Spurn bank regulators' false promises.

Sir, Martin Wolf makes a good case for “We should not throw liberal trade away for the wrong reasons and in the wrong way”, “Spurn the false promise of protectionism” FT June 16.

Yet, when regulators, decades ago, decided to throw liberal access to bank credit, by imposing credit risk weighted bank capital requirements, something which completely distorted the access to bank credit, Wolf and 99.99 percent of those who should have spoken up, kept mum.

Though I’ve no idea whether they read it, in a 2019 letter I wrote to the Executive Directors and Staff of the International Monetary Fund, I argued that these risk weights are to access to credit, precisely what tariffs are to trade, adding “only more pernicious” 

Wolf writes that “the US economy has suffered from high and rising inequality and a poor labour force performance” and includes among other explanations the “rent-extracting behaviour throughout the economy”

But anyone who reads “Keeping at it” 2018 in which Paul Volcker’s 2018 valiantly confessed: “The assets assigned the lowest risk, for which bank capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages”, should be able to understand that rent-extraction also occurs by means of cheaper and more abundant access to credit.

And boy did regulators throw away unencumbered access to credit in “the wrong way”

Here follows four examples: 

To establish their risk weights, they used the perceived credit risks, what’s seen “under the street light” while, of course, they should have used the risks for banks conditioned on how credit risks were perceived. 

By allowing banks, when the outlook was rosy, to hold little capital, meaning paying high dividends, lots of share buy backs, and huge bonuses, they placed business cycles on steroids.

Very little of their capital requirements cover misperceived credit risks or unexpected events. Therefore, just as in 2008 with the collapse of AAA rated mortgage back securities, and now with a pandemic, banks were doomed to stand there with their pants down.

With risk weights of 0% the sovereign and 100% the citizens, which de facto imply bureaucrats know better what to do with credit they’re not personally responsible for than e.g., entrepreneurs, they smuggled communism/statism/fascism into our banking system.

“We will make your bank systems safe with our credit risk weighted bank capital requirements” Sir, what amount of wishful thinking must have existed for the world, its Academia included, to so naively have fallen for the hubristic promises of some technocrats.

@PerKurowski

As long the mistake that caused a crisis gets to be treated as one that shall not be named, it is doomed to become a Groundhog Day event.

Sir, Martin Wolf writes “financial regulation is procyclical: it is loosened when it should be tightened and tightened when it should be loosened. We do, in fact, learn from history — and then we forget”“Why further financial crises are inevitable” March 19.

Yes and no!

Yes, it is procyclical especially when allowing banks to leverage more with those who, thanks to good times are perceived as safer, and much less in bad times with all those that then are perceived as risky, which of course includes many former very safe.

No, we have not learned from history, because there is too many interested in putting a veil on the mistake with the risk weighted capital requirements. And there is too many who do not want to admit they fell for the populist that told them to relax, because they have weighted the risks.

Even though a leverage ratio has been introduced, the following Basel II risk weights that which evidences an absolute lack of understanding of the concept of conditional probabilities have not been changed, and this even after a crisis that exploded in AAA rated territory.

AAA to AA rated = 20%; allowed leverage 62.5 times to 1.

Below BB- rated = 150%; allowed leverage 8.3 times to 1

Also, the distortion the risk weighting creates in the allocation of credit to the real economy is mindboggling. Just consider the following tail risks:

The best, that which perceived as very risky turning out to be very safe.

The worst, that which perceived as very safe turning out to be very risky.

And so the risk weighted capital requirements kills the best and puts the worst on steroids… dooming us to suffer from a weakened economy as well as an especially severe bank crisis, resulting from especially large exposures, to what was especially perceived as safe, against especially little capital.

Wolf writes: “The bigger the disaster, the longer stiff regulation is likely to last. [But] Over time, regulation degrades, as the forces against it strengthen and those in its favour corrode.” I agree, but I would have to add something to it, namely, the bigger the disaster the more the running away from responsibilities… and accountability. 

@PerKurowski

Thanks to bank regulators, if in need, there are now way too little defences to deploy in a countercyclical way

Sir, you hold that there are “reasons to be wary [as bank] regulation is, once again, being eased just at the moment when it ought to be tightened” “Easing financial controls is cause for wariness” March 11.

In support: “Many market participants, moreover, think credit and market cycles are at their peak — just the time when counter-cyclical defences might be deployed”

Sir, is it really when markets are at their peak that we should kick off its drop, by tightening regulations? At the peak of the market, what we really should have is our ordinary defences, like bank capital, to be at their highest levels, so that adequate counter-cyclical defences can be deployed if needed. Are these defences now at the highest? Absolutely not!

Why? Among others, the results from an absolute incapacity to comprehend the pro-cyclicality of many regulations, such as those of the risk weighted/ credit ratings capital requirements for banks. These are based on the ex ante perceptions of risk when times are good, and not on the ex post possibilities when times are less good. The result, in terms of deployable counter-cyclical defences, is total unpreparedness.

Sir you write: “A Financial Times series has highlighted the risks of the rapid expansion of credit to lowly rated, more indebted companies.” No that is wrong! It were the “good times”, made possible by low interest rates and huge liquidity injections, which allowed for too many securities to be rated, ex ante, as being of investment grade, which caused a rapid expansion of credit. What, ex post, perceived rougher times cause, is a rapid expansion of those securities becoming rated as junk.

@PerKurowski

Does not common sense dictate that in good times we want our banks to be weary about what they perceive as safe? Does not what’s seen as risky take care of itself?

Joe Rennison writes: “Investors and rating agencies have warned that companies might struggle to refinance huge debt burdens, resulting in downgrades from triple B into high yield or “junk” territory.” “BIS sounds alarm on risk of corporate debt fire sale” March 6.

What does that mean? Namely the risk that ex ante perceptions of risk might, ex post, turn out really wrong.

Also, “Bond fund managers could then have to sell the bonds as many are bound by investment mandates barring them from holding large amounts of debt rated below investment grade. ‘Rating-based investment mandates can lead to fire sales,’ warned Sirio Aramonte and Egemen Eren, economists, in the BIS quarterly review released yesterday.”

And what does that mean? Clearly procyclicality in full swing! Just like the insane procyclicality caused by the risk weighted capital requirements for banks.

Sir, does not common sense tell you that in good times we want our banks to be weary about what they perceive as safe, as what they perceive as risky takes care of itself? And in bad times, do we not want our banks not to be too weary of the risky, and burdened with having to raise extra capital when it could be the hardest for them?

Sir, so what are regulators doing allowing banks to hold less capital against what they in good times might wrongly perceive as safe, and imposing higher capital on what they would anyhow want to stay away from, especially in bad times?

Sir, for literally the 2,781 time, why does not the Financial Times want to dig deeper into unavailing what must be the greatest regulatory mistake ever? 

Are you scared of then not being invited to BIS’s Basel Committee’s and central banks’ conferences? “Without fear and without favour” Frankly!

@PerKurowski

Bad bank regulations have placed the procyclicality of credit ratings on steroids

Sir, Joe Rennison writes: “Big US companies [have] spent the years since the financial crisis gorging on cheap debt [forgoing] higher credit ratings and [slipping] down into the lower reaches of borrowers deemed “investment grade”, which implies a relatively low risk of default. Growing debt piles have fed fears among investors that… worsening economic conditions… could potentially send credit ratings even lower, into the junkyard of ‘high yield’ [which would make the financing more expensive and thereby increase the difficulties]” “Investors urge debt-bloated US companies to shape up” March 5.

Good times allow good credit ratings giving an easy going; bad times produce worse credit ratings causing harder goings. No doubt credit ratings are procyclical. But then consider the fact that current risk weighted capital requirements for banks, better credit ratings less capital – worse credit ratings more capital, places an additional level of procyclicality on top of it all, and one of the principal faults of Basel Committee’s should lay bare in front of you. 

It has not been corrected yet. It has not even really been discussed yet.

@PerKurowski

And the lesson number one is....

Sir, Martin Wolf in “The lessons to be learnt from today’s financial crisis” July 2, 2008 quotes the Bank of International Settlements annual report stating “loans of increasingly poor quality have been made and then sold to the gullible and greedy”. Although I find it hard to think of a market that does not use greed as one of its main motors it is really the “gullible” part of it all that really blows my mind.

Who on earth is BIS to talk about gullibility. Was it not the Basel Committee on Banking Supervision that BIS hosts that set up a system based on credit risk assessments and that appointed the credit rating agencies as the supreme risk measurers? If we normal citizens and investors are gullible of anything it has been of believing that the Basel bank regulations had taken care of the problem once and for all, and that the credit rating agencies knew what they were doing.

BIS also mentions “the inherent procyclicality of the financial system” to argue for tighter monetary conditions when credit soars…but not a word about how the risk rating and the consequent “massive re-rating of risk” can send cyclicality soaring to the moon.

No, if there is a first lesson to be learnt it is that central bankers and bank regulators are, no matter how knowledgeable and pompous they act, only humans prone to err, and so it behoves us not give them too much powers, which is what makes them truly scary and dangerous.

PS. A letter on this theme to FT back in 2004.

PS. Here is a current summary of why I know the risk weighted capital requirements for banks, is dangerous nonsense.