Mario Draghi, President of the ECB and Chair of the European Systemic Risk Board shows, again, he has dangerous little understanding about the true nature of systemic risks.

“Systemic risk refers to the risk of a breakdown of an entire system rather than simply the failure of individual parts. In a financial context, it captures the risk of a cascading failure in the financial sector, caused by interlinkages within the financial system, resulting in a severe economic downturn.”

I refer to Mario Draghi’s welcome remarks at the third annual conference ofthe European Systemic Risk Board (ESRB), September 27, 2018

1. “The need for high-quality data: Policymakers’ ability to act hinges crucially on the availability of high-quality data. Data allow policymakers to identify, analyse and quantify emerging risks. Data also provide policymakers with the necessary knowledge to be able to target and calibrate their tools and to be aware of possible spillovers, or attempts to circumvent regulations”

a. The more you believe you are in possession of “high-quality data” the more you set yourself up for a systemic risk, like when banks were led by their regulators to believe that risk of assets rated AAA were minimal.

b. The more regulators might be tempted to “target and calibrate their tools” without considering how the markets might already have calibrated and targeted that “high-quality data”, the more they might generate the systemic risk of giving that “high-quality data” excessive consideration. Like when bank regulators, ignoring the conditional probabilities, based their risk weighted capital requirements basically on the same credit risk bankers were already perceiving and clearing for.

2. “Reflecting the targeted nature with which macroprudential policy can be applied, some countries have considered varying implementation by geographical area, to strengthen the impact on local hotspots. These policy actions have helped mitigate movements in real estate prices.”

But trying to contain “hotspots” and not allowing the market to determine the movements of real estate prices contains the clear and present systemic risk of pushing credit into “weak-spots” and not where it could be mots useful for the economy. Like when bank regulators by giving preferential risk weights to the “safe” sovereign and “safe” houses, negates credit to the “risky” entrepreneurs.

3. “Non-bank finance is playing an increasingly important role in financing the economy. Policymakers need a comprehensive macroprudential toolkit to act in case existing risks migrate outside the banking sector or new risks emerge.And that means widening the toolkit so that policymakers are able to effectively confront risks emerging beyond the banking sector.”

No, regulators who have not been able to regulate banks, and caused the 2008 crisis, and caused the tragedy of Greece, have not earned the right to expand their regulatory franchise anywhere.

4. “Conclusion: Policymakers across Europe have proven willing to use macroprudential policy to address risks and vulnerabilities. These measures have helped counter the build-up of risks”

NO! Regulators who still use risk weighted capital requirements based on that what is perceived as risky is more dangerous to our bank system than what is perceived as safe, have no idea about basic macroprudential policies.

NO! Regulators who still believe that with their risk weighted capital requirements for banks they can distort the allocation of credit without weakening the real economy; and who do not understand how dangerously pro cyclical the risk weighted bank capital requirements are, have no idea about basic macroprudential policies.

PS. My views on some systemic risks, as expressed at the Board of the World Bank in 2003.

PS. Here is an aide memoire on the mistakes in the risk weighted capital requirements for banks.

FSB reports: “G20 reforms are building a safer, simpler, fairer financial system”. What a triple lie!

FSB reports to G20 Leaders on progress in financial regulatory reforms, and it starts with: G20 reforms are building a safer, simpler, fairer financial system

“Safer”? Major bank crises do not result from excessive exposures against what is perceived risky, but always from unexpected events or excessive exposures to what was ex ante perceived, decreed or concocted as safe, but that, ex post, turned out to be very risky.

In the FSB video they say “A safe banking system needs enough capital to absorb unexpected losses” and so my question is: So why require capital based on expected risks?

“Simpler”? Don’t be ridicule! Just have a look at the Basel Committee’s absurdly obscure “Minimum capital requirements for market risk” of January 2016, and on its consultative document for a "simplification" of July 2017.

The FSB video does not really even dare to explain the "simpler" factor.

“Fairer”? Forget it! The discrimination in the access to bank credit in favor of those perceived, decreed or concocted as safe, like the Sovereigns and the AAA-risktocracy is still alive and kicking; just like that one against “the risky”, the SMEs and entrepreneurs. It is an inequality driver.

No wonder the FSB video has the comments disabled.

G20 you want to understand what is wrong with current bank regulations? Start here!

Here follows my linked four tweets to bank regulators

The ex post risk of Basel Committee’s bank capital requirements, based on models based on ex ante risk perceptions, is huge!

All these capital requirements do is to seriously distort the allocation of bank credit to the real economy, for no good purpose at all.

Bank capital requirements should be based on ex post risks that considers the risks of models based on ex ante risks perceptions.

Mario Draghi, Mark Carney, Stefan Ingves, Janet Yellen, Martin Gruenberg...  Capisci?

When and where did the last bank crisis resulting from excessive exposures to something ex ante believed risky occur?

I don't know. Ask the regulators in the Basel Committee on Banking Supervision and the Financial Stability Board. 

I mean they must have much data on this because, without it, why would they impose credit risk weighted capital requirements for banks, knowing that carried the huge cost of distorting the allocation of bank credit to the real economy?

I mean that if they use the theorem that what's perceived as risky is riskier to the bank system than what is perceived as safe, then they are indeed using a loony theorem.

Or did they not look for the data?  Or did they not understand it?

Most concerns about derivatives derive from the fact that it sounds so deligtfully sophisticated

In a derivative, there is a buyer and a seller, and so whatever happens someone wins and someone loses and in essence it’s a wash out… of course as long as all can live up to their commitments.

But, in a real market loss, like that of a lower value of a stock, a lower value of a painting, or a lower value of a real estate, there is at that time only a loser… and no winner… that is unless you count he who way back have earlier sold the stock.

And in this respect the trading in derivatives will depress much less the market than a depression of the values of the underlying vanilla assets.

The big fuss that is raised around the issue of trading of derivatives, again, besides the possibility of one side of the trade not living up to his commitments, has much more to do with the fact that “derivatives” sounds so delightfully sophisticated when you let it roll down your tongue.

But topping that must be the introduction of “delta, vega and curvature risk” into the discussions. Just read the index of the Basel Committee’s “Minimum capital requirements for market risk” of January 2016. Mindboggling! Do those who are responsible for what is coming out of the Basel Committee truly understand the implications of that for the banking system?

I am quite 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 bank regulators… perhaps to all.

Otherwise how come the real failures of the risk weighted capital requirements for banks, are not yet even discussed?

Mr Mario Draghi. For Europe’s good, why not take a sabbatical year and do all it takes for you to understand the RWCR?

The citations below are extracted from the speech “Cross-border markets and common governance” delivered by Mario Draghi, President of the ECB, during the Bank of England Open Forum, London, 11 November 2015.

These evidence that the former Chair of the Financial Stability Board, does yet not understand what caused the current crisis, namely the distortion in banks assets allocation to the real economy produced of Basel II’s risk weighted capital requirements for banks (RWCR); more ex ante perceived risk, more capital – less risk, less capital.

Draghi: “To reap the benefits of openness, markets require appropriate governance. Indeed, a market stipulates not just the freedom to take part in the market, but also the means to protect that freedom. That means the confidence that contracts entered into will be enforced. It means the assurance that the rules of fair competition will be upheld, that property rights will be respected, that standards and codes will be applied properly. It means, in short, the Rule of Law.”

Mr. Draghi: The RWCR violated directly the rules of fair competition in the markets for bank credits. These allow banks to earn higher risk adjusted returns on equity on assets perceived as safe than on assets perceived as risky. As a consequence those perceived as safe and who already pay lower interest rates and have access to more bank credit are, because of the RWCR, treated even better, in direct detriment to the fair access to bank credit of those perceived as risky. And negating the risky fair access to bank credit is a prime inequality driver. 

Draghi: “For financial markets this is especially important given their inherent fragility. If rules and standards are not effectively applied, it can produce information asymmetries and other destabilising forces which, in turn, lead to sudden reversals of confidence in the market. We have seen in the past how markets have run ahead of regulation leaving them vulnerable to such dynamics.”

Mr. Draghi: Those RWCR produced gigantic information asymmetries and destabilising forces. Go back and read all the specialized newspaper that spoke of well capitalized banks, like of a 10 to 1 leverage, without understanding that this was based on risk-weighted assets and that their real leverage was often 50 to 1.

Draghi: “Here is one illustration: during the crisis, the market for securitised assets was all but destroyed by a collapse of confidence. Lack of oversight allowed excesses to be committed and market abuse to take place” 

Mr. Draghi. The fact that Basel II of June 2004 allowed banks to hold those securities against only 1.6 percent in capital if they achieved an AAA to AA rating; which means an almost unimaginable allowed leverage of 62.5 to 1, provided the incentives for excesses and market abuse to be committed. Before that there had been mortgages to the subprime sector for many decades, without these causing any problems.

Draghi: “Securities that were previously deemed safe, certainly with some measure of complacency and too much blind confidence, turned out to be very unsafe indeed, and imparted significant losses on their holders.”

Mr. Draghi: Securities or loans "that were previously [ex ante] deemed safe, certainly with some measure of complacency and too much blind confidence, and turn out [ex post] to be very unsafe” is precisely the stuff all major bank crises in history are made of. Show us one bank asset that was perceived as risky when it was placed on the balance sheets and that amounted to such an importance that it caused a major bank crisis? There is none! 

Draghi: “What is also unfortunate is that the subsequent attempts to re-regulate that market have threatened to undermine the parts that are beneficial to many. There was too much opacity as to the nature of the assets underpinning asset-backed securities, too damaging a breakdown of confidence in the integrity of those who packaged and sold them. And the immediate temptation of regulators was to impose punishing capital charges on holdings of asset-backed securities, independent of their individual characteristics, mixing the wheat with the chaff.”

Mr. Draghi. Regulators should not substitute for the markets. Let the market value the individual characteristics of the wheat and the chaff. At this moment all the stimulus to the economy are being dangerously wasted because regulators have decided, with their risk weights to treat the “risky” SMEs and entrepreneurs as chaff, and not as the nutrient and for the economy indispensable wheat they represent. 

Mr. Draghi the capital of banks is to cover for unexpected losses, and that is something explicitly accepted by the regulators. And so here follows some basics in risk management you and your colleagues could benefit from knowing:

It does not make any sense setting what is to cover for the unexpected based on expected credit losses already cleared for.

The RWCR doubled up on credit risk; and any risk, even if perfectly perceived, results in the wrong actions if excessively considered.

The regulators concerned themselves with the risks of bank assets while their worry should have exclusively been on how banks manage the risks of those assets.

You allowed big banks to decide on the capital required by using risk models. That was like telling your kids they can pick anything they want from a menu of ice-cream chocolate cake, spinach and broccoli. Is that a market?

The safer something is perceived the greater its potential to deliver unexpected losses.

Motorcycles are riskier than cars, but car accidents cause more deaths than motorcycle accidents.

It is not by telling banks to avoid risks that we can live up to that holy intergenerational bond Edmund Burke spoke of.

Mr Mario Draghi. For the good of Europe, why do you not take a sabbatical year to reflect on this? You said you were willing to do all it takes.

Hopefully Mr Draghi you would end up understanding that the biggest systemic risks for banks are always imbedded in the assets perceived as the safest or so safe that all must have them; and that excessive risk aversion is about the riskiest there is for the economy...

A public letter to Mr. Stefan Ingves, the chair of the Basel Committee for Banking Supervision

Mr. Stefan Ingves.

There are cowards and there are braves, ranging from extreme cowards to stupidly foolish braves, but that has less to do with how these perceive risks, and much more to do with how they assume and manage risks.

And then there are those blind to risks… so blind they do not even see a credit rating.

The Basel Committee’s risk weighted capital requirements for banks, based on precisely the same perceived risks (credit ratings) that seeing banks can already see, have clearly been designed for blind bankers.

I do not know how many such blind bankers there are, and if they exist they should not even be allowed to be in business. But, your risk weighted capital requirements, sure poses a big problem for all other banks, and for the economy in general.

Since non-blind banks already clear for any perceived credit risk, by means of interest rates and size of exposure, to force them to again, now in the capital, clear for exactly the same perceived credit risk, gives credit risk perceptions a double weight.

And any perceived risk, even if perfectly perceived, if excessively considered, leads to the wrong action.

In the case all credit risk ratings were perfect… that would then mean banks would lend more than what they should, to what is perceived “safe”, and less than what they should, to what is perceived "risky". And that misallocation of bank credit must be bad for all, especially for the real economy.

Also if credit ratings indicate a “safe” asset to be safer than what it really is, then of course a bank could collapse. Indeed this is precisely the stuff all major bank crises have been made of. No crisis has resulted from too much exposures to something ex ante perceived as risky.

Of course, if a credit rating is imperfect, in the way of informing the asset to be less risky, or less safe, than what it really is, then you might have helped banks to nail it. I doubt though your intention was really to base it on credit ratings being adequately wrong.

Mr. Stefan Ingves, may I suggest the following?

For once think of the purpose of banks being that of allocating credit efficiently to the real economy; and then go back to the drawing board, to see what non-distortionary capital requirements for banks you can come up with.

While doing so, may I suggest you remember that the purpose of the capital requirements for banks, is to cover for some unexpected losses, and not like now, for the expected credit losses?

You could still use credit ratings, if that helps you to save face… but, instead of basing it until now on those credit ratings being correct, why not require banks to have for instance 8 percent of capital against all assets, based on the risks of credit ratings, and other risk perceptions, being wrong... and other risks like that of cyber-attacks.

Please Mr. Ingves... wake up! The risk with banks has nothing to do with the risk of their assets, and all to do with how they manage the risk of their assets… Don’t make it harder than it already is for banks to manage credit risks correctly.

Yours sincerely,

Per Kurowski

PS. Could you please send a copy of this letter to Marc Carney, the current chair of the Financial Stability Board? It could also be of interest  to BIS's Jaime Caruana, ECB's Mario Draghi, and Fed's Janet Yellen. 

When are we going to get regulators concerned with banks allocating credit efficiently to the real economy?

I just wonder… because clearly current bank regulators do not care one iota about that.

If they did they would not have concocted their silly credit-risk-weighted equity requirements for banks which allow banks to earn much higher risk adjusted returns on equity lending to “the safe” that when lending to “the risky.”

And that of course means banks will lend much too much to "the safe" and much too little to "the risky"

Current credit-risk-weighted capital (equity) requirements for banks, besides being stupid and dangerous, are immoral

This is what the current bank regulators have decreed, on their own, without any real consultations:

The lower the perceived credit risk of an asset, the lower the equity a bank has to have against it… and so of course, the higher the perceived credit risk of an asset, the higher the equity a bank has to have against it.

It is stupid: because never ever have major bank crises resulted from excessive bank exposures to what is perceived as risky, these have always resulted, no exceptions, from excessive bank exposure to something perceived as save.

It is dangerous (even from a national security perspective): because allowing banks to leverage their equity, and the support they receive from taxpayers, differently based on perceived risks, will seriously distort the allocation of bank credit to the real economy and thereby weaken it.

And it is immoral: because having those perceived as risky and who already, precisely because of those perceptions, have less and more expensive access to bank credit, to have even lesser and even more expensive access to bank credit, is an odious and immoral regulatory discrimination, which kills opportunities and increases inequality.

Our economies are bloated by QEs, low interests and other stimuli, and the lack of real risk-taking.

Tarps, fiscal deficits, QEs and minimal interest rates, in an economy where regulators have by means of risk-weighted equity requirements de facto prohibited banks to take real risks, like lending to SMEs and entrepreneurs, only to take on false risks, like leveraging too much on what is "safe", has created a bloated economy full of assets with inflated values... and helped finance the permanence of inefficiencies that should have been long gone.

The economy now needs to fart, urgently, but boy is it going to be embarrassing smelly… and painful!

That deflation is not curable with factory produced inflation but only with the type of sturdy growth that can justify the relative values of all assets. You do not live on existing assets alone.

You cannot grow muscles by staying in bed just eating fats and carbs... you need exercise and proteins... even if "risky" 

Way back I had a feeling this had to come sooner or later. 

PS. I now feel sort of like a Chance the gardener (Physician) :-)

But who knows, Mario Draghi and his colleagues might all just be Chauncey Gardiners too :-( 

And what could lead to less inequality: to inflate the value of assets that are already owned or to try to create new assets?

What Europe most needs, Europe does not get, courtesy of their bank regulators.

Where would that liquidity injected by the ECB’s QE printing machine best be put to use in Europe? Since there is a limit to how much you can inflate demand by inflating the value of existing assets, without any doubt, what Europe most needs now is for that liquidity to flow by means of bank credits to SMEs entrepreneurs and start-ups, those who stand the best chance of producing something new to advance the European economies. 

But no, that is not going to happen, not as long as Europe’s bank regulators, Mario Draghi, Stefan Ingves and Mark Carney included, have anything to say about it. 

Those regulators dangerously blocked the fair access to bank credit to anyone perceived as risky from a credit point of view, because they do not dare European banks take the risk of lending to these. That they have done by means of portfolio invariant credit-risk weighted equity requirements for banks. 

Those equity requirements work like hallucinogens on banks, intensifying their perception of credit risk, making what’s perceived as safe look much safer yet, and what is perceived as risky so much riskier.

It’s insane. It demonstrates the Basel Committee, Financial Stability Board, ECB, Mario Draghi and so many more are way over their heads in Europe.

Look at ECB, European banks, pension funds, widows and orphans, all scrambling in order to lay their hands on the ever smaller inventory of safe assets, those which by means of negative interests, are now so "absolutely safe" they already guarantee you a minimum haircut. 

What I would be tempted to say to Mario Draghi of the ECB, if I were Yanis Varoufakis of Greece

Mr. Mario Draghi.

You were the chairman of the Financial Stability Board for some years. In this respect, and especially since we have never heard you say otherwise, you were in full agreement with current bank regulations.

These regulations allowed any European bank to leverage much more when lending to the Government of Greece, or to other sovereigns, than when doing any other type of lending in Europe. For instance, Basel II restricted banks to leverage their equity to not more than 12 to 1 when lending to any unrated small business or entrepreneur in Europe, while allowing a leverage of more than 60 to 1 when lending to our government.

And so bankers became too interested in tempting our government with credit; and sadly our government-officials/politicians were unable to resist the sirens, and got too much into debt; and those Greek small businesses or entrepreneurs, those who with their activities are to generate the fiscal income needed to pay for our government’s expenses, they have had their fair access to bank credit severely curtailed.

And so I hold that you, Mario Draghi, are directly co-responsible for Greece’s current tragic predicaments.

Therefore, please allow me to speak with somebody else in the ECB.

PS. What is not included in the Memorandum on Economic and Financial Policies.

PS. Mr. Yanis Varoufakis, ask your own Greek bank regulators the following:

"Why on earth should a bank, operating in Greece, be allowed to lend to well-rated corporations elsewhere, or to sovereign governments, holding less equity than when lending to Greek SMEs and entrepreneurs?

I mean that does not sound right. That sound like a regulatory tax on our “risky” borrowers and a regulatory subsidy to strange “safe” borrowers."