Are bank regulators violating human rights with their perceived-credit-risk obsession?

It is not only the suffering bank regulators have caused, and cause, but also that their regulations, especially in Europe, amounts to intellectual torture… pure waterboarding. Listen to this:

Bank regulators ask (instructs) the credit rating agencies: “Go out there and do a perfect credit rating job”.

And logically the banks will consider those perfect credit ratings in order to set their interest rates, and decide on the amount of their exposure to the credit risks indicated by those ratings.

But then the regulators also require the banks to hold capital (equity), based on the same perfect credit ratings.

That is because even though regulators knew that capital is to be required against unexpected losses, since they faced difficulties in calculating the unexpected, they decided to base it on the expected credit losses.

And, if you give an excessive consideration to a perfect credit rating, then of course the resulting credit decision will be wrong.

And so now, for these capital requirements to be able to allocate bank credit correctly to the real economy, the credit ratings need to be adequately wrong. What is perceived as safe must be much safer, and what is perceived as risky must be much riskier.

And of course, who has ever heard of a major bank crisis that resulted from banks lending too much to what they perceived as risky?

And with this dangerous regulatory nonsense: more perceived credit risk more capital – less perceived credit risk less capital, regulators allow banks to leverage their equity (and the support they receive from taxpayers) much more when lending to The Safe than when lending to The Risky; and which meant banks earn higher risk-adjusted returns on equity when lending to The Safe than when lending to The Risky; which means banks will lend too much to The Safe and too little to The Risky.

And so a monstrous financial crisis resulted… as always, from excessive financial exposures to what was perceived a safe, but in this case aggravated by the fact that banks, thanks to the regulators, stood there naked with especially little capital to cover themselves up with. And the resulting human sufferings are huge.

And so our banking system, because of its regulators' obsessive credit-risk aversion, also negates the future generations that kind of risk taking that helped the current one to be where it is. And so the resulting human sufferings will be huge.

And because now, years later, some regulators discovered that their risk weights might have impeded the fair access to bank credit of the “risky” SMEs… they now, magnanimously, decided that: “Capital charges for exposures to SMEs should be reduced through the application of a supporting factor equal to 0,7619 to allow credit institutions to increase lending to SMEs.”… 0,7619? Why not 0,7618? Why not 0,0001? At least for the small and micro, those with less than 50 employees… when have excessive bank loans to these “risky” ever created a financial crisis?

Please Basel Committee, please Financial Stability Board, and please European Commission, no more waterboarding… I can’t stand it more… my head, and my heart, hurts… what do you want me to do? What do you want me to confess?

How we all got really phished by the phished phools

George A. Akerlof and Robert J. Shiller wrote “Phishing for Phools: The economics of manipulation and deception”, 2015.

Phishing “is about getting people to do things that are in the interest of the phisherman, but not in the interest of the target. It is about angling, about dropping an artificial lure into the water and sitting and waiting as wary fish swim by, make an error and get caught.”

“A phool is someone who, for whatever reason, is successfully phished. There are two kinds of phool: psychological and informational. Psychological phools, in turn, come in two types. In one case, the emotions of a psychological phool override the dictates of his common sense. In the other, cognitive biases, which are like optical illusions, lead him to misinterpret reality, and he acts on the basis of that misinterpretation… Information phools act on information that is intentionally crafted to mislead them.”

And so here is the story about how the regulation phools got fished by the bankers.

What could be heaven for bankers? Wet dreams come true? Clearly, to obtain high returns on equity and large bonuses, while taking as little risk as possible.

That is not easy, because whatever is perceived as safe, will not accept to pay the banks a lot. And so bankers also had to give loans to the risky, charging of course higher risk premiums and limiting the exposures... a lot of sweaty job, for small returns.

But there were the bank regulators swimming warily around, after having seen the Latin American bank crisis. And the phishers tested a lure: more perceived risk more capital - less perceived risk less capital. The results were great, it intuitively shined and sounded so very right. 

But, in order not to scare away the prospective phool, their first lure, Basel I, basically included solely the risk weight of zero percent for the sovereign and a 100 percent weight for the private sector.

“Since it is the sovereign that assist banks when these run into troubles, it is only logical that the sovereign should have a zero risk weight; and besides, you regulators, don’t forget that it is governments who pay your salaries”; ran the argument, and the phools swallowed the Basel I bait.

But when in 1997 the Asian financial crisis occurred, followed by the Russian crisis and by the Long-Term Capital Management L.P. debacle, the regulators started to swim very warily again. 

And that was a godsend opportunity for the phishers to use their Basel II bait: 

Phishers: “Basel I is too rough… so bankers go out and do all kind of silly risky things… and so you better give the banks incentives to keep to what is safe. and Sim Sala Bim, everything will be fine”

Phools: “How?” 

Phishers: “By lowering the capital requirements against the safe assets of the private sector too; so that banks can earn decent returns on what is safe, without having to expose themselves to the risky”. 

Phools: “But how do we know it is safe?” 

Phishers: “The big ones, that have super-duper sophisticated financial models, and for all the rest there is always the credit rating agencies”

Phools: “Ok let us do Basel II” And, in sotto voce “that will also make us look very sophisticated too... something which is clearly not bad for our image" 

And so the world got saddled with capital requirements that allowed banks to leverage:

Infinitely with loans those sovereigns rated AAA to AA

Over 60 to 1 with loans to sovereign rated A+ to A, as Greece was until November 2009.

Over 60 to 1 on AAA rated securities, like those backed with mortgages to the subprime sector. 

Over 60 to 1 on anything that carried an AAA rated companies guarantee, like that of AIG 

Boy, did the phools get phished! 

And as a result of all that phool phishing, our “risky” SMEs and entrepreneurs, those tough we most need to get going when the going gets tough; those who because they are perceived as risky never cause a major crisis, these were left without fair access to bank credit.

Boy, did we all get really phished by the phools!

Boy, did we end up with the mother of all regulatory stupidities!

The mother of all regulatory stupidities!

This data is found on the web:

The fatality rate per 100 million vehicle miles traveled in motorcycles is 21.45

The fatality rate per 100 million vehicle miles traveled in cars is 1.14

In 2011 in the US, 4,612 persons died in motorcycle accidents 

In 2011 in the US, 32,479 persons died in vehicle accidents

And so, even though travelling by motorcycle is about 20 times riskier than cars, cars cause about 7 times more deaths than motorcyclists. That is of course because the riskier something is perceived, the more care is taken to avoid the risk. And because the safer something is perceived, the higher its potential for delivering unexpected tragedies/losses.

And yet the Basel Committee of Banking Supervision decided on higher capital requirements for banks when lending “the risky” motorcyclist of the economy, the SMEs and entrepreneurs, than when lending to “the safe” car drivers, sovereigns and corporations with high credit ratings… even though clearly dangerous excessive bank lending to the latter is much more likely to occur.

And that even though serious misallocations of bank credit to the real economy had to result.

The regulatory loonies did not even care to look at what had caused the major bank crises in the past.

The regulatory loonies did not even care to define the purpose of banks, like that of allocating bank credit efficiently, before regulating the banks.

Shame on them!

And to top it up, in 1988, the Basel Accord introduced a risk weight of zero percent for sovereigns and 100 percent for the private sector. Rarely has statism been able to advance its agenda faster and more than with that.

And IMF, Financial Stability Board, Federal Reserve Bank, Bank of England, European Central Bank, World Bank, Financial Times... and many more, they just don't see it, or keep mum about this, the mother of all regulatory stupidities.

How can we foolproof our banks from being regulated by fools?

Greg Ip has written a great book “Foolproof: Why Safety Can Be Dangerous and How Danger Makes Us Safe”. It is on topics about which I have screamed for soon two decades; such as there is nothing as risky as excessive risk-aversion; and that going for the perfect perfectly applied to all, only creates mindboggling fragility.

Unfortunately Ip does not draw the most important conclusion his own book suggests, namely that what we have really to foolproof, is our regulatory system, so as to impede the risk-adverse to add their risk-aversion, for instance on top of our banking system. 

In 1999 in an Op-Ed 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 its collapse”

And the Bang sure happened. To me it is obvious what that systemic error is, but regulators don’t want to even acknowledge the problem…and so they keep taking us down the same suicidal path, to the next even bigger Bang.

The systemic error I refer to, the pillar of bank regulations, is the credit risk weighted capital requirements. More credit risk more capital – less credit risk less capital.

And let me explain what happens using non-bank risks from data found on the web.

The fatality rate per 100 million vehicle miles traveled in cars is 1.14

The fatality rate per 100 million vehicle miles traveled in motorcycles is 21.45

And so, undoubtedly, the risk of dying going by motorcycle seems to be about 19 times larger than by cars.

And that, translated into banking, would signify regulators requiring much higher capital when traveling on motorcycles than when travelling in cars.

But then on the web we also find these final statistics:

In 2011 in the US, 4,612 persons died in motorcycle accidents.

In 2011 in the US 32,479 persons died in vehicle accidents

And which, translated into banking, would mean that what is perceived as safer, caused about 7 times more losses than what is perceived as risky. Something logical since, as going on motorcycles is riskier, more choose going in safer cars.

Our bank regulators simply ignored that banks already cleared for credit risks, with risk premiums and amounts of exposure, and so on top of bankers’ risk aversion (see Mark Twain) they added their own risk aversion and caused the mother of all regulatory risk aversion. They never even bothered to analyze what had caused major bank crises in the past.

And there are two very tragic consequences that derives from that regulatory negligence.

First, that banks, since they could not leverage as much when lending to those going on motorcycles, are able to earn higher risk adjusted returns on equity when lending to those going by cars… they stop lending to motorcyclists… meaning our “risky” SMEs and entrepreneurs… and the economy stutters.

The second that when suddenly too many car deaths result, then banks will have little capital to cover themselves up with.

One reason Ip has not discovered this mistake, is because he mistakenly believes that “Capital serves as a shock absorber: it absorbs losses from bad loans” Not so, capital serves a shock absorber against unexpected losses not against expected credit losses. The regulators agreed with that, explicitly, but then inexplicably proceeded to estimate the unexpected with the expected… ignoring completely that what is perceived as safe has by pure logic much more potential of delivering unexpected losses than what is perceived as risky.

In Basel II, the risk weight for a private sector asset rated AAA (cars) was 20 percent… while the risk-weight for the below BB- rated (motorcycles) was 150 percent. Frankly, who in his right mind, can believe credits rated BB- are more risky to the banking system than credits rated AAA to AA? 

Ip very correctly writes: “Cost benefit analysis brings clarity and discipline to rule making… We owe it to ourselves to decide how safe we want to be though analysis, not emotion”. But what Ip has not realized, probably because its implications are so outrageous to make that believable, is that in all bank regulations there is nothing stated about the purpose of our banks, and, without that, how can you do a cost-benefit analysis?

Ip writes: “The solution for banks’ excessive risk taking as Paul Volcker saw it, was to force them to hold more capital, so that bad lending decision would not sink them”…meaning, when confusing ex ante risks with ex-post realities, that they should not lend to motorcyclist. Well no! 

Of course in Europe regulators were (are) even worse, but in the US, Volcker, Greenspan, Bernanke and from what we see Yellen… none of them have been concerned about the distortion of bank credit allocation to the real economy their regulatory pillar causes… and so when I refer to the need to foolproof bank regulations, I do include fool-proofing these against Fed Chairs too.

What if super duper scientists of Koshland Science Museum helped me to call out bank regulators’ monstrous mistake?

I was walking by the Koshland Science Museum in Washington, when I saw some windows that shouted out to me…maybe some real scientists can help me out fighting bank regulations, those which in my opinion are destroying our economies and the job opportunities of our young. Though I have objected in a thousand ways the regulators just do not want to answer. If they are too embarrassed about their mistake, I understand them perfectly well. But, for a mistake to be corrected, it needs first to be acknowledged.

WINDOW 1: CAUSE? EFFECT?

CAUSE: The pillar of current bank regulations is the credit risk weighted capital requirements for banks. More perceived credit risk – less perceived credit risk. These give banks much larger incentives to finance what is perceived as safe than what is perceived as risky.

EFFECT: Banks dangerously overpopulate the safe havens and, equally dangerous underexplore the more risky bays where SMEs and entrepreneurs live. 

WINDOW 2: FACT? FICTION?

FACT: Banks already consider perceived risk when setting interest rates and amounts of exposures, so that also make them consider the same perceived credit risks, in the capital assigns double importance to credit risks.

FICTION: Major bank crisis occur because of excessive exposure to what ex ante is perceived as risky. The truth is that all major bank crises occur because of excessive exposure to assets ex ante perceived as safe, but that ex-post turned out to be risky.

WINDOW 3: RISK? BENEFIT?

RISK: Though banks might not always be able to manage the perceived risks correctly, or the perceptions might be wrong, we must risk allowing banks to allocate credit to the real economy without any regulatory distortion.

BENEFIT:  Risk taking, reasoned audacity, is the oxygen of all development. That is what brought us here, and that is what we must allow, in order for our economies not to stall and fall, in order to give our children and grandchildren the same opportunities we were given. 

WINDOW 4: ACTION? REACTION?

ACTION: To enlist Koshland Science Museum and all its affiliated scientists’ support in forcing regulators to explain themselves; and also express their opinion on Kurowski’s bank risk management rules:

1. Any risk, even if perfectly perceived, leads to wrong decisions, if excessively considered.

2. Capital requirement should cover unexpected losses, not expected credit losses; and the safer an asset is perceived, the larger it’s potential to deliver unexpected losses.

REACTION: Hopefully to make bank regulators wake up and rethink all their strategy; starting with defining the purpose of banks, something that, amazingly, they never did before regulating the banks.

There is nothing as risky as excessive risk aversion - God make us daring.

If only regulators had set their capital requirements to be risk-weighted for banks’ management of perceived credit risks. As is we are better of with capital requirements for banks based on regulators not knowing what they are doing. For that, let us have 8-10% capital on all bank assets!

PS. But be very careful how you go from here to there... the journey has its dangers.

PS. I see you are interested in sustainability. What if banks earned higher risk adjusted returns on equity when helping out with that?

The Basel Committee for Banking Supervision flagrantly violates the precautionary principle by turning a blind eye to the dangers.

The precautionary principle states that if an action or policy has a suspected risk of causing harm to the public or to the environment, in the absence of scientific consensus that the action or policy is not harmful, the burden of proof that it is not harmful falls on those taking an action.

I have for years denounced that the credit-risk weighted capital requirements for banks adopted by the Basel Accord as the pillar of their regulations seriously distort the allocation of bank credit to the real economy.

The consequences of too much bank credit to what is perceived as “safe” and too little credit to what is perceived is that banks do not any longer finance the risky future, our children and grandchildren need to be financed, but only refinance the safer past. With this the world is slowly but surely coming to a grinding halt.

But the Basel Committee, the Financial Stability Board, the European Commission on Banking and Finance, IMF, BIS, ECB, Fed, FDIC, BoE and all other relevant institutions just look away and do not want that issue discussed.

It sure is a flagrant violation of the precautionary principle that will cause immense damage. 

Please… help me break the silence of that irresponsible mutual admiration club!

The Basel Committee, with Basel I, II and III, has condemned our grandchildren to secular stagnation and lack of jobs

Secular stagnation, a condition of negligible or no economic growth in a market-based economy, is explained in terms of investment demand falling relative to savings supply. 

Overall investment can be subdivided in: safe investments that can remain safe, safe investments that can become risky, risky investments that are in fact risky, and risky investments that turn out safe. The last group provides by far the most dynamism to our economies. 

The Basel Committee’s portfolio invariant credit risk weighted capital requirements for banks; more risk more capital – less risk less capital; allow banks to leverage their equity more when financing the safe; which allows banks to earn higher risk adjusted returns when financing the safe; which impedes the fair access to bank credit of the risky, among these the SMEs and entrepreneurs.

In short its credit-risk-aversion causes banks to over-refinance the safer past and under-finance the riskier future and thereby condemns our children to lack of opportunities, and our grandchildren to secular stagnation and lack of jobs.

And all for nothing since bank crisis are always caused by excessive bank exposure to something perceived as safe but that ex post turns out risky, and never because of excessive exposures to something perceived as risky.

This bank regulation was introduced with Basel I en 1988 and made much more distorting of credit allocation with Basel II in June 2004… and Basel III keeps the risk-weighting.

And the distortions they cause are not even discussed. In much because too many economists find it unworthy to dirty their hands with bank regulation technicalities. How vulgar! Keynes knew much about banks and finances, modern Keynesian do not.

God make us daring!

Don’t ever take members of the Basel Committee with you to the races. They’re dangerous!

I went to the races with some members of the Basel Committee for Banking Supervision.

They were so afraid I would lose money and blame any bad luck on them, so they offered to pay twice the odds, if I only bet on favorite horses paying less than 2 to 1. 

And I started making profits like a bandit, even paid the bookies big bonuses, and logically I increased and increased my bets on safe favorites more and more… that is until a favorite turned out to be a real dud, and I lost all I had.

If I had only gone on my own that would never have happened.

These lunatics should be hauled in front of courts for illegally manipulating the odds. Of course they can always argue they had no idea about what they were doing.

As handicap officials on the racetrack the bank regulators would be taking off weights from the stronger horses and placing these on the weaker.

Note: When the Basel Committee allows banks to leverage more on assets perceived as safe, than on assets perceived as risky, they are in effect manipulating the odds of the risk adjusted returns on the banks equity, and thereby distorting the credit markets. 

PS. With all horses carrying the same weight, the pay-out on betting Rich Strike winning the 148th Kentucky Derby was 80-1. If a Basel Committee for Horse-racing Supervision had ruled, it would have ordered the Kentucky Derby to be a handicap race. And with such a “betting risk” odds, Rich Strike would have been carrying so much extra-weight, it could easily have come in last in the race.

Other examples of odds manipulations

Who helps me getting bank regulators to even acknowledge the biggest systemic error in Basel I, II and III?

In 1999 in an Op-Ed 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 its collapse”

A Big Bang happened. I know what that systemic error is, but embarrassed regulators don’t want to even acknowledge the problem… and so they keep us traveling down the same crazy road... on route to the next Big Bang.

The most fundamental systemic error, is the credit risk weighted capital requirements.

To estimate the unexpected losses for which banks should have capital, the dummkopfs used expected credit risk. 

Banks consider credit risks when setting the interest rates, the amounts of exposures and other contractual terms.

So when regulators decided that the capital banks should hold against unexpected losses was to be based on ex ante expected credit losses, then they force-fed the banks to consider credit risk twice.

And any risk, even when perfectly perceived, produces a wrong decision if excessively considered.

And so here are our bank lending too much to The Safe, like the governments (sovereigns) and the AAArisktocracy, and too little, or nothing to The Risky, the SMEs and entrepreneurs… those tough we need to get going, especially when the going gets tough.

And you can find in my blogs and in several publications innumerable occasions when I have presented this argument… and most other “experts”, or media like the Financial Times, have not yet even acknowledged the existence of the problem in clear terms.

Friends, can you help me stop these besserwisser busybody hubristic bank regulators from interfering with the allocation of bank credit to the real economy?

What important institution dares to set up a conference on the theme “Do credit-risk weighted capital requirements dangerously distort the allocation of bank credit to the real economy? World Bank? IMF?

PS. Perhaps I should refer to the Basel regulators as just another bunch of statists? I say this because, believe it or not, in the Basel Accord of 1988, they assigned a zero percent risk weight to the sovereign, and a 100 percent risk weight to the private sector. 

PS. There was of course another systemic error. The exaggerated use of the credit ratings On that, in January 2003, in a letter to FT I wrote: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds. Friends, as it is, the world is tough enough.”

PS. While I was an Executive Director of the World Bank, 2002-04, the following were my totally ignored comments on bank regulations.

The Basel Committee’s besserwissers, on top of the ordinary defenses of banks, built a dangerous Maginot Line,

When banks use ex ante perceived credit risks (EAPCRs) to determine the interest rates (risk premiums) the amounts and other contractual terms of their exposures… all these their defenses, it might still at the end of the day, at least for some individual banks, end up like a totally useless Maginot Line.

But, when regulators decide to base their capital requirements for banks on precisely the same EAPCRs, then they are, de facto, on top of the defenses built by the bankers, building an extremely dangerous Maginot Line that could bring the whole banking system down.

That is because giving 200% weight to the EAPCRs will mean that “The Safe” be perceived as safer than what the EAPCRs validate, and “The Risky” will be perceived as riskier than the EACPRs validate. And the banking system will therefore lend too much to The Safe ("infallible sovereigns" and AAArisktocracy) and too little to The Risky (SMEs and entrepreneurs.

God make us daring!

God save us from hubristic besserwisser regulators’ mumbo jumbo scheming!

The only moment when we currently could deem our banks to be safe, and the credit allocation to the real economy is not distorted, is when the EAPCRs are adequately wrong. Meaning The Safe are in reality safer than perceived; and The Risky are in reality riskier than perceived… What a crazy world!

PS. May I humbly remind you of The Per Kurowski’s Rule?

Overreacting to ex-ante perceived risks, whether credit or climate change related, is NOT in BoE’s remit.

Mark Carney, the Governor of the Bank of England, recently expressed some warnings on climate change, and specifically about the risks with “stranded fossil fuels”. 

I criticized that, considering the dangers that overreacting to perceived risks poses.

I got an official, very courteous and kind reply from the Public Enquiries Group of BoE. Unfortunately it is clear that they have not understood what I am referring to… it could be my fault... English is not my mother tongue.

And so here I will try to explain it again, briefly, with a reference to what is happening to banks.

Banks act on ex ante perceived credit risks, by means of setting risk premiums, the amounts of exposures and other contractual terms.

But bank regulators (Mark Carney is the current chair of the Financial Stability Board) decided to also act, on precisely the same ex ante perceived credit risks, by setting their capital requirements for banks.

And so we now have TWO bank reactions related to the same ex ante perceived credit risks. 

This results, of course, in that banks will hold more of assets perceived as “safe” than what those ex ante credit-risk perceptions would validate; and hold less of assets perceived as “risky”, than what those ex ante credit-risk perceptions would validate. 

In other words there is now a dangerous distortion in the allocation of bank credit to the real economy.

And I am sure that overreacting to ex-ante perceived risks, whether credit or climate change related, is NOT in BoE’s remit.

And I have seen no specific government policy approving of it. Would Winston Churchill have ever said: “We need twice the walls we need to keep out the ex ante risks we perceive"? Or, "We need to build one more Maginot Line on top of the other!"?

And so, back to my letter to BoE: The market is already worried, on its own, about “stranded fossils fuel assets” and so when big powerful BoE comes along and starts implicating that it also worries about those assets, and so it might conceivably do something about it, that again could provoke a dangerous overreaction to the ex ante perceived risks of stranded fossil fuels.

Do I make myself clearer now?

PS. When there is an overreaction then the only way ex ante perceived risks are correctly acted upon, is when these are adequately misperceived. That is how crazy all is.

PS. Of course, since climate change has much more long-term risk implications that are harder to clear for in the markets, allowing banks to hold less capital when financing sustainability, so that banks earn higher risk adjusted returns on equity when financing sustainability, could serve as a good stimulus that though distorting does so in the right direction.