A world obsessed with Best Practices may calcify its structure and break with any small wind.

Sir, Nicholas Dorn in his letter “Drive for global banking conformity increases systemic risk” of September 18, refers to your leader article, “Waning co-operation will make the next financial crisis worse”, and MEP Molly Scott Cato’s letter “Global finance can work if rulemakers co-operate”, September 14. Dorn writes:

“Converging international financial regulation encourages similar business models and greater homogeneity of finance, raising systemic risk”.

“No one knows where the next crisis is going to come from. The more useful question is how the propagation of crises through the system can be minimised”

“The plain implication is the need for greater variation in finance, so that such risks as do arise cannot so easily ripple through the global ensemble. What is desperately needed, therefore, is not bland global conformity but more variation between important regulatory regimes.”

I could not agree more. In April 2003, as an Executive Director of the World Bank, I made the following formal statements at the Board, which relate directly to those fundamental points Dorn raises.

"A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind.”

“Nowadays, when information is just too voluminous and fast to handle, market or authorities have decided to delegate the evaluation of it into the hands of much fewer players such as the credit rating agencies. This will, almost by definition, introduce systemic risks in the market and we are already able to discern some of the victims, although they are just the tip of an iceberg.”

What else can I say? Well perhaps that that statement also included:

“Basel dictates norms for the banking industry that might be of extreme importance for the world’s economic development. In Basel’s drive to impose more supervision and reduce vulnerabilities, there is a clear need for an external observer of stature to assure that there is an adequate equilibrium between risk-avoidance and the risk-taking needed to sustain growth”

Sadly Sir, as I have written to you umpteenth times, a different purpose for banks than just being a safe place where to stash away cash (and implicit to help fund the sovereign) is nowhere to be found in all the voluminous official writings about bank regulation.

Was I able to get my message thru? No! I guess the attraction of that with risk weighted capital requirements the regulators would be able to make our banks safer, was such that not even FT was (is) able to resist the songs of Basel Committee’s sirens. 

@PerKurowski

Globalizing the conclusions of members of mutual admiration clubs, like the Basel Committee’s, is a huge systemic risk.

Sir, I refer to Gillian Tett’s interesting discussion of Paula Jarzabkowski’s “Making a Market for Acts of God” “The doublethink insurance club”, September 26.

Tett writes: “insurance executives …love to talk about how they are now using diversified strategies that bundle different risks together, and price this according to a global pattern of supply and demand – or a “market”… But there is a rub. As consolidation has taken hold, this has cut sharply the number of players who handle reinsurance products – And [so] while the insurance companies say they want to “diversify” their risks, they are all doing this in exactly the same way –which produces less, not more, diversity.”

Indeed that of diversifying more and more in ever fewer and fewer diversified ways is a clear and present danger in days of increased globalization. The following is what I had to say on that subject in April 2003 at the World Bank, as an Executive Director:

“Ages ago, when information was less available and moved at a slower pace, the market consisted of a myriad of individual agents acting on limited information basis. Nowadays, when information is just too voluminous and fast to handle, market or authorities have decided to delegate the evaluation of it into the hands of much fewer players such as the credit rating agencies. This will, almost by definition, introduce systemic risks in the market and we are already able to discern some of the victims, although they is just the tip of an iceberg… A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind.”

Tett writes “this project touches on a point that matters beyond the insurance world: namely we all have an amazing tendency to fool ourselves… insurance brokers…they are so clubby that they are susceptible to both groupthink and doublethink – and an inability to see the contradictions that underpin their world.”

And if that goes for insurance brokers, then think of what a mutual admiration club of regulators could come up with, when trying to impose the same one and only set of regulations on the banks of the world. Holy moly! Just for a starter, when setting the capital requirements needed to partly cover unexpected Acts of God losses, without blinking, they decided to use the human perceptions of the expected losses… and no member of the Basel Committee club objected... naturally... members are not supposed to do that.

@PerKurowski

Nonsense! Why should ECB worry about banks' risk models being right, when its problem is when these are wrong?

Sir, I refer to Laura Noonan’s “ECB doubles the time needed for ‘intrusive’ review into banks’ complicated risk models”, August 18.

All those studies are utter nonsense. Let us suppose banks’ risk models work well. Would ECB have any problem with that? No! Its only problem is when those risk models do not function. And, so if you are going to ask banks to hold capital, it is precisely against that or any other unexpected risk… and frankly, who can evaluate those risks?

Noonan writes: “various studies have found widespread differences in banks’ Risk Weighted Assets models… The 123 banks together have more than 7,000 internal models”. Though all those models are most certainly used to justify lower capital needs of banks, I still find that slightly comforting… since, this way, there are less risk these could all be wrong in the same way.

Because when I read: “Harmonising supervisor’s approaches — including to risk models — was a priority, said the ECB.”, that scares me even more, because the possibility of introducing a fatal not diversifiable systemic risk is much increased. 

In 2003, as an Executive Director of the World Bank, with respect to Basel Committee regulations I warned: "A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind.”

The absolute least we must require of ECB is that all the consultants who would be working at this, and who at the end of the day are paid by taxpayers, put up their conclusions on the web, so that we can really shame them if they get it wrong. (Or shoot them if they get it wrong… since as a consequence much people will most likely suffer… and even die).

In my mind, and pardon the vulgarity, with these studies ECB is just trying to cover its behind… at taxpayers’ expense.

I dare ECB to allow me, on a pro-bono basis, to formally record my complete criticism of the pillar of current bank regulations, namely the risk-weighted capital requirements for banks.

ECB, IMF, Basel Committee, FSB, Fed, FDIC, Systemic Risk Council, anyone involved, for the umpteenth time I warn you: One thing is a simple fixed capital requirement on all bank assets, which allows the markets to figure out and manage the risks as best as it can. Something entirely different is many, few, or even one single model that sets the risk-weights that determine the capital requirements of banks. That can only confound the markets making it impossible for anyone to better estimate the real risks… making it more possible for the last safe haven to become overpopulated, and us dying suffocated there for lack of oxygen.

Please regulators… you are playing around with extremely dangerous explosive material.

In 1999 in an Op-ED I wrote: “The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause its collapse”

In 2008 we already saw one AAA-rated bomb explode… and we sure do not need more of those. 

PS. Come to think about it. This ECB research project sound about the most useless navel gazing project I have ever heard of. A risk model, if it is worth anything, must be very dynamic, meaning the one you researched like an hour ago, could perhaps have very little to do with the one being used in this minute. Or, will the banks now require ECB’s or Basel Committee's permission to change the model they use?

PS. On the other hand ECB’s research project formally indicts the Basel Committee and FSB as being clueless about what they are doing.

Just one more thing!

So ECB, during 4 years you intend to contract many expensive consultants to check 7,000 different models that determine the risks weighted assets of banks, in order to determine the risk for banks.

So ECB: How many consultants will be checking the risks all these risk-weighted asset models imply in terms of possible bad allocation of bank credit to the economy? 

@PerKurowski

A world obsessed with Best Practices may calcify its structure and break with any small wind

In reference to Mr. Flash Crash’s supposedly malevolent disruption of the market in 2010, John Plender writes interestingly about globalization, regulations and fragility “Global financial regulation meets a cul-de-sac” April 23.

In this respect I would like to recall a written statement that I delivered as an Executive Director of the World Bank on April 2, 2003, while discussing its Stategic Framework 04-06. In it I wrote:

“Ages ago, when information was less available and moved at a slower pace, the market consisted of a myriad of individual agents acting on limited information basis. Nowadays, when information is just too voluminous and fast to handle, market or authorities have decided to delegate the evaluation of it into the hands of much fewer players such as the credit rating agencies. This will, almost by definition, introduce systemic risks in the market and we are already able to discern some of the victims, although they are just the tip of an iceberg.

A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind. Who could really defend the value of diversity, if not The World Bank?"

http://subprimeregulations.blogspot.com/2003/03/my-comments-on-world-banks-strategic.html

@PerKurowski

It's what's safe that's risky!

When "setting bank equity requirements, it is essential to recognise that so-called “risk-weighted” assets can and will be gamed by both banks and regulators. As Per Kurowski, a former executive director of the World Bank, reminds me regularly, crises occur when what was thought to be low risk turns out to be very high risk." Martin Wolf

https://www.ft.com/content/7a95df3e-cb50-11e1-b896-00144feabdc0

Wolf ends with:“We cannot hope for miracles. But we can make bankers more useful and less dangerous. Focus on that.”

Indeed, let's all focus on that.

Please free us from imprudent risk aversion and give us some prudent risk-taking

My 2019 letter to the Financial Stability Board: Acknowledged and Ignored.

PS. Read what #AI ChatGPT OpenAI opines on this.

Here a 2010 homemade YouTube in which I tried to explain the Global Financial Crisis with a 2x2 matrix.

“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.” Paul Volcker

PS. 2023 tweets

A tweet: "Incentives matter: The escape valves of risk weighted bank capital (equity) requirements, cause banks’ risk models to be more about equity-minimizing/leverage-maximizing, than about analyzing bank assets’ true risks. That’s life!"

Another tweet: "The world has been duped/lulled into a false sense of security by the use of risk weighted assets (RWA) as a real and valid measure of banks' risk exposure. E.g., the duration risk of #SVB long-term government bonds is not included in the weighted risks."

Another tweet: “SVB regulators were ‘asleep at the wheel’” What’s a supervisor to do? Inform his boss Treasury bonds' 0% risk weight must be increased?  It is difficult to get a man to understand something, when his salary depends on his not understanding it” Upton Sinclair

Another tweet: "The most dangerous risk banks take, #unwittingly, is the buildup of huge exposures with assets perceived as safe, those which caused all major bank crisis. Regulators’ risk weighted bank capital/equity requirements, unwittingly, puts that risk on steroids."

Another tweet: "A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices [risk weighted bank capital/equity requirements] may calcify its structure and break with any small wind."

Another tweet: "Bank capital/equity requirements mostly based on perceived credit risks, not misperceived risks or unexpected events, e.g., covid, inflation, war, interest rate rise, doom banks to stand naked, when needed the most, when hardest to raise equity"

Another tweet: “A regulation that regulates less, but is more trigger-happy & treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might lead us to… the mother of all bank crises”

Another tweet: "Risk weighted bank capital/equity with decreed weights: 0% government – 100% citizens, as if bureaucrats know better what to do with credit than e.g., small businesses and entrepreneurs, is that communism, fascism or just plain vanilla Banana Republic?"

Another tweet: "#SVB have all besserwissers Monday morning quarterbacks explaining us duration risk; why holding long-term government bonds was dangerous. Not a word about why regulators require so little capital/equity/skin-in-the game against these assets.

Another tweet: "The stress test that shall not be dared. What if that what’s perceived as safe is more dangerous to bank systems than what’s perceive risky, and therefore the risk weighted bank capital/equity requirements do not reflect real bank risks?"

Another tweet: "When concocting the risk weighted bank equity requirements, evidently no regulator asked: What would Mark Twain opine about with what assets banks might create dangerously large exposures, with some perceived as risky or with some perceived as safe?

On bank regulations, I’m not a newcomer nor a Monday morning quarterback.