Reading, little by little, Adam Tooze’s “Crashed: How a Decade of Financial Crises Changed the World” 2018

Here a comment I made before beginning to read the book

Chapter 14 “Greece 2010: Extend and pretend”

I read: “As recently as 2007 Greece’s bonds had traded at virtually the same yield as Gemany’s”

The credit rating of Greece in 2007 was A, and that of Germany AAA. According to Basel II’s risk weighted capital requirements Greece should have a risk weight of 20% while Germany 0%.

But, European authorities extended Sovereign Debt Privileges to all Eurozone nations, and assigned Greece also risk weight of 0%. All this even though these nations are all taking on debt in a currency that de facto is not their own printable one. 

When Greece’s crisis breaks lose Greece has still a risk weight of 0%... meaning European banks could lend to Greece against no capital at all... and it is still 0% risk weighted. 

How is Greece going to extract itself from that corner into which it has been painted is anybody's guess. And extract itself it must, as  must all nations. A 0% risk weight for the sovereign and 100% for the citizens is an unsustainable statist proposition.

It all makes me wonder how Tooze would have written this chapter had he considered this. Perhaps he could have been closer to opine this?

September 2, 1986 was the tragic night when Paul A. Volcker, in London, gave in to (insane) European bank regulators.

Paul A. Volcker in his autobiography “Keeping at it” of 2018, penned together with Christine Harper, valiantly accepted that the risk weighted bank capital requirements he helped to promote, had serious problems. In pages 146-148 he writes:

"The travails of First Pennsylvania and Continental Illinois, the massive threat posed by the Latin American crisis, and the obvious strain on the capital of thrift institutions had an impact on thinking over time, but strong action was competitively (and politically) stalled by the absence of an international consensus.

An approach toward dealing with that problem was taken by the G-10 central banking group meeting under the auspices of the Bank for International Settlements (BIS) headquartered in Basel, Switzerland. A new Basel Committee would assess existing standards and practices in a search for an analytic understanding.

Progress was slow… 

The US practice had been to asses capital adequacy by using a simple “leverage ratio”-in other words, the bank’s total assets based compared with the margin of capital available to absorb any losses on those assets. (Historically, before, the 1931 banking collapse, a ten percent ratio was considered normal)

The Europeans, as a group, firmly insisted upon a “risk-based” approach, seemingly more sophisticated because it calculated assets based on how risky they seemed to be. They felt it was common sense that certain kind of assets –certainly including domestic government bonds but also home mortgages and other sovereign debt- shouldn’t require much if any capital. Commercial loans, by contrast, would have strict and high capital requirements, whatever the credit rating might be.

Both approaches could claim to have strengths. Each had weaknesses. How to solve the impasse?

At the end of a European tour in September in 1986, I planned to stop in London for an informal dinner with the Bank of England’s then governor Robin Leigh-Pemberton. In that comfortable setting without a lot of forethought, I suggested to him that if it was necessary to reach agreement, I’d try to sell the risk-based approach to my US colleagues.

Over time, the inherent problems with the risk-based approach became apparent. The assets assigned the lowest risk, for which capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages. Ironically, losses on those two types of assets would fuel the global crisis in 2008 and a subsequent European crisis in 2011. The American “overall leverage” approach had a disadvantage as well in the eyes of shareholders and executives focused on return on capital; it seemed to discourage holdings of the safest assets, in particular low-return US government securities."

September 2? From here

And so in 1988, with Basel I, the regulators assigned the sovereigns a 0% risk weight and citizens 100%, as if bureaucrats know better what to do with credit for which repayment they're not personally responsible for than entrepreneurs. 

I ask: Insane? I answer: Absolutely!

As if bureaucrats know better what to do with credit for which repayment they're not personally responsible for than entrepreneurs.

How can one believe that what bankers perceive as risky is more dangerous to bank systems than what bankers perceive as safe? 

Should it not be clear that dooms our bank system to especially severe crises, resulting from excessive exposures the what ex ante is perceived as especially safe, but that  ex post might not be, against especially little capital?

These self-nominated besserwisser experts had (have) just not the faintest understanding of conditional probabilities.

Here a list of the many mistakes with the risk weighted bank capital requirements

Here is my 2019 letter to the Financial Stability Board

PS. Here, my since June 2023 dialogue with #AI #OpenAI #ChatGPT about bank regulations.

Anat Admati explains the financial crisis better than most, but does still not get to the real heart of it.

I refer to Promarket.org and Evonomics.com where Stanford professor Anat Admati discusses her paper“It Takes a Village of Media, Business, Policy, and Academic Experts to Maintain a Dangerous Financial System” May 2016.

In it she explains how a mix of distorted incentives, ignorance, confusion, and lack of accountability contributes to the persistence of a dangerous and poorly regulated financial system.

Here some quotes and comments:

1. “Admati draws a contrast with aviation. Although tens of thousands of airplanes take off and land, often in crowded skies, busy airports, and within short time spans, crashes are remarkably rare. Everyone involved in aviation collaborates to maintain high safety standards”

PK. The main explanation for that is that everything in aviation is considered risky… and there are no aviation regulators giving anyone the excuse of “at this point you can relax”.

2. “When they seek profits banks effectively compete to endanger their depositors and the public. An analogy would be subsidizing trucks to drive at reckless speed even as slower driving would cause fewer accidents.”

PK. Of course allowing reckless speeds, like no limit at all when lending to Greece, and 62.5 times when AAA to AA ratings are present, must cause serious crashes.

But, the worst part of it all is that banks are not allowed to drive all assets at the same speed. As a consequence, being paid on delivery, banks will not go to where they must go slower, like the leverage speed limits that apply when lending to entrepreneurs, and will therefore not perform their vital function of allocating credit efficiently to the economy. The words “the purpose of banks is” are sadly nowhere to be seen in bank regulations.

3. “Politicians, find implicit guarantees attractive because they are an ‘invisible form of subsidy’ that appear free because they do not show up on budgets, as the costs associated are ultimately paid for by the citizenry.”

PK. At this moment the statist regulators and politicians find those “implicit guarantees” especially attractive because of its quid-pro-quo component. “We scratch your back with implicit guarantees and you scratch ours something for which we in 1988, with the Basel Accord assigned to the sovereign a 0% risk weight, and one of 100% to the citizen” And ever since the “good and friendly” sovereigns have had access to subsidized credit… and the regulators have now painted themselves into a corner. 

4. “Credit rating agencies, “private watchdogs,” have conflicted interests because they derive revenues from regulated companies as well as sometimes from regulators.”

PK. Yes but notwithstanding that, even if the credit rating agencies have behaved totally independent, there can be little doubt that assigning so much decision power to some few human fallible credit rating agencies would introduce the mother of all systemic risks.

And besides, since bankers already consider risks perceived when deciding on size of exposures and risk premiums to charge, to have perceived risks also reflected in the capital requirements, violates the “Kurowski dixit” rule: “Risks, even when perfectly perceived, leads to the wrong actions, if excessively considered.” 

5. “I had expected academics and policy makers to engage and care about whether what they were saying and doing was appropriate, particularly since they often know more than the public about the issues and are entrusted to protect the public”

PK. So had I. They, Anat Admati included, are still not able to explain to regulators about conditional probabilities. And so regulators keep on regulating based on the perceived risk of assets and not based on the risk of assets based on how these are perceived.

In terms of airplanes they regulate based on how the pilots perceive the risks and not based on that the pilots could perceive the wrong risks or act incorrectly when facing the correct risks.

6. “Lawmakers are rarely held accountable for the harmful effect of implicit guarantees combined with poor regulations.”

PK. Yes not one single regulators have been forced to parade down 5thAvenue wearing a dunce cap. On the contrary many of them have been promoted and are still regulating without even considering the possibility they have been mistaken all the time.

PS. Even though Daniel Moynihan is supposed to have opined: “There are some mistakes it takes a Ph.D. to make”, the challenges still remain for the PhDs about what to do with the opinions of the lowlier graduates, like with just an MBA. Do we dare to quote him?

Here my very early opinions on this issue

Here some letters Washington Post have published

And here my soon 2.800 letters to the Financial Times on this. Am I obsessed? Sure, but so are they ignoring my arguments.

And finally here a humble home-made youtube https://youtu.be/TUdKhm6_a8Y

Fed, during the last 15 years what were the capital requirements for a US bank when lending to Puerto Rico?

The single most important reason for which Greece’s debt levels got so out of whack was that the European bank regulators, out of misunderstood solidarity, also gave Greece, for purposes of capital requirements for banks a 0% risk weight. 

That of course allowed banks to leverage much more loans to Greece than loans let us say to an unrated European SME, which of course allowed banks to earn higher risk adjusted returns on equity lending to Greece than lending to an unrated European SME. (The Greek citizens now suffering have not held those regulators accountable for that lunacy)

Now we read: “The Puerto Rico debt, a result of generations of mismanagement, was enabled by Wall Street, which was enticed by the fact it was tax free everywhere in the U.S. and risky enough to provide rich yields.” “Trump Suggests Puerto Rico’s Debt May Need to Be ‘Wiped Out’” Justin Sink, Bloomberg, October 3.

“Mismanagement?” With respect to debt it takes as a minimum two to tango, the borrower and the creditor; and since distorting risk weighted capital requirements were introduced, the regulators also participate in that dance. 

So my immediate info request to the Fed would be: Over the last 15 years, so that we have some pre 2007-08 crisis figures too, can you show us precisely the evolution of how much capital American banks were required to hold when lending to Puerto Rico?

Who knows, Puerto Rican citizens might want to sue the Fed for stimulating an excessive lending/borrowing to Puerto Rico.

PS. It would also be interesting to know how much banks were required to hold against loans to unrated SMEs in Puerto Rico. To compare those requirements would allow us to establish whether there was some statist regulatory favoritism of the Puerto Rico government. 

The Riskiness of Country Risk

An Unsustainable Debt Sustainability 

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 an example of their crazy regulatory algorithm, it suffices to mention they assigned a risk weight of 20% for the so dangerously AAA rated while one of 150% to the so innocous below BB- rated.

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

PS. How do you regulate a regulators' algorithm?

Why are excessive bank exposures to what’s perceived safe considered as excessive risk-taking when disaster strikes?

In terms of risk perceptions there are four basic possible outcomes:

1. What was perceived as safe and that turned out safe.

2. What was perceived as safe but that turned out risky. 

3. What was perceived as risky and that turned out risky.

4. What was perceived as risky but that turned out safe.

Of these outcomes only number 2 is truly dangerous for the bank systems, as it is only with assets perceived as safe that banks in general build up those large exposures that could spell disaster if they turn out to be risky.

So any sensible bank regulator should care more about what the banks ex ante perceive as safe than with what they perceive as risky.

That they did not! With their risk weighted capital requirements, more perceived risk more capital – less risk less capital, the regulators guaranteed that when crisis broke out bank would be standing there especially naked in terms of capital. 

One problem is that when exposures to something considered as safe turn out risky, which indicates a mistake has been made, too many have incentives to erase from everyones memory that fact of it having been perceived as safe.

Just look at the last 2007/08 crisis. Even though it was 100% the result of excessive exposures to something perceived as very safe (AAA rated MBS), or to something decreed by regulators as very safe (sovereigns, Greece) 99.99% of all explanations for that crisis put it down to excessive risk-taking.

For Europe that miss-definition of the origin of the crisis, impedes it to find the way out of it. That only opens up ample room for northern and southern Europe to blame each other instead.

The truth is that Europe could disintegrate because of bank regulators doing all they can to avoid being blamed for their mistakes.

IMF: The “I scratch your back if you scratch my back” crony statism deal between sovereigns and banks, must stop.

In 1988, with the Basel Accord, Basel I, for the purpose of capital requirements for banks, regulators assigned to the sovereigns a risk weight of 0%, while citizens got one of 100%.

That meant banks would be able to leverage more their capital when lending to sovereigns than when lending to citizens. 

That meant banks would be able to earn higher expected risk adjusted returns on equity when lending to sovereigns than when lending to citizens. 

That meant that banks would lend more and at lower rates than usual to sovereigns and in relative terms less and at higher rates than usual to citizens.

That de facto established the Sovereign-Bank Nexus. I Sovereign help to guarantee you banks, and you help to finance me abundantly and cheap.

IMF, in its Global Financial Stability Report 2017, page 36 and 37 have a section titled “The Sovereign-Bank Nexus could reemerge”. It correctly spells out how banks can be affected by difficulties of sovereigns and how sovereigns can be affected by difficulties of banks. 

But it makes absolutely no reference to the regulatory support of the Sovereign-Bank Nexus previously described. Why?

That runaway statism must stop!

IMF, Basel Committee for Banking Supervision: Don’t tell me you do not know who did the Eurozone in?

PS. November 2016 Olivier Blanchard agreed on that there was a need to research the distortions produced by these regulations. Has that started?

Current bank regulation, more risk more capital - less risk less capital, is something as fake and dumb as it gets.

1. Even though the most important function of banks is to allocate credit efficiently to the real economy, let’s forget that and concentrate solely on banks becoming super safe mattresses in which we can store our savings.

So let us not worry about banks being able to leverage more their equity and the support we give them on what is perceived as safe than on what is perceived as risky; which obviously means banks will be able to earn higher expected risk adjusted returns on equity on what is perceived as safe than on what is perceived as risky; which obviously means banks will lend too much to what is perceived as safe and too little to what is perceived as risky.

2. Even though that reduces the opportunities of those coming from behind to access bank credit, and therefore basically decrees more inequality, let’s also forget about that.

3. Even though the distortion will cause banks to finance less the risky that our young need in order for them to have jobs and a workable economy, let us forget about that and go for short term safety, we baby-boomers aren’t that young, are we?

4. Even though all banking crisis have resulted from unexpected events, like natural disasters and devaluations, from criminal activity and from excessive exposures to something ex ante perceived as safe but that ex post turned out to be very risky, let us ignore that and require banks to hold more capital when holding assets perceived as risky. 

5. Even though we know that banks will do their utmost to lower their capital requirements so as to obtain higher returns on assets, let us allow the big banks to run their own risk models, as they will love us for that and make our yearly visits to Davos so much more agreeable.

6. Even though it is clear that our economies would never have developed the same had these regulations been in place before, let us ignore that, in order as regulators to feel more tranquil.

7. Even though the distortion will cause banks to finance less the risky SMEs and entrepreneurs that our young need to be financed in order for them to have jobs and a workable economy, let us forget about that and go for short term safety, we baby-boomers aren’t that young, are we?

8. Even though 0% risk weight for the Sovereign and 100% for We the People gives away that we believe government bureaucrats know better how to use bank credit than the private sector, let’s stand firm on it. We are true statists, aren’t we?

9. Even though Greece and AAA rated securities, and the ensuing stagnation, and the ensuing waste of so much stimulus has proved us so very wrong, let us ignore that, since otherwise we could lose our jobs.

10. There is probably not a clearer evidence that current bank regulators have no clue about they are doing that Basel II's risk weights. These assign 20% to the dangerous AAA to AA rated while sticking the so innocuous below BB- rated with 150%.

PS. I have tried for over a decade to get some answers from regulators to some very basic questions, unfortunately in that area the technocrats are seemingly following a strict Zero Contestability policy.

If ever allowed, the following would be my brief testimony about what caused the 2008 bank crisis

The following, if I am ever allowed to give it, as so many would not like to hear it, would be my brief testimony on what caused the 2008 bank crisis 

Sir, as I have learned to understand it, the 2008 crisis resulted from a combination of 3 factors.

The first were some very minimal capital requirements for some assets that had been approved, starting in 1988 with Basel I, for sovereigns and the financing of residential housing; and made extensive in Basel II of 2004 to private sectors assets with good credit ratings.

These allowed banks then to earn much higher expected risk adjusted returns on equity on some assets than on other, which introduced a serious distortion. After Basel II the allowed bank equity leverages were almost limitless when lending to “sound” (or friendly) sovereigns; 36 times to 1 when financing residential housing; and over 60 to 1 with private sector assets rated AAA to AA. Just the signature, on some type of guarantee by an AAA rated, like AIG, also allowed an operation to become leveraged over 60 times to 1. 

The second was Basel II’ extensive conditioning of the capital requirements for banks to the decisions of some very few (3) human fallible credit rating agencies. As I so many times warned about (in a letter published in FT January 2003 and even clearer in a written statement at the World Bank) this introduced a very serious systemic risk.

The third factor is a malignant element present in the otherwise beneficial process of securitization. The profits of that process are a function of how much implied and perceived risk-reduction takes place. To securitize something safe to something safer does not yield great returns for the securitization process. Neither does to securitize something risky into something less risky. 

What produces BIG profits is to securitize something really risky, and sell it off as something really safe. Like awarding really lousy subprime mortgages and packaging them in securities that could achieve an AAA rating. A 11%, 30 years, $300.000 mortgage, packaged into a security rated AAA and sold at a 6 percent yield, can be sold for $510.000, and provide those involved in the process an instantaneous profit of $210.000

With those facts it should be easy to understand the explosiveness of mixing the temptations of limitless, 36, and more than 60 to 1 allowed bank equity leverages providing huge expected risk adjusted ROEs; with subjecting the risk-assesment too much to the criteria of too few; with the huge profit margins when securitizing something very risky into something “very safe”. Here follows some indicative consequences:

As far as I have been able to gather, over a period of about 2 years, over a trillion dollars of the much larger production of subprime mortgages dressed up in AAA-AA ratings, ended up only in Europe. Add to that all the American investment banks’ holdings of this shady product.

To that we should also add Europe’s own problems with mortgages, like those in Spain derived in much by an excessive use of “teaser interest rates”, low the first years and then shooting up with vengeance.

And sovereigns like Greece, would never have been able to take on so much debt if banks (especially those in the Eurozone) would not have been able to leverage their equity so much with these loans.

Without those consequences there would have been no 2008 crisis, and that is an absolute fact.

The problem though with this explanation is that many, especially bank regulators, especially bank bashers, especially equity minimizing bankers, especially inattentive finance academicians, especially faulty besserwissers (those who love the sophisticated taste of words like "derivatives"), they all do not like this explanation, so it is not even discussed.

The real question though is: Who is the guiltiest party, those who fell for the temptations, or those who allowed the creation of the temptations?

I mean how far can you go blaming the children from eating some of that deliciously looking chocolate cake you left on the table, at their reach?

PS. Please do not categorize misregulation as deregulation. 

PS. A 2008 GFC tweet summary:
The pushers: Those harvesting mortgages in subprime fields; packaging these in MBS and getting rating agencies’ enthusiastic thumbs up.
The addicts: The banks
The drug, the hallucinogen: The Basel Committee's ultra-low bank capital requirements. 

PS. Here's a letter published by the Washington Post, December 2009

P.S. Here’s a 2010 YouTube explanation

PS. Here is a current summary of why the risk weighted capital requirements for banks, is utter and dangerous nonsense.

PS. And here is my letter to the Financial Stability Board that was officially received. Will it be answered?

How could a crisis resulting from statist interventions, morph into a backlash against banks, capitalism and markets?

1988 with the Basel Accord, Basel I, the regulators, for the purpose of determining the capital requirements for banks, set the risk weight of the Sovereign (the government) to be zero percent while that of the private sector was set at 100 percent. Have you ever seen something more statist than that?

And in 2004, with Basel II, regulators within the private sector, assigned risk weights that ranged from 20 to 150 percent.

Those risk weights translated into banks needing to hold much less capital (mostly equity) against the Sovereign and the Safe Privates (the AAArisktocracy and houses) than against the Risky Privates (SMEs and entrepreneurs).

That meant banks could leverage their equity much more with Sovereign and Safe Privates, than with Risky Privates.

And that meant banks could obtain much higher risk-adjusted returns on equity with Sovereign and Safe Privates, than with Risky Privates… have you ever heard of something that distorts the allocation of bank credit more than that?

And of course the world ended up with a typical bank crisis, one of those that always result from excessive exposures to something ex ante perceived (or deemed) as safe (AAA-rated securities – Greece), but in this case made so much worse by the banks having been allowed to hold especially little capital against “The Infallible”.

But yet this utterly faulty regulation has been framed in terms of “de-regulation”, which has placed the full blame for the crisis on banks, free markets and capitalism.

How did that happened… who are the responsible for that?

A question: Basel II required banks to hold 1.6 percent in capital against what is AAA rated and 12 percent against the below BB- rated. What do you think poses greater danger to the stability of the banking sector: what’s AAA or what’s below BB-?

Facts:

Bank capital is to help cover for unexpected losses.

The safer something is perceived the greater the potential of unexpected losses.

No bank crisis ever has resulted from excessive exposures to something ex ante perceived as risky.

Current capital requirements for banks are much lower for what is perceived as risky than for what is perceived as safe.

So the current capital requirements for banks seem to be 180 degrees wrong... could that be?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Understand what originated the bank crisis and what stops the economies from recovering in 157 words

Bank regulators told our credit risk adverse banks: 

“If you take on Safe assets, we will allow you to leverage your equity and the support you receive from the society more than 60 to 1 times but, if Risky assets then you cannot leverage more than 12 to 1.” 

And that of course meant banks would be earning much higher risk adjusted returns on equity on assets perceived or made out to be Safe, than on “Risky” assets. 

It was like telling children: “If you eat up your ice cream then you can have chocolate cake too but, if you eat spinach, then you must eat broccoli too. 

And so banks built up excessive dangerous financial exposures to “Safe” assets, like AAA rated securities and loans to Greece, which detonated the crisis. 

And so banks are reluctant to hold Risky assets, like loans to SMEs and entrepreneurs, which makes it impossible to get out of the crisis.” 

And, amazingly, most describe what happened and is happening with our banks in terms of deregulated entities and failed markets.

How we all got really phished by the phished phools

George A. Akerlof and Robert J. Shiller wrote “Phishing for Phools: The economics of manipulation and deception”, 2015.

Phishing “is about getting people to do things that are in the interest of the phisherman, but not in the interest of the target. It is about angling, about dropping an artificial lure into the water and sitting and waiting as wary fish swim by, make an error and get caught.”

“A phool is someone who, for whatever reason, is successfully phished. There are two kinds of phool: psychological and informational. Psychological phools, in turn, come in two types. In one case, the emotions of a psychological phool override the dictates of his common sense. In the other, cognitive biases, which are like optical illusions, lead him to misinterpret reality, and he acts on the basis of that misinterpretation… Information phools act on information that is intentionally crafted to mislead them.”

And so here is the story about how the regulation phools got fished by the bankers.

What could be heaven for bankers? Wet dreams come true? Clearly, to obtain high returns on equity and large bonuses, while taking as little risk as possible.

That is not easy, because whatever is perceived as safe, will not accept to pay the banks a lot. And so bankers also had to give loans to the risky, charging of course higher risk premiums and limiting the exposures... a lot of sweaty job, for small returns.

But there were the bank regulators swimming warily around, after having seen the Latin American bank crisis. And the phishers tested a lure: more perceived risk more capital - less perceived risk less capital. The results were great, it intuitively shined and sounded so very right. 

But, in order not to scare away the prospective phool, their first lure, Basel I, basically included solely the risk weight of zero percent for the sovereign and a 100 percent weight for the private sector.

“Since it is the sovereign that assist banks when these run into troubles, it is only logical that the sovereign should have a zero risk weight; and besides, you regulators, don’t forget that it is governments who pay your salaries”; ran the argument, and the phools swallowed the Basel I bait.

But when in 1997 the Asian financial crisis occurred, followed by the Russian crisis and by the Long-Term Capital Management L.P. debacle, the regulators started to swim very warily again. 

And that was a godsend opportunity for the phishers to use their Basel II bait: 

Phishers: “Basel I is too rough… so bankers go out and do all kind of silly risky things… and so you better give the banks incentives to keep to what is safe. and Sim Sala Bim, everything will be fine”

Phools: “How?” 

Phishers: “By lowering the capital requirements against the safe assets of the private sector too; so that banks can earn decent returns on what is safe, without having to expose themselves to the risky”. 

Phools: “But how do we know it is safe?” 

Phishers: “The big ones, that have super-duper sophisticated financial models, and for all the rest there is always the credit rating agencies”

Phools: “Ok let us do Basel II” And, in sotto voce “that will also make us look very sophisticated too... something which is clearly not bad for our image" 

And so the world got saddled with capital requirements that allowed banks to leverage:

Infinitely with loans those sovereigns rated AAA to AA

Over 60 to 1 with loans to sovereign rated A+ to A, as Greece was until November 2009.

Over 60 to 1 on AAA rated securities, like those backed with mortgages to the subprime sector. 

Over 60 to 1 on anything that carried an AAA rated companies guarantee, like that of AIG 

Boy, did the phools get phished! 

And as a result of all that phool phishing, our “risky” SMEs and entrepreneurs, those tough we most need to get going when the going gets tough; those who because they are perceived as risky never cause a major crisis, these were left without fair access to bank credit.

Boy, did we all get really phished by the phools!

Boy, did we end up with the mother of all regulatory stupidities!

The financial crisis explained to dummies in terms of capital requirements for banks: Lehman Brothers - AIG - Greece

The regulators, with Basel II, decided that against any private sector assets rated AAA banks, and against any sovereign rated as Greece was until November 2009, banks needed to hold only 1,6 percent in capital, meaning these could with those assets leverage their capital over 60 times to 1. (When holding “risky” assets like loans to entrepreneurs and SMEs they were only allowed to leverage 12 times to 1. 

On April 28, 2004 the SEC decided that was good for the Basel Committee was good enough for them and allowed Lehman to leverage over 60 times to 1 with AAA rated securities guaranteed with mortgages to the subprime sector… Since Europe were allowing their banks to do the same… the demand for these AAA securities became so huge that it overpowered all the quality controls in their manufacturing and packaging process… and Bang!

If AIG that was AAA rated guaranteed an asset, banks could dramatically reduce the capital they needed to hold against that assets, and this overwhelmed AIG’s capacity to resist selling “very profitable” loan default guarantees… and Bang!

Greece was of coursed offered loans in such amounts and in such generous terms, so their otherwise "so" disciplined and fiscally conservative governments could not resist the temptations… and Bang!

And as should have been expected not one single asset class that was perceived as risky played any role in causing the financial crisis… although of course these assets also suffered a lot when the “safe” came tumbling down.

One would think regulators would by now have discovered that banks already clear for the perceived risks with their risk premiums and the size of their exposure; and so to also force them to also clear in the capital for exactly the same risks, would cause banks to overdose on perceived risks. But no, they haven’t. So this little financial history lesson for dummies is of course primarily directed to them.

What is our major problem now? John Kenneth Galbraith explained it well: “If one is pretending to knowledge one does not have, one cannot ask for explanations to support possible objections.”

The Basel Committee is a pitiful bunch of bank regulators incapable of expressing even the smallest “We’re sorry Greece”

There is no doubt whatsoever that had regulators not allowed to leverage their equity over 60 times to 1 when lending to Greece, Greece not matter what accounting shenanigans it could come up with, would not have been able to borrow as much as it did. 

And now, as a consequence, we read about Greece having to hand over 16 of its airports to those who  in order for the creditors to be paid, have paid for the right of charging a toll on much of the future tourism to Greece.

And yet not even the slightest hint of the Basel Committee telling Greece, and its creditors, they're sorry. What a sad bunch of technocrats.

Who did the Eurozone in?

Why has not a proper independent autopsy of the financial crisis 2007-08 been done? The answer: What would be found!

When we see with how much care and dedication investigators perform the autopsy of the causes of an accident whenever a plane crashes, one can truly be surprised about how little autopsy has been performed on the 2007-08 financial crash.

But of course those performing the autopsy of a plane crash are not the designers of the plane, nor those responsible for its maintenance, nor air-traffic controllers nor, of course, those who were flying it… and so there are no conflicts of interests present in the investigation (I presume).

In the case of the Financial Crisis 2007-08 crisis any outside completely independent investigator would have determined its principal cause to be:

The very low capital requirements for banks when holding assets perceived as “safe”, and which created unmanageable perverse incentives for banks to lend or invest excessively in what was ex ante perceived as safe.

Evidences?: Just look at the debris: a) AAA rated securities and credit default swaps issued by AAA rated AIG that, at least US investment banks and European banks were allowed to leverage 62.5 times with; b) loans to sovereigns like Greece to which EU authorities had assigned a 0% risk weight, meaning no capital requirements at all; and c) loans to real estate like in Spain. Nowhere is something ex ante perceived as "risky" found to have caused any problem. What more can you need for a prosecutor to rest his case?

But since those investigating the Financial Crash 2007-08 were, by commission or omission, directly responsible for those risk weighted capital requirements, they all found it in their best interest to classify these as truths that shall not be named.

Until now their strategy has worked splendidly for them... even deregulation is denounced a thousand times more as the source of the problem than their misregulation... and some of the regulators have even been promoted, like to BIS and ECB... and other have found job working on Basel III.

PS. At least I managed to get through with some comments to the Financial Stability Board.