Tuesday, September 30, 2014
Bankers should be able by means of interest rates, amounts of exposure and other terms be able to clear for any perceived credit risks, such as those expressed in credit ratings. And if they cannot do so, then clearly the faster they refrain from banking the better for all.
But regulators, though they should in fact be making sure that banks had some reserves for unexpected events, which obviously has nothing to do whatsoever with ex ante perceived credit risks, decided that the capital (equity) that banks needed to hold, was also to be based on exactly the same perceived credit risks.
And this led to the perceived credit risks being considered twice, which has caused banks to lend too much at too low rates to what is for the time being considered ex ante as “absolutely safe”, like to “infallible sovereigns”, housing finance and the AAAristocracy; and nothing or way too little, at too high risk adjusted interest rates, to what is for the time being officially considered as “risky”, like medium and small companies, entrepreneurs and start-ups.
And of course that is not smart, actually it is quite dumb, something which the too much lending against too little capital to Greece, to real estate in Spain, or investments in AAA rated securities backed with mortgages to the subprime sector in the US, and which caused the current crisis, can attest to.
And of course that is not smart, actually it is quite dumb, as all those tough “risky” risk-takers that we need to get going when the going gets tough, have now no fair access to bank credit.
And of course those who will bear the brunt of the costs of this what I refer to as a malignant regulatory concoction, are all the young who not only will face larger tax bills in the future but also the perspective of much less jobs.
But no! The regulatory establishment, which seemingly includes those penning in FT, have circled the wagons, and refuse to even acknowledge, less answer, the questions this little howling Indian has been throwing at them over the years.
And not that this little Indian is unqualified to ask… much the contrary, he belongs to those who in very clear terms, long before the crisis, warned that something was completely wrong. For a starter he held that those regulators were regulating banks, without even mentioning their purpose.
“A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926.
And to which today I would add that a ship in harbor is really not safe at all, if the harbor, no matter how safe it seems, becomes dangerously overcrowded.
So, do you want to join those within the circled wagons, or do you want to help this little Indian holding those regulators accountable for what they have done?
Monday, September 29, 2014
Comments on: IMF WP 14/169 "Reconsidering Bank Capital Regulation" Connel Fullenkamp and Céline Rochon
IMF Working Paper “Reconsidering Bank Capital Regulation: A New Combination of Rules, Regulators, and Market Discipline”, Connel Fullenkamp and Céline Rochon, September 2014.
“Despite revisions to bank capital standards, fundamental shortcomings remain: the rules for setting capital requirements need to be simpler, and resolution should be an essential part of the capital requirement framework. We propose a new system of capital regulation that addresses these needs by making changes to all three pillars of bank regulation: only common equity should be recognized as capital for regulatory purposes, and risk weighting of assets should be abandoned; capital requirements should be assigned on an institution-by-institution basis according to a regulatory (s,S) approach developed in the paper; a standard for prompt, corrective action is incorporated into the (s,S) approach.
Some brief comments:
1. For someone who like me has for more than a decade profoundly objected the whole concept of risk-weighted capital requirements for banks, a recommendation that “risk weighting of assets should be abandoned”, is of course very much welcomed.
But, that said, if the recommendation is not based on a total understanding of what is really wrong with risk-weighing, it is difficult to develop adequate remedies… and most specially to be able to transition from here to there, without causing serious and dangerous disruptions to banks and economy.
And, unfortunately, that is the case with this paper. It is solely written from the very limited perspective of trying to make banks safe, ignoring banks’ fundamental role of allocating bank credit efficiently to the real economy.
Let me briefly resume my argument. Risk-weighing, based on credit risks which are cleared by banks through interest rates and amounts of exposure, and which result in lower capital requirements for holding assets which ex ante are perceived as safe when compared to assets which ex ante are perceived as risky; make banks able to earn much higher risk adjusted returns on “safe” assets than on “risky” asset; something which distorts and causes banks to lend too much and at too low rates to “the safe”, and too little and at too high relative interest rates to “the risky”.
And all this derives from the sad fact that nowhere in all current Basel bank regulations, do we find a word about what is the purpose of banks. “A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926.
For example the paper makes the comment: “Acharya et al (2013) provides evidence that risk weights are not the right tools to use in assessing the level of bank capital requirement”. But, that paper referenced only discusses the risk weights – those that cause different capital charges - in terms of the distortion they produce in the portfolio of banks, with no mention whatsoever of the, directly corresponding, distortions in the allocation of bank credit. That is evidenced when the Acharya paper comments “Also note that the portfolio distortion problem does not exist for banks that are only leverage-constrained since the additional charges are the same for all assets.”
Note: The existence of “additional charges” are there openly recognized and yet no one seems concerned about how these, by favoring “The Infallible”, would odiously discriminate against the fair access to bank credit of “The risky”.
2. And the proposed alternative: “capital requirements assigned on an institution-by-institution basis according to a regulatory (s,S) approach developed in the paper”, which is of course also based on ex ante perceived risks, if it does not start from defining the purpose of banks, and how to avoid the distortions in credit allocation, could even make these much worse.
3. The proposed alternative: “capital requirements assigned on an institution-by-institution basis”, no matter how much authors believe “our framework aims to significantly improve market discipline and focus it directly on the regulators”, is plain dangerous as it increases the discretionary powers of regulators, something that will, sooner or later, one way or another lead to abuse.
“This will enable market participants to monitor regulators’ actions” What market participants? It really sounds like an insult to someone who has in vain tried to get an explanation for the “portfolio invariant ex-ante perceived credit risks and nothing but the portfolio invariant ex-ante perceived credit risks already previously weighted for, weighted capital (equity) requirements for banks”
Sunday, September 28, 2014
There I was trying to dry my hands wringing them in some tepid air blowing from the round hole of an appliance, thinking about how much more efficient the flat whole hand reaching drier was, when suddenly I thought… if I were a bank regulator I would at least give Dyson’s engineering group a call to see what they would think I should do….
And from there my mind wandered of into thinking about how monumentally important banks are too our economy… and about how monumentally crazy we have been allowing some very few untested bureaucrats, who we know very little about, to draw up the regulations that defines much of the functioning of our banks all around the world…
And into thinking that the least we could have done was to set up a public competition to search for the best bank regulations, similar to that which awarded Brunelleschi the right to build the dome of the cathedral in Florence.
And into thinking that such competition should be televised, perhaps ‘The Regulator’, so as to better ascertain that the interests of all stakeholders in banks were represented, not just those bankers who just think of banks as profit making machines, and not just those risk adverse nannies who think of banks solely in terms of more sophisticated places to stash away money than mattresses…
And finally into sadly reflecting on that in such a competition, the Basel II and Basel III bank regulation drawings would not make it into the final 12, probably not even pass the early qualification round…
I could imagine the judges asking the members of the Basel Committee.
“Do you really believe ordinary bankers to be so dumb, so you must require them to hold 5 times as much capital (equity) when they lend to someone they know has a BBB+ to a BB- rating, or no rating at all, than when they lend to someone they know has an AAA to AA rating?
Or, are you really so dumb to believe bankers when they argue they should be allowed to hold only a fifth of capital when lending to someone who has an AAA to AA rating, than what they are required to hold when lending to someone with a BBB+ to BB- rating, or no rating at all?
Don’t you know bankers already adjust to differences in credit ratings by means of interest rates and the size of exposure they are willing to take, for you to also require these to adjust the capital they need to hold… 5 times?
Don't you think this would utterly distort the allocation of bank credit to the real economy… with those having BBB+ to BB- ratings, or no ratings at all, getting much too little bank credit, and those with AAA to AA ratings getting much too much bank credit?”
And here, I could imagine the experts of the Basel Committee and their family members of the Financial Stability Board, becoming quite teary-eyed.
And I could hear the judges concluding: “There is no chance someone would want regulations which, in the name of what at best could seem like short term bank stability, discriminates against those who we in fact most need to have access to bank credit, the “risky”, like middle and small businesses, entrepreneurs and start-ups, those who might get us the next generation of jobs, favoring an AAAristocracy.”
And then I could hear another contestant auditioning:
“We must of course start with asking ourselves what is the purpose of our banks and in this respect I suggest we remember John Augustus Shedd’s ‘A ship in harbor is safe, but that is not what ships are for’’’.
And I could hear and see in front of me the judges standing up and enthusiastically applauding.
And so I concluded…let a 1.000 regulation proposal’s bloom! And let us hope the final regulations can infuse our bankers with reasoned audacity, and not disable them with an extreme aversion to credit risk. Enough of this insane de-testosterone-mania! We send our kids to war but we don't allow our banks to take the risks we need them to take?
Monday, September 22, 2014
IMF, the darkest corner, is where Basel II’s mistake with risk-weighted capital requirements for banks is hidden.
In “Where Danger Lurks” Finance & Development, IMF, September 2014 Olivier Blanchard writes: “The recent financial crisis has taught us to pay attention to dark corners, where the economy can malfunction badly”
Indeed but what is most dangerous is that the darkest corner which brought on this crisis, regulatory stupidity, is not even acknowledged… probably because many of the frontline responsible feel, rightly so, that their own jobs could be at stake... or it upsets other agendas.
Blanchard: “economists recognized that bank regulatory constraints, such as the minimum amount of capital (essentially a bank’s net worth; that is, its ability to absorb losses) institutions had to hold, could force banks to react more sharply to decreases than to increases in their capital”
… which only leaves us with the question of why bank regulators were not told of this.
Blanchard: “The Great Moderation had fooled not only macroeconomists. Financial institutions and regulators also underestimated risks. The result was a financial structure that was increasingly exposed to potential shocks.”
Nonsense! It was not underestimation of risks which caused the crisis but the hubris of regulators who thought they could play risk managers for the world with their “risk-weighted capital requirements for banks”; and did not care one iota about how allowing banks to earn much much higher risk-adjusted returns on equity on exposures which, ex ante, from a credit risk point of view were considered as absolutely safe than on exposures considered the same way as risky, would distort the allocation of bank credit.
And here we are, years after the crisis, and the dark corner of the distortion of bank credit allocation is not even being discussed… and that dark corner of bank regulations is still well alive and kicking in Basel III.
Blanchard writes: “So-called diabolical loops developed between public and private debt: weak governments weakened banks that held government bonds in their portfolios; weakened banks needed more capital, which often had to come from public funds, weakening governments.”
But he does not mention that diabolical, I would dare say communistic styled sovereign debt favoring, which occurs when banks need not to hold zero or very little capital, when lending to sovereigns/governments, when compared to what they need to hold when lending to a citizen.
And Blanchard when writing about the too small effect of fiscal profligacy, massing quantitative easing and low interest has had in the growth of the real economy and the generation of jobs, he seems to be wanting to keep his reader in a dark corner, not noticing that current bank regulations stop bank credit from going to where it should… namely to all those tough daring risky risk-takers we need to get going when the times are tough.
What a shame that IMF has allowed the Basel Committee for Banking Supervision to act as if the stability of banks is more important than the state of the economy. As evidence of this, let me here remind the IMF, again, that in all Basel I, II, III regulations, there is not a word about what is the purpose of banks.
“A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926.
There is one central Basel Committee paper that explains the risk weights used by Basel II. I wish Olivier Blanchard would read it, and try to explain it to us.
Sunday, September 21, 2014
The Basel Committee instructs banks to lend as if they were old retirees and not young professionals
Viktor Munkhammar in “Dagens industri”, Stockholm, September 21, wrote “Åldrande befolkning ger centralbankirer gråa hår”.
In it Munkhammar analyses the growing fright about deflation, and most especially what demographic changes can help to produce it… and I agree with most of his arguments.
But, when he writes: “For central banks, this means that the fight against low inflation is unlikely to be over when the consequences of the financial and debt crisis eventually folded.”, then I must intervene to remind him that, in many ways, the financial and debt crisis was already the result of a demographic change… as the Basel Committee for Banking Supervision was hijacked by some retirees’ risk adverse criteria.
What do I mean with that?
We all know that any financial advisor, counseling a young professional on his in investments, would indicate the need for a high degree of risk-taking, like investing in the stock market. And any advisor, similarly counseling an aging professional, soon a retiree, would recommend a much more cautious strategy, which includes for instance highly rated corporate bonds and sovereign debt. And, were the advisor not to follow these simple rules, the possibilities of him losing his license as an investment counsel would be very high.
But the Basel Committee, by means of the pillar of their regulations, the risk weighted capital requirements, have allowed banks to hold much much less capital (equity) against assets perceived ex ante, from a credit risk point of view, to be “absolutely safe”, like “infallible sovereigns”, housing finance and lending to the AAAristocracy, than what banks are required to hold against assets perceived as “risky”; like lending to medium and small businesses, entrepreneurs and start-ups.
And that translates into banks being able to leverage much much more their equity with “The Infallibles” than with “The Risky”; which means banks can earn much higher risk adjusted returns on equity when lending to “The Infallibles” than when lending to “The Risky”; which means banks must and will follow an investments strategy much much more adequate for the old than for the young.
And who pays for all that? The economy, which can therefore only grow obese, as risk taking is the oxygen for any sturdy and healthy economic growth; and as a direct consequence of that all of our young who might not get jobs, because of lack of bank credit to those tough risky risk-takers we need to get going when the going gets tough.
And all for what? For nothing, as this bank crisis was not caused by exposures to what is perceived a risky, bank crisis never are, but because of too much exposure to what was ex ante officially perceived as safe, like AAA rated securities, Greece and real estate in Spain.
Frankly, if regulators absolutely must distort, to show us they are working, why do they not weigh the capital requirements for banks, not based on perceived credit risks which are already cleared for by bankers... but for something with a purpose, like potential-of-job-creation ratings, sustainability-of-planet-earth ratings, or, in the case of sovereigns, ethic and good governance ratings?
And just think how sad it is that a country like Sweden, which became what it is because of daring risk-taking, and where in its churches we hear “God make us daring”, now has the dubious honor of having a Swede, Stefan Ingves, chairing the bank regulatory committee which castrates and de-testosterones our banks.
Wednesday, September 17, 2014
And a speech by Wayne Byres the Chairman of the Australian Prudential Regulation Authority APRA titled “Perspectives on the global regulatory agenda” fell into my inbox.
And again, as is usual nowadays there was not a word about what I consider is the absolutely most important, namely getting rid of those distortions in the allocation of bank credit to the real economy that the risk-weighted capital requirements for banks cause.
These make banks lend too much at too low rates to those perceived as “absolutely safe” and too little and in relative terms too expensive to those perceived as “risky”.
Having just come from Toronto and seen the play “Our Country's Good” advertised with “Thieves, murderers, prostitute, actors…this is what made Australia”… it struck me that one could at least have expected Australia’s APRA not to have swallowed such regulatory nonsense.
And in case no one has explained the implications of the risk-weighting, here is the link to more fuller real version of the terminology:
Friday, September 12, 2014
We have bank regulator who seem to have decided that their role is to make banks safe, even if they have to take the real economy down. And that means that they are either too dumb, or too irresponsible, or too much both things.
By imposing capital (equity) requirements for banks based on the ex ante perceived credit risk of borrowers, and making these much much smaller when lending to those perceived as “absolutely safe” than when lending to those perceived as “risky”, regulators allow banks to earn much much higher risk-adjusted returns on equity when lending to the “absolutely safe” than when lending to the “risky”.
And that means banks will lend much too much to those perceived as “absolutely safe”, to such an extent that more sooner than later some of these will turn into very risky and could implode the banks; and much too little to those perceived as "risky", those which include medium and small businesses, entrepreneurs and start up, which will make the economy stall and fall.
And we are not talking peanuts here. In Basel II, though when lending to the risky they required banks to hold 8% in capital (equity), they allowed banks to lend to someone of the AAAristocracy holding only 1.6% in capital. That means banks could leverage their equity a generous but still reasonable 12.5 times to 1 when lending to the risky, and were allowed to leverage a truly mindboggling 62.5 times to 1 lending to the “absolutely safe”. And, when lending to “infallible sovereigns”, the banks needed to hold no capital at all, and so not even the sky was the limit on allowed leverage.
Allowing banks to lend to Greece leveraging their equity 62.5 times? And of course Greece got too much loans.
Allowing banks to earn more on what is perceived safe than on what is perceived risky? And of course the tough risky risk-takers we need to get going when times are tough, will not get the loans they need, and so jobs will not be created and many of our kids doomed to become part of a lost generation.
“Oh but they have rectified in the new Basel III” I hear you say. Forget it! Pure propaganda, in many ways they have only made it worse... they are only digging us deeper into the hole.
And so now you tell me… are bank regulators too dumb or too irresponsible or, as I believe, much too much of both things?
But, we citizens are not too bright either, allowing some regulators who we do not know, to concoct their potions, in splendid isolation in their mutual admiration clubs of the Basel Committee for Banking Supervision and the Financial Stability Board, and without holding them accountable for what they do.
Friends, were we to tackle the challenge of climate change in a similar way, I assure you our planet earth... would be toast.
Wednesday, September 10, 2014
HERE THE REAL TERMINOLOGY NOT THE ABRIDGED DUMB ONE
“Risk weighted capital requirements for banks”, meaning more capital (equity) for what is perceived as risky less capital for what is perceived as safe, sounds so logical and so reassuring.
“Risk weighted capital requirements for banks”, meaning more capital (equity) for what is perceived as risky less capital for what is perceived as safe, sounds so logical and so reassuring.
Until... you understand what these really mean!
First, the risk that is weighted for if of course the ex-ante perceived risk, something which does not necessarily mean that is the same as the real ex-post risk.
And so a more accurate terminology should be “the ex-ante perceived risk weighted, capital (equity) requirements for banks”
Second, the risk that is weighted for has noting to do with the health of the economy, the sustainability of mother earth, job creation for our young or any other such other laudable concern. It has only to do with the credit risks of the assets, of the borrowers.
And so a more accurate terminology should be “the ex-ante perceived credit risk and nothing but the ex-ante credit risk, weighted capital (equity) requirements for banks”
Third, but those perceived credit risks have already been weighted for by the banks who have of course also perceived these, among other by using the available credit ratings, when determining what size of exposure they are willing to accept, at what interest rates, and in what other terms.
And so now a more accurate terminology should be “the ex-ante perceived credit risk and nothing but the ex-ante perceived credit risk already previously weighted for, weighted capital requirements for banks”
Fourth, but the risk weighted for has exclusively to do with the ex ante perceived credit risk of the borrower and has nothing to do with how large an exposure could be, meaning how much of the bank’s portfolio is exposed to that risk.
And so now a more accurate terminology should be “the portfolio invariant ex-ante perceived credit risk and nothing but the portfolio invariant ex-ante perceived credit risk already previously weighted for, weighted capital (equity) requirements for banks”.
And, described that way, anyone should be able to understand how this regulation:
Odiously distorts the allocation of bank credit in the real economy, by having banks lending way too little at way too relative high interest rates to those perceived as “risky”, some of whom are those who most need bank credit, and way too much at way too low interest rated to those perceived as “absolutely safe”, some of whom are those who least need bank credit.
And makes sure that when an ex-ante perceived as absolutely safe asset, and which therefore will probably represent a large part of the portfolio, ex post turns out to be very risky, something which will always happen sooner or later, the bank will stand there naked with little capital (equity) to cover up with
What a nightmare!
Saturday, September 6, 2014
If a bank perceives Mr. Safe as an absolutely safe credit risk, it will probably be willing to lend him much money at a low interest rate. And regulators, sort of just for good measure are currently also willing to allow the bank to lend to Mr. Safe against very little capital (equity), meaning the bank will be able to leverage its capital a lot.
If on the contrary a bank perceives Mr. Risky as a bad credit risk, if it anyhow lends to him, it will be little money, at high interest rates. And regulators, also sort of just for good measure, then currently requires the bank to hold more capital, meaning the bank will be able to leverage much less its capital.
Q. Why on earth should a lot of money lent at low rates to Mr. Safe be safer, or less risky for the bank, than little money lent at high rates to Mr. Risky?
Q. Is the truth not that the risk of banks have nothing to do with the credit risks of Mr. Safe or Mr. Risky, and all to do with how banks lend to Mr. Safe or Mr. Risky which, as they say in French, is pas la meme chose?
Q. Why on earth would bank regulators expect the bank to keep on lending to Mr. Risky if it cannot leverage its equity as much as it is allowed to do when lending to Mr. Safe?
Q. And if banks only lend to the Mr. Safe of this world and avoid all the Mr. Risky, what might become of this world… a safer or a riskier place?
Friday, September 5, 2014
What if regulator X knows about the distortions risk-weighted capital requirements for banks produce and keeps mum?
Regulators, who by mistake develop bad regulations, are of course not committing any sort of criminal activity for which they can be sued… unless perhaps they have presented false credentials, which led them to be appointed to such task.
But, what if the regulators are aware they are enforcing the wrong regulations, but they are not willing to change these because this would entail admitting to a mistake that could make them lose their jobs and be exposed to shame? And what if their mistake has caused, for instance, millions of young Europeans to become a lost generation?
I ask this because I have been trying for years to explain to the regulators of the Basel Committee and the Financial Stability Board, the horrendous distortions credit-risk weighted capital requirements for banks produce, with no luck…
And then it struck me… what if they know it and for whatever reason just don’t want to admit it? Could they really be so irresponsible?
If so, sincerely, I consider they should be hauled in front of a criminal court.
Thursday, September 4, 2014
Those perceived as belonging to The Infallible, like the sovereigns, the members of the AAAristocracy and the housing sector, benefit from very positive externalities derived from bank regulations, since because banks need to hold very little, almost no capital at all when lending to them, they get much larger loans at much lower rates.
Those perceived as belonging to The Risky, like medium and small businesses, entrepreneurs and startups, are hit with the costs of very negative externalities derived from bank regulations, since because banks need to hold much more capital when lending to them than when lending to the former, they need to make up for that competitive disadvantage when accessing bank credit, and so they get much smaller loans, at much higher rates, or no loans at all.
Those in society who are old, and whose only concern is the short term stability of the banks, in other words those who gladly sign up on the après nous le deluge objective, benefit from positive externalities, as short term, banks are expected to be safer.
Those in society who are young, and whose future wellbeing depends much on banks financing without distortions the real economy, so that the economy has a chance to grow sturdy and generate jobs, are hit with the costs of very negative externalities derived from bank regulations, because the differences in capital requirements based on credit risks alone, introduce a very dangerous and distortive risk aversion.
And we all suffer the very negative externality of having bank regulators who seemingly do not understand, and do not care one iota, about what externalities their regulations cause.
And in this respect we also suffer the externalities of a financial press much too much in awe of regulators so as to dare to call their bluff.
And in this respect we also suffer the externalities caused by political agendas that need to blame it all on the banks, markets and deregulations, and which cannot accept the possibility of regulators and bad regulations being responsible for the disasters.
Tuesday, September 2, 2014
In “The land of the brave” banks are given incentives to avoid “The Risky” and to stock up on “The Infallible”
I refer to Kevin Dowd’s “Math Gone Mad”, Policy Analysis of the Cato Institute, September 2014
Dowd’s conclusion “The solution to these problems is legislation to prohibit risk modeling by financial regulators and establish a simple conservative capital standard for banks based on reliable capital ratios instead of unreliable models”, is completely in line with which I have been arguing for more than a decade, except for that I would use the word “sensible” instead of reliable… since reliability is good to have, but it cannot be the final objective of our banks.
“A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926
I agree of course with all the examples Dowd gives about how the credit allocation to the real economy is distorted by regulations, but I would make even clearer the fact that what can most help to bring stability banks is a sturdy economy… and current credit risk-weighting of capital has only managed to introduce, in the land of the brave, a senseless risk-aversion… which will only weaken it… which will only reduce its chances of creating the next generation of jobs our youth needs
But also, current regulations are based on a principle that sounds so very logical, “more-risk-more-capital and less-risk-less-capital”, so too few take time needed to think about it; and regulators are so unwilling to admit mistakes that would show them not having been marginally wrong, but 180-degrees wrong. And, in this respect, the paper might be strengthened by some additional arguments, and by providing some idea on how to motivate and facilitate the legislator to act.
The first is that if banks’ individual risk management is correct, then regulators have nothing to fear. Their problem begins when the banks’ risk management fails. For instance, regulators have no special reason to concern themselves with the credit-worthiness of the clients of the banks’, as their concern should be the creditworthiness of the bank, which is by far not the same. A bank with a well-diversified exposure to many risky borrowers might be immensely safer than a bank with a few large exposures to those perceived as absolutely safe. One of the unbelievable surreal failings with the current risk-weighted capital requirements is that, by the regulators own admission, these are portfolio invariant.
Also it is precisely the fact that the risk-weights used for the capital requirements clear for precisely the same risks already cleared for by the banks, through interest rates and size of exposures, which originates the most severe distortions. As a result banks now earn much higher risk adjusted returns on equity when lending to The Infallible than when lending to The Risky. The regulators, also by their own admission, have used expected losses as a substitute for the unexpected losses, and this represents of course one amazing intellectual regulatory mistake.
I have, even as an Executive Director of the World Bank objected to these regulations, long before Basel II was approved. And I have tried to extract answers from the regulators by all means possible, with very little luck. Therefore, as a tool to begin breaking down the wall, I would suggest legislators request from regulators the answer to some very simple questions, which would evidence how crazy it all is…but they should brace themselves because, once one finds out how incredibly wrong current bank regulations are… it is truly scary. And I would also request from regulators that when they stress test banks balance sheets, they also take notice of what is not any longer on banks’ balance sheets… since that is a part of a stress test of the economy at large.
And, one of the most important lessons to extract from it all this is the… “How could it happen?” and so that never again a small group of unelected bureaucrats will get the chance to influence global markets in this way, with no real accountability. I have often said that if the world would allow a Basel Committee on Climate Change to decide what to do in this way… then earth would most definitely be toast.
Finally when Dowd suggests “a minimum capital ratio of 15 percent” (I could do with even less) the most important part is how to get from here to there, a journey costing at least a trillion dollars only in the US and that poses many dangers, and that perhaps requires a full change of the regulatory team… since we know that Hollywood would never ever authorize those responsible for a monumental box-office flop like Basel II, to follow up with a Basel III production, using the same scriptwriters.
PS. As curiosa let me mention that the Dodd-Frank Act, in all its many pages, does not even mention the Basel Committee’s regulations to which the US is a signatory.
Thursday, August 28, 2014
Do bank regulators really believe ordinary bankers to be so stupid, or are they really so stupid themselves?
As in Basel II, do bank regulators believe ordinary bankers to be so blind and dumb, so they need to require them to hold 5 times as much capital when they lend to someone they know has a BBB+ to a BB- rating, or no rating at all, than when they lend to someone they know has an AAA to AA rating? Do they not know this will distort the allocation of bank credit to the real economy? Do they not know this means those with BBB+ to BB- ratings, or no ratings at all, will get much too little bank credit?
Or, as in Basel II, are bank regulators so dumb so as to believe ordinary bankers when they argue they should need only to hold a fifth of capital when lending to someone who has an AAA to AA rating, than what they are required to hold when lending to someone with a BBB+ to BB- rating, or no rating at all? Do they not know this will distort the allocation of bank credit to the real economy? Do they not know this will mean those with AAA to AA ratings will get much too much bank credit?
Sunday, August 24, 2014
An urgent message to those holed up in Jackson Hole. Stop profiling risk! Our economies need regulatory neutrality.
Forget risk-weights and apply exclusively your leverage ratio capital requirement for all exposures that represent for instance less than a 1000nd of a bank’s balance sheet.
There is no reason on earth why a bank should find it harder to lend a small amount to a medium or a small business, an entrepreneur or a start-up, than a huge amount to an infallible sovereign or to a member of the AAAristocracy.
Please, on our knees, we beg you… Stop profiling risk! That is an odious discrimination that impedes banks allocating credit efficiently. We need regulatory neutrality.
PS. And all you reporters there... dare to ask The Question!
Friday, August 22, 2014
Bank regulators hate me when I ask this simple question. They refuse to answer it. They can’t! That’s the real problem!
The Question: Sir, current risk weighted capital requirements for banks are based on the perceptions of risk by credit rating agencies and bankers. But if bankers and credit rating agencies perceive the risks correctly there should be no major problems. So why are not the capital requirements for banks based instead on the credit risks not being correctly perceived by bankers and credit agencies?
As is, the perceived risks are now, besides being cleared for in the interest rate charged by the banks and in the amount of exposure accepted,also cleared, for a second time, in the required bank capital (equity). And that has created the distortions that make the banks lend dangerously much to what is perceived as “absolutely safe”, and dangerously little to what is perceived as “risky”, like to medium and small businesses, entrepreneurs and start ups.
As is, the risk with risk weighted capital requirements for banks is much greater than the risks which are being weighted! Got it?
I suspect the whole mess results from the fact that when regulators were given an explanation similar to that which appears in “The Basel Committee on Banking Supervision´sExplanatory Note on the Basel II IRB Risk Weight Functions of July 2005”… they did not understand one iota of it, but did not want to admit that in front of their equally befuddled colleagues. In other words, could it be the weak egos of expert bank regulators which provoked this financial crisis.
A subsequent problem is of course that too few are capable of daring to think that globally renowned experts can be so utterly wrong… and so they do not dare to help me to ask The Question.
Thursday, August 21, 2014
US Congress, you are the legislators, so who of you ordered the banks in the home of the brave to become risk adverse?
Fact: Banks give larger loans, charging lower interest rates and allowing for leaner terms to those perceived as absolutely safe, than when lending to those perceived as risky. And that so much, that your Mark Twain described bankers as those who lend you the umbrella when the sun shines but want it bad as soon as it seems it might rain.
Fact: Your regulators now allow banks to hold much less capital for what from a credit risk perspective is perceived as “absolutely safe” than against what is perceived as “risky”.
Fact: And that means banks can leverage their equity much more when lending to those perceived as “absolutely safe” than when lending to those perceived as “risky”.
Fact: And that means banks will earn much higher expected risk adjusted returns on their equity when lending to those perceived as “absolutely safe” than when lending to those perceived as “risky”.
Fact: And that means banks will lend almost exclusively to those perceived as “absolutely safe”, and basically nothing at all to those perceived as “risky”.
Fact: And that seems as far away as can be for the home of the brave which became a great land of the free primarily because of risk-takers… as few risk adverse crossed the ocean to reach its coasts.
And so the question: Who of you US legislators ordered the banks in the home of the brave to become even more risk adverse than what Mark Twain held these to be?
And legislators, if you are somewhat confused by these comments, may I suggest you invite your bank regulators to an open hearing to explain their main scripture, “The Basel Committee on Banking Supervision´s Explanatory Note on the Basel II IRB Risk Weight Functions of July 2005” to you.
But then you might really going to be scared.
Thursday, August 14, 2014
Perceived credit risks are similar to those risks described by Hans Karl Emil von Mangoldt in his 1855 example about the risks that a bottle of champagne bursts, and referred to by Frank H. Knight in his 1921 “Risk, uncertainty and profit”.
In essence it all boils down to that those risks do not alter the results, the profits, because they can be accounted and provisioned for.
And yet, our too creative and I would say too loony bank regulators decided that if a bank was going to produce champagne using “risky” bottles, it needed to hold much more capital (equity), than if it was going to produce milk using safer milk bottles.
No wonder we now find less and less of the exciting champagne in our economies.
But “we have at least milk” you say? Not so, there are risks with binging on milk too.
Our bank crises have never ever resulted from banks drinking too much risky champagne, these have always resulted from drinking too much of what ex ante was considered as very safe milk, but that ex post turned out to be quite soured milk... or even dangerously spoiled milk.
Tuesday, August 12, 2014
We believe that banks should give larger loans, on lower interest rates and on softer terms than usual, to those who are ex ante perceived as “absolutely safe”, like the infallible sovereigns and the AAA-ristocracy; and that they should give smaller loans, at higher interest rates and on harsher terms than usual, to those who are ex ante perceived as risky, like medium and small businesses, entrepreneurs and start-ups… so that we can go home and sleep calmly.
Since that could expose us to accusations of being discriminatory, we believe that the risk-weighted capital requirements for banks, by which we allow banks to earn higher risk-adjusted returns on equity when lending to the “absolutely safe” than when lending to “the risky”, is the least transparent and therefore the most effective regulatory pillar by which we can reach our objectives.
And, to those who might criticize us we say… we believe it is not our role to guarantee an efficient allocation of bank credit so that the economy grows sturdy and stays healthy… that is definitely somebody else’s business.
Monday, August 11, 2014
Europe beware, you´ve got yourself a very sad bunch of systemic risk experts reviewing the systemic risks of your banking system.
In the so posh sounding European Systemic Risk Board’s Advisory Scientific Committee´s report titled “Is Europe overbanked?” dated June 2014, we read:
“Large banks were able to increase their leverage - and therefore their return on equity (unadjusted for risk) – while complying with risk-based regulatory ratios”
And that is not correct... the lower risk weights in the risk-weighted capital requirements for banks, translates into allowing banks to hold much less capital against assets perceived as “absolutely safe”, which signifies that banks can leverage their equity much more with assets perceived as “absolutely safe”, and therefore earn much higher expected RISK-ADJUSTED returns on equity when lending to “The Infallible” than when lending to “The Risky.”
And this has made a true mockery of the report´s: “Financial development can also foster growth by allocating capital more efficiently, channeling resources to better projects and thus boosting total productivity”
Current risk weighted capital requirements signify that resources will be transferred in function of ex-ante perceived credit risks, which has of course not one iota to do with guaranteeing the transfer of these resources to better projects that can boost total productivity.
And in this respect, as I have been arguing for more than a decade, the risk weighted capital requirements represents the largest possible systemic risk to our banks and to our economies... as it basically prohibits much of the risk-taking necessary for our economies to move forward and for our descendants to have a future.
As an example January 2003 in a letter published by FT 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. Friend, please consider that the world is tough enough as it is.”
And yet, now soon 7 years after the crisis broke out, that systemic risk has not even been identified by those who allow themselves to be called experts in systemic risk. How come?
The report refers to “some reason, such as badly designed prudential regulation” in order to get to “banks’ rapid expansion into loans secured against residential real estate”
And yet the report does not mention the truly bad design of the prudential regulations that resulted from assigning very low risk weights against loans secured against residential real estate… which meant that banks could leverage much more their equity when giving loans secured against residential rate… which of course meant that banks would earn much higher than normal relative risk adjusted returns on equity on loans secured against residential real estate… which of course led to an explosion of bank loans secured against residential real estate.
And the report asks “Why has overbanking occurred?” and advances the explanation of “deposit insurance schemes may themselves generate moral hazard. Capital requirements can often be circumvented by banks, especially the largest ones, which have greater capacity to engage in risk-weight manipulation”
Circumvented? Hell no! The regulators allowed banks to hold only 1.6 percent in capital against securities rated AAA which meant authorizing a mindboggling leverage of 62.5 to 1… does as a bank really need to circumvent that? No! What they might need though, is to find some AAA ratings issued by the friendly and human fallible credit rating agencies.
And let us not even go to the area of bank lending to the “Infallible Sovereigns” where no equity is required and the sky is the limit for bank leverage. In November 2004 FT published a letter in which I asked “How many Basel propositions will it take before they start realizing the damage they are doing by favoring so much bank lending to the public sector (sovereigns)?”
And so I must conclude in a: “Europe, beware, you´ve got yourself a very sad bunch of systemic risk experts reviewing the systemic risks of your banking system”
Am I to harsh in my criticism? Absolutely! If this was the first time I criticized. But, considering I have been asking the regulators my questions for more than a decade, all over the web and in hundreds of conferences, and they have never ever dared to give me a straight answer (with one incredible exception) and much less have dared debate me on these issues… I do not feel I am too harsh or too impolite in any way shape or form.
On the contrary, I feel it is my responsibility to shame them in all the ways I can, so that no regulator dares to act ever again with so much hubris, believing he can be the risk manager for the world.
To finalize… may I kindly suggest these systemic risk experts that their so impressive list of 130 documents referenced does not include the most basic and important document required to understand the mumbo jumbo of financial regulators namely the Basel Committee on Banking Supervision´s Explanatory Note on the Basel II IRB Risk WeightFunctions of July 2005. That this document, has clearly not been reviewed by those preparing the report, is by itself something impossible to understand, unless of course they want to avoid shaming some members in a mutual admiration club.
Friday, August 8, 2014
Living wills: “Detailed plans that would enable banks to stipulate in advance how they would raise funds in a crisis and how their operations could be dismantled after a collapse”.
The whole concept of living wills for banks’ designed by the bankers themselves, for how to handle a collapse, seems to me a bit of a show by regulators to show they are doing something and to have something to put the blame on tomorrow…. “They gave us a bad living will”
I mean if I was a regulator, and wanted to go down that route, I would at least have a third party to look into what could be done in the case a bank passed away, and now and again confront the managers of the bank with those plans, in order to hear their opinions.
For instance there is a world of difference between a living will where the dead are going to be the own executors of the will, and one in which the dead will be dead and others will take care of the embalming.
And talking about this should not the Fed or the FDIC first state what contingent plan they really want… one where the bank is placed on artificial survival mode, and for how long, or one where it is sold in one piece, by pieces or even cremated?
To me it would seem that the Fed and FDIC need to give much clearer instructions about what they want those bankers who are currently working under the premise the bank will live on forever to do… as I can very much understand bankers being currently utterly confused.
PS. And, to top it up, regulators should worry more about how banks live than about how they die. Thanks in much to the distortions created by the regulators with their risk-based capital requirements, the banks are not allocating credit efficiently and their legacy is therefore condemned to be poor. And… excuse me, that´s a far more serious problem.