Could we have avoided the crisis if Mandelbrot had gone to Basel?

Sir Christopher Caldwell writes how the recently deceased Benoit Mandelbrot “zeroed in on the besetting flaw [with financial] models that understated risk” and references The (Mis)behaviour of Markets a book that Mandelbrot co-authored with Richard L. Hudson in 2004, “Mandelbrot tips of the market”, October 23.

I do not have sufficient memory to recall it but it is very possible that it was the referenced book that, in October 2004, as an Executive Director of the World Bank, made me make a formal written statement that contained: “We believe that much of the world’s financial markets are currently being dangerously overstretched through an exaggerated reliance on intrinsically weak financial models that are based on very short series of statistical evidence and very doubtful volatility assumptions.”

The world could have benefitted incredibly from ascertaining the presence of skeptics like Mandelbrot at the Basel Committee for Banking Supervision. I am absolutely sure he would have been horrified at what its members were up to managing risks with truly faulty models and conceptions of the reality and tried his utmost to stop their regulatory nonsense in time.

But since even after its evident failure, the Basel Committee is not going back on anything, but is instead forging ahead and scaling it up, as if nothing has happened, now even wanting to tackle cyclicality and systemic risk, it is most likely that Mandelbrot would not have been heard at all by the self-sufficient scheming high-priests of the regulatory establishment.

The AAA pattern is extremely dangerous.

Sir, John Authers in “The Long View”, July 11, quotes Benoit Mandelbrot (who at least I never heard about before) calling the bubbles and crashes “the inevitable consequence of the human need to find patterns in the patternless”. One is left with the question of whether our financial regulators are not supposed to know that sort of stuff when they regulate. At least I always complained how the regulators were developing their own dangerous patterns... the just follow the AAAs.

The capital requirements for banks as determined by the Basel Committee in Basel II requires a bank to hold 1.6 percent in capital when lending to a corporation rated AAA to AA, and 12 percent when lending to a client rated below BB- .

Sir, how many bank crisis have you seen happening because banks have lend too much to AAA or AA rated clients who later turned out not to merit those ratings? All! And how many crisis have you seen happening because the banks lend too much to those rated BB-? None! If so, can you please explain what the regulators were thinking? If anything, would it not seem that the inverse of these capital requirements would be more valid?

Why should a poor BB-rated company, who surely must find it very difficult and expensive to raise finance, on top of it all, have to pay the banks an additional compensation in order to make up for the competitive advantages awarded by the regulators to the much more dangerous AAAs?