Five sad musings on the current bank regulations autocratically dictated by central bankers.

It is so hard for me to muster enough interest about central bankers’ monetary policies, while they make these so ineffective by imposing regulations that dangerously distort the allocation of bank credit.

“Credit risk weighted bank capital (equity) requirements” 

translates as 

“Worthy of credit allowed bank capital (equity) leverages”

Their lower bank capital requirements when lending to the government than when lending to citizens, de facto implies bureaucrats know better what to do with credit they’re not personally responsible for than e.g. entrepreneurs... and so are more worthy of it.

Their lower bank capital requirements for banks when financing the central government than when financing local governments, de facto implies federal bureaucrats know much better what to do with credit than local bureaucrats... and so are more worthy of it.

Their lower bank capital requirements for banks when financing residential mortgages, de facto implies that those buying a house are more important for the economy than, e.g. small businesses and entrepreneurs... and so are more worthy of it.

Their lower bank capital requirements for banks when financing the “safer” present than when financing the “riskier” future, de facto implies placing a reverse mortgage on the current economy and giving up on our grandchildren’s future.

And all that for nothing. Those excessive bank exposures that could be dangerous to our bank systems are always built-up with assets perceived or decreed as safe, and never ever with assets perceived as risky.

It’s despairing to see a Federal Reserve not understanding how these bank shareholders’ capital (equity) requirements distort the interest rates e.g., the risk-free rate.

Is all this in accordance to the U.S. Constitution? 

https://subprimeregulations.blogspot.com/2019/07/risk-weights-are-to-access-to-credit.html

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 banks 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 banks 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

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

Mario Draghi, President of the ECB and Chair of the European Systemic Risk Board shows, again, he has dangerous little understanding about the true nature of systemic risks.

“Systemic risk refers to the risk of a breakdown of an entire system rather than simply the failure of individual parts. In a financial context, it captures the risk of a cascading failure in the financial sector, caused by interlinkages within the financial system, resulting in a severe economic downturn.”

I refer to Mario Draghi’s welcome remarks at the third annual conference ofthe European Systemic Risk Board (ESRB), September 27, 2018

1. “The need for high-quality data: Policymakers’ ability to act hinges crucially on the availability of high-quality data. Data allow policymakers to identify, analyse and quantify emerging risks. Data also provide policymakers with the necessary knowledge to be able to target and calibrate their tools and to be aware of possible spillovers, or attempts to circumvent regulations”

a. The more you believe you are in possession of “high-quality data” the more you set yourself up for a systemic risk, like when banks were led by their regulators to believe that risk of assets rated AAA were minimal.

b. The more regulators might be tempted to “target and calibrate their tools” without considering how the markets might already have calibrated and targeted that “high-quality data”, the more they might generate the systemic risk of giving that “high-quality data” excessive consideration. Like when bank regulators, ignoring the conditional probabilities, based their risk weighted capital requirements basically on the same credit risk bankers were already perceiving and clearing for.

2. “Reflecting the targeted nature with which macroprudential policy can be applied, some countries have considered varying implementation by geographical area, to strengthen the impact on local hotspots. These policy actions have helped mitigate movements in real estate prices.”

But trying to contain “hotspots” and not allowing the market to determine the movements of real estate prices contains the clear and present systemic risk of pushing credit into “weak-spots” and not where it could be mots useful for the economy. Like when bank regulators by giving preferential risk weights to the “safe” sovereign and “safe” houses, negates credit to the “risky” entrepreneurs.

3. “Non-bank finance is playing an increasingly important role in financing the economy. Policymakers need a comprehensive macroprudential toolkit to act in case existing risks migrate outside the banking sector or new risks emerge.And that means widening the toolkit so that policymakers are able to effectively confront risks emerging beyond the banking sector.”

No, regulators who have not been able to regulate banks, and caused the 2008 crisis, and caused the tragedy of Greece, have not earned the right to expand their regulatory franchise anywhere.

4. “Conclusion: Policymakers across Europe have proven willing to use macroprudential policy to address risks and vulnerabilities. These measures have helped counter the build-up of risks”

NO! Regulators who still use risk weighted capital requirements based on that what is perceived as risky is more dangerous to our bank system than what is perceived as safe, have no idea about basic macroprudential policies.

NO! Regulators who still believe that with their risk weighted capital requirements for banks they can distort the allocation of credit without weakening the real economy; and who do not understand how dangerously pro cyclical the risk weighted bank capital requirements are, have no idea about basic macroprudential policies.

PS. My views on some systemic risks, as expressed at the Board of the World Bank in 2003.

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

Current bank regulators should undergo a psychological test. They clearly seem to be afflicted by “false safety behavior”

I extract the following from “False Safety Behaviors: Their Role in Pathological Fear” by Michael J. Telch, Ph.D. 

“What are false safety behaviors? 

We define false safety behaviors (FSBs) as unnecessary actions taken to prevent, escape from, or reduce the severity of a perceived threat. There is one specific word in this definition that distinguishes legitimate adaptive safety behaviors - those that keep us safe - from false safety behaviors - those that fuel anxiety problems? If you picked the word unnecessary you’re right! But when are they unnecessary? Safety behaviors are unnecessary when the perceived threat for which the safety behavior is presumably protecting the person from is bogus.”

The risk weighted capital requirements for banks, more perceived risk more capital – less perceived risk less capital, fits precisely that of being unnecessary. If a risk is perceived the banker will naturally take defensive measures, like limiting the exposure or charging higher risk premiums. If there is a real risk that is of the assets being perceived ex ante as safe, but turning up ex post as risky.

The consequences of such false safety behavior by current bank regulators are severe:

They set banks up to having the least capital when the most dangerous event can happen, something very safe turning very risky. 

Equally, or even more dangerous, it distorts the allocation of bank credit to the real economy, it hinder the needed “riskier” financing of the future, like entrepreneurs, in order to finance the “safer” present, like house purchases and sovereigns.

It creates a false sense of security because why should anyone really expect that “experts” picked the wrong risks to weigh, the intrinsic risk of the asset, instead of the risk of the asset for the banking system.

I quote again from the referenced document:

“How do false safety behaviors fuel anxiety? 

There seems to be a growing consensus that FSB’s fuel pathological anxiety in several different ways. One way in which FSBs might do their mischief is by keeping the patient’s bogus perception of threat alive through a mental process called misattribution. Misattribution theory asserts that when people perform unnecessary safety actions to protect themselves from a perceived threat, they falsely conclude (misattribute) their safety to the use of the FSB, thus leaving their perception of threat intact. Take for instance, the flying phobic who copes with their concern that the plane will crash by repeatedly checking the weather prior to the flight’s departure and then misattributes her safe flight to her diligent weather scanning rather than the inherent safety of air travel.” 

In this respect stress tests and living wills could perhaps be identified as “unnecessary safety actions” the “checking of the weather”. 

Finally: “FSBs may fuel anxiety problems by also interfering with the basic process through which people come to learn that some of their perceived threats are actually not threats at all…threat disconfirmation…For this important perceived threat reduction process to occur, not only must new information be available but it also must be processed.”

The 2007/08 crisis provided all necessary information on that the risk weighting did not work, since all bank assets that became very problematic, had in common low capital requirements since they were perceived as safe. And this information has simply not been processed.

Conclusion, I am not a psychologist but given that our banking system operates efficiently is of utmost importance, perhaps a psychological screening of all candidates to bank regulators should be a must. Clearly the current members of the Basel Committee and of the Financial Stability Board, and those engaged with bank regulations in many central banks, would not pass such test.

I feel sorry for them, especially after finding on the web someone referring to "anxiety disorder" with: “I don’t think people understand how stressful it is to explain what’s going on in your head when you don’t even understand it yourself”

PS. Here is a brief summary of the mistakes of the risk weighted capital requirements for banks.

  

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

Ten years ago ECB decided to ignore the benefits of a hard landing and go for kicking the can down the road

In August 2006, when we were already hearing worrisome comments about complex securities linked to mortgages, I wrote a letter to FT titled “The Long Term Benefits of a Hard Landing”. At that moment I had not yet been censored by FT and so they published it.

One year later, when panic about the AAA rated securities backed with mortgages to the subprime sector impacted the financial markets, ECB (and the Fed earlier) decided to ignore that option and go for the politically more convenient short-termish option of kicking the can down the road, with QEs and ultralow interest rates.

It could have worked, if only what had caused the crisis and what hindered the stimuli to flow in the correct directions had been removed. But no, the regulators refused to admit their mistake with the risk weighted capital requirements.

And so here we are, a full decade later, still allowing banks to multiply the net margins obtained more when it relates to assets perceived, decreed or concocted as safe, than with assets perceived as risky, and so obtain higher expected risk adjusted returns on their equity financing the safe than financing the risky.

In a historic analogy, regulators still believe the sun to be circling around the earth; in this case that what is perceived as risky is more dangerous to the banking system than what is perceived as safe.

As a result “safe” sovereigns, AAArisktocracy and residential houses still dangerously get way too much bank credit, while “risky” SMEs and entrepreneurs, way too little to keep our economies dynamic.

Every day we allow regulators like Mario Draghi to regulate based on a flawed theory, the worse for all of us.

But what are we to do when there are so many vested interests in shutting up this the mother of all bank regulation mistakes?

Can you have a neutral interest rate when bank regulations are not neutral?

That theoretical interest rate that neither pushes nor restrains the economy from its natural rhythm of growth, is called the neutral interest rate, and is of course the subject of much interest by central bankers.

But what these bankers never discuss, who knows why, is what happens to this neutral interest rate, if bank regulations are not neutral.

Current risk weighted capital requirements for banks which allow banks to earn higher risk adjusted returns on equity with what is perceived, decreed or concocted as safe, than with what is perceived as risky, are clearly not neutral.

They push bank credit to the “safe” areas and away from the “risky” and that distortion must have a real cost for the economy.

Just for a starter, since the risk-weight assigned to the sovereign is 0%, all those “risky” SMEs and entrepreneurs who will not get credit or need to pay more for it, only because of these regulations that are biased against them, are paying a regulatory tax that is directly subsidizing lower interest rates for the government.

As I have argued many times before … we do not have real risk-free rates, we have subsidized risk-free interest rates.

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.

To lower the real real-interests in order to stimulate the real economy, take away the too costly subsidies of public debt.

Would any serious economist discuss gas prices at the pump ignoring taxes? No!

Would any serious economist discuss milk prices ignoring various subsidies? No!

Then why have almost all serious economists been discussing low real interest rates on public debt ignoring regulatory subsidies? I have no idea!

In 1988, the Basel Accord, Basel I, for the purpose of setting the capital requirements for banks, decided that the risk weight of the sovereign was 0% and that of We the People 100%. 

That would hence mean that banks would be able to leverage much more their equity, and the value of any explicit or implicit government guarantees they received, with loans to the public sector than with loans to the private sector. 

That would hence mean banks could obtain higher risk-adjusted returns on equity when lending to the public sector than when lending to the private sector.

That would hence mean that the interest rates of bank loans to the public sector included a regulatory subsidy.

That would hence mean that the subsidies for the access to bank credit by the public sector was to be paid by taxing the private sector with more restricted or more expensive access to bank credit.

And that should hence have meant that in order to know the real real-rate on public debt, to the nominal rates, we would have to add the cost of the regulatory taxes paid by the private sector.

That has not been done! All references to the interest rates of public debt have been limited to using the nominal rates. That has led experts like Lawrence Summers, Lord Adair Turner, Martin Wolf and many other, to argue that the public sector should take advantage of extraordinary low rates in order to finance public investments, like in infrastructure.

That is very wrong! If we include the economic cost of restricting the access to bank credit over the decade and around the world, for many millions of SMEs and entrepreneurs, the current real real-interests rates on public debt could in fact be the highest ever.

So, if the Fed, ECB, BoE or any other central bank, really wants to lower the interests in order to stimulate the real economy, then they should begin by asking bank regulators to take away those so very costly subsidies of public debt.

Central bankers might start doing this, in the name of equality, since making it harder than necessary for “the risky” to access bank credit, can only help to increase inequality. 

If bank regulators get too anxious and nervous about this, central bankers can (gently) remind them that there has never ever been a major bank crises caused by excessive exposures to what was ex ante perceived as risky. 

But what if the central banker also wears the hat of bank regulator? Then he has a problem he needs to solve… maybe with the help of some outside counseling assistance?

12 years after Basel II, ECB sees faults in risk weighted capital requirements for banks, but still doesn’t get it

ECB has published a document titled “The limits of model-based regulation” ECB Working Paper 1928, July 2016. In it the authors find that risk-weighted capital requirements based on sophisticated models applied by big banks, are basically dangerous and worthless.

Of course that regulation is worthless, it does not serve any useful purpose, and only increases the probabilities of financial instability.

But from its “Non-technical summary” it is harrowing to see that they still do not fully understand why these risk weighted capital requirements are dangerous; not only for the big banks with their models, but also for the smaller that apply the standard approach risk weights declared by the Basel Committee; and also, primarily, for the real economy.

For a starter it declares: “In recent decades, policy makers around the world have concentrated their efforts on designing a regulatory framework that increases the safety of individual institutions as well as the stability of the financial system as a whole.”

And so the first observation is: Who gave policy makers the right to concentrate on designing a regulatory framework that completely ignores whether the allocation of bank credit to the real economy is efficient or not? Is the real economy to serve banks or are the banks to serve the real economy? “A ship in harbor is safe, but that is not what ships are for.” John A Shedd, 1850-1926 

Then it states: “an important innovation has been the introduction of complex, model-based capital regulation that was meant to promote the adoption of stronger risk management practices by financial intermediaries, and ultimately to increase the stability of the banking system”... “banks that opted for the introduction of the model-based approach experienced a reduction in capital charges and consequently increased their lending by about 9 percent relative to banks that remained under the traditional [standard risk weights] approach”... “Back-of-the-envelope calculations (abstracting from risk-based pricing of the cost of capital) suggest that underreporting of PDs allowed banks to increase their return on equity by up to 16.7 percent”

How come regulators believed the adoption of “stronger risk management practices by financial intermediaries” would trump the maximization by banks of their risk-adjusted returns on equity? This is like given children a book with indication of calories and expecting them to stay away from the chocolate cake. Worse, in the case of the big banks applying their internal models, it was like allowing the children to calculate on their own the calories of the chocolate cake they desire. How mind-boggling naive are regulators allowed to be?

From the conclusion “Certainly, one would expect less of a downward bias in risk estimates if model outputs were generated by the regulator and not the banks themselves” one could believe the authors favor the standard approach risk weighting. 

Of course that is better than the sophisticated modelling by the big banks, which only guarantees Too Big To Fail Banks. But the all the principal faulty characteristics of the whole risk weighting process remain intact even then... and are still ignored:

Like why basing capital on ex ante perceived credit risks, when all major bank crises have resulted either from unexpected events or excessive exposures to what was ex ante perceived as safe?

Like why if banks by the size of the exposures and interest rates already clear for perceived risk, should they also be cleared for in the capital? Do not regulators understand that any risk, even if perfectly perceived, leads to the wrong actions if excessively considered?

Earlier, on the same issue

And like so many other whys?

Here follows my linked four tweets to bank regulators

The ex post risk of Basel Committee’s bank capital requirements, based on models based on ex ante risk perceptions, is huge!

All these capital requirements do is to seriously distort the allocation of bank credit to the real economy, for no good purpose at all.

Bank capital requirements should be based on ex post risks that considers the risks of models based on ex ante risks perceptions.

Mario Draghi, Mark Carney, Stefan Ingves, Janet Yellen, Martin Gruenberg...  Capisci?

When and where did the last bank crisis resulting from excessive exposures to something ex ante believed risky occur?

I don't know. Ask the regulators in the Basel Committee on Banking Supervision and the Financial Stability Board. 

I mean they must have much data on this because, without it, why would they impose credit risk weighted capital requirements for banks, knowing that carried the huge cost of distorting the allocation of bank credit to the real economy?

I mean that if they use the theorem that what's perceived as risky is riskier to the bank system than what is perceived as safe, then they are indeed using a loony theorem.

Or did they not look for the data?  Or did they not understand it?

ECB, Single Supervisory Mechanism (SSM), with respect to banks, still pisses out of the pot; and McKinsey keeps mum

The declared supervisory priorities for 2016 of ECB's Single Supervisory Mechanism (SSM) with respect to banks are: “(i) business model and profitability risk, (ii) credit risk, (iii) capital adequacy, (iv) risk governance and data quality, and (v) liquidity”

As you can see, ECB still does not care one iota about the allocation of bank credit to the real economy. Not one single indication of trying to figure out what should be on banks’ balance sheets and is not.

And as you can see, ECB still thinks that if it only can make banks stay away from what is ex ante perceived as risky, all will be fine and dandy. It has no idea that what caused all bank crises has been, either unexpected events, like currency crises, or excessive exposures to something erroneously perceived ex ante as absolutely safe… never ever what was ex ante perceived as risky.

And leading consulting companies in the world, like McKinsey, play along and don't say a word, probably because they expect to profit hugely from the so inept bank regulators.

As far as consultancies go, bank regulations is the new piñata in town.

You want to know what I am talking about? Serve yourself a good cognac and read this.

Wake up! Our banks are regulated by highly unprofessional technocrats; all members of a small mutual admiration club

Could there be something more dangerous to the real economy, and to banks, than distorting the allocation of credit? Not really.

And yet that is what the current batch of bank regulators did, without even considering that possibility a factor. They did not even care about it.

They imposed risk weighted capital (equity) requirements for banks. More ex ante perceived risk more capital – less risk less capital.

With that they allowed banks to leverage their equity more when lending to ”the safe” than when lending to ”the risky”.

With that they caused banks to be able to earn higher risk adjusted returns on equity on assets perceived as safe than on assets perceived as risky.

And so of course the banks are lending more than normal to those who already had easier and cheaper access to bank credit, ”The Safe”, like the sovereigns (governments) and members of the AAArisktocracy.

And so of course banks are lending less and relatively more expensive than usual to those who already found it harder and more expensive to access bank credit, ”The Risky”, like the SMEs and entrepreneurs.

And you ask how the hell did this happen? There are many explanations but the most important one was that they regulated without even asking themselves what was the purpose of those banks they were regulating.

And if that is not unprofessional what is?

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

And to top it up they have not made our banks safer, since never ever do major bank crises result from excessive exposures to something perceived risky, these always result from excessive exposures to something perceived or deemed to be safe when booked... you see even the safest harbor can become dangerously overpopulated.

We must rid ourselves from these lousy and already very proven failed bank regulators. Urgently!

When will judges in Europe or in America drag bank regulator X in front of a court, in order to ask these questions?

Judge: Is bank capital to be there primarily to cover for unexpected losses?

The regulators’ expected answer: “Yes your honor”

Judge: What has more potential to deliver unexpected losses that which is perceived as safe, or that that is perceived as risky?

The regulators’ expected answer… after a while: “Perhaps that which is perceived as safe your honor”

Judge: What has caused major bank crisis, excessive exposures to what was perceived as risky or excessive exposures to what was wrongly perceived as safe?

The regulators’ … after a while, in a very low voice: “The latter your honor”

Judge: So why have you imposed higher capital requirements for banks for what is perceived as risky than for what has perceived as risky?

The regulators’ possible answer: “That was not my idea your honor… it was probably some consultant, and it sounded so logical; more risk more capital - less risk less capital”

The judge: But don’t banks already consider credit risks when they set their interest rates and amounts of exposure?

The regulators’ possible answer: “Yes your honor but we want to be doubly sure they have the right incentives to avoid credit risks.”

Judge: Do you understand how that distorted the allocation of bank credit to the real economy and hindered the fair access to credit of those perceived as risky like SMEs and entrepreneurs?

The regulators’ possible answer: “Yes your honor but our responsibility was exclusively to the safety of the banks and not the real economy.”

Judge: Do you understand how many young persons could now go without a job in their whole lives only because of that distortion?

The regulators’ possible answer: “Your honor, my lawyers have advised me not to answer that.”

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 Mario Draghi. For Europe’s good, why not take a sabbatical year and do all it takes for you to understand the RWCR?

The citations below are extracted from the speech “Cross-border markets and common governance” delivered by Mario Draghi, President of the ECB, during the Bank of England Open Forum, London, 11 November 2015.

These evidence that the former Chair of the Financial Stability Board, does yet not understand what caused the current crisis, namely the distortion in banks assets allocation to the real economy produced of Basel II’s risk weighted capital requirements for banks (RWCR); more ex ante perceived risk, more capital – less risk, less capital.

Draghi: “To reap the benefits of openness, markets require appropriate governance. Indeed, a market stipulates not just the freedom to take part in the market, but also the means to protect that freedom. That means the confidence that contracts entered into will be enforced. It means the assurance that the rules of fair competition will be upheld, that property rights will be respected, that standards and codes will be applied properly. It means, in short, the Rule of Law.”

Mr. Draghi: The RWCR violated directly the rules of fair competition in the markets for bank credits. These allow banks to earn higher risk adjusted returns on equity on assets perceived as safe than on assets perceived as risky. As a consequence those perceived as safe and who already pay lower interest rates and have access to more bank credit are, because of the RWCR, treated even better, in direct detriment to the fair access to bank credit of those perceived as risky. And negating the risky fair access to bank credit is a prime inequality driver. 

Draghi: “For financial markets this is especially important given their inherent fragility. If rules and standards are not effectively applied, it can produce information asymmetries and other destabilising forces which, in turn, lead to sudden reversals of confidence in the market. We have seen in the past how markets have run ahead of regulation leaving them vulnerable to such dynamics.”

Mr. Draghi: Those RWCR produced gigantic information asymmetries and destabilising forces. Go back and read all the specialized newspaper that spoke of well capitalized banks, like of a 10 to 1 leverage, without understanding that this was based on risk-weighted assets and that their real leverage was often 50 to 1.

Draghi: “Here is one illustration: during the crisis, the market for securitised assets was all but destroyed by a collapse of confidence. Lack of oversight allowed excesses to be committed and market abuse to take place” 

Mr. Draghi. The fact that Basel II of June 2004 allowed banks to hold those securities against only 1.6 percent in capital if they achieved an AAA to AA rating; which means an almost unimaginable allowed leverage of 62.5 to 1, provided the incentives for excesses and market abuse to be committed. Before that there had been mortgages to the subprime sector for many decades, without these causing any problems.

Draghi: “Securities that were previously deemed safe, certainly with some measure of complacency and too much blind confidence, turned out to be very unsafe indeed, and imparted significant losses on their holders.”

Mr. Draghi: Securities or loans "that were previously [ex ante] deemed safe, certainly with some measure of complacency and too much blind confidence, and turn out [ex post] to be very unsafe” is precisely the stuff all major bank crises in history are made of. Show us one bank asset that was perceived as risky when it was placed on the balance sheets and that amounted to such an importance that it caused a major bank crisis? There is none! 

Draghi: “What is also unfortunate is that the subsequent attempts to re-regulate that market have threatened to undermine the parts that are beneficial to many. There was too much opacity as to the nature of the assets underpinning asset-backed securities, too damaging a breakdown of confidence in the integrity of those who packaged and sold them. And the immediate temptation of regulators was to impose punishing capital charges on holdings of asset-backed securities, independent of their individual characteristics, mixing the wheat with the chaff.”

Mr. Draghi. Regulators should not substitute for the markets. Let the market value the individual characteristics of the wheat and the chaff. At this moment all the stimulus to the economy are being dangerously wasted because regulators have decided, with their risk weights to treat the “risky” SMEs and entrepreneurs as chaff, and not as the nutrient and for the economy indispensable wheat they represent. 

Mr. Draghi the capital of banks is to cover for unexpected losses, and that is something explicitly accepted by the regulators. And so here follows some basics in risk management you and your colleagues could benefit from knowing:

It does not make any sense setting what is to cover for the unexpected based on expected credit losses already cleared for.

The RWCR doubled up on credit risk; and any risk, even if perfectly perceived, results in the wrong actions if excessively considered.

The regulators concerned themselves with the risks of bank assets while their worry should have exclusively been on how banks manage the risks of those assets.

You allowed big banks to decide on the capital required by using risk models. That was like telling your kids they can pick anything they want from a menu of ice-cream chocolate cake, spinach and broccoli. Is that a market?

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

Motorcycles are riskier than cars, but car accidents cause more deaths than motorcycle accidents.

It is not by telling banks to avoid risks that we can live up to that holy intergenerational bond Edmund Burke spoke of.

Mr Mario Draghi. For the good of Europe, why do you not take a sabbatical year to reflect on this? You said you were willing to do all it takes.

Hopefully Mr Draghi you would end up understanding that the biggest systemic risks for banks are always imbedded in the assets perceived as the safest or so safe that all must have them; and that excessive risk aversion is about the riskiest there is for the economy...