My tweet comments on Stephen Cecchetti's and Kim Schoenholtz's "The financial crisis, ten years on", Vox August 2017

"The financial crisis, ten years on"

Does a crisis start when the bomb is armed, the fuse is lit, the explosion occurs, or when the explosion is noted? http://voxeu.org/article/financial-crisis-ten-years#

In 2003 FT published a letter I wrote about the systemic risk of giving credit rating agencies so much power https://teawithft.blogspot.com/2003/01/credit-ratings-for-developing-nations.html

In 2004 the fuse was lit when Basel II authorized banks to leverage 62.5 times with what was rated AAA

https://subprimeregulations.blogspot.com/2010/06/impose-higher-bank-capital-requirements.html

 

In August 2006 clearly the bomb had already exploded https://teawithft.blogspot.com/2006/08/long-term-benefits-of-hard-landing.html

Unfortunately it was not until July 2007 credit rating agencies woke up and in August that the fan started to spread out the shit.

AI Watson, would you ever feed robobankers those algorithms current bank regulators feed human bankers?

The normal real world rules banks had to follow for about 600 years before 1988, in order to become and remain successful bankers, was to while carefully considering their portfolio, to lend or invest in whatever they perceived would produce them the highest risk adjusted returns on equity. One dollar of equity lost in an operation perceived as risky would hurt just as much as a dollar lost in an operation perceived as safe. 

And even though bankers in general suffered from a risk aversion bias, expressed well by Mark Twain’s “a banker is one to lend you the umbrella when the sun shines and wanting it back when it seems it could rain”, that obviously served our economies well. 

As John Kenneth Galbraith argued, even when in some cases “Banks opened and closed doors and bankruptcies were frequent, as a consequence of agile and flexible credit policies, the failed banks left a wake of development in their passing.”

But then came the Basel Committee for Banking Supervision, and out of the blue decided to assume bankers did not perceive risks; and so came up with their risk weighted capital requirements. These instructed banks, with no consideration to their portfolio, to hold more capital (equity) against what is perceived risky and less against what is perceived safe.

As an example of their crazy regulatory algorithm, it suffices to mention they assigned a risk weight of 20% for the so dangerously AAA rated while one of 150% to the so innocous below BB- rated.

As a consequence of this bankers had to morph from being mainly risk perceivers into also having to be capital (equity) minimizers. Being able to leverage more the “safe “ than the “risky” allowed them to obtain higher risk adjusted returns on equity lending with the safe than with the risky.

As a consequence we have already suffered major bank crisis resulting from excessive exposures to what was erroneously perceived, decreed or concocted as safe, like AAA rates securities and sovereigns like Greece.

As a consequence of not enough lending to the “risky”, like SMEs and entrepreneurs, development is coming to a halt.

Since regulators refuse to listen to little me, I can’t wait for IBM’s Watson developing lending and investment algorithms for robobankers. These would help show bank current regulators how dangerously wrong they are.

Watson would understand that with current distortions banks go wrong even if they perceive the risks absolutely correct.

Watson would understand that what is perceived risky ex ante becomes by that fact alone less dangerous ex post; and that what is perceived safe ex ante becomes by that fact alone more dangerous ex post.

“May God defend me from my friends, I can defend myself from my enemies” Voltaire.

Regulator Watson, in contrast to the Basel Committee, would not be looking in the same direction the bankers look

PS. Here on the regulators' confirmation bias

PS. Here my letter to the Financial Stability Board

PS. How do you regulate a regulators' algorithm?

Our modern statist rulers insidiously debase our currencies with their decreed zero-risk weighting of sovereigns

Lawrence W. Reed in “Did You Know about the Great Hyperinflation of the 17th Century?” FEE August 2017, quotes Nicolaus Copernicus (1473–1543) with: “The greatest and most forbidding mistake has to be when a ruler tries to make a profit from the minting of coins by introducing and circulating new coins with an inferior weight and fineness, alongside the originals, and claims that they are of equal value”

And Reed notes: “Desperate to raise cash and secure material for war, many of the German states in 1618 resorted to the debasement of coinage. They clipped and they melted. At first, they adulterated their own coin but then discovered that they could do the same to that of their neighbors too.”

Our modern governments use much more refined and insidious debasement methods. In order they say to make our banks safe, regulators came up with the risk weighted capital requirements which assigned to the sovereign a risk weight of 0%... yes, you read it well, zero percent.

That means that banks are able to leverage any little net margin obtained on public debt, into great returns on equity. That means that banks will be offering to hold a lot of public debt at low rates which will help to confound all the rest of investors into believing the markets believe that debt to be intrinsically safe.

That also means banks are going to absorb much more of the governments injections of liquidity than would otherwise have been the case.

One day buyers of public debts of these by regulators decreed ultra-safe sovereigns, are going to wake up.

When that happens all bets are off. Interest rates on public debt will shoot up, repaying governments will inject liquidity that will be impossible to drain… and economic realities will be hyper-inflation/hyper-recession messy.

When will that happen? Who knows, in Europe governments have already recruited insurance companies to also operate under a scheme similar to the banks’ Basel I, II and III, and which has quite cynically been named Solvency II.

Why is this all unsustainable? Any system, in which government bureaucrats can, without being responsible for its repayment, have easier access to other peoples’ money than for instance the 100% risk weighted SMEs and entrepreneurs, simply cannot end well.

PS. I often hear the argument that if sovereigns borrow in their own currency they represent indeed a zero risk because they will always be able to repay. Wow they’ve got to be kidding! True repayment does only happen when done with purchase power that has not been diluted by inflation.

PS. The confession that shall not be heard: “Assets for which capital requirements were nonexistent, were what had most political support: sovereign credits… A simple ‘leverage ratio’ discouraged holdings of low-return government securities" Paul Volcker 2018

PS. Here is a current summary of why I know the risk weighted capital requirements for banks, is utter and dangerous nonsense.

PS. My 2019 letter to the Financial Stability Board

Ten years ago ECB decided to ignore the benefits of a hard landing and go for kicking the can down the road

In August 2006, when we were already hearing worrisome comments about complex securities linked to mortgages, I wrote a letter to FT titled “The Long Term Benefits of a Hard Landing”. At that moment I had not yet been censored by FT and so they published it.

One year later, when panic about the AAA rated securities backed with mortgages to the subprime sector impacted the financial markets, ECB (and the Fed earlier) decided to ignore that option and go for the politically more convenient short-termish option of kicking the can down the road, with QEs and ultralow interest rates.

It could have worked, if only what had caused the crisis and what hindered the stimuli to flow in the correct directions had been removed. But no, the regulators refused to admit their mistake with the risk weighted capital requirements.

And so here we are, a full decade later, still allowing banks to multiply the net margins obtained more when it relates to assets perceived, decreed or concocted as safe, than with assets perceived as risky, and so obtain higher expected risk adjusted returns on their equity financing the safe than financing the risky.

In a historic analogy, regulators still believe the sun to be circling around the earth; in this case that what is perceived as risky is more dangerous to the banking system than what is perceived as safe.

As a result “safe” sovereigns, AAArisktocracy and residential houses still dangerously get way too much bank credit, while “risky” SMEs and entrepreneurs, way too little to keep our economies dynamic.

Every day we allow regulators like Mario Draghi to regulate based on a flawed theory, the worse for all of us.

But what are we to do when there are so many vested interests in shutting up this the mother of all bank regulation mistakes?

Capital requirements for banks should be ex ante perceived risks neutral.

Professor Steve Hanke writes: “The calculated risk that a financial institution takes is best understood by the institution itself, not the government or any outside party” “Let Banks Manage Risks, Not Regulators” Forbes July 30, 2017.

I agree: For about 600 years banks use to run their banks as if each dollar invested in any asset was worth the same. Not any longer, since Basel I, 1988 and Basel II, 2004 some assets produce net margins that regulators allow them to leveraged much more than other. That meant that banks would find it easier to obtain higher risk adjusted returns on equity on some assets, those perceived ex ante as safe, than on other, those perceived as risky.

That of course distorted dangerously the allocation of bank credit to the real economy. The 2007-08 problems resulting mainly from excessive exposures to AAA rated securities and sovereigns, as well as the mediocre response to ultra large stimulus like QEs and minimal interest rates should suffice to prove it.

And I disagree: Because bank regulators should consider the risks that banks are not able to manage the risks they perceive, or that some unexpected events can put the system in danger. But since that has absolutely nothing to do with ex ante perceived risks per se, the capital requirements should be risk-perceived neutral, like for instance solely a leverage ratio. 

Besides, if regulators insist in risk weighing, only to show off some regulatory sophistication, so as to be known as important experts, then they should never forget that what really poses dangers to the banks system is what is perceived safe and never ever what is ex ante perceived very risky.