With Basel II, how many times could banks multiply net risk adjusted margins, so as to obtain their returns on equity?

The expected pretax return on equity for banks is the amount of net risk adjusted margins they earn over the capital they need to hold.

For instance if banks had to hold the 8% basic capital requirement defined in Basel II, they could leverage (multiply) those net risk adjusted margins 12.5 times. And so if a bank wanted to earn a 20% pre tax ROE, it would need to collect an average net risk adjusted margin of 1.6% (20%/12.5) on assets equivalent to 12.5 times its capital.

Clearly, the more banks can leverage (multiply) those net risk adjusted margins, the higher the expected return on its equity, or the lower do those margins need to be.

For instance if banks had to hold only 1.6% in capital they would be able to leverage (multiply) those net risk adjusted margins 62.5 times. And so if banks wanted to earn the same 20% pre tax ROE as before, they would need to collect an average net risk adjusted margin of only 0.32% (20%/12.5) on assets equivalent to 62.5 times its capital. If the bank was abled to collect the same 1.6% average net risk adjusted margins, then its expected ROE would be a whopping 100%. 

The problem (for us) though, of Basel II, is that it, based on credit ratings, risk adjusted the capital requirements. And so, according to Basel II’s standardized risk weights, the banks were allowed to multiply their net risk adjusted margins the following way: 

SOVEREIGNS:

AAA to AA = Unlimited

A+ to A = 62.5 times

BBB+ to BBB- 25 times

BB+ to B- = 12.5 times

Below B- = 8.3 times

Unrated = 12.5 times

CORPORATES:

AAA to AA = 62.5 times

A+ to A = 25 times

BBB+ to BB- = 12.5 times

Below BB- = 8.3 times

Unrated = 12.5 times

Residential mortgages = 35.7 times

Anyone who does not immediately understand how this distorts the allocation of bank credit; in favour of those who can have their net margin offers multiplied more by banks; and against those who have these multiplied less, does not understand finance, or has a vested interest in not wanting to understand it.

Can there be any question that these regulations pushed banks overboard with exposures to AAA rated securities and loans to sovereigns, like to Greece?

But, someone might say, this is all in order to make banks safer. Bullshit! There has never ever been a major bank crisis resulting from excessive exposures to something perceived as risky when placed on banks’ balance sheets.

Of course with Basel III, which has a leverage ratio that is not risk depended, the differences in the times net risk adjusted margins can be multiplied are smaller, but that does not mean for one second that the Basel discrimination keeps on being kicking and alive.

God help our young… God help our Western civilization. These idiotic risk-adverse regulators are hindering banks from financing our young ones’ riskier future, and have banks only refinancing their parents’ (and their regulators’) safer present and past. 

Risk-taking is the oxygen of development. God make us daring!

Bank regulators, the Basel Committee, FSB, and other, insist on putting systemic risk on ever-larger doses of steroids

What was the biggest systemic risk we used to refer ages ago? That which Mark Twain described with “The bankers are those who want to lend you an umbrella when the sun shines and take it away as soon as it looks like it is going to rain”. In other words that bankers could be too risk adverse, and therefore not be allocating credit efficiently to the real economy. 

But what did regulators do with their risk weighted capital requirements for banks? They told banks to lend out even more the umbrella when the sun shines. 

I have written on bank regulations for a long time, not as a regulator, but as a consultant that has walked up and down on Main Street helping corporations of all types to access that bank credit that seems so impossible or so expensive when one is perceived as risky. 

And as an Executive Director of the World Bank 2002-2004 I also raised my voice on many related issues. You can read some of my public opinions here. 

Today I was made aware of a paper from the International Institute for Applied Systems Analysis, IIASA, authored by Sebastian Poledna, Olaf Bochmann, Stefan Thurner and that is said to suggest: “smart transaction taxes based on the level of systemic risk” 

Holy Moly, when will they ever learn? All intrusions that tilt regulations in favor of something or someone become, immediately, a new source of systemic risk? 

And the more and the better you are in guarding against some identified systemic risk, the higher you are climbing up the very dangerous mountain. 

In April 2003, when commenting on the World Bank's Strategic Framework 04-06 I held: "A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind." 

Everywhere I look I see more and more sources of systemic risks in our banking system. Like which? 

Continuing to rely on too few human fallible and capturable credit rating agencies. 

Continuing to use risk weighted capital requirements that distort for no good reason at all. 

Liquidity requirements that can only increase the distortions. 

Forcing the use of standardized risk weights, which imposes a single set of criteria on too many. 

Regulators now wanting to assure that banks all apply similar approved risk models. 

The stress tests of the stresses that are a la mode. 

Living wills. 

And of course that pure ideological interference that have statist regulators assigning a 0% risk weight to sovereign and a 100% to citizens. 

All in all, in terms of creating dangerous systemic risks, hubris filled bank regulators are the undisputable champions. 

The main cause for all this is that our bank regulators seem to find it more glamorous to concern themselves with trying to be better bankers, than with being better regulators. 

Regulators, let the banks be banks, perceive the risks and manage the risks. The faster a bank fails if its bankers cannot be good bankers, the better for all. Your responsibility is solely related to what to do when banks fail to be good banks. Please?

And regulators always remember these two rules of thumb: 

1. The safer something is perceived to be, the more dangerous to the system it gets; and the riskier it is perceived, the less dangerous for the system it becomes. 

2. All good risk management must begin by clearly identifying what risk can we not afford not to take. In banking the risk banks take when allocating credit to the real economy is precisely that kind of risks we cannot afford them not to take. 

So when can we get bank regulators humble enough to understand their role is to regulate banks against risks they themselves cannot understand? Please?

Could a hostile power create bank regulations capable of destroying our Western financial system? It would seem so :-(

David Bookstaber in his “The End of Theory”, 2017 refers to the following question:

“If you were a hostile foreign power, how could you disrupt or destroy the U.S. financial system? That is how do you create a crisis?

Well one way to do it begins, as does any strategic offensive, with the right timing. Wait until the system exposes a vulnerability. Maybe that is when it’s filled with leverage, and when assets become shaky.”

Then Bookstaber suggests: “create a fire sale by pressing down prices to trigger forced selling…freeze funding by destroying confidence… maybe pull out your money from some institutions with some drama… and to make money, short the market before you start pushing things off the cliff”

That is Bookstaber’s interesting tale on what “turned the vulnerabilities of 2006 and 2007 into the crisis of 2008, and nearly destroyed our system.” “And we didn’t need an enemy power; we did it all by ourselves.

But what if it all had started with a hostile foreign power taking over bank regulations in order to create the vulnerabilities?

I mean like telling banks they could hold 1.6% in capital or less, meaning a 62.5 to 1 or more leverage, against assets with an AAA rating (like some fatal MBS) or against sovereigns, like Greece. That would give banks the chance to earn fabulous expected risk adjusted margins on those assets, and therefore build up huge exposures to these against very little capital (equity).

I ask, because that was exactly what the Basel Committee for Banking Supervision did with its Basel II of 2004.

And to top it up their AAA-bomb was so powerful that, because it discriminates against the access to bank credit of “the risky”, like SMEs and entrepreneurs, the economy would find it almost impossible to recover on its own; and the crisis-can had to be kicked further and further down the road, with Tarps, QEs, fiscal deficits and silly low interest rates? 

http://theaaa-bomb.blogspot.com

What if traffic regulators, to make your town safe, limited motorcycles to 8 mph but allowed cars to speed at 62 mph?

The fatality rate per 100 million vehicle miles traveled in cars is 1.14

The fatality rate per 100 million vehicle miles traveled in motorcycles is 21.45

That could indicate that in terms of risks measured and expressed as credit ratings, the cars should be rated AAA, and motorcycles below BB-.

But in 2011, in the US, 4,612 persons died in motorcycle accidents.

And in 2011, in the US, 32,479 persons died in vehicle accidents.

That explains the differences between ex-ante perceived risk and the ex-post dangers conditioned by the ex-ante perceptions. Cars are more dangerous to the society than motorcycles, in much because the latter are perceived as much riskier.

But what did bank regulators do in Basel II, 2004?

By weighting for ex-ante perceived risks their basic capital requirement of 8%, they allowed banks to leverage 62.5 times to 1 when AAA-ratings were present, and 8.3 times in the case of below BB- ratings.

So, what if traffic regulators, in order to make your hometown safe, limited motorcycles to 8 mph but allowed cars to speed at 62 mph?

Do you see why I argue that current bank regulators in the Basel Committee and in the Financial Stability Board have no idea about what they are doing?

But it is even worse. We need SMEs and entrepreneurs to access bank credit in order to generate future opportunities for our kids. Unfortunately, since when starting out these usually have to drive more risky motorcycles than safe cars, our future real economy gets also slapped in the face. 

An 8% capital requirement translates into a 12.5 to 1 leverage. Why can’t our regulators allow banks to speed through our economy at 12.5mph, independently of whether they go by cars or motorcycles?

PS: Here is a more detailed explanation of the mother of all regulatory mistakes.

Regulators looking after the same risks bankers look at

How the Western civilization is being lost because of regulatory induced risk aversion.

Mark Twain has been attributed opining that bankers lend you the umbrella when the sun shines and want it back as soon as it looks it could rain.

And never ever has there been a bank crisis caused by excessive exposures to something perceived as risky when placed on banks’ balance sheets.

But that did not stop scared lack of testosterone bank nannies to also require banks to hold more equity when lending to the risky than when lending to the “safe”.

So what happened? 

As banks earned much higher risk adjusted returns on the safe they could not resist the AAA rated securities backed with mortgages to the subprime sector, or sovereigns like Greece. And so a typical bank crisis, that of excessive exposures to what was ex-ante perceived as safe but that ex post turned out very risky ensued. 

In this case the crisis was made specifically worse, by means of the lower equity banks had been authorized to maintain. For example in the case of the AAA rated securities, Basel II, because of the standardized risk weights, banks were required to only hold 1.6% in capital, meaning an authorized leverage of 62.5 to 1. 

But much worse, since banks of course find it harder to earn higher risk adjusted ROEs on more capital, they have abandoned lending to risky SMEs and entrepreneurs, those who open up new roads on the margins of our economy, and so of course slower economic growth results.

Lack of testosterone, risk aversion, is not a fundamental value of the Western civilization. On the contrary in churches we sometimes sang, or at least used to sing, “God make us daring!”

@PerKurowski

Can you have a neutral interest rate when bank regulations are not neutral?

That theoretical interest rate that neither pushes nor restrains the economy from its natural rhythm of growth, is called the neutral interest rate, and is of course the subject of much interest by central bankers.

But what these bankers never discuss, who knows why, is what happens to this neutral interest rate, if bank regulations are not neutral.

Current risk weighted capital requirements for banks which allow banks to earn higher risk adjusted returns on equity with what is perceived, decreed or concocted as safe, than with what is perceived as risky, are clearly not neutral.

They push bank credit to the “safe” areas and away from the “risky” and that distortion must have a real cost for the economy.

Just for a starter, since the risk-weight assigned to the sovereign is 0%, all those “risky” SMEs and entrepreneurs who will not get credit or need to pay more for it, only because of these regulations that are biased against them, are paying a regulatory tax that is directly subsidizing lower interest rates for the government.

As I have argued many times before … we do not have real risk-free rates, we have subsidized risk-free interest rates.

FSB reports: “G20 reforms are building a safer, simpler, fairer financial system”. What a triple lie!

FSB reports to G20 Leaders on progress in financial regulatory reforms, and it starts with: G20 reforms are building a safer, simpler, fairer financial system

“Safer”? Major bank crises do not result from excessive exposures against what is perceived risky, but always from unexpected events or excessive exposures to what was ex ante perceived, decreed or concocted as safe, but that, ex post, turned out to be very risky.

In the FSB video they say “A safe banking system needs enough capital to absorb unexpected losses” and so my question is: So why require capital based on expected risks?

“Simpler”? Don’t be ridicule! Just have a look at the Basel Committee’s absurdly obscure “Minimum capital requirements for market risk” of January 2016, and on its consultative document for a "simplification" of July 2017.

The FSB video does not really even dare to explain the "simpler" factor.

“Fairer”? Forget it! The discrimination in the access to bank credit in favor of those perceived, decreed or concocted as safe, like the Sovereigns and the AAA-risktocracy is still alive and kicking; just like that one against “the risky”, the SMEs and entrepreneurs. It is an inequality driver.

No wonder the FSB video has the comments disabled.

G20 you want to understand what is wrong with current bank regulations? Start here!

ECB Working Paper 2079, as is standard, also suffers from confusing ex ante perceived risks with ex post realities.

Jonathan Acosta Smith, Michael Grill, Jan Hannes Lang have produced a paper titled “The leverage ratio, risk-taking and bank stability”, ECB Working Paper 2079, June 2017, which analyzes the non-risk based leverage ratio (LR) that has been introduced in Basel III to work alongside the risk-based capital framework.

I quote: “The main concern relates to the risk-insensitivity of the LR: assets with the same nominal value but of different riskiness are treated equally and face the same capital that an LR has a skewed impact, binding only for those banks with a large share of low risk-weighted assets on their balance sheets, this move away from a solely risk-based capital requirement may induce these banks to increase their risk-taking; potentially offsetting any benefits from requiring them to hold more capital.” 

Unfortunately this paper suffers from the usual and tragic mistake of confusing ex ante perceived risks with ex post realities.

Basel Committee bank regulators acted like bankers and not like regulators, when they got fixated on the risk of the assets of the banks, and not on the risk those assets posed for the banking system. Had they done some empirical research on what caused previous bank crises, they would have seen that what was ex ante perceived as risky never played a mayor role.

As is Basel II’s risk weighted capital requirements allow banks to earn higher risk adjusted returns on equity with assets ex ante perceived (decreed or concocted) as safe, than with assets perceived as risky. That results in banks building up dangerous exposures, against little capital, to assets that though ex ante perceived were perceived as very safe, could ex post turn out very risky. E.g. the AAA rated securities backed with mortgages to the subprime sector.

The clearest way I have found to illustrate the regulator’s fundamental error is by referencing Basel II’s standardized risk weights:

It allocates a meager 20% risk weight to corporates "dangerously" rated AAA to AA, while assigning a 150% risk weight to the "innocuous" below BB- rated, that which banks would never touch with a ten feet pole.

And, with their risk weighting the regulators, with serious consequences, are also distorting the allocation of bank credit to the real economy. Since the introduction of Basel II, millions of “risky” SMEs and entrepreneurs have not been able to access bank credit, or have had to pay extra compensatory interest charges, precisely because of this pillar.

Bank capital requirements should not be based on what is perceived but on the possibilities that the perceptions are wrong, that the perceptions are right but not adequately managed or that unexpected events could happen. 

In this respect I am all for one single capital requirement for all assets (including of course sovereign loans).

So does the introduction of the leverage ratio partly fulfill what I want? Unfortunately not! The more a leverage ratio translates into banks finding it difficult to meet regulatory bank capital requirements, the more will the risk-weighted requirements distort on the margin. I often refer this to the Drowning Pool simile.

Here is a more detailed list of the mistakes with risk weighting.