The current bank regulatory system is fundamentally flawed, at its core.

Even if the credit ratings are absolutely right, using them as they are used, as a basis for calculating capital requirements of banks, is wrong, because the regulators have no business introducing an arbitrary regulatory bias against risk-taking. The world moves forward taking risk, the world lies down and dies avoiding risk.

“The First Pillar” of our current bank regulations (Basel) establishes the “Minimum Capital Requirements” for the banks (MCRs).

The MCRs depend on a risk assessment of a quite vaguely defined risk of default. The risk assessment is to be carried out primarily by the Credit Rating Agencies but, in the case of larger banks, also by using their internal risk models. In this respect, as an example, the MCRs rule that if a bank lends to an ordinary not rated client, it is required to hold 8 percent in equity, which is equivalent to an authorized leverage of 12.5 to 1, but, if lending to a client that is rated AAA, then it only needs to hold 1.6 percent in equity, which is equivalent to an authorized leverage of 62.5 to 1.

The above represents two risks, both clearly evidenced in the current crisis.

The first is that the credit rating agencies, by being captured by other interests or plainly because of human fallibility, could be wrong in their assessments, with the consequences that too much capital will follow the wrong ratings in the wrong direction. The current crisis did not result from investment in anything that could be considered as risky but almost exclusively from investments in instruments carrying an AAA rating and which were considered to be absolutely free of risk.

The second risk with the structure of the MDCs is that they effectively imply a subsidy to anything perceived as having a low risk and, comparatively, a tax on whatever seems to carry a higher risk. The subsidies, or costs, of these regulatory risk-weights, are layered on whatever risk differentials the market already prices in their interest rate spreads. This creates confusion in the risk allocation mechanism of the market as the signals are obscured and no one knows for sure whether the low spreads are the result of low risks or the result of low capital requirements. But, so much worse, these risk-subsidies or risk-taxes help to channel and push capital flows into “risk-free” territories that could already be swamped or serve no real societal purpose, or stop capitals from flowing into dried areas much in need of capitals and which represent important societal purposes.

All human endeavors to move forward are risky by nature, and there is absolutely nothing that in economic terms justifies a regulatory bias in favor of what is perceived as having a low risk. In the current crisis immense amounts of capital were lost sustaining a useless and artificial housing boom in a developed country, and not lost in projects that for instance tried to combat climate change or create sustainable jobs.

The Gini Coefficient, in economics, measures the inequalities in the distribution of wealth and income, from cero, no inequalities, to 1, absolute inequality. The current bank regulatory system, by design, with the MDCs pushes up the world’s Gini Coefficient. Do we really want that?

Please help us mend the faulty core of our bank regulations. Without this, all our other important and needed efforts to reform our financial sector are meaningless.

Per Kurowski

perkurowski@gmail.com
http://financefordevelopment.blogspot.com/

The Basel Committee castrated our banks.

One of the most serious threats to development, both in developing and developed countries, is the castration of our banks by the Basel Committee by means of the minimum capital requirements for banks based on assessments of default-risk.

The real stability of a financial system does not depend so much on avoiding the risk of defaults but on making sure that the underlying growth of the economy in which the banks function is healthy and sustainable as a whole. In this respect, imposing “risk-weights”, could quite plausibly elevate the risks of getting the wrong sort of growth in which not only the banks would fail but also the rest of the economy.

The default-risk based capital requirements for banks have effectively imposed a tax on all lending to what is perceived by credit rating agencies as more risky, notwithstanding that these loans could be the most productive for the society; and effectively introduced a subsidy to anything that can dress up as having a low risk, notwithstanding that these loans could be the most unproductive for the society.

The default-risk based capital requirements for banks are effectively increasing the world’s Gini coefficient.

Therefore, if the wimps of the Basel Committee absolutely insist on discriminating between borrowers with their “default-risk weights”, then the society should at least have the right to request the introduction of some “loan-purpose weights” as counterweight to the risk-adverse maniacs.

Over the last years (2004-2007) trillions of dollars of funds, more than the World Bank and the IMF have lent altogether since they were created over sixty ago, were diverted, by the false AAA signs set up by the credit rating agencies, to finance an artificial housing boom. Had it not been for those signs much of those funds could have gone for instance to solve bottleneck problems in the infrastructure in developed and developing countries; to create decent jobs in developed and developing countries alike; or to help fight climate change.

Think of it, don’t you see that if the AAA ratings of the subprime mortgages had been absolutely correct then we could be on our way to something even more disastrous, as the world concentrated more and more all its scarce financial resources in the building and the revaluing of houses in the USA.

Friend, please act now and help us recover our banks.

And also, please stop calling what detonated because of investments in the supposedly safest assets, mortgages and houses, in the supposedly safest country, the USA, and in the supposedly safest instruments, those rated AAA, a financial crisis resulting from excessive risk-taking. It is a financial crisis caused by an excessive and completely misguided risk-aversion.

Comments on the “Principles for Reforming the U.S. and International Regulatory Capital Framework for Banking Firms”

If the regulatory principles involved had been right then the proposal would represent a quite reasonable to good tweaking of the current regulatory system. Unfortunately since the underlying regulatory principle is wrong the tweaking will not achieve the results that are needed.

The real stability of a financial sector does not depend so much on avoiding the risk of individual banks failing, but on making sure that the underlying growth of the economy in which the banks function, is healthy and sustainable as a whole.

In this respect introducing regulatory biases in favor of risk-aversion could quite plausibly elevate the risks of getting the wrong sort of growth in which not only the banks would fail but also the rest of the economy.

Therefore if the regulators absolutely insist on discriminating between borrowers with their “risk of default weights” then the society should at least have the right to request the introduction of some “purpose weights” as counterweight to the regulator’s extreme risk adverse bias.

Most of the problem we encounter with the reform derives from the fact that most still believe that this crisis resulted from some excessive risk-taking, even when staring at the evidence that most of the losses resulted from trying to earn a couple of more basis points investing in AAA rated securities. The day regulators are able to see it as it is, the result of a misguided risk-aversion, much of it induced by the regulators, that day we stand a better chance for a better reform of our financial sector.

As to the financial crisis Paul Krugman does not know what he is talking about.

Paul Krugman in "How Did Economists Get It So Wrong?", September 6 writes “There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year”

Absolutely not! Paul Krugman, in relation to the financial crisis, has no idea of what he is talking about. The collapse was doomed to happen, courtesy of the financial regulations in place.

In January 2003 the Financial Times published a letter I wrote and that ended with “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. Friends, please consider that the world is tough enough as it is.” http://bit.ly/5i1Bu

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

A diminished diversification of risk. No matter what bank regulators can invent to guarantee the diversification of risks in each individual bank, there is no doubt in my mind that less institutions means less baskets in which to put one’s eggs. One often reads that during the first four years of the 1930’s decade in the U.S.A., a total of 9,000 banks went under. One can easily ask what would have happened to the U.S.A. if there had been only one big bank at that time.

The risk of regulation. In the past there were many countries and many forms of regulation. Today, norms and regulation are haughtily put into place that transcend borders and are applicable worldwide without considering that the after effects of any mistake could be explosive.

Excessive similitude. By trying to insure that all banks adopt the same rules and norms as established in Basle, we are also pushing them into coming ever closer and closer to each other in their way of conducting business. Unfortunately, however, nor are all countries the same, nor are all economies alike. This means that some countries and economies necessarily will end up with banking systems that do not adapt to their individual needs. http://bit.ly/HIi3x

Truth is only some PhD regulators who have never ever stepped outside their offices to walk the real streets of finance could have been as naïve and gullible to believe they could empower the credit rating agencies so much to determine the financial flows without setting them up to be captured.

The sooner the world stops the financial regulations from falling excessively in the hands of the PhDs the better and this, of course, does not mean that I do not recognize the importance of the PhDs.

And, by the way, I am an economist… only that I have walked the streets as a professional for over 30 years.

I am so disappointed with conservative, progressive and of course middle of the road think-tanks.

The minimum capital requirements for the banks drafted by the Basel Committee and that apply or inspire most bank regulations in the world establishes that if a bank gives a loan to a normal entrepreneur who does not have a credit rating then it needs 8 percent in capital; if the loan is to a client with an AAA rating then 1.6 percent in capital will do and if it is a loan to its government then there is no capital requirement at all.

Dear libertarians/conservatives.

Eight percent in capital when lending to a citizen and zero when lending to the government…does this not upset you?

Is not risk taking what keeps a society moving forward? Is not taxing risks and subsidizing risk adverseness something like having your country lie down and die?

Do you not find it crazy that some few credit rating agencies, even if private, shall have so much to say in orientating the capital markets and messing up the risk allocation systems?

Dear progressives.

Eight percent in capital when lending to an ordinary citizen and 1.6 percent when lending to a company rated AAA… do you agree with such discrimination? Does not the AAAristocracy have enough advantages already?

Don´t you know that AAA ratings in just a couple of years drove more capitals to the US housing market than all the loans given by the World Bank and the IMF ever since they were founded? How come you can applaud silly initiatives like Banco del Sur when obviously a Credit Rating Agency del Sur seems to carry so much punch nowadays?

Low capital requirements just because someone has got an AAA rating and is supposedly risk free… and what about the purpose of the loans should not that count too?

Dear middle of the roaders.

All of the above plus:

Think about it, even if the credit rating agencies had been perfectly right in their assessments what would the country have gained… more mortgages to ever bigger houses?… more financing from abroad in order to keep on buying even more imports?

The way you kids growing up with GPS might never know what north, south, east and west means… do you want your bankers just to follow credit rating agencies opinions and never learn themselves about analyzing a client, looking him in the eyes and shaking his hand?

Do you really want to have your financial sector watched over by regulators so naive and gullible that they did not know that sooner or later the credit rating agencies that they empowered so much would be captured?

No, all of you think tanks!… what´s wrong with you?…. Too lazy to even read the Basel Epistles that governs most of your current financial regulatory system? As a fact, from all of the books articles comments and other ways of expression we see from those selling themselves as experts on the crisis, there is clear evidence that 99 percent of them have not even read an abridged version of what is contained in Basel II.

Or are you all just a bunch of baby-boomers who follow whoever promises most to avoid risks, while you are around, placing your reverse mortgage of the world and shouting “Après nous le deluge”? If so, shame on you all!

Do you?

Societies, do you want your bankers to know about credit risks or do you give them credit rating agencies? (Like in: Parents, do you want your children to know about north, south, east and west or do you give them a GPS?)

http://perkurowski.blogspot.com/2009/08/gps-and-aaas.html

And, what about some minimum capital requirements to cover for the credit rating agencies’ exposure in credit risk opinions?

If the banks invest in AAA rated securities then these are risk-weighted by the regulator to only signify an exposure of 20 percent and so if the banks invest $1 trillion of 1.000 billion dollars in these securities they have to put up only $16 billion in equity, the result of multiplying the now risk-weighted exposure of $200 billion times the basic capital requirement of 8 percent.

And so $16 to cover $1.000! The question that hangs in the air is why then do not the rating agencies need some capital requirements to back up the accurateness of their ratings.

I mean after taking away the $16 billion of equity of the banks their opinions are sort of backing the remaining $ 984 billion. Is it prudent to trust the word of the credit rating agency so much? You tell me!

We live in a crazy world, our financial regulators in Basel were so naïve and gullible they did not even know they were setting the credit rating agencies to be captured.

Capital requirements for banks could use a "credit risk - credit purpose" matrix

On July 29 2009, in Venezuela, the financial regulator, Sudeban, issued a norms by which the risk weights used to establish the capital requirements of the banks were lowered to 50%, when banks lend to agriculture, micro-credits, manufacturing, tourism and housing. As far as I know this is the first time when these default risk-weights and which resulted from the Basel Committee regulations, are also weighted by the purpose of the loan.

The way it is done Venezuela lack a lot of transparency and it could further confuse the risk allocation mechanism of the markets (though in Venezuela that mechanism has already almost been extinguished) but, clearly, a more direct connection between risk and purpose in lending is urgently needed.

In this respect the Venezuelan regulator is indeed poking a finger in the eye of the Basel regulator who does not care one iota about the purpose of the banks and only worry about default risks and, to top it up, have now little to show for all his concerns.

I can indeed visualize a system where the finance ministry issues “purpose weights” and the financial regulator “risk-weights” and then the final weight applicable to the capital requirements of the banks are a resultant of the previous two.

Does this all sound like interfering too much? Absolutely, but since this already happens when applying arbitrary “risk weights” you could also look at this as a correction of the current interference.

Mark to market the government’s bail-out efforts

In order to bring some transparency to what the government is doing in bailouts it should sell in the market, at 100% of nominal value, a portion of the instruments they have received in return for their bailout funds; and compensate any differences in the market value of these instruments with a tax-credit. How would it work?

Let us say the government has received $100 in shares of GM. If these shares are worth that amount the government would get their money back immediately but, if not, buyers would ask to receive a tax credit. If the market only asks for a 10% tax credit, meaning $10 in tax credit to purchase the GM shares for $100 then the government is not doing so bad but, if the market asks for 90% in tax credits, then clearly the government is pouring money down the drain.

That would certainly pressure the government into doing better. Problem though is that most probably government would never dare to have their own actions marked to market that way.

The risk in not running the risk of the risky

The current crisis detonated because of investments in assets of the safest type, houses and mortgages; in the safest country, the US; and in the safest type of zero-risk instruments, triple-A rated, that turned out bad. Even so the immense majority of financial experts, even Nobel Prize winners, explain the crisis as the result of “excessive risk-taking”. They are wrong; the crisis is clearly the result of an extremely misguided excessive risk-aversion.

Looking to help the large international banks to compete better with the smaller local banks, and wanting also to avert a new bank crisis, the regulators from some developed countries got together behind closed doors in Basel and came up with what they thought was the brilliant idea of determining the capital requirements for the banks, based on how the credit rating agencies rated a loosely defined default risk of borrowers and securities.

We are not talking about something insignificant. According to the regulations known as Basel II and that apply or at least inspire most banking regulations in the world, in order to lend funds to a corporation that does not have a credit rating a bank is required to hold 8 percent in capital, but, if lending to someone rated AAA it is only required to have 1.6 percent. As you understand, these regulations, approved in June 2004, started a wild chase after the AAAs… and here we find ourselves where the global losses in what was supposed to be risk-free exceed many times what has been lost in what was considered to be more risky… among others because what is perceived as risky by itself always inspires more care.

This regulatory system is still applicable, causing immense hardships in the world economy. In tandem with how the ratings of borrowers worsen the banks need to obtain more capital and since bank equity is scarce, they try to obtain it freeing themselves from clients for whom because these have even worse credit ratings, they are required to hold even more capital. With that all bank clientele that is perceived as more risky, but that is just as or even more important to the economy, is exposed to additional pressures, just when they least need it.

Companies that are presenting difficulties and have to restructure their liabilities are among those most affected by these puritan and intrusive regulatory inventions. Clearly if the difficulties of a borrower seem to be unsurpassable the best things to do, for all, is to speedily cut it off from credit, but, if after having analyzed it, the decision is taken to help it out, it does not make any sense making it even more difficult for it, like by imposing higher capital requirements on its creditor banks. It should be just the opposite, not only because these companies need to be treated with delicacy, but also since normally, they have been more scrutinized than the majority of firms that show themselves off as representing zero risk.

It is natural that creditors would charge more or less for a loan in accordance with how they perceive the risk but… on account of what does a regulator arbitrarily intrude in the decision? Is by any chance a job in a company rated B- less important than a job in a company rated AAA?

Risk is the oxygen of all development and in this respect regulations oriented to conserve what has been developed because it is more likely to be perceived as less risky, are unacceptable. Less risky for whom? For the world? How naïve! There is nothing so risky for the world than to refuse to run the risk of the risky.

The triple-A ratings have, in only about four years, without leaving much development in its wake, taken over the precipice more capital than all that lent by the World Bank and the International Monetary Fund since their creation sixty years ago. I have for years debated and fought these regulations from Basel, in the World Bank, in the United Nations and on the web… while others lose their time and our oil revenues in such absolute irrelevancies as a Banco del Sur.

Translated from El Universal, July 23, 2009

Something´s terribly wrong

When parents seem to give more importance to their children´s credit score than their school grades, like setting them up to the fact that they will have to work their whole life in just to pay interests, something´s terribly wrong

The danger with financial literacy programs

They usually start with the "A"... as in AAA

A bank with a purpose

Let´s give Darwin a hand and tax those prone to sickness and subsidize those who rate healthy!

If the regulators of the insurance companies would decide to follow the regulatory paradigm concocted by the Basel Committee, then they would pick three health inspection agencies to rate the health of the insured and require the insurance companies putting up more capital when insuring someone with a low health rating and letting it of the almost off the hook if the insured is deemed to be in tip top form.

Since equity costs a lot, especially in times of crisis, the above is equivalent to placing a de-facto tax on those prone to sickness or giving a de-facto subsidy to those who rate healthy, both these on top of what the market already charges for any differences in health

With their minimum capital requirements based on a vaguely defined and extremely narrow concept of risk and as measured by their three amigos the credit rating agencies, the Basel Committee subsidizes anything that finds it easier to dress up in AAA clothing and castigates what is perceived as higher risk.

With these regulations they drove in a wedge that further increases the differences between the unsustainable status-quo and the sustainable future we all must try to reach, which of course requires a lot of risk-taking.

The misguided risk-aversion these regulations was the major force behind channeling in just a couple of years more than two trillion dollars into the supposedly safest asset, houses, into the supposedly safest country, the USA and into the supposedly safest instruments, AAAs…for no particular good reason at all.

All in all these Basel financial regulations add up to a crime against humanity and against common-sense.

The UN Conference Crisis & Development June 2009 - My Disapointments

UN Conference Crisis & Development June 2009 Disappointments
Uploaded by PerKurowski. - News videos from around the world.

0:30 Millennium Development Goals

2:00 Risk weighted capital requirements for banks 

5:08 Polarization

6:25 Migrants in the world

Madoff got 54.900 days of jail, that’s ok, but should not regulators get at least 1 day in the slammer?

Madoff got a sentence of 54.900 days it serves him right but having said that the regulators should also spend at least one day in the slammer for the sake of justice, just to help us restore some minimum accountability. Are they not 1/54.900 part responsible for this crisis? Of course they are. Not only those who were paid to keep an eye on Madoff but even more so those in Basel who are responsible for setting up a system that stimulated the financial sector to depend so much on the opinions of the credit rating agencies and the race for the triple-As.

They’ve left the rotten apple in the Financial Regulatory Reform barrel!

Though the proposed financial regulatory reform often speaks about more stringent capital requirements it still conserves the principle of “risk-based regulatory capital requirements” and by doing so the “new foundation” builds upon the most fundamental flaw of the current regulatory system.

Regulators have no business in trying to discriminate risks since by doing so they alter the risks and make it more difficult for the normal risk allocation mechanism in the markets to function.

Financial risk cannot only be managed by looking at the recipients of funds as lenders or investors are also an integral part of the risk. High risks could be negligible risks when managed by the appropriate agents while perceived low risks could be the most dangerous ones if the fall in the wrong hands.

The recent crisis detonated because some very simple and straight-forward awfully badly awarded mortgages to the subprime sector, managed to camouflage themselves in some shady securities and thereby hustle up an AAA rating. This crisis did not grew out of risky and speculative railroads in Argentina this crisis had its origins in financing the safest assets, houses, in supposedly the safest country, the US.

Are you aware of that for a loan to a borrower that has been able to hustle up an AAA the regulators require the banks to have only 1.6 percent in equity, authorizing the banks to leverage their equity 62.5 to 1?

The credit rating agencies and the GPS

Not so long ago I asked my daughter to key in an address in the GPS and then even while I continuously heard a little voice inside me telling me I was heading in the wrong direction I ended up where I did not want to go. That is exactly what the credit ratings did to the financial markets, especially when the regulators created so many incentives to follow them.

“Too large to fail” are yet in some ways small fry

“Too large to fail banks” are regulatory peccata minutiae when compared to that of having created the credit rating agency’s oligopoly. The opinions of the credit rating agencies, that the regulators induced, brought on much worse systemic concentration of risks than the “too large to fail” banks.

And don’t get me wrong I was one of the few ones who spoke out against the “too large to fail” while they were still considered to be too large to fail and people kept mum about them. While an Executive Director at the World Bank in May 2003 I told a workshop of some hundred regulators for all over the world “Knowing that the larger they are, the harder they fall, if I were regulator, I would be thinking about a progressive tax on size”.

I don’t know… you tell me!

Of course most of the free-market oriented gurus had not the faintest idea about the possibility of the world running into a regulatory induced crisis, and much less did they warn the world about it, but, let’s face it, neither did the gurus of the other side, the Stiglitzes of the world. This should be more than a valid reason for the world to proceed with much caution when heeding the advice of experts. The Queen’s question about why nobody had seen it coming is as valid as ever, and LSE's Professor Luis Garicano answer to her "At every stage, someone was relying on somebody else and everyone thought they were doing the right thing" equally so.

I who as a severe critic of Basel II (and of Basel I) has followed closely the issues and the debates on bank regulations, I am aghast about having read so many reasonable arguments and proposals being ignored. If these small voices had been heard they could have saved us from the current disasters and hundreds of millions of individuals around the world would not have been condemned to misery. So what could we do about it? My number one, two and three recommendation is to beware of the self or media appointed experts who are mostly only concerned with pushing themselves or their agendas… and to severely limit their access to the microphone.

Now how do we do that? I don’t know… you tell me!