Bank regulators have placed the consequences of volatility on steroids

I refer to Robert Burgess’ “Volatility Is the Price of a Safer Banking System”

October 2004, at the World Bank, as an Executive Director, I stated: “Much of the world’s financial markets are currently being dangerously overstretched through an exaggerated reliance on intrinsically weak financial models based on very short series of statistical evidence and very doubtful volatility assumptions.”

Most of current bank capital requirements, whether Basel I, II or III are based on perceived credit risks. That means banks can leverage their capital/equity/skin-in-the-game the most with what’s perceived as safe. That means banks can build up those huge exposures to “safe assets” which can become extremely dangerous to bank system if volatility kicks in, and turn these supposed safe into very risky assets.

April 2003, at the World Bank I had also opined: "Nowadays, when information is just too voluminous and fast to handle, market or authorities have decided to delegate the evaluation of it into the hands of much fewer players such as the credit rating agencies. This will, almost by definition, introduce systemic risks in the market"

The 2008 crisis was caused by assets rated AAA to AA, which after Basel II banks were allowed to leverage with a mind-boggling 62.5 times, suddenly were discovered as very risky assets… you want having increased the impact of volatility any higher?

May 2003, at a workshop for regulators, I argued: “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”. That translates into that the regulator should not try to hinder volatility, but learn to live with it. 

So, if we want a safer bank system, we must first get rid of the risk weighted bank capital requirements which have placed the consequences of volatility on steroids.

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

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

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

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

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

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

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

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

The Basel Committee incorrectly assumes “The Risky” will cause more “unexpected losses” than “The Infallible”

A discussion on a blog with someone who insisted that it is ok for the current capital requirements for banks to be higher for those perceived as risky that for those perceived as absolutely safe “because of the volatility”; and called me stupid because I “appear not to understand the whole concept of expected and unexpected losses” made me realize that I had to clarify again The Great Basel Committee Mistake… namely that Basel II (and III) base the capital requirements for banks, those which are to cover for the “unexpected losses”, on the “expected losses” derived from perceived credit risks.

“An Explanatory Note on the Basel II IRB (internal ratings-based) Risk Weight Functions” expresses: 

“The model [is] portfolio invariant and so the capital required for any given loan does only depend on the risk of that loan and must not depend on the portfolio it is added to.”

And the explicit reason for that mindboggling simplification was because it was: 

“This characteristic has been deemed vital in order to make the new IRB framework applicable to a wider range of countries and institutions. Taking into account the actual portfolio composition when determining capital for each loan - as is done in more advanced credit portfolio models - would have been a too complex task for most banks and supervisors alike.”

And which then leads to:

“In the context of regulatory capital allocation, portfolio invariant allocation schemes are also called ratings-based. This notion stems from the fact that, by portfolio invariance, obligor specific attributes like probability of default, loss given default and exposure at default suffice to determine the capital charges of credit instruments. If banks apply such a model type, they use exactly the same risk parameters for expected losses (EL) and unexpected losses (UL), namely probability of default (PD), loss given default (LGD) and exposure at default (EAD).”

And to justify their approach they write:

In the specification process of the Basel II model, it turned out that portfolio invariance of the capital requirements is a property with a strong influence on the structure of the portfolio model. It can be shown that essentially only so-called Asymptotic Single Risk Factor (ASRF) models are portfolio invariant (Gordy, 2003). ASRF models are derived from “ordinary” credit portfolio models by the law of large numbers. When a portfolio consists of a large number of relatively small exposures, idiosyncratic risks associated with individual exposures tend to cancel out one-another and only systematic risks that affect many exposures have a material effect on portfolio losses. In the ASRF model, all systematic (or system-wide) risks, that affect all borrowers to a certain degree, like industry or regional risks, are modeled with only one (the “single”) systematic risk factor

But suspecting they might be simplifying beyond reason, just in case, the Basel Committee added:

“It should be noted that the choice of the ASRF for use in the Basel risk weight functions does by no means express any preference of the Basel Committee towards one model over others. Rather, the choice was entirely driven by above considerations. Banks are encouraged to use whatever credit risk models fit best for their internal risk measurement and risk management needs.”

And this very flimsy approach, which ignores any correlation between unexpected losses, and shows very little concern with the problems of rapidly changing volatility, caused the Great Basel Committee Mistake of setting the capital requirements for banks, based on exactly the same perceived risks already cleared for.

In essence the regulators determined that a “risky” creditor, by the single fact of presenting more “expected losses”, also had to provide for more capital to cover for more “unexpected losses”. They never understood the hard truth that the safer something is perceived the greater its potential to deliver awful unexpected negative consequences.

And this the regulator did without absolutely any concern for how that could affect the efficiency of bank credit allocation in the real economy… something that can also be derived from the tragic fact that nowhere in the Basel Committee literature is there a word about the purpose of our banks.

And so they introduced an odious regulatory discrimination against those perceived as “risky”, something which introduces a dangerous risk-aversion, and, consequentially, introduces a favoring of what is perceived as “absolutely safe” that can only guarantee the dangerous overcrowding of safe-havens.

As perhaps the best example of what I am arguing is the absurdity of having what can really grow into dangerous excessive bank exposures, like the AAA to AA rated, being risk-weighted at 20%, while the totally innocuous below BB-rated, get a 150% risk weight.

    

In essence bank regulators have now ended up being the greatest systemic risk producers to the banking system. 

In short we do not need bank regulators, what we need are regulators who understand the banking system. 

In short we need regulators who understand that more important than looking at the portfolio of individual banks, is to look at the portfolio of banks in the whole banking system... and how it relates to the needs of the real economy.

Perhaps our bank regulators do not understand the possibility of a  "regression to the mean"

Did the "A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules" paper of 2002, by Michael B. Gordy, cause the downfall of our bank systems? Yes! It was an essential factor, but Gordy is not solely responsible for it... all those who sat there and did not understand one iota, and therefore never dared to question, are even more to blame.

“Margin Call” sells it as a surprised discovery of faulty volatility assumptions. Bullshit!

October 19, 2004, in a formal statement delivered as an Executive Director at the World Bank Board I wrote: 

“Phrases such as ‘absolute risk-free arbitrage opportunities’ should be banned in our ‘Knowledge Bank’. We (I) believe that much of the world’s financial markets are currently being dangerously overstretched through an exaggerated reliance on intrinsically weak financial models that are based on very short series of statistical evidence and very doubtful volatility assumptions.” 

And I was even only a lowly financial and strategic consultant who had never worked in the area of investment banking or portfolio management.

As others who might have made similar warnings I was just too right too early… and therefore I and many others are now being ignored by all those who have an interest in wanting to explain the current crisis as a Black Swan event… and by those media producers who feel more comfortable with their Monday Morning Quarterbacks.

My statement on IBRD's Liquidity Management and Borrowing Program

We join in the chorus of praise of the World Bank Group's "Financial Complex." It is precisely because they could just become too good for our own sake, and thereby fall into the human traps of complacency and excess of confidence, that we need to put forward some comments, in order to pinch.

Phrases such as "absolute risk-free arbitrage income opportunities" should be banned in our "Knowledge Bank." We believe that much of the world's financial markets are currently being dangerously overstretched through an exaggerated reliance on intrinsically weak financial models that are based on short series of statistical evidence and doubtful volatility assumptions.

Just as an example, we should not forget how all the risk assessment models had to be recalibrated to take into account for Argentina.

If the "Financial Complex" identifies an arbitrage opportunity where it feels reasonably confident that it can close out positions in a brief period and register a profit, so be it. However, some important opportunity costs of keeping arbitrage positions on book might be present, and we feel they are not sufficiently considered in the current presentation.

Specifically, the Review of IBRD Liquidity Policy of March 2000 refers in paragraph 15 and 16 to the value of "borrowing flexibility", but primarily to discuss this issue in terms of the need to borrow while the conditions are good and the markets are not closed. In our opinion, we should also look at the other side of the coin, as the opportunity cost of borrowing today should also reflect the possibility that we could perhaps obtain even better conditions tomorrow. The finance department itself points to this when it refers to "record sub-Libor rates during the Asia Crisis as a consequence of the flight to safe haven."

We all share the concern of lower lending activity in the Bank but, form another perspective, this could in fact allow us to assist more forcefully when needs really are present. Clearly, we are not a "lender of last resort." but I believe we need to reflect on what we could have done now had we not participated in the build-up of the debt of Argentina while their markets were open and had thereby been leveraged to help out when the crisis occurred. US$10 billion, in long-term loans from the World Bank, would have provided more than enough incentives to achieve a satisfactorily restructuring of the current debt of Argentina (and the only conditionality would of course have been asking Argentina not to incur in more public debt, but allowing the private sector to breathe).

In good times the differences in basis points of the funding costs between the World Bank and Argentina might have been, say, 100, while in bad times they might easily have reached 2000. You tell me... when is the right moment for the World Bank to help out?