I warned many about the coming crisis, long before it happened, on many occasions and in many places, even at the World Bank. The regulators did not want to listen and that´s ok, it usually happens, but what's not ok, is that they still do not seem to want to hear it. “We can easily forgive a child who is afraid of the dark; the real tragedy of life is when men are afraid of the light.” (Plato: 427 BC – 347 BC)
“What financial crisis should be harder to predict, those were banks are required to hold the same capital/equity against all assets, a leverage ratio, or those where risk weighted requirements allow banks to hold less capital against some assets?”
ChatGPT answered:
Good question.
Crises under a leverage ratio (same capital against all assets) are usually easier to anticipate: banks grow more or less evenly, and risks accumulate more visibly across their balance sheets. If a bubble builds in a specific asset class (say real estate or sovereign bonds), banks cannot concentrate excessively there without also tying up more of their own equity. The constraint is blunt, but it makes emerging vulnerabilities more transparent.
By contrast, crises under risk-weighted capital requirements are harder to predict: regulators assign low risk weights to certain assets (e.g. sovereign bonds, mortgages), letting banks hold very little equity against them. This encourages systemic concentration in officially “safe” exposures. Because reported capital ratios look strong, early warning indicators are masked—until the supposedly safe assets lose value, at which point losses cascade across the system. The 2008 crisis (mortgage-backed securities) and the eurozone sovereign crisis illustrate this: both were amplified by risk weights that understated true risk.
So: financial crises under risk-weighted regimes are harder to foresee, because risk is distorted by regulatory design, cloaked in the appearance of safety, and correlated across many banks at once.
Would you like me to illustrate this with a short comparison of how each system might have affected the visibility of the 2008 subprime crisis?
I said: If brief, please do.
ChatGPT answered:
Sure.
· Leverage ratio: U.S. banks would have needed the same equity against subprime mortgage securities as against Treasuries. Their balance sheets would have shown visibly higher leverage as they loaded up on subprime, making the buildup of risk easier to spot.
· Risk weights (Basel): Subprime securities often received low risk weights thanks to high credit ratings. Banks could report healthy capital ratios while piling on hidden leverage. The crisis appeared suddenly because regulators, investors, and even banks themselves underestimated how much true risk was concentrated.
Result: under risk weights, the 2008 crisis was much harder to see coming.
I said: Thanks!
It replied: You’re welcome!
I asked Grok:
"What financial crisis should be harder to predict, those were banks are required to hold the same capital/equity against all assets, a leverage ratio, or those where risk weighted requirements allow banks to hold less capital against some assets?"
Grok answered:
"Financial crises should be harder to predict in systems where risk-weighted requirements allow banks to hold less capital against some assets. This is because risk weights can fail to accurately reflect true portfolio risks, especially during economic booms when they tend to compress, encouraging excessive leverage and risk-taking that builds up systemic vulnerabilities.
These misestimations—such as underweighting the risks of assets like mortgage-backed securities before 2008—make banks appear well-capitalized on paper while hiding potential instabilities, leading to surprises when conditions deteriorate. In contrast, a uniform leverage ratio provides a simpler, more transparent backstop that directly limits overall leverage regardless of perceived risk, offering better predictive power for failures, particularly among large banks during crises. It performs at least as well as risk-weighted ratios over short horizons (one to two years) and acts in a more countercyclical manner."
I said: Thanks!
It replied: You're welcome! If you have more questions on finance or anything else, feel free to ask.
Note: The answers are copied exactly from those given to me by ChatGPT and Grok.
"If since 1988, with Basel I, banks had not been required to hold more capital/equity against loans to small businesses and entrepreneurs, than against residential mortgages, compared to now, what would be the availability of affordable houses/homes?"
ChatGPT answered:
If since 1988, banks had not been required to hold more capital against loans to small businesses and entrepreneurs compared to residential mortgages, the availability and affordability of housing might look quite different today. Let’s break down why:
1. Capital Requirements and Loan Pricing
The Basel I Accord, introduced in 1988, set different risk weightings for different types of loans, requiring banks to hold more capital for loans considered riskier, like small business loans, compared to relatively safer loans, such as residential mortgages. The result of this was:Cheaper mortgage financing: Banks could issue mortgage loans more easily and at lower interest rates because they were required to hold less capital against them.
Costlier business loans: Since small business loans carried higher capital requirements, they became more expensive and less accessible for entrepreneurs.
If the capital requirements for small business and mortgage loans had been more balanced, banks might have allocated more resources toward business lending rather than predominantly focusing on the housing market. This could have had several long-term effects:
2. Less Emphasis on Mortgage Lending
With fewer regulatory incentives to prioritize mortgage lending, banks might have directed more funding toward small business loans or other productive investments. This might have led to:
Slower growth in housing demand: Without easy access to cheap mortgages, the demand for residential properties may not have increased as rapidly as it did.
Fewer housing bubbles: Looser lending standards for mortgages contributed to housing bubbles in many markets (most notably in the mid-2000s, leading to the 2008 crisis). With tighter control on mortgage lending, housing prices may have grown more slowly and sustainably.
3. More Balanced Economic Growth
If small businesses and entrepreneurs had easier access to credit, the broader economy might have diversified its growth sources. Instead of an overreliance on housing, there could have been:Greater job creation in sectors outside real estate: Small businesses are key to job creation. If they had better access to financing, there might have been more innovation and employment opportunities, possibly reducing reliance on housing as a primary source of economic activity.
Less speculative real estate investment: When credit is too focused on housing, speculative investment in real estate becomes more likely. If more resources had been available for business creation, some of that speculative pressure might have been diverted.
4. More Affordable Homes?
Moderated Housing Prices: With fewer mortgages being issued and a slower rate of price appreciation, housing prices might have remained more affordable over time.
More demand for rental housing: If fewer people could easily access mortgage loans, the demand for rental properties might have been higher, possibly increasing rents but keeping homeownership more selective.
5. Impact on Housing Availability
The availability of homes might have been influenced in two key ways:
Less speculative home building: With more balanced lending practices, developers may have built fewer homes purely for speculative purposes, leading to a more rational supply-demand balance.
Higher business growth leading to more balanced urbanization: A stronger small business sector might have led to more evenly distributed economic growth across regions, reducing pressure on housing in urban centers.
Summary of Housing Affordability and Availability Impacts:
Less pressure on housing markets could have kept prices from rising as fast as they did, making homes more affordable for many people.
A slower rise in housing prices would likely have resulted from less aggressive mortgage lending practices.
A better-diversified economy with more resources for small businesses might have reduced the economy’s over-reliance on housing, leading to more sustainable economic growth overall.
In this alternate scenario, housing availability might have increased at a steadier rate, and prices could have been more affordable due to less speculative activity and more focus on productive investments in the broader economy.
I said: Thanks!
It said: You're welcome! Feel free to reach out if you have more questions anytime!
Note: The answers are copied exactly from those given to me by OpenAI
"In about 600 words, what would be your explanation for the Global Financial Crisis 2008-09?"
ChatGPT answered:
"The Global Financial Crisis (GFC) of 2008-09 was one of the most severe financial crises in modern history, with far-reaching consequences that impacted economies worldwide. This crisis had its roots in a complex interplay of factors spanning financial markets, government policies, and individual behaviors. In this explanation, I will outline the key factors that contributed to the GFC, providing a comprehensive overview of the events leading up to and during the crisis.
1. Housing Bubble and Subprime Mortgages: The GFC was triggered by the bursting of the U.S. housing bubble. In the early 2000s, there was a rapid increase in housing prices, fueled by speculative investments and easy credit. Lenders offered subprime mortgages to borrowers with poor credit history, allowing them to purchase homes they could not afford.
2. Securitization and Financial Innovation: Financial institutions bundled these risky subprime mortgages with other loans and assets, creating complex financial products known as mortgage-backed securities (MBS) and collateralized debt obligations (CDOs). These securities were then sold to investors worldwide, who believed in their high credit ratings and returns.
3. Deteriorating Loan Quality: As the housing market slowed and interest rates increased, many homeowners found it difficult to repay their mortgages. Defaults on subprime loans surged, leading to a significant decline in the value of MBS and CDOs held by financial institutions.
4. Leverage and Overexposure: Financial institutions had heavily invested in MBS and CDOs, often using high levels of leverage to amplify returns. When the value of these assets plummeted, banks faced enormous losses, which eroded their capital base.
5. Collapse of Lehman Brothers: In September 2008, Lehman Brothers, a major investment bank heavily involved in subprime mortgage investments, filed for bankruptcy. This event sent shockwaves through the global financial system, eroding confidence and triggering a liquidity crisis.
6. Contagion and Credit Freeze: Fearful of potential losses, banks and financial institutions became reluctant to lend to one another. The credit markets froze, causing a severe shortage of liquidity, which further exacerbated the crisis and contributed to a severe global recession.
7. Government Responses: Governments and central banks worldwide implemented various measures to stabilize the financial system. These included bailouts of failing financial institutions, interest rate cuts, and injecting liquidity into the markets to restore confidence and encourage lending.
8. Spillover Effects: The crisis spread beyond the financial sector, affecting businesses, consumers, and workers. Unemployment rates surged, housing markets collapsed, and consumer spending declined, leading to a severe downturn in economic activity.
9. Global Impact: The interconnectedness of the global financial system meant that the GFC had widespread repercussions on economies around the world. Many countries experienced recessions, and international trade and investment suffered.
10. Regulatory Reforms: In the aftermath of the crisis, there were widespread calls for regulatory changes to prevent similar events in the future. Governments introduced measures to increase oversight of financial institutions, improve risk management practices, and enhance transparency in financial markets.
In conclusion, the Global Financial Crisis of 2008-09 was a result of a perfect storm of factors, including the housing bubble, risky lending practices, complex financial products, and overexposure to mortgage-related assets. The collapse of Lehman Brothers acted as a catalyst, leading to a severe liquidity crisis and a broader economic downturn. Governments and central banks took unprecedented measures to stabilize the financial system, but the consequences of the crisis were felt globally for years. It served as a wake-up call for policymakers to address the vulnerabilities in the financial system and implement reforms to prevent similar crises in the future.
I asked ChatGPT:
Basel II assigned a 20% risk weight for securities rated AAA to AA; and a 50% risk weight for what was rated A+ to A-
That meant US investment banks and European banks had to hold 1.6% in capital/equity against securities e.g., MBS rated AAA to AA; and 4% against what was rated A+ to A- or against securities covered by a CDO issued by a similarly rated insurance company, e.g., AIG
That meant US investment banks and European banks had to hold 1.6% in capital/equity against securities rated AAA to AA; and 4% against what was rated A+ to A-
That meant US investment banks and European banks could leverage their capital/equity 62.5 times with securities rated AAA to AA; and 25 times against what was rated A+ to A-
Even higher capital/equity leverages, according to their credit ratings, were allowed for holding sovereign debts
I asked ChatGPT: "Would the Global Financial Crisis (GFC) of 2008-09 have happened if banks had needed to hold e.g., 8% in capital/equity against all assets?"
ChatGPT answered:
"The Global Financial Crisis (GFC) of 2008-09 was a complex event with multiple contributing factors, and it is difficult to attribute the entire crisis to a single regulatory measure such as the capital/equity requirements. While higher capital/equity requirements could have had some impact on the severity of the crisis, it is unlikely that they would have entirely prevented it from occurring.
Higher capital requirements, such as an 8% capital/equity ratio against all assets, would have made banks more resilient to losses and potentially reduced the extent of risk-taking and leverage in the financial system. This, in turn, could have dampened the scale of the crisis and mitigated its impact to some extent.
However, it's important to consider that the GFC had multiple underlying causes beyond just capital requirements:
1. Subprime Mortgage Crisis: The crisis was triggered by the bursting of the U.S. housing bubble and the subsequent defaults on subprime mortgages. These defaults led to significant losses for financial institutions holding mortgage-backed securities and other related assets.
2. Complex Financial Products: The proliferation of complex financial instruments, such as mortgage-backed securities and collateralized debt obligations, made it difficult to accurately assess the true risk exposure of financial institutions and investors.
3. Excessive Risk-Taking: Financial institutions engaged in high levels of risk-taking and leverage, which amplified the impact of the housing market downturn on their balance sheets.
4. Lack of Transparency: There was a lack of transparency in financial markets, making it challenging for investors and regulators to fully understand the risks associated with various financial products.
5. Regulatory Failures: Some regulatory agencies failed to effectively supervise and enforce regulations, allowing risky practices to go unchecked.
6. Contagion Effects: The interconnectedness of global financial markets meant that problems in one sector or region could quickly spread to others, leading to a contagion effect.
While higher capital requirements might have made banks more resilient, they would not have addressed all the underlying issues that led to the crisis. For example, even with higher capital requirements, the interconnectedness of financial institutions and the reliance on complex financial products could have still propagated risks throughout the system.
Moreover, it's important to note that post the GFC, regulatory reforms were indeed implemented to strengthen the financial system. For instance, the Basel III framework introduced stricter capital and liquidity requirements, stress testing, and enhanced risk management practices to address the vulnerabilities that contributed to the crisis.
In summary, while higher capital/equity requirements might have had a positive impact on bank stability and risk management, the GFC was a complex event with multiple factors at play. The crisis would likely have required a comprehensive and multifaceted approach to regulation, oversight, and risk management to prevent its occurrence or mitigate its severity significantly.
I asked ChatGPT:
"Do you hold the proliferation of complex financial instruments, such as mortgage-backed securities and collateralized debt obligations, which much caused the 2008 Global Financial Crisis, was not primarily driven by the financial engineering incentives provided by Basel II’s risk weighted bank capital/equity requirements?"
ChatGPT answered:
The proliferation of complex financial instruments, such as mortgage-backed securities (MBS) and collateralized debt obligations (CDOs), was indeed a significant contributing factor to the 2008 Global Financial Crisis (GFC). These financial products were at the center of the crisis as they played a role in amplifying and spreading risks throughout the financial system. However, it's important to note that Basel II's risk-weighted bank capital/equity requirements were not the sole or primary driver behind the development and use of these complex instruments.
Basel II was a set of international banking regulations that aimed to establish risk-based capital standards for banks. It did provide some incentives for banks to hold less capital against assets that were perceived to be less risky, such as those with high credit ratings. This led to a potential underestimation of risk and encouraged banks to hold relatively lower capital against certain types of assets, including highly rated MBS and CDOs.
The lower capital requirements for higher-rated assets may have contributed to some degree of financial engineering and the creation of complex financial products to achieve higher returns while maintaining regulatory compliance. Financial institutions sought to improve their risk-adjusted returns by holding assets that were assigned lower risk weights under Basel II.
However, it's essential to recognize that the rise of MBS and CDOs was driven by a combination of factors beyond just Basel II capital requirements:
1. Investor Demand: Investors, including banks, pension funds, and other financial institutions, sought higher yields and diversification through complex financial products, which offered seemingly attractive risk-return profiles.
2. Misaligned Incentives: Financial industry participants, including mortgage lenders and investment banks, had incentives to originate and securitize large volumes of mortgages, regardless of their quality, due to the lucrative fees and profits associated with these transactions.
3. Rating Agencies' Role: Credit rating agencies assigned high ratings to many MBS and CDOs, leading investors to perceive them as safe and reliable investments, despite their underlying risks.
4. Lack of Transparency: The complexity of these financial products made it challenging for investors and regulators to fully understand their underlying risks, leading to a lack of transparency in the financial system.
While Basel II's risk-weighted capital requirements may have played a role in shaping banks' behavior and asset allocation decisions, the underlying issues that contributed to the crisis were more extensive and multifaceted. The GFC was a culmination of a housing market bubble, excessive risk-taking, inadequate risk management practices, and the interconnectedness of global financial markets, all of which interacted to create a perfect storm.
In response to the lessons learned from the GFC, regulatory reforms, such as Basel III, were implemented to address the weaknesses and limitations of Basel II and enhance the resilience of the global banking system. These reforms introduced more stringent capital and liquidity requirements, stress testing, and improved risk management practices to reduce the likelihood of similar crises in the future."
I asked ChatGPT:
"You hold: 'Financial institutions sought to improve their risk-adjusted returns by holding assets that were assigned lower risk weights under Basel II.'
Does that not imply banks moved from allocating assets based on their risk adjusted interest rates returns, to do so based on the risk interest rates returns adjusted for the capital/equity requirements?
And, if so, would the resulting allocation of bank credit remain the same?"
ChatGPT answered:
"Apologies for any confusion. You are correct; the statement I made implies that banks, under Basel II, considered risk-adjusted returns based on the capital/equity requirements in their asset allocation decisions. The risk-adjusted returns in this context refer to the returns adjusted for the capital that banks were required to hold against different assets based on their risk weights under Basel II.
When Basel II was implemented, it introduced a risk-sensitive framework that required banks to allocate capital based on the perceived risk of different assets. This led to banks considering not only the interest rate returns on assets but also the capital requirements associated with them.
As a result, banks may have been incentivized to allocate more credit and investment to assets that carried lower risk weights, such as highly rated securities like MBS and CDOs. This was because the capital required to hold against these assets was lower, making them more capital-efficient choices for banks.
The resulting allocation of bank credit, to some extent, was influenced by the capital requirements under Basel II. Banks had an incentive to allocate more of their capital to assets that offered relatively higher returns adjusted for the capital required to be held against them. This contributed to the growth of complex financial products, including MBS and CDOs, as they were perceived as offering attractive risk-adjusted returns under the capital framework of Basel II.
However, it's important to note that while the capital/equity requirements under Basel II played a role in shaping banks' asset allocation decisions, they were not the only driving factor. Other market conditions, investor demand, regulatory environment, and business strategies of financial institutions also influenced their credit allocation decisions.
The GFC exposed weaknesses and flaws in Basel II's risk-weighted capital approach, as it did not fully capture the systemic risks and interconnectedness of complex financial products. In response, subsequent regulatory reforms, such as Basel III, sought to address these shortcomings and introduced more comprehensive and stringent capital and liquidity requirements to improve the stability and resilience of the global banking system."
Thanks!
You're welcome! If you have any more questions or need further assistance, feel free to ask. Have a great day!
Note: The answers are copied exactly from those given to me by ChatGPT and Grok
Paul A. Volcker in his autobiography “Keeping at it” of 2018, penned together with Christine Harper, valiantly accepted that the risk weighted bank capital requirements he helped to promote, had serious problems. In pages 146-148 he writes:
"The travails of First Pennsylvania and Continental Illinois, the massive threat posed by the Latin American crisis, and the obvious strain on the capital of thrift institutions had an impact on thinking over time, but strong action was competitively (and politically) stalled by the absence of an international consensus.
An approach toward dealing with that problem was taken by the G-10 central banking group meeting under the auspices of the Bank for International Settlements (BIS) headquartered in Basel, Switzerland. A new Basel Committee would assess existing standards and practices in a search for an analytic understanding.
Progress was slow…
The US practice had been to asses capital adequacy by using a simple “leverage ratio”-in other words, the bank’s total assets based compared with the margin of capital available to absorb any losses on those assets. (Historically, before, the 1931 banking collapse, a ten 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 kind 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 solve the impasse?
At the end of a European tour in September in 1986, I planned to stop in London for an informal dinner with the Bank of England’s then governor Robin Leigh-Pemberton. In that comfortable setting without a lot of forethought, I suggested to him that if it was necessary to reach agreement, I’d try to sell the risk-based approach to my US colleagues.
Over time, the inherent problems with the risk-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."
As if bureaucrats know better what to do with credit for which repayment they're not personally responsible for than entrepreneurs.
How can one believe that what bankers perceive as risky is more dangerous to bank systems than what bankers perceive as safe?
Should it not be clear that dooms our bank system to especially severe crises, resulting from excessive exposures the what ex ante is perceived as especially safe, but that ex post might not be, against especially little capital?
These self-nominated besserwisser experts had (have) just not the faintest understanding of conditional probabilities.
The Basel Committee for Banking Supervision (BCBS) in order to make bank systems safer imposed risk weighted bank capital requirements. The lower the perceived risk the lower the capital the higher the leverage allowed. The higher the perceived risk the more capital the lower leverage allowed.
For example, in Basel II of June 2004 they held that against any private sector asset that was rated AAA to AA banks needed to hold 1.6% in capital, meaning they were allowed to leverage 62.5 times. Against any private sector asset that was rated below BB- banks needed to hold 12% in capital, meaning they were allowed to leverage 8.3 times.
In terms of tennis that would mean that those players ranked the highest would be able to play with the best rackets, and be allowed many more serves than those player ranked lower. Someone not only unranked but also lousy player like me would be happy having one serve and at least be allowed to use a ping-pong racket if playing against Roger Federer.
But what would have happened if there had been a Basel Committee on Tennis Supervision that implemented these regulations?
To make a long story short, the best tennis players would have it easier and easier to win, and would have less and less need to practice. Those betting on them would bet ever-larger amounts at ever-lower odds… until “Boom!” (2008 Crisis) suddenly the best player was discovered to completely have lost his ability to play and lost in three blank sets to a newcomer.
From Wikipedia we read the following about the causes for the Iceland bank crisis:
“In 2001, banks were deregulated in Iceland. This set the stage for banks to upload debts when foreign companies were accumulated. The crisis unfolded September 2008, when banks became unable to refinance their debts. It is estimated that the three major banks held foreign debt in excess of €50 billion, or about €160,000 per Icelandic resident, compared with Iceland's gross domestic product of €8.5 billion”
That seems true. But where does it say anything about why Iceland's banks were able to get so much debt? For instance from UK and Holland?
If I were an investigative reporter, which I am not, I would start by looking at how much capital UK and Dutch banks had to hold when lending to these banks of Iceland... and then compared this to how much capital they needed to hold when lending to a small or medium unrated enterprises in the UK or in Holland.
That should give you an idea of where UK and Dutch banks would think they would earn their highest risk-adjusted returns on equity... and the rest should be easy to figure out.
Perhaps Iceland should have sued the Basel Committee for Banking Supervision.
The following, if I am ever allowed to give it, as so many would not like to hear it, would be my brief testimony on what caused the 2008 bank crisis
Sir, as I have learned to understand it, the 2008 crisis resulted from a combination of 3 factors.
The first were some very minimal capital requirements for some assets that had been approved, starting in 1988 with Basel I, for sovereigns and the financing of residential housing; and made extensive in Basel II of 2004 to private sectors assets with good credit ratings.
These allowed banks then to earn much higher expected risk adjusted returns on equity on some assets than on other, which introduced a serious distortion. After Basel II the allowed bank equity leverages were almost limitless when lending to “sound” (or friendly) sovereigns; 36 times to 1 when financing residential housing; and over 60 to 1 with private sector assets rated AAA to AA. Just the signature, on some type of guarantee by an AAA rated, like AIG, also allowed an operation to become leveraged over 60 times to 1.
The second was Basel II’ extensive conditioning of the capital requirements for banks to the decisions of some very few (3) human fallible credit rating agencies. As I so many times warned about (in a letter published in FT January 2003 and even clearer in a written statement at the World Bank) this introduced a very serious systemic risk.
The third factor is a malignant element present in the otherwise beneficial process of securitization. The profits of that process are a function of how much implied and perceived risk-reduction takes place. To securitize something safe to something safer does not yield great returns for the securitization process. Neither does to securitize something risky into something less risky.
What produces BIG profits is to securitize something really risky, and sell it off as something really safe. Like awarding really lousy subprime mortgages and packaging them in securities that could achieve an AAA rating. A 11%, 30 years, $300.000 mortgage, packaged into a security rated AAA and sold at a 6 percent yield, can be sold for $510.000, and provide those involved in the process an instantaneous profit of $210.000
With those facts it should be easy to understand the explosiveness of mixing the temptations of limitless, 36, and more than 60 to 1 allowed bank equity leverages providing huge expected risk adjusted ROEs; with subjecting the risk-assesment too much to the criteria of too few; with the huge profit margins when securitizing something very risky into something “very safe”. Here follows some indicative consequences:
As far as I have been able to gather, over a period of about 2 years, over a trillion dollars of the much larger production of subprime mortgages dressed up in AAA-AA ratings, ended up only in Europe. Add to that all the American investment banks’ holdings of this shady product.
To that we should also add Europe’s own problems with mortgages, like those in Spain derived in much by an excessive use of “teaser interest rates”, low the first years and then shooting up with vengeance.
And sovereigns like Greece, would never have been able to take on so much debt if banks (especially those in the Eurozone) would not have been able to leverage their equity so much with these loans.
Without those consequences there would have been no 2008 crisis, and that is an absolute fact.
The problem though with this explanation is that many, especially bank regulators, especially bank bashers, especially equity minimizing bankers, especially inattentive finance academicians, especially faulty besserwissers (those who love the sophisticated taste of words like "derivatives"), they all do not like this explanation, so it is not even discussed.
The real question though is: Who is the guiltiest party, those who fell for the temptations, or those who allowed the creation of the temptations?
I mean how far can you go blaming the children from eating some of that deliciously looking chocolate cake you left on the table, at their reach?
PS. Please do not categorize misregulation as deregulation.
PS. A 2008 GFC tweet summary: The pushers: Those harvesting mortgages in subprime fields; packaging these in MBS and getting rating agencies’ enthusiastic thumbs up. The addicts: The banks The drug, the hallucinogen: The Basel Committee's ultra-low bank capital requirements.
It is based on the information available at the time it was completed on August 19, 2008 and provided background information to the staff report on the 2008 Article IV consultation discussions with Iceland, which was discussed by the Executive Board on September 10, 2008, prior to the recent Board discussion on a Stand-By Arrangement for Iceland.”
It makes fascinating reading, especially in these times when the regulators now want to tackle systemic risks while ignoring that their regulations are in fact the prime source of systemic risk.
In it, dated just a month before the crisis exploded at the end of September 2008, we can, among other, read the following:
“The banking system’s reported financial indicators are above minimum regulatory requirements and stress tests suggest that the system is resilient. Bank capital averaged almost 13 percent of risk-weighted assets between 2003 and 2006, dropped to 12 percent in 2007 and to approximately 11 percent in the first half of 2008, but remain above the 8 percent minimum. Liquidity ratios are likewise above minimum levels.
Notwithstanding the positive indicators, vulnerabilities are high and increasing, reflecting the deteriorating financial environment”
To me once again, this just proves that no one had the faintest idea of what the “risk-weighted assets” really meant and, if they did, they had no will to question the significance of risk-weighting.
The less the perceived risk of default is, and the higher the leverage allowed, the greater the systemic risk.
My huge problem!
Q. "If Kurowski is right, why are his arguments so ignored? A. If I had argued that the regulators were 5 to 10 degrees wrong, I would be recognized, but since I am arguing they are 150 to 180 degrees wrong, I must be ignored.
The deafening noise of the Agendas
The fundamental reasons why it is so hard to advance the otherwise so easy explainable truth of this financial crisis, is because of the deafening noise of the Agendas…
On one side, we have the "progressives" who want to put all the blame on capitalistic banksters, and, on the other, the "conservatives" who want to blame the socialistic government sponsored enterprises GSEs of Fanny Mae and Freddy Mac.
For any of both sides accepting the fact that it was mostly a regulatory failure of monstrous proportions would seemingly be a highly inconvenient truth that would not help them to advance their respective agendas.
What is more dangerous in a systemic way, that which is perceived as risky or that which is perceived as not risky? Right!
How can the Basel Committee be so dumb?
Systemic risks is about something that can become as big so as to threaten the system… and our bank regulators in the Basel Committee are incapable or unwilling to understand that what has the largest possibilities of growing as big so as to threaten the system is what is perceived as having little or no risk, not what is perceived as risky… which makes their first and really only pillar of their regulations, that of capital requirements of banks that are lower when perceived risks are lower… so utterly dumb!
We must stop our gullible and naive financial regulators from believing in never-risk-land.
The stuff that bonuses are made of
Whenever a credit rating corresponds exactly to real underlying risk neither borrower nor lender loses but the intermediary cannot make profits… it is only when the credit ratings are too high or too low that those margins that can generate that profitable stuff that bonuses are paid for exist.
What were they thinking?
The default of a debtor is about the most common, natural and even benign risk in capitalism, so it is so hard to really get a grip on what was going around in the minds of the regulators when they decided to construe capital requirements for banks based exclusively on discriminating against that risk as it was perceived by some credit rating agencies.
Day by the day it is becoming more relevant... scary!
http://theaaa-bomb.blogspot.com
This I published in November 1999... Read it!
The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause the collapse of the OWB (the only bank in the world) or of the last financial dinosaur that survives at that moment.
Currently market forces favors the larger the entity is, be it banks, law firms, auditing firms, brokers, etc. Perhaps one of the things that the authorities could do, in order to diversify risks, is to create a tax on size.”
This I wrote, October 2004, as an Executive Director of the World Bank
We believe that much of the world’s financial markets are currently being dangerously overstretched through an exaggerated reliance on intrinsically weak financial models that are based on very short series of statistical evidence and very doubtful volatility assumptions.
https://subprimeregulations.blogspot.com/2004/10/my-statement-on-ibrds-liquidity.html
Regulatory hubris
In a world with so many different risks, some naïve gullible and outright stupid regulators thought everything would be fine and dandy if they just had some few credit rating agencies determine default risks and then gave the banks great incentives, by means of different capital requirements, to follow those credit risk opinions.
On bs.
When experts bs..t the world that’s bad news, but when experts allowed themselves to be bs..ted by bs..ing experts that’s is when the world goes really bad.
This crisis resulted directly from the Potemkin credit ratings the market produced to satisfy the demand for AAAs created by the regulators.
Lower the capital requirements for banks on:
the loans to those who had nothing to do with creating the current AAA crisis, like small businesses and entrepreneurs but are anyhow the ones which most suffer the current scarcity of bank capital
My most current proposal on the regulatory reform for banks
They were supposed to teach the world prudent risk-taking and instead they taught it imprudent risk-aversion.
The deal!
This was the deal! If you convinced risky and broke Joe to take a $300.000 mortgage at 11 percent for 30 years and then, with more than a little help from the credit rating agencies, you could convince risk-adverse Fred that this mortgage, repackaged in a securitized version, and rated AAA, was so safe that a six percent return was quite adequate, then you could sell Fred the mortgage for $510.000. This would allow you and your partners in the set-up, to pocket a tidy profit of $210.000
Calling it quits?
A world that taxes risk-taking and subsidizes risk adverseness is a world that seems to want to lie down and die
Let´s neutralize the wimps!
If we are to keep on using Basel methodology for establishing the minimum capital requirements for banks, beside better risk weights, we must demand it also uses “societal purpose” weights.
What other word could describe a bank regulatory system designed exclusively to avoid bank crisis as if that is the only purpose of banking. You might just as well order the kids to stay in bed all life so as to diminish the risk of them tripping.
The minimum capital requirements of Basel that are based on default risks as measured by the credit rating agency amount to a dangerous tax on the risk, the oxygen of development.
Blindly focusing on default and leaving out any consideration that a credit with a low default risk but for a totally useless or perhaps even an environmentally dangerous purpose is much more risky for the society than a credit with a higher default risk destined to trying to help create decent jobs or diminish an environmental threat, is just silly.
But do I have to be disrespectful and call them silly? Well, individually perhaps they are not, but, as a group, bank regulators are so full of hot air that someone has to help them to puncture their cocoon balloon and let them out.
Breathe!
I’m going to third-pillar what?
By now the desperate bank regulators are throwing at us the third pillar of their Basel regulations which implies the need that we ourselves privately monitor our banks. Great, in my country, a couple of decades ago, I did just that and had a fairly good grip on whom of my banker neighbors were good bankers and whom to look out for.
But sincerely what am I supposed to do know when about 50 per cent of the retail deposits in my country are in hand of international banks (Spain) and that might be losing their shirt making investments in subprime mortgages in California?
Tragedy!
It is very sad when a developed nation decides making risk-adverseness the primary goal of their banking system and places itself voluntarily on the way down but it is a real tragedy when developing countries copycats it and fall into the trap of calling it quits.
Development rating agencies?
A bank should be more than a mattress!
When considering the role of the commercial banks should not the developing countries use development rating agencies instead of credit rating agencies?
Clearly more important than defending what we have is defending what we want to have.
What do we want from our banks?
Over the last two decades we have seen hundreds if not thousands of research papers, seminars, workshops conferences analyzing how to exorcize the risks out of banking; and if in that sense the bank regulation coming out from Basel was doing its job; and centred around words like soundness, stability, solvency, safeness and other synonyms. Not one of them discussed how the commercial banks were performing their other two traditional functions, namely to help to generate that economic growth that leads to the creation of decent jobs and the distribution of the financial resources into the hands of those capable of doing the most with it.
At this moment when we are suddenly faced with the possibilities that all the bank regulator’s risk adverseness might anyhow have come to naught, before digging deeper in the hole where we find ourselves fighting the risks, is it not time to take a step back and discuss again what it is we really want our commercial banks to do for us? I mean, if it is only to act as a safe mattress for our retail deposits then it would seem that could be taken cared of by authorizing them only to lend to the lender of last resort; but which of course would leave us with what to do about the growth and the distribution of opportunities.
We are suffering from more and more answers than questions begging for them, and so I work on the latter.
Read it all in my one and only book!"Voice and Noise"
Pssst... so few have read this book so it is slowly turning into a collector item (I do not say a "cult"... yet) and so you might benefit from getting your very own copy now.
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