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.

Helping the Financial Times’ experts to understand the distortions produced by risk-weighted capital requirements for banks

Since I do not belong to any Academic Community, or special sphere of influence, or mutual adoration club, I have very little voice, even when noisy, even when being an Executive Director of the World Bank, 2002-2004. 

So, in this respect I decided long ago to try to use the Financial Times as my channel to express my absolute rejection of bank regulations coming out from the Basel Committee. If for instance a Martin Wolf got to understand my arguments, he would be much more effective communicating these to the world than little me. 

What I had not counted on, were the immense difficulties in making the FT experts understand what I was talking about, even now after more than eight hundred letters on the subject. But, I am insistent, and I will manage to do so, one day. 

And so here below is another attempt to explain, in the simplest possible terms, so that perhaps even FT experts could understand, if they wanted to, the distortions produced by the risk-weighted capital requirements for banks, and which represent the pillar of Basel II and III regulations.

If for instance a German bank, lent to Greece as one of “The semi-Infallible” Greece was rated just a couple of years ago then, according to Basel II, if it could earn doing so a 1 percent net after perceived risk and cost, then it could earn 62.5 percent on its equity. But, if instead lent to a small German or Greek unrated business and earn the same net margin then it could only achieve 12.5 percent on equity. Does this make any sense to FT? Sincerely I cannot think so. And yet, what am I suppose to think?

And so the result is a world with dangerous obese bank exposures to “The Infallible”, and for us equally dangerous anorexic exposure to “The Risky”, and all aggravated by the fact that even the most infallible safe-haven can become extremely dangerous, if overpopulated. 

Capisce FT, or do I need to explain it again?

PS. Me, London, banks,regulators, lions, pussycats and FT’s pink

A Financial AAAristocracy… in the US?

Bank regulators, who knows based on what right, created a financial aristocracy. It is composed by “The Noble Infallible” borrowers, like “The Noble AAAs”, and “The Noble Systemic Important Financial Institutions”, technically known as “The Noble SIFI’s” or, in more vulgar terms, “The Noble Too-Big-To-Fail banks”, “The Noble TBTF”.

When compared to the commons, like any unrated borrower, “The Risky”, like small businesses and entrepreneurs, and to smaller banks, like community banks, also known as “systemic un-important financial institutions”, the Financial Aristocracy has been endowed with immense privileges.

Just as an example, according to the Basel II orders, a bank can lend to a “Noble AAA” holding only 1.6 percent in capital, while if lending to any lowly member of ‘The Risky”, it needs to hold 8 percent in capital, five times as much!

The previous signifies of course that every dollar paid in risk adjusted interest rates by a Noble AAA represents five times in return on bank equity that the same risk-adjusted dollar in interests paid by the unrated "risky" commoner.

Of course to keep their rulers happy, bank regulators also named these as “The Absolute Infallible” and which, again according to the rulings of Basel II, signified that banks needed to hold no capital at all when lending to the Supreme Sovereign.

I can understand perhaps how this appointments of a Financial Aristocracy, or more precise yet an AAArisktocracy might have slipped through in Europe, but, in America, where its Constitution establishes: “No Title of Nobility shall be granted by the United States”... how on earth did that happen?

And though the United States in June 2004 formally committed to implementing the Basel II bank regulations; and though the SEC in April 2004 delegated supervision decisions to the Basel Committee,  there is surrealistically enough not one single mention of these regulations, or of the Basel Committee for Banking Supervision, in the 848 pages of the Dodd-Frank Act. And this though that Act makes reference to foreign organizations like the Extractive Industry Transparency Review (EITI). It would seem like someone somewhere, has been playing some dirty tricks on someone.

And, by the way, discriminating against risk-taking, in a land which became what it is thanks to risk-taking, in “the land of the brave”… You’ve got to be kidding!

Why?

Why if they call bankers immoral greedy gangsters, or worse, there is almost no protest, but, if I simply call regulators dumb, because I hold their dumb regulations to be directly responsible for the current crisis, I then get so many admonishments to be more polite? 

Is it that bank regulators are of a kinder and gentler breed, and so therefore we must treat them with more delicacy? Well forget it! Too much is at stake!

I am not giving up on making the thick as a brick bank regulatory establishment, understand.

By allowing banks to hold much less capital when lending to “The Infallible” than when lending to “The Risky”, the regulators allow banks to earn immensely higher risk-adjusted returns on their equity when lending to “The Infallible” than when lending to “The Risky”.

That is very dangerous because it makes “The Infallible”, those including sovereigns and triple-A rated, so much riskier for banks than what they normally are… remember that it is excessive exposures to “The Infallible” which always been the origin of major bank crises.

That entirely distorts the economic efficient resource allocation banks are supposed to do; for instance by disfavoring more than normal the lending to “The Risky”, the group that includes as members, small businesses and entrepreneurs.

And, that regulatory discrimination in favor of those normally already favored, creates disfavors against those already disfavored, and is therefore also, simply put, odiously immoral.

The World Bank’s “World Development Report 2013 - Jobs” makes me feel like an absolute failure.

The World Bank has recently launched their World Development Report 2013 titled “Jobs”. It is an impressive accumulation of interesting facts and analysis but, unfortunately, it lacks what for me is one of the most important issues in job creation…how banks can help out. 

What “WDR 2013-Jobs” has to say about the finance sector is limited to (page 294): 

"Across firms and countries at varying levels of development, the most important constraints on formal private sector businesses are remarkably consistent: access to finance, infrastructure, and aspects of regulation including taxation and unfair competition… 

Access to finance provides firms with the ability to expand, to invest in new technologies, or to smooth out cash flow over time. Financial markets also play an important role in the allocation of resources towards a more productive use. 

Transparency within the financial sector avoids resources being channeled to those with political connections or economic power, and it also supports financial inclusion.” 

And though all that is perfectly correct, it makes me feel like an absolute failure, because I have not, nor as an Executive Director (2002-2004), nor in the hundreds of hours of participating in different conferences, been able to make the World Bank understand that the current pillar of bank regulations, namely capital requirements for banks based on ex-ante perceived risk, does absolutely nothing to create jobs, much the contrary. 

I feel a bit tired to discuss the issue for the umpteenth time, so let it suffice to say that favoring so much bank lending to “The Infallible” and thereby discriminating so much against “The Risky”, like small businesses and entrepreneurs, cannot lead to an economy with sturdy job creation. 

A brief technical explanation: By allowing banks to hold much less capital when lending to “The Infallible” than when lending to “The Risky”, the regulators allowed banks to earn immensely higher risk-adjusted returns on their equity when lending to “The Infallible” than when lending to “The Risky”, and we all know that return on equity is, as it must be, the main driver for banks.

And, in this respect, if only as a mental exercise, once again I urge the World Bank to think on how ratings based on the potential for job creation, especially for the youth, would compare to those credit ratings currently used to determine the risk weights which determine the effective capital requirements.

And since “WDR 2013 – Jobs” also states: “The financial crisis of 2008 has reopened heated debates about the appropriate level of regulations of the financial sector and the need to balance prudence and stability with innovation and inclusion” let me again ask The World Bank. 

Is not all that has resulted from the current bank regulations, obese bank exposures to what was ex-ante perceived as absolutely not risky, and anorexic exposures to what was perceived as risky? 

And with respect to inclusion and equality, World Bank, again, favoring the access to bank credit of those already favored by markets and banks, “The infallible” and disfavoring those already disfavored by the markets and banks, “The Risky” is: 

Stupid, as The Risky have never ever caused a major bank crisis, only “The Infallible” have done that. 

Dangerous, as these regulations so completely distort the economic efficient resource allocation that banks are supposed to do. 

And immoral, because that is what regulatory discrimination, layered on top of markets’ and banks’ natural discrimination is. 

World Bank, if you really want to close the “gaps”, like you so often announce, why not start by closing the gap between “The Infallible” and “The Risky” generated by these regulations?

What in the genetics of the World Bank, the world’s premier development institution, makes it so hard for it to understand that risk is the oxygen of development?

Why can I not make the World Bank understand that when a nation begins to care more about what it’s got, “what is safe”, than about what it can get, “what is risky”, its economy will stall and fall?

Why can I not make the World Bank understand that when a nation begins to care more about the jobs it’s got, for the old, than about the jobs it can create, for the young, it will stall and fall.

Who on earth authorized bank regulators to call it quits on our behalf?

Why can’t I get through to those bright World Bank experts?

PS. I do appreciate some initial small efforts by the Word Bank to discuss the theme, but, of course, we need for it to be more outright discussing about what to do with those we are never ever going to find jobs for, before it is too late.

The regulatory destruction of the 1 plus the 99 percent

Chrystia Freeland begins her thought provoking “The self destruction of the 1 percent”, New York Times, October 13, describing how Venice became one of the richest cities:

“At the heart of its economy was the colleganza, a basic form of joint-stock company created to finance a single trade expedition. The brilliance of the colleganza was that it opened the economy to new entrants, allowing risk-taking entrepreneurs to share in the financial upside with the established businessmen who financed their merchant voyages.”

But then the wealthy closed up, with La Seratta, which sounds like a quite natural reaction from those who have more interest in defending what they’ve got than what they could get. And that began to hinder the opportunities for new entrants, and, of course, it all went downhill from there.

Yes, that certainly explains a lot of what happened, and much of a “La Seratta” is most certainly present in the USA, as it is in most other places where truly important fortunes or powers have been accumulated by some few plutocrats or some few of a party nomenklatura.

And, Freeland concludes her article with “The irony of the political rise of the plutocrats is that, like Venice’s oligarchs, they threaten the system that created them.”

But, to give you my own perspective on this issue, and on its possible relation to the current crisis which is indeed threatening all of us, most plutocrats included, I would like to ask:

What would have happened if a group of prominent Venetian bureaucrats, acting as colleganza regulators, in order to safeguard the investors, had decided to impose a tax on any venture perceived as risky, and pay a subsidy to any venture perceived as particularly safe?

The simple answer is that Venice would not have become one of the wealthiest cities, or, if already wealthy when these regulations were imposed, would not have remained a wealthy city, and this, no matter how much a L'Apertura reigned. 

What is now bringing down our economies, is precisely some truly loony bank regulations which, by their capital requirements and risk-weights based on ex-ante perceived risk, hugely favor the access to bank credit of “The Infallible” and thereby hugely discriminates against “The Risky”.

And that immoral discrimination gave the banks incentives to stay away from taking manageable risks on “The Risky”, like the small businesses and entrepreneurs, those who never ever caused a major bank crisis, and to instead take on unmanageable risks on “The Infallible”, like the AAA rated, real estate, or some “absolutely safe sovereigns”.

And here we are. Of course we need to control our plutocrats, but we also need to control our modern bank regulatory mandarins. I sincerely doubt they had to take a sufficiently rigorous Imperial Examination before they've got started; and neither can I understand who really authorized them to do what they did.

Immoral, useless and outright dangerous; what more do you need to repel Basel bank regulations?

The fundamental pillar of the Basel Committee's bank regulations is capital requirements with risk-weights based on ex-ante perceived risk.

The way those capital requirements favor the access to bank credit of “The Infallible”, those already favored by markets and banks, and discriminate against that of “The Risky”, those already discriminated against by banks and markets… is immoral.

Those capital requirements are also useless, because they give banks incentives to stay away from taking manageable risks on “The Risky”, those who never ever caused a major bank crisis, and to instead take unmanageable risk on “The Infallible”, those who always have been the origin of all bank crises.

Those capital requirements are also outright dangerous, as these completely hinder the banks from performing an efficient economic resource allocation.

What more do you need to repel them?

What Imperial Examination did the Basel Committee Mandarins have to take to be allowed to regulate our banks?

Unfortunately they did not have to do that, and that is why we ended up with these stupid regulations, which require the banks to hold more capital when their assets are perceived as "The Risky" while allowing them to hold immensely less capital when their assets were perceived as belonging to "The Infallible", and all this even though only assets perceived as "The Infallible" have always created a major bank crisis.

We need to put our banks urgently back on the right track…but?

How on earth can someone who has not understood how capital requirements for banks, based on ex ante perceived risk, can so completely distort the economy, be able to get our banks back on track? No way Jose!

If governments and congresses around the world does not wake up to the fact that they need to produce a major shake-up of the regulatory establishment, they will pay for it… as of course will we citizens also have to do.

Would there not be a major shake-up in the Ministry of Health if it became known that it was directly responsible for having spread a very dangerous virus? You can bet there would be one!

Bank Regulator! How dare you distort the markets this way! Look at what you’ve done! And you’re not even sorry. Shame on you!

Arrogant regulatory busybodies thought they could stop bank crisis forever, by setting capital requirements for banks based on perceived risk. The higher the perceived risk, the higher the capital needed to be, and the lower the perceived risk, the lower the capital.

And, in doing so, the regulators completely ignored the fact that banks and markets already clear for risk by means of interest rates, amounts exposed and contractual terms. And as a result banks could earn much higher returns on equity when financing what was officially perceived as “not-risky” than when financing what was officially perceived as “risky”, like our small unrated businesses and entrepreneurs.

And we are not talking about minor differences. Basel II required banks to hold 8 percent in capital when lending to small businesses, which meant banks could leverage 12.5 to 1, but allowed banks to hold only 1.6 percent in equity against a private asset rated AAA, (or a loan to Greece) allowing the banks to leverage a mindboggling 62.5 to 1. Five times less bank equity!

And the result is that these regulations added immense regulatory bias in favor of what is perceived as not risky, on top of the natural bias that already existed in their favor, and, consequentially, added immense regulatory bias against what is perceived as “risky”, on top of the natural bias that already existed against the risky.

And all this the regulators did without ever bothering to ask themselves the question of…what is the purpose of the banks?

And all this the regulators did without ever bothering to reflect on the fact that all bank crises ever have occurred because of excessive exposures to what was erroneously perceived ex ante as “not risky” and never because of excessive exposures to what was ex-ante correctly perceived as risky.

And as a consequence here we find us mired in a deep crisis with obese bank exposures to what was ex-ante perceived as “not risky” and anorexic banks exposures to what was considered “risky”.

And, of course, by maintaining the same fundamental capital requirement discrimination based on ex-ante perceived risk, there is no way we can work ourselves out of a crisis, in which our economies are turning flabbier and flabbier by the second.

Regulators, don’t you know that nations develop by generously allowing for daring opportunities, and fail and fall when turning stingy and coward?

What would the US Supreme Court opine about bank regulations which discriminate against The Risky and favor The Infallible?

No! Shame on you bank regulators! Who gave you the right to distort our economy this way? And shame on you too financial journalists who keep silencing this, not daring to question the regulating establishment.

A small question about bank regulators

In relation to bank regulations I have frequently found myself in need to comment that 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”. 

But, between us... are not bank regulators supposed to know this very basic stuff? 

Where did all our current bank regulators, those who are writing up Basel I, Basel II, Basel 2.5, Basel III or what have you, study their Bank Regulations 101? Who checks the CVs of these appointees, or do they appoint themselves? Might they just have dropped in like any Chauncey Gardiner?

Any Gardener: "If you do not like weeds use pesticide on them and fertilize the flowers" 

Basel Committee: "Ah, smart! If we want our banks to avoid risks, we need to pay them a lot in return on their equity to make them grow us the not-risks we so much desire"