My letters on our so mistaken bank regulations that have been published by the Washington Post. Thanks WP!

September 6, 2007: Factors in the Financial Storm

June 20, 2008: An Aspect of the Bubble

December 27, 2009: Another 'worst': Faulty bank regulation

January 6, 2012: Handcuffed by a triple-A rating 

May 1, 2013: An American approach to banking

December 23, 2014: Let the market rule on risky trades

November 11, 2015: Reverse-mortgaging the future

August 9, 2016: Banks, regulators and risk

April 16, 2017: When banks play it too safe 

July 11, 2018: There is another tariff war that is being dangerously ignored. 

December 30, 2018: Affordable homes or investment assets?

Bank regulators in the Basel Committee are getting loonier by the minute.

I have always objected to that corporates with good credit ratings, who already have better access to bank credit, shall have even more preferential access to it because of bank regulations. That because credit ratings can be wrong; and because the risks are especially big when it is good credit ratings that are wrong (AIG); and mostly because doing so distorts the allocation of bank credit in the real economy.

And now the Basel Committee for Banking Supervision, in their Consultative Document: “Revision to the Standardized Approach for credit risk” writes:

“The committee seeks to substantially improve the standardized approach in a number of ways. These include reducing reliance on external credit ratings; increasing risk sensitivity; reducing national discretions; strengthening the link between the standardized approach and the internal ratings-based approach; and enhancing compatibility of capital requirements across banks.”

“Corporate exposures would no longer be risk-weighted by reference to the external credit rating of the corporate but they would instead be based on a look-up table where risk weights range from 60% to 300% on the basis of two risk drivers: revenue and leverage.”

The risk weights above, calculated for the basic 8% capital requirement of Basel III, translates into 4.8% to 24% capital requirements; which then translates into a range of allowed leverages of bank capital of 19.8-3.1 to 1.

And that means now it is those corporate who come up as winners on a “look-up-table”, having more revenues and less leverage, which will generate less capital requirements for banks; and therefore allow banks to leverage their capital more when lending to them; and so therefore allow banks to earn higher risk-adjusted returns when lending to them; and therefore have preferential access to bank credit.

And so now I ask, regulators… why on earth shall corporates have more or less access to bank credit based on their revenues and leverage, than what access to bank credit corporates already have based on their revenues and leverage?

Basel Committee, why do you besserwisser insist in distorting the allocation of bank credit to the real economy this way? Is not the health of the real economy what in the long run is the most important factor in achieving bank stability?

“Look-up-table”? Man, you sure are getting loonier by the minute! Do you really think your table can do a better job analyzing credits than credit rating agencies? Do you think good banking is something achievable by children connecting dots?

PS. And it is stated: “These alternative risk drivers have been selected on the basis that they should be simple, intuitive, readily available and capable of explaining risk consistently across jurisdictions.”

What on earth do the regulators mean with that? That what is truly important when regulating banks is that the criteria of how to regulate banks should be comfortable and easy to manage for bank regulators?

PS. We have seen some merger activity based on tax considerations. Are we now to see mergers based on the Basel Committee’s “look-up-table” positioning?

The principle of bank regulations that has been and is so rudely violated

Regulators should accept that bankers believe they can master quite adequately the risks of default. Who would want to deal with a banker who does not believe so?

But in the same vein the regulators should always tell the bankers “No you can’t… and besides there are so many other risks to be considered than just avoiding the defaults of your clients and the defaults of yourselves”.

And foremost regulators should never ever themselves become risk-managers… a principle that was and is so rudely violated.

It is bad enough when regulators fall for the sales pitch of bankers and believe too much in their risk-management ability, but so much worse when the regulators arrogantly believe, as they currently do, that they know themselves what the risks are and that they know themselves how to properly manage and master these… with or without a little help from the credit rating agencies.

A credit rating sends out on its own a very positive or negative signal to the market. When regulators based the capital requirements of banks on those same credit ratings, they dramatically augmented the strength of those signals… to such an extent that banks went and drowned themselves in triple-A rated waters wearing no capital at all… to such an extent that lending to the “risky” small businesses and entrepreneurs has come to a halt because that requires too much capital, especially when bank capital is very scarce as a result of having invested or lent too much to the ex-ante “not risky”.

Currently the regulators, who like risk-managers already failed in conquering some simple risks of defaults, when foolishly playing around with their capital requirements based on perceived risks, and ignoring that systemic crisis never ever results from timely perceived risks, are now tackling more God-like events like pro-cyclicality. God help us!

To reform financial regulations we need to reform in depth the Basel Committee.

In May 2003, as an Executive Director of the World Bank, I told those many present at a risk management workshop for regulators the following with respect to the role of the Credit Rating Agencies. “I simply cannot understand how a world that preaches the value of the invisible hand of millions of market agents can then go out and delegate so much regulatory power to a limited number of human and very fallible credit-rating agencies. This sure must be setting us up for the mother of all systemic errors.” And this I repeated over and over again, even in the press.

Now the IMF is finally admitting “Policy makers should continue their efforts to reduce their own reliance on credit ratings, and wherever possible remove or replace references to ratings in laws and regulations, and in central bank collateral policies”

That is good, better late than never. But the real question has to be why on earth it had to take a financial crisis of monstrous proportions to reach a conclusion that should have been apparent to any regulator from the very beginning.

I saw it happen and I know why it happened. As I wrote in a letter published in the Financial Times in November 2004, it was the result of the whole debate about bank regulations being sequestered by the members of a small mutual admiration club.

If there is now something even more important than rectifying the faulty financial regulations, that is to break up the Basel Committee and make absolutely sure it represents a much more diversified group of thinkers. That would have at least guaranteed that the basic question of what the purpose of the banks should be would have been put in the forefront before regulating them. Current regulations do not contain one word about that.

Besides me there were not too many but still plenty of experts who raised the question of whether the credit rating agencies should have such a prominent role. These persons should participate in designing and putting in place the needed reforms. It is simply unacceptable that these reforms with huge global implications are implemented exclusively by Monday morning quarterbacks.

We need to stop the credibility asymmetry that exists in the credit risk information market

One of the problems with credit ratings is that they are never sufficiently publicly debated, unless when it is too late, and when that happens then it is mostly the case of a small questioner against the mother of all father authorities in the markets.

Too often have I heard bankers ask me “Per, how on earth do you think I could convince my colleagues on the Board that the credit rating agencies were getting it so extraordinarily wrong that we should exit from what seemed to be an extraordinarily good business for us?”

In our efforts to solve the asymmetry in information we have increased the asymmetry of the credibility with respect to financial information, making it now almost impossible for divergent opinions to nudge the markets on the margin, and being only considered when the causes for the divergence become much too apparent, which is of course then much too late.

The first thing that should happen is that the credit rating agencies should be required to post, real time, all the questions and answers received with respect to every particular ratings, so to allow the market to express their viewpoints and to allow configure the necessary opinion majorities that could force the credit rating agencies to revise what they are doing.

If that Bank Director friend of mine could have referred to a place where those same suspicions were uttered by others, then he would stand a much better chance of being heard.

I repeat. We need an official online forum where we can question each and every single credit rating. That’s transparency!

The lover’s spat between Goldman Sachs, Paulson and “sophisticated investors” is not the real problem!

The beauty of the action of the SEC against Goldman Sachs is that it allows us to understand with a real and public example a lot of what happened all over the market. Let us see it here from the perspective of IKB the German Bank who invested $150 million in ABACUS 2007-AC1.

In paragraph 58 we read that IKB bought $50 million of the A1 tranche paying Libor plus 85 basis points, and $100 million of the A-2 tranche paying Libor plus 110 basis points. The average return comes to about 102 basis points.

Since these $150 million were rated Aaa by Moody’s and AAA by S&P when purchased, that meant that IKB’s investment, for bank capital requirement purposes, would be weighted at only 20% signifying only $30 million for which 8% capital requirements had to be held. IKB would therefore need $2.4 million of their own capital to back the operation, a leverage of 62.5 to 1.

$150 million at 102 basis points and $ 2.4 million in capital signifies then an expected gross return of 63.75% on IKB’s capital.

In order for IKB to make a comparable return when lending to their traditional client base of small and medium sized businesses, most certainly unrated, and who therefore are risk weighted at 100%, IKB would have to lend them the funds at Libor plus 510 basis points.

And here we have it, the way the current capital requirements for banks are based on the risks perceived by the credit rating agencies, provide huge incentives for the banks to enter into the virtual world and invest in these “synthetic” operations, instead of lending to the real world... and, that problem is so much larger than a simple lover’s spat between Goldman Sachs, Paulson and “sophisticated investors”.

Do you understand why I beg of you to keep your eyes on the ball? Do you understand why I am upset nothing of this is even discussed in the current proposals for financial regulatory reform?

Goldman’s ABACUS 2007-AC1: The whole truth and nothing but the inconvenient truth!

But the whole truth and nothing but the truth would in the case of ABACUS 2007-AC1 have to include the following facts, no matter how politically or agenda inconvenient they might be:

IKB, a commercial bank headquartered in Germany did not use $150 million to lend to small and medium sized German companies, as they historically had done, but instead invested and lost “$50 million in Class A-1 notes at face value” and “$100 million in Class A-2 Notes at face value” in ABACUS 2007-AC1, exclusively because of the following two reasons:

First both tranches, the A1 paying Libor plus 85 basis points, and the A-2 paying Libor plus 110 basis, points were rated Aaa by Moody’s and AAA by S&P when purchased by IKB.

Second, in order to invest $150 million in these securities which because of their ratings were risk-weighted by Basel II at only 20%, IKB needed only to have $2.4 million of capital, 1.6%, compared to the $12 million it would be required to have if lending that amount to unrated small and medium sized German companies.

If IKB had known that Paulson had had his hand in the picking, and known fully about his motives, then they might have asked for a slightly higher interest rate, maybe 10 basis points more, and still have bought the securities.

If the securities did not have the splendid credit ratings assigned to them by the credit rating agencies then they would probably not have bought them even if Mother Teresa had done the picking.

If the regulators had placed the same type of capital requirements on all assets then IKB would have stayed home, lending to their traditional clients, instead of going to California to dig prime rated subprime gold.


And so while naturally we should lend all our support to efforts to eliminate wrong-doings like those described in the SEC action against Goldman that should not signify we take our eyes of the unfortunate truth of having been saddled with grossly inept regulations, creating grossly bad regulations.

Now all of this does of course not imply that the Goldman Sachs, the Tourres, the Paulsons or the ACAs of this world are angels… it is just about putting it all in the right perspective.

A letter in Washington Post: Another 'worst': Faulty bank regulation

Another 'worst': Faulty bank regulation 

The Dec. 20 Outlook compilation of the decade’s worst ideas did not include the one most to blame for the loss of most of the past decade’s growth: regulations that allowed banks to hold absolute minimums of capital as long as they lent to clients or invested in instruments rated AAA, for having no risk. This launched a frantic race to find AAA-rated investments wherever and finally took the markets over the cliff of the subprime mortgages. 

The most horrific part is that it seems likely to endure because regulators can’t seem to let go of this utterly faulty regulatory paradigm. Let me remind you that banks are allowed to hold zero capital when lending to sovereign countries rated AAA and that there are already many reasons to think that the credit quality of many sovereign states has been more than a bit overrated.

Here other of my letters in the Washington Post on the same theme:
http://subprimeregulations.blogspot.com/2018/07/trade-wars-will-mean-new-tariffs.html
http://subprimeregulations.blogspot.com/2017/04/when-banks-play-it-too-safe-putting.html
http://subprimeregulations.blogspot.com/2016/08/banks-and-regulators-dont-care-about.html
http://subprimeregulations.blogspot.com/2015/11/the-reverse-mortgage-on-economy-baby.html
http://subprimeregulations.blogspot.com/2014/12/another-letter-in-washington-post-let.html
http://subprimeregulations.blogspot.com/2013/04/another-letter-in-washington-post.html
https://subprimeregulations.blogspot.com/2008/06/a-letter-in-washington-post-aspect-of.html

https://subprimeregulations.blogspot.com/2007/09/factors-in-financial-storm.html