Current regulators in the Basel Committee, and in the Financial Stability Board need to be fired!

Bankers are expected to guard the front door from all expected losses entering their business, and this they do by means of interest rates, size of exposures and other terms. Though sometimes one or another banker fails in doing that, in general, as a system, they perform quite well.

But the banker cannot guard the back-door, that of the unexpected losses too, because were he to do so, he would not be able to attend competitively his ordinary business at the front door.

And so it is the regulators’ responsibility to make sure that the back door is sufficiently guarded. Unfortunately, current regulators, explicitly for reasons of simplicity, stupidly decided to guard against unexpected losses, with a wall which height was determined based on the perceptions of expected losses.

And to top it up, also explicitly for reasons of simplicity, they decided And that means that “expected losses” are considered twice, while the “unexpected losses” are ignored.

And that means that the banking system overdoses on perceptions of expected losses, something which make it impossible for banks to allocate credit efficiently in the real economy.

And that means that when some unexpected losses occur, usually in assets previously deemed as safe, the risk of banks not having sufficient capital has dramatically increased.

The leverage ratio, that which is not based on risk-weights, was to partially solve one problem, though of course that of the distortion would remain, as other risk-weighted capital requirements would still be in place.

But the way the Basel Committee seems now proceeding to dilute the leverage ratio, seemingly even introducing risk-weighting for off-balance sheet items, while if something needed to be diluted was the discriminations produced by risk-weights, is evidence that the regulators really do not know what they are doing. And it therefore behooves us to fire them… urgently.

An alternative "Abstract" for my paper

The expected losses of a bank should normally be covered by its operations. The capital requirements are imposed by regulators primarily to cover for the “unexpected losses”.

But the risk-weighted capital requirements of Basel II and III have nothing to do with “unexpected losses” and all to do with a double counting of “expected losses”.

In fact an “Explanatory note of the risk weights function” July 2005, clearly spells out that: 

Because “Taking into account the actual portfolio composition when determining capital for each loan - as is done in more advanced credit portfolio models - would have been a too complex task for most banks and supervisors alike… The model [is] portfolio invariant and so the capital required for any given loan does only depend on the risk of that loan and must not depend on the portfolio it is added to”

In other words, a bank portfolio with extremely dangerous concentrations in what ex ante is perceived as “absolutely safe” will be deemed much safer than an extremely well diversified portfolio of assets perceived as “risky”.

And the note explains: “In the context of regulatory capital allocation, portfolio invariant allocation schemes are also called ratings-based. This notion stems from the fact that, by portfolio invariance, obligor specific attributes like probability of default, loss given default and exposure at default suffice to determine the capital charges of credit instruments. If banks apply such a model type, they use exactly the same risk parameters for expected losses (EL) and unexpected losses (UL), namely probability of default (PD), loss given default (LGD) and exposure at default (EAD).”

And so in fact there is never a provisioning for unexpected losses, but only a double provisioning for expected losses. 

The net result of these capital requirements are then that banks will be earn a much higher “perceived risk” adjusted return on equity when lending to those perceived as “safe” than when lending to those perceived as “risky”. And that causes a huge regulatory discrimination in favor of those perceived as “absolutely safe” and against those perceived as “risky”.

And all this the Basel Committee has done even admitting to that “intuition tells that low PD borrowers (safer) have, so to speak, more “potential” and more room for down-gradings than high PD (riskier) borrowers”. 

But, instead of considering this larger unexpected loss potential in the capital requirements, they postpone any adjustments to the moment of when a downgrading occurs, completely ignoring that a downgrading is nothing but the unexpected increase of expected losses.

This regulatory mistake, by pushing excessive bank credit to what was perceived as “absolutely safe” caused the current crisis, and by not allowing for sufficient bank credit to flow to the "risky", impedes us from getting out of the crisis.

PS. The current version of the paper

The Basel Committee incorrectly assumes “The Risky” will cause more “unexpected losses” than “The Infallible”

A discussion on a blog with someone who insisted that it is ok for the current capital requirements for banks to be higher for those perceived as risky that for those perceived as absolutely safe “because of the volatility”; and called me stupid because I “appear not to understand the whole concept of expected and unexpected losses” made me realize that I had to clarify again The Great Basel Committee Mistake… namely that Basel II (and III) base the capital requirements for banks, those which are to cover for the “unexpected losses”, on the “expected losses” derived from perceived credit risks.

“An Explanatory Note on the Basel II IRB (internal ratings-based) Risk Weight Functions” expresses: 

“The model [is] portfolio invariant and so the capital required for any given loan does only depend on the risk of that loan and must not depend on the portfolio it is added to.”

And the explicit reason for that mindboggling simplification was because it was: 

“This characteristic has been deemed vital in order to make the new IRB framework applicable to a wider range of countries and institutions. Taking into account the actual portfolio composition when determining capital for each loan - as is done in more advanced credit portfolio models - would have been a too complex task for most banks and supervisors alike.”

And which then leads to:

“In the context of regulatory capital allocation, portfolio invariant allocation schemes are also called ratings-based. This notion stems from the fact that, by portfolio invariance, obligor specific attributes like probability of default, loss given default and exposure at default suffice to determine the capital charges of credit instruments. If banks apply such a model type, they use exactly the same risk parameters for expected losses (EL) and unexpected losses (UL), namely probability of default (PD), loss given default (LGD) and exposure at default (EAD).”

And to justify their approach they write:

In the specification process of the Basel II model, it turned out that portfolio invariance of the capital requirements is a property with a strong influence on the structure of the portfolio model. It can be shown that essentially only so-called Asymptotic Single Risk Factor (ASRF) models are portfolio invariant (Gordy, 2003). ASRF models are derived from “ordinary” credit portfolio models by the law of large numbers. When a portfolio consists of a large number of relatively small exposures, idiosyncratic risks associated with individual exposures tend to cancel out one-another and only systematic risks that affect many exposures have a material effect on portfolio losses. In the ASRF model, all systematic (or system-wide) risks, that affect all borrowers to a certain degree, like industry or regional risks, are modeled with only one (the “single”) systematic risk factor

But suspecting they might be simplifying beyond reason, just in case, the Basel Committee added:

“It should be noted that the choice of the ASRF for use in the Basel risk weight functions does by no means express any preference of the Basel Committee towards one model over others. Rather, the choice was entirely driven by above considerations. Banks are encouraged to use whatever credit risk models fit best for their internal risk measurement and risk management needs.”

And this very flimsy approach, which ignores any correlation between unexpected losses, and shows very little concern with the problems of rapidly changing volatility, caused the Great Basel Committee Mistake of setting the capital requirements for banks, based on exactly the same perceived risks already cleared for.

In essence the regulators determined that a “risky” creditor, by the single fact of presenting more “expected losses”, also had to provide for more capital to cover for more “unexpected losses”. They never understood the hard truth that the safer something is perceived the greater its potential to deliver awful unexpected negative consequences.

And this the regulator did without absolutely any concern for how that could affect the efficiency of bank credit allocation in the real economy… something that can also be derived from the tragic fact that nowhere in the Basel Committee literature is there a word about the purpose of our banks.

And so they introduced an odious regulatory discrimination against those perceived as “risky”, something which introduces a dangerous risk-aversion, and, consequentially, introduces a favoring of what is perceived as “absolutely safe” that can only guarantee the dangerous overcrowding of safe-havens.

As perhaps the best example of what I am arguing is the absurdity of having what can really grow into dangerous excessive bank exposures, like the AAA to AA rated, being risk-weighted at 20%, while the totally innocuous below BB-rated, get a 150% risk weight.

    

In essence bank regulators have now ended up being the greatest systemic risk producers to the banking system. 

In short we do not need bank regulators, what we need are regulators who understand the banking system. 

In short we need regulators who understand that more important than looking at the portfolio of individual banks, is to look at the portfolio of banks in the whole banking system... and how it relates to the needs of the real economy.

Perhaps our bank regulators do not understand the possibility of a  "regression to the mean"

Did the "A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules" paper of 2002, by Michael B. Gordy, cause the downfall of our bank systems? Yes! It was an essential factor, but Gordy is not solely responsible for it... all those who sat there and did not understand one iota, and therefore never dared to question, are even more to blame.

Trying to understand the how come of the so loony bank regulations, by reading Daniel Kahneman’s “Thinking, Fast and Slow” 2011.

I hold that the current risk-weighted capital requirements for banks, more risk more capital, less risk much less capital, is sheer regulatory lunacy.

Fact: These are based on perceived risks which have already been cleared for by banks in interest rates, size of exposure, duration and other terms (the numerator). And so, re-clearing for the same perceived risks in the capital (the denominator) causes the risk price equation to go haywire. 

And that allows banks to earn much higher risk-adjusted returns on equity when lending to what is perceived as “safe” than on what is perceived as “risky”, making it thereby impossible for banks to efficiently allocate bank credit in the real economy. It instills an additional dose of unproductive risk-aversion in the banking system.

And it also guarantees that when something ex ante perceived as "absolutely safe", turns out ex post to be very risky, precisely the stuff all bank crises are made off, that banks will then stand there naked with no capital.

And so, how could regulators be so dumb? How could it be that so long after the 2007-08 crises exploded, this truly monstrous regulatory mistake is not even discussed?

Here, I will try to get to the answer to those questions by reading Nobel Prize winner Daniel Kahneman’s “Thinking, fast and slow” Farrar Straus and Giroux, 2011. I begin in “Part 3 Overconfidence”

But first I need to start with expressing one reservation with respect to the following which Professor Kahneman writes there in Chapter 19:

“I have heard too many people who ‘knew well before it happened that the 2008 financial crisis was inevitable’. This sentence contains a highly objectionable word, which should be removed from our vocabulary in discussions of major events. The word is, of course, knew. … [that] language implies that the world is more knowable than it is.”

In the sense that could be construed as a “nobody knew”, and could like the Black Swan story serve as an excuse for the regulators for not doing their job, I must strongly object to it, as we then will not hold them sufficiently accountable for their mistakes.

Professor Kahneman refers to an “outcome bias [that] makes it almost impossible to evaluate a decision properly – in terms of the beliefs that were reasonable when the decision was made… Actions that seem prudent in foresight can look irresponsibly negligent in hindsight.” 

Yes, but what when an action that should have been declared irresponsibly negligent in hindsight, survives as if nothing has happened? In our case the Basel III is just some tweaking of Basel II… and it hangs on to the risk-weighted capital requirements... as if nothing has happened.

Of course I had no idea that the crisis would happen in 2008, or where it would finally explode, but there could be no doubt that assigning so much regulatory importance to the already known and cleared for credit ratings, introduced a systemic risk that had to explode, somewhere somehow, sooner or later. 

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

But now back to the how comes of this post.

The first Great Explainer I find, chapter 20 is “The illusion of validity”. Professor Kahneman writes about how a good coherent story triumphs the absence and the quality of evidence… and, in this case, what could initially sound a more coherent story than “more perceived risk more bank capital (equity), less perceived risk less capital”?

In reality since all bank crisis have originated from excessive exposures to what was perceived as "absolutely safe", and none from excessive exposures to something perceived ex ante as “risky”, the truth is that, if anything, the capital requirements for banks should be higher for what is perceived as absolutely safe than for what is perceived as risky… but, Professor Kahneman, how the hell do you sell that storyline?

Another Great Explainer, chapter 20: “The illusion of validity and skill… supported by a powerful professional culture…. We know that people can maintain an unshakable faith in any proposition, however absurd, when they are sustained by a community of like-minded believers”.

Indeed that is when regulators are allowed to assemble in a mutual admiration club… like the one I protested in another letter in the Financial Times in November 2004.

(December 24, 2013) And in chapter 21 in “intuitions vs. formulas” we read how, when there is “a significant degree of uncertainty and unpredictability” then, in terms of explicatory powers, “the accuracy of experts was matched or exceeded by simple algorithms”. One possible explanation for that, provided by Paul Mehl, is that experts “try to be clever” and “feel they can overrule the formula because they have additional information”. And some examples of powerful algorithms are provided like the five variables rule developed by Dr. Virginia Apgar to determine whether a new born baby was in distress.

But this chapter does really not provide me with much explanation with respect to the regulations I object. This is first because I feel that in this case we are not really in the presence of real experts who possess the minimum intuitions required, and secondly the formula itself, the risk-weighting, is just a very bad formula.

How can I explain it? Perhaps saying that an expert bank regulator should have started by defining a purpose for the banks, and then analyzing the risks and whys and consequences of a banks failing while pursuing that purpose, and not, as has been done by just analyzing the risks of the clients of a bank failing, and which of course is far from being the same.

But yes “do not try to be too clever” is always a good recommendation for any regulator, and yes, that our current bank regulators start from the premise of them being very clever, is hard to doubt. The 30 pages of Basel I are by means of Basel III and Dodd-Frank Act, evolving into ten thousand of pages of regulations.

And yes I bet one formula, one single capital requirement for any type of bank asset, is a superior formula… and so do not tell me I harbor a “hostility to algorithms”. What I really do feel hostility against, is for regulators to dig us even deeper into the hole where they have placed us.

(December 25, 2013) Chapter 22: “Expert intuition: when can we trust it?” Professor Kanehman holds that an expert’s intuition can only be trusted if the area of expertise in question contains “an environment that is sufficiently regular to be predictable”, and if the experts have had “an opportunity to learn these regularities through prolonged practice”

Considering bank regulations not only as firefighting but within a complete framework of how banks help to finance the growth and the strengthening of the real economy, in other words the mystery of development, the answer must of course be a rotund NO! There is just too much involved for it to be predictable.

But even in the case of bank regulation designed only to stop bank failures we would have to answer with an equally rotund NO!, the question of whether regulators in the Basel Committee and the Financial Stability Board had sufficient expertise. 

Kahneman writes: “The acquisition of expertise in complex tasks such as… firefighting is intricate and slow because expertise in a domain is not a single skill but rather a collection of miniskills”, and I sincerely doubt that persons such as Stefan Ingves, Mark Carney, Mario Draghi, Ben Bernanke have had many specific experiences of bank failures which they have managed and even more importantly understood.

In short this chapter only reinforces the concerns I referred to in an Op-Ed which I wrote in 1999: “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 its collapse”

If Professor Kahneman was asked whether it was reasonable and wise to vest so much regulatory power over our banks in the hands of some few “experts”, I suspect he would express serious doubts.

December 26. 2013. Chapter 23. “Irrational perseverance” “sunk-cost fallacy” Professor Kahneman recounts an experience: “If pressed further I would have admitted that we had started the project on faulty premises and we should at least consider the option of declaring defeat and going home. But nobody pressed me…..we had already invested a great deal of effort… It would have been embarrassing for us… I can best describe our state as a form of lethargy – an unwillingness to think about what had happened. So we carried on."

And this describes a lot of why, after the clearly evident failures of Basel II, we now have basically the same failed regulators, using basically the same “risk-weighted capital” script, producing, directing and acting in a Basel III, as if nothing has happened. Neither Hollywood nor Bollywood would be so dumb, so as to follow up a huge box-office flop without major revisions. 

December 31, Chapter 24. Professor Kahneman refers to an extremely interesting idea suggested by Gary Klein to combat dangerous overconfidence, “The premortem”… “Imagine that we are a year into the future. We implemented the plan as it now exists. The outcome was a disaster. Please take 5 to 10 minutes to write a brief history of that disaster” “The main virtue of the premortem is that it legitimizes doubts” Otherwise “public doubts about the wisdom of the planned move are gradually suppressed and eventually come to be treated 

If regulators had done that with Basel II…can you imagine if someone in his premortem had written that the crisis was a direct result of clearing for the same risk twice, which would cause banks earning higher risk adjusted returns on equity on what was perceived as absolutely safe, which distorted the allocation of bank credit to the real economy?

Can you imagine if someone in his premorten had written…”And there stood all the banks in the world, on with all that exposure to that AAA rated, against almost no capital… and the unexpected happened”?

Can you imagine if someone had written…”And since therefore no bank financed “the risky”, those who help to build the future, the real economy was placed in a death-spiral that brought the banks down.

As is, the faults with the risk-weighted capital requirements are not even recognized in the postmortem

(January 4, 2014) Chapter 17, “Regression to the mean”

The expected losses of a bank should normally be covered by its operations. It is to cover the “unexpected losses” for which regulators primarily require banks to hold capital.

And the Basel Committee has defined that the capital requirements for banks should be higher for what is considered “risky” than for what is considered as “absolutely safe”. 

That has always sounded wrong to me, as it is in the sector of the “absolutely safe” that the most unpleasant unexpected events roam.

In fact if something is considered 100% risky there should be 0% unexpected losses, but if something is considered 0% risky, the unexpected losses could be 100%. 

And why current bank regulators, even when faced with a crisis derived from unexpected losses in what was considered “absolutely safe” do not even want to discuss my arguments, has always been a mystery to me.

But reading chapter 17 it occurs to me that one explanation is that regulators do simply not understood the meaning of regression to the mean, and the fact that the timing of any unexpected result should not be perfectly correlated with, for instance, recent credit ratings. 

And that might be explained by “our mind is strongly biased towards casual explanations”, and what is more casual than “risky is risky and safe is safe and there´s no more to that!” 

(January 15, 2014) Chapter 31, Risk Policies, “Broad or Narrow?” Professor Kahneman writes.

“These attitudes make you willing to pay a premium to obtain a sure gain rather than to face a gamble, and also willing to pay a premium (in expected value) to avoid a sure loss”.

Could that translate into… bank regulators were willing to pay a premium to make sure banks did not fail, and were also willing to pay a premium to avoid a sure bank failure?

If so could that be the reason for which regulators failed to identify the benefits of bank failures, namely just that they were willing to take risks?

I am not sure. Perhaps they did so in a subconscious way. But, consciously?, I am sure they were and are not even aware of what they are doing with their excessive risk aversion... that of banks must not fail.

How different our world would be if regulators had set as an objective, for instance… in order to insure that sufficient risk taking is taking place 1-2 percent of the banks should fail yearly.

And I will keep on commenting here...

The more I think of it I come to the conclusion that “more-risk-more-equity and less-risk-less-equity”, is such a powerful System 1 intuition so it stops System 2 deliberations rights in its tracks and does not allow these to begin.

How can we measure at what moment an intuition turns into such an overpowering prejudice that it blocks all deliberate decision making?

Mr. Alan Greenspan… tell us the story… why were your legitimate concerns waived… what really happened?

In 1998, celebrating the tenth anniversary of the Basel Accord Alan Greenspan gave a speech titled “The Role of Capital in Optimal Banking Supervision and Regulation”, FRBNY Economic Policy Review/October 1998”. Three comments stand out:

First: “It is argued that the heightened complexity of these large bank’s risk-taking activities, along with the expanding scope of regulatory arbitrage, may cause capital ratios as calculated under the existing rules to become increasingly misleading. I, too, share these concerns”

And there was Greenspan only referring to the measly 30 pages of Basel I… and so how on earth, with this type of miss-feelings, can we now have arrived to our tens of thousands of pages of Basel III and Dodd-Frank Act?

Second: “regulatory capital arbitrage… is not costless and therefore not without implications for resource allocation. Interestingly, one reason that the formal capital standards do not include many risk buckets is that regulators did not want to influence how banks make resource allocation. Ironically, the one-size-fits-all standard does just that, by forcing the banks into expending effort to negate the capital requirement, or to exploit it, whenever there is a significant disparity between the relatively arbitrary standard and internal, economic capital requirements.” 

And so here if the implications for resource allocation (of bank credit in the real economy) is considered as an issue… how on earth did they go from some risk-weights depending of the category of assets, to something even so much distortive for resource allocation as risk weights depending on credit ratings?

Third: “For internal purposes, these large institutions attempt explicitly to quantify their credit, market and operating risks, by estimating loss probabilities distribution for various risk positions. Enough economic, as distinct from regulatory, capital is then allocated to each risk position to satisfy the institution’s own standard for insolvency probability.”

And so what happened to the distinction between economic and regulatory capital? Is it not so that a regulator´s real problem begins when the economic capital is miscalculated by the banks? If so, why the hell would he then want to calculate regulatory capital as it was economic capital?

No I am sorry… Alan Greenspan… as well as his successor Ben Bernanke… and of course all the other regulators like those in the Basel Committee and the Financial Stability Board… they will have a lot of explanation to do… when history finally catches up on them.

And I would certainly not want to be in their shoes. “Daddy why was grandfather so dumb? … It is because of his stupid regulatory risk aversion that banks stopped financing the future and only refinanced the past, and which is why I and my friends now do not have jobs.”

Can you imagine regulator XXX, academician XXX or financial journalist XXX... to be so dumb?

Can you imagine regulator XXX, academician XXX or financial journalist XXX... sincerely believes that if banks hold capital based on how risky their assets seem to be, then they are safe, as if the problems with banks do not all arise from when banks do not identify how risky their assets are.

In other words how could regulators base the capital requirements for banks on the perceived risks of bank assets, and as if these perceptions were correct, when their troubles begin when the perceptions of risks turn out to be incorrect?

Aren't they dumb? It is just amazing how we have allowed our banks to fall into their hands.

If your handy man was driving in a screw with a hammer, would you not be allowed to call him dumb and not knowing what he was doing? If so why can I not call bank regulators dumb?

ECB's ex-FSB's Mario Draghi, why base bank capital requirements on perceived risk when the problem is when those perceptions are wrong?

Financial Stability Board’s Mark Carney, why base bank capital requirements on perceived risk when the problem is when those perceptions are wrong? 

Basel Committees’ Stefan Ingves, why base bank capital requirements on perceived risk when the problem is when those perceptions are wrong?

My issue with the Anat R. Admati, Peter M. de Marzo, Martin Hellwig and Paul Pfleiderer, October 2013, paper.

The authors referenced have published a revised paper titled “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Socially Expensive”. I agree with much… except for…

The author states on page 9: “Another issue we do not elaborate on here is the current use of risk weights to determine the size of asset base against which equity is measured. As discussed in Brealey (2006) Hellwig 2010, and Admati and Hellwig (2013) this system is complex, easily manipulated and it can lead to distortions in the lending and investment decisions of banks.”

And that issue is too important to be set aside in the context of any discussion of bank equity, and what is said also leaves dangerous space for doubts. I have argued for years that risk weights, which effectively determine the capital requirements for banks against different exposures, even if not manipulated, do distort the allocation of bank credit in the real economy... and there should be no doubts about that.

If there is anything that with respect to the banking system has put our western economies on a downward slippery slope, that is not so much the problem of banks having too low capital requirements, but the issue of allowing banks to earn much much higher risk-adjusted returns on their equity on what is perceived as “absolutely safe”, than on what is perceived as “risky”. 

That guarantees the dangerous overpopulation of the “absolute safe havens”, and that the “risky-bays” our economies need to be visited in order to move forward… will be dangerously underexplored.

“The Infallible”, those with extremely low risk weights, 20% or less, comprise the infallible sovereigns, the AAAristocracy and the housing sector.

“The Risky”, those with 100% or higher risk weights, count among its ranks, medium and small businesses, entrepreneurs and start-ups.

That has made it more profitable for the banking sector, on risk adjusted terms, for instance to finance the houses where we are to live in, than to finance the job creation that will allow us to pay for the utilities.

That has made it more profitable for the banking sector, on risk adjusted terms, for instance to finance the King Johns of the world, than to finance the Robin Hoods and their friends.

The regulator (the neo-Sheriff of Nottingham) amazingly ignored (unless it was on purpose) that the ex ante perceived risks he considers in order to define the capital required (the denominator), are cleared for by banks and markets by means of interest rates, size of exposure, duration and other terms (the numerator). 

And so the regulator screwed up the whole risk price equation and caused banks to overdose on perceived risks… and funnily, if not so tragic, some still call all this a market failure 

The regulator, amazingly, instead of analyzing as a regulator why banks fail, analyzed, like if he was a banker, why the clients of the banks fail… and that, of course…c’est pas la meme chose.

On page 59 the authors write: “The use of risk-weighted assets for capital regulation is based on the idea that the riskiness of the asset should in principle guide regulators on how much of an equity cushion they should require” 

And that is precisely what is so nutty with the whole concept. The risk for the regulator is the bank, not its assets, and the prime risk for the bank is getting the risk-weights wrong.

In fact, for the regulators to really cover their real risk, capital requirements for banks should be higher for what is perceived as “absolutely safe” than for what is perceived as risky.

And, amazingly, the academic world, basically keeps mum on this almost criminal regulatory failure.

Please, can someone of you help to explain it all to the finance ministers around the world, to Congressmen, to all those who, naturally, do not understand one iota of the Basel Committee’s mumbo-jumbo

Performing the asset quality review of European banks will ECB’s staff have the guts to call out the mistakes of Mario Draghi?

If the European banks’ asset quality review is going to serve any real purpose, the ECB must dare to question everything.

Foremost that should mean not having to accept at face value those ludicrous low risk-weightings concocted by the neo-Sherriff of Nottingham, the Basel Committee, in order to induce banks to lend more and cheaper to the King John’s of Europe, and to its AAAristocracy; and to lend less to Robin Hood and his small businesses and entrepreneurial friends… while arguing all the time that this regulatory nonsense would make banks safer.

And so, in its review, ECB needs to identify the risk of all excessive exposures to any “absolutely safe assets”, like of the loans to the “infallible sovereigns”. 

And ECB also needs to identify all those really productive European “risky” bank assets, like loans to small businesses and start-ups, and that should have been on bank balances, but unfortunately are not... only because these have basically been prohibited by the regulators senseless risk adverse risk-weighted capital requirements.

But Mario Draghi, the current President of the ECB, was also for many years the chair of the Financial Stability Board; and is therefore very much to blame for these very wrong incentives given to the banks… those that signified that banks could earn much much higher risk-adjusted returns on their equity when lending to "The Infallible" than when lending to "The Risky".

And so do you really think ECB's staff  will dare get down to the truth? Even if that truth implies their ECB’s boss credentials are not good? Or will they still try to leave Europe in blissful ignorance of why Europe is going down, down, down... as it is giving the incentives to avoid keeping taking the risks which made it into what it is.

Can you imagine? XXX does not understand…

… how the risk-weighted capital requirements for banks completely distorts the allocation of bank credit in the real economy.

Let me try to explain it to XXX again.

If there was no risk weighing of Basel II’s 8 percent capital requirements for banks, then the banks would allocate their credit in the real economy, based on who produces the highest risk-adjusted return on eight units of bank capital for each 100 units of loans. 

But there is risk weighing in Basel II, and so banks allocate their credit, for instance to the private sector, in terms of:

For those rated AAA to AA, risk weight of 20%, based on who produces the highest risk-adjusted return on 1.6 units of bank capital for each 100 units of loans.

For those rated A+ to A, risk weight of 50%, based on who produces the highest risk-adjusted return on 4 units of bank capital for each 100 units of loans.

For those rated BBB+ to BB-, and those unrated, risk weight of 100%, based on who produces the highest risk-adjusted return on 8 units of bank capital for each 100 units of loans.

For those rated AAA to AA, risk weight 20%, based on who produces the highest risk-adjusted return on 1.6 units of bank capital, for each 100 units of loans.

And so of course those perceived as “safer” produce banks much higher risk-adjusted returns on their equity than those perceived as riskier.

And that of course causes banks to lend more than what they should to those perceived as “safe”, like the “infallible sovereign” and the AAAristocracy, and much less, sometimes even nothing, to those perceived as “risky”… like to medium and small businesses, entrepreneurs and start-ups.

But, amazingly, XXX has not understood that this completely upsets the price-risk equation in the markets, and thereby, as said before, completely distorts the economically effective allocation of bank credit in the real economy.

What are we to do with XXX? XXX is though a very influential figure… and too many find it so difficult to believe XXX could really have been so wrong.

And what is history going to say about, for instance Europe, falling into the hands of nerdy sissies who cannot understand that what is safe today, is the result of a lot of risk-taking yesterday, and that our children and grandchildren has the right to expect from this generation, to also incur in its share of risk-taking… so that they too have a future and decent jobs.

PS. And to top it up, all for no good reason, since all big bank crises have always resulted from excessive exposures to what was ex ante perceived as “absolutely safe”… and none because of excessive exposures to something ex ante perceived as “risky”.

The mother of all market rigging is carried out by regulators in the allocation of bank credit to the real economy.

And we read about some calling for more disclosure on foreign exchange market rigging.

Forget it! If anyone should ask about more disclosure, that should be those borrowers who had the access to bank credit rigged against them by the regulators, only on account of them being perceived as “risky”, and this even though they already had to pay higher interest rates, get smaller loans and accept harsher terms, precisely because they are perceived as risky.

And this is how the rigging was carried out.

Before current Basel Accord inspired bank regulations came into effect a bank looked at how to maximize the return on equity by analyzing the lending all over the spectrum of perceived risks… and that is what can lead to an efficient allocation of bank credit in the real economy. 

Not now, with the Basel Committee's risk weighted capital requirements. Now banks evaluate the returns on loans to the AAA rated, in terms of holding only 20 percent of the basic capital requirement, while when evaluating the competing return offered by a loan to a “risky” small business, and entrepreneur or a start-up, it must use 100 percent of the basic capital requirements. And, if lending to an “infallible sovereign”, then it can basically measure its returns on zero percent of basic capital requirements.

And perhaps what is the saddest of it all, might be that the bank regulators are not even aware of that this is rigging the access to bank credit all in favor of "The Infallible" and all against "The Risky"... those risky who act on the margins of the real economy and who we most want to have access to bank credit in competitive terms.

Damn these sissy regulators. God, make us daring!

Europe’s unemployed youth, is a result of expulsing testosterone from its banking system. Is it accident or terrorism?

To call banks cuddling up excessively in loans to the Infallible Sovereign and the AAAristocracy, an excessive risk-taking which results from too high testosterone levels, is ludicrous. That is just cowardly hiding away, guided by computer models, in havens officially denominated as absolutely safe.

The risk-taking which requires true banking testosterone is the lending to medium and small businesses, entrepreneurs and start ups.

Unfortunately bank regulators, by means of allowing for far less capital when lending “to the safe than when lending to “the risky”, guaranteed that the expected risk-adjusted returns on bank equity when lending to the former were much much higher than when lending to the latter. 

And, as any economist knows, equity goes to where the highest returns are offered. And so bankers possessing true testosterone, were all made redundant. And since the safe jobs of tomorrow need the risk-taking of today, and “the risky” got and get no loans, the European youth ended up without jobs… or even the prospective of jobs.

I have always thought this regulatory calamity was an accident resulting from allowing some very few regulators to engage in intellectual incest, in some small mutual admiration club where it is prohibited by rules to call out any member as being at fault.

But now, since more than five years after the detonation of the bomb that was armed in 2004 with Basel II, the issue of the distortion these capital requirements produce in the allocation of bank credit in the real economy is not yet even discussed, reluctantly, because I am no conspirator theories freak, forces me to admit the possibility of terrorism.

And frankly what is the difference between injecting bankers with a testosterone killing virus, and doing so with a mumbo jumbo bank regulation no one really understands?

Poor European youth… they are not yet aware that unless they expulse the current bank regulators from the Basel Committee and the Financial Stability Board, for being dumb or terrorists, they live in an economy that is going down, down, down.

All dollars (or Pounds, or Euros) should be equal!

The efficient market hypothesis, and the capacity of free markets to allocate efficiently financial resources have, as a consequence of the recent financial crisis, been seriously questioned. There is absolutely no cause for that.

In a free market all dollars pursuing assets are equal, and so the prices reflect the markets appreciations of returns, risks, and other factors… and so in essence, all assets will produce equivalent all included risk-adjusted returns. Like any bet on the roulette.

But then came bank regulators, with their risk-weighted capital requirements, more risk more capital, less risk less capital, and determined that some dollars, those being lent to what was perceived as “absolutely safe” were worth much more because these could be leveraged by banks much much more, than the dollars lent to what was perceived as “risky”. Like doubling the roulette payout when playing it safe, like betting on a color.

And of course that made it impossible for the markets to function. It would be like pricing assets in dollars Euros and Pounds, simultaneously without informing the markets of which currency was used. In fact, since bank capital when in “risk-free” land could sometimes be leveraged about 40 times more than when in “risky” land, the currencies used are perhaps more like dollars, pesos and yen. 

And so a dollar going to someone “risky” is for the banks worth de facto much much less than a dollar going to the AAAristocracy. Talk about financial exclusion! Talk about increasing inequality gaps!

Discriminating against risk-taking, in the "Home of the Brave"... you´ve got to be kidding!

Please regulators, allow a dollar to be a dollar for everyone! So that markets will work again!

PS. By the way who authorized all that?

Do you want your bank regulators have a total lack of confidence in your banks?

Markets, banks, bankers they do all one way or another perceive risk of default of borrowers and adjust to these by means of interest rates, size of exposures and other terms. 

And so when bank regulators order banks to also adjust to the same perceived risk in their capital requirements then they are implicitly considering the banks to be absolutely blind. 

Frankly, is that the type of regulators you want? 

Don´t you think that if a regulator believes in that kind of nonsense, he is a regulator that can be too easily be taken for a ride?

America, more bank capital (equity) required for loans to “The Risky” than to “The Infallible”, is contrary to Liberty & Opportunity

Yesterday, in the good company of friends who value liberty above all, I visited the Statue of Liberty for the first time. As a son of immigrants, though not to America, looking at her my eyes went tearful, thinking about the challenges of leaving all behind, and beginning, from scratch, a new life in a new unknown foreign country.

And sitting there listening to a great audio guide I was reminded all the time of that she, Lady of Liberty, stood there greeting all, to the Land of Freedom and Opportunities.

And it all made me reflect again on the fact that current bank regulations, odiously discriminate against what is perceived as “risky”... And my eyes went tearful again. Let me explain.

Of course, a newly arrived unknown immigrant, with nothing or little to his name, would be perceived as risky by any banker, and therefore be charged higher interests, be lent lesser amounts, and have to accept stricter terms, than what applied to those residents of the Americas who already had the opportunity to made a good name and some assets for themselves.

But, those days, luckily, there was not a bank regulator in America who ordered that, on top of a bankers natural risk-adverseness, banks also needed to hold much much more capital when lending to “The Risky” than when lending to “The Infallible”.

And so those days’ bankers were free to apply their own criteria, and “The Risky” free to access opportunities, without the interference of some dumb and overly concerned nanny.

Now though, since 1988, Basel Accord, bank regulations are based on capital requirements which are much much lower when lending to “The Infallible” than when lending to “The Risky”. And that means that banks make a much much higher risk-adjusted return on assets when lending to The Infallible, than when lending to The Risky.

And that means that a current immigrant, or an American who has not yet made it to the AAAristocracy (or the AAArisktocracy) has much lesser opportunities of obtaining a bank credit to make real the kind of America’s dreams which made America what it is… because please don’t tell me that America was just built upon house ownership credit cards and consumption.

Dear Friends, "The Home of the Brave" should not accept this kind of suicidal regulatory risk-aversion, which stops banks from financing the "riskier" future and only propels these to refinance the "safer" past.

By the way I read the law, though only a layman it seems to me it is even prohibited.

God make us daring!

PS. On any Thanksgiving Day, Americans should be deeply grateful for all those who dared take the risks they all needed, and for those days bank regulators did not stand in their way. 

PS. I am not an American, but since my father was freed from a concentration camp by Americans in 1945… I confess being much biased in its favor… at least of that 1945's America.

PS. I have absolutely no objection to all the security measures taken around the Statue of Liberty but, the way some security officers voiced their authority, unfortunately, made me think of a sacrilege.

PS. Risk weights of 100% for the Sovereign and 0% for “We the People” reads like a slap in the face of USA’s Founding Fathers

PS. Here is an aide memoire on the mistakes in the risk weighted capital requirements for banks.

PS. And here are some of my early opinions on these regulations, some of them while being an Executive Director at the World Bank, 2002-04

PS. And here is a very humble home-made youtube comment on it all, from 2010

In Europe banks no longer finance the future

These just refinance the past... (and so Europe is going down, down, down)

Let me refer again to the tragically misguided banking regulations in the world, designed by some who do not care one iota for the real economy, that which are not the banks.

The main principle of such regulations are capital requirements (equity) based on perceived risks. More risk more capital, less risk less capital.

And that results in the bank can expect to earn much higher expected risk-adjusted returns on equity , when financing the safe (refinancing the past) than when finance the risky (the future).

And that results in that the economies do not take enough risks to produce its absolutely-safes of tomorrow ... but will dedicated itself to milk the cows of yesterday, to extract their last drop of milk.

And all sheer stupidity. Regulators ignored, and still ignore, that perceived risks, such as those reflected in credit ratings, have already been cleared for by banks and markets when setting interest rates, the amounts of the loans, duration and other clauses, And so when the same perceptions of risk, are reused, now to determine the required capital, this only ensures that the banking system overdoses on perceived risk.

They also forgot that their regulatory risk with banks has nothing to do with the perceived risks of the bank's customers ... and everything to do with how the bankers perceive and react to these perceptions.

And that the above causes distortions in the allocation of bank credit in the real economy, still nothing is discussed.

For an older person, retired, with barely sufficient savings, a financial advisor must recommend a super safe conservative investment strategy which provides liquidity, traditionally bonds. But, in the case of a young professional, who is saving for retirement in 30 years, the obligatory advice is to take much more risks, such as buying stocks.

And so you can say that bank regulators follow rules adequate for the old, and not for the young. I assure you that if the European youth, such as that in Spain, Italy, Portugal and Greece, lifted their eyes just a little while from their iPads, or similar devices, and realized what was being done to them, many sites would burn...like Troy.

Worse yet, the regulators require banks to have an 8% capital when lending to an ordinary citizen entrepreneur, but allow these to lend to their governments, holding no capital at all. This has quietly introduced a perverse communism, and disrupted all price-risk equations in capital markets. Of course, all in close association with other beneficiaries like the members of the AAAristocracy.

But, you might say ... "At least we will have safe banks". Do not delude yourself. All banking crisis, whenever not a case of outright fraud, have been unleashed by excessive lending to what ex ante was perceived as absolutely safe, and which, ex post, turned out to be risky, and no banking crisis in history, has resulted because of excessive loans to what was correctly perceived as risky.

As a young man, in Sweden, in the churches where from time to time I went, they sang psalms which implored, "God, make us daring". European regulators, with respect to their banks, are now rewarding cowardice... (and so Europe is going down, down, down)

Translated from El Universal

The Financial Stability Board evidences its utter confusion, again, with their G-SIBs list, a subset of the G-SIFIs.

In reference to “the policy judgment to be informed by various empirical analysis of the systemic risk that the Globally Systemic Important Banks Institutions” pose, in order to set the G-SIBs cutoff score, and determine to which of five “buckets” each one of the monster too big to fail banks belong, the Financial Stability Board published, on November 11, their end-2012 data G-SIB list.

For those who need some translation the G-SIBs are the banks among the Globally Financial Important Financial Institutions, the G-SIFIs.

And we there now find 29 banks, since recently Bank of China was added to the original 28, perhaps because China objected to not having one single bank among that exclusive group of banks.

But, what does all this mean? There are 5 buckets indicating how much additional capital each bank as a percentage of risk-weighted assets a banks needs to hold, for the regulators feeling reasonably sure, the world is secure. These buckets are 1%, 1.5%, 2%, 2.5% and, the horror, the empty 3.5% bucket.

I mention that last one because although “the bucket thresholds will be set initially such that bucket 5 is empty, if this bucket should become populated in the future, a new bucket will be added to maintain incentives for banks to avoid becoming more systemically important… eg if bucket 5 should become populated, bucket 6 would be created with a minimum higher loss absorbency requirement of 4.5% etc)."

If you think the above to sound as a quite infantile regulations, like scaring the children with the boogeyman, I would probably share your appreciation… because what do you think could happen if suddenly regulators got so scared that empty bucket had to be occupied? Would that not cause a crisis by itself?

But let us see how boogeyman the boogeyman really is. The secret is in the “as a percentage of risk-weighted assets”. If the risk weights are low enough that extra capital banks need to hold does not mean much. 

If a G-SIB holds 1/3 each of 0%, 20% and 50% risk-weighted assets, then the currently most G-SIBs, those in the additional 2.5% capital budget, then it is authorized to leverage over 40 to 1. Is this sane?

Why do they not try with an extra 3 percent on all assets, no matter an asset’s risk-weight. That would really put a cracker in the G-SIBs’ pants. Perhaps Bank of China would scream… “Take me out, I don’t belong here”

No friends let me assure you that if I was a Global Systemic Important Bank, and that the price for being The Most Systemic Important Global Bank in the world, would be to have an additional 1% or risk-weighted assets in equity… I would gladly say… “Sure, bring it on!”

But the saddest part of the story is, sine qua nom, that the more regulators insist on the risk-weighing of assets the less access to bank credit will those who most need it and who we most want to have access to it, namely “The Risky”, like medium and small businesses, entrepreneurs and start-ups.

Here is THE QUESTION for Janet Yellen during her US Senate confirmation hearings as Chair of the Federal Reserve

Ms. Janet Yellen

Is it not a fact that, with the sole exceptions of when pure fraud was present, all major bank crises have always resulted from excessive exposures to what was ex ante perceived as “absolutely safe”, and never ever from excessive exposures to what was ex ante perceived as “risky”?

And, if so, can you please explain to us the rationale behind the pillar of current regulations, the risk weighting of the capital requirements, which allow banks to hold much much less capital against what is ex ante perceived as “absolutely safe” than against what is perceived as risky?

Could it not be that in reality it should perhaps be the complete opposite?

Is it correct that in the “home of the brave” we impose this type of bank regulations which discriminate against those perceived as “risky”? And by the way, is such thing really allowed under the Equal Credit Opportunity Act, “Regulation B”?

Finally, do not these regulations created such distortions that it makes it impossible for the banks to allocate credit efficiently in the real economy? 

PS. Oh I almost forgot. I remember the Constitution of the United States of America, in Section 8 states “The Congress shall have the power to…fix the Standard of Weights and Measures.” Can you please refresh our minds as to when we delegate fixing the risk-weights to the Fed?

PS. Oh and I almost also forgot too. The US Constitution in its section 9 states: “No Title of Nobility shall be granted by the United States”. Now, is that not something that de facto happens when we sort of recognize the existence of an AAAristocracy or AAArisktocracy?

Have the risk weights used in current bank regulations really been approved by the US Congress, in accordance to the Constitution?

As a Venezuelan I regretfully know much too much about the violations of a Constitution, but I cannot say that I know much about the Constitution of the United States.

For instance, the Constitution of the United States of America, in Section 8 states, “The Congress shall have the power to…fix the Standard of Weights and Measures.”

And I know that bank regulators, by setting risk weights determine how much capital (equity) banks need to hold against different assets... which means that banks will be able to obtain different risk adjusted returns on equity for different assets.

And so I ask, did the United States Congress really approve those risk weights? I say this because I find that concept to be anathema to “The Home of the Brave”.

And I also ask because the US Constitution, in its section 9 states: “No Title of Nobility shall be granted by the United States”… and that seems precisely what the US might have allowed by allowing regulatory preferences, much lower risk weights, on loans to the Sovereign (the Monarch) and to an AAAristocracy... or more precisely an AAArisktocracy.

And what are those risk weights? The sovereign, meaning the government, meaning bureaucrats deciding on the use of bank credit was given 0%, the “AAArisktocracy” 20%, and WE THE PEOPLE are deemed to be 100% 

But what do these risk weights really signify? The answer is quite straightforward. Those with low risk weights will have even more access at even easier terms to bank credit, than what the natural order of banking would give them. And so those with higher risk weights will, consequentially, have less even access to bank credit and have to pay even more for it, than what the natural order of banking would give them.

And so, in words of Mark Twain, this means that bankers are even much more prone than usual to lend out the umbrella when the sun shines, and to take it back when it rains.

And the tragic consequences for the US are many:

It increases the inequality gap between The Infallible and the Risky

It stops bank from financing the future and make them mostly refinance the past.

And in the case of the sovereign, it translates into an effective subsidy of the interest rates paid by the Government, and so everyone is flying blind, not knowing what the real not subsidized risk free rate would be.

And at the end of the day this piece of regulation guarantee excessive bank exposures to what’s ex ante perceived, decreed or concocted as safe, but which might turn out risky, and when that happens are held against especially little capital, and so will result in especially severe bank crises.

And the list goes on...

The silly doubling down on ex ante perceived risks is killing the Western economies... and not so softly

The interest rates, the size of the exposures and all other terms of assets that banks put on their balance sheet, are a function of their ex ante perceived risks, like those reflected in credit ratings.

But current bank regulations also determines that the capital (equity) banks are required to hold against those assets, are also to be a function of risk weights determined from ex ante perceived risk, like those of credit ratings.

And that fundamental mistake of doubling down on the same ex ante perceived risks, like those in credit ratings, potentiating risk aversion, is killing the western economies as we knew them... and not so softly.

Trusting excessively ex ante perceived risks, regulators have allowed banks to hold much much less capital against assets perceived ex ante as “absolutely safe”, than against assets perceived as risky. And that resulted in that banks earn much much higher risk adjusted returns on equity on “The Infallible”, like exposures to sovereigns, housing sector and the AAAristocracy, than on The Risky, like medium and small businesses, entrepreneurs and start ups.

And that means that banks have dangerously leveraged up much too much on The Infallible and, equally dangerously, much too little on The Risky.

And so when one of “The Infallible” ex post turns out to belong to “The Risky”, as always happens sooner or later, often precisely because it has had too much access to bank credit, then the banks stand there naked with almost no capital.

And so “The Risky”, those who on the margins of the real economy most need and should have access to bank credit, in order to help our economies to move forward, they will not get it.

In essence this all means that banks will not help to finance the western economies future, but only help to refinance its past.

Senator Patrick Moynihan is quoted with saying “There are some mistakes it takes a PhD to make”. Unfortunately most of us equally seem to believe “There are mistakes, so dumb, these just cannot be made by a PhD”.

We baby-boomers extract as much equity as possible from the risk-taking our parents allowed banks to take, while refusing now to allow banks to take the risks our grandchildren need.

Why the Bank of England, BoE, like most other bank regulators, is pissing outside the pot.

I invite you to read the Bank of England publication “Bank capital and liquidity”

It states: “It is the role of bank prudential regulation to ensure the safety and soundness of banks, for example by ensuring that they have sufficient capital and liquidity resources to avoid a disruption to the critical services that banks provide to the economy.”

But, if that comes with avoiding that those in the real economy who most need and deserve access to bank credit, do not get it, only because they are perceived as more “risky”, then the regulators are most definitively pissing outside the pot.

The regulator divides here the balance sheet of the bank in 3 categories: Cash and Guilts, Safer loans, and Riskier loans.

If then, as they do, they allow banks to hold much much less capital against Guilts and Safer loans than against Riskier loans, that simply means that banks will be earning much much higher expected risk adjusted return on Guilts and Safer loans, that on Riskier loans.

And that means that “The Infallible” will have even more access to bank credits, which could turn these into risky, and make it very dangerous for the banks, while “The Risky” will get even less access to bank credit and make it very dangerous for the real economy.

“The Infallible” are the sovereigns, the housing sector and the AAAristocracy. “The Risky” are medium and small businesses, entrepreneurs and start-ups.