Sunday, September 2, 2018

Had there been a Basel Committee on Tennis Supervision, Roger Federer would be history by now.

The Basel Committee for Banking Supervision (BCBS) in order to make bank systems safer imposed risk weighted bank capital requirements. The lower the perceived risk the lower the capital the higher the leverage allowed. The higher the perceived risk the more capital the lower leverage allowed. 

For example, in Basel II of June 2004 they held that against any private sector asset that was rated AAA to AA banks needed to hold 1.6% in capital, meaning they were allowed to leverage 62.5 times. Against any private sector asset that was rated below BB- banks needed to hold 12% in capital, meaning they were allowed to leverage 8.3 times. 

In terms of tennis that would mean that those players ranked the highest would be able to play with the best rackets, and be allowed many more serves than those player ranked lower. Someone not only unranked but also lousy player like me would be happy to have one serve and at least be allowed a to uses a ping-pong racket if playing against Roger Federer. 

But what would have happened if there had been a Basel Committee on Tennis Supervision that implemented these regulations?

To make a long story short, the best tennis players would have it easier and easier to win, and would have less and less need to practice. Those betting on them would bet ever-larger amounts at ever-lower odds… until “Boom!” (2008 Crisis) suddenly the best player was discovered to completely have lost his ability to play and lost in three blank sets to a newcomer.


Tuesday, August 28, 2018

Anat Admati explains the financial crisis better than most, but does still not get to the real heart of it.

I refer to Promarket.org and Evonomics.com where Stanford professor Anat Admati discusses her paper“It Takes a Village of Media, Business, Policy, and Academic Experts to Maintain a Dangerous Financial System” May 2016.

In it she explains how a mix of distorted incentives, ignorance, confusion, and lack of accountability contributes to the persistence of a dangerous and poorly regulated financial system.

Here some quotes and comments:

1. “Admati draws a contrast with aviation. Although tens of thousands of airplanes take off and land, often in crowded skies, busy airports, and within short time spans, crashes are remarkably rare. Everyone involved in aviation collaborates to maintain high safety standards”

PK. The main explanation for that is that everything in aviation is considered risky… and there are no aviation regulators giving anyone the excuse of “at this point you can relax”.

2. “When they seek profits banks effectively compete to endanger their depositors and the public. An analogy would be subsidizing trucks to drive at reckless speed even as slower driving would cause fewer accidents.”

PK. Of course allowing reckless speeds, like no limit at all when lending to Greece, and 62.5 times when AAA to AA ratings are present, must cause serious crashes.

But, the worst part of it all is that banks are not allowed to drive at the same speed. As a consequence, being paid on delivery, banks will not go to where they must go slower, like the leverage speed limits that apply when lending to entrepreneurs, and will therefore not perform their vital function of allocating credit efficiently to the economy. The words “the purpose of banks is” are sadly nowhere to be seen in bank regulations.

3. “Politicians, find implicit guarantees attractive because they are an ‘invisible form of subsidy’ that appear free because they do not show up on budgets, as the costs associated are ultimately paid for by the citizenry.”

PK. At this moment the statist regulators and politicians find those “implicit guarantees” especially attractive because of its quid-pro-quo component. “We scratch your back with implicit guarantees and you scratch ours something for which we in 1988, with the Basel Accord assigned to the sovereign a 0% risk weight, and one of 100% to the citizen” And ever since the “good and friendly” sovereigns have had access to subsidized credit… and the regulators have now painted themselves into a corner. 

4. “Credit rating agencies, “private watchdogs,” have conflicted interests because they derive revenues from regulated companies as well as sometimes from regulators.”

PK. Yes but notwithstanding that, even if the credit rating agencies have behaved totally independent, there can be little doubt that assigning so much decision power to some few human fallible credit rating agencies would introduce the mother of all systemic risks.

And besides, since bankers already consider risks perceived when deciding on size of exposures and risk premiums to charge, to have perceived risks also reflected in the capital requirements, violates the “Kurowski dixit” rule: “Risks, even when perfectly perceived, leads to the wrong actions, if excessively considered.” 

5. “I had expected academics and policy makers to engage and care about whether what they were saying and doing was appropriate, particularly since they often know more than the public about the issues and are entrusted to protect the public”

PK. So had I. They, Anat Admati included, are still not able to explain to regulators about conditional probabilities. And so regulators keep on regulating based on the perceived risk of assets and not based on the risk of assets based on how these are perceived.

In terms of airplanes they regulate based on how the pilots perceive the risks and not based on that the pilots could perceive the wrong risks or act incorrectly when facing the correct risks.

6. “Lawmakers are rarely held accountable for the harmful effect of implicit guarantees combined with poor regulations.”

PK. Yes not one single regulators have been forced to parade down 5thAvenue wearing a dunce cap. On the contrary many of them have been promoted and are still regulating without even considering the possibility they have been mistaken all the time.

PS. Even though Daniel Moynihan is supposed to have opined: “There are some mistakes it takes a Ph.D. to make”, the challenges still remain for the PhDs about what to do with the opinions of the lowlier graduates, like with just an MBA. Do we dare to quote him?



And here my soon 2.800 letters to the Financial Times on this. Am I obsessed? Sure, but so are they ignoring my arguments.

And finally here a humble home-made youtube https://youtu.be/TUdKhm6_a8Y

Thursday, August 16, 2018

Risk weighted capital requirements for banks should consider the conditional probabilities

What are the conditional probabilities of assets being dangerous to bank systems when conditioned to that bankers have perceived these assets as risky?

Assets perceived by bankers as risky become safer, not riskier.

What are the conditional probabilities of assets being dangerous to bank systems when conditioned to that bankers have perceived these assets as safe?
Assets perceived by bankers as safe become riskier, not safer.

So regulators who base their capital requirements for banks on that what’s perceived as risky is more dangerous to the bank systems than what’s perceived as safe, is that because they have never heard about conditional probabilities?

Here is an aide-mémoire on some of the many mistakes with the risk weighted capital requirements for banks.

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

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

Wednesday, July 11, 2018

Trade wars will mean new tariffs

There is another tariff war that is being dangerously ignored. 

The July 6 editorial "A splendid little tariff war?" rightly held that "tariffs create all sort of inefficiencies, unintended consequences and uncertainty."

The risk-weighted capital requirements for banks also translate de facto into subsidies and tariffs, which have resulted in a too much-ignored allocation of bank credit war. 

One consequence is that those perceived as risky, such as entrepreneurs, have their access to bank credit made more difficult than usual, and our economy suffers. Another is that by promoting excessive exposures to what is especially dangerous, because it is perceived as safe, against especially little capital, guarantees that when a bank crisis results, it will be especially bad. 

In terms of Mark Twain's supposed saying, these regulations have bankers lending out the umbrella faster than usual when the sun shines and wanting it back faster than usual when it looks like it is going to rain.

Letter published in the Washington Post



Here other of my letters in the Washington Post on this issue:
September 6, 2007: Factors in the Financial Storm

Tuesday, June 19, 2018

Should we not expect the Fed to do something if they hear they are distorting the allocation of bank credit?

I refer to the letter from Managed Funds Association to the Board of Governors of the Federal Reserve System titled “Supplemental Comments in Response to Federal Reserve Staff Questions on Managed Funds Association Regulatory Priorities

In it, discussing “the flow-through impacts of the supplementary leverage ratio (SLR) on the buy- side’s use of centrally cleared derivatives” MFA comments: 

“At present the SLR is having a more direct impact on banks… [there are] cases in which certain banks have exited the clearing business altogether,or have reduced client clearing services.

Of course, banking organizations allocate capital to business lines based on expected returns. As such, an organization will use its balance sheet to fund businesses that can meet return-on-equity (“ROE”) targets given the amount of capital required to be held against the activities of each business.”

That is a crystal clear explanation (or confession) that bank’s business lines ROE targets are adjusted by “the amount of capital required to be held against the activities of each business.”

So therefore it should be crystal clear that whatever is ex ante perceived, decreed or can be concocted as safe, currently, because of the risk weighted capital requirements for banks, can easier meet the ROE targets of banks than what is perceived as risky.

So therefore it should be crystal clear the “safe” financing of house purchases, sovereigns and AAA rated securities, will stand too much better chances to meet the ROE targets of banks than the financing of “risky” entrepreneurs or SMEs.

So therefore it should be crystal clear that house purchases, sovereigns and AAA rated securities will obtain much easier credit, and that entrepreneurs or SMEs will see their difficulties to access credit only be increased.

Damn that distortion!

By giving banks the incentives to further increase, against especially little capital, the exposures to what being perceived as “safe” always represent the detonators, they set bank crisis on steroids.

By giving banks the incentives to further reduce the exposures to what’s “risky”, that dooms the economies to stagnation.

And as usual, most probably the Board of Governors of the Federal Reserve System won’t care one iota about that, as they until now see as their only bank regulatory role, that of keeping the banks as safe mattresses into which to stash away cash… and never concern themselves whether these mattresses might be infested by the lice of dangerous uselessness.

Tuesday, May 22, 2018

The Bank of England’s Museum’ explanation of “credit risk” keeps mum on how BoE, as a regulator, helped to mess it all up

Yesterday I visited the Bank of England’s Museum, and there I read the following:

“Banks have ways of reducing credit risk. When you apply for a loan, the lender will look at what’s known as the five C’s: credit history, capacity, collateral, capital and conditions.

Credit history, also known as character, is basically your track record for repaying debts.

Capacity refers to your ability to repay a loan by looking at your job stability and your debt compared to your income, known as the debt-to-income ratio.

If you can’t pay back your secured loan, the lender will seize an asset such as your house or car as collateral.

Would you still be able to pay your loan if you lost your job? To know, the lender looks at any savings, investments and other assets you might own to determine how much capital you have.

Finally, the purpose – or conditions – of the loan can affect whether someone wants to lend you money or not.

The bank’s assessment determines how much interest they’ll charge you. If you are seen as a risky customer, for example by having a bad credit history, your loan will be more expensive.”


Now that is how it used to be, before 1988, before overly creative and full of hubris regulators ,with Basel I, imposed risk weighted capital requirements on banks.

After that, and especially after 2004 Basel II, the banks must also consider how much capital (equity) the regulators require it to have against that loan... as that will determine their final risk adjusted expected return on equity.

I did not find a single word in the BoE museum about how these risk weighted capital requirements for banks distort the allocation of bank credit to the real economy.

I did not find a single word in the BoE museum about the fact that absolutely all assets that caused the 2007/08 crisis, had one single thing in common, namely very low capital requirements, that because these assets were perceived (residential mortgages), decreed (sovereigns) or concocted (AAA rated securities) as very safe. 

I can only conclude that the Bank of England is engaging in covering up their own fatal mistakes. Let us pray that at least internally they admit and learn from these.

I saw there that Bank of England is also presenting itself as the “Knowledge Bank”. When in 2002-04, as an Executive Director of the World Bank, I heard the same promo I begged WB to try being a “Wisdom Bank” instead, or at least a “Common Sense” bank.


“Banks need to manage risks, and they monitor their lending carefully, spreading the risk among many loans to different sectors.”

Yes, that is how a portfolio is managed… but the risk weighted capital requirements for banks were explicitly made “portfolio invariant” because to have these being “portfolio variant” presented too many complications for the regulator.

“Banks need enough capital to provide a strong basis for their lending in case things go wrong.” 

Indeed but the question remains when does a bank need the most of capital, when something perceived as risky turns up even more risky; or when something perceived safe turns up risky?

Sunday, May 20, 2018

If the Basel Committee had only been asked these four simple questions about its risk weighted capital requirements for banks?

1. What? Do you really know what the real risks for banks are? If you do, why are you not bankers?

2. What? Don’t you see that allowing banks to leverage differently with different assets will lead to a new not market set of risk adjusted returns on equity. Are you not at all concerned this could dangerously distort the allocation of credit to the real economy?

3. What? Do you think that what’s perceived risky by bankers that which they adjust by means of lower exposures and higher risk premiums, is more dangerous to the bank system than what they perceive as safe?

4. What? A 0% risk weight of sovereigns? That could only be explained by their capacity to print currency in order to get out of debt. But is that not also one of their worst possible misbehaviors?

How much sufferings and how many unrealized dreams would not have been avoided?

And now, 30 years after that faulty regulation was introduced with the Basel Accord in 1988, these questions are still waiting for an answer.

PS. Here a list of some of the horrendous mistakes of the risk weighted capital requirements

Sunday, May 13, 2018

Current risk weighted capital requirements are de facto regressive regulatory taxes imposed on the access to bank credit.


“When you tax all income earning activities the same, then the relative prices of different types of labor services stay the same. With progressive taxes you create greater distortion in the economy and that makes us all a bit less wealthy than we would otherwise be”

Why is never a flat capital requirement for banks defended with the same impetus as a flat tax on income?

As is the risk weighted capital requirements for banks, which even though some leverage ratio has been imposed still operate on the margin, impose de facto different taxes on the access to bank credit.

To make it worse though in the case of taxes on income these are currently progressive, in the sense that they most affect those who are already by being perceived as risky have less and more expensive access to bank credit, these regulatory taxes are regressive.

PS. Why did Classical Liberals or Libertarians not speak up when, in 1988, with the Basel Accord, Basel I, the regulators risk weighted the sovereign with 0% and the citizens with 100%?

Monday, April 30, 2018

Which business cycle would you prefer?

There is one business cycle during which the capital requirements for banks against all assets are the same. 

And so banks offer, the risky and the safe, credit based on the size of exposure and the net margin adjusted for risk. 

Sooner or later because of unforeseen events, criminal behavior, or excessive exposures to what was ex ante perceived as safe but that ex post turned out risky, there will be a bank crisis, everyone will hurt, and the economy will suffer a set back. 

Hopefully, usually, the net economic gain, since this business cycle started, will anyhow be positive.


Now there is another business cycle, like the current one, during which the capital requirements for banks are risk-weighted… more ex ante perceived risk more capital – less ex ante perceived risk less capital.

And so banks then offer, the risky and the safe, credit based on the size of exposure the net margin adjusted for risk and the allowed leverage resulting from the capital that is required.

Sooner or later because of unforeseen events, criminal behavior, or excessive exposures to what was ex ante perceived as safe but that ex post turned out risky, there will be a bank crisis, and everyone will hurt. 

But this crisis could be so much worse because the exposures to what is perceived as safe, those which therefore contain more dangerous fatter tail risks, will be so much higher, and will be held against especially little capital. 

And because most credit financed the safer present, creating a reverse mortgage on it, and way too little financed the risky future, the economy might suffer a set back that puts it much worse off than when this business cycle got started.


Unfortunately the difference in the business cycles bank regulations can cause, is rarely discussed.

Monday, March 12, 2018

Charles Goodhart also pointed out the stupidity of risk weighted capital requirements for banks based on ex ante perceived risks… also with no luck!

In the very last page (540) of Charles Goodhart’s “The Basel Committee on Banking Supervision: A history of the Early Years, 1947-1997” of 2011 we read the following:

“Capital is supposed to be a buffer against unexpected loss: In so far as capital is required against unexpected loss, since expected loss should be handled by appropriate interest margins, the use of credit ratings as a guide to risk weights for capital adequacy requirements (CARs) is wrong and inconsistent, since these give a measure of expected loss. What is needed instead is a measure of the uncertainty of such losses, the second moment rather than the first.

If capital risk weights had been based, as they should logically have been, on the uncertainty attending future losses, rather than their expected modal performance, the financial system might have avoided much of the worst disasters of the 2007/08 financial crisis.

It remains surprisingly difficult to persuade regulators of this simple point.”

But to that Goodhart adds “It does however, get recognized from time to time”… though the examples he then indicates, are not so clear.

In the Epilogue (page 581) Goodhart list some of the failings of the BCBS’s regulations:

1. The lack of any theoretical basis.

2. The focus on the individual institution, rather that the system

3. The failure to reach an accord on liquidity;

4. The lack of empirical analysis;

5. The unwillingness to discuss either sanctions or crisis resolution, and so on.

That clearly adds up to a total regulatory failure... no wonder they don't want to discuss sanctions. 

But, unfortunately as I see it, Charles Goodhart, though absolutely right, is only scratching the surface. What is most dangerously ignored are the distortions in the allocation of bank credit to the real economy that these risk weighted capital requirements for banks cause.



Friday, March 9, 2018

30 years after the introduction of risk weighted capital requirements for banks, the European Commission's Action Plan, finally spills the beans on that these can distort the allocation of bank credit, for a good (or for a bad) purpose.


“Incorporating sustainability in prudential requirements: banks and insurance companies are an important source of external finance for the European economy. The Commission will explore the feasibility of recalibrating capital requirements for banks (the so-called green supporting factor) for sustainable investments, when it is justified from a risk perspective, while ensuring that financial stability is safeguarded.”

To my knowledge this is the first time in 30 years, since the introduction in 1988 of risk weighted capital requirements for banks, that an official entity has recognized that by distorting the allocation of bank credit, in favor or against something, regulators can make banks serve a purpose different from safeguarding financial stability.

PS. Sadly though not even “safeguarding financial stability” was well served as all this regulation did was to doom banks to dangerously overpopulate safe-havens holding especially little capital


PS. And on Earth Day 2015 I made a proposal exactly like what the EC will now study, namely to base the capital requirements for banks based on the Sustainable Development Goals SDGs, which of course include environmental sustainability.

@PerKurowski

Did regulators, when developing the fundamentally wrong risk weighted capital requirements for banks, suffer some kind of “perception controlled hallucination” or any other psychological disorder?

In 1988, with the Basel Accord, Basel I, the Basel Committee for Banking Supervision introduced the use of risk-weighted capital requirements for banks. That scheme was further much expanded in 2004 with Basel II.

In essence that meant that banks had to hold more capital against what is (ex ante) perceived as risky than against what is perceived as safe. 

The stated goal of this regulation, was and is to avoid the failure of banks that can put the economy in jeopardy and that could cause big loses for depositors or big costs for tax payers derived from official rescue interventions.

Nothing wrong with that intention, except for what they did and what they ignored when developing these risk-weighted capital requirements.

What did they do? 

They looked at the risk of the assets just like bankers do, and not at the risk that bankers might be perceiving the risks wrong, or acting wrongly to risks well perceived. 

What’s the worst case scenario about risks perceived wrong? Clearly that something ex ante perceived as very safe turns out ex post as very risky. The opposite, something perceived as very risky turning out very safe should obviously not bother anyone… except of course the borrower who had to pay too high risk premiums.

What did they ignore? 

First that all major bank crises have resulted from, criminal behavior, unexpected events or excessive exposures to something ex ante perceived as safe but that ex post turned out to be very risky. “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.” Mark Twain. The mistake can perhaps be illustrated by the fact that regulators, in their standardized risk weights of 2004, assigned a 150% to the below BB- rated, that which bankers won’t touch with a teen feet pole, but a meager 20% to what is AAA to AA rated.

Second, that these risk weighted capital requirements, which allowed banks to leverage more with what was perceived safe, would have banks earning higher expected risk adjusted returns with what was perceived safe, which would naturally increase the risk of some perceived safe havens become dangerously overpopulated, against especially little capital. In a Roulette in a casino,  2 to 1 and 36 to 1 are equivalent winnings paid out to those playing it “safe” on color or those playing it “risky” on a number. If the winning for those same bets were for example 3 to 1 and 30 to 1, that would break the bank and sink the casino.

Third, that the real economy, in order to move forward depends much on risky entrepreneurs and small and medium enterprises (SMEs) having access to bank credit. “A ship in harbor is safe, but that is not what ships are for.” John A Shedd.

I do not think it is prudent to distort the allocation of bank credit to the real economy, so I would favor one single capital requirement against all assets, but if I absolutely had to distort in this way, then my risk weighting would have to be 180 degrees in the opposite direction, higher perceived risk-lower capital, lower perceived risk-higher capital. 

It was 30 years when this monumental mistake was initiated, and for all practical purposes it is not yet even discussed… so the stickiness of that mistake has proven to be equally monumental.

Friends, is it something in “Predictive Processing” that could explain this so fundamental mistake in our current bank regulation, and its stickiness?

And more importantly still, in what way can “Predictive Processing” help us to avoid this type of extremely costly mistakes.

Here a brief aide memoire on the major mistakes with the risk weighted capital requirements

@PerKurowski

Thursday, March 1, 2018

Here, there is good money to be earned, by just explaining the risk weighted capital requirements for banks to me.

I will pay a US$ cash bonus to the first who manage to extract clear answers from any regulator on two questions that have had me intrigued for a way too long time… so much that many tell me I am obsessive about… which of course I am.

I start with US$ 100 for each one of the answers and increase it by U$10 each month... for some time

US$100 to the first who gets a clear answer from a regulator on: Why do you want banks to hold more capital against what, by being perceived as risky has been made quite innocous, than against what, because it is perceived as safe, is much more dangerous? 


And also US$100 to the first who gets a clear answer from a regulator on: Why are banks allowed to leverage much more when financing homes, than when financing the entrepreneurs who could help create jobs needed to pay utilities and service the mortgages?




Wednesday, February 21, 2018

Current bank regulators should undergo a psychological test. They clearly seem to be afflicted by “false safety behavior”

I extract the following from “False Safety Behaviors: Their Role in Pathological Fear” by Michael J. Telch, Ph.D. 

“What are false safety behaviors? 

We define false safety behaviors (FSBs) as unnecessary actions taken to prevent, escape from, or reduce the severity of a perceived threat. There is one specific word in this definition that distinguishes legitimate adaptive safety behaviors - those that keep us safe - from false safety behaviors - those that fuel anxiety problems? If you picked the word unnecessary you’re right! But when are they unnecessary? Safety behaviors are unnecessary when the perceived threat for which the safety behavior is presumably protecting the person from is bogus.”

The risk weighted capital requirements for banks, more perceived risk more capital – less perceived risk less capital, fits precisely that of being unnecessary. If a risk is perceived the banker will naturally take defensive measures, like limiting the exposure or charging higher risk premiums. If there is a real risk that is of the assets being perceived ex ante as safe, but turning up ex post as risky.

The consequences of such false safety behavior by current bank regulators are severe:

They set banks up to having the least capital when the most dangerous event can happen, something very safe turning very risky. 

Equally, or even more dangerous, it distorts the allocation of bank credit to the real economy, it hinder the needed “riskier” financing of the future, like entrepreneurs, in order to finance the “safer” present, like house purchases and sovereigns.

It creates a false sense of security because why should anyone really expect that “experts” picked the wrong risks to weigh, the intrinsic risk of the asset, instead of the risk of the asset for the banking system.

I quote again from the referenced document:


“How do false safety behaviors fuel anxiety? 

There seems to be a growing consensus that FSB’s fuel pathological anxiety in several different ways. One way in which FSBs might do their mischief is by keeping the patient’s bogus perception of threat alive through a mental process called misattribution. Misattribution theory asserts that when people perform unnecessary safety actions to protect themselves from a perceived threat, they falsely conclude (misattribute) their safety to the use of the FSB, thus leaving their perception of threat intact. Take for instance, the flying phobic who copes with their concern that the plane will crash by repeatedly checking the weather prior to the flight’s departure and then misattributes her safe flight to her diligent weather scanning rather than the inherent safety of air travel.” 

In this respect stress tests and living wills could perhaps be identified as “unnecessary safety actions” the “checking of the weather”. 

Finally: “FSBs may fuel anxiety problems by also interfering with the basic process through which people come to learn that some of their perceived threats are actually not threats at all…threat disconfirmation…For this important perceived threat reduction process to occur, not only must new information be available but it also must be processed.”

The 2007/08 crisis provided all necessary information on that the risk weighting did not work, since all bank assets that became very problematic, had in common low capital requirements since they were perceived as safe. And this information has simply not been processed.

Conclusion, I am not a psychologist but given that our banking system operates efficiently is of utmost importance, perhaps a psychological screening of all candidates to bank regulators should be a must. Clearly the current members of the Basel Committee and of the Financial Stability Board, and those engaged with bank regulations in many central banks, would not pass such test.

I feel sorry for them, especially after finding on the web someone referring to "anxiety disorder" with: “I don’t think people understand how stressful it is to explain what’s going on in your head when you don’t even understand it yourself”


  

Friday, February 16, 2018

ECB’s Sabine Lautenschläger explains why the risk weighted capital requirements for banks is total lunacy but, unfortunately, not even she hears it.

I quote the following from ECB’s Sabine Lautenschläger’s speech on February 15, 2018, “A stable financial system – more than the sum of its parts” 

“Logic can be a tricky thing. Apply it in the right way, and you always arrive at a consistent conclusion. But apply it in the wrong way, and it can lead you astray. And that happens all too easily. There are indeed many wrong ways in which we can apply logic.”

One of them is known as the fallacy of composition. It refers to the idea that the whole always equals the sum of its parts. Well, that idea is wrong. As we all know, the whole can be more than the sum of its parts – or less.

Consider this statement: if each bank is safe and sound, the banking system must be safe and sound as well. By now, we have learnt the hard way that this might indeed be a fallacy of composition.

Let me give you just one example. Imagine that a certain asset suddenly becomes more risky. Each bank that holds this asset might react prudently by selling it. However, if many banks react that way, they will drive down the price of the asset. This will amplify the initial shock, might affect other assets, and a full-blown crisis might result. Each bank has behaved prudently, but their collective behaviour has led to a crisis.

The business of banking is ripe with externalities, with potential herding and with contagion. These factors may not be visible when looking at individual banks, but they can threaten the stability of the entire system. This is one of the core insights from the financial crisis.”

Let me comment on the implications of this quite lengthy quotation: 

First: “a certain asset suddenly becomes more risky” That means that the real problem is that it was perceived as safer before.

Second: “The business of banking is ripe with externalities, with potential herding and with contagion.” There can be no doubt that potential herding” is much mote likely to occur with assets perceived as safe.

So what is Sabine Lautenschläger really saying with all this? That the current risk weighted capital requirements, Pillar 1, more perceived risk more capital – less perceived risk less capital, is sheer lunacy, though she might not understand it. 

The truth is that the real logic, not that pseudo logic applied by bank regulators, is that the safer an asset is perceived, the greater the potential danger to the bank system it poses.

Lautenschläger also said: “Imagine that there is a downturn in the financial cycle. From the viewpoint of each bank, credit risks increase and microprudential supervisors may want to increase Pillar 2 capital demands. Looking at the same trend, macroprudential supervisors might want to support credit growth and counter the cycle over a longer time horizon and from a systemic point of view. Thus, they may want to decrease Pillar 2 capital demands.”

“credit risks increase” That goes in the direction from safer to riskier. Does going from riskier to safer pose any danger? No!

So is not assigning the lowest capital requirements to what is ex ante perceived as safe just the mother of procyclical regulations, or in other words, the mother of all macroprudential imprudences? 

Ex post dangers are a function of ex ante perceptions. The safer something is perceived the more real danger it poses. The riskier something is perceived, the less harm it can cause.

How on earth could one expect a good application of Basel Committee’s Pillar 2 (Supervisory Review Process) from those who are messing it all up with a so faulty Pillar 1?

Recommendation: Ask a regulator: “What is more dangerous to the bank system, that which is perceived risky or what is perceived safe?” If he answers, the “risky”, ban him from regulating banks.

Tuesday, January 30, 2018

Basel III - sense and sensitivity”? No! Much more “senseless and insensitivity”

I refer to the speech titled “Basel III - sense and sensitivity” on January 29, 2018 by Ms Sabine Lautenschläger, Member of the Executive Board of the European Central Bank and Vice-Chair of the Supervisory Board of the European Central Bank.

“Senseless and insensitive” is how I would define it. It evidences that regulators have still no idea about what they are doing with their risk weighted capital requirements for banks.

Ms Lautenschläger said: With Basel III we have not thrown risk sensitivity overboard. And why would we? Risk sensitivity helps align capital requirements with actual levels of risk and supports an efficient capital allocation. It prevents arbitrage and risk shifting. And risk-sensitive rules promote sound risk management.

“Risk sensitivity helps align capital requirements with actual levels of risk and supports an efficient capital allocation” No! The ex ante perceived risk of assets is, in a not distorted market aligned to the capital by means of the size of exposure and the risk premium charged. Considering the perceived risk in the capital too, means doubling down on perceived risks; and any risk, even if perfectly perceived, if excessively considered causes the wrong actions.

“It prevents arbitrage” No! It stimulates arbitrage. Bankers have morphed from being diligent loan officers into too diligent equity minimizers. 

“It prevents risk shifting.” No! It shifts the risks from assets perceived as risky to risky excessive exposures to assets perceived as safe.

“It promote sound risk management” No! With banks that compete by offering high returns on equity, allowing some assets to have lower capital requirements than other, makes that impossible.

Ms Lautenschläger said: “for residential mortgages, the input floor increases from three basis points to five basis points. Five basis points correspond to a once-in-2,000 years default rate! Is such a floor really too conservative?”

The “once-in-2000 years default rate on residential mortgages!” could be a good estimate on risks… if there were no distortions. But, if banks are allowed to leverage more their capital with residential mortgages and therefore earn higher expected risk adjusted returns on residential mortgages then banks will, as a natural result of the incentive, invest too much and at too low risk premiums in residential mortgages… possibly pushing forward major defaults from a “once-in-2000 years default” to one "just around the corner". That is senseless! Motorcycles are riskier than cars, but what would happen if traffic regulators therefore allowed cars to speed much faster?

I guess Basel Committee regulators have never thought on how much of their lower capital requirement subsidies are reflected in higher house prices?

Then to answer: “Does this mean that Basel III is the perfect standard - the philosopher's stone of banking regulation? Ms Lautenschläger considers “What impact will the final Basel III package have on banks - and on their business models and their capital?”

Again, not a word about how all their regulations impacts the allocation of bank credit to the real economy… as if that did not matter… that is insensitivity!

Our banks are now financing too much the “safer” present and too little the “riskier” future our children and grandchildren need and deserve to be financed.

PS. In 2015 I commented another speech by Ms Lautenschläger on the issue of “trust in banks”.