Some are unfortunately the “Too Small To Be Invited To Basel Or Davos Banks”

Sir, Tracy Alloway reports on that “New rules hit small US banks ‘hardest’” February 9. She is right, but this has been since the imposition of credit-risk-weighted equity requirements, because:

Small banks, compared to big, attend proportionally much more the borrowing needs of clients who are perceived as “risky”, like local small businesses and entrepreneurs.

Small banks, compared to big, find it more difficult to engage in that financial sophistication, whether real or pseudo, used to dress up balance sheets as safer.

And therefore small banks, compared to big, must usually hold proportionally more equity, which makes it more difficult for these to produce competitive returns for their shareholders.

The small banks and their “risky” clients are never invited to discuss their problems with the Basel Committee or the Financial Stability Board…they are too small to be able to adequately feed the ego of regulators.

Small banks are never invited to Davos, as neither are their small “risky” clients.

Thanks to credit risk weighted equity requirements, borrowers and banks now share the objective of fooling regulators.

Sir, Tracy Alloway refers to the transformation of unsafe loans into super-duper “safe” ones “eBonds that strip out risk would be financial alchemy at its oddest” February 7. She misses out on what I would hold to be the most important incentive for such process.

Borrowers have of course always been interested in selling themselves to the banks as having a very low credit risk, in order to negotiate lower risk premiums.

And bankers used always to be very interested in questioning the creditworthiness of borrowers, in order to obtain higher risk premiums.

And that struggle helped to allocate bank credit efficiently to the real economy.

But then came regulators with their credit-risk-weighted equity requirements for banks and changed the priorities for the banks.

Now more important for the risk adjusted return on bank equity than the negotiation of risk premiums with borrowers, is dressing up the credit operation in such a way so as to make it seem as safe as possible, so as to allow the highest possible leverage of bank equity.

In other words regulators, instead of fully exploiting the tensions between borrowers and lenders, managed to align both of these with the objective of fooling them. Not too bright doings Basel Committee!

Beware of excessive information. (Blissful) ignorance is a potent driver of financial markets and of human activities.

Sir, Tracy Alloway describes the possibility of adding on, as you go along, new pieces of information that will enhance the knowledge of the risks, for instance in securities backed with residential mortgages, “New mutations beckon for system that shares DNA of each loan’s risk” January 3.

And Alloway quotes David Walker of Marketcore saying “This could be very disruptive, because not everybody is for transparency and accountability. Even if they say they are publicly, they may not be privately.”

It is worse than that! If risks were perfectly known, the price of the securities would reflect this and so there would be little profits to be made trading these, and so perhaps there would be no Wall Street. It is imperfect information that has prices zigzagging, which induces market participant to get out of bed in order to sell the not-too-well-perceived risks and buy the not-so-real-safeties.

In other words, ignorance is one of the most potent drivers of financial markets and human activities; and is therefore quite often characterized as quite blissful… at least by the winners.

But the worst that can happen with excessive information, that is when we, because of it, become convinced that we know it all. Like when bank regulators caused our banks to follow excessively the credit risk perceptions issued by some few human fallible credit rating agencies. Clearly some more information (and humility) about our ignorance would have come in handy.

Gauging the level of understanding of Fed statements assumes, kindly, Fed understands what it writes. Does it?

Sir, Tracy Alloway tackles the issue of “Why Fed statements have become literally harder to read” November 29, which generously assumes that the Fed understands what it writes. Can we be so sure of that?

One of the most important documents of our time is the Explanatory Note on the Basel II IRB Risk-Weight Functions issued by the Basel Committee; as with it the regulators try to explain what they are betting all of our banking system on. And, that document is such a mumbo jumbo, that the only thing I can conclude is that none of the experts and not-experts who read it understood one iota of it, and therefore did not dare to question it.

And so seemingly the rule is that the more complicated a document is, the less the chances it will be questioned. And the add-on to that would be, the more expert an expert think he is, the less likely he will confess not understanding something.

Therefore friends, given that FOMC statements currently “require reading grade levels of 18 to 19 to understand” hold on to your hats, someone might want to hide something, and we might soon be in to suffer the Chinese curse, I refer of course to that of “May you live in interesting times!”

Basel Committee and Financial Stability Board: “Beware, beware, walk with care, care for what you do, or Mumbo-Jumbo is going to hoo-doo you, or Mumbo-Jumbo is going to hoo-doo you, boom le boom le boom le boom!”… and hoo-doo our banks, and hoo-doo us. Please, we are NOT expendable!

We citizens need to lay down some strict terms for taming bad regulations risk.

Sir, Sam Fleming and Tracy Alloway report: “Rulemakers lay down terms for taming shadow banking risk” October 14.

And my wish would be for us citizens to be able to lay down some strict terms for taming any bad regulations risk.

For instance, in all shadow banking, a Euro, a Dollar, a Pound or whatever other currency of equity, are all the same equity, no matter what assets risks they are exposed to. Not so in formal regulated banks. There a Euro, a Dollar, a Pound or whatever other currency in equity, represents a different equity, according to the respective credit risk weight of the assets it is backing.

How regulators were fooled by naturally higher returns on bank equity seeking bankers, into believing that would not distort the allocation of bank credit, with great dangers to the real economy and to the stability of the banks, beats me.

And so the first term I would as a concerned citizen lay down for the regulators would be: “Whatever you do, don’t think yourselves smarter than the markets. And if you absolutely must distort the allocation of bank credit, one way or another, make sure you obtain the permission to do so, including of course that of those borrowers who will see their access to bank credit made more difficult and expensive because of it.

Investors driven out of safe investments by bank regulations and QEs, are they yield-hungry or just yield-starved?

Sir, Tracy Alloway and Michael MacKensie write that “Sales of US corporate bonds reflect a worrying lack of ratings differentiation” and they title that “Yield-hungry investors overlook credit risk” September 19.

All Fed’s QE’s, as well as the risk-weighted capital requirements for banks, as well as the upcoming liquidity requirements for banks, as well as much other risk-adverse regulations, only end up crowding out normal investors from what is deemed as “absolutely safe”, that which used to be said belonged to widows and orphans. 

And in that respect I wonder if “yield-hungry” is really the correct description of investors who seem more to have been yield-starved by official governments actions.

But also, let us not forget to ask ourselves… when can the extremely safe havens become so extremely dangerous crowded, so that suddenly the risky waters outside are actually safer?

And, is it not sad to read that increased corporate leverage is not resulting from increased real economic activity but only from “the combination of share buybacks dividend increases and M&A activities? I bet some years from now some authorities will once again try to explain that to us as just the result of “unintended consequences”… let us not be fooled by that… at least to me they are guilty, until they proved beyond any reasonable doubt it was not their intentions… or they plead insanity :-).

Most of the concern with derivatives derives only from the fact that “derivatives” sounds so deliciously sophisticated.

Sir, Tracy Alloway and Michael Mackenzie when reporting on the “Dangers to system from derivatives´ new boom", August 20, might not understand the most important differences between underlying markets and the derivatives traded based on these.

In a derivative, there is a buyer and a seller, and so whatever happens someone wins and someone loses and in essence it’s a wash out… of course as long as all can live up to their commitments.

But, in a real market loss, like that of a lower value of a stock, a lower value of a painting, or a lower value of a real estate, there is at that time only a loser… and no winner… that is unless you count he who might have way back earlier sold the stock.

And in this respect the trading in derivatives will depress much less the market than a depression of the values of the underlying vanilla assets.

The big fuss that is raised around the issue of trading of derivatives, again, besides the possibility of one side of the trade not living up to his commitments, has much more to do with the fact that “derivatives” sounds so deliciously sophisticated.

We must stop building that mountain of dangerous elusive safety that is sure to crumble and fall on us.

Sir, I refer to Tracy Alloway’s and Michael MacKenzie´s “Finance: The FICC and the dead” August 12.

In October 2004, in a formal written statement delivered at the World Bank as an Executive Director, I warned

“I believe that much of the world’s financial markets are currently being dangerously overstretched through an exaggerated reliance on intrinsically weak financial models that are based on very short series of statistical evidence and very doubtful volatility assumptions.”

I have of course been much ignored ever since, as it is not considered comme il faut to be too right especially in the company of credited experts.

But Sir, now we are back to that period, and again… and it is not that the waves have disappeared… it is that the wave is building up… Just you wait ´enry ´igggins, just you wait, until it breaks.

When bank regulators with their risk-weighted capital requirements of Basel II basically ordered banks to stay away from what is "risky"… and now make those orders even more imperative with the liquidity requirements in Basel III, and when we now read about asset managers “steering clear of certain bonds, such as asset-backed instruments whose so-called secondary markets are not deep” one thing is clear… and that is… the world is trying to build a more and more, a higher and higher, mountain of safe assets.

Perhaps something on its very top and its very center might survive, but the rest is going to come crumbling down… sooner or later, there is just not enough safety material to go around for that kind of mountain.

They seek it here. They seek it there. Those Basel bank regulators seek it everywhere. Is it in heaven? Is it in hell? That damned elusive bank stability… (which does not even have the decency to rhyme!)

There are two entirely different kinds of risks. Investing in “risky”, and excessive investment in “safe”

Sir, Tracy Alloway reports that, as a result of “low volatility” which sets off ‘feedback loop”, “Banks warn of ‘excessive’ risk taking” August 7.

Excessive risk taking comes in two forms. Investing in something ex ante perceived as risky, and the most dangerous one, investing excessively in something, ex ante, perceived as “absolutely safe”.

It is important to make that distinction because while other investors might be running more of the first kind of risk, banks, especially because of risk-weighted capital requirements, are much more exposed to the second kind of risk.

For the society the second kind of risk is of course much more dangerous, since excessive investments in what is perceived as “absolutely safe” will take us nowhere.

The genie in the Basel Committee’s Aladdin lamp… is as dumb as genies can come

Sir, I had no idea of the existence of the “state of the art risk and order management system” described interestingly by Tracy Alloway in “Genie not included in BlackRock´s Aladdin” July 12.

Of course “none of these tools are meant to supplant the basic human intelligence required to make informed investment decisions”… but they do. Perhaps, in order to avoid unnecessary introduction of systemic risk, there should be fairly low limit to how much of the market can be served by the same risk modeling tool.

But again it surprises me how Alloway can write such an insightful article, and still not comprehend that the Basel risk-weights which determine the capital banks need to hold, amounts to an Aladdin lamp with a residing genie as inept as they can come. Imagine, just for a starter that genie believes that what is risky for banks and bankers is what is perceived as risky… how dumb is not that?

And distorting the allocation of bank credit following the advice of that genie is as dangerous as it comes for the real economy.

PS. Tracy Alloway on Wall Street, how many shares are traded in the Dow Jones index? Could the increase in its value be a function of shrinkage of its base?

Ever more complex finance requires denser and duller, bordering on brain-less, hard-headed stubborn bank regulators.

Sir, Tracy Alloway writes “If the institutions which create these [sophisticated financial] products cannot correctly asses their value, then what hope is there for us?”, “Ever more complex finance parts way with economic reality” May 3.

Indeed but it is worse than that… because what hope can we have that our bank regulators understand those products? In 2003, when Basel II was being discussed I told some hundred regulators during a workshop the following: “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.”

The truth is that regulators did not know what they were doing with simple Basel II and they know of course much less with Basel III, which is about a hundred times more complex and technical.

And this should lead us to the truth of regulations… the more complex the issue is the more dumb must the regulators act, like refusing trying to understand it all, and stubbornly holding to some simple rules of thumb… like 8 percent of shareholder’s equity against any asset.

The role of the regulators is not to control the banks for the perceived ex ante risks, the expected losses, that is the job of the bankers and, if they can’t do that they should not be bankers. The role of the regulator is to safeguard against eventual ex post risks, unexpected losses, and since the unexpected cannot be calculated, they can for instance allow themselves not having any knowledge of calculus.

God save us from the hubris driven intelligent besserwisser spread-sheet equipped regulators trying to outsmart bankers.

Excessive exposures to what is “absolutely safe” by regulated banks could be much more dangerous than whatever lurks in the shadows.

Sir Tracy Alloway writes “Shadow banks, we are told, are unregulated institutions that lurk in the dark corners of the financial system – away from the supervised activities of run-of-the-mill commercial banks”, “Competition for banking business lurks in the shadows” January 18.

But perhaps we should keep in mind that those unregulated shadow institutions are not able to leverage remotely as much as the banks who operate in sunlight… so the question of safety is sort of relative.

And Alloway also comments “that there is perhaps an underappreciated danger: that non bank lenders will encourage riskier behavior at larger banks that find themselves compelled to try to compete with the shadows”. But that would only happen if banks are able to dress up that riskier behavior in such as way that it is perceived as “absolutely safe” so that they do not need to hold much capital.

As is, the real risky behavior of banks is building up excessive and dangerous exposures to what is perceived as “absolutely safe”… all a consequence of capital requirements which are portfolio invariant.

Alloway hopes that these “shadow lenders serve a purpose” satisfying “the needs of the real economy”. Indeed let us hope and pray it is so, because as is, the supervised banks, with the risk aversion imposed on them, are kept from doing so.

Good for you, Commodity Futures Trading Commission

Sir, Tracy Alloway writes that “last week the Commodity Futures Trading Commission upset many traders when it announced it would require cash to backstop Treasuries used as collateral for derivative trades, “Asset price ‘security alerts’ can mask complex risk”, November 23.

And Alloway follows up on that opining that “if the markets cannot agree on the value of one of the most liquid and relative safe assets in the world – an $11tn – then it is tempting to believe than even the most basic assumption are open to interpretation”.

This is an opening to clarify precisely what has gone wrong with bank regulations. In a nutshell, the Commodity Futures Trading Commission is NOT the market, it is the regulator, and should therefore always be open to believe in that all assumptions in the market are open to interpretations.

Stupid were the bank regulators because, in their capital requirements based on perceived risk, they followed the opinions of the same credit ratings market and banks followed.

Yes the Homeland Security Advisor System, with its different colors ranging from green to red to indicate risk levels that Alloway also refers to, might indeed be “A classification system that offers little differentiation provides only limited information value”… but the nightmare would not be much the passengers relying on the colors, but Homeland´s security personnel doing so too.

And, by the way, an $11tn market, of just one borrower…might very well be the systemically most important and therefore the most dangerous market in the world.

The Financial Stability Board, one of the Great Distorters, goes at it again

Sir Brooke Master and Tracy Alloway write about how the Financial Stability Board is focusing on securities lending, like the “repo” market. “Shadow banks face fresh limits to trading” August 30.

The FSB wants to impose: “a minimum .05 percent haircut for corporate debt securities with maturity of less than a year – so a $100 security could be used to raise $99.50. Equities and securitizations made up of debt with durations of five years and longer would be hit by a 4 percent haircut” allowing consequentially these latter only to be able to raise $96 for each $100,

Here one of the great distorters goes at it again. Do they not understand that by differentiating between short and long term they are distorting how the markets will allocate financial resources.

Come on FSB, in general terms of stability, what is wrong with long term debt? In terms of needed liquidity... does not long term debt need that perhaps even more than short term debt?

And I sure hope that Mark Carney, the Bank of England governor, and the FSB chairman, was joking when he called the proposal “an essential first step towards… transforming shadow banking into market-based financing” If not… “Houston we’ve got a problem”

The incongruency of current risk-weighted capital requirements shine s through again.

Sir, Tracy Alloway and Vivianne Rodriguez end their “US repo finance faces threat from new capital rules” August 21, by quoting a person familiar with the regulatory effort saying “Repo reform is about recognizing the risk in pricing those repo transactions… What we learnt in 2008 was that the risks were not fully appreciated and therefore not fully priced into the transactions.”

That leads to the following two questions: First, if admitting that by fully appreciating the risk, you can fully price the transaction, then why allow for different capital requirements based on different risks? Does that not just create distortions in the allocation of resources between different classes of risk?

Second, if you cannot fully appreciate the risks, is that no what the ordinary not adjusted for risk capital requirements should be there for?

Fabrice Tourre has been duly scalped, but where is the SEC’s mea culpa?

Sir, I have no doubt whatsoever that the prime responsible for the current financial mess were dumb bank regulators. That’s is why I dislike so much reading when Tracy Alloway and Kara Scanell report “SEC elated after claiming Tourre’s scalp.” August 3.

The whole story can either begin with the little guy, the mortgage underwriter underwriting bad mortgages to the subprime sector; and those bad ingredients were then sold by underwriter bosses to security packagers, who packaged these bad mortgages into very bad subprime sausages; but who were are able to turn these into valuable delicacies, only because of the high credit ratings these received from human fallible credit rating agents. And then the story could end with those selling the sausages to the investors, and some of them, like Goldman Sachs, even taking bets on that these would make their buyers puke. And all involved in the bad sausage chain made huge profits… and should all be ashamed, some more than others.

Or the story can begin with bank regulators, the Basel Committee, who with its Basel II of June 2004 authorized banks to hold AAA rated sausages on their books against only 1.6 percent in capital (equity), which meant they authorized banks to leverage their capital a mindboggling 62.5 to 1 times with these sausages; and who with this created the irresistible profit motivations that induced all humans previously mentioned to break all the rules.

Fabrice Tourre’s own word “More and more leverage in the system, the whole building is about to collapse any time now” says it all. Those directly responsible for that leverage were the bank regulators. Without the explicit blessing of regulations which allowed it, the system would never ever have been able to leverage as much. And the SEC was all in agreement with is, as can be read in its Open Meeting records of April 28, 2004.

Yes, Fabrice Tourre and all others involved in the subprime sausage chain are guilty and should be held responsible. But, if we allow regulators to get away, feeling elated, without even a mea culpa, then we truly have not learned the lessons we most need to learn from this crisis.

Higher capital will soon turn into banks’ new competitive edge.

Sir I refer to Tracy Alloway’s and Patrick Jenkins’ “US banks face strict leverage proposals” July 10.

At this moment, when warning signs stating “bank creditors, caveat emptor, you won’t be bailed out like before” are being put up all over the world, starting in Cyprus, banks have to be truly insane not knowing they have to substantially raise their capital.

In this respect, though some dumb US banks are complaining that their regulators, are setting too high capital requirements for them, these might turn out to be a blessing in disguise… and perhaps soon all will understand that those even higher ratios favored by FDIC’s Martin Gruenberg and foremost Thomas Hoenig, make all sense in the world.

Just wait until the recent decision of the Basel Committee about having to publish the leverage ratio comes into effect. Then there is a lot of bank-running that is going to be happening from those banks leveraged over 30 to 1 to those banks leveraged 10 to 1, and this no matter the riskiness of the underlying assets.

Frankly, European banks should beware

If it looks like a distortion, quacks like a distortion, and walks like a distortion then it probably is a distortion.

Sir, Brooke Masters, Tracy Alloway and Shahien Nasiripour report on how banks use “pricey credit default swaps to cut their capital requirements”, “Watchdog to close Basel loophole over use of pricey credit protection” March 25.

And yet these reporters even confronting the willingness of someone to pay “pricey default swaps” cannot seem to understand that must only be because someone has created a distortion, in this particular case that one introduced by Basel regulations which permit banks to hold some assets against less capital than others.

The unhappy Barings’ Bank trader Nick Leeson writes in his memoirs: “And they never dared ask me any basic questions, since they were afraid of looking stupid about not understanding futures and options.”

And how I would like these three reporters to dare ask the regulators for the reason of having capital requirement based on perceived risks which are already cleared for by other means, and, of course, not settling for that fuzzy explanation of “more-risk-more-capital, less-risk-less-capital, does that not sound logical?”

I repeat, our banks are not moved by some invisible hand of the markets, they are moved by the invisible and completely unauthorized and dumb hand of the Basel Committee.

Sir, where have all the daring journalists gone? Worse, where have all the daring editors gone?

The Basel Committee’s nanny-cartel’s truly colossal bribery of global bank business must be stopped.

Sir I refer to “Banks’ risk tactic under fire” by Shahien Nasiripour, Brooke Masters and Tracy Alloway, February 18.

I sincerely cannot understand how supposedly intelligent people, acting as regulators, can allow themselves to be dragged in by bankers into such silly discussion as to the adequate length of the periods to be used in VAR.

Can’t they get it into their heads that they do not have to concern themselves much with credit risk models, or credit ratings being correct, and concentrate on what to do when these prove to be wrong? This is just like the fire brigade worrying excessively about the quality of the fire detectors installed in homes, while forgetting to maintain the engines of their fire-trucks.

But of course, the real problem with current bank regulators is that they do not understand the magnitude of the distortions they have created. For instance a rule that “could force some banks to increase sharply the amount of capital they hold against trading assets” will immediately make bank capital much scarcer and thereby dramatically impact negatively the lending to what requires higher levels of capital.

The fact that banks were allowed to hold silly little capital for what was ex ante perceived as safe resulted into that, ex post, when some of it turn out to be risky, they had little capital to cover for it. Also let us not forget that whatever capital they had left came mostly from those requirements imposed on them when lending to the "risky". And it all meant then that banks had to retrench from lending to the “risky”, which is what they will now be forced to do even more.

Huw Van Stenis, a Morgan Stanley analyst, is quoted praising the Basel committee “harmonising some inputs makes a lot of sense”, but that of course ignores the fact of life that the greater the harmonization the greater the dangers of a catastrophic systemic risk. 

Sir, you have an editorial today titled “Beating bribery in global business”. Since the Basel Committee’s nanny-cartel fixed the game, bribed the bankers, with their capital requirements based on perceived risk, and got us the crisis it paid for, I sincerely hope Sir you one day accept that is a colossal bribery of global business that must be stopped... and not covered for.

“Under distortion”

Sometimes I like to peek at sites with an “Under construction” sign to have a look at how things go. Nowadays one can also get a look of “Under distortion” market sites, like thanks to Tracy Alloway’s and Nicole Bullock’s “Banksoffer debt product to help skirt new liquidity rules” January 30.

An nescis, mi fili, quantilla prudentia mundus regatur? Axel Oxenstierna, 1583 – 1654