Loony risk-weighted capital requirements block entrepreneurs’ access to fair credit.

Sir, Eric Schmidt writes“Right now, the UK, the EU and the US share a growing problem: we are experiencing a market failure in the way we support entrepreneurs.” “Our narrow view of entrepreneurs squanders talent”, November 28. 

Absolutely! But some market failures are government produced. 

If a bank lends to someone wanting to buy a house, something perceived as safe, the regulators allow it to hold much less capital that if it lends to an entrepreneur, something perceived as risky. 

So if a bank lends to someone wanting to buy a house, something “safe”, it will be able to leverage its capital much more than it can do if it lends to an entrepreneur, something

So if a bank lends to someone wanting to buy a house, something “safe”, it will be able earn much higher expected risk adjusted returns on its equity than it can do if it lends to an entrepreneur, something “risky”. 

But was it always this way? Of course not! This happened when bank regulators introduced the risk weighted capital requirements for banks. That which is based on that truly loony concept that what bankers perceive as risky, is more dangerous to our bank system than that what bankers perceive as safe. 

Since then millions of credit requests have been either negated or if approved, have had to support a higher than needed interest rate. 

Schmidt also writes about the need to “drop the tunnel vision promoted by many academic and professional specialisations”.

Absolutely! I have often argued that had there been: 

a plumber or a nurse disturbing the regulators’ group-think with an innocent question like “what has caused big bank crises in the past?” 

or a professional that had taken a course in conditional probabilities, 

or someone (incorrectly) quoting Mark Twain with “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain”, 

or a golfer asking “why would you assign more handicap strokes to good players taking these away from lousy players like me?”, 

then the 2008 crisis would not have happened… and Lehman Brothers would still be alive and kicking.

God make us daring!

@PerKurowski

If only bank regulators had taken their clues from fixed odds betting terminal regulators.

Sir, Henry Mance and Camilla Hodgson write about the reduction of The government announced last year that it would reduce “the maximum stake on fixed-odds betting terminals — such as roulette — from £100 to £2 to tackle problem gambling.” “Problem gambling shake-up set to be brought forward” October 15.

Of course that will operationally distort fixed odds betting terminal playing, slowing it down, but by keeping the odds as designed for the game, meaning every bet having exactly the same probability adjusted payout, it will not alter the nature of it. 

We can only wish our current bank regulators had used a similar route because these, by allowing banks to leverage assets differently based on their perceived (or decreed) credit risk, actually determined that banks would obtain higher risk adjusted returns on equity on assets perceived as safe than on assets perceived as risky… and that has clearly distorted the whole nature of banks, when fulfilling their expected role of allocating credit efficiently to the real economy. How long would the game of roulette have survived such regulations?

In terms of betting on horses at the racetrack that would be like handicap officials taking off weights from the stronger and faster horses and placing these on the weaker slower ones. How long would horseracing tracks survive such distortions?

In terms of our ordinary golf that would be like handicap officials giving more strokes to the better players than to lousy players like me. How long would our golf clubs survive such distortion?

What’s going to happen to our bank systems? If these regulations persist, they are going to implode on some especially excessive exposures, to what is especially perceived (or decreed) as safe, against especially little capital. No doubt about it!

@PerKurowski

Let us hope the golf handicap system does not fall into the hands of something like the banks' Basel Committee.

Sir I refer to Anjum Hoda’s “The Bank of England´s fixation with price stability has cost us all” August 26.

Hoda puts squarely the blame for current problems, like weak wage growth and banking crisis, on “central bank’s decisions to price money incorrectly- a mistake that led to disjointed, mutually unsupportive outcomes in the capital and in the labour markets”.

I do not know sufficiently to hold an opinion on what role that played, but I do firmly believe that much more culpable were the risk-weighted capital requirements for banks, based on perceived risks already cleared for, which profoundly distorted the allocation of bank credit.

Since after soon a thousand letters to you trying to explain it I have not been able to do so, and though I do not know whether Anjum Hoda or you play golf, let me use its handicap system to illustrate what is going on.

The golf handicap system allows good and bad players to compete. Of course, now and again, the handicaps do not reflect the real golfing abilities of the players, just like credit ratings sometime misses the credit risk.

But what would happen if a Basel Committee for Golfing, because those with higher handicaps could be cheating themselves into some unjust winnings, decided to copycat their colleagues in the Basel Committee for Banking Supervision and instruct the following:

All those with handicap between 13 and 18 will have their handicap automatically reduced with 9 strokes, those between 7 and 12 with 6, and those between 1 and 6 with 3 strokes. 

Would that solve it? No, the unfortunate “unexpected consequence” of it would be that only scratch players were to be able to play golf competitively. Just like risky small businesses and entrepreneurs cannot currently compete in a fair way for access to bank credit, since that credit is now given primarily to the credit risk scratch players, namely the “infallible sovereigns”, the members of the AAAristocracy and house purchase financing.

PS. August 14 FT published a special report on Golf. In it Roger Blitz in “Sport stuck in a rut has to get a grip on its future” wrote “A single [governing] body would appear a logical outcome for an increasingly global game”. Let us golf lovers pray it does not fall in hands similar to the Basel Committee… since our breed would die out so much faster.

Regulators are quite busy fooling themselves.

Sir in “A smaller role for Wall Street” December 29 you write “Above all, regulators do not want to be fooled again”. Let me assure you that no one fooled the regulators more than they fooled themselves, and, from the looks of Basel III, they still keep on doing that.

June 2010, in Washington D.C. I commented to Lord Adair Turner, the Chairman of the FSA, that he as a regulator was acting like a confused handicap officer on a horse-racetrack, taking away the weights of the good runners (triple-As) and placing these on the bad runners or debutants (small businesses and entrepreneurs), without even informing the bettors and the bookies, and believing this would lead to a fair and good race. This layer of discrimination, slapped on top of the market´s natural adverseness to risk, pushed the banks excessively into AAA land and is affecting quite seriously the real economy.

I also reminded Lord Turner that even from a pure limited regulatory perspective it made no sense, as the only thing capable of posing a systemic threat to the banking system was precisely what was perceived as not risky, by banks and regulators alike. Lord Turner, in an email answered that “Our ability to know ex ante what is low and high risk is clearly limited” and that my “argument certainly poses a challenge which I need to think about”. It would seem he is still thinking about it… or trying to forget the inconvenience.

A day at the races

Sir, Michael J. Mauboussin in “Flutter on mispriced US equities could prove a winner” November 24, writes “You don’t make money knowing which horse will win or lose; you make money determining which horse has odds that are mispriced”.

Absolutely, and this is as good an occasion to remind of the fact that if credit-ratings were set perfectly, all bank lending transactions would be perfect barters, and there would not longer be any profit opportunity for any side… and therefore markets and banking would slowly die out. Of course, that is not going to happen because credit-ratings are by definition always imperfect… no matter how much bank regulators want them to be perfect so that they do not have to worry about the only risk that worries them, even if this leaves the rest of the world to worry about all other risks, like the lack of jobs.

By the way, back to the races, do you know why the crisis? The handicap officers place extremely low risk-weights on the triple-A rated horses and much heavier risk-weight on the debutant or weaker BB- horses, without telling the bookies or the gamblers, and thought they were going to have a great and fair race… a total chaos that surpassed what even the Marx Brothers could have come up with in their wildest dreams ensued.

The strangest thing though is that we, bookies and gamblers, allow those same crazy handicap officers in the Basel Committee to keep on deciding the handicap system for our banks.