Bank regulations put Minsky’s “financial instability hypothesis” on steroids, boosting its speed towards “the moment”.

The Economist refers to Hyman Minsky’s important “financial instability hypothesis”, but concludes that it “would be a stretch to see that hypothesis becoming a new foundation for economic theory, “Minsky’s moment” July 30, 2016

That might be, but it should become an essential foundation of financial regulations because, by ignoring it, with the risk weighted capital requirements for banks, the regulators set the “boom that can sow the seeds of busts” on steroids.

Normally, without distortions, bank credit should be allocated to whoever offers the highest perceived risk adjusted rate. That of course might quite often not be true, because “a safe” can be riskier or safer than what it is perceived; just llke “a risky, could equally be safer or riskier.

But, when regulators decided banks needed to hold less capital against what was perceived, decreed or concocted as safe, than against what was perceived as risky, they dramatically distorted the allocation of bank credit to the real economy.

Suddenly the booms of what was perceived as safe got a tremendous boost, as banks could earn higher risk adjusted rates there; all while “the risky” saw their access to bank credit severely curtailed.

We only need to go the crisis of 2007-08 to see that what caused it, was all which had very low capital requirements because it was perceived as safe when placed on the bank’s balance sheets.

And of course, the power of those regulatory steroids, was further strengthen by the fact that so much decision power, over deciding what was safe and what was risky, was placed in the hands of some very few human fallible credit rating agencies.

PS. I was just a consultant from a developing country who happened to end up on the Board of the World Bank as an Executive Director, and so I can of course not aspire, by far, to receive the same attention as Hyman Minsky, but you might anyhow be interested in what were my very early opinions on these issues

PS. And here is my most recent aide memoire on what is monstrously wrong with Basel Committee’s regulations.

@PerKurowski ©

Regulatory risk-weights: The sovereign = Zero percent and We the (risky) People = 100%. In America?

I am not an American, and I am not well versed on its Constitution,  but there's one issue which has for a long time been a mystery to me. 

How on earth could America, in 1988, as a signatory of the Basel Accord, accept that for the purpose of setting capital requirements for banks, the risk-weight for the sovereign, meaning the government, was going to be zero percent, while the risk-weight for the citizen, meaning We The People was set at 100%; and all without a major discussion?

I know that “sovereigns” currently means the government but, from reading for instance Randy E. Barnett’s “Our Republican Constitution”, one could have expected some debate about something that is akin to risk weighing the King with an "infallible" 0%, and his subservients with a "risky" 100%.

Barnett's book states that Justice James Wilson, in the Chisholm v. Georgia case of 1793, opined that “To the Constitution of the United States the term Sovereign is totally unknown…and if the term sovereign is to be used at all, it should refer to the individual people”. And the book also frequently refers to the importance of the required consent of the people, which of course is also a thorny issue. 

And, since those risk-weights effectively permit banks to leverage their equity much more when lending to the sovereign, than when lending to the citizen; banks will earn higher risk adjusted returns when lending to the sovereign than when lending to the citizens; and so banks will de facto, sooner or later, lend much too much to the sovereign and much too little to the citizens… and I can simply not fathom how citizens, be they individual or majority, could give their consent to something like that.

De-facto those risk weights signify that regulators believe that government bureaucrats can make better use of bank credit than citizens… it is statism running amok.

But it became even worse. In 2004, in Basel II, regulators also made a distinction between those private who had great credit ratings, like AAA to AA, and who received a 20% risk-weight, and for instance those who had no ratings, and who kept their 100% risk weight. That to creates a sort of AAA-risktocracy that does not square well with the Constitution’s “No Title of Nobility shall be granted by the United States.

But even without entering into constitutional issues, there is even a current law that seems to prohibit this type of discrimination, but that is not applied to bank regulations. And I refer to the Equal Credit Opportunity Act: “Regulation B”.

So in the land in which its Declaration of Independence states: “We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness.”, I just must ask: How could regulators dare to decree such regulatory inequality?

And to top it up, the current risk-weighted capital requirements for banks, more ex ante perceived risk more capital – less risk less capital, are arbitrary and irrational. And that because no major bank crises have ever result from the build up of excessive dangerous bank exposures to something perceived as risky, that has always happened with something, erroneously, perceived as very safe. If you want to understand how really crazy these bank regulations are, here is a brief memo.

And frankly what would a Governor answer to this question: Why can our banks leverage their equity lending more to a foreign sovereign or a foreigner with a high credit rating, than when lending to us, the local SMEs and entrepreneurs?

No! America would never have become what it is, had it had this type of risk averse discriminatory bank regulations before.

And by the way the Dodd Frank Act, in all its 848 pages, surrealistically, does not mention the Basel Committee nor the Basel Accord, not even once.

Have the risk weights used in current bank regulations really been approved by the US Congress, in accordance to the Constitution?

PS. In his book Professor Barnett defends Federalism from the perspective of making diversity more possible. That rhymes well with what I stated at the World Bank as an Executive Director 2002-04: "A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind”

Would Bernardine of Siena have accused the Basel Committee for Banking Supervision of usury?

In Samuel Gregg’s “For God and Profit” 2016 I read “Bernardine of Siena (1380-1444)…a member of the famously ascetic Franciscan order [opined that] “Usury concentrates the money of the community in the hands of the few, just as if all the blood in a man’s body ran to his heart and left his other organ depleted”

And I wondered what would Bernardine of Siena have opined on the Basel Committee’s risk weighted capital requirements for banks? These, no doubt about it, concentrates bank credit in the few hands of those perceived, decreed and concocted ex ante as “safe”, like sovereigns and the AAArisktocracy; and leave the other vital organ of the real economy, like the SMEs and entrepreneurs lacking of it.

Pope Francis, please go and explain “The Parable of Talents” to the members of the Basel Committee

Should not a consultant group like McKinsey, if it sees-something dangerous for the society, have to say something?

During many years I have been wondering why consultants, like those in McKinsey, have not spoken out against the risk-weighted capital requirements for banks.

I do understand that McKinsey must have many bank clients who just love the idea of being able to earn higher-risk adjusted returns on equity with assets deemed as safe than with assets deemed as risky.

But any financial consultant should also be able to understand that, in the medium or long term, that will cause banks to dangerously overpopulate safe-havens; just as he must understand that the resulting under-exploration of the risky-bays, like SMEs and entrepreneurs, poses great dangers for the sustainability of the economy. 

Or is it that McKinsey, like the Basel Committee does not understand the difference between risk and uncertainty?

Now I just read two new articles published by McKinsey. One “The future of bank risk management” by Philipp Härle, Andras Havas, and Hamid Samandari; and the other “Poorer than their parents? A new perspective on income inequality” by Richard Dobbs, Anu Madgavkar, James Manyika, Jonathan Woetzel, Jacques Bughin, Eric Labaye, and Pranav Kashyap.

None of these touch even remotely on the fact that current regulatory risk-aversion, distorts the allocation of bank credit to the real economy; and that the regulatory discrimination against those perceived as “risky”, cannot but increase inequality.

On its website McKinsey tells us: “Social Impact: We help address societal challenges” Again, why does it not address this super societal challenge? 

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

God make us daring!

Here is a brief summary of some of the monstrous mistakes in current bank regulations.

Nothing promotes secular stagnation as much as the regulatory promotion of risk aversion

J. Bradford DeLong, in “The Scary Debate Over Secular Stagnation: Hiccup ... or Endgame?” published October 19, 2015 in the Milken Institute Review, refers to that Martin Feldstein, at Harvard back in the 1980s, taught that "badly behaved investment demand and savings supply functions," could have six underlying causes:

1. Technological and demographic stagnation that lowers the return on investment and pushes desired investment spending down too far.

2. Limits on the demand for investment goods coupled with rapid declines in the prices of those goods, which together put too much downward pressure on the potential profitability of the investment-goods sector.

3. Technological inappropriateness, in which markets cannot figure out how to properly reward those who invest in new technologies even when the technologies have enormous social returns – which in turn lowers the private rate of return on investment and pushes desired investment spending down too far.

4. High income inequality, which boosts savings too much because the rich can't think of other things they'd rather do with their money.

5. Very low inflation, which means that even a zero safe nominal rate of interest is too high to balance desired investment and planned savings at full employment.

6. A broken financial sector that fails to mobilize the risk-bearing capacity of society and thus drives too large a wedge between the returns on risky investments and the returns on safe government debt.

J. Bradford DeLong points out that Kenneth Rogoff in his debt supercycle focuses on cause-six; Paul Krugman in “return of depression economics” focuses on five and six; and Lawrence Summers with “secular stagnation” has, at different moments, pointed to each of the six causes.

And then J. Bradford DeLong writes: “Rogoff has consistently viewed what Krugman sees as a long-term vulnerability to Depression economics as the temporary consequences of failures to properly regulate debt accumulation. Eventually, a large chunk of debt thought of as relatively safe is revealed to be risky, and financial markets choke on the lump. As the riskiness of the debt structure is revealed, interest rate spreads go up – which means that interest rates on assets already known to be risky go up, and interest rates on assets still believed to be safe go down."

And Rogoff is later quoted with "In a world where regulation has sharply curtailed access for many smaller and riskier borrowers, low sovereign bond yields do not necessarily capture the broader 'credit surface' the global economy faces,"

And here is when I just have to intervene: Of course, stupid credit risk weighted capital requirements for banks have impeded the mobilization of the so vital risk-taking willingness and capacity of the society, that which has traditionally been much exercised by its banking sector. That it did by driving a large wedge between the banks’ ROEs for risky investments, like loans to SMEs and entrepreneurs, and the returns on “safe” investments, like loans to governments, AAArisktocracy and the financing of houses.

And “stupid” it is: “Eventually, a large chunk of debt thought of as relatively safe is revealed to be risky, and financial markets choke on the lump”. The capital requirements, that are to guard against the unexpected, were based on the expected, the perceived credit risks.

Dare to read more here about the mind-blowing regulatory mistakes that have been ignored by the experts.

PS. Anyone who talks about low interest rates on public debt without considering the regulatory subsidy implied with: risk weight of sovereign = 0%, and risk weight of We The People = 100%, is either a full-fledged statist or has no idea of what he is talking about.

PS. #4 "the rich can't think of other things they'd rather do with their money" is one of the reasons I much favor the Universal Basic Income concept.

Does Deutsche Bundesbank want research that now “discovers” bank regulation mistakes it should have known of before?

Discussion Paper: Deutsche Bundesbank No 40/2015

Arbitraging the Basel securitizationsframework: evidence from German ABS investment

Matthias Efing: (Swiss Finance Institute and University of Geneva)

"Non-technical summary Research Question: The 2007-2009 financial crisis has raised fundamental questions about the effectiveness of the Basel II Securitization Framework, which regulates bank investments into asset-backed securities (ABS). The Basel Committee on Banking Supervision (2014) has identified “mechanic reliance on external ratings” and “insufficient risk sensitivity” as two major weaknesses of the framework. Yet, the full extent to which banks actually exploit these shortcomings and evade regulatory capital requirements is not known. This paper analyzes the scope of risk weight arbitrage under the Basel II Securitization Framework. 

Contribution: A lack of data on the individual asset holdings of institutional investors has so far prevented the analysis of the demand-side of the ABS market. I overcome this obstacle using the Securities Holdings Statistics of the Deutsche Bundesbank, which records the on-balance sheet holdings of banks in Germany on a security-by-security basis. I analyze investments in ABS with an external credit rating to uncover risk weight arbitrage on the demand-side of the ABS market."

Results: The analysis delivers three main results.

“First, I provide security-level evidence that banks arbitrage Basel II risk weights for ABS. Banks tend to buy the securities with the highest yields and the worst collateral in a group of ABS with the same risk weight (and, therefore, the same capital charge). My findings corroborate the hypothesis that institutional invsstors bought risky ABS to some extent for motives of regulatory arbitrage.”

What does that mean? That banks, for the “same risk weight”, buy what offers them the highest expected risk adjusted return on equity. Is that not what they are supposed to do? Would we, or the regulators like banks to minimize their risk-adjusted returns on equity?

"Second, banks operating with low capital adequacy ratios close to the regulatory minimum requirement are found to arbitrage risk weights most aggressively. From a financial stability perspective this finding is troubling as it smplies that the presumably more fragile banks are also most pervasively optimizing the very capital regulation designed to constrain them." 

What does that mean? That banks that are more pressured by capital constraints might act more aggressively? Is that not to be expected? 

"Third, banks with tight regulatory constraints buy riskier ABS with lower capital requirements than other banks. The ABS bought by banks that arbitrage risk weights, promise an as much as four times higher return on required capital than the ABS bought by other banks."

What does “riskier ABS with lower capital requirements” mean? ABS perceived ex ante as safer have lower capital requirements. It looks like confusing ex post realities with ex ante perceptions. 

What does ”as much as four times higher return on required capital” mean? Simply that capital requirement minimization has become more important in delivering expected risk-adjusted returns on equity than the correct analysis of risk.

My conclusion:

This paper just evidences that the most important research needed is that which explains how on earth the regulators of our banks could have come up with something so stupid as the portfolio invariant ex ante perceived risk based capital requirements for banks.

And again how these regulations distort the allocation of bank credit to the real economy remains a non-issue.

Here is a link to a brief aide memoire on some of the fundamental Basel capital requirements’ mistakes.

Brief Housing Bubble 2.0 explanation

Reference

Housing Bubble 1.0, created in part by Basel II risk-weights of only 20% to AAA rated securities backed with mortgages to the subprime sectors, exploded, and a lot of liquidity was then injected with Tarp, QEs and other means.

Much of that liquidity was channeled through banks with not much capital and which, because of lower capital requirements (risk-weights sovereign = 0% and residential housing = 35%), channeled that liquidity into financing the government (low interest rates) and housing. The SMEs and entrepreneurs, with a risk-weight of 100%, had no chance to access loans at correct risk premiums.

If there is no change we all end up in houses with mortgages, but no jobs to pay the utilities and service the mortgages with.

If a banker, I would ask: Is our bank being fooled by Basel regulators to dangerously overcrowd safe havens?

Gentlemen,

We are allowed to hold less capital against what is ex ante perceived (decreed or concocted to be safe than against what I perceived to be risky.

That, when compared to if we had to hold the same capital against any asset now permit us to expect higher risk adjusted returns on equity for what is perceived as safe than on what is perceived as risky.

To be able to earn more ROE on the safe than on the risky sounds wonderful, but it has its costs: 

First we might be willing to accept risk adjusted rates from “the safe” than might be lower than what would be the case in an undistorted market.

Second, to compensate for the above, we might be requiring “the risky”, like SMEs and entrepreneurs to pay us higher risk adjusted rates than what they would have to pay us in the case of an undistorted market, and that means we might lose out on some interesting business or otherwise make “the risky” riskier. 

If it was only our bank that had access to this regulatory distortion, then we might benefit without rocking the boat, but the fact is that the whole banking system is doing the same, and so the distortions in the allocation of bank credit to the real economy are huge.

So friends, it is clear that if we go on following the directives of our bank regulators, and basically only keep to refinancing the safer past, we are doomed to end up, sooner or later, gasping for oxygen in an overpopulated safe haven. 

And by abandoning the financing of the riskier future, we are also neglecting our duties to the real economy, and our children and grandchildren might, should, hold us accountable for that.

So what are we to do? What can we do? 

May I suggest we look into the possibility of ignoring the different capital requirements and, based of course on a sound bank diversification and portfolio management, begin, without discrimination, to look at the risk premiums offered by all, risky and safe, on an equal dollar to dollar basis.

Or, as our famous colleague Mr. George Banks once suggested, we could all go and fly a kite!