When the going gets risky, the risky should get going!

Sir in your “Financial markets at their wit’s end” August 13 you hold that in the midst of all turmoil “credit market stayed relatively robust. Much sovereign debt in fact rallied”. 

Currently banks facing scarcity of regulatory capital are forced to go where the capital requirements are the smallest. If you want to call that something related to a robustness of the credit markets I guess you have not asked the opinion of those bank borrowers whose access to bank credit is being severely curtailed because lending to them requires a lot of that capital. 

It is vital for the economy that the natural risk-takers, the “risky” small businesses and entrepreneurs, have access to bank credit in competitive terms, and that it is not monopolized by those belonging to the regulatory “safe” franchise, the sovereigns and triple-A rated. Any levelheaded regulator would, in an emergency like this, long ago have reduced substantially the capital requirements for banks when lending to the “risky”, instead of sometimes even allowing a very risky zero capital when lending to some of the “safe”.

“We need to learn how to fail”

Sir, in the first session of IFC’s and World Bank’s “Building Competitiveness” FPD Forum 2011, April 4, titled “Youth, Employment, and Revolution in the Middle East, Amr Shady, the CEO of T.A. Telecom of Egypt, said something like: “US entrepreneurs know how to fail, our entrepreneurs need to learn the skill of failure, so to have access to the resources we can pivot into successes”... That should be applicable to South Africa too.

That is a message that should urgently be conveyed to the Basel Committee for Banking Supervision and the Financial Stability Board where they keep insisting on raising the incentives for banks to lend to what is officially perceived as not risky and to avoid like plague what is officially perceived as risky. With it, instead of having the banks fish for something important and productive in risky deep waters, they make them waste their time fishing in unproductive triple-A rated shallow waters... where they nonetheless overcrowd and drown.

PS. Please free us from imprudent risk aversion 

The regulator was the noisiest!

Sir, Justin Baer in “Noise of the financial herd will drown out risk concerns? February 5 writes that the crisis exposed flaws in the way Wall Street measures and limits risks. That might be, but let us never forget that the biggest flaws of them all were those present in the bank regulations of Basel II, which allowed banks to leverage their capital 60 times and more just because a triple-A rating was involved in the operation, like in the case of most of those collateralized debt obligations referred to in the article.

If there was a margin of 1 percent in the operation, then the returns on capital could be catapulted into over 60 percent a year. Talk about real noise!

The bank crisis and the Basel Committee banking regulations explained to a golfer

Once there was a golf Club with a somewhat narrow golf course and where, even though the members were very careful, sometimes the hooking or slicing of the golf balls into adjacent holes, caused some serious accidents.

The Club’s Board was ordered to find a solution. To that effect the elected members of the Board consulted with some Experts and asked for recommendations. The Experts told the Board “most of the slicing and hooking is the product of bad players and so, if you want to solve this problem, you need to get rid of them”. Knowing this idea would not be received with much enthusiasm, and could in fact pose a direct threat to their reelection as members of the Board, they all decided to immediately delegate the “how” to a Committee of Experts.

The Committee of Experts decided that they needed to appoint some Golf-Player Rating Agencies (GPRAs) to rate the real quality of the players and thereafter created a parallel handicap adjustment requirement that effectively eliminated the bad players… without these even noticing it. According to their ratings, the AAA rated players had their normal handicap increased by 5 strokes, while the players rated B- or worse had their normal handicaps officially reduced by 5 strokes.

It worked! Though, just initially… Since having to play with a very low handicap was pure hell for a bad player, most of the bad players rapidly decided to change clubs and, as a result, the Club gained immense recognition for having the best players and being the safest club in the country… and the Committee of Experts was wildly acclaimed for having true experts. We will never ever have more accidents in our Club… was the Board’s self congratulatory message at the year’s end… four years ago.

But life is life, even among golfers, even in a golf club… and so the membership of the Club started changing. For instance, many great golfing has-beens around the country were attracted by a system that so clearly could help to pro-cyclically prolong their golf-life, just like many never-able-to-be-good players were also attracted by the possibility of joining a club renowned for having exclusively good golf players… and so they all started to read up and converse with the GPRAs about what was necessary in order to be conveniently rated.

There was such an avalanche of enquiries that the GPRAs got confused and overworked and started to make mistakes… to such an extent that the Club rapidly became overcrowded with dubiously rated golf-players. This would, of course, not have meant anything in the old days, but, since everyone had been duly informed that the accidents had been forever eliminated and that therefore there was no need for being careful… the accident rate shot up and rapidly turned, three years ago, into a pandemic disaster that threatens even the survival of the Club… and aggravated by the fact that the beginners and the decent-bad players, those who really are the heart and soul and economical support of a golf club, want nothing to do with a club that has a handicap system that so harshly discriminates against them, and have therefore joined other clubs.

But, golfing friends, the saddest part of this story is that since the logic of “getting rid of bad players and allowing only good players” sounds so very attractive and so very logical, the Board has not even today understood what they did wrong and so they insist on using exactly the same Committee of Experts to come up with better solutions. And the Committee of Experts is currently studying only refinements of their original handicap adjustment requirement formulas because, as “experts”, they cannot under any circumstances acknowledge that they were so fundamentally wrong.

And, unfortunately, the local media is not sufficiently "without fear and without favour" to dare to really fundamentally question the wisdom of the local Club´s Board or of the Committee of Experts.

FT, you are looking in the wrong direction and with the wrong glasses.

Sir, in “A sector still in need of reform” September 27 you write “if the regulator disliked the approach a bank was taking, it could increase the capital charge to offset the higher risk”. May I humbly suggest that phrase proves that, as so many others, you do not really understand the real problem.

If a regulator suddenly disliked something an approach a bank was taking, chances are that the banks would already discovered it themselves and taken measures. Why do you suppose regulators know more than bankers? If you think so why do you not make regulators the bankers? No the real risk, and what caused this crisis and all others, lie always in all the approaches both bankers and regulators like the most, and that precisely because of that can grow into a dangerous systemic risk.

When regulating banks more than concerning yourselves with what you do not like or perceived as risky, you need to worry much more about what you and the bankers like and perceive as not risky.

Bank regulators need a better understanding of risk

Sir Martin Wolf holds that “The world economy has no easy way out of the mire” February 24. Who could argue with that... except perhaps in terms of it being an understatement.

Wolf holds that, ceteris paribus, we will not get out of the crisis unharmed and that either through a bigger financial crisis in the future or the “the fiscal rope” running out we will ultimately have a “sovereign debt crisis”. No doubt he is right. And as the only possibility for avoiding collapse he argues, quite correct again, having the world to grow out of its debt overhang.

But what I have not been able to convince Martin Wolf about, no matter hundreds of letters is that to grow out of the debt overhang we need a completely different paradigm with respect of how we regulate our banks. The current one, based exclusively on risk-avoidance, will not take us anywhere and on the contrary will just help to reinforce the dangerous fairytales that there are enough safe-havens and AAAs to go around for all, and that it is in safe havens you can generate real growth.

Martin Wolf quotes William White former chief economist of the Bank of International Settlements referencing “the explosion of the balance sheet of the financial sector and increase in its exposure to risk” as one of the imbalances that led to this crisis.

If our bank regulators were more capable of performing what Arthur Koestler labelled as bisociation they would have long ago discovered the irony in that the explosion of the balance sheet and the exposure to risk that occurred and failed was almost all in supposedly risk-free AAA rated operations.

If all the bright students went to Wall Street… who became the regulators?

Sir Avinash Persaud declares “risk is a chameleon” and then describes many absolutely perfect reasons why no one should build a bank regulatory system centered around capital requirements based on perceived risks; all this reasons perfectly ignored by the regulators, “Boomtime politicians will never rein in the bankers” November 27.

Having often in serious jest forwarded the idea that perhaps bank capital requirements need to be higher for what is perceived as risky since that perception could introduce pro-cyclicality and carelessness into the system I fully agree with Persaud’s comments on risk.

Persaud also asks “why the universities and press, falling over themselves to kick bankers today, did not play a more effective counterveiling force” hindering the bankers from capturing the regulators. To phrase that question one has to assume the expert PhDs and expert reporters really knew what was going on, but seeing that so many of them are still not capable to free themselves from the paradigms they bought and wake up to the real facts, that might not really be the case; which is of course even more unfortunate for us all. They say that all the bright students went to Wall Street… if that’s true, then who stayed at the universities, who went to the press and who became the regulators?

The regulator should regulate not discriminate

Sir Dirk Bezemer in “Lending must support the real economy” November 5, points in the right direction, but yet fails in connecting all the dots. When a bank lends to the really real economies, the unrated or BB+ and below rated clients, it is required to have 8 percent equity, while, when lending to or investing in anything related to an AAA rating, then the bank gets off the hook with only 1.6 percent in capital. This signifies a de facto subsidy to those who least need the support and, in relative terms, a tax on those who most in need of support. Therein resides the fundamental equivocation of the current bank regulations designed by the Basel Committee.

While the banks are having to rebuild their capitals to make up for all those “no risk” AAA rated operations that went gone wrong the real economy, we have to see to that the really real economy is not crowded out from access to bank credits. In this respect I am doing what I can to pro-bono lobbying in favour of temporarily reducing the capital requirements for banks, when lending to unrated clients or to BB+ and below rated clients, to 4 percent; and that later, once out of the woods of this crisis, when capital requirements are further strengthened, the capital requirements are the same for all type of access. A regulator is there to regulate and not to discriminate.

Risk avoidance is an extremely risky business

Sir surprised I read Mr. Stuart M Turnbull´s and Mr. Lee M. Wakeman’s whishing that “the rating agencies published and kept current, term structures of survival probabilities [so that] investors would be able to compare directly the risk of default for various maturities across corporate and municipal bond markets”, “Investors value accuracy ahead of stability” October 8.

Since presumably the whole market, and not only these two gentlemen would have access to this information, have they not given a thought to what this would do to the risk-weighted returns they would receive? I will tell them. They would be condemned to absolute mediocre return rates, as the intermediaries will previously have sucked out any arbitrage profits there are… that is until the day the credit ratings get it wrong again, as they, being humanly fallible are doomed to, and that day they lose it all unless, they are again bailed out by their grandchildren picking up the tax tab.

Yes, the investor values accuracy and stability, but they also value the possibility of some special returns, just for them. If these two gentlemen believe there is even a remote possibility of regulating a financial market so that it will be just and fait to everyone, when all the rest is not just and fair, then they clearly belong among all the other naïve and gullible financial regulators out there.

John Kay is utterly lost!

Sir over the years I have often commented on John Kay’s articles, sometimes I have agreed, sometimes I have disagreed. But now I have been utterly disappointed discovering that Mr. Kay does not really know what he is talking about. In “Narrow banking can help protect the taxpayer” September 16 he writes “An 8 per cent capital cushion is inadequate as the amounts for winding up these banks will show”. Absolutely wrong! For those credits not perceived as risk-free and for which the banks took their ordinary precautions the 8 per cent equity requirement was most probably quite sufficient. What was highly insufficient was the only 1.6 percent capital requirement allowed by the regulatros for any operation involving an AAA rated security or client.

It was not the risky which provided the explosive material for this crisis but the not-risky, something that Mr Kay proposes we pursue even more, burrowing ourselves into narrow banks, so that once again we can feel the bliss of believing we are safe… so that once again we place ourselves further away from the risks we need to take in order to move forward.

No, Mr. Baby-boomer Kay, move over and let the future take over, even if it entails risks.

The originally “risky” are being diabolically squeezed

Sir Gillian Tett in “Pipes remain clogged even as liquidity is pumped in” August 7, writes that “now most banks seem unwilling to use spare liquidity to engage in activity that regulators or shareholders might deem risky”. This is not surprising, anything risky requires more regulatory capital, and the banks have more than enough with all their currently outstanding loan and investments that require more capital when they are downgraded, and so even though the banks have liquidity they cannot afford more risky business.

This is placing an excruciating squeeze on the weak and more risky clients of the banks, because even if these are performing much better than the originally “risk-free” banks might choose to liberate capital by getting rid of these exposures without booking losses so as to be able to keep on the books AAAs turned into junk and that if sold would hit the banks harder.

Also let us not forget that the capital requirement for any investment in an AAA rated public instrument is 0%. In all, with their minimum capital requirements for banks based on risk, the regulators have created a monster.

Risk is risk is risk!

Sir David Walker with “America’s triple A rating is at risk” May 13 gives new evidence on how dangerously the world has got itself trapped by some erroneous concepts about risk. Of course, America’s triple-A rating is always at risk, there is no absolute quality or anything inherently permanent with a credit rating, this no matter how much the financial regulators want us to think so.

That the US, and the dollar are in trouble, that there can be no doubt about, but the truth is that the US and the dollar could still remain for a very long time the most de-facto triple-A in the world, because, at the end of the day, risk is always relative, except of course, when we really reach the end of the day.

Now on the rest of David Walker’s message I could not agree more. Last year, during the annual meeting of the World Bank and the IMF, I went around asking “how are we going to pay for it all?”, and proposing a new generation of taxes, such as taxing income from protected intellectual property rights, only to be met with a “what is he talking about?”

Revamp completely the minimum capital requirements for the banks

Sir (as you probably must gather from my hundreds of letters to you on the subject and that you decided to ignore for reasons of your own) I totally agree with John Stroughair in that “Rating agency system stifles innovation and competition” March 5. The fact though is that the reason that we even have to discuss the issue of the credit rating opining are minimum capital requirements for the banks issued by Basel which stifles something worse risk taking and promotes something really bad, the reliance on others.

Currently if a corporation is rated AAA to AA- a bank needs to hold only 1.60 dollars for each 100 of lending, which signifies an astonishing 62 to 1 of authorized leverage. But in the case of a corporation rated below BB- the banks need to hold 12 dollars for each 100 of lending, 7.5 times more than in the case of an AAA, notwithstanding the fact that the bank will most certainly be more careful when it comes to lending to a below BB- corporation than to a AAA.

The difference of 10.40 dollars of required equity, especially in times when bank equity is so scarce and expensive, is a de-facto regulatory tax on risk, levied on top of what the market requires for accepting risks and which stifles anything that smells innovation and which often implies more perceived risk.

In this respect it is not only the credit rating agencies we need to get rid of but also of the current malfunctioning system of minimum capital requirements based exclusively on the limited concept of default risks. Just as an example, is not the risk of the default of our planet because of climate change much worse?

The scary cognitive dissonance of the Basel Committee

Sir Whitney Tilson in “Lessons to be learnt from losses” February 10 writes about some harmless “cognitive dissonance” in a group “who believed the earth was going to be destroyed by a flood on December 21, 1954” and then extrapolates from that in order to explain some recent investment behaviour.

But there is also quite dangerous “cognitive dissonance”. For instance the way in which the Basel Committee is now responding to its absolute failure in trying to avoid a crisis by creating disincentives for bank to assume credit risks as measured by others, is now slowly evolving into the belief that they could and should measure and fight systemic risk. That is indeed a really scary “cognitive dissonance”.

Please, do not dig us deeper into the sophistications of risk management!

Sir Michel Schrage in “How to sharpen banks´ corporate governance” November 18, tells us “that the most important governance reform in financial services would make risk management the explicit duty of the board.” “insisting that directors be more conversant in and accountable for risk.”

As someone who knows quite a bit about risk management and that also, while an Executive Director served on the audit committee of the World Bank, drowning in Sarbanes Oxley procedures, I feel this is a very dangerous approach that could lead to an over-specialization of the boards which would, sooner or later, end up with some extremely sophisticated blinds leading some quite expert blinds.

No, what we need is a much diversified board of directors, where before any approval all directors have to certify, in writing, that they fully understand what they approve. What cannot fully be understood, by reasonably intelligent Directors, without a PhD in financial risk management, has absolutely no place in any financial institution that has the benefit of a public lender of last resort.

This is especially so because financial studies of financial risk management does not guarantee knowing about all the risks of life in general, such as the possibility of credit rating agencies suddenly not knowing what they are up to and sending us, the herd, away into crazy directions.

And with respect to the “too big to fail” the solution is simple. A tax on size, because the bigger they are the more it will hurt when they fall on us, as they will, sooner or later.

And good luck to them!

Sir Ms Gail Easterbrook in his letter “Act locally to embed the right attitude to risk” November 17 when referring to giving new regulatory powers to IMF to provide “early warning” of risk to the global economy summarizes it adequately with an “And good luck to them.”

The case for more humility and lower expectations with respect “early warnings” is laid out with crude clarity by the United States General Accounting Office (GAO) in its study of the IMF’s capacity to predict crisis, published in June 2003 (SecM2003-03-734). In it, GAO states, among other things, that of 134 recessions occurring between 1991 and 2001, IMF was able to forecast correctly only 11 percent of them, and that it was similarly bad in forecasting current accounts results. Moreover, when using their Early Warning Systems Models (EWS), in 80 percent of the cases where a crisis over the next 24 months was predicted by IMF no crisis occurred. Furthermore, in about 9 percent of the cases where no crisis was predicted, there was a crisis.

Ms Gail Eastebrook also receives my warmest nod of approval when reminding us that we need to embrace risks and that “without risks there are no rewards”. This is something our financial regulators should have thought upon before they so arrogantly decided to drive risks out of banking, with their minimum capital requirements for banks based on a vague concept of risks of defaults, and that, because it also led the regulators to empower the credit rating agencies, created the current crisis when these lousy pipers led us into the swampland of badly awarded mortgages to the subprime sector.

Financial traffic jams are also caused by financial Global Positioning System

Sir we are grateful to Christopher Caldwell for drawing our attention to "Traffic" by Tom Vanderbilt, "Caught in the human traffic", August 23. From what we see that book should urgently be made obligatory reading to all bank regulators in Basel, so that they learn what happens when you impose credit rating agencies as the Global Positioning System supposed to direct the financial flows of the world.

That "Predictions about traffic become 'self-destroying'" is exactly what lies behind that systemic risk that brought us the subprime mess. They should have known it!

"Once everyone gets the same reliable real-time information about traffic everyone mobs the same route" questions the whole underpinnings of our current bank regulations, namely that you are able to measure risks without affecting the risks.

When the book quotes German physicist Michael Schreckenberg "telling them the whole truth is not the best way" we begin to understand Angela Merkel's request for a purely European credit rating agency.

FT you’re obsessed!

Here is the world confronting truly frightening scenarios and one is trying to argue that one way forward is not to blindly pursue the avoidance of the risk of defaults, just for the sake of it, but to be able to better embrace the risks of default by placing them in the perspective of what could be achieved in terms of sustainable growth… and you keep on busy with your quite silly and almost sissy chit-chat on the testosterone levels among male traders, Calibrating cojones, April 16.

Let me just remind you so that you can get over this discussion and return to your senses, that for each trade induced by an overdose of testosterone, there should be a counterparty suffering from an under-dose of testosterone.

Have 100% guaranteed incomprehensive financial model…will travel!

This is a great and handy tool for hedge funds when valuating portfolios and that will produce maximum commissions; and for the large US banks that have recently been authorized by their regulators to apply Basel II rules and now need to catch up with European competitors in lowering their capital requirements.

Low maintenance costs with access to an exclusive well churned and pliable data set licensed by the proprietor and that reaches back to 1840 and is equally impossible to scrutinize.

A myth or a plain vanilla fraud?

Sir Tony Jackson in “Myth that could undermine credit derivatives”, July 2, describes the possibility that the traders on both ends of a deal could, by using their own models, show themselves to be making a profit for years and collect bonuses on these. Jackson describes these mark to market mechanisms in terms of myths, though I would read them slightly more like frauds. Anyhow it all makes me think that the hedge-fund-derivative traders could in a near future be facing the same type of difficulties a tourist has when he needs to talk himself out of a serious problem in a language no one understands... well until now they have all at least gained a lot in the translation.