J'accuse the Basel Committee for Banking Supervision

The following are facts that should be understood by any economist.

The Basel Committee’s risk weighted bank capital/equity requirements distort the allocation of credit.

By favoring the refinancing of the safer present, it builds up dangerous large exposures to what’s perceived or decreed safe e.g., public debt, residential mortgages and AAA rated securities.

By hindering the financing of the riskier future, e.g., loans to small businesses and entrepreneurs, the economy weakens and grows less.

These are extremely procyclical. When times are good and risk perceived low, banks are allowed to hold less equity, therefore able to pay much dividends and buy back shares. When times turn bad, banks stand there naked, just when its hardest for these to raise new equity.

As valiantly confessed by Paul Volcker the risk weights are much influenced by politics. 

The Nobel Prize in Economic Sciences has not been awarded to anyone who has warned or much less criticized this risk weighted regulations. As a very active member of the Basel Committee, Sveriges Riksbank that stands behind such prize, has a serious conflict of interest it has not been able to manage.

#AI #ChatGPT #Grok: Are the current risk weighted bank capital requirements dangerously procyclical?

“What goes up must come down, spinning wheel got to go 'round”

I asked: 

"When times are good and the risks seem lower, with its risk weighted capital requirements, the Basel Committee allows banks to hold less capital/equity against their assets. 

When times are hard and the risk seem higher, banks are required to hold more capital against their assets, just when it must be harder for banks to raise new capital.

With a Yes or a No, is that not a dangerous pro-cyclical regulation?

If 'Yes' then please, with one number, since 1989, how many Nobel Prize winners in Economic Sciences warned about that?"

ChatGPT answered

"Yes, that is a dangerous pro-cyclical regulation.

Since 1989, zero Nobel Prize winners in Economic Sciences have explicitly and publicly warned about the pro-cyclicality of Basel's risk-weighted capital requirements in the form you've described."

I asked: "Any brief max 200 words commentary on this?"

"The pro-cyclicality of Basel’s risk-weighted capital requirements poses a fundamental flaw in global banking regulation. By allowing banks to hold less capital in good times—when asset prices are high and risks appear low—it encourages excessive leverage and credit expansion. Conversely, in downturns, when risks seem higher, banks are required to hold more capital, just when raising equity is most difficult and expensive. This amplifies financial cycles, turning booms into bubbles and busts into crises.

That no Nobel laureate in Economic Sciences since 1989 has explicitly called this out in clear terms is striking. It may reflect a broader academic detachment from the regulatory nuts and bolts of finance, or perhaps an overreliance on theoretical risk models that assume away systemic feedback loops. The silence from top economists has arguably left the field of banking regulation dominated by technocrats who, while well-intentioned, may lack the independence or macro-critical mindset needed to challenge pro-cyclical dogma. It’s a missed opportunity for economic leadership—one with real-world consequences for financial stability."

Thanks!

"You're very welcome! If you ever want to dig deeper into this or explore related topics—like alternatives to Basel or historical case studies—just let me know."

Grok, after thinking 1 minute and 12 seconds in 15 hidden web pages, answered:

"Yes, the Basel Committee's risk-weighted capital requirements can indeed be considered a dangerous pro-cyclical regulation. This is because they allow banks to hold less capital during good economic times when perceived risks are lower, encouraging increased risk-taking and lending that can fuel economic booms. Conversely, during hard times when risks are perceived as higher, banks are required to hold more capital against their assets. This requirement comes at a moment when raising new capital is most challenging, forcing banks to reduce lending or sell assets, which can deepen recessions and amplify financial instability. This dynamic exacerbates economic cycles, making the regulation pro-cyclical and potentially harmful.

Since 1989, 6 Nobel Prize winners in Economic Sciences have warned about the pro-cyclical nature of such banking regulations, including those established by the Basel Committee. These economists are:

Joseph Stiglitz (2001) - Criticized the Basel framework, particularly Basel II, for encouraging pro-cyclical lending that increases risk during booms and worsens downturns, as noted in his book Freefall.

Paul Krugman (2008) - Highlighted the limitations of Basel capital requirements in his writings, pointing out their pro-cyclical effects during financial crises.

Robert Shiller (2013) - Discussed the pro-cyclical tendencies of financial regulations like Basel in works such as Finance and the Good Society, emphasizing the need for countercyclical measures.

Jean Tirole (2014) - Advocated for countercyclical regulation in banking to mitigate pro-cyclical effects, referencing Basel III in his research and book The Theory of Corporate Finance.

Bengt Holmström (2016) - Addressed how Basel III capital requirements can lead to pro-cyclical bank behavior in his paper Understanding the Role of Debt in the Financial System.

Ben Bernanke (2022) - Promoted countercyclical capital buffers to counteract the pro-cyclical impacts of Basel requirements, drawing from his expertise as a former Federal Reserve Chair.

These economists, through their research and commentary since the Basel I accord in 1988, have consistently pointed to the dangers of pro-cyclicality in these regulations, reinforcing the affirmative answer to the query.

Thanks!

After thinking 13 minutes and 5 seconds Grok announced “Completed” and was not able to utter a simple “You’re welcome”

I've no idea what has happened to Grok. (PS. He has later recovered from this :-) )

Note: The answers are copied exactly from those given to me by ChatGPT and Grok

Here are my many other questions to ChatGPT – Grok on bank regulations.

Am I and AI confronting the Regulatory Inquisition? Will we be silenced?

The current risk weighted bank capital requirements: A Maginot Line

My Twitter thread:

What if generals concentrate too much on the immediate risk sergeants perceive?

I ask because regulators now concentrate too much of their bank capital requirements on the risk perceived by credit rating agencies and bankers.

The result? A false sense of security. A Maginot Line.

Any risk, even if perfectly perceived, if excessively considered, causes the wrong action.

With bankers adjusting for risk with interest rates, and regulators with bank capital requirements, there will be dangerously much “safety” and dangerously little risk-taking.

Too much safety? 

The excessive bank exposures and the assets bubbles that can become dangerous for bank systems and the economy, are always built-up with assets perceived (or decreed) as safe, never ever with assets perceived as risky.

Too little risk taking? 

Risk taking is the oxygen of any development

If e.g., residential mortgages are favored much more than bank loans to small businesses and entrepreneurs, we will end up with too expensive houses and too little job income for food, utilities… and mortgages

What if the generals took much more care of the needs of their headquarters, than those of the soldiers in the battlefield?

I ask because the regulators who, for bank capital requirements, have decreed risk-weights of 0% the government and 100% the citizens, are doing just that.

What if armies don’t arm during peace?

I ask because when times are good, is when banks should buildup capital

The risk weighted bank capital requirements, do the opposite

So, when times turn bad, our banks will stand there naked, just when we need them the most

Good Job! 😡

Regulators, the Basel Committee for Banking Supervision, imposed bank capital requirements based mostly on perceived risks, not on misperceived risks or on unexpected events e.g., a pandemic or a war. 

Oh, if only they had taken time off to play some war games before doing so.

PS. Not the first time I've mentioned the Maginot Line

The main causes the so objectionable risk-weighted bank capital requirements are not objected.

A brief summary:

No understanding about what immense hubris “experts” are capable of, like believing they can weigh bank capital requirements for perceived credit risks… and then mostly ignoring misperceived risks and unexpected events e.g., pandemic war.

No understanding of how allowing banks to leverage their capital differently with different assets, will make it easier/harder for banks to obtain the desired risk adjusted returns on equity; something which distorts the allocation of credit.

No knowledge about conditional probabilities; which therefore helps to believe those excessive exposures that could become truly dangerous to bank systems, are built up with assets perceived as risky.

Not understanding that risk-taking is the oxygen of all development.

Consequentially:

No understanding of their pro-cyclicality. When risks are perceived low, credit ratings are high, banks can hold little capital, buy back stock, pay much dividends and bonuses, and so, when times worsen, or something unexpected like a pandemic or a war occurs, banks will stand there naked, precisely when it would be the hardest for them to raise new capital, precisely when we need them the most

No understanding of that since the capital requirements are lower for lending to the “safe” government than to the risky citizens, this implies bureaucrats/politicians know better what to do with (taxpayer’s) credit than e.g., small businesses and entrepreneurs. (Of course, they could also be agreeing with that for pure ideological considerations.)

No understanding of what capital requirements being lower for “safe” residential mortgages than for loans to risky small businesses and entrepreneurs, implies to the possibilities of generating the jobs/incomes needed to service mortgages and pay living costs.

The saddest part is that all these limitations seem to entirely apply to our current Academia. 

How does the Law of Unanticipated Consequences apply to risk weighted bank capital requirements?

There’s Murphy’s Law type unanticipated consequences: “What Can Go Wrong, Will Go Wrong”; and there are perverse effects that result in the opposite of what was intended. 

And then there is Robert K. Merton’s, Law of Unanticipated Consequences. This one identifies five principle causes of unanticipated consequences: 

Ignorance, making it impossible to anticipate everything, thereby leading to incomplete analysis.

Ignorance? Yes, but much spiced up with that abundant hubris that made regulators believe that they, from their desks, and with the help of some few human fallible credit rating agencies, could get a grip on what the risks for bank systems are. 

Errors in analysis of the problem or following habits that worked in the past but may not apply to the current situation.

Errors? Many but perhaps none worse than the following:

1. Risk weights 0% the government and 100% citizens, as if bureaucrats know better what to do with credit for which repayment they're not personally responsible for than e.g., small businesses and entrepreneurs.

2. Fixating on the perceived credit risks and not on the risks conditioned to how the credit risks are perceived.

3. Ignoring how dangerously procyclical these bank capital requirements would be.

Immediate interests overriding long-term interests.

Immediate interests? Absolutely, and perhaps none as clear as that valiantly but sadly so late confessed one by Paul Volcker “The assets assigned the lowest risk, for which bank capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages.”

Basic values which may require or prohibit certain actions even if the long-term result might be unfavourable.

Basic values? Can’t think of anyone except of course that “it’s not come-il-faut to question your colleagues”, and which tends to prevail in all mutual admiration clubs defending the jobs of their members.

Self-defeating prophecy, or, the fear of some consequence which drives people to find solutions before the problem occurs, thus the non-occurrence of the problem is not anticipated.

Self-defeating prophecy? Perhaps, in terms of listening too much to Monday Morning Quarterback besserwisser prophets. The morning after a crisis they describe in detail the risky assets. What they never mention before the crisis, is with what "safe" assets those dangerous bank exposures are being built-up with. 

And the Academia says nothing

Some unasked questions that all nominees to the Federal Reserve Board, and of course its current members, should be dared to answer

Intro: The Federal Reserve’s risk weighted bank capital requirements allow banks to hold much less capital, translating into being able to leverage much more with assets perceived (or decreed) as safe e.g., Treasuries, residential mortgages and those with an AAA rating, than with e.g., small businesses, entrepreneurs and assets rated below BB-.

Q. With what assets do you think all those excessive bank exposures that have and could cause really serious bank crisis are built up with: with those perceived as safe or with those perceived as risky?

Intro: When times are rosy, these risk weighted bank capital requirements, allow banks: to lend dangerously much to what’s perceived as very safe; to hold much less capital; to do more stock buybacks and to pay more dividends & bonuses.

Q. Does this not sound like that when times turn bad, banks will stand naked when they are most needed? 

Intro: It is much easier for banks to obtain the risk adjusted returns on equity they look for with assets they can leverage more, and so therefore banks will naturally prefer these, that is unless assets which could be leveraged less, provide additional risk adjusted margins.

Q. Do you think it is more important for banks to finance residential mortgages than to finance those loans to small businesses that could help people get the jobs with which service mortgages and pay utilities?

Intro: The Fed when in 1988 it accepted the Basel Committee’s risk adverse bank capital requirements, it decreed weights of 0% the federal government and 100% “We the people”. 

Q. Do you think the Founding Fathers of The Home of the Brave would agree with regulators imposing risk aversion on its banks; and with bureaucrats knowing better what to do with credit for which repayment they’re not personally responsible for than American small businesses?

Q. Do you have an opinion on how much the strength of the US dollar depends on the United States remaining being perceived as the foremost military power in the world, and of course on its willingness and capacity of exercising such power?

Please, if I may, one last question:

Q. Where do you think America would be, if these bank regulations had been in place the last couple of centuries?

@PerKurowski

Zero dividends, buy-backs and big bonuses, before banks have ten percent in capital against all assets

We urgently need our banks to be banks again

Current bank capital requirements, with capital meaning equity, meaning the skin in the game bank shareholders should have, are mostly based on perceived credit risks; not on misperceived risks, or the unexpected, like a Covid-19.

That would be less of a problem, if those capital requirements were based on risks conditioned to how credit risks are perceived.

But they’re not! What’s perceived more creditworthy, meaning what’s preferred by banks, have much lower capital requirements than what’s perceived less creditworthy.

And lower capital requirements mean higher leverages, making it therefore easier to earn risk adjusted returns on equity with what’s perceived (or decreed by regulators) as safe, than with what’s perceived as risky.

The consequence? A procyclicality that fosters higher and higher exposures to what’s safe, against less and less capital.

And what’s defined as “safe”? Loans to sovereigns, residential mortgages and assets with very high credit ratings?

And what’s risky? E.g., loans to small businesses and entrepreneurs.

So precisely like in 2007-08, when banks were caught with their pants down because of huge exposures to mortgage-backed securities with misperceived AAA ratings, they’re now standing there naked because of the unforeseen economic consequences of Covid-19; especially those derived from lockdowns.

The procyclicality of it all; when times are rosy banks can hold little capital but when times get hard banks have a hard time raising capital, sets us up to the fact 

And so, just when we now most need banks to help us out, it’s the hardest for them to raise the capital that would allow them to do so. What a mess!

And on all that the Academia has for decades kept total silence.

So, what would I propose? In few words, the following: 

“Banks, you can now hold zero capital, but that comes with: zero dividends, zero buy-backs and zero bonuses until you have ten percent in capital against all assets; and until you’ve paid back, including a reasonable interest, all what central banks or taxpayers have assisted you with.”

To ease the transition one could allow all bank assets incorporated some months before the change, to be held, until its maturity, against the capital requirement valid when put on banks' balances.

And I would allow small investors to buy some of that bank equity that helps these meet that ten percent requirement on favorable conditions… so as to connect the banks with the citizens again

Fellow citizens, let’s rescue our banks from hands of those financial engineers concerned with “how much can we leverage this asset?”, so as to put these back into hands of loan officers whose first question to applicants is, “what are you going to use the money for?”

And let’s rescue banks from that statism/communism/fascism implied with risk weights of 0% the Government, 100% the citizens… all as if bureaucrats/politicians know better what to do with credit for which repayment they’re not personally responsible for, than e.g., entrepreneurs.

Let’s be clear. Risk taking is the oxygen of all development and so, in that vein, for the real economy what’s “safe” represents carbs, while what’s “risky”, proteins and vitamins.

God make us daring!

And finally let’s stop putting financial instability on steroids. The large dangerous exposures that could become dangerous for our bank systems are always built up with what’s perceived as safe, never ever with what’s perceived risky. 

For the record, most of the "zero-zero-zero-ten percent" idea is inspired in how Chile so intelligently managed their huge 1981-1983 bank crisis.

Give it a thought, the newspaper you read; would it dare to publish a Galileo-heliocentric opinion and risk being confronted by the Basel Inquisition?

More on Chile: https://ideas.repec.org/p/wbk/wbrwps/300.html

My 2019 letter to the Financial Stability Board

And the Academia kept silence.

Note: The Basel Committee’s use of the term “capital” in “risk weighted bank capital requirements” has sowed loads of confusions. Its real significance is “risk weighted bank shareholders’ equity/skin-in-the-game requirements". It has nothing to do with in what bank assets it’s invested.

“A ship in harbor is safe, but that is not what ships are for”. John A. Shedd, 1928. Does that not apply for banks too?

For about 600 years banks allocated credit based on risk adjusted interest rates. After risk weighted capital requirements were introduced, they allocate it based on risk adjusted returns on regulatory equity (RORE). Huge distortions ensued! 

And the Academia kept silence.

The risk weighted bank capital requirements are based on perceived credit risks and not on risks conditioned to how bankers react to perceived risks. Clearly the regulators know nothing about conditional probabilities.

And the Academia kept silence.

To delegate so much of the determination of credit risk into the hands of some few human fallible credit rating agencies, had, almost by definition, to introduce into our banking systems, a dangerous systemic risk.
And the Academia kept silence.

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

And the Academia kept silence.

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.

And the Academia kept silence.

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.

And the Academia kept silence.

Lower bank capital requirements for banks when refinancing 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.

And the Academia kept silence.

When outlook is rosy, investment grade abounds, banks can: hold little capital, leverage a lot, obtain high returns on equity, buy back lots of shares, pay lots of dividends and huge bonuses. When rain starts, junk grades appear… banks will stand naked.
And the Academia kept silence.

And all for nothing. Those excessive bank exposures that could be dangerous to our bank systems are always built-up with assets perceived or decreed as safe, and never ever with assets perceived as risky.

And the Academia kept silence.

Could it be that? “One has to belong to the intelligentsia to believe things like that: no ordinary man could be such a fool.” George Orwell

The statist confession that shall not be heard

“Assets for which capital requirements were nonexistent, were what had most political support: sovereign credits. A simple ‘leverage ratio’ discouraged holdings of low-return government securities" Paul Volcker

And in the USA those risk weighted bank capital requirements seem to be unconstitutional

On the Nobel Prize: The Economic Sciences Prize Committee of the Royal Swedish Academy of Sciences selects the Nobel prize winner in economic sciences. That prize was established by Sveriges Riksbank in 1968. The current Governor of said central bank, is Stefan Ingves who, from 2011 until 2019, served as the Chairman of the Basel Committee on Banking Supervision.

https://subprimeregulations.blogspot.com/2025/12/ai-chatgpt-grok-does-basel-committees.html

Could anyone arguing that what’s perceived as safe is much more dangerous to our bank system (heliocentric) than what’s perceived as risky (geocentric), be nominated for that prize by such a (Inquisition) committee? 

https://subprimeregulations.blogspot.com/2020/12/how-come-we-ended-up-with-stupid.html

PS: With the appearance ChatGPT – Grok, Academia will be asked much more on the why of its almost total silence on the outright dangerous bank regulations. Just wait until their peer reviewed papers get reviewed by #AI.

https://subprimeregulations.blogspot.com/2023/06/my-questions-to-ChatGPT-Grok-about.html

Since we know all about risks, to make your banks safe, we regulators, we the Basel Committee, we give you our risk weighted bank capital requirements. And the Academia (desperately wanting to be counted among the Pigs on Orwell’s farm) kept silence.

http://perkurowski.blogspot.com/2023/05/has-orwells-big-brother-already.html

Any risk, even if perfectly perceived, causes the wrong answer to it, if excessively considered.

Any risk, even if perfectly perceived, causes the wrong action, if excessively considered.

“A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it looks to rain” Mark Twain (supposedly)

And Mark Twain is right in that bankers, in general are risk adverse and, when they accept taking some, it is usually in small amounts and against high risk premiums.

And, for around 600 years, bank credit was allocated, usually with a view on the portfolio, based on risk adjusted net interest rates.

But then, in 1988 with Basel I, the Basel Committee introduced (I would say ‘concocted’ is a more precise term) the concept of risk weighted bank capital requirements, based on exactly the same credit risk aversion.

With that the regulators ignored that any risk, even if perfectly perceived, causes the wrong answer to it, if excessively considered.

If Twain was alive he could just as well be writing: “A bank regulator is a fellow that allow banks to hold little capital when the sun is shining, so that banks can pay lots of dividends and buy back lots of stock, but wants banks to hold much more capital, the moment it starts to rain”

And, since then, bank credit is allocated based on risk adjusted returns on equity and, of course, the higher the allowed leverage is the easier it is to obtain a higher return on equity.

John A. Shedd (1859 – 1928) wrote “A ship in harbor is safe, but that is not what ships are for”. And that should also apply to banks. Unfortunately, these capital requirements guarantee that banks stay in safe harbors, running the risk of dangerously overcrowding these, and stay away from the risky oceans, and most certainly not lending enough to those “risky” entrepreneurs and SMEs on which our real economies so much depend.

In his book “Money: Whence it came, where it went” (1975), John Kenneth Galbraith wrote “The function of credit in a simple society is, in fact, remarkably egalitarian. It allows the man with energy and no money to participate in the economy more or less on a par with the man who has capital of his own. And the more casual the conditions under which credit is granted and hence the more impecunious those accommodated, the more egalitarian credit is”

By doubling up on credit risk, the regulators made it so much more difficult for banks to fulfill such important societal function.

And it’s all so much worse. With their much lower bank capital requirements on loans to governments than on loans to citizens, statist/communist/ fascist regulators de facto imply bureaucrats/politicians know better what to do with credit for which repayment they’re not personally responsible for, than e.g. entrepreneurs.

And it is all so stupid. There’s never ever been a major bank crisis caused by the buildup of excessive exposures to what’s perceived as risky, those exposures have always been built up with assets perceived as safe.

The regulators, by basing most of their pro-cyclical bank capital requirements on perceived credit risks; not on misperceived credit risks, or unexpected dangers, like a pandemic, guaranteed all banks now stand there with their pants down. Basel Committee, Good Job!

My 2019 letter to the Financial Stability Board. Received and never answered 

And the Academia, scared of the Banking Inquisition’s High Priests, have kept silence, for decades

Risk-taking is the oxygen of all human development: God make us daring!

Some tweets on macro-imprudent policies

I tweeted this to BIS in response to a speech by Mario Draghi, President of the European Central Bank and Chair of the European Systemic Risk Board, titled "Macroprudential policy in Europe" delivered September 26, 2019

Macro-imprudent policy 1:

Regulators have based their risk weighted bank capital requirements on that what’s perceived as risky is more dangerous to our bank systems than what is perceived, decreed or concocted as safe. That puts bank crises on steroids.

Macro-imprudent policy 2:

The risk weighted bank capital requirements is as pro-cyclical as it gets. Getting rid of these is the best countercyclical measure.

Macro-imprudent policy 3:

The 0% capital requirements assigned to all Eurozone sovereigns’ debts, even when these are not denominated in their own printable fiat currency. This WILL blow up the Euro and perhaps, sadly, the EU too.

The “experts” in the independent agencies, those most likely to introduce systemic risks, must be continuously questioned and supervised.

Paul Tucker for more than 30 years a central banker and a regulator at the Bank of England writes in his "Unelected Power" 2018

“Unlike price stability, the authorities cannot ‘produce’ financial stability by their own efforts but must stop or deter private intermediaries from eroding the system’s resilience.

That cannot be delivered by looking at intermediaries one by one because the financial system is just that - a system, with components parts connected within sectors and markets, via interactions with the real economy, and across countries. 

As the first chairman of the Basel Supervision Committee, George Blunden said in the mid-1980s: It is part of the [supervisors] job to take a wider systemic view and sometimes to curb practices which even prudent banks might, if left to themselves, regard as safe.”

And yet with Basel I in 1988, Basel II in 2004 and current Basel III the regulators in the Basel Committee, ignoring the system, ignoring the distortions it causes in the allocation of credit to the real economy and ignoring that no major bank crisis have resulted from excessive exposures to what ex ante was perceive as risky, went ahead and introduced that mother of all systemic risk and procyclical regulation, which is the risk weighted capital requirements for banks.

“Curb practices which even prudent banks might, if left to themselves, regard as safe”? No way, it only guarantees especially large exposures, to what is especially perceived as safe, against especially little capital, laying the ground for especially large crisis.

I did note that in the 568 pages of “Unelected Power” I found no explicit reference to the risk weighted capital requirements for banks.

At the end of his book Paul Tucker suggests “The principles for delegating to independent agencies insulated from day to day politics”. I agree with these. Had they been in place Basel I II or III would not have existed. Just for a starter, in all of Basel’s bank regulations there is not one single word about the purpose of the banking system, one that must surely contain the need to allocate credit efficiently to the real economy.

There is one aspect though that is not sufficiently laid out in Tucker’s principles and that is the absolute must for the independent agency to contain sufficient diversity, not only to foster better discussion but also in order to hinder, as much as possible, these turning into closed mutual admiration clubs.

PS. In the 568 pages of “Unelected Power” I found no explicit reference to the risk weighted capital requirements for banks, those which for a start caused the 2008 crisis. 

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

What goes up too much must come down too much. The best countercyclical policy there is, is the elimination of the pro-cyclical ones.

“What goes up must come down, spinning wheel got to go 'round” David Clayton Thomas

Governor Lael Brainard on December 07, 2018, in “Assessing Financial Stability over the Cycle” a speech delivered at the Peterson Institute for International Economics, Washington, D.C., said:

“In an economic downturn, widespread downgrades of these low-rated investment-grade bonds to speculative-grade ratings could induce some investors to sell them rapidly--for instance, because lower-rated bonds have higher regulatory capital requirements or because bond funds have limits on the share of non-investment-grade bonds they hold.”

And Brainard then proceeds to extensively describe the advantages of countercyclical capital requirements (CCyB) for building additional resilience in the financial system.

YES...BUT, the other side of the mirror is: In an economic upturn, higher credit ratings of bonds could induce some investors to buy them rapidly--for instance, because higher-rated bonds have lower regulatory capital requirements, or because bond funds have lesser or no limits on investment-grade bonds they hold.

So if that is not procyclical what is?

Therefore, before thinking of using countercyclical capital requirements, which by themselves might be introducing distorting signals, which might make the use of these at the right moment when they are really needed harder, let’s get rid, altogether, of the risk weighted capital requirements for banks. Those, which, by the way, even when the economic cycles are correctly identified, still distort the allocation of bank credit to the real economy.

And since credit ratings were mentioned, in April 2003, at the World Bank I opined:

"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 credit rating agencies. This will introduce systemic risks in the market"

Here is my 2004 letter to the Financial Times, FT, "Towards a counter cyclical Basel?" It was not published 

The Minsky Moments were put on steroids

You need not to be an Einstein 

PS. Here my 2019 letter to the Financial Stability Board

PS. Here my 2019 letter to the IMF

PS. ChatGPT Grok: Are the current risk weighted bank capital requirements dangerously pro-cyclical?

ECB’s Sabine Lautenschläger explains why the risk weighted capital requirements for banks is total lunacy but, unfortunately, not even she hears it.

I quote the following from ECB’s Sabine Lautenschläger’s speech on February 15, 2018, “A stable financial system – more than the sum of its parts” 

“Logic can be a tricky thing. Apply it in the right way, and you always arrive at a consistent conclusion. But apply it in the wrong way, and it can lead you astray. And that happens all too easily. There are indeed many wrong ways in which we can apply logic.”

One of them is known as the fallacy of composition. It refers to the idea that the whole always equals the sum of its parts. Well, that idea is wrong. As we all know, the whole can be more than the sum of its parts – or less.

Consider this statement: if each bank is safe and sound, the banking system must be safe and sound as well. By now, we have learnt the hard way that this might indeed be a fallacy of composition.

Let me give you just one example. Imagine that a certain asset suddenly becomes more risky. Each bank that holds this asset might react prudently by selling it. However, if many banks react that way, they will drive down the price of the asset. This will amplify the initial shock, might affect other assets, and a full-blown crisis might result. Each bank has behaved prudently, but their collective behaviour has led to a crisis.

The business of banking is ripe with externalities, with potential herding and with contagion. These factors may not be visible when looking at individual banks, but they can threaten the stability of the entire system. This is one of the core insights from the financial crisis.”

Let me comment on the implications of this quite lengthy quotation: 

First: “a certain asset suddenly becomes more risky” That means that the real problem is that it was perceived as safer before.

Second: “The business of banking is ripe with externalities, with potential herding and with contagion.” There can be no doubt that potential herding” is much mote likely to occur with assets perceived as safe.

So what is Sabine Lautenschläger really saying with all this? That the current risk weighted capital requirements, Pillar 1, more perceived risk more capital – less perceived risk less capital, is sheer lunacy, though she might not understand it. 

The truth is that the real logic, not that pseudo logic applied by bank regulators, is that the safer an asset is perceived, the greater the potential danger to the bank system it poses.

Lautenschläger also said: “Imagine that there is a downturn in the financial cycle. From the viewpoint of each bank, credit risks increase and microprudential supervisors may want to increase Pillar 2 capital demands. Looking at the same trend, macroprudential supervisors might want to support credit growth and counter the cycle over a longer time horizon and from a systemic point of view. Thus, they may want to decrease Pillar 2 capital demands.”

“credit risks increase” That goes in the direction from safer to riskier. Does going from riskier to safer pose any danger? No!

So is not assigning the lowest capital requirements to what is ex ante perceived as safe just the mother of procyclical regulations, or in other words, the mother of all macroprudential imprudences? 

Ex post dangers are a function of ex ante perceptions. The safer something is perceived the more real danger it poses. The riskier something is perceived, the less harm it can cause.

How on earth could one expect a good application of Basel Committee’s Pillar 2 (Supervisory Review Process) from those who are messing it all up with a so faulty Pillar 1?

Recommendation: Ask a regulator: “What is more dangerous to the bank system, that which is perceived risky or what is perceived safe?” If he answers, the “risky”, ban him from regulating banks.

IMF, the Basel Committee’s procyclical risk weighted capital requirements puts financial cycles, global or local, on steroids

This year’s IMF Jacques Polak Annual Research Conference on November 2–3 is titled “The Global Financial Cycle.” 

It aims to bring together contributions by leading experts on the topic—from both within and outside the IMF—to improve the “understanding of a range of issues, including the causes and consequences of the global financial cycle, the transmission channels of global financial shocks, and the role of domestic policies in dampening the impact of global shocks.”

I wonder if, again, for the umpteenth time, the distortions produced by risk weighted capital requirements in the allocation of credit to the real economy will be ignored.

The following is the comment I posted on the IMF Blog

Risk weighted capital requirements, more risk more capital – less risk less capital, allows banks to earn much higher risk adjusted returns on equity with what is perceived decreed or concocted as safe, than on what is perceived as risky. 

That pushes more than ordinary the financial pursuit of “the safe” and the avoidance of “the risky”.

That de facto puts financial cycles, whether global or local, on steroids.

Will this comment be considered? I have not seen much action on the one I made last year.

PS. I have now read all the papers presented in the conference and the only one that makes somewhat of a reference to risk weighted capital requirements, is “Global financial cycles and risk premiums?” authored by Oscar Jorda, Moritz Schularick, Alan M. Taylor and Felix Ward, October 2017

It includes “If banks hold foreign assets on their balance sheets and mark them to market, price changes can synchronize the risk appetite and the trading behavior of banks around the world. For instance, if Federal Reserve policy affects U.S. equity prices, falling asset prices in the U.S. decrease (risk-weighted)-asset-capital ratios of U.S. as well as international banks, which start to cut down their risk-taking in sync with U.S. banks.

If no large risk-neutral player steps in to compensate for the lower risk taking of the leverage-constrained intermediaries, risk-spreads will increase.”

But as one can see that is how financial cycles or event affect “(risk-weighted)-asset-capital ratios”, but not how these risk weighted capital requirements affect the financial cycles.

For instance Greece would never ever have been able to obtain so much debt had it not been for the ridiculous low capital requirements on that debt.

Credit ratings do not reflect timely possible severe drops in commodity prices or volatile monetary policies

What is happening with commodities, like oil, and with emerging countries should open the eyes of bank regulators… but probably it won’t. 

Our bank nannies based their requirements of that capital that is to cover for unexpected losses on what they perceived as the one and only risk, namely the ex ante perceived expected credit risk… in much as it was reflected in the credit ratings. 

And the credit rating agencies rate the companies based on what they currently see. 

Where did the credit ratings reflect the possibility of a dramatic drop in the price of oil before it happened? Nowhere! 

Where do credit ratings consider the consequences, like for emerging markets, of shocking volatile monetary policies before they hit the market? Nowhere! 

And so now there is a lot of downgrading going on, and as a result lots of new capital is being required of banks, something that only accentuates the general downturn. 

The truth is that banks should already have had the capital to cover for unexpected losses, when they placed the assets on their balance sheets.

You need not to be an Einstein to know that current bank regulations are procyclical.

Jon Cunliffe, Deputy Governor for Financial Stability of the Bank of England spoke on November 15, 2015 about “The outlook for countercyclical macro prudential policy” 

He began with: “It is an interesting experiment to think what Einstein might have accomplished had he chosen the world of economics rather than physics. Would he have brought to our world the same brilliant simplicity and achieved the same lasting change in our understanding?”

I have no idea what Einstein would have done in such case but I am absolutely certain about what he would not have done.

He would not have set up pro-cyclical credit risk weighted capital requirements for banks, those which are lower for what is perceived as safe than for what is perceived as risky; those which allow banks to leverage more with what is perceived as safe than what is perceived as risky; those which therefore allow banks to earn higher risk-adjusted returns on what is perceived as safe than on what is perceived as risky; those which therefore in Mark Twain’s supposed words make bankers lend you the umbrella even faster than usual when the sun is out and take it away even faster than usual when it looks like it is going to rain.

When times are rosy and so much can seem safe, then banks need to hold little capital and so when times get bad, and so much seems risky, then banks, on top of their difficulties must also come up with additional capital or shed assets. No Mr Cunliffe Einstein would never have done a stupid thing like that.

Einstein would also have understood that the safer an asset is perceived the larger is its potential to deliver those unexpected losses that bank equity is to serve as a buffer against. To set capital requirements based on the ex ante expected credit losses is as dumb as it gets.

And Einstein would of course, before regulating the banks have asked: “What is the purpose of banks?” And when stress-testing banks, besides looking at what is on their balance sheets, Einstein would also have looked at what is not and perhaps should be.

But come to think of it… you should not have to be an Einstein to get all that!

With respect to developing countercyclical macro prudential policy Cunliffe expresses “I have some sympathy of the ‘don’t do it at all’ approach.

Yes Mr. Cunlifee. The regulators have done more than enough damage as is. Just eliminate the re-clearing in the capital of the perceived credit risk that has already been cleared for with interest rates and the size of the exposure. Don’t you understand that any risk, even though perfectly perceived, leads to the wrong actions if excessively considered?

PS.“What goes up must come down, spinning wheel got to go 'round” David Clayton Thomas