Sunday, April 19, 2015

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!


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