To explain the 2008 financial crisis a two pieces puzzle could suffice.

Sir, Tim Harford writes, “Raghuram Rajan, when he was chief economist of the IMF, came closest to predicting the 2008 financial crisis. He later observed that economists had written insightfully on all the key issues but had lacked someone capable of putting all the pieces together”, “How economics can raise its game” June 29.

According to 2004’s Basel II, a corporate rated AAA to AA, could offer banks to leverage their equity 62.5 times (100%/(8%*20%)) with its risk adjusted interest rate, while one rated BB+ to BB-, or not rated at all, could only offer banks to have their risk adjusted interest rate leveraged 12.5 times (100%/(8%*100%))

Sir, I am not arguing whether it is better to be a hard or a soft economist but, any economist looking at that proposition and not seeing it would cause serious misallocation of bank credit, should either go back to school, perhaps to take some classes on conditional probabilities, or go out on Main-street, and learn a bit of what real life is about.

62.5 times leverage? What banker could dare resists that temptation and stay out of competition thinking, what if that AAA to AA rating is true?

PS. That leverage applied for European banks and US investment banks supervised by SEC.

@PerKurowski

To salvage the European Union, its authorities must be held responsible for the travails of Italy, Greece and other.

Sir, with respect to what’s happening in Italy you write: “The guardians of the single currency failed to mend the roof while the sun was shining… Even if disaster has been averted on this occasion, the economic and political fragility of the eurozone remain all too clear” “Italy sets a stress test for the eurozone, again” June 2.

True. From the very start, soon 20 years ago, it must have been clear for all the proponents of the Euro that adopting it, meant for all countries using it giving up the possibility of adapt to different economic circumstances through foreign exchange rates adjustments.

And a Germany would benefit with a too weak for it Euro, and others, like Italy and Greece would suffer a too strong for them Euro.

What have the Eurozone authorities done to meet that challenge? Way too little! They busied themselves with all other type of lower priority issues and outright minutia. Worse yet, they also stupidly silenced the full disequilibrium signals that the interest rates on the Euro members’ public debt level could send the markets by assigning to all a 0% risk weight. Something that made the sun seem shine brighter than what it really did!

Fabio Panetta, the Deputy Governor of the Bank of Italy in a speech in London in February 2018, with respect to the possibility of raising the capital requirements on sovereign debt had the temerity to say: “The problem of high public debt should be addressed by Governments directly, with determination. It should not be improperly tackled with prudential regulation.”

If I were an Italian or a Greek, given a chance I would have told (shouted) him: 

“With your 0% risk weighing you regulators imprudently created temptations for our politicians to be able to take on much more public debt at much lower rates than would otherwise have been the case, and now you argue they should have been able to resist such temptations? Just the same way you argue that banks should have resisted the temptations to leverage over 60 times with assets that carried an AAA rating? Have you and your colleagues no shame?” 

Sir, while regulators keep on giving banks more incentives to finance the “safer” present consumption than the future “riskier” production, the chances for Europe (and America) to get out of its problems lie, at least in the case of Italy, as so many times before, in the strength of its economia sommerza.

@PerKurowski

As banks “pressure employees to hawk products”, regulators pressure banks to odiously discriminate against the risky

Sir, John Gapper writes about “the intense pressure Wells Fargo placed on employees to hawk products” “Wells Fargo reaches the end of its journey” September 22.

But, by means of the risk weighted capital requirements for banks, regulators have placed much pressure on banks to lend to what was perceived, decreed or concocted as safe; because that’s were they could leverage the most their equity; because that’s where they could earn the highest expected risk adjusted returns of equity; and so banks end up with excessive exposures to residential home financing, AAA rated securities, loans to sovereigns like Greece and other such fancy safe stuff.

That created also a de facto immoral regulatory discrimination against the access to bank credit of those who ex ante are perceived as “risky”, like SMEs and entrepreneurs. I place quotation marks around risky because in fact, by being perceived as that, they are never as dangerous to the bank system than what is perceived as “safe”.

Incentives are temptations, aren’t they? 

@PerKurowski

Senator Elizabeth Warren, what about the staggering bad bank regulations that came out of the Basel Committee?

Sir, Patrick Jenkins writes: “Today, Mr Stumpf will face an inquisition at the Senate banking committee. It promises to be a hostile experience — no-nonsense committee member Elizabeth Warren is not known for her love of the banking sector and has already talked of Wells’ “staggering fraud”. “Wells Fargo chief ’s high noon is Senate committee grilling” September 20.

I’ve got no problem with any “grilling” of bankers, give it to them! But, Senator Warren, in all fairness, do not turn it all into another simpleton Bank-Bashing fair, We the People need it to be much more. If anything, look at how the bank regulators set up all the incentives for bankers to do wrong.

Why on earth should we expect bankers to be saints and resist the temptations? Aren’t they supposed to maximize their risk adjusted returns on equity?

What am I talking about? THIS

http://subprimeregulations.blogspot.com/2016/09/if-ever-allowed-following-would-be-my.html

PS. And Senator Warren, why would you agree with those who decreed inequality?

http://subprimeregulations.blogspot.com/2016/03/decreed-inequality.htm

@PerKurowski ©

When securitization wedded the capital requirements for banks, the subprime mortgages' inferno overheated.

Sir, I refer to Gillian Tett’s “Unorthodox answers to the inflation enigma” April 1.

Ms Tett writes: “If the Fed, or any central bank, wants an illustration of why ethnographic research matters, they need only look at the last credit bubble, when most economists missed the subprime mortgage boom because they shunned on-the-ground research. Fed officials need to get into consumers’ lives. Or else hire a few anthropologists to work with those office-bound, and baffled, economists.”

Unfortunately central bankers have yet to understand the missed subprime mortgage boom, and so has anthropologists like Gillian Tett.

Anyone who has read Kirsten Grind’s spectacular tale of the Washington Mutual failure “The Lost Bank” 2012, Gillian Tett has praised it, should have been intrigued by a question the book poses but that remains unanswered. Why was there especially such huge demand for basically the lousiest mortgages?

An objective researcher would then have found that combining the dark secret of securitization, with the importance given to the credit rating agencies for determining the capital requirements for banks, created a temptation impossible for any ordinary humans to resist.

What “dark secret of securitization”? That the worse the assets to be securitized are, the more can those involved in the securitization process profit. Selling of a $300.000, 30 years, 11 percent mortgage, packaged in a security for which an investor thought that 6 percent was a great return, would immediately yield $210.000 in profits.

And on credit ratings, if a security got an AAA to AA rating, then the banks, according to Basel II, needed only to hold 1.6 percent in capital against it, and were therefore allowed to leverage a mind-blowing 62.5 times to 1.

The problem with any central bank research though, is that it would lay much blame on all central bankers involved with bank regulations… and, among colleagues, we can’t have that, can we?

Oh how I wish Kirsten Grind would go back to the subprime inferno and research the causes for why it overheated.

@PerKurowski ©

The Banking Standards Board should also require bank regulators to uphold higher ethical standards

Sir, Patrick Jenkins’ discusses what the Banking Standards Board can do influencing the ethics of banks. “Banks gain help on the scandal-strewn road to better behaviour” March 8.

If I were the BSB then, in the case of the fatidical mis-sold mortgage-backed securities, I would come out swinging against the regulators stating:

How on earth did you allow us banks to buy AAA to AA rated securities against only 1.6 percent in capital, meaning we could leverage our bank equity 62.5 times to 1 with that kind of paper? Don’t you know there are very few human bankers able to resist such temptation because, if they did, they would find other banks earning much higher expected risk adjusted returns on equity, leaving them as the dumb kids of the block, or as those who refused to dance while the music was playing?

And now, should those who created the temptations, the devils in the play, be able to go free, while we who fell for the temptations, the weak in flesh, shall bear all guilt? No! That’s not acceptable!

And, if I were accused of the manipulation of Libor, I would at least declare in my defense that such manipulation was really quite harmless when compared to the regulators’ manipulation of the allocation of bank credit to the real economy. That manipulation, which regulators committed with their risk weighted capital requirements for banks, was and is also something completely unethical.

@PerKurowski ©