Borio, deflation and bank intermediation

Some time ago, I wrote that the BIS seemed to be on the dark side of macroeconomics. Earlier this month, Borio et al seemed to confirm this by publishing a quite fascinating paper titled The costs of deflations: a historical perspective. A number of economists, such as George Selgin or a number of market monetarists, had already pointed out the difference between good and bad deflation, which went against the mainstream view that deflation is always a bad thing. Borio and his team went even further.

Analysing inflation data in a sample of 38 countries since 1870, they come to the remarkable conclusion that the link between deflation and low growth/recession is almost non-existent:

On balance, the relationship between changes in the consumer price index and output growth is episodic and weak. Higher inflation is consistently associated with higher growth only in the second half of the interwar period, which is dominated by the Great Depression – the coefficients are positive and statistically significant. At other times, no statistically significant link is apparent except in the postwar era, in which higher inflation actually coincides with lower output growth, with no significant change in the correlation during deflations. In other words, the only sign that price deflation coincides with lower output growth comes from the Great Depression and its immediate aftermath.

Their paper is a great data gathering exercise:

List of deflations

As we can see, many countries were used to experiencing long deflationary periods before the Great Depression. Surprisingly (for some), all deflationary periods actually coincided with rapid productivity growth and real income improvements. Long deflationary periods virtually disappeared after WW2 as the mainstream economic view started to associate deflation and depressions following the experience of the 1930s. While the authors do not find any correlation between deflation and slow economic growth, rerunning their regression only taking into account ‘persistent’ deflations (at least 5 years long) gave the same results: none, as long as the Great Depression is excluded (and very low if included).

However, Borio finds a strong relationship between asset price falls (house prices in particular) and decline in economic performance, both on annual and persistent bases, which seems to explain most decline in output throughout his sample period:

The results are rather striking. Once we control for persistent asset price deflations and country-specific average changes in growth rates over the sample periods, persistent goods and services (CPI) deflations do not appear to be linked in a statistically significant way with slower growth even in the interwar period. They are uniformly statistically insignificant except for the first post-peak year during the postwar era – where, however, deflation appears to usher in stronger output growth. By contrast, the link of both property and equity price deflations with output growth is always the expected one, and is consistently statistically significant.

To a bank analyst like me, this is expected. A general decline in prices of some asset classes affects banks in very specific ways. On-balance sheet, banks classify assets either as ‘held to maturity’ (HTM), ‘available for sales’ (AFS), or ‘fair valued/held for trading’ (FV). While asset price variations do not affect HTM assets, FV ones directly impact banks’ net income, and hence banks’ equity capital. AFS asset price fluctuations, on the other hand, do not affect bank’s profitability but indirectly impact banks’ capitalisation through ‘comprehensive’ income. As a result, a decline a in a number of asset prices can severely reduce banks’ capitalisation. For instance, Barclays said that

if the yields on 10-year Treasury bonds reverted back to their historical average it would wipe nearly a fifth off the tangible book value of European banks.

But falls in asset prices also affect banks through the collateral and off-balance sheet channels: they have to pledge more collateral to secure funding, limiting growth. As mortgages now represent most of banks’ assets, a general fall in property prices is the most problematic. Banks calculate the amount of provisions they need to put aside against their mortgage portfolio. In order to do this, they calculate borrowers’ probability of default (PD), their own exposure at the time of default (EAD), and the loss they would experience given an actual default (LGD). Mortgages are loans collateralised by property. The LGD component of the equation increases a lot when property prices collapse, even if the other variables remain stable.

For example, when a bank originates a 90% loan-to-value mortgage, the value of the loan remains below the value of the property (= collateral) as long as property prices don’t decline by more than 10%. (To which needs to be added legal/foreclosure/reselling costs) When property prices decline strongly enough, even if other economic factors are unaffected, banks have to increase their provisioning, which directly impacts their net income and, indeed, the strength of their capitalisation. The ability of banks to intermediate between depositors and borrowers becomes temporarily impaired, and other potential real economy borrowers suffer. As such, Borio’s results are unsurprising.

Moreover, the Basel regulatory framework seems to have amplified this phenomenon. As Borio says

And notably, the slowdown following property price peaks appears to be somewhat stronger in the postwar era.

Let’s recall this recent research, which highlighted that, due to government interference and regulation, real estate lending had become the main driver of bank’s lending growth in the post-WW2 era, to which I pointed out that most of this growth was due to changes introduced by Basel.

Historical aggregate lending

Those results strongly question the current central bank focus on inflation, and inflation targeting in general. While it sounds unreasonable to ask central banks to identify bubbles (they can’t), wide asset price fluctuations could be indicators that monetary policy is too ‘loose’. Remember that Wicksell defined the natural rate of interest as the rate that is neutral in respect to commodity prices. In the financial community, a growing number of investors and bankers are now warning of the potential consequences of what they view as overvalued prices (see here, here, here…).

However, the effect of monetary policy on asset prices has become harder to disentangle from Basel-only effects. How is monetary policy supposed to respond to regulatory-induced distortions? Even by trying to maintain a stable NGDP growth, another property bubble pop could severely affect the banking channel of the transmission mechanism and banks’ ability to finance the real economy.

Update: a 90% LTV loan means that the value of the loan is BELOW the property value, which is what I originally meant but wrote ‘above’ for some reason. This has been corrected. I thank Justin Merril for pointing that out.

PS: Borio’s paper also published the 2 following charts, which I reproduced below and added the introduction of Basel:

Historical evolution of debt

Bashing? Only in banking

Let’s go back in time. In 2008 and 2009, a global industry experienced a collapse on a scale not seen for decades, partly because it had overexpanded into areas that were unsustainable and that did not match customers’ expectations. The US was badly hit. An unprecedented $85bn bailout was set up to save three of the main US firms. A few years later, some of these had recovered. Others had been acquired by foreign companies.

This industry was the auto industry. Its fate was relatively similar to the one of the banking system. However, their post-crisis treatment cannot be more different. One industry is celebrated; the other one has become politicians’ punching bag.

The collapse of any industry is evidently catastrophic. But let me ask: how would we react if, following the crisis, governments appointed auto regulators to approve (or not) any new product developed by the industry in order to ensure that this product would match customers’ demand (as viewed by those regulators), and that as a result the firms’ future would not be endangered by a few failed products? What would we say if regulation forced all those auto companies to maintain a much higher pre-defined liquidity (and/or capital) buffer against all accrued income? Or if leverage caps were introduced to prevent any firm from taking on too much debt, despite growing revenues and investments prospects and/or new business opportunities?

My guess is that most people would be infuriated to witness such economic micromanagement. Economic planning has been attempted a number of times. And failed. Every single time. And, indeed, governments have not implemented such measures.

But clearly, the auto industry had failed and a large amount of taxpayer money was injected. Despite this, nobody (to my knowledge) talked of prosecuting auto industry employees for their failure. Nor did politicians speak of implementing auto industry-specific taxes to ‘punish’ them for their collapse and the subsequent use of taxpayer money.

But for some reason, all the measures described above suddenly become acceptable once we move into banking realms. Vengeance (and deficits), rather than reason, seems to be what guide politicians’ decisions. Take the new UK budget revealed last week, which comprises an extension of the ‘exceptional’ bank levy. The reason:

The banks got support going into the crisis; now they must support the whole country as we recover from the crisis

Such short-term political view is counterproductive in the medium-term. Regulators themselves complain that, while they try to build banks’ capital buffers, the same capital evaporates into uncontrollable, opaque and often hard to justify large fines*. To the list, regulators could now add those unending ‘exceptional’ bank levies. Extracting money from banks has effectively become a new convenient and politically acceptable way of financing the state, alongside regular taxation, debt and inflation. The rule of law seems to be evolving into the rule of government deficit.

The only effect of all those measures is to further weaken the banking system, reducing its ability to lend and therefore strengthen the economic recovery. Politicians are shooting themselves in the foot. You cannot have your cake and eat it.

Apply the same measure to any other industry and brace yourself for a public outcry. I can already hear the rebuttals from here: ‘but banking is different’. It is only partially true. Banks control a large share of the payment system, but one of the reasons is that governments have historically raised barriers to entry. Of course, if banks collapse, a number of savers may not be able to recover the entirety of their savings. But the same applies to any other non-banking investment. What would have happened to savers that had invested their life savings and pensions in auto equity and bonds if this industry had fully collapsed? Following such logic, no other non-banking firm would ever be allowed to fail as this would lead to job and savings losses.

Banks of course intermediate between depositors and borrowers. When they fail, credit cannot be properly allocated to sectors where it is economically efficient, making banking failures disruptive. But over-protecting banks make them weaker (i.e. moral hazard). And bashing bankers do not heal banks. It weakens them further. And, in the end, it weakens all of us, including politicians, legislators and regulators.

*I am not saying that fraud should not be punished. It should. But the legal basis for extracting such large amounts from banks is extremely unclear, as The Economist pointed out:

To a public angry at banks for their role in the financial crisis, this may all seem like reasonable retribution. Yet in many cases the rush to punish is overturning basic principles of justice.

Or also see this now ‘old’, but prescient, article (2012):

If banks once did banking, now they practise law. […]

A settlement often suits the authorities as well as the banks. Fines are frequently used to fund government budgets; and many a political career has been launched on the back of a high-profile deal, without the need to prove allegations in court. […]

Oklahoma’s attorney-general, Scott Pruitt, was the only one of his colleagues not to participate in the national mortgage settlement earlier this year. Mr Pruitt said it had nothing to do with genuine fairness or justice, rewarded bad behaviour and reflected an illicit expansion of regulatory power.

Basel 3, or 4, or 57, always the same problem

Basel standards have been amended with Basel 3, though the issue of risk-weighted assets (RWAs) remain. I have pointed out how economically distortive RWAs were, and I consider them to be a major factor that led to the financial crisis. Banks’s flexibility in estimating the capital they needed against certain assets was partially restored with the implementation of Basel 2’s IRB (‘Internal Rating-Based’), although those risk-weights were still validated by regulators to make sure they stuck to ‘acceptable’ standards (according to them). This resulted in Basel 1’s economic distortions remaining, if not sometimes amplified as bankers, expecting to boost RoE, were incentivised to overstate the quality of certain assets that regulators viewed favourably.

Now regulators are trying to manipulate RWAs further by implementing floors and removing their (half) reliance on credit ratings, what a number of people have already called Basel 4 (not an official name however). According to a member of the American Bankers Association reported by Euromoney:

“As Basel III was an admission that Basel II got things wrong, Basel IV is a clear recognition that there is much that is wrong with Basel III,” he says. “Yet the folks at Basel have not yet looked in the mirror and asked whether what is mostly wrong might be happening in Basel, that the simple concept of Basel I, to have some basic global capital standards, has been lost in an effort to over-engineer and micromanage at the global level the fine details of capital standards.”

Most people seem to understand the limitations of metrics-based RWAs:

BCBS wants to end the practice of risk-weighting lenders’ exposures by reference to external credit ratings and instead suggests using measures such as capital adequacy and asset-quality metrics on exposures to other banks, for example. For corporates, the BCBS argues a given borrower’s revenue and leverage should determine credit risk weights rather than ratings, with the latter typically discriminating between industries and local-accounting standards.

Bankers see plenty of problems. Since this way of risk-weighting exposure to other banks is determined by common tangible equity ratios and the non-performing assets ratio, it does not adequately take into account divergent liquidity and business-risk profiles, nor differences in supervisory processes under Pillar 2 of the Basel regime, says a senior regulatory adviser to the CEO of a large European universal bank.

The adviser adds: “Credit rating agencies look at a multitude of factors and these metrics are always richer, incorporating thorough timely reviews, and engagement with counterparties and agencies. You can also never empirically replace these qualitative assessments.”

I cannot agree more. I have seen a number of ‘models’ that attempted to estimate firms’ riskiness based on a few metrics. They are not accurate and sometimes way off. Qualitative assessment remains key. According to Euromoney, this new Basel methodology could largely amplify the RWA gap:

For example, the risk-weighting attached to corporates will jump from 30%-150% to 60%-300%. Meanwhile, the proposed risk weights for mortgages is in the 25%-100% range, compared with a flat 35% currently, based on the loan-to-value (LTV) ratio and a borrower’s indebtedness.

This won’t help correct the economic distortions that Basel has introduced. Quite the opposite. While Basel policymakers are right that there are problems with RWAs, the way they hope to correct them is far off the mark.

Moreover, I have only recently found out that Basel 3’s leverage ratio, which was supposed to correct some of those distortions by getting rid of RWAs altogether, actually introduces……a new RWA-type capital calculation framework, called ‘Credit Conversion Factors’. It effectively applies a ‘weight’ on certain type of off-balance sheet exposures in order to calculate the leverage ratio. It becomes obvious that, consequently, banks are going to be incentivised to leave aside banking products that suffer from a high CCF and pile into those that benefit from a low CCF. It is possible that CCFs end up not being as distortive as RWAs given their focus on banking products rather than on types of counterparties.

Still, Basel seems to be repeating the same mistakes over and over again. Applying any sort of ‘weighing’ system to micromanage the financial system can only lead to disaster through the economic incentives and distorted price of credit that it creates. How many iterations of Basel standards will it take to figure it out is anyone’s guess.

PS: Some of you might be surprised by this table compiled by Euromoney/SNL, which clearly shows that European banks use ridiculously low average risk-weights on their assets compared to their American peers:

EU US Banks RWA Density

Well, keep in mind that accounting standards are different. US GAAP allows for a lot more derivatives to be netted than IFRS (used by European firms). Consequently, many European banks end up with derivatives accounting for more than 35/40% of their total assets, whereas American peers’ derivatives only account for a few percent of their balance sheet, making them look much less leveraged.

The Economist’s flawed logic

The Economist this week accused global banks of being “badly managed and unrewarding” (also see its second, more comprehensive article here). It is true that banks have been hit by the crisis and the following regulatory outburst. But the logic underpinning the two articles of the newspaper in this week’s edition is badly flawed and only seems to demonstrate the paper’s bias against banks.

The newspaper admits that

on paper global banks make sense. They provide the plumbing that allows multinationals to move cash, manage risk and finance trade around the world. Since the modern era of globalisation began in the mid-1990s, many banks have found the idea of spanning the world deeply alluring.

Indeed. Global banks evolved from a need: the need to maintain a single (or just a few) banking relationship throughout the world. Globalisation of trade and capital flows inherently implies the globalisation of banking. The current de-globalisation trend that we witness among Western banks is dangerous as this will not help corporations grow their business and hence generate growth.

However, the Economist’s bias appears in that it does not distinguish between banks that are truly global and the rest, and between banks that suffered from the crisis, and the rest. Comparing HSBC, Standard Chartered and Citi with the likes of RBS or Societe Generale doesn’t make much sense. Some have a truly global presence in both retail and investment banking operations, while others only have representative offices or limited product ranges. They do not have the same business models and, despite this, all struggle to generate meaningful RoEs. Moreover, tiny to medium-sized domestic banks also struggle to generate RoEs that cover their cost of capital. Accusing global banks of underperformance thus makes no sense. Identifying some banks that perform relatively well because they focus on regulatory-advantaged businesses such as mortgage lending is irrelevant.

The Economist also targets both banks that needed bailouts and others that did survive the crisis with limited damages. That bailouts mostly involved banks that were not global and that some global banks indeed were saved by their diversified operations doesn’t seem to have rung a bell at the newspaper.

This is unfortunate, as The Economist does acknowledge the impact of regulatory changes:

The wave of regulation since the financial crisis is partly to blame. Regulators rightly decided not to break up global banks after the financial crisis in 2007-08 even though Citi and RBS needed a full-scale bail-out. Break-ups would have greatly multiplied the number of too-big-to-fail banks to keep an eye on. Instead, therefore, supervisors regulated them more tightly—together JPMorgan Chase, Citi, Deutsche and HSBC carry 92% more capital than they did in 2007. Global banks will probably end up having to carry about a third more capital than their domestic-only peers because, if they fail, the fallout would be so great. National regulators want banks’ local operations to be ring-fenced, undoing efficiency gains. The cost of sticking to all the new rules is vast. HSBC spent $2.4 billion on compliance in 2014, up by about half compared with a year earlier. A discussion of capital requirements in Citi’s latest regulatory filing takes up 17 riveting pages.

Indeed. Though regulation isn’t ‘partly’ to blame. It is the primary factor (along with low interest rates) driving the underperformance of banks of all sizes and shapes. The Economist itself several times attacked current regulatory reforms as being unnecessarily costly (see here and here). It now seems to have forgotten and ‘mismanagement’ has become to culprit. For any other industry, The Economist would have blamed regulatory overreach for the industry’s poor performance, in turn pleading for growth-liberating liberalisation. But not for banking. The Economist still hasn’t come to terms with the fact that banks were not the origin, but only the tool, that led to the financial crisis, and as a result remains a ‘classical liberal’ newspaper only when it wants to.

The demand for cash and its consequences

I came across this very interesting chart on Twitter (apparently actually coming from JP Koning’s excellent blog) showing the demand for cash over time in various countries.

Demand for cash

The demand for cash is a form of money demand. And it varies over time and across cultures and evolves as technology changes. In most countries, the demand for cash increases around times when the number of transactions increases (Christmas/New year for instance, although some countries, such as South Korea, present an interesting pattern – not sure why). But there are very wide variations across countries: notice the difference between the Brazilian and the Swedish, British or Japanese demand for cash. Countries that have implemented developed card and/or cashless/contactless payment systems usually see their domestic demand for cash decrease and banks less under pressure to convert deposits into cash.

Overall, this has interesting consequences for the financial analysis of banks, bank management, and for the required elasticity of the currency. Every time the demand for cash peaks, banks find themselves under pressure to provide currency. Loans to deposit ratios increase as deposits decrease, making the same bank’s balance sheet look (much) worse at FY-end than at any point during the rest of the year. A peaking cash demand effectively mimics the effect of a run on the banking system. Temporarily, banks’ funding structure are weakened as reserves decrease and they rely on their portfolio of liquid securities to obtain short-term cash through repos with central banks or private institutions (or, at worst, calling in or temporarily not renewing loans)*. Central bankers are aware of this phenomenon and accommodate banks’ demand for extra reserves.

In a free banking system though, banks can simply convert deposits into privately-issued banknotes without having to struggle to find a cash provider. This ability allows free banks to economise on reserves and makes the circulating private currencies fully elastic. In a 100%-reserve banking system, cash balances at banks are effectively maintained in cash (i.e. not lent out). Therefore, any increase in the demand for cash should merely reduce those cash balances without any destabilising effects on banks’ funding structure (which aren’t really banks the way we know them anyway). However, if some of this demand for cash is to be funded through debt, this can end up being painful: in a sticky prices world, as available cash balances (i.e. loanable funds not yet lent out) temporarily fall while short-term demand for credit jump, interest rates could possibly reach punitive levels, with potentially negative economic consequences (i.e. fewer commercial transactions).

However, technological innovations can improve the efficiency of payment systems and lower the demand for cash in all those cases. Banks of course benefit from any payment technology that bypass cash withdrawals, alleviating pressure on their liquidity and hence on their profitability. Unfortunately not all countries seem willing to adopt new payment methods. The cases of France and the UK are striking. Despite similar economic structures and population, whereas the UK is adopting contactless and innovative payment solutions at a record pace, the French look much more reluctant to do so.

As the chart above did not include France, I downloaded the relevant data in order to compare the evolution and fluctuations of cash demand over the same period of time vs. the UK. Unsurprisingly, the demand for cash has grown much more in France than in the UK and fluctuations of the same magnitude have remained, despite the availability of internet and mobile transfers as well as contactless payments, which all have appeared over the last 15 years**. What this shows is that the demand for cash had a strong cultural component.

Demand for cash UK FR

*Outright securities sale can also occur but if all banks engage in the sale of the same securities at the exact same time, prices crashes and losses are made in order to generate some cash.

** I have to admit that the cash demand growth for the UK looks surprisingly steady (apart from a small bump at the height of the crisis) with effectively no seasonal fluctuations.

Negative interest rates and free banking

Is the universe about to make a switch to antimatter? Interest rates in negative territory is the new normal. Among regions that introduced negative rates, most have only put them in place on deposit at the central bank (like the -0.2% at the ECB for instance). Sweden’s Riksbank is innovating with both deposit and repo rates in negative territory. It now both has to pay banks that borrow from it overnight and… charge commercial banks that deposit money with it, like a mirror image of the world we used to know. However, like antimatter and matter and the so-called CP violation (which describes why antimatter has pretty much disappeared from the universe), positive rates used to dominate the world. Until today.

Matter Antimatter

Many of those monetary policy decisions seem to be taken in a vacuum: nobody seems to care that the banking regulation boom is not fully conductive to making the banking channel of monetary policy work (and bankers are attempting to point it out, but to no avail). In some countries, those decisions also seem to be based on the now heavily-criticised inflation target, as CPI inflation is low and central bankers try to avoid (whatever sort of) deflation like the plague.

As I described last year with German banks, negative rates have….negative effects on banks: it further amplifies the margin compression that banks already experience when interest rates are low by adding to their cost base, and destabilise banks’ funding structure by providing depositors a reason to withdraw, or transfer, their deposits. Some banks are now trying to charge some of their largest, or wealthiest, customers to offset that cost. At the end of the day, negative rates seem to slightly tighten monetary policy, as the central bank effectively removes cash from the system.

It is why I was delighted to read the below paragraphs in the Economist last week, a point that I have made numerous times (and also a point that many economists seem not to understand):

In fact, the downward march of nominal rates may actually impede lending. Some financial institutions must pay a fixed rate of interest on their liabilities even as the return on their assets shrivels. The Bank of England has expressed concerns about the effect of low interest rates on building societies, a type of mutually owned bank that is especially dependent on deposits. That makes it hard to reduce deposit rates below zero. But they have assets, like mortgages, with interest payments contractually linked to the central bank’s policy rate. Money-market funds, which invest in short-term debt, face similar problems, since they operate under rules that make it difficult to pay negative returns to investors. Weakened financial institutions, in turn, are not good at stoking economic growth.

Other worries are more practical. Some Danish financial firms have discovered that their computer systems literally cannot cope with negative rates, and have had to be reprogrammed. The tax code also assumes that rates are always positive.

In theory, most banks could weather negative rates by passing the costs on to their customers in some way. But in a competitive market, increasing fees is tricky. Danske Bank, Denmark’s biggest, is only charging negative rates to a small fraction of its biggest business clients. For the most part Danish banks seem to have decided to absorb the cost.

Small wonder, then, that negative rates do not seem to have achieved much. The outstanding stock of loans to non-financial companies in the euro zone fell by 0.5% in the six months after the ECB imposed negative rates. In Denmark, too, both the stock of loans and the average interest rate is little changed, according to data from Nordea, a bank. The only consolation is that the charges central banks levy on reserves are still relatively modest: by one estimate, Denmark’s negative rates, which were first imposed in 2012, have cost banks just 0.005% of their assets.

Additionally, a number of sovereign, and even corporate, bonds yields have fallen (sometimes just briefly) into negative territory, alarming many financial commentators and investors. The causes are unclear, but my guess is that what we are seeing is the combination of unconventional monetary policies (QE and negative rates) and artificially boosted demand due to banking regulation (and there is now some evidence for this view as Bloomberg reports that US banks now hoard $2Tr of low-risk bonds). Some others report that supply is also likely to shrink over the next few years, amplifying the movement. There are a few reasons why investors could still invest in such negative-yielding bonds however.

As Gavyn Davies points out, we are now more in unknown than in negative territory. Nobody really knows how low rates can drop and what happens as monetary policy (and, I should add, regulation) pushes the boundaries of economic theory. At what point, and when, will economic actors start reacting by inventing innovative low-cost ways to store cash? The convenience yield of holding cash in a bank account seems to be lower than previously estimated, although it is for now hard to precisely estimate it as only a tiny share of the population and corporations is subject to negative rates (banks absorb the rest of the cost). The real test for negative rates will occur once everyone is affected.

Free markets though can’t be held responsible for what we are witnessing today. As George Selgin rightly wrote in his post ‘We are all free banking theories now’, what we currently experience and the options we could possibly pick have to measure up against what would happen in a free banking framework.

Coincidentally, a while ago, JP Koning wrote a post attempting to describe how a free banking system could adapt to a negative interest rates environment. He argued that commercial banks faced with negative lending rates would have a few options to deal with the zero lower bound on deposit rates. He came up with three potential strategies (I’ll let you read his post for further details): remove cash from circulation by implementing ‘call’ features, cease conversion into base money, and penalize cash by imposing through various possible means what is effectively a negative interest rate on cash. I believe that, while his strategies sound possible in theory, it remains to be seen how easy they are to implement in practice, for the very reason that the Economist explains above: competitive forces.

But, more fundamentally, I think his assumptions are the main issue here. First, the historical track record seems to demonstrate that free banking systems are more stable and dampen economic and financial fluctuations. Consequently, a massive economic downturn would be unlikely to occur, possibly unless caused by a massive negative supply shock. Even then, the results in such economic system could be short-term inflation, maintaining nominal (if not real) interest rates in positive territory.

Second (and let’s leave my previous point aside), why would free banks lend at negative rates in the first place? This doesn’t seem to have ever happened in history (and surely pre-industrial rates of economic growth were not higher than they are now, i.e. ‘secular stagnation’) and runs counter to a number of theories of the rate of interest (time preference, liquidity preference, marginal productivity of capital, and their combinations). JPK’s (and many others’) reasoning that depositors wouldn’t accept to hold negative-yielding deposits for very long similarly applies to commercial banks’ lending.

Why would a bank drop its lending rate below zero? In the unrealistic case of a bank that does not have a legacy loan book, bankers would be faced by two options: lend the money at negative rates, during an economic crisis with all its associated heightened credit and liquidity risk, or keep all this zero-yielding cash on its balance sheet and make a loss equivalent to its operating costs. If a free bank is uncertain to be able to lower deposit rates below lending rates, better hold cash, make a loss for a little while, the time the economic crisis passes, and then increase rates again. This also makes sense in terms of competitive landscape. A bank that, unlike its competitors, decides to take a short-term loss without penalising the holders of its liabilities is likely to gain market shares in the bank notes (and deposits) market.

Now, in reality, banks do have a legacy loan book (i.e. ‘back book’) before the crisis strike, a share of which being denominated at fixed, positive, nominal interest rates. Unless all customers default, those loans will naturally shield the bank from having to take measures to lower lending rates. The bank could merely sit on its back book, generating positive interest income, and not reinvest the cash it gets from loan repayments. Profits would be low, if not negative, but it’s not the end of the world and would allow banks to support their brand and market share for the longer run*.

Finally, the very idea that lending rates (on new lending, i.e. ‘front book’) could be negative doesn’t seem to make sense. Even if we accept that the risk-free natural rate of interest could turn negative, once all customer-relevant premia are added (credit and liquidity**), the effective risk-adjusted lending rate is likely to be above the zero bound anyway. As the economic crisis strikes, commercial banks will naturally tend to increase those premia for all customers, even the least risky ones. Consequently, a bank that lent to a low-risk customer at 2% before the crisis, could well still lend to this same customer at 2% during the crisis (if not higher), despite the (supposed) fall of the risk-free natural rate.

I conclude that it is unlikely that a free banking system would ever have to push lending (or even deposit) rates in negative territories, and that this voodoo economics remains a creature of our central banking system.


*Refinancing remains an option for borrowers though. However, in crisis times, it’s likely that only the most creditworthy borrowers would be likely to refinance at reasonable rates (which, as described above, could indeed remain above zero)

**Remember this interest rate equation that I introduced in a very recent post:

Market rate = RFR + Inflation Premium + Credit Risk Premium + Liquidity Premium

Photo: MIT

Pushing market rationality too far

In a new post on Switzerland, Scott Sumner said (my emphasis):

The following graph shows that the SF has fallen from rough parity with the euro after the de-pegging, to about 1.08 SF to the euro today:


And this graph shows that the Swiss stock market, which crashed on the decision that some claimed was “inevitable” (hint, markets NEVER crash on news that is inevitable), has regained most of its losses.



I often enjoy what Scott Sumner writes, but this comment is from someone who doesn’t understand, or has no experience in, financial markets. We all know that Sumner strongly believes in rational expectations and the EMH. But this is pushing market efficiency and rationality too far.

According to Sumner, “markets never crash on news that is inevitable”. Really? Is he saying that markets believed the Euro peg would remain in place forever (which is the only necessary condition for the de-pegging not being ‘inevitable’)?

In reality many investors, if not most (though it can’t be said with certainty), were aware that the peg would be removed and of the resulting potential consequences for Swiss companies. So why the crash?

While investors surely knew that the peg wouldn’t last, they didn’t know when it would end. They were acting on incomplete information. However, this is perhaps what Sumner implies: the Swiss central bank should have provided markets with a more precise statement of when, and in what conditions, the peg would end. Markets would have revised their expectations and priced in the information. This reasoning underpins the rationale for monetary policy rules and forward guidance. But in practice, providing ‘guidance’ isn’t easy: central bankers are not omniscient, have imperfect access to information and cannot accurately forecast the future in an ever-changing world. See what happened to the BoE’s forward guidance policy, which ended up not being much guidance at all as central bankers changed their minds as the economic situation in the UK evolved*.

But the rational expectations argument itself can be used to describe many different situations. If investors believe the peg will end at some point, but don’t know exactly when, it is arguably as ‘rational’ for them to try to maximise gains as long as they could and to try to exit the market just before it crashes, as it is ‘rational’ to adapt their positions to minimise their risk exposure. When the market finally does crash, it often overshoots, for the same reason: benefiting from a short-term situation to maximise profits.

Taking advantage of monetary policy is what traders do. It is their job. Of course, many will fail in their attempt. But necessarily identifying rational expectations with strong short-term risk-aversion and immediate inclusion of external information into prices is abusive.

This latest Bloomberg article shows that close to 20% of traders expect the Fed to raise rates in June, and consequently have surely put in place trading strategies around this belief, and are likely to react negatively if their expectations aren’t fulfilled. However, who doubts that a rate rise is ‘inevitable’? This demonstrates the price-distorting ability of central banks. In order to limit extreme price fluctuations and crashes, the better central banks can do is to disappear from the marketplace entirely.


*Other practical restrictions on guidance include the fact that, while professional investors are likely to be aware of their significance, the rest of the population has no idea what the hell you’re talking about, if it has even heard of it. As a result, the efforts the BoE made to reassure UK borrowers that rates would not rise in the short-run seemed pointless, as virtually no average Joe got it, implying that most people didn’t change their borrowing behaviour/plan in consequence.

I have made a case for rule-based policies a while ago, which I do believe would limit distortions to an extent.

Crush RWAs to end secular stagnation?

Some BIS researchers very recently published this piece of research demonstrating that the growth of the financial sector was linked to lower productivity in the economy. MCK in FT Alphaville commented on it and reached the wrong conclusion (the title of his post is ‘Crush the financial sector, end the great stagnation?’, though he could be forgiven given that the BIS paper itself is titled ‘Why does financial sector growth crowd out real economic growth?’).

I have attempted in previous posts to explain why Basel risk-weighted assets (RWAs) were the root cause of the misallocation of bank credit and hence the misallocation of capital in the economy prior to the financial crisis: in order to optimise return on equity, bankers were incentivised by RWAs to allocate a growing share of available loanable funds to the real estate sector, creating an unsustainable boom. I also speculated that, consequently, fewer financial resources were hence available for sectors that were penalised by regulatory-defined high RWAs (i.e. business lending), and that this could be one of the main causes of the so-called ‘secular stagnation’.

I have also regularly criticized governments’ and central banks’ schemes such as FLS and TLTRO when they were announced, as they could simply not address the fundamental problem that Basel had introduced a few decades earlier.

I have recently pointed out that new studies seem to highlight that, indeed, real estate lending had overtaken business lending for the first time in the past 150 years exactly after Basel 1 was put in place at the end of the 1980s, and that the growth of business lending had been lower since then. (Same chart again. Yes it is that important)

Historical aggregate lending

This new BIS study is remarkably linked, although its authors don’t seem to have noticed. This is what they conclude:

In our model, we first show how an exogenous increase in financial sector growth can reduce total factor productivity growth. This is a consequence of the fact that financial sector growth benefits disproportionately high collateral/low productivity projects. This mechanism reflects the fact that periods of high financial sector growth often coincide with the strong development in sectors like construction, where returns on projects are relatively easy to pledge as collateral but productivity (growth) is relatively low. […]

First, at the aggregate level, financial sector growth is negatively correlated with total factor productivity growth. Second, this negative correlation arises both because financial sector growth disproportionately benefits to low productivity/high collateral sectors and because there is an externality that creates a possible misallocation of skilled labour.

Replace some of the terms above with RWAs and you get the right picture. What those researchers miss is that the growth of the financial sector has been similar in previous periods over the past 150 years, with no decline in secular growth rate and productivity. However, what changed since the 1980s is the allocation of this growth. And the dataset this BIS piece examines only starts…in 1980. Their conclusion that high collateral industries would attract a higher share of lending is also coherent with my views, as higher lending collateralisation reduces the required capital buffer than banks need to maintain.

MCK is right when he declares that

the growth of the financial sector has been concentrated in mortgage lending, which means that more lending usually just leads to more building. That’s a problem for aggregate productivity, since the construction industry is one of the few that has consistently gotten less productive over time. For example, Spain had no productivity growth between 1998 and 2007, a period when 20 per cent of all the net job growth can be attributed to the building sector.

But his conclusion that regulation needs to force the banking industry to get smaller is off the mark. Getting rid of the incentives created by RWAs, and the resulting unproductive misallocations, is what is needed.

Central banks don’t/do/don’t/do control interest rates

Ben Southwood and I agree on most things but a few topics. Whether central banks’ decisions affect interest rates is one of those, though I do think we have more common than we’re willing to admit. Here are the various reasons that convince me that central banks exert a relatively strong influence on most market rates.

On ASI’s blog, Ben wrote a piece about a 2013 research paper from Fama, who looked into interest rate time series to determine whether or not the Fed controlled interest rates. According to Ben’s own interpretation of the paper, the answer is ‘probably not’. Ironically, my take is completely different.

Throughout most of his paper, Fama’s results do indicate that the Fed exercises a relatively firm grip on all sorts of interest rates, as he admits it himself many times. For example, in his conclusion he writes:

A good way to test for Fed effects on open market interest rates is to examine the responses of rates to unexpected changes in the Fed’s target rate. Table 5 confirms that short-term rates (the one month commercial paper rate and three-month and six-month Treasury bill rates), respond to the unexpected part of changes in TF. Table 5 is the best evidence of Fed influence on rates, and event studies of this sort are center stage in the active Fed literature.

But I find Fama a little biased as he always tries to defend his original position that the Fed does not exert such a strong control:

But skeptics have a rejoinder. The response of short rates to unexpected changes in the Fed’s target rate might be a signaling effect. Rates adjust to unexpected changes in TF because the Fed is viewed as an informed agent that sets TF to line up with its forecasts of how market forces will shape open market rates.

Or also:

The Table 4 evidence that short-term interest rates forecast changes in the Fed funds target rate is not news (Hamilton and Jorda 2002). For those who believe in a powerful Fed, the driving force is TF, the concrete expression of Fed interest rate policy, and the forecast power of short rates simply says that rates adjust in advance to predictable changes in the Fed’s target rate. (See, for example, Taylor 2001.) The evidence is, however, also quite consistent with a passive Fed that changes TF in response to open market interest rates. There are, of course, scenarios in which both forces are at work, possibly to different extents at different times. The Fed may go passive and let the market dictate changes in TF when inflation and real activity are satisfactory, but turn active when it is dissatisfied with the path of inflation or real activity. This mixed story is also consistent with the evidence in Table 3 that the Fed funds rate moves toward both the open market commercial paper rate and the Fed’s target rate.

However Fama never explains why the Fed would simply passively change its base rate in response to private markets. This seems to defeat the purpose of having an active monetary policy.

In short, most of the evidences that Fama finds seem to demonstrate that the Fed indeed does control most interest rates to an extent (in particular short-term ones). But he does not seem to accept his own result and tries to come up with alternative explanations that are less than convincing, to say the least. He concludes by basically saying that…we cannot come to a conclusion.

But Fama’s paper suffers from a major flaw. Let’s break down a market interest rate here:

Market rate = RFR + Inflation Premium + Credit Risk Premium + Liquidity Premium

Fama’s dataset wrongly runs regressions between Fed’s base rate movements and observable market yields on some securities. The rate that the Fed influences is the risk free rate (RFR). But as seen above, market rates contain a number of premia that vary with economic conditions and the type of security/lending and on which the Fed has limited control.

For instance, when a crisis strikes, the credit risk premium is likely to jump. In response, the Fed is likely to cut its base rate, meaning the RFR declines. But the observable rate does not necessarily follow the Fed movement. It all depends on the amplitude of the variation in each variable of the equation above. Hence the correlation will only provide adequate results if the economic conditions are stable, with no expected change in inflation or credit risk. Does this imply that the Fed has no control over the interest rate? Surely not, as the RFR it defines is factored in all other rates. In the example above, the market rates ends up lower than it would have normally been if fully set by private markets.

David Beckworth had a couple of interesting charts on its blog, which attempted to strip out premia from the 10-year Treasury yield (it’s not fully accurate but better than nothing):

Adjusted US yield

Now compare the 1990-2014 non-adjusted and adjusted 10-year Treasury yield with the evolution of the Fed base rate below:

Fed Rate

The shapes of the adjusted 10-year yield and the Fed funds rate curves are remarkably similar, whereas this isn’t the case for the unadjusted yield*. Yet most of Fama’s argument about the Fed having a limited influence on long-term rates rests on his interpretation of the evolution of the spread between the Fed funds target rate and the unadjusted 10-year yield.

(the same reasoning applies to commercial paper spread, though the inflation premium is close to nil in such case)


Second, I find it hard to understand Ben’s point that markets set rates, when central banks’ role is indeed to define monetary policies and, by definition, impact those market rates. If only markets set rates, then surely it is completely pointless to have central banks that attempt to control monetary policies through various tools, including the control on the quantity of high-powered money. In a simple loanable funds model (let’s leave aside the banking transmission mechanism), in which the interest rate is defined by the equilibrium point between supply and demand for loanable funds, it is quite obvious that a central bank injecting, or removing, base money from the system (that is, pushing the supply curve one way or another) will affect the equilibrium rate. Of course the central bank does not control the demand curve. But the fact that the bank does not have a total control over the interest rate does not imply that it has none and that its policies have no effect. What does count is that the resulting equilibrium rate differs from the outcome that free markets would have produced.

Loanable Funds

I am also trying to get my head around what I perceive as a contradiction here (I might be wrong). Market monetarists (of whom Ben seems to belong) believe that money has been ‘tight’ throughout the recession due to central banks’ misguided monetary policies. They seem to think that rates would have dropped much faster in a free market. This seems to demonstrate that market monetarist believe in the strong influence of central banks on many rates. But according to Ben, central banks do not have much influence on rates. Does he imply that free markets were responsible for the ‘tight’ policy that followed the crisis?


So far in this post we’ve only seen cases in which the central bank indirectly affects market rates. But some markets are linked to the central bank base rate from inception. For instance, in the UK, most mortgage rates (‘standard variable rates’) are explicitly and contractually defined as ‘BoE Base Rate + Margin’**. The margin rarely changes after the contract has been agreed. Any change in the BoE rate ends up being automatically reflected in the rate borrowers have to pay (that is, before banks are all forced to widen the contract margin because of the margin compression phenomenon, as I described in my previous exchange with Ben here and here). The only effect of banking competition is to lead to fluctuations of a few bp up or down on newly originated mortgages (i.e. one bank offers you BoE + 1.5% and another one BoE + 1.3%).


At the end of the day, I have the impression that a part of our disagreement is merely due to semantics. I don’t think anybody has declared that central banks fully control rates. This would be foolish. But they certainly exert a strong influence (at least) through the risk-free rate, and this reflects on all other rates across maturities and risk profiles.


*To be fair, it does look like some of the Fed’s decisions were anticipated by markets and reflected in Treasury yields just before the target rate was changed.

**In some other countries the link is looser, as the central bank rate is replaced by the local interbank lending rate (Libor, Euribor…).

McKinsey on banking and debt

A recent report by the consultancy McKinsey highlights how much the world has not deleveraged since the onset of the financial crisis. Many newspapers have jumped on the occasion to question whether or not the policies adopted since the crisis were the right ones (FT, Telegraph, The Economist…). This is how the total stock of debt has evolved since 2000:

McKinsey 1As the following chart shows, the vast majority of countries saw their overall level of debt increase:

McKinsey 2McKinsey affirms that “household debt continues to grow rapidly, and deleveraging is rare”, and that the same broadly applies to corporate debt. China is an extreme case: total debt level, as a share of GDP, grew from 121% of GDP in 2000, to 158% in 2007 to…282% at end-H114. And growing.

Unsurprisingly, household debt is driven by mortgage lending (including in China). It isn’t a surprise to see house prices increasing in so many countries. How this is a reflection that we currently are in a sustainable recovery, I can’t tell you. How this is a signal that monetary policy has been ‘tight’, I can’t tell you either. If monetary policy has indeed been ‘tight’, then it shows the power of Basel regulation in transforming a ‘tight’ monetary policy into an ‘easy’ one for households through mortgage lending. How this total stock of debt will react when interest rates start rising is anyone’s guess…

McKinsey’s claim that “banks have become healthier” is questionable at best, as they use regulatory Tier 1 ratios as a benchmark. Indeed a lot of banks have boosted their Tier 1 ratio by reducing RWA density (i.e. the average risk-weight applied to their assets) rather than actually raising or internally generating extra capital.

McKinsey 3As expected given how capital intensive corporate lending has become thanks to our banking regulatory framework, and in line with recent research, banks are now mostly funding households at the expense of businesses:

McKinsey 4

McKinsey highlights that P2P lending, while still small in terms of total volume, doubles in size every year, and is mostly present in China and the US.


And in fact, in another article, McKinsey explains that the digital revolution is going to severely hit retail banking. I have several times described that banks’ IT systems were on average out-of-date, that this weighed on their cost efficiency and hence profitability, and that it even possibly impaired the monetary policy transmission channel. I also said that banks needed to react urgently if they were not to be taken over by more recent, more efficient, IT-enabled competitors. A point also made in The End of Banking, according to which technology allows us to get rid of banks altogether.

McKinsey is now backing up those claims with interesting estimates. According to the consultancy, and unsurprisingly, operating costs would be the main beneficiary of a more modern IT framework:

McKinsey 5McKinsey goes as far as declaring that:

The urgency of acting is acute. Banks have three to five years at most to become digitally proficient. If they fail to take action, they risk entering a spiral of decline similar to laggards in other industries.

Unfortunately, current extra regulatory costs and litigation charges are making it very hard for banks to allocate any budget to replace antiquated IT systems.

If banks already had those systems in place as of today, I would expect to see lending rates declining further – in line with monetary policy – across all lending products as margin compression becomes less of an issue. In a world where banks have zero operating cost, its net interest income doesn’t need to be high to generate a net profit.

In the end, regulators are shooting themselves in the foot: not only new regulations and continuous litigations may well have the effect of facilitating new non-banking firms’ takeover of the financial system, but also monetary policy cannot have the effect that regulators/central bankers themselves desire.

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