Free us from imprudent risk-aversion

There is no reason to believe the world would be better if financial regulators provided extra incentives to those who, perceived as having a lower default risk, are already favoured by lower interest rates, or punish further those who, perceived as more risky, are already punished by higher interest rates. In fact, the opposite is probably true.

According to the bank regulations of the Basel Committee, the global standard-setters for much of the world, if a bank lends to an unrated corporation then it must hold 8 per cent in equity, but when lending to an AAA rated client only 1.6 per cent will suffice. Given the high cost of bank equity, the difference between 8 and 1.6 per cent, a 400 per cent increase, entails substantial costs that increase the premiums on risk and confuse the market’s risk allocation mechanisms. The capital requirements for lending to governments, however, and I hope you are seated, is quite often zero per cent.

The debate over the current financial crisis ignores what really hit us. We still hear the most influential experts, Nobel Prize winners included, repeat the mantra of “excessive risk-taking”. How can they be blind? This crisis did not arise as a result of financing “risky projects”, but from financing the safest of assets, houses and mortgages, in the supposedly safest of countries, the US, and using instruments rated AAA, which are supposed to carry no risk.

This crisis resulted from some misguided and imprudent risk-aversion policies put in place by regulators employing capital requirements for banks based on risk and the empowerment of the credit rating agencies, which, with their rating signals, caused herds of capital to stampede over a subprime precipice.
If we do not want to understand and accept this, how are we supposed to move out of this crisis and into a better future, something which, as history has proved, always requires prudent and sometimes even a dose of imprudent risk-taking?

I have been writing about this issue for a long time, to little or no avail, as the financial regulatory system is founded upon an almost unbreakable paradigm created by regulators who are not interested in the larger scheme of things. Instead, they concentrate furiously on trying to live out their fantasies of a world without any bank failure — as if a world without bank failures has anything to do with a better world. Actually, the more frequent bank failures are, the smaller the risk of a systemic crisis like the current one.

If you need evidence for the above, read the 347 pages of the bank regulations known as Basel II. You will not find a single phrase that has anything to do with establishing the purpose for our banks. Regulators, when regulating, should you not start by doing just that?

In January 2003 the Financial Times published a letter in which I wrote: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds.” The most important part to understand, and the hardest one to accept, is that the systemic errors for the world at large would occur even if the credit rating agencies had got their ratings absolutely right.

Between 2002 and 2004, as an executive director at the World Bank, I did what I could to remind the development bank that risk is the oxygen of all development, but I was never really heard. The World Bank, forced to harmonise with Mr. Stability, the IMF, had been effectively silenced.

Today, when there are renewed puritan screams against “risks” I hope that the World Bank finally comes to grips with its role and turns into a champion of prudent risk-taking. The world needs it. Just as an intellectual exercise, think how much better off our children and grandchildren could be, had the trillions that were wasted on a useless housing boom in the US been lost instead financing projects which adapt for and mitigate climate change?

Dear baby-boomers, there is a world that needs a whole lot of risk-taking in order to stand a chance of a better future — a world which does not want to lay down and die in tranquillity just yet.

Published in the FT.com/Economistforum

Two comments on the G20 draft

1st comment:. On financial sector compensation, the draft said the G20 fully endorsed the standards of the Financial Stability Board "aimed at aligning compensation with long-term value creation, not excessive risk taking."

And do not the poor and the developing world, where most of the “perceived risks” tend to live, also have an equal right to ask for “long-term value creation”, not excessive risk-aversion, as that which is present in the current Basel capital requirements for banks?

2nd comment: The G20 draft said it supported the introduction of a leverage ratio as an additional measure to the Basel II capital framework and that all major G20 capital centers committed to adopt that framework by 2011.

The introduction of a leverage ratio as an additional measure does not, on the margin, diminish any of the arbitrary risk averseness introduced by Basel II and that creates additional costs for the financing of all perceived as risky, and that are layered on top of the risk spreads already charged by the markets on perceived risks.

This amounts to an outright discrimination of development and an outright indirect subsidy to what has already been developed. This is simply shameful!

The 800 pound gorilla not seen in development finance

The current regulatory system of the banks agreed upon in Basel by some developed nations and applied in all of the developed world and much of the rest, orders the bank to have 8 percent in capital when lending to an ordinary client with no credit rating but only 1.6 percent when lending to an AAA rated client. 8 percent is 400 percent more than 1.6 percent.

The above amounts to an immense discrimination that pushes up the volume of funds available and down the cost when financing the “lower-risk” part of the world; and pushes down the funds available and up the cost when financing the “higher-risk” part of the world.

The rich and developed, where are they most likely to be perceived to live, in the “higher-risk” or in the “lower-risk” part of the world?

The poor and developing, where are they most likely to be perceived to live, in the “higher-risk” or in the “lower-risk” part of the world?

That is why when the rich and developed offer the poor and developing world the possibilities of a non-distorting and transparent Tobin tax of 0.005 percent on financial transactions they should answer “Thank you very much, but we much prefer you eliminate the distorting and opaque Basel tax on risk instead”

And this is no minor issue. Just in 2004 to 2008, about three trillions of dollars, more than the World bank has lent or given out in grants in total since it was created; thanks to the bias in favor of perceived low risk in the capital requirements for banks, and thanks to the AAA signs set up by the credit rating agencies, were channeled to finance what, when compared with the real needs in the world (even of the rich and developed), can only be classified as a quite useless house-value boom.

The world to move forward needs risk-taking. We cannot afford to have the future of the world to be placed in the hands of a neurotic generation of baby-boomers, who wish to create a lien on the whole world, through a reverse mortgage, so as to lie down and die in tranquility while murmuring their “Après nous le deluge”

Please stop worrying so much about bank defaults and more about the default of the world.

Recurrent questions to my friends in the financial sector of the World Bank

When are you going to stop worrying so much about the development of the financial sector and start worrying more about the role of the financial sector in the development of the other sectors of the economy?

For how long are you going to accept those minimum capital requirement for banks based on risks of default as perceived by credit rating agencies and try to suggest some capital weights based on the purpose of the lending?

For how long are you going to accept harmonizing with the IMF frantically focusing on avoiding any bank crisis instead of focusing on getting the most development out of the whole growth and bust cycle? Are we not a "take-risks" development bank while they are a "goodnight, sleep-tight" institution?


These are no new questions. Just as an example, in March 2003, as an Executive Director of the World Bank, I said the following when discussing the “Financial Sector Assessment Program: Review, Lessons, and Issues Going Forward”

“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. Similarly, the role of the assessor –in this case, WB– is to fight poverty, and development is a task where risks need to be taken.

From this perspective we have the impression that the Financial Assessment Program Report might revolve too much around issues such as risk avoidance, vulnerabilities, stress tests and compliance with international regulations, without referring sufficiently to how the sector is performing its social commitments.

As an example, only in Supplement 3, Development Issues in the FSAP, does the Bank acknowledge that; “for lower income countries with less-developed financial system, in order to be relevant to country authorities, the emphasis in the FASP must change… how residents can get a better access to a wider range of financial services”, and having to confess, on the very same page, that “no formal methodologies exist for how to address development issues in the FSAP”.

Another example is present in the survey of countries’ experiences, when in the case of country X, in response to the problems of “(i) weak credit culture with the prevalence of non-payments mechanism that undermine the development of the formal financial sector; (ii) limited access to formal, affordable financing by small and medium enterprises, a typical development trap in transition economies; and (iii) the slow pace of banking sector consolidation”, the only exemplified recommendations are; “(i) enhancement of the central bank’s ability to deal with insolvent banks, (ii) strengthening of penalty provisions and (iii) increase in minimum capital requirements”,

On a separate issue, the document Global Development Finance 2003 in relation to the minimum capital requirements of the Basel II proposals, states that they “include the likelihood of increased costs of capital to emerging market economies; and an “unleveling” of the playing fields for domestic banking in favor of international banks active in developing countries”. I believe this issue, and similar ones, should be addressed in many FSAPs, especially since WB should act as an honest broker in these matters.

Please friend, in these matters, help the Knowledge Bank evolve into the Wisdom Bank or, more humbly, the Common Sense Bank.

Thank You”

Capital requirements for banks could be based on a “credit risk - credit purpose” matrix

On July 29 2009, in Venezuela, the financial regulator, Sudeban, issued a normative by which the risk weights used to establish the capital requirements of the banks were lowered to 50%, when banks lend to agriculture, micro-credits, manufacturing, tourism and housing. As far as I know this is the first time when these default risk-weights and which resulted from the Basel Committee regulations, are also weighted by the purpose of the loan.

The way it is done Venezuela lacks a lot of transparency and it could further confuse the risk allocation mechanism of the markets (though in Venezuela that mechanism has by other means already almost been extinguished) but, clearly, a more direct connection between risk and purpose in lending is urgently needed.

In this respect the Venezuelan regulator is indeed poking a finger in the eye of the Basel regulator who does not care one iota about the purpose of the banks and only worry about default risks and, to top it up, have now little to show for all his concerns.

I can indeed visualize a system where the finance ministry issues “purpose weights” and the financial regulator “risk-weights” and then the final weight applicable to the capital requirements of the banks are a resultant of the previous two.

Does this all sound like interfering too much? Absolutely, but since this already happens when applying arbitrary “risk weights” you could also look at this as a correction of the current interference.

Something´s terribly wrong

When parents seem to give more importance to their children´s credit score than their school grades, like setting them up to the fact that they will have to work their whole life in just to pay interests, something's terribly wrong

Let´s then also tax those prone to sickness and subsidize those who rate healthy!

If the regulators of the insurance companies would decide to follow the regulatory paradigm concocted by the Basel Committee, then they would pick three health inspection agencies to rate the health of the insured and require the insurance companies putting up more capital when insuring someone with a low health rating and letting it of the almost off the hook if the insured is deemed to be in tip top form.

Since equity costs a lot, especially in times of crisis, the above is equivalent to placing a de-facto tax on those prone to sickness or giving a de-facto subsidy to those who rate healthy, both these on top of what the market already charges for any differences in health

With their minimum capital requirements based on a vaguely defined and extremely narrow concept of risk and as measured by their three amigos the credit rating agencies, the Basel Committee subsidizes anything that finds it easier to dress up in AAA clothing and castigates what is perceived as higher risk. It all adds up to a crime against common-sense.

With these regulations they drove in a wedge that further increases the differences between the unsustainable status-quo and the sustainable future we all must try to reach, which of course requires a lot of risk-taking.

The misguided risk-aversion these regulations was the major force behind channeling in just a couple of years more than two trillion dollars into the supposedly safest asset, houses, into the supposedly safest country, the USA and into the supposedly safest instruments, AAAs…for no particular good reason at all.

All in all these Basel financial regulations add up to a crime against humanity and against common-sense.

The UN Conference Crisis & Development June 2009 - My Dissapointments

UN Conference Crisis & Development June 2009 Disappointments
Uploaded by PerKurowski. - News videos from around the world.

What I asked the Commission of UN experts chaired by Professor Joseph Stiglitz

My question:

Strong and rich borrowers in developed countries are more prone to be considered as having a low-risk of default and will therefore in general have to pay lower interest rates than the weak and poor clients in developing countries. That we know, c’est la vie!

But, in June 2004, ministers of the G10 countries, poured salt on the wounds when they endorsed the minimum capital requirements for banks proposed by the Basel Committee and which are solely based on vaguely defined default risks, as measured by the credit rating agencies.

The above signified, for instance, that if a bank lends to a corporation without a credit rating it has to put up 8 percent in capital (12 to 1 leverage) but, if lending to a corporation that has managed to obtain a credit rating of AAA to AA- then only 1.6 percent of equity is required; and which by the way also implies authorizing an astonishing leverage of 62.5 to 1.

With this, the regulators, in a highly discriminatory way, arbitrarily imposed on the financial markets a de-facto subsidy on anything that could dress up as a low risk, and a de-facto tax on anything that could not.

This regulation gave way to a crazy race after the triple-As; which in just a couple of years and though many insist in calling it “excessive risk taking” (even the experts here present) diverted, by means of misguiding risk-adverse capital, around 2 trillion dollars to the finance of the “safest” assets, mortgages on houses, in the “safest” country, the US and in the “safest” instruments, those rated AAA, in a very haphazard way. These funds, an amount in the range of what the World Bank and the IMF have lent since their creation, could have been put to better use all over the world, had it not been for these regulations that, astonishingly, are still in place.

The current draft of the “Report of the Commission of Experts of the President of the United Nations General Assembly on Reforms of the International Monetary and Financial System” opines something on the issue of the oligopoly of the credit rating agencies that resulted from the “additional boost with Basel II, which incorporates the CRAs’ ratings into the rules for assessing credit risk” but does not say a single word about the much more vital issue of the regulators playing God and toying around with risks they know nothing about. How come Mr Stiglitz? Does this not tell us something about how little prepared we, “experts” included, really are to confront the challenges of globalization and development?

And of course, from what we see, in the final resolution of the conference, again, not a single word will be said about this which in essence constitutes a regulatory subsidy of status quo and a tax on development, as well as a fatal and arbitrary intromission in the risk allocation mechanisms of the market. What a shame! Risk is the oxygen of life and development!


The answer: Professor Stiglitz did not personally answer this question but Mr. Yaga Venugopal Reddy, an expert on the panel, replied that in India these Basel regulations only apply to the larger banks that are internationally active and so they do not discriminate against smaller banks.

My comment to that answer: Yes the discrimination in favor of the “too large to fail banks” that the capital requirements established by the Basel Committee is also a problem, but what I was referring to in my question was to the so much worse discrimination among borrowers.

PS. I have personally and also as a former Executive Director of the World Bank been arguing about this issue for years but the profound respect that the Basel Committee has enjoyed and a misguided peer solidarity among the regulators have made it difficult for any outsider to have a voice. In 2007 at a conference of Finance for Development at the UN I was allowed to intervene in a round table and also to post a document on the issue. Unfortunately, this time, in 2009, the sole chance I had was in the NGO meeting with the panel of experts.

http://www.un.org/esa/ffd/hld/HLD2007/UN_FFD_Statement_Basel_Accord.pdf

In May 2003, the Financial Times published the following letter I wrote

“Just a new breed of systemic error”

“Sir, except for regulations relative to money laundering, the developing countries have been told to keep the capital markets open and to give free access to all investors, no matter what their intentions are, and no matter for how long or short they intend to stay. Simultaneously the developed countries have, through the use of credit-rating agencies, imposed restrictions as to what developing countries are allowed to be visited by their banks and investors.

That two-faced Janus syndrome, “you must trust the market while we must distrust it,” has created serious problems, not the least by leveraging the rate differentials between those liked and those rejected by our financial censors. Today, whenever a country loses its investment-grade rating, many investors are prohibited from investing in its debt, effectively curtailing demand for those debt instruments, just when that country might need it the most, just when that country can afford it the least. 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.”

http://subprimeregulations.blogspot.com/
http://teawithft.blogspot.com/search/label/subprime%20banking%20regulations

A small note: In the dialogue with the Commission a NGO representative argued for more presence of women in finance since they were more “prudent”. Though I do definitely not oppose more representation of women in finance (how could I with a wife and three daughters one of whom is already in banking) I am not so sure the argument is valid… since that could have led even more capital to pursue the “safe and prudent” AAA ratings.

Psst! Why don’t we just throw out some of the dinosaurs so that we can do some good thinking inside the box instead of us always being shown having to go outside to think?

The financial discrimination of development

What would the world say if besides the costs of getting water to the driest areas in the world the driest area would have to pay a tax for the water being shipped there? That is exactly what is happening in the financial world with a de-facto arbitrary regulatory taxation of risk. Yet, not a single word on it appears in any pre-statements or background papers to the United Nation´s conference on the world financial and economic crisis and its impact on development, now re-scheduled June 24-26, 2009.

The Basel II: International Convergence of Capital Measurement and Capital Standards of June 2006 in its Standardised Approach requires a bank to hold the following minimum $ equity for each 100 dollars lent by a bank to a sovereign country, depending on the credit rating of that sovereign.

AAA to AA- = $0
A+ to A- = $1.6
BBB + to BBB- = $4
BB + to B = $8
Unrated = $8
Below B- = $12

And I guess you all know how expensive bank equity is, especially now.

Since clearly the lower rated sovereigns will anyhow have to pay a market rates which are considerably higher than what the better rated sovereigns need to pay, it is clear that these differences in capital requirements imply an additional arbitrary tax on capital and that subsidizes anything better able to dress up as risk-free and penalizes anything expected to be perceived as more risky.

Some could argue that this does not amount to any discriminatory protectionism since these criteria are applied across the whole globe but that argument ignores the fact of how the perceived riskiness is unequally distributed around the globe.

This financial arbitrary discrimination against risk and that is present in the minimum capital requirement for bank established by the Basel Committee and that cover all public and private bank finance makes it not only more expensive for capital to go where they could are most needed but they also falsely induce them to go where they should not.

As an example of the above suffices to see how two trillions of dollars, over a period of less than three years, was because of its AAA ratings diverted to the useless financing of a housing boom in the US, instead of for instance financing the creation of sustainable decent jobs; the elimination of many infrastructure bottlenecks that exists in developing countries; or the adaptation and mitigation efforts that climate change threat requires. Two trillion dollars is most certainly more than all the financing provided by all the development banks over all the years.

In fact the current crisis from which so much suffering will result is a direct consequence of the regulatory authorities arbitrary intervening in the risk allocation mechanism of the market… in favor of what a small and incestuous group of bank regulators from some developed countries felt like favoring. Well now those developed countries are not so developed… but this is clearly not the way we should go in order to reduce inequalities.

Friends in the development community, I ask, how long will you ignore this fundamental issue?

Comments on the Draft Outcome Document dated May 8, 2009 for the United Nations Conference “World Financial and Economic Crisis and its impact on Deve

Comments on the Draft Outcome Document dated May 8, 2009 for the United Nations Conference “World Financial and Economic Crisis and its impact on Development”

H.E. Mr. Miguel d'Escoto Brockmann
President of the 63rd session of the United Nations General Assembly

1. Sir, what is going on? The Basel Committee officially endorsed the capabilities of the credit rating agencies’ to identify for the whole world the whereabouts of “risk-free” investments and then, through their minimum capital requirements for the banks, they provided additional incentives for those “risk-free” AAA signs to be followed… and there, right in front of our eyes, over just a couple of years, about 2 trillion dollars were diverted to finance an almost useless and clearly risky housing and consumption boom in the USA, instead of financing the creation of sustainable decent jobs; the elimination of many infrastructure bottlenecks that exists especially in developing countries; or the adaptation and mitigation efforts that the climate change threat requests...and the Draft Outcome Document says basically nothing at all about that!

2. I am one of the very few who can evidence a track record of having in a timely fashion criticized the current financial regulatory framework that originated with the Basel Accord, both in terms of that it doomed the world to a horrendous financial crisis and in relation to the negative impact it has on development. In fact, on the latter issue, I might even be the only voice. Just as an example the following is a letter to the editor titled “Credit ratings for developing nations are just a new breed of systemic error” that I wrote and that was published in Financial Times, January 11, 2003

“Sir, Except for regulations relative to money-laundering, the developing countries have been told to keep their capital markets open and to give free access to all investors, no matter what their intentions are and no matter for how long they intend to stay. Simultaneously, the developed countries have, through the use of credit-rating agencies, imposed restrictions as to which developing countries are allowed to be visited.
This Janus syndrome – “you must trust the market while we must distrust it” – has created serious problems, not the least by leveraging the rate differentials between those liked and those rejected by our modern-day financial censors. Today, whenever a country loses its investment grade rating, many investors are prohibited from investing in its debt, effectively curtailing the demand for it just when that country might need it the most.
Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds. Friends, please consider that the world is tough enough as it is.”

3. In this respect and notwithstanding that I agree with much of what is said therein I wish hereby to record some fundamental objections to the Draft Outcome Document dated May 8, 2009 (the Draft) and which relates to the G192 Conference on World Economic Crisis and its impact on Development. Many of these comments are extensive to the Recommendations of the Commission of experts of the President of the General Assembly on Reforms of the International Monetary and Financial System (the Recommendations).

Regulation

4. Paragraph 55 of the Draft states “The collapse in confidence in the financial sector is widely recognized as central in the economic crisis; restoration of confidence will be central in the recovery. But it will be hard to restore confidence without changing the incentives and constraints facing the financial crisis”

5. Of course restoration of confidence is central for economic recovery but for the recovery of confidence to happen a full understanding of what happened is a must. That a Bernard Madoff can cheat does not affect confidence in the markets because the markets are much aware that cheaters have always been around and are in fact themselves a part of the market.

6. But, if the credit rating agencies who were so recently officially bestowed with so much power in the surveillance of risks, and therefore must be the best, sort of an “Appointed Risk Surveyor to the Majesty” managed to fail so miserably, then that is of course a tremendous blow to confidence. That loss of confidence can only be cured by fully acknowledging that the mistake was in the creation of an oligopoly in risk surveillance and that this oligopoly will now be eliminated… not strengthened.

7. Paragraph 55 also states “It is imperative that the regulatory reforms be real and substantive, and go beyond the financial sector to address underlying problems in corporate governance and competition policy, and in tax structures, giving preferential treatment to capital gains, that may provide incentives for excessive leverage.”

8. The above says that not taxing the profits is at fault and so that presumably we now must tax profits? Not really so, the problem is not that the profits had tax incentives but that the profits proved to not be profits at all. The “incentives for excessive leverage” those were in fact provided by the regulators and thank God the maximum authorized financial leverages were never even reached by any bank before the crisis. This does of course not preclude that there might be many other valid reasons to tax profits, but that is a quite different matter.

9. Paragraph 55 also states “Even if there had been full disclosure of derivative positions, their complexity was so great as to make an evaluation of the balance sheet position of the financial institutions extraordinarily difficult”.

10. First the crisis was not caused by “derivative positions” and second, the “complexity” argument is irrelevant because the instruments that were so complex that they were not even understood by those who generated them, would never even have reached the balance sheet of a bank, or an investor, had they not been granted the triple-A rating which substituted for the understanding, unfortunately in a much imperfect way. There is of course a need for a better management of the exposures though central clearing houses but that is a quite different matter.

Purpose and objectives of the Financial System

11. Paragraph 57 of the Draft states: “Financial policies, including regulation, have as their objective not only ensuring the safety and soundness of financial institutions and stability of the financial system, but protection of bank depositors, consumers and investors and ensuring financial inclusion - such as access to all banking services including credit, and the provision of financial products which help individuals and families manage the risks they face and gain access to credit at reasonable terms. It is also imperative to make sure that the sector is competitive and innovative.”

12. First, the world needs to set as an explicit objective that individuals should be sufficiently gainfully employed so as not having to use debt except for the acquisition of long term capital goods or in the case of very special emergencies. Most current consumer debt does only help to advance current consumption, at interest rates higher than the risk-free rate and therefore, as a norm, only help to impoverish even more the poor consumers.

13. Second the real purpose of our financial policies should be to advance growth, the creation of decent jobs and to help society to confront special challenges such as climate change. If, in doing so, the financial sector remains stable that is of course a much welcome result, but little is gained from making stability per se the ex ante overriding objective, such as is currently the case. In fact I have even argued that a regulatory system that is much more “trigger-happy” and therefore allows financial institutions to fold much faster, would lead to more satisfactory and stable results.

14. Third, it is of course imperative that the financial sector remains competitive, but this only as long as the competition is carried out in a competitive way and not by assigning special favorable treatment to any parties. That said there is absolutely nothing that requires it to be innovative per se and much less so when the innovations, in this case regulatory innovations, can generate crisis like the current.

15. In this respect there is a need for a banking system that does not substitute bankers staring at monitors for bankers knowing their clients’ business, looking into their clients’ eyes or feeling the firmness of their clients’ handshake. It is indeed of extreme concern to see parents in developed countries giving almost more importance to some opaque credit scores than to the school grades of their children.

16. Therefore paragraph 57 should be rephrased placing as the primary objective of financial policies and regulations the development of the real economy in a sustainable and in a just way. The paragraph 28 of the Recommendations, though incomplete, reflects much of what needs to be stated.

The systemic risks of global arrangements

17. There are continuous references made to the need of “global institutional arrangements for governing the global economy” and this is all well, as longs as it comes with the absolute recognition of the systemic risks such global governance can produce. We should be aware that an objective analysis of the current financial regulations would have to conclude that the world would have been much better off without any of that global public common good we were told that the Basel Committee was, and which has now sadly revealed itself as a real global public common bad.

18. The worst regulator ever, in a small village, will produce harm of little aggregate significance. An extremely good regulator, globally connected, is a monumental menace. In this respect we need to value some of the diversity that different regulatory environments can bring and never underestimate the dangers of the rigidities that global regulations can introduce

Risk as the oxygen of development

19. According to the minimum capital requirements for banks established by the Basel Committee if a credit of $100 is given to a borrower who does not possess a credit rating, the banks need $8 in capital, but if the banks lends to a borrower that has an AAA to an AA- rating, the loans are risk-weighted at 20% and therefore the banks needs only $1.6 in equity. This is equivalent to an authorized 62.5 to 1 leverage.

20. That difference of $6.4 in required equity, especially in times when bank-equity is expensive, costs real money and acts like a de-facto tax on risk. This tax is laid as a surcharge tax on all the different risk spreads that the market already demands. Since the lack of development, just by itself normally generates in the market a perception of additional risk which has to be paid for, and since risk-taking is in so many ways the oxygen of development, it is clear that the developing countries are being especially discriminated by the current regulatory framework.

21. Now if you want to know the real extent of how the minimum capital requirements favored those able to dress up as risk free read paragraph 615 of the Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework - Comprehensive Version of June 2006 which refers to investment in securities that are risk weighted at only 7% and therefore signify an authorized leverage of 179 to 1.

22. The importance that risk-taking has for development and the need to avoid imposing de-facto taxes on risk as has been done with the minimum capital requirement for banks risk-weighted structure and much less introducing artificial incentives to direct funds to real or fictitious low risk investments is completely absent in the document.

23. Paragraph 14 of the Draft argues correctly that “Financial subsidies can be just as detrimental to the efficiency of a free and fair trading system as tariffs. Indeed, they may be more inequitable, because rich countries have more resources to support subsidies” and yet, neither the Draft nor the Recommendations mention even once the current minimum capital requirements for banks and which are as previously explained a real tax or a real tariff on risks, of which the developing countries have the most… at least as perceived by the markets.

24. For a more detailed comment on this I reference a document that I was honored to see posted in October 2007 in the Finance for Development site.
http://www.un.org/esa/ffd/hld/HLD2007/UN_FFD_Statement_Basel_Accord.pdf

Restructuring of International Institutions

25. There are many proposals related to the need of better more transparent and more democratic global institutions. They are all correct but missing from that is the following:

26. First it is not sufficient in structures like for instance the Financial Stability Forum (a name that in itself you might understand that I find much lacking) to have a representation of developing countries as this might not by itself guarantee diversity of thought. What is foremost needed is to avoid that the discussions of vital global issues are hijacked by clubs of mutual admirations and which, due to often strange ying-yang relations sometimes even include representatives from civil society.

27. Second in order to be able to introduce a more global perspective there is also need for more representatives who are not wedded to very local interests. As a former Executive Director of the World Bank I have often held that the least represented entity in the bank is planet earth itself.

Financing for Restructuring and Survival

28. Though I agree with some of the proposals made in paragraphs 21 trough 35 I just cannot comprehend how in paragraph 27 one finds room to mention minor initiatives such as PetroCaribe without even mentioning in the Recommendations or in the Draft the importance of remittances. Given that the enormous sacrifices of many migrants is what is holding many economies afloat it is truly an embarrassing omission.

29. Also and given the current role of the dollar as a kind of borrower of last resort, as a sort of last perceived safe-haven I certainly miss efforts to discuss the possibilities the US recycling some of those dollars to developing countries with perhaps some partial guarantees from other developed economies that also have a vested interest in it.

30. Paragraph 28 speaks of “efficient mechanisms for mobilizing the funds available in countries that have accumulated large reserves” and this could create the false illusion the existence of funds that have not already been deployed. In fact these reserves have one way or another already been invested and their divestment signifies by itself a major challenge.

31. Finally if there is a possibility for a Global Stimulus Fund, then now, in the midst of a crisis, this is not the best of times time to delay its workings by trying to also ascertain the voice of recipient countries.

Sincerely,

Per Kurowski
A concerned citizen and that while being an Executive Director at the World Bank 2002-2004 had little luck in having his voice heard on this issue.

My voice and noise on the financial sector during the spring meetings of the World Bank and the IMF, April 2008

As a former Executive Director at the World Bank (2002 - 2004) and now as Civil Society, the following are the three financial sector issues that I raised at the spring meetings of the World Bank and the IMF in Washington, April 10-13, 2008.

Risk is the oxygen of development!

It is absurd to believe that the US and other countries would have reached development without bank failures. When the Basel Committee imposes on the banks minimum capital requirements based solely on default risks, this signifies putting a tax on risk-taking, something which in itself carries serious risks. The real risk is not banks defaulting; the real risk is banks not helping the society in its growth and development. Not having a hangover (bank-crisis) might just be the result of not going to the party!

We need to stop focusing solely on the hangovers and begin measuring the results of the whole cycle, party and hangover, boom and bust! The South Korean boom that went bust in 1997-1998 seems to have been much more productive for South Korea than what the current boom-bust cycle seems to have been for the United States.

All over the world there is more than sufficient evidence that taxing risks has only stimulated the financing of anything that can be construed as risk free, like public sector and securitized consumer financing; and penalized the finance of more risky ventures like decent job creation. Is it time for capital requirements based on units of default risk per decent job created?

When is the World Bank as a development bank to speak up on this issue on which they have been silent in the name of "harmonization" with the IMF?

When are we to stop digging in the hole we're in?

The detonator of our current financial turmoil were the badly awarded mortgages to the subprime sector and that morphed into prime rated securities with the help of the credit rating agencies appointed as risk surveyors for the world by the bank regulators.

If we survive this one and since it is "human to err" we know that if we keep empowering the credit rating agencies to direct the financial flows in the world, it is certain that at some time in the future we will follow them over even more dangerous precipices.

Note: I have just read the Financial Stability Forum brotherhood's report on Enhancing Market and Institutional Resilience and while including some very common sense recommendations with respect to better liquidity management and "reliable operational infrastructure"; and some spirited words about more supervision and oversight (the blind leading the blind); with respect to the concerns expressed above, bottom line is that they recommend we should deepen the taxes on risks and make certain that the credit rating agencies behave better and get to be more knowledgeable… all so that we are more willing to follow them where we, sooner or later, do not and should not want to go.

Do micro-credit institutions make too much use of "predatory ratings"?

Any group of debtors that is charged a higher interest rate because it is considered a higher credit risk is composed by those spending their money servicing a debt that they will finally default on, and those who should have in fact deserved a lower interest rate. Are there any real winners among them?

Who is out there informing the poorly rated about how very dearly they are paying for their loans? Who is out there analyzing the murdering impact that credit ratings have in chipping away at the minimum levels of solidarity that any society needs to keeps itself a society?

If there is a minimum of things that needs to be done in the world of micro credits that is to focus more on transparent system of incentives that: 1. Stimulates and rewards good group behaviour and returns to the compliant borrowers some of the "extraordinary" margins earned. 2. Spreads out the costs of those who cannot make it over a much wider group of debtors.

And, by the way, this applies just the same to the financing of mortgages to the subprime sector.

ARE THE BASEL BANK REGULATIONS GOOD FOR DEVELOPMENT?

Document that I presented at the High-level Dialogue on Financing for Developing at the United Nations, New York, October 2007, as a member of New Rules for Global Finance.

ARE THE BASEL BANK REGULATIONS GOOD FOR DEVELOPMENT?

1. It is very sad when a developed nation decides making risk-adverseness the primary goal of their banking system and places itself voluntarily on a downward slope, since risk taking is an integral part of its economic vitality, but it is a real tragedy when developing countries copycats that and falls into the trap of calling it quits.

2. In his book “Money: Whence it came, where it went” (1975), John Kenneth Galbraith speculates on the fact that one of the basic fundamentals of the accelerated growth experienced in the western and south-western parts of the United States during the past century was the existence of an aggressive banking sector working in a relatively unregulated environment. Banks opened and closed doors and bankruptcies were frequent, but as a consequence of agile and flexible credit policies, even the banks that failed left a wake of development in their passing.

3. Few things can be so relevant to the financing of development as the regulations that are being applied to commercial banks. Unfortunately, as the world has been quite infatuated with the banking regulations emanating from Basel ; as they seemingly kept the bank crisis at bay so efficiently –although some of us believe they seemed more destined to stop the small tremors than to help to avoid the big quakes, or what in recent Alan Greenspan terminology would amount to a lack of "benevolent turbulence"– there has been no room to question the basic principles of the regulations, much less so from the perspective of developing countries that "needed" to be "saved" from their recurring bank crises.

4. As a former Executive Director at the World Bank (2002-2004) who tried to voice this issue frequently, among others at an ECOSOC-Bretton Woods-WTO meeting at the UN in April 2004, I can testify to the difficulties.

5. Some specific problems, such as the possible reinforcement of the pro-cyclicality of bank lending, and some specifics of the Basel II reforms such as its high costs, which could give the larger banks a comparative advantage, have been recorded as discussed, though resulting in nothing special of practical consequence. We should also comment that it is a bit surrealistic to debate the Basel II reforms without ever having entered into and much less exhausted the discussions on the fundamental principles imbedded in Basel I, which clearly contain the genesis of a series of factors that could affect the financing of development.

6. The recent financial turmoil that has cast some serious shadows on some of the Basel operational methods, for instance the high reliance on credit rating agencies, can perhaps now provide us with the opportunity to ask and debate "Are the bank regulations coming out from Basel truly compatible with the best interests of developing countries?" It is in this vein that we would like to start by raising the following issues:

Current regulatory arbitrage favors risk adverseness

7. The bank regulations that come out from Basel are almost exclusively against-risks-at-any-cost driven and so they completely ignore the other two major functions of banking systems, namely to help generate growth and to distribute opportunities.[1] The fact that in a developing society there are some risks more worthy to take than others is completely ignored in the minimum capital requirements ordained by Basel. The argument that "a stable banking system is critical to the long-term growth of an economy" is repeated like a mantra with no consideration of the stage of development and circle of growth in which a country finds itself.

8. Credits deemed to have a low default or collection risk will intrinsically always have the advantage of being better perceived and therefore being charged lower interest rates, precisely because they are lower risk. But, the minimum capital requirements of the Basel regulations, by additionally rewarding "low risk" with the cost saving benefits resulting from lower capital requirements, are unduly leveraging the attractiveness of "low risk" when compared to "higher risk" financing.

9. Allow us to illustrate this central argument in a very simplified way. Under the current Basel I Standardized Approach, a low risk corporate loan (rated AAA to AA-) requires a bank to hold only 20% of the basic 8% capital requirement, meaning 1.6 in units of capital, while a much riskier loan (rated below BB-) requires it to hold 150% of the basic 8%, meaning 12 units of capital. If the current cost of capital for the bank is 15%, then the bank's carrying cost for the low risk credit is 0.24% (8%*20%*15%) while the bank's carrying cost for the high risk credit is 1.80% (8%.150%*15%), thereby producing an additional cost of 1.56% that must be added on to the normal spread that the market already requires from a high risk compared to a low risk loan in a free market.

10. The extra Basel spread on risk makes it more difficult for higher risk borrowing needs to have access to credit from the commercial banks. In a developed country this might not be so serious because there are other alternative sources, but in a developing economy this is fatal, as the commercial banks frequently represent the only formal and supervised source of finance.

11. And of course the Basel effect does not limit itself to the extra carrying cost. From the perspective of the balance sheet we see that each unit of bank capital can sustain 62.5 units of low risk lending but only 8.3 units of high risk lending, and since bank capital itself is more scarce in a developing country, this also induces channeling of local savings increasingly towards the low risk side of the economy.

12. In Basel II, while the "Internal Ratings-Based Approach" provides a much more refined instrument for assessing risks it creates even more bias against risk, much the same as a health insurance scheme is able to offer more differentiated rates the more they know or think they know about the expected health prospects of their clients. We should not ignore that the finance of development requires the current generation to be willing to share in the risks of the future so as to help the society and coming generations to progress. In this respect the Basel risk adverseness could be described as a baby-boomer generation's invention to assure that their savings are there when they need them, with little consideration to what might come after.

13. By adding on a new layer of sophistication and digging deeper in the hole created by Basel I, Basel II will ironically increase the possibilities of new systemic risks and make the fight against the risks targeted by the Basel Committee even more difficult. This particular problem lies outside the context of this paper but for those interested we refer to the Statement number 160 of the Shadow Financial Regulatory Committee, March 2000,[2] where they propose instead the more logical route of harnessing more market discipline by using subordinated debt to make capital requirements more risk sensitive.

14. We are by no means implying that the risks in lending should be taken lightly, but since development normally does not make a living in the land of low risks, much the contrary, this regulatory arbitrage of overly benefiting risk adverseness, and adding on costs, is very costly for development. In short, Basel provides economic signals for maintaining the status quo rather than fostering development.

15. In this respect, and since the current Basel II proposals do contain much that could stimulate the banks to better quantify and manage risk, an alternative that could perhaps provide some of the benefits with less regulatory-ordered bias would be to require a flat percentage of assets as the capital requirement for the banks but forcing them to report to the market a Basel-calculated minimum capital, thereby allowing the market participants, investors or depositors, to price in their views on the differences between these two figures. Going this route would also diminish the quite dangerous possibility that the markets begin to believe that the Basel minimum capital requirements constitute a perfect risk equalization machine among banks with totally different risk structures.

16. As much of the risk management used by Basel is based on the analysis of old data, so as to establish loss probabilities, we also need to acknowledge the fact that a desired future does not stand on past statistical data, much less in the case of developing countries where that past statistical data refers precisely to what should be avoided in the future, and bears little relevance to what needs to be done.

17. But again we wish to make absolutely clear that this is NOT a proposal to abolish the Basel minimum capital requirements outright, but rather to study its other social costs in order to contain these or develop alternative methods that better balance the different societal objectives for the banks.

Current regulatory arbitrage leads to risk hiding

18. An excessive anti-risk bias will naturally stimulate risk hiding. Let us not forget that the need for assets to be qualified as more or less risky is exactly the reason why the credit rating agencies were so much empowered that now we also have the credit rating agencies bias risk, which already helped to create the sub-prime mortgages debacle.

19. One of the dangers for a developing country, where regulatory weaknesses might be more easily exploitable, is that the banks deviate all assets that in their opinion carry a lower capital requirement than what the regulator-credit rating agencies order into other formal or informal places of the market, while loading up their balance sheet with assets for which the risk/capital allocation seems a bargain; giving new meaning to the Thomas Gresham's principle that states that "bad money drives out good money.”

20. The mentioned risks are clearly not limited to developing countries and we can find a discussion of it in the context of developed countries in a speech of Alan Greenspan on "The Role of Capital in Optimal Banking Supervision and Regulation"[3] in 1998.

Excessive empowerment of new participants

21. Credit rating agencies. The Basel I Standardized Approach regulations led to the credit-rating agencies substituting for some of the traditional in-house credit analyst departments in local banks which, for better or for worse, had allowed credit analysis to be more colored by local factors. This has affected the whole credit environment, and the recent drive towards "development banks" and the establishing of the micro credit institutions can be seen in great part as efforts to satisfy needs created by the Basel inspired bank regulations.

22. It is indeed very difficult for developing countries to understand how authorities that have frequently preached to them the value of the invisible hand of millions of market agents can then go out and delegate so much regulatory power to a limited number of human and very fallible credit-rating agencies, especially as this must surely be setting us up for very serious new systemic errors.

23. Powers to the Supervisors. The Basel II "Internal Ratings-Based Approach" returns much of the credit analysis to the banks themselves, where it belongs, but in doing so it generates a series of new hands-on activities for bank supervisors who will need to consent, concur, approve and what have you, and which can only create new sources of distortions. In this respect suffice it to read the book by James R. Barth, Gerard Caprio, Jr. and Ross Levine, "Rethinking Bank Regulations: Till Angels Govern" [4] to reflect on the possible consequences.

We need much more research

24. When looking at how consumer credit is growing fast in so many developing countries, mainly because it can be more easily packaged (or camouflaged) as a low risk operation while traditional entrepreneurial credits barely skimp along, it would be natural to ask whether this could not be the direct result of the Basel regulations.

25. Could Basel be hindering development finance? What are the consequences of regulatory arbitrated risk adverseness? Is Basel introducing a bias in favor of public sector finance? Could the paradox of the increasing net outward financial flows from developing to developed countries be in any way related to these regulations?

26. These are all vital questions but there seems to be no ongoing research to try to understand how global financial flows have been affected by the Basel regulations and by the use of the credit rating agencies. The topic seems almost taboo, but given the importance of banking regulations for the financing of development, we would urge giving more priority to the research of these issues.

Who is the lender of last resort?

27. One concern, much aggravated by the new Basel II regulations, is that the world might have been irrevocably placed on a route that leads it to end up with just a couple of big international banks. In such a case, if one of these banks that have captured a very large share of local deposits in a developing country runs into problems, who is the real lender of last resort? Is the European Central Bank, for instance, willing to furnish Latin American countries with at least a letter of intent to provide support if a European-owned bank runs into problems while working in Latin America? Clearly there is an urgent need for close international collaboration on this matter.

28. The issue of a possible tendency to have fewer banks, which would seem to imply that damages caused by an individual bank default could grow as a result of upping the ante, also raises the question of why this is not considered by Basel. If the Basel risk assessment methodology favors a diversification in the portfolio of a particular bank, then shouldn’t society, and the lender of last resort, also apply this criteria to their own portfolio of banks? Is there not a need for an additional capital requirement based on the individual bank's market share?

What can be done?

29. There are no easy answers, but to discuss these problems openly and candidly is as good a start as any, and so therefore these questions and issues need to be brought to the forefront of the discussions, like for example:

30. Can and should the minimum capital requirements be supplemented or complemented in such a way as to neutralize the risk adverseness of current regulation by, for instance, providing an adjustment for credits destined to create jobs? If the bank regulators of the world insist on imposing the criteria of the credit rating agencies, should we development agents request the presence of our development rating agencies and distribution of opportunities rating agencies?

31. Instead of using the differences in the perceived risks of the credits to determine the formal capital requirements an alternative is to apply an equal percentage to all the assets of the bank but then having the banks to report something similar to a Basle risk valuation as an additional transparent information reference. Although this approach looks to incorporate a more holistic market view than the strictly risk related “subordinated debt route suggested by the Shadow Financial Regulatory Committee, there is nothing that stops it from being complementary to the former.

32. Some could argue that to rely on the markets is impossible in developing countries where markets are deemed to be non-existent or weak but the other side of that coin is that that constitutes precisely the reason for having to rely on whatever little market there is.

Who is debating?

33. Put together the chefs from many different countries and you might get a quite varied menu, but gather the brain-surgeons and there is not going to be a great deal of diversity in their opinions. One of the main problems in discussing the Basel issue, and more so of being able to introduce any changes, is the current lock-hold that central bankers and bank supervisors have on the debate. Sometimes it is argued that if developing countries are better represented in Basel, they will be better able to voice their development concerns, but if this representation of diversity is only to happen by convening experts from all around the world that profess the same principles and have the same mindset, then no matter where they come from, this will be a dead-end street.

34. The numerous comments made by Basel officials about the importance of not rushing the implementation of Basel II, would seem to indicate that experts from developing countries feel the pressure to be recognized as being just as up-to-date and risk-adverse as their peers in developed countries. This syndrome, that costs many developing countries dearly in many of their WTO negotiations, needs to be controlled by assuring the presence of professionals that have other interests beside bank regulations.

35. The World Bank, as a development institution, should have played a much more counterbalancing role in this debate, but unfortunately it has been often silenced in the name of the need to "harmonize" with the IMF. Likewise, the Financial Stability Forum is also, by its sheer composition and mission, too closely related to the Basel bank regulations to provide for an independent perspective, much less represent the special needs of developing countries. Therefore the introduction of independent development voices in the debate is absolutely crucial, and perhaps this could be arranged through a G77 or a G24 effort.

36. As evidence for the lack of inclusion of other points of view different from risk avoidance, let us just refer to the Policy Conclusion in the Report of the Secretary General on the International Financial System and Development dated July 6, 2007, where "surveillance" appears seven times and except for one reference to the development of the financial sector there is not a single word about development itself.

37. For the record, let us state that although we have made the above comments from the perspective of "finance for development," most of the criticism put forward is just as applicable to developed countries. In this respect it is interesting to note that in the United States there has been some serious questioning of whether those regulations are not too uniform as to be applicable to all of their banks.

38. To conclude, we wish to insist that no society can survive by simply maximizing risk avoidance; future generations will pay dearly for this current run to safety. So therefore, more than placing our trust in the banks’ financial standing, we need to trust in what the banks do. Let us make certain our bank regulations help us to do just that.

[1] http://www.bis.org/publ/bcbs107.htm

[2] http://www.aei.org/publications/pubID.16542/pub_detail.asp

[3] Federal Reserve Bank of New York Economic Policy Review of October 1998.

[4] Cambridge University Press, 2006

The mutual admiration club of firefighters in Basel

(A letter Financial Times did publish)

Sir, if a citizen from a developed country wishes to obtain finance from his local bank to buy a pricey retirement home in his local overheated market, then Basel poses no problem.

But should he want to buy a much more affordable home in a developing country and have his bank there finance him, then Basel slaps such capital-reserve requirements on the bank as to make it an impossibly onerous proposition.

This is just one way by which our bank supervisors in Basel are unwittingly controlling the capital flows in the world.

We also wonder how many Basel propositions it will take before they start realizing the damage they are doing by favoring so much bank lending to the public sector. In some developing countries, access to credit for the private sector is all but gone, and the banks are up to the hilt in public credits.

Please, help us get some diversity of thinking to Basel urgently; at the moment it is just a mutual admiration club of firefighters trying to avoid bank crisis at any cost—even at the cost of growth.

Towards a counter cyclical Basel?

(A letter to the Financial Times extracted from Voice and Noise, 2006)

Sir, the financial system is there to safeguard savings, to generate economic growth by channeling investments, and to promote equality by providing full and free access to capital and opportunities.

Currently, our bank regulators headquartered in Basel are primarily concerned with the first goal, that of avoiding bank collapses, and how could it be otherwise, if you have only firemen on the board that regulates building permits.

Now, one of these days, the financial system, neatly combed and dressed in a tuxedo, but lying more than seven feet under in the coffin of financial de-intermediation, is going to wake up to the fact that it needs the presence of others in Basel. At that moment, perhaps we might start hearing about flexible capital requirements, moving up to 8.2 % or down to 7.8% by region, in response to countercyclical needs.

Meanwhile it’s a shame that even their first goal might turn out to be elusive, since although the individual risks have fallen with Basel regulations, the stakes have increased, as those same regulations accelerate the tendency towards fewer and fewer banks.

About the Global Bank Insolvency Initiative

(An informal email sent in 2004 to my then colleagues Executive Directors of the World Bank extracted from Voice and Noise, 2006)

Dear Friends,

We recently had a technical briefing about the Global Bank Insolvency Initiative. Having had a special interest in this subject for some years, I wish to make some comments.

As I have always seen it, the costs related to a bank crisis are the following three:

The actual direct losses of the banks at the outbreak of the crisis. These are represented by all those existing loans that are irrevocably bad loans and therefore losses without a doubt.

The losses derived from mismanaging the interventions (workout costs). These include, for example, losses derived from not allowing some of the existing bad loans the time to work themselves out of their problems. They also include all the extraordinary legal expenses generated by any bank intervention in which regulators in charge want to make sure that they themselves are not exposed to any risk at all.

The long-term losses to the economy resulting from the “Financial Regulatory Puritanism,” that tends to follow in the wake of a bank crisis as thousands of growth opportunities are not financed because of the attitude “we need to avoid a new bank crisis at any cost.”

For the sake of the argument, I have hypothesized that each of these individual costs represents approximately a third of the total cost. Actually, having experienced a bank crisis at very close range, I am convinced that the first of the three above costs is the smallest ... but I guess that might be just too politically incorrect to pursue further at this moment.

In this respect, it is clear that any initiative that aims to reduce the workout costs of bank insolvency is always welcome and in fact the current draft contains many well-argued and interesting comments, which bodes well for its final findings and suggestions.

That said, the scope of the initiative might be somewhat limited and outdated, making it difficult to realize its full potential benefits. There is also the danger that an excessive regulatory bias will taint its findings.


Traditional financial systems, represented by many small local banks dedicated to very basic and standard commercial credits, and subject to normally quite lax local regulation and supervision, are mostly extinct.

They are being replaced by a system with fewer and bigger global bank conglomerates governed by a global Basel-inspired regulatory framework and they operate frequently by transforming the economic realities of their portfolios through mechanisms and instruments (derivatives) that are hard to understand even for savvy financial experts.

In this respect I believe that instead of dedicating scarce resources to what in some ways could be deemed to be financial archaeology, we should confront the new market realities head on, making them an explicit objective of this global initiative. For instance, what on earth is a small country to do if an international bank that has 30% of the local bank deposits goes belly up?

We all know that the financial sector, besides having to provide security for its depositors, needs also to contribute toward economic growth and social justice, by providing efficient financial intermediation and equal opportunities of access to capital. Unfortunately, both these last two objectives seem to have been relegated to a very distant plane, as the whole debate has been captured by regulators that seem only to worry about avoiding a bank crisis. Unfortunately, it seems that the initiative, by relying exclusively on professionals related to banking supervision, does little to break out from this incestuous trap. By the way if you want to see about conflict of interest, then read the section “Legal protection of banking authorities and their staff.” It relates exactly to those wide blanket indemnities that we so much criticize elsewhere.

And so, friends, I see this Global Bank Insolvency Initiative as a splendid opportunity to broaden the debate about the world’s financial systems and create the much needed checks and balances to Basel. However, nothing will come out of it if we just delegate everything to the hands of the usual suspects. By the way, and I will say it over and over again, in terms of this debate, we, the World Bank, should constitute the de facto check and balance on the International Monetary Fund. That is a role we should not be allowed to ignore—especially in the name of harmonization.

A NEW BREED OF SYSTEMIC ERRORS

(A letter Financial Times did publish)

Sir, except for regulations relative to money laundering, the developing countries have been told to keep the capital markets open and to give free access to all investors, no matter what their intentions are, and no matter for how long or short they intend to stay.

Simultaneously the developed countries have, through the use of credit-rating agencies, imposed restrictions as to what developing countries are allowed to be visited by their banks and investors.

That two-faced Janus syndrome, “you must trust the market while we must distrust it,” has created serious problems, not the least by leveraging the rate differentials between those liked and those rejected by our financial censors. Today, whenever a country loses its investment-grade rating, many investors are prohibited from investing in its debt, effectively curtailing demand for those debt instruments, just when that country might need it the most, just when that country can afford it the least.

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.

Some comments made at a Risk Management Workshop for Regulators

Dear Friends,

As I know that some of my comments could expose me to clear and present dangers in the presence of so many regulators, let me start by sincerely congratulating everyone for the quality of this seminar. It has been a very formative and stimulating exercise, and we can already begin to see how Basel II is forcing bank regulators to make a real professional quantum leap. As I see it, you will have a lot of homework in the next years, brushing up on your calculus—almost a career change.

But, my friends, there is so much more to banking than reducing its vulnerability—and that’s where I will start my devil’s advocate intrusion of today.

Regulations and development.

The other side of the coin of a credit that was never granted, in order to reduce the vulnerability of the financial system, could very well be the loss of a unique opportunity for growth. In this sense, I put forward the possibility that the developed countries might not have developed as fast, or even at all, had they been regulated by a Basel.

A wider participation.

In my country, Venezuela, we refer to a complicated issue as a dry hide: when you try to put down one corner, up goes the other. And so, when looking for ways of avoiding a bank crisis, you could be inadvertently slowing development.

As developing sounds to me much more important than avoiding bank failures, I would favor a more balanced approach to regulation. Talleyrand is quoted as saying, “War is much too serious to leave to the generals.” Well, let me stick my head out, proposing that banking regulations are much too important to be left in the hands of regulators and bankers.

Friends, I have been sitting here for most of these five days without being able to detect a single formula or word indicating that growth and credits are also a function of bank regulations. But then again, it could not be any other way. Sorry! There just are no incentives for regulators to think in terms of development, and then the presence of the bankers in the process has, naturally, more to do with their own development. I believe that if something better is going to come out of Basel, a much wider representation of interests is needed.

A wider Scope.

I am convinced that the direct cost of a bank crisis can be exceeded by the costs of an inadequate workout process and the costs coming from the regulatory Puritanism that frequently hits the financial system—as an aftershock.

In this respect, I have the impression that the scope of the regulatory framework is not sufficiently wide, since the final objective of limiting the social costs cannot focus only on the accident itself, but has also to cover the hospitalization and the rehabilitation of the economy. From this perspective, an aggressive bank, always living on the edge of a crisis, would once again perhaps not be that bad, as long as the aggressive bank is adequately foreclosed and any criminal misbehavior adequately punished.

On risks.

In Against the Gods Peter L. Bernstein (John Wiley & Sons, 1996) writes that the boundary between the modern times and the past is the mastery of risk, since for those who believe that everything was in God’s hands, risk management, probability, and statistics, must have seemed quite irrelevant. Today, when seeing so much risk managing, I cannot but speculate on whether we are not leaving out God’s hand, just a little bit too much.

If the path to development is littered with bankruptcies, losses, tears, and tragedies, all framed within the human seesaw of one little step forward, and 0.99 steps back, why do we insist so much on excluding banking systems from capitalizing on the Darwinian benefits to be expected?

There is a thesis that holds that the old agricultural traditions of burning a little each year, thereby getting rid of some of the combustible materials, was much wiser than today’s no burning at all, that only allows for the buildup of more incendiary materials, thereby guaranteeing disaster and scorched earth, when fire finally breaks out, as it does, sooner or later.

Therefore 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.

Knowing that “the larger they are, the harder they fall,” if I were regulator, I would be thinking about a progressive tax on size. But, then again, I am not a regulator, I am just a developer.

Conspiracy?

When we observe that large banks will benefit the most with Basel II, through many risk-mitigation methods not available to the smaller banks which will need to live on with Basel I, and that even the World Bank’s “Global Development Finance 2003” speaks about an “unleveling” of the playing field for domestic banks in favor of international banks active in developing countries, I believe we have the right to ask ourselves about who were the real negotiators in Basel?

Naturally, I assume that the way the small domestic banks in the developing countries will have to deal with these new artificial comparative disadvantages is the way one deals with these issues in the World Trade Organization, namely by requesting safeguards.

Credit Ratings

Finally, just some words about the role of the Credit Rating Agencies. I simply cannot understand how a world that preaches the value of the invisible hand of millions of market agents can then go out and delegate so much regulatory power to a limited number of human and very fallible credit-rating agencies. This sure must be setting us up for the mother of all systemic errors.

The Board As for Executive Directors (such as myself), it would seem that we need to start worrying about the risk of Risk Managers doing a de facto takeover of Boards—here, there, and everywhere. Of course we also have a lot of homework to do, most especially since the devil is in the details, and risk management, as you well know, has a lot of details.

Thank you.

PURITANISM IN BANKING

In his book Money: Whence it came, where it went” (1975), John Kenneth Galbraith discusses banks and banking issues which I believe may be applicable to the Venezuela of today.

In one section, he addresses the function of banks in the creation of wealth. Galbraith speculates on the fact that one of the basic fundamentals of the accelerated growth experienced in the western and south-western parts of the United States during the past century was the existence of an aggressive banking sector working in a relatively unregulated environment.

Banks opened and closed doors and bankruptcies were frequent, but as a consequence of agile and flexible credit policies, even the banks that failed left a wake of development in their passing.

In a second section, Galbraith refers to the banks’ function of democratization of capital as they allow entities with initiative, ideas, and will to work although they initially lack the resources to participate in the region’s economic activity. In this second case, Galbraith states that as the regulations affecting the activities of the banking sector are increased, the possibilities of this democratization of capital would decrease. There is obviously a risk in lending to the poor.

In Venezuela, the last few years [the 1990s] have seen a debate, almost puritan in its fervor, relative to banking activity and how, through the implementation of increased controls, we could avoid a repeat of a banking crisis like the one suffered in 1994 at a cost of almost 20% of GDP. Up to a certain point, this seems natural in light of the trauma created by this crisis.

However, in a country in which unemployment increases daily and critical poverty spreads like powder, I believe we have definitely lost the perspective of the true function of a bank when I read about the preoccupation of our Bank Regulating Agency that “the increase in credit activity could be accompanied by the risk that loans awarded to new clients are not backed up with necessary support (guarantees)” and that as a result we must consider new restrictions on the sector.

It is obvious that we must ensure that banks do not overstep their bounds while exercising their primary functions—a mistake which in turn would result in costly rescue operations. We cannot, however, in lieu of perfecting this control, lose sight of the fact that the banks’ principal purpose should be to assist in the country’s economic development and that it is precisely with this purpose in mind that they are allowed to operate.

I cannot believe that any of the Venezuelan banks were awarded their charters based purely and simply on a blanket promise to return deposits. Additionally, when we talk about not returning deposits, nobody can deny that—should we add up the costs caused by the poor administration, sins, and crimes perpetrated by the local private banking sector throughout its history—this would turn out to be only a fraction of the monetary value of the comparable costs caused by the public/government sector.

Regulatory Puritanism can affect the banking sector in many ways. Among others, we can mention the fact that it could obligate the banks to accelerate unduly the foreclosure and liquidation of a business client simply because the liquid value for the bank in the process of foreclosure is much higher than the value at which the bank is forced to carry the asset on its books. In the Venezuela of today, we do not have the social flexibility to be able to afford unnecessary foreclosures and liquidations.

In order to comprehend the process involved in the accounting of losses in a bank, one must understand that this does not necessarily have anything to do with actual and real losses, but rather with norms and regulations that require the creation of reserves. Obviously banks will be affected more or less depending on the severity of these norms. Currently, a comparative analysis would show that Venezuela has one of the most rigid and conservative sets of regulations in the world.

On top of this, we have arrived at this extreme situation from a base, extreme on the other end of the spectrum, in which not only was the regulatory framework unduly flexible, but in which, due to the absence of adequate supervision, the regulations were practically irrelevant.

Obviously, the process of going from one extreme to the other in the establishment of banking regulations is one of the explanations for the severe contraction of our banking sector. Until only a few years ago, Venezuela’s top banks were among the largest banks of Latin America. Today, they simply do not appear on the list.

It is evident that the financial health of the Venezuelan banking community requires an economic recovery and any Bank Superintendent complying with his mission should actively be supporting said recovery instead of, as sometimes seems evident, trying to receive distinctions for merit from Basel (home of the international bank regulatory agencies).

If we insist in maintaining a firm defeatist attitude which definitely does not represent a vision of growth for the future, we will most likely end up with the most reserved and solid banking sector in the world, adequately dressed in very conservative business suits, presiding over the funeral of the economy. I would much prefer their putting on some blue jeans and trying to get the economy moving.

Published in The Daily Journal, Caracas, June 1997 and republished in Voice and Noise (2006)