March 20, 2013

Europe, ask your bank regulators to explain why they did it, and you will not get an answer. They never knew!

Sir, Martin Wolf ends “Big trouble from a small country” March 20, with “Banking is dangerous everywhere. But it still threatens the eurozone’s survival. This has to change – and very soon”.

Yes indeed, its bank regulations have to change. All which finds itself under the influence of a tiny committee, the Basel Committee for Banking Supervision, is threatened, by completely failed regulations. 

And these regulations have not been sufficiently questioned, this even more than five years after their failure should have become evident to all. Why is that? At this moment the only explanation I can advance, is that the ego of those behind it does not allow them to admit that, in fact... they never even understood it!

Banks, before the Basel era, cleared for perceived (ex-ante) risk, that which for instance was to be found in the credit ratings, by means of interest rate (risk-premiums), size of exposure and other term; let us call that “in the numerator”.

But Basel II, and now Basel III, instruct the banks also to clear, I would call it re-clear, for exactly the same perceived (ex-ante risk) risk, credit ratings, “in the denominator”, by means of different capital requirements, more risk more capital, less risk less capital.

And so ask the regulators, or your own Martin Wolf, to explain to you:

Why considering twice the perceived risk is something rational from a regulatory perspective. 

Why that does not introduce distortions.

Why that, which allows the banks to earn so much more risk-adjusted margins when lending to The Infallible than when lending to “The Risky”, does not doom the banks to overpopulate safe-havens. 

Why that will allow the banks to allocate economic resources efficiently, even to “The Risky”.

Why if all bank crises ever have resulted from excessive exposures to what was perceived as safe, but ex post turned out no to be, and never from excessive exposures to what was perceived as "risky". 

If you get an answer different from “more risk more capital and less risk less capital sounds logical” please, I beg you, resend it to me. If not, you will begin to understand what I am saying. Yes I know, it is hard to swallow.

I now remembered a speech I gave to some hundred regulators in 2003, pre-Basel-II days, at the World Bank. It is in my book Voice and Noise, 2006 and where I said: 

“Let me start by sincerely congratulating everyone for the quality of this seminar. It has been a very formative and stimulating exercise, and we can already begin to see how Basel II is forcing bank regulators to make a real professional quantum leap. As I see it, you will have a lot of homework in the next years, brushing up on your calculus—almost a career change.”

Little did I suspect then that what was really dangerous was that the complexity of what was being presented, stopped all of them from asking the questions which should have been asked.

Anat Admati and Martin Hellwig, have written “The Bankers’ New Clothes” 2013. It is in many ways an excellent book and I highly recommend it, although “The Regulators’ New Clothes” would have been a better title. But in one passage the authors write: “Whatever merits of stating equity requirements relative to risk-weighted assets may be in theory, in practice…”. My problem is that over many years I have not been able to find or hear anything that I feel could be included in the “Whatever merits”.

Martin Wolf also quotes from that book saying “Banks have so little loss-absorbing capacity that they stand permanently on the edge of disaster”. Not exactly. Banks have sufficient loss-absorbing capacity when lending to “The Risky”, it is when lending to “The Infallible” they don’t, and this the courtesy of the Basel Committee

PS. Sir, just to remind you again that I am not copying Martin Wolf more. He has told me not to send him anything more on “capital requirements”… he already knows it all, so he thinks. But, as I said, if he has an answer, I would appreciate hearing it.