The 2007-08 crisis resulted not because of a natural Black Swan, but because of one bred by the Basel Committee.

“Martial arts legend Bruce Lee, whom many people regarded as immortal, died at the age of only 32 of a cerebral edema, or brain swelling, after taking some sort of aspirin. I have not the faintest idea whether that pill actually had anything to do with his death but I have frequently used (or misused) this sad death as an example of how an organism could be in such a highly tuned and perfect condition that it could not resist a small external shock.

And as a consultant I often used this metaphor to explain why companies nowadays, pressured by the stock market’s expectations for the next quarterly results; the latest theories in corporate finance as to how squeeze out the last drop in results; and, perhaps, even some bit of creative accounting, might be so well-tuned (no little reserve fat left) that they would not be able to withstand any minor recession. (Whenever I expose this theory, I can see in my wife’s eyes that she believes this is just my preparing an excuse for my growing—ok, grown—midline.)”

That and which I wrote in my book Voice and Noise (2006) should be more than enough evidence on how much I share and enjoy Nassim Nicolas Taleb’s discussions on fragility and the need for redundancy.

But where I have serious disagreements with NNT is when he relates his “black swan” to the financial crisis that occurred in 2007-08. And not because it was not a black swan event to most, it sure was, but because it provides bank regulators with the perfect excuse to avoid accountability. That Black Swan was not a natural black swan, it was a man made black swan… it was a Black Swan bred by the loony portfolio-invariant-credit-risk-equity-requirements for banks. 

For instance when NNT writes in “Thinking” 2013 “use of probabilistic methods for the estimation of risks did just blow up the banking system” I have to jump out of my chair to shout No! It was the use of the wrong risk factors that blew up the banking system. The Basel Committee used the risks of the banks assets when setting the equity requirements for banks, and not the risks banks would not be able to manage the risks of those assets.

Empirically, in terms of causing major bank crises, it is clear that banks are much worse managing “safe” assets than “risky” ones.

And when NNT, in the same chapter of “Thinking” writes about his four quadrants: Simple binary decisions in Mediocristan; Simple decisions in Extremistan; Complex decision in Mediocristan and; Complex decisions in Extremistan…no matter how much I agree and find that interesting, it has nothing to do with the bank 2007-08 bank crisis.

My more directly applicable to banks quadrangle, which explains the consequences for bank based on the ex ante perceptions of asset risks and ex post realities, IS THIS

Trying to understand the how come of the so loony bank regulations, by reading Daniel Kahneman’s “Thinking, Fast and Slow” 2011.

I hold that the current risk-weighted capital requirements for banks, more risk more capital, less risk much less capital, is sheer regulatory lunacy.

Fact: These are based on perceived risks which have already been cleared for by banks in interest rates, size of exposure, duration and other terms (the numerator). And so, re-clearing for the same perceived risks in the capital (the denominator) causes the risk price equation to go haywire. 

And that allows banks to earn much higher risk-adjusted returns on equity when lending to what is perceived as “safe” than on what is perceived as “risky”, making it thereby impossible for banks to efficiently allocate bank credit in the real economy. It instills an additional dose of unproductive risk-aversion in the banking system.

And it also guarantees that when something ex ante perceived as "absolutely safe", turns out ex post to be very risky, precisely the stuff all bank crises are made off, that banks will then stand there naked with no capital.

And so, how could regulators be so dumb? How could it be that so long after the 2007-08 crises exploded, this truly monstrous regulatory mistake is not even discussed?

Here, I will try to get to the answer to those questions by reading Nobel Prize winner Daniel Kahneman’s “Thinking, fast and slow” Farrar Straus and Giroux, 2011. I begin in “Part 3 Overconfidence”

But first I need to start with expressing one reservation with respect to the following which Professor Kahneman writes there in Chapter 19:

“I have heard too many people who ‘knew well before it happened that the 2008 financial crisis was inevitable’. This sentence contains a highly objectionable word, which should be removed from our vocabulary in discussions of major events. The word is, of course, knew. … [that] language implies that the world is more knowable than it is.”

In the sense that could be construed as a “nobody knew”, and could like the Black Swan story serve as an excuse for the regulators for not doing their job, I must strongly object to it, as we then will not hold them sufficiently accountable for their mistakes.

Professor Kahneman refers to an “outcome bias [that] makes it almost impossible to evaluate a decision properly – in terms of the beliefs that were reasonable when the decision was made… Actions that seem prudent in foresight can look irresponsibly negligent in hindsight.” 

Yes, but what when an action that should have been declared irresponsibly negligent in hindsight, survives as if nothing has happened? In our case the Basel III is just some tweaking of Basel II… and it hangs on to the risk-weighted capital requirements... as if nothing has happened.

Of course I had no idea that the crisis would happen in 2008, or where it would finally explode, but there could be no doubt that assigning so much regulatory importance to the already known and cleared for credit ratings, introduced a systemic risk that had to explode, somewhere somehow, sooner or later. 

In January 2003, while I was an Executive Director at the World Bank, Financial Times published a letter in which I wrote: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors to be propagated at modern speeds”.

But now back to the how comes of this post.

The first Great Explainer I find, chapter 20 is “The illusion of validity”. Professor Kahneman writes about how a good coherent story triumphs the absence and the quality of evidence… and, in this case, what could initially sound a more coherent story than “more perceived risk more bank capital (equity), less perceived risk less capital”?

In reality since all bank crisis have originated from excessive exposures to what was perceived as "absolutely safe", and none from excessive exposures to something perceived ex ante as “risky”, the truth is that, if anything, the capital requirements for banks should be higher for what is perceived as absolutely safe than for what is perceived as risky… but, Professor Kahneman, how the hell do you sell that storyline?

Another Great Explainer, chapter 20: “The illusion of validity and skill… supported by a powerful professional culture…. We know that people can maintain an unshakable faith in any proposition, however absurd, when they are sustained by a community of like-minded believers”.

Indeed that is when regulators are allowed to assemble in a mutual admiration club… like the one I protested in another letter in the Financial Times in November 2004.

(December 24, 2013) And in chapter 21 in “intuitions vs. formulas” we read how, when there is “a significant degree of uncertainty and unpredictability” then, in terms of explicatory powers, “the accuracy of experts was matched or exceeded by simple algorithms”. One possible explanation for that, provided by Paul Mehl, is that experts “try to be clever” and “feel they can overrule the formula because they have additional information”. And some examples of powerful algorithms are provided like the five variables rule developed by Dr. Virginia Apgar to determine whether a new born baby was in distress.

But this chapter does really not provide me with much explanation with respect to the regulations I object. This is first because I feel that in this case we are not really in the presence of real experts who possess the minimum intuitions required, and secondly the formula itself, the risk-weighting, is just a very bad formula.

How can I explain it? Perhaps saying that an expert bank regulator should have started by defining a purpose for the banks, and then analyzing the risks and whys and consequences of a banks failing while pursuing that purpose, and not, as has been done by just analyzing the risks of the clients of a bank failing, and which of course is far from being the same.

But yes “do not try to be too clever” is always a good recommendation for any regulator, and yes, that our current bank regulators start from the premise of them being very clever, is hard to doubt. The 30 pages of Basel I are by means of Basel III and Dodd-Frank Act, evolving into ten thousand of pages of regulations.

And yes I bet one formula, one single capital requirement for any type of bank asset, is a superior formula… and so do not tell me I harbor a “hostility to algorithms”. What I really do feel hostility against, is for regulators to dig us even deeper into the hole where they have placed us.

(December 25, 2013) Chapter 22: “Expert intuition: when can we trust it?” Professor Kanehman holds that an expert’s intuition can only be trusted if the area of expertise in question contains “an environment that is sufficiently regular to be predictable”, and if the experts have had “an opportunity to learn these regularities through prolonged practice”

Considering bank regulations not only as firefighting but within a complete framework of how banks help to finance the growth and the strengthening of the real economy, in other words the mystery of development, the answer must of course be a rotund NO! There is just too much involved for it to be predictable.

But even in the case of bank regulation designed only to stop bank failures we would have to answer with an equally rotund NO!, the question of whether regulators in the Basel Committee and the Financial Stability Board had sufficient expertise. 

Kahneman writes: “The acquisition of expertise in complex tasks such as… firefighting is intricate and slow because expertise in a domain is not a single skill but rather a collection of miniskills”, and I sincerely doubt that persons such as Stefan Ingves, Mark Carney, Mario Draghi, Ben Bernanke have had many specific experiences of bank failures which they have managed and even more importantly understood.

In short this chapter only reinforces the concerns I referred to in an Op-Ed which I wrote in 1999: “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 its collapse”

If Professor Kahneman was asked whether it was reasonable and wise to vest so much regulatory power over our banks in the hands of some few “experts”, I suspect he would express serious doubts.

December 26. 2013. Chapter 23. “Irrational perseverance” “sunk-cost fallacy” Professor Kahneman recounts an experience: “If pressed further I would have admitted that we had started the project on faulty premises and we should at least consider the option of declaring defeat and going home. But nobody pressed me…..we had already invested a great deal of effort… It would have been embarrassing for us… I can best describe our state as a form of lethargy – an unwillingness to think about what had happened. So we carried on."

And this describes a lot of why, after the clearly evident failures of Basel II, we now have basically the same failed regulators, using basically the same “risk-weighted capital” script, producing, directing and acting in a Basel III, as if nothing has happened. Neither Hollywood nor Bollywood would be so dumb, so as to follow up a huge box-office flop without major revisions. 

December 31, Chapter 24. Professor Kahneman refers to an extremely interesting idea suggested by Gary Klein to combat dangerous overconfidence, “The premortem”… “Imagine that we are a year into the future. We implemented the plan as it now exists. The outcome was a disaster. Please take 5 to 10 minutes to write a brief history of that disaster” “The main virtue of the premortem is that it legitimizes doubts” Otherwise “public doubts about the wisdom of the planned move are gradually suppressed and eventually come to be treated 

If regulators had done that with Basel II…can you imagine if someone in his premortem had written that the crisis was a direct result of clearing for the same risk twice, which would cause banks earning higher risk adjusted returns on equity on what was perceived as absolutely safe, which distorted the allocation of bank credit to the real economy?

Can you imagine if someone in his premorten had written…”And there stood all the banks in the world, on with all that exposure to that AAA rated, against almost no capital… and the unexpected happened”?

Can you imagine if someone had written…”And since therefore no bank financed “the risky”, those who help to build the future, the real economy was placed in a death-spiral that brought the banks down.

As is, the faults with the risk-weighted capital requirements are not even recognized in the postmortem

(January 4, 2014) Chapter 17, “Regression to the mean”

The expected losses of a bank should normally be covered by its operations. It is to cover the “unexpected losses” for which regulators primarily require banks to hold capital.

And the Basel Committee has defined that the capital requirements for banks should be higher for what is considered “risky” than for what is considered as “absolutely safe”. 

That has always sounded wrong to me, as it is in the sector of the “absolutely safe” that the most unpleasant unexpected events roam.

In fact if something is considered 100% risky there should be 0% unexpected losses, but if something is considered 0% risky, the unexpected losses could be 100%. 

And why current bank regulators, even when faced with a crisis derived from unexpected losses in what was considered “absolutely safe” do not even want to discuss my arguments, has always been a mystery to me.

But reading chapter 17 it occurs to me that one explanation is that regulators do simply not understood the meaning of regression to the mean, and the fact that the timing of any unexpected result should not be perfectly correlated with, for instance, recent credit ratings. 

And that might be explained by “our mind is strongly biased towards casual explanations”, and what is more casual than “risky is risky and safe is safe and there´s no more to that!” 

(January 15, 2014) Chapter 31, Risk Policies, “Broad or Narrow?” Professor Kahneman writes.

“These attitudes make you willing to pay a premium to obtain a sure gain rather than to face a gamble, and also willing to pay a premium (in expected value) to avoid a sure loss”.

Could that translate into… bank regulators were willing to pay a premium to make sure banks did not fail, and were also willing to pay a premium to avoid a sure bank failure?

If so could that be the reason for which regulators failed to identify the benefits of bank failures, namely just that they were willing to take risks?

I am not sure. Perhaps they did so in a subconscious way. But, consciously?, I am sure they were and are not even aware of what they are doing with their excessive risk aversion... that of banks must not fail.

How different our world would be if regulators had set as an objective, for instance… in order to insure that sufficient risk taking is taking place 1-2 percent of the banks should fail yearly.

And I will keep on commenting here...

The more I think of it I come to the conclusion that “more-risk-more-equity and less-risk-less-equity”, is such a powerful System 1 intuition so it stops System 2 deliberations rights in its tracks and does not allow these to begin.

How can we measure at what moment an intuition turns into such an overpowering prejudice that it blocks all deliberate decision making?

About banks, black donkeys and plain donkeys

There was a little town with a road on which some farmers in horse drawn carriages speeding along at 12.5 mph. sometimes suffered severe injuries when crashing into some of the black donkeys who roamed around the area. And the little town now wanted to prepare for the coming of speedy automobiles. 

But, before a town hall meeting could be held on the issue, Franz Basil, a local bully, presented regulations which stated: If a black donkey is seen, then the maximum speed allowed is 12.5 mph, but if there is no black donkey to be seen, 62.5 mph will be allowed. And to be absolutely sure about it, we are going to set up black donkey outlook outposts so as to rate the possibility there is one.

And since the proposal was immediately hailed as brilliant by some of Franz Basil´s comrade bullies, and some did not want to show they did not understand a iota about what he was talking about, and everyone was happy about a plan that offered the possibility of never ever more a black donkey incident, it was acclaimed, and some even discussed asking their king to knight Franz Basil.

For a while it looked as if all was going well, except for the fact that those who were allowed to drive at only 12.5 mph, were slowly driven off the road, “move over you slow stupid farmer”. 

But then, some weeks later, suddenly a real bloodbath resulted when a couple of vehicles driving at 62.5 mph smashed into some black donkeys.

One could hear the small weak voice of an old local farmer saying: “It had to happen, it was too silly to begin with, the crashing into black donkeys never ever occur when you see these, but only when you do not, for whatever reason, blinded by the sun, to dark to see, or just distracted thinking about coming home fast to your sweet wife. And who could think that those looking out for the black donkeys would not suffer of the same”.

But Franz Basil and his accolades, being the bullies they are, shut him up, offering the solution of allowing authorized speed differences to remain but now making certain that, at no point in time, the average speed of those driving on the road could be higher than 33.3 mph. And, again, understanding even less than before, no others said anything, but “Ah!” in awe.

And there the little town lays licking its wounds, just waiting for the next accident to occur and its farmers not being able to drive around.

But you may ask, “what about the plain donkeys?” Well I leave you to figure out who they are.

Data: The Basel Committee´s authorized speeds

Basel II risk weight for when there is perceived risk, “The Risky” is 100%, which on 8% basic capital requirement produces an authorized leverage of 12.5 to 1. 

Basel II risk weight for when there is no perceived risk, the AAAristocracy, is 20%, which on 8% basic capital requirement produces an authorized leverage of 62.5 to 1.

Basel III 3 percent leverage ratio is equivalent to a 33.3 to 1 average

Failed bank regulators must adore Nassim Nicholas Taleb’s black-swan.

In “Learning to love volatility”, Wall Street Journal, November 17, Nassim Nicholas Taleb writes:

“Several years before the financial crisis descended on us, I put forward the concept of "black swans": large events that are both unexpected and highly consequential. We never see black swans coming, but when they do arrive, they profoundly shape our world…. Still, through some mental bias, people think in hindsight that they "sort of" considered the possibility of such events; this gives them confidence in continuing to formulate predictions” 

And so Nassim Taleb still provides the failed bank regulators with the comfort of this being an unforeseeable crisis. Boy how much they must adore him and his black swan. 

Well several years before this crisis, me and others, put forward that this was a crisis doomed to happen… no black-swan… a totally man-made crisis.

When regulators allowed the banks to hold immensely less capital for exposures considered as not risky, “The Infallible”, than for exposures considered “The Risky”, they virtually doomed the banks to originate dangerously excessive exposures to “The Infallible”, precisely the kind of exposures that have always detonated major crisis when, ex-post, most often because they are too much financed, turn out, ex-post, as very risky…. like the triple-A rated securities backed with lousily awarded mortgages to the subprime sector, like Greece, like Spanish real estate… 

And by the way there is nothing much new in the concepts in “Learning to love volatility” or “Anti-fragility”, they represent precisely what we mean when praying in our churches “God make us daring!”

The fatidic black-swan explanation still keeps us in the crisis

When you restructure a company that has gotten itself into financial problems, you do not inject new funds before you have made the structural changes that allow you to reasonably expect that the company will recover, and so that you are not just throwing good money after bad. 

Unfortunately there has been no fundamental or significant restructuring carried out at all during the current crisis. And that is because so many bought into the fallacy of this crisis being caused by a “black swan” event, one which no one could foresee, and which therefore needed not to happen again. Bank regulators have of course been especially fond of this concept, as it reinforces their innocence.

But no! This was no black swan event. When regulators allowed the banks to hold immensely less capital for exposures considered as not risky, “The Infallible”, than for exposure considered “The Risky”, they virtually doomed the banks to originate dangerously excessive exposures to “The Infallible”, precisely the kind of exposures that have always detonated major crisis when, ex-post, these appear as very risky…. like triple-A rated securities backed with lousily awarded mortgages to the subprime sector, like Greece, like Spanish real estate… 

And so all bail outs, fiscal stimulus and quantitative easing done, without any fundamental structural change, like eliminating the capital requirements for banks which discriminate based on perceived risks, have just wasted preciously scarce fiscal and monetary policy space. 

When are our governments to wake up to the fact that those who messed it up were the not so white white-regulator-swans? And to the fact that the Basel regulatory paradigm is silly and sissy and must be thrown out the window... urgently?