“Confidence Levels”

In “An Explanatory Note on the Basel II IRB Risk Weight Functions” published by the Basel Committee on Banking Supervision in July 2005, we read in 5:1:

"The confidence level is fixed at 99.9%, i.e. an institution is expected to suffer losses that exceed its level of tier 1 and tier 2 capital on average once in a thousand years. This confidence level might seem rather high. However, Tier 2 does not have the loss absorbing capacity of Tier 1. The high confidence level was also chosen to protect against estimation errors, that might inevitably occur from banks’ internal PD (Probability of Default), LGD (Loss Given Default) and EAD (Exposure at Default) estimation, as well as other model uncertainties. The confidence level is included into the Basel risk weight formulas used to provide the appropriately conservative value of the single risk factor.”

Three things come to mind: First, of course, how little resilient those confidence levels turned out to be… in just about the first 3 years of those thousand years… not only a couple banks went down.

The second, much more important… Who authorized these regulators to set a confidence level for our banks at 99.9%? ... Are our banks not supposed to take more risks than that in order to help the society to move forward? Where would we be had that sort of confidence levels been applied?

And last, what kind of confidence level should we have in that these regulators, locked in their little incestuous mutual admiration club, really know what they are up to?

You need to learn think more about your financial regulations in terms of national security.

If you deposit you money in your local bank the current bank regulations stipulate the following:

If your bank relends that money to a sovereign rated AAA, like the US Government, then it needs no capital at all, meaning being allowed an unlimited leverage;

If it lends to a sovereign country that has been rated A+ to A, like Greece was from July 2000 until December 2009, or to a private client rated AAA, then it needs only 1.6 percent capital, implying that a leverage of 62.5 to one is allowed;

But, if it lends it to a small businesses or entrepreneurs, those on whom we depend so much for our jobs, those who cannot afford being rated by the raters, those who the banks are supposed to help while they make it to the capital markets, then your bank is required to have 8 percent in capital and need to limit their leverage to 12.5 to one.

This means that what is perceived as having low risks and which therefore already benefits from lower interest is now additionally benefitted by generating very lower capital requirements; while what is perceived as having higher risks and which is therefore already punished with higher interest rates, is, in relative terms, further punished by having to cover the costs of the higher capital requirements they generate.

That signifies that, in the land of the brave, the regulators, in a very non-transparent way, have created a totally arbitrary subsidy of risk adverseness, which is changing the character of your country, for no good reason at all, like the current crisis proves.

These regulations created a huge demand for anything rated AAA, and the market, being what it is, supplied AAAs, though most of them were naturally fakes, since we all know there is very little in life so truly free of risks that it can merit an AAA.

Besides, even if the credit rating agencies were to be 100% accurate in their ratings, who can guarantee us that the future of this, or any other country, is to be found in never-risk-land. Risk is the oxygen of any development. I ask how can you risk the life of your sons and daughter for the future of your country and not risk your money with those most likely to take your country forward.

And that is why you have to learn think of your financial regulation more in terms of national security.

What should be done? For the time being, while the banks are slowly rebuilding their capitals to cover for all the losses incurred in triple-A rated operations, we should at least lower their capital requirements when lending to the small businesses and entrepreneurs, who had nothing to do with creating this financial crisis.

We need to stop the credibility asymmetry that exists in the credit risk information market

One of the problems with credit ratings is that they are never sufficiently publicly debated, unless when it is too late, and when that happens then it is mostly the case of a small questioner against the mother of all father authorities in the markets.

Too often have I heard bankers ask me “Per, how on earth do you think I could convince my colleagues on the Board that the credit rating agencies were getting it so extraordinarily wrong that we should exit from what seemed to be an extraordinarily good business for us?”

In our efforts to solve the asymmetry in information we have increased the asymmetry of the credibility with respect to financial information, making it now almost impossible for divergent opinions to nudge the markets on the margin, and being only considered when the causes for the divergence become much too apparent, which is of course then much too late.

The first thing that should happen is that the credit rating agencies should be required to post, real time, all the questions and answers received with respect to every particular ratings, so to allow the market to express their viewpoints and to allow configure the necessary opinion majorities that could force the credit rating agencies to revise what they are doing.

If that Bank Director friend of mine could have referred to a place where those same suspicions were uttered by others, then he would stand a much better chance of being heard.

I repeat. We need an official online forum where we can question each and every single credit rating. That’s transparency!

Has the US Congress delegated to the Basel Committee the settings of capital requirements for banks?

Can anyone explain why the Basel Committee is not mentioned even once in the 1336 pages long reform bill presented to the US Senate or in the 1776 pages long H.R. 4173 financial regulatory Act approved by the House of Representatives?

Has the US Congress delegated into the Basel Committee the settings of capital requirements for banks? If so is the US citizen aware of it?

For instance is Congress unaware of that the SEC when it on April 28, 2004 allowed the US investment banks to substantially increase their leverage, it did so explicitly stating that “the consolidated computations of allowable capital and risk allowances [be] prepared in a form that is consistent with the Basel Standards”.

Don’t they know that if there is anything that has guided the evolution of the current financial regulations, those that I have for so long sustained doomed the world to exactly the type of crisis we now have, that is the Basel Committee. Basel’s AAA-bomb was ignited on June 26 2004, when the G10 countries, which includes the US endorsed the revised capital framework for banks known as the Basel II standards.

The financial crisis explained to non-experts, dummies and financial regulators.

The play: The dangerously safe playgrounds!

1st scene: Some extremely wimpy parents concerned so much more with their small children’s safety than with their development picked out three independent surveyors to rate the safety of the playgrounds their children frequented.

2nd scene: In order for their small children to want to go to the safest but somewhat boring playgrounds they presented them with the choice of having some very good goodies if they went there or having to settle for some bad cold porridge if they went to the more fun park.

Kids, this or that?

3rd scene: But since the good goodies were too good, and the cold porridge too bad, and there was a natural lack of safe playgrounds, too many children went to the few rated as "safe" parks… where, unfortunately... they trampled themselves to death.

Epilogue: When will they ever learn? Though the kids need some risk to develop strong and not obese, and though the truly safe playgrounds are a fidget of their imagination, during the funerals, we still hear the parents planning on making the good goodies gooder and the cold porridge colder.

What the play teaches us is that with wimpy, gullible and naïve parents like these, the kids are better off running alone in the street.

The cast:

As the wimpy parents, we have the financial regulators of the Basel Committee.

As the young children, we have the banks.

As good goodies, we have a 1.6 percent capital requirements for any bank lending related to an AAA rating.

As cold porridge, we have an 8 percent capital requirements for any bank lending related to an unrated small business or entrepreneur.
As safe playgrounds turned unsafe, we have the subprime mortgages.

As the playground safety rating agency… if you cannot figure it out for yourself you’re just too dumb.

And as all the grandparents or elder siblings who, because they were not interested or did not want to erode the parental authority, did not warn the parents… we have thousands of financial experts and PhDs.

PS. Oops! Some might now tell me they know their children prefer cold porridge to Wiener Nougat.

 

And from that playground, on to Fraulein Basel’s Chocolate Cake

PS. Now in 2024 I asked AI’s opinion on whether, as a grandfather, I should be concerned with the future current bank regulations might have doomed my grandchildren to encounter. It answered: "You're absolutely right to be concerned, and it's completely understandable to question the decisions that have shaped the financial world your children and grandchildren will inherit." 

The lover’s spat between Goldman Sachs, Paulson and “sophisticated investors” is not the real problem!

The beauty of the action of the SEC against Goldman Sachs is that it allows us to understand with a real and public example a lot of what happened all over the market. Let us see it here from the perspective of IKB the German Bank who invested $150 million in ABACUS 2007-AC1.

In paragraph 58 we read that IKB bought $50 million of the A1 tranche paying Libor plus 85 basis points, and $100 million of the A-2 tranche paying Libor plus 110 basis points. The average return comes to about 102 basis points.

Since these $150 million were rated Aaa by Moody’s and AAA by S&P when purchased, that meant that IKB’s investment, for bank capital requirement purposes, would be weighted at only 20% signifying only $30 million for which 8% capital requirements had to be held. IKB would therefore need $2.4 million of their own capital to back the operation, a leverage of 62.5 to 1.

$150 million at 102 basis points and $ 2.4 million in capital signifies then an expected gross return of 63.75% on IKB’s capital.

In order for IKB to make a comparable return when lending to their traditional client base of small and medium sized businesses, most certainly unrated, and who therefore are risk weighted at 100%, IKB would have to lend them the funds at Libor plus 510 basis points.

And here we have it, the way the current capital requirements for banks are based on the risks perceived by the credit rating agencies, provide huge incentives for the banks to enter into the virtual world and invest in these “synthetic” operations, instead of lending to the real world... and, that problem is so much larger than a simple lover’s spat between Goldman Sachs, Paulson and “sophisticated investors”.

Do you understand why I beg of you to keep your eyes on the ball? Do you understand why I am upset nothing of this is even discussed in the current proposals for financial regulatory reform?

Goldman’s ABACUS 2007-AC1: The whole truth and nothing but the inconvenient truth!

But the whole truth and nothing but the truth would in the case of ABACUS 2007-AC1 have to include the following facts, no matter how politically or agenda inconvenient they might be:

IKB, a commercial bank headquartered in Germany did not use $150 million to lend to small and medium sized German companies, as they historically had done, but instead invested and lost “$50 million in Class A-1 notes at face value” and “$100 million in Class A-2 Notes at face value” in ABACUS 2007-AC1, exclusively because of the following two reasons:

First both tranches, the A1 paying Libor plus 85 basis points, and the A-2 paying Libor plus 110 basis, points were rated Aaa by Moody’s and AAA by S&P when purchased by IKB.

Second, in order to invest $150 million in these securities which because of their ratings were risk-weighted by Basel II at only 20%, IKB needed only to have $2.4 million of capital, 1.6%, compared to the $12 million it would be required to have if lending that amount to unrated small and medium sized German companies.

If IKB had known that Paulson had had his hand in the picking, and known fully about his motives, then they might have asked for a slightly higher interest rate, maybe 10 basis points more, and still have bought the securities.

If the securities did not have the splendid credit ratings assigned to them by the credit rating agencies then they would probably not have bought them even if Mother Teresa had done the picking.

If the regulators had placed the same type of capital requirements on all assets then IKB would have stayed home, lending to their traditional clients, instead of going to California to dig prime rated subprime gold.


And so while naturally we should lend all our support to efforts to eliminate wrong-doings like those described in the SEC action against Goldman that should not signify we take our eyes of the unfortunate truth of having been saddled with grossly inept regulations, creating grossly bad regulations.

Now all of this does of course not imply that the Goldman Sachs, the Tourres, the Paulsons or the ACAs of this world are angels… it is just about putting it all in the right perspective.

And now, is it time for some “Razzle dazzle 'em”?

SEC’s action against Goldman Sachs in paragraph 53 states:

“IKB… late 2006, was no longer comfortable investing in the liabilities of CDOs that did not utilize a collateral manager, meaning an independent third-party with knowledge of the U.S. housing market and expertise in analyzing RMBS”.

The above sounds a lot like a type of b.s. excuse, construed by someone trying to hide their own responsibility in the affair… that of having invested solely based on the juicy interest rate offered when considering solely the credit ratings issued by the credit rating agencies.

Did for instance IKB really believe what is said on ABACUS 2007-AC1 flip book, on page 34, about ACA Capitals ABS Credit Selection including an “On-site Visit”? What a laugh! Checking up on the individual mortgages?

And so do not take your eyes of the IKB executives either, they most probably perpetrated real silly stuff against their own investors and so they might now be doing a “Razzle dazzle 'em” routine to cover their own fingerprints.

Are not victims inclined to perform as victims… especially when sophisticated? Are we seeing an Oscar class crocodile tears performance here? ... for which the SEC has also fallen?


Give 'em the old Razzle Dazzle, Razzle Dazzle 'em,

Show 'em the first rate sorceror you are

Long as you keep 'em way off balance

How can they spot you've got no talent

Razzle Dazzle 'em, Bazzle 'em,

And they'll make you a star!

Widespread criminal negligence!

I quote from the fraud action by SEC against Goldman Sachs… “for making materially misleading statements and omissions in connection with a synthetic collateralized debt obligation … ABACUS 2007¬AC1…tied to the performance of subprime residential mortgage-backed securities… was structured and marketed by GS&Co in early 2007 when the United States housing market and related securities were beginning to show signs of distress.”

“when the United States housing market and related securities were beginning to show signs of distress”?

Absolutely, at the date when ABACUS 2007AC1 was issued, April 26, 2007, I had already made four posts related to the subprime mortgage crisis… http://bit.ly/cwbLT2

And so: Where had the minimum caveat emptor we should expect from regulators gone? Where were the regulators? This has all the sign of being more complicated than it is been made out to be… Was it not all criminal negligence all over the place?

Hush! Less we lose the chance to beat on a foe or a convenient scapegoat.

The ABACUS 2007-AC1 flip book states:

“Although at the time of purchase, such Collateral will be highly rated, there is no assurance that such rating will not be reduced or withdrawn in the future, nor is a rating a guarantee of future performance.”

The truth is that had it not been because the investors believed that the credit ratings were correct, they would not have invested, no matter how much Goldman Sachs could have argued with them based on other false statements.

But this is of course is something many do not want to be known, because this would take away all the fun of being able to go after such a juicy foe as Goldman Sachs or such a convenient scapegoat to be used by the inept regulators.

We need to get to the real bottom of this... because that is were the truth can be found.

We can’t shame enough the irresponsible silent experts and the plain lousy regulators

As an Executive Director of the World Bank and a member of its Audit Committee 2002-2004, time and again I repeated what I extract below from my book Voice and Noise, 2006.

“From what I have read and seen, I believe there is a clear possibility that much of the world’s financial markets are currently being dangerously overstretched through an exaggerated reliance on intrinsically weak financial models that are based on very short series of statistical evidence and very doubtful volatility assumptions”

I also frequently spoke out on the risk posed by empowering the credit rating agencies too much and, in May 2003, I even had a letter published in the Financial Times which ended with “I simply cannot understand how a world that preaches the value of the invisible hand of millions of market agents can then go out and delegate so much regulatory power to a limited number of human and very fallible credit-rating agencies. This sure must be setting us up for the mother of all systemic errors.”

Therefore if someone like me, a non-expert on financial markets, could have said the previous back in 2003-2004, I can only conclude that a crime of pure negligence, of sheer monumental proportions, was committed against humanity by an incredibly large number of professionals.

And so even though I agree of course that all those who pulled the triggers should go to prison, like those accused in Goldman Sachs, if proved guilty, in that prison, for true justice to be served, they should be accompanied by all those who kept mum because it was generally convenient for them to keep mum… and of course by the plain lousy regulators.

We must not let the intellectual mum-keepers go free! The world deserves more than some mea-culpa, the world deserves to find how to make the responsible speak up in time… if need be even by law.

The largest moral hazard is not having banks-bailed out… it is not shaming enough the irresponsible silent experts and the plain lousy regulators.

Some argue no one saw the crisis, “20.000 blind economists”, this is pure nonsense. Our biggest problem is how some few egos in a mutual admiration club dominate the debate and sell us what they believe sounds the best.

Look what they’ve done to my bank Ma! .....

They placed an 8 percent capital requirement on it when lending to our local small businesses and entrepreneurs who give us jobs.

And then they required from it only 1.6 percent in capital when lending to anything rated AAA... and even zero percent when lending to an AAA rated sovereigns...

And all this while they should know that my bank has really no business at all lending to AAA rated borrowers or sovereigns....

Ils ont changé ma banque Ma!...

And so they led my bank to throw my deposits after some unexplainable AAA rated securities backed with some unknown tranches of low quality subprime mortgages...

And now, when the AAAs are not the AAAs the credit rating agencies had opined them to be, my bank must come up with more capital....

And since my bank can´t it must stop lending to the local small businesses and entrepreneurs who had nothing to do with creating this crisis.

Look what they’ve done to my bank Ma! .....

Yes, yes, but what about?

Yes, yes we agree that the rational market is a myth but, what about the perhaps even larger myth of a rational regulator?

Yes, yes we agree there is a moral hazard present when bailing out the banks but, what about the perhaps even larger moral hazard of not punishing the regulators who failed?

What we first must do is to cut off the currently too visible hand!

Here we are, standing in front of the ruins of a horrendous financial crisis…

provoked by the most outrageous market intervention ever…

which occurred when bank regulators thinking themselves so brilliant…

concocted capital requirements for banks based on the risk of default as perceived by some few credit rating agencies…

like only 1.6 percent capital, which means allowing a 62.5 to 1 leverage, for anything related to an AAA rating…

and thereby rewarded additionally what was already rewarded by the traditionally coward capital markets….

to such an extent that the financial system stampeded toward safe-havens and turned these into dangerously overcrowded traps…

and now some have the gall to tell us it is “Time for a Visible Hand”

NO! What we first must do is to cut off the current too visible hand

There´s a too big confusion about the “too big to fail” banks.

The losses that generated the current crisis were NOT caused because some banks were too big to fail.

It is the way many of those losses are now being distributed between the investors, the banks and the supposed taxpayers that is being affected by the too big to fail.

Absolutely, banks should be cut down to size, as I have been arguing before Simon Johnson and others could walk (well almost). http://bit.ly/HIi3x

If we get rid of the “too big to fail” banks but keep using credit rating agencies to allow for absurd low and discriminatory bank capital requirements we will have done nothing to correct what brought us this mess of absurdly stupid financial losses.

Absurd and naïve bank regulations stand in our way!

The European Commission initiated on February 26, 2010 additional public consultations on changes to the Capital Requirements Directive for banks (CRD). The following was my response.

Sir,

The world swallowed the idea proposed by the bank regulators that if one creates incentives for banks to finance what is perceived as having less risk, and disincentives to avoid what is perceived as having more risk, then we would all be better off.

The regulators implemented it by placing lower capital requirements on those bank operations that are perceived by the credit rating agencies to have lower risk of default, the AAAs, than on those perceived as having higher risk, the BBBs of the world.

What an absurd and naïve thing to do!

• As if there was enough real AAAs to go around!

• As if economic growth and human development resided primarily in AAA land!

• As if you need to give more incentives to the AAAs already favored by the natural cowardice of capitals!

• As if you can measure risks without risking affecting those same risks.

• As if those operations perceived as less risky did not face the risk of more carelessness.

• As if those human fallible credit rating agencies would not be subject to very strong pressures to award the AAAs.

What happened? What was doomed to happen!

Increasing the value of the perceived safe-havens created incentives for selling some not so safe havens as safe, by influencing perceptions, which led to dangerously overcrowding a subprime haven; which caused the current financial crisis.

What needs to be done? Start from scratch!

There is no way to build something good on top of a foundation as faulty as the Basel Committee´s “The First Pillar – Minimum Capital Requirements”. Unfortunately this could prove to be an impossible task if keeping those regulators who so entirely succumbed to the current paradigms.

Europe, wake up! The current crisis did not result from excessive risk-taking. It was the result of misguided excessive risk-aversion. The losses occurred in AAA land not in BBB land.

Europe, wake up! Risk-taking is what takes one forward. Risk aversion can only guarantee being diminished. Europe, do not allow yourself to be diminished! Rest of the world that goes for you too!

Per Kurowski

Governor Daniel K. Tarullo on Financial Regulatory Reform

U.S. Monetary Policy Forum, New York on February 26, 2010

Tarullo said: “But financial stability alone is not the aim of financial regulation”

About time! About 20 years too late! In the 347 pages of the bank regulations known as Basel II there is not one word about any other purpose for our banks than being stable

Tarullo said “Supervisors counted on capital and risk management to be supple tools that could ensure stability”

Absolute nonsense! They created a very crude and simple set of capital requirements based on perceived risks; then outsourced simplistically the risk-watch function to the credit rating agencies; and then they simply went to sleep.

Conclusion: A lot of good thoughts but yet not a word on the true problems with their current regulatory paradigm, being that there are not enough low-risk AAAs to go around for everyone; and that real economic growth and development does not happen in any risk-free AAA land.

Should we not have higher capital requirements for banks on what is perceived as less risky?

This “Not your average airport!” courtesy of “Learning from dogs” is a great example of that when something is risky everyone is more careful...



And so what we might really need is higher capital requirements on what is perceived as not risky and which therefore can induce carelessness. Just exactly the opposite of what the financial regulators have been and are doing.

Be more wary of the “too big to govern”

“Laissez govern” is infinitely more dangerous than “laissez faire” so we must never allow the “too big to govern” to become the substitute of “the too big to fail”.

Dangerous global coordination was the real cause of the crisis

Capital is intrinsically coward and loves anything triple-A rated. Therefore, when on top of this natural love, the global regulators in the Basel Committee awarded the triple-A rated additional benefits in terms of these generating much smaller capital requirements for banks... the demand for triple-A rated instruments soared. As should have been expected the supply mechanism of the market started to fabricate triple-A rated instruments in enormous volumes... something that by definition should be anathema to low risk.

There were of course many other economic imbalances that aggravated the final result but this, the excessive belief in that risk should and could be avoided, is why the current financial crisis came to happen.

In February 2000 in an article titled “Kafka and global banking” published in the Daily Journal of Caracas I wrote: “The risk of regulation: In the past there were many countries and many forms of regulation. Today, norms and regulation are haughtily put into place that transcend borders and are applicable worldwide without considering that the after effects of any mistake could be explosive.”

In January 2003 the Financial Times published a letter in which I wrote: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds.”

But now when the above has unfortunately been proved to be too true, Dominique Strauss-Kahn of the IMF, in “Nations must think globally on finance reform” February 18, keeps on going as if nothing has happened writing that “the work of [the Basel Committee and the Financial Stability Board] must be accelerated to harmonise rules that limit excessive risk taking”.

IMF, before going forward, needs to reflect more on the dangers that the very real possibility of a bad global coordination might signify.