Category Archive

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.

Today’s BIS email was an interesting one in the light of recent events. It has a speech by Christian Noyer, the Governor of the Bank of France, regarding Basel II’s implementation in France. Remember while you read it that a certain trader’s activities would have been classified as an operational risk loss.
This passage is interesting in the light of the problems at SocGen:

By 31 December 2007, over 30 on-site inspections will have been conducted in 20 institutions, involving at times up to 100 inspectors at a time. These on-site inspections examined IRB systems for credit risk and advanced operational risk measurement approaches.

As SocGen is one of the largest banks in Europe I am presuming that they were one of the banks visited - I think this a safe assumption. This means that SocGen was assessed for operational risk issues while all of the rogue trading activities was going on - the trading that was risking much more than the capital of the bank.
He goes on to say:

…and 5 institutions (accounting for almost 60% of the total assets in the French banking system) are expected to adopt an advanced operational risk measurement approach. As institutions have the possibility under Basel II of using their IRB approaches to calculate regulatory capital requirements, supervisors must ensure that these approaches are reliable.

I really wonder how reliable the regulators found SocGen’s risk management to be in their supervisory visit? How closely did they look? You would have thought that the trading arm, where most, if not all of these events have historically happened, would have been a primary focus of that review. What did they see?
At the very least, SocGen will probably have to carry a much heavier operational risk capital burden now than they would have originally calculated less than a month ago. I think the BoF will have to have a bit more to say on this in the not too distant future. Who is next in line to resign over this? They may not be at SocGen.

[Update]In the light of the latest revelations - see here it looks like a lot more than a single trader should lose his job. It looks like senior management were turning a blind eye to the trading while it was making a profit and only got concerned once it was making a loss. If so, it would make the criminal charge hard to sustain.

There is a lot more to come from this one…[/Update]

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.

Report in the BBC today saying the British government is about to nationalise Northern Rock. This was probably inevitable after the search for new owners failed. The loss of confidence in the name of the business meant that getting new depositors to replace the old, without a complete change in ownership, was always going to be impossible.

What will happen now looks fairly clear - the government will pass a bill, the doors will shut to new business and current depositors will walk away. Mortgage holders will be encouraged to refinance elsewhere. This will both increase the exposure to the government and reduce what value is left to pay out to shareholders, if any.

Really, it should have been allowed to fail. As my several posts on this situation have made clear, this would have resulted in the business closing, the depositors paid out a reasonable amount at first and then all of it (including interest) over time. Shareholders would then have got a return out of the residual funds - which there would have been. The FSA’s deposit insurance scheme would have been up for some payouts, but they would have recovered it all. The only (minor) losses would have been to shareholders.

Admittedly, this may have caused worries about other institutions - but none was in a position like the Rock and this could have been made clear.

The real panic here was from the regulators and the government, who were blind-sided by something they probably believe they should have spotted.

Interesting publication from the Markets Committee of the BIS yesterday. It does a pretty full comparison of the practices of 16 of the major world central banks, covering what their targets are, how they carry out any prudential functions they have and lots of information on how they carry out their other duties.

The 16 covered are the members of the committee: Reserve Bank of Australia, Central Bank of Brazil, Bank of Canada, People’s Bank of China, Eurosystem (European Central Bank plus the national central banks of Belgium, France, Germany, Italy, the Netherlands and Spain), Hong Kong Monetary Authority, Reserve Bank of India, Bank of Japan, Bank of Korea, Bank of Mexico, Monetary Authority of Singapore, Sveriges Riksbank, Swiss National Bank, Bank of England and Federal Reserve Bank of New York.

It is a very useful start for anyone researching the operations of the central banks and for general information on them.
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(Updated - link changed so you do not have to go hunting through the site from the press release. Thanks Sadashiv)

One event I missed posting on at the time was the final agreement of all of the US regulators on the way that Basel II will be implemented in the US that happened 10 days ago. After some seriously silly obstinate argument from the FDIC, I was please to note at the time that the Fed largely got its way in the end, and now those rules have now been given final agreement.

To those of us watching from the outside this has been a painful process. I can only imagine how difficult it must have been for the US banks. The end result was close to the right one - the one I suggested a full year ago. In this, at least, the delay was worthwhile. Going with the FDIC’s original position would have been close to suicide for the whole US banking system - and a long, slow suicide it would have been.

Randall Kroszner’s speech on the matter is worth a read. The way he delicately steps around the blithering idiocy errors of the FDIC and the local bank lobbyists is almost artful.

One bit irks me, though - at the bottom of page 5 of the speech he is seeming to say that the US regulators will be coming up with a “standardised”  method of implementing Basel II. Amazing - I wonder what paras 50 to 210 of the New Accord are?

Anyway, if you are interested in my opinion on the whole process read the category. Reading in reverse order is probably best. I think some of my best posts have been in there.

In most of the rest of the world the process has been fairly sedate - well, as sedate as a nearly complete change to the bank regulatory framework can ever be. What am I going to talk about in this way again while we wait for Basel III?

In this case I think you have to admire the ambition, at least. Perhaps not the cover story though.

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.

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 »

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 »

No real time at the moment for a full post, but if you watch this and do not think it is over the top we will have to disagree.

Some judicious work is a good idea - this sort of reaction is not.

The more I read about the resignation of Susan Schmidt Bies from the board of the Fed the more convinced I am that the reason behind her leaving is a total disenchantment with the whole Basel II process in the US.

The reason given (”to spend more time with her family”) is the usual one given when you cannot say why you are really leaving. It is just such a cliché as to not be credible. The lack of follow up releases is indicative. Read the rest of this entry »

The collapse of Amaranth earlier this year, with a loss of about USD6 billion, was easily absorbed by the financial markets, a far better reaction than the collapse of LTCM in 1998, with a smaller loss (USD 4.5b).

An interesting speech by Lars Nyberg, deputy governor of the Swedish central bank, entitled “Are hedge funds dangerous?” goes through many of the issues that arise from hedge fund market operations very well and covers the three differing types of hedge funds quickly, but understandably. Read the rest of this entry »

It would be funny if it were not so serious. The (so-called) Basel IA rules either may, or might not, be released for public comment on December 5. The FDIC is ready to initial them, but the other regulators probably will not be. This means the full Basel II rules will remain open for public comment throught the period when most other places on the planet have actually started implementing them (OK - only the standardised parts that are being ignored in the US, but you get the idea).

Surely this means the target implementation date will also be set back - banks the size of the 20 largest in the US, those implementing the accord, must have a target to shoot at and, at the moment they only have a fuzzy idea of it, and one that could change anyway. The lack of discussion between the regulators and the regulated, the late rule making, the uncertainly if they are even going to be allowed to reap the benefits of the improved risk sensitivity - what next?

If the US regulators just really thought about it, the full set of rules they should implement are here, with associated commentary here. It would be a great improvement.

First of all: an apology. There seems to be a lot of posts recently on the US implementation of Basel II (or Basel IA or Basel I). This is largely because in Australia we have a few things going well - the regulator is progressing well on implementation, the banks know what the rules are and either are very busy putting them in to practice or have done so and are now refining then and the market is well informed.

This is not the case in the US. Even the basic rules are not yet clear, as a speech by Ben Bernanke has made clear. The US has consistently proposed (to the combined, at best, polite comment and, at worst, outright derision of fellow regulators) that Basel II needed another layer of conservatism - a layer that is not risk sensitive.

Bernanke’s speech has now thrown that, as well as whether their “Basel IA” rules up in the air. Essentially, he is saying that the US regulators will now review whether those additional rules make sense (note to the Fed, they do not) and therefore whether they should drop them.

The so called “Basel IA” rules are also under re-consideration for at least the smallest banks. Apparently, they may be too complex for the very smallest to implement, so they should be allowed to remain under Basel I.

The ”Basel IA” (I use inverted commas as they are a US formulation, not a Basel Committee formulation) are essentially dumbed-down Basel II standardised rules. In Australia, even the smallest ADI is using Basel II (the standardised approach). I cannot see why an Australian ADI can do it and a US one cannot.

Maybe we are getting some sense from the US regulators, at long last - but it comes too late and is going to introduce more uncertainty into the US implementation. The sooner they can get this sorted oout, the better. About 3 years ago would have been right.

[UPDATE]Looks like Sheila Bair at the FDIC is fighting back - at the ABA convention in Phoenix yesterday she is reported to have said that the leverage ratio “would ensure a minimum cushion of capital for safety-and-soundness throughout the global banking system”.
Looks like we are in for a nice little stoush. Arguments in bank regulation - always good fun. Lets see who wins.[/UPDATE]

[UPDATE 2]Ben Bernanke fights back! This just gets better. On the linked speech, look at the 6th and 7th paragraph on the section on bank capital (the section is on page 2, with those paras on page 3). Bernanke’s focus is on what is “…likely to add to implementation costs and home-host issues…” rather than Bair’s emphasis on “…safety-and-soundness…”.

I would like to be a fly on the wall when they next meet.[/UPDATE2]

The BIS have just released their quarterly statistical review. The statistics are good for those interested in the area - they are the authoratative resourse on international banking -but the real interest is in the articles (remind you of another publication?).

There are 5 this time. They are summarised as

…five special feature articles: the first on the changing composition of official reserves; another on the domestic implications of foreign exchange reserve accumulation in emerging markets; a third on forward currency markets in Asia and lessons from the Australian experience; a fourth on derivatives activity and monetary policy; and a fifth on the past 150 years of financial market volatility.

The first is interesting for its picture of the general moves in official reserves away from the rock solid investments and into the more speculative. The second is more interesting from a macro perspective - looking particularly at China, Taiwan and the other East Asian countries an the effects of their building up absolutely huge positions in the USD.

If you like really long term views of the markets, though, it is difficult to go past the last of the articles. 150 years of stock and bond yields to look at volatility - I would not like to have been involved in that data cleansing exercise. If anyone is looking for a topic for a PhD thesis, the rise in volatility since 1970 identified in this paper would be a good one.

The implementation in the US just seems to get more confusing. Currently, the 20 or so banks that the Fed judge to be internationally active will have to apply the Basel II advanced methods. Everyone else will have to apply a modified version of the current, Basel I standards - this modification is termed Basel IA in the US. Clear enough - if not consistent with the rest of the planet.

A fair enough, too, in a way. The whole Basel framework is only meant to apply to internationally active banks. If a bank is not internationally active, then there is no need, within the accord, to apply Basel at all.

Read the rest of this entry »

While I try to avoid posting on matters not directly relevant to Australia, this one I thought had particular importance to the global financial system and anti-money laundering in particular.

This article on the FT Asia website today, if confirmed to be true, may indicate that China is starting to realise that money laundering, even by close friends, is not in its interest.

On the other hand, they could just be trying to send a political message and will resume normal service soon. Either way, it will be some time before Australian banks can certify any Chinese bank as a true partner in the fight against money laundering.

It is a good first step, though. Maybe the amount of US currency arriving here that was not printed in the US will diminish.

Two important papers on the BIS website today. The paper on sound credit risk assessment and valuation for loans should be an interesting one for those managing the credit risk areas and the one on the use of the fair value option for financial instruments also promises to be interesting for treasury and finance staff.

Give them a read and pass comments.