Dear Ministers, you who are concerned with the real economy, during World Bank and IMF Spring Meetings 2013, ask your bank regulators for an explanation of the rationale behind capital requirements based on perceived risk.

Even though perceived risks were already cleared for by banks, in their numerator, on the asset side of the balance sheet, by means of interest rates, amount of exposure and other terms, their regulators, the Basel Committee, decided to clear for the same perceived risk, in the banks denominator, the liabilities and equity side of their balance sheet, by means of risk-weighted capital requirements.

And that doomed the banks to overdose on perceived risks, causing the current crisis, characterized by excessive bank exposures to what was supposedly “absolutely safe” while holding very little capital; and hindering the real economy from getting out of the crisis and generating the jobs we need, by discriminating against the bank borrowings of the “risky” economic agents, like medium and small businesses.

And now, soon six years after the crisis detonated, this issue of the distortion produced by the regulator's hand is not even discussed.

Here follows a more detailed explanation:

Current capital requirements for banks are much lower for what is perceived as “absolutely safe” than for what is perceived as “risky”.

And, as a result, banks are allowed to leverage their equity immensely more when lending to “The Infallible” than when lending to “The Risky”.

Just as an example, the banks in Cyprus and Germany, when financing small businesses in Cyprus or Germany could leverage 12.5 to 1 but, when buying bonds of Greece, 62.5 to 1… 50 times more!

And, as a result, banks make immensely higher expected risk-adjusted returns on equity when lending to “The Infallible” than when lending to “The Risky”. 

And, as a result “The Risky” need pay banks much higher risk premiums in order to make up for this regulatory competitive disadvantage. 

And as a result banks head with little capital towards dangerously excessive exposures to what always have caused bank crises, namely to “The Infallible” 

And as a result of this distortion by the regulator's hand, the most important actors on the margins of the real economy, namely “risky” small businesses and entrepreneurs do not have access to bank credit in competitive terms. 

And as a result millions of young people all around the world will never be able to have a job.

And as a result, the all important “risk-free rate” for which the borrowing rates of “infallible sovereigns” normally serves as proxies, does not indicate the “real-risk-free-rate” but a “subsidized risk-free-rate” instead.

And as a result of this odious discrimination the gap between the haves, the old, the history, “The infallible” and the have-nots, the young, the future, “The Risky”, only widens.

In summary our banks, more than de-regulated were misregulated.

And so ministers, please ask the regulators to explain to you the rationale behind the risk-weighted capital requirements.

And please, do not accept as an answer from your bank regulating anti-risk zealots, the “more-risk more-capital, less-risk less-capital, does that not sound logical?” mumbo jumbo, and much less, of course, “so that the banks can earn more return on their equity.

And please do not allow yourself to be distracted by an unpredictable “Black Swan” argument, this crisis was entirely manmade.

And if you are asking yourself “can experts really get it so wrong?” let me quote you George Orwell´s “one has to belong to the intelligentsia to believe things like that: no ordinary man could be such a fool”; or Patrick Moynihan´s "there are some mistakes it takes a Ph.D. to make”; or Axel Oxenstierna´s “An nescis, mi fili, quantilla prudentia mundus regatur?”

Ministers, as an ordinary citizen, I can only remind you of the fact that never would Hollywood, nor Bollywood, allow the same scriptwriters and directors who produced such an extraordinary flop like Basel II, to go ahead with Basel III… something which is now digging us even deeper into the hole, by introducing liquidity requirements for banks that are also much based on ex-ante perceived risks.

But also Ministers, again as an ordinary citizen, I need to ask you. Did you really authorize this little mutual admiration club called the Basel Committee for Banking Supervision to, with so little accountability, impose on the world de facto capital controls which has bank credit flowing massively to “The Infallible” and away from those who ex ante have been deemed to be “The Risky”?

And Ministers from countries rated BB+ or worse, be aware that you too are paying higher interest rates on your sovereign debt than what you would have to pay in the absence of this odious regulatory discrimination.

Am I saying there should be no capital requirements for banks? Absolutely not! And I do believe the basic 8 percent established in Basel II, would be sufficient and reasonable, if applied to all assets, and not diluted by risk-weights into so many close-to-nothing.

And if you absolutely cannot restrain regulators from interfering, and they must use weights to calculate capital requirements, why do you not ask them to, instead of basing these on silly credit ratings, think more in terms of basing these on job creation potential ratings, or environmentally friendly ratings?

I do acknowledge that Andy Haldane, the Executive Director for Financial Stability at the Bank of England, and Thomas Hoenig a director of the FDIC, have begun making some important comments questioning the wisdom of Basel’s current regulatory paradigm. Nevertheless, since the mistakes are so huge that even mentioning these could seem impolite towards those they could regard as colleagues, and so I dare say Ministers they could be in dire need of more of your direct and urgent support.

Let me also take this opportunity to ask the World Bank and the IMF:

Why does you research department not run a regression between all what had low capital requirements for banks because it was perceived as “absolutely safe”, and all bank exposures which caused the current crises?

Do you know of any major bank crisis that has resulted from excessive bank exposures to what was perceived as risky and not to what was erroneously perceived to be safe?

If banks are given such extraordinary incentives to finance what is “absolutely safe” and to stay away from what is “risky”, who do you suggest should finance “The Risky”, government bureaucrats, widows and orphans?

World Bank, do you really not understand why in churches of some developed countries psalms praying “God make us daring!” are sung? Do you really think development is a risk-free affair?

What will it take to end poverty? #ittakes a lot of risk-taking, of all sort, often even dumb; and of staying away from stupidly excessive regulatory prudence... in other words the world, especially its poor, is in dire need of more reasoned audacity.

IMF, the current capital requirements generate regulatory subsidies to the “infallible sovereign”, and which are mostly paid by “The Risky” when accessing bank credit. If that had been calculated and made known, then perhaps the current crisis would never have happened. I therefore ask your “Revitalizing the Fiscal Transparency Agenda” to include an effort to identify and value these type of quite obscure regulatory favors and disfavors.

Mme Lagarde, in a Civil Society Town Hall Meeting at the IMF, September 2011 I asked whether you did not think it was important for the regulators to define the purpose of the banks before regulating, and you agreed. What has happened with that? We now ask of central banks to include job creation as one of their objectives, but why do we not ask that of our banks? 

And who am I?

Per Kurowski, someone who in 1999 in an Op-Ed wrote “The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause its collapse” 

Someone who had the honor of serving as an Executive Director in the World Bank for two brief years, 2002-2004, who then loudly protested the introduction in Basel II of the systemic risk of credit ratings, and who, in October 2004, in a written statement at the Board warned: “I believe that much of the world’s financial markets are currently being dangerously overstretched, through an exaggerated reliance on intrinsically weak financial models, based on very short series of statistical evidence and very doubtful volatility assumptions”. 

In other words, I am someone who suffers from the misfortune of having been unbecomingly right.

And if by any chance any bank regulator comes up with a rational explanation for their concoctions, please send it to me, and, if they prove to be correct, I would, as they say, have to eat my hat and much humble pie.

Am I too aggressive here? I guess so. But it is hard not to be, after so many years of polite criticism has not even brought out the issue of how these capital requirements distort into the discussions. How many times have you heard that argument discussed?

And for crying out loud, these regulators are endangering the world of my grandchildren, and no loving grandfather should take that lightly.

perkurowski@gmail.com

My comments for IMF's revision of its "Code of Good Practices on Fiscal Transparency"

Washington, February 4, 2013

International Monetary Fund

Dear Sirs,

You hold that “Fiscal transparency – defined as the clarity, reliability, timeliness, and relevance of public fiscal reporting and the openness to the public of government’s fiscal policy-making process - is a critical element of effective fiscal policymaking and risk management. Without comprehensive, reliable and timely fiscal information, governments cannot understand the fiscal risks they face or make good budget decisions. If citizens don’t have access to this information, they cannot hold governments accountable for those decisions.”

And the IMF, now seeking comments for the revision of its Code of Good Practices on Fiscal Transparency and related instruments specifically asks:

“Does the Code adequately address all of the most important aspects of fiscal transparency? What practices should be dropped? What practices should be added? Which practices should be updated to reflect recent developments in fiscal reporting standards and practices or the lessons learned from the crisis?”

In this respect I would submit that any “Good Practice on Fiscal Transparency” should also look to identify the presence of any hidden subsidies and or taxes that might affect government’s fiscal affairs, and, if possible, provide estimates as to their significance.

Specifically I refer to the fact that current bank regulations require banks to hold much more capital against assets perceived as risky, like loans to small businesses and entrepreneurs, than for assets perceived as “absolutely safe”, like loans to “infallible sovereigns”.

This translates into that a bank can leverage its equity man y time more the dollars paid by “the infallible sovereign” in risk-adjusted interests, than the same risk-adjusted dollars paid by “the risky”.

That translates directly into a regulatory subsidy of the government’s bank borrowings, paid by “the risky bank borrowers” by means of higher interest rates, and paid by the society at large by means of the opportunity cost that might be present in allowing the public sector to borrow much easier and much cheaper than the “risky” private sector, than what would have been the case in the absence of this regulations.

That translates into giving banks incentives to dangerously overpopulated safe-havens, and equally dangerous for the real economy, under explore some more risky but perhaps more productive bays; something which of course introduces a distortion that makes it impossible for banks to perform their utterly important function of allocating economic resources efficiently.

That also translates into that one of the most important theoretical rates there is in finance, the risk-free rate, usually approximated by the rate to the “most infallible sovereign” is a subsidized rate and which of course makes it impossible for the government and the markets, to know where the real risk free rate is. In other words one of the fundamental instruments needed to navigate the economy gives wrong readings.

Since there are also sovereigns who are deemed not so infallible and so against their borrowings banks are required to hold more capital, this also translates into an effective global capital control that helps to channel funds away from what is ex-ante perceived as risky into what is ex ante perceived as infallible. In other words these capital controls only help to increase the existing gaps between “the risky developing” and the “infallible developed”.

In conclusion I ask of the IMF to try to estimate all the fiscal effects of what is described above, or to respond publicly why in IMF’s opinion my arguments might be wrong, or plain irrelevant.

Sincerely,

Per Kurowski

A former Executive Director at the World Bank (2002-2004)