#AI OpenAI ChatGPT: Do risk weighted bank capital/equity requirements generate qualitatively different GDP’s?

I asked ChatGPT:

Does one bank capital/equity requirement against all assets, a leverage ratio, generate the same allocation of bank credit to the economy as with risk weighted bank capital/equity requirements? Please answer Yes or No. 

ChatGPT answered:

No.

I asked ChatGPT:

Could that classify as a distortion? Please answer Yes or No.

ChatGPT answered:

Yes.

I asked ChatGPT:

Would that distortion be compatible with what’s normally referred to as a free market? Please answer Yes or No. 

ChatGPT answered:

No.

I asked ChatGPT:

Could that distortion generate qualitatively different GNP’s or GDP’s? Please answer Yes or No.

ChatGPT answered:

Yes.

I asked ChatGPT:

Has that distortion been sufficiently discussed and considered by e.g., regulators, academia, central banks, congress, financial experts and main street media? Please answer Yes or No.

ChatGPT answered:

Yes.

I asked ChatGPT:

Since you answer "Yes", what has been their conclusions?

ChatGPT answered:

"I don't have real-time information on specific conclusions or discussions that may have occurred since my last training cut-off in January 2022. Financial regulations and discussions on capital requirements are complex and can vary by country and jurisdiction. It's advisable to consult more recent and specific sources, such as regulatory reports, academic papers, or news articles, to understand the latest developments and conclusions in this area."

I asked ChatGPT:

If so how can you argue that distortion has been sufficiently discussed and considered?

ChatGPT answered:

"I don't have real-time information on the extent or depth of discussions on specific financial distortions or regulatory issues since my last update in January 2022. The assertion that a distortion has been sufficiently discussed and considered is based on the general understanding that regulatory bodies, academics, central banks, and financial experts regularly engage in discussions and assessments of the financial system.

However, the level of discussion, consideration, and agreement can vary, and it's important to note that the effectiveness of discussions and their outcomes may be a matter of ongoing debate. Additionally, opinions on whether a particular distortion has been adequately addressed or not may differ among different stakeholders. For the latest and most accurate information, it's recommended to consult current sources and reports from relevant authorities and experts."

I asked ChatGPT:

Should a grandfather prefer his grandchildren to grow up in an economy in which banks take plenty of risks with loans to small businesses and entrepreneurs, or in one in which these lend mostly to safe government debt and residential mortgages? Please answer Yes or No.

ChatGPT answered:

This question involves subjective judgment and depends on one's perspective. There isn't a universally correct answer. It depends on the individual's values, priorities, and beliefs about economic policy. Therefore, I cannot provide a simple "Yes" or "No" answer.

Thanks!

You're welcome! If you have any more questions or if there's anything else I can help you with, feel free to ask.

Note: The answers are copied exactly from those given to me by OpenAI

Some older notes:

Have regulators imposed a lousy diet of bank credits with way too much carbs and way too little proteins?

Can IMF/World Bank develop a Body Mass Index for GDP? 

Here my many other questions to ChatGPT – OpenAI on bank regulations

#AI ChatGPT – OpenAI: What should be expected by allowing banks to leverage more with residential mortgages than with small business loans?

I asked OpenAI:

"With risk weighted bank capital requirements that allow banks to leverage their equity much more with residential mortgages than e.g., with loans to small businesses and entrepreneurs, what expected effect should this have on the price of houses?"

OpenAI answered:

"When risk-weighted bank capital requirements allow banks to leverage their equity more with residential mortgages compared to loans to small businesses and entrepreneurs, it can potentially have an impact on the price of houses. However, it is important to note that the relationship between bank capital requirements and house prices is complex and influenced by various factors.

1. Increased availability of mortgage credit: If banks are incentivized to allocate more capital to residential mortgages due to favorable risk weights, it can lead to increased availability of mortgage credit. This can potentially stimulate demand for housing as more individuals are able to secure financing for home purchases.

2. Higher demand for housing: Increased availability of mortgage credit can lead to higher demand for housing, which, in turn, can put upward pressure on house prices. If more buyers are competing for limited housing supply, prices may increase as a result.

3. Potential housing market imbalances: If the demand for housing outpaces the supply, it can create imbalances in the housing market. This can lead to higher prices, reduced affordability, and potential risks of a housing bubble in certain regions.

4. Impact on small businesses and entrepreneurs: If banks are allocating less capital to loans for small businesses and entrepreneurs due to less favorable risk weights, it may limit their ability to access financing. This can impact their growth and investment potential, which, in turn, may have broader economic effects.

It's important to consider that the relationship between risk-weighted bank capital requirements and house prices is influenced by a range of factors, including overall economic conditions, housing supply dynamics, government policies, and regulatory frameworks. These factors can interact in complex ways, making it difficult to isolate the specific impact of capital requirements on house prices.

It's worth noting that policies and regulations related to mortgage lending and capital requirements are subject to ongoing evaluation and revision. Authorities seek to strike a balance between promoting access to housing finance and managing risks in the financial system.

To assess the specific effects of risk-weighted bank capital requirements on house prices, it would be necessary to conduct comprehensive analyses that consider these various factors and take into account the specific dynamics of the housing market in a given context."

Note: The answers are copied exactly from those given to me by OpenAI

Here my many other questions to ChatGPT – OpenAI on bank regulations

PS. In that real class war (that which shall not be named) between those who have houses as investment assets, and those who just want affordable homes, where do you all stand?

Your Honor, can I sue the bank regulators?

Your Honor, 

My small riskier less creditworthy business always got less credit and paid higher interest rates than the more creditworthy, and that was ok. 

But the regulators, with their risk weighted bank capital requirements, also decreed it to be less worthy of credit and, since it now has to compensate the banks for these not being able to leverage as much their capital/equity as much as they can with other “safer” assets, they made it get even less credit and pay even higher interests. 

Can I sue them?

On the morality of current banker's decisions

A banker confronts a choice:

On one hand, Alt. A, a number of not so creditworthy borrowers who are asking for small loans, accepting to pay what could rightly be deemed a bit higher interest rate than what the risk adjusted interest rate should be.

On the other hand, Alt. B, a very creditworthy borrower, that is asking for a very large loan, at a rate lower than what an adequate risk adjusted interest rate should be.

Years ago, the banker would gladly gone for Alt. A, but, after the introduction of risk weighted bank capital requirements, which mean banks can leverage much more with what’s more creditworthy than with what’s less so, means the bank would obtain a higher risk adjusted return on its equity with Alt. B.

A banker has to pick Alt B. or he’s toast… and so he picks it… (that is unless he would not want to be a banker any more… and instead, like George Banks, go and fly a kite)

In reference to Per Bylund’s twitter thread on “morality of actions”, how would you classify the banker’s action.

Here a simple as can be one-minute explanation of the distortions produced by the risk weighted bank capital requirements in the allocation of credit to the real economy.

For 600 years, before the Basel Accord of 1988, banks, with an eye to their overall portfolio, allocated their assets/credits depending on the perceived risk adjusted return these were to produce.

For instance, if a safe AAA to AA rated asset at 4% interest rate and a riskier asset rated BBB+ to BB- a 7% interest were, in the mind of the banker, both producing an acceptable 1% net risk adjusted return, he could pick either one or both. If banks were allowed (by markets or regulators) to leverage their assets 12.5 times, that would produce the bank a 12.5% risk adjusted return on equity.

But the introduction of the risk weighted bank capital requirements changed all that.

Basel II, 2004, standardized risk weights banks assigned a risk weight of 20% to AAA to AA rated assets, and 100% BBB+ to BB- rated assets.

That based on a basic capital requirement of 8% translated into a 1.6% capital requirement for AAA to AA rated assets, and 8% for BBB+ to BB- rated assets.

That mean banks could leverage AAA to AA rated assets 62.5 times, while only 12.5 times with BBB+ to BB- rated assets.

So, with the same previous 1% net risk adjusted return AAA to AA rated assets would now yield a 62.5% risk adjusted return on equity while the BBB+ to BB- rated assets would keep on yielding a 12.5% risk adjusted return on equity.

And so either the BBB+ to BB- rated risky had to be charged 12% instead of 7%, so as to deliver the 5% risk adjusted return that, with a 12.5 times allowed leverage would earn banks a 62.5% risk adjusted return on equity, something which naturally made the risky even riskier; or the AAA to AA rated could be charged a lower 3.2 % interest rate instead of 4%, and still deliver a 12.5% risk adjusted return on equity.

What happened? The risky, like unsecured loans to entrepreneurs, were abandoned by banks, or had to pay much higher interest rates, while the safe, like sovereigns, residential mortgages and AAA rated, were much more embraced by banks, and even offered lower interest rates than in the past.

This is the distortion in the allocation of bank credit to the real economy that the regulators have caused. Is that good? Absolutely not! It promotes excessive credit to what’s perceived or decreed safe, and insufficient to what’s perceived as risky. 

And since risk taking is the oxygen of all development, with it, regulators have doomed our real economy and financial sector to suffer from lack of muscles, severe obesity and osteoporosis.

“A ship in harbor is safe, but that is not what ships are for.” John A. Shedd. But the Basel Committee for Banking Supervision is causing banks to dangerously overpopulate safe harbors, while leaving the riskier oceans to other investors and small time savers.

And the savvy loan officers were substituted by creative bank equity minimizing financial engineers

And the risk-free rate became a subsidized risk-free rate.

The risk weights in the risk weighted bank capital requirements are to access to credit, what tariffs are to trade, only more pernicious.

https://subprimeregulations.blogspot.com/2016/09/if-ever-allowed-following-would-be-my.html

Clearing for perceived risk vs. discriminating based on perceived risk.

If making good down payments house buyers normally had more and cheaper access to bank credit than an entrepreneurs wanting loan for risky ventures.

But when regulators, with their risk weighted bank capital requirements decreed that banks needed to hold less capital against residential mortgages than against unsecured loans to entrepreneurs; which meant that banks could leverage much more their equity with residential mortgages than with unsecured loans to entrepreneurs; which meant that with the same risk adjusted interest than before banks could earn higher risk adjusted returns on equity with residential mortgages than with unsecured loans to entrepreneurs, the regulators de facto discriminated the access to bank credit in favor of house buyers and against entrepreneurs.

So there’s a world of difference between banks clearing for perceived credit risk and the regulators discriminating the access to bank credit based on perceived credit risk.

With their discrimination regulators decreed inequality

With their 0% risk weighted sovereign and 100% risk weighted citizens regulators decreed that the sovereign has more rights to more and cheaper access to bank credit than citizens.

And, at the end of the day it's all for nothing. That discrimination only sets up our banks to especially large bank crises, caused by especially large exposures to something ex ante perceived, decreed or concocted as especially safe, and which ex post turns into being especially risky, while being held against especially little capital.

A letter to the Financial Stability Board

A letter to the IMF titled: "The risk weights are to access to credit, what tariffs are to trade, only more pernicious."

PS. And do the risk weighted bank capital requirements make the risky riskier?

Had there been a Basel Committee on Tennis Supervision, Roger Federer would be history by now.

The Basel Committee for Banking Supervision (BCBS) in order to make bank systems safer imposed risk weighted bank capital requirements. The lower the perceived risk the lower the capital the higher the leverage allowed. The higher the perceived risk the more capital the lower leverage allowed. 

For example, in Basel II of June 2004 they held that against any private sector asset that was rated AAA to AA banks needed to hold 1.6% in capital, meaning they were allowed to leverage 62.5 times. Against any private sector asset that was rated below BB- banks needed to hold 12% in capital, meaning they were allowed to leverage 8.3 times. 

In terms of tennis that would mean that those players ranked the highest would be able to play with the best rackets, and be allowed many more serves than those player ranked lower. Someone not only unranked but also lousy player like me would be happy having one serve and at least be allowed to use a ping-pong racket if playing against Roger Federer. 

But what would have happened if there had been a Basel Committee on Tennis Supervision that implemented these regulations?

To make a long story short, the best tennis players would have it easier and easier to win, and would have less and less need to practice. Those betting on them would bet ever-larger amounts at ever-lower odds… until “Boom!” (2008 Crisis) suddenly the best player was discovered to completely have lost his ability to play and lost in three blank sets to a newcomer.

PS. Here is somewhat more extensive aide memoire on the mistakes in the risk weighted capital requirements for banks.

Our modern statist rulers insidiously debase our currencies with their decreed zero-risk weighting of sovereigns

Lawrence W. Reed in “Did You Know about the Great Hyperinflation of the 17th Century?” FEE August 2017, quotes Nicolaus Copernicus (1473–1543) with: “The greatest and most forbidding mistake has to be when a ruler tries to make a profit from the minting of coins by introducing and circulating new coins with an inferior weight and fineness, alongside the originals, and claims that they are of equal value”

And Reed notes: “Desperate to raise cash and secure material for war, many of the German states in 1618 resorted to the debasement of coinage. They clipped and they melted. At first, they adulterated their own coin but then discovered that they could do the same to that of their neighbors too.”

Our modern governments use much more refined and insidious debasement methods. In order they say to make our banks safe, regulators came up with the risk weighted capital requirements which assigned to the sovereign a risk weight of 0%... yes, you read it well, zero percent.

That means that banks are able to leverage any little net margin obtained on public debt, into great returns on equity. That means that banks will be offering to hold a lot of public debt at low rates which will help to confound all the rest of investors into believing the markets believe that debt to be intrinsically safe.

That also means banks are going to absorb much more of the governments injections of liquidity than would otherwise have been the case.

One day buyers of public debts of these by regulators decreed ultra-safe sovereigns, are going to wake up.

When that happens all bets are off. Interest rates on public debt will shoot up, repaying governments will inject liquidity that will be impossible to drain… and economic realities will be hyper-inflation/hyper-recession messy.

When will that happen? Who knows, in Europe governments have already recruited insurance companies to also operate under a scheme similar to the banks’ Basel I, II and III, and which has quite cynically been named Solvency II.

Why is this all unsustainable? Any system, in which government bureaucrats can, without being responsible for its repayment, have easier access to other peoples’ money than for instance the 100% risk weighted SMEs and entrepreneurs, simply cannot end well.

PS. I often hear the argument that if sovereigns borrow in their own currency they represent indeed a zero risk because they will always be able to repay. Wow they’ve got to be kidding! True repayment does only happen when done with purchase power that has not been diluted by inflation.

PS. The confession that shall not be heard: “Assets for which capital requirements were nonexistent, were what had most political support: sovereign credits… A simple ‘leverage ratio’ discouraged holdings of low-return government securities" Paul Volcker 2018

PS. Here is a current summary of why I know the risk weighted capital requirements for banks, is utter and dangerous nonsense.

PS. My 2019 letter to the Financial Stability Board

With Basel II, how many times could banks multiply net risk adjusted margins, so as to obtain their returns on equity?

The expected pretax return on equity for banks is the amount of net risk adjusted margins they earn over the capital they need to hold.

For instance if banks had to hold the 8% basic capital requirement defined in Basel II, they could leverage (multiply) those net risk adjusted margins 12.5 times. And so if a bank wanted to earn a 20% pre tax ROE, it would need to collect an average net risk adjusted margin of 1.6% (20%/12.5) on assets equivalent to 12.5 times its capital.

Clearly, the more banks can leverage (multiply) those net risk adjusted margins, the higher the expected return on its equity, or the lower do those margins need to be.

For instance if banks had to hold only 1.6% in capital they would be able to leverage (multiply) those net risk adjusted margins 62.5 times. And so if banks wanted to earn the same 20% pre tax ROE as before, they would need to collect an average net risk adjusted margin of only 0.32% (20%/12.5) on assets equivalent to 62.5 times its capital. If the bank was abled to collect the same 1.6% average net risk adjusted margins, then its expected ROE would be a whopping 100%. 

The problem (for us) though, of Basel II, is that it, based on credit ratings, risk adjusted the capital requirements. And so, according to Basel II’s standardized risk weights, the banks were allowed to multiply their net risk adjusted margins the following way: 

SOVEREIGNS:

AAA to AA = Unlimited

A+ to A = 62.5 times

BBB+ to BBB- 25 times

BB+ to B- = 12.5 times

Below B- = 8.3 times

Unrated = 12.5 times

CORPORATES:

AAA to AA = 62.5 times

A+ to A = 25 times

BBB+ to BB- = 12.5 times

Below BB- = 8.3 times

Unrated = 12.5 times

Residential mortgages = 35.7 times

Anyone who does not immediately understand how this distorts the allocation of bank credit; in favour of those who can have their net margin offers multiplied more by banks; and against those who have these multiplied less, does not understand finance, or has a vested interest in not wanting to understand it.

Can there be any question that these regulations pushed banks overboard with exposures to AAA rated securities and loans to sovereigns, like to Greece?

But, someone might say, this is all in order to make banks safer. Bullshit! There has never ever been a major bank crisis resulting from excessive exposures to something perceived as risky when placed on banks’ balance sheets.

Of course with Basel III, which has a leverage ratio that is not risk depended, the differences in the times net risk adjusted margins can be multiplied are smaller, but that does not mean for one second that the Basel discrimination keeps on being kicking and alive.

God help our young… God help our Western civilization. These idiotic risk-adverse regulators are hindering banks from financing our young ones’ riskier future, and have banks only refinancing their parents’ (and their regulators’) safer present and past. 

Risk-taking is the oxygen of development. God make us daring!

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?

Economist Andrew Haldane. At least when acting as a bank regulator, you are admitting the wrong error you committed

Chief economist of Bank of England Andrew Haldane says “his profession must adapt to regain the trust of the public, claiming narrow models ignored ‘irrational behaviour’” “Chief economist of Bank of England admits errors in Brexit forecasting” The Guardian, January 5, 2017.

Hold it Mr Haldane! What you and other economists ignored. when acting as regulators, was that banks would, as always, behave perfectly rational, and lend to what they expected would yield them the highest risk adjusted returns on equity.

That is what you failed to understand when allowing banks to hold less capital against what was perceived, decreed or concocted as safe. That meant banks could leverage more, and so earn higher expected risk adjusted returns on equity, when lending to the “safe”. 

That distortion in the allocation of bank credit to the real economy, resulted in that banks end up lending too much at too low interest rates to the “safe”… which could be risky for the banks; and to little and too expensive to “risky” SMEs and entrepreneurs which is very dangerous for the economy.

Come on Mr. Haldane I dare you to answer the following verybasic questions.

Here is the succinct but complete explanation of the subprime crisis. One, which apparently should not be told.

Here's a prologue, on the 10th anniversary of the Lehman Brothers collapse: In 2006 in a letter to the Financial Times I argued for the long-term benefits of a hard landing. The Fed and ECB decided to kick the can forward and upwards, which could have worked; better at least, had they removed the distortions that created the crisis. 

Just four factors explains it all, or at least 99.99%.

Securitization: The profits for those involved in securitization are a function of the betterment in risk perceptions and the duration of the underlying debts being securitized. The worse we put in the sausage – and the better it looks - the more money for us. Packaging a $300.000, 11%, 30 year mortgage, and selling it off for US$ 510.000 yielding 6% produces an immediate net profit of $210.000 for those involved in the process. (Those signing the mortgages do not participate in the profits)

Credit ratings: Too much power to measure risks was concentrated in the hands of some very few human fallible credit rating agencies.

Capital requirements for banks. Basel II, June 2004, brought down the risk weight for residential mortgages from 50% to 35%. Additionally, it set a risk weight of only 20% for whatever was rated AAA to AA. The latter, given a basic 8%, translated into an effective 1.6% capital requirement, which meant bank equity could be leveraged 62.5 times to 1.

Borrowers: As always there were many financially uneducated borrowers with needs and big dreams that were easy prey for strongly motivated salesmen, of the sort that can sell a lousy time-share to a very sophisticated banker. 

Clearly the temptations became too much to resist for all involved.

The European banks, thinking that if they could make a 1% net margin they could obtain returns on equity of over 60% per year, went nuts demanding more and more of these securities; and the mortgage producers and packagers were more than happy to oblige, signing up lousier and lousier mortgages and increasing the pressure on credit rating agencies. The US investment banks, like Lehman Brothers, also participated, courtesy of the SEC.

Of course it had to end bad... and it did!

Can you image what would have happened if the craze had gone on one or two years more?

I have explained all the above in many shapes or form, for much more than a decade. Unfortunately it is an explanation that is not allowed to move forward, because it would put some serious question marks about the sanity of some of the big bank regulators.

Might I need to go on a hunger strike to get some answers from the Basel Committee and the Financial Stability Board?

PS. Here is a somewhat more extensive aide memoire on the mistakes in the risk weighted capital requirements for banks.

PS. And here are some of my early opinions on these regulations, some of them while being an Executive Director at the World Bank, 2002-04

PS. Here’s my recent, 2019, comments sent to the Financial Stability Board

PS. Here’s my recent, 2019, letter sent to the IMF

PS. And here is a very humble home-made youtube comment on it all, from 2010

If ever allowed, the following would be my brief testimony about what caused the 2008 bank crisis

The following, if I am ever allowed to give it, as so many would not like to hear it, would be my brief testimony on what caused the 2008 bank crisis 

Sir, as I have learned to understand it, the 2008 crisis resulted from a combination of 3 factors.

The first were some very minimal capital requirements for some assets that had been approved, starting in 1988 with Basel I, for sovereigns and the financing of residential housing; and made extensive in Basel II of 2004 to private sectors assets with good credit ratings.

These allowed banks then to earn much higher expected risk adjusted returns on equity on some assets than on other, which introduced a serious distortion. After Basel II the allowed bank equity leverages were almost limitless when lending to “sound” (or friendly) sovereigns; 36 times to 1 when financing residential housing; and over 60 to 1 with private sector assets rated AAA to AA. Just the signature, on some type of guarantee by an AAA rated, like AIG, also allowed an operation to become leveraged over 60 times to 1. 

The second was Basel II’ extensive conditioning of the capital requirements for banks to the decisions of some very few (3) human fallible credit rating agencies. As I so many times warned about (in a letter published in FT January 2003 and even clearer in a written statement at the World Bank) this introduced a very serious systemic risk.

The third factor is a malignant element present in the otherwise beneficial process of securitization. The profits of that process are a function of how much implied and perceived risk-reduction takes place. To securitize something safe to something safer does not yield great returns for the securitization process. Neither does to securitize something risky into something less risky. 

What produces BIG profits is to securitize something really risky, and sell it off as something really safe. Like awarding really lousy subprime mortgages and packaging them in securities that could achieve an AAA rating. A 11%, 30 years, $300.000 mortgage, packaged into a security rated AAA and sold at a 6 percent yield, can be sold for $510.000, and provide those involved in the process an instantaneous profit of $210.000

With those facts it should be easy to understand the explosiveness of mixing the temptations of limitless, 36, and more than 60 to 1 allowed bank equity leverages providing huge expected risk adjusted ROEs; with subjecting the risk-assesment too much to the criteria of too few; with the huge profit margins when securitizing something very risky into something “very safe”. Here follows some indicative consequences:

As far as I have been able to gather, over a period of about 2 years, over a trillion dollars of the much larger production of subprime mortgages dressed up in AAA-AA ratings, ended up only in Europe. Add to that all the American investment banks’ holdings of this shady product.

To that we should also add Europe’s own problems with mortgages, like those in Spain derived in much by an excessive use of “teaser interest rates”, low the first years and then shooting up with vengeance.

And sovereigns like Greece, would never have been able to take on so much debt if banks (especially those in the Eurozone) would not have been able to leverage their equity so much with these loans.

Without those consequences there would have been no 2008 crisis, and that is an absolute fact.

The problem though with this explanation is that many, especially bank regulators, especially bank bashers, especially equity minimizing bankers, especially inattentive finance academicians, especially faulty besserwissers (those who love the sophisticated taste of words like "derivatives"), they all do not like this explanation, so it is not even discussed.

The real question though is: Who is the guiltiest party, those who fell for the temptations, or those who allowed the creation of the temptations?

I mean how far can you go blaming the children from eating some of that deliciously looking chocolate cake you left on the table, at their reach?

PS. Please do not categorize misregulation as deregulation. 

PS. A 2008 GFC tweet summary:
The pushers: Those harvesting mortgages in subprime fields; packaging these in MBS and getting rating agencies’ enthusiastic thumbs up.
The addicts: The banks
The drug, the hallucinogen: The Basel Committee's ultra-low bank capital requirements. 

PS. Here's a letter published by the Washington Post, December 2009

P.S. Here’s a 2010 YouTube explanation

PS. Here is a current summary of why the risk weighted capital requirements for banks, is utter and dangerous nonsense.

PS. And here is my letter to the Financial Stability Board that was officially received. Will it be answered?

There is only one 100 percent sure cause for the financial crisis 2007/08, and it is discussed less than 0.01 percent

The crisis exploded because of excessive exposures to AAA rated securities, real estate (Spain), loan to sovereigns (Greece) and short-term loans to banks (Iceland). They all one thing in common, namely that banks were required by regulators to hold very very little capital against these assets, and so banks could leverage very very much their equity with these assets, meaning that banks could expect to earn very very high risk adjusted returns on equity for these assets.

Had banks been required to hold the same level of capital against all assets, other crisis could have happened, but not one as large as the one in 2007/08.

So how much have you read about the problems related to the distortions produced by the risk weighted capital requirements in the allocation of credit to the real economy? Probably nothing!

Why? There are many explanations to that but, one of the most important, is that there is much more political interest in blaming bad bankers than laying it on good regulators.

Is this a problem? 

Yes, those regulations are still in place and so could still lead banks to create similar dangerously large exposures to something perceived or deemed safe. 

And since that still favors The Safe over The Risky, those who could most help us get our economies moving again, the SMEs and the entrepreneurs, have a lousy access to bank credit.

Right now banks are not financing the risky future, they are just refinancing the safer past, that which might soon turn risky, because of excessive financing.

PS. Here is a more extensive aide memoire on the mistakes in the risk weighted capital requirements for banks.

The bank regulators of the Basel Committee are dumb and dangerous; and are not being held accountable for that

The pillar of current bank regulations is the credit risk weighted minimum capital requirements for banks; more perceived credit risk-more capital and less risk-less capital.

For instance, in Basel II of 2004, paragraph 66, we find the following risk weights for claims on corporates depending on their credit assessment.

AAA to AA rated = 20%; A+ to A- = 50%; BBB+ to BB- = 100%; Below BB- = 150%; Unrated = 100%

Since the basic capital requirement in Basel II was 8 percent then the respective minimum capital requirements were:

AAA to AA rated = 1.6%; A+ to A- = 4%; BBB+ to BB- = 8%; Below BB- = 12%; Unrated = 8%

And that translates into that banks were allowed to leverage capital (equity) as many times as follows:

AAA to AA rated = 62.5; A+ to A- = 25; BBB+ to BB- = 12.5; Below BB- = 8.3; Unrated = 12.5

That is dumb and that is dangerous.

The dumb part is easily evidenced by just asking: Who can think that what has a credit rating of below BB-; which means moving from “highly speculative” through “extremely speculative” and up to “default imminent”, is more dangerous to banks than any of the other “safer” assets?

With a reference to Mark Twain’s saying that “bankers want to lend you the umbrella when the sun shines and take it back when it looks like it is going to rain”, one could even make a case for the totally opposite, a 20% risk weight for assets rated below BB- and a 150% risk weight for assets rated AAA to AA.

And clearly no major bank crises have ever resulted from excessive exposures to risky type below BB- exposures; these have always resulted from excessive exposures to something ex ante perceived as “safe” but that ex post turned out to be risky. In fact it only guarantees that if something really bad happens with an excessive exposure to something erroneously perceived as safe, that banks will stand there naked, with especially little capital to cover them up with. 

But it is also very dangerous, primarily because it distorts the allocation of bank credit to the real economy.

By allowing banks to leverage more with the Safe than with the Risky, banks will be able to earn higher expected risk adjusted returns on equity with the Safe than with the Risky; which means banks will lend more than it would ordinarily lend to the Safe and less than it would ordinarily lend to the Risky… and that cannot be good for the real economy.

The day someone calculates how many small loans to SMEs and entrepreneurs have not been awarded because of this silly regulatory risk aversion; and we think of all the opportunities for job creation that have been lost; we will all cry... and our young could get mad as hell, as they should.

But the real story is even worse. Regulators gave the sovereigns (governments) a risk weight of zero percent; which means they think government bureaucrats are worthier of bank credit than those in the private sector. That is pure unabridged statism.

And since these regulations discriminate against the bank credit opportunities of the Risky, it also serves as a potent driver for increased inequality.

There is soon a decade since that crisis which resulted from excessive exposures to AAA rated securities, and to sovereigns like Greece, broke out; and the arguments here presented are not even being discussed. If that lack of accountability is not scary, what is?

PS. My letter in 2019 to the Financial Stability Board

Shame on you bank regulators… you even dared lie to your own Queen, to her face!

November 2008, Her Majesty, Queen Elizabeth asked: why did nobody notice the “awful" financial crisis earlier?

But now I see that in December 2012, four years later the “Queen finally finds out why no one saw the financial crisis coming”. Interested I went to read about it and, not really unsurprisingly, they are shamelessly lying to their own Queen, in her face.

It states: “As she toured the Bank of England's gold vault, Sujit Kapadia, an economist and one of the Bank's top financial policy experts, stopped the Queen to say he would like to answer the question she had posed. And Kapadia went on to explain that as the global economy boomed in the pre-crisis years, the City had got "complacent" and many thought regulation wasn't necessary.

Kapadia told Her Majesty that financial crises were a bit like earthquakes and flu pandemics in being rare and difficult to predict, and reassured her that the staff at the Bank were there to help prevent another one. "Is there another one coming?" the Duke of Edinburgh joked, before warning them: "Don't do it again."

When the Queen was leaving the governor of the Bank, Sir Mervyn King, said: "The people you met today are really the unsung heroes, the people that kept not just the banking system but the economy as a whole functioning in the most challenging of circumstances.”

Holy moly what bullshit! If it was my Queen, I would never have lied to her that way,I would have asked her instead for her pardon.

Of course financial crisis are difficult to predict but, in this case it was a crises fabricated by bad bank regulations.

Kapadia explained: “the City had got "complacent" and many thought regulation wasn't necessary”. 

Absolutely not! The regulators intervened perhaps more than ever and in doing so completely distorted the allocation of bank credit to the real economy.

With their risk adjusted capital requirements they allowed banks to leverage immensely more on assets ex ante perceived or deemed as "safe", like AAA rated securities or loans to Greece, than with assets perceived as "risky", like small loans wit high risk premiums to SMEs and entrepreneurs. 

And that meant they allowed bankers fulfill their wet dreams of earning the highest expected risk adjusted profits on what’s safe. And if, as a regulator, you do a thing like that, something is doomed , sooner or later, to go very bad.

In January 2003 I had already warned in a letter to the Financial Times: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds. Friends, as it is, the world is tough enough.”

And worst of all is that basically the same regulators keep on regulating basically the same way, Basel I, II and III.

And all for nothing, since never ever have major bank crises resulted from excessive exposures to what was ex ante perceived as risky; these always resulted from excessive exposures to something ex ante perceived as risky, but that ex post turned out to be very risky.

The absolute truth is that had the regulators not regulated at all, banks would never have been leverage as much as they did.

World Bank, the credit risk weighted capital requirements for banks promote financial instability and exclusion

May 9-13, 2016 the World Bank will hold “The 13th Overview Course on Financial Issues: Promoting Stable and Inclusive Financial Systems”

And I wonder if they are still going to ignore the distortions produced by the credit risk weighted capital requirements for banks; more risk, more capital – less risk less capital.

These capital requirements allow banks to leverage more with “the safe” than with “the risky”; which means banks will earn higher risk adjusted returns on equity lending to “the safe” than when lending to “the risky”; which means banks will lend too much to “the safe” and too little to “the risky”. And that will:

Promote financial instability since all major bank crisis have always resulted from excessive exposures to something ex ante perceived as safe but that ex post resulted risky.… in this case aggravated by the fact that banks against that hold especially little capital.

Promote exclusion, as it odiously discriminates against the risky… like SMEs and entrepreneurs.

I quote John Kenneth Galbraith from “Money: Whence it came where it went” 1975. “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.”

And when will the World Bank, the world’s premier development bank remind the world of that risk-taking is the oxygen of any development.

Again I quote John Kenneth Galbraith from “Money: Whence it came where it went” 1975. “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.”

In March 2003, as an Executive Director of the World Bank I gave the following formal statement on this:

http://subprimeregulations.blogspot.com/2003/03/financial-sector-assessments-program.html

And soon 12 years later, I am still waiting L

The Big Short is short on the whole truth. There’s too much vested interest in “Bank regulators can’t be that wrong!”

Paul Krugman, in the New York Times of December 18, 2015 wrote: “You want to know whether the movie [The Big Short] got the underlying economic, financial and political story right. And the answer is yes, in all the ways that matter”

No! I now saw “The Big Short”. It is a very good movie that describes accurately many elements of the crisis that resulted from excessive exposures to AAA and AA rated securities; those that were backed with badly awarded mortgages to the subprime sector.

But, unfortunately, just as I suspected, it remains totally mum on what really propelled the crisis, namely outlandishly bad bank regulations.

In the over two hours movie, we do not hear a single word about that banks in Europe, and investments banks in the USA, thanks to the Basel Committee and the SEC, were allowed to hold these securities against only 1.6 percent in capital… meaning they could leverage their equity, and the support they received from society, a mind-blowing 62.5 times to 1.

The risk-adjusted returns on equity banks expected to make on AAA to AA rated securities by leveraging them over 60 times, blinded everyone. When in the movie it is mentioned that even though the default rate of the subprime mortgages was increasing dramatically, and yet the price of those securities was rising, they ignored among others the runaway European demand for these. These securities, CDO, MBS, ABS or what you want to call them were in fact thought to be the new gold to be found in California, and way over a trillion Euros pursued that gold during less than two years. 

Want to read about it? Here is what happened to little Narvik of Norway in “And then the roof caved in”, page 114. 

Anything that could be traced back to an AAA rated security allowed banks to finance any operation with it against almost no capital. For instance if AAA rated AIG sold you a credit default swap, that was enough… and so everyone bought CDS’s from AIG, who could not resist selling CDS’s on AAA rated securities.

Paul Krugman and others like Joseph Stiglitz, even though bank regulations odiously discriminate against “The Risky” and in doing so increases inequality, cannot find it in themselves, or in their agendas, to accept that technocratic regulators, regulating on behalf of governments, could be so wrong.

The Big Short mentions though a prime driver of the disaster. One broker confesses he would make immensely higher commissions supplying truly lousy adjustable rate mortgages to the packagers of AAA security, than sending them reasonable fix rate prime mortgage. The way the incentives worked, the worse the mortgage, the higher was the added value of the to AAA-ratings conversion process.

PS. And not only The Big Short is guilty of omission. In its 848 pages the Dodd Frank Act, though the US is a signatory, does not even mention the Basel Accord and the Basel Committee

PS. I just looked at the index of Michael Lewis’ “The Big Short again”. It does not mention Basel regulations, risk weighted capital requirements for banks, nor the meeting on April 28, 2004 when SEC decided that the investment banks in the US, would be able to play by Basel rules… and thereby open the way for the minimum capital requirements against anything AAA rated for these banks.