FT, on banking and finance who are you to believe, Francis Fukuyama or Paul Volcker?

Sir, Francis Fukuyama in “The war on liberalism” FT March 5, writes:

“Liberals understand the importance of free markets — but under the influence of economists such as Milton Friedman and the “Chicago School”, the market was worshipped and the state increasingly demonised as the enemy of economic growth and individual freedom. Advanced democracies under the spell of neoliberal ideas trimmed back welfare states and regulation, and advised developing countries to do the same under the “Washington Consensus”. Cuts to social spending and state sectors removed the buffers that protected individuals from market vagaries, leading to big increases in inequality over the past two generations.

While some of this retrenchment was justified, it was carried to extremes and led, for example, to deregulation of US financial markets in the 1980s and 1990s that destabilised them and brought on financial crises such as the subprime meltdown in 2008.”

Paul A. Volcker in his autobiography “Keeping at it” of 2018, penned together with Christine Harper, with respect to the risk weighted bank capital requirements he helped to promote and which were approved in 1988 under the name of Basel I wrote:

“The assets assigned the lowest risk, for which capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages. Ironically, losses on those two types of assets would fuel the global crisis in 2008 and a subsequent European crisis in 2011. The American “overall leverage” approach had a disadvantage as well in the eyes of shareholders and executives focused on return on capital; it seemed to discourage holdings of the safest assets, in particular low-return US government securities."

Sir, in reference to advising developing countries with the “Washington Consensus”, in November 2004 you kindly published a letter in which I wrote:

“Our bank supervisors in Basel are unwittingly controlling the capital flows in the world. How many Basel propositions will it 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.”

So, there are two completely different bank systems:

Before 1988, one in which banks needed to hold the same capital against all assets, credit was allocated based on risk adjusted interest rates and the market considering the bank’s portfolio, accurately or not, values its capital.

After 1988, one risk weighted capital requirement banks where credit is allocated based on risk adjusted returns on equity, something which clearly depends on how much regulators have allowed their capital to be leveraged with each asset... clearly favoring government credit, which de facto implies bureaucrats know better what to do with (taxpayers') credit than e.g., small businesses and entrepreneurs. Communism!

Sir, I am of course just small fry, not even a PhD, but, if you have to choose between describing what has happened in the financial markets since 1988 as a “deregulation”, as Fukuyama opines, or an absolute statist and politically influenced misregulation, as Volcker valiantly confesses, who do you believe?

Sir, is this topic taboo… or just a too hot potato for the “Without fear and without favour” Financial Times?

PS. In Steven Solomon’s “The Confidence Game” 1995 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…”

@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

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 ©

Central banks, when are you going to lift that dangerous capital control the Basel Commitee concocted? Its urgent!

Sir, Donal O’Mahony speaks out loud and clear. We do have many reasons to question whether central bankers have a good idea about what they are doing, or only making it worse with their "we invent as we go along" creativity. “Experimental policies of central banks pose threat to confidence” March 10.

O’Mahony refers primarily to QEs and zero or even negative interest measures. I personally concern myself much more with their much more insidous and so very dangerous distortion of bank credit allocation to the real economy.

Their credit risk weighted capital requirements for banks, are in all essence a strict capital control. It tells banks “Lend to ‘the safe’, the sovereigns and members of the AAArisktocracy, and stay away from ‘the risky’, the SMEs and entrepreneurs”

That capital control must be lifted, urgently, if we are ever going to have a chance of a sturdy economy able to generate those jobs our kids need.

Sir, you know I have mentioned it before but again, between you and me, perhaps we should seriously consider firing all central bankers. They are just too dangerous for our health.

Already in 1995, in “The Confidence Game” Steven Solomon wrote of “how central bankers have shaped the course of economic and political events in the past fifteen years, why their influence relative to elected political leaders has reached a historical zenith, and how it reveals one of the greatest pressing dangers facing free democracy.”

@PerKurowski ©