Prompted by a few recent debates I feel some clarity on why banks actually exist would be interesting. The glib answer is “to make profits by borrowing and lending” - although many would put it in terms much more offensive than that.

Why are these profits available, though? What actual function does a bank perform? In short, what economic use is a bank? Read the rest of this entry »

I was re-reading last week’s The Economist last night when I happened across the Buttonwood column that I had missed on my first pass. The title, “Heart of Glass” was not promising, but the tagline was very interesting - “Existing regulation seems to encourage banks to get into trouble“.

Buttonwood makes the very valid point that, despite often being derided as the “Wild West” operators, the hedge funds have come through all this (so far at least) without too many major losses. Only a very few have failed (I can think of only one so far, although I am sure there are more) and there have not been many major losses announced.

Banks, on the other hand, have not had a good record. Apart from actually being behind much of the lending that actually caused the issues in the first place the big losses also seem to be concentrated there - just not in the banks that originated the loans. The question Buttonwood asks, but ultimately shies away from is this - is this despite, or because of, the regulations?

Buttonwood puts it this way:

This suggests two main possibilities. Either the standard of bank regulation is very poor or there is something about being regulated that leads to trouble.

The answer from Buttonwood is that it is both - but clearly puts more weight on the first. I would, respectfully, disagree on where the weight should lie.

There are many faults with bank regulation around the world - Basel I, for example, I regard as having improved matters to the extent it was global, but made matters worse by its reliance on simple rules - for example that a loan secured on residential real estate shall attract a 50% weight - regardless as to whether it was super-prime, prime or sub-prime. It also created strong incentives to “game” the system by the “originate and distribute” model that really gave rise to securitisations. This gave a logical reason why a bank may choose to eliminate assets from its balance sheet (other than the possibility they were bad assets) and the market for these assets grew - and ultimately the market got fed some rubbish oops, I mean high-yield assets.

Basel II, particularly the Advanced methodologies, is much better in that economic capital is much closer to regulatory capital - a point I have made many times. It is, however, nearly impossible for smaller banks to implement and most regulators have also said that, to an extent at least, Basel I will effectively continue to apply for a while through the capital flaws floors.

The incentive to game the system, then, will continue, particularly for the banks going Standardised. There are also many other examples of regulations that, while possibly carefully thought out, end up causing many more problems than the one they were originally designed to stop (submissions invited in comments).

Buttonwood’s proposed solution is, essentially, to re-introduce the US Glass-Steagal Act of 1933, essentially separating commercial banks (that interact with the general public) and investment banks (that do not). The commercial banks would attract a government guarantee and the investment banks would be free to fail. Entities like Citigroup would have to break themselves into two.

In the (probably too many) years I have been dealing with bank regulation I have seen it fall into several categories - ranging from the ones that simply mandate what would otherwise be common sense to the merely annoying to the outright catastrophic. The last ones tend to be introduced and then pulled pretty quickly.

Some of it is needed for legal or criminal purposes - AML/CTF falls into this category. For the rest I would like, as I have said earlier, to see the regulation substantially removed (or at least pared back) and solutions other than a single monolithic regulator for each country to be tried. If a single regulator gets it wrong now the whole system is at risk until the government rides in on its White Charger - see Northern Rock. A truly competitive system would not allow a single regulator to have that much downside on its failure.

Interesting article (possibly behind the paywall) in Friday’s the Economist on the causes of the lax lending standards that have subsequently blown up. It points to some research by Atif Mian and Amir Sufi of the University of Chicago’s graduate school of business which points the finger directly (and unsurprisingly) at the process of securitisation, where the loan assets were parcelled up and sold off with little or no residual risk being held by the originator of the mortgage (i.e. the lender).

While this is the consensus on why this happened, the evidence presented is useful and should allow for these deals to be better structured in the future - with a fair amount of the residual risk retained by the actual lender.

Perhaps the first question that purchasers of such instruments should ask in the future is how much of the risk is with the originating lender - and do not touch it if the answer is either “not much” or “none”. The actual lender should be in the first loss (or “equity”) position for a reasonable amount.

The speech given yesterday by the Archbishop of Canterbury is interesting - to say the least. He goes in great depth into many of the issues confronted by those trying to give some effect to Sharia in Western jurisdictions. For those interested in the area a close read is worthwhile. While his focus, given his background, is on family and allied areas of law, he does touch on other issues.

This blog’s focus is on financial matters I would be interested in feedback on the questions of what real impediments are there in Western (and in particular Australian) law to allowing Sharia to govern financial arrangements? Given there is wide freedom of contract (within the regulatory limits) I am not aware of many contractual problems - provided the parties to a contract agree to the terms then generally the courts here will enforce it - regardless of whether it is founded on Sharia or not.

Regulatory and taxation issues seem to be the big ones - the banking regulatory system as it stands essentially does not cope with many Sharia compliant frameworks.

A good example of this is a Sharia compliant mortgage institution, which would not be allowed to treat its mortgages in the same way as interest bearing ones and would be effectively penalised with a much heavier capital load. This can be fixed, though - the IFSB regulatory framework could be allowed in the same way that the Basel II one has been.

Insurance would be another regulatory issue. A Takaful structure is also not coped with under current APRA standards - but there is no reason why they cannot be. In theory at least, because a Takaful insurance structure is truly mutual it should be less likely to fall over that a traditional Western insurer.

Funds management and superannuation I have dealt with previously, but as these can be dealt with under the “ethical” banner these should be the least trouble of all.

Taxation is an issue. Like the UK, the  tax law is not set up here for many of the Sharia structures - with the bond-like instruments a particular example. Again, like the regulatory issues, and like the UK, these could be dealt with through fairly simple legislative changes.

On question that often arises from situations like the recent, unusual, drop in US interest rates and the stimulus package to support the markets is one of moral hazard. Simply put, the question is whether the tendency of the monetary regulators to respond to widespread market drops with action to push more cash into the system creates moral hazard - a willingness to take more risk in the knowledge that the US Fed (for example) will ride in on a White Charger and help.

My answer is that routine “While Charger” action certainly does create the impression that the “Greenspan Put” is a way out of bad decisions - there is always in the back of the mind the thought that the regulators will act to stop “long-tail” events.

Does this impression actually show through into the real world, though? As the market is really a series of micro events that go to make up a macro picture I would doubt it would have a large impact. To put it another way - will the thought that the Fed may act to bail out the market change the way an individual bond issuer or buyer behaves? If I am considering changing a bond position worth maybe a few million I am really going to consider the possibility of an industry wide bailout if an entire class of assets heads south? Will the thought that the Fed will change rates in the event of a general collapse change the way I trade?

Personally, I doubt it. The individuals actually trading can never really tell whether their position is going to be one of those actually rescued by a general interest rate drop or other action. The only point where this may become a thought is where there is already a widespread drop - but in this circumstance the action would be to point the dealers out of the drop, not into it.

That said, it may affect the risk appetites of the largest of players such as the really big banks, so there is certainly a risk of it. I just think it is overstated by people who look at the macro effects of moral hazard and think that the markets act as some sort of a collective intelligence, rather than looking at it as a series of micro events, which, in reality, it is.

For those interested in how regulatory prudential policy interacts with monetary policy around the world, you could do worse than go to a new paper produced by the Monetary and Economic Department of the BIS.

Introductory paragraphs:

It has long been recognised that that there is a strong complementarity between monetary and prudential policies. A sound financial system is a prerequisite for an effective monetary policy; just as a sound monetary environment is a prerequisite for an effective prudential policy. A weak financial system undermines the efficacy of monetary policy measures and can overburden the monetary authorities; a disorderly monetary environment can easily trigger financial instability and render void the efforts of prudential authorities. Economic history attests to this, as illustrated by the anatomy and consequences of the financial crises that have affected the industrialised and developing world, going back to previous centuries.
So much is agreed. What is more contentious is the view that some fundamental changes in the economic environment over the last quarter of a century may actually have tightened the interdependence between monetary and prudential policies, potentially calling for significant refinements in policy frameworks. In some research at the BIS in recent years we have been exploring this possibility in some detail.

I, personally would disagree with what is “agreed” above - to me, the contrast between “weak” and “sound” is a false one - a “sound” prudential policy can also be a “weak” one, such as using a free banking paradigm and allowing competitive non-state regulators. The “agreement” here is more likely to be amongst regulators and others in the regulatory industry.

That said, within the confines of the current system this is a very useful paper, even if it needs a little bit more proof-reading^*. The authors’ access to data and people looks very good and the conclusions they have drawn out of the data and their references look useful.

The real “meat” here, though, is in the tables starting on page 20 - the analysis of the response of regulatory authorities to various financial events over the last 10 to 15 years. The last column in the table could be fuel for weeks of blog posts and discussion. The annex is also useful, being a “first pass” at assessing the impact of the measures taken. Again, for those interested in the area, this stuff is highly contentious, but this analytical framework is a useful one - comparing those countries with took both prudential and monetary approaches to tackling what was viewed as an imbalance to those which only took a prudential measures and looking at the results.

I am not strong enough in statistics to fully evaluate the results, but the methodology looks sound. If you are interested give it a look - and if your stats knowledge is better than mine feel free to give some feedback.

*Last time I checked it was the United States that had an S&L crisis, not the “Untied States”.

The blog debate on the practicalities, or otherwise, of “fractional reserve” continues. The more informed debates also make the point, correctly, that it is not just “fractional reserve” in there, but the whole question of maturity (or term) transformation. If you are interested I would like to compile a listing of current blog debates.
These are the few I am aware of - feel free to link to more in comments. Just be aware that if you put more than 2 links into a single comment I will have to rescue it from moderation. Not a problem, it will just take a bit of time.

• Catallaxy: “Rothbard and the Social Credit Theorists” has restarted after a bit of an hiatus.
• Unqualified Reservations: “A straightforward explanation of the current credit crisis, part 1” explains the process well - but just to re-iterate, I disagree. The debate is considerably more civilised, though.
• Marginal Revolution: “New money does not have to enter the loanable funds market” seems to confuse Rothbard with the whole of Austrian economics, but is worth a good read.

Those are the three that I am aware of that are currently active. If you know of more, let me know. I know this is not strictly bank regulation, but I enjoy the topic.

Normal service on banking regulation will resume one I have completed a current job at one of my clients.

My earlier piece on Rothbard and Social Credit sparked off a long thread on another blog. One of the arguments made over there was that, in the absence of much other regulation, “fractional reserve”, as Rothbard understood it, simply could not be effectively banned.

Rothbard’s (and the Social Credit mob) saw fractional reserve as an evil thing as it allows banks to create money, as it is commonly defined - in that accepting a call deposit and then making a loan from the funds deposited effectively creates money. Both the deposited funds and the loan funds are money - so the bank has created money. I explored this a bit further on the earlier thread and so will not go into it here.

The point I would like to raise here is whether, in the absence of much other regulation, it can just be banned. My point is this. Say a government (for some odd reason) decides to agree with Rothbard and then bans the maturity transformation of call funds. I believe there will be a couple of major problems with this:

1. Firstly, the legislation would have to define “call” precisely. Once you think about this is becomes, to me at least, a tricky thing. How long a call period, and under what conditions, means that a deposit remains “money”? Is it only instant call, 1 second call, 1 hour call, 24 hour call, 11am call or what? Additionally, would a term deposit (of, say, 12 months) that has a call option with penalties remain a  term deposit or does the call option render it a call deposit? If so, what penalties would be needed to make it a “term” deposit?

2. Would the banks not just walk around this anyway? Say the call period decided upon was one week. Could the customer not just deposit funds on one week term and the bank then just grant a revolving line of credit up to the value of the deposited funds, effectively allowing the customer full access to the total value of their deposit (and creating the same effect as an instant call deposit) without breaking the legal definition of “call”?

To me, the only things keeping banks within any mandated ratios that they could walk around are:

1. The ratio is set at a point where the bank would keep it anyway, such as a typical 7% reserve asset ratio (or 9% HQLA in Australia); or

2. The regulators have lots of other tools that the banks fear so they do not bother to try.

Rothbard imagined a world where the “fractional reserve” could be banned and then other regulations become unnecessary.  I cannot see how he could be right.

I am gradually coming to a general rule on actually reading the speeches published by the BIS - the less interesting the title is, the more likely it is that the speech is actually worth reading.

This one “Some thoughts on securitization and financial turbulences” by Jean-Pierre Landau, Deputy Governor of the Bank of France, is a good example. Fairly boring title - quite good content. His (or, more likely, his underling’s) analysis is robust, with a good idea of what happened over the last few months. He is also right that the worst is currently behind us as the real problem was always the liquidity freezing up, not the size of the actual losses.

Where I feel he is wrong, though, is in the policy prescription:

Strong capital will not guarantee liquidity in all circumstances. There can be panics and sudden increases in the demand for liquidity. That’s the job of Central Banks to help in those circumstances. But a strong capital base in the system – and in all its components – is likely to limit future liquidity shocks.

The first two sentences are perfectly correct. Capital is simply not a substitute for liquidity. The next two, though, are wrong - and they do not logically flow from any of the analysis in the rest of his “Thoughts”. Bank regulators commonly get fixated on capital as the be-all and end-all of bank risk management. The attitude commonly seems to be more risk (of any type)? More capital needed. Liquidity, though, is not improved by having more capital; in fact, it may be hurt.

The best capitalised bank in the world will not be able to pay its debts as and when they fall due without liquidity - i.e. it will be bankrupt. Liquidity management is, and always should be, considered separately from capital management.

He is right that a well capitalised bank will find it easier to get liquidity in a liquidity poor market - but Northern Rock was, by the standards of the industry, well capitalised and profitable. Having to go to the Central Bank (the Bank of England) was what destroyed them. Adequate liquidity would have meant that they had no problems and no need for the Bank of England’s help.

The message? Good capital will help - but in a liquidity crisis what you actually need is liquidity. Also, don’t always believe that a Central Banker is right.

After several interesting and, on other blogs at least, long discussions on the nature of money, my view on what money is and why it matters has changed and, in some aspects at least, hardened.

What I remain agnostic on is the need for commodity money - returning to the gold standard or some other commodity. The efficiency of fiat money appeals to me - there is no need to confuse money with gold (or silver), nor is there any need to store anything against the possibility that people will want to redeem their notes and coin for the commodity.

The upside of commodity money is the discipline - the need for the currency issuer to ensure that they will be able to meet any call. This imposes at least some limits on how much they should actually issue. Without it being fully backed, though, there is a long history of governments, at least, cheating on this. The history extends from the collapse of Bretton Woods in the early 1970s to the over-issue of assignats in revolutionary France and past that in many places.

The point to note here is that, as far as I can see, this sort of cheating has been largely restricted to government issuers - but this may just be because private issuers have been rare over the last few centuries.

In the rest of this post, though, I am interested only in the current position - not anyone’s ideal of where we need to get to.

Monetarism

Perhaps a good starting point for a consideration of money is the economics school that focused (or obsessed) on it. A crude monetarist position runs from the old MV=PQ¹ equation - the theory being that since V and Q only changed slowly and predictably, changes in the money supply would directly feed through the general price level. Clear enough - if you know what the money supply is.

Many monetarists took M3 to be the most reliable broad measure. This is normally defined as being:

• M0: The total of all physical currency, plus accounts at the central bank that can be exchanged for physical currency.
• M1: M0 - those portions of M0 held as reserves or vault cash + the amount in demand accounts (”checking” or “current” accounts).
• M2: M1 + most savings accounts, money market accounts, and small denomination time deposits (certificates of deposit of under $100,000).
• M3: M2 + all other CDs, deposits of eurodollars and repurchase agreements. (Thanks Wikipedia)

Other publications

As “Jim” noted in comments on a previous post on this topic, most, if not all, of the textbooks on this topic are adamant that banks create money - he was right in this - but the question is whether they are right, and whether it matters.

By the traditional calculation of the money supply above, he and they are right. Any simpleton can see that, if a bank accepts a demand deposit and then makes a loan on the back of it, the money supply, as calculated above, has increased. The deposit is still money, the loan out (once drawn down) is money, ergo money has been created.

The issue

The problem I have with this is a serious one - are all bank deposits truly “money”? There are probably as many definitions of what money is as there are people - but let’s use this one for the moment:

Money is anything, which has reached such a degree of acceptability, no matter of what it is made, or why people want it, no one will refuse it in exchange for his goods if he is a willing seller. (Professor Walker - Money, Trade and Industry) (thanks to Jim again)

Now, look at bank deposits and some of the other things in M3. Would someone seriously take my bank deposit or CD in exchange for his goods? No. He or she will normally accept cleared funds of one description or another, but not my bank account - there is no real way I can transfer that, other than changing the name on the account, which would be silly. They may accept a cheque, but if it is not met at the bank then I still owe them money (and the bank some additional fees).

The M3 calculation also fails to take into account banking practice, or even the transaction processing ability of banks. If all of the bank deposits, CDs, eurodollars were suddenly to be used for transactions the system would simply collapse - not only because there is not enough physical cash to redeem them all but also because the system would not be able to process that much at once - or even over a few days.

The practice of banks of borrowing short and lending long also, to me at least, makes the bulk of the amount in deposits less than fully “money”. Any given depositor can normally withdraw all of his or her funds, but, as we saw with Northern Rock, if all the depositors appear at once for their “money” there are serious problems.

If much of the amount in the banks cannot be used for transactions, are they still money? Should we only regard the amount held in banks as liquid reserves - or even only the expected daily funds usage as money?

Why does it matter?

Application

In some ways it does matter - and in other ways not. From an individual’s point of view it does not matter - and this was my previous point of view. In practice, I can go and get “my money” from the bank and spend it - using any one of several differing methods. It does not matter if some economist somewhere thinks of it as money or not.

From an bank’s point of view it probably matters only as far as the ALM² function cares - can we meet expected or stressed withdrawals?

From a central bank’s point of view, though, I was wrong - it may be important. Government central banks are now typically charged with maintaining the general price level (remember P above?). The clear result of the obvious disconnect between all of the monetary measures (including M3) and the general price level has resulted in the dropping of monetary targeting and the use of (a measure of) inflation targeting using interest rates to achieve this.

The problem is that the measure of inflation being used is never going to be able to encompass all (or even much) of the detail of a modern economy. Typically, they also ignore asset prices as they are difficult to incorporate. As a result, P is difficult to calculate, much less target. Consumer Price Inflation is typically used as a proxy

Hypothesis

One possible reason for much of the disconnect between the calculated money supply and the (much lower) growth in measured inflation is due to the steadily dropping reserve ratios of banks - and therefore their increased lending ratios. The lower reserve ratios have been driven by improved ALM within the banks - the assets of the banks are sweating more and the amount of needed as liquid reserves is reducing. Deposits, though, are still needed to allow the lending. This means that, using M3 as a measure, the money supply is bounding ahead - but inflation is comparatively static.

If this hypothesis is correct, a better way to calculate the money supply would be to include only physical currency not currently in the hands of the banking system and the amount held at banks and available for either deposits or withdrawals - these being the only amounts that are truly liquid within the system and therefore the only components of M that are actually able to be used for transactions.

Is this useful? Probably not. But I have enjoyed thinking about it.

1. Money supply times Velocity equals the general Price level times the Quantity of transactions. I know the arguments were much more detailed than this, but this is a blog post, not a textbook.

2. ALM - Asset and Liability Management - the function of the bank that is primarily charged with ensuring the bank can continue to pay out what it owes and making sure the assets of the bank make enough profit to keep the res of the show going.

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?

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 »

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]

It is always interesting to see bankers, and in particular central bankers, lift their eyes from the day to day and have a look at the long term. Most of the time this is a view forward - which will hopefully be forgotten by the time that the predictions are meant to have come true by as they are frequently embarrassing to look back on.

Someone looking the other direction, which is a much safer option, is Ric Battellino (Deputy Governor of the RBA), in a speech given to the Finsia Banking Conference last week. Unfortunately, it glories in the really boring, almost Greenspanesque¹, title of “Some observations on financial trends”. In it, Ric has a look at the long term growth patterns in the credit market over the last 30 years, with some glimpses further back to look at whether the growth in credit is sustainable.

The argument, backed up with a strong look at the statistics, is that credit growth to households has been artificially suppressed by bank regulation and that, far from being an unsustainable credit bubble, the current period of credit growth is simply a logical result of consumers and suppliers reacting to the relaxation of regulation and increase in financial innovation. It is therefore sustainable. Read the rest of this entry »

The seeming desire on the part of our politicians to regulate practices known as “predatory lending” simply does not stack up. I say this for a number of reasons:

1. Other than a few anecdotes¹ there is no real evidence that this is commonly happening in Australia.
2. It is covered in any case by the UCCC (Uniform Consumer Credit Code) unless people sign a document stating the loan is for business purposes.
3. A new regulatory regime is not going to be cheap.
4. There is no evidence it is going to help in any case.
5. There is in fact good evidence that “usurious” lending actually helps the borrower.

Regular readers here would know that, while I work in one of the more regulated industries, I generally oppose more regulation and believe that regulation should be minimised and only added to where there is evidence it will help. Basel II is an example of this - while much larger than the regulations it is replacing, the movement towards a truly economic base for regulation is a good thing.

Going back to Middle Ages style usury laws is not. If there might be a serious problem, let’s check it out first. Come up with some evidence it is a problem. work out whether the regulation is going to cost more than the problem does etc. etc. etc. You know, the basic stuff that should be done before you add an additional burden on us all.

1. And remember, the plural of “anecdote” is not evidence.

OK - bit of a sensationalist headline, but the point I would like to make here is a valid one. The current drops in the markets can easily (and correctly) be put down to a big failure in risk management - in one or more of credit risk (for the institutions originating the loans), market risk (for companies buying the dodgy paper) and operational risk - where the institution’s systems simply miss the risks involved.

Each of these can, and have, resulted in poor management or trading decisions, resulting in losses.

The point I would like to make here, though, is that these errors in risk management should become less likely over the next few years as the larger banks increasingly use their advanced risk management systems to genuinely allocate capital based on risk across their groups. A large bank here or there may get it wrong, but these sorts of systemic frights should become less likely.

Current Position

The problem at the moment (under Basel I) is simple - a housing loan is a housing loan is a housing loan. There is no difference in treatment between a loan secured by residential real estate where the loan to valuation ratio (LVR) is 20% and the borrower has many times the income to pay the mortgage off and one with an LVR of 80% and the borrower has bearly enough income to cover the repayments and feed the kids. Given the risks in the second one the bank has to price it higher than the first.

The incentives for banks chasing high returns, therefore, is to load up on poor quality, but high-paying, debt. The costs before you consider credit losses are the same. If you consider credit losses unlikely then you can load up on these - and even start dropping the price to sell more.

Effects of Basel II

Why do I consider that this will be less likely in the future? The answer is simple. Basel II forces the banks going advanced to consider, and price, capital for credit losses explicitly. The models being used to do this need to have at least seven, more normally as much as ten, years worth of data, covering at least one credit cycle.

The smaller ones, going standardised (or, in the US, staying with Basel I) will be in the same space they were before - so they will still be originating the loans - but most of them rely on funding from the bigger banks through securitisations, so the funding should cut off before the number gets too large. A few of them may go due to poor lending practices, but the big ones should not be at risk.

So - this should be the last great risk management failure.

Note the use of “should be” - rather than “will”. I need to manage my own risks.

I would invite readers to have a read of Chris Skinner’s post over at Finextra today. As I am not a beta tester over there, I cannot comment directly, but the basic premise of the post is that most money-launderers use cash at some stage of the laundering process, so the solution to money laundering is to do away with cash entirely.

Personally, I find this a bit extreme a solution. Cash is useful to me for several reasons beyond the illegal (not, of course, that I would do illegal stuff with it). It is handy for small payments and for buying things like lunch it is a lot quicker. Paying for things I buy off mates is easier in cash as I do not always have a web browser with me to make a direct payment into their bank account (although my new toy, a Nokia N95, comes close) and it saves me having to note everything down to transfer the funds later.

It also makes it easier to hide purchases (like birthday presents) where I do not want my wife to know how much I spent.

What do readers think? Is the proposed solution worse than the proposed cure?

This piece in Bobsguide is a touch self-serving (it was inserted by Algorithmics), but it makes a valid point.

Much of the press coverage concerning the ‘subprime meltdown’ has focused on the products themselves and the credit risk involved. They have variously been characterized as too risky, unsuitable or designed to appeal to unsophisticated buyers by offering cheap teaser interest rates.
However many of the subprime mortgage product cases appearing in Algorithmics’ FIRST database of loss events involve an element of insufficient operational risk processes; primary among these processes is lax underwriting, which often involves insufficient background checks, inadequate documentation and a failure to train and supervise front-line personnel. Eighty three per cent of the cases can be attributed to relationship risk, including mis-selling, suitability issues, contract obligations and regulatory and compliance violations.

Much of the bad lending that gets done is not simply lending that goes bad after being written - they are loans that probably should not have been written in the first place. If the loan is written in contravention of established procedures, or was written due to fraud, that is not a credit risk loss but an operational risk loss. The difference is crucial when it comes to finding a solution.

Credit risk can properly be regarded as something that happens as part of the business of writing loans - some of them will go bad. If too many go bad, then you need to update your policies and procedures and maybe find some additional capital. If loans are being written in contravention of policies and procedures, however, then a different solution is needed. This may include retraining, counselling, targeted redundancies (i.e. sackings) and probably some management changes.

If you identify the problem incorrectly, the proposed solution will also be wrong.

Just reading an interesting article on the Economist’s website on the past and present of investment banking. Selected quotes:

AT LEAST since 1823, when Byron’s Don Juan described “Jew Rothschild, and his fellow Christian Baring” as the “true Lords of Europe”, investment bankers have inspired awe, envy and, rightly or wrongly, a measure of disdain.

Read the rest of this entry »

For those of us that maintain a strong interest in the theory of bank regulation (sad, I know) a speech by Ben Bernanke provides a very interesting read. (Thanks to Bank Law Professor for another great link).

In this speech, he runs through what amounts to a history of bank regulation in the USA to illustrate his various points, on what he terms “command and control” bank regulation, deposit insurance and the moral hazard inherent in it, minimum capital requirements and Basel II. A real tour de force.

I was disappointed, though, that he did not mention one major possibility for the regulation of major banking markets. Read the rest of this entry »

Interesting, if short, paper today from the BIS on the impact of credit risk transfer. In a way, this is just a warning shot across the bows of the credit risk transfer industry and a timely reminder not to treat the current, benign, conditions as if they were normal.

The paper highlights the important parts of the risk transfer - that a lot of the risk is moved from the bank’s balance sheet to other financiers, including hedge funds, that may have a higher appetite for risk. Overall, the greater dispersal of the risks improves systemic stability. The problem he highlights, though, is often missed.

Read the rest of this entry »

Another hat-tip to the Banking Law Prof blog for a pointer to this piece of testimony from Roger Cole of the US Federal Reserve on the sub-prime lending problems in the US.

From this, it looks like the Fed understand the problem much better than the US Senators in the banking committee - which is understandable. The problem is not serious to the banking system as a whole, but is serious for those banks that have been lending heavily in this way, as well as being serious for those losing their homes.

To me, this shows the banking system is working - one or a few banks start lending less than carefully, they lose money and close up. Where there is insurance it pays out. Lessons are learnt, models are updated and business processes re-examined. The system as a whole is not hurt, but helped by what has been learned.

The pity here is that the borrowers lose their homes - but they are homes they would not have been able to buy without the poor lending practices that were the problem in the first place.

The Senators, being politicians, have to play to the audience. After a while they will calm down and, if a serious problem is revealed, legislate then. We just have to live in hope that, unlike the Sarbanes-Oxley debacle, legislation is not passed in the heat of the moment.

While I specialise in bank regulation the more I see of it, in general, the less I believe in it. I tend to spend a fair part of my time trying to mitigate its worst effects. A good example of this is what I call reverse regulatory capture - where the stronger the regulation the more the banks (and any other regulated entity) tend to start trying to run their enterprise to please the regulator, rather than to please the stakeholders in the business and the less real thought they put into . Read the rest of this entry »

Thanks to the Banking Law Prof Blog for pointing to this press release from the FDIC about a sub-prime lender in the US getting a “cease and desist” consent order from the FDIC. In Australia these would be termed an “EU” - an enforceable undertaking.

If I can use this example to illustrate how the three Basel II pillar would actually work in practice I think it would be a useful exercise. Read the rest of this entry »

Prompted by this piece over at the Banking Law Professor’s Blog, the situation in regards the US Basel II implementation is getting a little clearer.

What is clear to me now is that the US regulators are trying to achieve two, contradictory, objectives. They are:

1. Implement Basel II in the US; and
2. Not disadvantage the banks that cannot achieve “Advanced” accreditation.

Problem is, you cannot do both. The result is the confusing muddle you now see in the US.

Read the rest of this entry »

As the result of discussions on other blogs¹, I thought a discussion here of the merits or otherwise of fractional reserve banking may be interesting. As the subject has been discussed frequently on blogs on Australian politics, I thought one here with a predominately banking audience would be enlightening. Read the rest of this entry »