“The Risky” those discriminated against by banks, and by regulators, need to have a voice at the Fed

I read that the State banking associations and several other groups sent a letter to President Obama on Tuesday urging the president to nominate a community banker to serve on the Federal Reserve Board of Governors. 

In doing so they write: We offer our request and recommendation in view of our shared desire for economic growth that reaches to all parts of our nation, and in the recognition that community banks are fundamental to achieving that growth.” 

And I entirely support such motion.

But, that said, if we are talking about the need of having a voice at the Fed, then no one needs it more at this injunction, than the medium and small businesses, the entrepreneurs and the start ups.

For a starter this is what they would say:

“We are punished by bankers with smaller loans, higher interest rates and harsher terms because we are perceived as risky from a creditor point of view. And that we understand... that’s life. 

But why must you regulators have to make it even harder for us to get loans at competitive rates by requiring the banks to hold more capital when lending to us than when lending to those of the AAAristocracy? 

We fully understand you must require banks to hold capital, and this primarily to be able to confront unexpected losses. But why would you think that we, we who represent higher expected losses, also represent the risk of higher unexpected losses? Is it not the other way round? Has history not proven sufficiently that the AAAristocracy is the most dangerous source of that kind of unexpected losses that can really shake the system?”

Will anyone in UK help me file the following complaint against bank regulators through the Financial Conduct Authority?

(As a foreigner not living in the UK, if I filed it, the complaint would probably be ignored)

Below is the link for filing it:

http://www.bankofengland.co.uk/about/Documents/complaints/complaintsform.pdf

The complaint!

Even though bank capital is primarily needed in order to cover for unexpected losses, regulators have set the capital requirements based on the perceptions about expected losses.

And since the perceptions of expected losses are already cleared for by banks by means of interest rates, size of exposure and other terms, this means that perceptions of expected losses get to be considered twice.

And of course that favors those already favored by being perceived as safe, and punishes those already punished by being perceived as risky.

And of course that makes it impossible for banks to allocate credit efficiently to the real economy, with all the negative consequences that entails... among other to the job prospects of the unemployed youth.

And, to top it up, since the capital requirements are portfolio invariant, which means that these do not consider the dangers caused by excessive exposures to what is perceived as absolutely safe but could turn out to be risky, these do not foment the stability of the banking sector. 

On the contrary, these capital requirements guarantee that in the worst case scenarios, which is when banks encounter that something “absolutely safe” has become “risky”, banks will have too little capital to respond with.

These regulations are therefore destructive and should be changed.

What a bank regulator could be asking himself on his deathbed…

Even though I knew that the capital I should require a bank to hold was primarily a protection against unexpected losses… how could I have been so dumb so as to base the capital requirements on the perceptions about the expected losses?

And how could I have been so dumb so as to accept “portfolio invariant” capital requirements, which obviously does not consider the danger of excessive exposures to what is perceived as “absolutely safe”, nor the benefits of diversification among what is considered as “risky”?

That caused of course banks to make much much higher risk-adjusted returns on equity when lending to “the infallible sovereigns” and the AAAristocracy than when lending to the “Risky”.

And that caused banks to overpopulate some “safe havens” turning these into deadly traps, like AAA rated securities, Greece, real estate in Spain; and equally dangerously to under-explore the more risky but more productive bays, represented by medium and small businesses, the entrepreneurs and the start-ups.

And with all that I helped to screw up the whole Western world economy... especially Europe's

I know most of the world will not forgive me, but I sure pray for that my unemployed children and grandchildren understand that, though admittedly I was very dumb and arrogant, I did not regulate so dumb on purpose… in fact my whole problem began when I and my colleagues started to regulate the banks without even caring to define their purpose.

The “too-big-too-fail” bank facilitators... or even promoters

The Basel Committee, with its Risk-weighting of Assets and Tier Capital mumbo jumbo, introduced horrendous confusion in the market.

One way to get a clearer picture of what banks are really up to, at least with respect to leverages, is to use that old trustworthy debt to equity ratio.

Using it on one of the European big bank´s balance sheets as of December 2012, I found that its Liabilities amounted to 1.96 T, I guess in Euros, and its Equity to 54.41bn. Well that would indicate a 36.02 Debt Equity Ratio.

Let me be clear… any bank regulator willing to allow for a higher than 12 to 1 Debt to Equity Ratio is most definitely a “too big to fail” bank facilitator, or even a promoter.

Inequality production 101

Lecture 2: Set much lower capital requirements for banks when lending to the "Infallible Sovereign" and the AAAristocracy than when lending to "The Risky", so that banks earn much higher risk-adjusted returns on equity when lending to the former than when lending to the latter.

That signifies that those who have made it thanks to risk taking in the past and/or are now perceived as "absolutely safe" will receive too much too cheap bank credit, while those perceived as "risky", and who have to risk it in order to make it in the future, will get too little and too expensive bank credit.

That guarantees the inequality of opportunities, and which as you should remember from Lecture 1, is the prime ingredient in any inequality production.

If asked by Janet Yellen about risk-weighted bank capital requirements, how would Margaret Thatcher have answered?

Although I am sure Janet Yellen fulfills all the formal qualifications, I really do not know sufficient about her so as to be able to provide any credible input as to her chances of doing a good job as the new Chair of the Fed. What I am sure of though, is that Yellen will need to show a type of Margaret Thatcher type of character strength, if she is going to be able to stand a chance against what is to come.

And in this respect I would also have liked, if Janet Yellen had been able to pose the following question to Margaret Thatcher:

By requiring banks to hold much more capital against what is perceived as risky than against what is perceived as absolutely safe, banks earn higher risk-adjusted returns on equity when lending to The Infallible Sovereign and to the AAAristocracy than when lending to The Risky. This causes of course banks to lend less than what they would ordinarily do, and more expensively so, to all “risky” medium and small businesses, entrepreneurs and start ups. Margaret do you think this is sane? Do you think this makes our banks safer? Do you think this helps the economy to grow muscular and sturdy?

And though certainly uttered in some much better way than what my poor British English allows me, I can almost hear Margaret Thatcher answering something as follows:

“No Dear Janet, that is as insane as it comes. We the western world did not become what we are by foolishly telling risk-adverse bankers to avoid taking risks, or by allowing bankers to binge profitably on what we for now, in shortsighted blissful ignorance, believe to be absolutely safe.”

The deforestation of the economy leads to flooding and to its dangerous desertification

Through “Learning with dogs” I was recently made aware of an article by George Monbiot, titled “Drowning in Money”, written on the subject of “The hidden and remarkable story of why devastating floods keep happening”, published in The Guardian, 14th January 2014. 

It refers to “a major research programme, which produced the following astonishing results: water sinks into the soil under the trees at 67 times the rate at which it sinks into the soil under the grass. The roots of the trees provide channels down which the water flows, deep into the ground. The soil there becomes a sponge, a reservoir which sucks up water then releases it slowly. In the pastures, by contrast, the small sharp hooves of the sheep puddle the ground, making it almost impermeable: a hard pan off which the rain gushes.

And, writes Monbiot: “here we start to approach the nub of the problem – there is an unbreakable rule laid down by the Common Agricultural Policy. If you want to receive your single farm payment – by the far biggest component of farm subsidies – that land has to be free from what it calls ‘unwanted vegetation’ Land covered by trees is not eligible. The subsidy rules have enforced the mass clearance of vegetation from the hills.” And, consequently, there is much dangerous flooding.

I immediately identified with the problem. For more than 15 years I have argued that medium and small businesses, entrepreneurs and start ups, constitute the most important root system that allows the economy to grow muscular, and not just obese. 

But, the regulators in the Basel Committee, with their utterly senseless risk-weighted capital requirements for banks, denied fair access to bank credit to these vital trees of the economy, only because these are perceived as risky. The consequence is that the economy turns into a paved parking lot where most rain just flows out to the sea without nurturing the economy. And it also guarantees that, when any AAA-rated levee breaks, true disaster will ensue.

Banks are there to fulfill an extremely important function of efficiently allocating credit in the real economy, and not simply to survive. But that was of no importance for regulators who, so fixated on keeping banks from failing, are not even considered the need for pruning.

In UK the Prudential Regulation Authority (PRA) is responsible for the supervision of banks, and its role is defined in terms promoting the safety and soundness of these. There is not one single reference to promoting the safety and soundness of the real economy, though nothing can be so dangerous for the long term prospects of an economy than an excess of prudence. 

If the UK, like most other economies, wants to avoid being dragged down in the death spiral of excessive risk aversion, it better starts thinking more in terms of an authority that understands the need for trees, perhaps about a Reasoned Audacity Regulation Authority.

Dr Jens Weidman, why did it take you so long to figure this out?

Dr Jens Weidmann, President of the Deutsche Bundesbank, at the Tagesspiegel event "Deutschland Agora 2014", Berlin, 16 January 2014 said the following.

“In order to break the disastrous nexus of banks and governments, the regulatory treatment of government bonds will, however, also have to be changed.

Currently, banks can invest unlimited amounts in euro-area government bonds. Under the current capital rules, a zero risk weight applies to these assets, which means that these government bonds can be fully funded with borrowed money, in other words, they do not require any capital backing. This constitutes preferential treatment, and has been a factor in banks in several peripheral euro-area states, in particular, raising their exposure to domestic sovereign bonds during the crisis; they have thereby tied their fate to that of their national government.

In my opinion, credit ceilings and risk-based capital backing would be a sensible way of breaking the nexus - that would basically mean applying similar rules to those for bank loans to private-sector debtors. Such rules would also promote bank lending to enterprises.

Support for this proposal is growing, its logic is compelling, but implementation is probably not on the cards for 2014… In the longer term, however, such regulations are, in my opinion, an indispensable prerequisite for a stable monetary union and a healthy financial system.”

And I just ask Dr Jens Weidman… why did it take you so long to figure this out? And if you accept that correcting for it is "indispensable", why not more urgency?

In November 2004, soon 10 years ago, after ending my 2 year term at the World Bank as one of its Executive Directors, in a letter published by the Financial Times I wrote: 

“Our bank supervisors in Basel are unwittingly controlling the capital flows in the world. How many Basel propositions it will take before they start realizing the damage they are doing by favoring so much bank lending to the public sector (sovereigns)?

A simple question, on bank regulations, to Basel Committee, Financial Stability Board, FED, ECB, FDIC, PRA and other

Do you really believe that those “unexpected losses” which could destabilize the banking system, should be estimated based on the estimations of “expected losses”? 

I ask that because that is what you have, in my opinion irresponsibly so, bet our whole banking system on... in fact even bet the health of our real economy on.

The capital requirements for banks should primarily cover for any unexpected losses, as any expected losses should primarily be covered by bankers knowing what they are doing. But, by your own confessions you have based the unexpected losses on the perceived risk of expected losses, like those contained in a credit rating. And that leads to the expected losses to be counted twice, while the unexpected losses are not considered at all.

And to top it up your current capital requirements for banks are, again by your own confessions, “portfolio invariant”, which means that the benefits of asset diversification among “the risky” or the dangers of excessive concentration of assets to something perceived as “absolutely safe” are not considered at all.

What you have done allow the banks to earn much higher risk-adjusted returns on capital when lending to The Infallible than when lending to The Risky, and this seriously distorts the allocation of bank credit in the real economy, with tragic implications for its future health.

And all for nothing, because you should know that what can cause the unexpected losses that can really bring a banking system down, are really to be found among what is perceived to generate the lowest expected losses.

What can I say regulators? That you have no idea of what you are up to? Frankly, I can’t find any other explanation.

You have a lot of explaining to do all that unemployed youth that you might turn into a lost generation. 

You fill pages after pages with talk about prudential regulations, but let me remind you of that the first rule of prudence is to cause not even larger damages! And that you have done.

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.