What a flabby pillar!

When the credit ratings are perfect, borrowers pay the exact interest rate and lenders earn the exact interest rate and so there is no profit for anyone.

Therefore the implicit profit driver in any operation using credit ratings is for these to be off as much as possible.

That is when you can sell a badly awarded mortgage of $300.000 at 11% for 30 years for $510.000 because when packed in a triple-A rated security you could convince someone 6% was a great rate.

And so I ask… how on earth could the regulators use as a pillar of their regulations the assumption that the credit ratings were to be right and people would trade without a profit motive? Seems to me like a very a flabby pillar!

What do the financial regulations say about the mental capacity of the regulators, and ours?

1st Quadrangle: Excessive lending to those who are perceived as having a low risk of default:

2nd Quadrangle: Excessive lending to those who are perceived as having a high risk of default:

3rd Quadrangle: Insufficient lending to those who are perceived as having a low risk of default:

4th Quadrangle: Insufficient lending to those who are perceived as having a high risk of default:

Let us analyze which role each quadrangle plays in causing a financial crisis.

By far, the most likely and perhaps even exclusive cause of a financial crisis is found in the first quadrangle that of excessive investments to what was perceived ex-ante as not being risky.

Next, insomuch as it could cause a problematic lack of economic development, we could mention quadrangle 4 that of insufficient investments to those representing an ex-ante higher risk of default.

Quadrangle 3 that of insufficient lending to those who are perceived as having a low risk of default is quite unlikely to occur.

Finally, what really never ever causes a financial crisis, as it goes against the coward nature of capitals and bankers, is quadrangle 2 represented by an excessive lending to those who are perceived as having a high risk of default.

If we then observe how the current regulators have imposed very low capital requirements, zero to 1.6 percent on the quadrangles represented by those being perceived ex-ante as having a low risk of default, and a much higher though quite reasonable 8 percent on the quadrangles represented by those who ex-ante are perceived as having a high risk of default, what does this say about the mental clarity of the current regulators?

I can only conclude in tha they are thick as a brick! And so are we, allowing these regulators to play out, totally unsupervised their bedroom fantasies of a world without any bank failures.

What on earth are we to do with a world where no banks fail when doing their jobs and we all might fail because banks are not doing their job?

Q. Where do bankers' bonuses come from?

A. From huge bank profits of course.

Q. Where do then huge bank profits come from?

A. From lending using little own capital and from trading faulty risk assessments.

Q. Can you please explain?

A. Of course!

Lending: If a bank had to keep 8 percent of capital when lending to triple-A rated borrowers, the same as when lending to a small business, and which implies a leverage of 12.5 to 1, then if the margin on that lending was .5 it would earn a profit of 6.25%, decent but nothing to write home about. But, when courtesy of the regulators they are allowed to hold only 1.6 percent in capital, and which implies a leverage of 62.5 to 1percent, then the margin on lending to triple-A clients have the potential to increase to 31.25 percent a year (.5 x 62.5), meaning that type of stuff that real big bonuses are made of.

Trading: The profits from trading a paper with an absolute perfect credit rating are nil. But the profits from selling a paper that is much riskier than their credit rating indicates, or buying a paper that is much less risky than their credit rating indicates, those can be huge. A risky 11%, 30 years, $300.000 mortgage, sold as what it is could be worth even less than $300.000. But, sold as part of a triple-A security believed to merit a return of only 6%, it is worth $510.000, resulting in an immediate profit of $210.000…meaning that kind of stuff that real big bonuses are made of.

Conclusion: If you think bank profits and bankers´ bonuses are excessive, then you need to focus much more on where the stuff is generated and much less on how it gets distributed.

¿Reguladores tapados?

Por cuanto ni la mejor regulación bancaria del mundo serviría para algo dentro de un entorno económico tan absurdo como el nuestro, lo siguiente no es un tema muy relevante para Venezuela. No obstante habiendo desde 1997 criticado las regulaciones bancarias globales surgidas del Comité de Basilea, de vez en cuando necesito retomar el tema.

El pilar fundamental y casi único de las regulaciones de Basilea, son unos requerimientos de capital que se basan en el riesgo del no pago, tal como este riesgo sea percibido por las agencias calificadoras de crédito. No obstante que eso pueda sonar lógico, a más riesgo más capital, considero a tales requerimientos un absurdo. Permítame explicar.

Primero. Por cuanto los capitales y los banqueros en esencia son cobardes, jamás en la historia ha ocurrido una crisis financiera o bancaria que se haya derivado de un exceso de préstamos o inversiones en algo que a priori se haya considerado como riesgoso. Todas las crisis bancarias y financieras, sin exclusión y hasta casi por definición, han resultado del exceso de préstamos o inversiones en lo que a priori se ha considerado no tener riesgo alguno.

En tal sentido, incentivar a los bancos a prestar o invertir más en lo que a priori se percibe como de menor riesgo va en contrasentido a lo que la historia nos indica… por lo que me permito creer que los reguladores allá en Basilea, o están metidos en un club de mutua admiración con una discusión incestuosa degenerante o son simplemente unos tapados.

Segundo. Por cuanto quienes se perciben como de poco riesgo casi siempre tienen acceso a los mercados de capitales, son las pequeñas y medianas empresas, las que sin duda son más riesgosas, quienes de verdad más necesitan de los bancos para satisfacer sus necesidades financieras.

En tal sentido, el dificultarle a los bancos, en términos relativos, el prestar o invertir dinero justamente a quienes más los necesitan; siendo además estos clientes los más probables proveedores de los empleos decentes del mañana, carece totalmente de sentido… por lo que me permito creer que los reguladores allá en Basilea, o están metidos en una discusión en un club de mutua admiración con una discusión incestuosa degenerante o son simplemente unos tapados.

Tercero. Veamos lo que actualmente rige en muchos países. Si un banco desea efectuar un préstamo a una pequeña y mediana empresa entonces se le requiere tener 8 por ciento de capital. Pero si ese banco le presta al gobierno de uno de los soberanos clasificados como AAA, para que sus burócratas le hagan los préstamos a las pequeñas y medianas empresas de su agrado, entonces el banco no necesita de capital alguno.

En tal sentido, hay vemos que un socialismo incompetente del siglo XXI, no es una exclusividad venezolana. Hasta Dalí se queda chiquito en surrealismo comparado con lo que inventan los reguladores bancarios del Comité de Basilea. Ya causaron su primera crisis global con esa estampida en busca de los triple-A que provocaron. Falta ver lo que nos harán la próxima.

La semana pasada, en una competencia donde el G20 anda pescando soluciones para ver cómo el sector privado financia más y mejor a la pequeña y mediana empresa, presenté una propuesta dirigida a corregir parte de lo que he criticado. Si les interesa, pueden ver cómo me irá en mi pelea contra el establishment regulador global, en la página web de www.changemakers.com/en-us/SME-Finance 

We’re in big trouble with these financial regulators!

I have just read the “Interim Report: Assessing the macroeconomic impact of the transition to stronger capital and liquidity requirements” produced by the Macroeconomic Assessment Group established by the Financial Stability Board and the Basel Committee on Banking Supervision.” August 2010.

By far the most prominent feature of the current bank regulations is that it discriminates the capital requirements for the banks based on the perceived risk of default, and therefore for instance allows a bank to leverage up their capital 62.5 times to 1 when lending or investing to triple-A rated clients while only permitting them to leverage up 12.5 to 1 when lending to unrated small businesses and entrepreneurs.

If a triple A rated client presented the banks with a margin of .5 percent then had it been regulated like when the bank lent to the small business, it would have produced the bank a return of 6.25 percent, decent but nothing to write home about. Instead because of the regulators’ inexplicable largess it could obtain a return of 31.25 percent a year. No wonder our banks disappeared in the AAA swamps and our small businesses and entrepreneurs, whom we depend so much for our next generation of decent jobs are ignored.

Since the existence of the discrimination which obviously must have macroeconomic impact, is not even mentioned as a problem, much less studied, I assume the document to be basically worthless, as it clearly reflects that those who wrote it know little about banking and care even less about its purpose.

Basically it is the same authors, or type of authors who, in “An Explanatory Note on the Basel II IRB Risk Weight Functions” of July 2005, produced a prime candidate for the mother of all bullshit papers ever, where they assured us that “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.”

Indeed, we’re in big trouble with these financial regulators!

My response to the G-20 SME Finance Challenge

Friends,

The Group of 20 and Ashoka’s Changemakers, with support from the Rockefeller Foundation, launched the G-20 SME Finance Challenge, where competitors are to submit proposals on solutions or projects for how public finance can unlock private finance to small and medium enterprise on a sustainable and scalable basis. 

The goal is to identify catalytic and well-targeted public interventions to unlock private finance for SMEs. Maximizing leverage of scarce public resources is at the core of the Challenge.

The following is my proposal:

The taking of risks is the oxygen of any development!

We need to eliminate the regressive discrimination of SMEs caused by imposing different capital requirements on banks based on perceived risk of default. Its primary reason is that risk of default of a debtor is a natural, manageable and secondary degree risk that banks and society need to take. As a bonus it also corrects a huge regulatory error that only increases the possibilities of systemic disasters.”

Here follows some of the questions and answer given on the entry form:

What makes your innovative solution unique? 

It rejects completely the first pillar of the current regulatory paradigm developed by the Basel Committee, that of construing “safer” banks by means of discriminating precisely against those whom, because of their limited access to capital markets, the banks should most help with their lending, the SMEs. 

To discriminate against the more “risky” while favoring those who because of their good credit ratings most likely already have access to the capital markets, is nonsensical. 

It is like the handicap officials on a racetrack taking off weights from the stronger horses and placing them on the weaker. It could only have been thought up by regulatory zealots who, shortsightedly, have only the immediate safeness of the banks on their minds and care little or nothing about development and banks’ real long term purpose. 

If you consider how unelected officials are influencing in a quite non-transparent way how global finances operate, I also hope this proposal helps to open up a much needed debate on regulatory transparency.

How does your proposed innovation leverage public intervention in catalyzing private SME finance?

If a bank was required to hold the same capital requirement when lending to a triple-A rated company than it has to hold when lending to an SME, namely 8 percent, it could leverage its capital 12.5 times to 1. If the bank then made a margin of .5 percent when lending to the triple-A rated, it would obtain a total return on capital of 6.25 percent. 

But, since the regulators allow the banks to hold only 1.6 percent in capital when lending to the triple-A rated, and so that they could therefore leverage themselves 62.5 to 1, the total capital return on this lending for the banks becomes instead 31.25 percent. 

To make up for that difference of 25% of regulatory advantage awarded to the triple-A lending (31.25-6.25), and be able to compete for access to bank credit, the SMEs therefore need to pay an additional interest rate of 2 percent (25/12.5), on top of the higher risk premiums they are anyhow charged with because of their higher perceived and real risk. 

Leveling the playing field, by eliminating this arbitrary regressive and discriminatory regulatory tax on risk that affects many of those accessing bank credits, is the most important public intervention needed in order to catalyze private SME financing. 

As an important bonus it would also remove the regulatory incentives which caused the stampede after triple-As in the market and thereby originated the current crisis. 

What barriers does your proposed solution address? Describe how so? 

SMEs are more prone to be considered as risky. Therefore the elimination of the current regulatory de-facto tax on the perceived risk of default will help to decrease the disincentives for the banks to serve these clients; or, in other words, it will increase the competitiveness of SMEs in their race against all those perceived to represent lesser risk for access to bank credits.

In the same vein the natural higher transaction costs for financial intermediaries to lend to SME’s would cease to be further compounded by the costs derived from higher discriminatory capital requirements. 

Additionally it would help to fight the excessive asymmetrical empowerment of the credit rating agencies as credit information providers, and thereby help to reestablish banking as a truly accountable profession that is not induced to rely robotically on a general type of GPS guidance system. In other words, it will provide an opportunity for bankers to be bankers again.

Provide empirical evidence of your proposed solution’s success/impact at present: 

This should be superfluous. The genesis of the current financial crisis was the stampede after the incentivized and open to capture triple-A ratings; and which since there were naturally not enough of these AAAs to satisfy the demand, being the AAAs in many ways only fidgets of imagination, this led the markets to provide some Potemkin ratings instead. 

It suffices to know that since capital and bankers are by nature coward, the world would have even been better off, if totally opposite capital requirements had been imposed on the banks, meaning capital requirements which progressively discriminated against those who represent lesser perceived risk. In such a case there would have been less rush after AAAs, while the lending to “the risky” would never have occurred in volumes that could systemically endanger the system.

All banks crisis in history have always resulted from excessive lending to what is perceived ex-ante as not being risky and no bank crisis has ever occurred because of excessive lending to anything perceived ex-ante as risky. Do you need more empirical evidence than that?

In 1999 I wrote “The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause the collapse”… and indeed the AAA-bomb exploded.

How many firms do you expect to reach?

All SMEs, most of them are not even rated.

What is the volume of private SME finance you aim to catalyze? 

The current capital requirements stimulated trillions of dollars to finance triple-A rated securities collateralized with badly awarded subprime mortgages in the US. I would be satisfied if it could help to catalyze just a decent fraction of that amount in new lending to the SMEs.

What time frame will be required to reach these targets? 

The market lost their trillions in about three years, from mid 2004 until mid 2007. The speed of the proposed adjustment should be further studied carefully monitored in order to avoid any problems in the middle of an economic crisis. 

I envisage the possibility of an immediate reduction of the maximum capital requirements for banks on all lending from 8 percent to 4 percent and then, over a period of 4 to 6 years elevating it to a 8-10 percent capital requirement, on any lending to all type of private borrowers. 

The adjustment of the capital requirements for public debt, and which for triple-As currently amazingly requires no capital at all, could take longer time though. Where would interest rates on public debt be without this arbitrary and non-transparent regulatory subsidy?

Does your innovation seek to have an impact on public policy?

Yes it looks precisely to correct an utterly wrong public policy.

What might prevent your innovative solution from succeeding?

From success, nothing! Though from being implemented, the difficulties with thick-as-a-brick regulators who are unable to break free from their current regulatory paradigm and who have a vested interest of remaining in total control of their own mutual admiration club.

Tell us about the social impact of your innovation. 

Since among the small SMEs we probably have our best chance of finding our next generation of decent jobs, the social impact of this innovative regulatory stepping back cannot be overstated. 

How many SMEs are there and how many more could there be if regulators did not discriminate against them? That is the number of SMEs that will benefit!

Demonstrate how your proposed solution has the capacity to graduate from dependence on public finance. What is the time frame? 

Currently if a bank lends to a SME it is required to have 8 percent in capital but, if it lends to an A-rated government so that this government in its turn can lend or give stimulus to a SME, then it needs zero capital. Could there be a more direct way of decreasing the dependence on public finance…immediately?

Please tell us if your proposed solution aims to scale up through a high growth sector, expand immediately to multiple sectors, and/or scale up geographically.

Absolutely, it aims to be applied to all the countries which have fallen in the current Basel Committee risk-adverseness trap. The fact that many emerging countries did not suffer so much from these regulations has a lot to do with the absence in these countries of AAA rated clients.

Please tell us what kind of partnerships, if any, could be critical to the greater success and sustainability of your innovation. 

We need a complete new crew of bank regulators with diverse backgrounds and able to break out from the current paradigm. 

We also need legislators that dare to face the problem. The final statement of the recent G20 meeting in Toronto mentions the Basel Committee on Banking Supervision 11 times and the Financial Stability Board (FSB) 27 times. But, in the 2319 pages of the Financial Regulatory Reform approved by the US Congress, those entities are not mentioned even once. Such disconnect is unmanageable!

In these days many, including Nobel-prize winners, speak about the excessive risk-taking of banks, while turning a blind eye to the fact that the crisis originated entirely in triple-A operations and so that we could just as well speak about an excessive and regulatory induced risk adverseness. I acknowledge though that this proposal is indeed noisy and difficult to move forward… and so a decided support from sturdy and eager group of changemakers is of course much needed and also much appreciated.

Friends, as you know I have been shouting about this issue for years, to very little avail, since most prefer either not to criticize the regulatory establishment or, for their own piece of mind, to think the regulatory establishment incapable of being as thick-as-a-brick as I hold them to be. In this respect, as you can understand, I very much look forward to the comments from the qualified jurors and commentators… some of whom might have some conflicts of interest on this issue.

By the way, since I am not a PhD, not a financial operator, not a banker and not a bank regulator, and just in case you should think that my criticism, as often happens, is facilitated by a lack of deeper knowledge on the subject, let me just copy below one example of the many formal and informal statements that I gave at the board of the World Bank as an Executive Director (1 of 24) on the subject. In October 2004 I wrote:

“We believe 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.”

Who knows, perhaps after this proposal even the World Bank will invite me to discuss my objections to Basel regulations. Last time I did so, in May 2003, what little I then told them, sort of sent me off to their own Siberia.

Regards,

Per

Thick as a brick

Never has there been a financial or bank crisis that has originated from too much investments or lending to what was perceived as being risky… capitals and bankers are much too coward for that.

All financial or bank crisis have always originated from lending or investing too much in what was wrongly perceived as not risky… even Dutch tulips would certainly have had an AAA rating.

So when therefore we see how regulators were fooled into giving bankers special incentives for investing or lending to what is perceived as not being risky, by means of allowing in those circumstances the banks to have specially low capital requirements, we can only conclude that the regulators in the Basel Committee are thick as a brick… just like we are when we allow those same regulators to keep on regulating.

If the handicap officials on a racetrack took of the weights from the best horses and placed these on the weakest… would they be allowed to remain as handicap officials? I don’t think so!

The Gameboy regulators of Basel

Looking at how they try to control for risk by appointing credit rating agencies as risk-surveyors and then concocting some risk-weights to determine the capital requirements, it should be clear that we have fallen into the hands of a first generation of Nintendo-Gameboy-players’ type of regulators who believe life, risk and who knows perhaps even love can be controlled by just pushing some buttons.

When is the world going to speak out and say that it has had enough of this infantile approach to bank regulation? If we don´t speak out we´re doomed.

Dodd-Frank Act… legislative surrealism!

The Dodd-Frank Act signed today seems to me a surrealistic piece of legislation. 

Though the United States in June 2004 formally committed to implementing the Basel II bank regulations; and though the SEC in April 2004 delegated supervision decisions to the Basel Committee, surrealistically, there is not one single mention of these regulations, or of the Basel Committee for Banking Supervision, in all 848 pages of the Dodd-Frank Act. And this though the Act makes reference to foreign organizations like the Extractive Industry Transparency Review (EITI). It would seem like someone somewhere, has been playing some dirty tricks on someone.

PS. (Dated later) And it does not mention the fact that risk-weighted capital requirements for banks, in the home of the brave, does seem to be quite un-American. What do you mean regulators about discriminating against "the risky", those who are already being discriminated by the banks because they are perceived as risky?

The fact that the distortions in the allocation of bank credit caused by the risk-weighted capital requirements had not been understood, much less accepted, made it impossible for the Dodd-Frank Act to really serve its purpose... in many ways... by opening discussions on so many other fronts and thereby distracting the attention from what most urgently matters, only made it worse.

PS. Homeland Security. Bad regulations could be used as a lethal weapon of terrorism

PS. The complaint I presented to the Consumer Financial Protection Bureau

PS. In essence the Dodd-Frank Act did absolutely nothing to correct the most fundamental mistake in current bad regulations. It did not even recognize it!

PS. A letter published in Washington Post

The Basel Committee makes small businesses and entrepreneurs pay much more for their bank credit

When compared to a regulatory system with equal bank capital requirements for all type of assets, the Basel system that imposes different requirements based on some arbitrary risk-weights related to credit ratings, implies that a small business needs to pay about 2 percent (200 basis points) more in interest rates in order to stay competitive when accessing bank credit.

Suppose a bank feels that the normal risk premium should be .5 percent for an AAA rated company and 4 percent for a small business. If the bank was required to have 8 percent for both assets and could therefore leverage itself 12.5 to 1, then the expected before credit loss margin on bank equity for the AAAs would be 6.25% and for the small business 50%, a difference of 43.75%.

But, since the bank is allowed by Basel to hold only 1.6 percent against AAA rated assets, which implies permitting a leverage of 62.5 to 1, the previous margin 6.25% margin for AAA assets becomes a whopping 31.25%, which now implies a difference in the margins on equity of only 18.75% when compared to that generated by the small businesses.

In order to restore the initial required competitive margin difference of 43.75, now only 18.75% the small businesses will have to generate for the banks an additional gross margin of 25 percent, which, divided by the 12.5 to 1 leverage allowed for their class of assets, comes out to be the additional 2 percent in interest rate referred to.

Of course a complete analysis would require considering many other dynamic factors, but those would only help to fog the basic truth that our regulators are discriminating against those the banks are most supposed to serve.

What will it take for the regulator to understand that this is no minor problem, especially when so much of any job recovery lies in the hands of small businesses and entrepreneurs?

What will it take for the regulator to understand and admit that the regulatory discrimination in favor of the AAAs caused the current financial crisis?

All bank crisis have started in what was perceived as AAA land

It is not so much whether the capital requirements for banks are high or low that matters, but more so the way they discriminate among assets based on default risk-weights?

Let us suppose that banks, with no special regulations, would be willing to lend at .5% over their own cost of funds to those who are rated triple-A, and with a 4% spread to more risky small businesses.

If the banks were obliged to hold 8 percent against any asset, which means they can have a leverage of 12.5 to 1 (100/8) then their net results on capital, before credit losses, when lending to the AAAs would be 6.25% (.5x12.5); and 50% (4x12.5) when lending to the small businesses. With such a difference the banks would do their utmost trying to lend well to the small businesses… as there are clearly no major bonuses to be derived from lending to the AAAs.

But when the regulators allow, as they do, the bank to hold only 1.6 percent in capital when lending to AAA rated clients, which implies a leverage of 62.5 to one (100/1.6), then the expected net result on capital for the banks when lending to AAAs, before credit losses, becomes a whopping 31.25% (.5x62.5).

And of course, a bank, and bankers, being able to make 31.25% before credit losses when lending to no risk-AAAs, would be crazy going after the much more difficult 50% margin before credit losses available when lending to the riskier small businesses and entrepreneurs.

And this is how the risk-adverse regulators pushed our banks into the so dangerous “risk-free-AAA-land” while blithely ignoring that no bank or financial failure has ever occurred because of something perceived as risky, they were all the result from something perceived as not risky; and while ignoring that what we most want out of our banks is precisely that they be good in nurturing with credit those small businesses that might grow up to be the AAAs of tomorrow.

And this is really why we find ourselves in a crisis of monumental proportions, never ever before had our regulators dared to be so publicly wimpy so as to ask the banks to so excessively embrace what was, ex-ante, perceived as having no risk.

By the way, who gave the regulators the right to discriminate solely based on perceived default risks? The small businesses, in order to have a chance to access credit, are as a direct consequence of these capital requirements forced by the regulators to pay much more for their loans... as simple as that! Do not forget that whatever little capital the banks currently have, it is mostly because of those perceived as being risky.

What the G20 or the US Congress or the regulators do not understand they cannot fix.

Have you ever heard about a financial crisis that happened from lending or investing in anything considered risky? Of course not, these have all started with lending or investments to something that offered more returns than what its perceived very low risk merited. Even the infamous Dutch tulips, in their own bubble time, would probably have been rated AAA.

That is why the current paradigm of assigning lower capital requirements to what the credit rating agencies perceive as having lower risk, like if they possessed some extraterrestrial sensorial abilities others don’t, is plain ludicrous. That only increases the expected returns from what is perceived as having no risk… precisely what would be prescribed for a financial heart-attack.

And since the Congress and the G20 do not yet get that, do not hold your breath waiting for any major progress in financial regulatory reform.

Also, to allow financial regulators to focus so excessively on the risk that lies closest to their heart, namely the risk of default, is, in a world with so many other risks, like the AAA rated BP can attest to, plain scandalous.

The biggest risk for society is that our banks will not perform efficiently their role in allocating capitals and it is always better for them to fail when taking real and worthy risks than to survive or fail taking useless Potemkin risks!

Impose the higher bank capital requirements on what has the best credit ratings

Published in Voxeu VOX CEPR

There can be no doubt that capital, in general, is risk-adverse, which creates considerable bias in favor of anything that is perceived as having a lower risk of default. In such circumstances the dangers of any systemic default lie much more in the realm of capital stampeding after investments that are erroneously perceived ex-ante as representing lower risk, than capital pursuing investments perceived ex-ante as having a higher risk of default.

In fact there has never ever been a major or systemic bank crisis that has resulted from the banks being involved with what ex-ante was perceived as risky; they have all resulted from lending and investing in what ex-ante was considered as not risky, given the returns offered. Even the Dutch tulips would, in their own bubble time, have earned them AAA ratings.

In view of the above the Basel regulations that lowers the capital requirements for what ex-ante is perceived by the credit rating agencies as having lower risks, and thereby increases the banks’ expected ex-ante returns from pursuing these “low risk” opportunities, seems sort of stupid to say the least.

We are now two years into a crisis that has resulted from many banks and lookalikes following some minuscule capital requirements when investing in securities collateralized with subprime mortgages and rated AAA. We are also in big trouble resulting from lending to well rated fancy sovereigns, like Greece, much because of similarly minuscule capital requirements.

Therefore what is most worrisome of it all is to see how our financial regulators simply do not yet get it, not even ex-post, and keep on insisting on their utterly faulted regulatory paradigm of risk-weighted assets.

What can we do to save the world from our financial regulators´ regulatory exuberance? Perhaps to shock them out of their lethargy asking them to invert the current capital requirements for banks, forcing any bank lending to a triple-A to require 8 percent of capital and allowing banks to lend to their natural clients the small businesses and entrepreneurs (who have never caused any crisis) with only 1.6 percent in capital.

Of course, I would much rather prefer regulators to totally refrain from meddling and discriminating based on risk; not only because of the previous argument, but also because risk is not confined to what we and regulators believe it to be, like clearly the AAA rated BP is reminding us of.

Lord Turner, please help save the world from our financial regulators´ regulatory exuberance!

In June 2010, during a conference given by Adair Turner at the Brookings Institute, I asked the following: 

1:20:07 MR. KAROFSKY: Pere Karofsky (In the transcripts that's me) from the Voice of Noise Foundation (You can also hear it in the audio).

"Big companies in consolidated sectors, like BP in oil, tend to have much better credit ratings than those participating in developing markets like wind energy. Do you really think the banks will perform better their societal capital allocation role if regulators allow them to have much lower capital requirements when lending to the consolidated sectors than when lending to the developing? Do you think we can reach a meaningful financial regulatory reform without opening up the discussion on the issue of risk in development? I mean to combat the regulatory exuberance of the Basel Committee."

1:26:08 To that Lord Turner responded: "The point about lending to large companies development, I'm not sure. I'm trying to think about that. I mean we try to develop risk weights which are truly related to the underlying risks. And the fact is that on the whole lending to small and medium enterprises does show up as having both a higher expected loss but also a greater variance of loss. And, of course, capital is there to absorb unexpected loss or either variance of loss rather than the expected loss. I think, therefore, it's quite difficult for us to be as regulators, skewing the risk weights to achieve, as it were, developmental goals. There are some developmental goals, for instance, in a renewable energy, which I'm very committed to wearing one of my other hats on climate change, where I do think you may need to do, you know, in a straight public subsidy rather than believing that we can do it through the indirect mechanism of the risk weights. So I may have misunderstood your question, but I'm sort of cautious of the sort of the leap to introducing developmental roles into -- I think we, as regulators, have to focus simply on how risky actually is it?"

I replied (not authorized, perhaps even rudely) the following: 1:27:19 

"But you do do make all regulatory discrimination based on credit risk and that risk is just one of the many risk we face".

My prime conclusion of it all was that when Lord Turner states "capital is there to absorb unexpected loss, or either variance of loss rather than the expected loss" he does not understand the sillines of estimating unexpected loss using expected loss. The safer something is perceived de facto de larger its potential to deliver unexpected losses. And he also does not understand the purposelessness of weighing capital requirements based on one of the only risks banks have already cleared for, by means of risk premiums and the size of the exposure

And on June 22, 2010 I sent Lord Turner the following letter:

Dear Lord Turner.

In November 1999 I wrote: “The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which at the end will cause the collapse of the last standing bank in the world.”

There has never ever been a major or systemic bank crisis that has resulted from the banks being involved with what ex-ante was perceived as risky; they all resulted from lending and investing in what ex-ante was considered as not risky, given the returns offered. 

But then came the Basel Committee regulators and, to top it up, lowered the capital requirements for what ex-ante is perceived by the credit rating agencies as having lower risks, which of course increased the banks’ expected ex-ante returns from pursuing these “low risk” opportunities. 

And now, when two years after an explosion that resulted from so many banks following the minuscule capital requirements when investing in securities collateralized with subprime mortgages; and there is a bank explosion awaiting round the corner because of the minuscule capital requirements when lending to well rated fancy sovereigns, like Greece; they keep on applying the same regulatory paradigm of risk-weighted assets, we can only deduct that our financial regulators simply do not get it, not even ex-post.

Please, Lord Turner, help save the world from our financial regulators´ regulatory exuberance!

Regards

Per Kurowski

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

I received and answer but since its states "This communication and any attachments contains information which is confidential and may be subject to legal privilege" I refrain from making it known unless I am duly authorized.

But I then answered:

Dear Lord Turner

Yes, we met yesterday at Brookings... and it is not only that “our ability to know ex ante what is low and high risk is clearly limited and we have undoubtedly placed too much faith in apparently sophisticated but conceptually flawed VAR type approaches” but that, ex-post, the most benign risk for the society, might be the risk of default on which the regulators concentrate exclusively.

Think about the horror or a world without defaults and with corporations and banks becoming larger and larger. What about the risks of our banks not performing efficiently their role in allocating capitals?

By the way, lending to Greece and BP required the banks to have only 1.6 percent in capital.

Regards

Per Kurowski

To that I received no answer.

“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?