12 years after Basel II, ECB sees faults in risk weighted capital requirements for banks, but still doesn’t get it

ECB has published a document titled “The limits of model-based regulation” ECB Working Paper 1928, July 2016. In it the authors find that risk-weighted capital requirements based on sophisticated models applied by big banks, are basically dangerous and worthless.

Of course that regulation is worthless, it does not serve any useful purpose, and only increases the probabilities of financial instability.

But from its “Non-technical summary” it is harrowing to see that they still do not fully understand why these risk weighted capital requirements are dangerous; not only for the big banks with their models, but also for the smaller that apply the standard approach risk weights declared by the Basel Committee; and also, primarily, for the real economy.

For a starter it declares: “In recent decades, policy makers around the world have concentrated their efforts on designing a regulatory framework that increases the safety of individual institutions as well as the stability of the financial system as a whole.”

And so the first observation is: Who gave policy makers the right to concentrate on designing a regulatory framework that completely ignores whether the allocation of bank credit to the real economy is efficient or not? Is the real economy to serve banks or are the banks to serve the real economy? “A ship in harbor is safe, but that is not what ships are for.” John A Shedd, 1850-1926 

Then it states: “an important innovation has been the introduction of complex, model-based capital regulation that was meant to promote the adoption of stronger risk management practices by financial intermediaries, and ultimately to increase the stability of the banking system”... “banks that opted for the introduction of the model-based approach experienced a reduction in capital charges and consequently increased their lending by about 9 percent relative to banks that remained under the traditional [standard risk weights] approach”... “Back-of-the-envelope calculations (abstracting from risk-based pricing of the cost of capital) suggest that underreporting of PDs allowed banks to increase their return on equity by up to 16.7 percent”

How come regulators believed the adoption of “stronger risk management practices by financial intermediaries” would trump the maximization by banks of their risk-adjusted returns on equity? This is like given children a book with indication of calories and expecting them to stay away from the chocolate cake. Worse, in the case of the big banks applying their internal models, it was like allowing the children to calculate on their own the calories of the chocolate cake they desire. How mind-boggling naive are regulators allowed to be?

From the conclusion “Certainly, one would expect less of a downward bias in risk estimates if model outputs were generated by the regulator and not the banks themselves” one could believe the authors favor the standard approach risk weighting. 

Of course that is better than the sophisticated modelling by the big banks, which only guarantees Too Big To Fail Banks. But the all the principal faulty characteristics of the whole risk weighting process remain intact even then... and are still ignored:

Like why basing capital on ex ante perceived credit risks, when all major bank crises have resulted either from unexpected events or excessive exposures to what was ex ante perceived as safe?

Like why if banks by the size of the exposures and interest rates already clear for perceived risk, should they also be cleared for in the capital? Do not regulators understand that any risk, even if perfectly perceived, leads to the wrong actions if excessively considered?

Earlier, on the same issue

And like so many other whys?

“Too defined and too encompassing to go wrong regulations” is riskier than “Too big to fail banks”

Mark Carney the Chairman of the Financial Stability Board, in his Statement delivered to the International Monetary and Financial Committee Washington, DC, 11 October 2014, makes no reference whatsoever to the distortions credit risk-weighted capital requirements have in the allocation of bank credit to the real economy. 

And so Carney at least, evidences he has not learned anything from this crisis, or that he absolutely agrees with the idea of banks dangerously overpopulating safe havens and withholding completely from exploring any riskier though perhaps of us more productive bays. 

As you can read, still not one single word about the purpose of our banks… banks just standing there, without any other purpose, seems perfectly all-right to him. 

“A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926

Mark Carney also refers to the fact that one of the goals of the Basel Committee is to set out its plan to address excessive variability in risk-weighted asset calculations. He seems still not able to understand that, the lack of variability in risk-weighted asset calculations, by leveraging the consequences of errors made in their calculations, is also a possible horrendous source of systemic risk.

Really how can someone worrying about too big to fail banks, simultaneously preach a one set of can’t go wrong regulations? What’s the difference between too big to fail banks and too defined to go wrong regulations?

In short Mark Carney, and the rest of regulators out there, have not been able to understand that even if their risk-weights are based on perfect risk perceptions, applying these to bank capital requirements is wrong, because these “perfect” risk perceptions should already be cleared for banks in the interest rates, in the size of the exposures and in the other terms that apply.

Mark Carney…and you other regulators out there… stop being so stubborn… you should not concern yourselves with the risk of bank assets, which is the concern of bankers. You instead must concern yourselves with the fact that the banks could perhaps not manage those risks… something that, as they say here in Paris, is pas la meme chose. 

You regulators you do not solve anything for us managing the risks of banks because you yourself then become our largest systemic risk with banks… and, I am sorry, but, I at least, see absolutely no reason to trust some central bankers to know what risks should or should not be taken out there in the real world, for my grandchildren to have a great future. And much less so when you all, with your Basel II, have already proven yourself to be huge failures.

Sincerely I find your hubris of believing yourself capable of being the risk managers of the world quite disgusting. 

Look around you… I would hold that capital requirements based on potential of job creation ratings, sustainability of planet earth ratings, and good governance and ethics ratings of governments, though distorting, would do so in a better directions than your credit ratings, which in fact promotes inequality and exclusion.

The Financial Stability Board evidences its utter confusion, again, with their G-SIBs list, a subset of the G-SIFIs.

In reference to “the policy judgment to be informed by various empirical analysis of the systemic risk that the Globally Systemic Important Banks Institutions” pose, in order to set the G-SIBs cutoff score, and determine to which of five “buckets” each one of the monster too big to fail banks belong, the Financial Stability Board published, on November 11, their end-2012 data G-SIB list.

For those who need some translation the G-SIBs are the banks among the Globally Financial Important Financial Institutions, the G-SIFIs.

And we there now find 29 banks, since recently Bank of China was added to the original 28, perhaps because China objected to not having one single bank among that exclusive group of banks.

But, what does all this mean? There are 5 buckets indicating how much additional capital each bank as a percentage of risk-weighted assets a banks needs to hold, for the regulators feeling reasonably sure, the world is secure. These buckets are 1%, 1.5%, 2%, 2.5% and, the horror, the empty 3.5% bucket.

I mention that last one because although “the bucket thresholds will be set initially such that bucket 5 is empty, if this bucket should become populated in the future, a new bucket will be added to maintain incentives for banks to avoid becoming more systemically important… eg if bucket 5 should become populated, bucket 6 would be created with a minimum higher loss absorbency requirement of 4.5% etc)."

If you think the above to sound as a quite infantile regulations, like scaring the children with the boogeyman, I would probably share your appreciation… because what do you think could happen if suddenly regulators got so scared that empty bucket had to be occupied? Would that not cause a crisis by itself?

But let us see how boogeyman the boogeyman really is. The secret is in the “as a percentage of risk-weighted assets”. If the risk weights are low enough that extra capital banks need to hold does not mean much. 

If a G-SIB holds 1/3 each of 0%, 20% and 50% risk-weighted assets, then the currently most G-SIBs, those in the additional 2.5% capital budget, then it is authorized to leverage over 40 to 1. Is this sane?

Why do they not try with an extra 3 percent on all assets, no matter an asset’s risk-weight. That would really put a cracker in the G-SIBs’ pants. Perhaps Bank of China would scream… “Take me out, I don’t belong here”

No friends let me assure you that if I was a Global Systemic Important Bank, and that the price for being The Most Systemic Important Global Bank in the world, would be to have an additional 1% or risk-weighted assets in equity… I would gladly say… “Sure, bring it on!”

But the saddest part of the story is, sine qua nom, that the more regulators insist on the risk-weighing of assets the less access to bank credit will those who most need it and who we most want to have access to it, namely “The Risky”, like medium and small businesses, entrepreneurs and start-ups.

Mr. Irving Fisher, could you please explain the rationale behind Basel's capital requirements for banks, to us “The Risky”?

Mr Irving Fisher.

On March 13 you gave a speech titled “Ending too-big-to-fail”. 

In it you said “I am here today to speak of the plight of hardworking Main Street bankers who simply want to be given a level playing field and fair treatment in competing with megabanks”. And you then frequently and correctly mention all the subsidies of TBTF banks paid through the implicit government guarantees. 

It is a great speech, nothing wrong with it, BUT, when is someone of your caliber to stand up and equally ask for a level playing field and fair treatment of all those bank borrowers perceived as “risky”. 

“The Risky” they know and accept they have to pay higher interest rates, get smaller loans, and be subject to harsher contractual terms, “that’s life”. But why on earth should they have to pay even higher interest rates, and get even smaller loans just because some regulators decide to impose on banks, capital requirements which are also based on the same perceived risk. 

That allows the banks to hold much less capital when lending to “The Infallible” than when lending to “The Risky”. 

And that allows the banks to leverage the risk-adjusted-margins many times more when lending to “The Infallible” than when lending to “The Risky”. 

And that allows the banks to earn much higher expected risk adjusted returns on their equity when lending to “The Infallible” than when lending to “The Risky”. 

And that forces “The Risky” to compensate the banks additionally. And that is not a level playing field or a fair treatment 

And these very low capital requirements associated with anything dressed up as “safe” also constitute one really potent growth hormone for the TBTF banks. 

Mr. Fisher you said “Regulators cannot enforce rules that are not easily understood” 

Recently Floyd Norris, in “Masked by Gibberish, the Risks Run Amok” March 21, quoted the following from the unhappy Barings trader Nick Leeson´s memoirs: “And they never dared ask me any basic questions, since they were afraid of looking stupid about not understanding futures and options.” 

And that is precisely what I think happened with the capital requirements for banks, once these had been accidentally concocted, all regulators were afraid of looking stupid about not understanding these, and kept silence… and, this really unforgivable, they are still silent about it

And so Mr. Irving Fisher, on behalf of all those medium and small businesses and entrepreneurs, discriminated against twice by the fact they are perceived as "risky", if you have understood it, please explain to us the rationale behind those capital requirements for banks. 

I mean since “The Risky” have never ever caused a major bank crisis, only “The Infallible” who turn out risky do that, one could even make a case for higher bank capital requirement for banks when lending to “The Infallible” than when lending to us “The Risky”. 

And by the way Mr. Fisher, I also believe that giving “The Risky“ a level playing field and fair treatment, is the best way, by helping their clients, to help those hardworking Main Street bankers.

Sincerely,

Per Kurowski

Be more wary of the “too big to govern”

“Laissez govern” is infinitely more dangerous than “laissez faire” so we must never allow the “too big to govern” to become the substitute of “the too big to fail”.

My voice and noise on the regulatory reform of banks

As I am just a citizen working on his own I would appreciate any comment or editing suggestion and which you can send to my email perkurowski@gmail.com

My voice and noise on the regulatory reform of banks

Introduction

It is we the people who are supposed to be able to invest our savings in low-risk-operations. It is them the bankers, those who are supposed to be the professionals, whom we should count on to identify those risky risk-taking entrepreneurs most capable of restoring fiscally sustainable growth and create decent jobs, and then take the risk of lending to them.

Why then has the regulator been so set on having the banks avoiding ordinary banking risks, and have instead create incentives for our banks to finance those already rated AAA and who should not even need the help of a bank? In truth, the AAAs should be the almost exclusive territory of widows and orphans.
The bank regulatory framework which emanated from Basel and which promoted a highly imprudent risk-aversion in our banks, instead of a prudent risk-taking, represents a failure of immense proportions and it needs to be stopped, right now.

The following are some suggestions on that route and I call on anyone who knows the value of living in a “land of braves” to help to stop the arbitrary taxes on risks imposed on our banks by the Basel wimps.

We should temporarily lower the capital requirements for what is perceived as high risk.

The first, and basically only pillar of the Basel regulations, the minimum capital requirements, establishes that when a bank has an asset that carries an AAA rating it is required to hold 1.6 percent equity while, if it lends to an unrated entrepreneur it needs 8 percent. The difference of 6.4 percent, especially when bank equity is scarce and expensive, represents effectively a high and totally arbitrary regulatory tax on perceived risk; and which has to be added on to what the market already charges in premiums for risk.
Therefore and while we are increasing the extraordinary low capital requirements for the “low-risk” operations, which have proven to be so dangerous, we must, in order to avoid that "high-risk" borrowers are unduly crowded out from bank lending, substantially reduce the capital requirements for all those operations that are deemed more risky, in essence those rated BB+ or below. As an initial level I suggest 4 percent.This is real counter-cyclicality.

Once the banks have achieved a level of 4 percent (tier-one) capital for all of their assets (including government) and once out of the woods of this crisis, we must rebuild the capital base of the banks to a level ranging between 8 and 12 percent, for all assets, government included, cash excepted, a level that could fluctuate depending on where we find ourselves in the economic cycle.

Can the banks currently handle a 4 percent in capital requirements when lending to a risky entrepreneur? Yes, I am absolutely sure that a shell-shocked banking sector will behave prudently with what is perceived as “high-risk”. In fact since what normally produces certain carelessness are those loans and investments perceived as being less-risky, one could build a case for arguing that it is the “lower-risks” that should have higher capital requirements.

Since I am aware that the above sounds somewhat strange in the midst of the knee-jerk rule tightening reactions that a crisis always produces let me remind you that the first wave of bank losses sustained in this crisis from lending or investing in what required 8 percent of capital were only a fraction of those first wave losses sustained in “safe” 1.6 percent endeavors.

By the way, arguing in the first place that the losses that arose in connections to the safest assets, houses and mortgages, in the safest of the countries, the USA; and in the safest instruments, rated AAA, has anything to do with excessive risk-taking, seems to me somehow to include a dose of intellectual dishonesty.

Suppose a person entered a modern building and took an elevator that was supposed to be duly checked and then died in an accident because some inspectors did not do their job… would you call that excessive risk-taking? Of course not!

Purpose of the banks

The 347 pages of Basel II regulations contains not one single phrase, much less a paragraph that has anything to do with establishing the purpose of our banks.

Therefore we must require from the bank regulators to define the purpose for our banks, because without doing so, how can they regulate and how can we be sure they are taking the banks to where we want them to go? Let me below give you a hint

What’s in it for humanity for the banks to finance the AAA rated? Nothing! The real or fake AAAs are already more than strong enough, and so who we really need for our banks to support are those with BB+ or below ratings in order for these to have the chance of becoming the real AAAs of tomorrow. What the banks are supposed to do is to help society to evaluate the BB+ or below rated in order to generate new winners, while creating the lowest possible contingency risks for having to bail out the depositors if the banks fail in their mission.

Governments

Currently when a bank lends or invests in paper of the government there are no capital requirements. This amounts to an outright discrimination in favor of the government and against the citizen. I do not see how see how this could have been in the minds of any founding fathers.

Over a period of time we should reach a point where the capital requirements for banks when lending to the government, are the same to those when lending to an ordinary unrated citizen.

Credit rating agencies.

In January 2003 the Financial Times published a letter I wrote that included
“Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds”

And of course if we insist on blindly following the opinions of the credit rating agencies, as has been the case, we are sooner or later doomed to be back to the point where this crisis started.

But, what need is there to have the credit rating agencies pointing out the directions with 100 percent accuracy, if we should not be going to the place we are going? None! We cannot afford to channel scarce funds, by means of very low capital requirements for what is perceived as “low-risk”… into financing something, if that something is useless… like perhaps building a huge inventory of coffins. at zero percent interest rates.

And so, referring to the previous point, we should not waste a single second by reforming the credit rating agencies, when by reforming what really needs to be reformed, namely eliminating the regulations that discriminate based on risk of defaults, the problem of humanly faulty credit rating agencies will be solved on its own.

"Too big to fail."

In February 2000, in the Daily Journal of Caracas, in an article title “Kafka and global banking” I wrote:

"… thank God we still have several banks to work with". Imagine if we would have had to discuss the issue with an official of the One and Only World Bank (OOWB). Without a doubt this would present us with a future full of horrendous Kafkaesque possibilities. With every day that passes we have fewer and fewer banking institutions worldwide with which to work. This trend has been marketed as one of the seven wonders of globalization.”

Also in May 2003 in a risk management workshop for regulators at the World Bank I held:

“There is a thesis that holds that the old agricultural traditions of burning a little each year, thereby getting rid of some of the combustible materials, was much wiser than today’s no burning at all, that only allows for the buildup of more incendiary materials, thereby guaranteeing disaster and scorched earth, when fire finally breaks out, as it does, sooner or later.

Therefore a regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises.

Knowing that the larger they are, the harder they fall, if I were regulator, I would be thinking about a progressive tax on size.”

But, having said all that, I equally believe firmly in that we are not well served by rushing to solve this particular problem, especially while we have much more urgent matters at hand, such as getting out of the woods.

And neither should we break up large banks while we still have regulations in place that breed and support large banks… does that not seem logical?

If there is one alternative that should definitely be explored is that of using a Non Operating Holding Company (NOHC) under which to separate the different activities of the typical huge bank of today and which I have seen proposed by OECD in their "The Financial Crisis: Reform and Exit Stategies". I find this route to be a very sensible and not too traumatic alternative and, if it would prove not to be working, we would at least already have it cut up in more digestible pieces.

Therefore my suggestion on the "Too Big To Fail" issue would be to give the largest banks some basic separation guidelines and ask them to come back for a proposal on how they would wish to set up their NOHC, if so required, and then take it from there.

On derivatives

Just get a central clearing house for anything that seems to taking on the form of a mass market and let all the rest be, stating of course, very loud and very clear, your caveat emptor and your caveat venditor.
Derivatives which cover real original risks are never as dangerous as derivatives designed to exploit arbitrary differences of a regulatory system.

The reason is that in real derivatives, for each seller taking the risk of being a seller, you always find a buyer taking the same sized opposite risk as a buyer… and all they have to do is being sure that the other counterpart has the means to pay out if he has to.

But, when derivatives are entered into in order to exploit a regulatory arbitrage, you find sellers and buyers more like partners eagerly sharing a free prize, and which often means they will let down their guards somewhat on each other´s respective counterparty risk.

Example: If a bank has an exposure to a an A- client then it needs a 4 percent equity but if it bought a CDS from a AAA rated insurance company (AIG) then it can get away with only 1.6 percent of capital. The saved difference of the costs of 2.4 percent of expensive bank equity, and which of course has nothing to do with real risks, can then be shared between a bank and an AIG.

When and if, as is here proposed, one eliminates the differences in capital requirements for banks based on risk, there are no longer incentives for this type of bastard derivatives…problem solved!

Systemic Risk

How are those who came up with the minimum capital requirements and enforced the use of credit rating, and thereby introduced so much systemic risk in the financial system, now going to control for systemic risk? They now mostly take systemic risk means to be institutions that are so large and important so as to create a risk for the system… that is just one of many systemic risks.

Bailouts

One thing is to bail out depositors for some fixed amount. But to think about the possibility of bailing out institutions because they might constitute a systemic risk is a totally different ballgame. That could be an open checkbook to disaster. As a government you should never want to have a pre-authorization to bailout a financial institution because then you are supposed to do so, or at least it is harder to say no.

We must measure and act during the full cycle.

If we are going to get the best out of our banks we have to stop measuring them only at their worst. We need to look at the full boom bust cycle since there are some busts where all the pains of a crisis are more than compensated with all achieved during the preceding boom, while at the same time there could also be booms that are so unproductive booms that no lack of a crisis pays for them.

Final Note:

I have been a financial advisor all my life never a regulator but when I started hearing about what the Basel Committee was up to I had to raise my voice. The surprise of my life is that still, two years into the crisis, the issue of the dangerous arbitrary risk aversion the Basel regulations were introducing in our financial system is not yet even discussed

Here is the link to the very first article I wrote on the subject in 1997
http://subprimeregulations.blogspot.com/1997/06/puritanism-in-banking.html

If you want to see more you can find it in: http://www.subprimeregulations.blogspot.com/
or in http://financefordevelopment.blogspot.com/
and in the more than 330 letters that I sent to the Financial Times on this issue and that can all be found in http://teawithft.blogspot.com/ searching under the label of subprime banking regulations.

And you can also find a fun conspiracy theory of it all in: http://www.theaaa-bomb.blogspot.com/

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

Beware of bank consolidation (An early manifesto against too big to fail and too hard to govern banks, and against too few bank regulation criteria)

Every day there are fewer banks in the world. Those horror stories about bank clients trying to discuss with anonymous voices on the phone about fraudulent uses of their credit cards, while trying desperately to sound as innocent as they are, should make us think twice about the possibility that someday we will, in the best Kafka style, have just one bank. 

But apart from these experiences sometimes worthy of a Stephen King, bank consolidation, a trend that we have been sold as a marvel, may contain other risks not discussed enough - or happily ignored. Among these the following: 

Low risk diversification: Whatever the authorities do to ensure the diversification of banks, there is no doubt that fewer banks mean lesser baskets where to carry the eggs. When I read that during the first four years of the decade of the 30’s in the United States, a total of 9,000 banks failed- I wonder what would have become of that country if it then had only one single bank. 

The regulatory risk: Before there were many countries and many ways of how to regulate banks. Today, with Basel proudly issuing rules that should apply worldwide, the effects of any mistake could be truly explosive. 

Excessive similarity: Encouraging banks to adopt common rules and standards, is to ignore the differences between economies, so some countries end up with inadequate banking systems not tailored to their needs. Certainly, regulations whose main objective appears to be only to preserve bank capital, conflict directly with other banking functions, such as promoting economic growth, and democratize access to capital. 

Low diversity of criteria: A smaller number of participants, less diversity of opinion and, with it, increased risk of misconceptions prevail. Whoever doubts, read the dimensional analysis that ratings agencies publish. 

Backlash: The development of decision-making processes has benefits but also risks. Thus we see that the speed of information itself, which promotes quick and immediate response, can exacerbate problems. Before, those who took the problem home to study it, and those who simply found out late, provided the market a damper, which often might have saved it from hurried and ill-conceived reactions. 

Few clear benefits: To date we have not seen a foreign bank grant for example mortgage loans with globalized terms of maturity and interests. In this respect there seems not to be so many clear benefits of a global bank, when it operates only replacing local banks. 

Cost of global aid: When banks in Venezuela suffered their last crisis, among other reasons because of buying other banks at inflated prices, the cost of that was sadly but logically paid by our country. Today, with globalized banks, and which are not immune to commit equally dumb things, like also buying banks at excessive prices, who will then pay the bill? 

Today, when the world seems to be asking much for bank mergers or consolidations, I wonder if we on the contrary should be imposing on banks special reserves depending on their size. The bigger the bank is, the worse the fall, and the greater our need to avoid being hurt. 

Translated from El Universal, March 7, 2001