If the IMF and the World Bank bites the Basel Committee, that should be news.

Capital requirements for banks that discriminate based on ex-ante perceived risk of default, with higher requirements when risks are perceived as higher and lower when risks are perceived as lower, is about the only tool in the Basel Committee for Banking Supervision’s toolbox. This single tool is completely inadequate, even outright dumb, on two counts:

First, it is totally counterfactual as all the financial and bank crisis have always originated from excessive investments in what ex-ante is perceived as having a low risk of default and no crisis has ever originated from excessive investments in what is perceived as risky. The perception of being risky is as big a weight as it comes and does not need to be supported by additional arbitrary risk-weights imposed by regulators. Risk premiums reflected in higher interest rates that goes directly to the capital of the banks are more than sufficient risk-weights. If anything we might need regulatory risk-weights to make up for the risk of the ex-ante perceptions of low risk turn out to be false.

Second, these capital requirements unduly and odiously discriminate against those perceived as having higher risk like the small business and entrepreneurs, and who happen to be precisely those whose financial needs the society has the largest interest in that the banks help to satisfy.

That a Mr. Kurowski voices the above arguments over and over again is of no importance, but, when these arguments begin to find an echo in the World Bank and the IMF… which would mean that these two institutions would be the one calling out that “The Basel Committee has no clothes” then one could presume they get to be newsworthy.

Below is the link to the video where you can find the questions I made during a Civil Society Town-Hall meeting (minute 47.28) and Dominique Strauss-Kahn’s answer (minute 1.01.08) and Robert Zoellick’s answer (minute 1.16.32)

http://www.imf.org/external/mmedia/view.aspx?vid=628246206001

Today I had a great day

For someone who since 1997 has been opposing the regulatory paradigm used by the Basel Committee for Banking Supervision, even as an Executive Director of the World Bank 2002-2004, today was a great day.

As a member of Civil Society, whatever that now means, at a Civil Society Town-hall Meeting during the 2010 Annual Meetings, I had the opportunity to pose a question to Dominique Strauss-Kahn, the Managing Director of the International Monetary Fund, and to Robert B. Zoellick, the President of the World Bank:

My question: (minute 47:35) “Right now, when a bank lends money to a small business or an entrepreneur it needs to put up 5 TIMES more capital than when lending to a triple-A rated clients. When is the World Bank and the IMF speak out against such odious discrimination that affects development and job creation, for no good particular reason since bank and financial crisis have never occurred because of excessive investments or lending to clients perceived as risky?”

Dominique Strauss-Kahn's answer: (minute 1:01:05) "Well, the question about requirements, a couple of requirements for banks. You know, it's a very technical question and a very difficult one, but the way you asked the question, which is why there any kind of discrimination against SMEs is an interesting way of looking at that. In fact, there is no reason to have any kind of discrimination. The right thing for the Bank is to know whether or not their borrower is reliable, but you can be as reliable being a small enterprise than not reliable when you're a big company. So this kind of systematic discrimination has, in our view, no reason to be.

Robert B. Zoellick's answer: (minute 1:16:30) "On the new rules for global finance, you asked when would speak up on the bank capital. I've been doing so for two years. It's all over the website, because I started with trade finance, knowing that field pretty well. Pascal Lamy, the head of the WTO, and I have led a campaign that said you're going to make it harder for trade finance for developing countries if you have higher capital levels for doing trade finance. So we've pressed very hard on that issue. You get an advanced notice, because tomorrow morning I'll be doing a PowerPoint briefing of all the Governors, and what I'll be mentioning is that for developing countries as a whole, we are seeing foreign direct investment go up, access to bond markets go up, but a net negative inflow of banks, in part, because I think of some of the capital standards and other regulatory issues."

The question that now floats around there out in the open, is what the Basel Committee on Banking Supervision, the supreme global regulatory authority, has to say about that, because bank capital requirement discriminations based on perceived risks is precisely the heart and soul of their regulatory paradigm… without that they have nothing!

The video of the meeting

Is it really possible that the Basel Committee bank regulators did not think of this?

When a bank client, perceived as more risky, like for instance your average small business or entrepreneur, is requested to pay for instance 5 percent or more on their loans than what a triple-A rated client pays, where do you think that 5 percent or more goes to when it gets repaid? The answer is to bank equity of course. That is what we could call the market´s risk-weights.

And when a regulator decides that a triple-A rated client generates only a 1.4 percent capital requirement for the bank (the Basel III 7 percent, adjusted by the risk-weight of 20 percent), while your average risky small business or entrepreneur generates a capital requirement of 7 percent, where do you think the about 2 percent in additional interest that your average small business or entrepreneur has to pay the bank in order to make up for the bank´s opportunity costs goes? The answer is to bank equity of course. This is what we call the regulator´s risk weights.

And so we have a world where, out of the blue, the Basel Committee decided that all our small businesses and entrepreneurs, those whom we should be most interested that our banks finance, well they have to run with under the weight of two different sets of risk-weights.

What kind of handicap officer is thia Basel Committee, taking off weights from those who have been running nicely and putting weights on those who have not run as good or are debutants? I would say that handicap officer is completely nuts or he has completely misunderstood his role.

The best way to end the markets’ addiction to the credit rating agencies is to end the regulator´s obsession with the credit rating agencies.

To reform financial regulations we need to reform in depth the Basel Committee.

In May 2003, as an Executive Director of the World Bank, I told those many present at a risk management workshop for regulators the following with respect to the role of the Credit Rating Agencies. “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.” And this I repeated over and over again, even in the press.

Now the IMF is finally admitting “Policy makers should continue their efforts to reduce their own reliance on credit ratings, and wherever possible remove or replace references to ratings in laws and regulations, and in central bank collateral policies”

That is good, better late than never. But the real question has to be why on earth it had to take a financial crisis of monstrous proportions to reach a conclusion that should have been apparent to any regulator from the very beginning.

I saw it happen and I know why it happened. As I wrote in a letter published in the Financial Times in November 2004, it was the result of the whole debate about bank regulations being sequestered by the members of a small mutual admiration club.

If there is now something even more important than rectifying the faulty financial regulations, that is to break up the Basel Committee and make absolutely sure it represents a much more diversified group of thinkers. That would have at least guaranteed that the basic question of what the purpose of the banks should be would have been put in the forefront before regulating them. Current regulations do not contain one word about that.

Besides me there were not too many but still plenty of experts who raised the question of whether the credit rating agencies should have such a prominent role. These persons should participate in designing and putting in place the needed reforms. It is simply unacceptable that these reforms with huge global implications are implemented exclusively by Monday morning quarterbacks.

Are you ok with a 71.4 to 1 leverage for banks?

Basel III now tells us that the basic capital requirement for banks is not any longer going to be the 8 percent of wishy-washy made up capital of Basel II, but a more real and solid 7 percent. Good news!

But unfortunately Basel III completely ignores mentioning the risk-weights, though these were the real source of the problems with Basel II.

And so now with Basel III, since the risk-weight for operations with triple-A rated securities is still 20%, the “more real and solid” equity required is 1.4 percent; the new authorized leverage for banks when investing in exactly the same type of securities that set of the current crisis, is 71.4 to 1.

Are you really ok with this?

The bare-naked Basel Committee

The innocent child´s "But he isn't wearing anything at all!" in “The Emperor’s new clothes” tale by Hans Christian Andersen, would not have been written today, since modern emperors and their spin doctors are much too savvy to let an innocent voice get due attention.

As a sort of innocent child I have been clamoring for a long time that the Basel Committee on Banking Regulations, no matter their standing as the great global expert on these matters, is bare-naked and completely wrong… so wrong that they are in fact the primary cause of the current crisis… but the Basel Committee just ignores me.

In this respect I am searching for a voice stronger than mine who could pose some simple questions to the Basel Committee and have them answered. A Senator of the US concerned with that the banks in the land of the free and the home of the brave are not really free and are instructed to be coward, could be a perfect such voice.

Question 1: All major bank and financial crisis in the world have, without exceptions, resulted from excessive investments in what was ex-ante perceived as not risky but that ex-post turned out to be risky; and no crisis has never ever resulted from excessive investments in what was perceived as risky. In this respect, guys, what are your fundaments for creating regulations that give banks extra-incentives to lend or invest in what ex-ante is perceived as not risky; and thereby create extra disincentives for the banks to lend or invest in what is perceived as risky?

Question 2: In the whole set of bank regulations that has emanated from the Basel Committee over the last two decades, there is not one single word about the purpose of the banks. Guys, is not defining the purpose of the entity you are to regulate the basic required element for any successful regulation?

Question 3: Banks are allowed to lend to triple-A rated governments, like the US, with no capital at all, but are required to post 8 percent in capital when lending to any small business or entrepreneur. Guys, are you communist?

Question 4: Inducing the banks to follow too much the opinion of some few credit rating agencies must increase the risk that when these agents go wrong the banks will go dramatically and exponentially wrong. Guys why on earth would you do a dumb thing like this?

Question 5: Guys, when you have by the results been proven absolutely wrong are you not supposed to pause and perhaps even hit the reset button? Why then are you now forging ahead and perhaps digging us deeper in the hole we are in by now so arrogantly even trying to control for economic cycles?

Question 6: Guys, since even hedge funds rarely manage to leverage more than 15 to 1, would the banks without you explicitly allowing them to do so, even contemplate to leverage themselves 40 to 1?

Question 7: What was going on in your minds guys authorizing banks during the last five years to lend to a country like Greece or investing in triple-A rated securities, leveraging 62.5 to 1, and thereby converting for instance a .5 percent margins in an astonishing 31.25% return on equity… precisely that sort of returns that giant bonuses and too-big-to-fail banks are made of?

Question 8: It is evident that given the scarcity of bank capital, the small businesses and entrepreneurs, and who might be able to develop the next generation of jobs, are being crowded out from bank credits by your regulations are. Guys, why do you find that acceptable? Especially considering that these clients are supposed to be the banks´ most natural clients; and that they have nothing to do with creating a systemic crisis.

Question 9: Guys in the Basel Committee, who are you, how do you get appointed, who sets and pay your salaries?

There are of course many more questions, but for a starter these would do.

Is there any free and brave Senator fed up with being Razzle Dazzle Razzle Bazzled willing to make them? I sincerely hope so the whole world needs it… urgently!

PS. My 2019 letter to the Financial Stability Board

And now they are “Razzle Dazzle 'em, Razzle Bazzle III 'em” us

Published in Voxeu VOX CEPR

What really detonated this crisis? The fact that because of the risk-weights the banks needed only to hold 20% of the basic capital requirements when investing in triple-A rated securities backed by the lousily awarded mortgages to the subprime sector. Would it have happened if the risk-weight for those investments had been 100%? Of course not!

And the fact that the risk-weights are not even mentioned in Basel III points to its absolute irrelevance… except of course that the higher, the better, the stronger the basic capital requirements for banks are, the bigger is the regressive discrimination produced by its arbitrary risk-weights against those who, notwithstanding the fact that they have never ever caused any major bank crisis, are perceived as presenting a bigger risk, like the small businesses and entrepreneurs.

The regulatory paradigm on which the Basel Committee stands will quite soon be discovered as one of the biggest regulatory failures ever, and all the experts will be looking for ways how to disassociate from them.

This is so because those regulations are primarily based on requiring the banks to have more capital when risk are perceived as high while allowing for much lower capital when risks are perceived as low, even though all financial and bank crisis in history have occurred from excessive investments in what is perceived as having low risk. 

Only what is perceived as having a low risk can grow into systemic risk. A high perceived risk always takes care of itself and does never grow to be a systemic threat.

The regulators fixated themselves so much on stopping a bank from failing, that they ignored the system. Besides, who would like to live in a world where banks did not fail?

Currently small businesses and entrepreneurs, only because of the arbitrary, regressive and discriminatory capital requirements, need to pay the banks 2 percent more per year in order to provide the banks with the same return on capital that a loan or an investment to a triple-A rated client yields them. And this on top of the higher interests the small businesses and entrepreneurs anyway have to pay. Crazy!

To top it up… a visitor from outer space, if observing our bank regulations which require a bank to hold 100% of the standard capital requirement when lending to a small business but only 0% of it when lending to its triple-A rated government would most likely conclude that planet earth is communistic… and laugh at how we currently can have no idea what the real interest rate on public debt would be without this regulatory favor. 

We’ve have all been “Razzle Dazzle 'em, Razzle Bazzle 'em”… So let us urgently get out of that trance!

If you got the time let me invite you to a brief lesson on how bank regulators have become so fixated on seeing the gorilla in the room that they completely lost track of the ball.

http://subprimeregulations.blogspot.com/2010/09/the-financial-crisis-simple-why-and.html

My letter to the Independent Commission on Banking in UK

You’ve all been “Razzle Dazzle 'em, Razzle Bazzle 'em”… Get out of that trance!

Sir,

The regulatory paradigm on which the Basel Committee stands will quite soon be discovered as one of the biggest regulatory failures ever, and all the experts will be looking for ways how to disassociate from them.

This is so because those regulations are primarily based on requiring the banks to have more capital when risk are perceived as high while allowing for much lower capital when risks are perceived as low, even though all financial and bank crisis in history have occurred from excessive investments in what is perceived as having low risk.

Only what is perceived as having a low risk can grow into systemic risk. A high perceived risk always takes care of itself and does never grow to be a systemic threat.

The regulators fixated themselves so much on stopping a bank from failing, that they ignored the system. Besides, who would like to live in a world where banks did not fail?

Currently small businesses and entrepreneurs, only because of the arbitrary, regressive and discriminatory capital requirements, need to pay the banks 2 percent more per year in order to provide the banks with the same return on capital that a loan or an investment to a triple-A rated client yields them. And this on top of the higher interests the small businesses and entrepreneurs anyway have to pay. Crazy!

I invite you to a brief lesson on how bank regulators have become so fixated on seeing the gorilla in the room that they completely lost track of the ball. 

http://subprimeregulations.blogspot.com/2010/09/the-financial-crisis-simple-why-and.html

Per Kurowski

A former Executive Director at the World Bank (2002-2004)

Basel Committee, what are you, a naïve regulator, a terminator, a communist or just plain stupid?

All financial and bank crisis have resulted from excessive investments or loans where the risk of default was perceived as low. If so what are you doing dramatically lowering the capital requirements for banks when they invest or lend to what is perceived as safe?

One of the primary purposes of banks is tending to the financial needs of those small businesses and entrepreneurs who might be the source for the future generation of decent jobs, but are yet too small for the capital markets. If so why are you making it less attractive for banks to do just that by, in relative terms, placing much higher capital requirements on whom naturally must be perceived as riskier? Is not being perceived as riskier a heavy weight by itself? Do these clients not have to pay higher interest rates anyhow?

A banker’s most important mission is to learn to analyze a client and find ways of how to safely satisfy his credit needs. If so why are you implicitly ordering all bankers just to follow the opinions of some few credit rating agencies?

An absolute perfect credit rating, guarantees an exact pricing, and therefore provides no special profits to any side of the operation. Special profits, for one side or another, do only arise from incorrect perceptions of risk. If so, why are you creating risk information oligopolies which, when captured, can only leverage incorrect risk perceptions into a systemic risk?

Current financial regulations requires a bank to hold 100% of the standard Basel II or Basel III capital requirement when lending to a small business or entrepreneur, but allows it to hold zero percent of that same standard Basel II or Basel III capital requirement when lending to a triple-A rated sovereign like that of the USA. If so could not a visitor from outer space, looking solely at the financial regulations, simply conclude that planet earth is communistic?

In order to regulate banks, one would naturally assume the need of establishing a purpose for the banks. The Basel Committee does no such thing!

Titling the comment as I do, am I to harsh with the Basel Committee? I don’t think so!

In 1999 I wrote “The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause the collapse”; and as an Executive Director at the World Bank I did all I could to warn about what I was certain was doomed to happen. But I was blithely ignored by this small group of regulators who were just too cozy in their little mutual admiration club.

Well the AAA-bomb finally exploded and the Basel Committee does still not take any questions from outside their own circle, which now includes the Financial Stability Board. And now they are only giving us their “Razzle Dazzle 'em, Bazzle III 'em” treatment. That is inacceptable for a world that is and will be going through much suffering, precisely because of the Basel Committee.

The Basel Committee’s lousy/dangerous Maginot Line

It is impossible not to see now that the financial regulators in the Basel Committee, trying to fend off a bank and a financial crisis, constructed an incredibly faulty Maginot Line.

It was built with lousy materials, like arbitrary risk-weights and humanly fallible credit rating opinions.

And it was built on the absolutely wrong frontier, for two reasons:

First, it was build where the risk are perceived high, and where therefore no bank or financial crisis has ever occurred, because all those who make a living there, precisely because they are risky, can never grow into a systemic risk. Is being perceived as risky not more than a sufficient risk-weight?

Second it was built where it fends of precisely those clients whose financial needs we most expect our banks to attend, namely those of small businesses and entrepreneurs, those who could provide us our next generation of decent jobs and who have no alternative access to capital markets.

Now with their Basel III the Basel Committee insists on rebuilding with the same faulty materials on the same wrong place and it would seem that we are allowing them to do so.

I am trying to stop them… are you going to help me or do you prefer to swim in the tranquil waters of automatic solidarity with those who are supposed to know better?

The implicit stupidity of the current Basel regulations could, seeing the damage these are provoking, represent an economic crime against humanity!

PS. And the Academia says nothing. Why?

We are all being subject to a “Razzle Dazzle 'em, Bazzle III 'em” scheme

In Basel III, as in Basel II, the capital requirements are set “in relation to risk-weighted assets (RWAs)” even though it was the risk weights which proved to be most wrong.

It was a low risk weight of only 20% which generated a capital requirement of only 1.6 percent (.08 x .2) allowing banks to leverage 62.5 times to 1, which drove the banks to stampede after the triple-A rated securities collateralized with lousily awarded mortgages to the subprime sector.

Also if a bank lends to a small business then it needs 8 percent in capital but if it instead lends that money to the government of a sovereign rated AAA to AA then the bank needs no capital for the risk-weighted assets since the weight is 0%... lunacy!

Since the risk weights have not been modified at all in Basel III, let me assure you that the Basel Committee still has no idea about what they are doing. Frightening!

Basel III does mention that “These capital requirements are supplemented by a non-risk-based leverage ratio that will serve as a backstop to the risk-based measures described” but since that supplement seemingly will be small and what really counts are the marginal capital requirements for different assets Basel III does not provide a solution.

The Basel Committee is still so fixated with looking at the gorilla called “perceived risk” so as to completely lose track of the ball.

No financial or bank crisis has ever occurred from something ex-ante perceived as risky they have all resulted, no exceptions, from excessive lending or investment in something perceived as not risky.

Basel III still constitutes an arbitrary and regressive discrimination of small businesses and entrepreneurs whose needs we in fact most want our banks to attend. With the same risk-weight discriminations, the higher the capital requirements are, the higher the real effective discrimination.

Banks were authorized by the Basel Committee to lend to Greece leveraging 62.5 to 1! Now even after being sunk, we are still in the hands of exactly the same banks with exactly the same regulators following exactly the same fundamentally faulty regulatory paradigm… Help!

Give 'em the old Razzle Dazzle, Razzle Bazzle 'em,

Show 'em the first rate sorceror you are

Long as you keep 'em way off balance

How can they spot you've got no talent

Razzle Dazzle 'em, Bazzle III 'em,

And they'll make you a star!

The financial crisis: The simple why and what to do?

When I talk about an authorized leverage of "64.5 to 1" the real figure is "62.5 to 1". Since there could be some debate on whether I was trying to see if you were following me, catch you sleeping, or because I did not use a calculator I made a mistake... be my guest and pick any explanation you choose, it won´t matter anyhow for the conclusions… and I will not repeat the class just because of that.

The six questions the Financial Regulatory Establishment refuses to answer.

1.- Knowing as we know that all bank or financial crisis have had their origin in excessive investments in what was ex-ante is perceived as having no risk... can you please explain the rationale behind a regulatory system that by means of allowing much lower capital requirements when lending or investing in anything is related to triple-A rated operations, provides the banks further incentives to accumulate excesses in what ex-ante is perceived as having lower risks?

2.- Knowing as we know that a perfect credit rating, though providing some useful information for capital allocation, provides none of the two sides in a operation with any real profit, something which only wrong risk appreciations can do, the wronger the larger the profits for the side that benefits... what is the rationale behind empowering the credit rating agencies with asymmetrical risk information oligopolies which dramatically increases the financial system´s exposure to catastrophic systemic risk?

3.- What is the rationale of a regulatory system where if the bank lends to an unrated small business or entrepreneur it needs to have 8 percent in capital but, if it instead lends to the government of an AAA rated sovereign, like the USA, so that government bureaucrats lend or give stimulus to the unrated small businesses and entrepreneurs, the banks need to hold zero capital? Is this not plain pro too-obese-to-succeed government regulation? What do the interest rates on public debt really signal with this type of regulations interfering?

4.- If a bank was required to have the same capital when lending to a country with a credit rating like that of Greece before year end 2009, as when lending to a small unrated businesses, then it could leverage itself 12.5 to 1. If it then made a spread of .5 percent when lending to a Greece it would obtain a return on capital of 6.25percent per year. But since the banks were allowed to do the above with only 1.6 percent in capital they could leverage their capital 62.5 to 1 and earn 31.25 percent on capital. Is this not exactly the stuff from which unbelievable bonuses are made of? Is this not exactly the growth hormones that results in too-big-to-fail banks?

5.- How come when regulating the banks the Basel Committee does not establish what is the purpose of banks? Is that not a pre-requisite for adequate regulation? When you regulate traffic it is to facilitate the traffic between two points... not to guarantee that the road will never need maintenance. Do the regulators really aspire for a world where there are no bank defaults? I shiver at the thought!

6.- Institutionally and given that the world will be in need of more global regulations, how is the oversight of the Basel Committee and the Financial Stability Board managed? To whom are they transparently accountable? I ask this because for instance if we had delegated the solving of global warming into a global institution that made mistakes like those made in the regulation of banks... there´s no question we would all be toast.

The questions at the IMF blog

PS. The Link no longer works https://blogs.imf.org/2010/08/26/a-problem-shared-is-a-problem-halved-the-g-20’s-“mutual-assessment-process”/#comment-2699

What a flabby pillar!

When the credit ratings are perfect, borrowers pay the exact interest rate and lenders earn the exact interest rate and so there is no profit for anyone.

Therefore the implicit profit driver in any operation using credit ratings is for these to be off as much as possible.

That is when you can sell a badly awarded mortgage of $300.000 at 11% for 30 years for $510.000 because when packed in a triple-A rated security you could convince someone 6% was a great rate.

And so I ask… how on earth could the regulators use as a pillar of their regulations the assumption that the credit ratings were to be right and people would trade without a profit motive? Seems to me like a very a flabby pillar!

What do the financial regulations say about the mental capacity of the regulators, and ours?

1st Quadrangle: Excessive lending to those who are perceived as having a low risk of default:

2nd Quadrangle: Excessive lending to those who are perceived as having a high risk of default:

3rd Quadrangle: Insufficient lending to those who are perceived as having a low risk of default:

4th Quadrangle: Insufficient lending to those who are perceived as having a high risk of default:

Let us analyze which role each quadrangle plays in causing a financial crisis.

By far, the most likely and perhaps even exclusive cause of a financial crisis is found in the first quadrangle that of excessive investments to what was perceived ex-ante as not being risky.

Next, insomuch as it could cause a problematic lack of economic development, we could mention quadrangle 4 that of insufficient investments to those representing an ex-ante higher risk of default.

Quadrangle 3 that of insufficient lending to those who are perceived as having a low risk of default is quite unlikely to occur.

Finally, what really never ever causes a financial crisis, as it goes against the coward nature of capitals and bankers, is quadrangle 2 represented by an excessive lending to those who are perceived as having a high risk of default.

If we then observe how the current regulators have imposed very low capital requirements, zero to 1.6 percent on the quadrangles represented by those being perceived ex-ante as having a low risk of default, and a much higher though quite reasonable 8 percent on the quadrangles represented by those who ex-ante are perceived as having a high risk of default, what does this say about the mental clarity of the current regulators?

I can only conclude in tha they are thick as a brick! And so are we, allowing these regulators to play out, totally unsupervised their bedroom fantasies of a world without any bank failures.

What on earth are we to do with a world where no banks fail when doing their jobs and we all might fail because banks are not doing their job?

Q. Where do bankers' bonuses come from?

A. From huge bank profits of course.

Q. Where do then huge bank profits come from?

A. From lending using little own capital and from trading faulty risk assessments.

Q. Can you please explain?

A. Of course!

Lending: If a bank had to keep 8 percent of capital when lending to triple-A rated borrowers, the same as when lending to a small business, and which implies a leverage of 12.5 to 1, then if the margin on that lending was .5 it would earn a profit of 6.25%, decent but nothing to write home about. But, when courtesy of the regulators they are allowed to hold only 1.6 percent in capital, and which implies a leverage of 62.5 to 1percent, then the margin on lending to triple-A clients have the potential to increase to 31.25 percent a year (.5 x 62.5), meaning that type of stuff that real big bonuses are made of.

Trading: The profits from trading a paper with an absolute perfect credit rating are nil. But the profits from selling a paper that is much riskier than their credit rating indicates, or buying a paper that is much less risky than their credit rating indicates, those can be huge. A risky 11%, 30 years, $300.000 mortgage, sold as what it is could be worth even less than $300.000. But, sold as part of a triple-A security believed to merit a return of only 6%, it is worth $510.000, resulting in an immediate profit of $210.000…meaning that kind of stuff that real big bonuses are made of.

Conclusion: If you think bank profits and bankers´ bonuses are excessive, then you need to focus much more on where the stuff is generated and much less on how it gets distributed.

¿Reguladores tapados?

Por cuanto ni la mejor regulación bancaria del mundo serviría para algo dentro de un entorno económico tan absurdo como el nuestro, lo siguiente no es un tema muy relevante para Venezuela. No obstante habiendo desde 1997 criticado las regulaciones bancarias globales surgidas del Comité de Basilea, de vez en cuando necesito retomar el tema.

El pilar fundamental y casi único de las regulaciones de Basilea, son unos requerimientos de capital que se basan en el riesgo del no pago, tal como este riesgo sea percibido por las agencias calificadoras de crédito. No obstante que eso pueda sonar lógico, a más riesgo más capital, considero a tales requerimientos un absurdo. Permítame explicar.

Primero. Por cuanto los capitales y los banqueros en esencia son cobardes, jamás en la historia ha ocurrido una crisis financiera o bancaria que se haya derivado de un exceso de préstamos o inversiones en algo que a priori se haya considerado como riesgoso. Todas las crisis bancarias y financieras, sin exclusión y hasta casi por definición, han resultado del exceso de préstamos o inversiones en lo que a priori se ha considerado no tener riesgo alguno.

En tal sentido, incentivar a los bancos a prestar o invertir más en lo que a priori se percibe como de menor riesgo va en contrasentido a lo que la historia nos indica… por lo que me permito creer que los reguladores allá en Basilea, o están metidos en un club de mutua admiración con una discusión incestuosa degenerante o son simplemente unos tapados.

Segundo. Por cuanto quienes se perciben como de poco riesgo casi siempre tienen acceso a los mercados de capitales, son las pequeñas y medianas empresas, las que sin duda son más riesgosas, quienes de verdad más necesitan de los bancos para satisfacer sus necesidades financieras.

En tal sentido, el dificultarle a los bancos, en términos relativos, el prestar o invertir dinero justamente a quienes más los necesitan; siendo además estos clientes los más probables proveedores de los empleos decentes del mañana, carece totalmente de sentido… por lo que me permito creer que los reguladores allá en Basilea, o están metidos en una discusión en un club de mutua admiración con una discusión incestuosa degenerante o son simplemente unos tapados.

Tercero. Veamos lo que actualmente rige en muchos países. Si un banco desea efectuar un préstamo a una pequeña y mediana empresa entonces se le requiere tener 8 por ciento de capital. Pero si ese banco le presta al gobierno de uno de los soberanos clasificados como AAA, para que sus burócratas le hagan los préstamos a las pequeñas y medianas empresas de su agrado, entonces el banco no necesita de capital alguno.

En tal sentido, hay vemos que un socialismo incompetente del siglo XXI, no es una exclusividad venezolana. Hasta Dalí se queda chiquito en surrealismo comparado con lo que inventan los reguladores bancarios del Comité de Basilea. Ya causaron su primera crisis global con esa estampida en busca de los triple-A que provocaron. Falta ver lo que nos harán la próxima.

La semana pasada, en una competencia donde el G20 anda pescando soluciones para ver cómo el sector privado financia más y mejor a la pequeña y mediana empresa, presenté una propuesta dirigida a corregir parte de lo que he criticado. Si les interesa, pueden ver cómo me irá en mi pelea contra el establishment regulador global, en la página web de www.changemakers.com/en-us/SME-Finance 

We’re in big trouble with these financial regulators!

I have just read the “Interim Report: Assessing the macroeconomic impact of the transition to stronger capital and liquidity requirements” produced by the Macroeconomic Assessment Group established by the Financial Stability Board and the Basel Committee on Banking Supervision.” August 2010.

By far the most prominent feature of the current bank regulations is that it discriminates the capital requirements for the banks based on the perceived risk of default, and therefore for instance allows a bank to leverage up their capital 62.5 times to 1 when lending or investing to triple-A rated clients while only permitting them to leverage up 12.5 to 1 when lending to unrated small businesses and entrepreneurs.

If a triple A rated client presented the banks with a margin of .5 percent then had it been regulated like when the bank lent to the small business, it would have produced the bank a return of 6.25 percent, decent but nothing to write home about. Instead because of the regulators’ inexplicable largess it could obtain a return of 31.25 percent a year. No wonder our banks disappeared in the AAA swamps and our small businesses and entrepreneurs, whom we depend so much for our next generation of decent jobs are ignored.

Since the existence of the discrimination which obviously must have macroeconomic impact, is not even mentioned as a problem, much less studied, I assume the document to be basically worthless, as it clearly reflects that those who wrote it know little about banking and care even less about its purpose.

Basically it is the same authors, or type of authors who, in “An Explanatory Note on the Basel II IRB Risk Weight Functions” of July 2005, produced a prime candidate for the mother of all bullshit papers ever, where they assured us that “The confidence level is fixed at 99.9%, i.e. an institution is expected to suffer losses that exceed its level of tier 1 and tier 2 capital on average once in a thousand years.”

Indeed, we’re in big trouble with these financial regulators!

My response to the G-20 SME Finance Challenge

Friends,

The Group of 20 and Ashoka’s Changemakers, with support from the Rockefeller Foundation, launched the G-20 SME Finance Challenge, where competitors are to submit proposals on solutions or projects for how public finance can unlock private finance to small and medium enterprise on a sustainable and scalable basis. 

The goal is to identify catalytic and well-targeted public interventions to unlock private finance for SMEs. Maximizing leverage of scarce public resources is at the core of the Challenge.

The following is my proposal:

The taking of risks is the oxygen of any development!

We need to eliminate the regressive discrimination of SMEs caused by imposing different capital requirements on banks based on perceived risk of default. Its primary reason is that risk of default of a debtor is a natural, manageable and secondary degree risk that banks and society need to take. As a bonus it also corrects a huge regulatory error that only increases the possibilities of systemic disasters.”

Here follows some of the questions and answer given on the entry form:

What makes your innovative solution unique? 

It rejects completely the first pillar of the current regulatory paradigm developed by the Basel Committee, that of construing “safer” banks by means of discriminating precisely against those whom, because of their limited access to capital markets, the banks should most help with their lending, the SMEs. 

To discriminate against the more “risky” while favoring those who because of their good credit ratings most likely already have access to the capital markets, is nonsensical. 

It is like the handicap officials on a racetrack taking off weights from the stronger horses and placing them on the weaker. It could only have been thought up by regulatory zealots who, shortsightedly, have only the immediate safeness of the banks on their minds and care little or nothing about development and banks’ real long term purpose. 

If you consider how unelected officials are influencing in a quite non-transparent way how global finances operate, I also hope this proposal helps to open up a much needed debate on regulatory transparency.

How does your proposed innovation leverage public intervention in catalyzing private SME finance?

If a bank was required to hold the same capital requirement when lending to a triple-A rated company than it has to hold when lending to an SME, namely 8 percent, it could leverage its capital 12.5 times to 1. If the bank then made a margin of .5 percent when lending to the triple-A rated, it would obtain a total return on capital of 6.25 percent. 

But, since the regulators allow the banks to hold only 1.6 percent in capital when lending to the triple-A rated, and so that they could therefore leverage themselves 62.5 to 1, the total capital return on this lending for the banks becomes instead 31.25 percent. 

To make up for that difference of 25% of regulatory advantage awarded to the triple-A lending (31.25-6.25), and be able to compete for access to bank credit, the SMEs therefore need to pay an additional interest rate of 2 percent (25/12.5), on top of the higher risk premiums they are anyhow charged with because of their higher perceived and real risk. 

Leveling the playing field, by eliminating this arbitrary regressive and discriminatory regulatory tax on risk that affects many of those accessing bank credits, is the most important public intervention needed in order to catalyze private SME financing. 

As an important bonus it would also remove the regulatory incentives which caused the stampede after triple-As in the market and thereby originated the current crisis. 

What barriers does your proposed solution address? Describe how so? 

SMEs are more prone to be considered as risky. Therefore the elimination of the current regulatory de-facto tax on the perceived risk of default will help to decrease the disincentives for the banks to serve these clients; or, in other words, it will increase the competitiveness of SMEs in their race against all those perceived to represent lesser risk for access to bank credits.

In the same vein the natural higher transaction costs for financial intermediaries to lend to SME’s would cease to be further compounded by the costs derived from higher discriminatory capital requirements. 

Additionally it would help to fight the excessive asymmetrical empowerment of the credit rating agencies as credit information providers, and thereby help to reestablish banking as a truly accountable profession that is not induced to rely robotically on a general type of GPS guidance system. In other words, it will provide an opportunity for bankers to be bankers again.

Provide empirical evidence of your proposed solution’s success/impact at present: 

This should be superfluous. The genesis of the current financial crisis was the stampede after the incentivized and open to capture triple-A ratings; and which since there were naturally not enough of these AAAs to satisfy the demand, being the AAAs in many ways only fidgets of imagination, this led the markets to provide some Potemkin ratings instead. 

It suffices to know that since capital and bankers are by nature coward, the world would have even been better off, if totally opposite capital requirements had been imposed on the banks, meaning capital requirements which progressively discriminated against those who represent lesser perceived risk. In such a case there would have been less rush after AAAs, while the lending to “the risky” would never have occurred in volumes that could systemically endanger the system.

All banks crisis in history have always resulted from excessive lending to what is perceived ex-ante as not being risky and no bank crisis has ever occurred because of excessive lending to anything perceived ex-ante as risky. Do you need more empirical evidence than that?

In 1999 I wrote “The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause the collapse”… and indeed the AAA-bomb exploded.

How many firms do you expect to reach?

All SMEs, most of them are not even rated.

What is the volume of private SME finance you aim to catalyze? 

The current capital requirements stimulated trillions of dollars to finance triple-A rated securities collateralized with badly awarded subprime mortgages in the US. I would be satisfied if it could help to catalyze just a decent fraction of that amount in new lending to the SMEs.

What time frame will be required to reach these targets? 

The market lost their trillions in about three years, from mid 2004 until mid 2007. The speed of the proposed adjustment should be further studied carefully monitored in order to avoid any problems in the middle of an economic crisis. 

I envisage the possibility of an immediate reduction of the maximum capital requirements for banks on all lending from 8 percent to 4 percent and then, over a period of 4 to 6 years elevating it to a 8-10 percent capital requirement, on any lending to all type of private borrowers. 

The adjustment of the capital requirements for public debt, and which for triple-As currently amazingly requires no capital at all, could take longer time though. Where would interest rates on public debt be without this arbitrary and non-transparent regulatory subsidy?

Does your innovation seek to have an impact on public policy?

Yes it looks precisely to correct an utterly wrong public policy.

What might prevent your innovative solution from succeeding?

From success, nothing! Though from being implemented, the difficulties with thick-as-a-brick regulators who are unable to break free from their current regulatory paradigm and who have a vested interest of remaining in total control of their own mutual admiration club.

Tell us about the social impact of your innovation. 

Since among the small SMEs we probably have our best chance of finding our next generation of decent jobs, the social impact of this innovative regulatory stepping back cannot be overstated. 

How many SMEs are there and how many more could there be if regulators did not discriminate against them? That is the number of SMEs that will benefit!

Demonstrate how your proposed solution has the capacity to graduate from dependence on public finance. What is the time frame? 

Currently if a bank lends to a SME it is required to have 8 percent in capital but, if it lends to an A-rated government so that this government in its turn can lend or give stimulus to a SME, then it needs zero capital. Could there be a more direct way of decreasing the dependence on public finance…immediately?

Please tell us if your proposed solution aims to scale up through a high growth sector, expand immediately to multiple sectors, and/or scale up geographically.

Absolutely, it aims to be applied to all the countries which have fallen in the current Basel Committee risk-adverseness trap. The fact that many emerging countries did not suffer so much from these regulations has a lot to do with the absence in these countries of AAA rated clients.

Please tell us what kind of partnerships, if any, could be critical to the greater success and sustainability of your innovation. 

We need a complete new crew of bank regulators with diverse backgrounds and able to break out from the current paradigm. 

We also need legislators that dare to face the problem. The final statement of the recent G20 meeting in Toronto mentions the Basel Committee on Banking Supervision 11 times and the Financial Stability Board (FSB) 27 times. But, in the 2319 pages of the Financial Regulatory Reform approved by the US Congress, those entities are not mentioned even once. Such disconnect is unmanageable!

In these days many, including Nobel-prize winners, speak about the excessive risk-taking of banks, while turning a blind eye to the fact that the crisis originated entirely in triple-A operations and so that we could just as well speak about an excessive and regulatory induced risk adverseness. I acknowledge though that this proposal is indeed noisy and difficult to move forward… and so a decided support from sturdy and eager group of changemakers is of course much needed and also much appreciated.

Friends, as you know I have been shouting about this issue for years, to very little avail, since most prefer either not to criticize the regulatory establishment or, for their own piece of mind, to think the regulatory establishment incapable of being as thick-as-a-brick as I hold them to be. In this respect, as you can understand, I very much look forward to the comments from the qualified jurors and commentators… some of whom might have some conflicts of interest on this issue.

By the way, since I am not a PhD, not a financial operator, not a banker and not a bank regulator, and just in case you should think that my criticism, as often happens, is facilitated by a lack of deeper knowledge on the subject, let me just copy below one example of the many formal and informal statements that I gave at the board of the World Bank as an Executive Director (1 of 24) on the subject. In October 2004 I wrote:

“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 very short series of statistical evidence and very doubtful volatility assumptions.”

Who knows, perhaps after this proposal even the World Bank will invite me to discuss my objections to Basel regulations. Last time I did so, in May 2003, what little I then told them, sort of sent me off to their own Siberia.

Regards,

Per

Thick as a brick

Never has there been a financial or bank crisis that has originated from too much investments or lending to what was perceived as being risky… capitals and bankers are much too coward for that.

All financial or bank crisis have always originated from lending or investing too much in what was wrongly perceived as not risky… even Dutch tulips would certainly have had an AAA rating.

So when therefore we see how regulators were fooled into giving bankers special incentives for investing or lending to what is perceived as not being risky, by means of allowing in those circumstances the banks to have specially low capital requirements, we can only conclude that the regulators in the Basel Committee are thick as a brick… just like we are when we allow those same regulators to keep on regulating.

If the handicap officials on a racetrack took of the weights from the best horses and placed these on the weakest… would they be allowed to remain as handicap officials? I don’t think so!