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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

And on page 253-4 Wolf writes: “Each institution may be diversified. But they will be vulnerable if all are diversified in the same way. Worse, being subjected to similar microprudential regulation makes it more likely that firms will end up being diversified in much the same way and exposed to many of the same risks”. Indeed! As someone who in 1999 wrote in an Op-Ed “The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause the collapse of all of our banks”… you can be sure I annotated a clear and big “YES!” next to that too.

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

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

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

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

For instance:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

No! Mr. Martin Wolf. 

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

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

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

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

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

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

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

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

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

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