Europe, if you spoil your kids too much they will not grow strong. That goes for banks too.

Sir, Patrick Jenkins analyzes several concerns expressed about European banks when policymakers gathered to mark the retirement of Danièle Nouy from ECB’s Single Supervisory Mechanism (SSM); who is to be succeeded by Andrea Enria as the Eurozone’s chief banking regulator. “As European banks regulator retires, six big challenges remain” December 11.

The former Grand-Chair of the Federal Reserve, Paul Volcker, in his recent book “Keeping at it”, co-written with Christine Harper, recounts the following when, in 1986, the G10 central banking group tried to establish an international consensus on bank regulations and capital requirements:

“The US practice had been to asses capital adequacy by using a simple “leverage ratio”-in other words, the bank’s total assets based compared with the margin of capital available to absorb any losses on those assets. (Historically, before, the 1931 banking collapse, a ten percent ratio was considered normal)

The Europeans, as a group, firmly insisted upon a “risk-based” approach, seemingly more sophisticated because it calculated assets based on how risky they seemed to be. They felt it was common sense that certain kind of assets –certainly including domestic government bonds but also home mortgages and other sovereign debt- shouldn’t require much if any capital. Commercial loans, by contrast, would have strict and high capital requirements, whatever the credit rating might be.”

Sir, even though the Basel Accord was signed in 1988 and further developed in 2004 with Basel II, and with which the European risk weighting was adopted, I am sure we can trace the differences between US and Europe banks to these original differences on capital requirements. The US has been much more strict on capital than Europe. In fact the problems with American banks during the 2008 crisis were mostly restricted to those investment banks, which supervised by the SEC, had been allowed in 2004 to adopt Basel II criteria.

In Europe meanwhile banks could do with much less capital, which meant that much more was left over for bankers’ bonuses. In essence, Europe’s banks were dangerously spoiled. The challenge these now faces is having to substitute their equity minimizing financial engineers with good old time loan officers; and convince the capital markets of that. Good luck!

@PerKurowski

Stress tests for banks, performed by mighty regulators, signify dangerous systemic risks, as well as useless predictors

Sir, Caroline Binham reports on how “Andrea Enria, the outgoing head of the European Banking Authority, who is set to become the Eurozone’s top banking regulator, has questioned the value of its stress tests of lenders’ balance sheets, arguing that elements of them are no longer ‘tenable’ and need a redesign” “European regulator questions value of stress tests” November 16.

I could not agree more for two reasons:

First: Stress tests introduce a systemic risk. The fact that banker know their banks will be the object of stress tests causes them to distract their attention from what they might think to be more dangerous, in order to concentrate more on what they think regulators might think more dangerous.

Second: The stress tests are useless since they avoid stress testing many real stresses. In 2003 the United States General Accounting Office (GAO), in its study of the IMF’s capacity to predict crisis concluded, among other things, that of 134 recessions occurring between 1991 and 2001, IMF was able to forecast correctly only 11 percent of them. Moreover, when using their Early Warning Systems Models (EWS), in 80 percent of the cases where a crisis over the next 24 months was predicted by IMF no crisis occurred. Furthermore, in about 9 percent of the cases where no crisis was predicted, there was a crisis.

Much of that has to be a consequence of that if IMF forecasts a crisis; it could quite possibly be blamed for detonating that crisis. Similarly, regulators will avoid to stress test the risks they might be blamed for having produced. For instance when will they stress test the banks on the possibility that their risk weight of 0% to sovereign would have to be increased, and the market reactions to that news. Never! They have painted themselves into a corner.

Sir, when it comes to banks, and their regulations, worry much more about what might be perceived as safe than about what is perceived as risky. In that respect, if I were to perform stress tests on banks, I would look to stress test the risks that seemingly would least need to be stress tested.

@PerKurowski

FSA, you’re on to something good. I hope all your European and American colleagues now follow suit.

Sir Brooke Masters and Patrick Jenkins report “UK banking watchdog eases reins on capital ratios” October 10, and refers to something I have been actively promoting for quite some time, namely the absolute need to get bank credit flowing again to those, who perceived as risky, have been locked out from it by the current capital requirements for banks based on perceived risk, like to small businesses and entrepreneurs.

Simon Gleeson, refers to the possibility of creating “a perverse incentive [for banks] to load up with the highest-risk corporate loans you can find, while completely ignoring that the real perverse incentives that have been in place, and which helped to cause the crisis, are those which favored banks to load up so excessively on assets officially perceived as absolutely safe. 

No, this is indeed a much welcomed development, about time, and I sure hope that other regulators now follow suit. 

Master and Jenkins qualify this though as “Banking regulators are gambling”. If they refer to regulators gambling on that bankers, if not molested by regulators, will be more able to efficiently allocate the resources in the economy than what government or regulation bureaucrats can, then that to me sounds like a very safe bet. 

Master and Jenkins also warn “if it goes bad, and a deeper recession follows, banks will have less equity to absorb the inevitable losses” Oh so scary! If a deeper recession follows then more of those absolute safe assets on the balance sheet of bank will go awry, and, in that case, I guarantee them that the lack of bank equity will be among the of their worries.