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!