Thursday, December 31, 2020

How come we ended up with stupid portfolio invariant risk weighted bank capital requirements?

Which are based on:

That those excessive exposures that can really be dangerous to our bank systems are build up with assets perceived as risky and not with assets perceived as safe.



That substituting risk adjusted returns on equity for risk adjusted interest rates, would not seriously distort the allocation of bank credit.



Though Paul A. Volcker, in his autography “Keeping at it”, valiantly confessed “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”


And here my explanations:

All bank regulators faced/face a furious attack mounted by dangerously creative capital minimizing / leverage maximizing financial engineers, who, getting rid of traditional loan officers, those with their “know your client” and their “what are you going to use the money for?”, managed to capture the banks. (And, since less capital means less dividends, they can also pay themselves larger bonuses.)

Hubris! “We regulators, we know so much about risks so we will impose risk weighted capital requirements on banks, something which will make our financial system safer” Yep, what’s risky is risky, what’s safe is safe. What is there not to like with such an offer? And the world, for the umpteenth time, again fell for demagogues, populists, Monday morning quarterbacks and those who find it so delightful to impress us rolling off their tongues sophisticated words like derivatives.

In a world full of mutual admiration clubs, like the Basel Committee and Academia in general, you do not ask questions that can imply criticism of any of your colleagues or superiors, “C’est pas comme il faut», nor, if you are a high shot financial journalist, do you risk not being invited to Davos or IMF meetings.

"It is difficult to get a man to understand something, when his salary depends upon his not understanding it!" Upton Sinclair

Clearly there are many more jobs with ever growing thousands of pages of regulations than with just a one liner: “Banks shall have one capital requirement (8%-15%) against all assets”. And so, instead of getting rid of the extremely procyclical credit risk weighted capital requirements, they designed new insufficient countercyclical ones.

“The time spent on any item of the agenda will be in inverse proportion to the sum involved." Parkinson’s law

Since bank regulators must have heard of (supposedly) Mark Twain’s “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it looks to rain” it is clear they all missed their lectures on conditional probabilities.


“There are some mistakes it takes a Ph.D. to make”, Daniel Moynihan.

“One has to belong to the intelligentsia to believe things like that: no ordinary man could be such a fool”, George Orwell, in Notes on Nationalism


And so now: 

“A ship in harbor is safe, but that is not what ships are for” John A. Shedd, something that should apply to banks too. Sadly, dangerously our bank systems, banks are overpopulating safe harbors and, equally dangerous for our economy, underexploring risky waters. 

“What gets us into trouble is not what we don't know. It's what we know for sure that just ain't so.” Mark Twain

And since current bank capital requirements are mostly based on the expected credit risks banks should clear for on their own; not on misperceived credit risks, like 2008’s AAA rated MBS, or unexpected dangers, like COVID-19, now banks stand there with their pants down.

Let us pray 2021 will not be too hurtful.

PS. Might “availability heuristic” “availability bias” help explain these loony risk weighted bank capital requirements?

Saturday, December 26, 2020

My very brief summary of Basel I, II, III history... and my hopes for a future Basel IV

1988 Basel I (30 pages) decreed risk weighted bank capital requirements with risk weights of 0% the sovereign and 100% citizens, which de facto indicates bureaucrats know better what to do with credit they’re not personally responsible for than citizens.


2004 Basel II (251 pages), (creative capital minimizing/leverage maximizing financial engineers, fooled regulators into believing that the buildup of those excessive exposures that could endanger our bank systems, is done with assets perceived as risky.

2010 Basel III (the current version has so many pieces it’s hard to say how many pages it contains but it's at least 1.600), some small gestures of rationality like a leverage ratio and countercyclical capital buffers BUT, on the margins of bank capital requirements, which is where it most counts, Basel I's and Basel II's distortions are alive and kicking.

202X Basel IV, lets pray they throw Basel I, II and III out, and set a fix bank capital requirement of 10%-15% on absolutely all assets. That would allow the so much needed traditional bank loan officers to return to the banks

Sunday, December 20, 2020

Small businesses (like restaurants) besides Covid-19 lockdowns, when it comes to bank credit, these have also for a long time suffered lockouts

Before Basel Committee’s risk weighted capital requirements, if a residential mortgages and loans small businesses produced the same risk adjusted expected net margin/return on asset (eROA), these would produce the same risk adjusted expected returns on equity (eROE)

That was then: Now, with Basel III a residential mortgage with e.g., a loan to value of 80% to 90%, has a risk weight of 40%; which times the basic 8% requirement, results in a capital requirement of 3.2%, which allows banks to leverage 31.25 times their capital (equity).

While a loan to small businesses have a risk weight of 100%; which results in a capital requirement of 8%, which allows banks to leverage 12.5 times their capital.

So, if the eROA for residential mortgages and loans to small businesses is 1%, then residential mortgages produce a eROE of 31.25%, while loans to small businesses only a eROE of 12.5%

And so, even if interest rates on residential mortgages were reduced by e.g. 0.5%, resulting in a lower risk adjusted expected ROA of 0.5%, residential mortgages, yielding banks a 15.625% risk adjusted eROE, would still be more interesting to banks than loans to small businesses

And therefore, small businesses, in order to access credit, must pay higher interest rates so as to increase the expected risk adjusted ROA, in order to produce banks a competitive risk adjusted eROE.

And so, though the less creditworthy (small businesses/entrepreneurs) always got smaller bank loans and paid higher interest rates but, with risk weighted bank capital requirements, the regulator also decreed them to be less worthy of credit.

What’s the net result of all this? Too much credit at too low interest rates for the purchase of houses, and too little credit to the small businesses/entrepreneurs who could generate the jobs/the incomes/the down-payments, for house buyers to service their mortgages and pay food and utilities.

Conclusion: The risk weighted bank capital requirements have, de facto, 0% to do with credit risk reduction, and 100% to do with risk generating distortions.


Basel Committee… Good Job!

PS. There has too be and adequate equilibrium between risk-avoidance and the risk-taking needed to sustain growth.

The Basel Committee for Banking Supervision’s dangerous distortion of the allocation of bank credit, all explained for dummies in just four tweets.

If a safe borrower’s 4% and a riskier borrower’s 6% provide banks the same 1% risk adjusted net margin then, before the introduction of BCBS’s credit risk weighted capital requirements, those would have been the rates charged by banks.

But now, because the “safer” can e.g. be leveraged 25 times while the riskier e.g. only 12.5 times, with those initial rates, the safer will provide banks a 25% risk adjusted return on equity, while the riskier only 12.5%.

So, now the safer could be offered less than a 4% rate, even down to 3.5% (new risk adjusted net margin of .5%) and still be competitive vs. the riskier when accessing bank credit, and/or be awarded too much credit… which could (will, sooner or later) turn him risky.

And the riskier will now have to pay 7% (new risk adjusted net margin of 2%) in order to remain competitive vs. the safer, which would make him even riskier, or not have access to credit at all, which could hurt the growth possibilities of the real economy



Saturday, December 12, 2020

Basel Committee’s members, when will they ever learn, when will they ever learn?

On their own, banks would naturally charge higher interest on residential mortgages to those with higher loan to value ratios (LTV) than to those with lower LTVs. 

But with Basel III, the first will be charged even higher rates, in order to compensate for the fact that banks are now allowed to leverage more with lower LTVs; which means it's easier for banks to obtain higher risk weighted returns on equity with “safer” lower LTVs.

That makes the riskier even more risky, and, by lowering the risk adjusted interest rate they would pay without this regulatory distortion, could even turn the “safer” into becoming very risky. 

When will the Basel Committee ever learn that any risk, even if perfectly perceived, will lead to the wrong responses, if excessively considered?

When will the Basel Committee ever learn that what’s dangerous to our bank system is not what’s perceived as risky, but what’s perceived as safe?

Thursday, December 3, 2020

About prices in kid’s lemonade stands and interest rates on sovereign debt

If a mother gives her children lemons for them to make lemonade to sell, and then their grandfather comes to their stand and buys lemonade at an extravagant price, would any economist refer to that as the market price of lemonade in lemonade stands? I hope not.

And if regulators allow banks much lower capital requirements when holding Treasuries/Gilts than when holding loans to citizens, and then Fed/BoE with their quantitative easing, QEs, buys up loads of Treasuries/Gilts, are the low interests on these, free market rates?


@PerKurowski

Thursday, October 8, 2020

Any risk, even if perfectly perceived, causes the wrong answer to it, if excessively considered.

Any risk, even if perfectly perceived, causes the wrong action, if excessively considered.

“A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it looks to rain” Mark Twain (supposedly)

And Mark Twain is right in that bankers, in general are risk adverse and, when they accept taking some, it is usually in small amounts and against high risk premiums.

And, for around 600 years, bank credit was allocated, usually with a view on the portfolio, based on risk adjusted net interest rates.

But then, in 1988 with Basel I, the Basel Committee introduced (I would say ‘concocted’ is a more precise term) the concept of risk weighted bank capital requirements, based on exactly the same credit risk aversion.

With that the regulators ignored that any risk, even if perfectly perceived, causes the wrong answer to it, if excessively considered.

If Twain was alive he could just as well be writing: “A bank regulator is a fellow that allow banks to hold little capital when the sun is shining, so that banks can pay lots of dividends and buy back lots of stock, but wants banks to hold much more capital, the moment it starts to rain”

And, since then, bank credit is allocated based on risk adjusted returns on equity and, of course, the higher the allowed leverage is the easier it is to obtain a higher return on equity.

John A. Shedd (1859 – 1928) wrote “A ship in harbor is safe, but that is not what ships are for”. And that should also apply to banks. Unfortunately, these capital requirements guarantee that banks stay in safe harbors, running the risk of dangerously overcrowding these, and stay away from the risky oceans, and most certainly not lending enough to those “risky” entrepreneurs and SMEs on which our real economies so much depend.

In his book “Money: Whence it came, where it went” (1975), 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”


And it’s all so much worse. With their much lower bank capital requirements on loans to governments than on loans to citizens, statist/communist/ fascist regulators de facto imply bureaucrats/politicians know better what to do with credit for which repayment they’re not personally responsible for, than e.g. entrepreneurs.

And it is all so stupid. There’s never ever been a major bank crisis caused by the buildup of excessive exposures to what’s perceived as risky, those exposures have always been built up with assets perceived as safe.

The regulators, by basing most of their pro-cyclical bank capital requirements on perceived credit risks; not on misperceived credit risks, or unexpected dangers, like a pandemic, guaranteed all banks now stand there with their pants down. Basel Committee, Good Job!



Wednesday, September 9, 2020

My #CatoFinReg tweets during “The Evolution of Banking: The 2020 Cato Summit on Financial Regulation”


Many of these tweet were retweeted and or liked by @CatoEvents and @CatoCMFA, something that I much appreciate. 
That said, I do believe the “risk weighted bank capital requirements”, merit a public discussion that is long overdue.


Why does the Emperor wear no clothes?
Why do regulators base their risk weighted bank capital requirements on that what’s perceived as risky is more dangerous to our bank system than what’s perceived as safe?


Should for instance Texas be happy with that banks in Texas have to hold much more capital (equity) when lending to Texan entrepreneurs than when lending to a AAA rated corporation elsewhere or to the Federal government?


Regulators based bank capital requirements mostly on perceived credit risk banks, not on misperceived credit risks, or unexpected dangers, like Covid-19… so now banks stand there with pants down, with no capital to support lending… when most needed


Lower bank capital requirements on loans to the government than on loans to entrepreneurs, de facto implies bureaucrats/politicians know better what to do with credit they’re not personally responsible for, than entrepreneurs. 
Do they really?


The risk weighted bank capital requirements improve opportunities of credit of… “those that have the most political support, sovereign credits and home mortgages” Paul Volcker, 2018. 
Have not federal regulators exceeded their authority when doing so?



Sunday, April 19, 2020

A letter in Washington Post: The capacity to borrow at reasonable interest rates is a strategic sovereign asset

In his April 12 op-ed, "How economists led us astray" Robert J. Samuelson wrote, "What we conveniently overlooked was the need to preserve our borrowing power for an unknown crisis that requires a huge infusion of federal cash."

Yes, the capacity to borrow at a reasonable interest rate (or the seigniorage when printing money) is a very valuable strategic sovereign asset, and it should not be squandered away by benefiting the members of the current generations or with some nonproductive investments. 

So, when public borrowings are authorized, that should require Congress being upfront that a part of that borrowing capacity is being consumed, which has a cost, and give an indication of who (children or grandchildren born what year) are expected to have to pay back that debt.

Mr. Samuelson also referred to "low dollar interest rates [that] will keep down the costs of servicing the debt." Sadly, those current "low dollar interest rates" are artificial rates, much subsidized in that since 1988, with Basel I regulations, banks are not required to hold any capital against Treasuries, and of course subsidized by the Federal Reserve purchasing huge quantities of Treasuries.

PS. A reverse mortgage on our children’s and grandchildren’s future

Friday, April 3, 2020

What if golf, roulette, horse-racing or tennis, had fallen into the hands of a Basel Committee?

What would have happened to golf, if its handicap system had fallen into hands as those of the Basel Committee who designed the risk weighted bank capital requirements?

What would have happened to casinos, if odds settings, like for roulette, had fallen into hands as those of the Basel Committee who designed the risk weighted bank capital requirements?

What would have happened to horse racing, if the handicapping of horses with weights had fallen into hands as those of the Basel Committee who designed the risk weighted bank capital requirements?

What would have happened to tennis, if the ranking of the players had fallen into hands of those of the Basel Committee who designed the risk weighted bank capital requirements?

Thursday, March 12, 2020

The Basel Committee for Banking Supervision’s bank regulations vs. mine.

A tweet to: @IMFNews, @WorldBank, @BIS_org @federalreserve, @ecb @bankofengland @riksbanken @bankofcanada
"Should you allow the Basel Committee to keep on regulating banks as it seems fit, or should you not at least listen to other proposals?

Bank capital requirements used to be set as a percentage of all assets, something which to some extent covered both EXPECTED credit risks, AND UNEXPECTED risks like major sudden downgrading of credit ratings, or a coronavirus.

BUT: Basel Committee introduced risk weighted bank capital requirements SOLELY BASED ON the EXPECTED credit risk. It also assumes that what is perceived as risky will cause larger credit losses than what regulators perceive or decreed as safe, or bankers perceive or concoct as safe. 

The different capital requirements, which allows banks to leverage their equity differently with different assets, dangerously distort the allocation of bank credit, endangering our financial system and weakening the real economy.

The Basel Committee also decreed a statist 0% risk weight for sovereign debts denominated in its domestic currency, based on the notion that sovereigns can always print itself out of any problem, something which clearly ignores the possibility of inflation, but, de facto, also implies that bureaucrats/politicians know better what to do with bank credit they are not personally responsible for, than for instance entrepreneurs, something which is more than doubtful.

Basel Committee's motto: Prepare banks for the best, for what's expected, and, since we do not know anything about it, ignore the unexpected 

I propose we go back to how banks were regulated before the Basel Committee, with an immense display of hubris, thought they knew all about risks; which means one single capital requirements against all assets; 10%-15%, to cover for the EXPECTED credit risk losses and for the UNEXPECTED losses resulting from wrong perceptions of credit risk, like 2008’s AAA rated securities or from any other unexpected risk, like COVID-19.

My one the same for all assets' capital requirement, would not distort the allocation of credit to the real economy.

My motto: Prepare banks for the worst, the unexpected, because the expected has always a way to take care of itself.

PS. My letter to the Financial Stability Board
PS. A continuously growing list of the risk weighted bank capital requirements mistakes
PS. Risk-weights are to access to credit what protectionist tariffs are to trade, only more pernicious.
PS. I am no newcomer to this issue

Friday, March 6, 2020

“The raison d’être of macroprudential policy is to ensure the financial system supports the economy.” Mark Carney left out: “EFFICIENTLY”.


“The raison d’être of macroprudential policy is to ensure the financial system supports the economy.”

Yes, but absolutely not in the way of how a brochure at the Bank of England’s museum, explaining quantitative easing, states it, by: “Putting more money into our economy to boost spending”

Our financial system should support our economy by allocating financial resources as efficiently as possible… and that, with current risk weighted bank capital requirements is something it definitely does not achieve. For example:

Assigning a risk weight of 0% to the sovereign’s debt and one of 100% to the citizen’s debts de facto implies that a bureaucrat knows better what to do with a credit for which’s repayment he is not personally responsible for than for example and entrepreneur. And that sort of veiled communism has failed here, there and everywhere.

Assigning a risk weight of 0% to residential mortgages and one of 100% to debts of unrated entrepreneurs’, de facto implies that financing the purchase of a house is more important than financing those who could help create the jobs needed to be able to service utilities and repay mortgages… something which I hope everyone understands is not so. It caused houses to morph from being affordable homes into being risky investment assets.

Assigning a risk weight of 20% to corporate AAA rated debt and one of 150% to corporate debt rated below BB-, de facto implies that the former, besides being able to obtain much more credit and at much lower rates, also deserves even better terms… and that is plainly an immoral discrimination… and besides an utterly stupid one. Anyone who believes that the excessive bank exposures that could cause profound bank crises are built up more with assets rated below BB- than with assets rated AAA, has never ever left his desk and walked on Main-Street.

Soon the history on banking will include: Between 1988 and 202x, believe it or not, banks were regulated by experts using risk weighted bank capital requirements based on that what was perceived as risky, was more dangerous to our bank system than what was perceived as safe


Monday, March 2, 2020

Central banks and regulators should not be allowed to discriminate in favor of asset owners or those perceived or decreed as safe.

Again, I visited the Bank of England’s museum.


Into my hands came a brochure titled “Quantitative easing explained: Putting more money into our economy to boost spending” It reads:


A direct cash injection: The Bank creates new money to buy assets from private sector institution’

Purchases of financial assets push up their price, as demand for those assets increases and corporate credit markets unblocked

Total wealth increases when higher asset prices make some people wealthier either directly or, for example, through pension funds.

My comment: “some people” this is a clear recognition that quantitative easing helps more those who own assets than those who don’t. Central banks should not be allowed to carry out such under the table non transparent discrimination.

The cost of borrowing reduces as higher asset prices mean lower yields, making it cheaper for households and businesses to finance spending.

My comment: Because of risk weighted bank capital requirements the benefits of any “lower yields” are primarily transmitted to those perceived or decreed as safe, for example, the sovereign and the beneficiaries of residential mortgages. 

More money means private sector institutions receive cash which they can spend on goods and services or other financial assets. Banks end up with more reserves as well as the money deposited with them.

Increased reserves mean banks can increase their lending to households and businesses, making it easier to finance spending.

My comment: Again, because of risk weighted bank capital requirements, banks increases in lending will primarily benefit those perceived or decreed as safe, for example, the sovereign and the beneficiaries of residential mortgages. 

My conclusion: Central banks should not be allowed to carry out such here confessed under the table non transparent discrimination in favor of those who own assets and those who generate lower capital requirements for banks. The combination of quantitative easing with the main transmission channel for monetary policy, bank credit, being distorted by risk weighted bank capital requirements has de facto introduced communism/crony capitalism into the financial sector.


Saturday, January 11, 2020

Paul Volcker valiantly accepted that the risk weighted bank capital requirements he had helped to promote had serious problems.

In his 2018 autobiography “Keeping at It” Paul Volcker wrote:

“The US practice had been to assess capital requirements by using a simple “leverage” ratio-in other words, the bank’s total assets compared with the margin of capital available to absorb any losses on those assets. (Historically, before the 1931 banking collapse, a 10 percent ratio was considered normal.) 

The Europeans, as a group, firmly insisted upon a “risk based” approach, seemingly more sophisticated because it calculated assets based on how risky they seemed to be. They felt it was common sense that certain kinds of assets-certainly including domestic government bonds but also home mortgages and other sovereign debt-shouldn’t require much if any capital. Commercial loans, by contrast, would have strict and high capital requirements, whatever the credit rating might be.

Both approaches could claim to have strengths. Each had weaknesses. How to resolve the impasse?...

The Fed and the Bank of England came to a bilateral understanding, announced in early 1987… It became known as the “Basel Agreement” …

Over time, the inherent problems with the risk weighted bank capital-based approach became apparent. 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. The American “overall leverage” approach had a disadvantage as well in the eyes of shareholders and executives focused on return on capital; it seemed to discourage holdings of the safest assets, in particular low-return US government securities.

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