Should risk weighted bank capital requirements be based on perceived risks, or conditioned-on the risks perceived?

The Basel Committee, and co-regulators all base it on perceived risks. Mark Twain would have gone for the conditioned-on risks perceived. Why? “A banker is a fellow who wants to lend you the umbrella when the sun shines and wants it back when it rains”. (Supposedly)

Twain understood that bankers, conditioned upon them perceiving risks as low, will gladly hand out loads of loans which, when conditioned on them perceiving the risks as high, they would want to collect, as fast as they could.

Sadly, all current bank regulators clearly missed their lectures on conditional probabilities, and therein lies the problem.

Now, when credit risks are perceived as low, their risk weighted bank capital requirements allow banks to lend profusely against little capital, meaning being able to pay high bonuses and dividends and do plenty of stock-buy-backs. When risks are or become perceived as high, e.g., in a recession, then banks must hold more capital, just when it is the hardest for them to raise it, just when we probably need banks the most.

To understand the point, an on the scene live reportage the morning after a bank crisis interviewing all those Monday Morning Quarterbacks that beg to be interviewed all mornings after, would satiate us with the mention of some huge specific loads of very risky assets. And those suffering the availability heuristic a.k.a. the availability bias, would nod their heads in agreement. 

From Wikipedia we read: “The availability heuristic operates on the notion that if something can be recalled, it must be important, or at least more important than alternative solutions which are not as readily recalled. Subsequently, under the availability heuristic, people tend to heavily weigh their judgments toward more recent information, making new opinions biased toward that latest news.”

But, if a documentary was produced on what years/moths lead up to that crisis, it would certainly retell how those huge dangerous bank exposures were built up with assets deemed very safe. That documentary would seriously contradict the live reportage and the Basel Committee, and strongly agree with Mark Twain.

The problem with data is that when they are taken/registered also matters a lot.

Sadly, the safety of our bank systems is not only what’s endangered. Also the health of our economies. These risk averse bank capital requirements cause too large exposures to what’s “safe”, e.g., government debt and residential mortgages, think of it as demand pushing carbs; and too small exposures to what’s “risky” e.g., loans to small businesses and entrepreneurs, think of these as supply producing proteins. The result? Dangerous economic obesity.

Edmund Burke would have required the current bank regulations to be totally reformed

In a letter published by Washington Post 2015 titled “Reverse mortgaging the future” I wrote that the current risk weighted bank capital requirements implied that “we refused those coming after us the risk-taking that brought us here and, in such a way, we baby boomers — or at least our elite — allowed the intergenerational holy bond that Edmund Burke wrote about to be violated.”

Days ago, I began reading the introduction to “Edmund Burke and the Perennial Battle, 1789-1797” written by Daniel B. Klein and Dominic Pino. I got to page 9 and there found Edmund Burke mentioning “four hurdles that an abuse must clear in order to be worthy of reform.”

So here I go.

First. “The object affected by the abuse should be great and important.”

I submit that banks and their allocation of credit to the real economy is of utmost importance.

Second. “The abuse affecting this great object ought to be a great abuse.”

I submit that imposing how much capital/equity/skin in the game banks should hold against different assets will much determine to what/whom, how much and at what interest rates banks are willing to lend. 

Third. “It ought to be habitual, and not accidental.

I am sure the risk weighted bank capital requirements concocted by the Basel Committee for Banking Supervision and implemented for more than three decades by bank regulators all around the world meet perfectly both these criteria.

Fourth. “It ought to be utterly incurable in the body as it now stands constituted”.

Regulators who for decades have been unable to even acknowledge, much less discuss the existence of serious problems with their rulings, has sufficiently demonstrated a total incapacity to change and reform on its own.

And to what regulatory abuse am I referring to?

1.- Even though ALL bank crises ever have resulted from the build-up of excessive exposures with assets ex-ante perceived as safe but that ex-post turned out risky, regulators based their risk weighted bank capital requirements on that what’s perceived risky is more dangerous to bank systems than what’s perceived safe.

2.- Banks mostly subject to capital requirements based on perceived credit risks, not on the certainty of misperceived risks or unexpected events, e.g., a pandemic or a war, will stand there naked, just when we surely need them the most.

3.- When outlook seems rosy and risks are perceived low, banks will be allowed to pay large bonuses, large dividends and carry out share buy backs so, when times turn bad, banks will stand there naked, just when we might need them the most, just when it is harder for them to raise capital.

4.- By decreeing risk weights of 0% governments and 100% citizens the regulators indicate their belief bureaucrats know better what to do with (taxpayer’s) credit than e.g., small businesses and entrepreneurs with their own; something which has strongly empowered the Bureaucracy Autocracies around the world

5.- Risk weighted bank capital requirements much favor banks holding “safe” government debt & residential mortgages (demand-carbs-the present) over loans to “risky” businesses (supply-proteins-the future). The result: economic obesity that morphs into stagnation.

6.- Allowing banks to leverage more their capital/equity/skin-in-the-game when financing the safer present than when financing the riskier future, clearly violates that holy intergenerational bond Edmund Burke wrote about.

7.- And so on… and on and on.

PS. Here’s a reference to a more recent violation of that holy intergenerational social contract Edmund Burke spoke about. The response to Covid.

PS. And the elder will also be hurt since social security will be failing too.

Your Honor, can I sue the bank regulators?

Your Honor, 

My small riskier less creditworthy business always got less credit and paid higher interest rates than the more creditworthy, and that was ok. 

But the regulators, with their risk weighted bank capital requirements, also decreed it to be less worthy of credit and, since it now has to compensate the banks for these not being able to leverage as much their capital/equity as much as they can with other “safer” assets, they made it get even less credit and pay even higher interests. 

Can I sue them?

Neoliberalism’s history is not being correctly recorded

The two policies most mentioned in connection with neoliberalism (please google it) are “privatization”, referring to that the private sector knows better, and “deregulation”, referring to that it's better when the government interferes less. And one of the moments most mentioned about when neoliberalism crumbled, is the 2008 global financial crisis GFC.

But, in 1988, with Basel I, bank capital requirements changed from one single capital requirement e.g., 10 percent against all assets, to multiple risk weighted requirements, and with its most defining weights being 0% the government, 100% citizens. Basel III, the short version, contains 1626 pages.

So, banks being allowed to leverage more their capital... meaning making it easier for banks to earn higher risk adjusted returns on equity with government debt than with loans to e.g., small businesses and entrepreneurs, please, what has that to do with the private sector knowing better what to do than the public sector?

So, deregulation, please, has that not much more to do with putting regulations (with all its possible miss-regulations) in overdrive?

And please, would there ever have been a 2008 GFC if banks had been limited to leverage their equity 10 times with AAA to AA rated mortgage-backed securities, and not the 62.5 times European banks and US investment banks 2004’s Basel II allowed them to do?

Does arguing this make me defender of neoliberalism? No and Yes! 

I often identified the privatizations, for instance of utilities, as just a trick by the bureaucrats in turn to lay their hands on some easy fiscal revenues, which would later have to be repaid by us consumers through higher tariffs.

But, do I believe that small businesses and entrepreneurs know better what to do with bank credit than the bureaucrats not personally responsible for the repayment of it do? You bet!

Has the end of neoliberalism in 1988 been recorded for the history books? No! There's surely many who even swear it is still alive and kicking.

PS. You don't have to just take my word on it: “Assets for which bank capital requirements were nonexistent, were what had most political support: sovereign credits. A simple ‘leverage ratio’ discouraged holdings of low-return government securities” Paul Volcker

The regulatory distortion that shall not be understood… or at least not be named

My twitter thread.

The regulatory distortion that shall not be understood… or at least not be named.

After the operational costs and the perceived credit risks have been cleared for with higher or lower cost/risk adjusted interest rates, we get the expected risk adjusted return of a bank asset.

If a bank asset produces an expected risk adjusted return of 1 percent, then, if the capital requirement is 8 percent, it can be leveraged 12.5 times and it will produce an expected risk adjusted return on bank equity of 12.5 percent. 

But if a bank asset produces an expected risk adjusted return of 1 percent, and the capital requirement is only 2.8 percent, it can be leveraged 35 times, and it will produce an expected risk adjusted return on bank equity of 35 percent.

So, exactly the same expected risk adjusted return on assets, if deemed “safe” by regulators, e.g., residential mortgages, could produce almost three times the expected risk adjusted return on bank equity than if regulators deem it “risky”, e.g., loans to small businesses.

The consequence?

For the bank system, dangerously too many residential mortgages, most at lower than their correct risk-adjusted interest rates, and, for the economy, dangerously too few loans to small businesses, most at higher than their correct risk-adjusted interest rates.

Those perceived less creditworthy and who always got less credit and paid higher rates were, with this, also declared less worthy of credit. Does that promote or decrease inequality?

And since banks are subject to capital requirements mostly based on perceived credit risks, not misperceived risks or unexpected events, e.g., pandemic or war, they will now stand there naked, just when we surely need them the most.

Basel Committee… Good Job!

And what if the bank capital requirement is much lower and the allowed leverage much higher for government debt, Treasuries?

Well then, the regulators are really empowering the Bureaucracy Autocracy with loads of credit at ultra-low rates… and this even before the QEs.

And don’t just take my word for it.

“Assets for which bank capital requirements were nonexistent, were what had most political support: sovereign credits. A simple ‘leverage ratio’ discouraged holdings of low-return government securities” Paul Volcker

https://subprimeregulations.blogspot.com/2018/12/september-2-1986-was-tragic-night-when.html

https://twitter.com/PerKurowski/status/1521865964450725889?s=20&t=22OHr9fVrCTrNc-0VkcuuQ

The current risk weighted bank capital requirements: A Maginot Line

My Twitter thread:

What if generals concentrate too much on the immediate risk sergeants perceive?

I ask because regulators now concentrate too much of their bank capital requirements on the risk perceived by credit rating agencies and bankers.

The result? A false sense of security. A Maginot Line.

Any risk, even if perfectly perceived, if excessively considered, causes the wrong action.

With bankers adjusting for risk with interest rates, and regulators with bank capital requirements, there will be dangerously much “safety” and dangerously little risk-taking.

Too much safety? 

The excessive bank exposures and the assets bubbles that can become dangerous for bank systems and the economy, are always built-up with assets perceived (or decreed) as safe, never ever with assets perceived as risky.

Too little risk taking? 

Risk taking is the oxygen of any development

If e.g., residential mortgages are favored much more than bank loans to small businesses and entrepreneurs, we will end up with too expensive houses and too little job income for food, utilities… and mortgages

What if the generals took much more care of the needs of their headquarters, than those of the soldiers in the battlefield?

I ask because the regulators who, for bank capital requirements, have decreed risk-weights of 0% the government and 100% the citizens, are doing just that.

What if armies don’t arm during peace?

I ask because when times are good, is when banks should buildup capital

The risk weighted bank capital requirements, do the opposite

So, when times turn bad, our banks will stand there naked, just when we need them the most

Good Job! 😡

Regulators, the Basel Committee for Banking Supervision, imposed bank capital requirements based mostly on perceived risks, not on misperceived risks or on unexpected events e.g., a pandemic or a war. 

Oh, if only they had taken time off to play some war games before doing so.

PS. Not the first time I've mentioned the Maginot Line

My brevissimus criticism lecture on the Basel Committee’s bank regulations

Students. 

Let’s refer to two types of bank assets, those perceived as safe, e.g., government debt and residential mortgages; and those perceived as risky, e.g., loans to small businesses and entrepreneurs.

Let’s also assume all these assets, whether the Safe or the Risky, are offering perfect risk adjusted interest rates.

Before the Basel Committee regulations, the banks, with a general look to the safety of their whole portfolio, would have given all of these assets, whether safe or risky, a quite similar consideration.

But, when the Basel Committee imposed risk weighted bank capital requirements, more capital/equity for what’s perceived as risky than for what’s perceived (or decreed) as safe, that all changed.

Because banks can now leverage their capital/equity much more with what’s “safe”, the risk adjusted interest rates offered by the Safe, produce them higher risk adjusted returns on their equity, than the risk adjusted interest rates offered by the Risky.

That dramatically distorted the allocation of bank credit. 

The Safe now get too much credit, often at rates lower than what their correct risk adjusted interest rate would demand. As a consequence, excessive bank exposures are construed, turning the Safe effectively into risky and very dangerous to the stability of bank systems. (Have you ever heard of a dangerous asset bubble built-up with assets perceived as risky?)

The Risky now get too little credit and, whatever they get, is at interest rates higher than what their correct risk adjusted interest rates would merit. As a consequence, the Risky become riskier, and too little risk-taking, the oxygen of all development, takes place, something which, of course, weakens the economy.

Why would regulators do this? As Paul Volcker (valiantly) confessed “The assets assigned the lowest risk, for which bank capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages”

Students, one big problem is that the Academia seem not to care one iota about it, so this might have been your only chance to hear this explanation. 

Why should you care? Having banks give much priority to refinancing the safer present than financing the riskier future, cannot be in your best interests.

What about some transparency on state aid given to the State?

Matthew Lesh discusses “level playing field”, “state aid”, domestic subsidies and transparency: “Relaxed subsidies rules are a free rein to pick winners without transparency” City AM, March 16, 2022.

In 1988, risk weighted bank capital requirements were introduced. Basel I, decreed weights of 0% the government, 40% residential mortgages and 100% citizens. Though modified by the introduction of more risk categories in 2004’s Basel II, the discrimination in the access to bank credit still remains.

That regulation translates into banks being allowed to leverage their capital, basically their equity, much more when lending to the State, than to the citizens. That means banks can much easily earn desired risk adjusted returns on equity when lending to the State than when lending to the citizens. That translates into a subsidy of government borrowings.

Don’t just take my word for it. Paul Volcker, in his 2018 autobiography “Keeping at it”, wrote: “Assets for which bank capital requirements were nonexistent, were what had most political support: sovereign credits. A simple ‘leverage ratio’ discouraged holdings of low-return government securities"

The scary truth is that we confront an utterly creative and non-transparent financial statism/communism of monstrous proportions, which impedes the markets to signal what the undistorted interest rate on governments debts should be. 

Are current ultra-low interest rates on government debt something weird? Of course not: a) require banks to hold the same capital against all assets (as it used to be); b) stop central banks from purchasing with their QE government debt; c) take away liquidity requirements that force banks to hold government debt; d) stop ordering pension funds and insurers to buy “safe” government debt irrespective of the price; and you would see government debt traded at much higher rates.

The difference between the interest rates governments would pay on their debts in absence of all above mentioned favors, and the current low interests is, de facto, a well camouflaged debt, retained before the holders of those debts could earn it.

All this empowers the Autocratic Bureaucracy.

Who has approved these subsidies that are not recognized much less measured? What if the owner of a small British businesses makes the case to the Competition Appeal Tribunal, that he believes an unfair subsidy to a competitor in the access to bank credit, has been provided by the Prudential Regulation Authority (PRA)?

PS. 2012 Citi AM published an opinion of mine. It was much on the same theme

Bank regulators have placed the consequences of volatility on steroids

I refer to Robert Burgess’ “Volatility Is the Price of a Safer Banking System”

October 2004, at the World Bank, as an Executive Director, I stated: “Much of the world’s financial markets are currently being dangerously overstretched through an exaggerated reliance on intrinsically weak financial models based on very short series of statistical evidence and very doubtful volatility assumptions.”

Most of current bank capital requirements, whether Basel I, II or III are based on perceived credit risks. That means banks can leverage their capital/equity/skin-in-the-game the most with what’s perceived as safe. That means banks can build up those huge exposures to “safe assets” which can become extremely dangerous to bank system if volatility kicks in, and turn these supposed safe into very risky assets.

April 2003, at the World Bank I had also opined: "Nowadays, when information is just too voluminous and fast to handle, market or authorities have decided to delegate the evaluation of it into the hands of much fewer players such as the credit rating agencies. This will, almost by definition, introduce systemic risks in the market"

The 2008 crisis was caused by assets rated AAA to AA, which after Basel II banks were allowed to leverage with a mind-boggling 62.5 times, suddenly were discovered as very risky assets… you want having increased the impact of volatility any higher?

May 2003, at a workshop for regulators, I argued: “A regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation”. That translates into that the regulator should not try to hinder volatility, but learn to live with it. 

So, if we want a safer bank system, we must first get rid of the risk weighted bank capital requirements which have placed the consequences of volatility on steroids.

The main causes the so objectionable risk-weighted bank capital requirements are not objected.

A brief summary:

No understanding about what immense hubris “experts” are capable of, like believing they can weigh bank capital requirements for perceived credit risks… and then mostly ignoring misperceived risks and unexpected events e.g., pandemic war.

No understanding of how allowing banks to leverage their capital differently with different assets, will make it easier/harder for banks to obtain the desired risk adjusted returns on equity; something which distorts the allocation of credit.

No knowledge about conditional probabilities; which therefore helps to believe those excessive exposures that could become truly dangerous to bank systems, are built up with assets perceived as risky.

Not understanding that risk-taking is the oxygen of all development.

Consequentially:

No understanding of their pro-cyclicality. When risks are perceived low, credit ratings are high, banks can hold little capital, buy back stock, pay much dividends and bonuses, and so, when times worsen, or something unexpected like a pandemic or a war occurs, banks will stand there naked, precisely when it would be the hardest for them to raise new capital, precisely when we need them the most

No understanding of that since the capital requirements are lower for lending to the “safe” government than to the risky citizens, this implies bureaucrats/politicians know better what to do with (taxpayer’s) credit than e.g., small businesses and entrepreneurs. (Of course, they could also be agreeing with that for pure ideological considerations.)

No understanding of what capital requirements being lower for “safe” residential mortgages than for loans to risky small businesses and entrepreneurs, implies to the possibilities of generating the jobs/incomes needed to service mortgages and pay living costs.

The saddest part is that all these limitations seem to entirely apply to our current Academia. 

What if in the early 19th century The First Bank of the United States had regulated banks as the Federal Reserve began to do in 1988.

Sir, it is only now I read Steven Pearlstein reviewing Jonathan Levy’s “Age of American Capitalism”, “From commerce to chaos: An economic history of the United States”, Washington Post, June 4, 2021 

It says: “The ‘American system’ … required a new system of credit built around a government-chartered National Bank and government debt”.

That contrasts with John Kenneth Galbraith's: “Banks opened and closed doors and bankruptcies were frequent, but as a consequence of agile and flexible credit policies, even the banks that failed left a wake of development in their passing” “Money” (1975)

Why does not Washington Post invite some prominent financial historians to debate: Where would America be if “The First Bank of the United States” (1791-1811) had imposed bank capital requirements similar to those the Federal Reserve did in 1988? 

What the Fed did was succinctly explained by Paul Volcker in his 2018 autobiography in terms of: “The assets assigned the lowest risk, for which bank capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages”. 

Would that not be an important debate that should have been started long ago? 

PS. That quote from Galbraith’s “Money” has a very personal meaning to me. It inspired my very first Op-Ed, 1997 in Caracas Venezuela. 

PS. Steve Pearlstein wrote: “Moral Capitalism: Why Fairness Won’t Make Us Poor”. Since current bank capital requirements, by doubling down on perceived credit risk unfairly decrees that the less creditworthy are also less worthy of credit, he could be interested in what Galbraith, opined in that same “Money”.

“The banks’ function of democratization of capital as they allow entities with initiative, ideas, and will to work although they initially lack the resources to participate in the region’s economic activity. In this second case, Galbraith states that as the regulations affecting the activities of the banking sector are increased, the possibilities of this democratization of capital would decrease. There is obviously a risk in lending to the poor.” 

Indeed, when it comes to access to bank credit, fairness, can only help to make us rich.

How does the Law of Unanticipated Consequences apply to risk weighted bank capital requirements?

There’s Murphy’s Law type unanticipated consequences: “What Can Go Wrong, Will Go Wrong”; and there are perverse effects that result in the opposite of what was intended. 

And then there is Robert K. Merton’s, Law of Unanticipated Consequences. This one identifies five principle causes of unanticipated consequences: 

Ignorance, making it impossible to anticipate everything, thereby leading to incomplete analysis.

Ignorance? Yes, but much spiced up with that abundant hubris that made regulators believe that they, from their desks, and with the help of some few human fallible credit rating agencies, could get a grip on what the risks for bank systems are. 

Errors in analysis of the problem or following habits that worked in the past but may not apply to the current situation.

Errors? Many but perhaps none worse than the following:

1. Risk weights 0% the government and 100% citizens, as if bureaucrats know better what to do with credit for which repayment they're not personally responsible for than e.g., small businesses and entrepreneurs.

2. Fixating on the perceived credit risks and not on the risks conditioned to how the credit risks are perceived.

3. Ignoring how dangerously procyclical these bank capital requirements would be.

Immediate interests overriding long-term interests.

Immediate interests? Absolutely, and perhaps none as clear as that valiantly but sadly so late confessed one by Paul Volcker “The assets assigned the lowest risk, for which bank capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages.”

Basic values which may require or prohibit certain actions even if the long-term result might be unfavourable.

Basic values? Can’t think of anyone except of course that “it’s not come-il-faut to question your colleagues”, and which tends to prevail in all mutual admiration clubs defending the jobs of their members.

Self-defeating prophecy, or, the fear of some consequence which drives people to find solutions before the problem occurs, thus the non-occurrence of the problem is not anticipated.

Self-defeating prophecy? Perhaps, in terms of listening too much to Monday Morning Quarterback besserwisser prophets. The morning after a crisis they describe in detail the risky assets. What they never mention before the crisis, is with what "safe" assets those dangerous bank exposures are being built-up with. 

And the Academia says nothing

Some unasked questions that all nominees to the Federal Reserve Board, and of course its current members, should be dared to answer

Intro: The Federal Reserve’s risk weighted bank capital requirements allow banks to hold much less capital, translating into being able to leverage much more with assets perceived (or decreed) as safe e.g., Treasuries, residential mortgages and those with an AAA rating, than with e.g., small businesses, entrepreneurs and assets rated below BB-.

Q. With what assets do you think all those excessive bank exposures that have and could cause really serious bank crisis are built up with: with those perceived as safe or with those perceived as risky?

Intro: When times are rosy, these risk weighted bank capital requirements, allow banks: to lend dangerously much to what’s perceived as very safe; to hold much less capital; to do more stock buybacks and to pay more dividends & bonuses.

Q. Does this not sound like that when times turn bad, banks will stand naked when they are most needed? 

Intro: It is much easier for banks to obtain the risk adjusted returns on equity they look for with assets they can leverage more, and so therefore banks will naturally prefer these, that is unless assets which could be leveraged less, provide additional risk adjusted margins.

Q. Do you think it is more important for banks to finance residential mortgages than to finance those loans to small businesses that could help people get the jobs with which service mortgages and pay utilities?

Intro: The Fed when in 1988 it accepted the Basel Committee’s risk adverse bank capital requirements, it decreed weights of 0% the federal government and 100% “We the people”. 

Q. Do you think the Founding Fathers of The Home of the Brave would agree with regulators imposing risk aversion on its banks; and with bureaucrats knowing better what to do with credit for which repayment they’re not personally responsible for than American small businesses?

Q. Do you have an opinion on how much the strength of the US dollar depends on the United States remaining being perceived as the foremost military power in the world, and of course on its willingness and capacity of exercising such power?

Please, if I may, one last question:

Q. Where do you think America would be, if these bank regulations had been in place the last couple of centuries?

@PerKurowski

How do you regulate a regulator’s algorithm?

Sir, I refer to your opinion “Want to regulate ‘the algorithm’? It won’t be easy” Washington Post December 3, 2021, in which you discuss the thorny issue of how to regulate social media in general and Facebook in particular.

Regulators, like the Federal Reserve, de facto also use an algorithm, the risk weighted bank capital requirements. This one determines how much capital/equity banks need to hold and, by its incentive of allowing more or less leverage of bank capital, influences how credit is allocated to the economy.

Let me list a few of too many worrisome aspects of that algorithm:

That what’s perceived as risky is more dangerous to bank systems than what’s perceived as safe

That bureaucrats know better what to do with taxpayer’s credit than e.g.., entrepreneurs with theirs.

That banks should refinance much more our “safer” present than finance our children’s and grandchildren’s’ “riskier” future.

That residential mortgages should be prioritized over small business loans.

How did we get there? My briefest answer: Groupthink by deskbound members of a mutual admiration club. Anyone who has walked on main-streets would e.g., understand that the real risks are conditioned to how risks are perceived, signifying assets can become very risky by the sole fact of being perceived very safe.

John A. Shedd, in “Salt from my attic” 1928 wrote: “A ship in harbor is safe, but that is not what ships are for”. Sir, I submit that goes for banks too. Try to ask current regulators about the purpose of our banks.

PS. IBM, we need our bank regulators to be helped by your Watson.

PS. Rachel Siegel wrote on December 3 “Biden’s pledge to bring ‘new diversity’ to Federal Reserve to soon be tested” I just hope the true meaning of diversity is really understood.

To help moor (my) inflationary expectations, get rid of what facilitates it.

Paul Volcker, in his autography “Keeping at it”, penned together with Christine Harper in 2018, wrote: “The assets assigned the lowest risk [in 1988], for which capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages… The American ‘overall leverage’ approach had a disadvantage as well in the eyes of shareholders and executives focused on return on capital; it seemed to discourage holdings of the safest assets, in particular low-return US government securities."

Washington Post, in reference to your “Do not underestimate inflation” November 11 let me assure you that, just as lower bank capital requirements against residential mortgages fuels house prices; lower bank capital requirements against Treasuries, by artificially lowering the interest rate on these, sooner or later, are bound to facilitate those excessive injections of liquidity that fuels inflation.

I’m not an expert on the US Constitution, I’m not even an American citizen, but I cannot understand how Section 8’s "The Congress shall have the power to borrow Money on the credit of the United States" could be read as to include the assistance of a Federal Reserve quantitative easing; and bank capital requirements with risk weights: 0% the Federal Government, 100% We the People.

If I had a chance to be heard by the Fed, here’s a Basel IV I would suggest

PS. Fight inflation, from bottom up! Injecting liquidity while banks obtain higher risk adjusted returns on equity with Treasuries & residential mortgages (carbs) than with loans to small businesses & entrepreneurs (proteins), that favors demand over supply, something which can only help to inflate inflation.

PS. To top it up, are we really sure that the inflation that's pursued is the inflation that matters?

@PerKurowski

But with questions that shall not to be heard, courage might not suffice

“A lot of people want to convince you that you need a Ph.D. or a law degree or dozens of hours of free time to read dense texts about critical theory to understand the woke movement and its worldview. You do not. You simply need to believe your own eyes and ears.”

So begins Bari Weiss’ “We Got Here Because of Cowardice. We Get Out With Courage… Say no to the Woke Revolution”

Indeed: 

We should need nothing of that sort in order to understand that… risk weighted bank capital requirements based on that what’s perceived as risky is more dangerous to our bank systems than what’s perceived as safe, is as wrong/as woke as can be.

2004, Basel II assigned to the safest of the perceived safe, a risk weight of 20% and, to the riskiest of the perceived risky, a risk weight of 150%... Translating into a Basel II capital requirement of 1.6.% for the safest and 12% for the riskiest... Meaning banks were allowed by their regulators to leverage their capital 62.5 with assets some few human fallible credit rating agencies consider to be the safest, and 8.3 times with what these agencies consider to be the riskiest.

Should we really agree with that those excessive exposures that could become risky for bank systems are more built up with assets rated below BB- than with assets rated AAA? Does it not suffice to remember the 2008 global financial crisis?

We should need nothing of that sort in order to understand that… decreed risk weights of 0% the government and 100% citizens, de facto implies that bureaucrats know better what to do with credit for which repayment they’re not personally responsible for than e.g., small businesses and entrepreneurs. 

Should we agree with such statism/communism/fascism?

We should need nothing of that sort in order to understand that… allowing banks to leverage more their capital with some assets than others, make it easier for them to obtain a higher risk adjusted return on equity with some assets than with other. 

Should we agree with such in distortion of the allocation of bank credit?

We should need nothing of that sort in order to understand that… those less creditworthy already get less credit and pay higher interest rates.

Should we agree with bank regulations that declare the less creditworthy to also be less worthy of credit?

We should need nothing of that sort in order to understand that… … and on this issue I could go on and on… like wondering why the Academia says nothing. Might it be an Inquisition has declared questions on this issue shall not be heard?

My questioning began decades ago

PS. My 1999 Op-Ed in which, like Bari Weiss, I quote Arthur Koestler. “I automatically learned to classify all that is repugnant as an »inheritance from the past», and all that is attractive as the »seed of the future». With the aid of this automatic classification it was still possible for a European in 1932 to visit Russia and continue to be a communist.”

The confession of a regulatory hit man… one that shall not be heard.

Paul Volcker, in his autography “Keeping at it”, penned together with Christine Harper in 2018, wrote: “The assets assigned the lowest risk, for which capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages… The American ‘overall leverage’ approach had a disadvantage as well in the eyes of shareholders and executives focused on return on capital; it seemed to discourage holdings of the safest assets, in particular low-return US government securities."

What does that mean? It means exactly, no way around it, that if banks needed to hold as much capital against government securities and residential mortgages than what they were required to hold against e.g., loans to small businesses and entrepreneurs, banks would either hold less governments securities or residential mortgages or require higher interest rates on that… which also translates into banks holding more loans to small businesses and entrepreneurs at lower interest rates.

Volcker referred therein to 1988 Basel I regulations’ risk weighted bank capital requirements, but that remains totally applicable to Basel II and Basel III.

Thirty-three years without free-market set interest rates in the Western world, and I believe not one single Nobel Prize in Economic Sciences winner, or reputable or disreputable PhD anywhere, or distinguished journalist, has referred to this. Could it be that risk weights 0% government, 40% residential mortgages have created such a strong alliance between statists/communists and home owners, that the 100% risk weighted citizens stand no chance.

With banks giving too much credit at too low rates to what’s perceived or decreed as safe, where do you think this will all end? Have a guess. 

http://subprimeregulations.blogspot.com/2019/03/my-letter-to-financial-stability-board.html

https://subprimeregulations.blogspot.com/2018/12/september-2-1986-was-tragic-night-when.html

https://subprimeregulations.blogspot.com/2013/01/the-subsidized-risk-free-rate.html

https://subprimeregulations.blogspot.com/2020/12/small-businesses-like-restaurants.html

https://subprimeregulations.blogspot.com/2004/11/some-of-my-early-public-opinions-on.html

https://perkurowski.blogspot.com/2005/07/perkins-confessions-rough-book-tour-is.html

“NOISE” defines me as noisy. I've got no problem with that.

Reading “Noise: A Flaw in Human Judgment" by Daniel Kahneman, Olivier Sibony and Cass R. Sunstein

Noise: “People who make judgments behave as if true value exists, regardless of whether it does. The think and act [as besserwissers] as if there were an invisible bull’s eye at which to aim, one that they and others should not miss by much”

Me: The Basel Committee’s risk weighted bank capital requirements, based on that what’s perceived as risky being more dangerous to our bank systems than what’s perceived (or decreed) as safe, is a pure and unabridged baseless judgment, held by Monday Morning Quarterbacks.

Noise: “Bias exist when most errors in a set of judgments are in the same direction”

Me: 2004, Basel II’s risk weights of 20% for what human fallible credit ratings agencies have assigned a AAA to AA rating, and 150% for assets assigned a below BB-rating, is clearly the previous judgement was set on steroids, by an ex-ante runaway risk aversion.

Noise: “Eliminating bias from a set of judgments will not eliminate all error. The errors that remain that remain when bias is removed are not shared. They are unwanted divergency of judgments, the unreliability of the measuring instrument we apply to reality. They are noise.” 

Me: So, I who for decades have been convinced of that what’s perceived (or decreed) as safe is much more dangerous to our bank system than what’s perceived as risky, seem to have been declared here, as pure unadulterated noise.

Be that so, for my grandchildren’s sake, I'll keep on being as noisy as can be.

The Basel Committee's Bank Credit Principles

Bureaucrats know better what to do with credit than entrepreneurs

Better refinancing the safer present than financing the riskier future

Residential mortgages are more important than small business loans

The more creditworthy are also much more worthy of credit

Are indeed as noisy as noise can be

PS. Would Daniel Kahneman have been awarded the Nobel Memorial Prize in Economic Sciences if Sveriges Riksbank had known how much his 2011 “Thinking, fast and slow” helps explain how stupid their risk weighted bank capital requirements are?

P.S. After titling my book “Voice and Noise” I found an article by Ingo R. Titze, Ph.D., in the Journal of Singing titled “Noise in the Voice”. It argued “A little noise, turned on at the right time, can go a long way toward enlarging the interpretive tool”. It reassured me a lot.

PS. My 2019 letter to the Financial Stability Board 

PS. Here, how my noise on bank regulations began

A much-needed and much overdue conference

John A. Shedd, in his 1928 “Salt from my attic” wrote: “A ship in harbor is safe, but that is not what ships are for”. 

Does that not apply to banks too? In his autobiography “Keeping at it”, penned together with Christine Harper in 2018, Paul Volcker, the Chair of the Federal Reserve from August 1979 to August 1987, with respect to the credit risk weighted bank capital requirements approved in 1988 and which are known as Basel I, valiantly confessed:

“The assets assigned the lowest risk, for which capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages… The American ‘overall leverage’ approach had a disadvantage as well in the eyes of shareholders and executives focused on return on capital; it seemed to discourage holdings of the safest assets, in particular low-return US government securities."

Allowing banks to leverage much more with Treasuries and residential mortgages, which means it is easier for them to obtain satisfactory returns on equity with these assets, made it of course much harder for the “risky” e.g., small businesses and entrepreneurs to compete for credit. They now get less credit or pay higher interest rates than in absence of these regulations. Direct results? More government debt, higher house prices and less private sector jobs/incomes.

The harsh truth is that with the risk-weighting, the Fed decreed the less creditworthy to also be less worthy of credit, and that banks financing or refinancing the “safer” present would have priority over their financing the riskier future. 

An even harsher truth is that, in terms of financial stability, it’s all for nothing… even counterproductive. All the excessive exposures that could lead to major systemic bank crises, have always been built-up with what’s perceived as safe, never ever with what’s perceived as risky.

Who is going to pay by far the most for all the consequences? Our children and grandchildren.

“Where would America, the Home of the Brave be, if the credit risk averse bank regulations had not been introduced?”, is that not a question that merits a conference transmitted live on prime time? 

Why has it not taken place yet? Thirty-three years of silence clearly evidences this is not a red or blue issue and, sadly, violet is so out of fashion.

Why does your paper/organization sponsor such a conference?

Zero dividends, buy-backs and big bonuses, before banks have ten percent in capital against all assets

We urgently need our banks to be banks again

Current bank capital requirements, with capital meaning equity, meaning the skin in the game bank shareholders should have, are mostly based on perceived credit risks; not on misperceived risks, or the unexpected, like a Covid-19.

That would be less of a problem, if those capital requirements were based on risks conditioned to how credit risks are perceived.

But they’re not! What’s perceived more creditworthy, meaning what’s preferred by banks, have much lower capital requirements than what’s perceived less creditworthy.

And lower capital requirements mean higher leverages, making it therefore easier to earn risk adjusted returns on equity with what’s perceived (or decreed by regulators) as safe, than with what’s perceived as risky.

The consequence? A procyclicality that fosters higher and higher exposures to what’s safe, against less and less capital.

And what’s defined as “safe”? Loans to sovereigns, residential mortgages and assets with very high credit ratings?

And what’s risky? E.g., loans to small businesses and entrepreneurs.

So precisely like in 2007-08, when banks were caught with their pants down because of huge exposures to mortgage-backed securities with misperceived AAA ratings, they’re now standing there naked because of the unforeseen economic consequences of Covid-19; especially those derived from lockdowns.

The procyclicality of it all; when times are rosy banks can hold little capital but when times get hard banks have a hard time raising capital, sets us up to the fact 

And so, just when we now most need banks to help us out, it’s the hardest for them to raise the capital that would allow them to do so. What a mess!

And on all that the Academia has for decades kept total silence.

So, what would I propose? In few words, the following: 

“Banks, you can now hold zero capital, but that comes with: zero dividends, zero buy-backs and zero bonuses until you have ten percent in capital against all assets; and until you’ve paid back, including a reasonable interest, all what central banks or taxpayers have assisted you with.”

To ease the transition one could allow all bank assets incorporated some months before the change, to be held, until its maturity, against the capital requirement valid when put on banks' balances.

And I would allow small investors to buy some of that bank equity that helps these meet that ten percent requirement on favorable conditions… so as to connect the banks with the citizens again

Fellow citizens, let’s rescue our banks from hands of those financial engineers concerned with “how much can we leverage this asset?”, so as to put these back into hands of loan officers whose first question to applicants is, “what are you going to use the money for?”

And let’s rescue banks from that statism/communism/fascism implied with risk weights of 0% the Government, 100% the citizens… all as if bureaucrats/politicians know better what to do with credit for which repayment they’re not personally responsible for, than e.g., entrepreneurs.

Let’s be clear. Risk taking is the oxygen of all development and so, in that vein, for the real economy what’s “safe” represents carbs, while what’s “risky”, proteins and vitamins.

God make us daring!

And finally let’s stop putting financial instability on steroids. The large dangerous exposures that could become dangerous for our bank systems are always built up with what’s perceived as safe, never ever with what’s perceived risky. 

For the record, most of the "zero-zero-zero-ten percent" idea is inspired in how Chile so intelligently managed their huge 1981-1983 bank crisis.

Give it a thought, the newspaper you read; would it dare to publish a Galileo-heliocentric opinion and risk being confronted by the Basel Inquisition?

More on Chile: https://ideas.repec.org/p/wbk/wbrwps/300.html

My 2019 letter to the Financial Stability Board