Willful (or naive) blindness of epical proportions, reigns in the world of the Basel Committe’s bank regulations

Note: The following comments have been inspired by beginning to read Margaret Hefferman’s “Willful Blindness”

To agree with bank regulations for which the regulators have not even defined the purpose of the banks they regulate… is that not an act of willful (or naive) blindness?

To agree with bank regulations that look to hinder banks to hold assets ex ante perceived as risky, when these kinds of assets have never created a bank crisis… is that not an act of willful (or naive) blindness?

To agree with bank regulations based on perceived credit risks, when obviously what matter are unexpected events or not perceived credit risks… is that not an act of willful (or naive) blindness?

To believe that you could place so much decision power into the hands of some few human fallibe credit rating agencies, without intriducing a systemic risk of gigantic proportions… is that not an act of willful (or naive) blindness?

Not seeing that allowing banks to leverage their equity, and the support they receive from society differently, with different assets, will produce a serious distortion in the allocation of bank credit to the real economy… is that not an act of willful (or naive) blindness?

Not seeing that curtailing the access to bank credit of the risky, more than it is already curtailed increases inequality… is that not an act of willful (or naive) blindness?

Not seeing that future generations will be affected by denying them the risk-taking that brought current generation to where its at… is that not an act of willful (or naive) blindness?

Not understanding that banks, if allowed to use their own risk models to set their capital requirements will lower these so as to maximize their expected risk adjusted returns on equity… is that not an act of willful (or naive) blindness?

Believing that some Basel I and II regulators who were totally surprised by the 2007/08 crisis have it in them to fix it with a Basel III… is that not an act of willful (or naive) blindness?

To believe that a 2007/08 crisis and the following stagnation can be cured by just throwing QEs, fiscal deficits and low interest rates at it… is that not an act of willful (or naive) blindness?

And the list of questions related to current bank regulations that gives ground to believing willful acts of blindness takes place goes on and on and on… and I might add some with time after finishing the book that inspired this. 

PS to Financial Times: To receive thousands of letters on these problems from someone that has been showned right on many letters previously published… is that not an act of willful (not naive) blindness?

12 years after Basel II, ECB sees faults in risk weighted capital requirements for banks, but still doesn’t get it

ECB has published a document titled “The limits of model-based regulation” ECB Working Paper 1928, July 2016. In it the authors find that risk-weighted capital requirements based on sophisticated models applied by big banks, are basically dangerous and worthless.

Of course that regulation is worthless, it does not serve any useful purpose, and only increases the probabilities of financial instability.

But from its “Non-technical summary” it is harrowing to see that they still do not fully understand why these risk weighted capital requirements are dangerous; not only for the big banks with their models, but also for the smaller that apply the standard approach risk weights declared by the Basel Committee; and also, primarily, for the real economy.

For a starter it declares: “In recent decades, policy makers around the world have concentrated their efforts on designing a regulatory framework that increases the safety of individual institutions as well as the stability of the financial system as a whole.”

And so the first observation is: Who gave policy makers the right to concentrate on designing a regulatory framework that completely ignores whether the allocation of bank credit to the real economy is efficient or not? Is the real economy to serve banks or are the banks to serve the real economy? “A ship in harbor is safe, but that is not what ships are for.” John A Shedd, 1850-1926 

Then it states: “an important innovation has been the introduction of complex, model-based capital regulation that was meant to promote the adoption of stronger risk management practices by financial intermediaries, and ultimately to increase the stability of the banking system”... “banks that opted for the introduction of the model-based approach experienced a reduction in capital charges and consequently increased their lending by about 9 percent relative to banks that remained under the traditional [standard risk weights] approach”... “Back-of-the-envelope calculations (abstracting from risk-based pricing of the cost of capital) suggest that underreporting of PDs allowed banks to increase their return on equity by up to 16.7 percent”

How come regulators believed the adoption of “stronger risk management practices by financial intermediaries” would trump the maximization by banks of their risk-adjusted returns on equity? This is like given children a book with indication of calories and expecting them to stay away from the chocolate cake. Worse, in the case of the big banks applying their internal models, it was like allowing the children to calculate on their own the calories of the chocolate cake they desire. How mind-boggling naive are regulators allowed to be?

From the conclusion “Certainly, one would expect less of a downward bias in risk estimates if model outputs were generated by the regulator and not the banks themselves” one could believe the authors favor the standard approach risk weighting. 

Of course that is better than the sophisticated modelling by the big banks, which only guarantees Too Big To Fail Banks. But the all the principal faulty characteristics of the whole risk weighting process remain intact even then... and are still ignored:

Like why basing capital on ex ante perceived credit risks, when all major bank crises have resulted either from unexpected events or excessive exposures to what was ex ante perceived as safe?

Like why if banks by the size of the exposures and interest rates already clear for perceived risk, should they also be cleared for in the capital? Do not regulators understand that any risk, even if perfectly perceived, leads to the wrong actions if excessively considered?

Earlier, on the same issue

And like so many other whys?

Luckily credit rating agencies got it wrong and put a temporary stop on it. Otherwise we would have been much worse off

Few can really evidence having warned so much against the use of credit rating agencies in bank regulations, as I can. So I believe that should give me the right to dare to opine that the fact that the credit rating agencies got it wrong, was and is not the worst part of the current bank regulation horror story.

As for examples of the first, in January 2003 the Financial Times published a letter in which I wrote: “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, as an Executive Director of the World Bank, in April 2003, at its Board I formally stated: “Ages ago, when information was less available and moved at a slower pace, the market consisted of a myriad of individual agents acting on limited information basis. Nowadays, when information is just too voluminous and fast to handle, market or authorities have decided to delegate the evaluation of it into the hands of much fewer players such as the credit rating agencies. This will, almost by definition, introduce systemic risks in the market and we are already able to discern some of the victims, although they are just tips of the icebergs.”

And of course, when then the credit rating agencies later messed it up, and got it so amazingly wrong with the AAA rated securities backed with truly lousy mortgages to the subprime sector, it was a real disaster. But, I tell you, it could have been much worse, like if they had rated correctly for a much longer period.

The reason for that lies in the malignant error of the Basel Committee’s risk weighted capital requirements for banks; more ex ante perceived credit risk more capital – less risk less capital.

Perceived credit risk is the risk most cleared for by banks; they do so by means of interest rate risk premiums and size of exposures. And so when regulators decided to clear for exactly the same risk, now in the capital, that perceived credit risk got to be excessively considered. And any risk, no matter how correctly it is perceived, if it is excessively considered, will cause the wrong actions.

For instance banks were (and are) allowed to leverage much more when financing the purchase of residential houses, or when investing in AAA rated securities backed with mortgages, “The Safe”, than what they are allowed to leverage when lending to the core of the bank credit needing part of the economy, the SMEs and entrepreneurs, those who help create the new generation of jobs, “The Risky”.

And that has resulted in that banks earn much higher expected risk adjusted returns on The Safe than on The Risky; which results banks will finance much more The Safe than The Risky.

So, had it gone on (oops it still goes on) we will all end up in houses with no more houses to be built, and without that new generation of jobs that could help us, or foremost our children and grandchildren, to service mortgages and pay utilities.

So let’s be thankful the credit rating agencies got it wrong, but, please, let us also correct for the regulators' mistakes. Thinking on my grandchildren, I would in fact prefer lower capital requirements for banks when financing unrated SMEs and entrepreneurs than when financing the purchase of a house.

But how did this happen and how could it have been avoided.

Well perhaps it would have been nice if the regulators, before regulating the banks ,had defined their purpose. Then perhaps John A. Sheed’s “A ship in harbor is safe, but that is not what ships are for”, could have come to their mind.

And also it would have been nice if the regulators had done some empirical research on what causes bank crisis; and then they would have discovered that never ever excessive exposures to what is perceived as risky; and then they might have thought of Voltaire’s “May God defend me from my friends [AAA rated]: I can defend myself from my enemies [the unrated]”

If ever allowed, the following would be my brief testimony about what caused the 2008 bank crisis

The following, if I am ever allowed to give it, as so many would not like to hear it, would be my brief testimony on what caused the 2008 bank crisis 

Sir, as I have learned to understand it, the 2008 crisis resulted from a combination of 3 factors.

The first were some very minimal capital requirements for some assets that had been approved, starting in 1988 with Basel I, for sovereigns and the financing of residential housing; and made extensive in Basel II of 2004 to private sectors assets with good credit ratings.

These allowed banks then to earn much higher expected risk adjusted returns on equity on some assets than on other, which introduced a serious distortion. After Basel II the allowed bank equity leverages were almost limitless when lending to “sound” (or friendly) sovereigns; 36 times to 1 when financing residential housing; and over 60 to 1 with private sector assets rated AAA to AA. Just the signature, on some type of guarantee by an AAA rated, like AIG, also allowed an operation to become leveraged over 60 times to 1. 

The second was Basel II’ extensive conditioning of the capital requirements for banks to the decisions of some very few (3) human fallible credit rating agencies. As I so many times warned about (in a letter published in FT January 2003 and even clearer in a written statement at the World Bank) this introduced a very serious systemic risk.

The third factor is a malignant element present in the otherwise beneficial process of securitization. The profits of that process are a function of how much implied and perceived risk-reduction takes place. To securitize something safe to something safer does not yield great returns for the securitization process. Neither does to securitize something risky into something less risky. 

What produces BIG profits is to securitize something really risky, and sell it off as something really safe. Like awarding really lousy subprime mortgages and packaging them in securities that could achieve an AAA rating. A 11%, 30 years, $300.000 mortgage, packaged into a security rated AAA and sold at a 6 percent yield, can be sold for $510.000, and provide those involved in the process an instantaneous profit of $210.000

With those facts it should be easy to understand the explosiveness of mixing the temptations of limitless, 36, and more than 60 to 1 allowed bank equity leverages providing huge expected risk adjusted ROEs; with subjecting the risk-assesment too much to the criteria of too few; with the huge profit margins when securitizing something very risky into something “very safe”. Here follows some indicative consequences:

As far as I have been able to gather, over a period of about 2 years, over a trillion dollars of the much larger production of subprime mortgages dressed up in AAA-AA ratings, ended up only in Europe. Add to that all the American investment banks’ holdings of this shady product.

To that we should also add Europe’s own problems with mortgages, like those in Spain derived in much by an excessive use of “teaser interest rates”, low the first years and then shooting up with vengeance.

And sovereigns like Greece, would never have been able to take on so much debt if banks (especially those in the Eurozone) would not have been able to leverage their equity so much with these loans.

Without those consequences there would have been no 2008 crisis, and that is an absolute fact.

The problem though with this explanation is that many, especially bank regulators, especially bank bashers, especially equity minimizing bankers, especially inattentive finance academicians, especially faulty besserwissers (those who love the sophisticated taste of words like "derivatives"), they all do not like this explanation, so it is not even discussed.

The real question though is: Who is the guiltiest party, those who fell for the temptations, or those who allowed the creation of the temptations?

I mean how far can you go blaming the children from eating some of that deliciously looking chocolate cake you left on the table, at their reach?

PS. Please do not categorize misregulation as deregulation. 

PS. A 2008 GFC tweet summary:
The pushers: Those harvesting mortgages in subprime fields; packaging these in MBS and getting rating agencies’ enthusiastic thumbs up.
The addicts: The banks
The drug, the hallucinogen: The Basel Committee's ultra-low bank capital requirements. 

PS. Here's a letter published by the Washington Post, December 2009

P.S. Here’s a 2010 YouTube explanation

PS. Here is a current summary of why the risk weighted capital requirements for banks, is utter and dangerous nonsense.

PS. And here is my letter to the Financial Stability Board that was officially received. Will it be answered?

Here follows my linked four tweets to bank regulators

The ex post risk of Basel Committee’s bank capital requirements, based on models based on ex ante risk perceptions, is huge!

All these capital requirements do is to seriously distort the allocation of bank credit to the real economy, for no good purpose at all.

Bank capital requirements should be based on ex post risks that considers the risks of models based on ex ante risks perceptions.

Mario Draghi, Mark Carney, Stefan Ingves, Janet Yellen, Martin Gruenberg...  Capisci?

Here is conclusive evidence of that current bank regulation experts, dangerously, do not know what they are doing

The risk-weight the regulators assigned in Basel II to those corporates (private sector) rated AAA to AA was 20%; and to those rated below BB- one of 150%

That might have been a correct reflection of the ex ante risks of the AAA to AAA and the below BB- rated failing but, it is definitely not the risk for banks conditioned on the bankers having seen and acted upon those perceived risks.

That is: what are the real risks considering the risks that are perceived?

That is: motorcycles are very risky, that’s why so many more people die in accidents of the safer cars.

That is: clearly the below BB- rated do not pose danger for the banking system while the AAA to AA rated to which banks could build up excessive exposures definitely do.

In other words the bank regulators assumed bankers did not perceive credit risks at all, that bankers were totally blind, and so that they, the regulators, had to shoulder that whole responsibility.

That completely distorted the allocation of bank credit to the real economy, something that represents huge dangers for the banking system and for the health of the rest of the real economy.

This amazing incompetence of the regulators, mostly of the Basel Committee and the Financial Stability Board, has remained unquestioned by most experts. Could that be because they are all suffering from an excessive confidence in fellow experts, or could it be because of what John Kenneth Galbraith once said: “If one is pretending to knowledge one does not have, one cannot ask for explanations to support possible objections.”?

You tell me!

PS. Here a more extensive aide mémoire on the horrors of current risk weighted capital requirements for banks

When and where did the last bank crisis resulting from excessive exposures to something ex ante believed risky occur?

I don't know. Ask the regulators in the Basel Committee on Banking Supervision and the Financial Stability Board. 

I mean they must have much data on this because, without it, why would they impose credit risk weighted capital requirements for banks, knowing that carried the huge cost of distorting the allocation of bank credit to the real economy?

I mean that if they use the theorem that what's perceived as risky is riskier to the bank system than what is perceived as safe, then they are indeed using a loony theorem.

Or did they not look for the data?  Or did they not understand it?

Dumb G20 ministers reiterated in Hangzhou their support of the inept Basel Committee on Banking Supervision (BCBS)

We read in the “G20 Leaders’ Communique Hangzhou Summit”

“We reiterate our support for the work by the Basel Committee on Banking Supervision (BCBS) to finalize the Basel III framework by the end of 2016, without further significantly increasing overall capital requirements across the banking sector, while promoting a level playing field”

Clearly the Ministers did not dare to ask the regulators some minimum minimorum questions like:

What do you believe is the purpose of banks? Should it not have something to do with what like John A Shedd opined: “A ship in harbor is safe, but that is not what ships are for” 

If the purpose of the banks includes that of allocating credit efficiently to the real economy, why then do you distort that with risk weighted capital requirements for banks?

Can you indicate us one single bank crisis derived from excessive exposures to what was perceived as risky when incorporated to the balance sheets of banks? Voltaire said “May God defend me from my friends. I can defend myself from my enemies”. 

So, could that lack of questioning by the ministers be explained by John Kenneth Galbraith’s “If one is pretending to knowledge one does not have, one cannot ask for explanations to support possible objections”?

Frankly, neither Hollywood nor Bollywood, would insist in supporting the work of someone producing such Basel I-II flop, as the 2007/08 crisis and the thereafter continued stagnation evidences.

PS. Here is a short aide memoire on some of the monstrous regulatory mistakes

The Basel Committee imagined a theorem that allowed it to intervene in the allocation of bank credit

In Deirdre Nansen McCloskey’s “Bourgeois Equality” we read:

“Economists collect Nobel Prizes for imagining in existence theorems of this or that ‘market failure’, which they never show are important enough to justify utopian schemes of state intervention” 

Precisely what I argue is also the case when: 

Regulators imagined that what was perceived ex ante as risky, was risky for banks. 

With this theorem they justified imposing risk weighted capital requirements for banks; more perceived risk more capital – less risk less capital. 

Or, with this theorem they gave in to the banks’ wishes of being able to leverage their capital much more; like if the asset had an AAA to AA rating, a mindboggling 62.5 times to 1 

They did so without even trying in the least to ascertain if that theorem was true; something which it is definitely not. 

What are risky for the bank system are unexpected events; and that which precisely because it is perceived as safe, could,generate dangerous excessive financial exposures. 

That regulation distorted completely the allocation of bank credit to the real market; but perhaps that was what some statist regulators wanted, since the risk weights they assigned to We the People was 100%, while that of the Sovereign was set at 0%.

PS. Here an aide memoire on some of that regulatory monstrosity

The Basel Committee injected cowardice into our bank system and doomed us all to doom and gloom.

In 1988 with the Basel Accord, Basel I, and then in 2004, with Basel II, the Basel Committee on Banking Supervision introduced risk-weighted capital requirements for banks. More perceived risk more capital – less risk less capital.

That allowed banks to leverage their equity more with what was perceived, decreed or concocted as safe, than with what was risky. That allowed banks to earn higher expected risk adjusted returns on equity when lending to The Safe, the government, housing and the AAArisktocracy than when lending to The Risky, like SMEs and entrepreneurs.

Just look at these risk weights: Sovereign = 0%, AAArisktocracy = 20% and We the People = 100%

That effectively injected cowardice into the banking system, which prevents it from allocating credit efficiently to the real economy.

There is no chance in hell capitalism can function and deliver anything good with such regulations… the regulators doomed us all to doom and gloom.

And all for nothing! There has never been a major banking crisis that has resulted from excessive financial exposures assets perceived as risky when incorporated to banks’ balance sheets. These always result from unexpected events or from excessive exposures to something erroneously perceived as safe.

And the saddest part is that this regulatory distortion is not even acknowledged, much less discussed.

Six easy questions that bank regulators should answer

Here some questions that need to be asked urgently at the Financial Services Committee 

What do you believe is the purpose of banks? Should it not have something to do with what like John A Shedd opined: “A ship in harbor is safe, but that is not what ships are for” 

If it includes to allocate credit efficiently to the real economy, why then do you distort that with risk weighted capital requirements for banks?

Voltaire said “May God defend me from my friends. I can defend myself from my enemies”. And so why do you base your capital requirements on what the bank perceives and not on what it has less chance to perceive?

Why do you give the AAA–AA rated a risk weight of 20% and the below BB- rated one of 150%? Do you really believe bankers could create excessive dangerous exposures to what ex ante was perceived as below BB-rated?

Why must the bank in my state hold more capital when lending to a local SME or entrepreneur, than when lending to, for instance, the German government?

By the way, is not the risk weights of Sovereign = 0% and We the People = 100%, an outrageous example of a runaway statism?

Why do you want to impose risk aversion in the Home of the Brave?