Chile can also set a great example for the developed world.

Sir, in “Chile can set an example for the developing world” FT, March 10, 2022, you refer to “the risk of European levels of debt”

With bank capital requirements mostly based on perceived credit risks, not on misperceived risks or unexpected events, like a pandemic or a war in Ukraine, you can bet that, at any moment, many banks will stand there naked, precisely when they’re most needed. 

When that happens Chile could set a great example for the developed world… and FT could provide much help with a Big Read that describes better than I can, how Chile so intelligently managed their huge 1981-1983 bank crisis.

The main elements of Chile’s plan were, in general terms:

a. The purchase of risky/defaulted loans by the Central Bank by means of long-term promissory notes accruing real interest rates and with a repurchase obligation out of the profits of the banks' shareholders before those promissory notes came due, plus some limitations on the use of their operative income… e.g., limits on bonuses. 

b. A forced recapitalization of the banks, in those pre-Basel days one capital requirement against all assets, and in which any shares not purchased by current shareholders, would be acquired by the Central Bank, and resold over a determined number of years. 

c. And finally also an extremely generous long-term plan for small investors to purchase equity of banks. 

Just think about where e.g., Deutsche Bank could be, if the Bundesbank and Germany’s Federal Financial Supervisory Authority (BaFin), had applied a similar mechanism during the 2008 crisis?

Here's more details on Chile's handling of its bank crisis

PS. Not the first time I suggest this

@PerKurowski

With respect to Eurozone sovereign debts, European banks were officially allowed to ignore credit ratings.

Sir, Rachel Sanderson writes, “Data from the Bank of Italy on holdings of Italian government debt, usually the prime conduit of contagion, suggests any Italian crisis now will be more contained than in the 2011-12 European debt and banking crisis, argue analysts at Citi” “Rome political climate is uncomfortable even for seasoned Italy Inc.” August 22.

“But Citi [also] warns of sovereign downgrades. Italy is now closer to the subinvestment grade rating threshold compared with 2011, according to all three main rating agencies.”

But the European authorities, European Commission, ECB all, for purposes of Basel Committee’s risk weighted bank capital requirements, officially still consider Italy’s debt AAA to AA rated, as they still assign it a 0% risk weight.

So in fact all the about €400bn of Italian government debt Italian banks hold, and all what the European financial institutions hold of about €460bn of Italian sovereign debt, most of it, are held against none or extremely little bank capital. Had EU followed Basel regulations they would have at least 4% in capital against these holding, certainly way too little. Lending to any private sector Italian would with such ratings would require 8% in capital… the difference is explained by the pro-state bias of the Basel Committee. 

And that is a political reality that must also be extremely uncomfortable for the not sufficiently seasoned European Union Inc.

Sir, what will the rest of Europe say when they realize that it was not all Italy’s fault, as it was not all Greece’s fault?

@PerKurowski

How many Greece will it take before the bank-sovereign doom loop is really discussed and then dismantled?

Sir, Isabel Schnabel, a member of the German Council of Economic Experts writes about a “contentious issue: the regulation of banks’ sovereign exposures. Currently, this benefits from regulatory privileges, being exempt from capital requirements and large exposure limits. The result is high volumes of sovereign debt on banks’ balance sheets, with a strong bias towards domestic bonds… it is up to the European Commission to shift this important issue to the top of the agenda”, “How to break the bank-sovereign doom loop”, August 29.

About time! It is now thirty years since regulators, with the Basel Accord, Basel I, introduced risk weighted capital requirements for banks; and thereto assigned risk weights of 0% to sovereigns and 100% to citizens, and so gave birth to the bank-sovereign doom loop.

It was European Authorities who assigned a 0% risk weight to Greece and thereby doomed it to its current tragedy.

If there is something the EC firsts need to come clear with, is how that happened.

When I first heard rumors about that regulatory statism, around 1997, I just did not believe it… I mean did not the Berlin wall fall in 1989? 

In a letter published by FT in November 2004, soon 14 years ago, I wrote: “We wonder how many Basel propositions it will 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.” And of course that applies to developed nations too.

Why has this issue never really been discussed? How come the world has allowed itself to be painted into a corner with sovereign risk-weights it dares not change scared of that would on its own set off a crisis? Why did Greece have to pay for a EU mistake? Is that a way to treat a union member? And thousands of questions more.

Sir, how do we stop this "I guarantee you and you lend to me (against no capital)” incestuous relationship between sovereigns and banks?

@PerKurowski

Europe (and the rest of the world) needs to get rid of the distortions produced by QEs and risk weighted capital requirements for banks.

Sir, Karen Ward, discussing ECB’s asset purchase programme writes: “It’s very hard to get the population to worry about government borrowing when interest rates seem impervious to how much the government wants to borrow”… “to truly put the European economy on a long-term sustainable footing it may be time for the ECB to step back and let the market do its job”… “Bond vigilantes are an essential part of the micro economy and vital for a thriving macro economy” “Investors should resist urge to run for the hills if ECB calls time on asset purchases” June 12.

Absolutely! Right on the dot! But besides suspending the distorting asset purchase program, there is also much need for to eliminate the risk weighted capital requirements for banks, that which so much and so uselessly distorts the allocation of bank credit to the economy.

PS. “Mario Draghi, ECB’s president, is under pressure to provide guidance” Forget it! Draghi is one of those regulators who decided to assign a 0% risk weights to sovereigns like Greece, and thereby helped to cause the crisis. Therefore Draghi should be prohibited to provide any further guidance.

https://teawithft.blogspot.com/2018/06/to-salvage-european-union-its.html

@PerKurowski

FT, how can you with a straight face hold that bank capital buffers in EU are more ample than they were five years ago?

Sir, you write “True, banks’ capital buffers are more ample than they were five years ago”, “EU bank regulators need to do more to foster faith”, August 1.

More ample? That is just if you believe the regulators’ risk weights are correct… something which was evidenced in 2007-08 they were not.

Because, if you read EBA’s stress result, you should have read that “the aggregate leverage ratio decreases from 5.2% to 4.2% in the adverse scenario”.

And in terms of real leverage that means that in their “adverse scenario” the bank leverage of equity increased from 19.2 to 23.8 to 1… and that’s just the average!... Which means the real capital buffers, those of real unadulterated life, are just smaller.

@PerKurowski ©

When paid by Volkswagen, the fines should go to patent free research of better diesel engines… and emission controls

Sir, Brooke Masters write “Drivers who bought VW’s “clean diesel” engines are now faced with technical fixes that could well reduce both fuel efficiency and power. Their communities have much dirtier than anticipated air” “Lawsuit on behalf of 1m $1 investors is something to fear. Somebody ought to sue” October 3.

Indeed but when suing make sure that if you win it can make a difference, not just make up for something secondary.

Many Volkswagen’s diesel engine buyers, who said they bought it out of environmental concern, many of them just green show-offs, now have a legitimate grievance being left out hanging like fools. But, if they are going to sue, they should at least request that, if successful, all fines paid by VW should go to finance the development of patent free better diesel motors.

Brooke Master’s also writes: “There are many frivolous [and not non frivolous] law suites were the attorneys on both sides walked away with millions of dollars in fees”. And with that she reminds me of that, at least in the case of banks being sued, all lawyers should be paid their fees in bank shares… I mean so that we do not hurt the lending capacity of banks and with that of ten thousands of innocent bystanders borrowers… the sort of civilian casualties.

Perhaps if we start looking into the issue of where compensation payments and fees go to, and how it is paid, then perhaps we will start looking at tort reform from a much more productive angle.

@PerKurowski

Warning: The “much more bank equity” puritans, while correct, if told to implement it, might be extremely dangerous

Sir, I refer to John Plender’s “Prospect of fund outflows puts banks in tricky territory” October 15.

In it he writes: “Bloomberg has estimated that the cost of equity of 300 large banks was 13 per cent at the end of March, 5 percentage points higher than its 2000-05 average. The authors [of The International Monetary Fund’s Global Financial Stability Report] reckon that the return on equity at banks accounting for 80 per cent of total assets of the largest institutions is lower than the cost of capital demanded by shareholders. This return on equity gap casts doubt on their ability to build up capital buffers to address the next crisis.”

That should be a clear indication of the difficulties that lie before the banks, and a warning sign of having to be very careful with all those puritans out there screaming for much more bank equity, no matter what, and not caring one iota about how to get from here to there.

PS. The first article I ever published, in June 1997, was titled “Puritanism in banking”. In it I wrote: “If we insist in maintaining a firm defeatist attitude which definitely does not represent a vision of growth for the future, we will most likely end up with the most reserved and solid banking sector in the world, adequately dressed in very conservative business suits, presiding over the funeral of the economy. I would much prefer their putting on some blue jeans and trying to get the economy moving.”… It seems like time has stood still.

Can bank regulators keep silence on the conversion to equity probabilities of cocos?

Sir, I have one question in reference to Alice Ross’ and Christopher Thompson’s “German banks line up to join coco party”, April 24.

Do regulators have any moral or formal duty to reveal to any interested buyers of cocos if they suspect the possibilities of these having to be converted into bank equity being very high? I say this because if so, and if they keep silent on it, that would make them sort of accomplices of bankers. Would it not?

Of course banks need capital, lots of it, but tricking investors into it, does not seem like the right way for getting it.

With respect to increasing bank capital we need banks and regulators to be partners, not enemies.

Sir I refer to Gina Chon and Camilla Hall’s “Fed looks beyond bank’s financial targets” March 27.

As a result of regulators falling for the risk-weights’ trick, banks are now, ate least when compared to pre-Basel Committee history, dramatically undercapitalized. It behooves everyone in the economy to see that capital increased substantially so that bank credit is not unduly blocked.

I have no idea of what the Fed saw in Citibank when performing its stress testing and that caused it to reject its capital plan for dividends and share buybacks, but I do know that if the word “punishment” describes it appropriately, the Fed is on the wrong track.

If the real economy is going to get out of this mess… and it is a mess… the Fed and the banks must be partners in finding lots of new bank capital in a credible way. And bank capital will not be raised sufficiently by mistreating the shareholders of banks… nor by fooling some investors into buying Coco bonds, suspecting the probabilities for these to be converted, are knowingly underrepresented.

In fact the Fed and other regulatory authorities must tread on the issue of Coco bonds with extreme care, less they also be liable for withholding information and misrepresentation. And for this I refer to “Flurry of Coco bonds sends yields tumbling” by Christopher Thompson.

If I buy a Coco today and become converted into a bank shareholder three years from now I guess I cannot complain... but what if that happens three weeks from now?

What European banks need is not to de-leverage but more capital, lots of it

Sir, Christopher Thompson reports on a Royal Bank of Scotland analysis that states “Banks need ‘to shrink’ balance sheets, to shrink their balance sheets dramatically to ensure that the continent could withstand another financial crisis… But as European banks deleverage, such as by selling loan books, there are knock-on effects to the real economy… It’s a catch-22”, July 22.

Forget it! What Europe's real economy and European banks need is more bank capital, lots of it.

Beware of bank regulators acting like gods

Sir John Plender asks what is the right level of capital for today´s financial world, “Investors pray for acts of God but even they come at a cost” December 19. His question contains its own answer. Since it is in fact impossible to calculate the right capital then the best thing would be to be humble about it and require one single capital requirement for all assets, instead of arrogantly trying to outwit the market as the regulators did when they created their current minimum capital requirements that differentiates based on how risks are perceived, primarily by the credit rating agencies.

It is when the bank regulators themselves start acting like God that they really set us up for the big systemic disasters.

We need to rewrite bank regulation from scratch before accidents are unmanageable

Sir Martin Wolf asks “how do banks get away with holding so little capital that they make the most debt-laden of private equity deals in other industries look well capitalized?”, “Why banking remains an accident waiting to happen”, November 28.

Mr Wolf could do well reading carefully the minimum bank capital requirements that have been imposed on the banks by their regulators. There he would see that if the banks lend to the public sector, or to creditors qualified as utterly safe by the credit rating agencies, such as securities backed by subprime mortgages, they need very little capital. If, on the contrary they would want to give credit to an unknown and not to well capital endowed entrepreneur, who might help to create those decent jobs the society needs, then the bank has to put up a lot of capital. With this incentive structure guess which route the banks are taking?

Wolf also mentions Henry Kaufmann’s suggestion to submit to special intense scrutiny banks that are deemed “to big to fail”. As the failure of any of this to big to fail banks would clearly have much worse consequences for the world than a little Northern Rock has, I have always suggested that the best way to insure us against the putting all the eggs into the same basket risk, is a small progressive tax on the size of banks. We might lose out on some of the economies of scale, but then again we have always been told that you can’t have the cake and eat it too.

Give the banks some time to adjust

Sir currently when financial assets like the bonds collateralized with subprime mortgages suffer a downgrading by the credit rating agencies, a bank, according to the minimum capital requirements, has to come up with new capital in the case he did not have more capital than needed. When downgradings become epidemic, as currently is the case, this might force such a scramble for bank capital that it could make matters worse.

Again, many downgradings are really not about the assets turning sour but more about discovering that they always were and so really the capital should have been there from the very start, and if so why the rush to now fix it all immediately if the rushing might turn into panic?

In this respect I would suggest that our bank regulators start thinking about giving the banks some time to adjust their capital base, for instance by giving them at least one year to come up with more capital for any asset that is suffering epidemic downgradings.

Why should bank regulators be so lenient? Well for a starter they were the ones who got us into this mess with their minimum capital requirements adjusted to risk invention and with their appointment of the credit rating agencies as their financial commissars.