Major bank crisis, are they most likely to result from excessive exposures to what’s perceived risky than for what’s perceived safe?

Izabella Kaminska ends her fun “Festive inefficiencies would be missed in Big Tech’s perfect world” of December 20 with “Since inefficiency has a way of popping up no matter what we do, it is human experience that should be prioritised before all else.”

Sir, let me phrase some questions:

How long could it take for a bank system to suffer a major crisis because of excessive exposures to what is perceived risky?

How long could it take for a bank system to suffer a major crisis because of excessive exposures to what is perceived safe?

Do our bank regulators care at all about human experiences when they require banks to hold more capital against what is perceived as risky than for what is perceived as safe?

Sir, do you really care about what human experiences teaches us?

@PerKurowski

True bank regulations should also not be like gambling.

Sir, I refer to Izabella Kaminska’s “True investing is not the same as gambling” November 22.

But Sir, what did bank regulators do with their risk-weighted capital requirements for banks if not gambling? They gambled on that bankers and credit rating agencies would perceive and manage risks correctly…and this even when bank crisis, when not the result of unexpected events, have always resulted from banks having ex ante perceived something as safe, but which ex post turned out to be risky.

Here again are the four possible outcomes of any bank lending:

1. Ex ante perceived safe – ex post turns out safe – “Just what we thought!”

2. Ex ante perceived risky – ex post turns out safe – “What a pleasant surprise! Another entrepreneur who makes it because we are so good bankers.”

3. Ex ante perceived risky – ex post turns out risky: How lucky we only lend little and at high rates to it.

4. Ex ante perceived safe – Ex post turns out risky: “Holy Moly now what do we do? Call the Fed for a new QE?”

The role of a bank regulator would of course be to work solely on the possibilities that banks did not perceive risks correctly or, if they did, did not manage these perceptions correctly.

And in that respect, the safer something is perceived the more dangerous it can become, and the riskier something is perceived the safer it becomes. Just the same reason for why so many more die in car accidents than in motorcycle accidents. 

The saddest part though is that even if bankers or credit rating agencies perceived risks correctly, the final results of all this would be bad. That because any risk, even if perfectly perceived causes the wrong actions, if excessively considered.

Bankers consider perceived credit risk when determining the size of their exposures and the risk premiums they should collect… but there, after 600 years of banking, suddenly the regulators invented that exactly the same perceived risks needed also to be considered in their capital too. And, since then, what is perceived as safe is getting way too easy credit while, what is perceived as risky, like SMEs and entrepreneurs are not getting the credits the real economy need them to get.

Sir, come one, don’t be so scared, live up to your motto of “Without fear and without favor”. Dare request from any regulator, for instance from FSB’s Mark Carney, an explanation for Basel II’s risk weights: that of a meager 20% for the so dangerous AAA rated, and a whopping 150% for the so innocous below BB-

https://youtu.be/TUdKhm6_a8Y

@PerKurowski

Systemic risks in the financial sector keep growing. Yesterday risk weighted capital requirements and credit rating agencies. Today artificial intelligence

I refer to Izabella Kaminska’s discussion of a report published by FSB on the financial stability implications of artificial intelligence and machine learning in financial services. “When AI becomes too big to fail”, FT Alphaville, November 1 

1: “This warrants a societal discussion on the desired extent of risk sharing, how the algorithms are conceived, and which information are admissible.”

That is a discussion that should also have taken place before regulators, with their risk weighted capital requirements, created incentives for our banks, one societal prime risk-takers, to avoid all what is perceived as risky, like SMEs and entrepreneurs, and concentrate exclusively on what is perceived, decreed or concocted as safe. 

2:“Fintech and AI are being aggressively marketed as our best and only opportunity to diminish the concentrated power of the banks. The terms “new entrants”, “disruption”, “fragmentation” and “open access” form the foundations of the movement. And yet… none of these clever systems, if the FSB is to be believed, are necessarily clever enough to fend off the forces of consolidation that bring about systemic risks.”

What can I say except to repeat what I as an Executive Director of the World Bank opined when in 2003 I learned that the Basel Committee was going to put so much power in the hands of some few human fallible rating agencies… and now we are to switch into some, or one, hackable AI?

“Ages ago, when information was less available and moved at a slower pace, the market consisted of a myriad of individual agents acting on limited information basis. Nowadays, when information is just too voluminous and fast to handle, market or authorities have decided to delegate the evaluation of it into the hands of much fewer players such as the credit rating agencies. This will, almost by definition, introduce systemic risks in the market and we are already able to discern some of the victims, although they are just the tip of an iceberg.” 

“A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind.”

FT, do you really think bank regulators know what they are doing? Wake up!

Sir, Izabella Kaminska reminds us of “the fact that information is not the same thing as knowledge” “Imperfect information dims the vision of a digital utopia” September 27.

And she refers: “In a new paper, Nobel-winning economist Joseph Stiglitz, building on decades of work on the economics of information, argues that the information paradigm being promoted by technologists could — if left unregulated by government — lead to the sort of market distortions that constrain welfare creation and innovation for the long term.” 

Hold it there! Government regulations can also “lead to the sort of market distortions that constrain welfare creation and innovation for the long term”

Just look at how the regulators imposed risk-weighted capital requirements for banks that completely distorted the allocation of credit to the real economy.

Sir, do you really think bank regulators know what they are doing? Wake up! They have no idea.

Here two questions:

1. What are the risks banks could build up such excessive exposure to the below BB- rated so that, if the ex ante perception of super riskiness turned out ex post even more risky, that could cause a major bank crisis?

2. What are the risks banks could build up such excessive exposures to the AAA rated so that, if the ex ante perception of super safety turned out ex post wrong, that could cause a major bank crisis?

Hint! Mark Twain described a banker as he who wants to lend out the umbrella when the sun shines and wants it back as soon as it looks like it is going to rain.

Ponder now on that our bank regulators, in their own 2004 standardized Basel II risk-weights, assigned to the first possibility a risk weight of 150%, and to the second, one of only 20%.

Meaning that banks, given a basic capital requirements of 8%, when lending to the below BB- rated needed to hold a reasonable12% of capital, while when lending to the AAA rated, they were only required to hold a sliver of 1.6% in capital.

Meaning that banks, when lending to the below BB- rated, could only leverage some reasonable 8.3 times while, when lending to the AAA rated, they were allowed to leverage their capital (equity) a mindboggling 62.5 times.

Sir, do we really deserve such feeble minded regulators? If not, why do you keep supporting these?

@PerKurowski

Low interest rates stimulate laziness in project execution and in revision of investment decisions

Sir, Izabella Kaminska is not going to be much loved today as she bravely points out to many the very uncomfortable possibility that they might have fallen head over heels “for fanciful narratives or investor cults”. Well done! That is going to generate a lot of soul-searching. “Cultish long-termism can hobble investors” September 13.

I would though like to remind Kaminska that much of “investors’ forgiving attitudes” could be explained by current extraordinary low interest rates. Just like these introduce much laziness in the execution of projects these can also provoke fewer revisions of investment strategies. Also, do not the sheer existence of negative interest rates help fuel the “grandeur of the futuristic visions being touted”?

PS. I would not refer to Andrew Haldane as a great champion for long-termism. As a regulator he has supported the extraordinary short-termism imbedded in the risk weighted capital requirements for banks. These keep banks from financing the “riskier” future our grandchildren need to be financed, having them basically just refinancing the “safer” present.

@PerKurowski

On which road will our grand-grandchildren travel, on those with only driverless cars, with only human drivers, or in mingled ones?

Sir, I refer to Izabella Kaminska’s “Self-driving cars discover the limits of autonomy” March 29.

30 years from now there could be some roads where only driverless cars can travel, other in which only humans drive and some where both humans and driverless cars go. On which one will our grandchildren send their children to school?

As Kaminska hints at, the last one of these would probably be the one road “in which humans and autonomous vehicles will have to interact”.

But, for safety reasons, future parents will probably rather prefer to send their children on the driverless road, than trust the roads in which humans do their not always their best.

I would of course love for my descendants to keep their ability to drive cars. It is, or at least was such an enjoyment for me. But if I was nowadays told to take a horse drawn carriage down the road, I would not really know what to do, but neither I nor humanity would suffer too much from me lacking that piece of know-how.

Sir, as I recently wrote to you I visited a museum in Sweden that impacted me, the Blekinge Museum, not because it was not a museum of times gone by, it was a museum of my times gone by.

And much more dangerous than losing the ability to drive cars would, as I once also wrote you, be the “diminishing human fighting spirit” that the use of drones and robots could cause.

@PerKurowski