Archive | May 2014

The BoE’s FLS delusion

The Bank of England reported yesterday the latest statistics of one of its flagship measures, the Funding for Lending Scheme. Unsurprisingly, they are disappointing. No, more than that actually: the FLS has been pretty much useless.

When launched mid-2012, the FLS was supposed to offer cheap funding to British banks in exchange for increased business and mortgage lending (though originally, authorities strongly emphasised SMEs in their PR as you can imagine) in order to ‘stimulate the economy’. The only effect of the scheme was to boost… mortgage lending.

The BoE, unhappy, decided to refocus the scheme on businesses (including SMEs) only, in November last year. Well, as I predicted, it was evidently a great success: in Q114, net lending to businesses was –GBP2.7bn and net lending to SMEs was –GBP700m. Since the inception of the scheme, business lending has pretty much constantly fallen (see chart below).

UK Business Lending

According to the FT:

Figures from the British Bankers’ Association showed net lending to companies fell by £2.3bn in April to £275bn, the biggest monthly decline since last July.

The BoE argues that we don’t know what would have happened without the scheme. Perhaps lending would have fallen even more? That’s a poor argument for a scheme that was supposed to boost lending, not merely reduce its fall. Not even all large UK banks participated in the scheme (HSBC and Santander didn’t). Moreover, some banks withdrew only modest amounts because they could already access cheaper financial markets by issuing covered bonds and other secured funding instruments, or, if they couldn’t, used the FLS to pay off existing wholesale funding rather than increase lending… The FLS funding that did end up being used to lend was effective in boosting… the mortgage lending supply.

The UK government has also ‘urged’ banks to extend more credit to SMEs. Still, nothing is happening and nobody seems to understand why. For sure, low demand for credit plays a role as businesses rebuild their balance sheet following the pre-crisis binge. Still, nobody seems to understand the role played by current regulatory measures. Central bankers are supposed to understand the banking system. The fact that they seem so oblivious to such concepts is worrying.

On the one hand, you have politicians, regulators and central bankers trying to push bankers to lend to SMEs, which often represent relatively high credit risk. On the other hand, the same politicians, regulators and central bankers are asking the banks to… derisk their business model and increase their capitalisation. You can’t be more contradictory.

The problem is: regulation reflects the derisking point of view. Basel rules require banks to increase their capital buffer relatively to the riskiness of their loan book; riskiness measures (= risk-weighted assets) which are also derived from criteria defined by Basel (and ‘validated’ by local regulators when banks are on an IRB basis, i.e. use their own internal models).

Those criteria require banks to hold much more capital against SME exposures than against mortgage ones. Banks that focus on SMEs end up squeezed: risk-adjusted SME lending return is not enough to generate the RoE that covers the cost of capital on a thicker equity base. Banks’ best option is to reduce interest income but reduce proportionally more their capital base to generate higher RoEs. Apart from lending to sovereigns and sovereign-linked entities, the main way they can currently do that is to lend… secured on retail properties…

(I have already described here how this process creates misallocation of capital and possibly business cycles)

As such, it is unsurprising that mortgage lending never turned negative in the UK (even a single month) throughout the crisis. Even credit card exposures haven’t been cut by banks, as their risk-adjusted returns were more beneficial for their RoE than SMEs’. Furthermore, alternative lenders, who are not subject to those capital requirements, actually see demand for credit by SMEs increase (see also here).

Let’s get back to the 29th of November 2013. At that time, after it was announced that the FLS would be modified, I declared:

RWAs are still in place! Mortgage and household lending will still attract most of lending volume as it is more profitable from a capital point of view.


As long as those Basel rules, which have been at the root of most real estate cycles around the world since the 1980s, aren’t changed, SMEs are in for a hard time. And economic growth too in turn. Secular stagnation they said?



PS: this topic could easily be linked to my previous one on intragroup funding and regulators “killing banking for nothing”. Speaking of the ‘death of banking’, Izabella Kaminska managed to launch a new series on this very subject without ever saying a word about regulation, which is the single largest driver behind financial innovations and reshaped business models. I sincerely applaud the feat.

PPS: The FT reported how far regulators (here the FCA) are willing to go to reshape banking according to their ideal: equity research in the UK is in for a pretty hard time. This is silly. Let investors decide which researchers they wish to remunerate. Oversight of the financial sector is transforming into paternalism, if not outright regulatory threats and uncertainty.

PPS: I wish to thank Lars Christensen who mentioned my blog yesterday and had some very nice comments about it.


The importance of intragroup funding – 19th century Canada

This is a quick follow-up post on intragroup funding, as promised in the one focusing on the US experience during the 19th century.

The Canadian case is interesting, because Canada is also a ‘recent’ country that experienced its own banking development at the same time as its close, also ‘recent’, neighbour, the US. Though the contrast cannot be starker; while the US was prone to recurrent financial crises during the 19th century, Canada’s financial system remained pretty stable throughout the period, and continued to do so until today.

19th century Canadian banknote

The main difference between the Canadian and the US banking systems was their fragmentation and regulation. The US, as described earlier, had a very fragmented and highly regulated (though much less than today…) banking system, whereas Canada had a lightly regulated and quite concentrated one (some could argue that it was pretty much an oligopoly). In the US, a multitude of unit banks with no branches and local monopolies prevailed. In Canada, large nationwide banks with multitude of branches prevailed. This was due to the specific political and institutional arrangements in Canada: unlike in the US, where states had most of the powers to charter banks, the Canadian government was the one who decided whether or not to grant a bank charter, not the provinces. In 1890, there were 38 chartered banks in Canada and around 8000 in the US.

It is easy to understand why the Canadian banking system was more stable: nationwide branch network allowed banks to move liquidity around and continue to accept each others’ notes at par, and loan books were much more diversified and less prone to local asset quality deterioration. When branches in the West of the country were experiencing a liquidity shortage, it was easy to provide them with extra liquidity from their cousin in the East in order to avoid contagion as banks tried to protect their name and reputation. Moreover, the fact that only a few banks had large market shares in the country made it a lot easier to coordinate a response in times of financial tension, pretty much like the US clearinghouse system, but on a much larger scale.

The consequences of this design were that banks operated on thinner liquidity and capital buffers than banks in the US, as credit and liquidity risks could be consolidated and diversified away. Furthermore, credit was as available in Canada as in the US and deposit rates were higher, while banks were nonetheless more profitable thanks to centralised back office functions on a nationwide basis (i.e. economies of scale).

In the end, Canada experienced not a single bank failure during the Great Depression, despite having no central bank nor deposit insurance, the two tenets of current banking regulatory ‘good practices’.

What is striking from my series of posts on intragroup funding is that history is crystal clear: it is large, diversified, banking groups that represent a more stable ideal than insulated, but reinforced, smaller local banks. Unfortunately, most regulators and economists don’t seem to know much banking history…

The importance of intragroup funding – 19th century US vs. modern Germany

I recently explained the importance of intragroup liquidity and capital flows to prevent or help solve financial crises and why new regulations are weakening banks, and showed the inherent weakness in the design of the 19th century US banking system. Today I wish to highlight the similarities, and more importantly, the differences, between the 19th century US banking system and the modern German banking system.

As previously described, the peculiar US banking system had a multitude of tiny unit banks that were not allowed to branch, with very little financial flows and support behind them (at least until they started setting up local clearinghouses). By 1880, there were about 3,500 banks in the US, meaning about 1 bank for 14,000 people. Nowadays, there are about 1,800 banks in Germany, meaning one bank for 45,000 people. Germany’s banking system isn’t as fragmented as the 19th century US one, but it is still very fragmented by developed economies’ standards.

By comparison, in the UK, there is one bank for 410,000 people, though most banks have no retail banking market share, meaning this figure is probably way overestimated (my guess is that there is actually one bank for about 3m people). In Germany though, most banks have a retail banking market share: the banking system is divided between the large private banks (which actually don’t account for much of the local retail market share and focus mostly on corporate lending and investment banking), the cooperative banks group (the Volksbanken and Raiffeisenbanken, representing around 1,200 small retail banks), and the savings banks group, the largest banking group in Germany (the Sparkassen-Finanzgruppe, representing slightly less than 450 retail banks).


Those Sparkassen, for instance, cannot compete with each other and cannot branch out of their local area, making both their loan books and funding structures highly undiversified, with restrictions very similar to those that applied to 19th century US banks. Moreover, many of those banks have relatively small capital and liquidity buffers, at least compared to the US banks. Nevertheless, the Sparkassen have demonstrated remarkable resilience over time, experiencing very few failures (all have been bailed out). How to explain this?

First, all Sparkassen depend on local Landesbanks, which, quite similarly to clearinghouses in 19th century US, play the role of local central banks, moving liquidity around according to the needs of their Sparkassen members. This process alleviates acute liquidity crises. But this isn’t enough to avert regional crises or national, systemic ones.

Second, the Sparkassen rely on another mechanism: several regional and interregional support funds that allow healthy banks to recapitalise or provide liquidity to endangered sister Sparkassen. Those support funds can be complemented by extra contributions from healthy Sparkassen if ever needed. This mechanism is akin to some sort of intragroup funds flows*.

Here we go: instead of insulating each bank, raising barriers to allegedly make them more resilient, the Sparkassen allow funds to circulate when needed. They understand that the actual failure of one of their members would have catastrophic ramifications for the rest of the group (and for their shared credit rating). It is in their best interest to mutually support each other. But guess what? Some Sparkassen now fear that European regulators will take action to make such intragroup mutual support flows illegal…


* The Volksbanken have a relatively similar structure and intragroup support mechanism, though there are differences. Both groups are also actively involved in intragroup peer monitoring, which is important to limit moral hazard.

The importance of intragroup funding – The 19th century US experience

This is a follow-up post to my previous one on banks’ intragroup funding.

Financial and banking historians have known for a long time what the BoE believes it has ‘discovered’. A prime example of the importance of being able to move funds around (whether under the form of capital or liquidity) is the experience of US banking in the 19th century.

In the 19th century, the US was plagued by recurrent banking crises. This was mostly due to strict limitations on the development and growth of banks that basically isolated banks from each other. The result was known as ‘unit banking’. I am not going to enter into all the details (and this post mainly refers to the North of the US) but I strongly advise you to check the references at the bottom of this post.

The US’ political arrangements made it very difficult for the federal government to charter banks on a national basis, as the experiments of the First and the Second Banks of the United States demonstrate. States, on the other hand, could charter banks of issue within their borders to help finance the states’ expenditures. They also tended to forbid interstate branching in order not to leak out sources of funds to other states and artificially limit competition within their borders, as banking monopoly rents led to more abundant funding resources for the states (taxes could account for close to a quarter or even a third of total state financing). Many large cities ended up having a single bank at the very beginning of the 19th century.

Windham bank private note 1850s

The race for financing led states to charter increasingly more banks. However, new laws divided states into districts and allowed only a very limited number of banks to be chartered within each of them. Banks also did not have the right to open branches throughout the states. In the end, the whole banking system was completely fragmented in a myriad of small banks that enjoyed local monopolies.

From the 1830s, ‘free banks’ started to appear, a trend that accelerated following the 1837 banking crisis during which many banks failed throughout the country. This prompted a movement to increase competition in banking and access to credit for those who could not access the traditional, restricted, banking system. Free banks could be opened without any approval by state regulators. They still came to the funding need of state governments as the free banking laws required the full-backing of banknotes with high-quality securities, mostly government debt. Crucially, free banks were not allowed to branch. The previous system of larger banks that were constrained in their growth by their inability to open branch in other states, or simply in other districts, was progressively replaced by a system of a multitude of tiny ‘unit’ banks. In the end, the number of banks massively grew but unit banks often retained local monopolies. The federal government eventually tried to find ways to increase the number of nationally-chartered banks, but in the end those banks faced the same legal constraints that prevented free banks to branch.

There was political power behind those unit banks: because they couldn’t expand, unit banks were incentivised to lend to their local community even when times were tough (if they didn’t, they wouldn’t make any money and would fail anyway…). Banks were numerous (there were more than 27,000 banks in the US early-20th century, 95% of which had no branches…) but geographically isolated. As a result, they suffered from high levels of concentration in their loan books and deposit base, and were particularly badly hit by local economic problems. Liquidity risk was high and banks could hardly get hold of extra funds to face bank runs when they occurred.

Some banks tried to organise themselves into holding companies, owning several unit banks. However, the law prevented any financial or operational integration between various banks. The only thing they ended up sharing was a common ownership structure. A partial solution came up with the setup of clearinghouses, which basically settled interbank transactions, but also played the role of coordinator during local crises.

As a result of this poorly-designed banking structure, financial crises were recurrent: there were 11 of them between 1800 and 1914.                 Post-clearinghouses crises were nonetheless milder as clearinghouses allowed some liquidity to circulate.

Where does this lead us?

I described in my previous post how intragroup funding allows banking systems to remain more stable by allowing liquidity to circulate from stronger entities to weaker ones (this also applies to capital).

The 19th century US is an extreme example of what happens when you prevent this free movement of funds: a few banks fail and indirect contagion weakens even the stronger banks, leading to a systemic collapse. When banking groups are larger and free to move funds around, on the other hand, they have an incentive to reinforce their weaker links. Think about those 19th century ‘bank holdings’, which could not operationally integrate their various unit banks: the collapse of one of their ‘unit bank subsidiaries’ could potentially endanger the existence of all unit banks owned by that holding company through economic and financial contagion. Wouldn’t it be simpler to allow the transfer of funds from one unit bank to another to prevent any failure in the first place and actually reassure depositors that their banks are solid?

Unfortunately, current regulations aims at fragmenting and isolating national banking systems (and types of banks). This is likely to transform our globalised banking system into a mild version of what happened in the US, rather than into the stronger and more resilient systems that regulators hope to build. In the US, each unit bank had to maintain relatively high levels of capital and liquidity given their inherent weakness and lack of diversification. Was it enough to prevent crises? Not at all. This is in contrast with the Canadian experience, whose banking system comprised a few, very large, lightly regulated, branching banks. The Canadian banking system remained very stable throughout the period (and later).

More on 19th century Canada in a subsequent post.


Recommended readings:

  • Charles A. Conant, A History of Modern Banks of Issue
  • Charles Calomiris and Stephen Haber, Fragile by Design
  • Christopher Whalen, Inflated: How Money and Debt Built the American Dream
  • Milton Friedman and Anna Schwartz, A Monetary History of the United States

Update: I added one very important and great book to the list…

Is regulation killing banking… for nothing? The importance of intragroup funding

Last week, Barclays, the large UK-based bank, announced massive job cuts and asset reductions in its investment banking division which effectively signal the end of its ambition to compete with Tier 1 US banks. One of the main causes of that withdrawal is clear: regulations now make it a lot more costly to sustain capital market activities as Basel 3 has increased market risk capital requirements. But also, UK-specific rules, which advocate a ring-fencing of retail activities, also played a role in disadvantaging British banks. By ring-fencing retail banks from their sister investment ones, banks have to set up separate funding structures and look for separate funding sources, which makes it more expensive to fund investment banking divisions. Some would say that this is a good thing, as investment banking is “risky and caused the crisis”. This is wrong. In the UK and most of the world, it is mostly retail banks that failed as their asset quality strongly declined following the lending boom*.

This clampdown on investment banking is unfortunate, but wouldn’t undermine the whole banking system by itself. Regrettably, all aspects of banking are now being revisited and harmonised to please ‘out of control’ (in the words of one of my friends) regulators. Often though, the measures they take actually make banks weaker.

A brand new study published last month by the Bank of England itself (does the BoE read its own reports?) highlighted this very contradiction (see summarised post on Vox). What did it find?

The left-hand side panel of Figure 3 shows that interbank funding fell on average across our sample of BIS reporters by almost 30% between September 2008 and the end of 2009. Yet, in contrast, intragroup funding increased in the immediate aftermath of the collapse of Lehman Brothers and was stable for the remainder of the crisis period.

The contrasting behaviour of interbank and intragroup flows is not limited, however, to the recent global financial crisis. To see this, in the right-hand side panel of Figure 3, we present the distributional relationship across time between cross-border bank-to-bank funding and the VIX index.

We find that on average, between 1998 and 2011, interbank funding contracted by 2% during quarters when the VIX index was at an elevated level (upper-25th percentile), while during the same quarters intragroup funding expanded by over 2%. In the quarters when the VIX index was particularly low (lower-25th percentile), both intragroup and interbank funding expanded by approximately 4%.

Intragroup Funding Flows


This is self-explanatory. Globalisation of banking led to increased stability of funding flows. Local subsidiaries with excess liquidity were able to transfer some reserves to sister subsidiaries in other countries (or within the same country) and parent banks were also able to retrieve some of those excess funds in case they were under pressure at home. Banking system whose interbank funding comprises high share of intragroup experienced much lower drop in funding during the crisis**.

But, wait a minute… What’s the current regulatory logic? In the UK, the goal of ring-fencing is clear: ‘insulation’ (see the UK Commission report on banking reform). Globally, Basel 3 regulations now require each subsidiary of international banking groups to hold high levels of liquid assets and comply with a Net Stable Funding Ratio. By itself, this means that subsidiaries have a limited power to transfer liquidity intragroup even if they don’t need it at a given moment. Only liquidity/funding in excess of those (already high) limits could be transferred. In theory, local regulators can decide to supersede the original Basel framework. In practice, regulators are often reluctant to allow cross-border intragroup support, as they narrowly focus on their own national banking system and actually raise extra barriers, including capital controls. This happened during the crisis and potentially made it worse. This is what a BIS survey reported:

Respondents indicated that in some jurisdictions a banking parent can easily and almost without limit support its subsidiaries provided the parent continues to meet its liquidity standards. However, banking subsidiaries face legal lending limits on the amount of liquidity they can upstream to their parent even when they have excess liquidity.

Certain respondents claimed that these legal lending limits are inefficient when managing the liquidity and funding position of a banking group overall and advised that they expect future banking regulation to further institutionalise these inefficiencies. As such, in their view, subsidiaries will need a liquidity buffer for their own positions that the greater group is not able to use.

Furthermore, since the survey, financial nationalism has increased. As Bloomberg reported in February:

The Federal Reserve approved new standards for foreign banks that will require the biggest to hold more capital in the U.S., joining other countries in erecting walls around domestic financial systems.

In turn, European regulators threatened to retaliate… In short, regulators throughout the world, in an attempt to make their own financial system safer, are raising barriers and fragmenting the global financial system. But as this new research demonstrates, reducing the ability of banking groups to move funds around is weakening both global and domestic financial systems, not strengthening them.

I find bewildering that regulators don’t seem to get that logic. Let’s imagine that Bank X, based in the UK, has a subsidiary that shares the same name in the US. The US authorities believe that by making the US-based subsidiary stronger it will make it less likely to fail. Fair enough. Let’s now imagine that Bank X in the UK is experiencing difficulties and need to recover some funds located in its US sub to ensure its survival. Unfortunately, US rules prevent this transfer and Bank X effectively collapses. Do US regulators really believe that the US sub will remain untouched? Even if looking solid locally, this sub suffers massive reputational and operational damages from the collapse of its parent. This is likely to trigger a downward spiral, if not an outright bank run on those US operations. The original goal of the US authorities was thus self-defeating.

While such regulations can indeed make domestic subsidiaries look stronger, this isn’t the case on a consolidated basis. We have another fallacy of composition example here. None of those regulatory requirements can ever make banks fully crisis-proof. Consequently, when a truly large crisis strikes, healthy banks won’t be able to support their struggling sister banks, which can potentially even endanger their own existence through indirect contagion.

Even during non-crisis times, banks, and in turn economies, get penalised by those measures as banks’ cost of funding rises to reflect the inherent higher riskiness of each subsidiary/parent companies, making credit either more scarce and/or expensive.

Coincidentally, I am currently reading Fragile by Design, a new book by Calomiris and Haber, which argues that nations’ political frameworks influence the design of local banking systems and that some political arrangements (including the one in the US) are more prone to banking collapses. I guess current events are proving them right…

There are other, ‘counterintuitive’, solutions to stability in banking (which, guess what, involve less government intervention in banking, not more). Unfortunately, what we are currently witnessing is the sacrifice of competition in banking on the altar of instability… In the end, everybody loses.


* I should add that a lot of losses in investment banking divisions actually emanated from structured products (RMBS, CDOs) based on… dodgy retail lending. Nonetheless, those losses were marked-to-market and only few structured products outright defaulted (see also here). But mark-to-market losses, even when temporary, are enough to make a bank insolvent, according to current IFRS and US GAAP accounting rules.

** I am however a little curious about the claim of the authors that this result contradicts economic theory. I don’t know what ‘economic theory’ they are referring to, but those results look fully logical to me. Banking groups know what part of the group lacks liquidity. Because of reputational reasons, they have a clear incentive to transfer extra liquidity to struggling subsidiaries/divisions/holding companies. Letting a part of the group collapse is likely to trigger a dangerous chain reaction for the whole group.

Update: I modified the title of this post to more accurately reflect the content and the follow-up posts

News digest: P2P lending and HFT, CoCo bonds, Co-op Bank…

Ron Suber, President at Prosper, the US-based P2P lending company, sent me a very interesting NY Times article a few days ago. The article is titled “Loans That Avoid Banks? Maybe Not.” This is not really accurate: the article indeed mentions institutional investors such as mutual and hedge funds increasingly investing in bundles of P2P loans through P2P platforms, but never refers to banks. Unlike what the article says, I don’t think platforms were especially set up to bypass institutional investors… They were set up to bypass banks and their costly infrastructure and maturity transformation.

Some now fear that the industry won’t be ‘P2P’ for very long as institutional investors increasingly take over a share of the market. I think those beliefs are misplaced. Last year, I predicted that this would create opportunities for niche players to enter the market, focusing on real ‘P2P’.

A curious evolution is the application of high-frequency trading strategies to P2P. I haven’t got a lot of information about their exact mechanisms, but I doubt they would resemble the ones applied in the stock market given that P2P is a naturally illiquid and borrower-driven market.

The main challenge of the industry at the moment seems to be the lack of potential customer awareness. Despite offering better deals (i.e. cheaper borrowing rates) than banks, demand for loans remains subdued and the industry tiny next to the banking sector.


In this FT article, Alberto Gallo, head of macro-credit research at RBS, argues that regulators should intervene on banks’ contingent convertible bonds’ risks. I think this is strongly misguided. Investors’ learning process is crucial and relying on regulators to point out the potential risks is very dangerous in the long-term. Not only such paternalism disincentives investors to make their own assessment, but also regulators have a very bad track record at spotting risks, bubbles and failures (see Co-op bank below).


This piece here represents everything that’s wrong with today’s banking theory:

We know that a combination of transparency, high capital and liquidity requirements, deposit insurance and a central bank lender of last resort can make a financial system more resilient. We doubt that narrow banking would.

Not really… They also argue that 100% reserve banking would not prevent runs on banks:

The mutual funds of the narrow banking world would be subject to the same runs. Indeed, recent research highlights that – in the presence of small investors – relatively illiquid mutual funds are more likely to face exit in the event of past bad performance. […] Since the mutual funds would be holding illiquid loans – remember, they are taking over functions of banks – collective attempts at liquidation to meet withdrawal requests would lead to ruinous fire sales.

They misunderstand the purpose of such a banking system. Those ‘mutual funds’ would not be similar to the ones we currently have, which invests in relatively liquid securities on the stock market, and can as a result exit their positions relatively quickly and easily. Those 100% reserve funds would invest in illiquid loans and investors in those funds would have their money contractually locked in for a certain time. With no legal power to withdraw, no risk of bank run.


The FT reported a few days ago the results of the investigation on the Co-operative bank catastrophe. Despite regulators not noticing any of the problems of the bank, from corporate governance to bad loans and capital shortfall, as well as approving unsuitable CEOs and mergers, the report recommends to… “heed regulatory warnings.” I see…


The impossible sometimes happens: I actually agree with Paul Krugman’s last week piece on endogenous money. No guys, the BoE paper didn’t reveal any mystery of banking or anything…


Finally, Chris Giles wrote a very good article in the FT today, very clearly highlighting the contradictions in the Bank of England policies and speeches, and their tendency to be too dovish whatever the circumstances:

Mark Carney, the governor, certainly displays dovish leanings. Before he took the top job, he said monetary policy could be tightened once growth reached “escape velocity”. But now that growth has shot above 3 per cent, he advocates waiting until the economy has “sustained momentum” – without acknowledging that his position has changed. His attitude to prices also betrays a knee-jerk dovishness. When inflation was above target, he stressed the need to look at forecasts showing a more benign period ahead. Now that inflation is lower it is apparently the short-term data that matters – and it justifies stimulus.

So much for forward guidance… Time to move to a rule-based monetary policy?

A new regulatory-driven housing bubble?

The FT reported today that house prices were booming in many different countries, in particular in Israel, Norway, Australia, Canada…

FT House Prices

There is nothing surprising at all in what’s happening. As I have already pointed out several times, Basel regulations are still incentivising banks to channel the flow of new lending towards property-related sectors. A repeat of what happened, again and again, since the end of the 1980s, when Basel was first introduced. I cannot be 100% certain, but I think this is the first time in history that so many housing markets in so many different countries experience such coordinated waves of booms and busts.

So far we’ve had two main waves: the first one started when Basel regulations were first implemented in the second half of the 1980s. It busted in the first half of the 1990s before growing so much that it would make too much damage. The second wave started at the very end of the 1990s, this time growing more rapidly thanks to the low interest rate environment, until it reached a tragic end in 2006-2008. It now looks like the third wave has started, mostly in countries where house prices haven’t collapsed ‘too much’ during the crisis.

The Economist House Prices

Sam Bowman was indeed right that lack of supply (through planning restrictions) is a real factor in driving up house prices in the UK. However, this cannot be the only issue at play here. A chronic lack of supply would lead to chronically increasing housing prices, not to wave-like variations, especially when those waves happen to be very well coordinated with those of other countries.

I still have to dig more in details into the data of each country, and I’ll do it in subsequent posts. For sure, some countries seemed to ‘skip’ one wave or to experience a mild one, but banking regulation is only part of the explanation. Local factors such as monetary policy, population growth, building restrictions, etc., are also important in determining local prices.

What’s interesting in the FT article is also the fact that a lot of countries have implemented macro-prudential policies over the last few years. Their effects on house bubbles seemed to have been close to nil… Indeed, low real interest rates compounded by regulatory-boosted mortgage lending supply still make housing an attractive asset class.

As long as this deadly combination remains in place, brace yourself for a recurring pattern of housing bubble cycles.


RWA-based ABCT Series:

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

Felix Martin and the credit theory of money

I just finished reading a book that had been on my shelves for a few months, Money: The Unauthorised Biography, by Felix Martin (the book has only just been released in the US). Martin argues that our conventional view of money is wrong. Money isn’t a commodity used as a medium of exchange that evolved from the inconvenience of barter, but a system of mutual credit. Martin is not the first one to articulate this view, called the credit theory of money.

Martin Money

While overall Martin’s book is interesting, particularly for its historic descriptions and for bringing an ‘original’ view of the origins of money, it is plagued by a few problems and misinterpretations. Throughout the book, it feels like money, at least in its modern sense, is a ‘bad’ thing that is at the root of most of our current excesses, from inequality to financial crises. Perhaps, but the book never really discusses monetary calculation and economic efficiency. Money might have cons, but it also has pros. The fact that some ancient, very hierarchical – or even totally backward, societies were not using such ‘money’ is in no way something to be worried about…

Throughout his book, Martin seems to misinterpret former authors’ writings. Take Bagehot, whom Martin believes understood money and trust a lot better than most academic economists since then. Martin incorrectly reports Bagehot as saying that central banks should lend to insolvent banks. More importantly, he also didn’t seem to notice that Bagehot had never been a fan of the central banking system. In fact, Bagehot thought that system was not natural and even dangerous. This becomes a serious flaw of the book when Martin justifies his economic and reform ideas on a system that Bagehot himself saw as far from perfect.

Martin also seems to praise inflation without ever mentioning its downsides and the potential economic disruptions it can bring about. In turn, this leads him to praise… John Law. While John Law is most of the times seen as a model of economic mismanagement, Martin sees in him a ‘genius’, whose only faults was to have lived too early and to have believed in benevolent dictators:

Law’s system was ingenious, innovative and centuries ahead of his time.

To Martin, John Law’s system mainly failed because of… the vested interests of the old financial establishment! As with most other topics the book cover, I found this was a very selective reading of the historical facts.


This is the book’s main issue: it draws the wrong conclusions from a very superficial reading of history (including our latest financial crisis).

The book’s main thesis (admittedly, it’s also other people’s) suffers from the same problem. Why opposing credit theory of money and metalism? To me money can be both credit and commodity. This is not irreconcilable. Let’s suppose you provide me with a service or a product. The consequence of this transaction is that I am in credit to you. From there, what can you do? To settle the transaction, you can either accept one of my products or services. This is barter. Or you could use my ‘debt’ to you (my IOU) to purchase another product from someone else. However, in order to accept the ‘debt transfer’, the other person needs to make sure that my credit is good (i.e. that I will close the transaction at some point) in order to reduce the probability of losses (i.e. credit risk). This other person can further transfer my IOU, which ends up serving as money in a chain of transactions. Nevertheless, settlement (i.e. debt cancellation) is still expected at some point, and with no generally accepted medium of exchange, this settlement is similar to barter. This system still suffers from lack of granularity and from the double coincidence of wants problem.

Enter commodities. Excluding its barter-like issues, the process described above works, but involves credit risk. Developed societies discovered a way to reduce this credit risk to a minimum: a direct settlement of the IOU against what we view as the same value of a granular, easily transferable and measurable commodity. Think about it: you can either take the risk that my IOU will not be transferable any further or that I will fail to close the transaction, or you can settle the transaction directly by accepting some sort of commodity in exchange, which makes credit risk entirely disappear. But the system remains a system of credit: the only difference now is that IOU transfer chains end directly after the first transaction. This is still valid nowadays: everybody still says “how much do I owe you?” in order to pay for a good in store*.

(Note: of course if my credit is good, my IOU could still be transferred and ‘used’ as a medium of exchange, but would still merely remain a claim on the same easily transferable commodity.)

Strangely, Martin seems to downplay the settlement issue. He takes the Yap islands as an example of a pure system of credit money. But this is not accurate: Martin himself says that locals eventually settle their mutual debt using stone money (the fei/rai)!

I ended up quite confused about the book. It is hard to figure out what Martin really believes. Some of his proposals, such as money that would be some sort of state equity, look unworkable and closer to statist dreams than economic freedom; although this shouldn’t be surprising, as Martin never really questions the state, regulators and central bankers, and blindly accepts the Keynesian criticism of Say’s law. Money is more a history book than an economics book, but whether this is financial history or monetary theory you’re looking for, there is already a lot more comprehensive out there.


*The story I just described is essentially similar to Carl Menger’s theory of the origins of money. However, I added in a new factor: credit risk.


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