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.

Since they believe it to be safer, regulators want banks to finance house purchases much more than job creating entrepreneurs. Doesn’t anyone of them have grandchildren?

Let us suppose that in a world without risk weighted capital requirements, like the world of banking was for around 600 years before 1988’s Basel Accord, a world with one single capital requirement against all bank assets, for instance 8%.

Let us also suppose that in that world banks would view residential mortgages at 5% interest rate to be, when adjusted to perceived credit risks, equivalent to 9% interest rate on loans to entrepreneurs, and that, for both these assets, their expected risk adjusted net margin was 1%.

In that case, since banks could leverage 12.5 times their equity (100/8) the expected risk adjusted return on equity, on both these assets, would be 12.5%

How many residential mortgages and how many loans to entrepreneurs were given in such a world? I have no idea but adjusted for their perceived credit risk, it was clear both house buyers and entrepreneurs competed equally for credit. 

But then came the Basel Committee with its risk weighted bank capital requirements, and for instance in its 2004 Basel II, assigned a risk weight of 35% to residential mortgages and 100% for loans to unrated entrepreneurs. 

That, for Basel’s basic capital requirement of 8%, meant banks needed to hold 2.8% in capital against residential mortgages and 8% against loans to entrepreneurs.

This in turn meant banks could in the case of loans to entrepreneurs still leverage 12.5 times but now, with residential mortgages, they could leverage almost 36 times (100/2.8). 

And in this case, with the same as expected risk adjusted margin of 1%, banks could still earn12.5% in expected risk adjusted return on equity, but residential mortgages now offered them the possibility of earning a whooping 36% in expected risk adjusted return on equity.

Clearly house buyers were much favored since banker would offer residential mortgages much more and even contemplate some interest rate reductions, while the entrepreneurs had their access to credit much curtailed that is unless they offered to pay higher interest rates.

So what does all this result in? Houses morphing from affordable home into being risky investment assets, while at the same time much less of those job opportunities that entrepreneurs might have helped to create for us and our descendants.

Thinking of our grandchildren’s future is this kind of bank regulations acceptable? Absolutely not! “A ship in harbor is safe, but that is not what ships are for.” John A. Shedd.

PS. Much worse statist regulators assigned 0% risk weights on loans to the sovereign, which de facto implied government bureaucrats to use credit for which they are not personally responsible for much better, than for instance entrepreneurs.

PS. Here's a probably still not finished list of the mistakes with the risk weighted bank capital requirements 

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?

Anat Admati explains the financial crisis better than most, but does still not get to the real heart of it.

I refer to Promarket.org and Evonomics.com where Stanford professor Anat Admati discusses her paper“It Takes a Village of Media, Business, Policy, and Academic Experts to Maintain a Dangerous Financial System” May 2016.

In it she explains how a mix of distorted incentives, ignorance, confusion, and lack of accountability contributes to the persistence of a dangerous and poorly regulated financial system.

Here some quotes and comments:

1. “Admati draws a contrast with aviation. Although tens of thousands of airplanes take off and land, often in crowded skies, busy airports, and within short time spans, crashes are remarkably rare. Everyone involved in aviation collaborates to maintain high safety standards”

PK. The main explanation for that is that everything in aviation is considered risky… and there are no aviation regulators giving anyone the excuse of “at this point you can relax”.

2. “When they seek profits banks effectively compete to endanger their depositors and the public. An analogy would be subsidizing trucks to drive at reckless speed even as slower driving would cause fewer accidents.”

PK. Of course allowing reckless speeds, like no limit at all when lending to Greece, and 62.5 times when AAA to AA ratings are present, must cause serious crashes.

But, the worst part of it all is that banks are not allowed to drive all assets at the same speed. As a consequence, being paid on delivery, banks will not go to where they must go slower, like the leverage speed limits that apply when lending to entrepreneurs, and will therefore not perform their vital function of allocating credit efficiently to the economy. The words “the purpose of banks is” are sadly nowhere to be seen in bank regulations.

3. “Politicians, find implicit guarantees attractive because they are an ‘invisible form of subsidy’ that appear free because they do not show up on budgets, as the costs associated are ultimately paid for by the citizenry.”

PK. At this moment the statist regulators and politicians find those “implicit guarantees” especially attractive because of its quid-pro-quo component. “We scratch your back with implicit guarantees and you scratch ours something for which we in 1988, with the Basel Accord assigned to the sovereign a 0% risk weight, and one of 100% to the citizen” And ever since the “good and friendly” sovereigns have had access to subsidized credit… and the regulators have now painted themselves into a corner. 

4. “Credit rating agencies, “private watchdogs,” have conflicted interests because they derive revenues from regulated companies as well as sometimes from regulators.”

PK. Yes but notwithstanding that, even if the credit rating agencies have behaved totally independent, there can be little doubt that assigning so much decision power to some few human fallible credit rating agencies would introduce the mother of all systemic risks.

And besides, since bankers already consider risks perceived when deciding on size of exposures and risk premiums to charge, to have perceived risks also reflected in the capital requirements, violates the “Kurowski dixit” rule: “Risks, even when perfectly perceived, leads to the wrong actions, if excessively considered.” 

5. “I had expected academics and policy makers to engage and care about whether what they were saying and doing was appropriate, particularly since they often know more than the public about the issues and are entrusted to protect the public”

PK. So had I. They, Anat Admati included, are still not able to explain to regulators about conditional probabilities. And so regulators keep on regulating based on the perceived risk of assets and not based on the risk of assets based on how these are perceived.

In terms of airplanes they regulate based on how the pilots perceive the risks and not based on that the pilots could perceive the wrong risks or act incorrectly when facing the correct risks.

6. “Lawmakers are rarely held accountable for the harmful effect of implicit guarantees combined with poor regulations.”

PK. Yes not one single regulators have been forced to parade down 5thAvenue wearing a dunce cap. On the contrary many of them have been promoted and are still regulating without even considering the possibility they have been mistaken all the time.

PS. Even though Daniel Moynihan is supposed to have opined: “There are some mistakes it takes a Ph.D. to make”, the challenges still remain for the PhDs about what to do with the opinions of the lowlier graduates, like with just an MBA. Do we dare to quote him?

Here my very early opinions on this issue

Here some letters Washington Post have published

And here my soon 2.800 letters to the Financial Times on this. Am I obsessed? Sure, but so are they ignoring my arguments.

And finally here a humble home-made youtube https://youtu.be/TUdKhm6_a8Y

The risk weighted capital requirements for banks should have had to consider Bayesian conditional probabilities... it did not!

What is the conditional probability of assets being dangerous to bank systems when conditioned to that bankers have perceived these assets as risky?

Assets perceived by bankers as risky become safer, not riskier.

What is the conditional probability of assets being dangerous to bank systems when conditioned to that bankers have perceived these assets as safe?

Assets perceived by bankers as safe become riskier, not safer.

So regulators who base their capital requirements for banks on that what’s perceived as risky is more dangerous to the bank systems than what’s perceived as safe, is that because they have never heard about conditional probabilities?

The current risk-weighted capital requirements for banks guarantee especially large exposures, against especially little capital, to what is ex-ante perceived, decreed or concocted as especially safe, dooming our bank systems ex-post to especially large crisis... like that one in 2008.

Its what’s safe that’s risky!

Here is an aide-mémoire on some of the many mistakes with the risk weighted capital requirements for banks.

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

Universities, like Harvard Business School, do have "Conditional Probability and Bayes' Theorem" on the curriculum. Could it be that professors are kept too busy preparing these courses so to have time to look out at what’s happening in the world? Or could it be that their students never understood them?

PS. Here's my comment that was received by the Financial Stability Board

PS. Not the first time I've written about the ignored conditional probability.

PS. Basel Committee’s distortion of credit allocation explained to dummies, in just four tweets.

PS. Here’s the opinion of #AI ChatGPT on this issue.

PS. Here’s the opinion of #AI Grok4 SuperGrok on this issue

PS. And below a humble 2010 home-made youtube comment, dared by someone with no PhD and not a single peer reviewed paper... but perhaps with AI on his side. :-)

Now in 2026:

The Finalization of Basel III’s is just a photo-op for the Committee members to go home for Christmas with, as it does nothing to correct the fundamental flaws of current bank regulations.

The Basel Committee’s “Finalizing Basel III” brief states: 

1. “What is Basel III? The Basel III framework is a central element of the Basel Committee’s response to the global financial crisis. It addresses a number of shortcomings in the pre-crisis regulatory framework and provides a foundation for a resilient banking system that will help avoid the build-up of systemic vulnerabilities. The framework will allow the banking system to support the real economy through the economic cycle.”

Since the risk weighted capital requirements are kept, that is simply not true! The global financial crisis was a direct consequence of regulations that allowed banks to leverage immensely their capital as long as they kept to “safe” assets: limitless leverage with exposures to friendly sovereigns, 62.5 times with private sector exposures rated AAA to AA, and 35.7 times with residential mortgages. 

The exaggerated demand these regulations created for residential mortgages and highly rated securities, which caused serious deteriorations in their quality, and of loans to low risk decreed sovereigns, like Greece, explains 99.9% of the financial crisis.

In contrast when lending to an entrepreneur or an unrated small or medium size enterprise, as that was (is) considered risky, banks were only allowed to leverage 12.5 times. The differences in potential risk adjusted returns on equity between “safe” and “risky” assets hindered, and hinders, the banking system from adequately supporting the real economy

2. “What do the 2017 reforms do? “The 2017 reforms seek to restore credibility in the calculation of risk-weighted assets (RWAs) and improve the comparability of banks’ capital ratios. RWAs are an estimate of risk that determines the minimum level of regulatory capital a bank must maintain to deal with unexpected losses. A prudent and credible calculation of RWAs is an integral element of the risk-based capital framework.”

But the fundamental question of why it should be prudent to require banks to hold more capital against what is perceived risky, when the real dangers to the bank system is when something perceived as safe turns out risky, remains unanswered.

3. “Credibility of the framework: A range of studies found an unacceptably wide variation in RWAs across banks that cannot be explained solely by differences in the riskiness of banks’ portfolios. The unwarranted variation makes it difficult to compare capital ratios across banks and undermines confidence in capital ratios. The reforms will address this to help restore the credibility of the risk-based capital framework.

Internal models should allow for more accurate risk measurement than the standardised approaches developed by supervisors. However, incentives exist to minimise risk weights when internal models are used to set minimum capital requirements. In addition, certain types of asset, such as low-default exposures, cannot be modelled reliably or robustly. The reforms introduce constraints on the estimates banks make when they use their internal models for regulatory capital purposes, and, in some cases, remove the use of internal models.” 

Where do regulators get the idea that if there are less-variations in RWAs, the standardized RWAs, based on how regulators perceive risks, are any more accurate? Excessive hubris? Have they forgotten their own “Standardized” risk weights? Alzheimer? 

Also, since banks should clear for perceived risks in the size of the exposures and interest rates, making them clear for those same risks in the capital too, causes an excessive consideration of perceived risks. The regulators clearly keep on ignoring that any risk, even if perfectly perceived, causes the wrong actions, if excessively considered.

That regulators now, at long last, have understood that “incentives exist to minimise risk weights when internal models are used to set minimum capital”, serves little as consolation, as it just evidences their original naiveté.

PS. As an aide memoire for the regulators to take home for Christmas here’s a list of their mistakes. Am I being nasty? No! How many millions of entrepreneurs have over the years been negated access to the life changing opportunities of a bank credit, only because of these regulators? How many young must live in the basement of their parents houses without jobs, only because regulator think it is safer to finance houses than job creation opportunities? Let’s pray all the Ebenezer Scrooge in the Basel Committee will see light one day... or at least have the decency to fade away.  

Banking before and after 1988

For about 600 years, before 1988, the exposures of banks to assets were a function of the by bankers ex-ante perceived risks (bpr), the risk premiums (rp), and bankers’ risk tolerance (brt) 

Pre 1988 Bank exposures = f (bpr, rp, brt)

Bank capital (equity) followed the rule of "One for all and all for one".

After 1998, Basel Accord, soon 30 years, with the introduction of the risk weighed capital requirements, the exposures of banks to assets are a function of the by bankers ex-ante perceived risks (bpr), the 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 regulators' risk tolerance (rrt)

After 1988 Bank exposures = f (bpr, rp, brt, rcc=f (rpr, rrt))

Anyone thinking banking remained the same after 1988 is either naïve or dumb.

Anyone thinking the allocation of bank credit to the real economy was not distorted by this, is dumb.

Anyone thinking that distorting bank credit to the real economy is not something very risky, is either ignorant or a populist technocrat suffering from excessive hubris.

Anyone thinking that distorting bank exposures this way make banks safer, is an ignoramus who has no idea about what bank crises are made of: namely unexpected events, criminal doings and what was ex ante perceived as very safe but that ex post turned out very risky.

Anyone thinking this does not promote inequality has no idea of what the opportunity to bank credit does to fight it 

PS. With respect to the perceived risks, both the bankers’ and the regulators, let me remind you that any risk, even if perfectly perceived, causes the wrong actions if excessively considered; something here done by design.

Luckily credit rating agencies got it wrong and put a temporary stop on it. Otherwise we would have been much worse off

Few can really evidence having warned so much against the use of credit rating agencies in bank regulations, as I can. So I believe that should give me the right to dare to opine that the fact that the credit rating agencies got it wrong, was and is not the worst part of the current bank regulation horror story.

As for examples of the first, in January 2003 the Financial Times published a letter in which I wrote: “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, as an Executive Director of the World Bank, in April 2003, at its Board I formally stated: “Ages ago, when information was less available and moved at a slower pace, the market consisted of a myriad of individual agents acting on limited information basis. Nowadays, when information is just too voluminous and fast to handle, market or authorities have decided to delegate the evaluation of it into the hands of much fewer players such as the credit rating agencies. This will, almost by definition, introduce systemic risks in the market and we are already able to discern some of the victims, although they are just tips of the icebergs.”

And of course, when then the credit rating agencies later messed it up, and got it so amazingly wrong with the AAA rated securities backed with truly lousy mortgages to the subprime sector, it was a real disaster. But, I tell you, it could have been much worse, like if they had rated correctly for a much longer period.

The reason for that lies in the malignant error of the Basel Committee’s risk weighted capital requirements for banks; more ex ante perceived credit risk more capital – less risk less capital.

Perceived credit risk is the risk most cleared for by banks; they do so by means of interest rate risk premiums and size of exposures. And so when regulators decided to clear for exactly the same risk, now in the capital, that perceived credit risk got to be excessively considered. And any risk, no matter how correctly it is perceived, if it is excessively considered, will cause the wrong actions.

For instance banks were (and are) allowed to leverage much more when financing the purchase of residential houses, or when investing in AAA rated securities backed with mortgages, “The Safe”, than what they are allowed to leverage when lending to the core of the bank credit needing part of the economy, the SMEs and entrepreneurs, those who help create the new generation of jobs, “The Risky”.

And that has resulted in that banks earn much higher expected risk adjusted returns on The Safe than on The Risky; which results banks will finance much more The Safe than The Risky.

So, had it gone on (oops it still goes on) we will all end up in houses with no more houses to be built, and without that new generation of jobs that could help us, or foremost our children and grandchildren, to service mortgages and pay utilities.

So let’s be thankful the credit rating agencies got it wrong, but, please, let us also correct for the regulators' mistakes. Thinking on my grandchildren, I would in fact prefer lower capital requirements for banks when financing unrated SMEs and entrepreneurs than when financing the purchase of a house.

But how did this happen and how could it have been avoided.

Well perhaps it would have been nice if the regulators, before regulating the banks ,had defined their purpose. Then perhaps John A. Sheed’s “A ship in harbor is safe, but that is not what ships are for”, could have come to their mind.

And also it would have been nice if the regulators had done some empirical research on what causes bank crisis; and then they would have discovered that never ever excessive exposures to what is perceived as risky; and then they might have thought of Voltaire’s “May God defend me from my friends [AAA rated]: I can defend myself from my enemies [the unrated]”

One thing is a risk appraisal, a credit rating, and another, totally different, how much importance you give to it.

In January 2003, in a letter published in the Financial Times I wrote:

“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 so here they go again? When will they ever learn?

Do these regulators still not know that banks already look at credit ratings when they set their interest rates and decide on the size of their exposures? To also have credit ratings to set the capital requirements, give their risk appraisal a double weighting. And, a double weighting of even a perfect correct risk appraisal, produces the wrong result. One thing is a risk appraisal and another, totally different, how much importance you give to it. 

The Per Kurowski rule

Could the science of moral psychology help to explain the greatest regulatory mistake in history?

In Chapter 15 of “The New Science of Morality” by Jonathan Haidt in “Thinking”, 2013, edited by John Brockman we read:

“We need metaphors and analogies to think about difficult topics, such as morality… let’s think of… a perceptual analogy…

I think taste offers the closest, the richest, source domain for understanding morality. First, the links between taste, affect, and understanding behavior are as clear as could be. Tastes are either good or bad.

The good tastes, sweet and savory, and salt to some extent, these make us feel ‘I want more’. They make us want to approach. They say ‘this is good’. Whereas sour and bitter tells us, ‘Whoa, pull back, stop.’

Second, the taste metaphor fits with our intuitive morality so well that we often use it in our everyday moral language. We refer to acts as ‘tasteless’, as ‘leaving a bad taste in our mouths. We make disgust faces in response to certain violations.”

And I want to ask whether something of that could be helpful in explaining what is a great mystery to me, namely current bank regulations. Here a brief resume of my problem:

One of the pillars of current regulations is the risk-weighted capital requirements for banks;which in general terms requires banks to hold more equity against assets perceived as risky, than against assets perceived as safe. The justification of that is of course that what is perceived as risky carries more dangers for the banks than what is thought safe.

That could indeed occasionally be true for some individual banks but, for the bank system at large, I hold that what ex-ante is perceived as very safe, but that ex-post can turn out to be very risky, is what poses the real dangers.

And if my opinion were correct, then current regulations would, in principle, be 180 degrees off the target.

So here is the question to Professor Haidt, or to anyone else related to this field of “moral psychology”.

Does "risky" and "safe" play the same role as what tastes bad and what tastes good… and is there anything down this line of thought that could explain a mistake that I feel is endangering the economies of the Western world… as those regulations introduce a very serious distortion in the allocation of bank credit to the real economy.

Does this not represent an urgent, vital and fascinating research topic for you in the field? 

A proposal to the Office of Financial Research (OFR) about some urgent research needed on the causes of bank crises.

I extract the following from the webpage of the Office of Financial Research (OFR) established by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 in order to support the Financial Stability Oversight Council, the Council’s member organizations, and the public.

“OFR helps to promote financial stability by looking across the financial system to measure and analyze risks, perform essential research, and collect and standardize financial data.

Our job is to shine a light in the dark corners of the financial system to see where risks are going, assess how much of a threat they might pose, and provide policymakers with financial analysis, information, and evaluation of policy tools to mitigate them.”

I have a very important research that I would suggest the OFR to take on, as soon as possible. It is a follows:

One of the pillars of current capital requirements is portfolio invariant credit-risk-weighted equity requirements for banks, also less transparently known as “risk-weighted capital requirements for banks”.

And this regulation in general terms requires banks to hold more equity against assets perceived as risky than against assets perceived as safe.

And since that introduces a discriminatory distortion factor in the allocation of bank credit, something that could prove very dangerous to the real economy, the only possible justification is of course that what is perceived as risky carries more dangers for the system than what is thought safe.

I do not believe that. Of course that could be true for some individual banks but, for the bank system at large, I hold that it is what ex ante is perceived as very safe, but that ex post can turn out to be very risky that poses the real dangers.

And in this respect it would be very important for the US, as well as for the world, to research what perceived credit risks could be identified as having caused major bank crisis. Of course I do not mean an ex-post analysis, but an analysis of the perceptions on credit risk present at the moment banks incorporated the later troublesome assets on their balance sheets.

As you can understand, if my opinion is proven right, then current regulations would, in principle, be 180 degrees off target.

Thanks.

Those in Davos might be famous and rich but, as the elite the world needs, they surely don't cut it.

Dumb bank regulators that should be concerned with the possibilities of banks perceiving credit risks wrongly, decided instead to introduce equity requirements for banks based on ex ante perceived credit risks.

And simplistically they applied a more-risk-more-equity and less-risk-less-equity rule, ignoring that a real bank system crisis only results from when something ex ante perceived as absolutely safe, turns out ex post to be very risky.

And that caused banks to lend excessively to some infallible sovereigns, the AAArisktocracy and real estate, which brought on the current crisis 

And that keeps us from getting out of the crisis, since those tough risky risk taking small businesses and entrepreneurs we need to get going when the going gets tough, are denied fair access to bank credit by equity starved banks. 

And this fundamental problematic was not even part of the agenda discussed in Davos 2015. I must say, they might be very famous and rich, but as the financial elite the world needs, those in Davos 2015, they sure don't cut it.

PS. Is there a record of all those who, since 1971, have assisted the WEF meetings in Davos?

The Basel Committee seems not to get it, and therefore insists on being dumb... or?

I have just read the Basel Committee’s “Revisions to the securitization framework”. In it they have approved to “reduce the reliance on external ratings”… as if that was the real problem.

Whoever is the perceiver of risks, internal or external, if the perceived risks used are correct, then banks would need no capital… and any bank then in problem, should better just be put out of business… as fast as possible. 

The real systemic dangerous problem arises when those risk perceptions of are wrong…and that is why it is so silly to have capital (equity) requirements for banks based on the used perceived risks being correct… independently of who is the perceiver of these risks… internal or external. 

Though in fact, since the more credible the “risk perceiver” is, the bigger is the risk of creating potentially dangerous exposures, the Basel Committee might have opted for a strategy of decreasing the credibility of the risk perceivers… if so it is undoubtedly an interesting development... 

At least the Basel Commitee could finally be understanding what I meant when in the Financial Times, in January 2003 I wrote: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds”

 

Comment on BoE´s Sir Jon Cunliffe´s speech, July 17, 2014, on the leverage ratio in bank regulations.

Sir Jon Cunliffe of the Bank of England, Deputy Governor Financial Stability, Member of the Monetary Policy Committee, Member of the Financial Policy Committee, Member of the Prudential Regulatory Authority Board gave a speech on July 17 on the role of the leverage ratio. In it he states: 

“The underlying principle of the Basel 3 risk-weighted capital standards – that a bank’s capital should take account of the riskiness of its assets – remains valid. But it is not enough. Concerns about the vulnerability of risk-weights to ‘model risk’ call for an alternative, simpler lens for measuring bank capital adequacy – one that is not reliant on large numbers of models. 

This is the rationale behind the so-called ‘leverage ratio’ – a simple unweighted ratio of bank’s equity to a measure of their total un-risk-weighted exposures. 

By itself, of course, such a measure would mean banks’ capital was insensitive to risk. For any given level of capital, it would encourage banks to load up on risky assets. 

But alongside the risk-based approach, as an alternative way of measuring capital adequacy, it guards against model risk. This in turn makes the overall capital adequacy framework more robust. 

… bank capital adequacy is subject to different types of risks. It needs to be seen through a variety of lenses. Measuring bank capital in relation to the riskiness of assets guards against banks not taking sufficient account of asset risk. Using a leverage ratio guards against the inescapable weaknesses in banks’ ability to model risk. 

Whether the leverage ratio or the risk weighted capital ratio bites on any individual bank will depend on what are the greatest risks facing that bank” 

And those assertions contain some important impreciseness and problems on which I must comment. 

First “that a bank’s capital should take account of the riskiness of its assets – remains valid… Measuring bank capital in relation to the riskiness of assets guards against banks not taking sufficient account of asset risk” 

Absolutely not so! A banks capital should take account of the risk of the bank, which though related to the risk of its assets, is something quite different from the risk of its assets. For instance a bank that has an overconcentration in some few very absolutely safe assets might be infinitely more risky than a bank that has a great diversified exposure to risky assets. The most unfortunate part of current capital requirements is that they are portfolio invariant. 

Second “a leverage ratio guards against the inescapable weaknesses in banks’ ability to model risk”.

Not just so! Models are based on expected risks, while leverage ratios should cover primarily for unexpected risks, and “model risks”, the risk of models sometimes not being correct, has even a lot of being an expected risk. And so in this respect the leverage ratio is to cover for much more unknowns than model risk.

Third “Whether the leverage ratio or the risk weighted capital ratio bites on any individual bank will depend on what are the greatest risks facing that bank”

Not so! What will bite an individual bank has nothing to do with risks, and all to do with its current capital position. If a bank is under the leverage ratio then that is its binding constraint, and if over it, the risk-weighted capital is.

And here is where I need to express my most serious concern with the leverage ratio, and that is that as it increases the floor of minimum capital, it will intensify the distortions produced by risk-weighing. Do you remember the movie the “Drowning pool” where Paul Newman and Joanne Woodward are pressured against the ceiling by an increasing level of water? Precisely that way!

Conclusion: I want a leverage ratio 6-8% but not in the company of the so odiously distorting risk-weights.

This is how are banks are regulated, and how they could have been, if only they listened to what we want our banks do for us.

The pillar of current bank regulations is capital (equity) requirements based on perceived risk. It allows for much lower capital for assets perceived as safe than for assets perceived as risky… which means banks will be able to leverage much more their equity when lending to the safe than when lending to the risky… which means banks will earn much higher risk-adjusted returns on equity when lending to the safe than when lending to the risky… and which means banks will not lend to the risky, like medium and small businesses, entrepreneurs and start ups.

Unfortunately, that will not stop major bank crises, because these result only from excessive exposures to what was wrongly perceived as absolutely safe, and never from excessive exposures to what was ex ante correctly perceived as risky… just like the latest crisis happened.

Had regulators asked us, we would have suggested the following:

First, forget about perceived credit risks. Bankers already consider these when they set interest rates size of exposures and other terms. And if as bankers they are not able to handle credit risk, then it is better their banks go broke, fast, before these grow into too-big-to-fail banks.

Now if you want banks to have capital as a reserve, as you should, set these based on unexpected risks. And since you never really know where these unexpected risks can occur, better set one fix percentage, for instance 8%, against any bank assets.

But also, if you really want banks to help out, then perhaps you could reduce slightly that 8% floor, not based on credit ratings, but based on potential-for-job-creation ratings, or sustainability-of-Mother-Earth ratings. That way banks will be able to earn a little bit more on their equity, when trying to do something good for us.

Because, at the end of the day, what are banks for, if not to help us, our economy and our planet? And by the way doing that is the only way for banks to achieve long term stability. There is no such thing as banks standing intact among economic rubble.

I guarantee you that had bank regulators followed this road, we might have some other type of crisis, but not one as serious as the current one… and definitely banks would be helping out much more in terms of creating jobs for our young, and in terms of helping the environment in many ways.

I ask for your help in putting our banks back on track... current regulators juts refuse to admit their monstrous mistakes... they do not even answer my questions.

In November 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 unfortunately that they keep on doing! Basel III is in many ways only digging our banks deeper into the hole.

Have the risk weights used in current bank regulations really been approved by the US Congress, in accordance to the Constitution?

Note: When reading about “bank capital requirements”, know that you are reading about “bank equity requirements” or about “bank shareholders’ skin-in-the game requirements”

The confession that shall not be heard

“Assets for which bank 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

New foreword, January 2021: For about 600 years banks allocated credit based on risk adjusted interest rates. After risk weighted capital requirements were introduced, 1988 Basel I, they began allocating it based on risk adjusted returns on equity.

Lower bank capital requirements when lending to the government than when lending to citizens, de facto implies bureaucrats know better what to do with credit they’re not personally responsible for than e.g. entrepreneurs

Lower bank capital requirements for banks when financing the central government than when financing local governments, de facto implies federal bureaucrats know much better what to do with credit than local bureaucrats.

Lower bank capital requirements for banks when financing residential mortgages, de facto implies that those buying a house are more important for the economy than, e.g. small businesses and entrepreneurs.

Lower bank capital requirements for banks when financing the “safer” present than when financing the “riskier” future, de facto implies placing a reverse mortgage on the current economy and giving up on our grandchildren’s future.

Those bank capital requirements, de facto ruled that those less creditworthy were even less worthy of credit, and that those more creditworthy were even more worthy of credit.

Can this really be in accordance with the U.S. Constitution? Is it not a Shadow-Insurrection?

Original post May 2013:

As a Venezuelan I regretfully know much too much about the violations of a Constitution, but I cannot say that I know much about the Constitution of the United States.

For instance, the Constitution of the United States of America, in Section 8 states, “The Congress shall have the power to…fix the Standard of Weights and Measures.”

And I know that bank regulators, by setting risk weights determine how much capital (equity) banks need to hold against different assets... which means that banks will be able to obtain different risk adjusted returns on equity for different assets.

And so I ask, did the United States Congress really approve those risk weights? I say this because I find that concept to be anathema to “The Home of the Brave”.

And I also ask because the US Constitution, in its section 9 states: “No Title of Nobility shall be granted by the United States”… and that seems precisely what the US might have allowed by allowing regulatory preferences, much lower risk weights, on loans to the Sovereign (the Monarch) and to an AAAristocracy... or more precisely an AAArisktocracy.

And clearer yet the Constitution, in Section.8. states: "The Congress shall have the power to borrow Money on the credit of the United States". I am absolutely sure the Founding Fathers did not mean that United States’ Treasury should have the power to borrow money based on bank regulation favors.

And what are those risk weights? The sovereign, meaning the Federal Government, meaning bureaucrats/politicians deciding on the use of bank credit, were assigned a 0% weight, the “AAArisktocracy” one of 20%, and We The People, we were sentenced to have a 100% risk weight.

But what do these risk weights really signify? The answer is quite straightforward. Those with low risk weights will have even more access at even easier terms to bank credit, than what the natural order of banking would give them. And so those with higher risk weights will, consequentially, have less even access to bank credit and have to pay even more for it, than what the natural order of banking would give them.

And so, in words of Mark Twain, this means that bankers are even much more prone than usual to lend out the umbrella when the sun shines, and to take it back when it rains.

And the tragic consequences for the US are many:

It increases the inequality gap between The Infallible and the Risky

It stops bank from financing the future and make them mostly refinance the past.

And in the case of the sovereign, it translates into an effective subsidy of the interest rates paid by the Government, and so everyone is flying blind, not knowing what the real not subsidized risk free rate would be.

And at the end of the day this piece of regulation guarantee excessive bank exposures to what’s ex ante perceived, decreed or concocted as safe, but which might turn out risky, and when that happens are held against especially little capital, and so will result in especially severe bank crises.

And the list goes on...

For a starter: Shall the credit of the USA be helped by the Fed with its Quantitative Easing (QEs)?

“Paraphrasing someone; regulation of the financial system is too important to be left in the hands of regulators and bankers”

PS. The risk-weighted capital requirements for banks are, de facto, tariffs on the allocation of bank credit.

PS. Financial Communism

PS. And it was introduced one year before the fall of the Berlin Wall

PS. It empowered a Bureaucracy Autocracy

PS. And the Academia’s silence on this, makes it a complicit.

PS. I enrolled ChatGPT OpenAI to assist me on this issue.

Do the risk weighted bank capital/equity requirements constitute, de facto, a tax?

Here AI’s ChatGPT and Grok on what the Founding Fathers would have opined.

PS. I'm not an American, do not even intend to be, so why do I care about all this?

If it had not been for America I would not exist.

I come from a nation cursed by centralized oil revenues so, naturally, I despair when I see regulators giving governments preferential access to bank credit.

The silly doubling down on ex ante perceived risks is killing the Western economies... and not so softly

The interest rates, the size of the exposures and all other terms of assets that banks put on their balance sheet, are a function of their ex ante perceived risks, like those reflected in credit ratings.

But current bank regulations also determines that the capital (equity) banks are required to hold against those assets, are also to be a function of risk weights determined from ex ante perceived risk, like those of credit ratings.

And that fundamental mistake of doubling down on the same ex ante perceived risks, like those in credit ratings, potentiating risk aversion, is killing the western economies as we knew them... and not so softly.

Trusting excessively ex ante perceived risks, regulators have allowed banks to hold much much less capital against assets perceived ex ante as “absolutely safe”, than against assets perceived as risky. And that resulted in that banks earn much much higher risk adjusted returns on equity on “The Infallible”, like exposures to sovereigns, housing sector and the AAAristocracy, than on The Risky, like medium and small businesses, entrepreneurs and start ups.

And that means that banks have dangerously leveraged up much too much on The Infallible and, equally dangerously, much too little on The Risky.

And so when one of “The Infallible” ex post turns out to belong to “The Risky”, as always happens sooner or later, often precisely because it has had too much access to bank credit, then the banks stand there naked with almost no capital.

And so “The Risky”, those who on the margins of the real economy most need and should have access to bank credit, in order to help our economies to move forward, they will not get it.

In essence this all means that banks will not help to finance the western economies future, but only help to refinance its past.

Senator Patrick Moynihan is quoted with saying “There are some mistakes it takes a PhD to make”. Unfortunately most of us equally seem to believe “There are mistakes, so dumb, these just cannot be made by a PhD”.

We baby-boomers extract as much equity as possible from the risk-taking our parents allowed banks to take, while refusing now to allow banks to take the risks our grandchildren need.