Saturday, May 16, 2020

Risk weighted bank capital requirements endangers and de-purposes our banks.

A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain” Mark Twain (supposedly).
But Basel Committees’ bank regulators did not know about conditional probabilities and so, instead of setting their risk weighted bank capital requirements based on how bankers act upon perceived risks, they set these based on the perceived expected credit risk.   

That risk weighting of the capital requirements, which also included allowing the bigger banks to use their own risk models, resulted in banks being taken out of the hands of savvy loan officers and placed into the custody of dangerously creative equity minimizing, leverage maximizing financial engineers.

Since banks already cleared for perceived credit risk by means of risk adjusted interest rates and size of exposures, having to clear for those same risks in the capital, results in an excessive consideration of perceived credit risk. And, “any risk, even if perfectly perceived, causes the wrong reactions, if excessively considered” me dixit.

In 2004 Basel II set the following standardized risk weights (RW) to be applied to its basic 8% bank capital requirement (CR)
AAA to AA rated Sovereigns: = RW=0%, CR=zero = unlimited leverage
AAA to AA rated corporates: RW=20%, CR=1.6% = 62.5 times leverage
Residential mortgages: RW=35%, CR =2.8% = 36 times leverage    
Citizens: RW=100%, CR= 8% = 12.5 times leverage 
Below BB- rated assets: RW=150% = 12% capital = 8.3 times leverage

April 2003, at the World Bank, with respect of assigning (human fallible) credit rating agencies so much power to influence capital requirements, I warned "Nowadays, when information is just too voluminous and fast to handle, market or authorities have decided to delegate the evaluation of it into the hands of much fewer players such as the credit rating agencies. This will, almost by definition, introduce systemic risks in the market"

You've gotta eat your spinach baby” (Alice Faye) No Spinach, take away that awful greenery” (Shirley Temple)
Allowing bankers to hold less capital against what’s perceived as safe, meaning they could leverage much more with what’s perceived as safe, meaning they could earn higher risk adjusted returns on equity on what’s perceived as safe than on what’s perceived as risky, de facto translated into telling Shirley “If you eat your spinach you’ll have to eat broccoli too, but if you eat up all your ice cream, then you can have as much chocolate cake you want

A ship in harbor is safe, but that is not what ships are for.” John A Shedd.

Indeed, in March 2003, at the World Bank, I argued The financial sector’s role, the reason why it is granted a license to operate, is to assist society in promoting economic growth by stimulating savings, efficiently allocating financial resources satisfying credit needs and creating opportunities for wealth distribution. 
Sadly though, in all regulations coming out from the Basel Committee there is not one single mention about banks having a different purpose than being a safe mattress in which stash away cash.

Andsince regulators pay banks with higher risk adjusted returns on equity for the “safe”, like loans to the sovereign, residential mortgages and AAA rated, than on loans to the “risky”, like entrepreneurs and SMEs, banks began to dangerously overcrowd safe harbors, like 2008’s AAAs, 2011’s Greece, and Italy and so many other overindebted nations now. 

With this, in essence, our bank systems are doomed to especially large crises resulting from especially large exposures to something especially perceived as safe but that could turn out to be especially risky and are held against especially little bank capital.

Answer: What’s more dangerous to bank systems, something rated AAA turning out risky or something rated below BB- being confirmed as very risky?

And those of us who used to need to remain in safe harbors, like us citizens wanting to have something safe for our retirement, even though much less prepared for that than banks, we had to take to the risky oceans.

Risk taking is the oxygen of all development. Pope John Paul II reminded us that Jesus Christ invited the Apostle to "put out into the deep" for a catch: "Duc in Altum". But the regulators ignored all that and incentivized banks to fish in shallow risk-free waters full of carbohydrates and with no proteins, something which causes our real economies to become obese and suffer from lack of muscles and from osteoporosis.

What goes up must come down, spinning wheel got to go 'round” David Clayton Thomas
And so, utterly procyclical, when times are good and much perceived safe. banks are allowed to hold very little capital, and so they pay dividends and buy back shares. But, when times get rough, and something unexpected happens, like coronavirus, our bank stand there with their pants down, precisely at the worst moment to raise new capital.  

Risk weights of 0% the sovereign and 100% citizens, is communism through regulations.
With less bank capital requirements for the safe than for the risky, inequality was decreed.
How it all started
A pour memoire on the mistakes 
My 2019 letter to the Financial Stability Board
My 2019 comments sent to IMF
My one and only book

And this is what Paul A. Volcker opined in “Keeping at it” 2018
“Over time, the inherent problems with the risk-based approach became apparent. The assets assigned the lowest risk, for which capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages. Ironically, losses on those two types of assets would fuel the global crisis in 2008 and a subsequent European crisis in 2011.” 

PS. Today May 16, 2020 I reached 70 years of age.