Do bank regulators really believe ordinary bankers to be so stupid, or are they really so stupid themselves?

As in Basel II, do bank regulators believe ordinary bankers to be so blind and dumb, so they need to require them to hold 5 times as much capital when they lend to someone they know has a BBB+ to a BB- rating, or no rating at all, than when they lend to someone they know has an AAA to AA rating? Do they not know this will distort the allocation of bank credit to the real economy? Do they not know this means those with BBB+ to BB- ratings, or no ratings at all, will get much too little bank credit?

Or, as in Basel II, are bank regulators so dumb so as to believe ordinary bankers when they argue they should need only to hold a fifth of capital when lending to someone who has an AAA to AA rating, than what they are required to hold when lending to someone with a BBB+ to BB- rating, or no rating at all? Do they not know this will distort the allocation of bank credit to the real economy? Do they not know this will mean those with AAA to AA ratings will get much too much bank credit?

An urgent message to those holed up in Jackson Hole. Stop profiling risk! Our economies need regulatory neutrality.

Forget risk-weights and apply exclusively your leverage ratio capital requirement for all exposures that represent for instance less than a 1000nd of a bank’s balance sheet. 

There is no reason on earth why a bank should find it harder to lend a small amount to a medium or a small business, an entrepreneur or a start-up, than a huge amount to an infallible sovereign or to a member of the AAAristocracy.

Please, on our knees, we beg you… Stop profiling risk! That is an odious discrimination that impedes banks allocating credit efficiently. We need regulatory neutrality. 

PS. And all you reporters there... dare to ask The Question!

Bank regulators hate me when I ask this simple question. They refuse to answer it. They can’t! That’s the real problem!

The Question: Sir, current risk weighted capital requirements for banks are based on the perceptions of risk by credit rating agencies and bankers. But if bankers and credit rating agencies perceive the risks correctly there should be no major problems. So why are not the capital requirements for banks based instead on the credit risks not being correctly perceived by bankers and credit agencies?

As is, the perceived risks are now, besides being cleared for in the interest rate charged by the banks and in the amount of exposure accepted,also cleared, for a second time, in the required bank capital (equity). And that has created the distortions that make the banks lend dangerously much to what is perceived as “absolutely safe”, and dangerously little to what is perceived as “risky”, like to medium and small businesses, entrepreneurs and start ups.

As is, the risk with risk weighted capital requirements for banks is much greater than the risks which are being weighted! Got it?

I suspect the whole mess results from the fact that when regulators were given an explanation similar to that which appears in “The Basel Committee on Banking Supervision´sExplanatory Note on the Basel II IRB Risk Weight Functions of July 2005”… they did not understand one iota of it, but did not want to admit that in front of their equally befuddled colleagues. In other words, could it be the weak egos of expert bank regulators which provoked this financial crisis?

A subsequent problem is of course that too few are capable of daring to think that globally renowned experts can be so utterly wrong… and so they do not dare to help me to ask The Question.

Friends, we have to put a stop to the lack of accountability of those working in Committees which decisions have global implications. Can you imagine what could happen to the earth if similar weak egos are placed in charge of a Global Warming Supervision Committee in Basel?

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

US Congress, you are the legislators, so who of you ordered the banks in the home of the brave to become credit risk adverse?

Fact: Banks give larger loans, charging lower interest rates and allowing for leaner terms to those perceived as absolutely safe, than when lending to those perceived as risky. And that so much, that your Mark Twain described bankers as those who lend you the umbrella when the sun shines but want it back as soon as it seems it might rain.

Fact: Your regulators now allow banks to hold much less capital for what from a credit risk perspective is perceived as “absolutely safe” than against what is perceived as “risky”.

Fact: And that means banks can leverage their equity much more when lending to those perceived as “absolutely safe” than when lending to those perceived as “risky”.

Fact: And that means banks will earn much higher expected risk adjusted returns on their equity when lending to those perceived as “absolutely safe” than when lending to those perceived as “risky”.

Fact: And that means banks will lend almost exclusively to those perceived as “absolutely safe”, and basically nothing at all to those perceived as “risky”.

Fact: And that seems as far away as can be for the home of the brave which became a great land of the free primarily because of risk-takers… as few risk adverse crossed the ocean to reach its coasts.

And so the question: Who of you US legislators ordered the banks in the home of the brave to become even more risk adverse than what Mark Twain held these to be?

And legislators, if you are somewhat confused by these comments, may I suggest you invite your bank regulators to an open hearing to explain their main scripture, “The Basel Committee on Banking Supervision´s Explanatory Note on the Basel II IRB Risk Weight Functions of July 2005” to you. 

But then you might really going to be scared.

PS. Here is an updated list on the many mistakes with risk weighted capital requirements

No more champagne, only milk, and which sooner or later could turn sour or even dangerously spoiled

Perceived credit risks are similar to those risks described by Hans Karl Emil von Mangoldt in his 1855 example about the risks that a bottle of champagne bursts, and referred to by Frank H. Knight in his 1921 “Risk, uncertainty and profit”. 

In essence it all boils down to that those risks do not alter the results, the profits, because they can be accounted and provisioned for.

And yet, our too creative and I would say too loony bank regulators decided that if a bank was going to produce champagne using “risky” bottles, it needed to hold much more capital (equity), than if it was going to produce milk using safer milk bottles.

No wonder we now find less and less of the exciting champagne in our economies.

But “we have at least milk” you say? Not so, there are risks with binging on milk too.

Our bank crises have never ever resulted from banks drinking too much risky champagne, these have always resulted from drinking too much of what ex ante was considered as very safe milk, but that ex post turned out to be quite soured milk... or even dangerously spoiled milk.

The Basel Committee’s and the Financial Stability Board’s Credo

We believe that banks should give larger loans, on lower interest rates and on softer terms than usual, to those who are ex ante perceived as “absolutely safe”, like the infallible sovereigns and the AAA-ristocracy; and that they should give smaller loans, at higher interest rates and on harsher terms than usual, to those who are ex ante perceived as risky, like medium and small businesses, entrepreneurs and start-ups… so that we can go home and sleep calmly.

Since that could expose us to accusations of being discriminatory, we believe that the risk-weighted capital requirements for banks, by which we allow banks to earn higher risk-adjusted returns on equity when lending to the “absolutely safe” than when lending to “the risky”, is the least transparent and therefore the most effective regulatory pillar by which we can reach our objectives.

And, to those who might criticize us we say… we believe it is not our role to guarantee an efficient allocation of bank credit so that the economy grows sturdy and stays healthy… that is definitely somebody else’s business.

Europe beware, you´ve got yourself a very sad bunch of systemic risk experts reviewing the systemic risks of your banking system.

In the so posh sounding European Systemic Risk Board’s Advisory Scientific Committee´s report titled “Is Europe overbanked?” dated June 2014, we read:

“Large banks were able to increase their leverage - and therefore their return on equity (unadjusted for risk) – while complying with risk-based regulatory ratios”

And that is not correct... the lower risk weights in the risk-weighted capital requirements for banks, translates into allowing banks to hold much less capital against assets perceived as “absolutely safe”, which signifies that banks can leverage their equity much more with assets perceived as “absolutely safe”, and therefore earn much higher expected RISK-ADJUSTED returns on equity when lending to “The Infallible” than when lending to “The Risky.”

And this has made a true mockery of the report´s: “Financial development can also foster growth by allocating capital more efficiently, channeling resources to better projects and thus boosting total productivity”

Current risk weighted capital requirements signify that resources will be transferred in function of ex-ante perceived credit risks, which has of course not one iota to do with guaranteeing the transfer of these resources to better projects that can boost total productivity.

And in this respect, as I have been arguing for more than a decade, the risk weighted capital requirements represents the largest possible systemic risk to our banks and to our economies... as it basically prohibits much of the risk-taking necessary for our economies to move forward and for our descendants to have a future. 

As an example January 2003 in a letter published by FT 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. Friend, please consider that the world is tough enough as it is.”

And yet, now soon 7 years after the crisis broke out, that systemic risk has not even been identified by those who allow themselves to be called experts in systemic risk. How come?

The report refers to “some reason, such as badly designed prudential regulation” in order to get to “banks’ rapid expansion into loans secured against residential real estate”

And yet the report does not mention the truly bad design of the prudential regulations that resulted from assigning very low risk weights against loans secured against residential real estate… which meant that banks could leverage much more their equity when giving loans secured against residential rate… which of course meant that banks would earn much higher than normal relative risk adjusted returns on equity on loans secured against residential real estate… which of course led to an explosion of bank loans secured against residential real estate.

And the report asks “Why has overbanking occurred?” and advances the explanation of “deposit insurance schemes may themselves generate moral hazard. Capital requirements can often be circumvented by banks, especially the largest ones, which have greater capacity to engage in risk-weight manipulation”

Circumvented? Hell no! The regulators allowed banks to hold only 1.6 percent in capital against securities rated AAA which meant authorizing a mindboggling leverage of 62.5 to 1… does as a bank really need to circumvent that? No! What they might need though, is to find some AAA ratings issued by the friendly and human fallible credit rating agencies. 

And let us not even go to the area of bank lending to the “Infallible Sovereigns” where no equity is required and the sky is the limit for bank leverage. In November 2004 FT published a letter in which I asked “How many Basel propositions will it take before they start realizing the damage they are doing by favoring so much bank lending to the public sector (sovereigns)?”

And so I must conclude in a: “Europe, beware, you´ve got yourself a very sad bunch of systemic risk experts reviewing the systemic risks of your banking system”

Am I to harsh in my criticism? Absolutely! If this was the first time I criticized. But, considering I have been asking the regulators my questions for more than a decade, all over the web and in hundreds of conferences, and they have never ever dared to give me a straight answer (with one incredible exception) and much less have dared debate me on these issues… I do not feel I am too harsh or too impolite in any way shape or form. 

On the contrary, I feel it is my responsibility to shame them in all the ways I can, so that no regulator dares to act ever again with so much hubris, believing he can be the risk manager for the world.

To finalize… may I kindly suggest these systemic risk experts that their so impressive list of 130 documents referenced does not include the most basic and important document required to understand the mumbo jumbo of financial regulators namely the Basel Committee on Banking Supervision´s Explanatory Note on the Basel II IRB Risk WeightFunctions of July 2005. That this document, has clearly not been reviewed by those preparing the report, is by itself something impossible to understand, unless of course they want to avoid shaming some members in a mutual admiration club.

Does really a bank´s "living will" make much sense?

Living wills: “Detailed plans that would enable banks to stipulate in advance how they would raise funds in a crisis and how their operations could be dismantled after a collapse”.

The whole concept of living wills for banks’ designed by the bankers themselves, for how to handle a collapse, seems to me a bit of a show by regulators to show they are doing something and to have something to put the blame on tomorrow…. “They gave us a bad living will” 

I mean if I was a regulator, and wanted to go down that route, I would at least have a third party to look into what could be done in the case a bank passed away, and now and again confront the managers of the bank with those plans, in order to hear their opinions.

For instance there is a world of difference between a living will where the dead are going to be the own executors of the will, and one in which the dead will be dead and others will take care of the embalming.

And talking about this should not the Fed or the FDIC first state what contingent plan they really want… one where the bank is placed on artificial survival mode, and for how long, or one where it is sold in one piece, by pieces or even cremated?

To me it would seem that the Fed and FDIC need to give much clearer instructions about what they want those bankers who are currently working under the premise the bank will live on forever to do… as I can very much understand bankers being currently utterly confused.

PS. And, to top it up, regulators should worry more about how banks live than about how they die. Thanks in much to the distortions created by the regulators with their risk-based capital requirements, the banks are not allocating credit efficiently and their legacy is therefore condemned to be poor. And… excuse me, that´s a far more serious problem.