Sunday, December 27, 2009

A letter in the Washington Post

Another 'worst': Faulty bank regulation

The Dec. 20 Outlook compilation of the decade’s worst ideas did not 
include the one most to blame for the loss of most of the past decade’s 
growth: regulations that allowed banks to hold absolute minimums of 
capital as long as they lent to clients or invested in instruments rated 
AAA, for having no risk. This launched a frantic race to find AAA-rated 
investments wherever and finally took the markets over the cliff of the 
subprime mortgages.

The most horrific part is that it seems likely to endure because 
regulators can’t seem to let go of this utterly faulty regulatory 
paradigm. Let me remind you that banks are allowed to hold zero capital 
when lending to sovereign countries rated AAA and that there are already 
many reasons to think that the credit quality of many sovereign states has 

Thursday, December 17, 2009

The day SEC delegated to the Basel Committee

On April 28, 2004 in an Open Meeting the SEC had the following as Item 3 on the Agenda:

"Alternative Net Capital Requirements for Broker-Dealers that are Part of Consolidated Supervised Facilities and Supervised Investment Bank Holding Companies"

The following was considered and approved:

"The Commission will consider whether to adopt rule amendments and new rules under the Securities Exchange Act of 1934 ("Exchange Act") that would establish two separate voluntary regulatory programs for the Commission to supervise broker-dealers and their affiliates on a consolidated basis.

One program would establish an alternative method to compute certain net capital charges for broker-dealers that are part of a holding company that manages risks on a group-wide basis and whose holding company consents to group-wide Commission supervision. The broker-dealer's holding company and its affiliates, if subject to Commission supervision, would be referred to as a "consolidated supervised entity" or "CSE." Under the alternative capital computation method, the broker-dealer would be allowed to compute certain market and credit risk capital charges using internal mathematical models. The CSE would be required to comply with rules regarding its group-wide internal risk management control system and would be required periodically to provide the Commission with consolidated computations of allowable capital and risk allowances (or other capital assessment) prepared in a form that is consistent with the Basel Standards. Commission supervision of the CSE would include recordkeeping, reporting, and examination requirements. The requirements would be modified for an entity with a principal regulator.

The other program would implement Section 17(i) of the Exchange Act, which created a new structure for consolidated supervision of holding companies of broker-dealers, or "investment bank holding companies" ("IBHCs") and their affiliates. Pursuant to the Exchange Act, an IBHC that meets certain, specified criteria may voluntarily register with the Commission as a supervised investment bank holding company ("SIBHC") and be subject to supervision on a group-wide basis. Registration as an SIBHC is limited to IBHCs that are not affiliated with certain types of banks and that have a substantial presence in the securities markets. The rules would provide an IBHC with an application process to become supervised by the Commission as an SIBHC, and would establish regulatory requirements for those SIBHCs. Commission supervision of an SIBHC would include recordkeeping, reporting and examination requirements. Further, the SIBHC also would be required to comply with rules regarding its group-wide internal risk management control system and would be required periodically to provide the Commission with consolidated computations of allowable capital and risk allowances (or other capital assessment) consistent with the Basel Standards."

In other words, that day the SEC, explicitly, delegated some of its functions to the Basel Committee.

That day Goldman Sachs, Morgan Stanley, Bear Stern, Lehman Brothers, Merrill Lynch were authorized to leverage themselves way more than was traditional. In fact 62.5 times to 1 when in the presence of a AAA rating. That day those firms were authorized to use their own financial models to govern themselves. “With that the five big investment firms were unleashed”.

That day a very serious warning by Mr. Leonard D Bole was blithely ignored.

You can hear the New York times commenting more about that highly unfortunate delegation here

Friday, December 11, 2009

Risk management is not a petit committee issue! Regulators and credit rating agencies should not preempt the markets!

The report by the Institute of International Finance, IIF, “Reforms in the Financial Services Industry” states not surprisingly that “Strengthening risk management is a top priority, and risk functions are being reconfigured and upgraded to give firms a more integrated approach to risk management."

The report, making many good and valid observations in reference to risk management, also warns about the risk of it "becoming too prescriptive, inducing many firms to adopt the same risk management approach. That would detract from the important competitive benefits resulting from each firm being free to make its own choices regarding risk appetite. More important, it would create significant “model risk.” If all firms were required to use similar approaches and models in managing risk, they could tend increasingly to behave in the same way, reinforcing procyclicality."

For someone who in 2000 warned of new regulatory risks arising in Basel writing “In the past there were many countries and many forms of regulation. Today, norms and regulation are haughtily put into place that transcend borders and are applicable worldwide without considering that the after effects of any mistake could be explosive.”, those comments are pure music.

I have also argued that the only valid regulatory response that fosters market diversity in risk management is the establishment of some very simple rules that do not introduce more distortions and complications than those already abundant in the real world.

In this respect, the regulator, instead of permitting different capital requirements for different assets depending on perceived risks should require equal capital requirements for any type of assets and let the risk appraisal process to unhindered fully take place in the market, between bankers, shareholders and creditors… instead of, as currently is the case, between bankers, regulators and credit rating agencies.

The IIF report though understandably not totally clear on the issue, acknowledges it when it makes a sort of veiled leave-us-alone pleading stating among its “leading points”:

Communication and disclosure of risk appetite: Firms should improve their disclosure practices regarding their risk appetite determination (e.g., what metrics they use, their level of tolerance, their decision-making processes). These disclosures display to stakeholders, analysts, and creditors —in short to the market—how rigorous and robust the risk management framework is at an individual firm, hence contributing to effective market discipline.

Regulators and risk appetite: Some supervisors’ reports have called for authorities to monitor and regulate banks’ risk appetite. While it is legitimate for macroprudential regulation to gather information on firms’ risk appetites, and it is legitimate for supervisors to challenge the firm’s risk appetite and the means by which this is identified and transmitted, firms should be able to define their own risk appetites with the interests of their direct stakeholders in mind.”

Friday, November 20, 2009

An unconstitutional odious discrimination!

When a bank lends to the government it is required to hold zero percent in equity; when it lends to a corporation rated AAA by one of three credit rating agencies then they need 1.6 percent; but, when lending to an entrepreneur or a small business that has not been rated, then the bank is required to hold 8 percent in equity. As bank equity is scarce and expensive this amount to an arbitrary discrimination against unrated entrepreneurs and small businesses.

If I was an entrepreneur or a small business in the US I would go to a judge and denounce that I am being discriminated against by the financial regulators, in an unconstitutional way.

I would also take the opportunity to explain to the judge how perfectly stupid this discrimination is considering that it is precisely the entrepreneurs and small businesses those who can create the real fiscally sustainable jobs, as well as the AAAs of tomorrow; and also remind the judge that entrepreneurs and small businesses had nothing to do in creating this crisis.

PS. What would the US Supreme court opine if asked: “Is a regulatory discrimination against The Risky and in favor of The Infallible, not an odious and unconstitutional negative action?”

Wednesday, October 28, 2009

Bubble talk!

I am getting a bit nervous with all this bubble talk.

How are they intent to do their bubble-busting? Are the regulators now going to appoint bubble-measurers? Are we going to have these assets bubble-meters being showed off in Times Square? What instruments to puncture them are going to be used? Talk about value of inside information!

Much the same way it sounded so utterly reasonable to have the credit rating agencies influence how much equity banks should have, and look where it led us. This reasoning just like it assumed that a risk of default was a risk of default, assumes that a bubble is a bubble, and that there are no risks derived from pre-announcing that a bubble will not happen.

And what if the prime motor of development is the belief in the possibilities of the next bubble? If we ex-ante eliminate the possibility of a real bubble, how many will just stay in bed while other countries, those with no qualms about a crisis because for them any status quo is worse, will go forward?

If there is something truly lacking in the current discussion on regulatory reform that is the consideration of the good things that come with risk-taking and now, the good things that come from bubbles.

Me, I really would love the world to keep on taking risks and blowing bubbles, even at the cost of suffering huge setbacks, as long as that takes us forward. Because of this, more than worrying about where the next precipice might be, I would try to make more certain that we are heading in the right direction.

Others, baby-boomers and wimps, on the contrary, seem to be satisfied with what they have achieved and are happy settling for just keeping it.

This is a great opportunity for developing countries to catch up... I can already see the billboards “Have bubbles, willing to party, for real, no adult supervision, foreign investors welcome!” While the developed countries set up theirs, on Wall Street, announcing “Welcome... guaranteed no bubbles!”

Real capital might be coward... but it sure loves bubbles.

Saturday, October 24, 2009

My voice and noise on the regulatory reform of banks

I will keep here, at the top of, my most recent version of my proposal on how to reform the regulations of our banks. Since I am just a citizen working on his own I would appreciate any comment or editing suggestion and which you can send to my email

My voice and noise on the regulatory reform of banks


It is we the people who are supposed to be able to invest our savings in low-risk-operations. It is them the bankers, those who are supposed to be the professionals, whom we should count on to identify those risky risk-taking entrepreneurs most capable of restoring fiscally sustainable growth and create decent jobs, and then take the risk of lending to them.

Why then has the regulator been so set on having the banks avoiding ordinary banking risks, and have instead create incentives for our banks to finance those already rated AAA and who should not even need the help of a bank? In truth, the AAAs should be the almost exclusive territory of widows and orphans.

The bank regulatory framework which emanated from Basel and which promoted a highly imprudent risk-aversion in our banks, instead of a prudent risk-taking, represents a failure of immense proportions and it needs to be stopped, right now.

The following are some suggestions on that route and I call on anyone who knows the value of living in a “land of braves” to help to stop the arbitrary taxes on risks imposed on our banks by the Basel wimps.

We should temporarily lower the capital requirements for what is perceived as high risk.

The first, and basically only pillar of the Basel regulations, the minimum capital requirements, establishes that when a bank has an asset that carries an AAA rating it is required to hold 1.6 percent equity while, if it lends to an unrated entrepreneur it needs 8 percent. The difference of 6.4 percent, especially when bank equity is scarce and expensive, represents effectively a high and totally arbitrary regulatory tax on perceived risk; and which has to be added on to what the market already charges in premiums for risk.

Therefore and while we are increasing the extraordinary low capital requirements for the “low-risk” operations, which have proven to be so dangerous, we must, in order to avoid that "high-risk" borrowers are unduly crowded out from bank lending, substantially reduce the capital requirements for all those operations that are deemed more risky, in essence those rated BB+ or below. As an initial level I suggest 4 percent.This is real counter-cyclicality.

Once the banks have achieved a level of 4 percent (tier-one) capital for all of their assets (including government) and once out of the woods of this crisis, we must rebuild the capital base of the banks to a level ranging between 8 and 12 percent, for all assets, government included, cash excepted, a level that could fluctuate depending on where we find ourselves in the economic cycle.

Can the banks currently handle a 4 percent in capital requirements when lending to a risky entrepreneur? Yes, I am absolutely sure that a shell-shocked banking sector will behave prudently with what is perceived as “high-risk”. In fact since what normally produces certain carelessness are those loans and investments perceived as being less-risky, one could build a case for arguing that it is the “lower-risks” that should have higher capital requirements.

Since I am aware that the above sounds somewhat strange in the midst of the knee-jerk rule tightening reactions that a crisis always produces let me remind you that the first wave of bank losses sustained in this crisis from lending or investing in what required 8 percent of capital were only a fraction of those first wave losses sustained in “safe” 1.6 percent endeavors.

By the way, arguing in the first place that the losses that arose in connections to the safest assets, houses and mortgages, in the safest of the countries, the USA; and in the safest instruments, rated AAA, has anything to do with excessive risk-taking, seems to me somehow to include a dose of intellectual dishonesty.

Suppose a person entered a modern building and took an elevator that was supposed to be duly checked and then died in an accident because some inspectors did not do their job… would you call that excessive risk-taking? Of course not!

Purpose of the banks

The 347 pages of Basel II regulations contains not one single phrase, much less a paragraph that has anything to do with establishing the purpose of our banks

Therefore we must require from the bank regulators to define the purpose for our banks, because without doing so, how can they regulate and how can we be sure they are taking the banks to where we want them to go? Let me below give you a hint

What’s in it for humanity for the banks to finance the AAA rated? Nothing! The real or fake AAAs are already more than strong enough, and so who we really need for our banks to support are those with BB+ or below ratings in order for these to have the chance of becoming the real AAAs of tomorrow. What the banks are supposed to do is to help society to evaluate the BB+ or below rated in order to generate new winners, while creating the lowest possible contingency risks for having to bail out the depositors if the banks fail in their mission.


Currently when a bank lends or invests in paper of the government there are no capital requirements. This amounts to an outright discrimination in favor of the government and against the citizen. I do not see how see how this could have been in the minds of any founding fathers.

Over a period of time we should reach a point where the capital requirements for banks when lending to the government, are the same to those when lending to an ordinary unrated citizen.

Credit rating agencies.

In January 2003 the Financial Times published a letter I wrote that included

“Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds”

And of course if we insist on blindly following the opinions of the credit rating agencies, as has been the case, we are sooner or later doomed to be back to the point where this crisis started.

But, what need is there to have the credit rating agencies pointing out the directions with 100 percent accuracy, if we should not be going to the place we are going? None! We cannot afford to channel scarce funds, by means of very low capital requirements for what is perceived as “low-risk”… into financing something, if that something is useless… like perhaps building a huge inventory of coffins. at zero percent interest rates.

And so, referring to the previous point, we should not waste a single second by reforming the credit rating agencies, when by reforming what really needs to be reformed, namely eliminating the regulations that discriminate based on risk of defaults, the problem of humanly faulty credit rating agencies will be solved on its own.

"Too big to fail."

In February 2000, in the Daily Journal of Caracas, in an article title “Kafka and global banking” I wrote:

"… thank God we still have several banks to work with". Imagine if we would have had to discuss the issue with an official of the One and Only World Bank (OOWB). Without a doubt this would present us with a future full of horrendous Kafkaesque possibilities. With every day that passes we have fewer and fewer banking institutions worldwide with which to work. This trend has been marketed as one of the seven wonders of globalization.”

Also in May 2003 in a risk management workshop for regulators at the World Bank I held

“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, having said all that, I equally believe firmly in that we are not well served by rushing to solve this particular problem, especially while we have much more urgent matters at hand, such as getting out of the woods.

And neither should we break up large banks while we still have regulations in place that breed and support large banks… does that not seem logical?

If there is one alternative that should definitely be explored is that of using a Non Operating Holding Company (NOHC) under which to separate the different activities of the typical huge bank of today and which I have seen proposed by OECD in their "The Financial Crisis: Reform and Exit Stategies". I find this route to be a very sensible and not too traumatic alternative and, if it would prove not to be working, we would at least already have it cut up in more digestible pieces.

Therefore my suggestion on the "Too Big To Fail" issue would be to give the largest banks some basic separation guidelines and ask them to come back for a proposal on how they would wish to set up their NOHC, if so required, and then take it from there.

On derivatives

Just get a central clearing house for anything that seems to taking on the form of a mass market and let all the rest be, stating of course, very loud and very clear, your caveat emptor and your caveat venditor.

Derivatives which cover real original risks are never as dangerous as derivatives designed to exploit arbitrary differences of a regulatory system.

The reason is that in real derivatives, for each seller taking the risk of being a seller, you always find a buyer taking the same sized opposite risk as a buyer… and all they have to do is being sure that the other counterpart has the means to pay out if he has to.

But, when derivatives are entered into in order to exploit a regulatory arbitrage, you find sellers and buyers more like partners eagerly sharing a free prize, and which often means they will let down their guards somewhat on each other´s respective counterparty risk.

Example: If a bank has an exposure to a an A- client then it needs a 4 percent equity but if it bought a CDS from a AAA rated insurance company (AIG) then it can get away with only 1.6 percent of capital. The saved difference of the costs of 2.4 percent of expensive bank equity, and which of course has nothing to do with real risks, can then be shared between a bank and an AIG.

When and if, as is here proposed, one eliminates the differences in capital requirements for banks based on risk, there are no longer incentives for this type of bastard derivatives…problem solved!

Systemic Risk

How are those who came up with the minimum capital requirements and enforced the use of credit rating, and thereby introduced so much systemic risk in the financial system, now going to control for systemic risk? They now mostly take systemic risk means to be institutions that are so large and important so as to create a risk for the system… that is just one of many systemic risks.


One thing is to bail out depositors for some fixed amount. But to think about the possibility of bailing out institutions because they might constitute a systemic risk is a totally different ballgame. That could be an open checkbook to disaster. As a government you should never want to have a pre-authorization to bailout a financial institution because then you are supposed to do so, or at least it is harder to say no.

We must measure and act during the full cycle.

If we are going to get the best out of our banks we have to stop measuring them only at their worst. We need to look at the full boom bust cycle since there are some busts where all the pains of a crisis are more than compensated with all achieved during the preceding boom, while at the same time there could also be booms that are so unproductive booms that no lack of a crisis pays for them.

Final Note:

I have been a financial advisor all my life never a regulator but when I started hearing about what the Basel Committee was up to I had to raise my voice. The surprise of my life is that still, two years into the crisis, the issue of the dangerous arbitrary risk aversion the Basel regulations were introducing in our financial system is not yet even discussed

Here is the link to the very first article I wrote on the subject in 1997

If you want to see more you can find it in:
or in
and in the more than 330 letters that I sent to the Financial Times on this issue and that can all be found in searching under the label of subprime banking regulations.

And you can also find a fun conspiracy theory of it all in:

Saturday, October 3, 2009

In the land of the brave?

The difference in bank capital requirement between an unrated client and an AAA is 6.4 percent, which at a capital cost of 15 percent, results in 1 percent a year. This represents a 1 percent tax on perceived default risk! Do the regulatory wimps really believe that creating jobs and moving the world forward is a risk free affair?

Read more at the Financial Times Economist Forum

Sunday, September 27, 2009

The financial regulator’s exam

Do you believe that the capacity of a client to repay his debt to a bank is so important to the health of the financial system and the economy so that you should not have any other concern than measuring the risk of default?

Do you believe that risk of default could be defined and measured in such a consistent way so as to be used for establishing different capital requirements for banks?

Do you believe there are credit rating organizations capable to resist being captured by those rated even if their ratings are used for establishing the capital requirements of banks?

If you decide to use different capital requirements for banks dependent on credit ratings will this be sufficiently transparent for the markets and not distort their risk allocation mechanism?

As a financial regulator do you see it your duty to stop any bank from defaulting?

Our financial regulators answered yes to all questions above and that is why we are in a mess. What is most incredible is that we allowed our financial regulators to elaborate and correct their exam themselves. From their answers anyone should have been able to see they were not ready to be financial regulators.

Wednesday, September 16, 2009

The current bank regulatory system is fundamentally flawed, at its core.

Even if the credit ratings are absolutely right, using them as they are used, as a basis for calculating capital requirements of banks, is wrong, because the regulators have no business introducing an arbitrary regulatory bias against risk-taking. The world moves forward taking risk, the world lies down and dies avoiding risk.
“The First Pillar” of our current bank regulations (Basel) establishes the “Minimum Capital Requirements” for the banks (MCRs).

The MCRs depend on a risk assessment of a quite vaguely defined risk of default. The risk assessment is to be carried out primarily by the Credit Rating Agencies but, in the case of larger banks, also by using their internal risk models. In this respect, as an example, the MCRs rule that if a bank lends to an ordinary not rated client, it is required to hold 8 percent in equity, which is equivalent to an authorized leverage of 12.5 to 1, but, if lending to a client that is rated AAA, then it only needs to hold 1.6 percent in equity, which is equivalent to an authorized leverage of 62.5 to 1.

The above represents two risks, both clearly evidenced in the current crisis.

The first is that the credit rating agencies, by being captured by other interests or plainly because of human fallibility, could be wrong in their assessments, with the consequences that too much capital will follow the wrong ratings in the wrong direction. The current crisis did not result from investment in anything that could be considered as risky but almost exclusively from investments in instruments carrying an AAA rating and which were considered to be absolutely free of risk.

The second risk with the structure of the MDCs is that they effectively imply a subsidy to anything perceived as having a low risk and, comparatively, a tax on whatever seems to carry a higher risk. The subsidies, or costs, of these regulatory risk-weights, are layered on whatever risk differentials the market already prices in their interest rate spreads. This creates confusion in the risk allocation mechanism of the market as the signals are obscured and no one knows for sure whether the low spreads are the result of low risks or the result of low capital requirements. But, so much worse, these risk-subsidies or risk-taxes help to channel and push capital flows into “risk-free” territories that could already be swamped or serve no real societal purpose, or stop capitals from flowing into dried areas much in need of capitals and which represent important societal purposes.

All human endeavors to move forward are risky by nature, and there is absolutely nothing that in economic terms justifies a regulatory bias in favor of what is perceived as having a low risk. In the current crisis immense amounts of capital were lost sustaining a useless and artificial housing boom in a developed country, and not lost in projects that for instance tried to combat climate change or create sustainable jobs.

The Gini Coefficient, in economics, measures the inequalities in the distribution of wealth and income, from cero, no inequalities, to 1, absolute inequality. The current bank regulatory system, by design, with the MDCs pushes up the world’s Gini Coefficient. Do we really want that?

Please help us mend the faulty core of our bank regulations. Without this, all our other important and needed efforts to reform our financial sector are meaningless.

Per Kurowski

Wednesday, September 9, 2009

The Basel Committee castrated our banks.

One of the most serious threats to development, both in developing and developed countries, is the castration of our banks by the Basel Committee by means of the minimum capital requirements for banks based on assessments of default-risk.

The real stability of a financial system does not depend so much on avoiding the risk of defaults but on making sure that the underlying growth of the economy in which the banks function is healthy and sustainable as a whole. In this respect, imposing “risk-weights”, could quite plausibly elevate the risks of getting the wrong sort of growth in which not only the banks would fail but also the rest of the economy.

The default-risk based capital requirements for banks have effectively imposed a tax on all lending to what is perceived by credit rating agencies as more risky, notwithstanding that these loans could be the most productive for the society; and effectively introduced a subsidy to anything that can dress up as having a low risk, notwithstanding that these loans could be the most unproductive for the society.

The default-risk based capital requirements for banks are effectively increasing the world’s Gini coefficient.

Therefore, if the wimps of the Basel Committee absolutely insist on discriminating between borrowers with their “default-risk weights”, then the society should at least have the right to request the introduction of some “loan-purpose weights” as counterweight to the risk-adverse maniacs.

Over the last years (2004-2007) trillions of dollars of funds, more than the World Bank and the IMF have lent altogether since they were created over sixty ago, were diverted, by the false AAA signs set up by the credit rating agencies, to finance an artificial housing boom. Had it not been for those signs much of those funds could have gone for instance to solve bottleneck problems in the infrastructure in developed and developing countries; to create decent jobs in developed and developing countries alike; or to help fight climate change.

Think of it, don’t you see that if the AAA ratings of the subprime mortgages had been absolutely correct then we could be on our way to something even more disastrous, as the world concentrated more and more all its scarce financial resources in the building and the revaluing of houses in the USA.

Friend, please act now and help us recover our banks.

And also, please stop calling what detonated because of investments in the supposedly safest assets, mortgages and houses, in the supposedly safest country, the USA, and in the supposedly safest instruments, those rated AAA, a financial crisis resulting from excessive risk-taking. It is a financial crisis caused by an excessive and completely misguided risk-aversion.

Tuesday, September 8, 2009

Comments on the “Principles for Reforming the U.S. and International Regulatory Capital Framework for Banking Firms”

If the regulatory principles involved had been right then the proposal would represent a quite reasonable to good tweaking of the current regulatory system. Unfortunately since the underlying regulatory principle is wrong the tweaking will not achieve the results that are needed.

The real stability of a financial sector does not depend so much on avoiding the risk of individual banks failing, but on making sure that the underlying growth of the economy in which the banks function, is healthy and sustainable as a whole.

In this respect introducing regulatory biases in favor of risk-aversion could quite plausibly elevate the risks of getting the wrong sort of growth in which not only the banks would fail but also the rest of the economy.

Therefore if the regulators absolutely insist on discriminating between borrowers with their “risk of default weights” then the society should at least have the right to request the introduction of some “purpose weights” as counterweight to the regulator’s extreme risk adverse bias.

Most of the problem we encounter with the reform derives from the fact that most still believe that this crisis resulted from some excessive risk-taking, even when staring at the evidence that most of the losses resulted from trying to earn a couple of more basis points investing in AAA rated securities. The day regulators are able to see it as it is, the result of a misguided risk-aversion, much of it induced by the regulators, that day we stand a better chance for a better reform of our financial sector.

Saturday, September 5, 2009

As to the financial crisis Paul Krugman does not know what he is talking about.

Paul Krugman in "How Did Economists Get It So Wrong?", September 6 writes “There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year”

Absolutely not! Paul Krugman, in relation to the financial crisis, has no idea of what he is talking about. The collapse was doomed to happen, courtesy of the financial regulations in place.

In January 2003 the Financial Times published a letter I wrote and that ended with “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds. Friends, please consider that the world is tough enough as it is.”

Also, in February 2000 in the Daily Journal of Caracas in an article titled “Kafka and global banking” I wrote the following:

A diminished diversification of risk. No matter what bank regulators can invent to guarantee the diversification of risks in each individual bank, there is no doubt in my mind that less institutions means less baskets in which to put one’s eggs. One often reads that during the first four years of the 1930’s decade in the U.S.A., a total of 9,000 banks went under. One can easily ask what would have happened to the U.S.A. if there had been only one big bank at that time.

The risk of regulation. In the past there were many countries and many forms of regulation. Today, norms and regulation are haughtily put into place that transcend borders and are applicable worldwide without considering that the after effects of any mistake could be explosive.

Excessive similitude. By trying to insure that all banks adopt the same rules and norms as established in Basle, we are also pushing them into coming ever closer and closer to each other in their way of conducting business. Unfortunately, however, nor are all countries the same, nor are all economies alike. This means that some countries and economies necessarily will end up with banking systems that do not adapt to their individual needs.

Truth is only some PhD regulators who have never ever stepped outside their offices to walk the real streets of finance could have been as naïve and gullible to believe they could empower the credit rating agencies so much to determine the financial flows without setting them up to be captured.

The sooner the world stops the financial regulations from falling excessively in the hands of the PhDs the better and this, of course, does not mean that I do not recognize the importance of the PhDs.

And, by the way, I am an economist… only that I have walked the streets as a professional for over 30 years.

Wednesday, September 2, 2009

I am so disappointed with conservative, progressive and of course middle of the road think-tanks.

The minimum capital requirements for the banks drafted by the Basel Committee and that apply or inspire most bank regulations in the world establishes that if a bank gives a loan to a normal entrepreneur who does not have a credit rating then it needs 8 percent in capital; if the loan is to a client with an AAA rating then 1.6 percent in capital will do and if it is a loan to its government then there is no capital requirement at all.

Dear libertarians/conservatives.

Eight percent in capital when lending to a citizen and zero when lending to the government…does this not upset you?

Is not risk taking what keeps a society moving forward? Is not taxing risks and subsidizing risk adverseness something like having your country lie down and die?

Do you not find it crazy that some few credit rating agencies, even if private, shall have so much to say in orientating the capital markets and messing up the risk allocation systems?

Dear progressives.

Eight percent in capital when lending to an ordinary citizen and 1.6 percent when lending to a company rated AAA… do you agree with such discrimination? Does not the AAAristocracy have enough advantages already?

Don´t you know that AAA ratings in just a couple of years drove more capitals to the US housing market than all the loans given by the World Bank and the IMF ever since they were founded? How come you can applaud silly initiatives like Banco del Sur when obviously a Credit Rating Agency del Sur seems to carry so much punch nowadays?

Low capital requirements just because someone has got an AAA rating and is supposedly risk free… and what about the purpose of the loans should not that count too?

Dear middle of the roaders.

All of the above plus:

Think about it, even if the credit rating agencies had been perfectly right in their assessments what would the country have gained… more mortgages to ever bigger houses?… more financing from abroad in order to keep on buying even more imports?

The way you kids growing up with GPS might never know what north, south, east and west means… do you want your bankers just to follow credit rating agencies opinions and never learn themselves about analyzing a client, looking him in the eyes and shaking his hand?

Do you really want to have your financial sector watched over by regulators so naive and gullible that they did not know that sooner or later the credit rating agencies that they empowered so much would be captured?

No, all of you think tanks!… what´s wrong with you?…. Too lazy to even read the Basel Epistles that governs most of your current financial regulatory system? As a fact, from all of the books articles comments and other ways of expression we see from those selling themselves as experts on the crisis, there is clear evidence that 99 percent of them have not even read an abridged version of what is contained in Basel II.

Or are you all just a bunch of baby-boomers who follow whoever promises most to avoid risks, while you are around, placing your reverse mortgage of the world and shouting “Après nous le deluge”? If so, shame on you all!

Saturday, August 22, 2009

Do you?

Societies, do you want your bankers to know about credit risks or do you give them credit rating agencies? (Like in: Parents, do you want your children to know about north, south, east and west or do you give them a GPS?)

Thursday, August 20, 2009

And, what about some minimum capital requirements to cover for the credit rating agencies’ exposure in credit risk opinions?

If the banks invest in AAA rated securities then these are risk-weighted by the regulator to only signify an exposure of 20 percent and so if the banks invest $1 trillion of 1.000 billion dollars in these securities they have to put up only $16 billion in equity, the result of multiplying the now risk-weighted exposure of $200 billion times the basic capital requirement of 8 percent.

And so $16 to cover $1.000! The question that hangs in the air is why then do not the rating agencies need some capital requirements to back up the accurateness of their ratings.

I mean after taking away the $16 billion of equity of the banks their opinions are sort of backing the remaining $ 984 billion. Is it prudent to trust the word of the credit rating agency so much? You tell me!

We live in a crazy world, our financial regulators in Basel were so naïve and gullible they did not even know they were setting the credit rating agencies to be captured.

Friday, July 31, 2009

Capital requirements for banks could use a "credit risk - credit purpose" matrix

On July 29 2009, in Venezuela, the financial regulator, Sudeban, issued a norms by which the risk weights used to establish the capital requirements of the banks were lowered to 50%, when banks lend to agriculture, micro-credits, manufacturing, tourism and housing. As far as I know this is the first time when these default risk-weights and which resulted from the Basel Committee regulations, are also weighted by the purpose of the loan.

The way it is done Venezuela lack a lot of transparency and it could further confuse the risk allocation mechanism of the markets (though in Venezuela that mechanism has already almost been extinguished) but, clearly, a more direct connection between risk and purpose in lending is urgently needed.

In this respect the Venezuelan regulator is indeed poking a finger in the eye of the Basel regulator who does not care one iota about the purpose of the banks and only worry about default risks and, to top it up, have now little to show for all his concerns.

I can indeed visualize a system where the finance ministry issues “purpose weights” and the financial regulator “risk-weights” and then the final weight applicable to the capital requirements of the banks are a resultant of the previous two.

Does this all sound like interfering too much? Absolutely, but since this already happens when applying arbitrary “risk weights” you could also look at this as a correction of the current interference.

Friday, July 24, 2009

Mark to market the government’s bail-out efforts

In order to bring some transparency to what the government is doing in bailouts it should sell in the market, at 100% of nominal value, a portion of the instruments they have received in return for their bailout funds; and compensate any differences in the market value of these instruments with a tax-credit. How would it work?

Let us say the government has received $100 in shares of GM. If these shares are worth that amount the government would get their money back immediately but, if not, buyers would ask to receive a tax credit. If the market only asks for a 10% tax credit, meaning $10 in tax credit to purchase the GM shares for $100 then the government is not doing so bad but, if the market asks for 90% in tax credits, then clearly the government is pouring money down the drain.

That would certainly pressure the government into doing better. Problem though is that most probably government would never dare to have their own actions marked to market that way.

Thursday, July 23, 2009

The risk in not running the risk of the risky

The current crisis detonated because of investments in assets of the safest type, houses and mortgages; in the safest country, the US; and in the safest type of zero-risk instruments, triple-A rated, that turned out bad. Even so the immense majority of financial experts, even Nobel Prize winners, explain the crisis as the result of “excessive risk-taking”. They are wrong; the crisis is clearly the result of an extremely misguided excessive risk-aversion.

Looking to help the large international banks to compete better with the smaller local banks, and wanting also to avert a new bank crisis, the regulators from some developed countries got together behind closed doors in Basel and came up with what they thought was the brilliant idea of determining the capital requirements for the banks, based on how the credit rating agencies rated a loosely defined default risk of borrowers and securities.

We are not talking about something insignificant. According to the regulations known as Basel II and that apply or at least inspire most banking regulations in the world, in order to lend funds to a corporation that does not have a credit rating a bank is required to hold 8 percent in capital, but, if lending to someone rated AAA it is only required to have 1.6 percent. As you understand, these regulations, approved in June 2004, started a wild chase after the AAAs… and here we find ourselves where the global losses in what was supposed to be risk-free exceed many times what has been lost in what was considered to be more risky… among others because what is perceived as risky by itself always inspires more care.

This regulatory system is still applicable, causing immense hardships in the world economy. In tandem with how the ratings of borrowers worsen the banks need to obtain more capital and since bank equity is scarce, they try to obtain it freeing themselves from clients for whom because these have even worse credit ratings, they are required to hold even more capital. With that all bank clientele that is perceived as more risky, but that is just as or even more important to the economy, is exposed to additional pressures, just when they least need it.

Companies that are presenting difficulties and have to restructure their liabilities are among those most affected by these puritan and intrusive regulatory inventions. Clearly if the difficulties of a borrower seem to be unsurpassable the best things to do, for all, is to speedily cut it off from credit, but, if after having analyzed it, the decision is taken to help it out, it does not make any sense making it even more difficult for it, like by imposing higher capital requirements on its creditor banks. It should be just the opposite, not only because these companies need to be treated with delicacy, but also since normally, they have been more scrutinized than the majority of firms that show themselves off as representing zero risk.

It is natural that creditors would charge more or less for a loan in accordance with how they perceive the risk but… on account of what does a regulator arbitrarily intrude in the decision? Is by any chance a job in a company rated B- less important than a job in a company rated AAA?

Risk is the oxygen of all development and in this respect regulations oriented to conserve what has been developed because it is more likely to be perceived as less risky, are unacceptable. Less risky for whom? For the world? How naïve! There is nothing so risky for the world than to refuse to run the risk of the risky.

The triple-A ratings have, in only about four years, without leaving much development in its wake, taken over the precipice more capital than all that lent by the World Bank and the International Monetary Fund since their creation sixty years ago. I have for years debated and fought these regulations from Basel, in the World Bank, in the United Nations and on the web… while others lose their time and our oil revenues in such absolute irrelevancies as a Banco del Sur.

Translated from El Universal, July 23, 2009

Tuesday, July 21, 2009

Something´s terribly wrong

When parents seem to give more importance to their children´s credit score than their school grades, like setting them up to the fact that they will have to work their whole life in just to pay interests, something´s terribly wrong

Tuesday, July 14, 2009

The danger with financial literacy programs

They usually start with the "A"... as in AAA

Sunday, July 12, 2009

Thursday, July 9, 2009

Let´s give Darwin a hand and tax those prone to sickness and subsidize those who rate healthy!

If the regulators of the insurance companies would decide to follow the regulatory paradigm concocted by the Basel Committee, then they would pick three health inspection agencies to rate the health of the insured and require the insurance companies putting up more capital when insuring someone with a low health rating and letting it of the almost off the hook if the insured is deemed to be in tip top form.

Since equity costs a lot, especially in times of crisis, the above is equivalent to placing a de-facto tax on those prone to sickness or giving a de-facto subsidy to those who rate healthy, both these on top of what the market already charges for any differences in health

With their minimum capital requirements based on a vaguely defined and extremely narrow concept of risk and as measured by their three amigos the credit rating agencies, the Basel Committee subsidizes anything that finds it easier to dress up in AAA clothing and castigates what is perceived as higher risk.

With these regulations they drove in a wedge that further increases the differences between the unsustainable status-quo and the sustainable future we all must try to reach, which of course requires a lot of risk-taking.

The misguided risk-aversion these regulations was the major force behind channeling in just a couple of years more than two trillion dollars into the supposedly safest asset, houses, into the supposedly safest country, the USA and into the supposedly safest instruments, AAAs…for no particular good reason at all.

All in all these Basel financial regulations add up to a crime against humanity and against common-sense.

Tuesday, June 30, 2009

Madoff got 54.900 days of jail, that’s ok, but should not regulators get at least 1 day in the slammer?

Madoff got a sentence of 54.900 days it serves him right but having said that the regulators should also spend at least one day in the slammer for the sake of justice, just to help us restore some minimum accountability. Are they not 1/54.900 part responsible for this crisis? Of course they are. Not only those who were paid to keep an eye on Madoff but even more so those in Basel who are responsible for setting up a system that stimulated the financial sector to depend so much on the opinions of the credit rating agencies and the race for the triple-As.

Sunday, June 21, 2009

They’ve left the rotten apple in the Financial Regulatory Reform barrel!

Though the proposed financial regulatory reform often speaks about more stringent capital requirements it still conserves the principle of “risk-based regulatory capital requirements” and by doing so the “new foundation” builds upon the most fundamental flaw of the current regulatory system.

Regulators have no business in trying to discriminate risks since by doing so they alter the risks and make it more difficult for the normal risk allocation mechanism in the markets to function.

Financial risk cannot only be managed by looking at the recipients of funds as lenders or investors are also an integral part of the risk. High risks could be negligible risks when managed by the appropriate agents while perceived low risks could be the most dangerous ones if the fall in the wrong hands.

The recent crisis detonated because some very simple and straight-forward awfully badly awarded mortgages to the subprime sector, managed to camouflage themselves in some shady securities and thereby hustle up an AAA rating. This crisis did not grew out of risky and speculative railroads in Argentina this crisis had its origins in financing the safest assets, houses, in supposedly the safest country, the US.

Are you aware of that for a loan to a borrower that has been able to hustle up an AAA the regulators require the banks to have only 1.6 percent in equity, authorizing the banks to leverage their equity 62.5 to 1?

Saturday, June 20, 2009

The credit rating agencies and the GPS

Not so long ago I asked my daughter to key in an address in the GPS and then even while I continuously heard a little voice inside me telling me I was heading in the wrong direction I ended up where I did not want to go. That is exactly what the credit ratings did to the financial markets, especially when the regulators created so many incentives to follow them.

“Too large to fail” are yet in some ways small fry

“Too large to fail banks” are regulatory peccata minutiae when compared to that of having created the credit rating agency’s oligopoly. The opinions of the credit rating agencies, that the regulators induced, brought on much worse systemic concentration of risks than the “too large to fail” banks.

And don’t get me wrong I was one of the few ones who spoke out against the “too large to fail” while they were still considered to be too large to fail and people kept mum about them. While an Executive Director at the World Bank in May 2003 I told a workshop of some hundred regulators for all over the world “Knowing that the larger they are, the harder they fall, if I were regulator, I would be thinking about a progressive tax on size”.

Tuesday, May 19, 2009

I don’t know… you tell me!

Of course most of the free-market oriented gurus had not the faintest idea about the possibility of the world running into a regulatory induced crisis, and much less did they warn the world about it, but, let’s face it, neither did the gurus of the other side, the Stiglitzes of the world. This should be more than a valid reason for the world to proceed with much caution when heeding the advice of experts. The Queen’s question about why nobody had seen it coming is as valid as ever, and LSE's Professor Luis Garicano answer to her "At every stage, someone was relying on somebody else and everyone thought they were doing the right thing" equally so.

I who as a severe critic of Basel II (and of Basel I) has followed closely the issues and the debates on bank regulations, I am aghast about having read so many reasonable arguments and proposals being ignored. If these small voices had been heard they could have saved us from the current disasters and hundreds of millions of individuals around the world would not have been condemned to misery. So what could we do about it? My number one, two and three recommendation is to beware of the self or media appointed experts who are mostly only concerned with pushing themselves or their agendas… and to severely limit their access to the microphone.
Now how do we do that? I don’t know… you tell me!

Saturday, May 2, 2009

Iceland: Financial System Stability Assessment—an Update completed August 2008

I invite you to read: “The update to the Financial System Stability Assessment on Iceland was prepared by a staff team of the International Monetary Fund and the World Bank as background documentation for the periodic consultation with the member country. It is based on the information available at the time it was completed on August 19, 2008 and provided background information to the staff report on the 2008 Article IV consultation discussions with Iceland, which was discussed by the Executive Board on September 10, 2008, prior to the recent Board discussion on a Stand-By Arrangement for Iceland.”

It makes fascinating reading, especially in these times when the regulators now want to tackle systemic risks while ignoring that their regulations are in fact the prime source of systemic risk.

In it, dated just a month before the crisis exploded at the end of September 2008, we can, among other, read the following:

“The banking system’s reported financial indicators are above minimum regulatory requirements and stress tests suggest that the system is resilient. Bank capital averaged almost 13 percent of risk-weighted assets between 2003 and 2006, dropped to 12 percent in 2007 and to approximately 11 percent in the first half of 2008, but remain above the 8 percent minimum. Liquidity ratios are likewise above minimum levels.

Notwithstanding the positive indicators, vulnerabilities are high and increasing, reflecting the deteriorating financial environment”

To me once again, this just proves that no one had the faintest idea of what the “risk-weighted assets” really meant and, if they did, they had no will to question the significance of risk-weighting.

Monday, April 20, 2009

Where were they when needed?

On June 26, 2004 the central bank governors and the heads of bank supervisory authorities in the Group of Ten (G10) countries met and endorsed the publication of the International Convergence of Capital Measurement and Capital Standards: a Revised Framework, the new capital adequacy framework commonly known as Basel II.

The framework was primarily based on the concept that financial risk could be measured and that the measurement itself would not affect risks. It therefore represented one of the most astonishingly naive financial regulatory innovations in the history of mankind.

As an example, the framework stated that if a bank lent to a corporation that did not have a credit rating then it needed to have equity of 8 percent, resulting in an authorized leverage of 12.5 to 1. But, if the corporation had been awarded an AAA to AA- credit rating by a human fallible credit agency, then the loan would be risk-weighed at only 20%, effectively elevating the authorized leverage to an amazing 62.5 to 1.

We all know that the market always contains plenty of incentives for high-risk credit propositions to dress up as being of lower risk, and so, when these incentives were exponentially elevated by the regulators, the biggest race ever towards false AAAs got started.

It took just a couple of months for the home mortgages to the subprime sector to manage to dress up about the lousiest awarded mortgages ever as AAAs. And It took just a couple of years for the market to massively follow those AAAs over a precipice, detonating one of the most horrendous financial crisis the world has ever encountered.

Now, one of the questions we need to answer, in order to have a better chance of finding a sustainable solution to this crisis, and alert us to the many other future crisis that will most certainly threaten us, is where were all the financial experts, the tenured professors and the members of think-tanks, all of whom we pay, honor and invite to opine, and that said absolutely nothing about all this? How come they did not see that this crisis was doomed to happen? Or, if they saw it, why did they not speak out?

At the end of the day, the simple truth is that the costs of regulatory innovations far exceeded the costs of financial innovations, and that the benefit from financial innovations far exceeded the benefits from regulatory innovations. And so, if we cannot have much better and more intelligent regulations then we are better off without them altogether.

Friday, April 3, 2009

Financial Stability Forum, please, show some courage to tell it as it is.

“Addressing procyclicality in the financial system is an essential component of strengthening the macroprudential orientation of regulatory and supervisory frameworks.” [and so there is a need to] “mitigate mechanisms that amplify procyclicality in both good and bad times”. That is part of what the Financial Stability Forum recommends in their report of 2 April 2009.

Indeed it sounds a so very impressive and technically solid conclusion? Yet it completely ignores that the prime reason why we find ourselves in the current predicament has much less to do with prociclicality in good times or bad times and much more with some good old fashioned plain vanilla type plain bad investment judgments. What had the world to do, whether in good or bad times, investing in securities collateralized by awfully bad awarded mortgages to the subprime sector in the USA? Would we be so deep in this mess had not the credit rating agencies awarded AAA to such securities? Of course not!

It is a shame that the Financial Stability Forum does not have in it to openly accept the fact that the whole risk based minimum capital requirements for banks idea imposed by Basel is fundamentally flawed, in so many ways. They only accept it in a veiled way when they recommend a “supplementary non-risk based measure to contain bank leverage”.

The lack of forthrightness serves no purpose and can only supply further confusion. Let me here just spell out two of the arguments I have been making.

The current minimum capital requirements are based on requiring less capital for investments that are perceived as being of lower risk while in fact, in a cumulative way, what most signifies a truly systemic risk for the world, lies exclusively in the realms of the investments that are perceived and sold as being of a low risk. In other words systemically the world at large does never enter B- land it goes like a herd to where it is told the AAAs live. The problem was not so much that the world went to play at the casino, the real problem was that the tables were rigged, one way or another.

In the current minimum capital requirements dictated by Basel a loan by a bank to a corporation rated AAA by a human fallible credit rating agencies requires only $1.60 for each $100 lent, equivalent to a 62.5 to 1 leverage and this obviously has much more to do with regulators losing their marbles than with times being good or bad.

This financial and economic crisis will cause more misery in the world than most if not perhaps all wars. Do you really not think the world merits the truth and nothing but the truth?

Wednesday, March 18, 2009

Two different approaches

There are two completely different approaches to commercial banking.

In the one that has been in vogue over the last decades you look at a monitor, check the credit ratings and invest where the spread is the largest, and then you key in your approval code. This approach allows you, supposedly, to manage the bank from a faraway distance.

The other system, the more traditional one, is based on looking into the eyes of your clients and to get to know them and their business intimately and then to shake their hands when you approve the loan. This approach has the added benefit of developing bankers.

I hold that the traditional approach, call it community banking, is immensely better for developing and middle income countries… that was in fact also the approach the developed countries used.

I hold that the traditional approach, call it community banking, has a better chance of helping to develop the growth that could generate jobs than to finance the anticipation of consumption at the cost of high interest rates and that only generates impoverishment.

I hold that the traditional approach, call it community banking, has a better chance of helping to develop the growth that could generate jobs instead of financing the anticipation of consumption at very high interest rates and that only generates impoverishment.

Sunday, March 1, 2009

62.5 times leverage?

I wonder what many of those out there discussing so pompously the financial crisis would be saying if they only knew such basic facts that the Basel Committee in their minimum capital requirements for the banks have actually authorized a bank to leverage its equity 62.5 times if it lends to clients perceived by the human and fallible credit rating agencies as AAA to AA-.

These so knowledgeable discussants would do well picking up some basic knowledge here:

Saturday, February 21, 2009

Thursday, February 19, 2009

Laissez-Faire? Ha!

The regulators ordered minimum capital requirements for banks based on the regulator’s very limited knowledge of about what risk is and thereafter effectively ordered the banks and markets to follow the opinions of the regulators favorite risk sentries the credit rating agencies. The banks and the investors obeyed and entered the swamplands of badly awarded mortgages to the subprime sector.

And they now dare to call that Laissez-Faire? They haven’t the faintest clue of what they are talking about.

Sunday, January 11, 2009

Do not stimulate until you drop!

A letter to the Washington Post that was not published:

Sir given that the consumer shopped until they dropped the only thing to hope for after reading Greg Ip's article on January 11 where he analysis a possible default option of the US on its public debts… is that the US does not now stimulate until it drops. 

Even though there are many seminars on "How to restore Global Financial Stability" let us not forget that the most important role for the US is to preserve the global financial stability we still have, namely the current role of the dollar in the international financial system.

And so, just in case, and especially after the unsettling recent experience with the adjustable mortgages, could we not ask the US to build up its debt with long term paper at fixed rates? I mean allowing so many to anchor their boats so close to the exit of that safe-haven the dollar currently represents seems not the wisest thing to do.