“Confidence Levels”

In “An Explanatory Note on the Basel II IRB Risk Weight Functions” published by the Basel Committee on Banking Supervision in July 2005, we read in 5:1:

"The confidence level is fixed at 99.9%, i.e. an institution is expected to suffer losses that exceed its level of tier 1 and tier 2 capital on average once in a thousand years. This confidence level might seem rather high. However, Tier 2 does not have the loss absorbing capacity of Tier 1. The high confidence level was also chosen to protect against estimation errors, that might inevitably occur from banks’ internal PD (Probability of Default), LGD (Loss Given Default) and EAD (Exposure at Default) estimation, as well as other model uncertainties. The confidence level is included into the Basel risk weight formulas used to provide the appropriately conservative value of the single risk factor.”

Three things come to mind: First, of course, how little resilient those confidence levels turned out to be… in just about the first 3 years of those thousand years… not only a couple banks went down.

The second, much more important… Who authorized these regulators to set a confidence level for our banks at 99.9%? ... Are our banks not supposed to take more risks than that in order to help the society to move forward? Where would we be had that sort of confidence levels been applied?

And last, what kind of confidence level should we have in that these regulators, locked in their little incestuous mutual admiration club, really know what they are up to?

You need to learn think more about your financial regulations in terms of national security.

If you deposit you money in your local bank the current bank regulations stipulate the following:

If your bank relends that money to a sovereign rated AAA, like the US Government, then it needs no capital at all, meaning being allowed an unlimited leverage;

If it lends to a sovereign country that has been rated A+ to A, like Greece was from July 2000 until December 2009, or to a private client rated AAA, then it needs only 1.6 percent capital, implying that a leverage of 62.5 to one is allowed;

But, if it lends it to a small businesses or entrepreneurs, those on whom we depend so much for our jobs, those who cannot afford being rated by the raters, those who the banks are supposed to help while they make it to the capital markets, then your bank is required to have 8 percent in capital and need to limit their leverage to 12.5 to one.

This means that what is perceived as having low risks and which therefore already benefits from lower interest is now additionally benefitted by generating very lower capital requirements; while what is perceived as having higher risks and which is therefore already punished with higher interest rates, is, in relative terms, further punished by having to cover the costs of the higher capital requirements they generate.

That signifies that, in the land of the brave, the regulators, in a very non-transparent way, have created a totally arbitrary subsidy of risk adverseness, which is changing the character of your country, for no good reason at all, like the current crisis proves.

These regulations created a huge demand for anything rated AAA, and the market, being what it is, supplied AAAs, though most of them were naturally fakes, since we all know there is very little in life so truly free of risks that it can merit an AAA.

Besides, even if the credit rating agencies were to be 100% accurate in their ratings, who can guarantee us that the future of this, or any other country, is to be found in never-risk-land. Risk is the oxygen of any development. I ask how can you risk the life of your sons and daughter for the future of your country and not risk your money with those most likely to take your country forward.

And that is why you have to learn think of your financial regulation more in terms of national security.

What should be done? For the time being, while the banks are slowly rebuilding their capitals to cover for all the losses incurred in triple-A rated operations, we should at least lower their capital requirements when lending to the small businesses and entrepreneurs, who had nothing to do with creating this financial crisis.

We need to stop the credibility asymmetry that exists in the credit risk information market

One of the problems with credit ratings is that they are never sufficiently publicly debated, unless when it is too late, and when that happens then it is mostly the case of a small questioner against the mother of all father authorities in the markets.

Too often have I heard bankers ask me “Per, how on earth do you think I could convince my colleagues on the Board that the credit rating agencies were getting it so extraordinarily wrong that we should exit from what seemed to be an extraordinarily good business for us?”

In our efforts to solve the asymmetry in information we have increased the asymmetry of the credibility with respect to financial information, making it now almost impossible for divergent opinions to nudge the markets on the margin, and being only considered when the causes for the divergence become much too apparent, which is of course then much too late.

The first thing that should happen is that the credit rating agencies should be required to post, real time, all the questions and answers received with respect to every particular ratings, so to allow the market to express their viewpoints and to allow configure the necessary opinion majorities that could force the credit rating agencies to revise what they are doing.

If that Bank Director friend of mine could have referred to a place where those same suspicions were uttered by others, then he would stand a much better chance of being heard.

I repeat. We need an official online forum where we can question each and every single credit rating. That’s transparency!