The Basel Committee’s besserwissers, on top of the ordinary defenses of banks, built a dangerous Maginot Line,

When banks use ex ante perceived credit risks (EAPCRs) to determine the interest rates (risk premiums) the amounts and other contractual terms of their exposures… all these their defenses, it might still at the end of the day, at least for some individual banks, end up like a totally useless Maginot Line.

But, when regulators decide to base their capital requirements for banks on precisely the same EAPCRs, then they are, de facto, on top of the defenses built by the bankers, building an extremely dangerous Maginot Line that could bring the whole banking system down.

That is because giving 200% weight to the EAPCRs will mean that “The Safe” be perceived as safer than what the EAPCRs validate, and “The Risky” will be perceived as riskier than the EACPRs validate. And the banking system will therefore lend too much to The Safe ("infallible sovereigns" and AAArisktocracy) and too little to The Risky (SMEs and entrepreneurs.

God make us daring!

God save us from hubristic besserwisser regulators’ mumbo jumbo scheming!

The only moment when we currently could deem our banks to be safe, and the credit allocation to the real economy is not distorted, is when the EAPCRs are adequately wrong. Meaning The Safe are in reality safer than perceived; and The Risky are in reality riskier than perceived… What a crazy world!

PS. May I humbly remind you of The Per Kurowski’s Rule?

Overreacting to ex-ante perceived risks, whether credit or climate change related, is NOT in BoE’s remit.

Mark Carney, the Governor of the Bank of England, recently expressed some warnings on climate change, and specifically about the risks with “stranded fossil fuels”. 

I criticized that, considering the dangers that overreacting to perceived risks poses.

I got an official, very courteous and kind reply from the Public Enquiries Group of BoE. Unfortunately it is clear that they have not understood what I am referring to… it could be my fault... English is not my mother tongue.

And so here I will try to explain it again, briefly, with a reference to what is happening to banks.

Banks act on ex ante perceived credit risks, by means of setting risk premiums, the amounts of exposures and other contractual terms.

But bank regulators (Mark Carney is the current chair of the Financial Stability Board) decided to also act, on precisely the same ex ante perceived credit risks, by setting their capital requirements for banks.

And so we now have TWO bank reactions related to the same ex ante perceived credit risks. 

This results, of course, in that banks will hold more of assets perceived as “safe” than what those ex ante credit-risk perceptions would validate; and hold less of assets perceived as “risky”, than what those ex ante credit-risk perceptions would validate. 

In other words there is now a dangerous distortion in the allocation of bank credit to the real economy.

And I am sure that overreacting to ex-ante perceived risks, whether credit or climate change related, is NOT in BoE’s remit.

And I have seen no specific government policy approving of it. Would Winston Churchill have ever said: “We need twice the walls we need to keep out the ex ante risks we perceive"? Or, "We need to build one more Maginot Line on top of the other!"?

And so, back to my letter to BoE: The market is already worried, on its own, about “stranded fossils fuel assets” and so when big powerful BoE comes along and starts implicating that it also worries about those assets, and so it might conceivably do something about it, that again could provoke a dangerous overreaction to the ex ante perceived risks of stranded fossil fuels.

Do I make myself clearer now?

PS. When there is an overreaction then the only way ex ante perceived risks are correctly acted upon, is when these are adequately misperceived. That is how crazy all is.

PS. Of course, since climate change has much more long-term risk implications that are harder to clear for in the markets, allowing banks to hold less capital when financing sustainability, so that banks earn higher risk adjusted returns on equity when financing sustainability, could serve as a good stimulus that though distorting does so in the right direction.

Fair and equitable growth has been made impossible by current bank regulations.

Even though banks already take into consideration the perceived credit risks when setting their interest rates and amount of exposure the regulators also use exactly the same perceived risk when setting the capital requirements.

And that means the banks’ sensitivity to perceived credit risk, is multiplied by two.

So what is perceived as safe will now mean doubly perceived as safe, and so it will have even more access to bank credit; and what is perceived as risky will now mean doubly perceived as risky, and so it will have even less access to bank credit.

How on earth can you have fair and equitable growth with such regulations?

The world’s banking system has been instructed by its regulator to give perceived credit risk a 200% weighting.

With bankers using perceived credit risk to set their interest rates and amount of exposures; and regulators using the same perceived credit risk to set their capital requirements for banks; it is clear that perceived credit risks get a 200% weighting. 

Any banking system that becomes 200% sensitive to perceived credit risks, dooms itself to lend dangerously much to The Safe, the Infallible Sovereigns and the AAArisktocracy; and way too little to The Risky, like to SMEs and entrepreneurs; which is of course fatal for the real economy and therefore also to the banks.

What would have happened if Winston Churchill, when confronted with the dangers had said: "In order to avoid our houses being bombed, we need to become 200% sensitive to risk."

This whole blog is dedicated to explaining how fatally flawed current Basel Committee originated bank regulations are. Here is a recent public letter to its current chair Mr. Stefan Ingves.

A public letter to Mr. Stefan Ingves, the chair of the Basel Committee for Banking Supervision

Mr. Stefan Ingves.

There are cowards and there are braves, ranging from extreme cowards to stupidly foolish braves, but that has less to do with how these perceive risks, and much more to do with how they assume and manage risks.

And then there are those blind to risks… so blind they do not even see a credit rating.

The Basel Committee’s risk weighted capital requirements for banks, based on precisely the same perceived risks (credit ratings) that seeing banks can already see, have clearly been designed for blind bankers.

I do not know how many such blind bankers there are, and if they exist they should not even be allowed to be in business. But, your risk weighted capital requirements, sure poses a big problem for all other banks, and for the economy in general.

Since non-blind banks already clear for any perceived credit risk, by means of interest rates and size of exposure, to force them to again, now in the capital, clear for exactly the same perceived credit risk, gives credit risk perceptions a double weight.

And any perceived risk, even if perfectly perceived, if excessively considered, leads to the wrong action.

In the case all credit risk ratings were perfect… that would then mean banks would lend more than what they should, to what is perceived “safe”, and less than what they should, to what is perceived "risky". And that misallocation of bank credit must be bad for all, especially for the real economy.

Also if credit ratings indicate a “safe” asset to be safer than what it really is, then of course a bank could collapse. Indeed this is precisely the stuff all major bank crises have been made of. No crisis has resulted from too much exposures to something ex ante perceived as risky.

Of course, if a credit rating is imperfect, in the way of informing the asset to be less risky, or less safe, than what it really is, then you might have helped banks to nail it. I doubt though your intention was really to base it on credit ratings being adequately wrong.

Mr. Stefan Ingves, may I suggest the following?

For once think of the purpose of banks being that of allocating credit efficiently to the real economy; and then go back to the drawing board, to see what non-distortionary capital requirements for banks you can come up with.

While doing so, may I suggest you remember that the purpose of the capital requirements for banks, is to cover for some unexpected losses, and not like now, for the expected credit losses?

You could still use credit ratings, if that helps you to save face… but, instead of basing it until now on those credit ratings being correct, why not require banks to have for instance 8 percent of capital against all assets, based on the risks of credit ratings, and other risk perceptions, being wrong... and other risks like that of cyber-attacks.

Please Mr. Ingves... wake up! The risk with banks has nothing to do with the risk of their assets, and all to do with how they manage the risk of their assets… Don’t make it harder than it already is for banks to manage credit risks correctly.

Yours sincerely,

Per Kurowski

PS. Could you please send a copy of this letter to Marc Carney, the current chair of the Financial Stability Board? It could also be of interest  to BIS's Jaime Caruana, ECB's Mario Draghi, and Fed's Janet Yellen. 

One thing is a risk appraisal, a credit rating, and another, totally different, how much importance you give to it.

In January 2003, in a letter published in the Financial Times I wrote:

“Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds. Friends, as it is, the world is tough enough.”

And so here they go again? When will they ever learn?

Do these regulators still not know that banks already look at credit ratings when they set their interest rates and decide on the size of their exposures? To also have credit ratings to set the capital requirements, give their risk appraisal a double weighting. And, a double weighting of even a perfect correct risk appraisal, produces the wrong result. One thing is a risk appraisal and another, totally different, how much importance you give to it. 

The Per Kurowski rule

Here is what those who believe risk weighted capital requirement for banks is smart must be thinking.

Are you one of them?

The pillar of current bank regulations is risk weighted capital requirements for banks: More perceived credit risk more capital – less perceived credit risk less capital.

Below what those who believe risk weighted capital requirement for banks is smart, must be thinking. Are you one of them?

That though with banks so many other aspects are risky, like the possibility of cyber attacks, the only thing that matters are credit risks.

That even though banks perceive credit risks, and adjust for that with risk premiums and the size of their exposures, that’s not enough, banks must also adjust for the same perceived risks in their capital.

That lending little at high-risk premiums to something perceived risky, is riskier than lending a lot at very low risk premiums to something perceived safe.

That bankers, no matter what Mark Twain thinks, love to lend out the umbrella when it rains and abhor doing so when the sun shines.

That it is the specific credit risk of the assets that matter, and not how banks manage those risks.

That the expected credit risks are good estimators of the unexpected losses banks need to hold capital against.

That the safer an asset is perceived the less is its potential to deliver unexpected losses.

That the riskier and asset is perceived the greater is its potential to deliver unexpected losses. 

That as long as banks do not fail, the rest, like if they allocate bank credit efficiently to the real economy or not, does not matter. 

That even though a bank is required to hold more capital lending to someone perceive risky than when lending to the AAArisktocracy, that has nothing to do with inequality.

That even if a sovereign depends on its citizens, the sovereign can have a zero risk weight while the citizens, like SMEs and entrepreneur should have a 100 percent risk weight.

That though all major bank crises have occurred because of excessive exposures to what was erroneously perceived as safe, that has nothing to do with tomorrow's bank crises.

That even though no major crisis has have occurred because of excessive exposures to what ex ante was perceived as risky, that has nothing to do with tomorrow's bank crises.

That if you, to the banker’s natural risk aversion, add on the regulators natural risk aversion, you will not risk getting an excessive risk aversion that could be dangerous for the real economy.

That if the perceived credit risk is correct, it does not matter how much importance you give to that perception.

That if you play around with the odds of roulette it will survive as a viable game

All economic research that has not controlled for the distortions produced by bank regulations could be worthless.

In 1988 with the Basel Accord the concept of risk-weighted capital requirements for banks was introduced. The first decision: Zero percent risk weight for sovereigns and 100 percent for private sector.

In June 2004 Basel II introduced risk weights for the private sector of 20 percent for the AAA-AA rated, 50 percent for the A+ to A rated, 150 percent risk weight for those rated below BB-, and 100 percent for all others.

That meant that the risk-adjusted returns on banks equity would not only depend on the risks of the assets, but also on the regulatory capital requirements for those assets.

Therefore, all economic research that should but that has not controlled for the serious distortions in the allocation of bank credit to the real economy these regulations produce, could be worthless.

Q. Watson, what about requiring banks to hold more capital against risky assets than against safe? A. Dumb!

Let me explain:

If banks must hold more capital against assets perceived ex ante as risky than against assets perceived as safe then: banks will earn higher risk adjusted returns on equity for assets perceived as safe than for assets perceived as risky; and that distorts the economic efficient allocation of bank credit to the real economy, which of course attempts against a vital purpose of banks.

More dumbness: Since major bank crisis always occur because something ex ante perceived as safe turns out ex post as very risky, this would guarantee that banks stand there with the pants down and little capital to cover themselves up, precisely when they most need it.

More dumbness: Bank capital is required in order to cover for unexpected risks so as to estimate these based on the expected losses from perceived credit risks is, to put it delicately, not smart at all.

More dumbness: To make it more difficult for The Risky, like SMEs and entrepreneurs to have fair access to bank credit, does certainly produce increased inequality

Do you want me to keep going on its dumbness?

What about this? The risk weight for those that being perceived as safe could pose so much danger for the banking system like the AAA rated, was set at 20% in Basel II. The risk weight for those totally innocuous below BB- rated, was set at 150%.

No Mr Watson, that should be more than enough. Thank you. I will immediately call the Basel Committee, the Financial Stability Board and the IMF, and suggest they consult you on this delicate matters, that in my opinion is taking our economies down.

BoE´s Mark Carney should mind his own business, as a bank regulator managing risks he has no right to throw stones.

Mark Carney, the current Chair of the Financial Stability Board, has recently been warning many about the financial risks that could be derived from climate change, like leaving a lot of fossil fuels stranded. He should first take better care of his own risk management responsibilities. In that area he has not earned the right to throw stones.

Regulators allow banks to hold much less capital against what, from a credit risk point of view, is perceived as safe than against what is from a credit point of view ex ante perceived as risky.

That means that banks can earn much higher risk adjusted returns on equity when lending to what is perceived safe, than when lending to those perceived risky, like the SMEs and entrepreneurs.

That is a huge economic risk, because the risky need to have fair access to bank credit in order to help the real economy to avoid to stall and fall.

That is a huge financial risk, because it guarantees excessive exposures against little capital, to precisely that of which great bank crisis are made of, that which ex post can come up as having been erroneously perceived as absolutely safe.

My bank regulator went to Basel, and all he brought me was this lousy credit risk weighted capital requirements

I sent my bank regulator to learn with the big boys in the Basel Committee for Banking Supervision about how to regulate banks. Among what he was supposed to pick up was an idea of how much capital he should require banks to hold, primarily against any unexpected losses.

He could have come back with capital requirements that considered all type of events that unexpectedly could blow a hole in a banks solvency like: cyber-attacks, a weather event with disastrous consequences, a major earthquake, the central banks or even the regulators themselves not knowing what to do, inflation suddenly popping up, crazy governments (I am from Venezuela), a set of important companies suddenly turning up engaged in some hanky panky, Systemic Important Financial Institutions (SIFIs) going belly up, internal or external fraud, a major loss from an authorized or unauthorized position in a speculative trading, unexpected consequences from new regulations and thousand of other things… BUT NO all he brought me was this silly risk weighted capital requirements based on expected credit risks, about the only risks banks are supposed to really take care of on their own.

If only it had been based on the risk that banks were not able to manage expected credit risk, then I could have accepted it… but that had of course nothing to do with the credit risk per se, in fact usually it is what is perceived as safe that could pose the biggest dangers for a bank. 

And, to top it up, these credit risk based capital requirements were portfolio invariant, meaning independent of the size of the exposures, only because otherwise it would be too hard for him and his regulating colleagues to handle.

And, to top it up, these credit risk based capital requirements also smuggled in the absurd statist notion that sovereigns were infallible, de facto implying government bureaucrats knew better what to do with bank credit than "the risky" SMEs and entrepreneurs.

And to top it up, during his whole stay with the Basel Committee, and during his study visits to the Financial Stability Board and the IMF, not one single word was said about the societal purpose of banks.

And, so these credit risk based capital requirements guarantees to dangerously distort the allocation of bank credit to the real economy... which they did, look at how much credit Greece got... which they do, look at how little credit SMEs get.

And so these credit risk based capital requirements now guarantee that the next time a bank crisis results from excessive exposures to something that was erroneously perceived as very safe, which is precisely the stuff major bank crisis are made of, then banks will stand there with their pants down and no capital to cover themselves up with.

No! I will surely never ever send my bank regulator to Basel again.

Forget it, I at least trust banks and bankers much more than their current regulators.

I quote from a recent speech by Ms Sabine Lautenschläger, Member of the Executive Board of the European Central Bank and Vice-Chair of the Supervisory Board of the Single Supervisory Mechanism given September 28, 2015, titled Reintegrating the banking sector into society – earning and re-establishing trust 

"Ladies and Gentlemen, esteemed audience,

How can bankers regain the trust that was lost during the crisis? 

How can the banking sector be reintegrated into society? 

There is no doubt that banks, bankers and the whole industry are experiencing one of the worst crises of confidence ever. The turmoil of 2008 and 2009 played a major role in this loss of public trust, but the problem did not end after the most acute phase of the crisis. Even seven years later, confidence in the banking sector is still very low. 

Numerous scandals, like the manipulation of LIBOR rates…have reinforced the perception that wrongdoing is widespread in the banking sector. 

But mistrust is not only confined to banks themselves. Investors and clients also have less confidence in the correct functioning of the banking sector and in the ability of supervisors and regulators to prevent excessive risk-taking. 

We should worry about this loss of trust in the banking sector: 

   It impairs the proper functioning of banks to reallocate resources. 

   It hampers growth. 

   It leads to instability and costly crises. 

But how can trust in the banking sector be restored? Who are the key players in this process? Is it enough to reform the regulatory and supervisory framework, as we have done in recent years?

But are the efforts of regulators and supervisors enough? Can trust be rebuilt simply by having better and more credible rules? 

No! Rebuilding trust in the banking sector requires the active engagement of bankers and their stakeholders. Regulatory and supervisory reforms are necessary, but not sufficient to restore people’s trust in banks. 

My view is that, while regulatory reform and supervisory action were certainly necessary to lay the foundations on which banks can restore trust, regulators and supervisors are not the key players in this process."

My comments: 

Bank regulators told banks: “We allow you to hold much less capital against assets perceived as safe than against assets perceived as risky, so that you can earn much higher risk adjusted returns on equity when lending to the safe than when lending to the risky.

That’s it! Just avoid the credit risks and you earn more, not a word about a purpose for banks, like helping to generate jobs for the young or making the planet more sustainable. Anyone regulating without defining the purpose of what he is regulating is as loony as they come.

And to top it up, the regulators assigned a risk weight of zero percent to the sovereigns (governments) and of 100 percent to the citizens and private sectors on which that sovereign depends. Which means they believe government bureaucrats can use bank credit more efficiently than SMEs and entrepreneurs.

And of course those regulations distort completely the allocation of bank credit to the real economy and, by diminishing the opportunities of the risky to gain access to bank credit, increases inequalities.

The manipulation of Libor rates is pure chicken shit when compared to the manipulation of the credit markets done by regulators with their credit risk weighing.

And here many years after it was clearly seen that the regulators efforts to prevent excessive risk taking only produced excessive risk taking in what was perceived as safe, here they are still talking about the need of “the ability of supervisors and regulators to prevent excessive risk-taking”. Without their regulations banks would have never ever been able to leverage as much as they did.

So forget it, I at least trust banks and bankers much more than their current regulators.

Should not the Financial Stability Board discuss the risk that the Basel Committee has no idea about what its doing?

The Financial Stability Board plenary met in London to discuss policy measures to end too-big-to-fail, concerns on market liquidity, shadow banking, derivatives, misconduct risks, audit and climate change.

For me, the number one issue they should discuss is whether their colleagues in the Basel Committee have the faintest idea of what they are doing and whether it is not hight time for capital requirements for banks to be set based on the risk their regulators are loony... or are smoking something not so good.

The financial crisis explained to dummies in terms of capital requirements for banks: Lehman Brothers - AIG - Greece

The regulators, with Basel II, decided that against any private sector assets rated AAA banks, and against any sovereign rated as Greece was until November 2009, banks needed to hold only 1,6 percent in capital, meaning these could with those assets leverage their capital over 60 times to 1. (When holding “risky” assets like loans to entrepreneurs and SMEs they were only allowed to leverage 12 times to 1. 

On April 28, 2004 the SEC decided that was good for the Basel Committee was good enough for them and allowed Lehman to leverage over 60 times to 1 with AAA rated securities guaranteed with mortgages to the subprime sector… Since Europe were allowing their banks to do the same… the demand for these AAA securities became so huge that it overpowered all the quality controls in their manufacturing and packaging process… and Bang!

If AIG that was AAA rated guaranteed an asset, banks could dramatically reduce the capital they needed to hold against that assets, and this overwhelmed AIG’s capacity to resist selling “very profitable” loan default guarantees… and Bang!

Greece was of coursed offered loans in such amounts and in such generous terms, so their otherwise "so" disciplined and fiscally conservative governments could not resist the temptations… and Bang!

And as should have been expected not one single asset class that was perceived as risky played any role in causing the financial crisis… although of course these assets also suffered a lot when the “safe” came tumbling down.

One would think regulators would by now have discovered that banks already clear for the perceived risks with their risk premiums and the size of their exposure; and so to also force them to also clear in the capital for exactly the same risks, would cause banks to overdose on perceived risks. But no, they haven’t. So this little financial history lesson for dummies is of course primarily directed to them.

What is our major problem now? John Kenneth Galbraith explained it well: “If one is pretending to knowledge one does not have, one cannot ask for explanations to support possible objections.”

We’ve heard a lot about predatory lending, and it should be avoided, but why allow predatory regulations?

An audit report from the office of inspector general of the FDIC broadly defines predatory lending as "imposing unfair and abusive loan terms on borrowers”

Regulators know very well that those perceived as risky have to pay higher risk premiums and have less access to bank credit than those perceived as safe. 

Nonetheless regulators currently also require banks to hold much more capital against loans to those perceived as risky, when compared to what they need to hold against assets perceived as safe. And as a direct consequence those perceived as risky, when compared to those perceived as safe, will have to pay even higher interests and have even less access to bank credit. 

Since that imposes unfair and abusive loan terms on borrowers… it should be regarded as predatory regulations… and of course, to top it up, by negating fair access to the opportunities for credit of those perceived as risky, these also represent a driver of inequality.

Let me quote here two passages from John Kenneth Galbraith’s “Money: Whence it came where it went” 1975.

First: “For the new parts of the country [USA’s West]… there was the right to create banks at will and therewith the notes and deposits that resulted from their loans…[if] the bank failed…someone was left holding the worthless notes… but some borrowers from this bank were now in business...[jobs created]

It was an arrangement which reputable bankers and merchants in the East viewed with extreme distaste… Men of economic wisdom, then as later expressing the views of the reputable business community, spoke of the anarchy of unstable banking… The men of wisdom missed the point. The anarchy served the frontier far better than a more orderly system that kept a tight hand on credit would have done…. what is called sound economics is very often what mirrors the needs of the respectfully affluent.”

Second: “The function of credit in a simple society is, in fact, remarkably egalitarian. It allows the man with energy and no money to participate in the economy more or less on a par with the man who has capital of his own. And the more casual the conditions under which credit is granted and hence the more impecunious those accommodated, the more egalitarian credit is… Bad banks, unlike good, loaned to the poor risk, which is another name for the poor man.”

And finally, let me just add that never ever are truly dangerous financial bank excesses built up with assets perceived as risky; these are always caused by excessive bank exposure to what is perceived ex ante as safe but that ex-post tum out to be risky… and so all this odious regulatory discrimination against the risky… is all for nothing.

PS. “If one is pretending to knowledge one does not have, one cannot ask for explanations to support possible objections” John Kenneth Galbraith dixit.

Here are 7 questions on bank capital regulations that US Congressmen and Governors should ask the Fed, FDIC and OCC.

Gentlemen 

We have been made aware that currently banks are required to hold more capital, meaning equity, when lending to those perceived as safe from a credit risk point of view, like many sovereigns and private entities with good credit ratings, than what banks need to hold in capital when lending to those perceived as more risky, like SMEs and entrepreneurs.

Notwithstanding that sounds intuitively as quite reasonable, one can also argue the following:

Those perceived as safe from a credit point of view, without these regulations, already count with the benefit of larger loans and lower interest rates; while those perceived as risky have less access to bank credit and have to pay higher interest rates. Mark Twain’s saying that a banker is he who lends you the umbrella when the sun shines, but wants it back when it looks like it is going to rain, comes to mind.

So these capital requirements allow banks to leverage more their equity, and the support they in many ways receive from society, many times more when lending to The Safe than when lending to The Risky; and so banks can earn much higher risk adjusted returns on equity when lending to The Safe than when lending to The Risky.

As a result, these capital requirements enlarge the natural differences in access to bank credit between The Safe and The Risky. For instance we could say these regulations artificially favors American banks lending to European sovereigns and highly rated corporations, over lending to American small businesses and entrepreneurs.

And so we must ask you:

Q. Is such regulatory risk-aversion, which distorts the allocation of bank credit, a valid principle for regulating banks in the Land of the Free and the Home of the Brave?

Q. Do we not owe our descendants the same willingness to take risks as that which our fathers allowed our banks to take to get us here?

Q. Cannot it be said of such regulations, by creating incentives for these to refinance the safer past, impede banks from financing the riskier future?

Q. Is not fair access to bank credit an indispensable part of generating the opportunities that helps to reduce inequalities?

Q. Do we not have something called the Equal Credit Opportunity Act, Regulation B, which would seem to forbid this type of regulatory discrimination?

Q. Since the purpose of capital requirements for bank is to shield it against unexpected losses, how can it be you base these on the expected credit losses?

Q. Since what is perceived as risky never generate dangerous excessive financial exposures, that honor goes to what is perceived as safe but ends up being risky, do these regulations really help to build up a safer banking system?

Thank you... oh by the way, since I also heard that your capital requirements are portfolio invariant it just occurred to me to also ask: Should we not require banks to hold capital against the risk of their exposures instead of the credit risk of their assets?

I hereby nominate the Basel Committee’s bank regulators to the Circle of Reason’s Hall of Shame

The Circle of Reason will ask: "What did they do?" 

My answer is that they decided banks needed to hold more capital against assets perceived as risky than against assets perceived as safe.

The Circle of Reason might then say: "But that sounds fairly reasonable, so why is it wrong?"

So here is a non-exhaustive list of reasons, in no particular order:

Banks already clear for perceived credit risk by means of risk premiums charged, size of exposure and other contractual terms so re-clearing for the same perceived risk only distorts.

Instead of looking at the risks of how banks managed the perceived risks of their assets, the regulators also focused on the same perceived risks.

Perceived credit risks are to be managed by the banks and if they cannot do that they should close down as fast as possible. Bank capital is to cover for unexpected losses and so to set the requirements of it based on the expected losses derived from perceived risks make absolutely no sense whatsoever.

The regulators decided that the capital requirements should be portfolio invariant, meaning these had nothing to do with the size of any bank exposure, meaning that all the benefits from diversification were ignored, meaning that they did not know one iota about what they were doing.

To top it up bank regulators decided that the risk weight of sovereigns was to be zero percent while the risk weight for the citizens that make up that sovereign was to be 100 percent, which, unless you are a runaway statist or communist, makes absolutely no sense.

The regulators never understood that allowing banks to have less capital against The Safe, would allow banks to leverage the equity and the support of society much more on loans to The Safe, which allowed banks to earn much higher risk adjusted returns on equity when lending to The Safe than when lending to The Risky.

The regulators regulated the banks without defining what the purpose of banks is, which meant that they for instance ignored the whole topic of allocating credit efficiently to the real economy. Only that should suffice to earn them a place in the Hall of Shame.

The regulators never studied what had caused major bank crises and so confused the ex ante perceived risks with the ex-post real risks. Had they done so they would have noticed that major bank crises result from excessive exposures to something ex ante perceived as safe… and so their capital requirements should perhaps be 180°different, higher for what is perceived safe than for what is perceived risky.

The regulators just focused on the bust event of an economic cycle, not caring about what the whole boom-bust cycle produced… and so they totally ignored that risk-taking is in fact the oxygen of any development.

In these days in which inequality is much discussed the regulators never understood that denying a fair access to bank credit to those perceived as risky, is a potent inequality driver.

If they absolutely wanted to distort, in order to show they were working, why did they not distort with a purpose, like basing the capital requirements on job-creation and sustainability ratings? 

The regulators awarded so much power to some human fallible credit rating agencies so that credit ratings became a huge source of systemic risk that would travel at globalized speeds.

The regulators have, now soon ten years after a crisis that was initiated by excessive exposure to AAA rated securities, sovereigns like Greece, real estate in Spain and much other assets that all shared the commonality of generating very low capita requirements for banks, not yet been able to understand the causality.

I could probably go on for quite some time, but this should be enough to at least establish The Basel Committee (and the Financial Stability Board) as serious candidates to be inducted to The Circle of Reasons' Hall Of Shame.

Per Kurowski

@PerKurowski

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

http://subprimeregulations.blogspot.com

G20, keeping our economies from stalling and falling might depend on unregulated shadow banks… a ‘Banca sommerza’.

On September 17, New Rules for Global Finance and the International Trade Union Confederation are hosting a seminar titled “Reducing Unemployment & Inequality: Policy Options for the G20”

And I wanted the participants, in preparation for it, to read the following which is quoted from John Kenneth Galbraith’s “Money: Whence it came where it went” 1975.

“For the new parts of the country [USA’s West]… there was the right to create banks at will and therewith the notes and deposits that resulted from their loans…[if] the bank failed…someone was left holding the worthless notes… but some borrowers from this bank were now in business...[jobs created] 

It was an arrangement which reputable bankers and merchants in the East viewed with extreme distaste… Men of economic wisdom, then as later expressing the views of the reputable business community, spoke of the anarchy of unstable banking… The men of wisdom missed the point. The anarchy served the frontier far better than a more orderly system that kept a tight hand on credit would have done…. what is called sound economics is very often what mirrors the needs of the respectfully affluent.

The function of credit in a simple society is, in fact, remarkably egalitarian. It allows the man with energy and no money to participate in the economy more or less on a par with the man who has capital of his own. And the more casual the conditions under which credit is granted and hence the more impecunious those accommodated, the more egalitarian credit is… Bad banks, unlike good, loaned to the poor risk, which is another name for the poor man.”

And then I wanted the participants to reflect on the fact that the pillar of current bank regulations, is the perceived-credit-risk capital requirements for banks, less risk less capital - more risk more capital.

That allows banks to earn much higher risk-adjusted returns on equity on what is perceived as safe than on what is perceived as risky. And this, as should easily be understood, kills the opportunities for SMEs and entrepreneurs to have fair access to that bank credit with which they could help generate the next harvest of decent jobs. As you should understand it also serves as a potent inequality driver.

Friends, or we free our formal banks from this loony regulatory risk aversion to credit risk already cleared for by risk premiums and size of exposures, or the interests of job creation and equality might be best served by unregulated banks operating in the shadows… a Banca Sommersa. 

You decide, personally I am surprised to see a big majority of progressives keeping silence on bank regulations that clearly serve best the interests of “the respectfully affluent”… or those of aging baby-boomers’ après nous le deluge.

Let us responsibly live up to our part in that intergenerational continuum of the past, the living and the unborn, that Edmund Burke spoke about.

And this issue is also relevant to many of those you would define as being as far away as possible from the progressives… but which is of course no reason to shy away from it... much the contrary.

As an example, Mark R. Levin initiates his “Plunder and Deceit” by asking: “Can we simultaneously love our children but betray their generations and generations yet born? 

G20, please, for the future of our descendants, let us pray together “God make us daring!”

Why on earth do regulators refuse to discuss the issue of how their bank capital requirements distort the allocation of credit to the real economy? I once again refer to Galbraith’s Money: “If one is pretending to knowledge one does not have, one cannot ask for explanations to support possible objections.”

What shall we do with regulators that have clearly failed? I once again refer to Galbraith’s Money: “We should be kind to those whose performance has been poor. But we must never be so gracious as to keep them in office.”

Frankly, what does for instance a Thomas Piketty from University Boulevard, know about unequal opportunities on Main Street?

@Per Kurowski

Am I a radical of the middle? Yes, or perhaps only an extremist of the center.

The Basel Committee’s credit risk weighted capital requirements for banks… explained by Mark Twain

Many hold that Mark Twain said: “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain”... and so

The so anxious Basel Committee for Banking Supervision thought banks lend out their umbrella much too little when the sun was out, and much too much when it looked like it was going to rain.

And so even though banks already cleared for credit risk perceptions, by means of risk premiums and size of exposures, the bank nannies decided that the capital banks should be required to have, should also consider those same credit risk perceptions; more risk more capital – less risk less capital.

And that means banks can now leverage much more their equity, and the societal support they receive, for instance by means of deposit guarantees, when lending out the umbrella on sunny days than when lending it out on rainy days.

And so banks are lending out less than ever the umbrella when it looks like to rain… and as a consequence the real economy is getting wet and getting a cold.

And all for nothing since never ever have major bank crises resulted from too much lending of the umbrella on days perceived as rainy, but always from too much lending when a sunny day was announced, but the weatherman got it all wrong.

I ask, where would we be if our forefathers’ banks had been subject to credit-risk weighted capital requirements?