On risk-taking, retirement accounts, and lousy bank regulations.

What would have happened with anyone’s retirement plan if, when a young professional and starting to save, his instructions would have included paying his investment manager much higher commissions on returns produced by safe investments, than on returns produced by riskier investments. 

There is no doubt that in such circumstances, his investment manager would have played it overly safe, and he, the beneficiary, would probably have had to retire on a very meager income.

But, by means of their credit-risk weighted equity requirements, which allow banks to earn much higher risk adjusted returns on their equity when lending to something “safe”, than when lending to something “risky”, the regulators are instructing the banks to act in precisely this way.

Whether we like it or not, banks have a very important role to play as investment managers for our economies. And the reason we taxpayers implicitly agree to support banks, is not for them to avoid risks, but to, with reasoned audacity, take intelligent risks on our behalf. 

And so, even if we have to pay banks high commissions, we need them to act much more like aggressive growth funds taking risks but looking to produce for us investors better returns; and for our economies sturdier growth; and for our young better good future employment opportunities.

So let's get these regulators out of our way!

Would the Basel Committee or the Financial Stability Board approve the following exam question?

Suppose they ask you to calculate the risks of accidents in crossroads, and you based it on how drivers suffer accidents in general. Would you pass the exam? I don’t think so.

I ask this because the Basel Committee, when setting their equity requirements for banks, based it on the risks that bank borrowers would fail, and not on the risks that banks would fail.

And based on that they allow banks to hold less equity when lending to "the safe" than when lending to "the risky.

Something like allowing drivers with good driving records to speed faster through the crossroad than more accident prone drivers… even though records would show that it is precisely when drivers drive too fast through a crossroad, or the lights are malfunctioning, that the worst accidents occur. 

Scary eh!

Financial regulations, if wrong, could destroy the economy of a nation, and is therefore an issue of utmost importance for national security.

Suppose military regulations which implicitly stated that those who avoided taking direct risks when fighting the enemy, for instance by using drones, had much better possibilities to advance in the ranks than those who dared to risk hand to hand combat. Would this not impact negatively, at least in the long term, the strength of the Home of the Brave?

And should bank regulators not have to consider the dangers of introducing distortions in credit allocation, which might weaken the economy and thereby weaken the defense of the nation?

In 1988, the G10, a group which includes United States, decided to introduce risk-weighted capital requirements for banks; where “risk” means credit risk, and “capital” means bank equity. As a consequence, those bank assets with a low risk-weight require banks to hold less equity than those assets with a high risk-weight.

The initial big risk-weight differentiation, in 1992 with Basel I, was that loans to the central governments of the OECD nations had a cero risk-weight, while loans to the private sector carried a 100 percent risk-weight. In 2004, with Basel II, many more risk buckets were added and in the private sector the risk-weights were set from 20 to 150 percent.

And it all sounds like prudent bank regulations… more-risk-more-equity - less-risk-less-equity. But, unfortunately, bank regulators, I pray unwittingly, did not notice that by doing that, they were introducing an extremely dangerous distortion of how bank credit was allocated to the real economy.

It signified that the equity of a bank, to which we have to add the value of the support a society and taxpayers lend the banks, could be leveraged many times more for assets with a low risk weight, than with assets with a high risk-weight. 

And that meant banks could earn much higher risk adjusted returns on equity on assets that carry a low risk-weight than on assets with a high risk-weight.

Just for a starter it meant that regulators effectively instructed banks to allocate more credit to the central government than to the private sector… implying thereby of course that a government bureaucrat has more capacity to allocate financial resources efficiently to the real economy than a private agent, like a SME or an entrepreneur

And anyone who thinks this regulatory risk aversion will not affect the strength of the USA’s economy, has no idea about how the USA got to be strong

And to top it up, it is all for nothing, since all major bank crises have always resulted from too big exposures to something that was perceived as “safe” that turned out risky, and never ever from excessive bank exposures to something perceived as risky.

Really; are the risk weighted bank capital requirements with decreed weights: 0% Federal Government, 100% We the People, in accordance to the US Constitution?

 

@PerKurowski

A message sometime ago to Homeland Security

A letter on the issue of defense in the Washington Post

Current credit-risk-weighted capital (equity) requirements for banks, besides being stupid and dangerous, are immoral

This is what the current bank regulators have decreed, on their own, without any real consultations:

The lower the perceived credit risk of an asset, the lower the equity a bank has to have against it… and so of course, the higher the perceived credit risk of an asset, the higher the equity a bank has to have against it.

It is stupid: because never ever have major bank crises resulted from excessive bank exposures to what is perceived as risky, these have always resulted, no exceptions, from excessive bank exposure to something perceived as save.

It is dangerous (even from a national security perspective): because allowing banks to leverage their equity, and the support they receive from taxpayers, differently based on perceived risks, will seriously distort the allocation of bank credit to the real economy and thereby weaken it.

And it is immoral: because having those perceived as risky and who already, precisely because of those perceptions, have less and more expensive access to bank credit, to have even lesser and even more expensive access to bank credit, is an odious and immoral regulatory discrimination, which kills opportunities and increases inequality.

Our economies are bloated by QEs, low interests and other stimuli, and the lack of real risk-taking.

Tarps, fiscal deficits, QEs and minimal interest rates, in an economy where regulators have by means of risk-weighted equity requirements de facto prohibited banks to take real risks, like lending to SMEs and entrepreneurs, only to take on false risks, like leveraging too much on what is "safe", like with government debt and residential mortgages, has created a bloated economy full of assets with inflated values... and helped finance the permanence of inefficiencies that should have been long gone.

The economy now needs to fart, urgently, but boy it is going to be embarrassing smelly… and painful!

That deflation is not curable with factory produced inflation but only with the type of sturdy growth that can justify the relative values of all assets. You do not live on existing assets alone.

You cannot grow muscles by staying in bed just eating fats and carbs... you need exercise and proteins... even if "risky" 

Way back I had a feeling this had to come sooner or later. 

PS. Sometimes I feel sort of like a Chance the gardener :-)

But who knows, Mario Draghi and his colleagues might all just be Chauncey Gardiners too :-( 

And what could lead to less inequality: to inflate the value of assets that are already owned or to try to create new assets?

I don’t know whether to laugh or cry, but current bank regulations are just as loony as they can be

With Basel II, the regulators decreed for instance that the risk-weight of a private corporation rated AAA to AA, was 20%, while the risk weight of a corporation rated below BB-, was 150%.

Since their basic bank equity requirement was 8 percent, that meant that banks needed to hold only 1.6 percent in equity against any loan to an AAA to AA rated corporation, while having to hold 12 percent in equity when lending to a corporation rated below BB-. 

And that meant that banks were allowed to leverage their equity over 60 times to 1 when lending to an AAA to AA rated corporation, but limited to a 8 to 1 leverage in the case of lending to BB- rated private corporations. 

And all that… in the name of bank safety! 

As if there was any sort of danger that many banks in the banking system would dangerously overexpose themselves to BB- rated private corporations? 

As if the danger does not lie in the possibility that an AAA to AA rated corporation, those which bankers love to lend to, could suddenly turn up to be worse than a BB-rated private corporation. 

Regulators, like Jaime Caruana, Mario Draghi, Mark Carney, Stefan Ingves and some other are just like nannies telling kids…

If you go into that dark forest that looks horrible to you...

then we will force you to eat broccoli and spinach...

But, if you stay out on the fields where everything looks safe and beautiful...

then we will allow you to eat as much chocolate cake and ice cream you want.

This even though you could become dangerously obese (or too big to fail)

It can also be rephrased as if you eat broccoli you must eat spinach too but, if you eat chocolate cake you can have as much ice cream as you want.

How infantile is it be to believe the real dangers are hidden in what’s perceived as risky?

And worse, much worse, some banks, the biggies, the TBTF, those would hurt the most if they failed, they are allowed to run their own internal models to decide on how much broccoli or spinach (not) to eat

“May God defend me from my friends: I can defend myself from my enemies” Voltaire

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

“One has to belong to the intelligentsia to believe things like that: no ordinary man could be such a fool.” George Orwell

“There are some mistakes it takes a Ph.D. to make”. Patrick Moynihan (supposedly)

At the World Bank 2003: “In Basel Committee’s drive to reduce bank vulnerabilities, there’s a clear need for an external observer of stature to assure that there’s an adequate equilibrium between risk-avoidance and the risk-taking needed to sustain growth.”

PS. My 2019 letter to the Financial Stability Board

PS. All those distortions have also been put on steroids by excessive quantitative easing QEs.

PS. A tweet to IMF and World Bank April 2021. "Excess of carbs e.g., government loans, residential mortgages; insufficient proteins e.g., bank loans to entrepreneurs and lack of exercise e.g., no creative destruction/zombification, causes GDP obesity. Can IMF/WBG develop a Body Mass Index for GDP?"

PS. A recent dialogue with AI - ChatGPT about the credit diet banks are supposed to feed the economy 

Are these the bank regulators the world needs?

We central bank bureaucrats, we think government bureaucrats are much better at deciding whereto the savings of a society should be allocated, than what private bankers, SMEs and entrepreneurs are. 

And therefore we as bank regulators, government bureaucrats ourselves, have decided to launch the Basel Accord, that which allows banks to hold no equity when lending to the government but requires these to hold 8 percent in equity against any loan to the private sector.

This way we guarantee that whatever net margin our governments, our employers, pay our banks can be infinitely leveraged, so as to be able to produce the banks much higher risk adjusted returns on equity, than whatever returns banks can obtain when lending in fair terms to the private sector.

But of course, our only motivation, is to make banks safer :-)

Down with risky privates! Long live the infallible sovereigns! Government bureaucrats of the World unite!

July 1988: The Basel Capital Accord

PS. One of the benefits with this Accord is that all the subsidies our governments, our employers, are going to receive by having preferential access to bank credit, will not be identified as a tax. Another one is of course that markets will be seen perceiving us as much less risky than usual, which is good. Here among us, in our petit mutual admiration club, we often talk about “the subsidized risk-free rate”.

PS. Warning: We need though to be careful and not overdo it and suddenly have our governments pay negative interest rates on its debts; since then the citizens might begin to suspect not all smells right in the Kingdom.

World, beware of statist and communists dressed up as bank regulators

In July 1988 the Basel Accord (Basel I) approved that banks had to hold 8 percent in capital (equity) when lending to the private sector but that banks were allowed to lend to OECD’s central governments against no capital (equity) at all.

The introduction of such an amazing pro-government bias, I would even call it outright communism, distorted all common sense out of the allocation of bank credit to the real economy. 

And with Basel II, in June 2004, the Basel Committee made it even worse by allying themselves with the private AAArisktocracy, which of course left even more out in the cold, those we most need to have fair access to bank credit, our SMEs and entrepreneurs. 

And now with Basel III, the Basel Committee, with the blessing of the Financial Stability Board, and counting with the collegial silence of the IMF, is increasing regulatory complexity tenfold, and digging us even deeper into the hole.

PS. And, amazingly, Basel I happened while the attention was diverted discussing the supposed pro-private sector bias of the "Neo-Liberal" Washington Consensus.

PS. And even more amazingly... in its many hundred of pages... the Dodd-Frank Act does not even mention the Basel Accord of which US is a signatory or the Basel Committee

PS. Paul Mason just wrote "PostCapitalism". Since pure capitalism clearly ended with the Basel Accord, he must be referring to PostStateCapitalism.

The Basel Committee does not yet even acknowledge the biggest mistake with risk-weighted capital requirements

The Basel Committee on Banking Supervision has issued a Consultative Document on “Revisions to the Standardised Approach for credit risk” and that it wants responses to before March 27 2015.

“In seeking to enhance the current standardised approach for credit risk, the Committee has identified a number of weaknesses that the proposals set out in this consultative document aim to address, namely: 

Over-reliance on external credit ratings 

Lack of granularity and risk sensitivity 

Out-of-date calibrations 

Lack of comparability and misalignment of treatment with exposures risk weighted under the IRB approach 

Excessive complexity and lack of clarity within the standards 

As you can see the document does not even acknowledge the most fundamental error with current portfolio invariant credit-risk based equity requirements for banks.

In a free market perceived credit risks are cleared for by interest rates, size of exposure and other contract terms.

But by allowing some assets (the safe) to be held against less equity than other (the risky) the perceived credit risks will now also be cleared for regulatory equity requirements, something which completely distorts the allocation of bank credit to the real economy.

The real net interest margins paid by those perceived as "safe" will, as bank equity can be leveraged much more with these, be worth much more than the real net interest margins paid by those perceived as risky and for which bank equity can be less leveraged.

That introduces an odious regulatory discrimination in favor of what is perceived as safe, that which is already favored by the markets, because they; and against that perceived as risky, that which is already disfavored by the markets.

The regulators are so utterly mistaken looking at the risk of a bank’s assets. What the regulator should be looking at is at the risks of bank assets not being correctly perceived and or correctly managed.

ASAP the Basel Committee must eliminate credit-risk weighted bank equity requirements which, on top of producing dangerous distortions serves no stability purpose either… since never ever have major bank crises resulted from excessive exposure to something ex ante perceived as risky, these have all, no exceptions resulted from excessive exposure to something ex ante erroneously perceived as safe.

I have been criticizing these regulations but the Basel Committee has refused to even listen.

All what this document proposes seems only to be digging our banks deeper and more complexly into the for our economies so dangerous risk-adverse hole they find themselves in.

And meanwhile the safer assets which banks have ben instructed to compete with pension funds widows and orphans for, are becoming scarcer by the second.

Neither Hollywood nor Bollywood would allow scriptwriters, producers, directors and actors of a box office flop like Basel II, to proceed to work as if nothing on a Basel III.

What Europe most needs, Europe does not get, courtesy of their bank regulators.

Where would that liquidity injected by the ECB’s QE printing machine best be put to use in Europe? Since there is a limit to how much you can inflate demand by inflating the value of existing assets, without any doubt, what Europe most needs now is for that liquidity to flow by means of bank credits to SMEs entrepreneurs and start-ups, those who stand the best chance of producing something new to advance the European economies. 

But no, that is not going to happen, not as long as Europe’s bank regulators, Mario Draghi, Stefan Ingves and Mark Carney included, have anything to say about it. 

Those regulators dangerously blocked the fair access to bank credit to anyone perceived as risky from a credit point of view, because they do not dare European banks take the risk of lending to these. That they have done by means of portfolio invariant credit-risk weighted equity requirements for banks. 

Those equity requirements work like hallucinogens on banks, intensifying their perception of credit risk, making what’s perceived as safe look much safer yet, and what is perceived as risky so much riskier.

It’s insane. It demonstrates the Basel Committee, Financial Stability Board, ECB, Mario Draghi and so many more are way over their heads in Europe.

Look at ECB, European banks, pension funds, widows and orphans, all scrambling in order to lay their hands on the ever smaller inventory of safe assets, those which by means of negative interests, are now so "absolutely safe" they already guarantee you a minimum haircut. 

If I were a Senator a Congressman or a Governor of a US state, here is what I would ask the Fed and the FDIC.

Why on earth can a state-chartered bank, or any other bank for that matter, operating in my state, be allowed to lend to well-rated corporations elsewhere, or to sovereign governments, holding less equity than when lending to our own local SMEs and entrepreneurs? 

I mean that does not sound right. That sounds like a regulatory tax on my “risky” borrowers, those who already get less credit and pay higher risk premiums, and a regulatory subsidy to strange “safe” borrowers, those who already get larger loans at cheaper rates.

If I were a bank regulator, the last thing I do, would be to regulate against the fair access to bank credit of "the risky" of my own hometown.