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

Basel III - sense and sensitivity”? No! Much more “senseless and insensitivity”

I refer to the speech titled “Basel III - sense and sensitivity” on January 29, 2018 by Ms Sabine Lautenschläger, Member of the Executive Board of the European Central Bank and Vice-Chair of the Supervisory Board of the European Central Bank.

“Senseless and insensitive” is how I would define it. It evidences that regulators have still no idea about what they are doing with their risk weighted capital requirements for banks.

Ms Lautenschläger said: With Basel III we have not thrown risk sensitivity overboard. And why would we? Risk sensitivity helps align capital requirements with actual levels of risk and supports an efficient capital allocation. It prevents arbitrage and risk shifting. And risk-sensitive rules promote sound risk management.

“Risk sensitivity helps align capital requirements with actual levels of risk and supports an efficient capital allocation” No! The ex ante perceived risk of assets is, in a not distorted market aligned to the capital by means of the size of exposure and the risk premium charged. Considering the perceived risk in the capital too, means doubling down on perceived risks; and any risk, even if perfectly perceived, if excessively considered causes the wrong actions.

“It prevents arbitrage” No! It stimulates arbitrage. Bankers have morphed from being diligent loan officers into too diligent equity minimizers. 

“It prevents risk shifting.” No! It shifts the risks from assets perceived as risky to risky excessive exposures to assets perceived as safe.

“It promote sound risk management” No! With banks that compete by offering high returns on equity, allowing some assets to have lower capital requirements than other, makes that impossible.

Ms Lautenschläger said: “for residential mortgages, the input floor increases from three basis points to five basis points. Five basis points correspond to a once-in-2,000 years default rate! Is such a floor really too conservative?”

The “once-in-2000 years default rate on residential mortgages!” could be a good estimate on risks… if there were no distortions. But, if banks are allowed to leverage more their capital with residential mortgages and therefore earn higher expected risk adjusted returns on residential mortgages then banks will, as a natural result of the incentive, invest too much and at too low risk premiums in residential mortgages… possibly pushing forward major defaults from a “once-in-2000 years default” to one "just around the corner". That is senseless! Motorcycles are riskier than cars, but what would happen if traffic regulators therefore allowed cars to speed much faster?

I guess Basel Committee regulators have never thought on how much of their lower capital requirement subsidies are reflected in higher house prices?

Then to answer: “Does this mean that Basel III is the perfect standard - the philosopher's stone of banking regulation? Ms Lautenschläger considers “What impact will the final Basel III package have on banks - and on their business models and their capital?”

Again, not a word about how all their regulations impacts the allocation of bank credit to the real economy… as if that did not matter… that is insensitivity!

Our banks are now financing too much the “safer” present and too little the “riskier” future our children and grandchildren need and deserve to be financed.

PS. In 2015 I commented another speech by Ms Lautenschläger on the issue of “trust in banks”.

The Finalization of Basel III’s is just a photo-op for the Committee members to go home for Christmas with, as it does nothing to correct the fundamental flaws of current bank regulations.

The Basel Committee’s “Finalizing Basel III” brief states: 

1. “What is Basel III? The Basel III framework is a central element of the Basel Committee’s response to the global financial crisis. It addresses a number of shortcomings in the pre-crisis regulatory framework and provides a foundation for a resilient banking system that will help avoid the build-up of systemic vulnerabilities. The framework will allow the banking system to support the real economy through the economic cycle.”

Since the risk weighted capital requirements are kept, that is simply not true! The global financial crisis was a direct consequence of regulations that allowed banks to leverage immensely their capital as long as they kept to “safe” assets: limitless leverage with exposures to friendly sovereigns, 62.5 times with private sector exposures rated AAA to AA, and 35.7 times with residential mortgages. 

The exaggerated demand these regulations created for residential mortgages and highly rated securities, which caused serious deteriorations in their quality, and of loans to low risk decreed sovereigns, like Greece, explains 99.9% of the financial crisis.

In contrast when lending to an entrepreneur or an unrated small or medium size enterprise, as that was (is) considered risky, banks were only allowed to leverage 12.5 times. The differences in potential risk adjusted returns on equity between “safe” and “risky” assets hindered, and hinders, the banking system from adequately supporting the real economy

2. “What do the 2017 reforms do? “The 2017 reforms seek to restore credibility in the calculation of risk-weighted assets (RWAs) and improve the comparability of banks’ capital ratios. RWAs are an estimate of risk that determines the minimum level of regulatory capital a bank must maintain to deal with unexpected losses. A prudent and credible calculation of RWAs is an integral element of the risk-based capital framework.”

But the fundamental question of why it should be prudent to require banks to hold more capital against what is perceived risky, when the real dangers to the bank system is when something perceived as safe turns out risky, remains unanswered.

3. “Credibility of the framework: A range of studies found an unacceptably wide variation in RWAs across banks that cannot be explained solely by differences in the riskiness of banks’ portfolios. The unwarranted variation makes it difficult to compare capital ratios across banks and undermines confidence in capital ratios. The reforms will address this to help restore the credibility of the risk-based capital framework.

Internal models should allow for more accurate risk measurement than the standardised approaches developed by supervisors. However, incentives exist to minimise risk weights when internal models are used to set minimum capital requirements. In addition, certain types of asset, such as low-default exposures, cannot be modelled reliably or robustly. The reforms introduce constraints on the estimates banks make when they use their internal models for regulatory capital purposes, and, in some cases, remove the use of internal models.” 

Where do regulators get the idea that if there are less-variations in RWAs, the standardized RWAs, based on how regulators perceive risks, are any more accurate? Excessive hubris? Have they forgotten their own “Standardized” risk weights? Alzheimer? 

Also, since banks should clear for perceived risks in the size of the exposures and interest rates, making them clear for those same risks in the capital too, causes an excessive consideration of perceived risks. The regulators clearly keep on ignoring that any risk, even if perfectly perceived, causes the wrong actions, if excessively considered.

That regulators now, at long last, have understood that “incentives exist to minimise risk weights when internal models are used to set minimum capital”, serves little as consolation, as it just evidences their original naiveté.

PS. As an aide memoire for the regulators to take home for Christmas here’s a list of their mistakes. Am I being nasty? No! How many millions of entrepreneurs have over the years been negated access to the life changing opportunities of a bank credit, only because of these regulators? How many young must live in the basement of their parents houses without jobs, only because regulator think it is safer to finance houses than job creation opportunities? Let’s pray all the Ebenezer Scrooge in the Basel Committee will see light one day... or at least have the decency to fade away.  

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

FSB reports: “G20 reforms are building a safer, simpler, fairer financial system”. What a triple lie!

FSB reports to G20 Leaders on progress in financial regulatory reforms, and it starts with: G20 reforms are building a safer, simpler, fairer financial system

“Safer”? Major bank crises do not result from excessive exposures against what is perceived risky, but always from unexpected events or excessive exposures to what was ex ante perceived, decreed or concocted as safe, but that, ex post, turned out to be very risky.

In the FSB video they say “A safe banking system needs enough capital to absorb unexpected losses” and so my question is: So why require capital based on expected risks?

“Simpler”? Don’t be ridicule! Just have a look at the Basel Committee’s absurdly obscure “Minimum capital requirements for market risk” of January 2016, and on its consultative document for a "simplification" of July 2017.

The FSB video does not really even dare to explain the "simpler" factor.

“Fairer”? Forget it! The discrimination in the access to bank credit in favor of those perceived, decreed or concocted as safe, like the Sovereigns and the AAA-risktocracy is still alive and kicking; just like that one against “the risky”, the SMEs and entrepreneurs. It is an inequality driver.

No wonder the FSB video has the comments disabled.

G20 you want to understand what is wrong with current bank regulations? Start here!

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.

Dr Andreas Dombret your Basel I, II and III will be discovered as a truly ugly piece of Ramsey statue.

I will quote from Dr Andreas Dombret speech “Basel III - goal within sigh” delivered at the Bundesbank symposium on "Banking supervision in dialogue", Frankfurt am Main, 15 March 2017. 

The Member of the Executive Board of the Deutsche Bundesbank stated:

“The statue of Ramses is not only a work of art; it is also testament to the highest quality of craftsmanship, which is one major reason it has survived for three thousand years. Figuratively speaking, this is how we, too, must approach the Basel reform package. It’s not just about developing uniform, consistent rules – risk sensitivity is another of our guiding principles. During the negotiations, we will therefore call for higher risk to go hand in hand with higher capital requirements.”

Dr. Dombret if you and your regulatory technocrat buddies keep on insisting that what is perceived as risky is the stuff major bank crises are made of, your Basel regulations will doom the banks and the real economy.

You state “The equity ratio of German banks and savings banks has risen by more than half a percentage point to currently 16.2% since September last year, which was due primarily to the reduction in risk-weighted assets”, and I ask: How do you know that the reduction in risk-weighted assets did not affect those assets your banks most need to hold for your real economy not to stall and fall? 

Dr. Dombret, if you read this comment please answer these following questions, if you dare!

http://subprimeregulations.blogspot.com/2016/12/must-one-go-on-hunger-strike-to-have.html

The regulatory powers of our bank regulators need to be urgently regulated, at least those of the Basel Committee.

What do you think the world would have said if the Basel Committee had informed it that it would regulate the banks, without considering the purpose of the banks? 

What do you think the world had said if the Basel Committee had informed that in order to make the banks safer, they were going to distort the allocation of credit to the real economy?

What do you think the world would have said if the Basel Committee had informed it that even though all major bank crises have always resulted from excessive exposures to something ex ante erroneously perceived as safe, they would allow for especially low capital requirements against bank exposures to what ex ante was perceived as safe.

What do you think the world would have said if the Basel Committee had informed it that even though the society considered that banks giving credit to SMEs and entrepreneurs was very important, they would saddle the banks with especially large capital requirements on account of those “risky” being risky.

What do you think the world would have said if the Basel Committee had informed it that it was going to assign a zero risk weight to sovereigns and a 100 percent risk weight to the citizens, and which indicated their belief that government employees could make better use of other people’s money than private citizens could use theirs. 

What do you think the world would have said if the Basel Committee had informed it that even though banks already cleared for credit risks with interest rates and size of exposure they would also require banks to clear for that same risk in the capital; and that even though any risk that is excessively considered leads to the wrong actions even if perfectly perceived.

What do you think the world would have said if the Basel Committee had informed it that because they could not estimate the unexpected losses that bank capital is primarily to cover for, they would use expected credit risks as a proxy for the unexpected.

What do we think about that even when the 2007-08 clearly evidenced the failure of the regulators, they go on as if nothing, using the same regulatory principles? I just know that neither Hollywood nor Bollywood would ever have permitted those creating the box-office flop of Basel II, to go on working on Basel III.

Sincerely, are we really sure all these regulators in the Basel Committee, and in the Financial Stability Board, are just not some Chauncey Gardiner characters?

Again the Basel Committee for Banking Supervision evidences it is a clueless producer of systemic risks.

I refer to a speech by William Coen the Secretary General of the Basel Committee, given in Sydney on 5 April 2016 and titled “The global policy reform agenda: completing the job” Coen said: 

“A bridge is an apt metaphor for the Basel framework. Bridges must be safe and sound. A safe and sound banking system is exactly what the Basel framework aims to support. Bridges facilitate movement, commerce and trade. The financial system plays a crucial role in directing investment and funds between individuals and businesses…

For the past 25 years, the foundation of the international approach to the prudential regulation of banks has been a risk-based capital ratio.

The level of capital is a difficult question. There are many views on what the "right amount" should be”

So it is clear that the Basel Committee still does not understand the distortion they cause. Its risk-based capital ratios, which allows banks to leverage equity differently with different assets depending on their ex ante perceived risk, amounts to building some very wide bridges where banks and “the safe” can interact a lot with ease, and then some very narrow bridges that make the relations between banks and “the risky” much harder than they already were.

Coen confesses: “We have spent several years developing a framework to make sure that banks' capital and liquidity buffers are strong enough to keep the system safe and sound.” And that is precisely the problem; they only cared about the condition of the banks and not one iota about the fundamental social purpose of banks, which is allocating credit efficiently to the real economy.

And Coen also quoted the Dutch central bank with: "today's undesirable behavior in financial institutions is at the root of tomorrow's solvency and liquidity problems".

That is correct but I would also add: Today’s undesirable regulatory failure is and will be at the root of tomorrows problems with the real economy… and in the long run no bank system cam be safe and sound, if the underlying real economy is not safe and sound.

And by the way, the root of 2007-08’s solvency and liquidity problems, laid in those authorized leverages of over 60 to 1 for AAA rated securities and sovereigns like Greece.

What are we to do with this bunch of not accountable to any technocrats that have never walked on Main Street, and are incapable of understanding that risk-taking is the oxygen of all development? 

“A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926 

Please, give our banks one sole equal capital requirement for all assets, to protect banks not against expected credit risks already cleared for, but against unforeseen risks, such as the Basel Committee falling into the hands of clueless regulators.

Let us never forget that the most dangerous systemic risks can easily be introduced by the regulators.

God make us daring!

My sincere Christmas wish: That our bank regulators wake up and understand what they are doing to our children.

On December 24, 1941, in Washington DC, Winston Churchill ended his Christmas speech to war torn England with: “By our sacrifice and daring, [our] children shall not be robbed of their inheritance or denied their right to live in a free and decent world.”

I absolutely do not pretend being something like Winston Churchill but, here in Washington, on December 24, 2015, 74 years later, I assure you all that: By us not daring to allow our banks to dare, we are robbing our children of their inheritance and denying their right to live in a free and decent world.

I pray our bank regulators in 2016 wake up to understand how much their credit risk weighted capital requirements for banks, distort the allocation of bank credit to the real economy.

By allowing banks to earn higher risk adjusted returns on what is perceived as safe than on what is perceived as risky banks do not any longer finance the riskier future but only keep to refinancing the safer past.

In essence we are placing a reverse mortgage on our economies, which will extract its value, without allowing the risk taking needed for something new to take its place.

Understand what originated the bank crisis and what stops the economies from recovering in 157 words

Bank regulators told our credit risk adverse banks: 

“If you take on Safe assets, we will allow you to leverage your equity and the support you receive from the society more than 60 to 1 times but, if Risky assets then you cannot leverage more than 12 to 1.” 

And that of course meant banks would be earning much higher risk adjusted returns on equity on assets perceived or made out to be Safe, than on “Risky” assets. 

It was like telling children: “If you eat up your ice cream then you can have chocolate cake too but, if you eat spinach, then you must eat broccoli too. 

And so banks built up excessive dangerous financial exposures to “Safe” assets, like AAA rated securities and loans to Greece, which detonated the crisis. 

And so banks are reluctant to hold Risky assets, like loans to SMEs and entrepreneurs, which makes it impossible to get out of the crisis.” 

And, amazingly, most describe what happened and is happening with our banks in terms of deregulated entities and failed markets.

Our current bank regulatory tragedy: Interference without a purpose

Bank regulators have two choices. They can allow everyone to compete equally for the access to bank credit; or they can interfere in the allocation of bank credit by favoring one group’s access, which of course affects negatively those not favored.

And of course interference, though arrogant and dangerous, could be justified if it was done with the purpose of trying to make the real economy stronger... like for instance when financing projects that have special potential to deliver job creation, or the sustainability of our planet.

Unfortunately, current bank regulators, with their credit risk weighted capital requirements for banks, are interfering with the allocation of bank credit without a real purpose. The only thing they achieve with that, is allowing those who because they are perceived as safe already have ample access to bank credit, to find even more generous conditions; and to make it even more difficult for those who because they are perceived as risky already find it harder to access bank credit.

And by doing so regulators are not making banks any safer either, since all-major bank crises result from excessive financial exposure to something ex ante believed safe but that ex-post turned out to be risky.

And so too much credit, in too generous terms, against too little bank capital is given to those perceived as safe, like governments and corporates with high credit ratings; and too little credit, in too expensive terms, to those perceived as risky, like our absolutely vital SMEs and entrepreneurs.

What a tragedy! Let us pray the Basel Committee, the Financial Stability Board and the IMF wake up in time, before our stalling economies really fall into pieces.

16 tweet-sized fundamental mistakes with regulatory credit-risk weighted capital requirements for banks… and counting

The regulators are regulating the banks without having defined the purpose of the banks. 

Regulators ignored that banks need and should allocate credit efficiently to the real economy.

Regulators ignore that for the society, what is not on the balance sheet of banks, could be as important as what is.

To allow bank equity to be leveraged with net margins of assets differently, distorts the allocation of bank credit.

The scarcer the bank capital is, the greater the distortions produced by the risk weighted capital requirements.

Bank capital is to cover for unexpected losses, yet regulators base the requirements on expected credit risks.

The safer something is perceived the greater is its potential for unexpected losses.

The risk of a bank has little to do with perceived risk of assets, and much to do with how the bank manages risks.

Banks clear for credit risk with interest rates and exposures, so to also do in the capital double-counts that risk.

Any perfectly perceived risk causes the wrong actions if the risk is excessively considered.

The standard risk weights that determine the capital requirements for banks are, amazingly, portfolio invariant.

The undue importance given to few information sources, credit rating agencies, introduced a serious systemic risk.

That imposing similar and specific regulations on any system stiffens it and increases its fragility was ignored.

Any regulatory constraint that can be gamed will be gamed and benefit the worst gamers in detriment of lesser gamers.

A risk weight of zero percent for the sovereign, and of 100 percent for the private sector, is pure unabridged statism.

Impeding “the risky” to have fair access to bank credit blocks opportunities and thereby increases inequality

Consequences: Too much bank credit against too little capital to whatever is perceived or can be construed as being safe, and too little credit to what is perceived as risky. In other words banks that do not finance the “risky” future, but only refinance the “safer” past.

Questions: Of these mistakes how many have been sufficiently debated and corrected? How many of the responsible for these mistakes have been held accountable?

Mr Stefan Ingves, Chairman of the Basel Committee. Basel III contains the same major design flaw of Basel I & II

Mr Stefan Ingves, Chairman of the Basel Committee and Governor of Sveriges Riksbank in a recent speech has likened Basel II to the Swedish warship Vasa that sank “after sailing only 1,300 metres, on 10 August 1628”… because “the Vasa was well constructed but incorrectly proportioned”.

Ingves states that Basel II “looked impressive on paper. In the Committee's quest for greater risk sensitivity, Basel II introduced the role of internally modelled approaches for credit risk and operational risk and expanded the role of models for market risk.

But things did not work out precisely according to plan. The financial crisis highlighted a number of shortcomings with the banking system and the regulatory framework, including:

• too much leverage, with insufficient high-quality capital funding banks' assets;

• excessive credit growth, fuelled in part by weak underwriting standards and an underpricing of credit and liquidity risk;

• a high degree of systemic risk, interconnectedness among financial institutions and common exposures to similar shocks;

• inadequate capital buffers to mitigate the inherent procyclicality of financial markets and maintain lending to the real economy in times of stress; and

• insufficient liquidity buffers and excessive exposure to liquidity risk. This was in terms of both direct and indirect liquidity risk (for example, through the shadow banking system).”

And according to Ingves now: “The Basel III framework seeks to address the weaknesses I mentioned and provides the foundation for a resilient banking system”.

First, any regulator who approved of capital requirements that allowed banks to leverage their equity 60 times to 1 or more, should be ashamed of speaking of “too much leverage”, “excessive credit growth” and “inadequate capital buffers” as “shortcomings with the banking system and the regulatory framework”. It is not about “shortcomings” it is about a monstrous definite flaw in bank regulations that caused the financial crisis. 

And since Mr. Ingves and his colleagues have apparently yet not understood the basic design flaw of Basel I and II, Basel III will also sink.

The number one problem is that regulators have never defined what was the purpose of banks. Had they done so, they would have had to include that of allocating bank credit efficiently to the real economy. And, had they spelled out that purpose, then they would not have been able to use credit-risk weighted capital requirements for banks. 

Allowing banks to leverage their equity and the support they receive from society differently, based on credit risks, results in banks being able to earn higher risk adjusted returns on equity on some assets than on others. Because that did of course totally distorts the allocation of bank credit.

And then Ingves says: “In addition, another important lesson is that the quest for perfection - or in this case, ever-more precision in measuring risk - can be illusory. Spending years on developing a "perfect" risk-sensitive framework may not deliver the results we would hope for. Instead, having in place multiple regulatory constraints provide more safeguards against the risk of a defect in any single element of the framework.”

Once again he evidences not having understood the real problem. It is not about the precision in measuring the risk. Since banks already clear for risks with interest rates and size of exposures, forcing them to re-clear for the same risk in the capital, means that credit risk will be excessively considered. And any risk, even if perfectly perceived, causes the wrong actions, if excessively considered.

And then Ingves says: “Instead, having in place multiple regulatory constraints provides more safeguards against the risk of a defect in any single element of the framework.”

And once again he shows he does not get it. Banks are to hold capital against unexpected losses, and unexpected losses cannot be derived from expected risks. The most that can be said in that respect is that the safer an asset is perceived to be the bigger is its potential to deliver unexpected losses.

Mr Ingves concludes with “The Committee's ongoing policy reforms are grounded in trying to balance the simplicity, risk sensitivity and comparability of the risk-weighted framework.”

No! We, and especially the generations to follow us need a banking system that believes in the future. Capital requirements based on credit risk gives banks the incentives to stay away from financing the “risky” future and to keep solely refinancing the “safer” past. God make us daring!

May I humbly suggest a different course?

For a start the same basic capital requirement for all assets, like 8 percent, to cover for unexpected losses, like those for instance that can be caused by regulators not knowing what they are doing, cyber attacks, or an asteroid hitting earth. Of course one would have to design a very careful course for taking banks from here to there since it is fraught with a lot of dangers for the banks and the real economy.

Then and even when it is arrogant and dangerous to interfere in any way with the market, if you must, why not make some capital requirements for banks based on purpose weights, like for instance the SDGs? In such a case we would allow banks to earn a little higher risk adjusted returns on equity when they are doing something that society might want them to do, and not like now, just when they avoid credit risks.

Would the bank system become unstable because of that? Not at all, major bank crisis have never resulted from excessive bank exposure to assets that were perceived as risky when they were put on the balance sheet… they have always resulted from excessive exposures to something wrongly believed to be safe… or to something that was a safe haven but became dangerously overpopulated.

PS. Ingves states with relation to Basel II: "Six years were spent on developing this new framework. Hundreds were involved - central bankers, regulators and supervisors, not to mention the untold bankers, academics and others who commented on the Committee's proposals. Perhaps the equivalent of 40 acres of timber were consumed in the form of internal BCBS papers, consultation papers and responses received by stakeholders!" No! At the end of the day, it was something brought out by the members of a very small mutual admiration club.

PS. Mr Ingves. I recently suggested Mario Draghi he should take a sabbatical year in order to study the mistakes of current Basel bank regulations. You should too!

According to Winston Churchill I am clearly a fanatic “one who can't change his mind and won't change the subject.”

Yes! I have over the last 18 years written more than 3.000 comments, articles, blog-posts, and letters to the editor, about how flawed I know the portfolio invariant credit risk weighted capital requirements for banks are. And I won’t change my mind or change the subject. And so in Winston Churchill’s words I am a fanatic… I would say a really obsessive fanatic.

But, on the other hand, the silence on this problem by thousand of experts is equivalent to billions of comments, articles, blog-posts and letters to the editor from the opposite side; and so I am not sure about who is more obsessively fanatic, they or little me.

And of course, when compared to those statist regulators who came up with that crazy surreal nonsense of a zero percent risk weighting for the sovereign and a 100 percent risk weighting of those citizens the sovereign depends upon, I am just fanatic obsessive chicken shit.

The world’s banking system has been instructed by its regulator to give perceived credit risk a 200% weighting.

With bankers using perceived credit risk to set their interest rates and amount of exposures; and regulators using the same perceived credit risk to set their capital requirements for banks; it is clear that perceived credit risks get a 200% weighting. 

Any banking system that becomes 200% sensitive to perceived credit risks, dooms itself to lend dangerously much to The Safe, the Infallible Sovereigns and the AAArisktocracy; and way too little to The Risky, like to SMEs and entrepreneurs; which is of course fatal for the real economy and therefore also to the banks.

What would have happened if Winston Churchill, when confronted with the dangers had said: "In order to avoid our houses being bombed, we need to become 200% sensitive to risk."

This whole blog is dedicated to explaining how fatally flawed current Basel Committee originated bank regulations are. Here is a recent public letter to its current chair Mr. Stefan Ingves.

A public letter to Mr. Stefan Ingves, the chair of the Basel Committee for Banking Supervision

Mr. Stefan Ingves.

There are cowards and there are braves, ranging from extreme cowards to stupidly foolish braves, but that has less to do with how these perceive risks, and much more to do with how they assume and manage risks.

And then there are those blind to risks… so blind they do not even see a credit rating.

The Basel Committee’s risk weighted capital requirements for banks, based on precisely the same perceived risks (credit ratings) that seeing banks can already see, have clearly been designed for blind bankers.

I do not know how many such blind bankers there are, and if they exist they should not even be allowed to be in business. But, your risk weighted capital requirements, sure poses a big problem for all other banks, and for the economy in general.

Since non-blind banks already clear for any perceived credit risk, by means of interest rates and size of exposure, to force them to again, now in the capital, clear for exactly the same perceived credit risk, gives credit risk perceptions a double weight.

And any perceived risk, even if perfectly perceived, if excessively considered, leads to the wrong action.

In the case all credit risk ratings were perfect… that would then mean banks would lend more than what they should, to what is perceived “safe”, and less than what they should, to what is perceived "risky". And that misallocation of bank credit must be bad for all, especially for the real economy.

Also if credit ratings indicate a “safe” asset to be safer than what it really is, then of course a bank could collapse. Indeed this is precisely the stuff all major bank crises have been made of. No crisis has resulted from too much exposures to something ex ante perceived as risky.

Of course, if a credit rating is imperfect, in the way of informing the asset to be less risky, or less safe, than what it really is, then you might have helped banks to nail it. I doubt though your intention was really to base it on credit ratings being adequately wrong.

Mr. Stefan Ingves, may I suggest the following?

For once think of the purpose of banks being that of allocating credit efficiently to the real economy; and then go back to the drawing board, to see what non-distortionary capital requirements for banks you can come up with.

While doing so, may I suggest you remember that the purpose of the capital requirements for banks, is to cover for some unexpected losses, and not like now, for the expected credit losses?

You could still use credit ratings, if that helps you to save face… but, instead of basing it until now on those credit ratings being correct, why not require banks to have for instance 8 percent of capital against all assets, based on the risks of credit ratings, and other risk perceptions, being wrong... and other risks like that of cyber-attacks.

Please Mr. Ingves... wake up! The risk with banks has nothing to do with the risk of their assets, and all to do with how they manage the risk of their assets… Don’t make it harder than it already is for banks to manage credit risks correctly.

Yours sincerely,

Per Kurowski

PS. Could you please send a copy of this letter to Marc Carney, the current chair of the Financial Stability Board? It could also be of interest  to BIS's Jaime Caruana, ECB's Mario Draghi, and Fed's Janet Yellen. 

My bank regulator went to Basel, and all he brought me was this lousy credit risk weighted capital requirements

I sent my bank regulator to learn with the big boys in the Basel Committee for Banking Supervision about how to regulate banks. Among what he was supposed to pick up was an idea of how much capital he should require banks to hold, primarily against any unexpected losses.

He could have come back with capital requirements that considered all type of events that unexpectedly could blow a hole in a banks solvency like: cyber-attacks, a weather event with disastrous consequences, a major earthquake, the central banks or even the regulators themselves not knowing what to do, inflation suddenly popping up, crazy governments (I am from Venezuela), a set of important companies suddenly turning up engaged in some hanky panky, Systemic Important Financial Institutions (SIFIs) going belly up, internal or external fraud, a major loss from an authorized or unauthorized position in a speculative trading, unexpected consequences from new regulations and thousand of other things… BUT NO all he brought me was this silly risk weighted capital requirements based on expected credit risks, about the only risks banks are supposed to really take care of on their own.

If only it had been based on the risk that banks were not able to manage expected credit risk, then I could have accepted it… but that had of course nothing to do with the credit risk per se, in fact usually it is what is perceived as safe that could pose the biggest dangers for a bank. 

And, to top it up, these credit risk based capital requirements were portfolio invariant, meaning independent of the size of the exposures, only because otherwise it would be too hard for him and his regulating colleagues to handle.

And, to top it up, these credit risk based capital requirements also smuggled in the absurd statist notion that sovereigns were infallible, de facto implying government bureaucrats knew better what to do with bank credit than "the risky" SMEs and entrepreneurs.

And to top it up, during his whole stay with the Basel Committee, and during his study visits to the Financial Stability Board and the IMF, not one single word was said about the societal purpose of banks.

And, so these credit risk based capital requirements guarantees to dangerously distort the allocation of bank credit to the real economy... which they did, look at how much credit Greece got... which they do, look at how little credit SMEs get.

And so these credit risk based capital requirements now guarantee that the next time a bank crisis results from excessive exposures to something that was erroneously perceived as very safe, which is precisely the stuff major bank crisis are made of, then banks will stand there with their pants down and no capital to cover themselves up with.

No! I will surely never ever send my bank regulator to Basel again.

The Basel Accord was an important turning point for the bad for the whole Western civilization...and it has sadly been ignored

In 1988, the G10 countries, signed up on the Basel Accord. With it, with Basel I, the regulators imposed on banks capital requirements based on ex-ante perceived credit risks.

And the risk weight assigned to the private sector was 100 percent, while the risk weight assigned to their governments was zero percent.

That meant banks needed to hold NO capital when lending to their governments, but 8 percent when lending to the private sector (the basic Basel 8 percent standard capital requirement, multiplied by the risk weight).

That meant that banks could leverage their equity and the support they explicitly and implicitly received from taxpayers infinitely, when lending to their governments, but only about 12 to 1, when lending to the citizens.

That meant in essence, that the regulators decreed that government bureaucrats would be able to use bank credit much more efficiently than the private sector.

That meant in essence, that the free Western world signed up to communistic precepts.

Is that not a historic turning point for our Western World? Tell me, how many times have you heard this being discussed?

And then, in 2004, with Basel II, regulators decided that the risk weight for those private sector borrowers rated AAA to AA was to be 20 percent, while for the unrated ordinary citizens and their SMEs, it remained 100 percent.

And that meant that regulatory risk aversion was also introduced with respect to bank credit to the private sector in the Western world... making it impossible for SMEs and entrepreneurs to have fair access to bank credit.

And since that its been going down down down and these two sad historical event are still being ignored.

Any civilization unwilling to take risks will stall and fall.

God make us daring again!