Is the Independent Evaluation Office (IEO) of the International Monetary Fund (IMF) independent enough?

In October 2014, the Independent Evaluation Office of the International Monetary Fund presents a report titled: “IMF responses to the financial and economic crisis: An IEO Assessment”

And it does not mention what I am convinced is the primary cause of the 2007-08 crisis; and also what most obstructs our way out of it. 

I refer to the Basel Committee for Banking Supervision’s credit-risk-weighted capital/equity requirements for banks.

These allowed banks to hold assets perceived as “absolutely safe” against extremely small capital (equity) requirements, which translated into extremely high leverages of equity (62.5 times to 1 and more). 

That allowed banks to earn much higher expected risk-adjusted returns on equity when lending to what was perceived as “absolutely safe” than when lending to what was perceived as “risky”, which translated, naturally, into dangerously high exposures to what was perceived as absolutely safe”.

And any simple observation of the crisis makes clear the direct relation that existed between bank assets in problem, and bank assets with low risk-weights. For instance: i. AAA rated securities backed with mortgages to the subprime sector in the US. ii. Real estate backed financing, like that in Spain. iii. Loans to “infallible sovereigns”, like to Greece.

And we have not been able to get out of that crisis because banks still need to hold much more equity when lending to what is perceived as “risky”, like to medium and small businesses, entrepreneurs and start-ups… and that has of course impeded the liquidity provided by central banks to reach where it is needed the most.

And this regulatory risk aversion that so much distorts the allocation of bank credit to the real economy, and is dooming our economies to stall and fall, is not even part of the IMF discussions on what to do.

And so those criticizing IMF for “austerity” are not addressing the worst one of these, namely the risk-taking austerity regulatory virus that has invaded our banks... slaying the animal spirit of our economies.

And so how do you think I feel about IEO. I have to doubt its real independency… I must suspect it is also into the pockets of a groupthink incapable of understanding, or not daring to consider the possibility that bank regulators could have been so utterly mistaken. Not daring to lay the blame for the crisis more on regulators than on the bankers.

Houston, we’ve got a problem: The IMF is lost in space.

The IMF has just published their Global Financial Stability Report: Chapter 3 is titled: The Reform Agenda: An interim report on progress toward a safer financial system, and Chapter 4: Changing Global Financial Structures: Can they improve economic outcomes? 

Even though the report mentions “the banks’ likely increase in their allocation to safer but low-yielding assets to accommodate regulatory requirements” it completely fails to understand the distortions that precisely this causes in the economy. In fact, the word distortion does not even appear in the report. 

And, if there is anything current regulations have done, that is to distort the economic efficient resource allocation so much, by favoring banks holding assets that ex-ante are perceived as “not-risky”, against banks holding assets that ex-ante are perceived as “risky”. 

Basel II allowed a bank to leverage its equity 62.5 to 1, if the asset had an AAA rating, but only 12.5 to 1, if it was unrated. And which means that the profitability for banks, their return on equity, when holding “not-risky” assets, becomes much higher than when holding “risky” assets, like loans to small businesses and entrepreneurs. And, if this is not hugely distortive, I do not know what is. 

Distortive, and utterly useless… since we know that no major bank crisis ever, has resulted from banks holding excessive assets that, when acquired, were perceived as “risky”, these have all resulted, no exceptions, from banks holding excessive assets that, when acquired, were perceived as "absolutely not-risky".

IMF does a lot of empirical research, but the research they have completely failed to do, is to run a simple regression between all the current problem assets, and the fact that these were ex-ante perceived as “not-risky”, and so therefore the banks were allowed to hold much less bank equity. That should have given them a clue.

And so, about five years after the beginning of the crisis, the IMF does yet not understand why a crisis that was doomed to happen, because of plain dumb regulations, happened. 

The Independent Evaluation Officer of the IMF (IEO) in their report “IMF Performance in the Run-Up to the Financial and Economic Crisis: IMF Surveillance in 2004-07” of 2011 wrote: 

“The IMF’s ability to correctly identify the mounting risks was hindered by a high degree of groupthink, intellectual capture, a general mindset that a major financial crisis in large advanced economies was unlikely, and inadequate analytical approaches. Weak internal governance, lack of incentives to work across units and raise contrarian views, and a review process that did not “connect the dots” or ensure follow-up also played an important role, while political constraints may have also had some impact.” 

It would sure seem that no one in IMF read that report. What a shame!

PS. And by the way Houston we've got another serious problem too

The Basel Committee makes a shocking confession!

The Basel Committee for Banking Supervision, speaking for all sophisticated bank regulators around the world, issued today an urgent statement regarding the discovery of a fundamental mistake committed in Basel II and which they now understand was responsible for causing the current financial crisis.

The mistake was that though the markets and the banks were already incorporating the information about the possibilities of default that were contained in the credit ratings when calculating the corresponding risk premiums to set interest rates for their clients, the regulators based the capital requirements for banks on exactly the same credit ratings, and so, unwittingly, accounted for said credit information twice.

The result of it was, of course, the excessive financing of everything that was officially deemed as having a low risk of default, like whatever had swell ratings like Greece and securities backed by lousily awarded mortgages to the subprime sector; and the insufficient financing of whatever was officially deemed as more risky, like the small businesses and entrepreneurs who are vital for maintaining that dynamism of the economy that creates jobs.

The Basel Committee expresses its most sincere regrets for such a mistake and promises to take immediate corrective action.

PS. April Fool´s joke disclaimer: Sorry, unfortunately, the Basel Committee and the sophisticated bank regulators, three years into a crisis of its own making, are still not (publicly) aware of their mistake.

The Independent Evaluation Officer of the International Monetary Fund has recently in an Evaluation Report come to the conclusion that, for IMF at least, “the ability to correctly identify the mounting risks was hindered by a high degree of groupthink…” The reason why the truth of what happened does not come out must probably now be attributed to group-interests.