Tag Archive | Bank of England

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

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

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

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

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

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

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

Intragroup Funding Flows

 

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

 

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

 

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

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

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

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

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

 

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

 

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

 

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

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

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

A central banker contradiction?

Last week, Mark Carney, the governor of the Bank of England, was at Cass Business School in London for the annual ‘Mais Lecture’. Coincidentally, I am an alumnus of this school. And I forgot to attend… Yes, I regret it.

Carney’s speech was focused on past, current, and future roles of the BoE. In particular, Carney mentioned the now famous monetary and macroprudential policies combination. It’s a classic for central bankers nowadays. They all have to talk about that.

In January, Andrew Haldane, a very wise guy and one my ‘favourite’ regulators, also from the BoE, made a whole speech about the topic. As Jens Weidmann, president of the Bundesbank, did in February.

I am not going to come back to the all the various possible problems caused and faced by macroprudential policies (see here and here). However, there seems to be a recurrent contradiction in their reasoning.

Uncertainty-300x1991

This is Carney:

The transmission channels of monetary and prudential policy overlap, particularly in their impact on banks’ balance sheets and credit supply and demand – and hence the wider economy. Monetary policy affects the resilience of the financial system, and macroprudential policy tools that affect leverage influence credit growth and the wider economy. […]
The use of macroprudential tools can decrease the need for monetary policy to be diverted from managing the business cycle towards managing the credit cycle. […]
That co-ordination, the shared monitoring of risks, and clarity over the FPC’s tools allows monetary policy to keep Bank Rate as low as necessary for as long as appropriate in order to support the recovery and maintain price stability. For example expectations of the future path of interest rates – and hence longer-term borrowing costs – have not risen as the housing market has begun to recover quickly.

First, it is very unclear from Carney’s speech what the respective roles of monetary policy and macroprudential policies are. He starts by saying (above) that “monetary policy affects the resilience of the financial system”, then later declares “macroprudential policy seeks to reduce systemic risks”, which is effectively the same thing. At least, he is right: both policy frameworks overlap. And this is the problem.

This is Haldane:

In the UK, the Bank of England’s Monetary Policy Committee (MPC) has been pursuing a policy of extra-ordinary monetary accommodation. Recently, there have been signs of renewed risk-taking in some asset markets, including the housing market. The MPC’s macro-prudential sister committee, the Financial Policy Committee (FPC), has been tasked with countering these risks. Through this dual committee structure, the joint needs of the economy and financial system are hopefully being satisfied.

Some have suggested that having monetary and macro-prudential policy act in opposite directions – one loose, the other tight – somehow puts the two in conflict [De Paoli and Paustian, 2013]. That is odd. The right mix of monetary and macro-prudential measures depends on the state of the economy and the financial system. In the current environment in many advanced economies – sluggish growth but advancing risk-taking – it seems like precisely the right mix. And, of course, it is a mix that is only possible if policy is ambidextrous.

Contrary to Haldane, this does absolutely not look odd to me…

Let’s imagine that the central bank wishes to maintain interest rates at a low level in order to boost economic activity after a crisis. After a little while, some asset markets start looking ‘frothy’ or, as Haldane says, there are “renewed signs of risk-taking.” Discretionary macroprudential policy (such as increased capital requirements) is therefore utilised to counteract the lending growth that drives those asset markets. But there is an inherent contradiction here: one of the goals that low interest rates try to achieve is to boost lending growth to stimulate the economy…whereas macroprudential policy aims at…reducing it. Another contradiction: while low interest rates tries to prevent deflation from occurring by promoting lending and thus money supply growth, macroprudential policy attempts to reduce lending, with evident adverse effects on money supply and inflation…

Central bankers remain very evasive about how to reconcile such goals without entirely micromanaging the banking system.

I guess that the growing power of central bankers and regulators means that, at some point, each bank will have an in-house central bank representative that tells the bank who to lend to. For social benefits of course. All very reminiscent of some regions of the world during the 20th century…

Weidman is slightly more realistic:

We have to acknowledge that in the world we live in, macroprudential policy can never be perfectly effective – for instance because safeguarding financial stability is complicated by having to achieve multiple targets all at the same time.

Indeed.

 

Photograph: Intermonk

The BoE says that money is endo, exo… or something

The Bank of England just published an already very controversial paper, titled “Money creation in the modern economy”. Scott Sumner, Nick Rowe, Cullen Roche, Frances Coppola, JKH, and surely others have already commented on it. Some think the BoE is wrong, some, like Frances, think that this confirms that “the money multiplier is dead”. Some think that the BoE endorses an endogenous money point of view. Many are actually misreading the BoE paper.

To be fair, this might not even be an official BoE report, and might only reflect the views of some of its economists. That type of paper is published in many institutions.

I am unsure what to think about this piece… They seem to get some things right and some other things wrong, and even in contradiction to other things they say. Overall, it is hard to reconcile. What I read was a piece written by economists. Not by banks analysts or market participants. Therefore, some ‘ivory tower’ ideas were present, though in general the paper was surprisingly quite realistic.

I have also been left with a weird feeling. I might be wrong, but almost the whole ‘Limits on how much banks can lend’ section really seems to be paraphrasing my two relatively recent posts on the topic (here, where I criticise the MMT version of endogenous money theory, and here, where I respond to Scott Fullwiller). The paper does say that

The limits to money creation by the banking system were discussed in a paper by Nobel Prize winning economist James Tobin and this topic has recently been the subject of debate among a number of economic commentators and bloggers. (emphasis added)

Indeed…

Contrary to what some seem to believe, the BoE does not endorse a fully endogenous view of the monetary system, and certainly not an MMT-type endogenous money theory.

Let me address point by point what I think they got wrong or contradictory (I am not going to address the points in the QE section, which simply follow the mechanism described in the first section of the paper).

  • First, there seems to be an absolute obsession with differentiating the ‘modern’ from the ‘pre-modern’ banking and monetary system. The paper keeps repeating that

in reality, in the modern economy, commercial banks are the creators of deposit money. (page 2)

Well… You know what, guys? It was already the case in the pre-fiat money era… Banks also created broad money on top of gold reserves, thereby creating deposits, the exact same way they now do it on top of fiat money reserves. The only difference is the origins of the reserves/monetary base.

  • They very often refer to Tobin’s ‘new view’. But they never mention Leland Yeager, who strongly criticised Tobin’s theory in his article ‘What are Banks?’ As a result, their view is one-sided.
  • The point that “saving does not by itself increase the deposits or ‘funds available’ for banks to lend” (page 2) is slightly misinterpreted. By not saving, and hence, consuming, customers are likely to maintain higher real cash balances, leading to a reserve drain. Moreover, even if no reserve drain occurs, banks end up with a much less stable funding structure, that does not make it easier to undertake maturity transformation. It is always easier to lend when you know that your depositors aren’t going to withdraw their money overnight. This is also in contradiction with their later point that

banks also need to manage the risks associated with making new loans. One way in which they do this is by making sure that they attract relatively stable deposits to match their new loans, that is, deposits that are unlikely or unable to be withdrawn in large amounts. This can act as an additional limit to how much banks can lend. (page 5)

  • In their attempt to attack the money multiplier theory, they mistakenly say that the theory assumes a constant ratio of broad money to base money (page 2). There is nothing more wrong. What the money multiplier does is to demonstrate the maximum possible expansion of broad money on top of the monetary base. The theory does not state that banks will always, at all times, thrive to achieve this maximum expansion. I still find surreal that so many clever people cannot seem to understand the difference between ‘potentially can’ and ‘always does’. Moreover, the BoE economists once again contradict themselves, when on pages 3 and 5 to 7 they essentially describe a pyramiding system akin to the money multiplier theory!
  • The paper also keeps mistakenly attacking the money multiplier theory and reserve requirements while entirely forgetting all the successful implementations of reserve requirement policies by central banks throughout the world (China, Turkey, Brazil…).
  • The ‘banks lend out their reserves’ misconception is itself misconceived. I strongly suggest those BoE economists to read my recent post on this very topic. Here again this is in opposition with their later point that individual banks can suffer reserve drains and withdrawals through overlending…
  • The ‘Limits on how much banks can lend’ section is very true (though I might be biased given how similar to my posts this section is), and I appreciate the differentiation between individual banks and the system as a whole, differentiation that I kept emphasizing in my various posts and that I believe is absolutely crucial in understanding the banking system. Nonetheless, while their description of the effects of over-expanding individual banks and what this implies for broad money growth is accurate, it is less so in regards to the system as a whole. Indeed, they seem to believe that all banks could expand simultaneously, resulting in each bank avoiding adverse clearing and loss of reserves. This situation cannot realistically occur. Each bank wishes to have a different risk/return profile. As a result, banks with different risk profile would not be expanding at the exact same time, resulting in the more aggressive ones losing reserves at the expense of the more conservative ones in the medium term, stopping their expansion. At this point, we get back to the case I (and they) made of what happens to over-expanding single banks.
  • Finally, despite describing a banking system in which lending is built up on top of reserves (pages 3 and 4)  and in which banks cannot over-expand due to reserve drains (pages 5 and 6), they still dare declaring that:

In reality, neither are reserves a binding constraint on lending, nor does the central bank fix the amount of reserves that are available. (page 2) (emphasis added)

I just don’t know what to say…

What do we learn from this piece? For one thing, those BoE economists do not believe in the endogenous money theory. This is self-explanatory in the mechanism described in pages 5 and 6. They clearly know that an individual bank cannot expand broad money by itself. They seem to admit that the central bank does not have the ability to provide reserves on demand (despite saying a couple of times that the BoE supplies them on demand, another apparent contradiction). Their only qualification is that this can happen when all banks simultaneously expand their lending. This is theoretically true but impossible in practice as I said above.

Why would the central bank not have the ability to provide those reserves on demand? Actually, it can. It’s just that there is no (or low) demand for those reserves. This is due to the central bank funding stigma, an absolutely key factor that is not referred to even once in this BoE paper. As a result, their description seems to lack something: if individual banks lack reserves to expand further, why aren’t they simply borrowing them from the central bank? By overlooking the stigma, their mechanism lacks a coherent whole.

This is how things work (in the absence of innovations that economise on reserves): money supply expansion is endogenous in the short-term. But any endogenous expansion will also lead to an endogenous contraction in the short-term. In the long-term, only an increase in the monetary base can expand broad money. Only central bank injections free of any stigma, such as OMO, can sustainably expand the monetary base by swapping assets for reserves without touching at banks’ funding structure.

Banking expansion cycle

I have a minor qualification to add to this mechanism though. The endogenous contraction does not necessarily always occur around the same time. A period of economic euphoria could well lead to lower risk expectations, allowing banks to reshape their funding structure and the liquidity of their balance sheet in a riskier way than usual before the natural contractionary process kicks in.

In the end, the few ‘ivory tower’ ideas that are present in this research paper make it look incoherent and internally inconsistent. Central banks are notorious for their intentional or unintentional twisting of economic reality and history (see this brand new article by George Selgin on the Fed misrepresenting its history and performance. Brilliant read), so we should always take everything they say with a pinch of salt.

Could P2P Lending help monetary policy break through the ‘2%-lower bound’?

The ‘cut the middle man’ effect of P2P lending is already celebrated for offering better rates to both lenders and borrowers. But what many people miss is that this effect could also ease the transmission mechanism of central banks’ monetary policy.

I recently explained that the banking channel of monetary policy was limited in its effects by banks’ fixed operational costs. I came up with the following simplified net profit equation for a bank that only relies on interest income on floating rate lending as a source of revenues:

Net Profit = f1(central bank rate) – f2(central bank rate) – Costs, with

f1(central bank rate) = interest income from lending

= central bank rate + margin and,

f2(central bank rate) = interest expense on deposits

= central bank rate – margin

(I strongly advise you to take a look at the details here, which was a follow-up to my response to Ben Southwood’s own response on the Adam Smith Institute blog to my original post…which was also a response to his own original post…)

Consequently, banks can only remain profitable (from an accounting point of view) if the differential between interest income and interest expense (i.e. the net interest income) is greater than their operational costs:

Net interest income >= Costs

When the central bank base rate falls below a certain threshold, f2 reaches zero and cannot fall any lower, while f1 continues to decrease. This is the margin compression effect.

Above the threshold, the central bank base rate doesn’t matter much. Below, banks have to increase the margin on variable rate lending in order to cover their costs. This was evidenced by the following charts:

Rate floor

Rate floor 4

As the UK experience seems to show, banks stopped passing BoE rate cuts on to customers around a 2% BoE rate threshold. I called this phenomenon the ‘2%-lower bound’. I have yet to take a look at other countries.

Enter P2P lending.

By directly matching savers and borrowers and/or slicing and repackaging parts of loans, P2P platforms cut much of banks’ vital cost base. P2P platforms’ online infrastructure is much less cost-intensive than banks’ burdensome branch networks. As a result, it is well-known that both P2P savers and borrowers get better rates than at banks, by ‘cutting the middle man’. This is easy to explain using the equations described above, as costs approach zero in the P2P model. This is what Simon Cunningham called “the efficiency of Peer to Peer Lending”. As Simon describes:

Looking purely at the numbers, Lending Club does business around 270% more efficiently than the comparable branch of a major American bank

Simon calculated the ‘efficiency’ of each type of lender by dividing the outstanding loans of Wells Fargo and Lending Club by their respective operational expenses (see chart below). I believe Lending Club’s efficiency is still way understated, though this would only become apparent as the platform grows. The marginal increase in lending made through P2P platforms necessitates almost no marginal increase in costs.

Wells vs Lending Club

Perhaps P2P platforms’ disintermediation model could lubricate the banking channel of monetary policy the closer central banks’ base rate gets to the zero bound?

Possibly. From the charts above, we notice that the spread between savings rates and lending rates that banks require in order to cover their costs range from 2 to 3.5%. This is the cost of intermediation and maturity transformation. Banks hire experts to monitor borrowers and lending opportunities in-house and operate costly infrastructures as some of their liabilities (i.e. demand deposits) are part of the money supply and used by the payment system.

However, disintermediated demand and supply for loanable funds are (almost) unhampered by costs. As a result, the differential between borrowers and savers’ rate can theoretically be minimal, close to zero. That is, when the central bank lowers its target rate to 0%, banks’ deposit rates and short-term government debt yield should quickly follow. Time deposits and longer-dated government debt will remain slightly above that level. Savers would be incentivised to invest in P2P if the proposed rate at least matches them, adjusting for credit risk.

Let’s take an example: from the business lending chart above, we notice that business time deposit rates are currently quoted at around 1%. However, business lending is currently quoted at an average rate of about 3%. Banks generate income from this spread to pay salaries and other fixed costs, and to cover possible loan losses. Let’s now imagine that companies deposit their money in a time deposit-equivalent P2P product, yielding 1.5%. Theoretically, business lending could be cut to only slightly above 1.5%. This represents a much cheaper borrowing rate for borrowers.

P2P platforms would thus more closely follow the market process: the law of supply and demand. If most investments start yielding nothing, P2P would start attracting more investors through arbitrage, increasing the supply of loanable funds, and in turn lowering rates to the extent that they only cover credit risk.

The only limitation to this process stems from the nature of products offered by platforms. Floating rate products tend to be the most flexible and quickly follow changes in central banks’ rates. Fixed rate products, on the other hand, take some time to reprice, introducing a time lag in the implementation of monetary policy. I believe that most P2P products originated so far were fixed rate, though I could not seem to find any source to confirm that.

In the end, P2P lending is similar to market-based financing. The bond market already ‘cuts the middle man’, though there remains fees to underwriting banks, and only large firms can hope to issue bonds on the financial markets. In bond markets, investors exactly earn the coupon paid by borrowers. There is no differential as there is no middle man, unlike in banking. P2P platforms are, in a way, mini fixed-income markets that are accessible to a much broader range of borrowers and investors.

However, I view both bond markets and P2P lending as some version of 100%-reserve banking. While they could provide an increasingly large share of the credit supply, banks still have a role to play: their maturity transformation mechanism provides customers with a means of storing their money and accessing it whenever necessary. Would P2P platform start offering demand deposit accounts, their cost base would rise closer to that of banks, potentially raising the margin between savers and borrowers as described above.

It seems that, by partly shifting from the banking channel to the P2P channel over time, monetary policy could become more effective. I am sure that Yellen, Carney and Draghi will appreciate.

Is the zero lower bound actually a ‘2%-lower bound’?

Following my recent reply to Ben Southwood on the relationship between mortgage rates, BoE base rate and banks’ margins and profitability (see here and here), a question came to my mind: if the BoE rate can fall to the zero lower bound but lending rates don’t, should we still speak of a ‘zero lower bound’? It looks to me that, strictly in terms of lending and deposit rates, setting the base rate at 0% or at 2% would have changed almost nothing at all, at least in the UK.

The culprit? Banks’ operational expenses. Indeed, it looks like the only way to break through the ‘2%-lower bound’ would be for banks to slash their costs…

Let’s take a look at the following mortgage rates chart from one of my previous posts:

Rate floorFrom this chart, it is clear that lowering the BoE rate below around 2.5% had no further effect on lowering mortgage rates. As described in my other posts, this is because banks’ net interest income necessarily has to be higher than expenses for them to remain profitable. When the BoE rate falls below a certain threshold that represents operational expenses, banks have to widen the margins on loans as a result.

What about business lending rates? Since business lending is funded by both retail and corporate deposits (and excluding wholesale funding for the purpose of the exercise), the analysis must take a different approach. Banks don’t often disclose the share of corporate deposits within their funding base, but I managed to find a retail/corporate deposit split of 75%/25% at a large European peer, which I am going to use as a rough approximation to estimate banks’ business lending margins. Here are the results of my calculations (first chart: margin over time deposits, second chart: margin over demand deposits):

Rate floor 2

Rate floor 3No surprise here, the same margin compression effect appears as a result of the BoE rate collapsing (as well as Libor, as floating corporate lending is often calculated on a Libor + margin basis, unlike mortgages, which are on a BoE + margin basis). Before that period, changes in the BoE and Libor rates had pretty much no effect on margins. After the fall, banks tried to rebuild their margins by progressively repricing their business loan books upward (i.e. increasing the margins over Libor).

Here again we can identify a 1.5% BoE rate floor, under which lowering the base rate does not translate into cheaper borrowing for businesses:

Rate floor 4This has repercussions on monetary policy. The banking/credit channel of monetary policy aims at:  1. easing the debt burden on indebted household and businesses and, 2. stimulating investments and consumption by making it cheaper to borrow. However, it seems like this channel is restricted in its effectiveness by banks’ ability in passing the lower rate on to customers. Banks’ short-term fixed cost base effectively raises the so-called zero lower bound to around 2%. The only way to make the transmission mechanism more efficient would be for banks to drastically improve their cost efficiency and have assets of good-enough quality not to generate impairment charges, which is tough in crisis times. Unfortunately, there are limits to this process, and a bank without employee and infrastructure is unlikely to lend in the first place…

Don’t get me wrong though, I am not saying that lowering the BoE rate (and unconventional monetary policies such as QE) is totally ineffective. Lowering rates also positively impact asset prices and market yields, ceteris paribus. This channel could well be more effective than the banking one but it isn’t the purpose of this post to discuss that topic. Nevertheless, from a pure banking channel perspective, one could question whether or not it is worth penalising savers in order to help borrowers that cannot feel the loosening.

PS: I am not aware of any academic paper describing this issue, so if you do, please send me the link!

A clarification on mortgage rates for ASI’s Ben Southwood

Ben Southwood from the Adam Smith Institute replied to my previous post here. I am still confused about Ben’s claim that the spread varied “widely”. As the following chart demonstrates, the margins of SVR, tracker and total floating lending over the BoE base rate remained remarkably stable between 1998 and 2008, despite the BoE rate varying from a high 7.5% in 1998 to a low of 3.5% in 2003:

Lending margins over BoE

Everything changed in 2009 when the BoE rate collapsed to the zero lower bound. Following his comments, I think I need to address a couple of things. Two particular points attracted my attention. Ben said:

If other Bank schemes, like Funding for Lending or quantitative easing were overwhelming the market then we’d expect the spread to be lower than usual, not much higher.

His second big point, that the spread between the Bank Rate and the rates banks charged on markets couldn’t narrow any further 2009 onwards perplexes me. On the one hand, it is effectively an illustration of my general principle that markets set rates—rates are being determined by banks’ considerations about their bottom line, not Bank Rate moves. On the other hand, it seems internally inconsistent. If banks make money (i.e. the money they need to cover the fixed costs Julien mentions) on the spread between Bank Rate and mortgage rates (i.e. if Bank Rate is important in determining rates, rather than market moves) then the absolute levels of the numbers is irrelevant. It’s the spread that counts.

It looks to me that we are both misunderstanding each other here. It is indeed the spread that counts. But the spread over funding (deposit) cost, not BoE rate! (Which seems to me to be consistent with my posts on MMT/endogenous money.) Let me clarify my argument with a simple model.

Assumptions:

  • A medium-size bank’s only assets are floating rate mortgages (loan book of GBP1bn). Its only source of revenues is interest income. The bank maintains a fixed margin of 1% above the BoE rate but keeps the right to change it if need be.
  • The bank’s funding structure is composed only of demand deposits, for which the bank does not pay any interest. As a result, the bank has no interest expense.
  • The bank has a 100% loan/deposit ratio (i.e. the bank has ‘lent out’ the whole of its deposit base and therefore does not hold any liquid reserve).
  • The bank has an operational cost base of GBP20m that is inflexible in the short-term (not in the long-term though there are upwards and downwards limits) and no loan impairment charge.

Of course this situation is unrealistic. A 100% loan/deposit bank would necessarily have some sort of wholesale funding as it needs to maintain some liquidity. It would also very likely have a more expensive saving deposit base and some loan impairment charges. But the mechanism remains the same therefore those details don’t matter.

In order to remain profitable, the bank’s interest income has to be superior to its cost base. Moreover, the bank’s interest income is a direct, linear function, of the BoE rate. The higher the rate, the higher the income and the higher the profitability. As a result, the bank’s profitability obeys the following equation:

Net Profit = Interest Income – Costs = f(BoE rate) – Costs,

with f(BoE rate) = BoE rate + margin = BoE rate + 1%.

Consequently, in order for Net Profit > 0, we need f(BoE rate) > Costs.

Now, we know that the bank’s cost base is GBP20m. The bank must hence earn more than GBP20m on its loan book to remain profitable (which does not mean that it is enough to cover its cost of capital).

The BoE rate is 2%, making the rate on the mortgage book of the bank 3%, leading to a GBP30m income and a GBP10m net profit. Almost overnight, the BoE lowers its rate to 0.5%. The bank’s loan book’s average rate is now 1.5%, and generates GBP15m of income. The bank is now making a GBP5m loss. Having inflexible short-term costs, it’s only way of getting back to profitability is to increase its margin by at least 0.5%. The bank’s net profit profile is summarised by the following chart:

Bank net profit profile - simple

However, a more realistic bank would pay interest on its deposit base (its funding). Let’s now modify our assumptions and make that same bank entirely demand deposit-funded, remunerated at a variable rate. The bank pays BoE rate minus a fixed 2% margin on its deposit base. As a result, what needs to cover the banks operational costs isn’t interest income but net interest income. The bank’s net profit equation is now altered in the following way:

Net Profit = Net Interest Income – Costs

Net Profit = Interest Income – Interest Expense – Costs

Net Profit = f1(BoE rate) – f2(BoE rate) – Costs

with f1(BoE rate) = BoE rate + margin = BoE rate + 1%,

and f2(BoE rate) = BoE rate – margin = BoE rate – 2%.

The equation can be reduced to: Net Profit = 3% (of its loan book) – Costs, as long as BoE rate >= 2% (see below).

Let’s illustrate the net profit profile of the bank with the below chart:

Bank net profit profile - compression

What happens is clear. Independently of its effects on the demand for credit and loan defaults, the BoE rate level has no effect on the bank’s profitability. Everything changes when deposit rates reach the zero lower bound (i.e. there is no negative nominal rate on deposits), which occurs before the BoE rate reaches it. From this point on, the bank’s interest income decreases despite its funding cost unable to go any lower. This is the margin compression effect that I described in my first post. In reality, things obviously aren’t that linear but follow the same pattern nevertheless.

Realistic banks are also funded with saving deposits and senior and subordinated debt, on which interest expenses are higher. This is when schemes such as the Funding for Lending Scheme kicks in, by providing cheaper-than-market funding for banks, in order to reduce the margin compression effect. The other way to do it is to reflect a rate rise in borrowers’ cost, while not increasing deposit rates. This is highly likely to happen, although I guess that banks would only partially transfer a rate hike in order not to scare off customers.

Overall, we could say that markets determine mortgage rates to an extent. But this is only due to the fact that banks have natural (short-term) limits under which they cannot go. It would make no sense for banks not to earn a single penny on their loan book (and they would go bust anyway). Beyond those limits, the BoE still determines mortgage rates.

Although I am going to qualify this assertion: the BoE roughly determines the rate and markets determine the margin. At a disaggregated level, banks still compete for funding and lending. They determine the margins above and below the BoE rate in order to maximise profitability. They, for instance, also have to take into account the fact that an increase in the BoE rate might reduce the demand for credit, thereby not reflecting the whole increase/decrease to customers as long as it still boosts their profitability. Those are some of the non-linear factors I mentioned above. But they remain relatively marginal and the aggregate, competitively-determined, near-equilibrium margin remains pretty stable over time as demonstrated with the first chart above.

With this post I hope to have clarified the mechanism I relied on in my previous post, but feel free to send me any question you may have!

Mortgage rates are still determined by the BoE

Ben Southwood from the Adam Smith Institute wrote an interesting piece this week. I have an objection to his title and the conclusion he reached. Ben wrote:

However, it was recently pointed out to me that since a high fraction of UK mortgages track the Bank of England’s base rate, a jump in rates, something we’d expect as soon as UK economic growth is back on track, could make mortgages much less affordable, clamping down on the demand for housing.

This didn’t chime with my instincts—it would be extremely costly for lenders to vary mortgage rates with Bank Rate so exactly while giving few benefits to consumers—so I set out to check the Bank of England’s data to see if it was in fact the case. What I found was illuminating: despite the prevalence of tracker mortgages the spread between the average rate on both new and existing mortgage loans and Bank Rate varies drastically.

Wait. I really don’t reach the same conclusion from the same dataset. This is what I extracted from the BoE website (using the BoE’s old reporting format, as the new one only started in 2011):

BoE Mortgage Rates 1

Banks and building societies offer two main types of floating rate mortgages: standard variable rate (SVR) and trackers. Trackers usually follow the BoE rate closely. SVR are slightly different: margins above the BoE rate are more flexible. Banks vary them to manage their revenues but usually fix them for an extended period of time before reviewing them again. During the crisis, some banks that had vowed to maintain their SVR at a certain spread angered their customers when this situation became unsustainable due to low base rates. Some banks and building societies made losses on their SVR portfolio as a result and had to break their promise and increase their SVR.

What we can notice from the chart above is clear: since the mid-1990s, it is the BoE that determine both mortgage and deposit rates. Not the market. All rates moved in tandem with the BoE base rate. Still, the linkage was broken when the BoE rate collapsed to the zero lower bound in 2009. And this is probably why Ben declared that

but what is clear is that tracker mortgages be damned, interest rates are set in the marketplace.

I think this is widely exaggerated. Ben missed something crucial here: banks have fixed operational costs. Banks generate income by earning a margin between their interest income (from loans) and interest expense (from deposits and other sources of funding). They usually pay demand deposits below the BoE rate and saving/time deposits at around the BoE rate, and make money by lending at higher rates. From this net interest income, banks have to deduce their fixed costs (salaries and other administrative expenses) and bad debt provisions.

There is a problem though. Setting the BoE rate near zero involves margin compression. Banks’ back books (lending made over the previous years) on variable rates see their interest income collapse. Banks’ deposit base is stickier: many saving accounts are not on variable rates. Therefore, there is a time lag before the deposit base reprice (we can see this on the chart above: whereas lending reprices instantaneously when the BoE rate moves, deposits show a lag). Moreover, near the zero bound, the spread between demand deposit rates and the BoE rates all but disappears. The two following charts clearly illustrate this margin compression phenomenon:

BoE Mortgage Rates 2

BoE Mortgage Rates 3

It is clear that banks started to make losses when the BoE rate fell, as the margin on the floating rate back book (stock) became negative. Using the new BoE reporting would make those margins look even worse*. To offset those losses, banks started to increase the spread on new lending, leading to a spike on the interest margin of the front book (green line above). Banks can potentially reprice their whole loan book at a higher margin, but this takes time, especially with 15 to 30-year mortgages. Consequently, banks not only increased the spread on new lending, but also decided to break their SVR promises and increase their back book SVR rates (see black line in charts). This usually did not go down well with their customers, but some banks had no choice, having entered the crisis with too low SVRs.

What happens to a bank whose net interest income is negative (assuming it has no other income source)? It reports net accounting losses as it still has fixed operational expenses… Continuously depressed margins explain why banks’ RoE remains low. For banks to report net profits, their net interest income must cover (at least) both operational expenses and loan impairment charges. What Ben identified as ‘market-defined interest rates’ or the ‘spread over BoE’s rate’ from 2009 onwards is simply the floor representing banks’ operational costs, under which banks cannot go… The only other (and faster) way to rebuild banks’ bottom line would be to increase the BoE rate.

A mystery though: why didn’t banks decrease their time deposit rates further? I am unsure to have an answer to that question. A possibility is that the spread between demand and time deposits remained the same. Another possibility is that banks’ time deposit rates remained historically roughly in line with UK gilts rates. Decreasing time deposit rates much below those of gilts would provide savers with incentives to invest their money in gilts rather than in banks’ saving accounts.

BoE Mortgage Rates 4

What would a rate hike mean? Ben thinks it would have little impact, probably because the spread over BoE seems to show quite a lot of breathing space before the base rate impacts lending rates. I don’t think this is the case. A rate increase would likely push lending rates upwards on bank’s back book (i.e. banks are not going to reduce the spread in order to maintain stable mortgage rates). Why? Banks’ net interest margin and return on equity are still very depressed. Moreover, new Basel III regulations are forcing banks to hold more equity, further reducing RoE. Consequently, banks will seek to rebuild their margin and profitability, making customers pay higher rates to compensate for years of low rates and newly-introduced regulatory measures.

* I am unsure why the BoE changed its reporting and what the differences are, but reported lending rates are much lower than with the old reporting standards. Tracker mortgage rates even seem to be lower than time deposit rates. See below and compare with my first chart. If anybody has an explanation, please enlighten me:

BoE Mortgage Rates 5

Update: I replaced ‘ceiling’ with ‘floor’ in the post as it makes a lot more sense!

Update 2: Ben Southwood replies here…

Update 3: …and I replied there!

A UK housing bubble? Sam Bowman doubts it

On the Adam Smith Institute’s blog, Sam Bowman had a couple of posts (here and a follow-up here, and mentioned by Lars Christensen here) attempting to explain that there might not have been any house price bubble in the UK. He essentially says that there was no oversupply of housing in the 1990s and 2000s. Here’s Sam:

These charts show that housing construction was actually well below historical levels in the 1990s and 2000s, both in absolute terms and relative to population. It is difficult to see how someone could claim that the 2008 bust was caused by too many resources flowing toward housing and subsequently needing time to reallocate if there was no bubble in housing to begin with.

What this suggests is that the Austrian story about the crisis may be wrong in the UK (and, if Nunes’s graphs are right, the US as well). The Hayek-Mises story of boom and bust is not just about rises in the price of housing: it is about malinvestments, or distortions to the structure of production, that come about when relative prices are distorted by credit expansion.

Well, I think this is not that simple. Let me explain.

First, the Hayek/Mises theory does not apply directly to housing. In the UK, there are tons of reasons, both physical and legal, why housing supply is restricted. As a result, increased demand does not automatically translate into increased supply, unlike in Spain, which seems to have lower restrictions as shown by the housing start chart below:

UK Spain Housing Starts

Second, Sam overlooks what happened to commercial real estate. There was indeed a CRE boom in the UK and CRE was the main cause of losses for many banks during the crisis (unlike residential property, whose losses remained relatively limited).

available-floor-space-in-the-UK

UK Commercial_property

Third, the UK is also characterised by a lot of foreign buyers, who do not live in the UK and hence not included in the population figures. Low rates on mortgages help them purchase properties, pushing up prices, triggering a reinforcing trend while supply in the demanded areas often cannot catch up.

Fourth, the impact of Basel regulations seems to be slightly downplayed. Coincidence or not, the first ‘bubble’ (in the 1980s) appeared right when Basel’s Risk Weighted Assets were introduced. And it is ‘curious’, to say the least, that many countries experienced the same trend at around the same time. Would house lending and house prices have increased that much if those rules had never been implemented? I guess not, as I have explained many times. I have yet to write posts on what happened in several countries. I’ll do it as soon as I find some time.

I recommend you to take a look at my RWA-based Austrian Business Cycle Theory, which seems to show that, while there should indeed be long-term real estate projects started (depending on local constraints of course), there is also an indirect distortion of the capital structure of the non-real estate sector.

While there may well be ‘real’ factors pushing up real estate prices in the UK, there also seems to be regulatory and monetary policy factors exacerbating the rise.

Blame the rich for the next asset bubble. Or not.

First of all, happy new year to all of you! Fingers crossed we don’t witness another market crash this year! 🙂

Indeed, credit markets are hot. Equity markets are also hot. The FT published an article yesterday with some striking facts about the ‘improvements’ in credit markets over the past couple of years. Some would say that it’s encouraging. I am not convinced…

Most credit indicators are close to or above their pre-credit crisis high. Sales of leveraged loans and high-yield bonds are above their pre-crisis peak. The average leverage level of US LBOs is back to 2006 level. Issuance of collateralised loan obligations is close to its pre-crisis peak. Even CCC-rated junk bonds are way above their previous peak. I’ve already mentioned some of those facts a few months ago.

FT1FT4

FT3FT2

In a relatively recent presentation, Citi’s strategist Hans Lorenzen confirmed the trend: central banks are indirectly suppressing most risky investments’ risk premia. Most investors expect junk bonds’ spreads to tighten further or at least to stabilise at those narrow levels and emerging markets bonds and equities, as well as junk bonds are now among investors’ top asset classes .

 

Citi1Citi2

My ‘theory’ at the time was that (see also here), if investors were piling in increasingly riskier asset classes, bringing their yield down to record low levels in the process, and nonetheless accepting this level of risk for such low returns, it was because current central bank-defined nominal interest rates were below the Wicksellian natural rate of interest. Inflation, as felt by investors rather than the one reported by national statistics agencies, was higher than most real rates of return on relatively safe assets. In order to see their capital growing (or at least to prevent it from declining), they were forced to pick riskier assets, such as high-yield bonds, which were not really high-yield anymore as a result but remained junk nonetheless. This would result in capital misallocation as, under ‘natural’ interest rate conditions, those investments would have never taken place. Thomas Aubrey’s Wicksellian differential, an indicator of the likely gap between the nominal and the natural rates of interest, was, in line with credit markets, reaching its pre-crisis high and seemed to confirm that ‘theory’.

Well, I now think that not all investors are responsible for what we are witnessing today. The (very) rich are.

This came to my mind some time ago while reading that FT piece by John Authers. This was revealing.

“Their wealth gives them scope to try imaginative investments, but they are terrified of inflation, even as deflation is emerging as a greater risk. That is in part because inflation for the goods and services bought by the very rich is running about 2 percentage points faster than retail inflation as a whole in the UK.” (my emphasis)

In the UK, real gilts’ yields were already in negative territory: adjusted by the (potentially underestimated) consumer price index, gilts were yielding around -1% early 2013. Savers were effectively losing money by investing in those bonds. Now think about the rich: by investing in such bonds, they would get a real return of around -3% instead.

UK Gilts CPI

Moreover, “71 per cent of respondents said they were more worried now about a steep rise in inflation than they were five years ago.”

Does it start to make sense? The cost of living I was mentioning earlier is increasing particularly quickly for the rich. And… they are the ones who own most financial assets. In order to offset those rising living costs, they naturally look for higher-yielding investments. And it is exactly what the FT reports:

“Their favourite asset classes for the next three decades are emerging markets equities, developed equities and agricultural land, in that order. Private equity comes close after farmland, while art and collectables were also a more popular asset class than any kind of bonds. […]

Hedge funds, as a group, have not fared well since the crisis. But wealthy investors preoccupied by inflation, and robbed of the easy option of bonds, are evidently disposed to give them a try, with an average projected allocation for the next three decades of 25 per cent. Meanwhile, the chance of a bubble in agricultural land prices, or in art, looks very real.”

Are the rich responsible for our current frothy markets then? Obviously not. They are acting rationally in response to central banks’ policies. Nonetheless, this raises an interesting question. Mainstream economics only considers a high aggregate inflation rate as dangerous. What about ‘class warfare’-type inflation? It does look like inflation experienced by one socioeconomic class could inadvertently lead to asset bubbles and bursts, despite aggregate inflation remaining subdued. This may be another destabilising effect of monetary injections on relative prices.

Granted, central banks possibly are on a Keynesian’s ‘euthanasia of the rentier’-type scheme in order to try to alleviate the pain of over-indebted borrowers (and/or to encourage further lending). But financial repression avoidance might well end-up coming back with a vengeance if savers’ reactions, and in particular, rich savers’, make financial markets bubble and crash.

Charts: FT (link above), Citi and Societé Générale

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