Our modern statist rulers insidiously debase our currencies with their decreed zero-risk weighting of sovereigns

Lawrence W. Reed in “Did You Know about the Great Hyperinflation of the 17th Century?” FEE August 2017, quotes Nicolaus Copernicus (1473–1543) with: “The greatest and most forbidding mistake has to be when a ruler tries to make a profit from the minting of coins by introducing and circulating new coins with an inferior weight and fineness, alongside the originals, and claims that they are of equal value”

And Reed notes: “Desperate to raise cash and secure material for war, many of the German states in 1618 resorted to the debasement of coinage. They clipped and they melted. At first, they adulterated their own coin but then discovered that they could do the same to that of their neighbors too.”

Our modern governments use much more refined and insidious debasement methods. In order they say to make our banks safe, regulators came up with the risk weighted capital requirements which assigned to the sovereign a risk weight of 0%... yes, you read it well, zero percent.

That means that banks are able to leverage any little net margin obtained on public debt, into great returns on equity. That means that banks will be offering to hold a lot of public debt at low rates which will help to confound all the rest of investors into believing the markets believe that debt to be intrinsically safe.

That also means banks are going to absorb much more of the governments injections of liquidity than would otherwise have been the case.

One day buyers of public debts of these by regulators decreed ultra-safe sovereigns, are going to wake up.

When that happens all bets are off. Interest rates on public debt will shoot up, repaying governments will inject liquidity that will be impossible to drain… and economic realities will be hyper-inflation/hyper-recession messy.

When will that happen? Who knows, in Europe governments have already recruited insurance companies to also operate under a scheme similar to the banks’ Basel I, II and III, and which has quite cynically been named Solvency II.

Why is this all unsustainable? Any system, in which government bureaucrats can, without being responsible for its repayment, have easier access to other peoples’ money than for instance the 100% risk weighted SMEs and entrepreneurs, simply cannot end well.

PS. I often hear the argument that if sovereigns borrow in their own currency they represent indeed a zero risk because they will always be able to repay. Wow they’ve got to be kidding! True repayment does only happen when done with purchase power that has not been diluted by inflation.

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

A safer banking system compared to our current dangerously misregulated one with so many systemic risks on steroids

What is a safer banking system?

One in which thousand banks compete and those not able to do so fail as fast as possible, before some major damage has been done, while even, as John Kenneth Galbraith explained, often leaving something good in their wake. 

What is a dangerous banking system?

One were all banks are explicitly or implicitly supported, by taxpayers, as long as they follow one standard mode that includes living wills, stress tests, risk models, credit ratings, standardized risk weights... all potential sources of dangerous systemic risks.

A bank system in which whenever there is a major problem, the can gets kicked down the road with QEs and there is no cleaning up, and banks just get bigger and bigger.

One that make it more plausible that the banks will all come crashing down on us, at the same time, with excessive exposures to something ex ante perceived safe that ex-post turned out risky, and therefore the banks holding especially little capital.

But you don’t worry; the regulators have it all under control with their Dodd-Frank’s Orderly Liquidation Authority (OLA). “Orderly”? Really?

So that is why when I hear about banks “cheating” with their risk models I am not too upset, since that at least introduces some diversity. 

Also that cheating stops, at least for a while, the Basel Committee regulators from imposing their loony standardized risk weights of 20% for what has an AAA rating, and so therefore could be utterly dangerous to the system; and one of 150% for the innocuous below BB- rated that bankers don’t like to touch with a ten feet pole.

How did we end up here? That is where you are bound to end up if you allow some statist technocrats, full of hubris, to gather in a mutual admiration club, and there engage into some intellectually degenerating incestuous groupthink.

Statist? What would you otherwise call those who assign a 0% risk weight to the Sovereign and one of 100% to the citizen?

And it is all so purposeless and useless!

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

Useless? “May God defend me from my friends, I can defend myself from my enemies”, Voltaire

In essence it means that while waiting for all banks to succumb because of lack of oxygen in the last overpopulated safe-haven available, banks will no longer finance the "riskier" future our grandchildren need is financed, but only refinance the "safer" present and past.

In April 2003, as an Executive Director of the World Bank I argued: "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."

PS. FDIC... please don't go there!

Note: For your info, before 1988, we had about 600 years of banking without risk weighted capital requirements for banks distorting the allocation of bank credit to the real economy.

PS. The best of the Financial Choice Act is a not distorting, not systemic risks creating, 10% capital requirement for all assets. Its worst? That this is not applied to all banks.

PS. If I were a regulator: Bank capital requirements = 3% for bankers' ineptitude + 7% for unexpected events = 10% on all assets = Financial Choice Act
 

The almost 600 year long history of banks changed dramatically, for the worse, in 1988, with the Basel Accord.

If we use the Medici Bank as the first bank, it was established in 1397. From there on, until 1988, a bank’s capital (equity) followed the simple “one for all and all for one” principle. 

Then with the Basel Accord, Basel I, the regulators introduced risk weighted capital requirements for the banks. More ex ante perceived risk more capital – less risk less capital. That had serious and non-transparent consequences for the borrowers, for the economy, for bank stability and for the balance between the government and We the People.

It promoted inequality among the borrowers:

The ex ante perceived “risky” borrowers, those who precisely because of those perceptions, already got less credit and had to pay higher interest rates, now also had to face the costs of generating higher capital requirements for banks; while the ex ante perceived “sage” borrowers, those who precisely because of those perceptions, already got more credit and had to pay lower interest rates, now also received the subsidy of generating lower capital requirements for banks.

It stopped the economy to move forward, so it stalls and falls

Banks, because of the higher leverage allowed with assets perceived as safe, obtained higher expected risk adjusted returns on equity when financing, the “safe” than when financing the “risky”, like SMEs. The new regulations stopped banks from financing the riskier future and mostly dedicate themselves to refinance the safer past and present. They now finance safe basements where jobless kids can live with parents, but not the SMEs that could get the kids jobs.

It destabilized the bank system.

By assigning ultra low capital requirements for what was perceived as safe it caused the dangerous overpopulation of “safe havens”, like the AAA rated securities built-up with lousy mortgages to the subprime sector… and against very little capital.

It brought in statism thru the bathroom window.

Risk weights of 0% for the Sovereign and 100% for We the People, expresses unabridged statism in that it, de facto, implies regulators think government bureaucrats are able to use bank credit better than SMEs and entrepreneurs.

Just try to imagine what the Médicis would have said about assigning a 0% risk weight to the Sovereign?

PS. Here's a more extensive aide memoire on some of the monstrosities of such regulations

The Vasa and the Basel I, II and III disasters

Stefan Ingves, the chair of the Basel Committee, in a speech titled "From the Vasa to the Basel framework: The dangers of instability" last November, said the following:

“In 1625, King Gustav II Adolf of Sweden ordered the construction of…the mighty Vasa. 

It took three years and 300 men to build the Vasa. And 40 acres of timber were consumed. 

The final result was impressive. The Vasa had two gun decks, 64 bronze cannons, and its tallest mast soared to 57 metres. The ship was the result of a quest for perfection. 

This perfection was, alas, short-lived. Tragically, the Vasa sank on its maiden voyage, after sailing only 1,300 metres, on 10 August 1628. 

After so much planning, so many resources and so much time and effort, why did the Vasa sink? According to the King, it was the result of ‘foolishness and incompetence’ 

But historians generally agree that a key factor in the Vasa's fate was the lack of stability and the hull's excessive rigidity… the Vasa was well constructed but incorrectly proportioned” 

As I read it if the historians are right, then clearly so is the King.

And bank regulations designed by the Basel Committee, especially the risk weighing of the capital requirements, was absolutely “incorrectly proportioned”, and so to me the regulators have been foolish and utterly incompetent.

And with respect to Basel III Stefan Ingves said: “The framework has remained unchanged from Basel II across two broad dimensions: first, the way in which risk is measured - and in particular, the reliance on banks' own estimates of risk - has remained the same following the crisis; and second, the risk-weighted approaches are essentially the same as they were before the crisis"

But, in order to “address the fault lines that emerge from these two dimensions” Ingves now tells us that the regulators are working to fix that with "(i) enhancing the risk sensitivity and robustness of standardized approaches; (ii) reviewing the role of internal models in the capital framework; and (iii) finalizing the design and calibration of the leverage ratio and capital floors."

As I see it, in Vasa terms, the hull of Basel III still lacks stability, but the Basel Committee just keeps on loading more “bronze cannons” on its deck.

“Enhancing the risk sensitivity”? For God’s sake, they are still looking at the risk of the assets and not at the risk those assets pose to the banks… and so they still do not understand that the safer an asset might be perceived, the riskier it could be for the banking system.

And they still have not defined the purpose of the banks, and so they still do not care one iota about if their risk weighing distorts the allocation of credit to the real economy.

I ask, would, King Gustav II Adolf of Sweden have given the constructors of Vasa the resources to build another boat, like we allow the same regulators who designed Basel I and Basel II to now work on Basel III? I don’t think so!

And in wikipedia we read “An inquiry was organized by the Swedish Privy Council to find those responsible for the Vasa disaster, but in the end no one was punished for the fiasco.”

Lucky Stefan Ingves... in the case of the monumental failings of Basel II there has not even been an inquiry!

“A ship in harbor is safe, but that is not what ships are for.” said John Augustus Shedd, 1850-1926. Well, if built by something like the Basel Committee, it is not even safe in the harbor J

PS. Had the Vasa and the Titanic been perceived as "risky" would the outcomes have been the same? No! The outcomes were quite much partly conditioned on the ships being ex ante perceived as safe.

Basel‘s monstrous regulatory mistake

The regulators notwithstanding that the market and the banks already considered the credit ratings when setting their risk premiums and interest rates, considered exactly the same information when setting their capital requirements for the banks. This double consideration, which would have been wrong even in the case of perfect credit ratings, leveraged incredibly the systems dependence on the human fallible credit ratings.

And now, more than three years into the crisis, the Basel Committee, FSB, FAS, Fed, IMF, World Bank, PhDs and finance experts, specialized journalists, like all those in FT, and most other who have and give opinions on the issue of bank regulations, have yet to say one single word about a mistake that really makes it impossible to construe any worthy bank regulation on top of it.

One really wonders what world we live in, when the regulators is turning our whole banking system sissy... and making it impossible for banks to allocate credit efficiently to the real economy.

Postscript: Basel Committee, please listen to Violet Crawley, don't be so defeatist, it’s so middle class.

https://youtu.be/g9XQ3_LCl-Q

The principle of bank regulations that has been and is so rudely violated

Regulators should accept that bankers believe they can master quite adequately the risks of default. Who would want to deal with a banker who does not believe so?

But in the same vein the regulators should always tell the bankers “No you can’t… and besides there are so many other risks to be considered than just avoiding the defaults of your clients and the defaults of yourselves”.

And foremost regulators should never ever themselves become risk-managers… a principle that was and is so rudely violated.

It is bad enough when regulators fall for the sales pitch of bankers and believe too much in their risk-management ability, but so much worse when the regulators arrogantly believe, as they currently do, that they know themselves what the risks are and that they know themselves how to properly manage and master these… with or without a little help from the credit rating agencies.

A credit rating sends out on its own a very positive or negative signal to the market. When regulators based the capital requirements of banks on those same credit ratings, they dramatically augmented the strength of those signals… to such an extent that banks went and drowned themselves in triple-A rated waters wearing no capital at all… to such an extent that lending to the “risky” small businesses and entrepreneurs has come to a halt because that requires too much capital, especially when bank capital is very scarce as a result of having invested or lent too much to the ex-ante “not risky”.

Currently the regulators, who like risk-managers already failed in conquering some simple risks of defaults, when foolishly playing around with their capital requirements based on perceived risks, and ignoring that systemic crisis never ever results from timely perceived risks, are now tackling more God-like events like pro-cyclicality. God help us!

The mystery of the unconnected dots!

We have two outstanding pieces of evidence that can help us understand the current financial crisis and therefore help us to avoid repeating the same mistake… and so we could at least give new mistakes a chance to show what they are worth.

The first evidence is the really mindboggling acceleration in demand after mid 2004 for securities rated triple-A and which led to over two trillion dollars from all over the world to be invested and lost in securities which were collateralized with very badly awarded mortgages to the subprime sector.

The second evidence is represented by two dates and one piece of bank regulations:

On April 28, 2004 in an Open Meeting the SEC discussed "Alternative Net Capital Requirements for Broker-Dealers that are Part of Consolidated Supervised Facilities and Supervised Investment Bank Holding Companies" and in both cases it was approved that the respective parties “would be required periodically to provide [their respective] Commission with consolidated computations of allowable capital and risk allowances (or other capital assessment) consistent with the Basel Standards." In other words, that day, the SEC, almost explicitly, delegated some of its fundamental functions to the Basel Committee.

On June 26 2004 the G10 substituted the 30 pages long Basel I adopted in 1988 with the 251 pages long Basel II.

And Basel II, required for instance a bank to hold if it wanted to invest in triple-A rated private securities only 1.6 percent of fairly loosely defined capital, signifying that the bank was there allowed to leverage a quite loosely defined capital 62.5 to 1, signifying that if a Bank bought a triple-A rated security on which it expected to make a margin of .5 percent that it could expect a return on its capital of 31.25 percent a year. Needless to say the banks went berserk demanding triple-A rated securities. And since there were not sufficient real triple-A securities, the market, as markets do, supplied them with fake Potemkin-triple-A ratings.

It should not be difficult to connect the dots for anyone who wants to connect the dots and so the big lingering question about this crisis and its explanation remains… why do so very few experts want to connect the dots? A real mystery!

What are we to do with the Financial Stability Board?

The Financial Stability Board (FSB) reported from their meeting in Seoul on October 20 ahead of the G20 Summit in Seoul and endorsed principles for reducing reliance on credit rating agency (CRA) ratings as follows:

“The goal of the principles is to reduce the cliff effects from CRA ratings that can amplify procyclicality and cause systemic disruption. The principles call on authorities to do this through:

Removing or replacing references to CRA ratings in laws and regulations, wherever possible, with suitable alternative standards of creditworthiness assessment;

Expecting that banks, market participants and institutional investors make their own credit assessments, and not rely solely or mechanistically on CRA ratings.”

Since FSB does not even mention the risk-weights we can only assume FSB feels that all what went wrong was the excessive reliance on the credit ratings. They have no clue. What went really wrong was the way the regulators arbitrarily assigned to the different credit ratings the different risk-weights which determined the capital requirements for banks… like the 20% risk-weight for any lending to private entities rated triple-A or 0% risk weight on any lending to sovereigns rated triple-A.

In other words the FSB is unable or unwilling to understand that the credit rating agencies could have been totally wrong and yet they would never have produces the damage they did with their faulty ratings, had they not been so incredible endorsed by the bank regulators.

And neither does FSB understand that their regulatory favors to what is perceived as having a low risk of default, amounts only to an odious discrimination of what is perceived as having a higher risk of default, and all for no real purpose at all, since we all know that what is perceived as risky does never carry the potential to turn into a systemic danger.

And so friends what are we to do with the thick-as-a-brick Financial Stability Board?