Any risk, even if perfectly perceived, cause the wrong reactions, if excessively considered.

Sir, I refer to Patrick Jenkins “In our warming world, stranded energy assets are a growing concern” March 3. It evidences the difficulties in understanding how bankers adjust to risks, before and after the introduction of risk weighted bank capital requirements.

The current risk weighted bank capital requirements, which are based on that what’s perceived as risky is more dangerous to our bank systems than what’s perceived safe, only guarantees too much exposures to what’s “safe” and too little to what’s “risky”. So now banks, while “goose herds and whaling ships” are perceived as safe, run the risk of building up too large exposures that are harder to manage when these begin to look risky. 

Therefore, in the old days, before these regulatory distortions, banks were able to handle much better than now any slowly becoming apparent perceived risks, like with “goose herds and whaling ships”. 

What was more dangerous then, and MUCH more dangerous now, is of course the unexpected… like coronavirus.

Again Sir, for the umpteenth time, before, for around 600 years, banks cleared for perceived risk by means of interest rates and size of exposures. But then the Basel Committee instructed banks to clear for exactly those same risks, in the capital too. Sadly Sir, any risk, even if perfectly perceived, cause the wrong reactions, if excessively considered.

@PerKurowski

Even perfectly perceived risks, if excessively considered, cause wrong reactions

Sir, John Authers writes that John Locke…when asked if we have an idea of the substance behind our perceptions, answered that we have “no such clear idea at all, and therefore signify nothing by the word substance, but only an uncertain supposition of we know not what”. “Economic reality is hard to fathom after years of distortion” April 28.

And then Authers argues: “Uncertainty is nothing new, particularly about the future. But it is rare for the present to be so hard to perceive as it is now. After a decade of desperate monetary measures to stave off the Great Recession, there is also a reluctance to believe what the markets are telling us, as their signals are distorted.”

At least when it comes to banks and their allocation of credit to the real economy, the signals are indeed extremely distorted, all as a result of the risk weighted capital requirements.

Bankers perceived credit risks and cleared for these by means of the size of the exposure they accepted and the risk premiums they demanded. But then came regulators and ordered that precisely those same perceived risks, should also be cleared for with the capital requirements.

With that they just ignoredthat any risk, even if perfectly perceived, leads to the wrong actions, if excessively considered.

As a result there are now way too high exposures, at too low risk premiums, to what is perceived as safe (and which therefore contains the fattest dangerous tail risks) and too little exposures, at too high risk premiums, to what is perceived as risky, like entrepreneurs.

@PerKurowski

True bank regulations should also not be like gambling.

Sir, I refer to Izabella Kaminska’s “True investing is not the same as gambling” November 22.

But Sir, what did bank regulators do with their risk-weighted capital requirements for banks if not gambling? They gambled on that bankers and credit rating agencies would perceive and manage risks correctly…and this even when bank crisis, when not the result of unexpected events, have always resulted from banks having ex ante perceived something as safe, but which ex post turned out to be risky.

Here again are the four possible outcomes of any bank lending:

1. Ex ante perceived safe – ex post turns out safe – “Just what we thought!”

2. Ex ante perceived risky – ex post turns out safe – “What a pleasant surprise! Another entrepreneur who makes it because we are so good bankers.”

3. Ex ante perceived risky – ex post turns out risky: How lucky we only lend little and at high rates to it.

4. Ex ante perceived safe – Ex post turns out risky: “Holy Moly now what do we do? Call the Fed for a new QE?”

The role of a bank regulator would of course be to work solely on the possibilities that banks did not perceive risks correctly or, if they did, did not manage these perceptions correctly.

And in that respect, the safer something is perceived the more dangerous it can become, and the riskier something is perceived the safer it becomes. Just the same reason for why so many more die in car accidents than in motorcycle accidents. 

The saddest part though is that even if bankers or credit rating agencies perceived risks correctly, the final results of all this would be bad. That because any risk, even if perfectly perceived causes the wrong actions, if excessively considered.

Bankers consider perceived credit risk when determining the size of their exposures and the risk premiums they should collect… but there, after 600 years of banking, suddenly the regulators invented that exactly the same perceived risks needed also to be considered in their capital too. And, since then, what is perceived as safe is getting way too easy credit while, what is perceived as risky, like SMEs and entrepreneurs are not getting the credits the real economy need them to get.

Sir, come one, don’t be so scared, live up to your motto of “Without fear and without favor”. Dare request from any regulator, for instance from FSB’s Mark Carney, an explanation for Basel II’s risk weights: that of a meager 20% for the so dangerous AAA rated, and a whopping 150% for the so innocous below BB-

https://youtu.be/TUdKhm6_a8Y

@PerKurowski

Draghi, the more confidence we have in risk weighted capital requirements for banks, the dumber and more fooled we are

Sir, Caroline Binham and Emma Dunkley quote Michael Lever, head of prudential regulation at AFME, which represents the biggest banks and other markets participants, with: “It is important to take the time to create a framework that is capable of accurately measuring the risks that banks are assuming” “Banks win Basel reforms reprieve” January 4.

Hold it there! The problem is not only in measuring risks. The problem is also in assigning the relative importance to the risks measured.

The current capital requirements for banks are based on ex ante perceived risks that should be cleared for by bankers, by means of interest rates and size of exposures. The result is that ex ante perceived risks are excessively considered. Therefore that causes a wrong allocation of bank credit; and this even if the perceived risks are perfectly accurately measured.

This regulation now causes that what is perceived as “safe”, like AAA rated or Sovereigns, get too much credit at too low rates, which is dangerous for the banks; and that what is perceived as “risky”, like SMEs and entrepreneurs, receive too little or too expensive credit, which is very dangerous for the real economy

Mario Draghi, president of the European Central Bank, who chairs the Basel committee supervisory board, is here quoted with: “Completing Basel III is an important step towards restoring confidence in banks’ risk-weighted capital ratios, and we remain committed to that goal.”

To that my only one answer, for the umpteenth time, is “No!” The more confidence in something that is so rotten to its core the worse.

PS. FT, why do you not do all of us a favor and dare ask bank regulators some very basic questions

@PerKurowski

It is only the bankers’ responsibility to clear for risks. The regulators should only prepare banks for uncertainty.

Gillian Tett writes that Axel Weber, the chairman of UBS, “suggests investors urgently need to think about the difference between ‘risk’ and ‘uncertainty’: the former refers to events that can be predicted with a certain probability; the latter refers to unknown future shocks.” “Emerging markets offer clues for investors in 2017: Extraordinary political events have upended western assumptions about risk and uncertainty” January 1.

Let us see if this distinction helps Ms Tett to see that with risk weighted capital requirements for banks, both bankers and regulators are clearing for risk. The result is that “risk” is excessively considered while “uncertainty” plays a secondary role. Seemingly it is too hard for regulators and anthropologists to understand the simple truth that any risk, even if perfectly perceived, causes the wrong actions if excessively considered.

To subject banks to this double counting of risk means banks will lend too much to what is ex ante perceived, decreed or concocted as “safe” like AAA rated securities and sovereigns like Greece, and too little to what is perceived “risky” like SMEs and entrepreneurs.

Only the exclusive use of a leverage ratio, which represents a capital requirement that has nothing to do with perceived risk, is what could help banks prepare for uncertainty, without distorting the allocation of bank credit to the real economy.

@PerKurowski

Mark Carney, as bank regulator, has no right to talk about an “unprecedented desire for safety”

Chris Giles writes: Mark Carney, governor of the Bank of England, talks about an “unprecedented desire for safety”. “Fed faces dilemma over how high rates should go” December 14.

Hah! Mark Carney is one of those regulators who set the capital requirements for banks based on ex ante perceived risks, and if that’s not an unprecedented run amok desire for safety, what is? Current bank regulators have not failed somewhat, they have failed in such a fundamental way that they should never ever be allowed to even get close to banks again.

Bankers perceive risk, and the more risk they see, the less they lend, and the higher the interest they charge… and yet regulators, if they also perceived more risk, also wanted banks to hold more capital… and so the ex ante perceived risks became excessively considered.

With the Basel Committee’s goggles, the safe seems safer, the risky riskier and the allocation of bank credit to the real economy goes bananas.

@PerKurowski

Why is it so hard to understand that risks should not only be correctly perceived but also correctly considered?

Sir, Patrick Jenkins, discussing the Basel Committee’s push “to finalise another leg of post-crisis global financial reform” writes that “financial and economic stability is more important than a blinkered crackdown.”, “Basel Committee boss needs to reconsider hard line on reform” October 18.

What? “financial AND economic stability”? That’s a new one. Until now it has only been financial stability, which is why regulators (and journalists) have not cared to analyze how much current bank regulations distort the allocation of credit to the real economy. For instance Stefan Ingves, the chair of the Swedish Riksbank and of the Basel Committee, seems not to understand at all that the so much lower risk weight assigned to financing houses (35% in Basel II), when compared to the risk weight when financing SMEs (100%), has something to do with prices of houses going up and up, and the credits to SMEs going down and down.

Jenkins, on the possibility of part of the capital requirements to be based on the conduct of the banks, like misdeeds, argues: “The logic is flawed”, since “basing future capital demands on past fines duplicates the impact of a penalty”.

Indeed, but why Sir is it so hard for Jenkins, for the Basel Committee, for you and for all other in FT to understand that, basing capital requirements on ex ante perceived credit risks already cleared for by banks with interest rates and size of exposures, also “duplicates the impact” of perceived credit risks?

Is it really so hard to understand that any risk, even if perfectly perceived, causes faulty actions, if that risk is excessively considered?

@PerKurowski ©

Risks, even if perfectly perceived, can lead to very wrong actions if excessively considered

Sir you write: “as the expansion of world trade has slowed over the past few years, familiar warnings about the political risks to growth have re-emerged… The International Monetary Fund warned this week that political risk was one of the biggest threats to the world economy… But unless and until these political risks materialise, there is no need to panic about trade, and the best way of keeping it expanding is simply to encourage overall economic growth” “The IMF sends a signal on political risk realities” October 6.

That is entirely correct Sir. Risks, even if perfectly perceived, can lead to very wrong actions, if excessively considered. But Sir, why do you refuse to apply that kind of argument to current bank regulations?

There we had the banks perceiving credit risk, some doing it well an others less so, and then deciding on what amount of exposure they wanted, and what interest rate, risk premium, they would charge. But NO! that was deemed insufficient by the meddling and nervously nannying technocrats in the Basel Committee, and so they invented that they should also react to the same risk perception, and set the capital a bank should have against an asset accordingly. And so credit risk (or credit safety too) got to be excessively considered, which has completely distorted the allocation of bank credit to the real economy.

But not a word is spoken about this; probably because it is all backed by some very hard to understand risk management concepts that few dare to discuss. And so now we have for instance ended up with the absurdity of having what can really grow into dangerous excessive bank exposures, like the AAA to AA rated, being risk-weighted at 20%, while the totally innocuous below BB-rated get a 150% risk weight. Sheer lunacy!

So now, ironically, in order for bank credit to be efficiently allocated to the real economy; and not endanger the banking system’s stability, the perceived risks need to be wrong. What is “safe” must be perceived riskier and what is “risky” must be perceived safer. 

PS. An aide mémoire on the loony risk weighted capital requirements

@PerKurowski ©

Had regulators left their desk and soiled their shoes, our banks and our economies would be in much better shape.

Sir, Sarah O’Connor is right on spot writing: “What we really need is experts with dirty shoes” “The best economist is one with mucky soles” July 20.

The first Op-Ed ever I wrote Puritanism in Banking was the result of suddenly having a feeling that many of my clients who, because they were perceived as “risky” always found it harder to access bank credit, were suddenly faced by even larger difficulties, as a result of new bank regulations coming out of Basel.

The “expert” bank regulators there, scared to death of banks failing, from their desks declared that more-perceived-risk more-capital and less-perceived-risk less-capital, and believed that should take care of it all.

They did not walk history to understand that what is ex ante perceived as risky never ever has created those excessive exposures that crises are made of, those have always resulted from excessive exposures to what was perceived as very safe when incorporated on the balance sheets of banks.

And they did not walk main-street so as to understand that banks already clear for perceived risks, with size of exposures and risk premiums, and therefore, when they cleared for the same perceived risk again in the capital, they over-sensitized the system to perceived risk. And even though they stayed at their desks the experts blithely ignored that any risk, even if perfectly perceived, causes the wrong actions, if excessively considered.

And here we are and even in the face of failure, the regulators still refuse to walk and soil their shoes. Let’s take away their desks!

@PerKurowski ©

Mervyn King, for bank regulators to use the expected, as a direct proxy for the unexpected was, and is, radically dumb

Sir, John Plender, March 3, reviewed Mervyn King’s book “The End of Alchemy: Money, Banking and the Future of the Global Economy" And in doing so Plender writes that King argues that in a world of what economists now call “radical uncertainty”, it is not always possible to compute the expected utility of any action. There is simply no way of identifying the probabilities of all future events and no set of economist’s equations that describe people’s attempts to cope with that uncertainty.”

And according to Plender, King proposes a “central bankerly pawnbroking” facility to supply “liquidity, or emergency money, within a framework that eliminates the incentive for bank runs… That would displace what King regards as a flawed risk-weighted capital regime ill-suited to addressing radical uncertainty.”

And John Kay ends his discussion of King’s book with: “There is a world of difference between low-probability events drawn from the tail of a known statistical distribution and extreme events that happen but had not previously been imagined”, “The enduring certainty of radical uncertainty”, April 6.

Hold it there has all that really anything to do with the current risk weighted capital requirements for banks? Absolutely not!

What happened was that since the regulators did not know how to estimate the unexpected losses, those that bank capital is foremost to safeguard agains, they went out and used the expected credit risks. And since those risk were already cleared for by banks, with interest rates and the size of exposures, credit risks, when also used to set capital requirements, were given too much consideration.

And, for the umpteenth time: any risk, even if perfectly perceived leads to wrong actions if excessively considered.

And Plender also wrote about King arguing: “Banks satisfied investors’ desperate search for income by creating increasingly complex and risky financial products based chiefly on mortgage debt. Bank balance sheets grew explosively as property lending ballooned. At the same time, the capital of banks shrank as they took on more risk.

Again that is not really so! The increasingly complex and risky financial products chosen were entirely based on that these could be argued to be very safe, and therefore require banks to hold less capital. For instance mortgage debt would never ever have exploded as it did, if instead of receiving a 35 percent risk weight, it had the 100 percent risk weight assigned to “risky” SMEs and entrepreneurs.

And Plender also wrote about King arguing: “They were trapped by what game theorists call a prisoner’s dilemma. If they retreated from riskier lending and trading strategies while reducing their borrowings, a decline in short-term profits relative to their competitors would have caused staff to defect in pursuit of higher bonuses elsewhere and prompted calls for the chief executive’s head.”

Those “short tem profits” are not some absolute profits, but returns on equity, and so banks, searching for the highest profits, naturally favored those exposures that provided the highest expected risk adjusted returns on equity, in other words those that could be most leveraged.

Sir, I have no respect for a regulator like Mervyn King. He and all his colleagues decided to regulate banks without defining their purpose. Had they done so they would have known, that the most important social purpose of banks is to allocate credit efficiently to the real economy.

Now our banks do not finance the riskier future they just refinance the, for the short time being, safer past.

“A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926 

I can understand journalists covering the reputation of old friends… but is that really their role and duty? “Without fear and without favor”… Hah!

@PerKurowski ©

If regulators insist on that any information gathered by banks must be doubly considered, that would be real dangerous.

Sir, Martin Wolf writes: “Finance is an information business. Indeed it already spends a higher share of its revenues on information technology than any other. It seems ripe for disruption by information technologies. Consider its three essential functions: payment; intermediation between savings and investment; and insurance. All these activities are information-intensive.” “Good news — fintech could disrupt finance” March 9.

Banks already perceived information about credit risks, and cleared for it with interest rates and the amounts of their exposures... and they were not doing that bad when it came to identify “the risky”, where they sometimes really failed, badly, was when they identified some as very safe.

But then came the regulators and told the banks they also had to consider the same perceived risks in the capital. And so banks did doubly stay away from the risky, and doubly fall into the traps tended by the false safes.

And so if all that information is going to be of value for the banks and for us, be sure to keep the regulators away from it.

Martin Wolf also quotes John Kay on that “parts of the financial sector today . . . demonstrate the lowest ethical standards of any legal industry”.

Not so. Compared to the ethical standards of regulators who abusing their powers distort the allocation of bank credit to the real economy; and by discriminating against the opportunities for fair access to bank credit of “The Risky” increase inequalities, one could argue that bankers are saints.

@PerKurowski ©

A ‘light touch’ does not distort. Risk weighted capital requirements for banks was pure ‘heavy-handed dumb touch’

Sir, commenting on “Bank of England’s damning report on the 2008 failure of HBOS — seven years since the financial crisis” you write: “A [drawback] is that the regulators themselves — and the politicians who established the “light touch” regulatory regime for the City of London that encouraged the HBOS failure — do not face similar action… Meanwhile, the FSA, which was supposed to ensure that the UK’s biggest banks did not run aground and put the taxpayer at risk, was broadly deficient in its job. It operated within the prevailing political assumption of the time that the FSA “had to be ‘light touch’ in its approach and mindful of the UK’s competitive position”, “Better late then never for banking discipline”, November 20.

Twice you reference ‘light touch’. Wrong! A ‘light touch’ does not distort. The portfolio invariant credit risk weighted capital requirements for banks was pure and unabridged ‘heavy handed dumb hugely distortive touch!

I have explained it to you and your columnists and reporters a thousand of times, in hundreds of different ways, and so here comes a reprise of some of my arguments:

Bank capital is to be a buffer against unexpected losses. To base them on expected credit losses does not make any sense.

Any risk, like credit risk, even if perfectly perceived, causes the wrong actions if excessively considered.

All major bank crises have resulted from excessive exposures to assets perceived ex ante as safe, never from excessive exposures to what was perceived as risky.

To allow banks to hold less capital against some assets allow the banks to earn higher risk adjusted returns on equity on these. And that distorts the allocation of bank credit to the real economy.

To allow some banks to use their own risk models to determine the capital requirements is like allowing kids decide how much ice cream and chocolate to eat that leaves out the spinach and the broccoli.

Without these regulations banks would never ever have been allowed to leverage as much as they did.

To regulate banks without considering their purpose, like allocating bank credit efficiently to the real economy, is utterly irresponsible.

To allow some few credit rating agencies to have such importance for the capital banks needed to hold was to invite systemic risk.

Sir, it was clear that with this piece of regulations banks would dangerously overpopulate safe havens and, equally dangerous for the real economy, underexplore risky, but potentially very rewarding, bays. And that is what happened, and still you have difficulties of seeing it, I do not understand why. Is the difference between ex ante risks and ex post realities too much to handle?

Not understand the role of risk-taking in keeping the economy moving forward so as not to stall and fall, shows lack of vision and wisdom.

And you know I could go on and on.

You write: “By naming [some] who ran HBOS “without due regard to basic standards of banking” and recommending that several face possible bans from working in the industry, it clarifies responsibility.

I wish that would be valid for failed bank regulators too. Most of them have been promoted and are busy hiding or ignoring their own responsibilities.

@PerKurowski ©

Something dysfunctional is hindering FT from living up to its motto of “Without fear and without favour”

Sir, Martin Wolf holds that “The relentless decline in the proportion of prime-aged US adults in the labour market indicates a significant dysfunction. It deserves attention and analysis. But it also merits action.” “America’s labour market is not working” November 4.

There is a whole lot of things that do not work as we want them to work, and there are certainly many major dysfunctions causing that, and clearly not only in America.

For instance one truly major dysfunction is that our banks, those who should allocate credit as efficiently as possible to the real economy, have been awarded huge incentives, not to manage perceived credit risks, but to avoid credit risks.

That is so because even though banks consider credit risk when deciding on the size of exposures and interest rates, the regulators decided those same perceived credit risks should also determine the capital banks needed to hold. The end result of that regulatory nonsense is of course too much bank credit to what is perceived as safe, and too little to what is perceived as risky… and, among the risky, we find the SMEs and entrepreneurs, precisely those who have the best chances of delivering new jobs.

That dysfunction which started in 1988 with a major destructive tsunami known as the Basel Accord, in which the regulators amazingly set the risk weights of sovereigns to zero percent, and that of the private sector at 100 percent, has been in crescendo ever since.

The regulators have just not been able to understand that even a perfectly perceived credit risk, leads to imperfect results, if excessively considered.

But that dysfunction might be topped by an even worse dysfunction, namely that of the academia and other influential actors, like journalists, simply not daring to accept the possibility that regulators could have made such a fatal blunder, and therefore keeping silent about it.

Sir, since during the last decade I have written Martin Wolf over 250 letters about that problem, which I accept is slightly dysfunctional in its own way. But, the only time Wolf publicly acknowledged these was when in 2012 he wrote: “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. For this reason, unweighted leverage matters.”

And yet, even describing the argument that showed that the regulators, with their more risk more capital – less risk less capital, could be 180 degrees off mark, he left it at that.

Sir, I am sorry to say but there seems to be something very dysfunctional at FT that hinders it from living up to its motto of “Without fear and without favour”

@PerKurowski ©

Do I have a question to The Shrink & The Sage!

Sir, The Shrink, Julian Baggini writes “It’s hard to give our environment the right importance. Sometimes we assign it too much weight, sometimes too little.” "How important is our environment?" October 18.

He and The Sage, Antonia Macaro, also request questions to be sent to them on their email. Boy, do I have one for them!

Bankers obviously look at the credit risks of a client, or of an investment, before deciding what risk premiums (interest rates), how much exposure they want to have t that risk and what other contractual clauses they need in order to serve their own interests as good as possible. And that makes perfectly good sense. If they did not, they should not be in banking.

But then, sort of surprisingly, bank regulators also require that the capital a bank is required to hold against different assets, are also based on the same perceived credit risks.

So here is the question: Shrink, Sage, do you think ex ante perceived credit risks are getting due importance, or are they getting too much importance? If the second, this would obviously distort the allocation of bank credit to the real economy, even if the credit risks were perfectly perceived.

And if the second, and given that The Sage writes “Just as the quality of a grape is rooted in the earth in which the vine grows, so 'the ground of our opinions' is the human environment in which we are raised”, the question is… can these regulators rectify or is rectifying way beyond their reach?

I am anxiously waiting to see their answers… if they are allowed to answer.

@PerKurowski ©