My tweets on “How the Basel Committee doomed our bank systems and our economies”

The Basel Committee doomed our bank systems and our economies.

For around 600 years risk adverse bankers had, not always successfully, tried to do their best to clear for perceived credit risks, by means of risk adjusted interest rates and the size of bank exposures. 

When what bankers had perceived as risky turned out to be even more risky, since the exposures were generally quite small, it hurt but banks could manage. 

When what bankers perceived as safe turned out to be risky, since the exposures were then very large, big crises often ensued. 

But then, starting in 1988 with Basel I, and really exploding in 2004 with Basel II, risk adverse regulators decided they also wanted to clear for those same perceived credit risks, and to that effect introduced risk weighted bank capital requirements.

In the softest words I can muster, that was extremely dumb. As bank supervisors they should be almost exclusively concerned with bankers not perceiving the credit risks correctly. Instead they bet our bank systems on that bankers would perceive credit risks correctly.

Banks everywhere were then taken out of the hands of savvy loan officers, and placed in the hands of creative equity minimizing financial engineers, who then ably marketed the nonsense that more bank capital hindered bank lending and was therefore bad for the real economy 

The 2008 crisis caused by AAA rated securities backed with mortgages to the US subprime sector, with which European banks and US investment banks were allowed to leverage 62.5 times with these, should have loudly reminded them about the dangers of the “safe”. 

But regulators refused to admit their mistake and kept risk weighting in Basel III.

The result is an ever increasing dangerous overcrowding of “safe harbors” and the abandonment of the “riskier oceans.

“A ship in harbor is safe, but that is not what ships are for.” John A. Shedd.

And those who used to populated safe harbors, like insurance companies, pension funds, personal saving accounts and other, have been expelled to the risky oceans, confronting loans to leveraged corporates, emerging markets and others for which they're less prepared than bankers

To sum it up, risk-weighted bank capital requirements guarantees especially large crises, resulting from especially large exposures to what’s perceived especially safe, and is held against especially little capital. 

Let’s get rid of these regulators… now!

http://perkurowski.blogspot.com/2016/04/here-are-17-reasons-for-why-i-believe.html

And not only are they dangerously bad regulators… by decreeing risk weights of 0% for the sovereign and 100% for the citizens, they also evidence being dangerous statist/communist regulators.

http://perkurowski.blogspot.com/2019/09/financial-communism.html

PS. My 2019 letter to the Financial Stability Board

PS. My 2019 letter to the IMF

Lawrence Summers, like most, is still blinded by the fairy tale of the risk-weighted capital requirements for banks

I refer to Professor Lawrence Summers “Five suggestions for avoiding another banking collapse” of May 21, 2017

In it Summers clearly evidences he has not yet woken up to the fact that the whole notion of the risk weighted capital requirements of banks is pure and unabridged nonsense… a regulatory fairytale. He still actually believes that risk weighting has anything to do with real risk weighting of the risks to our bank system.  In fact bad-luck risk weighted capital requirements might better cover for the unexpected risk in banking. And so here I explain it again, for the umpteenth time.

The current risk weighting is based on the ex ante perceived risk of bank assets, and NOT on the possibility of that those assets could ex post be risky for the banks and for the bank system

That is for example why regulators in Basel II assigned to what was perceived as AAA rated and that because of such perception of safety could lead to a build up of dangerously excessive exposures, a tiny 20% risk weight; while to the below BB- rated, so innocuous because the banks would never voluntarily create large exposures to it, they assigned a whamming 150%.

Rule: If bankers are not capable of managing perceived risks, then zero capital might be the best requirement, because the faster they would fold.

Truth: A bank system can collapse because of unexpected events (like devaluations), major financial fraud, and when assets ex ante perceived as very safe suddenly turn out ex post as very risky. None of these risks is covered by the Basel Committees’ risk weighted capital requirements.

Summers writes: “there is distressingly little evidence in favor of the proposition that banks that are measured as better capitalized by their regulators are less likely to fail than other banks.” That might be true but only to believe that the measuring of the “measured as better capitalized” is correct, is absurd. Too much reputable research has taken the historical not “risk weighted” capital to asset ratios to be the same as the current capital to risk-weighted asset ratios, which is comparing apples to oranges.

Summers explains: “Our paper examines a comprehensive suite of volatility measures including actual volatility, volatility implied by option pricing, beta, credit default spreads, preferred stock yields and earnings price ratios… none [of which] suggest a major reduction in leverage for the largest US financial institutions, large global institutions or midsize domestic institutions.” I just ask, Professor, amongst so much glamorous sophistications, did you examine the gross not risk weighted assets to capital ratio? That would have probably sufficed.

Summers recommends, “First, it is essential to take a dynamic view of capital” Absolutely! But Professor, do you not believe that a real dynamic view would have to take into account what the shape of the future real economy would be if regulators insist in distorting with their risk weighing the allocation of bank credit to the real economy? For instance should a real stress test not also look at what is not on banks’ balance sheets… like for instance to see if vital risky loans to SMEs and entrepreneurs are too inexistent?

Summers recommends: “banks should not be permitted to take excessive risks or treat customers unfairly in order to raise their franchise value.” Indeed, but what about by means of current risk weighting unfairly allowing those perceived, decreed (sovereigns) or concocted as safer, to have much better access to bank credit than usual than those perceived as risky? Does that not foster more inequality?

Summers very correctly write: “it is high time we move beyond a sterile debate between more and less regulation. No one who is reasonable can doubt that inadequate regulation contributed to what happened in 2008 or suppose that market discipline is sufficient to contain excessive risk-taking in the financial industry” But that requires understanding and accepting that the risk weighting, which so favored what was AAA rated and sovereigns was “the inadequate regulation”. Moreover, as Einstein said, “No problem can be solved from the same level of consciousness that created it”, that requires us to completely change all our current regulators and start from scratch. 

SO NO! Professor Lawrence Summers, with respect to bank regulations, may I respectfully suggest you either wake up or shut up!

PS. And that goes for most of you others bank regulation experts out there.

PS. This is not the first way I have told Professor Summers he does not get it.

PS. Here is a set of questions current bank regulators do not dare to answer.

Should not science matter to bank regulators, at least a little?

I ask because though I am no scientist, far from it, have never really understood Einstein’s relativity theory, I know that if I were asked to regulate banks there would be two basic questions I would have to ask:

First, what is the purpose of our banks? Quite early someone would have mentioned John A Shedd’s “A ship in harbor is safe, but that is not what ships are for” and I would have ascertained that purpose to be, to allocate credit to the real economy, carefully but efficiently. 

Second, what has caused major bank crises? a. Unexpected events, like devaluations, b. criminal behavior, like lending to affiliates; and c. dangerously large exposures to something ex ante perceived as very safe but that ex post turned out to be very risky. Surely someone would have also cited Voltaire’s “May God defend me from my friends, I can defend myself from my enemies” as a reminder that what is perceived as risky is, precisely because of that perception, quite innocuous.

After that initial mini research, the last thing I would have come up with is the current risk weighted capital requirements, more risk more capital – less risk less capital, that which distorts the allocation of bank credit, for no stability purpose at all... much the contrary.

So again… should not science matter to bank regulators, at least a little?

Here is a question to all of you who have read Charles P. Kindleberger’s emblematic “Manias, Panics and Crashes”

In that book, a History of Financial Crises, (6 editions!) did you find something whatsoever that would in the least indicate to you, that current risk-weighted capital requirements for banks could bring stability to our banking system?

I haven’t, much the contrary!

This non-portfolio adjusted risk weighted regulation would only seem to feed more into speculative bubbles… when times are good, a lot seems good, and so a lot gets bank credit… until something gets too much bank credit... and is not so good any longer. 

And if so many crises were caused by unexpected events... how can you settle on regulating based on expected risks?

Could it be that current bank regulators never ever read this book? 

Could it be that regulators never even looked for what has caused bank crises before regulating these? 

Yes, apparently, amazingly, that’s how it seems.

If in doubt just reflect that in Basel II of 2004, the regulators awarded a risk weight of only 20% to that so dangerous for the banking system as what’s rated AAAs, and slammed a 150% risk weight on the so really innocuous below BB- rated, that which would never ever attract excessive bank exposures.

If you happen upon a bank regulator ask him these questions and see him cringe

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

Here is what those who believe risk weighted capital requirement for banks is smart must be thinking.

Are you one of them?

The pillar of current bank regulations is risk weighted capital requirements for banks: More perceived credit risk more capital – less perceived credit risk less capital.

Below what those who believe risk weighted capital requirement for banks is smart, must be thinking. Are you one of them?

That though with banks so many other aspects are risky, like the possibility of cyber attacks, the only thing that matters are credit risks.

That even though banks perceive credit risks, and adjust for that with risk premiums and the size of their exposures, that’s not enough, banks must also adjust for the same perceived risks in their capital.

That lending little at high-risk premiums to something perceived risky, is riskier than lending a lot at very low risk premiums to something perceived safe.

That bankers, no matter what Mark Twain thinks, love to lend out the umbrella when it rains and abhor doing so when the sun shines.

That it is the specific credit risk of the assets that matter, and not how banks manage those risks.

That the expected credit risks are good estimators of the unexpected losses banks need to hold capital against.

That the safer an asset is perceived the less is its potential to deliver unexpected losses.

That the riskier and asset is perceived the greater is its potential to deliver unexpected losses. 

That as long as banks do not fail, the rest, like if they allocate bank credit efficiently to the real economy or not, does not matter. 

That even though a bank is required to hold more capital lending to someone perceive risky than when lending to the AAArisktocracy, that has nothing to do with inequality.

That even if a sovereign depends on its citizens, the sovereign can have a zero risk weight while the citizens, like SMEs and entrepreneur should have a 100 percent risk weight.

That though all major bank crises have occurred because of excessive exposures to what was erroneously perceived as safe, that has nothing to do with tomorrow's bank crises.

That even though no major crisis has have occurred because of excessive exposures to what ex ante was perceived as risky, that has nothing to do with tomorrow's bank crises.

That if you, to the banker’s natural risk aversion, add on the regulators natural risk aversion, you will not risk getting an excessive risk aversion that could be dangerous for the real economy.

That if the perceived credit risk is correct, it does not matter how much importance you give to that perception.

That if you play around with the odds of roulette it will survive as a viable game

A proposal to the Office of Financial Research (OFR) about some urgent research needed on the causes of bank crises.

I extract the following from the webpage of the Office of Financial Research (OFR) established by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 in order to support the Financial Stability Oversight Council, the Council’s member organizations, and the public.

“OFR helps to promote financial stability by looking across the financial system to measure and analyze risks, perform essential research, and collect and standardize financial data.

Our job is to shine a light in the dark corners of the financial system to see where risks are going, assess how much of a threat they might pose, and provide policymakers with financial analysis, information, and evaluation of policy tools to mitigate them.”

I have a very important research that I would suggest the OFR to take on, as soon as possible. It is a follows:

One of the pillars of current capital requirements is portfolio invariant credit-risk-weighted equity requirements for banks, also less transparently known as “risk-weighted capital requirements for banks”.

And this regulation in general terms requires banks to hold more equity against assets perceived as risky than against assets perceived as safe.

And since that introduces a discriminatory distortion factor in the allocation of bank credit, something that could prove very dangerous to the real economy, the only possible justification is of course that what is perceived as risky carries more dangers for the system than what is thought safe.

I do not believe that. Of course that could be true for some individual banks but, for the bank system at large, I hold that it is what ex ante is perceived as very safe, but that ex post can turn out to be very risky that poses the real dangers.

And in this respect it would be very important for the US, as well as for the world, to research what perceived credit risks could be identified as having caused major bank crisis. Of course I do not mean an ex-post analysis, but an analysis of the perceptions on credit risk present at the moment banks incorporated the later troublesome assets on their balance sheets.

As you can understand, if my opinion is proven right, then current regulations would, in principle, be 180 degrees off target.

Thanks.