Archive | May 2015

Central bankers and free markets: a convenient hate story

I often wonder why the level of understanding of the banking system and banking history at central banks is so low. Last week I mentioned this study that concluded that private money issuance is inherently unstable, despite all the available evidences that contradict this conclusion. Overall, the mistrust that central banks have towards free markets is frightening.


Vítor Constâncio, ECB Vice-President, is an expert at this game. His April speech titled Financial regulation and the global recovery cannot be more typical: all new regulations are effective, needed and actually have a ‘beneficial impact’ on economic growth (which, obviously, needs a ‘safe’ banking system that new regulatory measures indeed provide), and macro-prudential policies are exactly the tool needed for the clever and omniscient men in central banks to guide us, mere ignorant, risk-prone private market actors. Never ever does Constâncio even slightly question the measures taken over the past years. Everything is for the best in the best of all possible worlds. The whole speech makes for a quite uncomfortable, and depressing, reading. Pretty much everything he says is questionable (though it’s not the first time, far from that, see here). It seems like the ECB needs its own Andy Haldane, a (light) contrarian who dares questioning what the institution does.

But what’s really scary is central banker’s belief that finance was ‘deregulated’ since the 1980s, and that this was the cause of our boom and bust. As central bankers, and supposedly experts on banking, they should know that it is not the case. Constâncio says that we should not “return to deregulation and boom-bust cycles.” In a recent speech, Olsen, governor of the Norges Bank, declared that the crisis “showed that, left alone, the financial system is prone to excessive risk-taking.” I’m sorry but when has the financial system ever been ‘left alone’ since the old days of the free banking era (and only in a limited number of countries)? Certainly nowhere in the world over the past 80 years.

Equally, Sabine Lautenschläger, member of the ECB Executive Board, in another speech said that “after a long phase of deregulation, a comprehensive re-regulation has been in vogue since 2009.” Again, what ‘long phase of deregulation’? I’m still trying to figure out whether those central bankers and I have been living in the same world. Then she adds that she does “not believe in self-regulation, at least not in financial markets. You cannot have stable and functional banks without comprehensive regulation and energetic supervision.” Central bankers’ mistrust of free markets is startling*.

Philip Booth, from the Institute of Economic Affairs, just published a new report titled Thatcher: The Myth of Deregulation. Absolutely recommended reading. While the report only focuses on the UK, its conclusions are easily applicable to most of the Western World, especially Europe. Moreover, the report purposely avoids speaking about banking regulation, which has witnessed a boom from the 1980s with the worldwide introduction of Basel 1. But, as Booth makes clear, all other aspects of financial services became more regulated during and after Thatcher’s ‘Big Bang’ reforms. In his words:

Big Bang itself was undoubtedly an act of deregulation – but not in relation to state regulation. It is better seen as an act of prohibition. Big Bang prevented private regulatory bodies from developing their own rules for the benefit of their members and, arguably, wider society. This was one of two acts within the financial sector – the other being the abolition of the maximum commission agreement amongst insurance companies – where the power of the state was used to prevent private-sector rule setting on competition grounds in a way that led to unfortunate consequences. It could also be argued that this prohibition on private rule setting then led to government regulatory agencies filling the gap and doing so in ways that involved granting effectively unlimited powers to a statutory regulatory bureau or to a body that was ultimately accountable to politicians rather than to participants in the market. Certainly that is exactly what happened in the years that followed Big Bang. […]

Soon after Big Bang – the act of prohibition of private regulation – there was a huge extension of the statutory regulation of securities markets as a result of the Financial Services Act 1986 which came into operation in 1988. It is impossible to go through all the requirements of the regime in detail in this brief paper. Goodhart in Seldon ed (1988) suggested that just one rule book relating to one aspect of regulation that was developed as a result of the 1988 Act weighed around two kilograms. The Act itself is reproduced in 230 pages in the standard textbook by Wedgwood et al (1986) (not including the associated regulations). Regulation of this extent, detail and prescription had never been known before in the financial sector in the UK.

Add in the whole Basel banking rulebook, and subtract some actual banking deregulations that have happened (mostly in the US, like interstate banking limitations or interest rate cap on deposits, as well as reduced controls on UK-based building societies), and you end up with a financial system whose regulatory framework has largely boomed on a net basis between the 1980s and the financial crisis.

So much for deregulation and so much for central banker’s arguments, which seem to rest on the erroneous believes that 1. banking crises originate in Mynsky/Post-Keynesian-style endogenous imbalances and, 2. that finance has been deregulated since the 1980s. In short, facts seem to get distorted to ‘accommodate’ central bankers’ convenient rhetoric. By supressing a legitimate debate, this renders a disservice to society as a whole.

PS: Martin Taylor, of the BoE, dismisses all critics of ring-fencing as people who “have either failed to understand it or have chosen not to”… He of course doesn’t address any of the points I made in this year old post.

PPS: Glasner has a post on Is finance parasitic? that demonstrates he has a limited understanding of finance. Finance becomes parasitic when regulation and interest rates below their natural Wicksellian levels make it that way.

*Admittedly, unlike Constâncio, both Olsen and Lautenschläger seem to acknowledge some of regulatory and macro-prudential limitations. As does Taylor:

Charles Goodhart and others have pointed out that macroprudential policy, while intended by its very nature to be counter-cyclical, generally turns out to be the complete opposite. Put simply, we tend to tighten regulatory policies straight after a financial crash, when the economy is so weak that – all else being equal – we should prefer to loosen them.


A few links for the weekend

Here are a selection of a few interesting articles for you to read on the weekend.

Free banking: the limits of mathematical models

Theoretical economic worlds are so nice. Only equations and equilibria, and no need to bother about empirical evidences or simply historical facts: you design your nice imaginary world and you reach conclusions from it. Conclusions that have the potential to influence policymaking or economic teaching.

Equation Fed PaperA new paper produced by a Philly Fed economist illustrates exactly that (see one of its nice systems of equations above). The paper is titled On the inherent instability of private money. Here is the abstract (my emphasis):

A primary concern in monetary economics is whether a purely private monetary regime is consistent with macroeconomic stability. I show that a competitive regime is inherently unstable due to the properties of endogenously determined limits on private money creation. Precisely, there is a continuum of equilibria characterized by a self-fulfilling collapse of the value of private money and a persistent decline in the demand for money. I associate these equilibrium allocations with self-fulfilling banking crises. It is possible to formulate a fiscal intervention that results in the global determinacy of equilibrium, with the property that the value of private money remains stable. Thus, the goal of monetary stability necessarily requires some form of government intervention.

That’s it. He just validated the existence of central banking. No need to go any further, the mathematics just demonstrated it: private currencies are unstable and we need government intervention for the better good.

What’s interesting though is that this paper does not contain a single reference to the now relatively large free banking literature of the likes of White, Selgin, Horwitz, Dowd, Salter, Sechrest, Cachanosky… Which, you’d admit, is curious for a paper discussing precisely that topic. Perhaps this would have helped him avoid the embarrassment of discovering that historical reality was, well, the exact opposite of the conclusions his equations reached. That in fact, private currency-based systems had been more stable than monopoly issuance-based ones (see here for the track record, but everywhere on this blog for other evidences, as well as numerous papers and books such as Selgin’s The Theory of Free Banking: Money Supply under Competitive Note Issue).

Coincidentally, George Selgin published a new post a couple of days ago criticising the current state of monetary economics which, in his opinion, rely too much on abstract maths and not enough on historical evidence. Ben Southwood also mentioned this paper, along with the fact that even ‘far from perfect’ free banking systems (i.e. the 19th century US experience) outperformed central banking ones. He also asks a very good question:

My real issue is why this evidence isn’t breaking through? Why are so many smart, knowledgeable people opposed to free banking? Why is the ruling tendency now towards practically outlawing bank/debt finance altogether in favour of steps toward equity financing everything? I don’t have a good answer.

This is also something that worries me. Why does a paper on free banking not reference (let alone discuss) a single free banking paper or book? Why is this literature avoided? Is it inconvenient? Unless ignorance is the culprit, despite the fact that quite a few articles show up after a quick Google search for the terms ‘free banking’ or ‘competitive private note issuance’. What’s wrong with the mainstream academic world?

Banking regulation gives P2P lending a major boost

A few weeks ago, I mentioned a new KPMG report describing the evolution of the current bank regulatory framework. The consultancy published its ‘Part 2’ a couple of weeks ago and it is interesting reading.

KPMG effectively reaches similar conclusions to the ones of this blog: the current regulatory framework makes it uneconomic for banks to extend credit to corporates (small to large), and the structural separation of investment and retail banking activities is nonsense.

In the case of corporate lending, KPMG points out that “many SMEs are disillusioned with banks, leading them to seek alternative channels of borrowing, including peer to peer lending.” This sounds spot on: regulation has always been self-defeating by driving financial activities into the shadows. And, coincidentally, Morgan Stanley just published a large report on P2P lending (which they call ‘marketplace lending’ as it’s not really P2P anymore…) forecasting that it could reach 10% of total unsecured consumer and SME lending in the US by 2020 (with other countries, in particular the UK or China, to follow).

MS P2P Lending Growth Forecast

Perhaps this is the key to unlocking corporate/SME lending growth and getting rid of this secular stagnation theory.

Partly mirroring the arguments I developed in a series of posts starting here, KPMG’s arguments against the structural separation of the various activities of banking are worth reproducing here in whole:

KPMG Structural Separation

KPMG Structural Separation 2

Further evidence of regulatory distortion in Standardised and IRB frameworks

On his new blog Alt-m, George Selgin points to a piece of academic research published last year about ‘The Limits of Model-Based Regulation, from Behn, Haselmann and Vig. This paper is very interesting and illustrates quite well how regulatory capital ratios are distorted by the use of math models encouraged by Basel 2 and 3 regulations. It nevertheless suffers from a few questionable conclusions, although those remain minor and do not affect the quality of the rest of the research.

As I described a long time ago (and also summarised in this paper), banks can calculate the risk-weighs they apply to their assets based on a few different methodologies since the introduction of Basel 2 in the years prior to the crisis. Under the ‘Standardised Method’ (which is similar to Basel 1), risk-weights are defined by regulation. Under the ‘Internal Rating Based’ method, banks can calculate their risk-weights based on internal model calculations. Under IRB, models estimate probability of default (PD), loss given default (LGD), and exposure at default (EAD). IRB is subdivided between Foundation IRB (banks only estimate PD while the two other parameters are provided by regulators) and Advanced IRB (banks use their own estimate of those three parameters). Typically, small banks use the Standardised Method, medium-sized banks F-IRB and large banks A-IRB. Basel 2 wasn’t implemented in the US before the crisis and was only progressively implemented in Europe in the few years preceding the crisis.

So what are the effects of those different regulatory capital frameworks? First, they found that

At the aggregate level, we find that reported probabilities of default (PDs) and risk-weights are significantly lower for portfolios that were already shifted to the IRB approach compared with SA portfolios still waiting for approval. In stark contrast, however, ex-post default and loss rates go in the opposite direction—actual default rates and loan losses are significantly higher in the IRB pool compared with the SA pool. […]

The loan-level analysis yields very similar insights. Even for the same firm in the same year, we find that both the reported PDs and the risk-weights are systematically lower, while the estimation errors (i.e., the difference between a dummy for actual default and the PD) are significantly higher for loans that are subject to the IRB approach vis-a-vis the SA approach. […]

Interestingly, we find that the breakdown in the relationship between risk-weights and actual loan losses is more severe the more discretion is given to the bank: while the same patterns are present for both F-IRB and A-IRB portfolios, the results are much more pronounced for loans under the A-IRB approach, which is clearly more complex and accords more autonomy to the bank.

This is pretty interesting. This demonstrates that Basel 2 (and 3) rules provide incentives to game regulatory reporting in order to maximise RoE (more on this below).

They also noticed that:

[On aggregate] to dig deeper into the mechanism, we examine the interest rate that banks charge on these loans, as interest rates give us an opportunity to assess the perceived riskiness of these loans. Interest rates in the IRB pool are significantly higher than in the SA pool, suggesting that banks were aware of the inherent riskiness of these loan portfolios, even though reported PDs and risk-weights did not reflect this. Putting it differently, while the PDs/risk-weights do a poor job of predicting defaults and losses, the interest rates seem to do a better job of measuring risk. Moreover, the results are present in every year until the end of the sample period in 2012 and are quite stable across the business cycle. […]

[Moreover, at granular loan-level] the interest rates charged on IRB loans are higher despite the reported PDs and risk-weights being lower.

This is also interesting, although I suspect partially wrong (and to be fair, they do point that out). Indeed, the German banking system is very peculiar, with small public-sector and mutual banks (likely on Standardised) having a very large market share and usually able to underprice much larger commercial banks (likely on IRB) thanks to the lack of pressure on them for profitability. Interest rates are thus likely to be understated for Standardised banks. The only way to confirm the researchers’ feeling that IRB banks charged more than Standardised ones because they knew their portfolio to be riskier is to re-run the analysis on a country with a more ‘standard’ banking system.


What is their conclusion?

All in all, our results suggest that complex, model-based regulation has failed to meet its objective of tying capital charges to actual asset risk. Counter to the stated objective of the reform, aggregate credit risk of financial institutions has increased. […]

Our results suggest that simpler rules may have their benefits, and encourage caution against the current trend towards higher complexity of financial regulation.

I cannot but only agree with this statement, despite having some doubts about the validity of their interest rate argument as explained above.

However, I will have to differ with the researchers on one particular point: that the differences we see between Standardised and IRB banks is mostly due to banks trying to game the system. Their reasoning is as follows: Basel 1 had excessively strict risk-weights, leading to ‘distortion in lending’ (absolutely agree). But the flexibility provided to banks by Basel 2’s model-based framework gets rid of this distortion and the issues described above are pretty much due to banks only (this is where I disagree).

Why do I disagree? Because of reasons I have explained before, and that are also explained within this paper: regulators validate models. Consequently, models are biased to match regulators’ expectations and biases in the first place: as it is very unlikely that regulators will consider corporate lending as less risky than real estate lending, they are also unlikely to validate a model that would do exactly this (or at least narrow the risk parameter differential). As a result, for capital optimisation purposes, banks tend to exacerbate the risk differential between those two lending types (or at least maintain the original Basel 1 risk-weight differential), in order to get regulatory approval*.

So what we’re left with is an increasingly opaque regulatory system that incentivises banks to optimise capital usage with the actual support of regulators (often against shareholders), distorting credit allocation in the meantime. Sounds effective.

*And this is exactly what the authors of this piece say!

Risk models were certified by the supervisor on a portfolio basis, and supervisors delayed the approval of each model until they felt comfortable about the reliability of the model. […]

Banks have to validate their models on an annual basis and adjust them if their estimates are inconsistent with realized default rates (see also Bundesbank 2003). Further, risk models have to be certified by the supervisor and banks have to prove that a specific model has been used for internal risk management and credit decisions for at least three years before it can be used for regulatory purposes.

PS: They also provide the following interesting chart. The same way that the introduction of RWAs triggered a real estate lending boom, at the expense of corporate lending, the introduction of Basel 2 led to a lending differential between IRB banks, which could optimise capital usage, and Standardised banks, potentially exacerbating the original real estate/corporate lending dichotomy introduced by Basel 1.


PPS: Sorry not many update recently despite having quite a lot to say… I just can’t seem to find the time to write those posts for some reason.

Modeling a Free Banking economy and NGDP: a Wicksellian portfolio approach (guest post by Justin Merrill)

My friend Alex Salter and his coauthor, Andrew Young, have an interesting new paper called “Would a Free Banking System Target NGDP Growth?” that I believe was presented at a symposium on monetary policy and NGDP targeting.

I too have wondered the same question. I believe there are real reasons why a dynamic economy might not have stable NGDP. One reason is demographic changes (maybe target NGDP per capita?). Another reason is problems with GDP accounting in general such as the underground economy, changes in workforce participation of women and the vertical integration of firms. Another micro-founded effect might be the income elasticity of demand and substitution effects. But even abstracting from these problems, it is still a worthy question to ask if monetary equilibrium is synonymous with stable NGDP and its relationship to free banking. If they are synonymous, we might expect stable NGDP from free banking. In my paper on a theoretical digital currency called “Wixle” I outline a currency that automatically adjusts its supply to respond to demand by arbitraging away the liquidity premium over a specified set of securities. This is a way to ensure monetary equilibrium without regard for aggregate spending, which is particularly useful if the currency is internationally used.

A small criticism I have of my free banking and Market Monetarist friends is that they often assert that monetary equilibrium and stable NGDP are the same thing, usually by applying the equation of exchange. As useful as the equation of exchange is, it is tautologically true as an accounting identity. But just as we know from C+I+G=Y, accounting identities’ predictive powers are limited when thinking about component variables. I have argued for the conceptual disaggregation of the money supply and money demand, because the motives for holding currency and deposits are different and the classification of money is more of a spectrum. So I was pleased to see that Salter and Young did this in their paper and added the transaction demand for money into their model. This leads them to conclude that a free banking system will respond to a positive supply shock, which results in an increased transaction demand for money, by stabilizing the price level rather than NGDP. This might be true, and whether this is good or bad is another question. Would this increase in currency lead to a credit fueled boom, or is this a feature and not a bug?

I have long been upset with the way that economists overly focus on reserve ratios and net clearings from a quantity perspective. This abstracts away from the micro-foundations of the banking system and ignores the mechanics of banking. This is the point I made at the Mises Institute when I rebutted Bagus and Howden. My moment of clarity for the theory of free banking actually came from reading the works of James Tobin and Gurley & Shaw, as well as Knut Wicksell. The determination of the money supply is the public’s willingness to hold inside money, and this willingness creates the profit opportunity for the financial sector to intermediate by borrowing short and lending long. I believe the case for free banking can be made more robust by adding the portfolio approach, as well as the transactions approach. I will outline here what that would look like without sketching a formal model.

The Model is a three sector economy: households, corporations and banks. Households hold savings in the form of corporate and bank liabilities and have bank loans as liabilities. Corporations hold real capital, bank notes and deposits as assets and bank loans, stocks and bonds as liabilities. Banks hold reserves, securities and loans as assets and net borrowed reserves, notes, deposits and equity as liabilities.

JM 1

Households can hold their wealth in risky securities or safe, but lower yielding interest paying deposits that pay the risk-free rate in the economy or non-interest paying notes used for transactions. The model could include interest-free checking accounts, but these are economically the same as notes in my model.

Banks can then choose to invest in loans, securities or lending reserves. They fund investments largely by borrowing at the risk-free rate and borrowing reserves at the margin. Logically then, the cost of borrowed reserves will be higher than deposits but lower than that of loans and securities and arbitraging ensures this. If the cost of reserves goes above the return on securities, banks will sell bonds to households and lend reserves to each other. If the cost of reserves goes below the rate on deposits, banks will borrow reserves and deposit with each other. The return on loans and securities (adjusted for risk) will tend towards uniformity because they are close substitutes. Also, as Wicksell pointed out, if loan rates are below the return on securities or the return on real capital, households and firms would borrow from banks and invest.

Empirical evidence for the interest rate channels is provided here. Interestingly, the rules set out above were only violated in times of monetary disequilibrium, such as the Volcker contraction:

JM 2

The natural rate of interest is equal to the return on assets for corporations. Most economists that try to model the natural rate mistakenly do it as the risk free rate or the policy rate. This is a misreading of Wicksell since he identified the “market rate” as the rate which banks charge for loans, and the important thing was the difference between the market rate and the natural rate. If the market rate is too low, people will borrow from banks and invest, increasing the money supply.

We can now apply the framework to the CAPM model and conceptualize the returns on various assets:

JM 3

The slope of the securities market line (SML) is determined by the risk aversion/liquidity preference of the public. Should the public become more risk averse and demand a larger share of their wealth be in the form of money, they will sell securities in favor of deposits. If in aggregate, the household sector is a net seller, the only buyers are banks (ignoring corporate buybacks since this doesn’t change the results since corporations would end up needing to finance the repurchases with bank loans). So the banking sector would purchase the securities (at a bargain price) from households, crediting their accounts and simultaneously increasing the inside money supply. This becomes more lucrative as the yield curve steepens or other kinds of risk premia widen, increasing the net interest margins (NIMs). As the banking sector responds to changes in demand it equilibrates asset prices.

JM 4

This is another way of coming to the same conclusion: that a free banking system would tend to stabilize NGDP in response to endogenous demand shocks. But how about supply shocks? We know that when the spread between the banks’ return on assets and costs of funding widens, the balance sheet will increase. An increase in productivity will raise both the return on new investments and the rate the banks have pay on deposits. We can assume for now these cancel out. But the public will have a higher demand for notes, and since notes pay no interest, they are a very cheap source of funding. This lowers the average cost of funding overall. However, more gross clearings will increase the demand for reserves and their cost of borrowing relative to the yield on other assets. This would put a check on overexpansion and excess maturity transformation. The net effect on the total inside money supply is uncertain, but probably positive assuming the amount of currency held by the public is larger than borrowed reserves by banks.

Another thing to consider about supply shocks: despite the lower funding costs of increased note issuance, an increase in the natural rate of interest will decrease banks’ net interest margins because their loan book will be locked in at the old, lower rate, but the rate on deposits will have to go up. This is a counter-cyclical effect (in both directions) that may outweigh the transaction demand effect. Another possible counter-cyclical effect is the psychological liquidity preference effect that accompanies optimism associated with supply shocks. So in a strong economy individuals will be more willing to hold the market portfolio directly, which flattens the SML. Depending on the strength of these effects, it may lead to different results than Salter and Young.


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