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

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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. My letter to the Financial Stability Board

Charles Goodhart also pointed out the stupidity of risk weighted capital requirements for banks based on ex ante perceived risks… also with no luck!

In the very last page (540) of Charles Goodhart’s “The Basel Committee on Banking Supervision: A history of the Early Years, 1947-1997” of 2011 we read the following:

“Capital is supposed to be a buffer against unexpected loss: In so far as capital is required against unexpected loss, since expected loss should be handled by appropriate interest margins, the use of credit ratings as a guide to risk weights for capital adequacy requirements (CARs) is wrong and inconsistent, since these give a measure of expected loss. What is needed instead is a measure of the uncertainty of such losses, the second moment rather than the first.

If capital risk weights had been based, as they should logically have been, on the uncertainty attending future losses, rather than their expected modal performance, the financial system might have avoided much of the worst disasters of the 2007/08 financial crisis.

It remains surprisingly difficult to persuade regulators of this simple point.”

But to that Goodhart adds “It does however, get recognized from time to time”… though the examples he then indicates, are not so clear.

In the Epilogue (page 581) Goodhart list some of the failings of the BCBS’s regulations:

1. The lack of any theoretical basis.

2. The focus on the individual institution, rather that the system

3. The failure to reach an accord on liquidity;

4. The lack of empirical analysis;

5. The unwillingness to discuss either sanctions or crisis resolution, and so on.

That clearly adds up to a total regulatory failure... no wonder they don't want to discuss sanctions. 

But, unfortunately as I see it, Charles Goodhart, though absolutely right, is only scratching the surface. What is most dangerously ignored are the distortions in the allocation of bank credit to the real economy that these risk weighted capital requirements for banks cause.

Here is my own, also ignored, current brief aide memoire on the major mistakes with the risk weighted capital requirements

Current bank regulators should undergo a psychological test. They clearly seem to be afflicted by “false safety behavior”

I extract the following from “False Safety Behaviors: Their Role in Pathological Fear” by Michael J. Telch, Ph.D. 

“What are false safety behaviors? 

We define false safety behaviors (FSBs) as unnecessary actions taken to prevent, escape from, or reduce the severity of a perceived threat. There is one specific word in this definition that distinguishes legitimate adaptive safety behaviors - those that keep us safe - from false safety behaviors - those that fuel anxiety problems? If you picked the word unnecessary you’re right! But when are they unnecessary? Safety behaviors are unnecessary when the perceived threat for which the safety behavior is presumably protecting the person from is bogus.”

The risk weighted capital requirements for banks, more perceived risk more capital – less perceived risk less capital, fits precisely that of being unnecessary. If a risk is perceived the banker will naturally take defensive measures, like limiting the exposure or charging higher risk premiums. If there is a real risk that is of the assets being perceived ex ante as safe, but turning up ex post as risky.

The consequences of such false safety behavior by current bank regulators are severe:

They set banks up to having the least capital when the most dangerous event can happen, something very safe turning very risky. 

Equally, or even more dangerous, it distorts the allocation of bank credit to the real economy, it hinder the needed “riskier” financing of the future, like entrepreneurs, in order to finance the “safer” present, like house purchases and sovereigns.

It creates a false sense of security because why should anyone really expect that “experts” picked the wrong risks to weigh, the intrinsic risk of the asset, instead of the risk of the asset for the banking system.

I quote again from the referenced document:

“How do false safety behaviors fuel anxiety? 

There seems to be a growing consensus that FSB’s fuel pathological anxiety in several different ways. One way in which FSBs might do their mischief is by keeping the patient’s bogus perception of threat alive through a mental process called misattribution. Misattribution theory asserts that when people perform unnecessary safety actions to protect themselves from a perceived threat, they falsely conclude (misattribute) their safety to the use of the FSB, thus leaving their perception of threat intact. Take for instance, the flying phobic who copes with their concern that the plane will crash by repeatedly checking the weather prior to the flight’s departure and then misattributes her safe flight to her diligent weather scanning rather than the inherent safety of air travel.” 

In this respect stress tests and living wills could perhaps be identified as “unnecessary safety actions” the “checking of the weather”. 

Finally: “FSBs may fuel anxiety problems by also interfering with the basic process through which people come to learn that some of their perceived threats are actually not threats at all…threat disconfirmation…For this important perceived threat reduction process to occur, not only must new information be available but it also must be processed.”

The 2007/08 crisis provided all necessary information on that the risk weighting did not work, since all bank assets that became very problematic, had in common low capital requirements since they were perceived as safe. And this information has simply not been processed.

Conclusion, I am not a psychologist but given that our banking system operates efficiently is of utmost importance, perhaps a psychological screening of all candidates to bank regulators should be a must. Clearly the current members of the Basel Committee and of the Financial Stability Board, and those engaged with bank regulations in many central banks, would not pass such test.

I feel sorry for them, especially after finding on the web someone referring to "anxiety disorder" with: “I don’t think people understand how stressful it is to explain what’s going on in your head when you don’t even understand it yourself”

PS. Here is a brief summary of the mistakes of the risk weighted capital requirements for banks.

  

My tweets asking very courteously bank regulators for an explanation

Dear bank regulators, please explain your current risk weighted capital requirements for banks against these four scenarios:

1. Ex ante perceived safe – ex post turns out safe - "Just what we thought!"
2. Ex ante perceived risky – ex post turns out safe - "What a pleasant surprise! That's why I am a good banker"
3. Ex ante perceived risky – ex post turns out risky - "That's why we only lent little and at high rates to it."
4. Ex ante perceived safe – ex post turns out risky - "Now what do we do? Call the Fed for a new QE?"

Because, as I see it, from this perspective, your 20% risk weights for the dangerous AAA rated, and 150% for the so innocous below BB- sounds as loony as it gets.

Here are some of my current explanations of why I believe the risk weighted capital requirements for banks are totally wrong.

And below an old homemade youtube, published September 2010, on this precise four scenarios issue

Paul Krugman there's huge Excel type data mistake that is bringing the Western economies down into deep depression

Ref: http://economistsview.typepad.com/economistsview/2013/04/paul-krugman-the-excel-depression.html

The regulators of the Basel Committee for Banking Supervision, when designing their risk weighted capital requirements for banks made the outrageous mistake of looking at the specific risks of banks assets, and not at the risk of those assets to the banks, or to the bank system.

That is why they came to assign a whopping 150% risk weight to what is rated below BB-, something so risky that bankers wont even touch it with a ten feet pole; while only a minuscule risk weight of 20% to what is rated AAA and that because of its perceived safety, could cause banks to create such exposures that if ex post the asset turn out riskier, these could bring the whole system down.

That makes banks dangerously lend too much to what is perceived safe and for the economy equally dangerous too little to what is perceived as risky, like SMEs and entrepreneurs. 

The Western world has thrived on risk-taking not risk aversion.

PS. The 0% risk weighing of sovereigns is just as mind-boggling.

Nothing could be so dangerous as big data wrongly interpreted and manipulated

Regulators gathered data on credit risks and developed their risk weighted capital requirements for banks… more risk, more capital – less risk less capital.

But the data they were looking at was the ex-ante perceived credit risks, and not the ex-post possible risks after the ex-ante risks had been cleared for.

And therefore they never realized that what is most dangerous for the banking system is what is perceived very safe and could therefore create large exposures; while what is perceived as very risky is by that fact alone, made innocuous for the banking system

And as a consequence we have already suffered a big crisis because of excessive exposures to AAA rated securities backed with mortgages to the subprime sector; and millions of those risky young dreaming of an opportunity of a bank credit to prosper, have had to give up their dreams or pay higher interest rates that made them even riskier. 

So friends, always prefer well interpreted and well manipulated small data over mishandled big data.

What if traffic regulators, to make your town safe, limited motorcycles to 8 mph but allowed cars to speed at 62 mph?

The fatality rate per 100 million vehicle miles traveled in cars is 1.14

The fatality rate per 100 million vehicle miles traveled in motorcycles is 21.45

That could indicate that in terms of risks measured and expressed as credit ratings, the cars should be rated AAA, and motorcycles below BB-.

But in 2011, in the US, 4,612 persons died in motorcycle accidents.

And in 2011, in the US, 32,479 persons died in vehicle accidents.

That explains the differences between ex-ante perceived risk and the ex-post dangers conditioned by the ex-ante perceptions. Cars are more dangerous to the society than motorcycles, in much because the latter are perceived as much riskier.

But what did bank regulators do in Basel II, 2004?

By weighting for ex-ante perceived risks their basic capital requirement of 8%, they allowed banks to leverage 62.5 times to 1 when AAA-ratings were present, and 8.3 times in the case of below BB- ratings.

So, what if traffic regulators, in order to make your hometown safe, limited motorcycles to 8 mph but allowed cars to speed at 62 mph?

Do you see why I argue that current bank regulators in the Basel Committee and in the Financial Stability Board have no idea about what they are doing?

But it is even worse. We need SMEs and entrepreneurs to access bank credit in order to generate future opportunities for our kids. Unfortunately, since when starting out these usually have to drive more risky motorcycles than safe cars, our future real economy gets also slapped in the face. 

An 8% capital requirement translates into a 12.5 to 1 leverage. Why can’t our regulators allow banks to speed through our economy at 12.5mph, independently of whether they go by cars or motorcycles?

PS: Here is a more detailed explanation of the mother of all regulatory mistakes.

Regulators looking after the same risks bankers look at

Why are excessive bank exposures to what’s perceived safe considered as excessive risk-taking when disaster strikes?

In terms of risk perceptions there are four basic possible outcomes:

1. What was perceived as safe and that turned out safe.

2. What was perceived as safe but that turned out risky. 

3. What was perceived as risky and that turned out risky.

4. What was perceived as risky but that turned out safe.

Of these outcomes only number 2 is truly dangerous for the bank systems, as it is only with assets perceived as safe that banks in general build up those large exposures that could spell disaster if they turn out to be risky.

So any sensible bank regulator should care more about what the banks ex ante perceive as safe than with what they perceive as risky.

That they did not! With their risk weighted capital requirements, more perceived risk more capital – less risk less capital, the regulators guaranteed that when crisis broke out bank would be standing there especially naked in terms of capital. 

One problem is that when exposures to something considered as safe turn out risky, which indicates a mistake has been made, too many have incentives to erase from everyones memory that fact of it having been perceived as safe.

Just look at the last 2007/08 crisis. Even though it was 100% the result of excessive exposures to something perceived as very safe (AAA rated MBS), or to something decreed by regulators as very safe (sovereigns, Greece) 99.99% of all explanations for that crisis put it down to excessive risk-taking.

For Europe that miss-definition of the origin of the crisis, impedes it to find the way out of it. That only opens up ample room for northern and southern Europe to blame each other instead.

The truth is that Europe could disintegrate because of bank regulators doing all they can to avoid being blamed for their mistakes.

Here is one mystery in current bank regulations that regulators refuse to reveal to us.

That which has an AAA rating, meaning it is perceived as very safe, will of course have much access to bank credit, and be required to pay very low risk premiums. If those ratings then turn out to be wrong, sometimes precisely because since it was considered very safe too much credit was given to it, individual banks, and the bank system, face a very serious problem.

That which has a below a BB- rating, meaning it is perceived as extremely risky, has access to much less credit and, when it gets it, will be by paying much higher risk premiums. If those ratings turn out to be even worse, some individual bank might have a smaller problem, but the bank system as such, would face no problems at all.

But, an here is the mystery, bank regulators, with their Basel II, in June 2004, for the purpose of setting the capital requirements for banks, set a 20% risk weight for the AAA rated and 150% for what is below BB-.

Why so? If "safe" could be dangerous and "risky" is innocuous, could it not really be the other way around?

And that, since regulators refuse to explain it, is now, soon 13 years later, still a mystery to us

PS. Questions regulators refuse to answer

Has history known a worse and more dangerous case of confirmation bias than that of current bank regulators?

From Wikipedia:

Confirmation bias, also called confirmatory bias or myside bias,[is the tendency to search for, interpret, favor, and recall information in a way that confirms one's preexisting beliefs or hypotheses, while giving disproportionately less consideration to alternative possibilities. It is a type of cognitive bias and a systematic error of inductive reasoning. People display this bias when they gather or remember information selectively, or when they interpret it in a biased way. The effect is stronger for emotionally charged issues and for deeply entrenched beliefs. People also tend to interpret ambiguous evidence as supporting their existing position. Biased search, interpretation and memory have been invoked to explain attitude polarization (when a disagreement becomes more extreme even though the different parties are exposed to the same evidence), belief perseverance (when beliefs persist after the evidence for them is shown to be false), the irrational primacy effect (a greater reliance on information encountered early in a series) and illusory correlation (when people falsely perceive an association between two events or situations).

A series of experiments in the 1960s suggested that people are biased toward confirming their existing beliefs. Later work reinterpreted these results as a tendency to test ideas in a one-sided way, focusing on one possibility and ignoring alternatives. In certain situations, this tendency can bias people's conclusions. Explanations for the observed biases include wishful thinking and the limited human capacity to process information. Another explanation is that people show confirmation bias because they are weighing up the costs of being wrong, rather than investigating in a neutral, scientific way.

Confirmation biases contribute to overconfidence in personal beliefs and can maintain or strengthen beliefs in the face of contrary evidence. Poor decisions due to these biases have been found in political and organizational contexts:

The Basel Committee for Banking Supervision's and other bank regulator's confirmation bias. 

Regulators think, as they should, as it is, that what is rated below BB- is much more riskier than what is rated AAA. 

But when deciding on the risk weights to be used for the capital requirements of banks in Basel II of 2004, the regulators directly extrapolated from these beliefs and assigned 20% to the AAA rated and 150% to the below BB-. That is probably one of the most dangerous cases of confirmation bias in history.  Regulator should not have looked at the risk of the assets but at the risk of the assets to the banks, which is not the same thing.

The truth is that precisely because the below BB- is perceived as very risky, that makes it much less risky for the banks; while the AAA rated which is perceived as very safe, precisely because of such perceptions, is what could lead to those dangerously high bank exposures that can cause a huge bank crisis if the ex-post reality turns out to be different.

We are in 2017 and the regulators, because of "belief perseverance", have still not discovered their own confirmation bias… and that even after the mother of all evidences, represented by the AAA rated securities backed with mortgages to the subprime sector turning out to be so very risky.

That this was the fault of credit rating agencies is hugely irrelevant. The better the ratings are, the more confidence is deposited in these, and so the worse do the doomsday scenarios become.

Does anyone know a worse case of confirmation bias?

The dangers? First of course that banks will get caught with their pants down, little capital, precisely when one big exposure might get hit. But second, it introduced a senseless risk aversion that have banks no longer financing the riskier future but only refinancing the “safer” past and present… so our economies are stalling and falling.

PS. Are you still unsure of this? Then try to get the regulators to answer you these questions. 

PS. In this case it is not only regulators who suffer from “belief perseverance”. Prestigious and influential economists like Martin Wolf, even when being told that the safer is riskier and the riskier is safer, can’t get a grip on the issue.