Require banks to hold capital against the unexpected, making sure those not able to manage perceived risks fail, fast

Sir, Nobuchika Mori, commissioner of Japan’s Financial Services Agency writes: “Regulators have made the global financial system more resilient by major regulatory reforms. Banks now have much bigger capital and liquidity buffers. Resolution frameworks have been strengthened. Derivatives markets are being made safer, while toxic forms of shadow banking have been detoxified.” “A holistic approach to future-proofing the financial system” May 26.

Holy moly! How come bank regulators have not been nominated for a Nobel Prize? I mean, if Bob Dylan and Juan Manuel Santos could each get one, and if what the author says is true, these also sound to be worthy one or two.

But no! Nobuchika Mori then goes on describing some pending issues that would not make them worthy of a prize, on the contrary, more worthy of being sacked.

He writes: “It is possible that funds are not being allocated in ways that foster economic growth. Credit should be provided in ways that enhance productivity, revitalise industry, foster innovations and create new businesses.”

Indeed! But should not the purpose of the banks have been defined before regulating these?

He writes: “We need supervision to establish whether regulation offers perverse incentives to banks to accumulate excessive risks.”

More than supervision what is needed are regulators that understand that with their current capital requirements, banks will accumulate too large exposures against what is ex ante perceived as safe (but that ex post could be risky) and too little exposures to what is perceived as risky, like those “small and medium-size enterprises” those who according to the author could “help to revitalise local communities”

“An Explanatory Note on the Basel II IRB (internal ratings-based) Risk Weight Functions” expresses: 

“The model [is] portfolio invariant and so the capital required for any given loan does only depend on the risk of that loan and must not depend on the portfolio it is added to.”

The explicit reason for that mindboggling simplification was: 

“This characteristic has been deemed vital in order to make the new IRB framework applicable to a wider range of countries and institutions. Taking into account the actual portfolio composition when determining capital for each loan - as is done in more advanced credit portfolio models - would have been a too complex task for most banks and supervisors alike.”

But here Nobuchika Mori wants the supervisors to take on even a more active and complex role. That would not be helpful. That implies assigning the supervisors too much capability and, explicitly, too much power.

Much better it is to get rid of all risk weighting setting a reasonable leverage ratio, like 10% capital for all assets (sovereigns included), to cover in part for what is unexpected… all in the knowledge that the faster banks that cannot manage perceived risks fail, the better for all.

The Questions!

@PerKurowski

Regulators make banks earn higher risk adjusted ROE’s lending out the umbrella to those in the sun than to those in the rain

Sir, in 2003 as an Executive Director of the World Bank, in a formal statement I wrote: “The financial sector’s role, the reason why it is granted a license to operate, is to assist society in promoting economic growth by stimulating savings, efficiently allocating financial resources satisfying credit needs and creating opportunities for wealth distribution. Similarly, the role of the assessor –in this case, the Bank– is to fight poverty, and development is a task where risks need to be taken.

From this perspective the Financial Assessment Program Report might revolve too much around issues such as risk avoidance, vulnerabilities, stress tests and compliance with international regulations, without referring sufficiently to how the sector is performing its social commitments.

We all know that risk aversion comes at a cost - a cost that might be acceptable for developed and industrialized countries but that might be too high for poor and developing ones. In this respect the Bank has the responsibility of helping developing countries to strike the right balance between risks and growth possibilities.

In this respect let us not forget that the other side of the Basel [Committee’s regulatory] coin might be many, many developing opportunities in credit foregone.”

And I had started this fight against senseless credit-risk aversion already in 1997 with the first Op-Ed I had ever published “Puritanism in banking” 

And in 2009, in Martin Wolf’s Economist Forum, I prayed “Free us from imprudent risk aversion”

So you can imagine how much I agree with Nobuchika Mori when he, as Japan’s regulator of financial markets and institutions now writes: “too much emphasis on stability can be harmful, especially in the long run. It may prolong and even perpetuate stagnation. Based on this experience, a shift to supporting finance for growth is needed now”, “Too much 'medicine' could make the system sicker” December 15.

Think of it. Mark Twain is quoted with saying “Bankers want to lend you the umbrella when the sun is out and take it back when it rains”. With credit risk weighted capital requirements, the regulators now also give our banks higher risk adjusted returns on equity when lending out the umbrella to those in the sun than when lending it to those in the rain.

@PerKurowski ©