Regulators introduced into banking a very serious systemic error that is being totally ignored

Banks used to evaluate all credit applications based on the same own bank capital, because that was on the margin true. And so all borrowers could compete with their cost and risk adjusted interest rates offers, on equal terms. Not any longer.

Since the introduction of the risk weighted capital requirements for banks, more perceived risk more capital – less risk less capital, the offers from different borrowers will be evaluated based on different levels of bank capital.

Since the offers provided by The Safe can be leveraged more by the banks than the offers provided by The Risky, The Safe have now a regulatory advantage that, when compared to The Risky, allows them a preferential access to bank credit.

And that seriously distorts the allocation of bank credit to the real economy. “The Safe” get more and cheaper access to bank credit while The Risky, like the SMEs and entrepreneurs, they get less and more costly bank credit. 

To argue that to be a very serious systemic error seems very obvious to me but, in all the discussions on bank regulations, that error has been completely ignored. Why?

For instance, I might have written to the Financial Times and its various reporters and columnists over a thousand letters about it, but its editor has preferred to keep total silence. It must be because of something much more important than perhaps FT thinking little me a nuisance since I write too many letters to the editor.

And of course, in terms of bringing more stability to the banking system, that regulation is absurd and useless. The risk for the system of what is ex ante perceived as safe, but that ex post could be very risky, is clearly much higher than the risk for the system of what is ex ante already perceived as risky.

And of course, the creation of predatory regulations that subsidize The Safe and penalize The Risky, can only accentuate existing inequalities

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”.

What to do when even describing it, an eminence like Martin Wolf is yet unable to see The Great Bank Distortion?

On page 251 of his “The shifts and the shocks” Martin Wolf writes: 

“But [bank] shareholders should only be interested in their risk adjusted returns. If taking on more risk does not raise risk-adjusted returns, shareholders should flee.”

But let me now give you the fuller version of what he writes:

So: "If taking on more risk [like lending to small businesses and entrepreneurs] “does not raise risk-adjusted returns, [because when doing so bank regulators require banks to hold more equity] “shareholders should flee”.

The result: No bank credit to “risky” small businesses and entrepreneurs.

And the other side of the coin would be: "If taking on less risk, like lending to the infallible sovereigns, the housing sector or to members of the AAAristocracy, does raise risk-adjusted returns, because when doing so bank regulators allow banks to hold much less equity, shareholders will love it.

The result: Too much bank credit to the infallible sovereigns, the housing sector and members of the AAAristocracy.

And Martin Wolf, on page 243 concludes that: “Risk-weighted assets can play a secondary role. That way one would have a ‘belt and braces’ approach: a strong leverage ratio, plus a risk–weighted capital ratio as a back-up.

And that he does because on page 251 he argues: “Risk-weighting is extremely unreliable, because the samples from which the weights are derived are always too small or irrelevant”. 

Wolf simply does not understand the dangerous distortion produced by risk weighting... even if the risk-weights are perfect. If perfect they would be perfectly cleared for in the interest rates, the size of bank exposures and all other contractual terms. To also clear for these perfect risk-weights in the capital, signifying a double counting of the perfect risk weights, is just sheer regulatory lunacy. 

“A ship in harbor is safe, but that is not what ships are for”, wrote John Augustus Shedd (1850-1926),.And that goes for our banks too.

And precisely because we all want our ships, or our banks, to sail as safe as possible to the ports we want them to sail to… the last think we should do… is what bank regulators, thinking themselves with 'fatal conceit' capable of being risk managers to the world did… namely to start tinkering with risk weights with their compasses. 

And so no Martin Wolf, not even as a back-up is there a role for credit risk weighted bank capital.

And if we really get down to what Wolf writes on page 252: "the disaster came from what banks wrongly thought to be safe", and which by the way is what all empirical evidence would point at as the usual suspect of causing bank disasters, then the capital requirements should be totally opposite; larger for what is perceived as absolutely safe and lower for what is perceived as risky.

In short, the number one "Macro-prudential Policy" that needs to be implemented, is to get rid of the current batch of distorting bank regulators. But, for that to happen, it is helpful that eminences, like Martin Wolf, also understands what is going on.

What if regulator X knows about the distortions risk-weighted capital requirements for banks produce and keeps mum?

Regulators, who by mistake develop bad regulations, are of course not committing any sort of criminal activity for which they can be sued… unless perhaps they have presented false credentials, which led them to be appointed to such task.

But, what if the regulators are aware they are enforcing the wrong regulations, but they are not willing to change these because this would entail admitting to a mistake that could make them lose their jobs and be exposed to shame? And what if their mistake has caused, for instance, millions of young Europeans to become a lost generation?

I ask this because I have been trying for years to explain to the regulators of the Basel Committee and the Financial Stability Board, the horrendous distortions credit-risk weighted capital requirements for banks produce, with no luck… 

And then it struck me… what if they know it and for whatever reason just don’t want to admit it? Could they really be so irresponsible?

If so, sincerely, I consider they should be hauled in front of a criminal court.

Mr. George Banks, asked by his board about risk weights, Tier 1 capital and CoCos, decides to better go and fly a kite

At the Board of Directors of Dawes Tomes Mousley Grubbs Fidelity Fiduciary Bank

Mr. Dawes Sr asks: Mr. Banks as it is for us to decide what do you suggest we do?

Should we stop lending to our old and loyal small businesses and entrepreneurs which, because of their high risk weights might lead us to not be in compliance with Tier 1 capital requirements?

Because if we do not do so we will force those old and loyal investors of ours who bought our Contingent Convertible bonds, the CoCos, because they paid slightly higher interest, to convert these into bank shares.

Mr. Banks answers: Yes banking, used to be such fun for a loan officer like me but, since those equity minimizing financial engineers took over, that has all changed. It is now all so loony and strange to me. So sorry Sir, I really don’t know how to answer your question, perhaps I better go and fly a kite...

Yes, indeed I think I will!!!

Splendid idea George, with loony regulators like the Basel Committee we all better fly a kite too!

Caveat emptor!

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