Thanks to bank regulators, if in need, there are now way too little defences to deploy in a countercyclical way

Sir, you hold that there are “reasons to be wary [as bank] regulation is, once again, being eased just at the moment when it ought to be tightened” “Easing financial controls is cause for wariness” March 11.

In support: “Many market participants, moreover, think credit and market cycles are at their peak — just the time when counter-cyclical defences might be deployed”

Sir, is it really when markets are at their peak that we should kick off its drop, by tightening regulations? At the peak of the market, what we really should have is our ordinary defences, like bank capital, to be at their highest levels, so that adequate counter-cyclical defences can be deployed if needed. Are these defences now at the highest? Absolutely not!

Why? Among others, the results from an absolute incapacity to comprehend the pro-cyclicality of many regulations, such as those of the risk weighted/ credit ratings capital requirements for banks. These are based on the ex ante perceptions of risk when times are good, and not on the ex post possibilities when times are less good. The result, in terms of deployable counter-cyclical defences, is total unpreparedness.

Sir you write: “A Financial Times series has highlighted the risks of the rapid expansion of credit to lowly rated, more indebted companies.” No that is wrong! It were the “good times”, made possible by low interest rates and huge liquidity injections, which allowed for too many securities to be rated, ex ante, as being of investment grade, which caused a rapid expansion of credit. What, ex post, perceived rougher times cause, is a rapid expansion of those securities becoming rated as junk.

@PerKurowski

The risk weighted capital requirements for banks, is the most potent steroid ever for having to suffer some truly bad “Minsky moments”.

Sir, John Plender correctly writes: “If Hyman Minsky were alive today, he would regard the current economic cycle as a testing ground for his instability hypothesis. That which holds the financial system has an innate tendency to swing from robustness to fragility because periods of financial stability breed complacency and encourage excessive risk-taking.” “Complacent investors face a Minsky moment as pendulum swings” November 14.

But what Plender does not mention, perhaps because it belongs to that which shall not be mentioned, is the greatest procyclical pro-Minsky-moment steroid ever, namely the risk weighted capital requirements for banks.

When times are good and credit rating outlooks are sunny, that regulation allows banks to leverage immensely with what’s perceived as safe but, when a hard rain seems its going to fall, and credit ratings fall, all recessionary implications are made so much worse by banks then, suddenly, having to hold much more capital… and since such capital might be hard to find during bad times, they take refuge in whatever is still perceived, or decreed as in the case of sovereigns, to be of less risk… just increasing the stakes

In 2004 I sent the first letter to FT on the pro-cyclical/counter-cyclical theme, FT never picked up on it.

Plender writes: “It is historically atypical in that central banks have been encouraging deflationary threat”. Really? At least with respect to banks they have encouraged these to build up ever-larger exposures to what’s perceived as safe, like residential mortgages, or to what’s decreed as safe, like loans to friendly sovereigns. 

https://teawithft.blogspot.com/search/label/pro-cyclical

@PerKurowski

Capital requirements for banks based on how much “distressed debts” hedge funds raise money?

Sir, Joe Rennison’s and Lindsay Fortado’s “Distressed debt tempts investors in anticipation of the next downturn”, June 19, raises the following question:

Could an index that tracks how “US hedge funds specialising in distressed debt are raising money in anticipation [of] the next economic downturn” be useful to base bank capital requirements on? 

At least it should be much better than current regulations, which allow banks to build up dangerous exposures to what is perceived as safe, against especially low capital requirements, especially when a Jason Mudrick, founder of $1.9bn Mudrick Capital can state “This economy is roaring right now”

@PerKurowski

It is the run of banks to what is perceived, decreed or concocted as safe that is scary

Sir, you opine: “If there was ever a moment for bankers to take on too much risk, thereby planting the seeds of a nasty downturn, it is now”, “The unsettling return of bullish investment banks” June 18.

Given current regulation a more exact phrasing of “to take on much risk” would be “to build up risky exposures to assets that are perceived (houses), decreed (sovereigns) or concocted (AAA rated securities) as safe against the least capital possible” 

When you write: “there are other indications of a cyclical top. Assets remain expensive worldwide, and in the US business confidence is at a peak, unemployment is very low and tax cuts have delivered a big fiscal stimulus”… you are describing a world in which the regulators with their risk weighted capital requirements, more than warning the banks are spelling out a go ahead. Their countercyclical capital requirements when leaving in place the distortions of risk weighing are a joke. 

Bank crisis never result from exposures to what is ex ante perceived as risky but only from exposures to something perceived as safe. By allowing those risky sized exposures to build up against especially little capital, the regulators have set bank crises on steroids.

The regulator’s tiny countercyclical capital requirements are, when leaving in place the distortions of risk weighing, just a joke. 

If only banks went for much more of the truly “risky”, like loans to entrepreneurs or SMEs. Those exposures would of course also be hurt in a crisis but, meanwhile, they could at least help our economies to move forward in a more dynamic way. Risk-taking is the oxygen of development. God make us daring!

@PerKurowski

IBM, Watson could have a role in regulations that accept the need of the real economy for banks to take credit risks

Sir, I refer to Richard Waters report on the difficulties IBM faces in expanding the application of its Jeopardy champion Watson, “FT Big Read: Artificial Intelligence: Can Watson save IBM” January 6.

In it quotes Lynda Chin mentioning the challenge that “On Jeopardy! there’s a right answer to the question, but, in the medical world, [in the real world] there are often just well-informed opinions… [So how to know] how much trust to put in the answers the system produces. Its probabilistic approach makes it very human-like… [Watson] Having been trained by experts, it tends to make the kind of judgments that a human would, with the biases that implies.”

Indeed how much trust is just another way of stating how much risk is one willing to take.

For instance if one wants driverless cars to provide absolutely security, then traffic will probably become very slow, or even come to a standstill. And one of the difficulties these cars will encounter will be based on defining the acceptable amount of risk taking.

Likewise, if one wants our banks to be absolutely secure, then one would be better off with hiding money under mattresses in bank vaults… but the real economy would be languishing because of the lack of credit.

So there might be a big role for Watson in bank regulations. First of all it could help me convince the Basel Committee of that their credit risk weighted capital requirements are based on a very faulty human bias against risk; something which at the end of the day only endangers banks, since it causes excessive exposures to what is perceived as safe, precisely that which has caused all major bank crisis.

And, if fed with continuous information on bank credit and the state of the real economy, Watson could also be used to automatically send out countercyclical adjustments. Too much growth in credit… increase capital requirements somewhat… too little growth in credit reduce capital requirements somewhat. The most important thing needed for that would be to make Watson immune to lobbying pressures of all sorts.

What I would not allow Watson to do though is to display that kind of human arrogance of thinking itself capable of setting different capital requirements for different assets, so as to distort the allocation of bank credit as it thinks fit to distort.

To do that, I would still want a human to be behind that kind of risk taking… of course a human who understand what he is doing and is willing to be held very much accountable, if taking the next generations down the wrong path.

@PerKurowski ©

Bank regulators make sophisticated remarks about the need of countercyclical regulations and design pro-cyclical ones.

Sir, I refer to Joe Leahy’s “Rating agency pressure on BTG Pactual” November 27.

Downgrading… depending on whether it crosses some regulatory thresholds, could mean banks are required to hold more capital against loans assets so affected. Were it to happen, this could, in a pro-cyclical fashion, only help to increase the resulting problems.

And what would usually trigger such a credit degrading? Mostly some unexpected events, like in this case the arrest of BTG Pactual’s chief executive, André Esteves.

And this evidences, for the umpteenth time, the dangers with using ex ante perceived expected credit risks to define the capital banks should hold against unexpected losses.

When the outlook is rosy and so many could be perceived as safe then the capital requirements go down, so bank can leverage even more, so bank can give even more credit, and everything will look even rosier.

When the outlook is darker and many could be perceived as risky, then the capital requirements go up, so bank can leverage less, so banks have to contract the credit they have awarded, and so everything will look even darker yet.

Regulators fill their mouths with sophisticated remarks about the need of countercyclical regulations but manage somehow, with a little help from silent FT, to avoid being held accountable when they design pro-cyclical nonsense.

@PerKurowski ©

After banks have placed assets on their balance sheets, they are de-facto “after the curve”

Sir, Gillian Tett with respect to the difficulties posed by a possible drop in the oil price write that “now [regulators] are keen to show they have learnt the right lessons from last decade’s crisis — by getting ahead of the curve and forcing banks to be tough”, “The tangle of loose lending to tight oil” October 16.

Getting ahead of what curve? In the case of bankers after they have placed the asset on their book they are already de facto after any curve that is going to be thrown at them.

What is it with these statists? They abhor fiscal austerity and they love lots of QEs and minimal interest rates, but they do instruct banks to be austere… and regulators have many adoring fans cheering them on.

Why do regulators require banks to act be pro-cyclical and not counter-cyclical? If when oil were over $100 per barrel, banks would have stopped putting oil related loans on their balance sheets… that would have meant, quite correctly, “getting ahead of the curve”.

When will regulators learn… or it is just so that they just refuse to learn? 

PS. How long will we have to live with dumb regulators who make banks clear for ex ante perceived credit risk in their capital... when that is about the only risk banks have already cleared for, with interest rates and amounts of exposures? 

@PerKurowski ©

Bank fines should be paid with bank equity, not with cash, unless we are masochists and want to be cruel to the economy.

Increasing the capital requirements for banks in the midst of a slow economy, while at the same time eroding bank capital with fines, is sheer economic cruelty… pure masochism. And especially so against those who for which cruel regulators decided, for no other reason that they think that to be a great idea to keep banks safe, that banks need to hold especially much capital when lending to them, like the SMEs and the entrepreneurs.

Sir, with respect to the reimbursement of claims for mis-sold insurance, you write that “As of this year, banks have already paid out about £20bn” and at long last take notice of that “The consequent erosion of banking equity can hinder credit provision in ways that damage the economy as much as the stimulus has helped” “UK banking’s sorry tale draws slowly to a close” October 3.

At long last FT! £20bn times a prudent level of 12 to 1 leverage gives you £240bn less lending capacity… at current imprudent sort of 30 to 1 leverage that would signify £600bn less lending capacity.

I hold “At long last FT!” because I have written you several letters on this problem but that, as usual, for your own internal reasons decided to ignore.

But I repeat. We must find a new way of imposing fines on banks. I have suggested that instead of cash banks pay in new shares issued at current market value. These shares if paid to the State could be non-voting and if paid to persons, like in this case, could include preferred dividends for some years.

PS. Having those mistreated by banks become their shareholders, seems like a innovative way of educating banks  J 

PS. Allowing authorities decide at each moment in what proportion of cash or equity these fines should be paid, would give them a new countercyclical tool  J

PS. The payment in bank shares should apply, of course, to all legal fees too J

PS. How come so many that loudly complain about government austerity loudly support bank credit austerity… do they all carry the virus of statism in their hearts? L

@PerKurowski

The standardized risk-weights of Basel II, provided the coverage banks needed to hold minimum capital

Sir, your “In praise of bank leverage ratios”, July 11, though I agree with its title, just shows how little you have understood about the underlying causes of the North Atlantic banking crisis.

You write “rather than imposing standardized risk weight, regulators have let banks use their own model. This undermines the credibility of the exercise.”

The standardized weight in Basel II, for holding for instance the AAA rated securities backed with mortgages to the subprime sector in the USA, or loans to Greece, was only 20 percent; which signified that banks could hold these assets against only 1.6 percent in capital; which meant banks could leverage their equity 62.5 to 1 with these assets.

In fact, without the guidance of these standardized weights, the banks would not even have dared to convince their regulators that so little capital could be needed.

Since you also hold that the leverage ratios needs to be combined with effective risk-weighted capital ratios, you also show not having understood how these distort when it comes to banks allocating credit to the real economy.

But, with respect to that macroprudential policy should be counter-cyclical, on that we agree completely, as I indicated in a letter to you in 2004.

Nonetheless most of this discussion will be a moot point in January 2015. The Basel Committee has instructed the banks to report their leverage ratio from that day on. And after all recent signs of “bank creditors, caveat emptor, you won’t be bailed out like before”, like in Cyprus, banks have to be truly insane not knowing they have to substantially raise their capital, in order to survive the coming stampede from banks leveraged over 30 to 1 to those leveraged 10 to 1, no matter the riskiness of the underlying assets.

And the USA, thanks to FDIC, is taking the lead lowering those ratios. Europe, beware!

Who placed and keep the banks on a eurozone knife-edge?

Sir, part of the problems with banks is that those same regulators who should have required equity from the banks when these placed sovereign loans on their books, but did not, because the regulators wished to consider these sovereigns as infallible, are now dumb enough to require the banks to immediately adjust to the fact that the sovereigns might not be so infallible after all. In other words, the banks are forced to deleverage, which hits of course the most those who require the most of bank equity, namely the officially decreed as risky, namely the small businesses and entrepreneurs, namely those least responsible for this crisis. 

In a period where countercyclical action is required, new bank equity should be raised to support new lending and not to cover capital requirements for old bad lending. But, even though Martin Wolf now begins to admit the need “to break the adverse loop between subpar growth, deteriorating fiscal positions, increasing recapitalization needs, and deleveraging”, he still refuses to do a full Monty disclosing the regulatory stupidity, probably because he does not want hurt his buddies, “Banks are on a eurozone knife-edge” April 25. 

Of course, it also reflects the fact that Martin Wolf, the chief economics commentator at FT, from an ideological point of view, much rather prefers government bureaucrats to run the Keynesian deficit spending he favors, than allowing the banks to allocate those resources without the interference of regulating bureaucrats. 

Yes banks are indeed on a eurozone knife-edge, but we surely need to look more into who placed them there and who keeps them there?

Should we not have a serious man to man conversation with our bank regulating chaps at the Basel Committee?

Sir, if you and I were going to design some capital requirements for banks based on the risk of default of borrowers as measured by the credit rating agencies, would we use the default rates those credit ratings generally imply, or would we use the default rates suffered by the banks after the bankers received that credit rating information? I am sure you and I would agree on using the second alternative, since the first really makes no sense as it would imply that bankers do not take notice of the credit ratings, something that with the capital requirements based on these ratings, we are really making sure they do.

If we so then use the default risk for banks after credit rating information, would we also adjust our risk-weights to the fact that those perceived as riskier are charged much higher interest by the banks than those perceived as less risky? I am sure we would definitely consider that important risk mitigation factor and do so, since otherwise we would be perceived as foolishly assuming that all borrowers paid the bank the same interest rate.

But since we now know that our bank regulating chaps at the Basel Committee did nothing of the sort, they just used gross default rates unfiltered by the bankers applying their own credit analysis criteria, and they completely ignored the mitigation of a higher default risk provided by higher interest rates, isn´t it time we call them home so as to have a serious man to man conversation about what they are up to? I mean before they go on to tackle even much bigger problems like counter-cyclicality and systemic risk. I mean so as to inform them about the fact that they, in their own right, are becoming our greatest source of systemic risk.

 

I believe we should. Just consider the mess they did by making the banks stampede after some lousy securities just because these were rated triple-A; and all the small businesses and entrepreneurs who have seen their access to bank credit curtailed or made more expensive just because their odious regulatory discrimination against perceived risk.

A verse of a Swedish Psalm reads: “God, from your house, our refuge, you call us out to a world where many risks await us. As one with your world, you want us to live. God make us daring!”

“God make us daring!” That is indeed a prayer that the members of the Basel Committee do not even begin to understand the need for.

Psalm 288 Text: F Kaan 1968 B G Hallqvist 1970, Music Chartres1784

Yes we need regulatory dynamism... in the right direction of course

Sir I much appreciate Tony Jackson’s call “Let’s get some dynamism into dynamic provisioning” March 22. He is absolutely right, as I have been arguing for more than two years, now is the time to lower the capital requirements for banks, at least for those small businesses and entrepreneurs and though they caused the largest regulatory capital needs had nothing to do with causing this crisis.

What two years? I have been on this much longer

http://teawithft.blogspot.com/2004/08/towards-counter-cyclical-basel.html

Towards a counter cyclical Basel?

Sir, the financial system is there to safeguard savings, to generate economic growth by channeling investments, and to promote equality by providing full and free access to capital and opportunities.

Currently, our bank regulators headquartered in Basel are primarily concerned with the first goal, that of avoiding bank collapses, and how could it be otherwise, if you have only firemen on the board that regulates building permits.

Now, one of these days, the financial system, neatly combed and dressed in a tuxedo, but lying more than seven feet under in the coffin of financial de-intermediation, is going to wake up to the fact that it needs the presence of others in Basel. At that moment, perhaps we might start hearing about flexible capital requirements, moving up to 8.2 % or down to 7.8% by region, in response to countercyclical needs.

Meanwhile it’s a shame that even their first goal might turn out to be elusive, since although the individual risks have fallen with Basel regulations, the stakes have increased, as those same regulations accelerate the tendency towards fewer and fewer banks. 

PS. This letter that, while being an Executive Director of the World Bank I sent to the Financial Times. It was not published. But, because of its importance, I included it in my book Voice and Noise of February 2006