If only Basel Committees’ bank regulations applied to the World Bank.

Then perhaps it would have been easier for the World Bank to understand how flawed these bank regulations, which are basically being imposed on the whole world, really are. 

Can you imagine the Executive Directors having to discuss that one way of reaching capital sufficiency for the bank, so as to satisfy regulators, is to lend more to those countries perceived as ‘infallible” and lend less to those countries perceived as “risky”, because the latter requires the bank to hold much more capital as a percentage… and this even though the “risky”, precisely because they are perceived as “risky”, already receive much smaller loans under much more demanding terms? 

Risk-taking is the oxygen of all development, and the “risky” are usually the actors in the real economy who, living on its margins, most need access to bank credit. In fact no country has been able to develop by means of regulations which would favor “The Infallible, those already favored by banks and markets, and thereby odiously discriminating against “The Risky” those already discriminated by banks and markets. 

And not only that, since no major bank crisis has ever resulted from excessive exposures to "The Risky" but always from excessive exposures to who were wrongly thought as being “The Infallible, the whole regulatory exercise is completely useless. 

That the world’s premier development bank, and which I as a former executive director have learned to admire in so many ways, has not been able to stand up to regulators and speak out in the name of risk-taking and in the name of “The Risky”, is a terrible disappointment to me. 

Much as a result of its silence, regulators around the world are now castrating the banks, making these completely useless in terms of performing their vital social function of allocating financial resources efficiently. 

Also much as a result of its silence, banks around the world are dangerously overpopulating whatever is perceived as a “safe-haven” 

And much as a result of its silence, youth all around the world are suffering from the lack of jobs which have resulted from banks not lending to small, mediums and large businesses and entrepreneurs who do not possess top credit ratings in equitable terms. 

Perhaps the World Bank would benefit from the recommendation Katie Couric says she once received, namely that "A boat is always safe in the harbor, but that's not what boats are built for."

PS. Some in the World Bank are perfectly aware of how much, during my two brief years as an ED, I warned about the crisis that was doomed to happen. And yet, these meek do not dare to officially invite me to the World Bank to expose to a wider audience the fundaments of my criticisms against the pillar, the pride and the joy of the Basel Committee, the risk-weighted capital requirements. 

Davis Polk quite faulty analysis of the Brown-Vitter Bill

Davis Polk when analyzing the Brown-Vitter Bill evidences that they, like most discussants of the issue, have not yet understood the very dangerous implications for the banking system which results from risk-weighing bank assets so as to determine their specific capital requirements for banks. With respect to this they write the following: 

“The Brown-Vitter leverage ratio is too blunt an instrument for prudential financial regulation because it is not capable of distinguishing between risky and non-risky assets, and could result in two banks with vastly different risk profiles holding exactly the same amount of capital. 

By making a leverage ratio the centerpiece of its capital framework, the Brown-Vitter bill represents a deliberate departure from the risk-based capital framework, notwithstanding the fact that the risk-based approach has been endorsed and adopted by all major economies around the world."

Let me explain a couple of real street life facts to these lawyers who have so clearly been captured by some desk illusions. If they then need more they can always go to my blog or call me. 

The perceived risks which are considered for setting the risk-weights are already cleared for by the banks on the assets side of the balance sheet, by means of interest rates (risk-premiums) amount of exposure and other terms. So therefore, forcing the banks to clear for the same perceived risks on the other side of the balance sheet, in their equity, only guarantees banks will overdose on perceived risks. 

When banks are able to hold less equity for “safe” asset than for the “risky” that translates directly into the expected risk adjusted return on bank equity on assets perceived as safe will be much higher than the same expected risk adjusted return on equity on assets perceived as “risky”, something which obviously introduces huge distortions and which make it impossible for the banks to perform their vital social function of allocating resources as efficiently as possible in the economy. 

The following question could also help to shed some light on this issue: “Do you approve that those who by being perceived as “The Infallible” are already much favored, should be additionally favored by the banks, and that those who by being perceived as “The Risky” are already discriminated against, should be additionally discriminated against by the banks?” Davis Polk, how do you think US Congressmen, in “the land of the brave” would respond to that? 

Davis Polk writes: 

“The inherent disadvantage of a leverage ratio such as the one in the Brown-Vitter bill is its inability to distinguish between risky and non-risky assets. Imagine two banks with exactly the same amount of tangible common equity and exactly the same amount of total assets. Bank A’s assets primarily consist of U.S. Treasury bonds backed by the full faith and credit of the U.S. government. Bank B’s assets primarily consist of the junior tranches of commercial real estate securitizations and equity exposures. 

The two banks would have exactly the same leverage ratio under the Brown-Vitter bill, notwithstanding their entirely different risk profiles. In contrast, under a risk-based capital framework, Bank B’s risk-based capital ratio would be lower than Bank A’s risk-based capital ratio, reflecting Bank B’s riskier balance sheet” 

And my question to Davis Polk would be: How do you know for sure Bank B is riskier than Bank A? What if Bank A held some long term U.S Treasury bonds and interest rates increased? Is not the US Government's strength a direct result of the audacity of its risk-taking citizens? 

Davis Polk also writes: 

“The Brown-Vitter rose-colored glasses view of U.S. banking history in the 19th century is contradicted by the facts” 

Well, Davis Polk, if you were to go to history then you would see that all major bank crisis have always been detonated by excessive exposures to what was ex-ante perceived as belonging to “The Infallible”, but turned out ex-post not to be, and never ever by excessive bank exposures to what ex-ante was perceived as part of “The Risky”. And just look at the current crisis… all bank assets that have created problems were those for which regulators allowed low capital requirements. And not a single of all bank exposure to “The Risky” has caused a capital insufficiency to appear. 

No, you in Davis Polk, instead of admiring so much what the Basel Committee has been up to, should really start to question their lack of wisdom. 

In November 1999, in an Op-Ed I 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” 

And that is precisely what the Basel Committee did when it concocted the risk-weighted capital requirements, and no one questioned it sufficiently on it. Davis Polk, after the 2007-08 shock are you going to help the regulators to set us up for the next one? If we let them it seems it can only get worse, since now with Basel III they also want to add liquidity requirements based fundamentally on the same perceived risks. 

Davis Polk. I know you are lawyers… but do you really believe the US became what it is by having the banks avoiding risks? If the banks do not help society to take the risk it needs for the real economy to move forward, and to create the next generation of jobs our kids and grandchildren will need... who is going to do that? You and me? 

PS. Does this mean that I agree with the entire Brown-Vitter bill and with nothing of what Davis Polk states? Of course not! For instance I believe that capital requirements between 8 and 10 would suffice if we got rid of all of risk weighting? And I also think much thought should be given to how to help banks raise equity fast, so as to get over that problem and not allowing it to be a drag on the economy for years.

PS. Oh I forgot to mention the fact that minuscule capital requirements, resulting from minuscule risk-weights, are the best growth hormones ever for the too-big-to-fail banks.

The Basel Committee violates democracy

Imagine that in the parliament of any European country (or in the US Congress) supposedly to make banks safer, someone proposes the following: 

To allow banks to hold far less capital when lending to "The Infallible" than when lending to “The Risky”; so that they earn a return on equity far higher when they lend to "The Infallible" that when they lend to "The Risky"; so that they lend to "The Infallible" and refrain from lending to "The Risky". 

And then, in the discussion of such a proposal, it is concluded that this would mean that those being perceived as "The Infallible" and who already pay less interest, and who already have more access to credit when compared with that of "The Risky", shall have even more generous access to bank credit. 

And so therefore this would also mean that those being perceived as "The Risky" and who already pay much higher interest, and who already have a much more restricted access to credit when compared with that of "The Infallible", will suffer even more adversities accessing bank credit. 

And in the debate, when asked about who "The Infallible", those favored are, and who "The Risky", those to be so obnoxiously discriminates are, the response is: "The Infallible" are primarily good governments and private borrowers who have a triple-A credit rating, and "The Risky" are primarily all those small, medium and large businesses and entrepreneurs who do not have a credit rating issued by one of the three major rating agencies. 

What possibilities do you believe the previous proposal has to be approved? 

None! They would throw it out faster than fast, and surely its proponent would have to wave goodbye to his political career, as he would be the laughing-stock of the year. 

And especially so when in the discussions it appears that no banking crisis in history has resulted from excessive lending to "The Risky", as these have all resulted from excessive lending to who were considered members of “The Infallible", but were not. 

And especially so when you hear the question: "If banks will not finance " The Risky", those who perhaps most can generate the new sources of employments our youth craves for and needs ... who the hell will finance then? You and me?” 

And especially so when you hear the opinion: "The signaling of some bureaucrats intervening the signals of the market, sounds to me a recipe for making banking much more insecure than it currently is". 

But the sad fact is that these banking regulations exist and are called Basel II and are already applied throughout Europe. 

According to Basel II, a Spanish bank, for example, must maintain 8 percent in capital when lending to a "risky" Spanish businessman, but was required to hold only 1.6 percent in capital when lending to Greece, or even zero capital when lending to its own government, or for example to the government of Germany. 

And therefore citizens, I suggest you find out where on earth did the Basel Committee get the authority to impose something of such fundamental importance, something which all your respective parliaments would never have approved of. It seems to me that it completely violates the procedures of a democracy.

El Universal

The Shadow Financial Regulatory Committee seems composed by besserwissers who do not know what they are talking about

The Shadow Financial Regulatory Committee, a group of academic critics of federal financial regulatory policies met on December 10, 2012, and elaborated on its critique of Dodd-Frank as “not accounting properly for the risks and costs of the programs and for reinforcing incentives to engage in risky activity that increases the risk of future bailouts”.

These besserwissers have no idea of what they are talking about. The current incentives, much lower capital requirements for banks when lending to "The Infallible" than when lending to "The Risky" are all aligned towards making the banks engage in what is perceived as absolutely safe activities… and which of course, by handing out incentives that will sooner or later lead to a dangerous overpopulation of the safe-havens, increases dramatically the risk of future bailouts. 

Now they have a meeting on May 13, 2013, and I sure hope and pray, they have learnt something in the interim.

Professor Alan S Blinder. If you listen carefully enough, you will notice the music hasn´t stopped.

Professor Alan S. Blinder in his book “After the music stopped” 2013, discusses the origins of the recent bank crisis. In it he lists as “the malevolent seven” the following factors as the villains that conspired to create the recent financial crisis. (Page 28)

1. inflated asset prices, especially of houses but also of certain securities; 

2. excessive leverage throughout the financial system and the economy; 

3. lax financial regulation both in terms of what was left unregulated and how poorly the various regulators performed their duties; 

4. disgraceful banking practices in subprime and other mortgage lending; 

5. the crazy-quilt of unregulated securities and derivatives that were built on these bad mortgages; 

6. The abysmal performance of the statistical rating agencies, which helped the crazy-quilt get stitch together; and 

7. the perverse compensation system in many financial institutions that created powerful incentives to go for broke. 

These are no doubt malevolent villains, but Professor Blinder misses what really helped to insufflate so much life into these: 

In chapter 10 Professor Blinder writes: “A bank that earns1 percent profit on assets will earn a 15 percent return in capital, if it is leveraged 15 to 1. But if its leverage drops to 10 to 1, that same 1 percent return on asset will translate to only a 10 percent return on capital. If a bank is forced to hold larger volumes of highly liquid assets like Treasury bills, its average return on assets will decline. This is just arithmetic.” 

That is indeed correct arithmetic, but, unfortunately, as currently regulated, it does not apply to banking. This is so because regulators have imposed a system of different capital requirements based on “perceived risk”, and mostly as perceived by the credit rating agencies. 

These capital requirements allow banks to hold much lower capital against exposures to what is perceived as “absolutely safe” than for exposures perceived as “risky”. Just as an example, a German bank, to which after June 2004 Basel II applied, needed, and needs, to hold 8 percent in capital when lending to for instance a small German business, signifying a leverage of 12.5 to 1, but if buying a triple A rated security, like those collateralized by lousy awarded mortgages to the subprime sector, then it only needed, and needs, to hold 1.6 percent in capital, signifying a mindboggling authorized leverage of 62.5 to 1. Fifty times more! 

In fact the advantages that these capital requirements gave anything officially perceived as “safe” suddenly signified that the expected risk-adjusted returns on equity when lending to The Infallible became much larger than when lending to The Risky. 

That the US had not yet fully implemented Basel II is somewhat irrelevant. The US had committed to do so, and in fact SEC in April of 2004 had already approved that these capital requirements were going to apply for the investment banks they supervised. 

As Professor Blinder should be able to understand this senseless regulations introduced huge distortions into the banking system. Since those distortions are far from over, and could in fact become even worse with the introduction of liquidity requirements which are also much based on perceived risk, he might also understand that in reality, the very bad music, hasn’t stopped. 

“Did Bear Sterns, Lehman Brothers and AIG founder over insolvency or illiquidity?” asks Professor Blinder. He advances that is “Not easy to answer”. I have no doubt though. It was an insolvency which resulted from bad incentives and which led banks to dangerously overpopulate safe-havens. 

AIG, as an example, would not have been able to sell a fraction of the credit default swaps they sold had it not been for the fact that since AIG was rated AAA, the purchase of such a CDS immediately allowed the banks to reduce the capital they needed to hold against the exposure being insured.

Are bank regulators violating the human rights of the next generations?

The current capital requirements for banks in Basel II, which are based on perceived risks already previously cleared for, are immensely lower for exposures to “The Infallible”, like to some favored sovereigns and the AAA rated, than for exposures to “The Risky”, like to small and medium businesses and entrepreneurs. And therefore, banks earn immensely more expected risk-adjusted returns on equity when lending to “The Infallible”, than when lending to “The Risky”. 

And that in essence means that banks are following lending and investment objectives much more suitable to retiring baby-boomers, those who adore safety and cash liquid values, than those of the many young, who need much more daring long-term risk-taking... in order to stand a chance to find a job...during their lifetime. 

And nobody even wants to discuss that distortion, not even the World Bank, the world´s premier development bank. 

And as a result, the gap between the haves, the old, the history, the developed, “The Infallible” and the have-nots, the young, the future, the not developed, “The Risky”, is also increasing. 

Damn those aprės nous le déluge regulators. They castrated our banks and made these abandon our young ones. With what authority do they think they can do a thing like that? 

And, forgive me for asking, but is not a discrimination against the needs of the next generations, in all essence some sort of violation of human rights? And of course one thing is for the regulators to do so unwittingly... but persisting in it even after someone has explained it to them?

Should we not haul the Basel Committee and Financial Stability Board in front of the International Criminal Court in Hague, so as to at least demand the immediate suspension of this odious regulatory policy?

An American approach to banking

Regarding your April 29 Washington Post editorial “A diet for the big banks”:

It suffices to remember the saying about “a banker being that chap who lends you the umbrella when the sun shines but wants it back as soon as it looks like it is going to rain” to know that those assets perceived as safe are already much favored over those perceived as risky. The risk weights applied by the Basel III regulations and based on exactly those same perceived risks only increase the gap between “The Infallible” and “The Risky.”

And that is why I very much salute the bill by Sens. Sherrod Brown (D-Ohio) and David Vitter (R-La.) that looks to “require more capital and better capital but also limit the ‘risk-weighting’ of assets.” More capital is a perfectly legitimate requirement, but the imposition of risk weights is fundamentally incompatible with “a land of the brave.” The United States did not become what it is by avoiding risks.

That the bill puts the United States at odds with Basel III regulations does not matter, as those regulations have been proven harmful enough. On the contrary, Europe would also do better with a Brown-Vitter proposal.

Per Kurowski, Rockville

The writer was an executive director of the World Bank from 2002 to 2004.

Ps. A recent comment to the Financial Stability Board

Here other of my letters in the Washington Post on this issue:
June 20, 2008: An Aspect of the Bubble
December 27, 2009: Another 'worst': Faulty bank regulation

January 6, 2012: Handcuffed by a triple-A rating
December 23, 2014: Let the market rule on risky trades
November 11, 2015: Reverse-mortgaging the future
August 9, 2016: Banks, regulators and risk
April 16, 2017: When banks play it too safe 

July 11, 2018: There is another tariff war that is being dangerously ignored. 

December 30, 2018: Affordable homes or investment assets?