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.

Europe beware, you´ve got yourself a very sad bunch of systemic risk experts reviewing the systemic risks of your banking system.

In the so posh sounding European Systemic Risk Board’s Advisory Scientific Committee´s report titled “Is Europe overbanked?” dated June 2014, we read:

“Large banks were able to increase their leverage - and therefore their return on equity (unadjusted for risk) – while complying with risk-based regulatory ratios”

And that is not correct... the lower risk weights in the risk-weighted capital requirements for banks, translates into allowing banks to hold much less capital against assets perceived as “absolutely safe”, which signifies that banks can leverage their equity much more with assets perceived as “absolutely safe”, and therefore earn much higher expected RISK-ADJUSTED returns on equity when lending to “The Infallible” than when lending to “The Risky.”

And this has made a true mockery of the report´s: “Financial development can also foster growth by allocating capital more efficiently, channeling resources to better projects and thus boosting total productivity”

Current risk weighted capital requirements signify that resources will be transferred in function of ex-ante perceived credit risks, which has of course not one iota to do with guaranteeing the transfer of these resources to better projects that can boost total productivity.

And in this respect, as I have been arguing for more than a decade, the risk weighted capital requirements represents the largest possible systemic risk to our banks and to our economies... as it basically prohibits much of the risk-taking necessary for our economies to move forward and for our descendants to have a future. 

As an example January 2003 in a letter published by FT I wrote “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds. Friend, please consider that the world is tough enough as it is.”

And yet, now soon 7 years after the crisis broke out, that systemic risk has not even been identified by those who allow themselves to be called experts in systemic risk. How come?

The report refers to “some reason, such as badly designed prudential regulation” in order to get to “banks’ rapid expansion into loans secured against residential real estate”

And yet the report does not mention the truly bad design of the prudential regulations that resulted from assigning very low risk weights against loans secured against residential real estate… which meant that banks could leverage much more their equity when giving loans secured against residential rate… which of course meant that banks would earn much higher than normal relative risk adjusted returns on equity on loans secured against residential real estate… which of course led to an explosion of bank loans secured against residential real estate.

And the report asks “Why has overbanking occurred?” and advances the explanation of “deposit insurance schemes may themselves generate moral hazard. Capital requirements can often be circumvented by banks, especially the largest ones, which have greater capacity to engage in risk-weight manipulation”

Circumvented? Hell no! The regulators allowed banks to hold only 1.6 percent in capital against securities rated AAA which meant authorizing a mindboggling leverage of 62.5 to 1… does as a bank really need to circumvent that? No! What they might need though, is to find some AAA ratings issued by the friendly and human fallible credit rating agencies. 

And let us not even go to the area of bank lending to the “Infallible Sovereigns” where no equity is required and the sky is the limit for bank leverage. In November 2004 FT published a letter in which 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 (sovereigns)?”

And so I must conclude in a: “Europe, beware, you´ve got yourself a very sad bunch of systemic risk experts reviewing the systemic risks of your banking system”

Am I to harsh in my criticism? Absolutely! If this was the first time I criticized. But, considering I have been asking the regulators my questions for more than a decade, all over the web and in hundreds of conferences, and they have never ever dared to give me a straight answer (with one incredible exception) and much less have dared debate me on these issues… I do not feel I am too harsh or too impolite in any way shape or form. 

On the contrary, I feel it is my responsibility to shame them in all the ways I can, so that no regulator dares to act ever again with so much hubris, believing he can be the risk manager for the world.

To finalize… may I kindly suggest these systemic risk experts that their so impressive list of 130 documents referenced does not include the most basic and important document required to understand the mumbo jumbo of financial regulators namely the Basel Committee on Banking Supervision´s Explanatory Note on the Basel II IRB Risk WeightFunctions of July 2005. That this document, has clearly not been reviewed by those preparing the report, is by itself something impossible to understand, unless of course they want to avoid shaming some members in a mutual admiration club.