Since bank regulators in 1988 decreed sovereign debt to be risk free, the market has not set the risk-free rates

In the discussion by Lawrence Summers and Adair Turner on secular stagnation in the Institute of New Economic Thinking INET, on October 28, I extract the following:

15:25 Lord Adair Turner

“The longer we have the slow growth and sub-target inflation, the more you have to think that there is something secular is at work. And the thing that makes me pretty sure that Larry is right in his hypothesis that something secular is at work, is to look at the 30, not the 10 year trend, but the 30 year trend, in real risk-free interest rates. 

Take UK’s 10 year yields on real index linked gilts. 

Take an average for each five year period, from 86-90, 91 to 95 and so six of those 5 year periods until the last

And the sequence is 3.8%; 3.6; 2.5%; 1.9%; 1.2%; minus 0.6%, and the value is now minus 1.5%. 

When you see a trend like that you begin to think that there may be something secular, petty strong, about that; with a dramatic fall even before the 2008 crisis, so you can’t put all this down to central bank intervention, quantitative easing.

So we seem to have entered a world where savings and investments only balance at very low or negative real interest rates. And of course those very low interests rates themselves, played a role in stimulating the excessive private credit growth which landed us with the debt overhang. 

But despite this those low interest we have low growth and below target inflation, and so it is vital we try work why is this… 

17:58 Well logically, the long term decline in real interest rates must mean that we have faced over the last 30 year either:

an increase in the ex ante desired aggregate global saving rate 

or a decline in the ex ante desired or intended global investment rate 

or a mix of both.”

Lord Adair Turner, the former chairman of the Financial Service Authority, FSA (2008-2013), and therefore supposedly a technocrat well versed in bank regulations, had not a word to say about: 

That extraordinary moment when, after about 600 years of “one for all and all for one” capital in banking, in 1988, with the Basel Accord, Basel I, regulators introduced risk weighted capital requirements for banks and, to that purpose, set the risk weight for the sovereign at 0%, while the risk weight for We the People was set at 100%.

That of course signified an extraordinary regulatory subsidy of sovereign debt, that had to set the UK’s 10 year yields on real index linked gilts, on a negative path.

From that moment on, since the regulators had decreed sovereign debt to be risk free, we can no longer really hold the market, using public debt as a proxy, can provide a reliable risk free rate estimate.

For now those artificially decreed risk-free rates can only go down and down and down… until BOOM!

The low “real” public debt interests might be the highest real rates ever, in that these regulations also make banks finance less the riskier, like SMEs and entrepreneurs, those who could provide us with our future incomes, and therefore governments with its future tax revenues.

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 :-)

Now I am extremely worried

Holy Moly!

Is it that regulators, economists, even Nobel Prize winners, do not understand that… lower capital requirements for banks on some assets than others, means that banks will earn higher expected risk adjusted returns on some assets than others?

Have not anyone of these studied finance?

You, the bank regulating scientists, would you please explain something to a layman?

Below what I saw while walking around in the Washington Zoo with my constituency (my grandchild) and which inspired me to ask our bank regulation scientists friends a question.

Smithsonian scientists learn a lot by observing animals. 

Now its your turn to WATCH AND LEARN

So now it is with you bank regulator. You are the scientist. Scientist learns a lot, by observing banks and bankers. So please explain.

Observe what type of bank exposures have caused all major bank crises:

1. One or many of those ex ante considered risky, and that ex-post turned out to be risky?

2. One or many of those ex ante considered risky, and that ex-post turned out to be safe?

3. One or many of those ex ante considered absolutely safe risky, and that ex-post turned out to be safe?

4. One or many of those ex ante considered absolutely safe risky and that ex-post turned out to be very risky?

And now, you bank scientists answer us non bank scientists. 

For what type of exposures would the empirical evidence suggest the capital requirements for banks should be higher?

Aha! 

And so then explain to us, in easy terms, why you, the Basel Committee for Banking Supervision, the Supreme Global Bank Supervisor, set rules which allowed the banks to have much much less capital for what was ex ante perceived as "absolutely safe", than for what ex ante is perceived as risky?

Please?

PS. My own humble opinion is that our bank regulation scientist friends have got themselves trapped in quite a bit of confusion. They keep on analyzing the possible failure of bank borrowers and not, as they should, the reasons for why banks fail, as entities or in allocating credit to the real economy. And that is of course not the same thing, or, as they say in French, c’est pas la même chose… For instance instead of looking at the ex ante credit ratings of bank borrowers they should look at what bankers do when they see those same credit ratings.

In other words, the regulators instead of analyzing so much the ex ante creditworthiness of bank borrowers, to determine their risk weights, should have analyzed, at least a little, the ex-post explanations for why banks fail and for why bank crises occur. Holy moly!

PS. As I see it: The world (with its banks) is much better off thinking that the risky are less risky than we think them to be, than that the "safe" are as safe as we think.

Three Qs and As on our banks

Q. What is the first worst that can happen to our banks, excessive exposures to the risky?

A. No, the “risky” never poses any risk of excessive exposures, The first worst is when something considered as “absolutely safe”, and to which therefore bank exposures could be huge, blows up in their face.

Q. What is then the second worst?

A. That when the first worst happens, the banks would not have the capital needed to cover for the losses.

Q. But, if then regulators, by setting quite decent capital requirements for banks for holding what is perceived as “risky”, but almost nonexistent for exposures to what is perceived as “absolutely safe”, make it more likely that the first worst and the second worst come together… is that not sort of dumb?

A. Yes, indeed, I take it back. The first worst thing that can happen to our banks, are dumb regulators.

Conclusion: Throw out Basel's capital requirements for banks based on perceived risk and use a simple and straightforward leverage ratio of between 8 and 10%

IMF’s “Rethinking Macro Policy II was a great conference, though My Question, again, went unanswered.

Very thankful for the invitation I attended IMF’s “Rethinking Macro Policy II” conference, April 16 and 17, and in which there was a special session on financial regulations. 

There were many good presentations and discussions and if I absolutely must pick one as the best that must be the one on financial cycles presented by Claudio Borio who currently is the Research Director and Deputy Head of the Monetary and Economic Department at the Bank for International Settlements (BIS). 

And as I usually have done over the last six years when attending conferences like these, I asked as many experts as possible:

My Question: 

If all bank crisis in history have resulted from excessive exposures to what was perceived as “absolutely safe”, or at least very safe, and none ever from excessive exposures to what was perceived as "risky"… what is the rationale behind the pillar of current Basel regulations, namely capital requirements for banks which are much lower for what is perceived as "absolutely safe", or at least very safe, than those for what is perceived as “risky”? Does not all empirical evidence suggest instead that the capital requirements should be slightly higher for what is perceived as "absolutely safe" than for what is perceived as "risky"?

As to the answers, as usual, some were intrigued, others stuttered, and many replied “Oh I know there is a clear explanation for the current capital requirements, I just can't remember right now what it was”.

And though I try to avoid asking those I know I have asked before, like Martin Wolf and Lord Turner, I found one participant who answered: “Yes, you asked me that 3 years ago and I have not been able to figure it out yet either”. 

By the way, have a look at a letter which asks a related question, and that I am trying to deliver to as many Ministers as possible during these World Bank and IMF Spring Meetings in Washington, April 19-20 

Please, anyone reading this post and possessing an answer to my Question, I would much appreciate sending it to me at perkurowski@gmail.com

PS. In the conference I met someone who like me knows there is no rational answer.

PS. Here is a more extensive list of the horrendous mistakes of the risk weighted capital requirements

Basel Committee, Financial Stability Board, please do not make fun of us, or bullshit yourselves

Here is a document, which in 2005 explains why bank regulators like Mario Draghi, Lord Turner, Alan Greenspan, Mark Carney, Stefan Ingves, Michel Barnier and many other, and commentators like Martin Wolf, decided to give their full backing, in 2004, to Basel II capital requirements based on perceived risk.

It says: “This paper purely focuses on explaining the Basel II risk weight formulas in a non-technical way by describing the economic foundations as well as the underlying mathematical model and its input parameters”… and so unfortunately “By its very nature this means that this document cannot describe the full depth of the Basel Committee’s thinking as it developed the IRB framework”… but luckily for us “For further, more technical reading, references to background papers are provided.” 

Is someone trying to make fun of us? 

The document details: 

“The model should be portfolio invariant, i.e. the capital required for any given loan should only depend on the risk of that loan and must not depend on the portfolio it is added to. This characteristic has been deemed vital in order to make the new IRB framework applicable to a wider range of countries and institutions. 

Taking into account the actual portfolio composition when determining capital for each loan - as is done in more advanced credit portfolio models - would have been a too complex task for most banks and supervisors alike. The desire for portfolio invariance, however, makes recognition of institution-specific diversification effects within the framework difficult: diversification effects would depend on how well a new loan fits into an existing portfolio. 

As a result the Revised Framework was calibrated to well diversified banks. Where a bank deviates from this ideal it is expected to address this under Pillar 2 of the framework. If a bank failed at this, supervisors would have to take action under the supervisory review process (pillar 2).” 

And so that means to tell us our and all other bank supervisors around the globe who have adopted Basel II are up to this? 

Bullshit!

PS. Who wrote it?

PS. Please help me ask the question that debunks all this Basel II nonsense.

You bank regulators... get your priorities right, urgently, or we depict you on some shame poles.

Very few of us like having banks "too big to fail" or bankers receiving exaggerated bonuses. 

But, if banks are “too big to fail” and bonuses to bankers seem immorally large, but our banks still do a good job allocating economic resources efficiently, that is hard, but still quite livable. 

But if banks do not allocate economic resources efficiently, then even if all our banks are small, and easy to liquidate, and all our bankers do not receive more compensation than anyone else, that is still, something completely unacceptable. 

So please, European Parliament, European Commission, Basel Committee, Financial Stability Board, Michel Barnier, Stefan Ingves, Mario Draghi, Mark Carney, Lord Turner, Ben Bernanke… get your priorities right! 

The way YOU allow banks to hold lower capital against exposures considered as risky, than for exposures considered as safe, and which allows banks to earn higher expected risk-adjusted returns on what is perceived as safe than on what is perceived as risky, is bloody murdering the economies of the Western World, those economies which became prosperous thanks to a lot of risk-taking. 

When I think of all those opportunities missed, forever, to generate good jobs for our youth, only because of your regulations, I tell you I would have no qualms whatsoever depicting you on some shame poles, and placing these totems all around the most public places in Europe and America.

What are historians going to say about the Basel Committee's capital requirements for banks based on perceived risk?

I am sure historians will be scratching their heads trying to figure out how the bank regulators of the Basel Committee for Banking Supervision, and of the Financial Stability Board, could have been so dumb so as to base their capital requirements for banks on perceived risks already cleared for by markets and banks through interest rates, amounts exposed and other contractual terms. 

And with it they doomed our banking system to overdose on perceived risks and create obese exposures to "The Infallible" and anorexic exposures to "The Risky". 

In other words the regulators castrated the banks of the Western World and made these sing in falsetto.

Most probably the historians will be explaining it in terms of the incestuous group think which can result when allowing “experts” to debate such matters in a mutual admiration club subject to absolutely no accountability at all.

Damn you dumb bank regulators!

Are “Those magnificent men in their flying machines” the explanation for the so failed bank regulations?

Was this what the current generation of bank regulators, like Lord Turner and Mario Draghi, watched as kids, and so that they could grow up arrogantly thinking that by deftly pulling at some risk-weights levers they could guarantee an ever bliss of adequate bank capital ratios? 

I mean there has to be some kind of explanation for the stupidity of higher capital requirements for banks when lending to “The Risky”, when it is always excessive exposures to “The Infallible” that has posed dangers to our banks.

What I do not understand then is why regulators were so lack in daring as clearly “the magnificent” were not. But that might be because there must be a tremendous difference between flying a plane in the air, and flying some banks while sitting at your desk, especially in safe Basel.

Those magnificent men in their flying machines,

they go up tiddly up up,

they go down tiddly down down.

They enchant all the ladies and steal all the scenes,

with their up tiddly up up

and their down tiddly down down.

Up, down, flying around,

looping the loop and defying the ground.

They're all frightfully keen,

those magnificent men in their flying machines.

They can fly upside with their feet in the air,

They don’t think of danger, they really don’t care.

Newton would think he had made a mistake,

To see those young men and the chances they take.

Those magnificent men in their flying machines,

they go up tiddly up up,

they go down tiddly down down.

They enchant all the ladies and steal all the scenes,

with their up tiddly up up

and their down tiddly down down.

Up, down, flying around,

looping the loop and defying the ground.

They're all frightfully keen,

those magnificent men in their flying machines.

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.

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.

Regulators, consider yourselves officially challenged to debate the wisdom of your bank regulations

I hold that current bank regulations, most especially capital requirements based on perceived risk, are utterly absurd, and dangerous, and that regulators have behaved irresponsibly when imposing these; and should be held accountable for participating directly, though certainly unwittingly, in causing the current economic difficulties... which are threatening to take the Western world down. 

I have argued the above in hundreds of conferences and thousands of blog comments, emails and articles, soon for a whole decade, and I have never ever received the hint of any type of counterargument from any regulator. 

Therefore I challenge all regulators, most especially the hot-shots like Mario Draghi, Lord Turner, Michel Barnier, Timothy Geithner, Mervyn King, Ben Bernanke, or of course whoever they want to designate to champion their cause, to publicly debate the issue with me, in depth.

Regulators, please stop waging war on the "risky"... they have it hard enough as is!

Per Kurowski 

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

Currently also censored by the Financial Times 

perkurowski@gmail.com

PS. Do you really want me to lower myself so much as to name you “The sissy bunch”, in order to get your attention? Well, if you absolutely want me to, if I absolutely have to... I guess I must and will.

PS. If you do not know what it is to wake up in the middle of the night, sweating, thinking, “what is it that I have missed” you have no clue about how it feels to question, so fundamentally as I do You… The Regulatory Establishment.

PS. Do I have the necessary qualifications to participate in the debate? You bet! Just read some of my earliest comments and warnings on this issue. Few if any has been so clear so early on what was expecting us.

PS. A similar challenge, more than a year ago!

PLEASE!, all those of you who feel regulators should dare to debate their regulations, do whatever you can do to support this challenge… tweeting re-tweeting or even calling your congressman!

Mr. Bank Regulator. Please explain yourself!

In banking (as with most in life) with respect to perceived risks, there are only four possibilities: 

Risky/risky: What was perceived as risky turns out to be risky. Because of the higher interest rates usually charged to those perceived as risky, which serves as a shield, the harsher terms, and the lower bank exposures that follow, this quadrangle has never ever been the source of any major bank disaster. 

Risky/not-risky: What was perceived as risky turn out not to be risky. This can only be of course, a source of good news. 

Not-risky/not-risky: What was perceived as not-risky turn out not to be not-risky. In other words, all as expected. 

Not-risky/risky: What was perceived as not risky, turned out to be risky. This is of course the only source of all major bank crises, namely when major bank exposures gone sour. 

But, the current “pillar” of bank regulations, is capital requirement for banks which allow for much less bank capital when lending in the danger area of the perceived “not-risky”… and that does not seem too smart. 

Not only will the increased possibilities of leveraging bank equity attract too much bank interest in lending to the “not-risky”, but also, when things go sour, the banks will stand there naked, with little or no capital. And it also creates a regulatory disincentive for banks to lend to the safe area of the perceived as risky… and which by the way includes the small businesses and entrepreneurs we so much need to have access to bank credit. 

Indeed that regulation sounds very dumb, which leads me having to consider you, as a bank regulator, to be very dumb. I have for almost a decade now tried to get an explanation from you, but you have consistently refused to do so. You have not even acknowledged the arguments. And so, here is a new opportunity for you to explain yourself. 

Let me assure you that I would love for you to be able to convince me that, with your regulations, you are not castrating our banks, that important channel by which a risk adverse society takes the risks it needs for it to take, without making these safer, but in fact even endangering these. 

What’s my problem? I tell you! If you would run a regression between all the obese bank exposures that have lately gone bad, and the extremely low capital requirements allowed banks for holding these assets, one should conclude that your dumb regulations fundamentally caused this crisis. And, for that, you need to be held accountable, most especially when you seem quite unwittingly to be digging our economies even deeper in the hole. 

Sincerely 

Per Kurowski 

Lord Adair Turner on the Euro

Lord Adair Turner recently said “the thing that has gone wrong is the way we've encouraged Italian banks to hold to Italian debt” 

And so much more with their outright stupid capital requirements for banks based on perceived risks. These drove the banks to excessive exposure to “no-risk-land”, that land which as an example included the AAA rated securities and Greece, precisely the land that they, as regulators, should now is where all the excessive exposures and unpleasant surprises and systemic bank crises occur, while at the same time driving away the banks from helping out those in “risk-land”, where all the small businesses and entrepreneurs live, and in which never ever has a bank crises occurred. 

How much in extra interest rates, or in less access to credit, have the job creating small UK businesses and entrepreneurs have had to pay over the years, just because of Lord Turner and his chums’ regulatory nanny like anti-perceived-risk bias 

And here he is still “not advocating any deviation from the path set by Basel” 

Still I guess we can count ourselves lucky that Lord Turner is not also in charge of the golf handicap system, because if so, he would long ago killed that popular sport by allowing the good players like you more strokes, while taking strokes away from bad players like me.

PS. If you allow here´s a video that explains part of the craziness of our bank regulations http://bit.ly/mQIHoi

Our crazy bank regulations explained in red and blue

Nannies care for risks perceived, regulators should care for the risks not perceived. So you tell me, the Basel Committee, the FSA and the FSB, what are they?

What Lord Turner hasn´t the foggiest about!

Since the 8 per cent capital requirement of Basel II and applied with a risk-weight of 100 per cent proved to be more than sufficient to cover for the risks of bank lending or investing in what was officially perceived as “risky”, it is clear that the problem does not lie with a too low basic capital requirement but with the too low risk-weights applied to all what is officially perceived as “not risky”.

This is what a Mr. Lord Turner, who now says “security can only come with 15 to 20 per cent” capital requirements, hasn´t the foggiest about.

Mr. Lord Turner also says “Financial instability is driven by human myopia and imperfect rationality” Absolutely! But when is he going to realize that the regulator´s myopia, including his own, might be the most systemically dangerous.

Lord Turner, please help save the world from our financial regulators´ regulatory exuberance!

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

1:20:07 MR. KAROFSKY: Pere Karofsky (In the transcripts that's me) from the Voice of Noise Foundation (You can also hear it in the audio).

"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? I mean to combat the regulatory exuberance of the Basel Committee."

1:26:08 To that 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 think we, as regulators, have to focus simply on how risky actually is it?"

I replied (not authorized, perhaps even rudely) the following: 1:27:19 

"But you do do make all regulatory discrimination based on credit risk and that risk is just one of the many risk we face".

My prime conclusion of it all was that when Lord Turner states "capital is there to absorb unexpected loss, or either variance of loss rather than the expected loss" he does not understand the sillines of estimating unexpected loss using expected loss. The safer something is perceived de facto de larger its potential to deliver unexpected losses. And he also does not understand the purposelessness of weighing capital requirements based on one of the only risks banks have already cleared for, by means of risk premiums and the size of the exposure

And on June 22, 2010 I sent Lord Turner the following letter:

Dear Lord Turner.

In November 1999 I wrote: “The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which at the end will cause the collapse of the last standing bank in the world.”

There has never ever been a major or systemic bank crisis that has resulted from the banks being involved with what ex-ante was perceived as risky; they all resulted from lending and investing in what ex-ante was considered as not risky, given the returns offered. 

But then came the Basel Committee regulators and, to top it up, lowered the capital requirements for what ex-ante is perceived by the credit rating agencies as having lower risks, which of course increased the banks’ expected ex-ante returns from pursuing these “low risk” opportunities. 

And now, when two years after an explosion that resulted from so many banks following the minuscule capital requirements when investing in securities collateralized with subprime mortgages; and there is a bank explosion awaiting round the corner because of the minuscule capital requirements when lending to well rated fancy sovereigns, like Greece; they keep on applying the same regulatory paradigm of risk-weighted assets, we can only deduct that our financial regulators simply do not get it, not even ex-post.

Please, Lord Turner, help save the world from our financial regulators´ regulatory exuberance!

Regards

Per Kurowski

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

I received and answer but since its states "This communication and any attachments contains information which is confidential and may be subject to legal privilege" I refrain from making it known unless I am duly authorized.

But I then answered:

Dear Lord Turner

Yes, we met yesterday at Brookings... and it is not only that “our ability to know ex ante what is low and high risk is clearly limited and we have undoubtedly placed too much faith in apparently sophisticated but conceptually flawed VAR type approaches” but that, ex-post, the most benign risk for the society, might be the risk of default on which the regulators concentrate exclusively.

Think about the horror or a world without defaults and with corporations and banks becoming larger and larger. What about the risks of our banks not performing efficiently their role in allocating capitals?

By the way, lending to Greece and BP required the banks to have only 1.6 percent in capital.

Regards

Per Kurowski

To that I received no answer.