What if a Basel Committee had regulated the payouts of casinos?

Sir, in “The risks of fund­ing states via casi­nos” FT, July 3, Martin Wolf writes: “In the run-up to the GFC, the dom­in­ant form of lend­ing was to the private sec­tor, particularly in the form of mort­gages.”

The dominant form of lending was indeed mortgages but that obscures the truth of what really happened.

Mortgages to the subprime sector were packaged into securities which, if obtaining an AAA to AA rating could, thanks to 2004 Basel II, be held by US investment banks and European banks against only 1.6 percent in capital, meaning they could leverage 62.5 times with these. 

As should have been expected, the temptation to package MBS sausages with the worst ingredient, which maximizes profits when then able to sell these as made with pure tenderloin, proved irresistible.

Sir, how long will FT keep being obsessed with minimizing the distortions of the Basel Committee’s risk weighted bank capital requirements?

Casinos? Ask Mr. Wolf whether he believes there would be any casinos left if its regulators ordered these to make higher payouts on safer bets, e.g., red or black than on riskier ones, e.g., a number?

https://subprimeregulations.blogspot.com/2012/12/the-basel-ii-roulette-manipulation.html

If only bank regulators had taken their clues from fixed odds betting terminal regulators.

Sir, Henry Mance and Camilla Hodgson write about the reduction of The government announced last year that it would reduce “the maximum stake on fixed-odds betting terminals — such as roulette — from £100 to £2 to tackle problem gambling.” “Problem gambling shake-up set to be brought forward” October 15.

Of course that will operationally distort fixed odds betting terminal playing, slowing it down, but by keeping the odds as designed for the game, meaning every bet having exactly the same probability adjusted payout, it will not alter the nature of it. 

We can only wish our current bank regulators had used a similar route because these, by allowing banks to leverage assets differently based on their perceived (or decreed) credit risk, actually determined that banks would obtain higher risk adjusted returns on equity on assets perceived as safe than on assets perceived as risky… and that has clearly distorted the whole nature of banks, when fulfilling their expected role of allocating credit efficiently to the real economy. How long would the game of roulette have survived such regulations?

In terms of betting on horses at the racetrack that would be like handicap officials taking off weights from the stronger and faster horses and placing these on the weaker slower ones. How long would horseracing tracks survive such distortions?

In terms of our ordinary golf that would be like handicap officials giving more strokes to the better players than to lousy players like me. How long would our golf clubs survive such distortion?

What’s going to happen to our bank systems? If these regulations persist, they are going to implode on some especially excessive exposures, to what is especially perceived (or decreed) as safe, against especially little capital. No doubt about it!

@PerKurowski

How can banks price risks correctly when regulators interfere and alter the payouts?

Sir, Gillian Tett writes: “If you peer into the weeds of global finance, you will see peculiarities sprouting all over the place… there is [a] pessimistic explanation: years of ultra-loose monetary policy have made investors so complacent that they are mis-pricing risk.” “Markets appear calm but are behaving abnormally” June 22.

Years of ultra-loose monetary policy, QEs or asset purchase program have indeed distorted the markets so there has to be much mis-pricing going on. But that’s not all.

The expected winnings (the dividends or payouts times the odds of winning) is exactly the same for all possible bets in a game of roulette. This is why roulette functions as a game. The credit markets with all the signals read and emitted, by all its many participants, givers and takers, continuously work towards equal payouts. And achieving these is what an efficient credit allocation is all about. 

But what if someone altered the payouts in roulette, like the regulators, with their risk-weighted capital requirements for banks did in the market of bank credit, how long would roulette survive as game?

Sir, just remember the 0% risk weight assigned by European central bankers to Greece. Those allowed banks immense leveraging and see such ROE payout possibilities that it went overboard lending to Greece; just in the same way Greece went overboard borrowing too much. 

And what about mispricing the risk of securities with a 20% risk weight in Basel II, which allowed banks to leverage 62.5 times only because some human fallible rating agencies had assigned these an AAA to AA rating? Frankly, is not the current bunch of bank regulators the mother of all mispricers ever?

So, to blame the investors, markets, banks for mispricing risks while blithely ignoring the regulatory (and other) distortions that exists is irresponsible; and could only be understood in terms of wanting to favour bank regulators… something which you hold in your motto you do not. 

Sir, let’s get rid of as many distortions as possible, so as to let investors, markets, and our banks stand a decent chance to do a good job allocating credit. The future of our grandchildren depends on it.

For a starter, and though the road there is full of difficulties, we must get back to one single capital requirement (8-15%) for banks, so that these can leverage the same against absolutely all assets.

@PerKurowski

Brexit contains more true catastrophic risks for the EU and the Euro than it does for Britain

Sir, I refer to Martin Wolf’s “Britain’s leap into the unknown” February 8.

Do I disagree with him? No, if I look at Brexit as Wolf does with a microscope focused solely on Britain. But, from a wider perspective, looking at so many other unknowns, his Brexit concerns takes on some Lilliput against Blefuscu war characteristics.

Why? Many would probably start by mentioning the environmental problems of the earth and overpopulation. But setting these aside there are many other challenges that needs to be considered so as to weigh correctly what could be coming with Brexit. Let me just briefly mention the following three.

First, I have the impression that Brexit carries with it more risk of true catastrophes for EU and the Euro than what it has for Britain. This is not a case Britain leaving a happy family behind. It is more like running away from a very messy dam full of repressed feelings of discontent, ready to burst at the urgings of any able populist, and to which its comfortable and full of themselves technocracy is unable to respond to adequately.

Second the banking system. Its regulators, with their risk weighted capital requirements, manipulated and distorted the system in such a way that the real economy is not being fed the nourishment it needs; and the banks themselves are bound to collapse, as would collapse any casino that had its roulette table equally manipulated.

Third, the growing structural unemployment caused by robots and automation. The only reasonable response to that seems to be some sort of Universal Basic Income floor, and that is something that must be much easier to develop within a nation. Just thinking of some EU Commissioners having to agree to a uniform Universal Basic Income policy applicable to Germany and Greece is too challenging.

Of course Brexit represents difficulties… but like all difficulties it also encompasses some opportunity. My dear English friends think of it like this. You are now sailing back to your homeland and soon, for good or for bad, you will at least be able to see the white cliffs of Dover again. 

@PerKurowski

PS. And of course you want to be as far away as possible when the Eurozone's debt bomb explodes

Gillian Tett, worry less about grey-hair’s casinos and much more about your young’s bank regulators manipulated ones.

Sir, Gillian Tett, as she should, becomes depressed when she ends up at an Atlantic City casino that “looked more like an electronic opium den for senior citizen.” “The rise of the silver slotter leaves me with a sour taste” October 29.

But, unless there is fraud, each one of those bets at the Atlantic City casino, has exactly the same expected pay out; namely a slight negative value because of the houses wins, like that when a zero comes up on the roulette. The cost of entertainment.

But out there in the other world, in the Main-Street, regulators have told banks that if they play it safe, like on black or read, like on sovereigns, AAA rated, or financing residential houses, they will earn much higher (expected) returns on equity, than if they bet on risky SMEs or entrepreneurs.

If Gillian Tett is concerned about the future of her children and grandchildren, that should depress her much more.

Sir, even though I have seen some few casino players fading away in absolute tragic destitution, I assure you that what the Basel Committee has done to the grey haired future of my, and your children and grand children, leaves me with a much more sour taste than thousands of Atlantic City casinos.

@PerKurowski ©

No casino roulette game would survive a Basel Committee kind of manipulation of the winnings of different bets

Sir, Adam Kucharski writes: “When math students at MIT discovered a lottery loophole in 2005, they formed a company — By the time the lottery was discontinued, they had… brought in a pre-tax profit of $3.5m.” “Investment and betting require similar skills — and luck” May 6.

The expected payout for every bet in roulette is exactly the same, and that’s why roulette has not been discontinued. So how long would Kucharski expect roulette to last if some regulators decided to multiply by some factor the winnings on the low paying “safe” bets, so that player could play for a longer time? Not long eh?

But that is exactly what bank regulators did when they allowed banks to leverage their equity more with what was perceived, decreed or concocted as safe, like when playing a color, than with what was viewed as risky, like when playing a number.

And so when Kucharski writes: “The boundaries between luck and skill, and gambling and investment, are not defined by industry or activity, but rather by the person playing, and who they are playing against”, we need to add, “and by the regulators”… especially if the regulators with hubris think they can distort for the better.

Unfortunately the bets of the banks are much more important than the bets in a casino. A bank, when it does not play a “risky” number, is in effect not giving loans to risky SMEs and entrepreneurs, those who might find the way of helping us to move forward the economy, so as it does not to stall and fall. And the banks, when they play too much the safe bets, AAA ratings, housing finance and sovereigns like Greece, then they will dangerously overpopulate safe havens, and cause crisis like the 2007-08 crash.

PS. Sports? What would be of golf if the handicap commission awarded the great players more strokes than what the lousy ones like me got?

PS. Sports? What would be of horseracing if the handicap commission reduced the weight the fast running horses had to carry, as a reward, and increased that of the slower horses, in punishment.

@PerKurowski ©

The crash was not caused by casino capitalism but by bank regulators who manipulated the odds at the casino

Sir, Simon Schama writes of “a crash engineered by the worst excesses of casino capitalism”, “New revolutionaries generate much heat but little action” April 23.

That “casino” reference is so utterly wrong!

In roulette, absolutely all bets have the exact same expected value, and if not so, there would be no casinos in which to play roulette.

In the same way all bank credits used to have the same expected risk adjusted return. That is, before regulators came up with the risk-weighted capital requirements for banks. By allowing banks to leverage their equity more with what was perceived, decreed or concocted as safe, than with what was perceived as risky, suddenly banks made higher expected risk adjusted profits with The Safe than with The Risky.

It was that manipulation of the odds, which promoted the “safe” like AAA rated securities, sovereigns like Greece and mortgages, that caused the crisis 2007-08.

And it is that manipulation of the odds, which hinders the access to bank credit of the risky like SMEs and entrepreneurs that blocks the road for an effective recovery.

All other manipulations like that of Libor put together have not caused even a fraction of the damages the full of hubris and besserwisser manipulating regulators have caused.

@PerKurowski ©

Gillian Tett, Anthony Bourdain and Selena Gomez might not explain it all in the “The Big Short”

Sir, I refer to Gillian Tett’s discussion of “The Big Short”, a film based on Michael Lewis’s bestselling book. “Finance gets the Hollywood treatment” November 28.

Tett writes: “We have Anthony Bourdain, the famous chef, standing in a kitchen, describing how a CDO is similar to fish stew (bankers resold old mortgages by mixing them up into fresh broth, just as chefs conceal old fish by turning it into soup). We also see the actress Selena Gomez elaborating the principles of synthetic derivatives while sitting in a casino, placing chips on a table, as groupies mimic her bets.”

I have not seen the film yet but, if Anthony Bourdain did not include mentioning the fact that the quality of the fish stew was to be determined by some very few fish-stew rating agencies; and that the casino in which Selena Gomez placed bets had abandoned the traditional payout scheme in which all bets have exactly the same expected economic value, in favor of one where the safer bets, black or red, pay more than the risky bets, a number, then the film does not fully explain what happened.

Gillian Tett writes “a decade ago [she] was alarmed by the bubble brewing in complex finance…” and indeed in January 2007 she wrote “The unease bubbling in today’s brave new world”

Myself, as an Executive Director of the World Bank, in a formal statement I delivered in October 2004, have also done my fair share of warning writing: “We believe that much of the world’s financial markets are currently being dangerously overstretched through an exaggerated reliance on intrinsically weak financial models that are based on very short series of statistical evidence and very doubtful volatility assumptions”. And in January 2003 in FT I had warned about allowing credit ratings to become a systemic risk.

@PerKurowski ©

The regulation of the finance industry might need more male skills.

Sir, John Kay referring to linkages between “testosterone and risk-taking” writes “We might have better banks if there was rather less male risk-taking and more female regulating and organizing”, “The finance industry needs more female skill” March 18.

If we in a game of roulette bet one dollar on either a safe color or a risky number, we are talking about exactly the same expected financial results, in this case a loss because of the zero the house reserves to itself. But, from that testosterone risk taking point of view are they really similar bets?

Currently we have bank regulations which, even though all major bank crisis have resulted from excessive betting on what was ex ante perceived as safe but that ex post turned out to be risky, allow banks to leverage much more their equity with what is perceived safe.

Since for instance they give a risk weight of only 20% to an AAA rated private borrower but a 100% risk-weight to an unrated borrower, the regulator is indicating, in roulette terms, that betting one dollar on the safe color, gives you five times the expected risk adjusted return than betting that same dollar on a risky number.

And all that while the real economy needs banks to give fair access to bank credit to “risky” numbers, the SMEs and entrepreneurs.

So, since regulators seem to have been blinded by some excessive misguided risk-aversion, what might most be needed, is instead more male risk-taking among regulators.

PS. http://subprimeregulations.blogspot.com/2012/12/the-basel-ii-roulette-manipulation.html

@PerKurowski

Sir FT Bank regulations were not lax at all. They were, and still are, extremely dangerous.

Sir in your “A weak hand on casino banking”, December 11, you write “Lax regulation did little to discourage rash behavior”

No! You are wrong Sir. Allowing banks to leverage 60 times or more their equity with assets only because these are perceived as absolutely safe, has nothing to do with lax regulations, and all to do with dangerous regulations that encouraged rash behavior.

With the laxest regulation of them all, meaning no regulation at all, some other crisis might have happened but not the current one, a really free market would never ever have permitted such leverages.

And since you make a reference to casino banking, let me remind you that it was the regulators who, with their risk-weighted capital requirements, altered all the pay-out ratios on the different casino bets, and thereby created the distortions in the allocation of bank credit to the real economy that led to the current chaos.

And where do you get to know that “the financial system is now safer that it was four years ago”? Do you mean you think so because it is holding more infallible sovereign assets against less capital?

Your objection to Carney´s salary, though correct, is a very petty minded objection not worthy of FT.

Sir, I questioned Mark Carney´s appointment to become the next governor of the Bank of England based on the fact that as the current chairman of the Financial Stability Board he was one of those regulators who did not understand the distortions that their capital requirements based on perceived risks were causing, and therefore he could be of no real service to the real economy of Britain. 

That is a real objection! Your objection to Carney, “True cost of Carney”, December 22, based on his high salary, though correct, is a very petty minded objection not worthy of FT. 

PS. In another effort to make you understand the Basel II distortions I invite you to read a comment where I explain these in terms of the distortions similar regulatory changes to the pay-out for roulette bets would cause.