Bank systems’ “Fifth Risk”: When shit really hits the fan, banks will be holding especially little capital.

Sir, Brooke Masters reviews Michael Lewis’ “The Fifth Risk”, a book that got its titled when John MacWilliams, a former Goldman Sachs investment banker told the author about the “fifth risk”, referring to ‘project management’, the risk society runs when it falls into the habit of responding to long-term risks with short-term solutions.” “Why boring government matters”, November 3.

Well-intentioned bank regulators, wanting to make our bank system safer, and came up with risk weighted capital requirements based on the perceived credit risks. If the perceived credit risks (those that bankers saw and used to adjust to with size of exposure and risk premiums) do not represent the most immediate short-term outlook on risk for banks what does? 

The real long-term risk is obviously that something that was ex ante perceived as safe, and with which banks could therefore build up large exposures, suddenly, ex post turned out very risky. The regulators with their short-term solutions only guaranteed that when shit really hit the fan, banks would stand naked with especially little capital.

Brooke Masters quotes Ronald Reagan with “the nine most terrifying words in the English language are ‘I’m from the government, and I’m here to help’ ”.

Indeed! Just like when regulators told us “we credit rating agencies know all about risks so, with our regulations, we will make your bank systems safer”. As a result they gave us the 2008 crisis, way too much credit for house purchases, and mountains of 0% risk weighted sovereign debt around the world. If only they had stayed home.

Sir, “good boring government” is indeed needed, but beware, few things as dangerous as bored bureaucrats… they’re truly frightening.

@PerKurowski

Bank regulators violated both the efficient markets hypothesis and the rational expectations assumptions.

I refer to Martin Wolf’s “Economics failed us before the global crisis: A framework that does not include the possibility of collapse misses the essential” March 21.

Wolf writes: “David Vines and Samuel Wills explain… the core macroeconomic model rested on two critical assumptions: the efficient markets hypothesis and rational expectations”

Bank regulators, those who should rationally be more weary of the unexpected, by basing their capital requirements on what was perceived risky, that which bankers were assumed to manage efficiently and rationally, made efficient allocation of bank credit impossible, and so both those critical assumptions were violated.

Wolf writes: “We need also to understand the risks of crises and what to do about them. This is partly because crises are, as the Nobel-laureate Joseph Stiglitz notes, the most costly events”. 

I disagree entirely with this limited Monday morning quarterback view. To measure the real cost we have to measure the full boom and bust cycle. Having, like now, bank regulations that favor banks financing the “safer” present consumption (houses), over the “riskier” future production (entrepreneurs), is a certain way to minimize the returns from our current circle of life.

Wolf writes: “Doctors’ first response to a heart attack is, after all, not to tell the patient to go on a diet. That happens only after they have dealt with the attack itself.” 

True, but even more important then that, is to correctly diagnostic the illness. In this case, the doctors, the bank regulators, do not want the diagnosis of missregulation to occur, so they are perfectly happy with most of the world blaming bankers or arguing deregulation.

Wolf writes: “We may never understand how such complex systems as our economies— animated, as they are, by human desires and misunderstandings — actually function. This does not mean that attempting to improve understanding is a foolish exercise.”

This is precisely what I have been trying to do with thousands of letters to the Financial Times and Martin Wolf, looking to explain how incredibly faulty the current risk weighted capital requirements for banks are, only to be silenced by FT and classified as obsessive by Martin Wolf.

Yes Sir, I admit being obsessive about this all, especially since I know the future of my children and grandchildren are affected by bad regulations. But, in his keeping mum on all this, Wolf is just as obsessive, I believe though because of much less worthy motives.

@PerKurowski

Beware, the more you trust data, the more you have to be absolutely sure about how to interpret it, and about what to do with it.

Sir, John Thornhill writes: “In his Alan Turing Institute lecture, MIT professor Sandy Pentland outlined the massive gains that could result from trusted data… the explosion of such information would give us the capability to understand our world in far more detail than ever before”, “Trustworthy data will transform the world” March 6.

Indeed, but that also leads to other bigger dangers, not only because we might trust that trusted data too much, but also because we might not know how to interpret or what to do with that trusted data.

Like for instance the regulators with their current risk weighted capital requirements for banks. These establish that the riskier an asset is perceived the larger the capital a bank has to hold against it. Does that make sense? Absolutely not!

It is not if the perceived risk is correct, meaning the ex ante risk perceived ends up being the real ex post risk, that poses any major danger for our banking system. It is if the risk perceived is incorrect, that the real big dangers arise. And, of course, the safer an asset is perceived, and the more bankers trust that perception to be right, the longer and the faster it can travel down the dangerous lane of wrong perceived risks.

What detonated the most the 2007 crisis? The securities backed with mortgages to the subprime sector rated AAA by “trustworthy” credit rating agencies, in fact so trusted that the Basel Committee, with Basel II, allowed banks to leverage 62.5 times their equity with such “safe” assets.

@PerKurowski

In terms of estrogen and testosterone, are there differences between bank exposures to what is perceived risky, and risky excessive exposures to what is perceived as safe?

“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” Mark Twain

Sir, Cordelia Fine writes: “Risk management in financial institutions is too important to be guided by scientific ideas well beyond their sell-by date. Blaming financial misadventures on a testosterone-fuelled male drive distracts us from what’s more likely to make a difference: regulation and culture. The best in-house antidote for bankers selling junk products and regulators bending to conflicts of interest isn’t women; it’s a dismissal slip”, “The Testosterone Rex delusion” March 3.

Absolutely! But with reference to the risks taken on by the banks that caused the 2007/08 crisis, that dismissal slip should foremost be given to regulators for having the ex ante perceived risks of banks assets substitute for the ex post dangers to our banking system.

And with reference to the absurd low response of the economy to the extremely high stimulates provided, the regulators should also be given that dismissal slip, for ignoring the purpose of banks, something that includes the efficient allocation of credit to the real economy.

Fine references Swedish journalist Katrine Marçal with whether “an investment bank named Lehman Sisters could handle its over-exposure to an overheated American housing market.” That is an ex post description that has little to do with the ex ante perception of the risks, and clearly less to do with bankers wanting to lend when it rained.

If some testosterone is needed to understand that risk-taking is the oxygen of development, and so the need for banks to also lend to those perceived as risky, like to entrepreneurs, then the regulators showed a fatal lack of it.

Their risk weighted capital requirements, more ex ante perceived risk more capital – less risk less capital is as dangerously nonsensical as can be. These only guarantee that when the true risks for our banking system happens, namely the dangerous overpopulation of safe havens, banks will stand there with especially little capital.

By allowing banks to leverage much more with assets perceived, decreed or concocted as safe, like AAA rated securities, like residential mortgages, like sovereigns (Greece) they allowed banks to earn the highest expected risk adjusted returns on equity on what was perceived as safe. Mark Twain could have said that made bankers wet dreams come true; and that was, while playing, the music to which Citigroup’s Chuck Prince held bankers had to dance.

And so, since what the members of the Basel Committee and the Financial Stability Board and most of their colleagues have really proven, is to be suffering from an excessive risk aversion, what would then Cordelia Fine opine, in terms of testosterone and estrogens?

God make us daring!

Here is an aide memoire on the major mistakes with the risk weighted capital requirements

@PerKurowski

To base bank regulations on that ex ante perceived risks reflects the ex post possible dangers, is pure an unabridged naïve over-optimism

Sir, Martin Wolf writes “Over-optimism is the natural precursor of excessive risk-taking, asset price bubbles and then financial and economic crises.” “A bit of fear is exactly what markets need” February 14.

Indeed, and what is more a naïve “Over-optimism” than bank regulator’s risk weighted capital requirements for banks, based on ex ante perceived risks reflect the ex post possibilities?

Wolf writes of “the hope that those who manage systemically significant financial institutions remain scarred by the crisis and are managing risks more prudently than before”. Why should they? The incentives provided by the risk weighted capital requirements for banks still distort the allocation of credit. In this context “prudently” means more banks assets going to perceived, decreed or concocted safe-havens, some of which, as a consequence, are doomed to be dangerously overpopulated. 

Wolf admonishes, “If a policy [quantitative easing] designed to stabilise our economies destabilises finance, the answer has to be even more radical reform of the latter.”

I would argue that the “quantitative easing” was not correctly designed to help the economy, precisely because it ignored the regulatory distortions that impeded the economy to, by way of bank credit, use that liquidity efficiently.

Wolf correctly states “It is immoral and ultimately impossible to sacrifice the welfare of the bulk of the people in order to placate the gods of the financial markets”. But I ask, is that not what is being done by allowing banks to obtain higher expected risk adjusted returns on equity when financing the safer present, than when financing the “riskier” future our grandchildren need to be financed?

Again, I dare Martin Wolf to explain why he believes regulators are correct in wanting 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?

Bank regulators have the right to be fearful, but they should fear more what is perceived safe than what is perceived risky.

PS. Here a brief aide memoire on the major mistakes with the risk weighted capital requirements

@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

If you pick the wrong data stream, as bank regulators did, real tragedies can happen

Sir, Rana Foroohar writes: “The ability of a range of companies — in insurance, healthcare, retail and consumer goods — to personalise almost every kind of product and service based on data streams is not just a business model shift. It is a fundamental challenge to liberal democracy.” “Digital democracy is dangerous” January

Yesterday I received the following message from Amazon: “Based on your recent activity, we thought you might be interested in: The Complete Guide to Building with Rocks & Stone: Stonework Projects and Techniques”. Since, at least after the age of eight, I am absolutely sure I have never harbored any intention, much less a burning desire, to build with Rocks & Stone, I suppose that, in terms of using the correct data streams, they business are not really there yet. Neither are bank regulators, though that has much more serious consequences than me not clicking on that book.

Foroohar writes: “Illah Nourbakhsh, a professor at the Robotics Institute of Carnegie Mellon, [has] launched a project to educate elementary school children about the power of data, its risks and rewards, and how to use it to advocate for themselves.”

Great! I hope professor Nourbakhsh makes a case of explaining to the young that the regulators, when setting their current risk weighted capital requirements for banks, used the data about the riskiness of assets, and not the data about what risks those assets posed to the bank system. Had they picked the correct data stream, they would never ever have assigned a minimal risk-weight of 20% to what, perceived so safe as to be rated AAA, could be truly dangerous, and 150% to what, being perceived so risky so as to validate a below BB- rating, is totally innocous.

And then the professor could also, if he dares, explain to these youngsters that these perceived risk adverse regulations now have banks solely refinancing and extracting all value from the “safer” present economy; and not financing the “risky” future that they as young need to be financed, if they are going to have a reasonable future.

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

@PerKurowski

To apply the Socratic method successfully requires students to be somewhat interested in the questions.

Sir, with respect to Lucy Kellaway’s "End of Term Diary” (December 23), David Parker writes: “It’s the teacher’s job to facilitate and motivate. Show students the beauty of things. And, teach by the Socratic method. Ask a question. If the student doesn’t understand, ask another question. Keeping asking. When they understand, they’ve learned” “Teach by the Socratic method — keep asking” December 30.

I have tried to apply the Socratic method during years trying to make Financial Times understand the mistakes of risk weighted capital requirements for banks. Among the questions:

Why do regulators require banks to hold more capital against what has been made innocous by being perceived as risky, than against what has become dangerous by being perceived as very safe?

Why did regulators not define the purpose of banks before regulating these?

Why did bankers use as input for their risk weighted capital requirements for banks the intrinsic risks of bank assets and not the risk of those assets for the banks?

Why do regulators not understand that allowing banks to leverage differently with different assets will distort the allocation of bank credit? And, if they understood that, who gave them the right to distort? Etc. 

But FT shows no interest in these questions… so I have to find another method… any idea Lucy Kellaway?

@PerKurowski

Current risk weighted capital requirements for banks are a stand out example of “garbage in garbage out”

Sir, when discussing artificial intelligence and “how much power should be ceded to the machines” you mention: First. “the need to overcome limitations in machine learning techniques”; Second. “garbage in, garbage out…the need for better quality control”; and Third. “the need to develop a clear and transparent governance structure for AI”, “The paradox in ceding powers of decision to AI” December 30.

Sir, human intelligence is quite often in need of all that too.

When bank regulators used intrinsic risks of bank assets as inputs for developing their risk weighted capital requirement, they could not produce anything but garbage out. What they should have used is unexpected events or the risk those assets could pose to our bank system, namely the risk that bankers would not be able to adequately manage perceived risks.

And little evidences the need for a transparent governance structure for human intelligence too, as current regulators refusal to answer the very basic questions: “Why do you require banks to hold more capital against assets made innocous by being perceived as risky than against assets becoming dangerous by being perceived as safe?”.

Humans must also also overcome some technical limitations: An Explanatory Note by the Basel Committee on the Basel II IRB (internal ratings-based) Risk Weight Functions” expresses: “The model [is] portfolio invariant and so the capital required for any given loan does only depend on the risk of that loan and must not depend on the portfolio it is added to.”

And the explicit reason for that mindboggling simplification is: “This characteristic has been deemed vital in order to make the new IRB framework applicable to a wider range of countries and institutions. Taking into account the actual portfolio composition when determining capital for each loan - as is done in more advanced credit portfolio models - would have been a too complex task for most banks and supervisors alike.”

Sir, finally, I would add a fourth requirement, namely to make sure artificial intelligence is kept free from that excessive hubris and besserwisserism that too often affect humans. Like that which kept regulators from even having to define the purpose or banks before regulating these,

@PerKurowski

Financial liberalism died when the Basel Committee establishment concocted the risk weighted capital requirements for banks

Sir, Joe Zammit-Lucia writes: “True liberals have always understood the need for continual reform as stagnating systems inevitably get progressively captured by powerful interests. Liberalism dies when it becomes the Establishment, itself captured by vested interests and an apologia for the status quo” “True liberals understand the need for reform” December 29.

What better example of that than when the regulatory establishment, gathered in the mutual admiration club of the Basel Committee decided to protect with lower capital requirements for banks the lending to the safer status quo than any lending to a riskier future.

Bankers loved it, because that allowed them to fulfill their wet dreams of being able to achieve the highest risk adjusted returns on equity on what is perceived as safe; and lower capital requirements naturally opened up much more space for their own bonuses.

Regulators, dumb enough to take ex ante perceived risks to represent real ex post dangers love it, because they think they are making banks safer.

And the world stagnates because of that risk aversion, and turns statist as regulators risk-weighted sovereigns with a 0%, thereby subsidizing public borrowings.

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

@PerKurowski

What magical misleading thinking could explain the Basel Committee’s bank regulation idiocy?

I refer to Andrew Hill’s “The magical thinking that misleads managers” November 27.

Sir, what magical misleading thinking could lay behind regulators wanting banks to hold the most capital for when something perceived risky turns out risky, when it really is when something perceived very safe turns out to be very risky, that one would like banks to have the most of it?

“Numerology…mumbo-jumbo”? Well if you read through the Basel Committee’s 2005 “An Explanatory Note on the Basel II IRB (Internal Rating Based) Risk Weight Function”, that could be it.

“Leaps of faith”? Absolutely. Believing that by allowing some few human fallible credit rating agencies to decide instead of millions of eyes, and thereby intrducing the mother of all systemic risks (as I warned in 2003 in a letter published by FT) was effectively one of the greatest centralized leap of faiths ever.

“Throw a coin and make a wish”? Believing that the risk weighted capital requirements would not distorts the allocation of bank credit can only remind me of “Three coins in the fountain”, although in that movie the girls' dreams came true.

“Chants and mantras”? The whole minute by minute growing and expanding Basel Committee’s regulations cannot but be a prime example of that.

“Human sacrifice”? Though they never ever cause a major bank crisis how many millions of entrepreneurs have not been denied the often life changing opportunity of a credit in the name of this so badly understood stability.

“Hero worship”? Just look at all those members of that mutual admiration club of technocrats who are able to promote themselves even in the face of a financial crisis that resulted from allowing banks to leverage so excessively when lending to the 0% risk weighted “infallible” sovereigns, the 20% risk weighted AAArisktocracy and the 35% risk weighted financing of houses?

Hill ends arguing that “humble deference to unpredictable and poorly understood outside forces would be healthy”. Indeed, but how is that to happen if public opinion makers, like the Financial Times, refuse to hold the regulators accountable, perhaps because they all like to be seen as part of thei exclusive network... and be invited to Davos.

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

@PerKurowski

Mr. Tim Harford, so you want an intriguing puzzle that might engage your curiosity? Have I got one for you!

Sir, Tim Harford writes: “Marina Della Giusta and colleagues at the University of Reading recently conducted a linguistic analysis of the tweets of the top 25 academic economists and the top 25 scientists on Twitter and found that the economists tweeted less and had fewer Twitter conversations with strangers. “Economicky words are just plain icky” November 25.

But not only might they tweet less, they might block more. I say that because I have never, as far as I know, been blocked by a scientists, but I sure have been blocked by an economists, the undercover economist Tim Harford.

Why could that have happened? Perhaps because I might have complained too much that Harford, as an economist, shoud also be out there dennouncing one of the most important economic regulatory cock-ups in world history, namely the risk weighted capital requirements for banks.

Harford writes “If we use a surprising fact as an ambush, that will provoke a defensive response; far better to present an intriguing puzzle.”

Okey Mr Harford here is one for you:

Why on earth do regulators want banks to hold the most capital when something ex ante perceived risky turns out risky? Is it not when something perceived very safe turns out ex post to be very risky one would really like banks to have it the most?

PS. But Sir, of course it is not just Tim Harford. You yourself, advertising a “Without fear and without favor”, seemingy do not dare to ask bank regulators where they got the idea of risk weighting the so dangerous AAA rated with a minimum 20%, and those by being rated below BB- made so innocous with a whopping 150%?

PS. As an aide memoire, here is again a list of the mistakes

@PerKurowski

True bank regulations should also not be like gambling.

Sir, I refer to Izabella Kaminska’s “True investing is not the same as gambling” November 22.

But Sir, what did bank regulators do with their risk-weighted capital requirements for banks if not gambling? They gambled on that bankers and credit rating agencies would perceive and manage risks correctly…and this even when bank crisis, when not the result of unexpected events, have always resulted from banks having ex ante perceived something as safe, but which ex post turned out to be risky.

Here again are the four possible outcomes of any bank lending:

1. Ex ante perceived safe – ex post turns out safe – “Just what we thought!”

2. Ex ante perceived risky – ex post turns out safe – “What a pleasant surprise! Another entrepreneur who makes it because we are so good bankers.”

3. Ex ante perceived risky – ex post turns out risky: How lucky we only lend little and at high rates to it.

4. Ex ante perceived safe – Ex post turns out risky: “Holy Moly now what do we do? Call the Fed for a new QE?”

The role of a bank regulator would of course be to work solely on the possibilities that banks did not perceive risks correctly or, if they did, did not manage these perceptions correctly.

And in that respect, the safer something is perceived the more dangerous it can become, and the riskier something is perceived the safer it becomes. Just the same reason for why so many more die in car accidents than in motorcycle accidents. 

The saddest part though is that even if bankers or credit rating agencies perceived risks correctly, the final results of all this would be bad. That because any risk, even if perfectly perceived causes the wrong actions, if excessively considered.

Bankers consider perceived credit risk when determining the size of their exposures and the risk premiums they should collect… but there, after 600 years of banking, suddenly the regulators invented that exactly the same perceived risks needed also to be considered in their capital too. And, since then, what is perceived as safe is getting way too easy credit while, what is perceived as risky, like SMEs and entrepreneurs are not getting the credits the real economy need them to get.

Sir, come one, don’t be so scared, live up to your motto of “Without fear and without favor”. Dare request from any regulator, for instance from FSB’s Mark Carney, an explanation for Basel II’s risk weights: that of a meager 20% for the so dangerous AAA rated, and a whopping 150% for the so innocous below BB-

https://youtu.be/TUdKhm6_a8Y

@PerKurowski

No Ms. Tett! It was bank regulators clear lack of testosterone that caused the 2007 crisis and the current slow growth

Sir, Gillian Tett seems to argue that the 2008 bank crisis resulted from excessive testosterone. “Traders on a hot streak risk a double fault”

Not so Ms. Tett! I do not if he really said it but Mark Twain has been attributed opining that bankers lend you the umbrella when the sun shines and want it back as soon as it looks it could rain.

And never ever has there been a bank crisis caused by excessive exposures to something perceived as risky when placed on banks’ balance sheets.

But that did not stop scared lack of testosterone bank nannies to also require banks to hold more equity when lending to the risky than when lending to the “safe”.

So what happened? As banks earned much higher risk adjusted returns on the safe they could not resist the AAA rated securities backed with mortgages to the subprime sector, or sovereigns like Greece. And so a typical bank crisis, that of excessive exposures to what was ex-ante perceived as safe but that ex post turned out very risky ensued. In this case made specifically worse, by means of the lower equity banks had been authorized to maintain. For example in the case of the AAA rated securities Basel II, because of the standardized risk weights, banks were required to only hold 1.6% in capital, meaning an authorized leverage of 62.5 to 1. 

And since banks now find it harder to earn higher risk adjusted ROEs on more capital, they have abandoned lending to risky SMEs and entrepreneurs, those who open up roads on the margins of the economy, and so of course slower economic growth results.

The lack of testosterone is not a fundamental value of the Western civilization. On the contrary in churches we sometimes sang, or at least used to sing, “God make us daring!”

@PerKurowski

In an age of “pervasive uncertainty”, how can bank regulators trusts ex ante perceived risks so much?

Sir I refer to Oliver Ralph’s “Age of uncertainty takes its toll” March 13, in order to make just one question… that in the title.

Sir, I dare you to explain to me, or to anyone, why the capital requirements for banks should be based on the risks perceived, and not on those risk that might not be perceived?

@PerKurowski

Europe, America, G20, don’t walk away from Basel Committee risk weighted bank capital regulations…you’d better run!

Sir, John Dizard writes about a “meeting of the Basel Committee on Banking Supervision on November 28 and 29… is scheduled to agree a “standardised approach for credit risk” and impose limits on the use of internal models. The idea is that banks in the G20 countries, a group of the world’s most powerful economies, will not engage in regulatory arbitrage, or international game playing that results in a lowering of credit standards.” “Basel’s background noise for the next crisis”, FTfm, November 7.

Of course, the Basel Committee should prohibit banks from using their own models to define their own capital requirements; allowing it, is like letting children use their own nutrition models to pick between chocolate cake, ice cream, broccoli or spinach.

But, to impose a regulators’ defined “standardised approach for credit risk”, is just as loony; it suffices to have a look at what the standardized risk weights included in previous Basel Committee regulations.

One example: Basel II, 2004, set the risk weight for an asset rated AAA to AA at 20% while that of an asset rated below BB- was set at 150%. Anyone believing that what is rated as highly speculative, almost bankrupt, below BB-, is more dangerous to the bank system than what is rated AAA to AA, must be smoking some weird stuff.

Sir, unfortunately Dizard, as most of you in FT, shows little understanding for the whole issue when he questions: “under the current version of the Basel “standardised approach”, unsecured lending to a non-public, below investment-grade corporate borrower requires the same bank capital commitment as project financing secured by assets, liens on equity and cash lockbox arrangements. Based on the past low loss rates for project lending, that is between two and three times as much capital as the risk should require.”

If that is so, should not the difference in risk reflect itself sufficiently in the interest rate and the size of exposures? Why should that same perceived risk also have to be reflected in the capital? Does Dizard (or you Sir) not know that any risk, even if perfectly perceived, leads to the wrong decision if excessively considered?

Sir, ask Dizard: “Why should a bank when lending to a below investment-grade corporate borrower have to hold more capital than when lending to “safe” projects? Will not the “risky” corporate anyhow get less credit and pay higher risk premiums than the “safe” project? 

Sir, again, for the umpteenth time, bank capital should not be required to cover for expected risks; it should be there to cover for the unexpected.

Sir, again, for the umpteenth time, the risk weighted capital requirements for banks have introduced absolutely insane distortions in the allocation of credit to the real economy. If Europe, America, G20, or the whole world do not run away from the regulators’ senseless doubling down on ex ante perceived risk, their economies are doomed to stall and fall.

@PerKurowski

Could Gillian Tett possibly find something positive in removing the incentives for banks to lend to SMEs and entrepreneurs?

Sir, Gillian Tett, discussing whether to have or not to have bins, as these could be used by terrorists writes: “Losing them shows …– that trust and confidence can unravel in the face of terrorism and fear. Indeed, the symbolism is so stark that I am tempted to argue that it is a mistake to “give in” by removing those bins; in statistical terms, the risk of actually dying in a terrorist bomb attack is exceptionally small.” “Don’t throw our bins away” September 24. 

Well, the risk of having a bank crisis resulting from excessive exposures to what was ex ante perceived as risky, is exceptionally small, I would say none. Yet bank regulators clearly gave in to some imagined fear and decided the capital requirements for banks should be much higher for what is perceived as risky, than for what is much more dangerous, namely what is perceived as safe. 

And contrary to how Ms. Tett might find something positive in the removal of bins, and which with one could agree, I cannot understand what positive one could possibly find in removing the incentives for banks giving loans to “risky” SMEs and entrepreneurs; those who in fact most need bank credit; those who we in fact most want to have bank credit, so that our economies do not stall and fall. 

Perhaps Ms. Tett would be interested in reading a recent working paper published by the ECB, “The limits of model-based regulation”. It shows that some of those who like Ms. Tett with close to willful blindness trusted Basel’s risk based regulations, are now reluctantly beginning to have some serious doubts. 

@PerKurowski ©

What’s perceived safe could be much more dangerous than what’s perceived risky. Why is that so hard to understand?

Sir, Gillian Tett, responding to “Why on earth would anyone buy a bond that yields a negative interest rate?” includes in the answer: “desperation” (they cannot think of anywhere else to park their funds) or “regulation” (they have to buy bonds to comply with financial supervision rules or investment mandates)” “The alchemists who turn negative yields into profit” September 16.

And then Ms. Tett explains interestingly how “some investors have found ways to make those negative yields pay” with “the rather esoteric corner of finance of dollar-yen cross currency swaps”.

But, if “government intervention to reinvigorate stagnant economies has left markets so peculiarly distorted” is the search for profit opportunities derived from distortions more important than eliminating the distortions?

I ask, because in all these years Ms. Tett has been unwilling to touch, even with a ten-foot pole, one of the most fundamental sources of distortion, namely the risk weighted capital requirements for banks.

That piece of regulation, by focusing on the ex-ante perceived risk of bank assets, and not on the ex-post risk for the banking system conditioned to how banks manage those ex-ante perceived risks, is loony and dangerous. As an example it allowed regulators to come up with a risk weight of only 20% for AAA to AA rated assets, while placing one of 150% on the so much less dangerous assets like the below BB- rated.

Sir, am I wrong to think an anthropologist should be able understand this?

@PerKurowski ©

Even sophisticated up-in-the-fronters can fall victims to populists, like those dressed up as bank regulators.

Sir, John Lloyd correctly writes that “rising inequality, wage stagnation and workplace insecurity merge with concern about fragmenting communities, exacerbated by fear of unregulated immigration and terrorism…produces a popular energy” that can be captured by populists. “For left-behinders, populists paint a picture of a better future” August 17.

But not only left-behinders can be victims of cheap populism, those up-in-the-front too, and populism can come in all shapes of form, including camouflaged as bank regulations.

Like that populism imbedded in: “If banks avoid risks, this will keep them from failing, and we will all prosper. So more risk more capital - less risk less capital”

And what is amazing is to see the how many famed journalists, Nobel Prize winners, academicians and politicians, fell for it, ignoring that what is risky is already made safer by being perceived as risky, but made even riskier if perceived as safe.

And what is even more amazing is how, even after a crisis brought on by excessive bank exposures against too little capital to what was perceived as safe; and an economy that is stagnating and not showing increased productivity, they still can’t open their eyes to the distortions in the allocation of bank credit to the real economy caused by that grievous piece of bank regulation.

Or is it like John Kenneth Galbraith said: “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.

@PerKurowski ©