There are three causes for major bank crises. Regulators focused on one that’s not. Basel Committee & FSB... Good Job!

What are the causes of major bank crises?

1. Unexpected events, like major devaluations and natural disasters.

2. What was ex ante perceived as very safe turned out ex post to be very risky.

3. Shenanigans like unauthorized speculative trading or banks lending to their own directors or shareholders.

What did the regulators do? 

They introduced credit-risk-weighted capital requirements: more ex ante perceived risk more capital - less risk less capital... clearing agains for basically the only risk that was already being cleared for, by means of size of exposure and interest rates.

For instance, prime AAA to AA rated got 20% risk weight ,while the highly speculative almost broke below BB- rated, got a 150% risk weight...

As if banks would ever build up dangerous excessive exposures to what is below BB- rated 

Good job regulators!

PS. Here is more on that

The Basel Committee, Financial Stability Board and other frightened risk adverse bank nannies, they mandated stagnation.

When you allow banks to hold less capital when financing what’s perceived as safe than when financing the risky; banks earn higher expected risk adjusted returns on equity when financing the safe than when financing the risky; and so you are de facto instructing the banks to stop financing the riskier future and keep to refinancing the safer past… something which guarantees stagnation… a failure to develop, progress or advance… something which guarantees lack of employment for the young and retirement hardships for the old. 

I would prefer not to distort the allocation of bank credit but, if I had to, then I would try to ascertain that bank credit goes to where it could do the society the most good; in which case I would consider basing these on job creation ratings and environmental sustainability ratings, and not on some useless credit ratings already cleared for by banks with the size of their exposures and interest rates.

PS. If you want more explanations on the statist and idiotic bank regulations that are taking our Western society down, here is a brief aide memoire.

PS. If you want to know whether I have any idea of what I am talking about, here is a short summary of my early opinions on this issue since 1997.

Mr R Gandhi, ignore the Basel Committee’s mutual admiration club, and concentrate on the needs or your India.

Mr R Gandhi, Deputy Governor of the Reserve Bank of India, at the FIBAC 2016 in a speech titled “New horizons in Indian banking”, Mumbai, 17 August 2016 said the following: 

“I regret that at the very end of these two days deliberations on future of banks, I have to paint such a dismal future for your existence as banks….One big area, you vacated and / or let others to occupy by your lackluster attitude is there for your rightful reclaim, if only you make concerted and conscious effort. That is SME financing. Small and medium sized enterprises (SMEs) are a major, yet often overlooked sector by formal financial institutions. The SMEs reportedly account for more than half of the world’s gross domestic product (GDP) and employ almost two-thirds of the global work force. However, they are the neglected lot world over. As reported by the International Financial Corporation (IFC), a “funding gap” of more than $2 trillion exists for small businesses in emerging markets alone...

I can only conclude with the idea that if you make yourself socially relevant, not just relevant in economic sense alone, you can have hopes to exist”

Holy moly. unless Mr R Gandhi is simply thickheaded and does not understand, he should be ashamed of trying to blame the banks for this ignoring his own responsibilities as a regulator.

Who told banks to get out of SME financing? The bank regulators did; by requiring banks to hold much more capital when lending to SMEs than when lending to those perceived as safer. That made it difficult for banks to earn competitive risk adjusted returns on equity lending to the SMEs.

Who made banks socially irrelevant? The bank regulators did, by regulating banks without ever having defined their purpose… like that of allocating credit efficiently to the real economy.

And since risk-taking is the oxygen of any development, a developing country like India is one of those who could least afford to introduce regulatory risk aversion. Not as if those developed can either, but at least they have reached higher altitudes before starting to climb down their mountains.

In 2007, at the High-level Dialogue on Financing for Developing at the United Nations, I explained why the Basel regulations were harmful to development, and my opinion was even reprinted in October 2008 in the Icfai University Journal of Banking Law.

Sadly though, as happens with most central bankers and regulators from developing countries, they end up more interested in being accepted by their peers in the developed countries, and in belonging to their mutual admiration club, than in doing what is best for their own countries.

Basel Committee’s mindboggling naiveté: Banks, thou shall not misbehave and fudge to lower your capital requirements

In the “Statement on capital arbitrage transactions” Basel Committee newsletter No 18 of June 2016 we read:

“Transactions that are designed to offset regulatory adjustments employ a variety of strategies. For example, these may include: (1) the issuance of senior or subordinated securities with or without contingent write off mechanisms; (2) sales contracts that transfer insufficient risk to be deemed sales for accounting purposes; (3) fully-collateralised derivative contracts; and (4) guarantees or insurance policies. These types of transactions… can have the effect of overestimating eligible capital or reducing capital requirements, without commensurately reducing the risk in the financial system, thus undermining the calibration of minimum regulatory capital requirements.

Banks should therefore not engage in transactions that have the aim of offsetting regulatory adjustments.”

What a mindboggling naiveté! While regulators allow banks to hold less capital against assets perceived, decreed or concocted as safe, and the risk-adjusted return on equity is how banks compete for capital (and bonuses), how can they think banks will not do their utmost to lower the required equity?

PS. Children, listen to your Basel nannie, though there is ice-cream and chocolate cake in the fridge, she still expects you to eat the spinach and the broccoli.

PS. You want your children not to arbitrage and eat of everything... blend it all together.

PS.You want your banks not to arbitrage... set one capital requirements for all assets.

It is prudent for our banks to take risks on the not so creditworthy, especially if these are up to something worthy

In a recent article in the Financial Times a bank was mentioned to be “an exemplar of prudence…[because] The target loan loss ratio is zero; [and] low loan losses, in turn, allow the bank to offer competitively priced loans and personalized service to creditworthy customers.”

To me that points clearly to what’s wrong with banks nowadays. “A target loan loss ratio of zero”… might allow “to offer competitively priced to creditworthy customers” but it will clearly not offer sufficient opportunities of credit to the not so creditworthy, those which includes too many risky SMEs and entrepreneurs, but also that could help provide the proteins the economy needs to move forward, in order not to stall and fall.

And the real truth is that, in the medium and long term, the creditworthy could benefit much more by banks taking much more risks on the not creditworthy, especially if these seem to be up to something worthy, than by they just getting low priced loans.

And if to the “zero loss loan target” you then add the distortion in the allocation of bank credit caused by the risk weighted capital requirements for banks, you might get a feel for why our economies seem to stagnate. 

Those regulations require the banks to hold more equity when lending to someone perceived risky, than when lending to someone perceived safe. And so that results in banks earning higher expected risk adjusted returns on equity when lending to someone perceived, decreed or concocted as safe, than when lending to someone perceived as risky. And that signifies that, around the world, millions of “risky” SMEs and entrepreneurs are not given the opportunity they might deserve and we might need for them to get.

As is, the banking system no longer finances the “riskier” future but only refinances the “safer” past, and that is as imprudent as can be, at least for our grandchildren.

Those bankers who with reasoned audacity take chances on the future are good servants of the society. Those who only maximize return on equity by diminishing the required capital and avoiding risks are, in the best of cases, absolutely boring.

And don’t get me wrong; I do not want to endanger our banking system, it is just the opposite. The forgotten truth is that major bank crises never ever result from banks building up excessive exposures to what ex ante is perceived as risky, it is not in the nature of bankers, as Mark Twain explained in terms of sun, rain and umbrellas.

The big crises always result from unexpected event of because of excessive exposures to something erroneously considered as safe.

PS. With their risk weighted capital requirements the regulators decreed inequality.

Statist baby-boomers want us to extract all existent public borrowing capacity, leaving nothing for the future

An article by M. Barton Waring and Laurence B. Siegel titled "The Only Spending Rule Article You Will Ever Need" is introduced by Bob Dannhauser, CFA, the head of global private wealth management at CFA Institute with the following:

“Retirement portfolios can fail us in two ways: living cautiously might ‘leave too much on the table’ when our money outlasts us, but spending too much can mean running out of money before we run out of life.”

In the same way, those statist baby-boomers who scream for more debt financed government spending, taking advantage of current low borrowing rates, seem also to be doing their utmost to extract whatever public borrowing capacity they can from the current economy. You can call it placing a reverse mortgage on the economy if you want, so as to leave absolutely nothing on the table for the next generations. Our children and grandchildren will get the bill!

But, if the baby-boomers live long enough, and economic disasters result from too many bridges to nowhere being built, or just the markets catching up on the fact that even the safest haven can become dangerously over populated, then they could also end up in poverty.

Personally, since I am convinced that because of regulatory subsidies, and the use of monetary policies like quantitative easing, the current low interest rates on public debts are artificially low, I find calls for further indebtedness based on low rates to be highly irresponsible.

Moreover as statist bank regulators have decreed a 0% risk weight for the government and a 100% risk weight for We-the-risky-People, those who could really help to build future, like SMEs and entrepreneurs, are now not getting the credit our children and grandchildren need for them to get.

"Time to Borrow" August 8, 06 by Paul Krugman

Banks and regulators don’t care about our economy

Banks, regulators and risk

The Aug. 5 Economy & Business article “What happens when lines blur between banks, regulators” referred to several issues and conflicts of importance between banks and regulators but did not mention the prime point of agreement between all regulators and all banks: None of these actors cares about the state of the real economy.

Banks love to earn high-risk adjusted returns on equity when lending to something perceived as absolutely safe, so they love when regulators allow them to hold much less equity when lending to something perceived, decreed or concocted as safe.

Regulators love it when banks avoid taking risks, so they are more than happy to allow banks to hold much less equity when lending to something ex-ante perceived by them as safe, and therefore allow banks to earn much higher risk-adjusted returns on equity when staying away from the risky.

Our problem, though, is that we need for our banks to lend to the risky, such as small and medium-size enterprises and entrepreneurs, to keep our economy moving forward.

Regulators have never defined the purpose of the banks, so they do not care about whether these banks allocate credit efficiently to our real economy.

Per Kurowski, Rockville

The writer was an executive director at the World Bank from 2002 to 2004.

A letter in the Washington Post

My letters in the Washington Post on bank regulations:
September 6, 2007: Factors in the Financial Storm
June 20, 2008: An Aspect of the Bubble
December 27, 2009: Another 'worst': Faulty bank regulation
January 6, 2012: Handcuffed by a triple-A rating
May 1, 2013: An American approach to banking
December 23, 2014: Let the market rule on risky trades
November 11, 2015: Reverse-mortgaging the future
August 9, 2016: Banks, regulators and risk
April 16, 2017: When banks play it too safe
July 11, 2018: There is another tariff war that is being dangerously ignored.
December 30, 2018: Affordable homes or investment assets?
April 19, 2020: The capacity to borrow is a valuable sovereign asset.
November 28, 2022: Before the debt ceiling is lifted
August 22, 2023: The economic revolution

ECB, Single Supervisory Mechanism (SSM), with respect to banks, still pisses out of the pot; and McKinsey keeps mum

The declared supervisory priorities for 2016 of ECB's Single Supervisory Mechanism (SSM) with respect to banks are: “(i) business model and profitability risk, (ii) credit risk, (iii) capital adequacy, (iv) risk governance and data quality, and (v) liquidity”

As you can see, ECB still does not care one iota about the allocation of bank credit to the real economy. Not one single indication of trying to figure out what should be on banks’ balance sheets and is not.

And as you can see, ECB still thinks that if it only can make banks stay away from what is ex ante perceived as risky, all will be fine and dandy. It has no idea that what caused all bank crises has been, either unexpected events, like currency crises, or excessive exposures to something erroneously perceived ex ante as absolutely safe… never ever what was ex ante perceived as risky.

And leading consulting companies in the world, like McKinsey, play along and don't say a word, probably because they expect to profit hugely from the so inept bank regulators.

As far as consultancies go, bank regulations is the new piñata in town.

You want to know what I am talking about? Serve yourself a good cognac and read this.

Regulators stupidly infantilized our bankers, and so we ended up with a dangerously obese economy

Jonathan Klick and Greg Mitchell  in "Infantilization by Regulation” “Cato:Regulation” Summer 2016." write:

“With the rise of libertarian paternalism has come greater acceptance of the view that citizens often fail to act in their best interests and that it is the government’s job to put a stop to that. In this mindset, the market is a predator rather than a check on stupid mistakes. 

If the behavioral assumptions behind libertarian paternalism gain widespread acceptance among policymakers, then we should prepare for an onslaught of nudges and shoves. And every time a nudge is adopted, an opportunity for learning and individual development is lost. 

Perhaps the gains from intervention will be sufficient to justify the opportunity cost, but those costs should be included in the cost-benefit analysis. Too often only the predicted benefits are considered, while the attendant long-term costs go unseen.”

Absolutely! When regulators, even knowing that bankers already cleared for perceived risks by means of interest rates and size of exposure, told bankers they also needed to clear for the same perceived risk in their capital, they essentially infantilized bankers… in a very dumb and dangerous way.

They told the bankers: “If you eat ice cream (what’s perceived as safe) then we will reward you with chocolate cake (lower capital requirements that allows for higher leverage that allows for high risk adjusted rates of return on equity); but if you eat broccoli (what is perceived as risky) then you will also have to eat spinach (higher capital requirements that causes lower leverage that causes lower risk adjusted rates of return on equity.”

And so what have we? A debt obesity crisis that was resulted caused by excessive eating of ice cream and chocolate cake… and an economy that does not want to ignite because of the lack of the nutrients present in spinach and broccoli.

Stiglitz doesn’t understand that regulators, when doubling down on credit risk perceptions, are bullying those perceived as “risky”

Joseph E. Stiglitz together with George A. Akerlof and A. Michael Spence won the 2001 Nobel Prize in Economics "for their analyses of markets with asymmetric information". The Nobel Prize website indicates that in the case of Professor Stiglitz his contribution was to show “that asymmetric information can provide the key to understanding many observed market phenomena, including unemployment and credit rationing.”

In a 1998 paper by Thomas Hellmann and Joseph Stiglitz titled “Credit and equity rationing in markets with adverse selection” we read: "The meaning of rationing: “Those entrepreneurs who are willing to accept the higher price are rationed in the sense that they cannot obtain funds at the same price as other observationally identical entrepreneurs. Those entrepreneurs who are not willing to accept the higher price fail to receive funding in this market. Some of them may seek funding in the other market. If there is rationing in the other market too, they may fail to obtain any funding. Even if there is no rationing some of them may not find any acceptable offer in the other market, and again they are left without funding. The point is that while an outside observer may look at this environment and argue that there are many opportunities for the entrepreneur to obtain funding, it may well be that the funding that is still available comes at unacceptable terms, and the funding that has acceptable terms is rationed." 

And in his most recent book “Re-writing the rules of the American Economy” 2016, in the “Fix the Financial Sector”, Stiglitz writes “it is regrettable that almost all of the discussions of reforming the financial sector have focused on simply preventing harm on the rest of society and not in developing a financial system that actually serves our society- for instance by helping to effectively finance small business, education and housing”.

Yet in his very long and somewhat questionable what-to-do list, Stiglitz does not include getting rid of the pillar of current bank regulations, the risk-weighted capital requirements for banks, those by which regulators bully those who are usually perceived as risky borrowers.

By allowing banks to leverage more with what is safe than with what is risky, banks now earn higher risk-adjusted returns on equity when lending to the safe than when lending to the risky… with all its logical consequences.

I have read Professor’s Stiglitz cv. (boy!) and in it I find absolutely nothing that indicates he has ever walked on main-street. So most probably he therefore knows nothing about the difficulties of SMEs and entrepreneurs have to access bank credit. These borrowers, perceived as risky, quite often have to cheat, lie, or at least withhold the whole truth, or even bribe someone, in order to get the opportunity they believe can transform their lives and that of their children. 

And all those difficulties were present even before regulators told the banks that, besides clearing for ex-ante perceived credit risks by means of risk premiums and amounts of exposure, they also had to clear for the same perceived risks in the capital. 

One should expect someone that has won a Nobel Prize researching “credit rationing” to know that any perceived risk, an information, even if perfectly perceived, leads to the wrong conclusions, if excessively considered. But apparently it is not so.

The current risk weight of an unrated SME or entrepreneur, “We the people”, is 100%. The corresponding risk-weights for the Sovereign is 0%, for the members of the AAArisktocracy 20% and for the financing of houses 35%.

For instance the 100% for SMEs and the 35% for houses will cause we end up in houses without the jobs to pay the mortgages and utilities.

For instance the 0% for the sovereign and the 100% for We the People means that regulators believe government bureaucrats can use bank credit better than citizens... an outrageous statism.

Stiglitz has also aspired to a lot of fame as a champion against inequality… but, though he won the “John Kenneth Galbraith Award, American Agricultural Economics Association, August 2004” perhaps he should have included in his academic library John Kenneth Galbraith’s “Money: “whence it came, where it went” (1975). There on job creation and fighting inequality we read:

“For the new parts of the country [USA’s West]… there was the right to create banks at will and therewith the notes and deposits that resulted from their loans…[if] the bank failed…someone was left holding the worthless notes… but some borrowers from this bank were now in business...[jobs created] 

It was an arrangement which reputable bankers and merchants in the East viewed with extreme distaste… Men of economic wisdom, then as later expressing the views of the reputable business community, spoke of the anarchy of unstable banking… The men of wisdom missed the point. The anarchy served the frontier far better than a more orderly system that kept a tight hand on credit would have done…. what is called sound economics is very often what mirrors the needs of the respectfully affluent.

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.”

Professor Stiglitz was the Chairman in the Commission of Experts of the President of the UN General Assembly on Reforms of the International Monetary and Financial System 2008 and 2009.

And, during the 2007 High-level Dialogue on Financing for Developing at the United Nations, from the perspective of the developing nations, I protested this regulatory risk aversion but no one really wanted to listen. 

And so when it all came down to the conclusions of the UN Conference Crisis & Development I suffered great disappointments.

I have said before and I repeat it again and again. Nobel Prizes should be recallable, especially if they are used for uttering opinions on matters the winners have no idea about… like bank regulations and Main Streets. Besserwissers from mutual-admiration-group-thinking-clubs monopolizing discussions, are just too costly for the future of our kids and grandchildren