Archive | April 2014

New research on banking

New York Fed researchers published new papers on banking over the past few months on the Fed’s blog Liberty Street Economics.

The first one, titled Stability of Funding Models: an Analytical Framework, is summarised through two different blog posts (here and here). The researchers present a banking model that graphically illustrates the factors that influence the risk of a bank becoming insolvent or illiquid (namely: low asset returns, high leverage, loss of funding (short-term debt maturity profile), asset encumbrance…).

Bank model

Nothing ground breaking. The model simply graphically represents what all banks’ analysts already know. But the principle is interesting. They also published an interactive model you can play with to simulate your own bank (here). I think the internal microeconomic impacts of the firm are also downplayed here: cost efficiency also plays a crucial role, ceteris paribus. Two banks’ asset returns (and in turn revenues), funding profile (and in turn net interest margin) and leverage could be the same, but the bank with the higher cost/income will have a lot less financial flexibility to absorb the exact same asset impairments when they arise and as a result presents a higher risk of insolvency.


The second piece of research, titled Do “Too-Big-to-Fail” Banks Take On More Risk? (see related blog post here), aims at analysing the influence of being classified as ‘systemically important’ on risk-taking. The report concludes that:

The results of our investigation show that a greater likelihood of government support leads to a rise in bank risk-taking. Following an increase in government support, we see a larger volume of bank lending becoming impaired. Further, and in line with this finding, our results show that stronger government support translates into an increase in net charge-offs. Additionally, we find that the effect of government support on impaired loans is stronger for riskier banks than safer ones, as measured by their issuer default ratings. Our findings offer novel evidence that government support does play a role in bank risk-taking incentives.

Fed researchers decided to use the rating agency Fitch’s Support Rating Floor as an indication of sovereign support, as most other rating agencies do not distinguish between institutional/parental and sovereign supports in their rating uplift. This is Fitch’s methodology, which you can find in their financial institutions rating criteria here (gated but free registration):

Fitch Methodology

Nothing very surprising here either, but this research adds to the increasingly large literature that underlines the benefits (and the risks) of being a large (and possibly government-linked) bank. Artificially cheaper funding and riskier behaviour pushes the banking system away from its equilibrium state, which is supposed to reflect savers’ intertemporal preferences. This, combined with inaccurate central bank monetary policy and regulatory-distorted interest rates, is a definitive recipe for the misallocation of capital on a massive scale. No surprise financial and economic crises are so recurrent.


Finally, other Fed employees developed yet another liquidity measure, the liquidity stress ratio. I’m not sure about its usefulness to be honest as well as some of the conclusions that the authors draw from some of the spurious correlations they calculate. Take the following chart for example:

Liquidity stress ratio

From this, the authors conclude:

The positive relationship [between capitalisation and liquidity stress ratio] may indicate that when banks are less vulnerable to undercapitalization, they take more liquidity risk. In other words, capital and liquidity may act as substitutes.

Really? Take the red line off the chart above and you end up with no clear pattern at all. Some banks play it safe; some others are willing to take on more risk; some are in between. This seems to me to be a clear case of mathematical regression interpretation abuse.


On another platform, Vox, a group of economists have come up with an interesting experiment. They found that

Economic linkages between banks give rise to contagion of deposit withdrawals across banks, especially when depositors are aware of these economic linkages. Systemic risk due to the contagion of panic-based deposit withdrawals is thus likely to be more acute for banking systems characterised by clusters of domestic banks which share the same business model (e.g. cajas in Spain or Sparkassen/Volksbanken in Germany).

This is very interesting. However, their recommendation is way off:

For regulators this accentuates the question of how to monitor and regulate economic linkages between banks stemming from similar exposures, in order to mitigate financial fragility and to encourage greater diversity in the financial system.

Are they aware that regulators have been doing the exact opposite of their recommendation for many, many years? Regulations have been trying to harmonise business models since the 1980s, when Basel regulations were first implemented. Moreover, regulators now try to influence banks’ internal organisation and structure to comply with what they see as adequate. The result of all those policies is an increasing lack of diversification between banks. You want more diversity in the financial system? Then tell regulators to back away.


PS: Martin Wolf had a piece in the FT this week in which he came on favour of… 100% reserve banking. That’s right. That was a little bit of a surprise to say the least. Izabella Kaminska discussed it here, though she seems again to get mixed up between various terms and definitions, and Frances Coppola had a good article criticising Wolf’s idea (though I don’t entirely agree with everything she says).

Greenspan put, Draghi call? (guest post by Vaidas Urba)

(This is a monetary economics guest post by Vaidas Urba, a market monetarist from Lithuania. He has previously appeared at The Insecurity Analyst blog and TheMoneyIllusion. You can follow him on Twitter here)

Greenspan put, Bernanke put – everybody uses these expressions half-jokingly to describe monetary policy and asset prices. Ricardo Caballero and Emmanuel Farhi have proposed a very serious classification of policy tools, distinguishing between monetary puts and calls. According to Caballero and Farhi, policy puts support the economy in bad states of the world, while policy calls support the economy in good states of world. There is much to disagree with in their “Safety Traps and Economic Policy” paper, but their definition of policy puts and calls is very useful.

QE1 and ARRA stimulus in 2009 are examples of policy puts. On the other hand, QE3 and Evans rule are primarily policy calls. Evans rule supported expectations of low interest rates in good states of the world, while QE3 compressed the term premium by reducing the risk of bond market volatility during the recovery. Policy calls are riskier than policy puts. Evan’s rule increased the risk of suboptimally low interest rates during late stages of recovery, while QE3 increased the risk of losses in Fed’s portfolio. Indeed, on March 1, 2013 Bernanke indicated that the estimated treasury term premium is negative. The Fed has walked back from policy calls. Tapering has restored the bond term premium to more normal levels, and the Fed has replaced the Evans rule with a more vague guidance. Bernanke call was replaced by Yellen put.

The Fed has used both monetary puts and calls, but the ECB has never used policy calls, and is not planning to use them. The policy of the ECB was a succession of impressive policy puts. Temporary liquidity injection in August 2007 has addressed the liquidity panic. Full allotment in October 2008 has placed a floor on the functioning of euro and dollar money markets. Three year LTROs in 2011 have prevented Greece’s default from becoming Lehman II. OMTs are out-of the money policy puts – they were never activated. Forward guidance is a policy put too, the ECB describes it as being all about “subdued outlook for inflation and broad-based weakness of the economy”, and low rates are signalled in bad states of the world without affecting interest rate expectations in good states of the world.

On further weakness the ECB is likely to start QE. Executive Board member Benoit Coeure has recently given us a glimpse of likely modalities of QE in his “Asset purchases as an instrument of monetary policy” speech. Coeure has stressed the continuity of ECB’s approach, he also said that “asset purchases in the euro area would not be about quantity, but about price”, and the ECB will use the yardstick of “the observable effect of our operations on term premia”. Presumably, the intent of QE will be to reduce term premia that are unduly high (policy put), and not to recreate boom conditions in financial markets by driving term premia to excessively low levels (policy call).

The Eurozone economy is very far away from any sensible macro equilibrium, and monetary call would be a very sensible step to take. Unfortunately, a blocking minority exists for any explicit decision. However, Draghi could communicate an implicit policy call by signalling the existence of majority coalition which would block a premature interest rate increase. The rate hike of 2011 was unanimous, so the bar is high for any such communication. Draghi’s talk of “plenty of slack” is a step to the right direction, but stronger and clearer words are needed to persuade the markets that ECB’s reaction function has changed unrecognizably since 2011.

What most people seem to have missed about high-frequency trading

I finished reading Michael Lewis’ new book Flashboys last week. I wasn’t a specialist of high-frequency trading (HFT) at all, so I found the book interesting. Overall, it was an easy read. Perhaps too easy. I am always suspicious of easy-to-read books and articles that supposedly describe complex phenomena and mechanisms. Flashboys partly falls in that trap. Lewis has a real talent to entertain the reader. He unfortunately often slightly exaggerates and attacks the HFT industry without giving them the opportunity to respond. More annoyingly, the whole book reads like a giant advertising campaign for IEX, the new ‘fair’ exchange set up by Brad Katsuyama. In the end, I was left with a slightly strange aftertaste: the book is very partisan. I guess I shouldn’t have been surprised.


The book, as well as HFT, have been the topic of much discussion over the past few weeks*. I won’t come back to most of those comments, but I wish here to highlight what many people seem to have missed. Lewis, as well as many commenters, drew the wrong conclusions from the recent HFT experience. They misinterpret both the role of regulation and the market process itself.

What is most people’s first answer to the potential ‘damage’ caused by HFT? Regulation. I would encourage those people to read the book a second time. Perhaps a third time. This is Lewis:

How was it legal for a handful of insiders to operate at faster speeds than the rest of the market and, in effect, steal from investors? He soon had his answer: Regulation National Market System. Passed by the SEC in 2005 but not implemented until 2007, Reg NMS, as it became known, required brokers to find the best market prices for the investors they represented. The regulation had been inspired by charges of front-running made in 2004 against two dozen specialists on the floor of the old New York Stock Exchange – a charge the specialists settled by paying a $241 million fine.


Until 2007, brokers had discretion over how to handle investors’ trade orders. Despite the few cases of fraud/front-running, most investors didn’t seem to particularly hate that system. In a free market, investors are free to change broker if they are displeased with the service provided by their current one. At the very least, nothing seemed to really justify government’s intervention to institutionalise and regulate the exact way brokers were supposed to handle trade orders. In fact, when government took private discretion away, investors started feeling worse off. This is the very topic of the book (though Lewis didn’t seem to notice): government and regulation created HFT.

Brad Katsuyama sums it up pretty well (emphasis mine):

I hate them [HFT traders] a lot less than before we started. This is not their fault. I think most of them have just rationalized that the market is creating inefficiencies and they are just capitalizing on them. Really, it’s brilliant what they have done within the bound of regulation. They are much less a villain than I thought. The system has let down the investor.

Brad is definitely less naïve than Lewis, who still believed in the power of regulation throughout his book**:

Like a lot of regulations, Reg NMS was well-meaning and sensible. If everyone on Wall Street abided by the rule’s spirit, the rule would have established a new fairness in the U.S. stock market.

Meanwhile, David Glasner questioned the ‘social value’ of HFT on his blog:

Lots of other people have weighed in on both sides, some defending high-frequency trading against Lewis’s accusations, pointing out that high-frequency trading has added liquidity to the market and reduced bid-ask spreads, so that ordinary investors are made better off, not worse off, as Lewis charges, and others backing him up. Still others argue that any problems with high-frequency trading are caused by regulators, not by high-speed trading as such.

I think all of this misses the point. Lots of investors are indeed benefiting from the reduced bid-ask spreads resulting from low-cost high-frequency trading. Does that mean that high-frequency trading is a good thing? Um, not necessarily.

I believe that here it is Glasner who completely misses the point. Should we blame HFT traders from exploiting loopholes created by regulation? Economists are better placed than anyone to know that people respond to economic incentives. The resources ‘wasted’ by HFT on ‘socially useless informational advantages’ emanate from government intervention. It is highly likely that HFT would have never developed under its current form should Reg NMS had not been passed. What we instead witness is another case of regulatory-incentivised spontaneous financial innovation.


The second problem lies in the fact that most people seem to have become particularly impatient and dependent on short-term (and short-sighted) regulatory interventions. They spot a new ‘problem’ in the way markets work (here, HFT) and highlight it as a ‘market inefficiency’. This evidently cannot be tolerated any longer and regulators need to intervene right now to make markets ‘fairer’ (putting aside the fact that they were the ones who created this ‘inefficiency’ in the first place).

This demonstrates a fundamental misinterpretation of the market process. Markets’ and competitive landscapes’ adaptations aren’t instantaneous. This allows first movers to take advantage of consumers/investors demand and/or regulatory loopholes to generate supernormal profits… temporarily. In the medium term, the new economic incentives attract new entrants, which progressively erode the first movers’ advantage.

This occurs in all industries. Financial firms are no different (assuming no government protection or subsidies). And, despite Lewis’ outrage at HFT firms’ super profits, the fact is… that the mechanism I just described has already applied to them. It was reported that the whole industry experienced an 80% fall in profits between 2009 and 2012 (which Tyler Cowen had already ‘predicted’ here).

Besides, the story the book tells is a pure free-market story: a group of entrepreneurs wish to offer an alternative platforms to investors who also decide to follow them. There is no government intervention here. The market, distorted for a little while, is sorting itself out. Even the big banks see the tide turning and start switching sides (Goldman Sachs is depicted in a relatively positive light in the book). Lewis’ book itself is also part of that free-market story: the finger-pointing and informational role it plays is a necessary feature of the market process. To me, this demonstrates the ability of markets to right themselves in the medium-term. Patience is nevertheless required. It unfortunately seems to be an increasingly scarce commodity nowadays.


There was a very good description of HFT and its strategies published by Oliver Wyman at the end of last year (from which the chart below is taken). Surprisingly, they described HFT’s strategies and the effects of Reg NMS before the publication of Lewis’ book, without unleashing such a public outcry…

Oliver Wyman_Trading Process


* See some there: FT’s John Gapper, The Economist, David Glasner, Noah Smith, Zero Hedge, Tyler Cowen (and here), ASI’s Tim Worstall, as well as this new paper by Joseph Stiglitz, who completely misinterprets the market process. See also this older, but very interesting, article by JP Koning on on HFT seen through both Walrasian and Mengerian descriptions of the pricing process.

I also wish to congratulate Bob Murphy for this magical tweet:

Bob Murpy tweet

** This is also despite Lewis reporting this hilarious dialogue between Brad Katsuyama and SEC regulators (emphasis his):

When [Brad, who had just read a document describing how to prevent HFT traders from front-running investors] was finished, an SEC staffer said, What you are doing is not fair to high-frequency traders. You’re not letting them get out of the way.

Excuse me? said Brad

And to continue saying that 200 SEC employees had left their government jobs to go work for HFT and related firms, including some who had played an important role in defining HFT regulation. It reminded me of this recent study that showed that SEC employees benefited from abnormal positive returns on their securities portfolios

News digest: central bank independence, TBTF and ironic regulators

I’m quite busy at the moment so not many updates here. However I am almost done with Michael Lewis’ new book on high-frequency trading Flashboys. I’ll surely write something about it soon.

The FT had this week an interesting and quite comprehensive article on fintech and new financial start-ups (not sure they all qualify as ‘fintech’ though…). It’s a good introduction for those who don’t know what’s going on in the sector.

On the other hand, about a week ago, Martin Wolf had one of the worst articles on the recent BoE paper on money creation I have had the occasion to read. It looks like Wolf is oblivious to the intense debate on the blogosphere (and elsewhere) that was triggered by the publication of this controversial, and flawed, paper. But… I guess I have given up on Martin Wolf…

US banks have published (through the Clearinghouse association) a new paper arguing that large banks had not been benefiting from the ‘too big to fail’ funding advantage since 2013. I believe this study is quite right but I also think it misses the point made by previous research papers (see one of them here): the main question wasn’t “are banks subsidised for being TBTF?” but “were banks subsidised for being TBTF?”, which could lead to a crisis. There are many reasons why spreads between TBTF and non-TBTF banks would narrow in the short-term. A simple one could be: many large banks are actually currently in a worse financial shape than smaller banks. Another one: states have kept repeating their intentions not to bail out banks and introduced bail-in mechanisms. The paper doesn’t seem to have an answer to this and takes a way too short time horizon to really assess the effectiveness of anti-TBTF measures. It will take another few years to have a definitive answer.

As I said in a recent post, regulators are taking over all the corners of our modern financial system. Another recent target: bank overdraft fees. They basically complain that overdrafts can be more expensive than…payday loans. But they attacked payday loans as predatory. They didn’t seem to get the underlying mechanism at play here… So what’s their logic? Protecting the consumer. But by limiting payday loans, some people will be cut off credit altogether, while some others will have to use…more expensive overdrafts. If overdrafts costs are then pushed down, then it is highly likely that the cost of other services will be pushed up. In the end, regulators just move the problem rather than solve it.

The ironic news of the week is: US state regulators are concerned about the methods used by US federal regulators to crack down on payday lenders (gated link). Just wow.

Christine Lagarde, head of the IMF, declared this week that central bank independence from government control should probably end. While central banks are already arguably not fully independent, I find really scary the types of reaction brought about by the financial crisis. It is like humanity had all of a sudden forgotten the lessons learnt from several centuries of financial history.

Finally, the FT reports a new research paper on the use of pseudo-mathematical models in investment strategies (paper available here). Researchers argue that most of those models are deeply flawed as they are twisted to fit past data. I haven’t read the paper yet but I will soon as I suspect their conclusions also involve other parts of the banking industry.

The Economist declares that financial crises are due to…

The Economist surprised me this week. In a good way.

Over the past few years, the newspaper’s main rhetoric has been that the financial system needed to be more regulated. From time to time, the ancient roots of the venerable newspaper seemed to make a comeback to denounce the increasing red tape that financial businesses were now subject to. But overall, The Economist seemed to have been partly taken over by statist fever and the general editorial line was: regulation and inflation will be the saviours of our capitalist system. Unsurprisingly, I tended to disagree (euphemism spotted).

When this week The Economist decided to publish two articles under the umbrella title of A History of Finance in Five Crises, and How the Next One Could be Prevented (see here and here), I was very sceptical. I was indeed expecting the usual arguments that bankers try to abuse the system, that regulation is necessary to prevent those abuses, that more central bank control of the financial system is a good thing, that financial innovations should be regulated out of existence.

I was plain, delightfully, wrong.

The Economist Financial Crises


This is The Economist:

Whatever was wrong with the American housing market, it was not lack of government: far from a free market, it was one of the most regulated industries in the world, funded by taxpayer subsidies and with lending decisions taken by the state.


In a very timely and remarkable echo to my very recent post on the obsession of financial stability, the newspaper also pointed out the risk of too much protection:

The more the state protected the system, the more likely it was that people in it would take risks with impunity.

[…] In many cases the rationale for the rules and the rescues has been to protect ordinary investors from the evils of finance. Yet the overall effect is to add ever more layers of state padding and distort risk-taking.

This fits an historical pattern. As our essay this week shows, regulation has responded to each crisis by protecting ever more of finance. Five disasters, from 1792 to 1929, explain the origins of the modern financial system. This includes hugely successful innovations, from joint-stock banks to the Federal Reserve and the New York Stock Exchange. But it has also meant a corrosive trend: a gradual increase in state involvement.

The newspaper even attacked… deposit insurance! Blasphemy! To tell you the truth, I still find it hard to believe:

The numbers would amaze Bagehot. In America a citizen can now deposit up to $250,000 in any bank blindly, because that sum is insured by a government scheme: what incentive is there to check that the bank is any good?

[…] Today America is an extreme case, but insurance of over $100,000 is common in the West. This protects wealth, and income, and means investors ignore creditworthiness, worrying only about the interest-rate offer, sending deposits flocking to flimsy Icelandic banks and others with pitiful equity buffers.

[…] How can the zombie-like shuffle of the state into finance be stopped? Deposit insurance should be gradually trimmed until it protects no more than a year’s pay, around $50,000 in America. That is plenty to keep the payments system intact. Bank bosses might start advertising their capital ratios, as happened before deposit insurance was introduced.

Those are two brilliant articles. Personally, I find that very encouraging. It means that my blog, as well as the work of the very few people who think like me, aren’t pointless.

Dear Economist, welcome back.

(and please stay with us this time)

Endogenous Money vs. the Money Multiplier (guest post by Justin Merrill)

(This is a guest post by Justin Merrill, an investment advisor in Fairfax, Virginia, who independently studies banking, free banking and monetary theory. He is also a media editor at and you can find some of its work here and here)

The proponents of the “New View”, especially Tobin and Gurley and Shaw, have been a large influence on me, but so has Leland Yeager. This discussion prompted me to reread Yeager’s work, “What are Banks?” and see if their views could be reconciled.

I believe the following to be true:

  • Outside money is exogenous with a couple (Post-Keynesian) qualifications and also a “hot potato”.
  • Inside money is endogenously created and subject to market forces.
  • The reserve multiplier explanation should die a quick, painful death.
  • Monetary policy does influence inside money creation through controlling expectations and liquidity, which affects banks’ cost of funds.
  • Attempts to regulate inside money creation for “macro-prudential” purposes are folly because the problem is monetary policy. The only way to keep both money and credit harmonized is by allowing a natural rate of interest.


Framing the Discussion:

To be clear, what is being debated is the usefulness of the money multiplier model (MMM) and the endogeneity of money and how these are related. Someone (I think it was Julien) recently blogged that the pro-endo critics of the MMM are contradicting themselves because the model explicitly states that commercial banks create the majority of money. But this is not what the debate is. The debate is what limits the creation of money (reserve requirements or market forces) and if the textbook MMM is remotely accurate or even useful.

James Tobin and the “New View”:

I mostly agree with the new view. I believe that inside money is determined mostly by market forces and that banks compete with other financial intermediaries. They provide liquidity by optimally allocating society’s wealth between deposits and risk assets.

Where I disagree with the New View is when they go so far as to say that banks are pure intermediaries and not in anyway special. This overlooks the other functions of banks and also leads one to ask why banks exist at all when we could all just hold diversified financial assets with lower fees/higher yields? While these financial assets compete with bank deposits, they are not perfect substitutes. Banks’ liabilities are special and so are some other functions they provide.

Leland Yeager’s Monetarist view:

In Yeager’s essay, “What are Banks?”, he explicitly says that the broad money supply is exogenously controlled by the monetary authority. He argues that fluctuations in money demand don’t impact money supply, only the price level and nominal income.

Yeager thinks the old view, that reserves multiplied by reserve ratios determine the broad money supply, is correct. His most convincing argument is that banks will invest any excess reserves in marketable securities. One flaw in this particular argument is that the return on excess reserves isn’t just the opportunity cost of marketable securities, but also of lending to other banks, which is a usually higher rate than T-bills. One notable difference is that lending Federal Funds is an unsecured market while T-bills are “riskless” and this risk difference might explain some of the spread. The more recent innovation of interest on reserves also complicates the MMM explanation and has partially caused the Fed Funds market to dry up since implementation. If interbank lending rates or IOR are higher than the return of near perfect substitutes (marketable securities such as T-bills), the reserves will stay in the system.

Some Problems with the Money Multiplier Model:

The reason I want to see the MMM die a fast, painful death is because it abstracts away from real decisions of individuals involved in the market process and turns the entire banking system into a policy lever for bureaucrats to adjust.

One way we could attempt to settle the validity of the MMM is empirically. We could survey bank treasurers and ask them what their bottlenecks are, such as: costs of funding, lending opportunities, or reserve maintenance. In the US, banks report their regulatory reserve status every two weeks and have to maintain reserve requirements over the average of the period. This means that if a firm sees an outflow of reserves in week one, in week two they must retain a surplus to offset last week’s deficit.

We could also use macro data to try to verify if reserve requirements determine the money supply and if the banking system remains fully loaned up. I would rather challenge it with the following proposition: imagine a truly free banking system with no central bank and no special regulations. The outside money could be a commodity but that is irrelevant to my point. The point is that with no regulator to enforce reserve requirements, what determines the inside money supply? Some might answer that individual banks would determine their own reserve ratio and that would in aggregate set the money supply, but this begs the question because it doesn’t explain what the prudent bank treasurer is thinking when deciding on a ratio or even if they are thinking in terms of reserve ratios at all!

I suspect that the prudent bank treasurer is only tangentially thinking about reserve ratios in regards to net redemptions and that what they are really thinking about is maximizing profits. If they can make a loan at a risk adjusted rate that is higher than what they can borrow on the wholesale market, why wouldn’t they make a loan and borrow reserves? This kind of interbank lending usually has higher costs than interest paid on deposits so it is not the ideal source of funding, but if the marginal investment return is high enough, the treasurer will authorize the loan and borrow reserves until they can secure more “sticky” and affordable funding. One thing I noticed is that both sides of the debate, Tobin and Yeager, accuse the other side of assuming that banks are not profit maximizers. I suspect it is Yeager who is guilty because the New View actually incorporates marginal profit/loss into its analysis.

Checking accounts aren’t that interesting, or interest bearing. The textbook version explains that reserves create bank deposits without any specification between demand and time deposits. When Tobin was writing, both were subject to reserve requirements, if I’m not mistaken. Interest on checking accounts was also forbidden. My interpretation of Tobin’s point is that bank deposits compete with other financial assets, and should they be allowed to pay interest, will do so. Time deposits are a better characterization of Tobin’s point because they are held for their certainty and return, whereas demand deposits are for transactions.The MMM is still taught like it is the 1960’s even though we have financial liberalization and innovation. No longer do time deposits have interest ceilings, MMMFs are checkable, NOW accounts enable demand deposits to pay interest (and I think Dodd-Frank scrapped all prohibitions of interest on demand deposits), and maybe most importantly, time deposits are not subject to reserve requirements. So how do MMM proponents explain the supply and yield of time deposits, especially if savings accounts are still counted as money? This leads into a paradox that can only be countered with either a concession that the Fed doesn’t control M2, or only M1 is money, or maybe that the MMM should be abandoned.

A Final Note on Institutional Analysis:

Regulatory reserve requirements are an intervention, to be specific, a quota. Interventions only take effect if they are binding. The reason the MMM is insufficient is because it is a specific theory of money creation, not a general theory. Relying on the MMM is as naive as relying on minimum wage laws to explain labor market wages for unskilled labor. Some might argue that binding reserve requirements are required to create artificial scarcity and give a fiat currency a positive value, but I’m sufficiently convinced by Eugene Fama’s “Banking in the Theory of Finance” that the services rendered from money are sufficient to give it positive value so long as the issuer constrains the supply. I also believe that monetary policy can be effective (or destructive) absent reserve requirements. One final argument for reserve requirements is that someone needs to make the banks stay liquid enough to pay off depositors. This justification was codified at the national level under the National Banking Act of 1863 and was made obsolete with the creation of the Federal Reserve System. The central bank can offset a reserve drain and be the lender of last resort. Empirically, reserve requirements were an ineffective tool for regulating liquidity and theoretically may even contribute to panics, but that’s worthy of a different post altogether. I also plan on writing a more detailed post explaining the mechanics behind the reasoning that inside money is not a “hot potato”.

New research on finance and Austrian capital theories

Two brand new pieces of academic research have been published last month, directly or indirectly related to the Austrian theory of the business cycle (some readers might already know my RWA-based ABCT: here, here, here and here).

The first one, called Roundaboutness is Not a Mysterious Concept: A Financial Application to Capital Theory (Cachanosky and Lewin) attempts to start merging ABCT (or rather, Austrian capital theory) with corporate finance theory. The authors use the finance concepts of economic value added (EVA), modified duration, Macaulay duration and convexity in order to represent the Austrian concepts of ‘roundaboutness’ and ‘average period of production’. The paper provides a welcome and well-defined corporate finance background to the ABCT.

However, finance practitioners still don’t have the option to use a ‘full-Austrian’ alternative financial framework, as this paper still relies on some mainstream concepts. For instance, the EVA calculation for a given period t is as follows:


where ROIC is the return on invested capital, WACC the weighted average cost of capital and K the financial capital invested.

In order to compute the project’s market value added (MVA, i.e. whether or not the project has added value), it is then necessary to discount the expected future EVAs of each period t1, t2…, T, by the WACC of the project:


The WACC represents the minimum return demanded by investors to compensate for the risk of such a project (i.e. the opportunity cost), and is dependent on the interest rate level. The problem arises in the way it is calculated in modern mainstream finance. While the cost of debt capital is relatively straightforward to extract, the cost of equity capital is commonly computed using the capital asset pricing model (CAPM). Unfortunately, the CAPM is based on the Modern Portfolio Theory, itself based on new-classical economics and rational expectations/efficient market hypothesis premises, which are at odds with Austrian approaches.

(And I am not even mentioning some of the very dubious assumptions of the theory, such as “all investors can lend and borrow unlimited amounts at the risk-free rate of interest”…)

While it is easy for researchers to define a cost of equity for a theoretical paper, practitioners do need a method to estimate it from real life data. This is how the CAPM comes in handy, whereas the Austrian approach still has no real alternative to suggest (as far as I know).

Nevertheless, putting the cost of equity problem aside, the authors view the MVA as perfectly adapted to capital theory:

Note that the MVA representation captures the desired characteristics of capital-theory; (1) it is forward looking, (2) it focuses on the length of the EVA cash-flow, and (3) it captures the notion of capital-intensity.

Using the corporate finance framework outlined above, the authors easily show that the more capital intensive investments are the more they are sensitive to variations in interest rates (i.e. they have a larger ‘convexity’). They also show that more ‘roundabout’/longer projects benefit proportionally more from a decline in interest rates than shorter projects. Unsurprisingly, those projects are also the first ones to suffer when interest rates start going up.

The following chart demonstrates the trajectory of the MVA of both long time horizon (high roundabout – HR) and short time horizon (low roundabout – LR) projects as a function of WACC.


Overall, this is a very interesting paper that contains a lot more than what I just described. I wish more research was undertaken on that topic though.


The second paper, pointed by Tyler Cowen, while not directly related to the ABCT, nonetheless has several links to it (I am unsure why Cowen thinks this piece of research actually reflects the ABCT). What’s interesting in this paper is that it seems to confirm the link between credit expansion, financial instability and banks stock prices, as well as the ‘irrationality’ of bank shareholders, who do not demand a higher equity premium when credit expansion occurs (which doesn’t seem to fit the rational expectations framework very well…).

The obsession of stability

One of the outcomes of the financial crisis has been that regulators are now obsessed with instability. Or stability. Or both.

They have been on a crusade to eliminate the evil risks to ‘financial stability’, and nothing seems to be able to stop them (ok, not entirely true). Banks, shadow banking, peer-to-peer lending, crowdfunding, private equity, payday lenders, credit cards

Their latest target is asset managers. In a new speech at London Business School, Andrew Haldane, a usually ‘wise’ regulator, seems to have now succumbed to the belief that regulators know better and have the powers to control and regulate the whole financial industry (see also here). This is worrying.

Haldane now views every large asset manager as dangerous and many investment strategies as potentially amplifying upward or downward spiral in asset prices, representing ‘flaws’ in financial markets that regulators ought to fix. I believe this is strongly misguided.

In their quest to cure markets from any instability, regulators are annihilating the market process itself. I would argue that some level of instability is not only necessary, but is also desirable.

First, instability reflects human action; the allocation of resources by investors and entrepreneurs. Some succeed, some fail, prices go up, prices go down, everybody adapts. Sometimes many, too many, investors believe that a new trend is emerging, indeed amplifying a market movement and subsequently leading to a crash. But crashes and failures are part of the learning process that is inherent to any capitalist and market-based society. Suppress or postpone this process and don’t be surprised when very large crashes occur. On the other hand, an unhampered market would naturally limit the size of bubbles and their subsequent crashes as market actors continuously learn from their mistakes.

Second, instability enhances risk management. Instability is necessary because it induces fear in markets participants’ behaviour, who then take risks more seriously. By suppressing instability, regulators would suppress risk assessment and encourage risky behaviours: “there is nothing to fear; regulators are making sure markets are stable.” The illusion of safety is one of the most potent risks there is.

Nevertheless, regulators, on their quest for the Holy Grail of stability, want to regulate again and again. On the back of flawed instability or paternalistic consumer protection arguments, and despite seemingly showing poor understanding of financial industries, they are trying to implement regulations that would at best limit, at worst dictate, market actors’ capital allocation decisions. Adam Smith would turn in his grave (along with his invisible hand, who is now buried next to him).

Adam Smith Grave

In the end, regulators’ obsession for stability and protection creates even stronger systemic risks. In fact, the only ‘stable’ society is what Mises called the evenly-rotating economy, the one that never experiments. Nothing really attractive.

Funny enough, in his speech, Haldane even acknowledged regulation as one of the reasons underlying some of the current instability:

Risk-based regulatory rules can contribute further to these pro-cyclical tendencies. […]

There have been several incidences over recent years of regulators loosening regulatory constraints to forestall concerns about pro-cyclical behaviour in a downswing. […]

In particular, regulation and accounting appear to have played a significant role.

I guess he didn’t get the irony.

Mobile banking keeps growing, payday lenders perhaps not so much anymore

The Fed published last week a new mobile banking survey in the US. Here are the highlights: 33% of all mobile phone owners have used mobile banking over the past twelve months, up from 28% a year earlier. When only considering smartphones, those figures increased to 51% and 48% respectively, with 12% of mobile users who plan to move on to mobile banking soon. 39% of the ‘underbanked’ population used mobile banking over the period. Checking balances, monitoring transactions and transferring money are the most common activities.

Still more than half of mobile users who do not currently use mobile banking are reluctant to use it in the future though. But usage is correlated with age. 18 to 29yo users represent 39% of all mobile banking users but only 21% of mobile phones users, whereas 45 to 60yo represent 27% of mobile banking users but 53% of mobile users. I am indeed not surprised by those results, and, as I have described in a previous post, as current young people age, the bank branch will slowly disappear and mobile banking become the norm. (Bloomberg published an article on the end of the bank branch yesterday)

That the underbanked naturally benefit from mobile banking isn’t surprising, and isn’t new at all. The widespread use of the M-Pesa system in Kenya rested on the fact that a very large share of the population had no or limited access to banking services. However, some African countries with slightly more developed banking systems are resisting the introduction of mobile money in order not to interfere with the business as usual of the local incumbent banks. Another case of politicians and regulators acting for the greater good of their country. Anyway, mobile money/banking is now instead making its way to… Romania, as almost everyone there owns a mobile phone but more than a third of the population does not have access to conventional banking.

Meanwhile, in the UK, the regulators are doing what they can to clamp down on payday lenders. As I have described in a previous post, the result of this move is only likely to prevent underbanked people from accessing any sort of credit, as other regulations seriously limit mainstream banks’ ability to lend to those higher-risk customers.

Here again, the Fed mobile banking survey is quite enlightening. They asked underbanked people their reasons for using payday lenders. Here are their answers:

Payday Loans Stats 1

Payday Loans Stats 2

Right… So what are the consequences when you prevent people from temporarily borrowing small amount of cash that their bank aren’t willing to provide and who need it to pay for utility bills or buying some food or for any other emergency expenses? It looks like regulators believe that those families would indeed be better off not being able to pay their water bills.

Of course, over-borrowing is an issue (as are abuse and fraud), but regulators are merely clamping down on symptoms here. Society is confronted with a dilemma: either those households are unable to pay their bills or buy enough food, or they might face over-indebtedness… None of those two options are attractive. But in such a situation, it is customers’ responsibility to choose. If they can avoid payday lenders, so they should. If they really can’t, this option should remain on the table. Sam Bowman from the Adam Smith Institute made very good comments on BBC radio Wales earlier today (see here from 02:05:00) on this topic.

I know I am repeating myself, but you cannot regulate problems away.


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