Reckless (and dumb) bank regulators, with their distortions, are a drag on the economy

Sir, I refer to Anat Admati and Martin Hellwigs letter “A reckless banking industry is a drag on the economy” September 10.

What an unfortunate title. The drag on the economy that banks are causing now, has nothing to do with them being reckless, and all to do with reckless risk-adverse regulators who de facto decided, with their credit risk weighted capital requirements, that banks should not lend to the risky, even at the risk of lending too much to the infallible.

And of course banks need to hold more capital, meaning more equity, as Admati and Hellwig suggest. Were the regulation of banks to be left to the market, with the market paying the consequences of bank failures, it would be very hard to imagine bank equity leverages more than 10 to 1. Compare that with the allowed 62.5 to 1 leverage when lending to Greece authorized by this generation of loony regulators.

And of course banks need to hold more equity, but, let us not ignore the fact that the journey from undercapitalized banks to well capitalized banks is a journey full of dangers to the real economy. Just for a starter, before requiring banks to hold more capital, we need to eliminate the credit-risk weighing of capital, since otherwise the distortions will become even more intense.

Finally with respect to all those fines paid by banks… I just wished the judges had not been so masochistic as to ask for those fines to be paid in cash, against equity, but had asked these to be paid instead in voting shares, priced at current market values.

FT, do not silence the fact that for our youth to find jobs, banks must return to risking it with “the risky”

Sir, in “Struggling youth” you refuse to even mention what I know is one of the most fundamental causes why our youth is struggling to find jobs, and about which I have written you some hundreds of letters.

And so here we go again: Regulations which allow banks to hold much less capital for exposures considered “absolutely safe” than for exposures considered “risky” translates directly into banks earning a much higher expected risk adjusted return on the “absolutely safe” exposures than on the “risky” exposures. And that as you should be able to understand discriminates directly the access to bank credit of all those small and medium businesses and entrepreneurs who can provide our youth with jobs.

As is, all our banks are going to end up gasping for oxygen on some stupidly overpopulated ex-absolutely-safe beach… and that is not how jobs are created.

For the sake of our youth, swallow your silly pride and don´t silence this.

PS. The truth about how incredibly wrong current bank regulations will come out sooner or later and then FT´s silence on it, will shame it. I invite you to for instance take a look here on page 21-24 http://www.scribd.com/doc/149858219/Journal-of-Regulation-Risk-North-Asia-Volume-V-Issue-II-Summer-2013

And Anat Admati and Martin Hellwig have also in "The Banker's New Clothes" written the following about risk-weighted assets:

“The risk-weighting approach gives the impression of being scientific”.

“The risk-weighting approach is extremely complex and has many unintended consequences that harm the financial system. It allows banks to reduce their equity by concentrating on investments that the regulations treats as safe.”

“The official approach to the regulation of bank equity, enshrined in the different Basel agreements is unsatisfactory… the complex attempts in this regulation to fine tune-equity requirements – for example, by relying on risk measurements and weights- are deeply flawed and create many distortions, among them a bias against traditional business lending.”

And recently in “The Parade of the Bankers’ New Clothes Continues: 23 Flawed Claims Debunked”, “the studies that support the Basel III proposals are based on flawed models and their quantitative results are meaningless. For example, they assume that the required return on equity is independent of risk”.

The pillar of Basel bank regulations being based on “flawed models” and “meaningless results” and FT is silence on this? Amazing! That on its own is worth a book.

Besides setting the target for bank capital, we need to think about how to get there.

Sir, Anat Admati and Martin Hellwig write that “capital ratios in Basel III rely on a complex, distortive and manipulable system of risk-weights”, “Banks are not a special case on debt-equity ratio” May 21.

They are absolutely correct, on all three counts, and that is applicable to Basel II too. But what I would like to mention is the curious fact that the “distortive” element, and which to me is the most serious flaw of Basel regulations, as it affects not only the banks but the whole market too, has received the least of attention.

There is no doubt that we need to go down the route of substantially increasing the capital requirements of banks, whether to the 8-12 percent level I favor, or the 25-30 percent level Admati and Hellwig favor. But, when considering the fact that bank capital is going to be extremely scarce while travelling on the route to the final bank capital that is needed, we should not forget that the distortive effects of the risk-weights will be more important than ever.

In this respect I opine that regulators, more than thinking about how to force bank capital increases, need to think in terms of how to help these increases to happen as fast and as smooth as possible. There might be many other ways, but personally I favor either large public sector capital injections in the banks accompanied by clear rules as to how current shareholders could repurchase that capital in order not to be diluted, or some strong tax incentives awarded to any bank that achieves a capital increase which in the short term meets the final long term target.

Higher bank capital ratios without eliminating distortions based on perceived risks, would make banks riskier

Sir, John Plender refers both to the draft legislation advanced by US senators David Vitter and Sherrod Brown, and to Anad Admati’s and Martin Hellwig’s “The bankers’ New Clothes”, in order to point out that “Support is growing for higher bank capital ratios”, May 8.

Plender unfortunately entirely misses what is most important. Many have asked for higher capital requirements but, what sets those he references apart from many others is that they also want to do away with the pillar, and the pride and joy of Basel regulations, namely that the capital requirements are to be based on perceived risk.

Let me ask Plender. Today, according to Basel II, a bank can hold some zero risk weighted sovereign assets against zero capital, while giving a loan to a business requires it to hold 8 percent of it in capital. If tomorrow the risk-weights for some sovereign would remain zero, but banks were instead required to hold 30 percent against a loan to a business, would the distortions be smaller or larger?

Europe, ask your bank regulators to explain why they did it, and you will not get an answer. They never knew!

Sir, Martin Wolf ends “Big trouble from a small country” March 20, with “Banking is dangerous everywhere. But it still threatens the eurozone’s survival. This has to change – and very soon”.

Yes indeed, its bank regulations have to change. All which finds itself under the influence of a tiny committee, the Basel Committee for Banking Supervision, is threatened, by completely failed regulations. 

And these regulations have not been sufficiently questioned, this even more than five years after their failure should have become evident to all. Why is that? At this moment the only explanation I can advance, is that the ego of those behind it does not allow them to admit that, in fact... they never even understood it!

Banks, before the Basel era, cleared for perceived (ex-ante) risk, that which for instance was to be found in the credit ratings, by means of interest rate (risk-premiums), size of exposure and other term; let us call that “in the numerator”.

But Basel II, and now Basel III, instruct the banks also to clear, I would call it re-clear, for exactly the same perceived (ex-ante risk) risk, credit ratings, “in the denominator”, by means of different capital requirements, more risk more capital, less risk less capital.

And so ask the regulators, or your own Martin Wolf, to explain to you:

Why considering twice the perceived risk is something rational from a regulatory perspective. 

Why that does not introduce distortions.

Why that, which allows the banks to earn so much more risk-adjusted margins when lending to The Infallible than when lending to “The Risky”, does not doom the banks to overpopulate safe-havens. 

Why that will allow the banks to allocate economic resources efficiently, even to “The Risky”.

Why if all bank crises ever have resulted from excessive exposures to what was perceived as safe, but ex post turned out no to be, and never from excessive exposures to what was perceived as "risky". 

If you get an answer different from “more risk more capital and less risk less capital sounds logical” please, I beg you, resend it to me. If not, you will begin to understand what I am saying. Yes I know, it is hard to swallow.

I now remembered a speech I gave to some hundred regulators in 2003, pre-Basel-II days, at the World Bank. It is in my book Voice and Noise, 2006 and where I said: 

“Let me start by sincerely congratulating everyone for the quality of this seminar. It has been a very formative and stimulating exercise, and we can already begin to see how Basel II is forcing bank regulators to make a real professional quantum leap. As I see it, you will have a lot of homework in the next years, brushing up on your calculus—almost a career change.”

Little did I suspect then that what was really dangerous was that the complexity of what was being presented, stopped all of them from asking the questions which should have been asked.

Anat Admati and Martin Hellwig, have written “The Bankers’ New Clothes” 2013. It is in many ways an excellent book and I highly recommend it, although “The Regulators’ New Clothes” would have been a better title. But in one passage the authors write: “Whatever merits of stating equity requirements relative to risk-weighted assets may be in theory, in practice…”. My problem is that over many years I have not been able to find or hear anything that I feel could be included in the “Whatever merits”.

Martin Wolf also quotes from that book saying “Banks have so little loss-absorbing capacity that they stand permanently on the edge of disaster”. Not exactly. Banks have sufficient loss-absorbing capacity when lending to “The Risky”, it is when lending to “The Infallible” they don’t, and this the courtesy of the Basel Committee

PS. Sir, just to remind you again that I am not copying Martin Wolf more. He has told me not to send him anything more on “capital requirements”… he already knows it all, so he thinks. But, as I said, if he has an answer, I would appreciate hearing it.

About “Why bank regulators are intellectually naked”, and about besserwisser journalists

Sir, Martin Wolf has suddenly seen light as he now writes “A sophisticated mistake is the idea that capital can be properly ‘risk-weighted’. This has proved fatally flawed”, “Why bankers are intellectually naked” March 18.

I have over the last five years written more than a hundred of letters to the editor commenting on articles by Martin Wolf explaining that capital requirements for banks based on perceived risks which have already been cleared for, is sheer stupidity, and creates all type of distortions. But my arguments have been mostly ignored and Wolf has even qualified me as a monothematic bore… something which I accept might very well be true, but all for a good cause.

And so of course I will read “The Bankers’ New Clothes” by Anat Admati and Martin Hellwig, with much interest, to see with what arguments they finally convinced Wolf. That is of course as long as Wolf’s new found conviction is the correct one. I say this because why then did he not title his book review “Why bank regulators are intellectually naked”

Wolf writes the book reveals why “we have failed to remove the causes of the crisis”, and I wonder whether the arrogant besserwisser attitude of some financial journalists who think they know it all, might be included there.

PS. I have not read it yet, but if Admati and Hellwig’s suggestion of a 20-30 percent equity ratio is based on risk-weighted assets, then sadly they have not understood it completely either, and the distortions could be even worse. And, if that 20-30 ratio is for unweighted assets, then it would be very interesting to hear how they propose to raise the bank capital needed to fill the hole created by the zero percent risk-weighting of sovereigns.

PS. Sir, just to remind you that I am not copying Martin Wolf more. He has told me not to send him anything more on “capital requirements”… he already knows it all, so he thinks.

For the health of our banks, much more important than more capital, is less capital distortion by the regulator

Sir, Tom Braithwaite writes that “Regulators will have to be watchful that banks do not dream up new risky products that evade high charges… but… safer businesses such as advisory work or retail brokerage are being preferred because they are ‘capital light’ and hence good for overall ROE”, “Quest for profit in high-capital world can make bank safer” February 19.

Is advisory work or retail brokerage what our banks should all be about now? What about their vital function of helping to allocate economic resources efficiently? Tom Braithwaite might have a job, for now, but what about those millions of unemployed counting on banks to finance those who could create jobs?

And Braithwaite ignores that dreaming up new risky functions to evade high charges and obtain high ROE has been made a competitive necessity, by the sheer fact that the regulators allow there to be some “capital light” pockets.

I have not read The Bankers New Clothes by Anat Admati and Martin Hellwig, yet, but if it holds that “Bank’s obsession with return on equity is at the root of the problem…this makes the whole system more fragile”, would that not precisely indicate the dangers of capital requirements which, quite arbitrarily, allow some bank bets to make a larger ROE than others? If a regulator I would for instance much prefer banks having diversified exposures to “The Risky” than having to trust the infallibility of some monumentally large exposures to “The Infallible”.

And, if that is not in the book, then I must say that Sir Mervyn King unfortunately still does not understand “what is wrong with banks and what needs to be done to make them safe”. Yes, more capital is needed, but that capital should primarily be required as a result of eliminating differences in capital requirements, and not feeding these.

“There is far more capital in the banking system than there was in 2007” it is written. That could indeed be true, I do not have the figures, but it could also be a very devious half-truth, if the increase in capital is just the result from banks exiting “capital heavy” in order to, quite dangerously, overpopulate some “capital light” pockets.

Finally some real heavy-weight support!

Sir at long last an important number of academicians are speaking out asking to remove “the biases created by the current risk-weighting system” imposed on the world by the Basel Committee on Banking Supervision for the purpose of determining the capital requirements of banks, “Healthy banking system is the goal, not profitable banks” November 9.

The hundreds of letters related to this issue that I sent to the Financial Times over the last five years, and that were ignored, will serve as proof of the immense difficulties of fighting a regulatory paradigm that sounds so extremely logical as capital requirements based on (ex-ante) perceived risk does, but that is still so utterly faulty. In fact it has proven even more difficult than making Citi’s Charles Prince stop dancing.

I hope that the fundamental revisions to the financial regulations, when they come, as they sure will come, will also include the need of avoiding the trap of placing important regulatory issues in the hand of non-transparent mutual-admiration clubs like the Basel Committee which are not diversified sufficiently so as to avoid the risk of degenerative intellectual-incest.

By the way, just for additional clarity, I wish the title of their letter had said “Healthy and useful banking system is the goal”, but again I am more than glad enough, for the time being.