Bank supervisors/examiners as well as the banks’ own risk managers, find themselves between a rock and a hard place.

Note: This post is based on to “How Bank Oversight Failed: The Economy Changed, Regulators Didn’t” by Andrew Ackerman, Angel Au-Yeung and Hannah Miao, WSJ March 24, 2023, but it could refer to many of the articles currently being published on #SVB,

“If examiners thought the bank should prepare for a scenario such as rapid growth, soaring interest rates and abrupt loss of deposits, as later happened to SVB, examiners would be hobbled by the absence of explicit regulatory guidance calling for such preparations”

Worse! They would be hobbled by the presence of explicit regulatory guidance, namely the risk weighted bank capital/equity requirements (RWCR) based on perceived credit risks, not on misperceived risks, unexpected events or ignored risks, such as duration risk. To top it up, these requirements are based on that what’s perceived as risky is more dangerous to bank systems than what’s perceived.

That places the supervisors/examiners and the banks’ own risk managers between a rock and a hard place. 

What bank risk manager, wanting to keep his job and be paid a bonus, would currently want to address his Board of Directors with: “Our model, because of too many assets we have perceived as safe could now turn out risky, indicates that you have to raise a substantial amount of equity”?

What supervisors/examiners, would dare to argue that the Basel Committee and their other superiors, have not the faintest idea of how to regulate banks? Among other because they all clearly missed their lectures on conditional probabilities?

“Banking regulators will spend months, if not years, getting to the bottom of what happened.” Of course, they will. They do not want the world to understand what hair-raising regulatory mistake they committed.

The GFC, 2008 crisis, was much caused by the excessive exposures US investment banks and European banks held of AAA to AA rated mortgage-backed securities (MBS), against which they were required by Basel II to hold only 1.6% in capital/equity. 

Basel III introduced new capital and liquidity requirements but let the RWCR intact, which meant that on the margin, there were it most counts, the distortive effect of these were even strengthened. (Think of the “Drowning pool”)

What if an investment bank had reported to a little old lady her long-term bond holdings based on value on maturity (as banks are allowed to do), and she then suffered unexpected unaffordable losses when selling these, would it be fined? Just asking.

And what about all journalists? Will they admit they were duped/lulled into a false sense of security by reporting on strong and satisfactory levels of capital based on the naïve assumption that the risk weighted assets reported (RWA), were a valid measure of the banks' risk exposure.

Here's much more on the issue

“Age of Easy Money” ignored the risk weighted bank capital/equity requirements.

I’m stunned. 1:54 hours of a very interesting “Age of Easy Money”, that does contain one single reference to the credit risk weighted bank/equity requirements which distorted the allocation of bank credit and allowed bureaucrats and asset owners, to live on Easy Street.

James Jacoby: With all due respect, I wonder if you could be a little bit more explicit with me. What will the Fed own when it comes to the vulnerability of the system?

Neel Kashkari: Well, I reject the thesis. I actually don't think it's been the Fed's monetary policy that has led to these vulnerabilities. I think it's been incomplete regulatory policy that has led to these vulnerabilities.

My comment: Central banks’ monetary policies, e.g., liquidity injections, have to pass many corianders/strainers before reaching the economy. The most important one, bank credit allocation. Think of risk weighted bank capital requirements as one of these.

Then think of central bankers not caring about the fact that coriander/strainer contains different sized holes. Larger for “safe” government debt, residential mortgages and AAA rated assets; smaller for “risky” loans to small businesses and entrepreneurs. 

Sheila Bair: The entire business community has had a taste of bailouts. I fear that now, the Fed stepping in, not just to bail out Wall Street, but the entire corporate America, is starting to be embedded into people's thinking. People talk about the survival of capitalism, but this is the biggest threat to capitalism. In good times, when anybody can make money, you reap those profits. In bad times, the Fed just keeps stepping in. You have this never-ending ratchet up. The markets never correct.

James Jacoby: It's like a no-lose casino.

Sheila Bair: It is. It is a no-lose casino. That's exactly right

My comment: No! Its more of a doomed casino. In a roulette table, the payouts are all a direct function of the probabilities of any one of the outcomes. E.g., black or red, 50% chance, a payout of 1 plus the bet; any single number, a payout of 35 plus the bet. Imagine then that a casino regulator arguing that the gamblers should be saved from losing too much, decreed that the pay out on “safe” bets, e.g., black or red, should double. The casino would be doomed.

That’s what the perceived credit risk weighted bank capital requirements do. These allow banks to leverage much more their equity, increasing the payout, with assets perceived (or decreed, or concocted) as safe than with assets perceived as risky.

James Jacoby: Was there a concern at the White House that the Fed was running the economy too hot for too long?

Brian Deese: That is a question that I will institutionally not answer.

James Jacoby: Why?

Brian Deese: Because one of the hallmarks of our system is the independence of monetary policymaking.

My comment: Independence? Hah! Here follows the confession that seemingly shall not be heard.

“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… 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." Paul Volcker in “Keeping at it” 2018.

My questions, to all: 

Where would the market’s “risk-free” interest rates be, if not allowing banks to earn higher risk adjusted returns on government debt? 

Would government debt (government spendings) have become as large, if not allowing banks to earn higher risk adjusted returns on government debt? 

Where would house prices be if not allowing banks to earn higher risk adjusted returns on residential mortgages?

Christopher Leonard: The financial system globally has been built around extremely low, ultra-low interest rates for 10 years.

My comment: And around bank regulations based on that what’s perceived (or decreed or concocted as safe) is more dangerous to our bank systems than what’s perceived as risky. What would Mark Twain have opined about that?

Mohamed El-Erian: In 2022, we've had this very unusual situation whereby you've made double-digit losses on both risky assets, stocks, and risk-free assets, U.S. Treasuries. That's not supposed to happen.

My question: Should it suffice for regulators to argue that what’s safe is not supposed to become risky?

Mohamed El-Erian: A big issue for retirement plans, pension systems, because no matter how well you diversified your portfolio, there was no risk mitigation in it at all.

My question: How much of current bank regulations that so much favors the refinancing the “safer” present, over the financing of the “riskier” future (a reverse mortgage) have also seeped through to contaminate retirement plans and pension systems? 

Nouriel Roubini: We have had literally a few decades of ever-increasing bubbles that have been fed and supported by central banks. And not only have we had bubbles, but we've had bubbles that have been fed by excessive leverage, excessive private and public borrowing and excessive risk-taking.

My comment: All of that, except “excessive risk-taking”. What happened was the buildup of excessive exposures to assets that were perceived, decreed or concocted as safe.

Rana Foroohar, Associate editor, Financial Times: When interest rates start to rise and the tide pulls out, as Warren Buffet would say—

Charles Duhigg: The New York Times: You don't know who's swimming naked—

My comment: With bank capital/equity requirements mostly based on perceived credit risks, not misperceived risks or unexpected events, e.g., covid, war, inflation, one should know banks will stand there naked, just when they’re needed the most, just when its hardest to raise bank equity.

James Jacoby: So I guess the question though is how much disruption in the financial markets are you willing to tolerate now that they're adjusting to this new interest rate environment, after more than a decade of zero rates?

Neel Kashkari:

We live in a market economy.

My comment: “A market economy”, with risk weighted bank capital requirements and Quantitative Easing? Sorry you have not the faintest idea of what a market economy is. Have you ever left your desk and walked on Main-street?

James Jacoby: Are you basically saying that we should be preparing right now? That there would be a bursting of this massive credit bubble?

Jim Millstein: It's happening right in front of us. It may—It's happening right now.

My opinion: Yes! What can be done? Not a full plan, but here's a start:

1. Zero dividends, buy-backs and big bonuses, before banks have ten percent in capital against ALL assets.

2. Debt to equity conversion should be one of the most important resolution tools.

Female newsreader: In breaking news, a U.S. Federal Reserve has bailed out the Silicon Valley Bank, which had collapsed over the weekend.

Joe Biden: There are important questions of how these banks got into the circumstance in the first place.

My comment: SVB was holding a high number of Treasury and other government bonds — amounting to more than half of its assets. Mr. President dare to ask its regulators: How much capital/equity/skin-in-the game, did SVB's shareholders need to hold against that?

James Jacoby: How do you think we’ll look back at this era of easy money?

Steven Pearlstein: Unfortunately, I think we may look back on it as something of a golden era, because cheap and free money, without consequences, is great. But in other ways, we will think about it as a lesson for the future, which is that it was a mistake.

My comment: Yes, and those after us will recognize it as a violent violation of that social intergenerational contract Edmund Burke spoke about. 

Mohamed El-Erian: I think that we're going to look back on this era as being totally exceptional historically, and one where we didn't fulfill its potential. We lost sight of something critical: We lost sight of how we grow our economy in a sustainable and inclusive fashion.

My comment: Absolutely, and all because bank regulators focused solely on the safety of banks and totally ignored what their real purpose is; way more important than safe mattresses in which to stash away cash.

Christopher Leonard: When you have a society with the middle struggling and the rich realizing almost unimaginable gains, it starts to corrode the civic foundation. People start to feel like this cliche you hear all the time: that the system is rigged.

My comment: It is rigged. The more creditworthy have always paid lower risk adjusted interest rates than the less creditworthy, and that's as it should be. But credit risk weighted bank capital/equity requirements, have also decreed the less creditworthy to be less worthy of credit. And that's not how it should be.

Mohamed El-Erian: This is a political problem.

My comment: Absolutely. It was all about empowering a Bureaucracy Autocracy.

Bank capital requirements with decreed risk weights; 0% Federal Government – 100% We the People. What would America’s Founding Fathers have opined on that?

@PerKurowski In all this, where do I come from?

Bailouts, which could carry significant costs to taxpayers, to be justified, must have a great purpose.

Note: I’m simultaneously sending out this type of "J'accuse" letter to Financial Times, Washington Post, New York Times, Wall Street Journal, The Globe and Mail, and The Economist.

SVB was holding a high number of Treasury and other government bonds — amounting to more than half of its assets. When will one dare ask regulators: How much capital/equity/skin-in-the game, were SVB's shareholders required to hold against that?

Bailouts, which could carry significant costs to taxpayers, to be justified, must have a great purpose.

We do not need “tougher” rules for our banks, we need better rules. Risk weighted bank capital/equity requirements based on what’s perceived as risky being more dangerous to bank systems than what’s perceived as risky, make absolutely no sense. 

Not only, by feeding the creation of excessive exposures to what’s “safe”, these put the dangers to bank systems on steroids but also, by distorting the allocation of credit, make it much harder for the economy to reach its true potential.

By incentivizing banks to refinance much more the "safer present" than to finance the "riskier future" it effectively imposes a reverse mortgage on the economy that will be very costly for future generations.

 

Additionally, by de-facto declaring the more creditworthy more worthy of credit, and as a consequence the less creditworthy to be less worthy of credit, they hinder equality of opportunities.

And since banks are one if not the most important channel to transmit central banks’ monetary policies, these regulations impede those to work as expected. Just think about how these distort the risk-free interest rate.

To top it up, with decreed risk weights of 0% governments – 100% citizens, as if bureaucrats/apparatchiks know better what to do with credit, for which repayment they’re not personally responsible for than e.g., small businesses, that’s communism or fascism, that has empowered a Bureaucracy Autocracy.

And I could go on and on.

Therefore, assisting the banks in need during a conversion from risk weighted bank equity requirements to solely a strong leverage ratio, 10% equity against all assets, has a great purpose. Especially if it stimulates and democratizes new bank equity.

A Chilean styled bailout could do. Zero bonuses, dividends and buy-backs, until the bank’s shareholders have 10% of equity in it against all assets, and until all the financial assistance provided has been repaid with some interest.

In short: The world needs to rescue its banks from the hands of equity minimizing / leverage maximizing creative financial engineers, much empowered by regulators, and return these to old style “know your client” bank loan officers. Welcome back George Banks.

PS. I might not be a PhD, and I have never been a regulator, but I'm not a newcomer to these issues.

@PerKurowski

Bank regulators were contaminated by the virus of totalitarianism

Mario Vargas Llosa in “The Call of the Tribe”, 2023, has a chapter titled Friedrich August von Hayek (1859-1992). It mentions Hayek, in “The Road to Serfdom” 1946, opining “that centralized planning of the economy inevitable undermines the bases of democracy, and that fascism and communism were therefore two expressions of the same phenomenon of totalitarianism. By the same token, all regimes, even those appearing to be free, would be contaminated by the virus of totalitarianism if they sought to control the functioning of the market.”

Paul Volcker in his “Keeping at it” 2018 (valiantly) confessed: “Assets assigned the lowest risk, [1988] for which bank capital [equity] requirements were therefore nonexistent or low, were what had the most political support: sovereign credits & home mortgages… A ‘leverage ratio’ discouraged holdings of low-return government securities”

Bank capital requirements with decreed risk weights 0% Federal Government and 100% We the People; could that have been a "spontaneous evolution of institutions"? NO!

Tell me, is that not about the greatest example of regimes appearing to be free, having been contaminated by the virus of totalitarianism, bringing fascism and communism by stealth?  (What would the Founding Fathers have opined)

All those declaring themselves followers, admirers and promoters of Hayek, how can they have ignored all this, for more than three decades?

On three side issues: 

Regulators allow banks to hold much less capital/equity when financing what’s perceived (or decreed) as “safe” e.g., public debt, residential mortgages and AAA rated, than when financing what’s perceived as “risky” e.g., loans to small businesses and entrepreneurs. I’m sure Hayek would have known, as any economist should have known, that such incentives had to cause dangerously much lending to the “safe”, and weakening too little lending to the “risky”

I’m sure Hayek would also have objected assigning some few human fallible credit rating agencies so much power when determining how much capital/equity banks had to hold against assets.

If asked about bank capital/equity requirements based on what’s perceived as risky being more dangerous to bank systems than what’s perceived as safe, Hayek could have probably asked: What were the large exposures that detonated bank crises built-up with, with assets perceived as risky or with assets perceived as safe?