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.