Thursday, April 28, 2016

Here are 26 reasons for why I believe the bank regulators in the Basel Committee are complete idiots… or something worse.

A brief comment. Do you think it is disrespectful of me to call the Basel Committee's regulators “idiots”? If you had tried for more than a decade to get some answers in all politely thinkable ways, and you have only been met by silence… and if you were as convinced as me that their regulations are utterly disrespectful of the future world of my children and grandchildren… then you might call them something much worse.

In 1999 in an Op-Ed I wrote: “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 the banks”. But little did I suspect the regulators in the Basel Committee would be so incredibly inept!

So here are the reasons... for now 26... but still counting!


Undefined purpose: The regulators never defined the purpose of our banks before regulating these. That’s why they only cared about banks’ safety, as mattresses into which stuck away cash, and cared not one iota about the vital social purpose of banks of allocating credit efficiently to the real economy. “A ship in harbor is safe, but that is not what ships are for.” John A Shedd, 1850-1926

Boundless hubris: To think that, from their desks, they could be the risk managers for the whole banking world, and with some standard risk-weights, make the banks allocate credit better and safer to the real economy, is pure mind-boggling hubris.

Confusion about relevant risks: The regulators looked at the risks of the clients of the banks, while they should have looked at the risks of the clients of the bank for the banks. They never studied empirically what has caused bank crises. That is why for instance in Basel II of 2004 they assigned a risk weight of 150 percent to clients rated below BB-, those clients that banks would never ever build up dangerous exposures to, and of only a 20 percent to those rated AAA to AA. In essence like a nanny telling kids to stay away from the ugly and foul smelling, and embrace more those nice looking gentlemen who offer them candy.

Total confusion with the ex-ante and the ex-post: What is the ex post credit risk conditioned on what has been ex ante perceived? Hint - motorcycles are correctly viewed as much riskier than cars… and therefore much more people die in car accidents than in motorcycle accidents.

Using the expected as a proxy for the unexpected: Capital requirements are there to cover for un-expected events. Credit risk is part of the expected and so using this as a proxy for the unexpected is senseless. In fact, the safer something is perceived, the bigger its potential for delivering the unexpected.

Excessive consideration of credit risk: Frankly of all risks out there these regulators had to pick “credit risk”? The risk most already cleared for by banks on the asset side, by means of risk premiums and size of exposures, is credit risk. To clear for that same credit risk in the capital signifies giving too much consideration to credit risk. And let us never forget that any risk, even if perfectly perceived, leads to the wrong actions if excessively considered.

Overreliance on data and models: In October 2004 in a formal statement at the World Bank I warned: “Much of the world’s financial markets are currently being dangerously overstretched through an exaggerated reliance on intrinsically weak financial models that are based on very short series of statistical evidence and very doubtful volatility assumptions.

Ignoring how vital true risk taking is: Risk taking is the oxygen of any development. For banks to take risks, albeit in small amounts, on “The Risky”, like with SMEs and entrepreneurs, is absolutely vital for the economy to move forward, in order not to stall and fall. Instead regulators gave banks incentives for building up excessive exposures to “The Safe”, a quite useless and very dangerous kind of risk-taking. In short this regulation keeps Keynes' animal spirits caged.

When stress testing banks, they reveal ignorance: A banks’ balance sheets need to be tested not only for what is on these, but also for what is lacking. Have they done that? Of course not; again they never defined the purpose of banks.

No understanding of distortion on the margin. When now, playing tough, real macho-men, regulators increase capital requirements, they evidence they have no understanding of how their distortions distort on the margin. The scarcer a bank finds its regulatory capital to be, the more it has to stay away from what requires high capital requirements, namely “The Risky”

Runaway statism: In 1988 with Basel I they assigned a risk weight of zero percent to their friendly sovereigns, and of 100 percent to the citizens. That in effect meant that they believed government bureaucrats to be able to use bank credit more efficiently than the citizens. That in effect ignored that the strength of a sovereign is mostly defined by the strength of its citizens.

No financial acumen: They never understood that with risk weighted capital requirements, the banks would be able to leverage differently different assets, and that would produce different risk-adjusted returns on equity for different assets, than would have been the case in the absence of the risk-weighting. The result was of course favoring more than usual those perceived decreed or concocted as safe, and disfavoring more than usual the access of bank credit of those perceived as risky.

Misalignment of the evaluation bias: Bank used to have a bias to increase the perception of risk, so as to charge higher risk premiums; and borrowers to reduce the risk perception o as to reduce the risk premiums. That conflict was useful for all. Now suddenly bankers also want to reduce the perception of risk, so as to reduce the capital requirement. And that aligns dangerously both parties on the same side, against the regulators.

Banks’ business model suffered bad changes. From banks earning their returns on equity by allocating bank credit based on the highest risk adjusted margins, these currently do so based on who offers the highest risk adjusted margins when adjusted by the lowest risk weighted capital requirement that could be applied. That has turned banks away from traditional banking, towards being more of capital (equity) minimization banks.

No understanding of systemic risks: In January 2003 I wrote in Financial Times: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds. Friends, as it is, the world is tough enough.” What more can I say?

No understanding of fragility: In April 2003, as an Executive Director of the World Bank I stated: “A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind.” What more can I say?

No understanding of pro-cyclicality: When times are good, credit-risks seem low, so the risk-weighted capital requirements allow banks to expand more than they should; and when times are bad, the credit risk are naturally perceived higher, and so the capital requirements force banks to contract credit, precisely when less bank credit austerity is needed. What more can I say?

No understanding of TBTF banks growth hormones. Nothing like the micro capital requirements, against assets of large international banks with a lot of specialized activities, has served as the growth hormones for the Too Big Too Fail banks.  

Mind-blowing naiveté: How can anyone believe that the big sophisticated banks authorized to use internal risk models, would not use these to minimize the capital they need to hold …so that they could maximize their returns on equity? That is like allowing Volkswagen to test their own emmissions.

Macro-imprudence: Prudential regulation helps failed banks to fail expediently. Macro-imprudent regulation impedes failed banks from failing… which builds up huge mountains of combustible materials waiting for a Big Bang.

Confusing and misleading information. Because regulators wanted for them and the markets to have better information one now can read about a bank’s common equity tier one ratio, being for instance 10.8 per cent, which is something that could seem indicative of a leverage of less than 10 to 1; “A fairly well capitalized bank”. But no! The real leverage could at that moment be over 30 to 1.

Disdain for equality of opportunities: John Kenneth Galbraith wrote in “Money: Whence it came where it went” “The function of credit in a simple society is, in fact, remarkably egalitarian. It allows the man with energy and no money to participate in the economy more or less on a par with the man who has capital of his own. And the more casual the conditions under which credit is granted and hence the more impecunious those accommodated, the more egalitarian credit is” And so, with their discrimination against “The Risky”, you could say the regulators decreed inequality.

Financialization of the economy: By allowing ridiculously low capital requirements for assets perceived as safe, the regulators allowed banks to leverage 60 times to 1 and more their equity, and the support they received from society (taxpayers). That facilitated the current generation to extract more borrowing capacity to sustain their own consumption than any other previous generation, like with reverse mortgages. That left little borrowing capacity over for the future generations.

No capacity or will to rectify: Here we are soon a decade after the 2007-08 crisis and the regulators have yet not been able to connect the dots between what caused it; real estate, AAA rated securities and sovereigns like Greece, all with very low risk weights and therefore very low capital requirements for these assets.

And they only dig us deeper in the hole: Basel I has only 30 pages, Basel II grew into 347 pages and Basel III is growing into a more than a thousand pages monster. It seems they want to solve the shortage of jobs by creating bank regulation consultancy jobs. Every day that goes our banks finance less and less of the riskier future only to refinance more and mote the, for the time being, safer past.

And you wont believe this: The standard risk weighted capital requirements for banks were decided by using a portfolio invariant model; “so the capital required for any given loan does only depend on the risk of that loan and must not depend on the portfolio it is added to.” And the explanation for this horrible simplification was because that to do it portfolio variant, “would have been a too complex task for most banks and supervisor”. What more can I say... but they certainly did not find it too complex to distort it all.

A Spanish proverb: "From safe tranquil waters free me God, from dangerous turbulent ones, I’ll free myself"

Or Voltaire’s “May God defend me from my friends: I can defend myself from my enemies.


PS. Why do I mention the possibility of “something worse”? Because for me it would be hard to think of a more efficient and devious way to destroy capitalism, and the Western Society, than infusing it with an extraordinary silly risk aversion. The AAA-bomb

PS. I am sure there must be a lot of other good examples and explanations of the Basel Committee's idiocy that I have expressed here and here.

PS. Deregulation? Hah! Had banks not been regulated at all, the Crash 2007-08 would never have happened. Markets would knowingly never allowed banks to leverage their equity 30-50 times to 1, no matter how secure their assets seemed… as did happen. The regulators, with their “risk-weighing of assets” confounded the markets into thinking that, one way or another all risks had been taken cared of. They even confounded their own. Too often we read “experts” like Alan Greenspan discussing the evolution of bank capital, comparing capital to asset ratios with capital to risk-weighted assets ratios… something as oranges-and-apples as can be.

PS. Bank capital requirements would be better if based on ex-post risks of models based on ex-ante risk perceptions.
  
PS. It seems like we need robots in the Basel Committee for Banking Supervision in order to free us from some weak egos incapable of admitting mistakes.

PS. And what to say about those who keep the failed Basel Committee regulators regulating?  Perhaps another John Kenneth Galbraith quote applies: If one is pretending to knowledge one does not have, one cannot ask for explanations to support possible objections.

The truth is that hiring some fortune tellers to read the palms of the bankers so as to weigh for bad-luck the capital requirement for banks, would be more effective to cover for the unexpected than the current risk weighted capital requirements.

I AM CALLING THEM INEPT "IDIOTS"! 
SO ASK YOURSELVES, IF I AM WRONG, 
WHY DO THEY NOT EXPLAIN AND MAKE ME THE INEPT IDIOT?