Widespread criminal negligence!

I quote from the fraud action by SEC against Goldman Sachs… “for making materially misleading statements and omissions in connection with a synthetic collateralized debt obligation … ABACUS 2007¬AC1…tied to the performance of subprime residential mortgage-backed securities… was structured and marketed by GS&Co in early 2007 when the United States housing market and related securities were beginning to show signs of distress.”

“when the United States housing market and related securities were beginning to show signs of distress”?

Absolutely, at the date when ABACUS 2007AC1 was issued, April 26, 2007, I had already made four posts related to the subprime mortgage crisis… http://bit.ly/cwbLT2

And so: Where had the minimum caveat emptor we should expect from regulators gone? Where were the regulators? This has all the sign of being more complicated than it is been made out to be… Was it not all criminal negligence all over the place?

Hush! Less we lose the chance to beat on a foe or a convenient scapegoat.

The ABACUS 2007-AC1 flip book states:

“Although at the time of purchase, such Collateral will be highly rated, there is no assurance that such rating will not be reduced or withdrawn in the future, nor is a rating a guarantee of future performance.”

The truth is that had it not been because the investors believed that the credit ratings were correct, they would not have invested, no matter how much Goldman Sachs could have argued with them based on other false statements.

But this is of course is something many do not want to be known, because this would take away all the fun of being able to go after such a juicy foe as Goldman Sachs or such a convenient scapegoat to be used by the inept regulators.

We need to get to the real bottom of this... because that is were the truth can be found.

We can’t shame enough the irresponsible silent experts and the plain lousy regulators

As an Executive Director of the World Bank and a member of its Audit Committee 2002-2004, time and again I repeated what I extract below from my book Voice and Noise, 2006.

“From what I have read and seen, I believe there is a clear possibility 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”

I also frequently spoke out on the risk posed by empowering the credit rating agencies too much and, in May 2003, I even had a letter published in the Financial Times which ended with “I simply cannot understand how a world that preaches the value of the invisible hand of millions of market agents can then go out and delegate so much regulatory power to a limited number of human and very fallible credit-rating agencies. This sure must be setting us up for the mother of all systemic errors.”

Therefore if someone like me, a non-expert on financial markets, could have said the previous back in 2003-2004, I can only conclude that a crime of pure negligence, of sheer monumental proportions, was committed against humanity by an incredibly large number of professionals.

And so even though I agree of course that all those who pulled the triggers should go to prison, like those accused in Goldman Sachs, if proved guilty, in that prison, for true justice to be served, they should be accompanied by all those who kept mum because it was generally convenient for them to keep mum… and of course by the plain lousy regulators.

We must not let the intellectual mum-keepers go free! The world deserves more than some mea-culpa, the world deserves to find how to make the responsible speak up in time… if need be even by law.

The largest moral hazard is not having banks-bailed out… it is not shaming enough the irresponsible silent experts and the plain lousy regulators.

Some argue no one saw the crisis, “20.000 blind economists”, this is pure nonsense. Our biggest problem is how some few egos in a mutual admiration club dominate the debate and sell us what they believe sounds the best.

Look what they’ve done to my bank Ma! .....

They placed an 8 percent capital requirement on it when lending to our local small businesses and entrepreneurs who give us jobs.

And then they required from it only 1.6 percent in capital when lending to anything rated AAA... and even zero percent when lending to an AAA rated sovereigns...

And all this while they should know that my bank has really no business at all lending to AAA rated borrowers or sovereigns....

Ils ont changé ma banque Ma!...

And so they led my bank to throw my deposits after some unexplainable AAA rated securities backed with some unknown tranches of low quality subprime mortgages...

And now, when the AAAs are not the AAAs the credit rating agencies had opined them to be, my bank must come up with more capital....

And since my bank can´t it must stop lending to the local small businesses and entrepreneurs who had nothing to do with creating this crisis.

Look what they’ve done to my bank Ma! .....

Yes, yes, but what about?

Yes, yes we agree that the rational market is a myth but, what about the perhaps even larger myth of a rational regulator?

Yes, yes we agree there is a moral hazard present when bailing out the banks but, what about the perhaps even larger moral hazard of not punishing the regulators who failed?

What we first must do is to cut off the currently too visible hand!

Here we are, standing in front of the ruins of a horrendous financial crisis…

provoked by the most outrageous market intervention ever…

which occurred when bank regulators thinking themselves so brilliant…

concocted capital requirements for banks based on the risk of default as perceived by some few credit rating agencies…

like only 1.6 percent capital, which means allowing a 62.5 to 1 leverage, for anything related to an AAA rating…

and thereby rewarded additionally what was already rewarded by the traditionally coward capital markets….

to such an extent that the financial system stampeded toward safe-havens and turned these into dangerously overcrowded traps…

and now some have the gall to tell us it is “Time for a Visible Hand”

NO! What we first must do is to cut off the current too visible hand

There´s a too big confusion about the “too big to fail” banks.

The losses that generated the current crisis were NOT caused because some banks were too big to fail.

It is the way many of those losses are now being distributed between the investors, the banks and the supposed taxpayers that is being affected by the too big to fail.

Absolutely, banks should be cut down to size, as I have been arguing before Simon Johnson and others could walk (well almost). http://bit.ly/HIi3x

If we get rid of the “too big to fail” banks but keep using credit rating agencies to allow for absurd low and discriminatory bank capital requirements we will have done nothing to correct what brought us this mess of absurdly stupid financial losses.

Absurd and naïve bank regulations stand in our way!

The European Commission initiated on February 26, 2010 additional public consultations on changes to the Capital Requirements Directive for banks (CRD). The following was my response.

Sir,

The world swallowed the idea proposed by the bank regulators that if one creates incentives for banks to finance what is perceived as having less risk, and disincentives to avoid what is perceived as having more risk, then we would all be better off.

The regulators implemented it by placing lower capital requirements on those bank operations that are perceived by the credit rating agencies to have lower risk of default, the AAAs, than on those perceived as having higher risk, the BBBs of the world.

What an absurd and naïve thing to do!

• As if there was enough real AAAs to go around!

• As if economic growth and human development resided primarily in AAA land!

• As if you need to give more incentives to the AAAs already favored by the natural cowardice of capitals!

• As if you can measure risks without risking affecting those same risks.

• As if those operations perceived as less risky did not face the risk of more carelessness.

• As if those human fallible credit rating agencies would not be subject to very strong pressures to award the AAAs.

What happened? What was doomed to happen!

Increasing the value of the perceived safe-havens created incentives for selling some not so safe havens as safe, by influencing perceptions, which led to dangerously overcrowding a subprime haven; which caused the current financial crisis.

What needs to be done? Start from scratch!

There is no way to build something good on top of a foundation as faulty as the Basel Committee´s “The First Pillar – Minimum Capital Requirements”. Unfortunately this could prove to be an impossible task if keeping those regulators who so entirely succumbed to the current paradigms.

Europe, wake up! The current crisis did not result from excessive risk-taking. It was the result of misguided excessive risk-aversion. The losses occurred in AAA land not in BBB land.

Europe, wake up! Risk-taking is what takes one forward. Risk aversion can only guarantee being diminished. Europe, do not allow yourself to be diminished! Rest of the world that goes for you too!

Per Kurowski

Governor Daniel K. Tarullo on Financial Regulatory Reform

U.S. Monetary Policy Forum, New York on February 26, 2010

Tarullo said: “But financial stability alone is not the aim of financial regulation”

About time! About 20 years too late! In the 347 pages of the bank regulations known as Basel II there is not one word about any other purpose for our banks than being stable

Tarullo said “Supervisors counted on capital and risk management to be supple tools that could ensure stability”

Absolute nonsense! They created a very crude and simple set of capital requirements based on perceived risks; then outsourced simplistically the risk-watch function to the credit rating agencies; and then they simply went to sleep.

Conclusion: A lot of good thoughts but yet not a word on the true problems with their current regulatory paradigm, being that there are not enough low-risk AAAs to go around for everyone; and that real economic growth and development does not happen in any risk-free AAA land.

Should we not have higher capital requirements for banks on what is perceived as less risky?

This “Not your average airport!” courtesy of “Learning from dogs” is a great example of that when something is risky everyone is more careful...



And so what we might really need is higher capital requirements on what is perceived as not risky and which therefore can induce carelessness. Just exactly the opposite of what the financial regulators have been and are doing.

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”.

Dangerous global coordination was the real cause of the crisis

Capital is intrinsically coward and loves anything triple-A rated. Therefore, when on top of this natural love, the global regulators in the Basel Committee awarded the triple-A rated additional benefits in terms of these generating much smaller capital requirements for banks... the demand for triple-A rated instruments soared. As should have been expected the supply mechanism of the market started to fabricate triple-A rated instruments in enormous volumes... something that by definition should be anathema to low risk.

There were of course many other economic imbalances that aggravated the final result but this, the excessive belief in that risk should and could be avoided, is why the current financial crisis came to happen.

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

In January 2003 the Financial Times published a letter in which I wrote: “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.”

But now when the above has unfortunately been proved to be too true, Dominique Strauss-Kahn of the IMF, in “Nations must think globally on finance reform” February 18, keeps on going as if nothing has happened writing that “the work of [the Basel Committee and the Financial Stability Board] must be accelerated to harmonise rules that limit excessive risk taking”.

IMF, before going forward, needs to reflect more on the dangers that the very real possibility of a bad global coordination might signify.

A letter in Washington Post: Another 'worst': Faulty bank regulation

Another 'worst': Faulty bank regulation 

The Dec. 20 Outlook compilation of the decade’s worst ideas did not include the one most to blame for the loss of most of the past decade’s growth: regulations that allowed banks to hold absolute minimums of capital as long as they lent to clients or invested in instruments rated AAA, for having no risk. This launched a frantic race to find AAA-rated investments wherever and finally took the markets over the cliff of the subprime mortgages. 

The most horrific part is that it seems likely to endure because regulators can’t seem to let go of this utterly faulty regulatory paradigm. Let me remind you that banks are allowed to hold zero capital when lending to sovereign countries rated AAA and that there are already many reasons to think that the credit quality of many sovereign states has been more than a bit overrated.

Here other of my letters in the Washington Post on the same theme:
http://subprimeregulations.blogspot.com/2018/07/trade-wars-will-mean-new-tariffs.html
http://subprimeregulations.blogspot.com/2017/04/when-banks-play-it-too-safe-putting.html
http://subprimeregulations.blogspot.com/2016/08/banks-and-regulators-dont-care-about.html
http://subprimeregulations.blogspot.com/2015/11/the-reverse-mortgage-on-economy-baby.html
http://subprimeregulations.blogspot.com/2014/12/another-letter-in-washington-post-let.html
http://subprimeregulations.blogspot.com/2013/04/another-letter-in-washington-post.html
https://subprimeregulations.blogspot.com/2008/06/a-letter-in-washington-post-aspect-of.html

https://subprimeregulations.blogspot.com/2007/09/factors-in-financial-storm.html

The day SEC delegated to the Basel Committee

On April 28, 2004 in an Open Meeting the SEC had the following as Item 3 on the Agenda:

"Alternative Net Capital Requirements for Broker-Dealers that are Part of Consolidated Supervised Facilities and Supervised Investment Bank Holding Companies"

The following was considered and approved:

"The Commission will consider whether to adopt rule amendments and new rules under the Securities Exchange Act of 1934 ("Exchange Act") that would establish two separate voluntary regulatory programs for the Commission to supervise broker-dealers and their affiliates on a consolidated basis.

One program would establish an alternative method to compute certain net capital charges for broker-dealers that are part of a holding company that manages risks on a group-wide basis and whose holding company consents to group-wide Commission supervision. The broker-dealer's holding company and its affiliates, if subject to Commission supervision, would be referred to as a "consolidated supervised entity" or "CSE." Under the alternative capital computation method, the broker-dealer would be allowed to compute certain market and credit risk capital charges using internal mathematical models. The CSE would be required to comply with rules regarding its group-wide internal risk management control system and would be required periodically to provide the Commission with consolidated computations of allowable capital and risk allowances (or other capital assessment) prepared in a form that is consistent with the Basel Standards. Commission supervision of the CSE would include recordkeeping, reporting, and examination requirements. The requirements would be modified for an entity with a principal regulator.

The other program would implement Section 17(i) of the Exchange Act, which created a new structure for consolidated supervision of holding companies of broker-dealers, or "investment bank holding companies" ("IBHCs") and their affiliates. Pursuant to the Exchange Act, an IBHC that meets certain, specified criteria may voluntarily register with the Commission as a supervised investment bank holding company ("SIBHC") and be subject to supervision on a group-wide basis. Registration as an SIBHC is limited to IBHCs that are not affiliated with certain types of banks and that have a substantial presence in the securities markets. The rules would provide an IBHC with an application process to become supervised by the Commission as an SIBHC, and would establish regulatory requirements for those SIBHCs. Commission supervision of an SIBHC would include recordkeeping, reporting and examination requirements. Further, the SIBHC also would be required to comply with rules regarding its group-wide internal risk management control system and would be required periodically to provide the Commission with consolidated computations of allowable capital and risk allowances (or other capital assessment) consistent with the Basel Standards."

In other words, that day the SEC, explicitly, delegated some of its functions to the Basel Committee.

That day Goldman Sachs, Morgan Stanley, Bear Stern, Lehman Brothers, Merrill Lynch were authorized to leverage themselves way more than was traditional. In fact 62.5 times to 1 when in the presence of a AAA rating. That day those firms were authorized to use their own financial models to govern themselves. “With that the five big investment firms were unleashed”.

That day a very serious warning by Mr. Leonard D Bole was blithely ignored.

You can hear the New York times commenting more about that highly unfortunate delegation here

Risk management is not a petit committee issue! Regulators and credit rating agencies should not preempt the markets!

The report by the Institute of International Finance, IIF, “Reforms in the Financial Services Industry” states not surprisingly that “Strengthening risk management is a top priority, and risk functions are being reconfigured and upgraded to give firms a more integrated approach to risk management."

The report, making many good and valid observations in reference to risk management, also warns about the risk of it "becoming too prescriptive, inducing many firms to adopt the same risk management approach. That would detract from the important competitive benefits resulting from each firm being free to make its own choices regarding risk appetite. More important, it would create significant “model risk.” If all firms were required to use similar approaches and models in managing risk, they could tend increasingly to behave in the same way, reinforcing procyclicality."

For someone who in 2000 warned of new regulatory risks arising in Basel writing “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.”, those comments are pure music.

I have also argued that the only valid regulatory response that fosters market diversity in risk management is the establishment of some very simple rules that do not introduce more distortions and complications than those already abundant in the real world.

In this respect, the regulator, instead of permitting different capital requirements for different assets depending on perceived risks should require equal capital requirements for any type of assets and let the risk appraisal process to unhindered fully take place in the market, between bankers, shareholders and creditors… instead of, as currently is the case, between bankers, regulators and credit rating agencies.

The IIF report though understandably not totally clear on the issue, acknowledges it when it makes a sort of veiled leave-us-alone pleading stating among its “leading points”:

“Communication and disclosure of risk appetite: Firms should improve their disclosure practices regarding their risk appetite determination (e.g., what metrics they use, their level of tolerance, their decision-making processes). These disclosures display to stakeholders, analysts, and creditors —in short to the market—how rigorous and robust the risk management framework is at an individual firm, hence contributing to effective market discipline.

Regulators and risk appetite: Some supervisors’ reports have called for authorities to monitor and regulate banks’ risk appetite. While it is legitimate for macroprudential regulation to gather information on firms’ risk appetites, and it is legitimate for supervisors to challenge the firm’s risk appetite and the means by which this is identified and transmitted, firms should be able to define their own risk appetites with the interests of their direct stakeholders in mind.”

An unconstitutional odious discrimination!

When a bank lends to the government it is required to hold zero percent in equity; when it lends to a corporation rated AAA by one of three credit rating agencies then they need 1.6 percent; when it holds a residential mortgage 2.8 percent but, when lending to an entrepreneur or a small business that has not been rated, then the bank is required to hold 8 percent in equity. As bank equity is scarce and expensive this amount to an arbitrary discrimination against unrated entrepreneurs and small businesses.

If I was an entrepreneur or a small business in the US I would go to a judge and denounce that I am being discriminated against by the financial regulators, in an unconstitutional way.

I would also take the opportunity to explain to the judge how perfectly stupid this discrimination is considering that it is precisely the entrepreneurs and small businesses those who can create the real fiscally sustainable jobs, as well as the AAAs of tomorrow; and also remind the judge that entrepreneurs and small businesses had nothing to do in creating this crisis.

PS. What would the US Supreme court opine if asked: “Is a regulatory discrimination against The Risky and in favor of The Infallible, not an odious and unconstitutional negative action?”

In the land of the brave there is a tax on risk

Bubble talk!

I am getting a bit nervous with all this bubble talk.

How are they intent to do their bubble-busting? Are the regulators now going to appoint bubble-measurers? Are we going to have these assets bubble-meters being showed off in Times Square? What instruments to puncture them are going to be used? Talk about value of inside information!

Much the same way it sounded so utterly reasonable to have the credit rating agencies influence how much equity banks should have, and look where it led us. This reasoning just like it assumed that a risk of default was a risk of default, assumes that a bubble is a bubble, and that there are no risks derived from pre-announcing that a bubble will not happen.

And what if the prime motor of development is the belief in the possibilities of the next bubble? If we ex-ante eliminate the possibility of a real bubble, how many will just stay in bed while other countries, those with no qualms about a crisis because for them any status quo is worse, will go forward?

If there is something truly lacking in the current discussion on regulatory reform that is the consideration of the good things that come with risk-taking and now, the good things that come from bubbles.

Me, I really would love the world to keep on taking risks and blowing bubbles, even at the cost of suffering huge setbacks, as long as that takes us forward. Because of this, more than worrying about where the next precipice might be, I would try to make more certain that we are heading in the right direction.

Others, baby-boomers and wimps, on the contrary, seem to be satisfied with what they have achieved and are happy settling for just keeping it.

This is a great opportunity for developing countries to catch up... I can already see the billboards “Have bubbles, willing to party, for real, no adult supervision, foreign investors welcome!” While the developed countries set up theirs, on Wall Street, announcing “Welcome... guaranteed no bubbles!”

Real capital might be coward... but it sure loves bubbles.

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.

In the land of the brave?

The difference in bank capital requirement between an unrated client and an AAA is 6.4 percent, which at a capital cost of 15 percent, results in 1 percent a year. This represents a 1 percent tax on perceived default risk! Do the regulatory wimps really believe that creating jobs and moving the world forward is a risk free affair?

Read more at the Financial Times Economist Forum