“The Great Divide” by Andrew Haldane

This speech by Andrew Haldane (Chief Economist at the Bank of England) was given in 2016 but is sill worth reading for anyone interested in the question of what role banks play in society and why their reputation is not what it once was. Some of my long term correspondents will be familiar with the paper and may have seen an earlier draft of this post.

“The Great Divide” refers to a gap between how banks perceive themselves and how they are perceived by the community. Haldane references a survey the BOE conducted in which the most common word used by banks to describe themselves was “regulated” while “corrupt” was the community choice closely followed by “manipulated”, “self-serving”, “destructive” and “greedy”. There is an interesting “word cloud” chart in the paper representing this gap in perception.

While the focus is on banks, Haldane makes the point that the gap in perceptions reflects a broader tension between the “elites” and the common people. He does not make this explicit connection but it seemed to me that the “great divide” he was referencing could also be argued to be manifesting itself in the increasing support for populist political figures purporting to represent the interests of the common people against career politicians. This broader “great divide” idea seemed to me to offer a useful framework for thinking about the challenges the banking industry is facing in rebuilding trust.

Haldane uses this “great divide” as a reference for discussing

  • The crucial role finance plays in society
  • The progress made so far in restoring trust in finance
  • What more needs to be done

The crucial role finance plays in society

Haldane argues that closing the trust deficit between banks and society matters for two reasons

  • because a well functioning financial system is an essential foundation for a growing and well functioning economy – to quote Haldane “that is not an ideological assertion from the financial elite; it is an empirical fact”
  • but also because the downside of a poorly functioning financial system is so large

Haldane uses the GFC to illustrate the downside in terms of the destruction of the value of financial capital and physical capital but he introduces a third form of capital, “social capital” that he argues may matter every bit as much to the wealth and well being of society. He defines social capital as the “relationships, trust and co-operation forged between different groups of people over time. It is the sociological glue that binds diverse societies into a cohesive whole”. The concept of “trust” is at the heart of Haldane’s definition of social capital.

Haldane cites evidence that trust plays an important role at both the micro and macro level in value creation and growth and concludes that “… a lack of trust jeopardises one of finance’s key societal functions – higher growth”.

In discussing these trends, Haldane distinguishes “personalised trust” and “generalised trust“. The former refers to mutual co-operation built up through repeated personal interactions (Haldane cites example like visits to the doctor or hairdresser) while the latter is attached to an identifiable but anonymous group (Haldane cites trust in the rule of law, or government or Father Christmas).

He uses this distinction to explore why banks have lost the trust of the community;

He notes that banking was for most of its history a relationship based business. The business model was not perfect but it did deliver repeated interactions with customers that imbued banking with personalised trust. At the same time its “mystique” (Haldane’s term) meant that banking maintained a high degree of generalised trust as well.

He cites the reduction in local branches, a common strategy pre GFC, as one of the changes that delivered lower costs but reduced personal connections thereby contributing to reducing personalised trust. For a while, the banking system could reap the efficiency gains while still relying on generalised trust but the GFC subsequently undermined the generalised trust in the banking system. This generalised trust has been further eroded by the continued run of banking scandals that convey the sense that banks do not care about their customers.

What can be done to restore trust in finance

He notes the role that higher capital and liquidity have played but that this is not enough in his view. He proposes three paths

  1. Enhanced public education
  2. Creating “Purpose” in banking
  3. Communicating “Purpose” in banking

Regarding public education, there is a telling personal anecdote he offers on his experience with pensions. He describes himself as “moderately financially literate” but follows with “Yet I confess to not being able to make the remotest sense of pensions. Conversations with countless experts and independent financial advisors have confirmed for me only one thing – that they have no clue either”. This may be dismissed as hyperbole but it does highlight that most people will be less financially literate than Haldane and are probably poorly equipped to deal with the financial choices they are required to make in modern society. I am not sure that education is the whole solution.

Regarding “purpose” Haldane’s main point seems to be that there is too much emphasis on shareholder value maximisation and not enough balance. This seems to be an issue that is amplified by the UK Companies Act that requires that directors place shareholder interests as their primary objective. To the best of my knowledge, the Australian law does not have an equivalent explicit requirement to put shareholders first but we do grapple with the same underlying problem. Two of my recent posts (“The World’s Dumbest Idea” and “The Moral Economy” touch on this issue.

Regarding communicating purpose, Haldane cites some interesting evidence that the volume of information provided by companies is working at cross purposes with actual communication with stakeholders. Haldane does not make the explicit link but Pillar 3 clearly increases the volume of information provided by banks. The points raised by Haldane imply (to me at least) that Pillar 3 might actually be getting in the way of communicating clearly with stakeholders.

This is a longish post but I think there is quite a lot of useful content in the speech so I would recommend it.

Recently read – “The Moral Economy: Why Good Incentives Are No Substitute For Good Citizens” by Samuel Bowles

The potential for incentives to create bad behaviour has been much discussed in the wake of the GFC while the Financial Services Royal Commission in Australia has provided a fresh set of examples of bankers behaving badly. It is tempting of course to conclude that bankers are just morally corrupt but, for anyone who wants to dig deeper, this book offers an interesting perspective on the role of incentives in the economy.

What I found especially interesting is Bowles account of the history of how the idea that good institutions and a free market based economy could “harness self interest to the public good” has come to dominate so much of current economic and public policy. Building on this foundation, the book examines the ways in which incentives designed around the premise that people are solely motivated by self interest can often be counter-productive; either by crowding out desirable behaviour or by prompting people to behave in ways that are the direct opposite of what was intended.

Many parts of this story are familiar but it was interesting to see how Bowles charted the development of the idea over many centuries and individual contributors. People will no doubt be familiar with Adam Smith’s “Invisible Hand”  but Bowles also introduces other thinkers who contributed to this conceptual framework, Machiavelli and David Hume in particular. The idea is neatly captured in this quote from Hume’s Essays: Moral, Political and Literary (1742) in which he recommended the following maxim

“In contriving any system of government … every man ought to be supposed to be a knave and to have no other end … than private interest. By this interest we must govern him, and, by means of it, make him notwithstanding his insatiable avarice and ambition, cooperate to public good” .

Bowles makes clear that this did not mean that people are in fact solely motivated by self-interest (i.e “knaves”), simply that civic virtue (i.e. creating good people) by itself was not a robust platform for achieving good outcomes. The pursuit of self interest, in contrast, came to be seen as a benign activity that could be harnessed for a higher purpose.

The idea of embracing self-interest is of course anathema to many people but its intellectual appeal is I think obvious.  Australian readers at this point might be reminded of Jack Lang’s maxim “In the race of life, always back self-interest; at least you know it’s trying“. Gordon Gekko’s embrace of the principle that “Greed is good” is the modern expression of this intellectual tradition.

Harnessing self-interest for the common good

Political philosophers had for centuries focused on the question of how to promote civic virtue but their attention turned to finding laws and other public policies that would allow people to pursue their personal objectives, while also inducing them to take account of the effects of their actions on others. The conceptual foundations laid down by David Hume and Adam Smith were progressively built on with competition and well defined property rights coming to be seen as important parts of the solution.

“Good institutions displaced good citizens as the sine qua non of good government. In the economy, prices would do the work of morals”

“Markets thus achieved a kind of moral extraterritoriality … and so avarice, repackaged as self-interest, was tamed, transformed from a moral failing to just another kind of motive”

Free market determined prices were at the heart of the system that allowed the Invisible Hand to work its magic but economists recognised that competition alone was not sufficient for market prices to capture everything that mattered. For the market to arrive at the right (or most complete) price, it was also necessary that economic interactions be governed by “complete contracts” (i.e. contracts that specify the rights and duties of the buyer and seller in all future states of the world).

This is obviously an unrealistic assumption. Apart from the difficulty of imagining all future states of the world, not everything of value can be priced. But all was not lost. Bowles introduces Alfred Marshall and Arthur Pigou who identified, in principle, how a system of taxes and subsidies could be devised that compensated economic actors for benefits their actions conferred on others and made them liable for costs they imposed on others.

These taxes and subsidies are of course not always successful and Bowles offers a taxonomy of reasons why this is so. Incentives can work but not, according to Bowles, if they simplistically assume that the target of the incentive cares only about his or her material gain. To be effective, incentives must account for the fact that people are much more complex, social and moral than is strictly rational from an economic perspective. Bowles devotes a lot of the book to the problem with incentives (both positive and negative, including taxes, fines, subsidies, bonuses etc) which he categorises under three headings:

  1. “Bad News“; incentives send a signal and the tendency is for people to read things into incentives which may not have been intended but prompt them to respond negatively (e.g. does this incentive signal that the other party believes I am not trustworthy or lazy)
  2. Moral Disengagement”; the incentive may create a context in which the subject can distance themselves from the moral consequences of how they respond
  3. “Control Aversion”; an incentive that compromises a subject’s sense of autonomy or pride in the task may reduce their intrinsic motivation to perform the task well

Having noted the ways that incentives can have adverse impacts on behaviour, Bowles notes that civic minded values continue to be an important feature of market based economies and examines why this might be.

“If incentives sometimes crowd out ethical reasoning, the desire to help others, and intrinsic motivations, and if leading thinkers celebrate markets as a morality-free zone, it seems just a short step to Karl Marx’s broadside condemnation of capitalist culture”

One answer is that trading in markets encourages people to trust strangers and that the benefits of trading over time teach people that trust is a valuable commodity (the so called “doux commerce” theory).

While admitting his answer is speculative, Bowles rejects “doux commerce” as the whole answer. He argues that the institutions (property rights, rule of law, etc) developed by liberal societies to protect citizens from worst-case outcomes such as personal injury, loss of property, and other calamities make the consequences of mistakenly trusting a defector much less dire. As a result, the rule of law lowers the bar for how much you would have to know about your partner before trusting him or her, thereby promoting the spread of trusting expectations and hence of trusting behavior in a population.

The “institutional structure” theory is interesting but there is still much in the book worth considering even if you don’t buy his explanation. I have some more detailed notes on the book here.

Lessons for banking in Pixar’s approach to dealing with uncertainty and the risk of failure.

The report on the Prudential Inquiry into the CBA (“CBA Report”) is obviously required reading in banking circles this week. Plenty has been written on the topic already so I will try to restrain myself unless I can find something new to add to the commentary. However, while reading the report, I found myself drawing links to books that I think bankers would find well worth reading. These include Foolproof (by Michael Ip) and “The Success Equation: Untangling Skill and Luck in Business, Sports and Investing (by Michael Mauboussin).

I have put up some notes on Foolproof here and intend to do the same for The Success Equation sometime soon. The focus for today’s post however is a book titled “Creativity, Inc” by Ed Catmull who founded and led Pixar. The overall theme of the book is about developing and sustaining a creative culture but dealing with risk and uncertainty emerges as a big part of this.

What does making movies have to do with banking?

One of the lessons Catmull emphasised was that, notwithstanding Pixar’s success, it was important not to lose sight of the role that random factors play in both success and failure. A quote from Ch 8 illustrates this point;

“… a lot of our success came because we had pure intentions and great talent, and we did a lot of things right, but I also believe that attributing our success solely to our own intelligence without acknowledging the role of accidental events, diminishes us.”

He goes on to describe how success can be a trap for the following reasons;

  • it creates the impression that what you are doing must be right,
  • it tempts you to overlook hidden problems and
  • you may be confusing luck with skill.

There is a discussion in Ch 9 of the kinds of things that can lead you to misunderstand the real nature of both your success and your failure. These include various cognitive biases (such as “confirmation” where you weight information that supports what you believe more than the counter evidence) and mental models we use to simplify the world in which we operate. These are hard wired into us so the best we can do is be aware of how these things can take us off track; that at least puts us ahead of those who blindly follow their mental models and biases.

His answer to building the capacity to adapt to change and respond to setbacks is to trust in people but trust does not mean you trust that people won’t make mistakes. Catmull accepts setbacks and screw ups as an inevitable part of being creative and innovative but trust is demonstrated when you support your people when they do screw up and trust them to find the solution.

This is interesting because the CBA Report indicates that CBA did in fact place a great deal of trust in their executive team and senior leaders, which implies trust alone is not enough. The missing ingredients in CBA’S case were accountability and consequence when the team failed to identify, escalate and resolve problems.

The other interesting line of speculation is whether CBA’s risk culture might have benefited from a deeper reflection on the difference between skill and luck. Maboussin’s book (The Success Equation) is particularly good in the way in which he lays out his framework for making this distinction.

I plan to come back to this topic once I have completed a review of Maboussin’s book but in the interim I can recommend all of the books mentioned in this post.

“Between Debt and the Devil: Money, Credit and Fixing Global Finance” by Adair Turner (2015)

This book is worth reading, if only because it challenges a number of preconceptions that bankers may have about the value of what they do. The book also benefits from the fact that author was the head of the UK Financial Services Authority during the GFC and thus had a unique inside perspective from which to observe what was wrong with the system. Since leaving the FSA, Turner has reflected deeply on the relationship between money, credit and the real economy and argues that, notwithstanding the scale of change flowing from Basel III, more fundamental change is required to avoid a repeat of the cycle of financial crises.

Overview of the book’s main arguments and conclusions

Turner’s core argument is that increasing financial intensity, represented by credit growing faster than nominal GDP, is a recipe for recurring bouts of financial instability.

Turner builds his argument by first considering the conventional wisdom guiding much of bank prudential regulation prior to GFC, which he summarises as follows:

  • Increasing financial activity, innovation and “financial deepening” were beneficial forces to be encouraged
  • More compete and liquid markets were believed to ensure more efficient allocation of capital thereby fostering higher productivity
  • Financial innovations made it easier to provide credit to households and companies thereby enabling more rapid economic growth
  • More sophisticated risk measurement and control meanwhile ensured that the increased complexity of the financial system was not achieved at the expense of stability
  • New systems of originating and distributing credit, rather than holding it on bank balance sheets, were believed to disperse risks into the hands of those best placed to price and manage it

Some elements of Turner’s account of why this conventional wisdom was wrong do not add much to previous analysis of the GFC. He notes, for example, the conflation of the concepts of risk and uncertainty that weakened the risk measurement models the system relied on and concludes that risk based capital requirements should be foregone in favour of a very high leverage ratio requirement. However, in contrast to other commentators who attribute much of the blame to the moral failings of bankers, Turner argues that this is a distraction. While problems with the way that bankers are paid need to be addressed, Turner argues that the fundamental problem is that:

  • modern financial systems left to themselves inevitably create debt in excessive quantities,
  • in particular, the system tends to create debt that does not fund new capital investment but rather the purchase of already existing assets, above all real estate.

Turner argues that the expansion of debt funding the purchase or trading of existing assets drives financial booms and busts, while the debt overhang left over by the boom explains why financial recovery from a financial crisis is typically anaemic and protracted. Much of this analysis seems to be similar to ideas developed by Hyman Minsky while the slow pace of recovery in the aftermath of the GFC reflects a theme that Reinhart and Rogoff have observed in their book titled “This time is different” which analyses financial crises over many centuries.

The answer, Turner argues, is to build a less credit intensive growth model. In pursuing this goal, Turner argues that we also need to understand and respond to the implications of three underlying drivers of increasing credit intensity;

  1. the increasing importance of real estate in modern economies,
  2. increasing inequality, and
  3. global current account imbalances.

Turner covers a lot of ground, and I do not necessarily agree with everything in his book, but I do believe his analysis of what is wrong with the system is worth reading.

Let me start with an argument I do not find compelling; i.e. that risk based capital requirements are unreliable because they are based on a fundamental misunderstanding of the difference between risk (which can be measured) and uncertainty (which cannot):

  • Distinguishing between risk and uncertainty is clearly a fundamental part of understanding risk and Turner is not alone in emphasising its importance
  • I believe that means that we should treat risk based capital requirements with a healthy degree of scepticism and a clear sense of their limitations but that does not render them entirely unreliable especially when we are using them to understand relative differences in risk and to calibrate capital buffers
  • The obvious problem with non-risk based capital requirements is that they create incentives for banks to take higher risk that may eventually offset the supposed increase in soundness attached to the higher capital
  • It may be that Turner discounts this concern because he envisages a lower credit growth/intensity economy delivering less overall systemic risk or because he envisages a more active role for the public sector in what kinds of assets banks lend against; i.e. his support for higher capital may stem mostly from the fact that this reduces the capacity of private banks to generate credit growth

While advocating much higher capital, Turner does seem to part company with M&M purists by expressing doubt that equity investors will be willing to accept deleveraged returns. His reasoning is that returns to equity investments need a certain threshold return to be “equity like” while massively deleveraged ROE still contains downside risks that are unacceptable to debt investors.

Turning to the arguments which I think raise very valid concerns and deserve serious attention.

Notwithstanding my skepticism regarding a leverage ratio as the solution, the arguments he makes about the dangers of excessive credit growth resonate very strongly with what I learned during my banking career. Turner is particularly focussed on the downsides of applying excessive debt to the financing of existing assets, real estate in particular. The argument seems to be similar to (if not based on) the work of Hyman Minsky.

Turner’s description of the amount of money that banks can create as being “infinitely elastic” seems an overstatement to me (especially in the Australian context with the Net Stable Funding Ratio (NSFR) weighing on the capacity to grow the balance sheet) but the general point he is making about the way that credit fuelled demand for a relatively inelastic supply of desirable residential property tends to result in inflated property values with no real social value rings true.

What banks can do about this remains an open question given that resolving the problem with inelastic supply of property is outside their direct control but it is obviously important to understand the dynamics of the market underpinning their largest asset class and it may help them engage more constructively with public policy debates that seek to address the problem.

Turner’s analysis of the downsides of easy monetary policy (the standard response to economic instability) also rings true. He identifies the fact that lower interest rates tend to result in inflated asset values (residential property in particular given its perceived value as a safe asset) which do not address the fundamental problem of over-indebtedness and may serve to increase economic inequality. His discussion of the impact of monetary policy and easy credit on economic inequality is also interesting. The banks providing the credit in the easy money environment may not necessarily be taking undue risk and prudential supervisors have tools to ensure sound lending standards are maintained if they do believe there is a problem with asset quality. What may happen however is that the wealthier segments of society benefit the most under easy money because they have the surplus cash flow to buy property at inflated values while first homebuyers become squeezed out of the market. Again their capacity to address the problem may be limited but Turner’s analysis prompted me to reflect on what increasing economic inequality might mean for bank business models.

In addition to much higher bank capital requirements, Turner’s specific recommendations for moving towards a less credit intensive economy include:

  • Government policies related to urban development and the taxation of real estate
  • Changing tax regimes to reduce the current bias in favour of debt over equity financing (note that Australia is one of the few countries with a dividend imputation system that does reduce the bias to debt over equity)
  • Broader macro prudential powers for central banks, including the power to impose much larger countercyclical capital requirements
  • Tough constraints on the ability of the shadow banking system to create credit and money equivalents
  • Using public policy to produce different allocations of capital than would result from purely market based decisions; in particular, deliberately leaning against the market signal based bias towards real estate and instead favouring other “potentially more socially valuable forms of credit allocation”
  • Recognising that the traditional easy monetary policy response to an economic downturn (or ultra-easy in the case of a financial crisis such as the GFC) is better than doing nothing but comes at a cost of reigniting the growth in private credit that generated the initial problem, creating incentives for risky financial engineering and exacerbating economic inequality via inflating asset prices.

For those who want to dig deeper, I have gone into a bit more detail here on what Turner has to say about the following topics:

  • The way in which inefficient and irrational markets leave the financial system prone to booms and busts
  • The dangers of debt contracts sets out how certain features of these contracts increase the risk of instability and hamper the recovery
  • Too much of the wrong sort of debt describes features of the real estate market that make it different from other asset classes
  • Liberalisation, innovation and the credit cycle on steroids recaps on the philosophy that drove the deregulation of financial markets and what Turner believes to be the fundamental flaws with that approach. In particular his conclusion that the amount of credit created and its allocation is “… too important to be left to bankers…”
  • Private credit and money creation offers an outline of how bank deposits evolved to play an increasing role (the key point being that it was a process of evolution rather than overt public policy design choices)
  • Credit financed speculation discusses the ways in which credit in modern economies tends to be used to finance the purchase of existing assets, in particular real estate, and the issues that flow from this.
  • Inequality, credit and more inequality sets out some ways in which the extension of credit can contribute to increasing economic inequality
  • Capital requirements sets out why Turner believes capital requirements should be significantly increased and why capital requirements (i.e. risk weights) for some asset classes (e.g. real estate) should be be calibrated to reflect the social risk of the activity and not just private risks captured by bank risk models
  • Turner defence against the argument that his proposals are anti-markets and anti-growth.

“The End of Alchemy” by Mervyn King

Anyone interested in the conceptual foundations of money and banking will I think find this book interesting. King argues that the significant enhancements to capital and liquidity requirements implemented since the GFC are not sufficient because of what he deems to be fundamental design flaws in the modern system of money and banking.

King is concerned with the process by which bank lending creates money in the form of bank deposits and with the process of maturity transformation in banking under which long term, illiquid assets are funded to varying degrees by short term liabilities including deposits. King applies the term “alchemy” to these processes to convey the sense that the value created is not real on a risk adjusted basis.

He concedes that there will be a price to pay in foregoing the “efficiency benefits of financial intermediation” but argues that these benefits come at the cost of a system that:

  • is inherently prone to banking crises because, even post Basel III, it is supported by too little equity and too little liquidity, and
  • can only be sustained in the long run by the willingness of the official sector to provide Lender of Last Resort liquidity support.

King’s radical solution is that all deposits must be 100% backed by liquid reserves which would be limited to safe assets such as government securities or reserves held with the central bank. King argues that this removes the risk/incentive for bank runs and for those with an interest in Economic History he acknowledges that this idea originated with “many of the most distinguished economists of the first half the twentieth century” who proposed an end to fractional reserve banking under a proposal that was known as the “Chicago Plan”. Since deposits are backed by safe assets, it follows that all other assets (i.e. loans to the private sector) must be financed by equity or long term debt

The intended result is to separate

  • safe, liquid “narrow” banks issuing deposits and carrying out payment services
  • from risky, illiquid “wide” banks performing all other activities.

At this point, King notes that the government could in theory simply stand back and allow the risk of unexpected events to impact the value of the equity and liabilities of the banks but he does not advocate this. This is partly because volatility of this nature can undermine consumer confidence but also because banks may be forced to reduce their lending in ways that have a negative impact on economic activity. So some form of central bank liquidity support remains necessary.

King’s proposed approach to central bank liquidity support is what he colloquially refers to as a “pawnbroker for all seasons” under which the  central bank agrees up front how much it will lend each bank against the collateral the bank can offer;

King argues that

“almost all existing prudential capital and liquidity regulation, other than a limit on leverage, could be replaced by this one simple rule”.

which “… would act as a form of mandatory insurance so that in the event of a crisis a central bank would be free to lend on terms already agreed and without the necessity of a penalty rate on its loans. The penalty, or price of the insurance, would be encapsulated by the haircuts required by the central bank on different forms of collateral”

leaving banks “… free to decide on the composition of their assets and liabilities… all subject to the constraint that alchemy in the private sector is eliminated”

Underpinning King’s thesis are four concepts that appear repeatedly

  • Disequilibrium; King explores ways in which economic disequilibrium repeatedly builds up followed by disruptive change as the economy rebalances
  • Radical uncertainty; this is the term he applies to Knight’s concept of uncertainty as distinct from risk. He uses this to argue that any risk based approach to capital adequacy is not built on sound foundations because it will not capture the uncertain dimension of unexpected loss that we should be really concerned with
  • The “prisoner’s dilemma” to illustrate the difficulty of achieving the best outcome when there are obstacles to cooperation
  • Trust; he sees trust as the key ingredient that makes a market economy work but also highlights how fragile that trust can be.

My thoughts on King’s observations and arguments

Given that King headed the Bank of England during the GFC, and was directly involved in the revised capital and liquidity rules (Basel III) that were created in response, his opinions should be taken seriously. It is particularly interesting that, notwithstanding his role in the creation of Basel III, he argues that a much more radical solution is required.

I think King is right in pointing out that the banking system ultimately relies on trust and that this reliance in part explains why the system is fragile. Trust can and does disappear, sometimes for valid reasons but sometimes because fear simply takes over even when there is no real foundation for doubting the solvency of the banking system. I think he is also correct in pointing out that a banking system based on maturity transformation is inherently illiquid and the only way to achieve 100% certainty of liquidity is to have one class of safe, liquid “narrow” banks issuing deposits and another class of risky, illiquid institution he labels “wide” banks providing funding on a maturity match funded basis. This second class of funding institution would arguably not be a bank if we reserve that term for institutions which have the right to issue “bank deposits”.

King’s explanation of the way bank lending under the fractional reserve banking system creates money covers a very important aspect of how the modern banking and finance system operates. This is a bit technical but I think it is worth understanding because of the way it underpins and shapes so much of the operation of the economy. In particular, it challenges the conventional thinking that banks simply mobilise deposits. King explains how banks do more than just mobilise a fixed pool of deposits, the process of lending in fact creates new deposits which add to the money supply. For those interested in understanding this in more depth, the Bank of England published a short article in its Quarterly Bulletin (Q1 2014) that you can find at the following link

He is also correct, I think, in highlighting the limits of what risk based capital can achieve in the face of “radical uncertainty” but I don’t buy his proposal that the leverage ratio is the solution. He claims that his “pawnbroker for all seasons” approach is different from the standardised approach to capital adequacy but I must confess I can’t see that the approaches are that different. So even if you accept his argument that internal models are not a sound basis for regulatory capital, I would still argue that a revised and well calibrated standardised approach will always be better than a leverage ratio.

King’s treatment of the “Prisoner’s Dilemma” in money and banking is particularly interesting because it sets out a conceptual rationale for why markets will not always produce optimal outcomes when there are obstacles to cooperation. This brings to mind Chuck Prince’s infamous statement about being forced to “keep dancing while the music is playing” and offers a rationale for the role of regulation in helping institutions avoid situations in which competition impedes the ability of institutions to avoid taking excessive risk. This challenges the view that market discipline would be sufficient to keep risk taking in check. It also offers a different perspective on the role of competition in banking which is sometimes seen by economists as a panacea for all ills.

I have also attached a link to a review of King’s book by Paul Krugman

“The World’s Dumbest Idea” by James Montier of GMO.

Anyone interested in the question of shareholder value will I think find this paper by James Montier interesting.

The focus of the paper is to explore problems with elevating Shareholder Value to be the primary objective of a firm. Many companies are trying to achieve a more balanced approach but the paper is still useful background given that some investors appear to believe that shareholder value maximisation is the only valid objective a company should pursue. The paper also touches on the question of how increasing inequality is impacting the environment in which we operate.

While conceding that the right incentives can prompt better performance, JM argues that there is a point where increasing the size of the reward actually leads to worse performance;

“From the collected evidence on the psychology of incentives, it appears that when incentives get too high people tend to obsess about them directly, rather than on the task in hand that leads to the payout. Effectively, high incentives divert attention away from where it should be”

The following extracts will give you a sense of the key points and whether you want to read the paper itself.

  • “Let’s now turn to the broader implications and damage done by the single-minded focus on SVM. In many ways the essence of the economic backdrop we find ourselves facing today can be characterized by three stylized facts: 1) declining and low rates of business investment; 2) rising inequality; and 3) a low labour share of GDP (evidenced by Exhibits 7 through 9).” — Page 7 —
  • “This preference for low investment tragically “makes sense” given the “alignment” of executives and shareholders. We should expect SVM to lead to increased payouts as both the shareholders have increased power (inherent within SVM) and the managers will acquiesce as they are paid in a similar fashion. As Lazonick and Sullivan note, this led to a switch in modus operandi from “retain and reinvest” during the era of managerialism to “downsize and distribute” under SVM.” — Page 9 —
  • “This diversion of cash flows to shareholders has played a role in reducing investment. A little known fact is that almost all investment carried out by firms is financed by internal sources (i.e., retained earnings). Exhibit 13 shows the breakdown of the financing of gross investment by source in five-year blocks since the 1960s. The dominance of internal financing is clear to see (a fact first noted by Corbett and Jenkinson in 1997”— Page 10 —
  • “The obsession with returning cash to shareholders under the rubric of SVM has led to a squeeze on investment (and hence lower growth), and a potentially dangerous leveraging of the corporate sector” — Page 11 —
  • “The problem with this (apart from being an affront to any sense of fairness) is that the 90% have a much higher propensity to consume than the top 10%. Thus as income (and wealth) is concentrated in the hands of fewer and fewer, growth is likely to slow significantly. A new study by Saez and Zucman (2014) … shows that 90% have a savings rate of effectively 0%, whilst the top 1% have a savings rate of 40%…. ultimately creating a fallacy of composition where they are undermining demand for their own products by destroying income).” —Page 13 —
  • “Only by focusing on being a good business are you likely to end up delivering decent returns to shareholders. Focusing on the latter as an objective can easily undermine the former. Concentrate on the former, and the latter will take care of itself.” — Page 14 —
  • “… management guru Peter Drucker was right back in 1973 when he suggested “The only valid purpose of a firm is to create a customer.”” — Page 14 —

People want money

This post draws on a FT article titled “People want money” which led me to an interesting paper by Gary Gorton and George Pennacchi titled “Financial Intermediaries and Liquidity Creation”.  I took the following points away from the Gorton/Pennacchi paper:

  • The modern financial markets based economy relies on “money” to facilitate the bulk of its economic activity and bank deposits are the dominant form of money
  • There is however a continuous search for ways to expand the domain of what matches the liquidity of “money” while offering a better return
  • History has seen a variety of instruments and commodities operate as money but a critical issue is whether they retain their “moneyness” during adverse economic conditions (I think this is something that the crypto currency advocates don’t seem to fully grasp)
  • Gorton/Pennacchi argue that the liquidity of an instrument and hence its capacity to be accepted and used as money depends on the ability of uninformed agents to trade it without fear of loss; i.e. the extent to which the value of the instrument is insulated from any adverse information about the counterparty – This I think is their big idea
  • The role of a bank has traditionally been characterised as one of credit intermediation between savers and borrowers but Gorton/Pennacchi argue that the really critical role of banks is to provide a liquid asset in the form of bank deposits that serves as a form of money
  • Note that other functions offered by banks can be replicated by non-banks (e.g. non-banks are increasingly providing payment functions for customers and offering loans)  but the capacity to issue liabilities that serve as money is unique to banks
  • The challenge is that banks tend to hold risky assets and to be opaque which undermines the liquidity of bank deposits/money (as an aside, Gorton/Pennacchi offer some interesting historical context in which opacity was useful because people trusted banks and the opacity helped shield them from any information which might undermine this trust)
  • There are a variety of ways to make bank deposits liquid in the sense that Gorton/Pennacchi define it (i.e. insensitive to adverse information about the bank) but they argue for solutions where depositors have a sufficiently deep and senior claim on the assets of the bank that any volatility in their value is of no concern to them
  • This of course is what deposit insurance and giving deposits a preferred claim in the bank loss hierarchy does (note that the insured deposit a preferred claim on a bank’s assets also means the government can underwrite deposit insurance with very little risk of loss)
  • A lot of the regulatory change we have seen to date (more equity, less short term funding) contribute to that outcome without necessarily being expressed in terms of improving the liquidity of bank deposits in the way Gorton/Pennacchi frame the desired outcome

A lot of the above is not necessarily new but I do see some interesting connections with the role of banks in the money creation process and how this influences the debate about what is the optimum capital structure for a bank

  • It has been argued that more (and more) equity is a costless solution to the problem of how much is enough because the cost of equity will decline as the percentage of equity in the balance sheet increases
  • This conclusion depends in turn on the Modigliani and Miller (M&M) thesis that the value of a firm is independent of its financing structure
  • The Money Creation analysis however shows that banks are in fact unique (amongst private companies) in that one of the things they produce is money (or bank deposits to be more precise) – Gorton/Pennacchi explicitly call this out as a factor that means that M&M does not apply to banks in the simplistic way proponents of very high capital assert (most other critiques of higher bank capital just focus on the general limitations of M&M)
  • If you accept Gorton/Pennacchi’s argument that bank deposits need to be risk free in the minds of the users if they are to serve as money (the argument makes sense to me) then it follows that the cost of deposits does not change incrementally with changes in the financing structure in the way that M&M assume
  • In practice, bank deposits are either assumed to be risk free or they lose that risk free status – the risk trade-off is binary – one or the other, but not a smooth continuum assumed by M&M
  • That implies that all the real risk in a bank balance sheet has to reside in other parts of the loss hierarchy (i.e. equity, other loss absorbing capital and senior instruments)
  • And this will be even more so under Basel III because the government is developing the capacity to impose losses on all these stakeholders without having to resort to a formal bankruptcy and liquidation process (i.e. via bail-in and TLAC)
  •  Critics of bail-in argue that you can’t impose losses on liabilities but here I think they are conflating what you can’t do to depositors (where I would very much agree) with what can and does happen to bondholders relatively frequently
  • Bondholders have faced losses of principal lending to a range of counterparties (including sovereigns) so I don’t see why banks should be special in this regard – what matters is that bondholders understand the risk and price it appropriately (including not lending as much as they might otherwise have done)
  • I would also argue that imposing the risk of bail in onto bondholders is likely to be a much more effective risk discipline than requiring banks to hold arbitrarily large equity holdings that mean they struggle to earn an adequate equity like return

Gorton and Pennacchi’s paper did not explicitly raise this point but I also see an interesting connection with the Basel III Net Stable Funding Ratio (NSFR) requirement that does not get much attention;

  • The NSFR places great value on having a high level of depositor funding but, the greater the share of deposits in the liability stack, the more exposed those deposits are to any volatility in the value of the bank’s assets
  • So holding too many deposits might in fact be counterproductive and less resilient than an alternative structure in which there is slightly more long term wholesale funding and less retail deposits
  • This line of analysis also calls into question the logic underpinning the Open Bank Resolution regime in NZ where deposits can be bailed in pro rata with senior unsecured liabilities
  • The NZ regime allows some de minimis value of deposits to be excluded from bail in but there is no depositor preference such as Australia has under the Banking Act
  • The RBNZ seems to assume that applying market discipline to deposits is desirable on Moral Hazard grounds but Gorton/Pennacchi’s thesis seems to me to imply the exact opposite

Tell me what I am missing …

Worth reading – “Foolproof” by Greg Ip

I have set up a page on this blog where I intend to write up summaries of book I have found worth reading. This post contains the introduction to some notes I did on a book by Greg Ip titled “Foolproof”. I don’t agree with everything he writes but I do think he makes a very important point about the potential for successful risk management to create the preconditions for larger risk management failure in the future. This may seem counter intuitive but his point is that a sense of danger can often be useful in that it promotes good risk management while a feeling of safety can promote behaviour that results in risk reemerging often in new and less obvious forms.

“Stability … may … be illusory, hiding the buildup of hidden risks or nurturing behavior that will bring the stability to an end”

“Our environment evolves, and successfully preventing one type of risk may simply funnel it elsewhere, to reemerge, like a mutated bacteria, in a more virulent fashion.” (Chapter 1)

Ip is not arguing that attempts to improve safety are pointless. All other things being equal, there are many ways in which systems and processes can be made safer, but all other things are rarely equal in the real world. The potential for unintended consequence is also increasingly being amplified by the complexity and inter linkages that characterise the environment, economy and financial systems we have created in the pursuit of growth and efficiency.

Ip also sounds a timely warning on the dangers of seeing adverse events as a morality plays in which the required response is simply to identify/punish the guilty and then devise more rules to stop the specific behaviour that caused the problem. The desire for justice and to punish the guilty is a deeply embedded human behaviour but the risk is that these distract attention from the underlying systemic issues that will see the risk manifest via another avenue.

If you are interested, then you can find more detail here

The Countercyclical Capital Buffer

This post uses a recent BCBS working paper as a stepping off point for a broader examination of how the countercyclical capital buffer (CCyB) can help make the banking system more resilient.

This post uses a recent BCBS working paper as a stepping off point for a broader examination of how the countercyclical capital buffer (CCyB) can help make the banking system more resilient. The BCBS paper is titled “Towards a sectoral application of the countercyclical capital buffer: A literature review – March 2018” (BCBS Review) and its stated aim is to draw relevant insights from the existing literature and use these to shed light on whether a sectoral application of the CCyB would be a useful extension of the existing Basel III framework under which the CCyB is applied at an aggregate country level credit measure. The views expressed in Working Papers like this one are those of their authors and do not represent the official views of the Basel Committee but they do still offer some useful insights into what prudential supervisors are thinking about.

Key points

  1. I very much agree with the observation in the BCBS Review that the standard form of the CCyB is a blunt instrument by virtue of being tied to an aggregate measure of credit growth
  2. And that a sectoral application of the CCyB (operating in conjunction with other sector focussed macro prudential tools) would be an improvement
  3. But the CCyB strategy that has been developed by the Bank of England looks to be a much better path to pursue
  4. Firstly, because it directly addresses the problem of failing to detect/predict when the CCyB should be deployed and secondly because I believe that it results in a much more “usable” capital buffer
  5. The CCyB would be 1% if APRA adopted the Bank of England strategy (the CCyB required by APRA is currently 0%) but adopting this strategy does not necessarily require Australian banks to hold more capital at this stage of the financial cycle
  6. One option would be to align one or more elements of APRA’s approach with the internationally harmonised measure of capital adequacy and to “reinvest” the increased capital in a 1% CCyB.

First a recap on the Countercyclical Capital Buffer (aka CCyB).

The CCyB became part of the international macro prudential toolkit in 2016 and is intended to ensure that, under adverse conditions, the banking sector in aggregate has sufficient surplus capital on hand required to maintain the flow of credit in the economy without compromising its compliance with prudential requirements.

A key feature in the original BCBS design specification is that the buffer is intended to be deployed in response to high levels of aggregate credit growth (i.e high relative to the sustainable long term trend rates) which their research has identified as an indicator of heightened systemic risk. That does not preclude bank supervisors from deploying the buffer at other times as they see fit, but responding to excess credit growth has been a core part of the rationale underpinning its development.

The BCBS Review

The BCBS Review notes that the CCyB works in theory but concedes there is, as yet, virtually no empirical evidence that it will work in practice. This is not surprising given that it has only been in place for a very short period of time but still important to remember. The BCBS Review also repeatedly emphasises the point that the CCyB may help to mitigate the credit cycle but that is a potential side benefit, not the main objective. Its primary objective is to ensure that banks have sufficient surplus capital to be able to continue lending during adverse economic conditions where losses will be consuming capital.

The Review argues that the CCyB is a useful addition to the supervisor’s tool kit but is a blunt instrument that impacts all sectors of the economy indiscriminately rather than just targeting the sectors which are the source of systemic concern. It concludes that applying the CCyB at a sectoral level might be more effective for three reasons

  • more direct impact on the area of concern,
  • stronger signalling power, and
  • smaller effects on the wider economy than the Basel III CCyB.

The Review also discusses the potential to combine a sectoral CCyB with other macro prudential instruments; in particular the capacity for the two approaches to complement each other;

Quote “Generally, macroprudential instruments that operate through different channels are likely to complement each other. The literature reviewed indicates that a sectoral CCyB could indeed be a useful complement to alternative sectoral macroprudential measures, including borrower-based measures such as LTV, LTI and D(S)TI limits. To the extent that a sectoral CCyB is more effective in increasing banks’ resilience and borrower-based measures are more successful in leaning against the sectoral credit cycle, both objectives could be attained more effectively and efficiently by combining the two types of instruments. Furthermore, there is some evidence that suggests that a sectoral CCyB could have important signalling effects and may therefore act as a substitute for borrower-based measures.”

A Sectoral CCyB makes sense

Notwithstanding repeated emphasis that the main point of the CCyB is to ensure banks can and will continue to support credit growth under adverse conditions, the Review notes that there is not much, if any, hard empirical evidence on how effective a release of the CCyB might be in achieving this. The policy instrument’s place in the macro prudential tool kit seems to depend on the intuition that it should help, backed by some modelling that demonstrates how it would work and a pinch of hope. The details of the modelling are not covered in the Review but I am guessing it adopts a “homo economicus” approach in which the agents act rationally. The relatively thin conceptual foundations underpinning the BCBS version of the CCyB are worth keeping in mind.

The idea of applying the CCyB at a sectoral level seems to make sense. The more targeted approach advocated in the Review should in theory allow regulators to respond to sectoral areas of concern more quickly and precisely than would be the case when the activation trigger is tied to aggregate credit growth. That said, I think the narrow focus of the Review (i.e. should we substitute a sectoral CCyB for the current approach) means that it misses the broader question of how the CCyB might be improved. One alternative approach that I believe has a lot of promise is the CCyB strategy adopted by the Bank of England’s Financial Policy Committee (FPC).

The Bank of England Approach to the CCyB (is better)

The FPC published a policy statement in April 2016 explaining that its approach to setting the countercyclical capital buffer is based on five core principles. Many of these are pretty much the same as the standard BCBS policy rationale discussed above but the distinguishing feature is that it “… intends to set the CCyB above zero before the level of risk becomes elevated. In particular, it expects to set a CCyB in the region of 1% when risks are judged to be neither subdued nor elevated.”

This contrasts with the generic CCyB, as originally designed by the BCBS, which sets the default position of the buffer at 0% and only increases it in response to evidence that aggregate credit growth is excessive. This might seem like a small point but I think it is a material improvement on the BCBS’s original concept for two reasons.

Firstly, it directly addresses the problem of failing to detect/predict when systemic risk in the banking system requires prudential intervention. A lot of progress has been made in dealing with this challenge, not the least of which has been to dispense with the idea that central banks had tamed the business cycle. The financial system however retains its capacity to surprise even its most expert and informed observers so I believe it is better to have the foundations of a usable countercyclical capital buffer in place as soon as possible after the post crisis repair phase is concluded rather than trying to predict when it might be required.

The FPC still monitors a range of core indicators for the CCyB grouped into three categories.

  • The first category includes measures of ‘non-bank balance sheet stretch’, capturing leverage in the broader economy and in the private non-financial (ie household and corporate) sector specifically.
  • The second category includes measures of ‘conditions and terms in markets’, which capture borrowing terms on new lending and investor risk appetite more broadly.
  • The third category includes measures of ‘bank balance sheet stretch’, which capture leverage and maturity/liquidity transformation in the banking system.

However the FPC implicitly accepts that it can’t predict the future so it substitutes a simple, pragmatic and error resilient strategy (put the default CCyB buffer in place ASAP) for the harder problem of trying to predict when it will be needed. This strategy retains the option of increasing the CCyB, is simpler to administer and less prone to error than the BCBS approach. The FPC might still miss the turning point but it has a head start on the problem if it does.

The FPC also integrates its CCyB strategy with its approach to stress testing. Each year the stress tests include a scenario:

“intended to assess the risks to the banking system emanating from the financial cycle – the “annual cyclical scenario”

The severity of this scenario will increase as risks build and decrease after those risks crystallise or abate. The scenario might therefore be most severe during a period of exuberance — for example, when credit and asset prices are growing rapidly and risk premia are compressed. That might well be the point when markets and financial institutions consider risks to be lowest. And severity will be lower when exuberance has corrected — often the time at which markets assess risks to be largest. In leaning against these tendencies, the stress-testing framework will lean against the cyclicality of risk taking: it will be countercyclical.”

The Bank of England’s approach to stress testing the UK banking system – October 2015 (page 5)

The second reason  I favour the FPC strategy is because I believe it is likely to result in a more “usable” buffer once risk crystallizes (not just systemic risk) and losses start to escalate. I must admit I have struggled to clearly articulate why this would be so but I think the answer lies partly in the way that the FPC links the CCyB to a four stage model that can be interpreted as a stylised description of the business cycle. The attraction for me in the FPC’s four stage model is that it offers a coherent narrative that helps all the stakeholders understand what is happening, why it is happening, what will happen next and when it will happen.

The BCBS Review talks about the importance of communication and the FPC strategy offers a good model of how the communication strategy can be anchored to a coherent and intuitive narrative that reflects the essentially cyclical nature of the banking industry. The four stages are summarised below together with some extracts setting out the FPC rationale.

Stage 1: The post-crisis repair phase in which risks are subdued – the FPC would expect to set a CCyB rate of 0%

FPC rationale: “Risks facing the financial system will normally be subdued in a post-crisis repair and recovery phase when the financial system and borrowers are repairing balance sheets. As such, balance sheets are not overextended. Asset and property prices tend to be low relative to assessed equilibrium levels. Credit supply is generally tight and the risk appetite of borrowers and lenders tends to be low. The probability of banks coming under renewed stress is lower than average.”

Stage 2: Risks in the financial system re-emerge but are not elevated – the FPC intends to set a positive CCyB rate in the region of 1% after the economy moves into this phase.

FPC rationale: ‘In this risk environment, borrowers will not tend to be unusually extended or fragile, asset prices are unlikely to show consistent signs of over, or under, valuation, and measures of risk appetite are likely to be in line with historical averages”. As such, it could be argued that no buffer is required but the FPC view is that a pre-emptive strategy is more “robust to the inherent uncertainty associated with measuring risks to financial stability”. It also allows subsequent adjustments to be more graduated than would be possible if the CCyB was zero.

Stage 3: Risks in the financial system become elevated: stressed conditions become more likely – the FPC would expect to increase the CCyB rate beyond the region of 1%. There is no upper bound on the rate that can be set by the FPC.

FPC rationale: “As risks in the financial system become elevated, borrowers are likely to be stretching their ability to repay loans, underwriting standards will generally be lax, and asset prices and risk appetite tend to be high. Often risks are assumed by investors to be low at the very point they are actually high. The distribution of risks to banks’ capital at this stage of the financial cycle might have a ‘fatter tail’ [and] stressed outcomes are more likely.”

Stage 4: Risks in the financial system crystallise – the FPC may cut the CCyB rate, including where appropriate to 0%.

FPC rationale: “Reducing the CCyB rate pre-emptively before losses have crystallised may reduce banks’ perceived need to hoard capital and restrict lending, with consequent negative impacts for the real economy. And if losses have crystallised, reducing the CCyB allows banks to recognise those losses without having to restrict lending to meet capital requirements. This will help to ensure that capital accumulated when risks were building up can be used, thus enhancing the ability of the banking system to continue to support the economy in times of stress.”

The March 2018 meeting of the FPC advised that the CCyB applying to UK exposures would remain unchanged at the 1% default level reflecting its judgement that the UK banking system was operating under Stage 2 conditions.

Calibrating the size of the CCyB

The FPC’s approach to calibrating the size of the CCyB also offers some interesting insights. The FPC’s initial (April 2016) policy statement explained that a “CCyB rate in the region of 1%, combined with other elements of the capital framework, provides UK banks with sufficient capital to withstand a severe stress. Given current balance sheets, the FPC judges that, at this level of the CCyB, banks would have sufficient loss-absorbing capacity to weather a macroeconomic downturn of greater magnitude than those observed on average in post-war recessions in the United Kingdom — although such estimates are inherently uncertain.”

The first point to note is that the FPC has chosen to anchor their 1% default setting to a severity greater than the typical post war UK recession but not necessarily a GFC style event. There is a school of thought that maintains that more capital is always better but the FPC seems to be charting a different course. This is a subtle area in bank capital management but I like the the FPC’s implied defence of subtlety.

What is sometimes lost in the quest for a failure proof banking system is a recognition of the potential for unintended consequence. All other things being equal, more capital makes a bank less at risk of insolvency but all other things are almost never equal in the real world. Banks come under pressure to find ways to offset the ROE dilution associated with more capital. I know that theory says that a bank’s cost of equity should decline as a result of holding more capital so there is no need to offset the dilution but I disagree (see this post for the first in a proposed series where I have started to set out my reasons why). Attempts to offset ROE dilution also have a tendency to result in banks taking more risk in ways that are not immediately obvious. Supervisors can of course intervene to stop this happening but their already difficult job is made harder when banks come under pressure to lift returns. This is not to challenge the “unquestionably strong” benchmark adopted by APRA but simply to note that more is not always better.

Another problem with just adding more capital is that the capital has to be usable in the sense that the capital ratio needs to be able to decline as capital is consumed by elevated losses without the bank coming under pressure to immediately restore the level of capital it is expected to hold. The FPC strategy of setting out how it expects capital ratios to increase or decrease depending on the state of the financial cycle helps create an environment in which this can happen.

Mapping the BOE approach to Australia

APRA has set the CCyB at 0% whereas the BOE approach would suggest a value of at least 1% and possibly more given that APRA has felt the need to step in to cool the market down. It is important to note that transitioning to a FPC style CCyB does not necessarily require that Australian banks need to hold more capital. One option would be to harmonise one or more elements of APRA’s approach to capital measurement (thereby increasing the reported capital ratio) and to “reinvest” the surplus capital in a CCyB. The overall quantum of capital required to be unquestionably strong would not change but the form of the capital would be more usable to the extent that it could temporarily decline and banks had more time to rebuild  the buffer during the recovery phase.

Summing up

A capital adequacy framework that includes a CCyB that is varied in a semi predictable manner over the course of the financial cycle would be far more resilient than the one we currently have that offers less flexibility and is more exposed to the risk of being too late or missing the escalation of systemic risk all together.

Tell me what I am missing …

Are banks a special kind of company (or at least different)?

This is a big topic, and somewhat irredeemably technical, but I have come to believe that there are some unique features of banks that make them quite different from other companies. Notwithstanding the technical challenges, I think it is important to understand these distinguishing features if we are to have a sensible debate about the optimum financing structure for a bank and the kinds of returns that shareholders should expect on the capital they contribute to that structure.

You could be forgiven for thinking that the Australian debate about optimum capital has been resolved by the “unquestionably strong” benchmark that APRA has set and which all of the major banks have committed to meet. However, agreeing what kind of return is acceptable on unquestionably strong capital remains contentious and we have only just begun to consider how the introduction of a Total Loss Absorbing Capital (TLAC) requirement will impact these considerations.

The three distinctive features of banks I want to explore are:

  • The way in which net new lending by banks can create new bank deposits which in turn are treated as a form of money in the financial system (i.e. one of the unique things banks do is create a form of money);
  • The reality that a large bank cannot be allowed to fail in the conventional way (i.e. bankruptcy followed by reorganisation or liquidation) that other companies and even countries can (and frequently do); and
  • The extent to which bank losses seem to follow a power law distribution and what this means for measuring the expected loss of a bank across the credit cycle.

It should be noted at the outset that Anat Admati and Martin Hellwig (who are frequently cited as authorities on the issues of bank capital discussed in this post) disagree with most if not all of the arguments I intend to lay out. So, if they are right, then I am wrong. Consequently, I intend to first lay out my understanding of why they disagree and hopefully address the objections they raise. They have published a number of papers and a book on the topic but I will refer to one titled “The Parade of the Bankers’ New Clothes Continues: 31 Flawed Claims Debunked” as the primary source of the counter arguments that I will be attempting to rebut. They are of course Professors whereas I bring a lowly masters degree and some practical experience to the debate. Each reader will need to decide for themselves which analysis and arguments they find more compelling.

Given the size of the topic and the technical nature of the issues, I also propose to approach this over a series of posts starting with the relationship between bank lending and deposit creation. Subsequent posts will build on this foundation and consider the other distinctive features I have identified before drawing all of the pieces together by exploring some practical implications.

Do banks create “money”? If so, how does that impact the economics of bank funding?

The Bank of England (BoE) released a good paper on the first part of this question titled “Money creation in the modern economy” .  The BoE paper does require some banking knowledge but I think demonstrates reasonably clearly that the majority of bank deposits are created by the act of a bank making a new loan, while the repayment of bank loans conversely reduces the pool of deposits. The related but more important question for the purposes of this discussion is whether you believe that bank deposits are a form of money.

Admati and Hellwig identify the argument that “banks are special because they create money” as Flawed Claim #5 on the grounds that treating deposits as money is an abuse of the word “money”. They are not disputing the fact that monetary economists combine cash with demand deposits in one of the definitions of money. As I understand it, the essence of their argument is that deposits are still a debt of the issuing bank while “real” money does not need to be repaid to anyone.

It is true that deposits are a bank debt and that some deposits are repayable on demand. However, I believe the bigger issues bearing on the economics of bank financing stem from the arguments Admati and Hellwig advance to debunk what they label as Flawed Claim #4 that “The key insights from corporate finance about the economics of funding, including those of Modigliani and Miller, are not relevant for banks because banks are different from other companies“.

Their argument appears to focus on using Modigliani and Miller (“M&M”) as an “analytical approach” in which the cost (contractual or expected) of the various forms of financing are connected by a universal law of risk and reward. Their argument is that this universal law (analogous to the fundamental laws of physics) demands that using more or less equity (relative to debt) must translate to a lower or higher risk of insolvency and that rational debt investors will respond by adjusting the risk premium they demand.

I have no issue with the analytical approach or the premise that funding costs should be related to risk. What happens however when one of the primary forms of debt funding is largely protected from the risk of insolvency? In the case of the major Australian banks, deposits account for over half of a bank’s total funding but are largely isolated from the risk of insolvency by a number of features. One is the Banking Act that confers a preferred claim in favour of Australian depositors over the Australian assets of the bank. The other is government guaranteed deposit insurance coverage capped at $250,000 per person per bank. The rationale for these acts of apparent government generosity is a contentious subject in itself but, for the purposes of this post, my working hypothesis is that the preferred claim and deposit insurance are a consequence of the fact that the community treats bank demand deposits as a form of money.

Consequently, the risk that an Australian depositor will face a loss of principal in the already remote event of insolvency is arguably de minimis and the way that demand deposits are priced and the way they are used as a substitute for cash reflects this risk analysis. There remains a related, though separate, risk that a bank may face a liquidity problem but depositors (to the extent they even think about this) will assume that central bank Lender of Last Resort liquidity support covers this.

Admati and Hellwig do not, to the best of my knowledge, consider the implications of these features of bank funding. In their defence, I don’t imagine that the Australian banking system was front of mind when they wrote their papers but depositor preference and deposit insurance are not unique Australian innovations. However, once you consider these factors, the conclusion I draw is that the cost of a substantial share of a bank’s debt financing is relatively (if not completely) insensitive to changes in the amount of equity the bank employs in its financing structure.

One consequence is that the higher levels of common equity that Australian banks employ now, compared to the position prior to the GFC, has not resulted in any decline in the cost of deposit funding in the way that M&M say that it should. In fact, the more conservative funding and liquidity requirements introduced under Basel III have required all banks to compete more aggressively for the forms of deposit funding that are deemed by the prudential requirements to be most stable thereby driving up the cost.

The point here is not whether these changes were desirable or not (for the record I have no fundamental issue with the Unquestionably Strong capital benchmark nor with more conservative funding and liquidity requirements). The point is that the cost of deposit funding, in Australian banking at least, has not declined in the way that Admati and Hellwig’s analytical approach and universal law demands that it should.

Summing up, it is possible that other forms of funding have declined in cost as Admati and Hellwig claim should happen, but there is both an analytical rationale and hard evidence that this does not appear to be the case, for Australian bank deposits at least.

The next post will consider the other main (non equity) components of a bank funding structure and explore how their risk/cost has evolved in response both to the lessons that investors and rating agencies took away from the GFC and to the changes in bank regulation introduced by Basel III. A subsequent post will review issues associated with measuring the Expected Loss and hence the true “Through the Cycle” profitability of a bank before I attempt to bring all of the pieces together.

There is a lot of ground to cover yet. At this stage, I have simply attempted to lay out a case for why the cost of bank deposits in Australia has not obeyed the universal analytical law posited by Admati and Hellwig as the logical consequence of a bank holding more equity in its financing structure but if you disagree tell me what I am missing …

Tony

Post script: The arguments I have laid out above could be paraphrased as “banks deposits differ from other kinds of debt because banks themselves create deposits by lending” which Admati and Hellwig specifically enumerate as Flawed Claim #6. I don’t think their rebuttal of this argument adds much to what is discussed above but for the sake of completeness I have copied below the relevant extract from their paper where they set out why they believe this specific claim is flawed. Read on if you want more detail or have a particular interest in this topic but I think the main elements of the debate are already covered above. If you think there is something here that is not covered above then let me know.

Flawed Claim 6: Bank deposits differ from other kinds of debt because banks create deposits by lending.

What is wrong with this claim? This claim is often made in opposition to a “loanable funds” view of banks as intermediaries that collect deposits in order to fund their loans. Moreover, this “money creation through lending” is said to be the way money from the central bank gets into the economy.19 The claim rests on a confusion between stocks and flows. Indeed, if a commercial bank makes a loan to a nonfinancial firm or to a private household it provides its borrowers with a claim on a deposit account. Whereas this fact provides a link between the flow of new lending and the flow of new deposits, it is hardly relevant for the bank’s funding policy, which concerns the stocks of different kinds of debt and equity that it has outstanding, which must cover the stocks of claims on borrowers and other assets that the bank holds.

A nonfinancial firm or household that receives a loan from a bank will typically use the associated claim on a deposit account for payments to third parties. The recipients of these payments may want to put some of the money they get into deposits, but they may instead prefer to move the money out of the banking system altogether, e.g., to a money market fund or a stock investment fund. 20

From the perspective of the individual bank, the fact that lending goes along with deposit creation does not change the fact that the bank owes its depositors the full amount they deposited. The key difference between deposits and other kinds of debt is not that deposits are “like money” or that deposits may be created by lending, but rather that the bank provides depositors with services such as payments through checks and credit cards or ATM machines that make funds available continuously. The demand for deposits depends on these services, as well as the interest that the bank may offer, and it may also depend on the risk of the bank becoming insolvent or defaulting.21

The suggestion that bank lending is the only source of deposit creation is plainly false.22 Deposits are created when people bring cash to the bank, and they are destroyed when people withdraw cash. In this case, the reduction in deposits – like any reduction in funding – goes along with a reduction in the bank’s assets, i.e., a shortening of its balance sheet, but this reduction affects the bank’s cash reserves rather than its lending. The impact of such withdrawals on banks and entire banking systems are well known from the Great Depression or from the recent experience of Greece. In Greece in the spring and summer of 2015, depositors also were worried about the prospect that in the event of the country’s exit from the euro, their denomination of their deposits would be changed, whereas a stack of bills under a matrass would not be affected.