What would have happened if, since Basel I, 1988, there had just been one 8% bank capital requirement for all assets?

The “safe” sovereigns would not have seen their borrowings subsidized by the “risky” SMEs and entrepreneurs lesser access to bank credit. 

Sovereigns like Greece would never have been able to run up such large debts on such low initial interest rates.

House financing would not have been so much available at artificial low rates so house prices would be lower.

Much more financing would have gone to those “risky” SMEs and entrepreneurs who could create the jobs the house owners need in order to repay mortgages and service utilities, and that so many young need in order not having to live in the basements of their parents’ houses.

Some other crisis could have resulted, but the catastrophic sized one with the AAA rated securities collateralized with mortgages to the subprime sector, would never have happened.

Central banks would not have needed to kick the crisis can down the road with trillions of QEs… that are still out there on the road menacing to run back on us.

Central banks would not have needed to kick the crisis can down the road with ultra low interest rates that are creating havoc on all pension plans.

The world would not have served up the table with so much for the populists to munch on.

The saddest part though is that now, ten years after those assets that caused the big crisis correlated completely with those assets that required banks to hold the least capital, regulators still apply risk weighted capital requirements. I guess, as Upton Sinclair Jr. said, “it is difficult to get a man to understand something when his salary depends upon his not understanding it.”

Could a hostile power create bank regulations capable of destroying our Western financial system? It would seem so :-(

David Bookstaber in his “The End of Theory”, 2017 refers to the following question:

“If you were a hostile foreign power, how could you disrupt or destroy the U.S. financial system? That is how do you create a crisis?

Well one way to do it begins, as does any strategic offensive, with the right timing. Wait until the system exposes a vulnerability. Maybe that is when it’s filled with leverage, and when assets become shaky.”

Then Bookstaber suggests: “create a fire sale by pressing down prices to trigger forced selling…freeze funding by destroying confidence… maybe pull out your money from some institutions with some drama… and to make money, short the market before you start pushing things off the cliff”

That is Bookstaber’s interesting tale on what “turned the vulnerabilities of 2006 and 2007 into the crisis of 2008, and nearly destroyed our system.” “And we didn’t need an enemy power; we did it all by ourselves.

But what if it all had started with a hostile foreign power taking over bank regulations in order to create the vulnerabilities?

I mean like telling banks they could hold 1.6% in capital or less, meaning a 62.5 to 1 or more leverage, against assets with an AAA rating (like some fatal MBS) or against sovereigns, like Greece. That would give banks the chance to earn fabulous expected risk adjusted margins on those assets, and therefore build up huge exposures to these against very little capital (equity).

I ask, because that was exactly what the Basel Committee for Banking Supervision did with its Basel II of 2004.

And to top it up their AAA-bomb was so powerful that, because it discriminates against the access to bank credit of “the risky”, like SMEs and entrepreneurs, the economy would find it almost impossible to recover on its own; and the crisis-can had to be kicked further and further down the road, with Tarps, QEs, fiscal deficits and silly low interest rates? 

http://theaaa-bomb.blogspot.com

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?

Perhaps I did not understand all Professor Lawrence Summers answered me at IMF, but he might have understood less of what I asked/argued.

In the IMF’s Annual Research Conference at the end of Professor Lawrence Summers' Mundell Fleming Lecture I had a chance the pose a question (1:18:25)

Here is the short explanation for my question:

Suppose banks believe that a 10% return on equity to shareholder’s resulting from lending to the sovereign is, in terms of risk, equivalent to a 25% return derived from a diversified portfolio of loans to SMEs.

Then if banks held on average 10% in equity, meaning a leverage of 10 to 1, banks would have to earn about 1% in net margins on sovereigns and on average 2.5% to SMEs to produce those desired ROEs.

But, then suppose that banks were told by regulators that though they must hold the usual 10% of equity against SME loans, they were now allowed to lend to the sovereign holding only 5% in equity, meaning an authorized 20 to 1 leverage. Then banks could produce that 10% ROE on equity by obtaining only a .5% net margin on sovereign loans. That would clearly but downward pressure on the interest rates paid on public debt.

And in 1988, with the Basel Accord, the regulators decided that the risk weight for the sovereign was 0% and that of SMEs 100%... meaning banks were allowed to leverage equity immensely more with public debt than with loans to the private sector.

My question: Professor Summers, today you showed a graph that showed the risk free rate going down over the last 30 years, the risk free rate based on the proxy of public debt of course. And Lord Turner also recently showed that same trend. And it started around 1989/90. Can that not have anything to do with the very clear evidence that in 1988 the Basel Accord decided that for purposes of the risk weighted capital requirements for banks, the risk weight of the public sector, of the sovereign was 0%, and the risk weight for us, we the people, 100% 

Professor Summers' answer: Could it have anything to do with it? Yes it could have something to do with it. 

Notice that your explanation is in the category of Ricardo Caballero’s explanation. Its in the category of something has happened that has shifted the relative demand for government bonds versus other things.

And my argument is that, if that were true, what you would expect to see as the major counterpart to the decline in government rates is a major increase in risk premiums. And the fact is that I think is closer to right, a better first approximation I believe, to assume that risk premiums have been relative constant, or not long term trending, and that real rates have declined, than it is to believe that risk premiums have been long term trending.

And therefore I prefer the saving and investment based explanations, rather than the asset specific explanations of the kind that Ricardo adduces, or of the kind you suggest.

My afterthoughts: 

How is it possible to hold that such in favor of the public sector distorting bank regulations, would not have “shifted the relative demand for government bonds versus other things”?

How is it possible, like Professor Summer does, to use the “artificially low public sector debt rates”, as a justification of putting more financial resources in hands of government bureaucrats, to build infrastructure, than in the hands of the private sector’s SMEs and entrepreneurs?

PS. The day after, I got a much more straightforward answer from Mr. Olivier Blanchard.
PS. Here’s my recent, 2019, comments sent to the Financial Stability Board
PS. Here’s my recent, 2019, letter sent to the IMF

To lower the real real-interests in order to stimulate the real economy, take away the too costly subsidies of public debt.

Would any serious economist discuss gas prices at the pump ignoring taxes? No!

Would any serious economist discuss milk prices ignoring various subsidies? No!

Then why have almost all serious economists been discussing low real interest rates on public debt ignoring regulatory subsidies? I have no idea!

In 1988, the Basel Accord, Basel I, for the purpose of setting the capital requirements for banks, decided that the risk weight of the sovereign was 0% and that of We the People 100%. 

That would hence mean that banks would be able to leverage much more their equity, and the value of any explicit or implicit government guarantees they received, with loans to the public sector than with loans to the private sector. 

That would hence mean banks could obtain higher risk-adjusted returns on equity when lending to the public sector than when lending to the private sector.

That would hence mean that the interest rates of bank loans to the public sector included a regulatory subsidy.

That would hence mean that the subsidies for the access to bank credit by the public sector was to be paid by taxing the private sector with more restricted or more expensive access to bank credit.

And that should hence have meant that in order to know the real real-rate on public debt, to the nominal rates, we would have to add the cost of the regulatory taxes paid by the private sector.

That has not been done! All references to the interest rates of public debt have been limited to using the nominal rates. That has led experts like Lawrence Summers, Lord Adair Turner, Martin Wolf and many other, to argue that the public sector should take advantage of extraordinary low rates in order to finance public investments, like in infrastructure.

That is very wrong! If we include the economic cost of restricting the access to bank credit over the decade and around the world, for many millions of SMEs and entrepreneurs, the current real real-interests rates on public debt could in fact be the highest ever.

So, if the Fed, ECB, BoE or any other central bank, really wants to lower the interests in order to stimulate the real economy, then they should begin by asking bank regulators to take away those so very costly subsidies of public debt.

Central bankers might start doing this, in the name of equality, since making it harder than necessary for “the risky” to access bank credit, can only help to increase inequality. 

If bank regulators get too anxious and nervous about this, central bankers can (gently) remind them that there has never ever been a major bank crises caused by excessive exposures to what was ex ante perceived as risky. 

But what if the central banker also wears the hat of bank regulator? Then he has a problem he needs to solve… maybe with the help of some outside counseling assistance?

Professor Summers, fixing potholes using 0% public debt will not fix America. Don’t put the cart before the horse.

Professor Larry Summers, and many others with him, promote the idea that the government in America (and other governments too) should take advantage of the extraordinarily low interest rates on public debt, in order to finance new infrastructure and the maintenance of old.

Briefly their calculation is as follows: If government takes on debt at 0% and invest it in infrastructure projects that renders a 5% economic return, then the government, with a 30% tax on that, will have earned a net 1.5%... and we can all live happily ever-after.

NO! First, even if the government nominally pays 0% on its debt, that does not mean that debt has a zero cost. To begin with we should have to add the cost of all those giving up (cheated out of) some long term decent earnings on their saving, in order to finance the government for free. But, even more importantly, those zero or low rates are not free and clear market rates, but rates that are non-transparently subsidized by regulations.

In 1988, with the Basel Accord, Basel I; for the purpose of calculating the risk weighted capital requirements for banks, the regulators decided that the risk-weight for the sovereign was 0%, while that of We the People was 100%. And those risk-weights are still in full force.

I cannot say how much of the low interest rates on public debts are explained by this regulatory distortion, but it sure has to be quite a lot.

I have lately seen Professor Summers, and Lord Adair Turner, showing these rates trending down for the last 30 years. Unfortunately for reasons that are beyond my grasp, they have not been able to see a connection between this and 1988’s bank regulations.

But I do know that piece of egregious regulation, introduced such distortions in the allocation of bank credit that, worldwide, millions of SMEs and entrepreneurs have been negated the opportunities   provided by access to bank credit. That is a real huge cost that should be added to the nominal 0% rate. In other words the rates on public debt are the nominal rates, plus the economic and human costs of the distortions.

Since because of this regulatory risk aversion (even in the Home of the Brave) the economies are stalling and falling. So in this respect one could argue that in reality, never ever before have the interest rates on public debt been as high.

Which also leads me to my second objection, that of “infrastructure projects rendering a 5% economic return”. The final real return of any infrastructure project is a function of how it meets the needs of the economy, and of the state of the economy. If regulatory distortions impede the growth of the economy, those infrastructure projects, even if perfectly carried out, even if financed at 0%, might really turn out to provide a negative return.

Professor Summer, let us, very carefully, get rid of those regulatory distortions so that the banks of America, and those of the world, can return to the normality that was so rudely interrupted by regulatory hubris and statism in 1988. That would allow infrastructure to be financed by governments out of real economic growth, something that would then certainly even justify having to pay much higher nominal interest rates than now.

Please don’t put the cart before the horse! Don’t refuse “the risky” the opportunities to access bank credit only because they are risky. Our economies were all built on risk-taking, even when some of it was not adequately reasoned.

To lay on regulatory risk aversion on top of bankers natural risk-aversion, is an insult to intelligence and human wisdom.

God make us daring!

Why has IMF kept silence on what was done to banks in 1988?

What happened?

Before 1988, for about 600 years, bank exposures were a function of the by bankers ex-ante perceived risks (bpr), risk premiums (rp) meaning interest rates, and bankers’ risk tolerance (brt) 

Pre 1988 bank exposures =ƒ(bpr, rp, brt)

Bank credit was then allocated to what produced banks the highest expected risk adjusted return on equity

But 1998, with the Basel Accord, risk weighted capital requirements were introduced. With that bank exposures became a function of the: by bankers ex-ante perceived risks (bpr), risk premiums (rp), bankers’ risk tolerance (brt), and regulatory capital requirements (rcc), this last itself a function of the by regulators ex-ante perceived (or decreed) risks (rpr) and the regulator’s risk tolerance (rrt)

After 1988 bank exposures = ƒ(bpr, rp, brt, rccƒ(rpr, rrt))

Bank credit was thereafter allocated to what produced banks the highest expected risk/capital-requirement adjusted return on equity

And of course banking changed dramatically, and the allocation of bank credit to the real economy became hugely distorted.

With Basel II of 2004, which introduced risk weighting within the private sector, and made the process much dependent on credit ratings, the distortions and the systemic risks were dramatically increased.

Fundamental mistakes:

1. Although hard to believe, bank regulators never defined what the purpose of banks is before regulating these. “A ship in harbor is safe, but that is not what ships are for.” John A Shedd, 1850-1926

2. Although hard to believe, as the purported reason was to make banks safer, the regulators never researched what had caused bank crisis in the past; namely unexpected events, criminal doings and what was ex ante perceived as very safe but that ex post turned out very risky. What is perceived as very risky is, precisely because of that perception, what is least dangerous to the system. “May God defend me from my friends, I can defend myself from my enemies” Voltaire

3. Any risk, even if perfectly perceived, causes the wrong actions if excessively considered; and here the regulators doubled down on ex ante perceived risks.

4. Ignoring risk-taking is the oxygen of development. For banks to take risks, albeit in smaller amounts on “risky” SMEs and entrepreneurs, is absolutely vital for the economy to move forward, in order not to stall and fall. Where would we be had these regulations been in place during the previous 600 years? In April 2003 as an Executive Director of the World Bank I stated: “The Basel Committee dictate norms for the banking industry… there is a clear need for an external observer of stature to assure that there is an adequate equilibrium between risk-avoidance and the risk- taking needed to sustain growth.” In fact the risk of excessive risk aversion was the theme of my first ever Op-Ed. 

5. Little understanding of systemic risks: In January 2003 I wrote in 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.”

6. Little understanding of fragility: In April 2003, as an ED of the World Bank I stated: “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.”

7. Little understanding of pro-cyclicality: When times are good, credit-risks seem low, so the risk-weighted capital requirements allow banks to expand more than they should; and when times are bad, the credit risk are naturally perceived higher, and so the capital requirements force banks to contract credit, precisely when less bank credit austerity is needed.

8. Macro-imprudence: Prudential regulation helps failed banks to fail expediently. Macro-imprudent regulation impedes failed banks from failing… which builds uphuge mountains of combustible materials waiting for a Big Bang.

9. Overreliance on data and models: In October 2004 in a formal statement at the World Bank I warned: “Much of the world’s financial markets are currently being dangerously overstretched through an exaggerated reliance on intrinsically weak financial models that are based on very short series of statistical evidence and very doubtful volatility assumptions.”

Consequences:

Statism: Basel Accord’s risk weights of 0% for “The (infallible) Sovereign” and 100% for “We the (risky) People” introduced runaway statism. Since then the proxies for risk-free rates have been subsidized. We have no idea what the current low interest rates on much sovereign debt would be if government bureaucracy bank borrowings were affected by a risk-weight similar to SMEs’. De facto those risk-weights imply that regulators believe public bureaucrats know better what to do with bank credit, than the private sector.

Crisis resulting from dangerous overpopulation of “safe” havens: The first crisis, that of 2008, resulted from excessive exposures to AAA rated securities (Basel II risk weight 20% = allowed leverage 62 to 1), sovereigns like Greece, and residential housing (Basel II risk weight 35% = allowed leverage 32 to 1)  

Stagnation: Banks have stopped financing the riskier future and basically keep to refinancing the safer past and present. As an example banks finance much more “safe” basements where jobless kids can stay with their parents, than the SMEs that could create the jobs that could allow the kids afford to also become parents. In short this regulation keeps Keynes' animal spirits caged.

Stimulus waste: Since credit will not flow were they could most be needed, much of the stimuli fiscal deficits, quantitative easing and low interest could produce, is wasted.

More inequality: The result of making it harder and more expensive for the “risky” weaker to access opportunities of bank credit for productive purposes.

Too Big Too Fail: Clearly minimalistic capital requirements, for so many assets, has served as a potent growth hormone for the TBTF banks.

Over indebtedness: By allowing ridiculously low capital requirements for assets perceived as safe, the regulators allowed banks to leverage too much their equity and the support they received from society (taxpayers). That facilitated the current generation to extract more borrowing capacity to sustain its own consumption than any other previous generation. That has left little borrowing capacity over for the future generations.

What to do?

To accept the problem exists!

To know neither Hollywood nor Bollywood, would allow new movies on the same theme to be produced by directors and scriptwriters responsible for such box-office flops as Basel I-II-III.

To understand that bank capital requirements would be better if based on ex-post risks of models based on ex-ante risk perceptions.

To know that if you absolutely must distort, it is better to do so based on some useful social purpose, like based on job-creation and environmental-sustainability ratings.

To understand that getting our banks and our economies out of the Basel mess is a very delicate process, which does not permit an ounce more of that technocrats’ hubris that caused it all.

IMF, will you keep on being silent on this?

Per Kurowski

PS. Here is an updated list of the many mistakes with risk weighing.

Why I distrust governments so much, and about which the World Bank and IMF could do a lot.

Sir, as a Venezuelan, I of course distrust completely any government that thinks it can manage, on behalf of its people, 97% of the country’s exports, better than what each citizen could manage his per capita share of the net revenues from those exports. 

But the following comment has to do with a completely different issue and that applies to many more countries than my own, namely: I entirely distrust governments that can allow bank regulators to do what they have done... Here's a short summary of it:

Without defining the purpose of the banks, in a way with which governments and We the People could agree on, the regulators decided that the only role of banks was not to fail. To be a safe mattress in which you could stash away cash. For instance, how they allocated credit to the real economy, did not matter. “A ship in harbor is safe, but that is not what ships are for.” John A Shedd, 1850-1926

Then in order to keep banks from failing, without absolutely no empirical research on what makes banks and bank systems fail, they proceeded to impose credit risk weighted capital requirements on banks. More ex ante perceived risk more capital – less risk less capital.

Sheer lunacy! This seriously distorted the allocation of bank credit to the real economy, overpopulating “safe” havens like AAA rated securities and sovereigns like Greece, and for the real economy dangerously underexploring risky but perhaps productive bays, like SMEs.

These regulations, since implemented, have certainly hindered millions of SMEs and entreprenuers to have access to credit who otherwise would have been awarded by banks. No wonder QEs, fiscal deficits and low interests, fail to stimulate the economy.  Now banks finance “safe” basements where jobless kids can live with their parents, but not the risky SMEs, those that could create the jobs that could allow the kids to also become parents themselves.

And all for no good stability purpose at all. Just an example, the risk-weight for the dangerous AAA to AA rated corporate was set to 20%, while that for the absolutely innocuous below BB- rated was determined to be 150%. Motorcycles are clearly riskier than cars, which is why, having the choice of transport, so many more people die in car accidents. “May God defend me from my friends, I can defend myself from my enemies” Voltaire.

To top it up with these regulations the bank regulators helped to decree inequality

So World Bank and IMF, could I at least trust you to take up this with all finance ministers present during the meetings in October 2016? I have asked it of you many times before, but until now, nothing, zilch, nada.

PS. Here is a link to a somewhat expanded description of the horrors of the Basel Committee’s risk weighted capital requirements for banks.

Per Kurowski

@PerKurowski

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

http://subprimeregulations.blogspot.com

http://perkurowski.blogspot.com

Our economies are bloated by QEs, low interests and other stimuli, and the lack of real risk-taking.

Tarps, fiscal deficits, QEs and minimal interest rates, in an economy where regulators have by means of risk-weighted equity requirements de facto prohibited banks to take real risks, like lending to SMEs and entrepreneurs, only to take on false risks, like leveraging too much on what is "safe", has created a bloated economy full of assets with inflated values... and helped finance the permanence of inefficiencies that should have been long gone.

The economy now needs to fart, urgently, but boy is it going to be embarrassing smelly… and painful!

That deflation is not curable with factory produced inflation but only with the type of sturdy growth that can justify the relative values of all assets. You do not live on existing assets alone.

You cannot grow muscles by staying in bed just eating fats and carbs... you need exercise and proteins... even if "risky" 

Way back I had a feeling this had to come sooner or later. 

PS. I now feel sort of like a Chance the gardener (Physician) :-)

But who knows, Mario Draghi and his colleagues might all just be Chauncey Gardiners too :-( 

And what could lead to less inequality: to inflate the value of assets that are already owned or to try to create new assets?

Is there a point at which a Nobel Prize must be recalled so as to avoid reputational and other damages?

How much can Nobel Prize winners be allowed to ignore facts relevant to what they are discussing?

Facts: 

1. The pillar of current bank regulations is the risk-weighted capital requirements for banks. 

2. These because regulators cannot differentiate between ex ante and ex post risks, allow banks to leverage their shareholder´s capital much higher when lending to “the infallible” than when lending to “the risky”. 

3. And that results in that banks can earn much higher risk-adjusted returns on their equity when lending to “the infallible” than when lending to the risky.

4. And that distorts and makes it impossible for medium and small businesses, entrepreneurs and start-ups to have access to bank credit in fair market conditions.

5. And that makes it impossible for the liquidity or stimulus provided by quantitative easing (QEs), fiscal deficits or low interest rates, to reach what needs most to be reached.

6. And all that for no good reason at all since bank crises are never ever the result of excessive exposures to what is ex ante perceived as risky.

And so when time and time again I read that a Nobel Prize winner asks for more economic stimulus and less austerity, without the slightest reference to the need of removing that huge regulatory boulder that stands in the way of job creation and sturdy economic growth, I can´t help but to ask… is there a point at which a Nobel Prize must be recalled so as to avoid reputational damage?

Of course I do understand the difficulties for the Committee for the Prize in Economic Sciences in Memory of Alfred Nobel. That prize was endowed by the Swedish central bank… and the current president of Sveriges Riksbank, Stefan Ingves, is also the current chairman of the Basel Committee, the committee responsible for creating the regulatory boulder that stands in our way... and that is a huge reputational risk in itself.

How dangerous it can be when reputational risks intertwine so much... in mutual admiration clubs.