Andrew Haldane

Claire Jones writing for the Financial Times Alphaville column confesses a fondness for the speeches of Andrew Haldane (departing chief economist at the Bank of England) . She offered a selection of favourites (you can access her column by signing up to Alphaville if you are not an FT subscriber).

I also rate pretty much everything he writes as worth reading often more than once to reflect on the issues he raises. To her top three Haldane speeches, I will add one he did in 2016 titled “The Great Divide” which explored the gap between the way banks perceive themselves and how they are perceived by the community.

Tony – From the Outside

Fed money printing and inflation

I will always worry about inflation but I found a post by Morgan Housel offering an interesting counter perspective on what the Fed is doing with the money supply

“The risk of rising inflation over the next few years is probably the highest it’s been in decades. Inflation happens when too much money chases too few goods, and Covid-19 closed a lot of businesses and gave people an unprecedented amount of money. The stars align.

That out of the way, let me cool things down: The Fed is printing a lot of money, but not nearly as much as it looks.”

The short version is that the dramatic increase in recent times can be attributed to a redefinition of savings accounts in the US – link to the post here. The inflation question is obviously way more complex than this simple data point but the post is short and worth reading.

Tony – From the Outside

Another reason why monetary authorities might not like stablecoins

Marc Rubinstein’s post (here) on Facebook’s attempt to create an alternative payment mechanism offers a useful summary of the state of play for anyone who has not had the time, nor the inclination, to follow the detail. It includes a short summary of its history, where the initiative currently stands and where it might be headed.

What caught my attention was his discussion of why central banks do not seem to be keen to support private sector initiatives in this domain. Marc noted that Facebook have elected to base their proposed currency (initially the “Libre” but relabelled a “Diem” in a revised proposal issued in December 2020) on a stable coin approach. There are variety of stable coin mechanisms (fiat-backed, commodity backed, cryptocurrency backed, seignorage-style) but in the case of the Diem, the value of the instrument is proposed to be based on an underlying pool of low risk fiat currency assets.

A stable value is great if the aim for the instrument is to facilitate payments for goods and services but it also creates concerns for policy makers. Marc cites a couple of issues …

But this is where policymakers started to get jumpy. They started to worry that if payments and financial transactions shift over to the Libra, they might lose control over their domestic monetary policy, all the more so if their currency isn’t represented in the basket. They worried too about the governance of the Libra Association and about its compliance framework. Perhaps if any other company had been behind it, they would have dismissed the threat, but they’d learned not to underestimate Facebook.”

“Facebook’s Big Diem”, Marc Rubinstein – https://netinterest.substack.com/p/facebooks-big-diem
One more reason why stable coins might be problematic for policy makers responsible for monetary policy and bank supervision?

Initiatives like Diem obviously represent a source of competition and indeed disruption for conventional banks. As a rule, policy makers tend to welcome competition, notwithstanding the potential for competition to undermine financial stability. However “fiat-backed” stable coin based initiatives also compete indirectly with banks in a less obvious way via their demand for the same pool of risk free assets that banks are required to hold for Basel III prudential liquidity requirements.

So central banks might prefer that the stock of government securities be available to fund the liquidity requirements of the banks they are responsible for, as opposed to alternative money systems that they are not responsible for nor have any direct control over.

I know a bit about banking but not a lot about cryptocurrency so it is entirely possible I am missing something here. If so then feedback welcome.

Tony – From the Outside

The tension between competition and financial stability …

… is a topic on which I have long been planning to write the definitive essay.

Today is not that day.

In the interim, I offer a link to a post by Marc Rubinstein that makes a few points I found worth noting and expanding upon.

Firstly, he starts with the observation that there are very few neat solutions to policy choices – mostly there are just trade-offs. He cites as a case a point the efforts by financial regulators to introduce increased competition over the past forty years as a means to make the financial system cheaper and more efficient. Regulators initially thought that they could rely on market discipline to manage the tension between increased freedom to compete and the risk that this competition would undermine credit standards but this assumption was found wanting and we ended up with the GFC.

When financial regulators think about trade-offs, the one they’ve traditionally wrestled with is the trade-off between financial stability and competition. It arises because banks are special: their resilience doesn’t just impact them and their shareholders; it impacts everybody. As financial crises through the ages have shown, if a bank goes down it can have a huge social cost. And if there’s a force that can chip away at resilience, it’s competition. It may start out innocently enough, but competition often leads towards excessive risk-taking. In an effort to remain competitive, banks can be seduced into relaxing credit standards. Their incentive to monitor loans and maintain long-term relationships with borrowers diminishes, credit gets oversupplied and soon enough you have a problem. 

The Policy Triangle, Marc Rubinstein -https://netinterest.substack.com/

We have learned that regulators may try to encourage competition where possible but, when push comes to shove, financial stability remains the prime directive. As a consequence, the incumbent players have to manage the costs of compliance but they also benefit from a privileged position that has been very hard to attack. Multiple new entrants to the Australian banking system learned this lesson the hard way during the 1980s and 1990s.

For a long time the trade-off played out on that simple one dimensional axis of “efficiency and competition” versus “financial stability” but the entry of technology companies into areas of financial services creates additional layers of complexity and new trade-offs to manage. Rubinstein borrows the “Policy Triangle” concept developed by Hyun Song Shin to discuss these issues.

Hyun Song Shin, Economic Adviser and Head of Research, Bank for International Settlements
  1. Firstly, he notes that financial regulators don’t have jurisdiction over technology companies so that complicates the ways in which they engage with these new sources of competition and their impact on the areas of the financial system that regulators do have responsibility for.
  2. Secondly, he discusses the ways in which the innovative use of data by these new players introduces a whole new range of variables into the regulatory equation.
Jurisdiction

New entrants have been able to make inroads into certain areas of finance, the payments function in particular. Some regulators have supported these areas of innovation but Rubinstein notes that regulators start to clamp down once new entrants start becoming large enough to matter. The response of Chinese authorities to Ant Financial is one example as is the response of financial regulators globally to Facebook’s attempt to create a digital currency. The lessons seems to be that increased regulation and supervisions is in store for any new entrant that achieves any material level of scale.

Data

The innovative use of data offers the promise of enhanced competition and improved ways of managing credit risk but this potentially comes at the cost of privacy. Data can also be harnessed by policy makers to gain new real-time insights into what is going on in the economy that can be used to guide financial stability policy settings.

Conclusion

Rubinstein has only scratched the surface of this topic but his post and the links he offers to other contributions to the discussion are I think worth reading. As stated at the outset, I hope to one day codify some thoughts on these topics but that is a work in progress. That post will consider issues like the “prisoner’s dilemma” that are I think an important part of the competition/stability trade-off. It is also important to consider the ways in which banks have come to play a unique role in the economy via the creation of money.

Tony – From the Outside

p.s. There are a few posts I have done on related topics that may be of interest

The Bitcoin energy use debate

Bitcoin’s energy use has been one of the more interesting, and less explored, avenues of the brave new world the crypto community is building. To date I have mostly seen this play out in very simplistic arguments along the lines that Bitcoin is bad because it uses as much energy as whole countries use. On those terms it certainly sounds bad but I came across a more nuanced discussion of the question in this post on the “Principlesandinterest” blog.

Toby lays out some of the counter arguments used to support Bitcoin and in doing so gets into some of the history of how we value things. While my bias remains that Bitcoin’s energy use is a concern, Toby’s post opened my mind up to some of the broader issues associated with the question. Definitely worth reading if you are interested in the question of cryptocurrency and the nature of money.

Tony – From the Outside

JP Koning – What Tether Means When It Says It’s ‘Regulated’ – CoinDesk

Useful article on Coindesk discussing what underpins the integrity of one of the more popular forms of Stabecoins

“Newcomers to the crypto space are quickly confronted with a popular distinction between regulated stablecoins and unregulated stablecoins. But what is the difference? Tether, the largest of the stablecoins, is often described as unregulated. But Tether executives and supporters disagree with this claim. Who is right?”
— Read on www.coindesk.com/what-tether-means-when-it-says-its-regulated

I don’t profess any real insight or expertise in this space but it does feel to me like a question that any serious student of banking needs to come to terms with.

Tony – From the Outside

Allowing companies to fail

I suspect (but can’t prove) that creative destruction is one of the under appreciated factors that underpin the health of the economy. There is quite a lot of evidence however that creative destruction has been suppressed since the 2008 Global Financial Crisis. The rights and wrongs of the extent to which bail-outs were and continue to be necessary is too big a topic to cover in this post.

For the record, I do believe that the bail-outs of the banks were necessary at the time but that “bail-in” gives bank supervisors a very real option to avoid having to do this in the future. The increase in capital requirements are also likely to reduce the risk of a bail-in being required. Others may disagree and my views chiefly relate to the Australian banking system which is where my professional expertise is based. The issues associated with COVID-19 raise a whole lot of related but, in many ways, different issues. At the risk of stating the obvious, it’s complicated.

Against that background, I found this short article published on the VoxEU website worth reading as another reminder of the value of allowing companies to fail and/or be restructured. The conclusion of the article (copied below) gives you the key points the authors derive from their research

We investigate a large number of stakeholders that could be negatively affected by a fire sale but find little evidence for negative externalities. The main effect of fire sales is a wealth transfer from the seller to the buyer. Thus, from a welfare perspective, the costs associated with fire sales of corporate assets are much lower than previously thought based on an analysis of seller costs only. From a policy perspective, these findings indicate that the merits of bailouts as a response to the potential losses associated with fire sales are limited, especially given the moral hazard and the other distortions caused by these bailouts. 

We recognise that the economic shock caused by the COVID-19 pandemic is unparalleled since the WWII and the Great Depression, and hence, some emergency measures and bailouts were likely necessary to prevent a meltdown of economic activity. However, one difference between the current crisis and the Global Crisis is the apparent lack of fire sales of struggling companies or investments into such companies at fire-sale prices. Warren Buffett’s Berkshire Hathaway, for instance, invested $5 billion in Goldman Sachs in September 2008 and $3 billion in General Electric in October 2008, while Warren Buffett’s firm has not undertaken any major investments during the COVID-19 crisis (Financial Times 2020). Our results therefore suggest that, at least at the margin, fire sales would have been an effective alternative to bailouts, especially for large bailouts such as for the airlines in the US.

“The merits of fire sales and bailouts in light of the COVID-19 pandemic”, Jean-Marie Meier and Henri Servaes, 18 January 2021.

Dee Hock, the Father of Fintech

Marc Rubinstein writing in his “Net Interest” newsletter has a fascinating story about the history of Visa. The article is interesting on a number of levels.

It is partly a story of the battle currently being played out in the “payments” area of financial services but it also introduced me to the story of Dee Hock who convinced Bank of America to give up ownership of the credit card licensing business that it had built up around the BankAmericard it had launched in 1958. His efforts led to the formation of a new company, jointly owned by the banks participating in the credit card program, that was the foundation of Visa.

The interesting part was that Visa was designed from its inception to operate in a decentralised manner that balanced cooperation and competition. The tension between cooperation (aka “order”) and competition (sometimes leading to “disorder”) is pervasive in the world of money and finance. Rubinstein explores some of the lessons that the current crop of decentralised finance visionaries might take away from this earlier iteration of Fintech. Rubinstein’s post encouraged me to do a bit more digging on Hock himself (see this article from FastCompany for example) and I have also bought Hock’s book (“One from Many: VISA and the Rise of Chaordic Organization“) to read.

There is a much longer post to write on the issues discussed in Rubinstein’s post but that is for another day (i.e. when I think I understand them so I am not planning to do this any time soon). At this stage I will just call out one of the issues that I think need to be covered in any complete discussion of the potential for Fintech to replace banks – the role “elasticity of credit” plays in monetary systems.

“Elasticity of credit”

It seems pretty clear that the Fintech companies offer a viable (maybe compelling) alternative to banks in the payment part of the monetary system but economies also seem to need some “elasticity” in the supply of credit. It is not obvious how Fintech companies might meet this need so maybe there remains an area where properly regulated and supervised banks continue to have a role to play. That is my hypothesis at any rate which I freely admit might be wrong. This paper by Claudio Borio offers a good discussion of this issue (for the short version see here for a post I did on Borio’s paper).

Recommended

Tony – From the Outside

The potential for computer code to supplant the traditional operating framework of the economy and society

I am very far from expert on the issues discussed in the podcast this post links to, I am trying however to “up-skill”. The subject matter is a touch wonky so this is not a must listen recommendation. That said, the questions of DeFi and cryptocurrency are ones that I believe any serious student of banking and finance needs to understand.

In the podcast Demetri Kofinas (Host of the Hidden Forces podcast) is interviewed by two strong advocates of DeFi and crypto debating the potential of computer code to supplant legal structures as an operating framework for society. Demetri supports the idea that smart contracts can automate agreements but argues against the belief that self-executing software can or should supplant our legal systems. Computer code has huge potential in these applications but he maintains that you will still rely on some traditional legal and government framework to protect property rights and enforce property rights. He also argues that it is naïve and dangerous to synonymize open-source software with liberal democracy.

I am trying to keep an open mind on these questions but (thus far) broadly support the positions Demetri argues. There is a lot of ground to cover but Demetri is (based on my non-expert understanding of the topic) one of the better sources of insight I have come across.

Tony – From the Outside

Financing the Danish home

There is a surprising (to me at least) variety of ways that countries address the common problem of financing the purchase of residential property. To date, I have mostly approached the question from the perspective of trying to understand differences in mortgage risk weights across different banks in Australia (see here). The topic also has implications for cross border comparisons of capital adequacy ratios (see here and here).

Marc Rubinstein wrote a great piece looking at the mysteries of the the 30-year fixed-rate fully prepayable mortgage that finances the majority of home purchases in America. Marc noted in passing that Denmark is the only other country that offers a comparable form of mortgage financing. That is broadly true but I think the Danish mortgage financing system has some distinct and intriguing features of its own. A paper published by the New York Fed in 2018 comparing the US and Danish mortgage systems has been especially useful in gaining some deeper insights into the different ways that countries solve the residential property finance challenge.

This extract from the New York Fed paper gives you a flavour of the history and main features of the Danish system

In Denmark, mortgage lending has long been dominated by specialized mortgage banks. Denmark’s first mortgage bank was established in 1797, and Nykredit, the country’s largest mortgage bank today, traces its origins to 1851 (Møller and Nielsen 1997). Originally, these firms were set up as mutual mortgage credit associations with a local focus. But several waves of mergers—some encouraged or even prescribed by their then-regulator—led to the formation of the handful of large mortgage banks that today dominate mortgage lending in Denmark.


Because the original mortgage credit associations were founded by borrowers, lending terms were to a large extent designed to reflect borrowers’ objectives and interests. At the same time, the associations needed to build trust among the investors in covered bonds, and this led to a business model aimed at balancing borrower and investor interests (Møller and Nielsen 1997).

Key aspects of this business model included:

# Mortgage lenders could not call for early redemption of a loan unless the borrower became delinquent.

# Investors could not call the covered bonds.

# Homeowners had a right to prepay the mortgage loan at par on any payment day without penalty.

# Homeowners were personally liable for the mortgage debt.

# Homeowners were jointly and severally liable for the covered bonds issued by the mortgage credit association.

# Mortgage margins could be increased for the entire stock of mortgage loans—for example, if needed in order to increase capitalization or cover loan losses.

# Strict lending guidelines were instituted that were regulated by law (maximum LTV ratio, maximum maturity, and so forth).

With the exception of joint and several liability, these principles still apply to mortgage banks today.

Berg J, Baekmand Nielsen M, and Vickery J, “Peas in a Pod? Comparing the U.S. and Danish Mortgage Financing Systems”, Federal Reserve Bank of New York Economic Policy Review 24, no. 3, December 2018

The paper summarises the comparison between the two systems as follows

The U.S. and Danish mortgage finance models both rely heavily on capital markets to fund residential mortgages, transferring interest rate and prepayment risk, but not credit risk, to investors. But in Denmark, homeowners can buy back their mortgages or transfer them in a property sale, avoiding the “lock-in” effects present in the U.S. system, and easier refinancing reduces defaults and speeds the transmission of lower interest rates in a downturn. Denmark’s tighter underwriting standards and strong creditor protections help limit credit losses, while its higher capital requirements make lenders more stable.

Worth reading.

Tony – From the Outside