My letter to the Basel Committee on Banking Supervision and the Financial Stability Board

Basel Committee on Banking Supervision
Financial Stability Board

Dear Regulators

Since you still seem to be completely unaware of it, let me put forward a kindly reminder:

There has never ever been a major bank crisis caused by excessive lending or investments to what was perceived as risky, and these have all resulted from either unlawful behavior or excessive lending or investment into what was perceived as not risky, but later turned out to be.

Against that fact your capital requirements, based on the perceived risk, as perceived by your official risk-perceivers, the credit rating agencies, that establishes higher capital requirements for what is perceived as risky and lower for what is perceived as not risky, seems to be sort of a dumb idea. If anything, on a purely empirical basis, higher capital requirements for what is perceived as not risky would make more sense.

And, while I am at it, let me also remind you that the banks already use the information provided by the credit rating agencies when deciding what amounts and at what margins to lend to a client, and so to force them to also consider these for their capital base, gives the credit ratings a double weight, and, as we all know, even the best information, if it is excessively considered, is wrong.

By the way, your capital requirements, amount to an outright discrimination of those who we most need our banks to attend, the small businesses and entrepreneurs. Shame on you!

Best regards,

Per Kurowski
A former Executive Director at the World Bank (2002-2004)
http://subprimeregulations.blogspot.com/

Basel‘s monstrous regulatory mistake

The regulators notwithstanding that the market and the banks already considered the credit ratings when setting their risk premiums and interest rates, considered exactly the same information when setting their capital requirements for the banks. This double consideration, which would have been wrong even in the case of perfect credit ratings, leveraged incredibly the systems dependence on the human fallible credit ratings.

And now, more than three years into the crisis, the Basel Committee, FSB, FAS, Fed, IMF, World Bank, PhDs and finance experts, specialized journalists, like all those in FT, and most other who have and give opinions on the issue of bank regulations, have yet to say one single word about a mistake that really makes it impossible to construe any worthy bank regulation on top of it.

One really wonders what world we live in, when the regulators is turning our whole banking system sissy... and making it impossible for banks to allocate credit efficiently to the real economy.

PS. The monstrous mistake, which evidences our bank regulators have never walked on main-street, is that they believe what’s perceived as risky, is much more dangerous to our bank systems than what’s perceived as safe:  My 2019 letter to the Financial Stability Board 

Postscript: Basel Committee, please listen to Violet Crawley, don't be so defeatist, it’s so middle class. 

https://youtu.be/g9XQ3_LCl-Q

Fraulein Basel’s Chocolate Cake

There was once a family where mother father, elder brothers and sisters and, of course, the grandparents, all lovingly cared for the well-being of the youngest family member, little Bob. For instance, they always informed little Bob about the risks they perceived existed in park AAA when compared to those present in the riskier park BBB. But, that said, they were also very careful of not producing any undue temerity in little Bob, since, besides wanting him to grow up and become a daring man, and not remain a frightened boy, they also knew he needed to go and play in park BBB, quite often, because there was where he could get the exercise that could make him strong. All in all, little Bob was growing up nicely.

Unfortunately, one day the family hired a governess to watch out over young Bob, Fraulein Basel. She, scared stiff she would be blamed for anything bad that could happen to little Bob, promised him a whole chocolate cake every day, if he would only go and play in the super-safe park AAA. Little Bob, as any healthy young boy, was naturally thrilled with the idea, and thereafter visited only park AAA. But, after eating a whole cake every day, one day in park AAA, suddenly, out of the blue, an  extremely slow but yet venomous snake appeared, and little obese Bob could not run away, and so little Bob tragically died.

And that my friend is what happened to our banks when we placed them in the overly caring nervous hands of Fraulein Basel Committee. 

But now, more than three years into a crisis that has caused so much misery around the world, we have yet to hear the World Bank and the IMF or anyone else for that matter commenting on the role of Fraulein Basel’s stupid chocolate cake. 

And our banks are still in Fraulein Basel hands even though we know she has not abandoned the stupid idea of the chocolate cake, and thinks it is only a matter of a better chocolate cake, Basel III; which she will soon present to another little Bob… or Hans… or Pedro… since her reach is global.

Translation: The mother of all regulatory mistakes

The Basel Committee even though they knew that banks were already considering the information on risks of default when they calculated the risk premiums and set the interest rates, decided to use that same risk information to set their capital requirements. Of course, considering the same risk information twice, exposed the bank more than ever to the very real possibility of that risk information not being perfect.

That stupid and unforgivable mistake resulted in: 

1. The setting of minimalist capital requirements that served as growth hormones for the ‘too-big-to-fail’. 

2. That banks overcrowded and drowned themselves in shallow waters, whether of triple-A rated securities backed with lousily awarded mortgages to the subprime sector, or of equally or slightly less well rated “infallible” sovereigns, like Greece. 

3. A serious shrinkage of all bank lending to small businesses and entrepreneurs, as lending to these generated, in relative terms, much higher capital requirement, which made it difficult for them to deliver a competitive return on bank equity.

And the dumb regulators have still not understood, that you do not regulate banks based on perceived risks, but based on what banks might do with perceived risks.

A sort of a shoddy investigation!

I refer to the “Wall Street and the Financial Crisis: Anatomy of a Financial Collapse” report by the Senate Permanent Subcommittee on Investigations. It is a sort of shoddy investigative work. Why?

On April 28, 2004 the Securities and Exchange Commission authorized the investment banks to dramatically increase their leverage, among other when investing in securities backed by mortgages to the subprime sector. The SEC resolution establishes the explicit condition that it has all to be done “consistent with the Basel Standards”.

The Report of 650 pages, does not mention the Basel Committee once!

And why do the Basel Standards, issued by the Basel Committee matter? The answer is simple; it was the Basel Committee which produced and disseminated the regulatory mistake that caused this crisis. Here follows a very brief description of that fatal mistake.

The Basel Committee’s mistake

If all sovereign and private bank clients were paying the banks exactly the same risk-premiums, then the risk-weights used in Basel II to apportion the basic capital requirements for banks according to the various categories of credit ratings could have been right. But, they don’t!

The banks and the markets already incorporates in the setting of their risk-premiums the risk information provided by the credit rating agencies, and so when the regulators also used the same credit ratings for setting their risk-weights they made these ratings count twice. That huge mistake resulted in:

1. The setting of minimalistic capital requirements that served as growth hormones for the ‘too-big-to-fail’.

2. That banks overcrowded and drowned themselves in shallow waters, whether of triple-A rated securities backed with lousily awarded mortgages to the subprime sector, or of equally or slightly less well rated “rich” sovereigns, like Greece.

3. A serious shrinkage of all bank lending to small businesses and entrepreneurs as lending to these generated, in relative terms, much higher capital requirement, which made it difficult for them to deliver a competitive return on bank equity.

With Basel III, regulators might be trying to correct for this mistake, instead of correcting the mistake. In other words, the Basel Committee is digging us deeper in the hole where they placed us.

The Shocking Basel II Discrimination

The market, looking at all risk information, which includes that of the credit rating agencies establishes some risk premiums that will make lending to different perceived risks equivalent. But then tha Basel II regulators made the mistake of using the same information provided by the credit rating agencies by mean of the risk-weights they applied and in doing so discriminated excessively in favor of what was officially perceived as having a very low risk of default. the AAAs. The following table illustrates the gigantic magnitude of that regulatory anti-risk-bias for a figurative example of how the market could be viewing a  AAA risk versus a Not Rated risk:

Is “Inside job” doing an inside job on us?

“Inside Job” the Oscar winning documentary on the financial crisis that has put the global financial stability in jeopardy touches upon most issues and actors involved, spending even several minutes of the role of cocaine and prostitutes. Yet, amazingly, it does not mention even once the Basel Committee for Banking Supervision, the global bank regulator and that in my opinion is the one most to blame for the crisis.

Should it? In one of the opening scenes of “Inside Job” refers to the Securities and Exchange Commission’s meeting on April 28, 2004 when the SEC authorized the investment banks to dramatically increase their leverage, among other when investing in securities backed by mortgages to the subprime sector. That SEC resolution explicitly made an explicit reference that it has all to be done “consistent with the Basel Standards”.

Is “Inside job” doing an inside job on us?

The Basel Committee makes a shocking confession!

The Basel Committee for Banking Supervision, speaking for all sophisticated bank regulators around the world, issued today an urgent statement regarding the discovery of a fundamental mistake committed in Basel II and which they now understand was responsible for causing the current financial crisis.

The mistake was that though the markets and the banks were already incorporating the information about the possibilities of default that were contained in the credit ratings when calculating the corresponding risk premiums to set interest rates for their clients, the regulators based the capital requirements for banks on exactly the same credit ratings, and so, unwittingly, accounted for said credit information twice.

The result of it was, of course, the excessive financing of everything that was officially deemed as having a low risk of default, like whatever had swell ratings like Greece and securities backed by lousily awarded mortgages to the subprime sector; and the insufficient financing of whatever was officially deemed as more risky, like the small businesses and entrepreneurs who are vital for maintaining that dynamism of the economy that creates jobs.

The Basel Committee expresses its most sincere regrets for such a mistake and promises to take immediate corrective action.

PS. April Fool´s joke disclaimer: Sorry, unfortunately, the Basel Committee and the sophisticated bank regulators, three years into a crisis of its own making, are still not (publicly) aware of their mistake.

The Independent Evaluation Officer of the International Monetary Fund has recently in an Evaluation Report come to the conclusion that, for IMF at least, “the ability to correctly identify the mounting risks was hindered by a high degree of groupthink…” The reason why the truth of what happened does not come out must probably now be attributed to group-interests.