No one but a PhD or an MBA could have come up with the foolish risk weighted capital requirements for banks

Sir, Philip Delves Broughton in his “The business school tradition feels like an outdated Grand Tour”, October 7, refers to a book I am just to begin to read, Mihir Desai´s The Wisdom of Finance.

In that book Desai, writes about “how many of his MBA students avoid risk in order to retain their ‘optionality’... a concept they had picked up from finance… [but] often remain in companies saying to themselves, ‘Why not stay another year and create more options for down the road?’; ending up frustrated. The tool that was supposed to lead to more risk-taking ends up preventing it.”

Sir, I am not sure an option-searcher has ever in him to be a real risk-taker. That normally belongs to those who just close their eyes and jump at any opportunities in front of them. But, that said, I sure know of a tool that produces just the opposite. It was supposed to lead to less risk-taking, but ends up causing much more of it.

I mean of course the risk weighted capital requirements for banks. By giving banks the incentives to create excessive exposures, holding the least capital, to what has always caused major bank crisis, namely what was ex ante perceived as safe but that ex post turned out to be very risky, instead of reducing the risks to the bank system, it increased it exponentially.

Broughton also refers to a book by Will Dean, It Takes a Tribe, in which the author holds that entrepreneurs learn by doing, while MBAs fail by over-thinking. Will Dean is by far not the first to argue such a thing.

My daughter Alexandra, an art fanatic, on hearing my explanation about the mistake of the Basel Committee, pointed me to “The forger’s spell”, a book by Edward Dolnick about the falsification of Vermeer paintings. Boy was she right! 

In that book Dolnick makes a reference to having heard Francis Fukuyama in a TV program saying that Daniel Moynihan opined: “There are some mistakes it takes a Ph.D. to make”. And Dolnick also speculates, in the footnotes, that perhaps Fukuyama had in mind George Orwell’s comment, in “Notes on Nationalism”, that “one has to belong to the intelligentsia to believe things like that: no ordinary man could be such a fool.” 

I am very happy with the MBA degree I received from IESA in Caracas 1974; but that does not stop me from being extremely disappointed with all MBA and Finance Schools all around the world, for not having been able to see, and much less stop, those regulations that are so dangerously distorting the allocation of bank credit.

Dolnick wrote: “Experts have little choice but to put enormous faith in their own opinions. Inevitably, that opens the way to error, sometimes to spectacular error.”

All of which leaves me with the problem that seemingly no ordinary financial reporters either, like those in FT, can really come to grips with believing, or even daring to believe, that experts could be such fools.

@PerKurowski

PS. My letter in 2019 to the Financial Stability Board 

For sturdy long term stability we need lots of short term instability, and bank regulations which do not distort.

Sir I refer to Paul Tucker´s “Financial regulation needs principles as well as rules” June 19,

Sir, I do not care much for stability in the financial system, if that stability impedes clearing out lousy banks or bankers, or if that stability is obtained by tools that hinder growth. In fact little can assure to bring on the sturdy long term stability we need, than the existence of a lot of short term instabilities.

And that is why I do get nervous when I read Paul Tucker asking regulators to go for “systemic stability” and to assign them “an explicit goal in preserving stability”… “Financial regulation needs principles as well as rules” June 19. Forget it! The unemployed European youth that could become a lost generation need moving forward more than they need stability.

But when Tucker writes “we need a clearer framework for the regulations of markets, articulated as a coherent whole and based on clear economic and policy principles addressed to real-world vulnerabilities” there I whole heartedly agree.

Problem is though that would indicate the importance of not distorting the allocation of credit to the real economy, which is precisely what the risk-weighted capital requirements do; and that out there, in the real financial world, what is most dangerous is not what is perceived as risky but what is perceived as absolutely safe, something which would point to that the risk-weighted capital requirements for banks are weighing risks 180 degrees in the wrong direction.

PS. Today in an Op-Ed in Venezuela I published “The capital control the IMF supports” you may want to have a look at it.

The deafening silence of universities on The Basel Committee Distortion is scary.

Sir, I refer to John Kay’s “Angry economics students are naïve- and mostly right” May 21.

When John Kay invests his capital he looks at risk and returns when deciding what to do. How would it impact his decisions if suddenly the government told him “Citizen Kay, if you invest in what is perceived ex ante as “absolutely safe”, I will pay you additionally a couple of hundred basis points.”? Would he also think that subsidy carries no cost?

Allowing banks to hold less capital when lending to “the safe” than when lending to “the risky” causes banks to earn much higher risk-adjusted returns on equity when lending to “the safe” than when lending to “the risky”, and this means, no doubt about it, that banks will lend too much to “the safe” and too little to “the risky”.

And so though I am not an angry economic student, I am an economist very angry with our universities for ignoring the distortions caused by the risk-weighted bank capital requirements in the allocation of credit in the real economy. Their deafening silence on this issue makes it so much harder to extract an explanation from the regulators who in my mind are either blind or plain stupid.

That you for instance can obtain an MBA from Harvard, or get a CFA certification, without having been made aware of the existence of The Basel Committee Distortion, and much less of its financial consequences, is truly scary.

If only an “intellectual vacuum”, but, sadly, it is worse than that Professor Michael Ignatieff.

Sir, Michael Ignatieff writes about “the waning power of ideas” and begs “Free polarized politics from its intellectual vacuum”, January 10. Although, as a self described “radical of the middle”, or “extremist of the center”, I do agree with most of what he writes, I must still confess feeling that the absence of ideas would at least be better that the presence of some really bad ideas.

And a truly bad idea currently present, are the risk-weighted capital requirements for banks, and which allow these to earn much higher risk adjusted returns on equity on exposures deemed as “absolutely safe”, than on exposures deemed as “risky”.

And that makes it of course impossible for banks to allocate credit efficiently to the real economy. And that guarantees that the chances of any major bank crisis, those usually caused by dangerously overpopulating some safe-haven, have been exponentially increased.

Technically the mistake is explained by the fact that regulators estimate the “unexpected losses”, those for which you mainly require banks to hold capital, based on the same perceptions used by the banks to estimate “expected losses”.

And here we have all the free market believers not complaining about that horrible interference with the market that risk-weighting causes … and here we have all progressives not saying a word about the odious discrimination in favor of the AAAristocracy and against the “risky” that risk-weighting causes.

And meanwhile the chances for our youth to find employment in their lifetime are evaporating, thanks to this nonsense of banishing risk-taking from our banks.

Do financial regulators have a legal right to discriminate?

Sir, Benjamin Friedman writes that the activity of so many of our young well educated luminaries working in finance “adds no economic value” “Overmighty finance levies a tithe on growth”, August 27. My first question is how does he really know it is because they are well educated and not because they work in a quasi-monopolistic environment? My second, if so are we not to blame professors for it? And third, should the world sue Harvard and other for their teachings?

Of course Friedman has a point but what really levies a financial tithe on growth are the various tolls on financial risk. Regulators for instance order banks to have more equity for clients perceived as more risky, and credit cards financiers are more than happy to have the credit rating scores create the illusion they charge the right level of interests to their customers.

Anyway I would argue that much more important than what the financial sector has earned in profits (before the losses of the crisis are netted out) is to think on what other growth opportunities could have been financed with those trillions of dollars wasted in the housing sector only because some hustlers managed to hustle up some credit ratings made overly important by the regulators.

A question to the Professor, when the regulators impose on the banks an 8 percent capital requirement when lending to unrated citizens and zero if lending to the government... are they not exceeding their mandate? Do they have a legal right to discriminate this way?

What we need is to pay bonuses for the right kind of risk taking!

Sir the world is definitely confused. Lucian Bebchuk writes “Regulate financial pay to reduce risk-taking” August 4 even though as a Harvard professor he should now that we as a society need risk-taking if we are going to move forward, and so the issue should obviously be more that of regulating financial pay so as to promote the right kind of risk taking.

Also let us stop from hiding the truth. Had the regulators not created the risk arbitrage opportunities derived from the minimum capital requirements and their excessive trust in the credit rating agencies billions of temporary artificial profits would not have been generated and with that there would have been so much money to pay the bonuses to begin with.

Just don´t pay Harvard cash-up-front!

Sir Lucy Kellaway answering “Am I mad to invest in a Harvard course in a downturn?” July 2, does not tackle the real madness of it which is the way that the course would seem to be contracted with terms of $ 60.000 cash-up-front.

I would suggest a better offer to Harvard would be $3.000 up front to cover for your marginal costs and then 20% of any additional earning produced by the graduate during the next 5 years, even if that comes to be much more than $60.000. I mean that would make the so much recently discussed incentive structures better.