Welcome to European Tribune. It's gone a bit quiet around here these days, but it's still going.

A tract on banking reform

by JakeS Fri Jan 14th, 2011 at 08:58:33 AM EST

The financial system encompasses, roughly speaking, seven different kinds of activities, in declining order of importance:

  1. Retail banking - letters of credit, payment clearing, overdrafts, debit cards, checking accounts, etc.

  2. Maintaining orderly exchanges.

  3. Pensions.

  4. Insurance (not including "insurance" against losses of financial assets - insurance schemes require losses to be mostly uncorrelated, and financial losses are almost always highly correlated).

  5. Investment banking - long-term credits to finance development of capital-intensive industrial plant.

  6. Long-term lending against existing capital - real estate being the prime example, but successful investment banking turns into this once the plant it funds is up and running.

  7. The rest - venture capital, corporate raiders, hedge funds, brokers' loans, etc.

We'll look at #1, 5 and 6: A lot of (but by no means all) crises originate in investment banking and mortgaging of existing assets, and retail banking usually gets taken along for the ride because of the joint ownership of retail and investment banking houses.

front-paged by afew


Traditionally, banking regulation has taken the form of solvency requirements and an overnight interest rate enforced by open market operations and liquidity requirements (plus the banks' internal risk management, which enforces lending standards). Under the traditional system a bank lends out money, which creates deposits. It then subsequently goes to the interbank market to obtain central bank reserves in order to meet its liquidity requirement. The central bank then buys sovereign bonds from the banks, thereby injecting reserves into the interbank market, in order to maintain the target overnight rate (repaying the loan reverses all these operations).

When you consolidate these transactions, the net result is that central bank has obtained a sovereign bond (thus extinguishing a government liability) and in exchange committed central bank reserves to the lending bank (thus creating a matching government liability); the lending bank has obtained a private bond or note (an asset for the bank), an amount of central bank reserves (an asset), an amount of interbank debt (a liability) and a deposit (a liability); and the rest of the interbank market has divested of a sovereign bond (an asset) and obtained an interbank loan (another asset).

This system has two crucial weaknesses and causes a moderate inconvenience on the side.

The first weakness is that there is no integral solvency check in the loan origination and funding process. It's all about liquidity. So bank solvency will have to be enforced at one remove from the daily operations of the bank. Solvency requirements thereby become an external constraint on banking activity, and the agency that enforces them is therefore likely to be perceived as a spielverderber, to be captured or worked around whenever possible. And working around or capturing solvency regulators is easy when they are not embedded in the core operations of a bank: Since the solvency enforcement is incidental to the daily operations, it depends on the solvency regulator asking questions. While you can penalise banks for not answering fully and honestly, there is no practical way to force the solvency regulator to ask questions about operations that it does not know is going on, or that it finds it impolitic to enquire into.

The second weakness is the interbank market. Recall the list of consolidated transactions above: The interbank market simply serves to swap assets that are, under all ordinary (that is to say non-crisis) conditions as close to being equally safe and remunerative as it is possible to be. The problem with this is that it causes bad banks to become "contagious" - a bad bank can take down the banks that lent it money on the interbank market. Now, you may argue that this is only fair - after all, those banks should know better than to lend to people who are crooked or incompetent.

But what about those banks who were two degrees of separation away from the bad bank? Three degrees of separation? At some point it becomes unreasonable to keep punishing them, but there is nothing in the interbank market's mechanics that prevents the transmission of a crisis beyond that cutoff. And, more importantly, interbank market panics carry such large macroeconomic costs that it is unfair to the non-financial sector to demand that banks several degrees of separation from the bad bank must be punished by the market before ordinary commercial activity can resume.

Under an exchangeable currency, such as the gold standard, there was an excellent reason for the central bank to insist on only taking on perfectly pristine assets: After all, under a convertible currency system, you can have a run on the central bank. But under a modern, non-convertible currency system there is no reason that the central bank must restrict itself to swapping reserves for sovereign bonds - it can now bypass the interbank market by using the discount window.

Another inconvenience arises from the separate enforcement of solvency and liquidity requirements: By grafting on solvency enforcement in a crude hack, rather than building it into the ordinary operations of the system, you necessarily split the solvency enforcement into enforcement of bank solvency and enforcement of borrower solvency. There is no compelling economic justification for this: What matters to the integrity of the financial system is the margin on the loans, not whether this margin is carried by bank equity or borrower equity. Moreover, it means that the financial regulators can only enforce the bank solvency part and must leave enforcement of borrower solvency to the banks' own risk management. In order to enforce a safe level of margin in the financial system overall, the financial regulators will therefore have to place the full margin requirement upon the banks. But the banks will naturally demand margin from their customers as well, so the financial regulator will be faced with the choice between accepting more margin than is necessary for the system as a whole or losing the ability to guarantee that sufficient margin is provided by bank and borrower taken together. This is obviously undesirable.

However, as hinted in the section on the interbank market, a non-redeemable currency raises certain interesting options for the central bank and other financial regulators. Specifically, since the central bank is now freed from having to worry about a run on the currency, it can take less liquid assets onto its balance sheet through the discount window. This would allow central banks to set margin requirements on the assets that are accepted as collateral at the discount window, and, by largely or wholly curtailing the interbank market, to discriminate between different sorts of banking when it comes to setting policy rates.

In order to use the discount window to set margin requirements, the liquidity requirement will have to be raised to 100 % of deposits and other important liabilities. This, in itself, will cause no trouble, since the central bank will always provide any amount of reserves that member banks desire anyway. The central bank can keep doing open market operations in sovereign bonds, or it can accept them as collateral against the discount window with a minimal haircut (though obviously doing both at the same time requires some care to ensure that traders can't arbitrage between the discount window and the sovereign bond market).

Under such a system, a bank lends to a borrower, and then goes to the discount window with the resulting note. The central bank then lends reserves against the note up to the limit of its value as collateral. The margin will have to be deposited by the bank, the borrower and/or other institutions or individuals who are prepared to extend unsecured loans to the bank. The bank and borrower don't have to possess the entire margin - they can borrow the balance from other banks - but those banks must have an excess of reserves, bonds or discount window collateral over what they need to secure their own deposits. In principle, the bank can demand that the borrower overcollateralises his loan to the tune of the entire margin, thus permitting the bank to operate with zero equity, or, at the other extreme, the bank can offer a no-money-down loan if and only if it is able to post the margin itself. In the real world, of course, even properly collateralised loans occasionally go tits-up, so it will be prudent to still enforce a solvency requirement for the banks. But tying margin requirements intimately into the lending process makes this a back-up rather than the main safety system.

- Jake

Display:
Another advantage of relying extensively on the discount window is that the central bank does not have to send out margin calls until the assets posted as collateral have fallen below the value of the reserves lent against it. Delaying margin calls against impaired by not yet underwater assets serves to dampen systemic margin calls

Conversely, the central bank should not permit the value of an asset as discount window collateral to increase after it is issued. Locking the value of an asset as collateral once it is issued means that even if the central bank takes leave of its senses and allows assets to be posted as collateral at bubble-inflated values it will only apply to new assets originated during the bubble. (And, of course, if one wants to avoid having to mark collateral to market on the way down, one must also avoid marking it to market on the way up.)

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Jan 11th, 2011 at 05:12:57 PM EST
Under the traditional system a bank lends out money, which creates deposits. It then subsequently goes to the interbank market to obtain central bank reserves in order to meet its liquidity requirement. The central bank then buys sovereign bonds into the interbank market in order to maintain the target overnight rate (repaying the loan reverses all these operations).

Could you explain what is meant by "The central bank buys sovereign bonds INTO the interbank market..."? I can understand selling into or buying from but buying into sounds like what happens when one is taken by a con - one buys into the con, i.e. believes it is real. Knowing how so much of our financial system works.....

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Tue Jan 11th, 2011 at 11:52:41 PM EST
That's an edit snafu. The central bank injects reserves into the interbank market by purchasing bonds.

It's fixed now.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Wed Jan 12th, 2011 at 06:29:00 AM EST
[ Parent ]
Sounded sufficiently like confounding jargon that I felt compelled to ask.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Jan 12th, 2011 at 09:13:23 AM EST
[ Parent ]

Britain's highest-profile banker argued that it was not possible to stop paying bonuses without severe consequences for business and the broader banking sector.

(...)

"There was a period of remorse and apology; that period needs to be over. We need our banks willing to take risks, to be confident and to work with the private sector in the UK to create jobs and improve economic growth," he said at a hearing examining the retail banking sector.

FT


Wind power

by Jerome a Paris (etg@eurotrib.com) on Wed Jan 12th, 2011 at 03:57:53 AM EST
Because under a system where margin requirements are effectively enforced, bankers can pay each other all the bonuses they want without irritating public scrutiny of their remuneration.

Of course, there won't be as much easy money around to pay bonuses with...

But actually, the problem is convincing the central bank to do this. The retail banks can be bought simply by paying the policy rate on regulatory reserves as well as excess reserves. Do they deserve that subsidy? Arguably yes, since regulatory reserves arise when people deposit money (or keep borrowed money) in the bank. So the difference between the support rate and the retail rate would be the government subsidy for banks who manage the payment clearing infrastructure.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Wed Jan 12th, 2011 at 06:26:43 AM EST
[ Parent ]
"There was a period of remorse and apology; that period needs to be over. We need our banks willing to take risks, to be confident and to work with the private sector in the UK to create jobs and improve economic growth," he said at a hearing examining the retail banking sector.

After all, the politicians expect their contributions, don't they? Where do they think they come from?

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Jan 12th, 2011 at 09:11:57 AM EST
[ Parent ]
The European Commission agrees: EUROPA - Press Releases - Annual Growth Survey : Summary of the economic analysis and messages
Repairing the financial sector swiftly to find the path to recovery

There is a strong correlation between healthy credit expansion and sustained economic development. Balance sheet repair in the banking sector is essential to improve cost efficiency, restore competitiveness and return to normal lending. A swift exit from sizable public support to banks will remove possible distortions to competition in the financial industry. Furthermore, confidence in the banking sector is a prerequisite for maintaining financial stability. This is now being corrected through a more robust EU regulatory framework, a future permanent "European Stability Mechanism" to be established by 2013 to safeguard the financial stability of the euro area as whole, as well as tougher capital requirements on banks (Basel III agreement).



Of all the ways of organizing banking, the worst is the one we have today — Mervyn King, 25 October 2010
by Migeru (migeru at eurotrib dot com) on Wed Jan 12th, 2011 at 09:36:01 AM EST
[ Parent ]
There's one question I'd like to ask publicly - of Bob Diamond, for instance - "You've had all these millions in bonuses. What do you spend it on?"

You can't be me, I'm taken
by Sven Triloqvist on Wed Jan 12th, 2011 at 05:21:55 PM EST
[ Parent ]
The Big Boys, (capitalists), measure their power in accumulated wealth, so most of the money likely has been retained to buttress that power, and to provide "fuck you" money. I would guess that about 10-20% has been spent on political contributions to insure that the game continues and that about 5% has been spent on "charity" to provide PR cover.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri Jan 14th, 2011 at 09:15:50 AM EST
[ Parent ]
This brings to mind a recent long guest post by Richard Smith on naked capitlaism:

JP Morgan Markets Its Latest Doomsday Machine (or Why Repo May Blow Up the Financial System Again)   By Richard Smith

Readers of ECONned will be very familiar with the name of Gary Gorton, author of `Slapped in The Face by the Invisible Hand', which explores the relation of the so-called shadow banking system to the financial crisis. His work is pretty fundamental to understanding some of the mechanisms which made the crisis so acute. Now he's done an interview, which I would like to have a growl at; but first, he has some basic points about shadow banking, useful later in this rather long post. Gorton explains repo thus:

   You take your $200 million to the bank, to Lehman Brothers, say. You deposit it, so to speak, overnight so you can have access to it the next morning if you want to. They pay you 3 percent. And you want it to be safe, so they give you a bond as collateral. But Lehman earns the interest on the bond, say, 6 percent.

..and then "haircuts" (an extra margin of security in case that bond isn't so safe after all):

   There may be a haircut. If you deposit $100 million and they give you bonds worth $100 million, there's no haircut. If you deposit $90 million and they give you bonds worth $100 million, then there's a 10 percent haircut.

...and then "rehypothecation":

   If you put a dollar in your checking account and the bank has to keep 10 percent of it on reserve, they lend out 90 cents. Somebody deposits that 90 cents, the bank can lend out 81 cents (because of the 10 percent reserve requirement) and so on. So you end up creating $10 of checking accounts for $1 of demand deposits, assuming there's a demand for loans...And that can happen in repo as well because if you're Lehman and I'm the depositor, and you give me a bond as collateral, I can use that bond somewhere else. So there is a similar money multiplier process.

...and finally the link to regulated banking:

   And shadow banking very importantly is not a separate system from traditional banking. These are all one banking system.

Much more detail and discussion follows, but eventually we come to this:

What you have here, in the equivalent language of repo, is a 10 per cent haircut, with unlimited rehypothecation (so that you can just keep reusing the collateral to raise more and more liquidity, haircutting away until the amount you can still pledge isn't worth bothering with), and a credit multiplier of 10. To get a general picture of how the credit multiplier, haircuts and rehypothecations tie together, we now need a tiny spot of mathematics.

An aside: one of the peculiarities of mathematical economics, as opposed to mathematics, is the relative frequency of "theorems". In mathematics, theorems are as rare as unicorn droppings, things of near-holy awesomeness; in mathematical economics, by contrast, they occur horribly frequently, like depictions of unappealing sexual acts in the oeuvre of the Marquis de Sade.

So I should probably try to get people to give this shoddily presented and deeply unoriginal formula,

some kind of grand title: Smith's Unrestricted Rehypothecation Theorem, perhaps. What does it mean? It describes the relation between the credit multiplier under unrestricted rehypothecation, Cm¥, and h, the haircut, which is a value between 0% and 100%; k keeps count of the number of rehypothecations. Any charges levied for the rehypothecation are assumed to be negligible (I won't keep saying this, but bear it in mind - it means that the credit multiplier is never quite as big as I say it is, though pretty close, because the charge for a rehypothecation is not huge). As you see, with unrestricted rehypothecation, you just invert the haircut to get the credit multiplier. That is the big picture.

I don't claim to fully understand this, but it does seem to show why there is so much pressure to demand lower and lower amounts of "haircut". From here: On to Dragon Country!

With lots of rehypothecation, it gets worse. To get a better idea of how haircuts, rehypothecation and the credit multiplier work together, it's time for a picture of Dragon Country.

This is my two equations, graphed. Some more explanation:

    * Haircut: the 1.0 (bottom right hand corner) is of course 100% , in other words, there is no repo, and the credit multiplier is 1, so there is no effect on credit. I've assumed the charge for rehypothecation is negligible.
    * The thick black curving line shows the theoretical maximum credit multiplier when there is an infinite number of rehypothecations. On the basis that a 1000x credit multiplier is absurd enough, I stopped at 0.1% haircuts, though 0% haircuts have supposedly been used in repo.
    * The unimaginable top left hand corner won't fit on the graph: a haircut of zero and an infinite credit multiplier.
    * The thin green line shows the credit multiplier for various haircuts when there are just 4 rehypothecations. You can see from the graph that this gives to a credit multiplier of around 4, for a range of haircuts from 0-20% or so.
    * The just about detectable blue curve, above the green one, shows the credit multiplier when there are 20 rehypothecations: already enough to move the credit multiplier to worrying levels when the haircut is less than 20%, and when there is only a 0.25% haircut, to an absurd 17x.
    * I've assumed that Q4 `08 is nasty enough for all of us, and that therefore an overall credit multiplier of 4 is as much as we want; so that's where I've put the horizontal red line.
    * The red area is Dragon Country, where low haircuts and lots of rehypothecation result in huge credit multipliers, and very great (exponential-like) sensitivity to increases in haircuts.
    * I've used a logarithmic scale on the y-axis to cram the whole thing in. Dragon country would be impressively vast on a linear scale.
    * The graph shows you something else Gorton doesn't really emphasize: the only reason to like a small haircut is to maximize the amount of liquidity you create via repeated rehypothecation.

Have I just put forward one of those daft theoretical constructs beloved of economists and technocrats? I think not, for a couple of reasons.

If the US electorate is dumb enough to allow you a ride on "the full faith and credit" why not make it a really good ride for yourself?

"It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri Jan 14th, 2011 at 04:55:41 PM EST
Sort of but not quite.

A repo is really just a fancy interbank loan that can be extended by entities that aren't part of the ordinary interbank market. The reason that a bank might want to borrow in the money markets rather than the discount window is that the widows and orphans in the money market don't have access to the central bank support rate, so they might charge a lower interest rate.

I can't quite see how this can come back to bite anybody on the ass who is remotely important for the continued functioning of the financial system. The solution to a speculative bubble in a non-critical part of the financial system is to let the suckers go tits-up, and apply Ye Olde-Fashioned Keynesian Stimulus to the real economy. But if you don't like money market players repoing with the banking system, just allow money market players to make deposits in a central bank reserve account like regular banks, and pay the overnight target rate as a support rate for central bank reserves. That should kill the repo business stone dead.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sat Jan 15th, 2011 at 12:04:06 PM EST
[ Parent ]
I would suppose that the danger of such a "Dragon Country" scenario emerging could be determined by the "haircut" being required for repo operations. I would expect the collateral damage to be in stocks and commodities that had soared on credit generated in such a manner. If they can make a buck I certainly doubt that JP Morgan would show much restraint, backed up as they are by the full faith and credit of the US taxpayer.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sat Jan 15th, 2011 at 03:57:53 PM EST
[ Parent ]
It seems that such a process could explain how the stock markets continue to climb while stock mutual funds continue to show large redemptions. They could be being levitated money from "dark pools" derived in such a means and controlled by the TBTFs.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sat Jan 15th, 2011 at 04:07:00 PM EST
[ Parent ]
by money

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sat Jan 15th, 2011 at 04:10:35 PM EST
[ Parent ]
I would suppose that the danger of such a "Dragon Country" scenario emerging could be determined by the "haircut" being required for repo operations.

It's not a problem with repo operations. It's a problem with banks accepting shit collateral against their loans. You don't solve that problem by prohibiting repo operations, you solve that problem by making the banks stop accepting shit collateral against loans.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sat Jan 15th, 2011 at 04:12:04 PM EST
[ Parent ]
True enough, but the problem in the US is that Bernanke's Fed has lead the way in "trash for cash" and he had to know the "assets" were trash, starting with the Maiden Lane "facilities". I strongly suspect that the TBTFs have been much more circumspect than the Fed since 2008. The problem with low haircut high multiplier scenarios could well be that of creating 10 or 20 to one multipliers with "high powered money" and then using that money to blow asset bubbles in stocks and commodities. If, as I suspect, the TBTFs are doing this starting with Fed money from one of the many "credit facilities", it will make it very difficult for the Fed to ever rein in the money supply by raising rates or reserve requirements without causing a monster crash. But it still remains that it is of the nature of bubbles to pop, so....

The whole situation is rather like a rich family or a royal family having a criminal in their midst who is empowered to continue his crime spree because, if found out, it would damage the family. If things get too out of hand, he could suffer an "accident". Except in this situation, failing a thorough-going housecleaning, none of the guilty are likely to pay any price, at least not a serious price. But there is already a world full of victims.

"It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sat Jan 15th, 2011 at 05:26:26 PM EST
[ Parent ]
The problem with low haircut high multiplier scenarios could well be that of creating 10 or 20 to one multipliers with "high powered money" and then using that money to blow asset bubbles in stocks and commodities.

The multiplier is irrelevant. It is an ex post accounting construct, not an ex ante operational constraint. As long as the financial regulator does not wish to ensure that banks do not finance speculative ventures, and as long as the central bank wants to retain control of the overnight funding cost (that is, the monetary policy rate), a lower multiplier simply means that more of the trash goes on the central bank balance sheet and a higher multiplier that it stays on member bank balance sheets.

If, as I suspect, the TBTFs are doing this starting with Fed money from one of the many "credit facilities", it will make it very difficult for the Fed to ever rein in the money supply by raising rates or reserve requirements without causing a monster crash.

Well, yeah, if you're using Maiden Lane facilities to cover up the fact that your big money market banks are insolvent, then it will end with Stuff Blowing Up. But a high money multiplier won't make stuff blow up any more spectacularly than it would with a low money multiplier. The money multiplier is a liquidity thing. You are having a solvency problem.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sat Jan 15th, 2011 at 06:04:29 PM EST
[ Parent ]
Correct.

The insolvency of the general population - or rather a 'solvency' dependent purely upon inflated property prices - is a much greater problem than the related problem of the insolvency of the intermediary banks.

As Michael Hudson points out, 90% of the population are in debt to the other 10% who own substantially all the unencumbered productive assets.  

And again, as he points out as an economic historian, there is nothing new about this: it's what always happens when compounding debt combines with private property in land, and is why debt relief such as Jubilees has been necessary, and is once again.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Sun Jan 16th, 2011 at 09:19:57 AM EST
[ Parent ]


Display:
Go to: [ European Tribune Homepage : Top of page : Top of comments ]