We need bank regulators who do not believe themselves the risk-managers of the world

I refer to the Financial Crisis Inquiry Final Report, issued January 2011 by The National Commission on the Causes of the Financial and Economic Crisis in the United States.

Unfortunately, though it contains much valuable information and analysis, the report does not identify the fundamental cause of the crisis, namely that the bank regulator, primarily the Basel Committee, with amazing hubris, took upon itself to act as the risk-manager of the world.

In effect, when the Basel Committee set capital requirements for banks imposing risk-weights based on its arbitrary perception of the risk reflected by the credit ratings issued by the credit ratings agencies, it de-facto determined what was to be ground zero for most other risk-managers. 

In effect, it was precisely those capital requirements for banks that tempted too much the banks to enter excessively and with minuscule equity life vests the triple-A waters, where they drowned.

In effect, those arbitrary capital requirements cause an odious and regressive discrimination requiring from those perceived as risky and who already pay higher interests rates, to carry an inordinate weight of the capital requirements of banks that is needed to support the system; effectively subsidizing those perceived ex-ante as having “low risks” and who therefore already pay lower interest rates.

In effect, from a regulatory point of view those capital requirements based on perceived risks, are plain silly, knowing that what causes systemic disasters in banking are always those risks that have not been perceived or are ignored by the collective.

It is very urgent we throw out the paradigm of capital requirements for banks based on perceived risk of default, which only distorts the markets and serves no purpose at all. But that will not happen until the problem is fully understood, and sadly it looks like, with this report, that the world missed another good opportunity.

PS. Sadly the Academia has kept total silence on how these regulations have dangerously distorted the allocation of credit.

Old Lady, careful, the “risky” should not be asked to bear the risks of the “not risky”.

Bank of England economist David Miles has suggested that UK banks should hold double the amount of capital than that prescribed by Basel III.

Of course Old Lady (Bank of England) is right in that the capital requirements for banks should be doubled and more… but only for those loan and investments where they have been proven insufficient… like all those operations which included triple-A ratings and where the risk-weight applied was a minuscule 20%.

But, for all those operations where the risk-weights were 100%, like when lending to “risky” small businesses and entrepreneurs, the capital requirements have proven more than sufficient… and should not go up one iota…that is unless one holds that those perceived as “risky” should subsidize the capital requirements needed to support those perceived as not risky. Does Old Lady think that? I don’t think so… but I am not sure they are aware of this argument.

We need to fire the self appointed supreme risk manager of the world!

When the Basel Committee on Banking Supervision decreed capital requirements for banks that resulted from assigning risk-weights based on the risk of default, as perceived by the credit rating agencies… with incredible hubris they took upon themselves to act in the role of supreme risk manager of the world.

How have they been doing? Worse than lousy! Basel II failed monumentally only 3 years after its approval in June 2004.

As an Executive Director in the World Bank, 2002-2004, and in many published articles since 1997, I protested loudly the regulatory paradigm that the Basel Committee is built upon, and I warned precisely about those risks that caused the current crisis.

With whatever credibility that should give me I guarantee you that the Basel Committee, with their Basel III, is only digging us and our banks further down into the hole where they placed us.

The role of a bank regulator is not to guard us against those risks of default perceived by credit rating agencies, and which are therefore also perceived by the markets and by the banks. No bank crisis has ever resulted from excessive lending or investments in what is perceived as risky… they have all resulted from excessive lending or investment in what was ex-ante perceived as not risky. Therefore the fundamental role of a bank regulator is to take precautions against those risks that might not have been perceived.

The role of a bank regulator, more than guard us against bank failures, is to guard us against the risk that the banks and whom the tax payers lend so much support to, do not serve their purpose for the society… and the Basel Committee has not yet said even one single word about what the purpose of the banks should be.

Let absolutely no one regulate before they do state the full purpose of the entities they are regulating… and that “purpose” has of course been deemed acceptable to us.

The principle of bank regulations that has been and is so rudely violated

Regulators should accept that bankers believe they can master quite adequately the risks of default. Who would want to deal with a banker who does not believe so?

But in the same vein the regulators should always tell the bankers “No you can’t… and besides there are so many other risks to be considered than just avoiding the defaults of your clients and the defaults of yourselves”.

And foremost regulators should never ever themselves become risk-managers… a principle that was and is so rudely violated.

It is bad enough when regulators fall for the sales pitch of bankers and believe too much in their risk-management ability, but so much worse when the regulators arrogantly believe, as they currently do, that they know themselves what the risks are and that they know themselves how to properly manage and master these… with or without a little help from the credit rating agencies.

A credit rating sends out on its own a very positive or negative signal to the market. When regulators based the capital requirements of banks on those same credit ratings, they dramatically augmented the strength of those signals… to such an extent that banks went and drowned themselves in triple-A rated waters wearing no capital at all… to such an extent that lending to the “risky” small businesses and entrepreneurs has come to a halt because that requires too much capital, especially when bank capital is very scarce as a result of having invested or lent too much to the ex-ante “not risky”.

Currently the regulators, who like risk-managers already failed in conquering some simple risks of defaults, when foolishly playing around with their capital requirements based on perceived risks, and ignoring that systemic crisis never ever results from timely perceived risks, are now tackling more God-like events like pro-cyclicality. God help us!

The bank crisis and the Basel Committee banking regulations explained to a golfer

Once there was a Golf Club with a somewhat narrow golf course and where, even though the members were very careful, sometimes the hooking or slicing of the golf balls into adjacent holes, caused some serious accidents.

The Club’s Board was ordered to find a solution. To that effect the elected members of the Board consulted with some Experts and asked for recommendations. The Experts told the Board “most of the slicing and hooking is the product of bad players and so, if you want to solve this problem, you need to get rid of them”. Knowing this idea would not be received with much enthusiasm, and could in fact pose a direct threat to their reelection as members of the Board, they all decided to immediately delegate the “how to” to a Committee of Experts.

The Committee of Experts decided they needed to appoint some Golf-Player Rating Agencies (GPRAs) to rate the real quality of the players and thereafter created a parallel handicap adjustment requirement that effectively eliminated the bad players… without these even noticing it. According to their ratings, the AAA rated players had their normal handicap increased by 5 strokes, while the players rated B- or worse had their normal handicaps officially reduced by 5 strokes.

It worked! Though, just initially… Since having to play with a very low handicap was pure hell for a bad player, most of the bad players rapidly decided to change clubs and, as a result, the Club gained immense recognition for having the best players and being the safest club in the country… and the Committee of Experts was wildly acclaimed for having true experts. We will never ever have more accidents in our Club… was the Board’s self congratulatory message at the year’s end… four years ago.

But life is life, even among golfers, even in a golf club… and so the membership of the Club started changing. For instance, many great golfing has-beens around the country were attracted by a system that so clearly could help to pro-cyclically prolong their golf-life, just like many never-able-to-be-good players were also attracted by the possibility of joining a club renowned for having exclusively good golf players… and so they all started to read up and converse with the GPRAs about what was necessary in order to be conveniently rated.

There was such an avalanche of enquiries that the GPRAs got confused and overworked and started to make mistakes… to such an extent that the Club rapidly became overcrowded with dubiously rated golf-players. This would, of course, not have meant anything in the old days, but, since everyone had been duly informed that the accidents had been forever eliminated and that therefore there was no need for being careful… the accident rate shot up and rapidly turned, three years ago, into a pandemic disaster that threatens even the survival of the Club… and aggravated by the fact that the beginners and the decent-bad players, those who really are the heart and soul and economical support of a golf club, want nothing to do with a club that has a handicap system that so harshly discriminates against them, and have therefore joined other clubs.

But, golfing friends, the saddest part of this story is that since the logic of “getting rid of bad players and allowing only good players” sounds so very attractive and so very logical, the Board has not even today understood what they did wrong and so they insist on using exactly the same Committee of Experts to come up with better solutions. And the Committee of Experts is currently studying only refinements of their original handicap adjustment requirement formulas because, as “experts”, they cannot under any circumstances acknowledge that they were so fundamentally wrong.

And, unfortunately, the local media has not been sufficiently “without fear and without favour” to dare to really fundamentally question the wisdom of the local Club´s Board or of the Committee of Experts.

PS. What if golf, roulette, horse-racing or tennis had fallen into the hands of a Basel Committee?