The (Odious) Bank Credit Redistribution Act: The Great Financialization

1988 Basel I: Risk weighted bank capital requirements with decreed weights: 0% government, 50% residential mortgages and 100% the rest, e.g., small businesses and entrepreneurs; all as if bureaucrats know better what to with credit, for which repayment they’re not personally responsible for than e.g., small businesses and entrepreneurs; all as if financing the purchase of a house is more important than financing those who can create the jobs, the incomes, by which repay mortgages and service utilities.

Why? “Assets assigned the lowest risk, for which bank capital requirements were therefore nonexistent or low, were what had the most political support: sovereign credits & home mortgages” Paul Volcker

2004 Basel II: The introduction of the systemic risk of bank capital requirements depending hugely on human fallible credit rating agencies. To top it up the decreed weights e.g., 20% AAA to AA fated – 150% below BB- rated, continued to ignore the fact that all dangerous large bank exposures have always been built up with assets perceived as safe.

2007-2009 A global financial crisis (GFC) caused by excessive exposures to AAA rated mortgage-backed-securities (MBS).

2010 Basel III: Kicking the can forward so as not t be blamed the regulators, trying to mend regulatory blackholes concocted a mishmash of hundreds or regulations. Sadly, these all still leave intact, on the margin, which is where it most counts, the distortion in the allocation of credit produced by the risk weighted capital requirements.

2009… 2022: Job possibilities for bank supervisors and bank supervision responders keeps on booming… and just you wait for the ESG based capital requirements based on ESG ratings.

In short:

Bank capital requirements that so much favor government debts, has empowered Bureaucracy Autocracies all around the world. Central banks’ later Quantitative Easing (QEs), put that assistance on steroids

Before risk weighted bank capital requirements, bank credit was allocated based on risk adjusted interest rates. After, based on risk adjusted returns on required capital/equity (ROrE). That distorts even central banks’ monetary policy.

Bank capital requirements mostly based on perceived credit risks, not on misperceived risks or unexpected events, e.g., pandemic/war, guarantees banks will, sooner or later, stand there naked, just when we need them the most.

Favoring with much lower capital requirements banks holding “safe” government debt and residential mortgages (the present-demand-carbs), than loans to “risky” businesses (the future-supply-proteins), inflates inflation and causes obese - not muscular economic growth.

The Great Financialization, supported by low bank capital requirements, central banks’ QEs, and MMT preaching, produced way too much easy money... manna from heaven. That emptied many churches. Coming Minsky moments will fill these up again.

Extremely short:

These  risk weighted bank capital requirements have put Minsky moments on steroids.

PS. I have now, one way or another, been on this theme for twenty-five years

What would Hyman Minsky say if able to observe how his financial instability moments were put on steroids by bank regulators?

On Minsky moments

“In many cases even trying to regulate banks runs the risk of giving the impression that by means of strict regulations, the risks have disappeared. History is full of examples of where the State, by meddling to avoid damages, caused infinite larger damages”

“Old agricultural traditions of burning a little each year, thereby getting rid of some of the combustible materials, was much wiser than no burning at all, which only guarantees disaster and scorched earth, when fire finally breaks out, as it does, sooner or later. Therefore a regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises.”

“Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds”

The Basel Committee’s credit risk weighted bank capital requirements cause our banks to be dangerously overexposed to what’s expected, and to be woefully unprepared for the unexpected. 

Current risk weighted bank capital requirements guarantee especially large bank crises, caused by especially large exposures to what’s perceived as especially safe but might not be, and is held against especially little capital.

"A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind."

What goes up too much must come down too much. The best countercyclical policy there is, is the elimination of the pro-cyclical ones.

“What goes up must come down, spinning wheel got to go 'round” David Clayton Thomas

Governor Lael Brainard on December 07, 2018, in “Assessing Financial Stability over the Cycle” a speech delivered at the Peterson Institute for International Economics, Washington, D.C., said:

“In an economic downturn, widespread downgrades of these low-rated investment-grade bonds to speculative-grade ratings could induce some investors to sell them rapidly--for instance, because lower-rated bonds have higher regulatory capital requirements or because bond funds have limits on the share of non-investment-grade bonds they hold.”

And Brainard then proceeds to extensively describe the advantages of countercyclical capital requirements (CCyB) for building additional resilience in the financial system.

YES...BUT, the other side of the mirror is: In an economic upturn, higher credit ratings of bonds could induce some investors to buy them rapidly--for instance, because higher-rated bonds have lower regulatory capital requirements, or because bond funds have lesser or no limits on investment-grade bonds they hold.

So if that is not procyclical what is?

Therefore, before thinking of using countercyclical capital requirements, which by themselves might be introducing distorting signals, which might make the use of these at the right moment when they are really needed harder, let’s get rid, altogether, of the risk weighted capital requirements for banks. Those, which, by the way, even when the economic cycles are correctly identified, still distort the allocation of bank credit to the real economy.

And since credit ratings were mentioned, in April 2003, at the World Bank I opined:

"Nowadays, when information is just too voluminous and fast to handle, market or authorities have decided to delegate the evaluation of it into the hands of much fewer players such as credit rating agencies. This will introduce systemic risks in the market"

Here is my 2004 letter to the Financial Times, FT, "Towards a counter cyclical Basel?" It was not published 

The Minsky Moments were put on steroids

You need not to be an Einstein 

PS. Here my 2019 letter to the Financial Stability Board

PS. Here my 2019 letter to the IMF

PS. ChatGPT Grok: Are the current risk weighted bank capital requirements dangerously pro-cyclical?

Bank regulations put Minsky’s “financial instability hypothesis” on steroids, boosting its speed towards “the moment”.

The Economist refers to Hyman Minsky’s important “financial instability hypothesis”, but concludes that it “would be a stretch to see that hypothesis becoming a new foundation for economic theory, “Minsky’s moment” July 30, 2016

That might be, but it should become an essential foundation of financial regulations because, by ignoring it, with the risk weighted capital requirements for banks, the regulators set the “boom that can sow the seeds of busts” on steroids.

Normally, without distortions, bank credit should be allocated to whoever offers the highest perceived risk adjusted rate. That of course might quite often not be true, because “a safe” can be riskier or safer than what it is perceived; just llke “a risky, could equally be safer or riskier.

But, when regulators decided banks needed to hold less capital against what was perceived, decreed or concocted as safe, than against what was perceived as risky, they dramatically distorted the allocation of bank credit to the real economy.

Suddenly the booms of what was perceived as safe got a tremendous boost, as banks could earn higher risk adjusted rates there; all while “the risky” saw their access to bank credit severely curtailed.

We only need to go the crisis of 2007-08 to see that what caused it, was all which had very low capital requirements because it was perceived as safe when placed on the bank’s balance sheets.

And of course, the power of those regulatory steroids, was further strengthen by the fact that so much decision power, over deciding what was safe and what was risky, was placed in the hands of some very few human fallible credit rating agencies.

PS. I was just a consultant from a developing country who happened to end up on the Board of the World Bank as an Executive Director, and so I can of course not aspire, by far, to receive the same attention as Hyman Minsky, but you might anyhow be interested in what were my very early opinions on these issues

PS. And here is my most recent aide memoire on what is monstrously wrong with Basel Committee’s regulations.

@PerKurowski