How do you regulate a regulator’s algorithm?

Sir, I refer to your opinion “Want to regulate ‘the algorithm’? It won’t be easy” Washington Post December 3, 2021, in which you discuss the thorny issue of how to regulate social media in general and Facebook in particular.

Regulators, like the Federal Reserve, de facto also use an algorithm, the risk weighted bank capital requirements. This one determines how much capital/equity banks need to hold and, by its incentive of allowing more or less leverage of bank capital, influences how credit is allocated to the economy.

Let me list a few of too many worrisome aspects of that algorithm:

That what’s perceived as risky is more dangerous to bank systems than what’s perceived as safe

That bureaucrats know better what to do with taxpayer’s credit than e.g.., entrepreneurs with theirs.

That banks should refinance much more our “safer” present than finance our children’s and grandchildren’s’ “riskier” future.

That residential mortgages should be prioritized over small business loans.

How did we get there? My briefest answer: Groupthink by deskbound members of a mutual admiration club. Anyone who has walked on main-streets would e.g., understand that the real risks are conditioned to how risks are perceived, signifying assets can become very risky by the sole fact of being perceived very safe.

John A. Shedd, in “Salt from my attic” 1928 wrote: “A ship in harbor is safe, but that is not what ships are for”. Sir, I submit that goes for banks too. Try to ask current regulators about the purpose of our banks.

PS. IBM, we need our bank regulators to be helped by your Watson.

PS. Rachel Siegel wrote on December 3 “Biden’s pledge to bring ‘new diversity’ to Federal Reserve to soon be tested” I just hope the true meaning of diversity is really understood.

Basel global bank regulations: What blocked timely warnings from even being heard and much less considered?

Charles Goodhart has written “The Basel Committee on Banking Supervision: A History of the Early Years 1974-1997, 2011” For someone like me who became slightly aware of the existence of the Basel Committee in 1997 and who as an Executive Director of the World Bank 2002-04 questioned much of what it was up to, it is an extraordinary interesting book and I will comment it frequently… jumping all over it.

Close to the end, page 578, Goodhart writes. “The regulatory process itself is likely to exacerbate internal self-reinforcing dynamics… by introducing a single set of international standards, it tends towards making more banks behave in the same way at the same time (Alexander, Eatwell, Persaud and Reoch 2007). Thus it adds to the likelihood of crowded trades forcing major and sudden price readjustments”.

Precisely, in April 2003, a time during which Basel II was discussed, when commenting on the World Bank’s Strategic Framework 2004-06, I formally warned:

“Ages ago, when information was less available and moved at a slower pace, the market consisted of a myriad of individual agents acting on 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 the 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. Once again, perhaps only the World Bank has the sufficient world standing to act in this issue. 

A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind. Who could really defend the value of diversity, if not The World Bank?"

How do such comments become so totally ignored? Was it because I did not belong to any mutual admiration network of experts?

Is being consistent better than being right? Is the quest for consistency not just a cover up for mediocrity?

We read: “The members of the Financial Stability Board´s Regional Consultative Group for Europe were updated by the Basel Committee on Banking Supervision on the findings of the regulatory consistency assessment of risk-weighted assets for market risk and credit risk in banks’ portfolios, and shared national perspectives on regulatory consistency of risk weights.”

Of course we like consistency, but what is more important, that all these European countries are consistent in their assessment of risk-weighted assets for market risk and credit risk in banks’ portfolios, or that some in the group, could get it right, even if this meant acting inconsistently?

Has the biodiversity of opinions no longer any value? Is this quest for consistency not just a cover up for mediocrity?

Only consistence can create a dangerous systemic risk, inconsistency does not!

“Consistent implementation of the Basel framework is fundamental to raising the resilience of the global banking system”

Silly, silly, silly! Here the regulators once again enter into an exercise of futile navel gazing. Why should regulators be concerned with whether the risk weighting of assets is consistent or not? 

Their problem is not if any risk-weighing is correct, or consistent, their problem is when the risk-weighing is incorrect and what to do about the consequences. 

Let us instead pray for tremendous amounts of inconsistency since that is the only thing that can save us from building up a systemic risk that will bring all the banks down, simultaneously.

A free market is not made up by consistencies, but by millions of inconsistencies!

My comments on the World Bank's Strategic Framework 04-06

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

“Ages ago, when information was less available and moved at a slower pace, the market consisted of a myriad of individual agents acting on 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 the 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. Once again, perhaps only the World Bank has the sufficient world standing to act in this issue.” 

"A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind. Who could really defend the value of diversity, if not The World Bank?"

PS. A 2003 letter in the Financial Times on this systemic risk

PS. My 2019 letter to the Financial Stability Board

Beware of bank consolidation (An early manifesto against too big to fail and too hard to govern banks, and against too few bank regulation criteria)

Every day there are fewer banks in the world. Those horror stories about bank clients trying to discuss with anonymous voices on the phone about fraudulent uses of their credit cards, while trying desperately to sound as innocent as they are, should make us think twice about the possibility that someday we will, in the best Kafka style, have just one bank. 

But apart from these experiences sometimes worthy of a Stephen King, bank consolidation, a trend that we have been sold as a marvel, may contain other risks not discussed enough - or happily ignored. Among these the following: 

Low risk diversification: Whatever the authorities do to ensure the diversification of banks, there is no doubt that fewer banks mean lesser baskets where to carry the eggs. When I read that during the first four years of the decade of the 30’s in the United States, a total of 9,000 banks failed- I wonder what would have become of that country if it then had only one single bank. 

The regulatory risk: Before there were many countries and many ways of how to regulate banks. Today, with Basel proudly issuing rules that should apply worldwide, the effects of any mistake could be truly explosive. 

Excessive similarity: Encouraging banks to adopt common rules and standards, is to ignore the differences between economies, so some countries end up with inadequate banking systems not tailored to their needs. Certainly, regulations whose main objective appears to be only to preserve bank capital, conflict directly with other banking functions, such as promoting economic growth, and democratize access to capital. 

Low diversity of criteria: A smaller number of participants, less diversity of opinion and, with it, increased risk of misconceptions prevail. Whoever doubts, read the dimensional analysis that ratings agencies publish. 

Backlash: The development of decision-making processes has benefits but also risks. Thus we see that the speed of information itself, which promotes quick and immediate response, can exacerbate problems. Before, those who took the problem home to study it, and those who simply found out late, provided the market a damper, which often might have saved it from hurried and ill-conceived reactions. 

Few clear benefits: To date we have not seen a foreign bank grant for example mortgage loans with globalized terms of maturity and interests. In this respect there seems not to be so many clear benefits of a global bank, when it operates only replacing local banks. 

Cost of global aid: When banks in Venezuela suffered their last crisis, among other reasons because of buying other banks at inflated prices, the cost of that was sadly but logically paid by our country. Today, with globalized banks, and which are not immune to commit equally dumb things, like also buying banks at excessive prices, who will then pay the bill? 

Today, when the world seems to be asking much for bank mergers or consolidations, I wonder if we on the contrary should be imposing on banks special reserves depending on their size. The bigger the bank is, the worse the fall, and the greater our need to avoid being hurt. 

Translated from El Universal, March 7, 2001