To tell us “What really went wrong in the 2008 financial crisis” might require more distance to the events

Martin Wolf reviewing Adam Tooze’ “Crashed: How a Decade of Financial Crisis Changed the World” refers to the author’s question of “How do huge risks build up that are little understood and barely controllable?” “What really went wrong in the 2008 financial crisis?” July 18.

May I suggests as one cause, the nonsensical ideas that can be developed through incestuous groupthink in mutual admiration clubs of great importance, such as bank regulators gathering around with their colleagues of the central banks in the Basel Committee for Banking Supervision.

Wolf writes: “The crisis marked the end of the dominant consensus in favour of economic and financial liberalisation” 

Not so! The end in “favour of economic and financial liberalisation” happened much earlier when the regulating besserwissers decided they knew enough about making our bank systems safer, so as to allow themselves to distort the allocation of bank credit.

In 1988, the regulators, with the Basel Accord, Basel I, surprisingly, with none or very few questioning them, decided that what’s perceived as risky was more dangerous to our bank system than what’s perceived as safe, and proceeded to apply such nonsense with their risk weighted capital requirements for banks. More risk, more capital – less risk, less capital. 

That meant that banks could then leverage more their regulatory capital (equity) with “the safe” than with “the risky”; which translated into banks earning higher expected risk-adjusted returns on equity with “the safe” than with “the risky”. That would of course from thereon distort the allocation of bank credit more than usual in favor of the safe and in disfavor of “the risky”.

That of course ignored the fact that what is perceived as risky has historically proven much less dangerous to the bank system than that which is perceived as safe. 

Basel I, which already included much fiction, like assigning a 0% risk weight to sovereigns and 100% to citizens, was bad enough but then, in 2004, with Basel II, the regulators really outdid themselves allowing for instance banks to leverage 62.5 times their capital with assets that had an AAA to AA rating, issued by human fallible rating agencies was present.

We have already paid dearly for that stupidity, as can be evidenced by the fact that absolutely all assets that detonated the 2007/08 crisis had in common generating especially low capital requirements for banks, because these were perceived (houses), decreed (Greece) or concocted (AAA rated securities) as safe.

I have ordered it but of course I have not read Adam Tozze’s book yet. When I do I will find out if it makes any reference to this. If not, I might just have to wait for other historians who are more distant from the events.

@PerKurowski

To understand risk-weighted capital requirements for banks distort, is not geeky, just thinking outside The Group.

Sir, Gillian Tett mentions that Hyun Song Shin, and economic adviser at the Bank for International Settlements, “believes that modern economists have a crucial blind spot: they tend to ignore how the financial system really works, since they operate with idealised models of money and investor incentives.” “A blind spot masks the crisis danger signs” March 17.

Of course! As I had written to FT, in thousands of letters, the risk weighted capital requirements for banks has completely distorted the allocation of credit.

That distortion has similarity to those found in a “BIS study of German life insurance companies, which have recently accounted for 40 per cent of government bond purchases, concluded these were gobbling bonds not due to deflation forecasts, or an enhanced appetite for risk… but because “accounting rules and solvency regulation” forced insurers to match assets to liabilities.”

But then Ms. Tett goes into writing of the “kinks in how these rules work (too complex to spell out here)… The result was a bizarre, self-reinforcing feedback loop that traders describe as “negative convexity” (and George Soros, the hedge fund manager, calls “reflexivity”). This sounds geeky.”

No Ms. Tett, it’s not geeky at all! It just requires simple 101 economics to understand that if banks are allowed to leverage more with some assets than with others, that is going to produce a complete different set of expected risk adjusted return on assets than those that would be present in the absence of such regulatory distortion... and of course willingness to think outside The Group.

For instance, if the sovereign has a zero percent risk weight, and an SME a 100% one, this means banks need to hold much less capital when lending to a sovereign than when lending to a bank. Ms. Tett, honestly, is it really geeky or should it not be quite simple to then understand that the sovereign is going to be favored more than he would ordinarily been favored, and that the SME will find it more difficult than usual to access bank credit?

Sir, day by day we are getting closer to some real fundamental problems, like:

Who sold the regulators that fake idea that what is perceived as safe is more dangerous to the bank system than what is perceived as risky.

Who were the regulators who believed such crap and did not even care about defining the purpose of banks before regulating these?

Where were all the economists (and journalists) that should have raised the question that needed to be raised?

Sir, with an insistence for which I am not ashamed to be called an obsessive, I have and still do my part. Are you doing yours? 

@PerKurowski

If they do not belong to her The Group, the tribe, Gillian Tett does not seem to read what her readers write to her.

Sir, Gillian Tett writes “Echoes of 2008 as danger signs are ignored ” and mentions the “Jackson Hole tribe barely mentioned these at all”. “We had all better hope that by the summer of 2017 a debate about finance gets a proper billing at Jackson Hole” September 2.

I invite you here to read the probably more than hundred letters I have sent Ms Tett over the years, but that she has decided to ignore, probably because I do not belong to her The Group.

Who am I? Just a former Executive Director of the World Bank who, in October 2004, in a formal statement delivered at the Board wrote:

“Phrases such as ‘absolute risk-free arbitrage income opportunities’ should be banned in our Knowledge Bank. We believe that much of the world’s financial markets are currently being dangerously overstretched through an exaggerated reliance on intrinsically weak financial models that are based on very short series of statistical evidence and very doubtful volatility assumptions.”

In January 2003, in FT, I warned “that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds”

Here are more of my documented early opinions (1997-2004) on bank regulations

So what would I like Ms Tett to do? To be more than a groupie and do her job asking those she might meet in Jackson Hole, Davos and similar The Group meetings, some of the too many questions that have gone unasked by journalists over the last soon 30 years, like:

How have you defined the purpose of banks before regulating these?

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

Why do you base your capital requirements on the ex ante perceived risks?

“May God defend me from my friends. I can defend myself from my enemies” Voltaire.

Had Tett, or any other important financial journalist, like Martin Wolf, asked some of these questions much earlier, we might not have the need to even reference 2008.

The Basel Accord, Basel I, 1988, set the risk weight of the Sovereign at 0% and that of We the People at 100%... which de facto means that regulators believe government bureaucrats give better use to bank credit than the private sector… something that most of us on Main Street and who are not runaway statists, would find sort of questionable.

@PerKurowski ©

Choosing based on merits defined by the group is often another source of dangerous group-think.

Sir I could not agree more with the arguments presented by Martin Wolf when he writes that “Europe should not control the IMF” May 25, summing it all up in the phrase “The person chosen [as managing director of the IMF] should be willing to take the risks of leading… though, of course, that risk-taking leader could be a European.

The recent Independent Evaluation Officer’s report on the “IMF Performance in the Run-Up to the Financial and Economic Crisis” comes to the conclusion that “The IMF’s ability to correctly identify the mounting risks was hindered by a high degree of group-think”.

This would indicate that the willingness to accept and push for diversity in thinking is one of the most important qualities we need to look for in the next managing director of the IMF.

That said, and fully agreeing with the managing director being chosen by the members based on merit, let us not forget that choosing based on the merits defined by the group, could turn out to be just the mother of all sources of group-think.

The truth about the crisis that the different silos, including FT’s, does not want or cannot see.

Sir, if all sovereign and private bank clients were paying the banks exactly the same risk-premiums, then the risk-weights used in Basel II to apportion the basic capital requirements for banks according to the various categories of credit ratings could have been right. But, they don’t!


The banks and the markets already incorporates in the setting of their risk-premiums the risk information provided by the credit rating agencies, and so when the regulators also used the same credit ratings for setting their risk-weights they made these ratings count twice. It was a huge mistake that resulted in:

1. The setting of minimalistic capital requirements that served as growth hormones for the ‘too-big-to-fail’.

2. That banks overcrowded and drowned themselves in shallow waters, whether of triple-A rated securities backed with lousily awarded mortgages to the subprime sector, or of equally or slightly less well rated “rich” sovereigns, like Greece.

3. A serious shrinkage of all bank lending to small businesses and entrepreneurs as lending to these generated, in relative terms, much higher capital requirement, which made it difficult for them to deliver a competitive return on bank equity.

With Basel III, regulators might be trying to correct for this mistake, instead of correcting the mistake. In other words, the Basel Committee would be digging us deeper in the hole where they placed us.

Too much ‘Group think’ C’est la vie!

Sir Gillian Tett in “Banking oversight and the danger of ‘group think’” March 28 mentions the “difficulty the staff of the Financial Services Authority’s (FSA) face in terms of challenging the dominant financial creed” mostly because they lack the glamour needed to be allowed to question the glamorous.

Something similar happens when a modest MBA like me, with only 30 years street experience, in only a developing country, tries to get through to journalists to alert them of what has and is really happening out there, only to be ignored because it is so much more glamorous when appearing surrounded by PhDs. I guess c’est la vie! Regulatory authorities will not get to see the full truth, and neither will the journalists, not even some columnists.

Now if Gillian Tett sees danger in the above when occurring in FSA she should have a look at what happens in that mutual admiration club composed by The Basel Committee on Banking Supervision, the International Monetary Fund and all their members the Central Bankers…talk about the mother of all ‘group think’ they even have their own checks and balances, like The Financial Stability Forum. The World Bank and that should presumably do some of the questioning, was just told to shut up and harmonize.