My tweets on “How the Basel Committee doomed our bank systems and our economies”

The Basel Committee doomed our bank systems and our economies.

For around 600 years risk adverse bankers had, not always successfully, tried to do their best to clear for perceived credit risks, by means of risk adjusted interest rates and the size of bank exposures. 

When what bankers had perceived as risky turned out to be even more risky, since the exposures were generally quite small, it hurt but banks could manage. 

When what bankers perceived as safe turned out to be risky, since the exposures were then very large, big crises often ensued. 

But then, starting in 1988 with Basel I, and really exploding in 2004 with Basel II, risk adverse regulators decided they also wanted to clear for those same perceived credit risks, and to that effect introduced risk weighted bank capital requirements.

In the softest words I can muster, that was extremely dumb. As bank supervisors they should be almost exclusively concerned with bankers not perceiving the credit risks correctly. Instead they bet our bank systems on that bankers would perceive credit risks correctly.

Banks everywhere were then taken out of the hands of savvy loan officers, and placed in the hands of creative equity minimizing financial engineers, who then ably marketed the nonsense that more bank capital hindered bank lending and was therefore bad for the real economy 

The 2008 crisis caused by AAA rated securities backed with mortgages to the US subprime sector, with which European banks and US investment banks were allowed to leverage 62.5 times with these, should have loudly reminded them about the dangers of the “safe”. 

But regulators refused to admit their mistake and kept risk weighting in Basel III.

The result is an ever increasing dangerous overcrowding of “safe harbors” and the abandonment of the “riskier oceans.

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

And those who used to populated safe harbors, like insurance companies, pension funds, personal saving accounts and other, have been expelled to the risky oceans, confronting loans to leveraged corporates, emerging markets and others for which they're less prepared than bankers

To sum it up, risk-weighted bank capital requirements guarantees especially large crises, resulting from especially large exposures to what’s perceived especially safe, and is held against especially little capital. 

Let’s get rid of these regulators… now!

http://perkurowski.blogspot.com/2016/04/here-are-17-reasons-for-why-i-believe.html

And not only are they dangerously bad regulators… by decreeing risk weights of 0% for the sovereign and 100% for the citizens, they also evidence being dangerous statist/communist regulators.

http://perkurowski.blogspot.com/2019/09/financial-communism.html

PS. My 2019 letter to the Financial Stability Board

PS. My 2019 letter to the IMF

J’Accuse[d] the Basel Committee for Banking Supervision (BCBS) a thousands times, but I am no Émile Zola and there’s no L’Aurore

J’Accuse the Basel Committee of setting up our bank systems to especially large crises, caused by especially large exposures to something perceived as especially safe, which later turns into being especially risky, while held against especially little capital.

My letter to the Financial Stability Board

J’Accuse the Basel Committee for distorting the allocation of bank credit to the real economy by favoring the sovereign and the safer present, AAA rated and residential mortgages, while discriminating against the riskier future, SMEs and entrepreneurs.

My letter to the International Monetary Fund

A question to the Fed: When in 1988 bank regulators assigned America’s public debt a 0.00% risk weight, its debt was about $2.6 trillion, now it is around $22 trillion and still has a 0.00% risk weight. When do you think it should increase to 0.01%?

My letter to the Financial Stability Board was received.

http://www.fsb.org/wp-content/uploads/Per-Kurowski.pdf

From: Per Kurowski

Sent: 18 March 2019 19:16

To: Financial Stability Board (FSB)

Subject: SME financing evaluation

I have not found sufficient strength to sit down and formally write up my comments, because I feel I would just be like a heliocentric Galileo writing to a geocentric Inquisition.

The Basel Committee’s standardized risk weights are based on the presumption that what is ex ante perceived as risky is more dangerous to our bank system.

And I hold a totally contrarian opinion. I believe that what is perceived a safe when placed on banks balance sheets to be much more dangerous to our bank system ex post than what is perceived ex ante as risky; and this especially so if those “safe” assets go hand in hand with lower capital requirements, meaning higher leverages, meaning higher risk adjusted returns on equity for what is perceived safe than for what is perceived as risky.

The following Basel II risk weights are signs of total lunacy or an absolute lack of understanding of the concept of conditional probabilities.

AAA to AA rated = 20%; allowed leverage 62.5 times to 1. Below BB- rated = 150%; allowed leverage 8.3 times to 1

The distortion the risk weighting creates in the allocation of credit to the real economy is mindboggling. Just consider the following tail risks.

The best, that which perceived as very risky turning out to be very safe. The worst, that which perceived as very safe turning out to be very risky.

And so the risk weighted capital requirements kills the best and puts the worst on steroids... dooming us to suffer an weakened economy as well as an especially severe bank crisis, resulting from especially large exposures, to what was especially perceived as safe, against especially little capital.

In relative terms all that results in much more and less (see note) expensive credit to for instance sovereigns and the purchase of houses, and less and more expensive credit to SMEs

I am neither a banker nor a regulator but I do believe that the following post helps to give some credibility to my opinions on the issue. And, as a grandfather, I am certainly a stakeholder.

http://subprimeregulations.blogspot.com/2004/11/some-of-my-early-public-opinions- on.html

And here is a more detailed list of my objections to the risk weighting

http://perkurowski.blogspot.com/2016/04/here-are-17-reasons-for-why-i-believe.html

Now if by any chance you would dare open your eyes to the mistakes of your risk weighted bank capital requirements and want more details from me, you know where to find me.

Sincerely

Per Kurowski

A former Executive Director of the World Bank (2002-2004) 

@PerKurowski

Note: In the original letter I erroneously wrote "more and more expensive credit to sovereigns" and not "less expensive", but this should be easily understood as a mistake.

PS. FSB keeps avoiding the issue: June 7, 2019 FSB published a Consultative Document: “Evaluation of the effects of financial regulatory reforms on small and medium-sized enterprise (SME) financing” I quote two parts of it.

1. “For the reforms that are within the scope of this evaluation, post-crisis financial regulatory reforms, the analysis, does not identify negative effects on SME financing in general.” 

Comment: The scope of the analysis does explicitly not include pre-crisis financial regulatory reform, like Basel II. When compared to what was introduced in Basel II, the changes in Basel III produced not really that much “more stringent risk-based capital requirements”. Therefore to limit the analysis to the impact of Basel III changes to risk-based capital requirements, is basically to avoid the issue of how these have, especially since Basel II, profoundly distorted the allocation of credit, and negatively affected the financing of SMEs.

2. “There is some evidence that the more stringent risk-based capital requirements under Basel III slowed the pace and in some jurisdictions tightened the conditions of SME lending at those banks that were least capitalised ex ante relative to other banks.”

Comment: That the Basel III risk-based changes, which in my opinion are minor relative to their importance, “tightened the conditions of SME lending at those banks that were least capitalised ex ante relative to other banks” is something to be expected. There, close to the roof, on the margin, is where the risk weighting most affects; think of “The drowning pool”

PS. A letter to the IMF: "The risk weights in the risk weighted bank capital requirements are to access to credit, what tariffs are to trade, only more pernicious.

Here, there is good money to be earned, by just explaining the risk weighted capital requirements for banks to me.

I will pay a US$ cash bonus to the first who manage to extract clear answers from any regulator on two questions that have had me intrigued for a way too long time… so much that many tell me I am obsessive about… which of course I am.

I start with US$ 100 for each one of the answers and increase it by U$10 each month... for some time

US$100 to the first who gets a clear answer from a regulator on: Why do you want banks to hold more capital against what, by being perceived as risky has been made quite innocous, than against what, because it is perceived as safe, is much more dangerous? 

http://perkurowski.blogspot.com/2016/04/here-are-17-reasons-for-why-i-believe.html

And also US$100 to the first who gets a clear answer from a regulator on: Why are banks allowed to leverage much more when financing homes, than when financing the entrepreneurs who could help create jobs needed to pay utilities and service the mortgages?

https://perkurowski.blogspot.com/2018/01/many-of-our-young-will-be-without-jobs.html

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.

  

It behooves us to revise the purposes of our banks, as these are defined by current capital requirements

The lower a capital requirement is, the higher can a bank leverage its equity, the higher is the risk adjusted return on equity it can obtain.

Risk weights of: sovereign 0%, AAA rated 20%, residential housing 35% and unrated SMEs 100%, clearly indicate that the de facto purpose regulators have imposed on banks, is to finance sovereigns, those who already enjoy the lowest risk-premiums, and those buying houses and therefore implicitly house prices. 

Regulators have told us this is so that our banks are made safe. Silly! Our bank systems are never threatened by “risky” SMEs and entrepreneurs, only by that perceived ex ante as very safe and that ex post turns out to be very risky. 

I would expect much more from our banks, like financing development, sustainability and job creation; and I would assume many would agree with me.

If we want that produced by banks, by means of allocating credit as efficiently as possible to the real economy, then we should make sure every single bank asset, except for cash, generates exactly the same capital requirement.

Now if regulators absolutely insist on nudging, so to be perceived as earning their pay, then perhaps they could base their capital requirements on how the asset helps to finance development, sustainability and job creation.

And, if regulators want to be really sophisticated about it, then the could even fill each box of a purpose/credit risk matrix with individual capital requirements… always of course remembering the golden rule of the riskier it seems ex ante the safer it is ex post. 

PS. Perhaps the capital requirements could even be slightly based on gender, so as to give women some compensation for all the disadvantages we are told they suffer. (Psst some tell me that loans to women also carry less risk)

The litmus test any aspiring central banker or bank regulator should have to pass

Fact: Banks are allowed to leverage more with assets considered safe, like loans to sovereigns, the AAArisktocracy and mortgages, than with assets considered risky, like loans to SMEs and entrepreneurs.

So ask the candidates:

Does that mean “the safe” have even more and easier access to bank credit than usual; and “the risky” have even less and on more expensive terms access to bank credit than usual?

If the answer is no, disqualify the candidate.

If the answer is yes, then ask: 

Do you think that might dangerously distort the allocation of bank credit to the real economy? Or impede QE stimulus flow to where it could be most productive?

If the answer is no, disqualify the candidate.

If the answer is yes, then ask: 

In terms of what can pose the greatest risk to the bank system, would you agree with Basel II’s risk weights of 20% for what is rated AAA to AA and 150% for what is rated below BB-?

If the answer is yes, disqualify the candidate.

If the answer is no, then ask: 

Do you agree with a 0% risk weighting of sovereigns?

If the answer is yes, the candidate should be classified as an incurable statist, not independent at all, and accordingly dismissed.

If the answer is no, then one could proceed applying any other criteria considered relevant.

As a relevant criteria, the way the world looks, being a lucky person seems a quite valid one.

PS. How many of those currently in central banks, or in the Basel Committee for Banking Supervision, or in the Financial Stability Board would pass this test?

@PerKurowski

AI Watson, would you ever feed robobankers those algorithms current bank regulators feed human bankers?

The normal real world rules banks had to follow for about 600 years before 1988, in order to become and remain successful bankers, was to while carefully considering their portfolio, to lend or invest in whatever they perceived would produce them the highest risk adjusted returns on equity. One dollar of equity lost in an operation perceived as risky would hurt just as much as a dollar lost in an operation perceived as safe. 

And even though bankers in general suffered from a risk aversion bias, expressed well by Mark Twain’s “a banker is one to lend you the umbrella when the sun shines and wanting it back when it seems it could rain”, that obviously served our economies well. 

As John Kenneth Galbraith argued, even when in some cases “Banks opened and closed doors and bankruptcies were frequent, as a consequence of agile and flexible credit policies, the failed banks left a wake of development in their passing.”

But then came the Basel Committee for Banking Supervision, and out of the blue decided to assume bankers did not perceive risks; and so came up with their risk weighted capital requirements. These instructed banks, with no consideration to their portfolio, to hold more capital (equity) against what is perceived risky and less against what is perceived safe.

As a consequence of this bankers had to morph from being mainly risk perceivers into also having to be capital (equity) minimizers. Being able to leverage more the “safe “ than the “risky” allowed them to obtain higher risk adjusted returns on equity lending with the safe than with the risky.

As a consequence we have already suffered major bank crisis resulting from excessive exposures to what was erroneously perceived, decreed or concocted as safe, like AAA rates securities and sovereigns like Greece.

As a consequence of not enough lending to the “risky”, like SMEs and entrepreneurs, development is coming to a halt.

Since regulators refuse to listen to little me, I can’t wait for IBM’s Watson developing lending and investment algorithms for robobankers. These would help show bank current regulators how dangerously wrong they are.

Watson would understand that with current distortions banks go wrong even if they perceive the risks absolutely correct.

Watson would understand that what is perceived risky ex ante becomes by that fact alone less dangerous ex post; and that what is perceived safe ex ante becomes by that fact alone more dangerous ex post.

“May God defend me from my friends, I can defend myself from my enemies” Voltaire.

Regulator Watson, in contrast to the Basel Committee, would not be looking in the same direction the bankers look

PS. Here on the regulators' confirmation bias

PS. Here my letter to the Financial Stability Board

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

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

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

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

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

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

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

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

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

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

http://theaaa-bomb.blogspot.com

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Regulators looking after the same risks bankers look at

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.

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!

Task Force on Climate Related Financial Disclosures is clueless about the allocation of resources to the economy.

The Task Force on Climate Related Financial Disclosures begins the summary of its “Final TCFD Recommendations Report” with: 

“One of the essential functions of financial markets is to price risk to support informed, efficient capital-allocation decisions. Accurate and timely disclosure of current and past operating and financial results is fundamental to this function, but it is increasingly important to understand the governance and risk management context in which financial results are achieved. The financial crisis of 2007-2008 was an important reminder of the repercussions that weak corporate governance and risk management practices can have on asset values. This has resulted in increased demand for transparency from organizations on their governance structures, strategies, and risk management practices. Without the right information, investors and others may incorrectly price or value assets, leading to a misallocation of capital.”

Efficient credit and capital allocation to the real economy is indeed the most essential function of financial markets, but let me here inform TCFD that bank regulators, like the Basel Committee and the Financial Stability Board gave zero importance to that. Had they done so, they would never ever have come up with the risk weighted capital requirements for banks, which make that impossible. 

“The financial crisis of 2007-2008 was an important reminder of the repercussions that weak corporate governance and risk management practices can have on asset values”

No! It was an important but ignored reminder of what dangers lie in allowing regulators to regulate within a mutual admiration club breeding intellectual incest. 

When you allow banks to leverage more their equity with what is ex ante perceived, decreed or concocted as safe, so that banks can earn higher risk adjusted returns on equity on what’s “safe”, then you will end up, sooner or later, with dangerous excessive bank exposures, against little capital, to what’s “safe”, like AAA rated securities backed with mortgages to the subprime sector and loans to sovereigns like Greece, but that ex post can turn out to be very risky.

Who the hell authorized regulators to direct (distort) the allocation of bank credit that way?

Listen up Mark Carney, Michael Bloomberg and you other! Any risk, even if perfectly perceived, if excessively considered, causes the wrong actions. Let banks be banks!

Let me end this comment by just asking: How many profiteering climate-change consultants will now banks have to employ in order to fulfill what is requested by this report?

Want some more detailed objections to the idiotic current bank regulations? Here!