Lord Adair Turner’s awakening as a bank regulator has at least begun, and that’s good news.

In June 2010, during a conference given by Adair Turner at the Brookings Institute, I asked him the following: 

"Big companies in consolidated sectors, like BP in oil, tend to have much better credit ratings than those participating in developing markets, like wind energy. Do you really think the banks will perform better their societal capital allocation role if regulators allow them to have much lower capital requirements when lending to the consolidated sectors than when lending to the developing? Do you think we can reach a meaningful financial regulatory reform without opening up the discussion on the issue of risk in development?"

Lord Turner responded: "The point about lending to large companies development, I'm not sure. I'm trying to think about that. I mean we try to develop risk weights, which are truly related to the underlying risks. And the fact is that on the whole, lending to small and medium enterprises does show up as having both a higher expected loss but also a greater variance of loss. And, of course, capital is there to absorb unexpected loss or either variance of loss rather than the expected loss. I think, therefore, it's quite difficult for us to be as regulators, skewing the risk weights to achieve, as it were, developmental goals. There are some developmental goals, for instance, in a renewable energy, which I'm very committed to wearing one of my other hats on climate change, where I do think you may need to do, you know, in a straight public subsidy rather than believing that we can do it through the indirect mechanism of the risk weights. So I may have misunderstood your question, but I'm sort of cautious of the sort of the leap to introducing developmental roles into -- I thinks we, as regulators, have to focus simply on how risky actually is it?"

Lord Turner did not understand what I was referring to, and what was wrong:

Lord Turner: “we try to develop risk weights which are truly related to the underlying risks”. No! The real underlying risk with banks is not the risk of their assets, but how banks manage the perceived risks of their assets.

Lord Turner: “capital is there to absorb unexpected loss or either variance of loss rather than the expected loss”

Yes “capital is there to absorb unexpected loss”, and that is why it is so ridiculous to base the capital requirements for banks on something expected, like the perceived credit risks.

Now Lord Turner in his recent book, “Between Debt and the Devil”, though he still evidences he does not understand the distortions in the allocation of bank credit to the real economy the risk weighted capital requirements produce, he seems to become more flexible about using other criteria. From the “I think we, as regulators, have to focus simply on how risky actually is it” he now states: “We need to manage the quantity and influence the allocation of credit bank create… Capital requirements against specific categories of lending should ideally reflect their different potential impact of financial and macroeconomic stability. 

Though Turner has not yet reached as far as banks actually having a social purpose more important than that of just not failing, like financing job creation and the sustainability of our planet, this is a good and welcome start. And I say so especially because Lord Turner’s awakening might reflect what hopefully might be going on in other regulators' minds.

Lord Turner even though he gets it that “it is rational for banks to maximize their own leverage, increasing the returns on equity”, still fails to understand how allowing different leverages, much higher for safe assets than for risky, make banks finance more than usual what is perceived as safe, and much less than usual what is perceived as risky… which is precisely why banks finance so much houses and so little the SMEs and entrepreneurs, those that help create the jobs needed to pay mortgages and utilities.

Lord Turner also mentions in his book the issue of inequality. For the hopefully revised and corrected sequel to his book, I would suggest he thinks about the following quote from John Kenneth Galbraith’s “Money: Whence it came where it went” 1975. 

“The function of credit in a simple society is, in fact, remarkably egalitarian. It allows the man with energy and no money to participate in the economy more or less on a par with the man who has capital of his own. And the more casual the conditions under which credit is granted and hence the more impecunious those accommodated, the more egalitarian credit is… Bad banks, unlike good, loaned to the poor risk, which is another name for the poor man.”

But clearly Galbraith was referring to credit to producers and not to consumers. 

And of course I wish Lord Turner, like so many other, stops referring to the financial crisis as a result of free markets running amok. Free markets would never ever have authorized banks to leverage over 60 to 1 when investing in AAA rated securities, or when lending to Greece. Markets were not free. Banks were not deregulated. Banks were utterly misregulated.

PS. Cross your fingers. There might be something there that wasn't there before :-)

Fight for the American dream giving opportunities to everyone, but not by using a bank in my backyard

I refer to a great report produced by a AEI/Brookings Working Group titled “Opportunity, responsibility and security: A consensus plan for reducing poverty and restoring the American Dream”

With respect to Opportunity it states: “The concept of ‘opportunity’ draws nearly universal support among Americans, and it’s the core concept of the American Dream. We endorse Truslow Adams’ definition of opportunity as the state of affairs when “each man and each woman shall be able to attain to the fullest stature of which they are capable,” regardless of offer opportunity, in this sense, to all its residents… Progressives generally believe that government should be more active and can be more effective than do conservatives. But this difference shouldn’t obscure the fact that nearly all Americans would prefer to live in a society in which opportunities for self- advancement are more widely available, especially to those at the bottom of the income distribution, than is now the case. 

I have no objections, but, from what I have seen, both conservatives and progressives have ignored how regulators affected the opportunities of The Risky to access bank credit.

Regulators, with their credit risk weighted capital (equity) requirements, allow banks to earn much higher risk adjusted returns on assets perceived as safe, than on assets perceived as risky. And that of course distorts the allocation of bank credit in favor of The Safe, those already favored by banks with lower interests and larger loans, and against The Risky, those already punished by banks with higher interests and smaller loans. And that, by impeding The Risky the opportunity of fair access to bank credit, is of course great driver of inequality.

Why is that so ignored by all who write against increased inequality and in favor of opportunities? Could it be a symptom of let’s fight against inequality, and let’s give everyone opportunities, but never ever with the bank in my backyard doing that?

Holy moly! I always suspected bank regulators regulated from an ideological position, but I had never heard such a confession.

I arrived to Washington in November 2002 to take up a two year position, until October 2004, as one of 24 Executive Directors at the World Bank.

I was then already warning about the distortions that capital requirements for banks based on perceived risks would cause in the allocation of credit to the real economy… and already predicting that it all had to end with a big AAA-Bang.

As an example in November 2004, in a letter published by the Financial Times I wrote: “Our bank supervisors in Basel are unwittingly controlling the capital flows in the world. 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 (sovereigns)? 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."

That because already in 1988 with Basel I the Basel Accord regulators gamed the equity requirements for banks in favor of the sovereigns, meaning the governments, meaning their bosses. This they did by allowing banks to hold much less equity against loans to the infallible sovereigns than against loans to the risky citizens.

But over the years in hundred of conferences, I never got anyone reasonably high up to explain the why they did it… that is, until May 1 2014, at Brookings Institute, during a presentation of Jean Pisani-Ferry’s book “The Euro crisis and its aftermath”, Jörg Decressin, a deputy director in the IMF’s European Department, a former deputy director of IMF's Research Department gave me a very straightforward answer… bless him. 

I could not believe what I heard… and neither will you.

My question: (audio 58.30-59.30)

"I am Per Kurowski, a Polish citizen, A European, at least since last Monday, since I suffered a little intermezzo due to a minor problem with the translation of my birth certificate (from Venezuela).

In Sweden we heard in churches psalms that prayed for “God make us daring!” And risk-taking is definitive something that has made and created Europe.

But in June 2002 the Basel Committee introduced capital requirements which really subsidized risk aversion, and taxed risk-taking. For instance a German bank when lending to a German business man need to hold 8 percent in capital but if they lent to Greece they needed zero. 

And those capital requirements distorted the allocation of bank credit in the whole Europe. That is not mentioned in the book. Would you care to comment?"

Decressin’s answer: (audio 1.03.50 – 1.05.37) 

"The capital requirements taxing entrepreneurs… 8% on entrepreneurs, 0% on governments

You raise a very good question and an answer to this revolves around: 

Do you believe that governments have a stabilizing function in the economy? Do you believe that government is fundamentally something good to have around?

If that is what you believe then it does not make sense necessarily to ask for capital requirements on purchases of government debt, because you believe that the government in the end has to have the ability to act as a stabilizer, when the private sector is taking flight from risk, that is when the government has to be able to step in and the last thing we want is then for people also to dump government debt and basically I do not know what they would do, basically buy gold. 

If on the other hand your view is that the government is the problem then you would want a capital requirement, so it depends on where you stand 

I think the issue of the governments being the problem was very much a story of the 1970s and to some extent the 1980s. The problems we are dealing with now are more problems in the private sector, we are dealing with excesses in private lending and borrowing and it proves very hard for us to get a handle on this. We have hopes for macro prudential instruments but they are untested, and only the future will show how we deal with them when new credit booms evolve.”

Jean Pisani-Ferry… agreed and left it at that. 

Holy Moly! I always suspected it, but I never believed I would be able to extract a confession from regulators that they really are regulating from an ideological position!!!

And sadly I had no chance to ask back: Are you Mr. Decressin arguing that we must help government borrowings ex ante, so that government can better help us ex post? As I see it then, when we might really need the government, it will not be able to help us out because by then it would itself already have too much debt… like Greece.

In short, the structural reform most needed to make Europe grow, is to throw out the bank regulators and their risk aversion, and their pro-government and anti-citizens ideology!

The audio: http://www.brookings.edu/events/2014/05/01-european-crisis-aftermath#

Who authorized the regulators to apply their ideology when regulating banks?

How does this square with the frequent accusations of IMF representing the extreme neo-liberalism?

Am I new to the problems of the euro and the eurozone? Judge yourself!

PS. Jean Pisany-Ferry's completely ignored this problem in his book. The approval in June of 2004 of Basel II, is not even listed among the 119 dates and events presented in the “Euro crisis timeline”. A timeline which begins in February 1992 with the signing of the Maastricht Treaty and ends on December 18, 2014, with the European Council reaching an agreement on the Single Resolution Mechanism.

Houston, we’ve got another problem: Our central bankers’ are flying blind

In February of 2011, Alan Greenspan gave the keynote address during an event at the Brookings Institution on “Reforming the Mortgage Market”. He ended his speech by expressing that he really would like to know what the real mortgage rates would be in the US, without any of those many distortions which affect it.

I got no chance to question him in public but at the end of the event I managed to ask him: 

“Mr. Greenspan, would you likewise not want to know what the most important interest rate in the market, the interest rate on US Treasuries would be without distortions?” 

He looked at me and asked “What do you mean?” I told him: “I mean that interest rate which would result if banks were required to hold as much capital when lending to the US Treasury as they are when lending to a US citizen, a small businesses or entrepreneurs.” I felt for a moment Greenspan nervously doubting, but then he answered “Yes, I would!” 

And that is one of the sad facts today. Central banks, in the US and Europe, are basically flying blind, because they have not the faintest idea about what their real Treasury rates would be without the regulatory subsidies in favor of public borrowings they have introduced. 

And then we hear so much nonsense about this being a great time for public indebtedness because rates are so low… Rates low? Has no one factored in all the opportunity costs for the economy and job creation of all those small businesses and entrepreneurs who did, and do still not have access to bank credit in competitive terms? 

PS. So, Houston, we sure have got ourselves another serious problem.

PS. Might someone at long last be waking up?