How does the Law of Unanticipated Consequences apply to risk weighted bank capital requirements?

There’s Murphy’s Law type unanticipated consequences: “What Can Go Wrong, Will Go Wrong”; and there are perverse effects that result in the opposite of what was intended. 

And then there is Robert K. Merton’s, Law of Unanticipated Consequences. This one identifies five principle causes of unanticipated consequences: 

Ignorance, making it impossible to anticipate everything, thereby leading to incomplete analysis.

Ignorance? Yes, but much spiced up with that abundant hubris that made regulators believe that they, from their desks, and with the help of some few human fallible credit rating agencies, could get a grip on what the risks for bank systems are. 

Errors in analysis of the problem or following habits that worked in the past but may not apply to the current situation.

Errors? Many but perhaps none worse than the following:

1. Risk weights 0% the government and 100% citizens, as if bureaucrats know better what to do with credit for which repayment they're not personally responsible for than e.g., small businesses and entrepreneurs.

2. Fixating on the perceived credit risks and not on the risks conditioned to how the credit risks are perceived.

3. Ignoring how dangerously procyclical these bank capital requirements would be.

Immediate interests overriding long-term interests.

Immediate interests? Absolutely, and perhaps none as clear as that valiantly but sadly so late confessed one by Paul Volcker “The assets assigned the lowest risk, for which bank capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages.”

Basic values which may require or prohibit certain actions even if the long-term result might be unfavourable.

Basic values? Can’t think of anyone except of course that “it’s not come-il-faut to question your colleagues”, and which tends to prevail in all mutual admiration clubs defending the jobs of their members.

Self-defeating prophecy, or, the fear of some consequence which drives people to find solutions before the problem occurs, thus the non-occurrence of the problem is not anticipated.

Self-defeating prophecy? Perhaps, in terms of listening too much to Monday Morning Quarterback besserwisser prophets. The morning after a crisis they describe in detail the risky assets. What they never mention before the crisis, is with what "safe" assets those dangerous bank exposures are being built-up with. 

And the Academia says nothing

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.

A safer banking system compared to our current dangerously misregulated one with so many systemic risks on steroids

What is a safer banking system?

One in which thousand banks compete and those not able to do so fail as fast as possible, before some major damage has been done, while even, as John Kenneth Galbraith explained, often leaving something good in their wake. 

What is a dangerous banking system?

One were all banks are explicitly or implicitly supported, by taxpayers, as long as they follow one standard mode that includes living wills, stress tests, risk models, credit ratings, standardized risk weights... all potential sources of dangerous systemic risks.

A bank system in which whenever there is a major problem, the can gets kicked down the road with QEs and there is no cleaning up, and banks just get bigger and bigger.

One that make it more plausible that the banks will all come crashing down on us, at the same time, with excessive exposures to something ex ante perceived safe that ex-post turned out risky, and therefore the banks holding especially little capital.

But you don’t worry; the regulators have it all under control with their Dodd-Frank’s Orderly Liquidation Authority (OLA). “Orderly”? Really?

So that is why when I hear about banks “cheating” with their risk models I am not too upset, since that at least introduces some diversity. 

Also that cheating stops, at least for a while, the Basel Committee regulators from imposing their loony standardized risk weights of 20% for what has an AAA rating, and so therefore could be utterly dangerous to the system; and one of 150% for the innocuous below BB- rated that bankers don’t like to touch with a ten feet pole.

How did we end up here? That is where you are bound to end up if you allow some statist technocrats, full of hubris, to gather in a mutual admiration club, and there engage into some intellectually degenerating incestuous groupthink.

Statist? What would you otherwise call those who assign a 0% risk weight to the Sovereign and one of 100% to the citizen?

And it is all so purposeless and useless!

Purposeless? “A ship in harbor is safe, but that is not what ships are for”, John A Shedd

Useless? “May God defend me from my friends, I can defend myself from my enemies”, Voltaire

In essence it means that while waiting for all banks to succumb because of lack of oxygen in the last overpopulated safe-haven available, banks will no longer finance the "riskier" future our grandchildren need is financed, but only refinance the "safer" present and past.

In April 2003, as an Executive Director of the World Bank I argued: "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."

PS. FDIC... please don't go there!

Note: For your info, before 1988, we had about 600 years of banking without risk weighted capital requirements for banks distorting the allocation of bank credit to the real economy.

PS. The best of the Financial Choice Act is a not distorting, not systemic risks creating, 10% capital requirement for all assets. Its worst? That this is not applied to all banks.

PS. If I were a regulator: Bank capital requirements = 3% for bankers' ineptitude + 7% for unexpected events = 10% on all assets = Financial Choice Act
 

IMF does still not understand how the risk weighted capital requirements for banks distort. Why? Groupthink?

IMF’s Global Financial Stability Report 2017 on page 43 and 44 Box 1.2. “Regulatory Reform at a Crossroads” states:

Finalization of the Basel III package of reforms— the revision of the “standardized” approach to the calculation of risk-weighted assets and limits on the use of internal models to assess risks—appears to have faltered… The outstanding challenge is to reconcile views on the weight to attach to each element, particularly to the balance between reliance on internal models and constraint through the calibration of the floor [based on a standardized approach]”

So regulators wants to reconcile between:

Use of internal risk models, which is basically similar to allowing Volkswagen to calculate their own carbon emissions. 

Using the standardized approach designed by regulators and which included, for instance risk weights of only 20% for what is perceived very safe, like what’s AAA rated, and which precisely because of that perception can lead banks to build up dangerously large exposures; and a 150% risk weight for what is rated below BB-, something to which banks would never dream to expose their balance sheets much to.

We all know that minus times minus leads to a positive number but does reconciling one craziness with another craziness lead to a sane regulation. NO!

Box 1.2 also includes: “countries outside the central standards-setting bodies [in particular emerging markets]…rely heavily on a strong global standard to level the playing field and support financial stability”

Question: Does allowing the safe to have better access than usual and the risky less than usual really signify to “level the playing field”?

Box 1.2 concluding states: “Completion of the reforms is vital to address previously identified fault lines and thus ensure that the global financial system is safe and can promote economic activity and growth.”

Congratulations! I believe this is the first time I have read from somebody close to the regulators, as IMF is, that besides “safe and resilient”, the banking system needs also to “promote economic activity and growth.”

It is truly sad this comes at such a late stage. Anyone wanting banks to promote economic activity and growth, would never have accepted the risk weighted capital requirements for banks, as these dangerously distorts the allocation of credit to the real economy. 

So clearly, IMF still has much internal analysis to do before they get there. I hope its groupthink allows it.

Stiglitz doesn’t understand that regulators, when doubling down on credit risk perceptions, are bullying those perceived as “risky”

Joseph E. Stiglitz together with George A. Akerlof and A. Michael Spence won the 2001 Nobel Prize in Economics "for their analyses of markets with asymmetric information". The Nobel Prize website indicates that in the case of Professor Stiglitz his contribution was to show “that asymmetric information can provide the key to understanding many observed market phenomena, including unemployment and credit rationing.”

In a 1998 paper by Thomas Hellmann and Joseph Stiglitz titled “Credit and equity rationing in markets with adverse selection” we read: "The meaning of rationing: “Those entrepreneurs who are willing to accept the higher price are rationed in the sense that they cannot obtain funds at the same price as other observationally identical entrepreneurs. Those entrepreneurs who are not willing to accept the higher price fail to receive funding in this market. Some of them may seek funding in the other market. If there is rationing in the other market too, they may fail to obtain any funding. Even if there is no rationing some of them may not find any acceptable offer in the other market, and again they are left without funding. The point is that while an outside observer may look at this environment and argue that there are many opportunities for the entrepreneur to obtain funding, it may well be that the funding that is still available comes at unacceptable terms, and the funding that has acceptable terms is rationed." 

And in his most recent book “Re-writing the rules of the American Economy” 2016, in the “Fix the Financial Sector”, Stiglitz writes “it is regrettable that almost all of the discussions of reforming the financial sector have focused on simply preventing harm on the rest of society and not in developing a financial system that actually serves our society- for instance by helping to effectively finance small business, education and housing”.

Yet in his very long and somewhat questionable what-to-do list, Stiglitz does not include getting rid of the pillar of current bank regulations, the risk-weighted capital requirements for banks, those by which regulators bully those who are usually perceived as risky borrowers.

By allowing banks to leverage more with what is safe than with what is risky, banks now earn higher risk-adjusted returns on equity when lending to the safe than when lending to the risky… with all its logical consequences.

I have read Professor’s Stiglitz cv. (boy!) and in it I find absolutely nothing that indicates he has ever walked on main-street. So most probably he therefore knows nothing about the difficulties of SMEs and entrepreneurs have to access bank credit. These borrowers, perceived as risky, quite often have to cheat, lie, or at least withhold the whole truth, or even bribe someone, in order to get the opportunity they believe can transform their lives and that of their children. 

And all those difficulties were present even before regulators told the banks that, besides clearing for ex-ante perceived credit risks by means of risk premiums and amounts of exposure, they also had to clear for the same perceived risks in the capital. 

One should expect someone that has won a Nobel Prize researching “credit rationing” to know that any perceived risk, an information, even if perfectly perceived, leads to the wrong conclusions, if excessively considered. But apparently it is not so.

The current risk weight of an unrated SME or entrepreneur, “We the people”, is 100%. The corresponding risk-weights for the Sovereign is 0%, for the members of the AAArisktocracy 20% and for the financing of houses 35%.

For instance the 100% for SMEs and the 35% for houses will cause we end up in houses without the jobs to pay the mortgages and utilities.

For instance the 0% for the sovereign and the 100% for We the People means that regulators believe government bureaucrats can use bank credit better than citizens... an outrageous statism.

Stiglitz has also aspired to a lot of fame as a champion against inequality… but, though he won the “John Kenneth Galbraith Award, American Agricultural Economics Association, August 2004” perhaps he should have included in his academic library John Kenneth Galbraith’s “Money: “whence it came, where it went” (1975). There on job creation and fighting inequality we read:

“For the new parts of the country [USA’s West]… there was the right to create banks at will and therewith the notes and deposits that resulted from their loans…[if] the bank failed…someone was left holding the worthless notes… but some borrowers from this bank were now in business...[jobs created] 

It was an arrangement which reputable bankers and merchants in the East viewed with extreme distaste… Men of economic wisdom, then as later expressing the views of the reputable business community, spoke of the anarchy of unstable banking… The men of wisdom missed the point. The anarchy served the frontier far better than a more orderly system that kept a tight hand on credit would have done…. what is called sound economics is very often what mirrors the needs of the respectfully affluent.

The function of credit in a simple society is, in fact, remarkably egalitarian. It allows the man with energy and no money to participate in the economy more or less on a par with the man who has capital of his own. And the more casual the conditions under which credit is granted and hence the more impecunious those accommodated, the more egalitarian credit is… Bad banks, unlike good, loaned to the poor risk, which is another name for the poor man.”

Professor Stiglitz was the Chairman in the Commission of Experts of the President of the UN General Assembly on Reforms of the International Monetary and Financial System 2008 and 2009.

And, during the 2007 High-level Dialogue on Financing for Developing at the United Nations, from the perspective of the developing nations, I protested this regulatory risk aversion but no one really wanted to listen. 

And so when it all came down to the conclusions of the UN Conference Crisis & Development I suffered great disappointments.

I have said before and I repeat it again and again. Nobel Prizes should be recallable, especially if they are used for uttering opinions on matters the winners have no idea about… like bank regulations and Main Streets. Besserwissers from mutual-admiration-group-thinking-clubs monopolizing discussions, are just too costly for the future of our kids and grandchildren

The most important behavioral, cognitive psychology, research program ever

Bank system crises never ever result from excessive exposures to what is perceived as risky, these always results from the buildup of excessive exposures to what was ex ante perceived as safe.

And yet bank regulators imposed on banks credit-risk-weighted equity requirements that are much higher for what is perceived as risky than for what is perceived as safe.

That is very clearly a monstrous mistake. It means that is something really bad happens to banks where that usually happens, regulators have made sure banks will stand there especially naked, with no equity to cover themselves up with. 

And my thesis is that the at-first-sight, Daniel Kahneman's “System 1: Fast, automatic, frequent, emotional, stereotypic, subconscious” standard basic intuition of “risky-is risky and safe-is safe”, is way too strong so as to permit opening a more reflective “System 2: Slow, effortful, infrequent, logical, calculating, conscious” analysis… and this most specially if that means questioning some other members of a mutual-admiration/ mutual-importance-reinforcement club. 

And that is the subject I would like to see researched by experts in behavioral finance and in cognitive psychology.

But why do I call this “the most important research program ever”?

Easy! Those regulations allow banks to leverage the back-stop supports that for instance central banks give more on assets perceived as safe than on assets perceived as risky; and that means banks will obtain higher risk-adjusted returns on their equity on assets perceived as safe than on assets perceived as risky.

That has introduced a regulatory risk aversion that seriously distorts the allocation of bank credit to the real economy.

And since risk-taking is the oxygen of any development, and what helped to bring the Western world to where it is, suspending it, de facto prohibiting banks from taking risks on the “risky”, our economies will first stall and then fall. And I hope you’d agree that’s not entirely unimportant.

Reading Daniel Kahneman's "Thinking Fast and Slow"
https://www.americanbanker.com/opinion/basel-iii-doubles-down-on-basel-iis-mistake

PS. Confirmation Bias

Houston, we’ve got a problem: The IMF is lost in space.

The IMF has just published their Global Financial Stability Report: Chapter 3 is titled: The Reform Agenda: An interim report on progress toward a safer financial system, and Chapter 4: Changing Global Financial Structures: Can they improve economic outcomes? 

Even though the report mentions “the banks’ likely increase in their allocation to safer but low-yielding assets to accommodate regulatory requirements” it completely fails to understand the distortions that precisely this causes in the economy. In fact, the word distortion does not even appear in the report. 

And, if there is anything current regulations have done, that is to distort the economic efficient resource allocation so much, by favoring banks holding assets that ex-ante are perceived as “not-risky”, against banks holding assets that ex-ante are perceived as “risky”. 

Basel II allowed a bank to leverage its equity 62.5 to 1, if the asset had an AAA rating, but only 12.5 to 1, if it was unrated. And which means that the profitability for banks, their return on equity, when holding “not-risky” assets, becomes much higher than when holding “risky” assets, like loans to small businesses and entrepreneurs. And, if this is not hugely distortive, I do not know what is. 

Distortive, and utterly useless… since we know that no major bank crisis ever, has resulted from banks holding excessive assets that, when acquired, were perceived as “risky”, these have all resulted, no exceptions, from banks holding excessive assets that, when acquired, were perceived as "absolutely not-risky".

IMF does a lot of empirical research, but the research they have completely failed to do, is to run a simple regression between all the current problem assets, and the fact that these were ex-ante perceived as “not-risky”, and so therefore the banks were allowed to hold much less bank equity. That should have given them a clue.

And so, about five years after the beginning of the crisis, the IMF does yet not understand why a crisis that was doomed to happen, because of plain dumb regulations, happened. 

The Independent Evaluation Officer of the IMF (IEO) in their report “IMF Performance in the Run-Up to the Financial and Economic Crisis: IMF Surveillance in 2004-07” of 2011 wrote: 

“The IMF’s ability to correctly identify the mounting risks was hindered by a high degree of groupthink, intellectual capture, a general mindset that a major financial crisis in large advanced economies was unlikely, and inadequate analytical approaches. Weak internal governance, lack of incentives to work across units and raise contrarian views, and a review process that did not “connect the dots” or ensure follow-up also played an important role, while political constraints may have also had some impact.” 

It would sure seem that no one in IMF read that report. What a shame!

PS. And by the way Houston we've got another serious problem too

I am so disappointed with conservative, progressive and of course middle of the road think-tanks.

The minimum capital requirements for the banks drafted by the Basel Committee and that apply or inspire most bank regulations in the world establishes that if a bank gives a loan to a normal entrepreneur who does not have a credit rating then it needs 8 percent in capital; if the loan is to a client with an AAA rating then 1.6 percent in capital will do and if it is a loan to its government then there is no capital requirement at all.

Dear libertarians/conservatives.

Eight percent in capital when lending to a citizen and zero when lending to the government…does this not upset you?

Is not risk taking what keeps a society moving forward? Is not taxing risks and subsidizing risk adverseness something like having your country lie down and die?

Do you not find it crazy that some few credit rating agencies, even if private, shall have so much to say in orientating the capital markets and messing up the risk allocation systems?

Dear progressives.

Eight percent in capital when lending to an ordinary citizen and 1.6 percent when lending to a company rated AAA… do you agree with such discrimination? Does not the AAAristocracy have enough advantages already?

Don´t you know that AAA ratings in just a couple of years drove more capitals to the US housing market than all the loans given by the World Bank and the IMF ever since they were founded? How come you can applaud silly initiatives like Banco del Sur when obviously a Credit Rating Agency del Sur seems to carry so much punch nowadays?

Low capital requirements just because someone has got an AAA rating and is supposedly risk free… and what about the purpose of the loans should not that count too?

Dear middle of the roaders.

All of the above plus:

Think about it, even if the credit rating agencies had been perfectly right in their assessments what would the country have gained… more mortgages to ever bigger houses?… more financing from abroad in order to keep on buying even more imports?

The way you kids growing up with GPS might never know what north, south, east and west means… do you want your bankers just to follow credit rating agencies opinions and never learn themselves about analyzing a client, looking him in the eyes and shaking his hand?

Do you really want to have your financial sector watched over by regulators so naive and gullible that they did not know that sooner or later the credit rating agencies that they empowered so much would be captured?

No, all of you think tanks!… what´s wrong with you?…. Too lazy to even read the Basel Epistles that governs most of your current financial regulatory system? As a fact, from all of the books articles comments and other ways of expression we see from those selling themselves as experts on the crisis, there is clear evidence that 99 percent of them have not even read an abridged version of what is contained in Basel II.

Or are you all just a bunch of baby-boomers who follow whoever promises most to avoid risks, while you are around, placing your reverse mortgage of the world and shouting “Après nous le deluge”? If so, shame on you all!