Failed bank regulators cuddled up for comfort in the bosom of Her Majesty’s “Why did no one see this coming?”

IEA, I refer to your Discussion Paper No. 65 “Britain’s Baker’s dozen of disasters” and specifically No. 13 “2000-2008: The Gordon Brown bubble”

It starts by quoting HM The Queen at London School of Economics, November 2008 asking with respect to the financial crisis “Why did no one see this coming?”

What a marvelous question, for failed regulators. It allows all of them to hide as a group, avoiding thereby any personal responsibility.

But of course some of us saw it coming! 

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”

In January 2003, in a letter published in the Financial Times I warned: “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.”

And in October 2004, as an Executive Director of the World Bank I formally stated: “We believe that much of the world’s financial markets are currently being dangerously overstretched through an exaggerated reliance on intrinsically weak financial models that are based on very short series of statistical evidence and very doubtful volatility assumptions.”

In 1988, with the Basel Accord, Basel I, bank regulators set a zero percent risk weight for sovereigns and a 100 percent risk weight for the private sector. A zero risk weight for governments that in your face set inflation targets that mean you will be repaid with less worth money, or that mention that in need they will have to raise taxes, is truly a surreal concept. With it, obviously statist regulators implicitly told the world that government bureaucrats make more efficient use of bank credit than the private sector.

And in June 2004, with Basel II, they introduced different risk weights for the private sector. These were 20, 50, 100 and 150 percent, depending on the credit rating. Since the basic capital requirement was 8 percent, that meant that in order to buy a $100 asset, banks had to put down $1.6, $4, $8 or $12 of their own capital, depending on the credit rating.

The fundamental errors committed by the regulators were/are mind-blowing.

Bank capital is to cover for unexpected losses and they designed the capital requirements based on the perceived credit risk losses that were already being cleared for by the banks by mean of risk premiums and size of exposures. 

That caused a double consideration of ex ante perceived credit risk and any risk, even if perfectly perceived, results in wrong actions if excessively considered.

It also ignored the simple fact that the safer something is perceived, by definition, the larger is its potential to deliver an unexpected shock.

In fact regulators regulated the banks without even defining the purpose of the banks, like that of allocating bank credit efficiently to the real economy.

And so that allowed banks to leverage much more their equity on assets perceived as safe than on assets perceived as risky; which allowed banks to earn much higher risk adjusted returns on equity on assets perceived as safe, or made to be perceived as safe, than on assets perceived as risky, like lending to small business and entrepreneurs. And that of course distorted the allocation of bank credit to the real economy. 

It caused the creation of dangerous excessive exposures to something ex ante perceived as safe but that ex post turn out risky, precisely the stuff major bank crises are made of: like AAA rated securities and Greece. This time aggravated by the fact that since the assets were perceived as safe, banks needed to hold very little capital. 

And it introduced a credit risk aversion that impedes our banks to help us live up to our commitment towards the next generations. Risk taking is the oxygen of any development. Without it the economy stalls and falls.

And the distortion this portfolio invariant credit-risk weighted capital requirements produces in the allocation of bank credit, is an issue that is not yet even discussed. The regulators are trying to hide their mistake imposing a not risk weighted leverage ratio but, by still keeping the risk weighted part, the distortion are well alive and kicking. If only in their stress testing of banks they would also look at what is not on the balance sheets but should be there. 

Why do nations fail? When they care more about what they already have than about what they can get! God make us daring!

And no one of the regulators responsible for the mess seems to have been held accountable… in fact most of them seem to have been promoted.