The credit rating agencies; if not the biggest, one of the biggest empowered systemic risks of my times.

The hardest part when warning and having a small voice, is when those you most need should heed it, since they’re the ones who can most loudly voice it,  or do something about it, have themselves kept silence on it, or caused the dangers you warn about.

On the margin of the risk weighted bank capital/equity requirements, there, where it most counts for the final bank credit allocation decisions, the systemic risk of the undue influence assigned to the credit rating agencies, is still well alive and kicking.

It would seem that the regulators thought the credit rating agencies possessed some extraterrestrial sensorial abilities that other humans did not. One must be truly desperate for safety to believe such nonsense.

https://www.imf.org/external/pubs/ft/fandd/2010/06/web_letterto.htm

Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds. Friends, please consider that the world is tough enough as it is. 

http://teawithft.blogspot.com/2003/01/credit-ratings-for-developing-nations.html

Nowadays, when information is just too voluminous and fast to handle, market or authorities have decided to delegate the evaluation of it into the hands of much fewer players such as the credit rating agencies. This will, almost by definition, introduce systemic risks in the market 

http://subprimeregulations.blogspot.com/2003/03/my-comments-on-world-banks-strategic.html

Let us not forget that the need for assets to be qualified as more or less risky is exactly the reason why the credit rating agencies were so much empowered that now we also have the credit rating agencies bias risk, which already helped to create the sub-prime mortgages debacle.

https://subprimeregulations.blogspot.com/2007/10/are-bank-regulations-coming-from-basle.html

It would seem that the regulators thought the credit rating agencies possessed some extraterrestrial sensorial abilities that other humans did not. One must be truly desperate for safety to believe such nonsense.

https://www.imf.org/external/pubs/ft/fandd/2010/06/web_letterto.htm

Basel Committee, imposed on the banks capital requirements based on perceived risks and specifically referring to the risks already reflected in the ratings. The product is a hallucinogen, a bankers’ LSD. It increases the banker’s sensitivity to risk: he sees good credit ratings in much brighter lights; not-so-good ratings seem far scarier.

https://subprimeregulations.blogspot.com/2012/01/holy-moly-banks-were-drugged-by-basels.html

PS. In 2023, two decades later, here I am dialoguing with #AI ChatGPT - Grok about it.

https://subprimeregulations.blogspot.com/2023/06/ai-chatgpt-openai-assigning-so-much.html

#AI ChatGPT – OpenAI: Assigning too much power to some few (human fallible) credit rating agencies, does that not introduce a systemic risk?

I asked OpenAI:

"Assigning so much power to some few (human fallible) credit rating agencies to determine how much capital a bank needs to hold against assets, could that be regarded as introducing a systemic risk?"

OpenAI answered:

"Assigning significant power to credit rating agencies in determining capital requirements for banks can introduce certain risks, including the potential for systemic risk. Here are some considerations:

1. Concentration of Power: Relying heavily on a few credit rating agencies concentrates significant power in their hands. This concentration can lead to a lack of diversity in risk assessment methodologies and potential biases in credit ratings. If these agencies make errors or fail to accurately assess risks, it can have far-reaching consequences for the banking system and broader economy.

2. Herding Behavior and Pro-Cyclicality: Reliance on credit rating agencies can contribute to herding behavior among market participants. If multiple institutions rely on the same set of ratings, it can amplify market movements and contribute to pro-cyclical dynamics. During periods of market stress, widespread downgrades or rating adjustments by credit rating agencies can exacerbate systemic risks and market volatility.

3. Overreliance on Ratings: Assigning excessive importance to credit ratings can lead to overreliance on these assessments by market participants, including banks, investors, and regulators. Overreliance can create a false sense of security and reduce incentives for independent risk assessment, potentially overlooking underlying risks and vulnerabilities in the banking system.

4. Limited Transparency and Accountability: The methodologies and criteria used by credit rating agencies are not always transparent or readily accessible. This lack of transparency can hinder market participants' ability to fully understand and assess the accuracy and reliability of the credit ratings. It also limits the agencies' accountability for their ratings and decisions.

5. Regulatory Capture and Conflicts of Interest: There is a risk of regulatory capture or conflicts of interest when credit rating agencies have close relationships with the institutions they rate. These relationships can potentially compromise the objectivity and independence of the ratings, raising concerns about the accuracy and reliability of the assessments.

To mitigate these risks, regulators and policymakers have implemented measures to enhance the oversight and regulation of credit rating agencies. This includes improving transparency, encouraging competition among rating agencies, promoting independent risk assessment within banks, and diversifying the sources of credit analysis.

Additionally, efforts are underway to explore alternative methods of risk assessment and capital requirements, such as stress testing, internal risk models, and broader consideration of risk factors beyond credit ratings alone."

Note: The answers are copied exactly from those given to me by OpenAI

PS. More than two decades ago, at the World Bank. "Nowadays, when information is just too voluminous and fast to handle, market or authorities have decided to delegate the evaluation of it into the hands of much fewer players such as the credit rating agencies. This will, almost by definition, introduce systemic risks in the market"

Here my many other questions to ChatGPT – OpenAI on bank regulations

ChatGPT- OpenAI: Credit rating agencies, empowered by bank capital/equity requirements, is that a systemic risk?

As an Executive Director at the World Bank, I often warned that assigning some few human fallible credit rating agencies so much power for deciding how much capital/equity banks needed to hold against assets, introduced a huge systemic risk in the financial sector. E.g.:

http://teawithft.blogspot.com/2003/01/credit-ratings-for-developing-nations.html

http://subprimeregulations.blogspot.com/2003/03/my-comments-on-world-banks-strategic.html

http://subprimeregulations.blogspot.com/2007/06/some-comments-made-at-risk-management.html

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

Given now the opportunity to chat with ChatGPT – OpenAI, I asked:

"Borrowers love great credit ratings as that allows them to borrow more at lower interest rates. But if banks are also allowed to leverage their equity much more with assets that have great credit ratings, could this alignment of incentives cause disastrous results?"

OpenAI answered:

"The alignment of incentives between borrowers and banks regarding credit ratings can indeed create potential risks and contribute to financial instability if not properly regulated. While borrowers benefit from lower interest rates and increased borrowing capacity with excellent credit ratings, banks may be tempted to leverage their equity more with assets that have high credit ratings.

This situation can lead to several problems:

1. Excessive risk-taking: Banks may become overly confident in the safety of assets with high credit ratings and increase their leverage beyond reasonable levels. This behavior can result in a higher concentration of risk within the financial system.

2. Mispricing of risk: If banks rely too heavily on credit ratings without conducting their due diligence, they may underestimate the true risk associated with certain assets. This mispricing can create a false sense of security and lead to the accumulation of risky assets in the banking system.

3. Contagion effect: In the event of a downturn or a shock to the financial system, the interconnectedness of banks and their reliance on highly rated assets can amplify the impact and lead to contagion. If the credit quality of these assets deteriorates, multiple institutions could face severe losses simultaneously.

4. Systemic risk: When a large number of banks engage in excessive leverage based on assets with great credit ratings, the overall stability of the financial system may be compromised. If these assets were to experience a sudden decline in value or suffer from rating downgrades, it could trigger a broader financial crisis.

To mitigate these risks, regulatory measures are necessary. Regulators should ensure that banks have robust risk management frameworks in place and are not solely relying on credit ratings when assessing the quality and risk of assets. Strengthening capital and liquidity requirements can also enhance the resilience of banks and mitigate the potential negative effects of excessive leverage.

Moreover, improving the accuracy and transparency of credit ratings and reducing conflicts of interest in the rating process can contribute to a more reliable assessment of risk. This would help prevent a situation where banks overly rely on ratings without conducting their independent analysis.

Overall, it is crucial to strike a balance between encouraging lending and maintaining the stability of the financial system."

Here my many other questions to ChatGPT – OpenAI on bank regulations

What if taking down our bank systems was/is an evil masterful plan for winter to come?

Tweets on "What if taking down our bank systems was/is an evil masterful plan for winter to come?"

The poison used is that of basing bank capital requirements on ex ante perceived risks, more risk more capital, less risk much less capital.

That way banks were given incentives to build up the largest exposures to what is ex ante perceived by bankers as safe, something which, as we know, in the long run, when ex post some of it turns out very risky, is what always take bank systems down.

For that they made sure no one considered making the risks conditional on how bankers perceive the risks.

And that hurdle cleared, some very few human fallible credit rating agencies were given an enormous influence in determining what is risky and what is safe.

And taking advantage of some statists or that few noticed, sovereigns were assigned a 0% risk weight, while citizens 100%. That guaranteed government bureaucrats got too much of that credit they’re not personally responsible, and e.g. the entrepreneurs too little.

And to make the plan even more poisonous some European authorities were convinced to also assign to all Eurozone sovereigns a 0% risk weight, and this even though these all take up loans in a currency that is not their domestic printable one.

And because banks were allowed to leverage much more with “safe” residential mortgages than with loans to “risky” small and medium businesses, houses prices went up faster than availability of jobs, and houses morphed from homes into investment assets

And finally, by means of bailouts, Tarps, QE’s, fiscal deficit, ultra low interest rates and other concoctions, enormous amounts of financial stimuli was poured on that weak structure… and so the evil now just sit back and wait for winter to come

http://theaaa-bomb.blogspot.com

PS. At the World Bank I warned that assigning too much influence to credit rating agencies introduced a dangerous systemic risk. 

PS. My letter to the Financial Stability Board

Even perfectly perceived risks cause wrong decisions if excessively considered

Should banks consider risk factors, such as the probability of default (PD) and the expected loss given a default (LGD), when setting the interest rates it charges clients? Of course, higher perceived risk-higher interests, lower risks-lower interest rates. 

But regulators curiously decided that these risks should also be cleared for in the capital requirements for banks, and decreed: higher perceived risk-higher capital, lower risks-lower capital.

So now banks clear for these risks both with risk adjusted interest rates and risk adjusted capital. That’s a real serious problem because any risk excessively considered, will produce the wrong decision, even if the risk is perfectly perceived.

Now a higher interest rate perfectly set in accordance to a perfectly perceived higher risk translates, because of higher capital requirement, meaning a lower leverage, into a lower risk adjusted expected return on equity. 

Now a lower interest rate perfectly set in accordance to a perfectly perceived lower risk translates, because of a lower capital requirement, meaning a higher leverage, into a higher risk adjusted expected return on equity.

So now banks, even when the risks are perfectly perceived, lend too little to the risky, or in order to compensate for lower ROEs, at too high risk adjusted interest rates; and lend too much to the safe, or thanks to higher ROEs, at too low risk adjusted interest rates.

This is insane! It produces dangerous misallocation of bank credit to the real economy. Too little financing of the "riskier" future and too much refinancing of the "safer" present.

PS. There is still a possibility of credit being allocated efficiently to the real economy, but that requires that what's perceived as safe to be much safer and what’s perceived as risky to be much riskier. What credit rating agencies could guarantee us such mistakes?

Regulators and bankers looking out for the same risks 

My tweet comments on Stephen Cecchetti's and Kim Schoenholtz's "The financial crisis, ten years on", Vox August 2017

"The financial crisis, ten years on"

Does a crisis start when the bomb is armed, the fuse is lit, the explosion occurs, or when the explosion is noted? http://voxeu.org/article/financial-crisis-ten-years#

In 2003 FT published a letter I wrote about the systemic risk of giving credit rating agencies so much power https://teawithft.blogspot.com/2003/01/credit-ratings-for-developing-nations.html

In 2004 the fuse was lit when Basel II authorized banks to leverage 62.5 times with what was rated AAA

https://subprimeregulations.blogspot.com/2010/06/impose-higher-bank-capital-requirements.html

 

In August 2006 clearly the bomb had already exploded https://teawithft.blogspot.com/2006/08/long-term-benefits-of-hard-landing.html

Unfortunately it was not until July 2007 credit rating agencies woke up and in August that the fan started to spread out the shit.

Willful (or naive) blindness of epical proportions, reigns in the world of the Basel Committe’s bank regulations

Note: The following comments have been inspired by beginning to read Margaret Hefferman’s “Willful Blindness”

To agree with bank regulations for which the regulators have not even defined the purpose of the banks they regulate… is that not an act of willful (or naive) blindness?

To agree with bank regulations that look to hinder banks to hold assets ex ante perceived as risky, when these kinds of assets have never created a bank crisis… is that not an act of willful (or naive) blindness?

To agree with bank regulations based on perceived credit risks, when obviously what matter are unexpected events or not perceived credit risks… is that not an act of willful (or naive) blindness?

To believe that you could place so much decision power into the hands of some few human fallibe credit rating agencies, without intriducing a systemic risk of gigantic proportions… is that not an act of willful (or naive) blindness?

Not seeing that allowing banks to leverage their equity, and the support they receive from society differently, with different assets, will produce a serious distortion in the allocation of bank credit to the real economy… is that not an act of willful (or naive) blindness?

Not seeing that curtailing the access to bank credit of the risky, more than it is already curtailed increases inequality… is that not an act of willful (or naive) blindness?

Not seeing that future generations will be affected by denying them the risk-taking that brought current generation to where its at… is that not an act of willful (or naive) blindness?

Not understanding that banks, if allowed to use their own risk models to set their capital requirements will lower these so as to maximize their expected risk adjusted returns on equity… is that not an act of willful (or naive) blindness?

Believing that some Basel I and II regulators who were totally surprised by the 2007/08 crisis have it in them to fix it with a Basel III… is that not an act of willful (or naive) blindness?

To believe that a 2007/08 crisis and the following stagnation can be cured by just throwing QEs, fiscal deficits and low interest rates at it… is that not an act of willful (or naive) blindness?

And the list of questions related to current bank regulations that gives ground to believing willful acts of blindness takes place goes on and on and on… and I might add some with time after finishing the book that inspired this. 

PS to Financial Times: To receive thousands of letters on these problems from someone that has been showned right on many letters previously published… is that not an act of willful (not naive) blindness?

One thing is a risk appraisal, a credit rating, and another, totally different, how much importance you give to it.

In January 2003, in a letter published in the Financial Times I wrote:

“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. Friends, as it is, the world is tough enough.”

And so here they go again? When will they ever learn?

Do these regulators still not know that banks already look at credit ratings when they set their interest rates and decide on the size of their exposures? To also have credit ratings to set the capital requirements, give their risk appraisal a double weighting. And, a double weighting of even a perfect correct risk appraisal, produces the wrong result. One thing is a risk appraisal and another, totally different, how much importance you give to it. 

The Per Kurowski rule

The Basel Committee seems not to get it, and therefore insists on being dumb... or?

I have just read the Basel Committee’s “Revisions to the securitization framework”. In it they have approved to “reduce the reliance on external ratings”… as if that was the real problem.

Whoever is the perceiver of risks, internal or external, if the perceived risks used are correct, then banks would need no capital… and any bank then in problem, should better just be put out of business… as fast as possible. 

The real systemic dangerous problem arises when those risk perceptions of are wrong…and that is why it is so silly to have capital (equity) requirements for banks based on the used perceived risks being correct… independently of who is the perceiver of these risks… internal or external. 

Though in fact, since the more credible the “risk perceiver” is, the bigger is the risk of creating potentially dangerous exposures, the Basel Committee might have opted for a strategy of decreasing the credibility of the risk perceivers… if so it is undoubtedly an interesting development... 

At least the Basel Commitee could finally be understanding what I meant when in the Financial Times, in January 2003 I wrote: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds”

 

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 leverage

Here my 2009 video on the 62.5 times bank leverage

Poor rich Oprah Winfrey should get herself a buyer-power-rating, issued by one of few big agencies.

Sir, I refer to James Shotter´s “Swiss image suffers after asylum row and Winfrey furore” August 10.

Poor rich Oprah Winfrey considers herself discriminated against because of how a certainly much poorer sales assistant in an upmarket Zürich boutique, dared to express the opinion that a ludicrous expensive handbag was too expensive, instead of perhaps increasing its price 50 percent as any much more able vendor would have done.

Frankly, this whole affair is so incredibly petty when I compare it to that other official discrimination which also originates in Switzerland, through the Basel Committee. That one establishes that even though “The Infallible” borrowers are already much favored in the markets, and “The Risky” much disfavored, that banks are allowed to hold much less capital when lending to the former, and thereby earn a much higher expected risk-adjusted return on its equity, than when lending to the latter.

I guess that if these bank regulators were asked, they would suggest that Oprah Winfrey equips herself with an AAA buyer power rating, issued by one of few formidable buyer-power-rating agencies.

Of course, the instinct of any normal ludicrous expensive handbags store owner, upon seeing an AAA buying-power-rating, would be to increase the listed price of the handbag, but I am sure that our Basel Committee regulators could also come up with a way of favoring these ultra rich buyers, and thereby discriminate against those who, immensely poorer, just want to feel like an Oprah Winter holding that completely unaffordable handbag in their hands for some seconds.

It is truly amazing how much we can hear about any discrimination based on color or other factor, when compared how little the officially sanctioned discrimination based on perceived risks are not even debated. Could it be because we are ashamed of having to admit to ourselves that we have changed from being risk-taking into risk-adverse nations? 

In the name of my constituency, my granddaughter, I protest though: “Damn you BaselCommittee… for having castrated our banks”

The correct blog for this post is here

Good morning, Your Honor. May I approach the bench, to do a sort of defense of Standard and Poor’s, pro bono?

There are many reports which indicate that the US department of justice is expected to file a civil lawsuit against Standard & Poor’s for the issuing of overly rosy credit ratings with respect of some collateralized debt obligations. 

If I was allowed to defend S&P, pro bono, without of course implying that any outright illegalities committed by it should not be punished, I would state the following: 

Your honor: Credit rating agencies have been around for a long time issuance opinions which are certainly quite often very wrong, by being very rosy or by painting a too dark picture. Doing the first investors and lenders might lose out in favor of borrowers, doing the latter borrowers might lose out in favor of investors or lenders. C’est la vie. 

But one thing I am absolutely sure of is that, had the bank regulators not assigned so much importance and so much credibility to some human fallible rating agencies, like by allowing banks to hold AAA to AA rated securities against only 1.6 percent in capital, and which translates into a mindboggling approved leverage of bank capital of 62.5 to 1 times, we would not be standing here. 

There would have not been the kind of pressures exerted on credit rating agencies to produce these AAA to AA ratings, and if produced there would not have been the same outrageous demand for these securities, and the consequences would not have been something to write home about. 

And so, if you ask me, the credit rating agencies broke the window, but the bank regulators, placed the stone in their hands. 

Your honor, in evidence of what I am saying I introduce here a letter I wrote in January 2003, and which was published by the Financial Times. It states: “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” 

Also, in April 2003, in a formal written statement delivered as an Executive Director of the World Bank I held: “Ages ago, when information was less available and moved at a slower pace, the market consisted of a myriad of individual agents acting on a limited information basis. Nowadays, when information is just too voluminous and fast to handle, market or authorities have decided to delegate the evaluation of it into the hands of much fewer players such as credit rating agencies. This will, almost by definition, introduce systemic risks in the market and we are already able to discern some of the victims, although they are just the tip of an iceberg.” 

And in May 2003 in an Op-Ed I also wrote “In a world that preaches the worth of the invisible hands of the market, with its millions of mini-regulators we find it so strange that the Basel Committee delegate, without any protest, so much responsibility in the hand of so very few and so very fallible credit rating agencies” 

Your honor, unfortunately the bank regulators did not want to listen, just as they still do not want to do. If you find Standard and Poor’s guilty of misdoings, something which you might do, I beg of you not to ignore those who unwittingly, but with extreme arrogance, set us up to all this disaster.

On bankers and weathermen

Do you remember Mark Twain’s banker, he who wants to lend you the umbrella when the sun shines but wants to take it back as soon as it seems like it is going to rain? Well that banker would surely be taking some notice of what the weathermen opined, in order to set the interest rates, the amounts and the other terms of the loan. 

But what if the regulators also told this banker that if the weatherman spoke of sun, his bank was allowed to hold very little capital, which meant being able to leverage its equity much more, but, if he spoke of rain, it was then required to hold much more capital and leverage less? 

Obviously, since a banker must love returns on bank equity, since otherwise he would be booted, that would doom Twain’s banker to choke on sunny forecasts (like AAAs and infallible sovereigns), and avoid like the pest all possible rains (like small business and entrepreneurs)… only to find out, much too late, that weather reports are not always that accurate. 

And so shall we exclude using weather forecast from bank capital requirement calculations, or shall we regulate the weatherman… so that he gives our bankers absolutely accurate forecasts… so that our Mark Twain banker can trust these even more?

Ps. here a letter published by the Financial Times in January 2003.

We need to fire the self appointed supreme risk manager of the world!

When the Basel Committee on Banking Supervision decreed capital requirements for banks that resulted from assigning risk-weights based on the risk of default, as perceived by the credit rating agencies… with incredible hubris they took upon themselves to act in the role of supreme risk manager of the world.

How have they been doing? Worse than lousy! Basel II failed monumentally only 3 years after its approval in June 2004.

As an Executive Director in the World Bank, 2002-2004, and in many published articles since 1997, I protested loudly the regulatory paradigm that the Basel Committee is built upon, and I warned precisely about those risks that caused the current crisis.

With whatever credibility that should give me I guarantee you that the Basel Committee, with their Basel III, is only digging us and our banks further down into the hole where they placed us.

The role of a bank regulator is not to guard us against those risks of default perceived by credit rating agencies, and which are therefore also perceived by the markets and by the banks. No bank crisis has ever resulted from excessive lending or investments in what is perceived as risky… they have all resulted from excessive lending or investment in what was ex-ante perceived as not risky. Therefore the fundamental role of a bank regulator is to take precautions against those risks that might not have been perceived.

The role of a bank regulator, more than guard us against bank failures, is to guard us against the risk that the banks and whom the tax payers lend so much support to, do not serve their purpose for the society… and the Basel Committee has not yet said even one single word about what the purpose of the banks should be.

Let absolutely no one regulate before they do state the full purpose of the entities they are regulating… and that “purpose” has of course been deemed acceptable to us.

The financial crisis: What went wrong and what to do… in the eyes of an interested and concerned citizen observer.

In explaining the current financial crisis there are some very few pieces that allow for a quite clear image of the final puzzle and are obviously needed in order to find the best way to avoid repeating the same mistake… and so that we could at least give some new mistakes a chance to show what they´re worth.

1st piece: The Basel Committee had decided that the only risk it needed to consider with respect to the banking system was the risk that banks lent or invested in operations that could default. All other risks related to whether banks fulfilled adequately their capital allocation responsibilities, were taken off the table.

2nd piece: The Basel Committee because of its hysterical aversion of risk turned a blind eye to the fact that all bank crisis have resulted from excessive lending or investment in what was perceived ex-ante as having a low risk of default and never from excessive lending or investment in what ex-ante was perceived as having a high risk of default.

3rd piece: The Basel Committee, when determining the risk-weights by which it arbitrarily discriminated on the risk of default, amazingly ignored the fact that the market and the banks already clear for risks by the risk premiums they charge in interest rates, and so ex-ante perceived low risk was twice benefitted while ex-ante perceived higher risk were twice punished.

4th piece: The regulators naively ignored that the oligopoly of risk surveyors they empowered, the credit rating agencies, where human fallible and could also be captured. There has been a lot of comments with respect to the excessive trust placed by banks and markets in general in the “opinions” of the credit rating agencies but, if there is anyone that has showed the way for such excessive trust, that is of course the Basel Committee itself.

5th piece: On June 26 2004 the G10 substituted the 30 pages long Basel I adopted in 1988 with the 251 pages long Basel II, which allowed a bank to hold only 1.6 percent of fairly loosely defined capital (8 percent basic capital requirement multiplied by its 20 percent risk-weight) when lending or investing in anything related to a private triple-A rated client or security; which signified that a bank could leverage its equity on those operations to 62.5 to 1; which signified that if a bank expected to make a margin of .5 percent on a triple-A rated operation, it could expect a return on its capital of 31.25 percent a year.

6th piece: The primary and really only detonator of this crisis were the over two trillion dollars from all over the world invested and lost in triple-A rated securities collateralized with very badly awarded mortgages to the subprime sector. The market, as markets do, in response to a really mindboggling acceleration in demand after mid 2004 for triple-A rated securities, and because almost by definition real triple-A financial operations are extremely scarce, resorted to fabricate and supply fake Potemkin-triple-A ratings.

What are the first conclusions we should draw when seeing the image these six pieces create?

1st conclusion: If we are going to have global regulators, which we will need, it absolutely behooves us to make sure those regulators are chosen from an extremely diversified pool of talents, since the least we need is to allow for creation of incestuous mutual admiration clubs… like the Basel Committee is. We need urgently to change at least 80 percent of the professionals involved with the Basel Committee and guarantee the existence of multidisciplinary professional participation. Think of it, if the challenge of global climate change is placed into the hands of something like the current Basel Committee, we are all toast, before it even begins to heat up!

2nd conclusion: Before regulating the banks we need to define what the purpose of banks is. As just mattresses to stash away cash, mattresses might be better. For this the world, but especially the submerging countries, need to reconsider completely the issue of what is the necessary risk-taking a society must be willing to absorb in order to move forward.

3rd conclusion: Throw away the capital requirements for banks based on ex-ante perceived risk of default as fast as possible. As long as small businesses and entrepreneurs are discriminated to such an extent that banks need to hold 5 TIMES as much capital when lending to them when compared to when lending to triple-A rated clients, there is no sustainable way out of this crisis nor sufficient job creation.

4th conclusion: We also need all to work ourselves out of that amazing regulatory bias in favor of big governments represented by the fact that when banks lend to a triple-A rated sovereign, they need zero capital; a distortion that among others hinders us from seeing the real interest rates on public debt.

What are we to do with the Financial Stability Board?

The Financial Stability Board (FSB) reported from their meeting in Seoul on October 20 ahead of the G20 Summit in Seoul and endorsed principles for reducing reliance on credit rating agency (CRA) ratings as follows:

“The goal of the principles is to reduce the cliff effects from CRA ratings that can amplify procyclicality and cause systemic disruption. The principles call on authorities to do this through:

Removing or replacing references to CRA ratings in laws and regulations, wherever possible, with suitable alternative standards of creditworthiness assessment;

Expecting that banks, market participants and institutional investors make their own credit assessments, and not rely solely or mechanistically on CRA ratings.”

Since FSB does not even mention the risk-weights we can only assume FSB feels that all what went wrong was the excessive reliance on the credit ratings. They have no clue. What went really wrong was the way the regulators arbitrarily assigned to the different credit ratings the different risk-weights which determined the capital requirements for banks… like the 20% risk-weight for any lending to private entities rated triple-A or 0% risk weight on any lending to sovereigns rated triple-A.

In other words the FSB is unable or unwilling to understand that the credit rating agencies could have been totally wrong and yet they would never have produces the damage they did with their faulty ratings, had they not been so incredible endorsed by the bank regulators.

And neither does FSB understand that their regulatory favors to what is perceived as having a low risk of default, amounts only to an odious discrimination of what is perceived as having a higher risk of default, and all for no real purpose at all, since we all know that what is perceived as risky does never carry the potential to turn into a systemic danger.

And so friends what are we to do with the thick-as-a-brick Financial Stability Board?

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 financial crisis explained to non-experts, dummies and financial regulators.

The play: The dangerously safe playgrounds!

1st scene: Some extremely wimpy parents concerned so much more with their small children’s safety than with their development picked out three independent surveyors to rate the safety of the playgrounds their children frequented.

2nd scene: In order for their small children to want to go to the safest but somewhat boring playgrounds they presented them with the choice of having some very good goodies if they went there or having to settle for some bad cold porridge if they went to the more fun park.

Kids, this or that?

3rd scene: But since the good goodies were too good, and the cold porridge too bad, and there was a natural lack of safe playgrounds, too many children went to the few rated as "safe" parks… where, unfortunately... they trampled themselves to death.

Epilogue: When will they ever learn? Though the kids need some risk to develop strong and not obese, and though the truly safe playgrounds are a fidget of their imagination, during the funerals, we still hear the parents planning on making the good goodies gooder and the cold porridge colder.

What the play teaches us is that with wimpy, gullible and naïve parents like these, the kids are better off running alone in the street.

The cast:

As the wimpy parents, we have the financial regulators of the Basel Committee.

As the young children, we have the banks.

As good goodies, we have a 1.6 percent capital requirements for any bank lending related to an AAA rating.

As cold porridge, we have an 8 percent capital requirements for any bank lending related to an unrated small business or entrepreneur.
As safe playgrounds turned unsafe, we have the subprime mortgages.

As the playground safety rating agency… if you cannot figure it out for yourself you’re just too dumb.

And as all the grandparents or elder siblings who, because they were not interested or did not want to erode the parental authority, did not warn the parents… we have thousands of financial experts and PhDs.

PS. Oops! Some might now tell me they know their children prefer cold porridge to Wiener Nougat.

 

And from that playground, on to Fraulein Basel’s Chocolate Cake

PS. Now in 2024 I asked AI’s opinion on whether, as a grandfather, I should be concerned with the future current bank regulations might have doomed my grandchildren to encounter. It answered: "You're absolutely right to be concerned, and it's completely understandable to question the decisions that have shaped the financial world your children and grandchildren will inherit." 

Hush! Less we lose the chance to beat on a foe or a convenient scapegoat.

The ABACUS 2007-AC1 flip book states:

“Although at the time of purchase, such Collateral will be highly rated, there is no assurance that such rating will not be reduced or withdrawn in the future, nor is a rating a guarantee of future performance.”

The truth is that had it not been because the investors believed that the credit ratings were correct, they would not have invested, no matter how much Goldman Sachs could have argued with them based on other false statements.

But this is of course is something many do not want to be known, because this would take away all the fun of being able to go after such a juicy foe as Goldman Sachs or such a convenient scapegoat to be used by the inept regulators.

We need to get to the real bottom of this... because that is were the truth can be found.