3 questions on IMF’s Global Financial Stability Report’s, “Where Are the U.S. Corporate Sector’s Vulnerabilities?”

That section, on page 9 states:

“The corporate sector has tended to favor debt financing, with $7.8 trillion in debt and other liabilities added since 2010. Bank lending to the corporate sector has continued to recover and could well rise further in response to more favorable market valuations. In contrast, equity finance has traditionally been outstripped by share buybacks and has recently leveled off. A drop in the cost of equity capital may stimulate equity financing, but it could coincide with higher corporate debt—particularly if additional share buybacks are financed through debt.” 

That begs three questions: 

First: How much of the recent increase in the stock markets is the result of buybacks; that which helps earnings per share to get a sort of artificial boost; that which results in less equity controlling the corporations? 

Second: Do the recent stock-market prices increases duly reflect the increase riskiness derived from much higher corporate debts? 

Third: Have Central Banks therefore, with their low interests rate policies, de facto, dangerously lowered the capital (equity) requirements of corporations? 

On the first two questions I have no answers, though just having to ask them should suffice to at least raise some eyebrows. 

On the third the IMF clearly seems to respond, “Yes!” when on that same page, under the subtitle “High Leverage Combined with Tighter Borrowing Conditions Could Affect Financial Stability” it writes: 

“As leverage has risen, so too has the proportion of income devoted to debt servicing, notwithstanding low benchmark borrowing costs. Although the absolute level of debt servicing as a proportion of income is low relative to what it was during the global financial crisis, the 4 percentage point rise has brought it to its highest level since 2010, which leaves firms vulnerable to tighter borrowing conditions. The average interest coverage ratio—a measure of the ability for current earnings to cover interest expenses— has fallen sharply over the past two years. Earnings have dropped to less than six times interest expense, close to the weakest multiple since the onset of the global financial crisis.” 

Holy Moly! And interest rates have not yet returned to something more "normal"; and the Fed's balance sheet is still so huge it leaves little space for any future QE assistance...and not to speak of the already too large public debts. 

My intuition tells me that if we do not develop something along the lines of a Universal Basic Income, fast, we will not be able to counter sufficiently upcoming recessions and huge unemployment so as to keep truly horrendous populists away.

Really, how on earth can we have left so much power in so few so intellectually incestuous hands?

Compared to The Really Great Distortion by the Basel Committee, The Economist’s Debt/Tax Distortion seems smaller.

The Economist makes some good points about the distortion produced by the tax deductibility of borrowing costs, “The great distortion” May 16.

Indeed but compared with the distortions produced in the allocation of bank credit by the credit-risk-weighted requirements for banks, those distortions seem minor. The distortion The Economist refers to, favors debt over equity, and produces a suboptimal debt/equity mix. The distortion current bank regulations cause affects the access to debt. Those perceived as safe, and who therefore already have better access to bank credit, will have even more so. And those perceived as risky, and who therefore already have difficulties accessing bank credit will have even less so. And that, which kills opportunities, is a real potent inequality driver.

The Economist writes: “Corporate financial decisions are motivated by maximizing the relief on debt instead of the needs of the underlying business.” But in the same vein, minimizing equity is now more important for banks maximizing the risk-adjusted returns on equity, than looking out for worthy borrowers.

In the briefing “Ending the debt addiction”, “the implicit government guarantee that props up big banks” is identified as a distortion. But that implicit guarantee is made much larger, and regressive, by the fact that it can be leveraged much more when lending to the safe than when lending to the risky.

I am glad to see The Economist could favor “to abolish corporate tax entirely- and instead have one layer of tax levied on the income individuals receive from investments in firms. That is indeed something that I have often proposed, like in “My tax paradise”

Where I differ strongly with The Economist though, is when it refers to the lower tax revenues government receives because of the deductibility of interest on debts as “a cost in forfeited tax revenues”. Refer to it only as "lower tax revenues", instead of a “cost”, it can sometimes signify a benefit… for all. Besides how much tax is paid yearly because of the higher property values?

Analysis of current equity requirements for banks in light of ex ante perceptions of risks and ex post realities

The Kurowski Matrix:

1st: ex ante Risky – ex post Safe; the results for banks (and the economy) are Positive

2nd: ex ante Risky – ex post Risky; the results for banks can be Moderately Negative. The riskier the ex ante perceptions the smaller the ex post consequences.

3rd: ex ante Safe – ex post Safe; the results for banks are basically Neutral.

4th: ex ante Safe – ex post Risky; here the results for banks are Potentially Extremely Negative as the distance between the initial ex ante perception and the ex post sad reality can be the largest. 

And now the horrible truth!

The Basel Committee set their portfolio-invariant-credit-risk-weighted-equity-requirements for banks by far the lowest, for what was perceived as the safest assets, the 4th quadrant, precisely where the potential size of disaster is by far the largest. 

The Basel Committee committed that horrible mistake because they used the risks of bank assets, instead of the risks that banks would not be able to manage the risks of those assets. 

In other words the capital requirements for banks are based solely on ex ante perceived risks of assets and not on ex post observed risks for banks.

And their mistake was compounded by the fact they did not understand, or did not care one iota about, the fact that different equity requirements for different assets seriously distorts the allocation of bank credit to the real economy. 

Conclusion: It is clear the Basel Committee, and the Financial Stability Board, had no idea about what they were doing… and that they still don´t.

Unless they’re idiots, bank regulators, the Basel Committee, are total lunatics. You pick! To me they're both!

Regulators, like those of the Basel Committee and the Financial Stability Board, allow banks to hold much less equity when lending to a sovereign than when lending to a small businesses or an entrepreneur.

With that they are explicitly telling us they believe a government bureaucrat knows much more about how to deploy other peoples money efficiently for the society, than what the small business or the entrepreneurs know when they invest in their own projects… and, if so, I hold that to be sheer lunacy.

Of course, that is unless the regulators believe that the sovereigns are truly less risky for banks (and society) because sovereigns can always pay by collecting more in taxes, or having central banks print money… in which case it is pure idiocy.

Have your pick! Personally I think they have a lot of both!

Scene 6 on the crazy reality lived while “Banking in times of the Basel Committee”

Jr. Credit Officer Martin: “But Sir, how can we put this 30 years, 11 percent, lousily awarded mortgage into a security that aspires an AAA rating?” 

Bank President Wally: “Easy, let me explain it to you Martin. To put a proper AAA quality mortgage, with a proper interest rate into that security, would be absolutely useless, as it would generate no profits for us. But, if we put that very bad mortgage you refer to in a security, and manage to get an AAA rating for it, then we can resell it as earning solely a six percent return… and that would mean an instant profit to be share among us all of $210.000. Irresistible eh?” 

Jr. Credit Officer Martin: “But Sir, would not the bankers find out how bad these AAA rated securities were?” 

Bank President Wally: “Dear Martin, when you are allowed, by your regulator, to leverage your equity more than 60 times, only because an AAA to AA rating is present, and which means that if you believe you can make a 1 percent margin means you expect a 60 percent return on your equity, you do not make a lot of questions. You see, if the ratings only go down to the range of A+ to A, then banks can only leverage those securities less than 25 times. Imagine from more than 60 to less than 25!...

In fact Martin, it is the European banks and our US investment banks who are demanding these AAA securities so much that frankly we have to cut corners… don’t forget that we are a service company… and we do what our clients wants us to do... hi-hi-hi!”

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Here’s another crazy real life scene from “Banking in times of the Basel Committee”

Bank President Wally: "Colleagues, in order to obtain a higher risk adjusted return on our equity, it is more important to ascertain that the loans is perceived as safe, so that they require us to hold less equity against it, than to negotiate a higher interest rate with the borrower.

And so lets go out there and fight to find us those real low equity requirements that helps us maximizes our return to our shareholders (and our bonuses) because, if we don’t, you can be damn sure our competitors will."

Jr. Credit Officer Martin: "Hear, hear!"

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Here’s a crazy real life scene from “Banking in times of the Basel Committee”

Jr. Credit Officer Martin: “But Sir, I believe that borrower to be riskier than what the credit rating agencies and we perceive” 

Bank President Wally: “That might be Martin, but that possible extra risk is more than compensated by the fact that having to hold less equity against it, produces us anyhow a higher risk adjusted return on equity than many of our other loans… and so you better keep that perception to yourself… don’t forget our bonuses”

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I have a very specific question for President Obama on his State of the Unions address.

President Obama in his State of the Union Address — Remarks As Prepared for Delivery states:

“Will we accept an economy where only a few of us do spectacularly well? Or will we commit ourselves to an economy that generates rising incomes and chances for everyone who makes the effort?”

And which makes me ask: Are we supposed to keep bank regulations who so much favors the infallible sovereigns’ and the AAArisktocracy’ access to bank credit, when compared to that of the “risky” small businesses’ and entrepreneurs’?

To me it is amazing to see how much regulatory aversion against “the risky” exists in the home of the brave.

http://subprimeregulations.blogspot.com/2010/04/please-explain.html

http://subprimeregulations.blogspot.com/2013/11/have-risk-weights-of-current-bank.html

http://subprimeregulations.blogspot.com/2012/07/complaint-i-presented-to-consumer.html

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.

What to do when even describing it, an eminence like Martin Wolf is yet unable to see The Great Bank Distortion?

On page 251 of his “The shifts and the shocks” Martin Wolf writes: 

“But [bank] shareholders should only be interested in their risk adjusted returns. If taking on more risk does not raise risk-adjusted returns, shareholders should flee.”

But let me now give you the fuller version of what he writes:

So: "If taking on more risk [like lending to small businesses and entrepreneurs] “does not raise risk-adjusted returns, [because when doing so bank regulators require banks to hold more equity] “shareholders should flee”.

The result: No bank credit to “risky” small businesses and entrepreneurs.

And the other side of the coin would be: "If taking on less risk, like lending to the infallible sovereigns, the housing sector or to members of the AAAristocracy, does raise risk-adjusted returns, because when doing so bank regulators allow banks to hold much less equity, shareholders will love it.

The result: Too much bank credit to the infallible sovereigns, the housing sector and members of the AAAristocracy.

And Martin Wolf, on page 243 concludes that: “Risk-weighted assets can play a secondary role. That way one would have a ‘belt and braces’ approach: a strong leverage ratio, plus a risk–weighted capital ratio as a back-up.

And that he does because on page 251 he argues: “Risk-weighting is extremely unreliable, because the samples from which the weights are derived are always too small or irrelevant”. 

Wolf simply does not understand the dangerous distortion produced by risk weighting... even if the risk-weights are perfect. If perfect they would be perfectly cleared for in the interest rates, the size of bank exposures and all other contractual terms. To also clear for these perfect risk-weights in the capital, signifying a double counting of the perfect risk weights, is just sheer regulatory lunacy. 

“A ship in harbor is safe, but that is not what ships are for”, wrote John Augustus Shedd (1850-1926),.And that goes for our banks too.

And precisely because we all want our ships, or our banks, to sail as safe as possible to the ports we want them to sail to… the last think we should do… is what bank regulators, thinking themselves with 'fatal conceit' capable of being risk managers to the world did… namely to start tinkering with risk weights with their compasses. 

And so no Martin Wolf, not even as a back-up is there a role for credit risk weighted bank capital.

And if we really get down to what Wolf writes on page 252: "the disaster came from what banks wrongly thought to be safe", and which by the way is what all empirical evidence would point at as the usual suspect of causing bank disasters, then the capital requirements should be totally opposite; larger for what is perceived as absolutely safe and lower for what is perceived as risky.

In short, the number one "Macro-prudential Policy" that needs to be implemented, is to get rid of the current batch of distorting bank regulators. But, for that to happen, it is helpful that eminences, like Martin Wolf, also understands what is going on.

Bye bye Europe! Having introduced financial feudalism, Europe has gone back to the Middle Ages.

The AAAristocracy, those who posses or have access to an AAA rating; and the sovereigns, those who have declared themselves to be infallible have, with the witting or unwittingly cooperation of neo-vassal bank regulators, managed to introduce a system that guarantees them, more than ever, preferential access to bank credit.

That has been achieved by means of the portfolio invariant credit risk based capital, meaning equity, requirements for banks. More perceived credit risk - more equity; less risk - less equity. Because that insidious piece of regulation allow banks to earn more risk-adjusted returns on equity when lending to the AAAristocracy or when lending to the “infallible sovereign”, than when lending to the “risky”, like to small businesses and entrepreneurs.

And, as anyone should be able to understand, the more you subsidize the access to bank credit for some, in this case through regulations, the harder it is for those excluded to compete for it.

In short, a sort of financial feudalism has taken over Europe. 

And since that impedes fair access to bank credit, the land, to those Europe most needs to have it, its peasants, there is but one way it can go... and that is down down down.

And clearly this odious discrimination against the opportunities of the peasants, can only increase the inequalities in the society. 

But of course it will all come to an end, when the banks fail because of lending too much at too low rates, to a not so infallible sovereigns or to a false AAAristocrat... since that is why banks have always failed. Never ever have they failed by lending too much to peasants.

PS. It is not only Europe that is affected. The Basel Committee is spreading financial feudalism around the world... now even in America, "the land of the free", they have AAAristocrats... more precise yet AAArisktocrats

Current capital (meaning equity) requirements for banks are unethical, regressive, dangerous, stupid and promote inequality

Allowing banks to hold assets perceived as absolutely safe against much less capital (meaning equity) than against assets perceived as risky, allows banks to earn much higher risk-adjusted returns on bank equity when lending to the “absolutely safe” like the infallible sovereigns and the AAAristocracy, than when lending to the “risky”.

And that effectively hinders the fair access to bank credit of the “risky”… like that of the small businesses and the entrepreneurs.

And that effectively curtails opportunities and promotes inequalities.

And that odious regressive regulatory discrimination of the risky, as if these were not already sufficiently discriminated against, is unethical; and kills opportunities, which leads to ever increasing inequalities.

And that regulatory distortion is extremely dangerous since it impedes the banks to allocate credit efficiently, which means the real economy will, more sooner than later, stall and fall.

And finally it is all so useless and so stupid… because never ever has a major bank crisis resulted from excessive bank exposures to what was perceived as risky; these have all resulted from excessive exposures to what was erroneously perceived as absolutely safe.

G20, the Financial Stability Board does not know what it is doing, or is simply hiding a monstrous regulatory mistake.

“In Washington in 2008, the G20 committed to fundamental reform of the global financial system. The objectives were to correct the fault lines that lead to the global crisis and to build safer, more resilient sources of finance to serve better the needs of the economy”

That is how FSB on November 14, 2014 introduces its report to the G20 leaders titled “Overview of Progress in the Implementation of the G20 Recommendation for Strengthening the Financial Stability”

And the letter that accompanies it states: “The job of agreeing measures to fix the fault lines that caused the crisis is now substantially complete.” 

But the sad fact is that the report does not even mention what in my opinion constitutes the most important fault line, and in not doing so, makes it also impossible for banks to serve the needs of the economy.

As I see it that "fault line" was the Perceived Credit Risk Weighted Equity Requirements for Banks. Here follows my explanation:

Banks already clear for perceived credit risks (in the numerator) by means of interest rates, size of exposure and other terms of contract.

And so, when regulators cleared for the same perceived risks in the equity (more risk more equity – less risk less equity) they allowed banks to earn much higher risk adjusted returns on equity when lending to those perceived as “absolutely safe”, than when lending to those perceived as “risky”

The following are some examples of risk weights and leverages based on the original 8% equity requirement and that are indicated in the Basel II approved in June 2004.

Infallible sovereigns: zero percent RW, allowing infinite leverage.

Members of the AAAristocracy: 20 percent RW, allowing a leverage of 62.5 to 1.

Financing of houses: around 25 percent RW, allowing a leverage of 50 to 1

Medium and small businesses, entrepreneurs and start-ups, and citizens: 100 percent RW, allowing a leverage of 12.5 to 1.

And there is a perfect correlation between the troubled bank assets that caused the crisis, and the presence of ultralow capital requirements.

And this monumental distortion in the allocation of bank credit is not even mentioned.

Either the FSB has not understood the problem, or it is hiding the truth about this horrendous regulatory mistake.

And even from the perspective of medium term stability of banks, these regulations are absolutely useless. That is so since all really serious bank crises never result from excessive exposures to what is perceived as risky, but always from excessive exposures to what has erroneously perceived as “absolutely safe”. And so, if anything one could even argue the equity requirements should be totally the opposite, higher for what is perceived as “absolutely safe” and lower for what is perceived as “risky”. 

And these risk weighted equity requirements are impeding bank credit from reaching where it is most needed and therefore wasting all the liquidity support provided by QEs and similar programs.

Yes regulators will tell you that Basel III has the Leverage Ratio which is not risk-weighted. What they do not understand though is that raising the floor, only increases the pressure of those living close to the roof... namely "the risky".

Bank regulators who as we all have prospered thanks to the risk-taking of the banks of our parents, are now negating that risk taking to our children.

As a consequence our banks are now not financing the risky future, only refinancing the safer past.

Risk taking is the oxygen of development, and these regulators have no right whatsoever to believe with astonishing hubris they can be the risk-managers of the word, and go behind our back, calling it quit, and so making our economy stall and fall.

Conclusion: Basel III has NOT fixed the distortions in the allocation of bank credit. In some ways it has even made it worse. And, to top it up the risk-adverse regulatory monsters also want to go after the insurance sector.

God make us daring!

Comments on: IMF WP 14/169 "Reconsidering Bank Capital Regulation" Connel Fullenkamp and Céline Rochon

IMF Working Paper “Reconsidering Bank Capital Regulation: A New Combination of Rules, Regulators, and Market Discipline”, Connel Fullenkamp and Céline Rochon, September 2014.

Its abstract: 

“Despite revisions to bank capital standards, fundamental shortcomings remain: the rules for setting capital requirements need to be simpler, and resolution should be an essential part of the capital requirement framework. We propose a new system of capital regulation that addresses these needs by making changes to all three pillars of bank regulation: only common equity should be recognized as capital for regulatory purposes, and risk weighting of assets should be abandoned; capital requirements should be assigned on an institution-by-institution basis according to a regulatory (s,S) approach developed in the paper; a standard for prompt, corrective action is incorporated into the (s,S) approach.

Some brief comments:

1. For someone who like me has for more than a decade profoundly objected the whole concept of risk-weighted capital requirements for banks, a recommendation that “risk weighting of assets should be abandoned”, is of course very much welcomed.

But, that said, if the recommendation is not based on a total understanding of what is really wrong with risk-weighing, it is difficult to develop adequate remedies… and most specially to be able to transition from here to there, without causing serious and dangerous disruptions to banks and economy. 

And, unfortunately, that is the case with this paper. It is solely written from the very limited perspective of trying to make banks safe, ignoring banks’ fundamental role of allocating bank credit efficiently to the real economy.

Let me briefly resume my argument. Risk-weighing, based on credit risks which are cleared by banks through interest rates and amounts of exposure, and which result in lower capital requirements for holding assets which ex ante are perceived as safe when compared to assets which ex ante are perceived as risky; make banks able to earn much higher risk adjusted returns on “safe” assets than on “risky” asset; something which distorts and causes banks to lend too much and at too low rates to “the safe”, and too little and at too high relative interest rates to “the risky”.

And all this derives from the sad fact that nowhere in all current Basel bank regulations, do we find a word about what is the purpose of banks. “A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926.

For example the paper makes the comment: “Acharya et al (2013) provides evidence that risk weights are not the right tools to use in assessing the level of bank capital requirement”. But, that paper referenced only discusses the risk weights – those that cause different capital charges - in terms of the distortion they produce in the portfolio of banks, with no mention whatsoever of the, directly corresponding, distortions in the allocation of bank credit. That is evidenced when the Acharya paper comments “Also note that the portfolio distortion problem does not exist for banks that are only leverage-constrained since the additional charges are the same for all assets.”

Note: The existence of “additional charges” are there openly recognized and yet no one seems concerned about how these, by favoring “The Infallible”, would odiously discriminate against the fair access to bank credit of “The risky”.

2. And the proposed alternative: “capital requirements assigned on an institution-by-institution basis according to a regulatory (s,S) approach developed in the paper”, which is of course also based on ex ante perceived risks, if it does not start from defining the purpose of banks, and how to avoid the distortions in credit allocation, could even make these much worse.

3. The proposed alternative: “capital requirements assigned on an institution-by-institution basis”, no matter how much authors believe “our framework aims to significantly improve market discipline and focus it directly on the regulators”, is plain dangerous as it increases the discretionary powers of regulators, something that will, sooner or later, one way or another lead to abuse. 

“This will enable market participants to monitor regulators’ actions” What market participants? It really sounds like an insult to someone who has in vain tried to get an explanation for the “portfolio invariant ex-ante perceived credit risks and nothing but the portfolio invariant ex-ante perceived credit risks already previously weighted for, weighted capital (equity) requirements for banks”