We need bank regulators who do not believe themselves the risk-managers of the world

I refer to the Financial Crisis Inquiry Final Report, issued January 2011 by The National Commission on the Causes of the Financial and Economic Crisis in the United States.

Unfortunately, though it contains much valuable information and analysis, the report does not identify the fundamental cause of the crisis, namely that the bank regulator, primarily the Basel Committee, with amazing hubris, took upon itself to act as the risk-manager of the world.

In effect, when the Basel Committee set capital requirements for banks imposing risk-weights based on its arbitrary perception of the risk reflected by the credit ratings issued by the credit ratings agencies, it de-facto determined what was to be ground zero for most other risk-managers. 

In effect, it was precisely those capital requirements for banks that tempted too much the banks to enter excessively and with minuscule equity life vests the triple-A waters, where they drowned.

In effect, those arbitrary capital requirements cause an odious and regressive discrimination requiring from those perceived as risky and who already pay higher interests rates, to carry an inordinate weight of the capital requirements of banks that is needed to support the system; effectively subsidizing those perceived ex-ante as having “low risks” and who therefore already pay lower interest rates.

In effect, from a regulatory point of view those capital requirements based on perceived risks, are plain silly, knowing that what causes systemic disasters in banking are always those risks that have not been perceived or are ignored by the collective.

It is very urgent we throw out the paradigm of capital requirements for banks based on perceived risk of default, which only distorts the markets and serves no purpose at all. But that will not happen until the problem is fully understood, and sadly it looks like, with this report, that the world missed another good opportunity.

PS. Sadly the Academia has kept total silence on how these regulations have dangerously distorted the allocation of credit.

Old Lady, careful, the “risky” should not be asked to bear the risks of the “not risky”.

Bank of England economist David Miles has suggested that UK banks should hold double the amount of capital than that prescribed by Basel III.

Of course Old Lady (Bank of England) is right in that the capital requirements for banks should be doubled and more… but only for those loan and investments where they have been proven insufficient… like all those operations which included triple-A ratings and where the risk-weight applied was a minuscule 20%.

But, for all those operations where the risk-weights were 100%, like when lending to “risky” small businesses and entrepreneurs, the capital requirements have proven more than sufficient… and should not go up one iota…that is unless one holds that those perceived as “risky” should subsidize the capital requirements needed to support those perceived as not risky. Does Old Lady think that? I don’t think so… but I am not sure they are aware of this argument.

We need to fire the self appointed supreme risk manager of the world!

When the Basel Committee on Banking Supervision decreed capital requirements for banks that resulted from assigning risk-weights based on the risk of default, as perceived by the credit rating agencies… with incredible hubris they took upon themselves to act in the role of supreme risk manager of the world.

How have they been doing? Worse than lousy! Basel II failed monumentally only 3 years after its approval in June 2004.

As an Executive Director in the World Bank, 2002-2004, and in many published articles since 1997, I protested loudly the regulatory paradigm that the Basel Committee is built upon, and I warned precisely about those risks that caused the current crisis.

With whatever credibility that should give me I guarantee you that the Basel Committee, with their Basel III, is only digging us and our banks further down into the hole where they placed us.

The role of a bank regulator is not to guard us against those risks of default perceived by credit rating agencies, and which are therefore also perceived by the markets and by the banks. No bank crisis has ever resulted from excessive lending or investments in what is perceived as risky… they have all resulted from excessive lending or investment in what was ex-ante perceived as not risky. Therefore the fundamental role of a bank regulator is to take precautions against those risks that might not have been perceived.

The role of a bank regulator, more than guard us against bank failures, is to guard us against the risk that the banks and whom the tax payers lend so much support to, do not serve their purpose for the society… and the Basel Committee has not yet said even one single word about what the purpose of the banks should be.

Let absolutely no one regulate before they do state the full purpose of the entities they are regulating… and that “purpose” has of course been deemed acceptable to us.

The principle of bank regulations that has been and is so rudely violated

Regulators should accept that bankers believe they can master quite adequately the risks of default. Who would want to deal with a banker who does not believe so?

But in the same vein the regulators should always tell the bankers “No you can’t… and besides there are so many other risks to be considered than just avoiding the defaults of your clients and the defaults of yourselves”.

And foremost regulators should never ever themselves become risk-managers… a principle that was and is so rudely violated.

It is bad enough when regulators fall for the sales pitch of bankers and believe too much in their risk-management ability, but so much worse when the regulators arrogantly believe, as they currently do, that they know themselves what the risks are and that they know themselves how to properly manage and master these… with or without a little help from the credit rating agencies.

A credit rating sends out on its own a very positive or negative signal to the market. When regulators based the capital requirements of banks on those same credit ratings, they dramatically augmented the strength of those signals… to such an extent that banks went and drowned themselves in triple-A rated waters wearing no capital at all… to such an extent that lending to the “risky” small businesses and entrepreneurs has come to a halt because that requires too much capital, especially when bank capital is very scarce as a result of having invested or lent too much to the ex-ante “not risky”.

Currently the regulators, who like risk-managers already failed in conquering some simple risks of defaults, when foolishly playing around with their capital requirements based on perceived risks, and ignoring that systemic crisis never ever results from timely perceived risks, are now tackling more God-like events like pro-cyclicality. God help us!

The bank crisis and the Basel Committee banking regulations explained to a golfer

Once there was a Golf Club with a somewhat narrow golf course and where, even though the members were very careful, sometimes the hooking or slicing of the golf balls into adjacent holes, caused some serious accidents.

The Club’s Board was ordered to find a solution. To that effect the elected members of the Board consulted with some Experts and asked for recommendations. The Experts told the Board “most of the slicing and hooking is the product of bad players and so, if you want to solve this problem, you need to get rid of them”. Knowing this idea would not be received with much enthusiasm, and could in fact pose a direct threat to their reelection as members of the Board, they all decided to immediately delegate the “how to” to a Committee of Experts.

The Committee of Experts decided they needed to appoint some Golf-Player Rating Agencies (GPRAs) to rate the real quality of the players and thereafter created a parallel handicap adjustment requirement that effectively eliminated the bad players… without these even noticing it. According to their ratings, the AAA rated players had their normal handicap increased by 5 strokes, while the players rated B- or worse had their normal handicaps officially reduced by 5 strokes.

It worked! Though, just initially… Since having to play with a very low handicap was pure hell for a bad player, most of the bad players rapidly decided to change clubs and, as a result, the Club gained immense recognition for having the best players and being the safest club in the country… and the Committee of Experts was wildly acclaimed for having true experts. We will never ever have more accidents in our Club… was the Board’s self congratulatory message at the year’s end… four years ago.

But life is life, even among golfers, even in a golf club… and so the membership of the Club started changing. For instance, many great golfing has-beens around the country were attracted by a system that so clearly could help to pro-cyclically prolong their golf-life, just like many never-able-to-be-good players were also attracted by the possibility of joining a club renowned for having exclusively good golf players… and so they all started to read up and converse with the GPRAs about what was necessary in order to be conveniently rated.

There was such an avalanche of enquiries that the GPRAs got confused and overworked and started to make mistakes… to such an extent that the Club rapidly became overcrowded with dubiously rated golf-players. This would, of course, not have meant anything in the old days, but, since everyone had been duly informed that the accidents had been forever eliminated and that therefore there was no need for being careful… the accident rate shot up and rapidly turned, three years ago, into a pandemic disaster that threatens even the survival of the Club… and aggravated by the fact that the beginners and the decent-bad players, those who really are the heart and soul and economical support of a golf club, want nothing to do with a club that has a handicap system that so harshly discriminates against them, and have therefore joined other clubs.

But, golfing friends, the saddest part of this story is that since the logic of “getting rid of bad players and allowing only good players” sounds so very attractive and so very logical, the Board has not even today understood what they did wrong and so they insist on using exactly the same Committee of Experts to come up with better solutions. And the Committee of Experts is currently studying only refinements of their original handicap adjustment requirement formulas because, as “experts”, they cannot under any circumstances acknowledge that they were so fundamentally wrong.

And, unfortunately, the local media has not been sufficiently “without fear and without favour” to dare to really fundamentally question the wisdom of the local Club´s Board or of the Committee of Experts.

PS. What if golf, roulette, horse-racing or tennis had fallen into the hands of a Basel Committee?

The short and true story of the financial crisis

This crisis originated in what are supposedly very safe assets, houses and mortgages, in what is supposedly the strongest and financially safest country, the USA, and in what are supposedly the absolute safest instruments, the triple-A rated. When we then hear even Nobel Prize winners talking about excessive-risk taking, it should be clear to all of us that something very serious has happened to risk. It happened in Basel.

The Basel Committee on Banking Supervision, in their irrational fear of bank defaults, while forcing the banks to have 8 percent of equity when lending to “risky” small companies or entrepreneurs, completely ignored the fact that bank crisis originate only where ex-ante risks are perceived as low, and allowed the banks to hold only 1.6 percent in capital when investing in triple-A rated securities, like those backed with lousily awarded mortgages to the subprime sector, or when lending to sovereigns rated A+ to A like Greece, and which implied allowing the banks to leverage 62.5 to 1, 

Of course, needing less capital when doing business with the “less risky”, made the profitability of bank business with the “less risky” shoot up to the skies, and so the banks forgot all the small businesses and entrepreneurs, and gorged up anything that had a good rating on it… until they choked on the triple-As and the Greeces of the world.

God make us daring!

Asking about Propositum Bancos could help the Basel Committee break the Confundus spell.

Surely the Basel Committee must know by now that no matter how poorly defined their basic capital requirement for banks of 8% of the assets was in Basel II, this was not what caused many banks to hold insufficient capital. That was entirely the consequence of those so faulty risk-weights applied, those which for instance when investing in triple-A rated securities such as those collateralized with lousily awarded mortgages to the subprime sector, or lending to countries like Greece and Ireland, allowed banks to hold only 20% of the 8%, 1.6%, and therefore being able to leverage their capital 62.5 times to 1.

The basic mistake that caused Basel II to be so shamefully inappropriate was that the Basel Committee explicitly ignored the fact that perceived risk of default is already cleared for in the market by means of the risk premiums charged and so making a difference for it in the capital requirements accounts twice for the same risk. And that leads to making access for those perceived as less risky even easier and cheaper, creating the perfect storm conditions as bank crisis only occur because of excessive investments or lending to what is ex-ante perceived as not risky; and causes that those who already have difficulties accessing bank credit at a reasonable rate, like the small business and entrepreneurs, will find it even harder and more onerous to do so.

But the Basel Committee, instead of tackling the fundamental weakness of Basel II, the risk-weights, is in Basel III working on important but yet marginal issues. Clearly the lower but much stricter and cleared defined basic capital requirement of 7 percent announced is an improvement, but, its final effectiveness depends 100% on correcting the issue of the risk-weights... and which basically means throwing them out completely.

And that is why we get so nervous when according to re-“Calibrating regulatory minimum capital requirements and capital buffers: a top-down approach” October 2010 we read of how the Basel Committee tries to capture empirical knowledge by analyzing the “Return on Risk-Weighted Assets” completely ignoring that risk-weighted assets when weighted with their risk weights have no real meaning at all.

Clearly the Basel Committee has fallen under that spell identified by J.K. Rowling as “Confundus” (causes the victim to become confused, befuddled) and the first order of day must be to break it. How can it be achieved? First, we need to get rid of those regulators in the Basel Committee who are way beyond any salvage; and then we must awake the rest by asking the magical question “Propositum Bancos”… what is the purpose of the banks?

Of course too many banks should not fail by not being able to maintain sufficient capital to survive throughout a significant sector-wide downturn, but that is more of a minimum requirement, a restriction, and not at all a purpose. If we, after their huge failure, are to allow the Basel Committee on Banking Supervision to keep on regulating globally the banks, the least they should tell us is what they think the purpose of the banks is, and we should be able to agree on that.

Does the devil reside in Basel?

The following is a verse of a Swedish psalm (244).

“God, from your house, our refuge, you call us, out to a world where many risks await us.

As one with your world, you want us to live. God make us daring!”

“God make us daring!” expresses extraordinarily well the need that society has of risk-taking, in order to move forward, so as not to start rotting.

Unfortunately that is a need that our current global bank regulators, the Basel Committee, has not the least understanding of. They give banks huge incentives to operate in areas where risks are perceived as low, as if bankers would not do enough of that of their own will, and punish banks when entering areas where risks are perceived as high, as if bankers would not, on their own will, mostly avoid those.

The regulatory risk-adverseness is clearly evidenced by that banks, when lending to a small business or an entrepreneur, are now required to hold FIVE TIMES as much capital than when lending to a triple-A rated entrepreneur. That signifies that although the banks already compensate for perceived risk of default by charging different risk premiums, they have now to discriminate twice on that perception having to charge different premiums with relation to capital requirements.

As a result small businesses or entrepreneurs have their access to bank credit curtailed and their borrowings made much more onerous than needed, while those perceived as less risky have more access and cheaper access to bank credit than what they would otherwise have.

As a result we are suffering a huge financial crisis that has precisely resulted from what is always the cause of bank crisis, excessive investments and lending to what ex-ante is perceived as having a low risk of default, because, of course, no financial nor bank crisis has ever resulted from excessive investments and lending to what ex-ante is perceived as having a high risk of default.

We need to stop this regulatory nonsense that is killing the vitality of our economies. There is nothing as so risky long term as turning into cowards unwilling to run risks… and the Basel Committee has no right or reason for tempting the world into believing that development and growth can take place in a park with only safe attractions, only because the regulators are so childishly frightened of their so innocent and even indispensable default monsters. Scary is a world without defaults!

What about the risk of billions of young people around the globe not finding jobs? That is a real risk to write home about!

Let us never forget that the door to enter into a better and more sustainable, and more job-rich future, might only be found by taking the craziest risks in the middle of the craziest boom… that’s life… that’s development.

Honestly, the current risk weighted capital requirements for banks, are an insolence to the memory our risk-taking forefathers.

Scary indeed!

Over 90 percent of the direct explanation of this crisis is to be found in the more than two trillions lost over a very short period of time, in triple-A rated securities collateralized by lousily awarded mortgages in the subprime sector. The marketability of these securities, and of the value of an AIG´s triple-A ratings, had been so extremely, almost obnoxiously, increased by the Basel Committee when they, in June 2004, with Basel II, allowed the banks to invest in these securities requiring only a 1.6 percent of a quiet loosely defined capital, signifying that the banks could leverage their equity over 60 times, signifying that if a bank expected to made a .5 percent margin on a triple-A rated securities they could make over 30 percent of return on their equity.

I just saw the “Inside Job” the film about “The Global economic crisis of 2008 cost ten millions of people their savings, their jobs, and their home. This is how it happened”. The movie is promoted as “Scarier than anything Wes Craven and John Carpenter have ever made”

Covering in a good and expensive production almost all under the sun, like money laundering by Riggs bank for Pinochet, academicians writing papers without disclosing that they have been paid to do so, the role of prostitutes and cocaine in finance, as well as most of the other actors we have seen related to this crisis over the last couple of years, the movie does not mention, not even once, the Basel Committee and it brethren the Financial Stability Board; just like the recent over 2.000 pages of financial reform approved by the US Congress does not mention them either.

Since the Basel Committee and the Financial Stability Board are now preparing Basel III, that is indeed as scary as it gets!

Mary and Richard Corliss of the Time opine “If you´re not ENRAGED by the end of the movie, you weren´t paying attention”. I paid much attention and by the end of the movie I was also enraged AT the movie.

The financial crisis: What went wrong and what to do… in the eyes of an interested and concerned citizen observer.

In explaining the current financial crisis there are some very few pieces that allow for a quite clear image of the final puzzle and are obviously needed in order to find the best way to avoid repeating the same mistake… and so that we could at least give some new mistakes a chance to show what they´re worth.

1st piece: The Basel Committee had decided that the only risk it needed to consider with respect to the banking system was the risk that banks lent or invested in operations that could default. All other risks related to whether banks fulfilled adequately their capital allocation responsibilities, were taken off the table.

2nd piece: The Basel Committee because of its hysterical aversion of risk turned a blind eye to the fact that all bank crisis have resulted from excessive lending or investment in what was perceived ex-ante as having a low risk of default and never from excessive lending or investment in what ex-ante was perceived as having a high risk of default.

3rd piece: The Basel Committee, when determining the risk-weights by which it arbitrarily discriminated on the risk of default, amazingly ignored the fact that the market and the banks already clear for risks by the risk premiums they charge in interest rates, and so ex-ante perceived low risk was twice benefitted while ex-ante perceived higher risk were twice punished.

4th piece: The regulators naively ignored that the oligopoly of risk surveyors they empowered, the credit rating agencies, where human fallible and could also be captured. There has been a lot of comments with respect to the excessive trust placed by banks and markets in general in the “opinions” of the credit rating agencies but, if there is anyone that has showed the way for such excessive trust, that is of course the Basel Committee itself.

5th piece: On June 26 2004 the G10 substituted the 30 pages long Basel I adopted in 1988 with the 251 pages long Basel II, which allowed a bank to hold only 1.6 percent of fairly loosely defined capital (8 percent basic capital requirement multiplied by its 20 percent risk-weight) when lending or investing in anything related to a private triple-A rated client or security; which signified that a bank could leverage its equity on those operations to 62.5 to 1; which signified that if a bank expected to make a margin of .5 percent on a triple-A rated operation, it could expect a return on its capital of 31.25 percent a year.

6th piece: The primary and really only detonator of this crisis were the over two trillion dollars from all over the world invested and lost in triple-A rated securities collateralized with very badly awarded mortgages to the subprime sector. The market, as markets do, in response to a really mindboggling acceleration in demand after mid 2004 for triple-A rated securities, and because almost by definition real triple-A financial operations are extremely scarce, resorted to fabricate and supply fake Potemkin-triple-A ratings.

What are the first conclusions we should draw when seeing the image these six pieces create?

1st conclusion: If we are going to have global regulators, which we will need, it absolutely behooves us to make sure those regulators are chosen from an extremely diversified pool of talents, since the least we need is to allow for creation of incestuous mutual admiration clubs… like the Basel Committee is. We need urgently to change at least 80 percent of the professionals involved with the Basel Committee and guarantee the existence of multidisciplinary professional participation. Think of it, if the challenge of global climate change is placed into the hands of something like the current Basel Committee, we are all toast, before it even begins to heat up!

2nd conclusion: Before regulating the banks we need to define what the purpose of banks is. As just mattresses to stash away cash, mattresses might be better. For this the world, but especially the submerging countries, need to reconsider completely the issue of what is the necessary risk-taking a society must be willing to absorb in order to move forward.

3rd conclusion: Throw away the capital requirements for banks based on ex-ante perceived risk of default as fast as possible. As long as small businesses and entrepreneurs are discriminated to such an extent that banks need to hold 5 TIMES as much capital when lending to them when compared to when lending to triple-A rated clients, there is no sustainable way out of this crisis nor sufficient job creation.

4th conclusion: We also need all to work ourselves out of that amazing regulatory bias in favor of big governments represented by the fact that when banks lend to a triple-A rated sovereign, they need zero capital; a distortion that among others hinders us from seeing the real interest rates on public debt.

The mystery of the unconnected dots!

We have two outstanding pieces of evidence that can help us understand the current financial crisis and therefore help us to avoid repeating the same mistake… and so we could at least give new mistakes a chance to show what they are worth.

The first evidence is the really mindboggling acceleration in demand after mid 2004 for securities rated triple-A and which led to over two trillion dollars from all over the world to be invested and lost in securities which were collateralized with very badly awarded mortgages to the subprime sector.

The second evidence is represented by two dates and one piece of bank regulations:

On April 28, 2004 in an Open Meeting the SEC discussed "Alternative Net Capital Requirements for Broker-Dealers that are Part of Consolidated Supervised Facilities and Supervised Investment Bank Holding Companies" and in both cases it was approved that the respective parties “would be required periodically to provide [their respective] Commission with consolidated computations of allowable capital and risk allowances (or other capital assessment) consistent with the Basel Standards." In other words, that day, the SEC, almost explicitly, delegated some of its fundamental functions to the Basel Committee.

On June 26 2004 the G10 substituted the 30 pages long Basel I adopted in 1988 with the 251 pages long Basel II.

And Basel II, required for instance a bank to hold if it wanted to invest in triple-A rated private securities only 1.6 percent of fairly loosely defined capital, signifying that the bank was there allowed to leverage a quite loosely defined capital 62.5 to 1, signifying that if a Bank bought a triple-A rated security on which it expected to make a margin of .5 percent that it could expect a return on its capital of 31.25 percent a year. Needless to say the banks went berserk demanding triple-A rated securities. And since there were not sufficient real triple-A securities, the market, as markets do, supplied them with fake Potemkin-triple-A ratings.

It should not be difficult to connect the dots for anyone who wants to connect the dots and so the big lingering question about this crisis and its explanation remains… why do so very few experts want to connect the dots? A real mystery!

What do I, Per Kurowski, want with respect to the current bank regulations?

I want the current capital requirements for banks based on perceived risk of default concocted by the Basel Committee to be thrown out forever.

Why do I want that?

1st because these capital requirements ignore that the risk of default, as perceived, among other by the credit rating agencies, is already taken care of by the risk premiums charged by the markets and the banks, and so we end double counting for the same perceived default risk; which causes those who already are benefitted by lower interest rates, because they are perceived as having a low risk of return, to be additionally benefitted by having to provide a return on less capital; and punishes additionally those who already have to pay higher interest rates because they are perceived as “risky”, by means of having to provide a satisfactory return on more bank capital.

2nd because the more we strengthen the basic capital requirements like for instance going from a very wishy-washy 8 percent in Basel II to a more solid composed 7 percent in Basel III the more damage will the discrimination produced by the risk-weights cause.

3rd because the risk of default compared to many other risks we face, like climate change or a world with billions of young people with no jobs, is really a minor and almost innocent risk that is an integral part of an operating market, something which becomes even more apparent if we think about the possibilities of markets without defaults and which, of course, could only end up with the mother of the mother of all the too-big-to-fail banks.

4th because it is always dangerous to identify and empower a risk-assessment oligopoly of credit rating agencies, which will leverage whatever mistakes they make on their own or because they are captured.

5th because in order to go forward and not stagnate and fade away humanity always needs a hefty dose of risk-taking, and you can therefore not allow that the banks turn solely into mattresses, where to stash away your savings. To accept sending your children away to war where they could die but at the same time arbitrarily make it harder for young entrepreneurs to access the capital he feels he needs to take himself, and us, forward, does not seem like a reasonably balances proposition.

Why would they want to give it to me?

1st since the regulators have recently been reminded of the fact that all monstrous financial and bank crisis always occur because of excessive investments in what is perceived as not risky, the triple-A rated of each time, and never because of excessive investments or lending to like what is considered as not risky, that should get them thinking. Don’t you think so?

2nd because it is obvious that we need to give small businesses and entrepreneurs, of any age, more fair access to bank credit if they are going to have a chance to make something useful out of all that cash thrown on the economy by fiscal spending and quantitative easing. For your information, right now, the banks when lending to small businesses or entrepreneurs, because their Basel decreed risk-weight is 100 percent, need to have 5 TIMES as much capital than when lending to a triple-A rated client whose Basel decreed risk-weight are merely 20 percent.

And would that be all?

Absolutely not! If we are going to have global regulators, which we will need, it absolutely behooves us to make sure those regulators are chosen from an extremely diversified pool of talents, since the least we need is to allow for creation of incestuous mutual admiration clubs… like the Basel Committee is. Think of it, if the challenge of global climate change is placed into the hands of something like the current Basel Committee, we are all toast.

Are these extravagant wishes?

I don’t think so. Do you?

Capital requirements for banks based on job creation, makes more sense than those based on risk of default.

And there they are again, the G20, now in South Korea, lost for words, but yet babbling.

If I were to be given one minute of voice there, I would ask all of them to throw away the capital requirements based on the risk of default, because the risk of default is already being priced in the interest rates of the market, so there’s no need to discriminate through bank regulations against the unrated small businesses and other “risky” elements.

And, if the government official could just not resist meddling with the markets, then I would suggest them to impose capital requirements for banks based on the job creation potential of the borrower… more jobs less capital less jobs more capital… I mean, is not to help create job a primary function of banks?

But, of course, history has recently taught us that we need to be very careful with the job-creation-rating-agencies we empower.

Members of the Basel Committee consider yourselves insulted and challenged

The Basel Committee of Banking Supervision, that extremely important global regulatory agency, instructed the credit rating agencies to set up their warnings sign of perceived risk of default, ordered the banks to follow these signs, and then proceeded to calibrate the capital requirements of banks as if the banks did not see them. Somewhat like setting up traffic-lights all over town and synchronizing them under the assumption that drivers are blind.

Of course, if the regulators wanted to calibrate adequately for the default risk of any bank exposure to any credit rating, they could only do so by taking into account how the banks would react to those credit ratings…as well as considering the banks’ relative exposure to the different credit ratings. If a bank lends only to triple-A rated clients then its systemic danger, is only represented by its triple-A rated clients.

Since perceived risk is cleared in the market through the interest rates charged, this has signified that the relative profitability for the banks of lending to what is perceived as not risky, like what has a triple-A rating, increased dramatically, while the relative profitability for the banks of lending to what is perceived as more risky, like unrated small business and entrepreneurs, decreased.

Knowing as we should know that no bank crisis has ever resulted from excessive lending to what is perceived risky and that they have all resulted from excessive investments to what is perceived ex-ante as not risky, applying the Basel Committee’s current regulatory paradigm of capital requirements based on risk results clearly in counterfactual and stupid regulations. Also, since the most important role of commercial banks is to help satisfy the financial needs of those who are perceived as more risky and have not yet access to the capital markets, the odious discrimination against these clients (who are already paying much higher interest rates into the capital of banks) is doubly stupid.

If by any chance the issue of regulating on climate change would fall in the lap of an entity like the Basel Committee… we would all be toast.

For over a decade, even as an Executive Director of the World Bank 2002-2004 and always under my own name and indicating my email, I have presented many arguments against the current central regulatory paradigm use by the Basel Committee, that of capital requirements based on perceived risk of default, and called it stupid, stupid, stupid!

And by the way, if the regulators absolutely have an existential need to calibrate for risks, what is so particularly risky with defaults? Is not the risk of not creating jobs or the risk of increased un-sustainability worse? Does not just to think of a world without defaults make you shiver?

Having said that, not once, in all these years, has anyone identified as having anything to do with the Basel Committee ever denied my accusations, presented any counter-argument, or shown the least willingness to discuss the issue. Is it not strange? Could it really be that little me is right and these so expert experts are so utterly wrong? I dare them to prove me wrong!

In October 2010, during the annual meetings of the International Monetary Fund I publicly asked “Right now, when a bank lends money to a small business or an entrepreneur it needs to put up 5 TIMES more capital than when lending to a triple-A rated clients. When is the IMF to speak out against such odious discrimination that affects development and job creation, for no good particular reason since bank and financial crisis have never occurred because of excessive investments or lending to clients perceived as risky?” Dominique Strauss-Kahn, IMF’s Managing Director, answered in no uncertain terms that “capital requirement discrimination has no reason to be”, and so it seems that there are also other who agree with that the Basel Committee stands there completely naked without a functional regulatory paradigm.

In this moment when an extremely serious financial crisis affects the world and when the Basel Committee is digging us even deeper in the hole they placed us in, would we all not feel more comfortable if the Basel Committee at least agreed to a public debate on what I criticize?

Therefore…members and professionals of the Basel Committee consider yourselves slapped on the face with a glove and dared to accept the challenge. Wear with dignity your cones of shame!

Want a more detailed explanation? Listen to this home made video
http://subprimeregulations.blogspot.com/2010/09/the-financial-crisis-simple-why-and.html

Per Kurowski   @Per Kurowski

PS. I appreciate any help I could get in provoking the Basel Committee to respond to this challenge

PS. Risk taking is the oxygen of any development. God Make Us Daring!

PS. Has the Basel Committee just suffered the Nut Island effect? 

PS. US Congress, what are you up to? Over 2.000 pages of financial reform and you do not even mention once the Basel Committee which has so messed up the capital requirements of your banks.

PS. A small numeric example: If banks were allowed to leverage only 12.5 to 1 when lending to triple-A rated clients, which is what they were allowed to leverage when lending to small businesses under Basel II, then if they made a .5% margin, they would obtain return on capital of 6.25% lending to AAAs, decent but nothing to write home about, less pay bonuses on. But since they were allowed to leverage 62.5 to 1 they could, with the same .5% margin then make a return of capital of 31.25%. No wonder banks stampeded wanting the AAAs!

PS. A visitor from outer space, observing that banks are required to have 8% of equity when lending to a small businesses, but zero% when lending to a triple-A rated sovereign as the US, would he be at fault thinking he had landed on a communistic planet? With such an arbitrary discrimination in favor of the public sector, do you really know the real market interest rates on public debt?

PS. Since I am no regulator, or a PhD with published research on the subject, here are some of my early opinions on these regulations, which should evidence that I am far from being  very few pieces just another Monday morning quarterback:

http://subprimeregulations.blogspot.com/
http://financefordevelopment.blogspot.com/
http://baselcommittee.blogspot.com/
http://teawithft.blogspot.com/search/label/subprime%20banking%20regulations
http://www.theaaa-bomb.blogspot.com/

God make us daring!

Update: In 2025 I dialogued with ChatGPT on risk aversion, bank regulation and the role that Christian churches should play

It opined: "Churches around the world could inject a much-needed ethical dimension into a conversation dominated by technical and economic considerations."

Original post

GOD MAKE US DARING!

Matthew 17:7 Jesus came up, touched them, and said, “Get up; don’t be afraid.”

Matthew 14:26-27 When the disciples saw Jesus, walking on the lake, they were terrified. It’s a ghost,” Jesus said: “Take courage! It is I. Don’t be afraid”

"Be not afraid. Open wide the doors to Christ." Pope John Paul 1978

The Western World was built-up with a lot of risk-taking but, 1988, one year before the fall of the Berlin Wall, its  regulators, with risk weighted bank capital requirements, imposed on its banks a dangerous risk aversion.

A Swedish psalm 288 Text: F Kaan 1968 B G Hallqvist 1970

Gud, från ditt hus, vår tillflykt, du oss kallar

ut i en värld där stora risker väntar.

Ett med din värld, så vill du vi skall leva.

Gud, gör oss djärva!

“God, from your house, our refuge, you call us

out to a world where many risks await us. 

As one with your world, you want us to live.

God make us daring!”

“God make us daring!” That is indeed a prayer that the regulators in the Basel Committee for Banking Supervision do not even begin to understand the need for.

The Parable of Talents

In 2000, Pope John Paul II reminded us that Jesus Christ invited the Apostle to "put out into the deep" for a catch: "Duc in Altum" (Lk5:2) "When they had done this, they caught a great number of fish" (Lk5:6). That's something regulators should remember when, with their risk weighted capital requirements, they want our banks to fish only from “safe” shores.

And Pope Francis addressing the European Parliament in 2014, might have delicately phrased its risk-aversion with: “In many quarters we encounter a general impression of weariness and aging, of a Europe which is now a “grandmother”, no longer fertile and vibrant. As a result, the great ideas which once inspired Europe seem to have lost their attraction, only to be replaced by the bureaucratic technicalities of its institutions”

“A ship in harbor is safe, but that is not what ships are for.” John A Shedd.

“A decline in courage is particularly noticeable among the ruling and intellectual elites, causing an impression of a loss of courage by the entire society. There remain many courageous individuals, but they have no influence.” Alexander Solzhenitsyn's Commencement Address, Harvard University, 1978

In “Against the Gods” Peter L. Bernstein writes that the boundary between the modern times and the past is the mastery of risk, since for those who believe that everything was in God’s hands, risk management, probability, and statistics, must have seemed quite irrelevant. Today, when seeing so much risk managing, I cannot but speculate on whether we are not leaving out God’s hand, just a little bit too much.

And all for nothing! At the end of the day the current risk-weighted capital requirements for banks guarantees especially large bank crises, caused by especially large exposures to something ex ante perceived, decreed or concocted as especially safe, and which ex post turns into being especially risky, while being held against especially little capital.

Here is a letter to the Financial Stability Board

Here is a letter to the IMF

Here is an aide-mémoire on what is so wrong with the current risk weighted capital requirements for banks.

And here is #AI, trained on human intelligence, opining on regulatory risk aversion. 

Excuse me… what calibration?

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

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

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

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

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

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

What are we to do with the Financial Stability Board?

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

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

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

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

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

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

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

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

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

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

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

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

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

Sort of like Basel Committee shocked!

The Basel Committee on Banking Supervision is guilty of gross negligence

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

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

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

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

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

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

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

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