Bank regulators insist on feeding the systemic risk of credit ratings, even after it became tragically evident.

Sir, Kate Allen writes “Funds that allocate capital based on instruments’ investment grades and index weighting may look as if they are playing it safe but they are, in fact, taking a gamble, creating towers of risk, any floor of which could prove unstable… do not look to the canaries in the financial markets’ coal mines to sound an early warning. By the time the downgrades come, it will be too late” “Tail Risk” February 28.

Indeed by the “time issuers’ credit ratings were downgraded, [banks] were already staring the worst-case scenario in the face.

Basel II’s standardized risk weights for the risk weighted bank capital requirements:

AAA to AA rated = 20%; allowed leverage 62.5 times to 1.

Below BB- rated = 150%; allowed leverage 8.3 times to 1

Absolute lunacy! With the same risk weight banks would anyway build up much more exposure to what they ex ante perceived as very safe, than against what they perceived as very risky.

As is, that regulation dooms our bank systems to especially large crisis, resulting from especially large exposures, to what is perceived as especially safe, against especially little capital. 

Allen observes: “An investment structure that is revealed to have done a bad job only when disaster arrives, as in the financial crisis”. Unfortunately no. Bank regulators blamed the credit rating agencies, and not themselves for betting too much on these, and so that so faulty regulations that should have been eliminated with a big “Sorry!” is still very well active. 

PS. In FT January 2003: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds. Friends, please consider that the world is tough enough as it is.”

PS. At World Bank: April 2003: "Market or authorities have decided to delegate the evaluation of risk into the hands of much fewer players such as the credit rating agencies. This will, almost by definition, introduce systemic risks in the market"

@PerKurowski

If Germany’s euro debt gets to be redenominated in Deutsche Marks, what would happen to its commercial surplus?

Sir, Kate Allen writes: “German bonds, or Bunds… are the eurozone’s safe asset… the spread against equivalent Italian bond yields to about 2.9 per cent.” “Tail Risk” February 19.

So if Bunds is the Eurozone’s safe asset, how come EU authorities assign it a risk weight that is just the same as all other Eurozone sovereigns’ debts, namely 0%? And this even when they all are indebted in a currency that is not really their own domestic (printable) one.

That 0% risk weight translates into that European banks do not have to hold any capital against debts of the Eurozone sovereigns… a clear subsidy... especially to those sovereigns most remote from earning that 0%.

So, had that not been the spreads of many eurozone sovereigns against Bunds would have been much larger, and in such case many of those sovereigns, like Greece, like Italy, like Spain, like Portugal would have had to borrow less, and would therefore have had to reduce their commercial deficits, reducing by that Germany’s commercial surplus.

Allen opines: “Investors need to put their money somewhere and [if there are not enough Bunds they are forced into substitutes which then rapidly become overloaded and suffer price bubbles.”

Indeed but when we consider that much of that investment money was supplied by ECB buying European sovereign debt, including Bunds, perhaps we should start by looking there before we might add fuel to a dangerous fire.

PS. Brexit,  the 0% risk weight and the EU

@PerKurowski

What would happen to German Bunds, denominated in Euros, if Italy refuses to walk the plank like Greece?

Sir, I am not sure I follow Kate Allen’s discussion about the future of German Bunds. It is almost as she was discussing these as denominated in Deutsche Mark. The fact is these are in Euros, the same currency other weaker eurozone sovereign-debtors have their bonds denominated in. For instance, what would happen if Italy refuses to walk the plank like Greece? “German bond buyers bank on smooth withdrawal from QE”, November 6.

The European Union has clearly not dedicated itself wholeheartedly to solve the fundamental challenges posed by the adoption of the Euro by so many of its members, twenty years ago. For instance the European Commission has wasted its time on so many issues of minuscule importance that were really none of its business. As a result that Euro, which was created to unite Europe, might now disunite it. 

So what would happen if the Euro breaks in pieces? I have no idea but, in the case of Germany, if asked, I assume holders of German Bunds would probably accept to convert these into German Neo-DM Bunds. But of course that would also put an end to the eurozone “weaklings” subsidizing Germany’s competitiveness… like what if 1US$ = 0.75 Neo-DM? It would be a whole new ball game for everyone, Germany included!

Sir, as I recently wrote to you, for all those who want a peaceful European Union to thrive, which of course should include both Britain’s Brexiters and Remainers, the acts commemorating the end of WWI, provides an opportunity for important reflections.

In this respect the European Commission, the European Central Bank, the European Parliament, all of them, when imposing armistice conditions on capitulating eurozone sovereign debtors, should do well remembering the Versailles Treaty.

PS. Greece walked the plank

@PerKurowski

Allowing banks to hold sovereign debt against the lowest capital is evil, as it dooms nations to unsustainable levels of public debt.

Sir, Miles Johnson, Kate Allen and Federica Cocco report “Italian bank shares were hit yesterday after the Fitch credit rating agency said banks’ balance sheets were under pressure because of their exposure to Italian government debt.” “Italy’s central bank warns of slowdown” October 21.

Here we go again!

In a 2002 Op-Ed titled "The Riskiness of Country Risk I wrote": “What a difficult job for those assigning credit ratings to sovereigns! If they overdo it and underestimate the risk of a given country, the latter will most assuredly be inundated with fresh loans and will be leveraged to the hilt. The result will be a serious wave of adjustments sometime down the line. If on the contrary, they exaggerate the country’s risk level, it can only result in a reduction in the market value of the national debt, increasing interest expense and making access to international financial markets difficult. The initial mistake will unfortunately turn out to be true, a self-fulfilling prophecy. Any which way, either extreme will cause hunger and human misery.

In his book The Future of Ideas: The Fate of the Commons in a Connected World” Lawrence Lessig maintains that an era is identified not so much by what is debated, but by what is actually accepted as true and so is not debated at all. In this sense, given the risk that the perceived country risk actually becomes the real country risk, it is best not to assign an AAA rating blithely to credit rating agencies—perhaps not even a two-thumbs-up.”

In 2004, in a letter published by FT I asked “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?” 

Then by means of the “Sovereign Debt Privileges” or “Equity Capital Privilege” enacted by EU authorities, Greece was assigned, for the purpose of the risk weighted capital requirements for banks, a 0% risk weight... and consequently it went down the tubes.

A 2017 paper by Dominik Meyland and Dorothea Schäfer titled “Risk weighting for government bonds: challenge for Italian banks” and produced by the German research institute DIW Berlin states: “Although banks are required to document their equity capital for loans, corporate bonds, and other receivables, they are currently exempted from the procedure when investing in government bonds: they enjoy an “equity capital privilege.” As part of the Basel III regulatory framework redraft, the privilege may be eliminated in order to disentangle the default risks between sovereigns and banks. The present study examines how much additional equity capital the banks of the euro area’s major nations would require if the equity capital privilege were eliminated. At nine billion euros, the estimates show the highest capital requirement for Italian banks… The primary reason for this is that Italian banks hold relatively large amounts of Italian government bonds” 

That paper was written when “Italian government bonds had a Fitch Rating of BBB+, yielding a risk weight of 50 percent based on the [Basel II] standard approach.”On August 31 Reuters reported “Fitch Ratings on Friday cut Italy’s sovereign debt outlook to ‘negative’, citing expectations that the new coalition government’s fiscal loosening would leave the country’s high levels of debt more exposed to potential shocks.” If Italy’s rating drops further, those capital requirements would only increase… or worse losses having to be recorded.

I wonder if EU will put the blame solely on Italy as they did with Greece, ignoring they caused the tragedy with their “Sovereign Debt Privileges”.

The DIW Berlin paper also states: “German banks also exhibited a strong home bias, but German government bonds have an AAA rating. Unlike the Italian banks, the German banks’ home bias is thus inconsequential regarding the banks’ capital needs.”

So I would say that Germany is also on the same 0% sovereign risk weight road that took down Greece, and sadly, perhaps Italy too.

When will they ever learn? 

@PerKurowski

How long are you going to allow statist bank regulators subsidize the public sector borrowings with a zero percent risk weighting?

Sir I refer to Kate Allen’s and Chris Giles write “The total stock of OECD countries’ sovereign debt has increased from $25tn in 2008 to more than $45tn this year” “Rising tide of sovereign debt to hit rich nation budgets, warns OECD” February 23.

I do not know what the total OECD debt was in 1988, but the US public debt was t$2.6 trillion when then statist bank regulators assigned it a 0% risk weight. At end of 2017, much because of the subsidies imbedded in that 0% weight, US’s public debt was now US$20.2 trillion. It still has a 0% risk weight.

In 2004, in a letter you published I wrote: We wonder 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. 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.

I came then from a development country, Venezuela, but that comment clearly applies to the OECD too.

In December 2009, on the eve of the new decade, FT also published a letter in which I wrote: “My worst nightmare is that unmanageable Versailles-type public debts will become fertile ground for those monsters that thrive on hardships”. That nightmare is only getting worse and worse.

@PerKurowski

It’s not the role of regulators and central banks to help governments fund their operations, behind the back of citizens

Sir, Kate Allen writes that “euro-area financial institutions” have reduced their holdings of public debt “17 per cent in the past two years [but] the ECB made nearly €1.5tn of cumulative net purchases of eurozone public sector bonds through its quantitative easing programme — effectively replacing the purchasing role that banks had played. “Post-crisis reforms force European governments to curtail size of debt sales” January 5.

It all forms part of the same statist subsidizing of public debt. 

What would sovereign rates be if banks had to hold the same capital against sovereign debt than against loans to citizens; and if ECB had not purchased “eurozone public sector bonds through its quantitative easing programme”? The answer would have to be rates much higher, which would send quite different risk-free-rate signals.

In 1988, with Basel Accord, statist regulators, with their 0% risk weighted bank capital requirements, began subsidizing immensely government borrowings. When the 2007/08 crisis came along, central banks, perhaps in order to hide own their regulatory failures, with their quantitative easing purchases generated, wittingly or not, new sovereign debt subsidies.

This has dramatically changed the economical relations between governments and private sectors. It amounts to statist hanky-panky behind the backs of citizens. Since besides needing servicing it consumes, for nothing really special, sovereign indebtedness space that could be urgently needed tomorrow, it might become deemed as high treason by future generations. Where this is going to end is anyone’s guess, but it sure won’t be pretty.

@PerKurowski

Its worse! To central banks’ holdings of public debt we must add that of normal banks holding it against zero capital

Sir, Kate Allen and Keith Fray with respect to the QEs write that “The Fed’s balance sheet has expanded significantly several times in the past, including during the second world war when it soaked up debt sales in a bid to improve market conditions. But the current era is the first time in history that such a large group of central banks has undertaken such a substantial volume of co-ordinated buying over the space of nearly a decade.” “Decade of QE leaves big central banks owning fifth of public debt” August 16.

That’s not the only “first time in history” event. Thomas Hale and Kate Allen, in “Europe weighs potential ‘doom loop’ solution” write “A critical factor in deciding demand for sovereign bonds is risk weightings, which determine how much capital a bank needs against its investments in different kinds of asset. Sovereign bonds in Europe have benefited from a zero risk weighting, making them highly attractive to banks, many of which borrowed cheaply from the European Central Bank to buy sovereign debt after the crisis.”

That should make clear for anyone not interested in hiding it that, to whatever public debts the central banks hold, we must add those that all banks hold only because they are allowed to do so against zero capital. Q. What is a 0.1% return worth if you can leverage it 1000 times? A. 100%

Sir, as I have told you umpteenth times before, in 1988, one year before the Berlin wall fell, that which was taken to be a big blow to statism, bank regulators, through the back door, introduced a zero risk weighting of sovereign debt. The statists have been playing us for fools ever since.

And now, when reality is catching up, they want to package and hide all this public debt in some securities they have the gall to name these European Safe Bonds “ESBies”, issued in order to “make the continent’s financial system safer”. Or, as Gianluca Salford, a strategist at JPMorgan disguises it, to “transport sovereign risk to a place where it’s more manageable”.

Sir, try to sell all central banks’ and banks zero weighted held public debt into a free market and see what rate you get. Taking current artificial public debts for real, or for being revenue neutral rates, or for being risk free rates, or for justifying public investment in infrastructure, is either stupidity or a shameful manipulation of truth. 

Sir, the day our citizens discover what is being done by these statist they will flee all sovereign debts and governments will be left, like Maduro in Venezuela, with central banks that can only print money to keep the can rolling and rolling until…

PS. Mr Salford argues: “Securitisation is not an innately bad thing — it can be used well as a stabilising source” No! If securities are sold at their correct securitized risks they do not provide remotely as much profits as those sold incorrectly offering securitized safety. In other words, suffering from innately bad incentives damns these.

@PerKurowski

Like social bonds’ growth the antisocial bonds’ seem also to be doing fine

Sir, Kate Allen writes: “a host of other financial products have begun to emerge, promising to tackle social issues including homelessness, access to education, clean water, crime prevention and helping disadvantaged children…. The market is still small — just $3.5bn of social bonds were issued in the second quarter of 2017” “Ethical investing branches out from green roots” July 18.

And small it might really be when comparing to all of the antisocial financing that goes around. As an example just in that quarter the Maduro government of Venezuela, that one who is publicly and notoriously violating human rights and has its people starving and dying because of lack of food and medicines, sold $2.8bn in bonds. These antisocial bonds were initially picked up for a mere $800 million by a “with those possible returns, why should we give a shit about ethics”' Goldman Sachs.

Allen points out the fact that “The [social] bonds must perform socially as well as financially.” Yes, and if they don’t perform socially, as is clearly the case with Venezuela, then they should not perform well financially either. The Western civilization has an obligation to put a stop to odious anti-social financing. Otherwise our heirs will end up having to refer to that civilization as a once was.

Hopefully we will see an important socialite publicly disinviting a seemingly totally unrepentent Lloyd Blankfein from an important social event, because of Venezuela.

PS. I wonder how much $ in bonuses Blankfein will receive from this operation.

@PerKurowski

In relative terms, banks finance too much house buying, and too little the job creation needed to serve the mortgages.

Sir, Kate Allen reports: “Last year the BoE introduced tougher mortgage lending rules and warned that a possible resurgence in the country’s pre-credit crunch house price boom risked derailing Britain’s economic recovery’ “ECB easing raises fears on house price bubble” July 21.

But what BoE is not mentioning or doing a lot about, is the fact that allowing banks to hold less equity financing mortgages, than when financing for instance SMEs, means that banks will perceive they can obtain higher risk-adjusted returns on equity when financing mortgages than when financing SMEs; which means banks will, relatively, finance too much mortgages and too little SMEs… or as I prefer to phrase it… too much house buying and too little jobs with which serve the resulting mortgages… and the utilities.

@PerKurowski