Bank regulators, the Basel Committee, FSB, and other, insist on putting systemic risk on ever-larger doses of steroids

What was the biggest systemic risk we used to refer ages ago? That which Mark Twain described with “The bankers are those who want to lend you an umbrella when the sun shines and take it away as soon as it looks like it is going to rain”. In other words that bankers could be too risk adverse, and therefore not be allocating credit efficiently to the real economy. 

But what did regulators do with their risk weighted capital requirements for banks? They told banks to lend out even more the umbrella when the sun shines. 

I have written on bank regulations for a long time, not as a regulator, but as a consultant that has walked up and down on Main Street helping corporations of all types to access that bank credit that seems so impossible or so expensive when one is perceived as risky. 

And as an Executive Director of the World Bank 2002-2004 I also raised my voice on many related issues. You can read some of my public opinions here. 

Today I was made aware of a paper from the International Institute for Applied Systems Analysis, IIASA, authored by Sebastian Poledna, Olaf Bochmann, Stefan Thurner and that is said to suggest: “smart transaction taxes based on the level of systemic risk” 

Holy Moly, when will they ever learn? All intrusions that tilt regulations in favor of something or someone become, immediately, a new source of systemic risk? 

And the more and the better you are in guarding against some identified systemic risk, the higher you are climbing up the very dangerous mountain. 

In April 2003, when commenting on the World Bank's Strategic Framework 04-06 I held: "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." 

Everywhere I look I see more and more sources of systemic risks in our banking system. Like which? 

Continuing to rely on too few human fallible and capturable credit rating agencies. 

Continuing to use risk weighted capital requirements that distort for no good reason at all. 

Liquidity requirements that can only increase the distortions. 

Forcing the use of standardized risk weights, which imposes a single set of criteria on too many. 

Regulators now wanting to assure that banks all apply similar approved risk models. 

The stress tests of the stresses that are a la mode. 

Living wills. 

And of course that pure ideological interference that have statist regulators assigning a 0% risk weight to sovereign and a 100% to citizens. 

All in all, in terms of creating dangerous systemic risks, hubris filled bank regulators are the undisputable champions. 

The main cause for all this is that our bank regulators seem to find it more glamorous to concern themselves with trying to be better bankers, than with being better regulators. 

Regulators, let the banks be banks, perceive the risks and manage the risks. The faster a bank fails if its bankers cannot be good bankers, the better for all. Your responsibility is solely related to what to do when banks fail to be good banks. Please?

And regulators always remember these two rules of thumb: 

1. The safer something is perceived to be, the more dangerous to the system it gets; and the riskier it is perceived, the less dangerous for the system it becomes. 

2. All good risk management must begin by clearly identifying what risk can we not afford not to take. In banking the risk banks take when allocating credit to the real economy is precisely that kind of risks we cannot afford them not to take. 

So when can we get bank regulators humble enough to understand their role is to regulate banks against risks they themselves cannot understand? Please?

If bank regulators head east, when they should head west, is that a minor mistake?

All bank crises in the world has resulted from something perceived as safer that it really was, and no bank crisis ever from excessive exposures to what was perceived as risky when booked. 

And so therefore when the Basel Committee and the Financial Stability Board set up bank regulations known as Basel II and that as its pillar has capital requirements which are much lower for bank exposures to what is perceived as to “The Infallible” than for what is perceived as “The Risky”, then it would seem they are heading in the totally wrong direction. 

And so of course we got ourselves a traditional bank crisis because of excessive exposures to assets perceived as safe like AAA rated securities, sovereigns like Greece and Spanish real estate. 

And those regulations also cause that “The Risky”, those already discriminated against on account of that perception, end up paying even higher risk-premiums, getting even smaller loans and having to accept even harsher contract terms. 

And so of course making it more difficult for "The Risky", like small and medium businesses and entrepreneurs, we can not get our real economy going, so as to create the jobs we need, especially for our young. 

I have not been able to extract an answer on this from the regulators for many years now, and now they are threatening to make it even worse when, in Basel III, they are concocting some liquidity requirements also based on perceived risks. Can you please help me with that?

Our current bank regulators are dangerous fools.

Bank regulators foolishly allow banks to hold much less capital against assets which are perceived as “safe” than when holding assets perceived as “risky”. 

That means that bank regulators foolishly allow banks to leverage their capital many times more when holding assets which are perceived as “safe” than when holding assets perceived as “risky”. 

And that means that bank regulators foolishly allow banks to earn a much higher expected risk-adjusted return on equity when holding assets perceived as “safe” than when holding assets perceived as “risky”. 

And I say “foolishly” because with that bank regulators introduce a distortion that makes it absolutely impossible for banks to perform their vital social function of allocating resources efficiently. 

And I say “foolishly” because that guarantees that when something ex-ante perceived as safe, ex post turns out to be risky, bank exposures to it will be huge, and the bank capital to cover for it totally insufficient. 

And I hold our current bank regulators to be dangerous fools, because they don´t even understand the harm their capital requirements based on perceived risk of Basel II does to our banking system and that it caused the current crisis; and because they now want to dig us even deeper down into the hole with Basel III adding liquidity requirements which are also based on perceived risk. 

A bank is there to take intelligent risks on behalf of the risk-adverse society, and not to be treated as just another widow or orphan by some dumb overanxious nannies.

A perfect depiction of our bank regulators… looking out in the same direction of bankers for what is perceived as risky, forgetting that in banking, as in so much other, what is really risky is what is considered absolutely safe. (Thanks "Learning from dogs" for the heads up for the photo)

All really conscientious bank board directors should resign immediately, because of their regulators

All board directors should be the-buck-stops-here responsible for a bank’s risk management. 

But what if some external actor, in this case their own regulator, messed around and imposed his own capital allocation formulas, based on perceived risks, like indeed the regulator has done with Basel II, and wants to do even more with Basel III, when he now also wants to add liquidity requirements based on perceived risks. 

Should not then all really conscientious bank board directors immediately resign, telling the regulators “You have made our mission impossible”? 

I think they should! If they take their bank to where the regulator wants them to go with his capital requirements, and where therefore they have to go if they want their bank to remain competitive, they, and their competitors alike, are all doomed to mess up the whole real economy of the world, by lending too much to “The Infallible” and too little to “The Risky” 

The capital and liquidity requirements for banks based on perceived risk, imposed by bank regulators, is such a fundamental distortion of the markets that no really responsible bank director should accept it.

PS. I extract the following from one official Bank Director’s Responsibility statement 

Primary Role (among other): To act as trustees for all of the Bank’s constituencies. 

Duties and Responsibilities (among other): Provide that risk management policies (broadly defined) and internal controls are in place and functioning, and provide a balance between the risks and benefits of the Bank’s activities. 

Each Director should exhibit:

Integrity and Accountability: Character is the primary consideration in evaluating any Director. Directors must have high ethical standards and integrity in their personal and professional dealings. Directors must be willing to act on and remain accountable for their Boardroom decisions. 

Informed Judgment: A Director should be able to provide wise, thoughtful counsel on a wide range of issues. Directors should possess high intelligence and wisdom, and be able to apply it to decision making. Directors should be able to comprehend new concepts quickly. 

Financial Literacy: Directors should be financially literate. Directors should know how to read a financial statement and understand financial ratios. Directors should have a working familiarity with basic finance and accounting practices. 

Mature Confidence: Directors should approach others in a self-assured, responsible and supportive manner. Directors should be able to raise tough questions in a manner that encourages open discussions. Directors should be inquisitive and curious and ask questions of management.

Basel Committee please, no more Mumbo-Jumbo, with Basel III you are going to hoo-doo us, even more than with Basel II

Basel Committee and Financial Stability Board: “Beware, beware, walk with care, care for what you do, or Mumbo-Jumbo is going to hoo-doo you, or Mumbo-Jumbo is going to hoo-doo you, boom le boom le boom le boom!”… and hoo-doo our banks, and hoo-doo us. Please we are NOT expendable!

And in case you wonder what Mumbo-Jumbo I refer to, please have a look at: 

“An Explanatory Note on the Basel II IRB Risk Weight Functions”, July 2005, Bank of International Settlements 

“A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules” by Michael B. Gordy a senior economist at the Board of Governors of the Federal Reserve System, October 22, 2002. 

And then consider that in those papers, which refer to the risk-weights that should determine different capital requirements for banks, there is not one word that shows any awareness of the fact that: if you allow a bank to leverage its equity more when lending to “The Infallible” than when lending to “The Risky”, you are introducing and odious discrimination and a completely senseless distortion that will make it impossible for banks to help the society to allocate efficiently economic resources.

PS. Here you can read more about what that mumbo jumbo entails

Citizens, do you agree?

We, your public servants, intend to allow the banks to hold much less capital against our absolutely safe sovereign debts than what they will be required to hold against your risky borrowings. 

This would mean that bank will be able to leverage many times more when lending to us your sovereign than when lending to you. 

And that will de-facto mean that we, as a sovereign, will have to pay much lower interest rates than what would have been the case in the absence of this regulation, while you of course will have to pay higher interest rates. 

In the name of true transparency we should perhaps disclose that this will translate into a huge tax paid by all you citizens who borrow, and of course by all the opportunities for good future jobs that are lost when we in this way curtail the access to bank credit of your risky businesses and entrepreneurs. 

Well in the name of the same true transparency we should perhaps disclose that we have already imposed these regulations with the generous assistance of the Basel Committee for Banking Supervision. They did that with Basel II. 

Though that, you should have already noticed. Frankly, how would otherwise Greece been able to rack up so much debt had it not been for banks being required to hold only 1.6 percent in capital when lending to it? 

Yes we can hear you: “What! Did you authorize our banks to leverage their capital 62.5 times to 1 when lending to Greece? Are you crazy?” 

Yes, we agree, we might have overdone it a bit, but you must also understand that for us, as public servants, it is also very important to show solidarity with fellow public servants of other sovereigns. 

Oh, before we forget, would you agree with that besides the capital requirements we should also develop liquidity requirements which in basically the same way favors our infallible sovereign and discriminates against you risky citizens? Well it really doesn’t matter as we will do it anyhow, now with Basel III. 

Sincerely, 

Your baby-boomer public servants 

Après nous, le déluge.

The Basel Committee’s bank regulations, seen from the perspective of “Les Miserable”

Small and medium businesses and entrepreneurs, not rated or having a not-so-good credit ratings have been condemned by the Basel Committee for Banking Supervision as belonging to “The Risky”, and sentenced to generate much higher capital requirements for banks whenever they access bank credit, than when “The Infallible” do that.

The odious discrimination implicit in that sentence has doomed our banks to dangerous obese exposures to “The Infallible”, and to equally dangerous anorexic exposures to those who on the margin are the most important actors in the real economy.

That sentence is absurd as it completely ignores that many of those considered as utterly safe and productive today, yesterday were just some of the “Les miserable” who had the good fortune of being taken out of their precarious position by a Jean Valjean banker.

The bank inspectors have no idea of what they are doing, and in their fanaticism in pursuing “risk”, their mistake in Basel II of capital requirements based on perceived risks, is now being compounded in Basel III, with the addition of liquidity requirements also based on perceived risk.

When will the Javerts of banking supervision realize what they are doing and jump?

The Basel II Roulette Manipulation

Because of what they perceive as reckless speculative risk-taking by banks, many refer to banking as a casino. And so let us think of the alternative loans and investments a bank can make, as the alternative bets on a roulette table.

On it there were for instance “Safe Bets”, black or red, with a payout of 1 plus the bet; “Intermediate bets”, columns, with a payout of 2 plus the bet; and “Risky Bets”, any single number, with a payout of 35 plus the bet. All bets had of course a similar expected value of return, the same risk-adjusted return, though in the case of the roulette, a somewhat negative one, because the House always wins when the zero or double zero comes up, the House Edge. In banking, good credit and investment analysis, is expected to provide positive yields, even for the "zero" and "double zero".

But imagine then that a Basel Committee for Roulette Supervision suddenly got too concerned with that some players were making too many risky plays, and losing all their money, very fast, and that this was something for which they felt that, as a regulatory authority, they could be blamed for, and so decided to do something about it.

And so they decreed their Basel Roulette II Regulations and by which, in order to keep the players playing longer and not losing it all so fast, they allowed the payout for “Safe Bets” to be five times higher, 5 plus the bet, the payout for “Intermediate Bets” double the current, 4 plus the bet, while the payout for “Risky Bets” would remain the same, 35 plus the bet. 

And so what do you think would happen? Just what had to happen! Every player ran to make “Safe Bets”, and now and again, just for kicks, perhaps an “Intermediate Bet”, but they all stayed away from “Risky Bets”, since these just did not make sense any longer.

And the players got so excited with their profits, and bet more than ever, and so when suddenly the zero or double zero appeared, as had to happen, sooner or later, they lost fortunes, and really got wiped out, more than ever, and to such an extent that the casino even had to pay for their taxi ride home. 

Before current Basel bank regulations, all bank lending or investment alternatives produced basically the same expected risk and cost of transaction adjusted returns on equity; because that is what a free competitive market and banking mostly produces. But this was precisely what The Basel Committee for Banking Supervision changed when, with their Basel II, they imposed different risk-weights to determine the capital requirements for banks for different assets.

For instance, when lending to “The Infallible”, like “solid sovereigns” and what is triple-A rated, the banks had to hold only 1.6 percent in capital, and so were allowed to leverage their equity 62.5 times to 1. And that is FIVE times as much allowed leverage than when lending to “The Risky”, like small businesses and entrepreneurs, and where banks had to hold 8 percent in capital and therefore could only leverage their bank equity 12.5 to 1. And for “The Intermediate”, in a similar fashion, a doubling of the pay-out ratio, to 25 to 1 was authorized. 

This absolutely loony manipulation of the odds of banking; and which obviously not only guaranteed that when disaster struck the banks would be standing there naked without any capital; also made it impossible for the banks to perform with any sort of efficiency their vital role of allocating economic resources. 

And the most crazy thing is that soon five years after the disaster occurred, this manipulation of the odds of banking is not even being discussed, and the regulators with Basel III are even adding on liquidity requirements based on perceived risk, which can only have a similar effect of improving the expected risk-adjusted returns from lending to “The Infallible” instead of lending to “The Risky” 

And instead of discussing this monstrous and odious odd manipulation that favors those already favored, "The Infallible", and discriminate against those already discriminated against “The Risky” the world, and the specialized press, like Financial Times, keep themselves busy with the clearly illegal, but immensely less relevant “Libor Affair”.

Poor us! These banking regulations are castrating our banks, making them sing is falsetto by accumulating more and more on their balance sheets exposure to the safe-havens perceived as not yet too dangerously overpopulated; while avoiding like the plague exposure to the more risky but probably more productive bays where our young could find the next generation of jobs they so urgently need.

PS. And it would be so comic, if not so tragic, that absolutely most experts, including Nobel Prize winners, keep on referring to the crisis as a result of excessive risk-taking by banks, and which is of little assistance when trying to explain that what all banks were doing, was betting excessively on boring safe bets, red or black, and this only because of bad regulations… rien ne va plus.

Why our nations are failing!

Daron Acemoglu and James A. Robinson have written an interesting book titled “Why Nations Fail”. In it they detail the importance of having adequate economic institutions and of creating incentives that rewards innovation and allows everyone to participate in economic opportunities. 

To my surprise though, the importance of the willingness to take risks, is not mentioned. 

Bank regulators, about a decade ago, with Basel II, out of the blue, authorized by I don’t know who, suddenly decided that our banks should take less risks than usual, and allowed the banks to hold much lower capital when exposed to assets perceived as “The Infallible” than when holding “The Risky”. 

That meant that banks would be able to earn immensely higher expected risk adjusted returns on their equity when lending to “The Infallible” than when lending to “The Risky”. 

That meant that our bank regulators effectively locked out “The Risky”, like small businesses and entrepreneurs from having access to bank credit on equal terms. 

And that also meant the bank regulators doomed our banks to end up overexposed and holding too little capital to assets that though they ex-ante could qualify as “The Infallible” got too much access to bank credit, on too generous terms, and therefore, ex-post, turned into extremely risky assets. 

And I know for sure, that when a nation starts worrying more about its “History”, “What It Has Got”, “The Infallible”, “The Old”, than about its “Future”, “What It Can Get”, “The Risky”, “The Young”, it will stall and fall… no doubt about that. Risk-taking is the oxygen of any economic development.

And now our bank regulators are even doubling down on their mistakes. Basel III will not only conserve the capital requirements based on perceived risk, it will now also have liquidity requirements based on perceived risks. 

Come on, Europe, America (Home of the Brave)… what happened to our “God make us daring” that we used to pray for in our churches?