Great expert bank regulators of Europe, why do you believe in this regulatory nonsense?

Banks are now required to hold much much more capital when lending to SMEs than when financing houses; and so banks, because of a much much higher leverage, earn much higher risk-adjusted returns on equity when financing houses than when financing those who could create the next generation of jobs our young needs. 

What do you mean, are we all going to sit in or houses playing with our I-pads without jobs? 

Banks are now required to hold much much more capital when lending to citizens than when lending to the supposedly “infallible sovereigns”; and so banks, because of much much higher leverage, earn much much higher risk adjusted returns on equity when lending to governments than when lending to citizens.

What do you mean, what kind of back-door communism is this?

Do you really think you are making the world a safer and better place with this nonsense? Don’t you all see you are bloody killing the economy of Europe with this dumb risk aversion? Don't you see you are with no right whatsoever closing the horizons of our young?

John Augustus Shedd, 1850-1926 said: “A ship in harbor is safe, but that is not what ships are for.”... And that goes for banks too!

Q. Why do you agree with this regulatory nonsense, Mario Draghi, President of the European Central Bank and former Chairman of the G20s Financial Stability Board?

Q. Why do you agree with this regulatory nonsense Stefan Ingves, Governor of Sveriges Riksbank and current Chairman of the Basel Committee on Banking Supervision?

Q. Why do you agree with this regulatory nonsense Jaime Caruana, Chairman of the International Bank of Settlements and former Chair of the Basel Committee on Banking Supervision?

Q. Why do you agree with this regulatory nonsense Mark Carney, Governor of the Bank of England and current Chairman of the G20s Financial Stability Board?

PS. I am sorry... but somebody has to ask... and keep on asking. God make us daring!

Mark Carney violates the ethics of Adam Smith that he himself emphasizes.

Mark Carney, Governor of the Bank of England, in the Commonwealth Games Business Conference, Glasgow 23 July 2014, in a speech titled “Winning the economic marathon” stated:

“Adam Smith emphasized the importance of conduct, or what he referred to as ‘the established rules of behavior,’ by which ‘many men behave very decently, and through the whole of their lives avoid any considerable degree of blame. Those established rules of behavior – social capital – underpin the functioning of the free market. In short, to be effective, markets must also be fair”

And in this respect Mark Carney, as a bank regulator, as the Chairman of the Financial Stability Board, should take note that he himself, by approving of risk-weighted capital requirements for banks, those which discriminate against those who are already discriminated against by being perceived as “risky”, is not behaving fairly, distorts the functioning of the free markets, and is in utterly noncompliance with what “Adam Smith emphasized”.

PS. My 2019 letter to the Financial Stability Board

Comment on BoE´s Sir Jon Cunliffe´s speech, July 17, 2014, on the leverage ratio in bank regulations.

Sir Jon Cunliffe of the Bank of England, Deputy Governor Financial Stability, Member of the Monetary Policy Committee, Member of the Financial Policy Committee, Member of the Prudential Regulatory Authority Board gave a speech on July 17 on the role of the leverage ratio. In it he states: 

“The underlying principle of the Basel 3 risk-weighted capital standards – that a bank’s capital should take account of the riskiness of its assets – remains valid. But it is not enough. Concerns about the vulnerability of risk-weights to ‘model risk’ call for an alternative, simpler lens for measuring bank capital adequacy – one that is not reliant on large numbers of models. 

This is the rationale behind the so-called ‘leverage ratio’ – a simple unweighted ratio of bank’s equity to a measure of their total un-risk-weighted exposures. 

By itself, of course, such a measure would mean banks’ capital was insensitive to risk. For any given level of capital, it would encourage banks to load up on risky assets. 

But alongside the risk-based approach, as an alternative way of measuring capital adequacy, it guards against model risk. This in turn makes the overall capital adequacy framework more robust. 

… bank capital adequacy is subject to different types of risks. It needs to be seen through a variety of lenses. Measuring bank capital in relation to the riskiness of assets guards against banks not taking sufficient account of asset risk. Using a leverage ratio guards against the inescapable weaknesses in banks’ ability to model risk. 

Whether the leverage ratio or the risk weighted capital ratio bites on any individual bank will depend on what are the greatest risks facing that bank” 

And those assertions contain some important impreciseness and problems on which I must comment. 

First “that a bank’s capital should take account of the riskiness of its assets – remains valid… Measuring bank capital in relation to the riskiness of assets guards against banks not taking sufficient account of asset risk” 

Absolutely not so! A banks capital should take account of the risk of the bank, which though related to the risk of its assets, is something quite different from the risk of its assets. For instance a bank that has an overconcentration in some few very absolutely safe assets might be infinitely more risky than a bank that has a great diversified exposure to risky assets. The most unfortunate part of current capital requirements is that they are portfolio invariant. 

Second “a leverage ratio guards against the inescapable weaknesses in banks’ ability to model risk”.

Not just so! Models are based on expected risks, while leverage ratios should cover primarily for unexpected risks, and “model risks”, the risk of models sometimes not being correct, has even a lot of being an expected risk. And so in this respect the leverage ratio is to cover for much more unknowns than model risk.

Third “Whether the leverage ratio or the risk weighted capital ratio bites on any individual bank will depend on what are the greatest risks facing that bank”

Not so! What will bite an individual bank has nothing to do with risks, and all to do with its current capital position. If a bank is under the leverage ratio then that is its binding constraint, and if over it, the risk-weighted capital is.

And here is where I need to express my most serious concern with the leverage ratio, and that is that as it increases the floor of minimum capital, it will intensify the distortions produced by risk-weighing. Do you remember the movie the “Drowning pool” where Paul Newman and Joanne Woodward are pressured against the ceiling by an increasing level of water? Precisely that way!

Conclusion: I want a leverage ratio 6-8% but not in the company of the so odiously distorting risk-weights.

This is how are banks are regulated, and how they could have been, if only they listened to what we want our banks do for us.

The pillar of current bank regulations is capital (equity) requirements based on perceived risk. It allows for much lower capital for assets perceived as safe than for assets perceived as risky… which means banks will be able to leverage much more their equity when lending to the safe than when lending to the risky… which means banks will earn much higher risk-adjusted returns on equity when lending to the safe than when lending to the risky… and which means banks will not lend to the risky, like medium and small businesses, entrepreneurs and start ups.

Unfortunately, that will not stop major bank crises, because these result only from excessive exposures to what was wrongly perceived as absolutely safe, and never from excessive exposures to what was ex ante correctly perceived as risky… just like the latest crisis happened.

Had regulators asked us, we would have suggested the following:

First, forget about perceived credit risks. Bankers already consider these when they set interest rates size of exposures and other terms. And if as bankers they are not able to handle credit risk, then it is better their banks go broke, fast, before these grow into too-big-to-fail banks.

Now if you want banks to have capital as a reserve, as you should, set these based on unexpected risks. And since you never really know where these unexpected risks can occur, better set one fix percentage, for instance 8%, against any bank assets.

But also, if you really want banks to help out, then perhaps you could reduce slightly that 8% floor, not based on credit ratings, but based on potential-for-job-creation ratings, or sustainability-of-Mother-Earth ratings. That way banks will be able to earn a little bit more on their equity, when trying to do something good for us.

Because, at the end of the day, what are banks for, if not to help us, our economy and our planet? And by the way doing that is the only way for banks to achieve long term stability. There is no such thing as banks standing intact among economic rubble.

I guarantee you that had bank regulators followed this road, we might have some other type of crisis, but not one as serious as the current one… and definitely banks would be helping out much more in terms of creating jobs for our young, and in terms of helping the environment in many ways.

I ask for your help in putting our banks back on track... current regulators juts refuse to admit their monstrous mistakes... they do not even answer my questions.

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 unfortunately that they keep on doing! Basel III is in many ways only digging our banks deeper into the hole.

“The Parade of the Bankers’ New Clothes Continues: 28 Flawed Claims Debunked” by Anat Admati and Martin Hellwig

I refer here to their revised document of July 6 2014

As I have argued before the authors present a better description than most of the problems of current bank regulations.

Unfortunately, though they correctly identify that relying capital requirements that are risk-weighted is a flawed concept, they do not yet identify the most serious problem with doing so, namely that it dramatically distorts the allocation of bank credit to the real economy.

Since the perceived risks, like for instance those reflected in credit ratings, are already cleared for by means of interest rates, size of exposure and other contract terms, to also clear for the same perceptions of risks in the capital, signifies a double consideration of risk perceptions… and any risk perception, even if absolutely correct, will lead to the wrong conclusions if excessively considered.

In this particular case that signifies that banks will be able to earn much higher risk adjusted returns on equity on assets considered “absolutely safe” than on assets considered “risky”… and that in its turn means that banks will not serve in a fair way the credit needs of those who might most be need in access to it, like medium and small businesses, entrepreneurs and start-ups.

And the main reason for why we ended up with these bad regulations was that nowhere did bank regulators define the purpose of those entities they were regulating.

Another objection to risk-weighing not clearly identified by the authors, is that what regulators really need to consider when setting the capital requirements is not the expected risks or losses, but the unexpected risk and losses. And the Basel Committee, in a document where they explained the methodology of the risk-weighing explicitly stated that, since unexpected risks are hard to measure, they would use the expected risks in substitution of the not-expected… something which of course does not make any sense at all.

The same explicatory document from the Basel Committee on Basel II’s risk weights also states that the capital requirements are portfolio invariant, meaning that they do not consider the risk of over concentrating in what is perceived as safe, nor the benefits of diversifying in what is perceived as risky. And the argument to do so, amazingly, is that otherwise it would be too difficult for regulators to manage the system.

In summary one can say that regulators concentrated on the risks of the assets of the banks, and not on the risk of the banks… which is of course not the same.

Also any empirical study would have shown that bank crises always result from excessive exposures to something perceived as safe... and never from excessive exposures to something perceived as risky. 

Finally, and though there are some other issues I slightly disagree on, let me here conclude with reference to their remarks on:

"Flawed Claim 13: There is not enough equity around for banks to be funding with 30% equity."

"Flawed Claim 14: Because banks cannot raise equity, they will have to shrink if equity requirements are increased, and this will be bad for the economy."

"Flawed Claim 15: Increasing equity requirements would harm economic growth."

I agree with the authors those are mostly flawed claims, but primarily so from the point of view of a static analysis.

But unfortunately, the road from where our banks now find themselves, to where they propose and many would love the banks to be in terms of equity, makes for a very difficult journey.

In my opinion in order to speed up the travelling, before our young  run the risk of becoming a lost generation, will for instance perhaps require awarding special tax exemptions, in order to make those equity increases feasible over a not too long time span…. because we might in fact be talking about at least a trillion dollars of new equity.

And of course, meanwhile, make all fines payable in voting shares.

Please... again...more important than more bank capital is less distorting bank capital requirements.

Mr. George Banks, asked by his board about risk weights, Tier 1 capital and AT1 / CoCos, decides to better go and fly a kite

At the Board of Directors of Dawes Tomes Mousley Grubbs Fidelity Fiduciary Bank

Mr. Dawes Sr asks: Mr. Banks as it is for us to decide what do you suggest we do?

Should we stop lending to our old and loyal small businesses and entrepreneurs which, because of their high risk weights might lead us to not be in compliance with Tier 1 capital requirements?

Because if we do not do so we will force those old and loyal investors of ours who bought our Contingent Convertible bonds, the CoCos, because they paid slightly higher interest, to convert these into bank shares.

Mr. Banks answers: Yes banking, used to be such fun for a loan officer like me but, since those equity minimizing / leverage maximizing financial engineers took over, that has all changed. It's now all too loony and strange to me. So sorry Sir, I really don’t know how to answer your question, perhaps I better go and fly a kite...

Yes, indeed I think I will!!!

Splendid idea George, with loony regulators like the Basel Committee we all better fly a kite too!

Caveat emptor!

Our dear George Bailey would also not have stood a chance against a Basel Committee.

PS. Here is an aide memoire on the mistakes in the risk weighted capital requirements for banks.

Is there a point at which a Nobel Prize must be recalled so as to avoid reputational and other damages?

How much can Nobel Prize winners be allowed to ignore facts relevant to what they are discussing?

Facts: 

1. The pillar of current bank regulations is the risk-weighted capital requirements for banks. 

2. These because regulators cannot differentiate between ex ante and ex post risks, allow banks to leverage their shareholder´s capital much higher when lending to “the infallible” than when lending to “the risky”. 

3. And that results in that banks can earn much higher risk-adjusted returns on their equity when lending to “the infallible” than when lending to the risky.

4. And that distorts and makes it impossible for medium and small businesses, entrepreneurs and start-ups to have access to bank credit in fair market conditions.

5. And that makes it impossible for the liquidity or stimulus provided by quantitative easing (QEs), fiscal deficits or low interest rates, to reach what needs most to be reached.

6. And all that for no good reason at all since bank crises are never ever the result of excessive exposures to what is ex ante perceived as risky.

And so when time and time again I read that a Nobel Prize winner asks for more economic stimulus and less austerity, without the slightest reference to the need of removing that huge regulatory boulder that stands in the way of job creation and sturdy economic growth, I can´t help but to ask… is there a point at which a Nobel Prize must be recalled so as to avoid reputational damage?

Of course I do understand the difficulties for the Committee for the Prize in Economic Sciences in Memory of Alfred Nobel. That prize was endowed by the Swedish central bank… and the current president of Sveriges Riksbank, Stefan Ingves, is also the current chairman of the Basel Committee, the committee responsible for creating the regulatory boulder that stands in our way... and that is a huge reputational risk in itself.

How dangerous it can be when reputational risks intertwine so much... in mutual admiration clubs.

  

Caveat emptor! Contingent Convertible Capital Instruments CoCos

Contingent Convertible Capital Instruments CoCos, which counts as Additional Tier 1 debt, and which could be forced to convert only because a regulatory change in risk-weights, or in the risk appreciation of some assets by credit rating agencies, or because of bank manipulations is pure lunacy for all… especially for investors.

Could investors sue regulators for forcing them to convert? What responsibilities have regulators on informing investors about the possibilities of conversion?

If getting close to a conversion do banks have an obligation toward investors to sell assets with high risk weights in order to avoid conversion, or can the banks instead take on assets with high risk weights in order to force conversion on investors?

The only cocos that could make some sense, are those based on a leverage ratio (not risk-weighted)…for instance not less than 8 percent.

What would the reactions be if capital requirements for banks discriminated against gays, the sick, women or black people?

Those perceived as risky credit risks do already pay higher interest rates, do get smaller loans and do have to accept harsher terms… and so why on earth would regulators require banks to have much more capital when lending to the risky than when lending to the “safe”, and so that the risky need to accept even higher interest rates, even smaller loans and even harsher terms… and all this when there has been no major bank crises in history that has resulted from excessive exposure to those ex ante perceived as not risky? Are current bank regulators sadists?

De facto, regulators tell banks to lend less or charge higher interests to those suffering the precondition of being perceived as risky

What would the reactions be if capital requirements for banks discriminated against gays?

What would the reactions be if capital requirements for banks discriminated against the sick?

What would the reactions be if capital requirements for banks discriminated against black people?

What would the reactions be if capital requirements for banks discriminated against women?

All hell would break lose!

But, no these only discriminate in favor of the “infallible” and against “the risky”, and so nobody cares.

Not even the Congress of the home of the brave

Not even those in charge of supervising the Equal Credit Opportunity Act

Fed Chair Janet Yellen has not been briefed on the real implications of current risk-weighted capital requirements for banks.

I refer to Fed Chair Janet L. Yellen speech At the 2014 Michel Camdessus Central Banking Lecture, International Monetary Fund, Washington, D.C. July 2, 2014 on Monetary Policy and Financial Stability.

From it I deduct that she has not yet been fully briefed about the real implications of the pillar of current bank regulations namely the risk-weighted capital requirements for banks.

I will illustrate this with two examples:

First Yellen states: “A smoothly operating financial system promotes the efficient allocation of saving and investment, facilitating economic growth and employment. A strong labor market contributes to healthy household and business balance sheets, thereby contributing to financial stability. And price stability contributes not only to the efficient allocation of resources in the real economy, but also to reduced uncertainty and efficient pricing in financial markets, which in turn supports financial stability.”

Absolutely, the problem though is that by means of risk-weighing the capital banks are required to hold, you allow banks to earn different risk-adjusted returns on equity something which stops in the tracks any possibility of efficiently allocating bank credit in ways that permit sturdy economic growth. In essence current requirements, by allowing banks to earn more on the “absolutely safe” it has stopped banks to lend sufficiently to the risky, like medium and small businesses, entrepreneurs and start-ups. And, an economy with insufficient risk-taking, is doomed to recede.

But also, from the perspective of financial stability the current risk weights are completely wrong, since never ever do big bank crises erupt from too much bank exposure to what is ex ante considered risky, they always result from too much bank exposures to what ex ante is considered absolutely safe, but that ex post turns out very risky.

Second Yellen states: “Tools that build resilience aim to make the financial system better able to withstand unexpected adverse developments. For example, requirements to hold sufficient loss-absorbing capital make financial institutions more resilient in the face of unexpected losses.”

Absolutely, the problem though is that the current risk weights have nothing to do with unexpected losses, and all to do with the expected losses derived from the perceived credit risks which are already cleared for in interest rates, size of exposures and other contractual terms.

And the consequence of that is that expected losses get cleared for twice, while the unexpected losses are not considered, and huge distortions ensue.

In the remote possibility that Janet Yellen would read this, let me end here by assuring her that if banks had had to hold the same capital against any asset, for instance the basic Basel II's 8 percent, something else might have happened… but not the current crisis.

PS. Here is a link to a fuller list of the Basel II mistakes.

My list of the biggest X mistakes of risk-weighted capital requirements for banks, which regulators (and FT) ignores

For the time being, and in no particular order… 

1. The risk-weights are portfolio invariant, which means these do not reflect the dangers of excessive concentration or the benefits of diversification. The main explanation for the why of this is, amazingly, that otherwise it would have been too difficult for regulators to manage.

2. The risk-weights are based on the expected risk which is already being cleared for by bankers, by means of interest rates, size of exposure and other contractual terms; and not based on the unexpected risks, that which should really be the concern of regulators.

3. The risk-weights with their consequential different capital requirements for different assets allow banks to earn higher risk-adjusted returns on its equity on assets classified as "safe" than on assets deemed "risky", something which hugely distorts the allocation of bank credit in the real economy.

4. One thing is the risk for the banks of the expected risks of their assets… and another completely different the risk for regulators of the banks not perceiving the expected risk correctly.

5. The less the number of those officially appointed to perceive credit risks, like the human fallible credit rating agencies, the larger the consequences of a magnificent risk-perception imperfection.

6. The only reason for which regulators can set higher capital requirements for banks when lending to “the infallible” than when lending to “the risky” is that they did not do any empirical research on what always causes bank crises, namely excessive exposures to something ex-ante considered "absolutely safe" but that ex-post turned out not to be.

7. To believe that the risks of huge loans to an infallible sovereign are greater than many small loans to that sovereigns subjects, is about as crazy as it gets… unless of course you are a communist.

8. Emphasizing the avoidance of short term perceived credit risks, without considering the benefit that loans to "the risky" might bring to the sturdiness of the real economy, causes banks to concentrate on financing the safer past and to avoid financing the riskier future… which is something our children will pay dearly for.

9. Ridiculously small capital requirements, 4%, 2.8%, 1.6% and even 0% constitute of course the best growth-hormones for the “too-big-to-fail” banks.

10. Diminishing the importance of bank capital allows for outrageous bankers’ bonuses.

11. Of course underlying all of the problems of Basel II is that there is not a word to be found in all the Basel Committee’s regulations about what is the real purpose of the banks. No wonder!

12. To ignore the consequences of all the distortions in the allocation of credit to the real economy the risk-weighing has and will cause, is sheer lunacy!

Basel Committee for Banking Supervision and the Financial Stability Board take notice: Anyone who imposes regulations that can be gamed is the wrongdoer’s best friend

PS. My 2019 letter to the Financial Stability Board FSB