The importance of being ignored… by for instance the Basel Committee, the IMF and the Financial Times

The pillar of current bank regulations is risk weighted capital requirements for banks; or more exactly portfolio invariant credit risk-weighted equity requirements for banks. It signifies banks are allowed to hold much less equity against assets perceived as safe, than against assets perceived as risky.

Though intuitively it might sound extremely correct, it is extremely flawed, primarily for three reasons:

First, it just doesn’t make any sense from the perspective of making the banking system safe, since all major bank crises have resulted from excessive exposure to something perceived as safe but that ex post turned out not to be; and none from excessive exposures to something ex ante perceived as risky.

Second, allowing banks to leverage their equity, and the support the society lends them, differently, depending on perceived credit risk already cleared for by other means, introduces a tremendous distortion in the allocation of bank credit to the real economy.

Third, by discriminating the access to bank credit against those who by being perceived as risky are already naturally discriminated against, it kills equal opportunities and thereby fosters inequality.

I have voiced my furious objections to that regulation, for way over a decade, to no avail.

The indifference with which my arguments have been met, by the Basel Committee, the Financial Stability Board, the IMF, the Fed, the Bank of England and all other institutions related to bank regulations; plus that of medias such as the Financial Times, has undoubtedly been a source of frustration. And worst has it been when I am told that my questioning is obsessive, something which I have never negated, but when I have always felt that the way they have ignored this issue shows even more obsessiveness.

But, little by little, I have started to appreciate the fact that being ignored, has added a much more important aspect to my criticism. Had regulators accepted and corrected for their mistakes immediately, that would have undoubtedly been good. But at the same time that would also perhaps have shed less light on the importance issue of how little contestability and accountability there exists in institutions ruled by a self-appointed technocrats.

And so, when the world wakes up to the horrendous implications of this regulatory risk aversion, it might hopefully also be able to wake up and correct for the horrible regulatory procedures... and for the sort of bias in favor of regulators that many in the media show.

Then perhaps the SMEs and entrepreneurs could get a real hearing about their difficulties to access bank credit in Basel, in Davos or in Washington during the Spring or Annual Meetings of the IMF and the World Bank. 

Martin Wolf, by not telling it like it was, is making it much harder to connect the dots.

On page 226 of his “The shifts and the shocks” Martin Wolf writes: 

“The essence of Basel I was risk weighting of assets… Ironically and dangerously these weights treated government debt as riskless and put triple-A-rated-mortgage-securities into the next least risky category… Basel II, initially published in 2004, was an extension of Basel I… In the event, the crisis occurred before Basel II had been fully implemented.”

That is not so! And to present it in this way, impedes the understanding of what happened… it makes it much more difficult to connect the dots.

Basel I had risk weighting but that was in relation to claims on sovereign, claims on non-central-government and public-sector entities (PSEs), loans secured with residential property and banks within or outside OECD.

Basel II introduced the use of credit ratings, Basel I had none of it:

I, then an Executive Director of the World Bank, protested this and in a letter published by the Financial Times in January 2003 I wrote: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds”

And it was Basel II that allowed any private sector bank asset backed by an AAA to AA rating to have a risk weight of only 20 percent. That, since the basic capital requirement was 8 percent, signified banks needed to hold only 1.6 percent in capital against these assets. In other words it was Basel II that authorized banks to leverage 62.5 times to 1 in the presence of an AAA to AA rating.

And Basel II approved in June 2004 was immediately implemented in Europe. In the US it was accepted even before its approval by the SEC and made applicable for those investment banks they were supervising.

And that opened a ferocious appetite for AAA’s in any which form they came, whether as the securities collateralized with mortgages awarded to the subprime sector, or by being able to add an AAA rated company to the guarantees, most notoriously AIG.

Also in order to understand the profits for those developing these AAA rated securities, it is illustrative to consider the following deal:

If you convinced risky and broke Joe to take a $300.000 mortgage at 11 percent for 30 years and then, with more than a little help from the credit rating agencies, you could convince risk-adverse Fred that this mortgage, repackaged in a securitized version, and rated AAA, was so safe that a six percent return was quite adequate, then you could sell Fred the mortgage for $510.000. This would allow you and your partners in the set-up, to pocket a tidy profit of $210.00

Martin Wolf, over a very short period which started when the banks were assured that Basel II was to be approved and many saw this as a buying opportunity for later resale to Basel II covered banks… and that ended sort of early 2007…there was a monstrous demand for these AAA rated securities… and that, and nothing else, detonated the crisis.

Martin Wolf, consider that 62.5 to 1 bank leverage was allowed only because an AAA rating was present! It is clear that our world fell into the hands of real regulatory morons.

And that is not even considering the worst of it, namely that favoring so much the AAA rated they odiously discriminated against the fair access to bank credit of all those not AAA rated.

And so it is our duty to see that such things never happen again… not to wittingly or unwittingly helping regulators not to be held accountable for what they did….

If the solution to planet earth’s environmental problems falls into the hands of something like the experts of the BCBS, then we are all toast! 

PS. Basel I has only 30 pages and though Basel II grew into 347 pages, one should have the right to think that someone writing about the “interactions between changes in the global economy and the financial system” had read these fundamental documents.

PS. Around 2008 I studied and complied with all the exams needed to be a licensed real estate and mortgage broker in the State of Maryland, USA; and that I did so that I could analyze from a closer distance what had happened. And everything I found there only confirms what I have here argued. I heard of: “Give us the worst mortgages you have to package, because when we get a good rating for the security, those are the most profitable ones”.

I agree with much in Martin Wolf’s “The Shifts and the Shocks”

Basically because it fails to correctly explain how the current financial crisis came about; and therefore makes it a bit harder for us to get out of it, I object strongly, on many aspects, to Martin Wolf’s “The Shifts and the Shocks”

But that does of course not mean that I do not agree with much of what is said there and so, in this comment to which I will come back when in need (I read jumping from here to there), I will post those aspects which I most agree with:

For instance on page 252 Wolf writes: “Indeed, so long as the [bank] system allows leverage of 30:1, these businesses are designed to fail. The belief that failure of a business can be managed smoothly and without effects, with hybrid capital instruments, resolution regimes and living wills, is naively optimistic”. And I have annotated a clear “YES!” next to that.

And on page 253-4 Wolf writes: “Each institution may be diversified. But they will be vulnerable if all are diversified in the same way. Worse, being subjected to similar microprudential regulation makes it more likely that firms will end up being diversified in much the same way and exposed to many of the same risks”. Indeed! As someone who in 1999 wrote in an Op-Ed “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 will cause the collapse of all of our banks”… you can be sure I annotated a clear and big “YES!” next to that too.

What to do when even describing it, an eminence like Martin Wolf is yet unable to see The Great Bank Distortion?

On page 251 of his “The shifts and the shocks” Martin Wolf writes: 

“But [bank] shareholders should only be interested in their risk adjusted returns. If taking on more risk does not raise risk-adjusted returns, shareholders should flee.”

But let me now give you the fuller version of what he writes:

So: "If taking on more risk [like lending to small businesses and entrepreneurs] “does not raise risk-adjusted returns, [because when doing so bank regulators require banks to hold more equity] “shareholders should flee”.

The result: No bank credit to “risky” small businesses and entrepreneurs.

And the other side of the coin would be: "If taking on less risk, like lending to the infallible sovereigns, the housing sector or to members of the AAAristocracy, does raise risk-adjusted returns, because when doing so bank regulators allow banks to hold much less equity, shareholders will love it.

The result: Too much bank credit to the infallible sovereigns, the housing sector and members of the AAAristocracy.

And Martin Wolf, on page 243 concludes that: “Risk-weighted assets can play a secondary role. That way one would have a ‘belt and braces’ approach: a strong leverage ratio, plus a risk–weighted capital ratio as a back-up.

And that he does because on page 251 he argues: “Risk-weighting is extremely unreliable, because the samples from which the weights are derived are always too small or irrelevant”. 

Wolf simply does not understand the dangerous distortion produced by risk weighting... even if the risk-weights are perfect. If perfect they would be perfectly cleared for in the interest rates, the size of bank exposures and all other contractual terms. To also clear for these perfect risk-weights in the capital, signifying a double counting of the perfect risk weights, is just sheer regulatory lunacy. 

“A ship in harbor is safe, but that is not what ships are for”, wrote John Augustus Shedd (1850-1926),.And that goes for our banks too.

And precisely because we all want our ships, or our banks, to sail as safe as possible to the ports we want them to sail to… the last think we should do… is what bank regulators, thinking themselves with 'fatal conceit' capable of being risk managers to the world did… namely to start tinkering with risk weights with their compasses. 

And so no Martin Wolf, not even as a back-up is there a role for credit risk weighted bank capital.

And if we really get down to what Wolf writes on page 252: "the disaster came from what banks wrongly thought to be safe", and which by the way is what all empirical evidence would point at as the usual suspect of causing bank disasters, then the capital requirements should be totally opposite; larger for what is perceived as absolutely safe and lower for what is perceived as risky.

In short, the number one "Macro-prudential Policy" that needs to be implemented, is to get rid of the current batch of distorting bank regulators. But, for that to happen, it is helpful that eminences, like Martin Wolf, also understands what is going on.

What is so mindboggling absent from Martin Wolf’s book “The shifts and the shocks”

If there is one thing that explains the origin of the current financial crisis and the main reason why we do not seem to find our way out of it, that has to be the crazy credit risk-weighted capital requirements for banks, approved as Basel II, in June 2004.

These risk weighs instructed banks to have different amounts of capital for based on the ex ante perceived credit risks of assets, with weights fluctuating from zero to 150 per cent.

As the basic capital requirement in Basel II was 8 percent this indicated capital (meaning equity) requirements that ranged from zero percent to 12 percent, which translates into different allowed equity leverages that range from infinite to till 8.33 to 1.

For instance:

A bank lending to an AAA to AA rated sovereign needed to hold no equity at all, implying an infinite allowed leverage.

A bank investing in a private AAA rated asset needed to hold only 1.6 in equity, indicating an allowed leverage of 62.5 to 1.

A bank lending to an unrated private needed to hold 8 per cent in equity, indicating a 12.5 to 1 allowed leverage, and

A bank lending to a below BB- rated client could only do so against 12 per cent in equity, which implied and allowed leverage of only 8.3 to 1.

And of course that distorted all economic sense out of the banks’ allocation of credit to the real economy.

And if there is one document one needs to read in order to understand what these risk weights were all about that is of course the “Explanatory Note on the Basel II IRB Risk-Weight Functions” issued by the Basel Committee in July 2005.

Well, Martin Wolf, in his book “The shifts and the shocks – What we’ve learned-and have still to learn-from the financial crisis”, references 526 documents or sources but does, amazingly, mind-boggling, not include this document.

Either he does not know of it, or he does not understand it and dares not to say so. You choose.

If the latter he should not be too nervous… it is an amazing mumbo jumbo.

No Martin Wolf, arrogance and stupidity were (and are) the real sins of bank regulators.

Martin Wolf in his recent book “The shifts and the shocks – What we’ve learned-and have still to learn-from the financial crisis” writes: “Regulators made errors of omission and commission:

Sins of omission are the result of excessively permissive regulations and supervision: they occur when regulators choose to ignore either gross malfeasance or excessive risk taking,

Sins of commission arise when regulators and lawmakers encourage financial institutions to take risks for political reasons.”

And Wolf holds that “Behind all this was the assumption that self-interest would, via Adam Smith’s invisible hand, ensure a stable, dynamic and efficient system… The application of these naïve ideas proved extraordinarily dangerous.

No! Mr. Martin Wolf. 

The first sin was the sin of arrogance by which regulators thought themselves capable to be the risk managers for the world and started to allocate credit risk weights that determined the capital (equity) requirements for banks.

And the second sin was stupidity, which took on two major expressions:

The first one not understanding that allowing different capital requirements against different assets would allow banks to earn different risk-adjusted returns on assets, and that had to distort the allocation of bank credit to the real economy.

The second, not being able to understand that the real dangers for the banking system do not loom among what was perceived as “risky”, but always among what is perceived as absolutely safe.

And the saddest part is that now, so many years after the outburst of the crisis, we have a book written by one of the mot influential columnists, which does not even mention these problems.

And it is not like no one has told Martin Wolf about this. For instance in July 2012, he himself writes: “Per Kurowski, a former executive director of the World Bank, reminds me regularly, crises occur when what was thought to be low risk turns out to be very high risk.”

And then there are more than hundred of letters over the years to him on this issue, many of which have been discussed in the interchange of emails.

And NO! Mr Martin Wolf. No one who could interfere in the allocation of bank credit like the regulators did, can be said to sincerely believe in the "invisible hand".

PS. Wolf touches on the fact of the safe being risky, by on page 252 writing: “the disaster came from what banks wrongly thought to be safe.” Yet he clearly does not understand its real meaning as he explains it as: “Risk-weighting is extremely unreliable, because the samples from which the weights are derived are always to small or irrelevant.” 

Apparently Wolf cannot come to grips with the notion that even perfect risk weights, can generate dangerous distortions, both for the economy and for the banks. That is so because if that perceived risk has already been cleared for, and so for to clear it again (now in the capital of banks) makes that perception to become over-considered. What if the risk aversion of one nannie was added to the risk aversion of other nannies? Would the kid ever be let out of his house?

Real banking risks do not revolve around what is perceived “risky”, as experts think, but around the “absolutely safe”

What happened with the experts swearing by geocentrism, or the Ptolemaic system, that with the cosmos having Earth stationary at the center of the universe, when Galileo Galilei, Nicolaus Copernicus, Tycho Brahe and Johannes Kepler, convinced the world of the heliocentric model, that with the Sun at the center of the Solar System?

I ask it curious to know of what will happen with all those experts in the Basel Committee, the Financial Stability Board the IMF and places like the academia and the press; like for instance Mario Draghi, Stefan Ingves, Jaime Caruana, Mark Carney, Olivier Blanchard, José Viñals, Martin Wolf and so many other; when it is finally realized that the real serious risks in banking do not revolve around assets perceived as “risky”, as they all think, but around assets perceived as “absolutely safe”.

These regulators’ silly portfolio invariant credit risk based capital (meaning equity) requirements for banks, by impeding the fair access to bank credit of “the risky”, like small businesses and entrepreneurs, not only distorts and hurts the real economy; but they also guarantee major system crisis, since banks are then doomed to, sooner or later, to get caught with their pants down (meaning little equity), with huge exposures to something which was perceived as “infallible” but which has turned into something very risky… often precisely because of too much credit at too low interest rates.

Should it be "More risk more equity – less risk less equity" as these regulators argue?

No! I prefer no distortion, but, if anything, then just the opposite.

These current regulators they all confuse the world of ex-ante perceived risks with the world of ex-post realized dangers.

These regulators have never heard or understood Mark Twain’s “A banker is he who lend you the umbrella when the sun is out, and wants it back as soon as it looks like it is going to rain”

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.

Helping the Financial Times’ experts to understand the distortions produced by risk-weighted capital requirements for banks

Since I do not belong to any Academic Community, or special sphere of influence, or mutual adoration club, I have very little voice, even when noisy, even when being an Executive Director of the World Bank, 2002-2004. 

So, in this respect I decided long ago to try to use the Financial Times as my channel to express my absolute rejection of bank regulations coming out from the Basel Committee. If for instance a Martin Wolf got to understand my arguments, he would be much more effective communicating these to the world than little me. 

What I had not counted on, were the immense difficulties in making the FT experts understand what I was talking about, even now after more than eight hundred letters on the subject. But, I am insistent, and I will manage to do so, one day. 

And so here below is another attempt to explain, in the simplest possible terms, so that perhaps even FT experts could understand, if they wanted to, the distortions produced by the risk-weighted capital requirements for banks, and which represent the pillar of Basel II and III regulations.

If for instance a German bank, lent to Greece as one of “The semi-Infallible” Greece was rated just a couple of years ago then, according to Basel II, if it could earn doing so a 1 percent net after perceived risk and cost, then it could earn 62.5 percent on its equity. But, if instead lent to a small German or Greek unrated business and earn the same net margin then it could only achieve 12.5 percent on equity. Does this make any sense to FT? Sincerely I cannot think so. And yet, what am I suppose to think?

And so the result is a world with dangerous obese bank exposures to “The Infallible”, and for us equally dangerous anorexic exposure to “The Risky”, and all aggravated by the fact that even the most infallible safe-haven can become extremely dangerous, if overpopulated. 

Capisce FT, or do I need to explain it again?

PS. Me, London, banks,regulators, lions, pussycats and FT’s pink

Bank Regulator! How dare you distort the markets this way! Look at what you’ve done! And you’re not even sorry. Shame on you!

Arrogant regulatory busybodies thought they could stop bank crisis forever, by setting capital requirements for banks based on perceived risk. The higher the perceived risk, the higher the capital needed to be, and the lower the perceived risk, the lower the capital.

And, in doing so, the regulators completely ignored the fact that banks and markets already clear for risk by means of interest rates, amounts exposed and contractual terms. And as a result banks could earn much higher returns on equity when financing what was officially perceived as “not-risky” than when financing what was officially perceived as “risky”, like our small unrated businesses and entrepreneurs.

And we are not talking about minor differences. Basel II required banks to hold 8 percent in capital when lending to small businesses, which meant banks could leverage 12.5 to 1, but allowed banks to hold only 1.6 percent in equity against a private asset rated AAA, (or a loan to Greece) allowing the banks to leverage a mindboggling 62.5 to 1. Five times less bank equity!

And the result is that these regulations added immense regulatory bias in favor of what is perceived as not risky, on top of the natural bias that already existed in their favor, and, consequentially, added immense regulatory bias against what is perceived as “risky”, on top of the natural bias that already existed against the risky.

And all this the regulators did without ever bothering to ask themselves the question of…what is the purpose of the banks?

And all this the regulators did without ever bothering to reflect on the fact that all bank crises ever have occurred because of excessive exposures to what was erroneously perceived ex ante as “not risky” and never because of excessive exposures to what was ex-ante correctly perceived as risky.

And as a consequence here we find us mired in a deep crisis with obese bank exposures to what was ex-ante perceived as “not risky” and anorexic banks exposures to what was considered “risky”.

And, of course, by maintaining the same fundamental capital requirement discrimination based on ex-ante perceived risk, there is no way we can work ourselves out of a crisis, in which our economies are turning flabbier and flabbier by the second.

Regulators, don’t you know that nations develop by generously allowing for daring opportunities, and fail and fall when turning stingy and coward?

What would the US Supreme Court opine about bank regulations which discriminate against The Risky and favor The Infallible?

No! Shame on you bank regulators! Who gave you the right to distort our economy this way? And shame on you too financial journalists who keep silencing this, not daring to question the regulating establishment.