Mercatus Center, in order to reframe financial regulations, you must dig in much deeper into the current mistakes.

I refer to “Reframing Financial Regulation: Enhancing Stability  and Protecting Consumers” 2016, by the Mercatus Center at George Mason University, and edited by Hester Peirce & Benjamin Klutskey.

The book includes many wise suggestions but, since it does not seem to capture how incredibly faulty current regulations really are, it has gaps that make it more difficult to understand how sensitive the financial system, primarily banks, and the real economy as such, is to the process of implementing a “reframing”.

For brevity and because my main reservations with current financial regulations have to do with the issue therein discussed, I will limit my comments to Chapter 1: Risk-Based Capital Rules by Arnold Kling.

The author writes: “Risk-based capital rules dramatically affect the rate of return banks earn from holding different type of assets. Regardless of the intent of these rules they strongly influence capital allocation in the economy.”

That is correct, although referring to the ex-ante expected risk adjusted returns on equity would be more precise.

Then the author states: “They substitute even crude regulatory judgment for individual bank discretion and market mechanism”. 

That is not entirely correct. The real problem is that since banks already clear for ex ante perceived risks, when setting interest rates and the amount of their exposures, that regulators also use basically the same ex ante risk perceptions for determining the capital requirements, means that “ex-ante perceived risks”, will be doubly considered. What regulators missed entirely, is that any risk, even if perfectly perceived, will cause the wrong actions, if excessively considered.

The book identifies partly what the distortion in the allocation of bank credit could do to the safety of banks, but what it most misses to comment on, is what the risk weights actually calculated and used, really meant and mean to the allocation of bank credit to the real economy. 

For instance Basel I, 1988, applied to the United States, set the risk weight of 0 percent for US Treasuries; 20 percent for claims to for instance local governments; 50 percent when financing residential properties and revenue bonds; and 100 percent all other claims on private obligors.

0% risk weight for the sovereign? If that’s not in runaway statism what is? De facto it implies that regulators consider government bureaucrats will give better use to bank credit than the private sector.

In 2001 the Federal Reserve Board, the Office of the Comptroller of the Currency and the FDIC set the following risk weight depending on credit rating; AAA to AA 20 percent; A 50%; BBB (the lowest investment grade) 100 percent; and BB (below investment grade) 200%.

If that’s not runaway stupidity what is? The regulators really seem to have thought (and think) that assets perceived as extremely risky, are more dangerous to the bank system than assets perceived as safe. As if they never heard of Mark Twain’s “A banker lends you the umbrella when the sun shines and wants it back when it looks it could rain”; as if they never heard of Voltaire’s “May God defend me from my friends, I can defend myself from my enemies”. 

Worse though, they never gave any consideration to the possibility that millions of “risky” 100% weighted SMEs and entrepreneurs, so vital to the sturdy growth of the real economy, would see their credit applications negated only because of this. 

Mercatus Center, any reframing of current financial regulations that is not based on a full understanding of how statists and stupid current regulations are, will not be able to adequately deliver what we, especially the young, so urgently need.

For instance all those propositions of increasing the capital requirements for banks with higher leverage ratios but that would keep of the risk weighting in place fail to understand that the bigger the capital squeeze the more will the risk weighing distort the allocation of bank credit to the real economy. (Think of “The Drowning Pool”)

For instance to avoid imposing on the real economy the bank credit austerity that would result in the initial stages of capital increases the grandfathering of old capital requirements for existing assets until these are disposed would be a must.

Mercatus Center, you have clout that I as a citizen have not! Do all us a favor and request straight answers from the regulators on some very basic questions.

Harvard Law School. I hope you did not believe Bill Coen with that the Basel Committee knows what it’s doing.

Bill Coen, the Secretary General of the Basel Committee on Banking Supervision, spoke at the Harvard Law School on December 12, 2016. In: “The global financial crisis and the future of international standard setting: lessons from the Basel Committee” Coen had this to say about the metric of the risk-weighted ratio:

“Its strength is that it sets capital requirements according to the perceived riskiness of a bank’s assets.” 

Comment: It is sheer lunacy to set capital requirements according to ex ante perceived risks, when you should set them according to the risk that banks might not adequately perceive the riskiness of their assets. In fact all bank crises have occurred from unforeseen events (like devaluations), criminal behaviors or excessive exposures to what ex ante was perceived as safe but that ex post turned out to be risky. No bank crisis has ever resulted from excessive bank exposures to something ex ante believed risky.

“Its weakness is that it is susceptible to setting too low capital requirements, either unintentionally (model risk), or intentionally (gaming).”

Comment: This evidences mindboggling naiveté. For banks to earn the highest possible risk adjusted returns on equity, they will automatically look to hold as little equity as possible. So it is like placing some delicious cookies in front of children, and expecting them to reach out for the spinach.

Students and professors at Harvard Law School, do us all a big favor. Send Bill Coen the following questions, and ask him formally to respond. At least that would save me from having to go on a hunger strike or other similar extremes in order to get some answers.

PS. You could also ask the Harvard Business School about why they have kept such silence on the monumental mistakes of current bank regulations.

Current bank regulation, more risk more capital - less risk less capital, is something as fake and dumb as it gets.

1. Even though the most important function of banks is to allocate credit efficiently to the real economy, let’s forget that and concentrate solely on banks becoming super safe mattresses in which we can store our savings.

So let us not worry about banks being able to leverage more their equity and the support we give them on what is perceived as safe than on what is perceived as risky; which obviously means banks will be able to earn higher expected risk adjusted returns on equity on what is perceived as safe than on what is perceived as risky; which obviously means banks will lend too much to what is perceived as safe and too little to what is perceived as risky.

2. Even though that reduces the opportunities of those coming from behind to access bank credit, and therefore basically decrees more inequality, let’s also forget about that.

3. Even though the distortion will cause banks to finance less the risky that our young need in order for them to have jobs and a workable economy, let us forget about that and go for short term safety, we baby-boomers aren’t that young, are we?

4. Even though all banking crisis have resulted from unexpected events, like natural disasters and devaluations, from criminal activity and from excessive exposures to something ex ante perceived as safe but that ex post turned out to be very risky, let us ignore that and require banks to hold more capital when holding assets perceived as risky. 

5. Even though we know that banks will do their utmost to lower their capital requirements so as to obtain higher returns on assets, let us allow the big banks to run their own risk models, as they will love us for that and make our yearly visits to Davos so much more agreeable.

6. Even though it is clear that our economies would never have developed the same had these regulations been in place before, let us ignore that, in order as regulators to feel more tranquil.

7. Even though the distortion will cause banks to finance less the risky SMEs and entrepreneurs that our young need to be financed in order for them to have jobs and a workable economy, let us forget about that and go for short term safety, we baby-boomers aren’t that young, are we?

8. Even though 0% risk weight for the Sovereign and 100% for We the People gives away that we believe government bureaucrats know better how to use bank credit than the private sector, let’s stand firm on it. We are true statists, aren’t we?

9. Even though Greece and AAA rated securities, and the ensuing stagnation, and the ensuing waste of so much stimulus has proved us so very wrong, let us ignore that, since otherwise we could lose our jobs.

10. There is probably not a clearer evidence that current bank regulators have no clue about they are doing that Basel II's risk weights. These assign 20% to the dangerous AAA to AA rated while sticking the so innocuous below BB- rated with 150%.

PS. I have tried for over a decade to get some answers from regulators to some very basic questions, unfortunately in that area the technocrats are seemingly following a strict Zero Contestability policy.

Stefan Ingves, years after Basel Committee’s failure, you all have still no idea about how to regulate banks.

On December 2, 2016 Stefan Ingves, the Chairman of the Basel Committee gave a Keynote speech at the second Conference on Banking Development, Stability and Sustainability, titled “Finalising Basel III: Coherence, calibration and complexity” 

In it Ingves stated: “an area of further research which would be welcome relates to how we should think about the capital benefits of allowing banks to use internally modelled approaches, and therefore the appropriate calibration of capital floors to such models. What are the pre-conditions for such models to produce better outcomes than, say, simpler standardised approaches? And to whom do the benefits of improved modelling accrue? If a bank using a model can lower its capital requirements by, say, 30%, what are the financial stability and real economy benefits of such an approach? To what extent do the benefits of modelling accrue to lower-risk borrowers as opposed to the parties being compensated for developing and using the models?”

That is clear evidence that the Basel Committee still, soon ten years after the crisis, their failure, has no idea about what it is doing. It should concern us all. 

Here’s one example on of how the Basel Committee’s has totally confused ex ante risks with ex post risks. In their Basel II standardized risk weights the weight assigned to AAA assets is 20% while the weight of a highly speculative below BB- rated assets was set at 150%. 

I ask: What has much greater chance of taking the banking system down, excessive exposures to something ex ante believed very safe or excessive exposures to something believed very risky? The answer should be clear. Never ever have bank crises resulted from excessive exposures to something believe risky when placed on the balance sheet; these have always resulted from unexpected events (like devaluations), criminal behavior or excessive exposures to something perceived ex ante as very safe but that ex post turned out to be very risky. 

The truth is that the Basel Committee told banks: “Go out and leverage your capital more than with assets that are safe”. And so when disaster happens, like with AAA rated securities, banks stand there more naked than ever.

Of course, the other side of that coin is, “Do not go and lend to what is risky”. So banks dangerously for the real economy stopped lending to SMEs and entrepreneurs… something that is never considered when stress testing.

To top it up, like vulgar statist activists, they set a risk weight of 0% for the Sovereign and one of 100% for We the People; which translates into a belief that government bureaucrats can use bank credit more efficiently than the private sector… something which of course created the excessive indebtedness of Greece and other.

One final comment, the regulators naivety is boundless: “to whom do the benefits of improved modeling accrue? asks Ingves” Clearly there is no understanding of that bankers will, as is almost their duty, always look to minimize capital if so allowed, in order to obtain the highest expected risk adjusted returns on equity. 

When fake regulators supervise banks; totally unsupervised banks is much better.

PS. Must one go on a hunger strike to have the Basel Committee on Banking Supervision answer some very basic questions? 

That banks allocate credit efficiently to the real economy is more important than avoiding bank failures

We read:

“THE MINNEAPOLIS PLAN reduces the risk of financial crises and bailouts to as low as 9 percent, at only a modest economic cost relative to the typical cost of a banking crisis. 

The Minneapolis Plan will (a) increase the minimum capital requirements for “covered banks” to 23.5 percent of risk- weighted assets, (b) force covered banks to be no longer systemically important—as judged by the U.S. Treasury Secretary—or face a systemic risk charge (SRC), bringing their total capital up to a maximum of 38 percent over time, (c) impose a tax on the borrowings of shadow banks with assets over $50 billion of 1.2 percent for entities not considered systemically important by the Treasury Secretary and 2.2 percent for shadow banks that are systemically important, and (d) create a much simpler and less burdensome supervisory and regulatory regime for community banks”

NO! Except for (d) “a simpler and less burdensome supervisory and regulatory regime for community banks” the Minneapolis plan suffers from the same fundamental mistake of current bank regulations. 

It fixates itself on avoiding bank failures, while entirely ignoring the much more important social purpose of the banks, that of allocating credit efficiently to the real economy.

To achieve that is impossible, while using risk weighting based on ex ante perceived risks to determine capital requirements. 

Would the Minneapolis Fed be able to provide me the answers to those questions the Basel Committee and the Financial Stability Board refuse to even acknowledge?

PS. And in any adjustment plan grandfathering existing capital requirements for the existing assets held by the banks would be required, so as to not risk contracting the credit market excessively. 

FSB’s Mark Carney is no one to lecture us on inequality, lack of opportunities and intergenerational divide

Mark Carney, the Governor of the Bank of England, in a speech titled “The Spectre of Monetarism” December 5, 2016 said: 

“For both income and wealth, some of the most significant shifts have happened across generations. A typical millennial earned £8,000 less during their twenties than their predecessors. Since 2007, those over 60 have seen their incomes rise at five times the rate of the population as a whole. Moreover, rising real house prices between the mid-1990s and the late 2000s have created a growing disparity between older homeowners and younger renters...  At the same time as these intergenerational divides are emerging, evidence suggests that equality of opportunity in the UK remains disturbingly low, potentially reinforcing cultural and economic divides.”

But Mark Carney is also the current Chairman of G20’s Financial Stability Board and, as such, one of the primarily responsible for current bank regulations… the pillar of which is the risk weighted capital requirements for banks.

That piece of regulation decrees inequality resulting from negating “the risky”, like SMEs and entrepreneurs fair access to bank credit. 

That piece of regulation favors the financing of “safe” basements where jobless kids can stay with their parents over “riskier” ventures that could provide the kids in the future the jobs, so that they had a chance to become responsible parents too.

That piece of regulations is a violation of that holy intergenerational bond Edmund Burke spoke about.

Carney also said: “Higher uncertainty has contributed to what psychologists call an affect heuristic amongst households, businesses and investors. Put simply, long after the original trigger becomes remote, perceptions endure, affecting risk perceptions and economic behaviour. Just like those who lived through the Great Depression, people appear more cautious about the future and more reluctant to take irreversible decisions. That means less willingness to put capital to work and, ultimately, lower growth.”

If any have suffered form “affect heuristic” that is the bank regulators. Mixing up ex ante perceptions with ex post possibilities, these decided on “more risk more capital – less risk less capital”, without: defining the purpose of banks “A ship in harbor is safe, but that is not what ships are for.” John A Shedd; or looking at what has caused bank crises in the past “May God defend me from my friends, I can defend myself from my enemies” Voltaire

Mark Carney also said “For two-and-a-half centuries, the prices of government bonds and the prices of equities tended to move together: the typical bull market entails rising equity prices and falling bond yields, with the reverse in bear markets. Since the mid-2000s, however, this pattern has reversed and bond yields have tended to fall along with equity prices”.

He is not able to connect that to the fact the risk weight given to sovereign debt is 0%, as compared to one of 100% for We the People… and that capital scarce banks therefore shed “riskier” assets in favor of public debt. As statist, Carney also ignores the fact that regulation has subsidized public borrowings, paid of course by negating credit opportunities to SMEs and entrepreneurs.

Must one go on a hunger strike in order to get some contestability from the Basel Committee or the Financial Stability Board?

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

Here is the succinct but complete explanation of the subprime crisis. One, which apparently should not be told.

Here's a prologue, on the 10th anniversary of the Lehman Brothers collapse: In 2006 in a letter to the Financial Times I argued for the long-term benefits of a hard landing. The Fed and ECB decided to kick the can forward and upwards, which could have worked; better at least, had they removed the distortions that created the crisis. 

Just four factors explains it all, or at least 99.99%.

Securitization: The profits for those involved in securitization are a function of the betterment in risk perceptions and the duration of the underlying debts being securitized. The worse we put in the sausage – and the better it looks - the more money for us. Packaging a $300.000, 11%, 30 year mortgage, and selling it off for US$ 510.000 yielding 6% produces an immediate net profit of $210.000 for those involved in the process. (Those signing the mortgages do not participate in the profits)

Credit ratings: Too much power to measure risks was concentrated in the hands of some very few human fallible credit rating agencies.

Capital requirements for banks. Basel II, June 2004, brought down the risk weight for residential mortgages from 50% to 35%. Additionally, it set a risk weight of only 20% for whatever was rated AAA to AA. The latter, given a basic 8%, translated into an effective 1.6% capital requirement, which meant bank equity could be leveraged 62.5 times to 1.

Borrowers: As always there were many financially uneducated borrowers with needs and big dreams that were easy prey for strongly motivated salesmen, of the sort that can sell a lousy time-share to a very sophisticated banker. 

Clearly the temptations became too much to resist for all involved.

The European banks, thinking that if they could make a 1% net margin they could obtain returns on equity of over 60% per year, went nuts demanding more and more of these securities; and the mortgage producers and packagers were more than happy to oblige, signing up lousier and lousier mortgages and increasing the pressure on credit rating agencies. The US investment banks, like Lehman Brothers, also participated, courtesy of the SEC.

Of course it had to end bad... and it did!

Can you image what would have happened if the craze had gone on one or two years more?

I have explained all the above in many shapes or form, for much more than a decade. Unfortunately it is an explanation that is not allowed to move forward, because it would put some serious question marks about the sanity of some of the big bank regulators.

Might I need to go on a hunger strike to get some answers from the Basel Committee and the Financial Stability Board?

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

PS. And here are some of my early opinions on these regulations, some of them while being an Executive Director at the World Bank, 2002-04

PS. Here’s my recent, 2019, comments sent to the Financial Stability Board

PS. Here’s my recent, 2019, letter sent to the IMF

PS. And here is a very humble home-made youtube comment on it all, from 2010

Must one go on a hunger strike to have the Basel Committee or FSB answer some very basic questions?

Before regulating banks did you ever define their purpose? I know we all want them to be safe but, as John Augustus Shedd said: “A ship in harbor is safe, but that is not what ships are for.” 

By allowing for different capital requirements based on ex ante perceived risks of assets, banks will be able to leverage their equity (and the support given by authorities) differently, which will cause quite different expected risk adjusted returns for different assets, than would have been the case in the absence of this regulation. Were you never concerned about how this would distort the allocation of bank credit to the real economy? 

Since ex ante perceived risk were already considered by bankers when deciding on the amounts of exposures and interest rates, when you decided that the perceived risk was also going to determine capital requirements, you doubled up on perceived risk. Don’t you know that any risk, even if perfectly perceived, causes the wrong actions if excessively considered? 

In the case of larger and more “sophisticated” banks, you allowed these to use their own internal risk models to determine capital requirements. (Something like allowing Volkswagen to calculate their own emissions) Was it not naïve of you to believe banks would not naturally aim for lower capital requirements, in order to increase their expected risk adjusted returns on equity?

What’s perceived as safe can be leveraged into being utterly dangerous, only because of that perception; while what’s perceived as risky is automatically less dangerous, precisely because of that perception. Or as Voltaire said: “May God defend me from my friends, I can defend myself from my enemies”. In this respect can you explain the logic behind your standardized Basel II risk weights of 20% for what is AAA to AA rated, and 150% for what is rated below BB-? 

In the same vein what empirical research did you carry out to determine that what is perceived ex ante as risky has caused major bank crises? I ask because as far as I know these have always been caused by unexpected event, like natural disasters or devaluations, by fraudulent criminal behavior, or by excessive exposures to what ex ante was considered as safe but that ex post turned out to be very risky. 

In other words since bank capital is there for the unexpected is it not dumb to require it based on the expected?

A risk weight of 0% for the sovereign, and 100% for We the People clearly implies you regulators all believe government bureaucrats make better use of bank credit than the private sector. Are you really such statists? Did you never consider that such dramatic rearrangement of economic power needed approval by for instance a Congress or a Parliament… or even a referendum? 

Finally do you really believe that with such risk adverse regulations, layered on top of banker’s own risk aversion, our economies would have developed as they did? Don't you see that banks are no longer financing the riskier future but only refinancing the "safer" present and past? Don't you see this decrees inequality?

PS. FT’s / Financial Times Establishment, notwithstanding my soon 2.500 letters to it on “subprime bank regulations” has also steadfastly refused to help me get answers to these questions.

PS. And here is one evidence of that I have posed my objections during formal consultations by the Basel Committee

PS. And I dreamt I got this letter with their answers!

PS. And I am 100% for the 10% on all assets capital requirement for small banks in the Financial Choice Act. I just hope it was applied to all banks, foremost the biggest, as these need it the most, as we need these to be better capitalized the most.