Is banking regulation unfinished business? You bet, risk weighted capital requirements are still used

Sir, I have not read Tamim Bayoumi’s “Unfinished Business” yet, so for the time being I have to go on what John Authers writes in “A fresh way to learn from the financial crash” October 2.

From what I see the book seems in much like another example of Monday morning quarterbacking. For instance when it states “In early 2007 anyone in Wall Street would have said that naive European banks were the most enthusiastic buyers for dubious debt securities” we must really ask what is meant by qualifying European banks as naïve? These were AAA rated securities, these were the type of securities that their own regulators had just in 2004 with Basel II authorized the to leverage 62.5 times to 1 their capital with.

What we had (and still have) is amazingly naïve bank regulators… who for instance still allow banks to use their own models, as if banks were not interested in generating the largest risk adjusted returns on equity, something that, because of regulators, is nowadays foremost done by minimizing capital requirements.

It also says: “the US widened the collateral that banks could use in repo transactions [this] rule encouraged them to create mortgage-based securities, and “game” rating agencies into giving them undeserved strong ratings”. But that is wrong, or at the most, just a minor cause of the disaster.

Anyone who has taken time as I did to understand what had happened (I passed exams for real estate and mortgage intermediation licenses in the US for that purpose) would be clear on the following. The profit potential in securitization is a direct function of the quality difference between what is put into the securities, and what comes out. To be able to feed the sausage with subprime mortgages yielding 11 percent, and then because of AAA ratings be able to resell these (to Europe) at 6%, was a profit opportunity to big and juicy to miss.

Finally Authers comments: “Meanwhile, models resting on assumptions disproved during the crisis are still in use. There is indeed unfinished business.” Indeed, the risk weighted capital requirements are still used.

Sir, the first of about 50 letters I have written to John Authers since July 2007, more than a decade ago, ended with: “This all is lunacy and we are being set up for even bigger disasters and it must end, before it ends us. We need urgently to punish the regulators, at least on the count of being very naive.”

But clearly someone in FT did not want to hear my arguments, or at least not these coming from me.

@Per Kurowski

To drop money on an economy, without cleaning its clogged pipes, is not to give helicopter money a fair chance to work

Sir, Adair Turner the former chairman of the Financial Services Authority writes: “Eight years after the 2008 financial crisis the global economy is still stuck with slow growth, inflation levels that are too low and rising debt burdens. Massive monetary stimulus has failed to generate adequate demand. Money-financed fiscal deficits — more popularly labeled “helicopter money” — seems one of the few policy options left.” “Not too much, not too little — the helicopter drop demands balance” May 22.

What? Should we not first begin by clearly understanding why the stimulus did not work?

Turner writes: “Can we design a regime that will guard against future excess, and that households, companies and financial markets believe will do so. The answer may turn out to be no: and if so we may be stuck for many more years facing low growth, inflation below target, and rising debt levels. But we should at least debate whether the problem can be solved.”

Yes we should really debate! But we should start that debate by questioning the risk weighted capital requirements for banks, those that were first introduced by the regulators almost three decades ago, and later, in 2004, made much more poisonous with Basel II.

And so, just for a starter, I would ask these five questions:

1. Where did you regulator get the idea of being able to regulate our banks without first clearly defining what is the purpose of our banks?

2. Where did you regulator get the idea of giving a risk weight of zero percent to the sovereign, and one of 100 percent to those citizens that define the sovereigns’ strength? Do you really believe bureaucrats know better what to do with other peoples’ money than citizens with their own?

3. Where did you regulator get the idea of assigning a risk weight of 150 percent to those below BB- rated, and only one of 20% to those rated ex ante AAA that you know cause more the major bank crises in the world, when they ex post turn out to be risky?

4. Where did you regulator get the idea that assigning different capital requirements, and thereby different equity leverage possibilities, would not seriously distort the allocation of credit to the real economy?

5. And, where did you regulator get the idea that requiring banks to hold more capital against the risky, would not make it harder for the risky to access bank credit, and thereby increase inequality?

Sir, it is soon a decade since a big bank crisis broke out because of excessive exposures to something that was backed with very little capital, only because it had been perceived, decreed and concocted as safe… and yet that truth is not being discussed. Sorry, that is totally unacceptable. All evidence points to the tragic truth that highly unqualified technocrats are regulating our banks.

I advance the explanation that the previous stimulus had no chance of working because these regulations had clogged some pipes of the economy. And to drop helicopter money on an economy, without cleaning those pipes, is not to give helicopter money even a fair chance to work.

PS. Also, why should we trust the helicopter pilots?

@PerKurowski ©

Let’s call on the Ghosts of Economies Past, Present and Yet To Come, to illuminate our central banks and regulators.

Sir, Tim Harford showing good Christmas spirit praises both the miser deflationist and the spending inflationist. “In praise of Ebenezer Scrooge”, December 18.

Harford writes: “In a deep recession, one might be concerned that Scrooge was failing to support aggregate demand but in normal economic times the effect of his skinflintery was to ensure that everyone else was able to enjoy a little more.”

Does Harford mean by that that the messaging by the three Ghosts of Christmas needs to be harmonized with central bankers? I ask because I am not really sure central bankers have enough of an intelligent Christmas spirit to be able to cooperate.

For instance, with respect to bank regulations, by agreeing with that banks should be able to leverage more when lending to the “safe” than when lending to the “risky”, central banks don’t mind that the risk adjusted net margins paid by the safe, are worth much more than those same margins paid by the risky. I am absolutely sure Ebenezer Scrooge would never discriminate like that, he would always lend to whoever paid him the highest exorbitant credit risk adjusted rate, no matter who paid it.

Perhaps we need to invoke the Ghosts of Economies Past, Present and Future in order to enlighten our bank regulators that good economies are never ever the result of credit risk aversion since they always come as a result of embracing risk. Hopefully the risks taken by banks are based on reasoned audacity. But, even if that’s not the case, and some banks fail, it is still much better when bankers dare jump and finance the risky future, and do not stay in bed, like now, just refinancing the safer past… developing constipation, bedsores, weak bones and muscles and other illnesses, like that which produces a chronic lack of job for our young (and old).

Finally Harford does well reminding central bankers who think the economy will respond to their ultra-low interest rates and QEs, that Scrooge, when finally embracing the Christmas spirit, “didn’t waste his money on demonstrative extravagances for people whose desires he didn’t really understand.

@PerKurowski ©