Bank regulators… dare to answer this single question

There are literally thousand of risks, especially many unexpected risks, which could bring our banking system down.

And so why on earth did you regulators base your capital requirements for banks, those which are to cover especially for unexpected risks, solely on the ex ante perceived credit risk, that which is basically the only risk already cleared for by banks, by means of interests risk premiums and the size of their exposures?

And, to top it up, you made those capital requirements portfolio invariant… as if diversification has no meaning?

If anything, should you not have based it on the risks that bankers were not able to clear for those perceived risks?

Since that dangerously distorts the allocation of bank credit to the real economy, do we not deserve a clear-cut answer on that?

I have been asking this for over a decade, and you have not even wanted to acknowledge my question. Does that not tell you something?

If the US stops distorting the allocation of bank credit to the real economy… does Europe dare to be left behind?

For 6.000 (out of 6.400) traditional US banks those that hold, effectively, zero trading assets or liabilities; no derivative positions other than interest rate swaps and foreign exchange derivatives; and whose total notional value of all their derivatives exposures - including cleared and non-cleared derivatives - is less than $3 billion...

Thomas M. Hoenig, the Vice Chairman of the FDIC is proposing the following:

“A bank should have a ratio of GAAP equity-to-assets of at least 10 percent. The substantial majority of [US] community banks already have equity-to-asset ratios of 10 percent or higher, and the number is in reach for those that do not.”

“Exempting traditional banks from all Basel capital standards and associated capital amount calculations and risk-weighted asset calculations.”

If approved, that would effectively mean the US begins to distance itself from the pillar of Basel Committees bank regulations, the credit-risk-weighted capital requirements.

Since those capital requirements odiously discriminate against the fair access to bank credit of borrowers deemed “risky”; and thereby distorts bank credit allocation, that would mean that most US banks would be able to return to real lending to the real economy.

Does Europe dare to be left behind in such development?

PS. Its about time the US suspended such regulatory discrimination, which should never have been allowed, according to the Equal Credit Opportunity Act (Regulation B)

Suppose a dictator decided on bank regulations.

What if in a country there was a dictator who told banks: I will allow you to leverage much more your equity, so that you can earn much higher risk adjusted returns on your equity and on the implicit support our taxpayers give your banks, that is as long as you lend to the government, meaning to me, your infallible sovereign, to my friends and courtesans, the AAArisktocracy, and stay away from lending to those perceived as risky, like our quite vulgar SMEs and entrepreneurs.

Would you not be upset? Especially considering that it is precisely SMEs and entrepreneurs who most need to have fair access to bank credit in order to help the real economy to move forward and not to stall and fall.

Would you not be upset? Especially considering that de facto means the dictator believes the government, or the AAArisktocracy, can use bank credit more efficiently than what SMEs and entrepreneurs can?

Would you not be upset? Especially considering that never ever do major bank crises result from excessive bank lending to those perceived as risky, these always result from excessive lending to those who were erroneously perceived as safe.

For your information, the Basel Committee, and the Financial Stability Board, with their portfolio invariant credit risk weighted capital requirements for banks, dictated precisely that... for the whole world. And the world so submissively, says nothing about it.

How do you explain to grownups the benefits of compound interests in times of zero or negative interest rates?

The Washington Post carried a story on June 21 titled “Where broke millennials go to learn aboutmoney – Financial planning for grownups.

In it its author Jonelle Marte, writes about a wine-tasting meeting organized by the Society of Grownups, in which “Stephanie Labelle was busy jotting notes as financial planner Jena Palisoul explained compound interest”.

And I was left wondering about how you go about and explain the benefits of compound interests, in times of zero or even negative interest rates.

Also, if I had been there to advise these young adults on the best way to guarantee their future I would, without a shadow of a doubt, told them to get rid of current bank regulators with their senseless risk-aversion. 

The currentcredit-risk-weighted capital requirements, make banks invest in assets much more compatible with the investment needs of a retiree with very few years of life expectancies, than with those of young grownups… those who needs banks to finance “risky” SMEs and entrepreneurs, in order to have the economy going and generating jobs.

Actually I would suggest the Society of Grownups writing the regulators a kind letter reminding them that major bank crisis are never ever caused by excessive exposures to what is perceived as risky, but always from too large exposures to what has been erroneously perceived as very safe.

Where could truly dangerous really unexpected events occur the most?

REALLY UNEXPECTED? THINK IT THROUGH?

Bank capital is to be held against unexpected losses because the expected losses derived from the perceived risks are already cleared for by smaller exposures and higher risk premiums,

The Basel Committee for banking supervision considered the dangerous looking forest had the greatest potential of the unexpected...

and therefore decided to require banks to hold the greatest capital when entering the dark scary forest (with its expected risks) than when entering that beautiful field (with its little expected risks).

Smart or extremely dumb?

Extremely dumb no doubt: That's why banks loaded up on what was perceived as safe, like AAA rated securities, like loans to Spanish real estate, like loans to the government of Greece... and do not give loans to those "risky" SMEs and entrepreneurs... who can help or economies to move forward, in order not to stall and not to fall.

Is the problem with our bank regulators a lack of testosterone?

We have read a lot about excessive testosterone levels producing excessive risk taking, for instance in banks. But, could a deficiency of testosterone equally produce an excessive risk aversion.

Let me explain. Even though the credit risks perceived by bankers are already cleared for by means of the size of the exposure and risk premiums, current bank regulators imposed on banks higher capital requirements for what is perceived as risky than for what is perceived as safe. 

And the above is like adding up the risk aversion of two nannies before deciding what the children can do; and so of course the children are not allowed to do much; and so of course banks will lend too much to the “safe” and too little to the “risky”… and so of course there is a monstrous distortion of the allocation of bank credit to the real economy.

To top it up, it does not serve any stability purpose, since all major bank crises have always resulted from excessive exposures to what was erroneously considered “safe” and never ever to something correctly perceived as risky.

This, being so scared of what is perceived as risky and so little suspicious of what is perceived as safe, is so loony that perhaps it points to a hormonal imbalance. Could it be that current bank regulators have a serious lack of testosterone?

I, as many others, suffer from too much risk aversion, and so I could be suffering from that lack of testosterone too. But, in me, that deficiency presents no major problem, except perhaps for my kids who might therefore not inherit what they could inherit. But, when the testosterone deficiency is present in those who regulate our banks, then we are talking about that kind of systemic illnesses that can even bring a Western world down on its knees.

God make us daring!

PS. Again. If you lend too much to what is perceived as risky and too little to what is perceived as safe, then it might be because of excessive testosterone… why then can if you lend too much too what is perceived as safe, and too little to what is perceived as risky, not be a lack of testosterone?

The Basel Accord was an important turning point for the bad for the whole Western civilization...and it has sadly been ignored

In 1988, the G10 countries, signed up on the Basel Accord. With it, with Basel I, the regulators imposed on banks capital requirements based on ex-ante perceived credit risks.

And the risk weight assigned to the private sector was 100 percent, while the risk weight assigned to their governments was zero percent.

That meant banks needed to hold NO capital when lending to their governments, but 8 percent when lending to the private sector (the basic Basel 8 percent standard capital requirement, multiplied by the risk weight).

That meant that banks could leverage their equity and the support they explicitly and implicitly received from taxpayers infinitely, when lending to their governments, but only about 12 to 1, when lending to the citizens.

That meant in essence, that the regulators decreed that government bureaucrats would be able to use bank credit much more efficiently than the private sector.

That meant in essence, that the free Western world signed up to communistic precepts.

Is that not a historic turning point for our Western World? Tell me, how many times have you heard this being discussed?

And then, in 2004, with Basel II, regulators decided that the risk weight for those private sector borrowers rated AAA to AA was to be 20 percent, while for the unrated ordinary citizens and their SMEs, it remained 100 percent.

And that meant that regulatory risk aversion was also introduced with respect to bank credit to the private sector in the Western world... making it impossible for SMEs and entrepreneurs to have fair access to bank credit.

And since that its been going down down down and these two sad historical event are still being ignored.

Any civilization unwilling to take risks will stall and fall.

God make us daring again!

Greece was taken down by loony statist technocrats or by hard line communists, acting as bank regulators.

More than six years ago, in jest, but also in all seriousness, I set up a blog named AAA-bomb. In it I recounted the actions of “Carlos Molotov Pavlov, a central planner who to avenge his loss of a cushy job in the Soviet entered the bank regulatory system in Basel and managed to create, seed and detonate an AAA-bomb in the heart of the capitalist Empire”

Already in 1999 in a Op-Ed I had written: “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 AAA-Bomb, which had been invented in 1988 with the Basel Accord, Basel I, and that had been further refined in 2004, Basel II, was the credit-risk-weighted capital requirements for banks.

While these required banks to hold 8 percent in capital when lending to any unrated SME in Europe, these allowed banks, in accordance to how Greece was then rated, to lend to the government of Greece against only 1.6 percent in capital. So banks could leverage their equity, and the support they received from taxpayers, over 60 times lending to Greece, compared to only about 12 times to 1 when lending to, for instance, a German or a Greek SME.

Implicitly those capital requirements meant that regulators believed government bureaucrats were capable of using bank credit more efficiently than the private sector.

And of course that had to mean sovereigns were going to become over-indebted… and Greece was just one of the AAA-bomb's first casualties.

PS. Citizens beware of the Basel Committee's bureaucrats/technocrats bearing gifts to government bureaucrats/technocrats.

PS. Reality was even worse since European Commission felt that the Greece sovereign, even though it could not print euros on its own and independent of credit ratings, should also be 0% risk weighted, which meant European banks could lend to Greece holding no capital (equity) at all. And then they left Greece to pay for all of that mistake.

Mark Twain vs. The Basel Committee for Banking Supervision… Who do you think is right?

Mark Twain is supposed to have said: “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain” 

The Basel Committee though, with its credit risk weighted capital requirements for banks, evidently argues: A banker lends you the umbrella when it rains but want it back when the sun shines”. 

I mean, otherwise, as regulators wanting banks to hold capital against unexpected losses, would it require banks to hold much more capital when lending to “the risky”, those in the rain, than when lending to “the safe”, those enjoying the sun? 

I side a hundred percent with Mark Twain… because I have never ever seen a major bank crisis that has resulted from bankers lending too much to those they perceive as being in the rain, these have always resulted from lending too much to those they believe find themselves in the sun.

If you think that would seem to mean I believe those in the Basel Committee have no idea of what they are doing… you are absolutely right… I don’t.

It is tragic. The direct consequences of what the Basel Committee is doing, is that banks will now earn much higher risk adjusted returns on what is in the sun than on what is in the rain, and therefore only lend the umbrella to those they see in the sun, and stay away entirely from lending to those they see in the rain... like to all the "risky" SMEs and entrepreneurs, those  who could create the future jobs our grandchildren will need.

The Minsky "displacement" that caused the ongoing crisis, was the credit risk weighted capital requirements for banks.

I cite from Charles P. Kindleberger’s “Manias, Panics and Crashes” 1978.

“Financial crisis are associated with the peaks of business cycles… the culmination of a period of expansion.

According to Hyman Minsky, events leading up to a crisis start with a ‘displacement’ some exogenous, outside shock to the macroeconomic system. The nature of this displacement varies from one speculative boom to another. It may be the outbreak or end of a war, a bumper harvest or crop failure, the widespread adoption of an invention with pervasive effects – canals, railroads, the automobile – some political event or surprising financial success, or a debt conversion that precipitously lower interest rates. But whatever the source of the displacement, if it is sufficiently large and pervasive, it will alter the economic outlook by changing profit opportunities in at least one important sector of the economy. Displacement brings opportunities for profit in some new or existing lines, and closes out others… a boom is under way.

In Minsky’s model, the boom is fed by an expansion of bank credit which enlarges the total money supply… Bank credit is, or at least has been, notoriously unstable and the Minsky model is based squarely on that fact.” End of quote

In 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” 

And I have no doubt that the systemic error, the Minsky displacement that brought on the credit expansion that resulted in the financial crisis of 2007-08, was the introduction by regulators of credit risk weighted capital requirements for banks.

That facilitated a tremendous credit expansion by allowing banks to hold absolute minimum equity against assets perceived as safe. We are talking about zero percent when lending to sovereigns (Basel I 1988) to 1.6 percent when lending to the private sector rated AAA to AA (Basel II 2004).

And allowing for such minimum equity, while still lending the banking sector much implicit and explicit government support, made possible immense leverages and thereby immense risk-adjusted returns on bank equity on assets perceived as safe, while closing out the fair access to bank credit for all those perceived as “risky”, like the SMEs.

And today, soon a decade later, that “displacement” which completely distorted the allocation of bank credit to the real economy has not even been acknowledged much less corrected.

PS. Read Charles P. Kindleberger’s “Manias, Panics and Crashes” and you will not find one evidence that supports current credit risk weighted capital requirements for banks… unless perhaps they are 180 degrees the opposite: higher for what is perceived as safe and lower for what is perceived as risky.

PS. In the Wikipedia on Hyman Minsky, I do not agree with how Paul McCulley translates the Minsky's hypothesis to the subprime mortgage crisis ignoring the minimum bank capital requirements associated with the AAA rated securities backed with mortgages to the subprime sector.

Are some consulting companies, e.g. McKinsey & Co. Too-Big-To-Think?

A book, “No ordinary Disruption”, which I paid for, arrived with my mail today. The authors are Richard Dobbs, James Manyika, Jonathan Woetzel all belong to McKinsey Global Institute, the economics and business research arm of the management-consulting firm McKinsey & Co

From its introduction “An intuition reset” I quote:

“Dramatic changes come from nowhere, and then from everywhere… The fortunes of industries, companies, products, technologies, and eve countries and cities rise and fall overnight and in completely unpredictable ways.”

That is true but it makes me ask: Where was McKinsey & Co when bank regulators decided that their capital [equity) requirements for banks, those that are expected to cover for unexpected losses, were to be based on the predictable expected losses derived from the ex ante perceived credit risks?

Why on earth should banks need capital against perceived credit risks, when what is perceived cannot really be what is that dangerous? 

Or is it that McKinsey does not understand the difference between risk and uncertainty?

And the McKinsey authors identifying their “Four great disruptive forces” list: (1) the locus of economic dynamism shifting to emerging markets like China; (2) the impact of technology; (3) demographics; (4) “The final disruptive force is the degree to which the world is much more connected through trade and through movements in capital, people, and information. 

But they leave out that monstrous source of disruptive force that can emanate at any moment from sheer regulatory stupidities with global reach. Why? 

And I ask this because I am convinced that McKinsey & Co., somewhere deep in its bowels, must have known that: allowing banks to hold so little equity against some assets, only because these were perceived as safe, had to end in tears; and that allowing for different capital requirements for different assets, based on perceived credit risk already cleared for, had to dangerously distort the allocation of bank credit to the real economy.

The authors present us with the management imperative for the coming decade, namely: “To realize that much of what we thought we knew about the how the world works is wrong.”... 

Wrong! That’s no excuse, McKinsey & Co. involved in so many areas should have known that when regulating banks you must do two things: First define what’s the purpose of banks, something which was not done; and second analyze what caused bank crises in the past… and it sure was not what was perceived as risky but always what was ex ante perceived as safe but that ex-pots turned out risky.

So if there is a management imperative for the next decade that should be: To realize why so much we think about how the world should work could turn out to be so fundamentally wrong; and how to avoid to become a silly mutual admiration club prone to groupthink.

When a consulting group is no longer able to freely question what’s going on, to freely be able to call the bluff of what’s dumb, then it will have grown too big. It will be weighed down by too many conflicts of interests of all nature; which hinders it from speaking or even thinking the truth… and finally, very sadly, it will end up as a highly paid endorser of stupidities.

When a consulting group with global reach reaches a point of too much importance, then it also becomes a dangerous source of systemic risks.

So do we now need capital requirements for banks based on the size of the consultant group they use? J