From the Outside

Bank dividends

Matt Levine’s “Money Stuff” column (Bloomberg) offers some interesting commentary on what is happening with bank dividends in the US. Under the sub heading “People are worried about dividends” he writes:

So, again, I am generally pretty impressed by the performance of bank regulation in the current crisis, but this is unfortunate:
US banks’ annual capital plans, due to be submitted to the Federal Reserve on Monday, are expected to include proposals to continue paying dividends, reinforcing comments from prominent bank chief executives in recent days, according to people familiar with the situation.
The bankers, including Goldman Sachs boss David Solomon, Morgan Stanley boss James Gorman and Citigroup chief Mike Corbat, argued that they had the means to continue paying dividends and that cutting them would be “destabilising to investors”.
“We’re in a very different position than what we see in Europe,” said Marty Mosby, a veteran banks analyst at Vining Sparks.
“How we set it up [post-crisis capital requirements] was to be able to not have those dividends collapse [in a crisis]. That’s what creates a financial crisis: when dividends start to be ratcheted lower that shakes confidence.”
What is unfortunate is not so much that U.S. banks want to continue paying dividends; for all I know some of them are so well capitalized and so well equipped to weather this crisis that they will actually make a lot of money and have plentiful profits to pay out to shareholders. What is unfortunate is that their explicit view is that cutting dividends would be destabilizing. Common shareholders are supposed to be the lowest-ranking claimants on a bank’s money. The point of equity capital is that you don’t have to pay it out, that it doesn’t create any cash drain in difficult times. But if your view is “we need to maintain our dividend every quarter or else there will be a run on the bank,” then that means that the dividend is destabilizing; it means that your common stock is really debt; it means that your equity capital is not as good—not as equity-like—as it’s supposed to be.
If you take seriously the claim that banks can’t cut dividends in a generational crisis, for fear of undermining investor confidence, then, fine, I guess, but then the obvious conclusion is that when times are good you can never let banks raise their dividends. Every time a bank raises its dividend, on this theory, it incurs more unavoidable quarterly debt and creates a new drain on its funding, one that can’t be turned off in the bad times for fear of being “destabilising to investors”
Bloomberg Opinion “Money Stuff” 7 April 2020

I get the argument that if banks have the means to pay a dividend then they should be free to make a commercial decision. People may however feel entitled to be skeptical given the ways in which some banks were slow to adjust to the new realities of the GFC. There is also a line where the position some US banks appear to be projecting risks becoming an expectation that the dividend should be stable even under a highly stressed and uncertain outlook. It is not clear if that is exactly what the US banks quoted in his column are saying but that is how Matt Levine frames it and it would clearly be a concern if that is their view. That does seem to a fair description of the view some investors and analysts are expressing.

Jamie Dimon seems to be offering a more nuanced perspective on this question. He has advised JP Morgan shareholders that the Board expects the bank to remain profitable under its base base projections but would consider suspending the dividend under an extremely adverse scenario.

Our 2019 pretax earnings were $48 billion – a huge and powerful earnings stream that enables us to absorb the loss of revenues and the higher credit costs that inevitably follow a crisis. For comparison, the Comprehensive Capital Analysis and Review (CCAR) results for 2020 that we submitted to the Federal Reserve in 2019 (which assumed outcomes like U.S. unemployment peaking at 10% and the stock market falling 50%) showed a decline in revenue of almost 20% and credit costs of approximately $20 billion more than what we experienced in 2019. We believe we would perform better than this if the Fed’s scenario were to actually occur. But even in the Fed’s scenario, we would be profitable in every quarter. These stress test results also show that following such a meaningful reduction in our revenue (and assuming we continue to pay dividends), our common equity Tier 1 (CET1) ratio would likely hold at a very strong 10%, and we would have in excess of $500 billion of liquid assets.
Additionally, we have run an extremely adverse scenario that assumes an even deeper contraction of gross domestic product, down as much as 35% in the second quarter and lasting through the end of the year, and with U.S. unemployment continuing to increase, peaking at 14% in the fourth quarter. Even under this scenario, the company would still end the year with strong liquidity and a CET1 ratio of approximately 9.5% (common equity Tier 1 capital would still total $170 billion). This scenario is quite severe and, we hope, unlikely. If it were to play out, the Board would likely consider suspending the dividend even though it is a rather small claim on our equity capital base. If the Board suspended the dividend, it would be out of extreme prudence and based upon continued uncertainty over what the next few years will bring.
It is also important to be aware that in both our central case scenario for 2020 results and in our extremely adverse scenario, we are lending – currently or plan to do so – an additional $150 billion for our clients’ needs. Despite this, our capital resources and liquidity are very strong in both models. We have over $500 billion in total liquid assets and an incremental $300+ billion borrowing capacity at the Federal Reserve and Federal Home Loan Banks, if needed, to support these loans, as well as meet our liquidity requirements (these numbers do not include the potential use of some of the Fed’s newly created facilities). We could, of course, make our capital and liquidity buffer better by restricting our activities, but we do not intend to do that – our clients need us.
JP Morgan Chairman and CEO Letter to Shareholders 2019 Annual Report

Banks are cyclical investments – who knew?

Stress testing models must of course be treated with caution but what I think this mostly illustrates is that banks are highly cyclical investments. That may seem like a statement of the obvious but there was a narrative post GFC that banks were public utilities and that bank shareholders should expect to earn public utility style returns on their investments.

There is an element of truth in this analogy in so far as banks clearly provide an essential public service. I am also sympathetic to the argument that banking is a form of private/public partnership. This pandemic is however a timely reminder of the limits of the argument that banks are just another low risk utility style of business. Bank shareholders are much more exposed to the cyclical impacts than true utility investments.

In the interests of full disclosure, I have a substantial exposure to bank shares and I for one need a lot more than a single digit return to compensate for the pain that part of my portfolio is currently experiencing. The only upside is that I never bought into the thesis that banks are a low risk utility style investment requiring a commensurately low return.

The higher capital and liquidity requirements built up in response to the lessons of the GFC increase the odds that banks will survive the crisis and be a big part of the solution but banks are, and remain, quintessentially cyclical investments and the return bank investors require should reflect this. I think the lesson here is not to worry about the extent to which dividend cuts would be destabilising to investors but to focus on what kind of return is commensurate with the risk.

I will let APRA have the final say on what to expect …

APRA expects ADIs and insurers to limit discretionary capital distributions in the months ahead, to ensure that they instead use buffers and maintain capacity to continue to lend and underwrite insurance. This includes prudent reductions in dividends, taking into account the uncertain outlook for the operating environment and the need to preserve capacity to prioritise these critical activities.
Decisions on capital management need to be forward-looking, and in the current environment of significant uncertainty in the outlook, this can be very challenging. APRA is therefore providing Boards with the following additional guidance.²
During at least the next couple of months, APRA expects that all ADIs and insurers will:
– take a forward-looking view on the need to conserve capital and use capacity to support the economy;
– use stress testing to inform these views, and give due consideration to plausible downside scenarios (periodically refreshed and updated as conditions evolve); and
– initiate prudent capital management actions in response, on a pre-emptive basis, to ensure they maintain the confidence and capacity to continue to lend and support their customers.
During this period, APRA expects that ADIs and insurers will seriously consider deferring decisions on the appropriate level of dividends until the outlook is clearer. However, where a Board is confident that they are able to approve a dividend before this, on the basis of robust stress testing results that have been discussed with APRA, this should nevertheless be at a materially reduced level. Dividend payments should be offset to the extent possible through the use of dividend reinvestment plans and other capital management initiatives. APRA also expects that Boards will appropriately limit executive cash bonuses, mindful of the current challenging environment.
“APRA issues guidance to authorised deposit-taking institutions and insurers on capital management”, 7 April 2020

Tony (From the Outside)

Why the real economy needs a prudential authority too

Isabella Kaminska (FT Alphaville) offers an interesting perspective on ways in which prudential initiatives in the areas of capital, liquidity and bail-in that have strengthened the banking sector post GFC might be applied to the “real economy”.

The global financial crisis taught us that laissez-faire finance, when left to its own devices, tends to encourage extreme fragility by under capitalising the system for efficiency’s sake and making it far more systemically interdependent.
Pre-2008, banks operated on the thinnest of capital layers while taking extreme liquidity risk due to the presumption that wholesale liquidity markets would always be open and available to them. It was in this way that they saved on capital and liquidity costs and increased their return on equity.
Regulatory responses to the crisis understandably focused on boosting resilience by hiking capital buffers, liquidity ratios and also by introducing new types of loss absorbing structures. While it’s still too early to claim regulatory efforts were a definitive success, it does seem by and large the measures have worked to stymie a greater financial crisis this time around.
But what the 2008 crisis response may have overlooked is that bolstering banks to protect the economy means very little if the underlying real economy remains as thinly spread and interconnected as the financial sector always used to be.

The assessment that these banking initiatives “means very little” is possibly overstating the case. The problems we are facing today would be an order of magnitude greater if the banking system was not able to plays its part in the solution.

The core point, however, I think is absolutely on the money, the focus on efficiency comes at the expense of resilience. More importantly, a free market system, populated by economic agents pursuing their own interests shaped by a focus on relatively short term time horizons, does not seem to be well adapted for dealing with this problem on its own. The lessons prudential regulators learned about the limits of efficient markets and market discipline also apply in the real world.

Isabella looks at the way prudential capital and liquidity requirements operate in banking and draws analogies in the real economy. With respect to liquidity, she notes for example,

“… the just-in-time supply chain system can be viewed as the real economy’s version of a fractional reserve system, with reserves substitutable for inventories.
Meanwhile, the real economy’s presumption that additional inventories can be sourced from third party wholesale suppliers at a price as and when demand dictates, is equivalent to the banking sector’s presumption that liquidity can always be sourced from wholesale markets.
Though there is obviously one important difference.
Unlike the banking sector, the real economy has no lender of last resort that can magically conjure up more intensive care beds or toilet paper at the stroke of a keyboard when runs on such resources manifest unexpectedly.

So what are our options? Companies could increase their inventories (analogous to holding more liquid assets) or build excess capacity (analogous to building up a capital buffer) but it is very difficult for companies acting independently to do this if their competitors choose the short term cost efficient play and undercut them on price. The Prisoner’s Dilemma trumps market discipline and playing the long game.

Isabella frames the problem as follows:

short-term supply shortages can only be responded to with real world manufacturing capability, which itself is constrained by physical availability To that extent crisis responses can only really take two forms: 1) immediate investment in the build-up of new manufacturing capacity that can address the specific system shortages or, 2) the temporary reallocation of existing resources (with some adaptation cost) to new production purposes.
The problem with the first option is that it is not necessarily time efficient. Not every country has the capability to build two new hospitals from scratch in just 10 days. Nor the capacity to create unexpected supply just-in-time to deal with the problem.
New investment may not be economically optimal either. What happens to those hospitals when the crisis abates? Do they stand empty and idle? Do they get repurposed? Who will fund their maintenance and upkeep if they go unused? And at what cost to other vital services and goods?

Isabella’s proposal …

That leaves the reallocation of existing assets as the only sensible and economically efficient mitigatory response to surge-demand related crises like pandemic flu. But it’s clear that on that front we can be smarter about how we anticipate and prepare for such reallocation shocks. An obvious thing to do is to take a leaf out of banking regulators’ books, especially with regards to bail-inable capital, capital ratios and liquidity profiles.

Isabella offers two examples to illustrate her argument; one is power companies and the other is the health system.

She notes that power utilities manage demand-surge or supply-shock risk with interruptible contracts to industrial clients. She argues that these contracts equate to a type of bail-inable capital buffer, since the contracts allow utilities to temporarily suspend services to clients (at their cost) if and when critical needs are triggered elsewhere and supplies must be diverted.

I think she has a good point about the value of real options but I am less sure that bail-in is the right analogy. Bail-in is a permanent adjustment to the capital structure in which debt is converted to equity or written off. Preferably the former in order to maintain the loss hierarchy that would otherwise apply in liquidation. A contract that enables a temporary adjustment to expenses is a valuable option but not really a bail-in style option.

What she is identifying in this power utility example is more a company buying real options from its customers that reduces operating leverage by enabling the company to reduce the supply of service when it becomes expensive to supply. Companies that have high operating leverage have high fixed costs versus revenue and will, all other things being equal, tend to need to run more conservative financial leverage than companies with low operating leverage. So reduced operating leverage is a substitute for needing to hold more capital.

Isabella then explores the ways in which the liquidity, capital and bail-in analogies might be applied in healthcare. I can quibble with some of the analogies she draws to prudential capital and liquidity requirements. As an example of a capital requirement being applied to health care she proposes that …

“… governments could mandate makers of non-perishable emergency goods (such as medicines, toilet paper, face masks, hand sanitiser) to always keep two-weeks’ worth of additional supply on hand. And companies could also be mandated to maintain some share of total supply chain production capability entirely domestically, making them more resilient to globalised shocks”

Two weeks supply looks more like a liquidity buffer than a capital buffer but that does not make the ideas any the less worth considering as a way of making the real economy more resilient. The banking system had its crisis during the GFC and the real economy is being tested this time around. There are arguments about whether the changes to banking went far enough but it is clearly a lot better placed to play its part in this crisis than it was in the last. The question Isabella poses is what kinds of structural change will be required to make the real economy more resilient in the face of the next crisis.

Another example of FT Alphaville being a reliable source of ideas and information to help you think more deeply about the world.

Tony (From the Outside)

The power of ideas

This post was inspired by a paper by Dani Rodrik titled “When Ideas Trump Interests: Preferences, Worldviews, and Policy Innovations”. I have set out some more detailed notes here for the policy wonks but the paper is not light reading. The short version here attempts to highlight a couple of ideas I found especially interesting.

Rodrik starts by noting a tendency to interpret economic and social outcomes through the lens of “vested interests” while paying less attention to the ideas that underpin these outcomes. The vested interest approach looks for who benefits and how much power they have to explain outcomes. Rodrik does not dispute the relevance of understanding whose interests are in play when economic choices are being made but argues that “ideas” are an equally powerful motivating force.

Rodrik expresses his point this way:

“Ideas are strangely absent from modern models of political economy. In most prevailing theories of policy choice, the dominant role is instead played by “vested interests”—elites, lobbies, and rent-seeking groups which get their way at the expense of the general public. Economists, political scientists, and other social scientists appeal to the power of special interests to explain key puzzles in regulation, international trade, economic growth and development, puzzles in regulation, international trade, economic growth and development, and many other fields.”
“When Ideas Trump Interests: Preferences, Worldviews, and Policy Innovations” Dani Rodrik, Journal of Economic Perspectives—Volume 28, Number 1—Winter 2014—Pages 189–208

Applying this lens offers a broader and more nuanced perspective of how self and vested interest operates (emphasis added).

“… a focus on ideas provides us with a new perspective on vested interests too. As social constructivists like to put it, “interests are an idea.” Even if economic actors are driven purely by interests, they often have only a limited and preconceived idea of where their interests lie. This may be true in general, of course, but it is especially true in politics, where preferences are tightly linked to people’s sense of identity and new strategies can always be invented. What the economist typically treats as immutable self-interest is too often an artifact of ideas about who we are, how the world works, and what actions are available.”
Ibid

The importance of understanding how ideas drive public policy and personal choices resonates with me. One of the examples Rodrik used to illustrate his argument was bank regulation pre the GFC. Rodrik does not dispute that self and vested interests play a significant role but he explores the equally important role of ideas in shaping how interests are defined and pursued and the ways in which the models people use to understand the world shape their actions.

Applying this lens to bank regulation

Many observers … have argued that the policies that produced the crisis were the result of powerful banking and financial interests getting their way, which seems like a straightforward application of the theory of special interests.

But this begs the question why were banking vested interests allowed to get their way. The “vested interest” argument is “regulatory capture” but Rodrik offers an alternative explanation …

Still, without the wave of ideas “in the air” that favored financial liberalization and self-regulation and emphasized the impossibility (or undesirability) of government regulation, these vested interests would not have gotten nearly as much traction as they did. After all, powerful interests rarely get their way in a democracy by nakedly arguing for their own self-interest. Instead, they seek legitimacy for their arguments by saying these policies are in the public interest. The argument in favor of financial deregulation was not that it was good for Wall Street, but that it was good for Main Street.

Other observers have argued that the financial crisis was a result of excessive government intervention to support housing markets, especially for lower-income borrowers. These arguments were also grounded on certain ideas—about the social value of homeownership and the inattentiveness of the financial sector to those with lower incomes. Again, ideas apparently shaped politicians’ views of how the world works— and therefore their interest in acting in ways that precipitated the crisis.

I want to come back to this topic in another post. I have touched on the issue of self interest in an earlier post looking at a book by Samuel Bowles titled “The Moral Economy”. Rodrik’s paper offers another perspective on the issue as does his book “Economics Rules: Why Economics Works, When It Fails, and How To Tell The Difference”. I have some notes on a couple of other books including “The Economists’ Hour” by Binyamin Applebaum and The Value of Everything” by Mariana Mazzucato. All of these have something interesting to say but I want to think some more before attempting to say something.

Let me conclude for the moment with John Maynard Keynes (emphasis added …

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas. Not, indeed, immediately, but after a certain interval; for in the field of economic and political philosophy there are not many who are influenced by new theories after they are twenty-five or thirty years of age, so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest. But, soon or late, it is ideas, not vested interests, which are dangerous for good or evil.”
The General Theory of Employment, Interest and Money, 1936

Tony (From the Outside)

Two perspectives on bail outs

Nassim Taleb makes the case for not repeating the mistakes made in the GFC adding his voice to others who have already spoke out on this question.

But at least one airline executive does not see it this way

I am with Nassim on this one

Tony

Stress testing – lessons from the pandemic

The COVID 19 pandemic will inflict a lot of damage on our economy and society. The only upside is to learn something from it and come away stronger. With respect to stress testing, some of these lessons just reinforce things we already knew, in particular a proper understanding of:

The potential for IFRS 9 to amplify the procyclicality of the banking system,
The zone of validity of the modelling employed in stress testing, and
What a bank can do on its own to deal with the inherent uncertainty associated with projecting the range of potential future outcomes

But there is another insight (an “inconvenient truth?”) that is obvious in hindsight but sometimes denied on the basis of the risk of moral hazard. COVID 19 reminds us that there are limitations to what a bank can achieve with its own resources and acting independently of other financial institutions. The task gets even harder when banks are competing, as they are meant to do, with each other and the shadow banking sector and while community trust in the financial system is very low.

This I think is an important lesson from the pandemic. There is a class of scenario that is so deeply systemic that the solutions require cooperation and coordinated responses led by the government or the official family of regulators responsible for the financial system. This is something that banks and supervisors may be reluctant to acknowledge lest it be construed to be expecting or encouraging a bail out, but true none the less.

If you are time poor then stop here. If you have the time and interest then read on for a longer discussion of these issues.

Managing risk and uncertainty

An earlier post discussed the way in which COVID 19 is the first real rest of the IFRS 9 (and CECL) approach to loan loss provisioning introduced in response to some of the lessons learned in the GFC. I argued that

IFRS 9 by itself will not address the core lesson the GFC taught us about being pre-positioned to deal with uncertainty and
that the pandemic will hopefully draw attention to the need for more thought on how the Capital Buffer framework can be better designed to absorb the potentially dangerous positive feedback loop that IFRS 9 introduces.

This post looks at what insights the pandemic offers on the use of stress testing to calibrate bank capital requirements. Let me state at the outset that I do not seek to downplay the value of stress testing. To the contrary, I see huge value in stress testing and was happy for it to play a central role in the ICAAP’s that I have been involved with.

That said, I also see stress testing being used in ways that do not respect the inherent limitations of the modelling process. I suspect that the “zone of validity” for this kind of work probably caps out around a 1:25 year scenario; roughly what you might expect for a severe recession impacting a basically sound banking system. Banks obviously need more capital than this but we also need to guard against the risks of using probability to disguise uncertainty (see here, here and here). Honestly acknowledging the limitations of what we can know and incorporating a margin of safety to absorb what we don’t know (“unknown unknowns”) is an intellectually more honest approach rather than pretending (or even worse believing) that a bit of statistical modelling will give us true insight and control.

Historical stress results are also applied in ways that are inconsistent with the current risk profile of the organisation and the external environment in which the bank is operating. I have previously argued that the kinds of really severe historical downturns typically used to calibrate capital buffers are usually associated with conditions where endogenous weaknesses within the banking system are a key element in explaining the extent of the asset price declines and weak recoveries.

This endogenous/exogenous distinction is especially important when using historical episodes to calibrate how much capital banks need to hold. We possibly tend to take flexible exchange rates and sensible policy responses for granted but the severity of some historical scenarios was arguably exacerbated by unhelpful exchange rate coupled with monetary and fiscal policy settings that could not respond to the stress or were prevented from doing so.

This is not to say that these historical episodes are irrelevant or an argument against using very severe downturns to calibrate the resilience of capital buffers in the banking system. The argument that “this time is different” should always be treated with suspicion if not disdain. My argument is simply that distinguishing the exogenous and/or exogenous components of a stress outcome is a better foundation for interpreting stress test outcomes. I would hazard a guess that it is almost essential for reconciling the understandably conservative supervisory approach with internal stress testing which is based on what management typically assume to be essentially soundly managed risk positions but supervisors implicitly assume are not.

The core point in these previous posts remains relevant but the pandemic offers another perspective on stress testing that I want to explore in this post

Some basic principles

Stress testing is generally predicated on the idea that the size of the scenario impact increases in inverse proportion to the likelihood of the scenario. So a 1:25 year scenario should have a larger impact on profit and capital than a 1:10 year and a 1:100 or worse scenario should be larger again. The size of the impact is also likely to increase in a non-linear manner as the probability of the outcome declines.

The response to the pandemic however has the potential to bend that stress testing rule of thumb.

Arguably we are looking at a 1:100 year style event with COVID 19 (at a minimum 1:50 year) but the weight of public resources being thrown at the problem means that the impact on bank capital buffers might not be much worse than a severe recession which is typically thought of as something like a 1:25 scenario. That is the plan in any case; we are throwing everything at the problem to mitigate the impact both on individuals but also on the economic infrastructure that generates employment, spending and profits. The government response matters a lot in these scenarios. Banks acting alone can be strong enough to be part of the solution but capital alone does not fix the underlying issue.

This is something that a thoughtful analysis of stress testing outcomes has probably long recognised but not something you want to put in writing in case it can be misconstrued to imply that the bank is expecting a bail-out.

The pandemic is clearly an exogenous shock for the banking system and the economy as a whole. Unlike the GFC, the banking system has done nothing to contribute to the severity of the impact of the pandemic.

Supervisors have indicated that this is the time for the capital and liquidity buffers built up in response to the GFC to be used but I don’t see any sign of doubt that Australian banks are strong enough to ride out this shock (This is NOT financial advice). In fact, this time round, the banks seem set to be a big part of the solution and are willing to bear the costs to shareholders that involves. Witness the various programs of forbearance that banks have volunteered to help customers get through the crisis.

The question in stress testing is where to draw the line on what external support can be expected without creating moral hazard. There seems to be a boundary in the loss distribution where an exogenous shock increasingly demands cooperative solutions and some degree of public support is necessary. The issue with moral hazard remains and there should be consequences for banks whose approach to risk has contributed to the problem. At the same time there are limits to what individual self discipline can achieve.

This is not just saying that stress testing analysis should incorporate reliance on a bail-out. It is saying that we need to be realistic and honest about this rather than pretending that the market based economic system can function in these kinds of scenarios without any reliance on government bodies.

Proponents of the big capital thesis (see here) that emphasises large amounts of common equity might feel vindicated by a large external shock but I am not sure that the degree of government support required to deal with this scenario is something that fits neatly with their world view. I also have in mind the 1:200 year benchmark that the RBNZ attempted to employ when calibrating the capital requirements review. This is partly based on my “Zone of Validity” concern with modelling noted above but it is also far from clear that holding more capital would have substantially changed the play book we see being employed to deal with the consequences of the pandemic.

This view should not be confused with arguing that strong capital does not matter. I am 100% behind the idea of banks being held to account against a benchmark of being “Unquestionably Strong”. Holding capital consistent with this benchmark clearly helps reduce the risk to government of any liquidity support offered but it does not really change the fact that liquidity support will be required under some scenarios. The whole idea of Lender of Last Resort (LOLR) was developed during a period when banks were supposedly much better capitalised so liquidity risk seems to be a feature of the system not a bug. And to be clear, the support banks are getting to keep the economy functioning and able to recover deals with liquidity issues not solvency. If that is unacceptable then we need to start looking at more radical alternatives (see here and here)

This is a big topic so it is entirely possible that I am missing something. If so please let me know since the whole point of the post is “lessons learned”. In the interim this is my perspective, honestly but “lightly held” as all opinions should be.

Tony – From the Outside

Whatever it takes – II

Yesterday I flagged a couple of interesting articles on the actions the Fed was taking to respond to the economic consequences of the pandemic. In that spirit, Cecchetti and Schoenholtz’s “Money and Banking” blog has a post that goes into some of the background issues including the ways in which the political consequences of these measures need to be dealt with.

Over the past two weeks, the Federal Reserve has resurrected many of the policy tools that took many months to develop during the Great Financial Crisis of 2007-09 and several years to refine during the post-crisis recovery. The Fed was then learning through trial and error how to serve as an effective lender of last resort (see Tucker) and how to deploy the “new monetary policy tools” that are now part of central banks’ standard weaponry.
The good news is that the Fed’s crisis management muscles remain strong. The bad news is that the challenges of the Corona War are unprecedented. Success will require extraordinary creativity and flexibility from every part of the government. As in any war, the central bank needs to find additional ways to support the government’s efforts to steady the economy. A key challenge is to do so in a manner that allows for a smooth return to “peacetime” policy practices when the war is past.
In this post, we review the rationale for reintroducing the resurrected policy tools, distinguishing between those intended to restore market function or substitute for private intermediation, and those meant to alter financial conditions to support aggregate demand.
The Fed Goes to War; Money and Banking, 23 March 2020

The politics of this are covered by their post here

Our concern is with the legitimate and sustainable delegation of authority in a democracy. Given the distributional consequences associated with the purchase of private equity or debt, Congress and the President should explicitly authorize and allocate funds for any government acquisition. And, since this can be viewed as a form of partial nationalization, we doubt that the central bank—which needs to preserve its independence in peacetime—should be directly involved. Importantly, limiting the credit risk on the balance sheet of the central bank (even if there are fiscal guarantees) makes exit easier when the time comes. Even when credit risk is absent, think of how the distributional consequences of selling mortgage-backed securities (MBS) make it so much easier to shrink holding of Treasurys.
Ibid

The actions and politics covered in their post also overlap with the question that Barry Ritholz covered in his opinion column referenced in this post. Paul Krugman also has a view on this.

Tony

Whatever it takes

There is a lot going on but this is worth noting. Under old school banking, one of the functions of the central bank is to stand ready to be the Lender of Last Resort to the banks.

Matt Levine’s Bloomberg column today covered a fairly radical extension of this 19 century banking principle with the Fed now creating the capacity to lend directly to business. There are reasons why the US market needs to consider unconventional solutions outside the banking system (big companies in the US tend to be less reliant on bank intermediated finance than is the case in Australia and Europe) but this is still something to note and watch.

Also worth reading John Cochrane’s “The Grumpy Economist” blog which goes into some of the mechanics. Matt Levine’s editor titled his column as “Companies can borrow from the Fed now”. I am not sure how much difference it takes in practice but John makes the point that technically it is the US Treasury doing the lending, not the Fed.

Interesting times

Tony

A better bail out

Interesting article by Barry Ritholz arguing the case to not repeat the mistakes made in the GFC.

www.bloomberg.com/opinion/articles/2020-03-23/coronavirus-u-s-needs-to-do-bailouts-the-right-way-this-time

“Today, we have a new crisis, one with roots in the last rescue plan. In fashioning our response to the 2020 Covid-19 pandemic, we should be careful to avoid the mistakes made in haste then. Consider three broad categories of the last crisis’ errors: 1) inadequate fiscal stimulus; 2) lack of support for the social safety net; and 3) overly generous bailouts terms for banks and other companies. All were unpardonable, but for now let’s focus on the third error.”

We are seeing clear evidence that fiscal support will be available and that government recognises the need to help individuals and small companies get through this crisis. What is up for grabs is the terms on which larger companies (Barry cites the airlines) are supported. His point that the government should make sure it retains a share of the upside seems fair to me. If a company can get a better deal somewhere else then it should take it.

Tony

APRA’s approach to COVID 19

I have been flagging the potential for IFRS 9 to amplify the impact of the COVID 19 pandemic. This announcement from APRA is broader than IFRS 9 but does seem to be responding to this risk. This is obviously a welcome response to the immediate issue but I still believe the design issue with procyclicality needs to be addressed once the crisis is over.

This link takes you to APRA’s announcement

https://www.apra.gov.au/news-and-publications/apra-advises-regulatory-approach-to-covid-19-support

ECB acknowledges the potential for IFRS 9 to amplify procyclicality

This ECB press release lists four initiatives to deal with impact of Covid 19

ECB gives banks further flexibility in prudential treatment of loans backed by public support measures
ECB encourages banks to avoid excessive procyclical effects when applying the IFRS 9 international accounting standard
ECB activates capital and operational relief measures announced on March 12, 2020
Capital relief amounts to €120 billion and could be used to absorb losses or potentially finance up to €1.8 trillion of lending

This guidance on flexibility is helpful (arguably necessary) but it would have been better if the relationship between loan loss provisioning and capital buffers was more clearly thought through and built into the design of the system before it was subject to its first real test.

Tony