Basel I, II, and III are all examples of pure unabridged regulatory statism

In July 1988 the G10 approved the Basel Accord. For its risk weighted bank capital requirements it assigned the following risk weights:

0% to claims on central governments and central banks denominated in national currency and funded in that currency. 

100% to claims on the private sector.

That means banks can leverage much more whatever net margin a sovereign borrower offers than what it can leverage loans like to entrepreneurs. That means banks will find it easier to earn high risk adjusted returns on their equity lending to the sovereign than for instance when lending to entrepreneurs. That means it will lend too much at too low rates to the sovereign and too little at too high rates to entrepreneurs.

In other words Basel I introduced pure and unabridged statism into our bank regulations. 

Basel II of June 2004 in its Standardized Risk Weight, for the same credit ratings, also set lower risk weights for claims on sovereigns than for claims on corporates.

In a letter published by FT November 2004 I asked: “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. In some developing countries, access to credit for the private sector is all but gone, and the banks are up to the hilt in public credits.”

And the European Commission, I do not know when, to top it up, assigned a Sovereign Debt Privilege of a 0% risk weight to all Eurozone sovereigns, even when these de facto do not take on debt in a national printable currency.

And, to top it up, the ECB launched its Quantitative Easing programs, QEs, purchasing European sovereign debts.

At the end of the day, the difference between the interest rates on sovereign debt that would exist in the absence of regulatory subsidies and central bank purchases, and the current ultra low or even negative rates, is just a non-transparent tax, paid by those who save. Financial communism

And all this began one year before the fall of the Berlin Wall

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

The Bank of England’s Museum’ explanation of “credit risk” keeps mum on how BoE, as a regulator, helped to mess it all up

Yesterday I visited the Bank of England’s Museum, and there I read the following:

“Banks have ways of reducing credit risk. When you apply for a loan, the lender will look at what’s known as the five C’s: credit history, capacity, collateral, capital and conditions.

Credit history, also known as character, is basically your track record for repaying debts.

Capacity refers to your ability to repay a loan by looking at your job stability and your debt compared to your income, known as the debt-to-income ratio.

If you can’t pay back your secured loan, the lender will seize an asset such as your house or car as collateral.

Would you still be able to pay your loan if you lost your job? To know, the lender looks at any savings, investments and other assets you might own to determine how much capital you have.

Finally, the purpose – or conditions – of the loan can affect whether someone wants to lend you money or not.

The bank’s assessment determines how much interest they’ll charge you. If you are seen as a risky customer, for example by having a bad credit history, your loan will be more expensive.”

Now that is how it used to be, before 1988, before overly creative and full of hubris regulators ,with Basel I, imposed risk weighted capital requirements on banks.

After that, and especially after 2004 Basel II, the banks must also consider how much capital (equity) the regulators require it to have against that loan... as that will determine their final risk adjusted expected return on equity.

I did not find a single word in the BoE museum about how these risk weighted capital requirements for banks distort the allocation of bank credit to the real economy.

I did not find a single word in the BoE museum about the fact that absolutely all assets that caused the 2007/08 crisis, had one single thing in common, namely very low capital requirements, that because these assets were perceived (residential mortgages), decreed (sovereigns) or concocted (AAA rated securities) as very safe. 

I can only conclude that the Bank of England is engaging in covering up their own fatal mistakes. Let us pray that at least internally they admit and learn from these.

I saw there that Bank of England is also presenting itself as the “Knowledge Bank”. When in 2002-04, as an Executive Director of the World Bank, I heard the same promo I begged WB to try being a “Wisdom Bank” instead, or at least a “Common Sense” bank.

PS. There was also a video at the museum that explained the vital role of the banks. It stated:

“Banks need to manage risks, and they monitor their lending carefully, spreading the risk among many loans to different sectors.”

Yes, that is how a portfolio is managed… but the risk weighted capital requirements for banks were explicitly made “portfolio invariant” because to have these being “portfolio variant” presented too many complications for the regulator.

“Banks need enough capital to provide a strong basis for their lending in case things go wrong.” 

Indeed but the question remains when does a bank need the most of capital, when something perceived as risky turns up even more risky; or when something perceived safe turns up risky?

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

My tweets asking very courteously bank regulators for an explanation

Dear bank regulators, please explain your current risk weighted capital requirements for banks against these four scenarios:

1. Ex ante perceived safe – ex post turns out safe - "Just what we thought!"
2. Ex ante perceived risky – ex post turns out safe - "What a pleasant surprise! That's why I am a good banker"
3. Ex ante perceived risky – ex post turns out risky - "That's why we only lent little and at high rates to it."
4. Ex ante perceived safe – ex post turns out risky - "Now what do we do? Call the Fed for a new QE?"

Because, as I see it, from this perspective, your 20% risk weights for the dangerous AAA rated, and 150% for the so innocous below BB- sounds as loony as it gets.

Here are some of my current explanations of why I believe the risk weighted capital requirements for banks are totally wrong.

And below an old homemade youtube, published September 2010, on this precise four scenarios issue

“If you see something say something”. Yes, but it’s not easy to be a whistleblower on our too inept bank regulators.

Sir, never ever has a bank crisis of any important magnitude resulted from excessive exposures to something that was perceived as risky when placed on the balance sheets of banks.

These have always resulted from unexpected events, like major devaluations, criminal behavior or excessive exposures to something that was perceived as safe when incorporated in the balance sheets of banks but that ex post turned out to be risky.

So when bank regulators, like with their Basel II of 2004 set the risk weights for what is rated AAA at 20%, and that of the below BB- rated at 150%, then this is a too serious clue of them not knowing what they’re doing.

And the above is far from being their only mistake or the only proof of that.

I have been shouting my lungs out about this basically since 1997, but it is very difficult for an ordinary citizen, even for someone who for some years was an Executive Director at the World Bank, to have someone to listen to him, when he holds that our supposed expert bank regulators left a bomb in our real economy.

PS. I will send the above letter to as many editors I can.

Financial Times

New York Times

Wall Street Journal

Washington Post

Svenska Dagbladet

The Economist

And here is my letter to the Financial Stability Board, March 2019

My tweet comments on Stephen Cecchetti's and Kim Schoenholtz's "The financial crisis, ten years on", Vox August 2017

"The financial crisis, ten years on"

Does a crisis start when the bomb is armed, the fuse is lit, the explosion occurs, or when the explosion is noted? http://voxeu.org/article/financial-crisis-ten-years#

In 2003 FT published a letter I wrote about the systemic risk of giving credit rating agencies so much power https://teawithft.blogspot.com/2003/01/credit-ratings-for-developing-nations.html

In 2004 the fuse was lit when Basel II authorized banks to leverage 62.5 times with what was rated AAA http://voxeu.org/debates/commentaries/impose-higher-bank-capital-requirements-what-has-best-credit-ratings

In August 2006 clearly the bomb had already exploded https://teawithft.blogspot.com/2006/08/long-term-benefits-of-hard-landing.html

Unfortunately it was not until July 2007 credit rating agencies woke up and in August that the fan started to spread out the shit.

Capital requirements for banks should be ex ante perceived risks neutral.

Professor Steve Hanke writes: “The calculated risk that a financial institution takes is best understood by the institution itself, not the government or any outside party” “Let Banks Manage Risks, Not Regulators” Forbes July 30, 2017.

I agree: For about 600 years banks use to run their banks as if each dollar invested in any asset was worth the same. Not any longer, since Basel I, 1988 and Basel II, 2004 some assets produce net margins that regulators allow them to leveraged much more than other. That meant that banks would find it easier to obtain higher risk adjusted returns on equity on some assets, those perceived ex ante as safe, than on other, those perceived as risky.

That of course distorted dangerously the allocation of bank credit to the real economy. The 2007-08 problems resulting mainly from excessive exposures to AAA rated securities and sovereigns, as well as the mediocre response to ultra large stimulus like QEs and minimal interest rates should suffice to prove it.

And I disagree: Because bank regulators should consider the risks that banks are not able to manage the risks they perceive, or that some unexpected events can put the system in danger. But since that has absolutely nothing to do with ex ante perceived risks per se, the capital requirements should be risk-perceived neutral, like for instance solely a leverage ratio. 

Besides, if regulators insist in risk weighing, only to show off some regulatory sophistication, so as to be known as important experts, then they should never forget that what really poses dangers to the banks system is what is perceived safe and never ever what is ex ante perceived very risky.

With Basel II, how many times could banks multiply net risk adjusted margins, so as to obtain their returns on equity?

The expected pretax return on equity for banks is the amount of net risk adjusted margins they earn over the capital they need to hold.

For instance if banks had to hold the 8% basic capital requirement defined in Basel II, they could leverage (multiply) those net risk adjusted margins 12.5 times. And so if a bank wanted to earn a 20% pre tax ROE, it would need to collect an average net risk adjusted margin of 1.6% (20%/12.5) on assets equivalent to 12.5 times its capital.

Clearly, the more banks can leverage (multiply) those net risk adjusted margins, the higher the expected return on its equity, or the lower do those margins need to be.

For instance if banks had to hold only 1.6% in capital they would be able to leverage (multiply) those net risk adjusted margins 62.5 times. And so if banks wanted to earn the same 20% pre tax ROE as before, they would need to collect an average net risk adjusted margin of only 0.32% (20%/12.5) on assets equivalent to 62.5 times its capital. If the bank was abled to collect the same 1.6% average net risk adjusted margins, then its expected ROE would be a whopping 100%. 

The problem (for us) though, of Basel II, is that it, based on credit ratings, risk adjusted the capital requirements. And so, according to Basel II’s standardized risk weights, the banks were allowed to multiply their net risk adjusted margins the following way: 

SOVEREIGNS:

AAA to AA = Unlimited

A+ to A = 62.5 times

BBB+ to BBB- 25 times

BB+ to B- = 12.5 times

Below B- = 8.3 times

Unrated = 12.5 times

CORPORATES:

AAA to AA = 62.5 times

A+ to A = 25 times

BBB+ to BB- = 12.5 times

Below BB- = 8.3 times

Unrated = 12.5 times

Residential mortgages = 35.7 times

Anyone who does not immediately understand how this distorts the allocation of bank credit; in favour of those who can have their net margin offers multiplied more by banks; and against those who have these multiplied less, does not understand finance, or has a vested interest in not wanting to understand it.

Can there be any question that these regulations pushed banks overboard with exposures to AAA rated securities and loans to sovereigns, like to Greece?

But, someone might say, this is all in order to make banks safer. Bullshit! There has never ever been a major bank crisis resulting from excessive exposures to something perceived as risky when placed on banks’ balance sheets.

Of course with Basel III, which has a leverage ratio that is not risk depended, the differences in the times net risk adjusted margins can be multiplied are smaller, but that does not mean for one second that the Basel discrimination keeps on being kicking and alive.

God help our young… God help our Western civilization. These idiotic risk-adverse regulators are hindering banks from financing our young ones’ riskier future, and have banks only refinancing their parents’ (and their regulators’) safer present and past. 

Risk-taking is the oxygen of development. God make us daring!

Could a hostile power create bank regulations capable of destroying our Western financial system? It would seem so :-(

David Bookstaber in his “The End of Theory”, 2017 refers to the following question:

“If you were a hostile foreign power, how could you disrupt or destroy the U.S. financial system? That is how do you create a crisis?

Well one way to do it begins, as does any strategic offensive, with the right timing. Wait until the system exposes a vulnerability. Maybe that is when it’s filled with leverage, and when assets become shaky.”

Then Bookstaber suggests: “create a fire sale by pressing down prices to trigger forced selling…freeze funding by destroying confidence… maybe pull out your money from some institutions with some drama… and to make money, short the market before you start pushing things off the cliff”

That is Bookstaber’s interesting tale on what “turned the vulnerabilities of 2006 and 2007 into the crisis of 2008, and nearly destroyed our system.” “And we didn’t need an enemy power; we did it all by ourselves.

But what if it all had started with a hostile foreign power taking over bank regulations in order to create the vulnerabilities?

I mean like telling banks they could hold 1.6% in capital or less, meaning a 62.5 to 1 or more leverage, against assets with an AAA rating (like some fatal MBS) or against sovereigns, like Greece. That would give banks the chance to earn fabulous expected risk adjusted margins on those assets, and therefore build up huge exposures to these against very little capital (equity).

I ask, because that was exactly what the Basel Committee for Banking Supervision did with its Basel II of 2004.

And to top it up their AAA-bomb was so powerful that, because it discriminates against the access to bank credit of “the risky”, like SMEs and entrepreneurs, the economy would find it almost impossible to recover on its own; and the crisis-can had to be kicked further and further down the road, with Tarps, QEs, fiscal deficits and silly low interest rates? 

http://theaaa-bomb.blogspot.com

What if traffic regulators, to make your town safe, limited motorcycles to 8 mph but allowed cars to speed at 62 mph?

The fatality rate per 100 million vehicle miles traveled in cars is 1.14

The fatality rate per 100 million vehicle miles traveled in motorcycles is 21.45

That could indicate that in terms of risks measured and expressed as credit ratings, the cars should be rated AAA, and motorcycles below BB-.

But in 2011, in the US, 4,612 persons died in motorcycle accidents.

And in 2011, in the US, 32,479 persons died in vehicle accidents.

That explains the differences between ex-ante perceived risk and the ex-post dangers conditioned by the ex-ante perceptions. Cars are more dangerous to the society than motorcycles, in much because the latter are perceived as much riskier.

But what did bank regulators do in Basel II, 2004?

By weighting for ex-ante perceived risks their basic capital requirement of 8%, they allowed banks to leverage 62.5 times to 1 when AAA-ratings were present, and 8.3 times in the case of below BB- ratings.

So, what if traffic regulators, in order to make your hometown safe, limited motorcycles to 8 mph but allowed cars to speed at 62 mph?

Do you see why I argue that current bank regulators in the Basel Committee and in the Financial Stability Board have no idea about what they are doing?

But it is even worse. We need SMEs and entrepreneurs to access bank credit in order to generate future opportunities for our kids. Unfortunately, since when starting out these usually have to drive more risky motorcycles than safe cars, our future real economy gets also slapped in the face. 

An 8% capital requirement translates into a 12.5 to 1 leverage. Why can’t our regulators allow banks to speed through our economy at 12.5mph, independently of whether they go by cars or motorcycles?

PS: Here is a more detailed explanation of the mother of all regulatory mistakes.

Regulators looking after the same risks bankers look at

How the Western civilization is being lost because of regulatory induced risk aversion.

Mark Twain has been attributed opining that bankers lend you the umbrella when the sun shines and want it back as soon as it looks it could rain.

And never ever has there been a bank crisis caused by excessive exposures to something perceived as risky when placed on banks’ balance sheets.

But that did not stop scared lack of testosterone bank nannies to also require banks to hold more equity when lending to the risky than when lending to the “safe”.

So what happened? 

As banks earned much higher risk adjusted returns on the safe they could not resist the AAA rated securities backed with mortgages to the subprime sector, or sovereigns like Greece. And so a typical bank crisis, that of excessive exposures to what was ex-ante perceived as safe but that ex post turned out very risky ensued. 

In this case the crisis was made specifically worse, by means of the lower equity banks had been authorized to maintain. For example in the case of the AAA rated securities, Basel II, because of the standardized risk weights, banks were required to only hold 1.6% in capital, meaning an authorized leverage of 62.5 to 1. 

But much worse, since banks of course find it harder to earn higher risk adjusted ROEs on more capital, they have abandoned lending to risky SMEs and entrepreneurs, those who open up new roads on the margins of our economy, and so of course slower economic growth results.

Lack of testosterone, risk aversion, is not a fundamental value of the Western civilization. On the contrary in churches we sometimes sang, or at least used to sing, “God make us daring!”

@PerKurowski

ECB Working Paper 2079, as is standard, also suffers from confusing ex ante perceived risks with ex post realities.

Jonathan Acosta Smith, Michael Grill, Jan Hannes Lang have produced a paper titled “The leverage ratio, risk-taking and bank stability”, ECB Working Paper 2079, June 2017, which analyzes the non-risk based leverage ratio (LR) that has been introduced in Basel III to work alongside the risk-based capital framework.

I quote: “The main concern relates to the risk-insensitivity of the LR: assets with the same nominal value but of different riskiness are treated equally and face the same capital that an LR has a skewed impact, binding only for those banks with a large share of low risk-weighted assets on their balance sheets, this move away from a solely risk-based capital requirement may induce these banks to increase their risk-taking; potentially offsetting any benefits from requiring them to hold more capital.” 

Unfortunately this paper suffers from the usual and tragic mistake of confusing ex ante perceived risks with ex post realities.

Basel Committee bank regulators acted like bankers and not like regulators, when they got fixated on the risk of the assets of the banks, and not on the risk those assets posed for the banking system. Had they done some empirical research on what caused previous bank crises, they would have seen that what was ex ante perceived as risky never played a mayor role.

As is Basel II’s risk weighted capital requirements allow banks to earn higher risk adjusted returns on equity with assets ex ante perceived (decreed or concocted) as safe, than with assets perceived as risky. That results in banks building up dangerous exposures, against little capital, to assets that though ex ante perceived were perceived as very safe, could ex post turn out very risky. E.g. the AAA rated securities backed with mortgages to the subprime sector.

The clearest way I have found to illustrate the regulator’s fundamental error is by referencing Basel II’s standardized risk weights:

It allocates a meager 20% risk weight to corporates "dangerously" rated AAA to AA, while assigning a 150% risk weight to the "innocuous" below BB- rated, that which banks would never touch with a ten feet pole.

And, with their risk weighting the regulators, with serious consequences, are also distorting the allocation of bank credit to the real economy. Since the introduction of Basel II, millions of “risky” SMEs and entrepreneurs have not been able to access bank credit, or have had to pay extra compensatory interest charges, precisely because of this pillar.

Bank capital requirements should not be based on what is perceived but on the possibilities that the perceptions are wrong, that the perceptions are right but not adequately managed or that unexpected events could happen. 

In this respect I am all for one single capital requirement for all assets (including of course sovereign loans).

So does the introduction of the leverage ratio partly fulfill what I want? Unfortunately not! The more a leverage ratio translates into banks finding it difficult to meet regulatory bank capital requirements, the more will the risk-weighted requirements distort on the margin. I often refer this to the Drowning Pool simile.

Here is a more detailed list of the mistakes with risk weighting.

Mr Watson IBM, besides helping wine growers, when are you going to tell bank regulators they’re so wrong?

Bank regulators, thinking they are so smart, assigned a meager 20% risk weight for what is rated AAA to AA, and a whopping 150% to what is rated below BB-.

That allows banks to hold much less capital against assets rated AAA to AA than against assets rated below BB-.

Now you tell me Watson, what is more dangerous to our banking system, that rated AAA to AA, that because is perceived as so safe could lead to the dangerous build-up of excessive bank exposures, or that which because it is rated below BB- bankers wont touch with a ten feet pole?

So, when are you going to offer to help the bank regulators? They sure need it! We sure need it!