On June 26, 2004 our banks in Europe and America got castrated, and our real economies became doomed... to stall and fall

On the 26th of June 2004 the G10 approved Basel II. With that they declared as a regulatory principle that if banks lent to a corporation rated AAA to AA- “The Infallible”, it needed to hold only 1.6 percent in capital, signifying an authorized leverage of bank equity of 62.5 to 1, but, if it lent to someone rated BBB+ to BB-, or without a rating, “The Risky” then it had to hold 8 percent in capital, and thereby being authorized to only leverage 12.5 times to 1. 

That meant of course that from that day on banks would earn much higher risk-adjusted returns on their equity when lending to “The Infallible” than when lending to “The Risky” and that meant, of course, that from that day on banks would only lend to “The Infallible”, that is unless “The Risky” were willing to pay the banks much higher interest rates than those higher interest rates they were already paying to the banks, because they were perceived as more risky. 

And that meant that the risk-taking that had helped Europe and America become what they were was halted in its track… and no longer did it help that in church hymns praying “God make us daring” were sung, from that day on Europe, and America, or at least their banks, had been castrated and sang in falsetto. 

And it only took some few years for Europe and America to start stalling and falling, with their banks drowning in excessive exposures to “The Infallible”, such as triple-A rated securities backed with lousily awarded mortgages to the subprime sector in the US, or loans to sovereigns like Greece. 

And from that day, day by day, less bank financing was awarded, on reasonable terms, to “The Risky”, those small and medium companies, and entrepreneurs, best in position to deliver to our youth the next generation of jobs.

Damn Basel II and all those responsible for it, and damn all those helping to silence what the regulators did, on their own, with absolutely no authorization.

Put an end to the Basel Committee’s and the Financial Stability Board’s absolutely crazy capital controls.

Channeling economic resources efficiently signifies channeling the next dollar of available funds to what produces the highest risk-adjusted return on equity, and that is one of the prime functions of a banking system. 

But banks have been impeded from performing such resource allocation efficiently because regulators, by means of capital requirements based on perceived risks, allow banks to earn much higher risk-adjusted returns when lending or investing in “The Infallible” than when lending or investing in “The Risky”. 

Like in roulette, it is like telling the banks they can earn much more on “safe bets”, red or black, that on “risky bets”, any number, even though from the start the expected result of all roulette bets are identical. 

And these de-facto Basel capital controls are, ever faster, dangerously overpopulating the safe-havens and equally dangerously, ever faster, causing the under-exploration of the more risky but also perhaps more productive bays.

As things goes, the western economies, at least the formal ones, are doomed to end up like penguins over-crowding the last AAA rated rock, and where they will suffocate because of the lack of that oxygen that risk-taking signifies.

In other words, Europe and America, in order to stop stalling and falling, need regulators who know the reasons of why our ancestors went to church and prayed “God make us daring!”

The Basel II Roulette Manipulation

Because of what they perceive as reckless speculative risk-taking by banks, many refer to banking as a casino. So, let us think of the different loans and investments a bank can make, in other words of their allocation of bank credit to the economy, as their alternative bets on a roulette table.

On such table there are e.g., “Safe Bets”, black or red, with a payout of 1 plus the bet; “Intermediate bets”, columns, with a payout of 2 plus the bet; and “Risky Bets”, any single number, with a payout of 35 plus the bet. All bets have of course a similar expected value of return, the same risk-adjusted return. In the case of the roulette, a somewhat negative one, because the House always wins when the zero or double zero comes up, the House Edge. In banking, good credit and investment analysis, is expected to provide positive yields, even for the "zero" and "double zero".

Imagine then that a Basel Committee for Roulette Supervision suddenly got concerned with that some players were making too many risky plays; losing all their money, very fast, and that this was something for which they, as a regulatory authority, could be blamed for, and decided to do something about it.

And so, they decreed their Basel Roulette Regulations by which, in order to keep the players playing longer and not losing it all so fast, they allowed the payout for “Safe Bets” to be five times higher, 5 plus the bet; the payout for “Intermediate Bets” double the current, 4 plus the bet; while the payout for “Risky Bets” would remain the same, 35 plus the bet. 

What do you think would happen? Just what had to happen! Every player ran to make “Safe Bets”, and now and again, just for kicks, perhaps an “Intermediate Bet”, but they all stayed away from “Risky Bets”, since these just did not any longer make sense.

And the players got so excited with their profits, and bet more than ever, and so when suddenly the zero or double zero appeared, as had to happen, sooner or later, they lost fortunes and got wiped out, more than ever, often to such an extent that the casino even had to pay for their taxi ride home. Of course casinos, as we know them, could no longer exist.

Before current Basel bank regulations, all bank lending or investment alternatives produced basically the same expected risk and cost of transaction adjusted returns on equity; because that is what a free competitive market and banking mostly produces. This was precisely what The Basel Committee for Banking Supervision changed when, with Basel II, it imposed different risk-weights to determine the banks shareholder's capital/equity/skin-in-the-game requirements for different assets.

For instance, against any AAA to AA rated asset, “The Infallible”, banks had to hold only 1.6 percent in shareholders’ capital/equity/skin-in-the-game, and were therefore allowed to leverage their equity with the net risk adjusted interest rate 62.5 times to 1. Against “The Risky” assets, like loans to unrated small businesses and entrepreneurs, banks must hold 8 percent in capital meaning they then can “only” leverage their equity 12.5 times to 1. For “The Intermediate” assets, with a 4 percent capital requirement, in a similar way a 25 to 1 leverage is authorized.

The result? When compared to the allowed leverage on equity of the net risk adjusted interest rate, the payout/ROE for “The Risky”, translates into a FIVE times higher allowed payout/ROE for “The Infallible”, and TWO times higher for “The Intermediate”. 

This absolutely loony manipulation of the odds of banking; and which obviously not only guaranteed that when disaster struck the banks would be standing there naked without any capital; also made it impossible for the banks to perform with any sort of efficiency their vital role of allocating economic resources. 

And the craziest thing is that soon five years after the 2008 GFC disaster occurred, this manipulation of the odds of banking is not even being discussed. Not even against clear evidence that, as usual, as these always are, this crisis was the result of banks building up excessive exposures to what’s perceived or decreed as safe, in this case AAA to AA rated securities backed with mortgages to USA’s subprime sector.

Poor us! These banking regulations are castrating our banks, making them sing in falsetto accumulating more balance sheets exposure to the "safe-havens", which will become dangerously overpopulated; while avoiding like the plague exposures to the riskier but probably more productive bays where our young could find the next generation of jobs they so urgently need.

PS. The distortion had already begun in 1988 with Basel I: “The assets assigned the lowest risk, for which bank capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages” Paul Volcker

PS. And it would be so comic, if not so tragic, that absolutely most experts, including Nobel Prize winners, keep on referring to the crisis as a result of excessive risk-taking by banks, and which is of little assistance when trying to explain that what all banks were doing, was betting excessively on boring safe bets, red or black, and this only because of bad regulations… rien ne va plus.

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

What are historians going to say about the Basel Committee's capital requirements for banks based on perceived risk?

I am sure historians will be scratching their heads trying to figure out how the bank regulators of the Basel Committee for Banking Supervision, and of the Financial Stability Board, could have been so dumb so as to base their capital requirements for banks on perceived risks already cleared for by markets and banks through interest rates, amounts exposed and other contractual terms. 

And with it they doomed our banking system to overdose on perceived risks and create obese exposures to "The Infallible" and anorexic exposures to "The Risky". 

In other words the regulators castrated the banks of the Western World and made these sing in falsetto.

Most probably the historians will be explaining it in terms of the incestuous group think which can result when allowing “experts” to debate such matters in a mutual admiration club subject to absolutely no accountability at all.

Damn you dumb bank regulators!

Are “Those magnificent men in their flying machines” the explanation for the so failed bank regulations?

Was this what the current generation of bank regulators, like Lord Turner and Mario Draghi, watched as kids, and so that they could grow up arrogantly thinking that by deftly pulling at some risk-weights levers they could guarantee an ever bliss of adequate bank capital ratios? 

I mean there has to be some kind of explanation for the stupidity of higher capital requirements for banks when lending to “The Risky”, when it is always excessive exposures to “The Infallible” that has posed dangers to our banks.

What I do not understand then is why regulators were so lack in daring as clearly “the magnificent” were not. But that might be because there must be a tremendous difference between flying a plane in the air, and flying some banks while sitting at your desk, especially in safe Basel.

Those magnificent men in their flying machines,

they go up tiddly up up,

they go down tiddly down down.

They enchant all the ladies and steal all the scenes,

with their up tiddly up up

and their down tiddly down down.

Up, down, flying around,

looping the loop and defying the ground.

They're all frightfully keen,

those magnificent men in their flying machines.

They can fly upside with their feet in the air,

They don’t think of danger, they really don’t care.

Newton would think he had made a mistake,

To see those young men and the chances they take.

Those magnificent men in their flying machines,

they go up tiddly up up,

they go down tiddly down down.

They enchant all the ladies and steal all the scenes,

with their up tiddly up up

and their down tiddly down down.

Up, down, flying around,

looping the loop and defying the ground.

They're all frightfully keen,

those magnificent men in their flying machines.

Allowing for risk-taking is an absolute necessity for having a vibrant economy.

Senior government officials who have served Democratic and Republican administrations, and former leaders in Congress from both parties, the Coalition for Fiscal and National Security, urgently call out “Addressing Our Debt is a National Security Imperative”, as U.S. national security in the 21st Century depends on a vibrant economy, and it not being undermined by the accumulation of excessive debt.

Unfortunately their proposed “The Framework”, does not include correcting the one fatal regulatory mistake that has destroyed the economies of both the U.S. and Europe and is impeding these from becoming vibrant again.

And I refer specifically to that odious policy, especially so in “the land of the brave”, of allowing banks to hold less capital (equity) when lending to those who are perceived as safe, “The Infallible” than when lending to those perceived as “The Risky”.

That results in the banks being able to earn immensely higher risk-adjusted returns on their equity when lending to “The Infallible” than when lending to The Risky”, and which effectively locks out the latter from having a competitive access to bank credit.

And those regulations are the sad result of bank regulators not having defined the purpose of the banks to include the efficient economic resource allocation, and to being completely oblivious to the fact that in order to even have “The Infallible”, “The Risky” play a fundamental role.

That truly odious regulatory discrimination, in favor of those already favored by markets and banks on account of being perceived as “safe”, and against those already disfavored by markets and banks on account of being perceived as “risky”, is sapping the economies of the necessary risk-taking and entrepreneurial spirit to keep these vibrant.

And the truly sad part of this fatal regulations is that they do nothing to diminish the risks of major bank failures because these, with the exception of when fraudulent behavior has been present, have always resulted from excessive exposures to what was ex-ante perceived as absolutely safe, and never ever from excessive exposures to something that was perceived as risky when incorporated in the balance sheets of the banks.

I, among others while being an Executive Director at the World Bank, 2002-2004, warned about the consequences of this regulatory risk-adverseness, but I have mostly hit the wall of disbelief in that the regulatory experts could have been so dumb. Well friends, they were!

I am not a U.S. citizen but I know that much of the future well being of my family depends directly on the well being of U.S. and Europe, and so this is also for me a vital issue... a real National Security Imperative.

Thanks for the attention. If you need more explanations you will find me at your service.

Per Kurowski

PS. In my church they sing a psalm that prays for "God make us daring"

Democrats and Republicans… for the sake of America, agree at least on eliminating bank regulations which discriminate against "The Risky” and in favor of "The Infallible"

The access to bank credit has been rigged against those perceived as "risky", like small businesses and entrepreneurs, by means of requiring banks to hold much higher capital when lending to them compared with what the banks need to hold when lending to those perceived as “not risky”. 

This, in a country that became what it is, thanks to risk-taking, and which also likes to refer to itself proudly as “the land of the brave”, is a direct affront to the American courage and spirit of entrepreneurship.

This, is what most neutralizes the impact of fiscal and QEs stimulus, and which most stands in the way of job creation.

Why cannot Democrats and Republicans set aside their differences for one second, and agree on eliminating any bank regulations which discriminate against those perceived as “risky”? 

Would they do so, there would be no reason to concern themselves with a heightened risk in the financial sector, since never ever has a major bank crisis resulted from excessive exposure to those perceived as “risky” (consult your Mark Twain), these have always resulted from excessive exposures to what was ex ante erroneously considered as “absolutely-not-risky”.

Republicans could sell it to their side, correctly, as an elimination of regulatory distortions that impede the markets to efficiently allocate economic resources. 

Democrats could sell it to his side, also correctly, as an elimination of a discrimination against the “risky-not-haves” and in favor of the “not-risky-haves” which drives increased inequality.

Both parties need to understand that discriminating against "The Risky" and in favor of "The Infallible" is about as Un-American it gets... in fact it is outright immoral!

http://perkurowski.blogspot.com/2008/08/discrimination-based-on-financial.html

Damn you the Basel Committee for Banking Supervision, and you the Financial Stability Board.

In the name of all those perceived as risky small businesses and entrepreneurs who always had to pay higher interest rates and manage with smaller loans, damn you bank regulators! Thanks to you allowing banks to leverage more their equity when lending to “The Infallible” than when lending to us, “The Risky”, we now have to pay even higher interest rates and need to manage with even smaller loans, if we can even get them. 

In the name of all those who are unemployed because there are not enough small businesses and entrepreneurs creating new jobs thank to your stupid kind of risk-adverseness, damn you bank regulators. 

In the name of all citizens of nations with too high public indebtedness only because you, statist bank regulators, allowed banks to lend to sovereigns holding much less capital than when lending to citizens, damn you bank regulators! 

In the name of all us taxpayers who will now be saddled with much higher tax payments for having to bail out so many banks, damn you bank regulators, for regulating without knowing what you are doing. Not only did you not define a purpose for our banks before regulating these, but you also failed to know that in banking, major crisis never ever occur, because of excessive bank exposure to “The Risky” but always because of excessive exposures to "The Infallible” 

Damn you bank regulators for not having the cojones to admit you were so wrong and for now, with Basel III, even doubling down on your huge mistakes of Basel II. Not only are you knighting the too-big-to fail banks as Systemic Important Financial Institutions, leaving all other banks as unimportant, but, on top of your nefarious capital requirements based on perceived risks, you also layer on liquidity requirements based on perceived risks. 

In the name of America and Europe, damn you, you “Great Castrators” who are taking our economies down and making our banks sing in falsetto. 

In our churches we prayed “God make us daring” and that is why we became great… and then you had to come along and spoil it all. Damn you! Don’t you know there can be no “The Infallible” without “The Risky” daring risking it all, and all of us risk adverse citizens being grateful to them for that?

One of the greatest myths is that if Greece had collected all taxes, Greece would not have been in trouble.

Greece is not in trouble because of the taxes it did not collect. Greece is in trouble because its government squandered away funds it borrowed. And because the Greek government was able to borrow so much, thanks to the loony bank regulations. 

For instance, if a German bank wanted to lend to a German entrepreneur, according to Basel II it needed to hold 8 percent in capital, which meant it could leverage its capital 12.5 to 1 times, but, if it lent to Greece, the way Greece was rated at the time, it only had to hold 1.6 percent in capital, which meant it could leverage its capital a mind-boggling 62.5 times to 1. No unregulated or shadow bank would ever manage to do that. 

And that meant, sort of, that if the bank could earn a risk and transaction cost adjusted margin of 1 percent when lending to a German small entrepreneur, it could expect to earn 12.5 percent on its capital, but, if it expected to earn the same margin lending to Greece, it could earn a whopping 62.5 percent on its equity per year. And that is of course a temptation that not even the most disciplined Prussian would be able to resist. And of course what Greek (and many not Greek) politician can resist the temptation of abundant and cheap loans? 

And so had all Greeks paid all their taxes that would have made no difference, in fact, since the Greek government could then have been able to show greater fiscal income, it could have justified keeping credit ratings great for a longer time, which meant having taken on even bigger debts.

Or did the Greek politicians think the loans Greece took on would be repaid by them being able to make of the Greeks exemplary tax–paying-citizens in just some few years? If they did, then they are more stupid than any ordinary politicians.

And now what? Yes Greeks, pay your taxes! But of course only after Greece creditors have accepted a reasonable deal based on a very substantial haircut, and only after you are sure your government will not keep squandering away your taxes.

It is of course very understandable that many Greeks are mad at those who have not paid their taxes but, let’s face it, on the other hand, the way things have turned out, those taxes that were not paid in earlier, might come in very handy now, and will, hopefully, we pray, be put to a much better use.

PS. This post was made before I realized that reality was much worse. Instead of applying to Greece the risk weights dependent on credit ratings that Basel II ordered, EU authorities assigned to all Eurozone sovereigns' debts, including Greece's a 0% risk weight, this even when none of theses nations can print the euro. So European banks, when lending to Greece, did/do not have to hold any capital at all. Now how crazy is that?

PS. At the end of the day the EU authorities kept total silence about their mistake and blamed Greece for it all. What a sad European Union L

Mario Draghi. Do the structural reforms in bank regulations needed to allow job creators to do their job. Or shut up!

Pan Pylas, AP, reports that “Eurozone unemployment hits another record high”, December 1, 2012. 

And in this context that Mario Draghi, the president of the European Central Bank, the former chairman of the Financial Stability Board, and as such one of the most responsible for current bank regulations declared: “We expect, however, that progress in structural reforms, especially those that improve the functioning of labor markets, will help lower unemployment and facilitate new employment opportunities” 

Of course Draghi is partially right, but neither he nor any of his other bank regulating colleagues, has a right to preach anything to anyone about unemployment. 

He and the other overly risk-adverse nannies decided to allow banks to hold much less equity when lending to “The Infallible” than when lending to “The Risky”; which of course made the banks expect earn much higher risk-adjusted returns when lending to The Infallible” than when lending to “The Risky”. And that effectively locked out, from having a competitive access to bank credit, the “risky” job creating small businesses and entrepreneurs. 

What Draghi should do, now, besides stating his mea culpa, are to push for the structural changes to bank regulations that are needed for our job creators to have a chance to do their job… or just shut up and go home, wearing of course his cone of shame.

Barclays’ fresh out of the oven contingent capital conundrum

We read that Barclays’ successfully issued $3bn in 10 years Contingent Capital Notes, with a coupon of 7.625%. Under the terms of the deal, that the bonds will be automatically written down to zero if the bank's Common Equity Tier 1 ratio falls below 7% of its risk-weighted capital.

We also read some estimates of that Barclays’ would have to lose about $16bn in capital before falling under the 7% trigger.

But, losing capital is not the only way this sort of trigger can be pulled in a risk-weighted world. Suppose Barclays’ management, next month, brings to the board the following proposal which includes an important shift of bank assets:

Management proposal to the Board of Director of Barclays

Friends, you know that one of the very few possibilities our dear Britain has to pull out of its current doldrums is to allow the small businesses and entrepreneurs to help out more. And in this respect we have now decided to try to do our part and sell a substantial amount of our UK government debt and instead invest these funds aggressively in small and well analyzed loans to our more risky daring and risk-taking community.

But, and here is the question, since UK government debt carries a risk-weight of zero and these small businesses and entrepreneurs have a risk-weight of 100% doing the above would cause our Common Equity Tier 1 ratio to fall below 7% and therefore trigger what converts into a zero liability our recent contingent capital notes issue. What are we to do?

The bondholders would clearly hate it but from the perspective of the shareholders this would imply an immediate very real profit of $3bn that, though we have to sort out the tax implications, can undoubtedly come in real handy. On a side note we are also checking on whether this extraordinary liability write down profit signifies having to pay higher bonuses to those who brought us the contingent capital notes’ deal.

An alternative we are also exploring is to see if the regulators, even if on a just a short term basis, would increase somewhat the risk-weights on all what is currently weighted between zero to and 20 percent. For instance a risk weigh of only 10 percent on UK public debt would probably suffice to trigger. For anyone of you who could worry about what that would mean to our UK public debt exposure, that would still mean we need to hold less than 1 percent in capital against UK public debt, which means that we could still leverage our capital more than a hundred times with UK public debt. Unfortunately, our first contacts with regulators about this possibility have not been very productive. It seems they feel a bit uncomfortable with the idea of them taking the blame for the fall of the bondholders.

We leave now this decision entirely in your hands though of course it is an appropriate moment to remind all that we owe ourselves primarily to our nation and our shareholders and of the fact that we are paying a not so insignificant coupon of 7.625% on those notes. 

Signed: The management 

Question: Would that not be the mother of the hot potatoes?

PS. The profitable trigger pull could also be caused by changes in accounting criteria… ours or theirs.

PS. This is a comment on which I sincerely hope I am profoundly mistaken in my analysis, and would love to hear an explanation about how it will really work.

Mr. Bank Regulator: Is a job in a triple-A rated company worth more for the society than a job in an unrated small business?

Currently, by your actions, you clearly respond “Yes!” to that question. 

The fact is that with your capital requirements for banks based on perceived risks, you make the access to bank credit for an unrated small business, much more difficult and expensive than what it would otherwise be, and that of a triple-A rated company, one of yours "The Infallible", so much easier and cheaper than what it would also otherwise be. 

It just makes no sense and completely distorts the economic resource allocation function of our banks. 

It is “The Risky”, small businesses and entrepreneurs who are most in need of access to bank credit on fair market terms, and it is also they who stand the greatest chance of coming up with the next generations of jobs. 

Also, why does a bank have to have more capital when lending to a small business that creates a private sector job than when lending to a government in order to create a public sector job? 

Mr. Bank Regulator, if I was a young European with poor future employment prospects, I would be kicking your but, as much as I could. Your regulatory discrimination in favor of “The Infallible” and against “The Risky” is just too odious.

Why our nations are failing!

Daron Acemoglu and James A. Robinson have written an interesting book titled “Why Nations Fail”. In it they detail the importance of having adequate economic institutions and of creating incentives that rewards innovation and allows everyone to participate in economic opportunities. 

To my surprise though, the importance of the willingness to take risks, is not mentioned. 

Bank regulators, about a decade ago, with Basel II, out of the blue, authorized by I don’t know who, suddenly decided that our banks should take less risks than usual, and allowed the banks to hold much lower capital when exposed to assets perceived as “The Infallible” than when holding “The Risky”. 

That meant that banks would be able to earn immensely higher expected risk adjusted returns on their equity when lending to “The Infallible” than when lending to “The Risky”. 

That meant that our bank regulators effectively locked out “The Risky”, like small businesses and entrepreneurs from having access to bank credit on equal terms. 

And that also meant the bank regulators doomed our banks to end up overexposed and holding too little capital to assets that though they ex-ante could qualify as “The Infallible” got too much access to bank credit, on too generous terms, and therefore, ex-post, turned into extremely risky assets. 

And I know for sure, that when a nation starts worrying more about its “History”, “What It Has Got”, “The Infallible”, “The Old”, than about its “Future”, “What It Can Get”, “The Risky”, “The Young”, it will stall and fall… no doubt about that. Risk-taking is the oxygen of any economic development.

And now our bank regulators are even doubling down on their mistakes. Basel III will not only conserve the capital requirements based on perceived risk, it will now also have liquidity requirements based on perceived risks. 

Come on, Europe, America (Home of the Brave)… what happened to our “God make us daring” that we used to pray for in our churches?

PS. To top it up, considering the more creditworthy more worthy of credit and the less creditworthy to also be less worthy of credit, when it comes to access to bank credit, is decreeing inequality.

PS. I have not finish reading the 2019 “The Narrow Corridor” but, at least from the Index, it would seem that their authors again ignore that the willingness to take risks is essential for any nation moving forward... and excessive risk aversion guarantees to bring it down.

PS. My 2019 letter to the Financial Stability Board (FSB)

Failed bank regulators must adore Nassim Nicholas Taleb’s black-swan.

In “Learning to love volatility”, Wall Street Journal, November 17, Nassim Nicholas Taleb writes:

“Several years before the financial crisis descended on us, I put forward the concept of "black swans": large events that are both unexpected and highly consequential. We never see black swans coming, but when they do arrive, they profoundly shape our world…. Still, through some mental bias, people think in hindsight that they "sort of" considered the possibility of such events; this gives them confidence in continuing to formulate predictions” 

And so Nassim Taleb still provides the failed bank regulators with the comfort of this being an unforeseeable crisis. Boy how much they must adore him and his black swan. 

Well several years before this crisis, me and others, put forward that this was a crisis doomed to happen… no black-swan… a totally man-made crisis.

When regulators allowed the banks to hold immensely less capital for exposures considered as not risky, “The Infallible”, than for exposures considered “The Risky”, they virtually doomed the banks to originate dangerously excessive exposures to “The Infallible”, precisely the kind of exposures that have always detonated major crisis when, ex-post, most often because they are too much financed, turn out, ex-post, as very risky…. like the triple-A rated securities backed with lousily awarded mortgages to the subprime sector, like Greece, like Spanish real estate… 

And by the way there is nothing much new in the concepts in “Learning to love volatility” or “Anti-fragility”, they represent precisely what we mean when praying in our churches “God make us daring!”

The fatidic black-swan explanation still keeps us in the crisis

When you restructure a company that has gotten itself into financial problems, you do not inject new funds before you have made the structural changes that allow you to reasonably expect that the company will recover, and so that you are not just throwing good money after bad. 

Unfortunately there has been no fundamental or significant restructuring carried out at all during the current crisis. And that is because so many bought into the fallacy of this crisis being caused by a “black swan” event, one which no one could foresee, and which therefore needed not to happen again. Bank regulators have of course been especially fond of this concept, as it reinforces their innocence.

But no! This was no black swan event. When regulators allowed the banks to hold immensely less capital for exposures considered as not risky, “The Infallible”, than for exposure considered “The Risky”, they virtually doomed the banks to originate dangerously excessive exposures to “The Infallible”, precisely the kind of exposures that have always detonated major crisis when, ex-post, these appear as very risky…. like triple-A rated securities backed with lousily awarded mortgages to the subprime sector, like Greece, like Spanish real estate… 

And so all bail outs, fiscal stimulus and quantitative easing done, without any fundamental structural change, like eliminating the capital requirements for banks which discriminate based on perceived risks, have just wasted preciously scarce fiscal and monetary policy space. 

When are our governments to wake up to the fact that those who messed it up were the not so white white-regulator-swans? And to the fact that the Basel regulatory paradigm is silly and sissy and must be thrown out the window... urgently?

Regulators, please, temporarily, lower capital requirements for banks on exposures to “The Risky”

Current capital requirements for banks, based on perceived risks, allow banks to expect to earn much more risk and transaction cost adjusted returns on equity when lending to “The Infallible”, than when lending to “The Risky”. 

And therefore, the already dangerous huge exposures of banks to “The Infallible” or to “The Infallible” who morphed into being risky are growing day by day, while the exposures to those originally perceived as “The Risky”, like small business and entrepreneurs, are, equally or even more dangerously for the economy, drying up. 

And, as bank capital gets scarcer and scarcer, the de-facto discrimination in favor of “The Infallible” and against “The Risky” increases. And now, with regulators doubling down on their mistake and also creating liquidity requirements based on perceived risk, it will all just get worse. 

Day by day “The Infallible” needs to pay lower interest rates, and “The Risky” higher ones, than what would have been the case without the distortions imposed by the regulators, or, as The Joker would call them The “Schemers”. 

We must urgently put a stop to this. Not only do our best chances of revitalizing economic growth rates lie in giving “The Risky” equal access to bank credit, but also we need to give our small savers, our widows and orphans and our pension funds, an equal opportunity to save with exposures to “The Infallible” that produce the returns they should produce. 

Therefore regulators, please…..temporarily lower the capital requirements for banks on exposures to “The Risky” and draw up a schedule for over some few years, making the capital requirements to be the same for the exposures to “The Infallible” and to “The Risky”. 

In fact since “The Risky” have never ever caused a major bank crisis and these have always, no exceptions resulted from excessive exposures to “The Infallible” that turned risky, if you schemers cannot refrain yourself from interfering and distorting, perhaps to feel you earn your salary, then why do you not set the capital requirements for banks slightly higher on exposures to “The Infallible” than on exposures to “The Risky”. That would make much more empirical sense, you dummkopfs! 

And you congressmen, please come up fast with some good tax incentives for those who inject fresh capital into our banks and that is so much needed.

Do you really think we can move forward discriminating in favor of “The Infallible” and against "The Risky"?

The kinder face of economic reality already favors the access to bank credit of “The Infallible”… lower interest rates, bigger loans and easier terms. 

And the harsher face of economic reality already disfavors the access to bank credit of “The Risky”…higher interest rates, smaller loans and stricter terms. 

But, when regulators allow banks to hold much less capital when lending to “The Infallible" than when lending to “The Risky”, then the banks will be able to earn a much higher risk-adjusted return on their equity lending to The Infallible than when lending to “The Risky”.

And so then “The Infallible” will be charged even lower interest rates, get even larger loans and on even easier terms, while “The Risky”, like our not-so-good rated or unrated small business and entrepreneurs, will be charged even higher interest rates, get even smaller loans and have to accept even stricter terms. 

And so let me ask you, do you really think this regulatory discrimination in favor of The Infallible and against The Risky makes an economic sense that might compensate for its injustice? I don’t, quite the opposite! 

It is outright foolish from an economic perspective, as it impedes banks to allocate our economic resources efficiently. And, to top it up, it brings more instability to the banking system because the bank exposures to what is ex-ante perceived as part of “The Infallible”, which are the only exposures that can set of a systemic crisis if ex-post these turn out to belong to “The Risky”, will not only be much higher but the banks will also be receiving the blows holding much less capital.

In truth bank regulators castrated our banks, and so these are all singing in falsetto now… and even badly so.

Frankly, between you and me, if I really thought the regulators had concocted these dumb regulations which are destroying our economies and causing so much suffering, knowingly and on purpose, I would consider that to be an act of high treason, and suggest they be shot, on the spot.

When facing a cliff… are you sure you want to go forward?

This economy did not collapse because of lack of stimulus, it collapsed because of bad regulations that gave banks too big incentives to acquire huge exposures with some of “The Infallible”, helping to make the not-risky risky, and by banks not wanting to hold exposures to “The Risky”, like to small businesses and entrepreneurs.

And since those basic bank regulation principles have not yet been changed one iota, I simply do not understand why any sort of stimulus package should be able to turn around the economy in a sustainable way, and that is why I find the whole discussions in the US about the fiscal cliff, although interesting quite irrelevant. 

And this cliff debate also makes me remember some politician somewhere, gloriously stating: “21 years ago, we were on the edge of the abyss, and we stepped forward”.

PS. That politician was Carlos Andres Perez, president of Venezuela

A wicked question to credit rating agencies, about risks and sovereign ratings

I suppose you are all professional with solid academic degrees and a lot of knowledge and experience rating the creditworthiness of borrowers. If not, excuse me and ignore the following question. 

You must be aware of course that bank regulators allow the banks to hold much less capital when investing in an asset that has been deemed to you as belonging to the privileged group of “The Infallible” than when holding an exposure to something less well rated or unrated. 

And you must be aware of course that this allows banks to expect to earn much higher much higher risk-adjusted returns on their equity when lending to “The Infallible” than when lending to “The Risky”. 

And of course you must understand that this means than banks will invest more and more in assets considered to be part of “The Infallible” and less and less to assets considered “The Risky”, like small businesses and entrepreneurs. 

And so here is my question to you: With banks that are given special regulatory subsidies to invest, almost exclusively, in “The Infallible” and abandon, almost totally, the lending to “The Risky”, in a competitive world, can any country keep a healthy economy that allows it to service its long term debt at current levels of public debt? Is not a very important degree of risk-taking by banks a must to keep economies rolling? 

Would you, as risk analysts and practitioners, in normal circumstances, ever think of giving your personal investment managers similar risk-adverse orders? 

I know what the extreme importance given by the regulators to your credit ratings has done to your business… but, come on, frankly, is that just not something too risky for the world you want to hand over to your children and grandchildren? 

Sincerely, 

Per 

A friend, not out to shoot the messengers

Our bank regulators, unwittingly, committed an act of high treason

There can hardly be a more insidious way to destroy a nation than to make its banking system more risk averse than what it normally is. 

And that our current bank regulators did, unwittingly, with Basel II, when they allowed the banks to hold so much less capital when lending to “The Infallible” than when lending to “The Risky”… and therefore to be able to earn so much more return on their equity when lending to “The Infallible” than when lending to “The Risky”… and therefore also to be able to pay the bankers so much higher bonuses when lending to “The Infallible” than when lending to “The Risky”. Doing so the regulators effectively "bribed" the banks to lend only to “The Infallible” and to abandon all bank lending to “The Risky”.

And that, of course, caused the bank exposures to “The Infallible”, those ex-ante perceived as absolutely not risky, precisely those to whom excessive lending has always caused all major bank crisis when they, ex-post, turn out to be “The Risky”, to explode as never before. 

Just one piece of evidence: Basel II, approved by G10 in June 2004, allowed the banks to lend to a sovereign rated like Greece holding only 1.6 percent of quite loosely defined bank capital (equity) while, if lending to a Greek small business or entrepreneur, they needed to hold 8 percent in capital. That allowed the banks to leverage their capital 62.5 times when lending to the Greek sovereign but only 12.5 times when lending to a Greek small business or entrepreneur. That, if the bank could make a net risk and cost adjusted margin of 1 percent when lending to either the sovereign the small business or the entrepreneur, meant the bank could expect to earn 62.5 percent on capital per year when lending to the Greek sovereign, compared to only 12.5 percent when lending to a Greek small business or entrepreneur. 

And of course the Greek sovereign received too much bank loans. And of course the Greek small business and entrepreneur received too little bank loans. 

And now when the Greek sovereign, as s direct result of this is in the absolute doldrums it cannot receive any more loans from banks, and Greek small businesses and entrepreneurs, those Greece most need to help it out of its current predicaments, are completely locked out from access to bank credit. 

I tell you, if I thought bank regulators had done this on purpose, to Greece, Europe and America, I would suggest shooting them… no doubt.

But what I cannot comprehend is how we can allow regulators who unwittingly were so dumb, to keep on regulating, to give us Basel III, which, with now also liquidity requirements based on ex-ante perceived risk, can only make it all so much worse. 

A nation is built and thrives on risk-taking. “God make us daring!” The moment the past, what has been built, “The Infallible”, becomes more valuable to its society than the future, what can be built, “The Risky”, and excessive risk adverseness sets in, the nation stalls and falls. It is as simple as that.

Three letters in June 2004

1st letter 

Basel, June 2004 

Dear Bankers 

We are fed up with you getting into so much trouble, and us being blamed for it. Therefore, and as we know that incentives matters, we will allow you, with our Basel II regulations, to hold much less capital when you do lending or investing business with those our expert consultants the credit rating agencies consider as The infallible, than when you do business with The Risky. 

Since that will allow you to obtain immensely higher returns on equity than what is usual in banking, and so be able to pay yourself much higher bonuses, we are sure to count on your full cooperation. 

Yours sincerely, 

The Bank Regulator, of the Basel Committee for Banking Supervision 

2nd letter 

America and Europe, June 2004 

Dear Bank Regulator 

Many thanks for Basel II! 

You can sure count with our fullest cooperation implementing it and in fact we already started to anxiously look around for (and some of use even create) AAA rated business.

Yours sincerely, 

The Bankers; mostly on behalf of the larger soon to be even larger banks 

3rd letter 

Washington, June 2004 

Dear Bank Regulator 

On behalf of my former and future clients, the not-so-good rated and unrated small businesses and entrepreneurs everywhere, “The Risky”, let me express my deepest concern with the Basel II you have just enacted. 

The pillar of those regulations is that banks will be able to hold much less capital when doing banking business with “The Infallible” than when doing so with “The Risky”. That means, of course, that banks will obtain much higher comparative risk adjusted returns on their equity when doing business with “The Infallible” than when doing business with “The Risky”. And that, pardon my sincerity, I find to be both stupid and obnoxious. 

First, my clients, “The Risky”, because bankers always tend to be very careful when doing business with them, have never ever caused a bank crisis. On the contrary, since all major bank crises have always resulted from excessive bank exposure to what was thought to be a member of “The Infallible”, your regulations will only guarantee that the resulting bank crises will be even larger than major. 

Second, the fact that those ex-ante considered as “The Infallible” will be treated so favorably, increases the chances of them becoming, ex post, “The Risky”; and with that that banks will find themselves standing naked with no capital at all in the midst of the next major crisis. 

Third, since credit raters are human, there is an immense danger in giving excessive credence to credit rating agencies, as for them being able to determine with sustainable preciseness who are “The Infallible” and who are “The Risky”. 

Fourth and most importantly, let me remind you that “The Infallible” of today have almost always been “The Risky” of yesterday and so, if you persists in regulations that favor those who built the past and discriminate against those building the future, you must understand that for a more systemic and larger trouble than ordinary bank troubles...  and that no bank can survive standing in the middle of the rubble of huge economic descent.

Yours sincerely, 

Per Kurowski 

An Executive Director of the World Bank (mind you, only one of 24)

World Bank, "Knowledge Bank”, why have you shut out the voice of a former Executive Director who clearly and timely warned about bad bank regulations?

From November 2002 through October 2004, I was one of the 24 Executive Directors (EDs) on the Board of the World Bank. And those were the years when bank regulations known as Basel II and which were approved in June 2004 were much discussed. And I was totally set against these.

Already in November 1999 in an Op-Ed titled “The SEC, the human factor, and laughing” I had written “The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause the collapse, of the only remaining bank in the world”

In February 2000, in an Op-Ed titled “Kafka and global markets" I warned about the following risks with global bank regulations:

1. A diminished diversification of risk: No matter what bank regulators can invent to guarantee the diversification of risks in each individual bank, there is no doubt in my mind that less institutions means less baskets in which to put one’s eggs. One often reads that during the first four years of the 1930’s decade in the U.S.A., a total of 9,000 banks went under. One can easily ask what would have happened to the U.S.A. if there had been only one big bank at that time.

2. The risk of regulation: 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.

3. Excessive similitude: By trying to insure that all banks adopt the same rules and norms as established in Basel, we are also pushing them into coming ever closer and closer to each other in their way of conducting business. Unfortunately, however, nor are all countries the same, nor are all economies alike. This means that some countries and economies necessarily will end up with banking systems that do not adapt to their individual needs.

4. The cost of global assistance: When Venezuela’s banking system went down the drain, there is no doubt that the cost of the crisis was paid integrally by the country itself. In today’s world, when we see that a series of international banks are investing in our country’s institutions, I often wonder what will happen when one of these behemoths runs into serious trouble in its own country. Will we have to pay for our part of the crisis, less than our part of the crisis or more than our part of the crisis?

In July 2002, firmly believing that risk-taking is the oxygen of development I was especially critic of Basel Bank regulations when applied in a developing country, as this quote, from an Op-Ed titled “Our economic policies suffer an inferiority complex” shows: “Our country has adopted, without blinking an eye, the regulations coming out of the Basel Committee, that are more appropriate for the banking sector of a developed country than for ours. There is nothing wrong being a developing country, the bad is only to believe that by just adopting different postures, one could reach a different degree of maturity… just like the little girl who borrows mother´s lipstick in order to feel big.”

And in September 2002, in an Op-Ed titled “The riskiness of country risk” I wrote the following: “If they underestimate the risk of a given country, the latter will most assuredly be inundated with fresh loans and will be leveraged to the hilt. The result will be a serious wave of adjustments sometime down the line. If on the contrary, they exaggerate the country’s risk level, it can only result in a reduction in the market value of the national debt, increasing interest expense and making access to international financial markets difficult. The initial mistake will unfortunately turn out to be true, a self-fulfilling prophecy.”

And so, even though I had never been a regulator, or a full-fledged banker, you can understand what was in my mind when I took up my duties as an ED. And, through my full two years I did as much as I could to express, in all shapes of forms, what I felt was wrong with the regulatory paradigm imposed by the Basel Committee for Banking Supervision.

Most of my more technical objections were expressed in the Audit Committee of the World Bank, of which I was a member, certainly the most vociferous one. I have no formal records of these meetings but any other ED member of that Committee or the WB staff who assisted should be able to attest my constant warnings about “counter-party risks” and about the AAA-bomb that was doomed to explode in the midst of our banking system. (I never knew specifically what AAA rating would explode, where and when, but I was certain one would)

But outside of that Committee I also spoke out and on this many records exist:

In January 2003 I finished a letter that the Financial Times published with “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds”

In March 2003 in a formal statement at the Board commenting the Global Development Finance 2003 report I wrote as example:

“In this otherwise very complete report there is no mention about the issue of the growing role of the Independent Credit Rating Agencies, and the systemic risks that might so be induced, when they are called to intervene and direct more and more the world’s capital flows. 

It is not a small issue. Today many insurance companies and pension funds are already limited by the credit ratings for their investments and, for banks we are only told things will get worse. 

The sole fact that emerging countries, when affected by lower credit ratings, face additional difficulties to access investors with availability of long term financing, forces them into more short term arrangements which, compounded by the much higher rates charged, almost guarantee a crisis, once the snowball starts rolling. 

The document does not analyze at all a very fundamental risk for the whole issue of Development Finance, being it that the whole regulatory framework coming out of the BCBS might possibly put a lid on development finance, as a result of being more biased in favor of safety of deposits as compared to the need for growth. 

As the financial sector grows ever more sophisticated, making it less and less transparent and more difficult to understand for ordinary human beings, like EDs, it is of extreme importance that the World Bank remains prudently skeptical and vigilant, and not be carried away by the glamour of sophistication. In this particular sense, we truly believe that the World Bank has a role to play that is much more important than providing knowledge per-se and that is the role of looking on how to supply the wisdom-of-last-resort.”

And also In March 2003 in a verbal statement as an ED at the board on the Financial Sector Assessment Program I urged the following: “Basel is getting to be a big rule book,” and, to tell you the truth, the sole chance the world has of avoiding the risk that Bank Regulators in Basel, accounting standard boards, and credit-rating agencies will introduce serious and fatal systemic risks into the world is by having an entity like the World Bank stand up to them—instead of rather fatalistically accepting their dictates and duly harmonizing with the International Monetary Fund.” 

In April 2003, discussing the World Bank’s Strategic Framework 2004-2006, I again urged: “Basel dictates norms for the banking industry that might be of extreme importance for the world’s economic development. In Basel’s drive to impose more supervision and reduce vulnerabilities, there is a clear need for an external observer of stature to assure that there is an adequate equilibrium between risk-avoidance and the risk-taking needed to sustain growth. Once again, the World Bank seems to be the only suitable existing organization to assume such a role."

In May 2003, in comments made at a workshop for regulators at the World Bank: I said among others: “A regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises. Knowing that “the larger they are, the harder they fall,” if I were regulator, I would be thinking about a progressive tax on size”. Please, if you can read my comments in their entirety

Also in May 2003, in an Op-Ed on Basel bank regulations I warned: “In a world that preaches the worth of the invisible hands of the market, with its millions of mini-regulators, we find it so strange that the Basel Committee delegates, without protest heard, so much responsibility in the hand of so very few and human-fallible credit rating agencies… Perhaps we need to include a label that states: Warning, excessive banking regulations from the Basel Committee can be very dangerous for the development of your country”

And in October 2004, in a written formal statement delivered as an ED at the Board of the World Bank I wrote: “Phrases such as “absolute risk-free arbitrage income opportunities” should be banned in our Knowledge Bank. We believe that much of the world’s financial markets are currently being dangerously overstretched though an exaggerated reliance on intrinsically weak financial models that are based on very short series of statistical evidence and very doubtful volatility assumptions.”

And then finally, in November 2004, having just concluded my term as an ED, in a letter published by the Financial Times I wrote: “Our bank supervisors in Basel are unwittingly controlling the capital flows in the world. How many Basel propositions it will take before they start realizing the damage they are doing by favoring so much bank lending to the public sector (sovereigns)? In some developing countries, access to credit for the private sector is all but gone, and the banks are up to the hilt in public credits. Please, help us get some diversity of thinking to Basel urgently; at the moment it is just a mutual admiration club of firefighters”

Sincerely, how many can like me document having timely warned about the impending AAA-bomb that exploded in 2007?

And now eight years have gone by since I ended my term as an ED of the World Bank. During these years I studied more in depth the Basel bank regulations, something which as an ED I never had time to do, and what I found has just shocked me more. These regulations are utterly dangerous. 

I even passed the exams needed to be a licensed real estate and mortgage broker (in Maryland) so as to better understand what happened with the AAA rated subprime debacle. That only confirmed to me my suspicions that what was most to blame were the faulty bank regulations.

Over the years I have refined my arguments keeping active two blogs on the issue; Subprime Regulations and Tea With FT. These blogs jointly have until now received about 140.000 hits, which is not bad for blogs on boring bank regulations which on top of it all do not accept comments, as I have no time to answer these. I had picked out the Financial Times as a channel to give my small voice more volume, but unfortunately I must have trampled on someones ego there or they just do not understand. I have though not given up on FT

And there are even some youtube videos floating around where I try to find the words that will allow me to shatter the current regulatory paradigm that has proved resistant beyond belief.

Given my interest in the issue of bank regulations I also tried, in-numerous times, to qualify for a staff job at the World Bank in the area of financial regulations, but I never made it even to a short-list. I guess c’est la vie!

But what I must confess really upsets or saddens me, especially since the World Bank has a great meaning to me, and I absolutely feel the World Bank should be in the forefront of explaining to the world the importance of risk-taking for development, is that over the years I have assisted to countless conferences at the World Bank on the issue of bank regulations, having had to listen mostly to the same invited speakers over and over again, and never have I been given an opportunity to address directly the World Bank staff with my arguments. 

In that respect I have been strictly limited to some interventions in the Q. and A. sessions of such conferences and a 5 minute chance to speak in one of the Civil Society sessions during spring and fall meetings, and this was only the courtesy of a civil society.

And so of course I feel have earned the right to wonder… how comes a “Knowledge Bank”, like the World Bank, can shut out so completely the voice of some who has inside its own walls shown to know and to timely warn?

The Independent Evaluation Officer of the IMF (IEO) in their report “IMF Performance in the Run-Up to the Financial and Economic Crisis: IMF Surveillance in 2004-07” of 2011 wrote: 

“The IMF’s ability to correctly identify the mounting risks was hindered by a high degree of groupthink, intellectual capture, a general mindset that a major financial crisis in large advanced economies was unlikely, and inadequate analytical approaches. Weak internal governance, lack of incentives to work across units and raise contrarian views, and a review process that did not “connect the dots” or ensure follow-up also played an important role, while political constraints may have also had some impact.”

Although the many research and articles published by the World Bank points at some incestuous relations, in the case of the World Bank more than groupthink I attribute its failings in discussing bank regulations to group-deafness, most of that resulting from that horrendous “harmonization agreement” signed with the IMF.

And now ten years later than the Global Development Financial Report 2003 that I commented on above, I find that the Global Development Financial Report 2013 only quite meekly comments on the role of “The State as Regulator and Supervisor”, timidly putting forward: “A key challenge of regulations is to better align private incentives with public interest without taxing or subsidizing private risk-taking”; but without getting into what taxes and what subsidies they really refer to.

Well let me give you a very brief summary on what the regulators did in very simple terms.

By allowing the banks to hold much less capital when lending or investing in the “absolutely not risky”, The Infallible”, than when lending to “The Risky”, the small businesses and entrepreneurs, they allowed the banks to obtain much higher risk-adjusted return on equity when financing "The Infallible" than when financing "The Risky". And that translates into a huge regulatory subsidy to "The Infallible" and therefore a huge regulatory tax on "The Risky".

And that: 

Guarantees that bank exposures to The Infallible, those who always are the origin of bank crises when their infallibility fails will be higher than ever.

Guarantees that the gap between The Infallible and The Risky will only widen

Guarantees that the safe-havens will become dangerously overpopulated

Guarantees that small businesses and entrepreneurs, will not have an equal opportunity accessing bank credit, and so will therefore not be able to help out as much creating jobs.

World Bank, why have you not yet used your huge voice to ask bank regulators to clearly define the purpose of banks before they regulate these?

It has also been sad for me to see that otherwise splendid "World Development Report 2013: Jobs" not including a word about what I most feel is absolutely necessary to create the next generation of jobs, namely abandoning the unreasonable risk-adverseness that is embedded in the Basel bank regulations.

Really, what is the use of Executive Directors, if their recommendations and warnings can be so blithely ignored by a World Bank that proudly has referred to itself as "The Knowledge Bank"?

Bank regulations, like American Football, or soccer, cannot only be defensive, it needs an offensive too

I cannot hold myself to be an expert on American Football, in fact I believe I have never ever thrown or received a real American football, but, that said, I am absolutely sure that any team who concentrated just on defense, would not go far. 

And that is what is happening with our banks. The bankers, defensively, consider the perceived risks of default of their clients, when deciding whether to lend or not, how much, at what rates and under what terms. But then came the regulators, and instead of acting as the umpires they should be, they also wanted to be defensive coaches, and used the same perceived risks in order to defensively set the capital requirements for the banks, more risk – more capital, less risk – less capital… and no one really cared one iota about the offensive, namely how banks are to allocate efficiently our economic resources.

And as a consequence, defensive bank plays, like lending to and investing in what is perceived as absolutely safe, “The Infallible”, was made so profitable in terms of return on equity so that these plays, and the defensive players, completely took over the game; while offensive plays, like lending to “The Risky”, like the small businesses and entrepreneurs, and offensive players, like community banks,  were completely ignored and abandoned. And, of course, it all lead to disastrous results. 

What a lunacy! Head coaches, players, umpires and most of the public are all, like on a ship of fools, still not able to even see what is happening, and many, in “the land of the brave”, begging for even more defensive plays; leaving me and some other few crazy minds all alone in the stands, monotonously shouting: “What about the offensive?”, “What about the jobs?” 

Friends, in American Football (and Europe, in soccer too) you can never win if you do not dare to go on the offensive with whatever risks that entails…capisce?

Congressmen of America and parliamentarians of Europe, here are two “Even though” questions on current bank regulations

Even though, those who are perceived as risky, let us, for lack of a better term, call them “The Risky”, get smaller bank loans, must pay higher interest rates, and accept stricter terms, all in line with Mark Twain’s perception of bankers, “he who lends you umbrella when the sun is out and wants it back when it looks it is going to rain”, and have never ever been the cause of a major bank crisis…should they have their access to bank credit made even more difficult by the bank regulators? 

Even though, those who are perceived as absolutely not risky, let us, for lack of a better term, call them “The Infallible”, get huge bank loans, ate very low interest rates, and with very soft terms, all in line with Mark Twain’s perception of bankers, “he who lends you umbrella when the sun is out and wants it back when it looks it is going to rain”, and have never ever been the cause of a major bank crisis…should they have their access to bank credit made even more easier by the bank regulators? 

If you respond “Yes!” to the two previous questions, you're fine and dandy with what the current bank regulators, like the Basel Committee for Banking Supervision and the Financial Stability Board are doing. If not, you better have a closer look at what’s up. I tell you, you will be surprised and extremely upset.

The two truths our current unwise bank regulators blithely ignored, and therefore screwed up our banking system, and our economies

1st truth: 

When you give someone a favor you are, often unintentionally, de facto, disfavoring the one not receiving that favor. 

So when regulators embraced that paradigm that makes the capital requirements for banks a function of ex-ante perceived risks, more risk more capital - less risk less capital, they favored “The Infallible” and disfavored “The Risky”. And that stopped our economies in their tracks. 

Because, when you favor access to bank credit for those who are already favored, those who have already made it and do not seem risky, “The Infallible”, and, thereby, additionally disfavor the access to bank credit of those who are already disfavored, those who have not yet made it, “The Risky”, small businesses and entrepreneurs, you are, in essence, subsidizing the past and taxing the future. 

But, it gets worse 

2nd truth: 

When you favor the access to bank credit to someone or somewhat more than what they should normally be able to access it, given their risk-profile, you are, de facto, guaranteeing it will be receiving too much credit and, de facto, sooner or later become extremely risky, no matter how infallible it initially might have been.

Conclusion:

We must get rid of these regulators, they are not wise enough. We can’t afford them! They are completely incapable of taking us out of the hole they dug and placed us in. They will only dig us deeper and deeper into it.

Banks regulators, please, more humility… and also read more Hayek

Friedrich Hayek in his essay of 1945 “The use of knowledge in society” wrote the following: 

“The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. 

The economic problem of society is thus not merely a problem of how to allocate "given" resources—if "given" is taken to mean given to a single mind which deliberately solves the problem set by these "data." It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge which is not given to anyone in its totality. 

This character of the fundamental problem has, I am afraid, been obscured rather than illuminated by many of the recent refinements of economic theory, particularly by many of the uses made of mathematics.” 

And this truth was completely ignored by our current generation of bank regulators, who arrogantly thought themselves capable to act as the risk managers for the whole world, and so haphazardly set their risk-weights which determined the effective capital requirements for banks, based on perceived risks.

Of course that distorted it all and the banking system blew up… but these regulators still think they are up to the task of managing risks… As I see it the only possibility we have to make them humbler, at least for a while, seems to be, unfortunately, humiliating them.