REVISED “The Bankers´ New Clothes”, by Anat Admati and Martin Hellwig, is a very good, and therefore [not] a dangerous book

Anat Admati and Martin Hellwig in their “The Bankers´ New Clothes” write the following about risk-weighted assets: 

“The risk-weighting approach gives the impression of being scientific”. 

“The risk-weighting approach is extremely complex and has many unintended consequences that harm the financial system. It allows banks to reduce their equity by concentrating on investments that the regulations treats as safe.” 

“The official approach to the regulation of bank equity, enshrined in the different Basel agreements is unsatisfactory… the complex attempts in this regulation to fine tune-equity requirements – for example, by relying on risk measurements and weights- are deeply flawed and create many distortions, among them a bias against traditional business lending.” 

And yet the authors when then writing “Whatever the merits of stating equity requirements relative risk-weighted assets may be in theory”, evidence they cannot or dare not free themselves entirely from believing there is something valuable in risk-weighting.

But no! There are no merits to risk-weighting, even in theory. It is just a big dumb regulatory mistake! Clearing in the capital requirements for perceived risks already cleared for on the assets side with risk premiums, amounts of exposure and other terms, just dooms banks to overdose on perceived risks, like those expressed in credit ratings, and at the same time effectively hinders the banks from performing an effective resource allocation which is so important for the society. 

The authors write “The idea behind risk-weighting is that if the assets banks hold are less risky, less equity may be needed for a bank to absorb potential losses”. What regulatory lunacy is that? If banks believe they hold less risky assets they will hold these at much lower risk-premiums, for much larger amounts, and on much more generous terms. Come on, does that sound like something which could merit banks holding less capital?

And because of their lingering doubts, what Anat Admati and Martin Hellwig propose in their book, is not so much the need of eliminating the distortion of the risk-weights, but the need for more capital. And that is why, especially as I considered it a very good book, and it includes so much of what I have argued over the last decade, I must also call it a very dangerous book.

Let me explain: If the capital requirements for a bank were zero, then risk-weights would not discriminate nor distort. It is the higher the capital requirements are, than the larger will the discrimination and the distortion the risk-weights produce. 

The authors argue: “Requiring that bank’s equity be at least on the order of 20-30 percent of their total assets would make the financial system substantially safer and healthier” Can you imagine what distortions that would cause if something like the current risk-weights are kept? 

No! and especially since I look at the banks not as separate entities in Mars, but a part of the real economy on Earth, I bet that a Basel II, 8 percent capital requirement that came with absolutely no risk-weighting, would make the financial system and the real economy substantially safer and healthier, and sturdier, than a 20-30 percent capital where regulators remain thinking of themselves as risk-managers of the world. 

And here is a previous comment on the same book

DISCLAIMER: I have just exchanged opinions with Anat Admati and she holds that contrary to what I interpreted the book makes clear that they completely oppose the pillar of Basel bank regulations, namely risk-weighted capital requirements based on perceived risk. Great! I wonder where this now leaves the Basel Committee and the Financial Stability Board, as risk-weighting is their Pillar, pride and joy.

Clearly this is a big support for the bank bill being introduced by Senators Sherrod Brown, Democrat of Ohio, and David Vitter, Republican of Louisiana. Go Brown-Vitter! Screw Basel! Enough is enough!

Its what’s safe that’s risky!

Matt Taibbi and other Libor-Scandal exploiters, distracts us from correcting a much worse interest rate manipulation.

The regulators, for absolutely no reason at all, allowed banks to hold immensely less capital when lending to the “infallible”, among these some sovereigns and the AAA rated, than when lending to the “risky”, among these the small and medium businesses and entrepreneurs. 

That completely distorted the access of the real economy to bank credit, as well as the most important reference rate, the borrowing rates of the most solid sovereigns, usually the proxy for the risk-free rates. 

And that has signified an enormous tax, paid directly by all those bank borrowers perceived as “risky”, and indirectly by the society, by means of the many lost economic growth and job creation opportunities. 

For me the real cost of the society of that regulatory manipulation of bank capital, could be about a million times higher than all the costs for the society produced by the Libor rate manipulation 

I explain: one day the quoted Libor could be somewhat higher than its true rate, and on that day, Libor based borrowers would pay somewhat more, and investors earn somewhat more; other days the quoted Libor could be somewhat lower than its true value and the opposite would hold. But, in the long run, not much distortion was created and very few were really harmed. 

I certainly do not condone any Libor rate manipulation and those guilty of it should be punished with prison sentences which requires them having to pay for their own prison costs, but I do object to Matt Taibbi and other’s so scandalous agenda driven attacks on "Gangster Bankers", because that only distracts us from correcting a much worse interest rate manipulation.

PS. Matt Taibbi quotes MIT professor Andrew Lo saying that the Libor Scandal “dwarfs by orders of magnitude any financial scam in the history of markets.” If it is true he said that, then this professor has no idea of what he is talking about. If Professor Andrew Lo were to accept to debate the issue, he might do himself a favor by looking at the following material for a small quiz.

PS. Below two comments on Matt Taibbi’s article which I posted on the RollingStone web. 

1. Anyone capable of explaining the payoff in “The Biggest Price-Fixing Scandal Ever” being some “sushi rolls from yesterday”? 

2. The Libor Manipulation Scandal started because of the reporting of Libor rates which were lower than what they should have been... not higher... and so all borrowers who were on a Libor plus spread basis had to pay banks less interests. Can someone explain the irony of that?

Two facts on Basel I, II and III

The first fact is that since banks are allowed to hold less capital, and therefore to leverage the risk-adjusted margins more on their capital, and therefore to obtain much higher expected returns on equity when lending to what is perceived as “safe” than when lending to what is perceived as “risky”, current regulations are completely distorting our financial system. 

That has caused banks to create excessive exposures to what was erroneously perceived as risky, like in AAA rated securities, Greece, real estate, and to refrain from lending to those in the real economy perceived as “risky”, like small businesses and entrepreneurs. 

The second fact is that the first fact is not even mentioned, much less discussed. 

CFA, revoke any certification given to anyone in the Basel Committee or the Financial Stability Board.

If a certified financial advisor was offering the same advice to a wealthy retiree and to a poor young professional, he would have his CFA certification immediately revoked. 

Yet that is exactly what all in the Basel Committee and the Financial Stability Board are doing when regulating our banks and primarily serving the interest of soon retiring baby-boomers’ Après moi le déluge philosophy.

They require all our banks to act in the same way, concentrating on lending to what is perceived or decreed as “absolutely safe”, like lending to its sovereign or financing residential mortgages, while avoiding all of what is perceived as “risky”, like the lending to small and medium businesses and entrepreneurs.

If bank regulators cannot refrain themselves from meddling, why do they not at least meddle in a more useful way?

Current capital requirements of the banks are based on the information provided in credit ratings, something that makes no sense because bankers and markets have already seen that information and considered it when they set their interest rates, decide how much to lend or invest, and under what terms. 

Therefore I often ask: “Bank regulators why do you use credit ratings in your capital requirements and not something like job creation potential ratings, or environmentally friendly ratings?” 

I am sure that if banks were allowed to hold a bit less capital... and therefore be allowed to leverage their equity more... and therefore be able to obtain a higher risk-adjusted return on equity… whenever lending or investing in something especially good from a job creation or sustainability point of view, then the banks would be performing better for the whole society. 

As is, the banks are only performing better for those who possess good credit ratings, for “The Infallible” leaving all “The Risky” out in the cold.

Other unanswered questions

Questions on bank regulations which experts are not answering... or even discussing

If all bank crisis in history have resulted from excessive exposures to what was perceived as “absolutely safe”, or at least very safe, and none ever, from excessive exposures to what was perceived as "risky"… what is the rationale behind the pillar of current Basel regulations, namely capital requirements for banks which are much lower for what is perceived as "absolutely safe", or at least very safe, than those for what is perceived as “risky”? Does not all empirical evidence suggest instead that the capital requirements should be slightly higher for what is perceived as "absolutely safe" than for what is perceived as "risky"? 

Since perceived risk is already cleared for by banks on the asset side of the balance sheet, by means of interest rates, amount of exposure and other terms, why did the Basel Committee for banking supervision decided banks needed to clear for the same perceived risk, in the liabilities and equity side of their balance sheet, by means of risk-weighted capital requirements? Does this not doom banks to overdose on perceived risk?

Current capital requirements, allow banks to earn a much higher risk-adjusted return on equity when lending to what is “absolutely safe”, “The “Infallible”, and so banks avoid lending to “The Risky”. But since “The Risky” includes for example small businesses and entrepreneurs, and whose access to credit is absolutely indispensable for the real economy to move forward, who is then supposed to finance what is “risky”? Bureaucrats or citizens? Is not taking smart risks on behalf of the society exactly what bankers are supposed to do?

Bank regulations that so much favor “The Infallible”, those already favored by bankers and markets, and so much discriminates against “The Risky”, those already sufficiently disfavored by bankers and markets, can only lead to increase the gap between the haves, the rich, the history, the old, the developed, and the have-nots, the poor, the future, the young, the undeveloped. Is that what you want?

Please, if you are able to extract an answer from the experts that is reasonable, send me a copy of it to

perkurowski@gmail.com

PS. If bank regulators must meddle, why do they not meddle in a more useful way?

IMF’s “Rethinking Macro Policy II was a great conference, though My Question, again, went unanswered.

Very thankful for the invitation I attended IMF’s “Rethinking Macro Policy II” conference, April 16 and 17, and in which there was a special session on financial regulations. 

There were many good presentations and discussions and if I absolutely must pick one as the best that must be the one on financial cycles presented by Claudio Borio who currently is the Research Director and Deputy Head of the Monetary and Economic Department at the Bank for International Settlements (BIS). 

And as I usually have done over the last six years when attending conferences like these, I asked as many experts as possible:

My Question: 

If all bank crisis in history have resulted from excessive exposures to what was perceived as “absolutely safe”, or at least very safe, and none ever from excessive exposures to what was perceived as "risky"… what is the rationale behind the pillar of current Basel regulations, namely capital requirements for banks which are much lower for what is perceived as "absolutely safe", or at least very safe, than those for what is perceived as “risky”? Does not all empirical evidence suggest instead that the capital requirements should be slightly higher for what is perceived as "absolutely safe" than for what is perceived as "risky"?

As to the answers, as usual, some were intrigued, others stuttered, and many replied “Oh I know there is a clear explanation for the current capital requirements, I just can't remember right now what it was”.

And though I try to avoid asking those I know I have asked before, like Martin Wolf and Lord Turner, I found one participant who answered: “Yes, you asked me that 3 years ago and I have not been able to figure it out yet either”. 

By the way, have a look at a letter which asks a related question, and that I am trying to deliver to as many Ministers as possible during these World Bank and IMF Spring Meetings in Washington, April 19-20 

Please, anyone reading this post and possessing an answer to my Question, I would much appreciate sending it to me at perkurowski@gmail.com

PS. In the conference I met someone who like me knows there is no rational answer.

PS. Here is a more extensive list of the horrendous mistakes of the risk weighted capital requirements

Bank regulations also flatter the fiscal accounts... too much

Claudio Boro, in a very useful and interesting presentation at IMF’s “Rethinking Macro Policy II” forum, mentioned the concept of how financial cycles, during their peak, could so dangerously be flattering the fiscal accounts. 

Indeed, but perhaps what flatters the fiscal accounts even more, are bank regulations, like Basel II, which so extremely flattering assigns a 0 to 20 percent risk-weights to "infallible" sovereigns, allowing the banks to lend to these against zero to 1.6 percent in capital which translates into a mindboggling 62.5 to 1 and up to infinity authorized leverage. 

That translates into much lower borrowing rates for the sovereign (mostly paid by higher borrowing rates for the rest) and as a by product produces what I term as subsidized proxies of risk-free rates.

No Mme Lagarde… you are wrong! Bank regulators are more to blame than bankers.

Christine Lagarde, the Managing Director of the International Monetary Fund, at the Economic Club of New York on April 10, 2013, with respect to the financial sector reform said: 

“The bottom line is that we need a global financial system that supports stability and growth” 

Yes! Absolutely! No doubt! And that is why during a Civil Society Town Hall meeting in 2011 I asked Mme Lagarde: 

“If bank regulators had defined a purpose for banks before regulating this, we might have had a very different bank crisis, but not as large, systemic, and dangerous as this one. IMF, World Bank, when are you, as our global development agents, going to require from the regulators in the Basel Committee to openly and explicitly define the purpose of our banks… to see if we all agree? 

And Mme Lagarde answered: 

“On the purpose of banks, it is a very good debate to have, and it is one that I think the Vickers Commission Report is actually helping to build--what are banks for, and what are the state guarantees or general deposit guarantees intended for? Is it to actually guarantee the savers and the depositors, or is it something that is intended to fuel and benefit other activities that are really within a completely different realm of activities? 

My sense is that the most critical mission for the banks--and that is what we are trying to say when say that banks have to rebuild their capital buffers--is to actually finance the economy, first and foremost, and that should be really the critical mission” 

But Mme Lagarde, unfortunately, as you know, that debate and the definition of the purpose of banks have not happened yet, and the Basel III producers keep on working as if that is not necessary. 

And so when Mme Lagarde now says: “we have seen what happens when a banking sector chooses the quick buck over the lasting benefit, backing a business model that ultimately destabilizes the economy” I must object, because much more that a wrong business model it was a wrong regulatory model that destabilized the economy and the banks. 

It was bank regulators that while for instance requiring German and Cyprus banks to hold 8 percent when lending to German and Cypriot small business and entrepreneurs, which implies a 12.5 to 1 authorized bank equity leverage, allowed German and Cypriot banks to lend to a sovereign like Greece, or buy triple-A rated securities in the US, holding only 1.6 percent in capital, and which implies a mindboggling 62.5 to 1 authorized bank equity leverage. 

Though banks clear for perceived risk in the numerator, by means of interest rates, amounts of loans and other terms, bank regulators required the banks to also clear for the same risks, in the denominator, with capital requirements based on the same perceived risk. 

And the consequence of that is that banks earn much higher expected risk-adjusted returns on equity when lending to “The Infallible” than when lending to “The Risky” and that has of course fully distorted out common sense from our banking system 

And this has been one of the greatest regulatory stupidities ever, and neither the IMF nor Christine Lagarde should help to cover it up. 

PS. Here is how Mr. Zoellick as the President of the World Bank answered my question during that same Town Hall Meeting: 

“Your point about the Bank regulators is a particularly intriguing one, and let me share with you a little anecdote. 

Bank regulators come out of the world of central banks, and central banks will be the last bastion to fall in openness and transparency. When Pascal Lamy, who is head of the WTO, who has dealt with civil society groups for many years, as I did, starting in the trade area--and I met with Mario Draghi at that time, head of the Financial Stability Board--we shared with him a story that some union groups had come to Basel and tried to get in the door and talk to people, and they were met with screams of uncertainty. And we have suggested--and I'll just pass this along--that they also have to build some outreach mechanism through the Financial Stability Board and openness and transparency. And I will just share this from my own learned experience. Some institutions--central banks in particular because of the sensitive market information--build in cultures of this, and it is understandable, but then, on the policy level, as you suggest, people need to get used to being more open about it. And I just think that that is something, again, that we can try to work with you with as a general principle. I think the world will move more in this direction, but it will take some time on it. 

And I agree with Christine's response to you about the fact that the good news is, as the discussion in Britain showed, that people are starting to debate the exact purpose of banks.” 

PS. Here is my letter to the Ministers gathering in Washington for Spring Meetings 2013 on the issue of subprime banking regulations and their odious discrimination of "The Risky".

PS. Here my 2019 letter to the Financial Stability Board

Dear Ministers, you who are concerned with the real economy, during World Bank and IMF Spring Meetings 2013, ask your bank regulators for an explanation of the rationale behind capital requirements based on perceived risk.

Even though perceived risks were already cleared for by banks, in their numerator, on the asset side of the balance sheet, by means of interest rates, amount of exposure and other terms, their regulators, the Basel Committee, decided to clear for the same perceived risk, in the banks denominator, the liabilities and equity side of their balance sheet, by means of risk-weighted capital requirements.

And that doomed the banks to overdose on perceived risks, causing the current crisis, characterized by excessive bank exposures to what was supposedly “absolutely safe” while holding very little capital; and hindering the real economy from getting out of the crisis and generating the jobs we need, by discriminating against the bank borrowings of the “risky” economic agents, like medium and small businesses.

And now, soon six years after the crisis detonated, this issue of the distortion produced by the regulator's hand is not even discussed.

Here follows a more detailed explanation:

Current capital requirements for banks are much lower for what is perceived as “absolutely safe” than for what is perceived as “risky”.

And, as a result, banks are allowed to leverage their equity immensely more when lending to “The Infallible” than when lending to “The Risky”.

Just as an example, the banks in Cyprus and Germany, when financing small businesses in Cyprus or Germany could leverage 12.5 to 1 but, when buying bonds of Greece, 62.5 to 1… 50 times more!

And, as a result, banks make immensely higher expected risk-adjusted returns on equity when lending to “The Infallible” than when lending to “The Risky”. 

And, as a result “The Risky” need pay banks much higher risk premiums in order to make up for this regulatory competitive disadvantage. 

And as a result banks head with little capital towards dangerously excessive exposures to what always have caused bank crises, namely to “The Infallible” 

And as a result of this distortion by the regulator's hand, the most important actors on the margins of the real economy, namely “risky” small businesses and entrepreneurs do not have access to bank credit in competitive terms. 

And as a result millions of young people all around the world will never be able to have a job.

And as a result, the all important “risk-free rate” for which the borrowing rates of “infallible sovereigns” normally serves as proxies, does not indicate the “real-risk-free-rate” but a “subsidized risk-free-rate” instead.

And as a result of this odious discrimination the gap between the haves, the old, the history, “The infallible” and the have-nots, the young, the future, “The Risky”, only widens.

In summary our banks, more than de-regulated were misregulated.

And so ministers, please ask the regulators to explain to you the rationale behind the risk-weighted capital requirements.

And please, do not accept as an answer from your bank regulating anti-risk zealots, the “more-risk more-capital, less-risk less-capital, does that not sound logical?” mumbo jumbo, and much less, of course, “so that the banks can earn more return on their equity.

And please do not allow yourself to be distracted by an unpredictable “Black Swan” argument, this crisis was entirely manmade.

And if you are asking yourself “can experts really get it so wrong?” let me quote you George Orwell´s “one has to belong to the intelligentsia to believe things like that: no ordinary man could be such a fool”; or Patrick Moynihan´s "there are some mistakes it takes a Ph.D. to make”; or Axel Oxenstierna´s “An nescis, mi fili, quantilla prudentia mundus regatur?”

Ministers, as an ordinary citizen, I can only remind you of the fact that never would Hollywood, nor Bollywood, allow the same scriptwriters and directors who produced such an extraordinary flop like Basel II, to go ahead with Basel III… something which is now digging us even deeper into the hole, by introducing liquidity requirements for banks that are also much based on ex-ante perceived risks.

But also Ministers, again as an ordinary citizen, I need to ask you. Did you really authorize this little mutual admiration club called the Basel Committee for Banking Supervision to, with so little accountability, impose on the world de facto capital controls which has bank credit flowing massively to “The Infallible” and away from those who ex ante have been deemed to be “The Risky”?

And Ministers from countries rated BB+ or worse, be aware that you too are paying higher interest rates on your sovereign debt than what you would have to pay in the absence of this odious regulatory discrimination.

Am I saying there should be no capital requirements for banks? Absolutely not! And I do believe the basic 8 percent established in Basel II, would be sufficient and reasonable, if applied to all assets, and not diluted by risk-weights into so many close-to-nothing.

And if you absolutely cannot restrain regulators from interfering, and they must use weights to calculate capital requirements, why do you not ask them to, instead of basing these on silly credit ratings, think more in terms of basing these on job creation potential ratings, or environmentally friendly ratings?

I do acknowledge that Andy Haldane, the Executive Director for Financial Stability at the Bank of England, and Thomas Hoenig a director of the FDIC, have begun making some important comments questioning the wisdom of Basel’s current regulatory paradigm. Nevertheless, since the mistakes are so huge that even mentioning these could seem impolite towards those they could regard as colleagues, and so I dare say Ministers they could be in dire need of more of your direct and urgent support.

Let me also take this opportunity to ask the World Bank and the IMF:

Why does you research department not run a regression between all what had low capital requirements for banks because it was perceived as “absolutely safe”, and all bank exposures which caused the current crises?

Do you know of any major bank crisis that has resulted from excessive bank exposures to what was perceived as risky and not to what was erroneously perceived to be safe?

If banks are given such extraordinary incentives to finance what is “absolutely safe” and to stay away from what is “risky”, who do you suggest should finance “The Risky”, government bureaucrats, widows and orphans?

World Bank, do you really not understand why in churches of some developed countries psalms praying “God make us daring!” are sung? Do you really think development is a risk-free affair?

What will it take to end poverty? #ittakes a lot of risk-taking, of all sort, often even dumb; and of staying away from stupidly excessive regulatory prudence... in other words the world, especially its poor, is in dire need of more reasoned audacity.

IMF, the current capital requirements generate regulatory subsidies to the “infallible sovereign”, and which are mostly paid by “The Risky” when accessing bank credit. If that had been calculated and made known, then perhaps the current crisis would never have happened. I therefore ask your “Revitalizing the Fiscal Transparency Agenda” to include an effort to identify and value these type of quite obscure regulatory favors and disfavors.

Mme Lagarde, in a Civil Society Town Hall Meeting at the IMF, September 2011 I asked whether you did not think it was important for the regulators to define the purpose of the banks before regulating, and you agreed. What has happened with that? We now ask of central banks to include job creation as one of their objectives, but why do we not ask that of our banks? 

And who am I?

Per Kurowski, someone who in 1999 in an Op-Ed wrote “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 its collapse” 

Someone who had the honor of serving as an Executive Director in the World Bank for two brief years, 2002-2004, who then loudly protested the introduction in Basel II of the systemic risk of credit ratings, and who, in October 2004, in a written statement at the Board warned: “I believe that much of the world’s financial markets are currently being dangerously overstretched, through an exaggerated reliance on intrinsically weak financial models, based on very short series of statistical evidence and very doubtful volatility assumptions”. 

In other words, I am someone who suffers from the misfortune of having been unbecomingly right.

And if by any chance any bank regulator comes up with a rational explanation for their concoctions, please send it to me, and, if they prove to be correct, I would, as they say, have to eat my hat and much humble pie.

Am I too aggressive here? I guess so. But it is hard not to be, after so many years of polite criticism has not even brought out the issue of how these capital requirements distort into the discussions. How many times have you heard that argument discussed?

And for crying out loud, these regulators are endangering the world of my grandchildren, and no loving grandfather should take that lightly.

perkurowski@gmail.com

Bank regulators who for no good reason favor “The Infallible” over “The Risky” are unethical, and dumb too.

Current Basel capital requirements for banks, being implemented all around the world have, as their fundamental pillar, capital requirements which are based on perceived risks, more-risk-more-capital, less-risk-less-capital, and this even though those perceptions have already been cleared for, by means of interest rates, size of exposure and other terms. 

That allows the banks to leverage their equity much higher for exposures to what is perceived as “safe” than for exposures to what is perceived as “risky”. 

And that allows the banks to earn much higher expected risk-adjusted returns for exposures to what is perceived as “safe” than for exposures to what is perceived as “risky”. 

And that favors those already favored by being perceived as “safe”, and this translates directly into additional regulatory discrimination against those already discriminated against, precisely by being perceived as “risky”, whether they really are risky or not. 

And that only helps to widen the gap between the haves, the old, history, the developed, “The Infallible” and the have-nots, the young, the future, the developing, “The Risky” and that is highly unethical.

And that is dumb too, not only because never ever have major bank crisis resulted from excessive exposures to what is perceived as risky, these have always resulted from excessive exposures to what is perceived as “absolutely safe” but turn out not to be; but also because keeping access to bank credit in competitive terms for "The Risky", is about the most important financial function of banks.