30 years after the introduction of risk weighted capital requirements for banks, the European Commission's Action Plan, finally spills the beans on that these can distort the allocation of bank credit, for a good (or for a bad) purpose.

The European Commission's Action Plan for a greener and cleaner economy, of March 8, 2018 includes the following statement:

“Incorporating sustainability in prudential requirements: banks and insurance companies are an important source of external finance for the European economy. The Commission will explore the feasibility of recalibrating capital requirements for banks (the so-called green supporting factor) for sustainable investments, when it is justified from a risk perspective, while ensuring that financial stability is safeguarded.”

To my knowledge this is the first time in 30 years, since the introduction in 1988 of risk weighted capital requirements for banks, that an official entity has recognized that by distorting the allocation of bank credit, in favor or against something, regulators can make banks serve a purpose different from safeguarding financial stability.

PS. Sadly though not even “safeguarding financial stability” was well served as all this regulation did was to doom banks to dangerously overpopulate safe-havens holding especially little capital

PS. In October 2013 I discussed this issue on my "Our-piead-a-terre blog"

PS. And on Earth Day 2015 I made a proposal exactly like what the EC will now study, namely to base the capital requirements for banks based on the Sustainable Development Goals SDGs, which of course include environmental sustainability.

@PerKurowski

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

“You’re crazy!” That’s what John K. Galbraith would have said; about Basel’s risk weighted capital requirements for banks

I quote from John Kenneth Galbraith’s “Money: Whence it came where it went” 1975.

“For the new parts of the country [USA’s West]… there was the right to create banks at will and therewith the notes and deposits that resulted from their loans…[if] the bank failed…someone was left holding the worthless notes… but some borrowers from this bank were now in business...[jobs created] 

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.”

[But that] was an arrangement which reputable bankers and merchants in the East viewed with extreme distaste… Men of economic wisdom, then as later expressing the views of the reputable business community, spoke of the anarchy of unstable banking… The men of wisdom missed the point. The anarchy served the frontier far better than a more orderly system that kept a tight hand on credit would have done…. what is called sound economics is very often what mirrors the needs of the respectfully affluent.”

So, on behalf of "the men of wisdom", in came the Basel Committee for Banking Supervision. With Basel I 1988, and Basel II 2004, it told bankers that even when they already consider perceived risk when setting interest rates and deciding on the amount of exposures, they also had to consider the perceived risks for how much capital their banks needed to hold.

In other words bank regulators ordered the banking system to double down on ex ante perceived, (decreed or concocted) risks.

For a while, while bankers were exploiting all the opportunities of being able to mind-boggling leverage their equity with what was thought safe (a banker’s wet dream come true) all seemed fine and dandy. 

The immense growth of bank credit (later followed up with QEs) injected tremendous amount of liquidity into the economy… all until some safe havens, like AAA rated securities and Greece, in 2007/08 became dangerously overpopulated and burst.

One should think the “men of wisdom” would have updated their wisdom, but no!

“The risky”, like SMEs and entrepreneurs, still have to compete with “The Safe” for access to bank credit while carrying the burden of generating larger capital requirements for the banks… while “the safe” havens run the risk of being dangerously overpopulated.

I have no doubt John Kenneth Galbraith, if alive, would say: “You’re crazy!”

My 1997 Puritanism in banking

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!

There are risks and risks. Bank regulators promote the worst and avoid the best.

We now read “US federal regulators this week proposed new pay rules intended to limit excessive risk-taking”

And so its time again to understand there are different “excessive risk-taking”.

One “excessive risk-taking”, is that of creating dangerously large exposures to what is perceived, decreed or concocted as safe. Those exposures currently require very little bank capital. That was the “excessive risk taking” that caused the 2007-08 crisis; AAA rated securities, residential housing finance and sovereigns like Greece.

Another different “excessive risk-taking” is taking risks on the risky, like on SMEs and entrepreneurs. These risks, because they currently generate much higher capital requirements, are risks not sufficiently taken by the banks, and the economy suffers from that.

Do regulators really know what “excessive risk-taking” they want to limit? I seriously doubt it. The “more-risk less-pay” and the “less-risk more-pay” is just the typical kind of intervention that brings on unexpected consequences.

More-risk more-capital less-pay. Less-risk less-capital more-pay. Friends with these regulations we will soon all end up suffocating because of lack of oxygen in some over-populated safe haven!

And our children, they will be without jobs. Because with this regulatory silliness banks do not finance the riskier future any longer, they just refinance the for the short time being safer past.

In short, any senseless risk aversion, whether in bank regulations or elsewhere, condemn our economies and nations to fizzle out.