Archive | October 2013

Financial innovation is back with a vengeance

What didn’t we hear about financial innovation throughout the crisis? Whereas innovation in general is good, financial innovation on the other hand was the worst possible thing coming out of a human mind. Paul Volcker, former Chairman of the Fed, famously declared that the ATM was the only useful financial innovation since the 1980s. Harsh.

True, some financial innovations are better than others. In particular, those used to bypass regulatory restrictions are more dangerous, not because they are intrinsically evil or anything, but simply because their often complex legal structure makes them opaque and difficult for external analysts and investors to analyse. This famous 2010 Fed paper attempted to map the shadow banking system (see picture), and usefully stated that not all shadow banking (and financial innovations) activities were dangerous (but those specifically designed to avoid regulations were). Ironically (and typically…) one of the first innovations to ever appear within the shadow banking system was money market funds. What was the rationale behind their creation? In the 1960s and 1970s in the US, interest payment on bank demand deposits was prohibited and capped on other types of deposits. The resulting financial repression through high inflation pushed financial innovators to come up with a way of bypassing the rule: money market funds became a deposit-equivalent that paid higher interests. Today we blame money market funds for being responsible for a quiet run on banks during the crisis, precipitating their fall. It would just be good to remember that without such stupid regulation in the first place, money market funds might have never existed…

Shadow Banking

The last decade has seen the growth of two particularly interesting innovations within the shadow banking system: one was relatively hidden (securitisation) while the other one grew in the spotlight (crowdfunding/peer-to-peer lending). One was deemed dangerous. The other one was more than welcome (ok, not in France). What had to happen happened: they are now combining their strength.

Various types of crowdfunding exist: equity crowdfunding, P2P lending, project financing… Today I’m going to focus on P2P lending only. What started as platforms enabling individuals to lend to other individuals are now turning into massive gates for complex institutional investors to lend to individuals and SMEs. Given the retreat of banks from the SME market (thank you Basel), various institutional investors (mutual and hedge funds, insurance firms) thought about diversifying their investments (and maximising their returns) by starting to offer loans to individuals and companies they normally can’t reach.

Basically, those funds had a few options: developing the capabilities to directly lend to those customers, investing in securitised portfolios of bank loans, or investing in securitised portfolios of P2P loans. The first option was very complex to implement and the required infrastructure would take a long time to develop. The second option had already existed for a little while, but was dependent on banks lending to customers, which current regulations limit due to higher capital requirements on such loans. The third option, on the other hand, allowed funds to maximise returns and attract more potential borrowers thanks to the reduction of the cost of borrowing by disintermediating banks. And funds could also strike deals with those still tiny online platforms that would have never happened with massive banks.

While securitisation sounds scary, it is actually only a simpler way of investing in loans of small sizes (the alternative being to invest in every single loan, some of them amounting to only USD500… Not only many funds don’t have the capability of doing such things, but many have also restrictions about the types of asset class and amounts they can invest in). Securitisation also bypasses Wall Street investment banks: funds directly invest in P2P loans, package them and sell them on to other investors while retaining a ‘tranche’ in the deal, which absorbs losses first. Now some entrepreneurs are even talking of setting up secondary markets to trade investments in loans, pretty much like a smaller version of the bond market.

Is this a welcome evolution for the P2P industry? I would say that it is a necessary evolution. It is once again a spontaneous development that merely reflects the need for funding of the P2P industry, which small retail investors cannot fulfil (unless all investment funds’ customers start withdrawing their money to directly invest in P2P, which is highly unlikely). Many start to think that large institutional investors will end up crowding out small retail investors. Possibly, but as long as regulation remains light, keeping barriers to entry low, new platforms only accepting retail investors could well appear if the demand is present.

All this is fascinating. Not only because technology and the internet enables new ways of channelling funds from savers to borrowers, but also because this is the growth of a parallel 100%-reserve banking system. The shadow banking system is effectively some version of a 100%-reserve banking. And it keeps growing through those various innovations. As I argued in a previous post, this may well have implications for monetary policy that current central banks and economists don’t take into account. A 100%-reserve banking system does not have a deposit multiplier and consequently does not have an elastic currency to respond to a sudden increase or decrease in the demand for money. However, such a system perfectly matches savers’ and borrowers’ intertemporal preferences, limiting malinvestments. Nonetheless, we for now remain in a mix system of 100% reserve (most of shadow banking) and fractional reserves (traditional banking). It would still be interesting to study the possible policy implications of a growth in the 100%-reserve part of the economy.

The Economist struggles with Wicksell

Looks like Wicksell is back in fashion. After years (decades?) with barely any mention of this distinguished Swedish economist outside of work from some heterodox economic schools academics (like the Austrians), he is now everywhere and has unleashed a great debate among academics and financial practitioners. This is the outcome of both the financial crisis (preceded by interest rates that were below their ‘natural’ level according to Wicksellian-based theories) and the current unconventional policies undertaken by central banks all over the world (that risk repeating the same mistakes according to those same theories).

Wicksell

This week’s Economist’s column Free Exchange tries to identify whether or not current interest rates are too low based on a Wicksellian framework (A natural long-term rate). The article is complemented by a Free Exchange blog post on the newspaper’s website.

I won’t get back to the definitions of Wicksell’s money and natural rates of interest as I’ve done it in two recent posts (here and here). I only wish today to comment on The Economist’s interpretation (and misconceptions) of the Wicksellian rate.

A few of things shocked me in this week’s column. First, the assertions that “the natural rate prevails when the economy is at full employment” and that “the natural interest rate is often assumed to be constant.” I’m sorry…what? Putting aside the fact that ‘full employment’ is hard to define, there can be full employment with interest rates below or above their natural level, and interest rates can be at their natural level with the economy not at full employment. Many other ‘real’ factors have effects on ‘full employment’. Using full employment as a basis for spotting the equilibrium rate is dangerous.

Second, where did they get that the natural interest rate was constant? This doesn’t make sense. The natural interest rate rises and decreases following a few variables (various economic schools of thought will have differing opinions) such as time preference (i.e. whether or not people prefer to use income for immediate or future consumption), marginal product of capital (demand for loanable funds by entrepreneurs would increase as long as they can make a profit on the marginal increase in capital stock, driving up the interest rate in the process), liquidity preference (i.e. whether or not people desire to hold money as cash rather than some other less liquid form of wealth – pretty much the only important factor driving the interest rate for Keynesians –)… As you can imagine, all those factors vary constantly, impacting the demand for money and the demand for credit and in turn the rate of interest. It clearly does not remain constant…

The Economist also dismisses the possibility that real interest rates are too low by the fact that sovereign bonds’ yields are low, not only in the US (where the Fed is engaged in massive bonds purchases), but also in other economies whose central banks are less active in purchasing sovereign debt. But it overlooks the fact that natural rates aren’t uniform and may well be lower in other countries (for example, the natural rate was probably lower in Germany than in Spain and Ireland before the crisis, despite having a common central bank). It also overlooks that ‘risk-free’ rates used as a basis of most financial calculations internationally are US Treasuries, not sovereign bonds of other countries.

Finally, in support of its point, the column argues that expected future low rates could also reflect investors’ expectations of sluggish future growth and that “despite profit margins near record levels and rock-bottom interest rates, business investment has been sluggish, recently peaking at just above 12% of GDP; it topped 14% in the late 1990s.” Once again, this is misinterpreting the natural rate: the level of the natural rate of interest does not necessarily depend on expected future economic growth as I described above. Sluggish business investments also are more likely to reflect current regulatory ‘regime uncertainty’ than entrepreneurs’ doubts about the future state of the economy. On top of that, using the dotcom bubble as a reference for business investment is intellectually dishonest. Moreover, the article contradicts itself starting with “central banks ignore this century-old observation at their peril” only to conclude that “all this suggests that policy rates, low as they seem, are not out of line with their natural level.” Hhhmmm, ok.

The Free Exchange blog post by Greg Ip is a little better but still overall quite confused and confusing. Interestingly, it cites a paper by Bill White (http://dallasfed.org/assets/documents/institute/wpapers/2012/0126.pdf) who argues that the sort of yield-chasing that we can witness in financial markets today is a symptom of nominal rates being lower than natural rates. Doesn’t this remind you of anything? That’s right; it was exactly my point in this post. But it then cites Brad de Long, who can be added to the list of people who don’t understand what regulatory uncertainty is, and who tries as a result to convince us that the natural rate is below zero. Theoretically, a below zero natural rate if possible in period of deflation. But it does not make much sense to have a natural rate below zero when inflation is above zero.

It is definitely a hard task to identify the natural rate of interest. Nonetheless, a few rules of thumb are sometimes better than overly-complex reasoning. Investors would be perfectly happy with negative nominal yields if cost of life was declining even faster. This is obviously not the case at the moment.

BoE’s Mark Carney is burying Walter Bagehot a second time

Banks were partying on Thursday. Mark Carney, the new governor of the Bank of England, decided to ‘relax’ rules that had been put in place by its predecessor, Mervyn King. From now on, the BoE will lend to banks (as well as non-bank financial institutions) for longer maturities, accept less quality collateral in exchange, and lower the interest rate on/cost off those facilities. Mervin King was worried about ‘moral hazard’. Mark Carney has no idea what that means.

carnking_retblom

According to the FT, Barclays quickly figured out what this move implied: “it reduces the need for, and the cost of, holding large liquidity buffers.” Just wow. So, while we’ve just experienced a crisis during which some banks collapsed because they didn’t hold enough liquid assets on their balance sheet as they expected central banks and governments to step in if required, Carney’s move is expected to make the banks hold……even less liquidity.

It’s obviously nothing to say that this goes against every possible piece of regulation devised over the last few years. While the regulators were right in thinking that banks needed to hold more liquid assets, they took on the wrong problem: it was government and central bank support that brought about low liquidity holdings, and not free-markets recklessness. Anyway, Carney’s move kind of undermines that effort and risks rewarding mismanaged banks at the expense of safer ones.

Carney’s decision also goes against all the principles devised by the ‘father’ of central banking: Walter Bagehot. I guess it is time to decipher Bagehot, as he has been constantly misquoted since the start of the crisis by people who have apparently never read him. As a result he was used to justify what were actually anti-Bagehot policies. Bagehot’s principles are underlined in his famous book Lombard Street, written in 1873. What should a central bank do during a banking crisis? According to Bagehot (as described in chapters 2, 4 and 7), it should:

  1. Lend freely to solvent banks and companies
  2. Lend at a punitive rate of interest
  3. Only accept good quality collateral in exchange

For instance, in chapter 2:

The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to ‘this man and that man,’ whenever the security is good.

In chapter 7:

First. That these loans should only be made at a very high rate of interest. This will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who do not require it. The rate should be raised early in the panic, so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it; that the Banking reserve may be protected as far as possible.

Secondly. That at this rate these advances should be made on all good banking securities, and as largely as the public ask for them. The reason is plain. The object is to stay alarm, and nothing therefore should be done to cause alarm. But the way to cause alarm is to refuse some one who has good security to offer… No advances indeed need be made by which the Bank will ultimately lose.

Walter Bagehot

No central bank applied Bagehot’s recommendations during the financial crisis. Granted, given the organisation of today’s financial system, it is difficult for central bank to lend to non-financial firms. Nonetheless, it took them a little while to start lending freely and lent to insolvent banks as well. They also started to accept worse quality collateral than what they used to (think about the Fed now purchasing mortgage/asset-backed securities for example). Finally, central banks have never charged a punitive rate on their various facilities. Quite the contrary: interest rates were pushed down as much as humanly possible on all normal and exceptional refinancing facilities.

While the ECB and the Fed have made clear that some of those were temporary measures, Carney now seems to imply that, not only are they here to stay, but they also will be extended in non-crisis times. He calls that being “open for business”. Poor Bagehot must be turning in his grave right now.

According to Carney, those measures will reinforce financial stability. Really? So no moral hazard involved? no bank taking unnecessary risks because it knows that the BoE has its back? If Mervyn King didn’t do everything perfectly while in charge, at least he had a point. Carney, after overseeing a large credit bubble in Canada over the past few years (he first joined the Bank of Canada in 2003, then rejoined it as Governor in 2008), is now applying his brilliant recipe to the UK.

Canada US debt

I think that Carney’s decisions introduce considerable incentive distortions in the banking system. This is clearly not what a free-market should look like. In any case, if a new crisis strikes as a result, I am pretty sure that laissez-faire will be blamed again. It is ironic to see that some of those central bankers destroy faith in free-markets while trying to protect them.

Bagehot also said other things that go against the principles driving our current banking and regulatory system. More details in another post!

Photograph: Reuters/Bloomberg

Chart: The Big Picture

Co-operative Bank’s new ownership ‘tragedy’ is rather a good thing

For those of you who don’t live in the UK, the Co-operative Bank has been struggling with a large GBP1.5bn capital shortfall (vs. a capital base of GBP1.6bn) since early summer due to losses on its loan book (most of them emanating from the takeover of Britannia Building Society in 2009, a struggling mutual mortgage bank). Moody’s, the rating agency, even downgraded it by six notches all of a sudden. The Co-operative Bank was a subsidiary of the Co-operative Group, a mutual company that owns multiple businesses.

I said ‘was’ because…it won’t be anymore. And it’s apparently causing some headaches.

Co-op

Mutual companies are owned by their members (who are some of their customers), and not by external shareholders. This was the case of both Britannia’s and Co-op’s equity capital (indirectly through the Co-op Group). However, due to their very nature, mutuals’ ability to raise capital is limited. Consequently, they raise complementary capital from external investors in order to grow. In the case of Co-op, its equity capital was complemented by some sort of hybrid capital: GBP60m of preference shares owned by retail investors and around GBP1.1bn of subordinated debt, which happened to be partly held by…hedge funds. Both counted towards the total regulatory capital ratio of the bank, as defined by Basel accords. Ranking of the capital structure in case of bankruptcy of the bank was as follows: after depositors and other senior creditors, subordinated creditors had the second claims on the liquidated assets of the bank, followed by preference shares-holders and members.

Following several months of negotiations that saw creditors threatening to block a deal under which they would take a loss on their investments, a deal was finally reached a few days ago: a conversion of their bonds into new equity. As a result, 70% of the capital of the bank will be owned by institutional investors, among which several hedge funds (representing around 30/40%). The Co-op Group (and hence members) will retain a 30% stake in the bank. It obviously sounds quite ironic to see a mutual company owned by vulture capitalists… It also looks quite ironic to see the failure of the now all-powerful UK regulators: they never spotted the problems at Co-op Bank, all their proposed solutions collapsed once after the other, and the agreed deal was reached in a perfect free-market type agreement without their intervention

Many people around me and in the media have raised concerns that the new hedge funds ownership was a bad thing due to the short-term view of their investment strategy. Those fears are misplaced. Hedge funds and private equity firms indeed invest for the short-term. As far as I’m aware, there aren’t many studies analysing the impacts of hedge funds on the performance of the firms in which they own a stake. This recent one found that activist hedge funds actually improved future performances! There are many more studies on the long-term effects of short-term private equity investments. It was actually the topic of my Masters’ research dissertation. The academic research was clear: private equity-owned firms suffered over the short-term through tough restructuring processes (involving job losses and pressure on salaries), but over the longer-term performed better than their peers and actually even hired more people…

Is this surprising? No. We really need to keep emotions aside and think about the underlying reasons for all this. What is the hedge fund’s goal? To maximise profits. What is the time frame? Usually quite short-term (= a few years). How can the fund exit the investment? By selling the company to external investors. Here we go. This is key. Do you think that funds would be able to maximise the selling price if external investors viewed the company as unlikely to perform well over time? Of course not. Prices are derived from future discounted cash flows. The more likely the company is to perform well after the sale, the higher the price the hedge (or private equity) fund can extract from it. As a result, it is not in the interest of the fund to seek “short-term gains at the expense of the future”.

Of course, this does not mean that no failure ever happens. Some funds also acquire companies to dismantle them. Which does not necessarily imply that they are evil. Some companies actually represent net economic losses to society with no prospect of improvements. Those companies should disappear and capital reallocated to more efficient ones. Funds that dismantle companies usually do it as there is no other way to realise profits. Some funds also fail in restructuring firms, or overload them with debt. But when the companies fail, funds also make massive losses that threaten their own existence. It is in the interest of both to succeed.

Co-op Bank’s former CEO declared that the restructuring process was a ‘tragedy’, that hedge funds were ‘maximising profits’ and were ‘unethical’. I would like to ask: what is actually a tragedy? Is mismanaging an institution leading to bankruptcy and potential losses for ordinary individuals that ethical? What about mis-selling financial products to naïve customers on top of that? Wouldn’t it be better to have a well-performing bank that generates economic profits? Are low profits, losses and waste of capital a way of proving that a company is behaving well? Or is a company more useful for human and social advancement if it actually delivers economic benefit and creates additional capital? Some people have serious rethinking to do.

There is no real need to worry about hedge funds owning a large stake in Co-operative Bank. Co-op may well at last become an asset to society instead of a liability. Its new hedge fund owners also seem to understand that to maximise the value of the brand, ethics must remain a focus, whatever that means. But if eventually Co-op does not survive, it may also well be because it couldn’t be saved in the first place.

Update: I don’t know how I originally missed the senior creditors but I did… Depositors aren’t the only senior creditors and this is now corrected

Quick update on recent news: John Kay, hedge funds and house prices control

John Kay wrote an interesting piece in the FT yesterday saying that finance should be treated like fast food to secure stability. I can’t agree more. A nice quote:

Still, would it not be better if proper supervision ensured that no financial institution could ever get into a mess like Northern Rock or Lehman – or Royal Bank of Scotland or Citigroup or AIG? No, it would not. Just replace “financial institution” with “fast-food outlet” or “supermarket” or “carmaker” in that sentence to see how peculiar is the suggestion.

I know what you’re going to say: “but banks are different!” To which I would reply: no, they aren’t. It is treating them as different that makes them different.

Another nice one:

We have experience of structures in which committees in Moscow or Washington take the place of the market in determining the criteria by which a well-run organisation should be judged, and that experience is not encouraging. The truth is that in a constantly changing environment nobody really knows how organisations should best be run, and it is through trial and error that we find out.

I am a little surprised though, as I have the impression that John Kay is kind of contradicting himself (see his post from June in which he seems to say that banking reforms are going the right direction).

Another piece highlighted how much regulation is changing the hedge fund industry. What’s going on is that regulation is now limiting new entrants in the market as they can’t cope with booming compliance costs. This results in the largest hedge funds experiencing most of new money inflow from investors. Is this a problem? Yes. First, small hedge funds have traditionally outperformed large and established ones on average. So preventing them from entering the market reduces market and economic efficiency: proper allocation of capital to where it would be the most profitable does not happen as a result (and consequently, returns to investors are lower). Second, and more worrying, is that regulation is now replicating what has happened in the banking industry: it’s creating too big to fail hedge funds (and nobody seems to remember LTCM). Well done guys.

Finally for today, echoing my earlier post, a BoE member thinks that it is not the role of the central bank to control house prices. I certainly agree.

Spontaneous finance at work

The FT reported today that non-bank lending to SMEs was at its highest level since 2008 in the UK, whereas bank lending had been declining constantly since the start of the crisis, despite politicians’ and central bankers’ actions to revive it (such as the BoE’s Funding for Lending Scheme).

small_business_775593XSml4-360x239

What kind of non-bank lending are we talking about? Personally, I would call this ‘shadow banks lending’, even though some other economists and analysts may have a different definition of shadow banking. To me, it comprises the less-regulated non-bank entities, from hedge funds to peer-to-peer lending platforms.

This is spontaneous finance at work: while the bloated, politically connected and over-regulated banking system does not seem to be able to channel resources (private savings) to smaller-than-large corporations, private actors, from investment funds to private individuals, step in to respond to their funding needs. This phenomenon has two sources: banks’ lending rates are often too high (blame regulatory capital requirements) and banks’ offered savings rate too low (blame too high inflation vs. BoE rate). And blame banks’ too high operating costs for both. As a result, there is a mismatch between what savers expect and what companies expect.

The solution? Bypass banks. Various investment companies (from hedge funds to more traditional mutual funds) are now setting up funds to gather savings and lend directly to companies that need them. Peer-to-peer and crowdfunding platforms basically act the same way by disintermediating all financial institutions: individuals directly lend to other individuals or firms. We also now see funds investing through P2P platforms (reversing the disintermediation process). Through those shadow banking channels, both savers and borrowers get better rates than they would do at a bank. At the time of my writing, savers can earn from 4% to 7% on their savings (even some hedge funds would love to get such steady returns). Rates vary for borrowers, but are on average lower than that of banks.

Lending volume is still pretty small as the wider public isn’t yet aware of those funding opportunities. In the UK, Funding Circle has only lent slightly less than GBP170m so far to small businesses (this compares to banks’ SME lending which stands at around GBP170…bn). But it’s growing quickly: it was only launched in 2010. Moreover, other shadow banks had lent around GBP17bn as of June (yes, a lot of 17 something, just a coincidence).

As this City AM article highlighted today, as usual, the main risk to those financial innovations is over-regulation, preventing their development and potentially leading to the creation of much riskier and opaque financial products. Regulators wish to ‘protect’ savers. I argue that savers do not need to be protected: they need to learn to invest responsibly and to understand the risks involved. Protection distorts risk-taking and capital allocation.

More worrying is the fact that some peer-to-peer industry actors are now even lobbying to be regulated… They claim that regulation will reassure potential investors. I claim that regulation will mainly protect the established firms by making it more difficult for new competitors to enter the market and offer competitive products to savers and borrowers. A brand new financial system is building before our eyes. It is important not to repeat mistakes that led to our current ineffective banking system.

Photograph: govopps.co.uk

Financial bloggers beware

The French financial regulator AMF may end up fining two bloggers (one retired French economics professor and one American investment advisor) who might possibly perhaps maybe hypothetically have influenced financial markets in 2011, when they declared that Societe Generale’s leverage was higher than what the bank officially reported.

This would be a dangerous precedent. Bloggers, financial analysts, journalists and other people are here to independently (or not) analyse news, data and information and express an opinion, whether it is right or wrong. The first question that comes out of this is: could only two bloggers influence markets in such a way? It sounds quite unlikely. Markets are formed by millions of individuals, who can (and do) also come up with their own views. When top-ranked analysts at top banks downgrade companies, markets react negatively, but nowhere near what happened to SocGen at that time (the bank’s share price fell 42% within just 20 days).

SocGen

Moreover, they also have the right to be wrong. If nobody believes them, their opinion won’t matter. In case people do believe them, it might well mean that there is at least some truth in their arguments.

All this once again looks like witch-hunting. No news here. Throughout the crisis, regulators tried to blame hedge funds, speculators, short-selling, rating agencies and other market participants as soon as a country’s credit spread was jumping or the share price of a bank collapsing. A classic case of ‘shoot the messenger’.

The eventual result of this is that information might become scarcer as analysts fear getting sued even if they are actually right. This is evidently the wrong solution. More analyses and opinions the better, as it would reduce the reliance on and impact of a handful of analysts and commentators. We need more competition in financial commentary, not less.

PS: The original links are here and here. The fines are likely to be around EUR10,000. Not too high, but still way too much.

Chart Source: Yahoo Finance

French entrepreneurs open a 100% reserve bank

Alright, I wasn’t planning to blog today but I suddenly got overexcited… I don’t know how I missed this news, as it’s been in the French media since June at least, but, well, I did miss it.

While the French government doesn’t like financial innovation, two French entrepreneurs just launched a 100% reserve bank… And this isn’t a tiny event. It’s reported everywhere in the media, for a simple reason: the bank’s cash and dealing machine will be located at the local…….tobacconist.

Yep, that’s right. We all knew that French people liked to smoke, but now, they will even be able to bank while buying cigarettes. A new revolution, I’m telling you.

This new bank is called ‘Compte Nickel’ and will open on the 1st of January 2014, pushed by the national tobacconist federation. The website was launched today. How does it work? Well, it simply works like any 100% reserve bank: it’s some kind of safe in which you deposit your money. Tobacconists open for you a payment account and provide you with an associated debit card. You can transfer money, pay your bills, withdraw money all around Europe and get your salary paid in the account. It’s virtually like a normal bank current account/demand deposit.

compte nickel

What’s the difference then? A (fractional reserve) bank lends out the money deposited in it by its current account customers or invests it in liquid securities to generate interest income. It then often pays an interest on the account as a result and there is no or little charge to maintain the account. Interest rate is usually very low on demand deposits, and virtually non-existent in France. Compte Nickel on the other hand really acts like a safe: the money is not lent out nor invested anywhere. It is simply deposited in Compte Nickel’s Banque de France account.

Consequently, Compte Nickel does not lend. There is no overdraft allowed, no credit card and no credit facilities available. As I said, it is an electronic safe. As the bank still has operating expenses, customers will be charged to maintain the account. This cost is expected to be around EUR34 per year.

It will be a pretty interesting experience to see how people react to that new type of banking, especially given the well-developed anti-bank sentiment in France. 100000 people are expected to sign up during the first year.

If ever this is a successful experience that leads to full reserve banking becoming more widespread, it will raise other questions though: what happens to lending volume in a 100% reserve banking world? It would necessarily decline. I am not saying that this is necessarily a bad thing, and many authors, including Friedman, Rothbard and Fisher have considered the benefits of such a system. On the other hand, other authors (I’m mainly thinking about the so-called ‘Free Bankers’ here), have argued that every time a 100% reserve bank was set up, it always eventually became a fractional reserve one… They also argued that, given the choice between the two models, people would go for a fractional reserve bank. How would the monetary system respond to an increase in money demand? What happens to central banks’ monetary policy? Central banks aren’t required in a full-reserve world…

Banking theorists and historians, get ready!

Update: There might be a few reasons why such an account could indeed attract French customers. As I said above, anti-bank sentiment is one. Many French people think that banks are casinos playing with their money. A second one is that French people already pay a lot of banking charges. French law actually prevented banks to pay interest on current accounts until 2005. There have traditionally been a lot of charges to maintain a current account as a result, which have not disappeared. Yes, once again another regulatory distortion… Therefore, it might not bother customers to be charged for a full reserve bank account (and it does look like normal banks charge more than Compte Nickel!). A simple reason why such a bank might take a while to take off is…. that French customers are often quite conservative and want proven business models.

Photograph: PFG/SIPA

The ‘great search for yield’ update, Taleb on bank disintermediation and Coeuré on Wicksell

This is a quick update on my post of last week on the rush for yield among private investors and what it meant in terms of interest rate disequilibrium.

Following my post, Thomas Aubrey from Credit Capital Advisory kindly provided me with an update of his ‘Wicksellian differential’ chart. You can also find it here.

WD 2012As you can see the differential between the estimated natural rate and the money rate of interest in the US have kept increasing and almost reached pre-crisis peak. According to his calculation, the potential differential now reaches………10%. It’s indeed huge. Try for a second to imagine the Fed all of a sudden increasing their target interest rate by 10%…… No you’re right, we just can’t imagine it. Frankly, I hope his calculation is wrong but…I wouldn’t bet my life on it. Consequently, Thomas Aubrey believes that it backs up my claim about malinvestments.

Meanwhile, in a speech called ‘The economic consequences of low interest rates’ at the International Center for Monetary and Banking Studies on the 9 October, Benoit Coeuré, member of the Executive Board of the European Central Bank, misunderstood Wicksell and inflation, justifying very low interest rates. Not only Mr Coeuré seems to believe that CPI adequately reflects inflation, but also, according to him, inflation is always zero when the money rate of interest equals the natural rate. This is not true: real shocks can temporarily push inflation one way or another, but over the longer term productivity becomes the main driver behind inflation and deflation. In a world of productivity increases (and increasing output), deflation should be the norm (as it was the case at the end of the 19th century and early 20th). A zero level of inflation in this context would actually mean that there is hidden inflation. George Selgin has written a lot on this. See his Less than Zero book or this video.

Last Friday, FT’s Henny Sender discussed the Fed’s impact on markets. According to a Hong Kong-based hedge fund “the Fed is always there. It is clear that it will not tolerate a decline in asset values. If you sell in the face of QE, you look like an idiot.” Sounds like the best way to completely distort markets. Free markets you said?

Today, John Authers, in another FT piece, says that “Western economy is overcentralised, creating extra risk”. I obviously won’t disagree with him. He cites Nicholas Taleb (reminding me of Larry White). But one thing particularly struck me: Taleb seems to think that hedge funds “are developing strategies that aim to disintermediate the banks, such as loan funds.” This is very, very close to my own opinion, which I haven’t mentioned yet on this blog: technological developments will enable shadow banking to grow under one form or another to desintermediate credit creation. This is something big, and it will require many blog posts and possibly a research paper…and some time.

Nobel Prize in Economics

Today Eugene Fama, Lars Peter Hansen and Robert Shiller share the 2013 The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.

While I do not share some of their beliefs (Fama’s efficient market hypothesis based on rational expectations or Shiller’s irrational exuberance are a few examples), I can only but welcome the award of the prize to pro-free markets academics.

Congratulations!

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