Free markets were set up to go bad, because of bad bank regulations.

John Thornhill writes: “The global financial crisis of 2008 exploded the ideology that markets always deliver the goods” “Three game-changing ideas to shape the post-pandemic world” Life and Arts, May 30.

Sir, that is the problem, because that is exactly what all those against free markets want us to believe. 

The 2008 crisis resulted from huge exposures to securities collateralized with mortgages to the subprime sector in the USA, turning out risky. 

And those huge exposures were a direct result of: Regulators allowing European banks and US investment banks to hold these securities, if these were rated AAA to AA, which they were, against only 1.6% in capital; meaning banks could leverage their equity an amazing 62.5 times. 

Securitization, just like making sausages, is the most profitable when you pack the worst and are able to sell it of as the best. If you can sell someone a $300.000 mortgage at 11 percent for 30 years, which was a typical mortgage to the subprime sector, and then package it in a security that you could get rated a AAA to AA, so that someone would want to buy it if it offered a six percent return, then you would pocket an immediate profit of $210.000. 

The combination of those two temptations proved irresistible.

With bank regulations biased against risk taking, the oxygen of development, emerging has been made so much more difficult for nations

Sir, I refer to Jonathan Wheatley’s report on emerging markets “Falling further behind” July 17. 

Banks used to apportion their credit between those perceived as risky, and those perceived as safe, based on their own portfolio considerations and risk adjusted interest rates. But that was before the Basel Committee’s risk weighted capital requirements.

Now banks apportion credit between those perceived as risky, and those perceived as safe, based on their own portfolio considerations, the risk adjusted interest rates, and the times bank equity can be leveraged with those risk adjusted interest rates, so as to be able to earn higher risk adjusted returns on equity.

That has leveraged whatever natural discrimination in access to bank credit there is in favor of the “safer present” against that of the riskier future. Since risk taking is the oxygen of any development, what might this have done to the emerging markets?

PS. Here is the document I presented in October 2007 at the High-level Dialogue on Financing for Developing at the United Nations, New York.

@PerKurowski

Many or perhaps most of our bankers would be much better off, at least happier, if they heeded George Bank’s “Let’s go fly a kite!”

Sir, John Gapper refers to “Two academics who studied investment bankers in London were surprised by their degree of cynicism and noted the absence of ‘meaningfulness, emotions and personal investment in work values’. “Bankers have been alienated from their jobs” July 11.

Call me a romantic if you want but, I know that when bankers who felt proud of being savvy loan officers were, with the introduction of the risk weighted bank capital requirements, pushed aside by equity minimizing and leverage maximizing financial engineers, there had to be a lot of frustrations.

Imagine if you as a loan officer had analyzed in depth the plan an entrepreneur presented in his credit application; and you had gotten to know him well; and you had agreed on a risk adjusted interest rate that made sense for both of you, and then your superiors told you: “No we can only leverage our equity 12.5 times with this loan so you either get him to accept a much higher interest rate, or we’re not interested”… and you knew that higher interest rate doomed the viability of the project? Would you not then feel like our beloved George Banks, that you’d better go and fly a kite?

Sir, most of those who became bankers during the last three decades must have a very hard time understanding what “It's a Wonderful World" is all about.

@PerKurowski

So where were those regulators who knew that “banks had wafer-thin capital levels and were accidents waiting to happen”? In some La-La Land!

Sir, Hans Hoogervorst, the chair of the International Accounting Standards Board, while discussing new accounting standard, IFRS 9, writes:“The truth is that HBOS met bank regulators’ capital requirements, and its financial statements clearly showed that its balance sheet was supported by no more than 3.3 per cent of equity. For investors who cared to look, the IFRS standards did a quite decent job of making crystal clear that many banks had wafer-thin capital levels and were accidents waiting to happen”, “Do not blame accounting rules for the financial crisis”, October 4.

Hoogervorst adds, “with markets swimming in debt and overpriced assets… we need management to own up to the facts — and auditors, regulators and investors to be vigilant.”

So where were the regulators who knew that “banks had wafer-thin capital levels and were accidents waiting to happen”? Clearly not where they should have been! Because regulators who, with Basel II in 2004, felt it was ok to allow a bank to leverage a mindboggling 62.5 times only because a human fallible credit rating agency awarded an asset an AAA to AA rating, must clearly have be away sleeping in some La-La-Land.

And since the regulators still do not understand how their risk weighted capital requirements for banks distorts the allocation of bank credit; first by pushing for especially large exposures against especially little capital to what can be especially dangerous to our bank system, because it is perceived as safe; and then by hindering that risk-taking, like when financing “risky” entrepreneurs, that the economy needs to keep on growing sustainable, which, at the end of the day, is what most matters to keep our bank system safe… they are still in La-La-Land or shamefully still sleeping on the job, or, even more shamefully, doing all they can to cover up their mistake, even if that means causing a new and even worse crisis.

But where was FT during these ten years? You tell me Sir; as for me I at least wrote you and your experts a couple of thousand letters on the issue. You can find these on my blog TeaWithFT searching the label “subprime banking regulations”

@PerKurowski

The pulmonary capacity of banks went from unlimited, through 62.5, 35.7 to 12.5 times of allowed leverage. Where do you think bubbles were blown?

Sir, I refer to John Authers review of “Ray Dalio’s” “A Template for Understanding Big Debt Crises” September 22, 2018.

I have not read the book, and something in it could apply to other bubbles but, if Dalio left out mentioning the distortions produced by the risk weighted capital requirements for banks, those that caused the 2008 crises, he would surely have failed any class of mine on the subject.

Sir, let me be as clear as I can be. 100%, not 99%, 100% of the bank assets that caused the 2008 crisis were assets that, because they were perceived as especially safe, dumb regulators therefore allowed banks to hold these against especially little capital. 

The allowed leverages, after Basel II, that applied to European banks and American investment banks like Lehman Brothers were:

AAA rated sovereigns, including those the EU authorities authorized, like Greece, had a 0% risk weight, which translated into unlimited leverage.

AAA rated corporate assets, were assigned a risk weight of 20%, signifying a permissible 62.5 times leverage.

Residential mortgages were assigned a risk weight of 35%, translating into a 35.7 allowed leverage.

Of course, after the crisis broke out, any few “risky” assets banks held, like loans to entrepreneurs, those that banks could only leverage 12.5 times with went through, (and still do), a serious crisis of their own, when banks began to dump anything that could help them improve that absolutely meaningless Tier 1 capital ratio.

http://subprimeregulations.blogspot.com/2016/12/here-is-succinct-but-complete.html

@PerKurowski

Sheer regulatory stupidity and statism caused the financial crisis. But that shall not be admitted!

Sir, Lord Adair Turner writes: “The financial crisis began because of dangerous features within the financial system itself. Massively leveraged investment banks engaged in socially useless trading of huge volumes of complex credit securities and derivatives… The excessive risk-taking was allowed by bad regulation justified by flawed economic theory.” “Banks are safer but debt remains a danger” September 12.

Turner, like all other involved, does just not tell it like it is! 

The “massively leveraged investments of banks” were caused, 100%, by the simple fact that regulators allowed for these.

The “socially useless” in complex securities were mortgages awarded to poorer house buyers in the US, the subprime sector. 

The “excessive risk-taking” was in fact an excessive risk aversion that led to the excessive build up of bank exposures to what was considered, decreed, or concocted as safe. 

Yes Turner mentions “bad regulation justified by flawed economic theory”, but there was none of that, there was only sheer stupidity. Like when regulators allow banks to leverage 62.5 times only because a human fallible credit rating agency has assigned it an AAA to AA rating.

And Sir, assigning a 0% risk weights to the sovereign, like to Greece is not based one iota on economic theory but all on flawed statist ideology.

Turner is right though when he writes that the “economic growth has been anaemic despite massive policy stimulus… “That poor performance reflects… inadequate capital regulation.”

Indeed, the distortions that the risk weighted capital requirements produced in the allocation of bank credit to the real economy that have not even been admitted much less were eliminated. “Debt burdens shifting around the world economy from private to public sectors” are just one symptom of those distortions. 

In fact by having raised the floor of bank capital requirements with leverage ratios, on the margins, the roof, the distortions of credit risk weighted capital requirements could be worse than ever.

Turner consoles us with “A deep economic recession, made worse by a large debt overhang, could occur even if not a single big bank went bankrupt or needed to be rescued with public money.”

Not true a deep economic recession, a dysfunctional economy is as dangerous as can be for the banks and for us. That is why the most important question that regulators need to answer before regulating banks is: what is the purpose of banks. Except for being safe mattresses to stack away cash there is not on word on this in the whole immense Basel Committee compendium on rules.

“The increasing role of real estate in modern economies is also crucial.” That is because, by means of giving house purchase access to credit on preferential conditions, a house is no longer just a home it has also become an investment asset. The day houses return to being home only it is going to hurt, a lot. 

“Rising inequality”… with capital requirements that favor the “safer” present over the riskier future, how could that be avoided?

PS. And Sir, you know it, FT has in many ways been complicit in the cover up of our mistakes stories peddled by regulators and their colleagues.

@PerKurowski

The priority of those who committed the mistakes that caused the financial crisis has been the cover up, not the corrections

Sir, Gillian Tett, similarly to like Martin Wolf wrote a couple of days ago, expresses surprise and concerns for the fact that so many things that were supposed to be corrected or at least bettered after the financial crisis seem worse today. She lists the level of debt and leverage, the market share of TBTF banks, the size of the shadow banks, and that no few bankers directly related to the crisis have been jailed. “Surprising outcomes of the financial crash”, September 7.

But how can one be surprised by so few corrections and betterments when those supposed to correct and better it remain being those who committed the mistakes, and have not been held accountable one iota for their mistakes? 

But how can one be surprised by so few corrections and betterments when in the aftermath of the crisis so many truths were classified as those that shall not be named, and consequently arduously silenced, like for instance:

Lack of regulations: Wrong! Total missregulation. Regulators for their risk weighted capital requirements for banks used the perceived risk of banks assets, those that bankers were already clearing for, and not the risk that bankers would perceive and manage the risks wrongly. They seemingly never heard of conditional probabilities.

Excessive risk taking: Wrong! It was the regulators excessive risk aversion that gave banks incentive to build up excessive exposure to what was perceived safe. Like allowing banks to leverage assets a mind-blowing 62.5 times only because some human fallible credit rating agencies had assigned it an AAA to AA rating.

Greece did it: Wrong! EU authorities did Greece in, when assigning a 0% risk weight to its debt. Is the statism implied in assigning a 0% risk weigh to the sovereign and one of 100% to the citizens discussed? No! There are too many interested in benefitting from crony statism for that.

Sir, Ms. Tett ends with “predictions are best presented with a dash of humility — and the knowledge that what does not happen can sometimes be even more significant than what actually does.”

Indeed but since “that what does not happen” could be much a result from a lack of questioning, to understand it could also require loads of humility from journalists. Capisce FT? 

@PerKurowski

The US 2008 financial crisis was born April 28, 2004

Sir, Janan Ganesh writes: “A financial crisis that was experienced as a fragmented chain of events is being commemorated as just one: the fall of Lehman Brothers, 10 years ago next month",” “Political distemper preceded the financial crisis” August 30.

That is only because the truth shall not be named. In the case of the United States, that crisis started on April 28, 2004 when the SEC decided that the supervised investment bank holding company ("SIBHC"), like Lehman Brothers, “would be required periodically to provide the Commission with consolidated computations of allowable capital and risk allowances (or other capital assessment) consistent with the Basel Standards." 

When the Basel standards approved in June 2004 included allowing banks to leverage a mind-boggling 62.5 times with any asset that have been assigned by human fallible credit rating agencies an AAA to AA rating, or had been guaranteed by an AAA rated corporation like AIG, the crisis began its construction. That in the European Union the authorities also included allowing banks to lend to sovereigns like Greece against no capital at all would only worsen the explosion.

Populism? What’s more populist than, “We will make your bank systems safer with our risk-weighted capital requirements for banks”? 

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

@PerKurowski

The US 2008 financial crisis was born April 28, 2004 – and different bank capital for different assets are worse than too little or too much bank capital.

Sir, I must refer to Janan Ganesh’s “Political distemper preceded the financial crisis” August 30, in order to make the following two comments:

1. “A financial crisis that was experienced as a fragmented chain of events is being commemorated as just one: the fall of Lehman Brothers, 10 years ago next month.”

That is only because the truth shall not be named. In the case of the United States, that crisis started on April 28, 2004 when the SEC decided that the supervised investment bank holding company ("SIBHC"), like Lehman Brothers, “would be required periodically to provide the Commission with consolidated computations of allowable capital and risk allowances (or other capital assessment) consistent with the Basel Standards." 

When the Basel standards approved in June 2004 included allowing banks to leverage a mind-boggling 62.5 times with any asset that have been assigned by human fallible credit rating agencies an AAA to AA rating, or had been guaranteed by an AAA rated corporation like AIG, the crisis began its construction. That in the European Union the authorities also included allowing banks to lend to sovereigns like Greece against no capital at all would only worsen the explosion.

Oops! The following part had nothing to do with Janan Ganesh, but all with Lex's "Bank capital: silly old buffer"

2. “Debates over bank capital resemble tennis rallies… On one side of the net you have the big global banks. They say they have plenty of capital and that forcing them to operate with more is a restraint on trade. Pow! On the other side are the regulators, who say more capital is better because you never know what losses you may have to absorb. Thwack!”

But there are some few, like me, who argue that much worse than there being much or little capital, is that there are different capital requirements for banks, based on the perceived risk of assets. Riskier, more capital – safer, less capital. In tennis terms it would be like judges allowing those highest ranked to be able to play with the best tennis rackets, and the last ranked to play with ping-pong rackets. And of course that distorted the allocation of bank credit.

Populism? What’s more populist than, “We will make your bank systems safer with our risk-weighted capital requirements for banks”? 

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

@PerKurowski

Competition among banks is healthy for all, except when banks are allowed to compete on stratospheric capital leveraged heights.

Sir, Nicholas Megaw reports on some natural concerns derived from the fact that “Britain’s banks and building societies are loosening lending standards and cutting fees to maintain growth, as competition and a weakening housing market squeeze profit margins.” “UK banks loosen mortgage standards to maintain growth” August 26.

Competition among banks is always good, what were we borrowers to do without it? If as a result, some banks fail, so be it, and in fact that is quite necessary for the long-term health of the system. 

But when competition occurs where regulators allows too much leverage, because they also perceive it as very safe, then the very high exposures to the same class of assets, by many banks, can really explode and endanger the bank system.

So in conclusion, welcome the lowering of lending standards for loans to entrepreneurs that bank competition can bring about; but the capital requirements for banks when financing residential mortgages need to be increased, in order to make competition less dangerous. 

PS. Here is the somewhat extensive aide memoire on some of the mistakes in the risk weighted capital requirements for banks.

@PerKurowski

Bank regulators would do well reading up on Shakespeare (and on conditional probabilities)

Sir, Robin Wigglesworth writing about risk and leverage quotes Shakespeare in Romeo and Juliet, “These violent delights have violent ends”, and argues “It is a phrase investors in the riskier slices of the loans market should bear in mind.” “Investors should beware leveraged loan delights that risk violent ends” August 25.

Sir, we would all have benefitted if our bank regulators had known their Shakespeare better. Then they might have been more careful with falling so head over heels in love with what looks delightfully safe.

The Basel Committee, Basel II, 2004, for their standardized approach risk weights for bank capital requirements, assigned a risk weight of 20% to what was AAA to AA rated, and one of 150% to what is below BB- rated. 

That meant, with a basic requirement of 8%, that banks needed to hold 1.6% in capital against what was AAA to AA rated and 12% against what is rated below BB-.

That meant that banks were allowed to leverage 62.5 times if only a human fallible rating agencies awarded an asset an AAA to AA rating, and only 8.3 times if it had a below BB- rating.

That meant that banks fell for the violent delights of the AAA to AA rated, which of course caused the violent ends we saw in 2007/08.

Sadly, from what it looks like, our current regulators might not have it in them to understand what Shakespeare meant, just as they have no idea about the meaning of conditional probabilities… if they could they might be able to understand that what is ex ante perceived as risky is really not that dangerous.

@PerKurowski

Are bankers stopping their regulators from boarding a ‘listening bus’, scared these might wake up and then wake them up?

Sir, Gillian Tett asks: “can lofty chief executives ever find a way to get out of the C-suite and view life from a completely different perspective?” “Jamie Dimon’s ‘listening’ bus? Get on board”

Sir, of course it is good that Jamie Dimon, or anyone else for that matter, tries to listen to different opinions, though a bus is not really needed for that. 

But much more important than Jamie Dimon doing so it would be for the lofty besserwisser bank regulators to walk down Main street in order to learn more about banking, and life.

Then they might begin to understand that it is not what bankers perceive as risky which is dangerous to the bank system, it is what they perceive as safe.

But, being able to hold assets perceived as safe against so little of bank equity, meaning obtaining the highest returns on equity with what’s “safe” and not having therefore to venture into riskier terrains, sounds like a banker’s wet dream come true. Therefore perhaps it is bankers, like Dimon, whom all block regulators from leaving their desks, except for some controlled visits to Davos and Jackson Hole.

PS. As the less equity that needs to be compensated the more room there is for big banker bonuses, I am really not referring to an insignificant wet dream

@PerKurowski

To really understand the 2007-08 crisis, it is the ex ante perceived risks that should be used, and not the ex post understood risks

Sir, Martin Sandbu, when reviewing Ashoka Mody’s “EuroTragedy: A drama in nine acts" writes: “Mody nails the biggest policy error of them all: the insistence that euro member states could not default on their own debt, or allow their banks to default on senior bondholders.” “A crisis made worse by poor policy choices” August 6.

That refers indeed to a great ex-post crisis policy error, but not to the biggest error of all, that which caused the crisis, namely the ex ante policy of the regulators, for the purpose of their risk weighted capital requirements for banks, assigning all EU sovereigns, Greece included, a 0% risk weight.

Mody (on page 168) includes the following: “If, for example, €100 of bank assets generate a return of €1, then a bank with €10 of equity earns a 10 percent return for its equity investors, but a bank with only €5 of equity earns a 20 percent return.” Though not entirely exact (because it might be slightly more difficult to generate that €1 with less capital) it shows clearly Mody understand the effect on returns on equity of different leverages.

But what Mody, and I would say at least 99.9% of the Euro crisis commentators do not get, or do not want to see, or do not dare to name, is that allowing banks different leverages for different assets, based on different perceived, decreed (or sometimes concocted) risks, distorts the allocation of bank credit to the real economy. In the case of the Euro, the two shining examples are: the huge exposures to securities backed with mortgages to the US subprime sector that, because they got an AAA to AA rating, could be leveraged 62.5 times; and the exposures to sovereigns, like Greece.

Sir, let us be clear, there is no doubt whatsoever that, had for instance German and French banks have to hold as much capital/equity against Greece that they had to hold against loans to German and French entrepreneurs, then they would never ever have lent Greece remotely as much.

The other mistake that Mody in his otherwise excellent book makes, and which is one that at least 99% of the crisis commentators also make, is that they fall into the Monday-morning-quarterback trap of considering ex post realized risks, as being the ex ante perceivable risks. Mody refers in the book to that George Orwell might have written about narrating history “not as it happened, but as it ought to have happened” In this case the risk referred to, are not the risks that were seen but the risks, we now know, that should have been seen.

Sir, Ashoka Mody’ EuroTragedy has so much going for it that it merits to be rewritten. Just reflect on what it means for the Greek citizens having to pay the largest share of sacrifices, for a mistake committed by European technocrats.

PS. Mody goes into the details of the demise of “the smallest of Wall Street’s five top tier investment banks” Bear Stearns. It “was an accident waiting to happen… it had borrowed $35 for every dollar of capital it held”. Had Mody added the fact that Bear Stearns had been duly authorized by the SEC to leverage this much and even more, the recounting of the events would have been different.

@PerKurowski

Auditing is important, but what causes a disaster, is more important than how it is being accounted.

Sir, “FT Big Read. Auditing in crisis: Setting flawed standards” of August 2, discusses, among other, the huge divergence of figures in the auditing of the value of derivative exposures of AIG and of Goldman Sachs, even though their auditor was the same, in this case PricewaterhouseCoopers. 

That it was “striking how little was verifiable, that there were few credible market prices, let alone transactions, to support the key valuations”, explains much of the divergence.

Sharon Bowles, former chair of the European Parliament’s economic and monetary affairs committee explains it with: “Accounts have always contained estimates; think of the provisions companies make against foreseeable future losses, but the un-anchoring of auditing from verifiable fact has become endemic.”

That “un-anchoring from verifiable facts” is not limited to auditing. 

Sir, for the umpteenth time, without absolutely no verifiable facts, regulators concocted their risk weighted capital requirements for banks, based on the quite infantile feeling that what was perceived risky must be more risky to the bank system than what was perceived safe. In fact what could have been verified, if only they had looked for it, was the opposite, namely that what’s perceived safe is more dangerous to our bank systems than what’s perceived risky.

With that the regulators assigned to AAA rated AIG, by only attaching its name to guarantee an asset, the power to reduce the capital requirements for investment banks in the US, and for all banks in Europe, to a meager 1.6%. That translated into an allowed 62.5 times leverage. Let me assure you Sir that without this the whole AIG and Goldman Sachs incident described would never have happened. 

As always, what causes the problems is much more important than how the problems are accounted for. Though of course I agree, sometimes bad-accounting could in itself be the direct cause of the problems. 

The article also refers to “the so-called efficient markets hypothesis… that now somewhat discredited theory”. Sir, no markets have any chance to be credited with performing efficiently with such kind of distortions. For instance how verifiable is it now that sovereign debt is as risk-free as markets would currently indicate, when statist regulators have assigned it a 0% risk free weight, and are thereby subsidizing it?

@PerKurowski

Should central bankers answer my questions, or are they better off ignoring these?

Gillian Tett writes: “A century ago…central bankers barely talked to the public. Montagu Norman, the Bank of England governor from 1920 to 1944, is thought to have said: “Never explain. Never excuse.” That was partly because bank chiefs did not expect ordinary mortals to understand finance. But they also believed aloof detachment increased their authority.” “Should central bankers engage with the public?” July 28.

Sir, consider that I have with all means, even begging journalists to ask the questions, not been able to get an answer on something that should be very much within the general area of interest and responsibilities of a central banker, namely bank regulations.

My questions are simple and straightforward.

Why do you think that the regulators think that what is perceived as risky is more dangerous to our bank systems than what is perceived as safe? Could it be because regulators look at the risk of the assets of a bank, like bankers do, and do not look at the risk those assets could pose to the bank system, as regulators should do?

Why do you think that allowing banks to leverage differently their capital (equity) with assets based on different capital requirements, could not very dangerously distort the allocation of bank credit to the economy?

When are those European central bankers/regulators who assigned a 0% risk weight to Greece, going to be named and shamed, for dooming that nation to the so tragic consequences of excessive public debt?

Sir, “If Montagu Norman saw [my questions] what would he make of it all?”

Perhaps: “Never explain. Never excuse”, most especially when you have no explanation and you have no excuse?

@PerKurowski

Bank regulators, get rid of risk weighted capital requirements, so that savvy loan officers mean more for banks’ ROE’s, than creative equity minimizers.

Sir, Gillian Tett referring to IMF’s recent warnings about the risks of overheating in risky loan and bonds markets; like “The proportion of US loans with a rating of single B or below (ie risky) rose from 25 per cent in 2007 to 65 per cent last year. And a stunning 75 per cent of all 2017 institutional loans were “covenant lite” writes: “it is possible — and highly probable — that non-banks are taking bigger risks, since they have less historical expertise than banks, and thinner capital buffers.” “The US has picked the wrong time to ease up on banks” April 27.

Yes, with risk weighted capital requirements banks ROE’s began to depend more on maximizing leverage, and so banks sent home many savvy loan officers and hired creative equity minimizers instead. As a result someone else had to serve “the risky”. 

But then Tett warns “Trump-era regulators” with a “it is foolish to be encouraging risky lending right now”. Wrong! It is always foolish to encourage risky lending. 

What Tett does not understand is that “risky lending” has nothing to do with a borrower being risky, and all to do with whether the lending to those perceived risky or those perceived safe, is done in such a way, with adequate exposures and risk premiums, so that the resulting bank portfolio is well balanced. 

The current extremely risky bank lending is the result of way too large exposures, at way too low risk premiums, to what is perceived, decreed or can be concocted as safe; and way too little exposures, at way too high risk premiums, to anything perceived as risky.

What regulators really should do, is to get rid of the risk-weighted capital requirements for banks. Then bank loan officers, those that could also show the non-banks the way would return, for the benefit of both the banks and the real economy.

Why do many bankers hate such possibility? Because high leverage, meaning little equity to serve, is the main driver of their outlandish bonuses. 

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

@PerKurowski

Why does the “Without Fear and Without Favour” FT, not ask bank regulators questions I have suggested for a decade?

Sir, Gillian Tett writes: “The financial world faces at least three key issues, with echoes of the past: cheap money has fuelled a rise in leverage; low rates have also fostered financial engineering; and regulators are finding it hard to keep track of the risks, partly because they are so fragmented. “The corporate debt problem refuses to recede” January 9

Sorry, it is much worse than “regulators finding it hard to keep track of the risks”. It is that regulators have no understanding of how they, with their risk weighted capital requirements for banks, have in so many ways distorted the reactions to risks.

And much more than cheap money fueling a rise in leverage, it is the bank regulators who, like with Basel II in 2004, allowed banks to leverage a mind-blowing 62.5 times with assets only because they possessed an AAA to AA rating, started it all. . 

And when it comes to financial engineering, it is the regulators who caused banks to send into early retirement many savvy loan officers, in order to replace these with skilled equity minimizer modelers, who allowed for the highest expected risk adjusted returns on equity (and the biggest bonuses). 

The regulators, by favoring what is “safe” on top of what is perceived as “safe” is usually favored, only guarantee that safe-havens will become dangerously overpopulated, against especially little capital. Great job chaps!

Why has Ms. Tett, or many other in FT, not asked regulators, for instance what I believe I the quite interesting question of: Why do you want banks to hold more capital against what, by being perceived as risky, has been made innocous to the bank system, than against what, precisely because it is perceived as safe, is so much more dangerous?

One explanation that comes to my mind is John Kenneth Galbraith’s “If one is pretending to knowledge one does not have, one cannot ask for explanations to support possible objections”, “Money: Whence it came, where it went” (1975)

Sir, the Basel Committees’ “With the risk-weighted capital requirements we will make banks safer”… is cheap and dangerous populism hidden away in technocratic sophistications. Sadly it would seem the Financial Times has fallen for it, lock, stock and barrel.

Oops! I guess I will never be invited to a "Lunch With FT" 

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

We would all benefit from algorithms tempering our bank regulators’ human judgments.

Sir, Sarah O’Connor, discussing the use of algorithms when for instance evaluating personnel writes: “The call centre worker told me the software gives lower scores to workers with strong accents because it doesn’t always understand them.”, “Management by numbers from algorithmic overlords” February 7.

What, should we assume that the capacity of someone in a call center being understood would not be one of the most important factors considered by a human evaluator?

And when O’Connor refers to “the subtle flexibility of human judgment; decisions tempered by empathy or common sense; the simple ability to sort a problem out by sitting down across a table and talking about it.”, I must state that is absolutely not what happens all the time.

Any reasonable algorithm, with access to good historical data, would never ever have concluded, as the human Basel Committee did, that what is perceived as risky is more dangerous to our bank systems than what is ex ante perceived as safe.

PS. Could we envision a world in which more predictable algorithms managed our wives reactions… and, if so, would we then not miss their lovable unpredictability?

@PerKurowski

Banks now invest based on the risk-adjusted yields of assets adjusted for allowed leverages; that distorts the allocation of credit to the real economy.

Sir, Lawrence Summers, when writing about the challenges Jay Powell will face as Fed chairman mentions “Even with very low interest rates, the normal level of private saving consistently and substantially exceeds the normal level of private investment in the US” “Powell’s challenge at the Fed” February 5.

Not too long ago, markets, banks included, invested based on the risk adjusted yields they perceived the assets were offering. Some more sophisticated investors also looked to maximize the risk adjusted yield of their whole portfolio.

But, then in 1988 with Basel I, and especially in 2004 with Basel II, the regulators introduced risk based capital requirements for banks. As a consequence, banks now invest based on the risk-adjusted yields adjusted for the leverage allowed that they perceive the assets offer. As banks are allowed to leverage more with safe assets, which helps to increase their expected return on equity, they now invest more than usual, and at lower rates than usual, in “safe” assets like loans to sovereigns, AAA rated and mortgages. And of course, banks also invest less than usual, and at even higher rates than usual, in loans to the “risky” like entrepreneurs and SMEs.

That has helped to push the “risk free” down, and also explains much of the lowering of the neutral rate. Since the regulators now de facto block the channel of banks to the “risky” part of the economy, there is a lot of private investment that simply is not taking place any longer.

It is sad and worrisome that neither the leaving Fed chairman, Janet Yellen, nor the arriving one, Jay Powell (nor Professor Summers for that matter) can apparently give a clear direct and coherent answer to the very straight forward questions of: “Why do regulators want banks to hold more capital against what’s been made innocous by being perceived as risky, than against what’s dangerous because it’s perceived as safe? Does that not set us up for slow growth and too-big-to-manage crises?

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

@PerKurowski

The financial-elite’s reluctance to ask bank regulators for clear explanations, seriously threatens the west’s liberal democracy and global order

Sir, Martin Wolf asks and answers: “What has created sharp (and usually unexpected) slowdowns? The answers have been financial crises, inflation shocks and wars” “The world economy hums as politics sour” January 10.

Indeed, but currently our economies are also suffering a slow but steady state slowdown as a consequence of the insane risk weighted capital requirements for banks, which were created in the name of making banks more stable. It all boils down to the following:

If a “safe” AAA rated offered a correct risk adjusted net interest margin to a bank, a loan to it could, according to the Basel Committee’s Basel II of 2002, be leveraged 62.5 times but, if that correct risk adjusted net interest margin was offered by a “risky” unrated entrepreneur or an SME, then a loan to these could only be leveraged 12.5 times.

As a direct result bank credit has been used to finance “safer” present consumption; to inflate values of mostly existing assets; and way too little to finance “riskier” future production.

In summary it amounts to having placed a reverse mortgage on our past and present economy, in order to extract all of its value now, not caring one iota about tomorrow, and much less about that holy social intergenerational contract Edmund Burke spoke about.

But Wolf could argue that this is evidently not true because: “Yet the world economy is humming, at least by the standards of the past decade. According to consensus forecasts, optimism about prospects for this year’s growth has improved substantially for the US, eurozone, Japan and Russia”

Sir, it’s all a debt financed economic growth. Like a family having a great Christmas by racking up debt on their credit cards. How much of the enormous recent growth of debt everywhere has gone to finance future builders like entrepreneurs and SMEs? The answer is surely a totally insignificant fraction.

Wolf here anew identifies threats: “The election of Donald Trump, a bellicose nationalist with limited commitment to the norms of liberal democracy, threatens to shatter the coherence of the west. Authoritarianism is resurgent and confidence in democratic institutions in decline almost everywhere.”

Sir, sincerely, what is all that compared to the fact that the world’s financial elites, either because it is not in their interests, or because lacking self confidence they are afraid they might have overlooked something, do not have the gut to firmly ask regulators: “Why do you want banks to hold more capital against what has been made innocous by being perceived risky, than against what is dangerous because it is perceived safe?”, and not accepting any flimsy nonsensical answer veiled in sophisticated voodoo technicalities.

Martin Wolf has moderated numerous important conferences on financial regulations, but not one has he dared to ask that simple question. Could it just be because he is scared he would then not be invited again as a moderator? Or is it that he just doesn’t get it.

And Sir, you have really not been living up to your motto either. Shame on you!

PS. And all that risk adverse regulations for nothing, since, as I have told Wolf and FT time after time, major bank crisis, like that of 2007/08, never ever result from excessive exposures to what is ex ante perceived as risky.

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

@PerKurowski