Why are not the absurd risk weighted capital requirements for banks more questioned?

John Kenneth Galbraith in his “Money: Whence it came, where it went” (1975) writes about similar silences:

“If one is pretending to knowledge one does not have, one cannot ask for explanations to support possible objections” 

“What people do not understand, they generally think important. This adds to the prestige and pleasure of the participants” 

"What politicians do not understand, adds to their fear of that in rejecting the resulting action, they may be doing serious damage”

Upton Sinclair Jr. would have been more direct with his “It is difficult to get a man to understand something, when his salary depends on his not understanding it.”

PS. An aide memoire on some of the absurdities

“You’re crazy!” That’s what John K. Galbraith would have said; about Basel’s risk weighted capital requirements for banks

I quote from John Kenneth Galbraith’s “Money: Whence it came where it went” 1975.

“For the new parts of the country [USA’s West]… there was the right to create banks at will and therewith the notes and deposits that resulted from their loans…[if] the bank failed…someone was left holding the worthless notes… but some borrowers from this bank were now in business...[jobs created] 

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 that] was an arrangement which reputable bankers and merchants in the East viewed with extreme distaste… Men of economic wisdom, then as later expressing the views of the reputable business community, spoke of the anarchy of unstable banking… The men of wisdom missed the point. The anarchy served the frontier far better than a more orderly system that kept a tight hand on credit would have done…. what is called sound economics is very often what mirrors the needs of the respectfully affluent.”

So, on behalf of "the men of wisdom", in came the Basel Committee for Banking Supervision. With Basel I 1988, and Basel II 2004, it told bankers that even when they already consider perceived risk when setting interest rates and deciding on the amount of exposures, they also had to consider the perceived risks for how much capital their banks needed to hold.

In other words bank regulators ordered the banking system to double down on ex ante perceived, (decreed or concocted) risks.

For a while, while bankers were exploiting all the opportunities of being able to mind-boggling leverage their equity with what was thought safe (a banker’s wet dream come true) all seemed fine and dandy. 

The immense growth of bank credit (later followed up with QEs) injected tremendous amount of liquidity into the economy… all until some safe havens, like AAA rated securities and Greece, in 2007/08 became dangerously overpopulated and burst.

One should think the “men of wisdom” would have updated their wisdom, but no!

“The risky”, like SMEs and entrepreneurs, still have to compete with “The Safe” for access to bank credit while carrying the burden of generating larger capital requirements for the banks… while “the safe” havens run the risk of being dangerously overpopulated.

I have no doubt John Kenneth Galbraith, if alive, would say: “You’re crazy!”

My 1997 Puritanism in banking

Bank regulators should be forced to see “Hell on Wheels” and read John Kenneth Galbraith’s “Money: Whence It Came, Where It Went”

In the TV series Hell on Wheels, its main character, Cullen Bohannon, when asked to testify before the US Senate about all the obvious corruption of Thomas ‘Doc’ Durant, someone absolutely not Bohannon’s friend, someone absolutely not one having been sanctimonious or behaved according to any social norms, repeats, over and over again, to the great chagrin of his interrogators: “The Transcontinental railroad could not have been built without Thomas Durant”

And John Kenneth Galbraith wrote in his “Money: Whence it came where it went” 1975 the following: “For the new parts of the country [USA’s West]… there was the right to create banks at will and therewith the notes and deposits that resulted from their loans…[if] the bank failed…someone was left holding the worthless notes… but some borrowers from this bank were now in business...[jobs created]

It was an arrangement which reputable bankers and merchants in the East viewed with extreme distaste… Men of economic wisdom, then as later expressing the views of the reputable business community, spoke of the anarchy of unstable banking… The men of wisdom missed the point. The anarchy served the frontier far better than a more orderly system that kept a tight hand on credit would have done…. what is called sound economics is very often what mirrors the needs of the respectfully affluent.”

And Galbraith also opined in his book that: “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.”

Therefore I cannot but conclude in that bank regulators should be forced to see “Hell on Wheels” and read John Kenneth Galbraith’s “Money: Whence It Came, Where It Went”. That in order to, hopefully, be able realize that with their risk weighted capital requirements for banks, these will not finance the risky future, but only refinance the safer past and present and, as a result, the economy will stall and fall. 

To add insult to the injury, bank regulators are doing all this in the belief that bank crises result from excessive exposures to what is perceived as risky, which is utter nonsense. Bank crises have always, and will always, result from uncertainties; that which includes unexpected events, like devaluations earthquakes and regulators not knowing what they are doing, criminal behavior and excessive exposures to something ex ante perceived as safe but that ex post turned out to be very risky.

“If you see something, say something”. Someone should run to the Homeland Security of the Home of the Brave and denounce that, most probably, unwittingly; some serious terrorism is taking place by means of dangerously risk adverse faulty bank regulations.

Dumb G20 ministers reiterated in Hangzhou their support of the inept Basel Committee on Banking Supervision (BCBS)

We read in the “G20 Leaders’ Communique Hangzhou Summit”

“We reiterate our support for the work by the Basel Committee on Banking Supervision (BCBS) to finalize the Basel III framework by the end of 2016, without further significantly increasing overall capital requirements across the banking sector, while promoting a level playing field”

Clearly the Ministers did not dare to ask the regulators some minimum minimorum questions like:

What do you believe is the purpose of banks? Should it not have something to do with what like John A Shedd opined: “A ship in harbor is safe, but that is not what ships are for” 

If the purpose of the banks includes that of allocating credit efficiently to the real economy, why then do you distort that with risk weighted capital requirements for banks?

Can you indicate us one single bank crisis derived from excessive exposures to what was perceived as risky when incorporated to the balance sheets of banks? Voltaire said “May God defend me from my friends. I can defend myself from my enemies”. 

So, could that lack of questioning by the ministers be explained by John Kenneth Galbraith’s “If one is pretending to knowledge one does not have, one cannot ask for explanations to support possible objections”?

Frankly, neither Hollywood nor Bollywood, would insist in supporting the work of someone producing such Basel I-II flop, as the 2007/08 crisis and the thereafter continued stagnation evidences.

PS. Here is a short aide memoire on some of the monstrous regulatory mistakes

Decreed Inequality

John Kenneth Galbraith wrote: “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.” “Money: Whence it came where it went” 1975.

And that pro-egalitarian function had to face that natural risk aversion of bankers supposedly described by Mark Twain with “A banker is a fellow who wants to lend you the umbrella when the sun shines and wants it back when it rains”.

But since “poor risks” could always offer to pay higher risk premiums than the “safe”, and a dollar paid in interest was a dollar whoever paid it, the “poor risks” of yesterday, frequently got the opportunities for bank credit that in many cases transformed these into the safe of today. 

No longer. Bank regulators, wanting nothing but safer banks, decided since the early 1990s that the natural risk aversion of bankers was insufficient, and decreed risk weighted capital requirements for banks.

With it banks are required to hold more capital (equity) against assets perceived as risky than against those perceived as safe; which meant banks are able to leverage equity less with loans to those perceived as risky than with loans to those perceived as safe; which meant banks earn lower expected risk adjusted returns on equity lending to the risky than lending to the safe; which means that dollars paid in net risk adjusted margins on loans by the risky do not any longer have the same value than the same dollars paid by the safe; which means that no longer have the “risky poor” fair access to bank credit, while that of the “safe rich” is de facto subsidized. 

And this is what I mean with “Decreed Inequality”. How many millions of SMEs and entrepreneurs have not been given the opportunity to advance with credits over the last 25 years as a direct result of it? That would never have resulted in a free market with unregulated banks. And it sadly also means that banks no longer finance the “riskier future” but only refinance the “safer past”.

And in terms of “safer banks” it was and is all for nothing, as major bank crises never ever result from excessive exposures to something perceived ex ante as risky. The 2007/2008-bank crisis would never have happened or, if so, remotely had been of the same scale had banks not been regulated. A free market would never have knowingly allowed banks to leverage 30 to 50 times their equity like regulators did.

Do I think banks should not be regulated? Absolutely not! I am only reminding everyone of the fact that the damage dumb bank regulators can cause with their meddling, by far surpasses anything the free market can do.

And please, please, please, stop talking about "deregulation" in the presence of such an awful and intrusive mis-regulation.The regulators imposed the worst kind of capital controls.

Note: I expressed concerns about the distortions that capital requirements based on perceived risks could cause in my very first Op-ed, back in 1997.

PS. Through the bathroom window of the Basel Committee for Banking Supervision, and by decreeing the risk weight of the sovereign to be zero percent, while that of the private sector was set at 100 percent, the regulators also smuggled in horrendous statism. 

P.S. Here is a link to a more detailed aide memoire on the horrible mistakes of risk-weighing the capital requirements

PS. Then on top of it all they top it up with QEs and other stimulus that primarily benefit those who already own assets.

PS. Here is a letter on this issue the Washington Post published 

And here is my 2019 letter to the Financial Stability Board

“delta, vega and curvature risk” Basel Committee’s member understand less and less what they are doing, by the minute

To read the Basel Committee’s “Minimum capital requirements for market risk” of January 2016 is truly mindboggling. Do yourself a favor and just look at the index.

Do those really responsible for what is coming out of the Basel Committee truly understand what is said there?

I am sure that John Kenneth Galbraith’s “If one is pretending to knowledge one does not have, one cannot ask for explanations to support possible objections”, applies to most of them.

And it is not like the Basel Committee has shown itself to be a good regulatory body. It has actually been one of the most failed ones… so failed that they should have been prohibited from having anything to do with bank regulations… forever.

Do you really think its current Chair, Stefan Ingves, could provide you with a lucid explanation of it?

I know enough about finance to know when our banks are being dug even deeper in the hole in which they should not be.

The regulators wrote that the bank capital requirements are portfolio invariant because … otherwise it “would have been a too complex task for most banks and supervisors alike”... and now they come with "delta, vega and curvature risk"?

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.”

We’ve heard a lot about predatory lending, and it should be avoided, but why allow predatory regulations?

An audit report from the office of inspector general of the FDIC broadly defines predatory lending as "imposing unfair and abusive loan terms on borrowers”

Regulators know very well that those perceived as risky have to pay higher risk premiums and have less access to bank credit than those perceived as safe. 

Nonetheless regulators currently also require banks to hold much more capital against loans to those perceived as risky, when compared to what they need to hold against assets perceived as safe. And as a direct consequence those perceived as risky, when compared to those perceived as safe, will have to pay even higher interests and have even less access to bank credit. 

Since that imposes unfair and abusive loan terms on borrowers… it should be regarded as predatory regulations… and of course, to top it up, by negating fair access to the opportunities for credit of those perceived as risky, these also represent a driver of inequality.

Let me quote here two passages from John Kenneth Galbraith’s “Money: Whence it came where it went” 1975.

First: “For the new parts of the country [USA’s West]… there was the right to create banks at will and therewith the notes and deposits that resulted from their loans…[if] the bank failed…someone was left holding the worthless notes… but some borrowers from this bank were now in business...[jobs created]

It was an arrangement which reputable bankers and merchants in the East viewed with extreme distaste… Men of economic wisdom, then as later expressing the views of the reputable business community, spoke of the anarchy of unstable banking… The men of wisdom missed the point. The anarchy served the frontier far better than a more orderly system that kept a tight hand on credit would have done…. what is called sound economics is very often what mirrors the needs of the respectfully affluent.”

Second: “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.”

And finally, let me just add that never ever are truly dangerous financial bank excesses built up with assets perceived as risky; these are always caused by excessive bank exposure to what is perceived ex ante as safe but that ex-post tum out to be risky… and so all this odious regulatory discrimination against the risky… is all for nothing.

PS. “If one is pretending to knowledge one does not have, one cannot ask for explanations to support possible objections” John Kenneth Galbraith dixit.