ECB policies: from flop to flop… to flop?
Even central bankers seem to be acknowledging that their measures aren’t necessarily effective…
ECB’s Benoit Coeuré made some interesting comments on negative deposit rates in a speech early September. Surprisingly, he and I agree on several points he makes on the mechanics of negative rates (he and I usually have opposite views). Which is odd. Given the very cautious tone of his speech, why is he even supporting ECB policies?
Here is Coeuré:
Will the transmission of lower short-term rates to a lower cost of credit for the real economy be as smooth? While bank lending rates have come down in the past in line with lower policy rates, there is a limit to how cheap bank lending can be. The mark-up that banks add to the cost of obtaining funding from the central bank compensates for credit risk, term premia and the cost of originating, screening and monitoring loans. The need for such compensation does not necessarily fall when policy rates are lowered. If anything, a central bank lowers rates when the economy needs stimulus, which is precisely when it is difficult for banks to find good loan making opportunities. It remains to be seen whether and to what extent the recent monetary policy accommodation translates into cheaper bank lending.
This is a point I’ve made many times when referring to margin compression: banks are limited in their ability to lower the interest rate they charge customers as, absent any other revenue sources, their net interest income necessarily need to cover their operating costs (at least; as in reality it needs to be higher to cover their cost of capital in the long run). Banks’ only solution to lower rates is to charge customers more for complimentary products (it has been reported that this is in effect what has been happening in the US recently).
Negative rates are similar to a tax on excess reserves, which evidently doesn’t make it easier for a bank to improve its profitability, and as a result its internal capital generation. And Coeuré agrees:
A negative deposit rate can, however, also have adverse consequences. For a start, it imposes a cost on banks with excess reserves and could therefore reduce their profitability. Note, however, that this applies to any reduction of the deposit rate and not just to those that make the rate negative. For sure, lower bank profitability could hamper economic recovery, especially in times when banks have to deleverage owning to stricter regulation and enhanced market scrutiny. But whether bank profitability really falls when policy rates are lowered depends more generally on the slope of the yield curve (as banks’ funding costs may also fall), on banks’ investment policies (as there is scope for them to diversify their cash investment both along the curve and across the credit universe) and on factors driving non-interest income.
Coeuré clearly understands the issue: central banks are making it difficult for banks to grow their capital base, while regulators (often the same central bankers) are asking banks to improve their capitalisation as fast as possible. Still, he supports the policy…
Other regulators are aware of the problem, and not all are happy about it… Andrew Bailey, from the Bank of England’s PRA, said last week that regulatory agencies should co-ordinate:
I am trying to build capital in firms, and it is draining out down the other side.
This says it all.
Meanwhile, and as I expected, the ECB’s TLTRO is unlikely to have much effect on the Eurozone economy… Banks only took up EUR83m of TLTRO money, much below what the central bank expected. It is also likely that a large share of this take up will only be used for temporary liquidity purposes, or even for temporary profitability boosting effects (through the carry trade, by purchasing capital requirement-free sovereign debt), until banks have to pay it off after two years (as required by the ECB, and without penalty, if they don’t lend the money to businesses).
Fitch also commented negatively on TLTRO, with an unsurprising title: “TLTROs Unlikely to Kick-Start Lending in Southern Europe”.
Finally, the ECB also announced its intention to purchase asset-backed securities (which effectively represents a version of QE). While we don’t know the details yet, the scheme has fundamentally a higher probability to have an effect on banks’ behaviour. There is a catch though: ABS issuance volume has been more than subdued in Europe since the crisis struck (see chart below, from the FT). The ECB might struggle to buy the quantity of assets it wishes. Perhaps this is why central bankers started to encourage European banks to issue such structured products, just a few years after blaming banks for using such products.
Oh, actually, there is another catch. ABSs are usually designed in tranches. Equity and mezzanine tranches absorb losses first and are more lowly rated than senior tranches, which usually benefit from a high rating. Consequently, equity and mezzanine tranches are capital intensive (their regulatory risk-weight is higher), whereas senior tranches aren’t. To help banks consolidate their regulatory capital ratios and prevent them from deleveraging, the ECB needs to buy the riskier tranches. But political constraints may prevent it to do so… Will this new ECB scheme also fail? As long as central bankers (and politicians) continue to push for schemes and policies without properly understanding their effects on banks’ internal ‘mechanics’, they will be doomed to fail.
PS: I have been busy recently so few updates. I have a number of posts in the pipeline… I just need to find the time to write them!
One year of blogging
Here we go; this blog was created exactly a year ago. This whole year, I have tried to defend and justify laissez-faire policies in banking and finance. This blog, as well as all the debates to which I have participated through it, have required me to question, or even revise, my views on banking and economics. I was forced to read and think about certain topics much more in depth that I would ever have done without it. My worldview and my knowledge have evolved.
I wish to thank all followers and guests, as well as all people who provided me with information and even those who have challenged me. Not only your views and comments persuaded me to continue, but you also made me a better person.
There is still a lot of work to do though. And I will continue to defend a classical liberal point of view in finance for the foreseeable future. Please don’t forget to share!
Here are some of the major series of posts that have defined this year of blogging:
Stable rules, macro-prudential policies and regulatory uncertainty (plenty of other posts build on those ones):
- Macro(un)prudential regulation
- The case for stable rules
- A few complementary notes on regime uncertainty
- BoE’s Mark Carney is burying Walter Bagehot a second time
- What Walter Bagehot really said in Lombard Street (and it’s not nice for central bankers and regulators)
The RWA-based Austrian business cycle theory (the distortive effects of RWAs is a recurrent theme):
- Banks’ risk-weighted assets as a source of malinvestments, booms and busts
- Banks’ RWAs as a source of malinvestments – Update
- Banks’ RWAs as a source of malinvestments – A graphical experiment
- Banks’ RWAs as a source of malinvestments – Some recent empirical evidence
- A new regulatory-driven housing bubble?
- Is the US dissociating from Basel banking rules?
- A tale of two US lending curves
- Basel vs. ECB’s TLTRO: The fight
- Sovereign debt crisis: another Basel creature?
- New research at last asks the right questions on RWAs
The endogenous money and MMT banking theory debates:
- The problems with the MMT-derived banking theory
- A response to Scott Fullwiler on MMT banking theory
- The central bank funding stigma
- Banks don’t lend out reserves. Or do they?
- The BoE says that money is endo, exo… or something
- Tobin vs. Yeager, my view
- More inside/outside money endogeneity confusion
Does the central bank control interest rates and implications:
- Mortgage rates are still determined by the BoE
- A clarification on mortgage rates for ASI’s Ben Southwood
- Is the zero lower bound actually a ‘2%-lower bound’?
- Could P2P Lending help monetary policy break through the ‘2%-lower bound’?
The importance of banks’ intragroup funding and free liquidity and capital flows:
- Balkanise or globalise banking, there is no middle way
- Is regulation killing banking… for nothing? The importance of intragroup funding
- The importance of intragroup funding – The 19th century US experience
- The importance of intragroup funding – 19th century US vs. modern Germany
- The importance of intragroup funding – 19th century Canada
- Felix Martin and the credit theory of money
- Calomiris and Haber are pretty much spot on
- A brief comment on Piketty
- A couple of comments on ‘House of Debt’
- Endogenous Money vs. the Money Multiplier (guest post by Justin Merrill)
- Greenspan put, Draghi call? (guest post by Vaidas Urba)
- Macroprudential policy tools: a primer (guest post by Justin Merrill)
And of course, plenty of other, more independent, posts (about financial history misinterpretation, financial innovation, central bankers as new central planners, etc.).
Two kinds of financial innovation
Paul Volcker famously said that the only meaningful financial innovation of the past decades was the ATM. Not only do I believe that his comment was strongly misguided, but he also seemed to misunderstand the very essence of innovation in the financial services sector.
Financial innovations are essentially driven by:
- Technological shocks: new technologies (information-based mostly) allow banks to adapt existing financial products and risk management techniques to new technological paradigms. Without tech shocks, innovations in banking and finance are relatively slow to appear.
- Regulatory arbitrage: financiers develop financial products and techniques that bypass or use loopholes in existing regulations. Some of those regulatory-driven innovations also benefit from the appearance of new technological and theoretical paradigms. Those innovations are typically quick to appear.
I usually view regulatory-driven innovations as the ‘bad’ ones. Those are the ones that add extra layers of complexity and opacity to the financial system, hiding risks and misleading investors in the process.
It took a little while, but financial innovations are currently catching up with the IT revolution. Expect to change the way you make or receive payments or even invest in the near future.
See below some of the examples of financial innovation in recent news. Can you spot the one(s) that is(are) the most likely to lead to a crisis, and its underlying driver?
- Bank branches: I have several times written about this, but a new report by CACI and estimates by Deutsche Bank forecasted that between 50% and 75% of all UK branches will have disappeared over the next decade. Following the growing branch networks of the 19th and 20th centuries, which were seen as compulsory to develop a retail banking presence, this looks like a major step back. Except that this is actually now a good thing as the IT and mobile revolution is enabling such a restructuring of the banking sector. SNL lists 10,000 branches for the top 6 UK bank and 16,000 in Italy. Cutting half of that would sharply improve banks’ cost efficiency (it would, however, also be painful for banks’ employees). It is widely reported that banks’ branches use has plunged over the past three years due to the introduction of digital and mobile banking.
- In China, regulators have introduced new rules to try to make it harder for mainstream banks to deal with shadow banks in order to slow the growth of the Chinese shadow banking system, which has grown to USD4.9 trillion from almost nothing just a few years ago. The Economist reports that, by using a simple accounting trick, banks got around the new rules. Moreover, while Chinese regulators are attempting to constrain investments in so-called trust and asset management companies, investors and banks have now simply moved the new funds to new products in securities brokerage companies.
- In London, underground travellers can now pay for their journey by simply using their contactless bank card. No need of a specific underground card anymore. NFC-enabled smartphones will be able to do the same in the near future.
- Barclays is experimenting contactless wristband that would effectively replace your contactless card for payments (or, for Londoners, your underground Oyster Card).
- Apple announced Apple Pay, a contactless payment system managed by Apple through its new iPhones and Watch devices. Apple will store your bank card details and charge your account later on. This allows users to bypass banks’ contactless payments devices entirely. Vodafone also just released a similar IT wallet-contactless chip system (why not using the phone’s NFC system though? I don’t know. Perhaps they were also targeting customers that did not own NFC-enabled devices).
- Lending Club, the large US-based P2P lending firm, has announced its IPO. This is a signal that such firms are now becoming mainstream, as well as growing competitors to banks.
Of course, a lot more is going on in the financial innovation area at the moment, and I only highlighted the most recent news. Identifying the regulatory arbitrage-driven innovations will help us find out where the next crisis is most likely to appear.
PS: the growth of cashless IT wallets has interesting repercussions on banks’ liquidity management and ability to extend credit (endogenous inside money creation), by reducing the drain of physical cash on the whole banking system’s reserves (outside money). If African economies are any guide to the future (see below, from The Economist), cash will progressively disappear from circulation without governments even outlawing it.
Some finance artefacts
I am back from my trip in North America, which led me to New York, where I saw some interesting finance artefacts in various locations. Here is a sample (click to enlarge):
World War finance propaganda
The very first US Treasury warrant
Private bank notes
Great Depression local government currencies printed to alleviate the lack of Fed money
US Treasury notes redeemable in gold
Various old bond certificates
A share certificate owned by… Bernard Madoff
And the most curious of them all: a Disney-decorated US Treasury WW2 bond… Slightly strange mix
The mystery of collateral
Collateral has been the new fashionable area of finance and capital markets research over the past few years. Collateral and its associated transactions have been blamed for all the ills of the crisis, from runs on banks’ short-term wholesale funding to a scarcity of safe assets preventing an appropriate recovery. Some financial journalists have jumped on the bandwagon: everything is now seen through a ‘collateral lens’. The words ‘assets’, and, to a lesser extent ‘liquidity’ and ‘money’ themselves, have lost their meaning: all are now being replaced by ‘collateral’, or used interchangeably, by people who don’t seem to understand the differences.
A few researchers are the root cause. The work of Singh keeps referring to any sort of asset transfer between two parties as ‘collateral transfer’. This is wrong. Assets are assets. Securities are securities, a subset of assets. Collateral can be any type of assets, if designated and pledged as such to secure a lending or derivative transaction. Real estate, commodities and Treasuries can all be used as collateral. Money too. Unlike what Singh and his followers claim, a securities lender lends a security not a collateral. Whether or not this security is used as collateral in further transactions is an independent event.
This unfortunate vocabulary problem has led to perverse ramifications: all liquid assets, or, as they often say, collateral, are now seen as new forms of money (see chart below, from this paper). Specifically, collateral becomes “the money of the shadow banking system”. I believe this is incorrect. Collateral is used by shadow banks to get hold of money proper. Building on this line of reasoning, people like Pozsar assert that repo transactions are money… This makes even less sense. Repos simply are collateralised lending transactions. Nobody exchanges repos. The assets swapped through a repo (money and securities) could however be exchanged further. Depressingly, this view is taken increasingly seriously. As this recent post by Frances Coppola demonstrates, all assets seem now to be considered as money. This view is wrong in many ways, but I am ready to reconsider my position if ever Treasuries or RMBSs start being accepted as media of exchange at Walmart, or between Aston Martin and its suppliers. Others have completely misunderstood the differences between loan collateralisation and loan funding, which is at the heart of the issue: you don’t fund a loan, whether in the light or the dark side of the banking system, with collateral! The monetary base/high-powered money/cash/currency, is the only medium of settlement, the only asset that qualifies as a generally-accepted medium of exchange, store of value and unit of account (the traditional definition of money).
There is one exception though. Some particular transactions involve, not a non-money asset for money swap, but non-money asset for another non-money asset swap. This is almost a barter-like transaction, which does occur from time to time in securities lending activities (the lender lends a security for a given maturity, and the borrower pledges another security as collateral). Nonetheless, the accounting (including haircuts and interest calculations) in such circumstances is still being made through the use of market prices defined in terms of the monetary base.
Still, collateral seems to have some mysterious properties and Singh’s work offers some interesting insights into this peculiar world. The evolution of the collateral market might well have very deep effects on the economy. The facilitation of collateral use and rehypothecation, as well as the requirements to use them, either through specific regulatory and contractual frameworks, through the spread of new technology, new accounting rules or simply through the increased abundance of ‘safe assets’ (i.e. increased sovereign debt issuance), might well play a role in business cycles, via the interest rate channel. Indeed, by facilitating or requiring the use of increasingly abundant collateral, interest rates tend to fall. The concept of collateral velocity is in itself valuable: when velocity increases, interest rates tend to fall further as more transactions are executed on a secured basis. Still, are those transactions, and the resulting fall in interest rates, legitimate from an economic point of view? What are the possible effects on the generation of malinvestments?
An example: let’s imagine that a legal framework clarification or modification, and/or regulatory change, increases the use and velocity of safe collateral (government debt). New technological improvements also facilitate the accounting, transfer, and controlling processes of collateral. This increases the demand for government debt, which depresses its yield. Motivated by lower yield, the government indeed issues more debt that flow through financial markets. As the newly-enabled average velocity of collateral increases substantially, more leveraged secured transactions take place and at lower interest rates. While banks still have exogenous limits to credit expansion (as the monetary base is controlled by the central bank), the price of credit (i.e. endogenous money creation) has therefore decreased as a result of a mere regulatory/legal/technological change.
I have been wondering for a while whether or not such a change in the regulatory paradigm of collateral use could actually trigger an Austrian-type business cycle. I do not yet have an answer. Implications seem to be both economic and philosophical. What are the limits to property rights transfer? How would a fully laisse-faire market deal with collateral and react to such technological changes? Perhaps collateral has no real influence on business fluctuations after all. There is nevertheless merit in investigating further. I am likely to explore the collateral topic over the next few months.
PS: I will be travelling in North America over the next 10 days, so might not update this blog much.
* There are many many flaws in Frances’ piece. See this one:
But suppose that instead of a sterling bank account, a smartcard or a smartphone app enabled me to pay a bill in Euros directly from my holdings of UK gilts? This is not as unlikely as it sounds. It would actually be two transactions – a sale of gilts for sterling and a GBPEUR exchange. This pair of transactions in today’s liquid markets could be done instantaneously. I would in effect have paid for my meal with UK government debt.
She fails to see that she would have paid for her mean with Sterling, not with government debt! Government debt must be converted into currency as it is not a medium of exchange/settlement.
Breaking banks won’t help economic recovery
In contrast with the bank-bashing environment of the post-crisis period, voices are increasingly being raised to moderate regulatory, political and judiciary risks on the banking system.
Last week, Gillian Tett wrote an article in the FT tittled “Regulatory revenge risks scaring investors away”. She says:
Last month [Roger McCornick’s] project team published its second report on post-crisis penalties, which showed that by late 2013 the top 10 banks had paid an astonishing £100bn in fines since 2008, for misbehaviour such as money laundering, rate-rigging, sanctions-busting and mis-selling subprime mortgages and bonds during the credit bubble. Bank of America headed this league of shame: it had paid £39bn by the end of 2013 for its transgressions. When the 2014 data are compiled, the total penalties will probably have risen towards £200bn.
She argues that “legal risk is now replacing credit risk.” This is a key issue. Banks have already been hit hard by new regulatory requirements, which sometimes require a fundamental restructuring of their business model. The consequences of this framework shift is that profitability, and hence internal capital generation, remain subdued, weakening the system as a whole. Banks now reporting double digit RoEs are more the exceptions than the rule. Moreover, low profitability also reduces the banks’ ability to generate capital externally (i.e. capital raising) because they do not cover their cost of capital. This scares investors away, as they have access to better risk-adjusted investment opportunities elsewhere.
The enormous amounts raised through litigation procedures make such a situation even worse. Admittedly, banks that purposely bypassed laws or committed frauds should be punished. But, as The Economist argues this week in a series of articles called “The criminalisation of American business” (see follow-up article here), the “legal system has become an extortion racket”, whose “most destructive part of it all is the secrecy and opacity” as “the public never finds out the full facts of the case” and “since the cases never go to court, precedent is not established, so it is unclear what exactly is illegal”:
This undermines the predictability and clarity that serve as the foundations for the rule of law, and risks the prospect of a selective—and potentially corrupt—system of justice in which everybody is guilty of something and punishment is determined by political deals. America can hardly tut-tut at the way China’s justice system applies the law to companies in such an arbitrary manner when at times it seems almost as bad itself.
Estimates of capital shortfall at European banks vary between EUR84bn and as much as EUR300bn (another firm, PwC, estimates the shortfall at EUR280bn). Compare those amounts with the hundreds of billions Euros paid or about to be paid by banks as litigation settlements, and it is no surprise that banks have to deleverage to comply with regulatory capital ratio deadlines and upcoming stress tests… Such high amounts, if justified, could probably have been raised by prosecutors at a slower pace in the post-crisis period without endangering the economic recovery (banks’ balance sheets would have been more solid more quickly, which would have facilitated the lending channel of the monetary transmission mechanism).
In the end, regulatory regime uncertainty strikes banks twice: financial regulations keep changing (and new ones are designed), and opaque litigation risk is at an all-time high. Banks are now very risk-averse, depressing lending and international transactions. This seems to me to replicate some of the mistakes made by Roosevelt during the Great Depression. Despite all the central banks’ money injection programmes, this may not be the best way out of an economic crisis…
PS: Commenting on the forthcoming P2P lender Lending Club IPO, Matt Levine argues that:
But Lending Club can grow its balance sheet all it wants. Lending Club is not a bank. So it’s not subject to banking regulation, which means that it can do a core function of banking much more efficiently than an actual bank can.
He is (at least) partly right. By killing banks, regulatory constraints are likely to trigger the emergence of new types of lenders.
Wait… Isn’t it what’s already happened (MMF and other shadow banking entities…)?