Saturday, May 31, 2014

What caused regulators to concoct crazy risk-weighted bank capital requirements? Lack of testosterone, cortisol, cocaine, hubris or ideology?

The pillar of current bank regulations are the risk weighted capital requirements for banks. For instance in Basel II: 0 percent when lending to an “infallible sovereign”; 1.6 percent when lending to a slightly less “infallible sovereign”, or to a private member of the AAAristocracy; and 8 percent when lending to “a risky” medium and small businesses, or to an entrepreneur or a start-up.

John Coates a PhD research fellow in neuroscience at the university of Cambridge in his “The hour between dog and the wolf: How risk taking transform us, body and mind” writes “The financial system, as we have recently discovered to our dismay, balances precariously on the mental health of [financial] risk-takers. And he mentions testosterone, cocaine and hubris as risk-taking inducers; and cortisol as a risk-aversion generating hormone.

It would be interesting to hear John Coates opinion of what he thinks was present in the bodies’ of bank regulators when they concocted their regulations.

For instance, was it cortisol which made regulators so adverse to banks taking any kind of risks? Clearly, by allowing banks to earn so much higher risk-adjusted returns on equity when lending to the “absolutely safe” than when lending to “the risky”, they evidenced they were so insanely risk-adverse against banks running into short term problems, they even preferred to risk the misallocation of bank credit, something which had to guarantee that our real economy, and our banks, would run into problems long term.

Or was it testosterone, cocaine, or hubris which turned our bank regulators, those who foremost should be on the outlook for unexpected losses, into some risk taking monsters?  Allowing banks to leverage their equity 62.5 to 1 when lending to a private corporation, only because of AAA ratings, or to a nation with ratings such like those Greece had; or to even assume the existence of “infallible sovereigns” and in which case they allowed banks to leverage their capital infinitely… points at nothing else but insane risk-taking. Unless they are plain dumb something external must have influenced regulators to blind themselves to the fact that financial crises are never caused by excessive exposures to "the risky", but always by excessive bank exposures to something erroneously thought as "absolutely safe"

Coates refers to Lord Owen, a former British foreign secretary and a neurologist by training describing the “hubris syndrome” as “a disorder of the possession of power, particularly power which has been associated with overwhelming success, held for a period of years and with minimal constraint on the leader [which] can result in disastrous leadership and cause damage on a large scale. And Coates further clarifies it writing “This syndrome is characterized by recklessness, an inattention to detail, overwhelming self-confidence and contempt for others.”

I do not know about testosterone, cortisol or cocaine but,  since I quite recently heard one of the most important bank regulators saying “if bankers don’t like it let them be shoemakers” I would settle for the hubris of bank regulators, that which made them think they could act as risk managers for the whole world, as being the principal cause of the financial crisis… sprinkled of course with a heavy dose of ideology.

In Bill Easterly´s terms... God save us from the tyranny of experts!