Saturday, December 20, 2014

Europe, a future built by avoiding risks, is as risky as futures come.

Europe, your bank regulators allow, your banks, to earn much higher risk adjusted returns on equity with assets perceived as absolutely safe than with assets perceived as risky.

And that means that an enormous amount of small businesses and entrepreneurs, only account of being perceived as more risky credit risks, are being denied fair access to bank credit.

And with that the European youth is being denied the job creation their parents got.

Risk-aversion is not a good building block for a better future. Any current risk aversion just eats into the prosperity achieved by old risk-taking… until there is no prosperity left.

Europe, you can’t pick and choose. What’s safe today was most probably very risky yesterday. Risks and safety are part of the same world.

Europe, your pusillanimous nannying bank regulators are too dangerous… and you better wake up to that fact before its too late.

Europe, I do not think your bank regulators are doing this to you on purpose. Otherwise they should be hauled in front of courts for committing crimes against humanity.

Thursday, December 18, 2014

Is telling banks “make your profits where it’s safe and stay away from what’s risky” an un-American act of cowardice?

I have heard many comments indicating as an “un-American act of cowardice”, that Sony cancelled the release of “The Interview”, after North Korean government hackers penetrated the studio's computers and threatened to attack theaters that showed the movie. 

I will not get into that but I would though take this opportunity to pop a question of my own on that epithet.

Currently regulations allow banks to hold much less capital (meaning equity) against assets perceived as absolutely safe than against assets perceived as risky; which allows banks to leverage their equity much more against assets perceived as absolutely safe than against assets perceived as risky; which of course means that banks will make much higher risk-adjusted returns on equity on assets perceived as absolutely safe than on assets perceived as risky… and which effectively means regulators are telling the banks “Go and make your profits where it is safe and stay away from the risky”. 

With that are not regulators inciting the banks in the Land of the Free and the Home of the Brave to commit un-American acts of cowardice?

Tuesday, December 16, 2014

What would have happened if Basel capital requirements for banks were lower for what’s “risky” than for what’s “safe”?

Many things! Among other:

First, since banks would then not be able to leverage their equity as much as they could with assets perceived as “absolutely safe”, then the risk of traditional bank crises those which result from excessive exposures to what is erroneously perceived as absolutely safe, would of course be lower. And, to top it up, if these were to occur, they would at least find banks covered with much more equity…not standing there bare-naked as now.

Second, the whole procedure of how to game the regulations would change 180 degrees. Instead of having a vested interest in dressing up assets as “absolutely safe”, they would want to dress up assets as “more risky” than they are… and that process would certainly faced more objections, since borrowers and lenders would definitely not share the same objective.

Third, small businesses and entrepreneurs would find it much easier to break that curse described by Mark Twain, of bankers being those who lend you the umbrella when the sun shines and wanting it back as soon as it looks like it is going to rain.

Fourth, it would be harder for too big to fail banks to grow, since low capital requirements hormones are not as effective where it is risky than where it is safe.

Fifth, there would be more “safe” investments available, for you, for me, and for the widows and orphans.

Sadly bank regulators went for an automatic decision: “safe is safe and risky is risky”; and did not take time to deliberate sufficiently on the fact that there where too many empirical evidences that, at least in banking, “risky” was usually safe but that “absolutely safe” could turn into horribly risky.

And here we are… and bank regulators have still not learned that lesson :-(

PS. This is not a proposal... just doing some speculative thinking :-)

Friday, December 12, 2014

The Basel Committee seems not to get it, and therefore insists on being dumb... or?

I have just read the Basel Committee’s “Revisions to the securitization framework”. In it they have approved to “reduce the reliance on external ratings”… as if that was the real problem.

Whoever is the perceiver of risks, internal or external, if the perceived risks used are correct, then banks would need no capital… and any bank then in problem, should better just be put out of business… as fast as possible. 

The real systemic dangerous problem arises when those risk perceptions of are wrong…and that is why it is so silly to have capital (equity) requirements for banks based on the used perceived risks being correct… independently of who is the perceiver of these risks… internal or external. 

Though in fact, since the more credible the “risk perceiver” is, the bigger is the risk of creating potentially dangerous exposures, the Basel Committee might have opted for a strategy of decreasing the credibility of the risk perceivers… if so it is undoubtedly an interesting development... 

At least the Basel Commitee could finally be understanding what I meant when in the Financial Times, in January 2003 I wrote: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds”

Tuesday, December 9, 2014

Bank regulators originated and institutionalized a “market imperfection”, causing less equality in opportunities

In presence of financial market imperfections, implying that the ability to invest of different individuals depends on their income or wealth level. If this is the case, poor individuals may not be able to afford worthwhile investments… In turn, under-investment by the poor implies that aggregate output would be lower than in the case of perfect financial markets (5). We will refer to this view, first formalized by Galor and Zeira (1993, 1998), as the “human capital accumulation” theory. (6)

(5) With perfect financial markets, all individuals would invest in the same (optimal) amount of capital, equalizing the marginal returns of investment to the interest rate. This occurs as complete markets allow poor individuals, whose initial wealth would not allow reaching the optimal amount of investment, to borrow from the rich (infra-marginal gains from trade). If, on the contrary, financial markets are not available, and the returns to individual investment projects are decreasing, under-investment by the poor implies that aggregate output would be lower, a loss which would in general increase in the degree of wealth heterogeneity (see e.g. Benabou, 1996; Aghion et al, 1999).

(6) Aghion and Bolton (1997) and Piketty (1997) explicitly modeled the supply side of the credit market, explaining imperfections based on moral-hazard (e.g. problems of input verifiability) or enforcement problems stemming from contract incompleteness (e.g. due to output verifiability). Moral-hazard would occur, for example, with limited liability (i.e. when a borrower's repayment to his lenders cannot be greater than his wealth); if the probability of success of the project depends on a (costly) effort exerted by the borrower, her incentives to exert efforts would be lower the larger the fraction of externally financed investment. Thus the interest rate on the loan will be an increasing function of its size (i.e. higher for the poorer).

And that provides me with a new opportunity to try to draw the attention to how bank regulators, during the last couple of decades, have originated and institutionalized a truly odious and discriminatory capital market imperfection.

The Basel Committee for Banking Supervision imposed credit-risk-weighted capital (equity) requirements for banks which are much much lower for assets perceived as “absolutely safe” than for assets perceived as “risky”.

And, of course, what is perceived as “absolutely safe”, correlates much more with wealth than what is perceived as risky.

And, of course, what is perceived as “absolutely safe”, correlates much more with what already exists (history) than with the riskier future.

And that allows banks to make much much higher risk adjusted returns on equity when lending to those perceived as safe (like the "infallible sovereigns", the AAAristocracy and the housing sector) than what they can obtain when financing "the risky".

And, as a consequence, small businesses and entrepreneurs, those creators of jobs that will allow mortgages and utilities to be serviced, have no longer fair access to bank credit.

And, as a consequence banks, no longer finance the future, they mostly refinance the past.

And in short, that is how our economies are stalling, while inequality is growing.

“A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926

Friday, December 5, 2014

Europe, America, you might use the average risk aversion of nannies, but, never ever, as the Basel Committee does, add these up.

Let us suppose a perfect credit rating. 

That perfect credit rating is then considered by the banks and the market in general, and cleared for by interest rates, the size of the exposure and other terms.

And so when bank regulators (Basel Committee) ordered that perfectly perceived credit risk, to also be cleared for in the capital of banks, they completely messed it up.

A perfectly perceived risk, excessively considered is a highly imperfect reaction to perceived risks. 

Let me explain it in the following way: 

Figure out the average risk aversion of nannies when letting your kids out to play… that might not be the best risk aversion to use, it might be too high, but anyhow it is acceptable. 

But, never ever add one nanny’s risk aversion to that of other nannies, because then your kid will never ever be allowed to go out and play… 

And if your kids only stay “safe” at home, they will eat too many cookies and turn obese… like some of their nannies.

And that’s what we have now, banks staying home, playing it safe and turning obese by lending to “infallible sovereigns”, house financing and member of the AAAristocracy; while not going out to play, in order to develop muscles, for instance by lending to small businesses and entrepreneurs.

Bank regulators, you can use their average risk aversion
But for our economies sake, please, never ever the sum of it

Wednesday, December 3, 2014

Reviving Economic Growth: A Cato Online Forum: My unsolicited opinion

Question: If you could wave a magic wand and make one or two policy or institutional changes to brighten the U.S. economy’s long-term growth prospects, what would you change and why?

My answer:

Anyone who thinks the US would have become what it is by allowing banks to earn much higher risk-adjusted returns on equity when financing what was perceived as absolutely safe than what was perceive as risky... raise his hand.

I say this because current credit-risk-weighted capital (equity) requirements for banks, allow banks to hold government debt and loans to the AAAristocracy against much less equity than when financing “risky” small businesses and entrepreneurs, and so that is de facto what you get.

And since risk taking is the essence of development, “the home of the brave” will go down if you continue to impose on your banks such regulatory risk-aversion.

Have you lately asked your friend the banker how much equity he needs to have in order to give a loan to an unrated fellow American citizen, compared to what he needs to have when lending to his government? Do that! And then you will begin to understand how much communism is creeping in on “the land of the free.”

You are already giving your banks a lot of support, so don’t also give them easy money allowing high returns leveraging on the safe… make them sweat their returns lending also to the risky... because that is how you build, or keep a nation great.

And so friends, if you want to have growth, get rid, urgently, of that distorting regulatory nonsense; which by the way does not make your banks safer, as never ever are major bank crisis the result of excessive exposures to what is perceived as risky… these always result from excessive exposure to something that was wrongly thought as absolutely safe.

Martin Wolf, by not telling it like it was, is making it much harder to connect the dots.

On page 226 of his “The shifts and the shocks” Martin Wolf writes: 

“The essence of Basel I was risk weighting of assets… Ironically and dangerously these weights treated government debt as riskless and put triple-A-rated-mortgage-securities into the next least risky category… Basel II, initially published in 2004, was an extension of Basel I… In the event, the crisis occurred before Basel II had been fully implemented.”

That is not so! And to present it in this way, impedes the understanding of what happened… it makes it much more difficult to connect the dots.

Basel I had risk weighting but that was in relation to claims on sovereign, claims on non-central-government and public-sector entities (PSEs), loans secured with residential property and banks within or outside OECD.

Basel II introduced the use of credit ratings, Basel I had none of it:

I, then an Executive Director of the World Bank, protested this and in a letter published by the Financial Times in January 2003 I wrote: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds”

And it was Basel II that allowed any private sector bank asset backed by an AAA to AA rating to have a risk weight of only 20 percent. That, since the basic capital requirement was 8 percent, signified banks needed to hold only 1.6 percent in capital against these assets. In other words it was Basel II that authorized banks to leverage 62.5 times to 1 in the presence of an AAA to AA rating.

And Basel II approved in June 2004 was immediately implemented in Europe. In the US it was accepted even before its approval by the SEC and made applicable for those investment banks they were supervising.

And that opened a ferocious appetite for AAA’s in any which form they came, whether as the securities collateralized with mortgages awarded to the subprime sector, or by being able to add an AAA rated company to the guarantees, most notoriously AIG.

Also in order to understand the profits for those developing these AAA rated securities, it is illustrative to consider the following deal:

If you convinced risky and broke Joe to take a $300.000 mortgage at 11 percent for 30 years and then, with more than a little help from the credit rating agencies, you could convince risk-adverse Fred that this mortgage, repackaged in a securitized version, and rated AAA, was so safe that a six percent return was quite adequate, then you could sell Fred the mortgage for $510.000. This would allow you and your partners in the set-up, to pocket a tidy profit of $210.00

Martin Wolf, over a very short period which started when the banks were assured that Basel II was to be approved and many saw this as a buying opportunity for later resale to Basel II covered banks… and that ended sort of early 2007…there was a monstrous demand for these AAA rated securities… and that, and nothing else, detonated the crisis.

Martin Wolf, consider that 62.5 to 1 bank leverage was allowed only because an AAA rating was present! It is clear that our world fell into the hands of real regulatory morons.

And that is not even considering the worst of it, namely that favoring so much the AAA rated they odiously discriminated against the fair access to bank credit of all those not AAA rated.

And so it is our duty to see that such things never happen again… not to wittingly or unwittingly helping regulators not to be held accountable for what they did….

If the solution to planet earth’s environmental problems falls into the hands of something like the experts of the BCBS, then we are all toast! 

PS. Basel I has only 30 pages and though Basel II grew into 347 pages, one should have the right to think that someone writing about the “interactions between changes in the global economy and the financial system” had read these fundamental documents.

PS. Around 2008 I studied and complied with all the exams needed to be a licensed real estate and mortgage broker in the State of Maryland, USA; and that I did so that I could analyze from a closer distance what had happened. And everything I found there only confirms what I have here argued. I heard of: “Give us the worst mortgages you have to package, because when we get a good rating for the security, those are the most profitable ones”.

I agree with much in Martin Wolf’s “The Shifts and the Shocks”

Basically because it fails to correctly explain how the current financial crisis came about; and therefore makes it a bit harder for us to get out of it, I object strongly, on many aspects, to Martin Wolf’s “The Shifts and the Shocks”

But that does of course not mean that I do not agree with much of what is said there and so, in this comment to which I will come back when in need (I read jumping from here to there), I will post those aspects which I most agree with:

For instance on page 252 Wolf writes: “Indeed, so long as the [bank] system allows leverage of 30:1, these businesses are designed to fail. The belief that failure of a business can be managed smoothly and without effects, with hybrid capital instruments, resolution regimes and living wills, is naively optimistic”. And I have annotated a clear “YES!” next to that.

And on page 253-4 Wolf writes: “Each institution may be diversified. But they will be vulnerable if all are diversified in the same way. Worse, being subjected to similar microprudential regulation makes it more likely that firms will end up being diversified in much the same way and exposed to many of the same risks”. Indeed! As someone who in 1999 wrote in an Op-Ed “The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause the collapse of all of our banks”… you can be sure I annotated a clear and big “YES!” next to that too.

Tuesday, December 2, 2014

What to do when even describing it, an eminence like Martin Wolf is yet unable to see The Great Bank Distortion?

On page 251 of his “The shifts and the shocks” Martin Wolf writes: 

“But [bank] shareholders should only be interested in their risk adjusted returns. If taking on more risk does not raise risk-adjusted returns, shareholders should flee.”

But let me now give you the fuller version of what he writes:

So: "If taking on more risk [like lending to small businesses and entrepreneurs] “does not raise risk-adjusted returns, [because when doing so bank regulators require banks to hold more equity] “shareholders should flee”.

The result: No bank credit to “risky” small businesses and entrepreneurs.

And the other side of the coin would be: "If taking on less risk, like lending to the infallible sovereigns, the housing sector or to members of the AAAristocracy, does raise risk-adjusted returns, because when doing so bank regulators allow banks to hold much less equity, shareholders will love it.

The result: Too much bank credit to the infallible sovereigns, the housing sector and members of the AAAristocracy.

And Martin Wolf, on page 243 concludes that: “Risk-weighted assets can play a secondary role. That way one would have a ‘belt and braces’ approach: a strong leverage ratio, plus a risk–weighted capital ratio as a back-up.

And that he does because on page 251 he argues: “Risk-weighting is extremely unreliable, because the samples from which the weights are derived are always too small or irrelevant”. 

Wolf simply does not understand the dangerous distortion produced by risk weighting... even if the risk-weights are perfect. If perfect they would be perfectly cleared for in the interest rates, the size of bank exposures and all other contractual terms. To also clear for these perfect risk-weights in the capital, signifying a double counting of the perfect risk weights, is just sheer regulatory lunacy. 

“A ship in harbor is safe, but that is not what ships are for”, wrote John Augustus Shedd (1850-1926),.And that goes for our banks too.

And precisely because we all want our ships, or our banks, to sail as safe as possible to the ports we want them to sail to… the last think we should do… is what bank regulators, thinking themselves with 'fatal conceit' capable of being risk managers to the world did… namely to start tinkering with risk weights with their compasses. 

And so no Martin Wolf, not even as a back-up is there a role for credit risk weighted bank capital.

And if we really get down to what Wolf writes on page 252: "the disaster came from what banks wrongly thought to be safe", and which by the way is what all empirical evidence would point at as the usual suspect of causing bank disasters, then the capital requirements should be totally opposite; larger for what is perceived as absolutely safe and lower for what is perceived as risky.

In short, the number one "Macro-prudential Policy" that needs to be implemented, is to get rid of the current batch of distorting bank regulators. But, for that to happen, it is helpful that eminences, like Martin Wolf, also understands what is going on.

Monday, December 1, 2014

What is so mindboggling absent from Martin Wolf’s book “The shifts and the shocks”

If there is one thing that explains the origin of the current financial crisis and the main reason why we do not seem to find our way out of it, that has to be the crazy credit risk-weighted capital requirements for banks, approved as Basel II, in June 2004.

These risk weighs instructed banks to have different amounts of capital for based on the ex ante perceived credit risks of assets, with weights fluctuating from zero to 150 per cent.

As the basic capital requirement in Basel II was 8 percent this indicated capital (meaning equity) requirements that ranged from zero percent to 12 percent, which translates into different allowed equity leverages that range from infinite to till 8.33 to 1.

For instance:

A bank lending to an AAA to AA rated sovereign needed to hold no equity at all, implying an infinite allowed leverage.

A bank investing in a private AAA rated asset needed to hold only 1.6 in equity, indicating an allowed leverage of 62.5 to 1.

A bank lending to an unrated private needed to hold 8 per cent in equity, indicating a 12.5 to 1 allowed leverage, and

A bank lending to a below BB- rated client could only do so against 12 per cent in equity, which implied and allowed leverage of only 8.3 to 1.

And of course that distorted all economic sense out of the banks’ allocation of credit to the real economy.

And if there is one document one needs to read in order to understand what these risk weights were all about that is of course the “Explanatory Note on the Basel II IRB Risk-Weight Functions” issued by the Basel Committee in July 2005.

Well, Martin Wolf, in his book “The shifts and the shocks – What we’ve learned-and have still to learn-from the financial crisis”, references 526 documents or sources but does, amazingly, mind-boggling, not include this document.

Either he does not know of it, or he does not understand it and dares not to say so. You choose.

If the latter he should not be too nervous… it is an amazing mumbo jumbo.

Sunday, November 30, 2014

No Martin Wolf, arrogance and stupidity were (and are) the real sins of bank regulators.

Martin Wolf in his recent book “The shifts and the shocks – What we’ve learned-and have still to learn-from the financial crisis” writes: “Regulators made errors of omission and commission:

Sins of omission are the result of excessively permissive regulations and supervision: they occur when regulators choose to ignore either gross malfeasance or excessive risk taking,

Sins of commission arise when regulators and lawmakers encourage financial institutions to take risks for political reasons.”

And Wolf holds that “Behind all this was the assumption that self-interest would, via Adam Smith’s invisible hand, ensure a stable, dynamic and efficient system… The application of these naïve ideas proved extraordinarily dangerous.

No! Mr. Martin Wolf. 

The first sin was the sin of arrogance by which regulators thought themselves capable to be the risk managers for the world and started to allocate credit risk weights that determined the capital (equity) requirements for banks.

And the second sin was stupidity, which took on two major expressions:

The first one not understanding that allowing different capital requirements against different assets would allow banks to earn different risk-adjusted returns on assets, and that had to distort the allocation of bank credit to the real economy.

The second, not being able to understand that the real dangers for the banking system do not loom among what was perceived as “risky”, but always among what is perceived as absolutely safe.

And the saddest part is that now, so many years after the outburst of the crisis, we have a book written by one of the mot influential columnists, which does not even mention these problems.

And it is not like no one has told Martin Wolf about this. For instance in July 2012, he himself writes: “Per Kurowski, a former executive director of the World Bank, reminds me regularly, crises occur when what was thought to be low risk turns out to be very high risk.”

And then there are more than hundred of letters over the years to him on this issue, many of which have been discussed in the interchange of emails.

And NO! Mr Martin Wolf. No one who could interfere in the allocation of bank credit like the regulators did, can be said to sincerely believe in the "invisible hand".

PS. Wolf touches on the fact of the safe being risky, by on page 252 writing: “the disaster came from what banks wrongly thought to be safe.” Yet he clearly does not understand its real meaning as he explains it as: “Risk-weighting is extremely unreliable, because the samples from which the weights are derived are always to small or irrelevant.” 

Apparently Wolf cannot come to grips with the notion that even perfect risk weights, can generate dangerous distortions, both for the economy and for the banks. That is so because if that perceived risk has already been cleared for, and so for to clear it again (now in the capital of banks) makes that perception to become over-considered. What if the risk aversion of one nannie was added to the risk aversion of other nannies? Would the kid ever be let out of his house?

Saturday, November 29, 2014

Should not the taxman also create incentives to avoid stupid risk-taking like the Basel Committee does?

The Basel Committee allows banks to earn much higher risk-adjusted returns on their equity when lending to “the infallible” than when lending to “the risky”. And that is done by means of the portfolio invariant bank equity requirements based on perceived credit risk

And seemingly most of the world, if it does not ignore that, finds that regulatory risk-aversion which I find so dangerous, to be a swell idea (at least those in FT).

Now if these anti-risk supporters truly believe in the powers of these incentives, why do they not propose their taxmen to design similar policies?

For instance they should propose that dividends and capital gains from investments in absolutely safe companies should be taxed at a higher rate than those deriving from investments in risky companies. That should do it, eh?

Thursday, November 27, 2014

Pope Francis, please go and explain “The Parable of Talents” to the members of the Basel Committee

At the European Parliament, Pope Francis spoke of a need to reinvigorate Europe, describing the continent as a "grandmother, no longer fertile and vibrant" and saying it risked "slowly losing its own soul".

"The great ideas which once inspired Europe seem to have lost their attraction, only to be replaced by the bureaucratic technicalities of its institutions," he said.

Indeed, but what else can you expect when bank regulators bureaucrats instruct banks not to lend to what seems "risky", that which most often includes the new and the future. And that they do by allowing banks to leverage immensely their equity, as long as they keep to what’s seems absolutely safe, that which most often includes the old and the history.

Had these regulations been in place earlier, Europe would not have become “a beacon of civilization” as Pope Francis believes it still is. Now it is with sadness we see regulators turning out its lights.

Next time Pope Francis would do better going to the Basel in order to explain The Parable of Talents to the members of the Basel Committee, those who have now castrated the European banks.

Lights are being turned out in Europe

PS. And Pope Francis could also remind regulators of Pope John Paul II saying

Our hearts ring out with the words of Jesus when one day, after speaking to the crowds from Simon's boat, he invited the Apostle to "put out into the deep" for a catch: "Duc in altum" (Lk 5:4). Peter and his first companions trusted Christ's words, and cast the nets. "When they had done this, they caught a great number of fish" (Lk 5:6).

Wednesday, November 26, 2014

Real banking risks do not revolve around what is perceived “risky”, as experts think, but around the “absolutely safe”

What happened with the experts swearing by geocentrism, or the Ptolemaic system, that with the cosmos having Earth stationary at the center of the universe, when Galileo Galilei, Nicolaus Copernicus, Tycho Brahe and Johannes Kepler, convinced the world of the heliocentric model, that with the Sun at the center of the Solar System?

I ask it curious to know of what will happen with all those experts in the Basel Committee, the Financial Stability Board the IMF and places like the academia and the press; like for instance Mario Draghi, Stefan Ingves, Jaime Caruana, Mark Carney, Olivier Blanchard, José Viñals, Martin Wolf and so many other; when it is finally realized that the real serious risks in banking do not revolve around assets perceived as “risky”, as they all think, but around assets perceived as “absolutely safe”.

These regulators’ silly portfolio invariant credit risk based capital (meaning equity) requirements for banks, by impeding the fair access to bank credit of “the risky”, like small businesses and entrepreneurs, not only distorts and hurts the real economy; but they also guarantee major system crisis, since banks are then doomed to, sooner or later, to get caught with their pants down (meaning little equity), with huge exposures to something which was perceived as “infallible” but which has turned into something very risky… often precisely because of too much credit at too low interest rates.

Should it be "More risk more equity – less risk less equity" as these regulators argue?

No! I prefer no distortion, but, if anything, then just the opposite.

These current regulators they all confuse the world of ex-ante perceived risks with the world of ex-post realized dangers.

These regulators have never heard or understood Mark Twain’s “A banker is he who lend you the umbrella when the sun is out, and wants it back as soon as it looks like it is going to rain”

Monday, November 24, 2014

Bye bye Europe! Having introduced financial feudalism, Europe has gone back to the Middle Ages.

The AAAristocracy, those who posses or have access to an AAA rating; and the sovereigns, those who have declared themselves to be infallible have, with the witting or unwittingly cooperation of neo-vassal bank regulators, managed to introduce a system that guarantees them, more than ever, preferential access to bank credit.

That has been achieved by means of the portfolio invariant credit risk based capital, meaning equity, requirements for banks. More perceived credit risk - more equity; less risk - less equity. Because that insidious piece of regulation allow banks to earn more risk-adjusted returns on equity when lending to the AAAristocracy or when lending to the “infallible sovereign”, than when lending to the “risky”, like to small businesses and entrepreneurs.

And, as anyone should be able to understand, the more you subsidize the access to bank credit for some, in this case through regulations, the harder it is for those excluded to compete for it.

In short, a sort of financial feudalism has taken over Europe. 

And since that impedes fair access to bank credit, the land, to those Europe most needs to have it, its peasants, there is but one way it can go... and that is down down down.

And clearly this odious discrimination against the opportunities of the peasants, can only increase the inequalities in the society. 

But of course it will all come to an end, when the banks fail because of lending too much at too low rates, to a not so infallible sovereigns or to a false AAAristocrat... since that is why banks have always failed. Never ever have they failed by lending too much to peasants.

PS. It is not only Europe that is affected. The Basel Committee is spreading financial feudalism around the world... now even in America, "the land of the free", they have AAAristocrats.

Friday, November 21, 2014

The tragic and not understood reality of a Mario Draghi ECB/SSM speech

Ladies and Gentlemen,

The current “crisis has caused many of our fellow citizens to question whether the European project can keep its promise of shared economic prosperity.”

In particular, we needed to decisively and credibly address the weaknesses in the banking sector. That is: “key to protecting citizens and businesses as taxpayers, depositors and borrowers.

And so I am happy to announce that ECB and our dear colleagues in the Basel Committee and the Financial Stability Board, have decided to continue imposing on banks capital, which means equity, requirements based on perceived risk.

More ex ante perceived risk-more equity; less ex ante perceived risk-less equity. 

And that means that our banks will keep on earning higher rates of return on equity when lending to for instance our infallible sovereigns and to members of the AAAristocracy, than when lending to risky medium and small businesses, entrepreneurs and start-ups.

And, as you can understand, banks will keep on acting according to those incentives… they’ve got no choice.

What do you think about that?

Yes I hear you… it did not work that well in Basel II… and insufficient job creation persist. Yes indeed, but you all know we are the experts and we know we can’t be wrong, and so we must insist, until we prevail.

Good night… and do not forget to turn out the lights!

Après nous le deluge

Wednesday, November 19, 2014

Current capital (meaning equity) requirements for banks are unethical, regressive, dangerous, stupid and promote inequality

Allowing banks to hold assets perceived as absolutely safe against much less capital (meaning equity) than against assets perceived as risky, allows banks to earn much higher risk-adjusted returns on bank equity when lending to the “absolutely safe” like the infallible sovereigns and the AAAristocracy, than when lending to the “risky”.

And that effectively hinders the fair access to bank credit of the “risky”… like that of the small businesses and the entrepreneurs.

And that effectively curtails opportunities and promotes inequalities.

And that odious regressive regulatory discrimination of the risky, as if these were not already sufficiently discriminated against, is unethical; and kills opportunities, which leads to ever increasing inequalities.

And that regulatory distortion is extremely dangerous since it impedes the banks to allocate credit efficiently, which means the real economy will, more sooner than later, stall and fall.

And finally it is all so useless and so stupid… because never ever has a major bank crisis resulted from excessive bank exposures to what was perceived as risky; these have all resulted from excessive exposures to what was erroneously perceived as absolutely safe.

Sunday, November 16, 2014

The Basel Committee, the Financial Stability Board and “The Parable of the Talents” Matthew 25:14-30

The governments, on behalf of us citizens, us taxpayers, support the banks in times of troubles, for instance by the Fed acting as a lender of last resort. And that can cost us citizens, us taxpayers, a lot.

But that risk of supporting the banks is not acceptable only in order to produce special profits to bank shareholders, or just to have the banks serve as a mattress where to safely stash away our money. It is accepted exclusively so that banks, by means of efficiently allocating bank credit, could help us to drive our economies forward.

And that willingness to support-the-banks-risk is, for its management, placed into the hands of bank regulators, like the Basel Committee and the Financial Stability Board.

But these regulators decided (on their own) that banks’ primary purpose was to avoid risks… something loony because that by itself would negate the reason for supporting the banks.

And so they concocted credit risk weighted equity requirements that made banks earn much higher risk-adjusted returns on equity when lending to those perceived as "absolutely safe", than when lending to "the risky".

And that regulatory risk aversion, besides stopping banks from lending to the risky, like to small businesses; also made banks lend excessively to what ex ante was perceived as absolutely safe, but that ex post turned out to be very risky, like AAA rated securities and Greece.

And that all resulted in a crisis that caused immense costs… this time without having generated sufficient and reasonable compensation in terms of creating sturdy economic growth.

And those risk adverse regulations now block our way out of the crisis... and might doom our young to become a lost generation.

And today in mass we were reminded of “The Parable of the Talents: Matthew 25:14-30, and of which I extract the following: 

14 “It will be like a man going on a journey, who called his servants and entrusted his wealth to them. 15 To one he gave five bags of gold, to another two bags, and to another one bag, each according to his ability. Then he went on his journey… 

24 “Then the man who had received one bag of gold came. ‘Master,’ he said, ‘I knew that you are a hard man, harvesting where you have not sown and gathering where you have not scattered seed. 25 So I was afraid and went out and hid your gold in the ground. See, here is what belongs to you.’

26 “His master replied, ‘You wicked, lazy servant! So you knew that I harvest where I have not sown and gather where I have not scattered seed? 27 Well then, you should have put my money on deposit with the bankers, so that when I returned I would have received it back with interest. 28 “‘So take the bag of gold from him and give it to the one who has ten bags. 29 For whoever has will be given more, and they will have an abundance. Whoever does not have, even what they have will be taken from them. 30 And throw that worthless servant outside, into the darkness, where there will be weeping and gnashing of teeth.’
And in the sermon we later heard abut the dangers of caution and of playing it safe; and about the security that comes from risk-taking.

And there was a reference to Erikson’s Theory… with its Generativity that includes reaching out to others in ways that give to and guide the next generation, and a commitment which extends beyond self; versus Stagnation with its placing own comfort and security above challenge and sacrifice, and its self-centered, self- indulgent, and self-absorbed.

And we prayed for “courage so that we can walk in the way of the Lord”… and of course I was reminded of “God make us daring!

And so I naturally identified with the “Master” in wanting to throw those “wicked lazy” bank regulators “outside, into the darkness, where there will be weeping and gnashing of teeth”

Friday, November 14, 2014

G20, the Financial Stability Board does not know what it is doing, or is simply hiding a monstrous regulatory mistake.

“In Washington in 2008, the G20 committed to fundamental reform of the global financial system. The objectives were to correct the fault lines that lead to the global crisis and to build safer, more resilient sources of finance to serve better the needs of the economy”

That is how FSB on November 14, 2014 introduces its report to the G20 leaders titled “Overview of Progress in the Implementation of the G20 Recommendation for Strengthening the Financial Stability

And the letter that accompanies it states: “The job of agreeing measures to fix the fault lines that caused the crisis is now substantially complete.” 

But the sad fact is that the report does not even mention what in my opinion constitutes the most important fault line, and in not doing so, makes it also impossible for banks to serve the needs of the economy.

As I see it that "fault line" was the Perceived Credit Risk Weighted Equity Requirements for Banks. Here follows my explanation:

Banks already clear for perceived credit risks (in the numerator) by means of interest rates, size of exposure and other terms of contract.

And so, when regulators cleared for the same perceived risks in the equity (more risk more equity – less risk less equity) they allowed banks to earn much higher risk adjusted returns on equity when lending to those perceived as “absolutely safe”, than when lending to those perceived as “risky”

The following are some examples of risk weights and leverages based on the original 8% equity requirement and that are indicated in the Basel II approved in June 2004.

Infallible sovereigns: zero percent RW, allowing infinite leverage.

Members of the AAAristocracy: 20 percent RW, allowing a leverage of 62.5 to 1.

Financing of houses: around 25 percent RW, allowing a leverage of 50 to 1

Medium and small businesses, entrepreneurs and start-ups, and citizens: 100 percent RW, allowing a leverage of 12.5 to 1.

And there is a perfect correlation between the troubled bank assets that caused the crisis, and the presence of ultralow capital requirements.

And this monumental distortion in the allocation of bank credit is not even mentioned.

Either the FSB has not understood the problem, or it is hiding the truth about this horrendous regulatory mistake.

And even from the perspective of medium term stability of banks, these regulations are absolutely useless. That is so since all really serious bank crises never result from excessive exposures to what is perceived as risky, but always from excessive exposures to what has erroneously perceived as “absolutely safe”. And so, if anything one could even argue the equity requirements should be totally the opposite, higher for what is perceived as “absolutely safe” and lower for what is perceived as “risky”. 

And these risk weighted equity requirements are impeding bank credit from reaching where it is most needed and therefore wasting all the liquidity support provided by QEs and similar programs.

Yes regulators will tell you that Basel III has the Leverage Ratio which is not risk-weighted. What they do not understand though is that raising the floor, only increases the pressure of those living close to the roof... namely "the risky".

Bank regulators who as we all have prospered thanks to the risk-taking of the banks of our parents, are now negating that risk taking to our children.

As a consequence our banks are now not financing the risky future, only refinancing the safer past.

Risk taking is the oxygen of development, and these regulators have no right whatsoever to believe with astonishing hubris they can be the risk-managers of the word, and go behind our back, calling it quit, and so making our economy stall and fall.

Conclusion: Basel III has NOT fixed the distortions in the allocation of bank credit. In some ways it has even made it worse. And, to top it up the risk-adverse regulatory monsters also want to go after the insurance sector.

God make us daring!