Excuse me… what calibration?

During a recent conference titled “Financial Reform: What´s next” I had the opportunity to ask one of the Keynote speakers Mr. Donald Kohn the former Vice Chairman of the Federal Reserve the following:

Current bank regulations ordained by the Basel Committee require the banks to hold 8 percent in capital when lending to unrated small businesses and entrepreneurs while allowing the bank to invest in US government debt against zero capital. When looking at the interest rates in the market, how much do you think they are distorted by these discriminatory regulations?

His answer: “If the calibration is done right there are no distortions.” The session ended there and I had no chance to ask him: Sir, what calibration?

That which solely considers the risk of default, as perceived by the credit rating agencies, and that should at least consider the defaults of bank operations after the banks are given the credit rating information, and that should at least consider that those who are perceived as riskier pay higher risk premiums that goes into bank capital.

Why not a calibration based on different criteria, since the current calibration would sort of indicate that lending the funds to the government is infinitely more efficient for the society than lending them to small businesses and entrepreneurs… and that sounds not about right?

I am aghast at the thought that a financial super-expert can even think that if they are only well calibrated, the capital requirements for banks that discriminate among borrowers based on the risk of default as perceived by some few credit rating agencies, they will not distort… mostly because that can only mean the regulators will now proceed to dig us even deeper in the hole they placed us in.

What are we to do with the Financial Stability Board?

The Financial Stability Board (FSB) reported from their meeting in Seoul on October 20 ahead of the G20 Summit in Seoul and endorsed principles for reducing reliance on credit rating agency (CRA) ratings as follows:

“The goal of the principles is to reduce the cliff effects from CRA ratings that can amplify procyclicality and cause systemic disruption. The principles call on authorities to do this through:

Removing or replacing references to CRA ratings in laws and regulations, wherever possible, with suitable alternative standards of creditworthiness assessment;

Expecting that banks, market participants and institutional investors make their own credit assessments, and not rely solely or mechanistically on CRA ratings.”

Since FSB does not even mention the risk-weights we can only assume FSB feels that all what went wrong was the excessive reliance on the credit ratings. They have no clue. What went really wrong was the way the regulators arbitrarily assigned to the different credit ratings the different risk-weights which determined the capital requirements for banks… like the 20% risk-weight for any lending to private entities rated triple-A or 0% risk weight on any lending to sovereigns rated triple-A.

In other words the FSB is unable or unwilling to understand that the credit rating agencies could have been totally wrong and yet they would never have produces the damage they did with their faulty ratings, had they not been so incredible endorsed by the bank regulators.

And neither does FSB understand that their regulatory favors to what is perceived as having a low risk of default, amounts only to an odious discrimination of what is perceived as having a higher risk of default, and all for no real purpose at all, since we all know that what is perceived as risky does never carry the potential to turn into a systemic danger.

And so friends what are we to do with the thick-as-a-brick Financial Stability Board?

With their “Risk-Weights” it is the regulator who is taking the load off the books of the banks

With reference to all being written about that “distasteful” behavior of banks of putting much of their exposure off the books, you should perhaps consider the following:

When the regulators used (and use) a risk-weight of only 20% to reflect the risk-weighted value on the books of banks, of for instance lousily awarded mortgages to the subprime sector that manage to hustle up a triple-A rating, it was (is) the regulator who is taking 80% off the balance sheet(books)of the banks.

When the regulators used (and use) a risk-weight of only 0% to reflect the risk-weighted value on the books of banks of loans to a sovereign rated triple-A, like the US or UK, it was (is) the regulator who is taking 100% off the balance sheet(books)of the banks.

Sincerely, I doubt the banks could have managed that kind of disappearance acts on their own.

Sort of like Basel Committee shocked!

The Basel Committee on Banking Supervision is guilty of gross negligence

I have since 1997 been criticizing the regulatory paradigm of capital requirements for banks based on ex-ante perceived risks and applied by the regulators of the Basel Committee, primarily because I felt these would only confuse the market when it cleared for default risks by means of its risk premiums and that there were systemic dangers in forcing the opinions of the credit rating agencies too much on the banks.

Since all past financial and bank crisis have resulted from excessive investments in what ex-ante was perceived as low risk, I also saw these requirements of more-risk-more-capital, less-risk-less-capital, to be absolutely counterfactual.

As I frequently spoke out about the previously in very clear and harsh words, and never received a response, I simply assumed the Basel Committee regulators to be lost for words and incapable of assuming their responsibility; or just plain thick-as-a-brick.

Unfortunately, now I must also accuse them of gross negligence, as I have only recently been able to internalize to its full extent that when the regulators calculated their risk-weights, they never considered the fact that the riskier pay much higher premiums, and which, when repaid, as it most often is, goes directly to the capital of the banks.

In “An Explanatory Note on the Basel II IRB Risk-Weight Functions", July 2005 prepared by the Basel Committee on Banking Supervision we read: “Interest rates, including risk premia, charged on credit exposures may absorb some components of unexpected losses, but the market will not support prices sufficient to cover all unexpected losses.” That would prove the regulators decided to completely ignore the markets… with premeditation.

This is exactly like if the insurance regulators required the insurance companies to post higher capital when insuring the health of persons who represent higher health-risks, without accounting for the fact that these persons will be obliged, precisely therefore, to pay much higher insurance premiums.

How negligent can one be? This negligence resulted in an odious regulatory discrimination of those perceived as “risky”, like the many small unrated businesses or entrepreneurs who, as a result did not get access to bank credit or had to pay much more than the market premiums for it. It also directly provoked the current crisis by creating the incentives that made the banks stampede after AAA-ratings, until they took the world over the subprime cliff.

I do not know whether or where you can present an accusation against the Basel Committee for gross negligence, but I do know that all its members should be forced to parade down the major streets of many capitals in the world, wearing their cone of shame.

Did really the Basel Committee dare to ignore the markets completely? 100%?

Since 1997 I have been speaking out against the regulatory paradigm of capital requirements for banks based on ex-ante perceived risks applied by the Basel Committee and I have never really been able to figure out what went on in the minds of the regulators to come up with such an idea that, though sounding so logical, more-risk-more-capital less-risk-less-capital, is so utterly faulty and counterfactual, since bank crisis never ever occur form excessive investments in what ex-ante is perceived as risky- when in fact it is just the opposite.

My main suspicion derived from the fact that I have never seen the Basel Committee define a purpose for the banks, and, not doing that, led of course to the wrong regulations.

But lately I am starting to get an inkling that an even more astonishing possibility lies behind it all.

Could it really be that regulators completely ignored what “the riskier”, when paying higher interest rates than for instance those rated triple-A, contributed to bank equity?

Currently a bank lending to a triple-A rated company needs 1.6 percent of capital which allows for a 62.5 to 1 leverage, but when lending to an unrated small business it needs 8 percent of capital and is therefore limited to a 12.5 to 1 leverage.

Let us assume that the margin before credit losses on a loan to a triple-A rated company is .4% and that of a loan to an unrated entrepreneur, 4%. In that case triple-A rated companies provide the banks of a before credit losses return on equity of 25 percent (.4*62.5) while the loans to an unrated small business would result in before credit losses return on equity of 50 percent.

But what if both types of loans could be made with a 62.5 to 1 leverage? Then the unrated small businesses would provide a before credit losses return on equity of 250 percent (4*62.5) in which case we would ask... why regulators feel they are safer with banks lending to triple-A rated clients for a 25 percent margin before credit losses than lending to small unrated businesses that provide a 250 percent margin before credit losses? Do regulators really believe that the bankers are so bad at analyzing credits to small businesses so they are better of just following the ratings of the credit rating agencies?

If both types of loans were made with a 14.5 to 1 leverage? Then the triple-A rated clients would provide the banks with only 5 percent before credit losses return on equity (.4*12.5) and of course then the banker would have a better incentive to try to do a good job lending to small businesses as they are supposed to do.

Please read from The Basel Committee on Banking Supervision the document “An Explanatory Note on the Basel II IRB Risk-Weight Functions", July 2005.

In it we find “Interest rates, including risk premia, charged on credit exposures may absorb some components of unexpected losses, but the market will not support prices sufficient to cover all unexpected losses.”

That leads us to suspect that the Basel Committee completely ignored all the differences in interest rates that the market charges based on perceived risk… something like saying “the market is absolutely and totally useless and so we need to impose our own risk-weights, independently of what it does". Is this what they understand as de-regulation? What hubris! Help!

The Basel Committee on Banking Supervision has only a completely wrong and harmful tool in its toolbox.

Capital requirements based on the perceived risk of default as perceived by credit rating agencies or bank’s own internal risk analysis, is the most important tool in the toolbox of the Basel Committee for Banking Supervision.

The higher the perceived risk the higher the capital requirement, and the lower the perceived risk the lower the capital requirements. It all sounds so extremely logical. Unfortunately as all bank and financial crisis have exclusively originated from excessive investments in what has been perceived ex-ante as having a low risk; and none from excessive investments I what has perceived ex-ante as having high risk, this regulatory tool is totally counterfactual; and therefore totally counterproductive, as this crisis in triple-A rated territory clearly evidences.

And it is even worse than that. As that tool discriminates precisely against the type of clients banks are supposed to help the most, the small businesses and entrepreneurs who have little alternative access to finance, it harms the economy and job creation.

Day by day more get to be aware of this problem, and I had the chance to take it to the forefront by making questions in three of the events during the annual meetings of the International Monetary Fund and the World Bank, October 8-11, 2010

The problem though is that seem they do not yet know what to do about it… and so they try to ignore it and whistle in the dark. In one of the final seminars “The financial sector: navigating the road ahead, where there was no Q. & A. opportunity the basic problem with the capital requirements based on risk was not even mentioned, though the additional layers of confusion currently contemplated, such as capital requirements for liquidity risks, for systemic risk and for cyclicality risks were. Can there be something more pro-cyclical than helping the triple-A rated?

It is truly amazing to see how difficult it is for so many to extract themselves from the regulatory paradigm, or almost regulatory voodooism that has entrapped them. The only truly invisible hand at work was… that of the scheming banking regulators messing around with risk-weights under the table.

Below are the three events that I referred to, and where I asked my question.

The Civil Society Town-Hall Meeting

In the video you can find my question in minute 47.28, Dominique Strauss-Kahn’s answer in minute 1.01.08, and Robert Zoellick’s answer in minute 1.16.32

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

Structural Reforms: Effective Strategies for Growth and Jobs

Here my first and second question can be seen from minute 1.14.25 on.

http://www.imf.org/external/am/mmedia/view.aspx?vid=629575645001

Accelerating Financial Inclusion–Delivering Innovative Solutions

My question (not the best sound quality, but it is a similar question) can be found in minute 1.04.03 on

http://www.imf.org/external/am/mmedia/view.aspx?vid=629531170001

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