Why do financial regulatory authorities, while preaching the value of diversification, act in favor of concentration?

Sir I refer to Harriet Agnew’s “FT BIG READ. Professional Services: Accounting for change” August 28.

In November 1999, in an Op-Ed in Caracas Venezuela, this is what I had to say on what is discussed there:

“I recently heard that SEC was establishing higher capital requirements for stockbroker firms, arguing that . . . ‘the weak have to merge to remain. We have to get rid of the rotten apples so that we can renew the trust in the system.’ As I read it, it establishes a very dangerous relationship between weak and rotten. In fact, the financially weakest stockbroker in the system could be providing the most honest services while the big ones, just because of their size, can also bring down the whole world. It has always surprised me how the financial regulatory authorities, while preaching the value of diversification, act in favor of concentration.

The SEC should not substitute the need for capital in place of the need for ethics, nor should it allow that fraudulent behavior hides amid the anonymity of huge firms. In this respect, let us not forget that the risk of social sanctions should be one of the most fundamental tools in controlling financial activities.

Currently market forces favors the larger the entity is, be it banks, law firms, auditing firms, brokers, etc. Perhaps one of the things that the authorities could do, in order to diversify risks, is to create a tax on size.”

@PerKurowski

The too few to follow is more dangerous than the too big to fail

Sir I refer to John Gapper’s “Squeeze the leviathans of finance” July 23. I go way back fighting the “too big to fail”, even when they were thought of being “too smart and expert to fail”, but let me assure you that a thousand small banks following one credit rating agency are still much more dangerous than the too large to fail with thousands of analysts.

And by the way the problem with the Basel minimum capital requirements is not so much that banks end up holding little capital but that these regulations discriminate among borrowers and who therefore go through all strange convolutions to dress up in AAAs.

The too few credit rating agencies opinions to follow are a larger source of systemic risk than the “too big to fail”

Sir, with respect to the “too big to fail” at a workshop on risk management in the World Bank in 2003 I told the financial regulators that “knowing that the larger they are the harder they fall on us, if I were a regulator, I would be thinking on a progressive tax on size” I can therefore evidence having stood up against the big while they were still believed invincible and few dared to do so. 

That said it is clear that this crisis, though it did hit some of the big especially bad, was not caused by these banks but by the “too few credit rating agencies opinions to follow” that were imposed on the system by the financial regulators. 

But as we can read from Martin Wolf’s “The cautious approach to fixing banks will not work” July 1, slowly and surely we are getting to the truth. Martin Wolf now informs us that the median leverage of commercial banks in Europe in 2007 was 45 to 1 and of course it is “insane”, anyone knows that, so the real question becomes why did not anyone, including Martin Wolf, say so? 

The answer lies in the risk weighting of the assets that was done and in this aspect Wolf still has something to learn. When he says “the required bank capital must also not be risk-weighted on the basis of bank models, which are not to be trusted” he blithely ignores that the bank models has little to do with that because the essential parts of the risk-weighting is derived from the arbitrarily rules on minimum capital requirements concocted by the regulators and from the opinions of the appointed supreme risk surveyors.

PS. Incentives matter. The escape valves of risk weighted bank capital (equity) requirements, cause banks’ risk models to be more about equity-minimizing/leverage-maximizing, than about analyzing bank assets’ true risks. That’s life!