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

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

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

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

My 2019 letter to the Financial Stability Board

My 2019 letter to the IMF

My current memo on the mistakes of the risk weighted bank capital requirements

I am not new to this

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

A tweet to: @IMFNews, @WorldBank, @BIS_org @federalreserve, @ecb @bankofengland @riksbanken @bankofcanada

"Should you allow the Basel Committee to keep on regulating banks as it seems fit, or should you not at least listen to other proposals?

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

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

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

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

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

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

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

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


PS. My letter to the Financial Stability Board
PS. A continuously growing list of the risk weighted bank capital requirements mistakes

PS. Risk-weights are to access to credit what protectionist tariffs are to trade, only more pernicious.

PS. I am no newcomer to this issue

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.

Since they believe it to be safer, regulators want banks to finance house purchases much more than job creating entrepreneurs. Doesn’t anyone of them have grandchildren?

Let us suppose that in a world without risk weighted capital requirements, like the world of banking was for around 600 years before 1988’s Basel Accord, a world with one single capital requirement against all bank assets, for instance 8%.

Let us also suppose that in that world banks would view residential mortgages at 5% interest rate to be, when adjusted to perceived credit risks, equivalent to 9% interest rate on loans to entrepreneurs, and that, for both these assets, their expected risk adjusted net margin was 1%.

In that case, since banks could leverage 12.5 times their equity (100/8) the expected risk adjusted return on equity, on both these assets, would be 12.5%

How many residential mortgages and how many loans to entrepreneurs were given in such a world? I have no idea but adjusted for their perceived credit risk, it was clear both house buyers and entrepreneurs competed equally for credit. 

But then came the Basel Committee with its risk weighted bank capital requirements, and for instance in its 2004 Basel II, assigned a risk weight of 35% to residential mortgages and 100% for loans to unrated entrepreneurs. 

That, for Basel’s basic capital requirement of 8%, meant banks needed to hold 2.8% in capital against residential mortgages and 8% against loans to entrepreneurs.

This in turn meant banks could in the case of loans to entrepreneurs still leverage 12.5 times but now, with residential mortgages, they could leverage almost 36 times (100/2.8). 

And in this case, with the same as expected risk adjusted margin of 1%, banks could still earn12.5% in expected risk adjusted return on equity, but residential mortgages now offered them the possibility of earning a whooping 36% in expected risk adjusted return on equity.

Clearly house buyers were much favored since banker would offer residential mortgages much more and even contemplate some interest rate reductions, while the entrepreneurs had their access to credit much curtailed that is unless they offered to pay higher interest rates.

So what does all this result in? Houses morphing from affordable home into being risky investment assets, while at the same time much less of those job opportunities that entrepreneurs might have helped to create for us and our descendants.

Thinking of our grandchildren’s future is this kind of bank regulations acceptable? Absolutely not! “A ship in harbor is safe, but that is not what ships are for.” John A. Shedd.

PS. Much worse statist regulators assigned 0% risk weights on loans to the sovereign, which de facto implied government bureaucrats to use credit for which they are not personally responsible for much better, than for instance entrepreneurs.

PS. Here's a probably still not finished list of the mistakes with the risk weighted bank capital requirements 

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

Tombstones

Here rests a bank regulator who all his life believed that what bankers perceived as risky was more dangerous to our bank systems than what bankers perceived as safe. 

May his soul rest in peace.

Here rests a bank regulator who based the risk weighted bank capital requirements on bankers perceiving risk correctly, and not on that they could be wrong.

May his soul rest in peace.

Here rests a regulator who missed his lectures on conditional probabilities, and therefore did not set the risk weighted capital requirements conditioned on how bankers respond to perceived credit risks.

May his soul rest in peace.

Here rests a regulator who even though bankers respond to perceived credit risks, with size of exposures and risk adjusted interest rates, also wanted bank capital to double up on that same perceived risk

May his soul rest in peace.

Here rests a bank regulator who never understood the systemic risks he introduced into banking, by for instance assigning so much power to credit rating agencies, or his stress-tests of the stresses a la mode.

May his soul rest in peace.

Here rests a bank regulator who for the risk weighted bank capital requirements agreed with risk weights of 20% for dangerous AAA rated and 150% for innocous below BB- rated

May his soul rest in peace.

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

Here rests a bank regulator who caused banks to dangerously overpopulate safe harbors, and sent other investors and small time savers out on the risky oceans. 

May his soul rest in peace.

Here rests a bank regulator who by favoring banks to finance the "safer" present and to stay away from the "riskier" future, blocked millions of entrepreneurs' access to bank credit and with it risk-taking… the oxygen of all development

May his soul rest in peace.

Here rests a statist bank regulator who believed a government bureaucrat knows better (Risk Weight 0%) what to do with credit he’s not personally responsible for, than an entrepreneur or SME (RW 100%)

May his soul rest in peace.

Here rests a bank regulator who for risk weighted bank capital requirements agreed with a low 35% risk weight to residential mortgages, which caused houses to morph from affordable homes to risky investment assets.

May his soul rest in peace.

Here rests a bank regulator with a Ph.D. who proved right Daniel Patrick Moynihan, who supposedly held “There are some mistakes only Ph.Ds. can make.

May his soul rest in peace.

Here lies a central banker who injected huge amounts of liquidity without understanding how risk weighted bank capital requirements distorted the allocation of credit

May his soul rest in peace.

Here lies a financial journalist who scared stiff he would never be invited to important conferences, never questioned the risk weighted bank capital requirements. 

May his soul rest in peace.

Here lies an ordinary citizen who wanting so much to believe it true, swallowed lock stock and barrel the regulatory technocrats' populism imbedded in the risk weighted bank capital requirements

May his soul rest in peace.

Here rests a regulator who helped guarantee especially large bank crises, caused by especially large exposures to what’s perceived especially safe and might not be, and is held against especially little capital

May his soul rest...

Here rests a regulator who assisted by his central bank colleagues, helped set horrible Minsky moments on steroids
May his soul rest...

PS. A summary of The Basel Committee for Banking Supervision's mistakes

My tweets on “How the Basel Committee doomed our bank systems and our economies”

The Basel Committee doomed our bank systems and our economies.

For around 600 years risk adverse bankers had, not always successfully, tried to do their best to clear for perceived credit risks, by means of risk adjusted interest rates and the size of bank exposures. 

When what bankers had perceived as risky turned out to be even more risky, since the exposures were generally quite small, it hurt but banks could manage. 

When what bankers perceived as safe turned out to be risky, since the exposures were then very large, big crises often ensued. 

But then, starting in 1988 with Basel I, and really exploding in 2004 with Basel II, risk adverse regulators decided they also wanted to clear for those same perceived credit risks, and to that effect introduced risk weighted bank capital requirements.

In the softest words I can muster, that was extremely dumb. As bank supervisors they should be almost exclusively concerned with bankers not perceiving the credit risks correctly. Instead they bet our bank systems on that bankers would perceive credit risks correctly.

Banks everywhere were then taken out of the hands of savvy loan officers, and placed in the hands of creative equity minimizing financial engineers, who then ably marketed the nonsense that more bank capital hindered bank lending and was therefore bad for the real economy 

The 2008 crisis caused by AAA rated securities backed with mortgages to the US subprime sector, with which European banks and US investment banks were allowed to leverage 62.5 times with these, should have loudly reminded them about the dangers of the “safe”. 

But regulators refused to admit their mistake and kept risk weighting in Basel III.

The result is an ever increasing dangerous overcrowding of “safe harbors” and the abandonment of the “riskier oceans.

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

And those who used to populated safe harbors, like insurance companies, pension funds, personal saving accounts and other, have been expelled to the risky oceans, confronting loans to leveraged corporates, emerging markets and others for which they're less prepared than bankers

To sum it up, risk-weighted bank capital requirements guarantees especially large crises, resulting from especially large exposures to what’s perceived especially safe, and is held against especially little capital. 

Let’s get rid of these regulators… now!

http://perkurowski.blogspot.com/2016/04/here-are-17-reasons-for-why-i-believe.html

And not only are they dangerously bad regulators… by decreeing risk weights of 0% for the sovereign and 100% for the citizens, they also evidence being dangerous statist/communist regulators.

http://perkurowski.blogspot.com/2019/09/financial-communism.html

PS. My 2019 letter to the Financial Stability Board

PS. My 2019 letter to the IMF

J’Accuse[d] the Basel Committee for Banking Supervision (BCBS) a thousands times, but I am no Émile Zola and there’s no L’Aurore

J’Accuse the Basel Committee of setting up our bank systems to especially large crises, caused by especially large exposures to something perceived as especially safe, which later turns into being especially risky, while held against especially little capital.

My letter to the Financial Stability Board

J’Accuse the Basel Committee for distorting the allocation of bank credit to the real economy by favoring the sovereign and the safer present, AAA rated and residential mortgages, while discriminating against the riskier future, SMEs and entrepreneurs.

My letter to the International Monetary Fund

A question to the Fed: When in 1988 bank regulators assigned America’s public debt a 0.00% risk weight, its debt was about $2.6 trillion, now it is around $22 trillion and still has a 0.00% risk weight. When do you think it should increase to 0.01%?

Clearing for perceived risk vs. discriminating based on perceived risk.

If making good down payments house buyers normally had more and cheaper access to bank credit than an entrepreneurs wanting loan for risky ventures.

But when regulators, with their risk weighted bank capital requirements decreed that banks needed to hold less capital against residential mortgages than against unsecured loans to entrepreneurs; which meant that banks could leverage much more their equity with residential mortgages than with unsecured loans to entrepreneurs; which meant that with the same risk adjusted interest than before banks could earn higher risk adjusted returns on equity with residential mortgages than with unsecured loans to entrepreneurs, the regulators de facto discriminated the access to bank credit in favor of house buyers and against entrepreneurs.

So there’s a world of difference between banks clearing for perceived credit risk and the regulators discriminating the access to bank credit based on perceived credit risk.

With their discrimination regulators decreed inequality

With their 0% risk weighted sovereign and 100% risk weighted citizens regulators decreed that the sovereign has more rights to more and cheaper access to bank credit than citizens.

And, at the end of the day it's all for nothing. That discrimination only sets up our banks to especially large bank crises, caused by especially large exposures to something ex ante perceived, decreed or concocted as especially safe, and which ex post turns into being especially risky, while being held against especially little capital.

A letter to the Financial Stability Board

A letter to the IMF titled: "The risk weights are to access to credit, what tariffs are to trade, only more pernicious."

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

Why are regulators allowed to introduce odious and dangerous discrimination in the access to bank credit?

Banks used to apportion their credit between those perceived as risky, and those perceived as safe, based on (1) the risk adjusted interest rates and (2) their own portfolio considerations.

But that was before the Basel Committee for Banking Supervision’s credit risk weighted capital requirements.

Now banks apportion credit between those perceived as risky and those perceived as safe, based on (1) the risk-adjusted interest rates (2) the times their bank equity can be leveraged with those risk-adjusted interest rates and (3) hopefully, since those risk weighted capital requirements are explicitly portfolio invariant, their own portfolio considerations.

That means the risk adjusted interest rates “the safe” now can offer in order to access bank credit have been lowered, while the risk adjusted interest rates “the risky” have to offer in order to access bank credit have been increased.

That has leveraged whatever natural discrimination in access to bank credit there was against the “riskier” in favor of the “safer”.

That dangerously distorts the access to bank credit in favor of the “safer” present, like sovereigns, house purchases and the AAA rated and against the “riskier” future, like entrepreneurs; which means that our banks have no other social purpose to fulfill than being safe mattresses into which stash away our savings.

And all so useless because the only thing these regulations guarantee, 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. 

My comments to the Financial Stability Board

De riskvägda bankkapitalkraven borde åtminstone ha baserats på betingade sannolikheter. Det var de/är de inte.

Här några tweets om P (A / B)

I sannolikhetsteori är betingat sannolikhet sannolikheten för att en händelse (A) inträffar (som att banker lånar för mycket till någon säker), med tanke på att en annan händelse (B) har inträffat (att bankirerna hade uppfattat denne någon som mycket säker).

I sannolikhetsteori är betingat sannolikhet sannolikheten för att en händelse (A) inträffar (som att  banker lånar för mycket till någon riskabel), med tanke på att en annan händelse (B) har inträffat (att bankirerna hade uppfattat denne någon som mycket riskabel).

Ingen tillsynsmyndighet som vet något om betingad sannolikhet skulle aldrig ha tilldelat, med tanke på riskvägda bankkapitalkrav, en låg riskvikt på bara 20% till de bedömda som mycket säkra AAA, och en hög 150% till de bedömda som mycket riskabla lägre än BB-

PS. En fråga till Herr Stefan Yngves 2015

PS. Mitt brev till Financial Stability Board

My letter to the Financial Stability Board was received.

http://www.fsb.org/wp-content/uploads/Per-Kurowski.pdf

From: Per Kurowski

Sent: 18 March 2019 19:16

To: Financial Stability Board (FSB)

Subject: SME financing evaluation

I have not found sufficient strength to sit down and formally write up my comments, because I feel I would just be like a heliocentric Galileo writing to a geocentric Inquisition.

The Basel Committee’s standardized risk weights are based on the presumption that what is ex ante perceived as risky is more dangerous to our bank system.

And I hold a totally contrarian opinion. I believe that what is perceived a safe when placed on banks balance sheets to be much more dangerous to our bank system ex post than what is perceived ex ante as risky; and this especially so if those “safe” assets go hand in hand with lower capital requirements, meaning higher leverages, meaning higher risk adjusted returns on equity for what is perceived safe than for what is perceived as risky.

The following Basel II risk weights are signs of total lunacy or an absolute lack of understanding of the concept of conditional probabilities.

AAA to AA rated = 20%; allowed leverage 62.5 times to 1. Below BB- rated = 150%; allowed leverage 8.3 times to 1

The distortion the risk weighting creates in the allocation of credit to the real economy is mindboggling. Just consider the following tail risks.

The best, that which perceived as very risky turning out to be very safe. The worst, that which perceived as very safe turning out to be very risky.

And so the risk weighted capital requirements kills the best and puts the worst on steroids... dooming us to suffer an weakened economy as well as an especially severe bank crisis, resulting from especially large exposures, to what was especially perceived as safe, against especially little capital.

In relative terms all that results in much more and less (see note) expensive credit to for instance sovereigns and the purchase of houses, and less and more expensive credit to SMEs

I am neither a banker nor a regulator but I do believe that the following post helps to give some credibility to my opinions on the issue. And, as a grandfather, I am certainly a stakeholder.

http://subprimeregulations.blogspot.com/2004/11/some-of-my-early-public-opinions- on.html

And here is a more detailed list of my objections to the risk weighting

http://perkurowski.blogspot.com/2016/04/here-are-17-reasons-for-why-i-believe.html

Now if by any chance you would dare open your eyes to the mistakes of your risk weighted bank capital requirements and want more details from me, you know where to find me.

Sincerely

Per Kurowski

A former Executive Director of the World Bank (2002-2004) 

@PerKurowski

Note: In the original letter I erroneously wrote "more and more expensive credit to sovereigns" and not "less expensive", but this should be easily understood as a mistake.

PS. FSB keeps avoiding the issue: June 7, 2019 FSB published a Consultative Document: “Evaluation of the effects of financial regulatory reforms on small and medium-sized enterprise (SME) financing” I quote two parts of it.

1. “For the reforms that are within the scope of this evaluation, post-crisis financial regulatory reforms, the analysis, does not identify negative effects on SME financing in general.” 

Comment: The scope of the analysis does explicitly not include pre-crisis financial regulatory reform, like Basel II. When compared to what was introduced in Basel II, the changes in Basel III produced not really that much “more stringent risk-based capital requirements”. Therefore to limit the analysis to the impact of Basel III changes to risk-based capital requirements, is basically to avoid the issue of how these have, especially since Basel II, profoundly distorted the allocation of credit, and negatively affected the financing of SMEs.

2. “There is some evidence that the more stringent risk-based capital requirements under Basel III slowed the pace and in some jurisdictions tightened the conditions of SME lending at those banks that were least capitalised ex ante relative to other banks.”

Comment: That the Basel III risk-based changes, which in my opinion are minor relative to their importance, “tightened the conditions of SME lending at those banks that were least capitalised ex ante relative to other banks” is something to be expected. There, close to the roof, on the margin, is where the risk weighting most affects; think of “The drowning pool”

PS. A letter to the IMF: "The risk weights in the risk weighted bank capital requirements are to access to credit, what tariffs are to trade, only more pernicious.

PS. From what I see my comments were totally ignored

The “experts” in the independent agencies, those most likely to introduce systemic risks, must be continuously questioned and supervised.

Paul Tucker for more than 30 years a central banker and a regulator at the Bank of England writes in his "Unelected Power" 2018

“Unlike price stability, the authorities cannot ‘produce’ financial stability by their own efforts but must stop or deter private intermediaries from eroding the system’s resilience.

That cannot be delivered by looking at intermediaries one by one because the financial system is just that - a system, with components parts connected within sectors and markets, via interactions with the real economy, and across countries. 

As the first chairman of the Basel Supervision Committee, George Blunden said in the mid-1980s: It is part of the [supervisors] job to take a wider systemic view and sometimes to curb practices which even prudent banks might, if left to themselves, regard as safe.”

And yet with Basel I in 1988, Basel II in 2004 and current Basel III the regulators in the Basel Committee, ignoring the system, ignoring the distortions it causes in the allocation of credit to the real economy and ignoring that no major bank crisis have resulted from excessive exposures to what ex ante was perceive as risky, went ahead and introduced that mother of all systemic risk and procyclical regulation, which is the risk weighted capital requirements for banks.

“Curb practices which even prudent banks might, if left to themselves, regard as safe”? No way, it only guarantees especially large exposures, to what is especially perceived as safe, against especially little capital, laying the ground for especially large crisis.

I did note that in the 568 pages of “Unelected Power” I found no explicit reference to the risk weighted capital requirements for banks.

At the end of his book Paul Tucker suggests “The principles for delegating to independent agencies insulated from day to day politics”. I agree with these. Had they been in place Basel I II or III would not have existed. Just for a starter, in all of Basel’s bank regulations there is not one single word about the purpose of the banking system, one that must surely contain the need to allocate credit efficiently to the real economy.

There is one aspect though that is not sufficiently laid out in Tucker’s principles and that is the absolute must for the independent agency to contain sufficient diversity, not only to foster better discussion but also in order to hinder, as much as possible, these turning into closed mutual admiration clubs.

PS. In the 568 pages of “Unelected Power” I found no explicit reference to the risk weighted capital requirements for banks, those which for a start caused the 2008 crisis. 

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

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

September 2, 1986 was the tragic night when Paul A. Volcker, in London, gave in to (insane) European bank regulators.

Paul A. Volcker in his autography “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."

September 2? From here


I ask: Insane? I answer: Absolutely! 

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.

Here a list of the many mistakes with the risk weighted bank capital requirements

To top it up 1988's Basel I assigned the sovereigns a 0% risk weight and citizens 100%, as if bureaucrats know better what to do with credit for which repayment they're not personally responsible for than entrepreneurs. 

If only I could tweet like Stephen Colbert perhaps I could be more effective warning about dangerously faulty bank regulations.

I saw a tweet from Stephen Colbert @StephenatHome where there was a photo of Melania Trump that I thought was caressing a baby elephant. (Later I found out the baby elephant had given her a push) 

The photo included the comment “I can’t wait for my stepsons to murder you”. 

I might be somewhat old fashioned and I did not like it. It was also obviously a comment that expressed much more Colbert's concern with the White House than his concerns about the destiny of the elephants… and those who follow me know how much I abhor any polarization profiteering.

I tweeted. “That comment reflects worse on you Colbert as it shows a lot of lack of taste.”

I am glad I went to bed shortly thereafter, as otherwise I would have been kept out all night, weathering a storm of hundred of tweets, about 2/3 of these angry at me.

Oh, if only I could receive a fraction of that attention to the following tweet.

“The current credit risk weighted capital requirements guarantee especially large exposures, to what’s perceived as especially safe, against especially little capital, which dooms our bank systems to especially severe crises.”

http://subprimeregulations.blogspot.com/2018/08/risk-weighted-capital-requirements-for.html

Perhaps I should ask Colbert to pardon my comment, and help me produce an attention grabbing tweet… something in line with “I cant’ wait for those in the Basel Committee turning our bank system into cosmic dust."

But then again who is the Basel Committee for Banking Supervision, that unelected committee that so dangerously distorts the allocation of bank credit around the world. Their members have so much less name recognition than any of Mrs. Trump’s stepsons.

Do you have any other tweet  suggestion for me?

Had there been a Basel Committee on Tennis Supervision, Roger Federer would be history by now.

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 to have one serve and at least be allowed a to uses 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.

PS. Here is somewhat more extensive aide memoire on the mistakes in the risk weighted capital requirements for banks.

If the Basel Committee had only been asked these four simple questions about its risk weighted capital requirements for banks?

1. What? Do you really know what the real risks for banks are? If you do, why are you not bankers?

2. What? Don’t you see that allowing banks to leverage differently with different assets will lead to a new not market set of risk adjusted returns on equity. Are you not at all concerned this could dangerously distort the allocation of credit to the real economy?

3. What? Do you think that what’s perceived risky by bankers that which they adjust by means of lower exposures and higher risk premiums, is more dangerous to the bank system than what they perceive as safe?

4. What? A 0% risk weight of sovereigns? That could only be explained by their capacity to print currency in order to get out of debt. But is that not also one of their worst possible misbehaviors?

How much sufferings and how many unrealized dreams would not have been avoided?

And now, 30 years after that faulty regulation was introduced with the Basel Accord in 1988, these questions are still waiting for an answer.

PS. Here a list of some of the horrendous mistakes of the risk weighted capital requirements

Charles Goodhart also pointed out the stupidity of risk weighted capital requirements for banks based on ex ante perceived risks… also with no luck!

In the very last page (540) of Charles Goodhart’s “The Basel Committee on Banking Supervision: A history of the Early Years, 1947-1997” of 2011 we read the following:

“Capital is supposed to be a buffer against unexpected loss: In so far as capital is required against unexpected loss, since expected loss should be handled by appropriate interest margins, the use of credit ratings as a guide to risk weights for capital adequacy requirements (CARs) is wrong and inconsistent, since these give a measure of expected loss. What is needed instead is a measure of the uncertainty of such losses, the second moment rather than the first.

If capital risk weights had been based, as they should logically have been, on the uncertainty attending future losses, rather than their expected modal performance, the financial system might have avoided much of the worst disasters of the 2007/08 financial crisis.

It remains surprisingly difficult to persuade regulators of this simple point.”

But to that Goodhart adds “It does however, get recognized from time to time”… though the examples he then indicates, are not so clear.

In the Epilogue (page 581) Goodhart list some of the failings of the BCBS’s regulations:

1. The lack of any theoretical basis.

2. The focus on the individual institution, rather that the system

3. The failure to reach an accord on liquidity;

4. The lack of empirical analysis;

5. The unwillingness to discuss either sanctions or crisis resolution, and so on.

That clearly adds up to a total regulatory failure... no wonder they don't want to discuss sanctions. 

But, unfortunately as I see it, Charles Goodhart, though absolutely right, is only scratching the surface. What is most dangerously ignored are the distortions in the allocation of bank credit to the real economy that these risk weighted capital requirements for banks cause.

Here is my own, also ignored, current brief aide memoire on the major mistakes with the risk weighted capital requirements