Monday, January 23, 2017

Has history known a worse and more dangerous case of confirmation bias than that of current bank regulators?

Confirmation bias, also called confirmatory bias or myside bias,[is the tendency to search for, interpret, favor, and recall information in a way that confirms one's preexisting beliefs or hypotheses, while giving disproportionately less consideration to alternative possibilities. It is a type of cognitive bias and a systematic error of inductive reasoning. People display this bias when they gather or remember information selectively, or when they interpret it in a biased way. The effect is stronger for emotionally charged issues and for deeply entrenched beliefs. People also tend to interpret ambiguous evidence as supporting their existing position. Biased search, interpretation and memory have been invoked to explain attitude polarization (when a disagreement becomes more extreme even though the different parties are exposed to the same evidence), belief perseverance (when beliefs persist after the evidence for them is shown to be false), the irrational primacy effect (a greater reliance on information encountered early in a series) and illusory correlation (when people falsely perceive an association between two events or situations).

A series of experiments in the 1960s suggested that people are biased toward confirming their existing beliefs. Later work reinterpreted these results as a tendency to test ideas in a one-sided way, focusing on one possibility and ignoring alternatives. In certain situations, this tendency can bias people's conclusions. Explanations for the observed biases include wishful thinking and the limited human capacity to process information. Another explanation is that people show confirmation bias because they are weighing up the costs of being wrong, rather than investigating in a neutral, scientific way.

Confirmation biases contribute to overconfidence in personal beliefs and can maintain or strengthen beliefs in the face of contrary evidence. Poor decisions due to these biases have been found in political and organizational contexts:

The Basel Committee for Banking Supervision's and other bank regulator's confirmation bias. 

Regulators think, as they should, as it is, that what is rated below BB- is much more riskier than what is rated AAA. 

But when deciding on the risk weights to be used for the capital requirements of banks in Basel II of 2004, the regulators directly extrapolated from these beliefs and assigned 20% to the AAA rated and 150% to the below BB-. That is probably one of the most dangerous cases of confirmation bias in history.  Regulator should not have looked at the risk of the assets but at the risk of the assets to the banks, which is not the same thing.

The truth is that precisely because the below BB- is perceived as very risky, that makes it much less risky for the banks; while the AAA rated which is perceived as very safe, precisely because of such perceptions, is what could lead to those dangerously high bank exposures that can cause a huge bank crisis if the ex-post reality turns out to be different.

We are in 2017 and the regulators, because of "belief perseverance", have still not discovered their own confirmation bias… and that even after the mother of all evidences, represented by the AAA rated securities backed with mortgages to the subprime sector turning out to be so very risky.

That this was the fault of credit rating agencies is hugely irrelevant. The better the ratings are, the more confidence is deposited in these, and so the worse do the doomsday scenarios become.

Does anyone know a worse case of confirmation bias?

The dangers? First of course that banks will get caught with their pants down, little capital, precisely when one big exposure might get hit. But second, it introduced a senseless risk aversion that have banks no longer financing the riskier future but only refinancing the “safer” past and present… so our economies are stalling and falling.

PS. Are you still unsure of this? Then try to get the regulators to answer you these questions

PS. In this case it is not only regulators who suffer from “belief perseverance”. Prestigious and influential economists like Martin Wolf, even when being told that the safer is riskier and the riskier is safer, can’t get a grip on the issue.

Saturday, January 14, 2017

Reflections on Terracotta Warriors, credit ratings, and capital requirements for banks

I read in Latin American Herald Tribune of January 14, 2017: “A Chinese state-run newspaper reported that armed with clubs authorities destroyed a museum with 40 fake Terracotta Warriors that tricked numerous tourists and prompted some complaints”

Oh I can already hear it! “Tom, you see, I told you those terracotta soldier boys they took us to see seemed fake. Why did you not listen to me? Why did we have to show those photos to Nancy and George? Do you think we could now sue the Chinese tourism authorities for those terra-whatever being fakes, or at least for disclosing those as fakes after the fact?

My head started to spin too. Some years ago I bought some small Terracotta Warriors in China. Because of their size and pricing, I always thought these to be absolute fakes. No problema! But are these now exposed to being crushed by some Chinese regulator? Might someone over there have a copyright on these that has been infringed?

Come to think of it, do we not need some Chinese Terracotta Authenticity rating agencies? 

Perhaps, but, if those rating agency fall for the temptations to be most certainly offered to them by shady Terracotta Warrior suppliers, hey we’re talking China here, could we ask our government to sue these agencies? 

I mean like the US has done with Moody’s and S&P with respect to their worse than lousy rating processes that produced totally unworthy AAAs for some of the securities backed with mortgages to the subprime sector in the US.

But then again, if these terracotta rating agencies mislead us, would we see some of the money from the fines, or would that only go to those who, to begin with, excessively empowered the rating agencies? 

And should then regulators in China request the vendors of Terracota Warriors to hold more capital, against the risk of being sued, the faker the rating shows its product to be; somewhat like what is being done with banks and their risk weighted capital requirements?

I would not think so. I would have bought my Terracota Warriors even if rated very fake; since the price was right.

Of course, the real problem, like in the case of the AAA rated securities, would be an AAA rated Terracota Warrior, and for which partly because of that rating, billions had been paid for at an auction, if it then later proves to be fake.

Does this mean that the better a Terracota Warrior would be rated, the more capital should the suppliers hold? Yes! Precisely! That’s what fundamentally current bank regulators got wrong.

The safer an asset is ex ante perceived, decreed concocted or rated, the riskier it could be ex post. They completely ignored Voltaire’s “May God defend me from my friends, I can defend myself from my enemies

Thursday, January 12, 2017

The SEC Regulatory Accountability Act is even more needed for the case of Fed / FDIC bank regulations

The SEC Regulatory Accountability Act, sponsored by Financial Services Committee member Rep. Ann Wagner (R-MO), passed 243-184.

Jeb Hensarling (R-TX), the Chairman of the Financial Services Committee explained it: 

“Ill-advised laws like the Dodd-Frank Act empower unelected, unaccountable bureaucrats to callously hand down crushing regulations without adequately considering what impact those regulations have on jobs…The true cost of Washington red tape includes the jobs not created, the small businesses not started and the dreams of our children not fulfilled.”

Now under the bill, before issuing a regulation the SEC will be required to:
identify the nature and source of the problem its proposed regulation is meant to address;
utilize the SEC’s Chief Economist to assess the costs and benefits of a proposed regulation to ensure the benefits justify the costs;
identify and assess available alternatives; and
ensure that any regulations are consistent and written in plain language.

Further, the legislation requires the SEC to engage in a retrospective review of its regulations every five years and conduct post-adoption impact assessments of major rules.

What great news! Not a moment too soon. Now the Financial Services Committee needs to, as fast as possible, issue a similar bill with respect to the regulations applied by the Fed and FDIC to the banks… because in their case they never even defined the purpose of banks before regulating these.

The current risk weighted capital requirements for banks are totally senseless.

Not only has regulators no business regulating based on perceived risks already cleared for by banks, as they should primarily require some capital reserves to face uncertainties, but these regulations also cause banks to no longer finance the “riskier” future but mainly refinance the “safer” present and past, at great costs for the real economy and for future generations.

Here are some questions I have not been able to have regulators to answer; perhaps the Financial Service Committee needs not to go on a hunger strike to manage that.

Bank regulators should be forced to see “Hell on Wheels” and read John Kenneth Galbraith’s “Money: Whence It Came, Where It Went”

In the TV series Hell on Wheels, its main character, Cullen Bohannon, when asked to testify before the US Senate about all the obvious corruption of Thomas ‘Doc’ Durant, someone absolutely not Bohannon’s friend, someone absolutely not one having been sanctimonious or behaved according to any social norms, repeats, over and over again, to the great chagrin of his interrogators: “The Transcontinental railroad could not have been built without Thomas Durant

And John Kenneth Galbraith wrote in his “Money: Whence it came where it went” 1975 the following: “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.”

And Galbraith also opined in his book that: “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.”

Therefore I cannot but conclude in that bank regulators should be forced to see “Hell on Wheels” and read John Kenneth Galbraith’s “Money: Whence It Came, Where It Went”. That in order to, hopefully, be able realize that with their risk weighted capital requirements for banks, these will not finance the risky future, but only refinance the safer past and present and, as a result, the economy will stall and fall. 

To add insult to the injury, bank regulators are doing all this in the belief that bank crises result from excessive exposures to what is perceived as risky, which is utter nonsense. Bank crises have always, and will always, result from uncertainties; that which includes unexpected events, like devaluations earthquakes and regulators not knowing what they are doing, criminal behavior and excessive exposures to something ex ante perceived as safe but that ex post turned out to be very risky.

“If you see something, say something”. Someone should run to the Homeland Security of the Home of the Brave and denounce that, most probably, unwittingly; some serious terrorism is taking place by means of dangerously risk adverse faulty bank regulations.

Do bank regulators, now with “output floor” based on their standardized risk weights, keep on making fun of us?

A 75-percent output floor signifies that no matter which outcome the bank’s internal calculation yields, the risk weight that determines the capital required, can’t be more than 25 percent lower than the standardized risk weighting method designed by the regulators.

So let’s see what that really means. 

For the standard method’s 0% risk weighted sovereign, unless some bank’s internal calculation comes up with a negative risk, it will still mean 0%.

For the standard method’s 20% risk weighted private asset, it means the weight cannot be less than 15%.

For the standard method’s 35% risk weighted residential mortgage, it means that weight cannot be less than 26.25%.

For the standard method’s 100% risk weighted private asset without a credit rating, like loans to SMEs, it means that the risk weight cannot be less than 75%.

Really? Are bank’s internal models worse than your standardized weights? Do you really think the Medici’s would have assigned a risk weight of 0% to the Sovereign?

There’s absolutely nothing wrong with allowing banks to use their own risk models in order to try to minimize their cost of capital, but that regulators concoct a set of ex ante perceived standardized risk weights in order to determine how much capital banks should have in order to be able to confront, not perceived risks, but uncertainty, is just as crazy as it gets.

Here some questions bank regulators refuse to answer, something that should make us all nervous. They really might not have a clue about what they are doing.

Sunday, January 8, 2017

Economist Andrew Haldane. At least when acting as a bank regulator, you are admitting the wrong error you committed

Chief economist of Bank of England Andrew Haldane says “his profession must adapt to regain the trust of the public, claiming narrow models ignored ‘irrational behaviour’” “Chief economist of Bank of England admits errors in Brexit forecasting” The Guardian, January 5, 2017.

Hold it Mr Haldane! What you and other economists ignored. when acting as regulators, was that banks would, as always, behave perfectly rational, and lend to what they expected would yield them the highest risk adjusted returns on equity.

That is what you failed to understand when allowing banks to hold less capital against what was perceived, decreed or concocted as safe. That meant banks could leverage more, and so earn higher expected risk adjusted returns on equity, when lending to the “safe”. 

That distortion in the allocation of bank credit to the real economy, resulted in that banks end up lending too much at too low interest rates to the “safe”… which could be risky for the banks; and to little and too expensive to “risky” SMEs and entrepreneurs which is very dangerous for the economy.

Friday, December 30, 2016

Mercatus Center, in order to reframe financial regulations, you must dig in much deeper into the current mistakes.

I refer to “Reframing Financial Regulation: Enhancing Stability  and Protecting Consumers” 2016, by the Mercatus Center at George Mason University, and edited by Hester Peirce & Benjamin Klutskey.

The book includes many wise suggestions but, since it does not seem to capture how incredibly faulty current regulations really are, it has gaps that make it more difficult to understand how sensitive the financial system, primarily banks, and the real economy as such, is to the process of implementing a “reframing”.

For brevity and because my main reservations with current financial regulations have to do with the issue therein discussed, I will limit my comments to Chapter 1: Risk-Based Capital Rules by Arnold Kling.

The author writes: “Risk-based capital rules dramatically affect the rate of return banks earn from holding different type of assets. Regardless of the intent of these rules they strongly influence capital allocation in the economy.”

That is correct, although referring to the ex-ante expected risk adjusted returns on equity would be more precise.

Then the author states: “They substitute even crude regulatory judgment for individual bank discretion and market mechanism”. 

That is not entirely correct. The real problem is that since banks already clear for ex ante perceived risks, when setting interest rates and the amount of their exposures, that regulators also use basically the same ex ante risk perceptions for determining the capital requirements, means that “ex-ante perceived risks”, will be doubly considered. What regulators missed entirely, is that any risk, even if perfectly perceived, will cause the wrong actions, if excessively considered.

The book identifies partly what the distortion in the allocation of bank credit could do to the safety of banks, but what it most misses to comment on, is what the risk weights actually calculated and used, really meant and mean to the allocation of bank credit to the real economy. 

For instance Basel I, 1988, applied to the United States, set the risk weight of 0 percent for US Treasuries; 20 percent for claims to for instance local governments; 50 percent when financing residential properties and revenue bonds; and 100 percent all other claims on private obligors.

0% risk weight for the sovereign? If that’s not in runaway statism what is? De facto it implies that regulators consider government bureaucrats will give better use to bank credit than the private sector.

In 2001 the Federal Reserve Board, the Office of the Comptroller of the Currency and the FDIC set the following risk weight depending on credit rating; AAA to AA 20 percent; A 50%; BBB (the lowest investment grade) 100 percent; and BB (below investment grade) 200%.

If that’s not runaway stupidity what is? The regulators really seem to have thought (and think) that assets perceived as extremely risky, are more dangerous to the bank system than assets perceived as safe. As if they never heard of Mark Twain’s “A banker lends you the umbrella when the sun shines and wants it back when it looks it could rain”; as if they never heard of Voltaire’s “May God defend me from my friends, I can defend myself from my enemies”. 

Worse though, they never gave any consideration to the possibility that millions of “risky” 100% weighted SMEs and entrepreneurs, so vital to the sturdy growth of the real economy, would see their credit applications negated only because of this. 

Mercatus Center, any reframing of current financial regulations that is not based on a full understanding of how statists and stupid current regulations are, will not be able to adequately deliver what we, especially the young, so urgently need.

For instance all those propositions of increasing the capital requirements for banks with higher leverage ratios but that would keep of the risk weighting in place fail to understand that the bigger the capital squeeze the more will the risk weighing distort the allocation of bank credit to the real economy. (Think of “The Drowning Pool”)

For instance to avoid imposing on the real economy the bank credit austerity that would result in the initial stages of capital increases the grandfathering of old capital requirements for existing assets until these are disposed would be a must.

Mercatus Center, you have clout that I as a citizen have not! Do all us a favor and request straight answers from the regulators on some very basic questions.

Sunday, December 25, 2016

Harvard Law School. I hope you did not believe Bill Coen with that the Basel Committee knows what it’s doing.

Bill Coen, the Secretary General of the Basel Committee on Banking Supervision, spoke at the Harvard Law School on December 12, 2016. In: “The global financial crisis and the future of international standard setting: lessons from the Basel Committee” Coen had this to say about the metric of the risk-weighted ratio:

“Its strength is that it sets capital requirements according to the perceived riskiness of a bank’s assets.” 

Comment: It is sheer lunacy to set capital requirements according to ex ante perceived risks, when you should set them according to the risk that banks might not adequately perceive the riskiness of their assets. In fact all bank crises have occurred from unforeseen events (like devaluations), criminal behaviors or excessive exposures to what ex ante was perceived as safe but that ex post turned out to be risky. No bank crisis has ever resulted from excessive bank exposures to something ex ante believed risky.

“Its weakness is that it is susceptible to setting too low capital requirements, either unintentionally (model risk), or intentionally (gaming).”

Comment: This evidences mindboggling naiveté. For banks to earn the highest possible risk adjusted returns on equity, they will automatically look to hold as little equity as possible. So it is like placing some delicious cookies in front of children, and expecting them to reach out for the spinach.

Students and professors at Harvard Law School, do us all a big favor. Send Bill Coen the following questions, and ask him formally to respond. At least that would save me from having to go on a hunger strike or other similar extremes in order to get some answers.

PS. You could also ask the Harvard Business School about why they have kept such silence on the monumental mistakes of current bank regulations.

Wednesday, December 14, 2016

Even though current bank regulation, more risk more capital / less risk less capital should be fake, it is true

1. Even though the most important function of banks is to allocate credit efficiently to the real economy, let’s forget that and concentrate solely on banks becoming super safe mattresses in which we can store our savings.

So let us not worry about banks being able to leverage more their equity and the support we give them on what is perceived as safe than on what is perceived as risky; which obviously means banks will be able to earn higher expected risk adjusted returns on equity on what is perceived as safe than on what is perceived as risky; which obviously means banks will lend too much to what is perceived as safe and too little to what is perceived as risky.

2. Even though that reduces the opportunities of those coming from behind to access bank credit, and therefore basically decrees more inequality, let’s also forget about that.

3. Even though the distortion will cause banks to finance less the risky that our young need in order for them to have jobs and a workable economy, let us forget about that and go for short term safety, we baby-boomers aren’t that young, are we?

4. Even though all banking crisis have resulted from unexpected events, like natural disasters and devaluations, from criminal activity and from excessive exposures to something ex ante perceived as safe but that ex post turned out to be very risky, let us ignore that and require banks to hold more capital when holding assets perceived as risky. 

5. Even though we know that banks will do their utmost to lower their capital requirements so as to obtain higher returns on assets, let us allow the big banks to run their own risk models, as they will love us for that and make our yearly visits to Davos so much more agreeable.

6. Even though it is clear that our economies would never have developed the same had these regulations been in place before, let us ignore that, in order as regulators to feel more tranquil.

7. Even though the distortion will cause banks to finance less the risky SMEs and entrepreneurs that our young need to be financed in order for them to have jobs and a workable economy, let us forget about that and go for short term safety, we baby-boomers aren’t that young, are we?

8. Even though 0% risk weight for the Sovereign and 100% for We the People gives away that we believe government bureaucrats know better how to use bank credit than the private sector, let’s stand firm on it. We are true statists, aren’t we?

9. Even though Greece and AAA rated securities, and the ensuing stagnation, and the ensuing waste of so much stimulus has proved us so very wrong, let us ignore that, since otherwise we could lose our jobs.

PS. I have tried for over a decade to get some answers from regulators to some very basic questions, unfortunately in that area the technocrats are seemingly following a strict Zero Contestability policy.

Friday, December 9, 2016

Stefan Ingves, years after Basel Committee’s failure, you all have still no idea about how to regulate banks.

On December 2, 2016 Stefan Ingves, the Chairman of the Basel Committee gave a Keynote speech at the second Conference on Banking Development, Stability and Sustainability, titled “Finalising Basel III: Coherence, calibration and complexity” 

In it Ingves stated: “an area of further research which would be welcome relates to how we should think about the capital benefits of allowing banks to use internally modelled approaches, and therefore the appropriate calibration of capital floors to such models. What are the pre-conditions for such models to produce better outcomes than, say, simpler standardised approaches? And to whom do the benefits of improved modelling accrue? If a bank using a model can lower its capital requirements by, say, 30%, what are the financial stability and real economy benefits of such an approach? To what extent do the benefits of modelling accrue to lower-risk borrowers as opposed to the parties being compensated for developing and using the models?”

That is clear evidence that the Basel Committee still, soon ten years after the crisis, their failure, has no idea about what it is doing. It should concern us all. 

Here’s one example on of how the Basel Committee’s has totally confused ex ante risks with ex post risks. In their Basel II standardized risk weights the weight assigned to AAA assets is 20% while the weight of a highly speculative below BB- rated assets was set at 150%. 

I ask: What has much greater chance of taking the banking system down, excessive exposures to something ex ante believed very safe or excessive exposures to something believed very risky? The answer should be clear. Never ever have bank crises resulted from excessive exposures to something believe risky when placed on the balance sheet; these have always resulted from unexpected events (like devaluations), criminal behavior or excessive exposures to something perceived ex ante as very safe but that ex post turned out to be very risky. 

The truth is that the Basel Committee told banks: “Go out and leverage your capital more than with assets that are safe”. And so when disaster happens, like with AAA rated securities, banks stand there more naked than ever.

Of course, the other side of that coin is, “Do not go and lend to what is risky”. So banks dangerously for the real economy stopped lending to SMEs and entrepreneurs… something that is never considered when stress testing.

To top it up, like vulgar statist activists, they set a risk weight of 0% for the Sovereign and one of 100% for We the People; which translates into a belief that government bureaucrats can use bank credit more efficiently than the private sector… something which of course created the excessive indebtedness of Greece and other.

One final comment, the regulators naivety is boundless: “to whom do the benefits of improved modeling accrue? asks Ingves” Clearly there is no understanding of that bankers will, as is almost their duty, always look to minimize capital if so allowed, in order to obtain the highest expected risk adjusted returns on equity. 

When fake regulators supervise banks; totally unsupervised banks is much better.

Thursday, December 8, 2016

That banks allocate credit efficiently to the real economy is more important than avoiding bank failures

“THE MINNEAPOLIS PLAN reduces the risk of financial crises and bailouts to as low as 9 percent, at only a modest economic cost relative to the typical cost of a banking crisis. 

The Minneapolis Plan will (a) increase the minimum capital requirements for “covered banks” to 23.5 percent of risk- weighted assets, (b) force covered banks to be no longer systemically important—as judged by the U.S. Treasury Secretary—or face a systemic risk charge (SRC), bringing their total capital up to a maximum of 38 percent over time, (c) impose a tax on the borrowings of shadow banks with assets over $50 billion of 1.2 percent for entities not considered systemically important by the Treasury Secretary and 2.2 percent for shadow banks that are systemically important, and (d) create a much simpler and less burdensome supervisory and regulatory regime for community banks”

NO! Except for (d) “a simpler and less burdensome supervisory and regulatory regime for community banks” the Minneapolis plan suffers from the same fundamental mistake of current bank regulations. 

It fixates itself on avoiding bank failures, while entirely ignoring the much more important social purpose of the banks, that of allocating credit efficiently to the real economy.

To achieve that is impossible, while using risk weighting based on ex ante perceived risks to determine capital requirements. 

Would the Minneapolis Fed be able to provide me the answers to those questions the Basel Committee and the Financial Stability Board refuse to even acknowledge?

PS. And in any adjustment plan grandfathering existing capital requirements for the existing assets held by the banks would be required, so as to not risk contracting the credit market excessively.