Friday, November 14, 2014

G20, the Financial Stability Board does not know what it is doing, or is simply hiding a monstrous regulatory mistake.

“In Washington in 2008, the G20 committed to fundamental reform of the global financial system. The objectives were to correct the fault lines that lead to the global crisis and to build safer, more resilient sources of finance to serve better the needs of the economy”

That is how FSB on November 14, 2014 introduces its report to the G20 leaders titled “Overview of Progress in the Implementation of the G20 Recommendation for Strengthening the Financial Stability

And the letter that accompanies it states: “The job of agreeing measures to fix the fault lines that caused the crisis is now substantially complete.” 

But the sad fact is that the report does not even mention what in my opinion constitutes the most important fault line, and in not doing so, makes it also impossible for banks to serve the needs of the economy.

As I see it that "fault line" was the Perceived Credit Risk Weighted Equity Requirements for Banks. Here follows my explanation:

Banks already clear for perceived credit risks (in the numerator) by means of interest rates, size of exposure and other terms of contract.

And so, when regulators cleared for the same perceived risks in the equity (more risk more equity – less risk less equity) they allowed banks to earn much higher risk adjusted returns on equity when lending to those perceived as “absolutely safe”, than when lending to those perceived as “risky”

The following are some examples of risk weights and leverages based on the original 8% equity requirement and that are indicated in the Basel II approved in June 2004.

Infallible sovereigns: zero percent RW, allowing infinite leverage.

Members of the AAAristocracy: 20 percent RW, allowing a leverage of 62.5 to 1.

Financing of houses: around 25 percent RW, allowing a leverage of 50 to 1

Medium and small businesses, entrepreneurs and start-ups, and citizens: 100 percent RW, allowing a leverage of 12.5 to 1.

And there is a perfect correlation between the troubled bank assets that caused the crisis, and the presence of ultralow capital requirements.

And this monumental distortion in the allocation of bank credit is not even mentioned.

Either the FSB has not understood the problem, or it is hiding the truth about this horrendous regulatory mistake.

And even from the perspective of medium term stability of banks, these regulations are absolutely useless. That is so since all really serious bank crises never result from excessive exposures to what is perceived as risky, but always from excessive exposures to what has erroneously perceived as “absolutely safe”. And so, if anything one could even argue the equity requirements should be totally the opposite, higher for what is perceived as “absolutely safe” and lower for what is perceived as “risky”. 

And these risk weighted equity requirements are impeding bank credit from reaching where it is most needed and therefore wasting all the liquidity support provided by QEs and similar programs.

Yes regulators will tell you that Basel III has the Leverage Ratio which is not risk-weighted. What they do not understand though is that raising the floor, only increases the pressure of those living close to the roof... namely "the risky".

Bank regulators who as we all have prospered thanks to the risk-taking of the banks of our parents, are now negating that risk taking to our children.

As a consequence our banks are now not financing the risky future, only refinancing the safer past.

Risk taking is the oxygen of development, and these regulators have no right whatsoever to believe with astonishing hubris they can be the risk-managers of the word, and go behind our back, calling it quit, and so making our economy stall and fall.

Conclusion: Basel III has NOT fixed the distortions in the allocation of bank credit. In some ways it has even made it worse. And, to top it up the risk-adverse regulatory monsters also want to go after the insurance sector.

God make us daring!