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For those with a quite British view of comedy and its relevance to the sub-prime market, try the youtube video over the fold.
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Now that many of the banks with some losses in the US sub-prime area have reported it may be a good time to look back at what has happened and then look forward to what is likely to happen over the next 6 to 12 months.

Current Situation

Looking back, I am glad to be able to say that I have been proven substantially correct. None of the bigger international banks have had any real problems – with most not even having this problem to cause them to drop into losses for the year, even though some have reported losses (after full write-downs) for the quarter.

Northern Rock was the only bank outside the US to suffer real problems and this was a liquidity issue – not a capital one. Inside the US several smaller banking insitiutions have failed, but these have been quite small banks that were heavily involved in the lending.

In Australia, again, none of the banks or larger ADIs have had any real problems and, after a few weeks of liquidity problems, we have largely returned to business as usual.

The ones that have had problems are the non-banks that have relied on wholesale funds to keep their businesses afloat – Rams Home Loans being a perfect example. Rams, as a business, did not fail, but they have been unable to secure funding to keep it going and had to be, effectively, rescued by one of the banks (Westpac).

Really, what this “crisis” has done is what any instability should do – prune out the weaker players and allow the well-managed and run (or just the lucky) to continue. The ones that have failed were the ones with a business model that was too reliant on other players in the market and / or had poor timing on their fund raisings. When there was instability they were the ones sitting there exposed. Again – the strong survive and the weak perish. If a firm cannot go for a few weeks withoutexternal funding then, honestly, why should they be able to survive?

As banking crises go, though, this was a puppy – if a bit of a vicious puppy.

The Medium Term

As the remainder of the US sub-prime stuff reprices over the next 6 to 12 months, though, will it get worse? In short, the answer is no. The bulk of it is still to re-price, but most of the banks that have reported have written down their entire sub-prime holdings, not just the stuff that has repriced already. The reason for this is clear – it is both prudent, and required, for them to do so.

A quick look at IAS 39 and FAS 133 (the relevant accounting standards for most of the banks) says that they have to write their assets down as soon as it looks like they have lost value.  In the case of the sub-prime stuff this has already happened. There will be some adjustments to the values over the next few months, but they can be expected to be upward revaluations as the market starts to clear of this stuff. The written down values would be the current worst case – not necessarily their expected outcome.

In situations like this banks (and other listed firms) are increasingly obeying the maxim that ou get the bad news out early, and, if anything, make it look worse that it is. The reason for this is that the market hates downside surprises, but likes upside ones. Getting the bad news out early and big is better than a situation where you just gradually dribble out the bad news.

A single, big, poor number is much better than a few smaller ones.

Banks will take a good look at their counterparties and see if they need to re-visit their lending policies, but the worst of this one can now be expected to be over.

On to the next “crisis”. A Chinese revolution anyone?

As noted in my last post on this area, working out who to deal with in some countries is very difficult. Trying to use the do not deal lists in any form of modern banking practice is very tricky and error prone at best.

A truly risk-based system, though, is going to need to apply differing weights to the differing circumstances of each deal.

Operating on the principle that no deal should be banned unless explicitly forbidden by legislation (a truly risk based system must deal on this basis) a possible, if very simple, way to organise this would be to assign differing risk weights to each deal, with the countries involved being allocated percentages.

As the risk percentage increases then higher and higher approval levels should be sought (and the regulators kept informed).

Under this system, dealing with a counterparty that the bank has been dealing with for decades, and the bank well understands the business and there have been no recent changes to cash flow may attract only a nominal risk weight – say 1%. Dealing with a new counterparty in the US would be, say, 10% and a new counterparty in a known tax haven 50%. Dealing with, say, North Korea, would attract an automatic 70%, with any North Korean government enterprises attracting an additional 30%, placing them in the highest-risk category.

Combine this with percentages based on information on other aspects of the deal and you have a system.

Deals with a total risk weight of under (say) 20% would get the usual process, with between 20 and 50% needing the sign-off of the head of risk management, deals between 50% and 75% needing CFO sign-off (and AUSTRAC notification) and deals over 75% needing Risk, CFO, CEO sign-off and AUSTRAC notification.

This sort of system would be easy to automate – at the simplest level put into a spreadsheet or simple database and could be implemented in a few days. Provided it is done on as part of the initiation of every new deal with the counterparty and updated on a regular basis (say quarterly) this should allow you to claim compliance with the relevant parts of the AUSTRAC requirements.

This is obviously going to slow down the deal process, though. Getting this into your primary databases, along with some further KYC work, will be needed for business reasons.

It is not too late to get this done by 12 December, as required under the regulations. Better hurry, though – AUSTRAC is already sounding annoyed with the apparent lack of progress. You do not want to be the one they choose to make an example of.

I would be interested in comments on this. (Warning for those on slow connections – youtube video over the fold. Read the rest of this entry »

A quick piece in today’s Bobsguide reminded me of another reason why smaller institutions, even when going standardised, need to improve their risk management in response to the implementation of Basel II. The reason is adverse selection.

As the Advanced banks improve their ability to pick the good credits and price all their lending much better they will be able to demand higher prices from the customers their systems identify as poor and give lower prices to the customers identified as good. This means that a institution offering a single price to all customers that meet a minimum standard (the current norm) will end up with, increasingly, the customers identified as poor by the Advanced banks’ systems.

This is a real problem. Banks currently lend at one price for all on the basis that, on average, the good credits will cover the bad and because the systems required to price for risk are expensive.

This implicit assumption breaks down once one or more lenders are genuinely pricing for risk – they will tend to pick up the good credits while the bad credits will tend to move to the institutions that are still offering a single credit price. This will mean that the implicit assumption on which single pricing models are built breaks down – over time, the bad credits will dominate over the good.

This trend will take time. Customers are always slow to change banks. However, proper credit pricing is no longer a nice to have – it is simply a matter of survival.

For those of us who inhabit regularly visit the Bank of International Settlements (BIS) website, today is an exciting day – the BIS have added RSS feeds. All that is really important in bank regulation on feeds. Yeahaa. Who said banking is behind the times and stodgy?

Even better, you can tailor the feeds to cover just the issues that matter to you. I my case that feed may be Basel II and Australia – but you can set up your own.

I will put the main feed on my RSS feeds down the side. Share and enjoy.

I was doing a quick round of the banking blogs that I link to from here and I thought that I cannot be getting all of the banking related blogs. If you have a favourite one that I do not know about, please put a link in the comments (no more than two per comment please – the anti-spam will pick them up). Add a few words about why you like them.

If I like the content and they look like they will be around for a while I will add a link from here.

Do not feel embarrassed about pimping your own blog – the links from other blogs drive considerable traffic both ways. Go for it.

The Reserve Bank of Australia issued updated international do not deal lists, with the consolidated version covering people from Yugoslavia, Zimbabwe and companies from North Korea. They also included a Swiss person (Jacob Steiger) on the North Korea list – presumably because they believe that Jacob has been helping the DPRK with a little bit of laundry on the side.

As a side note I doubt the use of such lists. Don’t get me wrong, they are a have to have, but is it likely that Mugabe is likely to be trying to open a bank account in Australia in his own name? Given that, at a minimum, he would be able to ask for a fake passport and other ID to be generated for him in whatever name he chose it does not seem likely to me that an Australian bank would be opening an account in the name of “MUGABE, Robert Gabriel, President – DOB 21/02/1924″ any time soon.

Anyway, if you are in operations in one of the banks checking your list against this would be a good thing to do. Do it now and you may even have it done before the APRA letter gets to you.

[UPDATE – looks like I was wrong. Jacob has allegedly been assisting in nuclear weapons activities]

Following on from the discussion in the previous post on whether bank1 deposits are money the question arises as to what happens when bank depositors try to convert their bank deposits into money – make a withdrawal, write out a cheque, pay a bill or uses any of the other methods to get at the funds. Will the bank be able to meet the demand for cold, hard, cash?

In short, how do banks manage liquidity?

The Problem

For banks, the problem is actually a fairly simple one to state. Long term, banks typically make money by borrowing short and lending long. As yield curves are typically upward sloping this works well – borrowing borrowing from people who want to deposit short and are prepared to receive between 0 and 4 or 5% to do so and then lending this to people who want to borrow to build homes and pay from 6 to 10%, run credit card balances at around 12% (or more) is a good business. With modern banking practice this even is profitable at a net interest margin of less than 2%.

Given that bank makes the most money by transforming short-dated liabilities into long dated loans the way to make the most money in the long term is to lend it all out and for as long as possible. Great strategy – with only one flaw. Some depositors are inconsiderate enough to want to be able to actually ask the bank to do what the bank has promised to do – pay their deposit at call.

The trick to making the most money, then, is to make sure that you only have enough liquid assets on hand to meet all your depositors calls on the funds and as little as possible more. This is because liquid assets pay little interest, with the most liquid, cash, paying none at all.

Getting this right is the responsibility of the ALM (Asset / Liability Management) function, usually headed by the (gloriously named) ALCO (Asset Liability Committee).

Get it wrong and, no matter how solvent your bank, if it cannot pay depositors calls you will very shortly not be a functioning institution. Read the rest of this entry »

Or – Why Murray Rothbard and the Social Credit Theorists are Wrong

One of the arguments that rumbles around some of the various blogs I read is an old one about the nature of what banks do. It pops up on a regular basis when economic theorists get involved in discussions about banking. This argument is founded in what I consider to be a misunderstanding of the nature of money itself.

To me, the argument boils down to a simple question – are deposits in banks “money”, properly so called? If it is, then banks can create money simply by accepting a deposit at call and then making a loan.

To those who are horrified at the idea that Rothbard (in this area at least) can be lumped together with the Social Credit of C. H. Douglas – sorry, but they are both wrong and for the same reason.

What follows is a short, but I believe still correct, discussion. If you want more, please raise points in the comments.

Rothbard’s Argument

Rothbard founds his argument against modern banking practice (see Chapter VII of the link – opens in new window) on what I believe to be a misconception: that when you deposit money in a bank what you have is still money, only in the form of a bank deposit, rather than a claim on the assets of the bank. To emphasise his point he calls bank deposits “warehouse receipts” as if the process of putting your money in the bank is the same as storing furniture in a warehouse.

Social Credit

The Rothbardians out there may be horrified at the thought, but he is making a very similar argument to Maj. C.H. Douglas in his Social Credit framework – that banks manufacture money. Here, in a speech to the King of Norway (opens in new window), is the clearest exposition of this I can find:

[banks] make … it in exactly the same sense that the brickmaker makes bricks, and not in the sense that Mr. Jones makes money; Mr. Jones only gets it from somebody else, but the banker makes it. The method by which the banker makes money is ingenious, and consists very largely of bookkeeping.

The social credit people then move from there is all sorts of directions, some into outright socialism and some to a position very close to (if not actually in full agreement with) the Rothbardians.

Why they Are Wrong

They are both wrong. Banks do not “manufacture” money and for a very simple reason. To use Rothbard’s analogy – when you deposit your furniture in a warehouse you pay the warehouse to store your furniture. When you “store” your money in a bank, the bank pays you. Why is this? Simple. When you loan your money to a bank you are (implicitly or explicitly) authorising them to lend that money back out to someone else and for the bank to make a return on it.

The interest I receive in lending my money to the bank is to compensate me for two main things (and several others, not important here):

  1. the time value of money, where I get compensated for delaying my use of the money while the bank uses it; and
  2. credit risk, the risk that the bank will not be able to pay me when I walk up to the bank (or now my web browser) and tell the bank I want to withdraw.

To use Rothbard’s analogy, if I was doing the equivalent thing with my furniture I would expect to get rent for it – the rent amount being to compensate me for not using the furniture for the time I do not have it and for the risk that my furniture will have been lost or stolen when I ask for it back.

To put it another way – when you deposit your money in a bank it is no longer your money. It is the bank’s money and you are compensated for this transformation through being paid interest – or at least not having to pay them a storage fee. In this I fully agree with Lord Cottenham in Foley v. Hill and Others (I am quoting here from Rothbard as the Google copy is not in text form)

Money, when paid into a bank, ceases altogether to be the money of the principal; it is then the money of the banker, who is bound to an equivalent by paying a similar sum to that deposited with him when he is asked for it . . . . The money placed in the custody of a banker is, to all intents and purposes, the money of the banker, to do with it as he pleases; he is guilty of no breach of trust in employing it; he is not answerable to the principal if he puts it into jeopardy, if he engages in a hazardous speculation; he is not bound to keep it or deal with it as the property of his principal; but he is, of course, answerable for the mount, because he has contracted . . . .

Rothbard, looking at Foley which clearly stated this principle, saw it as a disastrous mistake. I would agree if I were paying the bank to store my money. I am not, though. The bank pays me while they have it. Where do they get this money? By lending it out – therefore, when I deposit my money in a bank it is no longer my money, but a claim on the assets of the bank.

If what you want is a place to store your money and be sure that the money is safe, great. They are called safety deposit boxes and are available in the vaults of most major banks. Just expect to pay for their use.

[Update – I changed the title to more closely follow what I actually said in the post]

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