New research confirms the role of regulation and housing in modern business cycles

I think readers will find it hard to imagine how excited I was yesterday when I discovered (through an Amir Sufi piece in the FT) a brand new piece of research called: The Great Mortgaging: Housing Finance, Crises, and Business Cycles

(The authors, Jordà, Schularick and Taylor (JST), also published a free version here, and a summary on VOX)

I wish the authors had read my blog before writing their paper as it confirms many of my theses (unless they had?). It’s so interesting that I could almost quote two thirds of the paper here. I obviously encourage you to read it all and I will selectively copy and paste a few pieces below.

In my recent piece on updating the Austrian business cycle theory (ABCT), I pointed out that the nature of lending (and banks’ balance sheets) had changed over time since the 19th century (and particularly post-WW2), mainly due to banking regulation and government schemes. I had already provided a revealing post-WW2 chart for the US to demonstrate the effects of Basel 1 on business and real estate lending volumes.

US lending Basel

JST went further. They went further back in time and gathered a dataset of disaggregated lending figures covering 17 developed countries over close to 140 years. Their conclusions confirm my views. Regulations – and in particular Basel – changed everything.

Here is their aggregate credit to GDP chart across all covered countries, to which I added the introduction of Basel 1 as well as pre-Basel trends:


Historical aggregate lending

I don’t think there is anything clearer than this chart (I’m not sure that securitized mortgages are included, in which case those figures are understated). Since the 1870s, non-mortgage lending had been the main vector of credit and money supply growth, and mortgage lending represented a relatively modest share of banks’ balance sheet. Basel turned this logic upside-down. How? I have already described the process countless times (risk-weights and capital regulation), so let see what JST say about it:

Over a period of 140 years the level of non-mortgage lending to GDP has risen by a factor of about 3, while mortgage lending to GDP has risen by a factor of 8, with a big surge in the last 40 years. Virtually the entire increase in the bank lending to GDP ratios in our sample of 17 advanced economies has been driven by the rapid rise in mortgage lending relative to output since the 1970s. […]

In addition to country-specific housing policies, international banking regulation also contributed to the growing attractiveness of mortgage lending from the perspective of the banks. The Basel Committee on Bank Supervision (BCBS) was founded in 1974 in reaction to the collapse of Herstatt Bank in Germany. The Committee served as a forum to discuss international harmonization of international banking regulation. Its work led to the 1988 Basle Accord (Basel I) that introduced minimum capital requirements and, importantly, different risk weights for assets on banks’ balance sheets. Loans secured by mortgages on residential properties only carried half the risk weight of loans to companies. This provided another incentive for banks to expand their mortgage business which could be run with higher leverage. As Figure 1 shows, a significant share of the global growth of mortgage lending occurred in recent years following the first Basel Accord.

I wish they had expanded on this topic and made the logical next step: Basel helped set up the largest financial crisis in our lifetime through regulatory arbitrage. Nevertheless, the implications are crystal clear.

To JST, this growth in real estate lending is the reason underlying our most recent financial crises:

We document the rising share of real estate lending (i.e., bank loans secured against real estate) in total bank credit and the declining share of unsecured credit to businesses and households. We also document long-run sectoral trends in lending to companies and households (albeit for a somewhat shorter time span), which suggest that the growth of finance has been closely linked to an explosion of mortgage lending to households in the last quarter of the 20th century. […]

Since WWII, it is only the aftermaths of mortgage booms that are marked by deeper recessions and slower recoveries. This is true both in normal cycles and those associated with financial crises. […]

The type of credit does seem to matter, and we find evidence that the changing nature of financial intermediation has shifted the locus of crisis risks increasingly toward real estate lending cycles. Whereas in the pre-WWII period mortgage lending is not statistically significant, either individually or when used jointly with unsecured credit, it becomes highly significant as a crisis predictor in the post-WWII period.

JST confirm what I was describing in my post on updating the ABCT: that is, that banks don’t play the same role as in early 20th century, when the theory was first outlined:

The intermediation of household savings for productive investment in the business sector—the standard textbook role of the financial sector—constitutes only a minor share of the business of banking today, even though it was a central part of that business in the 19th and early 20th centuries.

JST describe the post-WW2 changes in mortgage lending originally as a result of government schemes to favour home building and ownership, followed by international regulatory arrangements (Basel) from the 1980s onward. Those measures and rules led to a massive restructuring of banks’ balance sheet, as demonstrated by this chart:

Historical aggregate RE lendingWhile the empirical findings of this paper will be of no surprise to readers of this blog, this research paper deserves praise: its data gathering and empirical analysis are simply brilliant, and it at last offers us the opportunity to make other mainstream academics and regulators aware of the damages their ideas and policies have made to our economy over the past decades. It also puts the idea of ‘secular stagnation’ into perspective: our societies are condemned to stagnate if regulatory arbitrage starve our productive businesses of funds and the only way to generate wealth is through housing bubbles.

China’s Frankenstein banking system keeps growing

Financial regulation in China is quite a mess. China seems to be the world testing ground for some of the most ridiculous banking rules. With all their related unexpected consequences.

Take this recent story: some time ago, Chinese regulators found it clever to cap Chinese banks’ loans/deposits ratios at 75% by the end of each quarter (it isn’t). The goal was to ensure that banks have enough liquidity to face large cash withdrawals. Nevermind that loans/deposits only take into account loans from the asset side of the balance sheet and that banks can use depositors cash to invest in many different sorts of assets (from liquid sovereign bonds and short-term repos to very illiquid securities). Perhaps Chinese banking rules forbid some of those investments (I am not an expert on the Chinese banking system). The fact that the rule was only enforced at quarter-end seemed not to be a problem either (arbitrage anyone?), or that the news that a bank hadn’t complied with the rule could trigger a panic.

Nevertheless, as usual with China, the spontaneous financial order reacts. As the FT reports:

In recent years, the final few days of each quarter have become a nervous time for banks. As liquidity has tightened and many depositors have shifted their savings into higher-yielding substitutes such as Alibaba’s online money-market fund, Yu’E Bao, many lenders have struggled to attract enough traditional deposits to stay below the maximum 75 per cent loan-to-deposit ratio.

That regulation, intended to ensure banks keep enough cash on hand to meet withdrawal demand, is enforced at the end of each quarter – providing an incentive to window-dress deposit totals. This was exacerbated by the desire to prettify quarterly reports to shareholders.

To meet the deposit challenge, many banks resorted to an all-hands-on-deck approach, requiring employees to meet a deposit target. That meant urging clients – and even family and friends – to transfer funds into the bank, typically only for a few days covering the quarter-end period.

Typical example of a rule that, not only introduces opacity, but also creates unintended consequences.

But the story isn’t over.

Chinese regulators didn’t really appreciate that bankers were trying to bypass their well-thought-out rule. They came up with another very ‘clever’ rule to fix the flawed rule:

Regulators will suspend business approvals to banks whose month-end deposit total deviates by more than 3 per cent from the daily average over the previous month.

Problem solved. Not.

To the uncertainty and unintended consequences of the previous rule, they added further uncertainty and unintended consequences. Nevermind that such a rule would limit competition for deposits (Chinese banks are for now forbidden to compete on price – this is about to change –, but can well use other means and advantages). A larger deposit inflow could well happen for any reason (run on a competitor, or simply good news about the financial strength of a bank leading to an inflow of new customers). Penalising banks for such reason sounds rather dubious to say the least.

One of the consequences is that banks now turn away deposits…

The rule can also easily trigger instability, as the FT adds:

A light-hearted commentary circulated among bankers on social media on Wednesday, carrying the headline “If there’s a bank you hate, send them all your money before 12 tonight”.

I’m sure Chinese people, with their usual banking rule-avoiding ingenuity, will soon enough find a way to use all the loopholes created by this combination of definitely very clever regulations. And that regulators, in turn, will come up with another rule to patch the rule that patched the rule. The Frankenstein experiment continues.

MC Klein and central bankers struggle to understand banking mechanics

I recently pointed out that many central bankers actually did not understand banks’ internal mechanics. We now have further evidence. In an FT Alphaville blog post, Matthew Klein quoted a recent report from the Reserve Bank of Australia, which usefully compared banking metrics across countries.

Cost Income by Country

MCK points out that Australian banks have some of the lowest cost/income ratios in the world, whereas Swiss, German and British banks have some of the highest ones. According to the report, the difference mostly comes from the lower income paid to Australian bankers, which (apparently) originates in the ‘simplicity’ of Australian banks, whose investment banking activities are relatively small.

Indeed, as the following chart demonstrates, Australian banks do generate a larger share of their revenues from net interest income than banks in other countries. MCK concludes:

In other words, the more a bank focuses on taking in deposits and making loans to households and businesses, the cheaper it is to run and the less money its employees make.

Cost and NII

And he then quotes the Australian central bank:

The Australian major banks’ focus on commercial banking – that is, lending to households and businesses – appears to be a contributor to their relatively low CI ratio. In 2013, those large banks that earned a greater share of their income from net interest income (a proxy for a bank’s focus on lending activities) tended to have lower CI ratios than ‘universal’ banks, which earned a larger share of their income through non-interest sources such as investment banking or wealth management.

The above analysis suggests that there may be diseconomies of scope for some large banks – that is, average costs increase as they diversify outside of commercial banking services. This is consistent with some literature which points to negative returns to scope when banks move into market-based activities. While market-based activities can provide a more diversified revenue stream for banks, they are typically a more volatile source of income and can expose banks to additional risks and complexity.

As simple as that.

But… wait. Are things really that simple?

Let’s take a look at some of the largest banks’ reported segmental cost/income ratios in 2013*. The segments in bold are the ones that include ‘simple’ retail banking:

  • UBS: its reported segmental cost/income ratios were the following in 2013: Wealth Management 70%, Wealth Management Americas 87%, Retail & Corporate 61%, Global Asset Management 70%, Investment Bank 73%
  • Credit Suisse: Wealth Management 75%, Corporate & Institutionals 51%, Asset Management 69%, Investment Banking 71%
  • Deutsche Bank: Corporate Banking & Securities 76%, Global Transaction Banking 65%, Asset & Wealth Management 83%, Private & Business Clients 76%
  • Commerzbank: Private Customers 90%, Mittlestandbank 46%, Central & Eastern Europe 54%, Corporates & Markets 65%, Non-Core Assets 98%
  • Barclays: UK RBB 67%, Barclaycard 43%, Africa RBB 71%, Europe RBB 126%, Wealth 87%, Investment Bank 72%, Corporate 58%

It is really not clear that straightforward retail banking boasts low cost/incomes. And if one thing is clear, it is that, even in their retail banking divisions, banks in Europe do not boast the same sort of cost/income as in Australia, far from that. Around 20 percentage points higher in fact. Small, retail-only, European banks’ cost/income ratios also reach the 60 to 75% level.

Perhaps the complexity/simple story isn’t that straightforward after all.

While it is true that investment banking, in theory, can lead to higher cost/income ratios (as can private banking), and that banking systems that rely on such activities inherently have bigger cost bases, this does not mean that those banking systems are necessarily unprofitable. Switzerland for instance has a very large number of private banks. The private banking business model leads to high level of costs… and low level of risk. In a bank’s income statement, loan impairment charges follow operating costs. A bank whose asset quality is low needs the financial flexibility to absorb losses on its loan portfolio. Hence the importance of a low cost/income. Many emerging markets banks indeed have low cost/income ratios.

That was the first point: cost/income by itself doesn’t mean much.

Second point is… by focusing on the cost side of the equation, both MCK and the Australian central bankers forgot the income side.

The income side comprises net interest income. This net interest income is partly dependent on the level of interest rates. When rates are set at a low level by central banks, margin compression appears. I have already described this phenomenon here. Unfortunately this concept seems to be foreign to most people.

Banks in the UK and Europe have been suffering from margin compression for many years, as interest rates have dropped near their zero lower bound, leading lending rates to fall while (deposit) funding rates were already stuck at the bottom. Many banks in the UK and the Eurozone now only have net interest margins of 1% or less. When margins are low, net interest income suffers and accounts for a lower share of total income.

What happened in Australia in the meantime? Well, interest rates are now at a record low of…2.5%. What are banks’ net interest margins? 2% to 2.25%… Given how strong those margins are, it is natural that Australian banks will also boast higher net interest incomes, and in turn higher incomes and lower cost/income ratios…

We now have a more comprehensive answer than the ‘simple’ (if not simplistic) explanation offered in this FT Alphaville column: low rates are partly responsible for European and American banks’ high cost/income ratio. ‘Complexity’, on the other hand, is an easy and convenient target for regulators. It fits the story they’ve been trying to sell since the crisis. Facts, unfortunately, are a little more stubborn.


* Segments aren’t fully comparable. Some include corporate/SME lending or wealth management, others not. Some one-offs could distort some of the figures somewhat. I didn’t correct for that. Some banks already exclude them from their reported segmental cost/income or include them in ‘non-core’ or ‘non-strategic’ units.

Why the Austrian business cycle theory needs an update

I have been thinking about this topic for a little while, even though it might be controversial in some circles. By providing me with a recent paper empirically testing the ABCT, Ben Southwood, from ASI, unconsciously forced my hand.

I really do believe that a lot more work must be done on the ABCT to convince the broader public of its validity. This does not necessarily mean proving it empirically, which is always going to be hard given the lack of appropriate disaggregated data and the difficulty of disentangling other variables.

However, what it does mean is that the theoretical foundations of the ABCT must be complemented. The ABCT is an old theory, originally devised by Mises a century ago and to which Hayek provided a major update around two decades later. The ABCT explains how an ‘unnatural’ expansion of credit (and hence the money supply) by the banking system brings about unsustainable distortions in the intertemporal structure of production by lowering the interest rate below its Wicksellian natural level. As a result, the theory is fully reliant on the mechanics of the banking sector.

The theory is fundamentally sound, but its current narrative describes what would happen in a relatively free market with a relatively free banking system. At the time of Mises and Hayek, the banking system indeed was subject to much lighter regulations than it is now and operated differently: banks’ primary credit channel was commercial loans to corporations. The Mises/Hayek narrative of the ABCT perfectly illustrates what happens to the economy in such circumstances. Following WW2, the channel changed: initiative to encourage home building and ownership resulted in banks’ lending approximately split between retail/mortgage lending and commercial lending. Over time, retail lending developed further to include an increasingly larger share of consumer and credit card loans.

Then came Basel. When Basel 1 banking regulations were passed in 1988, lending channels completely changed (see the chart below, which I have now used several times given its significance). Basel encouraged banks’ real estate lending activities and discouraged banks’ commercial lending ones. This has obvious impacts on the flow of loanable funds and on the interest rate charged to various types of customers.

US lending Basel

In the meantime, banking regulations have multiplied, affecting almost all sort of banking activities, sometimes fundamentally altering banks’ behaviour. Yet the ABCT narrative has roughly remained the same. Some economists, such as Garrison, have come up with extra details on the traditional ABCT story. Others, such as Horwitz, have mixed the ABCT with Yeager’s monetary disequilibrium theory (which is rejected by some other Austrian economists).

While those pieces of academic work, which make the ABCT a more comprehensive theory, are welcome, I argue here that this is not enough, and that, if the ABCT is to convince outside of Austrian circles, it also needs more practical, down to Earth-type descriptions. Indeed, what happens to the distortions in the structures of production when lending channels are influenced by regulations? This requires one to get their hands dirty in order to tweak the original narrative of the theory to apply it to temporary conditions. Yet this is necessary.

Take the paper mentioned at the beginning of this post. The authors find “little empirical support for the Austrian business cycle theory.” The paper is interesting but misguided and doesn’t disprove anything. Putting aside its other weaknesses (see a critique at the bottom of this post*), the paper observes changes in prices and industrial production following changes in the differential between the market rate of interest and their estimate of the natural rate. The authors find no statistically significant relationship.

Wait a minute. What did we just describe above? That lending channels had been altered by regulation and political incentives over the past decades. What data does the paper rely on? 1972 to 2011 aggregate data. As a result, the paper applies the wrong ABCT narrative to its dataset. Given that lending to corporations has been depressed since the introduction of Basel, it is evident that widening Wicksellian differentials won’t affect industrial structures of production that much. Since regulation favour a mortgage channel of credit and money creation, this is where they should have looked.

But if they did use the traditional ABCT narrative, it is because no real alternative was available. I have tried to introduce an RWA-based ABCT to account for the effects of regulatory capital regulation on the economy. My approach might be flawed or incomplete, but I think it goes in the right direction. Now that the ABCT benefits from a solid story in a mostly unhampered market, one of the current challenges for Austrian academics is to tweak it to account for temporary regulatory-incentivised banking behaviour, from capital and liquidity regulations to collateral rules. This is dirty work. But imperative.


Major update here: new research seems to confirm much of what I’ve been saying about RWAs and the changing nature of financial intermediation.


* I have already described above the issue with the traditional description of the ABCT in this paper, as well as the dataset used. But there are other mistakes (which also concern the paper they rely on, available here):

- It still uses aggregate prices and production data (albeit more granular): the ABCT talks about malinvestments, not necessarily of overinvestment. The (traditional) ABCT does not imply a general increase in demand across all sectors and products. Meaning some lines of production could see demand surge whereas other could see demand fall. Those movements can offset each other and are not necessarily reflected in the data used by this study.

- It seems to consider that aggregate price increases are a necessary feature of the ABCT. But inflation can be hidden. The ABCT relies on changes in relative prices. Moreover, as the structure of production becomes more productive, price per unit should fall, not increase.

Kupiec on central banking/planning

In the WSJ a couple of days ago, Paul Kupiec wrote an article that looks so similar to my blog that I had to quote it here.

Macroprudential regulation, macro-pru for short, is the newest regulatory fad. It refers to policies that raise and lower regulatory requirements for financial institutions in an attempt to control their lending to prevent financial bubbles. […]

There is also the very real risk that macroprudential regulators will misjudge the market. Banks must cover their costs to stay in business, and in the end bank customers will pay the cost banks incur to comply with regulatory adjustments, regardless of their merit. By the way, when was the last time regulators correctly saw a coming crisis?

He concludes with:

With Mr. Fischer now heading the Fed’s new financial stability committee, might we soon see regulations requiring product-specific minimum interest rates? Or maybe rules that single out new loan products and set maximum loan maturities and debt-to-income limits to stop banks from lending on activities the Fed decides are too “risky”? None of these worries is an unimaginable stretch.

Since the 2008 financial crisis, U.S. bank regulators have put in place new supervisory rules that limit banks’ ability to make specific types of loans in the so-called leverage-lending market—loans to lower-rated corporations—and for home mortgages. Since there is no scientific means to definitively identify bubbles before they break, the list of specific lending activities that could be construed as “potentially systemic” is only limited by the imagination of financial regulators.

Few if any centrally planned economies have provided their citizens with a standard of living equal to the standard achieved in market economies. Unfortunately the financial crisis has shaken belief in the benefits of allowing markets to work. Instead we seem to have adopted a blind faith in the risk-management and credit-allocation skills of a few central bank officials.

Government regulators are no better than private investors at predicting which individual investments are justified and which are folly. The cost of macroprudential regulation in the name of financial stability is almost certainly even slower economic growth than the anemic recovery has so far yielded.

This is very good, and I can’t agree more.

He points to his own research on macro-prudential policies. In a paper published in June 2014, Kupiec, Lee and Rosenfeld declare that

Compared to the magnitude of loan growth effects attributable to [increase in supervisory scrutiny or losses on loan/securities], the strength of macroprudential capital and liquidity effects are weak. This data suggest that traditional monetary policy (lowering banks’ cost of funding) is likely to be a much more potent tool for stimulating bank loan growth following widespread bank losses than modifying regulatory capital or liquidity requirements.

(note: they also say that the opposite logic applies)

While it doesn’t mean that they are wrong, I am not fully convinced by their arguments, especially given the dataset they base their analysis on (an economic and credit boom period, with less than tight monetary policy and many variables that could have been distorted as a result). In another paper, Aiyar, Calomiris and Wieladek point to the fact that macro-prudential policy can be effective at reducing banks’ lending, but that alternative sources of credit (i.e. shadow banking) grow as a result (they say that macro-prudential policies ‘leak’).

What is clear is that the effects of macro-prudential policies are unclear. What is also clear is that, whatever the effects of those policies, none are necessarily desirable. If macropru is indeed effective, then the resulting distorted capital allocation may be harmful. If macropru isn’t effective, then it may lead central bankers to (wrongly) believe they can maintain interest rates below/above their natural level while controlling the collateral damages this creates. In both cases the economy ends up suffering.

ECB policies: from flop to flop… to flop?

Even central bankers seem to be acknowledging that their measures aren’t necessarily effective…

ECB’s Benoit Coeuré made some interesting comments on negative deposit rates in a speech early September. Surprisingly, he and I agree on several points he makes on the mechanics of negative rates (he and I usually have opposite views). Which is odd. Given the very cautious tone of his speech, why is he even supporting ECB policies?

Here is Coeuré:

Will the transmission of lower short-term rates to a lower cost of credit for the real economy be as smooth? While bank lending rates have come down in the past in line with lower policy rates, there is a limit to how cheap bank lending can be. The mark-up that banks add to the cost of obtaining funding from the central bank compensates for credit risk, term premia and the cost of originating, screening and monitoring loans. The need for such compensation does not necessarily fall when policy rates are lowered. If anything, a central bank lowers rates when the economy needs stimulus, which is precisely when it is difficult for banks to find good loan making opportunities. It remains to be seen whether and to what extent the recent monetary policy accommodation translates into cheaper bank lending.

This is a point I’ve made many times when referring to margin compression: banks are limited in their ability to lower the interest rate they charge customers as, absent any other revenue sources, their net interest income necessarily need to cover their operating costs (at least; as in reality it needs to be higher to cover their cost of capital in the long run). Banks’ only solution to lower rates is to charge customers more for complimentary products (it has been reported that this is in effect what has been happening in the US recently).

Negative rates are similar to a tax on excess reserves, which evidently doesn’t make it easier for a bank to improve its profitability, and as a result its internal capital generation. And Coeuré agrees:

A negative deposit rate can, however, also have adverse consequences. For a start, it imposes a cost on banks with excess reserves and could therefore reduce their profitability. Note, however, that this applies to any reduction of the deposit rate and not just to those that make the rate negative. For sure, lower bank profitability could hamper economic recovery, especially in times when banks have to deleverage owning to stricter regulation and enhanced market scrutiny. But whether bank profitability really falls when policy rates are lowered depends more generally on the slope of the yield curve (as banks’ funding costs may also fall), on banks’ investment policies (as there is scope for them to diversify their cash investment both along the curve and across the credit universe) and on factors driving non-interest income.

Coeuré clearly understands the issue: central banks are making it difficult for banks to grow their capital base, while regulators (often the same central bankers) are asking banks to improve their capitalisation as fast as possible. Still, he supports the policy…

Other regulators are aware of the problem, and not all are happy about it… Andrew Bailey, from the Bank of England’s PRA, said last week that regulatory agencies should co-ordinate:

I am trying to build capital in firms, and it is draining out down the other side.

This says it all.

Meanwhile, and as I expected, the ECB’s TLTRO is unlikely to have much effect on the Eurozone economy… Banks only took up EUR83m of TLTRO money, much below what the central bank expected. It is also likely that a large share of this take up will only be used for temporary liquidity purposes, or even for temporary profitability boosting effects (through the carry trade, by purchasing capital requirement-free sovereign debt), until banks have to pay it off after two years (as required by the ECB, and without penalty, if they don’t lend the money to businesses).

Fitch also commented negatively on TLTRO, with an unsurprising title: “TLTROs Unlikely to Kick-Start Lending in Southern Europe”.

Finally, the ECB also announced its intention to purchase asset-backed securities (which effectively represents a version of QE). While we don’t know the details yet, the scheme has fundamentally a higher probability to have an effect on banks’ behaviour. There is a catch though: ABS issuance volume has been more than subdued in Europe since the crisis struck (see chart below, from the FT). The ECB might struggle to buy the quantity of assets it wishes. Perhaps this is why central bankers started to encourage European banks to issue such structured products, just a few years after blaming banks for using such products.

Europe ABS Issuance

Oh, actually, there is another catch. ABSs are usually designed in tranches. Equity and mezzanine tranches absorb losses first and are more lowly rated than senior tranches, which usually benefit from a high rating. Consequently, equity and mezzanine tranches are capital intensive (their regulatory risk-weight is higher), whereas senior tranches aren’t. To help banks consolidate their regulatory capital ratios and prevent them from deleveraging, the ECB needs to buy the riskier tranches. But political constraints may prevent it to do so… Will this new ECB scheme also fail? As long as central bankers (and politicians) continue to push for schemes and policies without properly understanding their effects on banks’ internal ‘mechanics’, they will be doomed to fail.


PS: I have been busy recently so few updates. I have a number of posts in the pipeline… I just need to find the time to write them!

One year of blogging


Here we go; this blog was created exactly a year ago. This whole year, I have tried to defend and justify laissez-faire policies in banking and finance. This blog, as well as all the debates to which I have participated through it, have required me to question, or even revise, my views on banking and economics. I was forced to read and think about certain topics much more in depth that I would ever have done without it. My worldview and my knowledge have evolved.

I wish to thank all followers and guests, as well as all people who provided me with information and even those who have challenged me. Not only your views and comments persuaded me to continue, but you also made me a better person.

There is still a lot of work to do though. And I will continue to defend a classical liberal point of view in finance for the foreseeable future. Please don’t forget to share!


Here are some of the major series of posts that have defined this year of blogging:

Stable rules, macro-prudential policies and regulatory uncertainty (plenty of other posts build on those ones):

Bagehot’s writings:

The RWA-based Austrian business cycle theory (the distortive effects of RWAs is a recurrent theme):

  1. Banks’ risk-weighted assets as a source of malinvestments, booms and busts
  2. Banks’ RWAs as a source of malinvestments – Update
  3. Banks’ RWAs as a source of malinvestments – A graphical experiment
  4. Banks’ RWAs as a source of malinvestments – Some recent empirical evidence
  5. A new regulatory-driven housing bubble?

The endogenous money and MMT banking theory debates:

Does the central bank control interest rates and implications:

The importance of banks’ intragroup funding and free liquidity and capital flows:

Book reviews:

Guest posts:


And of course, plenty of other, more independent, posts (about financial history misinterpretation, financial innovation, central bankers as new central planners, etc.).

Two kinds of financial innovation

Paul Volcker famously said that the only meaningful financial innovation of the past decades was the ATM. Not only do I believe that his comment was strongly misguided, but he also seemed to misunderstand the very essence of innovation in the financial services sector.

Financial innovations are essentially driven by:

  • Technological shocks: new technologies (information-based mostly) allow banks to adapt existing financial products and risk management techniques to new technological paradigms. Without tech shocks, innovations in banking and finance are relatively slow to appear.
  • Regulatory arbitrage: financiers develop financial products and techniques that bypass or use loopholes in existing regulations. Some of those regulatory-driven innovations also benefit from the appearance of new technological and theoretical paradigms. Those innovations are typically quick to appear.

I usually view regulatory-driven innovations as the ‘bad’ ones. Those are the ones that add extra layers of complexity and opacity to the financial system, hiding risks and misleading investors in the process.

It took a little while, but financial innovations are currently catching up with the IT revolution. Expect to change the way you make or receive payments or even invest in the near future.

See below some of the examples of financial innovation in recent news. Can you spot the one(s) that is(are) the most likely to lead to a crisis, and its underlying driver?

  • Bank branches: I have several times written about this, but a new report by CACI and estimates by Deutsche Bank forecasted that between 50% and 75% of all UK branches will have disappeared over the next decade. Following the growing branch networks of the 19th and 20th centuries, which were seen as compulsory to develop a retail banking presence, this looks like a major step back. Except that this is actually now a good thing as the IT and mobile revolution is enabling such a restructuring of the banking sector. SNL lists 10,000 branches for the top 6 UK bank and 16,000 in Italy. Cutting half of that would sharply improve banks’ cost efficiency (it would, however, also be painful for banks’ employees). It is widely reported that banks’ branches use has plunged over the past three years due to the introduction of digital and mobile banking.
  • In China, regulators have introduced new rules to try to make it harder for mainstream banks to deal with shadow banks in order to slow the growth of the Chinese shadow banking system, which has grown to USD4.9 trillion from almost nothing just a few years ago. The Economist reports that, by using a simple accounting trick, banks got around the new rules. Moreover, while Chinese regulators are attempting to constrain investments in so-called trust and asset management companies, investors and banks have now simply moved the new funds to new products in securities brokerage companies.
  • Apple announced Apple Pay, a contactless payment system managed by Apple through its new iPhones and Watch devices. Apple will store your bank card details and charge your account later on. This allows users to bypass banks’ contactless payments devices entirely. Vodafone also just released a similar IT wallet-contactless chip system (why not using the phone’s NFC system though? I don’t know. Perhaps they were also targeting customers that did not own NFC-enabled devices).
  • Lending Club, the large US-based P2P lending firm, has announced its IPO. This is a signal that such firms are now becoming mainstream, as well as growing competitors to banks.

Of course, a lot more is going on in the financial innovation area at the moment, and I only highlighted the most recent news. Identifying the regulatory arbitrage-driven innovations will help us find out where the next crisis is most likely to appear.

PS: the growth of cashless IT wallets has interesting repercussions on banks’ liquidity management and ability to extend credit (endogenous inside money creation), by reducing the drain of physical cash on the whole banking system’s reserves (outside money). If African economies are any guide to the future (see below, from The Economist), cash will progressively disappear from circulation without governments even outlawing it.

Mobile Money Africa

Some finance artefacts

I am back from my trip in North America, which led me to New York, where I saw some interesting finance artefacts in various locations. Here is a sample (click to enlarge):

World War finance propaganda

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The very first US Treasury warrant












Private bank notes

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Great Depression local government currencies printed to alleviate the lack of Fed money


US Treasury notes redeemable in gold


Various old bond certificates

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A share certificate owned by… Bernard Madoff


And the most curious of them all: a Disney-decorated US Treasury WW2 bond… Slightly strange mix


The mystery of collateral

Collateral has been the new fashionable area of finance and capital markets research over the past few years. Collateral and its associated transactions have been blamed for all the ills of the crisis, from runs on banks’ short-term wholesale funding to a scarcity of safe assets preventing an appropriate recovery. Some financial journalists have jumped on the bandwagon: everything is now seen through a ‘collateral lens’. The words ‘assets’, and, to a lesser extent ‘liquidity’ and ‘money’ themselves, have lost their meaning: all are now being replaced by ‘collateral’, or used interchangeably, by people who don’t seem to understand the differences.

A few researchers are the root cause. The work of Singh keeps referring to any sort of asset transfer between two parties as ‘collateral transfer’. This is wrong. Assets are assets. Securities are securities, a subset of assets. Collateral can be any type of assets, if designated and pledged as such to secure a lending or derivative transaction. Real estate, commodities and Treasuries can all be used as collateral. Money too. Unlike what Singh and his followers claim, a securities lender lends a security not a collateral. Whether or not this security is used as collateral in further transactions is an independent event.

This unfortunate vocabulary problem has led to perverse ramifications: all liquid assets, or, as they often say, collateral, are now seen as new forms of money (see chart below, from this paper). Specifically, collateral becomes “the money of the shadow banking system”. I believe this is incorrect. Collateral is used by shadow banks to get hold of money proper. Building on this line of reasoning, people like Pozsar assert that repo transactions are money… This makes even less sense. Repos simply are collateralised lending transactions. Nobody exchanges repos. The assets swapped through a repo (money and securities) could however be exchanged further. Depressingly, this view is taken increasingly seriously. As this recent post by Frances Coppola demonstrates, all assets seem now to be considered as money. This view is wrong in many ways, but I am ready to reconsider my position if ever Treasuries or RMBSs start being accepted as media of exchange at Walmart, or between Aston Martin and its suppliers. Others have completely misunderstood the differences between loan collateralisation and loan funding, which is at the heart of the issue: you don’t fund a loan, whether in the light or the dark side of the banking system, with collateral! The monetary base/high-powered money/cash/currency, is the only medium of settlement, the only asset that qualifies as a generally-accepted medium of exchange, store of value and unit of account (the traditional definition of money).

Singh M2 and Collateral

There is one exception though. Some particular transactions involve, not a non-money asset for money swap, but non-money asset for another non-money asset swap. This is almost a barter-like transaction, which does occur from time to time in securities lending activities (the lender lends a security for a given maturity, and the borrower pledges another security as collateral). Nonetheless, the accounting (including haircuts and interest calculations) in such circumstances is still being made through the use of market prices defined in terms of the monetary base.

Still, collateral seems to have some mysterious properties and Singh’s work offers some interesting insights into this peculiar world. The evolution of the collateral market might well have very deep effects on the economy. The facilitation of collateral use and rehypothecation, as well as the requirements to use them, either through specific regulatory and contractual frameworks, through the spread of new technology, new accounting rules or simply through the increased abundance of ‘safe assets’ (i.e. increased sovereign debt issuance), might well play a role in business cycles, via the interest rate channel. Indeed, by facilitating or requiring the use of increasingly abundant collateral, interest rates tend to fall. The concept of collateral velocity is in itself valuable: when velocity increases, interest rates tend to fall further as more transactions are executed on a secured basis. Still, are those transactions, and the resulting fall in interest rates, legitimate from an economic point of view? What are the possible effects on the generation of malinvestments?

An example: let’s imagine that a legal framework clarification or modification, and/or regulatory change, increases the use and velocity of safe collateral (government debt). New technological improvements also facilitate the accounting, transfer, and controlling processes of collateral. This increases the demand for government debt, which depresses its yield. Motivated by lower yield, the government indeed issues more debt that flow through financial markets. As the newly-enabled average velocity of collateral increases substantially, more leveraged secured transactions take place and at lower interest rates. While banks still have exogenous limits to credit expansion (as the monetary base is controlled by the central bank), the price of credit (i.e. endogenous money creation) has therefore decreased as a result of a mere regulatory/legal/technological change.

I have been wondering for a while whether or not such a change in the regulatory paradigm of collateral use could actually trigger an Austrian-type business cycle. I do not yet have an answer. Implications seem to be both economic and philosophical. What are the limits to property rights transfer? How would a fully laisse-faire market deal with collateral and react to such technological changes? Perhaps collateral has no real influence on business fluctuations after all. There is nevertheless merit in investigating further. I am likely to explore the collateral topic over the next few months.


PS: I will be travelling in North America over the next 10 days, so might not update this blog much.

* There are many many flaws in Frances’ piece. See this one:

But suppose that instead of a sterling bank account, a smartcard or a smartphone app enabled me to pay a bill in Euros directly from my holdings of UK gilts? This is not as unlikely as it sounds. It would actually be two transactions – a sale of gilts for sterling and a GBPEUR exchange. This pair of transactions in today’s liquid markets could be done instantaneously. I would in effect have paid for my meal with UK government debt.

She fails to see that she would have paid for her mean with Sterling, not with government debt! Government debt must be converted into currency as it is not a medium of exchange/settlement.


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