Iceland: Financial System Stability Assessment—an Update completed August 2008

I invite you to read: “The update to the Financial System Stability Assessment on Iceland was prepared by a staff team of the International Monetary Fund and as background documentation for the periodic consultation with the member country. 

It is based on the information available at the time it was completed on August 19, 2008 and provided background information to the staff report on the 2008 Article IV consultation discussions with Iceland, which was discussed by the Executive Board on September 10, 2008, prior to the recent Board discussion on a Stand-By Arrangement for Iceland.” 

It makes fascinating reading, especially in these times when the regulators now want to tackle systemic risks while ignoring that their regulations are in fact the prime source of systemic risk. In it, dated just a month before the crisis exploded at the end of September 2008, we can, among other, read the following: 

“The banking system’s reported financial indicators are above minimum regulatory requirements and stress tests suggest that the system is resilient. Bank capital averaged almost 13 percent of risk-weighted assets between 2003 and 2006, dropped to 12 percent in 2007 and to approximately 11 percent in the first half of 2008, but remain above the 8 percent minimum. Liquidity ratios are likewise above minimum levels. Notwithstanding the positive indicators, vulnerabilities are high and increasing, reflecting the deteriorating financial environment” 

To me once again, this just proves that no one had the faintest idea of what the “risk-weighted assets” really meant and, if they did, they had no will to question the significance of risk-weighting.

PS. Risk weights are to access to credit what protectionist tariffs are to trade, only more pernicious.

62.5 to 1!

In 2003, at the World Bank I warned: "Nowadays, when information is just too voluminous and fast to handle, market or authorities have decided to delegate the evaluation of it into the hands of much fewer players such as the credit rating agencies. This will, almost by definition, introduce systemic risks in the market"

The regulators they authorized a leverage of 62.5 to 1!

Uploaded by PerKurowski

PS. My 2019 letter to the Financial Stability Board (FSB)

 

Where were they when needed?

On June 26, 2004 the central bank governors and the heads of bank supervisory authorities in the Group of Ten (G10) countries met and endorsed the publication of the International Convergence of Capital Measurement and Capital Standards: a Revised Framework, the new capital adequacy framework commonly known as Basel II.

The framework was primarily based on the concept that financial risk could be measured and that the measurement itself would not affect risks. It therefore represented one of the most astonishingly naive financial regulatory innovations in the history of mankind.

As an example, the framework stated that if a bank lent to a corporation that did not have a credit rating then it needed to have equity of 8 percent, resulting in an authorized leverage of 12.5 to 1. But, if the corporation had been awarded an AAA to AA- credit rating by a human fallible credit agency, then the loan would be risk-weighed at only 20%, effectively elevating the authorized leverage to an amazing 62.5 to 1.

We all know that the market always contains plenty of incentives for high-risk credit propositions to dress up as being of lower risk, and so, when these incentives were exponentially elevated by the regulators, the biggest race ever towards false AAAs got started.

It took just a couple of months for the home mortgages to the subprime sector to manage to dress up about the lousiest awarded mortgages ever as AAAs. And It took just a couple of years for the market to massively follow those AAAs over a precipice, detonating one of the most horrendous financial crisis the world has ever encountered.

Now, one of the questions we need to answer, in order to have a better chance of finding a sustainable solution to this crisis, and alert us to the many other future crisis that will most certainly threaten us, is where were all the financial experts, the tenured professors and the members of think-tanks, all of whom we pay, honor and invite to opine, and that said absolutely nothing about all this? How come they did not see that this crisis was doomed to happen? Or, if they saw it, why did they not speak out?

At the end of the day, the simple truth is that the costs of regulatory innovations far exceeded the costs of financial innovations, and that the benefit from financial innovations far exceeded the benefits from regulatory innovations. And so, if we cannot have much better and more intelligent regulations then we are better off without them altogether.

Financial Stability Forum, please, show some courage to tell it as it is.

“Addressing procyclicality in the financial system is an essential component of strengthening the macroprudential orientation of regulatory and supervisory frameworks.” [and so there is a need to] “mitigate mechanisms that amplify procyclicality in both good and bad times”. That is part of what the Financial Stability Forum recommends in their report of 2 April 2009.

Indeed it sounds a so very impressive and technically solid conclusion? Yet it completely ignores that the prime reason why we find ourselves in the current predicament has much less to do with prociclicality in good times or bad times and much more with some good old fashioned plain vanilla type plain bad investment judgments. What had the world to do, whether in good or bad times, investing in securities collateralized by awfully bad awarded mortgages to the subprime sector in the USA? Would we be so deep in this mess had not the credit rating agencies awarded AAA to such securities? Of course not!

It is a shame that the Financial Stability Forum does not have in it to openly accept the fact that the whole risk based minimum capital requirements for banks idea imposed by Basel is fundamentally flawed, in so many ways. They only accept it in a veiled way when they recommend a “supplementary non-risk based measure to contain bank leverage”.

The lack of forthrightness serves no purpose and can only supply further confusion. Let me here just spell out two of the arguments I have been making.

The current minimum capital requirements are based on requiring less capital for investments that are perceived as being of lower risk while in fact, in a cumulative way, what most signifies a truly systemic risk for the world, lies exclusively in the realms of the investments that are perceived and sold as being of a low risk. In other words systemically the world at large does never enter B- land it goes like a herd to where it is told the AAAs live. The problem was not so much that the world went to play at the casino, the real problem was that the tables were rigged, one way or another.

In the current minimum capital requirements dictated by Basel a loan by a bank to a corporation rated AAA by a human fallible credit rating agencies requires only $1.60 for each $100 lent, equivalent to a 62.5 to 1 leverage and this obviously has much more to do with regulators losing their marbles than with times being good or bad.

This financial and economic crisis will cause more misery in the world than most if not perhaps all wars. Do you really not think the world merits the truth and nothing but the truth?

Two different approaches

There are two completely different approaches to commercial banking.

In the one that has been in vogue over the last decades you look at a monitor, check the credit ratings and invest where the spread is the largest, and then you key in your approval code. This approach allows you, supposedly, to manage the bank from a faraway distance.

The other system, the more traditional one, is based on looking into the eyes of your clients and to get to know them and their business intimately and then to shake their hands when you approve the loan. This approach has the added benefit of developing bankers.

I hold that the traditional approach, call it community banking, is immensely better for developing and middle income countries… that was in fact also the approach the developed countries used.

I hold that the traditional approach, call it community banking, has a better chance of helping to develop the growth that could generate jobs than to finance the anticipation of consumption at the cost of high interest rates and that only generates impoverishment.

I hold that the traditional approach, call it community banking, has a better chance of helping to develop the growth that could generate jobs instead of financing the anticipation of consumption at very high interest rates and that only generates impoverishment.

62.5 times leverage?

I wonder what many of those out there discussing so pompously the financial crisis would be saying if they only knew such basic facts that the Basel Committee in their minimum capital requirements for the banks have actually authorized a bank to leverage its equity 62.5 times if it lends to clients perceived by the human and fallible credit rating agencies as AAA to AA-.

These so knowledgeable discussants would do well picking up some basic knowledge here: http://www.bis.org/publ/bcbs128.htm

The true experts

Laissez-Faire? Ha!

The regulators ordered minimum capital requirements for banks based on the regulator’s very limited knowledge of about what risk is and thereafter effectively ordered the banks and markets to follow the opinions of the regulators favorite risk sentries the credit rating agencies. The banks and the investors obeyed and entered the swamplands of badly awarded mortgages to the subprime sector.

And they now dare to call that Laissez-Faire? They haven’t the faintest clue of what they are talking about.

The world at large would have been better off without any Basel Regulations

I refer to the Geneva Reports on the World Economy 11 titled The Fundamental Principles of Financial Regulation.

http://www.voxeu.org/reports/Geneva11.pdf

It is a good document, though, unfortunately, far from being good enough.

It is good because it recommends for instance “to exclude Credit Rating Organizations from the regulatory network altogether” and regards “both the Basel II approach to the use of credit ratings and the European proposals for their enhanced regulations as misconceived”, and this is something that goes to the very core of the Basel-failure.

It is far from being good enough because it does not take a sufficiently long step back from the trees so as to be able to see the forest. For that to happen there is a fundamemtal need of recognizing that the world, without the existence of the Basel Committee regulations, would certainly have suffered other financial crises, but never a crisis as destructive as the current one.

In other words, the world at large would have been better off without the work of the Basel Committee.

The previous recognition is needed so as to be able to introduce in the discussion the fact that one of the most prolific sources of systemic risk in the area of regulation is the existence of a monolithic mind-frame among the decision makers; like that of bank regulators who only have the avoidance of bank failures on their agenda and minds.

The above is necessary in order to remind all those involved of such simple facts that a bank that does not fail could still be a totally useless bank and that a bank that fails could still have been a very useful one. We need to measure more the whole boom-bust cycle and not look only at the crisis. We need to regulate our banks so as to make our banks useful and, if they fail in the process that it has at least been worth it.

We therefore must stop regulators from meddling with “risk” not only because risk is the oxygen of any development and we cannot afford having our regulators taxing risk, like they de facto do with their current formula of capital requirements; but also because the riskiest risks that exists are those risk that many believe have been taken care of.

A regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, would be a much more effective regulation.

The avoidance of a crisis, by any means, sets us up in the direction of the one and only bank – the mother of all moral hazards – the mother of all bank crisis.

Does this mean we should not regulate banks? Of curse not! But given that some of the authors of the document referred to also wrote “An Academic Response to Basel II” in May 2001 which contains much relevant and quite similar proposals and criticism, but that was blithely ignored by the deaf Basel, they should be among the first to understand that we need at least some new, different and less deaf members in the quire. http://www.bis.org/bcbs/ca/fmg.pdf

How more profoundly mistaken must you be in the world of financial regulators before you are held accountable?

What we as an absolute minimum should expect now from the regulators is that they do not dig us further in the hole we’re in. We have seen some worrying signs with proposals of systemic risk ratings for banks. Anything beyond very simple and transparent aspects, such as the amount of liabilities officially insured by governments, should be prohibited terrain.

In Against the Gods, Peter L. Bernstein (John Wiley & Sons, 1996) writes that the boundary between the modern times and the past is the mastery of risk, since for those who believe that everything was in God’s hands, risk management, probability, and statistics, must have seemed quite irrelevant. Today, when seeing where Basel’s self-appointed masters-of-the-risks have taken us with their regulatory risk management, it should be very clear that we have left out God’s hand, and the market, much too much.

Source: https://voxeu.org/debates/commentaries/world-large-would-have-been-better-without-any-basel-regulations#comment-0

Links
(1) http://www.voxeu.org/reports/Geneva11.pdf
(2) http://www.bis.org/bcbs/ca/fmg.pdf

Do not stimulate until you drop!

A letter to the Washington Post that was not published:

Sir given that the consumer shopped until they dropped the only thing to hope for after reading Greg Ip's article on January 11 where he analysis a possible default option of the US on its public debts… is that the US does not now stimulate until it drops. 

Even though there are many seminars on "How to restore Global Financial Stability" let us not forget that the most important role for the US is to preserve the global financial stability we still have, namely the current role of the dollar in the international financial system.

And so, just in case, and especially after the unsettling recent experience with the adjustable mortgages, could we not ask the US to build up its debt with long term paper at fixed rates? I mean allowing so many to anchor their boats so close to the exit of that safe-haven the dollar currently represents seems not the wisest thing to do.

The AAA bomb… or how I brought down the Capitalist Empire

Read the memoirs of a central planner who to avenge his defeat in Russia entered the bank regulatory system in Basel and created a formula of minimum capital requirements based on something titled default risks which allowed the build up of immense leverage for "risks" perceived as low; and thereafter managed to empower his credit rating moles to strike with nuclear force at the heart of the capitalist Empire.

A book dedicated to all those doing their utmost to provide the financial regulators with cover.

Tentatively published in fall 2009 by the Voice and Noise Foundation

Does the First Amendment protect the right to freely express a lie?

The bank regulators of the world decided over the last decades to give some few credit rating agencies an immense role channeling the financial flows of the world and, as was doomed to happen, sooner or later, such an information oligopoly led us into a disaster, in this particular case the badly awarded mortgages to the subprime sector.

Currently, defending themselves, the credit rating agencies argue, apparently with great success, that all they do is opine and that their opinions are protected by the First Amendment to the US Constitution.

To anyone knowledgeable about these issues, may I ask a simple question?

Suppose the credit rating agencies were giving opinions that were not really their firm opinions, or in fact might even have been opinions contrary to their own real opinions, does the First Amendment equally cover the right to express non-opinions or outright lies?

Bank regulators, why, why, why?

If all bank crisis in history have resulted from the build-up of excessive exposures to what was perceived as “absolutely safe”, or at least very safe, and none ever from the build-up of excessive exposures to what was perceived as risky… what is the rationale behind capital requirements for banks which are much lower for what is perceived as absolutely safe, or at least very safe, than those for what is perceived as “risky”? 

Some questions today to The Masters of Risk

The Joker on the Basel Committee

I can hear now the free market answering a confounded citizen by describing the bank regulators with the same words the Joker used in the movie The Dark Knight, 2008:

"You know, they're schemers. Schemers trying to control their worlds. I'm not a schemer. I try to show the schemers how pathetic their attempts to control things really are. So, when I say that … it was nothing personal, you know that I'm telling the truth. It's the schemers that put you where you are. I just did what I do best. I took your little plan and I turned it on itself. Look what I did to this city with a few…" AAA rated collateralized debt obligations and MBS, and some of their 0% risk weighted sovereigns

When I think of a small group of bureaucratic finance nerd technocrats in Basel, thinking themselves capable of exorcizing risks out of banking, for ever, by just cooking up a formula of minimum capital requirements for banks, based on some vaguely defined risks of default; and thereafter creating a risk information oligopoly empowering the credit rating agencies; and which all doomed, sooner or later, to take the world over a precipice of systemic risks; like what happened with the lousily awarded mortgages to the subprime sector, or to Greece when regulations assigned it only a 20% risk weight and doomed it to excessive public debt... I cannot but feel deep concern when I hear about giving even more advanced powers to the schemers.

PS. Years later I found out that even if Basel II would initially have risk weighted Greece 20%, European authorities assigned it a 0% risk weight, which meant European banks could lend to Greece's government without having to hold any capital against that exposure. Unbelievable! What champion schemers!

PS. Here is an updated aide-mémoire on some of the many mistakes with the risk weighted capital requirements for banks.

What is lacking in the Sarbanes-Oxley Act

Requiring all senior management and board members of companies to disclose publicly what they understand and what they do not understand of the business they are in charge of would do wonders for corporate governance, especially when we start hearing so many cries of “I did not know”. For instance, when using sophisticated financial instruments such as derivatives, we could suddenly realize that no one upstairs has a clue of what they, the experts downstairs, are up to, and this could be a quite instructive for the market and the credit-rating agencies when they assess the risks of a corporation.

By having clues I do of course not refer to any specific know-how needed to take apart and put back a carburetor, as very few would be able to do that, and in fact I am not even sure carburetors any longer exist. No, what I refer to is whether they to have a good working knowledge of some basics, like how a car drives, how it brakes, how much gasoline it consumes, and what to do if a tire explodes or an airbag suddenly inflates.

To oblige recognition and acceptance of where the buck really stops both in theory and practice and before mishaps occur could also be useful for shedding light on some systemic risks that, like lava in a volcano, might be building up dangerous pressures underneath the world of finance. It could also provide immediate relief to all those executives living out there, burdened with the constant stress of having to feign that they are in the know.

From Voice and Noise, 2006

In a truly free market this particular financial crisis would never have happened

I am not against regulations but when looking at how to re-regulate the financial markets after this crisis it really behooves us all to acknowledge the fact that in a really free financial market this particular financial crisis would never have happened.

In a free financial market there would have been no official endorsement of the illusion of safety like the one generated by the bank regulators when they created the minimum capital requirements for banks based on risk and that led many to believe that, as far as the risks goes, the banks had been equalized. And of course neither would the market have suffered the distortions that originated in the regulatory arbitrage of these capital requirements.

In a free financial market no one would have given so much credibility to some few credit rating agencies paid by the issuers of debt and therefore there would have been no opportunity to peddle in the market such an extraordinary amount of such extraordinary lousy awarded mortgages to the subprime sector.

In hindsight the bankers behaved rationally!

The September issue of Euromoney we Georges Pauget of the Crédit Agricole saying “Now if you go back over the decisions that were taken, and the context within which they were taken I have to say that, even with the benefit of hindsight they appear rational. We took triple-A-rated assets, reinsured with triple-A-guarantors and concluded that they carried zero risk”

And I ask:

Q. Who gave those triple-A-ratings? A. The credit rating agencies.

Q. Who empowered the credit rating agencies to have so much influence? A. The banking regulators of Basel.

Do we now want to really change things or do we just want to dig ourselves deeper in the hole of the over-trusting-some risk-information-oligopolies that we’re in?

The financial engineering bubble!

If you have been able to convince Joe to take a 300.000 dollar mortgage at 11 percent for 30 years and if then, with a little help from the credit rating agencies, you can convince Fred that the risk structure of this mortgage is such that it merits an investment at a rate of only six percent, then you can sell him the mortgage for 510.000 dollar, and pocket a tidy profit of 210.000 dollar.

We then have Joe, with a real liability of a mortgage of 300.000 dollar guaranteed with a house that might o might not be worth it, and Fred, with a 510.000 dollar investment in the willingness of Joe to service his original mortgage at 11 percent for 30 year.

And so, when all is sliced and diced, 210.000 dollar of this 510.000 dollar toxic asset has little to do with easy money or a house bubble, and all to do with the wizardry of an immense structured-finance-endorsed-by-the-credit-rating-agencies bubble.

The Financial Stability Forum has read and learned from Il Gattopardo!

In the best traditions of what Giuseppe Tomasi di Lampedusa’s says in Il Gattopardo about that "Everything must change in order to remain the same" the Financial Stability Forum in their Report on Enhancing Markets and Institutional Resilience, dated October 10, announces “Changes in the role and uses of credit ratings”, only to proceed digging us even deeper in the hole we are in.

FSF spells out these changes to be:

1. On the quality of the rating process… presumably meaning the CRAs will be better in the future… allowing the markets to trust the credit rating agencies even more.

2. Differentiated ratings and expanded information on structured products… presumably meaning that the CRAs will in the future provide the markets with more precise and tailor made information… allowing the markets to trust the credit agencies even more.

3. An enhanced assessment of underlying data quality… presumably meaning that in the future the CRAs will make sure they work with more relevant data… allowing the markets to trust the credit agencies even more.

4. Telling investors to address their over-reliance on ratings…meaning that investors associations should consider developing standards of due diligence for CRAs… allowing the markets to trust the credit agencies even more… while preparing the terrain for an “I told you to do it!”

5. And finally that the authorities will review their use of ratings in the regulatory and supervisory framework to address the excessive reliance on credit ratings… by launching the stocktaking of the uses of ratings in legislation, regulations and supervisory guidance by its member authorities in the banking, securities and insurance sectors… as if they already should not know that.

From what we read the FSF says, and the so little said about the credit rating agencies during the IMF/World Bank meetings, it would seem that the only ones who really had their institutional resilience strengthen these last weeks were the credit rating agencies… Why? How come?

Friends,

I do not know of anyone who knows anyone who knows anyone that has lost a single dollar giving a subprime mortgage on too generous or outright stupid terms to anyone who classifies as belonging to a subprime sector. Neither do you, I bet.

But I do know of many persons or institutions that have lost fortunes investing in securities collateralized with mortgages just because these securities were rated AAA by one two or even three of the only three credit rating agencies that are to be used by all of us, including by the financial regulators. And so do you, I bet.

Therefore, without any doubt, this crisis is a direct result of the credit rating agencies issuing the wrong ratings, and since these agencies were so much followed because they were excessively empowered by the financial regulators, we should have even less doubts about whom we really should blame.

The Axis of the credit rating agencies and the financial regulators has already cost the world trillions of dollars.

It is in the Basel-Consensus that the fault lies!

Forget debating about a Washington Consensus turned sort of irrelevant when it is the Basel Consensus that is really breaking into pieces.

If you set up a system that is composed of a.- minimum capital requirements for banks that are based on risk; b.- the empowerment of few agencies to measure the risks; and c.- the need to immediately respond and mark to market the consequences of any change in the perception of the risks, then you have gathered up the necessary and sufficient elements to guarantee that, sooner or later, you will suffer a financial tsunami, along the lines of that one we are currently seeing.