The cleansing effect of banking crises …

… is the title of an interesting post on the Voxeu website summarising some research conducted by a group of European academics.

I have only skimmed the research at this point but the conclusion that realising losses and restructuring banks sets the economy up for stronger growth seem intuitively logical. It is also a timely area of research at a time when there seems to be widespread concern that many so called “zombie” companies are only continuing to operate by virtue of extraordinary levels of liquidity and other financial support being injected into the financial system via central banks.

The post summarises their findings as follows …

Our findings show that restructuring of distressed banks during a crisis has positive long-term effects on productivity. We emphasise the importance of long-term productivity considerations in the design of optimal bank resolution mechanisms. Our results indicate that the challenge is the inherent trade-off between the short- and the long-term effects, which can complicate the political economy of the problem. For instance, in the short term, bailouts can look appealing to government officials, especially if the long-term costs bear less weight in their decision-making processes.

“The cleansing effect of banking crises”- Reint Gropp, Steven Ongena, Jörg Rocholl, Vahid Saadi; Voxeu – 7 August 200

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)

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 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 non 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

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

Capital Rules Get Less Stressful – Matt Levine

Nice quote from Matt Levine’s opinion piece on the change in US bank capital requirements

Everything in bank capital is controversial so this is controversial. Usually the controversy is that some people want higher capital requirements and other people want lower capital requirements. Here, pleasantly, part of the controversy is about whether this is a higher or lower capital requirement.

https://www.bloomberg.com/opinion/articles/2020-03-05/capital-rules-get-less-stressful