Even the best central bankers can mess it up, royally

Sir, Tim Harford writes: “A flint-hearted technocrat can at times deliver better results for everyone. In the early 1980s, Fed chair Paul Volcker demonstrated the basic idea that inflation could be crushed by a sufficiently badass central banker.” “Stop sniping at central banks and set clear targets” December 16.

Indeed, and Paul Volcker was a hero of mine too, that is until I realized his role as the facilitator of the risk weighted capital requirements for banks.

In his book “Keeping at it”, penned together with Christine Harper, Paul Volcker writes: “The Europeans, as a group, firmly insisted upon a “risk-based” approach, seemingly more sophisticated because it calculated assets based on how risky they seemed to be. They felt it was common sense that certain kind of assets –certainly including domestic government bonds but also home mortgages and other sovereign debt- shouldn’t require much if any capital. Commercial loans, by contrast, would have strict and high capital requirements, whatever the credit rating might be…. At the end of a European tour in September in 1986, at an informal dinner with the Bank of England’s then governor Robin Leigh-Pemberton… without a lot of forethought, I suggested to him that if it was necessary to reach agreement, I’d try to sell the risk-based approach to my US colleagues.”

And that was that! In that moment, accepting the European nonsense that what bankers perceive as risky is more dangerous to our bank systems than what banker perceive as safe, Paul Volcker, a central banker, helped condemn us to suffer especially severe bank crisis, resulting from especially large exposures, to what was especially perceived as safe, against especially little capital. I thank him not!

Harford opines “The health of our democracies demands that our politicians start taking responsibility again”

Absolutely! And with respect to bank regulations that requires the politicians to ask for explanations like: Why do you risk weigh the assets based on their perceived risk and not on their risk based on how bankers perceive their risk? Have you never heard about conditional probabilities?

PS. The Basel Committee document that provides an explanation on the portfolio invariant risk weighted capital requirements does not make any sense to me, but perhaps Tim Harford understands it. If so could you please ask him to explain it to us? 

@PerKurowski

If Paul Volcker leaves an explanation for why a person like he never saw the dangers of the risk weighted capital requirements for banks, it would be a truly important legacy.

Martin Wolf, the Chief Economics Commentator of the FT, rightly praises Paul Volcker for his gigantic work, as chairman of the Federal Reserve between August 1979 and July 1987 of slewing the run away inflation of those years. How could one like me who in 2006 wrote about the long-term benefits of a hard landing, disagree with that? “The last testament of Paul Volcker”, October 30.

But then Wolf opines: “Yet, unlike many who should have known better, he understood that the central bank is responsible for financial stability, too. The book is full of Volcker’s painful experiences with the financial sector and his deep doubts about it… 

It would be too much to insist that the financial crisis would not have happened if Volcker had been Fed chairman in the 2000s. But he would have done his best to prevent it.”

And there Wolf and I part ways, sadly, because Volcker was also a true hero of mine. As I found out, in March 2016, Volcker is one of the main original driving forces behind the insane risk weighted capital requirements for banks; so he sure helped to cause the crisis.

What could have come into the mind of a man like Wolf describes, “endowed to the highest degree with what the Romans called virtus (virtue): moral courage, integrity, sagacity, prudence and devotion to the service of country”, to consider that this way of interfering in the allocation of bank credit to the real economy, could bring stability without risking any other serious consequences? An effort to answer that would also be something very valuable to see included in a Paul Volcker’s testament,

PS: Charles Goodhart’s “The Basel Committee on Banking Supervision: A History of the early years 1974-1997” 2011, Cambridge Press Goodman (p.167) refers to Steven Solomon’s “The Confidence Game: How Unelected Central Bankers Are Governing the Changed Global Economy” (1995). In it we read:

On September 2, 1986, the fine cutlery was laid once again at the Bank of England governor’s official residence at New Change… The occasion was an impromptu visit from Paul Volcker… When the Fed chairman sat down with Governor Robin Leigh-Pemberton and three senior BoE officials, the topic he raised was bank capital…

At dinner the governor’s hopes had been modest: to find areas of sufficient convergence of goals and regulatory concepts to achieve separate but parallel upgrading moves… 

Yet the momentum it galvanized… produced an unanticipated breakthrough of a fully articulated, common bank capital adequacy regime for the United States and United Kingdom. This in turn catalyzed one of the 1980’s most remarkable achievements – the first worldwide protocol on the definitions, framework, and minimum standards for the capital adequacy of international active banks…

They literally wiped the blackboard clean, then explored designing a new risk-weighted capital adequacy for both countries… 

It included… a five-category framework of risk-weighted assets… It required banks to hold the full capital standard against the highest-risk loans, half the standard for the second riskiest category, a quarter for the middle category, and so on to zero capital for assets, such as government securities, without meaningful risk of credit default.”

@PerKurowski

Who should we most blame for distorting risk weighted bank capital requirements; central banks or politicians?

Sir, John Authers writes “Blaming central bankers, as many of the people behind the UK and US populist revolts tend to do, misses the point. The loose monetary policies of the past eight years helped deepen inequality by raising the wealth of those already with assets, without breathing sufficient life into those economies. But central bankers were for the most part following these policies to buy time for politicians to take the needed longer-term measures.”, “A bonfire of the certainties” November 10.

And Authers’ pities the “Central banks [that] have looked increasingly uncomfortable with their new role, while each fresh dose of monetary easing has had less impact than the one before.”

But what Authers’ does not do is to mention the bank regulations promoted and sheltered by central banks and which distorted the allocation of bank credit to the real economy. The statism, the silly risk aversion, the discrimination against the risky and the all that for no good safety reason, and that is imbedded in that piece of regulations, will go down in history as a shameful mistake, and disgrace all those who by commission or omission are responsible for it.

I ask, are central banks really auhorized to independently distort bank credit allocation

At the very end of the recent 2016 Annual Research Conference, none other than Olivier Blanchard, the former Chief Economist of the IMF, admitted that indeed more research was needed to better understand the underlying factors for the trend to lower public debt interests that can be observed the last 30 years; and that this trend might very well be explained to an important extent by current bank regulations.

When that research ends up showing we have for decades been navigating with a subsidized public borrowing rate as a proxy for the risk free rate, a financial compass distorted by the Basel Committee’s magnetic field, there will be many questions. Among these, why did FT silence more than 2.000 letters I wrote to it on this issue.

PS. The origin for this regulatory risk weighting can be found in Steven Solomon’s The Confidence Game” 1995. “On September 2, 1986, at the Bank of England governor’s official residence… when the Fed chairman Paul Volcker sat down with Governor Robin Leigh-Pemberton and three senior BoE officials, the topic he raised was bank capital”

@PerKurowski

The west did not lose the world; it unwittingly gave up the world, in a process that began in London, 2 September 1986

Sir, Philip Stephens puts forward the argument that “The global financial crash of 2007-08 cruelly exposed the weaknesses of liberal capitalism” is one of the causes for “How the west has lost the world” October 14.

Nonsense! Liberal capitalism, and much of the willingness of the west to dare to hang on to its position in the world, was abandoned the day bank regulators decided that the risk weight for sovereigns was 0% while that of We the People 100%; and the day they foolishly decided to base the capital requirements for banks, on ex ante perceived risks, as if these risk were not already cleared for by banks.

I extract here from Steven Solomon’s “The Confidence Game” 1995.

“On September 2, 1986, the fine cutlery was laid once again at the Bank of England governor’s official residence at New Change… The occasion was an impromptu visit from Paul Volcker… When the Fed chairman sat down with Governor Robin Leigh-Pemberton and three senior BoE officials, the topic he raised was bank capital… the momentum it galvanized… produced an unanticipated breakthrough of a fully articulated, common bank capital adequacy regime for the United States and United Kingdom. This in turn catalyzed one of the 1980’s most remarkable achievements – the first worldwide protocol on the definitions, framework, and minimum standards for the capital adequacy of international active banks… They literally wiped the blackboard clean, then explored designing a new risk-weighted capital adequacy for both countries…”

The Basel Committee’s risk weighting introduced a regulatory risk aversion that, had it been in place before, would never ever have allowed the west to become the leading west. To top it up, it distorted the allocation of bank credit to the real economy, for nothing, since what never ever causes major bank crises, is what is perceived as risky. These always result from unexpected events or excessive exposures to something that was erroneously perceived ex ante as very safe, or if really safe, made risky by receiving too much credit. The global financial crash of 2007-08 was a direct result of these capital requirements.

Sir, our grandchildren are going to look back with a lot of sadness to that day and ask themselves, how could our grandfathers have done this to us? Didn’t they know they themselves did well only because their parents had dared to take the risks the future needs? Why did they only settle for having their banks refinance the safer past and present?

And Sir, if you are still around, they are going to ask you: why did not papers like the Financial Times speak about this for many decades?

@PerKurowski ©