Several months ago, I provided theoretical and historical/empirical evidences that new bank rules put in place in most jurisdictions would harm banking by limiting cross-border and intragroup cross-entity flows of liquidity and capital* (see here, here, here and here). A few weeks ago, I pointed out that some of the most recent banking regulations that formed the pillars of the Basel 3 framework were also limiting market liquidity. Since then, the market liquidity issue has been all over the financial press (see Fitch, which published a warning precisely regarding this point, as well as David Riley, a former colleague of mine (though he probably has no idea who I am!) did the same in the FT here). I promised to get back to the topic so here we are.
Let’s sum up the current constraints on market liquidity:
- Market risk capital requirements: market-making requires banks (broker-dealers) to maintain a certain amount of various securities in inventory to face market demand at a certain price and provide… liquidity. The Basel 3 regime has increased the amount of capital banks have to maintain against various assets and activities. As market-makers, banks are faced with market risk capital requirements (market RWAs), which have been strengthened to help banks absorb losses that could emanate from fluctuations in the market value of their portfolio of securities. As banks try to minimise their capital buffer to maximise their RoE, they tend to now favour smaller inventory sizes, avoiding securities that experience too much market price variations.
- Credit risk capital requirements: but let’s not forget that market-makers are also exposed to default risk on their inventory of fixed income and derivative securities. Here again, Basel 3 has pushed RWAs up on a number of assets. Consequently, the more ‘risky’ bonds a bank holds, the higher its capital requirements. Many banks seem to have decided that the marginal decrease in fixed income inventory (and resulting revenues) would be more than offset by a marginal increase in RoE.
- Liquidity requirements: new rules (Liquidity Coverage Ratio) also require banks to hold a sufficient buffer of very liquid assets to face a 30-day outflow of cash (i.e. redemptions by depositors and other creditors). Of course, regulators have defined what they view as ‘safe and highly liquid’ assets: mostly sovereign and some other highly-rated bonds (and central bank reserves). As a result, many banks have to hold more of those assets than they had originally planned, reducing their available supply, with little flexibility to offload them in case of sudden high market demand. Liquidity rules that require broker-dealers to hold liquid assets against withdrawal of cash margin posted by clients have also been reinforced.
- Funding requirements: banks used to fund their inventories using typically short-term funding instruments such as repurchase agreements. Basel 3 has now introduced tighter standards (Net Stable Funding Ratio) that require some types of bonds to be funded through longer-term (and hence less flexible and possibly more expensive) funding sources (customer deposits or long-term debt). In the words of Daniel Tarullo of the Fed:
On its face, a perfectly matched book might seem to pose little risk to the firm, since it could run off assets as it lost funding. In reality, however, a firm may be reluctant to proceed in so symmetrical a fashion. In such a context, “running off assets” may mean denying needed funding to clients with which the firm has a valuable relationship. Moreover, even if the firm does run off assets, a firm with a large matched book will almost surely be creating liquidity squeezes for these other market actors. To partially address these risks, the NSFR will require firms to hold some stable funding against short-term loans to financial firms.
Unfortunately, all those new constraints reinforce each other. As banks have to hold more safe but low-yielding assets, this puts pressure on their net interest income and thus on their revenues (and this is exacerbated by the low interest rate environment). Those assets also have light (but not non-existent) extra capital requirements, and must be funded by longer-term instruments. By itself, this might lead to a lower level of RoE. Meanwhile, banks have also been subject to new minimum capital ratios, forcing many of them to deleverage. The only rational solution is to cut the balance sheet assets that use too much capital and don’t generate enough revenues, within the new liquidity and funding constraints. This means cutting on inventories (and business lending, but that’s another story).
And, as many have already described, cutting inventories imply reducing liquidity to investors, potentially amplifying a market crash.
Add this lack of market liquidity to a lack of cross-border and intragroup liquidity caused by financial balkanization, and you can potentially achieve a disaster of epic proportions.
Let’s consider this (very) hypothetical story: market tensions arise in a particular jurisdiction/region/country, leading to falling stock/bond market prices. As investors try to exit those markets, local banks experience significant pressure on their inventories and aren’t able to adequately provide the liquidity demanded. Prices fell further as a result, this time endangering banks themselves through their holdings of fair valued and AFS securities. There are bank run threats. Several of those banks are members of larger international banking groups, and their parents/subsidiaries are ready to provide them with extra capital and liquidity, but their regulators prevent them from doing so as they would breach local requirements. As the local banks collapse, news spread that members of international banking groups couldn’t be rescued by their group. International contagion is now likely.
Of course, central banks could provide extra short-term liquidity (though the central bank funding stigma would strike at some point), governments could bailout the banks, etc. But those options would have limited effectiveness: beyond the border, confidence in banking groups would be shattered.
Some regulators acknowledge that new regulations might create some problems. Still, they usually dismiss the issue by saying that, nevertheless, our new system will be more resilient. Ironically, we are now living in a bipolar world: one of excess liquidity injected by central banks and that investors are trying to invest, and another one of reduced liquidity levels as banks cannot deal with investors’ demand. How this mismatch is going to end is anyone’s guess.
* I only very recently found out about this excellent year old CATO Policy Analysis report that reaches the exact same conclusions:
We argue that these measures [i.e. UK’s ring-fencing and US’ Foreign Banking Organization proposals] amount to little more than a mandatory, inefficient shuffling of corporate entities and business units that will not help ward off future financial crises. At the macro level, both proposals interfere with the ability of global banks to allocate capital and liquidity in the manner they determine to be most efficient. We find that the proposals, therefore, threaten to increase financial instability and dampen economic growth and signal an unfortunate step in the wrong direction.
A recent Fed staff study also seems to find that intragroup lending plays the role of buffer against liquidity risk. I let you guess what happens when you limit those intragroup flows.
William Vincent, a veteran bank equity analyst, published a very good piece on the SNL website (gated unfortunately).
This is Vincent:
To most people in and around the banking industry, the term Basel III probably means a revised set of capital ratios, building on the two earlier, and failed, Basel structures. They are right, of course. But Basel III means a great deal more. When all of its measures are taken into account, it is clear that regulators are not just introducing another capital ratio regime. They are fundamentally altering how banks are controlled and run.
They are, in short, removing banks’ freedom, within limits, to run themselves as they and their shareholders see fit. In the pursuit of reducing the risk of another global banking crisis, they are tearing up a system that took centuries of trial and error to produce, replacing it with a set of rigid rules that will, in effect, mean that banks’ management will run their institutions on behalf of regulators, not the owners of the business.
To which he adds:
This in itself raises an interesting question: why should regulators be better placed to assess risk than the people who actually do it for a living?
Perhaps it is time we raise funds through Kickstarter to send thousands of copies of Hayek’s The Fatal Conceit to regulators?
Regular readers know that I blame risk-based capital requirements for many of the ills of our current banking system. Before the introduction of Basel regulations, banks’ capital level used to be assessed using more standard and simple leverage ratios (equity or capital/total assets). Those ratios have mostly disappeared since the end of the 1980s but Basel 3 is now re-introducing its own version (Tier 1 capital/total exposures).
While I believe there should not be any regulatory minimum capital requirement, I also do believe that, if regulators had to pick one main measure of capitalisation, it should be a standard leverage ratio. All RWA-based ratios should be scrapped.
A new study just added to the growing body of evidence that leverage ratios perform better than RWA-based ones as predictor of banks’ riskiness. Andrew Haldane, from the BoE, has been a long-time supporter of leverage ratios. Admati and Hellwig also backed non-risk weighted ratios. Another paper recently suggested that there was nothing in the literature that justified the level of risk-weights.
Still, most economists, central bankers and regulators consider leverage ratios as mere backstops to complement the more ‘scientific’ (read, more complex, as there is no science behind risk-weights) Basel RWA-based ratios. See this speech from Andreas Dombret, which sums up most criticisms towards simple leverage ratios:
Yet a leverage ratio would also create the wrong incentives. If banks had to hold the same percentage of capital against all assets, any institution wanting to maximise its profits would probably invest in high-risk assets, as they produce particularly high returns. This would eradicate the corrective influence of capital cover in reducing risk.
Unfortunately, Mr. Dombret and many others are very misinformed.
A leverage ratio would not incentivise banks to leverage up to the allowed limit. Under Basel’s RWA framework, no banks operated with the bare regulatory minimum. Critics forget that different banks have different risk aversion and different risk/reward profiles. Some banks generate relatively low RoEs in return for lower level of risk. Others are willing to take on more risks to generate higher margins and higher RoEs. Banks are not uniform.
Banks would not necessarily pile into the riskiest assets under a leverage ratio either. The answer to this is the same as above. Banks have different cultures and different risk/return profiles to offer to investors. There is no reason why all banks would suddenly lend to the riskiest borrowers to improve their earnings. Such criticism could also easily apply to Basel capital ratios: why didn’t all banks follow the same investment strategy? Critics forget that banks do not try to maximise their profits. They try to maximise their risk-adjusted profits. Finally, such argument only demonstrates its proponents’ ignorance of banking history, as if all banks had always been investing in the riskiest assets in the 300 years before Basel introduced those risk-weights.
RWA-based capital ratios are very patronising: because the riskiness of the assets is already embedded within the ratio, banks are effectively telling markets how risky they are. This became overly sarcastic with Basel 2, which allowed large banks to calculate their own risk-weights (i.e. the so-called ‘internal rating based’ method). It has been proved that, for a given portfolio of assets, risk-weights were considerably varying across banks (see here and here). Given the same balance sheet, one bank could, say, report a 10% Tier 1 ratio, and another one, 14%, implying massive variations in RWA density (RWAs/total assets). A given bank could also change its RWA calculation model (and hence its RWA density) in between two reporting periods, making a mockery of period to period comparison. Of course, all this is approved by regulators. Consequently RWA-based capital ratios became essentially meaningless.
As a result, a leverage ratio would provide a ‘purer’ measure of capitalisation that markets could then compare with their own assessment of banks’ balance sheet riskiness.
Scrapping RWA-based capital ratios would also provide major economic benefits. As regularly argued on this blog, RWA-incentivised regulatory arbitrage has been hugely damaging for the economy and is in large part responsible for the recent internationally-coordinated housing bubbles and ‘secular’ low level of business lending. Getting rid of such regulatory ratio would benefit us all by removing an indicator that has big distortionary effects on the economy.
Of course, there are still a few issues, though they remain relatively minor. The main one is that differences in accounting standards across jurisdictions do not lead to the same leverage ratios (i.e. US GAAP banks have much less restrictions to net their derivative positions than IFRS ones). But those accounting issues can easily be corrected if necessary for international comparison. The second one is what definition of capital to use: common equity? Tier 1 capital? Another problem is the fact that very low risk banks, which don’t need much capital, would also get penalised. In the end, it’s likely that any regulatory ratio will prove distortive in a way or another. Why not scrap them all and let the market do its job?
Some European banking regulators are currently considering the implementation of a sovereign bond exposure cap of 25% of capital to any one sovereign. Their goal is to break the link between sovereigns and banks. I think they don’t really know what they are doing.
European sovereign bond markets are distorted in all possible ways:
- The Basel banking regulation framework has been awarding 0% risk-weight to OECD sovereign debt since the 1980s, meaning purchasing such asset does not require any capital. Recent rules haven’t changed anything to this.
- On the contrary, Basel 3 introduces a liquidity ratio (LCR) basically requiring banks to hold even more sovereign debt on their balance sheet (as part of so-called highly-liquid ‘Level 1 assets’).
- Meanwhile, the ECB, as well as the BoE, have been trying to revive business lending (which suffers from the opposite problem: high risk-weights) by launching cheap funding programmes (LTRO, TLTRO, FLS…). Banks drawn on those facilities to invest in… more 0% weighted sovereign debt, and earn capital-free interest income. We call this the ‘carry trade’.
- Furthermore, investors (including banks) have started seeing peripheral European debt as virtually risk-free thanks to the ECB pledge that it would do whatever it takes to prevent defaults in those countries.
There you are: had European regulators wanted to reinforce the link between sovereigns and banks, they wouldn’t have been more successful. Their usual talk of breaking the link between banks and sovereigns has been completely undermined by their own actions.
The easy solution would have been to scrap risk-weights (or at least increase them on sovereign bonds). But this was too simple, so European policymakers decided to go the Chinese way: never scrap a bad rule; design a new one to fix it; and another one to fix the previous one that fixed the original one.
The new 25% cap would only add further distortion: while Basel’s risk-weights do not differentiate between Portuguese and German bonds, the 25% rule doesn’t either. But, you would retort, this isn’t the point: the point is to limit the exposure to any single sovereign. I agree that diversification is usually a good thing. But 1. lack of diversification has been encouraged by policymakers’ own decisions, and 2. forcing banks to diversify away from the safest sovereigns just for the sake of diversifying may well put many banks’ balance sheet more at risk.
Finally, Fitch estimates at EUR1.1Trn the amount of debt that would need to be offloaded. This is very likely to affect markets and could result in banks taking serious one-off hits on their available-for-sale and marked-to-market bond portfolios, resulting in weaker capital positions. This could also raise overall interest rates, in particular in riskier (and weaker) European countries. Fitch believes banks could rebalance into Level 1-elligible covered bonds. Maybe, but this would only introduce even more distortions in the market by artificially raising the demand for their underlying assets, and this would encumber banks’ balance sheets even further, creating other sorts of risks.
Why pick a simple solution when you can do it the Chinese way?
Photo: picture-alliance / dpa through www.dw.de
NESTA, a UK-based charity promoting innovation (and which also organised the annual UK Barcamp Bank), just released its new report on alternative finance trends in the UK. It is a goldmine. The report if full of interesting charts and figures and in many ways tells us a lot about the current state of our traditional financial sector (and possibly of the stance of monetary policy).
Some charts and comments are of particular interest. To my surprise, business lending through P2P platforms was the biggest provider of funds in terms of total amount:
According to the report:
79 per cent of borrowers had attempted to get a bank loan before turning to P2P business lending, with only 22 per cent of borrowers being offered a bank loan. 33 per cent thought it was unlikely or very unlikely that they would have been able to secure funding elsewhere had they not been successful in getting a loan through the P2P business lending platform, whereas 44 per cent of respondents thought they would have been likely or very likely to secure funding from other sources had they not used P2P business lending.
Given bank regulation that penalises banks for lending to small firms, none of this is surprising. As I keep saying, regulation is the primary driver of financial innovation. P2P business lending owes a lot to regulators… until it gets regulated itself?
Another very interesting chart was the following one:
This is crazy. Wealthy people pretty much shun P2P and other alternative finance forms. Why is that? Here’s my theory: wealthy people are usually well advised financially and have access to more investment opportunities than less-wealthy household. Consequently, a low interest environment isn’t that much of a problem (in the short-term): they have the ability to move down the risk scale to look for extra yield. On the other hand, household with more ‘moderate’ incomes do not have access to such investment opportunities: they are the ones hit by low returns on investments. P2P provides them with a unique opportunity to boost the meagre returns on their savings as long as real interest rates remain that low (i.e. lower than inflation):
[The funders] in P2P lending and equity-based crowdfunding were primarily driven by the prospect of financial returns with less concern for backing local businesses or supporting social causes.
Figures concerning P2P consumer lending are similar.
Those figures are both worrying and encouraging. Worrying because the harm that low interest rates and regulation seem to have on the economy and the traditional banking sector. Encouraging because finance is reorganising itself to respond to both borrowers’ and lenders’ demands. This is spontaneous order at work. Let just hope this does not add another layer of complexity and opacity to our already overly-complex financial system.
Busy week as I was on the road for business reasons, so no update over the past week.
Noah Smith published an article on Bloomberg arguing that Wall Street doesn’t hate low rates, but hates the Fed. He argues that low rates are beneficial for Wall Street, given that “lower rates mean higher asset values, at least mathematically”. Consequently, he says that the reason why Wall Street doesn’t like low rates is a ‘mystery’. He concludes that:
We may never know exactly why Wall Street hates easy monetary policy with such a violent passion.
I will argue that the only ‘mystery’ here is: why are economists so ignorant about banking and finance?
Unfortunately, and like plenty of central bankers, economists and economic commentators, Noah Smith is guilty of ignoring the margin compression phenomenon. The argument roughly follows those lines: “Why are all those bankers complaining?? Low rates are beneficial! Banks can refinance at lower rates and increase lending volume to boost their profits!” Well, no. I let you refer to my previous posts: under a certain threshold, lowering rates is actually a huge issue for banks, as loan repricing keeps pushing (gross) interest income down while interest expense cannot go down further because deposit funding (and even in certain cases wholesale funding) is stuck at the zero lower bound. Margin falls and net revenues suffer whereas fixed costs remain stable (or even increase due to regulatory and compliance requirements).
What about the buy-side? Surely they must like low rates? Well… to an extent, and more importantly, in the short run, yes. Securities reprice upwards and they make nice mark-to-market gains. Unfortunately for the theory, this is a one-off effect and the portfolio turnover process gets in the way. Fixed income investors, as their securities mature, have to replace them with lower-yielding ones. Investors mostly care about real rates. As their RoI starts trending downward and barely covers inflation, their natural reaction is to go down the rating scale to hunt for yield. This FT article highlights that subprime and leverage loans securitizations have jumped back to pre-crisis highs in the low-interest rate environment. With risk assessment suppressed, asset mispricing is widespread.
In both cases, the key isn’t low rates per se. It is interest rates that fall below a certain threshold.
I’m really wondering whether actual banking experience should become a prerequisite to become a central banker, or whether bank accounting/financial analysis courses shouldn’t be made compulsory for economists and journalists that wish to follow and comment on the banking and financial world…
Although prices were not perfectly steady, it is true, they were relatively stable for a period of time longer than any prior period involving comparable conditions. Yet depression ensued, in the face of what the advocates of the older form of monetary theory of the business cycle regarded as the sine qua non of freedom from depression.
It follows particularly from the point of view of the monetary theory of the trade cycle, that it is by no means justifiable to expect the total disappearance of cyclical fluctuations to accompany a stable price-level.
Where do these quotes come from? From any recent critic of inflation targeting, such as David Beckworth, referring to our latest crisis (which followed around two decades of inflation targeting by central banks)?
No. The first one is a 1937 quote from Chester Arthur Phillips, in his Banking and the Business Cycle. The second one is from F.A. Hayek, in his 1933 Monetary Theory and the Trade Cycle. I am sure it is possible to find tons of similar quotes from the pre-WW2 era.
In his book, Phillips has a sub-chapter called ‘Policy of Stabilization of Price Level Tends Towards its Own Collapse’, which is worth quoting here:
The endeavor has been to show that stabilization of the wholesale price level, or of any one price index, is not a proper objective of banking policy of credit control, because aberrations continue to occur in the case of particular types of prices when any one index is sought to be stabilized. […]
Stability of the price level is no adequate safeguard against depression, it is contended, because any policy aimed at stabilizing a single index is bound to set up countervailing influences elsewhere in the economic system. Although the policy of stabilization may appear to be successful for a time, eventually it will break down, because there is no way of insuring that the agencies of control will be able to make their influence at precisely those “points” of strategic importance. As long as economic progress is maintained, resulting in increasing productivity and an expanding total output, there will be an ever-present force working for lower prices. Any amount of credit expansion which will offset that force will find outlets unevenly in sundry compartments of the economic structure; the new credit will have an effect upon the market rate of interest, upon the prices of capital goods, upon real estate, upon security prices, upon wages, or upon all of these, as happened during the late boom. A policy which seeks to direct credit influences at any single index, whether it be of prices, either wholesale or retail, or production, or incomes, in the interest of stabilization, will result in unexpected and unforeseen repercussions which may be expected to prove disastrous in the long run.
What about the following one?
During recent years a number of pseudo-economists have indulged in much glibness about the passing of the “economy of scarcity” and the arrival of the “economy of abundance.” Sophistry of this sort has claimed the public ear far too long; it is high time that the speciousness of such fantastic views be clearly and definitely exposed.
An angry economist about some FT Alphaville blogger? No. Phillips again, in the same 1937 book.
George Selgin posted an old Keynes’ quote two days ago, which may be relevant for some of today’s theorists. Backhouse and Laidler also published a very good paper describing everything that has been ‘lost’ with the IS-LM framework following the post-war Keynesian revolution.
It is slightly scary to see that economics tends to easily forget more ‘ancient’ theories in favour of recent and trendy ones. The same is true regarding banking history: listening to most policymakers makes it clear that past experiences and knowledge have mostly been lost. With such short memories, it is unsurprising that crises occur.
PS: On a side note, George Soros completely misunderstands Hayek. I cannot even believe he could write this article. No, Hayek wasn’t a member of the Chicago School. No, Hayek never believed in the efficient market hypothesis (Hayek didn’t believe in rational expectations). No, Hayek didn’t believe in equilibrium economics but in dynamic frameworks that completely include uncertainty and perpetually fluctuating conditions and agents’ expectations, as well as entrepreneurial experiments (including failures, which are indeed healthy). So… basically the exact opposite of what Soros claims Hayek believed in.
After years of regulatory boom, some politicians, and regulators, seem to be – slowly – waking up. I have already described how UK’s Vince Cable seemed to now partially understand that regulation doesn’t make it easy for banks to lend to small and medium-sized businesses, and how Andrew Bailey, from the Bank of England’s Prudential Regulation Authority, complained about the lack of regulatory coordination across country:
I am trying to build capital in firms, and it is draining out down the other side.
Well, Bailey is at it again. Reuters summarized Bailey’s latest speech as:
The over-zealous application of anti-money laundering rules is hampering British banks abroad and cutting off poorer countries from global financial markets, a top Bank of England regulator said on Tuesday.
We have no sympathy with money laundering, but we are facing a frankly serious international coordination problem. […] We are seeing clear evidence … of parts of the world and activities that are being cut off from the mainstream banking system. […] It cannot be a good thing for the development of the world economy and the support of emerging countries … that we get into that situation. […] I have to spend a large part of my time dealing with the issues that come up in this field … because some of the consequences of the actions taken are potentially existential.
I find it quite ironic to see a regulator disapproving ‘over-zealous’ regulation. Another regulator, Jon Cunliffe, Deputy Governor of the Bank of England, declared that:
Liquidity and market making does seem to have been reduced. […] We’re not sure how much of it is the result of regulatory action, and how much of it is do with the change in business model for the institutions.
While he believes that some of the pre-crisis liquidity was ‘illusory’, his statement clearly indicates that he knows that regulation might not have had only positive effects. (Four days after I spoke about regulatory effects on market liquidity, Fitch published a press release arguing the exact same thing. I still have to write that post…)
Unfortunately, not all regulators are waking up. Reuters reported that David Rule, also from the BoE, said that:
banks had responded to regulatory incentives and increased their focus on the real economy, rather than financial market trading for its own sake.
Really? With business lending stuck at the bottom and mortgage lending (a very productive form a lending to the real economy) booming again? I see.
Andreas Dombret, of the Bundesbank, recently declared in a relatively reasonable speech* that:
But are we really overregulating? If we look at the benefits to society of a stable banking system and the social costs of a banking crisis, I believe the costs of regulation are justifiable.
Clearly he and Bailey should have a proper conversation…
Others, like Andrea Enria, Chairman of the European Banking Authority, which recently ran the European stress tests, warned that
The story is not over, even for the banks who passed it
I am unsure what the goal of that sort of threatening comment is, but I don’t see how this can reintroduce confidence in the European banking system. It certainly will push bankers to consolidate their balance sheet further rather than to start lending more. Let’s not forget that the EBA and ECB tests have the power to create a panic and destabilise markets when nothing would have occurred. Too soft and nobody would trust the tests. Too tough and a panic might set in (imagine the headlines: “Half of European banks at risk of failure!”). Another risk is that investors and commentators stop relying on their own judgment and analysis and start relying too much on regulators’ assessment. This would be extremely dangerous. Yet this already happens to an extent. Perhaps, as more and more regulators start waking up to the potentially harmful side effects of regulatory measures, they will back off and let the market play its role?
* While the speech is overall reasonable, Dombret still comes up with usual myths such as
Yet a leverage ratio would also create the wrong incentives. If banks had to hold the same percentage of capital against all assets, any institution wanting to maximise its profits would probably invest in high-risk assets, as they produce particularly high returns.
This is not correct.
Funnily, he also kind of admitted that regulators did not always understand how banking works, as I’ve been arguing a few times recently:
Do supervisors have to be the “better bankers”? No, absolutely not. Business decisions must be left to those being paid to make them. However, supervisors have to know – and understand – how banking works. Against this background, I personally would very much welcome an increase in the migration of staff between the banking industry and the supervisory agencies.
Still, many regulators influence business decisions…
Martin Wolf, FT’s chief economist, recently published a new book, The Shifts and the Shocks. The book reads like a massive Financial Times article. The style is quite ‘heavy’ and not always easy to read: Wolf throws at us numbers and numbers within sentences rather than displaying them in tables. This format is more adapted to newspaper articles.
Overall, it’s typical Martin Wolf, and FT readers surely already know most of the content of the book. I won’t come back to his economic policy advices here, as I wish to focus on a topic more adapted to my blog: his views on banking.
And unfortunately his arguments in this area are rather poor. And poorly researched.
Wolf is a fervent admirer of Hyman Minsky. As a result, he believes that the financial system is inherently unstable and that financial imbalances are endogenously generated. In Minsky’s opinion, crises happen. It’s just the way it is. There is no underlying factor/trigger. This belief is both cynical and wrong, as proved by the stability of both the numerous periods of free banking throughout history (see the track record here) and of the least regulated modern banking systems (which don’t even have lenders of last resort or deposit insurance). But it doesn’t fit Wolf’s story so let’s just forget about it: banking systems are unstable; it’s just the way it is.
Wolf identifies several points that led to the 2000s banking failure. In particular, liberalisation stands out (as you would have guessed) as the main culprit. According to him “by the 1980s and 1990s, a veritable bonfire of regulations was under way, along with a general culture of laissez-faire.” What’s interesting is that Wolf never ever bothers actually providing any evidence of his claims throughout the book (which is surprising given the number of figures included in the 350+ pages). What/how many regulations were scrapped and where? He merely repeats the convenient myth that the banking system was liberalised since the 1980s. We know this is wrong as, while high profile and almost useless rules like Glass-Steagall or the prohibition of interest payment on demand deposits were repealed in the US, the whole banking sector has been re-regulated since Basel 1 by numerous much more subtle and insidious rules, which now govern most banking activities. On a net basis, banking has been more regulated since the 1980s. But it doesn’t fit Wolf’s story so let’s just forget about it: banking systems were liberalised; it’s just the way it is.
Financial innovation was also to blame. Nevermind that those innovations, among them shadow banking, mostly arose from or grew because of Basel incentives. Basel rules provided lower risk-weight on securitized products, helping banks improve their return on regulatory capital. But it doesn’t fit Wolf’s story so let’s just forget about it: greedy bankers always come up with innovations; it’s just the way it is.
The worst is: Wolf does come close to understanding the issue. He rightly blames Basel risk-weights for underweighting sovereign debt. He also rightly blames banks’ risk management models (which are based on Basel guidance and validated by regulators). Still, he never makes the link between real estate booms throughout the world and low RE lending/RE securitized risk-weights (and US housing agencies)*. Housing booms happened as a consequence of inequality and savings gluts; it’s just the way it is.
All this leads Wolf to attack the new classical assumptions of efficient (and self-correcting) markets and rational expectations. While he may have a point, the reasoning that led to this conclusion couldn’t be further from the truth: markets have never been free in the pre-crisis era. Rational expectations indeed deserve to be questioned, but in no way does this cast doubt on the free market dynamic price-researching process. He also rightly criticises inflation targeting, but his remedy, higher inflation targets and government deficits financed through money printing, entirely miss the point.
What are Wolf other solutions? He first discusses alternative economic theoretical frameworks. He discusses the view of Austrians and agrees with them about banking but dismisses them outright as ‘liquidationists’ (the usual straw man argument being something like ‘look what happened when Hoover’s Treasury Secretary Mellon recommended liquidations during the Depression: a catastrophe’; sorry Martin, but Hoover never implemented Mellon’s measures…). He also only relies on a certain Rothbardian view of the Austrian tradition and quotes Jesus Huerta de Soto. It would have been interesting to discuss other Austrian schools of thought and writers, such as Selgin, White and Horwitz, who have an entirely different perception of what to do during a crisis. But he probably has never heard of them. He once again completely misunderstands Austrian arguments when he wonders how business people could so easily be misled by wrong monetary policy (and he, incredibly, believes this questions the very Austrian belief in laissez-faire), and when he cannot see that Austrians’ goals is to prevent the boom phase of the cycle, not ‘liquidate’ once the bust strikes…
Unsurprisingly, post-Keynesian Minsky is his school of choice. But he also partly endorses Modern Monetary Theory, and in particular its banking view:
banks do not lend out their reserves at the central bank. Banks create loans on their own, as already explained above. They do not need reserves to do so and, indeed, in most periods, their holdings of reserves are negligible.
He then takes on finance and banking reform. He doubts of the effectiveness of Basel 3 (which he judges ‘astonishingly complex’) and macro-prudential measures, and I won’t disagree with him. But what he proposes is unclear. He seems to endorse a form of 100% reserve banking (the so-called Chicago Plan). As I have written on this blog before, I am really unsure that such form of banking, which cannot respond to fluctuations in the demand for money and potentially create monetary disequilibrium, would work well. Alternatively, he suggests almost getting rid of risk-weighted assets and hybrid capital instruments (he doesn’t understand their use… shareholder dilution anyone?) and force banks to build thicker equity buffers and report a simple leverage ratio. He dismisses the fact that higher capital requirements would impact economic activity by saying:
Nobody knows whether higher equity would mean a (or even any) significant loss of economic opportunities, though lobbyists for banks suggest that much higher equity ratios would mean the end of our economy. This is widely exaggerated. After all, banks are for the most part not funding new business activities, but rather the purchase of existing assets. The economic value of that is open to question.
Apart from the fact that he exaggerates banking lobbyists’ claims to in turn accuse them of… exaggerating, he here again demonstrates his ignorance of banking history. Before Basel rules, banks’ lending flows were mostly oriented towards productive commercial activities (strikingly, real estate lending only represented 3 to 8% of US banks’ balance sheets before the Great Depression). ‘Unproductive’ real estate lending only took over after the Basel ruleset was passed.
The case for higher capital requirements is not very convincing and primarily depends on the way rules are enforced. Moreover, there is too much focus on ‘equity’. Wolf got part of his inspiration from Admati and Hellwig’s book, The Bankers’ New Clothes. But after a rather awkward exchange I had with Admati on Twitter, I question their actual understanding of bank accounting:
While his discussion of the Eurozone problems is quite interesting, his description of the Eurozone crisis still partly rests on false assumptions about the banking system. Unfortunately, it is sad to see that an experienced economist such as Martin Wolf can write a whole book attacking a straw man.
* In a rather comical moment, Wolf finds ‘unconvincing’ that US government housing policy could seriously inflate a housing bubble. To justify his opinion, he quotes three US Republican politicians who said that this view “largely ignores the credit bubble beyond housing. Credit spreads declined not just for housing, but also for other asset classes like commercial real estate.” Let’s just not tell them that ‘Real Estate’ comprises both residential housing and CRE…
Frances Coppola recently wrote an interesting article on the origins of the financial crisis, which reflects several of the points that I have made on this blog time and time again: the crisis is the resulting product of the combination of regulatory arbitrage and interest rates below their natural level (as well as a few other things). I encourage you to read her article (which is at least necessary to follow my own post).
Yet I believe her story isn’t fully accurate. While US banks were subject to a leverage ratio, they were also subject to Basel 1 rules. As I have demonstrated, Basel 1 caused a surge in real estate and sovereign lending, and boosted the use of securitization, through regulatory arbitrage as Basel applied low risk-weights to those asset classes (for the most recent evidence, see here). Unlike what Hyun Song Shin believes, banks were already circumventing the ‘spirit’ of Basel 1 as soon as it was published in 1988… Basel 2 didn’t change much, and its implementation in Europe was anyway too late to have much of an influence on the crisis storyline (which had been building up since the late 1980s).
As a result, I don’t believe that, if European banks had been subject to a leverage ratio, they would not have been able to invest in American securitized products. They would still have done it, and perhaps sacrificed other type of lending or investments in other securities instead. Why? Because RMBSs and other CDOs offered higher yields for lower capital requirements, ceteris paribus. Risk-adjusted profit-maximising banks quickly figure it out.
The story of the financial crisis is a story of the failure of safe assets. That is why it was so traumatic. People expect to take losses on risky investments. They don’t expect to take losses on safe ones. Yet we are still trying to make the financial system “safer” and encourage investors to invest in “safe” assets. When will we learn that the safest investment is a risky one, and the most dangerous investments are those that are believed to be completely safe?
And it is also a warning of the consequences of regulatory arbitrage. The fact that the US and European banks had different regulatory regimes created a golden opportunity for unregulated institutions to exploit, with catastrophic consequences. Yet the US, the UK and the EU are still devising their own systems of regulation with scant regard for international consistency. When will we learn that an international industry requires international regulation?
I would say that the crisis wasn’t a failure of safe assets per se. It was a failure of regulation that wanted us (or actually, forced us) to believe that some assets were safe, creating a vicious spiral as banks piled into those asset classes to maximise their return on regulatory capital.
Moreover, regulatory arbitrage isn’t a cross-border issue. Most countries experienced the same symptoms: increasing real estate prices and securitization-issuance volumes, and lower sovereign debt yields. This points to intra-Basel distortions within countries, not to extra-Basel arbitrage across countries. Regulatory arbitrage-driven financial imbalances are endogenous to Basel regulations. Cross-border arbitrage, the Euro, populist politics (which never dies, as US politicians – incredibly – want to revive Fannie and Freddie…), also played a secondary (and surely exacerbating) role, but they were not at the very root of the crisis.
PS: Frances just published a new article on the ECB stress tests. I don’t disagree with her, but I believe that it is easy to criticise the test in hindsight, once we found out the number of banks that failed: she could have attacked the methodology at the time it was published. She also missed that, if banks don’t increase lending post-result announcements, it isn’t necessarily because they are zombies (some may well be). But the test was run on phased-in Basel 3 CET1 figures, not fully-loaded ones. Many banks still have large capital adjustments/deleveraging to make before complying with fully-loaded Basel 3 requirements, which isn’t going to help lending growth, especially given that banks currently don’t cover their cost of capital. (Another inconsistency of the test is that some banks were tested against fully-loaded ratios, and in the end obviously appeared uglier than if they had been tested against the same standards as other banks. If all banks had been tested against fully-loaded capital ratios, 36 would have failed)