Future generations are and will pay dearly for regulators distorting bank lending in favor of sovereigns

Sir, I refer to Christopher Thompson’s “Risks lie in Eurozone banks’ government links”, February 10.

Thompson writes: “banks have boosted their profitability by using cheap ECB loans to buy government debt offering a higher yield. … An additional incentive is that holdings of sovereign debt do not incur any regulatory capital charge while, by contrast, loans to businesses would do.” 

And that is not exactly right. The capital (equity) requirements are not “an additional incentive” these are what make that operation possible. If banks had to hold as much equity against sovereign debt than against loans to businesses, they would not do this carry trade.

If banks had to hold as much equity against sovereign debt than against loans to businesses, they would not hold any sovereign debt at current rates… not in a million years.

The real risk of this regulatory discriminatory distortion is that governments are getting too much and paying too little for their debt, a subsidy paid initially by small businesses and entrepreneurs by means of less fair access to credit; and finally by the future generations that will suffer from the lack of real undistorted bank lending.

I qualify those regulations in favor of the sovereign simply as communism introduced by the backdoor.

PS. In 2004, in a letter published in FT I wrote: “bank supervisors in Basel are unwittingly controlling the capital flows in the world…how many Basel propositions it will take before they start realizing the damage they are doing by favoring so much bank lending to the public sector” and I now have serious doubts about the "unwittingly". 

All Eurozone’s banks are also in a periphery, which is something that should be considered by ECB’s-Draghi-QEs

Sir, I refer to Christopher Thompson’s “Banks seek lower cost risk capital” February 3.

It states “Under proposals from international regulators, the biggest 27 “globally systemic” banks will have to double the capital they must hold under the Basel III requirements by 2019. This implies a €200bn-€300bn capital shortfall in Europe alone according to estimates by Citi.”

Is that not a clear indication that where an ECB-Draghi-QE could be most useful, would be by filling that equity gap, as fast as possible, subscribing bank shares to be later resold to the market.

Otherwise the travel from here to there in terms of bank equity is going to hurt a lot… especially all those “risky” small businesses and entrepreneurs which borrowings generate the largest equity demands on banks.

And the beauty of that is that even Germany would agree because, in terms of the Eurozone’s banks, including the German, all find themselves, just like Greece, in the periphery.

The ECB might also benefit from looking at how Chile solved its bank problem

Mario Draghi lousy Basel bank diet does not work for Europe, or for anyone else.

Mario Draghi of ECB, as the former chairman of the Financial Stability Board, FSB, knows that current Basel bank regulations implies the following diet:

If banks take on exposures that are risky, and which is like eating spinach to kids, they will be punished with higher capital requirements, which means they earn less risk-adjusted returns on equity, which is something like eating broccoli to kids.

But, if banks take on exposures to what is believed as absolutely safe, something which would be like eating chocolate cake to kids, then they will be allowed to hold much much less capital allowing them to earn much much higher risk adjusted returns on equity, which is something like eating ice cream for the kids.

But seemingly Mario Draghi does not understand that the only economic growth that can result from such a bank diet is dangerous economic obesity, since only real risks, taken by banks with reasoned audacity, can lead to sturdy muscular economic growth.

But Mario Draghi is not alone in not understanding that, in FT he has a solid companion.

I say this with reference to Christopher Johnson’s analysis “Weak ECB loan take-up paves way for QE” September 20.

In it, Thompson referring to the low take-up by banks of “targeted longer-term refinancing operations” writes that “When historians come to write the story of the European Central Bank, they may look back at [that event] as the moment when the countdown to ‘quantitative easing’ began”.

And so clearly it is not yet understood that, because banks must hold more capital when financing what the ECB would want them to finance, SMEs for instance, they cannot oblige, for pure lack of bank capital; or that QEs, which would only be taking up more of the “absolutely safe” investments, can only help to further dangerously overcrowd the havens perceives as safe.

No, history, when it looks back, is primarily going to shocked reflect on how on earth such a bad bank diet came about.

PS. Without the need to look, we should be able to assume that the banks in the troubled periphery, those who are taking some of the TLTRO loans, are not lending to SMEs, but investing the proceeds in debt of periphery sovereigns, that which requires them to hold the least of capital. Please, tomorrow, don't call this an "unexpected consequence".

PS. Here, the full terminology for “risk-weighted capital requirements”

Europe, are you sure Mario Draghi has a clear idea of what he is doing? Scary question eh?

Sir I refer to the latest ECB/Draghi measures “to save the eurozone from economic stagnation, as reported and commented on in several ways in FT on September 5.

In the Short View James MacKintosh writes “they should… perhaps encourage mortgage and business lending”. Mortgage lending, yes, business lending, NO! Because business lending requires banks to hold much more of that extremely scarce bank capital than what mortgage lending does.

In fact anyone that in Europe, with added liquidity and lower interests tries to help medium and small business, entrepreneurs and startups, to gain some access to bank credit, without considering eliminating completely the considerable differences in capital requirement for banks when lending to these “The Risky” than when lending to “The Infallible”, has no idea of what he is doing. Scary eh?

But perhaps Draghi knows. When Claire Jones and Christopher Thompson, in “Draghi pins hopes on ‘orphan child’ plan” write about asset backed securities and capital charges and that “Mr Draghi said that decision was in the hand of independent regulators and beyond central bank’s control”, it sure sounds like the former chairman of the Financial Stability Board is trying to wash his hands.

And you argue “Purchases of asset-backed securities will only make a difference… if loans are genuinely taken off strained bank balance sheets, freeing space for new lending”. I ask, what kind of new lending are you referring to? I guess all the bank lending we would see would be that which requires them to hold little capital.

In fact, I suspect that most of what that part of the ECB exercise would achieve, is to dress up the banks before the oncoming asset quality review and stress tests… Might ECB be getting nervous about what it might find? Indeed, ignorance is often bliss!

Do FT reporters really understand that capital, as in capital requirements for banks, refers not to general funds but to equity?

Sir, Christopher Thompson reports “Europe´s banks set for €250bn injection” August 18.

And that money, which according to Mario Draghi could eventually increase to €850bn, is to counter the fact that “Overall eurozone banks have decreased lending to the region´s businesses by €561bn since 2009 according to research by RBS, as they seek to raise capital and cut bloated balance sheets”

And I wonder if it is really understood that what the European banks need for renewing lending, to for instance SMEs, much more than that kind of cheap ECB funding, is the bank equity that regulators require them to hold especially much of when lending to those deemed “risky”, as compared to the equity banks need to hold when lending to those deemed “absolutely safe”.

Could the confusion result from that, for instance FT reporters, think of “capital” more in terms of general funds and not in terms of equity?

Could as it would seem Mario Draghi be equally confused about it, even though he was the chairman of the Financial Stability Board? Holy moly!

The investors had priced market risks of CoCos, not the risks of bankers´ or regulators´ whims.

Sir, I refer to Christopher Thompson´s “CoCo sell-off uncovers high yield bargains” August 15, and which title surprises a bit as I did not know FT provided specific investment recommendations.

But that said, whenever we read about “underlining investor willingness to shoulder more risk in their hunt for higher-yielding bank assets” you can be absolutely sure that all risks have not been disclosed by the seller of that asset… so what the investor is really willing to shoulder is a little bit more of uncertainty or looked at it from the other angle, or just willing to trust his advisor a little bit more.

What has happened to CoCos is clear. Investors had priced in the risk that deteriorating market conditions could force the conversion of CoCos into bank capital… what they had not priced was the fact that conversions could happen as a result of bankers´ and regulators´ whim playing around with the current capital requirements for banks. In fact, regulators had not thought of this, and also just recently woke up to that fact.

PS. In case you do not remember I hereby send you the link to what George Banks had to say about CoCos.

http://subprimeregulations.blogspot.com/2014/07/mr-george-banks-asked-about-cocos.html

Banks, tell me who your “absolutely infallible” are, and I will tell you who your “really risky” are.

Sir, Thomas Hale, Christopher Thompson and Josh Noble report on that “most major Chinese banks have existing Tier-1 capital adequacy ratios of at least 9.5 percent according to CLSA, meeting Basel III requirements”, “China financials lead EM debt sales” July 16.

What does that really mean? Which are the low-risk weight bank assets in China? For instance in the case of European banks these were AAA rated securities, mortgages in Spain and loans to infallible sovereigns like Greece.

For instance if we divide the risk weighted capital Tier-1 ratio of a bank by its un-weighted leverage ratio, then we have a better idea of how much could be hiding in the officially sanctioned safety… the fictitious safety ratio... the Basel Risk Ratio

ECB European banks have no lack of funds but they do have an enormous lack of shareholders’ capital.

Sir, Christopher Thompson and Ralph Atkins report that despite targeted long term refinancing operations, TLTROs, some banks will not lend to SMEs, “Doubts grow over effect of ECB loans” May 10. 

Of course not! “There isn´t a funding crisis any more” they quote Ken Watrett of BNP Paribas saying and the full truth is that there has not been a funding crisis for a long time now. The crisis, in full bloom, is that of an enormous lack of that shareholders´ capital banks are required to have, especially if they to lend to SMEs.

Just days ago, June 4, Sam Fleming ends a comment in the Analysis "Still unstable" with: “Many euro area banks remain undercapitalized, and for the taxpayers to be insulated from future banking crises balance sheets may need to be strengthened by more than €400bn.” What an extraordinary coincidence that the TLTROs figure announced is also €400bn… could there be something there?

PS. By the way think of those chips used by Mario Draghi when doubling down, as the future of our kids.

PS. I have been writing to FT for years on this problem… but Sir, You have silenced me. My TeawithFT blog with all my letters are out there on the web though, and perhaps soon also in a book… and so one day you might have some explaining to do.

A comprehensive stress test of European banks must also include analyzing what is not on their balance sheets.

Sir, I would like to refer to analysis of the European banks “Still unstable” June 4. 

There, quoting RBS figure it says “for taxpayers to be isolated from future banking crises balance sheets need to be strengthened by more than €400bn”. Since that amount represents only about 1.3 percent of “the combined size of European’s banks balance sheets -€30.7tn-” I would indeed say that is quite an understatement, unless any future expected banking crises are extremely small.

But not only taxpayers are interested in the banks… what about the borrowers? How much capital will it take to satisfy the financing needs of Europe?

My objection with all stress-testing going on with respect of the assets that are on the balance sheets of European banks, is that it completely ignores the assets that needs to be on these balance sheets, if the unemployed European youth is going to stand a chance of not becoming a lost generation.

For instance what about all those loans to middle and small companies, entrepreneurs and start-ups which are not on the books only because dumb regulators require banks to hold more equity against these than against assets deemed, ex ante, as absolutely safe?

PS. Again, for the umpteenth time, there is no growth-hormone as potent for the Too Big To Fail banks, than the risk-weighted capital requirements which allow banks to hold very little capital against assets perceived ex ante as absolutely-safe… precisely those assets of which all major bank crises are made of.

Can bank regulators keep silence on the conversion to equity probabilities of cocos?

Sir, I have one question in reference to Alice Ross’ and Christopher Thompson’s “German banks line up to join coco party”, April 24.

Do regulators have any moral or formal duty to reveal to any interested buyers of cocos if they suspect the possibilities of these having to be converted into bank equity being very high? I say this because if so, and if they keep silent on it, that would make them sort of accomplices of bankers. Would it not?

Of course banks need capital, lots of it, but tricking investors into it, does not seem like the right way for getting it.

A positive carry over financing, on zero bank capital… is that not an infinite return on equity?

Sir, I refer to Christopher Thompson´s and Claire Jones´ “Eurozone banks load up on state debt” April 2.

There we find: “The Basel II rules allow regulators to treat sovereign debt as risk free, meaning banks do not have to hold any capital against it” and “Banks were given a chance to borrow at 1 percent from the ECB, invest in sovereign debt… and earn a positive carry.”

Is this not what I have been screaming my heart out over for more than a decade? Like when in November 2004 you published a letter of mine in which I asked… “What will it take before the Basel Committee starts realizing the damage they are doing by favoring so much bank lending to the public sector? In some developing countries, access to credit for the private sector is all but gone, and the banks are up to the hilt in public credits”

Sincerely, if you are in the hands of bank regulators, or financial journalists, who do not understand that the risk based capital requirements for banks has to produce different risk-adjusted returns on equity, which utterly distorts the allocation of bank credit to the real economy… I have to feel pity for all of us… of the Western World.

With respect to increasing bank capital we need banks and regulators to be partners, not enemies.

Sir I refer to Gina Chon and Camilla Hall’s “Fed looks beyond bank’s financial targets” March 27.

As a result of regulators falling for the risk-weights’ trick, banks are now, ate least when compared to pre-Basel Committee history, dramatically undercapitalized. It behooves everyone in the economy to see that capital increased substantially so that bank credit is not unduly blocked.

I have no idea of what the Fed saw in Citibank when performing its stress testing and that caused it to reject its capital plan for dividends and share buybacks, but I do know that if the word “punishment” describes it appropriately, the Fed is on the wrong track.

If the real economy is going to get out of this mess… and it is a mess… the Fed and the banks must be partners in finding lots of new bank capital in a credible way. And bank capital will not be raised sufficiently by mistreating the shareholders of banks… nor by fooling some investors into buying Coco bonds, suspecting the probabilities for these to be converted, are knowingly underrepresented.

In fact the Fed and other regulatory authorities must tread on the issue of Coco bonds with extreme care, less they also be liable for withholding information and misrepresentation. And for this I refer to “Flurry of Coco bonds sends yields tumbling” by Christopher Thompson.

If I buy a Coco today and become converted into a bank shareholder three years from now I guess I cannot complain... but what if that happens three weeks from now?

Risk weighted capital requirements for banks means some will receive too much credit, too cheap, others too little, too expensive.

Sir, John Plender in “How to spend $2.8tn of corporate cash” FTfm January 27, writes “The financial sector is there to intermediate between those with surplus funds and those who wish to invest. It can be relied to do so”

Not so fast Mr Plender. The most important financial intermediaries, the banks, are kept from efficiently allocating credit in the real economy, as a result capital requirements based on perceived risk. In fact, since banks can lend to “the infallible” against very little capital, the lending to “the risky”, which requires much more capital, is coming to a halt.

But seemingly the regulators are blissfully unaware of that it is them who are distorting. I say this because Christopher Thompson writes “Non-financial corporate loans in have fallen… creating a headache for regulators keen to encourage lending,, especially to small and medium sized businesses, which provide the bulk of Europe´s employment” “Balance sheets hint at EU bank confidence”, also January 27.

A “headache for regulators”, Europe has indeed fallen in the hands of a real inept bunch of bank regulators. What about the pain of the unemployed?

Regulators, stop the credit rating agencies from telling banks where it is safe to go. They haven’t a clue, as neither have you

Sir, Christopher Thompson quotes Bridget Gandy, managing director of Fitch “If you compel banks only to use a leverage ratio, the only way to be more profitable is to take more risks on the assets you have. You need to have balance between capital coverage of risk-weighted assets and leverage, risk is not just about size”, “Banks ‘need’ to cut €3.2tn of assets” August 12.

And that is precisely the type of mentality, which completely aligned with the mentality of the bank regulators in the Basel Committee, and which if allowed to prevail would guarantee that the €3.2tn of assets expected to be cut in Europe, would not be cut in the most economic efficient way, but only in accordance to its perceived riskiness.

And, as a direct consequence, Europe would end up with its banks stuffed with “absolutely safe” assets, which could be financed by other means, while it’s medium and small businesses, entrepreneurs and start-ups, those “risky” borrowers which might hold the best chances for Europe to return to sturdy economic growth, will be completely starved for access to bank credit.

A credit rating agency, incapable of looking around the corner to what might happen down the line, might be an extremely good agency for rating the creditworthiness of banks and borrowers this and the next quarter, but is extremely useless for rating the credit worthiness of anything some years ahead.

“The only way [for banks] to be more profitable is to take more risks on the assets you have” Yes Fitch, indeed… and what is wrong with that? The latest decades the way banks have become more profitable has only been by convincing the regulators they need to hold less and less capital on assets perceived as absolutely safe. And look what damages that has caused us.

No Fitch! I appreciate very much your credit ratings, and these will be used, but it is high time for regulators to stop you from telling the banks where it is safe to go, because, sincerely, you have not the faintest idea about it... as of course, neither have they.

What European banks need is not to de-leverage but more capital, lots of it

Sir, Christopher Thompson reports on a Royal Bank of Scotland analysis that states “Banks need ‘to shrink’ balance sheets, to shrink their balance sheets dramatically to ensure that the continent could withstand another financial crisis… But as European banks deleverage, such as by selling loan books, there are knock-on effects to the real economy… It’s a catch-22”, July 22.

Forget it! What Europe's real economy and European banks need is more bank capital, lots of it.