What if super duper scientists of Koshland Science Museum helped me to call out bank regulators’ monstrous mistake?

I was walking by the Koshland Science Museum in Washington, when I saw some windows that shouted out to me…maybe some real scientists can help me out fighting bank regulations, those which in my opinion are destroying our economies and the job opportunities of our young. Though I have objected in a thousand ways the regulators just do not want to answer. If they are too embarrassed about their mistake, I understand them perfectly well. But, for a mistake to be corrected, it needs first to be acknowledged.

WINDOW 1: CAUSE? EFFECT?

CAUSE: The pillar of current bank regulations is the credit risk weighted capital requirements for banks. More perceived credit risk – less perceived credit risk. These give banks much larger incentives to finance what is perceived as safe than what is perceived as risky.

EFFECT: Banks dangerously overpopulate the safe havens and, equally dangerous underexplore the more risky bays where SMEs and entrepreneurs live. 

WINDOW 2: FACT? FICTION?

FACT: Banks already consider perceived risk when setting interest rates and amounts of exposures, so that also make them consider the same perceived credit risks, in the capital assigns double importance to credit risks.

FICTION: Major bank crisis occur because of excessive exposure to what ex ante is perceived as risky. The truth is that all major bank crises occur because of excessive exposure to assets ex ante perceived as safe, but that ex-post turned out to be risky.

WINDOW 3: RISK? BENEFIT?

RISK: Though banks might not always be able to manage the perceived risks correctly, or the perceptions might be wrong, we must risk allowing banks to allocate credit to the real economy without any regulatory distortion.

BENEFIT:  Risk taking, reasoned audacity, is the oxygen of all development. That is what brought us here, and that is what we must allow, in order for our economies not to stall and fall, in order to give our children and grandchildren the same opportunities we were given. 

WINDOW 4: ACTION? REACTION?

ACTION: To enlist Koshland Science Museum and all its affiliated scientists’ support in forcing regulators to explain themselves; and also express their opinion on Kurowski’s bank risk management rules:

1. Any risk, even if perfectly perceived, leads to wrong decisions, if excessively considered.

2. Capital requirement should cover unexpected losses, not expected credit losses; and the safer an asset is perceived, the larger it’s potential to deliver unexpected losses.

REACTION: Hopefully to make bank regulators wake up and rethink all their strategy; starting with defining the purpose of banks, something that, amazingly, they never did before regulating the banks.

There is nothing as risky as excessive risk aversion - God make us daring.

If only regulators had set their capital requirements to be risk-weighted for banks’ management of perceived credit risks. As is we are better of with capital requirements for banks based on regulators not knowing what they are doing. For that, let us have 8-10% capital on all bank assets!

PS. But be very careful how you go from here to there... the journey has its dangers.

PS. I see you are interested in sustainability. What if banks earned higher risk adjusted returns on equity when helping out with that?

The Basel Committee for Banking Supervision flagrantly violates the precautionary principle by turning a blind eye to the dangers.

The precautionary principle states that if an action or policy has a suspected risk of causing harm to the public or to the environment, in the absence of scientific consensus that the action or policy is not harmful, the burden of proof that it is not harmful falls on those taking an action.

I have for years denounced that the credit-risk weighted capital requirements for banks adopted by the Basel Accord as the pillar of their regulations seriously distort the allocation of bank credit to the real economy.

The consequences of too much bank credit to what is perceived as “safe” and too little credit to what is perceived is that banks do not any longer finance the risky future, our children and grandchildren need to be financed, but only refinance the safer past. With this the world is slowly but surely coming to a grinding halt.

But the Basel Committee, the Financial Stability Board, the European Commission on Banking and Finance, IMF, BIS, ECB, Fed, FDIC, BoE and all other relevant institutions just look away and do not want that issue discussed.

It sure is a flagrant violation of the precautionary principle that will cause immense damage. 

Please… help me break the silence of that irresponsible mutual admiration club!

The Basel Committee, with Basel I, II and III, has condemned our grandchildren to secular stagnation and lack of jobs

Secular stagnation, a condition of negligible or no economic growth in a market-based economy, is explained in terms of investment demand falling relative to savings supply. 

Overall investment can be subdivided in: safe investments that can remain safe, safe investments that can become risky, risky investments that are in fact risky, and risky investments that turn out safe. The last group provides by far the most dynamism to our economies. 

The Basel Committee’s portfolio invariant credit risk weighted capital requirements for banks; more risk more capital – less risk less capital; allow banks to leverage their equity more when financing the safe; which allows banks to earn higher risk adjusted returns when financing the safe; which impedes the fair access to bank credit of the risky, among these the SMEs and entrepreneurs.

In short its credit-risk-aversion causes banks to over-refinance the safer past and under-finance the riskier future and thereby condemns our children to lack of opportunities, and our grandchildren to secular stagnation and lack of jobs.

And all for nothing since bank crisis are always caused by excessive bank exposure to something perceived as safe but that ex post turns out risky, and never because of excessive exposures to something perceived as risky.

This bank regulation was introduced with Basel I en 1988 and made much more distorting of credit allocation with Basel II in June 2004… and Basel III keeps the risk-weighting.

And the distortions they cause are not even discussed. In much because too many economists find it unworthy to dirty their hands with bank regulation technicalities. How vulgar! Keynes knew much about banks and finances, modern Keynesian do not.

God make us daring!

Don’t ever take members of the Basel Committee with you to the races. They’re dangerous!

I went to the races with some members of the Basel Committee for Banking Supervision.

They were so afraid I would lose money and blame any bad luck on them, so they offered to pay twice the odds, if I only bet on favorite horses paying less than 2 to 1. 

And I started making profits like a bandit, even paid the bookies big bonuses, and logically I increased and increased my bets on safe favorites more and more… that is until a favorite turned out to be a real dud, and I lost all I had.

If I had only gone on my own that would never have happened.

These lunatics should be hauled in front of courts for illegally manipulating the odds. Of course they can always argue they had no idea about what they were doing.

As handicap officials on the racetrack the bank regulators would be taking off weights from the stronger horses and placing these on the weaker.

Note: When the Basel Committee allows banks to leverage more on assets perceived as safe, than on assets perceived as risky, they are in effect manipulating the odds of the risk adjusted returns on the banks equity, and thereby distorting the credit markets. 

Who helps me getting bank regulators to even acknowledge the biggest systemic error in Basel I, II and III?

In 1999 in an Op-Ed I wrote: “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”

A Big Bang happened. I know what that systemic error is, but embarrassed regulators don’t want to even acknowledge the problem… and so they keep us traveling down the same crazy road... on route to the next Big Bang.

The most fundamental systemic error, is the credit risk weighted capital requirements.

To estimate the unexpected losses for which banks should have capital, the dummkopfs used expected credit risk. 

Banks consider credit risks when setting the interest rates, the amounts of exposures and other contractual terms.

So when regulators decided that the capital banks should hold against unexpected losses was to be based on ex ante expected credit losses, then they force-fed the banks to consider credit risk twice.

And any risk, even when perfectly perceived, produces a wrong decision if excessively considered.

And so here are our bank lending too much to The Safe, like the governments (sovereigns) and the AAArisktocracy, and too little, or nothing to The Risky, the SMEs and entrepreneurs… those tough we need to get going, especially when the going gets tough.

And you can find in my blogs and in several publications innumerable occasions when I have presented this argument… and most other “experts”, or media like the Financial Times, have not yet even acknowledged the existence of the problem in clear terms.

Friends, can you help me stop these besserwisser busybody hubristic bank regulators from interfering with the allocation of bank credit to the real economy?

What important institution dares to set up a conference on the theme “Do credit-risk weighted capital requirements dangerously distort the allocation of bank credit to the real economy? World Bank? IMF?

PS. Perhaps I should refer to the Basel regulators as just another bunch of statists? I say this because, believe it or not, in the Basel Accord of 1988, they assigned a zero percent risk weight to the sovereign, and a 100 percent risk weight to the private sector. 

PS. There was of course another systemic error. The exaggerated use of the credit ratings On that, in January 2003, in a letter to FT 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.”

PS. While I was an Executive Director of the World Bank, 2002-04, the following were my totally ignored comments on bank regulations.

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.