When will the history of the Basel Committee’s concoctions haunt us?

Sir, I refer to Owen Walker’s “Haunted by his­tory” FT Magazine, August 10. It ends with “Unfor­tu­nately Monte dei Pas­chi will not help to develop and sus­tain Siena as it has done for more than five and a half centuries.” 

Unfortunately, that goes for all banks that were of importance to their localities.

In 1988 regulations known as Basel I was approved. It favored government debt and residential mortgages. That distorted but not too much. Loan officers used to follow the wishes of diverse Medici, must not have been too surprised. But then, in 2004, Basel II hit the banking world. With its risk weighted bank capital requirements so much dependent on credit ratings, the traditional loan officers, like Britain’s beloved George Banks, were thrown out. In came dangerously creative financial engineers. Their mission was now to maximize return on equity, not by good lending, but by minimizing bank capital, meaning bank equity, meaning bank shareholder’s skin in the game; in other words by maximizing leverage.

Not that all loan officers have been saints. Of course not. As in all parts of life, embezzlement and general uselessness was way too often present; but it was localized. Now it has been globalized. Monte dei Paschi’s financial engineers’ use of derivatives fabricated by Deutsche Bank or Nomura is just a minor example of it. A major one is how those securities backed by USA subprime mortgages, that when rated AAA allowed banks to leverage 62.5 times their capital, inundated European banks and caused the 2008 GFC.

How long will it take for the world to wake up to the fact that their expert bank regulators and supervisor, who lately, with all Basel III complexities multiplied in number and complexities, all missed their lectures on Bayesian conditional probabilities. As a consequence, they never understood that if they were going to use risk weighted bank capital requirements, something that for a starter was a bad hubris filled idea, then at least the weights should be conditioned to how bankers could be expected to act when perceiving risks.

Sir, David Rossi’s death, no matter how it occurred, is sad, but not remotely as much as the death of our banking system, that which made the western world prosper beyond belief.

One day our grandchildren will ask: How could our grandfathers so much favor banks refinancing their safer present, instead of financing our riskier future.

PS. Recently I asked ChatGPT which alternative, a leverage ratio or risk weighted capital/equity requirements, would most empower loan officers, and which one creative financial engineers. Here its answer

@PerKurowski

http://teawithft.blogspot.com/2012/07/its-whats-safe-thats-risky.html

https://teawithft.blogspot.com/2016/12/the-way-ft-insists-in-treating-bank.html

Where would the City of London be if in the 19th Century it had been placed under the thumb of a Basel Committee?

Sir, I refer to your “The City must not be forgotten in Brexit talks” September 29. In view of the City’s real existential problem, I find it a bit irrelevant 

Creative financial engineers tricked or ably lobbied bank regulators into accommodating their wishes for leverage maximization/equity minimization, by introducing risk weighted bank capital requirements nonsensically based on that what’s perceived as risky is more dangerous to bank system than what’s perceived as safe.

That caused loan officers to allocate credit not as it used to by means risk adjusted interest rates but to allocate it by means of risk adjusted returns on equity. If the City of London is to survive as one of the prime banking centers of the world it needs to get rid of that distortion.

FT, without fear and without favor dare to think what would have been of the City of London if in the 19th Century it had to operate under the thumb of Basel Committee inspired risk adverse regulations?

PS. And if in 1910 that savvy loan officer George Banks had been asked about risk-weights, Tier 1 capital and CoCos, I am sure he would have gone to fly a kite.

Do we need bankers, as in good loan officers, or bankers, as in creative financial engineers?

Sir, I refer to your “Europe’s banks are losing the global race for talent” February 25. In general terms, and most especially with “Banks, like the best football clubs, should nurture their young talent”, I agree completely. That said my concern with respect to all banks, not just European, is about what banks would benefit us the most.

For around 600 years banks allocated their credit to what bankers thought would produce the highest risk adjusted net profit margins, something which required them to consider interest rates and operation costs. In those days good loan officers were of utmost importance.

After the introduction of risk weighted bank capital requirements, banks now allocate their credit to what bankers think will produce them the highest risk adjusted net profit margins adjusted to capital requirements, something which now, besides interest rates and operation costs requires them to consider leverage possibilities. In this new kind of banking creative financial engineers have an important role to play.

I am convinced traditional banking not only satisfied much more efficiently the credit needs of our economies but was also much less dangerous in terms of financial stability than “modern” banking. 

But Sir, you don’t have to take my non-PhD opinion on that. In his 2018 autobiography “Keeping at It” late Paul Volcker wrote: “Over time, the inherent problems with the risk weighted bank capital-based approach became apparent. The assets assigned the lowest risk, for which capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages. Ironically, losses on those two types of assets would fuel the global crisis in 2008 and a subsequent European crisis in 2011.”

Yes, Europe and the world, of course needs a new generation of bankers, but before that, for our own good, let’s make sure they have the right type of banks to lead.

http://perkurowski.blogspot.com/2016/04/here-are-17-reasons-for-why-i-believe.html

@PerKurowski