TWO EXAMS

The bank regulator’s exam

1. Which type of bank clients can create such a massive exposure so as to generate a systemic bank crisis?

a. Those perceived as risky (small businesses and entrepreneurs)

b. Those perceived as not risky (triple-A rated)

2. The needs of which clients do we most expect our banks to attend to?

a. Those perceived as risky with no access to capital markets (small businesses and entrepreneurs)

b. Those perceived as not risky and with access to capital markets (triple-A rated)

The bank regulators, represented by those in the Basel Committee answered (a) to the first question, and totally ignored the second. As a consequence they imposed higher capital requirements on banks when lending to client “officially” perceived as riskier, and vice versa.

Our exam

1. How did the bank regulators do?

a. They failed miserably

b. They excelled!

2. If your answer is (a) but we are yet leaving our regulations in the hands of exactly the same regulators what does that say about us?

a. We’re stupid

b. We’re smart

Our crazy bank regulations explained in red and blue

Nannies care for risks perceived, regulators should care for the risks not perceived. So you tell me, the Basel Committee, the FSA and the FSB, what are they?

2003: During many days I’ve not heard a single word indicating that growth and credits, are also a function of bank regulations.

2009: Please free us from imprudent risk aversion and give us some prudent risk taking

2023: Chatting with AI – Open AI – ChatGPT, about the kind of credit diet, nutrients, banks should feed the economy.

How sad bank regulators didn’t listen to Pope John Paul II

The Basel Committee for Banking Supervision, and other assorted bank regulators, decided to increase the risk-adverseness of banks by imposing on them capital requirements based on officially perceived risk, among other as perceived by some few officially appointed risk-perceivers, the credit rating agencies.

And, naturally, if when doing so one favors the financing of houses, public debt and whatever has managed to temporarily hustle up a good credit rating, and discriminate against all of what is officially perceived as “risky”, like small businesses and entrepreneurs, one will, naturally, end up with a lot of houses, dangerously excessive lending to what is triple-A rated, a huge public debt, and very few jobs which, to create, requires a lot of risk-taking.

How sad the regulators did not listen to Pope John Paul II when he said “Do not be afraid. Do not be satisfied with mediocrity. Put out into the deep and let down your nets for a catch.” "Duc in Altum"

My letter to the Basel Committee on Banking Supervision and the Financial Stability Board

Basel Committee on Banking Supervision
Financial Stability Board

Dear Regulators

Since you still seem to be completely unaware of it, let me put forward a kindly reminder:

There has never ever been a major bank crisis caused by excessive lending or investments to what was perceived as risky, and these have all resulted from either unlawful behavior or excessive lending or investment into what was perceived as not risky, but later turned out to be.

Against that fact your capital requirements, based on the perceived risk, as perceived by your official risk-perceivers, the credit rating agencies, that establishes higher capital requirements for what is perceived as risky and lower for what is perceived as not risky, seems to be sort of a dumb idea. If anything, on a purely empirical basis, higher capital requirements for what is perceived as not risky would make more sense.

And, while I am at it, let me also remind you that the banks already use the information provided by the credit rating agencies when deciding what amounts and at what margins to lend to a client, and so to force them to also consider these for their capital base, gives the credit ratings a double weight, and, as we all know, even the best information, if it is excessively considered, is wrong.

By the way, your capital requirements, amount to an outright discrimination of those who we most need our banks to attend, the small businesses and entrepreneurs. Shame on you!

Best regards,

Per Kurowski
A former Executive Director at the World Bank (2002-2004)
http://subprimeregulations.blogspot.com/

Basel‘s monstrous regulatory mistake

The regulators notwithstanding that the market and the banks already considered the credit ratings when setting their risk premiums and interest rates, considered exactly the same information when setting their capital requirements for the banks. This double consideration, which would have been wrong even in the case of perfect credit ratings, leveraged incredibly the systems dependence on the human fallible credit ratings.

And now, more than three years into the crisis, the Basel Committee, FSB, FAS, Fed, IMF, World Bank, PhDs and finance experts, specialized journalists, like all those in FT, and most other who have and give opinions on the issue of bank regulations, have yet to say one single word about a mistake that really makes it impossible to construe any worthy bank regulation on top of it.

One really wonders what world we live in, when the regulators is turning our whole banking system sissy... and making it impossible for banks to allocate credit efficiently to the real economy.

PS. The monstrous mistake, which evidences our bank regulators have never walked on main-street, is that they believe what’s perceived as risky, is much more dangerous to our bank systems than what’s perceived as safe:  My 2019 letter to the Financial Stability Board 

Postscript: Basel Committee, please listen to Violet Crawley, don't be so defeatist, it’s so middle class. 

https://youtu.be/g9XQ3_LCl-Q

Fraulein Basel’s Chocolate Cake

There was once a family where mother father, elder brothers and sisters and, of course, the grandparents, all lovingly cared for the well-being of the youngest family member, little Bob. For instance, they always informed little Bob about the risks they perceived existed in park AAA when compared to those present in the riskier park BBB. But, that said, they were also very careful of not producing any undue temerity in little Bob, since, besides wanting him to grow up and become a daring man, and not remain a frightened boy, they also knew he needed to go and play in park BBB, quite often, because there was where he could get the exercise that could make him strong. All in all, little Bob was growing up nicely.

Unfortunately, one day the family hired a governess to watch out over young Bob, Fraulein Basel. She, scared stiff she would be blamed for anything bad that could happen to little Bob, promised him a whole chocolate cake every day, if he would only go and play in the super-safe park AAA. Little Bob, as any healthy young boy, was naturally thrilled with the idea, and thereafter visited only park AAA. But, after eating a whole cake every day, one day in park AAA, suddenly, out of the blue, an  extremely slow but yet venomous snake appeared, and little obese Bob could not run away, and so little Bob tragically died.

And that my friend is what happened to our banks when we placed them in the overly caring nervous hands of Fraulein Basel Committee. 

But now, more than three years into a crisis that has caused so much misery around the world, we have yet to hear the World Bank and the IMF or anyone else for that matter commenting on the role of Fraulein Basel’s stupid chocolate cake. 

And our banks are still in Fraulein Basel hands even though we know she has not abandoned the stupid idea of the chocolate cake, and thinks it is only a matter of a better chocolate cake, Basel III; which she will soon present to another little Bob… or Hans… or Pedro… since her reach is global.

Translation: The mother of all regulatory mistakes

The Basel Committee even though they knew that banks were already considering the information on risks of default when they calculated the risk premiums and set the interest rates, decided to use that same risk information to set their capital requirements. Of course, considering the same risk information twice, exposed the bank more than ever to the very real possibility of that risk information not being perfect.

That stupid and unforgivable mistake resulted in: 

1. The setting of minimalist capital requirements that served as growth hormones for the ‘too-big-to-fail’. 

2. That banks overcrowded and drowned themselves in shallow waters, whether of triple-A rated securities backed with lousily awarded mortgages to the subprime sector, or of equally or slightly less well rated “infallible” sovereigns, like Greece. 

3. A serious shrinkage of all bank lending to small businesses and entrepreneurs, as lending to these generated, in relative terms, much higher capital requirement, which made it difficult for them to deliver a competitive return on bank equity.

And the dumb regulators have still not understood, that you do not regulate banks based on perceived risks, but based on what banks might do with perceived risks.

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."

A sort of a shoddy investigation!

I refer to the “Wall Street and the Financial Crisis: Anatomy of a Financial Collapse” report by the Senate Permanent Subcommittee on Investigations. It is a sort of shoddy investigative work. Why?

On April 28, 2004 the Securities and Exchange Commission authorized the investment banks to dramatically increase their leverage, among other when investing in securities backed by mortgages to the subprime sector. The SEC resolution establishes the explicit condition that it has all to be done “consistent with the Basel Standards”.

The Report of 650 pages, does not mention the Basel Committee once!

And why do the Basel Standards, issued by the Basel Committee matter? The answer is simple; it was the Basel Committee which produced and disseminated the regulatory mistake that caused this crisis. Here follows a very brief description of that fatal mistake.

The Basel Committee’s mistake

If all sovereign and private bank clients were paying the banks exactly the same risk-premiums, then the risk-weights used in Basel II to apportion the basic capital requirements for banks according to the various categories of credit ratings could have been right. But, they don’t!

The banks and the markets already incorporates in the setting of their risk-premiums the risk information provided by the credit rating agencies, and so when the regulators also used the same credit ratings for setting their risk-weights they made these ratings count twice. That huge mistake resulted in:

1. The setting of minimalistic capital requirements that served as growth hormones for the ‘too-big-to-fail’.

2. That banks overcrowded and drowned themselves in shallow waters, whether of triple-A rated securities backed with lousily awarded mortgages to the subprime sector, or of equally or slightly less well rated “rich” sovereigns, like Greece.

3. A serious shrinkage of all bank lending to small businesses and entrepreneurs as lending to these generated, in relative terms, much higher capital requirement, which made it difficult for them to deliver a competitive return on bank equity.

With Basel III, regulators might be trying to correct for this mistake, instead of correcting the mistake. In other words, the Basel Committee is digging us deeper in the hole where they placed us.

The Shocking Basel II Discrimination

The market, looking at all risk information, which includes that of the credit rating agencies establishes some risk premiums that will make lending to different perceived risks equivalent. But then tha Basel II regulators made the mistake of using the same information provided by the credit rating agencies by mean of the risk-weights they applied and in doing so discriminated excessively in favor of what was officially perceived as having a very low risk of default. the AAAs. The following table illustrates the gigantic magnitude of that regulatory anti-risk-bias for a figurative example of how the market could be viewing a  AAA risk versus a Not Rated risk:

Is “Inside job” doing an inside job on us?

“Inside Job” the Oscar winning documentary on the financial crisis that has put the global financial stability in jeopardy touches upon most issues and actors involved, spending even several minutes of the role of cocaine and prostitutes. Yet, amazingly, it does not mention even once the Basel Committee for Banking Supervision, the global bank regulator and that in my opinion is the one most to blame for the crisis.

Should it? In one of the opening scenes of “Inside Job” refers to the Securities and Exchange Commission’s meeting on April 28, 2004 when the SEC authorized the investment banks to dramatically increase their leverage, among other when investing in securities backed by mortgages to the subprime sector. That SEC resolution explicitly made an explicit reference that it has all to be done “consistent with the Basel Standards”.

Is “Inside job” doing an inside job on us?

The Basel Committee makes a shocking confession!

The Basel Committee for Banking Supervision, speaking for all sophisticated bank regulators around the world, issued today an urgent statement regarding the discovery of a fundamental mistake committed in Basel II and which they now understand was responsible for causing the current financial crisis.

The mistake was that though the markets and the banks were already incorporating the information about the possibilities of default that were contained in the credit ratings when calculating the corresponding risk premiums to set interest rates for their clients, the regulators based the capital requirements for banks on exactly the same credit ratings, and so, unwittingly, accounted for said credit information twice.

The result of it was, of course, the excessive financing of everything that was officially deemed as having a low risk of default, like whatever had swell ratings like Greece and securities backed by lousily awarded mortgages to the subprime sector; and the insufficient financing of whatever was officially deemed as more risky, like the small businesses and entrepreneurs who are vital for maintaining that dynamism of the economy that creates jobs.

The Basel Committee expresses its most sincere regrets for such a mistake and promises to take immediate corrective action.

PS. April Fool´s joke disclaimer: Sorry, unfortunately, the Basel Committee and the sophisticated bank regulators, three years into a crisis of its own making, are still not (publicly) aware of their mistake.

The Independent Evaluation Officer of the International Monetary Fund has recently in an Evaluation Report come to the conclusion that, for IMF at least, “the ability to correctly identify the mounting risks was hindered by a high degree of groupthink…” The reason why the truth of what happened does not come out must probably now be attributed to group-interests.

What Lord Turner hasn´t the foggiest about!

Since the 8 per cent capital requirement of Basel II and applied with a risk-weight of 100 per cent proved to be more than sufficient to cover for the risks of bank lending or investing in what was officially perceived as “risky”, it is clear that the problem does not lie with a too low basic capital requirement but with the too low risk-weights applied to all what is officially perceived as “not risky”.

This is what a Mr. Lord Turner, who now says “security can only come with 15 to 20 per cent” capital requirements, hasn´t the foggiest about.

Mr. Lord Turner also says “Financial instability is driven by human myopia and imperfect rationality” Absolutely! But when is he going to realize that the regulator´s myopia, including his own, might be the most systemically dangerous.

Our banks… a bad road leading from nowhere to nowhere!

A road can be extremely well constructed but lead from nowhere to nowhere. That is why it so extraordinary that we allow the global regulators in the Basel Committee to regulate our banks without defining a purpose for our banks. That said, since the Basel Committee proved that it was not even good at regulating basic road engineering, we now have a bad road coming from nowhere and leading to nowhere.

Let me explain why besides lacking a purpose, the regulations of our banks are so lousy.

The only risk the regulators considered in order to set the capital requirements for the banks in Basel II was the risk of default of their clients, mostly as this was perceived by the credit rating agencies. The higher the perceived risks, the higher were the capital requirements and vice versa.

The above though sounding logical completely ignored that the market already arbitrages for the information provided by the credit rating agencies about risk of defaults, by means of adjusting the risk-premiums it applies. Therefore, the unforeseen but should have been foreseen results of these capital requirements based on risk, was to dramatically increase the risk-adjusted return on bank capital when lending to anything perceived as “not-risky”, while making it, in relative terms, dramatically much less attractive to finance anything officially perceived as “risky” and that for its same adjusted risk premium requires more bank capital.

No wonder that the banks stampeded into the triple-A rated waters where, since real triple-As are and will always be extremely scarce or non-existent, the market had provided some Potemkin triple-A ratings.

The only real Black Swan event that caused this crisis was that amazingly inept regulators got hold of the Basel Committee… and the most amazing thing is that they are still there!

Is the USA now a submerging country?

"Are America's Best Days Behind Us?" by Fareed Zakaria in Time of March 3, 2011

Risk taking is the soul and essence of a country emerging, growing and moving forward. Risk-aversion is the natural reflection of a country that has had enough.

When the USA, which proudly refers to itself as “the land of the free and the home of the brave”, decided that their banks, their frontline of risk-takers, were going to be allowed to have immensely less capital when dealing with what was perceived as “not risky”, like what’s dressed up in triple-A ratings or lending to the government, than when lending to their small businesses and entrepreneurs, then the USA called it quits, and placed itself on the slippery slope of going down and down… fast or slow… but submerging.

The first thing the banks did was then to obediently go and massively enter the triple-A rated waters, where the sharks of the real economy where waiting for them… If that is not submerging what is?

Plenty of houses yes, but with good citizens living in them

(A letter to the Washington Post - that was not published)

Though not a US citizen but nevertheless a dependent on the strength and well being of the USA, as most of us in at least in the western world are, I have with sadness observed how much unethical behavior, from both sides, has taken over what should be the almost sacred relation between a debtor and a creditor.

This is extremely worrisome since the relation that exists between debtors and creditors constitutes a fundamental building block of a nation; and few of these are as important as those which relate to a mortgage which often constitute the major financial commitment a citizen has during his life.

In this respect I need to comment that the government’s recently announced plan to reform America´s housing finance market, though otherwise a well thought document, does unfortunately not begin by defining clearly what debtor-creditor relation is aspired, and so any reform might therefore risk to derail into the wrong direction.

For instance, if one considers, as I most definitely do, that a debtor should have the right to always be able to identify exactly who he undividedly owes his money to, this would not hinder all securitizations, but it would certainly prohibit the most extravagant forms of it, where for instance a mortgage is sliced and diced in so many pieces that no one can puzzle together and that are often even send off to a land where they don´t even speak English.

I sincerely hope that in the process of this reform someone gets down to defining early and correctly the relation I refer to, because in the long run it is better for a nation to have good citizens without houses than bad citizens dwelling in mansions.

The regulators, the banks and the sharks and their baits

The world’s bank regulators in the Basel Committee, assumed with unbelievable hubris the role of risk managers of the world; ignoring that perceived risks are not dangerous to the system, only those not-perceived are, authorized the banks to leverage their capital 60 times or more, when investing in or lending to anything related to a triple-A rating.

As should have been expected, the banks, carrying the minuscule life-vests ordained, in pursuit of easy profits, huge bonuses and too big to fail growth rates, entered massively the triple-A rated waters … where the sharks has baited them some triple-A rated securities collateralized with lousily awarded subprime mortgages paying juicy interests… and a true bloodbath ensued.

The saddest part of the story though, is that our banks are still regulated by the same regulators using precisely the same tools applied the same way… just more of it.

We need bank regulators who do not believe themselves the risk-managers of the world

I refer to the Financial Crisis Inquiry Final Report, issued January 2011 by The National Commission on the Causes of the Financial and Economic Crisis in the United States.

Unfortunately, though it contains much valuable information and analysis, the report does not identify the fundamental cause of the crisis, namely that the bank regulator, primarily the Basel Committee, with amazing hubris, took upon itself to act as the risk-manager of the world.

In effect, when the Basel Committee set capital requirements for banks imposing risk-weights based on its arbitrary perception of the risk reflected by the credit ratings issued by the credit ratings agencies, it de-facto determined what was to be ground zero for most other risk-managers. 

In effect, it was precisely those capital requirements for banks that tempted too much the banks to enter excessively and with minuscule equity life vests the triple-A waters, where they drowned.

In effect, those arbitrary capital requirements cause an odious and regressive discrimination requiring from those perceived as risky and who already pay higher interests rates, to carry an inordinate weight of the capital requirements of banks that is needed to support the system; effectively subsidizing those perceived ex-ante as having “low risks” and who therefore already pay lower interest rates.

In effect, from a regulatory point of view those capital requirements based on perceived risks, are plain silly, knowing that what causes systemic disasters in banking are always those risks that have not been perceived or are ignored by the collective.

It is very urgent we throw out the paradigm of capital requirements for banks based on perceived risk of default, which only distorts the markets and serves no purpose at all. But that will not happen until the problem is fully understood, and sadly it looks like, with this report, that the world missed another good opportunity.

PS. Sadly the Academia has kept total silence on how these regulations have dangerously distorted the allocation of credit.

Old Lady, careful, the “risky” should not be asked to bear the risks of the “not risky”.

Bank of England economist David Miles has suggested that UK banks should hold double the amount of capital than that prescribed by Basel III.

Of course Old Lady (Bank of England) is right in that the capital requirements for banks should be doubled and more… but only for those loan and investments where they have been proven insufficient… like all those operations which included triple-A ratings and where the risk-weight applied was a minuscule 20%.

But, for all those operations where the risk-weights were 100%, like when lending to “risky” small businesses and entrepreneurs, the capital requirements have proven more than sufficient… and should not go up one iota…that is unless one holds that those perceived as “risky” should subsidize the capital requirements needed to support those perceived as not risky. Does Old Lady think that? I don’t think so… but I am not sure they are aware of this argument.

We need to fire the self appointed supreme risk manager of the world!

When the Basel Committee on Banking Supervision decreed capital requirements for banks that resulted from assigning risk-weights based on the risk of default, as perceived by the credit rating agencies… with incredible hubris they took upon themselves to act in the role of supreme risk manager of the world.

How have they been doing? Worse than lousy! Basel II failed monumentally only 3 years after its approval in June 2004.

As an Executive Director in the World Bank, 2002-2004, and in many published articles since 1997, I protested loudly the regulatory paradigm that the Basel Committee is built upon, and I warned precisely about those risks that caused the current crisis.

With whatever credibility that should give me I guarantee you that the Basel Committee, with their Basel III, is only digging us and our banks further down into the hole where they placed us.

The role of a bank regulator is not to guard us against those risks of default perceived by credit rating agencies, and which are therefore also perceived by the markets and by the banks. No bank crisis has ever resulted from excessive lending or investments in what is perceived as risky… they have all resulted from excessive lending or investment in what was ex-ante perceived as not risky. Therefore the fundamental role of a bank regulator is to take precautions against those risks that might not have been perceived.

The role of a bank regulator, more than guard us against bank failures, is to guard us against the risk that the banks and whom the tax payers lend so much support to, do not serve their purpose for the society… and the Basel Committee has not yet said even one single word about what the purpose of the banks should be.

Let absolutely no one regulate before they do state the full purpose of the entities they are regulating… and that “purpose” has of course been deemed acceptable to us.

The principle of bank regulations that has been and is so rudely violated

Regulators should accept that bankers believe they can master quite adequately the risks of default. Who would want to deal with a banker who does not believe so?

But in the same vein the regulators should always tell the bankers “No you can’t… and besides there are so many other risks to be considered than just avoiding the defaults of your clients and the defaults of yourselves”.

And foremost regulators should never ever themselves become risk-managers… a principle that was and is so rudely violated.

It is bad enough when regulators fall for the sales pitch of bankers and believe too much in their risk-management ability, but so much worse when the regulators arrogantly believe, as they currently do, that they know themselves what the risks are and that they know themselves how to properly manage and master these… with or without a little help from the credit rating agencies.

A credit rating sends out on its own a very positive or negative signal to the market. When regulators based the capital requirements of banks on those same credit ratings, they dramatically augmented the strength of those signals… to such an extent that banks went and drowned themselves in triple-A rated waters wearing no capital at all… to such an extent that lending to the “risky” small businesses and entrepreneurs has come to a halt because that requires too much capital, especially when bank capital is very scarce as a result of having invested or lent too much to the ex-ante “not risky”.

Currently the regulators, who like risk-managers already failed in conquering some simple risks of defaults, when foolishly playing around with their capital requirements based on perceived risks, and ignoring that systemic crisis never ever results from timely perceived risks, are now tackling more God-like events like pro-cyclicality. God help us!

The bank crisis and the Basel Committee banking regulations explained to a golfer

Once there was a Golf Club with a somewhat narrow golf course and where, even though the members were very careful, sometimes the hooking or slicing of the golf balls into adjacent holes, caused some serious accidents.

The Club’s Board was ordered to find a solution. To that effect the elected members of the Board consulted with some Experts and asked for recommendations. The Experts told the Board “most of the slicing and hooking is the product of bad players and so, if you want to solve this problem, you need to get rid of them”. Knowing this idea would not be received with much enthusiasm, and could in fact pose a direct threat to their reelection as members of the Board, they all decided to immediately delegate the “how to” to a Committee of Experts.

The Committee of Experts decided they needed to appoint some Golf-Player Rating Agencies (GPRAs) to rate the real quality of the players and thereafter created a parallel handicap adjustment requirement that effectively eliminated the bad players… without these even noticing it. According to their ratings, the AAA rated players had their normal handicap increased by 5 strokes, while the players rated B- or worse had their normal handicaps officially reduced by 5 strokes.

It worked! Though, just initially… Since having to play with a very low handicap was pure hell for a bad player, most of the bad players rapidly decided to change clubs and, as a result, the Club gained immense recognition for having the best players and being the safest club in the country… and the Committee of Experts was wildly acclaimed for having true experts. We will never ever have more accidents in our Club… was the Board’s self congratulatory message at the year’s end… four years ago.

But life is life, even among golfers, even in a golf club… and so the membership of the Club started changing. For instance, many great golfing has-beens around the country were attracted by a system that so clearly could help to pro-cyclically prolong their golf-life, just like many never-able-to-be-good players were also attracted by the possibility of joining a club renowned for having exclusively good golf players… and so they all started to read up and converse with the GPRAs about what was necessary in order to be conveniently rated.

There was such an avalanche of enquiries that the GPRAs got confused and overworked and started to make mistakes… to such an extent that the Club rapidly became overcrowded with dubiously rated golf-players. This would, of course, not have meant anything in the old days, but, since everyone had been duly informed that the accidents had been forever eliminated and that therefore there was no need for being careful… the accident rate shot up and rapidly turned, three years ago, into a pandemic disaster that threatens even the survival of the Club… and aggravated by the fact that the beginners and the decent-bad players, those who really are the heart and soul and economical support of a golf club, want nothing to do with a club that has a handicap system that so harshly discriminates against them, and have therefore joined other clubs.

But, golfing friends, the saddest part of this story is that since the logic of “getting rid of bad players and allowing only good players” sounds so very attractive and so very logical, the Board has not even today understood what they did wrong and so they insist on using exactly the same Committee of Experts to come up with better solutions. And the Committee of Experts is currently studying only refinements of their original handicap adjustment requirement formulas because, as “experts”, they cannot under any circumstances acknowledge that they were so fundamentally wrong.

And, unfortunately, the local media has not been sufficiently “without fear and without favour” to dare to really fundamentally question the wisdom of the local Club´s Board or of the Committee of Experts.

PS. What if golf, roulette, horse-racing or tennis had fallen into the hands of a Basel Committee?