Thursday, November 3, 2016

Why has IMF kept silence on what was done to banks in 1988?

What happened?

Before 1988, for about 600 years, bank exposures were a function of the by bankers ex-ante perceived risks (bpr), risk premiums (rp) meaning interest rates, and bankers’ risk tolerance (brt) 

Pre 1988 bank exposures =ƒ(bpr, rp, brt)

Bank credit was then allocated to what produced banks the highest expected risk adjusted return on equity

But 1998, with the Basel Accord, risk weighted capital requirements were introduced. With that bank exposures became a function of the: by bankers ex-ante perceived risks (bpr), risk premiums (rp), bankers’ risk tolerance (brt), and regulatory capital requirements (rcc), this last itself a function of the by regulators ex-ante perceived (or decreed) risks (rpr) and the regulator’s risk tolerance (rrt)

After 1988 bank exposures = ƒ(bpr, rp, brt, rccƒ(rpr, rrt))

Bank credit was thereafter allocated to what produced banks the highest expected risk/capital-requirement adjusted return on equity

And of course banking changed dramatically, and the allocation of bank credit to the real economy became hugely distorted.

With Basel II of 2004, which introduced risk weighting within the private sector, and made the process much dependent on credit ratings, the distortions and the systemic risks were dramatically increased.

Fundamental mistakes:

1. Although hard to believe, bank regulators never defined what the purpose of banks is before regulating these. A ship in harbor is safe, but that is not what ships are for.” John A Shedd, 1850-1926

2. Although hard to believe, as the purported reason was to make banks safer, the regulators never researched what had caused bank crisis in the past; namely unexpected events, criminal doings and what was ex ante perceived as very safe but that ex post turned out very risky. What is perceived as very risky is, precisely because of that perception, what is least dangerous to the system. May God defend me from my friends, I can defend myself from my enemies” Voltaire

3. Any risk, even if perfectly perceived, causes the wrong actions if excessively considered; and here the regulators doubled down on ex ante perceived risks.

4. Ignoring risk-taking is the oxygen of development. For banks to take risks, albeit in smaller amounts on “risky” SMEs and entrepreneurs, is absolutely vital for the economy to move forward, in order not to stall and fall. Where would we be had these regulations been in place during the previous 600 years? In April 2003 as an Executive Director of the World Bank I stated: “The Basel Committee dictate norms for the banking industry… there is a clear need for an external observer of stature to assure that there is an adequate equilibrium between risk-avoidance and the risk- taking needed to sustain growth.” In fact the risk of excessive risk aversion was the theme of my first ever Op-Ed

5. Little understanding of systemic risks: In January 2003 I wrote in Financial Times:Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds. Friends, as it is, the world is tough enough.”

6. Little understanding of fragility: In April 2003, as an ED of the World Bank I stated: “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.”

7. Little understanding of pro-cyclicality: When times are good, credit-risks seem low, so the risk-weighted capital requirements allow banks to expand more than they should; and when times are bad, the credit risk are naturally perceived higher, and so the capital requirements force banks to contract credit, precisely when less bank credit austerity is needed.

8. Macro-imprudence: Prudential regulation helps failed banks to fail expediently. Macro-imprudent regulation impedes failed banks from failing… which builds uphuge mountains of combustible materials waiting for a Big Bang.

9. Overreliance on data and models: In October 2004 in a formal statement at the World Bank I warned: “Much of the world’s financial markets are currently being dangerously overstretched through an exaggerated reliance on intrinsically weak financial models that are based on very short series of statistical evidence and very doubtful volatility assumptions.

Consequences:

Statism: Basel Accord’s risk weights of 0% for “The (infallible) Sovereign” and 100% for “We the (risky) People” introduced runaway statism. Since then the proxies for risk-free rates have been subsidized. We have no idea what the current low interest rates on much sovereign debt would be if government bureaucracy bank borrowings were affected by a risk-weight similar to SMEs’. De facto those risk-weights imply that regulators believe public bureaucrats know better what to do with bank credit, than the private sector.

Crisis resulting from dangerous overpopulation of “safe” havens: The first crisis, that of 2008, resulted from excessive exposures to AAA rated securities (Basel II risk weight 20% = allowed leverage 62 to 1), sovereigns like Greece, and residential housing (Basel II risk weight 35% = allowed leverage 32 to 1)  

Stagnation: Banks have stopped financing the riskier future and basically keep to refinancing the safer past and present. As an example banks finance much more “safe” basements where jobless kids can stay with their parents, than the SMEs that could create the jobs that could allow the kids afford to also become parents. In short this regulation keeps Keynes' animal spirits caged.

Stimulus waste: Since credit will not flow were they could most be needed, much of the stimuli fiscal deficits, quantitative easing and low interest could produce, is wasted.

More inequality: The result of making it harder and more expensive for the “risky” weaker to access opportunities of bank credit for productive purposes.

Too Big Too Fail: Clearly minimalistic capital requirements, for so many assets, has served as a potent growth hormone for the TBTF banks.


Over indebtedness: By allowing ridiculously low capital requirements for assets perceived as safe, the regulators allowed banks to leverage too much their equity and the support they received from society (taxpayers). That facilitated the current generation to extract more borrowing capacity to sustain its own consumption than any other previous generation. That has left little borrowing capacity over for the future generations.

What to do?

To accept the problem exists!

To know neither Hollywood nor Bollywood, would allow new movies on the same theme to be produced by directors and scriptwriters responsible for such box-office flops as Basel I-II-III.

To understand that bank capital requirements would be better if based on ex-post risks of models based on ex-ante risk perceptions.

To know that if you absolutely must distort, it is better to do so based on some useful social purpose, like based on job-creation and environmental-sustainability ratings.

To understand that getting our banks and our economies out of the Basel mess is a very delicate process, which does not permit an ounce more of that technocrats’ hubris that caused it all.

IMF, will you keep on being silent on this?

Per Kurowski