The distortive risk weighted capital requirements for banks will haunt Ben Bernanke and Martin Wolf

Sir, Martin Wolf writes that contemporary “banks are constrained not by reserves but by their perception of risk and rewards of additional lending”, “Model of a modern central banker” January 22.

That is indeed so, but Wolf forgot to include that banks are also constrained by capital requirements, and by how the regulators’ perceptions of risks are transmitted by means of the risk-weighting of these.

When Wolf comments “An active an enterprising financial system creates risk, often by raising leverage dramatically in good times” he is ignoring the fact that the extreme high bank leverages of now, are actually leverages that were and are authorized by the regulators… and since banking itself is much about leveraging, banks must go to where they can earn the highest-risk adjusted returns on equity… which is usually where the capital requirements are the smallest.

And that created the distortions which not only produced the crisis when allowing investment banks and European banks to leverage immensely on AAA rated securities, and “infallible sovereigns”, but it also hindered the liquidity provided by for instance quantitative easing from reaching those who could do the most with it… like the medium and small businesses, entrepreneurs and start-ups. 

Ben Bernanke has most certainly done good things as a central banker, and Martin Wolf has definitely written great pieces as a journalist, but I do believe that history will hold their silence about this source of distortion seriously against them… and this even if they plead ignorance about it.

PS. Sir, just to let you know, I am not copying Martin Wolf with this, as he has asked me not to send him any more comments related to the capital requirements for banks, as he understands it all… at least so he thinks.

No Mr. Ralph Atkins. We know precisely that the next financial polar vortex is going to hit… where it always hits!

Sir, Ralph Atkins writes that “six years after the eruption of the financial crisis… we know remarkably little about where the next ice storm might break”, “Investors hunt for the financial polar vortex", January 10.

He is wrong. We know exactly that the next financial polar vortex is going to break out where these always do, namely in a haven that has been perceived as “absolutely safe”, but has become dangerously overpopulated.

And the damages will be worse than ever, because of the manmade fact that, when it hits, just like when the last 2007-08 hit, our banks will have little capital to cover up with, as a direct consequence of those nonsensical risk-weighted capital requirements the Basel Committee concocted.

If only an “intellectual vacuum”, but, sadly, it is worse than that Professor Michael Ignatieff.

Sir, Michael Ignatieff writes about “the waning power of ideas” and begs “Free polarized politics from its intellectual vacuum”, January 10. Although, as a self described “radical of the middle”, or “extremist of the center”, I do agree with most of what he writes, I must still confess feeling that the absence of ideas would at least be better that the presence of some really bad ideas.

And a truly bad idea currently present, are the risk-weighted capital requirements for banks, and which allow these to earn much higher risk adjusted returns on equity on exposures deemed as “absolutely safe”, than on exposures deemed as “risky”.

And that makes it of course impossible for banks to allocate credit efficiently to the real economy. And that guarantees that the chances of any major bank crisis, those usually caused by dangerously overpopulating some safe-haven, have been exponentially increased.

Technically the mistake is explained by the fact that regulators estimate the “unexpected losses”, those for which you mainly require banks to hold capital, based on the same perceptions used by the banks to estimate “expected losses”.

And here we have all the free market believers not complaining about that horrible interference with the market that risk-weighting causes … and here we have all progressives not saying a word about the odious discrimination in favor of the AAAristocracy and against the “risky” that risk-weighting causes.

And meanwhile the chances for our youth to find employment in their lifetime are evaporating, thanks to this nonsense of banishing risk-taking from our banks.

The standardized risk-weights of Basel II, provided the coverage banks needed to hold minimum capital

Sir, your “In praise of bank leverage ratios”, July 11, though I agree with its title, just shows how little you have understood about the underlying causes of the North Atlantic banking crisis.

You write “rather than imposing standardized risk weight, regulators have let banks use their own model. This undermines the credibility of the exercise.”

The standardized weight in Basel II, for holding for instance the AAA rated securities backed with mortgages to the subprime sector in the USA, or loans to Greece, was only 20 percent; which signified that banks could hold these assets against only 1.6 percent in capital; which meant banks could leverage their equity 62.5 to 1 with these assets.

In fact, without the guidance of these standardized weights, the banks would not even have dared to convince their regulators that so little capital could be needed.

Since you also hold that the leverage ratios needs to be combined with effective risk-weighted capital ratios, you also show not having understood how these distort when it comes to banks allocating credit to the real economy.

But, with respect to that macroprudential policy should be counter-cyclical, on that we agree completely, as I indicated in a letter to you in 2004.

Nonetheless most of this discussion will be a moot point in January 2015. The Basel Committee has instructed the banks to report their leverage ratio from that day on. And after all recent signs of “bank creditors, caveat emptor, you won’t be bailed out like before”, like in Cyprus, banks have to be truly insane not knowing they have to substantially raise their capital, in order to survive the coming stampede from banks leveraged over 30 to 1 to those leveraged 10 to 1, no matter the riskiness of the underlying assets.

And the USA, thanks to FDIC, is taking the lead lowering those ratios. Europe, beware!

We need to see the hiding-behind-regulatory-risk-weighting index of the banks

Sir Patrick Jenkins and Daniel Schäfer at the end of their “Banks in cash calls to meet Basel III” state the caveat with respect of the numbers shown that “Regulators [will] either raise risk-weightings and/or give more emphasis to nominal balance sheets.” Indeed, but it can also be, like the current crisis has clearly evidenced, that the risk-weights could also simply turn out to be very wrong.

And that is why I consider the illustration that shows Basel III core tier one capital ratios of 12 large banks to be quite opaque. As a minimum, next to each Basel III ratio they should have given us each banks capital to nominal balance sheet ratio.

That way, by dividing the first ratio by the second (or the other way round) we can build an index which allows us to identify how each bank hides behind risk-weights, whether these are calculated by themselves or by the regulators.

Higher bank capital ratios without eliminating distortions based on perceived risks, would make banks riskier

Sir, John Plender refers both to the draft legislation advanced by US senators David Vitter and Sherrod Brown, and to Anad Admati’s and Martin Hellwig’s “The bankers’ New Clothes”, in order to point out that “Support is growing for higher bank capital ratios”, May 8.

Plender unfortunately entirely misses what is most important. Many have asked for higher capital requirements but, what sets those he references apart from many others is that they also want to do away with the pillar, and the pride and joy of Basel regulations, namely that the capital requirements are to be based on perceived risk.

Let me ask Plender. Today, according to Basel II, a bank can hold some zero risk weighted sovereign assets against zero capital, while giving a loan to a business requires it to hold 8 percent of it in capital. If tomorrow the risk-weights for some sovereign would remain zero, but banks were instead required to hold 30 percent against a loan to a business, would the distortions be smaller or larger?

It was bank regulators who suffered the mother of all intellectual failures

Sir, John Kay writes that the left, were so horrified that a collapse of capitalism from its own global contradictions, might occur under their watch, that their only thought was to avert it by shoveling public money at the capitalists, “Sinister or silly, protest politicians are united in grievance” May 8. And Kay refers to that as an “intellectual failure”.

That is indeed true, but, as intellectual failures come, much worse was the one which preceded it, namely the regulatory theory that banks would be better off diverting their credits from what though perhaps productive was perceived as risky, and concentrate on earning high returns on their equity by giving credit to what was perceived as “absolutely safe”.

Capitalism might have contradictions but, allowing banks to leverage their equity 62.5 to 1 when lending for instance to Greece, but only 12.5 to 1 when lending for instance to a German medium sized business, has of course nothing to do with that.

In fact those regulations are more than stupid, they might in fact even signify a crime against humanity.

Bank regulators make the prospects of the living-hand-to-mouth especially bleak

Sir, Gillian Tett’s “The cost of living hand-to-mouth” May 5, is splendidly scary, especially when contrasted with all the how the US is doing great hoopla on FT's first page… especially since there is nothing in the “for our business it has become critical to understand the cycle – when pay [and benefit] cheques are arriving” that will increase the relative number of citizens who can afford a planning scenario that goes further than next pay cheque.

Of course, as Ms Tett has preferred to ignore it, even if she writes for the Financial Times, I must remind her again of the fact that if any of these “living hand to mouth” were to have access to bank credit, then the dollars, or pounds, or euros they would pay in interests, would be worth much less to a banker than those dollars, or pounds or euros paid by anyone dressed up as safe. And that is simply so because the regulators allow the banks to leverage much more a “safe” dollar, pound or euro, than a “risky” one.

Of course, as Ms Tett has preferred to ignore it, even if she is an anthropologist, I must remind her that one big reason many have possibilities of planning for a longer horizon, is that so many before them took many risks, assisted by the banks. And therefore, as a result of banks daring taking risks having been ordered out of fashion by too concerned and too dumb regulators, the future of the current living-hand-to-mouth looks especially bleak.

No nation and no economy has become great by playing it safe!!! God make us daring!!!

Risk-weighting for risks already weighted for, well that is regulatory zealotry you can write home about

Sir, you write that “the Fed’s monetary policy [is] much more efficient than in those economies where the transmission of central bank money-printing to real economy remains broken” “If the Fed ain’t broke, don’t fix it” May 1.

Indeed but the reason of that is that the US never adopted as fully as Europe did those Basel dictated capital requirements based on perceived risk, that so completely have clogged up the channels whereby bank lending can flow to the real economy.

And when you refer to that US Senators Sherrod Brown and David Vitter want banks to hold more capital you are ignoring that their bill contains the much more important provision of limiting [and hopefully making away altogether] with the obnoxiously dumb risk-weighting, something that is not explicitly mentioned in the Dodd-Frank law.

Sir, you mention the dangers of “zealotry”. Let me inform you that the worst example of regulatory zealotry is precisely the setting of capital requirements based on perceived risks that have already been cleared for.

Sir, as I wrote in a letter published today by the Washington Post, “Europe would also do better with a Brown-Vitter proposal”

Bank rules already hinder inclusion and widen the gap

Sir, Alfred Hannig in his letter “Rules shouldn’t hinder inclusion” writes about the importance of finding a balance in financial regulations between the need of protecting the banks from systemic risks and the need for the inclusion of those currently without access to the financial system. And he is of course right when holding that “infection in the financial system will not come from financial inclusion” just the same way that a financial crisis will never result from excessive exposures to “The Risky”, these will always come from excessive exposures to what has erroneously been considered a member of The Infallible”.

That said Mr. Hannig should take notice that current bank regulations, with their capital requirement based on “perceived risks” already cleared for by means of interest rates (risk premiums) amounts of exposure and other terms, already attempt against the inclusion of many; and only helps to further widen the gap between the haves, the old, history, the developed, “The Infallible” and the have-nots, the young, the future, the developing, “The Risky”.

With respect to increased capital requirements for banks, what matters most for growth and stability is how it is required.

Sir, I refer to Alex Barker´s and Tom Braithwaite´s “EU and Fed clash over US bank move” April 23. In all the hullaballoo what seems to be ignored, perhaps more by EU than by the Fed, is that with respect to increased capital requirements for banks, what matters the most is how it is required.

If bank regulators require banks to hold more capital, but keep the current risk-weighting system, that just means that The Infallible will be even more favored than The Risky, and since that would only increase the regulatory distortions… the result could only be increased instability.

But, if regulators instead require banks to hold more capital by eliminating the ridicule low risk-weights assigned to The Infallible, then The Risky agents of the real economy, like small and medium businesses and entrepreneurs, will be less discriminated, and therefore the real economy would stand a better chance of recovering… resulting in greater stability.

About “Why bank regulators are intellectually naked”, and about besserwisser journalists

Sir, Martin Wolf has suddenly seen light as he now writes “A sophisticated mistake is the idea that capital can be properly ‘risk-weighted’. This has proved fatally flawed”, “Why bankers are intellectually naked” March 18.

I have over the last five years written more than a hundred of letters to the editor commenting on articles by Martin Wolf explaining that capital requirements for banks based on perceived risks which have already been cleared for, is sheer stupidity, and creates all type of distortions. But my arguments have been mostly ignored and Wolf has even qualified me as a monothematic bore… something which I accept might very well be true, but all for a good cause.

And so of course I will read “The Bankers’ New Clothes” by Anat Admati and Martin Hellwig, with much interest, to see with what arguments they finally convinced Wolf. That is of course as long as Wolf’s new found conviction is the correct one. I say this because why then did he not title his book review “Why bank regulators are intellectually naked”

Wolf writes the book reveals why “we have failed to remove the causes of the crisis”, and I wonder whether the arrogant besserwisser attitude of some financial journalists who think they know it all, might be included there.

PS. I have not read it yet, but if Admati and Hellwig’s suggestion of a 20-30 percent equity ratio is based on risk-weighted assets, then sadly they have not understood it completely either, and the distortions could be even worse. And, if that 20-30 ratio is for unweighted assets, then it would be very interesting to hear how they propose to raise the bank capital needed to fill the hole created by the zero percent risk-weighting of sovereigns.

PS. Sir, just to remind you that I am not copying Martin Wolf more. He has told me not to send him anything more on “capital requirements”… he already knows it all, so he thinks.

Lex, explain why you consider a straight leverage ratio inferior to a risk-weighted assets ratio?

Current capital requirements for banks based on perceived risks using risk-weights allow banks to leverage more the risk adjusted margins when lending to “The Infallible” than when lending to “The Risky”; which means making a higher expected return on assets when lending to “The Infallible” than when lending to “The Risky”; which means that “The Infallible”, those already favored by markets and banks will be even more favored, while “The Risky”, those already discriminated against by banks and markets, precisely because they are perceived as “risky”, will be even more discriminated against.

And that of course creates the danger of excessive exposures to those of “The Infallible” who do not turn out to be really infallible, precisely those who have caused all major bank crises in history, as of course “The Risky” have never ever done that; in this case aggravated by the fact that bank then will have extremely little capital.

And that of course impedes the banks completely to perform their social function of helping us to allocate economic resources as efficiently as possible.

And so LEX, please explain to us why, in your column of February 27, you consider a straight leverage ratio inferior to a risk-weighted assets ratio?

And if you absolutely want to risk-weighed, because you cannot refrain from interfering, then why would not the capital requirements for banks for exposures to “The Infallible” be slightly higher than for exposures to “The Risky”, as all empirical data suggests?

How ridiculously childish and naïve can we allow our bank regulators to be?

Sir, Lex reports, on January 2, that now the credit rating agencies will “have to register, meet corporate governance standards and accept supervisory oversight, [which] should make it easier to sue agencies if they issue grossly negligent or deliberately erroneous ratings”.

And I just have to ask: And so now, when we are supposed to trust the credit rating agencies even more than before, something which can only mean digging ourselves deeper in the hole we’re in, who is going to rate the credit rating agencies’ financial capacity to make up for calamitous mistakes like the AAA ratings awarded to the securities collateralized with lousily awarded mortgages to the subprime sector in the USA? 

The naïveté of our bank regulators is just mindboggling.

Tax-payers, caveat emptor, “Our banks are regulated by the Basel Committee and the Financial Stability Board"!

The incredibly skewed bank exposure in favor of “The Infallible” and against “The Risky” is the Achilles’ heel of the real economy.

Sir, the regulatory standing order for the banks, especially when faced as they are with great scarcity of capital, is to stock up on “The Infallible” assets and get rid of “The Risky”, those for which they are required to hold much more capital. And that is becoming even more imperative when Basel III will impose liquidity requirements based on perceived risk. 

This is what creates the largest distortions in the financial market and so I keep being amazed by how for instance John Authers can write a “Message from Memphis gives a bonds perspective” December 29, completely ignoring the Basel regulations perspective. 

If, as in pre-Basel days, all bank assets generated the same requirements, the current markets would be dramatically different which just comes to show how loony it is to have placed us in the hands of some bank regulators who have no idea of what damage to the real economy they are doing with their silly risk-weights. 

Authers writes “many holders regard Treasuries as truly risk-free [and] this anomaly looks particularly dangerous.” Of course it is dangerous, but by now he should know that no market participants regards the Treasuries as risk-free as the regulators do, like when in Basel II they assigned these a zero risk-weight, and which meant there was no limit on how much banks could leverage their equity if stocking up on these assets.

In this age of media driven besserwissers we need to be more skeptical than ever about “expertise”

Sir, John Lloyd writes “It is a source of [British] pride that disorganization is transformed into magnificence” but “that now some have developed an anxiety about muddling through, and the lack of strategic thinking among leaders in public life”, and concludes in “That those who command the public and private summits of the future should be schooled away from the temptation to avoid recognizing complexities”, “Class notes from a course on the age of complexity” December 24. 

Yes! But also… No! Because sometimes the best and only cure to an excessive complexity is simplicity, and so it is vital for those involved in strategic thinking, never ever to consider themselves so superior so as to be capable to manage any complexity. 

Equally, in this age of media driven besserwissers, it is more important than ever for the society to remain healthy skeptical knowing that even the most reputable experts can be very wrong. 

For instance, the primary cause for the bank and economic crisis happening and for the real economy not recovering, lies squarely with the bank regulator “experts”. Arrogantly thinking themselves to be capable of managing the risks for the world, with their capital requirements based on perceived risk, and their risk-weights, they expelled all common sense from markets and banks. 

And five years after the outburst of the crisis nothing has really been corrected, and instead much has been made worse, only because, as a society, we find it so hard to accept that experts can be so incredibly dumb. 

But I assure you, there is no limit for how dumb experts can be, especially when gathered in a mutual admiration club where no one is held accountable. Occupy Basel!

Up here, on the already too high edge of "the fiscal cliff", forget jumping, but do we climb up or down?

Sir I refer to your “A fiscal cliff fall will cost us dear” December 15. 

“The fiscal cliff” is the name used to describe the possibility of big tax increases and important spending cuts that would send the economy in a downward tailspin which we do not know where it would stop. 

The alternative, which has no name, but I guess to remain “sitting on the edge” would do, though when adjusted for the fact that the edge is position higher and higher each day, “sitting on the ever higher edge” would seem to be more appropriate, does also seem like a quite scary proposition.

My problem is that no one discusses the reason why we find ourselves up here in the first place, and which is because of how the natural market driven Ying-Yang relation between what is perceived as safe and what is perceived as risky, was distorted by utterly intrusive bank regulations. 

Nervous desk-bound nannies created too big incentives (meaning too low capital requirements) for the banks to lend to "The Infallible", as if banks needed that, and to avoid "The Risky" (meaning higher capital requirements), as if banks were not doing that anyhow. And, as a natural result, they doomed our banks to dangerously overpopulate the safe-havens, and for the real economy equally dangerously, to under-explore the more risky but certainly more productive bays. And as a result banks do not finance the future, they only refinance the past.

And I know that safely climbing, up or down from where we find ourselves, already much too high, will require some serious risk-taking. 

And so the first action required before climbing, up or down, because of course we should climb and not stupidly jump, must be to free ourselves from the dead-weights of the risk-weights which were imposed by the most useless dangerous and stupid bank regulations ever.

Two concrete proposals on how to climb better, up or down:

1. Temporarily lower the capital requirements for banks on exposures to “The Risky” 

2. Long term tax exoneration on huge capital increases for banks that accept holding much more capital and not to discriminate based on risk

Now, if you in FT know about any better and safer way to get away from the dangers of the cliff then speak out, because all I read from you and others sounds a lot like just anxious baby-boomers wishing for the can to be kicked down the road, for a while, in the best aprės nous le déluge style. 

And America, before deciding whether to climb up or down the fiscal cliff, go to a church and pray, “God, in the Home of the Brave, make us daring!"

PS. By the way I cannot understand why someone who declares a motto “without favour”, with respect to tax-cut proposals, can hold that it is up to the Republican speaker of the House and not to the President “to make the first move”.

PS. Republicans and Democrats here is a bi-partisan proposal that could be acceptable to both of your extremes.

PS. But, in truth, in too many ways, we are already way over the cliff!

The regulatory lockout of small businesses and entrepreneurs from bank credit can only guarantee Europe´s and America´s insolvency.

Sir, Wolfgang Münchau writes “Why I remain a pessimists on Europe´ solvency” November 5, and though he speaks about the need for “growth” he fails to mention the current most important sine qua non barrier that must be removed for such growth to occur in a sustainable not stimulus fueled way. And I refer of course to the capital requirements for banks which discriminate in favor of “The Infallible” and against “The Risky”. 

I hold, and I believe few would disagree, that small businesses and entrepreneurs need to have access in competitive terms to bank credit. But currently, because there is such a huge scarcity of bank capital, and lending to these borrowers carries the burden of requiring the most of bank capital, these vital economic agents are for all practical purposes suffering a regulatory ordered lock-out. 

Gentlemen, there is no way for Europe or America to grow themselves out of their current predicament if keeping the risk-adverse regulations that so distort the efficient economic allocation of resources produced by the banks. On the contrary, keeping these can only guarantee Europe´s and America´s insolvency.

Debt restructuring will not suffice to save the euro. The immoral, useless and dangerous bank regulations must also be repelled.

Sir, William Buiter opines that “Only widespread debt restructuring can save the euro”, October 16. 

I agree that is indeed indispensable in order to take care of the past. But, to also offer a better future, the immoral, useless and outright dangerous bank regulations coming out of Basel must also be repelled. And I specifically refer to capital requirements with risk-weights based on ex-ante perceived risk. 

The way those regulations favor the access to bank credit of “The Infallible”, those already favored by markets and banks, and discriminate against that of “The Risky”, those already discriminated against by banks and markets… is immoral 

Those regulations are also useless, as never ever have those, ex-ante, perceived as risky caused a major bank crisis. 

Those regulations are also outright dangerous, as these completely hinder the banks from performing an efficient economic resource allocation. 

What more does the Eurozone, Europe, America and the rest need in order to repel these regulations completely?

Regulators´ occurrences often represent the most dangerous quicksand

I fully agree with John Gapper when he finds not “unreasonable” the proposal by Mary Chapiro, the SEC Chairman, that money market funds would have to, “either become more like investments funds by allowing their net asset value to float, or more like banks by raising a buffer capital”, “Don´t leave the financial system on quicksand” August 30. 

That said, with respect of that “buffer capital” I hope he, and Ms Chapiro, mean one same capital requirement for any type of assets. This because since most investors are currently convinced their buck is already broken, or will be broken, their main interest is it becoming broken as little as possible. 

And, as we should know by now, nothing guarantees a super-large breakage of the buck more, than when besserwisser regulators, full of hubris, believe themselves to be the risk managers of the world, and start interfering by mean of risk-weights, with the markets´ own risk assessments. 

And, so, when regulating the money market funds (and the banks) please never forget that regulatory occurrences can also often represent the most dangerous quicksand.