The Basel Committee for Banking Supervision’s bank regulations vs. mine.

A tweet to: @IMFNews, @WorldBank, @BIS_org @federalreserve, @ecb @bankofengland @riksbanken @bankofcanada

"Should you allow the Basel Committee to keep on regulating banks as it seems fit, or should you not at least listen to other proposals?

Bank capital requirements used to be set as a percentage of all assets, something which to some extent covered both EXPECTED credit risks, AND UNEXPECTED risks like major sudden downgrading of credit ratings, or a coronavirus.

BUT: Basel Committee introduced risk weighted bank capital requirements SOLELY BASED ON the EXPECTED credit risk. It also assumes that what is perceived as risky will cause larger credit losses than what regulators perceive or decreed as safe, or bankers perceive or concoct as safe. 

The different capital requirements, which allows banks to leverage their equity differently with different assets, dangerously distort the allocation of bank credit, endangering our financial system and weakening the real economy.

The Basel Committee also decreed a statist 0% risk weight for sovereign debts denominated in its domestic currency, based on the notion that sovereigns can always print itself out of any problem, something which clearly ignores the possibility of inflation, but, de facto, also implies that bureaucrats/politicians know better what to do with bank credit they are not personally responsible for, than for instance entrepreneurs, something which is more than doubtful.

Basel Committee's motto: Prepare banks for the best, for what's expected, and, since we do not know anything about it, ignore the unexpected 

I propose we go back to how banks were regulated before the Basel Committee, with an immense display of hubris, thought they knew all about risks; which means one single capital requirements against all assets; 10%-15%, to cover for the EXPECTED credit risk losses and for the UNEXPECTED losses resulting from wrong perceptions of credit risk, like 2008’s AAA rated securities or from any other unexpected risk, like COVID-19.

My one the same for all assets' capital requirement, would not distort the allocation of credit to the real economy.

My motto: Prepare banks for the worst, the unexpected, because the expected has always a way to take care of itself.

PS. My letter to the Financial Stability Board
PS. A continuously growing list of the risk weighted bank capital requirements mistakes

PS. Risk-weights are to access to credit what protectionist tariffs are to trade, only more pernicious.

PS. I am no newcomer to this issue

For Basel IV, what do I propose?

Ex ante perceived risks are already cleared for in the numerator, by means of interest rate (risk-premiums) size of exposure and other terms, and so it is just plain stupid to clear for the same risks in the denominator, with different capital requirements based on risk-weights. That only guarantees a distortion that makes nothing safer, and just causes banks to overdose on perceived risks. 

Therefore risk-weighted capital requirements are to be eliminated completely.

But, if bank regulators absolutely must meddle, in order to satisfy their egos, or show off their expertise, and there are going to be some higher capital requirements for some assets, those should be applied to what is ex ante perceived as “absolutely safe”, since all major bank crises ever, have originated in excessive bank exposures to this category of assets.

And, if bank regulators absolutely must meddle, in order to satisfy their egos, or show off their expertise, and there are going to be some lower capital requirements, to induce some higher returns on bank equity, those should be only accepted in as much as these stimulate the banks to better fulfill a social purpose, like basing it on potential for job creation ratings, or sustainability ratings.

And, in no way shall there be any discrimination that favors any short term financial instrument over a long term one.

And in this respect, the initial Basel IV proposition contains just one line, the following:

“Banks shall hold 8 percent in capital, as defined in Basel III, against all assets.”

The Basel IV capitalization can be reached by allowing each bank to apply its current capital to total assets ratio (including sovereigns), and then let it build up that ratio over a period of some years, with about 0.5 percent per year until reaching said 8 percent level. 

But, since the faster banks reach their final Basel IV capitalization, the better for the real economy, the regulators, accepting their full responsibility for the current extreme low capitalization of banks, should beg for some temporary important tax incentives on all bank capital increases taking place within one year of the Basel IV approval.

The mutual admiration club of firefighters in Basel

Towards a counter cyclical Basel?

(A letter to the Financial Times that was not published)

Sir, the financial system is there to safeguard savings, to generate economic growth by channeling investments, and to promote equality by providing full and free access to capital and opportunities.

Currently, our bank regulators headquartered in Basel are primarily concerned with the first goal, that of avoiding bank collapses, and how could it be otherwise, if you have only firemen on the board that regulates building permits.

Now, one of these days, the financial system, neatly combed and dressed in a tuxedo, but lying more than seven feet under in the coffin of financial de-intermediation, is going to wake up to the fact that it needs the presence of others in Basel. At that moment, perhaps we might start hearing about flexible capital requirements, moving up to 8.2 % or down to 7.8% by region, in response to countercyclical needs.

Meanwhile it’s a shame that even their first goal might turn out to be elusive, since although the individual risks have fallen with Basel regulations, the stakes have increased, as those same regulations accelerate the tendency towards fewer and fewer banks.

Extracted from my "Voice and Noise" 2006

About the Global Bank Insolvency Initiative

(An informal email sent in 2004 to my then colleagues Executive Directors of the World Bank.)

Dear Friends,

We recently had a technical briefing about the Global Bank Insolvency Initiative. Having had a special interest in this subject for some years, I wish to make some comments.

As I have always seen it, the costs related to a bank crisis are the following three:

The actual direct losses of the banks at the outbreak of the crisis. These are represented by all those existing loans that are irrevocably bad loans and therefore losses without a doubt.

The losses derived from mismanaging the interventions (workout costs). These include, for example, losses derived from not allowing some of the existing bad loans the time to work themselves out of their problems. They also include all the extraordinary legal expenses generated by any bank intervention in which regulators in charge want to make sure that they themselves are not exposed to any risk at all.

The long-term losses to the economy resulting from the “Financial Regulatory Puritanism,” that tends to follow in the wake of a bank crisis as thousands of growth opportunities are not financed because of the attitude “we need to avoid a new bank crisis at any cost.”

For the sake of the argument, I have hypothesized that each of these individual costs represents approximately a third of the total cost. Actually, having experienced a bank crisis at very close range, I am convinced that the first of the three above costs is the smallest ... but I guess that might be just too politically incorrect to pursue further at this moment.

In this respect, it is clear that any initiative that aims to reduce the workout costs of bank insolvency is always welcome and in fact the current draft contains many well-argued and interesting comments, which bodes well for its final findings and suggestions.

That said, the scope of the initiative might be somewhat limited and outdated, making it difficult to realize its full potential benefits. There is also the danger that an excessive regulatory bias will taint its findings.

Traditional financial systems, represented by many small local banks dedicated to very basic and standard commercial credits, and subject to normally quite lax local regulation and supervision, are mostly extinct.

They are being replaced by a system with fewer and bigger global bank conglomerates governed by a global Basel-inspired regulatory framework and they operate frequently by transforming the economic realities of their portfolios through mechanisms and instruments (derivatives) that are hard to understand even for savvy financial experts.

In this respect I believe that instead of dedicating scarce resources to what in some ways could be deemed to be financial archaeology, we should confront the new market realities head on, making them an explicit objective of this global initiative. For instance, what on earth is a small country to do if an international bank that has 30% of the local bank deposits goes belly up?

We all know that the financial sector, besides having to provide security for its depositors, needs also to contribute toward economic growth and social justice, by providing efficient financial intermediation and equal opportunities of access to capital. Unfortunately, both these last two objectives seem to have been relegated to a very distant plane, as the whole debate has been captured by regulators that seem only to worry about avoiding a bank crisis. Unfortunately, it seems that the initiative, by relying exclusively on professionals related to banking supervision, does little to break out from this incestuous trap. By the way if you want to see about conflict of interest, then read the section “Legal protection of banking authorities and their staff.” It relates exactly to those wide blanket indemnities that we so much criticize elsewhere.

And so, friends, I see this Global Bank Insolvency Initiative as a splendid opportunity to broaden the debate about the world’s financial systems and create the much needed checks and balances to Basel. However, nothing will come out of it if we just delegate everything to the hands of the usual suspects. By the way, and I will say it over and over again, in terms of this debate, we, the World Bank, should constitute the de facto check and balance on the International Monetary Fund. That is a role we should not be allowed to ignore—especially in the name of harmonization.

Some comments made at a Risk Management Workshop for Regulators... as an Executive Director

World Bank 2003 Risk Management Workshop for Regulators

Dear Friends,

As I know that some of my comments could expose me to clear and present dangers in the presence of so many regulators, let me start by sincerely congratulating everyone for the quality of this seminar. It has been a very formative and stimulating exercise, and we can already begin to see how Basel II is forcing bank regulators to make a real professional quantum leap. As I see it, you will have a lot of homework in the next years, brushing up on your calculus—almost a career change.

But, my friends, there is so much more to banking than reducing its vulnerability—and that’s where I will start my devil’s advocate intrusion of today.

Regulations and development.

The other side of the coin of a credit that was never granted, in order to reduce the vulnerability of the financial system, could very well be the loss of a unique opportunity for growth. In this sense, I put forward the possibility that the developed countries might not have developed as fast, or even at all, had they been regulated by a Basel [Committee].

A wider participation.

In my country, Venezuela, we refer to a complicated issue as a dry hide: when you try to put down one corner, up goes the other. And so, when looking for ways of avoiding a bank crisis, you could be inadvertently slowing development.

As developing sounds to me much more important than avoiding bank failures, I would favor a more balanced approach to regulation. Talleyrand is quoted as saying, “War is much too serious to leave to the generals.” Well, let me stick my head out, proposing that banking regulations are much too important to be left in the hands of regulators and bankers.

Friends, I have been sitting here for most of these five days without being able to detect a single formula or word indicating that growth and credits are also a function of bank regulations. But then again, it could not be any other way. Sorry! There just are no incentives for regulators to think in terms of development, and then the presence of the bankers in the process has, naturally, more to do with their own development. I believe that if something better is going to come out of Basel, a much wider representation of interests is needed.

A wider Scope.

I am convinced that the direct cost of a bank crisis can be exceeded by the costs of an inadequate workout process and the costs coming from the regulatory Puritanism that frequently hits the financial system—as an aftershock.

In this respect, I have the impression that the scope of the regulatory framework is not sufficiently wide, since the final objective of limiting the social costs cannot focus only on the accident itself, but has also to cover the hospitalization and the rehabilitation of the economy. From this perspective, an aggressive bank, always living on the edge of a crisis, would once again perhaps not be that bad, as long as the aggressive bank is adequately foreclosed and any criminal misbehavior adequately punished.

On risks.

In Against the Gods Peter L. Bernstein (John Wiley & Sons, 1996) writes that the boundary between the modern times and the past is the mastery of risk, since for those who believe that everything was in God’s hands, risk management, probability, and statistics, must have seemed quite irrelevant. Today, when seeing so much risk managing, I cannot but speculate on whether we are not leaving out God’s hand, just a little bit too much.

If the path to development is littered with bankruptcies, losses, tears, and tragedies, all framed within the human seesaw of one little step forward, and 0.99 steps back, why do we insist so much on excluding banking systems from capitalizing on the Darwinian benefits to be expected?

There is a thesis that holds that the old agricultural traditions of burning a little each year, thereby getting rid of some of the combustible materials, was much wiser than today’s no burning at all, that only allows for the buildup of more incendiary materials, thereby guaranteeing 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.

Knowing that “the larger they are, the harder they fall,” if I were regulator, I would be thinking about a progressive tax on size. But, then again, I am not a regulator, I am just a developer.

Conspiracy?

When we observe that large banks will benefit the most with Basel II, through many risk-mitigation methods not available to the smaller banks which will need to live on with Basel I, and that even the World Bank’s “Global Development Finance 2003” speaks about an “unleveling” of the playing field for domestic banks in favor of international banks active in developing countries, I believe we have the right to ask ourselves about who were the real negotiators in Basel?

Naturally, I assume that the way the small domestic banks in the developing countries will have to deal with these new artificial comparative disadvantages is the way one deals with these issues in the World Trade Organization, namely by requesting safeguards.

Credit Ratings

Finally, just some words about the role of the Credit Rating Agencies. I simply cannot understand how a world that preaches the value of the invisible hand of millions of market agents can then go out and delegate so much regulatory power to a limited number of human and very fallible credit-rating agencies. This sure must be setting us up for the mother of all systemic errors.

The Board As for Executive Directors (such as myself), it would seem that we need to start worrying about the risk of Risk Managers doing a de facto takeover of Boards—here, there, and everywhere. Of course we also have a lot of homework to do, most especially since the devil is in the details, and risk management, as you well know, has a lot of details.

Thank you

Included in "Voice and Noise", 2006

PS. My 2019 letter to the Financial Stability Board

Puritanism in banking

In his book Money: Whence it came, where it went” (1975), John Kenneth Galbraith discusses banks and banking issues which I believe may be applicable to the Venezuela of today.

In one section, he addresses the function of banks in the creation of wealth. Galbraith speculates on the fact that one of the basic fundamentals of the accelerated growth experienced in the western and south-western parts of the United States during the past century was the existence of an aggressive banking sector working in a relatively unregulated environment.

Banks opened and closed doors and bankruptcies were frequent, but as a consequence of agile and flexible credit policies, even the banks that failed left a wake of development in their passing.

In a second section, Galbraith refers to the banks’ function of democratization of capital as they allow entities with initiative, ideas, and will to work although they initially lack the resources to participate in the region’s economic activity. In this second case, Galbraith states that as the regulations affecting the activities of the banking sector are increased, the possibilities of this democratization of capital would decrease. There is obviously a risk in lending to the poor.

In Venezuela, the last few years [the 1990s] have seen a debate, almost puritan in its fervor, relative to banking activity and how, through the implementation of increased controls, we could avoid a repeat of a banking crisis like the one suffered in 1994 at a cost of almost 20% of GDP. Up to a certain point, this seems natural in light of the trauma created by this crisis.

However, in a country in which unemployment increases daily and critical poverty spreads like powder, I believe we have definitely lost the perspective of the true function of a bank when I read about the preoccupation of our Bank Regulating Agency that “the increase in credit activity could be accompanied by the risk that loans awarded to new clients are not backed up with necessary support (guarantees)” and that as a result we must consider new restrictions on the sector.

It is obvious that we must ensure that banks do not overstep their bounds while exercising their primary functions—a mistake which in turn would result in costly rescue operations. We cannot, however, in lieu of perfecting this control, lose sight of the fact that the banks’ principal purpose should be to assist in the country’s economic development and that it is precisely with this purpose in mind that they are allowed to operate.

I cannot believe that any of the Venezuelan banks were awarded their charters based purely and simply on a blanket promise to return deposits. Additionally, when we talk about not returning deposits, nobody can deny that—should we add up the costs caused by the poor administration, sins, and crimes perpetrated by the local private banking sector throughout its history—this would turn out to be only a fraction of the monetary value of the comparable costs caused by the public/government sector.

Regulatory Puritanism can affect the banking sector in many ways. Among others, we can mention the fact that it could obligate the banks to accelerate unduly the foreclosure and liquidation of a business client simply because the liquid value for the bank in the process of foreclosure is much higher than the value at which the bank is forced to carry the asset on its books. In the Venezuela of today, we do not have the social flexibility to be able to afford unnecessary foreclosures and liquidations.

In order to comprehend the process involved in the accounting of losses in a bank, one must understand that this does not necessarily have anything to do with actual and real losses, but rather with norms and regulations that require the creation of reserves. Obviously banks will be affected more or less depending on the severity of these norms. Currently, a comparative analysis would show that Venezuela has one of the most rigid and conservative sets of regulations in the world.

On top of this, we have arrived at this extreme situation from a base, extreme on the other end of the spectrum, in which not only was the regulatory framework unduly flexible, but in which, due to the absence of adequate supervision, the regulations were practically irrelevant.

Obviously, the process of going from one extreme to the other in the establishment of banking regulations is one of the explanations for the severe contraction of our banking sector. Until only a few years ago, Venezuela’s top banks were among the largest banks of Latin America. Today, they simply do not appear on the list.

It is evident that the financial health of the Venezuelan banking community requires an economic recovery and any Bank Superintendent complying with his mission should actively be supporting said recovery instead of, as sometimes seems evident, trying to receive distinctions for merit from Basel (home of the international bank regulatory agencies).

If we insist in maintaining a firm defeatist attitude which definitely does not represent a vision of growth for the future, we will most likely end up with the most reserved and solid banking sector in the world, adequately dressed in very conservative business suits, presiding over the funeral of the economy. I would much prefer their putting on some blue jeans and trying to get the economy moving.

As edited for "Voice and Noise" 2006

Originally published in The Daily Journal, Caracas, June 1997

PS. Here my 2019 letter to the Financial Stability Board

Traducción:

PURITANISMO BANCARIO

Con ocasión de una mudanza me reencontre con un libro escrito en 1975 por el reconocido economista John Keneth Galbraith titulado "Dinero. De donde vino y adonde fué" Ojeandolo me encontre con dos subrayados relativos a las funciones de la banca y los cuales creo son recordatorios oportunos en la Venezuela actual. El primer subrayado tiene que ver con la función creadora de riquezas que tiene la banca y donde Galbraith especula sobre el hecho de que una de las bases que fundamento en el siglo pasado en muy acelerado desarrollo del oeste y sur-oeste de los Estados Unidos era la existencia de una banca agresiva y no regulada que abria y cerraba puertas, quebrando con frecuencia, pero que, a consecuencia de una política de créditos agil y flexible, dejaba una estela de desarrollo. El segundo subrayado se refiere a la función democratizadora de capital que posee la banca al permitir a personas con iniciativas ideas y voluntad de trabajo pero sin recursos el participar en la actividad económica. En este último caso Galbraith indica con sagazidad que obviamente a menor grado de regulaciones que afecte la actividad bancaria, mayor es la posibilidad de democratizar el capital.

En Venezuela, durante los últimos años el debate relativo a la actividad bancaria se ha centrado con un fervor casi puritano sobre el como mediante el incremento de controles lograr evitar una repetición de la crisis bancaria. Hasta cierto punto lo anterior resulta natural ya que indudablemente la crisis bancaria venezolana fué traumática. Pero, cuando en una Venezuela donde el desempleo se incrementa a diário y la pobreza crítica se extiende como pólvora, se lee sobre una actual preocupación de la Superintendencia de Bancos por cuanto el "repunte de la actividad crediticia pueda traer consigo un riesgo en el otorgamiento de préstamos a nuevos clientes que no presenten los soportes necesarios." y por lo tanto hay que considerar nuevas restricciones, creo que definitivamente se ha perdido la perspectiva de la verdadera función de la banca.

Por supuesto se debe asegurar el que la banca no cometa excesos en el desempeño de sus funciones y que obligue acometer costosos rescates, pero en el ejercicio de dicha función controladora no puede perderse de vista de que el principal proposito de la banca debe ser coadyudar en el desarrollo económico del pais y justamente para cumplir dicha función es que se les permite operar. No creo que ninguno de los bancos venezolanos obtuvo su permiso de funcionamiento en base a una limitada promesa de devolver los depositos. Y si a la no devolución de depósitos vamos, nadie puede discutir que de sumar todos los costos de las malas administraciones, pecadillos, pecados y crimenes que toda la banca privada venezolana pueda haber acumulado en toda su historia, no llegarian ni a una fracción de haber causado perdidas en el valor del dinero comparable con los costos causados por el sector oficial. A tal fin y como simples ejemplos basta recordar los costos derivados del sistema de Recadi o simplemente aquellos derivados del manejo inadecuado de la crisis financieras y donde obviamente el costo que cobro el taller estatal por reparar el golpeado vehículo bancario venezolano, multiplico varias veces el costo original del daño.

Un puritanismo regulador puede afectar la banca de muchas formas. Entre los resultados podemos mencionar el que frecuentemente obliga la banca acelerar el proceso de liquidación de una empresa simplemente por el hecho de que el valor liquido que obtiene la banca en dicha liquidación supera los valores a los cuales se les permite mantenerlos contabilizados. En la Venezuela de hoy creo que no tenemos espacio social para permitirnos el lujo de cierres y liquidaciones no absolutamente necesarias.

Para entender el proceso del registro de las perdidas contables en un banco hay que comprender que estas a veces no tienen nada que ver con perdidas reales sino con simples exigencias normativas que obligan a la creación de reservas. De acuerdo a lo estricto de las normas la banca quedara afectado en mayor o menor grado. Actualmente cualquier analisis comparativo daria como resultado de que en Venezuela tenemos una de las normativas más rigidas y conservadoras del mundo. Para rematar, llegamos a dicho extremo, partiendo de una situación donde no solo las normativas eran muy flexibles sino que además, por la ausencia de una adecuada supervisión, eran practicamente irrelevantes.

Obviamente este proceso irracional de ir de un extremo a otro en la aplicacion de las regulaciones bancarias, y unido a la política devaluacionista de un sector fiscal ávido de recursos, implico un verdadero achicamiento del sector bancario. Hace pocos años Venezuela presentaba varios bancos entre los grandes bancos latinoamericanos, hoy en día ni siquiera aparecen en la lista.

Muchas veces y en respuesta a nerviosas interrogantes sobre la salud del sector bancario venezolano, originados sobre la cuantia de los ingresos extraordinarios, no me ha quedado otra respuesta que el indicar el hecho de que si a un banco le obligan reservar todo, pues todos sus ingresos futuros han de ser extraordinarios.

Resulta evidente que la misma salud financiera de la banca venezolana requiere de una urgente reactivación económica y una Superintendencia de Bancos que hoy estuviese cumpliendo sus funciones tendría que estar activamente apoyando dicha reactivación en vez de, como a veces se percibe, tratar de obtener distinciones al mérito emiitidos por Basilea. 

Si se persiste en mantener firme una actitud casi derrotista y que definitivamente no representa una visión de crecimiento futuro, puede que terminemos con la banca mas reservada y sólida del mundo, una banca vestida no de bluejean sino de etiqueta, pero lamentablemente no presenciando una fiesta sino el entierro económico de un pais.