The Finalization of Basel III’s is just a photo-op for the Committee members to go home for Christmas with, as it does nothing to correct the fundamental flaws of current bank regulations.

The Basel Committee’s “Finalizing Basel III” brief states: 

1. “What is Basel III? The Basel III framework is a central element of the Basel Committee’s response to the global financial crisis. It addresses a number of shortcomings in the pre-crisis regulatory framework and provides a foundation for a resilient banking system that will help avoid the build-up of systemic vulnerabilities. The framework will allow the banking system to support the real economy through the economic cycle.”

Since the risk weighted capital requirements are kept, that is simply not true! The global financial crisis was a direct consequence of regulations that allowed banks to leverage immensely their capital as long as they kept to “safe” assets: limitless leverage with exposures to friendly sovereigns, 62.5 times with private sector exposures rated AAA to AA, and 35.7 times with residential mortgages. 

The exaggerated demand these regulations created for residential mortgages and highly rated securities, which caused serious deteriorations in their quality, and of loans to low risk decreed sovereigns, like Greece, explains 99.9% of the financial crisis.

In contrast when lending to an entrepreneur or an unrated small or medium size enterprise, as that was (is) considered risky, banks were only allowed to leverage 12.5 times. The differences in potential risk adjusted returns on equity between “safe” and “risky” assets hindered, and hinders, the banking system from adequately supporting the real economy

2. “What do the 2017 reforms do? “The 2017 reforms seek to restore credibility in the calculation of risk-weighted assets (RWAs) and improve the comparability of banks’ capital ratios. RWAs are an estimate of risk that determines the minimum level of regulatory capital a bank must maintain to deal with unexpected losses. A prudent and credible calculation of RWAs is an integral element of the risk-based capital framework.”

But the fundamental question of why it should be prudent to require banks to hold more capital against what is perceived risky, when the real dangers to the bank system is when something perceived as safe turns out risky, remains unanswered.

3. “Credibility of the framework: A range of studies found an unacceptably wide variation in RWAs across banks that cannot be explained solely by differences in the riskiness of banks’ portfolios. The unwarranted variation makes it difficult to compare capital ratios across banks and undermines confidence in capital ratios. The reforms will address this to help restore the credibility of the risk-based capital framework.

Internal models should allow for more accurate risk measurement than the standardised approaches developed by supervisors. However, incentives exist to minimise risk weights when internal models are used to set minimum capital requirements. In addition, certain types of asset, such as low-default exposures, cannot be modelled reliably or robustly. The reforms introduce constraints on the estimates banks make when they use their internal models for regulatory capital purposes, and, in some cases, remove the use of internal models.” 

Where do regulators get the idea that if there are less-variations in RWAs, the standardized RWAs, based on how regulators perceive risks, are any more accurate? Excessive hubris? Have they forgotten their own “Standardized” risk weights? Alzheimer? 

Also, since banks should clear for perceived risks in the size of the exposures and interest rates, making them clear for those same risks in the capital too, causes an excessive consideration of perceived risks. The regulators clearly keep on ignoring that any risk, even if perfectly perceived, causes the wrong actions, if excessively considered.

That regulators now, at long last, have understood that “incentives exist to minimise risk weights when internal models are used to set minimum capital”, serves little as consolation, as it just evidences their original naiveté.

PS. As an aide memoire for the regulators to take home for Christmas here’s a list of their mistakes. Am I being nasty? No! How many millions of entrepreneurs have over the years been negated access to the life changing opportunities of a bank credit, only because of these regulators? How many young must live in the basement of their parents houses without jobs, only because regulator think it is safer to finance houses than job creation opportunities? Let’s pray all the Ebenezer Scrooge in the Basel Committee will see light one day... or at least have the decency to fade away.  

My tweets asking very courteously bank regulators for an explanation

Dear bank regulators, please explain your current risk weighted capital requirements for banks against these four scenarios:

1. Ex ante perceived safe – ex post turns out safe - "Just what we thought!"
2. Ex ante perceived risky – ex post turns out safe - "What a pleasant surprise! That's why I am a good banker"
3. Ex ante perceived risky – ex post turns out risky - "That's why we only lent little and at high rates to it."
4. Ex ante perceived safe – ex post turns out risky - "Now what do we do? Call the Fed for a new QE?"

Because, as I see it, from this perspective, your 20% risk weights for the dangerous AAA rated, and 150% for the so innocous below BB- sounds as loony as it gets.

Here are some of my current explanations of why I believe the risk weighted capital requirements for banks are totally wrong.

And below an old homemade youtube, published September 2010, on this precise four scenarios issue

When government bureaucrats are favored more than entrepreneurs in the access to bank credit, the game is soon over

In 1988, with Basel I, out of some Pandora box, for the purpose of setting the capital requirements for banks,the  regulators came up with a risk weight of 0% for sovereigns and of 100% for citizens. As a result banks need to hold much less equity when lending to sovereigns than when lending to citizens.

That 0% risk weight was premised on that sovereigns were in possession of the money-printing machines and could therefore always repay. I am sure the Medici’s would have shivered hearing such a generous risk assessment.

So, since then, banks have been allowed to leverage much more with loans to sovereigns than with loans to citizens; and therefore obtain much higher risk adjusted returns on equity when lending to sovereigns than when for instance lending to entrepreneurs. 

That de facto implies believing in that a government bureaucrat can use bank credit that he himself has not to repay, better than an entrepreneur.

That alone should suffice to make clear how loony and statist the current bank regulations are.

But the world keeps mum on this. As I see it this is a regulatory crime against humanity that should be punishable.

Here is a more extensive explanation of the mistakes of risk weighted capital requirements for banks.

Crimes against humanity can also unwittingly be committed through subtle and nonviolent means, like with bank regulations

Let us suppose a continuation of regulators who, in order for banks not to crash under their respective watch, decreed that banks should concentrate all their activity lending to “infallible” sovereigns, to those with good credit ratings, to the safe financing of houses; and to stay away from lending to all those who are perceived as risky.

That because they, like bankers, they looked at what could be risky for banks, and not as they should have done, as regulators, at the risks that might not be perceived.

And the consequences of it is that millions of those who though they are perceived as risky could help the economy move forward and generate new jobs, such as SMEs and entrepreneurs, have their access to bank credit denied.

And so hundred of millions of our young will not get jobs and have to remain living in their parents’ basements… that is unless they revolt and send their parents down to the basements.

And yet, sooner or later, especially large bank crisis will result, because of unexpected events, or because of excessive exposures to something that was perceived, decreed or concocted as safe, but that ex post turned to be risky. And these crises are made so much worse when banks have to hold especially little capital against those ex-safe assets.

This is precisely what the risk-weighted capital requirement for the banks created by the Basel Committee for Banking Supervision cause.

These allow banks to leverage more with what is “safe” than with what is “risky” and thereby obtain higher risk adjusted returns on capital with what is “safe” than with what is “risky”.

As a direct consequence, millions of job opportunities for our young have already been lost forever; and the first big crisis already occurred in 2007-08, only that in this case the central bankers, with their quantitative easing and ultra low interest rates, kicked that can forward.

And here we are, sitting on artificially inflated stock market valuations and house prices that, when true need arises, will never be able to be converted back into the same effective real purchase power that was invested in them.

And all that huge sovereign debts accumulated in the process can only be repaid with help of the printing machine, and never in terms of the real purchase power that was invested in its generation.

And the human sufferings, and the consequent strains all this will impose on our social fabric will be immense… especially when like now in many countries it will be compounded by big demographic changes.

Does all this not indicate that these regulations could be classified as a horrendous and perhaps even punishable regulatory crime against humanity?

Or will the inquisition of the high priests of bank regulations just excommunicate me, like any Galileo?

Where do I nail these my Theses about the risk weighted capital requirements for banks, so as to at least achieve a discussion of them? 

Or will the inquisition of the high priests of bank regulations just excommunicate me, like any Galileo?

“If you see something say something”. Yes, but it’s not easy to be a whistleblower on our too inept bank regulators.

Sir, never ever has a bank crisis of any important magnitude resulted from excessive exposures to something that was perceived as risky when placed on the balance sheets of banks.

These have always resulted from unexpected events, like major devaluations, criminal behavior or excessive exposures to something that was perceived as safe when incorporated in the balance sheets of banks but that ex post turned out to be risky.

So when bank regulators, like with their Basel II of 2004 set the risk weights for what is rated AAA at 20%, and that of the below BB- rated at 150%, then this is a too serious clue of them not knowing what they’re doing.

And the above is far from being their only mistake or the only proof of that.

I have been shouting my lungs out about this basically since 1997, but it is very difficult for an ordinary citizen, even for someone who for some years was an Executive Director at the World Bank, to have someone to listen to him, when he holds that our supposed expert bank regulators left a bomb in our real economy.

PS. I will send the above letter to as many editors I can.

Financial Times

New York Times

Wall Street Journal

Washington Post

Svenska Dagbladet

The Economist

And here is my letter to the Financial Stability Board, March 2019

IMF, the Basel Committee’s procyclical risk weighted capital requirements puts financial cycles, global or local, on steroids

This year’s IMF Jacques Polak Annual Research Conference on November 2–3 is titled “The Global Financial Cycle.” 

It aims to bring together contributions by leading experts on the topic—from both within and outside the IMF—to improve the “understanding of a range of issues, including the causes and consequences of the global financial cycle, the transmission channels of global financial shocks, and the role of domestic policies in dampening the impact of global shocks.”

I wonder if, again, for the umpteenth time, the distortions produced by risk weighted capital requirements in the allocation of credit to the real economy will be ignored.

The following is the comment I posted on the IMF Blog

Risk weighted capital requirements, more risk more capital – less risk less capital, allows banks to earn much higher risk adjusted returns on equity with what is perceived decreed or concocted as safe, than on what is perceived as risky. 

That pushes more than ordinary the financial pursuit of “the safe” and the avoidance of “the risky”.

That de facto puts financial cycles, whether global or local, on steroids.

Will this comment be considered? I have not seen much action on the one I made last year.

PS. I have now read all the papers presented in the conference and the only one that makes somewhat of a reference to risk weighted capital requirements, is “Global financial cycles and risk premiums?” authored by Oscar Jorda, Moritz Schularick, Alan M. Taylor and Felix Ward, October 2017

It includes “If banks hold foreign assets on their balance sheets and mark them to market, price changes can synchronize the risk appetite and the trading behavior of banks around the world. For instance, if Federal Reserve policy affects U.S. equity prices, falling asset prices in the U.S. decrease (risk-weighted)-asset-capital ratios of U.S. as well as international banks, which start to cut down their risk-taking in sync with U.S. banks.

If no large risk-neutral player steps in to compensate for the lower risk taking of the leverage-constrained intermediaries, risk-spreads will increase.”

But as one can see that is how financial cycles or event affect “(risk-weighted)-asset-capital ratios”, but not how these risk weighted capital requirements affect the financial cycles.

For instance Greece would never ever have been able to obtain so much debt had it not been for the ridiculous low capital requirements on that debt.

What’s the similitude of World Bank and IMF? That the Basel Committee has fooled them both!

World Bank has the function of development… and has ignored that risk weighted capital requirements for banks kills the risk-taking that is the oxygen of development.

IMF has the function of stability … and has ignored that bank crises are caused by excessive exposures to what’s wrongly perceived as safe, and never to what is rightly perceived as risky.

Explaining to World Bank and IMF the horrific mistakes of Basel’s bank regulations, has not been an easy journey

http://live.worldbank.org/civil-society-townhall-2017

28:30, I am Per Kurowski, of New Rules for Global Finance

This is a question for the umpteenth time to the World Bank:

As the world’s premier development bank the World Bank must know that risk-taking is the oxygen of any development. So why is it still not speaking out against the risk-weighted capital requirements for banks that put a brake on risk-taking, like on the lending to SMEs small and medium sized enterprises…even though never ever has a major bank crisis erupted because of excessive exposures to something ex ante perceived as risky.

30:50, World Bank, Jim Yong Kim

On risk taking I am not sure I understood the question correctly, but there is, because of in many ways I think very much necessary prudential rules, the Basel process, one of the side effects of it is that it has been a systematic de-banking of many developing countries, especially in Africa. 

And so many banks Standard Chartered and others that had very strong presence in the developing world have for the most part left. And so we have a terrible time in terms of accessing capital markets in the way that they did before.

So it’s a huge concern for us, and we are continuing to engage with the Basel process and we are continuing to try to talk about some of the side effects. For example it is much more difficult and expensive to send remittances back now because these institutions don’t exist. 

And so the problem of insuring that the poorest countries have access to capital markets is very-very high on our agenda, and is really at the core of the major issue we talked about in spring meetings which is our cascade; and the cascade is essentially recognition that on the one hand it is very difficult for very good emerging markets infrastructure projects to get capital, and on the other hand there is more than 10 trillion dollars in negative interest bond, and 25 plus trillions in very low earning bonds and another 8 trillion in cash sitting in peoples safes, and they would like to get a higher return, but the perception of risk in the emerging market is so high, that the capital is just not moving.

So we are putting so much of our effort into mitigating this situation where you have great projects, great potential for building infrastructure that would lead to growth but that are not being financed; we are really focusing on filling that void on the problem I think you are pointing to.

My comment: It was not answering my real question but it was still a very valid answer. If given a chance my re-question would have been: Do you think Standard Chartered would have left those development markets had it had to hold the same capital against all its assets than what it is required to hold on loans to these markets? The answer to that is surely “No!”

35:25, IMF, Mme Christine Lagarde.

I am actually tempted to address also this question, is that okay?

Because I think it is an important point and one that has very complex ramifications. It has complex ramifications in the banking regulations business, in the banking supervision business, and in the accounting business.

And then it is at the very junction of between sort of self-established model by the banks versus models established by the supervisors. 

I think we both would agree that methods that would actually encourage the lending by banks and by insurance companies and by pension fund to SMEs, you know with the risk associated with it, should actually be very much in order.

At the moment the risk weighing methods and the models that are being used are discouraging from actually investing and taking risk to benefit the small and medium sized enterprises 

And that’s not necessarily the best avenue to support the economy and to support entrepreneurs who want to have access to financing.

My comment: Many thanks, but Mme Lagarde, it really behooves the IMF, and the World Bank, to understand why it took them about 15 years, Basel II, to see this problem.

30:50 World Bank, Jim Yong Kim

Just to add to that, we are now trying to come up with lots of different innovative approaches to de-risking those investments, taking first loss, using political risk insurance credit enhancements, lot of tools that we are using now to try to respond to the situation

My comment: That is good to hear, but beware, de-risking credits, against distorted and inadequate bank regulations, could have very bad unexpected consequences.

PS. Very much inspired by John Kenneth Galbraith’s “Money: Whence it came, where it went” (1975), I started my fight against Basel Committee’s regulations in 1997, in my very first Op-Ed “Puritanism in Banking”.

And in 2003, as an Executive Director or the World Bank, in a workshop for bank regulators I warned: “The other side of the coin of a credit that was never granted, in order to reduce the vulnerability of the financial system, could very well be the loss of a unique opportunity for growth. In this sense, I put forward the possibility that the developed countries might not have developed as fast, or even at all, had they been regulated by a Basel.”

In 2007, ten years ago, at the High-level Dialogue on Financing for Developing at the United Nations, as civil society, I presented the document: “Are the Basel bank regulations good for development?”

And since then I do not know how many times, I have tried and failed to draw IMF’s and World Bank’s attention to the many very serious mistakes that are imbedded in Basel’s risk-weighted capital requirements for banks.

Have I arrived at the end of my journey? I am not 100% sure, but I do see some light J