Sunday, December 14, 2014

World Bank, the world urgently needs another chapter of your “World Development Report 2015: Mind, Society, and Behavior”

The World Bank argues in their “World Development Report 2015: Mind, Society, and Behavior”, that a more realistic account of decision-making and behavior will make development policy more effective. 

Indeed, and what a fabulous opportunity to ask the World Bank, in light of that report, to evaluate how expert regulators like those in the Basel Committee for Banking Supervision could have come up with something as irrational as their portfolio invariant perceived credit risk weighted capital (equity) requirements for banks… more risk more capital – less risk less capital.

Let me summarize its two main irrationalities.

Fact: All major bank crises have resulted from excessive exposures to assets that while they were being incorporated to the balance sheets of banks were considered safe, but that ex post turned out to be risky; and no bank crisis has resulted from excessive exposures to assets that while they were being incorporated to the balance sheets of the banks were considered risky, even if in fact they really turned out to be risky.

And yet: “more risk-more capital - less risk-less capital”? Should it not be the opposite?

Fact: Through interest rates, size of exposures and other terms, banks clear for perceived credit risk. To then make banks clear again for basically the same perceived risk in their capital (equity) condemns the banks to overdose on perceived credit risks. Worse yet, by allowing much lower capital against assets perceived as safe, the banks will earn much higher risk adjusted returns on equity on assets perceived as safe than on assets perceived as risky. 

And such distortion makes it completely impossible for banks to perform correctly what is its most important social function, namely to allocate bank credit efficiently to the real economy.

So how on earth could bank regulators have committed these two fundamental mistakes? And how on earth is it that so many years after the crisis exploded because of excessive bank exposures to what had very low capital requirements the causality has not been acknowledged? And how on earth is it that when clearly “risky” small businesses and entrepreneurs are squeezed out from access to bank credit because they cause the banks to need more capital this causality, again, is not acknowledged. These are questions the World Bank should help to get answers for.

In March 2003, as an Executive Director of the World Bank I stated: “Basel is getting to be a big rule book,” and, to tell you the truth, the sole chance the world has of avoiding the risk that Bank Regulators in Basel, accounting standard boards, and credit-rating agencies will introduce serious and fatal systemic risks into the world, is by having an entity like the World Bank stand up to them—instead of rather fatalistically accepting their dictates and duly harmonizing with the International Monetary Fund.”

And in April 2003, in a written statement delivered at the WB Board I wrote: "Basel dictates norms for the banking industry that might be of extreme importance for the world’s economic development. In Basle’s drive to impose more supervision and reduce vulnerabilities, 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. Once again, the World Bank seems to be the only suitable existing organization to assume such a role."

And I still hold all that. And so please, dear World Bank, as the world’s premier development bank don’t shy away from your responsibilities. Risk-taking is the oxygen of development and so these regulations are anathema to development. And by negating the risky a fair access to the opportunities of bank credit, these regulations are also impeding the world from being a more equitable world. 

As a starting point and having briefly read in this WDR-2015 about “automatic” and “deliberative” decisions system (and of course Daniel Kahneman) let me advance that those responsible for the risk weighting, automatically concluded that “safe is safe and risky is risky” and took it from there, without deliberating sufficiently on that in bank regulations, "safe could be risky and risky could be safe"; in other words without any consideration to differences in ex ante and ex post perceptions.

And as to the regulatory distortions in credit allocation these regulations could cause, and that were so blatantly and irresponsibly ignored, let me just point that nowhere in all the soon thousands of pages of Basel Committee and Financial Stability Board regulations, can we find a statement that indicates the “purpose of our banks”.

What do I specifically want? I want all those involved in writing the “WDR-2015” to tackle a rewriting of Chapter 10: “Improving the work of development professionals”, in terms of: “Improving the work of bank regulation professionals”. 

Since bank regulators can have a large systemic dangerous, or beneficial, influence on how our future is painted, the world would benefit enormously from that.

PS. I am not only referring to the developing world. Currently Europe is stalling and falling, as a direct consequence of these risk-adverse bank regulations, and so it is high time for someone like WB to remind them of what helped them to develop in the first place. Let us be clear, with bank regulations like Basel I, Basel II and now Basel III, Europe (or the rest of the Western world) would not have become what it is.