Current bank regulations present two absolute inexplicable lunacies, which can only be justified if you are a communist

Starting 1988, with the G10 Basel Accord of which the US is a signatory, bank regulators, in Basel I, for the purposes of establishing how much capital (equity) banks need to hold against assets, declared the following credit-risk-weights: Government Zero percent; citizens, or their SMEs, 100 percent.

Knowing that only the citizens are the real back up of any government, and that governments can be very creative dishonoring their debt, for instance by means of inflation… that is an absolute inexplicable lunacy... unless you’re a communist of course.

Worse yet. Those risk weights cause banks to lend more and at lower relative rates to the government than to the citizens and to their SMEs. And that would imply that government bureaucrats are more productive using bank credit than the citizens, or their SMEs.

In other words, the credit-risk-weights de facto simultaneously translates into bank-credit-productivity-weights of 100% for government bureaucrats and zero percent for citizens, or for their SMEs. 

And so the question lingers is the Basel Committee a tool for communists to infiltrate the financial system of the free world? It would certainly seem so.

Here: The confessions of an ideologue.

PS. Here my letter to the Financial Stability Board

The Basel Committee’s credit-risk weighted capital requirements for banks, is a leading cause of falling productivity

For the purpose of establishing how much capital (equity) banks need to hold against loans, the Basel Accord (Basel I), Basel II and Basel III defined the following credit-risk weights: Governments 0%; SMEs and entrepreneurs 100%.

I believe that to be absolutely crazy… but regulators won’t listen to me.

But those credit risk weights also de facto translates into that the Basel Committee deems the risk that bank credits are not used productively to be: Government bureaucrats = 0%; SMEs and entrepreneurs = 100%.

And that is of course even crazier… but regulators will still not listen to me.

Now when we reading about so many concerns with the lack of productivity in many economies… will anyone help me to explain to the Basel Committee the connection that exists between their credit-risk-weights and the falling productivity of economies?

Is it not time to think a little bit about productivity weights too?

When are we going to fine or shame the regulators, The Great Distorters, The Great Manipulators of bank-credit markets?

Of course I do not mind banks paying fines because of their misbehaving though I would like these fines to be paid with shares of the banks, since requiring these to be paid in cash, which weakens the banks, sounds like societal masochism to me.

But what I really would like to see, if not being fined, bank regulators being shamed for the horrible distortion, the horrible manipulation, their credit-risk-weighted requirements have caused to the allocation of bank credit to the real economy.

And all that distortion and all that manipulation for absolutely no reason… since major bank crises never result from excessive bank exposure to what is ex ante perceived as risky.

Just to think of all those potentially opportunity and job creating credits that have been and are negated to SMEs and entrepreneurs, only because regulators believe themselves able to manage the banking-risks for the world, makes me cry for all those Millennials, and their descendants, who will have to live with the consequences of these stupid risk-adverse Baby-boomers.

And some of these regulators are even ideological infiltrators… because how else can one describe anyone who comes up with the notion of assigning a zero-risk-weight to the government, and a 100 percent risk weight to the citizens who represent the only back-up of that government.

When are we going to get regulators concerned with banks allocating credit efficiently to the real economy?

I just wonder… because clearly current bank regulators do not care one iota about that.

If they did they would not have concocted their silly credit-risk-weighted equity requirements for banks which allow banks to earn much higher risk adjusted returns on equity lending to “the safe” that when lending to “the risky.”

And that of course means banks will lend much too much to "the safe" and much too little to "the risky"

Compared to The Really Great Distortion by the Basel Committee, The Economist’s Debt/Tax Distortion seems smaller.

The Economist makes some good points about the distortion produced by the tax deductibility of borrowing costs, “The great distortion” May 16.

Indeed but compared with the distortions produced in the allocation of bank credit by the credit-risk-weighted requirements for banks, those distortions seem minor. The distortion The Economist refers to, favors debt over equity, and produces a suboptimal debt/equity mix. The distortion current bank regulations cause affects the access to debt. Those perceived as safe, and who therefore already have better access to bank credit, will have even more so. And those perceived as risky, and who therefore already have difficulties accessing bank credit will have even less so. And that, which kills opportunities, is a real potent inequality driver.

The Economist writes: “Corporate financial decisions are motivated by maximizing the relief on debt instead of the needs of the underlying business.” But in the same vein, minimizing equity is now more important for banks maximizing the risk-adjusted returns on equity, than looking out for worthy borrowers.

In the briefing “Ending the debt addiction”, “the implicit government guarantee that props up big banks” is identified as a distortion. But that implicit guarantee is made much larger, and regressive, by the fact that it can be leveraged much more when lending to the safe than when lending to the risky.

I am glad to see The Economist could favor “to abolish corporate tax entirely- and instead have one layer of tax levied on the income individuals receive from investments in firms. That is indeed something that I have often proposed, like in “My tax paradise”

Where I differ strongly with The Economist though, is when it refers to the lower tax revenues government receives because of the deductibility of interest on debts as “a cost in forfeited tax revenues”. Refer to it only as "lower tax revenues", instead of a “cost”, it can sometimes signify a benefit… for all. Besides how much tax is paid yearly because of the higher property values?

The World Bank spoke out way too softly on faulty bank regulations, and finance ministers did not read carefully enough.

World Banks' The Global Development Finance 2003 (GDF-2003), “Striving for Stability in Development Finance” had this to say on Basel II, pages 50-52

“The new method of assessing the minimum-capital requirement [proposed by the Basel Committee for Banking Supervision (BCBS)]… will be explicitly linked to indicators of credit quality… The regulatory capital requirements would be significantly higher in the case of non-investment-grade emerging-market borrowers than under Basel I. At the same time, borrowers with a higher credit rating would benefit from a lower cost of capital under Basel II….

A recent study by the OECD (Weder and Wedow 2002) estimates the cost in spreads for lower-rated emerging borrowers to be possibly 200 basis points.”

What did the World Bank say with that?

It said that regulatory capital requirements would distort more than the previous Basel I did, the allocation of bank credit.

What did finance ministers of developing countries do?

They did not protest that as an outrageous odious discrimination of bank lending to countries like theirs that are naturally perceived as more risky.

What did finance ministers of developed countries do?

They did not understand that their own “risky”, the SMEs and entrepreneurs, would be exposed to exactly that same odious discrimination.

I, at that time an Executive Director of the World Bank, mostly representing developing countries, when commenting GDF-2003 formally stated:

“the document does not analyze at all a very fundamental risk for the whole issue of Development Finance, being that the whole regulatory framework coming out of the BCBS might possibly put a lid on development finance, as a result of being more biased in favor of safety of deposits as compared to the need for growth. Even though, in theory, we could agree that there should be no conflict between safety and growth, in practice there might very well be, most specially when the approach taken is by substituting the market with a few fallible credit rating agencies.”

And a couple of weeks later, also formally at the Board of the World Bank I held: “BCBS dictates norms for the banking industry that might be of extreme importance for the world’s economic development. In BCBS’s drive to impose more supervision and reduce vulnerabilities, there is a clear need for an external observer of stature to assure that there is an adequate equilibrium between risk-avoidance and the risk-taking needed to sustain growth. Once again, the World Bank seems to be the only suitable existing organization to assume such a role."

Now I hear some talking about that the World Bank is becoming irrelevant. Forget it! It could be more relevant than ever… but for that it has to be able to stand up for the risk-taking our children needs for us to take in order for their children to have a future.

PS. Come to think of it. The World Bank has been mum on this regulatory distortion of the allocation of bank credit to the real economy. Why? Does it not even listen to itself?

Today I got to be 65, and so I give myself a list of some of my ramblings on bank regulations, in no special order.

The current pillar of bank regulations “more-perceived-risk-more-equity and less perceived risk less equity” is absolutely wrong, but might intuitively seem too correct so as to allow Daniel Kahneman’s System 2 even to begin its deliberation.

Today banks compete to obtain higher returns on equity more by reducing the equity needed that by identifying those who pay the highest risk adjusted margins.

Today the dollar in net risk adjusted margin paid by those perceived “safe” is worth more to the bank than that same dollar paid by “the risky”.

If you have regulators that do not understand that different equity requirements affects the risk-adjusted returns on equity of assets, which dangerously distorts the allocation of bank credit to the real economy…then you’ve got to change your bank regulators… urgently.

If you have regulators that do not understand that the perceived risk of bank assets does not matter since what is important is how the banks manage those perceptions of risk…then you’ve got to change your bank regulators… urgently.

If you have regulators that do not even look at the empirical evidence of what has caused all major bank crisis, never something perceived ex ante as risky, always something erroneously perceived ex ante as safe...then you’ve got to change your bank regulators… urgently.

If you have regulators who cannot manage the differences between ex ante perceived risks and ex post realities, and so can understand that what really poses dangers for the banking system at large are assets perceived as “safe”… then you’ve got to change your bank regulators… urgently.

If you have regulators who regulate banks without clearly defining their purpose… then you’ve got to change your bank regulators… urgently... because then the current ones would only be freaking dangerous vigilantes. 

If you have regulators who believe they have the right to odiously discriminate against the fair access to bank credit of those perceived as "risky", SMEs, entrepreneurs and start-ups… then you’ve got to change your bank regulators… urgently.

If you have regulators who believe they have the right to specially favor the fair access to bank credit of those perceived as "safe" sovereigns and members of the AAArisktocracy… then you’ve got to change your bank regulators… urgently.

If you have regulators who set the weights for capital (equity) requirements for banks when lending to government at 0%, and at 100% when lending to SMEs, which means that banks will lend more and at lower relative rates to the government than to the SMEs… that means de facto they believe that government bureaucrats are more productive using bank credit than SMEs… and then you’ve got to change your bank regulators… urgently... because then the current ones would only be freaking dangerous communists. 

Had regulators thought abut the “what are banks for?”, they would have known that banks are to allocate credit efficiently to the real economy, and they would never have concocted those highly distortionary credit-risk weighted equity requirements for banks.

A different take on the previous, is that the first step of any good risk management, is to clearly identify the risks you cannot afford not to take.

Few things are as risky as an excessive risk aversion.

Why is so much discussed about excessive risk-taking… and so little about excessive risk aversion?

Risk taking is the oxygen of development and we owe it to our kids and grandchildren that banks take risks with reasoned audacity. Nothing as dangerous, as excessive risk avoidance. God make us daring!

Our grandchildren will damn current bank regulators for denying them the risk-taking needed for them to find decent jobs.

Banks do not finance the risky future anymore they just refinance the safer past.

  

Bank regulators recommended banks an investment strategy fitting old retirees with short life expectancies and completely ignored the need of our young ones.

The best macro-prudential regulations is one of micro-prudential regulations that help banks to fail… fast… not the current micro-prudential regulation, which only helps to create too big to fail banks.

Mini-bank-equity requirements are the best growth hormones for the too big to fail banks.

Perfect information makes everyone to stay in bed… why bother, there’s not going to be any real profits? Blissful ignorance and imperfect information is a great driver of the economy.

Don’t ever allow a failed regulator to get away with the “this was a Black Swan, a totally unexpected event, a completely unforeseen consequence” excuse.

If a regulator tells you that the risk-weight of a sovereign is 0% but the risk weight of the citizens of that sovereign is 100%, then the regulators is not a regulator, only a communist.

If the Home of the Brave were really the Land of the Free, would they have allowed the current risk aversion in bank regulations?

With an Equal Credit Opportunity Act (Regulation B) how come regulators are allowed to discriminate against somebody’s access to bank credit only because he is perceived as risky from a credit point of view?

How can a Governor allow that his state chartered banks can lend, for instance to Germany, against much less equity that when lending to a local entrepreneur? 

Hold your bank regulators accountable. If they fail like they did with Basel II, do not promote them, and much less allow them to design Basel III. Neither Hollywood nor Bollywood would never ever do a stupid thing like that, after a mega box-office-flop.

Do not allow regulators to regulate within the confinement of a mutual admiration club. That only guarantees degenerative groupthink.

Without regulators and regulations, how many banks, like those in Europe, would have been allowed to leverage their equity 30 to 50 times to 1? ¡Zero¡ 

When you regulate, remember that every rule carries in it the seeds of being a systemic risk that can explode as a truly dangerous systemic error.

If your Homeland Security cannot visualize that bad distortive bank regulations could be even more dangerous than a full fledge terrorist attack… then you’ve got to refresh your Homeland Security

If you have progressives who do not understand how higher bank equity requirements when lending to those perceived as risky kills opportunities and drives inequality, then you better get yourself some new progressives.

If you have some free-market defenders that do not see how regulators, with their credit risk weighted equity requirements for banks, impose capital controls on where bank credit should go, and accept to talk about a de-regulated market, then you better get yourself some new liberals.

Finance professor’s in university that do not care about such “vulgar” issues as bank regulations and how these can influence the economy should be send to a boot-camp for a refresher. There they could for instance learn that the risk-free rate they are using is currently a subsidized risk free rate.

Anyone talking about de-regulation when we are in fact facing one of the most intrusive and distortive regulations ever… has been brainwashed.

While current regulatory distortions exists the QEs are just a waste, since these only help to increase the value of the existing assets… sometimes by even reducing what there is… like with the buybacks of shares.

“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 the collapse of our banks.”

The whole regulatory framework coming out of the Basel Committee for Banking Supervision might possibly put a lid on development finance, as a result of being more biased in favor of safety of deposits as compared to the need for growth.

“A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind”

But... being too right is too bad for your own voice

Unless blessed with eternal ignorance, how can bank regulators live with themselves knowing what they're doing?

How naïve and infantile is it not to believe that what's perceived as risky is what's really risky?

PS. I will be editing and adding on to this points whenever I remember any other of my ramblings.

What are we to do with immoral and dumb dumb bank regulators?

Current bank regulators, with the Basel Accord of 1988, and further with their Basel II in 2004, decided to concoct and impose credit-risk weighted requirements for banks…more-risk-more-equity and less risk-less-equity.

That results in that bank can leverage more, and therefore obtain higher risk adjusted returns on their equity, and on the implicit and explicit support of taxpayers, when lending to “the safe” than when lending to “the risky”.

That constitutes a regulatory bias in favor of those who already are favored by bankers because they are perceived as safe, which results in an immoral and odious discrimination against “the risky”, those who are already naturally discriminated against by bankers.

And it is dumb because that distorts the allocation of bank credit to that real economy on which our pensions, our children and grandchildren’s future, and even our banks long-term safety depends upon.

And it is also dumb because never ever have major bank crisis resulted from excessive exposures to what was ex ante perceived as risky, these have all resulted from excessive exposures to what was ex ante perceived as safe but that ex post turned out to be very risky.

So what are we to do with these immoral and dumb dumb bank regulators? The Basel Committee and the Financial Stability Board, they don't even acknowledge that there is a problem.

PS. By the way, what are regulators really doing when they assign a zero risk weight to the government and a 100 percent risk weight to an unrated citizen? Does that not give out a very strong stench of communism?

Dumb bank regulators clearly evidence we need artificial intelligence, at least as a backup

Banks fail because: they cannot perceive the risks correctly, they cannot manage the correctly perceived risks correctly, or suddenly something truly bad an unexpected happens… like the economy falling to pieces.

So if banks should be required to hold equity, in order to build up a buffer before they need help from taxpayers, those equity requirements should be based on: the credit risks not being correctly perceived, the bankers not being able to manage perceived risks, and something truly not expected happening, like an asteroid hitting their borrowers.

But, the Basel Committee for Banking Supervision, based its equity requirements for banks on the ex ante credit risks being correctly perceived… and that is nothing but loony... seemingly they all missed the lecture on conditional probabilities.

Besides they regulate banks in thousand of pages, without defining what the purpose of banks is… and that is nothing but absolutely irresponsible.

Any artificial intelligence worthy of its name would have made two simple questions.

What is the purpose of banks?

What has caused major bank crisis?

And how different and better the world would then have been. We could surely have had other type of problems, but definitively not the current crisis, caused by excessive lending to what was ex ante perceived as safe; nor the current lousy economy, caused by the lack of lending to those perceived as “risky”, like the SMEs, precisely the tough we need to get going when the going gets tough.

Our grandchildren will damn current bank regulators, for not allowing banks to take the risks their future needs.

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

If we are going to give bankers new real clothes, let’s make really sure they fit our children’s needs

I have frequently commented on statements or writings of Anat Admati. I have done so mostly because I find reasons to think she understands better than many the problems with current bank regulations, and so therefore I am especially frustrated when I see her being somewhat imprecise.

Here I refer to Admati’s comments at the Finance and Society INET Conference May 6, 2015 “Making Financial Regulations Work for Society”

1. Admati writes: “What we are tricked into tolerating, even subsidizing, is the equivalent of allowing trucks full of dangerous chemicals to drive at 120 mph in residential neighborhoods (and having trouble actually measuring actual speed), which burns lots of fuel, harms the engine and risks explosions.”

That is indeed a good description of the risks of a blow-up of the banking system… but it needs clarifications in order not to create confusion… in order to correct the system.

Banks are currently allowed to drive at 120 mph or faster only if they are thought not to carry anything dangerous, like if they carry a cargo of loans to sovereigns or AAArisktocrats, if they carry a load that is perceived as risky, like loans to SMEs and entrepreneurs, then they must drive at much lower speeds. That is what the credit-risk-weighted equity requirements do.

The problem with that is twofold. First, since the drivers are paid based on how fast they complete the journey (returns on equity) they only carry “safe” cargo, which constitutes an odious discrimination against all those who need the transport of “risky” cargo. And second, that it does not make any traffic-safety-sense, because all major crashes have always occurred precisely when the drivers think they are carrying something safe and therefore speed too much.

2. Then Admati writes: “harm from finance is abstract and spread out. Connecting the harm to individual wrongdoing or recklessness is hard to establish. Courts might work for fraud, but you can't take someone to court for designing bad regulations.”

I believe you can. If somebody had designed regulations that discriminate based on race and gender they could be taken to court… at least so that those regulations were immediately suspended. Here the regulators are layering on artificial discrimination against the fair access to bank credit of those perceived as risky, precisely those who are already naturally discriminated against by bankers. There is an Equal Opportunity Act in the US, Regulation B, the problem is that no one is applying to what regulators concoct.

3. And Admati writes: “Goldman Sachs CEO was wrong when he said banking is ‘god's work.’ Creating and enforcing good financial regulation is god's work.” No way Jose! Neither Goldman Sachs CEO nor regulators can do God’s work. 1999 in a Op-Ed in 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 the collapse of our banks”.

4. Admati also gives some ideas of how to proceed: “First, increasing the pay of regulators may reduce revolving door incentives. Second, effective regulators might be industry veterans who are not inclined to go back. Third, we must try to reduce the role of money in politics.”

Yes... but totally insufficient! In terms of fixing current bank regulations there are three things that I find to be much more important. 

The first is to define a purpose for the banks that is agreeable to the society as a whole. In all thousand of pages of regulations, there is not a single word about what banks are supposed to do… and I ask: how on earth can you regulate what you do not know what it is to do?

The second to close up the mutual small admiration club bank regulators have turned themselves into. Sovereigns and AAArisktocrats might have access to regulators at the IMF or Davos… but risky borrowers are never invited.

The third is to fully understand the need of risk-taking. If nothing is done on that, rest assure, our grandchildren will damn the Basel Committee and the Financial Stability Board, for denying them the risk-taking of banks their economies need.

The parable of talents

God make us daring!

We might want to consider “Friends and Family” weighted equity requirements for banks.

Currently the equity requirements for banks are credit-risk-weighted… more-credit-risk-more-equity and so less-credit-risk-less-equity.

That is dumb because never ever has a major bank crisis resulted from excessive lending to someone perceived as “risky”, these have always resulted from excessive lending to what was ex ante perceived as “safe” but that ex post turned out to be risky.

The only case when individual banks have gotten into problems extending excessive credits to somebody perceived as risky is when there had been some close connections between bank and borrower.

It could therefore be a case for analyzing Friends & Family weighted equity requirements for banks… though it is hard to think of who could perform an adequate rating of such relations… as we would also need to rate his F&F relation with bank and borrower.

That said, the least we must do, is to get rid of the credit-risk-weighted equity requirements when applied to those who are not F&F. These, for absolutely no reason, odiously impede their fair access to bank credit. That kills opportunities and therefore drives inequality.