For now I will not buy Sebastian Mallaby’s risk averting potion, it might even enhance the risks.

Sir, I refer to Sebastian Mallaby’s “Economics must heed political risk” November 7. There he mentions the idea that “The familiar statistics on gross domestic product [could be] coupled with an index of financial risk-taking, so that the usual focus on growth would be tempered by a measure of the danger that growth might suddenly implode” and creating “a forecast of output divided by a measure of the risks to the forecasts; [something akin to] a Sharpe ratio for economic growth. 

Questions: Would that increase or decrease the risks? How would that help? Could that not also result into some risks becoming exaggeratedly considered? 

Quite recently, too radical academic finance regulators, believed they could control risks in banking, by setting up capital requirements based on ex-ante perceived risk of bank assets. And, what happened? Absolute disaster! 

Not only did they ignore that a bank has other purposes than just avoiding risks, but also, worse, the risk of default became excessively considered. It was taken into account when banks set their interest rates, amounts of exposure and other terms, and so to use precisely the same ex-risks to also set the capital requirements was sheer lunacy… though the responsible geniuses, seem not to have realized it yet. 

And how on earth does Mallaby suggest the IMF gives outlook projections that are not based on some simple assumptions, but based on a more diffuse concept of political risk? Would that be more accurate, or more believable? I doubt it. It is hard enough for the IMF as is. 

The US GAO Report in 2003, subtitled “Challenges Remain in IMF’s Ability to Anticipate, Prevent, and Resolve Financial Crises” stated: “Internal assessment of the Fund’s EWS (Early Warning System) models shows that they are weak predictors of actual crisis. The models’ most significant limitation is that they have high false-alarm rates. In about 80 percent of the cases where a crisis was predicted over the next 24 months, no crisis occurred. Furthermore, in about 9 percent of the cases where no crisis was predicted, there was a crisis.” From reading the report it is easy to understand that one of IMF’s problems is that what it opines, becomes a political and an economic risk too. 

Finally Mallaby seems to completely ignore the issue of retro alimentation of risk perceptions. When writing that if “eurozone authorities fail to contain sovereign and banking risk… Capital will flee from Europe’s periphery to the centre and from risky corporates to the remaining comparatively safe sovereigns”, he forgets that being the receptor of all that “”hot capital” flight, also carries enormous risks. 

Anyone should be free to manage risks the way he likes, and if someone wants to buy from an economic growth political risk ratio from Mallaby, he should feel absolutely free to do so. But, to sell us the institutionalization of a risk-neutralizing product, right now when our economies have been so neutralized by one of these, sounds to me too much like selling us magical potions on a country fair. So, no thanks!

Finally some real heavy-weight support!

Sir at long last an important number of academicians are speaking out asking to remove “the biases created by the current risk-weighting system” imposed on the world by the Basel Committee on Banking Supervision for the purpose of determining the capital requirements of banks, “Healthy banking system is the goal, not profitable banks” November 9.

The hundreds of letters related to this issue that I sent to the Financial Times over the last five years, and that were ignored, will serve as proof of the immense difficulties of fighting a regulatory paradigm that sounds so extremely logical as capital requirements based on (ex-ante) perceived risk does, but that is still so utterly faulty. In fact it has proven even more difficult than making Citi’s Charles Prince stop dancing.

I hope that the fundamental revisions to the financial regulations, when they come, as they sure will come, will also include the need of avoiding the trap of placing important regulatory issues in the hand of non-transparent mutual-admiration clubs like the Basel Committee which are not diversified sufficiently so as to avoid the risk of degenerative intellectual-incest.

By the way, just for additional clarity, I wish the title of their letter had said “Healthy and useful banking system is the goal”, but again I am more than glad enough, for the time being.