Showing posts with label risk adjusted interest rates. Show all posts
Showing posts with label risk adjusted interest rates. Show all posts

Saturday, April 16, 2022

My brevissimus criticism lecture on the Basel Committee’s bank regulations

Students. 

Let’s refer to two types of bank assets, those perceived as safe, e.g., government debt and residential mortgages; and those perceived as risky, e.g., loans to small businesses and entrepreneurs.

Let’s also assume all these assets, whether the Safe or the Risky, are offering perfect risk adjusted interest rates.

Before the Basel Committee regulations, the banks, with a general look to the safety of their whole portfolio, would have given all of these assets, whether safe or risky, a quite similar consideration.

But, when the Basel Committee imposed risk weighted bank capital requirements, more capital/equity for what’s perceived as risky than for what’s perceived (or decreed) as safe, that all changed.

Because banks can now leverage their capital/equity much more with what’s “safe”, the risk adjusted interest rates offered by the Safe, produce them higher risk adjusted returns on their equity, than the risk adjusted interest rates offered by the Risky.

That dramatically distorted the allocation of bank credit. 

The Safe now get too much credit, often at rates lower than what their correct risk adjusted interest rate would demand. As a consequence, excessive bank exposures are construed, turning the Safe effectively into risky and very dangerous to the stability of bank systems. (Have you ever heard of a dangerous asset bubble built-up with assets perceived as risky?)

The Risky now get too little credit and, whatever they get, is at interest rates higher than what their correct risk adjusted interest rates would merit. As a consequence, the Risky become riskier, and too little risk-taking, the oxygen of all development, takes place, something which, of course, weakens the economy.

Why would regulators do this? As Paul Volcker (valiantly) confessed “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”

Students, one big problem is that the Academia seem not to care one iota about it, so this might have been your only chance to hear this explanation. 

Why should you care? Having banks give much priority to refinancing the safer present than financing the riskier future, cannot be in your best interests.

Monday, May 24, 2021

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.

Saturday, January 30, 2021

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 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

“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


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.

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.


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.

Thursday, December 31, 2020

How come we ended up with stupid portfolio invariant risk weighted bank capital requirements?

Which are based on:

That those excessive exposures that can really be dangerous to our bank systems are build up with assets perceived as risky and not with assets perceived as safe.



That substituting risk adjusted returns on equity for risk adjusted interest rates, would not seriously distort the allocation of bank credit.



Though Paul A. Volcker, in his autography “Keeping at it”, valiantly confessed “The assets assigned the lowest risk, for which capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages”


And here my explanations:

All bank regulators faced/face a furious attack mounted by dangerously creative capital minimizing / leverage maximizing financial engineers, who, getting rid of traditional loan officers, those with their “know your client” and their “what are you going to use the money for?”, managed to capture the banks. (And, since less capital means less dividends, they can also pay themselves larger bonuses.)

Hubris! “We regulators, we know so much about risks so we will impose risk weighted capital requirements on banks, something which will make our financial system safer” Yep, what’s risky is risky, what’s safe is safe. What is there not to like with such an offer? And the world, for the umpteenth time, again fell for demagogues, populists, Monday morning quarterbacks and those who find it so delightful to impress us rolling off their tongues sophisticated words like derivatives.

In a world full of mutual admiration clubs, like the Basel Committee and Academia in general, you do not ask questions that can imply criticism of any of your colleagues or superiors, “C’est pas comme il faut», nor, if you are a high shot financial journalist, do you risk not being invited to Davos or IMF meetings.

"It is difficult to get a man to understand something, when his salary depends upon his not understanding it!" Upton Sinclair

Clearly there are many more jobs with ever growing thousands of pages of regulations than with just a one liner: “Banks shall have one capital requirement (8%-15%) against all assets”. And so, instead of getting rid of the extremely procyclical credit risk weighted capital requirements, they designed new insufficient countercyclical ones.

“The time spent on any item of the agenda will be in inverse proportion to the sum involved." Parkinson’s law

Since bank regulators must have heard of (supposedly) Mark Twain’s “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” it is clear they all missed their lectures on conditional probabilities.


“There are some mistakes it takes a Ph.D. to make”, Daniel Moynihan.

“One has to belong to the intelligentsia to believe things like that: no ordinary man could be such a fool”, George Orwell, in Notes on Nationalism


And so now: 

“A ship in harbor is safe, but that is not what ships are for” John A. Shedd, something that should apply to banks too. Sadly, dangerously our bank systems, banks are overpopulating safe harbors and, equally dangerous for our economy, underexploring risky waters. 

“What gets us into trouble is not what we don't know. It's what we know for sure that just ain't so.” Mark Twain

And since current bank capital requirements are mostly based on the expected credit risks banks should clear for on their own; not on misperceived credit risks, like 2008’s AAA rated MBS, or unexpected dangers, like COVID-19, now banks stand there with their pants down.

Let us pray 2021 will not be too hurtful.

PS. Might “availability heuristic” “availability bias” help explain these loony risk weighted bank capital requirements?

Sunday, December 20, 2020

The Basel Committee for Banking Supervision’s dangerous distortion of the allocation of bank credit, all explained for dummies in just four tweets.

If a safe borrower’s 4% and a riskier borrower’s 6% provide banks the same 1% risk adjusted net margin then, before the introduction of BCBS’s credit risk weighted capital requirements, those would have been the rates charged by banks.

But now, because the “safer” can e.g. be leveraged 25 times while the riskier e.g. only 12.5 times, with those initial rates, the safer will provide banks a 25% risk adjusted return on equity, while the riskier only 12.5%.

So, now the safer could be offered less than a 4% rate, even down to 3.5% (new risk adjusted net margin of .5%) and still be competitive vs. the riskier when accessing bank credit, and/or be awarded too much credit… which could (will, sooner or later) turn him risky.

And the riskier will now have to pay 7% (new risk adjusted net margin of 2%) in order to remain competitive vs. the safer, which would make him even riskier, or not have access to credit at all, which could hurt the growth possibilities of the real economy



Tuesday, December 10, 2019

Here a simple as can be one-minute explanation of the distortions produced by the risk weighted bank capital requirements in the allocation of credit to the real economy.

For 600 years, before the Basel Accord of 1988, banks, with an eye to their overall portfolio, allocated their assets/credits depending on the perceived risk adjusted return these were to produce.

For instance, if a safe AAA to AA rated asset at 4% interest rate and a riskier asset rated BBB+ to BB- a 7% interest were, in the mind of the banker, both producing an acceptable 1% net risk adjusted return, he could pick either one or both. If banks were allowed (by markets or regulators) to leverage their assets 12.5 times, that would produce the bank a 12.5% risk adjusted return on equity.

But the introduction of the risk weighted bank capital requirements changed all that.

Basel II, 2004, standardized risk weights banks assigned a risk weight of 20% to AAA to AA rated assets, and 100% BBB+ to BB- rated assets.

That based on a basic capital requirement of 8% translated into a 1.6% capital requirement for AAA to AA rated assets, and 8% for BBB+ to BB- rated assets.

That mean banks could leverage AAA to AA rated assets 62.5 times, while only 12.5 times with BBB+ to BB- rated assets.

So, with the same previous 1% net risk adjusted return AAA to AA rated assets would now yield a 62.5% risk adjusted return on equity while the BBB+ to BB- rated assets would keep on yielding a 12.5% risk adjusted return on equity.

And so either the BBB+ to BB- rated risky had to be charged 12% instead of 7%, so as to deliver the 5% risk adjusted return that, with a 12.5 times allowed leverage would earn banks a 62.5% risk adjusted return on equity, something which naturally made the risky even riskier; or the AAA to AA rated could be charged a lower 3.2 % interest rate instead of 4%, and still deliver a 12.5% risk adjusted return on equity.

What happened? The risky, like unsecured loans to entrepreneurs, were abandoned by banks, or had to pay much higher interest rates, while the safe, like sovereigns, residential mortgages and AAA rated, were much more embraced by banks, and even offered lower interest rates than in the past.

This is the distortion in the allocation of bank credit to the real economy that the regulators have caused. Is that good? Absolutely not! It promotes excessive credit to what’s perceived or decreed safe, and insufficient to what’s perceived as risky. 

And since risk taking is the oxygen of all development, with it, regulators have doomed our real economy and financial sector to suffer from lack of muscles, severe obesity and osteoporosis.

“A ship in harbor is safe, but that is not what ships are for.” John A. Shedd. But the Basel Committee for Banking Supervision is causing banks to dangerously overpopulate safe harbors, while leaving the riskier oceans to other investors and small time savers.

And the savvy loan officers were substituted by creative bank equity minimizing financial engineers

And the risk-free rate became a subsidized risk-free rate.

The risk weights in the risk weighted bank capital requirements are to access to credit, what tariffs are to trade, only more pernicious.

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