Archive | December 2014

Santa bank notes

A curious short post was published on the NY Fed’s Liberty Street Economics blog. Apparently, during the so-called ‘free banking’ era, some US banks printed Santa bank notes:

During the unregulated 19th century, a variety of banks issued their own holiday-themed currency. One popular figure featured on many bills was Santa Claus. Christmas was declared an official holiday in many northern states in the mid-1800s, and some banks celebrated by creating Santa Claus currency. This was a very popular time for Santa in the United States, spurred on by the publication of “A Visit from St. Nicholas” by Clement Clarke Moore in 1823.

The Santa Claus bank notes became very popular as keepsakes, because denominations were typically small and the subject was at the forefront of peoples’ minds given the brand-new official holiday. One motivation for the banks to release these and other collectible currencies was to dissuade people from redeeming the bills for their underlying gold value.

(on a side note: the “unregulated 19th century”? ahem…)

Here is an example of one of those private Santa notes:

santa note

Merry Christmas!

EU banking dis-union

The EU wants to put in place its now famous banking union. The ECB is taking over as the single regulator of all the banks of the Eurozone (and countries that wish to participate). The rationale is that the Eurozone banking system is getting ever more integrated within the ‘single market’, hence justifying having a single ruleset and a single supervisor. But is it really?

In a recent speech, Andrew Haldane pointed out that cross-border banking claims had strongly declined since the crisis:

Cross border bank claims

But a new paper by Bouvatier and Delatte (full version here) now provides some interesting disagregated data to this trend. Controlling for the impact of the economic and financial crisis on the integration of the banking system across Eurozone countries, they conclude that

the decline in banking activities observed after the crisis was due to temporary frictions in all countries outside the euro area. In contrast, the economic downturn faced by the euro area since 2008 is not sufficient to account for the massive retrenchement of international banking activities. Euro area banks have reduced their international exposure inside and outside the euro area to a similar extent. We also find that this decline is not a correction of previous overshooting but a marked disintegration.

According to their model, Eurozone banking integration is 37% below where it should be. So much for a banking union. On the other hand, they find that non-Eurozone banking systems have increased their claims on foreign countries.

Banking integrationThis is very interesting. However, I believe two minor issues distort some of their conclusions: 1. Their sample of banks only consider 14 OECD countries. It would have been interesting to include emerging economies. 2. Their analysis stops in 2012, which is a flaw. Since then, many non-Eurozone banks have cut in their cross-border activities as complying with the increasing regulatory burden became too onerous. I actually suspect that most banks from OECD/developed countries have started to dis-integrate, whereas banks from a number of emerging economies have actually started to grow outside of their domestic borders*.

They do not provide the reasons behind this phenomenon. However, I believe that regulatory and political pressure is the number 1 reason behind this retrenchment. In their haste to make banks safe, regulators are actually doing the exact opposite.

I have already reported on BoE research that demonstrated that global integration of banking systems led to stability of funding flows within what researchers called the ‘internal capital markets’ of banking groups (I also added several historical examples to back this research).

More and more research is produced that actually contradicts the whole current regulatory thinking. A new study by NY Fed researchers Correa, Goldberg and Rice also confirmed the importance of banking group’s internal liquidity transfers across cross-border entities:

In global banks, internal liquidity management is a consistent driver of explaining cross-sectional differences in loan growth in response to changing liquidity risk. Those banks with higher net borrowing from affiliated entities had consistently strong loan growth (domestic, foreign, cross-border, credit) when liquidity risks increased. As shown in the last column of Table 2 Panel B, these global banks with larger unused credit commitments borrow relatively more (net) from their affiliates when liquidity conditions worsen and then sustain lending to a greater degree.

Clearly, the ability of global groups to transfer liquidity and capital across borders can play the role of risk absorber when a crisis strikes. Yet national regulators are implementing new measures that have the exact opposite effect (i.e. ring-fencing and so on). Measures that, among others, result in the disintegration of banking across the Eurozone.

Consequently, regulators’ and politicians’ enthusiasm for the banking union seems a little bit misplaced. See this recent speech by Vítor Constâncio, Vice-President of the ECB:

Another important objective of Banking Union is to overcome financial fragmentation and promote financial integration. In particular, this will constitute a key task of the Single Supervisory Mechanism.

Really? This seems to me to contradict the very actions of regulators in the EU. It can only be one way Mr. Constancio, not both ways.

Then he adds something that is, I believe, a fundamental error:

There are four ways which I expect the SSM to make a difference to banking in Europe: by improving the quality of supervision; by creating a more homogeneous application of rules and standards; by improving incentives for deeper banking integration; and by strengthening the application of macro-prudential policies.

The prudential supervision of credit institutions will be implemented in a coherent and effective manner. More specifically, the Single Rule Book and a single supervisory manual will ensure that homogeneous supervisory standards are applied to credit institutions across euro area countries. This implies that common principles and parameters will be applied to banks’ use of internal models, for example. This will improve the reliability and coherence in banks’ calculation of risk-weighted assets across the Banking Union. On another front, the harmonisation in the treatment of non-performing exposures and provisioning rules will mean that investors can directly compare balance sheets across jurisdictions.

While I believe that the single resolution mechanism can indeed be beneficial (even though it looks overly complicated and it remains to be seen how it’s going to work in practice), a single regulatory treatment of all banks across economies and jurisdictions as varied as those of the EU is mistake. Here is what I said more than a year ago about the standardisation problem:

So a standardisation seems to be a good thing as data becomes comparable. Well, it is, and it isn’t. To be fair, standardisation within a country is probably a good thing, although shareholders, investors and auditors – rather than regulators – should force management to report financial data the way they deem necessary. However, it makes a lot less sense on an international basis. Why? Countries have different cultural backgrounds and legal frameworks, meaning that certain financial ratios should not be interpreted the same way from one country to another.

Let’s take a few examples. In the US, people are much more likely than Europeans on average to walk away from their home if they can’t pay off their mortgage. Most Europeans, on the other hand, will consider mortgage repayment as priority number 1. As a result, impaired mortgage ratios could well end-up higher in the US. But US banks know that and adapt their loan loss reserves in consequence. Within Europe, legal frameworks and judiciary efficiency are also key: UK banks often set aside fewer funds against mortgage losses as the legal system allows them to foreclose and sell homes relatively quickly and with minimal losses. In France on the other hand, the process is much longer with many regulatory and legal hurdles. Consequently, UK-based mortgage banks seem to have lower loan loss reserves compared with some of their continental Europe peers. Does it mean they are riskier? Not really.

Indeed, look at the World Bank’s Doing Business data. The Economist selected a few countries below, all of them from the EU:

EU legal frameworks

EU countries have very disparate legal frameworks and cultural backgrounds. What Constancio is saying is that the same criteria are going to be applied to all banks across all countries above. This does not make sense. The ‘single EU market’ remains for now a multiplicity of various heterogeneous markets, with their own rules, that have merely facilitated cross-border trade and labour movement.

This is a fundamental issue with the EU. Monetary and banking union should have come last, after all other laws had been harmonised. Not first. For now, EU politicians want to force a banking union on a geographical area that has limited legal and political integration. Let alone that domestic politicians and regulators are forcing their domestic banks to focus on business within their national borders, not within the EU borders.


* Indeed, another recent paper by Claessens and van Horen (summary on VOX here) suggests that

After a continued rise until 2008, the number of foreign banks from high-income countries has started to decline, from 948 in 2008 to 814 in 2013, mostly on account of a retrenchment by crisis-affected Western European banks.

On the other hand, banks from emerging markets and developing countries continued their pre-crisis growth and further increased their presence. Currently these banks own 441 foreign banks, representing 8% of all foreign assets, a doubling of their share as of 2007. As these banks tend to invest mainly in their own geographical regions, global banking now both encompasses a larger variety of players and at the same time is more regional, with the average intraregional share increasing by some five percentage points.

Number of banks


I’d rather not have a fox as bank regulator

We can sometimes read stupefying things on the internet. I almost fell off my chair yesterday when I read MC Klein’s latest banking piece on FT Alphaville. He suggests that the right way to regulate banks might well be to be “crazy like a fox”…


Throughout his ‘surprising’ post, he writes things like:

While simple rules about capital and short-term debt still have tremendous appeal, there is value in having a regulatory regime that is onerous precisely because of its complexity and its unpredictability.


As Matt Yglesias notes, the value of having lots of pointless but annoying rules is that they distract the bank lobbyists from the really important stuff. The swap pushout was the first in what is hopefully a long line of defence. We’re tempted to say that crafty policymakers should immediately propose several new and even more annoying rules for the banks.

Fortunately, regulators have other means of harassing their adversaries, hopefully keeping them busy enough to avoid exploiting the system too much.

Andrew Haldane must be having a heart attack right now.

This goes against some of the most basic economic principles, and against the very thing that allows any business to exist and thrive in the first place: the rule of law.

Let’s start with Matt Yglesias’ post. Perhaps not surprising for someone who once wrote that Dodd-Frank was an ‘achievement’ that created a ‘safer banking system’, Yglesias again proves that he has a very low understanding of how banking works. CDS contacts have apparently become ‘custom swaps’ that are used to “bet on the potential bankruptcy of a given country or company or the failure of a new financial product.” Hedging anyone? Insurance that can protect even the most vanilla-like institutions against some specific default risks? No, this is just an evil Wall Street speculative tool. Nevermind that some CDS are traded on behalf of clients, and banks’ positions taken to offset customers’ needs. Nevermind that siloing banking activities/liquidity/capital across different entities of a same banking group actually decrease the safety of the system (see also here).

Despite this rather limited knowledge of the industry, Klein builds on Yglesias’ reasoning: any repealed rule should be replaced by many pointless ones to distract lobbyists.

Now, I am still trying to understand the logic behind constantly adding red tape for no reason rather than judging rules and bureaucracy on their actual value-added and efficiency. Here again, nevermind that countries with the least efficient and most numerous rules are the least business-friendly, and that too much red tape and regulatory uncertainty is around the top issue for most US businesses at the moment. No, banking is (apparently) different.

Let me suggest that a few years working for a bank would probably help dispel some of those myths. That, lobbyists aren’t that dumb, and that, if they attack some specific rules, it is surely that these would be harmful for the banks (and indeed, both Yglesias and Klein are plain wrong in considering this CDS rule ‘pointless’). That the 30,000-page rulebook that Dodd-Frank created might not fully facilitate banking processes and lending. That, by constantly changing the rules as Klein suggests, banks might well be tempted to move away from any risky activity that might end up being considered unlawful at some point in the future, hurting risky lending in the process (i.e. usually SME lending, as if it were not already low enough) with all the associated potential economic consequences.

Banks have been closing entire lines of business, de-globalising, preventing international payments to go through, harming international trade and economic activity. The multiplication of rules could, not only lead to resource misallocation, but also to increased management time. Management time that would be better spent on analysing and controlling the business than on bureaucratic, ‘pointless’, but dangerous (because of potential fines) rules. Unexpected consequences if you like. Still, it looks acceptable for Klein.

This is exactly why avoiding regulatory uncertainty and discretionary policies, and applying a predictable set of rules (i.e. rule of law), is so crucial in facilitating business and economic development.

As Kevin Dowd clearly illustrates in a very good recent paper:

One has to understand that the banks have no defense against this regulatory onslaught. There are so many tens or hundreds of thousands or maybe millions of rules that no one can even read them all, let alone comply with them all: even with armies of corporate lawyers to assist you, there are just too many, and they contradict each other, often at the most fundamental level. For example, the main intent of the Privacy Act was to promote privacy, but the main impact of the USA PATRIOT Act was to eviscerate it. This state of lawlessness gives ample scope for regulators to pursue their own or the government’s agendas while allowing defendants no effective legal recourse. One also has to bear in mind the extraordinary criminal penalties to which senior bank officers are exposed. Government officials can then pick and choose which rules to apply and can always find technical infringements if they look for them; they can then legally blackmail bankers without ever being held to account themselves. The result is the suspension of the rule of law and a state of affairs reminiscent of the reign of Charles I, Star Chamber and all. Any doubt about this matter must surely have been settled with the Dodd-Frank Act, which doled out extralegal powers like confetti and allows the government to do anything it wishes with the banking system.

A perfect example of this governmental lawlessness was the “Uncle Scam” settlement in October 2013 of a case against JP Morgan Chase, in which the bank agreed to pay a $13billion fine relating to some real estate investments. This was the biggest ever payout asked of a single company by the government, and it didn’t even protect the bank against the possibility of additional criminal prosecutions. What is astonishing is that some 80 percent of the banks’ RMBS had been acquired at the request of the federal government when it bought Bear Stearns and WaMu in 2008, and now the bank was being punished for having them. Leaving aside its inherent unpleasantness, this act of government plunder sets a very bad precedent: going forward, no sane bank will now buy a failing competitor without forcing it through Chapter 11. It’s one thing to face an acquired institution’s own problems, but it is quite another to face looting from the government for cooperating with the government itself.

The argument’s logic is also very weak. If rules are believed to let excessive risks “fall through the cracks”, then they should never be adopted in the first place. Why even adopting rules which we already know create systemic risks? If regulators really believe those rules will cover most (or all) risks, there is no point in planning to replace them with other rules, just for the sake of changing the rules, as the new ones are likely to be less effective. Otherwise those new, more effective, rules are the ones that should have been implemented in the first place. The whole logic of the argument just doesn’t hold*.

What about the practicality of ever changing the regulatory framework? Here again the argument fails. There aren’t hundreds of derivative settlement options and assets acceptable as collateral or as liquidity buffer. While the theory sounds nice in FT Alphaville’s columns, it is simply not possible to implement in practice.

The financial imbalances that led to our previous crisis, for a large part, originated in the most complex banking rule set devised in history, compounded by politically-incentivised housing agendas (along with misguided monetary policy and accounting rules). Klein’s (and Yglesias’) failure is to ignore this and assume that more, and tighter, rules are more effective. Moreover, regulators’ failure to foresee crises has probably been a constant throughout history. Yet, Klein backs an ever-more complex and constantly-changing regulatory framework at the discretion of those same regulators.

Calomiris and Nissim, two academics that know and understand a thing or two about banking, declared that:

We worry that regulatory uncertainty – and especially the persistent waves of political attacks on global universal banks – is taking a toll.

It is important to recognize that bank stockholders are not alone in suffering from the low stock prices that result from these attacks. The supply of bank loans, and banks’ ability to provide other crucial financial services in support of economic growth, reflect the risk-bearing capacity of banks, which is directly related to market valuations of bank franchises. If banks’ earnings get little respect from the market, banks’ abilities to help the economy grow will be commensurately hobbled.

Even The Economist, which has been a supporter of banking regulatory reform over the past few years, is against regulatory discretion and is well-aware of regulators’ weaknesses (emphasis mine):

Attracting the capital that will make banking safer will be hard, with profit forecasts so anaemic. However it will also be made unnecessarily difficult by capricious behaviour from the very watchdogs who are ordering banks to raise the funds.

One problem is the endless tinkering with the rules. For all Mr Carney’s talk of finishing the job, global regulators have yet to set the minimum level for several of their new capital requirements. National regulators are just as bad. No bank can be certain how much capital it will need in a few years’ time. Pension funds and insurance companies rightly fret that even a tiny tweak in any of the new regulatory tests is enough to send a bank’s share price plummeting (or, less often, rocketing). […]

Banks can hardly be surprised that regulators have rewritten the rule-book and then thrown it at them. But, for the health of the system, the rules need to be predictable, transparent and consistent. Incredibly, the regulations emanating from America’s Dodd-Frank financial reforms are still being written, more than four years after the law was passed. Europe is scarcely better. Impose demanding capital rules, but stop adding more red tape: that should be the mantra of bank regulators just about everywhere.

The worst is: Klein does identify some of the problems with our current regulatory regime, which is easily gameable because of its complexity. In terms of regulation and forecasting, simple rules and models have always performed better (see some of the links above). But instead of stepping back and getting back to simpler, less distortive, rules, his policy of choice seems to be more bank-bashing, never-ending regulatory regime uncertainty, more complexity, the possible paralysis of bank lending and the build-up of risk within the more opaque shadow banking system. I guess it’s going to be a real success.


* He could reply that the very purpose of ‘pointless’ rules is that they have no real impact on anything. Let me clarify something: all rules have an impact, whether it is small, big, negative, positive, or both (and again, the CDS rule was far from pointless). He could also reply that changing the rules limit the gameability of the system. But this makes little sense, as ‘pointless’ rules changes would probably not prevent the accumulation of risk anyway and, even for ‘non-pointless’ rules, there are only a few available options as described above (changing capital requirements by 1% up or down, including or excluding A+ rated bonds as LCR-compliant, increasing/decreasing haircut requirements by 5%, and so forth, really would have very little impact on gameability or stability).

I am also a free banking theorist

George Selgin wrote a very true post on He claims that we are all, in a way or another, free banking theorists. Why? As Selgin very well explains:

Consider: an economist says that central banks prevent or limit the severity of financial crises, or that without mandatory deposit insurance even sound banks are likely to face runs, or that banks can never be expected to hold enough capital unless we force them to, or that commercially-supplied banknotes will tend to be discounted. All such claims–which is to say any claims about the need for or consequences of government intervention in banking–depend, if not on an explicit understanding of the nature and workings of a laissez-faire banking system, then on some implicit understanding. And this understanding in turn implies a theory of some sort, for reference to experience alone won’t suffice for drawing the sort of sweeping conclusions I’m talking about. It follows that all economists who have anything to say about the effects of government intervention in the banking system are either self-proclaimed free banking theorists or are free banking theorists who don’t admit (and perhaps don’t realize) it.

Indeed, most banking academic research studies and banking reform proposals base their ideas and models on certain assumptions of how the banking system, left to its own device, would behave, and how to correct the market failures that could possibly arise from such systems.

As my (and most people’s) experience can also testify, this tacit conventional wisdom is present in the mind of the general public and finance practitioners (I can still remember my father’s face when I told him we should get rid of central banks. Like he had just spotted some sort of ghost). The success of the usual US-centric misrepresentation of banking history is almost complete.

With this blog, I have been trying to explain what would (not) have happened if we had left banking free of all the rules that distort its natural behaviour. Seen this way, I am also a free banking theorist. I am trying to get back to the roots, asking questions such as: let’s supposed we never implemented Basel rules, would have real estate lending grown that much over the past three decades? What about securitization? Or interest rates on sovereign debt? And banks’ capital and liquidity buffers? What if we hadn’t had central banks nor deposit insurance over the period? What compounded what?

A lot of this is counterfactual, hence uncertain. Still, the intellectual challenge this represents is worth it, as current banking reformers and regulators still rely on and take for granted the inaccurate conventional story to justify the exponential growth of increasingly tight rules. Rules which, as I explain on this blog, are more likely to harm the banking system than to make it safer.

Larry White once says that free banks should be ‘anti-fragile’, and that the only reason they remain fragile is because of government-institutionalised rules that prevent them from self-correcting and learning. I have also already said that this does not mean that banks would never fail or that no crisis would ever occur. But it is likely that the accumulation of financial imbalances, which under our current system slowly emerge hidden behind the regulatory curtain until it is too late, would appear much sooner, limiting the destructive potential of any crisis. The market process, in order to become anti-fragile, needs to learn through experience. The more ‘safety’ rules one implement the less likely market actors will learn and the more likely the following crisis is going to be catastrophic. Institutionalised paternalism is self-defeating.

Unfortunately, the conventional story has seriously twisted everyone’s mind, and it is highly likely that any government announcing the end of the Fed/ECB/BoE/deposit insurance/currency monopoly would trigger market crashes and a lack of confidence in banks. Most commentators would describe the move as “crazy given what we’ve learnt from history”. In short, it would be a ‘history misreading-induced’ panic. While this would be short-lived, this would also be damaging. It is our role to tell the public that, in fact, it should not fear such changes. It should welcome them.

Myths are slowly being debunked. Slowly…

A few institutions have recently raised voices to try to debunk some of the banking legends that had appeared and became conventional knowledge as a result of the crisis. Here’s an overview.

S&P, the rating agency, just published a note declaring that, surprise surprise, the UK’s ring fencing plans could have clear adverse consequences. Those include: possible downgrade to ‘junk’ status and lower ‘stability’ of the non-ring fenced entities, costs for customers could rise, credit supply could be squeezed, and, what I view as the most important problem of all, ring fencing rules “will undoubtedly further constrain fungibility.” According to the S&P analyst, as reported by Reuters:

“The sharing of resources (and brand, expertise, and economies of scale) means we view most banking groups as being more than the sum of their parts,” the report said.

It said disrupting these benefits could lead S&P to have a weaker view of the group as a whole and to lower its credit ratings on some parts of the banks.

S&P said the complexity of separating functions “represents a significant operational challenge” for banks at a time of multiple other regulations.

I cannot agree more. I have already written four long pieces explaining why intragroup liquidity and capital transfers were key in maintaining a banking group safe. Ring fencing does the exact opposite, putting those liquidity buffers and capital bases in silos from which they cannot be used elsewhere, potentially endangering the whole bank.


The BoE just reported that households could actually cope with raising interest rates. One of the Bank’s justification for not raising rates was that it would push many households towards default, so it is now kind of contradicting itself. And anyway, as I have described previously, lowering rates ceased to translate into lower borrowing rates due to margin compression. Patrick Honohan, Governor of the central bank of Ireland, reported that the exact same phenomenon occurred in Ireland:

Because of the impact on trackers, though, the lower ECB interest rates have not directly improved the banks’ profitability, because the average and marginal cost of bank funds does not fall as much. The banks’ drive to restore their profitability, combined with the lack of sufficient new competition, has meant that, far from lowering their standard variable rates over the past three years as ECB rates have fallen, they have (as is well known) actually increased the standard variable rates somewhat. […] These rates indicate that standard variable rate borrowers are still paying less than they were before the crisis, but not by much. A widening of mortgage interest rate spreads over policy rates also occurred in the UK and in many euro area countries after the crisis, but spreads have begun to narrow in the UK and elsewhere. Until very recently bank competition has been too weak in Ireland to result in any substantial inroads on rates.

Ireland mortgage rates

This chart exactly looks like what happened in the UK. Spread over BoE/ECB rates have increased, and increasing rates could actually translate into the same level of mortgage rates. This is because, as margin compression starts disappearing, competition can start driving down the spread over BoE/ECB. Households may have to remortgage to benefit from the same rates though.


In Germany, regulators said that the ECB’s negative deposit rates could incite more risk-taking and declared that:

Excess liquidity could even threaten the banking system if it is put to poor use

Regulators vs. ECB. This is getting interesting.


In FT Alphaville, David Keohane reports a few charts from Morgan Stanley. One of them clearly shows the Chinese Central Bank’s use of reserve requirements to manage lending growth. I’m sure my MMT and ‘endogenous money’ friends will appreciate.

Chinese monetary policy

The Great Depression and the money multiplier

The money multiplier has collapsed following the introduction of new reserves as central banks engaged in quantitative easing. This has led many economic commentators to declare that the money multiplier did not exist.

M2 Money Multiplier US

While I have several times said that this wasn’t that straightforward, I stumbled upon a post by Mark Sadowski, on Marcus Nunes’ blog, which includes a very interesting graph of the M2 money multiplier (blue line below) from 1925 to 1970 (I have no idea how he obtained this dataset as I can’t seem to be able to go further back than 1959 on the FRED website).

Money Multiplier US Great Depression

The multiplier collapsed from 7 in 1930 to a low 2.5 in 1940 and banks that had not disappeared had plenty of excess reserves, which they maintained for a number of reasons (precautionary, lack of demand for lending, low interest rates, Hoover/FDR policies…). This situation looks very similar to what happened during our recent crisis. However, what’s interesting is that the multiplier did eventually increase. In 1970, 30 years after reaching the bottom, the multiplier was back at around 6, meaning a large increase in the money stock. This is what most people miss: it doesn’t just take a few years for new reserves to affect lending; it can take decades.

Unless the Fed takes specific actions to remove (or prevent the use of) current excess reserves, the money multiplier could well get back to its historical level within the next few decades.

Liquidity and collateral are two sides of the same coin

I recently wrote a piece listing all the current regulatory constraints that arise from banking regulation and which weigh on liquidity. Unfortunately, there is more. As Singh explained in this FT article (as well as in many of his research papers), monetary policy, and in particular quantitative easing, can have serious repercussions on market liquidity:

From a financial lubrication angle, markets need both good collateral and money for smooth market functioning and, ultimately, financial stability. Having a ready supply of good collateral like US Treasuries or German Bunds also helps in reallocating the not-so-good collateral.

QE that isolates good collateral from the wider market reduces financial lubrication. Its substitute, money that shows up as excess reserves, is basically contained in a closed circuit system built to avoid inflation by introducing “interest on excess reserves”.

Indeed, the combination of QE and Basel rules effectively drives so-called ‘high-quality assets’ out of the market by ‘siloing’ them in various places (central banks’ and banks’ balance sheets, clearinhouses’ margins…). This is what many have dubbed ‘scarcity of good collateral’. (I personally think that Singh is wrong to call all highly rated and liquid assets ‘collateral’. When the Fed buys Treasuries, it doesn’t purchase collateral. It purchases an asset that could potentially be used as collateral. Yet, Singh just uses the word ‘collateral’ in every single circumstance. Semantics I know, but the distinction is important I believe)

The potential solution? Governments could issue more debt, meaning more indebtedness. Not certain this is a good one, especially as increased indebtedness would at some point cause the quality of the asset to decline… (reducing the maturity of existing issues could potentially ease liquidity constraints, but the effect is going to be limited)

JP Koning once declared that he didn’t understand how such ‘collateral shortage’ could even happen. Any asset could serve as collateral, with bigger haircut applied to riskier asset to offset potential market value fluctuations. He is fundamentally right. In a free market, there is no real reason why such shortage should ever appear.

Unfortunately, we do not live in a fully free market, and financial regulations institutionalised the use of certain classes of assets as collateral for certain transactions and increased the required associated haircut (for example, see here for OTC derivatives, see here for shadow banking transactions). Many transactions are also pushed towards central clearing at clearinghouses, which often require posting more (standardised) collateral, hence reducing supply by placing high-quality assets in a silo.

Cash, which can also be used as collateral, is itself siloed at the central bank level because of interest on excess reserves*.

As a result of those new rules, the latest ISDA survey tells us that:

Estimated total collateral in circulation related to non-cleared OTC derivatives has decreased 14%, from $3.7 trillion at the end of 2012 to $3.2 trillion at the end of 2013 as a consequence of mandatory clearing.

Regulations have created a lot of ‘know unknowns’. How the entanglement of all those rules will unravel in a crisis will be ‘interesting’ to follow.

* I know that those reserves don’t usually leave the central bank (unless withdrawn by depositors). But when banks expand their loan book, reserves that were previously in excess suddenly become ‘required’ (unless there is no reserve requirement of course).

The rather curious and awkward alliance between statists and libertarians against free banking

Free banking has a very bad reputation within mainstream economics. As free banking scholars such as George Selgin, Larry White, Kevin Dowd or Steve Horwitz have been demonstrating over the past 30 years, this is mostly due to a misunderstanding of history. The track record of the systems that were as close as possible to free banking is crystal clear however: free banking episodes were more stable than any alternative banking frameworks.

However, this doesn’t seem to please many, from both sides of the political spectrum. Izabella Kaminska, a long-time libertarian critic from FT Alphaville, wrote a piece on the Alphaville blog partly criticizing non-central banking-based banking systems. In two separate replies (here and here), George Selgin highlighted all the self-serving ‘inaccuracies’ of her post (this is a euphemism). He also wrote a rebuttal in a follow-up post. Izabella skipped the interesting bits, accused Selgin of ad hominem, and wrote in turn another unsourced name-calling post on her own private blog. So much for the academic debate.

Perhaps more surprisingly, David Howden just posted a curious article on the Mises Institute website, which described the Fed as arising from “fractional-reserve free banks”. I say surprisingly, because Howden and the Mises Institute are at the other end of the political spectrum: libertarians, and often anarcho-capitalists. Nevertheless, he seemed to agree with Izabella Kaminska to an extent.


Unfortunately, Howden and Kaminska make the same mistake: they misread history, and/or focus far too much on US banking history. First, Howden  claims that:

The year 1857 is a somewhat strange one for these clearinghouse certificates to make their first appearance. It was, after all, a full twenty years into America’s experiment with fractional-reserve free banking. This banking system was able to function stably, especially compared to more regulated periods or central banking regimes. However, the dislocation between deposit and lending activities set in motion a credit-fuelled boom that culminated in the Panic of 1857.

This could not be more inaccurate. The so-called ‘US free banking era’ had nothing much to do with free banking. And the credit boom and crises that follow were unrelated to either free banking or fractional reserves (see here for details, as well as below). I’d like Howden to explain why other fractional reserve free banking systems did not experience such recurring crises…

I have been left bewildered by Howden’s claim that privately-created clearinghouses were ‘illegal’ entities involved in ‘illegal’ activities (i.e. issuing clearinghouse certificates to get bank runs under control). Not only does this ironically sound like contradicting laissez-faire principles, but his whole argument rests on a lacking understanding of 19th century US banking.

What Howden got wrong is that, if American banks had such recurring liquidity issues before the creation of the Fed, it wasn’t due to their fractional reserve nature, but to the rule requiring them to back their note issues with government debt, thereby limiting the elasticity of those issues and the ability of banks to respond to fluctuations in the demand for money. Laws preventing cross-state branching also weakened banks as their ability to diversify was inherently limited. Banks viewed local clearinghouses as a way to make the system more resilient. It was a free-market answer to a state-created problem. This does not mean that the system was perfect of course. But Howden the libertarian blames a free-market solution here, and completely ignores the laws that originally created the problem.

Moreover, clearinghouses weren’t only a characteristic of the 19th century US banking system. They were present in several major free banking systems throughout history and set up by private parties (Scotland being a prime example). Their original goal wasn’t to create ‘illegal money claims’, but to help settle large volume of interbank transactions and economise on reserves: they were a necessary part of a well-functioning privately-owned free banking system. US clearinghouse certificates were merely a private solution to tame state-created liquidity crises. Those solutions were not perfect, but Howden is guilty of shooting the messenger here.

Clearinghouse-equivalents still exist today: the German savings and cooperative banks, as well as the Austrian Raiffeisen operate under the same sort of model, in which multiple tiny institutions park their reserves at their local central bank/clearinghouse. Finally, it is necessary to point out that clearinghouse would also surely exist in a full reserve banking system and would have the same basic goal: settle interbank payments.

Why a libertarian such as Howden would be against this natural laissez-faire process is beyond me. My guess is that at the end of the day, it all goes down to the fractional/full reserve banking debate within the libertarian space. Howden is trying at all costs to justify his views that full reserve banking would be more stable. But this time, such rhetoric is counter-productive and only demonstrates Howden’s ignorance of the issue (at least as described in this article). Using the fractional reserve argument to explain the 19th century US crises is self-serving and wholly inappropriate. Blaming a free-market reaction (i.e. the clearinghouse system) to such crises for the creation of the Fed completely misses the point. By doing so, and cherry-picking facts, Howden helps Kaminska’s arguments (despite fundamentally disagreeing with her) and shoots himself in the foot.

Update: I mistakenly thought that Peter Klein had written the article as his profile appeared on it. I should have paid more attention, but David Howden was the author. I have updated the post and apologised to Peter.

Update 2: I only just found out that David Glasner and Scott Sumner also wrote two good posts on free banking and Iza Kaminska/Selgin, followed by very interesting comments (here and here).

Photo: Marvel


Small Steps Toward A Much Better World


Finding patterns in finance, econ and technology -- probably where there are none


When financial markets spontaneously emerge through voluntary human action

Pumpkin Person

The psychology of horror

Uneasy Money

Commentary on monetary policy in the spirit of R. G. Hawtrey

Spontaneous Finance

When financial markets spontaneously emerge through voluntary human action


Volatility Is The Energy That Drives Returns

The Insecurity Analyst

When financial markets spontaneously emerge through voluntary human action

Sober Look

When financial markets spontaneously emerge through voluntary human action

Social Democracy for the 21st Century: A Realist Alternative to the Modern Left

When financial markets spontaneously emerge through voluntary human action

EcPoFi - Economics, Politics, Finance

When financial markets spontaneously emerge through voluntary human action

Coppola Comment

When financial markets spontaneously emerge through voluntary human action

Lend Academy

Teaching the World About Peer to Peer Lending

Credit Writedowns

Finance, Economics and Markets

Mises Institute

When financial markets spontaneously emerge through voluntary human action

Paul Krugman

When financial markets spontaneously emerge through voluntary human action

Free exchange

When financial markets spontaneously emerge through voluntary human action


When financial markets spontaneously emerge through voluntary human action


When financial markets spontaneously emerge through voluntary human action