October 26, 2018

Paul Volcker warns public administration training is no longer on universities’ radar. Neither seems conditional probabilities and Bayes’ rule to be

Sir, interviewed by Gillian Tett, Paul Volcker’s tells her, “I would like my legacy to be some attention to public service. When I grew up good government was a good slogan. But now the phrase ‘good government’ is a mockery [and] universities have effectively abandoned practical public administration training, focusing instead on ‘policy’",“Volcker sets a challenge for the next generation” October 26. 

And Ms. Tett laments, “Few students want to make the type of financial sacrifices that Mr Volcker did for many decades, in the name of public service”

That concern has great merits, especially because the alternative would be to see our public service posts filled with experts in negotiating what crony statism could have to offer.

The Paul Volcker as Fed chair in the 1970s crushing inflation was a hero of mine. Unfortunately I woke up to the fact he helped doom to failure our banking system.


“On September 2, 1986, the fine cutlery was laid once again at the Bank of England governor’s official residence at New Change… The occasion was an impromptu visit from Paul Volcker… When the Fed chairman sat down with Governor Robin Leigh-Pemberton and three senior BoE officials, the topic he raised was bank capital…

Adequate capital – the bank’s buffer against bankrupting loss- was the keystone of a central banker’s mission to uphold financial system safety and soundness.

They literally wiped the blackboard clean, then explored designing a new risk-weighted capital adequacy for both countries… 

It included… a five-category framework of risk-weighted assets… It required banks to hold the full capital standard against the highest-risk loans, half the standard for the second riskiest category, a quarter for the middle category, and so on to zero capital for assets, such as government securities, without meaningful risk of credit default.”

That led to the Basel Accord, Basel I in 1988. And of course, setting the capital requirements for the banks based on the risks that bankers cleared the most for, credit risk, had to dangerously distort the allocation of bank credit to the real economy. As I say over and over again, any risk, even if perfectly perceived, will cause the wrong actions if excessively considered.

Suffices to say that 100% of the assets that caused the especially large 2007-08 crisis were assets that, because they were perceived as especially safe, generated especially low capital requirements for the banks.

When I consider the total silence by universities on the consequences for the stability of our banking system and for the dynamism of our economies produced by the risk weighted capital requirements for banks, I am also saddened.

Universities, like Harvard Business School, do have “Conditional Probabilities and Bayes’ rule” on the curriculum. Could it be that professors are kept too busy preparing these courses so to have time to look out at what’s happening in the world? Or could it be their students, like Paul Volcker, never understood them.

Sir, wake up! When hubris filled besserwisser regulators tell you: “We will make your bank system safer with our risk-weighted capital requirements”, as if they were great clairvoyants, and you believe them, you have fallen for some pure, unabridged and very dangerous populism. 

The risk weighted capital requirements for banks guarantee especially large exposures, to what’s perceived as especially safe, against especially little capital, which dooms bank systems to especially severe crises.

PS. If regulators want to use risk weighted bank capital requirements, these should be based not on the credit risk of assets per se, but on the risk for the bank system the assets pose, conditioned on how risks are perceived and acted on by bankers. Who has the power to tell them so?

@PerKurowski