Friday, August 26, 2016

There are three causes for major bank crises. Regulators focused on one that’s not. Basel Committee & FSB... Good Job!

What are the causes of major bank crises?

1. Unexpected events, like major devaluations and natural disasters.

2. What was ex ante perceived as very safe turned out ex post to be very risky.

3. Shenanigans like unauthorized speculative trading or banks lending to their own directors or shareholders.

What did the regulators do? 

They introduced credit-risk-weighted capital requirements: more ex ante perceived risk more capital - less risk less capital... clearing agains for basically the only risk that was already being cleared for, by means of size of exposure and interest rates.

For instance, prime AAA to AA rated got 20% risk weight ,while the highly speculative almost broke below BB- rated, got a 150% risk weight...

As if banks would ever build up dangerous excessive exposures to what is below BB- rated 

Good job regulators!

Tuesday, August 23, 2016

The Basel Committee, Financial Stability Board and other frightened risk adverse bank nannies, they mandated stagnation.

When you allow banks to hold less capital when financing what’s perceived as safe than when financing the risky; banks earn higher expected risk adjusted returns on equity when financing the safe than when financing the risky; and so you are de facto instructing the banks to stop financing the riskier future and keep to refinancing the safer past… something which guarantees stagnation… a failure to develop, progress or advance… something which guarantees lack of employment for the young and retirement hardships for the old. 

I would prefer not to distort the allocation of bank credit but, if I had to, then I would try to ascertain that bank credit goes to where it could do the society the most good; in which case I would consider basing these on job creation ratings and environmental sustainability ratings, and not on some useless credit ratings already cleared for by banks with the size of their exposures and interest rates.

PS. If you want more explanations on the statist and idiotic bank regulations that are taking our Western society down, here is a brief aide memoire.

PS. If you want to know whether I have any idea of what I am talking about, here is a short summary of my early opinions on this issue since 1997.

Monday, August 22, 2016

Mr R Gandhi, ignore the Basel Committee’s mutual admiration club, and concentrate on the needs or your India.

Mr R Gandhi, Deputy Governor of the Reserve Bank of India, at the FIBAC 2016 in a speech titled “New horizons in Indian banking”, Mumbai, 17 August 2016 said the following: 

“I regret that at the very end of these two days deliberations on future of banks, I have to paint such a dismal future for your existence as banks….One big area, you vacated and / or let others to occupy by your lackluster attitude is there for your rightful reclaim, if only you make concerted and conscious effort. That is SME financing. Small and medium sized enterprises (SMEs) are a major, yet often overlooked sector by formal financial institutions. The SMEs reportedly account for more than half of the world’s gross domestic product (GDP) and employ almost two-thirds of the global work force. However, they are the neglected lot world over. As reported by the International Financial Corporation (IFC), a “funding gap” of more than $2 trillion exists for small businesses in emerging markets alone...

I can only conclude with the idea that if you make yourself socially relevant, not just relevant in economic sense alone, you can have hopes to exist”

Holy moly. unless Mr R Gandhi is simply thickheaded and does not understand, he should be ashamed of trying to blame the banks for this ignoring his own responsibilities as a regulator.

Who told banks to get out of SME financing? The bank regulators did; by requiring banks to hold much more capital when lending to SMEs than when lending to those perceived as safer. That made it difficult for banks to earn competitive risk adjusted returns on equity lending to the SMEs.

Who made banks socially irrelevant? The bank regulators did, by regulating banks without ever having defined their purpose… like that of allocating credit efficiently to the real economy.

And since risk-taking is the oxygen of any development, a developing country like India is one of those who could least afford to introduce regulatory risk aversion. Not as if those developed can either, but at least they have reached higher altitudes before starting to climb down their mountains.

In 2007, at the High-level Dialogue on Financing for Developing at the United Nations, I explained why the Basel regulations were harmful to development, and my opinion was even reprinted in October 2008 in the Icfai University Journal of Banking Law.

Sadly though, as happens with most central bankers and regulators from developing countries, they end up more interested in being accepted by their peers in the developed countries, and in belonging to their mutual admiration club, than in doing what is best for their own countries.

Basel Committee’s mindboggling naiveté: Banks, thou shall not misbehave and fudge to lower your capital requirements

In the “Statement on capital arbitrage transactions” Basel Committee newsletter No 18 of June 2016 we read:

“Transactions that are designed to offset regulatory adjustments employ a variety of strategies. For example, these may include: (1) the issuance of senior or subordinated securities with or without contingent write off mechanisms; (2) sales contracts that transfer insufficient risk to be deemed sales for accounting purposes; (3) fully-collateralised derivative contracts; and (4) guarantees or insurance policies. These types of transactions… can have the effect of overestimating eligible capital or reducing capital requirements, without commensurately reducing the risk in the financial system, thus undermining the calibration of minimum regulatory capital requirements.

Banks should therefore not engage in transactions that have the aim of offsetting regulatory adjustments.”

What a mindboggling naiveté! While regulators allow banks to hold less capital against assets perceived, decreed or concocted as safe, and the risk-adjusted return on equity is how banks compete for capital (and bonuses), how can they think banks will not do their utmost to lower the required equity?

PS. Children, listen to your Basel nannie, though there is ice-cream and chocolate cake in the fridge, she still expects you to eat the spinach and the broccoli.

PS. You want your children not to arbitrage and eat of everything... blend it all together.

PS.You want your banks not to arbitrage... set one capital requirements for all assets.

Wednesday, August 17, 2016

It is prudent for our banks to take risks on the not so creditworthy, especially if these are up to something worthy

In a recent article in the Financial Times a bank was mentioned to be “an exemplar of prudence…[because] The target loan loss ratio is zero; [and] low loan losses, in turn, allow the bank to offer competitively priced loans and personalized service to creditworthy customers.”

To me that points clearly to what’s wrong with banks nowadays. “A target loan loss ratio of zero”… might allow “to offer competitively priced to creditworthy customers” but it will clearly not offer sufficient opportunities of credit to the not so creditworthy, those which includes too many risky SMEs and entrepreneurs, but also that could help provide the proteins the economy needs to move forward, in order not to stall and fall.

And the real truth is that, in the medium and long term, the creditworthy could benefit much more by banks taking much more risks on the not creditworthy, especially if these seem to be up to something worthy, than by they just getting low priced loans.

And if to the “zero loss loan target” you then add the distortion in the allocation of bank credit caused by the risk weighted capital requirements for banks, you might get a feel for why our economies seem to stagnate. 

Those regulations require the banks to hold more equity when lending to someone perceived risky, than when lending to someone perceived safe. And so that results in banks earning higher expected risk adjusted returns on equity when lending to someone perceived, decreed or concocted as safe, than when lending to someone perceived as risky. And that signifies that, around the world, millions of “risky” SMEs and entrepreneurs are not given the opportunity they might deserve and we might need for them to get.

As is, the banking system no longer finances the “riskier” future but only refinances the “safer” past, and that is as imprudent as can be, at least for our grandchildren.

Those bankers who with reasoned audacity take chances on the future are good servants of the society. Those who only maximize return on equity by diminishing the required capital and avoiding risks are, in the best of cases, absolutely boring.

And don’t get me wrong; I do not want to endanger our banking system, it is just the opposite. The forgotten truth is that major bank crises never ever result from banks building up excessive exposures to what ex ante is perceived as risky, it is not in the nature of bankers, as Mark Twain explained in terms of sun, rain and umbrellas.

The big crises always result from unexpected event of because of excessive exposures to something erroneously considered as safe.

PS. With their risk weighted capital requirements the regulators decreed inequality.

Wednesday, August 10, 2016

Statist baby-boomers want us to extract all existent public borrowing capacity, leaving nothing for the future

An article by M. Barton Waring and Laurence B. Siegel titled "The Only Spending Rule Article You Will Ever Need" is introduced by Bob Dannhauser, CFA, the head of global private wealth management at CFA Institute with the following:

“Retirement portfolios can fail us in two ways: living cautiously might ‘leave too much on the table’ when our money outlasts us, but spending too much can mean running out of money before we run out of life.”

In the same way, those statist baby-boomers who scream for more debt financed government spending, taking advantage of current low borrowing rates, seem also to be doing their utmost to extract whatever public borrowing capacity they can from the current economy. You can call it placing a reverse mortgage on the economy if you want, so as to leave absolutely nothing on the table for the next generations. Our children and grandchildren will get the bill!

But, if the baby-boomers live long enough, and economic disasters result from too many bridges to nowhere being built, or just the markets catching up on the fact that even the safest haven can become dangerously over populated, then they could also end up in poverty.

Personally, since I am convinced that because of regulatory subsidies, and the use of monetary policies like quantitative easing, the current low interest rates on public debts are artificially low, I find calls for further indebtedness based on low rates to be highly irresponsible.

Moreover as statist bank regulators have decreed a 0% risk weight for the government and a 100% risk weight for We-the-risky-People, those who could really help to build future, like SMEs and entrepreneurs, are now not getting the credit our children and grandchildren need for them to get.

Paul Krugman

Tuesday, August 9, 2016

Banks and regulators don’t care about our economy

The Aug. 5 Economy & Business article “What happens when lines blur between banks, regulators” referred to several issues and conflicts of importance between banks and regulators but did not mention the prime point of agreement between all regulators and all banks: None of these actors cares about the state of the real economy.

Banks love to earn high-risk adjusted returns on equity when lending to something perceived as absolutely safe, so they love when regulators allow them to hold much less equity when lending to something perceived, decreed or concocted as safe.

Regulators love it when banks avoid taking risks, so they are more than happy to allow banks to hold much less equity when lending to something ex-ante perceived by them as safe, and therefore allow banks to earn much higher risk-adjusted returns on equity when staying away from the risky.

Our problem, though, is that we need for our banks to lend to the risky, such as small and medium-size enterprises and entrepreneurs, to keep our economy moving forward.

Regulators have never defined the purpose of the banks, so they do not care about whether these banks allocate credit efficiently to our real economy.

Per Kurowski, Rockville
The writer was an executive director at the World Bank from 2002 to 2004.

Monday, August 8, 2016

ECB, Single Supervisory Mechanism (SSM), with respect to banks, still pisses out of the pot; and McKinsey keeps mum

The declared supervisory priorities for 2016 of ECB's Single Supervisory Mechanism (SSM) with respect to banks are: “(i) business model and profitability risk, (ii) credit risk, (iii) capital adequacy, (iv) risk governance and data quality, and (v) liquidity”

As you can see, ECB still does not care one iota about the allocation of bank credit to the real economy. Not one single indication of trying to figure out what should be on banks’ balance sheets and is not.

And as you can see, ECB still thinks that if it only can make banks stay away from what is ex ante perceived as risky, all will be fine and dandy. It has no idea that what caused all bank crises has been, either unexpected events, like currency crises, or excessive exposures to something erroneously perceived ex ante as absolutely safe… never ever what was ex ante perceived as risky.

And leading consulting companies in the world, like McKinsey, play along and don't say a word, probably because they expect to profit hugely from the so inept bank regulators.

As far as consultancies go, bank regulations is the new piñata in town.

You want to know what I am talking about? Serve yourself a good cognac and read this.

Thursday, August 4, 2016

Regulators stupidly infantilized our bankers, and so we ended up with a dangerously obese economy

Jonathan Klick and Greg Mitchell  in "Infantilization by Regulation” “Cato:Regulation” Summer 2016." write:

“With the rise of libertarian paternalism has come greater acceptance of the view that citizens often fail to act in their best interests and that it is the government’s job to put a stop to that. In this mindset, the market is a predator rather than a check on stupid mistakes. 

If the behavioral assumptions behind libertarian paternalism gain widespread acceptance among policymakers, then we should prepare for an onslaught of nudges and shoves. And every time a nudge is adopted, an opportunity for learning and individual development is lost. 

Perhaps the gains from intervention will be sufficient to justify the opportunity cost, but those costs should be included in the cost-benefit analysis. Too often only the predicted benefits are considered, while the attendant long-term costs go unseen.”

Absolutely! When regulators, even knowing that bankers already cleared for perceived risks by means of interest rates and size of exposure, told bankers they also needed to clear for the same perceived risk in their capital, they essentially infantilized bankers… in a very dumb and dangerous way.

They told the bankers: “If you eat ice cream (what’s perceived as safe) then we will reward you with chocolate cake (lower capital requirements that allows for higher leverage that allows for high risk adjusted rates of return on equity); but if you eat broccoli (what is perceived as risky) then you will also have to eat spinach (higher capital requirements that causes lower leverage that causes lower risk adjusted rates of return on equity.”

And so what have we? A debt obesity crisis that was resulted caused by excessive eating of ice cream and chocolate cake… and an economy that does not want to ignite because of the lack of the nutrients present in spinach and broccoli.

Wednesday, August 3, 2016

Stiglitz doesn’t understand how regulators, when doubling down on credit risk perceptions, bully those perceived as “risky”

Joseph E. Stiglitz together with George A. Akerlof and A. Michael Spence won the 2001 Nobel Prize in Economics "for their analyses of markets with asymmetric information". The Nobel Prize website indicates that in the case of Professor Stiglitz his contribution was to show “that asymmetric information can provide the key to understanding many observed market phenomena, including unemployment and credit rationing.”

In a 1998 paper by Thomas Hellmann and Joseph Stiglitz titled “Credit and equity rationing in markets with adverse selection” we read: "The meaning of rationing: “Those entrepreneurs who are willing to accept the higher price are rationed in the sense that they cannot obtain funds at the same price as other observationally identical entrepreneurs. Those entrepreneurs who are not willing to accept the higher price fail to receive funding in this market. Some of them may seek funding in the other market. If there is rationing in the other market too, they may fail to obtain any funding. Even if there is no rationing some of them may not find any acceptable offer in the other market, and again they are left without funding. The point is that while an outside observer may look at this environment and argue that there are many opportunities for the entrepreneur to obtain funding, it may well be that the funding that is still available comes at unacceptable terms, and the funding that has acceptable terms is rationed." 

And in his most recent book “Re-writing the rules of the American Economy” 2016, in the “Fix the Financial Sector”, Stiglitz writes “it is regrettable that almost all of the discussions of reforming the financial sector have focused on simply preventing harm on the rest of society and not in developing a financial system that actually serves our society- for instance by helping to effectively finance small business, education and housing”.

Yet in his very long and somewhat questionable what-to-do list, Stiglitz does not include getting rid of the pillar of current bank regulations, the risk-weighted capital requirements for banks, those by which regulators bully those who are usually perceived as risky borrowers.

By allowing banks to leverage more with what is safe than with what is risky, banks now earn higher risk-adjusted returns on equity when lending to the safe than when lending to the risky… with all its logical consequences.

I have read Professor’s Stiglitz cv. (boy!) and in it I find absolutely nothing that indicates he has ever walked on main-street. So most probably he therefore knows nothing about the difficulties of SMEs and entrepreneurs have to access bank credit. These borrowers, perceived as risky, quite often have to cheat, lie, or at least withhold the whole truth, or even bribe someone, in order to get the opportunity they believe can transform their lives and that of their children. 

And all those difficulties were present even before regulators told the banks that, besides clearing for ex-ante perceived credit risks by means of risk premiums and amounts of exposure, they also had to clear for the same perceived risks in the capital. 

One should expect someone that has won a Nobel Prize researching “credit rationing” to know that any perceived risk, an information, even if perfectly perceived, leads to the wrong conclusions, if excessively considered. But apparently it is not so.

The current risk weight of an unrated SME or entrepreneur, “We the people”, is 100%. The corresponding risk-weights for the Sovereign is 0%, for the members of the AAArisktocracy 20% and for the financing of houses 35%.

For instance the 100% for SMEs and the 35% for houses will cause we end up in houses without the jobs to pay the mortgages and utilities.

For instance the 0% for the sovereign and the 100% for We the People means that regulators believe government bureaucrats can use bank credit better than citizens... an outrageous statism.

Stiglitz has also aspired to a lot of fame as a champion against inequality… but, though he won the “John Kenneth Galbraith Award, American Agricultural Economics Association, August 2004” perhaps he should have included in his academic library John Kenneth Galbraith’s “Money: “whence it came, where it went” (1975). There on job creation and fighting inequality we read:

“For the new parts of the country [USA’s West]… there was the right to create banks at will and therewith the notes and deposits that resulted from their loans…[if] the bank failed…someone was left holding the worthless notes… but some borrowers from this bank were now in business...[jobs created] 

It was an arrangement which reputable bankers and merchants in the East viewed with extreme distaste… Men of economic wisdom, then as later expressing the views of the reputable business community, spoke of the anarchy of unstable banking… The men of wisdom missed the point. The anarchy served the frontier far better than a more orderly system that kept a tight hand on credit would have done…. what is called sound economics is very often what mirrors the needs of the respectfully affluent.

The function of credit in a simple society is, in fact, remarkably egalitarian. It allows the man with energy and no money to participate in the economy more or less on a par with the man who has capital of his own. And the more casual the conditions under which credit is granted and hence the more impecunious those accommodated, the more egalitarian credit is… Bad banks, unlike good, loaned to the poor risk, which is another name for the poor man.”

And, during the 2007 High-level Dialogue on Financing for Developing at the United Nations, from the perspective of the developing nations, I protested this regulatory risk aversion but no one really wanted to listen. 

And so when it all came down to the conclusions of the UN Conference Crisis & Development I suffered great disappointments.

I have said before and I repeat it again and again. Nobel Prizes should be recallable, especially if they are used for uttering opinions on matters the winners have no idea about… like bank regulations and Main Streets. Besserwissers from mutual-admiration-group-thinking-clubs monopolizing discussions, are just too costly for the future of our kids and grandchildren

Saturday, July 30, 2016

Bank regulations put Minsky’s “financial instability hypothesis” on steroids, boosting its speed towards “the moment”.

The Economist refers to Hyman Minsky’s important “financial instability hypothesis”, but concludes that it “would be a stretch to see that hypothesis becoming a new foundation for economic theory, “Minsky’s moment” July 30, 2016

That might be, but it should become an essential foundation of financial regulations because, by ignoring it, with the risk weighted capital requirements for banks, the regulators set the “boom that can sow the seeds of busts” on steroids.

Normally, without distortions, bank credit should be allocated to whoever offers the highest perceived risk adjusted rate. That of course might quite often not be true, because “a safe” can be riskier or safer than what it is perceived; just llke “a risky, could equally be safer or riskier.

But, when regulators decided banks needed to hold less capital against what was perceived, decreed or concocted as safe, than against what was perceived as risky, they dramatically distorted the allocation of bank credit to the real economy.

Suddenly the booms of what was perceived as safe got a tremendous boost, as banks could earn higher risk adjusted rates there; all while “the risky” saw their access to bank credit severely curtailed.

We only need to go the crisis of 2007-08 to see that what caused it, was all which had very low capital requirements because it was perceived as safe when placed on the bank’s balance sheets.

And of course, the power of those regulatory steroids, was further strengthen by the fact that so much decision power, over deciding what was safe and what was risky, was placed in the hands of some very few human fallible credit rating agencies.

PS. I was just a consultant from a developing country who happened to end up on the Board of the World Bank as an Executive Director, and so I can of course not aspire, by far, to receive the same attention as Hyman Minsky, but you might anyhow be interested in what were my very early opinions on these issues

@PerKurowski ©

Friday, July 29, 2016

Regulatory risk-weights: The sovereign = Zero percent and We the (risky) People = 100%. In America?

I am not an American, and I am not well versed on its Constitution, and there is one issue which has for a long time been a mystery to me. 

How on earth could America, in 1988, as a signatory of the Basel Accord, accept that for the purpose of setting capital requirements for banks, the risk-weight for the sovereign, meaning the government, was going to be zero percent, while the risk-weight for the citizen, meaning We The People was set at 100%; and all without a major discussion?

I know that “sovereigns” currently means the government but, from reading for instance Randy E. Barnett’s “Our Republican Constitution”, one could have expected some debate about something that is akin to risk weighing the King with an "infallible" 0%, and his subservients with a "risky" 100%.

Barnett's book states that Justice James Wilson, in the Chisholm v. Georgia case of 1793, opined that “To the Constitution of the United States the term Sovereign is totally unknown…and if the term sovereign is to be used at all, it should refer to the individual people”. And the book also frequently refers to the importance of the required consent of the people, which of course is also a thorny issue. 

And, since those risk-weights effectively permit banks to leverage their equity much more when lending to the sovereign, than when lending to the citizen; banks will earn higher risk adjusted returns when lending to the sovereign than when lending to the citizens; and so banks will de facto, sooner or later, lend much too much to the sovereign and much too little to the citizens… and I can simply not fathom how citizens, be they individual or majority, could give their consent to something like that.

De-facto those risk weights signify that regulators believe that government bureaucrats can make better use of bank credit than citizens… it is statism running amok.

But it became even worse. In 2004, in Basel II, regulators also made a distinction between those private who had great credit ratings, like AAA to AA, and who received a 20% risk-weight, and for instance those who had no ratings, and who kept their 100% risk weight. That to creates a sort of AAA-risktocracy that does not square well with the Constitution’s “No Title of Nobility shall be granted by the United States.

But even without entering into constitutional issues, there is even a current law that seems to prohibit this type of discrimination, but that is not applied to bank regulations. And I refer to the Equal Credit Opportunity Act: “Regulation B”.

So in the land in which its Declaration of Independence states: “We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness.”, I just must ask: How could regulators dare to decree such regulatory inequality?

And to top it up, the current risk-weighted capital requirements for banks, more ex ante perceived risk more capital – less risk less capital, are arbitrary and irrational. And that because no major bank crises have ever result from the build up of excessive dangerous bank exposures to something perceived as risky, that has always happened with something, erroneously, perceived as very safe. If you want to understand how really crazy these bank regulations are, here is a brief memo.

And frankly what would a Governor answer to this question: Why can our banks leverage their equity lending more to a foreign sovereign or a foreigner with a high credit rating, than when lending to us, the local SMEs and entrepreneurs?

No! America would never have become what it is, had it had this type of risk averse discriminatory bank regulations before.

And by the way the Dodd Frank Act, in all its 848 pages, surrealistically, does not mention the Basel Committee nor the Basel Accord, not even once.

PS. In his book Professor Barnett defends Federalism from the perspective of making diversity more possible. That rhymes well with what I stated at the World Bank as an Executive Director 2002-04: "A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind”

Thursday, July 28, 2016

Would Bernardine of Siena have accused the Basel Committee for Banking Supervision of usury?

In Samuel Gregg’s “For God and Profit” 2016 I read “Bernardine of Siena (1380-1444)…a member of the famously ascetic Franciscan order [opined that] “Usury concentrates the money of the community in the hands of the few, just as if all the blood in a man’s body ran to his heart and left his other organ depleted”

And I wondered what would Bernardine of Siena have opined on the Basel Committee’s risk weighted capital requirements for banks? These, no doubt about it, concentrates bank credit in the few hands of those perceived, decreed and concocted ex ante as “safe”, like sovereigns and the AAArisktocracy; and leave the other vital organ of the real economy, like the SMEs and entrepreneurs lacking of it.

Wednesday, July 27, 2016

Should not a consultant group like McKinsey, if it sees-something dangerous for the society, have to say something?

During many years I have been wondering why consultants, like those in McKinsey, have not spoken out against the risk-weighted capital requirements for banks.

I do understand that McKinsey must have many bank clients who just love the idea of being able to earn higher-risk adjusted returns on equity with assets deemed as safe than with assets deemed as risky.

But any financial consultant should also be able to understand that, in the medium or long term, that will cause banks to dangerously overpopulate safe-havens; just as he must understand that the resulting under-exploration of the risky-bays, like SMEs and entrepreneurs, poses great dangers for the sustainability of the economy. 

Now I just read two new articles published by McKinsey. One “The future of bank risk management” by Philipp Härle, Andras Havas, and Hamid Samandari; and the other “Poorer than their parents? A new perspective on income inequality” by Richard Dobbs, Anu Madgavkar, James Manyika, Jonathan Woetzel, Jacques Bughin, Eric Labaye, and Pranav Kashyap.

None of these touch even remotely on the fact that current regulatory risk-aversion, distorts the allocation of bank credit to the real economy; and that the regulatory discrimination against those perceived as “risky”, cannot but increase inequality.

On its website McKinsey tells us: “Social Impact: We help address societal challenges” Again, why does it not address this super societal challenge? 

A ship in harbor is safe, but that is not what ships are for.” John A Shedd, 1850-1926 

Sunday, July 24, 2016

Nothing promotes secular stagnation as much as the regulatory promotion of risk aversion

J. Bradford DeLong, in “The Scary Debate Over Secular Stagnation: Hiccup ... or Endgame?” published October 19, 2015 in the Milken Institute Review, refers to that Martin Feldstein, at Harvard back in the 1980s, taught that "badly behaved investment demand and savings supply functions," could have six underlying causes:

1. Technological and demographic stagnation that lowers the return on investment and pushes desired investment spending down too far.

2. Limits on the demand for investment goods coupled with rapid declines in the prices of those goods, which together put too much downward pressure on the potential profitability of the investment-goods sector.

3. Technological inappropriateness, in which markets cannot figure out how to properly reward those who invest in new technologies even when the technologies have enormous social returns – which in turn lowers the private rate of return on investment and pushes desired investment spending down too far.

4. High income inequality, which boosts savings too much because the rich can't think of other things they'd rather do with their money.

5. Very low inflation, which means that even a zero safe nominal rate of interest is too high to balance desired investment and planned savings at full employment.

6. A broken financial sector that fails to mobilize the risk-bearing capacity of society and thus drives too large a wedge between the returns on risky investments and the returns on safe government debt.

J. Bradford DeLong points out that Kenneth Rogoff in his debt supercycle focuses on cause-six; Paul Krugman in “return of depression economics” focuses on five and six; and Lawrence Summers with “secular stagnation” has, at different moments, pointed to each of the six causes.

And then J. Bradford DeLong writes: “Rogoff has consistently viewed what Krugman sees as a long-term vulnerability to Depression economics as the temporary consequences of failures to properly regulate debt accumulation. Eventually, a large chunk of debt thought of as relatively safe is revealed to be risky, and financial markets choke on the lump. As the riskiness of the debt structure is revealed, interest rate spreads go up – which means that interest rates on assets already known to be risky go up, and interest rates on assets still believed to be safe go down."

And Rogoff is later quoted with "In a world where regulation has sharply curtailed access for many smaller and riskier borrowers, low sovereign bond yields do not necessarily capture the broader 'credit surface' the global economy faces,"

And here is when I just have to intervene: Of course, stupid credit risk weighted capital requirements for banks have impeded the mobilization of the so vital risk-taking willingness and capacity of the society, that which has traditionally been much exercised by its banking sector. That it did by driving a large wedge between the banks’ ROEs for risky investments, like loans to SMEs and entrepreneurs, and the returns on “safe” investments, like loans to governments, AAArisktocracy and the financing of houses.

And “stupid” it is: “Eventually, a large chunk of debt thought of as relatively safe is revealed to be risky, and financial markets choke on the lump”. The capital requirements, that are to guard against the unexpected, were based on the expected, the perceived credit risks.

Dare to read more here about the mind-blowing regulatory mistakes that have been ignored by the experts.

PS. Anyone who talks about low interest rates on public debt without considering the regulatory subsidy implied with: risk weight of sovereign = 0%, and risk weight of We The People = 100%, is either a full-fledged statist or has no idea of what he is talking about.

PS. #4 "the rich can't think of other things they'd rather do with their money" is one of the reasons I much favor the Universal Basic Income concept.

Sunday, July 17, 2016

Does Deutsche Bundesbank want research that now “discovers” bank regulation mistakes it should have known of before?

Arbitraging the Basel securitizationsframework: evidence from German ABS investment
Matthias Efing: (Swiss Finance Institute and University of Geneva)

"Non-technical summary Research Question: The 2007-2009 financial crisis has raised fundamental questions about the effectiveness of the Basel II Securitization Framework, which regulates bank investments into asset-backed securities (ABS). The Basel Committee on Banking Supervision (2014) has identified “mechanic reliance on external ratings” and “insufficient risk sensitivity” as two major weaknesses of the framework. Yet, the full extent to which banks actually exploit these shortcomings and evade regulatory capital requirements is not known. This paper analyzes the scope of risk weight arbitrage under the Basel II Securitization Framework. 

Contribution: A lack of data on the individual asset holdings of institutional investors has so far prevented the analysis of the demand-side of the ABS market. I overcome this obstacle using the Securities Holdings Statistics of the Deutsche Bundesbank, which records the on-balance sheet holdings of banks in Germany on a security-by-security basis. I analyze investments in ABS with an external credit rating to uncover risk weight arbitrage on the demand-side of the ABS market."

Results: The analysis delivers three main results.

“First, I provide security-level evidence that banks arbitrage Basel II risk weights for ABS. Banks tend to buy the securities with the highest yields and the worst collateral in a group of ABS with the same risk weight (and, therefore, the same capital charge). My findings corroborate the hypothesis that institutional invsstors bought risky ABS to some extent for motives of regulatory arbitrage.”

What does that mean? That banks, for the “same risk weight”, buy what offers them the highest expected risk adjusted return on equity. Is that not what they are supposed to do? Would we, or the regulators like banks to minimize their risk-adjusted returns on equity?

"Second, banks operating with low capital adequacy ratios close to the regulatory minimum requirement are found to arbitrage risk weights most aggressively. From a financial stability perspective this finding is troubling as it smplies that the presumably more fragile banks are also most pervasively optimizing the very capital regulation designed to constrain them." 

What does that mean? That banks that are more pressured by capital constraints might act more aggressively? Is that not to be expected? 

"Third, banks with tight regulatory constraints buy riskier ABS with lower capital requirements than other banks. The ABS bought by banks that arbitrage risk weights, promise an as much as four times higher return on required capital than the ABS bought by other banks."

What does “riskier ABS with lower capital requirements” mean? ABS perceived ex ante as safer have lower capital requirements. It looks like confusing ex post realities with ex ante perceptions. 

What does ”as much as four times higher return on required capital” mean? Simply that capital requirement minimization has become more important in delivering expected risk-adjusted returns on equity than the correct analysis of risk.

My conclusion:
This paper just evidences that the most important research needed is that which explains how on earth the regulators of our banks could have come up with something so stupid as the portfolio invariant ex ante perceived risk based capital requirements for banks.

And again how these regulations distort the allocation of bank credit to the real economy remains a non-issue.

Saturday, July 16, 2016

Brief Housing Bubble 2.0 explanation

Housing Bubble 1.0, created in part by Basel II risk-weights of only 20% to AAA rated securities backed with mortgages to the subprime sectors, exploded, and a lot of liquidity was then injected with Tarp, QEs and other means.

Much of that liquidity was channeled through banks with not much capital and which, because of lower capital requirements (risk-weights sovereign = 0% and residential housing = 35%), channeled that liquidity into financing the government (low interest rates) and housing. The SMEs and entrepreneurs, with a risk-weight of 100%, had no chance to access loans at correct risk premiums.

If there is no change we all end up in houses with mortgages, but no jobs to pay the utilities and service the mortgages with.

Monday, July 11, 2016

If a banker, I would ask: Is our bank being fooled by Basel regulators to dangerously overcrowd safe havens?


We are allowed to hold less capital against what is ex ante perceived (decreed or concocted to be safe than against what I perceived to be risky.

That, when compared to if we had to hold the same capital against any asset now permit us to expect higher risk adjusted returns on equity for what is perceived as safe than on what is perceived as risky.

To be able to earn more ROE on the safe than on the risky sounds wonderful, but it has its costs: 

First we might be willing to accept risk adjusted rates from “the safe” than might be lower than what would be the case in an undistorted market.

Second, to compensate for the above, we might be requiring “the risky”, like SMEs and entrepreneurs to pay us higher risk adjusted rates than what they would have to pay us in the case of an undistorted market, and that means we might lose out on some interesting business or otherwise make “the risky” riskier. 

If it was only our bank that had access to this regulatory distortion, then we might benefit without rocking the boat, but the fact is that the whole banking system is doing the same, and so the distortions in the allocation of bank credit to the real economy are huge.

So friends, it is clear that if we go on following the directives of our bank regulators, and basically only keep to refinancing the safer past, we are doomed to end up, sooner or later, gasping for oxygen in an overpopulated safe haven. 

And by abandoning the financing of the riskier future, we are also neglecting our duties to the real economy, and our children and grandchildren might, should, hold us accountable for that.

So what are we to do? What can we do? 

May I suggest we look into the possibility of ignoring the different capital requirements and, based of course on a sound bank diversification and portfolio management, begin, without discrimination, to look at the risk premiums offered by all, risky and safe, on an equal dollar to dollar basis.

Or, as our famous colleague Mr. George Banks once suggested, we could all go and fly a kite!

Thursday, June 30, 2016

When will bank regulators stop making bankers’ wet dreams come true and do more for the beautiful dreams of our young?

What is a banker’s wet dream? Presumably to earn a lot of return on equity while not having to take risks. And the regulators granted that dream by allowing banks to have especially little capital against assets perceived as safe. Little capital means high leverage, and which means high-expected risk adjusted returns on equity. So banks just refinance the "safer" past.

What could our young ones dream of? To find decent jobs that allows them to form families and earn sufficiently to maintain these well. And that we know requires a lot of SMEs and entrepreneurs to open up new roads and ways to jobs in the real economy. But these dreams are denied by the regulators when requiring banks to hold more capital when lending to the “risky” than when lending to the safe. More capital means lower leverage, and which means lower expected risk adjusted returns on equity. So banks do not finance the "riskier" future.

And the current nightmare is that regulators are not even aware of what their credit risk aversion is doing. “A ship in harbor is safe, but that is not what ships are for.” John A Shedd

And the current nightmare is that regulators are not even aware that for the banking system, what’s perceived as safe, is the only that can generate those dangerous excessive exposures that bring on crises.  “May God defend me from my friends [what’s safe]: I can defend myself from my enemies [what’s risky]” Voltaire

Here is an aide-mémoire that explains some incredible mistakes in the risk weighted capital requirements for banks, the pillar of current regulations.