The Basel Committee’s bank regulators being replaced by an algorithm could be the best that could happen.

Sir, I refer to Gillian Tett’s “Self-driving finance could turn into a runaway train”, December 8.

Well human-driven banks are now not doing so well either. 

Any algorithm currently making credit decisions for a bank would do so based on maximizing risk-adjusted returns on equity, based on perceived risks of assets and on regulatory bank capital requirements regulations.

Where would it get the risk perceptions? Currently credit ratings… Who knows if in the future algorithms would also take over the credit rating functions… if these have not already done so?

Where would it get the capital requirements? Currently it get those from the Basel Committee’s standardized risk weights, or if the algorithm works for a sophisticated bank, from its own risk models.

So, if the algorithm does its job well, and works for a sophisticated banks, it would seem that in order to obtain the highest risk adjusted return on equity, its priority has to be creating the risk model that minimizes the capital requirement.

And if it works for a bank that uses the standardized risk weights, then it is clear it would not waste its time with what carries a 100% risk weight, like an entrepreneur, but concentrate entirely on those with much lower risk weights, sovereign 0%, AAA rated 20%, residential mortgages 35%.

So, with the risk weighted capital requirements it is clear that whether the banker is a human or an algorithm, we can forget about savvy loan officers… they will all be equity minimizers.

Of course, an entrepreneur can always offer to pay sufficiently high interest rates to overcome the regulatory handicap. But, would doing so not make him even more risky? With current regulatory risk aversion we should cry for the future real economy of our children.

Sir, in 2003, at the World Bank’s Executive Board (before Nassim Nicholas Taleb had appeared on the scene to discuss fragility) I stated: "A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind."

So, I guess you can you imagine how much I fret us humans falling into the hands of a final conquering algorithm.

Or having to suffer the consequences of the systemic risks resulting from banks using fewer and fewer human bankers… with probably higher bonuses to the remainders.

By the way since the replaced bankers used to pay taxes, will we at least be able to tax those algorithms?

But, come to think of it, if an algorithm substituted for bank regulators that could be great news. I mean any half-decent algorithm would be able to figure out that what is really risky for our bank system is not what is perceived as risky but what is perceived as safe.

And any half-decent algorithm would also require an answer to the question of “What is the purpose of banks?” And I suppose no regulator would dare tell it, “Only to make the maximum risk adjusted returns on equity” 

@PerKurowski

Embracing some inefficiency and duplication will improve resilience and recovery; and will reduce system fragility.

Sir, Gillian Tett writes “one of the problems of the modern world is that we live in such a tightly interconnected global system that it is a fantasy to think we can ever abolish all [terrorist] threats” and argues “the sooner our leaders can start talking bout resilience and recovery – and embracing some inefficiency and duplication– the better”, “Resilience in a time of crises”, June 25.

In March 2003, as an Executive Director at the World Bank, in a formal written statement I stated:

"A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind.

Ages ago, when information was less available and moved at a slower pace, the market consisted of a myriad of individual agents acting on limited information basis. Nowadays, when information is just too voluminous and fast to handle, market or authorities have decided to delegate the evaluation of it into the hands of much fewer players such as the credit rating agencies. This will, almost by definition, introduce systemic risks in the market and we are already able to discern some of the victims, although they are just the tip of an iceberg.

The Basel Committee dictates norms for the banking industry that might be of extreme importance for the world’s economic development. In Basel’s drive to impose more supervision and reduce vulnerabilities, there is a clear need for an external observer of stature to assure that there is an adequate equilibrium between risk-avoidance and the risk-taking needed to sustain growth."

But my warnings were ignored. With Basel II in June 2004, not only were credit rating agencies fully empowered to determine what was risky and what safe, but also the whole issue of the need for bank credit to be allocated efficiently to the real economy, was totally ignored.

Just like my over thousand letters on subprime banking regulations have been ignored by all in FT, probably because you cannot fathom the idea that regulators, experts, could be as dumb as I hold them to be.

Ms. Tett, first I dare you to answer this question: What assets are more likely to generate that kind of excessive exposures that could endanger the banking system, prime AAA rated assets or speculative and worse too below BB- rated assets?

And then reflect on that the risk weights for AAA rated assets was set to 20% while that of the below BB- at 150%.

And also reflect on that allowing bank to leverage equity differently, based on perceived risk, guarantees that the allocation of bank credit to the real economy will be distorted.

So Ms. Tett, when you then conclude that Donald Trump and other western politicians should be educated on issues of resilience and recovery, perhaps you might not have earned the right to throw the first stone.

@PerKurowski ©

A world obsessed with Best Practices may calcify its structure and break with any small wind

In reference to Mr. Flash Crash’s supposedly malevolent disruption of the market in 2010, John Plender writes interestingly about globalization, regulations and fragility “Global financial regulation meets a cul-de-sac” April 23.

In this respect I would like to recall a written statement that I delivered as an Executive Director of the World Bank on April 2, 2003, while discussing its Stategic Framework 04-06. In it I wrote:

“Ages ago, when information was less available and moved at a slower pace, the market consisted of a myriad of individual agents acting on limited information basis. Nowadays, when information is just too voluminous and fast to handle, market or authorities have decided to delegate the evaluation of it into the hands of much fewer players such as the credit rating agencies. This will, almost by definition, introduce systemic risks in the market and we are already able to discern some of the victims, although they are just the tip of an iceberg.

A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind. Who could really defend the value of diversity, if not The World Bank?"

http://subprimeregulations.blogspot.com/2003/03/my-comments-on-world-banks-strategic.html

@PerKurowski

Too well tuned?

Sir, John Plender in “It’s time to rewrite fashionable finance ideas”, May 4, refers to the need for some redundancy in the system so as to be able to respond better to unforeseen events. Below is how I addressed that issue in my Voice and Noise of 2006.

Too well tuned?: Martial arts legend Bruce Lee, whom many people regarded as immortal, died at the age of only 32 of a cerebral edema, or brain swelling, after taking some sort of aspirin. I have not the faintest idea whether that pill actually had anything to do with his death but I have frequently used (or misused) this sad death as an example of how an organism could be in such a highly tuned and perfect condition that it could not resist a small external shock. And I used this metaphor to explain why companies nowadays, pressured by the stock market’s expectations for the next quarterly results; the latest theories in corporate finance as to how squeeze out the last drop in results; and, perhaps, even some bit of creative accounting, might be so well-tuned (no little reserve fat left) that they would not be able to withstand any minor recession. (Whenever I expose this theory, I can see in my wife’s eyes that she believes this is just my preparing an excuse for my growing—ok, grown—midline.)

Europe needs and merits someone better than Mario Draghi

Sir, when Guy Dinmore, Quentin Peel and Peggy Hollinger report” Mario Draghi poised for ECB job”, April 27, they refer to "his prominence as head of the Financial Stability Board”. Let me remind you that the most adequate name for that board would be the “Financial Fragility Board”. With their artificial and global regulatory construes they are introducing a fragility that has made and will make the financial system more prone to breaking. When you for instance build resistance against earthquakes, more than the basic strength of material you need to consider their flexibility.

Since Mr. Mario Draghi is one of those who so many years into this crisis has not yet understood the immense damage the regulators of the Basel Committee produced, when they considered the credit ratings for the capital requirements of banks, even though these had already been considered when the market and banks set their risk premiums, he does not seem qualified for such an appointment. A Europe that is so messed up because of the excessive build up of sovereigns and “triple-A rated debt, very much induced by the Mario Draghis of this world, needs someone better.

What about accountability? Giving him a promotion? Would you have made a Chamberlain with his “Peace in our time” the War Minister? I don’t think so! But, that indeed seems to unfortunately be the name of the game, in a world where the too big to fail banks are allowed to grow bigger still.