Tag Archive | Regulation

Liquidity and collateral are two sides of the same coin

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

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

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

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

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

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

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

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

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

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

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

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

Vincent points at the new Fatal Conceit

William Vincent, a veteran bank equity analyst, published a very good piece on the SNL website (gated unfortunately).

This is Vincent:

To most people in and around the banking industry, the term Basel III probably means a revised set of capital ratios, building on the two earlier, and failed, Basel structures. They are right, of course. But Basel III means a great deal more. When all of its measures are taken into account, it is clear that regulators are not just introducing another capital ratio regime. They are fundamentally altering how banks are controlled and run.

They are, in short, removing banks’ freedom, within limits, to run themselves as they and their shareholders see fit. In the pursuit of reducing the risk of another global banking crisis, they are tearing up a system that took centuries of trial and error to produce, replacing it with a set of rigid rules that will, in effect, mean that banks’ management will run their institutions on behalf of regulators, not the owners of the business.

To which he adds:

This in itself raises an interesting question: why should regulators be better placed to assess risk than the people who actually do it for a living?

Thumbs up.

Perhaps it is time we raise funds through Kickstarter to send thousands of copies of Hayek’s The Fatal Conceit to regulators?

In defence of the leverage ratio

Regular readers know that I blame risk-based capital requirements for many of the ills of our current banking system. Before the introduction of Basel regulations, banks’ capital level used to be assessed using more standard and simple leverage ratios (equity or capital/total assets). Those ratios have mostly disappeared since the end of the 1980s but Basel 3 is now re-introducing its own version (Tier 1 capital/total exposures).

While I believe there should not be any regulatory minimum capital requirement, I also do believe that, if regulators had to pick one main measure of capitalisation, it should be a standard leverage ratio. All RWA-based ratios should be scrapped.

Leverage ratios historical

A new study just added to the growing body of evidence that leverage ratios perform better than RWA-based ones as predictor of banks’ riskiness. Andrew Haldane, from the BoE, has been a long-time supporter of leverage ratios. Admati and Hellwig also backed non-risk weighted ratios. Another paper recently suggested that there was nothing in the literature that justified the level of risk-weights.

Still, most economists, central bankers and regulators consider leverage ratios as mere backstops to complement the more ‘scientific’ (read, more complex, as there is no science behind risk-weights) Basel RWA-based ratios. See this speech from Andreas Dombret, which sums up most criticisms towards simple leverage ratios:

Yet a leverage ratio would also create the wrong incentives. If banks had to hold the same percentage of capital against all assets, any institution wanting to maximise its profits would probably invest in high-risk assets, as they produce particularly high returns. This would eradicate the corrective influence of capital cover in reducing risk.

Unfortunately, Mr. Dombret and many others are very misinformed.

A leverage ratio would not incentivise banks to leverage up to the allowed limit. Under Basel’s RWA framework, no banks operated with the bare regulatory minimum. Critics forget that different banks have different risk aversion and different risk/reward profiles. Some banks generate relatively low RoEs in return for lower level of risk. Others are willing to take on more risks to generate higher margins and higher RoEs. Banks are not uniform.

Banks would not necessarily pile into the riskiest assets under a leverage ratio either. The answer to this is the same as above. Banks have different cultures and different risk/return profiles to offer to investors. There is no reason why all banks would suddenly lend to the riskiest borrowers to improve their earnings. Such criticism could also easily apply to Basel capital ratios: why didn’t all banks follow the same investment strategy? Critics forget that banks do not try to maximise their profits. They try to maximise their risk-adjusted profits. Finally, such argument only demonstrates its proponents’ ignorance of banking history, as if all banks had always been investing in the riskiest assets in the 300 years before Basel introduced those risk-weights.

RWA-based capital ratios are very patronising: because the riskiness of the assets is already embedded within the ratio, banks are effectively telling markets how risky they are. This became overly sarcastic with Basel 2, which allowed large banks to calculate their own risk-weights (i.e. the so-called ‘internal rating based’ method). It has been proved that, for a given portfolio of assets, risk-weights were considerably varying across banks (see here and here). Given the same balance sheet, one bank could, say, report a 10% Tier 1 ratio, and another one, 14%, implying massive variations in RWA density (RWAs/total assets). A given bank could also change its RWA calculation model (and hence its RWA density) in between two reporting periods, making a mockery of period to period comparison. Of course, all this is approved by regulators. Consequently RWA-based capital ratios became essentially meaningless.

As a result, a leverage ratio would provide a ‘purer’ measure of capitalisation that markets could then compare with their own assessment of banks’ balance sheet riskiness.

Scrapping RWA-based capital ratios would also provide major economic benefits. As regularly argued on this blog, RWA-incentivised regulatory arbitrage has been hugely damaging for the economy and is in large part responsible for the recent internationally-coordinated housing bubbles and ‘secular’ low level of business lending. Getting rid of such regulatory ratio would benefit us all by removing an indicator that has big distortionary effects on the economy.

Of course, there are still a few issues, though they remain relatively minor. The main one is that differences in accounting standards across jurisdictions do not lead to the same leverage ratios (i.e. US GAAP banks have much less restrictions to net their derivative positions than IFRS ones). But those accounting issues can easily be corrected if necessary for international comparison. The second one is what definition of capital to use: common equity? Tier 1 capital? Another problem is the fact that very low risk banks, which don’t need much capital, would also get penalised. In the end, it’s likely that any regulatory ratio will prove distortive in a way or another. Why not scrap them all and let the market do its job?

Chart: Guardian

Chinese regulation, the European way

Some European banking regulators are currently considering the implementation of a sovereign bond exposure cap of 25% of capital to any one sovereign. Their goal is to break the link between sovereigns and banks. I think they don’t really know what they are doing.

China Europe

European sovereign bond markets are distorted in all possible ways:

  • The Basel banking regulation framework has been awarding 0% risk-weight to OECD sovereign debt since the 1980s, meaning purchasing such asset does not require any capital. Recent rules haven’t changed anything to this.
  • On the contrary, Basel 3 introduces a liquidity ratio (LCR) basically requiring banks to hold even more sovereign debt on their balance sheet (as part of so-called highly-liquid ‘Level 1 assets’).
  • Meanwhile, the ECB, as well as the BoE, have been trying to revive business lending (which suffers from the opposite problem: high risk-weights) by launching cheap funding programmes (LTRO, TLTRO, FLS…). Banks drawn on those facilities to invest in… more 0% weighted sovereign debt, and earn capital-free interest income. We call this the ‘carry trade’.
  • Furthermore, investors (including banks) have started seeing peripheral European debt as virtually risk-free thanks to the ECB pledge that it would do whatever it takes to prevent defaults in those countries.

There you are: had European regulators wanted to reinforce the link between sovereigns and banks, they wouldn’t have been more successful. Their usual talk of breaking the link between banks and sovereigns has been completely undermined by their own actions.

The easy solution would have been to scrap risk-weights (or at least increase them on sovereign bonds). But this was too simple, so European policymakers decided to go the Chinese way: never scrap a bad rule; design a new one to fix it; and another one to fix the previous one that fixed the original one.

The new 25% cap would only add further distortion: while Basel’s risk-weights do not differentiate between Portuguese and German bonds, the 25% rule doesn’t either. But, you would retort, this isn’t the point: the point is to limit the exposure to any single sovereign. I agree that diversification is usually a good thing. But 1. lack of diversification has been encouraged by policymakers’ own decisions, and 2. forcing banks to diversify away from the safest sovereigns just for the sake of diversifying may well put many banks’ balance sheet more at risk.

Finally, Fitch estimates at EUR1.1Trn the amount of debt that would need to be offloaded. This is very likely to affect markets and could result in banks taking serious one-off hits on their available-for-sale and marked-to-market bond portfolios, resulting in weaker capital positions. This could also raise overall interest rates, in particular in riskier (and weaker) European countries. Fitch believes banks could rebalance into Level 1-elligible covered bonds. Maybe, but this would only introduce even more distortions in the market by artificially raising the demand for their underlying assets, and this would encumber banks’ balance sheets even further, creating other sorts of risks.

Why pick a simple solution when you can do it the Chinese way?


Photo: picture-alliance / dpa through www.dw.de

NESTA’s alternative finance data goldmine

NESTA, a UK-based charity promoting innovation (and which also organised the annual UK Barcamp Bank), just released its new report on alternative finance trends in the UK. It is a goldmine. The report if full of interesting charts and figures and in many ways tells us a lot about the current state of our traditional financial sector (and possibly of the stance of monetary policy).

Some charts and comments are of particular interest. To my surprise, business lending through P2P platforms was the biggest provider of funds in terms of total amount:


According to the report:

79 per cent of borrowers had attempted to get a bank loan before turning to P2P business lending, with only 22 per cent of borrowers being offered a bank loan. 33 per cent thought it was unlikely or very unlikely that they would have been able to secure funding elsewhere had they not been successful in getting a loan through the P2P business lending platform, whereas 44 per cent of respondents thought they would have been likely or very likely to secure funding from other sources had they not used P2P business lending.

Given bank regulation that penalises banks for lending to small firms, none of this is surprising. As I keep saying, regulation is the primary driver of financial innovation. P2P business lending owes a lot to regulators… until it gets regulated itself?

Another very interesting chart was the following one:



This is crazy. Wealthy people pretty much shun P2P and other alternative finance forms. Why is that? Here’s my theory: wealthy people are usually well advised financially and have access to more investment opportunities than less-wealthy household. Consequently, a low interest environment isn’t that much of a problem (in the short-term): they have the ability to move down the risk scale to look for extra yield. On the other hand, household with more ‘moderate’ incomes do not have access to such investment opportunities: they are the ones hit by low returns on investments. P2P provides them with a unique opportunity to boost the meagre returns on their savings as long as real interest rates remain that low (i.e. lower than inflation):

[The funders] in P2P lending and equity-based crowdfunding were primarily driven by the prospect of financial returns with less concern for backing local businesses or supporting social causes.



Figures concerning P2P consumer lending are similar.

Those figures are both worrying and encouraging. Worrying because the harm that low interest rates and regulation seem to have on the economy and the traditional banking sector. Encouraging because finance is reorganising itself to respond to both borrowers’ and lenders’ demands. This is spontaneous order at work. Let just hope this does not add another layer of complexity and opacity to our already overly-complex financial system.

When regulators become defiant of… regulation

After years of regulatory boom, some politicians, and regulators, seem to be – slowly – waking up. I have already described how UK’s Vince Cable seemed to now partially understand that regulation doesn’t make it easy for banks to lend to small and medium-sized businesses, and how Andrew Bailey, from the Bank of England’s Prudential Regulation Authority, complained about the lack of regulatory coordination across country:

I am trying to build capital in firms, and it is draining out down the other side.

Well, Bailey is at it again. Reuters summarized Bailey’s latest speech as:

The over-zealous application of anti-money laundering rules is hampering British banks abroad and cutting off poorer countries from global financial markets, a top Bank of England regulator said on Tuesday.

He said:

We have no sympathy with money laundering, but we are facing a frankly serious international coordination problem. […] We are seeing clear evidence … of parts of the world and activities that are being cut off from the mainstream banking system. […] It cannot be a good thing for the development of the world economy and the support of emerging countries … that we get into that situation. […] I have to spend a large part of my time dealing with the issues that come up in this field … because some of the consequences of the actions taken are potentially existential.

I find it quite ironic to see a regulator disapproving ‘over-zealous’ regulation. Another regulator, Jon Cunliffe, Deputy Governor of the Bank of England, declared that:

Liquidity and market making does seem to have been reduced. […] We’re not sure how much of it is the result of regulatory action, and how much of it is do with the change in business model for the institutions.

While he believes that some of the pre-crisis liquidity was ‘illusory’, his statement clearly indicates that he knows that regulation might not have had only positive effects. (Four days after I spoke about regulatory effects on market liquidity, Fitch published a press release arguing the exact same thing. I still have to write that post…)

Unfortunately, not all regulators are waking up. Reuters reported that David Rule, also from the BoE, said that:

banks had responded to regulatory incentives and increased their focus on the real economy, rather than financial market trading for its own sake.

Really? With business lending stuck at the bottom and mortgage lending (a very productive form a lending to the real economy) booming again? I see.

Andreas Dombret, of the Bundesbank, recently declared in a relatively reasonable speech* that:

But are we really overregulating? If we look at the benefits to society of a stable banking system and the social costs of a banking crisis, I believe the costs of regulation are justifiable.

Clearly he and Bailey should have a proper conversation…

Others, like Andrea Enria, Chairman of the European Banking Authority, which recently ran the European stress tests, warned that

The story is not over, even for the banks who passed it

I am unsure what the goal of that sort of threatening comment is, but I don’t see how this can reintroduce confidence in the European banking system. It certainly will push bankers to consolidate their balance sheet further rather than to start lending more. Let’s not forget that the EBA and ECB tests have the power to create a panic and destabilise markets when nothing would have occurred. Too soft and nobody would trust the tests. Too tough and a panic might set in (imagine the headlines: “Half of European banks at risk of failure!”). Another risk is that investors and commentators stop relying on their own judgment and analysis and start relying too much on regulators’ assessment. This would be extremely dangerous. Yet this already happens to an extent. Perhaps, as more and more regulators start waking up to the potentially harmful side effects of regulatory measures, they will back off and let the market play its role?


* While the speech is overall reasonable, Dombret still comes up with usual myths such as

Yet a leverage ratio would also create the wrong incentives. If banks had to hold the same percentage of capital against all assets, any institution wanting to maximise its profits would probably invest in high-risk assets, as they produce particularly high returns.

This is not correct.

Funnily, he also kind of admitted that regulators did not always understand how banking works, as I’ve been arguing a few times recently:

Do supervisors have to be the “better bankers”? No, absolutely not. Business decisions must be left to those being paid to make them. However, supervisors have to know – and understand – how banking works. Against this background, I personally would very much welcome an increase in the migration of staff between the banking industry and the supervisory agencies.

Still, many regulators influence business decisions…

Martin Wolf’s not so shocking shocks

Martin Wolf, FT’s chief economist, recently published a new book, The Shifts and the Shocks. The book reads like a massive Financial Times article. The style is quite ‘heavy’ and not always easy to read: Wolf throws at us numbers and numbers within sentences rather than displaying them in tables. This format is more adapted to newspaper articles.

Overall, it’s typical Martin Wolf, and FT readers surely already know most of the content of the book. I won’t come back to his economic policy advices here, as I wish to focus on a topic more adapted to my blog: his views on banking.

And unfortunately his arguments in this area are rather poor. And poorly researched.

Wolf Shifts and Shocks

Wolf is a fervent admirer of Hyman Minsky. As a result, he believes that the financial system is inherently unstable and that financial imbalances are endogenously generated. In Minsky’s opinion, crises happen. It’s just the way it is. There is no underlying factor/trigger. This belief is both cynical and wrong, as proved by the stability of both the numerous periods of free banking throughout history (see the track record here) and of the least regulated modern banking systems (which don’t even have lenders of last resort or deposit insurance). But it doesn’t fit Wolf’s story so let’s just forget about it: banking systems are unstable; it’s just the way it is.

Wolf identifies several points that led to the 2000s banking failure. In particular, liberalisation stands out (as you would have guessed) as the main culprit. According to him “by the 1980s and 1990s, a veritable bonfire of regulations was under way, along with a general culture of laissez-faire.” What’s interesting is that Wolf never ever bothers actually providing any evidence of his claims throughout the book (which is surprising given the number of figures included in the 350+ pages). What/how many regulations were scrapped and where? He merely repeats the convenient myth that the banking system was liberalised since the 1980s. We know this is wrong as, while high profile and almost useless rules like Glass-Steagall or the prohibition of interest payment on demand deposits were repealed in the US, the whole banking sector has been re-regulated since Basel 1 by numerous much more subtle and insidious rules, which now govern most banking activities. On a net basis, banking has been more regulated since the 1980s. But it doesn’t fit Wolf’s story so let’s just forget about it: banking systems were liberalised; it’s just the way it is.

Financial innovation was also to blame. Nevermind that those innovations, among them shadow banking, mostly arose from or grew because of Basel incentives. Basel rules provided lower risk-weight on securitized products, helping banks improve their return on regulatory capital. But it doesn’t fit Wolf’s story so let’s just forget about it: greedy bankers always come up with innovations; it’s just the way it is.

The worst is: Wolf does come close to understanding the issue. He rightly blames Basel risk-weights for underweighting sovereign debt. He also rightly blames banks’ risk management models (which are based on Basel guidance and validated by regulators). Still, he never makes the link between real estate booms throughout the world and low RE lending/RE securitized risk-weights (and US housing agencies)*. Housing booms happened as a consequence of inequality and savings gluts; it’s just the way it is.

All this leads Wolf to attack the new classical assumptions of efficient (and self-correcting) markets and rational expectations. While he may have a point, the reasoning that led to this conclusion couldn’t be further from the truth: markets have never been free in the pre-crisis era. Rational expectations indeed deserve to be questioned, but in no way does this cast doubt on the free market dynamic price-researching process. He also rightly criticises inflation targeting, but his remedy, higher inflation targets and government deficits financed through money printing, entirely miss the point.

What are Wolf other solutions? He first discusses alternative economic theoretical frameworks. He discusses the view of Austrians and agrees with them about banking but dismisses them outright as ‘liquidationists’ (the usual straw man argument being something like ‘look what happened when Hoover’s Treasury Secretary Mellon recommended liquidations during the Depression: a catastrophe’; sorry Martin, but Hoover never implemented Mellon’s measures…). He also only relies on a certain Rothbardian view of the Austrian tradition and quotes Jesus Huerta de Soto. It would have been interesting to discuss other Austrian schools of thought and writers, such as Selgin, White and Horwitz, who have an entirely different perception of what to do during a crisis. But he probably has never heard of them. He once again completely misunderstands Austrian arguments when he wonders how business people could so easily be misled by wrong monetary policy (and he, incredibly, believes this questions the very Austrian belief in laissez-faire), and when he cannot see that Austrians’ goals is to prevent the boom phase of the cycle, not ‘liquidate’ once the bust strikes…

Unsurprisingly, post-Keynesian Minsky is his school of choice. But he also partly endorses Modern Monetary Theory, and in particular its banking view:

banks do not lend out their reserves at the central bank. Banks create loans on their own, as already explained above. They do not need reserves to do so and, indeed, in most periods, their holdings of reserves are negligible.

I have already written at length why this view (the ‘endogenous money’ theory) is inaccurate (see here, here, here, here and here).

He then takes on finance and banking reform. He doubts of the effectiveness of Basel 3 (which he judges ‘astonishingly complex’) and macro-prudential measures, and I won’t disagree with him. But what he proposes is unclear. He seems to endorse a form of 100% reserve banking (the so-called Chicago Plan). As I have written on this blog before, I am really unsure that such form of banking, which cannot respond to fluctuations in the demand for money and potentially create monetary disequilibrium, would work well. Alternatively, he suggests almost getting rid of risk-weighted assets and hybrid capital instruments (he doesn’t understand their use… shareholder dilution anyone?) and force banks to build thicker equity buffers and report a simple leverage ratio. He dismisses the fact that higher capital requirements would impact economic activity by saying:

Nobody knows whether higher equity would mean a (or even any) significant loss of economic opportunities, though lobbyists for banks suggest that much higher equity ratios would mean the end of our economy. This is widely exaggerated. After all, banks are for the most part not funding new business activities, but rather the purchase of existing assets. The economic value of that is open to question.

Apart from the fact that he exaggerates banking lobbyists’ claims to in turn accuse them of… exaggerating, he here again demonstrates his ignorance of banking history. Before Basel rules, banks’ lending flows were mostly oriented towards productive commercial activities (strikingly, real estate lending only represented 3 to 8% of US banks’ balance sheets before the Great Depression). ‘Unproductive’ real estate lending only took over after the Basel ruleset was passed.

The case for higher capital requirements is not very convincing and primarily depends on the way rules are enforced. Moreover, there is too much focus on ‘equity’. Wolf got part of his inspiration from Admati and Hellwig’s book, The Bankers’ New Clothes. But after a rather awkward exchange I had with Admati on Twitter, I question their actual understanding of bank accounting:

Admati Twitter exchange


While his discussion of the Eurozone problems is quite interesting, his description of the Eurozone crisis still partly rests on false assumptions about the banking system. Unfortunately, it is sad to see that an experienced economist such as Martin Wolf can write a whole book attacking a straw man.


* In a rather comical moment, Wolf finds ‘unconvincing’ that US government housing policy could seriously inflate a housing bubble. To justify his opinion, he quotes three US Republican politicians who said that this view “largely ignores the credit bubble beyond housing. Credit spreads declined not just for housing, but also for other asset classes like commercial real estate.” Let’s just not tell them that ‘Real Estate’ comprises both residential housing and CRE…

Frances Coppola on regulatory arbitrage

Frances Coppola recently wrote an interesting article on the origins of the financial crisis, which reflects several of the points that I have made on this blog time and time again: the crisis is the resulting product of the combination of regulatory arbitrage and interest rates below their natural level (as well as a few other things). I encourage you to read her article (which is at least necessary to follow my own post).

Yet I believe her story isn’t fully accurate. While US banks were subject to a leverage ratio, they were also subject to Basel 1 rules. As I have demonstrated, Basel 1 caused a surge in real estate and sovereign lending, and boosted the use of securitization, through regulatory arbitrage as Basel applied low risk-weights to those asset classes (for the most recent evidence, see here). Unlike what Hyun Song Shin believes, banks were already circumventing the ‘spirit’ of Basel 1 as soon as it was published in 1988… Basel 2 didn’t change much, and its implementation in Europe was anyway too late to have much of an influence on the crisis storyline (which had been building up since the late 1980s).

As a result, I don’t believe that, if European banks had been subject to a leverage ratio, they would not have been able to invest in American securitized products. They would still have done it, and perhaps sacrificed other type of lending or investments in other securities instead. Why? Because RMBSs and other CDOs offered higher yields for lower capital requirements, ceteris paribus. Risk-adjusted profit-maximising banks quickly figure it out.

She concludes:

The story of the financial crisis is a story of the failure of safe assets. That is why it was so traumatic. People expect to take losses on risky investments. They don’t expect to take losses on safe ones. Yet we are still trying to make the financial system “safer” and encourage investors to invest in “safe” assets. When will we learn that the safest investment is a risky one, and the most dangerous investments are those that are believed to be completely safe?

And it is also a warning of the consequences of regulatory arbitrage. The fact that the US and European banks had different regulatory regimes created a golden opportunity for unregulated institutions to exploit, with catastrophic consequences. Yet the US, the UK and the EU are still devising their own systems of regulation with scant regard for international consistency. When will we learn that an international industry requires international regulation?

I would say that the crisis wasn’t a failure of safe assets per se. It was a failure of regulation that wanted us (or actually, forced us) to believe that some assets were safe, creating a vicious spiral as banks piled into those asset classes to maximise their return on regulatory capital.

Moreover, regulatory arbitrage isn’t a cross-border issue. Most countries experienced the same symptoms: increasing real estate prices and securitization-issuance volumes, and lower sovereign debt yields. This points to intra-Basel distortions within countries, not to extra-Basel arbitrage across countries. Regulatory arbitrage-driven financial imbalances are endogenous to Basel regulations. Cross-border arbitrage, the Euro, populist politics (which never dies, as US politicians – incredibly – want to revive Fannie and Freddie…), also played a secondary (and surely exacerbating) role, but they were not at the very root of the crisis.

PS: Frances just published a new article on the ECB stress tests. I don’t disagree with her, but I believe that it is easy to criticise the test in hindsight, once we found out the number of banks that failed: she could have attacked the methodology at the time it was published. She also missed that, if banks don’t increase lending post-result announcements, it isn’t necessarily because they are zombies (some may well be). But the test was run on phased-in Basel 3 CET1 figures, not fully-loaded ones. Many banks still have large capital adjustments/deleveraging to make before complying with fully-loaded Basel 3 requirements, which isn’t going to help lending growth, especially given that banks currently don’t cover their cost of capital. (Another inconsistency of the test is that some banks were tested against fully-loaded ratios, and in the end obviously appeared uglier than if they had been tested against the same standards as other banks. If all banks had been tested against fully-loaded capital ratios, 36 would have failed)

The Economist on mobile payments and market liquidity

The Economist recently published an article on mobile payment, which is suspicious of its success to say the least:

The fragmentation [of mobile payment systems] confuses merchants and consumers, who have yet to see what is in it for them. From their perspective, the current system works well. Swiping a credit card is not much harder than tapping a phone. Nor is it too risky, especially in America, since credit cards are protected against fraud. Upgrading to a new system is a hassle. Merchants have to install new terminals. Consumers need to store their card details on their phones, but still carry their cards around, since most stores are not yet properly equipped.

I believe the newspaper is too pessimistic. Yes, swapping credit cards is easy. But then it involves signing a bill (not the fastest and most modern system ever) and the card can be replicated. Hence why most of the rest of the developed world has moved to a ‘chip and pin’ form of card payment, which is only slightly more burdensome (and not very fast either). The US is also taking the same direction.

Most people who have recently swapped their ‘chip and pin’ card for a contactless one can witness how convenient and quick the new system is. Yet, they also believed that the previous system “worked well”. Following the same argument, it would have been hard to convince people to switch to cards since carrying cash also “worked well” (ok, it’s not as strong an argument). Switching to smartphone-based contactless payment would make the system as fast, yet reduce the number of cards and devices one carries.

The Economist continues:

But even Apple’s magic may not be enough to make mobile payments fly. It is not clear how merchants will benefit from Apple’s new ecosystem: it does not offer them lower fees for processing payments or useful data about their customers, as CurrentC does. As a result, they may refuse to sign up for Apple Pay or discourage its use.

Yet, as described above, speed is mobile payment’s major asset. Any retailer regularly experiencing long queues is likely to lose customers. Contactless cards already speed up the checkout process considerably. Unfortunately, they are usually capped to pay small amounts (GBP20 in the UK). Contactless mobile payment/NFC systems would remove that cap.


In another article, The Economist once again highlights its ambivalent stance towards regulation:

But the illiquidity problem will still be there when the next crisis occurs. In a sense, it is a problem caused by regulators; they wanted banks to be less exposed to the vicissitudes of markets. But you cannot make risk disappear altogether; you can only shift it to another place. Get ready for more moments of sheer market terror.

The article refers to the recent market turbulence and points to regulatory requirements that have made lack of liquidity a rather new problem:

Due to new regulatory restrictions and capital rules that make bond-trading less profitable, banks have cut back their inventories to the level of 2002, even though the value of bonds outstanding has doubled since then (see chart).

That is a problem when trading surges, as it did between October 10th and 16th, when volumes rose by 67%. “Credit is not a continuously priced market,” says Richard Ryan of M&G Investments, a fund manager. “When a bond price falls from 100 to 90, it won’t do so smoothly, but in big drops.”

This is correct. Market-making (mostly fixed income) is becoming trickier because harsher capital requirements make it more expensive to carry a large inventory of bonds through three channels: 1. deleveraging, as banks are pushed towards higher regulatory capital ratios (and as the new leverage ratio is introduced), 2. credit risk, as credit risk-weights are on upward trend, 3. market risk, as holding larger inventories penalise banks through higher market RWAs than before. I may write a whole post on this topic soon.

But the newspaper forgets liquidity requirements: banks are required to hold enough very liquid assets on their balance sheet (‘liquidity coverage ratio’). Given the combination of leverage and liquidity constraints, banks have to sacrifice other asset classes: the riskier bonds. This leads to the following very good chart, from a Citigroup report and reported by Felix Salmon at Reuters:

Dealer inventories

This has been an issue with The Economist since the start of the crisis: the same newspaper declares that banks needs to be regulated and safer and complains about the negative effects of regulation at the same time. Perhaps time to be less contradictory?


PS: The ECB published its stress test results yesterday. I won’t comment on them. I just thought the AQR was an interesting exercise, but its consequences must be carefully weighted and it is crucial not to over-interpret them (I’ve already written about the danger of ‘harmonizing’ assessments across multiple jurisdictions and cultures).

New research confirms the role of regulation and housing in modern business cycles

I think readers will find it hard to imagine how excited I was yesterday when I discovered (through an Amir Sufi piece in the FT) a brand new piece of research called: The Great Mortgaging: Housing Finance, Crises, and Business Cycles

(The authors, Jordà, Schularick and Taylor (JST), also published a free version here, and a summary on VOX)

I wish the authors had read my blog before writing their paper as it confirms many of my theses (unless they had?). It’s so interesting that I could almost quote two thirds of the paper here. I obviously encourage you to read it all and I will selectively copy and paste a few pieces below.

In my recent piece on updating the Austrian business cycle theory (ABCT), I pointed out that the nature of lending (and banks’ balance sheets) had changed over time since the 19th century (and particularly post-WW2), mainly due to banking regulation and government schemes. I had already provided a revealing post-WW2 chart for the US to demonstrate the effects of Basel 1 on business and real estate lending volumes.

US lending Basel

JST went further. They went further back in time and gathered a dataset of disaggregated lending figures covering 17 developed countries over close to 140 years. Their conclusions confirm my views. Regulations – and in particular Basel – changed everything.

Here is their aggregate credit to GDP chart across all covered countries, to which I added the introduction of Basel 1 as well as pre-Basel trends:


Historical aggregate lending

I don’t think there is anything clearer than this chart (I’m not sure that securitized mortgages are included, in which case those figures are understated). Since the 1870s, non-mortgage lending had been the main vector of credit and money supply growth, and mortgage lending represented a relatively modest share of banks’ balance sheet. Basel turned this logic upside-down. How? I have already described the process countless times (risk-weights and capital regulation), so let see what JST say about it:

Over a period of 140 years the level of non-mortgage lending to GDP has risen by a factor of about 3, while mortgage lending to GDP has risen by a factor of 8, with a big surge in the last 40 years. Virtually the entire increase in the bank lending to GDP ratios in our sample of 17 advanced economies has been driven by the rapid rise in mortgage lending relative to output since the 1970s. […]

In addition to country-specific housing policies, international banking regulation also contributed to the growing attractiveness of mortgage lending from the perspective of the banks. The Basel Committee on Bank Supervision (BCBS) was founded in 1974 in reaction to the collapse of Herstatt Bank in Germany. The Committee served as a forum to discuss international harmonization of international banking regulation. Its work led to the 1988 Basle Accord (Basel I) that introduced minimum capital requirements and, importantly, different risk weights for assets on banks’ balance sheets. Loans secured by mortgages on residential properties only carried half the risk weight of loans to companies. This provided another incentive for banks to expand their mortgage business which could be run with higher leverage. As Figure 1 shows, a significant share of the global growth of mortgage lending occurred in recent years following the first Basel Accord.

I wish they had expanded on this topic and made the logical next step: Basel helped set up the largest financial crisis in our lifetime through regulatory arbitrage. Nevertheless, the implications are crystal clear.

To JST, this growth in real estate lending is the reason underlying our most recent financial crises:

We document the rising share of real estate lending (i.e., bank loans secured against real estate) in total bank credit and the declining share of unsecured credit to businesses and households. We also document long-run sectoral trends in lending to companies and households (albeit for a somewhat shorter time span), which suggest that the growth of finance has been closely linked to an explosion of mortgage lending to households in the last quarter of the 20th century. […]

Since WWII, it is only the aftermaths of mortgage booms that are marked by deeper recessions and slower recoveries. This is true both in normal cycles and those associated with financial crises. […]

The type of credit does seem to matter, and we find evidence that the changing nature of financial intermediation has shifted the locus of crisis risks increasingly toward real estate lending cycles. Whereas in the pre-WWII period mortgage lending is not statistically significant, either individually or when used jointly with unsecured credit, it becomes highly significant as a crisis predictor in the post-WWII period.

JST confirm what I was describing in my post on updating the ABCT: that is, that banks don’t play the same role as in early 20th century, when the theory was first outlined:

The intermediation of household savings for productive investment in the business sector—the standard textbook role of the financial sector—constitutes only a minor share of the business of banking today, even though it was a central part of that business in the 19th and early 20th centuries.

JST describe the post-WW2 changes in mortgage lending originally as a result of government schemes to favour home building and ownership, followed by international regulatory arrangements (Basel) from the 1980s onward. Those measures and rules led to a massive restructuring of banks’ balance sheet, as demonstrated by this chart:

Historical aggregate RE lendingWhile the empirical findings of this paper will be of no surprise to readers of this blog, this research paper deserves praise: its data gathering and empirical analysis are simply brilliant, and it at last offers us the opportunity to make other mainstream academics and regulators aware of the damages their ideas and policies have made to our economy over the past decades. It also puts the idea of ‘secular stagnation’ into perspective: our societies are condemned to stagnate if regulatory arbitrage starve our productive businesses of funds and the only way to generate wealth is through housing bubbles.


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