I often wonder why the level of understanding of the banking system and banking history at central banks is so low. Last week I mentioned this study that concluded that private money issuance is inherently unstable, despite all the available evidences that contradict this conclusion. Overall, the mistrust that central banks have towards free markets is frightening.

Vítor Constâncio, ECB Vice-President, is an expert at this game. His April speech titled Financial regulation and the global recovery cannot be more typical: all new regulations are effective, needed and actually have a ‘beneficial impact’ on economic growth (which, obviously, needs a ‘safe’ banking system that new regulatory measures indeed provide), and macro-prudential policies are exactly the tool needed for the clever and omniscient men in central banks to guide us, mere ignorant, risk-prone private market actors. Never ever does Constâncio even slightly question the measures taken over the past years. Everything is for the best in the best of all possible worlds. The whole speech makes for a quite uncomfortable, and depressing, reading. Pretty much everything he says is questionable (though it’s not the first time, far from that, see here). It seems like the ECB needs its own Andy Haldane, a (light) contrarian who dares questioning what the institution does.

But what’s really scary is central banker’s belief that finance was ‘deregulated’ since the 1980s, and that this was the cause of our boom and bust. As central bankers, and supposedly experts on banking, they should know that it is not the case. Constâncio says that we should not “return to deregulation and boom-bust cycles.” In a recent speech, Olsen, governor of the Norges Bank, declared that the crisis “showed that, left alone, the financial system is prone to excessive risk-taking.” I’m sorry but when has the financial system ever been ‘left alone’ since the old days of the free banking era (and only in a limited number of countries)? Certainly nowhere in the world over the past 80 years.

Equally, Sabine Lautenschläger, member of the ECB Executive Board, in another speech said that “after a long phase of deregulation, a comprehensive re-regulation has been in vogue since 2009.” Again, what ‘long phase of deregulation’? I’m still trying to figure out whether those central bankers and I have been living in the same world. Then she adds that she does “not believe in self-regulation, at least not in financial markets. You cannot have stable and functional banks without comprehensive regulation and energetic supervision.” Central bankers’ mistrust of free markets is startling*.

Philip Booth, from the Institute of Economic Affairs, just published a new report titled Thatcher: The Myth of Deregulation. Absolutely recommended reading. While the report only focuses on the UK, its conclusions are easily applicable to most of the Western World, especially Europe. Moreover, the report purposely avoids speaking about banking regulation, which has witnessed a boom from the 1980s with the worldwide introduction of Basel 1. But, as Booth makes clear, all other aspects of financial services became more regulated during and after Thatcher’s ‘Big Bang’ reforms. In his words:

Big Bang itself was undoubtedly an act of deregulation – but not in relation to state regulation. It is better seen as an act of prohibition. Big Bang prevented private regulatory bodies from developing their own rules for the benefit of their members and, arguably, wider society. This was one of two acts within the financial sector – the other being the abolition of the maximum commission agreement amongst insurance companies – where the power of the state was used to prevent private-sector rule setting on competition grounds in a way that led to unfortunate consequences. It could also be argued that this prohibition on private rule setting then led to government regulatory agencies filling the gap and doing so in ways that involved granting effectively unlimited powers to a statutory regulatory bureau or to a body that was ultimately accountable to politicians rather than to participants in the market. Certainly that is exactly what happened in the years that followed Big Bang. […]

Soon after Big Bang – the act of prohibition of private regulation – there was a huge extension of the statutory regulation of securities markets as a result of the Financial Services Act 1986 which came into operation in 1988. It is impossible to go through all the requirements of the regime in detail in this brief paper. Goodhart in Seldon ed (1988) suggested that just one rule book relating to one aspect of regulation that was developed as a result of the 1988 Act weighed around two kilograms. The Act itself is reproduced in 230 pages in the standard textbook by Wedgwood et al (1986) (not including the associated regulations). Regulation of this extent, detail and prescription had never been known before in the financial sector in the UK.

Add in the whole Basel banking rulebook, and subtract some actual banking deregulations that have happened (mostly in the US, like interstate banking limitations or interest rate cap on deposits, as well as reduced controls on UK-based building societies), and you end up with a financial system whose regulatory framework has largely boomed on a net basis between the 1980s and the financial crisis.

So much for deregulation and so much for central banker’s arguments, which seem to rest on the erroneous believes that 1. banking crises originate in Mynsky/Post-Keynesian-style endogenous imbalances and, 2. that finance has been deregulated since the 1980s. In short, facts seem to get distorted to ‘accommodate’ central bankers’ convenient rhetoric. By supressing a legitimate debate, this renders a disservice to society as a whole.

PS: Martin Taylor, of the BoE, dismisses all critics of ring-fencing as people who “have either failed to understand it or have chosen not to”… He of course doesn’t address any of the points I made in this year old post.

PPS: Glasner has a post on Is finance parasitic? that demonstrates he has a limited understanding of finance. Finance becomes parasitic when regulation and interest rates below their natural Wicksellian levels make it that way.

*Admittedly, unlike Constâncio, both Olsen and Lautenschläger seem to acknowledge some of regulatory and macro-prudential limitations. As does Taylor:

Charles Goodhart and others have pointed out that macroprudential policy, while intended by its very nature to be counter-cyclical, generally turns out to be the complete opposite. Put simply, we tend to tighten regulatory policies straight after a financial crash, when the economy is so weak that – all else being equal – we should prefer to loosen them.

Here are a selection of a few interesting articles for you to read on the weekend.

• Engadget reports that there is now a bitcoin-like system for real gold trading purposes. The gold is stored in various vaults and you are allocated a share of it every time you buy this gold-backed cryptocurrency (however, forget the last paragraph of the article, which is economic nonsense made in Engadget).

• Moldova decided to restrain inflation by… raising reserve requirements. What fools! They’ve clearly never heard of the endogenous and MMT theories! Unless…

• Benoit Coeuré, one of the top ECB officials, revealed some ECB plans to a selection of hedge funds/investors way in advance of the publication of his speech on the ECB website. Easy profits when you’re one of the privileged few… Funnily, regulators would have literally jumped down the throat of the private company that would have done exactly that. But the ECB? Well, you know, it just happens. No big deal really.

• Margin compression, margin compression, margin compression… HSBC just declared that it would start charging other banks for depositing non-GBP currencies at the bank. Who said negative rates were helping the financial sector?

• BuzzFeed writes that online lenders could “take billions of profit away from big banks.” It quotes a recent Goldman Sachs report which estimated that $4.6Bn of banking profits could be lost to P2P platforms, which could capture 15% of the consumer loan market (see my recent post that refers to a recent report by another investment bank, Morgan Stanley, on the exact same topic).

A few weeks ago, I mentioned a new KPMG report describing the evolution of the current bank regulatory framework. The consultancy published its ‘Part 2’ a couple of weeks ago and it is interesting reading.

KPMG effectively reaches similar conclusions to the ones of this blog: the current regulatory framework makes it uneconomic for banks to extend credit to corporates (small to large), and the structural separation of investment and retail banking activities is nonsense.

In the case of corporate lending, KPMG points out that “many SMEs are disillusioned with banks, leading them to seek alternative channels of borrowing, including peer to peer lending.” This sounds spot on: regulation has always been self-defeating by driving financial activities into the shadows. And, coincidentally, Morgan Stanley just published a large report on P2P lending (which they call ‘marketplace lending’ as it’s not really P2P anymore…) forecasting that it could reach 10% of total unsecured consumer and SME lending in the US by 2020 (with other countries, in particular the UK or China, to follow).

Perhaps this is the key to unlocking corporate/SME lending growth and getting rid of this secular stagnation theory.

Partly mirroring the arguments I developed in a series of posts starting here, KPMG’s arguments against the structural separation of the various activities of banking are worth reproducing here in whole:

On his new blog Alt-m, George Selgin points to a piece of academic research published last year about ‘The Limits of Model-Based Regulation’, from Behn, Haselmann and Vig. This paper is very interesting and illustrates quite well how regulatory capital ratios are distorted by the use of math models encouraged by Basel 2 and 3 regulations. It nevertheless suffers from a few questionable conclusions, although those remain minor and do not affect the quality of the rest of the research.

As I described a long time ago (and also summarised in this paper), banks can calculate the risk-weighs they apply to their assets based on a few different methodologies since the introduction of Basel 2 in the years prior to the crisis. Under the ‘Standardised Method’ (which is similar to Basel 1), risk-weights are defined by regulation. Under the ‘Internal Rating Based’ method, banks can calculate their risk-weights based on internal model calculations. Under IRB, models estimate probability of default (PD), loss given default (LGD), and exposure at default (EAD). IRB is subdivided between Foundation IRB (banks only estimate PD while the two other parameters are provided by regulators) and Advanced IRB (banks use their own estimate of those three parameters). Typically, small banks use the Standardised Method, medium-sized banks F-IRB and large banks A-IRB. Basel 2 wasn’t implemented in the US before the crisis and was only progressively implemented in Europe in the few years preceding the crisis.

So what are the effects of those different regulatory capital frameworks? First, they found that

At the aggregate level, we find that reported probabilities of default (PDs) and risk-weights are significantly lower for portfolios that were already shifted to the IRB approach compared with SA portfolios still waiting for approval. In stark contrast, however, ex-post default and loss rates go in the opposite direction—actual default rates and loan losses are significantly higher in the IRB pool compared with the SA pool. […]

The loan-level analysis yields very similar insights. Even for the same firm in the same year, we find that both the reported PDs and the risk-weights are systematically lower, while the estimation errors (i.e., the difference between a dummy for actual default and the PD) are significantly higher for loans that are subject to the IRB approach vis-a-vis the SA approach. […]

Interestingly, we find that the breakdown in the relationship between risk-weights and actual loan losses is more severe the more discretion is given to the bank: while the same patterns are present for both F-IRB and A-IRB portfolios, the results are much more pronounced for loans under the A-IRB approach, which is clearly more complex and accords more autonomy to the bank.

This is pretty interesting. This demonstrates that Basel 2 (and 3) rules provide incentives to game regulatory reporting in order to maximise RoE (more on this below).

They also noticed that:

[On aggregate] to dig deeper into the mechanism, we examine the interest rate that banks charge on these loans, as interest rates give us an opportunity to assess the perceived riskiness of these loans. Interest rates in the IRB pool are significantly higher than in the SA pool, suggesting that banks were aware of the inherent riskiness of these loan portfolios, even though reported PDs and risk-weights did not reflect this. Putting it differently, while the PDs/risk-weights do a poor job of predicting defaults and losses, the interest rates seem to do a better job of measuring risk. Moreover, the results are present in every year until the end of the sample period in 2012 and are quite stable across the business cycle. […]

[Moreover, at granular loan-level] the interest rates charged on IRB loans are higher despite the reported PDs and risk-weights being lower.

This is also interesting, although I suspect partially wrong (and to be fair, they do point that out). Indeed, the German banking system is very peculiar, with small public-sector and mutual banks (likely on Standardised) having a very large market share and usually able to underprice much larger commercial banks (likely on IRB) thanks to the lack of pressure on them for profitability. Interest rates are thus likely to be understated for Standardised banks. The only way to confirm the researchers’ feeling that IRB banks charged more than Standardised ones because they knew their portfolio to be riskier is to re-run the analysis on a country with a more ‘standard’ banking system.

What is their conclusion?

All in all, our results suggest that complex, model-based regulation has failed to meet its objective of tying capital charges to actual asset risk. Counter to the stated objective of the reform, aggregate credit risk of financial institutions has increased. […]

Our results suggest that simpler rules may have their benefits, and encourage caution against the current trend towards higher complexity of financial regulation.

I cannot but only agree with this statement, despite having some doubts about the validity of their interest rate argument as explained above.

However, I will have to differ with the researchers on one particular point: that the differences we see between Standardised and IRB banks is mostly due to banks trying to game the system. Their reasoning is as follows: Basel 1 had excessively strict risk-weights, leading to ‘distortion in lending’ (absolutely agree). But the flexibility provided to banks by Basel 2’s model-based framework gets rid of this distortion and the issues described above are pretty much due to banks only (this is where I disagree).

Why do I disagree? Because of reasons I have explained before, and that are also explained within this paper: regulators validate models. Consequently, models are biased to match regulators’ expectations and biases in the first place: as it is very unlikely that regulators will consider corporate lending as less risky than real estate lending, they are also unlikely to validate a model that would do exactly this (or at least narrow the risk parameter differential). As a result, for capital optimisation purposes, banks tend to exacerbate the risk differential between those two lending types (or at least maintain the original Basel 1 risk-weight differential), in order to get regulatory approval*.

So what we’re left with is an increasingly opaque regulatory system that incentivises banks to optimise capital usage with the actual support of regulators (often against shareholders), distorting credit allocation in the meantime. Sounds effective.

*And this is exactly what the authors of this piece say!

Risk models were certified by the supervisor on a portfolio basis, and supervisors delayed the approval of each model until they felt comfortable about the reliability of the model. […]

Banks have to validate their models on an annual basis and adjust them if their estimates are inconsistent with realized default rates (see also Bundesbank 2003). Further, risk models have to be certified by the supervisor and banks have to prove that a specific model has been used for internal risk management and credit decisions for at least three years before it can be used for regulatory purposes.

PS: They also provide the following interesting chart. The same way that the introduction of RWAs triggered a real estate lending boom, at the expense of corporate lending, the introduction of Basel 2 led to a lending differential between IRB banks, which could optimise capital usage, and Standardised banks, potentially exacerbating the original real estate/corporate lending dichotomy introduced by Basel 1.

PPS: Sorry not many update recently despite having quite a lot to say… I just can’t seem to find the time to write those posts for some reason.