Wednesday, June 21, 2017

A challenge: Can you spot a lunacy in the Basel Committee’s risk weighted capital requirements for banks?

These are the facts established by Basel II in 2004.

1. Very safe AAA to AA rated = 20% risk weight = 1.6% capital requirement = 62.5 times to 1 allowed leverage.

2. Very risky below BB- rated = 150% risk weight = 12% capital requirement = 8.3 times to 1 allowed leverage.

So what’s crazy with that?

Let me give you a clue! 

What can create those kinds of excessive bank exposures that could bring down a bank system?

Monday, June 19, 2017

Mr Watson IBM, besides helping wine growers, when are you going to tell bank regulators they’re so wrong?

Bank regulators, thinking they are so smart, assigned a meager 20% risk weight for what is rated AAA to AA, and a whopping 150% to what is rated below BB-.

That allows banks to hold much less capital against assets rated AAA to AA than against assets rated below BB-.

Now you tell me Watson, what is more dangerous to our banking system, that rated AAA to AA, that because is perceived as so safe could lead to the dangerous build-up of excessive bank exposures, or that which because it is rated below BB- bankers wont touch with a ten feet pole?

So, when are you going to offer to help the bank regulators? They sure need it! We sure need it!

Wednesday, June 14, 2017

Sadly the Basel Committee did not perform a Gedankenexperimente before regulating banks.

I just read about "Gedankenexperimente" in The Economist of June 10, 2017 "Quantum mechanics and relativity theory: Does one thing lead to another?

So, if the Basel Committee had done a Gedankenexperimente before regulating banks, then, if also applying Werner Heisenberg's uncertainty principle, they would have understood that the better current risks are perceived and the more you want banks to go for what is now safe, the riskier the future becomes.

First, because risk taking is the oxygen of development and a better future is built at least as much upon failures than upon successes. 

Second because what would be perceived as safe in the present would then get too much access to bank credit and thereby at one point in the future become very risky.

And so the regulators would have realized that with their risk weighted capital requirements for banks, they would be setting up the bank system for the worst kind of explosion imaginable, namely huge exposures to something very safe, turning very risky, against little capital, and with a real economy that has gone soft. 

PS. July 2011 I wrote twice to the Financial Times about Basel Committee’s regulations and Heisenberg’s uncertainty principle but, since I have been censored by FT, the editor was not interested. 

Tuesday, June 13, 2017

What causes the “motivated reasoning” that keeps Basel bank regulators from admitting their mother of all mistakes?

The Basel Committee for Banking Supervision developed, as a pillar of their regulations, the risk-weighted capital requirements for banks. 

They should never have done that because that completely ignored the fact that these would distort the allocation of credit to the real economy. 

But, when doing so, they also committed the mother of all regulatory mistakes, namely the following:

They set the risk weights based on the risk of the assets and not on the risks the assets represented for the bank system.

That for instance is why, in their standardized risk weights of Basel II, regulators assigned a meager 20% risk weight to what is AAA to AA rated, something which precisely because of such good rating, could lead to the build-up of dangerously large exposures; and a whopping 150% risk weight, to what is rated below BB-, and which is therefore of course rarely touched by bankers, not even with a ten-feet pole.

In other words regulators took the ex-ante risks to be the ex-post risks.

But it has been absolutely impossible to get anyone related to those regulations to admit such thing. And many of those who should have no reason to not divulge that mistake, like specialized journalists and finance professors, have also kept mum on it.

The Economist, June 10, 2017 writes on: “How to be wrong: To err is human. Society is suffering from an inability to acknowledge as much”. It refers there to a “framework for thinking about…[why] people frequently disregard information that conflicts with their view of the world”, elaborated by Roland Benabou and Jean Tirole.

The framework holds that: “Because beliefs… are treasured in their own right, new information that challenges them is unwelcome. People often engage in “motivated reasoning”. [This can be caused by]: “‘Strategic ignorance’… when a believer avoids information offering conflicting evidence.” or “In ‘reality denial’ troubling evidence is rationalized away”, or “in ‘self-signaling’, the believer creates his own tools to interpret the facts in the way he wants”

So Mr Roland Benabou and Mr Jean Tirole, I here ask you. Was, is, any of the three causes for “motivated ignorance” you mention, absent in this case of the Basel Committee’s so mistaken risk-weighted capital requirements for banks?

And also when illustrious Martin Wolf publicly acknowledges, without doubting the correctness of it, that “As Per Kurowski, a former executive director of the World Bank, reminds me regularly, crises occur when what was thought to be low risk turns out to be very high risk", Why is Wolf still not capable to understand how 180 degrees-off the risk weighted capital requirements are?

And about that society is suffering from this mistake there can be no doubt.

If you want even a more detailed explanation on The Mistake go here.

And if Econ Journal Watch wants to attract some confessions then help me ask these questions 

Thursday, June 8, 2017

A safer banking system compared to our current dangerously misregulated one with so many systemic risks on steroids

What is a safer banking system?

One in which thousand banks compete and those not able to do so fail as fast as possible, before some major damage has been done, while even, as John Kenneth Galbraith explained, often leaving something good in their wake. 

What is a dangerous banking system?

One were all banks are explicitly or implicitly supported, by taxpayers, as long as they follow one standard mode that includes living wills, stress tests, risk models, credit ratings, standardized risk weights... all potential sources of dangerous systemic risks.

A bank system in which whenever there is a major problem, the can gets kicked down the road with QEs and there is no cleaning up, and banks just get bigger and bigger.

One that make it more plausible that the banks will all come crashing down on us, at the same time, with excessive exposures to something ex ante perceived safe that ex-post turned out risky, and therefore the banks holding especially little capital.

But you don’t worry; the regulators have it all under control with their Dodd-Frank’s Orderly Liquidation Authority (OLA). “Orderly”? Really?

So that is why when I hear about banks “cheating” with their risk models I am not too upset, since that at least introduces some diversity. 

Also that cheating stops, at least for a while, the Basel Committee regulators from imposing their loony standardized risk weights of 20% for what has an AAA rating, and so therefore could be utterly dangerous to the system; and one of 150% for the innocuous below BB- rated that bankers don’t like to touch with a ten feet pole.

How did we end up here? That is where you are bound to end up if you allow some statist technocrats, full of hubris, to gather in a mutual admiration club, and there engage into some intellectually degenerating incestuous groupthink.

Statist? What would you otherwise call those who assign a 0% risk weight to the Sovereign and one of 100% to the citizen?

And it is all so purposeless and useless!

Purposeless? “A ship in harbor is safe, but that is not what ships are for”, John A Shedd

Useless? “May God defend me from my friends, I can defend myself from my enemies”, Voltaire

In essence it means that while waiting for all banks to succumb because of lack of oxygen in the last overpopulated safe-haven available, banks will no longer finance the "riskier" future our grandchildren need is financed, but only refinance the "safer" present and past.

In April 2003, as an Executive Director of the World Bank I argued: "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."

PS. FDIC... please don't go there!

Note: For your info, before 1988, we had about 600 years of banking without risk weighted capital requirements for banks distorting the allocation of bank credit to the real economy.

PS. The best of the Financial Choice Act is a not distorting, not systemic risks creating, 10% capital requirement for all assets. Its worst? That this is not applied to all banks.

PS. If I were a regulator: Bank capital requirements = 3% for bankers' ineptitude + 7% for unexpected events = 10% on all assets = Financial Choice Act

Wednesday, June 7, 2017

FDIC, don’t go there! The more similar living wills, stress tests & risk models are, the greater the systemic risks

I just received the FDICs “Supervisory Guidance on Model Risk Management"

It really scares me to read how concerned FDIC still is with how bankers’ develop and use their risk models, among these those for determining capital and reserve adequacy.

I just don’t get it! Let bankers do their job, which is to develop all the models they can that will facilitate their job as bankers, the best they can. And the more crazily diverse these risk models are, the better, as the less is their systemic risk.

FDIC should concern itself exclusively with the what if the bankers of some banks are not good enough when modeling.

And the same goes for living wills and stress tests. Force each bank to present what they think about that, and leave it like that.

In January 2003, while an ED of the World Bank, in a letter published by the Financial Times I argued: “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”

And in April 2003, commenting on the World Bank's Strategic Framework 04-06 I wrote: "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."

I still hold all that to be true… now more than ever!

FDIC, please, they are the bankers and you are the regulator (and insurer), don’t confuse the roles!

FDIC, please, don't insist on being a better banker than the bankers, just be their regulator!

Wednesday, May 24, 2017

Fortunetellers’ bankers' bad-luck weighted capital requirements for banks would be better than Basel Committee’s risk weighted

We have the Basel Committee’s risk weighted capital requirements for banks. More ex ante perceived risk more capital, less perceived risk less capital. These are loony. First since it considers that was is already perceived as risky, is riskier for the bank system than what is perceived as safe; and second because it distorts the allocation of bank credit to the real economy, hindering banks from the much needed financing of the riskier future, making them concentrate on refinancing the safer past and present. 

Now, if we were to weigh the capital requirements for banks based on the fortunetellers reading bankers' hands, to ascertain bankers' bad-luck, then we would at least have one capital requirement against all assets; something that would at least not distort the allocation of bank credit to the real economy. And since this procedure would be based on bad-luck, and not on good luck, we could expect that capital requirement to be fairly high.

And if the fortunetellers got it all wrong, since they did not distort credit allocation, that would be less dangerous when compared to the credit rating agencies being wrong.

I challenge any of all current bank regulators to, in public, defend their risk weighting against that of my fortunetellers.

My opening question to them would be: What do you think of that Basel II assigned a risk weight of only 20% to the so dangerous AAA rated, and one of 150% for the so innocuous below BB- rated?

PS. Of course fortunetellers could be captured... but so can credit rating agencies be too.

PS. Now, what I would not suggest to do, is to allow big banks to use their own internal fortunetellers, as they currently use their own internal risk modellers to weigh the risks, and thereby set the capital they are required to hold.

PS. Of course, if we land ourselves a fortuneteller that wants to show-off, and for instance insists on that bad-luck depends on the day of the week a credit is approved, we better look for a less sophisticated one.

Lawrence Summers, like most, is still blinded by the fairy tale of the risk-weighted capital requirements for banks

I refer to Professor Lawrence Summers “Five suggestions for avoiding another banking collapse” of May 21, 2017

In it Summers clearly evidences he has not yet woken up to the fact that the whole notion of the risk weighted capital requirements of banks is pure and unabridged nonsense… a regulatory fairytale. He still actually believes that risk weighting has anything to do with real risk weighting of the risks to our bank system.  In fact bad-luck risk weighted capital requirements might better cover for the unexpected risk in banking. And so here I explain it again, for the umpteenth time.

The current risk weighting is based on the ex ante perceived risk of bank assets, and NOT on the possibility of that those assets could ex post be risky for the banks and for the bank system

That is for example why regulators in Basel II assigned to what was perceived as AAA rated and that because of such perception of safety could lead to a build up of dangerously excessive exposures, a tiny 20% risk weight; while to the below BB- rated, so innocuous because the banks would never voluntarily create large exposures to it, they assigned a whamming 150%.

Rule: If bankers are not capable of managing perceived risks, then zero capital might be the best requirement, because the faster they would fold.

Truth: A bank system can collapse because of unexpected events (like devaluations), major financial fraud, and when assets ex ante perceived as very safe suddenly turn out ex post as very risky. None of these risks is covered by the Basel Committees’ risk weighted capital requirements.

Summers writes: “there is distressingly little evidence in favor of the proposition that banks that are measured as better capitalized by their regulators are less likely to fail than other banks.” That might be true but only to believe that the measuring of the “measured as better capitalized” is correct, is absurd. Too much reputable research has taken the historical not “risk weighted” capital to asset ratios to be the same as the current capital to risk-weighted asset ratios, which is comparing apples to oranges.

Summers explains: “Our paper examines a comprehensive suite of volatility measures including actual volatility, volatility implied by option pricing, beta, credit default spreads, preferred stock yields and earnings price ratios… none [of which] suggest a major reduction in leverage for the largest US financial institutions, large global institutions or midsize domestic institutions.” I just ask, Professor, amongst so much glamorous sophistications, did you examine the gross not risk weighted assets to capital ratio? That would have probably sufficed.

Summers recommends, “First, it is essential to take a dynamic view of capital” Absolutely! But Professor, do you not believe that a real dynamic view would have to take into account what the shape of the future real economy would be if regulators insist in distorting with their risk weighing the allocation of bank credit to the real economy? For instance should a real stress test not also look at what is not on banks’ balance sheets… like for instance to see if vital risky loans to SMEs and entrepreneurs are too inexistent?

Summers recommends: “banks should not be permitted to take excessive risks or treat customers unfairly in order to raise their franchise value.” Indeed, but what about by means of current risk weighting unfairly allowing those perceived, decreed (sovereigns) or concocted as safer, to have much better access to bank credit than usual than those perceived as risky? Does that not foster more inequality?

Summers very correctly write: “it is high time we move beyond a sterile debate between more and less regulation. No one who is reasonable can doubt that inadequate regulation contributed to what happened in 2008 or suppose that market discipline is sufficient to contain excessive risk-taking in the financial industry” But that requires understanding and accepting that the risk weighting, which so favored what was AAA rated and sovereigns was “the inadequate regulation”. Moreover, as Einstein said, “No problem can be solved from the same level of consciousness that created it”, that requires us to completely change all our current regulators and start from scratch. 

SO NO! Professor Lawrence Summers, with respect to bank regulations, may I respectfully suggest you either wake up or shut up!

PS. And that goes for most of you others bank regulation experts out there.

Tuesday, May 16, 2017

Why are excessive bank exposures to what’s perceived safe considered as excessive risk-taking when disaster strikes?

In terms of risk perceptions there are four basic possible outcomes:

1. What was perceived as safe and that turned out safe.

2. What was perceived as safe but that turned out risky. 

3. What was perceived as risky and that turned out risky.

4. What was perceived as risky but that turned out safe.

Of these outcomes only number 2 is truly dangerous for the bank systems, as it is only with assets perceived as safe that banks in general build up those large exposures that could spell disaster if they turn out to be risky.

So any sensible bank regulator should care more about what the banks ex ante perceive as safe than with what they perceive as risky.

That they did not! With their risk weighted capital requirements, more perceived risk more capital – less risk less capital, the regulators guaranteed that when crisis broke out bank would be standing there especially naked in terms of capital. 

One problem is that when exposures to something considered as safe turn out risky, which indicates a mistake has been made, too many have incentives to erase from everyones memory that fact of it having been perceived as safe.

Just look at the last 2007/08 crisis. Even though it was 100% the result of excessive exposures to something perceived as very safe (AAA rated MBS), or to something decreed by regulators as very safe (sovereigns, Greece) 99.99% of all explanations for that crisis put it down to excessive risk-taking.

For Europe that miss-definition of the origin of the crisis, impedes it to find the way out of it. That only opens up ample room for northern and southern Europe to blame each other instead.

The truth is that Europe could disintegrate because of bank regulators doing all they can to avoid being blamed for their mistakes.