Auditing is important, but what causes a disaster, is more important than how it is being accounted.

Sir, “FT Big Read. Auditing in crisis: Setting flawed standards” of August 2, discusses, among other, the huge divergence of figures in the auditing of the value of derivative exposures of AIG and of Goldman Sachs, even though their auditor was the same, in this case PricewaterhouseCoopers. 

That it was “striking how little was verifiable, that there were few credible market prices, let alone transactions, to support the key valuations”, explains much of the divergence.

Sharon Bowles, former chair of the European Parliament’s economic and monetary affairs committee explains it with: “Accounts have always contained estimates; think of the provisions companies make against foreseeable future losses, but the un-anchoring of auditing from verifiable fact has become endemic.”

That “un-anchoring from verifiable facts” is not limited to auditing. 

Sir, for the umpteenth time, without absolutely no verifiable facts, regulators concocted their risk weighted capital requirements for banks, based on the quite infantile feeling that what was perceived risky must be more risky to the bank system than what was perceived safe. In fact what could have been verified, if only they had looked for it, was the opposite, namely that what’s perceived safe is more dangerous to our bank systems than what’s perceived risky.

With that the regulators assigned to AAA rated AIG, by only attaching its name to guarantee an asset, the power to reduce the capital requirements for investment banks in the US, and for all banks in Europe, to a meager 1.6%. That translated into an allowed 62.5 times leverage. Let me assure you Sir that without this the whole AIG and Goldman Sachs incident described would never have happened. 

As always, what causes the problems is much more important than how the problems are accounted for. Though of course I agree, sometimes bad-accounting could in itself be the direct cause of the problems. 

The article also refers to “the so-called efficient markets hypothesis… that now somewhat discredited theory”. Sir, no markets have any chance to be credited with performing efficiently with such kind of distortions. For instance how verifiable is it now that sovereign debt is as risk-free as markets would currently indicate, when statist regulators have assigned it a 0% risk free weight, and are thereby subsidizing it?

@PerKurowski

Bank regulators violated both the efficient markets hypothesis and the rational expectations assumptions.

I refer to Martin Wolf’s “Economics failed us before the global crisis: A framework that does not include the possibility of collapse misses the essential” March 21.

Wolf writes: “David Vines and Samuel Wills explain… the core macroeconomic model rested on two critical assumptions: the efficient markets hypothesis and rational expectations”

Bank regulators, those who should rationally be more weary of the unexpected, by basing their capital requirements on what was perceived risky, that which bankers were assumed to manage efficiently and rationally, made efficient allocation of bank credit impossible, and so both those critical assumptions were violated.

Wolf writes: “We need also to understand the risks of crises and what to do about them. This is partly because crises are, as the Nobel-laureate Joseph Stiglitz notes, the most costly events”. 

I disagree entirely with this limited Monday morning quarterback view. To measure the real cost we have to measure the full boom and bust cycle. Having, like now, bank regulations that favor banks financing the “safer” present consumption (houses), over the “riskier” future production (entrepreneurs), is a certain way to minimize the returns from our current circle of life.

Wolf writes: “Doctors’ first response to a heart attack is, after all, not to tell the patient to go on a diet. That happens only after they have dealt with the attack itself.” 

True, but even more important then that, is to correctly diagnostic the illness. In this case, the doctors, the bank regulators, do not want the diagnosis of missregulation to occur, so they are perfectly happy with most of the world blaming bankers or arguing deregulation.

Wolf writes: “We may never understand how such complex systems as our economies— animated, as they are, by human desires and misunderstandings — actually function. This does not mean that attempting to improve understanding is a foolish exercise.”

This is precisely what I have been trying to do with thousands of letters to the Financial Times and Martin Wolf, looking to explain how incredibly faulty the current risk weighted capital requirements for banks are, only to be silenced by FT and classified as obsessive by Martin Wolf.

Yes Sir, I admit being obsessive about this all, especially since I know the future of my children and grandchildren are affected by bad regulations. But, in his keeping mum on all this, Wolf is just as obsessive, I believe though because of much less worthy motives.

@PerKurowski

A regulator’s rational risk aversion when mounted on top of that of the bankers, produces an irrational risk aversion

Sir, John Authers when commenting on Andrew Lo’s “Adaptive Markets” writes: “our susceptibility to judge risks incorrectly is rooted in the necessities of survival. Fear, our early warning system, makes us irrationally averse to loss. We run greater risks to avoid a loss than to make a profit. “An emotional way to look at market theory”

Indeed, just look at bank regulators.

Even though bankers, because of their rational loss aversion, never create excessive and dangerous exposures to something ex ante perceived as risky, the regulators, with their risk weighted capital requirements for banks, mounted their rational aversion to loss, on top of that of the bankers’, and so it all became an irrational aversion to loss.

If the father’s and the mother’s average risk aversion is used educating their children, these will turn out well. But, if it is the sum of the father’s and the mother’s risk aversion that becomes applied, then their kids are lost... they will dangerously go too much for what is safe, and dangerously too little for what is risky.

In other words, the efficient markets hypothesis, the rational utility-optimising “homo economicus”, has no chance of working efficiently when interfered by regulations produced by some hubris inflated homo distorters.

@PerKurowski

Credit-risk weighted capital requirements for banks makes efficient capital allocation, a mission really impossible

Sir, John Kay writes: “Efficient capital allocation requires above all the knowledge and experience to asses the quality of underlying assets, and the capabilities of those who manage them. Yet the ability most valued in the finance sector in the first decade of the 21st century was a keen appreciation of asset markets themselves. The deployment of such abilities by people with an exaggerated idea of the relevance of these skills, and an overblown sense of their own competence, plunged the global economy into the worst financial crisis since the Great Depression.” “The clever marketeers who crashed the economy”, September 2.

That is true but it is absolutely not the whole truth. Those clever markeeters would not have been able to get as far as they got, meaning to leverage the banks as much as they did, without the intimate cooperation provided by regulators. And these have even just as much, or perhaps even more overblown sense of their competence.

The bank manager John Kay remember from his schoolboy days in the 60s, and “who would base his lending decision as much on his local knowledge and the character of the borrower as on figures”, did not have to deal with credit-risk weighted bank capital requirements.

Sir, no matter how much “knowledge and experience to asses the quality of underlying assets” bankers could have, those capital regulations make any “efficient capital allocation” a mission really impossible.

Sir, dare an answer: Where would we be if our forefathers’ banks had been subject to credit-risk weighted capital requirements?

PS. Behind too many overblown senses of competence, hide too many uncritical journalists in awe.

@PerKurowski

Beware of excessive information. (Blissful) ignorance is a potent driver of financial markets and of human activities.

Sir, Tracy Alloway describes the possibility of adding on, as you go along, new pieces of information that will enhance the knowledge of the risks, for instance in securities backed with residential mortgages, “New mutations beckon for system that shares DNA of each loan’s risk” January 3.

And Alloway quotes David Walker of Marketcore saying “This could be very disruptive, because not everybody is for transparency and accountability. Even if they say they are publicly, they may not be privately.”

It is worse than that! If risks were perfectly known, the price of the securities would reflect this and so there would be little profits to be made trading these, and so perhaps there would be no Wall Street. It is imperfect information that has prices zigzagging, which induces market participant to get out of bed in order to sell the not-too-well-perceived risks and buy the not-so-real-safeties.

In other words, ignorance is one of the most potent drivers of financial markets and human activities; and is therefore quite often characterized as quite blissful… at least by the winners.

But the worst that can happen with excessive information, that is when we, because of it, become convinced that we know it all. Like when bank regulators caused our banks to follow excessively the credit risk perceptions issued by some few human fallible credit rating agencies. Clearly some more information (and humility) about our ignorance would have come in handy.

Regulators have purchased the illusion of bank safety, by forbidding these to finance the risky future.

Regulators have purchased the illusion of bank safety, by forbidding these to finance the risky future.

Sir, I refer to James Grant’s “Low rates are jamming the economy’s vital signals” October 13.

When Grant writes: “What is new today is the overlay of officially sponsored bull markets on governmentally suppressed interest rates”, he is quite right.

And when he writes: “True prices are discovered, not administered. They are set in the open market…. The world should spare some censure, too, for the central banks’ manipulation of money market interest rates, their heavy-handed administration of longer-dated bond yields and their sponsorship of rising share prices. Just because the public servants do their well-intended work under the banner of the law does not make the results any less subversive”, he is also quite right.

Unfortunately, what Grant misses in order to make the public servants “subversive” activities much clearer… is what is most jamming the economy’s vital signals, namely the credit risk weighted capital (equity) requirements for banks.

That regulation allows banks to earn much much higher risk adjusted returns on equity when lending to what regulators, with immense hubris, feel can be designated as “absolutely safe”, than for what they, with equally immense hubris, feel can be designated as risky. And that, instead of negating the efficient market hypothesis like so many hold, included Nobel Prize winners, has impeded the efficient open markets to work.

Grant concludes: “Central bankers… have purchased short-term relief with long-term instability”. I wish not to argue with that but, as I see it, what central bankers and regulators have most purchased, is the illusion of bank safety, and this by paying the price of forbidding the banks to do what they are most supposed to do, namely to finance the risky future, hopefully with reasoned audacity… since otherwise, as we know, the present will stall and fall.

PS. Grant should also try to figure out how the fact that banks on loans to the "infallible sovereigns" need to hold much less capital than against anything else, subsidizes the "risk-free rate".

Without free-banks it is baloney to argue that the efficient market hypothesis has been rejected

Sir, Tim Harford writes that in efficient markets every asset’s expected risk-adjusted return is the same, so “Pick a fund, any fund” October 4.

Yes that is indeed the theory, and the “returns” therein refers to the returns on one and same equity. And so when banks, because of credit risk-weighted capital requirements, need to hold different amounts of equity, for different assets, an “efficient market” has no chance to fulfill its theoretical role, and all talk about its failure is pure nonsense… the result of a severe intellectual blockage or political agendas.

In Harford’s supermarket example it would be like a supermarkets’ length-of-checkout-lines regulator, ordaining different lines for different uses, for instance one for all with fruits to be weighed. 

In fact if those lines were regulated by something like the Basel Committee, the risqué products and consumers: fruits, vegetable, alcohol, crisps and coupon holders, would have available many less check-out lines than the safely fast.

Of course, under some circumstances, as customers adjust, there is a chance all lines would still end up being of similar length… but there would be distortions… like less fruit being purchased at supermarkets and the need for shadow supermarkets.

Gillian Tett does just no get it!

Sir, Gillian Tett writes “Stern sermons and looser rules won’t get banks lending more” October 12. She does, not or wants not to really get it. 

It is simply not just a question of banks lending “more”, or having these as an alternate QE money injection in the economy so to say, but, primarily, to get the banks to lend better, in terms of what the economy most needs. That is known as searching for a more “efficient economic resource allocation”. 

Right now, because of capital requirements (plus now, to make it worse, also liquidity requirements) which are based on ex-ante perceived risks, and made stricter by the big scarcity lack of bank equity, banks tend to lend to “The Infallible” and avoid lending to “The Risky”. The latter include of course the small businesses and entrepreneurs. 

And so, what the British regulators are currently doing, at long last, thank God, with their “quietly loosening bank rules”, is discreetly trying to reduce the regulatory discrimination against “The Risky”. That it is hard for them to be too forthright about it is sort of understandable, because that would signify having to admit how stupidly they behaved earlier.

Frankly, on the face of it, it would seem to me that Gillian Tett could learn much more about banker behaviour from Mark Twain than from Phil Coffey.

The regulators never believed in the Efficient Financial Markets Hypothesis.

Sir, John Quiggin writes: “Claims of a Great Moderation were bolstered by the Efficient Financial Markets Hypothesis, which stated that the prices generated by financial markets represented the best possible estimate of the value of any asset, given the available information. It follows that market bubbles are impossible and that the deregulation of financial markets should help to stabilise the real economy.” “Why austerity and ‘zombie’ ideas are bound to fail” November 30.

That is obviously false because anyone truly believing in the “Efficient Financial Markets Hypothesis” would never have come up with such a screwed up idea of having bank regulators arbitrarily intervene in the markets by setting different capital requirements for banks depending on the perceived risk of default, when that risk was already being cleared for in the markets by their risk-premiums.

The regulators thinking that, with a little help from their friends the credit rating agencies, they had everything under control, allowed the banks to finance triple-A rated securities collateralized with badly awarded subprime mortgages, Greek public debt, or Irish banks with a leverage of 62.5 to 1. An efficient Financial Market, on its own would never have done such a stupid thing. For instance the unregulated hedge funds almost never exceed a 12 to 1 leverage.

This particular efficient market hypotheses was murdered and I am not buying any efficient regulator hypotheses

Sir James Montier observes that “The efficient market theory is as dead as Python’s parrot” June 25. After duly goggling what he meant by that, I agree, but only as to the death of this particular parrot and not to the extinction of its whole specie. You see our current efficient market parrot did not die of natural causes it was murdered. Murdered by some scheming banking regulators in Basel who decided that one of the lead actors of the market, the banks, had to swallow a pill of arbitrarily set of capital requirements based on vaguely defined risk and as measured by some external credit rating agencies. It proved to be just too venomous.

Montier could be suffering a state of shock like when he writes “new research shows that career risk and business risk are the prime drivers of most professional investors” as if that was something new, as if we really wanted or expected that to be different; or when he writes “there isn’t a scrap of evidence to suggest that we can actually see the future at all” like even if it were true we should not try to do our best to look into the future. Then again anyone capable of describing the current regulatory approach as “the markets know best” has either no idea of what he is talking about (I am always suspicious of anyone that uses many quotations) or is pursuing a completely different agenda. Just in case I rather go searching after any other efficient market hypotheses or even use the current carcass to clone a new one than to buy myself an efficient regulator hypothesis.