Paul Volcker valiantly accepted that the risk weighted bank capital requirements he 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.

Here a simple as can be one-minute explanation of the distortions produced by the risk weighted bank capital requirements in the allocation of credit to the real economy.

For 600 years, before the Basel Accord of 1988, banks, with an eye to their overall portfolio, allocated their assets/credits depending on the perceived risk adjusted return these were to produce.

For instance, if a safe AAA to AA rated asset at 4% interest rate and a riskier asset rated BBB+ to BB- a 7% interest were, in the mind of the banker, both producing an acceptable 1% net risk adjusted return, he could pick either one or both. If banks were allowed (by markets or regulators) to leverage their assets 12.5 times, that would produce the bank a 12.5% risk adjusted return on equity.

But the introduction of the risk weighted bank capital requirements changed all that.

Basel II, 2004, standardized risk weights banks assigned a risk weight of 20% to AAA to AA rated assets, and 100% BBB+ to BB- rated assets.

That based on a basic capital requirement of 8% translated into a 1.6% capital requirement for AAA to AA rated assets, and 8% for BBB+ to BB- rated assets.

That mean banks could leverage AAA to AA rated assets 62.5 times, while only 12.5 times with BBB+ to BB- rated assets.

So, with the same previous 1% net risk adjusted return AAA to AA rated assets would now yield a 62.5% risk adjusted return on equity while the BBB+ to BB- rated assets would keep on yielding a 12.5% risk adjusted return on equity.

And so either the BBB+ to BB- rated risky had to be charged 12% instead of 7%, so as to deliver the 5% risk adjusted return that, with a 12.5 times allowed leverage would earn banks a 62.5% risk adjusted return on equity, something which naturally made the risky even riskier; or the AAA to AA rated could be charged a lower 3.2 % interest rate instead of 4%, and still deliver a 12.5% risk adjusted return on equity.

What happened? The risky, like unsecured loans to entrepreneurs, were abandoned by banks, or had to pay much higher interest rates, while the safe, like sovereigns, residential mortgages and AAA rated, were much more embraced by banks, and even offered lower interest rates than in the past.

This is the distortion in the allocation of bank credit to the real economy that the regulators have caused. Is that good? Absolutely not! It promotes excessive credit to what’s perceived or decreed safe, and insufficient to what’s perceived as risky. 

And since risk taking is the oxygen of all development, with it, regulators have doomed our real economy and financial sector to suffer from lack of muscles, severe obesity and osteoporosis.

“A ship in harbor is safe, but that is not what ships are for.” John A. Shedd. But the Basel Committee for Banking Supervision is causing banks to dangerously overpopulate safe harbors, while leaving the riskier oceans to other investors and small time savers.

And the savvy loan officers were substituted by creative bank equity minimizing financial engineers

And the risk-free rate became a subsidized risk-free rate.

The risk weights in the risk weighted bank capital requirements are to access to credit, what tariffs are to trade, only more pernicious.

https://subprimeregulations.blogspot.com/2016/09/if-ever-allowed-following-would-be-my.html

“I am not sure about 'subsidised' sovereign. Since sovereign is ultimate safety net for entire financial system… the term is I'll suited.”

My answer:

Yes a sovereign, if we ignore inflation and the possibility of being repaid in worthless money, the sovereign represents no risk if it takes on debt denominated in a currency it can print. Which by the way is not the case with the sovereigns in the Eurozone.

But let us assume that in the open market the required risk/cost/inflation adjusted net return for a sovereign in .5% and for the risky SMEs 3%

Then if banks, as it used to be for almost 600 years, had to hold one single capital against the risks of its whole portfolio, and the authorities, or in their absence the markets, allowed banks to leverage 12 times then the risk/cost/inflation adjusted required expected return on equity would be 6% for sovereigns and 36% for SMEs.

BUT, since banks are now allowed to leverage immensely more with safe sovereigns, let us say 40 times and only 12 times with SMEs, the now distorted risk/cost/inflation adjusted expected ROEs are 20% for sovereigns and still 36% for SMEs. So now banks can offer to lower the interest rates to sovereigns and still obtain the risk/cost/inflation adjusted required expected return on equity of 6% for sovereigns, ergo the subsidized sovereign.

OR, since banks could now earn a risk/cost/inflation adjusted expected ROEs of 20% on sovereign debt, then in terms of comparable risk adjustments it would have to earn more than 36% on SMEs, or not lend to them at all, ergo that subsidy to the sovereign, is paid by others who find their access to bank credit made more difficult and expensive as a consequence of the risk weighted bank capital requirements. 

PS. Is there no sovereign risk present when some current rates are negative and central banks work like crazy to produce 2% inflation? 

PS. If you go back in time and start taking about risk-free sovereigns to bankers who sometimes had their head chopped off or were been burned when trying to collect from the sovereigns, they would think you were crazy.

The before and after the risk weighted bank capital adequacy ratio (RWCR)

The risk weighted bank capital requirements were introduced in 1988 by means of the Basel Accord, Basel I, and were much further developed in 2004, with Basel II. RWCR survives in Basel III.

Before RWCR banks, for their return on equity, leaned on savvy bank loan officers to obtain the highest risk adjusted net margins. A net margin of 1.5% when leveraged 10 times on their equity, would produce a 15% ROE. All wanting access to bank credit, whether perceived as safe or risky, competed equally with their risk adjusted net margin offers.

After the introduction of RWCR though banks, for their return on equity, still leaned somewhat on bank loan officers obtaining the highest ROE depended more on equity minimizing financial engineers. A risk adjusted net margin of 1%, when leveraged 20 times on equity, produces a 20% ROE. The risk adjusted net margin offers of those perceived or decreed as safe, which could be leveraged many times more, were now worth much more than those offered by the risky.

And what are the consequences?

The RWCR by favoring the financing of the “safer present” like sovereigns, residential mortgages and what’s AAA rated over the financing of the “riskier future, like entrepreneurs, leads to a more obese and less muscular economy.

All that RWCR really guarantees is especially large bank crisis, caused by especially large exposures to something perceived or decreed as especially safe, and that turn out to be especially risky, while being held against especially little bank capital. 

So what went wrong? Simply that regulators based their capital requirements on the same perceived risks that bankers already consider when they make their lending decisions, and not on the conditional probabilities of what bankers do when they perceive risks.

Any risk, even if perfectly perceived, will lead to the wrong actions, if excessively considered.

My letter to the Financial Stability Board

What I as a former Executive Director of the World Bank pray that any new President of it understands

I was an Executive Director at the World Bank from November 2002 until October 2004. During that time the Basel Committee's Basel II bank regulations were being discussed. It was approved in June 2004. 

I was against the basic principles of those regulations that had begun with the Basel Accord of 1988, Basel I. That should be clear from Op-Eds I had published earlier, transcripts of my statements at the WB Board, and in the letters that I wrote and FT published during that time. Here is a brief summary of all that 

Since then I haven't changed my mind... the risk weighted capital requirements for banks, which are a pillar of those bank regulations, is almost unimaginable bad.

I pray the next president of the world’s premier development bank, whoever he is, and wherever he comes from, at least, as a minimum minimorum, understands:

First, that risk-taking is the oxygen of any development, and therefore the regulators’ risk adverse risk weighted capital requirements, will distort against banks taking the risks that help to push our economies forward. “A ship in harbor is safe, but that is not what ships are for.”, John A Shedd.

Second, that what’s perceived as risky is much less dangerous to our bank systems than what’s perceived as safe, and so that these regulations doom us to especially large bank crises, because of especially large exposures to what is especially perceived (or decreed) as safe, against especially little capital.

Do you not agree that mine is a quite reasonable wish?

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

@PerKurowski

IMF: The “I scratch your back if you scratch my back” crony statism deal between sovereigns and banks, must stop.

In 1988, with the Basel Accord, Basel I, for the purpose of capital requirements for banks, regulators assigned to the sovereigns a risk weight of 0%, while citizens got one of 100%.

That meant banks would be able to leverage more their capital when lending to sovereigns than when lending to citizens. 

That meant banks would be able to earn higher expected risk adjusted returns on equity when lending to sovereigns than when lending to citizens. 

That meant that banks would lend more and at lower rates than usual to sovereigns and in relative terms less and at higher rates than usual to citizens.

That de facto established the Sovereign-Bank Nexus. I Sovereign help to guarantee you banks, and you help to finance me abundantly and cheap.

IMF, in its Global Financial Stability Report 2017, page 36 and 37 have a section titled “The Sovereign-Bank Nexus could reemerge”. It correctly spells out how banks can be affected by difficulties of sovereigns and how sovereigns can be affected by difficulties of banks. 

But it makes absolutely no reference to the regulatory support of the Sovereign-Bank Nexus previously described. Why?

That runaway statism must stop!

IMF, Basel Committee for Banking Supervision: Don’t tell me you do not know who did the Eurozone in?

PS. November 2016 Olivier Blanchard agreed on that there was a need to research the distortions produced by these regulations. Has that started?

Olivier Blanchard agrees there is a need for more research on whether bank regulations have distorted

In the IMF’s Annual Research Conference during the final Economic Forum: Policy challenge after the Great Recession I had the chance to pose Olivier Blanchard a question session of Professor Lawrence Summers Mundell Fleming Lecture I had a chance the pose a question (1:01:10)

My Question: 

I might insist here briefly on a point: Why do you say that interest rates on public debt are low, when they are based on so much of regulatory subsidies? Add to the zero low rates of the public debt, all those costs that comes from not giving SMEs and entrepreneurs, millions of them, the chances for credit, only as a result of the distortions produced by risk weighted capital requirements for banks.

Olivier Blanchard answer: 

This is a theme that you have explored over the years. You are absolutely right that the answer is: if the very low safe rates is due to distortions, then the first order of business, should be to eliminate the distortions.

That’s true, if your right, of regulations, but it may be true of the lack of social insurance in some countries which leads people to basically be willing to save enormous amounts that they should not be saving, it could also be true because of missing markets. 

For all this reason you are absolutely right, step zero in what I say, lets make sure that we have removed all the distortions which we can, which affect r (rates), so we have the right r. I take your point.

My afterthoughts: 

I sure appreciate Olivier Blanchard's acceptance of the relevance of my concerns, its been a long trip. In 2004 in a letter published by the Financial Times I wrote “How many Basel propositions will it take before they start realizing the damage they are doing by favoring so much bank lending to the public sector?" 

And I hope the research on it starts now, not only by the IMF. It is long overdue. In fact the possible distortions should have been analyzed before these regulations were imposed.

PS. The day earlier I had posed Professor Lawrence Summers a similar question

PS. Here’s my recent, 2019, comments sent to the Financial Stability Board

PS. Here’s my recent, 2019, letter sent to the IMF

 

Professor Summers, fixing potholes using 0% public debt will not fix America. Don’t put the cart before the horse.

Professor Larry Summers, and many others with him, promote the idea that the government in America (and other governments too) should take advantage of the extraordinarily low interest rates on public debt, in order to finance new infrastructure and the maintenance of old.

Briefly their calculation is as follows: If government takes on debt at 0% and invest it in infrastructure projects that renders a 5% economic return, then the government, with a 30% tax on that, will have earned a net 1.5%... and we can all live happily ever-after.

NO! First, even if the government nominally pays 0% on its debt, that does not mean that debt has a zero cost. To begin with we should have to add the cost of all those giving up (cheated out of) some long term decent earnings on their saving, in order to finance the government for free. But, even more importantly, those zero or low rates are not free and clear market rates, but rates that are non-transparently subsidized by regulations.

In 1988, with the Basel Accord, Basel I; for the purpose of calculating the risk weighted capital requirements for banks, the regulators decided that the risk-weight for the sovereign was 0%, while that of We the People was 100%. And those risk-weights are still in full force.

I cannot say how much of the low interest rates on public debts are explained by this regulatory distortion, but it sure has to be quite a lot.

I have lately seen Professor Summers, and Lord Adair Turner, showing these rates trending down for the last 30 years. Unfortunately for reasons that are beyond my grasp, they have not been able to see a connection between this and 1988’s bank regulations.

But I do know that piece of egregious regulation, introduced such distortions in the allocation of bank credit that, worldwide, millions of SMEs and entrepreneurs have been negated the opportunities   provided by access to bank credit. That is a real huge cost that should be added to the nominal 0% rate. In other words the rates on public debt are the nominal rates, plus the economic and human costs of the distortions.

Since because of this regulatory risk aversion (even in the Home of the Brave) the economies are stalling and falling. So in this respect one could argue that in reality, never ever before have the interest rates on public debt been as high.

Which also leads me to my second objection, that of “infrastructure projects rendering a 5% economic return”. The final real return of any infrastructure project is a function of how it meets the needs of the economy, and of the state of the economy. If regulatory distortions impede the growth of the economy, those infrastructure projects, even if perfectly carried out, even if financed at 0%, might really turn out to provide a negative return.

Professor Summer, let us, very carefully, get rid of those regulatory distortions so that the banks of America, and those of the world, can return to the normality that was so rudely interrupted by regulatory hubris and statism in 1988. That would allow infrastructure to be financed by governments out of real economic growth, something that would then certainly even justify having to pay much higher nominal interest rates than now.

Please don’t put the cart before the horse! Don’t refuse “the risky” the opportunities to access bank credit only because they are risky. Our economies were all built on risk-taking, even when some of it was not adequately reasoned.

To lay on regulatory risk aversion on top of bankers natural risk-aversion, is an insult to intelligence and human wisdom.

God make us daring!

Why has IMF kept silence on what was done to banks in 1988?

What happened?

Before 1988, for about 600 years, bank exposures were a function of the by bankers ex-ante perceived risks (bpr), risk premiums (rp) meaning interest rates, and bankers’ risk tolerance (brt) 

Pre 1988 bank exposures =ƒ(bpr, rp, brt)

Bank credit was then allocated to what produced banks the highest expected risk adjusted return on equity

But 1998, with the Basel Accord, risk weighted capital requirements were introduced. With that bank exposures became a function of the: by bankers ex-ante perceived risks (bpr), risk premiums (rp), bankers’ risk tolerance (brt), and regulatory capital requirements (rcc), this last itself a function of the by regulators ex-ante perceived (or decreed) risks (rpr) and the regulator’s risk tolerance (rrt)

After 1988 bank exposures = ƒ(bpr, rp, brt, rccƒ(rpr, rrt))

Bank credit was thereafter allocated to what produced banks the highest expected risk/capital-requirement adjusted return on equity

And of course banking changed dramatically, and the allocation of bank credit to the real economy became hugely distorted.

With Basel II of 2004, which introduced risk weighting within the private sector, and made the process much dependent on credit ratings, the distortions and the systemic risks were dramatically increased.

Fundamental mistakes:

1. Although hard to believe, bank regulators never defined what the purpose of banks is before regulating these. “A ship in harbor is safe, but that is not what ships are for.” John A Shedd, 1850-1926

2. Although hard to believe, as the purported reason was to make banks safer, the regulators never researched what had caused bank crisis in the past; namely unexpected events, criminal doings and what was ex ante perceived as very safe but that ex post turned out very risky. What is perceived as very risky is, precisely because of that perception, what is least dangerous to the system. “May God defend me from my friends, I can defend myself from my enemies” Voltaire

3. Any risk, even if perfectly perceived, causes the wrong actions if excessively considered; and here the regulators doubled down on ex ante perceived risks.

4. Ignoring risk-taking is the oxygen of development. For banks to take risks, albeit in smaller amounts on “risky” SMEs and entrepreneurs, is absolutely vital for the economy to move forward, in order not to stall and fall. Where would we be had these regulations been in place during the previous 600 years? In April 2003 as an Executive Director of the World Bank I stated: “The Basel Committee dictate norms for the banking industry… there is a clear need for an external observer of stature to assure that there is an adequate equilibrium between risk-avoidance and the risk- taking needed to sustain growth.” In fact the risk of excessive risk aversion was the theme of my first ever Op-Ed. 

5. Little understanding of systemic risks: In January 2003 I wrote in Financial Times: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds. Friends, as it is, the world is tough enough.”

6. Little understanding of fragility: In April 2003, as an ED of the World Bank I stated: “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.”

7. Little understanding of pro-cyclicality: When times are good, credit-risks seem low, so the risk-weighted capital requirements allow banks to expand more than they should; and when times are bad, the credit risk are naturally perceived higher, and so the capital requirements force banks to contract credit, precisely when less bank credit austerity is needed.

8. Macro-imprudence: Prudential regulation helps failed banks to fail expediently. Macro-imprudent regulation impedes failed banks from failing… which builds uphuge mountains of combustible materials waiting for a Big Bang.

9. Overreliance on data and models: In October 2004 in a formal statement at the World Bank I warned: “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.”

Consequences:

Statism: Basel Accord’s risk weights of 0% for “The (infallible) Sovereign” and 100% for “We the (risky) People” introduced runaway statism. Since then the proxies for risk-free rates have been subsidized. We have no idea what the current low interest rates on much sovereign debt would be if government bureaucracy bank borrowings were affected by a risk-weight similar to SMEs’. De facto those risk-weights imply that regulators believe public bureaucrats know better what to do with bank credit, than the private sector.

Crisis resulting from dangerous overpopulation of “safe” havens: The first crisis, that of 2008, resulted from excessive exposures to AAA rated securities (Basel II risk weight 20% = allowed leverage 62 to 1), sovereigns like Greece, and residential housing (Basel II risk weight 35% = allowed leverage 32 to 1)  

Stagnation: Banks have stopped financing the riskier future and basically keep to refinancing the safer past and present. As an example banks finance much more “safe” basements where jobless kids can stay with their parents, than the SMEs that could create the jobs that could allow the kids afford to also become parents. In short this regulation keeps Keynes' animal spirits caged.

Stimulus waste: Since credit will not flow were they could most be needed, much of the stimuli fiscal deficits, quantitative easing and low interest could produce, is wasted.

More inequality: The result of making it harder and more expensive for the “risky” weaker to access opportunities of bank credit for productive purposes.

Too Big Too Fail: Clearly minimalistic capital requirements, for so many assets, has served as a potent growth hormone for the TBTF banks.

Over indebtedness: By allowing ridiculously low capital requirements for assets perceived as safe, the regulators allowed banks to leverage too much their equity and the support they received from society (taxpayers). That facilitated the current generation to extract more borrowing capacity to sustain its own consumption than any other previous generation. That has left little borrowing capacity over for the future generations.

What to do?

To accept the problem exists!

To know neither Hollywood nor Bollywood, would allow new movies on the same theme to be produced by directors and scriptwriters responsible for such box-office flops as Basel I-II-III.

To understand that bank capital requirements would be better if based on ex-post risks of models based on ex-ante risk perceptions.

To know that if you absolutely must distort, it is better to do so based on some useful social purpose, like based on job-creation and environmental-sustainability ratings.

To understand that getting our banks and our economies out of the Basel mess is a very delicate process, which does not permit an ounce more of that technocrats’ hubris that caused it all.

IMF, will you keep on being silent on this?

Per Kurowski

PS. Here is an updated list of the many mistakes with risk weighing.

Banking before and after 1988

For about 600 years, before 1988, the exposures of banks to assets were a function of the by bankers ex-ante perceived risks (bpr), the risk premiums (rp), and bankers’ risk tolerance (brt) 

Pre 1988 Bank exposures = f (bpr, rp, brt)

Bank capital (equity) followed the rule of "One for all and all for one".

After 1998, Basel Accord, soon 30 years, with the introduction of the risk weighed capital requirements, the exposures of banks to assets are a function of the by bankers ex-ante perceived risks (bpr), the risk premiums (rp), bankers’ risk tolerance (brt), and regulatory capital requirements (rcc), this last itself a function of the by regulators ex-ante perceived (or decreed) risks (rpr) and the regulators' risk tolerance (rrt)

After 1988 Bank exposures = f (bpr, rp, brt, rcc=f (rpr, rrt))

Anyone thinking banking remained the same after 1988 is either naïve or dumb.

Anyone thinking the allocation of bank credit to the real economy was not distorted by this, is dumb.

Anyone thinking that distorting bank credit to the real economy is not something very risky, is either ignorant or a populist technocrat suffering from excessive hubris.

Anyone thinking that distorting bank exposures this way make banks safer, is an ignoramus who has no idea about what bank crises are made of: namely unexpected events, criminal doings and what was ex ante perceived as very safe but that ex post turned out very risky.

Anyone thinking this does not promote inequality has no idea of what the opportunity to bank credit does to fight it 

PS. With respect to the perceived risks, both the bankers’ and the regulators, let me remind you that any risk, even if perfectly perceived, causes the wrong actions if excessively considered; something here done by design.

Since bank regulators in 1988 decreed sovereign debt to be risk free, the market has not set the risk-free rates

In the discussion by Lawrence Summers and Adair Turner on secular stagnation in the Institute of New Economic Thinking INET, on October 28, I extract the following:

15:25 Lord Adair Turner

“The longer we have the slow growth and sub-target inflation, the more you have to think that there is something secular is at work. And the thing that makes me pretty sure that Larry is right in his hypothesis that something secular is at work, is to look at the 30, not the 10 year trend, but the 30 year trend, in real risk-free interest rates. 

Take UK’s 10 year yields on real index linked gilts. 

Take an average for each five year period, from 86-90, 91 to 95 and so six of those 5 year periods until the last

And the sequence is 3.8%; 3.6; 2.5%; 1.9%; 1.2%; minus 0.6%, and the value is now minus 1.5%. 

When you see a trend like that you begin to think that there may be something secular, petty strong, about that; with a dramatic fall even before the 2008 crisis, so you can’t put all this down to central bank intervention, quantitative easing.

So we seem to have entered a world where savings and investments only balance at very low or negative real interest rates. And of course those very low interests rates themselves, played a role in stimulating the excessive private credit growth which landed us with the debt overhang. 

But despite this those low interest we have low growth and below target inflation, and so it is vital we try work why is this… 

17:58 Well logically, the long term decline in real interest rates must mean that we have faced over the last 30 year either:

an increase in the ex ante desired aggregate global saving rate 

or a decline in the ex ante desired or intended global investment rate 

or a mix of both.”

Lord Adair Turner, the former chairman of the Financial Service Authority, FSA (2008-2013), and therefore supposedly a technocrat well versed in bank regulations, had not a word to say about: 

That extraordinary moment when, after about 600 years of “one for all and all for one” capital in banking, in 1988, with the Basel Accord, Basel I, regulators introduced risk weighted capital requirements for banks and, to that purpose, set the risk weight for the sovereign at 0%, while the risk weight for We the People was set at 100%.

That of course signified an extraordinary regulatory subsidy of sovereign debt, that had to set the UK’s 10 year yields on real index linked gilts, on a negative path.

From that moment on, since the regulators had decreed sovereign debt to be risk free, we can no longer really hold the market, using public debt as a proxy, can provide a reliable risk free rate estimate.

For now those artificially decreed risk-free rates can only go down and down and down… until BOOM!

The low “real” public debt interests might be the highest real rates ever, in that these regulations also make banks finance less the riskier, like SMEs and entrepreneurs, those who could provide us with our future incomes, and therefore governments with its future tax revenues.

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

Regulatory risk-weights: The sovereign = Zero percent and We the (risky) People = 100%. In America?

I am not an American, and I am not well versed on its Constitution, and there is one issue which has for a long time been a mystery to me. 

How on earth could America, in 1988, as a signatory of the Basel Accord, accept that for the purpose of setting capital requirements for banks, the risk-weight for the sovereign, meaning the government, was going to be zero percent, while the risk-weight for the citizen, meaning We The People was set at 100%; and all without a major discussion?

I know that “sovereigns” currently means the government but, from reading for instance Randy E. Barnett’s “Our Republican Constitution”, one could have expected some debate about something that is akin to risk weighing the King with an "infallible" 0%, and his subservients with a "risky" 100%.

Barnett's book states that Justice James Wilson, in the Chisholm v. Georgia case of 1793, opined that “To the Constitution of the United States the term Sovereign is totally unknown…and if the term sovereign is to be used at all, it should refer to the individual people”. And the book also frequently refers to the importance of the required consent of the people, which of course is also a thorny issue. 

And, since those risk-weights effectively permit banks to leverage their equity much more when lending to the sovereign, than when lending to the citizen; banks will earn higher risk adjusted returns when lending to the sovereign than when lending to the citizens; and so banks will de facto, sooner or later, lend much too much to the sovereign and much too little to the citizens… and I can simply not fathom how citizens, be they individual or majority, could give their consent to something like that.

De-facto those risk weights signify that regulators believe that government bureaucrats can make better use of bank credit than citizens… it is statism running amok.

But it became even worse. In 2004, in Basel II, regulators also made a distinction between those private who had great credit ratings, like AAA to AA, and who received a 20% risk-weight, and for instance those who had no ratings, and who kept their 100% risk weight. That to creates a sort of AAA-risktocracy that does not square well with the Constitution’s “No Title of Nobility shall be granted by the United States.

But even without entering into constitutional issues, there is even a current law that seems to prohibit this type of discrimination, but that is not applied to bank regulations. And I refer to the Equal Credit Opportunity Act: “Regulation B”.

So in the land in which its Declaration of Independence states: “We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness.”, I just must ask: How could regulators dare to decree such regulatory inequality?

And to top it up, the current risk-weighted capital requirements for banks, more ex ante perceived risk more capital – less risk less capital, are arbitrary and irrational. And that because no major bank crises have ever result from the build up of excessive dangerous bank exposures to something perceived as risky, that has always happened with something, erroneously, perceived as very safe. If you want to understand how really crazy these bank regulations are, here is a brief memo.

And frankly what would a Governor answer to this question: Why can our banks leverage their equity lending more to a foreign sovereign or a foreigner with a high credit rating, than when lending to us, the local SMEs and entrepreneurs?

No! America would never have become what it is, had it had this type of risk averse discriminatory bank regulations before.

And by the way the Dodd Frank Act, in all its 848 pages, surrealistically, does not mention the Basel Committee nor the Basel Accord, not even once.

PS. In his book Professor Barnett defends Federalism from the perspective of making diversity more possible. That rhymes well with what I stated at the World Bank as an Executive Director 2002-04: "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”

The Basel Committee used expected credit losses as a direct proxy for all the unexpected. Loony eh?

Steven Solomon in “The confidence game” Simon and Schuster 1995 writes about “who the central bankers are, how they have shaped the course of economic and political events in the past fifteen years, why their influence relative to elected political leaders has reached a historical zenith, and how it reveals one of the greatest pressing dangers facing free democracy.

And beginning Solomon quotes The Testament of Beauty by Robert Bridges with:

Our stability is but balance, and conduct lies

In masterfully administration of the unforeseen

And later Solomon writes: “On September 2, 1986, the fine cutlery was laid once again at the Bank of England governor’s official residence at New Change… The occasion was an impromptu visit from Paul Volcker… When the Fed chairman sat down with Governor Robin Leigh-Pemberton and three senior BoE officials, the topic he raised was bank capital…

At dinner the governor’s hopes had been modest: to find areas of sufficient convergence of goals and regulatory concepts to achieve separate but parallel upgrading moves… 

Yet the momentum it galvanized… produced an unanticipated breakthrough of a fully articulated, common bank capital adequacy regime for the United States and United Kingdom. This in turn catalyzed one of the 1980’s most remarkable achievements – the first worldwide protocol on the definitions, framework, and minimum standards for the capital adequacy of international active banks…

They literally wiped the blackboard clean, then explored designing a new risk-weighted capital adequacy for both countries… 

It included… a five-category framework of risk-weighted assets… It required banks to hold the full capital standard against against the highest-risk loans, half the standard for the second riskiest category, a quarter for the middle category, and so on to zero capital for assets, such as government securities, without meaningful risk of credit default.”

And which, in other words, means that these regulators determined the capital bank needs to hold to cover for unexpected losses, was to be a direct function of the ex ante perceived risk of expected credit losses. The expected substituting for the unexpected... loony eh!

Since the expected is already considered by bankers when setting the interest rates and the size of exposures, having it to also stand in for the unexpected in the capital, meant the expected got to be excessively considered. And any risk, even if perfectly perceived, causes the wrong actions, if excessively considered. What did we do to deserve such credit risk adverse fools?

September 2, 1986 was fatal for Western World’s economies. Its banks would be told not to finance the riskier future.

In Charles Goodhart’s “The Basel Committee on Banking Supervision: A History of the early years 1974-1997” 2012, Cambridge Press Goodman (p.167) refers to Steven Solomon’s The Confidence Game (1995), and we read:

On September 2, 1986, the fine cutlery was laid once again at the Bank of England governor’s official residence at New Change… The occasion was an impromptu visit from Paul Volcker… When the Fed chairman sat down with Governor Robin Leigh-Pemberton and three senior BoE officials, the topic he raised was bank capital…

At dinner the governor’s hopes had been modest: to find areas of sufficient convergence of goals and regulatory concepts to achieve separate but parallel upgrading moves… 

Yet the momentum it galvanized… produced an unanticipated breakthrough of a fully articulated, common bank capital adequacy regime for the United States and United Kingdom. This in turn catalyzed one of the 1980’s most remarkable achievements – the first worldwide protocol on the definitions, framework, and minimum standards for the capital adequacy of international active banks…

They literally wiped the blackboard clean, then explored designing a new risk-weighted capital adequacy for both countries… 

It included… a five-category framework of risk-weighted assets… It required banks to hold the full capital standard against against the highest-risk loans, half the standard for the second riskiest category, a quarter for the middle category, and so on to zero capital for assets, such as government securities, without meaningful risk of credit default.”

And that, as far as I am concerned, could be the opening scene for a Mission Impossible or Bond movie, describing the actions of terrorists wanting to destroy the world’s economies. 

Of course it was just dumb arrogant technocrats going abour their business of solely thinking about how banks could avoid failure, without giving even the slightest consideration to the possibility that when doing so they could dangerously distort the allocation of bank credit to the real economy.

The buckets with riskweights of 100%, 50% 25% 0%, and if the capital standard was set to 8 percent meant that a bank would be able to leverage its equity, and the implicit support of society, 12.5, 25, 50 and ∞ times to one respectively with the assets in each bucket.

That meant banks would earn higher risk adjusted returns on equity on assets in those buckets they could leverage more. And that meant that the net of risk margins offered by The Risky to the banks were worth less than the same margins offered by The Safe.

And what was also clear to these “statist conspirators”, was that the risk weight for the private sector would be 100% while that of their governments would be zero.

All in all that night the diners decided the Western World had had enough of risktaking and so the banks should stop giving credit to the riskier future and concentrate on refinancing the safer past.

You might argue that regulators did not force banks to do anything, but that would be to ignore that out there in the real world any bank that earns less risk adjusted returns on equity than other banks will, sooner or later, be eaten up.

And the baby conceived that night was born 21 months later in November 1988 and named the Basel Accord or Basel I. And that baby grew up to be a real monster in 2004, when it turned into Basel II.

And because of this financial terrorism act, millions of small loans to SMEs and entreprenuers that would otherwise have been awarded have now been denied. 

And with that the possibility of creating the new jobs that could substitute for the disappearing ones were greatly diminished.

And by so denying those in lack of capital the opportunities to access bank credit, inequality got a strong boost.

And, ridicously, all for nothing, since major bank crises never ever result from excessive exposures to what is ex ante perceived as risky.

Looking to level the playing field for banks to compete, regulators unleveled real economies’ access to bank credit

I refer to Charles Goodhart’s “The Basel Committee on BankingSupervision: A History of the early years 1974-1997” 2012, Cambridge Press.

Goodhart frequently mentions the importance given by bank regulators “towards preserving and, where necessary, enhancing national prudential standards and towards removing competitive inequalities arising from different regulatory requirements” (p.175)

But since the need for an efficient allocation of bank credit to the real economy was never in any way shape or form on the regulators’ agenda, while doing so they came up with risk weighted capital requirements for banks; which guaranteed unleveling the playing-field for all bank borrowers, by favoring the “safe” in detriment of the “risky”.

Goodman (p.195) writes “the risk weights to be applied to the various groups of assets were ad-hoc and broad-brush, based on subjective (and political judgement), not on any empirical studies. Their application soon led to serious distortions in bank bank asset portfolios that undermined Basel I. There was little or no discussion at the time about the impact that the Accord might or should have on bank behavior. The need was just to achieve the two desiderata: higher capital ratios and a level playing field” (p.195) 

And since the need for an efficient allocation of bank credit to the real economy was never, in any way shape or form part of the regulators’ agenda, they came up with risk weighted capital requirements for banks; which guaranteed and unlevel-playing-field for all bank borrowers, by favoring the “safe” in detriment of the “risky”. And with respect to the health and growth of the real economy, that was as imprudent as imprudent can be.

Goodman opines “any simple approach would tend to put into common groupings (or ‘buckets’) assets/liabilities that were in many respects dissimilar, thereby leading to anomalies, distortions and ‘gaming’” (p.158). I do not agree. It was the existence of different buckets, which received different capital requirements treatments, that led to distortions and gaming. Any assets might have arrived to a specific bucket by means of gaming, but once in that bucket, within that bucket, there were no further distortions as the risk weights were all the same.

In an undisturbed real economy, there is only one bucket, in which all have to live and fight for survival.