November 30, 2010

The regulators never believed in the Efficient Financial Markets Hypothesis.

Sir, John Quiggin writes: “Claims of a Great Moderation were bolstered by the Efficient Financial Markets Hypothesis, which stated that the prices generated by financial markets represented the best possible estimate of the value of any asset, given the available information. It follows that market bubbles are impossible and that the deregulation of financial markets should help to stabilise the real economy.” “Why austerity and ‘zombie’ ideas are bound to fail” November 30.

That is obviously false because anyone truly believing in the “Efficient Financial Markets Hypothesis” would never have come up with such a screwed up idea of having bank regulators arbitrarily intervene in the markets by setting different capital requirements for banks depending on the perceived risk of default, when that risk was already being cleared for in the markets by their risk-premiums.

The regulators thinking that, with a little help from their friends the credit rating agencies, they had everything under control, allowed the banks to finance triple-A rated securities collateralized with badly awarded subprime mortgages, Greek public debt, or Irish banks with a leverage of 62.5 to 1. An efficient Financial Market, on its own would never have done such a stupid thing. For instance the unregulated hedge funds almost never exceed a 12 to 1 leverage.

November 26, 2010

We need to start by fixing our banking infrastructure

Sir Martin Wolf correctly writes that “Assets matter just as much as cutting debt” November 26, asking the key question of “What is the sense of cutting spending today if the result is a poorer country tomorrow.” I have for more than a decade asked the very similar question of “What is the sense of trying to make our banks avoid risk-taking so that they do not default if the result is a poorer country”.

If there is some infrastructure that really needs strengthening that is our banking system, something that on top of it all does not require money but just a dose of common sense. If we just ask the bank regulators to tell us what they believe the purpose of the banks to be, and require it to be something more than just avoiding bank failures, which only places us on the road to the too big to fail banks, then we would advance significantly our chances to find the growth we all clamor for.

Let us just accept that by diminishing the capital requirements on what is perceived as not-risky will not lead us anywhere, as all it does is to increase the profitability for banks of doing business with what is perceived as not risky, without insulating us from the risk of the systemic bank defaults which all anyhow result exclusively from excessive investments in what ex-ante is perceived as not-risky.

I strongly object to Basel I, II and III.

Sir, I have written you hundreds of letters that reference my strong objections to the regulatory paradigms used by the Basel Committee and I know my arguments are not baseless… and you know that too. Can you at least once, for the record, publish these objections… or is there something that you want to silence? You are the Financial Times and so I should be able presume this topic should be of interest to you:


I strongly object what is basically the only pillar of bank regulations created by the Basel Committee in Basel I, II and III, namely having the capital requirements for banks to be based on perceived risk of default.

First: All systemic bank failures in history have occurred only as a result of excessive lending to what is perceived as not-risky, and never because of excessive lending to what is perceived as risky, which makes these capital requirements counterfactual.

Second: The market and the banks already discriminate against higher perceived risk by means of the risk-premiums imbedded in the interest rates, and so these capital requirements are just an extra layer of risk-aversion that hinders the banks to help the world to take the risks it needs in order to move forward.

Third: Since needing less capital when doing business with the “less risky” makes the profitability of bank business with the “less risky” to shoot up to the skies, this causes the banks to forget or discriminate against the “risky”, such as the small businesses and entrepreneurs on whom we depend so much for the future generation of jobs.

Ps. And the above does not even mention the problems of having empowered the credit rating agencies with a risk-information oligopoly.

November 24, 2010

A day at the races

Sir, Michael J. Mauboussin in “Flutter on mispriced US equities could prove a winner” November 24, writes “You don’t make money knowing which horse will win or lose; you make money determining which horse has odds that are mispriced”.

Absolutely, and this is as good an occasion to remind of the fact that if credit-ratings were set perfectly, all bank lending transactions would be perfect barters, and there would not longer be any profit opportunity for any side… and therefore markets and banking would slowly die out. Of course, that is not going to happen because credit-ratings are by definition always imperfect… no matter how much bank regulators want them to be perfect so that they do not have to worry about the only risk that worries them, even if this leaves the rest of the world to worry about all other risks, like the lack of jobs.

By the way, back to the races, do you know why the crisis? The handicap officers place extremely low risk-weights on the triple-A rated horses and much heavier risk-weight on the debutant or weaker BB- horses, without telling the bookies or the gamblers, and thought they were going to have a great and fair race… a total chaos that surpassed what even the Marx Brothers could have come up with in their wildest dreams ensued.

The strangest thing though is that we, bookies and gamblers, allow those same crazy handicap officers in the Basel Committee to keep on deciding the handicap system for our banks.

November 18, 2010

The diabolical mother of all quid-pro-quos goes back to 1988, to Basel I.

Sir, in “Europe heads back into the storm” November 18, you refer to “a diabolical bargain that has core states lend to peripheral ones so that they can support their banks, all to save financial institutions in the core from losses” but you do not mention the fact that the governments are just keeping up their end of that mother of all quid-pro-quos bargains between states and banks.

When the Basel Committee in 1988, in Basel I, set up capital requirements for banks that were dramatically lower when lending to governments, compared to when lending to their ordinary private clients that was when this Faustian bargain originated. When the Basel Committee accepted, on behalf of the governments, it must have been knowingly, that the credit rating agencies would when rating the banks also include the willingness of the government to support the banks, then the diabolical vicious circle was sublimely completed.

Of course when you say “this game of bail-out on the sly cannot be sustained for much longer” you are absolutely correct, but neither can a bank-regulation on the sly that permit UK banks to lend to the triple-A rated governments, like the UK, against zero capital, be sustained much longer. Why does FT, without fear, call out the first, but then not act without favour, calling out the second?

If only the Basel Committee had known more about behaviouralism

Sir, Ken Fisher writes: “Humans hate losses more than twice as much as they love gains – a 10 percent loss feels as bad as a 25 percent gain feels good. That´s proven behaviouralism”, “Gridlocked governments are good news for equity”, November 18.

Of course he is right. How sad the bank regulators in the Basel Committee did not consider this when they designed their capital requirements which require higher capital for lending when the perceived risk of default are high, and allows for much lower capital for lending when the perceived risks of default are low. Of course, those regulations, only lent further impetus to the creation of a bank crisis, those which always result from excessive lending to what is perceived as having a low risk, and never result from excessive lending to what is perceived as having no risk.

It is not about the bonuses, it is about the artificial profits from which bonuses are made of!

Sir I am so tired hearing about the discussion about unreasonable and outright shameful bonuses paid without making any reference to the fact that these must be based on outright shameful profit margins that are in large a direct result of regulatory interference, Patrick Jenkins, "Remuneration still the big sticking point", November 18.

If a bank when lending to a triple-A rated client were only permitted to leverage its equity as much as when lending to a small unrated business, namely 12.5 to 1, then the bank, if it made a .5 percent on a loan to a triple-A rated client would generate a 6.25% yearly return on equity, good, but nothing to pay huge bonuses on.

But since the Basel Committee authorized the banks to leverage 62.5 to 1 on these loans, the yearly returns, on supposedly risk-free investments, would with the same margins explode upwards to 31.25% a year, and that is indeed something to pay out huge bonuses on.

Forget about regulating bonuses, regulate the regulators instead.

November 11, 2010

Vikram Pandit might need to go back to banking school

Sir in “We must rethink Basel, or growth will suffer” November 11, Vikram Pandit, the Citigroup chief executive, after making a lot of sensible comments about the difficulties of measuring risk, says: “No one disputes that riskier loans should be backed by higher level of capital”.

Surprising, is Pandit not aware that Citigroup, and all other bank for that matter, charge riskier clients higher interest rates and that does risk-premiums go straight into capital? Does he not know that the risk level of any operation is often not reflected in the amount of capital required but in the cost of capital raised?

Capital requirements based on ex-ante risk perceptions simply do not make sense… except if you are to charge all bank clients the respective weighted-capital cost, plus the same risk-premium. Is Citigroup willing to do that?

Capital requirements for banks based on job creation, makes more sense than those based on risk of default.

Sir and there they are, the G20, in South Korea, lost for words, but yet babbling.

If I were to be given one minute of voice there, I would ask all of them to throw away the capital requirements based on the risk of default, because the risk of default is already being priced in the interest rates of the market, so there’s no need to discriminate through bank regulations against the unrated small businesses and other “risky” elements.

And, if the government official could just not resist meddling with the markets, then I would suggest them to impose capital requirements for banks based on the job creation potential of the borrower… more jobs less capital less jobs more capital… I mean, is not to help create job a primary function of banks?

But, of course, history has recently taught us that we need to be very careful with the job-creation-rating-agencies we empower.

November 10, 2010

The Fed has not asked the market what it is going to use the QE for.

I do not feel like classifying among the hysterics only because I do not see a real business plan behind the Fed´s new QE by which it is throwing sort of bad money after sort of bad money…. and frankly I do not give much for a business plan which according to Martin Wolf should include as a pillar the commitment of above target inflation so as to “shift inflation expectations upward”, “The Fed is right to turn on the tap” November 10.

Wolf describes “the essence of the contemporary monetary system [to be the] creation of money, out of nothing, by private banks’ often foolish lending” and then asks why a central cannot do that, Well the only reasonable answer to that is simply that no one should do foolish lending, since foolish lending cannot be anything but foolish no matter who does it. Why the all the fuss with Citi’s Chuck Prince not being able to stop dancing, if now all it was about was to allow the Fed to exhaust itself on the dance-floor. The first question all bankers are taught to ask when lending is, “what are you going to use that money for?”, and we have yet heard the Fed asking the markets that. And what if the markets answer... "to invest it abroad"?

Personally while bank regulators, Fed included, insist on discriminating against small businesses and entrepreneurs forcing banks to have much higher capital requirements when lending to these as compared to when lending to triple-A-ex-ante-rated clients and governments I believe the Fed has not earned it right to mambo or tango with our money.

Ps. By the way, is there something like becoming hysterically anti-hysterical?

November 09, 2010

Gold-bugs are preferable to house-bugs

Sir I cannot understand all the uproar about Robert Zoellick, the World Bank president´s recent comments on gold, “The G20 must look beyond Bretton Woods” November 8.

Sincerely, what is the difference between “employing gold as an international reference point of market expectations” and all that recent rhetoric on the need to measure and avoid assets bubbles? Gold, being movable, should be a more adequate asset to transparently measure market expectations than houses. Gold is allowed to fluctuate up and down, while falling house prices are fought against as if it signifies the end of the world, even though, rationally… what´s wrong with lower house prices?

I much rather have gold-bugs than house-bugs.

Finally some real heavy-weight support!

Sir at long last an important number of academicians are speaking out asking to remove “the biases created by the current risk-weighting system” imposed on the world by the Basel Committee on Banking Supervision for the purpose of determining the capital requirements of banks, “Healthy banking system is the goal, not profitable banks” November 9.

The hundreds of letters related to this issue that I sent to the Financial Times over the last five years, and that were ignored, will serve as proof of the immense difficulties of fighting a regulatory paradigm that sounds so extremely logical as capital requirements based on (ex-ante) perceived risk does, but that is still so utterly faulty. In fact it has proven even more difficult than making Citi’s Charles Prince stop dancing.

I hope that the fundamental revisions to the financial regulations, when they come, as they sure will come, will also include the need of avoiding the trap of placing important regulatory issues in the hand of non-transparent mutual-admiration clubs like the Basel Committee which are not diversified sufficiently so as to avoid the risk of degenerative intellectual-incest.

By the way, just for additional clarity, I wish the title of their letter had said “Healthy and useful banking system is the goal”, but again I am more than glad enough.

November 08, 2010

But who speaks out for the unrated small businesses and entrepreneurs?

Sir Patrick Jenkins, November 8, reports that HSBC considers “Basel III a severe threat to world trade” because the risk-weight for trade finance, increasing from 20% to 100%, would “unjustly” signify having to hold 5 times as much capital against trade finance as is currently required.

HSBC is absolutely right, any regulatory discrimination on capital requirements for banks, given that the markets already price in the risk premiums by means of higher interest rates… is arbitrary, regressive and odiously unjust. But, what about all those small businesses and entrepreneurs who have actually have had to carry a risk-weight of 100% for years now and have therefore been similarly discriminated against? Who speaks out for them? Are they going to be left out in the cold just because lending to them does not belong to the typical bank operations of one of the too-big-to-fail bank mammoths?

November 03, 2010

Are the banks now to set their own capital requirements?

Sir on October 27, 2010, the Financial Stability Board FSB issued “Principles for Reducing Reliance on CRA Ratings” and by which they endorse a substantial part of the criticisms against current bank regulations and that I have been writing about in hundreds of letters to the Financial Times over the last years and which, for whatever reasons, since 2005, you decided you were better off ignoring.

In fact what FSB states is that the Basel Committee needs to go back to square one and start their regulatory process all over again, since most of what it has on the table is absolutely worthless. It will be interesting to see what the G20 ministers and others will interpret about what they are now supposed to do with Basel III.

What is not yet clear from the FSB statement is how the capital requirements of banks are now to be calculated, because even though it speaks over and over again that “banks should be expected to make their own credit assessments” and “should ensure that they have sufficient resources to manage the credit risk that they are exposed to”, we must assume they do not really mean that banks will from now on set their own capital requirements… if so… that would indeed be real, pure and unbridled de-regulation.