Helping FT’s Gillian Tett (and other) to understand a little bit more about the SVB mess and bank crises.

I will be referring to Gillian Tett’s “What I learnt from three banking crises” FT March 6, 2023

Note: Tett writes: “So how respond? Regulators could bolster capital reserves”. Here, in order to further avoid the source of so much confusion, let me begin by explaining that regulatory “capital” refers to bank equity – the skin in the game of shareholders or of holders of subordinated debt - contingent convertible bonds (Cocos /AT1 bonds).

Introduction:

The world has been duped/lulled into a false sense of security by the use of risk weighted assets (RWA) as a real and valid measure of banks' risk exposure. E.g., the interest rate risk in the banking book IRRBB, the duration risk of SVB’s long-term government bonds is not included among the weighted risks.

In April 2016 the Basel Committee on Banking Supervision completed a review of its standards with respect to the interest rate risk in the banking book IRRBB.

It analyzed two options: “The regulatory treatments of IRRBB within the standardized Pillar 1 approach, namely the Risk Weighted Minimum Capital [Equity] Requirements; or with an enhanced Pillar 2 approach, meaning the Supervisory Review Process subject to guidance set out in the 2004 Principles for the management and supervision of interest rate risk. 

The Committee noted the industry’s feedback on the feasibility of a Pillar 1 approach to IRRBB, in particular the complexities involved in formulating a standardized measure of IRRBB which would be both sufficiently accurate and risk-sensitive to allow it to act as a means of setting regulatory capital [equity] requirements. It therefore concluded that the heterogeneous nature of IRRBB would be more appropriately captured in Pillar 2. 

What did that mean?

That the risk weighted bank equity requirements, e.g., decreed 0% risk weight of government debt, on the margin, where it most means when deciding to do something that might require more equity, remained unaltered. 

That whatever consideration of interest rate risks, were to be discussed between the supervisors and banks’ risk managers.

That placed these petit committee participants between a rock and a hard place. 

The risk weighted bank capital (meaning equity) requirements have caused the banks’ risk models to be used much more for equity-minimizing/leverage-maximizing, than for analyzing bank assets’ true risks. So, what bank risk manager would currently want to address his Board of Directors with: “Our model, because of too many assets we have perceived as safe could turn out risky, indicates that you have to raise a substantial amount of equity”?

What supervisors/examiners, would dare to suggest to the Basel Committee that it’s time for it to increase the Pillar 1 risk weights, e.g., the 0% of government debt, at least for the long-term portion, and by that force their superiors to handle a truly hot potato?

There’s where banks and regulators find themselves now. If by means of Pillar 1 or Pillar 2 the capital/equity requirements are increased for long term government debt, we will have to face a new dimension in the already abundant distortions of the allocation of bank credit.

Here on I will mention some aspects Gillian Tett seems to have missed in her article. If I am wrong sorry… but as Martin Wolf rightly mentioned once, I am obsessed with this issue. 

Tett holds “Fractional banking works brilliantly well in normal conditions, recycling funds into growth-boosting loans and bonds”. The “brilliantly well” might be a slight exaggeration but current regulations have clearly impeded banks to work reasonably well. 

And don’t take my words for it. Just listen carefully to Paul Volcker’s valiant confession (one that seemingly belongs to the confessions that shall not be heard). “Assets assigned the lowest risk, for which bank capital requirements were therefore nonexistent or low, were what had the most political support: sovereign credits and home mortgages… A ‘leverage ratio’ discouraged holdings of low-return government securities” 

Would SVB hold these bonds if it was required to hold as much equity against Treasuries than against e.g, loans to small businesses?

Growth boosting? I classify sovereign credits and home mortgages as “demand-carbs” and e.g., loans to small businesses and entrepreneurs as “supply-proteins”. If it is going to boost growth, that will be an obese one.

Tett, when arguing “with SVB: its Achilles heel was its portfolio of long-term Treasury bonds that are supposed to be the safest asset of all; so much so that regulators have encouraged (if not forced) banks to buy them” quotes Jamie Dimon correctly explaining “ironically banks were incented to own very safe government securities because they were considered highly liquid by regulators and carried very low capital [meaning equity] requirements” (i) But Tett then writes: “Rules to fix the last crisis — and create “safety” — sometimes create new risks.”

And there she’s wrong. No new risk rules, just the same ones all over again! Though “bankers told [her] in 2008 that one reason why the dangers around repackaged subprime mortgage loans were ignored was that these instruments had supposedly safe triple-A credit ratings — so risk managers paid scant attention”, the reality was that US investment banks, like Lehman Brothers, and European banks could at that time, thanks to Basel II, leverage their equity a mindboggling 62.5 times to one.

What’s the fundamental problem? That although most correctly, as any Monday morning quarterback would, identifies what’s risky the morning after a bank crisis, they do not reflect on that the large exposures that cause bank crises, are always built up with what’s perceived as safe.

And, if there’s a real dangerous Achille’s heel threatening our bank systems, that’s precisely the risk weighted bank equity requirements based on that what’s perceived as risky is more dangerous to bank systems than what’s perceived as safe.

Tett writes, “think of the crowd panic in the streets of London during the South Sea Bubble of 1720”. But why the panic? Because the South Sea investments they thought were very safe, suddenly appeared to be very risky. Has a “Bubble” ever been blown up with what’s perceived as risky?

In summary. If there’s any real lesson to be learned, it is the following. Bankers react to perceived risk with risk weighted interest rates. Bank regulators decided to also react to the same perceived risk with their bank equity requirement. Any risk, even if perfectly perceived, if excessively considered, will cause the wrong reactions.

Our current bank regulators never heard of Mark Twain’s “A banker is a fellow who wants to lend you the umbrella when the sun shines and wants it back when it rains”. (Supposedly) and, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so”

Our current bank regulators also missed their lectures on conditional probabilities… namely what’s the risk conditioned to the risk being perceived?

How can Gillian Tett, chair of the FT’s editorial board and US editor-at-large, and all the rest in FT help to correct the current regulatory failures?

By always clearly differentiating between the risk-taking taking risks; and the risk-taking by building up risky large exposures to what’s perceived safe.

Also, FT could help me, a grandfather, explain to regulators that bank regulations that favor much more the refinancing of the “safer” present than that of the “riskier” future is, a violation of that holy intergenerational social contract Edmund Burke spoke about.

Martin Wolf in his Economic Forum published in 2009 an article of mine titled: “Please free us from imprudent risk aversion and give us some prudent risk-taking.” More than a decade later, that plea is still valid.

(i) Jamie Dimon, why did it take you more than three decades to explain that? 

PS. On this issue I’m not a newcomer. 

Bank supervisors/examiners as well as the banks’ own risk managers, find themselves between a rock and a hard place.

Note: This post is based on to “How Bank Oversight Failed: The Economy Changed, Regulators Didn’t” by Andrew Ackerman, Angel Au-Yeung and Hannah Miao, WSJ March 24, 2023, but it could refer to many of the articles currently being published on #SVB,

“If examiners thought the bank should prepare for a scenario such as rapid growth, soaring interest rates and abrupt loss of deposits, as later happened to SVB, examiners would be hobbled by the absence of explicit regulatory guidance calling for such preparations”

Worse! They would be hobbled by the presence of explicit regulatory guidance, namely the risk weighted bank capital/equity requirements (RWCR) based on perceived credit risks, not on misperceived risks, unexpected events or ignored risks, such as duration risk. To top it up, these requirements are based on that what’s perceived as risky is more dangerous to bank systems than what’s perceived.

That places the supervisors/examiners and the banks’ own risk managers between a rock and a hard place. 

What bank risk manager, wanting to keep his job and be paid a bonus, would currently want to address his Board of Directors with: “Our model, because of too many assets we have perceived as safe could now turn out risky, indicates that you have to raise a substantial amount of equity”?

What supervisors/examiners, would dare to argue that the Basel Committee and their other superiors, have not the faintest idea of how to regulate banks? Among other because they all clearly missed their lectures on conditional probabilities?

“Banking regulators will spend months, if not years, getting to the bottom of what happened.” Of course, they will. They do not want the world to understand what hair-raising regulatory mistake they committed.

The GFC, 2008 crisis, was much caused by the excessive exposures US investment banks and European banks held of AAA to AA rated mortgage-backed securities (MBS), against which they were required by Basel II to hold only 1.6% in capital/equity. 

Basel III introduced new capital and liquidity requirements but let the RWCR intact, which meant that on the margin, there were it most counts, the distortive effect of these were even strengthened. (Think of the “Drowning pool”)

What if an investment bank had reported to a little old lady her long-term bond holdings based on value on maturity (as banks are allowed to do), and she then suffered unexpected unaffordable losses when selling these, would it be fined? Just asking.

And what about all journalists? Will they admit they were duped/lulled into a false sense of security by reporting on strong and satisfactory levels of capital based on the naïve assumption that the risk weighted assets reported (RWA), were a valid measure of the banks' risk exposure.

Here's much more on the issue

“Age of Easy Money” ignored the risk weighted bank capital/equity requirements.

I’m stunned. 1:54 hours of a very interesting “Age of Easy Money”, that does contain one single reference to the credit risk weighted bank/equity requirements which distorted the allocation of bank credit and allowed bureaucrats and asset owners, to live on Easy Street.

James Jacoby: With all due respect, I wonder if you could be a little bit more explicit with me. What will the Fed own when it comes to the vulnerability of the system?

Neel Kashkari: Well, I reject the thesis. I actually don't think it's been the Fed's monetary policy that has led to these vulnerabilities. I think it's been incomplete regulatory policy that has led to these vulnerabilities.

My comment: Central banks’ monetary policies, e.g., liquidity injections, have to pass many corianders/strainers before reaching the economy. The most important one, bank credit allocation. Think of risk weighted bank capital requirements as one of these.

Then think of central bankers not caring about the fact that coriander/strainer contains different sized holes. Larger for “safe” government debt, residential mortgages and AAA rated assets; smaller for “risky” loans to small businesses and entrepreneurs. 

Sheila Bair: The entire business community has had a taste of bailouts. I fear that now, the Fed stepping in, not just to bail out Wall Street, but the entire corporate America, is starting to be embedded into people's thinking. People talk about the survival of capitalism, but this is the biggest threat to capitalism. In good times, when anybody can make money, you reap those profits. In bad times, the Fed just keeps stepping in. You have this never-ending ratchet up. The markets never correct.

James Jacoby: It's like a no-lose casino.

Sheila Bair: It is. It is a no-lose casino. That's exactly right

My comment: No! Its more of a doomed casino. In a roulette table, the payouts are all a direct function of the probabilities of any one of the outcomes. E.g., black or red, 50% chance, a payout of 1 plus the bet; any single number, a payout of 35 plus the bet. Imagine then that a casino regulator arguing that the gamblers should be saved from losing too much, decreed that the pay out on “safe” bets, e.g., black or red, should double. The casino would be doomed.

That’s what the perceived credit risk weighted bank capital requirements do. These allow banks to leverage much more their equity, increasing the payout, with assets perceived (or decreed, or concocted) as safe than with assets perceived as risky.

James Jacoby: Was there a concern at the White House that the Fed was running the economy too hot for too long?

Brian Deese: That is a question that I will institutionally not answer.

James Jacoby: Why?

Brian Deese: Because one of the hallmarks of our system is the independence of monetary policymaking.

My comment: Independence? Hah! Here follows the confession that seemingly shall not be heard.

“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." Paul Volcker in “Keeping at it” 2018.

My questions, to all: 

Where would the market’s “risk-free” interest rates be, if not allowing banks to earn higher risk adjusted returns on government debt? 

Would government debt (government spendings) have become as large, if not allowing banks to earn higher risk adjusted returns on government debt? 

Where would house prices be if not allowing banks to earn higher risk adjusted returns on residential mortgages?

Christopher Leonard: The financial system globally has been built around extremely low, ultra-low interest rates for 10 years.

My comment: And around bank regulations based on that what’s perceived (or decreed or concocted as safe) is more dangerous to our bank systems than what’s perceived as risky. What would Mark Twain have opined about that?

Mohamed El-Erian: In 2022, we've had this very unusual situation whereby you've made double-digit losses on both risky assets, stocks, and risk-free assets, U.S. Treasuries. That's not supposed to happen.

My question: Should it suffice for regulators to argue that what’s safe is not supposed to become risky?

Mohamed El-Erian: A big issue for retirement plans, pension systems, because no matter how well you diversified your portfolio, there was no risk mitigation in it at all.

My question: How much of current bank regulations that so much favors the refinancing the “safer” present, over the financing of the “riskier” future (a reverse mortgage) have also seeped through to contaminate retirement plans and pension systems? 

Nouriel Roubini: We have had literally a few decades of ever-increasing bubbles that have been fed and supported by central banks. And not only have we had bubbles, but we've had bubbles that have been fed by excessive leverage, excessive private and public borrowing and excessive risk-taking.

My comment: All of that, except “excessive risk-taking”. What happened was the buildup of excessive exposures to assets that were perceived, decreed or concocted as safe.

Rana Foroohar, Associate editor, Financial Times: When interest rates start to rise and the tide pulls out, as Warren Buffet would say—

Charles Duhigg: The New York Times: You don't know who's swimming naked—

My comment: With bank capital/equity requirements mostly based on perceived credit risks, not misperceived risks or unexpected events, e.g., covid, war, inflation, one should know banks will stand there naked, just when they’re needed the most, just when its hardest to raise bank equity.

James Jacoby: So I guess the question though is how much disruption in the financial markets are you willing to tolerate now that they're adjusting to this new interest rate environment, after more than a decade of zero rates?

Neel Kashkari:

We live in a market economy.

My comment: “A market economy”, with risk weighted bank capital requirements and Quantitative Easing? Sorry you have not the faintest idea of what a market economy is. Have you ever left your desk and walked on Main-street?

James Jacoby: Are you basically saying that we should be preparing right now? That there would be a bursting of this massive credit bubble?

Jim Millstein: It's happening right in front of us. It may—It's happening right now.

My opinion: Yes! What can be done? Not a full plan, but here's a start:

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

2. Debt to equity conversion should be one of the most important resolution tools.

Female newsreader: In breaking news, a U.S. Federal Reserve has bailed out the Silicon Valley Bank, which had collapsed over the weekend.

Joe Biden: There are important questions of how these banks got into the circumstance in the first place.

My comment: SVB was holding a high number of Treasury and other government bonds — amounting to more than half of its assets. Mr. President dare to ask its regulators: How much capital/equity/skin-in-the game, did SVB's shareholders need to hold against that?

James Jacoby: How do you think we’ll look back at this era of easy money?

Steven Pearlstein: Unfortunately, I think we may look back on it as something of a golden era, because cheap and free money, without consequences, is great. But in other ways, we will think about it as a lesson for the future, which is that it was a mistake.

My comment: Yes, and those after us will recognize it as a violent violation of that social intergenerational contract Edmund Burke spoke about. 

Mohamed El-Erian: I think that we're going to look back on this era as being totally exceptional historically, and one where we didn't fulfill its potential. We lost sight of something critical: We lost sight of how we grow our economy in a sustainable and inclusive fashion.

My comment: Absolutely, and all because bank regulators focused solely on the safety of banks and totally ignored what their real purpose is; way more important than safe mattresses in which to stash away cash.

Christopher Leonard: When you have a society with the middle struggling and the rich realizing almost unimaginable gains, it starts to corrode the civic foundation. People start to feel like this cliche you hear all the time: that the system is rigged.

My comment: It is rigged. The more creditworthy have always paid lower risk adjusted interest rates than the less creditworthy, and that's as it should be. But credit risk weighted bank capital/equity requirements, have also decreed the less creditworthy to be less worthy of credit. And that's not how it should be.

Mohamed El-Erian: This is a political problem.

My comment: Absolutely. It was all about empowering a Bureaucracy Autocracy.

Bank capital requirements with decreed risk weights; 0% Federal Government – 100% We the People. What would America’s Founding Fathers have opined on that?

@PerKurowski In all this, where do I come from?