Jeb Hensarling asks: How we can make the economy work for working people? Here’s my answer:

Jeb Hensarling, the chairman of the Financial Services Committee asks: How we can make the economy work for working people

Here’s my answer:

Get rid of the risk-weighted capital requirements for banks!

These only distort the allocation of bank credit to the real economy.

These only help finance the “safe” basements where jobless kids can live with their parents but not the “risky” new job creation they would need to afford to become parents too. 

These stop banks from financing the risky future and make these only refinance the "safer" past and present.

Where would America, the Home of the Brave, have been if its banks had been subjected all the time to this type of regulatory risk aversion?

“A ship in harbor is safe, but that is not what ships are for.” John A Shedd, 1850-1926

The risk weighting has de facto decreed inequality

God make us daring!

Besides it is all for nothing. Bank crisis are caused by unexpected events, criminal behavior and excessive exposures to what was ex ante perceived as very safe when placed on the banks’ balance sheets, but that ex post turned out to be very risky. Never ever are bank crisis the result from excessive exposures to what was ex ante perceived as risky. “May God defend me from my friends, I can defend myself from my enemies” Voltaire

Now, if you are rightly concerned that getting rid of the risk weighting would initially create such bank capital shortages that it would put a serious squeeze on credit; then grandfather the current capital requirements for all their current assets, and apply a fixed percentage, like for instance 8%, on all new assets… including public debt, since a 0% risk weight for the Sovereign and 100% for We the People seems to me, I beg your pardon, an insult to your Founding Fathers.

Finally, if regulators absolutely must distort, so as to think they earn their salaries, may I suggest they use job-creation and environmental-sustainability ratings instead of credit ratings, which are anyhow already cleared for by banks.

Mark Carney, if you are so concerned about climate change risk, suggest capital requirements for banks should depend on it.

We read: Speaking at the COP21 Paris Climate Change Conference Mark Carney, FSB Chair, said “The FSB is asking the Task Force on Climate-related Financial Disclosures to make recommendations for consistent company disclosures that will help financial market participants understand their climate-related risks. Access to high quality financial information will allow market participants and policymakers to understand and better manage those risks, which are likely to grow with time.” 

Bullshit! If Mark Carney was really concerned about environmental sustainability (and about job creation for our young) he would suggest to base the capital requirements for banks on that, instead of as currently basing these on nonsensical credit risks that are anyhow cleared for by banks.

Frankly, if there is a real need for a Task Force, that should be one to determine the regulatory stupidities that distort the bank credit allocations to the real economy. Such Task Force might very well suggest getting rid of regulators like Mark Carney.

PS. As I have said before... if climate change regulation is to be handled by a task force in any way similar to the Basel Committee... then we're toast. 

I hereby nominate the Basel Committee’s bank regulators to the Circle of Reason’s Hall of Shame

The Circle of Reason will ask: "What did they do?" 

My answer is that they decided banks needed to hold more capital against assets perceived as risky than against assets perceived as safe.

The Circle of Reason might then say: "But that sounds fairly reasonable, so why is it wrong?"

So here is a non-exhaustive list of reasons, in no particular order:

Banks already clear for perceived credit risk by means of risk premiums charged, size of exposure and other contractual terms so re-clearing for the same perceived risk only distorts.

Instead of looking at the risks of how banks managed the perceived risks of their assets, the regulators also focused on the same perceived risks.

Perceived credit risks are to be managed by the banks and if they cannot do that they should close down as fast as possible. Bank capital is to cover for unexpected losses and so to set the requirements of it based on the expected losses derived from perceived risks make absolutely no sense whatsoever.

The regulators decided that the capital requirements should be portfolio invariant, meaning these had nothing to do with the size of any bank exposure, meaning that all the benefits from diversification were ignored, meaning that they did not know one iota about what they were doing.

To top it up bank regulators decided that the risk weight of sovereigns was to be zero percent while the risk weight for the citizens that make up that sovereign was to be 100 percent, which, unless you are a runaway statist or communist, makes absolutely no sense.

The regulators never understood that allowing banks to have less capital against The Safe, would allow banks to leverage the equity and the support of society much more on loans to The Safe, which allowed banks to earn much higher risk adjusted returns on equity when lending to The Safe than when lending to The Risky.

The regulators regulated the banks without defining what the purpose of banks is, which meant that they for instance ignored the whole topic of allocating credit efficiently to the real economy. Only that should suffice to earn them a place in the Hall of Shame.

The regulators never studied what had caused major bank crises and so confused the ex ante perceived risks with the ex-post real risks. Had they done so they would have noticed that major bank crises result from excessive exposures to something ex ante perceived as safe… and so their capital requirements should perhaps be 180°different, higher for what is perceived safe than for what is perceived risky.

The regulators just focused on the bust event of an economic cycle, not caring about what the whole boom-bust cycle produced… and so they totally ignored that risk-taking is in fact the oxygen of any development.

In these days in which inequality is much discussed the regulators never understood that denying a fair access to bank credit to those perceived as risky, is a potent inequality driver.

If they absolutely wanted to distort, in order to show they were working, why did they not distort with a purpose, like basing the capital requirements on job-creation and sustainability ratings? 

The regulators awarded so much power to some human fallible credit rating agencies so that credit ratings became a huge source of systemic risk that would travel at globalized speeds.

The regulators have, now soon ten years after a crisis that was initiated by excessive exposure to AAA rated securities, sovereigns like Greece, real estate in Spain and much other assets that all shared the commonality of generating very low capita requirements for banks, not yet been able to understand the causality.

I could probably go on for quite some time, but this should be enough to at least establish The Basel Committee (and the Financial Stability Board) as serious candidates to be inducted to The Circle of Reasons' Hall Of Shame.

Per Kurowski

@PerKurowski

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

http://subprimeregulations.blogspot.com

The Basel Committee instructs banks to lend as if they were old retirees and not young professionals

Viktor Munkhammar in “Dagens industri”, Stockholm, September 21, wrote “Åldrande befolkning ger centralbankirer gråa hår”.

In it Munkhammar analyses the growing fright about deflation, and most especially what demographic changes can help to produce it… and I agree with most of his arguments.

But, when he writes: “For central banks, this means that the fight against low inflation is unlikely to be over when the consequences of the financial and debt crisis eventually folded.”, then I must intervene to remind him that, in many ways, the financial and debt crisis was already the result of a demographic change… as the Basel Committee for Banking Supervision was hijacked by some retirees’ risk adverse criteria.

What do I mean with that?

We all know that any financial advisor, counseling a young professional on his in investments, would indicate the need for a high degree of risk-taking, like investing in the stock market. And any advisor, similarly counseling an aging professional, soon a retiree, would recommend a much more cautious strategy, which includes for instance highly rated corporate bonds and sovereign debt. And, were the advisor not to follow these simple rules, the possibilities of him losing his license as an investment counsel would be very high.

But the Basel Committee, by means of the pillar of their regulations, the risk weighted capital requirements, have allowed banks to hold much much less capital (equity) against assets perceived ex ante, from a credit risk point of view, to be “absolutely safe”, like “infallible sovereigns”, housing finance and lending to the AAAristocracy, than what banks are required to hold against assets perceived as “risky”; like lending to medium and small businesses, entrepreneurs and start-ups.

And that translates into banks being able to leverage much much more their equity with “The Infallibles” than with “The Risky”; which means banks can earn much higher risk adjusted returns on equity when lending to “The Infallibles” than when lending to “The Risky”; which means banks must and will follow an investments strategy much much more adequate for the old than for the young.

And who pays for all that? The economy, which can therefore only grow obese, as risk taking is the oxygen for any sturdy and healthy economic growth; and as a direct consequence of that all of our young who might not get jobs, because of lack of bank credit to those tough risky risk-takers we need to get going when the going gets tough.

And all for what? For nothing, as this bank crisis was not caused by exposures to what is perceived a risky, bank crisis never are, but because of too much exposure to what was ex ante officially perceived as safe, like AAA rated securities, Greece and real estate in Spain.

Frankly, if regulators absolutely must distort, to show us they are working, why do they not weigh the capital requirements for banks, not based on perceived credit risks which are already cleared for by bankers... but for something with a purpose, like potential-of-job-creation ratings, sustainability-of-planet-earth ratings, or, in the case of sovereigns, ethic and good governance ratings?

And just think how sad it is that a country like Sweden, which became what it is because of daring risk-taking, and where in its churches we hear “God make us daring”, now has the dubious honor of having a Swede, Stefan Ingves, chairing the bank regulatory committee which castrates and de-testosterones our banks.

This is how are banks are regulated, and how they could have been, if only they listened to what we want our banks do for us.

The pillar of current bank regulations is capital (equity) requirements based on perceived risk. It allows for much lower capital for assets perceived as safe than for assets perceived as risky… which means banks will be able to leverage much more their equity when lending to the safe than when lending to the risky… which means banks will earn much higher risk-adjusted returns on equity when lending to the safe than when lending to the risky… and which means banks will not lend to the risky, like medium and small businesses, entrepreneurs and start ups.

Unfortunately, that will not stop major bank crises, because these result only from excessive exposures to what was wrongly perceived as absolutely safe, and never from excessive exposures to what was ex ante correctly perceived as risky… just like the latest crisis happened.

Had regulators asked us, we would have suggested the following:

First, forget about perceived credit risks. Bankers already consider these when they set interest rates size of exposures and other terms. And if as bankers they are not able to handle credit risk, then it is better their banks go broke, fast, before these grow into too-big-to-fail banks.

Now if you want banks to have capital as a reserve, as you should, set these based on unexpected risks. And since you never really know where these unexpected risks can occur, better set one fix percentage, for instance 8%, against any bank assets.

But also, if you really want banks to help out, then perhaps you could reduce slightly that 8% floor, not based on credit ratings, but based on potential-for-job-creation ratings, or sustainability-of-Mother-Earth ratings. That way banks will be able to earn a little bit more on their equity, when trying to do something good for us.

Because, at the end of the day, what are banks for, if not to help us, our economy and our planet? And by the way doing that is the only way for banks to achieve long term stability. There is no such thing as banks standing intact among economic rubble.

I guarantee you that had bank regulators followed this road, we might have some other type of crisis, but not one as serious as the current one… and definitely banks would be helping out much more in terms of creating jobs for our young, and in terms of helping the environment in many ways.

I ask for your help in putting our banks back on track... current regulators juts refuse to admit their monstrous mistakes... they do not even answer my questions.

In November 1999 in an Op-Ed I wrote: “The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause its collapse”… and unfortunately that they keep on doing! Basel III is in many ways only digging our banks deeper into the hole.

Damn you, thick as a brick bank regulators.

Even though never ever have a bank crisis resulted from excessive exposures to what is perceived as “risky”, as these have always, no exceptions, resulted from excessive exposures to what has erroneously perceived as “absolutely safe”, our thick as a brick regulators require banks to hold immensely much more capital when lending to the medium and small businesses, the entrepreneurs and start-ups, than when lending to the “infallible sovereigns”, the AAAristocracy or the housing sector… and so of course no one is out there financing the creation of the jobs our young ones so urgently need. Damn you regulators!

They, the future, they do not need sissy risk adverse capital requirements based on credit ratings, they need capital requirements based on job creating ratings, and on planet earth sustainability ratings.

They do not need a bubble in our safe past... they need bubbles in their risky future!

For Basel IV, what do I propose?

Ex ante perceived risks are already cleared for in the numerator, by means of interest rate (risk-premiums) size of exposure and other terms, and so it is just plain stupid to clear for the same risks in the denominator, with different capital requirements based on risk-weights. That only guarantees a distortion that makes nothing safer, and just causes banks to overdose on perceived risks. 

Therefore risk-weighted capital requirements are to be eliminated completely.

But, if bank regulators absolutely must meddle, in order to satisfy their egos, or show off their expertise, and there are going to be some higher capital requirements for some assets, those should be applied to what is ex ante perceived as “absolutely safe”, since all major bank crises ever, have originated in excessive bank exposures to this category of assets.

And, if bank regulators absolutely must meddle, in order to satisfy their egos, or show off their expertise, and there are going to be some lower capital requirements, to induce some higher returns on bank equity, those should be only accepted in as much as these stimulate the banks to better fulfill a social purpose, like basing it on potential for job creation ratings, or sustainability ratings.

And, in no way shall there be any discrimination that favors any short term financial instrument over a long term one.

And in this respect, the initial Basel IV proposition contains just one line, the following:

“Banks shall hold 8 percent in capital, as defined in Basel III, against all assets.”

The Basel IV capitalization can be reached by allowing each bank to apply its current capital to total assets ratio (including sovereigns), and then let it build up that ratio over a period of some years, with about 0.5 percent per year until reaching said 8 percent level. 

But, since the faster banks reach their final Basel IV capitalization, the better for the real economy, the regulators, accepting their full responsibility for the current extreme low capitalization of banks, should beg for some temporary important tax incentives on all bank capital increases taking place within one year of the Basel IV approval.