Even perfectly perceived risks, if excessively considered, cause wrong reactions

Sir, John Authers writes that John Locke…when asked if we have an idea of the substance behind our perceptions, answered that we have “no such clear idea at all, and therefore signify nothing by the word substance, but only an uncertain supposition of we know not what”. “Economic reality is hard to fathom after years of distortion” April 28.

And then Authers argues: “Uncertainty is nothing new, particularly about the future. But it is rare for the present to be so hard to perceive as it is now. After a decade of desperate monetary measures to stave off the Great Recession, there is also a reluctance to believe what the markets are telling us, as their signals are distorted.”

At least when it comes to banks and their allocation of credit to the real economy, the signals are indeed extremely distorted, all as a result of the risk weighted capital requirements.

Bankers perceived credit risks and cleared for these by means of the size of the exposure they accepted and the risk premiums they demanded. But then came regulators and ordered that precisely those same perceived risks, should also be cleared for with the capital requirements.

With that they just ignoredthat any risk, even if perfectly perceived, leads to the wrong actions, if excessively considered.

As a result there are now way too high exposures, at too low risk premiums, to what is perceived as safe (and which therefore contains the fattest dangerous tail risks) and too little exposures, at too high risk premiums, to what is perceived as risky, like entrepreneurs.

@PerKurowski

Few things are as risky as letting besserwisser technocrats operate on their own, without adult supervision.

Sir, Martin Wolf when discussing Mariana Mazzucato’s “The Value of Everything: Making and Taking in the Global Economy” writes: “In her enthusiasm for the potential role of the state, the author significantly underplays the significant dangers of governmental incompetence and corruption.” “A question of value” April 28.

Indeed. Let me, for the umpteenth time, refer to those odiously stupid risk weighted capital requirements that the Basel Committee and their regulating colleagues imposed on our banks.

Had not residential mortgages been risk-weighted 55% in 1988 and 35% in 2004 while loans to unrated entrepreneurs had to carry a 100% risk weights, the “funded zero-sum competition to buy the existing housing stock at soaring prices” would not have happened.

Had not assets, just because they were given an AAA rating by human fallible credit rating agencies, been risk-weighted only 20%, which with Basel II meant banks could leverage 62.5 times, the whole subprime crisis would not have happened.

Had not Basel II assigned a sovereign then rated like Greece a 20% risk weight, and made worse by European central bankers reducing it to 0%, as it would otherwise look unfair, the Greek tragedy would only be a minor fraction of what happened.

Had not bank regulators intruded our banks would still prefer savvy loan officers over creative equity minimizers.

Had not regulators allowed banks to hold so little equity there would not have been so much extracted value left over to feed the bankers’ bonuses.

Having previously observed Mariana Mazzucato’s love and admiration for big governments, who knows she might even have been a Hugo Chavez fan, I am not surprised she ignores these inconvenient facts. But, for Martin Wolf to keep on minimizing the distortion, that is a totally different issue. 

The US public debt is certainly the financial risk with the fattest tail risk. It was risk weighted 0% in 1988, when its level was $2.6tn. Now it is $21tn, growing and still 0% risk weighted… and so seemingly doomed to become 100% risky. Are we not already helping governments way too much?

@PerKurowski

What kind of tariffs is protectionist Michel Barnier thinking of imposing on banking and financial services provided by the City of London to Europeans?

Sir, Mehreen Khan’s, Jim Brunsden’s and Sofia George Parker’s write thatin reference to that “the EU would have more to lose from cutting off the City of London than Britain would” Michel Barnier said: “This is not what we hear from market participants, and it is not the analysis that we have made ourselves.”“Barnier dismisses UK hopes of special market access for London after Brexit” April 27.

Sir, I must confess that Michel Barnier does not qualify as my favorite EU Brussels technocrat, but with this he certainly proves himself to be a protectionist, completely in the hands of the European financial intermediaries (the aluminum and steel producers) and with little consideration to all those European consumers of financial services that might prefer using the services and the legal framework provided by the City.

What kind of tariffs is Barnier thinking of imposing on banking and financial services? Has Michel Barnier really been authorized to impose on behalf of all the European Unions his will on all Brexit negotiations?

Sincerely, I do not think Barnier has thought this thru. He might be setting off a real European capital flight to London. 

@PerKurowski

Bank regulators, get rid of risk weighted capital requirements, so that savvy loan officers mean more for banks’ ROE’s, than creative equity minimizers.

Sir, Gillian Tett referring to IMF’s recent warnings about the risks of overheating in risky loan and bonds markets; like “The proportion of US loans with a rating of single B or below (ie risky) rose from 25 per cent in 2007 to 65 per cent last year. And a stunning 75 per cent of all 2017 institutional loans were “covenant lite” writes: “it is possible — and highly probable — that non-banks are taking bigger risks, since they have less historical expertise than banks, and thinner capital buffers.” “The US has picked the wrong time to ease up on banks” April 27.

Yes, with risk weighted capital requirements banks ROE’s began to depend more on maximizing leverage, and so banks sent home many savvy loan officers and hired creative equity minimizers instead. As a result someone else had to serve “the risky”. 

But then Tett warns “Trump-era regulators” with a “it is foolish to be encouraging risky lending right now”. Wrong! It is always foolish to encourage risky lending. 

What Tett does not understand is that “risky lending” has nothing to do with a borrower being risky, and all to do with whether the lending to those perceived risky or those perceived safe, is done in such a way, with adequate exposures and risk premiums, so that the resulting bank portfolio is well balanced. 

The current extremely risky bank lending is the result of way too large exposures, at way too low risk premiums, to what is perceived, decreed or can be concocted as safe; and way too little exposures, at way too high risk premiums, to anything perceived as risky.

What regulators really should do, is to get rid of the risk-weighted capital requirements for banks. Then bank loan officers, those that could also show the non-banks the way would return, for the benefit of both the banks and the real economy.

Why do many bankers hate such possibility? Because high leverage, meaning little equity to serve, is the main driver of their outlandish bonuses. 

http://perkurowski.blogspot.com/2016/04/here-are-17-reasons-for-why-i-believe.html

@PerKurowski

Could it be that we so much wish some forecasts to be right, that we are unable to see when they fail?

Sir, Miles Johnson ends his discussion of failing economic forecasts with: “It is not surprising that forecasters continue to get things wrong. What remains remarkable is that those who question the assumptions that underpin their repeatedly failing models are still treated as radicals” “Forecasters’ failings highlight the flaws in our assumptions” April 26.

Regulators, they say, based on some careful research, forecasted that what is perceived as risky is much more dangerous to our bank system than what is perceived as safe. And so they gave us risk weighted capital requirements with instance with Basel II’s risk weight of 20% to what is AAA rated and 150% to what is rated below BB-.

The 2007/08 crisis, caused exclusively by assets that because they were perceived, decreed or concocted as safe, residential mortgages, sovereigns like Greece or AAA rated securities, the banks were allowed to leverage much more with, proved without any doubt how wrong that forecast was. 

And there are many more faults with this regulations that completely distorts the allocation of credit to the real economy.

Yet the assumption that underpin that regulation is not questioned, and if someone does, like I have done persistently for about two decades, I get treated like a radical, or at least as someone obsessed that should not be given much voice. 

For instance FT’s Martin Wolf, even though in 2012 he writes: “Per Kurowski reminds me regularly, crises occur when what was thought to be low risk turns out to be very high risk”, in the same breath he holds that “it is essential to recognise that so called ‘risk-weighted’ assets can and will be gamed by both banks and regulators”. That of course means Wolf does not see this regulations as something build upon a fundamentally mistaken principle, but mostly just suffering a kind of technical glitch in its execution.

Why is this so? Perhaps it is because we all want so much our banks to be safe, so when regulators tell us the bank capital requirements are risk-weighted, we so much want that to be true that we don’t even dare contemplate the possibility that, the experts, could be 180 degrees off the mark.

http://perkurowski.blogspot.com/2016/04/here-are-17-reasons-for-why-i-believe.html

@PerKurowski

The severity of Greece’s financial crisis was caused, directly, by totally inept bank regulators

Sir, Jim Brunsden, Mehreen Khan and Kerin Hope report “Greece is approaching a momentous moment: the end of eight years of international bailouts that forced the country into unprecedented belt-tightening in exchange for a cash lifeline from eurozone governments and the IMF” “Eurozone and IMF are still to agree a package as deadline approaches” April 27.

What I find impossible to understand is how European bank regulators, and European central bankers, have been able to hide from the Greeks the fact that they directly caused that crisis to be so much worse than it would have been, had they not meddled.

For the purpose of the capital requirements for banks, they assigned Greece’s public debt a 0% risk weight, and this as if Basel II’s credit rating dependent minuscule risk weight of 20% was not bad enough.

Would Greece have found itself in such troubles had banks needed to hold the same capital when lending to the Greek government than when lending to Greek citizens? Absolutely not!

Those retirees protesting against pension reforms, and all those young Greeks who have had to left their country in order to stand a better chance in life, should now all jointly be protesting in Basel against the Basel Committee of Banking Supervision, the Financial Stability Board and all bank regulators.

https://teawithft.blogspot.com/2015/06/europe-you-want-truth-it-was-not-euro.html

@PerKurowski

Profits obtained under the protection of an IPR should be taxed higher than when obtained competing naked.

Sir, Martin Wolf discusses the vital topic of how intellectual property rights could, simultaneously, be agents that help promote the ideas and inventions needed for a better future, and an obstacle to competition. “Let knowledge spread around the world” April 25.

I have also grappled with this issue and although it might surely not be the only option, for a long time I have thought that placing a special tax on profits obtained under the coverage of an IPR, could help to bring forward that moment when sharing out freely the rights, instead of exploiting these up to the tilt, would make more business sense.

Also what justice is it in that those who have to compete completely naked in the market, should be taxed at the same rate as those who the society defends by defending their IPRs?

By the way, that special tax on IPR profits should go to partially fund, by means of a Universal Basic Income what could be considered as a Human Heritage Dividend.

@PerKurowski

Predictability, in bank regulations, is more a dangerous threat than help

Sir, I refer to Robin Wigglesworth’s excellent discussion on the difficulties and hard choices central banks face when communicating their feelings and policies “Central banks might benefit from a healthy dose of ‘constructive ambiguity’”. May 14.

But let me focus (for the umpteenth time) on the concluding note “Predictability may be a hindrance rather than a help”

The Fed’s Governor Laid Brainard, in a recent speech “An Update on the Federal Reserve's Financial Stability Agenda” said: “The primary focus of financial stability policy is tail risk (outcomes that are unlikely but severely damaging) as opposed to the modal outlook (the most likely path of the economy).”

That is how it should be, but it is not! That the riskiness of bank assets, for instance with the help of credit rating agencies, could be somewhat predicted, tempted regulators into creating risk weighted capital requirements for banks; but that same “predictability” also blinded them completely to the fact that the safer something is perceived, the more dangerous does its fat-tail-risk become. For instance they assigned a risk weight of only 20% to the AAA rated and one of 150% to that which was rated below BB-. Is not the fat-tail-risk of what has been rated below BB- almost inexistent?

Governor Leal Brainard also writes: “Treasury yields reflect historically low term premiums--. This poses the risk that term premiums could rise sharply--for instance, if investor perceptions of inflation risks increased.” 

Indeed, but to that we must also add the possibility of the investor perceptions of Treasury infallibility changes for the worse.

When in 1988 the regulators, with Basel I, decided to assign a 0% risk-weight to some sovereigns they painted these into a corner. If that risk weight is not increased, then sovereigns will become, sooner or later over-indebted, and risk will grow until it hits 100%. If that risk weight is increased, ever so slightly, markets will be very scared. How to get out of that corner is the most difficult challenge central banks and bank regulators face. Let us not forget that in 1988 US debt that was $2.6 trillion. Now it is US$21 trillion, growing, and still 0% risk weighted.

PS. The only way to solve the 0% sovereign risk weight conundrum that I see, is to increase the leverage ratio applicable to all assets, until that level where the risk weighted capital requirement totally loses its significance.

PS. Brainard also stated “Regulatory capital ratios for the largest banking firms at the core of the system have about doubled since 2007 and are currently at their highest levels in the post-crisis era.” Regulatory capital ratios, when risk weighted, might mean zilch.

@PerKurowski

Does not “safe(ish) activities such as holding government bonds” contain the fattest most dangerous tail risks?

Sir, Gillian Tett writes “the Fed and the Office of the Comptroller of the Currency introduced proposals to “tailor leverage ratio requirements to the business activities and risk profiles of the largest domestic firms”. In plain English, this means banks can operate with a little less capital to absorb losses, provided they focus on safe(ish) activities such as holding government bonds.” “Trump’s mixed record on rolling back bank reform” April 13.

The Fed’s Governor Laid Brainard, in a recent speech “An Update on the Federal Reserve's Financial Stability Agenda”said: “The primary focus of financial stability policy is tail risk (outcomes that are unlikely but severely damaging) as opposed to the modal outlook (the most likely path of the economy).”

So let me ask: What is the tail risk of “safe(ish) activities” compared to that of riskier activities?

How fat or dangerous is the tail risk of what is rated below BB-? Very skinny indeed.

How fat or dangerous is the tail risk of what is rated AAA? Very, very fat indeed.

Government bonds? When in 1988 the regulators, with Basel I, decided to assign a 0% risk-weight to some sovereigns they painted themselves into a corner. If that risk weight is not increased, then sovereigns will become, sooner or later over-indebted, and their risk will grow until it hits 100%. If that risk weight is increased, ever so slightly, markets will be very scared. How to get out of that corner is the most difficult challenge central banks and bank regulators face. Let us not forget that in 1988 US debt that was $2.6 trillion. Now it is US$21 trillion, growing, and still 0% risk weighted.

PS. The only way to solve the 0% sovereign risk weight conundrum that I see, is to increase the leverage ratio applicable to all assets, until that level where the risk weighted capital requirement totally loses its significance.

@PerKurowski

The US might be an SOB of a superpower, but it is our (or at least mine) SOB superpower.

Sir, Martin Wolf writes: “China is, not the real threat. The threat is the decadence of the west, very much including the US — the prevalence of rent extraction as a way of economic life, the indifference to the fate of much of its citizenry, the corrupting role of money in politics, the indifference to the truth, and the sacrifice of long-term investment to private and public consumption. It is indeed a tragedy that the best way we could find to escape from a financial crisis was via monetary policies that risked promoting new bubbles. We could be better than this.” “The rivalry that will shape the 21st century” April 11.

On the “sacrifice of long-term investment to private and public consumption” I could not agree more. But that is precisely why I have been attacking, day and night, obsessively, the risk weighted capital requirements for banks. These make our banks favor way too much the financing of the present “safer” consumption (houses-governments) and stay away, way too much, from financing the “riskier” future production (entreprenuers). Unfortunately too many, Martin Wolf included, have been indifferent to that truth.

But, that said, on the first part “the prevalence of rent extraction as a way of economic life, the indifference to the fate of much of its citizenry, the corrupting role of money in politics, the indifference to the truth”, is China really better than the west or the US? 

I don’t think so, but even if it was so, when push comes to show, there comes a point when you have to decide what superpower you prefer. I have no doubt preferring the west, the US… though Graham Allison of Harvard seems to harbor some doubts on that arguing that “China rivals the US in…ideology”.

In what I entirely agree with Wolf is when, explaining it so well, he states “The idea that intellectual property is sacrosanct is wrong. It is innovation that is sacrosanct. Intellectual property rights both help and hurt that effort. A balance has to be struck between rights that are too tight and too loose”

Yes, and for years I have suggested that balancing could start by taxing the profits obtained when competing protected by intellectual property rights, at a higher rate than profits derived from competing naked in the market. And since what becomes protected with IPRs is the last leg of our human heritage inventiveness, those taxes should perhaps also help to fund a Universal Basic Income, something which would be a de facto social dividend.

PS. That said, when Wolf says “the US can huff and puff about Chinese theft of intellectual property” then I am not sure really which SOB is Wolf’s favorite superpower.

PS. For full disclose, had it not been for the US, I would certainly not be around.

PS. All morphed faces look ugly but, in reference to Times’ recent cover, if faces have to morph, what faces would you prefer to see morphing, Trump-Putin, Trump-Xi Jinping or Putin Xi-Jinping?

@PerKurowski

Whether pension plans are based on defined benefits, defined contributions or a mixture thereof, in order to deliver, they all depend on the economy being healthy.

Sir, I refer to Martin Wolf’s “The case for an alternative pensions model” April 6.

For decades I have sustained that the best pension plan that exists, is to have loving children working in a functional and reasonably healthy economy. And that long before Venezuela proved how good pension plans could come rapidly to absolute naught by irresponsible governments.

If the economy is in shambles when pension fund assets have to be converted into purchasing capacity, it does not matter whether these are based on defined benefits, defined contributions or a mixture of these.

With risk weighted capital requirements for banks that favor an over-indebtedness resulting from financing the "safer" present consumption, like houses, over the financing of riskier future production, like entrepreneurs, there will be no economy capable to deliver even a fraction of what is currently expected from pensions.

Wolf refers to the importance to sharing “the risks among a very large group of people…across generations”. Indeed but those now young will tomorrow ask Wolf and his generation… why did you not allow banks to share in the risk taking needed for us to have a future?” and they might with justification give their elders the finger.

Currently, having already to live in the basements of their parents houses because of the lack of jobs, the minimum the young today will hold tomorrow is: “Mom, dad, you move downstairs, its our turn to live upstairs!”

PS. Yes, I am obsessive about the distortions that the risk weighted capital requirements for banks cause in the allocation of bank credit to the real economy, but Martin Wolf, for less worthy reasons, is even more obsessive when ignoring it.

PS. Current “midlife crisis” could be a piece of cake compared to what awaits.

@PerKurowski