The tyranny of [bank regulatory] experts. The forgotten rights of “the risky” to access bank credit.

Bank regulatory experts in the Basel Committee, and the Financial Stability Board, with their risk based capital requirements, by allowing banks to earn much higher risk adjusted returns on equity when lending to “The Infallible”, are blocking the access of “The Risky” to bank credit.

With that these tyrants are killing our economies… Who authorized them to such odious and senseless discrimination? Did we not become what we are because of risk taking? 

World Bank, IMF what’s wrong with you? You must know this is not right.

Note: Inspired by William Easterly’s “The Tyranny of experts”

European Union, ask the Basel Committee about regulatory distortions in the allocation of bank credit to the real economy

Regulation (EU) No 575/2013 dictated by The European Parliament concerning Prudential Requirements for Credit Institutions and Investment Firms establishes:

“44. Small and medium-sized enterprises (SMEs) are one of the pillars of the Union economy given their fundamental role in creating economic growth and providing employment. The recovery and future growth of the Union economy depends largely on the availability of capital and funding to SMEs established in the Union to carry out the necessary investments to adopt new technologies and equipment to increase their competitiveness. The limited amount of alternative sources of funding has made SMEs established in the Union even more sensitive to the impact of the banking crisis. It is therefore important to fill the existing funding gap for SMEs and ensure an appropriate flow of bank credit to SMEs in the current context. Capital charges for exposures to SMEs should be reduced through the application of a supporting factor equal to 0,7619 to allow credit institutions to increase lending to SMEs. To achieve this objective, credit institutions should effectively use the capital relief produced through the application of the supporting factor for the exclusive purpose of providing an adequate flow of credit to SMEs established in the Union.”

Favoring bank lending to the SMEs this way, implies that the European Parliament admits that the risk weighted capital requirements for banks distort the allocation of bank credit to the real economy. The question then is why has not the European Union, the European Parliament, formally asked the Basel Committee on Banking Supervision, about the implications of such distortions. Is that issue not of utmost importance? Have they, when regulating, not given any considerations to the purpose of banks?

And by the way where did the European Parliament get 0,7619 from? And by the way that still equates to an effective risk weight that is 3 times higher than that applicable to any AAA rated company which might be taking a bank loan only to repurchase its own shares.

And if this is the way to go would the European Union consider to design a similar “supporting factor” for any bank lending which promotes the sustainability of planet earth?

Basel III, risk based capital requirements, leverage ratio, distortions, and “The Drowning Pool”

I have for years seriously criticized the distortions in the allocation of bank credit to the real economy that the risk based capital requirements of Basel II produce. And now I am often being answered that these distortions have been in much removed because of the introduction in Basel III of the 3 percent leverage ratio, that which is applied on all assets without any risk weighing.

Unfortunately the truth is that could make the distortions even worse, and equally unfortunate, the why of it, is not so easy to explain… and so here I give it another go.

Have you seen “The Drowning Pool”, where Paul Newman and Gail Strickland are locked in a hydrotherapy room, with the water rising to the ceiling? Well think of the capital requirements as the hydrotherapy room, and the leverage ratio as the water level. 

In Basel II, there was a lot of room for banks maneuvering around the risk-weights but, in Basel III, by means of the water level having risen, there is now less room-oxygen for the banks to breathe… and so the more the distortion.

And so Basel III by making the search for breathing space harder will therefore make banks even more loath to give credit to “the risky” those which regulators decided consume more oxygen-capital. Get it?

And of course that is not helped by the fact that, with the introduction of liquidity requirements which is also based on ex ante perceptions of risks, new sources of distortion are being introduced.

We must stop bank regulators from increasing the risks of our banking system… they´ve done enough damage as is.

The real risks for a bank regulator, and ours as well, has nothing to do with one or even a couple of banks going busts; it has all to do with the whole banking system melting down, or not doing well what it is supposed to do, namely to allocate bank credit efficiently in the real economy.

And that translates into that the risk of a bank regulator has little to do with the type of assets a bank holds, and a lot to do with the capacity of bankers to pick the assets the banks should hold.

But current bank regulators, with their risk based capital requirements, allow banks to hold extremely large amounts of assets against extremely little capital only because bankers, and sometimes regulators themselves, say they perceive these as being “absolutely safe”. And that allows banks to earn much higher risk adjusted returns on equity when lending to for instance the “infallible sovereigns”, the housing sector and the AAAristocracy, than when lending to the “risky” medium and small businesses, entrepreneurs and start-ups.

And that means, effectively, that regulators are assisting banks to create that kind of excessive exposures to what is perceived as “absolutely safe” which has been the source of all bank system crisis when these, surprisingly, turn out to be risky. And all this is worsened by the fact that when now one of these safe exposures blows up, banks stand there holding extremely little capital in defense.

And that also means, effectively, that our banking sector is not allocating sufficient bank credit to those in the real economy who are in most need of it.

And so to sum it up: current regulators are betting more than ever our whole banking system on the bankers being able to pick the right assets… while at the same time distorting the picking of those assets. Sheer lunacy! We need to get rid of them urgently.

Regulators, what have the ex ante perceived as “risky” ever done to you, or to the banks?

Why do you require banks to hold more capital against loans to medium and small businesses, entrepreneurs and start-ups, only because these are perceived as “risky”, than the capital banks need to hold against loans to the “infallible sovereigns”, the housing sector or the AAAristocracy? 

Beats me! The former, those perceived as “risky” when originally incorporated in a bank balance, have never ever set of a major bank crisis, those crises have always resulted, no exceptions, because of excessive bank exposures to those erroneously perceived as "absolutely safe" .

And regulators, your risk aversion psychosis causes then banks to earn less return on equity when lending to the “risky” than when lending to the “safe”, and so banks stop lending to medium and small businesses, entrepreneurs and start-ups.

Is that really prudent from the perspective of keeping the real economy strong and sturdy so as to not pose a threat to the stability of the banking system? 

Is it because the “risky” are dirty, smelly and ugly when compared to the “absolutely safe”? Is that also the reason why you never invite them to Basel, or to other venues, so as to hear their opinions about these odiously discriminating risk-weighted bank capital requirements of yours? 

You've got to stop this nonsense… Now! If medium and small businesses, entrepreneurs and start-ups do not have access to bank credit in fair terms, our young will, no doubt about it, become a lost generation.

Mr. Stefan Ingves… I do seriously disagree with your “risk-based capital adequacy ratios”, and I dare you to debate it.

Mr. Stefan Ingves the Chairman of the Basel Committee on Banking Supervision delivered a speech titled “Banking on Leverage" during a High-Level Meeting on Banking Supervision, held Auckland, New Zealand, 25-27 February 2014.

In it Ingves stated: “Risk-based capital adequacy ratios have been the cornerstone of the Basel framework since it was introduced 25 years ago. Capital adequacy ratios measure the extent to which a bank has sufficient capital relative to the risk of its business activities. They are based on a simple principle: that a bank that takes higher risks should have higher capital to compensate. Of course, there are plenty of challenges in measuring risk -- something I will come back to shortly -- but I have yet to meet anyone who seriously disagrees with that simple principle.”

Well I am one who seriously disagrees with that principle… and I dare him to meet me and debate the issue.

A bank, when taking risks, high or low, should compensate for any probable expected losses, by means of interest rates (risk premiums), the size of the exposure, and other terms, like the duration of the loans and guarantees.

And, if the banker does his job well, and adjusts adequately to the risk, then capital has absolutely no role to play in that. And, if the banker does not know how to do his job well, and does not adjust adequately to the risks, then he should fail, the sooner the better for all, so that the bank accumulates as little combustible mistakes as possible.

But a bank regulator, like the Basel Committee, cannot and should not, entirely trust that all risks are being duly perceived by the bankers because, as we all know, there are such things as hidden risks and unexpected losses.

But any hidden risks and unexpected losses cannot be approximated by means of the perceived risks and the expected losses… in fact it is what is perceived as absolutely safe, what is expected to produce the smallest losses, and which therefore can lead to very high bank exposures, which always produce the most dangerous unexpected losses which pose a threat, not only to an individual bank, but to the whole banking system.

And so bank regulators should not require banks to have higher capital to compensate for higher perceived risk, as they do now, but require banks to have a reasonable level of capital in defense of what is not perceived… and since they can not presume to know about the hidden risks of unexpected losses, then they have no other alternative than to set one single capital requirements for all assets, independent of their perceived risks.

To have an idea of how much current risk based capital requirements miss the target, if anything, one could even make an empirical case for setting the capital requirements slightly higher for what is perceived as "absolutely safe" than for what is seen as "risky".   

And that would also eliminate a great source of distortion. The current capital requirements, more perceived risk more capital, less perceived risk less capital, translates into allowing banks to earn much higher risk-adjusted returns on equity on assets deemed as safe, than on assets deemed as risky… and that makes it impossible for banks to perform their function of allocating efficiently bank credit to the real economy.

Basel Committee, Financial Stability Board, know that Your risk-based capital ratios are stopping the banks to finance the risks our future needs to be financed, and only have banks refinancing the safer past. Our young, who now because of your regulations might end up being a lost generation, will hold You all accountable.

As I see it… anyone who allowed banks to leverage 62.5 to 1 on assets, only because these had an AAA rating… or allowed banks to lend to the “infallible sovereigns” against no capital at all, like the Basel Committee allowed for in Basel II, is just not fit to be a regulator. Capisce Mr. Ingves?

PS. Stefan Ingves also states that “The world's largest listed non-financial companies fund their assets around 50:50 with debt and equity. In banking, a more common ratio is 95:5” Let it be clear that 95:5 is 19 to 1 debt to equity… never ever, in the history of banking before the Basel Committee’s risk based capital ratios, have banks remotely been allowed to leverage this much, knowingly.

Regulators, please, your only problems with banks begin when their risk models stop to function.

Now we read that “Under rules being implemented by the Federal Reserve and the Office of the Comptroller of the Currency, the biggest U.S. banks will use their own models for judging their riskiness.”

Are they nuts? 

Bank regulators should have no problems whatsoever when banks own internal models which determine the “expected losses” function well.

The regulators only serious problems begin when these models do no function well... and “unexpected losses” result.

And so, frankly, it seems utterly absurd to allow for regulations which are based on trusting the bank models to function well.

And in this case, trusting primarily those banks which because of their systemic significance most can hurt if their risk models do not work... is like doubling up on the mistake.

If anything, trust the small banks which, if and when they fail, do not hurt us as much.

Basel III Doubles Down on Basel II's Mistake

http://www.americanbanker.com/bankthink/basel-three-doubles-down-on-basel-twos-mistake-1065689-1.html

More analysis of the Basel Committee Mistake reading Daniel Kahneman´s "Thinking Fast and Slow" 

“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.