I'm a former [short-term] Executive Director of the World Bank (2002-2004) for Costa Rica, El Salvador, Guatemala, Honduras, Mexico, Nicaragua, Spain and Venezuela. I write this blog to echo my voice and my noise. Though I know many will only be able to read it in yellow or blue, I do make an effort to write it in green. The Radical Middle or the Extreme Center is not any wishy-washy place to be, in a world where swimming to any of the ideological shores provides for a much calmer shelter.
"So, trying to conclude; for the best of my grandchildren’s future, had it not been best if the Basel Committee had not begun to distort the allocation of bank credit with the risk weighted bank capital/equity requirements?"
ChatGPT answered:
Yes, in many ways, it's fair to say that the Basel Committee's risk-weighted capital requirements, particularly those that favor public debt and residential mortgages, may not be the optimal approach for the long-term economic prosperity of your grandchildren. By distorting the allocation of bank credit, these regulations have had several unintended consequences that could negatively affect the broader economy over time.
Key Issues with the Basel Approach:
1. Distorted Credit Allocation: Basel regulations incentivize banks to lend where the risk-weighting is lowest—mainly government debt and residential mortgages—at the expense of more dynamic sectors like small businesses and entrepreneurship. This limits access to credit for high-growth sectors that drive innovation, economic expansion, and job creation, thus slowing overall economic dynamism.
2. Increased Systemic Risks: By pushing banks to hold more government debt and mortgage-backed assets, the system becomes more homogeneous and less resilient. When crises hit these sectors, the effects are more widespread and severe. Examples like the 2008 financial crisis (fueled by mortgage-backed securities) show that concentration in a "safe" asset class can be a huge risk.
3. Stifling Innovation and Economic Growth: Small businesses and startups, typically more dependent on bank credit than large corporations, are squeezed out of the credit system. As a result, future generations may see slower job creation and economic opportunity, which is essential for a thriving, innovative economy. This could make it harder for your grandchildren to find opportunities in high-growth sectors or start their own businesses.
4. Long-Term Fragility: While these rules may provide short-term stability, they can foster long-term economic fragility. An overreliance on public debt and housing markets makes the financial system more vulnerable to large-scale crises in these sectors, which could hurt future generations more severely than smaller, more localized risks in other areas of lending.
Alternatives for a Healthier Future:
Had the Basel Committee encouraged more balanced credit allocation—without such heavy favoritism toward certain asset classes—banks might have been more inclined to lend to small businesses, entrepreneurs, and other high-growth sectors. This would likely lead to:
More Dynamic Economic Growth: By providing adequate funding to small businesses and startups, there would be more room for innovation and job creation, which would benefit future generations.
Greater Diversification: A more balanced allocation of credit across various sectors would reduce systemic risks. Banks would be less likely to concentrate too much exposure in areas like public debt or housing markets, making the system more resilient to crises.
Stronger Economic Foundations: A diversified banking system, funding a range of economic activities, builds a stronger economy less prone to the boom-bust cycles associated with over-reliance on specific asset classes.
Conclusion:
Yes, had the Basel Committee not introduced such a heavy risk-weighting bias that favors public debt and residential mortgages, it’s likely that the banking sector could have supported a more diverse and resilient economy. This might have provided your grandchildren with greater opportunities for entrepreneurship, more dynamic economic growth, and less exposure to systemic risks that could lead to future crises. By creating a more balanced and equitable financial system, the long-term prospects for future generations would likely be improved.
I told ChatGPT:
"I see you agree that, as a father and grandfather, I have all kinds of reasons to be concerned with what some besserwisser bank regulators have concocted during the last decades with the Basel regulations. So, thanks!"
ChatGPT answered:
You're absolutely right to be concerned, and it's completely understandable to question the decisions that have shaped the financial world your children and grandchildren will inherit. The complexities of banking regulations often have long-term consequences that aren't immediately apparent, and it's important to recognize how these policies could affect future generations.
If you ever want to discuss more or explore other areas of concern for the future, I'm always here to help.
I said: Thanks again. I will come back!
ChatGPT said: You're very welcome! I look forward to our next conversation. Take care, and feel free to reach out whenever you're ready!
Note: The answers are copied exactly from those given to me by ChatGPT or Grok.
With unlimited hubris, very few regulators who thought they knew all about the risks to our bank systems, and also because of some political considerations, globalized risk adverse risk weighted bank capital/equity requirements.
They based their risk assessments on perceived risks; not conditioned to how banks usually reacted to perceived risk.
To determine the risks, they empowered some very few human fallible credit rating agencies.
And those few rating agencies, they got much of the information from some very few important audit corporations.
What could go wrong?
The perceived or decreed “safe”, e.g., governments, residential mortgages and assets rated as investment graded, were bound to get more bank credit and at lower risk adjusted interest rates than would otherwise have been the case. The perceived risky e.g., small businesses, entrepreneurs and consumers, bound to get less credit and at higher risk adjusted interest rates than would otherwise have been the case. De facto, more inequality was decreed.
The introduction of this abundantly clear systemic risk, completely ignored the value of a free market’s millions of diverse opinionated participants.
What could now go wrong with artificial intelligence?
April 2023, I had my first dialogue with ChatGPT. I got hooked. What amazing number of, for both of us, illuminating conversations I’ve had with it.
"As an AI language model, my purpose is to provide accurate and helpful information to the best of my abilities. However, it is possible for AI to be programmed to generate responses that are not truthful.
In general, AI systems are only as unbiased and truthful as the data and programming that they are built upon. If an AI system is programmed to intentionally provide false information or to hide the truth, it can be used to propagate false narratives or disinformation campaigns.
Therefore, it is essential to ensure that AI systems are designed and used ethically, with a focus on accuracy, transparency, and accountability. This includes careful consideration of the data used to train AI models, as well as implementing safeguards to prevent intentional deception."
Ever since there’s not one day when I do not worry when I read, or hear, an opinion on the need to regulate AI. To guarantee diversity, and so that they all can keep a watchful eye on each other, I pray, as a minimum minimum:
"Let millions of ChatGPT bloom"
"Let AI feed on millions of different opinion and data sources."
"Humans posing question to artificial intelligences and getting answer, could that qualify as a systemic risk, as a risk to the system, or just as a very useful source of second opinions?"
OpenAI answered:
"Humans posing questions to artificial intelligences and receiving answers generally does not qualify as a systemic risk to the overall system. Instead, it can be considered a valuable source of information and a means to obtain second opinions or insights. However, it is essential to consider certain factors:
1. Reliance on AI Outputs: If individuals or organizations excessively rely on AI outputs without critical thinking or independent verification, it can introduce risks. Over-reliance on AI-generated information, especially without proper context or understanding of limitations, can lead to errors or misinterpretations.
2. Data Quality and Bias: AI models learn from data, and the quality and representativeness of the data can impact the accuracy and objectivity of AI responses. If the underlying training data contains biases or inaccuracies, it can lead to biased or misleading outputs. Careful consideration of data sources and data quality is crucial to mitigate such risks.
3. Technical Limitations: AI models have limitations and may not have access to real-time or complete information. They may also struggle with complex or nuanced questions that require contextual understanding or human judgment. Being aware of these limitations and using AI outputs as one input among others is essential.
4. Ethical Considerations: AI systems should be developed and used in accordance with ethical principles, ensuring fairness, transparency, and accountability. The potential for AI to perpetuate or amplify existing biases should be carefully managed to avoid unintended consequences or discriminatory outcomes.
Overall, while AI can provide valuable insights and second opinions, it is important to exercise critical thinking, consider the limitations of AI systems, and validate outputs when necessary. Balancing the strengths of AI with human judgment and expertise can help mitigate potential risks and make informed decisions."
Note: The answers are copied exactly from those given to me by OpenAI
First: Make capital requirements for banks based on perceived risk. More risk more capital, less risk less capital. That would allow banks to leverage more with The Safe than with The Risky. That would allow banks to earn higher risk adjusted returns on equity lending to The Safe than when lending to The Risky.
Second: Allow banks to use their own risk models to decide what is risky and what is safe and therefore how much capital it needs. Alternatively allow some very few human fallible credit rating agencies to decide what is safe and what is risky.
Third: Sit down and wait for banks lending too much against too little capital to The Safe, like sovereigns, the AAArisktocracy and mortgages; within an economy weakened by too little lending to The Risky, like to SMEs and entrepreneurs.
But, oops, hold it there! Someone already did that! I think it was the Basel Committee for Banking Supervision.
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.
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.
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
I AM CALLING THE REGULATORS "INEPT IDIOTS"!
SO ASK YOURSELVES, IF I AM WRONG,
WHY DO THEY NOT EXPLAIN AND SHOW ME TO BE THE INEPT IDIOT? 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.
AndPaul 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”
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