Sir Jon Cunliffe. Tiberius would have regulated banks much better than the Basel Committee.

I hereby reference a speech titled “Macroprudential policy: from Tiberius to Crockett and beyond” given on July 28 by Sir Jon Cunliffe, Deputy Governor Financial Stability, Member of the Monetary Policy Committee, Member of the Financial Policy Committee and Member of the Prudential Regulation Authority Board 

Sir Cunliffe writes: “the underlying prudential standards – the reserves of capital and liquid assets that individual banks and other firms need to hold to enable them to withstand bad times – should be set not simply in relation to the risks in the individual firm, but also to reflect the importance of the firm to the financial system and the cost to the economy as a whole if the system fails”

Indeed but it was precisely there, when defining the risks of an individual firm, that regulators completely lost it:

Instead of considering the risks of unexpected losses, and the risk that banks would not be able to clear for the perceived risks, the regulators based “the reserves of capital and liquid assets that individual banks and other firms need to hold to enable them to withstand bad times” on the expected losses derived from the perceived credit risks… the only risks that were already being cleared for by banks by means of size of exposure and risk premiums…

And, as the regulator should have known, any risk even when perfectly perceived is wrongly managed if excessively considered. And that completely distorted the allocation of bank credit to the real economy.

If you’re a kid and your parents assign two nannies to care for you, you can still live a fairly ordinary childhood if the average of your two nannies’ risk aversion is applied. But, if their two risk aversions are added up, you stand no chance, then you better forget about having a childhood.

Sir Cunliffe writes: “The financial system does not simply respond to the economic cycle, growing as the economy grows and vice versa. It also feeds on its own exuberance in good times and on its fear in bad times which can in turn drive the real economy to extremes, as we have witnessed in recent years. The underlying causes of this phenomenon are interactions, feedback loops and amplifiers that exist within the financial system that can act as turbo chargers in both directions”

Precisely and perceived credit risks, credit ratings are main feedback loops and amplifiers that exist within the financial system. In January 2003 in a letter published in 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. Friends, please consider that the world is tough enough as it is.”

Sir Cunliffe writes: “recognition that what distinguishes ‘macroprudential’ from ‘microprudential’ and from ‘macroeconomic’ is its objective of financial system stability rather than the instruments it deploys.” 

Let me spell it out more directly: 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.

Sir Cunliffe so correctly writes: “The financial system plays a crucial role in a modern economy directing resources to where they can be most productive and can generate the greatest return. When the dynamics of the system itself distort incentives and judgments of risk and return, there can be a huge misallocation of resources in the economy. And when the bubble bursts and the economy has to adjust, a damaged financial system cannot guide the necessary reallocation of resources – indeed, as we have witnessed, it can slow it down.”

How unfortunate then that Sir Cunliffe, and his regulatory colleagues, cannot get themselves to understand that the pillar of their regulations, the portfolio invariant credit risk weighted capital requirements, is in fact the greatest source of distortion in the allocation of bank credit of them all. It guarantees the dangerous overpopulation of safe havens, as well as the equally dangerous lack of exploration of the riskier but perhaps much more productive bays.

Sir Cunliffe begins his speech by saying “Historians still argue about the exact causes of the financial crash of AD 33 that rocked the Roman Empire.” 

I guarantee him that historians will soon know perfectly well what caused the financial crash of 2008, and why it is taking so much time for the world to get out of it. And they will not be kind on the current batch of regulators. Without being clear about the crash of AD 33, they will have no doubt about that Tiberius would have known better than the Basel Committee.

Tiberius would have picked bank regulators who would have tried to understand why banks fail... not why bank clients fail. 

Tiberius would have picked bank regulators who would have known that the biggest risk for the banking system is that of not allocating bank credit efficiently to the real economy... as no bank can  remain safe while standing in the midst of the rubbles of a destroyed economy.

Do we really want to bet our economies on government bureaucrats using bank credit better than SMEs and entrepreneurs?

Those who protest government austerity the loudest are frequently those who most want to force banks to increase their capital. Let us analyze the implications of that position:

If governments are not going to be austere and spend more, and consequentially run deficits, it is only natural governments will need to take on more debt.

If banks are forced to hold more capital then, while the banks find more capital and adjust their business models to those new realities, there is going to be quite a lot of austerity when it comes to the supply of bank credit to the economy.

Since current capital requirements for banks are lower when lending to the government than when lending to the private sector, that will generate a bank credit squeeze on the private sector, affecting most especially those against which loans banks needs to hold more equity, like the SMEs and the entrepreneurs.

The only way to bridge the contradiction between government austerity being something bad for the economy, and bank credit austerity something good for the economy, is of course by believing that government bureaucrats can use bank credit more efficiently than SMEs and entrepreneurs. And that friends, is a truly doubtful proposition on which to bet the future of our economies.

Citizens, it behooves us to unite much more than what government bureaucrats/technocrats unite.

In the case of banks, the Modigliani-Miller Theorem is absolutely inapplicable

James Kwak of the Baseline Scenario, in a post titled: “More Misinformation about Banking Regulation” while discussing the effects of increased capital requirements writes:

“The Modigliani-Miller Theorem…says that a firm’s capital structure — the amount of equity it has relative to debt — doesn’t matter: in the case of the hypothetical bank, if you increase equity and reduce debt, after the reduced debt payments, there is just enough cash left over to compensate the larger number of shareholders at the lower rate that they are now willing to accept.

Now, the assumptions of Modigliani-Miller don’t hold in the real world, but the main reason they don’t hold is the tax subsidy for debt…

Since the cost of capital doesn’t change with capital requirements (except, again, because of the tax subsidy for debt), the amount of bank lending doesn’t change either.” 

Oops… that is in itself some misinformation! 

For banks, besides tax considerations, the Modigliani-Miller Theorem is absolutely inapplicable; since it does not consider the value of the support society (taxpayers) explicitly or implicitly give the holders of bank debt. If a bank has 100% equity then all risk falls on the shareholder and the societal support is 0. If a bank has 5% equity and 95% debt then society contributes a lot to the party.

Frankly, like in Europe, where some banks were leveraged about 50 to 1, and rates on bank deposits are still low, who on earth can one even dream to bring the Modigliani-Miller Theorem into the analysis?

And the fluctuating societal support, is one of the main reasons behind the argument I have been making for over a decade, about how credit-risk adjusted capital requirements for banks distort the allocation of credit. Regulators are telling the banks: If you lend to what is perceived as safe, like to the AAArisktocracy, then you are allowed to hold less capital, meaning leveraging more, meaning you will receive more societal (taxpayer) backing, than if you lend to a risky SME. 

And so of course, if you increase capital requirements which reduces the leverage, banks will get less taxpayer support… ergo lend less and at higher interest costs. Would that be bad for the economy? Of course it would keep billions out of the economy (it already happens) especially while business models are adjusted and bank capital increased. But that austerity J (less societal support spending) though it would hurt would not necessarily be bad… what is really bad for the economy are the different capital requirements for different assets… since that stops bank credit from being allocated efficiently.

Take away all deposit guarantees and all bailout assistance, and then the Modigliani-Miller Theorem, subject to tax considerations would be more applicable to banks.

Mark Carney: Would the Magna Carta include risk-weights like these: King John 0%, AAA-risktocracy 20% and Englishmen 100%?

With the Basel Accord of 1988 (signed one year before the Berlin wall fall) bank regulators assigned a 0% risk weight for loans to the sovereign and 100% to the private sector. Some years later, 2004, with Basel II, they reduced the risk-weight for loans to those in the private sector rated AAA to AA to 20%, and leaving the unrated with their 100%.

That introduced a considerable regulatory subsidy for the bank borrowings of the infallible sovereign (government bureaucrats) and for those of the private sector deemed almost infallible. And that taxed severely the fair access to bank credit, of those deemed as risky, like SMEs and entrepreneurs.

Reading Mark Carney’s interesting: “From Lincoln to Lothbury - Magna Carta and the Bank of England” I felt like asking him what he would think the Magna Carta would have to say about these risk-weights.

Fed: The biggest stress resulting from banks might be their misallocation of bank credit to the real economy.

The Federal Reserve System’s(Fed) Dodd-Frank Act Stress Tests.

Banks are not there just to make profits for their shareholders, or to be safe places where to stash away money… they are there to perform the social function of allocating as efficiently as possible bank credits to the real economy. That’s the only logical reason why taxpayers could be willing to lend them support.

In this respect any stress-test that does not include looking at assets banks have on their balance sheet from more than credit risk perspective, is an utterly incomplete test.

For instance taxpayers should be able to do know how much unsecured bank credit has gone to SMEs and entrepreneurs, and how that lending has evolved over the last 3 decades.

Prioritizing the financing of residential property over the financing of job creation is not the smartest thing to do

Based on Basel II’s standard capital requirements for banks, these are required to hold 2.8 percent in capital when lending secured by mortgages on residential property and 8 percent when lending to SMEs and entrepreneurs. 

That means that the adjusted for risk net margin paid by a residential borrower can be leveraged 35 times by the bank (100/2.8), while the same margin can only be leveraged 12.5 times (100/8) if paid by SMEs and entrepreneurs.

And that means banks can obtain much higher risk-adjusted returns on equity when lending secured by mortgages on residential property than when lending to SMEs and entrepreneurs. 

And that means that banks will find it much more interesting to finance residential property than to finance those who can help to create the jobs to help residential mortgages and utilities to be serviced.  

That definitely sound skewed the wrong way. If I was the regulator I would much rather prefer banks financing more the creation of jobs, so that people could better afford to buy their homes with less financing… but that’s just little me.

“But building homes creates jobs?” Indeed, but once everyone has a home, and a mortgage to service, which diminishes their available income, where are our grandchildren to work?

The Financial Stability Board makes efforts to identify “Risk Free Benchmarks”...and I don't know whether to laugh or cry

The Financial Stability Board issued a report on trying to identify “Risk Free Benchmarks”

That, in ordinary circumstances, is a very difficult thing to do, since so many other factors than just pure risk considerations, are involved in creating interest rates… for instance tax considerations. 

But, when bank regulators, with Basel I and II, introduced credit-risk weighted capital requirements for banks, by distorting the allocation of bank credit so completely, they made it impossible to determine anything close to real risk free-rates.

The easiest way I have found to explain this issue is by making the following question: What would the rates on for instance US Treasury Bonds and Germany’s Bunds be, if banks were required to hold the same percentage of capital against these that they are required to hold against a loan to an American or a German SME?

PS. The subsidized risk free rate

Greece urgently needs lower capital requirements for banks when lending to SMEs than when lending to its government

Between June 2004 and November 2009 thanks to Basel II, banks were allowed to lend to the Government of Greece against only 1.6 percent in capital while requiring banks to hold 8 percent in capital when lending to the private sector.

That meant that banks could leverage their equity 62.5 times lending to the Government but only 12.5 times when lending to the private sector.

That meant, of course, that banks ended up lending much too much to the government and much too little to the private sector, like to Greek SMEs and entrepreneurs.

And here we are with Greece stuck in the doldrums and not finding its way out.

If I were its doctor, I would immediately recommend that banks should be allowed to hold less capital when lending to the private sector than when lending to the government. Since the private sector is the heart of the economy it is very urgent it gets out of it flat-line, by banks pumping the oxygen it needs.

Just before the Berlin Wall felt, communists, statists, dictators and those who benefit from crony statism, gave the liberal capitalistic free-market world the finger.

In 1988, just before the fall of the Berlin Wall in 1989, some communists/statists hacked into the free market capitalist world’s bank regulations. By means of Basel I, and for the purpose of determining the capital requirements for banks, they arranged so that the risk weight for lending to OECD sovereigns was zero percent, the risk weight for lending secured with houses 50 percent, while the risk weight for lending to the private sector was set at 100 percent.

Since the basic capital requirement was set at 8 percent that meant that banks could leverage their capital unlimited times when lending to their sovereign, 25 times (100/4) when financing the purchase of houses and 12.5 times to 1 (100/8) when lending to the private sector, to the citizens.

That doomed bank to lend too much to the governments and too much to the housing sector, and basically to abandon the traditional role of banks, namely to provide credit for the private sector, like to SMEs and entrepreneurs. Of course those from the private sector that were exploiting crony statism, they just loved it. 

That de facto reflected the belief that government bureaucrats, the autocratic bureaucracy, know better what to do with bank credit for which repayment they are not personally responsible for, than for instance e.g., small businesses and entrepreneurs.

And that in turn doomed the liberal free-market and capitalistic economies of the western world.

In a letter published by Financial Times in 2004 I wrote: "Our bank supervisors in Basel are unwittingly controlling the capital flows in the world. 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?”

That the world is suffering under the thumb of neo-liberalism? That is just sad fake-news cover up invented by statists/communists.

How much public debt would have been avoided, or at least priced correctly if banks, when lending to the sovereign, needed to hold that same 8% they were required to hold when lending to the citizens?

Please, for the good of our grandchildren, it might already be too late for our children, help me tear down that wall the Basel Committee built… urgently … Greece was just the tip of the iceberg!

P.S. On that day, all around the world, Bureaucracy Autocracies were empowered. 

P.S. On that day, financial communism was decreed 

P.S. When 1988 regulators assigned America’s debt a 0.00% risk weight, its debt was $2.6 trillion, 50% GDP, now on route to $28 trillion, about 100% GDP, and it still has a 0.00% risk weight. When do you think that weight should increase to 0.001%?

P.S. Are those regulations in accordance with what the Founding Fathers expressed in the US Constitution?

PS. November 2023, there's 34 years since the world went from “Tear Down that Wall” to the “Build Up that Wall” for 34 years.

P.S. If Basel I had been imposed four decades earlier:

Would now John F. Kennedy have wanted to deliver his 1963 “Ich bin ein Berliner” speech?

If the Berlin Wall was still up, would now Ronald Reagan, if still with us, have needed to tell Putin “Tear down this wall!”?

PS. Here is an aide memoire on the mistakes in the risk weighted capital requirements for bank made so much worse with the introduction of Basel II in 2004.

PS. Here's the Confession (that shall not be heard). “The assets assigned the lowest risk, for which capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages. Ironically, losses on those two types of assets would fuel the global crisis in 2008 and a subsequent European crisis in 2011. The American 'overall leverage' approach had a disadvantage as well in the eyes of shareholders and executives focused on return on capital; it seemed to discourage holdings of the safest assets, in particular low-return US government securities." Paul A. Volcker, “Keeping at it” 2018.

A letter to the Financial Stability Board

A letter to the IMF titled: "The risk weights are to access to credit, what tariffs are to trade, only more pernicious."

I’ve recently enrolled ChatGPT - OpenAI to assist me in the fight against regulatory communism/fascism.

Here a letter the Washington Post published in August 2023 and that refers to Paul Volcker’s valiant courageous and honorable confession on what happened 1988.

Do we need capital requirements for banks based on willingness-and ability-to-lie-and-cheat-ratings?

With Basel II of June 2004, the Basel Committee imposed capital requirements for banks based on credit ratings... stupidly ignoring that bankers were already clearing for such ratings by means of risk-premiums and size of exposures… and naively thinking those credit ratings would always capture real risks.

After having seen the mess that has been caused by for instance much too good credit ratings for the AAA rated securities backed with mortgages to the subprime sector, and the loans to the government of Greece, one could suspect that smarter regulators would have based their capital requirements for banks based on willingness-and ability-to-lie-and-cheat-ratings.

Some decades ago somebody asked me… how come this honest Scandinavian country come up as  more honest than this other honest Scandinavian country on the worldwide corruption index? My instinctive reaction was… the first must have paid more.

Frankly, our current bank regulators have been taken for a ride… an extremely costly ride for us since regulators now dangerously distort the allocation of bank credit.