UN, World Bank, IMF, and NGO’s: Give the SDGs a fair chance. Kick out Basel Committee's bank regulations

The Sustainable Development Goals seem all very laudable, but given that bank credit is one of the most important financial resources, in order for these to stand a fair chance of being met, one would have to kick out all current bank regulators… or at least their regulatory pillar, the credit risk weighted capital requirements for banks. 

Hear me out!

Those capital requirements, where capital mostly signifies bank equity, decree more credit risk more capital – less credit risk less capital. That might sound logical, but it is not!

That means that banks are allowed to leverage more their equity (and the various sort of support they receive from taxpayers) when lending to what is perceive as safe than when lending to what is perceived as risky; which means banks can earn higher risk-adjusted returns on equity when lending to The Safe than when lending to The Risky; and which makes it impossible for banks to treat all borrowers fairly.

Specifically those bank regulations, which only single purpose is to avoid credit risk, something which has nothing to do with financing sustainability, poverty reduction or job creation, would directly impede the following SDG-Targets 

1.4: ensure that all men and women, in particular the poor and the vulnerable, have equal rights to economic resources 

1.5.a: Ensure significant mobilization of resources from a variety of sources….

2.3: equal access to… financial services… 

8.3: Promote development-oriented policies that support productive activities, decent job creation, entrepreneurship, creativity and innovation, and encourage the formalization and growth of micro-, small- and medium-sized enterprises, including through access to financial services 

8.10: Strengthen the capacity of domestic financial institutions to encourage and expand access to banking, insurance and financial services for all…

9.3: Increase the access of small-scale industrial and other enterprises, in particular in developing countries, to financial services, including affordable credit, and their integration into value chains and markets 

10.3: Ensure equal opportunity and reduce inequalities of outcome, including by eliminating discriminatory laws, policies and practices and promoting appropriate legislation, policies and action in this regard 

15.10.a: Mobilize and significantly increase financial resources from all sources to conserve and sustainably use biodiversity and ecosystems 

15.10.b: Mobilize significant resources from all sources and at all levels to finance sustainable forest management and provide adequate incentives to developing countries to advance such management, including for conservation and reforestation 

17.1: Strengthen domestic resource mobilization 

17.3: Mobilize additional financial resources for developing countries from multiple sources 

You might say that to ignore such capital requirements would put the banks at risks. Forget it! Major bank crisis do never result from excessive exposure to what is perceived as risky, these always, no exceptions, result from excessive exposures to what was erroneously perceived as safe.

Motorcycles are much riskier than cars, but much more people die when going in cars than when riding motorcycles.

If we do not want banks to take risks in order to create jobs, in order to reduce poverty and in order to help the sustainability of earth… then what the hell do we want banks for… safe mattresses would do. 

I am not much for distorting credit allocation in any way, I believe it is way too arrogant for us to pretend we know how, but, if we have to do it, I would much prefer allowing banks to hold a bit less capital when lending to something related to the SDGs, so that they make a bit more return on equity when lending to the SDGs, so that they lend a bit more to the SDGs.

Let me finalize here by quoting from John Kenneth Galbraith’s “Money: Whence it came where it went” 1975.

“The function of credit in a simple society is, in fact, remarkably egalitarian. It allows the man with energy and no money to participate in the economy more or less on a par with the man who has capital of his own. And the more casual the conditions under which credit is granted and hence the more impecunious those accommodated, the more egalitarian credit is.”

The IMF keeps on ignoring one of the prime causes for manmade inequality... the risk adverse bank regulations

In June 2015 the IMF made public a paper titled “Causes and Consequences of Income Inequality: A Global Perspective”. It was prepared by Era Dabla-Norris, Kalpana Kochhar, Frantisek Ricka, Nujin Suphaphiphat, and Evridiki Tsounta (with contributions from Preya Sharma and Veronique Salins) and authorized for distribution by Siddharh Tiwari.

Once again, one of the fundamental manmade and artificial drivers of inequality is not mentioned. I refer to the credit-risk-weighted capital requirements for banks which allow banks to earn much higher risk-adjusted returns on equity, when lending to what is perceived or made to be perceived as “safe”, than to what is perceived as “risky”, like to SMEs and entrepreneurs. 

That regulation kills opportunities and impedes banks from financing the future, dedicating them mostly to refinancing the past. Of course that promotes inequality.

Also there is no mention about the bailouts directed to safeguard the value of existing assets, which also promotes inequality, as it does not do remotely as much for those who have no assets. 

In the final remarks the paper states: “The promotion of credit without sufficient regard for financial stability, however, can result in crises, as evidenced by the subprime mortgage crisis in the United States, with disproportionately adverse effects on the poor and the middle class. Moreover, it illustrates the broader point that deep social issues cannot be resolved purely with an infusion of credit. Policies thus need to strike a balance between fostering prudence stability, and inclusion, while encouraging innovation and creativity.” 

In my opinion that is a serious misstatement of financial history. Mortgages to the subprime sector never represented major problems, until Basel II regulations in June 2004 allowed banks to hold securities against only 1.6 percent in capital, meaning allowed leverage of more than 60 to 1, as long as they were rated AAA to AA. That, as should have been expected, set of a frantic demand for, and an ensuing production of, AAA-AA rated securities. In January 2003 in FT I had written: “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”

I hold that credit risk weighted capital requirements for banks seriously distort the allocation of bank credit to the real economy. The World Bank in its Global Development Finance 2003, “Striving for Stability in Development Finance” already hinted at the distortion, since under the topic of Basel II it stated:  

“risk weights would be set for a bank’s exposure to sovereigns, corporations, and other banks based on ratings from major credit-rating agencies… the new methods of assessing the minimum-capital requirement is expected to have important implications for emerging-market economies, principally because capital charges for credit risks will be explicitly linked to indicators of credit quality… the regulatory capital requirements would be significantly higher in the case of non-investment grade emerging borrowers than under Basel I", plus finally “The current proposal places project loans in a higher risk category than corporate loans”

Unfortunately it seems this type of criticism was off-limit as it has since then been silenced.

World Bank, to help raise finance for MDGs and SDGs, suggest MDG and SDG-weighted equity requirements for banks.

Right now the banks finance more than ever what is perceived as safe, because that allows them to hold less equity than when financing what is perceived as “risky”, and so there is where they earn their highest risk adjusted returns on equity.

If the World Bank wonders how to get sufficient finance to meet the MDGs and the SDGs… then think of bank equity requirements not based on credit risk weights but on Millennium Development Goals DG and Sustainable Development Goal Weights. 

That way banks would earn higher risk adjusted returns on equity when doing good.

That would help to put some purpose back into banks… because credit risk weighted equity requirements certainly do not.

The Development Committee Communiqué, April 2015. Another missed opportunity to make a real difference

The Development Committee (DC) is a ministerial-level forum of the World Bank Group and the International Monetary Fund for intergovernmental consensus-building on development issues. Its mandate is to advise the Boards of Governors of the Bank and the Fund on critical development issues and on the financial resources required to promote economic development in developing countries.

In its Communiqué after the 2015 Spring Meetings in Washington on April 18, 2015 it included the following:

“We call on the World Bank Group (WBG) and the International Monetary Fund (IMF) to support countries’ efforts to spur inclusive growth and job creation and build resilience to adverse shocks, in order to reduce poverty, and enhance shared prosperity in a sustainable manner, and protect hard-won gains in these areas.”

And I have to ask: Why on earth can they not ask the Basel Committee for Banking Supervision (BCBS), the committee that designs bank regulations to be applied for banks around the globe, the same thing?

As is, the pillar of BCBS’s bank regulations is risk-weighted capital requirements for banks, or more precisely portfolio invariant credit-risk-weighted equity requirement for banks. And this has nothing to do with “inclusive growth and job creation and build resilience to adverse shocks”.

On the contrary, since it translates into less-risk-less-equity, and since all major bank crises in history have never resulted from excessive exposures to something perceived as risky but always from excessive exposures to something erroneously perceived as safe, it only set up the banking system to even larger adverse shocks.

Also, since it of course also translates into more-risk-more-equity it means that banks will lend less and relatively more expensive to the “risky”, like SMEs, something which kills opportunities and thereby foments more inequalities. 

In short the Development Committee should have taken the opportunity to ask BCBS to substitute for the credit-risk-weights with something more purposeful for the society. For example with the potential of planet earth sustainability, job generation and poverty reduction weights.

And indeed, since risk-taking is the oxygen of any development; and it is the future generations who most need banks to take astute risks in order for them to have a better future, the World Bank should be instructed to act as the Ombudsman for the best interests of our children and grandchildren.

The World Bank should act as an Ombudsman for our children and grandchildren

The Basel Committee for Banking Supervision (BCBS) is in charge of developing bank regulations that are applied by more and more countries around the world. That has increased the coherence and reduced somewhat the regulatory competition between countries. Unfortunately, it has also introduced a serious systemic mistake. 

The pillar of the BCBS’s current bank regulations, is the risk weighted capital requirements for banks; something which for more preciseness, should be termed the Portfolio Invariant Credit-Risk-Weighted Bank Equity Requirements. In essence it indicates: more-credit-risk-more-equity / less-credit-risk-less-equity. 

Though intuitively it sounds very reasonable, it contains two fundamental flaws.

First, the risk-weights used are based on the default possibilities of the assets of a bank, and not on a real analysis of what has caused the major bank crises in the past. In this respect it should be noted that the bank assets more likely to cause a major crisis, are not those perceived as risky, but those that are erroneously perceived as safe.

Second, much worse, allowing banks to leverage their equity, and the explicit and implicit support these receive from taxpayers, differently, depending on credit risks already cleared for with interest rates and size of exposures, seriously distorts the allocation of bank credit to the real economy. In essence it causes the bank system to lend too much and at too low rates to what is perceived as safe, like for instance to sovereigns and what I have termed as the AAArisktocracy; and too little, at relatively too high interest rates, to what is perceived as risky, like for instance to SMEs and entrepreneurs.

The origin of this mistake can primarily be traced to that regulators never really defined the purpose of our banks, beyond that of each one having to be safe. With that the regulators completely ignored that banks represent one of the most important agents through which the society distributes its savings, and the risk-taking that the economy needs in order to move forward, so as not to stall and fall.

Any regulatory interference and distortion of how bank credit is allocated, is very dangerous, and so, if it is to be considered and allowed, one needs to make certain that, at the very least, it is in pursuit of some extremely worthy purpose.

In this respect it could be illustrative, instead of credit-risk-weights, to think about the potential-of-job-generation weights, or environmental-sustainability-weights. That would allow the banks to earn their highest risk-adjusted returns on equity, financing what could most matter to us.

The World Bank, as the world’s premier development bank, must know that risk-taking is the oxygen of any development. It therefore has an enormously important role in supervising bank regulations from the point of view of how banks: promote development, allow for fair and inclusive access to finance, advance poverty reduction, generate jobs and help to bring on environmental sustainability.

The challenges loom large. Current credit risk based equity requirements, by making it harder than need be for those perceived as “risky” to access bank credit, kills opportunities and thereby promotes inequality. And, with its bias against credit-risk, it guarantees that banks will not finance sufficiently the “riskier” future, but mostly keep to refinancing a “safer” past.

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

The credit-risk-aversion present in current regulations could seem adequate for someone retired with a remaining short life expectancy. It is highly inadequate though, in fact dangerous, when set in the context of the needs of future generations. And in this respect I urge the World Bank to cast itself much more in the role of being the Ombudsman for our children and grandchildren.

And let us, somewhat older, never forget that much of what we can enjoy today, is the direct result of the willingness of the generations that preceded us to save and to take risks. We have the same duty… God make us daring!

@PerKurowski

PS. Here a statement closely related to this issue that I delivered as an Executive Director of the World Bank March 10, 2003

Reserve Bank of India: This is not so smart of you. In fact it is quite dumb.

The Reserve Bank of India has decided that Basel III standards for capital (equity) and liquidity shall apply for lenders operating in the country.

That means that in India they will keep applying the regulatory pillar of more-perceived-credit-risk-more-equity and less-perceived-credit-risk-less equity.

Which means lenders in India will be able to leverage their equity, and the support they receive from taxpayers, much more with net margins collected on loans to those perceived as “safe” than on loans to those perceived as “risky”.

Which means that lenders in India will make much higher risk adjusted returns on equity when lending to those perceived as “safe” than on loans to those perceived as “risky”.

Which means that lenders in India are doomed to lend too much at too low rates to those perceived as “absolutely safe” and too little at too high rates to those perceived as “risky”, like the SMEs, entrepreneurs and start-ups. 

That, for a developing country, does not sound so smart, in fact it is quite dumb.

And all this happens probably only so that some Indian regulators can show off in front of their colleagues in the developed countries.

But, even for developed countries that Basel pillar is dumb. It is like if a young professional setting up his retirement account he tells his investment manager: “I will pay you much higher commission on earned returns from investments in what is thought safe than what I will pay for the case of investments in what seems risky”. That will lead to excessive risk aversion and probably cause him a very poor retirement income.

Have India and other developing countries completely forgotten that risk-taking is the prime oxygen of any development?

Developing countries have clearly forgotten what made them develop… and have now, with these regulations that so odiously discriminate against the fair access to bank credit of “the risky” have call it quits, and begun un-developing.

And all for nothing since never ever do major bank crises result from excessive exposure to what is perceived as risky, these do always, no exceptions, result from excessive exposures to something perceived as absolutely safe, but that ex post turned out very risky.

PS. From some things I have heard about India, and from some experiences I have had in my country, Venezuela, it would seem that equity requirements based on closeness-to-borrower ratings could make some sense. The closer the bank, and its board are to the borrower, for instance they could be siblings, the higher the equity requirement.

It behooves us all to denounce the Basel Committee's dumb and odiously discriminating bank regulatory pillar.

Currently the pillar of regulations, peddled all over the world under the trademark of Basel Committee, is equity requirements for banks based on perceived credit risk… more risk more capital… less risk less capital.

That is extremely dangerous for all, especially for developing countries. 2 reasons:

By allowing banks to leverage more their equity when lending to the safe than when lending to the risky, banks will obtain higher risk adjusted returns on equity when lending to the safe than when lending to the risky, which results in banks lending too much at too low rates to the safe and too little at relative too high rates to the risky. And who are the "risky"? All those SMEs, entrepreneurs and start-ups everyone needs and wants to have fair access to bank credit, for the economy to grow and not stall and fall.

And all which that pillar guarantees is that whenever a major bank crisis happens, those which never result from excessive exposures to the risky, but always because of excessive exposures to the “safe”, the banks will stand there naked, with little or no equity to cover themselves up with.

The regulators should have asked: “What are the risks bankers will either not perceive the risks of bank assets, or be able to manage the risks correctly?”... and that is clearly something quite different from what the perceived risks of bank assets are.

It behooves us all to denounce that dumb and odiously discriminating regulatory pillar.

I hear you: “Could expert regulators really be that stupid?” Yes, that is perfectly possible, especially when they regulate in a mutual admiration club isolated from the real economy.

For instance, when was the last time you saw a small business owner or an aspiring not yet successful entrepreneur in need or bank credit in Davos, or being heard out by the Basel Committee or G20's Financial Stability Board? 

 

I prefer one and the same equity requirements against all bank assets, because for me it is always dangerous to distort the allocation of bank credit to the real economy.

But, if regulators absolutely must distort, in order to show us they are earning their salaries, then let us please ask them to substitute with potential of job-creation-ratings, sustainability-ratings, or any other rating of what could be the purpose of a bank, for those useless credit ratings which are already considered by bankers when giving the loans, and should therefore not be considered again in the equity.

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

God make us daring!