Current bank regulations are evidence free rather than evidence based

Tim Harford suggests, “Pick a topic that matters to you”, “How to survive an election with your sanity intact” November 16.

Ok. Bank regulations. And Harford argues, “Politics… is now evidence-free rather than evidence-based”. Indeed but so are current bank regulations. 

What has caused all big bank crises was something ex ante perceived very safe that ex post turned out very risky… in other words incorrect risk assessments.

But instead of basing the capital requirements based on this empirical evidence, regulators concocted risk-weighted capital requirements based on credit risks being correctly perceived. And so they assigned a meager 20% risk-weight to dangerous AAA rated, and 150% to the so innocous below BB- rated. 

If I were a regulator I would consider my role to guard against the possibility that bankers could perceive risks incorrectly, instead of, like the Basel Committee has done, betting our bank systems on bankers always being correct. Sir, wouldn’t you too?

Harford suggests, “When someone expresses an opinion, whether you agree or disagree, ask them to elaborate. Be curious.”

Unfortunately, when thousand of times I’ve asked the question “Why do you believe that what’s perceived as risky by bankers is more dangerous to our bank systems than what they perceive as safe?” that has not generated much curiosity. What it has generated is a lot of defensive circling of the wagons. “There again goes Kurowski with his obsession”

Harford also reminds us of Alberto Brandolini’s “bullshit asymmetry” principle, “The amount of energy needed to refute bullshit is an order of magnitude bigger than to produce it.” With soon 3.000 letters to FT on the topic of “subprime banking regulations”, I can sure attest to that being true.

https://teawithft.blogspot.com/search/label/subprime%20banking%20regulations

@PerKurowski

The silenced conversation on the risk weighted capital requirements for banks.

Sir, Thomas Hale writes, “From the eighties onwards, a focus on capital constraints on bank balance sheets encouraged banks to sell mortgages and other loans through securitisation. The regulatory framework meant that profitability had become at least in part a function of state-directed regulatory rules around capital — a fact that persists today. For this reason, lending against a house might be preferable to lending to a business, even if the former represents, for whatever reason, a greater risk.”, “The broken conversation about financial regulation”, Alphaville, September 19.

Hale’s “even if the former represents, for whatever reason, a greater risk” does not explain the whole problem because, being perceived as safe, and therefore subject to some regulatory subsidies, is precisely what can most make this house-lending dangerous to our bank systems.

The safety of the banking sector is also a secondary issue because, for the long term good of the economy, lending to “risky” entrepreneurs seems to be preferably than the “safe” financing of house purchases.

Hale writes: “Discussion of post-crisis regulations really only take place in extremely rarefied and specialist settings… there are a few people talking about regulating the banks, but the conversation is mostly inaccessible.”

Inaccessible? Read some of the over 2.800 letters that I have written to FT over the years, which includes even some to Thomas Hale, related precisely to the problem with the risk weighted capital requirements for banks; those that distort the allocation of bank credit; those that are based on the flawed theory that what’s perceived as risky is more dangerous to bank systems that what’s perceived as safe.

These letters, even when I could show some credentials as having formally spoken out against these regulations while being an Executive Director at the World Bank, in times of Basel II preparations, were for all practical purposes ignored. Someone in FT told me that I was obsessed with that problem. Of course I am, and as a grandfather I should be. But much more obsessed has the Financial Times been in ignoring it. 

Sir, a lot of internal soul searching on the why of FT’s silence on the risk weighted capital requirements for banks, should be a much-needed exercise for a paper that as its motto has “Without fear and without favour”.

I was also told to write a book. Why should I, the only book I have written “Voice and Noise”, and that contains some clear pointers to this problem, I believe that not including those I purchased to give away, sold only 51 exemplars.

But perhaps there might be a future book based on all the letters to the Financial Time that are included in this my TeaWithFT blog.

@PerKurowski

To be able to make our banks safe, at no cost, is a dream that passionately blinds way too many, like the Financial Times.

Sir, with respect to Bank of England’s interest rate increase you explain it with “The decision had all the hallmarks of a committee that has decided that it will only be comfortable when rates are at a higher level that feels more natural”, and so sees what it wants to see, and so you argue “It is far better for central banks to be more clearly and dispassionately guided by the data” “A rate rise and a Bank of England false step” August 3.

Of course, except those for some special reasons need blissful blindness, it is better for most “to be more clearly and dispassionately guided by data”. 

But let me ask you Sir: What data, during the last decades have you seen that in any way shape or form could support the current pillar of bank regulations, namely that what is ex ante perceived as risky is more dangerous to our bank systems ex post, than what is perceived as safe? 

None? Might it then not be that you are also too passionate about hoping to make our banks safe at no cost, so as to understand the data, or the lack of it? Or are you perhaps so passionate you do not even want to see any data that contradicts it.

Yes, I am obsessive about the distortions in credit allocation that the risk weighted capital requirements for banks cause, but Sir, you are just equally, or even more, obsessive with ignoring it.

@PerKurowski

There is not too much need for banks to game regulations when regulators have already gamed these so much.

Sir, John Plender addresses correctly many current concerns with the financial system in general and with banks in particular “Beware the threat of low-quality debt and opaque shadow banks” March 7.

But when he writes: “Remember, among the many things that lay behind the financial crisis of 2008-9 was the banks’ urge to game the Basel capital adequacy regime”, then I just have to step in.

There was no need to game regulations that had already been so much gamed by the regulators. Basel II, with its standardized risk weights, risk weighted any private sector carrying AAA to AA ratings with 20%, residential mortgages with 35% and, with much solidarity; European regulators risk weighted Greece 0%.

Translation: Based on the basic capital requirement of 8% banks needed to hold 1.6% in capital against the AAA to AA rated, 2.8% against residential mortgages and 0% against loans to sovereigns, like Greece.

Translation: Banks were therefore allowed to leverage their capitals 62.5 times with assets rated AAA to AA rated, 35.7 times with residential mortgages and limitless against loans to sovereigns, like Greece.

Also had regulators required banks to hold 8 percent against all assets the wriggling room for gaming would have been much reduced.

The risk weighted capital requirements for banks are most certainly the most absurd regulation concocted ever. It only guarantees that banks will dangerously overpopulate safe havens against especially little capital; and that those risky bays where for instance entrepreneurs are usually found, and that need to be explored for our economy to thrive, will not be sufficiently funded.

This should have been absolutely clear for more than a decade but yet, this is being obsessively ignored by most.

@PerKurowski

Placing our banks into the hands of a Basel Committee is surely one of the greatest acts of naïve realism ever

Tim Harford quotes George Carlin with “Have you ever noticed when you’re driving, that anybody driving slower than you is an idiot, and anyone going faster than you is a maniac?”, “Delusions of objectivity” April 2

And Harford refers to a new book, The Wisest One in the Room, co-authored by Lee Ross, a psychologist at Stanford University and that describes the problem of “naive realism”… “The seductive sense that we’re seeing the world as it truly is, without bias or error. This is such a powerful illusion that whenever we meet someone whose views conflict with our own, we instinctively believe we’ve met someone who is deluded, rather than realising that perhaps we’re the ones who could learn something”

But let me also quote from Tim Harford’s book “Adapt” of 2011. It states: “So far this book has argued that failure is both necessary and useful. Progress comes from lots of experiments. Many of which fail, and we are to be much more tolerant of failure if we are to learn from it. But the financial crisis showed that a tolerant attitude to failure is a dangerous tactic for the banking system.” In other words Harford holds that, those not allowing for sufficient risk-taking are idiots and those allowing too much risk taking are maniacs”.

And in his book Harford also quotes Charles Perrow, emeritus professor of sociology at Yale explaining that the dangerous combination is a system that is both complex and tightly coupled, and saying that the banking sector “exceeds the complexity of any nuclear plant I ever studied”.

And when commenting on the Piper Alpha (nuclear plant) disaster Harford writes: the “safety system introduced what an engineer would call a ‘new failure-mode’ – was precisely the problem in the financial crisis: not that it had safety systems, but that the safety system it did have made the problems worse”. Harford illustrates that with the example of credit default swaps CDS.

But finally, in “Adapt”, Hartford also argues: “Among the bitter recrimination over the financial crisis of 2008, if there’s a consensus about anything is that the financial system needs to be made safer. Rules must be introduced, one way or another, to prevent banks from collapsing in the future”.

And of course that’s wrong! Because that might precisely represent the worst kind of bank regulation risk!

In May 2003, in some comments delivered as an Executive Director of the World Bank during a workshop for regulators I said: “A regulation that regulates less, but is more active and trigger-happy, and 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 strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises.”

Coming back to Harford’s "Delusion of Objectivity" I would hold that one of the greatest acts of naïve realism of our times, is believing that a small group of technocrats, holed up in a mutual admiration club like the Basel Committee effectively is, can regulate our banks to be safer, without creating even larger risk.

Just for a starter they regulated the banks without defining the purpose of banks, which allowed them to introduce their risk weighted capital requirements, which completely distorted the allocation of bank credit to the real economy.

Clearly in reference to my criticism of Basel regulations, most in FT believe, or had been told to believe, that I am someone quite deluded, rather than realising that perhaps they are the ones who could learn something from me.

I confess I am obsessive on this issue. They should confess they are even more obsessive ignoring this issue. 

@PerKurowski ©

Martin Wolf, the uncertainty of whether those who govern us really know what they’re doing is always upon us.

Sir, Martin Wolf writes: “Productivity is not everything, but in the long run it is almost everything… But the prospects for productivity are…the most important uncertainty affecting the economic prospects of the British people. Is it reasonable to expect a return to buoyant pre-crisis productivity growth? Will productivity continue to stagnate? Or will it end up somewhere in between?” “The age of uncertainty is upon us” March 18.

Mr. Wolf, for the umpteenth time, obsessively, I do not understand how you and so many other can so obsessively ignore that if you tell banks they can leverage their equity more with what is safe than with what is risky; so that they can earn higher expected risk adjusted returns on equity with what is perceived or deemed to be safe, than with what is risky; that then banks will foremost be refinancing the safer past while ignoring too much the credit needs of the always riskier future. And since then productivity is not been given the chances it deserves, the prospects for its improvement must be really lousy.

“The age of uncertainty is upon us”? Please when did we have an age of certainty?

Current regulators regulate banks without having defined their purpose, and base those capital requirements for banks that should cover for the unexpected, on the expected credit risk. Those facts evidence the major uncertainty we always face, namely whether those who govern us have the faintest idea of what they’re doing.

@PerKurowski ©

Martin Wolf, much more than helicopter droppings, we need regulators who understand what banks are for

Sir, I refer to Martin Wolf’s “The helicopter drops might not be far away”, February 24.

As you well know I suffer a self-confessed obsession with denouncing the distortion that the credit risk weighted capital requirements for banks produce in the allocation of credit to the real economy. Martin Wolf, though he does not confess it, suffers a similar obsession, with ignoring that distortion.

Here Wolf refers again to “the major governments are able to borrow at zero or even negative real interest rates, long term”. And Wolf refuses to notice that sovereigns, with the low capital requirements they generate for the banks, have been declared by regulators to be preferential bank borrowers. And that is especially important when bank equity is scarce.

If you force the banks to hold the same capital against sovereigns than what they are required to hold against loans to SMEs and entrepreneurs, then you would know what the non-subsidized borrowing rates of governments really are.

Or if you allow the banks to hold the same capital against loans to SMEs and entrepreneurs than what they are required to hold against sovereigns and other preferential borrowers, then you would see investments increase. And that without increasing significantly the risk of banks, since loans to “risky” SMEs and entrepreneurs never cause major crises.

Wolf refers to the “lunatic…austerity obsession”. No! What’s really lunatic is the regulators’ risk weighing obsession… as if they were Gods.

Wolf should ask the following, for instance to Adair Turner whom he references:

How many bank loans to SMEs and entrepreneurs have not been awarded in America and Europe during the last decade only because of the risk weighted capital requirements for banks, ten thousands, hundred thousands, millions?

And so of course we might need helicopter money, that at least would be much better than QEs’ money redirectioned by bank regulators; but more, much more than that, we urgently need bank regulators who understand the concept of: “A ship in harbor is safe, but that is not what ships are for.” (John Augustus Shedd, 1850-1926)

PS. And that would also be the best way to dent inequality: “The function of credit in a simple society is, in fact, remarkably egalitarian. It allows the man with energy and no money to participate in the economy more or less on a par with the man who has capital of his own.” J.K. Galbraith’s “Money: Whence it came where it went” 1975

@PerKurowski ©