This is my New Year wish for the Western World.

I wish for the Western World to fully comprehend that it is not by allowing its banks to earn higher risk adjusted returns on what from a credit-risk perspective is perceived as safe, than on what is perceived as risky, that it can move forward.

Because this is what currently happens when its bank regulators, those in the Basel Committee and the Financial Stability Board, allow banks to hold much less capital (meaning equity) against assets perceived as safe, than against assets perceived as risky.

And not that this would make the banks safer either. We all know that what is really risky for banks, is not really what is perceived as risky, even if risky, but what is ex ante perceived as absolutely safe, but that ex post could turn out to be very risky.

It is vital that we, the older members of the Western World, understand that we have no moral right to impose on the future generations a baby-boomers’ risk-adverseness agenda more suitable to retirees. 

The risk-taking of our forefathers was what brought us where we are, and it requires a lot of risk-taking to keep the Western World moving forward, in order not to stall and fall.

Western World, please listen up, “God make us daring!” is a prayer as valid as ever.

Bank regulators in the Basel Committee are getting loonier by the minute.

I have always objected to that corporates with good credit ratings, who already have better access to bank credit, shall have even more preferential access to it because of bank regulations. That because credit ratings can be wrong; and because the risks are especially big when it is good credit ratings that are wrong (AIG); and mostly because doing so distorts the allocation of bank credit in the real economy.

And now the Basel Committee for Banking Supervision, in their Consultative Document: “Revision to the Standardized Approach for credit risk” writes:

“The committee seeks to substantially improve the standardized approach in a number of ways. These include reducing reliance on external credit ratings; increasing risk sensitivity; reducing national discretions; strengthening the link between the standardized approach and the internal ratings-based approach; and enhancing compatibility of capital requirements across banks.”

“Corporate exposures would no longer be risk-weighted by reference to the external credit rating of the corporate but they would instead be based on a look-up table where risk weights range from 60% to 300% on the basis of two risk drivers: revenue and leverage.”

The risk weights above, calculated for the basic 8% capital requirement of Basel III, translates into 4.8% to 24% capital requirements; which then translates into a range of allowed leverages of bank capital of 19.8-3.1 to 1.

And that means now it is those corporate who come up as winners on a “look-up-table”, having more revenues and less leverage, which will generate less capital requirements for banks; and therefore allow banks to leverage their capital more when lending to them; and so therefore allow banks to earn higher risk-adjusted returns when lending to them; and therefore have preferential access to bank credit.

And so now I ask, regulators… why on earth shall corporates have more or less access to bank credit based on their revenues and leverage, than what access to bank credit corporates already have based on their revenues and leverage?

Basel Committee, why do you besserwisser insist in distorting the allocation of bank credit to the real economy this way? Is not the health of the real economy what in the long run is the most important factor in achieving bank stability?

“Look-up-table”? Man, you sure are getting loonier by the minute! Do you really think your table can do a better job analyzing credits than credit rating agencies? Do you think good banking is something achievable by children connecting dots?

PS. And it is stated: “These alternative risk drivers have been selected on the basis that they should be simple, intuitive, readily available and capable of explaining risk consistently across jurisdictions.”

What on earth do the regulators mean with that? That what is truly important when regulating banks is that the criteria of how to regulate banks should be comfortable and easy to manage for bank regulators?

PS. We have seen some merger activity based on tax considerations. Are we now to see mergers based on the Basel Committee’s “look-up-table” positioning?

The Per Kurowski rule: The safer a bank asset is perceived, the worse its negative impact if it turns out to be risky.

If credit risks are correctly perceived by banks, one or another bank could still run into problems, but there will be no major bank system crises. It is when credit risks are incorrectly perceived that things with our bank system can get really bad.

So what the Basel Committee for Banking Supervision has done, which is creating credit risk weighted capital requirements for banks, based on as if the perceived risks are correct, makes absolutely no sense. If anything those capital requirements should have been based on the possibilities of those credit risks being more risky than what they are perceived to be. 

But the impact of all credit risk perceptions being wrong, is not the same over the whole spectrum of risks. In fact bank regulators ignored what I quite presumptuously have decided to dub the Per Kurowski rule; namely that the more the credit risk perception is one of safeness, the larger the negative impact on a bank if that perception turns out to be wrong.

That rule should be easy to understand when one realizes that it is for what is considered as very safe, that a bank most runs the risk of running up too high exposures, in too lenient terms, and charging too little compensating risk premiums.

The impact on banks of what is considered as risky, if it turns out to be more risky, is ameliorated by the fact that it usually represents smaller exposures, and usually belongs to a group of exposures  which are mutually covered through much larger risk premiums.

Since different capital requirements allows some assets to produce higher risk-adjusted returns than others, and that distorts the allocation of bank credit to the real economy, I favor one single percentage capital requirement for all bank assets.

But, if regulators absolutely feel they must meddle, in order to show they earn their salaries and their societal recognitions, then they should at least abandon the current capital requirements based on credit risk weighting, in favor of an impact weighting of credit risks being wrongly perceived.

What would this mean in practice? That our banks would again be allowed to lend to the risky but tough small businesses and entrepreneurs we all need to get going when the going gets tough.

In other words… just what a doctor would order, for example for Europe… and so that banks can help to produce the next generation of jobs for the next generations of Europeans.

Intuitive decision: Perceived safe is safe, perceived risky is risky.

Deliberate decision: Perceived safe is risky, perceived risky is safe.

PS. Per Kurowski's second rule: Any perfectly perceived credit risk, causes wrong credit decision, if the perceived risk of credit is excessively considered.

Santa, anyone, please give us a clue. What did the we in the Western world do to deserve so dumb bank regulators?

Our current crop of bank regulators, those who were put in place under the sign of the Basel Accord, and who operate out of the Basel Committee for Banking Supervision, and in close collaboration with the Financial Stability Board, decided that:

The pillar of their regulations was to be the Credit-Risk Weighted Capital Requirements for Banks.

And with that they allowed banks to hold much less capital (meaning equity), against exposures that were perceived as absolutely safe, than against exposures that were perceived as risky.

And all, as if what is perceived as absolutely safe does not attract sufficiently the bankers attention; and all, as if what is perceived as risky, makes the banks salivate.

And that allowed banks to earn much higher risk-adjusted returns on equity on “safe” exposures than on “risky” exposures... which distorts the allocation of credit to the real economy... and all as if creating distortions is something free of risks.

And of course this led banks to create dangerous and calamitous exposures, against little capital, to such supposedly safe assets like AAA rated securities and loans to infallible sovereigns like Greece… all of which set off the current crisis.

And of course this leads banks to reject lending to all those "risky" tough risk-taking small businesses and entrepreneurs we all need to get going when the going is tough, as it is now.

So please, Santa, anyone, show us some mercy: What did we do to deserve such dumb regulators and, much more importantly, since with Basel III they keep digging us deeper into the hole they have placed us in... how do we get rid of them? 

Bank regulation decisions:

Automatic: "Safe" is safe and "risky" is risky

Deliberate: "Risky" is safe and "safe" is risky

PS. Santa by helping us with this you could actually bring our unemployed youth many jobs… would that not be some great Christmas gifts?

Let the market rule on risky trades

Let the market rule on risky trades

Harold Meyerson referred in his Dec. 18 op-ed column, "Warren's friends on the right," to Democratic senators joining Sen. Elizabeth Warren (D-Mass.) in voting against "allowing publicly insured banks to trade risky derivatives."

How do these senators know that these derivatives are more risky than AAA-rated securities collateralized by subprime mortgages or loans to "infallible sovereigns" such as Greece? 

The economic crisis in the Western world can be traced to excessive bank lending - to borrowers regulators considered absolutely safe, against minimum capital, meaning minimum equity.

The home of the brave needs to beware of too much dangerous nannying because nannying is not what made it great.

The Washington Post

Here other of my letters in the Washington Post on this issue:
September 6, 2007: Factors in the Financial Storm
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
May 1, 2013: An American approach to banking
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?

Europe, a future built by avoiding risks, is as risky as futures come.

Europe, your bank regulators allow, your banks, to earn much higher risk adjusted returns on equity with assets perceived as absolutely safe than with assets perceived as risky.

And that means that an enormous amount of small businesses and entrepreneurs, only account of being perceived as more risky credit risks, are being denied fair access to bank credit.

And with that the European youth is being denied the job creation their parents got.

Risk-aversion is not a good building block for a better future. Any current risk aversion just eats into the prosperity achieved by old risk-taking… until there is no prosperity left.

Europe, you can’t pick and choose. What’s safe today was most probably very risky yesterday. Risks and safety are part of the same world.

Europe, your pusillanimous nannying bank regulators are too dangerous… and you better wake up to that fact before its too late.

Your bank regulators are giving banks the incentives to keep away from financing the risky future and  to stay making their profits by just refinancing the safer past.

Europe, I do not think your bank regulators are doing this to you on purpose. Otherwise they should be hauled in front of courts for committing crimes against humanity.

God make us daring! Free us from imprudent risk-aversion!

Is telling banks “make your profits where it’s safe and stay away from what’s risky” an un-American act of cowardice?

I have heard many comments indicating as an “un-American act of cowardice”, that Sony cancelled the release of “The Interview”, after North Korean government hackers penetrated the studio's computers and threatened to attack theaters that showed the movie. 

I will not get into that but I would though take this opportunity to pop a question of my own on that epithet.

Currently regulations allow banks to hold much less capital (meaning equity) against assets perceived as absolutely safe than against assets perceived as risky; which allows banks to leverage their equity much more against assets perceived as absolutely safe than against assets perceived as risky; which of course means that banks will make much higher risk-adjusted returns on equity on assets perceived as absolutely safe than on assets perceived as risky… and which effectively means regulators are telling the banks “Go and make your profits where it is safe and stay away from the risky”. 

With that are not regulators inciting the banks in the Land of the Free and the Home of the Brave to commit un-American acts of cowardice?

What would have happened if Basel capital requirements for banks were lower for what’s “risky” than for what’s “safe”?

Many things! Among other:

First, since banks would then not be able to leverage their equity as much as they could with assets perceived as “absolutely safe”, then the risk of traditional bank crises those which result from excessive exposures to what is erroneously perceived as absolutely safe, would of course be lower. And, to top it up, if these were to occur, they would at least find banks covered with much more equity…not standing there bare-naked as now.

Second, the whole procedure of how to game the regulations would change 180 degrees. Instead of having a vested interest in dressing up assets as “absolutely safe”, they would want to dress up assets as “more risky” than they are… and that process would certainly faced more objections, since borrowers and lenders would definitely not share the same objective.

Third, small businesses and entrepreneurs would find it much easier to break that curse described by Mark Twain, of bankers being those who lend you the umbrella when the sun shines and wanting it back as soon as it looks like it is going to rain.

Fourth, it would be harder for too big to fail banks to grow, since low capital requirements hormones are not as effective where it is risky than where it is safe.

Fifth, there would be more “safe” investments available, for you, for me, and for the widows and orphans.

Sadly bank regulators went for an automatic decision: “safe is safe and risky is risky”; and did not take time to deliberate sufficiently on the fact that there where too many empirical evidences that, at least in banking, “risky” was usually safe but that “absolutely safe” could turn into horribly risky.

And here we are… and bank regulators have still not learned that lesson :-(

PS. This is not a proposal... just doing some speculative thinking :-)

The Basel Committee seems not to get it, and therefore insists on being dumb... or?

I have just read the Basel Committee’s “Revisions to the securitization framework”. In it they have approved to “reduce the reliance on external ratings”… as if that was the real problem.

Whoever is the perceiver of risks, internal or external, if the perceived risks used are correct, then banks would need no capital… and any bank then in problem, should better just be put out of business… as fast as possible. 

The real systemic dangerous problem arises when those risk perceptions of are wrong…and that is why it is so silly to have capital (equity) requirements for banks based on the used perceived risks being correct… independently of who is the perceiver of these risks… internal or external. 

Though in fact, since the more credible the “risk perceiver” is, the bigger is the risk of creating potentially dangerous exposures, the Basel Committee might have opted for a strategy of decreasing the credibility of the risk perceivers… if so it is undoubtedly an interesting development... 

At least the Basel Commitee could finally be understanding what I meant when in the Financial Times, in January 2003 I wrote: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds”

 

Bank regulators originated and institutionalized a “market imperfection”, causing less equality in opportunities

The OECD has just released: OECD Social, Employment and Migration Working Papers No. 163, titled “Trends in income inequality and its impact on economic growth”, authored by Federico Cingano. On page 9 it states the following:

“In presence of financial market imperfections, implying that the ability to invest of different individuals depends on their income or wealth level. If this is the case, poor individuals may not be able to afford worthwhile investments… In turn, under-investment by the poor implies that aggregate output would be lower than in the case of perfect financial markets (5). We will refer to this view, first formalized by Galor and Zeira (1993, 1998), as the “human capital accumulation” theory. (6)

(5) With perfect financial markets, all individuals would invest in the same (optimal) amount of capital, equalizing the marginal returns of investment to the interest rate. This occurs as complete markets allow poor individuals, whose initial wealth would not allow reaching the optimal amount of investment, to borrow from the rich (infra-marginal gains from trade). If, on the contrary, financial markets are not available, and the returns to individual investment projects are decreasing, under-investment by the poor implies that aggregate output would be lower, a loss which would in general increase in the degree of wealth heterogeneity (see e.g. Benabou, 1996; Aghion et al, 1999).

(6) Aghion and Bolton (1997) and Piketty (1997) explicitly modeled the supply side of the credit market, explaining imperfections based on moral-hazard (e.g. problems of input verifiability) or enforcement problems stemming from contract incompleteness (e.g. due to output verifiability). Moral-hazard would occur, for example, with limited liability (i.e. when a borrower's repayment to his lenders cannot be greater than his wealth); if the probability of success of the project depends on a (costly) effort exerted by the borrower, her incentives to exert efforts would be lower the larger the fraction of externally financed investment. Thus the interest rate on the loan will be an increasing function of its size (i.e. higher for the poorer).”

And that provides me with a new opportunity to try to draw the attention to how bank regulators, during the last couple of decades, have originated and institutionalized a truly odious and discriminatory capital market imperfection.

The Basel Committee for Banking Supervision imposed credit-risk-weighted capital (equity) requirements for banks which are much much lower for assets perceived as “absolutely safe” than for assets perceived as “risky”.

And, of course, what is perceived as “absolutely safe”, correlates much more with wealth than what is perceived as risky.

And, of course, what is perceived as “absolutely safe”, correlates much more with what already exists (history) than with the riskier future.

And that allows banks to make much much higher risk adjusted returns on equity when lending to those perceived as safe (like the "infallible sovereigns", the AAAristocracy and the housing sector) than what they can obtain when financing "the risky".

And, as a consequence, small businesses and entrepreneurs, those creators of jobs that will allow mortgages and utilities to be serviced, have no longer fair access to bank credit.

And, as a consequence banks, no longer finance the future, they mostly refinance the past.

And in short, that is how our economies are stalling, while inequality is growing.

“A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926

Europe, America, you might use the average risk aversion of nannies, but, never ever, as the Basel Committee does, use a sum of these.

Let us suppose a perfect credit rating. 

And that perfect credit rating is then considered by the banks and the market in general, and cleared for by interest rates, the size of the exposure and other terms.

But when bank regulators (Basel Committee) ordered that perfectly perceived credit risk, to also be cleared for in the capital of banks, then they completely messed it up.

Because a perfectly perceived risk, when it is excessively considered, causes an imperfect reaction to it. 

Let me explain it in the following way: 

Figure out the average risk aversion of nannies when letting your kids out to play… that might not be the best risk aversion to use, it might be too high, but anyhow it is acceptable. 

But, never ever add one nanny’s risk aversion to that of other nannies, because then your kid will never ever be allowed to go out and play… or learn how to bike

And if your kids only stay “safe” at home, they will eat too many cookies and turn obese… like some of their nannies.

And that’s what we have now, banks staying home, playing it safe and turning obese by lending to “infallible sovereigns”, house financing and member of the AAAristocracy or the AAArisktocracy (carbs); while not going out to play, in order to develop muscles, for instance by lending to small businesses and entrepreneurs (proteins).

Our banks no longer finance the "risky" future they just refinance the "safer" past.

You can use their average risk aversion,
 but, for the sake of our kids (and our banks) please, never ever the sum of it

P.S. And anyone agreeing with bank capital requirements’ risk weights of 0% government, 100% citizens; which de facto imply the bureaucracies' nannies know better what to do with credit, than e.g.,  entrepreneurs, has no right to complain about living in a Nannie State

PS. Here is a current summary of why I know the risk weighted capital requirements for banks, is utter and dangerous nonsense.

Reviving Economic Growth: A Cato Online Forum: My unsolicited opinion

Question: If you could wave a magic wand and make one or two policy or institutional changes to brighten the U.S. economy’s long-term growth prospects, what would you change and why?

My answer:

Anyone who thinks the US would have become what it is by allowing banks to earn much higher risk-adjusted returns on equity when financing what was perceived as absolutely safe than what was perceive as risky... raise his hand.

I say this because current credit-risk-weighted capital (equity) requirements for banks, allow banks to hold government debt and loans to the AAAristocracy against much less equity than when financing “risky” small businesses and entrepreneurs, and so that is de facto what you get.

And since risk taking is the essence of development, “the home of the brave” will go down if you continue to impose on your banks such regulatory risk-aversion.

Have you lately asked your friend the banker how much equity he needs to have in order to give a loan to an unrated fellow American citizen, compared to what he needs to have when lending to his government? Do that! And then you will begin to understand how much communism is creeping in on “the land of the free.”

You are already giving your banks a lot of support, so don’t also give them easy money allowing high returns leveraging on the safe… make them sweat their returns lending also to the risky... because that is how you build, or keep a nation great.

And so friends, if you want to have growth, get rid, urgently, of that distorting regulatory nonsense; which by the way does not make your banks safer, as never ever are major bank crisis the result of excessive exposures to what is perceived as risky… these always result from excessive exposure to something that was wrongly thought as absolutely safe.

Martin Wolf, by not telling it like it was, is making it much harder to connect the dots.

On page 226 of his “The shifts and the shocks” Martin Wolf writes: 

“The essence of Basel I was risk weighting of assets… Ironically and dangerously these weights treated government debt as riskless and put triple-A-rated-mortgage-securities into the next least risky category… Basel II, initially published in 2004, was an extension of Basel I… In the event, the crisis occurred before Basel II had been fully implemented.”

That is not so! And to present it in this way, impedes the understanding of what happened… it makes it much more difficult to connect the dots.

Basel I had risk weighting but that was in relation to claims on sovereign, claims on non-central-government and public-sector entities (PSEs), loans secured with residential property and banks within or outside OECD.

Basel II introduced the use of credit ratings, Basel I had none of it:

I, then an Executive Director of the World Bank, protested this and in a letter published by the Financial Times in January 2003 I wrote: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds”

And it was Basel II that allowed any private sector bank asset backed by an AAA to AA rating to have a risk weight of only 20 percent. That, since the basic capital requirement was 8 percent, signified banks needed to hold only 1.6 percent in capital against these assets. In other words it was Basel II that authorized banks to leverage 62.5 times to 1 in the presence of an AAA to AA rating.

And Basel II approved in June 2004 was immediately implemented in Europe. In the US it was accepted even before its approval by the SEC and made applicable for those investment banks they were supervising.

And that opened a ferocious appetite for AAA’s in any which form they came, whether as the securities collateralized with mortgages awarded to the subprime sector, or by being able to add an AAA rated company to the guarantees, most notoriously AIG.

Also in order to understand the profits for those developing these AAA rated securities, it is illustrative to consider the following deal:

If you convinced risky and broke Joe to take a $300.000 mortgage at 11 percent for 30 years and then, with more than a little help from the credit rating agencies, you could convince risk-adverse Fred that this mortgage, repackaged in a securitized version, and rated AAA, was so safe that a six percent return was quite adequate, then you could sell Fred the mortgage for $510.000. This would allow you and your partners in the set-up, to pocket a tidy profit of $210.00

Martin Wolf, over a very short period which started when the banks were assured that Basel II was to be approved and many saw this as a buying opportunity for later resale to Basel II covered banks… and that ended sort of early 2007…there was a monstrous demand for these AAA rated securities… and that, and nothing else, detonated the crisis.

Martin Wolf, consider that 62.5 to 1 bank leverage was allowed only because an AAA rating was present! It is clear that our world fell into the hands of real regulatory morons.

And that is not even considering the worst of it, namely that favoring so much the AAA rated they odiously discriminated against the fair access to bank credit of all those not AAA rated.

And so it is our duty to see that such things never happen again… not to wittingly or unwittingly helping regulators not to be held accountable for what they did….

If the solution to planet earth’s environmental problems falls into the hands of something like the experts of the BCBS, then we are all toast! 

PS. Basel I has only 30 pages and though Basel II grew into 347 pages, one should have the right to think that someone writing about the “interactions between changes in the global economy and the financial system” had read these fundamental documents.

PS. Around 2008 I studied and complied with all the exams needed to be a licensed real estate and mortgage broker in the State of Maryland, USA; and that I did so that I could analyze from a closer distance what had happened. And everything I found there only confirms what I have here argued. I heard of: “Give us the worst mortgages you have to package, because when we get a good rating for the security, those are the most profitable ones”.

I agree with much in Martin Wolf’s “The Shifts and the Shocks”

Basically because it fails to correctly explain how the current financial crisis came about; and therefore makes it a bit harder for us to get out of it, I object strongly, on many aspects, to Martin Wolf’s “The Shifts and the Shocks”

But that does of course not mean that I do not agree with much of what is said there and so, in this comment to which I will come back when in need (I read jumping from here to there), I will post those aspects which I most agree with:

For instance on page 252 Wolf writes: “Indeed, so long as the [bank] system allows leverage of 30:1, these businesses are designed to fail. The belief that failure of a business can be managed smoothly and without effects, with hybrid capital instruments, resolution regimes and living wills, is naively optimistic”. And I have annotated a clear “YES!” next to that.

And on page 253-4 Wolf writes: “Each institution may be diversified. But they will be vulnerable if all are diversified in the same way. Worse, being subjected to similar microprudential regulation makes it more likely that firms will end up being diversified in much the same way and exposed to many of the same risks”. Indeed! As someone who in 1999 wrote in an Op-Ed “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 all of our banks”… you can be sure I annotated a clear and big “YES!” next to that too.