What a bank regulator could be asking himself on his deathbed…

Even though I knew that the capital I should require a bank to hold was primarily a protection against unexpected losses… how could I have been so dumb so as to base the capital requirements on the perceptions about the expected losses?

And how could I have been so dumb so as to accept “portfolio invariant” capital requirements, which obviously does not consider the danger of excessive exposures to what is perceived as “absolutely safe”, nor the benefits of diversification among what is considered as “risky”?

That caused of course banks to make much much higher risk-adjusted returns on equity when lending to “the infallible sovereigns” and the AAAristocracy than when lending to the “Risky”.

And that caused banks to overpopulate some “safe havens” turning these into deadly traps, like AAA rated securities, Greece, real estate in Spain; and equally dangerously to under-explore the more risky but more productive bays, represented by medium and small businesses, the entrepreneurs and the start-ups.

And with all that I helped to screw up the whole Western world economy... especially Europe's

I know most of the world will not forgive me, but I sure pray for that my unemployed children and grandchildren understand that, though admittedly I was very dumb and arrogant, I did not regulate so dumb on purpose… in fact my whole problem began when I and my colleagues started to regulate the banks without even caring to define their purpose.

The “too-big-too-fail” bank facilitators... or even promoters

The Basel Committee, with its Risk-weighting of Assets and Tier Capital mumbo jumbo, introduced horrendous confusion in the market.

One way to get a clearer picture of what banks are really up to, at least with respect to leverages, is to use that old trustworthy debt to equity ratio.

Using it on one of the European big bank´s balance sheets as of December 2012, I found that its Liabilities amounted to 1.96 T, I guess in Euros, and its Equity to 54.41bn. Well that would indicate a 36.02 Debt Equity Ratio.

Let me be clear… any bank regulator willing to allow for a higher than 12 to 1 Debt to Equity Ratio is most definitely a “too big to fail” bank facilitator, or even a promoter.

Inequality production 101

Lecture 2: Set much lower capital requirements for banks when lending to the "Infallible Sovereign" and the AAAristocracy than when lending to "The Risky", so that banks earn much higher risk-adjusted returns on equity when lending to the former than when lending to the latter.

That signifies that those who have made it thanks to risk taking in the past and/or are now perceived as "absolutely safe" will receive too much too cheap bank credit, while those perceived as "risky", and who have to risk it in order to make it in the future, will get too little and too expensive bank credit.

That guarantees the inequality of opportunities, and which as you should remember from Lecture 1, is the prime ingredient in any inequality production.

If asked by Janet Yellen about risk-weighted bank capital requirements, how would Margaret Thatcher have answered?

Although I am sure Janet Yellen fulfills all the formal qualifications, I really do not know sufficient about her so as to be able to provide any credible input as to her chances of doing a good job as the new Chair of the Fed. What I am sure of though, is that Yellen will need to show a type of Margaret Thatcher type of character strength, if she is going to be able to stand a chance against what is to come.

And in this respect I would also have liked, if Janet Yellen had been able to pose the following question to Margaret Thatcher:

By requiring banks to hold much more capital against what is perceived as risky than against what is perceived as absolutely safe, banks earn higher risk-adjusted returns on equity when lending to The Infallible Sovereign and to the AAAristocracy than when lending to The Risky. This causes of course banks to lend less than what they would ordinarily do, and more expensively so, to all “risky” medium and small businesses, entrepreneurs and start ups. Margaret do you think this is sane? Do you think this makes our banks safer? Do you think this helps the economy to grow muscular and sturdy?

And though certainly uttered in some much better way than what my poor British English allows me, I can almost hear Margaret Thatcher answering something as follows:

“No Dear Janet, that is as insane as it comes. We the western world did not become what we are by foolishly telling risk-adverse bankers to avoid taking risks, or by allowing bankers to binge profitably on what we for now, in shortsighted blissful ignorance, believe to be absolutely safe.”

The deforestation of the economy leads to flooding and to its dangerous desertification

Through “Learning with dogs” I was recently made aware of an article by George Monbiot, titled “Drowning in Money”, written on the subject of “The hidden and remarkable story of why devastating floods keep happening”, published in The Guardian, 14th January 2014. 

It refers to “a major research programme, which produced the following astonishing results: water sinks into the soil under the trees at 67 times the rate at which it sinks into the soil under the grass. The roots of the trees provide channels down which the water flows, deep into the ground. The soil there becomes a sponge, a reservoir which sucks up water then releases it slowly. In the pastures, by contrast, the small sharp hooves of the sheep puddle the ground, making it almost impermeable: a hard pan off which the rain gushes.

And, writes Monbiot: “here we start to approach the nub of the problem – there is an unbreakable rule laid down by the Common Agricultural Policy. If you want to receive your single farm payment – by the far biggest component of farm subsidies – that land has to be free from what it calls ‘unwanted vegetation’ Land covered by trees is not eligible. The subsidy rules have enforced the mass clearance of vegetation from the hills.” And, consequently, there is much dangerous flooding.

I immediately identified with the problem. For more than 15 years I have argued that medium and small businesses, entrepreneurs and start ups, constitute the most important root system that allows the economy to grow muscular, and not just obese. 

But, the regulators in the Basel Committee, with their utterly senseless risk-weighted capital requirements for banks, denied fair access to bank credit to these vital trees of the economy, only because these are perceived as risky. The consequence is that the economy turns into a paved parking lot where most rain just flows out to the sea without nurturing the economy. And it also guarantees that, when any AAA-rated levee breaks, true disaster will ensue.

Banks are there to fulfill an extremely important function of efficiently allocating credit in the real economy, and not simply to survive. But that was of no importance for regulators who, so fixated on keeping banks from failing, are not even considered the need for pruning.

In UK the Prudential Regulation Authority (PRA) is responsible for the supervision of banks, and its role is defined in terms promoting the safety and soundness of these. There is not one single reference to promoting the safety and soundness of the real economy, though nothing can be so dangerous for the long term prospects of an economy than an excess of prudence. 

If the UK, like most other economies, wants to avoid being dragged down in the death spiral of excessive risk aversion, it better starts thinking more in terms of an authority that understands the need for trees, perhaps about a Reasoned Audacity Regulation Authority.

Dr Jens Weidman, why did it take you so long to figure this out?

Dr Jens Weidmann, President of the Deutsche Bundesbank, at the Tagesspiegel event "Deutschland Agora 2014", Berlin, 16 January 2014 said the following.

“In order to break the disastrous nexus of banks and governments, the regulatory treatment of government bonds will, however, also have to be changed.

Currently, banks can invest unlimited amounts in euro-area government bonds. Under the current capital rules, a zero risk weight applies to these assets, which means that these government bonds can be fully funded with borrowed money, in other words, they do not require any capital backing. This constitutes preferential treatment, and has been a factor in banks in several peripheral euro-area states, in particular, raising their exposure to domestic sovereign bonds during the crisis; they have thereby tied their fate to that of their national government.

In my opinion, credit ceilings and risk-based capital backing would be a sensible way of breaking the nexus - that would basically mean applying similar rules to those for bank loans to private-sector debtors. Such rules would also promote bank lending to enterprises.

Support for this proposal is growing, its logic is compelling, but implementation is probably not on the cards for 2014… In the longer term, however, such regulations are, in my opinion, an indispensable prerequisite for a stable monetary union and a healthy financial system.”

And I just ask Dr Jens Weidman… why did it take you so long to figure this out? And if you accept that correcting for it is "indispensable", why not more urgency?

In November 2004, soon 10 years ago, after ending my 2 year term at the World Bank as one of its Executive Directors, in a letter published by the Financial Times I wrote: 

“Our bank supervisors in Basel are unwittingly controlling the capital flows in the world. How many Basel propositions it will take before they start realizing the damage they are doing by favoring so much bank lending to the public sector (sovereigns)?

A simple question, on bank regulations, to Basel Committee, Financial Stability Board, FED, ECB, FDIC, PRA and other

Do you really believe that those “unexpected losses” which could destabilize the banking system, should be estimated based on the estimations of “expected losses”? 

I ask that because that is what you have, in my opinion irresponsibly so, bet our whole banking system on... in fact even bet the health of our real economy on.

The capital requirements for banks should primarily cover for any unexpected losses, as any expected losses should primarily be covered by bankers knowing what they are doing. But, by your own confessions you have based the unexpected losses on the perceived risk of expected losses, like those contained in a credit rating. And that leads to the expected losses to be counted twice, while the unexpected losses are not considered at all.

And to top it up your current capital requirements for banks are, again by your own confessions, “portfolio invariant”, which means that the benefits of asset diversification among “the risky” or the dangers of excessive concentration of assets to something perceived as “absolutely safe” are not considered at all.

What you have done allow the banks to earn much higher risk-adjusted returns on capital when lending to The Infallible than when lending to The Risky, and this seriously distorts the allocation of bank credit in the real economy, with tragic implications for its future health.

And all for nothing, because you should know that what can cause the unexpected losses that can really bring a banking system down, are really to be found among what is perceived to generate the lowest expected losses.

What can I say regulators? That you have no idea of what you are up to? Frankly, I can’t find any other explanation.

You have a lot of explaining to do all that unemployed youth that you might turn into a lost generation. 

You fill pages after pages with talk about prudential regulations, but let me remind you of that the first rule of prudence is to cause not even larger damages! And that you have done.

Current regulators in the Basel Committee, and in the Financial Stability Board need to be fired!

Bankers are expected to guard the front door from all expected losses entering their business, and this they do by means of interest rates, size of exposures and other terms. Though sometimes one or another banker fails in doing that, in general, as a system, they perform quite well.

But the banker cannot guard the back-door, that of the unexpected losses too, because were he to do so, he would not be able to attend competitively his ordinary business at the front door.

And so it is the regulators’ responsibility to make sure that the back door is sufficiently guarded. Unfortunately, current regulators, explicitly for reasons of simplicity, stupidly decided to guard against unexpected losses, with a wall which height was determined based on the perceptions of expected losses.

And to top it up, also explicitly for reasons of simplicity, they decided And that means that “expected losses” are considered twice, while the “unexpected losses” are ignored.

And that means that the banking system overdoses on perceptions of expected losses, something which make it impossible for banks to allocate credit efficiently in the real economy.

And that means that when some unexpected losses occur, usually in assets previously deemed as safe, the risk of banks not having sufficient capital has dramatically increased.

The leverage ratio, that which is not based on risk-weights, was to partially solve one problem, though of course that of the distortion would remain, as other risk-weighted capital requirements would still be in place.

But the way the Basel Committee seems now proceeding to dilute the leverage ratio, seemingly even introducing risk-weighting for off-balance sheet items, while if something needed to be diluted was the discriminations produced by risk-weights, is evidence that the regulators really do not know what they are doing. And it therefore behooves us to fire them… urgently.

An alternative "Abstract" for my paper

The expected losses of a bank should normally be covered by its operations. The capital requirements are imposed by regulators primarily to cover for the “unexpected losses”.

But the risk-weighted capital requirements of Basel II and III have nothing to do with “unexpected losses” and all to do with a double counting of “expected losses”.

In fact an “Explanatory note of the risk weights function” July 2005, clearly spells out that: 

Because “Taking into account the actual portfolio composition when determining capital for each loan - as is done in more advanced credit portfolio models - would have been a too complex task for most banks and supervisors alike… The model [is] portfolio invariant and so the capital required for any given loan does only depend on the risk of that loan and must not depend on the portfolio it is added to”

In other words, a bank portfolio with extremely dangerous concentrations in what ex ante is perceived as “absolutely safe” will be deemed much safer than an extremely well diversified portfolio of assets perceived as “risky”.

And the note explains: “In the context of regulatory capital allocation, portfolio invariant allocation schemes are also called ratings-based. This notion stems from the fact that, by portfolio invariance, obligor specific attributes like probability of default, loss given default and exposure at default suffice to determine the capital charges of credit instruments. If banks apply such a model type, they use exactly the same risk parameters for expected losses (EL) and unexpected losses (UL), namely probability of default (PD), loss given default (LGD) and exposure at default (EAD).”

And so in fact there is never a provisioning for unexpected losses, but only a double provisioning for expected losses. 

The net result of these capital requirements are then that banks will be earn a much higher “perceived risk” adjusted return on equity when lending to those perceived as “safe” than when lending to those perceived as “risky”. And that causes a huge regulatory discrimination in favor of those perceived as “absolutely safe” and against those perceived as “risky”.

And all this the Basel Committee has done even admitting to that “intuition tells that low PD borrowers (safer) have, so to speak, more “potential” and more room for down-gradings than high PD (riskier) borrowers”. 

But, instead of considering this larger unexpected loss potential in the capital requirements, they postpone any adjustments to the moment of when a downgrading occurs, completely ignoring that a downgrading is nothing but the unexpected increase of expected losses.

This regulatory mistake, by pushing excessive bank credit to what was perceived as “absolutely safe” caused the current crisis, and by not allowing for sufficient bank credit to flow to the "risky", impedes us from getting out of the crisis.

PS. The current version of the paper

The Basel Committee incorrectly assumes “The Risky” will cause more “unexpected losses” than “The Infallible”

A discussion on a blog with someone who insisted that it is ok for the current capital requirements for banks to be higher for those perceived as risky that for those perceived as absolutely safe “because of the volatility”; and called me stupid because I “appear not to understand the whole concept of expected and unexpected losses” made me realize that I had to clarify again The Great Basel Committee Mistake… namely that Basel II (and III) base the capital requirements for banks, those which are to cover for the “unexpected losses”, on the “expected losses” derived from perceived credit risks.

“An Explanatory Note on the Basel II IRB (internal ratings-based) Risk Weight Functions” expresses: 

“The model [is] portfolio invariant and so the capital required for any given loan does only depend on the risk of that loan and must not depend on the portfolio it is added to.”

And the explicit reason for that mindboggling simplification was because it was: 

“This characteristic has been deemed vital in order to make the new IRB framework applicable to a wider range of countries and institutions. Taking into account the actual portfolio composition when determining capital for each loan - as is done in more advanced credit portfolio models - would have been a too complex task for most banks and supervisors alike.”

And which then leads to:

“In the context of regulatory capital allocation, portfolio invariant allocation schemes are also called ratings-based. This notion stems from the fact that, by portfolio invariance, obligor specific attributes like probability of default, loss given default and exposure at default suffice to determine the capital charges of credit instruments. If banks apply such a model type, they use exactly the same risk parameters for expected losses (EL) and unexpected losses (UL), namely probability of default (PD), loss given default (LGD) and exposure at default (EAD).”

And to justify their approach they write:

In the specification process of the Basel II model, it turned out that portfolio invariance of the capital requirements is a property with a strong influence on the structure of the portfolio model. It can be shown that essentially only so-called Asymptotic Single Risk Factor (ASRF) models are portfolio invariant (Gordy, 2003). ASRF models are derived from “ordinary” credit portfolio models by the law of large numbers. When a portfolio consists of a large number of relatively small exposures, idiosyncratic risks associated with individual exposures tend to cancel out one-another and only systematic risks that affect many exposures have a material effect on portfolio losses. In the ASRF model, all systematic (or system-wide) risks, that affect all borrowers to a certain degree, like industry or regional risks, are modeled with only one (the “single”) systematic risk factor

But suspecting they might be simplifying beyond reason, just in case, the Basel Committee added:

“It should be noted that the choice of the ASRF for use in the Basel risk weight functions does by no means express any preference of the Basel Committee towards one model over others. Rather, the choice was entirely driven by above considerations. Banks are encouraged to use whatever credit risk models fit best for their internal risk measurement and risk management needs.”

And this very flimsy approach, which ignores any correlation between unexpected losses, and shows very little concern with the problems of rapidly changing volatility, caused the Great Basel Committee Mistake of setting the capital requirements for banks, based on exactly the same perceived risks already cleared for.

In essence the regulators determined that a “risky” creditor, by the single fact of presenting more “expected losses”, also had to provide for more capital to cover for more “unexpected losses”. They never understood the hard truth that the safer something is perceived the greater its potential to deliver awful unexpected negative consequences.

And this the regulator did without absolutely any concern for how that could affect the efficiency of bank credit allocation in the real economy… something that can also be derived from the tragic fact that nowhere in the Basel Committee literature is there a word about the purpose of our banks.

And so they introduced an odious regulatory discrimination against those perceived as “risky”, something which introduces a dangerous risk-aversion, and, consequentially, introduces a favoring of what is perceived as “absolutely safe” that can only guarantee the dangerous overcrowding of safe-havens.

As perhaps the best example of what I am arguing is the absurdity of having what can really grow into dangerous excessive bank exposures, like the AAA to AA rated, being risk-weighted at 20%, while the totally innocuous below BB-rated, get a 150% risk weight.

    

In essence bank regulators have now ended up being the greatest systemic risk producers to the banking system. 

In short we do not need bank regulators, what we need are regulators who understand the banking system. 

In short we need regulators who understand that more important than looking at the portfolio of individual banks, is to look at the portfolio of banks in the whole banking system... and how it relates to the needs of the real economy.

Perhaps our bank regulators do not understand the possibility of a  "regression to the mean"

Did the "A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules" paper of 2002, by Michael B. Gordy, cause the downfall of our bank systems? Yes! It was an essential factor, but Gordy is not solely responsible for it... all those who sat there and did not understand one iota, and therefore never dared to question, are even more to blame.