Worrying inconsistency at the heart of policymaking

Imagine you read a book* stating that:

Banks do not lend out their reserves at the central bank. Banks create loans on their own, as already explained above. They do not need reserves to do so and, indeed, in most periods, their holdings of reserves are negligible.

Fine. I deeply disagree with this statement, but that person has the right to say it. Free speech is back in fashion nowadays.

The author of that book had actually said a few months earlier something similar in an FT article**:

Second, the “money multiplier” linking lending to bank reserves is a myth. In the past when bank notes could be freely exchanged for gold, that relationship might have been close. Strict reserve ratios could yet re-establish it. But that is not how banking operates today. In a fiat (or government-made) monetary system, the central bank creates reserves at will. It will then supply the banks with the reserves they need (at a price) to settle payments obligations.

So far so good.

2 economists

Now, imagine that, for some reason, you ended up on another FT article***, dating back five years, declaring this:

Indeed, the Fed explained precisely what it would do in its monetary report to Congress last July. If the worst came to the worst, it could just raise reserve requirements.

Point reiterated just two days ago**** by the same economist, commenting on the Swiss central bank euro unpegging:

Furthermore, the Swiss could have curbed inflationary dangers without abandoning the peg, for instance by increasing reserve requirements on banks.

‘Foolish’ you would say. This person should read the other author above, who said that reserve requirements were useless because banks did not ‘lend out’ their reserves and that central banks would provide those reserves on demand anyway. So how could a reserve requirement increase by the SNB prevent money creation and inflationary danger? These two economists clearly disagree with each other.


What if I told you economists

Ironically, this person also declared that other people “failed to understand how the monetary system works” and that this issue wasn’t “just academic” but that “understanding the monetary system [was] essential.” But has no problem switching from one side of the endogenous outside money debate to the other whenever it suits his argument.

More worryingly, this economist was also a member of the UK’s Independent Commission on Banking, which came up with the idea of ‘ringfencing’. I suddenly find it even harder than before to really trust his views on banking issues. I also find it bewildering that an economist of such reputation could be so internally inconsistent and blatantly contradict himself article after article. This isn’t very reassuring.

Oh, I forgot to say who this economist was. He’s called Martin Wolf.


* See my review of the book, published September 2014, here.

** See article here, dated April 2014

*** See article here, dated November 2010

**** See article here, dated January 2015

The end of banking? Not like this please

I recently read Jonathan McMillan’s The End of Banking, which I first heard of through FT Alphaville here (McMillan is actually a pseudonym to cover it two authors: an academic and a banker). I have mixed feelings about this book. I really wanted to agree with it. And I do, to some extent. But I simply cannot agree with a number of other points they make.

The End of Banking

Their proposal to reform banking is as follows (see the book for details): lending can be disintermediated through P2P lending platforms (and equivalent), which both monitor potential borrowers through credit scoring and allocate savers’ funds to minimise the probability of losses. Marketplaces set up by platforms would enable savers to sell their investments to generate cash if needed. What about the payment system? Their solution is for non-bank FIs to continuously provide market liquidity a number of financial instruments using algorithmic trading. Current accounts would in fact be invested like mutual funds, which would instantly convert those investments into cash when required for payment. They also propose accounting rule changes to prevent corporations from creating money-like instruments.

As such, they propose to end banks’ inside money and have a financial system exclusively based on digital outside money controlled by a monetary authority. While they don’t classify it this way, it does seem to me to be some sort of 100%-reserve banking proposal: the money supply is fixed in the very-short term and exogenously-defined by the monetary authority.

What I agree with:

  • The main thesis of the book is completely valid and is something I have also argued for a little while: technological disruptions are now allowing us to go beyond banking and disintermediate it. P2P lending, non-banking payment systems, decentralised payment frameworks and currencies, algorithm-driven credit scoring… In many areas, banks have almost become redundant. I totally adhere to the authors’ thesis (although credit scoring does have real limitations).
  • Technological developments have facilitated regulatory arbitrage, if not enabled it. Computing power now allow banks to optimise their capital requirements through the use of complex models which, it is important to point out, are validated by regulators.

What I disagree with:

  • The authors seem to believe that banking regulation is usually a good thing and cannot seem to understand the various distortions, bubbles and inefficiencies those regulations create. According to them, if only technology hadn’t boomed over the past three decades, the banking system would be more stable. I strongly disagree.
  • I dislike the top-down banking reform approach taken by their thesis. Free markets, driven by technology, should decide under what form the next iteration of banking should arise.
  • I also see weaknesses in their proposal. First, I cannot agree with their view that money belongs to the public sphere, and that IOUs must benefit from a state guarantee to qualify as money. This has been disproved by history over and over again. Second, I see their proposal to have algorithmic trading manage the payment system as not only unworkable, but also dangerous. As already witnessed, algorithmic trading is imperfect and can amplify crashes rather than prevent them. How their payment system would react during a crisis, when everyone tries to exit most investments and pile into a few others, is anyone’s guess. Mine is that the payment system would suddenly be down, paralysing the entire economy. To be fair, their treatment of cash is unclear: could we maintain a custody account comprising only digital cash in their framework?
  • Their 100%-reserve banking reform does not address fluctuations in the demand for money. Centralised monetary authorities do neither have access to the right information, nor within the right timeframe, to accurately provide extra media of exchange when needed by the public. Private entities, in direct contact with the public, can.
  • Finally, though this is a minor point, I disagree with their monetary policy stance. It is inaccurate to present price stability as ideal to avoid economic distortions: productivity increases should lead to mild deflation in a growing economy (see Selgin’s Less than Zero or any market monetarist or Austrian blog and research paper). I also reject their physical cash ban, from a libertarian standpoint: people should be able to withdraw cash if ever they wish to*. This would seriously limit their negative interest rates policy proposal.

Overall, it is a thought-provoking and interesting book, which also quite accurately describes our current banking system in its first part (mostly aimed at people who don’t know that much about banking). Its two authors are also right to point out the defects of regulation in an IT-intensive era. But, in my opinion, they draw the wrong conclusions and the wrong reform proposals from their original assessment.


* Here again, their treatment of cash is unclear: can cash be withdrawn in a digital form and maintain in a digital wallet outside the financial system? I doesn’t look so from their book but I cannot say for sure.

Are ETFs making markets less efficient?

I don’t have an answer to that question. But I have been wondering for a little while.

Noah Smith, on Bloomberg, and John Authers, in the FT, are pointing out that passive funds keep witnessing inflows at the expense of actively managed funds (which still represent the large majority of assets under management). Smith adds that academic research overwhelmingly demonstrates that active fund management (whether hedge funds or more traditional, and cheaper, mutual funds) is a ‘waste’ of money.


Market efficiency requires that many different individuals make their own investment assessment and decisions, in accordance with their limited means, knowledge and preferences. Some will gain, some will lose, market prices will continuously fluctuate one way or another in a permanent state of disequilibrium that reflects investors’ evolving views of what constitutes an efficient allocation of resources. In turn market price movements in themselves lead investors to reassess their opinions, bringing about further fluctuations but eventually producing something that resemble a near-equilibrium market, which almost accurately reflects investors’ preferences… for a few instants… after which other investors’ reactions are triggered. This is confusing; this is perpetual discovery and adaptation; this is the market process*.

Hence the importance of prices. And in particular, of relative prices. Investors can pick investments among a very wide range of securities. Such market granularity eases the market process: when one particular security looks underpriced relative to its peers, investors might start buying (until its price has gone up).

ETFs, index funds, on the other hand, allow investors to buy the whole market, or a large part of it, or a whole sector. They merely replicate market movements. As such, granularity, relative prices, and intra-market fluctuations disappear. Consequently, if everyone starts buying the whole market, there is no room left to pick winners within the market. Efficient firms and investments benefit as much from the inflow of capital as bad ones. Once a majority of investors start buying the whole market through index funds, stock pickers will have very limited choice to pick winners. Resources allocation, and in the end economic efficiency, becomes impaired**.

All this remains very theoretical. I haven’t been able to find any theoretical or empirical paper that researched this particular topic (please let me know if you know any). 2013 Nobel-winner Eugene Fama recently dismissed those concerns:

There’s this fallacy that you need active managers to make the market efficient. That’s true to some extent, but you need informed active managers to make it more efficient. Bad active managers make it less efficient.

Basically, he hasn’t answered the question. According to him, no, ETFs don’t make markets less efficient, but yes that’s true to an extent but no if you have bad active managers. Not that helpful to say the least. He is the father of the efficient market hypothesis so probably a little biased to start with.

Smith has another answer: he believes that asset-class picking could become the new stock-picking and that active management could shift from relative intra-market prices to relative inter-market prices. Basically, investors would take positions on, let’s say, the German stock market vs. the British one, instead of picking companies or securities within each of those markets. This is a possibility, albeit one that doesn’t really solve the economic resources allocation efficiency problem described above. Investors also don’t always have the option to invest outside of their domestic market, for contractual or FX fluctuation reasons.

It is likely that stock picking won’t disappear. Investors will always want to buy promising or sell disappointing individual securities. Still, the rise of index investing could have some interesting (and possibly far-reaching) implications for the market process and resource allocations. It is, as yet, unclear what form these implications may take.


* This ‘market efficiency’ definition is very close to the one defined by Austrian school scholars (which I prefer), as opposed to the more common market efficiency as defined under the equilibrium neo/new classical and Keynesian frameworks. See summaries here, as well as a more detailed description of the New classical efficient market hypothesis here.

** A real life comparison would be: instead of purchasing one TV, after carefully weighing the pros and cons of each option out there, everyone starts buying all possible models from all manufacturers, independently of their respective qualities. The company offering the worst product would benefit as much as the one offering the best product. Needless to say, this isn’t the best way of maximising economic resources.

Why can’t economists understand margin compression?

Are basic accounting statements so difficult to interpret? According to Viennacapitalist, who commented on my previous post, it does seem so. At least for macroeconomists. Indeed, Werner seemed to imply that most economists did not know that deposits sat on the liability side of a bank’s balance sheet (he’s surely wrong), and I have many times pointed out the central bankers’ and policymakers’ misunderstanding of banking mechanics.

Three researchers from the BIS just confirmed the trend. In a new working paper called ‘Has the transmission of policy rates to lending rates been impaired by the Global Financial Crisis?’, they wonder, and try to find out, why spreads between central banks’ base rates and lending rates have jumped once base rates reached the zero-lower bound.

It’s a debate I’ve already had almost a year ago, when I tried to explain that, due to the margin compression effect (an accounting phenomenon), spreads would have to increase in order allow banks to generate sufficient earnings to report (at least) positive accounting net incomes (see here and here).

Those BIS researchers have come up with the same sort of dataset and charts I did over the past year, although they also looked at the US (but didn’t look as other European countries, unlike what I did in this post). This is what they got:

BIS New lending ratesThis looks very very similar to my own charts. Clearly, spreads jumped across the board: pre-crisis, they were around 1.5% in the US, 1.5% in the UK and 1.25/1.5% in Spain and Italy. In 2009/2010, with base rate dropping to the zero-lower bound, things changed completely: spreads were of 3% in the US, 2.25% in the UK, 2% in Spain and 1.5% in Italy. Rates had not dropped as much as base rates. Worse, spreads on average increased afterwards: by 2013, spreads were around 2.5% in all countries.

The BIS researchers tried to understand why. Unfortunately, they focused on the wrong factors. They built a model that concluded that the “less pass-through seems to be related in part to higher premium for risk required by banks and by worsening of their financial conditions as well.” They are probably right that some of these factors did play a role. But they cannot explain why the spread remains so elevated even in economies that have experienced strong recoveries such as the US or, more recently the UK.

But their study also has a number of other problems. First, they used new lending data only. It is extremely tricky to extract credit risk information from new lending rate figures. Why? Because new lending rates only show credit actually extended. Many borrowers cannot access credit altogether or simply refuse to do so at high rates. Consequently, the figures could well only reflect borrowers that have relatively good credit risk in the first place as banks try to eliminate credit risk from their portfolio. Second, they never ever discuss operating costs and margin compression, as if banks could simply lower interest income to close to 0 and get away with it.

But for this, they should have looked at two things: deposit rates and banks’ back books (i.e. legacy lending). Not new lending only. When the margin between deposit rates and lending rates on back books fall below banks’ operating costs, banks have to offset that decline by increasing spreads. This is why I suggested that the actual lowering base rates ceased to be effective from around 1.5 to 2% downward as a means of reducing household and companies’ borrowing rates.

Problem is, very few researchers and policymakers seem to get it. Patrick Honohan, of the Irish Central Bank, and Benoit Coeuré, of the ECB, do seem to understand what the issue is. Bankers and consultants have for a while (see Deloitte at the end of this post). Some economic commentators assert that it is hard to figure out why bankers keep complaining about low rates. This dichotomy between theorists and practitioners is leading to misguided, and potentially harmful, policies.

But let me ask a simple question. How hard is it to understand bank accounting really?

More, more, more money endogeneity confusion

First of all, happy new year everyone! We are now in 2015, so keep your eyes open for Marty McFly on the 21st of October.

Let’s start the year with one of my favourite topics: money endogeneity. I’ve covered the subject a number of times, but it keeps coming back. On Mises Canada, Bob Murphy wrote a good post on the differences in reserve management between individual banks and the banking system as a whole (and describes very well the first step of Yeager’s ‘hot potato’ effect, that is, the increase in goods’ nominal prices). Murphy was replying to Nick Freiling’s post, who accused him of making a common mistake. Bob is right and Nick is wrong. In another ‘banks create money out of thin air’ post, Lord Keynes comments on (and, surprisingly, likes) a rather weird new piece of research by Richard Werner.

First, this is Nick:

Banks might decide to increase lending, but not at the expense of losing interest on reserves at the Fed. In fact, banks would rather earn interest on both new loans and reserves at the Fed (which is possible because new loans don’t require an outflow of reserves). Ideally, Bob would write a check against his loaned funds account that is addressed to another customer of that bank. Then the bank sees no loss in reserves (and so earns the same interest on the reserves as before) plus an increase in loaned funds which, of course, earns interest.

This is a very subtle point, but has huge implications for predicting inflation and gauging the effects of QE and growth in the monetary base. For example, there is no threat of sky-high levels of reserves “turning into” loans funds and thereby launching us into hyperinflation. Sure, a higher level of reserves pushes banks further from being constrained by their reserve-requirement ratio, which means they can increase lending. But banks are normally not reserve-constrained, so the relationship between reserves and loans is not direct, and might be hardly related at all.

There are some confusions here. Reserves can be in excess as long as banks aren’t fully ‘loaned up’ to the maximum allowed by reserve requirements. For instance, if the banking system has an aggregate $1,000 of reserves, and assuming a 10% reserve requirement, total lending can be expanded to $10,000. If overnight, reserves increase to $1,500 but lending remains at $10,000, the system holds $1,000 of ‘required’ reserves and $500 of ‘excess’ reserves. The Fed has been paying interest on this ‘excess’ for several years now (which wasn’t the case before). What happens if banks decide to increase lending following this reserves injection? $1,500 in reserves allows banks to lend an extra £5000. When lending reaches $15,000, there are no reserves in ‘excess’ anymore. Reserves have all become ‘required’. This is what many people mean by ‘lending out’.

Murphy’s point was that, at the individual bank level, the risk-adjusted yield on the ‘excess’ portion of reserves is compared to the risk-adjusted yield that the bank can make by expanding its loan book. Sure, the Fed still pays interest on required reserves, but it’s the excess reserves portion that is a monetary policy tool. Moreover, it is highly likely that the expanding bank is going to be subject to adverse clearing, thereby losing reserves to a competitor during the interbank settlement process, and hence the associated interests on reserves. Consequently, extending credit often leads to reserve outflows. The lower the market share of the bank, the more likely it is to suffer outflows. The system as a whole, on the other hand, does not lose reserves (unless withdrawn by depositors), and the interests on reserves lost by the first bank are now earned by another one.

The second point is trickier. There was indeed no inflation over the past few years despite the huge increase in reserves. And doomsayers (including Bob) have been wrong in predicting hyperinflation in the short-term. However, as I have recently pointed out, US excess reserves also massively increased during the Great Depression and the money multiplier collapsed. It took between 30 to 40 years for the multiplier to increase again, and guess what, this happened just before inflation levels jumped in the US (in the 1970s and 1980s). Coincidence? Maybe.

The problem is that Nick relies on a flawed banking theoretical framework. He quotes economist Paul Sheard as saying:

This is possible, again, because loans do not “come from” excess reserves. As Sheard explains:

…banks do not need excess reserves to be able to lend. They need willing borrowers and enough capital – the central bank will always supply the necessary amount of reserves, given its monetary stance (policy rate and reserve requirements).

This is the ‘endogenous money’ view (or, to be more precise, the ‘endogenous outside money’ view, as the fractional reserve banking theory necessary implies an endogenous inside money framework), also adopted by MMT-proponents (as well as Frances Coppola, though she says she doesn’t believe in MMT). It’s a nice theoretical construction. Just wrong. I have extensively written about this (see here, here, here and here). To be brief, there is no way an individual bank could continuously extend credit through central bank funding. This bank would suffer from central bank funding stigma (see also this recent paper) and be violently punished by the financial markets, forcing the contraction of its loan book (and of the money supply) in the medium-term. I advise Paul Sheard, who works for the rating agency S&P, to spend some time with his bank analyst colleagues, and ask them how they view a bank that increasingly relies on central banks for funding and liquidity. He might be surprised. In reality, banks’ inside money is endogenous but constrained by exogenous limits defined by the outside money supply (i.e. reserves).

At least, the MMT view is nicely-constructed, on a relatively sound theoretical basis. This isn’t the case of Richard Werner’s latest paper, titled ‘Can banks individually create money out of nothing? – The theories and the empirical evidence’.

I really don’t know what to think of it. It accumulates so many mistakes and misunderstandings that it becomes hard to take seriously. Its author seems to identify three banking theories: the credit creation theory of banking, the fractional reserve banking theory (FRB) and the financial intermediation theory of banking. The first one implies that banks are not constrained by reserves to extend credit, but not MMT-style: according to the theory (Werner has been a long-time proponent), banks apparently never need reserves (whereas MMT/endogenous theory says that banks can just borrow them from the central bank without limit). The last theory of the list emanates from Tobin’s work ‘Commercial Banks as Creators of Money’, which Werner considers the most dominant theory of banking nowadays. He makes a curious distinction between this view and FRB, as if they were unrelated. But Tobin’s ‘new view’ is based on FRB and the distinctions remain relatively minor.

Nevertheless, Werner manages to make the following (amazing) claim (my emphasis):

Starting by analysing the liability side information, we find that customer deposits are considered part of the financial institution’s balance sheet. This contradicts the financial intermediation theory, which assumes that banks are not special and are virtually indistinguishable from non-bank financial institutions that have to keep customer deposits off balance sheet. In actual fact, a bank considers a customers’ deposits starkly differently from non-bank financial institutions, who record customer deposits off their balance sheet. Instead we find that the bank treats customer deposits as a loan to the bank, recorded under rubric ‘claims by customers’, who in turn receive as record of their loans to the bank (called ‘deposits’) what is known as their ‘account statement’. This can only be reconciled with the credit creation or fractional reserve theories of banking.

Wait… really? So you mean that most economists did not know that deposits were sitting on the liability side of banks’ balance sheet?… Or perhaps they did, and the author simply completely misunderstood the ‘financial intermediation’ theory.

Furthermore, Werner also misunderstands the FRB theory:

Since the fractional reserve hypothesis requires such an increase in deposits as a precondition for being able to grant the bank loan, i.e. it must precede the bank loan, it is difficult to reconcile this observation with the fractional reserve theory.

This is also wrong. The FRB theory never states that a bank needs to get hold of reserves before extending credit. Indeed, the FRB states that a monopoly bank can extend credit up to several times its reserve base, because it is not subject to adverse interbank clearing. In a competitive market however, banks are likely to suffer from reserve outflows at some point. This implies that an individual bank needs to find extra reserves before the outflow occurs (in case it doesn’t already have some in excess) in order not to default on its interbank settlement. But this also implies that the bank can extend credit before finding those reserves*.

This leads Werner’s empirical evidence to completely miss the point: of course the bank can extend credit out of nowhere. But in this case the bank also knows that no cash is going to leave its vaults as the result of the transaction (which the researchers agreed to repay on the following day)**. But here we go: the paper ‘rejects’ the FRB theory on the ground that (brace yourself) “there seems no evidence that reserves (cash and claims on other financial institutions) declined in an amount commensurate with the loan taken out.”


There is evidently no discussion whatsoever in the paper of adverse clearing or evidences in banking history. No, instead, the paper concludes that

it can now be said with confidence for the first time – possibly in the 5000 years’ history of banking – that it has been empirically demonstrated that each individual bank creates credit and money out of nothing, when it extends what is called a ‘bank loan’. The bank does not loan any existing money, but instead creates new money. The money supply is created as ‘fairy dust’ produced by the banks out of thin air. The implications are far-reaching.

Nothing less.

According to the paper, Keynes:

was perhaps even more dismissive of supporters of the credit creation theory, who he referred to as being part of the “Army of Heretics and Cranks, whose numbers and enthusiasm are extraordinary”, and who seem to believe in “magic” and some kind of “Utopia” (Keynes, 1930, vol. 2, p. 215)

I am no fan of Keynes. But it does seem he got that right.

Ironically, Lord Keynes (the blogger) found this paper ‘excellent’, and seems not to be able to spot the many differences between Werner’s theory and post-Keynesian’s (and ‘endogenous money’) views.

* For a single transaction, it may not even have to look for extra reserves if the funds are transferred to one of its own customers.

** There are also plenty of other reasons why this bank, a member of the German cooperative banking group, would not seek extra reserves. The operational arrangements of this group (and of the German savings banks group too) are very specific and relatively unique in the world. Werner’s whole experiment is thus flawed. His accounting analysis is also far from clear and seems to mix up reserves and money market claims on intragroup banks and other financial institutions.

Santa bank notes

A curious short post was published on the NY Fed’s Liberty Street Economics blog. Apparently, during the so-called ‘free banking’ era, some US banks printed Santa bank notes:

During the unregulated 19th century, a variety of banks issued their own holiday-themed currency. One popular figure featured on many bills was Santa Claus. Christmas was declared an official holiday in many northern states in the mid-1800s, and some banks celebrated by creating Santa Claus currency. This was a very popular time for Santa in the United States, spurred on by the publication of “A Visit from St. Nicholas” by Clement Clarke Moore in 1823.

The Santa Claus bank notes became very popular as keepsakes, because denominations were typically small and the subject was at the forefront of peoples’ minds given the brand-new official holiday. One motivation for the banks to release these and other collectible currencies was to dissuade people from redeeming the bills for their underlying gold value.

(on a side note: the “unregulated 19th century”? ahem…)

Here is an example of one of those private Santa notes:

santa note

Merry Christmas!

EU banking dis-union

The EU wants to put in place its now famous banking union. The ECB is taking over as the single regulator of all the banks of the Eurozone (and countries that wish to participate). The rationale is that the Eurozone banking system is getting ever more integrated within the ‘single market’, hence justifying having a single ruleset and a single supervisor. But is it really?

In a recent speech, Andrew Haldane pointed out that cross-border banking claims had strongly declined since the crisis:

Cross border bank claims

But a new paper by Bouvatier and Delatte (full version here) now provides some interesting disagregated data to this trend. Controlling for the impact of the economic and financial crisis on the integration of the banking system across Eurozone countries, they conclude that

the decline in banking activities observed after the crisis was due to temporary frictions in all countries outside the euro area. In contrast, the economic downturn faced by the euro area since 2008 is not sufficient to account for the massive retrenchement of international banking activities. Euro area banks have reduced their international exposure inside and outside the euro area to a similar extent. We also find that this decline is not a correction of previous overshooting but a marked disintegration.

According to their model, Eurozone banking integration is 37% below where it should be. So much for a banking union. On the other hand, they find that non-Eurozone banking systems have increased their claims on foreign countries.

Banking integrationThis is very interesting. However, I believe two minor issues distort some of their conclusions: 1. Their sample of banks only consider 14 OECD countries. It would have been interesting to include emerging economies. 2. Their analysis stops in 2012, which is a flaw. Since then, many non-Eurozone banks have cut in their cross-border activities as complying with the increasing regulatory burden became too onerous. I actually suspect that most banks from OECD/developed countries have started to dis-integrate, whereas banks from a number of emerging economies have actually started to grow outside of their domestic borders*.

They do not provide the reasons behind this phenomenon. However, I believe that regulatory and political pressure is the number 1 reason behind this retrenchment. In their haste to make banks safe, regulators are actually doing the exact opposite.

I have already reported on BoE research that demonstrated that global integration of banking systems led to stability of funding flows within what researchers called the ‘internal capital markets’ of banking groups (I also added several historical examples to back this research).

More and more research is produced that actually contradicts the whole current regulatory thinking. A new study by NY Fed researchers Correa, Goldberg and Rice also confirmed the importance of banking group’s internal liquidity transfers across cross-border entities:

In global banks, internal liquidity management is a consistent driver of explaining cross-sectional differences in loan growth in response to changing liquidity risk. Those banks with higher net borrowing from affiliated entities had consistently strong loan growth (domestic, foreign, cross-border, credit) when liquidity risks increased. As shown in the last column of Table 2 Panel B, these global banks with larger unused credit commitments borrow relatively more (net) from their affiliates when liquidity conditions worsen and then sustain lending to a greater degree.

Clearly, the ability of global groups to transfer liquidity and capital across borders can play the role of risk absorber when a crisis strikes. Yet national regulators are implementing new measures that have the exact opposite effect (i.e. ring-fencing and so on). Measures that, among others, result in the disintegration of banking across the Eurozone.

Consequently, regulators’ and politicians’ enthusiasm for the banking union seems a little bit misplaced. See this recent speech by Vítor Constâncio, Vice-President of the ECB:

Another important objective of Banking Union is to overcome financial fragmentation and promote financial integration. In particular, this will constitute a key task of the Single Supervisory Mechanism.

Really? This seems to me to contradict the very actions of regulators in the EU. It can only be one way Mr. Constancio, not both ways.

Then he adds something that is, I believe, a fundamental error:

There are four ways which I expect the SSM to make a difference to banking in Europe: by improving the quality of supervision; by creating a more homogeneous application of rules and standards; by improving incentives for deeper banking integration; and by strengthening the application of macro-prudential policies.

The prudential supervision of credit institutions will be implemented in a coherent and effective manner. More specifically, the Single Rule Book and a single supervisory manual will ensure that homogeneous supervisory standards are applied to credit institutions across euro area countries. This implies that common principles and parameters will be applied to banks’ use of internal models, for example. This will improve the reliability and coherence in banks’ calculation of risk-weighted assets across the Banking Union. On another front, the harmonisation in the treatment of non-performing exposures and provisioning rules will mean that investors can directly compare balance sheets across jurisdictions.

While I believe that the single resolution mechanism can indeed be beneficial (even though it looks overly complicated and it remains to be seen how it’s going to work in practice), a single regulatory treatment of all banks across economies and jurisdictions as varied as those of the EU is mistake. Here is what I said more than a year ago about the standardisation problem:

So a standardisation seems to be a good thing as data becomes comparable. Well, it is, and it isn’t. To be fair, standardisation within a country is probably a good thing, although shareholders, investors and auditors – rather than regulators – should force management to report financial data the way they deem necessary. However, it makes a lot less sense on an international basis. Why? Countries have different cultural backgrounds and legal frameworks, meaning that certain financial ratios should not be interpreted the same way from one country to another.

Let’s take a few examples. In the US, people are much more likely than Europeans on average to walk away from their home if they can’t pay off their mortgage. Most Europeans, on the other hand, will consider mortgage repayment as priority number 1. As a result, impaired mortgage ratios could well end-up higher in the US. But US banks know that and adapt their loan loss reserves in consequence. Within Europe, legal frameworks and judiciary efficiency are also key: UK banks often set aside fewer funds against mortgage losses as the legal system allows them to foreclose and sell homes relatively quickly and with minimal losses. In France on the other hand, the process is much longer with many regulatory and legal hurdles. Consequently, UK-based mortgage banks seem to have lower loan loss reserves compared with some of their continental Europe peers. Does it mean they are riskier? Not really.

Indeed, look at the World Bank’s Doing Business data. The Economist selected a few countries below, all of them from the EU:

EU legal frameworks

EU countries have very disparate legal frameworks and cultural backgrounds. What Constancio is saying is that the same criteria are going to be applied to all banks across all countries above. This does not make sense. The ‘single EU market’ remains for now a multiplicity of various heterogeneous markets, with their own rules, that have merely facilitated cross-border trade and labour movement.

This is a fundamental issue with the EU. Monetary and banking union should have come last, after all other laws had been harmonised. Not first. For now, EU politicians want to force a banking union on a geographical area that has limited legal and political integration. Let alone that domestic politicians and regulators are forcing their domestic banks to focus on business within their national borders, not within the EU borders.


* Indeed, another recent paper by Claessens and van Horen (summary on VOX here) suggests that

After a continued rise until 2008, the number of foreign banks from high-income countries has started to decline, from 948 in 2008 to 814 in 2013, mostly on account of a retrenchment by crisis-affected Western European banks.

On the other hand, banks from emerging markets and developing countries continued their pre-crisis growth and further increased their presence. Currently these banks own 441 foreign banks, representing 8% of all foreign assets, a doubling of their share as of 2007. As these banks tend to invest mainly in their own geographical regions, global banking now both encompasses a larger variety of players and at the same time is more regional, with the average intraregional share increasing by some five percentage points.

Number of banks


I’d rather not have a fox as bank regulator

We can sometimes read stupefying things on the internet. I almost fell off my chair yesterday when I read MC Klein’s latest banking piece on FT Alphaville. He suggests that the right way to regulate banks might well be to be “crazy like a fox”…


Throughout his ‘surprising’ post, he writes things like:

While simple rules about capital and short-term debt still have tremendous appeal, there is value in having a regulatory regime that is onerous precisely because of its complexity and its unpredictability.


As Matt Yglesias notes, the value of having lots of pointless but annoying rules is that they distract the bank lobbyists from the really important stuff. The swap pushout was the first in what is hopefully a long line of defence. We’re tempted to say that crafty policymakers should immediately propose several new and even more annoying rules for the banks.

Fortunately, regulators have other means of harassing their adversaries, hopefully keeping them busy enough to avoid exploiting the system too much.

Andrew Haldane must be having a heart attack right now.

This goes against some of the most basic economic principles, and against the very thing that allows any business to exist and thrive in the first place: the rule of law.

Let’s start with Matt Yglesias’ post. Perhaps not surprising for someone who once wrote that Dodd-Frank was an ‘achievement’ that created a ‘safer banking system’, Yglesias again proves that he has a very low understanding of how banking works. CDS contacts have apparently become ‘custom swaps’ that are used to “bet on the potential bankruptcy of a given country or company or the failure of a new financial product.” Hedging anyone? Insurance that can protect even the most vanilla-like institutions against some specific default risks? No, this is just an evil Wall Street speculative tool. Nevermind that some CDS are traded on behalf of clients, and banks’ positions taken to offset customers’ needs. Nevermind that siloing banking activities/liquidity/capital across different entities of a same banking group actually decrease the safety of the system (see also here).

Despite this rather limited knowledge of the industry, Klein builds on Yglesias’ reasoning: any repealed rule should be replaced by many pointless ones to distract lobbyists.

Now, I am still trying to understand the logic behind constantly adding red tape for no reason rather than judging rules and bureaucracy on their actual value-added and efficiency. Here again, nevermind that countries with the least efficient and most numerous rules are the least business-friendly, and that too much red tape and regulatory uncertainty is around the top issue for most US businesses at the moment. No, banking is (apparently) different.

Let me suggest that a few years working for a bank would probably help dispel some of those myths. That, lobbyists aren’t that dumb, and that, if they attack some specific rules, it is surely that these would be harmful for the banks (and indeed, both Yglesias and Klein are plain wrong in considering this CDS rule ‘pointless’). That the 30,000-page rulebook that Dodd-Frank created might not fully facilitate banking processes and lending. That, by constantly changing the rules as Klein suggests, banks might well be tempted to move away from any risky activity that might end up being considered unlawful at some point in the future, hurting risky lending in the process (i.e. usually SME lending, as if it were not already low enough) with all the associated potential economic consequences.

Banks have been closing entire lines of business, de-globalising, preventing international payments to go through, harming international trade and economic activity. The multiplication of rules could, not only lead to resource misallocation, but also to increased management time. Management time that would be better spent on analysing and controlling the business than on bureaucratic, ‘pointless’, but dangerous (because of potential fines) rules. Unexpected consequences if you like. Still, it looks acceptable for Klein.

This is exactly why avoiding regulatory uncertainty and discretionary policies, and applying a predictable set of rules (i.e. rule of law), is so crucial in facilitating business and economic development.

As Kevin Dowd clearly illustrates in a very good recent paper:

One has to understand that the banks have no defense against this regulatory onslaught. There are so many tens or hundreds of thousands or maybe millions of rules that no one can even read them all, let alone comply with them all: even with armies of corporate lawyers to assist you, there are just too many, and they contradict each other, often at the most fundamental level. For example, the main intent of the Privacy Act was to promote privacy, but the main impact of the USA PATRIOT Act was to eviscerate it. This state of lawlessness gives ample scope for regulators to pursue their own or the government’s agendas while allowing defendants no effective legal recourse. One also has to bear in mind the extraordinary criminal penalties to which senior bank officers are exposed. Government officials can then pick and choose which rules to apply and can always find technical infringements if they look for them; they can then legally blackmail bankers without ever being held to account themselves. The result is the suspension of the rule of law and a state of affairs reminiscent of the reign of Charles I, Star Chamber and all. Any doubt about this matter must surely have been settled with the Dodd-Frank Act, which doled out extralegal powers like confetti and allows the government to do anything it wishes with the banking system.

A perfect example of this governmental lawlessness was the “Uncle Scam” settlement in October 2013 of a case against JP Morgan Chase, in which the bank agreed to pay a $13billion fine relating to some real estate investments. This was the biggest ever payout asked of a single company by the government, and it didn’t even protect the bank against the possibility of additional criminal prosecutions. What is astonishing is that some 80 percent of the banks’ RMBS had been acquired at the request of the federal government when it bought Bear Stearns and WaMu in 2008, and now the bank was being punished for having them. Leaving aside its inherent unpleasantness, this act of government plunder sets a very bad precedent: going forward, no sane bank will now buy a failing competitor without forcing it through Chapter 11. It’s one thing to face an acquired institution’s own problems, but it is quite another to face looting from the government for cooperating with the government itself.

The argument’s logic is also very weak. If rules are believed to let excessive risks “fall through the cracks”, then they should never be adopted in the first place. Why even adopting rules which we already know create systemic risks? If regulators really believe those rules will cover most (or all) risks, there is no point in planning to replace them with other rules, just for the sake of changing the rules, as the new ones are likely to be less effective. Otherwise those new, more effective, rules are the ones that should have been implemented in the first place. The whole logic of the argument just doesn’t hold*.

What about the practicality of ever changing the regulatory framework? Here again the argument fails. There aren’t hundreds of derivative settlement options and assets acceptable as collateral or as liquidity buffer. While the theory sounds nice in FT Alphaville’s columns, it is simply not possible to implement in practice.

The financial imbalances that led to our previous crisis, for a large part, originated in the most complex banking rule set devised in history, compounded by politically-incentivised housing agendas (along with misguided monetary policy and accounting rules). Klein’s (and Yglesias’) failure is to ignore this and assume that more, and tighter, rules are more effective. Moreover, regulators’ failure to foresee crises has probably been a constant throughout history. Yet, Klein backs an ever-more complex and constantly-changing regulatory framework at the discretion of those same regulators.

Calomiris and Nissim, two academics that know and understand a thing or two about banking, declared that:

We worry that regulatory uncertainty – and especially the persistent waves of political attacks on global universal banks – is taking a toll.

It is important to recognize that bank stockholders are not alone in suffering from the low stock prices that result from these attacks. The supply of bank loans, and banks’ ability to provide other crucial financial services in support of economic growth, reflect the risk-bearing capacity of banks, which is directly related to market valuations of bank franchises. If banks’ earnings get little respect from the market, banks’ abilities to help the economy grow will be commensurately hobbled.

Even The Economist, which has been a supporter of banking regulatory reform over the past few years, is against regulatory discretion and is well-aware of regulators’ weaknesses (emphasis mine):

Attracting the capital that will make banking safer will be hard, with profit forecasts so anaemic. However it will also be made unnecessarily difficult by capricious behaviour from the very watchdogs who are ordering banks to raise the funds.

One problem is the endless tinkering with the rules. For all Mr Carney’s talk of finishing the job, global regulators have yet to set the minimum level for several of their new capital requirements. National regulators are just as bad. No bank can be certain how much capital it will need in a few years’ time. Pension funds and insurance companies rightly fret that even a tiny tweak in any of the new regulatory tests is enough to send a bank’s share price plummeting (or, less often, rocketing). […]

Banks can hardly be surprised that regulators have rewritten the rule-book and then thrown it at them. But, for the health of the system, the rules need to be predictable, transparent and consistent. Incredibly, the regulations emanating from America’s Dodd-Frank financial reforms are still being written, more than four years after the law was passed. Europe is scarcely better. Impose demanding capital rules, but stop adding more red tape: that should be the mantra of bank regulators just about everywhere.

The worst is: Klein does identify some of the problems with our current regulatory regime, which is easily gameable because of its complexity. In terms of regulation and forecasting, simple rules and models have always performed better (see some of the links above). But instead of stepping back and getting back to simpler, less distortive, rules, his policy of choice seems to be more bank-bashing, never-ending regulatory regime uncertainty, more complexity, the possible paralysis of bank lending and the build-up of risk within the more opaque shadow banking system. I guess it’s going to be a real success.


* He could reply that the very purpose of ‘pointless’ rules is that they have no real impact on anything. Let me clarify something: all rules have an impact, whether it is small, big, negative, positive, or both (and again, the CDS rule was far from pointless). He could also reply that changing the rules limit the gameability of the system. But this makes little sense, as ‘pointless’ rules changes would probably not prevent the accumulation of risk anyway and, even for ‘non-pointless’ rules, there are only a few available options as described above (changing capital requirements by 1% up or down, including or excluding A+ rated bonds as LCR-compliant, increasing/decreasing haircut requirements by 5%, and so forth, really would have very little impact on gameability or stability).

I am also a free banking theorist

George Selgin wrote a very true post on Freebanking.org. He claims that we are all, in a way or another, free banking theorists. Why? As Selgin very well explains:

Consider: an economist says that central banks prevent or limit the severity of financial crises, or that without mandatory deposit insurance even sound banks are likely to face runs, or that banks can never be expected to hold enough capital unless we force them to, or that commercially-supplied banknotes will tend to be discounted. All such claims–which is to say any claims about the need for or consequences of government intervention in banking–depend, if not on an explicit understanding of the nature and workings of a laissez-faire banking system, then on some implicit understanding. And this understanding in turn implies a theory of some sort, for reference to experience alone won’t suffice for drawing the sort of sweeping conclusions I’m talking about. It follows that all economists who have anything to say about the effects of government intervention in the banking system are either self-proclaimed free banking theorists or are free banking theorists who don’t admit (and perhaps don’t realize) it.

Indeed, most banking academic research studies and banking reform proposals base their ideas and models on certain assumptions of how the banking system, left to its own device, would behave, and how to correct the market failures that could possibly arise from such systems.

As my (and most people’s) experience can also testify, this tacit conventional wisdom is present in the mind of the general public and finance practitioners (I can still remember my father’s face when I told him we should get rid of central banks. Like he had just spotted some sort of ghost). The success of the usual US-centric misrepresentation of banking history is almost complete.

With this blog, I have been trying to explain what would (not) have happened if we had left banking free of all the rules that distort its natural behaviour. Seen this way, I am also a free banking theorist. I am trying to get back to the roots, asking questions such as: let’s supposed we never implemented Basel rules, would have real estate lending grown that much over the past three decades? What about securitization? Or interest rates on sovereign debt? And banks’ capital and liquidity buffers? What if we hadn’t had central banks nor deposit insurance over the period? What compounded what?

A lot of this is counterfactual, hence uncertain. Still, the intellectual challenge this represents is worth it, as current banking reformers and regulators still rely on and take for granted the inaccurate conventional story to justify the exponential growth of increasingly tight rules. Rules which, as I explain on this blog, are more likely to harm the banking system than to make it safer.

Larry White once says that free banks should be ‘anti-fragile’, and that the only reason they remain fragile is because of government-institutionalised rules that prevent them from self-correcting and learning. I have also already said that this does not mean that banks would never fail or that no crisis would ever occur. But it is likely that the accumulation of financial imbalances, which under our current system slowly emerge hidden behind the regulatory curtain until it is too late, would appear much sooner, limiting the destructive potential of any crisis. The market process, in order to become anti-fragile, needs to learn through experience. The more ‘safety’ rules one implement the less likely market actors will learn and the more likely the following crisis is going to be catastrophic. Institutionalised paternalism is self-defeating.

Unfortunately, the conventional story has seriously twisted everyone’s mind, and it is highly likely that any government announcing the end of the Fed/ECB/BoE/deposit insurance/currency monopoly would trigger market crashes and a lack of confidence in banks. Most commentators would describe the move as “crazy given what we’ve learnt from history”. In short, it would be a ‘history misreading-induced’ panic. While this would be short-lived, this would also be damaging. It is our role to tell the public that, in fact, it should not fear such changes. It should welcome them.

Myths are slowly being debunked. Slowly…

A few institutions have recently raised voices to try to debunk some of the banking legends that had appeared and became conventional knowledge as a result of the crisis. Here’s an overview.

S&P, the rating agency, just published a note declaring that, surprise surprise, the UK’s ring fencing plans could have clear adverse consequences. Those include: possible downgrade to ‘junk’ status and lower ‘stability’ of the non-ring fenced entities, costs for customers could rise, credit supply could be squeezed, and, what I view as the most important problem of all, ring fencing rules “will undoubtedly further constrain fungibility.” According to the S&P analyst, as reported by Reuters:

“The sharing of resources (and brand, expertise, and economies of scale) means we view most banking groups as being more than the sum of their parts,” the report said.

It said disrupting these benefits could lead S&P to have a weaker view of the group as a whole and to lower its credit ratings on some parts of the banks.

S&P said the complexity of separating functions “represents a significant operational challenge” for banks at a time of multiple other regulations.

I cannot agree more. I have already written four long pieces explaining why intragroup liquidity and capital transfers were key in maintaining a banking group safe. Ring fencing does the exact opposite, putting those liquidity buffers and capital bases in silos from which they cannot be used elsewhere, potentially endangering the whole bank.


The BoE just reported that households could actually cope with raising interest rates. One of the Bank’s justification for not raising rates was that it would push many households towards default, so it is now kind of contradicting itself. And anyway, as I have described previously, lowering rates ceased to translate into lower borrowing rates due to margin compression. Patrick Honohan, Governor of the central bank of Ireland, reported that the exact same phenomenon occurred in Ireland:

Because of the impact on trackers, though, the lower ECB interest rates have not directly improved the banks’ profitability, because the average and marginal cost of bank funds does not fall as much. The banks’ drive to restore their profitability, combined with the lack of sufficient new competition, has meant that, far from lowering their standard variable rates over the past three years as ECB rates have fallen, they have (as is well known) actually increased the standard variable rates somewhat. […] These rates indicate that standard variable rate borrowers are still paying less than they were before the crisis, but not by much. A widening of mortgage interest rate spreads over policy rates also occurred in the UK and in many euro area countries after the crisis, but spreads have begun to narrow in the UK and elsewhere. Until very recently bank competition has been too weak in Ireland to result in any substantial inroads on rates.

Ireland mortgage rates

This chart exactly looks like what happened in the UK. Spread over BoE/ECB rates have increased, and increasing rates could actually translate into the same level of mortgage rates. This is because, as margin compression starts disappearing, competition can start driving down the spread over BoE/ECB. Households may have to remortgage to benefit from the same rates though.


In Germany, regulators said that the ECB’s negative deposit rates could incite more risk-taking and declared that:

Excess liquidity could even threaten the banking system if it is put to poor use

Regulators vs. ECB. This is getting interesting.


In FT Alphaville, David Keohane reports a few charts from Morgan Stanley. One of them clearly shows the Chinese Central Bank’s use of reserve requirements to manage lending growth. I’m sure my MMT and ‘endogenous money’ friends will appreciate.

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