Banks’ RWAs as a source of malinvestments – A graphical experiment
Today is going to be experimental and theoretical. I have already outlined the principles behind the RWA-based variation of the Austrian Business Cycle Theory (ABCT), which was followed by a quick clarification. I am now attempting to come up with a graphical representation to illustrate its mechanism. In order to do that, I am going to use Roger Garrison’s capital structure-based macroeconomics representations used in his book Time and Money: The Macroeconomics of Capital Structure. I am not saying that what I am about to describe is 100% right. Remember that this remains an experiment that I just wrote down over those last few days and that needs a lot more development. There may well also be other ways of depicting the impacts that Basel regulation’s RWAs have on the capital structure and malinvestments. Completely different analytical frameworks might also do. Comments and suggestions are welcome.
This is what Garrison’s representation of the macroeconomics of capital structure looks like:
It is composed of three elements:
- Bottom right: this is the traditional market for loanable funds, where the supply and demand for loanable funds cross at the natural rate of interest. It represents economic agents’ intertemporal preferences: the higher they value future goods over present goods, the more they save and the lower the interest rate. The x-axis represents the quantity of savings supplied (and investments) and the y-axis represents the interest rate.
- Top right: this is the production-possibility frontier (PPF). In Garrison’s chart, it represents the sustainable trade-off between consumption and gross investment. Only movements along the frontier are sustainable and supposed to reflect economic agents’ preferences. Positive net investments and technological shocks expand the frontier as the economy becomes more productive.
- Top left: this is the Hayekian triangle. It represents the various stages of production (each adding to output) within an industry. See details below:
I don’t have time to come back to the original ABCT and those willing to find out more about it can find plenty of examples online. Today I wish only to try to understand the impact of regulatory-defined risk-weighted assets on this structure. Ironically, it becomes necessary to disaggregate the Austrian capital-based framework to understand the mechanics and distortions leading to a likely banking crisis. In everything that follows, and unlike in the original Austrian theory, we exclude central banks from the picture (i.e. no monetary injection). We instead focus only on monetary redistribution. The story outlined below does not explain the financial crisis by itself. Rather, it outlines a regulatory mechanism that exacerbated the crisis.
Let’s take a simple example that I have already used earlier. Only two types of lending exist: SME lending and mortgage/real estate lending. Basel regulations force banks to use more capital when lending to SME and as a result, bankers are incentivised to maximise ROE through artificially increasing mortgage lending and artificially restricting SME lending, as described in my first post on the topic.
In equilibrium and in a completely free-market world with no positive net investment, the economy looks like Garrison’s chart above. However, bankers don’t charge the Wicksellian natural rate of interest to all customers: they add a risk premium to the natural rate (effectively a ‘risk-free’ rate) to reflect the risk inherent to each asset class and customer. Those various rates of interest do reflect an equilibrium (‘natural’) state, which factors in the free markets’ perception of risk. Because lending to SME is riskier than mortgage lending, we end up with:
natural (risk free) rate < mortgage rate (natural rate + mortgage risk premium) < SME rate (natural rate + SME risk premium)
What RWAs do is to impose a certain perception of risk for accounting purposes, distorting the normal channelling of loanable funds and therefore each asset class’ respective ‘natural’ rate of interest. Unfortunately, depicting all demand and supply curves, their respective interest rates and the changes when Basel-defined RWAs are applied would be extremely messy in a single chart. We’re going to illustrate each asset class separately with their respective demand and supply curve. Let’s start with mortgage (real estate) lending:
Given the incentives they have to channel lending towards capital-optimising asset classes, bankers artificially increase the supply of loanable funds to all real estate activities, pushing the rate of interest below the natural rate of the sector. As the actual total supply of loanable funds does not change, returns on savings remain the same. In our PPF, this pushes resources towards real estate. Any other industry would interpret the lowered rate of interest as a shift in people’s intertemporal preferences towards the future and increase long-term investments at the expense of short-term production. Indeed, long-term housing projects are started. This is represented by the thin dotted red triangle.
However, the short-term housing supply is inelastic and cannot be reduced. The resulting real estate structure of production is the plain red triangle. Nonetheless, real estate developers have been tricked by the reduced interest rate and the long-term housing projects they started do not match economic agents’ future demand. Meanwhile, savers, adequately rewarded for their savings, do not draw down on them (or don’t have to), but are instead incentivised to leverage as they (indirectly) see profit opportunities from the differential between the natural and the artificially reduced rate. Leverage effectively becomes a function of the interest rate differential:
The increased leverage boosts the demand for existing real estate, bidding up prices, starting a self-reinforcing trend based on expected further price increases. We end up in a temporary situation of both short-term ‘overconsumption’ of real estate and its associated goods, and long-term overinvestments (malinvestments). This situation is depicted by the thick dotted red triangle and represents an unsustainable state beyond the PPF.
On the other hand, bankers artificially restrict the supply of loanable funds to SME, pushing the rate of interest above the natural rate. Tricked by a higher rate of interest, SMEs are led to believe that consumers now value more highly present goods over future goods (as they ‘apparently’ now save less of their income). They temporarily reduce interest rate-sensitive long-term investments to increase the production of late stages consumer goods. This results in an overproduction of consumer goods relative to economic agents’ underlying present demand. Nonetheless, wealth effects from the real estate boom temporarily boost consumption, maintaining prices level. Overconsumption of present goods could also eventually appear if and when savers start leveraging their consumption through low-rate mortgages, as house prices seem to keep increasing. In the long-run, SMEs’ investments aren’t sufficient to satisfy economic agents’ future demand of consumer goods.
With leverage increasing and the economy producing beyond its PPF, the situation is unsustainable. As increasingly more people pile in real estate, demand for real estate loanable funds increases, pushing up the interest rate of the sector. Interest payments – which had taken an increasingly large share of disposable income in line with growing leverage – rise, putting pressure on households’ finances. The economy reaches a Minsky moment and real estate prices start coming down. Real estate developers, who had launched long-term housing projects tricked by the low rates, find out that these are malinvestments that either cannot find buyers or are lacking the financial resources to be completed. Bankruptcies increase among over-leveraged households and companies. Banks start experiencing losses, contract lending and money supply as a result, whereas savers’ demand for money increases. The economy is in monetary disequilibrium. Welcome to the financial crisis designed in the Swiss city of Basel.
This all remains very theoretical and I’ll try to dig up some empirical evidences in another post. Nonetheless, the story seems to match relatively well what happened in some countries during the crisis. Soon after Basel regulations were implemented, household leverage in Spain or Ireland took off and came along with increasing house prices and retail sales, which both collapsed once the crisis struck. Under this framework, the artificially restricted supply of loanable funds to SME and the consequent reduction in long-term investments could also partly explain the rich world manufacturing problems. However, I presented a very simple template. As I mentioned in a previous post, securitisation and other banking regulations (liquidity…) blur the whole picture, and central banks can remain the primary channel through which interest rates are distorted.
RWA-based ABCT Series:
- Banks’ risk-weighted assets as a source of malinvestments, booms and busts
- Banks’ RWAs as a source of malinvestments – Update
- Banks’ RWAs as a source of malinvestments – A graphical experiment
- Banks’ RWAs as a source of malinvestments – Some recent empirical evidence
- A new regulatory-driven housing bubble?
The ivory tower economist syndrome
Here we go. Academic economists are lost. Lawrence Summers just made a striking announcement in a speech a few days ago: we are likely to be in a secularly stagnating economy that needs recurrent bubbles to achieve full employment, as its natural rate of interest has been constantly below zero for a while. Evidently, Krugman, Sumner, Cowen, Wolf and many other economists started to discuss the issue. Some agree, some don’t. However, most seem to miss the main problem. I call that the ivory tower economist syndrome. Abstractly thinking in terms of aggregated economic figures locked in a university or government office won’t be of much help. Zerohedge rightly makes fun of Summers and Krugman, as the satiric newspaper The Onion made the same economic advices a few years ago:
Congress is currently considering an emergency economic-stimulus measure, tentatively called the Bubble Act, which would order the Federal Reserve to† begin encouraging massive private investment in some fantastical financial scheme in order to get the nation’s false economy back on track.
Who said that was fiction?
Many of them are backing their ideas using wrong arguments. For instance, Summers and Krugman don’t believe interest rates were too low before the crisis as… there was no inflation! Sure, but, how do you know that? CPI? RPI? GDP deflator? There are many problems with inflation figures. Let’s list some of them:
- They don’t accurately reflect inflation. You can change the calculation and the result changes dramatically. Moreover, the goods picked to calculate them and the weights applied to them are quite arbitrary. This is supposed to reflect the ‘average’ household basket. Well, I am not the average household apparently as my own inflation rate has been way higher than headline inflation over the past few years.
- 0% CPI increase does not mean that there is no inflation. Productivity increase drives inflation down. As a result, reasoning in terms of headline inflation is a mistake. Real inflation is hidden. The fastest economic growth in the history of the Western world (late 19th and early 20th century) occurred during a long period of secular deflation…
- Most asset prices aren’t reflected in inflation figures. Newly created money now mostly go to investments, a lot of which being speculation. Most of banks’ lending is mortgage lending. So newly-created money goes to housing, pushing up prices… which aren’t reflected in inflation figures. Sure, one can argue that, at some point, there will be inflationary pressure on consumer goods. But productivity increases reducing the price of domestically-produced goods (IT revolution anyone?) and cheap goods from developing countries mask that process. Moreover, when asset bubbles burst (which they eventually do), the wealth effect from asset price increases that could lead to inflation all but disappears. Lending was also different 50 or 100 years ago: much lending did not go directly to investments in financial or real assets. Consequently consumer goods inflation appeared a lot faster after new monetary injection (considering stable productivity).
So justifying the fact that nominal interest rates defined by central banks were not low because there was no inflation is in itself wrong, or at best inaccurate. In reality, low interest rates are very likely to have caused, or at least participated, in the recent credit bubble. Regarding the so-called ‘savings glut’, Cowen agrees with Kling on the fact that, if we really had ‘too much’ savings chasing ‘too few’ investment opportunities, we would not need central banks’ actions to push interest rates lower. The supply and demand of loanable funds would automatically drive the interest rate to a very low level.
But, most importantly, all those economists forget a fundamental fact that I have been mentioning a hundred times recently: regime uncertainty (yes, again…). For economists to speak in terms of monetary and spending aggregates alone and to not pay attention to the broader context surrounding businesses is a major mistake. I’ve kept repeating and giving many evidences recently (like here, here, and here) that businesses currently delay investments due to the uncertain regulatory and economic decisions taken by governments and regulators all around the world. This is now the major issue for SMEs and banks at least. Again today, Euromoney published an interesting short article on ‘renewed regulatory uncertainty’ for banks:
For all the populist fervor then about perceived policy inaction to address systemic risk, many banks see it differently: investor flight from banks’ equity and bond products has taken root over the years, amid fears that new rules will render business models uneconomic.
Take a look at that SEB and Deloitte chart summarising current regulatory reforms. It looks slightly messy doesn’t it? And look how it is named…
A bank analyst told Euromoney that:
Changes in regulations, changes in what other stakeholders consider to be acceptable, the risk that the behaviours of certain employees become associated with the institution as a whole – those are indeed much more expensive for banks these days than credit [risk].
As I have already highlighted in an earlier post, more than the number of rules, it is the fact that rules change that is crucial to business planning. You can’t play a certain game if the rules of the game constantly change. Yet none of those ‘great’ economists ever mentioned regulation, uncertainty, rules or anything related. Looks like abstract economic aggregates are a lot more interesting to manipulate…
Get out of your tower guys!
Banks’ risk-weighted assets as a source of malinvestments, booms and busts
Here I’m going to argue that Basel-defined risk-weighted assets, a key component of banking regulation, may be partly responsible for recent business cycles.
Readers might have already noticed my aversion to risk-weighted assets (RWAs), which I view as abominations for various reasons. They are defined by Basel accords and used in regulatory capital ratios. Basel I (published in 1988 and enforced from 1992) had fixed weights by asset class. For example, corporate loans and mortgages would be weighted respectively 100% and 50%, whereas OECD sovereign debt would be weighted 0%. If a bank had USD100bn of total assets, applying risk-weights could, depending on the lending mix of the bank, lead to total RWAs of anything between USD20bn to USD90bn. Regulators would then take the capital of the bank as defined by Basel (‘Tier 1’ capital, total capital…) and calculate the regulatory capital ratio of the bank: Tier 1 capital/RWAs. Basel regulation required this ratio to be above 4%.
Basel II (published in 2004 and progressively implemented afterwards) introduced some flexibility: the ‘Standardised method’ was similar to Basel I’s fixed weights with more granularity (due to the reliance on external credit ratings), while the various ‘Internal Ratings Based’ methods allowed banks to calculate their own risk-weight based on their internal risk management models (‘certified’ by regulators…).
This system is perverse. Banks are profit-maximising institutions that answer to their shareholders. Shareholders on the other hand have a minimal threshold under which they would not invest in a company: the cost of capital, or required return on capital. As a result, return on equity (ROE) has to at least cover the cost of capital. If it doesn’t, economic losses ensue and investors would have been better off investing in lower yielding but lower risk assets in the first place. But Basel accords basically dictate banks how much capital they need to hold. Therefore banks have an incentive in trying to ‘manage’ capital in order to boost ROE. Under Basel, this means pilling in some particular asset classes.
Let’s make very rough calculations to illustrate the point under a Basel II Standardised approach: a pure commercial bank (i.e. no trading activity) has a choice between lending to SMEs (option 1) or to individuals purchasing homes (option 2). The bank has EUR1bn in Tier 1 capital available and wishes to maximise returns while keeping to the minimum of 4% Tier 1 ratio. We also assume that external funding (deposits, wholesale…) is available and that the marginal increase in interest expense is always lower than the marginal increase in interest income.
- Option 1: Given the 100% risk-weight on SME lending, the bank could lend EUR25bn (25bn x 100% x 4% = 1bn), at an interest rate of 7% (say), equalling EUR1.75bn in interest income.
- Option 2: Mortgage lending, at a 35% risk-weight, allows the same bank to lend a total of EUR71.4bn (71.4bn x 35% x 4% = 1bn) for EUR1bn in capital, at an interest rate of 3% (say), equalling EUR2.14bn in interest income.
The bank is clearly incentivised to invest its funding base in mortgages to maximise returns. In practice, large banks that are under the IRB method can push mortgage risk-weights to as low as barely above 10%, and corporate risk-weights to below 50%. As a result, banks are involuntarily pushed by regulators to game RWAs. The lower RWAs, the lower capital the bank needs, the higher its ROE and the happier the regulators. Banks call this ‘capital optimisation’.
Consequently, does it come as a surprise that low-risk weighted asset classes were exactly the ones experiencing bubbles in pre-crisis years? Oh sorry, you don’t know which asset classes were lowly rated… Here they are: real estate, securitisation, OECD sovereign debt. Yep, that’s right. Regulatory incentives that create crises. And the new Basel III regime does pretty much nothing to change the incentivised economic distortions introduced by its predecessors.
Yesterday, Fitch, the rating agency, published a study of lending and RWAs among Europe’s largest banks (press release is available here, full report here but requires free subscription). And, what a surprise, corporate lending is going…down, while mortgage lending and credit exposures to sovereigns are going…up (see charts below). The trend is even exacerbated as banks are under pressure from regulators to boost regulatory capitalisation and from shareholders to improve ROE. And this study only covers IRB banks. My guess is that the situation is even more extreme for Standardised method banks that cannot lower their RWAs.
The ‘funny’ thing is: not a single regulator or central banker seems to get it. As a result, we keep seeing ill-founded central banks schemes aiming at giving SME lending a boost, like the Funding for Lending Scheme launched by the Bank of England in 2012, which provided banks with cheap funding. Yes, you guessed it: SME lending continued its downward trend and the scheme provided mortgage lending a boost.
Should the situation ‘only’ prevent corporates to borrow funds, bad economic consequences would follow but remain limited. Economic growth would suffer but no particular crisis would ensue. The problem is: Basel and RWAs force a massive misallocation of capital towards a few asset classes, resulting in bubbles and large economic crises when the crash occurs.
The Mises and Hayek Austrian business cycle theory emphasises the distortion in the structure of relative prices that emanates from central banks lowering the nominal interest rate below the natural rate of interest as represented by economic agents’ intertemporal preferences, resulting in monetary disequilibrium (excess supply of money). The consequent increase in money supply flows in the economy through one (or a few) entry points, increasing the demand in those sectors, pushing up their prices and artificially (and unsustainably) increasing their return on investment.
I argue here that due to Basel’s RWAs distortions, central banks could even be excluded from the picture altogether: banks are naturally incentivised to channel funds towards particular sectors at the expense of others. Correspondingly, the supply of loanable funds increases above equilibrium in the favoured sectors (hence lowering the nominal interest rate and bringing about an unsustainable boom) but reduces in the disfavoured ones. There can be no aggregate overinvestment during the process, but bad investments (i.e. malinvestments) are undertaken: the investment mix changes as a result of an incentivised flow of lending, rather than as a result of economic agents’ present and future demand. Eventually, the mismatch between expected demand and actual demand appears, malinvestments are revealed, losses materialise and the economy crashes. Central banks inflation worsen the process through the mechanism described by the Austrians.
I am not sure that regulators had in mind a process to facilitate boom and bust cycles when they designed Basel rules. The result is quite ‘ironic’ though: regulations developed to enhance the stability of the financial sector end up being one of the very sources of its instability.
RWA-based ABCT Series:
- Banks’ risk-weighted assets as a source of malinvestments, booms and busts
- Banks’ RWAs as a source of malinvestments – Update
- Banks’ RWAs as a source of malinvestments – A graphical experiment
- Banks’ RWAs as a source of malinvestments – Some recent empirical evidence
- A new regulatory-driven housing bubble?
The Economist struggles with Wicksell
Looks like Wicksell is back in fashion. After years (decades?) with barely any mention of this distinguished Swedish economist outside of work from some heterodox economic schools academics (like the Austrians), he is now everywhere and has unleashed a great debate among academics and financial practitioners. This is the outcome of both the financial crisis (preceded by interest rates that were below their ‘natural’ level according to Wicksellian-based theories) and the current unconventional policies undertaken by central banks all over the world (that risk repeating the same mistakes according to those same theories).
This week’s Economist’s column Free Exchange tries to identify whether or not current interest rates are too low based on a Wicksellian framework (A natural long-term rate). The article is complemented by a Free Exchange blog post on the newspaper’s website.
I won’t get back to the definitions of Wicksell’s money and natural rates of interest as I’ve done it in two recent posts (here and here). I only wish today to comment on The Economist’s interpretation (and misconceptions) of the Wicksellian rate.
A few of things shocked me in this week’s column. First, the assertions that “the natural rate prevails when the economy is at full employment” and that “the natural interest rate is often assumed to be constant.” I’m sorry…what? Putting aside the fact that ‘full employment’ is hard to define, there can be full employment with interest rates below or above their natural level, and interest rates can be at their natural level with the economy not at full employment. Many other ‘real’ factors have effects on ‘full employment’. Using full employment as a basis for spotting the equilibrium rate is dangerous.
Second, where did they get that the natural interest rate was constant? This doesn’t make sense. The natural interest rate rises and decreases following a few variables (various economic schools of thought will have differing opinions) such as time preference (i.e. whether or not people prefer to use income for immediate or future consumption), marginal product of capital (demand for loanable funds by entrepreneurs would increase as long as they can make a profit on the marginal increase in capital stock, driving up the interest rate in the process), liquidity preference (i.e. whether or not people desire to hold money as cash rather than some other less liquid form of wealth – pretty much the only important factor driving the interest rate for Keynesians –)… As you can imagine, all those factors vary constantly, impacting the demand for money and the demand for credit and in turn the rate of interest. It clearly does not remain constant…
The Economist also dismisses the possibility that real interest rates are too low by the fact that sovereign bonds’ yields are low, not only in the US (where the Fed is engaged in massive bonds purchases), but also in other economies whose central banks are less active in purchasing sovereign debt. But it overlooks the fact that natural rates aren’t uniform and may well be lower in other countries (for example, the natural rate was probably lower in Germany than in Spain and Ireland before the crisis, despite having a common central bank). It also overlooks that ‘risk-free’ rates used as a basis of most financial calculations internationally are US Treasuries, not sovereign bonds of other countries.
Finally, in support of its point, the column argues that expected future low rates could also reflect investors’ expectations of sluggish future growth and that “despite profit margins near record levels and rock-bottom interest rates, business investment has been sluggish, recently peaking at just above 12% of GDP; it topped 14% in the late 1990s.” Once again, this is misinterpreting the natural rate: the level of the natural rate of interest does not necessarily depend on expected future economic growth as I described above. Sluggish business investments also are more likely to reflect current regulatory ‘regime uncertainty’ than entrepreneurs’ doubts about the future state of the economy. On top of that, using the dotcom bubble as a reference for business investment is intellectually dishonest. Moreover, the article contradicts itself starting with “central banks ignore this century-old observation at their peril” only to conclude that “all this suggests that policy rates, low as they seem, are not out of line with their natural level.” Hhhmmm, ok.
The Free Exchange blog post by Greg Ip is a little better but still overall quite confused and confusing. Interestingly, it cites a paper by Bill White (http://dallasfed.org/assets/documents/institute/wpapers/2012/0126.pdf) who argues that the sort of yield-chasing that we can witness in financial markets today is a symptom of nominal rates being lower than natural rates. Doesn’t this remind you of anything? That’s right; it was exactly my point in this post. But it then cites Brad de Long, who can be added to the list of people who don’t understand what regulatory uncertainty is, and who tries as a result to convince us that the natural rate is below zero. Theoretically, a below zero natural rate if possible in period of deflation. But it does not make much sense to have a natural rate below zero when inflation is above zero.
It is definitely a hard task to identify the natural rate of interest. Nonetheless, a few rules of thumb are sometimes better than overly-complex reasoning. Investors would be perfectly happy with negative nominal yields if cost of life was declining even faster. This is obviously not the case at the moment.
Quick update on recent news: John Kay, hedge funds and house prices control
John Kay wrote an interesting piece in the FT yesterday saying that finance should be treated like fast food to secure stability. I can’t agree more. A nice quote:
Still, would it not be better if proper supervision ensured that no financial institution could ever get into a mess like Northern Rock or Lehman – or Royal Bank of Scotland or Citigroup or AIG? No, it would not. Just replace “financial institution” with “fast-food outlet” or “supermarket” or “carmaker” in that sentence to see how peculiar is the suggestion.
I know what you’re going to say: “but banks are different!” To which I would reply: no, they aren’t. It is treating them as different that makes them different.
Another nice one:
We have experience of structures in which committees in Moscow or Washington take the place of the market in determining the criteria by which a well-run organisation should be judged, and that experience is not encouraging. The truth is that in a constantly changing environment nobody really knows how organisations should best be run, and it is through trial and error that we find out.
I am a little surprised though, as I have the impression that John Kay is kind of contradicting himself (see his post from June in which he seems to say that banking reforms are going the right direction).
Another piece highlighted how much regulation is changing the hedge fund industry. What’s going on is that regulation is now limiting new entrants in the market as they can’t cope with booming compliance costs. This results in the largest hedge funds experiencing most of new money inflow from investors. Is this a problem? Yes. First, small hedge funds have traditionally outperformed large and established ones on average. So preventing them from entering the market reduces market and economic efficiency: proper allocation of capital to where it would be the most profitable does not happen as a result (and consequently, returns to investors are lower). Second, and more worrying, is that regulation is now replicating what has happened in the banking industry: it’s creating too big to fail hedge funds (and nobody seems to remember LTCM). Well done guys.
Finally for today, echoing my earlier post, a BoE member thinks that it is not the role of the central bank to control house prices. I certainly agree.
Should the Bank of England have tools to prick property bubbles?
The answer is no. (but not according to this FT article)
Wait… Actually, it already has tools: it’s called monetary policy. Place the interest rate at the right level and stop massively injecting cash in the economy and, perhaps, you won’t witness real estate bubbles?
There are other hugely distorting UK government policies at the moment: the Funding-for-Lending scheme and the more recent Help-to-Buy, which both push demand for property up through artificially low interest rates. I’ll explain that in details in another post.
So the question becomes: why adding other distorting tools (whether ‘macroprudential‘ or ‘microprudential‘) and policies, such as maximum loan-to-value or loan-to-income ratios, on top of already deficient tools and policies? I have another suggestion: why not trying to correct the failings of the first layer of policies? Just saying.
PS: Lord Turner is obviously mentioned in this FT article.
Spontaneous Finance 
Recent Comments