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