The financial crisis explained to dummies in terms of capital requirements for banks: Lehman Brothers - AIG - Greece

The regulators, with Basel II, decided that against any private sector assets rated AAA banks, and against any sovereign rated as Greece was until November 2009, banks needed to hold only 1,6 percent in capital, meaning these could with those assets leverage their capital over 60 times to 1. (When holding “risky” assets like loans to entrepreneurs and SMEs they were only allowed to leverage 12 times to 1. 

On April 28, 2004 the SEC decided that was good for the Basel Committee was good enough for them and allowed Lehman to leverage over 60 times to 1 with AAA rated securities guaranteed with mortgages to the subprime sector… Since Europe were allowing their banks to do the same… the demand for these AAA securities became so huge that it overpowered all the quality controls in their manufacturing and packaging process… and Bang!

If AIG that was AAA rated guaranteed an asset, banks could dramatically reduce the capital they needed to hold against that assets, and this overwhelmed AIG’s capacity to resist selling “very profitable” loan default guarantees… and Bang!

Greece was of coursed offered loans in such amounts and in such generous terms, so their otherwise "so" disciplined and fiscally conservative governments could not resist the temptations… and Bang!

And as should have been expected not one single asset class that was perceived as risky played any role in causing the financial crisis… although of course these assets also suffered a lot when the “safe” came tumbling down.

One would think regulators would by now have discovered that banks already clear for the perceived risks with their risk premiums and the size of their exposure; and so to also force them to also clear in the capital for exactly the same risks, would cause banks to overdose on perceived risks. But no, they haven’t. So this little financial history lesson for dummies is of course primarily directed to them.

What is our major problem now? John Kenneth Galbraith explained it well: “If one is pretending to knowledge one does not have, one cannot ask for explanations to support possible objections.”

Here are 7 questions on bank capital regulations that US Congressmen and Governors should ask the Fed, FDIC and OCC.

Gentlemen 

We have been made aware that currently banks are required to hold more capital, meaning equity, when lending to those perceived as safe from a credit risk point of view, like many sovereigns and private entities with good credit ratings, than what banks need to hold in capital when lending to those perceived as more risky, like SMEs and entrepreneurs.

Notwithstanding that sounds intuitively as quite reasonable, one can also argue the following:

Those perceived as safe from a credit point of view, without these regulations, already count with the benefit of larger loans and lower interest rates; while those perceived as risky have less access to bank credit and have to pay higher interest rates. Mark Twain’s saying that a banker is he who lends you the umbrella when the sun shines, but wants it back when it looks like it is going to rain, comes to mind.

So these capital requirements allow banks to leverage more their equity, and the support they in many ways receive from society, many times more when lending to The Safe than when lending to The Risky; and so banks can earn much higher risk adjusted returns on equity when lending to The Safe than when lending to The Risky.

As a result, these capital requirements enlarge the natural differences in access to bank credit between The Safe and The Risky. For instance we could say these regulations artificially favors American banks lending to European sovereigns and highly rated corporations, over lending to American small businesses and entrepreneurs.

And so we must ask you:

Q. Is such regulatory risk-aversion, which distorts the allocation of bank credit, a valid principle for regulating banks in the Land of the Free and the Home of the Brave?

Q. Do we not owe our descendants the same willingness to take risks as that which our fathers allowed our banks to take to get us here?

Q. Cannot it be said of such regulations, by creating incentives for these to refinance the safer past, impede banks from financing the riskier future?

Q. Is not fair access to bank credit an indispensable part of generating the opportunities that helps to reduce inequalities?

Q. Do we not have something called the Equal Credit Opportunity Act, Regulation B, which would seem to forbid this type of regulatory discrimination?

Q. Since the purpose of capital requirements for bank is to shield it against unexpected losses, how can it be you base these on the expected credit losses?

Q. Since what is perceived as risky never generate dangerous excessive financial exposures, that honor goes to what is perceived as safe but ends up being risky, do these regulations really help to build up a safer banking system?

Thank you... oh by the way, since I also heard that your capital requirements are portfolio invariant it just occurred to me to also ask: Should we not require banks to hold capital against the risk of their exposures instead of the credit risk of their assets?

How to blow up the banking system

Q. What is the most dangerous for banks?

A. That they build up excessive dangerous exposures to something that turns out much riskier than they expected

Q. When do banks usually build up such exposures?

A. Obviously when they perceive something as very safe and they expect to make very good returns on it.

Q. And what else can make those excessive bank exposures especially dangerous, for instance for the taxpayers?

A. That the banks, if something goes wrong, stand there almost naked with very little equity to cover the losses.

Q. So hypothetically, mind you, what would you think of credit-risk weighted capital requirements for banks that are especially low for what is perceived as safe?

A. Well, since that would allow banks to earn the highest risk adjusted returns on what is perceived as safe, it would therefore, sooner or later, cause banks to build up dangerously excessive exposures to what is perceived as safe against very little capital, and so it sure sounds like the perfect way to blow up the banking system..... Sir, excuse me, why do you ask all this?

PS. 1999 in an Op-Ed I wrote: “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 it collapse”

Note: My January 2009 AAA-Bomb blog

The Minsky "displacement" that caused the ongoing crisis, was the credit risk weighted capital requirements for banks.

I cite from Charles P. Kindleberger’s “Manias, Panics and Crashes” 1978.

“Financial crisis are associated with the peaks of business cycles… the culmination of a period of expansion.

According to Hyman Minsky, events leading up to a crisis start with a ‘displacement’ some exogenous, outside shock to the macroeconomic system. The nature of this displacement varies from one speculative boom to another. It may be the outbreak or end of a war, a bumper harvest or crop failure, the widespread adoption of an invention with pervasive effects – canals, railroads, the automobile – some political event or surprising financial success, or a debt conversion that precipitously lower interest rates. But whatever the source of the displacement, if it is sufficiently large and pervasive, it will alter the economic outlook by changing profit opportunities in at least one important sector of the economy. Displacement brings opportunities for profit in some new or existing lines, and closes out others… a boom is under way.

In Minsky’s model, the boom is fed by an expansion of bank credit which enlarges the total money supply… Bank credit is, or at least has been, notoriously unstable and the Minsky model is based squarely on that fact.” End of quote

In 1999 in a Op-Ed in I wrote: “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 our banks” 

And I have no doubt that the systemic error, the Minsky displacement that brought on the credit expansion that resulted in the financial crisis of 2007-08, was the introduction by regulators of credit risk weighted capital requirements for banks.

That facilitated a tremendous credit expansion by allowing banks to hold absolute minimum equity against assets perceived as safe. We are talking about zero percent when lending to sovereigns (Basel I 1988) to 1.6 percent when lending to the private sector rated AAA to AA (Basel II 2004).

And allowing for such minimum equity, while still lending the banking sector much implicit and explicit government support, made possible immense leverages and thereby immense risk-adjusted returns on bank equity on assets perceived as safe, while closing out the fair access to bank credit for all those perceived as “risky”, like the SMEs.

And today, soon a decade later, that “displacement” which completely distorted the allocation of bank credit to the real economy has not even been acknowledged much less corrected.

PS. Read Charles P. Kindleberger’s “Manias, Panics and Crashes” and you will not find one evidence that supports current credit risk weighted capital requirements for banks… unless perhaps they are 180 degrees the opposite: higher for what is perceived as safe and lower for what is perceived as risky.

PS. In the Wikipedia on Hyman Minsky, I do not agree with how Paul McCulley translates the Minsky's hypothesis to the subprime mortgage crisis ignoring the minimum bank capital requirements associated with the AAA rated securities backed with mortgages to the subprime sector.

When are we going to fine or shame the regulators, The Great Distorters, The Great Manipulators of bank-credit markets?

Of course I do not mind banks paying fines because of their misbehaving though I would like these fines to be paid with shares of the banks, since requiring these to be paid in cash, which weakens the banks, sounds like societal masochism to me.

But what I really would like to see, if not being fined, bank regulators being shamed for the horrible distortion, the horrible manipulation, their credit-risk-weighted requirements have caused to the allocation of bank credit to the real economy.

And all that distortion and all that manipulation for absolutely no reason… since major bank crises never result from excessive bank exposure to what is ex ante perceived as risky.

Just to think of all those potentially opportunity and job creating credits that have been and are negated to SMEs and entrepreneurs, only because regulators believe themselves able to manage the banking-risks for the world, makes me cry for all those Millennials, and their descendants, who will have to live with the consequences of these stupid risk-adverse Baby-boomers.

And some of these regulators are even ideological infiltrators… because how else can one describe anyone who comes up with the notion of assigning a zero-risk-weight to the government, and a 100 percent risk weight to the citizens who represent the only back-up of that government.

The World Bank spoke out way too softly on faulty bank regulations, and finance ministers did not read carefully enough.

World Banks' The Global Development Finance 2003 (GDF-2003), “Striving for Stability in Development Finance” had this to say on Basel II, pages 50-52

“The new method of assessing the minimum-capital requirement [proposed by the Basel Committee for Banking Supervision (BCBS)]… will be explicitly linked to indicators of credit quality… The regulatory capital requirements would be significantly higher in the case of non-investment-grade emerging-market borrowers than under Basel I. At the same time, borrowers with a higher credit rating would benefit from a lower cost of capital under Basel II….

A recent study by the OECD (Weder and Wedow 2002) estimates the cost in spreads for lower-rated emerging borrowers to be possibly 200 basis points.”

What did the World Bank say with that?

It said that regulatory capital requirements would distort more than the previous Basel I did, the allocation of bank credit.

What did finance ministers of developing countries do?

They did not protest that as an outrageous odious discrimination of bank lending to countries like theirs that are naturally perceived as more risky.

What did finance ministers of developed countries do?

They did not understand that their own “risky”, the SMEs and entrepreneurs, would be exposed to exactly that same odious discrimination.

I, at that time an Executive Director of the World Bank, mostly representing developing countries, when commenting GDF-2003 formally stated:

“the document does not analyze at all a very fundamental risk for the whole issue of Development Finance, being that the whole regulatory framework coming out of the BCBS might possibly put a lid on development finance, as a result of being more biased in favor of safety of deposits as compared to the need for growth. Even though, in theory, we could agree that there should be no conflict between safety and growth, in practice there might very well be, most specially when the approach taken is by substituting the market with a few fallible credit rating agencies.”

And a couple of weeks later, also formally at the Board of the World Bank I held: “BCBS dictates norms for the banking industry that might be of extreme importance for the world’s economic development. In BCBS’s drive to impose more supervision and reduce vulnerabilities, there is a clear need for an external observer of stature to assure that there is an adequate equilibrium between risk-avoidance and the risk-taking needed to sustain growth. Once again, the World Bank seems to be the only suitable existing organization to assume such a role."

Now I hear some talking about that the World Bank is becoming irrelevant. Forget it! It could be more relevant than ever… but for that it has to be able to stand up for the risk-taking our children needs for us to take in order for their children to have a future.

PS. Come to think of it. The World Bank has been mum on this regulatory distortion of the allocation of bank credit to the real economy. Why? Does it not even listen to itself?

Today I got to be 65, and so I give myself a list of some of my ramblings on bank regulations, in no special order.

The current pillar of bank regulations “more-perceived-risk-more-equity and less perceived risk less equity” is absolutely wrong, but might intuitively seem too correct so as to allow Daniel Kahneman’s System 2 even to begin its deliberation.

Today banks compete to obtain higher returns on equity more by reducing the equity needed that by identifying those who pay the highest risk adjusted margins.

Today the dollar in net risk adjusted margin paid by those perceived “safe” is worth more to the bank than that same dollar paid by “the risky”.

If you have regulators that do not understand that different equity requirements affects the risk-adjusted returns on equity of assets, which dangerously distorts the allocation of bank credit to the real economy…then you’ve got to change your bank regulators… urgently.

If you have regulators that do not understand that the perceived risk of bank assets does not matter since what is important is how the banks manage those perceptions of risk…then you’ve got to change your bank regulators… urgently.

If you have regulators that do not even look at the empirical evidence of what has caused all major bank crisis, never something perceived ex ante as risky, always something erroneously perceived ex ante as safe...then you’ve got to change your bank regulators… urgently.

If you have regulators who cannot manage the differences between ex ante perceived risks and ex post realities, and so can understand that what really poses dangers for the banking system at large are assets perceived as “safe”… then you’ve got to change your bank regulators… urgently.

If you have regulators who regulate banks without clearly defining their purpose… then you’ve got to change your bank regulators… urgently... because then the current ones would only be freaking dangerous vigilantes. 

If you have regulators who believe they have the right to odiously discriminate against the fair access to bank credit of those perceived as "risky", SMEs, entrepreneurs and start-ups… then you’ve got to change your bank regulators… urgently.

If you have regulators who believe they have the right to specially favor the fair access to bank credit of those perceived as "safe" sovereigns and members of the AAArisktocracy… then you’ve got to change your bank regulators… urgently.

If you have regulators who set the weights for capital (equity) requirements for banks when lending to government at 0%, and at 100% when lending to SMEs, which means that banks will lend more and at lower relative rates to the government than to the SMEs… that means de facto they believe that government bureaucrats are more productive using bank credit than SMEs… and then you’ve got to change your bank regulators… urgently... because then the current ones would only be freaking dangerous communists. 

Had regulators thought abut the “what are banks for?”, they would have known that banks are to allocate credit efficiently to the real economy, and they would never have concocted those highly distortionary credit-risk weighted equity requirements for banks.

A different take on the previous, is that the first step of any good risk management, is to clearly identify the risks you cannot afford not to take.

Few things are as risky as an excessive risk aversion.

Why is so much discussed about excessive risk-taking… and so little about excessive risk aversion?

Risk taking is the oxygen of development and we owe it to our kids and grandchildren that banks take risks with reasoned audacity. Nothing as dangerous, as excessive risk avoidance. God make us daring!

Our grandchildren will damn current bank regulators for denying them the risk-taking needed for them to find decent jobs.

Banks do not finance the risky future anymore they just refinance the safer past.

  

Bank regulators recommended banks an investment strategy fitting old retirees with short life expectancies and completely ignored the need of our young ones.

The best macro-prudential regulations is one of micro-prudential regulations that help banks to fail… fast… not the current micro-prudential regulation, which only helps to create too big to fail banks.

Mini-bank-equity requirements are the best growth hormones for the too big to fail banks.

Perfect information makes everyone to stay in bed… why bother, there’s not going to be any real profits? Blissful ignorance and imperfect information is a great driver of the economy.

Don’t ever allow a failed regulator to get away with the “this was a Black Swan, a totally unexpected event, a completely unforeseen consequence” excuse.

If a regulator tells you that the risk-weight of a sovereign is 0% but the risk weight of the citizens of that sovereign is 100%, then the regulators is not a regulator, only a communist.

If the Home of the Brave were really the Land of the Free, would they have allowed the current risk aversion in bank regulations?

With an Equal Credit Opportunity Act (Regulation B) how come regulators are allowed to discriminate against somebody’s access to bank credit only because he is perceived as risky from a credit point of view?

How can a Governor allow that his state chartered banks can lend, for instance to Germany, against much less equity that when lending to a local entrepreneur? 

Hold your bank regulators accountable. If they fail like they did with Basel II, do not promote them, and much less allow them to design Basel III. Neither Hollywood nor Bollywood would never ever do a stupid thing like that, after a mega box-office-flop.

Do not allow regulators to regulate within the confinement of a mutual admiration club. That only guarantees degenerative groupthink.

Without regulators and regulations, how many banks, like those in Europe, would have been allowed to leverage their equity 30 to 50 times to 1? ¡Zero¡ 

When you regulate, remember that every rule carries in it the seeds of being a systemic risk that can explode as a truly dangerous systemic error.

If your Homeland Security cannot visualize that bad distortive bank regulations could be even more dangerous than a full fledge terrorist attack… then you’ve got to refresh your Homeland Security

If you have progressives who do not understand how higher bank equity requirements when lending to those perceived as risky kills opportunities and drives inequality, then you better get yourself some new progressives.

If you have some free-market defenders that do not see how regulators, with their credit risk weighted equity requirements for banks, impose capital controls on where bank credit should go, and accept to talk about a de-regulated market, then you better get yourself some new liberals.

Finance professor’s in university that do not care about such “vulgar” issues as bank regulations and how these can influence the economy should be send to a boot-camp for a refresher. There they could for instance learn that the risk-free rate they are using is currently a subsidized risk free rate.

Anyone talking about de-regulation when we are in fact facing one of the most intrusive and distortive regulations ever… has been brainwashed.

While current regulatory distortions exists the QEs are just a waste, since these only help to increase the value of the existing assets… sometimes by even reducing what there is… like with the buybacks of shares.

“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 our banks.”

The whole regulatory framework coming out of the Basel Committee for Banking Supervision might possibly put a lid on development finance, as a result of being more biased in favor of safety of deposits as compared to the need for growth.

“A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind”

But... being too right is too bad for your own voice

Unless blessed with eternal ignorance, how can bank regulators live with themselves knowing what they are doing?

How naïve and infantile is it not to believe that what is perceived as risky is what is really risky?

PS. I will be editing and adding on to this points whenever I remember any other of my ramblings.

Dumb bank regulators clearly evidence we need artificial intelligence, at least as a backup

Banks fail because: they cannot perceive the risks correctly, they cannot manage the correctly perceived risks correctly, or suddenly something truly bad an unexpected happens… like the economy falling to pieces.

So if banks should be required to hold equity, in order to build up a buffer before they need help from taxpayers, those equity requirements should be based on: the credit risks not being correctly perceived, the bankers not being able to manage perceived risks, and something truly not expected happening, like an asteroid hitting their borrowers.

But, the Basel Committee for Banking Supervision, based its equity requirements for banks on the ex ante credit risks being correctly perceived… and that is nothing but loony... seemingly they all missed the lecture on conditional probabilities.

Besides they regulate banks in thousand of pages, without defining what the purpose of banks is… and that is nothing but absolutely irresponsible.

Any artificial intelligence worthy of its name would have made two simple questions.

What is the purpose of banks?

What has caused major bank crisis?

And how different and better the world would then have been. We could surely have had other type of problems, but definitively not the current crisis, caused by excessive lending to what was ex ante perceived as safe; nor the current lousy economy, caused by the lack of lending to those perceived as “risky”, like the SMEs, precisely the tough we need to get going when the going gets tough.

Our grandchildren will damn current bank regulators, for not allowing banks to take the risks their future needs.

PS. Here is an updated list on the many mistakes with risk weighted capital requirements

If we are going to give bankers new real clothes, let’s make really sure they fit our children’s needs

I have frequently commented on statements or writings of Anat Admati. I have done so mostly because I find reasons to think she understands better than many the problems with current bank regulations, and so therefore I am especially frustrated when I see her being somewhat imprecise.

Here I refer to Admati’s comments at the Finance and Society INET Conference May 6, 2015 “Making Financial Regulations Work for Society”

1. Admati writes: “What we are tricked into tolerating, even subsidizing, is the equivalent of allowing trucks full of dangerous chemicals to drive at 120 mph in residential neighborhoods (and having trouble actually measuring actual speed), which burns lots of fuel, harms the engine and risks explosions.”

That is indeed a good description of the risks of a blow-up of the banking system… but it needs clarifications in order not to create confusion… in order to correct the system.

Banks are currently allowed to drive at 120 mph or faster only if they are thought not to carry anything dangerous, like if they carry a cargo of loans to sovereigns or AAArisktocrats, if they carry a load that is perceived as risky, like loans to SMEs and entrepreneurs, then they must drive at much lower speeds. That is what the credit-risk-weighted equity requirements do.

The problem with that is twofold. First, since the drivers are paid based on how fast they complete the journey (returns on equity) they only carry “safe” cargo, which constitutes an odious discrimination against all those who need the transport of “risky” cargo. And second, that it does not make any traffic-safety-sense, because all major crashes have always occurred precisely when the drivers think they are carrying something safe and therefore speed too much.

2. Then Admati writes: “harm from finance is abstract and spread out. Connecting the harm to individual wrongdoing or recklessness is hard to establish. Courts might work for fraud, but you can't take someone to court for designing bad regulations.”

I believe you can. If somebody had designed regulations that discriminate based on race and gender they could be taken to court… at least so that those regulations were immediately suspended. Here the regulators are layering on artificial discrimination against the fair access to bank credit of those perceived as risky, precisely those who are already naturally discriminated against by bankers. There is an Equal Opportunity Act in the US, Regulation B, the problem is that no one is applying to what regulators concoct.

3. And Admati writes: “Goldman Sachs CEO was wrong when he said banking is ‘god's work.’ Creating and enforcing good financial regulation is god's work.” No way Jose! Neither Goldman Sachs CEO nor regulators can do God’s work. 1999 in a Op-Ed in I wrote: “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 our banks”.

4. Admati also gives some ideas of how to proceed: “First, increasing the pay of regulators may reduce revolving door incentives. Second, effective regulators might be industry veterans who are not inclined to go back. Third, we must try to reduce the role of money in politics.”

Yes... but totally insufficient! In terms of fixing current bank regulations there are three things that I find to be much more important. 

The first is to define a purpose for the banks that is agreeable to the society as a whole. In all thousand of pages of regulations, there is not a single word about what banks are supposed to do… and I ask: how on earth can you regulate what you do not know what it is to do?

The second to close up the mutual small admiration club bank regulators have turned themselves into. Sovereigns and AAArisktocrats might have access to regulators at the IMF or Davos… but risky borrowers are never invited.

The third is to fully understand the need of risk-taking. If nothing is done on that, rest assure, our grandchildren will damn the Basel Committee and the Financial Stability Board, for denying them the risk-taking of banks their economies need.

The parable of talents

God make us daring!

We might want to consider “Friends and Family” weighted equity requirements for banks.

Currently the equity requirements for banks are credit-risk-weighted… more-credit-risk-more-equity and so less-credit-risk-less-equity.

That is dumb because never ever has a major bank crisis resulted from excessive lending to someone perceived as “risky”, these have always resulted from excessive lending to what was ex ante perceived as “safe” but that ex post turned out to be risky.

The only case when individual banks have gotten into problems extending excessive credits to somebody perceived as risky is when there had been some close connections between bank and borrower.

It could therefore be a case for analyzing Friends & Family weighted equity requirements for banks… though it is hard to think of who could perform an adequate rating of such relations… as we would also need to rate his F&F relation with bank and borrower.

That said, the least we must do, is to get rid of the credit-risk-weighted equity requirements when applied to those who are not F&F. These, for absolutely no reason, odiously impede their fair access to bank credit. That kills opportunities and therefore drives inequality.

The Basel Committee for Banking Supervision’s tragic mistake of doubling down on perceived credit risks

Bankers manage the expected losses by means of perceiving credit risks. And if they are not good at it, they should fail.

Bank regulators on the other hand, need to impose equity requirements on banks to cover for unexpected losses. That is in order to create a buffer between a bank’s operations and the needs for taxpayers’ assistance.

Unfortunately, don’t ask me why, the Basel Committee for Banking Supervision imposed equity requirements on banks that are also based on perceived credit risks, more-risk-more-equity and less-risk-less equity.

That signified a doubling down on credit risk perceptions. And any risk, even when correctly perceived, can create much havoc, if it is given too little or too much importance.

As a consequence current allocations of bank credit to the real economy are utterly distorted, by favoring those perceived as “safe” and punishing those perceived as “risky”.

And also banks will most certainly have insufficient equity to cover for unexpected losses, simply because, the “safer” a borrower seems ex ante, the greater the possibility for the unexpected to cause truly huge disasters, ex post.

And this mistake that has been around for about 25 years, even after disaster struck, is still as of today, not yet even acknowledged by those responsible for it.

The amazing Achilles heels of the Basel Committee’s bank regulations

1. The unexpected losses (UL) are derived from the expected Probabilities of default (PD) adjusted with an arbitrary "Loss Given Default" factor. 

I cite directly from “An Explanatory Note on the Basel II IRB Risk Weight Functions” July 2005

“It was decided… to require banks to hold capital against Unexpected Losses (UL) only. However, in order to preserve a prudent level of overall funds, banks have to demonstrate that they build adequate provisions against Expected Losses” (Page 7)

"Under the implementation of the Asymptotic Single Risk Factor (ASRF) model used for Basel II, the sum of UL and EL for an exposure (i.e. its conditional expected loss) is equal to the product of a conditional PD and a “downturn” Loss Given Default (LGD) [a parameter that reflects adverse economic scenarios]. As discussed earlier, the conditional PD is derived by means of a supervisory mapping function that depends on the exposure’s average PD." (Page 4)

What does this mean? 

First, that the risk weights have nothing to do with the risk premiums banks charge. 

Second, the real dangerous unexpected losses in banking are most certainly inverse to the expected probabilities of default. The higher the expected losses the lower can we expect the probable size of the bank exposure to be… meaning, the safer an asset is perceived to be, the higher the possibilities of something really dangerous unexpected happening. In short this all does not make any sense.

Third, that this would not have been so serious if there had been an adjustment for portfolio risk, since most probably what is perceived as safe commands larger exposures...

but then, to top it up:

2. The risk weights are portfolio invariant... Holy Moly!

I cite directly from “An Explanatory Note on the Basel II IRB Risk Weight Functions” July 2005 (page 4) 

“The Basel risk weight functions used for the derivation of supervisory capital charges for Unexpected Losses (UL) are based on a specific model developed by the Basel Committee on Banking Supervision (cf. Gordy, 2003). The model specification was subject to an important restriction in order to fit supervisory needs: 

The model should be portfolio invariant, i.e. the capital required for any given loan should only depend on the risk of that loan and must not depend on the portfolio it is added to. This characteristic has been deemed vital in order to make the new IRB framework applicable to a wider range of countries and institutions. Taking into account the actual portfolio composition when determining capital for each loan - as is done in more advanced credit portfolio models - would have been a too complex task for most banks and supervisors alike. The desire for portfolio invariance, however, makes recognition of institution-specific diversification effects within the framework difficult: diversification effects would depend on how well a new loan fits into an existing portfolio. 

As a result the Revised Framework was calibrated to well diversified banks. Where a bank deviates from this ideal it is expected to address this under Pillar 2 of the framework. If a bank failed at this, supervisors would have to take action under the supervisory review process (pillar 2)."

What does this mean? 

That the benefits of diversification are completely ignored... that the risk weights have nothing to do with the size of the exposure… all because to consider diversification, that “would have been a too complex task for most banks and supervisors alike”, and so “the Revised Framework was calibrated to well diversified banks.” 

But, if a bank fail to be well diversified, then the supervisors, those who have just been deemed as not being able to understand what diversification is, shall address the problem under Pillar 2 of the framework, the “Supervisory Review Process.” Basel II (page 158) 

And if all that does not sound like sheer Kafkaesque lunacy, you tell me. 

As a result we then have portfolio invariant credit-risk-based equity requirements, which allow banks to hold less equity against safe assets than against risky assets, even though all major bank crises in history have never ever resulted from excessive exposures to what was perceived as risky, but always from excessive exposures to what ex ante was perceived as safe.

And that led to much lower equity requirements for what ex ante is perceived safe than for what is perceived risky.

And that caused banks to be able to leverage much more their equity, and the support society gives them, with assets ex ante perceived as safe than with assets perceived as risky.

And that caused banks to be able to generate much higher risk adjusted returns on equity with assets ex ante perceived as safe than with assets perceived as risky.

And that meant that banks would lend too much and at too easy terms to those perceived as safe, like to "infallible sovereigns" and the AAArisktocracy, and too little in relative too harsh terms, to those perceived as risky, like to SMEs and entrepreneurs.

And that means that though the standardized risk weighted capital requirements were “calibrated to well diversified banks”, its mere existence guarantees badly diversified banks.   

With bank regulators like these… who need enemies?

And please read the Explanatory Note and consider what a regular subordinated regulator would dare to opine about it :-)

PS. But the sophisticated (meaning large) banks can do whatever they like: In the inexplicable “Explanatory Note on the Basel II IRB Risk Weight Functions” we also read: “It should be noted that the choice of the ASRF (Asymptotic Single Risk Factor model) for use in the Basel risk weight functions does by no means express any preference of the Basel Committee towards one model over others… Banks are encouraged to use whatever credit risk models fit best for their internal risk measurement and risk management needs.” So seemingly all their nonsense needs not to be applied to large and sophisticated banks, only to the small. That said we must ask though, is there a risk model out there that allows banks to leverage more than 62.5 times with a corporate asset only because it has been AAA rated?

PS. Risk of cyber-attack weighted equity requirements for banks make much more sense than the credit-risk weighted

Bank regulators de facto create another type of illicit financial flows

When regulators allow banks to hold less equity against what is perceived as safe than against what is perceived as risky then they increase substantially the flow of bank credit to the infallible sovereign and the AAArisktocracy, and decrease substantially the flow of bank credit to SMEs and entrepreneurs.

That is an odious regulation that favors those already favored; and an odious regulatory discrimination against those already naturally discriminated against, precisely by virtue of being perceived as risky.

That impedes banks to allocate credit efficiently to the real economy and, by killing the opportunities of the risky to have fair access to bank credit, increases inequalities. 

And so those regulations could be accused of de facto stimulating the creation of another type of illicit financial flows.

PS. And all for nothing, since never ever has a major bank crisis ever resulted from excessive exposures to something perceived as risky, they have all, no exceptions, resulted from excessive exposures to something erronously perceived as safe. 

The World Bank should act as an Ombudsman for our children and grandchildren

The Basel Committee for Banking Supervision (BCBS) is in charge of developing bank regulations that are applied by more and more countries around the world. That has increased the coherence and reduced somewhat the regulatory competition between countries. Unfortunately, it has also introduced a serious systemic mistake. 

The pillar of the BCBS’s current bank regulations, is the risk weighted capital requirements for banks; something which for more preciseness, should be termed the Portfolio Invariant Credit-Risk-Weighted Bank Equity Requirements. In essence it indicates: more-credit-risk-more-equity / less-credit-risk-less-equity. 

Though intuitively it sounds very reasonable, it contains two fundamental flaws.

First, the risk-weights used are based on the default possibilities of the assets of a bank, and not on a real analysis of what has caused the major bank crises in the past. In this respect it should be noted that the bank assets more likely to cause a major crisis, are not those perceived as risky, but those that are erroneously perceived as safe.

Second, much worse, allowing banks to leverage their equity, and the explicit and implicit support these receive from taxpayers, differently, depending on credit risks already cleared for with interest rates and size of exposures, seriously distorts the allocation of bank credit to the real economy. In essence it causes the bank system to lend too much and at too low rates to what is perceived as safe, like for instance to sovereigns and what I have termed as the AAArisktocracy; and too little, at relatively too high interest rates, to what is perceived as risky, like for instance to SMEs and entrepreneurs.

The origin of this mistake can primarily be traced to that regulators never really defined the purpose of our banks, beyond that of each one having to be safe. With that the regulators completely ignored that banks represent one of the most important agents through which the society distributes its savings, and the risk-taking that the economy needs in order to move forward, so as not to stall and fall.

Any regulatory interference and distortion of how bank credit is allocated, is very dangerous, and so, if it is to be considered and allowed, one needs to make certain that, at the very least, it is in pursuit of some extremely worthy purpose.

In this respect it could be illustrative, instead of credit-risk-weights, to think about the potential-of-job-generation weights, or environmental-sustainability-weights. That would allow the banks to earn their highest risk-adjusted returns on equity, financing what could most matter to us.

The World Bank, as the world’s premier development bank, must know that risk-taking is the oxygen of any development. It therefore has an enormously important role in supervising bank regulations from the point of view of how banks: promote development, allow for fair and inclusive access to finance, advance poverty reduction, generate jobs and help to bring on environmental sustainability.

The challenges loom large. Current credit risk based equity requirements, by making it harder than need be for those perceived as “risky” to access bank credit, kills opportunities and thereby promotes inequality. And, with its bias against credit-risk, it guarantees that banks will not finance sufficiently the “riskier” future, but mostly keep to refinancing a “safer” past.

“A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926.

The credit-risk-aversion present in current regulations could seem adequate for someone retired with a remaining short life expectancy. It is highly inadequate though, in fact dangerous, when set in the context of the needs of future generations. And in this respect I urge the World Bank to cast itself much more in the role of being the Ombudsman for our children and grandchildren.

And let us, somewhat older, never forget that much of what we can enjoy today, is the direct result of the willingness of the generations that preceded us to save and to take risks. We have the same duty… God make us daring!

@PerKurowski

PS. Here a statement closely related to this issue that I delivered as an Executive Director of the World Bank March 10, 2003

Financial regulations, if wrong, could destroy the economy of a nation, and is therefore an issue of utmost importance for national security.

Suppose military regulations which implicitly stated that those who avoided taking direct risks when fighting the enemy, for instance by using drones, had much better possibilities to advance in the ranks than those who dared to risk hand to hand combat. Would this not impact negatively, at least in the long term, the strength of the Home of the Brave?

And should bank regulators not have to consider the dangers of introducing distortions in credit allocation, which might weaken the economy and thereby weaken the defense of the nation?

In 1988, the G10, a group which includes United States, decided to introduce risk-weighted capital requirements for banks; where “risk” means credit risk, and “capital” means bank equity. As a consequence, those bank assets with a low risk-weight require banks to hold less equity than those assets with a high risk-weight.

The initial big risk-weight differentiation, in 1992 with Basel I, was that loans to the central governments of the OECD nations had a cero risk-weight, while loans to the private sector carried a 100 percent risk-weight. In 2004, with Basel II, many more risk buckets were added and in the private sector the risk-weights were set from 20 to 150 percent.

And it all sounds like prudent bank regulations… more-risk-more-equity - less-risk-less-equity. But, unfortunately, bank regulators, I pray unwittingly, did not notice that by doing that, they were introducing an extremely dangerous distortion of how bank credit was allocated to the real economy.

It signified that the equity of a bank, to which we have to add the value of the support a society and taxpayers lend the banks, could be leveraged many times more for assets with a low risk weight, than with assets with a high risk-weight. 

And that meant banks could earn much higher risk adjusted returns on equity on assets that carry a low risk-weight than on assets with a high risk-weight.

Just for a starter it meant that regulators effectively instructed banks to allocate more credit to the central government than to the private sector… implying thereby of course that a government bureaucrat has more capacity to allocate financial resources efficiently to the real economy than a private agent, like a SME or an entrepreneur

And anyone who thinks this regulatory risk aversion will not affect the strength of the USA’s economy, has no idea about how the USA got to be strong

And to top it up, it is all for nothing, since all major bank crises have always resulted from too big exposures to something that was perceived as “safe” that turned out risky, and never ever from excessive bank exposures to something perceived as risky.

@PerKurowski

A message sometime ago to Homeland Security

A letter on the issue of defense in the Washington Post

Our economies are bloated by QEs, low interests and other stimuli, and the lack of real risk-taking.

Tarps, fiscal deficits, QEs and minimal interest rates, in an economy where regulators have by means of risk-weighted equity requirements de facto prohibited banks to take real risks, like lending to SMEs and entrepreneurs, only to take on false risks, like leveraging too much on what is "safe", has created a bloated economy full of assets with inflated values... and helped finance the permanence of inefficiencies that should have been long gone.

The economy now needs to fart, urgently, but boy is it going to be embarrassing smelly… and painful!

That deflation is not curable with factory produced inflation but only with the type of sturdy growth that can justify the relative values of all assets. You do not live on existing assets alone.

You cannot grow muscles by staying in bed just eating fats and carbs... you need exercise and proteins... even if "risky" 

Way back I had a feeling this had to come sooner or later. 

PS. I now feel sort of like a Chance the gardener (Physician) :-)

But who knows, Mario Draghi and his colleagues might all just be Chauncey Gardiners too :-( 

And what could lead to less inequality: to inflate the value of assets that are already owned or to try to create new assets?