The current risk weighted bank capital requirements: A Maginot Line

My Twitter thread:

What if generals concentrate too much on the immediate risk sergeants perceive?

I ask because regulators now concentrate too much of their bank capital requirements on the risk perceived by credit rating agencies and bankers.

The result? A false sense of security. A Maginot Line.

Any risk, even if perfectly perceived, if excessively considered, causes the wrong action.

With bankers adjusting for risk with interest rates, and regulators with bank capital requirements, there will be dangerously much “safety” and dangerously little risk-taking.

Too much safety? 

The excessive bank exposures and the assets bubbles that can become dangerous for bank systems and the economy, are always built-up with assets perceived (or decreed) as safe, never ever with assets perceived as risky.

Too little risk taking? 

Risk taking is the oxygen of any development

If e.g., residential mortgages are favored much more than bank loans to small businesses and entrepreneurs, we will end up with too expensive houses and too little job income for food, utilities… and mortgages

What if the generals took much more care of the needs of their headquarters, than those of the soldiers in the battlefield?

I ask because the regulators who, for bank capital requirements, have decreed risk-weights of 0% the government and 100% the citizens, are doing just that.

What if armies don’t arm during peace?

I ask because when times are good, is when banks should buildup capital

The risk weighted bank capital requirements, do the opposite

So, when times turn bad, our banks will stand there naked, just when we need them the most

Good Job! 😡

Regulators, the Basel Committee for Banking Supervision, imposed bank capital requirements based mostly on perceived risks, not on misperceived risks or on unexpected events e.g., a pandemic or a war. 

Oh, if only they had taken time off to play some war games before doing so.

PS. Not the first time I've mentioned the Maginot Line

My brevissimus criticism lecture on the Basel Committee’s bank regulations

Students. 

Let’s refer to two types of bank assets, those perceived as safe, e.g., government debt and residential mortgages; and those perceived as risky, e.g., loans to small businesses and entrepreneurs.

Let’s also assume all these assets, whether the Safe or the Risky, are offering perfect risk adjusted interest rates.

Before the Basel Committee regulations, the banks, with a general look to the safety of their whole portfolio, would have given all of these assets, whether safe or risky, a quite similar consideration.

But, when the Basel Committee imposed risk weighted bank capital requirements, more capital/equity for what’s perceived as risky than for what’s perceived (or decreed) as safe, that all changed.

Because banks can now leverage their capital/equity much more with what’s “safe”, the risk adjusted interest rates offered by the Safe, produce them higher risk adjusted returns on their equity, than the risk adjusted interest rates offered by the Risky.

That dramatically distorted the allocation of bank credit. 

The Safe now get too much credit, often at rates lower than what their correct risk adjusted interest rate would demand. As a consequence, excessive bank exposures are construed, turning the Safe effectively into risky and very dangerous to the stability of bank systems. (Have you ever heard of a dangerous asset bubble built-up with assets perceived as risky?)

The Risky now get too little credit and, whatever they get, is at interest rates higher than what their correct risk adjusted interest rates would merit. As a consequence, the Risky become riskier, and too little risk-taking, the oxygen of all development, takes place, something which, of course, weakens the economy.

Why would regulators do this? As Paul Volcker (valiantly) confessed “The assets assigned the lowest risk, for which bank capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages”

Students, one big problem is that the Academia seem not to care one iota about it, so this might have been your only chance to hear this explanation. 

Why should you care? Having banks give much priority to refinancing the safer present than financing the riskier future, cannot be in your best interests.

The Basel Committee for Banking Supervision’s dangerous distortion of the allocation of bank credit, all explained for dummies in just four tweets.

If a safe borrower’s 4% and a riskier borrower’s 6% provide banks the same 1% risk adjusted net margin then, before the introduction of BCBS’s credit risk weighted capital requirements, those would have been the rates charged by banks.

But now, because the “safer” can e.g. be leveraged 25 times while the riskier e.g. only 12.5 times, with those initial rates, the safer will provide banks a 25% risk adjusted return on equity, while the riskier only 12.5%.

So, now the safer could be offered less than a 4% rate, even down to 3.5% (new risk adjusted net margin of .5%) and still be competitive vs. the riskier when accessing bank credit, and/or be awarded too much credit… which could (will, sooner or later) turn him risky.

And the riskier will now have to pay 7% (new risk adjusted net margin of 2%) in order to remain competitive vs. the safer, which would make him even riskier, or not have access to credit at all, which could hurt the growth possibilities of the real economy

1988, when it all started, when statism/communism took over our bank system.

2019, my letter to the Financial Stability Board

Are these reasons not enough cause for impeaching the current bank regulators?

By setting higher bank capital requirements for what is already perceived as risky than against what could wrongly be perceived as safe, the regulators guarantee especially large bank crises, from especially big exposures to what’s perceived as especially safe, against especially little capital.

By the same token they guarantee more than ordinary access to credit for the “safer” present, which will cause bubbles, like in house prices, and less credit to the “riskier” future, like to entrepreneurs, which will weaken the real economy.

By the same token, giving the banks huge incentives to finance what’s safe, has expelled the rest of the economy, like pension funds and private savers into the shadow banking system, having to take on much more “risky” investments, like leveraged loans, for which they are much less prepared for than banks.

My 4 tweets on the access to bank credit war

1. Way too much discussions on whether bank capital requirements should be 4%, 8%, 15%, 20% or whatever, and way to little about the fact that different capital requirements for different assets, dangerously distorts the allocation of bank credit.

2. The risk weights in the risk weighted capital requirements for banks are de facto tariffs on the access to bank credit. Sovereigns 0%, AAA rated 20%, residential mortgages 35%, unrated citizens 100%, below BB- corporates 150%.

3. So why do all those who tear their clothes about trade protectionism, keep silence about the access to bank credit protectionism imposed by “the safe” on “the risky”, and which can have even much more serious implications for the world economy.

4. As is it guarantees especially large bank crises from especially big exposures to what’s perceived as especially safe, against especially little capital.

As is, by favoring credit to the “safer” present over the “riskier” future it guarantees stagnation.

http://subprimeregulations.blogspot.com/2019/03/my-letter-to-financial-stability-board.html

PS. It has caused houses to morph from being homes into being investment assets.

PS. More than a trade war it is actually this access to bank credit war that is most likely to bring the euro and then EU down.

PS. 0% risk weights will turn sovereign into spoiled filthy rich brats that will end up defaulting.

PS. Are these reasons not enough cause for impeaching the current bank regulators?

Had there been a Basel Committee on Tennis Supervision, Roger Federer would be history by now.

The Basel Committee for Banking Supervision (BCBS) in order to make bank systems safer imposed risk weighted bank capital requirements. The lower the perceived risk the lower the capital the higher the leverage allowed. The higher the perceived risk the more capital the lower leverage allowed. 

For example, in Basel II of June 2004 they held that against any private sector asset that was rated AAA to AA banks needed to hold 1.6% in capital, meaning they were allowed to leverage 62.5 times. Against any private sector asset that was rated below BB- banks needed to hold 12% in capital, meaning they were allowed to leverage 8.3 times. 

In terms of tennis that would mean that those players ranked the highest would be able to play with the best rackets, and be allowed many more serves than those player ranked lower. Someone not only unranked but also lousy player like me would be happy having one serve and at least be allowed to use a ping-pong racket if playing against Roger Federer. 

But what would have happened if there had been a Basel Committee on Tennis Supervision that implemented these regulations?

To make a long story short, the best tennis players would have it easier and easier to win, and would have less and less need to practice. Those betting on them would bet ever-larger amounts at ever-lower odds… until “Boom!” (2008 Crisis) suddenly the best player was discovered to completely have lost his ability to play and lost in three blank sets to a newcomer.

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

The risk weighted capital requirements for banks should have had to consider the conditional probability... it did not!

What is the conditional probability of assets being dangerous to bank systems when conditioned to that bankers have perceived these assets as risky?

Assets perceived by bankers as risky become safer, not riskier.

What is the conditional probability of assets being dangerous to bank systems when conditioned to that bankers have perceived these assets as safe?

Assets perceived by bankers as safe become riskier, not safer.

So regulators who base their capital requirements for banks on that what’s perceived as risky is more dangerous to the bank systems than what’s perceived as safe, is that because they have never heard about conditional probabilities?

The current risk-weighted capital requirements for banks guarantee especially large exposures, against especially little capital, to what is ex-ante perceived, decreed or concocted as especially safe, dooming our bank systems ex-post to especially large crisis... like that one in 2008.

Its what’s safe that’s risky!

Here is an aide-mémoire on some of the many mistakes with the risk weighted capital requirements for banks.

And here are some of my early opinions on these regulations, some of them while being an Executive Director at the World Bank, 2002-04

Universities, like Harvard Business School, do have "Conditional Probability and Bayes' Theorem" on the curriculum. Could it be that professors are kept too busy preparing these courses so to have time to look out at what’s happening in the world? Or could it be that their students never understood them?

PS. Here's my comment that was received by the Financial Stability Board

PS. Not the first time I've written about the ignored conditional probability.

PS. Basel Committee’s distortion of credit allocation explained to dummies, in just four tweets.

PS. Here’s the opinion of #AI ChatGPT on this issue.

PS. Here’s the opinion of #AI Grok4 SuperGrok on this issue

PS. And below a humble 2010 home-made youtube comment, dared by someone with no PhD and not a single peer reviewed paper... but perhaps with AI on his side. :-)

My tweets asking very courteously bank regulators for an explanation

Dear bank regulators, please explain your current risk weighted capital requirements for banks against these four scenarios:

1. Ex ante perceived safe – ex post turns out safe - "Just what we thought!"
2. Ex ante perceived risky – ex post turns out safe - "What a pleasant surprise! That's why I am a good banker"
3. Ex ante perceived risky – ex post turns out risky - "That's why we only lent little and at high rates to it."
4. Ex ante perceived safe – ex post turns out risky - "Now what do we do? Call the Fed for a new QE?"

Because, as I see it, from this perspective, your 20% risk weights for the dangerous AAA rated, and 150% for the so innocous below BB- sounds as loony as it gets.

Here are some of my current explanations of why I believe the risk weighted capital requirements for banks are totally wrong.

And below an old homemade youtube, published September 2010, on this precise four scenarios issue

Crimes against humanity can also unwittingly be committed through subtle and nonviolent means, like with bank regulations

Let us suppose a continuation of regulators who, in order for banks not to crash under their respective watch, decreed that banks should concentrate all their activity lending to “infallible” sovereigns, to those with good credit ratings, to the safe financing of houses; and to stay away from lending to all those who are perceived as risky.

That because they, like bankers, they looked at what could be risky for banks, and not as they should have done, as regulators, at the risks that might not be perceived.

And the consequences of it is that millions of those who though they are perceived as risky could help the economy move forward and generate new jobs, such as SMEs and entrepreneurs, have their access to bank credit denied.

And so hundred of millions of our young will not get jobs and have to remain living in their parents’ basements… that is unless they revolt and send their parents down to the basements.

And yet, sooner or later, especially large bank crisis will result, because of unexpected events, or because of excessive exposures to something that was perceived, decreed or concocted as safe, but that ex post turned to be risky. And these crises are made so much worse when banks have to hold especially little capital against those ex-safe assets.

This is precisely what the risk-weighted capital requirement for the banks created by the Basel Committee for Banking Supervision cause.

These allow banks to leverage more with what is “safe” than with what is “risky” and thereby obtain higher risk adjusted returns on capital with what is “safe” than with what is “risky”.

As a direct consequence, millions of job opportunities for our young have already been lost forever; and the first big crisis already occurred in 2007-08, only that in this case the central bankers, with their quantitative easing and ultra low interest rates, kicked that can forward.

And here we are, sitting on artificially inflated stock market valuations and house prices that, when true need arises, will never be able to be converted back into the same effective real purchase power that was invested in them.

And all that huge sovereign debts accumulated in the process can only be repaid with help of the printing machine, and never in terms of the real purchase power that was invested in its generation.

And the human sufferings, and the consequent strains all this will impose on our social fabric will be immense… especially when like now in many countries it will be compounded by big demographic changes.

Does all this not indicate that these regulations could be classified as a horrendous and perhaps even punishable regulatory crime against humanity?

Or will the inquisition of the high priests of bank regulations just excommunicate me, like any Galileo?

Where do I nail these my Theses about the risk weighted capital requirements for banks, so as to at least achieve a discussion of them? 

Or will the inquisition of the high priests of bank regulations just excommunicate me, like any Galileo?

IMF, the Basel Committee’s procyclical risk weighted capital requirements puts financial cycles, global or local, on steroids

This year’s IMF Jacques Polak Annual Research Conference on November 2–3 is titled “The Global Financial Cycle.” 

It aims to bring together contributions by leading experts on the topic—from both within and outside the IMF—to improve the “understanding of a range of issues, including the causes and consequences of the global financial cycle, the transmission channels of global financial shocks, and the role of domestic policies in dampening the impact of global shocks.”

I wonder if, again, for the umpteenth time, the distortions produced by risk weighted capital requirements in the allocation of credit to the real economy will be ignored.

The following is the comment I posted on the IMF Blog

Risk weighted capital requirements, more risk more capital – less risk less capital, allows banks to earn much higher risk adjusted returns on equity with what is perceived decreed or concocted as safe, than on what is perceived as risky. 

That pushes more than ordinary the financial pursuit of “the safe” and the avoidance of “the risky”.

That de facto puts financial cycles, whether global or local, on steroids.

Will this comment be considered? I have not seen much action on the one I made last year.

PS. I have now read all the papers presented in the conference and the only one that makes somewhat of a reference to risk weighted capital requirements, is “Global financial cycles and risk premiums?” authored by Oscar Jorda, Moritz Schularick, Alan M. Taylor and Felix Ward, October 2017

It includes “If banks hold foreign assets on their balance sheets and mark them to market, price changes can synchronize the risk appetite and the trading behavior of banks around the world. For instance, if Federal Reserve policy affects U.S. equity prices, falling asset prices in the U.S. decrease (risk-weighted)-asset-capital ratios of U.S. as well as international banks, which start to cut down their risk-taking in sync with U.S. banks.

If no large risk-neutral player steps in to compensate for the lower risk taking of the leverage-constrained intermediaries, risk-spreads will increase.”

But as one can see that is how financial cycles or event affect “(risk-weighted)-asset-capital ratios”, but not how these risk weighted capital requirements affect the financial cycles.

For instance Greece would never ever have been able to obtain so much debt had it not been for the ridiculous low capital requirements on that debt.

Should our nannie state tax all risk-taking at higher rates, as current bank regulators do?

Motorcycles, in terms of deaths per miles driven, are much riskier than cars. Should society therefore levy a special risk tax to compensate it for the unnecessary early death of its members? (Even though we know more people die in car than motorcycle accidents) 

Since sport injuries have a cost for the society should we tax sports based on their injury rates? For instance, applying a ten percent risk tax on cricket and only one percent on croquet (to cover for the pesky squirrels).

If one assumes that the risks involved with any activity are not adequately perceived or considered, one could of course construe a case for those taxes. But, should we dare to assume risks are not already perceived and cleared for if we therefore could end up with a very risky too risk adverse society?

And I ask all this because taxing risk-taking is exactly what current regulators do with their risk weighted capital requirements for banks.

They now require banks to hold more capital against what is already perceived as riskier (motorcycles) than against what is perceived as safe (cars). This translates into banks having much higher possibility of maximizing their returns on equity with what is “safe” than with what is “risky”; which de facto is a tax on “the risky”.

Consequences? Banks build up dangerously large exposures to what is perceived, decreed, or concocted as safe, like sovereigns, AAArisktocracy and mortgages; and to small exposures, or even no exposure at all to what is perceived as risky, like SMEs and entrepreneurs.

Clearly if the risks are already perceived and considered by bankers, in the size of the exposure and the interest rates charged, to then also have the capital reflect the perceived risks, cause these risks to be excessively considered; resulting in an excessively risk-adverse banking system.

Just consider that already, partly because of the higher risk perceptions, many more people die in car than in motorcycle accidents. 

Think of a society where no one drives motorcycles or plays cricket because the risk-taxes are too high, and all keep to cars and crocket. Is that the kind of society that will be strong enough to survive? Is that what we want?

I am sorry but there is no more figurative way to express it. The Basel Committee for Banking Regulations and their affiliated regulators have effectively castrated our banking system. Will that make us safer? Of course not! 

Our banks will dangerously overpopulate safe-havens; in which they will die from lack of oxygen.

Our economies are going to dwindle into nothing, when denied the oxygen of risk-taking necessary for all development.

Friends, we must urgently get rid of these dangerously inept bank nannies.

Even perfectly perceived risks cause wrong decisions if excessively considered

Should banks consider risk factors, such as the probability of default (PD) and the expected loss given a default (LGD), when setting the interest rates it charges clients? Of course, higher perceived risk-higher interests, lower risks-lower interest rates. 

But regulators curiously decided that these risks should also be cleared for in the capital requirements for banks, and decreed: higher perceived risk-higher capital, lower risks-lower capital.

So now banks clear for these risks both with risk adjusted interest rates and risk adjusted capital. That’s a real serious problem because any risk excessively considered, will produce the wrong decision, even if the risk is perfectly perceived.

Now a higher interest rate perfectly set in accordance to a perfectly perceived higher risk translates, because of higher capital requirement, meaning a lower leverage, into a lower risk adjusted expected return on equity. 

Now a lower interest rate perfectly set in accordance to a perfectly perceived lower risk translates, because of a lower capital requirement, meaning a higher leverage, into a higher risk adjusted expected return on equity.

So now banks, even when the risks are perfectly perceived, lend too little to the risky, or in order to compensate for lower ROEs, at too high risk adjusted interest rates; and lend too much to the safe, or thanks to higher ROEs, at too low risk adjusted interest rates.

This is insane! It produces dangerous misallocation of bank credit to the real economy. Too little financing of the "riskier" future and too much refinancing of the "safer" present.

PS. There is still a possibility of credit being allocated efficiently to the real economy, but that requires that what's perceived as safe to be much safer and what’s perceived as risky to be much riskier. What credit rating agencies could guarantee us such mistakes?

Regulators and bankers looking out for the same risks 

10 years after, the problem is not that some are forgetting bank regulations, but that most never learned about these.

1. Allowing banks to leverage their equity more with The Safe, like with Sovereigns and AAA rated, than with The Risky, like with SMEs, allows banks to earn higher risk-adjusted returns on their equity with The Safe than with The Risky. 

2. That distorts the allocation of bank credit to the real economy causing banks to lend too much to The Safe and too little to The Risky.

3. And all for nothing because all major bank crisis have resulted from excessive exposures to what was perceived as belonging to The Safe, and never ever from exposures to something perceived as belonging to The Risky when placed on bank's balance sheets. 

Since risk weighted capital requirements for banks are still used, we are still on the same route to new similar failures.

 

Here is much more on this

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!

Banks, regulators and sovereigns, colluded to introduce, statism, risk aversion and complacency.

It's hard to pinpoint the exact meaning of complacency, especially as that sentiment could have different origins. I am not really sure what it means to Tyler Cowen, but to me, complacency, is quite often only a more comfortable and somewhat hypocritical expression of a “Please don’t rock the boat” wish.

I now quote extensively from Tyler Cowen’s “The complacent class” (page 13)

“One thing most Americans agree on it politics–for all the complaining about the bank bailouts–is that there should be more guaranteed and very safe assets. The Federal Reserve Bank of Richmond has estimated that 61 percent of all private-sector financial liabilities are guaranteed by the federal government, either explicitly or implicitly. As recently as 1999, this figure was below 50 percent. We’re also more and more willing to hold government-supplied, risk free assets, even if they offer very small or zero yields… Plenty of commentators suggest that something about this isn’t right, but again the push to fix it is extraordinarily weak, especially since that would mean someone somewhere would have to take significant financial losses.

There is a Zeitgeist and a cultural shift well under way, so far under way in fact that it probably needs to play itself out before we can be cured of it. The America economy is less productivity and dynamic, Americans challenge fundamental ideas less, we move around less and change our lives less, and we are all the more determined to hold on to what we have, dig in, and hope (in vain) that, in this growing stagnation, nothing possibly can disturb our sense of calm.”

Is it really so as Cowen seems to argue, that the Home of the Brave, that which has developed based on considerable doses of risk-taking by risk-takers, now comes to this complacency on its own... or was it entrapped?

I argue the latter. One way or another, regulators managed to sell to a financially naïve political sector the concept that it was possible for bank regulators, or for the more sophisticated banks’ risk models to determine real-risks, and so introduced risk-weighted capital requirements… topping it up by putting aside all considerations as to whether this could distort the allocation of credit to the real economy.

In 1988 America induced and signed up on the Basel Accord, Basel I. That ruled that for the capital requirements banks needed to hold, the risk weight of the sovereign was to be zero percent, 0%; for mortgages to the residential housing 55%; and for loans to We the People 100%.

In 2004, with Basel II, the risk-weight for residential mortgages was reduced to 35%; We the People were also split up in “the safe”, the AAA rated, the AAArisktocracy with a risk weight of 20%; passing through a risk-weight of 100% for those not rated ordinary citizens; and topping it out at 150% for those rated below BB-.

What did this mean? First that regulating technocrats, sent out the falsely tranquilizing message to the market of “Don’t worry, banks are now risk-weighted”. Second, that statists told banks: “We scratch your back and you scratch ours… the State guarantees you, and you lend to the State as cheap as possible”. 

Of course that immediately resulted in that banks would search out any assets that were decreed, perceived or concocted as safe; as with these banks could leverage more and therefore obtain higher risk adjusted returns on equity… which much explains the much increased appetite for “safe assets”, in America and Europe.

Of course that meant that the sovereign would by artifice receive much more bank credit, at much lower rates than usual; making a joke of that “risk-free-rate” used in finance. 

Of course that immediately resulted in that banks would avoid all assets officially perceived as “risky”, like loans to SMEs and entrepreneurs, as with these banks could leverage much less and therefore obtain lower expected risk adjusted returns on equity… which of course affected the productivity and the dynamism of the real economy, in America and Europe.

Of course that meant banks would prefer financing the construction of the “safe” basements were young unemployed can live with their parents than the riskier future that could create the jobs they need… which reduces mobility as more and more get to be chained to houses with artificially high prices.

And a truly sad part of all these induced statism and risk aversion is that it does not lead to any more bank stability, much the contrary. Major bank crises are caused by unexpected events (e.g. devaluations), criminal behavior (e.g. loans to affiliate) and excessive exposures to what was ex ante perceived as very safe but that ex post turns out to be very risky, among others because being perceived as very safe often causes it to receive too much bank credit.

What caused the 2007-08 crisis? Excessive exposures to what was perceived or decreed as safe as AAA rated securities and sovereigns like Greece.

What has caused stagnation thereafter? Lack of lending to SMEs and entrepreneurs, those best equipped to open up new paths.

Where banks in on this? Answer would banks like being able to earn the highest risk adjusted returns on equity when holding what they perceived as the safest? Of course they would, that sounds like bankers’ wet dreams come true.

I find “The Complacent Class” to be a fun and very useful book, and it could help get very important and needed debates going. That said I would like to see Tyler Cowen substantially updating the second edition of it, by including that dangerous risk aversion and complacency imposed on banks and on America (and Europe) by its regulators.

Here is one mystery in current bank regulations that regulators refuse to reveal to us.

That which has an AAA rating, meaning it is perceived as very safe, will of course have much access to bank credit, and be required to pay very low risk premiums. If those ratings then turn out to be wrong, sometimes precisely because since it was considered very safe too much credit was given to it, individual banks, and the bank system, face a very serious problem.

That which has a below a BB- rating, meaning it is perceived as extremely risky, has access to much less credit and, when it gets it, will be by paying much higher risk premiums. If those ratings turn out to be even worse, some individual bank might have a smaller problem, but the bank system as such, would face no problems at all.

But, an here is the mystery, bank regulators, with their Basel II, in June 2004, for the purpose of setting the capital requirements for banks, set a 20% risk weight for the AAA rated and 150% for what is below BB-.

Why so? If "safe" could be dangerous and "risky" is innocuous, could it not really be the other way around?

And that, since regulators refuse to explain it, is now, soon 13 years later, still a mystery to us

PS. Questions regulators refuse to answer

Dear Mr Kurowski, here is our answer to your doubts. Sincerely, the experts in Basel Committee, FSB and affiliates

(I dreamt I got this letter from our bank regulators in response to my questions.)

Dear Mr Kurowski

It does not matter whether the risky already get less credit and pay higher interest rates, they must get even less credit and pay even higher interests… because they are risky. Don’t you get that!

It does not matter whether the safe already get more credit and pay lower interest rates, they must get even more credit and pay even lower interests… because they are safe. Don’t you get that!

It does not matter that the risky have never caused a major bank crisis. Risky is risky and that’s that! 

It does not matter that there could be too large exposures to what’s perceived safe but could in act not be; which could cause a huge crisis. Safe is safe and that’s that.

Yes, yes we understand, (we think) that our risk weighted capital requirements might introduce some serious credit austerity for the risky, like SMEs and entrepreneurs, and that this could affect the economic growth of the real economy. But that’s not our problem. Our sole concern is to keep banks safe. 

For economic growth there are infrastructure projects, like bridges, to be undertaken by the Sovereign taking advantage of the exceptionally low rates it is awarded, because it is really and truly safe. If we can’t trust the Sovereign who are we to trust? The citizens?

Oh, that the 2007-08 crisis was caused primarily because of too much investment in securities rated AAA that was supposed to be super-safe? Yes, but now we are imposing huge fines on those credit rating agencies, so they should have learned their lessons, and all will be fine and dandy. Trust us Mr Kurowski. We are after all, as you know, the experts. 

PS. For your own good stop writing those letters about us to the Financial Times. How many now, around 2500? You’re crazy! Don’t you see FT doesn’t care?

Yours sincerely,

Names withheld (by me)… out of delicacy

PS. Friends, as you can see, our bank regulators remain as captured as ever in their cognitive bias, poor us.

With risk weighted capital requirements, Basel Committee’s regulators fed the banking system brutish misinformation

If you have $100.000 to invest you might invest more and at a lower interest rate in what you perceive as safe, as compared to how you would invest in what you perceive as risky. But, even so, you would never ever think of your $1 invested in what you perceive as safe, to be any different than the $1 you have invested in what you perceive as risky. 

That is not the current case with banks. With the risk weighed capital requirements for banks, they have been told that $1 invested in what is perceived as safe, is worth much more than $1 invested in what’s is perceived as risky. That because regulators allow banks to leverage the former $1 much more than the latter; which means that $1 invested in what is ex ante perceived, decreed or concocted as safe, produce the banks a much higher expected risk-adjusted return on equity, than $1 invested in what is ex ante perceived or decreed as risky.

For instance Basel II, with its 8% basic capital requirement set a 20% risk weight for AAA rated private assets and 100% risk weights for unrated SMEs. That allow banks to leverage their equity, and the support they received from society 62.5 times with AAA rated assets and only 12.5 to 1 with loans to SMEs. That resulted into that for a bank to lend to a SME, as compared to lending to an AAA rated borrower, carried the cost of 50 times lesser leverage opportunities.

That signified that banks, in order to keep shareholders happy with high risk adjusted returns, and management bonuses high, had to keep to what was perceived as safe and abandon lending to what was perceived as risky.

So banks no longer finance the “riskier” future, they only refinance the “safer” past.

So banks are dangerously overpopulating safe havens and, for the real economy, dangerously underexploring riskier bays.

So banks are gladly financing those “safe” basements where jobless kids can live with their parents, and not those “risky” SMEs that stand a chance to create the jobs that could allow the kids to afford to become parents too. 

Damn those regulators who manipulated and still are manipulating the allocation of bank credit this way. They should be shamed and banned forever.

P.S. Washington Post. December 2018: “Affordable homes or houses as investment/retirement assets?”

Greenspan never understood the distortions in credit allocation the risk weighted capital requirements for banks caused

Fed chairman Alan Greenspan in January 2004 said: “There are several developments, however, that I find worrisome…The first is that yield spreads continue to fall. As yield spreads fall, we are in effect getting an incremental increase in risk-taking that is adding strength to the economic expansion. And when we get down to the rate levels at which everybody is reaching for yield, at some point the process stops and untoward things happen. The trouble is, we don’t know what will happen except that at these low rate levels there is a clear potential for huge declines in the prices of debt obligations such as Baa-rated or junk bonds.”

This is clear evidence Greenspan did not understand much of the distortions produced by the risk weighted capital requirements for banks.

The reality was that as “yield spreads continue to fall” banks reached out for those yields with which they could most leverage their equity with; not “Baa-rated or junk bonds” but AAA rated securities.

Bonds perceived ex ante as junk never ever signify a danger to the bank systems

Here is an aide mémoire

Luckily credit rating agencies got it wrong and put a temporary stop on it. Otherwise we would have been much worse off

Few can really evidence having warned so much against the use of credit rating agencies in bank regulations, as I can. So I believe that should give me the right to dare to opine that the fact that the credit rating agencies got it wrong, was and is not the worst part of the current bank regulation horror story.

As for examples of the first, in January 2003 the Financial Times published a letter in which I wrote: “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. Friends, as it is, the world is tough enough.”

And, as an Executive Director of the World Bank, in April 2003, at its Board I formally stated: “Ages ago, when information was less available and moved at a slower pace, the market consisted of a myriad of individual agents acting on limited information basis. 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 the credit rating agencies. This will, almost by definition, introduce systemic risks in the market and we are already able to discern some of the victims, although they are just tips of the icebergs.”

And of course, when then the credit rating agencies later messed it up, and got it so amazingly wrong with the AAA rated securities backed with truly lousy mortgages to the subprime sector, it was a real disaster. But, I tell you, it could have been much worse, like if they had rated correctly for a much longer period.

The reason for that lies in the malignant error of the Basel Committee’s risk weighted capital requirements for banks; more ex ante perceived credit risk more capital – less risk less capital.

Perceived credit risk is the risk most cleared for by banks; they do so by means of interest rate risk premiums and size of exposures. And so when regulators decided to clear for exactly the same risk, now in the capital, that perceived credit risk got to be excessively considered. And any risk, no matter how correctly it is perceived, if it is excessively considered, will cause the wrong actions.

For instance banks were (and are) allowed to leverage much more when financing the purchase of residential houses, or when investing in AAA rated securities backed with mortgages, “The Safe”, than what they are allowed to leverage when lending to the core of the bank credit needing part of the economy, the SMEs and entrepreneurs, those who help create the new generation of jobs, “The Risky”.

And that has resulted in that banks earn much higher expected risk adjusted returns on The Safe than on The Risky; which results banks will finance much more The Safe than The Risky.

So, had it gone on (oops it still goes on) we will all end up in houses with no more houses to be built, and without that new generation of jobs that could help us, or foremost our children and grandchildren, to service mortgages and pay utilities.

So let’s be thankful the credit rating agencies got it wrong, but, please, let us also correct for the regulators' mistakes. Thinking on my grandchildren, I would in fact prefer lower capital requirements for banks when financing unrated SMEs and entrepreneurs than when financing the purchase of a house.

But how did this happen and how could it have been avoided.

Well perhaps it would have been nice if the regulators, before regulating the banks ,had defined their purpose. Then perhaps John A. Sheed’s “A ship in harbor is safe, but that is not what ships are for”, could have come to their mind.

And also it would have been nice if the regulators had done some empirical research on what causes bank crisis; and then they would have discovered that never ever excessive exposures to what is perceived as risky; and then they might have thought of Voltaire’s “May God defend me from my friends [AAA rated]: I can defend myself from my enemies [the unrated]”