#AI ChatGPT Grok: Bank regulations that favor government debts, does that not doom nations to go broke and default on its debts?

Note: Since 1988 the Basel Committe has allowed much lower bank capital/equity requirements against government debts than against loans to farmers, small businesses and entrepreneurs... and so I asked artificial intelligence:

I asked ChatGPT:

Briefly, in about 200 words: If a nation decrees much lower bank capital/equity requirements against its government debt than against loans to its farmers small businesses and entrepreneurs, is it not doomed, sooner or later, to go broke and, one way or another, default on its debts?

ChatGPT answered:

"Brief answer: not automatically—but it meaningfully raises the risk over time.

If regulators require much less bank capital against government debt than against loans to farmers, small businesses, and entrepreneurs, banks will rationally shift balance sheets toward sovereign bonds. That makes government borrowing cheaper and private-sector credit relatively scarcer or more expensive.

In the short run, this can look stable: the government funds itself easily, banks appear well capitalized (because sovereign debt is treated as “safe”), and reported risk metrics improve.

But structurally, several risks build up:

1. Credit misallocation. Productive, growth-generating sectors receive less financing. Slower private investment reduces long-term GDP growth and the tax base.

2. Sovereign–bank doom loop. Banks become heavily exposed to their own government’s debt. If fiscal conditions deteriorate, doubts about sovereign solvency weaken banks simultaneously.

3. Fiscal moral hazard. Artificially cheap funding reduces pressure for fiscal discipline.

Whether this leads to default depends on factors such as monetary sovereignty (can it print its own currency?), external debt levels, political stability, and growth capacity. Countries with strong institutions and growth can sustain such distortions for long periods. Weak-growth, high-debt countries are more vulnerable.

So it is not “doomed” by definition—but systematically biasing capital rules toward government debt increases the probability of fiscal stress and, in extreme cases, restructuring or default."

I said: Thanks

It said: You’re most welcome. If you’d ever like to push the question further—say, how one might quantify that long-run probability using growth rates, debt dynamics, and regulatory distortions—I’d be glad to explore it with you.

I asked Grok:

Briefly, in about 200 words: If a nation decrees much lower bank capital/equity requirements against its government debt than against loans to its farmers small businesses and entrepreneurs, is it not doomed, sooner or later, to go broke and, one way or another, default on its debts?

Grok answered:

"Yes, such a policy is a recipe for eventual fiscal ruin—though "sooner or later" depends on reserve-currency status, printing presses, and political restraint.

By setting bank capital requirements near zero for government debt (standard Basel treatment: 0% risk weight for domestic sovereigns) while demanding 75–150%+ for loans to farmers, small businesses, or entrepreneurs, regulators force banks to favor the state. A bank earns the same return on equity lending $100 to the Treasury as $8–20 to a risky private borrower. Result: massive crowding-out of productive credit, slower growth, thinner tax bases, and politicians hooked on artificially cheap deficit financing.

The economy stagnates; government debt-to-GDP climbs. When markets finally balk, the sovereign either defaults outright, restructures, or—more commonly for currency issuers—inflates away the burden (a hidden default that destroys savings and trust). History is littered with examples: Argentina’s repeated cycles, Greece 2010s, Weimar, Zimbabwe. Even Japan (260%+ debt/GDP) and Europe’s periphery show the strain; only the US dollar’s exorbitant privilege buys extra time.

Neutral, risk-based capital rules (treating sovereigns like any other borrower) would restore market discipline and channel credit to wealth creators. Discriminating by decree is not prudence—it is a slow-motion suicide pact between banks and the state. Without reversal, insolvency is the logical endpoint."

I said: Thanks!

It said: You're very welcome! Happy to dive deeper anytime—whether on sovereign risk weights, historical blowups, or better alternatives. Just say the word.

My comment: With so many concerns expressed daily about artificial intelligence, is our human intelligence sufficiently questioned?

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

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

#AI #ChatGPT #Grok: Five questions on: What if there was the same bank capital/equity requirement against all bank assets?

I asked ChatGPT"

"If instead of 1988 Basel Committee’s risk weighted capital requirements, banks needed to hold e.g., a same 10 percent in capital against sovereign debts, residential mortgages, securities rated AAA and loans to small businesses and entrepreneurs, please:  With a Yes or a No:

Would the sovereigns’ debts be as high as when compared to current GDPs?

Would house prices be as high as these currently are?

Would the 2008 GFC, which in much detonated by AAA rated MBS turning risky, have happened?

Would the GDP of nations be lower or higher than today?

Would we all be better off today?"

If you like, in max 200 words, explain each of your answers.

 

ChatGPT answered: Yes or No answers:

Would sovereigns’ debts be as high as when compared to current GDPs? No

Would house prices be as high as these currently are? No

Would the 2008 GFC, which in much detonated by AAA rated MBS turning risky, have happened? No

Would the GDP of nations be lower or higher than today? Higher

Would we all be better off today? Yes

Brief Explanation (within 200 words):

 

"If banks had been required to hold the same capital (e.g., 10%) against all assets—government debt, AAA securities, mortgages, and small business loans—credit allocation would have been more balanced and market-driven. Governments would have faced real financing costs, limiting their debt growth. Housing prices would have risen more modestly without the capital incentive to overload on mortgages. The 2008 Global Financial Crisis was triggered largely because AAA-rated mortgage-backed securities attracted minimal capital requirements while hiding systemic risk; under equal capital rules, banks would have held fewer such assets or been better cushioned.

 

With better risk distribution and more capital backing loans to entrepreneurs, productive investment would likely have increased, supporting more resilient and inclusive GDP growth. Fewer distortions and crashes would mean less inequality and instability, making society better off overall—economically and socially.

 

This is not utopia—but better regulation could have enabled more sustainable growth."

I said: Thanks!

ChatGPT replied: 

You're very welcome! Always glad to help clarify. If you'd ever like to explore how such capital rules could be reformed today—or their political barriers—just let me know.

 

I asked Grok exactly the same question, in exactly the same way:

 

Grok answered:

 

Below are the Yes/No answers followed by brief explanations (max 200 words each) for each question, 

 

Would the sovereigns’ debts be as high as when compared to current GDPs? No

A uniform 10% capital requirement would constrain banks’ ability to hold large volumes of sovereign debt, as they’d need more capital than under Basel’s low or zero risk weights for sovereigns. This would limit sovereign borrowing, forcing governments to curb deficits or seek alternative funding, likely reducing debt-to-GDP ratios. Historical data suggests Basel’s framework enabled high sovereign debt (e.g., Eurozone debt-to-GDP peaked at 92% in 2014). A stricter requirement would discourage reckless lending to governments, fostering fiscal discipline and lower debt levels relative to GDP.

 

Would house prices be as high as these currently are? No

A 10% capital requirement on residential mortgages would reduce banks’ lending capacity compared to Basel’s low risk weights (e.g., 35% for mortgages). Less credit availability would dampen housing demand, lowering price growth. For example, post-2008, tight credit conditions in some markets curbed house price surges. Higher capital needs would limit speculative bubbles, keeping prices more aligned with incomes and fundamentals.

 

Would the 2008 GFC, which in much detonated by AAA-rated MBS turning risky, have happened? No

A 10% capital requirement on AAA-rated mortgage-backed securities (MBS) would have reduced banks’ exposure to these assets, as Basel assigned them near-zero risk weights, encouraging overinvestment. This overreliance fueled the 2008 crisis when MBS turned toxic. Higher capital buffers would have limited leverage and forced better risk assessment, likely preventing the scale of the crisis. The crisis’s roots in misrated securities would have been mitigated by stricter capital rules.

 

Would the GDP of nations be lower or higher than today? Higher

A uniform 10% capital requirement would shift lending toward productive sectors like small businesses, which Basel penalized with high risk weights. Increased credit access for entrepreneurs would spur innovation and growth, boosting GDP. While reduced sovereign and mortgage lending might initially slow consumption, long-term economic efficiency would improve. Historical evidence shows SMEs drive job creation (e.g., 60% of U.S. jobs). Balanced capital rules would support sustainable growth over debt-fueled bubbles.

 

Would we all be better off today? Yes

A 10% capital requirement would promote financial stability by reducing sovereign debt, housing bubbles, and risky MBS exposures, averting crises like 2008. More lending to small businesses would foster innovation, job creation, and equitable growth. While short-term consumption might dip, long-term economic resilience and fairer capital allocation would benefit society. Reduced inequality from less rent-seeking in housing and sovereign debt markets would enhance overall well-being.

Thanks!

 

You're welcome!

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

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

What about some transparency on state aid given to the State?

Matthew Lesh discusses “level playing field”, “state aid”, domestic subsidies and transparency: “Relaxed subsidies rules are a free rein to pick winners without transparency” City AM, March 16, 2022.

In 1988, risk weighted bank capital requirements were introduced. Basel I, decreed weights of 0% the government, 40% residential mortgages and 100% citizens. Though modified by the introduction of more risk categories in 2004’s Basel II, the discrimination in the access to bank credit still remains.

That regulation translates into banks being allowed to leverage their capital, basically their equity, much more when lending to the State, than to the citizens. That means banks can much easily earn desired risk adjusted returns on equity when lending to the State than when lending to the citizens. That translates into a subsidy of government borrowings.

Don’t just take my word for it. Paul Volcker, in his 2018 autobiography “Keeping at it”, wrote: “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"

The scary truth is that we confront an utterly creative and non-transparent financial statism/communism of monstrous proportions, which impedes the markets to signal what the undistorted interest rate on governments debts should be. 

Are current ultra-low interest rates on government debt something weird? Of course not: a) require banks to hold the same capital against all assets (as it used to be); b) stop central banks from purchasing with their QE government debt; c) take away liquidity requirements that force banks to hold government debt; d) stop ordering pension funds and insurers to buy “safe” government debt irrespective of the price; and you would see government debt traded at much higher rates.

The difference between the interest rates governments would pay on their debts in absence of all above mentioned favors, and the current low interests is, de facto, a well camouflaged debt, retained before the holders of those debts could earn it.

All this empowers the Autocratic Bureaucracy.

Who has approved these subsidies that are not recognized much less measured? What if the owner of a small British businesses makes the case to the Competition Appeal Tribunal, that he believes an unfair subsidy to a competitor in the access to bank credit, has been provided by the Prudential Regulation Authority (PRA)?

PS. 2012 Citi AM published an opinion of mine. It was much on the same theme

What if in the early 19th century The First Bank of the United States had regulated banks as the Federal Reserve began to do in 1988.

Sir, it is only now I read Steven Pearlstein reviewing Jonathan Levy’s “Age of American Capitalism”, “From commerce to chaos: An economic history of the United States”, Washington Post, June 4, 2021 

It says: “The ‘American system’ … required a new system of credit built around a government-chartered National Bank and government debt”.

That contrasts with John Kenneth Galbraith's: “Banks opened and closed doors and bankruptcies were frequent, but as a consequence of agile and flexible credit policies, even the banks that failed left a wake of development in their passing” “Money” (1975)

Why does not Washington Post invite some prominent financial historians to debate: Where would America be if “The First Bank of the United States” (1791-1811) had imposed bank capital requirements similar to those the Federal Reserve did in 1988? 

What the Fed did was succinctly explained by Paul Volcker in his 2018 autobiography in terms of: “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”. 

Would that not be an important debate that should have been started long ago? 

PS. That quote from Galbraith’s “Money” has a very personal meaning to me. It inspired my very first Op-Ed, 1997 in Caracas Venezuela. 

PS. Steve Pearlstein wrote: “Moral Capitalism: Why Fairness Won’t Make Us Poor”. Since current bank capital requirements, by doubling down on perceived credit risk unfairly decrees that the less creditworthy are also less worthy of credit, he could be interested in what Galbraith, opined in that same “Money”.

“The banks’ function of democratization of capital as they allow entities with initiative, ideas, and will to work although they initially lack the resources to participate in the region’s economic activity. In this second case, Galbraith states that as the regulations affecting the activities of the banking sector are increased, the possibilities of this democratization of capital would decrease. There is obviously a risk in lending to the poor.” 

Indeed, when it comes to access to bank credit, fairness, can only help to make us rich.

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.

“I am not sure about 'subsidised' sovereign. Since sovereign is ultimate safety net for entire financial system… the term is I'll suited.”

My answer:

Yes a sovereign, if we ignore inflation and the possibility of being repaid in worthless money, the sovereign represents no risk if it takes on debt denominated in a currency it can print. Which by the way is not the case with the sovereigns in the Eurozone.

But let us assume that in the open market the required risk/cost/inflation adjusted net return for a sovereign in .5% and for the risky SMEs 3%

Then if banks, as it used to be for almost 600 years, had to hold one single capital against the risks of its whole portfolio, and the authorities, or in their absence the markets, allowed banks to leverage 12 times then the risk/cost/inflation adjusted required expected return on equity would be 6% for sovereigns and 36% for SMEs.

BUT, since banks are now allowed to leverage immensely more with safe sovereigns, let us say 40 times and only 12 times with SMEs, the now distorted risk/cost/inflation adjusted expected ROEs are 20% for sovereigns and still 36% for SMEs. So now banks can offer to lower the interest rates to sovereigns and still obtain the risk/cost/inflation adjusted required expected return on equity of 6% for sovereigns, ergo the subsidized sovereign.

OR, since banks could now earn a risk/cost/inflation adjusted expected ROEs of 20% on sovereign debt, then in terms of comparable risk adjustments it would have to earn more than 36% on SMEs, or not lend to them at all, ergo that subsidy to the sovereign, is paid by others who find their access to bank credit made more difficult and expensive as a consequence of the risk weighted bank capital requirements. 

PS. Is there no sovereign risk present when some current rates are negative and central banks work like crazy to produce 2% inflation? 

PS. If you go back in time and start taking about risk-free sovereigns to bankers who sometimes had their head chopped off or were been burned when trying to collect from the sovereigns, they would think you were crazy.

My Fourth of July 2019’s tweets to the United States of America

This Fourth of July 2019, here below, are three tweets in which, to the United States of America that I admire and am so grateful to, I express my very heartfelt concerns.

In 1988 America signed on to the Basel Accord’s risk weighted capital requirements for banks. 

These gave banks huge incentives to finance what was perceived as safe, and to stay away from the “risky”. 

It is so contrary to a Home of the Brave opening opportunities for all.

And bank regulators decreed risk weights: 0% sovereign, 100% citizens

That implies bureaucrats know better what to do with credit than entrepreneurs

That has nothing to do with the Land of the Free, much more with a Vladimir Putin’s crony statist Russia

America, where do you think you would be if you had welcomed all your immigrants with risk weighted bank capital requirements?

PS. “grateful to”? Had my father, a polish soldier not been rescued by American’s from a German concentration camp April 1945, I would not be.

PS. As one of those millions Venezuelan in exile, I know my country’s future much depends on America’s will to support its freedom.

September 2, 1986 was the tragic night when Paul A. Volcker, in London, gave in to (insane) European bank regulators.

Paul A. Volcker in his autobiography “Keeping at it” of 2018, penned together with Christine Harper, valiantly accepted that the risk weighted bank capital requirements he helped to promote, had serious problems. In pages 146-148 he writes:

"The travails of First Pennsylvania and Continental Illinois, the massive threat posed by the Latin American crisis, and the obvious strain on the capital of thrift institutions had an impact on thinking over time, but strong action was competitively (and politically) stalled by the absence of an international consensus.

An approach toward dealing with that problem was taken by the G-10 central banking group meeting under the auspices of the Bank for International Settlements (BIS) headquartered in Basel, Switzerland. A new Basel Committee would assess existing standards and practices in a search for an analytic understanding.

Progress was slow… 

The US practice had been to asses capital adequacy by using a simple “leverage ratio”-in other words, the bank’s total assets based compared with the margin of capital available to absorb any losses on those assets. (Historically, before, the 1931 banking collapse, a ten percent ratio was considered normal)

The Europeans, as a group, firmly insisted upon a “risk-based” approach, seemingly more sophisticated because it calculated assets based on how risky they seemed to be. They felt it was common sense that certain kind of assets –certainly including domestic government bonds but also home mortgages and other sovereign debt- shouldn’t require much if any capital. Commercial loans, by contrast, would have strict and high capital requirements, whatever the credit rating might be.

Both approaches could claim to have strengths. Each had weaknesses. How to solve the impasse?

At the end of a European tour in September in 1986, I planned to stop in London for an informal dinner with the Bank of England’s then governor Robin Leigh-Pemberton. In that comfortable setting without a lot of forethought, I suggested to him that if it was necessary to reach agreement, I’d try to sell the risk-based approach to my US colleagues.

Over time, the inherent problems with the risk-based approach became apparent. 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. Ironically, losses on those two types of assets would fuel the global crisis in 2008 and a subsequent European crisis in 2011. The American “overall leverage” approach had a disadvantage as well in the eyes of shareholders and executives focused on return on capital; it seemed to discourage holdings of the safest assets, in particular low-return US government securities."

September 2? From here

And so in 1988, with Basel I, the regulators assigned the sovereigns a 0% risk weight and citizens 100%, as if bureaucrats know better what to do with credit for which repayment they're not personally responsible for than entrepreneurs. 

I ask: Insane? I answer: Absolutely!

As if bureaucrats know better what to do with credit for which repayment they're not personally responsible for than entrepreneurs.

How can one believe that what bankers perceive as risky is more dangerous to bank systems than what bankers perceive as safe? 

Should it not be clear that dooms our bank system to especially severe crises, resulting from excessive exposures the what ex ante is perceived as especially safe, but that  ex post might not be, against especially little capital?

These self-nominated besserwisser experts had (have) just not the faintest understanding of conditional probabilities.

Here a list of the many mistakes with the risk weighted bank capital requirements

Here is my 2019 letter to the Financial Stability Board

PS. Here, my since June 2023 dialogue with #AI #OpenAI #ChatGPT about bank regulations.

Since bank regulators in 1988 decreed sovereign debt to be risk free, the market has not set the risk-free rates

In the discussion by Lawrence Summers and Adair Turner on secular stagnation in the Institute of New Economic Thinking INET, on October 28, I extract the following:

15:25 Lord Adair Turner

“The longer we have the slow growth and sub-target inflation, the more you have to think that there is something secular is at work. And the thing that makes me pretty sure that Larry is right in his hypothesis that something secular is at work, is to look at the 30, not the 10 year trend, but the 30 year trend, in real risk-free interest rates. 

Take UK’s 10 year yields on real index linked gilts. 

Take an average for each five year period, from 86-90, 91 to 95 and so six of those 5 year periods until the last

And the sequence is 3.8%; 3.6; 2.5%; 1.9%; 1.2%; minus 0.6%, and the value is now minus 1.5%. 

When you see a trend like that you begin to think that there may be something secular, petty strong, about that; with a dramatic fall even before the 2008 crisis, so you can’t put all this down to central bank intervention, quantitative easing.

So we seem to have entered a world where savings and investments only balance at very low or negative real interest rates. And of course those very low interests rates themselves, played a role in stimulating the excessive private credit growth which landed us with the debt overhang. 

But despite this those low interest we have low growth and below target inflation, and so it is vital we try work why is this… 

17:58 Well logically, the long term decline in real interest rates must mean that we have faced over the last 30 year either:

an increase in the ex ante desired aggregate global saving rate 

or a decline in the ex ante desired or intended global investment rate 

or a mix of both.”

Lord Adair Turner, the former chairman of the Financial Service Authority, FSA (2008-2013), and therefore supposedly a technocrat well versed in bank regulations, had not a word to say about: 

That extraordinary moment when, after about 600 years of “one for all and all for one” capital in banking, in 1988, with the Basel Accord, Basel I, regulators introduced risk weighted capital requirements for banks and, to that purpose, set the risk weight for the sovereign at 0%, while the risk weight for We the People was set at 100%.

That of course signified an extraordinary regulatory subsidy of sovereign debt, that had to set the UK’s 10 year yields on real index linked gilts, on a negative path.

From that moment on, since the regulators had decreed sovereign debt to be risk free, we can no longer really hold the market, using public debt as a proxy, can provide a reliable risk free rate estimate.

For now those artificially decreed risk-free rates can only go down and down and down… until BOOM!

The low “real” public debt interests might be the highest real rates ever, in that these regulations also make banks finance less the riskier, like SMEs and entrepreneurs, those who could provide us with our future incomes, and therefore governments with its future tax revenues.

If ever allowed, the following would be my brief testimony about what caused the 2008 bank crisis

The following, if I am ever allowed to give it, as so many would not like to hear it, would be my brief testimony on what caused the 2008 bank crisis 

Sir, as I have learned to understand it, the 2008 crisis resulted from a combination of 3 factors.

The first were some very minimal capital requirements for some assets that had been approved, starting in 1988 with Basel I, for sovereigns and the financing of residential housing; and made extensive in Basel II of 2004 to private sectors assets with good credit ratings.

These allowed banks then to earn much higher expected risk adjusted returns on equity on some assets than on other, which introduced a serious distortion. After Basel II the allowed bank equity leverages were almost limitless when lending to “sound” (or friendly) sovereigns; 36 times to 1 when financing residential housing; and over 60 to 1 with private sector assets rated AAA to AA. Just the signature, on some type of guarantee by an AAA rated, like AIG, also allowed an operation to become leveraged over 60 times to 1. 

The second was Basel II’ extensive conditioning of the capital requirements for banks to the decisions of some very few (3) human fallible credit rating agencies. As I so many times warned about (in a letter published in FT January 2003 and even clearer in a written statement at the World Bank) this introduced a very serious systemic risk.

The third factor is a malignant element present in the otherwise beneficial process of securitization. The profits of that process are a function of how much implied and perceived risk-reduction takes place. To securitize something safe to something safer does not yield great returns for the securitization process. Neither does to securitize something risky into something less risky. 

What produces BIG profits is to securitize something really risky, and sell it off as something really safe. Like awarding really lousy subprime mortgages and packaging them in securities that could achieve an AAA rating. A 11%, 30 years, $300.000 mortgage, packaged into a security rated AAA and sold at a 6 percent yield, can be sold for $510.000, and provide those involved in the process an instantaneous profit of $210.000

With those facts it should be easy to understand the explosiveness of mixing the temptations of limitless, 36, and more than 60 to 1 allowed bank equity leverages providing huge expected risk adjusted ROEs; with subjecting the risk-assesment too much to the criteria of too few; with the huge profit margins when securitizing something very risky into something “very safe”. Here follows some indicative consequences:

As far as I have been able to gather, over a period of about 2 years, over a trillion dollars of the much larger production of subprime mortgages dressed up in AAA-AA ratings, ended up only in Europe. Add to that all the American investment banks’ holdings of this shady product.

To that we should also add Europe’s own problems with mortgages, like those in Spain derived in much by an excessive use of “teaser interest rates”, low the first years and then shooting up with vengeance.

And sovereigns like Greece, would never have been able to take on so much debt if banks (especially those in the Eurozone) would not have been able to leverage their equity so much with these loans.

Without those consequences there would have been no 2008 crisis, and that is an absolute fact.

The problem though with this explanation is that many, especially bank regulators, especially bank bashers, especially equity minimizing bankers, especially inattentive finance academicians, especially faulty besserwissers (those who love the sophisticated taste of words like "derivatives"), they all do not like this explanation, so it is not even discussed.

The real question though is: Who is the guiltiest party, those who fell for the temptations, or those who allowed the creation of the temptations?

I mean how far can you go blaming the children from eating some of that deliciously looking chocolate cake you left on the table, at their reach?

PS. Please do not categorize misregulation as deregulation. 

PS. A 2008 GFC tweet summary:
The pushers: Those harvesting mortgages in subprime fields; packaging these in MBS and getting rating agencies’ enthusiastic thumbs up.
The addicts: The banks
The drug, the hallucinogen: The Basel Committee's ultra-low bank capital requirements. 

PS. Here's a letter published by the Washington Post, December 2009

P.S. Here’s a 2010 YouTube explanation

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

PS. And here is my letter to the Financial Stability Board that was officially received. Will it be answered?

Is not the interest that is not earned on public debt because of public policies a tax?

In terms of taxation, who is affected by a higher real tax rate?

Someone earning 5 percent in interest on public debt and, supposing a tax rate of 20 percent, then has to pay 1 percent in taxes, resulting in net earnings of 4 percent, or, 

Someone only earning only 3 percent on public debt, because of QEs, lower capital requirements for banks when lending to sovereign, and other fancy stuff causes lower interest rates on public debt.

You tell me, or better yet, tell them!

The subsidized risk-free rate

PD. A confession that shall not be heard: “Assets for which bank capital requirements were nonexistent; sovereign credits. A ‘leverage ratio’ discouraged holdings of low-return government securities” “Keeping at it” 2018, Paul Volcker

A theoretical rate, and a major benchmark in the world of finance, is the one which is known as the "risk free rate". Of course, since nothing is completely free of risk, it is normal, as an approximation, to use as that the interest rate which country perceived to have the strongest economies need to pay in order to service their debt, for example the United States. 

But I argue that this "risk free rate" has been consciously or unconsciously (I pray for the latter) manipulated by the Basel Committee on Banking Supervision, the Committee which seeks to be the manager of all world’s banking risks. 

This committee came up with, and the imposed, capital requirements for banks which depend on the risk of the various assets, primarily as perceived by the credit rating agencies and to whom they outsourced much credit analysis. 

When doing so the committee completely ignored, consciously or without thinking (I pray for the latter) that the perceived risks were already considered by banks when setting the interest rates, the amount of the loans and all other terms, let us say of the numerator. Consequently, when the regulators decided the same perception of risks also needed to be reflected in the capital, let us say in the denominator, they condemned the entire banking system to overdose on perceived risk. 

And that has meant that all those who are perceived as being more risky, be they countries, companies or citizens, have to pay higher interest rates and receive smaller loans, than what would have been the case in the absence of these regulations. 

And so also that all who are perceived as less risky, like “solid” sovereigns and corporations with high credit ratings, will pay much lower interest rates and receive many more and larger loans, than what would have been the case in the absence of these regulations. 

And the above distorted and dislocated world economies more than you could believe. Not only did it encourage a dangerous overcrowding of all safe-havens, but also by dangerously ignoring that risk-taking is the oxygen of any development, and that the "absolutely not risky "of today, were almost always the "risky" of yesterday. 

And this means that the "risk free rate" which we today observe in the market, is actually the "risk-free rate less the value of the Basel Committee’s regulatory subsidy”. 

And this means that the flight instruments which the markets and the central banks in the world use, simply do not give correct readings. 

How is this possible? "One has to belong to the intelligentsia to believe things like that: no ordinary man would be such a fool" George Orwell, Notes on Nationalism, 1945. 

Or, as Patrick Moynihan would have explained it: "There are some mistakes it takes a Ph.D. to make”

Translated from El Universal 

Here in Spanish http://bombaaaa.blogspot.com/2013/01/la-subsidiada-tasa-libre-de-riesgo.html

PS. https://subprimeregulations.blogspot.com/2015/07/the-financial-stability-board-makes.html
PS. https://subprimeregulations.blogspot.com/2016/10/since-bank-regulators-in-1988-decreed.html
PS. https://subprimeregulations.blogspot.com/2016/11/olivier-blanchard-agrees-there-is-need.html

PS. http://perkurowski.blogspot.com/2019/09/financial-communism.html

One of the greatest myths is that if Greece had collected all taxes, Greece would not have been in trouble.

Greece is not in trouble because of the taxes it did not collect. Greece is in trouble because its government squandered away funds it borrowed. And because the Greek government was able to borrow so much, thanks to the loony bank regulations. 

For instance, if a German bank wanted to lend to a German entrepreneur, according to Basel II it needed to hold 8 percent in capital, which meant it could leverage its capital 12.5 to 1 times, but, if it lent to Greece, the way Greece was rated at the time, it only had to hold 1.6 percent in capital, which meant it could leverage its capital a mind-boggling 62.5 times to 1. No unregulated or shadow bank would ever manage to do that. 

And that meant, sort of, that if the bank could earn a risk and transaction cost adjusted margin of 1 percent when lending to a German small entrepreneur, it could expect to earn 12.5 percent on its capital, but, if it expected to earn the same margin lending to Greece, it could earn a whopping 62.5 percent on its equity per year. And that is of course a temptation that not even the most disciplined Prussian would be able to resist. And of course what Greek (and many not Greek) politician can resist the temptation of abundant and cheap loans? 

And so had all Greeks paid all their taxes that would have made no difference, in fact, since the Greek government could then have been able to show greater fiscal income, it could have justified keeping credit ratings great for a longer time, which meant having taken on even bigger debts.

Or did the Greek politicians think the loans Greece took on would be repaid by them being able to make of the Greeks exemplary tax–paying-citizens in just some few years? If they did, then they are more stupid than any ordinary politicians.

And now what? Yes Greeks, pay your taxes! But of course only after Greece creditors have accepted a reasonable deal based on a very substantial haircut, and only after you are sure your government will not keep squandering away your taxes.

It is of course very understandable that many Greeks are mad at those who have not paid their taxes but, let’s face it, on the other hand, the way things have turned out, those taxes that were not paid in earlier, might come in very handy now, and will, hopefully, we pray, be put to a much better use.

PS. This post was made before I realized that reality was much worse. Instead of applying to Greece the risk weights dependent on credit ratings that Basel II ordered, EU authorities assigned to all Eurozone sovereigns' debts, including Greece's a 0% risk weight, this even when none of theses nations can print the euro. So European banks, when lending to Greece, did/do not have to hold any capital at all. Now how crazy is that?

PS. At the end of the day the EU authorities kept total silence about their mistake and blamed Greece for it all. What a sad European Union L

A wicked question to credit rating agencies, about risks and sovereign ratings

I suppose you are all professional with solid academic degrees and a lot of knowledge and experience rating the creditworthiness of borrowers. If not, excuse me and ignore the following question. 

You must be aware of course that bank regulators allow the banks to hold much less capital when investing in an asset that has been deemed to you as belonging to the privileged group of “The Infallible” than when holding an exposure to something less well rated or unrated. 

And you must be aware of course that this allows banks to expect to earn much higher much higher risk-adjusted returns on their equity when lending to “The Infallible” than when lending to “The Risky”. 

And of course you must understand that this means than banks will invest more and more in assets considered to be part of “The Infallible” and less and less to assets considered “The Risky”, like small businesses and entrepreneurs. 

And so here is my question to you: With banks that are given special regulatory subsidies to invest, almost exclusively, in “The Infallible” and abandon, almost totally, the lending to “The Risky”, in a competitive world, can any country keep a healthy economy that allows it to service its long term debt at current levels of public debt? Is not a very important degree of risk-taking by banks a must to keep economies rolling? 

Would you, as risk analysts and practitioners, in normal circumstances, ever think of giving your personal investment managers similar risk-adverse orders? 

I know what the extreme importance given by the regulators to your credit ratings has done to your business… but, come on, frankly, is that just not something too risky for the world you want to hand over to your children and grandchildren? 

Sincerely, 

Per 

A friend, not out to shoot the messengers

Our bank regulators, unwittingly, committed an act of high treason

There can hardly be a more insidious way to destroy a nation than to make its banking system more risk averse than what it normally is. 

And that our current bank regulators did, unwittingly, with Basel II, when they allowed the banks to hold so much less capital when lending to “The Infallible” than when lending to “The Risky”… and therefore to be able to earn so much more return on their equity when lending to “The Infallible” than when lending to “The Risky”… and therefore also to be able to pay the bankers so much higher bonuses when lending to “The Infallible” than when lending to “The Risky”. Doing so the regulators effectively "bribed" the banks to lend only to “The Infallible” and to abandon all bank lending to “The Risky”.

And that, of course, caused the bank exposures to “The Infallible”, those ex-ante perceived as absolutely not risky, precisely those to whom excessive lending has always caused all major bank crisis when they, ex-post, turn out to be “The Risky”, to explode as never before. 

Just one piece of evidence: Basel II, approved by G10 in June 2004, allowed the banks to lend to a sovereign rated like Greece holding only 1.6 percent of quite loosely defined bank capital (equity) while, if lending to a Greek small business or entrepreneur, they needed to hold 8 percent in capital. That allowed the banks to leverage their capital 62.5 times when lending to the Greek sovereign but only 12.5 times when lending to a Greek small business or entrepreneur. That, if the bank could make a net risk and cost adjusted margin of 1 percent when lending to either the sovereign the small business or the entrepreneur, meant the bank could expect to earn 62.5 percent on capital per year when lending to the Greek sovereign, compared to only 12.5 percent when lending to a Greek small business or entrepreneur. 

And of course the Greek sovereign received too much bank loans. And of course the Greek small business and entrepreneur received too little bank loans. 

And now when the Greek sovereign, as s direct result of this is in the absolute doldrums it cannot receive any more loans from banks, and Greek small businesses and entrepreneurs, those Greece most need to help it out of its current predicaments, are completely locked out from access to bank credit. 

I tell you, if I thought bank regulators had done this on purpose, to Greece, Europe and America, I would suggest shooting them… no doubt.

But what I cannot comprehend is how we can allow regulators who unwittingly were so dumb, to keep on regulating, to give us Basel III, which, with now also liquidity requirements based on ex-ante perceived risk, can only make it all so much worse. 

A nation is built and thrives on risk-taking. “God make us daring!” The moment the past, what has been built, “The Infallible”, becomes more valuable to its society than the future, what can be built, “The Risky”, and excessive risk adverseness sets in, the nation stalls and falls. It is as simple as that.

Two whys on bank regulations

How can I, as an ordinary citizen, obtain a decent return on my savings when investing in safe securities, having to compete with banks who can leverage their equity more that 60 to 1 when they do so?

How can I, as an ordinary small businesses or entrepreneur, get a decent interest rate on my bank loans, when banks can leverage their equity so much more when lending to those officially perceived as not-risky? 

It is so unfair! Who are these bank regulators? Who invested them with so much power?

Financial repression

Financial repression, a term coined in 1973 by Stanford economists Edward S. Shaw and Ronald I. McKinnon, is used to describe several measures that governments employ to channel funds to themselves and which in a deregulated market, would go elsewhere. In other words it is a hidden non-transparent tax. 

How much financial repression is present by the fact that the banks need to hold immensely much less capital when lending to its “infallible” government than when lending to the “risky” citizens? We have no idea… as we are flying blind with instruments that long ago ceased to function.

Who did the eurozone in?

There are of course many suspicious characters to blame for the eurozone’s pains, not the least the fact that it was created without any strong fiscal root system.

In November 1998, in an Op-Ed titled “Burning the bridges in Europe”, which title had to do with the fact there no escape-route from the euro had been considered. I also wrote there: “That the European countries will subordinate their political desires to the whims of a common Central Bank that may be theirs but really isn’t, is not a certainty. Exchange rates, while not perfect, are escape valves. By eliminating this valve, European countries must make their economic adjustments in real terms. This makes these adjustments much more explosive.”

But, there is one huge piece of evidence that is ignored by most of those trying to explain the current troubles. That evidence is the “risk-weights”, the smoking-gun which we find in the hands of the butlers in charge of regulating the banks, and who have their quarters in the Basel Committee for Banking Supervision. Yes, it was some butlers who did the eurozone in! 

The bank butlers, naturally concerned about the safety of the banks, imposed a basic bank capital requirement of 8 percent; applicable for instance when banks lent to European small unrated businesses. In this case that limited the leverage of bank equity to a reasonable 12.5 times to one. 

But, when banks lent to a sovereign, with credit ratings such as those Greece-Portugal-Italy-Spain had during the buildup of their huge mountains of debt, the bank butlers, because this lending seemed so safe to them, and perhaps because they also wanted to be extra friendly with the governments who appointed them, they applied a “risk-weight” of only 20 percent. And that translated into an amazingly meager capital requirement of 1.6 percent; and which allowed the banks to leverage their capital when lending to the infallible a mind-blowing 62.5 times. 

The result was that if a bank lent to a small business and made a risk-and-cost-adjusted-margin of 1 percent, it could earn 12.5 percent a year, not much to write home about. But, if instead it earned that same risk-and-cost-adjusted-margin lending to a Greece, it could then earn 62.5 percent on your bank equity… and that, as you can understand, is really the stuff of which huge bank bonuses are made of, and also the hormones that cause banks to grow into too-big-to-fail. 

And, as should have been expected, the banks went bananas lending to “safe” sovereigns. With such incentives, who wouldn’t? Just the same way they went bananas buying those AAA rated securities that were collateralized with lousily awarded mortgages to the subprime sector, and to which the bank-regulating-butlers also applied the risk-weight of 20 percent. And of course the governments also went the way of the banana-republics, and borrowed excessively. What politicians could have resisted such temptations? 

And it was these generous financing conditions, and all the ensuing loans, which helped to hide all the misalignments and disequilibrium within the eurozone… until it was too late. 

Now how could these bank-regulating-butlers do a criminally stupid thing like that? The main reasons were: the bank butlers only concerned themselves trying to make the banks safe, and did not care one iota about who the banks were lending to and for what purpose; they ignored that banks were already discriminating based on perceived risks so what they were doing was to impose an additional layer of risk-perception-discrimination; they completely forgot that no bank crisis in history has ever resulted from an excessive exposure to what was considered as “risky”, but that these have always been the consequence of excessive exposures to what, at the moment when the loans were placed on the banks balance sheet, was considered to be absolutely “not-risky”. 

Also, when the bank-regulating-butlers decided to outsource much of the risk-perception function to some few credit-risk-rating-butlers, two additional mistakes were made. First, they completely forgot that what they needed to concern themselves with was not with the credit ratings being right, but with the possibility of these being wrong; and second, that what they needed most needed to look at was not so much the significance of the credit ratings meant, but how the bankers would act and react to these. 

And the consequences of these regulatory failure in the eurozone, are worsening by the day, or by the nanosecond… because these bank capital requirements have the banks jumping from the last ex-ante-officially-perceived-no-risk-sovereign now turned risky, to the next ex-ante-officially-perceived-no-risk-sovereign about-to-turn risky … all while bank equity is going more and more into the red… and becoming more and more scarce. 

What could be done? One solution could be that of declaring a ten year new capital requirement moratorium on all current bank exposures; allowing the banks to run new lending with whatever new capital they can raise, while imposing an equal 8 percent capital requirement on any bank business, no risk-weighting. If there’s an exception, that should be on lending to small businesses and entrepreneurs, in which case they could require, for instance, only 6 percent of capital, because these borrowers do not pose any systemic risk, and also because of: when the going gets to be risky, all of us risk-adverse need the “risky” risk-takers to get going. 

But that requires of course a complete new set of bank-regulating-butlers… as the current should not even be issued any letters of recommendations. Let’s face it, after such a horrendous flop as Basel II, neither Hollywood nor Bollywood, would ever dream of allowing the same producers and directors to do a Basel III, and much less with only small script changes and the same actors.

The saddest part is that many of those in charge of helping Europe to get out of the current mess that they helped to create, might be busying themselves more with dusting off their own fingerprints.

If there is any place that deserves an occupation... that is Basel!

PS. Years later I learned that all this was just so much worse. EU authorities had assigned all eurozone sovereigns’ debts a 0% risk weight, even Greece’s, even if they were all taking on debt denominated in a currency that was not denominated in their own domestic/printable fiat currency. Unbelievable! And then EU authorities put the whole blame for Greece's troubles on Greece and did not even consider paying for the cost of their own mistake. Is that a way to build a union? No way Jose!