And the Oscar for lax risk management should go to… The Bank Regulators!

Sir Tom Braithwaite in “Financial crisis report to blame Wall Street” January 26, reports that “The Financial Crisis Inquiry Commission will on Thursday blame unchecked Wall Street excess for much of the 2008 turmoil, highlighting lax risk management …and insufficient regulation”

I am not fully sure of the reasons the “Republican commissioners refused to endorse the report”, they usually are too Fannie Mae focused, but in my mind the report is fundamentally wrong. If anyone has to receive an Oscar for lax risk management that has to be the Basel Committee who with incredible hubris took upon themselves the role as risk-managers of the world, by means of their capital requirements for banks based on risks and that allowed among others for an insane bank leverage of over 60 to 1 just because a credit rating agency had perceived something to be a triple-A… in a world where we know for a fact that there is an absolute scarcity of true sustainable triple-As.

Since what was clearly pure lousy regulation is classified in the report as “insufficient regulation” then that may indeed be part of the agenda of those who want to regulate us more, and now even want to take care of pro-cyclicality and systemic risk; stubbornly refusing to acknowledge that they as regulators and governments are most to blame for pro-cyclicality and systemic risk. If there was an Oscar for the most intrusive and distorting regulations, that would be well-earned by the bank-regulators too.

How should then bank regulators be paid?

Sir, I fully agree with the wisdom of deferring the payment of bonuses to bankers in order to establish that the reasons for earning them were real and not purely a mirage “Paying bankers to be prudent” January 24.

That said the title seems to indicate you believe that the bankers, as a group, were imprudent. That fits poorly with the fact that what caused the current crisis was not excessive lending or investments in what was perceived as risky but excessive lending and investments in what was perceived as not risky.

If you really want to talk about imprudence then take a look at the financial regulators who indulging in the mother of all regulatory hubris assumed the role of risk-managers of the world, and if a triple-A rating was involved in the operation authorized the banks to leverage 62.5 to 1. The outrageous bank bonuses that we have seen are mostly the result of the outrageous profits resulting from these outrageously authorized bank leverages. I ask, how should then regulators be paid?

It is not the capital requirements that are wrong it is the risk-weights that have gone bananas

Sir, Anat Admati asks for higher equity requirements for banks “Force banks to put America´s first”, January 20. She is correct about that goal but wrong about how to reach it. The reason why banks have too little capital is not that the basic capital requirements are low; but that the arbitrary risk-weights which the regulators playing risk-managers assign to those risks perceived as low are obnoxiously low… especially when considering that it is precisely what is considered to have a low risk which poses the highest systemic risk. A society will not disappear because of the risk their children will turn all into risky bungee jumpers, but it could disappear because of the risk that they all pick the wrong subject to specialize in at the risk-free university.

The basic capital requirement under Basel II was 8 percent… but the risk-weight for lending to Irish banks or Greece, for instance, was only 20% which effectively diluted the previous decent 8 percent to an indecent 1.6 percent

PS. I later discovered that the risk weight of Greece was in fact an insane 0%

A case for capital requirements for banks based on corporate organization and management´s stake

We outsiders, we taxpayers, we do not run the risks of the clients of a bank we run the risk of how the bank is managed. Therefore, much more than being concerned with the credit ratings of the clients of a bank, we need to concern ourselves with how the bankers of that bank react to those credit ratings.

In this respect John Kay´s “How trust in finance was carried off by the carpetbaggers” January 19, makes a splendid case for having bank capital requirements for banks depend on such aspects as to how much of the risks of the bank are shared by the management of the bank. As an example, for a bank operating as a full partnership or a mutual, the capital requirements could be 6 percent of all assets, while for a fully public bank 12 percent, with the in-betweens covered proportionally.

The perceived risks are never as dangerous as those not perceived

Sir, according to what Tom Braithwaite reports Tim Geithner has embraced humility concluding that it is not possible “to make a judgment about what’s systemic and what’s not until you know the nature of the shock”, “Geithner queried risk concept” January 14.

Let us hope he can now used that as an intellectual bridge to understand why it is useless and dangerous having the regulators arrogantly playing sophisticated risk managers with their capital requirements based on perceived risks when we know that all bank crisis are caused by risks that have not been perceived.

Just the same old pound locks!

Sir, Gillian Tett in “Stand by for new ways to control hot money bubbles”, January 14, refers to instruments like special levies on banks foreign exchange positions. These instruments are far from new and have very often been used all over the world as pound-locks in order to guard for the asymmetries in the size of flows between the small lakes of small countries and the big global oceans.

For a time free market zealots were against even these pound-locks but most of us knew it was just a question of time before they were going to be used again. And by the way the zealots never realized that capital requirements for banks based on perceived risk were a hundred times more intrusive and distorting than these transparent levies and pound locks… just look at the tsunami into the triple-A rated waters they produced.

What would though be thought provoking, interesting and new would be to see the big oceans needing protection from the flows from the small lakes.

Bank regulators and FT should also heed Aristotle

Sir, on January 13 Martin Sandbu explained very well “Why Aristotle is the banker’s best friend” though besides the bankers he should have included their regulators. I say this because in all the current banking regulations originating from the Basel Committee there is not one single word about the purpose of the banks, as all that regulators expect from them is that they do not fail.

When on the theme of “granting impunity to lazy thinkers” he should also consider the responsibility of a paper like the Financial Times… as the way it has decided to silence opinions like the previous, and other, and “not engage in reasoning”, because seemingly it rubs some of its associates the wrong way, would not have been something approved by Aristotle.

Oh if bank regulators had only stuck to the dress code of bankers

Sir, John Kay directs his “A smart business is dressed in principles not rules” January 12, to the people in Basel dealing with the regulations of banks… and I cannot but reflect on how the current crisis would have been avoided if regulators had stuck to regulating the dress code of bankers.  Instead they went ahead and arrogantly discriminated among perceived risks with their capital requirements for banks, gladly ignoring that bank crisis always occur as a consequence of risks that have not been perceived.

And where are the smart principles for regulating regulations?

Sir, John Kay directs his “A smart business is dressed in principles not rules” January 12, to the people in Basel dealing with the regulations of banks. To that I would indeed add the following:

Bankers, as a principle or as rule, should believe they can master quite adequately default risks. Who wants to deal with a banker who does not?

The regulators, as a principle, and as a rule, should always answer the bankers “No you can’t… and besides there are so many other risks to be considered than just avoiding defaults”

It is bad enough when regulators fall for the sales pitch of bankers, but so much worse when regulators arrogantly decide what is the risk that should be regulated and try themselves to be the masters of that risk, with or without the help of credit rating agencies.

Currently the regulators who failed conquering simple risks of defaults are now tackling more God-like events like pro-cyclicality. God help us! Where are the smart principles for regulating regulations?

The bank crisis and the Basel Committee banking regulations explained to a golfer

Once there was a golf Club with a somewhat narrow golf course and where, even though the members were very careful, sometimes the hooking or slicing of the golf balls into adjacent holes, caused some serious accidents.

The Club’s Board was ordered to find a solution. To that effect the elected members of the Board consulted with some Experts and asked for recommendations. The Experts told the Board “most of the slicing and hooking is the product of bad players and so, if you want to solve this problem, you need to get rid of them”. Knowing this idea would not be received with much enthusiasm, and could in fact pose a direct threat to their reelection as members of the Board, they all decided to immediately delegate the “how” to a Committee of Experts.

The Committee of Experts decided that they needed to appoint some Golf-Player Rating Agencies (GPRAs) to rate the real quality of the players and thereafter created a parallel handicap adjustment requirement that effectively eliminated the bad players… without these even noticing it. According to their ratings, the AAA rated players had their normal handicap increased by 5 strokes, while the players rated B- or worse had their normal handicaps officially reduced by 5 strokes.

It worked! Though, just initially… Since having to play with a very low handicap was pure hell for a bad player, most of the bad players rapidly decided to change clubs and, as a result, the Club gained immense recognition for having the best players and being the safest club in the country… and the Committee of Experts was wildly acclaimed for having true experts. We will never ever have more accidents in our Club… was the Board’s self congratulatory message at the year’s end… four years ago.

But life is life, even among golfers, even in a golf club… and so the membership of the Club started changing. For instance, many great golfing has-beens around the country were attracted by a system that so clearly could help to pro-cyclically prolong their golf-life, just like many never-able-to-be-good players were also attracted by the possibility of joining a club renowned for having exclusively good golf players… and so they all started to read up and converse with the GPRAs about what was necessary in order to be conveniently rated.

There was such an avalanche of enquiries that the GPRAs got confused and overworked and started to make mistakes… to such an extent that the Club rapidly became overcrowded with dubiously rated golf-players. This would, of course, not have meant anything in the old days, but, since everyone had been duly informed that the accidents had been forever eliminated and that therefore there was no need for being careful… the accident rate shot up and rapidly turned, three years ago, into a pandemic disaster that threatens even the survival of the Club… and aggravated by the fact that the beginners and the decent-bad players, those who really are the heart and soul and economical support of a golf club, want nothing to do with a club that has a handicap system that so harshly discriminates against them, and have therefore joined other clubs.

But, golfing friends, the saddest part of this story is that since the logic of “getting rid of bad players and allowing only good players” sounds so very attractive and so very logical, the Board has not even today understood what they did wrong and so they insist on using exactly the same Committee of Experts to come up with better solutions. And the Committee of Experts is currently studying only refinements of their original handicap adjustment requirement formulas because, as “experts”, they cannot under any circumstances acknowledge that they were so fundamentally wrong.

And, unfortunately, the local media is not sufficiently "without fear and without favour" to dare to really fundamentally question the wisdom of the local Club´s Board or of the Committee of Experts.