Three letters in June 2004

1st letter 

Basel, June 2004 

Dear Bankers 

We are fed up with you getting into so much trouble, and us being blamed for it. Therefore, and as we know that incentives matters, we will allow you, with our Basel II regulations, to hold much less capital when you do lending or investing business with those our expert consultants the credit rating agencies consider as The infallible, than when you do business with The Risky. 

Since that will allow you to obtain immensely higher returns on equity than what is usual in banking, and so be able to pay yourself much higher bonuses, we are sure to count on your full cooperation. 

Yours sincerely, 

The Bank Regulator, of the Basel Committee for Banking Supervision 

2nd letter 

America and Europe, June 2004 

Dear Bank Regulator 

Many thanks for Basel II! 

You can sure count with our fullest cooperation implementing it and in fact we already started to anxiously look around for (and some of use even create) AAA rated business.

Yours sincerely, 

The Bankers; mostly on behalf of the larger soon to be even larger banks 

3rd letter 

Washington, June 2004 

Dear Bank Regulator 

On behalf of my former and future clients, the not-so-good rated and unrated small businesses and entrepreneurs everywhere, “The Risky”, let me express my deepest concern with the Basel II you have just enacted. 

The pillar of those regulations is that banks will be able to hold much less capital when doing banking business with “The Infallible” than when doing so with “The Risky”. That means, of course, that banks will obtain much higher comparative risk adjusted returns on their equity when doing business with “The Infallible” than when doing business with “The Risky”. And that, pardon my sincerity, I find to be both stupid and obnoxious. 

First, my clients, “The Risky”, because bankers always tend to be very careful when doing business with them, have never ever caused a bank crisis. On the contrary, since all major bank crises have always resulted from excessive bank exposure to what was thought to be a member of “The Infallible”, your regulations will only guarantee that the resulting bank crises will be even larger than major. 

Second, the fact that those ex-ante considered as “The Infallible” will be treated so favorably, increases the chances of them becoming, ex post, “The Risky”; and with that that banks will find themselves standing naked with no capital at all in the midst of the next major crisis. 

Third, since credit raters are human, there is an immense danger in giving excessive credence to credit rating agencies, as for them being able to determine with sustainable preciseness who are “The Infallible” and who are “The Risky”. 

Fourth and most importantly, let me remind you that “The Infallible” of today have almost always been “The Risky” of yesterday and so, if you persists in regulations that favor those who built the past and discriminate against those building the future, you must understand that for a more systemic and larger trouble than ordinary bank troubles...  and that no bank can survive standing in the middle of the rubble of huge economic descent.

Yours sincerely, 

Per Kurowski 

An Executive Director of the World Bank (mind you, only one of 24)

Bank regulations, like American Football, or soccer, cannot only be defensive, it needs an offensive too

I cannot hold myself to be an expert on American Football, in fact I believe I have never ever thrown or received a real American football, but, that said, I am absolutely sure that any team who concentrated just on defense, would not go far. 

And that is what is happening with our banks. The bankers, defensively, consider the perceived risks of default of their clients, when deciding whether to lend or not, how much, at what rates and under what terms. But then came the regulators, and instead of acting as the umpires they should be, they also wanted to be defensive coaches, and used the same perceived risks in order to defensively set the capital requirements for the banks, more risk – more capital, less risk – less capital… and no one really cared one iota about the offensive, namely how banks are to allocate efficiently our economic resources.

And as a consequence, defensive bank plays, like lending to and investing in what is perceived as absolutely safe, “The Infallible”, was made so profitable in terms of return on equity so that these plays, and the defensive players, completely took over the game; while offensive plays, like lending to “The Risky”, like the small businesses and entrepreneurs, and offensive players, like community banks,  were completely ignored and abandoned. And, of course, it all lead to disastrous results. 

What a lunacy! Head coaches, players, umpires and most of the public are all, like on a ship of fools, still not able to even see what is happening, and many, in “the land of the brave”, begging for even more defensive plays; leaving me and some other few crazy minds all alone in the stands, monotonously shouting: “What about the offensive?”, “What about the jobs?” 

Friends, in American Football (and Europe, in soccer too) you can never win if you do not dare to go on the offensive with whatever risks that entails…capisce?

The two truths our current unwise bank regulators blithely ignored, and therefore screwed up our banking system, and our economies

1st truth: 

When you give someone a favor you are, often unintentionally, de facto, disfavoring the one not receiving that favor. 

So when regulators embraced that paradigm that makes the capital requirements for banks a function of ex-ante perceived risks, more risk more capital - less risk less capital, they favored “The Infallible” and disfavored “The Risky”. And that stopped our economies in their tracks. 

Because, when you favor access to bank credit for those who are already favored, those who have already made it and do not seem risky, “The Infallible”, and, thereby, additionally disfavor the access to bank credit of those who are already disfavored, those who have not yet made it, “The Risky”, small businesses and entrepreneurs, you are, in essence, subsidizing the past and taxing the future. 

But, it gets worse 

2nd truth: 

When you favor the access to bank credit to someone or somewhat more than what they should normally be able to access it, given their risk-profile, you are, de facto, guaranteeing it will be receiving too much credit and, de facto, sooner or later become extremely risky, no matter how infallible it initially might have been.

Conclusion:

We must get rid of these regulators, they are not wise enough. We can’t afford them! They are completely incapable of taking us out of the hole they dug and placed us in. They will only dig us deeper and deeper into it.

Banks regulators, please, more humility… and also read more Hayek

Friedrich Hayek in his essay of 1945 “The use of knowledge in society” wrote the following: 

“The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. 

The economic problem of society is thus not merely a problem of how to allocate "given" resources—if "given" is taken to mean given to a single mind which deliberately solves the problem set by these "data." It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge which is not given to anyone in its totality. 

This character of the fundamental problem has, I am afraid, been obscured rather than illuminated by many of the recent refinements of economic theory, particularly by many of the uses made of mathematics.” 

And this truth was completely ignored by our current generation of bank regulators, who arrogantly thought themselves capable to act as the risk managers for the whole world, and so haphazardly set their risk-weights which determined the effective capital requirements for banks, based on perceived risks.

Of course that distorted it all and the banking system blew up… but these regulators still think they are up to the task of managing risks… As I see it the only possibility we have to make them humbler, at least for a while, seems to be, unfortunately, humiliating them.

Why?

Why if they call bankers immoral greedy gangsters, or worse, there is almost no protest, but, if I simply call regulators dumb, because I hold their dumb regulations to be directly responsible for the current crisis, I then get so many admonishments to be more polite? 

Is it that bank regulators are of a kinder and gentler breed, and so therefore we must treat them with more delicacy? Well forget it! Too much is at stake!

I am not giving up on making the thick as a brick bank regulatory establishment, understand.

By allowing banks to hold much less capital when lending to “The Infallible” than when lending to “The Risky”, the regulators allow banks to earn immensely higher risk-adjusted returns on their equity when lending to “The Infallible” than when lending to “The Risky”.

That is very dangerous because it makes “The Infallible”, those including sovereigns and triple-A rated, so much riskier for banks than what they normally are… remember that it is excessive exposures to “The Infallible” which always been the origin of major bank crises.

That entirely distorts the economic efficient resource allocation banks are supposed to do; for instance by disfavoring more than normal the lending to “The Risky”, the group that includes as members, small businesses and entrepreneurs.

And, that regulatory discrimination in favor of those normally already favored, creates disfavors against those already disfavored, and is therefore also, simply put, odiously immoral.

The regulatory destruction of the 1 plus the 99 percent

Chrystia Freeland begins her thought provoking “The self destruction of the 1 percent”, New York Times, October 13, describing how Venice became one of the richest cities:

“At the heart of its economy was the colleganza, a basic form of joint-stock company created to finance a single trade expedition. The brilliance of the colleganza was that it opened the economy to new entrants, allowing risk-taking entrepreneurs to share in the financial upside with the established businessmen who financed their merchant voyages.”

But then the wealthy closed up, with La Seratta, which sounds like a quite natural reaction from those who have more interest in defending what they’ve got than what they could get. And that began to hinder the opportunities for new entrants, and, of course, it all went downhill from there.

Yes, that certainly explains a lot of what happened, and much of a “La Seratta” is most certainly present in the USA, as it is in most other places where truly important fortunes or powers have been accumulated by some few plutocrats or some few of a party nomenklatura.

And, Freeland concludes her article with “The irony of the political rise of the plutocrats is that, like Venice’s oligarchs, they threaten the system that created them.”

But, to give you my own perspective on this issue, and on its possible relation to the current crisis which is indeed threatening all of us, most plutocrats included, I would like to ask:

What would have happened if a group of prominent Venetian bureaucrats, acting as colleganza regulators, in order to safeguard the investors, had decided to impose a tax on any venture perceived as risky, and pay a subsidy to any venture perceived as particularly safe?

The simple answer is that Venice would not have become one of the wealthiest cities, or, if already wealthy when these regulations were imposed, would not have remained a wealthy city, and this, no matter how much a L'Apertura reigned. 

What is now bringing down our economies, is precisely some truly loony bank regulations which, by their capital requirements and risk-weights based on ex-ante perceived risk, hugely favor the access to bank credit of “The Infallible” and thereby hugely discriminates against “The Risky”.

And that immoral discrimination gave the banks incentives to stay away from taking manageable risks on “The Risky”, like the small businesses and entrepreneurs, those who never ever caused a major bank crisis, and to instead take on unmanageable risks on “The Infallible”, like the AAA rated, real estate, or some “absolutely safe sovereigns”.

And here we are. Of course we need to control our plutocrats, but we also need to control our modern bank regulatory mandarins. I sincerely doubt they had to take a sufficiently rigorous Imperial Examination before they've got started; and neither can I understand who really authorized them to do what they did.

Bank Regulator! How dare you distort the markets this way! Look at what you’ve done! And you’re not even sorry. Shame on you!

Arrogant regulatory busybodies thought they could stop bank crisis forever, by setting capital requirements for banks based on perceived risk. The higher the perceived risk, the higher the capital needed to be, and the lower the perceived risk, the lower the capital.

And, in doing so, the regulators completely ignored the fact that banks and markets already clear for risk by means of interest rates, amounts exposed and contractual terms. And as a result banks could earn much higher returns on equity when financing what was officially perceived as “not-risky” than when financing what was officially perceived as “risky”, like our small unrated businesses and entrepreneurs.

And we are not talking about minor differences. Basel II required banks to hold 8 percent in capital when lending to small businesses, which meant banks could leverage 12.5 to 1, but allowed banks to hold only 1.6 percent in equity against a private asset rated AAA, (or a loan to Greece) allowing the banks to leverage a mindboggling 62.5 to 1. Five times less bank equity!

And the result is that these regulations added immense regulatory bias in favor of what is perceived as not risky, on top of the natural bias that already existed in their favor, and, consequentially, added immense regulatory bias against what is perceived as “risky”, on top of the natural bias that already existed against the risky.

And all this the regulators did without ever bothering to ask themselves the question of…what is the purpose of the banks?

And all this the regulators did without ever bothering to reflect on the fact that all bank crises ever have occurred because of excessive exposures to what was erroneously perceived ex ante as “not risky” and never because of excessive exposures to what was ex-ante correctly perceived as risky.

And as a consequence here we find us mired in a deep crisis with obese bank exposures to what was ex-ante perceived as “not risky” and anorexic banks exposures to what was considered “risky”.

And, of course, by maintaining the same fundamental capital requirement discrimination based on ex-ante perceived risk, there is no way we can work ourselves out of a crisis, in which our economies are turning flabbier and flabbier by the second.

Regulators, don’t you know that nations develop by generously allowing for daring opportunities, and fail and fall when turning stingy and coward?

What would the US Supreme Court opine about bank regulations which discriminate against The Risky and favor The Infallible?

No! Shame on you bank regulators! Who gave you the right to distort our economy this way? And shame on you too financial journalists who keep silencing this, not daring to question the regulating establishment.

Mark Twain, the bankers, and the nannies of the Basel Committee. What a sad tale.

I guess you have all read Mark Twain’s description of bankers as those who lend you the umbrella when the sun shines and want it back when it rains. And that most definitely rang true for someone as me trying to get banks to cooperate giving credit to my small and medium sized businesses and entrepreneur clients. 

But then along came the nannies of an outfit known as the Basel Committee, and their advisor the Financial Stability Board and said that that banker mode was still way too risky for them. And the nannies and, told the bankers that if they lent to those the sun was shining upon, the absolutely not risky, then they only needed 1.6 percent or less in capital, which meant they could leverage their equity 62.5 to 1 or even more in some cases, but if they dared lend to the “risky” who it seemed could be rained upon, then they needed 8 percent in capital and could only leverage 12.5 to 1. 

And, we all saw what happened. Here we are now with our banks up to their necks in dangerous excessive, really obese, exposures to what was erroneously perceived as “absolutely not-risky”, and anorexic exposure to those officially perceived as “risky”, like the small businesses and entrepreneurs, precisely those our young most count on generating the next generation of good jobs for them. 

Is it not a sad tale? Especially for a Western World that has become what it is thanks to risk-taking? Especially for an America that feels proud being known as the “land of the brave”? I wonder what Mark Twain would have to say about those nannies and the parents who entrust them with their banks?

Who do bank regulators think they are, unqualified and unauthorized, with immense hubris, playing risk managers for the world and destroying our economies?

Do conservatives and progressives not know or care about how regulators, with their silly risk weights based on perceived risk which determine the capital requirements for banks, so fundamentally distort the markets? 

Do conservatives and progressives not know or care about how regulators, with their silly risk weights based on perceived risk which determine the capital requirements for banks, so fundamentally increase the inequality between the “risky” and the “not-risky”? 

Does the Congress not know or care about how the regulators, with their silly risk weights based on perceived risk which determine the capital requirements for banks, effectively intrude in its domain and create subsidies for the “not-risky” and taxes for the “risky”? 

Are the current bank regulators really unqualified as risk managers? Absolutely yes!

The number one rule in any risk management must be to identify what risks you cannot risk not to take.

Regulators who do not define the purpose of what they are regulating cannot know one iota about risk-management. Or is it that they don’t care about our economies falling to pieces, as long as the banks stand there in shining armors among the rubble? 

Regulators who care about the perceived risks of bank assets, and not about how bankers react to the perceived risk of assets, have no idea of what they are up to. 

Regulators who give banks immense incentives to hold assets perceived as “not-risky” ignoring that all bank crisis ever have resulted, exclusively, from banks holding excessive assets that had erroneously been perceived as absolutely “not-risky”, have no idea of what they are up to. 

Regulators who do not know that when they allow a bank to hold less capital when an asset is perceived as “not-risky” discriminates against the access to bank credit of the “risky” like small businesses and entrepreneurs, and fundamentally distort the markets, have no idea of what they are up to. 

Regulators who do not understand that helping the “risky” to access bank credit is a fundamental part of building a growing and strong economy and jobs, and that favoring bank lending excessively to what is perceived as “not-risky” will only make for a flabby and imploding economy, have no idea of what they are up to. 

Risk managers who do not understand that risk-taking is a fundamental part of building a flexible and sturdy system, and that going excessively solely for what is perceived as “not-risky” makes for a

fragile system, have no idea of what they are up to.

Unauthorized? Yes! You tell me who authorized them to do what they did. Any volunteer?

What did the regulators really do? Scared witless by the possibility that bankers would expose themselves too much to assets deemed as “risky”, something that bankers never or very rarely do, they created huge incentives for banks to concentrate on assets that were, ex ante, perceived as “not risky”. In doing so, they fomented an incredible dangerous highly leveraged bank exposure to the “not risky”, and a truly anorexic exposure to the “risky”, like to the small businesses and entrepreneurs, something which has placed us almost over the brink of disaster.

What did the regulators really do? They created the prime cause for why now the US and other sovereigns are saddled by immense, almost unserviceable public debt burdens.

What did regulators really do? As I see it, by excessively promoting bank credit to “super-safe” sectors, like real estate in Spain, and to “infallible” sovereigns, like Greece, they have almost singlehandedly taken the eurozone down.

Sincerely, I am sick and tired of regulators who do not seem to care where they are taking our Western World, as long as they keep their “important” bureaucratic posts within their little mutual adoration club, apparently not accountable to anyone. 

Sincerely, I am sick and tired of those incapable of grasping the possibility of our current bank regulators being so fundamentally wrong, so that they, even when they proclaim “Without fear and without favor” do not even dare to ask the questions that needs to be asked.

Sincerely I am sick and tired, and anguished, about my children and grandchildren having to grow up in a world were so much de-facto power lies in the hands of some petit bank regulating bureaucrats.

The mother of all lacks of confidence

We so often hear about the lack of confidence, of so many, being the largest obstacle to manage to fully recover from this crisis. But, one of the most significant lacks of confidence, indeed the mother of them all, is not even mentioned. I refer to the lack of confidence in bankers, and the markets, shown by bank regulators.

Bank regulators, scared witless by the possibility that bankers would expose themselves too much to assets deemed as “risky”, something that bankers never or very rarely do, created incentives for bankers to concentrate on assets that were, ex ante, perceived as “not risky”. In doing so they fomented an incredible dangerous highly leveraged bank exposure to the “not risky”, something which has basically already placed us over the brink of disaster. 

What could help us is for bank regulators to show more confidence in those so useful and needed “risky”, like the small business and entrepreneurs, those who bring energy and vitality to the economy... but no!, the current generation of worried to death nannies of bank regulators just don’t seem to have that in them.

I am truly concerned about the future of the Western world

Regulators, on their own initiative, instructed banks, by means of capital requirements based on perceived risk, to stay away, more than usual, from what was perceived as “risky” like the small business and the entrepreneurs, and embrace, more than usual, what was perceived as “not-risky”, like the triple A-rated or the “infallible” sovereigns. The fact, that this does not raise any eyebrows, bodes badly for a Western world, which became what it is thanks to risk-taking. 

If we do not rid ourselves of these dumb overly nanny regulators, the Western world is doomed to perish in some dangerously overpopulated absolutely safe-haven.

The Financial Stability Forum has read and learned from Il Gattopardo!

In the best traditions of what Giuseppe Tomasi di Lampedusa’s says in Il Gattopardo about that "Everything must change in order to remain the same" the Financial Stability Forum in their Report on Enhancing Markets and Institutional Resilience, dated October 10, announces “Changes in the role and uses of credit ratings”, only to proceed digging us even deeper in the hole we are in.

FSF spells out these changes to be:

1. On the quality of the rating process… presumably meaning the CRAs will be better in the future… allowing the markets to trust the credit rating agencies even more.

2. Differentiated ratings and expanded information on structured products… presumably meaning that the CRAs will in the future provide the markets with more precise and tailor made information… allowing the markets to trust the credit agencies even more.

3. An enhanced assessment of underlying data quality… presumably meaning that in the future the CRAs will make sure they work with more relevant data… allowing the markets to trust the credit agencies even more.

4. Telling investors to address their over-reliance on ratings…meaning that investors associations should consider developing standards of due diligence for CRAs… allowing the markets to trust the credit agencies even more… while preparing the terrain for an “I told you to do it!”

5. And finally that the authorities will review their use of ratings in the regulatory and supervisory framework to address the excessive reliance on credit ratings… by launching the stocktaking of the uses of ratings in legislation, regulations and supervisory guidance by its member authorities in the banking, securities and insurance sectors… as if they already should not know that.

From what we read the FSF says, and the so little said about the credit rating agencies during the IMF/World Bank meetings, it would seem that the only ones who really had their institutional resilience strengthen these last weeks were the credit rating agencies… Why? How come?

Friends,

I do not know of anyone who knows anyone who knows anyone that has lost a single dollar giving a subprime mortgage on too generous or outright stupid terms to anyone who classifies as belonging to a subprime sector. Neither do you, I bet.

But I do know of many persons or institutions that have lost fortunes investing in securities collateralized with mortgages just because these securities were rated AAA by one two or even three of the only three credit rating agencies that are to be used by all of us, including by the financial regulators. And so do you, I bet.

Therefore, without any doubt, this crisis is a direct result of the credit rating agencies issuing the wrong ratings, and since these agencies were so much followed because they were excessively empowered by the financial regulators, we should have even less doubts about whom we really should blame.

The Axis of the credit rating agencies and the financial regulators has already cost the world trillions of dollars.