional probabilities.

AAA to AA rated = 20%; allowed leverage 62.5 times to 1. Below BB- rated = 150%; allowed leverage 8.3 times to 1

The distortion the risk weighting creates in the allocation of credit to the real economy is mindboggling. Just consider the following tail risks.

The best, that which perceived as very risky turning out to be very safe. The worst, that which perceived as very safe turning out to be very risky.

And so the risk weighted capital requirements kills the best and puts the worst on steroids... dooming us to suffer an weakened economy as well as an especially severe bank crisis, resulting from especially large exposures, to what was especially perceived as safe, against especially little capital.

In relative terms all that results in much more and less (see note) expensive credit to for instance sovereigns and the purchase of houses, and less and more expensive credit to SMEs

I am neither a banker nor a regulator but I do believe that the following post helps to give some credibility to my opinions on the issue. And, as a grandfather, I am certainly a stakeholder.

http://subprimeregulations.blogspot.com/2004/11/some-of-my-early-public-opinions- on.html

And here is a more detailed list of my objections to the risk weighting

http://perkurowski.blogspot.com/2016/04/here-are-17-reasons-for-why-i-believe.html

Now if by any chance you would dare open your eyes to the mistakes of your risk weighted bank capital requirements and want more details from me, you know where to find me.

Sincerely

Per Kurowski

A former Executive Director of the World Bank (2002-2004) 

@PerKurowski

Note: In the original letter I erroneously wrote "more and more expensive credit to sovereigns" and not "less expensive", but this should be easily understood as a mistake.

PS. FSB keeps avoiding the issue: June 7, 2019 FSB published a Consultative Document: “Evaluation of the effects of financial regulatory reforms on small and medium-sized enterprise (SME) financing” I quote two parts of it.

1. “For the reforms that are within the scope of this evaluation, post-crisis financial regulatory reforms, the analysis, does not identify negative effects on SME financing in general.” 

Comment: The scope of the analysis does explicitly not include pre-crisis financial regulatory reform, like Basel II. When compared to what was introduced in Basel II, the changes in Basel III produced not really that much “more stringent risk-based capital requirements”. Therefore to limit the analysis to the impact of Basel III changes to risk-based capital requirements, is basically to avoid the issue of how these have, especially since Basel II, profoundly distorted the allocation of credit, and negatively affected the financing of SMEs.

2. “There is some evidence that the more stringent risk-based capital requirements under Basel III slowed the pace and in some jurisdictions tightened the conditions of SME lending at those banks that were least capitalised ex ante relative to other banks.”

Comment: That the Basel III risk-based changes, which in my opinion are minor relative to their importance, “tightened the conditions of SME lending at those banks that were least capitalised ex ante relative to other banks” is something to be expected. There, close to the roof, on the margin, is where the risk weighting most affects; think of “The drowning pool”

PS. A letter to the IMF: "The risk weights in the risk weighted bank capital requirements are to access to credit, what tariffs are to trade, only more pernicious.

Nothing could be so dangerous as big data wrongly interpreted and manipulated

Regulators gathered data on credit risks and developed their risk weighted capital requirements for banks… more risk, more capital – less risk less capital.

But the data they were looking at was the ex-ante perceived credit risks, and not the ex-post possible risks after the ex-ante risks had been cleared for.

And therefore they never realized that what is most dangerous for the banking system is what is perceived very safe and could therefore create large exposures; while what is perceived as very risky is by that fact alone, made innocuous for the banking system

And as a consequence we have already suffered a big crisis because of excessive exposures to AAA rated securities backed with mortgages to the subprime sector; and millions of those risky young dreaming of an opportunity of a bank credit to prosper, have had to give up their dreams or pay higher interest rates that made them even riskier. 

So friends, always prefer well interpreted and well manipulated small data over mishandled big data.

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.

The curious border between what finance professors can understand, and what they cannot understand

If with regulations you allow banks to leverage much more their equity, and all the support these receives from society, with assets type A than with asset type B, then banks will be able to obtain higher expected risk adjusted returns on equity with assets A than with assets B. 

That finance professors can understand.

And the above will cause the banks to exclusively hold assets A, unless assets B offers these a much higher risk adjusted return than what would have been the case in the absence of such regulations.

That finance professors can understand.

And that clearly signifies a distortion in the allocation of bank credit. 

And that finance professors can understand.

But if you just substitute “safe assets” for assets “type A”, and “risky assets”, like loans to SMEs and entrepreneurs, for assets “type B”, then suddenly finance professors no longer understand.

And that I know because no one of them is protesting the distortions in the allocation of credit produced by the risk weighted capital requirements for banks. 

Strange eh?

What behavioral theory explains that?

Real banking risks do not revolve around what is perceived “risky”, as experts think, but around the “absolutely safe”

What happened with the experts swearing by geocentrism, or the Ptolemaic system, that with the cosmos having Earth stationary at the center of the universe, when Galileo Galilei, Nicolaus Copernicus, Tycho Brahe and Johannes Kepler, convinced the world of the heliocentric model, that with the Sun at the center of the Solar System?

I ask it curious to know of what will happen with all those experts in the Basel Committee, the Financial Stability Board the IMF and places like the academia and the press; like for instance Mario Draghi, Stefan Ingves, Jaime Caruana, Mark Carney, Olivier Blanchard, José Viñals, Martin Wolf and so many other; when it is finally realized that the real serious risks in banking do not revolve around assets perceived as “risky”, as they all think, but around assets perceived as “absolutely safe”.

These regulators’ silly portfolio invariant credit risk based capital (meaning equity) requirements for banks, by impeding the fair access to bank credit of “the risky”, like small businesses and entrepreneurs, not only distorts and hurts the real economy; but they also guarantee major system crisis, since banks are then doomed to, sooner or later, to get caught with their pants down (meaning little equity), with huge exposures to something which was perceived as “infallible” but which has turned into something very risky… often precisely because of too much credit at too low interest rates.

Should it be "More risk more equity – less risk less equity" as these regulators argue?

No! I prefer no distortion, but, if anything, then just the opposite.

These current regulators they all confuse the world of ex-ante perceived risks with the world of ex-post realized dangers.

These regulators have never heard or understood Mark Twain’s “A banker is he who lend you the umbrella when the sun is out, and wants it back as soon as it looks like it is going to rain”

Worse than truck being allowed high speeds, is that different speeds are allowed.

Anat Admati in “The Compelling Case for Stronger and More Effective Leverage Regulation in Banking” October 14, 2013, refers to “The speeding analogy” which appeared in hers and Martin Hellwig’s splendid book "The Bankers' new clothes"

“Imagine that trucks were allowed to drive faster than all other cars on the road even though they are the most dangerous. Further suppose that the trucking companies and the drivers are rewarded the faster they are able to make a delivery, benefit from subsidized insurance, and have a special safety system that protects the driver in case of accidents and explosions. The companies might produce narratives suggesting that their deliveries are essential and that the fast delivery is important for economic growth. They and others might produce models suggesting possible “tradeoffs” associated with a lower speed limit for the trucks. Whereas there probably are tradeoffs associated with trucks driving too slowly, it is clear that they are irrelevant, and there are no tradeoffs, when choosing between 90 miles per hour and 50 miles per hour for a truck carrying dangerous cargo in a residential neighborhood”

Yes, Admati is right in her analogy.

What guarantees mayhem more than a generally allowed high speed is, as I have argued for years, to allow different vehicles, based on safety ratings, to drive at different speeds (risk-weights) on the same streets. Sooner or later those safety ratings, will either be captured by interested speeders, or simply be wrong; and besides these loony traffic regulations will make it more difficult for doctors, fire trucks and other vital essentials to arrive in time.

But no, Admati is very wrong in her analogy when she mentions: “Imagine that trucks were allowed to drive faster than all other cars on the road even though they are the most dangerous.”

That is because what's perceived as “most dangerous”, the risky, the trucks, is what currently in banking must transit at the slowest speeds, the lowest allowed bank leverages; while those perceived as the safest, like sovereigns, residential mortgages and AAA rated securities, are those allowed to go through our residential neighborhoods at the highest speeds, the highest allowed leverages.

I do understand, it is hard to internalize that, at least when it comes to banking, that which is perceived as safe is so much more dangerous to the system than that which is perceived as risky. Sadly way too many missed their lectures on conditional probabilities. 

I've used a very similar though quite distinct analogy on my blog.

All this is of course why I give much more importance to eliminating the risk-weighting of the capital requirements for banks, than just increasing the basic capital required. In fact the more capital banks are asked to increase the capital means that, while that is being taken cared off, the worse will be the effective discrimination against those who, even though they in fact pose the least de facto risks for the banks, are been castigated with the highest risk weights. Remember "The drowning pool"

Two whys on bank regulations

How can I, as an ordinary citizen, obtain a decent return on my savings when investing in safe securities, having to compete with banks who can leverage their equity more that 60 to 1 when they do so?

How can I, as an ordinary small businesses or entrepreneur, get a decent interest rate on my bank loans, when banks can leverage their equity so much more when lending to those officially perceived as not-risky? 

It is so unfair! Who are these bank regulators? Who invested them with so much power?