Banking before and after 1988

For about 600 years, before 1988, the exposures of banks to assets were a function of the by bankers ex-ante perceived risks (bpr), the risk premiums (rp), and bankers’ risk tolerance (brt) 

Pre 1988 Bank exposures = f (bpr, rp, brt)

Bank capital (equity) followed the rule of "One for all and all for one".

After 1998, Basel Accord, soon 30 years, with the introduction of the risk weighed capital requirements, the exposures of banks to assets are a function of the by bankers ex-ante perceived risks (bpr), the risk premiums (rp), bankers’ risk tolerance (brt), and regulatory capital requirements (rcc), this last itself a function of the by regulators ex-ante perceived (or decreed) risks (rpr) and the regulators' risk tolerance (rrt)

After 1988 Bank exposures = f (bpr, rp, brt, rcc=f (rpr, rrt))

Anyone thinking banking remained the same after 1988 is either naïve or dumb.

Anyone thinking the allocation of bank credit to the real economy was not distorted by this, is dumb.

Anyone thinking that distorting bank credit to the real economy is not something very risky, is either ignorant or a populist technocrat suffering from excessive hubris.

Anyone thinking that distorting bank exposures this way make banks safer, is an ignoramus who has no idea about what bank crises are made of: namely unexpected events, criminal doings and what was ex ante perceived as very safe but that ex post turned out very risky.

Anyone thinking this does not promote inequality has no idea of what the opportunity to bank credit does to fight it 

PS. With respect to the perceived risks, both the bankers’ and the regulators, let me remind you that any risk, even if perfectly perceived, causes the wrong actions if excessively considered; something here done by design.

Since bank regulators in 1988 decreed sovereign debt to be risk free, the market has not set the risk-free rates

In the discussion by Lawrence Summers and Adair Turner on secular stagnation in the Institute of New Economic Thinking INET, on October 28, I extract the following:

15:25 Lord Adair Turner

“The longer we have the slow growth and sub-target inflation, the more you have to think that there is something secular is at work. And the thing that makes me pretty sure that Larry is right in his hypothesis that something secular is at work, is to look at the 30, not the 10 year trend, but the 30 year trend, in real risk-free interest rates. 

Take UK’s 10 year yields on real index linked gilts. 

Take an average for each five year period, from 86-90, 91 to 95 and so six of those 5 year periods until the last

And the sequence is 3.8%; 3.6; 2.5%; 1.9%; 1.2%; minus 0.6%, and the value is now minus 1.5%. 

When you see a trend like that you begin to think that there may be something secular, petty strong, about that; with a dramatic fall even before the 2008 crisis, so you can’t put all this down to central bank intervention, quantitative easing.

So we seem to have entered a world where savings and investments only balance at very low or negative real interest rates. And of course those very low interests rates themselves, played a role in stimulating the excessive private credit growth which landed us with the debt overhang. 

But despite this those low interest we have low growth and below target inflation, and so it is vital we try work why is this… 

17:58 Well logically, the long term decline in real interest rates must mean that we have faced over the last 30 year either:

an increase in the ex ante desired aggregate global saving rate 

or a decline in the ex ante desired or intended global investment rate 

or a mix of both.”

Lord Adair Turner, the former chairman of the Financial Service Authority, FSA (2008-2013), and therefore supposedly a technocrat well versed in bank regulations, had not a word to say about: 

That extraordinary moment when, after about 600 years of “one for all and all for one” capital in banking, in 1988, with the Basel Accord, Basel I, regulators introduced risk weighted capital requirements for banks and, to that purpose, set the risk weight for the sovereign at 0%, while the risk weight for We the People was set at 100%.

That of course signified an extraordinary regulatory subsidy of sovereign debt, that had to set the UK’s 10 year yields on real index linked gilts, on a negative path.

From that moment on, since the regulators had decreed sovereign debt to be risk free, we can no longer really hold the market, using public debt as a proxy, can provide a reliable risk free rate estimate.

For now those artificially decreed risk-free rates can only go down and down and down… until BOOM!

The low “real” public debt interests might be the highest real rates ever, in that these regulations also make banks finance less the riskier, like SMEs and entrepreneurs, those who could provide us with our future incomes, and therefore governments with its future tax revenues.

With risk weighted capital requirements, Basel Committee’s regulators fed the banking system brutish misinformation

If you have $100.000 to invest you might invest more and at a lower interest rate in what you perceive as safe, as compared to how you would invest in what you perceive as risky. But, even so, you would never ever think of your $1 invested in what you perceive as safe, to be any different than the $1 you have invested in what you perceive as risky. 

That is not the current case with banks. With the risk weighed capital requirements for banks, they have been told that $1 invested in what is perceived as safe, is worth much more than $1 invested in what’s is perceived as risky. That because regulators allow banks to leverage the former $1 much more than the latter; which means that $1 invested in what is ex ante perceived, decreed or concocted as safe, produce the banks a much higher expected risk-adjusted return on equity, than $1 invested in what is ex ante perceived or decreed as risky.

For instance Basel II, with its 8% basic capital requirement set a 20% risk weight for AAA rated private assets and 100% risk weights for unrated SMEs. That allow banks to leverage their equity, and the support they received from society 62.5 times with AAA rated assets and only 12.5 to 1 with loans to SMEs. That resulted into that for a bank to lend to a SME, as compared to lending to an AAA rated borrower, carried the cost of 50 times lesser leverage opportunities.

That signified that banks, in order to keep shareholders happy with high risk adjusted returns, and management bonuses high, had to keep to what was perceived as safe and abandon lending to what was perceived as risky.

So banks no longer finance the “riskier” future, they only refinance the “safer” past.

So banks are dangerously overpopulating safe havens and, for the real economy, dangerously underexploring riskier bays.

So banks are gladly financing those “safe” basements where jobless kids can live with their parents, and not those “risky” SMEs that stand a chance to create the jobs that could allow the kids to afford to become parents too. 

Damn those regulators who manipulated and still are manipulating the allocation of bank credit this way. They should be shamed and banned forever.

P.S. Washington Post. December 2018: “Affordable homes or houses as investment/retirement assets?”

The almost 600 year long history of banks changed dramatically, for the worse, in 1988, with the Basel Accord.

If we use the Medici Bank as the first bank, it was established in 1397. From there on, until 1988, a bank’s capital (equity) followed the simple “one for all and all for one” principle. 

Then with the Basel Accord, Basel I, the regulators introduced risk weighted capital requirements for the banks. More ex ante perceived risk more capital – less risk less capital. That had serious and non-transparent consequences for the borrowers, for the economy, for bank stability and for the balance between the government and We the People.

It promoted inequality among the borrowers:

The ex ante perceived “risky” borrowers, those who precisely because of those perceptions, already got less credit and had to pay higher interest rates, now also had to face the costs of generating higher capital requirements for banks; while the ex ante perceived “sage” borrowers, those who precisely because of those perceptions, already got more credit and had to pay lower interest rates, now also received the subsidy of generating lower capital requirements for banks.

It stopped the economy to move forward, so it stalls and falls

Banks, because of the higher leverage allowed with assets perceived as safe, obtained higher expected risk adjusted returns on equity when financing, the “safe” than when financing the “risky”, like SMEs. The new regulations stopped banks from financing the riskier future and mostly dedicate themselves to refinance the safer past and present. They now finance safe basements where jobless kids can live with parents, but not the SMEs that could get the kids jobs.

It destabilized the bank system.

By assigning ultra low capital requirements for what was perceived as safe it caused the dangerous overpopulation of “safe havens”, like the AAA rated securities built-up with lousy mortgages to the subprime sector… and against very little capital.

It brought in statism thru the bathroom window.

Risk weights of 0% for the Sovereign and 100% for We the People, expresses unabridged statism in that it, de facto, implies regulators think government bureaucrats are able to use bank credit better than SMEs and entrepreneurs.

Just try to imagine what the Médicis would have said about assigning a 0% risk weight to the Sovereign?

PS. “Assets for which bank capital/equity requirements were nonexistent, were what had the most political support; sovereign credits. A ‘leverage ratio’ discouraged holdings of low-return government securities” Paul Volcker

PS. Here's a more extensive aide memoire on some of the monstrosities of such regulations

Regulators make banks finance “safe” basements where young can live with their parents, not the risky jobs they need.

Ever since regulators introduced credit risk weighted capital requirements for banks, these are not financing sufficiently the "riskier" future, only refinancing excessively the "safer" past and present.

For instance, the risk weight of 35% when financing “safe” houses, and of 100% when financing “risky” SMEs, results only in the building of basements where the young can live with their parents, and not in the creation of the new generation of jobs the young need.

Here's an aide memoire on the monstrous mistakes of such capital requirements.

P.S. Washington Post. December 2018: “Affordable homes or houses as investment/retirement assets?”

Why I distrust governments so much, and about which the World Bank and IMF could do a lot.

Sir, as a Venezuelan, I of course distrust completely any government that thinks it can manage, on behalf of its people, 97% of the country’s exports, better than what each citizen could manage his per capita share of the net revenues from those exports. 

But the following comment has to do with a completely different issue and that applies to many more countries than my own, namely: I entirely distrust governments that can allow bank regulators to do what they have done... Here's a short summary of it:

Without defining the purpose of the banks, in a way with which governments and We the People could agree on, the regulators decided that the only role of banks was not to fail. To be a safe mattress in which you could stash away cash. For instance, how they allocated credit to the real economy, did not matter. “A ship in harbor is safe, but that is not what ships are for.” John A Shedd, 1850-1926

Then in order to keep banks from failing, without absolutely no empirical research on what makes banks and bank systems fail, they proceeded to impose credit risk weighted capital requirements on banks. More ex ante perceived risk more capital – less risk less capital.

Sheer lunacy! This seriously distorted the allocation of bank credit to the real economy, overpopulating “safe” havens like AAA rated securities and sovereigns like Greece, and for the real economy dangerously underexploring risky but perhaps productive bays, like SMEs.

These regulations, since implemented, have certainly hindered millions of SMEs and entreprenuers to have access to credit who otherwise would have been awarded by banks. No wonder QEs, fiscal deficits and low interests, fail to stimulate the economy.  Now banks finance “safe” basements where jobless kids can live with their parents, but not the risky SMEs, those that could create the jobs that could allow the kids to also become parents themselves.

And all for no good stability purpose at all. Just an example, the risk-weight for the dangerous AAA to AA rated corporate was set to 20%, while that for the absolutely innocuous below BB- rated was determined to be 150%. Motorcycles are clearly riskier than cars, which is why, having the choice of transport, so many more people die in car accidents. “May God defend me from my friends, I can defend myself from my enemies” Voltaire.

To top it up with these regulations the bank regulators helped to decree inequality

So World Bank and IMF, could I at least trust you to take up this with all finance ministers present during the meetings in October 2016? I have asked it of you many times before, but until now, nothing, zilch, nada.

PS. Here is a link to a somewhat expanded description of the horrors of the Basel Committee’s risk weighted capital requirements for banks.

Per Kurowski

@PerKurowski

A former Executive Director of the World Bank (2002-2004)

http://subprimeregulations.blogspot.com

http://perkurowski.blogspot.com

Greenspan never understood the distortions in credit allocation the risk weighted capital requirements for banks caused

Fed chairman Alan Greenspan in January 2004 said: “There are several developments, however, that I find worrisome…The first is that yield spreads continue to fall. As yield spreads fall, we are in effect getting an incremental increase in risk-taking that is adding strength to the economic expansion. And when we get down to the rate levels at which everybody is reaching for yield, at some point the process stops and untoward things happen. The trouble is, we don’t know what will happen except that at these low rate levels there is a clear potential for huge declines in the prices of debt obligations such as Baa-rated or junk bonds.”

This is clear evidence Greenspan did not understand much of the distortions produced by the risk weighted capital requirements for banks.

The reality was that as “yield spreads continue to fall” banks reached out for those yields with which they could most leverage their equity with; not “Baa-rated or junk bonds” but AAA rated securities.

Bonds perceived ex ante as junk never ever signify a danger to the bank systems

Here is an aide mémoire