What if taking down our bank systems was/is an evil masterful plan for winter to come?

Tweets on "What if taking down our bank systems was/is an evil masterful plan for winter to come?"

The poison used is that of basing bank capital requirements on ex ante perceived risks, more risk more capital, less risk much less capital.

That way banks were given incentives to build up the largest exposures to what is ex ante perceived by bankers as safe, something which, as we know, in the long run, when ex post some of it turns out very risky, is what always take bank systems down.

For that they made sure no one considered making the risks conditional on how bankers perceive the risks.

And that hurdle cleared, some very few human fallible credit rating agencies were given an enormous influence in determining what is risky and what is safe.

And taking advantage of some statists or that few noticed, sovereigns were assigned a 0% risk weight, while citizens 100%. That guaranteed government bureaucrats got too much of that credit they’re not personally responsible, and e.g. the entrepreneurs too little.

And to make the plan even more poisonous some European authorities were convinced to also assign to all Eurozone sovereigns a 0% risk weight, and this even though these all take up loans in a currency that is not their domestic printable one.

And because banks were allowed to leverage much more with “safe” residential mortgages than with loans to “risky” small and medium businesses, houses prices went up faster than availability of jobs, and houses morphed from homes into investment assets

And finally, by means of bailouts, Tarps, QE’s, fiscal deficit, ultra low interest rates and other concoctions, enormous amounts of financial stimuli was poured on that weak structure… and so the evil now just sit back and wait for winter to come

http://theaaa-bomb.blogspot.com

PS. At the World Bank I warned that assigning too much influence to credit rating agencies introduced a dangerous systemic risk. 

PS. My letter to the Financial Stability Board

If the Basel Committee had only been asked these four simple questions about its risk weighted capital requirements for banks?

1. What? Do you really know what the real risks for banks are? If you do, why are you not bankers?

2. What? Don’t you see that allowing banks to leverage differently with different assets will lead to a new not market set of risk adjusted returns on equity. Are you not at all concerned this could dangerously distort the allocation of credit to the real economy?

3. What? Do you think that what’s perceived risky by bankers that which they adjust by means of lower exposures and higher risk premiums, is more dangerous to the bank system than what they perceive as safe?

4. What? A 0% risk weight of sovereigns? That could only be explained by their capacity to print currency in order to get out of debt. But is that not also one of their worst possible misbehaviors?

How much sufferings and how many unrealized dreams would not have been avoided?

And now, 30 years after that faulty regulation was introduced with the Basel Accord in 1988, these questions are still waiting for an answer.

PS. Here a list of some of the horrendous mistakes of the risk weighted capital requirements

Current risk weighted capital requirements are de facto regressive regulatory taxes imposed on the access to bank credit.

When interviewed by Dave Rubin, Don Boudreaux, defending a flat tax states:

“When you tax all income earning activities the same, then the relative prices of different types of labor services stay the same. With progressive taxes you create greater distortion in the economy and that makes us all a bit less wealthy than we would otherwise be”

Why is never a flat capital requirement for banks defended with the same impetus as a flat tax on income?

As is the risk weighted capital requirements for banks, which even though some leverage ratio has been imposed still operate on the margin, impose de facto different taxes on the access to bank credit.

To make it worse though in the case of taxes on income these are currently progressive, in the sense that they most affect those who are already by being perceived as risky have less and more expensive access to bank credit, these regulatory taxes are regressive.

PS. Why did Classical Liberals or Libertarians not speak up when, in 1988, with the Basel Accord, Basel I, the regulators risk weighted the sovereign with 0% and the citizens with 100%?

Current bank regulators should undergo a psychological test. They clearly seem to be afflicted by “false safety behavior”

I extract the following from “False Safety Behaviors: Their Role in Pathological Fear” by Michael J. Telch, Ph.D. 

“What are false safety behaviors? 

We define false safety behaviors (FSBs) as unnecessary actions taken to prevent, escape from, or reduce the severity of a perceived threat. There is one specific word in this definition that distinguishes legitimate adaptive safety behaviors - those that keep us safe - from false safety behaviors - those that fuel anxiety problems? If you picked the word unnecessary you’re right! But when are they unnecessary? Safety behaviors are unnecessary when the perceived threat for which the safety behavior is presumably protecting the person from is bogus.”

The risk weighted capital requirements for banks, more perceived risk more capital – less perceived risk less capital, fits precisely that of being unnecessary. If a risk is perceived the banker will naturally take defensive measures, like limiting the exposure or charging higher risk premiums. If there is a real risk that is of the assets being perceived ex ante as safe, but turning up ex post as risky.

The consequences of such false safety behavior by current bank regulators are severe:

They set banks up to having the least capital when the most dangerous event can happen, something very safe turning very risky. 

Equally, or even more dangerous, it distorts the allocation of bank credit to the real economy, it hinder the needed “riskier” financing of the future, like entrepreneurs, in order to finance the “safer” present, like house purchases and sovereigns.

It creates a false sense of security because why should anyone really expect that “experts” picked the wrong risks to weigh, the intrinsic risk of the asset, instead of the risk of the asset for the banking system.

I quote again from the referenced document:

“How do false safety behaviors fuel anxiety? 

There seems to be a growing consensus that FSB’s fuel pathological anxiety in several different ways. One way in which FSBs might do their mischief is by keeping the patient’s bogus perception of threat alive through a mental process called misattribution. Misattribution theory asserts that when people perform unnecessary safety actions to protect themselves from a perceived threat, they falsely conclude (misattribute) their safety to the use of the FSB, thus leaving their perception of threat intact. Take for instance, the flying phobic who copes with their concern that the plane will crash by repeatedly checking the weather prior to the flight’s departure and then misattributes her safe flight to her diligent weather scanning rather than the inherent safety of air travel.” 

In this respect stress tests and living wills could perhaps be identified as “unnecessary safety actions” the “checking of the weather”. 

Finally: “FSBs may fuel anxiety problems by also interfering with the basic process through which people come to learn that some of their perceived threats are actually not threats at all…threat disconfirmation…For this important perceived threat reduction process to occur, not only must new information be available but it also must be processed.”

The 2007/08 crisis provided all necessary information on that the risk weighting did not work, since all bank assets that became very problematic, had in common low capital requirements since they were perceived as safe. And this information has simply not been processed.

Conclusion, I am not a psychologist but given that our banking system operates efficiently is of utmost importance, perhaps a psychological screening of all candidates to bank regulators should be a must. Clearly the current members of the Basel Committee and of the Financial Stability Board, and those engaged with bank regulations in many central banks, would not pass such test.

I feel sorry for them, especially after finding on the web someone referring to "anxiety disorder" with: “I don’t think people understand how stressful it is to explain what’s going on in your head when you don’t even understand it yourself”

PS. Here is a brief summary of the mistakes of the risk weighted capital requirements for banks.

  

When government bureaucrats are favored more than entrepreneurs in the access to bank credit, the game is soon over

In 1988, with Basel I, out of some Pandora box, for the purpose of setting the capital requirements for banks,the  regulators came up with a risk weight of 0% for sovereigns and of 100% for citizens. As a result banks need to hold much less equity when lending to sovereigns than when lending to citizens.

That 0% risk weight was premised on that sovereigns were in possession of the money-printing machines and could therefore always repay. I am sure the Medici’s would have shivered hearing such a generous risk assessment.

So, since then, banks have been allowed to leverage much more with loans to sovereigns than with loans to citizens; and therefore obtain much higher risk adjusted returns on equity when lending to sovereigns than when for instance lending to entrepreneurs. 

That de facto implies believing in that a government bureaucrat can use bank credit that he himself has not to repay, better than an entrepreneur.

That alone should suffice to make clear how loony and statist the current bank regulations are.

But the world keeps mum on this. As I see it this is a regulatory crime against humanity that should be punishable.

Here is a more extensive explanation of the mistakes of risk weighted capital requirements for banks.

The litmus test any aspiring central banker or bank regulator should have to pass

Fact: Banks are allowed to leverage more with assets considered safe, like loans to sovereigns, the AAArisktocracy and mortgages, than with assets considered risky, like loans to SMEs and entrepreneurs.

So ask the candidates:

Does that mean “the safe” have even more and easier access to bank credit than usual; and “the risky” have even less and on more expensive terms access to bank credit than usual?

If the answer is no, disqualify the candidate.

If the answer is yes, then ask: 

Do you think that might dangerously distort the allocation of bank credit to the real economy? Or impede QE stimulus flow to where it could be most productive?

If the answer is no, disqualify the candidate.

If the answer is yes, then ask: 

In terms of what can pose the greatest risk to the bank system, would you agree with Basel II’s risk weights of 20% for what is rated AAA to AA and 150% for what is rated below BB-?

If the answer is yes, disqualify the candidate.

If the answer is no, then ask: 

Do you agree with a 0% risk weighting of sovereigns?

If the answer is yes, the candidate should be classified as an incurable statist, not independent at all, and accordingly dismissed.

If the answer is no, then one could proceed applying any other criteria considered relevant.

As a relevant criteria, the way the world looks, being a lucky person seems a quite valid one.

PS. How many of those currently in central banks, or in the Basel Committee for Banking Supervision, or in the Financial Stability Board would pass this test?

@PerKurowski

Paul Krugman there's huge Excel type data mistake that is bringing the Western economies down into deep depression

Ref: http://economistsview.typepad.com/economistsview/2013/04/paul-krugman-the-excel-depression.html

The regulators of the Basel Committee for Banking Supervision, when designing their risk weighted capital requirements for banks made the outrageous mistake of looking at the specific risks of banks assets, and not at the risk of those assets to the banks, or to the bank system.

That is why they came to assign a whopping 150% risk weight to what is rated below BB-, something so risky that bankers wont even touch it with a ten feet pole; while only a minuscule risk weight of 20% to what is rated AAA and that because of its perceived safety, could cause banks to create such exposures that if ex post the asset turn out riskier, these could bring the whole system down.

That makes banks dangerously lend too much to what is perceived safe and for the economy equally dangerous too little to what is perceived as risky, like SMEs and entrepreneurs. 

The Western world has thrived on risk-taking not risk aversion.

PS. The 0% risk weighing of sovereigns is just as mind-boggling.

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

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

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

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

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

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

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

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

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

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

Lawrence Summers, like most, is still blinded by the fairy tale of the risk-weighted capital requirements for banks

I refer to Professor Lawrence Summers “Five suggestions for avoiding another banking collapse” of May 21, 2017

In it Summers clearly evidences he has not yet woken up to the fact that the whole notion of the risk weighted capital requirements of banks is pure and unabridged nonsense… a regulatory fairytale. He still actually believes that risk weighting has anything to do with real risk weighting of the risks to our bank system.  In fact bad-luck risk weighted capital requirements might better cover for the unexpected risk in banking. And so here I explain it again, for the umpteenth time.

The current risk weighting is based on the ex ante perceived risk of bank assets, and NOT on the possibility of that those assets could ex post be risky for the banks and for the bank system

That is for example why regulators in Basel II assigned to what was perceived as AAA rated and that because of such perception of safety could lead to a build up of dangerously excessive exposures, a tiny 20% risk weight; while to the below BB- rated, so innocuous because the banks would never voluntarily create large exposures to it, they assigned a whamming 150%.

Rule: If bankers are not capable of managing perceived risks, then zero capital might be the best requirement, because the faster they would fold.

Truth: A bank system can collapse because of unexpected events (like devaluations), major financial fraud, and when assets ex ante perceived as very safe suddenly turn out ex post as very risky. None of these risks is covered by the Basel Committees’ risk weighted capital requirements.

Summers writes: “there is distressingly little evidence in favor of the proposition that banks that are measured as better capitalized by their regulators are less likely to fail than other banks.” That might be true but only to believe that the measuring of the “measured as better capitalized” is correct, is absurd. Too much reputable research has taken the historical not “risk weighted” capital to asset ratios to be the same as the current capital to risk-weighted asset ratios, which is comparing apples to oranges.

Summers explains: “Our paper examines a comprehensive suite of volatility measures including actual volatility, volatility implied by option pricing, beta, credit default spreads, preferred stock yields and earnings price ratios… none [of which] suggest a major reduction in leverage for the largest US financial institutions, large global institutions or midsize domestic institutions.” I just ask, Professor, amongst so much glamorous sophistications, did you examine the gross not risk weighted assets to capital ratio? That would have probably sufficed.

Summers recommends, “First, it is essential to take a dynamic view of capital” Absolutely! But Professor, do you not believe that a real dynamic view would have to take into account what the shape of the future real economy would be if regulators insist in distorting with their risk weighing the allocation of bank credit to the real economy? For instance should a real stress test not also look at what is not on banks’ balance sheets… like for instance to see if vital risky loans to SMEs and entrepreneurs are too inexistent?

Summers recommends: “banks should not be permitted to take excessive risks or treat customers unfairly in order to raise their franchise value.” Indeed, but what about by means of current risk weighting unfairly allowing those perceived, decreed (sovereigns) or concocted as safer, to have much better access to bank credit than usual than those perceived as risky? Does that not foster more inequality?

Summers very correctly write: “it is high time we move beyond a sterile debate between more and less regulation. No one who is reasonable can doubt that inadequate regulation contributed to what happened in 2008 or suppose that market discipline is sufficient to contain excessive risk-taking in the financial industry” But that requires understanding and accepting that the risk weighting, which so favored what was AAA rated and sovereigns was “the inadequate regulation”. Moreover, as Einstein said, “No problem can be solved from the same level of consciousness that created it”, that requires us to completely change all our current regulators and start from scratch. 

SO NO! Professor Lawrence Summers, with respect to bank regulations, may I respectfully suggest you either wake up or shut up!

PS. And that goes for most of you others bank regulation experts out there.

PS. This is not the first way I have told Professor Summers he does not get it.

PS. Here is a set of questions current bank regulators do not dare to answer.

Why are excessive bank exposures to what’s perceived safe considered as excessive risk-taking when disaster strikes?

In terms of risk perceptions there are four basic possible outcomes:

1. What was perceived as safe and that turned out safe.

2. What was perceived as safe but that turned out risky. 

3. What was perceived as risky and that turned out risky.

4. What was perceived as risky but that turned out safe.

Of these outcomes only number 2 is truly dangerous for the bank systems, as it is only with assets perceived as safe that banks in general build up those large exposures that could spell disaster if they turn out to be risky.

So any sensible bank regulator should care more about what the banks ex ante perceive as safe than with what they perceive as risky.

That they did not! With their risk weighted capital requirements, more perceived risk more capital – less risk less capital, the regulators guaranteed that when crisis broke out bank would be standing there especially naked in terms of capital. 

One problem is that when exposures to something considered as safe turn out risky, which indicates a mistake has been made, too many have incentives to erase from everyones memory that fact of it having been perceived as safe.

Just look at the last 2007/08 crisis. Even though it was 100% the result of excessive exposures to something perceived as very safe (AAA rated MBS), or to something decreed by regulators as very safe (sovereigns, Greece) 99.99% of all explanations for that crisis put it down to excessive risk-taking.

For Europe that miss-definition of the origin of the crisis, impedes it to find the way out of it. That only opens up ample room for northern and southern Europe to blame each other instead.

The truth is that Europe could disintegrate because of bank regulators doing all they can to avoid being blamed for their mistakes.

IMF: The “I scratch your back if you scratch my back” crony statism deal between sovereigns and banks, must stop.

In 1988, with the Basel Accord, Basel I, for the purpose of capital requirements for banks, regulators assigned to the sovereigns a risk weight of 0%, while citizens got one of 100%.

That meant banks would be able to leverage more their capital when lending to sovereigns than when lending to citizens. 

That meant banks would be able to earn higher expected risk adjusted returns on equity when lending to sovereigns than when lending to citizens. 

That meant that banks would lend more and at lower rates than usual to sovereigns and in relative terms less and at higher rates than usual to citizens.

That de facto established the Sovereign-Bank Nexus. I Sovereign help to guarantee you banks, and you help to finance me abundantly and cheap.

IMF, in its Global Financial Stability Report 2017, page 36 and 37 have a section titled “The Sovereign-Bank Nexus could reemerge”. It correctly spells out how banks can be affected by difficulties of sovereigns and how sovereigns can be affected by difficulties of banks. 

But it makes absolutely no reference to the regulatory support of the Sovereign-Bank Nexus previously described. Why?

That runaway statism must stop!

IMF, Basel Committee for Banking Supervision: Don’t tell me you do not know who did the Eurozone in?

PS. November 2016 Olivier Blanchard agreed on that there was a need to research the distortions produced by these regulations. Has that started?

If bank regulations had been privatized, how much would a Basel Committee Ltd have paid in fines for 2007-08 crisis?

I ask, because in courts it would have been quite easy to demonstrate that the banking sectors excessive exposures, to for instance AAA rated securities backed with mortgages to the subprime sector in the US, or in loans to a sovereign like Greece, those which caused the crisis, were the direct result of the risk weighted capital requirements for banks.

By strangely awarding lower risk weights to what was perceived as safe, which translated into lower capital requirements, the banks could leverage their equity with exposures to the “safe” many times more than with exposures to what was perceived as risky, like loans to SMEs.

As an example the risk weight for the AAAs was 20%, for sovereigns it hovered between 0 and 20% (Greece) and for SMEs 100%. That meant banks could leverage their equity 62.5 times with AAAs, unlimited to 62.5 times with sovereigns, but only 12.5 times with SMEs. That meant banks would earn much higher expected risk adjusted returns on equity on AAAs and sovereigns than on SMEs. 

I mentioned above, “strangely awarding”, because any regulator who knows what he is doing, would have gone back to analyze what causes bank crisis. Doing so he would have discovered that excessive exposures to what were ex ante perceived as risky never ever occur, (ask Mark Twain). All crises result from either unexpected events (devaluations), criminal behavior (loans to affiliates) or excessive exposures to something ex ante perceived very safe but that ex post turned out to be very risky.

So if society had brought this in front of a court, how much would Basel Committee Ltd have been fined? Clearly so much that it would have been out of business; so much more than what happened to Arthur Andersen when it was brought down for failing in its auditing of Enron.

And all that before all those “risky” SMEs, those who as a result of these regulations had their access to bank credit impaired, would have sued Basel Committee Ltd for the loss of their lifetime opportunities. 

But what has happened to the regulators responsible for the Basel Committee for Banking Supervision? Nothing, zilch, zero, nada, in fact many of them have been promoted.

And anyone knows what has happened to those emission controllers that were cheated by Volkswagen? Nothing? Perhaps there is a real case for privatizing regulations and controls, that way we could at least have some accountability.

PS. In the case of the larger more “sophisticated” banks the Basel Committee even went as far as allowing these to use their own models to calculate capital requirements, something like allowing Volkswagen to calculate their own carbon emissions.