Too much longing for stability creates the perfect storm conditions for instability

Sir, Samuel Brittan refers to “artificial suppression of volatilities in the name of stability” “The follies and fallacies of our forecasters” May 27. That is precisely what as an Executive Director of the World Bank I was referring to when, in May 2003, in pre-Basel II days, I told a large group of regulators gathered for a risk-management workshop at the World Bank, the following: 

“There is a thesis that holds that the old agricultural traditions of burning a little each year, thereby getting rid of some of the combustible materials, was much wiser than today’s no burning at all, that only allows for the buildup of more incendiary materials, thereby guaranteeing disaster and scorched earth, when fire finally breaks out, as it does, sooner or later. 

Therefore a regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises.”

The regulators did not understand what I was talking about… mostly because they wanted so much to believe in forever stable banks.

PS. As you can see here, the link to Brittan’s article is gone.

A quiz for the candidates to Managing Director of IMF

Sir, as a humble contribution for the selection of the best Managing Director of the IMF may I submit the following little quiz the candidates should answer:

Q1. Which type of bank clients can generate such a massive exposure so as to trigger a systemic bank crisis?

a. Those perceived as risky (small businesses and entrepreneurs)
b. Those perceived as not risky (triple-A rated)

Q2. The needs of which clients do we most expect our banks to attend to?

a. Those perceived as risky with no access to capital markets (small businesses and entrepreneurs)
b. Those perceived as not risky and with access to capital markets (triple-A rated)

Q3. The Basel Committee allows for much lower capital requirements for banks (five times less) when lending to those perceived as not risky (triple-A rated). Based on your previous answers, which would be your most likely opinion?

a. I fully agree with the Basel Committee
b. The Basel Committee might have got it all completely upside down.

Note: The responses of “b, a, and b” would qualify the candidate to proceed to further tests.

Choosing based on merits defined by the group is often another source of dangerous group-think.

Sir I could not agree more with the arguments presented by Martin Wolf when he writes that “Europe should not control the IMF” May 25, summing it all up in the phrase “The person chosen [as managing director of the IMF] should be willing to take the risks of leading… though, of course, that risk-taking leader could be a European.

The recent Independent Evaluation Officer’s report on the “IMF Performance in the Run-Up to the Financial and Economic Crisis” comes to the conclusion that “The IMF’s ability to correctly identify the mounting risks was hindered by a high degree of group-think”.

This would indicate that the willingness to accept and push for diversity in thinking is one of the most important qualities we need to look for in the next managing director of the IMF.

That said, and fully agreeing with the managing director being chosen by the members based on merit, let us not forget that choosing based on the merits defined by the group, could turn out to be just the mother of all sources of group-think.

Save us from these irrational and hysterically risk-adverse bank regulators

Sir, Patrick Jenkins in “State lending targets are grist to the mill of history” (by the way a much too smart title for someone dumb like me) May 23, writes: “Experts estimate that the Basel III rules increase the capital that banks must hold against an average corporate loan by about 30 percent, and by closer to 100 percent for an SME loan”.

Can you now start to understand what I have been shouting about for years that Basel III is only digging us deeper into the hole? What on earth has SMEs, always perceived as risky, to do with this or any other bank crisis? Have not the current capital requirements against SMEs been more than enough? There is only one conclusion we are in the hands of irrational and hysterically risk-adverse regulators! And we will pay dearly for our silence!

Regulators should take the beam out of their own eyes

Sir, Richard Lambert makes a reference to a research paper by Andrew Haldane, the Executive Director for Financial Stability, and Richard Davies of the Bank of England where they evidence an increasing short-termism in the pricing of company shares and conclude by blaming it all on a market failure, “Sir Ralph´s lessons on how to end short-term capitalism” May 23.

Short-termism is indeed a serious problem that derives from human weaknesses, but Messrs Haldane and Davies should start by taking the beam out of their own eyes. The mother of all short-termism is how the bank regulators, on top of how the market favors those perceived as less risky, also, by means of their risk-weights which determine the effective capital requirements for banks, shamelessly layer on their own favoritism of the same.

For a starter that regulatory short-termism created our current crisis by pushing our banks excessively into sovereigns and triple-A rated business. Also those regulations make it much more difficult harder and much more expensive for our small businesses and entrepreneurs to access bank credit… and if that is no short-termism what is?

http://subprimeregulations.blogspot.com/2019/03/my-letter-to-financial-stability-board.html

Bank regulators are still acting dumb!

Sir, Tom Braithwaite, Brooke Masters and Jeremy Grant report on the current status of financial regulation in “A shield asunder” May 20.  When discussing bank capital and the calculation of the risk-weights used by the regulators for determining the effective capital requirements for banks, they give new evidence of that bank regulators have still not understood what they did wrong.

The risk-weights, as they are used, translate into higher capital requirements for what ex-ante is perceived as more risky and lower for what is perceived as less risky. And that is so dumb! The lesser the ex-ante perceived risk of default, the higher are the possibilities of a buildup of such an excessive exposure that, if ex-post the risk of default turns out to be higher, could detonate a dangerous systemic crisis. When are they going to get it into their thick skulls that what is perceived as risky poses no systemic risk?

What precisely caused the current crisis? The risk-weight for loans or investments in what had a triple-A rating was set at only 20%, and which meant that when some triple-A ratings turned out to be unjustified, the banks stood there naked with no capital.

PS. For how long is FT going to avoid this extremely serious problem, only because someone might not like the tone of a Kurowski?

The mother of all boundless optimists must be the bank regulator

Sir, John Plender asks “How long before we confront a new financial crisis? Usually a severe shock to the financial system damps risk appetite for some considerable time”, “There are still too many latent triggers of the next crisis”, May 18.  Plender considers that “boundless optimism, excessive leverage and overpriced assets” already places us in “dangerous territory”.

I agree with the conclusion but not with the analysis.  The current crisis was not caused by risk appetite but by regulatory risk-adverseness that stimulated banks to invest excessively in sovereign and triple-A rated securities, and so, a dampened risk appetite, when layered on top of that kind of regulations, can make it all so much worse, so rapidly.

Sincerely if we are to speak about boundless optimists, then the mother of all of them have to be the bank regulators who still arrogantly believe they can manage the risks, by means of imposing their own risk weights on the market… followed closely by those who believe these regulators capable of solving the problems they themselves created. Without any doubt the regulators remain firmly in place as the greatest source of systemic risk

Too well tuned?

Sir, John Plender in “It’s time to rewrite fashionable finance ideas”, May 4, refers to the need for some redundancy in the system so as to be able to respond better to unforeseen events. Below is how I addressed that issue in my Voice and Noise of 2006.

Too well tuned?: Martial arts legend Bruce Lee, whom many people regarded as immortal, died at the age of only 32 of a cerebral edema, or brain swelling, after taking some sort of aspirin. I have not the faintest idea whether that pill actually had anything to do with his death but I have frequently used (or misused) this sad death as an example of how an organism could be in such a highly tuned and perfect condition that it could not resist a small external shock. And I used this metaphor to explain why companies nowadays, pressured by the stock market’s expectations for the next quarterly results; the latest theories in corporate finance as to how squeeze out the last drop in results; and, perhaps, even some bit of creative accounting, might be so well-tuned (no little reserve fat left) that they would not be able to withstand any minor recession. (Whenever I expose this theory, I can see in my wife’s eyes that she believes this is just my preparing an excuse for my growing—ok, grown—midline.)

Risk-weighting is more than a game, it needs a purpose too.

Sir, Patrick Jenkins reports that Lord Turner, chairman of the Financial Services Authority told the Financial Times. “We have spent a lot of time over the past two years devising a standardized definition as the numerator in capital ratios. It would be sensible now to look in more detail at the denominator and examine [the risk-weights], “Drive for global standard on bank’s lending risks” May 3.

Jenkins also writes “Inaccurate calculations of risk-weighting can have a highly disruptive effect on capital ratios, potentially making a nonsense of a global minimum capital ratio.”

The above addresses one of the issues I criticize in the bank regulations coming out of the Basel Committee and that you know I have been for many years now writing to the Financial Times about, but that you also for whatever reason had decided to ignore.

What it does not address though is the problem that even if the risk-weights are perfect, and universally applied, that could just as well bring down the world because the banks would anyhow not be taking the risks we need them to take, if for instance we are going to find jobs for the new generations. And that is what Patrick Jenkins has not yet understood even if he writes “It’s about making regulations worthwhile”, “Time to work out the real odds in the weighting game”, May 3.

I explained that in person to Lord Turner, about a year ago, when I told him he was behaving like a handicap officer on a race track who took off the weights from the best running horses and placed these on the debutants and the slow horses, without telling the bettors and the bookies, and still hoped for a great race.

I also reminded Lord Turner of that there has never ever been a major or systemic bank crisis that has resulted from the banks being involved with what ex-ante was perceived as risky; they have, except for those where illegal behavior was present, all resulted from lending and investing in what ex-ante was considered as not risky.

PS. Sir, I guess you do not have it in you to acknowledge the fact of my relentless lobbying on these issues. Oh had I just been one member of your social network!

Would I have been better off with a Rockville Gazette than with the Financial Times?

You journalist who write about banking regulations, should you not find it somewhat curious at least?

Friend

If you as reporters on finance and bank regulations observe that someone has asked the global bank regulators in the Basel Committee some reasonable questions, for about a decade, and they have not yet been answered, would that not strike you at least as something curious?

The Questions:

Can you think of any major bank crisis that was caused by excessive lending or investments to what was perceived as risky? Is it not so that these crises have resulted from either unlawful behavior of bankers or excessive lending or investment to what was wrongfully perceived as not risky?

No and yes? If so can you explain why bank regulators have set the capital requirements for banks based on perceived risk? Ludicrous as it sounds, would then not totally opposite capital requirements than the current make more sense, like higher capital requirements for what is perceived as not risky, than for what is perceived as risky?

Since we know that the banks already consider the credit ratings when deciding whether to lend or not to a client, what amounts and at what interest rate, is it logical that the regulators t also use exactly the same credit ratings when deciding the capital requirements for banks? Is that not sort of double counting? If you consider good information excessively, does this not distort the value of that information?

We know that one of the prime objectives for our banks is to attend the credit needs of those small businesses and entrepreneurs that are so vital important for the creation of jobs, but who have no access to capital markets and who cannot even afford to get their creditworthiness rated by the agencies. If so does it make any sense to discriminate against the small businesses and entrepreneurs by means of forcing the banks to carry relatively much higher capital when lending to these than when lending to something with for instance a triple-A rating?

And now I ask you, if the Basel Committee and the Financial Stability Board are not able to satisfactory respond these simple questions, do you think they should have the right to dig us further down into a black-hole of regulatory complexity with their Basel III?

Per Kurowski

A former Executive Director at the World Bank (2002-2004)

http://subprimeregulations.blogspot.com/