About the Global Bank Insolvency Initiative

(An informal email sent in 2004 to my then colleagues Executive Directors of the World Bank.)

Dear Friends,

We recently had a technical briefing about the Global Bank Insolvency Initiative. Having had a special interest in this subject for some years, I wish to make some comments.

As I have always seen it, the costs related to a bank crisis are the following three:

The actual direct losses of the banks at the outbreak of the crisis. These are represented by all those existing loans that are irrevocably bad loans and therefore losses without a doubt.

The losses derived from mismanaging the interventions (workout costs). These include, for example, losses derived from not allowing some of the existing bad loans the time to work themselves out of their problems. They also include all the extraordinary legal expenses generated by any bank intervention in which regulators in charge want to make sure that they themselves are not exposed to any risk at all.

The long-term losses to the economy resulting from the “Financial Regulatory Puritanism,” that tends to follow in the wake of a bank crisis as thousands of growth opportunities are not financed because of the attitude “we need to avoid a new bank crisis at any cost.”

For the sake of the argument, I have hypothesized that each of these individual costs represents approximately a third of the total cost. Actually, having experienced a bank crisis at very close range, I am convinced that the first of the three above costs is the smallest ... but I guess that might be just too politically incorrect to pursue further at this moment.

In this respect, it is clear that any initiative that aims to reduce the workout costs of bank insolvency is always welcome and in fact the current draft contains many well-argued and interesting comments, which bodes well for its final findings and suggestions.

That said, the scope of the initiative might be somewhat limited and outdated, making it difficult to realize its full potential benefits. There is also the danger that an excessive regulatory bias will taint its findings.

Traditional financial systems, represented by many small local banks dedicated to very basic and standard commercial credits, and subject to normally quite lax local regulation and supervision, are mostly extinct.

They are being replaced by a system with fewer and bigger global bank conglomerates governed by a global Basel-inspired regulatory framework and they operate frequently by transforming the economic realities of their portfolios through mechanisms and instruments (derivatives) that are hard to understand even for savvy financial experts.

In this respect I believe that instead of dedicating scarce resources to what in some ways could be deemed to be financial archaeology, we should confront the new market realities head on, making them an explicit objective of this global initiative. For instance, what on earth is a small country to do if an international bank that has 30% of the local bank deposits goes belly up?

We all know that the financial sector, besides having to provide security for its depositors, needs also to contribute toward economic growth and social justice, by providing efficient financial intermediation and equal opportunities of access to capital. Unfortunately, both these last two objectives seem to have been relegated to a very distant plane, as the whole debate has been captured by regulators that seem only to worry about avoiding a bank crisis. Unfortunately, it seems that the initiative, by relying exclusively on professionals related to banking supervision, does little to break out from this incestuous trap. By the way if you want to see about conflict of interest, then read the section “Legal protection of banking authorities and their staff.” It relates exactly to those wide blanket indemnities that we so much criticize elsewhere.

And so, friends, I see this Global Bank Insolvency Initiative as a splendid opportunity to broaden the debate about the world’s financial systems and create the much needed checks and balances to Basel. However, nothing will come out of it if we just delegate everything to the hands of the usual suspects. By the way, and I will say it over and over again, in terms of this debate, we, the World Bank, should constitute the de facto check and balance on the International Monetary Fund. That is a role we should not be allowed to ignore—especially in the name of harmonization.

A letter to my colleagues on the "Global Insolvency Initiative"

Dear Friends,

We recently had a technical briefing about the Global Bank Insolvency Initiative. Having had a special interest in this subject for some years, I wish to make some comments.

As I have always seen it, the costs related to a bank crisis are the following three:

• The actual direct losses of the banks at the outbreak of the crisis. These are represented by all those existing loans that are irrevocably bad loans and therefore losses without a doubt.

• The losses derived from mismanaging the interventions (workout costs). These include, for example, losses derived from not allowing some of the existing bad loans the time to work themselves out of their problems. They also include all the extraordinary legal expenses generated by any bank intervention in which regulators in charge want to make sure that they themselves are not exposed to any risk at all.

• The long-term losses to the economy resulting from the “Financial Regulatory Puritanism,” that tends to follow in the wake of a bank crisis as thousands of growth opportunities are not financed because of the attitude “we need to avoid a new bank crisis at any cost.”

For the sake of the argument, I have hypothesized that each of these individual costs represents approximately a third of the total cost. Actually, having experienced a bank crisis at very close range, I am convinced that the first of the three above costs is the smallest ... but I guess that might be just too politically incorrect to pursue further at this moment.

In this respect, it is clear that any initiative that aims to reduce the workout costs of bank insolvency is always welcome and in fact the current draft contains many well-argued and interesting comments, which bodes well for its final findings and suggestions.

That said, the scope of the initiative might be somewhat limited and outdated, making it difficult to realize its full potential benefits. There is also the danger that an excessive regulatory bias will taint its findings.

Traditional financial systems, represented by many small local banks dedicated to very basic and standard commercial credits, and subject to normally quite lax local regulation and supervision, are mostly extinct. They are being replaced by a system with fewer and bigger global bank conglomerates governed by a global Basel-inspired regulatory framework and they operate frequently by transforming the Economic realities of their portfolios through mechanisms and instruments (derivatives) that are hard to understand even for savvy financial experts.

In this respect I believe that instead of dedicating scarce resources to what in some ways could be deemed to be financial archaeology, we should confront the new market realities head on, making them an explicit objective of this global initiative. For instance, what on earth is a small country to do if an international bank that has 30% of the local bank deposits goes belly up?

We all know that the financial sector, besides having to provide security for its depositors, needs also to contribute toward economic growth and social justice, by providing efficient financial intermediation and equal opportunities of access to capital. Unfortunately, both these last two objectives seem to have been relegated to a very distant plane, as the whole debate has been captured by regulators that seem only to worry about avoiding a bank crisis. Unfortunately, it seems that the initiative, by relying exclusively on professionals related to banking supervision, does little to break out from this incestuous trap. By the way if you want to see about conflict of interest, then read the section “Legal protection of banking authorities and their staff.” It relates exactly to those wide blanket indemnities that we so much criticize elsewhere.

And so, friends, I see this Global Bank Insolvency Initiative as a splendid opportunity to broaden the debate about the world’s financial systems and create the much needed checks and balances to Basel. However, nothing will come out of it if we just delegate everything to the hands of the usual suspects. By the way, and I will say it over and over again, in terms of this debate, we, the World Bank, should constitute the de facto check and balance on the International Monetary Fund. That is a role we should not be allowed to ignore—especially in the name of harmonization.

Warning about Basel bank regulations

Denying a loan for only seeking to reduce the vulnerability of the financial system could mean the loss of a unique opportunity to achieve economic growth.

All development involves risks, so its path, by definition, is littered with bankruptcies and tears, framed in the human oscillation of one little step forward and 0.99 little steps back. Perhaps then the best way to regulate is to allow some banks to fail, too, before their problems have calcified or become too great.

Developed countries may never have developed under the yoke of puritanical financial regulation, hence my insistence since 1997 on the need for the development perspective to be considered when regulating. Paraphrasing someone; regulation of the financial system is too important to be left in the hands of regulators and bankers. (See note)

Furthermore, in a world that so much preaches the benefits of the invisible hand of the market, with its millions of mini-regulators, we are surprised that Basel delegates, without question, so much responsibility in the hands of a very few and very fallible credit rating agencies.

Basel has recently come under significant criticism:

The World Bank in its 'Global Financial Development of 2003', referring to the new ways of calculating capital requirements, known as Basel 2, warns both about the risk of making access more expensive and more difficult for developing countries to financial sources, such as favoring international banks to the detriment of domestic banks.

Dr. Alexander Kern, from the University of Cambridge, recently stated at a seminar organized by the G24 (developing countries), that because standards have been developed almost exclusively by European countries (G10), they lack the transparency and legitimacy necessary to accept that they are subject to a quasi-mandatory international legalization process.

The comptroller of the United States Currency, in charge of supervising 55% of the banking system in his country, declared his disagreement with the Basel 2 regulations, and even said that they may simply ignore them.

Friends, it may be worth including in all encyclopedias issued by Basel: 'Warning, excessive banking regulations in Basel can be very detrimental to the development of your country'

Note: “War is too serious a matter to entrust to military men” Georges Clemenceau

PS. Sometime later I found out about the bank capital (equity) requirements with risk weights of 0% government and 100% citizens, as if bureaucrats know better what to do with credit than e.g., small businesses and entrepreneurs. If I was to help finance development in developing (and in developed) countries, the first condition for doing so would be to eliminate such loony regulations.

El Universal

PS. This I wrote while being an Executive Director of the World Bank 2002-2004

PS. Mi first Op-Ed ever June 12, 1997 Puritanism in banking

PS. Most of my Op-Eds in El Universal disappeared from the web when I was censored by the new owners in 2014 

Some comments made at a Risk Management Workshop for Regulators... as an Executive Director

World Bank 2003 Risk Management Workshop for Regulators

Dear Friends,

As I know that some of my comments could expose me to clear and present dangers in the presence of so many regulators, let me start by sincerely congratulating everyone for the quality of this seminar. It has been a very formative and stimulating exercise, and we can already begin to see how Basel II is forcing bank regulators to make a real professional quantum leap. As I see it, you will have a lot of homework in the next years, brushing up on your calculus—almost a career change.

But, my friends, there is so much more to banking than reducing its vulnerability—and that’s where I will start my devil’s advocate intrusion of today.

Regulations and development.

The other side of the coin of a credit that was never granted, in order to reduce the vulnerability of the financial system, could very well be the loss of a unique opportunity for growth. In this sense, I put forward the possibility that the developed countries might not have developed as fast, or even at all, had they been regulated by a Basel [Committee].

A wider participation.

In my country, Venezuela, we refer to a complicated issue as a dry hide: when you try to put down one corner, up goes the other. And so, when looking for ways of avoiding a bank crisis, you could be inadvertently slowing development.

As developing sounds to me much more important than avoiding bank failures, I would favor a more balanced approach to regulation. Talleyrand is quoted as saying, “War is much too serious to leave to the generals.” Well, let me stick my head out, proposing that banking regulations are much too important to be left in the hands of regulators and bankers.

Friends, I have been sitting here for most of these five days without being able to detect a single formula or word indicating that growth and credits are also a function of bank regulations. But then again, it could not be any other way. Sorry! There just are no incentives for regulators to think in terms of development, and then the presence of the bankers in the process has, naturally, more to do with their own development. I believe that if something better is going to come out of Basel, a much wider representation of interests is needed.

A wider Scope.

I am convinced that the direct cost of a bank crisis can be exceeded by the costs of an inadequate workout process and the costs coming from the regulatory Puritanism that frequently hits the financial system—as an aftershock.

In this respect, I have the impression that the scope of the regulatory framework is not sufficiently wide, since the final objective of limiting the social costs cannot focus only on the accident itself, but has also to cover the hospitalization and the rehabilitation of the economy. From this perspective, an aggressive bank, always living on the edge of a crisis, would once again perhaps not be that bad, as long as the aggressive bank is adequately foreclosed and any criminal misbehavior adequately punished.

On risks.

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 so much risk managing, I cannot but speculate on whether we are not leaving out God’s hand, just a little bit too much.

If the path to development is littered with bankruptcies, losses, tears, and tragedies, all framed within the human seesaw of one little step forward, and 0.99 steps back, why do we insist so much on excluding banking systems from capitalizing on the Darwinian benefits to be expected?

There is a thesis that holds that the old agricultural traditions of burning a little each year, thereby getting rid of some of the combustible materials, was much wiser than today’s no burning at all, that only allows for the buildup of more incendiary materials, thereby guaranteeing disaster and scorched earth, when fire finally breaks out, as it does, sooner or later.

Therefore a regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises.

Knowing that “the larger they are, the harder they fall,” if I were regulator, I would be thinking about a progressive tax on size. But, then again, I am not a regulator, I am just a developer.

Conspiracy?

When we observe that large banks will benefit the most with Basel II, through many risk-mitigation methods not available to the smaller banks which will need to live on with Basel I, and that even the World Bank’s “Global Development Finance 2003” speaks about an “unleveling” of the playing field for domestic banks in favor of international banks active in developing countries, I believe we have the right to ask ourselves about who were the real negotiators in Basel?

Naturally, I assume that the way the small domestic banks in the developing countries will have to deal with these new artificial comparative disadvantages is the way one deals with these issues in the World Trade Organization, namely by requesting safeguards.

Credit Ratings

Finally, just some words about the role of the Credit Rating Agencies. 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.

The Board As for Executive Directors (such as myself), it would seem that we need to start worrying about the risk of Risk Managers doing a de facto takeover of Boards—here, there, and everywhere. Of course we also have a lot of homework to do, most especially since the devil is in the details, and risk management, as you well know, has a lot of details.

Thank you

Included in "Voice and Noise", 2006

PS. My 2019 letter to the Financial Stability Board

My comments on the World Bank's Strategic Framework 04-06

"Basel dictates norms for the banking industry that might be of extreme importance for the world’s economic development. In Basel’s drive to impose more supervision and reduce vulnerabilities, there is a clear need for an external observer of stature to assure that there is an adequate equilibrium between risk-avoidance and the risk-taking needed to sustain growth. Once again, the World Bank seems to be the only suitable existing organization to assume such a role."

“Ages ago, when information was less available and moved at a slower pace, the market consisted of a myriad of individual agents acting on limited information basis. 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 and we are already able to discern some of the victims, although they are just the tip of an iceberg. Once again, perhaps only the World Bank has the sufficient world standing to act in this issue.” 

"A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind. Who could really defend the value of diversity, if not The World Bank?"

PS. A 2003 letter in the Financial Times on this systemic risk

PS. My 2019 letter to the Financial Stability Board

Financial Sector Assessments Program: Review, Lessons and Issues going forward

My written statement as an Executive Director of the World Bank, March 20, 2003

The financial sector’s role, the reason why it is granted a license to operate, is to assist society in promoting economic growth by stimulating savings, efficiently allocating financial resources satisfying credit needs and creating opportunities for wealth distribution. Similarly, the role of the assessor –in this case, the Bank– is to fight poverty, and development is a task where risks need to be taken.

From this perspective we have the impression that the Financial Assessment Program Report might revolve too much around issues such as risk avoidance, vulnerabilities, stress tests and compliance with international regulations, without referring sufficiently to how the sector is performing its social commitments.

As an example, only in Supplement 3, Development Issues in the FSAP, does the Bank acknowledge that; “for lower income countries with less-developed financial system, in order to be relevant to country authorities, the emphasis in the FASP must change… how residents can get a better access to a wider range of financial services”, having to confess, in the very same page, that “no formal methodologies exist for how to address development issues in the FSAP”.

Another example is present in the survey of countries’ experiences (Supplement 2), when in the case of Armenia, page 6, in response to the problems of “(i) weak credit culture with the prevalence of non-payments mechanism that undermine the development of the formal financial sector; (ii) limited access to formal, affordable financing by small and medium enterprises, a typical development trap in transition economies; and (iii) the slow pace of banking sector consolidation”, the only exemplified recommendations are; “(i) enhancement of the central bank’s ability to deal with insolvent banks, (ii) strengthening of penalty provisions and (iii) increase in minimum capital requirements”, 

On a separate issue, the document Global Development Finance 2003 discussed last week and in relation to the minimum capital requirements of the Basel II proposals, states that they “include the likelihood of increased costs of capital to emerging market economies; and an “unleveling” of the playing fields for domestic banking in favor of international banks active in developing countries”. We believe that this issue, and similar ones, should be addressed in many FSAPs, specially as the Bank could perhaps act as an honest broker in such matters.

Dear staff, management and colleagues, it is an appropriate time to remember Roosevelt when he said that “the only thing we have to fear is fear itself” and so, repeating what we have said in may other occasions, we have to find ways of helping the Knowledge Bank evolve into the Wisdom Bank or, more humbly, the Common Sense Bank.

Thank You

Oral Statement:

Mr. Chairman, although we already made a written statement, there are some brief comments that I wish to make in order to better illustrate our concerns, so please bear with me.

In Supplement 2, the Survey of Country Experiences, I believe that it is quite illustrative, that in the very, very first example listed: “After identifying the following problems: weak credit culture with a prevalence of nonpayment mechanisms that undermine the development of the formal financial sector; limited access to formal, affordable finance by small and medium enterprises; and the slow pace of banking sector consolidation”, the only recommendation put forward to the country in that example are: “enhancement of central bank’s ability to deal with involvement bank; strengthening of penalty provisions; and increase in minimal capital requirements.”

I don’t think that those are just the answers that should come from a development institution. We all know that risk aversion comes at a cost - a cost that might be acceptable for developed and industrialized countries but that might be too high for poor and developing ones. In this respect the Bank has the responsibility of helping developing countries to strike the right balance between risks and growth possibilities.

In this respect let us not forget that the other side of the Basel [Committee’s regulatory risk weighted capital requirements] coin might be many, many developing opportunities in credit foregone.

Why do I make these comments with such candor? Because personally I have been learning for many years the consequences of a financial puritanism that seems to be invading the world and that does not get the real culprits, either. In the specific case of my country [Venezuela] the commercial banks credit portfolio fell in real terms from about $16bn in 1982 to only about $4bn in 1997.

In such a scenario, to hear about Basel [Committee] and its regulations reminds one of the make up of an already rigor-morted corpse, although we must admit that in the case of this particular corpse, we should know that even almost six feet under, it has been able anyhow to generate surprisingly large profits. 

I am certain that funds invested in FSAPs are very well invested funds, as fully attests that all the countries in my constituency to have done it. Nonetheless, in the area of risk management of finance, it might be an appropriate time to remember Roosevelt and that the only thing we have to fear is fear itself.

And so, repeating what I have said on some other occasion in this particular respect, I believe that we truly have to find a way of helping the Knowledge Bank to try to evolve into something more of a Wisdom Bank, or, to put it more humbly, at least a “common sense Bank.

Lets start by making sure these Financial Sector Assessment Programs are true development tools. In this respect I would really like to make a brief reference to the issue of collaboration with the Fund. I think this is a particularly clear case that shows where the collaboration should perhaps not be that intense, because as a development unit, we have to look at the growth potential of the sector, the development side, and they probably have to look at the safety side. And it is between this type of balance and continuing balance that we can really assist.

Finally on a related issue, last week in a seminar on housing finance we heard that Basel is getting to be a big rulebook—this was said by the Bank. And, to tell you the truth, the sole chance the world has of avoiding the risk that Bank Regulators in Basel, accounting standard boards, and credit-rating agencies will introduce serious and fatal systemic risks into the world, is by having an entity like the World Bank stand up to them—instead of rather fatalistically accepting their dictates and duly harmonizing with the International Monetary Fund.

As an example the Bank has for some time unsuccessfully been trying to argue with the accounting boards that, following their current rulings is not the best way of reflecting the Banks’ own financial reality. Well if the Bank has difficulties, imagine the rest of the world.

Thank you.

PS. Are the bank regulations coming from Basle good for development?

The document that I presented at the High-level Dialogue on Financing for Developing at the United Nations, New York, October 2007

My comments on World Bank's "Global Development Finance 2003"

Chapter 3. Coping with Weak Private Debt Flows. 

Argentina’s External Debt furnace was stoked over a long period of time by high ratings issued by the credit rating agencies who, when they awoke surprised by the resulting mountains of debt, speedily reversed themselves 180 degrees, putting new pressure on interest rates and reinforcing the tragedy of a self-fulfilling prophecies.

Venezuela, even though during the last couple of years has had a very low public external debt, less than 30% of GDP, which it has been servicing, has in a continuum been brought down to a highly speculative CCC rating, and has probably no alternative except that of waiting for a de-rating, the day the credit agencies happen to discover that it no longer has any outstanding debt. 

We make these somewhat exaggerated examples so as to remark the fact that, in this otherwise very complete Global Development Finance 2003, there is no mention about the issue of the growing role of the Independent Credit Rating Agencies, and the systemic risks that might so be induced, when they are called to intervene and direct more and more the world’s capital flows. 

It is not a small issue. Today many insurance companies and pension funds are already limited by the credit ratings for their investments and, for banks, we are only told things will get worse. 

For instance, Basel II, page 47, states “risk weights would be set for a bank’s exposure to sovereigns, corporations, and other banks based on ratings from major credit-rating agencies… the new methods of assessing the minimum-capital requirement is expected to have important implications for emerging-market economies, principally because capital charges for credit risks will be explicitly linked to indicators of credit quality… the regulatory capital requirements would be significantly higher in the case of non-investment grade emerging borrowers than under Basel I", plus finally “The current proposal places project loans in a higher risk category than corporate loans”. 

The sole fact that emerging countries, when affected by lower credit ratings, face additional difficulties to access investors with availability of long term financing, forces them into more short term arrangements which, compounded by the much higher rates charged, almost guarantee a crisis, once the snowball starts rolling. 

Chapter 3 dedicates six full pages to the interesting issue of the search for better crisis management, especially the problems surrounding sovereign debt restructuring. We commend this discussion as we agree with the statement that “Debt crisis have severe implications for the poor, who had no role in making decisions on borrowing” but, this only highlights the importance of carefully identifying, reviewing and correcting the factors that might lead to a crisis. 

We would also like to make a comment with respect to “Bank retrenchment in context”, page 45. It is said that “The significant presence of BIS-area deposit taking institutions is one of the most important ways in which the poorest developing countries” and that their presence “should improve the efficiency of the local financial intermediation system” but then, on page 47, Basle II, we read that “If, as expected, most domestically owned banks in emerging market economies adopt the standardized approach to credit risk, they will be at a comparative disadvantage vis-à-vis cross border lending by international banks when attempting to lend to high quality domestic borrowers”. There is a clear conflict between those two statements inasmuch the “comparative disadvantage” might justly be interpreted only as a disadvantage unfairly decreed by Basle, something which relates poorly to improving the efficiency of the local market. 

With respect to Basle, we would also like to point out that the document does not analyze at all a very fundamental risk for the whole issue of Development Finance, being it that the whole regulatory framework coming out of the BCBS might possibly put a lid on development finance, as a result of being more biased in favor of safety of deposits as compared to the need for growth. Even though, in theory, we could agree that there should be no conflict between safety and growth, in practice there might very well be, most specially when the approach taken is by substituting the market with a few fallible credit rating agencies. 

We would also like to comment with respect to credit derivatives. This market for credit risk transfer, that between 1997 and 2002 has “expanded more than ten-fold… reaching $ 2 trillion in outstanding notional value, expected to increase to US$ 4.8 trillion by end of 2004” and “yet the use of credit derivatives to manage risk is still only about 2 percent of their use in managing interest rate and currency risk” carries its own very clear and present danger of blindfolding the market as to where the real risks are truly allocated. Recently, and in relation to the losses from energy trading and their related derivatives, there have been reports that markets are still unsure on where the losses are finally going to surface… and be paid for. 

As the financial sector grows ever more sophisticated, making it less and less transparent and more difficult to understand for ordinary human beings, like EDs, it is of extreme importance that the World Bank remains prudently skeptical and vigilant, and not be carried away by the glamour of sophistication. In this particular sense, we truly believe that the World Bank has a role to play that is much more important than providing knowledge per-se and that is the role of looking on how to supply the wisdom-of-last-resort.

A new breed of systemic errors

Sir, except for regulations relative to money laundering, the developing countries have been told to keep the capital markets open and to give free access to all investors, no matter what their intentions are, and no matter for how long or short they intend to stay.

Simultaneously the developed countries have, through the use of credit-rating agencies, imposed restrictions as to what developing countries are allowed to be visited by their banks and investors.

That two-faced Janus syndrome, “you must trust the market while we must distrust it,” has created serious problems, not the least by leveraging the rate differentials between those liked and those rejected by our financial censors. Today, whenever a country loses its investment-grade rating, many investors are prohibited from investing in its debt, effectively curtailing demand for those debt instruments, just when that country might need it the most, just when that country can afford it the least.

Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds. Friends, as it is, the world is tough enough.

The Riskiness of Country Risk

How horrible it must be to work as an air-traffic controller! Any slight error can provoke an unimaginable human tragedy. No wonder these professionals burn out so rapidly. I “suppose” the same must happen with the country-risk assessors, those people who carefully pass judgment as to what the country risk is for any given nation.

The all important mission of these risk evaluators is twofold. The first, that for which they are actually paid, consists of analyzing whether or not the debtor nation will ultimately be able to honor its obligations. This determines whether or not pension funds, banks, and insurance companies will be willing, or even allowed, to invest in that country’s sovereign debt instruments. The second, even more important than the first, is to send subtle signals to the governments of these nations in order to help them improve their performance.

What a difficult job this is! If they overdo it and underestimate the risk of a given country, the latter will most assuredly be inundated with fresh loans and will be leveraged to the hilt. The result will be a serious wave of adjustments sometime down the line. If on the contrary, they exaggerate the country’s risk level, it can only result in a reduction in the market value of the national debt, increasing interest expense and making access to international financial markets difficult. The initial mistake will unfortunately turn out to be true, a self-fulfilling prophecy. Any which way, either extreme will cause hunger and human misery.

What a nightmare it must be to be risk evaluator! Imagine trying to get some shuteye while lying awake in bed thinking that any moment one of those judges, those with the global reach that have a say in anything and everything, determinates that a country has become essentially bankrupt due to your mistake, and then drags you kicking and screaming before an International Court, accused of violating human rights. If I were to be in the position of evaluating country risk, I would insure that the process is totally transparent, even though this takes away some of the shine of the profession and obligates me to sacrifice some of my personal market value.

How lucky we are that we are neither air-traffic controllers nor sovereign-risk evaluators! However, since we can easily become victims of their missteps, it behooves us, if only because of our survival instinct, to make sure that both do their jobs correctly.

We have seen in recent Country Reports how, after having introduced a myriad of information into the black box of methodology, as if by magic, a credit qualification is produced. Many of these reports seem to me like the pronouncements of film critics. It would seem that, more often than not, the individual evaluator is determining more how much he likes the ways or forms the Directors of a nation try to honor its obligations than on producing an honest and profound financial analysis of the country’s capacity for servicing its debt correctly.

In his book The Future of Ideas: The Fate of the Commons in a Connected World (New York: Random House, 2001), Lawrence Lessig maintains that an era is identified not so much by what is debated, but by what is actually accepted as true and so is not debated at all. In this sense, given the risk that the perceived country risk actually becomes the real country risk, it is best not to assign an AAA rating blithely to the risk qualifiers—perhaps not even a two-thumbs-up.

From The Daily Journal, Caracas, September 27, 2002

Spanish version, El Universal, Caracas September 26,2002

Guacara is not Basel

The credit portfolio of the Venezuelan banks, which in 1982 amounted to 16,000 million dollars, by June 2002, in constant 1982 dollars, barely reached 3,300 million dollars, that is, 21% of that of 1982. Being the case that levels as low as these have not been seen since the end of 1996.

In an article that I published in June 1997, I warned about the danger that, faced with the panic of falling into another banking crisis, we would exaggerate banking regulations, forgetting the main function of banking, which should be none other than be an active agent in the economic development of the country and for which the license is granted.

Since then, I have argued in multiple articles that we have to take care of the Basel banking regulations, which as part of the globalization process, seek to be imposed throughout the world, since these, although they may be logical for a developed country, , which perhaps only seeks to take care of its money, may be too strict for a developing country like ours.

You will then understand the reason for my anguish, when in a full-page interview published in a national newspaper, the new superintendent of banks did not mention a word about how banking can promote economic growth and limited himself to testifying about restrictive aspects of the regulation, with phrases such as: “we are the strategic ally of the system to guarantee deposits…” and “I have set the objective of adapting the system's regulations to the fundamental principles of Basel.”

Given the deep economic crisis in which we find ourselves immersed, if I were superintendent, on the contrary, I would do nothing other than try to determine if the current regulations could, in some way, be unnecessarily slowing down the granting of credits and, if so, Thus, I would proceed to modify them... whatever Basel says.

In any case, it should be noted that the impact that one or another type of banking regulation may have on the health of the financial system will always be infinitely less than that on the real health of the economy in which banking operates.

If there is something worrying about globalization, it is that that category of dangerous public officials, who limited themselves to developing regulations from their air-conditioned offices in Caracas, ignoring the real world, continue doing the same today, but from even more remote offices... in Basel.

Translated from article published in TalCual, Caracas, August 14 2002

 

Our economical policies suffer from inferiority complex

Financial Regulations: …our country has adopted, without blinking an eye, the regulations coming out of the Basel Committee, are more appropriate for the banking sector of a developed country than for ours. There is nothing wrong being a developing country, the bad is only to believe that by just adopting different postures, one could reach a different degree of maturity… just like the little girl who borrows mother´s lipstick in order to feel big.

Beware of bank consolidation (An early manifesto against too big to fail and too hard to govern banks, and against too few bank regulation criteria)

Every day there are fewer banks in the world. Those horror stories about bank clients trying to discuss with anonymous voices on the phone about fraudulent uses of their credit cards, while trying desperately to sound as innocent as they are, should make us think twice about the possibility that someday we will, in the best Kafka style, have just one bank. 

But apart from these experiences sometimes worthy of a Stephen King, bank consolidation, a trend that we have been sold as a marvel, may contain other risks not discussed enough - or happily ignored. Among these the following: 

Low risk diversification: Whatever the authorities do to ensure the diversification of banks, there is no doubt that fewer banks mean lesser baskets where to carry the eggs. When I read that during the first four years of the decade of the 30’s in the United States, a total of 9,000 banks failed- I wonder what would have become of that country if it then had only one single bank. 

The regulatory risk: Before there were many countries and many ways of how to regulate banks. Today, with Basel proudly issuing rules that should apply worldwide, the effects of any mistake could be truly explosive. 

Excessive similarity: Encouraging banks to adopt common rules and standards, is to ignore the differences between economies, so some countries end up with inadequate banking systems not tailored to their needs. Certainly, regulations whose main objective appears to be only to preserve bank capital, conflict directly with other banking functions, such as promoting economic growth, and democratize access to capital. 

Low diversity of criteria: A smaller number of participants, less diversity of opinion and, with it, increased risk of misconceptions prevail. Whoever doubts, read the dimensional analysis that ratings agencies publish. 

Backlash: The development of decision-making processes has benefits but also risks. Thus we see that the speed of information itself, which promotes quick and immediate response, can exacerbate problems. Before, those who took the problem home to study it, and those who simply found out late, provided the market a damper, which often might have saved it from hurried and ill-conceived reactions. 

Few clear benefits: To date we have not seen a foreign bank grant for example mortgage loans with globalized terms of maturity and interests. In this respect there seems not to be so many clear benefits of a global bank, when it operates only replacing local banks. 

Cost of global aid: When banks in Venezuela suffered their last crisis, among other reasons because of buying other banks at inflated prices, the cost of that was sadly but logically paid by our country. Today, with globalized banks, and which are not immune to commit equally dumb things, like also buying banks at excessive prices, who will then pay the bill? 

Today, when the world seems to be asking much for bank mergers or consolidations, I wonder if we on the contrary should be imposing on banks special reserves depending on their size. The bigger the bank is, the worse the fall, and the greater our need to avoid being hurt. 

Translated from El Universal, March 7, 2001

Local banks and global regulations

Many still have in mind the latest crisis in the banking sector in Venezuela, a memory refreshed by the recent Cavendes incident. Hence, public opinion demands from banks, first of all, greater security in their placements. Additionally, apart from being provided with an efficient service in the operational management of their funds and eventually being granted some consumer credit, there are few other expectations that a normal client has regarding their bank.

That’s why in the ensuing debate two fundamental purposes of banks are often forgotten. That to be an active agent in the process of generating economic growth and to collaborate in the function of democratizing capital. In short, to allow access to capital to those people or regions that, even lacking resources, have initiatives and the will to work.

In Venezuela, until recently, the approval of a banking license depended, at least in theory, on how it was intended to fulfill such social functions, without the solvency to repay the money in the future seeming to be more relevant. How far is this from being true today!

In constant 1982-dollar terms, the total loan portfolio of banks in Venezuela for December of that year was around 16,000 million dollars. In February 2000 it was located at just about 5,300 million dollars – including consumer loans. These figures show a real crisis of growth and although the recent process of bank mergers in Venezuela may manage to generate, at the deposit-taking level, certain operational savings, however, it is not very clear how it should contribute to reactivating the economy.

When thinking about it, I believe that it’s also necessary to question the import, from Basel, of banking regulations, more appropriate for already developed countries, than for developing countries like ours. Many of the problems arise from the mere fact that since such provisions were developed for environments of certain macroeconomic stability, when transplanted in countries with inflation or exchange rate volatility, many times they become inoperative and even counterproductive.

In 1975 John Kenneth Galbraith, in his book "Money, its Origin and Destination", advanced the thesis that one of the fundamental reasons for the economic development of the West and Southwest of the United States in the last century was achieved, it was the existence of an aggressive and poorly regulated bank, which frequently went bankrupt, causing great losses to individual depositors, but which, due to an agile and flexible credit policy, left a trail of development.

Today, when contemplating the recession that reigns in our country and without making in any way an apology for the crimes that could have been present, the temptation arises to wonder if the country was wrong to cause its fugitive bankers to seek refuge in other countries, where they spend their money and efforts. Wouldn't it have been preferable to have forced them to develop, for example, the Orinoco Apure axis?

It is also timely to question the fact that notwithstanding the country needs to generate jobs and therefore, loans for productive purposes, its regulations are more oriented to facilitate the granting of consumer credit. Regarding the democratization of capital, Galbraith himself shrewdly indicates that obviously the lower the degree of regulations that affect banking activity, the greater the possibility of democratizing capital.

The saddest thing about the entire chapter on banking regulations is that in truth the risks not only persist but sometimes, when there are mergers, they can multiply, due to the fact that "the bigger they fall, the harder they fall."

And since we're talking about mergers, I can't resist the temptation to make a comment from a global perspective. A local bank has a serious commitment to its area of influence, since it simply has nowhere to go. Speculating that the process of globalization of local banking began when the Banco de Los Llanos, from Valle la Pascua, became the Banco Principal, from Caracas - we observed that this did not help us much. Could the process that leads to managing our bank from Madrid be better? 

 In El Universal of Caracas

Financial misregulation

July 2000. Extracted and translated from an Op-Ed in Venezuela titled "Our full of complexes economic policy."

"Financial regulations. Banking, in addition to promoting savings, offering reasonable returns and certainty of recovery, must fulfill the functions of supporting economic growth and democratizing access to capital. In terms of banking regulation, it would seem that the country has forgotten these last two functions, accepting, without blinking, the Basel regulations, much more appropriate for the banking of an already developed country than for ours. There is nothing wrong with being a developing country, what is wrong is believing that by simply adopting different positions, you can reach another level of maturity – like a little girl who borrows her mother's lipstick to feel grown up."

Finance for Development

Kafka and global banking

My partner had a problem with identity theft which forced him to “negotiate” with his bank. During his ordeal I remember thinking "thank God we still have several banks to work with". Imagine if we would have had to discuss this issue with an official of the One and Only World Bank. Without a doubt this would present us with a future full of horrendous Kafkaesque possibilities.

This led me to think about the consolidation currently going on among banks. With every day that passes we have fewer and fewer banking institutions worldwide with which to work. This trend has been marketed as one of the seven wonders of globalization. .. and I believe the trend introduces other risks which have either not been sufficiently commented on or which have simply been ignored. Among these I can identify the following:

A diminished diversification of risk. No matter what bank regulators can invent to guarantee the diversification of risks in each individual bank, there is no doubt in my mind that less institutions means less baskets in which to put one’s eggs. One often reads that during the first four years of the 1930’s decade in the U.S.A., a total of 9,000 banks went under. One can easily ask what would have happened to the U.S.A. if there had been only one big bank at that time.

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.

Excessive similitude. By trying to insure that all banks adopt the same rules and norms as established in Basle, we are also pushing them into coming ever closer and closer to each other in their way of conducting business. Unfortunately, however, nor are all countries the same, nor are all economies alike. This means that some countries and economies necessarily will end up with banking systems that do not adapt to their individual needs.

I remember that John K. Galbraith once wrote that the economic development of the west of USA was helped by the fact that in the eastern part of the United States, banks were big and solid but that in the west, banks tended to work with much greater flexibility. The fact that some of these banks went bankrupt from time to time was simply taken as a normal cost inherent in development. Today, Venezuela's economy might be in dire need of some Wild West banks.

The cost of global assistance. When Venezuela’s banking system went down the drain, there is no doubt that the cost of the crisis was paid integrally by the country itself. In today’s world, when we see that a series of international banks are investing in our country’s institutions, I often wonder what will happen when one of these behemoths runs into serious trouble in its own country. Will we have to pay for our part of the crisis, less than our part of the crisis or more than our part of the crisis?

As bank mergers and acquisitions increase and stock exchanges worldwide call for more consolidations, I have my doubts. Should we not be imposing the creation of special reserves for especially large banks? The larger they are, the harder they fall, and so the greater the need to avoid disaster.

Abridged version of an article published February 2000 in the Daily Journal of Caracas.

About the SEC, the human factor, and laughing

A couple of days ago, our SEC reported that their pension fund had also been the victim of a fraudulent stock-managing firm, and that they had lost a lot of money.

I also read recently about the Mars Climate Orbiter spaceship that, after having required an investment of 125 million dollars, had to be declared as a total loss due to a technical confusion derived from simultaneously applying metric and English measures.

If what happened to NASA or what happened to our SEC is of any mutual comfort to them, I don’t care, but what I do hope is that they have learned a bit more about humility.

I bring this opinion to the table since I recently heard that our SEC was now establishing higher capital requirements for stockbroker firms, arguing that “. . . the weak have to merge to remain. We have to get rid of the rotten apples so that we can renew the trust in the system.” As I read it, it establishes a very dangerous relationship between weak and rotten. In fact, the financially weakest stockbroker in the system could be providing the most honest services while the big ones, just because of their size, can also bring down the whole world. It has always surprised me how the financial regulatory authorities, while preaching the value of diversification, act in favor of concentration.

The SEC should not substitute the need for capital in place of the need for ethics, nor should it allow that fraudulent behavior hides amid the anonymity of huge firms. In this respect, let us not forget that the risk of social sanctions should be one of the most fundamental tools in controlling financial activities.

If there is a relation between weakness and a rotten apple, it could really be in the SEC itself, since, though they frequently complain about the lack of resources, that doesn’t stop them from transmitting institutional messages about how well they are fulfilling their responsibilities. Perhaps the best thing that the SEC could do is to stop all their actions that are creating a false sense of security in the investor, acknowledging the absence of any supervisory capacity, and instead stamp each share prospectus with a big “BUYERS BEWARE.”

We read an article in Newsweek (“Giving Big Blue a Shiner, November 1999), about the surprising 20% drop in value that IBM shares had suffered in just one day. It also states that this drop was not in any way the result of any especially surprising event. The purported lesson of the article was “To teach not to take too seriously the investigative capacity of Wall Street and to remember to laugh next time you hear that the stock-market is a rational place where the big investors know what they are doing.” I would also like to suggest remembering to laugh next time a regulator presumptuously assures you he is doing his job.

And last I want to comment on another risk of regulations. Reading about accidents in nuclear reactors in Japan and about the risks of proliferation of nuclear weapons there is no doubt that the fears of a nuclear Big Bang are being renewed.

That said, 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 the collapse of the OWB (the only bank in the world) or of the last financial dinosaur that survives at that moment.


Currently market forces favors the larger the entity is, be it banks, law firms, auditing firms, brokers, etc. Perhaps one of the things that the authorities could do, in order to diversify risks, is to create a tax on size.

Here the version in Spanish:

Regulations as enemies of bank missions

Note: Now 25 years later, when hearing about efforts to regulate cryptocurrencies, something which will clearly dilute the “caveat emptor”, the “buyers beware” principle, again I find reasons to refer to this article.

In Venezuela, much has been discussed about the solvency of the financial intermediation entities, mainly banking. In virtue of the great attention paid to the subject of banking regulation throughout the world and our recent banking crisis being quite recent, this should not surprise us.

In the debate I think, it is important to remember, that the functions of the financial sector are not limited, simply, to return the money received from its depositors, since, if so, the traditional mattress could be sufficient to fulfill this mission.

Apart from providing other opportunities, which serve to stimulate national savings, as well as fulfilling the task of facilitating monetary flows, there are two other functions, of great social importance, that banks must comply with. The first is to be a very active agent in the process of generating wealth and the second, to collaborate in the function of democratizing capital, that is, allowing access to capital to those people who, lacking resources, have initiatives and will to work.

Supposedly, with the commitment and ability to fulfill these last two functions, the creation and distribution of wealth, both the application and the approval of a banking license were justified. How far is it from being true today! Next, I present some reflections on the subject.

In 1975 John Kenneth Galbraith, in his book titled "Money, whence it came, where it went", advanced the thesis that one of the fundamental reasons, for the past century was achieved, the economic development of the West and the Southwest of the States United, it was the existence of an aggressive and unregulated bank, which frequently broke down, causing great losses to individual depositors, but which, because of an agile and flexible credit policy, left a trail of development.

As for the democratization of capital, it is clear that the new banking regulation, now more than ever, obliges the bank to lend to the one who has and refuse as a credit client, the one who does not. The days when a banker, on the simple basis of a character trial, could approve a loan, without having to incur the cost of creating reserves, which presumes in advance the non-payment, went down in history.

Of course, with the foregoing, I do not refer to the immense amounts consumer loans. Today, we can question the wisdom of the regulator, noting the ease with which a consumer gets a loan and compare it with how difficult it can be to acquire a loan for productive purposes.

The saddest part of the regulatory chapter is that it never really immunizes us against risk. Even in portfolio based on probabilistic expectations and compensations by means of high interest rates we know that, one way or another, risk remain… and in many cases even trying to regulate, runs the risk of giving the impression that by means of strict regulations risks have disappeared. Sometimes it's in good faith... sometimes it's only faith. When for example the SEC (Venezuela) arrogantly presumes of performing a significant mission, we know it is pure baloney.

Frequently, in matters of financial regulations, the most honest, logical and efficient is simply alert to alert about the risks and allow the market, by assigning prices for these, to develop its own paths.

I do not propose, not for a moment, that the State abandons completely the regulatory functions, much the contrary, what I propose is that it assumes it correctly. History is full of examples of where the State, by meddling to avoid damages, caused infinite larger damages. In the case of banking regulations developed to be applied in developed countries, I am not sure we are doing our country a favor adopting them with so much fervor.

But what are we to do? Regulations are fashionable and there are many bureaucrats in the world trying to find their little golden niche. I just read an article about a county in Maryland, USA, where, in order to be able to work as an astrologer and provider of horoscopes, you need to be registered and obtain a license in order to “read the hand palms. The cost of such license is 150 dollars.”

PS. And indeed the Basel Committee's risk weighted capital requirements has caused infinite damages.

PS. The page with the details of Maryland certified astrologers has disappeared, it might have been an early case of fake news :-( Now the certification is issued by AFA Certified Astrologers - American Federation of Astrologers

PS. And now, 25 years later, I find myself chatting with artificial intelligence about these bank regulations.

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