The Basel Committee incorrectly assumes “The Risky” will cause more “unexpected losses” than “The Infallible”

A discussion on a blog with someone who insisted that it is ok for the current capital requirements for banks to be higher for those perceived as risky that for those perceived as absolutely safe “because of the volatility”; and called me stupid because I “appear not to understand the whole concept of expected and unexpected losses” made me realize that I had to clarify again The Great Basel Committee Mistake… namely that Basel II (and III) base the capital requirements for banks, those which are to cover for the “unexpected losses”, on the “expected losses” derived from perceived credit risks.

“An Explanatory Note on the Basel II IRB (internal ratings-based) Risk Weight Functions” expresses: 

“The model [is] portfolio invariant and so the capital required for any given loan does only depend on the risk of that loan and must not depend on the portfolio it is added to.”

And the explicit reason for that mindboggling simplification was because it was: 

“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.”

And which then leads to:

“In the context of regulatory capital allocation, portfolio invariant allocation schemes are also called ratings-based. This notion stems from the fact that, by portfolio invariance, obligor specific attributes like probability of default, loss given default and exposure at default suffice to determine the capital charges of credit instruments. If banks apply such a model type, they use exactly the same risk parameters for expected losses (EL) and unexpected losses (UL), namely probability of default (PD), loss given default (LGD) and exposure at default (EAD).”

And to justify their approach they write:

In the specification process of the Basel II model, it turned out that portfolio invariance of the capital requirements is a property with a strong influence on the structure of the portfolio model. It can be shown that essentially only so-called Asymptotic Single Risk Factor (ASRF) models are portfolio invariant (Gordy, 2003). ASRF models are derived from “ordinary” credit portfolio models by the law of large numbers. When a portfolio consists of a large number of relatively small exposures, idiosyncratic risks associated with individual exposures tend to cancel out one-another and only systematic risks that affect many exposures have a material effect on portfolio losses. In the ASRF model, all systematic (or system-wide) risks, that affect all borrowers to a certain degree, like industry or regional risks, are modeled with only one (the “single”) systematic risk factor

But suspecting they might be simplifying beyond reason, just in case, the Basel Committee added:

“It should be noted that the choice of the ASRF for use in the Basel risk weight functions does by no means express any preference of the Basel Committee towards one model over others. Rather, the choice was entirely driven by above considerations. Banks are encouraged to use whatever credit risk models fit best for their internal risk measurement and risk management needs.”

And this very flimsy approach, which ignores any correlation between unexpected losses, and shows very little concern with the problems of rapidly changing volatility, caused the Great Basel Committee Mistake of setting the capital requirements for banks, based on exactly the same perceived risks already cleared for.

In essence the regulators determined that a “risky” creditor, by the single fact of presenting more “expected losses”, also had to provide for more capital to cover for more “unexpected losses”. They never understood the hard truth that the safer something is perceived the greater its potential to deliver awful unexpected negative consequences.

And this the regulator did without absolutely any concern for how that could affect the efficiency of bank credit allocation in the real economy… something that can also be derived from the tragic fact that nowhere in the Basel Committee literature is there a word about the purpose of our banks.

And so they introduced an odious regulatory discrimination against those perceived as “risky”, something which introduces a dangerous risk-aversion, and, consequentially, introduces a favoring of what is perceived as “absolutely safe” that can only guarantee the dangerous overcrowding of safe-havens.

As perhaps the best example of what I am arguing is the absurdity of having what can really grow into dangerous excessive bank exposures, like the AAA to AA rated, being risk-weighted at 20%, while the totally innocuous below BB-rated, get a 150% risk weight.

    

In essence bank regulators have now ended up being the greatest systemic risk producers to the banking system. 

In short we do not need bank regulators, what we need are regulators who understand the banking system. 

In short we need regulators who understand that more important than looking at the portfolio of individual banks, is to look at the portfolio of banks in the whole banking system... and how it relates to the needs of the real economy.

Perhaps our bank regulators do not understand the possibility of a  "regression to the mean"

Did the "A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules" paper of 2002, by Michael B. Gordy, cause the downfall of our bank systems? Yes! It was an essential factor, but Gordy is not solely responsible for it... all those who sat there and did not understand one iota, and therefore never dared to question, are even more to blame.

This is the mumbo jumbo that the Basel Committee bet our whole western world banking system on. Shame on it!

Here is the document which describes the risk-weight functions of Basel II

An Explanatory Note on the Basel II IRB Risk Weight Functions, Bank for International Settlements, July 2005

And these are the 3 papers referenced therein:

A risk-factor model foundation for ratings-based bank capital rules, by Michael B. Gordy, October 2002

Robert C Merton, On the pricing of corporate debt: The risk structure of interest rates. 1974, Journal of Finance 29, 449 - 470. 

Oldrich Vasicek, O. (2002) Loan portfolio value. RISK, December 2002, 160 - 162

All put together, does not make any sense!

And on that the Basel Committee, and the Financial Stability Board bet our whole western world banking system. Shame on it! How could they?

And that same crazy risk-weighing function is still part of Basel III

I wonder who wrote that “Explanatory Note”. “The confidence level is fixed at 99.9%, i.e. an institution is expected to suffer losses that exceed its level of tier 1 and tier 2 capital on average once in a thousand years”. That must indeed be the Bank Regulator’s real New Clothes.

Come on Mario Draghi, Adair Turner, Mark Carney, Stefan Ingves, Michel Barnier, or anyone else involved with bank regulations... have a go at explaining it to us! I bet you do not understand it either... but your egos stop you from recognizing that.

My objection to “An Explanatory Note on the Basel II IRB Risk Weight Functions”, July 2005, Bank of International Settlements

The document referred to in the title describes how the Basel II risk-weights came about. I have two major concerns with what it states and one immense with what it ignores: 

First, it describe one important simplification needed in order to allow a practical implementation of a rating based capital allocation, namely that “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…. . 

The simplification is justified with “A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules” by Michael B. Gordy a senior economist at the Board of Governors of the Federal Reserve System, October 22, 2002. 

And so it states “As a result the Revised Framework was calibrated to well diversified banks… If a bank failed at this, supervisors would have to take action under the supervisory review process” 

And that places an immense supervision burden on a body often not sufficiently equipped for it, and worse still, a body that had been sold a feeling that, with the rating based risk-weights, it had already solved the problem forever. 

Second it states: “Losses above expected levels are usually referred to as Unexpected Losses (UL) - institutions know they will occur now and then, but they cannot know in advance their timing or severity. Interest rates, including risk premia, charged on credit exposures may absorb some components of unexpected losses, but the market will not support prices sufficient to cover all unexpected losses. Capital is needed to cover the risks of such peak losses, and therefore it has a loss-absorbing function.” 

That is indeed correct, but that does not mean one can go ahead assuming that these risk premiums are covering zero of the unexpected losses, or that the market will “not support prices sufficient” the same over the whole range of perceived risks. In fact given basic bankers risk-aversion, I would make a case that where the markets do not support the prices correctly, is mostly for whatever is perceived as “absolutely safe”, and that, for the “risky”, it might overprice it instead.

Also if one must use credit rating information which is already available for the bankers to see, then instead of basing it on what the ratings indicate, one should base it on how bankers usually act when observing those ratings. Then they would have seen that bank crises never ever occur because of excessive exposures to "The Risky" but always from excessive exposures to "The Infallible".

Sincerely to use the expected as a proxy of the unexpected is as nutty as can be. The more safe an asset might seem the more room there is for bad unexpected events. The riskier an asset might seem the less the room for bad unexpected events.

And then finally, what the document completely ignores, is that the setting of differential risk-weights, by allowing banks to leverage risk and transaction cost adjusted margins immensely more for what is perceived as “absolutely safe”, introduces a very dangerous bias and distortion against what is considered as “risky”. 

And I just do not understand how that came to happen. Though banks do use risk-models to estimate appropriate capital levels, when looking for capital, they do not make separate share issues based on perceived risks, indeed, as all capital has usually to cover for all risks. 

In fact by allowing banks to hold much less capital against what is perceived as “safe” than against what is perceived as “risky”, regulators are in fact allowing for speculative profits, not on what is “risky” but on what is safe… and that turning the world upside down cannot be healthy. What about the efficient resource allocation function of our banks? With their risk weights the regulators are de facto telling us that those perceived as safe use bank credit more efficiently than those perceived as risky... and that we all know is not so.

And I must ask again: If banks are induced to make more profit on what is perceived as safe than on what is perceived as risky… then what is left for us… and for our orphans and widows?