The risk weighted bank capital requirements should at least, as a minimum, have been based on conditional probabilities. They weren’t.

Here a set of tweets on P(A/B)

In probability theory, conditional probability is a measure of the probability of an event (A) occurring (like bankers lending too much to someone safe), given that another event (B) has occurred (that bankers had perceived that someone as very safe).

In probability theory, conditional probability is a measure of the probability of an event (A) occurring (like bankers lending too much to someone risky), given that another event (B) has occurred (that bankers had perceived that someone as very risky).

Any regulators knowing something about conditional probability would never have assigned, for the purpose of risk weighted bank capital requirements, a risk weight of 20% to the very safe AAA rated, and one of 150% to the very risky below BB-rated.

Not the first time I've written about it

PS. Here is my letter to the Financial Stability Board

Bank regulation for dummies! Dedicated to those in the Basel Committee for Banking Supervision.

First, be aware that even though some individual banks could have troubles because a whole lot of issues, the banking system is never ever threatened by what is ex ante perceived as risky, but only by what ex ante is perceived as absolutely safe but that, ex post, surprises everyone by not being so.

So rule No.1: Make damn sure that banks have enough equity… especially against what is perceived as absolutely safe… which is, unfortunately, just the opposite of what is being required now.

Second, be aware that for the long term stability of banks, there is nothing as important as a sturdy economy. And that for a sturdy economy to exist, it is vital that the allocation of bank credit to the real economy is as efficient as can be.

So rule No.2: Make damn sure that banks allocate bank credit as efficiently as possible… and especially that those who most need access to credit, like small businesses and entrepreneurs get it… which is, unfortunately, just the opposite of what is happening now.

The Basel Committee Lunacy

First answer: What poses the larger risk to create a major bank crisis, those that can only result from major bank exposures? Exposures to what is rated below BB-, non investment grade and speculative, or exposures to what is rated AAA to AA, high grade and better? 

And then consider that Basel II requires banks to hold 12 percent in capital when lending or investing in something rated below BB-, an authorized 8.3 to 1 leverage of bank equity; and only 1.6 percent when lending or investing to what is rated AAA to AA, an authorized leverage of 62.5 to 1. 

Let me offer you a hint: Mark Twain described bankers as those who lend you the umbrella when the sun shines but want it back as soon as it looks it is going to rain. 

As I see, what I qualify as the Basel Lunacy, only guarantees that when a real sizable financial explosion occurs, those which can only result from excessive bank exposures, those excessive banks exposures that can only result to something being perceived as absolutely safe, that then the banks will stand there absolutely naked with no capital to speak of between them and the depositors or the taxpayers. 

In “Notes on Nationalism”, George Orwell wrote “one has to belong to the intelligentsia to believe things like that: no ordinary man could be such a fool.” Indeed no ordinary man would be such fools as our current bank regulators, those in The Basel Committee for Banking Supervision or those in the Financial Stability Board.

The confession of a "monstrous" banker

George Banks (the first)

Dear Per

I thought it was a good thing for my bank to purchase AAA rated securities collateralized with mortgages to the subprime sector, and to lend to A+ rated Greece, since in both cases my regulator only required me to hold 1.6 percent in capital against these assets, and which meant that my bank could leverage its capital 62.5 times to 1. 

More so, was my bank not to engage in these operations, it might lose out to other banks who by doing so would earn much higher returns on equity… to such an extent that they might even end buying up my bank, and then I would find myself in the awkward position of having to work for a too-big-to fail bank. 

What should I have done? What would you have done? Did that turn me into a vile bankster? Per, help me some even want to put me in jail!

Your banker friend 

George Banks III

PS. My answer

Dear George

Don't feel bad. I have not held you responsible for any of this mess for even a second. 

As an Executive Director of the World Bank, in a formal written statement in October 2004 I warned: “I believe that much of the world’s financial markets are currently being dangerously overstretched, through an exaggerated reliance on intrinsically weak financial models, based on very short series of statistical evidence and very doubtful volatility assumptions”

And in January 2003 in a letter published by the Financial Times I had written: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds”

And yet I really doubt that, if in your shoes, I could have put a stop to the purchase of the highly rated securities, or convinced any bank colleagues that they should incur in the costs of a special check up to see if their credit ratings were correct or not.

That said I do condemn though the regulators, those who created the temptations of the 60 to 1 or more authorized bank leverages. I can guarantee you that, in the absence of these loony regulations, there would never ever have been such a demand for these so subprime securities which created this crisis, or to indulge in excessive bank lending like to Greece. The Basel bank regulators, hopefully unwittingly, let us at least pray for that, they were the real vile Lucifers in this disaster.

Your non-banker friend that with much fondness remembers your ancestor George Banks

Per

PS. George perhaps this would, way back, have also made your ancestor to go and fly a kite instead.

It’s the stupid bank regulations stupid!

Those perceived as “not risky”, they have always paid lower interest rates, gotten larger loans, on softer terms, and attracted that type of large bank exposures that has caused all major bank crises, when some of them turn out to be very-risky. And so why, Mr. Bright Bank Regulator, do you allow the banks to hold less capital when lending to the “not risky”? That way the "not risky" get even lower interest, even larger loans, on even softer terms and we risk an even major systemic crisis, when some of these “not-risky”, like the triple-A rated securities, the infallible sovereigns like Greece, Icelandic banks, Spanish real estate borrowers and what awaits us, turn out to be very risky. Why are you so chummy with the dangerous not-risky, are you stupid? 

Those perceived as “risky”, like the small businesses and entrepreneurs, they have always paid higher interest rates, gotten smaller loans, on harsher terms, and never ever caused a major bank crisis. And so why, Mr. Bright Bank Regulator, do you require the banks to hold more capital when lending to the “risky” than when to the “not risky”, and so that the "risky" get charged even higher interests, get even smaller loans, on ever hasher terms, and so have even less chance of helping us to generate the growth and job opportunities we need, and, like now, help us out of the crisis generated by some “not-risky” ex-ante, turning very-risky, ex-post. Why do you treat the useful risky so bad, are you stupid? 

Mr. Bright Bank Regulator, if you absolutely must mess around with market signals, so you feel you have earned your salary, then why do you not at least base the capital requirements for banks on job creation and environmental sustainability ratings. That way these would at least serve a purpose.