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.

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

perkurowski@gmail.com
http://financefordevelopment.blogspot.com/

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.

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.

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.” http://bit.ly/5i1Bu

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. http://bit.ly/HIi3x

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.

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!