Here is THE QUESTION for Janet Yellen during her US Senate confirmation hearings as Chair of the Federal Reserve

Ms. Janet Yellen

Is it not a fact that, with the sole exceptions of when pure fraud was present, all major bank crises have always resulted from excessive exposures to what was ex ante perceived as “absolutely safe”, and never ever from excessive exposures to what was ex ante perceived as “risky”?

And, if so, can you please explain to us the rationale behind the pillar of current regulations, the risk weighting of the capital requirements, which allow banks to hold much much less capital against what is ex ante perceived as “absolutely safe” than against what is perceived as risky?

Could it not be that in reality it should perhaps be the complete opposite?

Is it correct that in the “home of the brave” we impose this type of bank regulations which discriminate against those perceived as “risky”? And by the way, is such thing really allowed under the Equal Credit Opportunity Act, “Regulation B”?

Finally, do not these regulations created such distortions that it makes it impossible for the banks to allocate credit efficiently in the real economy? 

PS. Oh I almost forgot. I remember the Constitution of the United States of America, in Section 8 states “The Congress shall have the power to…fix the Standard of Weights and Measures.” Can you please refresh our minds as to when we delegate fixing the risk-weights to the Fed?

PS. Oh and I almost also forgot too. The US Constitution in its section 9 states: “No Title of Nobility shall be granted by the United States”. Now, is that not something that de facto happens when we sort of recognize the existence of an AAAristocracy or AAArisktocracy?

A sort of a shoddy investigation!

I refer to the “Wall Street and the Financial Crisis: Anatomy of a Financial Collapse” report by the Senate Permanent Subcommittee on Investigations. It is a sort of shoddy investigative work. Why?

On April 28, 2004 the Securities and Exchange Commission authorized the investment banks to dramatically increase their leverage, among other when investing in securities backed by mortgages to the subprime sector. The SEC resolution establishes the explicit condition that it has all to be done “consistent with the Basel Standards”.

The Report of 650 pages, does not mention the Basel Committee once!

And why do the Basel Standards, issued by the Basel Committee matter? The answer is simple; it was the Basel Committee which produced and disseminated the regulatory mistake that caused this crisis. Here follows a very brief description of that fatal mistake.

The Basel Committee’s mistake

If all sovereign and private bank clients were paying the banks exactly the same risk-premiums, then the risk-weights used in Basel II to apportion the basic capital requirements for banks according to the various categories of credit ratings could have been right. But, they don’t!

The banks and the markets already incorporates in the setting of their risk-premiums the risk information provided by the credit rating agencies, and so when the regulators also used the same credit ratings for setting their risk-weights they made these ratings count twice. That huge mistake resulted in:

1. The setting of minimalistic capital requirements that served as growth hormones for the ‘too-big-to-fail’.

2. That banks overcrowded and drowned themselves in shallow waters, whether of triple-A rated securities backed with lousily awarded mortgages to the subprime sector, or of equally or slightly less well rated “rich” sovereigns, like Greece.

3. A serious shrinkage of all bank lending to small businesses and entrepreneurs as lending to these generated, in relative terms, much higher capital requirement, which made it difficult for them to deliver a competitive return on bank equity.

With Basel III, regulators might be trying to correct for this mistake, instead of correcting the mistake. In other words, the Basel Committee is digging us deeper in the hole where they placed us.