Thursday, April 28, 2016

Here are 40 reasons for why I believe/know the bank regulators in the Basel Committee are inept idiots… or something worse.

Opening question: If bankers’ perceived credit risk correctly, would they need supervision? Clearly not! So why use risk weighted bank capital requirements based on that bankers perceive credit risks correctly? Is that not irresponsible/loony?

Do you think it is disrespectful of me to call the Basel Committee's regulators “inept 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 some reasons... for now sort of 40... 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.

They never cared what the credits were for. The most important question a banker should ask: “What are you going to use the money for?” got kicked out of banking. There are credits directed to produce new revenue streams for their repayment, like loans to entrepreneurs, and there are credits that rely on other revenue streams for that, like when financing houses. In the long run, those first that help pull up, and not just push up the economy, even though riskier, are safer.

They unknowingly redefined the purpose of banks. The lower a capital requirement is, the higher can a bank leverage its equity, the higher is the risk adjusted return on equity it can obtain. In this respect the risk-weights de facto indicates banks to whom they should lend and in what they should invest.

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.

They never researched what has caused bank crises: What more to say?

They do not know about conditional probabilities: The regulators looked at the risks of the assets held by banks, while they should have looked at the risks for the banks of the assets held. That's 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 parents telling their children “If the stranger is ugly and foul smelling, stay away from him, but if he looks nice and offers you candy, befriend him a lot

They ignored the existence of risk premiums. The risk weighted capital requirements completely ignore that the perceived credit risks are cleared for by risk premiums...higher interest rates. It is like if insurance companies would be charging the same premium for different risks.

Confused on ex-ante and 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.

So they got it all upside down, killing the best . It is when something ex ante perceived as very safe, ex post turns out to be very risky, that one really would like banks to have the most capital, not when something perceived risky turns out risky. The best tail risk, that which perceived as very risky turns out to be very safe, they killed it. The worst tail risk, that which perceived as very safe turns out to be very risky, they put it on steroids.

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.

Not understanding they impose tariffs and give subsidies on the access to credit. In a free market, a banks’ capital is one and the same for all assets; and risks are considered with size of exposure, net risk margins, liquidity and general portfolio adequacy. In the current non-market, the risk weighted capital requirements, acting on top of those considerations, impose tariffs on the "risky's" access to credit... which also translates into subsidies for the "safe".

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. In short this regulations keeps Keynes' animal spirits caged.

Turns “The Safe” into risky: If those perceived safe are favored with regulations that allow them to access more credit at more favorable rates than usual, these will, with time, take on too much debt and turn risky… and so will the economy. The safe-havens will become dangerously overpopulated. Just as Dag Hammarskjöld said: “It is when we all play safe that we create a world of utmost insecurity.

Turns “The Risky” into riskier: If those perceived risky are punished with regulations that make them have less access to credit and at higher rates than usual, these will turn even more risky… and so will the economy

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.

Stress testing represents on its own a big systemic risk, as when all banks align themselves to the bank regulators' stress a la mode.

No understanding of distortion on the margin. When now, playing tough, real macho-men, regulators increase capital requirements with their leverage ratio in Basel III, they evidence they have no understanding of how their risk weighted capital requirements 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. 1988 US public debt was $2.6 trillion, at end of 2017, much because of that 0%, its debt was now US$20.2 trillion, and it still has a 0% risk. 

No understanding of that they were painting themselves into a corner. By assigning a 0% risk weight to US public debt… if in need be, and there will be need, how do you increase it, even to only 10%, without creating a panic? The only solution I see to that is to increase the leverage ratio applicable to all assets, until such level that the risk weighted capital requirements lose entirely their significance.

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?

Changes competition from being healthy to being dangerous: Competition among banks is always good, and that as a result some banks fail, something quite healthy. But when that competition occurs in a sector that because it is perceived safe allows for too much leverage, then it can spill over and endanger the bank system.

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 Minsky Moment.

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. “Our banks are now much better capitalized” message could mean not a dime more in capital, but just the result of banks moving out of “risky” assets into “safe” assets.

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 and block social mobility.

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 understanding of how markets incorporate distortions in prices: For instance how much of current house prices result from the regulatory subsidies provided by the low risk weights assigned to residential mortgages?

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. But then again, as Upton Sinclair said It is difficult to get a man to understand something when his salary depends upon his not understanding it.” 

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.

Basel Committee’s monstrous regulatory contradiction: The risk weighted bank capital requirements in “the Revised Framework was calibrated to well-diversified banks”. But the distortions caused by the risk weighting can only result in badly diversified banks.

But sophisticated (large) banks can do whatever they like: In the inexplicable “Explanatory Note on the Basel II IRB Risk Weight Functions” we also read: “It should be noted that the choice of the ASRF (Asymptotic Single Risk Factor model) for use in the Basel risk weight functions does by no means express any preference of the Basel Committee towards one model over others… Banks are encouraged to use whatever credit risk models fit best for their internal risk measurement and risk management needs.”

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.

Conclusion: The risk weighted capital requirements for banks, besides weakening the real economy, by fomenting especially large exposures, to what is especially perceived as safe, against especially little capital, only lays the ground for especially large crisis. Or in other words, by causing our banks to be dangerously overexposed to what’s expected, and woefully unprepared for the unexpected these do, effectively, put Minsky Moments on steroids.

PS. Why do I mention “something worse” only as a possibility? Because for me it would be hard to think of a more efficient and devious way to destroy capitalism, and the Western Society, than this of 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. “More food for the hungry - less food for the less hungry” also sounds logical, unless the hungry here are obese and the less hungry anorexic.

PS. Bank capital requirements would be better if based on ex-post risks of models based on ex-ante risk perceptions. I am not the only one arguing this. Here, for instance, Charles Goodhart.
PS. It seems like we need IBM's Watson to feed new algorithms to 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.

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

PS. Is it all because of what Daniel Patrick Moynihan supposedly said, “There are some mistakes only Ph.Ds. can make"

The risk weighted bank capital requirements have doomed banks to fire their traditional loan officers in order to hire creative equity minimizing financial engineers able to construe safety where there might be risks.

Would there not be sufficient appetite for investing in safer better-capitalized banks? Of course there would! The problem is that having to serve more shareholder equity would eat into bonuses, and so bankers hate it.

“As long as the roots are not severed, all is well, and all will be well, in the garden” said Chauncey Gardiner.

But since with risk weighted capital requirements regulators severed the roots of the economy, all is clearly not well, in our garden


Finally I got a clue why members of the Basel Committee, with their risk weighted capital requirements for banks, show they find what is perceived as risky to be more dangerous to bank systems than what is perceived as safe. They suffer an anxiety disorder, False Safety Behavior. Poor them and poor us!

PS. And here, from 2010, is a very humble home-made youtube effort of an explanation for dummies.

And Paul Volcker in his "Keeping At It" of 2018 wrote: “The inherent problems with the risk weighted bank capital-based approach is that the assets assigned the lowest risk, for which capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages