Warning about Basel bank regulations

Denying a loan for only seeking to reduce the vulnerability of the financial system could mean the loss of a unique opportunity to achieve economic growth.

All development involves risks, so its path, by definition, is littered with bankruptcies and tears, framed in the human oscillation of one little step forward and 0.99 little steps back. Perhaps then the best way to regulate is to allow some banks to fail, too, before their problems have calcified or become too great.

Developed countries may never have developed under the yoke of puritanical financial regulation, hence my insistence since 1997 on the need for the development perspective to be considered when regulating. Paraphrasing someone; regulation of the financial system is too important to be left in the hands of regulators and bankers. (See note)

Furthermore, in a world that so much preaches the benefits of the invisible hand of the market, with its millions of mini-regulators, we are surprised that Basel delegates, without question, so much responsibility in the hands of a very few and very fallible credit rating agencies.

Basel has recently come under significant criticism:

The World Bank in its 'Global Financial Development of 2003', referring to the new ways of calculating capital requirements, known as Basel 2, warns both about the risk of making access more expensive and more difficult for developing countries to financial sources, such as favoring international banks to the detriment of domestic banks.

Dr. Alexander Kern, from the University of Cambridge, recently stated at a seminar organized by the G24 (developing countries), that because standards have been developed almost exclusively by European countries (G10), they lack the transparency and legitimacy necessary to accept that they are subject to a quasi-mandatory international legalization process.

The comptroller of the United States Currency, in charge of supervising 55% of the banking system in his country, declared his disagreement with the Basel 2 regulations, and even said that they may simply ignore them.

Friends, it may be worth including in all encyclopedias issued by Basel: 'Warning, excessive banking regulations in Basel can be very detrimental to the development of your country'

Note: “War is too serious a matter to entrust to military men” Georges Clemenceau

PS. Sometime later I found out about the bank capital (equity) requirements with risk weights of 0% government and 100% citizens, as if bureaucrats know better what to do with credit than e.g., small businesses and entrepreneurs. If I was to help finance development in developing (and in developed) countries, the first condition for doing so would be to eliminate such loony regulations.

El Universal

PS. This I wrote while being an Executive Director of the World Bank 2002-2004

PS. Mi first Op-Ed ever June 12, 1997 Puritanism in banking

PS. Most of my Op-Eds in El Universal disappeared from the web when I was censored by the new owners in 2014 

Some comments made at a Risk Management Workshop for Regulators... as an Executive Director

World Bank 2003 Risk Management Workshop for Regulators

Dear Friends,

As I know that some of my comments could expose me to clear and present dangers in the presence of so many regulators, let me start by sincerely congratulating everyone for the quality of this seminar. It has been a very formative and stimulating exercise, and we can already begin to see how Basel II is forcing bank regulators to make a real professional quantum leap. As I see it, you will have a lot of homework in the next years, brushing up on your calculus—almost a career change.

But, my friends, there is so much more to banking than reducing its vulnerability—and that’s where I will start my devil’s advocate intrusion of today.

Regulations and development.

The other side of the coin of a credit that was never granted, in order to reduce the vulnerability of the financial system, could very well be the loss of a unique opportunity for growth. In this sense, I put forward the possibility that the developed countries might not have developed as fast, or even at all, had they been regulated by a Basel [Committee].

A wider participation.

In my country, Venezuela, we refer to a complicated issue as a dry hide: when you try to put down one corner, up goes the other. And so, when looking for ways of avoiding a bank crisis, you could be inadvertently slowing development.

As developing sounds to me much more important than avoiding bank failures, I would favor a more balanced approach to regulation. Talleyrand is quoted as saying, “War is much too serious to leave to the generals.” Well, let me stick my head out, proposing that banking regulations are much too important to be left in the hands of regulators and bankers.

Friends, I have been sitting here for most of these five days without being able to detect a single formula or word indicating that growth and credits are also a function of bank regulations. But then again, it could not be any other way. Sorry! There just are no incentives for regulators to think in terms of development, and then the presence of the bankers in the process has, naturally, more to do with their own development. I believe that if something better is going to come out of Basel, a much wider representation of interests is needed.

A wider Scope.

I am convinced that the direct cost of a bank crisis can be exceeded by the costs of an inadequate workout process and the costs coming from the regulatory Puritanism that frequently hits the financial system—as an aftershock.

In this respect, I have the impression that the scope of the regulatory framework is not sufficiently wide, since the final objective of limiting the social costs cannot focus only on the accident itself, but has also to cover the hospitalization and the rehabilitation of the economy. From this perspective, an aggressive bank, always living on the edge of a crisis, would once again perhaps not be that bad, as long as the aggressive bank is adequately foreclosed and any criminal misbehavior adequately punished.

On risks.

In Against the Gods Peter L. Bernstein (John Wiley & Sons, 1996) writes that the boundary between the modern times and the past is the mastery of risk, since for those who believe that everything was in God’s hands, risk management, probability, and statistics, must have seemed quite irrelevant. Today, when seeing so much risk managing, I cannot but speculate on whether we are not leaving out God’s hand, just a little bit too much.

If the path to development is littered with bankruptcies, losses, tears, and tragedies, all framed within the human seesaw of one little step forward, and 0.99 steps back, why do we insist so much on excluding banking systems from capitalizing on the Darwinian benefits to be expected?

There is a thesis that holds that the old agricultural traditions of burning a little each year, thereby getting rid of some of the combustible materials, was much wiser than today’s no burning at all, that only allows for the buildup of more incendiary materials, thereby guaranteeing disaster and scorched earth, when fire finally breaks out, as it does, sooner or later.

Therefore a regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises.

Knowing that “the larger they are, the harder they fall,” if I were regulator, I would be thinking about a progressive tax on size. But, then again, I am not a regulator, I am just a developer.

Conspiracy?

When we observe that large banks will benefit the most with Basel II, through many risk-mitigation methods not available to the smaller banks which will need to live on with Basel I, and that even the World Bank’s “Global Development Finance 2003” speaks about an “unleveling” of the playing field for domestic banks in favor of international banks active in developing countries, I believe we have the right to ask ourselves about who were the real negotiators in Basel?

Naturally, I assume that the way the small domestic banks in the developing countries will have to deal with these new artificial comparative disadvantages is the way one deals with these issues in the World Trade Organization, namely by requesting safeguards.

Credit Ratings

Finally, just some words about the role of the Credit Rating Agencies. I simply cannot understand how a world that preaches the value of the invisible hand of millions of market agents can then go out and delegate so much regulatory power to a limited number of human and very fallible credit-rating agencies. This sure must be setting us up for the mother of all systemic errors.

The Board As for Executive Directors (such as myself), it would seem that we need to start worrying about the risk of Risk Managers doing a de facto takeover of Boards—here, there, and everywhere. Of course we also have a lot of homework to do, most especially since the devil is in the details, and risk management, as you well know, has a lot of details.

Thank you

Included in "Voice and Noise", 2006

PS. My 2019 letter to the Financial Stability Board

My comments on the World Bank's Strategic Framework 04-06

"Basel dictates norms for the banking industry that might be of extreme importance for the world’s economic development. In Basel’s drive to impose more supervision and reduce vulnerabilities, there is a clear need for an external observer of stature to assure that there is an adequate equilibrium between risk-avoidance and the risk-taking needed to sustain growth. Once again, the World Bank seems to be the only suitable existing organization to assume such a role."

“Ages ago, when information was less available and moved at a slower pace, the market consisted of a myriad of individual agents acting on limited information basis. Nowadays, when information is just too voluminous and fast to handle, market or authorities have decided to delegate the evaluation of it into the hands of much fewer players such as the credit rating agencies. This will, almost by definition, introduce systemic risks in the market and we are already able to discern some of the victims, although they are just the tip of an iceberg. Once again, perhaps only the World Bank has the sufficient world standing to act in this issue.” 

"A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind. Who could really defend the value of diversity, if not The World Bank?"

PS. A 2003 letter in the Financial Times on this systemic risk

PS. My 2019 letter to the Financial Stability Board

Financial Sector Assessments Program: Review, Lessons and Issues going forward

My written statement as an Executive Director of the World Bank, March 20, 2003

The financial sector’s role, the reason why it is granted a license to operate, is to assist society in promoting economic growth by stimulating savings, efficiently allocating financial resources satisfying credit needs and creating opportunities for wealth distribution. Similarly, the role of the assessor –in this case, the Bank– is to fight poverty, and development is a task where risks need to be taken.

From this perspective we have the impression that the Financial Assessment Program Report might revolve too much around issues such as risk avoidance, vulnerabilities, stress tests and compliance with international regulations, without referring sufficiently to how the sector is performing its social commitments.

As an example, only in Supplement 3, Development Issues in the FSAP, does the Bank acknowledge that; “for lower income countries with less-developed financial system, in order to be relevant to country authorities, the emphasis in the FASP must change… how residents can get a better access to a wider range of financial services”, having to confess, in the very same page, that “no formal methodologies exist for how to address development issues in the FSAP”.

Another example is present in the survey of countries’ experiences (Supplement 2), when in the case of Armenia, page 6, in response to the problems of “(i) weak credit culture with the prevalence of non-payments mechanism that undermine the development of the formal financial sector; (ii) limited access to formal, affordable financing by small and medium enterprises, a typical development trap in transition economies; and (iii) the slow pace of banking sector consolidation”, the only exemplified recommendations are; “(i) enhancement of the central bank’s ability to deal with insolvent banks, (ii) strengthening of penalty provisions and (iii) increase in minimum capital requirements”, 

On a separate issue, the document Global Development Finance 2003 discussed last week and in relation to the minimum capital requirements of the Basel II proposals, states that they “include the likelihood of increased costs of capital to emerging market economies; and an “unleveling” of the playing fields for domestic banking in favor of international banks active in developing countries”. We believe that this issue, and similar ones, should be addressed in many FSAPs, specially as the Bank could perhaps act as an honest broker in such matters.

Dear staff, management and colleagues, it is an appropriate time to remember Roosevelt when he said that “the only thing we have to fear is fear itself” and so, repeating what we have said in may other occasions, we have to find ways of helping the Knowledge Bank evolve into the Wisdom Bank or, more humbly, the Common Sense Bank.

Thank You

Oral Statement:

Mr. Chairman, although we already made a written statement, there are some brief comments that I wish to make in order to better illustrate our concerns, so please bear with me.

In Supplement 2, the Survey of Country Experiences, I believe that it is quite illustrative, that in the very, very first example listed: “After identifying the following problems: weak credit culture with a prevalence of nonpayment mechanisms that undermine the development of the formal financial sector; limited access to formal, affordable finance by small and medium enterprises; and the slow pace of banking sector consolidation”, the only recommendation put forward to the country in that example are: “enhancement of central bank’s ability to deal with involvement bank; strengthening of penalty provisions; and increase in minimal capital requirements.”

I don’t think that those are just the answers that should come from a development institution. We all know that risk aversion comes at a cost - a cost that might be acceptable for developed and industrialized countries but that might be too high for poor and developing ones. In this respect the Bank has the responsibility of helping developing countries to strike the right balance between risks and growth possibilities.

In this respect let us not forget that the other side of the Basel [Committee’s regulatory risk weighted capital requirements] coin might be many, many developing opportunities in credit foregone.

Why do I make these comments with such candor? Because personally I have been learning for many years the consequences of a financial puritanism that seems to be invading the world and that does not get the real culprits, either. In the specific case of my country [Venezuela] the commercial banks credit portfolio fell in real terms from about $16bn in 1982 to only about $4bn in 1997.

In such a scenario, to hear about Basel [Committee] and its regulations reminds one of the make up of an already rigor-morted corpse, although we must admit that in the case of this particular corpse, we should know that even almost six feet under, it has been able anyhow to generate surprisingly large profits. 

I am certain that funds invested in FSAPs are very well invested funds, as fully attests that all the countries in my constituency to have done it. Nonetheless, in the area of risk management of finance, it might be an appropriate time to remember Roosevelt and that the only thing we have to fear is fear itself.

And so, repeating what I have said on some other occasion in this particular respect, I believe that we truly have to find a way of helping the Knowledge Bank to try to evolve into something more of a Wisdom Bank, or, to put it more humbly, at least a “common sense Bank.

Lets start by making sure these Financial Sector Assessment Programs are true development tools. In this respect I would really like to make a brief reference to the issue of collaboration with the Fund. I think this is a particularly clear case that shows where the collaboration should perhaps not be that intense, because as a development unit, we have to look at the growth potential of the sector, the development side, and they probably have to look at the safety side. And it is between this type of balance and continuing balance that we can really assist.

Finally on a related issue, last week in a seminar on housing finance we heard that Basel is getting to be a big rulebook—this was said by the Bank. And, to tell you the truth, the sole chance the world has of avoiding the risk that Bank Regulators in Basel, accounting standard boards, and credit-rating agencies will introduce serious and fatal systemic risks into the world, is by having an entity like the World Bank stand up to them—instead of rather fatalistically accepting their dictates and duly harmonizing with the International Monetary Fund.

As an example the Bank has for some time unsuccessfully been trying to argue with the accounting boards that, following their current rulings is not the best way of reflecting the Banks’ own financial reality. Well if the Bank has difficulties, imagine the rest of the world.

Thank you.

PS. Are the bank regulations coming from Basle good for development?

The document that I presented at the High-level Dialogue on Financing for Developing at the United Nations, New York, October 2007

My comments on World Bank's "Global Development Finance 2003"

Chapter 3. Coping with Weak Private Debt Flows. 

Argentina’s External Debt furnace was stoked over a long period of time by high ratings issued by the credit rating agencies who, when they awoke surprised by the resulting mountains of debt, speedily reversed themselves 180 degrees, putting new pressure on interest rates and reinforcing the tragedy of a self-fulfilling prophecies. 

Venezuela, even though during the last couple of years has had a very low public external debt, less than 30% of GDP, which it has been servicing, has in a continuum been brought down to a highly speculative CCC rating, and has probably no alternative except that of waiting for a de-rating, the day the credit agencies happen to discover that it no longer has any outstanding debt. 

We make these somewhat exaggerated examples so as to remark the fact that, in this otherwise very complete Global Development Finance 2003, there is no mention about the issue of the growing role of the Independent Credit Rating Agencies, and the systemic risks that might so be induced, when they are called to intervene and direct more and more the world’s capital flows. 

It is not a small issue. Today many insurance companies and pension funds are already limited by the credit ratings for their investments and, for banks, we are only told things will get worse. 

For instance, Basel II, page 47, states “risk weights would be set for a bank’s exposure to sovereigns, corporations, and other banks based on ratings from major credit-rating agencies… the new methods of assessing the minimum-capital requirement is expected to have important implications for emerging-market economies, principally because capital charges for credit risks will be explicitly linked to indicators of credit quality… the regulatory capital requirements would be significantly higher in the case of non-investment grade emerging borrowers than under Basel I", plus finally “The current proposal places project loans in a higher risk category than corporate loans”. 

The sole fact that emerging countries, when affected by lower credit ratings, face additional difficulties to access investors with availability of long term financing, forces them into more short term arrangements which, compounded by the much higher rates charged, almost guarantee a crisis, once the snowball starts rolling. 

Chapter 3 dedicates six full pages to the interesting issue of the search for better crisis management, especially the problems surrounding sovereign debt restructuring. We commend this discussion as we agree with the statement that “Debt crisis have severe implications for the poor, who had no role in making decisions on borrowing” but, this only highlights the importance of carefully identifying, reviewing and correcting the factors that might lead to a crisis. 

We would also like to make a comment with respect to “Bank retrenchment in context”, page 45. It is said that “The significant presence of BIS-area deposit taking institutions is one of the most important ways in which the poorest developing countries” and that their presence “should improve the efficiency of the local financial intermediation system” but then, on page 47, Basle II, we read that “If, as expected, most domestically owned banks in emerging market economies adopt the standardized approach to credit risk, they will be at a comparative disadvantage vis-à-vis cross border lending by international banks when attempting to lend to high quality domestic borrowers”. There is a clear conflict between those two statements inasmuch the “comparative disadvantage” might justly be interpreted only as a disadvantage unfairly decreed by Basle, something which relates poorly to improving the efficiency of the local market. 

With respect to Basle, we would also like to point out that the document does not analyze at all a very fundamental risk for the whole issue of Development Finance, being it that the whole regulatory framework coming out of the BCBS might possibly put a lid on development finance, as a result of being more biased in favor of safety of deposits as compared to the need for growth. Even though, in theory, we could agree that there should be no conflict between safety and growth, in practice there might very well be, most specially when the approach taken is by substituting the market with a few fallible credit rating agencies. 

We would also like to comment with respect to credit derivatives. This market for credit risk transfer, that between 1997 and 2002 has “expanded more than ten-fold… reaching $ 2 trillion in outstanding notional value, expected to increase to US$ 4.8 trillion by end of 2004” and “yet the use of credit derivatives to manage risk is still only about 2 percent of their use in managing interest rate and currency risk” carries its own very clear and present danger of blindfolding the market as to where the real risks are truly allocated. Recently, and in relation to the losses from energy trading and their related derivatives, there have been reports that markets are still unsure on where the losses are finally going to surface… and be paid for. 

As the financial sector grows ever more sophisticated, making it less and less transparent and more difficult to understand for ordinary human beings, like EDs, it is of extreme importance that the World Bank remains prudently skeptical and vigilant, and not be carried away by the glamour of sophistication. In this particular sense, we truly believe that the World Bank has a role to play that is much more important than providing knowledge per-se and that is the role of looking on how to supply the wisdom-of-last-resort.

A new breed of systemic errors

Sir, except for regulations relative to money laundering, the developing countries have been told to keep the capital markets open and to give free access to all investors, no matter what their intentions are, and no matter for how long or short they intend to stay.

Simultaneously the developed countries have, through the use of credit-rating agencies, imposed restrictions as to what developing countries are allowed to be visited by their banks and investors.

That two-faced Janus syndrome, “you must trust the market while we must distrust it,” has created serious problems, not the least by leveraging the rate differentials between those liked and those rejected by our financial censors. Today, whenever a country loses its investment-grade rating, many investors are prohibited from investing in its debt, effectively curtailing demand for those debt instruments, just when that country might need it the most, just when that country can afford it the least.

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.