To reform financial regulations we need to reform the Basel Committee.

In May 2003, as an Executive Director of the World Bank, I told those many present at a risk management workshop for regulators the following with respect to the role of the Credit Rating Agencies. “I simply cannot understand how a world that preaches the value of the invisible hand of millions of market agents can then go out and delegate so much regulatory power to a limited number of human and very fallible credit-rating agencies. This sure must be setting us up for the mother of all systemic errors.” And this I repeated over and over again, in FT, even in a formal statement at the Board.

Now as reported by Alan Beattie and James Politi in “IMF points to danger of ‘over-reliance’ on credit ratings for sovereign debtors” September 30, the IMF is finally admitting “Policy makers should work towards the elimination of rules and regulation that hardwire buy or sell decisions to ratings”

That is good, better late than never. But the real question that needs an answer is why on earth it had to take a financial crisis of monstrous proportions to reach a conclusion that should have been apparent to any regulator from the very beginning.

I saw it happen in front of my eyes and I know why it happened. As I wrote in a letter published in the Financial Times in November 2004, it was the result of the whole debate about bank regulations being sequestered by the members of a small mutual admiration club.

Therefore if there is now something even more important than rectifying the faulty financial regulations, that is to break up the Basel Committee and make absolutely sure it represents a much more diversified group of thinkers. That would have at least guaranteed that the basic question of what the purpose of the banks should be would have been put in the forefront before regulating them. Current regulations do not contain one word about that.

Besides me there were not plenty of experts who raised the question of whether the credit rating agencies should have such a prominent role and made many other valid criticisms. These persons should participate in designing and putting in place the needed reforms. It is simply unacceptable that the reforms that carry with them such huge global implications are implemented exclusively by Monday morning quarterbacks.

FT, you are looking in the wrong direction and with the wrong glasses.

Sir, in “A sector still in need of reform” September 27 you write “if the regulator disliked the approach a bank was taking, it could increase the capital charge to offset the higher risk”. May I humbly suggest that phrase proves that, as so many others, you do not really understand the real problem.

If a regulator suddenly disliked something an approach a bank was taking, chances are that the banks would already discovered it themselves and taken measures. Why do you suppose regulators know more than bankers? If you think so why do you not make regulators the bankers? No the real risk, and what caused this crisis and all others, lie always in all the approaches both bankers and regulators like the most, and that precisely because of that can grow into a dangerous systemic risk.

When regulating banks more than concerning yourselves with what you do not like or perceived as risky, you need to worry much more about what you and the bankers like and perceive as not risky.

You need global voices in the World Bank and the IMF

Sir, Paulo Nogueira Batista writes that “Europe must make way for a modern IMF” September 24, and states that “Real reform of the Fund is a critical test of advanced countries´ willingness to adapt to a changed world”. It is impossible to argue against fewer chairs for Europe and more for the developing world, in both the IMF and the World Bank but, if we are really to adapt to a changed world, we would have to assign some chairs to actors that are not bound to territorial considerations… like migrant workers and multinational companies.

As one of the very few, or perhaps even the only Executive Director to have served at the World Bank without absolutely no political or public sector experience (2002-2004), I keep repeating that the party who is most lacking representation in the World Bank is the world at large... planet earth! And I have no idea how we intend to tackle global issues without global perspectives.

In fact a global not territory constrained Executive Director, would be a stronger voice arguing for the world to share the costs of protecting environmentally the Amazon, than what a Brazilian Director could ever be.

If only the UK was rated BB+ to B-…

Then a UK small business would be able to compete with the government on equal grounds for bank credit, because only then would the bank have to post the same capital for both.

The nannies in the Basel Committee decided to hand out, through very low capital requirements for banks, generous incentives for these to go and play in “safe” places, even though, as regulators, they should have known that financial and bank crisis only occur where the perceived safety attracts the excessive volumes that pose a risk for the system… swamp land with alligators might now and again eat up a citizen, but never pose a threat to a nation.

But on top of it all, the Basel nannies also turned out to be communists in disguise, as they ordained that if a bank gave loans to a sovereign rated AAA by their risk kommissars then the bank needed no capital at all… and what small business can compete with that?

More than two years after the crisis started we read in a report by Brooke Masters and Patrick Jenkins that Lord Turner is now announcing tougher bank capital regime. But since he, like Basel III, does not mention a review of the arbitrary and regressive risk-weights that were the real causes of the disaster, we can only conclude he is not really fit to be a regulator, at least not in war time.

Don’t forget the non-AAAs

Sir Peter Spiegel, David Oakley and Ralph Atkins report that “EU rescue fund rated triple A” September 21. Do they really know what that means?

It means that the banks when at some point in the future they are asked to acquire bonds or otherwise lend to European Financial Stability Facility they be able to do so without the need of capital. It will mean that it will be cheaper to fill the hole of the past than to build the mountain of the future. Good or bad? If I owned Greek bonds and wanted to get bailed out I would find that great but, if what I wanted was a bank loan to set up a new venture it would surely be bad, because I would have to pay for the cost of the discrimination in favor of the EU.

Since Basel III kept intact all the risk-weight discriminations in favor of the AAAs and the Jean-Claude Trichet bureaucrats of this world, we should never forget the non-AAAs and private borrowers who are and will have to pay for it all.

It’s the risk-weights, stupid!

Sir what detonated this crisis? The fact that because of the risk-weights the banks needed only to hold 20% of the basic capital requirements when investing in triple-A rated securities backed by the lousily awarded mortgages to the subprime sector. Would it have happened if the risk-weight for those investments had been 100%? Of course not!

In this respect when one, on September 17, 2010, more than two years after the crisis exploded, reads the chairman of the Financial Stability Board Mario Draghy covering in “Next steps on the road to financial stability” about everything under the sun, except for the risk-weights, one feels, no matter how impolite, an urgent need to shout “It’s the risk-weights, stupid!”

The Basel Committee’s lousy Maginot Line

It is impossible not to see now that the financial regulators in the Basel Committee, trying to fend off a bank and a financial crisis, constructed an incredibly faulty Maginot Line.

It was built with lousy materials, like arbitrary risk-weights and humanly fallible credit rating opinions.

And it was built on the absolutely wrong frontier, for two reasons:

First, it was build where the risk are perceived high, and where therefore no bank or financial crisis has ever occurred, because all those who make a living there, precisely because they are risky, can never grow into a systemic risk. Is being perceived as risky not more than a sufficient risk-weight?

Second it was built where it fends of precisely those clients whose financial needs we most expect our banks to attend, namely those of small businesses and entrepreneurs, those who could provide us our next generation of decent jobs and who have no alternative access to capital markets.

Now with their Basel III the Basel Committee insists on rebuilding with the same faulty materials on the same wrong place and it would seem that we are allowing them to do so.

I am trying to stop them… are you going to help me or do you prefer to swim in the tranquil waters of automatic solidarity with those who are supposed to know better?

The implicit stupidity of the current Basel regulations could, seeing the damage these are provoking, represent an economic crime against humanity!

Lex woke up!

Sir the Lex Column "Basel Denominators" September 16 ends with: “Historically, true crisis are caused by assets perceived as low-risk that aren´t.”

That as you all must be aware of by now, has been one of the two main reasons for my criticism against the current regulatory paradigm that has been imposed by the Basel Committee on the banks… that of higher capital requirements on what is perceived as risky and lower for what is perceived as not risky, and that goes against everything that financial history teaches us.

Since realizing the above makes of course current bank regulations completely nonsensical it will be interesting to see how FT handles this issue from now on.

On my second reason for criticizing Basel you might want to go to the last post of Dominique Strauss-Kahn on the IMF blog. http://blog-imfdirect.imf.org/2010/09/14/saving-the-lost-generation/#comment-2762

What good work?

Sir Emilio Botín opines “Now we must build on Basel´s good work” September 16, as if the Basel Committee has done us any good. It undoubtedly created the current crisis by setting up a system of risk-weights for capital requirements that brought much confusion to the major financial markets.

When also reading Botín complaining about the possibilities of being discriminated against by levying additional capital requirements on the “too-big-to-fail” banks, one cannot but think of all the small businesses and entrepreneurs who have been unfairly discriminated by Basel, just because they cannot hustle up the triple-A ratings that would allow the banks to hold negligible capital requirements when lending to them.

Why is it so easy for big-bank-bankers to get a voice in the Financial Times but so hard for the small businesses and entrepreneurs who the banker´s should prioritize their lending to? FT´s “without favour” sometimes does just not ring true.

Break up the Basel Committee

Sir John Kay in “We must press on with breaking up banks” September 15, writes “The Basel regime based on capital controls proved useless in averting the crisis: indeed it was a principal cause of the regulatory arbitrage that led to the proliferation of complex debt instruments” and that the “pledges made in the immediate aftermath of the crisis have proved empty”.

The correctness of the above could not be more evidenced than by Basel III. It is not only a weak response to what it wants to respond, but, worse than that, it does not even try to respond to the problem of the regulatory arbitrage the regulators have caused with their arbitrary and inexplicable risk-weights.

From what we see the effort to break up banks or in other ways fix the financial sector, must start with breaking up the regulatory monopoly of the Basel Committee.

Do not subsidize small and medium-sized enterprises, eliminate the regulations that tax them.

Sir Martin Wolf in “Basel: the mouse that did not roar” September 15, out of the blue writes “to the extent that the public wants a specific form of risk taking subsidized – lending to small and medium-sized enterprise, for example – it should do so directly. Agree! But why does he then approve of the regulatory subsidies given out in terms of discriminatory lower capital requirements to those perceived as having a lower risk?

The capital requirements established in Basel II have been quite sufficient to cover the risks of the small and medium-sized enterprise, what it failed to cover for was for all falsely perceived as being a low risk.

The small business on top of the higher interest rates they need to pays because they are intrinsically riskier must currently pay an additional margin, a regulatory tax, about two percent per year, only to make up for the differences in capital requirement produced when regulators apply to them risk-weights of 100% while letting other slip by with only 20% or, in the case of Sovereign governments rated triple-A, zero percent.

Bank regulators give incentive for betting on failure rather than success.

Sir Peter Chapman at the very end of “Ten lessons of a banking collapse, in Lehman’s terms” September 15, writes “Capitalism now makes money by betting of failure rather that success” but unfortunately he does not expand into the causes of that. So why is it so?

One reason is that bank regulations, by taxing the operations perceived as having higher risk with special capital requirements (risk-weights of 100%) lowers the returns of betting on success where risk is high, while allowing for much lower capital requirements for what is perceived as having a low risk (risk-weights of 20% and even 0%) increases the yield that can be obtained from betting against the perceptions of low risk.

Sir, you could benefit from a class on finance in the kindergarten

Sir with reference to “Basel should stand firm on capital” September 10 you evidence you still cannot understand the real problem with the current capital requirements for the banks established by the Basel Committee. The reason why these have caused so much problem is not really their level but the fact that they arbitrarily discriminate in favor of lower perceived risk, ignoring the fact that never ever has there been a bank or a financial crisis derived from where risks were perceived as high, they have all originated where risks were perceived as low… as only these can grow into having any systemic significance

In case you have an interest in learning the truth about the financial crisis may I suggest a kindergartenish lesson? http://bit.ly/c66DLp

Gideon Rachman, as an historian, should not be allowed to play innocent!

Sir Gideon Rachman’s “Sweep economists off their throne” September 7, ignores completely the question of who put some of the economists on a throne?

I am an economist and I have definitively not been on a throne while for over a decade I have been criticizing some of my not too smart colleagues for not speaking out against outright dumb financial regulations, while the Rachman’s of the world were quite eagerly helping to coronate these economists.

Rachman should not think he can get away that easily from his share of responsibility by just pointing fingers and joining the crowd screaming for Madame Guillotine.

No bank or financial crisis has ever resulted from excessive lending or investments to clients perceived as risky but all have been a direct consequence of excessive lending or investments to clients perceived as not risky, which turns the Basel Committee’s capital requirements for banks based on ex-ante perceived risk into a stupidity of epic proportions. In this respect, may I ask when, Gideon Rachman, as an historian, helped to remind the world of that?