A letter in Washington Post: Another 'worst': Faulty bank regulation

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 been more than a bit overrated.

Here other of my letters in the Washington Post on the same theme:
http://subprimeregulations.blogspot.com/2018/07/trade-wars-will-mean-new-tariffs.html
http://subprimeregulations.blogspot.com/2017/04/when-banks-play-it-too-safe-putting.html
http://subprimeregulations.blogspot.com/2016/08/banks-and-regulators-dont-care-about.html
http://subprimeregulations.blogspot.com/2015/11/the-reverse-mortgage-on-economy-baby.html
http://subprimeregulations.blogspot.com/2014/12/another-letter-in-washington-post-let.html
http://subprimeregulations.blogspot.com/2013/04/another-letter-in-washington-post.html
https://subprimeregulations.blogspot.com/2008/06/a-letter-in-washington-post-aspect-of.html

https://subprimeregulations.blogspot.com/2007/09/factors-in-financial-storm.html

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

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.”