62.5 to 1!

In 2003, at the World Bank I warned: "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"

The regulators they authorized a leverage of 62.5 to 1!

Uploaded by PerKurowski

PS. My 2019 letter to the Financial Stability Board (FSB)

 

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.

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?