Houston we’ve got a huge problem. Bank regulators and other experts don’t get it!

With Basel II, banks were authorized to leverage their defined equity:

Unlimited times when lending to AAA to AA rated sovereigns
62.5 times to 1 when lending to the AAA to AA corporates, the AAArisktocracy
35.7 times to 1 when financing residential housing
And only 12.5 times to 1 when lending to unrated citizens SMEs and entrepreneurs

And that of course allowed banks to earn quite different expected risk adjusted returns on equity not based on what the market offered, but based on what the regulators dictated.

And regulators, finance professors, FT editors and journalists, and many other experts simply do not understand that this distorts the allocation of bank credit to the real economy.

What are we to do?

Mr Hiroshi Nakaso, you are wrong! You and your colleagues, so irresponsibly, changed the nature of our banks.

Mr Hiroshi Nakaso, Deputy Governor of the Bank of Japan gave on March 21, 2016 a speech titled “Challenges toward financial stability and the policy frontier – unconventional monetary policy, macro-prudence, and financial institutions’ low profitability” 

In it he said: “Joseph Alois Schumpeter, in his seminal “The Theory of Economic Development” stresses the important role played by the “banker”, as well as that of the “entrepreneur”. The banker profits from her ability to identify those entrepreneurs who develop truly innovative undertakings that are high-quality startups, and from generating information that leads to improved corporate performance. Schumpeter expects that such profit motives of the banker backed up by her exceptional ability to pick winners would bring about a more efficient reallocation of risks in the macro economy and lead to an endogenous rise in the economic growth rate.

This role of the banker- promoting the creative destruction through financial intermediation – has not changed since the time of Schumpeter.”

You are so wrong Mr Nakaso! You and your colleagues have changed the role of the banker.

With your risk weighted capital requirements for banks, which allow banks to leverage more their equity with what is perceived safe than with what is perceived risky; and thereby be able to obtain higher expected risk-adjusted returns on equity when financing what’s “safe” than when financing what’s “risky”, have certainly changed the role of the banker.

Nowadays his role, as you and you colleagues have seen it fit, is simply to avoid taking credit risks.

If you do not believe me look at the following authorized bank equity leverages in Basel II. (The risk weights in Basel III remains the same)

When lending to prime sovereigns, the sky is the limit. 

When lending to the AAArisktocracy 62.5 times to 1.

When financing residential housing 35.7 times to 1

And when lending to risky unrated SMEs and entreprenuers, only 12.5 times to 1

And that Mr Nakaso, is why banks do not any longer finance the riskier future, they just refinance the, for the very short time being, safer past.

The next generations will hold you and your colleagues accountable for this regulatory atrocity.

The lousier the sand turned into "gold", the more profitable is securitization… for the securitizers.

What can you earn by packaging a lot of AA rated instruments (like good 30 years fixed rate mortgages) into a security rated AAA? Very little, basically it is not even worth the effort.

But if you package something rated BB- or below into a security that gets an AAA rating, then there is a fortune to be shared, by all except, those who signed the original BB- obligations.

Securitization has been defended on the ground that it provides more financing to those who otherwise cannot afford it. That is 99% a lie. It provides much financing to those who cannot afford it, in order to benefit the originators, the packagers and the intermediaries.

Here’s the real deal! If you convinced risky and broke Joe to take a $300.000 mortgage at 11 percent for 30 years and then, with more than a little help from the credit rating agencies, you could convince risk-adverse Fred that this mortgage, repackaged in a securitized version, and rated AAA, was so safe that a six percent return was quite adequate, then you could sell Fred the mortgage for $510.000. This would allow you and your partners in the set-up, to pocket an immediate tidy profit of $210.000

But if you think that’s all with securitization looking to turn sand into gold, just you wait.

If an AA rated instrument is packaged into a security that gets an AAA rating it means nothing in terms of risk-weighted capital requirements for banks but, if a BB+ rated or an unrated instrument is packaged into a security that gets an AA rating, then the risk weight diminishes from 100 percent to 20 percent. And that, in terms of Basel II, meant that banks instead of having to hold 8 percent in capital against that instrument, were then only required to hold a meager 1.6 percent in capital. Meaning that instead of leveraging their equity 12.5 times to 1 they could leverage it a mind-blowing 62.5 times to 1.

PS. Should not those securitizing these mortgages, share the benefits with those being securitized? A 50% sharing in the example above, would allow the debtor $105.000 to help repay the mortgage. That would perhaps turn that subprime mortgage to earn a real AAA rating.

Please, let us not favor financing our houses more than the jobs our kids and grandchildren need

I refer to Avinash Persaud’s “Breaking the Link between Housing Cycles, Banking Crises, and Recession”

Avinash Persaud correctly states: “This story is not just about mortgages but also about the overall allocation of liquid and illiquid assets across the financial system” March 2016

Yes, indeed it is. I have for soon two decades criticized that the Basel Committee's concept of risk-weighted capital requirements for banks, dangerously distorts the allocation of bank credit.

Persaud writes: “Under Basel I, in the calculation of the amount of risk-weighted assets a bank had to fund with capital, securitized mortgages had a risk weight of 20 percent while nonsecuritized mortgages had a risk weight of 50 percent.” And Persaud translates that into “This allowed banks to earn fees and net interest margins on holding 2.5 times more credit”

A more precise description is that Basel I assigned a 50% weight to loans fully secured by mortgage on residential property that is rented or is (or is intended to be) occupied by the borrower, and Basel II reduced that to 35 percent. And Basel II also introduced that security or any financial operation that could achieve an AAA to AA- rating, was assigned a 20 percent weight.

And I translate that as: With Basel I and II’s standard risk weight of 8 percent, anything that has a risk weight of 100%, like loans to unrated SMEs and entrepreneurs, means banks can leverage its defined capital 12.5 times to 1 (100/8). 

But if it has access to a 20 percent risk weight, the bank can leverage its defined capital 62.5 times to 1 (100/1.6)

And banks, naturally, operate to maximize risk-adjusted returns on equity (and bonuses to the bankers).

And so there can be no doubt banks will allocate much to much credit, in much to easy conditions to mortgages and AAA rated securities (and to sovereigns with a zero percent risk weight) and much too little credit, in much to harsh relative terms, to what is risk weighted more than that like, SMEs and entrepreneurs.

And so, while I fully share Persaud’s argument about preferring insurance companies to banks to finance mortgages, so as to minimize maturities mismatches, my concerns go much further than his.

I do not want to favor, in any way shape or form, the “safe” financing of mortgages, whether by banks or insurance companies, over the “risky” financing of the job creation our children and grandchildren need.

PS. What would houses be worth if there was no financing available for buying houses? I ask because mortgages might now be financing more the credit available for buying houses than the real intrinsic value of houses. Oops!

PS. A memo on the many mistakes of current risk weighted capital requirements for banks

Dr Raghuram Rajan the color of the credit risk weighted capital requirement for banks policy is INTENSE RED

Dr Raghuram Rajan: in “Towards rules of the monetary game” a speech delivered in New Delhi March 12, 2016 during the conference" Advancing Asia: Investing for the Future" said: 

“To use a driving analogy, polices that are generally seen to have few adverse spillovers, and are even to be encouraged by the global community should be rated Green, policies that should be used temporarily and with care could be rated Orange, and policies that should be avoided at all times could be rated Red.” 

And I have a simple question for Dr Rajan: 

What color, Green, Orange or Red would he give the policy of the risk weighted capital requirements for banks? 

That which allows banks to hold much less capital against what is perceived ex ante as safe than against what is perceived as risky. 

That which therefore allows banks to leverage more their equity with what is perceived ex ante as safe than with what is perceived as risky.

That which therefore allows banks to earn higher risk adjusted returns on equity on what is perceived ex ante as safe than on what is perceived as risky.

That which therefore cause banks to create excessive and dangerous exposures to what is ex ante perceived as safe and insufficient exposures to what is perceived as risky. 

That which in real terms means causing the banks to extract the most refinancing much more the safer past abandoning their social responsibility of assisting in the financing of the riskier future. 

That which “has led to the debt overhang” that which makes it more difficult for “new technologies and new markets [to] come to the rescue” 

Dr Rajan asks and answers: 

“Why is there so much of a political need for growth in industrial countries? 

One reason is the need to fulfill government commitments such as debt and social security entitlements. 

Another reason is that growth is necessary for inter-generational equity, especially because the young, who are most benefited from job creation, are the generations that will be working to pay off commitments to older generations. 

A third reason is that, within country, long periods of below par growth can lead the unemployed to become unemployable.” 

Dr Raghuram Rajan, using your driving analogy the color of the policy of risk weighted capital requirement for banks is INTENSE RED, especially for developing countries like India.

PS. Here is the document I presented at the High-level Dialogue on Financing for Developing at the United Nations, New York, October 2007, and titled “Are the bank regulations coming from Basle good for development?” It was also reproduced in The Icfai University Journal of Banking Law Vol. VI No.4, India, October 2008

John D. Turner’s “Banking in Crisis” truly evidences a mind-blowing "Regulations in Crisis"

Turner writes: “If the rationale of bank regulation is to prevent banks from risk shifting and the banking system from collapsing, then the Basel approach to capital regulation failed dramatically”

That might seem like a correct statement but it is not. The true rationale of bank regulations is to assure banks serve their social and economic purpose of allocating bank credit to the real economy, without of course incurring excessive risks that could lead to the collapse of the banking system.

And in this respect the Basel approach, as it completely ignored that purpose of banks, and even went so far as to de-facto base its prime pillar, the risk-weighted capital requirements, on distorting the allocation of credit, fails even more dramatically.

Turner writes: "One reason for this failure was regulatory arbitrage… whereby capital regulations perversely incentivized banks to become riskier”

Absolutely wrong! The capital regulations perversely incentivized banks to create dangerous large exposures to what was perceived or deemed to be safe”

Turner writes: "Indeed, much bank lending to the residential-property market could have been partially due to the regulatory arbitrage because such lending had a 50 percent weighting in a Basel risk-weighted asset calculation, compared to 100 per cent for a commercial loan”

What regulatory arbitrage? Regulator set the weights that allowed banks to leverage twice as much on residential-property market loans than on commercial loans. Banks did not arbitrage, they did what they were instructed.

Turner writes: "To increase their return on equity, banks engaged in ’cherry-picking’ by shifting the composition of their loan portfolios towards riskier credits.”

What? In order to increase their expected risk-adjusted returns on equity they shifted the composition of their loan portfolios towards those credits that perceived or deemed as safer, allowed them to hold less capital. That is NOT ’cherry-picking’, that is something healthy banks are supposed to do to remain healthy, or does Turner believe it is good banks should on purpose try to lower their risk-adjusted returns on equity?

Of course with this type of regulations, there was much vested interest in hiding the risks. The pressures on the credit rating agencies to provide Potemkin AAA ratings were immense.

No! This current bunch of regulators, trying to avoid their own mental monsters, confusing ex ante risk with ex post realities, have distorted all common sense out of the allocation of bank credit. And so now banks no longer finance the riskier future they just keep on refinancing the for the time being safer past.

Our children and grandchildren will pay for their hubris.

The risk-weighted capital requirements clear in the capital for risks that have already been cleared for by means of risk premiums and size of exposures. And any perceived risk, even if perfectly perceived, if excessively considered, guarantees wrong actions.

“A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926

And regulators also forgot that even the safest harbors could turn into dangerous traps, if excessively populated.

We must completely clean the bank regulatory slate, which of course begins with retiring all current regulators who are suffering from the credit risk adverse Basel frame of mind.

PS. All the discussion here were limited to pages 195-199 of John D. Turner's "Banking in Crisis" 

There is only one 100 percent sure cause for the financial crisis 2007/08, and it is discussed less than 0.01 percent

The crisis exploded because of excessive exposures to AAA rated securities, real estate (Spain), loan to sovereigns (Greece) and short-term loans to banks (Iceland). They all one thing in common, namely that banks were required by regulators to hold very very little capital against these assets, and so banks could leverage very very much their equity with these assets, meaning that banks could expect to earn very very high risk adjusted returns on equity for these assets.

Had banks been required to hold the same level of capital against all assets, other crisis could have happened, but not one as large as the one in 2007/08.

So how much have you read about the problems related to the distortions produced by the risk weighted capital requirements in the allocation of credit to the real economy? Probably nothing!

Why? There are many explanations to that but, one of the most important, is that there is much more political interest in blaming bad bankers than laying it on good regulators.

Is this a problem? 

Yes, those regulations are still in place and so could still lead banks to create similar dangerously large exposures to something perceived or deemed safe. 

And since that still favors The Safe over The Risky, those who could most help us get our economies moving again, the SMEs and the entrepreneurs, have a lousy access to bank credit.

Right now banks are not financing the risky future, they are just refinancing the safer past, that which might soon turn risky, because of excessive financing.

PS. Here is a more extensive aide memoire on the mistakes in the risk weighted capital requirements for banks.

Hyman P Minsky stated the purpose of banks, but all Basel Committee regulators care about is avoiding credit risk.

John Lounsbury, having in his turn been informed by Joe Bongiovanni, has made us aware of a working paper by Hyman P Minsky, from October 1994, titled “Financial Instability and the Decline (?) of Banking: Public policy considerations” 

Lounsbury writes: “Minsky was concerned in the early 1990s that what he thought were the two roles of banking in a capitalist society were being performed to a decreasing extent by organizations that were chartered as banks.

The two primary functions of banking he describes as supplying the means of payments; and channeling resources into the capital development of the economy.

Minsky argued that this separation of banking from the real economy would diminish the role of central banks in influencing the economy in the traditional manner through monetary policy. Given this loss of influence through the traditional tools of "changing the availability or cost of financing". He felt that the variable remaining would be management of "uncertainty".

He argued that the changes in banking required regulation to be rethought”

And I ask, for the umpteenth time. What has the pillar of current bank regulations, the risk weighted capital requirements, to do with banks fulfilling efficiently those two primary functions?

The answer absolutely nothing but it is even worse than that, since the risk weighing totally distorts the allocation of bank credit to the real economy.

The current bunch of regulators holed up in that small mutual admiration club known as the Basel Committee for Banking Supervision, regulated our banks without even asking themselves what the purpose of our banks is.

They must be held accountable for that, and publicly paraded down our avenues wearing dunce caps.

It seems like it all started during a dinner in London on September 2, 1986

http://econintersect.com/pages/opinion/opinion.php?post=201603140225

This September 2016, there will be 30 years since regulators, scared of the climb, declared our economies should peak

In Steven Solomon’s "The Confidence Game" (1995) we read: 

"On September 2, 1986, the fine cutlery was laid once again at the Bank of England governor’s official residence at New Change… The occasion was an impromptu visit from Paul Volcker… When the Fed chairman sat down with Governor Robin Leigh-Pemberton and three senior BoE officials, the topic he raised was bank capital…

At dinner the governor’s hopes had been modest: to find areas of sufficient convergence of goals and regulatory concepts to achieve separate but parallel upgrading moves… 

Yet the momentum it galvanized… produced an unanticipated breakthrough of a fully articulated, common bank capital adequacy regime for the United States and United Kingdom. This in turn catalyzed one of the 1980’s most remarkable achievements – the first worldwide protocol on the definitions, framework, and minimum standards for the capital adequacy of international active banks…

They literally wiped the blackboard clean, then explored designing a new risk-weighted capital adequacy for both countries… 

It included… a five-category framework of risk-weighted assets… It required banks to hold the full capital standard against against the highest-risk loans, half the standard for the second riskiest category, a quarter for the middle category, and so on to zero capital for assets, such as government securities, without meaningful risk of credit default.” End of quote.

And that suddenly meant that banks were able to leverage equity much more with what was perceived, or deemed by regulators, as safe, than with what was perceived as risky.

And that of course meant banks would earn higher expected risk-adjusted rates of return on equity on what was perceived as safe than on what was perceived as risky.

And that meant banks would stop lending to the risky future and just keep to refinancing the safer past.

The bank regulators, scared of more climbing, had then declared that the Western Civilization had reached its peak. No more risk-taking!

The Basel Committee for Banking Supervision, with the Basel Accord of 1988, concocted Basel I and in 2004 Basel II... and they are now in Basel III... and it has all been going down down ever since. The liquidity injected byTarps, QEs and fiscal deficits, and which generate temporary illusions of growth, obesity, cannot reach those who could best produce sturdy growth, the "risky" SMEs and entrepreneurs.

Wake up! Our banks are regulated by highly unprofessional technocrats; all members of a small mutual admiration club

Could there be something more dangerous to the real economy, and to banks, than distorting the allocation of credit? Not really.

And yet that is what the current batch of bank regulators did, without even considering that possibility a factor. They did not even care about it.

They imposed risk weighted capital (equity) requirements for banks. More ex ante perceived risk more capital – less risk less capital.

With that they allowed banks to leverage their equity more when lending to ”the safe” than when lending to ”the risky”.

With that they caused banks to be able to earn higher risk adjusted returns on equity on assets perceived as safe than on assets perceived as risky.

And so of course the banks are lending more than normal to those who already had easier and cheaper access to bank credit, ”The Safe”, like the sovereigns (governments) and members of the AAArisktocracy.

And so of course banks are lending less and relatively more expensive than usual to those who already found it harder and more expensive to access bank credit, ”The Risky”, like the SMEs and entrepreneurs.

And you ask how the hell did this happen? There are many explanations but the most important one was that they regulated without even asking themselves what was the purpose of those banks they were regulating.

And if that is not unprofessional what is?

“A ship in harbor is safe, but that is not what ships are for” John Augustus Shedd, 1850-1926

And to top it up they have not made our banks safer, since never ever do major bank crises result from excessive exposures to something perceived risky, these always result from excessive exposures to something perceived or deemed to be safe when booked... you see even the safest harbor can become dangerously overpopulated.

We must rid ourselves from these lousy and already very proven failed bank regulators. Urgently!

The Basel Committee used expected credit losses as a direct proxy for all the unexpected. Loony eh?

Steven Solomon in “The confidence game” Simon and Schuster 1995 writes about “who the central bankers are, how they have shaped the course of economic and political events in the past fifteen years, why their influence relative to elected political leaders has reached a historical zenith, and how it reveals one of the greatest pressing dangers facing free democracy.

And beginning Solomon quotes The Testament of Beauty by Robert Bridges with:

Our stability is but balance, and conduct lies

In masterfully administration of the unforeseen

And later Solomon writes: “On September 2, 1986, the fine cutlery was laid once again at the Bank of England governor’s official residence at New Change… The occasion was an impromptu visit from Paul Volcker… When the Fed chairman sat down with Governor Robin Leigh-Pemberton and three senior BoE officials, the topic he raised was bank capital…

At dinner the governor’s hopes had been modest: to find areas of sufficient convergence of goals and regulatory concepts to achieve separate but parallel upgrading moves… 

Yet the momentum it galvanized… produced an unanticipated breakthrough of a fully articulated, common bank capital adequacy regime for the United States and United Kingdom. This in turn catalyzed one of the 1980’s most remarkable achievements – the first worldwide protocol on the definitions, framework, and minimum standards for the capital adequacy of international active banks…

They literally wiped the blackboard clean, then explored designing a new risk-weighted capital adequacy for both countries… 

It included… a five-category framework of risk-weighted assets… It required banks to hold the full capital standard against against the highest-risk loans, half the standard for the second riskiest category, a quarter for the middle category, and so on to zero capital for assets, such as government securities, without meaningful risk of credit default.”

And which, in other words, means that these regulators determined the capital bank needs to hold to cover for unexpected losses, was to be a direct function of the ex ante perceived risk of expected credit losses. The expected substituting for the unexpected... loony eh!

Since the expected is already considered by bankers when setting the interest rates and the size of exposures, having it to also stand in for the unexpected in the capital, meant the expected got to be excessively considered. And any risk, even if perfectly perceived, causes the wrong actions, if excessively considered. What did we do to deserve such credit risk adverse fools?

Regulators introduced into banking a very serious systemic error that is being totally ignored

Banks used to evaluate all credit applications based on the same own bank capital, because that was on the margin true. And so all borrowers could compete with their cost and risk adjusted interest rates offers, on equal terms. Not any longer.

Since the introduction of the risk weighted capital requirements for banks, more perceived risk more capital – less risk less capital, the offers from different borrowers will be evaluated based on different levels of bank capital.

Since the offers provided by The Safe can be leveraged more by the banks than the offers provided by The Risky, The Safe have now a regulatory advantage that, when compared to The Risky, allows them a preferential access to bank credit.

And that seriously distorts the allocation of bank credit to the real economy. “The Safe” get more and cheaper access to bank credit while The Risky, like the SMEs and entrepreneurs, they get less and more costly bank credit. 

To argue that to be a very serious systemic error seems very obvious to me but, in all the discussions on bank regulations, that error has been completely ignored. Why?

For instance, I might have written to the Financial Times and its various reporters and columnists over a thousand letters about it, but its editor has preferred to keep total silence. It must be because of something much more important than perhaps FT thinking little me a nuisance since I write too many letters to the editor.

And of course, in terms of bringing more stability to the banking system, that regulation is absurd and useless. The risk for the system of what is ex ante perceived as safe, but that ex post could be very risky, is clearly much higher than the risk for the system of what is ex ante already perceived as risky.

And of course, the creation of predatory regulations that subsidize The Safe and penalize The Risky, can only accentuate existing inequalities

Here is the explanation for the genesis of the financial crisis of 2007-08 and of the secular stagnation since.

Getting the clue from Charles Goodhart’s “The Basel Committee on Banking Supervision: A History of the Early Years 1974-1997”, in Steven Solomon's “The Confidence Game” we read:

“On September 2, 1986, the fine cutlery was laid once again at the Bank of England governor’s official residence at New Change… The occasion was an impromptu visit from Paul Volcker… When the Fed chairman sat down with Governor Robin Leigh-Pemberton and three senior BoE officials, the topic he raised was bank capital…

Adequate capital – the bank’s buffer against bankrupting loss- was the keystone of a central banker’s mission to uphold financial system safety and soundness. It was the banks’ capital inadequacy that made LDC (Less Developed Countries) over-indebtedness so grave a threat; upgrading U.S. bank capital was Volcker’s strategy to extricate the world financial system from that crisis. 

At dinner the governor’s hopes had been modest: to find areas of sufficient convergence of goals and regulatory concepts to achieve separate but parallel upgrading moves… 

Yet the momentum it galvanized… produced an unanticipated breakthrough of a fully articulated, common bank capital adequacy regime for the United States and United Kingdom. This in turn catalyzed one of the 1980’s most remarkable achievements – the first worldwide protocol on the definitions, framework, and minimum standards for the capital adequacy of international active banks…

They literally wiped the blackboard clean, then explored designing a new risk-weighted capital adequacy for both countries… 

It included… a five-category framework of risk-weighted assets… It required banks to hold the full capital standard against the highest-risk loans, half the standard for the second riskiest category, a quarter for the middle category, and so on to zero capital for assets, such as government securities, without meaningful risk of credit default.”

But then in Alexis Rieffel’s “Restructuring Sovereign Debt”,‪ Brookings Institution Press, 2003 we also read:

“Countries don’t go bankrupt” seems to be the most frequently repeated sound bite associated with the broad subject of sovereign debt workouts. It is everywhere. Former Citibank chairman Walter Wriston is usually cited as the originator of the quip [An Op Ed in New York Times 1982]. This is almost certainly wrong. It was considered conventional wisdom in the international financial community at least a decade earlier”

And there you have it! The regulators completely confused ex ante perceived risks with ex-post realities. The LDC crisis did not result from banks taking large ex ante perceived risks.

And so what resulted? The pillar of current bank regulations, the risk weighted capital requirements for banks. More ex ante perceived risk more capital - less risk less capital.

Which allowed banks to leverage more with The Safe than with The Risky.

Which allowed banks to earn higher risk adjusted returns on equity with The Safe than with The Risky.

Which made banks lend more against less capital to The Safe… like AAA rated securities and sovereigns like Greece. Hence the Financial Crisis!

And which make banks lend less to The Risky, like SMEs and entreprenuers. Hence Secular Stagnation!

Which make banks finance more the basements in which kids can live with parents, than the jobs they need.

PS. And here are Paul Volcker valiant confessions in 2018

PS. Here is an aide memoire on the final monstrous mistakes of such risk weighted capital requirements.

Most concerns about derivatives derive from the fact that it sounds so delightfully sophisticated

In a derivative, there is a buyer and a seller, and so whatever happens someone wins and someone loses and in essence it’s a wash out… of course as long as all can live up to their commitments. 

But, in a real market loss, like that of a lower value of a stock, a lower value of a painting, or a lower value of a real estate, there is at that time only a loser… and no winner… that is unless you count he who way back have earlier sold the stock, the painting or the house. 

And in this respect the trading in derivatives will depress much less the market than a depression of the values of the underlying vanilla assets. 

The big fuss that is raised around the issue of trading of derivatives, again, besides the possibility of one side of the trade not living up to his commitments, has much more to do with the fact that “derivatives” sounds so delightfully sophisticated when you let it roll down your tongue. 

But topping that must be the introduction of “delta, vega and curvature risk” into the discussions. Just read the index of the Basel Committee’s “Minimum capital requirements for market risk” of January 2016. Mindboggling! Do those who are responsible for what is coming out of the Basel Committee truly understand the implications of that for the banking system? 

I am quite sure that John Kenneth Galbraith’s “If one is pretending to knowledge one does not have, one cannot ask for explanations to support possible objections”, applies to most bank regulators… perhaps to all. 

Otherwise how come the real failures of the risk weighted capital requirements for banks, are not yet even discussed?

PS. My 2019 letter to The Financial Stability Board

PS. 2024: Inviting comments the Basel Committee issued a document on Technical Amendments. On e.g., “SCO60.80: Curvature charge for Group 2a crypto-assets”, I challenge you to draft a comment that an economist like me could understand.

The bank regulators of the Basel Committee are dumb and dangerous; and are not being held accountable for that

The pillar of current bank regulations is the credit risk weighted minimum capital requirements for banks; more perceived credit risk-more capital and less risk-less capital.

For instance, in Basel II of 2004, paragraph 66, we find the following risk weights for claims on corporates depending on their credit assessment.

AAA to AA rated = 20%; A+ to A- = 50%; BBB+ to BB- = 100%; Below BB- = 150%; Unrated = 100%

Since the basic capital requirement in Basel II was 8 percent then the respective minimum capital requirements were:

AAA to AA rated = 1.6%; A+ to A- = 4%; BBB+ to BB- = 8%; Below BB- = 12%; Unrated = 8%

And that translates into that banks were allowed to leverage capital (equity) as many times as follows:

AAA to AA rated = 62.5; A+ to A- = 25; BBB+ to BB- = 12.5; Below BB- = 8.3; Unrated = 12.5

That is dumb and that is dangerous.

The dumb part is easily evidenced by just asking: Who can think that what has a credit rating of below BB-; which means moving from “highly speculative” through “extremely speculative” and up to “default imminent”, is more dangerous to banks than any of the other “safer” assets?

With a reference to Mark Twain’s saying that “bankers want to lend you the umbrella when the sun shines and take it back when it looks like it is going to rain”, one could even make a case for the totally opposite, a 20% risk weight for assets rated below BB- and a 150% risk weight for assets rated AAA to AA.

And clearly no major bank crises have ever resulted from excessive exposures to risky type below BB- exposures; these have always resulted from excessive exposures to something ex ante perceived as “safe” but that ex post turned out to be risky. In fact it only guarantees that if something really bad happens with an excessive exposure to something erroneously perceived as safe, that banks will stand there naked, with especially little capital to cover them up with. 

But it is also very dangerous, primarily because it distorts the allocation of bank credit to the real economy.

By allowing banks to leverage more with the Safe than with the Risky, banks will be able to earn higher expected risk adjusted returns on equity with the Safe than with the Risky; which means banks will lend more than it would ordinarily lend to the Safe and less than it would ordinarily lend to the Risky… and that cannot be good for the real economy.

The day someone calculates how many small loans to SMEs and entrepreneurs have not been awarded because of this silly regulatory risk aversion; and we think of all the opportunities for job creation that have been lost; we will all cry... and our young could get mad as hell, as they should.

But the real story is even worse. Regulators gave the sovereigns (governments) a risk weight of zero percent; which means they think government bureaucrats are worthier of bank credit than those in the private sector. That is pure unabridged statism.

And since these regulations discriminate against the bank credit opportunities of the Risky, it also serves as a potent driver for increased inequality.

There is soon a decade since that crisis which resulted from excessive exposures to AAA rated securities, and to sovereigns like Greece, broke out; and the arguments here presented are not even being discussed. If that lack of accountability is not scary, what is?

PS. My letter in 2019 to the Financial Stability Board

“American corporations are sitting on trillions on cash stashed away abroad” Cash? Really?

How many times do we not read about it?

Do you really believe corporations are sitting on massive stashes of cash?

Is not all that money already invested one way or another in the real economy... perhaps even in US treasuries?

Yes, if that money returns to the US, the government would receive some additional tax revenues.

But, would that guarantee any fundamental difference in the real economy?

Decreed Inequality

John Kenneth Galbraith wrote: “The function of credit in a simple society is, in fact, remarkably egalitarian. It allows the man with energy and no money to participate in the economy more or less on a par with the man who has capital of his own. And the more casual the conditions under which credit is granted and hence the more impecunious those accommodated, the more egalitarian credit is… Bad banks, unlike good, loaned to the poor risk, which is another name for the poor man.” “Money: Whence it came where it went” 1975.

And that pro-egalitarian function had to face that natural risk aversion of bankers supposedly described by Mark Twain with “A banker is a fellow who wants to lend you the umbrella when the sun shines and wants it back when it rains”.

But since “poor risks” could always offer to pay higher risk premiums than the “safe”, and a dollar paid in interest was a dollar whoever paid it, the “poor risks” of yesterday, frequently got the opportunities for bank credit that in many cases transformed these into the safe of today. 

No longer. Bank regulators, wanting nothing but safer banks, decided since the early 1990s that the natural risk aversion of bankers was insufficient, and decreed risk weighted capital requirements for banks.

With it banks are required to hold more capital (equity) against assets perceived as risky than against those perceived as safe; which meant banks are able to leverage equity less with loans to those perceived as risky than with loans to those perceived as safe; which meant banks earn lower expected risk adjusted returns on equity lending to the risky than lending to the safe; which means that dollars paid in net risk adjusted margins on loans by the risky do not any longer have the same value than the same dollars paid by the safe; which means that no longer have the “risky poor” fair access to bank credit, while that of the “safe rich” is de facto subsidized. 

And this is what I mean with “Decreed Inequality”. How many millions of SMEs and entrepreneurs have not been given the opportunity to advance with credits over the last 25 years as a direct result of it? That would never have resulted in a free market with unregulated banks. And it sadly also means that banks no longer finance the “riskier future” but only refinance the “safer past”.

And in terms of “safer banks” it was and is all for nothing, as major bank crises never ever result from excessive exposures to something perceived ex ante as risky. The 2007/2008-bank crisis would never have happened or, if so, remotely had been of the same scale had banks not been regulated. A free market would never have knowingly allowed banks to leverage 30 to 50 times their equity like regulators did.

Do I think banks should not be regulated? Absolutely not! I am only reminding everyone of the fact that the damage dumb bank regulators can cause with their meddling, by far surpasses anything the free market can do.

And please, please, please, stop talking about "deregulation" in the presence of such an awful and intrusive mis-regulation.The regulators imposed the worst kind of capital controls.

Note: I expressed concerns about the distortions that capital requirements based on perceived risks could cause in my very first Op-ed, back in 1997.

Question: SCOTUS, does such discrimination in the access to bank credit reflect the spirit of the US Constitution?

PS. Through the bathroom window of the Basel Committee for Banking Supervision, and by decreeing the risk weight of the sovereign to be zero percent, while that of the private sector was set at 100 percent, the regulators also smuggled in horrendous statism. 

P.S. Here is a link to a more detailed aide memoire on the horrible mistakes of risk-weighing the capital requirements

PS. Then on top of it all, they top it up with QEs fiscal deficits and other stimulus, that primarily benefit those who already own assets (shares/houses)

PS. Here is a letter on this issue the Washington Post published 

And here is my 2019 letter to the Financial Stability Board

Here is a recent numerical explanation that might better illustrate my point

The basic premise of current bank regulations is bankers are blind suicidal fools. That’s what’s really dangerous!

Right now, with the risk weighted capital requirements banks, need to hold more capital against what is perceived as risky than against what is perceived as safe. That presumes bankers are blind, dumb and suicidal. And that’s what’s really dangerous.

The real ex post dangerous consequence of something goes down the riskier it is perceived ex ante. The real ex post dangerous consequence of something goes up the safer it is perceived ex ante. 

So, if you want to introduce risk weighted capital requirements, then the real question you as a regulator need to answer is: What are the chances banks create large dangerous excessive exposures to something ex ante perceived as safe, when compared to doing the same against something perceived as risky?

And the answer to that would indicate the current capital requirements for banks are 180 degrees wrong. But regulators don’t seem to care.

And the real consequence of that mistake is not only to expose banks to stand there with little capital precisely when they need it the most, but also to dangerously distorts the allocation of credit to the real economy. 

The regulators, by allowing banks to leverage much more with assets perceived as safe, allow banks to earn higher expected risk adjusted returns on equity on what is perceived as safe, than on assets perceived as risky.

And so, as a direct consequence, millions of “risky” SMEs and entrepreneurs, those who anyhow would have gotten smaller loans and paid higher risk premiums, have been denied fair access to bank credit. 

And so, as a direct consequence of that, tens or even hundred of millions of jobs around the world and that could have benefited the next generation, had no chance of being created.

And all for nothing as the truly dangerous bank crises keep on resulting, as always, from excessive exposures to something erronously perceived as safe… like AAA rated securities.

And all this while regulators keep on congratulating themselves for how smart they are.

Damn them!