Basel III - sense and sensitivity”? No! Much more “senseless and insensitivity”

I refer to the speech titled “Basel III - sense and sensitivity” on January 29, 2018 by Ms Sabine Lautenschläger, Member of the Executive Board of the European Central Bank and Vice-Chair of the Supervisory Board of the European Central Bank.

“Senseless and insensitive” is how I would define it. It evidences that regulators have still no idea about what they are doing with their risk weighted capital requirements for banks.

Ms Lautenschläger said: With Basel III we have not thrown risk sensitivity overboard. And why would we? Risk sensitivity helps align capital requirements with actual levels of risk and supports an efficient capital allocation. It prevents arbitrage and risk shifting. And risk-sensitive rules promote sound risk management.

“Risk sensitivity helps align capital requirements with actual levels of risk and supports an efficient capital allocation” No! The ex ante perceived risk of assets is, in a not distorted market aligned to the capital by means of the size of exposure and the risk premium charged. Considering the perceived risk in the capital too, means doubling down on perceived risks; and any risk, even if perfectly perceived, if excessively considered causes the wrong actions.

“It prevents arbitrage” No! It stimulates arbitrage. Bankers have morphed from being diligent loan officers into too diligent equity minimizers. 

“It prevents risk shifting.” No! It shifts the risks from assets perceived as risky to risky excessive exposures to assets perceived as safe.

“It promote sound risk management” No! With banks that compete by offering high returns on equity, allowing some assets to have lower capital requirements than other, makes that impossible.

Ms Lautenschläger said: “for residential mortgages, the input floor increases from three basis points to five basis points. Five basis points correspond to a once-in-2,000 years default rate! Is such a floor really too conservative?”

The “once-in-2000 years default rate on residential mortgages!” could be a good estimate on risks… if there were no distortions. But, if banks are allowed to leverage more their capital with residential mortgages and therefore earn higher expected risk adjusted returns on residential mortgages then banks will, as a natural result of the incentive, invest too much and at too low risk premiums in residential mortgages… possibly pushing forward major defaults from a “once-in-2000 years default” to one "just around the corner". That is senseless! Motorcycles are riskier than cars, but what would happen if traffic regulators therefore allowed cars to speed much faster?

I guess Basel Committee regulators have never thought on how much of their lower capital requirement subsidies are reflected in higher house prices?

Then to answer: “Does this mean that Basel III is the perfect standard - the philosopher's stone of banking regulation? Ms Lautenschläger considers “What impact will the final Basel III package have on banks - and on their business models and their capital?”

Again, not a word about how all their regulations impacts the allocation of bank credit to the real economy… as if that did not matter… that is insensitivity!

Our banks are now financing too much the “safer” present and too little the “riskier” future our children and grandchildren need and deserve to be financed.

PS. In 2015 I commented another speech by Ms Lautenschläger on the issue of “trust in banks”.

Should our nannie state tax all risk-taking at higher rates, as current bank regulators do?

Motorcycles, in terms of deaths per miles driven, are much riskier than cars. Should society therefore levy a special risk tax to compensate it for the unnecessary early death of its members? (Even though we know more people die in car than motorcycle accidents) 

Since sport injuries have a cost for the society should we tax sports based on their injury rates? For instance applying a 10 percent risk tax on cricket and one of only 1 percent on croquet (pesky squirrels).

If one assumes that the risks involved with any activity are not adequately perceived or considered, one could of course construe a case for those taxes. But, should we dare to assume risks are not already perceived and cleared for if we therefore could end up with a very risky too risk adverse society?

And I ask all this because taxing risk-taking is exactly what current regulators do with their risk weighted capital requirements for banks.

They now require banks to hold more capital against what is already perceived as riskier (motorcycles) than against what is perceived as safe (cars). This translates into banks having much higher possibility of maximizing their returns on equity with what is “safe” than with what is “risky”; which de facto is a tax on “the risky”.

Consequences? Banks build up dangerously large exposures to what is perceived, decreed, or concocted as safe, like sovereigns, AAArisktocracy and mortgages; and to small exposures, or even no exposure at all to what is perceived as risky, like SMEs and entrepreneurs.

Clearly if the risks are already perceived and considered by bankers, in the size of the exposure and the interest rates charged, to then also have the capital reflect the perceived risks, cause these risks to be excessively considered; resulting in an excessively risk-adverse banking system.

Just consider that already, partly because of the higher risk perceptions, many more people die in car than in motorcycle accidents. 

Think of a society where no one drives motorcycles or plays cricket because the risk-taxes are too high, and all keep to cars and crocket. Is that the kind of society that will be strong enough to survive? Is that what we want?

I am sorry but there is no more figurative way to express it. The Basel Committee for Banking Regulations and their affiliated regulators have effectively castrated our banking system. Will that make us safer? Of course not! 

Our banks will dangerously overpopulate safe-havens; in which they will die from lack of oxygen.

Our economies are going to dwindle into nothing, when denied the oxygen of risk-taking necessary for all development.

Friends, we must urgently get rid of these dangerously inept bank nannies.

What if traffic regulators, to make your town safe, limited motorcycles to 8 mph but allowed cars to speed at 62 mph?

The fatality rate per 100 million vehicle miles traveled in cars is 1.14

The fatality rate per 100 million vehicle miles traveled in motorcycles is 21.45

That could indicate that in terms of risks measured and expressed as credit ratings, the cars should be rated AAA, and motorcycles below BB-.

But in 2011, in the US, 4,612 persons died in motorcycle accidents.

And in 2011, in the US, 32,479 persons died in vehicle accidents.

That explains the differences between ex-ante perceived risk and the ex-post dangers conditioned by the ex-ante perceptions. Cars are more dangerous to the society than motorcycles, in much because the latter are perceived as much riskier.

But what did bank regulators do in Basel II, 2004?

By weighting for ex-ante perceived risks their basic capital requirement of 8%, they allowed banks to leverage 62.5 times to 1 when AAA-ratings were present, and 8.3 times in the case of below BB- ratings.

So, what if traffic regulators, in order to make your hometown safe, limited motorcycles to 8 mph but allowed cars to speed at 62 mph?

Do you see why I argue that current bank regulators in the Basel Committee and in the Financial Stability Board have no idea about what they are doing?

But it is even worse. We need SMEs and entrepreneurs to access bank credit in order to generate future opportunities for our kids. Unfortunately, since when starting out these usually have to drive more risky motorcycles than safe cars, our future real economy gets also slapped in the face. 

An 8% capital requirement translates into a 12.5 to 1 leverage. Why can’t our regulators allow banks to speed through our economy at 12.5mph, independently of whether they go by cars or motorcycles?

PS: Here is a more detailed explanation of the mother of all regulatory mistakes.

Regulators looking after the same risks bankers look at

The mother of all regulatory stupidities!

This data is found on the web:

The fatality rate per 100 million vehicle miles traveled in motorcycles is 21.45

The fatality rate per 100 million vehicle miles traveled in cars is 1.14

In 2011 in the US, 4,612 persons died in motorcycle accidents 

In 2011 in the US, 32,479 persons died in vehicle accidents

And so, even though travelling by motorcycle is about 20 times riskier than cars, cars cause about 7 times more deaths than motorcyclists. That is of course because the riskier something is perceived, the more care is taken to avoid the risk. And because the safer something is perceived, the higher its potential for delivering unexpected tragedies/losses.

And yet the Basel Committee of Banking Supervision decided on higher capital requirements for banks when lending “the risky” motorcyclist of the economy, the SMEs and entrepreneurs, than when lending to “the safe” car drivers, sovereigns and corporations with high credit ratings… even though clearly dangerous excessive bank lending to the latter is much more likely to occur.

And that even though serious misallocations of bank credit to the real economy had to result.

The regulatory loonies did not even care to look at what had caused the major bank crises in the past.

The regulatory loonies did not even care to define the purpose of banks, like that of allocating bank credit efficiently, before regulating the banks.

Shame on them!

And to top it up, in 1988, the Basel Accord introduced a risk weight of zero percent for sovereigns and 100 percent for the private sector. Rarely has statism been able to advance its agenda faster and more than with that.

And IMF, Financial Stability Board, Federal Reserve Bank, Bank of England, European Central Bank, World Bank, Financial Times... and many more, they just don't see it, or keep mum about this, the mother of all regulatory stupidities.

How can we foolproof our banks from being regulated by fools?

Greg Ip has written a great book “Foolproof: Why Safety Can Be Dangerous and How Danger Makes Us Safe”. It is on topics about which I have screamed for soon two decades; such as there is nothing as risky as excessive risk-aversion; and that going for the perfect perfectly applied to all, only creates mindboggling fragility.

Unfortunately Ip does not draw the most important conclusion his own book suggests, namely that what we have really to foolproof, is our regulatory system, so as to impede the risk-adverse to add their risk-aversion, for instance on top of our banking system. 

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

And the Bang sure happened. To me it is obvious what that systemic error is, but regulators don’t want to even acknowledge the problem…and so they keep taking us down the same suicidal path, to the next even bigger Bang.

The systemic error I refer to, the pillar of bank regulations, is the credit risk weighted capital requirements. More credit risk more capital – less credit risk less capital.

And let me explain what happens using non-bank risks from data found on the web.

The fatality rate per 100 million vehicle miles traveled in cars is 1.14

The fatality rate per 100 million vehicle miles traveled in motorcycles is 21.45

And so, undoubtedly, the risk of dying going by motorcycle seems to be about 19 times larger than by cars.

And that, translated into banking, would signify regulators requiring much higher capital when traveling on motorcycles than when travelling in cars.

But then on the web we also find these final statistics:

In 2011 in the US, 4,612 persons died in motorcycle accidents.

In 2011 in the US 32,479 persons died in vehicle accidents

And which, translated into banking, would mean that what is perceived as safer, caused about 7 times more losses than what is perceived as risky. Something logical since, as going on motorcycles is riskier, more choose going in safer cars.

Our bank regulators simply ignored that banks already cleared for credit risks, with risk premiums and amounts of exposure, and so on top of bankers’ risk aversion (see Mark Twain) they added their own risk aversion and caused the mother of all regulatory risk aversion. They never even bothered to analyze what had caused major bank crises in the past.

And there are two very tragic consequences that derives from that regulatory negligence.

First, that banks, since they could not leverage as much when lending to those going on motorcycles, are able to earn higher risk adjusted returns on equity when lending to those going by cars… they stop lending to motorcyclists… meaning our “risky” SMEs and entrepreneurs… and the economy stutters.

The second that when suddenly too many car deaths result, then banks will have little capital to cover themselves up with.

One reason Ip has not discovered this mistake, is because he mistakenly believes that “Capital serves as a shock absorber: it absorbs losses from bad loans” Not so, capital serves a shock absorber against unexpected losses not against expected credit losses. The regulators agreed with that, explicitly, but then inexplicably proceeded to estimate the unexpected with the expected… ignoring completely that what is perceived as safe has by pure logic much more potential of delivering unexpected losses than what is perceived as risky.

In Basel II, the risk weight for a private sector asset rated AAA (cars) was 20 percent… while the risk-weight for the below BB- rated (motorcycles) was 150 percent. Frankly, who in his right mind, can believe credits rated BB- are more risky to the banking system than credits rated AAA to AA? 

Ip very correctly writes: “Cost benefit analysis brings clarity and discipline to rule making… We owe it to ourselves to decide how safe we want to be though analysis, not emotion”. But what Ip has not realized, probably because its implications are so outrageous to make that believable, is that in all bank regulations there is nothing stated about the purpose of our banks, and, without that, how can you do a cost-benefit analysis?

Ip writes: “The solution for banks’ excessive risk taking as Paul Volcker saw it, was to force them to hold more capital, so that bad lending decision would not sink them”…meaning, when confusing ex ante risks with ex-post realities, that they should not lend to motorcyclist. Well no! 

Of course in Europe regulators were (are) even worse, but in the US, Volcker, Greenspan, Bernanke and from what we see Yellen… none of them have been concerned about the distortion of bank credit allocation to the real economy their regulatory pillar causes… and so when I refer to the need to foolproof bank regulations, I do include fool-proofing these against Fed Chairs too.