What would Hyman Minsky say if able to observe how his financial instability moments were put on steroids by bank regulators?

On Minsky moments

“In many cases even trying to regulate banks runs the risk of giving the impression that by means of strict regulations, the risks have disappeared. History is full of examples of where the State, by meddling to avoid damages, caused infinite larger damages”

“Old agricultural traditions of burning a little each year, thereby getting rid of some of the combustible materials, was much wiser than no burning at all, which only guarantees disaster and scorched earth, when fire finally breaks out, as it does, sooner or later. Therefore a regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises.”

“Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds”

The Basel Committee’s credit risk weighted bank capital requirements cause our banks to be dangerously overexposed to what’s expected, and to be woefully unprepared for the unexpected. 

Current risk weighted bank capital requirements guarantee especially large bank crises, caused by especially large exposures to what’s perceived as especially safe but might not be, and is held against especially little capital.

"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."

Since they believe it to be safer, regulators want banks to finance house purchases much more than job creating entrepreneurs. Doesn’t anyone of them have grandchildren?

Let us suppose that in a world without risk weighted capital requirements, like the world of banking was for around 600 years before 1988’s Basel Accord, a world with one single capital requirement against all bank assets, for instance 8%.

Let us also suppose that in that world banks would view residential mortgages at 5% interest rate to be, when adjusted to perceived credit risks, equivalent to 9% interest rate on loans to entrepreneurs, and that, for both these assets, their expected risk adjusted net margin was 1%.

In that case, since banks could leverage 12.5 times their equity (100/8) the expected risk adjusted return on equity, on both these assets, would be 12.5%

How many residential mortgages and how many loans to entrepreneurs were given in such a world? I have no idea but adjusted for their perceived credit risk, it was clear both house buyers and entrepreneurs competed equally for credit. 

But then came the Basel Committee with its risk weighted bank capital requirements, and for instance in its 2004 Basel II, assigned a risk weight of 35% to residential mortgages and 100% for loans to unrated entrepreneurs. 

That, for Basel’s basic capital requirement of 8%, meant banks needed to hold 2.8% in capital against residential mortgages and 8% against loans to entrepreneurs.

This in turn meant banks could in the case of loans to entrepreneurs still leverage 12.5 times but now, with residential mortgages, they could leverage almost 36 times (100/2.8). 

And in this case, with the same as expected risk adjusted margin of 1%, banks could still earn12.5% in expected risk adjusted return on equity, but residential mortgages now offered them the possibility of earning a whooping 36% in expected risk adjusted return on equity.

Clearly house buyers were much favored since banker would offer residential mortgages much more and even contemplate some interest rate reductions, while the entrepreneurs had their access to credit much curtailed that is unless they offered to pay higher interest rates.

So what does all this result in? Houses morphing from affordable home into being risky investment assets, while at the same time much less of those job opportunities that entrepreneurs might have helped to create for us and our descendants.

Thinking of our grandchildren’s future is this kind of bank regulations acceptable? Absolutely not! “A ship in harbor is safe, but that is not what ships are for.” John A. Shedd.

PS. Much worse statist regulators assigned 0% risk weights on loans to the sovereign, which de facto implied government bureaucrats to use credit for which they are not personally responsible for much better, than for instance entrepreneurs.

PS. Here's a probably still not finished list of the mistakes with the risk weighted bank capital requirements 

Here a simple as can be one-minute explanation of the distortions produced by the risk weighted bank capital requirements in the allocation of credit to the real economy.

For 600 years, before the Basel Accord of 1988, banks, with an eye to their overall portfolio, allocated their assets/credits depending on the perceived risk adjusted return these were to produce.

For instance, if a safe AAA to AA rated asset at 4% interest rate and a riskier asset rated BBB+ to BB- a 7% interest were, in the mind of the banker, both producing an acceptable 1% net risk adjusted return, he could pick either one or both. If banks were allowed (by markets or regulators) to leverage their assets 12.5 times, that would produce the bank a 12.5% risk adjusted return on equity.

But the introduction of the risk weighted bank capital requirements changed all that.

Basel II, 2004, standardized risk weights banks assigned a risk weight of 20% to AAA to AA rated assets, and 100% BBB+ to BB- rated assets.

That based on a basic capital requirement of 8% translated into a 1.6% capital requirement for AAA to AA rated assets, and 8% for BBB+ to BB- rated assets.

That mean banks could leverage AAA to AA rated assets 62.5 times, while only 12.5 times with BBB+ to BB- rated assets.

So, with the same previous 1% net risk adjusted return AAA to AA rated assets would now yield a 62.5% risk adjusted return on equity while the BBB+ to BB- rated assets would keep on yielding a 12.5% risk adjusted return on equity.

And so either the BBB+ to BB- rated risky had to be charged 12% instead of 7%, so as to deliver the 5% risk adjusted return that, with a 12.5 times allowed leverage would earn banks a 62.5% risk adjusted return on equity, something which naturally made the risky even riskier; or the AAA to AA rated could be charged a lower 3.2 % interest rate instead of 4%, and still deliver a 12.5% risk adjusted return on equity.

What happened? The risky, like unsecured loans to entrepreneurs, were abandoned by banks, or had to pay much higher interest rates, while the safe, like sovereigns, residential mortgages and AAA rated, were much more embraced by banks, and even offered lower interest rates than in the past.

This is the distortion in the allocation of bank credit to the real economy that the regulators have caused. Is that good? Absolutely not! It promotes excessive credit to what’s perceived or decreed safe, and insufficient to what’s perceived as risky. 

And since risk taking is the oxygen of all development, with it, regulators have doomed our real economy and financial sector to suffer from lack of muscles, severe obesity and osteoporosis.

“A ship in harbor is safe, but that is not what ships are for.” John A. Shedd. But the Basel Committee for Banking Supervision is causing banks to dangerously overpopulate safe harbors, while leaving the riskier oceans to other investors and small time savers.

And the savvy loan officers were substituted by creative bank equity minimizing financial engineers

And the risk-free rate became a subsidized risk-free rate.

The risk weights in the risk weighted bank capital requirements are to access to credit, what tariffs are to trade, only more pernicious.

https://subprimeregulations.blogspot.com/2016/09/if-ever-allowed-following-would-be-my.html

Tombstones

Here rests a bank regulator who all his life believed that what bankers perceived as risky was more dangerous to our bank systems than what bankers perceived as safe. 

May his soul rest in peace.

Here rests a bank regulator who based the risk weighted bank capital requirements on bankers perceiving risk correctly, and not on that they could be wrong.

May his soul rest in peace.

Here rests a regulator who missed his lectures on conditional probabilities, and therefore did not set the risk weighted capital requirements conditioned on how bankers respond to perceived credit risks.

May his soul rest in peace.

Here rests a regulator who even though bankers respond to perceived credit risks, with size of exposures and risk adjusted interest rates, also wanted bank capital to double up on that same perceived risk

May his soul rest in peace.

Here rests a bank regulator who never understood the systemic risks he introduced into banking, by for instance assigning so much power to credit rating agencies, or his stress-testings on the stresses a la mode.

May his soul rest in peace.

Here rests a bank regulator who never understood his own risk aversion and confirmation bias stress, before stress testing banks on the possibility of his own regulations being wrong.

May his soul rest in peace.

Here rests a bank regulator who for the risk weighted bank capital requirements agreed with risk weights of 20% for dangerous AAA rated and 150% for innocous below BB- rated

May his soul rest in peace.

“A ship in harbor is safe, but that is not what ships are for.” John A. Shedd.

Here rests a bank regulator who caused banks to dangerously overpopulate safe harbors, and sent other investors and small time savers out on the risky oceans. 

May his soul rest in peace.

Here rests a bank regulator who by much favoring banks to finance the "safer" present over the "riskier" future, blocked millions of SMEs' and entrepreneurs' access to bank credit and with it to risk-taking… the oxygen of all development

May his soul rest in peace.

Here rests a statist bank regulator who believed a government bureaucrat knows better (Risk Weight 0%) what to do with credit he’s not personally responsible for, than an entrepreneur or SME (RW 100%)

May his soul rest in peace.

Here rests a bank regulator who for risk weighted bank capital requirements agreed with a low 35% risk weight to residential mortgages, which caused houses to morph from affordable homes to risky investment assets.

May his soul rest in peace.

Here rests a bank regulator with a Ph.D. who proved right Daniel Patrick Moynihan, who supposedly held “There are some mistakes only Ph.Ds. can make.

May his soul rest in peace.

Here lies a central banker who injected huge amounts of liquidity without understanding how risk weighted bank capital requirements distorted the allocation of credit

May his soul rest in peace.

Here lies a financial journalist who scared stiff he would never be invited to WEF in Davos, never questioned the risk weighted bank capital requirements. 

May his soul rest in peace.

Here lies an ordinary citizen who wanting so much to believe it true, swallowed lock stock and barrel the regulatory technocrats' populism imbedded in the risk weighted bank capital requirements

May his soul rest in peace.

Here rests a regulator who helped guarantee especially large bank crises, caused by especially large exposures to what’s perceived especially safe and might not be, and is held against especially little capital

May his soul rest...

Here rests a regulator who assisted by his central bank colleagues, helped set horrible Minsky moments on steroids
May his soul rest...

PS. A summary of The Basel Committee for Banking Supervision's mistakes

My tweets on “How the Basel Committee doomed our bank systems and our economies”

The Basel Committee doomed our bank systems and our economies.

For around 600 years risk adverse bankers had, not always successfully, tried to do their best to clear for perceived credit risks, by means of risk adjusted interest rates and the size of bank exposures. 

When what bankers had perceived as risky turned out to be even more risky, since the exposures were generally quite small, it hurt but banks could manage. 

When what bankers perceived as safe turned out to be risky, since the exposures were then very large, big crises often ensued. 

But then, starting in 1988 with Basel I, and really exploding in 2004 with Basel II, risk adverse regulators decided they also wanted to clear for those same perceived credit risks, and to that effect introduced risk weighted bank capital requirements.

In the softest words I can muster, that was extremely dumb. As bank supervisors they should be almost exclusively concerned with bankers not perceiving the credit risks correctly. Instead they bet our bank systems on that bankers would perceive credit risks correctly.

Banks everywhere were then taken out of the hands of savvy loan officers, and placed in the hands of creative equity minimizing financial engineers, who then ably marketed the nonsense that more bank capital hindered bank lending and was therefore bad for the real economy 

The 2008 crisis caused by AAA rated securities backed with mortgages to the US subprime sector, with which European banks and US investment banks were allowed to leverage 62.5 times with these, should have loudly reminded them about the dangers of the “safe”. 

But regulators refused to admit their mistake and kept risk weighting in Basel III.

The result is an ever increasing dangerous overcrowding of “safe harbors” and the abandonment of the “riskier oceans. “A ship in harbor is safe, but that is not what ships are for.” John A. Shedd.

And those who used to populated safe harbors, like insurance companies, pension funds, personal saving accounts and other, have been expelled to the risky oceans, confronting loans to leveraged corporates, emerging markets and others for which they're less prepared than bankers

To sum it up, risk-weighted bank capital requirements guarantees especially large crises, resulting from especially large exposures to what’s perceived especially safe, and is held against especially little capital. 

Let’s get rid of these regulators… now!

http://perkurowski.blogspot.com/2016/04/here-are-17-reasons-for-why-i-believe.html

And not only are they dangerously bad regulators… by decreeing risk weights of 0% for the sovereign and 100% for the citizens, they also evidence being dangerous statist/communist regulators.

http://perkurowski.blogspot.com/2019/09/financial-communism.html

PS. My 2019 letter to the Financial Stability Board

PS. My 2019 letter to the IMF

My tweets to IMF and World Bank on risks and bank regulations during their Annual Meetings 2019

@IMFNews @WorldBank #IMFmeetings #WBGMeetings

The world needs the IMF and World Bank to hold a continuous and intensive back and forth debate, a give and take, on risk-taking. 

“A ship in harbor is safe, but that is not what ships are for.” John A. Shedd.

http://teawithft.blogspot.com/2009/10/please-free-us-from-imprudent-risk.html

The World Bank, as the world’s premier development bank should always make clear that risk taking is oxygen needed for moving forward.

And the IMF, as guardian of the world’s financial stability, is responsible for that risk taking not getting out of hands. 

http://subprimeregulations.blogspot.com/2003/03/financial-sector-assessments-program.html

That debate has sadly not been forthcoming.

That resulted in the acceptance of the credit risk weighted bank capital requirements. 

That introduced a regulatory risk aversion, dangerous both for the financial stability and for economic growth.

For financial stability, by creating excessive bank exposures to what’s perceived, decreed or concocted as especially safe, against especially little capital.

For the economy, by reducing the “risky” but vital SMEs’ and entrepreneurs’ access to bank credit.

A synchronized financialization: 

"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."

http://subprimeregulations.blogspot.com/2003/03/my-comments-on-world-banks-strategic.html

A synchronized disaster:

“Perceiving risks wrong: What happens when markets misprice risk?”

Wrong question! When markets see risks, it stays away 

Correct question! “Perceiving safety wrong: What happens when markets (and regulators) misprice safety?

http://subprimeregulations.blogspot.com/2019/07/risk-weights-are-to-access-to-credit.html

Some tweets on macro-imprudent policies

I tweeted this to BIS in response to a speech by Mario Draghi, President of the European Central Bank and Chair of the European Systemic Risk Board, titled "Macroprudential policy in Europe" delivered September 26, 2019

Macro-imprudent policy 1:

Regulators have based their risk weighted bank capital requirements on that what’s perceived as risky is more dangerous to our bank systems than what is perceived, decreed or concocted as safe. That puts bank crises on steroids.

Macro-imprudent policy 2:

The risk weighted bank capital requirements is as pro-cyclical as it gets. Getting rid of these is the best countercyclical measure.

Macro-imprudent policy 3:

The 0% capital requirements assigned to all Eurozone sovereigns’ debts, even when these are not denominated in their own printable fiat currency. This WILL blow up the Euro and perhaps, sadly, the EU too.

Basel I, II, and III are all examples of pure unabridged regulatory statism

In July 1988 the G10 approved the Basel Accord. For its risk weighted bank capital requirements it assigned the following risk weights:

0% to claims on central governments and central banks denominated in national currency and funded in that currency. 

100% to claims on the private sector.

That means banks can leverage much more whatever net margin a sovereign borrower offers than what it can leverage loans like to entrepreneurs. That means banks will find it easier to earn high risk adjusted returns on their equity lending to the sovereign than for instance when lending to entrepreneurs. That means it will lend too much at too low rates to the sovereign and too little at too high rates to entrepreneurs.

In other words Basel I introduced pure and unabridged statism into our bank regulations. 

Basel II of June 2004 in its Standardized Risk Weight, for the same credit ratings, also set lower risk weights for claims on sovereigns than for claims on corporates.

In a letter published by FT November 2004 I asked: “How many Basel propositions will it take before they start realizing the damage they are doing by favoring so much bank lending to the public sector. In some developing countries, access to credit for the private sector is all but gone, and the banks are up to the hilt in public credits.”

And the European Commission, I do not know when, to top it up, assigned a Sovereign Debt Privilege of a 0% risk weight to all Eurozone sovereigns, even when these de facto do not take on debt in a national printable currency.

And, to top it up, the ECB launched its Quantitative Easing programs, QEs, purchasing European sovereign debts.

At the end of the day, the difference between the interest rates on sovereign debt that would exist in the absence of regulatory subsidies and central bank purchases, and the current ultra low or even negative rates, is just a non-transparent tax, paid by those who save. Financial communism

And all this began one year before the fall of the Berlin Wall

J’Accuse[d] the Basel Committee for Banking Supervision (BCBS) a thousands times, but I am no Émile Zola and there’s no L’Aurore

J’Accuse the Basel Committee of setting up our bank systems to especially large crises, caused by especially large exposures to something perceived as especially safe, which later turns into being especially risky, while held against especially little capital.

My letter to the Financial Stability Board

J’Accuse the Basel Committee for distorting the allocation of bank credit to the real economy by favoring the sovereign and the safer present, AAA rated and residential mortgages, while discriminating against the riskier future, SMEs and entrepreneurs.

My letter to the International Monetary Fund

A question to the Fed: When in 1988 bank regulators assigned America’s public debt a 0.00% risk weight, its debt was about $2.6 trillion, now it is around $22 trillion and still has a 0.00% risk weight. When do you think it should increase to 0.01%?

Clearing for perceived risk vs. discriminating based on perceived risk.

If making good down payments house buyers normally had more and cheaper access to bank credit than an entrepreneurs wanting loan for risky ventures.

But when regulators, with their risk weighted bank capital requirements decreed that banks needed to hold less capital against residential mortgages than against unsecured loans to entrepreneurs; which meant that banks could leverage much more their equity with residential mortgages than with unsecured loans to entrepreneurs; which meant that with the same risk adjusted interest than before banks could earn higher risk adjusted returns on equity with residential mortgages than with unsecured loans to entrepreneurs, the regulators de facto discriminated the access to bank credit in favor of house buyers and against entrepreneurs.

So there’s a world of difference between banks clearing for perceived credit risk and the regulators discriminating the access to bank credit based on perceived credit risk.

With their discrimination regulators decreed inequality

With their 0% risk weighted sovereign and 100% risk weighted citizens regulators decreed that the sovereign has more rights to more and cheaper access to bank credit than citizens.

And, at the end of the day it's all for nothing. That discrimination only sets up our banks to especially large bank crises, caused by especially large exposures to something ex ante perceived, decreed or concocted as especially safe, and which ex post turns into being especially risky, while being held against especially little capital.

A letter to the Financial Stability Board

A letter to the IMF titled: "The risk weights are to access to credit, what tariffs are to trade, only more pernicious."

PS. And do the risk weighted bank capital requirements make the risky riskier?

“I am not sure about 'subsidised' sovereign. Since sovereign is ultimate safety net for entire financial system… the term is I'll suited.”

My answer:

Yes a sovereign, if we ignore inflation and the possibility of being repaid in worthless money, the sovereign represents no risk if it takes on debt denominated in a currency it can print. Which by the way is not the case with the sovereigns in the Eurozone.

But let us assume that in the open market the required risk/cost/inflation adjusted net return for a sovereign in .5% and for the risky SMEs 3%

Then if banks, as it used to be for almost 600 years, had to hold one single capital against the risks of its whole portfolio, and the authorities, or in their absence the markets, allowed banks to leverage 12 times then the risk/cost/inflation adjusted required expected return on equity would be 6% for sovereigns and 36% for SMEs.

BUT, since banks are now allowed to leverage immensely more with safe sovereigns, let us say 40 times and only 12 times with SMEs, the now distorted risk/cost/inflation adjusted expected ROEs are 20% for sovereigns and still 36% for SMEs. So now banks can offer to lower the interest rates to sovereigns and still obtain the risk/cost/inflation adjusted required expected return on equity of 6% for sovereigns, ergo the subsidized sovereign.

OR, since banks could now earn a risk/cost/inflation adjusted expected ROEs of 20% on sovereign debt, then in terms of comparable risk adjustments it would have to earn more than 36% on SMEs, or not lend to them at all, ergo that subsidy to the sovereign, is paid by others who find their access to bank credit made more difficult and expensive as a consequence of the risk weighted bank capital requirements. 

PS. Is there no sovereign risk present when some current rates are negative and central banks work like crazy to produce 2% inflation? 

PS. If you go back in time and start taking about risk-free sovereigns to bankers who sometimes had their head chopped off or were been burned when trying to collect from the sovereigns, they would think you were crazy.

The before and after the risk weighted bank capital adequacy ratio (RWCR)

The risk weighted bank capital requirements were introduced in 1988 by means of the Basel Accord, Basel I, and were much further developed in 2004, with Basel II. RWCR survives in Basel III.

Before RWCR banks, for their return on equity, leaned on savvy bank loan officers to obtain the highest risk adjusted net margins. A net margin of 1.5% when leveraged 10 times on their equity, would produce a 15% ROE. All wanting access to bank credit, whether perceived as safe or risky, competed equally with their risk adjusted net margin offers.

After the introduction of RWCR though banks, for their return on equity, still leaned somewhat on bank loan officers obtaining the highest ROE depended more on equity minimizing financial engineers. A risk adjusted net margin of 1%, when leveraged 20 times on equity, produces a 20% ROE. The risk adjusted net margin offers of those perceived or decreed as safe, which could be leveraged many times more, were now worth much more than those offered by the risky.

And what are the consequences?

The RWCR by favoring the financing of the “safer present” like sovereigns, residential mortgages and what’s AAA rated over the financing of the “riskier future, like entrepreneurs, leads to a more obese and less muscular economy.

All that RWCR really guarantees is especially large bank crisis, caused by especially large exposures to something perceived or decreed as especially safe, and that turn out to be especially risky, while being held against especially little bank capital. 

So what went wrong? Simply that regulators based their capital requirements on the same perceived risks that bankers already consider when they make their lending decisions, and not on the conditional probabilities of what bankers do when they perceive risks.

Any risk, even if perfectly perceived, will lead to the wrong actions, if excessively considered.

My letter to the Financial Stability Board

Why are regulators allowed to introduce odious and dangerous discrimination in the access to bank credit?

Banks used to apportion their credit between those perceived as risky, and those perceived as safe, based on (1) the risk adjusted interest rates and (2) their own portfolio considerations.

But that was before the Basel Committee for Banking Supervision’s credit risk weighted capital requirements.

Now banks apportion credit between those perceived as risky and those perceived as safe, based on (1) the risk-adjusted interest rates (2) the times their bank equity can be leveraged with those risk-adjusted interest rates and (3) hopefully, since those risk weighted capital requirements are explicitly portfolio invariant, their own portfolio considerations.

That means the risk adjusted interest rates “the safe” now can offer in order to access bank credit have been lowered, while the risk adjusted interest rates “the risky” have to offer in order to access bank credit have been increased.

That has leveraged whatever natural discrimination in access to bank credit there was against the “riskier” in favor of the “safer”.

That dangerously distorts the access to bank credit in favor of the “safer” present, like sovereigns, house purchases and the AAA rated and against the “riskier” future, like entrepreneurs; which means that our banks have no other social purpose to fulfill than being safe mattresses into which stash away our savings.

And all so useless because the only thing these regulations guarantee, is especially large bank crisis, caused by especially large exposures to something perceived or decreed as especially safe, and that turn out to be especially risky, while being held against especially little bank capital. 

My comments to the Financial Stability Board

What if taking down our bank systems was/is an evil masterful plan for winter to come?

Tweets on "What if taking down our bank systems was/is an evil masterful plan for winter to come?"

The poison used is that of basing bank capital requirements on ex ante perceived risks, more risk more capital, less risk much less capital.

That way banks were given incentives to build up the largest exposures to what is ex ante perceived by bankers as safe, something which, as we know, in the long run, when ex post some of it turns out very risky, is what always take bank systems down.

For that they made sure no one considered making the risks conditional on how bankers perceive the risks.

And that hurdle cleared, some very few human fallible credit rating agencies were given an enormous influence in determining what is risky and what is safe.

And taking advantage of some statists or that few noticed, sovereigns were assigned a 0% risk weight, while citizens 100%. That guaranteed government bureaucrats got too much of that credit they’re not personally responsible, and e.g. the entrepreneurs too little.

And to make the plan even more poisonous some European authorities were convinced to also assign to all Eurozone sovereigns a 0% risk weight, and this even though these all take up loans in a currency that is not their domestic printable one.

And because banks were allowed to leverage much more with “safe” residential mortgages than with loans to “risky” small and medium businesses, houses prices went up faster than availability of jobs, and houses morphed from homes into investment assets

And finally, by means of bailouts, Tarps, QE’s, fiscal deficit, ultra low interest rates and other concoctions, enormous amounts of financial stimuli was poured on that weak structure… and so the evil now just sit back and wait for winter to come

http://theaaa-bomb.blogspot.com

PS. At the World Bank I warned that assigning too much influence to credit rating agencies introduced a dangerous systemic risk. 

PS. My letter to the Financial Stability Board

Risk weights are to access to credit what protectionist tariffs are to trade, only more pernicious.

A letter to the Executive Directors and Staff of the International Monetary Fund.

For decades now IMF has helped to spread around all developing countries the pillar of the Basel Committee’s bank regulations; the risk weighted capital requirements for banks.

Since risk taking is in essence the oxygen of any development, that piece of regulation is fundamentally flawed, especially for developing countries.

How do risk weighted capital requirements alter the incentives for banks? 

If banks hold the same capital against their whole portfolio, as they used do until some three decades ago, then with an eye on their overall portfolio and funding structure, banks lend in accordance to what produces them the highest risk adjusted interest rate; which would also provide them with the highest risk adjusted return on equity.

But, when different assets have different capital requirements, obtaining the highest risk adjusted return on equity will depend on how many times the risk adjusted interest rate for any specific loan or asset will depend on how many times it can be leveraged. The higher the allowed leverage is, the easier it is to obtain a high ROE; which means that “safe” highly leveregable loans could be competitive at lower risk adjusted interest rates than before, while “risky” lower leveregable loans would require paying higher risk adjusted interest rates. 

In essence the introduction of that regulation has caused banks to substitute savvy loan officers with equity minimizing engineers.

How do risk weighted capital requirements distort the allocation of bank credit?

The regulators based their decision on how much banks were allowed to leverage their capital with for the different assets, solely on the perceptions of credit risk. It never explicitly had one iota to do with banks fulfilling their obligation of allocating credit efficiently to the real economy.

So the introduction of that regulation simply distorts the allocation of bank credit; in favor of “the safer present” and against “the riskier future”. 

“A ship in harbor is safe, but that is not what ships are for”, John A Shedd.

Specifically, a credit that is perceived as risky but that is directly related to helping reach a Sustainable Development Goal is much less favored by bankers, and now by bank regulators too, than a credit, perceived as safe, but which purpose could in fact be harmful to any SDG.

Specifically, safe credits for the purchase of houses are much more favored over credits to risky entrepreneurs, those who could create the jobs that would allow the income needed to service the mortgages and pay the utilities. 

Specifically, assigning lower risk weights to the sovereign than to citizens de implies de facto a statist belief that bureaucrats know better what to do with bank credit, than entrepreneurs who put their name on the line.

In other words these risk weight are to access to credit what tariffs are to trade, only much more pernicious. 

Do risk weighted capital requirements make our banks system safer?

If that regulation made the financial system safer there would at least be a favorable tradeoff. But it doesn’t, much the contrary. Too much easy credit can turn what is safe into something risky, like for instance morphing houses from being affordable homes into investment assets. 

The 2007/2008-bank crisis would never have happened or, if so, remotely had been of the same scale had regulators, for their risk weights, instead of perceived credit risk risks, used the probabilities of banks investing conditioned on how credit risks were perceived.

Many Eurozone sovereigns would not face current high levels of indebtedness had not EU authorities decreed a Sovereign Debt Privilege and assigned it a 0% risk weight, this even though they take on debt denominated in a currency that de facto is not their domestic printable one.

And so, at the end of the day, this regulation only guarantees especially large bank crisis, caused by especially large exposures to what was perceived (or decreed) as especially safe, which end up being especially risky, and are held against especially little capital.

Risk weighted capital requirements and inequality.

John Kenneth Galbraith wrote: “The function of credit in a simple society is, in fact, remarkably egalitarian. It allows the man with energy and no money to participate in the economy more or less on a par with the man who has capital of his own. And the more casual the conditions under which credit is granted and hence the more impecunious those accommodated, the more egalitarian credit is… the poor risk… is another name for the poor man.” “Money: Whence it came where it went” 1975.

So I ask, how many millions of SMEs and entrepreneurs have not been given the opportunity to advance with credits over the last 25 years as a direct result of it?

IMF, please, wake up!

Should banks not be regulated? 

Of course these need to be regulated! I am only reminding everyone of the fact that the damage dumb bank regulators can cause when meddling without taking enough care, by far surpasses anything the free market can do. A free market would never have knowingly allowed banks to leverage 62.5 times their equity like regulators did, only because some very few human fallible credit rating agencies had assigned an AAA to AA rating to some securities backed with mortgages to the US subprime sector. 

A simple leverage ratio between 10 to 15% for all banks assets would be a much mote effective regulation than all those thousands of pages that currently exist.

And please, please, please, stop talking about "deregulation" in the presence of such an awful and intrusive mis-regulation. The regulators imposed the worst kind of capital controls.

Of course, just in case, all problems here referred to, are clearly applicable to developed economies too.

Sincerely,

Per Kurowski

@PerKurowski

PS. Basel Committee’s distortion of credit allocation explained to dummies, in just four tweets.

PS. “The assets assigned the lowest risk, for which capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages. Ironically, losses on those two types of assets would fuel the global crisis in 2008 and a subsequent European crisis in 2011”, “Keeping at it” 2018, Paul Volcker

PS. My 2019 letter to the Financial Stability Board

PS. An ever growing aide memoire on Basel Committee’s many mistakes.

PS. The risk weighted bank capital requirements utterly distorted central banks’ monetary policy by directing way too much credit to what’s decreed or perceived as “safe”, sovereign/ residential mortgages/ AAA rated; and way too little to “risky” SMEs and entrepreneurs.

PS. Because it would also create distortions I am not proposing it, but would not risk weighted bank capital requirements based on SDGs ratings at least show more purpose for our banks? And, in the case of sovereigns, besides credit ratings, do we citizens not also need ethic ratings?

PS. “Are Basel bank regulations good for development?” a document presented at the High-level Dialogue on Financing for Developing at the United Nations, New York, October 2007.

PS. GDP growth based on too much carbs and too little proteins? Muscular or obese?

PS. Being creditworthy and being worthy of credit, c'est pas la même chose :-(

PS. And I am no newcomer to this issue

PS. ChatGPT, the risk weighted bank capital/equity requirements, could these distort the allocation of bank credit?

My Fourth of July 2019’s tweets to the United States of America

This Fourth of July 2019, here below, are three tweets in which, to the United States of America that I admire and am so grateful to, I express my very heartfelt concerns.

In 1988 America signed on to the Basel Accord’s risk weighted capital requirements for banks. 

These gave banks huge incentives to finance what was perceived as safe, and to stay away from the “risky”. 

It is so contrary to a Home of the Brave opening opportunities for all.

And bank regulators decreed risk weights: 0% sovereign, 100% citizens

That implies bureaucrats know better what to do with credit than entrepreneurs

That has nothing to do with the Land of the Free, much more with a Vladimir Putin’s crony statist Russia

America, where do you think you would be if you had welcomed all your immigrants with risk weighted bank capital requirements?

PS. “grateful to”? Had my father, a polish soldier not been rescued by American’s from a German concentration camp April 1945, I would not be.

PS. As one of those millions Venezuelan in exile, I know my country’s future much depends on America’s will to support its freedom.

The risk weighted bank capital requirements should at least, as a minimum, have been based on conditional probabilities. They weren’t.

Here a set of tweets on P(A/B)

In probability theory, conditional probability is a measure of the probability of an event (A) occurring (like bankers lending too much to someone safe), given that another event (B) has occurred (that bankers had perceived that someone as very safe).

In probability theory, conditional probability is a measure of the probability of an event (A) occurring (like bankers lending too much to someone risky), given that another event (B) has occurred (that bankers had perceived that someone as very risky).

Any regulators knowing something about conditional probability would never have assigned, for the purpose of risk weighted bank capital requirements, a risk weight of 20% to the very safe AAA rated, and one of 150% to the very risky below BB-rated.

Not the first time I've written about it

PS. Here is my letter to the Financial Stability Board

De riskvägda bankkapitalkraven borde åtminstone ha baserats på betingade sannolikheter. Det var de/är de inte.

Här några tweets om P (A / B)

I sannolikhetsteori är betingat sannolikhet sannolikheten för att en händelse (A) inträffar (som att banker lånar för mycket till någon säker), med tanke på att en annan händelse (B) har inträffat (att bankirerna hade uppfattat denne någon som mycket säker).

I sannolikhetsteori är betingat sannolikhet sannolikheten för att en händelse (A) inträffar (som att  banker lånar för mycket till någon riskabel), med tanke på att en annan händelse (B) har inträffat (att bankirerna hade uppfattat denne någon som mycket riskabel).

Ingen tillsynsmyndighet som vet något om betingad sannolikhet skulle aldrig ha tilldelat, med tanke på riskvägda bankkapitalkrav, en låg riskvikt på bara 20% till de bedömda som mycket säkra AAA, och en hög 150% till de bedömda som mycket riskabla lägre än BB-

PS. En fråga till Herr Stefan Yngves 2015

PS. Mitt brev till Financial Stability Board

IMF, your main role in supporting social spending, is helping to make sure the resources needed to be spent, are there.

I refer to IMF Policy Paper “A Strategy for IMF Engagement on Social Spending” dated June 2019.

The best strategy for IMF to engage on Social Spending is making sure the real economy, in a sustainable way, provides the most resources to it. That must at this moment begin by loudly protesting the risk weighted capital requirements for banks, something on which the IMF, sadly, has kept silence on for soon three decades.

Since 1988, with the Basel Accord, bank regulations have included, as its pillar, risk weighted capital requirements for banks. The higher the perceived credit risk is, the higher the capital banks need to hold and vice versa, the lower the perceived credit risk is, the lower the capital banks need to hold.

In Basel II of 2004 these risk weights ranged from 0% assigned to AAA to AA rated sovereigns, to 150% assigned to corporates rated below BB-. With a basic capital requirement of 8% that allowed banks to leverage their capital from, an infinite number of times till about 8.3 times.

By doing so that piece of regulation has seriously distorted the allocation of credit, putting both our bank systems at great risk and weakening the possibilities of our real economy to grow in a sustainable balanced way.

We already heard a canary clearly sing in the mine when a crisis exploded because of excessive demand for the securities backed by mortgages to the subprime sector. That demand resulted from that US investment banks and European banks, were allowed to leverage their capital with these securities a mind-boggling 62.5 times, if only a human fallible rating company had assigned it an AAA to AA rating. 

And all that “safe” financing of houses, have only caused these to morph from being homes into being investment assets, at great risk of causing future financial instability. 

And all those “risky” SMEs and entrepreneurs, who used to have their credit needs primarily serviced by banks, are now forced to fish in other less adequate waters. 

And what to say about the 0% risk weighting of all eurozone sovereigns that assume debt denominated in a currency that de facto is not their domestic printable one?

A lower risk weight assigned to the sovereign than to an entrepreneur implies the opinion that a bureaucrat knows better what to do with bank credit, than the entrepreneur who puts his own name to it. If that’s not statism what is? 

In summary: To favor the financing of the ‘safer present’ over the ‘riskier future’ only guarantees the weakening of the economy; and especially large bank crises, because of especially large exposures to what is especially perceived as safe, against especially little capital.

And sadly IMF has kept notorious silence on this.

Are these reasons not enough cause for impeaching the current bank regulators?

By setting higher bank capital requirements for what is already perceived as risky than against what could wrongly be perceived as safe, the regulators guarantee especially large bank crises, from especially big exposures to what’s perceived as especially safe, against especially little capital.

By the same token they guarantee more than ordinary access to credit for the “safer” present, which will cause bubbles, like in house prices, and less credit to the “riskier” future, like to entrepreneurs, which will weaken the real economy.

By the same token, giving the banks huge incentives to finance what’s safe, has expelled the rest of the economy, like pension funds and private savers into the shadow banking system, having to take on much more “risky” investments, like leveraged loans, for which they are much less prepared for than banks.

My 4 tweets on the access to bank credit war

1. Way too much discussions on whether bank capital requirements should be 4%, 8%, 15%, 20% or whatever, and way to little about the fact that different capital requirements for different assets, dangerously distorts the allocation of bank credit.

2. The risk weights in the risk weighted capital requirements for banks are de facto tariffs on the access to bank credit. Sovereigns 0%, AAA rated 20%, residential mortgages 35%, unrated citizens 100%, below BB- corporates 150%.

3. So why do all those who tear their clothes about trade protectionism, keep silence about the access to bank credit protectionism imposed by “the safe” on “the risky”, and which can have even much more serious implications for the world economy.

4. As is it guarantees especially large bank crises from especially big exposures to what’s perceived as especially safe, against especially little capital.

As is, by favoring credit to the “safer” present over the “riskier” future it guarantees stagnation.

http://subprimeregulations.blogspot.com/2019/03/my-letter-to-financial-stability-board.html

PS. It has caused houses to morph from being homes into being investment assets.

PS. More than a trade war it is actually this access to bank credit war that is most likely to bring the euro and then EU down.

PS. 0% risk weights will turn sovereign into spoiled filthy rich brats that will end up defaulting.

PS. Are these reasons not enough cause for impeaching the current bank regulators?

Many experts read, agree and rightfully praise Hans Rosling, yet don’t understand him at all.

I quote from “Factfulness”, 2018 by Hans Rosling, Ola Rosling and Anna Rosling Rönnlund. 

“Fear vs. Danger. Being afraid of the Right Things:

Fear can be useful but only if it is directed at the right things. The fear instinct is a terrible guide for understanding the world. It make us give our attention to the unlikely dangers that we are most afraid of, and neglect what is actually most risky…

‘Frightening’ and ‘Dangerous’ are different things. Something frightening poses a perceived risk. Something dangerous poses a real risk. Paying too much attention to what is frightening rather than to what is dangerous--that is, paying too much attention to fear--creates a tragic drainage of energy in the wrong directions.”

But here we are, with expert bank regulators who, with their credit risk weighted capital requirements, decided that what is frightening to them, namely what is perceived risky, is more dangerous to our bank system than what is really dangerous to it, namely what is perceived as safe.

And so by imposing their fear on our banks we have:

A banking system that is doomed to especially large crises, as a result of building up especially large exposures to what is especially perceived as safe, against especially little capital.

A banking system that finances way too much the safer present and way too little the riskier future, dooming our economy to a lack of the oxygen it most needs, namely that of risk taking.

And it is seemingly impossible to make them understand their mistake 

Where would we be had they introduced their fright of what they perceive as risky a couple of hundred years before their 1988 Basel Accord?

To top it up they decreed a risk weight of 0% to the sovereign and 100% to the citizen, and with that, they guaranteed way too high exposures to what I am most scared of, namely a great overhang of public debt that will cloud the future of my grandchildren.

A tweet thread on rational and irrational expectations

Rational expectations of something being risky, simply makes most stay away from it.

Irrational expectations of something being risky, though certainly not presenting a danger to our bank systems, might sadly means lost opportunities to grow the real economy.

Rational expectations of something being safe, does of course not hurt the economy nor the banking system.

Irrational expectations of something being safe can easily bring down our bank system, and our real economy with it.

But with their risk weighted capital bank requirements, much lower for what was perceived ex ante as safe, than for what was perceived as risky, the Basel Committee bank regulators, de facto, irrationally based it all on rational expectations.

http://subprimeregulations.blogspot.com/2018/08/risk-weighted-capital-requirements-for.html

PS. A tweet on tail risks

My letter to the Financial Stability Board was received.

Note: When reading this remember that “bank capital requirements” de facto translates into bank equity / bank shareholders’ skin in the game, requirements.

.

http://www.fsb.org/wp-content/uploads/Per-Kurowski.pdf

From: Per Kurowski

Sent: 18 March 2019 19:16

To: Financial Stability Board (FSB)

Subject: SME financing evaluation

I have not found sufficient strength to sit down and formally write up my comments, because I feel I would just be like a heliocentric Galileo writing to a geocentric Inquisition.

The Basel Committee’s standardized risk weights are based on the presumption that what is ex ante perceived as risky is more dangerous to our bank system.

And I hold a totally contrarian opinion. I believe that what is perceived a safe when placed on banks balance sheets to be much more dangerous to our bank system ex post than what is perceived ex ante as risky; and this especially so if those “safe” assets go hand in hand with lower capital requirements, meaning higher leverages, meaning higher risk adjusted returns on equity for what is perceived safe than for what is perceived as risky.

The following Basel II risk weights are signs of total lunacy or an absolute lack of understanding of the concept of conditional probabilities.

AAA to AA rated = 20%; allowed leverage 62.5 times to 1. Below BB- rated = 150%; allowed leverage 8.3 times to 1

The distortion the risk weighting creates in the allocation of credit to the real economy is mindboggling. Just consider the following tail risks.

The best, that which perceived as very risky turning out to be very safe. The worst, that which perceived as very safe turning out to be very risky.

And so the risk weighted capital requirements kills the best and puts the worst on steroids... dooming us to suffer an weakened economy as well as an especially severe bank crisis, resulting from especially large exposures, to what was especially perceived as safe, against especially little capital.

In relative terms all that results in much more and less (see note) expensive credit to for instance sovereigns and the purchase of houses, and less and more expensive credit to SMEs

I am neither a banker nor a regulator but I do believe that the following post helps to give some credibility to my opinions on the issue. And, as a grandfather, I am certainly a stakeholder.

http://subprimeregulations.blogspot.com/2004/11/some-of-my-early-public-opinions- on.html

And here is a more detailed list of my objections to the risk weighting

http://perkurowski.blogspot.com/2016/04/here-are-17-reasons-for-why-i-believe.html

Now if by any chance you would dare open your eyes to the mistakes of your risk weighted bank capital requirements and want more details from me, you know where to find me.

Sincerely

Per Kurowski

A former Executive Director of the World Bank (2002-2004) 

@PerKurowski

Note: In the original letter I erroneously wrote "more and more expensive credit to sovereigns" and not "cheaper and cheaper", but this should be easily understood as a mistake.

PS. FSB keeps avoiding the issue: June 7, 2019 FSB published a Consultative Document: “Evaluation of the effects of financial regulatory reforms on small and medium-sized enterprise (SME) financing” I quote two parts of it.

1. “For the reforms that are within the scope of this evaluation, post-crisis financial regulatory reforms, the analysis, does not identify negative effects on SME financing in general.” 

Comment: The scope of the analysis does explicitly not include pre-crisis financial regulatory reform, like Basel II. When compared to what was introduced in Basel II, the changes in Basel III produced not really that much “more stringent risk-based capital requirements”. Therefore to limit the analysis to the impact of Basel III changes to risk-based capital requirements, is basically to avoid the issue of how these have, especially since Basel II, profoundly distorted the allocation of credit, and negatively affected the financing of SMEs.

2. “There is some evidence that the more stringent risk-based capital requirements under Basel III slowed the pace and in some jurisdictions tightened the conditions of SME lending at those banks that were least capitalised ex ante relative to other banks.”

Comment: That the Basel III risk-based changes, which in my opinion are minor relative to their importance, “tightened the conditions of SME lending at those banks that were least capitalized ex ante relative to other banks” is something to be expected. But there, close to when hitting the roof, on the margin, is where the risk weighting most impacts; think of “The drowning pool”

PS. A letter to the IMF: "The risk weights in the risk weighted bank capital requirements are to access to credit, what tariffs are to trade, only more pernicious.

PS. From what I see my comments were totally ignored

PS. And the Academia has kept total silence on it.

PS. Now, April 2023, in ChatGPT – OpenAI #AI, I have at long last found an ally in my fight against the geocentric bank regulation Inquisition. 

Reading, little by little, Adam Tooze’s “Crashed: How a Decade of Financial Crises Changed the World” 2018

Here a comment I made before beginning to read the book

Chapter 14 “Greece 2010: Extend and pretend”

I read: “As recently as 2007 Greece’s bonds had traded at virtually the same yield as Gemany’s”

The credit rating of Greece in 2007 was A, and that of Germany AAA. According to Basel II’s risk weighted capital requirements Greece should have a risk weight of 20% while Germany 0%.

But, European authorities extended Sovereign Debt Privileges to all Eurozone nations, and assigned Greece also risk weight of 0%. All this even though these nations are all taking on debt in a currency that de facto is not their own printable one. 

When Greece’s crisis breaks lose Greece has still a risk weight of 0%... meaning European banks could lend to Greece against no capital at all... and it is still 0% risk weighted. 

How is Greece going to extract itself from that corner into which it has been painted is anybody's guess. And extract itself it must, as  must all nations. A 0% risk weight for the sovereign and 100% for the citizens is an unsustainable statist proposition.

It all makes me wonder how Tooze would have written this chapter had he considered this. Perhaps he could have been closer to opine this?

The “experts” in the independent agencies, those most likely to introduce systemic risks, must be continuously questioned and supervised.

Paul Tucker for more than 30 years a central banker and a regulator at the Bank of England writes in his "Unelected Power" 2018

“Unlike price stability, the authorities cannot ‘produce’ financial stability by their own efforts but must stop or deter private intermediaries from eroding the system’s resilience.

That cannot be delivered by looking at intermediaries one by one because the financial system is just that - a system, with components parts connected within sectors and markets, via interactions with the real economy, and across countries. 

As the first chairman of the Basel Supervision Committee, George Blunden said in the mid-1980s: It is part of the [supervisors] job to take a wider systemic view and sometimes to curb practices which even prudent banks might, if left to themselves, regard as safe.”

And yet with Basel I in 1988, Basel II in 2004 and current Basel III the regulators in the Basel Committee, ignoring the system, ignoring the distortions it causes in the allocation of credit to the real economy and ignoring that no major bank crisis have resulted from excessive exposures to what ex ante was perceive as risky, went ahead and introduced that mother of all systemic risk and procyclical regulation, which is the risk weighted capital requirements for banks.

“Curb practices which even prudent banks might, if left to themselves, regard as safe”? No way, it only guarantees especially large exposures, to what is especially perceived as safe, against especially little capital, laying the ground for especially large crisis.

I did note that in the 568 pages of “Unelected Power” I found no explicit reference to the risk weighted capital requirements for banks.

At the end of his book Paul Tucker suggests “The principles for delegating to independent agencies insulated from day to day politics”. I agree with these. Had they been in place Basel I II or III would not have existed. Just for a starter, in all of Basel’s bank regulations there is not one single word about the purpose of the banking system, one that must surely contain the need to allocate credit efficiently to the real economy.

There is one aspect though that is not sufficiently laid out in Tucker’s principles and that is the absolute must for the independent agency to contain sufficient diversity, not only to foster better discussion but also in order to hinder, as much as possible, these turning into closed mutual admiration clubs.

PS. In the 568 pages of “Unelected Power” I found no explicit reference to the risk weighted capital requirements for banks, those which for a start caused the 2008 crisis. 

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