Tier one capital ratios is a game invented by regulators for banks to play.

Sir, Jonathan Ford mentions “An average tier one capital ratio of 8 per cent —. An accounting measure of their soundness, it meant banks could lose that proportion of the value of their risk-weighted assets before their loss-absorbing capital was spent.” “Financial fragility lurks behind a confident façade” September 17.

No, not really-really so. Let us, just for the example suppose that a bank carries only very “safe” corporate assets rated AAA to AA assigned by the regulators a risk weight of 20%. Based on the Basel II basic capital requirement of 8%, that meant it needed to hold only 1.6% in capital against those assets. That would give the bank a tier one ratio of 8%... but how much could it afford to lose on its assets that had been risk weighted before its capital was completely gone? Not 8%, but 1.6%.

The risk-weighted assets only give a correct indication if the perceived risk reflected are correct and if bankers will manage those perceived risks correctly. What are the chances of that? Quite slim, especially when banks have all the incentives to minimize equity they are holding, something that makes it easier for them to maximize the return on equity to their shareholder (and of course the bankers’ own bonuses)

In other words, the Basel Committee tier-one bank capital ratio, based on risk-weighted assets, as if risks were known, is just devious and dangerous false information that feeds a false sense of security. Nothing of what accountancy can misreport beats that. Worse, by distorting the allocation of credit, much more than concealing realities, it changes realities… on a global scale.

PS. Here is an aide memoire on the mistakes in the risk weighted capital requirements for banks.

@PerKurowski

It would be helpful if Martin Wolf finally realizes the dangers the risk weighted capital requirements for banks pose.

Sir, now, more than 12 years after Basel II was approved Martin Wolf writes: “If one ignores the vanishing trick of risk-weighting, the true leverage of many large banks remains at more than 20 to one.” “Banks are weak links in the economic chain” February 17.

But, of course, the real question though is, why have regulators ignored the dangers “the vanishing trick of risk-weighting” poses? Not only can that risk weighting that was envisioned to provide better and more comparable information on banks confound the markets more; it also provides banks with an versatile instrument to game the regulations; and, worst of all, it distorts the allocation of bank credit to the economy.

On that last, the distortion, Wolf might at long last begin to wake up as he writes: “Banks are highly leveraged plays on economies. If economies are sick, banks are likely to be sicker.” So now let us hope that from that he could deduct that the way bank credit is allocated to the real economy carries real significance to the health of the economies and the banks.

And then, Hallelujah, Martin Wolf finally accepts “that banks are exposed to almost everything”. That should allow him to understand the idiocy of re-weighing for basically the only risk that banks with interest rates and amounts of exposure already clear for, while leaving the whole universe of other risks a bank faces out of the regulatory equation.

Sir, as you well know by now I will with much interest follow where Wolf goes to now because it would of course be very useful if the leading economic commentator of the Financial Times opened his eyes to what has and is really happening with our banks.

Currently, by regulators allowing banks to earn higher risk adjusted returns on equity financing on what is perceived or deemed as safe than on what is perceived as risky, banks have stopped financing the riskier future and settled on refinancing the safer past… and that cannot be good for anyone, least so for our children and grandchildren.

And of course, all for nothing because major bank crisis never ever result from excessive exposures to something ex ante perceived as risky.

@PerKurowski ©

A globalized harmonized regulatory approach, imbeds the greatest potential of producing truly fatal systemic risks.

Sir, Rick Lacaille, of State Street Global Advisors concludes with “Only a globally harmonised approach — where regulators and asset managers work together to scrutinise and overcome issues linked to systemic risk — will assure global financial stability.” “Regulators must keep tabs on twin risks of leverage and liquidity” November 26.

I find myself on exactly the opposite side. In 1999 in an Op-Ed I wrote “the possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause its collapse”

Let me just here quote from a list of regulatory mistakes, some relevant principles that are ignored by the current meddling scheming regulators. These are in much perfectly applicable to regulations of asset managers.

To allow bank equity to be leveraged with net margins of assets differently, distorts the allocation of bank credit.

The scarcer the bank capital is, the greater the distortions produced by the risk weighted capital requirements.

Bank capital is to cover for unexpected losses, yet regulators base the requirements on expected credit losses.

The safer something is perceived the greater is its potential for unexpected losses.

The risk of a bank has little to do with perceived risk of assets, and much to do with how the bank manages risks.

Any perfectly perceived risk causes the wrong actions if the risk is excessively considered.

The undue importance given to few information sources, credit rating agencies, introduced a serious systemic risk.

Regulators ignored that imposing similar and specific regulations on a system stiffens it and increases its fragility.

Any regulatory constraint that can be gamed will be gamed benefitting those gaming the most, in detriment of other.

Lacaille writes: “In our view, leverage should remain the guiding indicator of systemic risk. Regulators particularly need to look for managers that operate leveraged strategies, with a focus on identifying and closing loopholes for disguised leveraging.”

The best way of avoiding disguised leveraging is of course not allowing the costumes. One simple capital requirement for all assets would be the most transparent and the least risky way to go.

Will that lead to more risk-taking? Yes, but not to excessive systemically important financial exposures to what is risky. The dangers will, as always, remain being that of excessive financial exposures to what ex ante is perceived as safe, but that ex post can turn out to be risky.

@PerKurowski ©

Insurance sector: Again loony regulators are trying to cover for unexpected losses by analyzing the expected ones.

Sir, I refer to Alistair Gray’s report on “the capital [insurance companies] must hold against unexpected losses” “Insurers face tough new safety rules” October 5.

In it Gray writes: “A paper to be published quantifies the higher capital requirements for the designated insurers. The size of the hit will depend on each company’s mix of business and how systemically important regulators deem them to be. So-called non-traditional and non-insurance (NTNI) activities carry the largest surcharges, of between 12 per cent and 25 per cent.”

So again we have regulators, like those of banks, who set capital requirements for unexpected losses based on the expected risks they perceive. Loony! Do regulators really think they can perceive risks better than the insurance companies? Is there not a huge risk that both the insurance companies and the regulators will perceive the same risks, and so that there therefore will be an overreaction to these risks, which obviously means a sub-consideration of other risks? And boy, are these regulations just screaming to be gamed?

Also, at a moment that so many want infrastructure projects to be started as a way of reactivating the economy, who of the regulators is thinking about the fact that many of the risky long term projects, often financed by insurance companies… could perhaps not happen only because of wrong and distorting capital requirements.

Where have all humble regulators that know of the importance of not interfering gone? When will they ever learn, when will they ever learn?

Why do they in order to cover for unexpected losses not just set for instance a 10% capital requirement on all assets? Are they scared they would then look like less sophisticated regulators to the general public? If so, God save us from regulators suffering an inferiority complex.

@PerKurowski ©

Those creating regulations that can be cheated provide the cheaters competitive advantages.

Sir, Michael Skapinker writes: “Devising a system to detect when a car is being tested surely required planning, expertise and a specific decision. It must have required forethought. It is not something you can drift into through incrementally deteriorating behavior”, “Volkswagen, its software and the psychology of cheating” October 1.

Indeed and we must blast Volkswagen for doing that. But, is it not also the responsibility of regulators to make absolutely certain that cheating cannot happen? Otherwise they will be providing the cheaters with a competitive advantage to win over those who do not cheat. At the end of the day, though Volkswagen needs to be punished, severely, let us not forget that it all happened thanks to lazy regulators who thought it was enough to regulate and no would cheat or game it.

Exactly the same happened when bank regulators allowed banks to hold very little capital against what was perceived as absolutely safe, and the securities backed with lousy mortgages to the subprime sector were dressed to the nines, wearing false AAA ratings.

@PerKurowski

FT, why should bank regulators have the right to game the capital requirements with their credit risk weights?

Sir you write: “bad accounting practices can contribute to financial instability. Booms flatter their measured profitability, which encourages them to take more assets on to their balance sheets. Thus leverage begets more leverage throughout the banking system, until asset prices can rise no longer and the whole edifice comes crashing down.” “Banks should not be able to game accounting rules”, September 3.

Of course you are absolutely right we need the good accounting practices, but, frankly, don’t you think that no matter how bad the accounting, it could never have caused the kind of bank leverages that the regulators allowed for with their credit-risk weighted capital requirements. For example what about the over 60 to 1 leverages authorized in Basel II for bank exposures to AAA rated securities or to sovereigns rated like Greece was until November 2009? What about that infinite leverage authorized by Basel I in 1988 when regulators decreed the risk weights for OECD sovereign to be ZERO percent? If that is not gaming what is?

Sir, why do you insist in covering up for the fundamental mistake of the Base Committee; or when will anyone in FT dare to explain why these regulations do not dangerously distort the allocation of bank credit to the real economy?

And you also write: “Bankers complain that a tougher regime might force them to realise more losses in the short term. Tough.”… Yes, tough on banks… but, because of banks then having less capital, and the risk weighted capital requirements, it would also be tough on all those borrowers who would have even less access to bank credit… something which would also be tough for many unemployed.

@PerKurowski

If only our bank regulators in the Basel Committee / FSB grew up to wear long pants and assumed their responsibilities.

Sir, Gillian Tett holds that: “Credit derivatives deserve a revival — if financiers grow up” May 22. I agree… but that is far from being enough.

Though Ms. Tett rightly advices that these derivatives need to be a genuine tool in risk management, and not just a technique for regulatory arbitrage… she keeps mum on the fact that the only reason for which they are used to arbitrage, is the availability of regulations that can be too easily arbitraged, or are too tempting to arbitrage, like the current credit-risk-weighted capital (equity) requirements for banks.

In short for risk-management instrument to be useful you have to remove the distortions made possible and provided by regulations… and for that to occur it is even more important that regulators grow up. 

We can all wonder how immature regulators have to be to be looking at the risks of bank’s assets and not on how banks manage those assets… and we can all wonder how immature they have to be regulating banks without even defining their purpose... and we can all wonder how infantile they can be thinking themselves able to regulate with some formulas… that no one of them can explain.

@PerKurowski

Bank regulators caused lenders to also argue borrowers’ creditworthiness. Not so smart!

Sir I refer to Frank Partnoy’ “The Fed’s magic tricks will not make risk disappear” March 5.

In it Partnoy to that “complex rules create incentives for banks to… hide risks”, and he is perhaps more right than he knows.

For instance, what did we have before Basel Committee´s credit risk weighted equity requirements? We hade the banks interested in arguing the credit risk of the borrowers, so to be able to charge them higher interest rates; and the borrowers interested in proving they were very creditworthy safe, so to get larger loans at lower rates.

This of course created a certain tension that could only benefit a regulator… and helped foster an efficient allocation of bank credit.

What do we have now? We now have bankers and borrowers on the same side. Now the banker also wants to convince the regulator that the borrower is very creditworthy, so as to be able to hold less equity when lending to it, and thereby generate higher risk-adjusted returns on its equity. That cannot be helpful for a regulator, and can only lead to an inefficient allocation of bank credit. Not so smart!

The most extreme example of the previous is the alliance between banks and sovereigns. That one is based on: “I the sovereign lend you the bank my full support; and in return you the bank lend me the sovereign a lot of money; and to facilitate all that we both assume that I am an infallible sovereign, and represent no credit risk whatsoever, and so therefore, you banker, need to hold no equity when lending to me.

So Sir, when it comes to gaming regulations, the regulators, who work for governments, they also know how to game regulations, in order to take care of themselves, by taking care of their bosses’ wishes.

PS. How do you fire a regulatory mandarin who sucks up to his boss so much that he defines him to be an infallible sovereign?

How can you call the mother of all bank credit distortions an “opiate of ‘light touch’ regulation”?

Sir, Jonathan Ford refers to an “opiate of ‘light touch’ regulation before the financial crisis” “The right balance of banking regulation is still some way off” March 2.

He has no idea. How on earth can you call a regulation which restrict banks to leveraging their equity 12 times to 1 in the presence of something perceived as risky, but allows a 60 and even higher leverage for something perceived as absolutely safe, “light touch”?

Ford speaks about power passing to regulators after 2008. Wrong! Already with Basel I regulators gamed the equity requirements for banks in favor of the sovereigns, meaning the governments, meaning their bosses.

Yes Mr. Ford there is “the risk of starving some parts of bank’s business that, while costly to run and consumptive of capital, are of high social value”. But who decided the rates of capital (equity) consumption, the regulators with their “light touch”?

PS. Mr. Ford, give us one single bank crisis resulting from an excessive exposure to something that was perceived as risky, when banks placed that asset on their balance sheet.

Basel Committee and Financial Stability Board… please… Let it go¡

Sir, January 2003 in a letter you published I wrote: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds”.

And so one could assume that when Sam Fleming now, December 23, reports that “Banks face sharp restriction on use of rating agencies in loan risk assessment” I should be satisfied.

I am not! Because now the regulators want to impose other criteria to be used by banks for calculating how much capital (equity) they need to hold against an asset.

For instance: “Corporate exposures would no longer be risk-weighted by reference to the external credit rating of the corporate, but they would instead be based on a look-up-table where risk weights range from 60% to 300% on the basis of two risk drivers: revenue and leverage.”

And so all regulators are doing here is introducing new sources of systemic risks; and defining new tools to be used in gaming a system the regulators set up to be gamed.

Why can’t regulators just let it go and let the banks use any method each one of them finds appropriate to measure credit risks; and why can’t they just fix one capital requirement for all assets… no gaming allowed?

Sir, let me explain it to you again, for the umpteenth time.

Do you agree Sir with that a bank will and should decide how much to lend, at what interest rates and on what other terms, based on the credit-risk he perceives the borrower represents?

I assume you answer "yes" Sir, but so then, why on earth should bank regulators also stipulate that the same perceived credit-risk is also to be cleared for in the capital (equity) account of the bank? Is not clearing for the same perceived risk twice overdoing it? 

Does that not mean for instance that, if we instead of allowing two nannies to use their average risk aversion when taking care of our kids, we allow them to apply the sum their risk aversions, then we would run the risk of making real monumental wimps out of our kids?

Sir, it is very clear that our bank regulators are digging themselves and our banks ever deeper in a horrible hole of their own creation. That could be because they do not want to admit their mistakes or, much worse, God help us, because they still do not understand their mistakes.

Regulators gaming regulations massively, is so much worse than banks gaming regulations somewhat

Sir, Sam Fleming reports that “Global regulators are cracking down on banks that try to game capital rules for their trading businesses by proposing new standards for the way lenders assess risk… The new system will require banks to calculate risks according to a standardised approach in addition to their own in-house methodology” "Banks set for tougher trading rules", November 1.

There are rules which can be gamed, and then there are those which cannot. For instance, if Basel II had required banks to hold 8 percent of well defined capital against any asset, that would not have been possible to game. But, instead regulators went for the risk-weighing system which are so easy to game… even for the regulators.

In fact, it was the regulators who really gamed the whole system, with such lunacies as assigning risk weights of 20 percent, or even zero, which allowed banks to hold some assets, like AAA rated securities and loans to infallible sovereigns, against only 1.6, or even zero, capital, while assigning 100 percent risk weights, to “riskier” loans, which forced banks to hold 8 percent in capital, 500 percent more, on loans to medium and small businesses, entrepreneurs and start-ups.

And so if you ask me, much worse than banks gaming regulations, is when the regulators do so.

And let me ask. Do you think the banks, on their own, without this regulatory assistance would have been able to game themselves into 40 or even 50 to 1 leverages? No way Jose!

FT journalists don’t be so lame. Dare to ask bank regulators to explain risk-weighted capital requirements to you.

PS. Regulators are suffering from the Annie Oakley syndrome, and we because if that.

It's what's safe that's risky!

When "setting bank equity requirements, it is essential to recognise that so-called “risk-weighted” assets can and will be gamed by both banks and regulators. 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." Martin Wolf

https://www.ft.com/content/7a95df3e-cb50-11e1-b896-00144feabdc0

Wolf ends with:“We cannot hope for miracles. But we can make bankers more useful and less dangerous. Focus on that.”

Indeed, let's all focus on that.

Please free us from imprudent risk aversion and give us some prudent risk-taking

My 2019 letter to the Financial Stability Board: Acknowledged and Ignored.

PS. Read what #AI ChatGPT OpenAI opines on this.

Here a 2010 homemade YouTube in which I tried to explain the Global Financial Crisis with a 2x2 matrix.

“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.” Paul Volcker

PS. 2023 tweets

A tweet: "Incentives matter: The escape valves of risk weighted bank capital (equity) requirements, cause banks’ risk models to be more about equity-minimizing/leverage-maximizing, than about analyzing bank assets’ true risks. That’s life!"

Another tweet: "The world has been duped/lulled into a false sense of security by the use of risk weighted assets (RWA) as a real and valid measure of banks' risk exposure. E.g., the duration risk of #SVB long-term government bonds is not included in the weighted risks."

Another tweet: “SVB regulators were ‘asleep at the wheel’” What’s a supervisor to do? Inform his boss Treasury bonds' 0% risk weight must be increased?  It is difficult to get a man to understand something, when his salary depends on his not understanding it” Upton Sinclair

Another tweet: "The most dangerous risk banks take, #unwittingly, is the buildup of huge exposures with assets perceived as safe, those which caused all major bank crisis. Regulators’ risk weighted bank capital/equity requirements, unwittingly, puts that risk on steroids."

Another tweet: "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 [risk weighted bank capital/equity requirements] may calcify its structure and break with any small wind."

Another tweet: "Bank capital/equity requirements mostly based on perceived credit risks, not misperceived risks or unexpected events, e.g., covid, inflation, war, interest rate rise, doom banks to stand naked, when needed the most, when hardest to raise equity"

Another tweet: “A regulation that regulates less, but is more trigger-happy & treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might lead us to… the mother of all bank crises”

Another tweet: "Risk weighted bank capital/equity with decreed weights: 0% government – 100% citizens, as if bureaucrats know better what to do with credit than e.g., small businesses and entrepreneurs, is that communism, fascism or just plain vanilla Banana Republic?"

Another tweet: "#SVB have all besserwissers Monday morning quarterbacks explaining us duration risk; why holding long-term government bonds was dangerous. Not a word about why regulators require so little capital/equity/skin-in-the game against these assets.

Another tweet: "The stress test that shall not be dared. What if that what’s perceived as safe is more dangerous to bank systems than what’s perceive risky, and therefore the risk weighted bank capital/equity requirements do not reflect real bank risks?"

Another tweet: "When concocting the risk weighted bank equity requirements, evidently no regulator asked: What would Mark Twain opine about with what assets banks might create dangerously large exposures, with some perceived as risky or with some perceived as safe?

On bank regulations, I’m not a newcomer nor a Monday morning quarterback.