April 02, 2016

Placing our banks into the hands of a Basel Committee is surely one of the greatest acts of naïve realism ever

Tim Harford quotes George Carlin with “Have you ever noticed when you’re driving, that anybody driving slower than you is an idiot, and anyone going faster than you is a maniac?”, “Delusions of objectivity” April 2

And Harford refers to a new book, The Wisest One in the Room, co-authored by Lee Ross, a psychologist at Stanford University and that describes the problem of “naive realism”… “The seductive sense that we’re seeing the world as it truly is, without bias or error. This is such a powerful illusion that whenever we meet someone whose views conflict with our own, we instinctively believe we’ve met someone who is deluded, rather than realising that perhaps we’re the ones who could learn something”

But let me also quote from Tim Harford’s book “Adapt” of 2011. It states: “So far this book has argued that failure is both necessary and useful. Progress comes from lots of experiments. Many of which fail, and we are to be much more tolerant of failure if we are to learn from it. But the financial crisis showed that a tolerant attitude to failure is a dangerous tactic for the banking system.” In other words Harford holds that, those not allowing for sufficient risk-taking are idiots and those allowing too much risk taking are maniacs”.

And in his book Harford also quotes Charles Perrow, emeritus professor of sociology at Yale explaining that the dangerous combination is a system that is both complex and tightly coupled, and saying that the banking sector “exceeds the complexity of any nuclear plant I ever studied”.

And when commenting on the Piper Alpha (nuclear plant) disaster Harford writes: the “safety system introduced what an engineer would call a ‘new failure-mode’ – was precisely the problem in the financial crisis: not that it had safety systems, but that the safety system it did have made the problems worse”. Harford illustrates that with the example of credit default swaps CDS.

But finally, in “Adapt”, Hartford also argues: “Among the bitter recrimination over the financial crisis of 2008, if there’s a consensus about anything is that the financial system needs to be made safer. Rules must be introduced, one way or another, to prevent banks from collapsing in the future”.

And of course that’s wrong! Because that might precisely represent the worst kind of bank regulation risk!

In May 2003, in some comments delivered as an Executive Director of the World Bank during a workshop for regulators I said: “A regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises.”

Coming back to Harford’s "Delusion of Objectivity" I would hold that one of the greatest acts of naïve realism of our times, is believing that a small group of technocrats, holed up in a mutual admiration club like the Basel Committee effectively is, can regulate our banks to be safer, without creating even larger risk.

Just for a starter they regulated the banks without defining the purpose of banks, which allowed them to introduce their risk weighted capital requirements, which completely distorted the allocation of bank credit to the real economy.

Clearly in reference to my criticism of Basel regulations, most in FT believe, or had been told to believe, that I am someone quite deluded, rather than realising that perhaps they are the ones who could learn something from me.

I confess I am obsessive on this issue. They should confess they are even more obsessive ignoring this issue. 

@PerKurowski ©