What would happen to the yield curve if regulators dared to increase, ever so little, their current 0% risk weight for US Treasury debt?

Sir, Megan Greene discusses how the yield curve the spread between long- and short-term bonds may be influenced by, “The US Treasury is currently borrowing more money to finance predicted big budget deficits and it has mainly done so with short-term debt… and global quantitative easing has created a seemingly insatiable demand for five- to 10-year Treasuries, pushing down yields.” “How central banks distort the yield curve’s predictive power”, September 4.

But that’s not all the distortion in force. The risk weighted capital requirements for banks might distort even more; we recently saw how Greece was taken down by the 0% risk weigh EU authorities assigned to its debt, which caused European banks to drown in it, until they got rescued, by the victim Greece having to take on even more debt.

If the US, in face of its ever growing public debt, suddenly sees it as its responsibility to increase the risk weight of it, so that the interest rates send more correct signals, then I would hold that the rate on all longer term bonds would immediately shoot up, and many banks around the world would stand there with huge losses on their books. 

I here you “That will just not happen? Yes, they have with that 0% risk weight painted themselves into a corner but, sooner or later, there needs to be some adults in the room who start working against having to face a scenario of total collapse; this time with much less tools available than the last time they kicked the can down the road in 2007 2008 … or at least so we hope… or at least so we pray.

PS. Here on research that is still missing 

@PerKurowski

Predictability, in bank regulations, is more a dangerous threat than help

Sir, I refer to Robin Wigglesworth’s excellent discussion on the difficulties and hard choices central banks face when communicating their feelings and policies “Central banks might benefit from a healthy dose of ‘constructive ambiguity’”. May 14.

But let me focus (for the umpteenth time) on the concluding note “Predictability may be a hindrance rather than a help”

The Fed’s Governor Laid Brainard, in a recent speech “An Update on the Federal Reserve's Financial Stability Agenda” said: “The primary focus of financial stability policy is tail risk (outcomes that are unlikely but severely damaging) as opposed to the modal outlook (the most likely path of the economy).”

That is how it should be, but it is not! That the riskiness of bank assets, for instance with the help of credit rating agencies, could be somewhat predicted, tempted regulators into creating risk weighted capital requirements for banks; but that same “predictability” also blinded them completely to the fact that the safer something is perceived, the more dangerous does its fat-tail-risk become. For instance they assigned a risk weight of only 20% to the AAA rated and one of 150% to that which was rated below BB-. Is not the fat-tail-risk of what has been rated below BB- almost inexistent?

Governor Leal Brainard also writes: “Treasury yields reflect historically low term premiums--. This poses the risk that term premiums could rise sharply--for instance, if investor perceptions of inflation risks increased.” 

Indeed, but to that we must also add the possibility of the investor perceptions of Treasury infallibility changes for the worse.

When in 1988 the regulators, with Basel I, decided to assign a 0% risk-weight to some sovereigns they painted these into a corner. If that risk weight is not increased, then sovereigns will become, sooner or later over-indebted, and risk will grow until it hits 100%. If that risk weight is increased, ever so slightly, markets will be very scared. How to get out of that corner is the most difficult challenge central banks and bank regulators face. Let us not forget that in 1988 US debt that was $2.6 trillion. Now it is US$21 trillion, growing, and still 0% risk weighted.

PS. The only way to solve the 0% sovereign risk weight conundrum that I see, is to increase the leverage ratio applicable to all assets, until that level where the risk weighted capital requirement totally loses its significance.

PS. Brainard also stated “Regulatory capital ratios for the largest banking firms at the core of the system have about doubled since 2007 and are currently at their highest levels in the post-crisis era.” Regulatory capital ratios, when risk weighted, might mean zilch.

@PerKurowski

Of the demand for sovereign debt, how much comes from the free market, and how much from regulatory distortions?

Sir, Dave Shellock writes that among other, because of the possibilities of Brexit, and because of Fed’s Janet Yellen’s dovish speech, “Sovereign debt demand drives benchmark yields to record lows” June 11.

When will someone try to figure out how much of that demand for sovereign debt has been artificially inflated by regulations? For instance banks are allowed to hold the least capital against sovereign debt, and knowing about the general scarcity of bank capital that must influence its demand very much. And similarly others, like the insurance sector, have been nudged in many ways to hold sovereign debt.

The day banks and insurance company are allowed to hold private sector assets under the same conditions they can hold sovereign debt, then we would be able to know what the free market really indicates.

Sovereign debt, like US Treasury and bonds, are most often used as proxies for the all-important “risk-free rate”. Sir, it is therefore really hard for me to understand why the possibility we might not have a true risk-free rate proxy, because the rate of US Treasuries and bonds are subsidized by regulations, is not of any interest to the Financial Times. It is like a National Geographic not being interested in the earth's rotation being shifted.

@PerKurowski ©

“Treasury risks” and the zero percent risk weight for Treasuries, do seem a bit like odd bedfellows.

Sir, I refer to Robin Wigglesworth’s “Treasury risk rises as debt ceiling looms” October 9.

I just want to point out how strange it is to read about Treasury risks, in a world in which no one discusses the zero percent risk weights for Treasury, that set when determining the risk-weighted capital requirements for banks.

@PerKurowski ©  J

Who is to investigate how bank regulators manipulated markets in favor of US Treasury and similar sovereign debts?

In 1988, with the Basel Accord, bank regulators of the G20 countries decided that while the private sector should have a 100 percent risk weighing, their sovereigns, those represented by their bosses, the governments, were so safe so as to validate a zero percent risk weight.

That meant of course that, from that moment on, sovereigns have preferential access to bank credit… something that is of course paid by all those who do not count such preferential treatment.

Since de facto that also means regulators acted as if government bureaucrats could use bank credit more efficiently than the private sector, something that unless we are runaway statists or communists we know is absolutely false, the resulting distortion is also paid by future generations of unemployed.

And so, when compared to that manipulation, all the “potential manipulation of the US Treasury markets” referred to by Gina Chon and Martin Arnold” in “Probe into US Treasury markets” of September 10, is, excuse me, something like what is vulgarly known as chicken shit.

@PerKurowski

Could a beneficiary sue a pension fund for blatant breach of trust if it buys a bond with negative interest?

Sir I refer to Ralph Atkins’ and Elaine Moore’s “Negative rates to hit financial system”, February 16.

I have a question: Could a beneficiary sue a pension fund for blatant breach of trust if it buys a bond with negative interest? I mean is that not something like agreeing to a sort of prepaid pre-accepted haircut with somebody else’s money?

If I managed a pension fund, I would sure send a letter to all those who are expecting my management to provide them with a decent retirement stating something like: 

“Warning, we must inform you that central banks and governments are creating dangerously strange market conditions for which we hope you will not hold us personally responsible… and, for the time being, forget about expecting something like an 8 per cent return... if you earn enough with us to pay our costs, consider yourself a winner”.

What flight to quality? To dangerously overpopulated safe havens?

Jonathan Wheatley quotes Stuart Oakley, global head of EM foreign exchange trading at Nomura: “The point of QE is to inflate the real economy. But instead of driving growth it is creating asset bubbles”, “Emerging bubble”, February 16.

How could it be otherwise? The growth of the real economy depends much on allowing the real economies’ “risky” risk-takers, like SMEs and entrepreneurs, to do their job. And that has been blocked by capital requirements for banks that force equity scarce banks to hold more equity when lending to the “risky” than when lending to the “safe”.

And the article speaks about “Flight to quality”. What quality? The usually safe havens, those usually used by widows and orphans, are now being dangerously overpopulated by banks following the instructions imparted by regulators.

Wheatley also refers to “while the yield on the benchmark US Treasury bond has fallen from 6 per cent in 2000 to less than 2 per cent today, the returns sought by many US public pension funds have barely changed at about 8 per cent.” And Sir, if you consider that “less than 2 per cent”, in light of a by the Fed declared inflation target of 2 per cent, then buying those bonds would amount to a sort of prepaid pre-accepted haircut, which could be something prohibited for pension funds to do.

Today’s “risk-free-rates”, are not real risk free rates but subsidized risk free rates!

Sir, I refer to Amin Rajan’s “Portfolio theory has hypnotised asset managers” January 19.

Rajan, referring to Pascal Blanqué’s book “Essays in Positive Investment Management” writes:

“In practice, from 1999 to 2009, US 10-year Treasury bonds not only outperformed risky assets such as equities, their actual returns were also well above the expected ones. In fact, government bonds have violated every tenet of conventional investment wisdom over the past 30 years…

So what is the solution? The author is at pains to point out that there is no silver bullet. Our current knowledge of how markets operate is very limited. There is a crying need for more research and debate.”

Sir, when markets finally get to understand that the interest rates sovereigns are paying, is not just a consequence of their perceived “infallibility”, but also a result of them having awarded themselves regulatory subsidies… it might be too late… and all hell might break loose.

Here is the story. In the early 90s with Basel I, and then with Basel II, and currently with Basel III, banks need to hold very little or no equity at all when lending to the sovereigns, especially when compared to what they are required to hold when lending to “risky” citizens.

And that means: the more problem loans eats up bank equity; and the more regulators require banks to hold more equity; and even the more bank are fined (which eats into their equity)… the more will the banks de facto be forced to hold sovereigns.

Current US Treasury bond rates, those usually used as “risk-free-rates”, are not real risk free rates but subsidized free rates!

One question I dare John Authers not to pass over.

Sir, John Authers in “Four questions markets should not pass over” April 12, includes the following two: “Why are Treasury yields falling, when all other times when the Federal Reserve has prepared to raise interest rates, they have risen?” and “Why can Greece successfully borrow on the markets once more, when it is barely two years since it partially defaulted and nearly left the euro?”.

In response I would ask John Authers to respond: Could the fact that banks need to hold basically zero capital against those two assets, while they must hold 7 to 8 percent against any assets perceived as “risky”, have anything to do with it?

Would US Treasuries been safer, had there been no debt-roof discussions, just business as usual?

Sir, John Plender holds that as a consequence of the “debt-ceiling imbroglio”, and the recent partial closure of US government, “that anyone who can diversify out of US Treasuries will now feel impelled do so as far as possible.” “Treasuries have turned anything but risk-free”, October 23.

If Plender implies that had only the US just gone on lifting the debt-roof of which it has to jump off, sooner or later, and kept on spending as usual, while there is no tapering of the QE, and all without even a discussion, that then the US treasuries would be safer, I do not agree. That is not what “a responsible custodian for more than 60 per cent of the world’s official reserves” should do.

But that there are reasons to diversify, on that there is little doubt. The doubts are with respect to, diversify into what? Though Plender mentions China’s rising to challenge US hegemony, I do not think he is seriously thinking about putting his savings in Chinese banks. Could Plender have gold in mind?

And what about conceit in journalism?

Sir, Gillian Tett writes correctly that “Libor affair exposes big conceit at the heart of banking” June 29, but there might equally be some big conceit going on at the heart of journalism. 

Two questions: What is the most important dollar reference rate… the risk free US Treasury rate or Libor? And, who has effectively manipulated those rates the most, Barclays the Libor rate, or the bank regulators the US Treasury rate by means of allowing the banks to hold these instruments with less capital than other assets? 

Clearly, in terms of its significance, the manipulation of the US Treasury “risk free” rate has been much more significant than whatever Barclays can have done to Libor but that, Gillian and her colleagues at FT decided to ignore, with much conceit.


Should not an anthropologist be about the most humble of all professionals? 

Europe needs to eliminate the subsidy of the “risky” to the “safe”.

Sir, Martin Wolf gives a good but incomplete analysis in “Look beyond summits forsalvation” June 27. 

Like all others intellectual prisoners of the bank regulatory pillar of capital requirements based on ex ante perceived risk, he fails to understand how all the banks are currently condemned to end up gasping for air, and capital, on the last officially deemed safe-havens in town, Bundesbank and US Treasury, more sooner than later. 

As a result he also fails to understand the artificially imposed regulatory subsidies that the “risky” European countries pay to the “safe”, by means of the much lower interest rates the latter must pay when compared to what would have been the case absent these regulations.