Endogenous money creation is back with a vengeance
About a year ago, some BoE staff produced a paper on money creation that made some noise by (apparently) embracing an endogenous (outside) money view. A number of people, and I, pointed out the internal inconsistencies of the theory outlined, which in fact seemed to misunderstand what the traditional money multiplier was about.
A year later, here we go again.
A couple of weeks ago, other BoE staff published a working paper explicitly titled Banks are not intermediaries of loanable funds – and why this matters. Surprisingly, not many people seemed to have picked up on it so far. Unfortunately, the same sort of ‘ivory tower’ flaws and contradictions are present in this paper.
The very first page of the report declares that:
The bank therefore creates its own funding, deposits, in the act of lending, in a transaction that involves no intermediation whatsoever.
I just can’t believe that this is a serious assertion. This is repeated throughout the paper. Later they declare that a bank cannot lend more by attracting deposits from competitors (page 10). Given what I keep reading in academic economic research documents, I’d seriously advise all economists to speak to bankers, bank CFOs, bank treasurers, bank analysts and other market participants before writing such things. They would find out that when a bank lends it indeed creates new deposits, although those do not represent funding but extra pressure on the bank’s existing funding structure (and liquidity)!
They would also find out that banks actively compete for deposits, by raising the rate they pay. According to the authors’ theory, bankers are really really confused and should not bother attempting to attract deposits in the first place… This would mean the suppression of the market for deposits, which a quick reality check rapidly dispels. I have spoken to many bankers whose lending and external funding plans were carefully linked (and no, they never considered raising funds from the central bank, as the theory suggests, unless exceptional circumstances).
In fact, the whole purpose of funding is to get hold of extra reserves. Raising deposits (retail, corporate, interbank…) or raising wholesale funding (senior, sub, secured debt, repos) brings about a reserve (high-powered money) transfer from one bank to another. The one that suffers from the deposit outflow sees increased pressure on its funding structure as its liquidity declines. The one that benefits from the deposit inflow, on the other hand, is now awash with new liquidity it is willing to use.
Despite being a BoE paper, it seems like the UK experience has been quickly forgotten: Northern Rock failed exactly because it had funded its growth by raising mostly volatile wholesale funding that vanished all of a sudden when the crisis struck, leaving the bank illiquid and in a downward spiral. This would have never happened if it had been able to ‘create its own funding’.
As I have explained time and time again, it is naïve to believe that banks can simply continuously extend credit then borrow the reserves from the central bank, and get away with it. The central bank lending stigma is strong, and it is confirmed by the literature (see here or here). This fact is well-known by market participants but clearly not by endogenous money theorists, unfortunately. As the paper says:
The [deposit multiplier] model however does not recognise that modern central banks target interest rates, and are committed to supplying as many reserves (and cash) as banks demand at that rate. The quantity of reserves is therefore a consequence, not a cause, of lending and money creation.
It’s not that central banks don’t provide the reserves. It is that commercial banks are not willing to borrow them!
Ironically, the paper contradicts itself when it says (page 5, my emphasis):
They add that, from the (microeconomic) point of view of an individual bank that considers whether to deviate significantly from the behaviour of its competitors, other important limits exist, especially increased credit risk when lending too fast to marginal borrowers, and increased liquidity risk when creating deposits so fast that too many of them are lost to competitors.
Another problem of this paper is that it wrongly depicts the traditional money multiplier model. Banks can lend before they secure extra-reserves, as long as they have enough reserves to face adverse clearing during the interbank settlement process, or when the new loan is withdrawn as cash. See the following extracts as evidence they do not understand that the money multiplier model does allow for endogenous money creation through deposit creation (page 6):
The fact that banks create their own funds through lending is acknowledged in descriptions of the money creation process by leading central banks and policymaking authorities. The oldest goes back to Graham Towers (1939), the then governor of the central bank of Canada: “Each and every time a bank makes a loan, new bank credit is created — new deposits — brand new money”.
And (page 7):
The fact that banks create their own funds through lending is also repeatedly emphasised in the older economics literature. One of the earliest statements is due to Wicksell (1906): “The lending operations of the bank will consist rather in its entering in its books a fictitious deposit equal to the amount of the loan…”. Rogers (1929): “… a large proportion of … [deposits] under certain circumstances may be manufactured out of whole cloth by the banking institutions themselves.”
And (page 13):
The fact that the creation of broad monetary aggregates by banks comes prior to and in fact may (if commercial banks need more reserves) cause the creation of narrow monetary aggregates by the central bank is acknowledged in many descriptions of the money creation process by central banks and other policymaking authorities. The oldest and clearest comes from Alan Holmes (1969), who at the time was vice president of the New York Federal Reserve: “In the real world, banks extend credit, creating deposits in the process, and look for the reserves later.” This is exactly the view put forward in this paper.
The authors are mixing up ‘funding creation’ and what Chester Arthur Philipps, in his 1920 book Bank Credit, called ‘derivative deposits’, or temporary deposits created by the bank by the action of lending:
In fact, nobody has ever denied the endogenous money creation inherent to the money multiplier model. But this endogenous creation of deposit liabilities (inside money) is constrained by the exogenous variable of the availability of reserves (outside money), as I explained in this post. Is there a fixed limit in the absence of reserve requirements? No. But in this case banks estimate the amount of precautionary reserves and secondary reserves (i.e. mostly highly-rated/high-quality liquid securities they invest in for margin and liquidity management) they need. Apart from asset quality considerations (and other exogenously-defined factors like banking regulations), nothing prevents a bank from expanding its loan book, and hence its liabilities, ad infinitum. Except the threat of illiquidity.
During the Scottish free banking period, it was reported that banks maintained minimal reserve ratios of around 2% once clearinghouse were established, but sometimes as high as 60%+ before that (see Selgin’s The Theory of Free Banking). Things aren’t that different today: markets are more liquid, securities types more varied, volumes higher, facilitating day to day liquidity management, but the central bank funding stigma prevents banks from having a liquidity free lunch.
So in short, in the absence of reserve requirements, what we end up with is a banking system whose endogenous expansion is bound by the (also inherently endogenous) market actors’ perception of the need for an exogenous variable (reserves/high-powered money). (Not easy to formulate…)
The authors also don’t address the fact that many central banks (China, Turkey…) actively, and rather successfully, use reserve requirements as a monetary policy tool (the latest one being Moldova, but also see examples here).
Funnily, this new BoE staff paper on endogenous money theory disagrees with… last year BoE staff paper on the same topic. While last year’s paper considered that James Tobin’s famous publication Commercial Banks as Creators of Money fitted into their theoretical framework (by describing the limits to bank expansion), this year’s paper mostly views it as in contradiction with their own framework. This makes the whole endogenous outside money theory even more confusing.
Even more problems appear when they devise their model (page 12). Their banking system consists of a single bank that can extend credit without limitations. They fall in the trap that I explained in my detailed critique of the MMT version of the endogenous money theory (see also here). With no competitor expanding or contracting at different paces (as in the real world), this single bank is indeed freed from adverse clearing constraints on liquidity (with only cash withdrawal risk remaining, although cash is very rarely mentions in this article). And worse, they use Werner’s rather weird research paper (in which he ‘discovered’, for ‘the first time in 5000 years’, that customer deposits are part of the bank’s balance sheet… Yep, really…) as ‘evidence’ empirically validating their view (see my more comprehensive review of Werner’s piece here).
Let just finish with the fact that this latest BoE staff working paper never ever mentions any critique of endogenous outside money-type theories, and believe that DSGE models are appropriate for macro-economic modelling despite more and more people now turning against them.
In the end, this paper is a ‘rougher’ version of the theory than the piece published a year ago: fewer internal inconsistencies but also less realistic. Seems like the endogenous theory needs refinement.
PS: The authors say that S&P, the rating agency, endorsed their view. This is wrong. The paper they are referring to is a personal report published by the member of one of S&P’s economics department. S&P explicitly says that this report reflects the view of this economist only. He probably should have consulted his bank analysts before publication.
Banking supervision and the rule of law
Since the principles outlined in Locke’s Second Treatise of Government or in Montesquieu’s L’Esprit des Lois, the rule of law has been a major driver of Western advancement. It supports time preference (and hence long-term investments) by ensuring that market actors know what rules are they are subject to and plan accordingly. Discretionary policymaking, on the other hand, tends to raise the sentiment of uncertainty, leading to more risk-averse and short-sighted behaviour.
In Freedom and the Economic System, Hayek suggested that the rule of law was akin to
a system of general rules, equally applicable to all people and intended to be permanent, which provides an institutional framework within which the decisions as to what to do and how to earn a living are left to the individuals.
In The Road to Serfdom, he added that the rule of law meant that
government in all its actions is bound by rules fixed and announced beforehand.
In short, the rule of law is a legal framework that benefits economic development by suppressing the legal uncertainty and arbitrariness of discretionary power.
A new, quite interesting (although most of my readers will find it boring), paper published by NY Fed staff Eisenbach, Haughwout, Hirtle et al, and titled Supervising Large, Complex Financial Institutions: What do Supervisors Do?, describes in details what financial regulators and supervisors do and what actions they take.
What do we learn? (my emphasis)
Prudential supervision involves monitoring and oversight of these firms to assess whether they are in compliance with law and regulation and whether they are engaged in unsafe or unsound practices, as well as ensuring that firms are taking corrective actions to address such practices.
Supervisors send so-called MRIA letters (‘matters requiring immediate attention’) when they identify (my emphasis)
matters of significant importance and urgency that the Federal Reserve requires banking organizations to address immediately and include: (1) matters that have the potential to pose significant risks to the safety and soundness of the banking organization; (2) matters that represent significant noncompliance with applicable laws or regulations; [and] (3) repeat criticisms that have escalated in importance due to insufficient attention or inaction by the banking organization.
Essentially, US supervisors can require bankers to modify their business models, strategy, internal policies and controls, as well as the level of risk-taking they are willing to take, without those requirements being included within any banking regulatory framework signed into federal law. Those decisions are purely at the discretion of supervisors.
It doesn’t take long to figure out that such practices do not follow the principles of the rule of law as outlined above. Supervisors have full discretionary powers to address what they see as weaknesses in banks’ strategy, even if banks disagree.
Firstly, if supervisors’ discretionary demands and measures are indeed so important, why haven’t they been directly included within the (officially signed into law) regulatory framework in the first place?
Second, the traditional critique of any discretionary micromanagement and central planning applies: how can supervisors, many of them having no banking experience, know better than private bankers how to deal with the business of banking? How, with their limited market access, can they know what products customers want and at what price? This is all too reminiscent of Hummel’s depiction of central banking as the new central planning:
In the final analysis, central banking has become the new central planning. Under the old central planning—which performed so poorly in the Soviet Union, Communist China, and other command economies—the government attempted to manage production and the supply of goods and services. Under the new central planning, the Fed attempts to manage the financial system as well as the supply and allocation of credit.
Banking regulation (Dodd-Frank in the US, CRD4 in Europe…) has many, many flaws, as I keep highlighting on this blog. But at least it respects the rule of law to a certain extent. If only banking supervision simply was the practice of ensuring that banks comply with official regulations and not the practice of micromanaging and harmonising private institutions. If only.
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.
- Engadget reports that there is now a bitcoin-like system for real gold trading purposes. The gold is stored in various vaults and you are allocated a share of it every time you buy this gold-backed cryptocurrency (however, forget the last paragraph of the article, which is economic nonsense made in Engadget).
- Moldova decided to restrain inflation by… raising reserve requirements. What fools! They’ve clearly never heard of the endogenous and MMT theories! Unless…
- Benoit Coeuré, one of the top ECB officials, revealed some ECB plans to a selection of hedge funds/investors way in advance of the publication of his speech on the ECB website. Easy profits when you’re one of the privileged few… Funnily, regulators would have literally jumped down the throat of the private company that would have done exactly that. But the ECB? Well, you know, it just happens. No big deal really.
- Margin compression, margin compression, margin compression… HSBC just declared that it would start charging other banks for depositing non-GBP currencies at the bank. Who said negative rates were helping the financial sector?
- BuzzFeed writes that online lenders could “take billions of profit away from big banks.” It quotes a recent Goldman Sachs report which estimated that $4.6Bn of banking profits could be lost to P2P platforms, which could capture 15% of the consumer loan market (see my recent post that refers to a recent report by another investment bank, Morgan Stanley, on the exact same topic).
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.
A 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).
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:
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.
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:
http://research.stlouisfed.org/fred2/graph/?g=1aRY
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:
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.
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.
The Economist gets it wrong, again
About 10 days ago, The Economist published three articles on General Electric and mixing industrials with banking. Those articles follow GE’s decision to divest its banking business, GE Capital.
In its editorial (the follow-up article is available here), The Economist declares that:
GE shows why industrial firms should avoid owning big finance operations. Occasional successes such as Warren Buffett’s Berkshire Hathaway can combine insurance with hot dogs. But most manufacturers are even worse at managing financial risk than banks are—and they are harder to supervise. A blow-up at the finance arm can sink the entire company.
In another short article, the newspapers attempts to warn industrial CEOs not “to turn your firm into Goldman Sachs”:
The case for a split is clear. Managers are even worse at dealing with financial risk than bankers are. A blow-up in a firm’s financial arm can hurt its main business. And giving tycoons access to savers’ cash can lead them into all sorts of temptation.
Well, that’s not really true. What The Economist is describing is the situation in which a few large companies have been allowed to set up banking arms. This is indeed a situation to avoid as it limits entrants in the market and as a result gives an artificially high market share to those who could set up banking activities, which often transform into TBTF entities and put their parent company at risk if ever they fail. In the end, you end up with a few huge banks and a few very large banking arms owned by non-financial corporations. But this is not a free market outcome. The Economist is suggesting that we restrict banking to banks. It will not make the TBTF problem disappear but reinforce it.
We want the exact opposite of what The Economist is describing. We want every single company, every Google, Amazon, Apple or Walmart, to be able to set up a banking or finance arm if it wishes to, as long as it believes it can convince customers that it is able to provide a cheaper and more efficient alternative/product*. The more banks on the market the more likely market shares are going to be granular and the balance sheet of each entity limited in size. In turn, this competitive landscape would make the TBTF issue disappear and customers benefit. Finally, as each banking entity remains relatively small under competitive pressure, it is also less likely to endanger the financial health of its parent company (or of the whole banking system) if ever it collapses.
*And many of those companies are already entering the financial systems, in particular in the payment space, with some success.
ETFs and market efficiency – some evidence
A few weeks ago, I speculated that the rise of ETFs negatively impacted market efficiency. At that time I had not heard of any research that provided evidences to confirm or dismiss my fears. Not anymore.
A few articles (see here, here, here and here) have reported that a recent Goldman Sachs equity research piece (titled ETFs: The Rise of the Machines) found that ETFs had more influence than previously believed on share prices. I haven’t had access to this GS report, but here’s an extract from one of the articles:
Are exchange-traded funds an unseen force, like gravity, that help determine stock-price moves? New research suggests that the rise of ETFs may be complicating stock pickers’ chances of selecting winners or losers. That could make it even harder for stock-fund managers to outperform their benchmarks as assets in ETFs grow.
The $1.2 trillion in U.S. stock ETFs is having a much larger impact on the market than the fund industry claims, according to a recent report from Goldman Sachs. At issue: Heavy trading of index-tracking ETFs appears to be herding individual stocks up or down together, particularly in niche industries such as real estate and mining.
Goldman’s equity research team contends that increases in ETF trading appear to be tightening correlations, or the tendency for individual stocks and sectors to move up or down in lock step, regardless of a company’s fundamentals.
This was precisely my point in my previous post. But the extent of this ‘ETF distortion’ is hard to measure:
Comprehensive data aren’t available, but a study last year by the Investment Company Institute estimated that only 9% of ETF trades trigger buying or selling in individual stocks. Goldman, however, assumes the number is much higher, closer to 50% in some sectors.
As ETFs keep growing as an asset class, it is likely that those effects are going to be exacerbated. Perhaps we need even more activist investors to bring some balance back to the Force.
Spontaneous Finance 
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