The Western World, as we know it, is unintentionally being assassinated by Basel bank regulators

If a banker has two types of clients the absolutely not risky and the somewhat risky he will set the interest rates that makes it indifferent for him who he lends to. 

If then that indifference rate of the not-risky is allowed by the regulator by means of differentiating the capital requirements, to be much more leveraged than the indifference rate of the risky, three things will happen: 

First and foremost the banker will concentrate on lending to what is officially perceived as not risky and provides the highest expected risk adjusted return on equity. 

Second, he might even lower the interest rates when lending to the officially perceived as not risky, since he has room for doing that and still produce a risk-adjusted satisfactory return on equity. 

Third, he will ignore the officially perceived risky, that is unless these accept to pay an even higher interest rate. 

The final outcome of the system will be obese bank exposures to what has or is officially perceived as not risky and anorexic exposures to what is officially perceived as risky, like to small businesses or entrepreneurs… In other words… the current crisis.

I am not sure Professor Stiglitz is a valid spokesman for the de-equalized.

Professor Joseph E. Stiglitz has written "The Price of Inequality: How Today’s Divided Society Endangers Our Future". 

Now, if Professor Stiglitz is so worried about inequality, as he should rightfully be, how come he does not care about one of the most important inequality drivers of our time, namely that of the capital requirements for banks based exclusively on the perceived risks of a borrower´s default, and where, of course, the “not-risky” are closely correlated to the haves, and the risky” to the not-haves? 

Professor Stiglitz chaired the Commission of Experts of the President of the United Nations General Assembly on Reforms of the International Monetary and Financial System, which presented its final report in September 2009. In it we find no objection to this odious regulatory discrimination. 

I mean how can one not object a system which allows banks to lend to “infallible sovereigns”, those already obtaining the best conditions, against no capital at all, and at the same time require the banks to hold 8 percent in capital when lending, at high rates and low sums, to a sovereign rated BB+ or below? 

I mean how can one not object a system which allows banks to lend to the “infallible corporate”, those rated AAA to AA”, those already obtaining the best conditions, against only 1.6 percent in capital, and at the same time require the banks to hold 8 percent in capital when lending, at high interest rates and low amounts, to a corporate rated BBB+ or below, or to a small business or an entrepreneur? 

Is Stiglitz unaware that banks already discriminate for perceived risks by means of interest rates, amounts lend and other term, and so that this regulatory discrimination, placed on top of that, can only guarantee that banks overdose on perceived risks? 

Has Stiglitz never read Mark Twain describing bankers as those who lend you the umbrella when the sun shines but want it back, hurriedly, when it looks like it is going to rain? 

Can Stiglitz not understand the nature of the current crisis where our banks got saddled with obese bank exposures to what was, ex ante, officially perceived as absolutely not risky… like lousy securities disguised as splendid triple-A’s, loans to Icelandic banks, loans by the Spanish banks to the real estate sector in Spain, loans to an “infallible” Greek government, and other similar; and anorexic exposures to the “risky”, the small businesses and entrepreneurs, those we most need our banks to finance? 

And, because of all this, I am sorry, but for the time being, I am not sure Professor Stiglitz is a truly valid spokesman for the de-equalized.

The complaint I filed with the Federal Trade Commission.

Federal Trade Commission 

Reference: Discriminatory bank regulations. 

We refer to your stated mission of preventing business practices that are anticompetitive or deceptive or unfair to consumers; in this case to the consumers of bank credit. 

We are perfectly aware that banks are in their full right to discriminate their lending conditions, like the interest rates, the amounts lend and other terms, based on the risk of default they perceive. But, what we find to be extremely unfair, even outright immoral, is for the bank regulators to determine that the capital requirements of the banks should also be based on those same perceived risks. 

That makes the access to bank credit, for those officially deemed as absolutely not risky, much more abundant and cheaper than would have been the case without regulatory intervention, and the access to bank credit, for those officially deemed as risky, like small businesses and entrepreneurs, much more scarce and expensive than would again have been the case without any regulatory intervention. 

Or, in words of Mark Twain, it will make the banks much more prone than they already are to lend you the umbrella when the sun shines, and to take it away when it looks like it is going to rain. 

And, besides, it all serves no good regulatory purpose, since all it does is to guarantee that the officially perceived safe havens become dangerously overpopulated. 

And, besides, there is no factual reason for this type of regulatory discrimination against perceived risk, because there has never ever been a bank crisis because of excessive bank exposure to what was ex-ante considered as risky. 

Are bank regulators stupid, immoral, or both?

If free to do so, insurance companies charge more and insure for lesser amounts those who have a precondition, and that is as should be expected, or in other words, something normal. But suppose the insurance companies had to charge even more to insure someone with precondition, only because a regulator, in order to safeguard the insurance company, decided to impose a risk-tax on those with a precondition… would you consider that stupid or immoral? I myself would consider that to be both stupid and immoral. And so hear me out:

If a banker perceives a borrower to be risky he will charge him higher interest, lend him less and probably negotiate some harsher conditions to compensate for that… but that is all just again, normal and natural market discrimination. 

And, traditionally, bankers have proven to be almost too effective in adjusting to perceived risks; not only as noticed by Mark Twain, when describing them as those who lend you the umbrella when the sun is out and wanting it back when it looks like it is going to rain; but also by the fact that there never ever has been a bank crisis that has resulted from excessive lending to those ex ante perceived as risky. 

But, when the regulators, based on the same perceptions of risk that the banker see, decided to allow the banks to hold less equity when lending to those officially perceived as not-risky; we are effectively in the presence of an artificial regulatory discrimination against those perceived as risky… and that, as I see it, is both incredibly stupid and outright immoral.

The missing (perhaps prohibited) regression!

Run a regression for all the different serious problem loans of banks around the world, like lousy securities disguised as splendid triple-A’s, loans to Icelandic banks, loans to the real estate sector in Spain, loans to a Greek government, and other similar… on the risk-weight of 20 percent or less established in Basel II, and which allowed the banks to finance what´s mentioned above holding only 1.6 percent or less in capital, which means an authorized leverage of bank capital 62.5 to 1 … and then draw your conclusions.

Turning the bank capital thumbscrews in Europe!

According to Basel II, until January 13, 2012 European banks could hold sovereign debt of Spain against zero capital and then, until May 13, they were required to hold a modest 1.6 percent in capital; currently, with Spain rated BBB+, they need to hold 4 percent, and, if Spain would be downgraded 3 notches more, to BB+, then they would be required to have 8 percent of capital. 

Of course, the more capital you must hold against any asset, the higher must the interest rate be in order to produce the same return on bank equity… which is one of the torture instruments of that so cruel economic torture chamber the Basel Committee bank regulators unwittingly designed. 

Of course, if and when banks are required to hold 8 percent in capital when lending to Spain, the same capital they are required to hold when lending to ordinary small businesses or entrepreneurs, then that would be a more real market rate… since all those lower earlier rates where in fact regulatory subsidized rates. 

And Europe still has the same set of regulators using the same paradigm writing up Basel III! Go figure that out.

The Paper... the most current version

Excessive Regulatory Risk Adverseness Caused the Crisis 5912

Greece… even if expelled from the Eurozone, is free to use the Euro

Though it would obviously not enjoy any seigniorage benefits, Greece, if expelled from the Eurozone can very well keep on using the Euro… so at least not having to waste money changing vending machines or feeding the fx-changers. 

Yes, obviously, it would have to earn the Euros it needs, and not survive on some Drachmas it can print, if it finds buyers for them, but, having to earn ones livelihood seems like a reasonable point where to start the reconstruction.

Europe…what if?

What if European bank regulators had imposed their 8 percent capital requirement for banks on all their assets (12.5 to 1 leverage) like they did for instance on loans to small businesses and entrepreneurs, instead of allowing the banks to hold some ex ante perceived as no risk assets against a meager 1.6 percent or less (62.5 to 1 leverage)?

Just for starters, European banks would not have invested in triple-A rated securities backed by lousily awarded mortgages to the subprime sector in the USA; would not have lent the outrageous amounts they did to Icelandic banks or Greece; and Spanish banks would not have overexposed themselves to the real-estate sector. Do you want me to continue?

Thank God for timely capital flight!

Because of the regulatory incentives of only having to hold 1.6 percent in equity when lending to Greece, which meant being allowed to leverage their bank equity a mind-boggling 62.5 to 1, German and other European banks lent to Greece like crazy and at crazy low rates. What would you have liked the Greeks to do?... the same nonsense?... so that even more money had been lost down the same drain? 

No thank God there was some intelligent and timely capital flight, and private Greeks placed at least some or their funds out of harm´s way. 

Now it is up to these private Greeks, to see how, with their diminished resources they can best help their homeland, in times when helping it might actually produce some good results. 

But, whatever it does, Europe first needs to put the sparkplugs back into its economic engine.

Those sparkplugs, the risk-takers, the “risky” small business and entrepreneurs, were forcedly removed by the regulators when they decided to base the capital requirements for banks on the perceived risks of default, as if those perceptions were not already discriminated for sufficiently by the banks. 

What these regulations delivered, as should have been expected, are dangerous obese bank exposures to what is officially perceived as not-risky e.g., government debts, and, for us and economic growth, equally dangerous anorexic exposures to what is officially perceived as “risky”. 

But, unfortunately, what does Mario Draghi of FSB and ECB, and his fellow failed bank regulators of the Basel Commitee, know about sparkplugs?

A Nobel Prize recall

Frankly, any Nobel Prize winning economist, like Joseph Stiglitz, who is capable of defining over and over again a crisis resulting from excessive and obese bank exposures to what was officially perceived as absolutely not risky, as a demonstration of excessive risk-taking by the banks, should be asked to return his Nobel Prize.

Risk taking provides the financial system with the Lebensraum it needs to grow sturdy

The better the credit ratings are, and the better our risk models are, the better will we stack our financial system, for a while, but then also the higher¸ in Nassim Taleb´s terms, its fragility, or its brittleness will be. 

If we want a flexible, a sturdy, or in Nassim Taleb´s terms an anti-fragile system, then our financial system need risk-taking, a lot of it, of many varied kinds. Risk-taking is not only the oxygen of economic growth it is also what allows our financial system the Lebensraum it needs.. 

Risk-taking is “anti-fragility”, which is why in our churches we can hear the prayer of “God make us daring!” Our current problem is that our nanny bank regulators in the Basel Committee completely forgot all about it… or perhaps they never knew.

PS. What I spoke and wrote about fragility

The great risk of risk aversion

As part of the civil society, whatever that now means, I attended the recent spring meetings of the World Bank and International Monetary Fund (IMF), this time on behalf of my granddaughter who, being just some months old, has not yet sufficient capacity to protest what could be a usurpation of representation. One of the topics to be discussed there was the creation of jobs, and, of course, I figured my granddaughter and those of her generation, would all like to have an abundant access to good jobs.

The world now faces a financial crisis of monstrous proportions, far from being solved, as a natural consequence of the excessive incentives that regulators gave to the banks to lend or invest in what was or is, officially, ex ante, defined as little or absolutely not risky ... for example Greece, "subprime" triple-A securities, Icelandic banks and other weeds that can turn out so dangerous, ex post. In other words, a crisis caused by regulation which contained an excessive risk aversion.

But the experts cannot think of anything else. In the "Report on the Global Financial Stability 2012" prepared by the IMF, to continue to speak about safe assets, and to ignore that nothing can be as dangerous for some havens inherently safe than exaggerate their safety, and therefore run the risk of turning them into overcrowded death traps.

And in their report they listed "potentially marketable assets inventory Insurance", and where it would seem that "potentially" was included just reluctantly. The list contains a total of 74.4 trillion U.S. dollars: 33.2 (45%) in sovereign bonds AAA / AA 5 (7%) in sovereign bonds A / BBB, 16.2 (21%) in securities with special guarantees; 8.2 (11%) in corporate bonds rated investment grade, 3.4 (5%) in other governmental or supranational debt, and 8.4 (11%) in gold.

By the way, since at its current price gold can only have value as an insurance for the case that the other assets end up not being worth anything, I do not really understand how gold and the other "safe" assets can be in the same list.

And some experts mentioned time and again, almost as “triple-A” sovereign bond salesmen, almost as if to avoid the need for their own central banks to buy these bonds, that one of the most acute problems of the financial system is the scarcity of safe assets. Of course, we all want safe assets, who not, but, much of its real shortage, also depends on that the regulators require their regulated entities to possess these "safe" assets, and so that we, the ordinary citizens, find it difficult to acquire such safe assets at safe prices.

But, returning to the job prospects of my granddaughter, the report is unfortunately completely silent on the urgent need we have of “risky" assets, such as loans to small businesses and entrepreneurs, and which, at the moment of truth, are those which can most generate the jobs to eliminate the immense risk of millions and millions of unemployed youth.

Please regulators, the world needs to take real risks, and not hide in the skirts of that artificial safety which only produces fragility. Without risk-taking there can be no stability! ...except, of course, of the type you can get in the grave.

Translated from El Universal, Caracas, April 26, 2012

October 2009, in FT: “Free us from imprudent risk-aversion and give us some prudent risk-taking”

God make us daring!

One gap that sure needs to be closed

The Spring Meetings of the World Bank and the International Monetary Fund of April 2012 are surrounded with various calls about “reducing gaps” 

Well one gap that surely needs to be closed, and where the World Bank and the IMF should be at the forefront, is the one odiously increased by senseless bank regulators, between those perceived ex-ante as “not-risky” the AAAristocracy, and those similarly perceived as “risky”... the new untouchables. 

Again, the two basic questions the bank regulatory establishment does not dare, want or know how to answer.

If banks already look at the credit information provided by credit ratings when setting interest rates, amount to lend and other terms, do you think it is intelligent for the regulators to also look at the same credit ratings, or similar risk perceptions, in order to define the capital requirements for banks? Is that not overdoing the nanny part a bit too much? Could that not lead to a dangerous overexposure to whatever is officially deemed as absolutely not risky? Like to triple-A rated securities and infallible sovereigns? 

And is not the whole idea of lower capital requirement for banks when the perceived risks are low just a dumb idea from the very start, knowing, as we do, that big systemic bank crises never ever occur because of excessive exposures to what is believed to be risky, but that they always occur because of excessive exposures to what was wrongfully believed as absolutely not-risky?

About cruise ships and banking regulations

Put it this way. If you go on a cruise would you want it to be insured against all risks or not? As I see it if it is completely insured, chances are that the captain could be a social relations captain, and if it is completely uninsured, the chances are much larger that the captain is a real marine captain. Your pick! 

When the regulators allowed the banks those ridiculous capital requirements of 1.6 percent or less, just to navigate those waters perceived as absolutely not-risky, precisely the waters where in fact all the major bank crisis have occurred, they basically provided the banks with a total insurance… causing social-relation and trading bankers to substitute for real bankers.

Financial repression

Financial repression, a term coined in 1973 by Stanford economists Edward S. Shaw and Ronald I. McKinnon, is used to describe several measures that governments employ to channel funds to themselves and which in a deregulated market, would go elsewhere. In other words it is a hidden non-transparent tax. 

How much financial repression is present by the fact that the banks need to hold immensely much less capital when lending to its “infallible” government than when lending to the “risky” citizens? We have no idea… as we are flying blind with instruments that long ago ceased to function.

Bank regulators should learn about risk compensation and shared space philosophy.

Risk compensation, nothing to do with bonuses, is an effect whereby individual people may tend to adjust their behavior in response to perceived changes in risk. Individuals will behave less cautiously in situations where they feel "safer" or more protected. It is an argument that might help to explain the apparent paradox that reduced regulation leads to safer roads. 

The perceived risk of default in finance, functions like a natural traffic light. If the perceived risk for default of a borrower is high, the light yellow or red, banks lend less, at higher interest rates and on tougher terms. If the perceived risk for default of a borrower is low, the light green, banks lend more, at lower interest rates and on more lenient terms. 

The regulators though, with their capital requirements for banks based on perceived risks, by allowing for extraordinarily low capital requirements when the perceived risk were low, working like a collider, induced the banks to drive through the green lights much faster and with much lesser care, which resulted of course in this the mother of all financial pile-ups 

After a bank crisis characterized, as usual, by monstrously large exposures to what was officially considered as absolutely safe, like triple-A securities and infallible sovereigns, risk compensation is something our bank regulators should look into much more closely. 

According to the Shared-Space urban design philosophy, safety, congestion, economic vitality and other similar issues can be effectively tackled in streets and other public spaces by allowing traffic to be fully integrated with other human activity, not separated from it. Shared-Space streets have no traditional road markings, signs or traffic signals, and the distinction between "road" and "pavement" is blurred. The behavior of its users is more influenced and controlled by natural human interactions than by artificial regulation. 

Hans Monderman, 1945-2008, the Dutch traffic engineer known for his prominent role in the Shared-Space approach, was quoted saying: "We're losing our capacity for socially responsible behavior... The greater the number of prescriptions, the more people's sense of personal responsibility dwindles... When you don't exactly know who has right of way, you tend to seek eye contact with other road users... You automatically reduce your speed, you have contact with other people and you take greater care."

These days, when with their Basel III the regulators are digging our banks even deeper in the hole of excessive perceived safety, and we want and need our bankers to be better bankers and better citizens, we sure wish the Basel Committee would at least listen to some Shared-Space specialists.

PS. Risk-weighted capital requirements for banks, is also like allowing cars to go at different speeds depending on safety features, rated by "experts" and, of course, driven by fallible humans!!!

Let us thank our lucky star the credit rating agencies were not that good

Bank regulators gave tremendous importance to credit ratings, especially in the Basel II package approved in June 2004. 

One of the problems with that is that if a credit rating has already been issued, and if it is good one, like an AAA, there is absolutely no incentive for a second opinion, as no one is going to pay the price of a second opinion that might differ from the first opinion, only once in awhile. And this is especially true if the First and Official Opinionater, has had access to privileged information about the borrower, as they very often have. 

Though we are indeed already suffering seriously the consequences of some of the credit ratings being wrong… can you imagine where we would be if they had delayed making their mistakes ten more years, and the banks and regulators had had the time to invest so much more trust in them? Can you imagine the altitude from which we would have fallen? 

Indeed there is someone looking after us! So at least let us be grateful for that and make amends! 

PS. What on earth do you think I was referring to, when in January 2003, in a letter to the Financial Times I wrote, “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds”?