Members of the Basel Committee consider yourselves insulted and challenged

The Basel Committee of Banking Supervision, that extremely important global regulatory agency, instructed the credit rating agencies to set up their warnings sign of perceived risk of default, ordered the banks to follow these signs, and then proceeded to calibrate the capital requirements of banks as if the banks did not see them. Somewhat like setting up traffic-lights all over town and synchronizing them under the assumption that drivers are blind.

Of course, if the regulators wanted to calibrate adequately for the default risk of any bank exposure to any credit rating, they could only do so by taking into account how the banks would react to those credit ratings…as well as considering the banks’ relative exposure to the different credit ratings. If a bank lends only to triple-A rated clients then its systemic danger, is only represented by its triple-A rated clients.

Since perceived risk is cleared in the market through the interest rates charged, this has signified that the relative profitability for the banks of lending to what is perceived as not risky, like what has a triple-A rating, increased dramatically, while the relative profitability for the banks of lending to what is perceived as more risky, like unrated small business and entrepreneurs, decreased.

Knowing as we should know that no bank crisis has ever resulted from excessive lending to what is perceived risky and that they have all resulted from excessive investments to what is perceived ex-ante as not risky, applying the Basel Committee’s current regulatory paradigm of capital requirements based on risk results clearly in counterfactual and stupid regulations. Also, since the most important role of commercial banks is to help satisfy the financial needs of those who are perceived as more risky and have not yet access to the capital markets, the odious discrimination against these clients (who are already paying much higher interest rates into the capital of banks) is doubly stupid.

If by any chance the issue of regulating on climate change would fall in the lap of an entity like the Basel Committee… we would all be toast.

For over a decade, even as an Executive Director of the World Bank 2002-2004 and always under my own name and indicating my email, I have presented many arguments against the current central regulatory paradigm use by the Basel Committee, that of capital requirements based on perceived risk of default, and called it stupid, stupid, stupid!

And by the way, if the regulators absolutely have an existential need to calibrate for risks, what is so particularly risky with defaults? Is not the risk of not creating jobs or the risk of increased un-sustainability worse? Does not just to think of a world without defaults make you shiver?

Having said that, not once, in all these years, has anyone identified as having anything to do with the Basel Committee ever denied my accusations, presented any counter-argument, or shown the least willingness to discuss the issue. Is it not strange? Could it really be that little me is right and these so expert experts are so utterly wrong? I dare them to prove me wrong!

In October 2010, during the annual meetings of the International Monetary Fund I publicly asked “Right now, when a bank lends money to a small business or an entrepreneur it needs to put up 5 TIMES more capital than when lending to a triple-A rated clients. When is the IMF to speak out against such odious discrimination that affects development and job creation, for no good particular reason since bank and financial crisis have never occurred because of excessive investments or lending to clients perceived as risky?” Dominique Strauss-Kahn, IMF’s Managing Director, answered in no uncertain terms that “capital requirement discrimination has no reason to be”, and so it seems that there are also other who agree with that the Basel Committee stands there completely naked without a functional regulatory paradigm.

In this moment when an extremely serious financial crisis affects the world and when the Basel Committee is digging us even deeper in the hole they placed us in, would we all not feel more comfortable if the Basel Committee at least agreed to a public debate on what I criticize?

Therefore…members and professionals of the Basel Committee consider yourselves slapped on the face with a glove and dared to accept the challenge. Wear with dignity your cones of shame!

Want a more detailed explanation? Listen to this home made video
http://subprimeregulations.blogspot.com/2010/09/the-financial-crisis-simple-why-and.html

Per Kurowski   @Per Kurowski

PS. I appreciate any help I could get in provoking the Basel Committee to respond to this challenge

PS. Risk taking is the oxygen of any development. God Make Us Daring!

PS. Has the Basel Committee just suffered the Nut Island effect? 

PS. US Congress, what are you up to? Over 2.000 pages of financial reform and you do not even mention once the Basel Committee which has so messed up the capital requirements of your banks.

PS. A small numeric example: If banks were allowed to leverage only 12.5 to 1 when lending to triple-A rated clients, which is what they were allowed to leverage when lending to small businesses under Basel II, then if they made a .5% margin, they would obtain return on capital of 6.25% lending to AAAs, decent but nothing to write home about, less pay bonuses on. But since they were allowed to leverage 62.5 to 1 they could, with the same .5% margin then make a return of capital of 31.25%. No wonder banks stampeded wanting the AAAs!

PS. A visitor from outer space, observing that banks are required to have 8% of equity when lending to a small businesses, but zero% when lending to a triple-A rated sovereign as the US, would he be at fault thinking he had landed on a communistic planet? With such an arbitrary discrimination in favor of the public sector, do you really know the real market interest rates on public debt?

PS. Since I am no regulator, or a PhD with published research on the subject, here are some of my early opinions on these regulations, which should evidence that I am far from being  very few pieces just another Monday morning quarterback:

http://subprimeregulations.blogspot.com/
http://financefordevelopment.blogspot.com/
http://baselcommittee.blogspot.com/
http://teawithft.blogspot.com/search/label/subprime%20banking%20regulations
http://www.theaaa-bomb.blogspot.com/

God make us daring!

Matthew 17:7 Jesus came up, touched them, and said, “Get up; don’t be afraid.”

Matthew 14:26-27 When the disciples saw Jesus, walking on the lake, they were terrified. It’s a ghost,” Jesus said: “Take courage! It is I. Don’t be afraid”

"Be not afraid. Open wide the doors to Christ." Pope John Paul 1978

The Western World was built-up with a lot of risk-taking but, 1988, one year before the fall of the Berlin Wall, its  regulators, with risk weighted bank capital requirements, imposed on its banks a dangerous risk aversion.

A Swedish psalm 288 Text: F Kaan 1968 B G Hallqvist 1970

Gud, från ditt hus, vår tillflykt, du oss kallar

ut i en värld där stora risker väntar.

Ett med din värld, så vill du vi skall leva.

Gud, gör oss djärva!

“God, from your house, our refuge, you call us

out to a world where many risks await us. 

As one with your world, you want us to live.

God make us daring!”

“God make us daring!” That is indeed a prayer that the regulators in the Basel Committee for Banking Supervision do not even begin to understand the need for.

The Parable of Talents

In 2000, Pope John Paul II reminded us that Jesus Christ invited the Apostle to "put out into the deep" for a catch: "Duc in Altum" (Lk5:2) "When they had done this, they caught a great number of fish" (Lk5:6). That's something regulators should remember when, with their risk weighted capital requirements, they want our banks to fish only from “safe” shores.

And Pope Francis addressing the European Parliament in 2014, might have delicately phrased its risk-aversion with: “In many quarters we encounter a general impression of weariness and aging, of a Europe which is now a “grandmother”, no longer fertile and vibrant. As a result, the great ideas which once inspired Europe seem to have lost their attraction, only to be replaced by the bureaucratic technicalities of its institutions”

“A ship in harbor is safe, but that is not what ships are for.” John A Shedd.

“A decline in courage is particularly noticeable among the ruling and intellectual elites, causing an impression of a loss of courage by the entire society. There remain many courageous individuals, but they have no influence.” Alexander Solzhenitsyn's Commencement Address, Harvard University, 1978

In “Against the Gods” Peter L. Bernstein writes that the boundary between the modern times and the past is the mastery of risk, since for those who believe that everything was in God’s hands, risk management, probability, and statistics, must have seemed quite irrelevant. Today, when seeing so much risk managing, I cannot but speculate on whether we are not leaving out God’s hand, just a little bit too much.

And all for nothing! At the end of the day the current risk-weighted capital requirements for banks guarantees especially large bank crises, caused by especially large exposures to something ex ante perceived, decreed or concocted as especially safe, and which ex post turns into being especially risky, while being held against especially little capital.

Here is a letter to the Financial Stability Board

Here is a letter to the IMF

Here is an aide-mémoire on what is so wrong with the current risk weighted capital requirements for banks.

Excuse me… what calibration?

During a recent conference titled “Financial Reform: What´s next” I had the opportunity to ask one of the Keynote speakers Mr. Donald Kohn the former Vice Chairman of the Federal Reserve the following:

Current bank regulations ordained by the Basel Committee require the banks to hold 8 percent in capital when lending to unrated small businesses and entrepreneurs while allowing the bank to invest in US government debt against zero capital. When looking at the interest rates in the market, how much do you think they are distorted by these discriminatory regulations?

His answer: “If the calibration is done right there are no distortions.” The session ended there and I had no chance to ask him: Sir, what calibration?

That which solely considers the risk of default, as perceived by the credit rating agencies, and that should at least consider the defaults of bank operations after the banks are given the credit rating information, and that should at least consider that those who are perceived as riskier pay higher risk premiums that goes into bank capital.

Why not a calibration based on different criteria, since the current calibration would sort of indicate that lending the funds to the government is infinitely more efficient for the society than lending them to small businesses and entrepreneurs… and that sounds not about right?

I am aghast at the thought that a financial super-expert can even think that if they are only well calibrated, the capital requirements for banks that discriminate among borrowers based on the risk of default as perceived by some few credit rating agencies, they will not distort… mostly because that can only mean the regulators will now proceed to dig us even deeper in the hole they placed us in.

What are we to do with the Financial Stability Board?

The Financial Stability Board (FSB) reported from their meeting in Seoul on October 20 ahead of the G20 Summit in Seoul and endorsed principles for reducing reliance on credit rating agency (CRA) ratings as follows:

“The goal of the principles is to reduce the cliff effects from CRA ratings that can amplify procyclicality and cause systemic disruption. The principles call on authorities to do this through:

Removing or replacing references to CRA ratings in laws and regulations, wherever possible, with suitable alternative standards of creditworthiness assessment;

Expecting that banks, market participants and institutional investors make their own credit assessments, and not rely solely or mechanistically on CRA ratings.”

Since FSB does not even mention the risk-weights we can only assume FSB feels that all what went wrong was the excessive reliance on the credit ratings. They have no clue. What went really wrong was the way the regulators arbitrarily assigned to the different credit ratings the different risk-weights which determined the capital requirements for banks… like the 20% risk-weight for any lending to private entities rated triple-A or 0% risk weight on any lending to sovereigns rated triple-A.

In other words the FSB is unable or unwilling to understand that the credit rating agencies could have been totally wrong and yet they would never have produces the damage they did with their faulty ratings, had they not been so incredible endorsed by the bank regulators.

And neither does FSB understand that their regulatory favors to what is perceived as having a low risk of default, amounts only to an odious discrimination of what is perceived as having a higher risk of default, and all for no real purpose at all, since we all know that what is perceived as risky does never carry the potential to turn into a systemic danger.

And so friends what are we to do with the thick-as-a-brick Financial Stability Board?

With their “Risk-Weights” it is the regulator who is taking the load off the books of the banks

With reference to all being written about that “distasteful” behavior of banks of putting much of their exposure off the books, you should perhaps consider the following:

When the regulators used (and use) a risk-weight of only 20% to reflect the risk-weighted value on the books of banks, of for instance lousily awarded mortgages to the subprime sector that manage to hustle up a triple-A rating, it was (is) the regulator who is taking 80% off the balance sheet(books)of the banks.

When the regulators used (and use) a risk-weight of only 0% to reflect the risk-weighted value on the books of banks of loans to a sovereign rated triple-A, like the US or UK, it was (is) the regulator who is taking 100% off the balance sheet(books)of the banks.

Sincerely, I doubt the banks could have managed that kind of disappearance acts on their own.

Sort of like Basel Committee shocked!

The Basel Committee on Banking Supervision is guilty of gross negligence

I have since 1997 been criticizing the regulatory paradigm of capital requirements for banks based on ex-ante perceived risks and applied by the regulators of the Basel Committee, primarily because I felt these would only confuse the market when it cleared for default risks by means of its risk premiums and that there were systemic dangers in forcing the opinions of the credit rating agencies too much on the banks.

Since all past financial and bank crisis have resulted from excessive investments in what ex-ante was perceived as low risk, I also saw these requirements of more-risk-more-capital, less-risk-less-capital, to be absolutely counterfactual.

As I frequently spoke out about the previously in very clear and harsh words, and never received a response, I simply assumed the Basel Committee regulators to be lost for words and incapable of assuming their responsibility; or just plain thick-as-a-brick.

Unfortunately, now I must also accuse them of gross negligence, as I have only recently been able to internalize to its full extent that when the regulators calculated their risk-weights, they never considered the fact that the riskier pay much higher premiums, and which, when repaid, as it most often is, goes directly to the capital of the banks.

In “An Explanatory Note on the Basel II IRB Risk-Weight Functions", July 2005 prepared by the Basel Committee on Banking Supervision we read: “Interest rates, including risk premia, charged on credit exposures may absorb some components of unexpected losses, but the market will not support prices sufficient to cover all unexpected losses.” That would prove the regulators decided to completely ignore the markets… with premeditation.

This is exactly like if the insurance regulators required the insurance companies to post higher capital when insuring the health of persons who represent higher health-risks, without accounting for the fact that these persons will be obliged, precisely therefore, to pay much higher insurance premiums.

How negligent can one be? This negligence resulted in an odious regulatory discrimination of those perceived as “risky”, like the many small unrated businesses or entrepreneurs who, as a result did not get access to bank credit or had to pay much more than the market premiums for it. It also directly provoked the current crisis by creating the incentives that made the banks stampede after AAA-ratings, until they took the world over the subprime cliff.

I do not know whether or where you can present an accusation against the Basel Committee for gross negligence, but I do know that all its members should be forced to parade down the major streets of many capitals in the world, wearing their cone of shame.

Did really the Basel Committee dare to ignore the markets completely? 100%?

Since 1997 I have been speaking out against the regulatory paradigm of capital requirements for banks based on ex-ante perceived risks applied by the Basel Committee and I have never really been able to figure out what went on in the minds of the regulators to come up with such an idea that, though sounding so logical, more-risk-more-capital less-risk-less-capital, is so utterly faulty and counterfactual, since bank crisis never ever occur form excessive investments in what ex-ante is perceived as risky- when in fact it is just the opposite.

My main suspicion derived from the fact that I have never seen the Basel Committee define a purpose for the banks, and, not doing that, led of course to the wrong regulations.

But lately I am starting to get an inkling that an even more astonishing possibility lies behind it all.

Could it really be that regulators completely ignored what “the riskier”, when paying higher interest rates than for instance those rated triple-A, contributed to bank equity?

Currently a bank lending to a triple-A rated company needs 1.6 percent of capital which allows for a 62.5 to 1 leverage, but when lending to an unrated small business it needs 8 percent of capital and is therefore limited to a 12.5 to 1 leverage.

Let us assume that the margin before credit losses on a loan to a triple-A rated company is .4% and that of a loan to an unrated entrepreneur, 4%. In that case triple-A rated companies provide the banks of a before credit losses return on equity of 25 percent (.4*62.5) while the loans to an unrated small business would result in before credit losses return on equity of 50 percent.

But what if both types of loans could be made with a 62.5 to 1 leverage? Then the unrated small businesses would provide a before credit losses return on equity of 250 percent (4*62.5) in which case we would ask... why regulators feel they are safer with banks lending to triple-A rated clients for a 25 percent margin before credit losses than lending to small unrated businesses that provide a 250 percent margin before credit losses? Do regulators really believe that the bankers are so bad at analyzing credits to small businesses so they are better of just following the ratings of the credit rating agencies?

If both types of loans were made with a 14.5 to 1 leverage? Then the triple-A rated clients would provide the banks with only 5 percent before credit losses return on equity (.4*12.5) and of course then the banker would have a better incentive to try to do a good job lending to small businesses as they are supposed to do.

Please read from The Basel Committee on Banking Supervision the document “An Explanatory Note on the Basel II IRB Risk-Weight Functions", July 2005.

In it we find “Interest rates, including risk premia, charged on credit exposures may absorb some components of unexpected losses, but the market will not support prices sufficient to cover all unexpected losses.”

That leads us to suspect that the Basel Committee completely ignored all the differences in interest rates that the market charges based on perceived risk… something like saying “the market is absolutely and totally useless and so we need to impose our own risk-weights, independently of what it does". Is this what they understand as de-regulation? What hubris! Help!

The Basel Committee on Banking Supervision has only a completely wrong and harmful tool in its toolbox.

Capital requirements based on the perceived risk of default as perceived by credit rating agencies or bank’s own internal risk analysis, is the most important tool in the toolbox of the Basel Committee for Banking Supervision.

The higher the perceived risk the higher the capital requirement, and the lower the perceived risk the lower the capital requirements. It all sounds so extremely logical. Unfortunately as all bank and financial crisis have exclusively originated from excessive investments in what has been perceived ex-ante as having a low risk; and none from excessive investments I what has perceived ex-ante as having high risk, this regulatory tool is totally counterfactual; and therefore totally counterproductive, as this crisis in triple-A rated territory clearly evidences.

And it is even worse than that. As that tool discriminates precisely against the type of clients banks are supposed to help the most, the small businesses and entrepreneurs who have little alternative access to finance, it harms the economy and job creation.

Day by day more get to be aware of this problem, and I had the chance to take it to the forefront by making questions in three of the events during the annual meetings of the International Monetary Fund and the World Bank, October 8-11, 2010

The problem though is that seem they do not yet know what to do about it… and so they try to ignore it and whistle in the dark. In one of the final seminars “The financial sector: navigating the road ahead, where there was no Q. & A. opportunity the basic problem with the capital requirements based on risk was not even mentioned, though the additional layers of confusion currently contemplated, such as capital requirements for liquidity risks, for systemic risk and for cyclicality risks were. Can there be something more pro-cyclical than helping the triple-A rated?

It is truly amazing to see how difficult it is for so many to extract themselves from the regulatory paradigm, or almost regulatory voodooism that has entrapped them. The only truly invisible hand at work was… that of the scheming banking regulators messing around with risk-weights under the table.

Below are the three events that I referred to, and where I asked my question.

The Civil Society Town-Hall Meeting

In the video you can find my question in minute 47.28, Dominique Strauss-Kahn’s answer in minute 1.01.08, and Robert Zoellick’s answer in minute 1.16.32

http://www.imf.org/external/mmedia/view.aspx?vid=628246206001

Structural Reforms: Effective Strategies for Growth and Jobs

Here my first and second question can be seen from minute 1.14.25 on.

http://www.imf.org/external/am/mmedia/view.aspx?vid=629575645001

Accelerating Financial Inclusion–Delivering Innovative Solutions

My question (not the best sound quality, but it is a similar question) can be found in minute 1.04.03 on

http://www.imf.org/external/am/mmedia/view.aspx?vid=629531170001

If the IMF and the World Bank bites the Basel Committee, that should be news.

Capital requirements for banks that discriminate based on ex-ante perceived risk of default, with higher requirements when risks are perceived as higher and lower when risks are perceived as lower, is about the only tool in the Basel Committee for Banking Supervision’s toolbox. This single tool is completely inadequate, even outright dumb, on two counts:

First, it is totally counterfactual as all the financial and bank crisis have always originated from excessive investments in what ex-ante is perceived as having a low risk of default and no crisis has ever originated from excessive investments in what is perceived as risky. The perception of being risky is as big a weight as it comes and does not need to be supported by additional arbitrary risk-weights imposed by regulators. Risk premiums reflected in higher interest rates that goes directly to the capital of the banks are more than sufficient risk-weights. If anything we might need regulatory risk-weights to make up for the risk of the ex-ante perceptions of low risk turn out to be false.

Second, these capital requirements unduly and odiously discriminate against those perceived as having higher risk like the small business and entrepreneurs, and who happen to be precisely those whose financial needs the society has the largest interest in that the banks help to satisfy.

That a Mr. Kurowski voices the above arguments over and over again is of no importance, but, when these arguments begin to find an echo in the World Bank and the IMF… which would mean that these two institutions would be the one calling out that “The Basel Committee has no clothes” then one could presume they get to be newsworthy.

Below is the link to the video where you can find the questions I made during a Civil Society Town-Hall meeting (minute 47.28) and Dominique Strauss-Kahn’s answer (minute 1.01.08) and Robert Zoellick’s answer (minute 1.16.32)

http://www.imf.org/external/mmedia/view.aspx?vid=628246206001

Today I had a great day

For someone who since 1997 has been opposing the regulatory paradigm used by the Basel Committee for Banking Supervision, even as an Executive Director of the World Bank 2002-2004, today was a great day.

As a member of Civil Society, whatever that now means, at a Civil Society Town-hall Meeting during the 2010 Annual Meetings, I had the opportunity to pose a question to Dominique Strauss-Kahn, the Managing Director of the International Monetary Fund, and to Robert B. Zoellick, the President of the World Bank:

My question: (minute 47:35) “Right now, when a bank lends money to a small business or an entrepreneur it needs to put up 5 TIMES more capital than when lending to a triple-A rated clients. When is the World Bank and the IMF speak out against such odious discrimination that affects development and job creation, for no good particular reason since bank and financial crisis have never occurred because of excessive investments or lending to clients perceived as risky?”

Dominique Strauss-Kahn's answer: (minute 1:01:05) "Well, the question about requirements, a couple of requirements for banks. You know, it's a very technical question and a very difficult one, but the way you asked the question, which is why there any kind of discrimination against SMEs is an interesting way of looking at that. In fact, there is no reason to have any kind of discrimination. The right thing for the Bank is to know whether or not their borrower is reliable, but you can be as reliable being a small enterprise than not reliable when you're a big company. So this kind of systematic discrimination has, in our view, no reason to be.

Robert B. Zoellick's answer: (minute 1:16:30) "On the new rules for global finance, you asked when would speak up on the bank capital. I've been doing so for two years. It's all over the website, because I started with trade finance, knowing that field pretty well. Pascal Lamy, the head of the WTO, and I have led a campaign that said you're going to make it harder for trade finance for developing countries if you have higher capital levels for doing trade finance. So we've pressed very hard on that issue. You get an advanced notice, because tomorrow morning I'll be doing a PowerPoint briefing of all the Governors, and what I'll be mentioning is that for developing countries as a whole, we are seeing foreign direct investment go up, access to bond markets go up, but a net negative inflow of banks, in part, because I think of some of the capital standards and other regulatory issues."

The question that now floats around there out in the open, is what the Basel Committee on Banking Supervision, the supreme global regulatory authority, has to say about that, because bank capital requirement discriminations based on perceived risks is precisely the heart and soul of their regulatory paradigm… without that they have nothing!

The video of the meeting

Is it really possible that the Basel Committee bank regulators did not think of this?

When a bank client, perceived as more risky, like for instance your average small business or entrepreneur, is requested to pay for instance 5 percent or more on their loans than what a triple-A rated client pays, where do you think that 5 percent or more goes to when it gets repaid? The answer is to bank equity of course. That is what we could call the market´s risk-weights.

And when a regulator decides that a triple-A rated client generates only a 1.4 percent capital requirement for the bank (the Basel III 7 percent, adjusted by the risk-weight of 20 percent), while your average risky small business or entrepreneur generates a capital requirement of 7 percent, where do you think the about 2 percent in additional interest that your average small business or entrepreneur has to pay the bank in order to make up for the bank´s opportunity costs goes? The answer is to bank equity of course. This is what we call the regulator´s risk weights.

And so we have a world where, out of the blue, the Basel Committee decided that all our small businesses and entrepreneurs, those whom we should be most interested that our banks finance, well they have to run with under the weight of two different sets of risk-weights.

What kind of handicap officer is thia Basel Committee, taking off weights from those who have been running nicely and putting weights on those who have not run as good or are debutants? I would say that handicap officer is completely nuts or he has completely misunderstood his role.

The best way to end the markets’ addiction to the credit rating agencies is to end the regulator´s obsession with the credit rating agencies.