IMF does still not understand how the risk weighted capital requirements for banks distort. Why? Groupthink?

IMF’s Global Financial Stability Report 2017 on page 43 and 44 Box 1.2. “Regulatory Reform at a Crossroads” states:

Finalization of the Basel III package of reforms— the revision of the “standardized” approach to the calculation of risk-weighted assets and limits on the use of internal models to assess risks—appears to have faltered… The outstanding challenge is to reconcile views on the weight to attach to each element, particularly to the balance between reliance on internal models and constraint through the calibration of the floor [based on a standardized approach]”

So regulators wants to reconcile between:

Use of internal risk models, which is basically similar to allowing Volkswagen to calculate their own carbon emissions. 

Using the standardized approach designed by regulators and which included, for instance risk weights of only 20% for what is perceived very safe, like what’s AAA rated, and which precisely because of that perception can lead banks to build up dangerously large exposures; and a 150% risk weight for what is rated below BB-, something to which banks would never dream to expose their balance sheets much to.

We all know that minus times minus leads to a positive number but does reconciling one craziness with another craziness lead to a sane regulation. NO!

Box 1.2 also includes: “countries outside the central standards-setting bodies [in particular emerging markets]…rely heavily on a strong global standard to level the playing field and support financial stability”

Question: Does allowing the safe to have better access than usual and the risky less than usual really signify to “level the playing field”?

Box 1.2 concluding states: “Completion of the reforms is vital to address previously identified fault lines and thus ensure that the global financial system is safe and can promote economic activity and growth.”

Congratulations! I believe this is the first time I have read from somebody close to the regulators, as IMF is, that besides “safe and resilient”, the banking system needs also to “promote economic activity and growth.”

It is truly sad this comes at such a late stage. Anyone wanting banks to promote economic activity and growth, would never have accepted the risk weighted capital requirements for banks, as these dangerously distorts the allocation of credit to the real economy. 

So clearly, IMF still has much internal analysis to do before they get there. I hope its groupthink allows it.

3 questions on IMF’s Global Financial Stability Report’s, “Where Are the U.S. Corporate Sector’s Vulnerabilities?”

That section, on page 9 states:

“The corporate sector has tended to favor debt financing, with $7.8 trillion in debt and other liabilities added since 2010. Bank lending to the corporate sector has continued to recover and could well rise further in response to more favorable market valuations. In contrast, equity finance has traditionally been outstripped by share buybacks and has recently leveled off. A drop in the cost of equity capital may stimulate equity financing, but it could coincide with higher corporate debt—particularly if additional share buybacks are financed through debt.” 

That begs three questions: 

First: How much of the recent increase in the stock markets is the result of buybacks; that which helps earnings per share to get a sort of artificial boost; that which results in less equity controlling the corporations? 

Second: Do the recent stock-market prices increases duly reflect the increase riskiness derived from much higher corporate debts? 

Third: Have Central Banks therefore, with their low interests rate policies, de facto, dangerously lowered the capital (equity) requirements of corporations? 

On the first two questions I have no answers, though just having to ask them should suffice to at least raise some eyebrows. 

On the third the IMF clearly seems to respond, “Yes!” when on that same page, under the subtitle “High Leverage Combined with Tighter Borrowing Conditions Could Affect Financial Stability” it writes: 

“As leverage has risen, so too has the proportion of income devoted to debt servicing, notwithstanding low benchmark borrowing costs. Although the absolute level of debt servicing as a proportion of income is low relative to what it was during the global financial crisis, the 4 percentage point rise has brought it to its highest level since 2010, which leaves firms vulnerable to tighter borrowing conditions. The average interest coverage ratio—a measure of the ability for current earnings to cover interest expenses— has fallen sharply over the past two years. Earnings have dropped to less than six times interest expense, close to the weakest multiple since the onset of the global financial crisis.” 

Holy Moly! And interest rates have not yet returned to something more "normal"; and the Fed's balance sheet is still so huge it leaves little space for any future QE assistance...and not to speak of the already too large public debts. 

My intuition tells me that if we do not develop something along the lines of a Universal Basic Income, fast, we will not be able to counter sufficiently upcoming recessions and huge unemployment so as to keep truly horrendous populists away.

Really, how on earth can we have left so much power in so few so intellectually incestuous hands?

IMF, "cash" what cash? Have you any idea how the $2.2 trillion in retained foreign earnings is invested?

I quote from page 7 and 8 of IMF’s Global Financial Stability Board 2017.

“Is the U.S. Corporate Sector Ready to Accelerate Expansion—Safely?

The potential for a one-off repatriation of retained foreign earnings, including liquid funds held abroad.

Repatriating liquid assets held abroad by U.S. companies would also benefit the information technology and health care sectors, where 60 percent of the $2.2 trillion in unremitted foreign earnings held abroad is concentrated.

Cash windfalls from repatriation would likely accrue to cash abundant sectors”

In order to analyze the effects of any repatriation of retained foreign earnings, one would need to know how that money is invested… because you can be absolutely sure it is not in cash under corporate treasurers’ mattresses.

That is why I ask IMF whether they know. If they don’t then they better find out before they speculate on what the repatriation of these retained foreign earnings would signify. 

What if the $2.2 trillion is all invested in treasuries? J

This is somewhat similar to all those divisive statements that reference that the wealth of the 62 richest equals that of 3.6 billion poorest, without the slightest thought given to how that wealth could be transferred.

IMF: The “I scratch your back if you scratch my back” crony statism deal between sovereigns and banks, must stop.

In 1988, with the Basel Accord, Basel I, for the purpose of capital requirements for banks, regulators assigned to the sovereigns a risk weight of 0%, while citizens got one of 100%.

That meant banks would be able to leverage more their capital when lending to sovereigns than when lending to citizens. 

That meant banks would be able to earn higher expected risk adjusted returns on equity when lending to sovereigns than when lending to citizens. 

That meant that banks would lend more and at lower rates than usual to sovereigns and in relative terms less and at higher rates than usual to citizens.

That de facto established the Sovereign-Bank Nexus. I Sovereign help to guarantee you banks, and you help to finance me abundantly and cheap.

IMF, in its Global Financial Stability Report 2017, page 36 and 37 have a section titled “The Sovereign-Bank Nexus could reemerge”. It correctly spells out how banks can be affected by difficulties of sovereigns and how sovereigns can be affected by difficulties of banks. 

But it makes absolutely no reference to the regulatory support of the Sovereign-Bank Nexus previously described. Why?

That runaway statism must stop!

IMF, Basel Committee for Banking Supervision: Don’t tell me you do not know who did the Eurozone in?

PS. November 2016 Olivier Blanchard agreed on that there was a need to research the distortions produced by these regulations. Has that started?

Should not science matter to bank regulators, at least a little?

I ask because though I am no scientist, far from it, have never really understood Einstein’s relativity theory, I know that if I were asked to regulate banks there would be two basic questions I would have to ask:

First, what is the purpose of our banks? Quite early someone would have mentioned John A Shedd’s “A ship in harbor is safe, but that is not what ships are for” and I would have ascertained that purpose to be, to allocate credit to the real economy, carefully but efficiently. 

Second, what has caused major bank crises? a. Unexpected events, like devaluations, b. criminal behavior, like lending to affiliates; and c. dangerously large exposures to something ex ante perceived as very safe but that ex post turned out to be very risky. Surely someone would have also cited Voltaire’s “May God defend me from my friends, I can defend myself from my enemies” as a reminder that what is perceived as risky is, precisely because of that perception, quite innocuous.

After that initial mini research, the last thing I would have come up with is the current risk weighted capital requirements, more risk more capital – less risk less capital, that which distorts the allocation of bank credit, for no stability purpose at all... much the contrary.

So again… should not science matter to bank regulators, at least a little?

PS. My 2019 letter to the Financial Stability Board

Regulatory risk aversion distorts credit and causes dangerous bank exposures to what is perceived, decreed or concocted as safe.

Mark Carney, Governor of the Bank of England, and the Chair of the Financial Stability Board, on April 7, 2017 gave a speech titled: “The high road to a responsible, open financial system”. 

Carney said: “The pillars of responsible financial globalisation eroded prior to the global financial crisis. Regulation became light touch and ineffective…. few participants were exposed to the full consequences of their actions as governance and compensation arrangements focused on the short term.”

But to call regulations that as a pillar has risk weighted capital requirements for banks, which allow banks to leverage assets differently because of perceived or decreed risk, “light touch”, is pure nonsense. And if there is anything as focused on the short term, that must be regulations that give banks incentives not to lend to the “riskier” future, but to take refuge in refinancing the “safer” past and present.

Carney bragged: “The system is safer because banks are now much more resilient, with capital requirements for the largest global banks that are ten times higher than before the crisis and a new leverage ratio that guards against risks that may seem low but prove not.” 

Since that “ten times higher” refers to capital in relation to risk weighted assets, and he has no way to ascertain the ex ante risk perceptions will coincide with the ex post realities, that number may or may not be true. The improvement might come from banks shedding a lot of safe “risky” assets and taking on more exposures to potentially risky “safe” assets. Finally, mentioning “a new leverage ratio that guards against risks that may seem low but prove not”, amounts to admitting they had no idea what they were doing before.

Carney opined: “The financial system is simpler. As banks have become less complex and more focused, they are lending more to households and businesses and less to each other. A series of measures are eliminating toxic and fragile forms of shadow banking while reinforcing the best of resilient market-based finance. And more durable market infrastructure is simplifying the previously complex – and dangerous – web of exposures in derivative markets.”

He wishes!

But when I object the strongest is when Carney states “The financial system is fairer because of reforms that are ending the era of “too big to fail” banks and addressing the root causes of a torrent of misconduct.”

Fairer? With regulators favoring those who perceived as safe were already favored with easier access to bank credit, and increasing the obstacles for those who perceived as risky already found it harder to access bank credit, has nothing to do with fairness. It is just odious regulatory discrimination.

Bank regulators, de facto, decreed more inequality.

IMF and World Bank, have you really thought about what bank regulators are doing to our grandchildren?

Beginning 1988, with the Basel Accord, and much expanded in 2004, with Basel II, the Basel Committee for Banking Supervision, imposed on banks risk weighted capital (equity) requirements. Less perceived risk less capital - more perceived risks more capital.

The regulators also decreed that the sovereign would carry less risk weight than their subjects, which de facto implies they believe government bureaucrats use bank credit more efficiently than the private sector.

That means!

Banks can leverage more their equity with assets perceived as safe than with assets perceived as risky. 

Banks can earn higher risk adjusted returns on equity with assets perceived as safe than with assets perceived as risky. 

So sovereigns (the government), the AAA-risktocracy and those buying houses will have ampler and cheaper access than usual to bank credit.

So the “risky” SMEs and entrepreneurs, no matter how useful they might be for moving the economy forward, will find it harder and more expensive than usual to access bank credit.

So banks will be financing insufficiently the “riskier” future of our grandchildren, keeping busy refinancing the “safer” past and present of parents and grandparents. 

Grandfathers or grandfathers to be, I ask you,do you believe this is to act responsibly with respect to our grandchildren’s future?

I don’t! 

It is pure statism!

It distorts the allocation of credit in such way that it guarantees our real economies to stall and fall. As John A Shedd said: “A ship in harbor is safe, but that is not what ships are for”

It means our banks, and we all, are sooner or later going to end up gasping for oxygen in some dangerously overpopulated safe-havens. As Voltaire said: “May God defend me from my friends, I can defend myself from my enemies”. 

God make us daring!

When banks play it too safe - putting inequality on steroids - the McKinsey silence

In his April 9 Outlook essay, “Public Policy, Inc.,” Daniel W. Drezner, writing about how consultancies such as McKinsey have started to act like policy knowledge brokers, mentioned that these “have their own biases.” Indeed.

Bankers love to hold assets perceived as safe against very little capital. It helps them earn great risk-adjusted returns on equity.

But we citizens have no reason for loving that:

By going too much for the safe, banks will not lend sufficiently to the riskier entrepreneurs who are the prime builders of our grandchildren’s future. Sooner or later, banks will get caught with little capital holding dangerously large exposures to something that was perceived safe but that turned out risky. Depositors and taxpayers will suffer.

There is no question that banks are more important clients for consultant companies such as McKinsey than citizens are. That must be why financial consultants have not denounced how the Basel Committee on Banking Supervision’s risk-weighted capital requirements for banks dangerously distort the allocation of bank credit to the real economy.

Millions of entrepreneurs around the world have, as a direct consequence of these capital requirements, been denied the opportunity of bank credit. Talk about putting inequality on steroids. 

Per Kurowski, Rockville

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

Washington Post

Here other of my letters in the Washington Post on this issue:
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

July 11, 2018: There is another tariff war that is being dangerously ignored. 

December 30, 2018: Affordable homes or investment assets?

Mme Lagarde. I don’t agree with that IMF is “Building a More Resilient and Inclusive Global Economy”.

On April 12, Christine Lagarde, Managing Director of IMF gave a speech titled “Building a More Resilient and Inclusive Global Economy”

Mme Lagarde stated: “We have found that technology has been the major factor behind the relative decline of lower- and middle-skilled workers’ incomes in recent years, with trade contributing to a much lesser extent” So where was IMF with this argument during the recent walls against foreign workers debate? Jobs are of course important but is it not also time to start thinking about the need for decent and worthy unemployments?

Mme Lagarde also stated: “Financial stability requires that we complete the reform of global financial regulations. These rules—especially on bank capital, liquidity, and leverage” Hah! With capital requirements for banks that are especially low for what can cause bank crises, namely what’s perceived as safe? Like the ultra low risk weighted assets of the AAA rated securities and a sovereign like Greece? IMF has to be joking.

Mme Lagarde spoke about IMF’s efforts for “avoiding protectionist measures as well as distortive policies that give rise to competitive advantage.” So why then does IMF keep silence on capital requirements for banks that make it harder than it already is for those perceived as risky, to access bank credit, like the SMEs and entrepreneurs?

Mme Lagarde holds that “today’s policies should not disadvantage future generations, who would be left to pay for the imprudent actions of today’s generation.” Hold it there! The current imprudent risk adverse bank regulations that give banks incentives to stay away from financing the riskier future and just keep to refinancing the safer present, does precisely disadvantage future generations.

Mme Lagarde, let me assure you that the current Basel Committee’s bank regulations do not live up to any of the three principles proposed by the great Roman architect Vitruvius:

Durability: No! “May God defend me from my friends, I can defend myself from my enemies” Voltaire”.

Utility: No! “A ship in harbor is safe, but that is not what ships are for” John A Shedd.

Beauty: No! Besides perhaps delighting some anxious nannies that regulation raises no one’s spirits. God make us daring!

@PerKurowski