Hollow promises

Frances Coppola regularly offers detailed and useful analysis on exactly what is wrong with some of the claims made by crypto banks. I flagged one of her posts published last November and her latest post “Hollow Promises”continues to offer useful insights into the way traditional banking concepts like deposits, liquidity and solvency get mangled.

Well worth reading.

Tony – From the Outside

“From the Outside” takes stock

This is possibly a bit self indulgent but “From The Outside” is fast approaching the 5th anniversary of its first post so I thought it was time to look back on the ground covered and more importantly what resonated with the people who read what I write.

The blog as originally conceived was intended to explore some big picture questions such as the ways in which banks are different from other companies and the implications this has for thinking about questions like their cost of equity, optimal capital structure, risk appetite, risk culture and the need for prudential regulation. The particular expertise (bias? perspective?) I brought to these questions was that of a bank capital manager, with some experience in the Internal Capital Adequacy Assessment Process (ICAAP) applicable to a large Australian bank and a familiarity with a range of associated issues such as risk measurement (credit, market, operational, interest rate etc), risk appetite, risk culture, funds transfer pricing and economic capital allocation.

Over the close to 5 years that the blog has been operational, something in excess of 200 posts have been published. The readership is pretty limited (196 followers in total) but hopefully that makes you feel special and part of a real in crowd of true believers in the importance of understanding the questions posed above. Page views have continued to grow year on year to reach 9,278 for 2022 with 5,531individual visits.

The most popular post was one titled “Milton Friedman’s doctrine of the social responsibility of business” in which I attempted to summarise Friedman’s famous essay “The Social Responsibility of Business is to Increase its Profits” first published in September 1970. I was of course familiar with Friedman’s doctrine but only second hand via reading what other people said he said and what they thought about their framing of his argument. You can judge for yourself, but my post attempts to simply summarise his doctrine with a minimum of my own commentary. It did not get as much attention but I also did a post flagging what I thought was a reasonably balanced assessment of the pros and cons of Friedman’s argument written by Luigi Zingales.

The second most popular post was one titled “How banks differ from other companies. This post built on an earlier one titled “Are banks a special kind of company …” which attempted to respond to some of the contra arguments made by Anat Admati and Martin Hellwig. Both posts were based around three distinctive features that I argued make banks different and perhaps “special” …

  • 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.

The third most popular post was titled “What does the “economic perspective” add to can ICAAP and this to be frank this was a surprise. I honestly thought no one would read it but what do I know. The post was written in response to a report the European Central Bank (ECB) put out in August 2020 on ICAAP practices it had observed amongst the banks it supervised. What I found surprising in the ECB report was what seemed to me to be an over reliance on what economic capital models could contribute to the ICAAP.

It was not the ECB’s expectation that economic capital should play a role that bothered me but more a seeming lack of awareness of the limitations of these models in providing the kinds of insights the ECB was expecting to see more of and a lack of focus on the broader topic of radical uncertainty and how an ICAAP should respond to a world populated by unknown unknowns. It was pleasing that a related post I did on John Kay and Mervyn King’s book “Radical Uncertainty : Decision Making for an Unknowable Future” also figured highly in reader interest.

Over the past year I have strayed from my area of expertise to explore what is happening in the crypto world. None of my posts have achieved wide readership but that is perfectly OK because I am not a crypto expert. I have been fascinated however by the claims that crypto can and will disrupt the traditional banking model. I have attempted to remain open to the possibility that I am missing something but remain sceptical about the more radical claims the crypto true believers assert. There are a lot of fellow sceptics that I read but if I was going to recommend one article that offers a good overview of the crypto story to date it would be the one by Matt Levine published in the 31 October 2022 edition of Bloomberg Businessweek.

I am hoping to return to my bank capital roots in 2023 to explore the latest instalment of what it means for an Australian bank to be “Unquestionably Strong” but I fear that crypto will continue to feature as well.

Thank you to all who find the blog of interest – as always let me know what I missing.

Tony – From the Outside

Using the term “deposit” is a red flag

True believers may want to dispute her headline (“The entire crypto ecosystem is a ponzi”) but this post by Frances Coppola I think clearly illustrates the reasons why the term “deposit” should never be applied to anything associated with a crypto application.

Tony – From the Outside

Fed Finalizes Master Account Guidelines

The weekly BPI Insights roundup has a useful summary of what is happening with respect to opening up access to Fed “master accounts”. This is a pretty technical area of banking but has been getting broader attention in recent years due to some crypto entities arguing that they are being unfairly denied access to this privileged place in the financial system. BPI cites the example of Wyoming crypto bank Custodia, formerly known as Avanti, which sued the Kansas City Fed and the Board of Governors over delays in adjudicating its master account application.

The Kansas Fed is litigating the claim but the Federal Reserve has now released its final guidelines for master account access.

The BPI perspective on why it matters:

Over the past two years, a number of “novel charters” – entities without deposit insurance or a federal supervisor – have sought Fed master accounts. A Fed master account would give these entities – which include fintechs and crypto banks — access to the central bank’s payment system, enabling them to send and receive money cheaply and seamlessly. BPI opposes granting master account access to firms without consolidated federal supervision and in its comment letter urged the Fed to clarify which institutions are eligible for master accounts.

The BPI highlights two main takeaways from the final guidelines:

The Fed does not define what institutions are eligible to seek accounts and declined to exclude all novel charter from access to accounts and services.

The guidelines maintain a tiered review framework that was proposed in an earlier version, sorting financial firms that apply for master accounts into three buckets for review. Firms without deposit insurance that are not subject to federal prudential supervision would receive the highest level of scrutiny. The tiers are designed to provide transparency into the expected review process, the Fed said in the guidelines — although the final guidelines clarify that even within tiers, reviews will be done on a “case-by-case, risk-focused basis.”

The key issue here, as I understand it, is whether the crypto firms are really being discriminated against (I.e has the Fed been captured by the banks it regulates and supervises) or whether Crypto “banks” are seeking the privilege of master account access without all the costs and obligations that regulated banks face.

Let me know what I am missing

Tony – From the Outside

History of the Fed

I love a good podcast recommendation. In that spirit I attached a link to an interview with Lev Menand on the Hidden Forces podcast. The broader focus of the interview is the rise of shadow banking and the risks of a financial crisis but there is a section (starting around 21:20 minute mark) where Lev and Demetri discuss the origin of central banking and the development of the Fed in the context of the overall development of the US banking system.

The discussion ranges over

  • The creation of the Bank of England (23:20)
  • The point at which central banks transitioned from being simple payment banks to credit creation (24:10) institutions with monetary policy responsibilities
  • The problems the US founders faced creating a nation state without its own money (25:30)
  • Outsourcing money creation in the US to private banks via public/private partnership model (26:50)
  • The problems of a fragmented national market for money with high transmission costs (27:40)
  • The origin of the Federal Reserve in 1913 (31.50) and the evolution of banking in the US that preceded its creation which helps explain the organisational form it took

… and a lot more including a discussion of the rise of shadow banking in the Euromarket.

The topic is irredeemingly nerdy I know and it will not tell you much new if you are already engaged with the history of banking but it does offer a pretty good overview if you are interested but not up for reading multiple books.

Tony – From the Outside

Red flags in financial services

Nice podcast from Odd Lots discussing the Wirecard fraud. Lots of insights but my favourite is to be wary when you see a financial services company exhibit high growth while maintaining profitability.

There may be exceptions to the rule but that is not how the financial services market normally works.

podcasts.apple.com/au/podcast/odd-lots/id1056200096

Tony — From the Outside

Where do bank deposits come from …

This is one of the more technical (and misundersood) aspects of banking but also a basic fact about money creation in the modern economy that I think is useful to understand. For the uninitiated, bank deposits are typically the largest form of money in a modern economy with a well developed financial system.

One of the better explanations I have encountered is a paper titled “Money creation in the modern economy” that was published in the Bank of England’s Quarterly Bulletin in Q1 2014. You can find the full paper here but I have copied some extracts below that will give you the basic idea …

In the modern economy, most money takes the form of bank deposits.  But how those bank deposits are created is often misunderstood:  the principal way is through commercial banks making loans.  Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.

The reality of how money is created today differs from the description found in some economics textbooks:

Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.  In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.

Although commercial banks create money through lending, they cannot do so freely without limit.  Banks are limited in how much they can lend if they are to remain profitable in a competitive banking system.  Prudential regulation also acts as a constraint on banks’ activities in order to maintain the resilience of the financial system.  And the households and companies who receive the money created by new lending may take actions that affect the stock of money — they could quickly ‘destroy’ money by using it to repay their existing debt, for instance.

Money creation in the modern economy, Michale McLeay, Amar Radia and Ryland Thomas, Bank of England Quarterly Bulletin 2014 Q1

The power to create money is of course something akin to magic and the rise of stablecoins has revived a long standing debate about the extent to which market discipline alone is sufficient to ensure sound money. My personal bias (forged by four decades working in the Australian banking system) leans to the view that money creation is not something which banker’s can be trusted to discharge without some kind of supervision/constraints. The paper sets out a nice summary of the ways in which this power is constrained in the conventional banking system …

In the modern economy there are three main sets of constraints that restrict the amount of money that banks can create.

(i) Banks themselves face limits on how much they can lend.  In particular:

– Market forces constrain lending because individual banks have to be able to lend profitably in a competitive market.

– Lending is also constrained because banks have to take steps to mitigate the risks associated with making additional loans.

– Regulatory policy acts as a constraint on banks’ activities in order to mitigate a build-up of risks that could pose a threat to the stability of the financial system.

(ii) Money creation is also constrained by the behaviour of the money holders — households and businesses. Households and companies who receive the newly created money might respond by undertaking transactions that immediately destroy it, for example by repaying outstanding loans.

(iii) The ultimate constraint on money creation is monetary policy. By influencing the level of interest rates in the economy, the Bank of England’s monetary policy affects how much households and companies want to borrow. This occurs both directly, through influencing the loan rates charged by banks, but also indirectly through the overall effect of monetary policy on economic activity in the economy.  As a result, the Bank of England is able to ensure that money growth is consistent with its objective of low and stable inflation.

The confidence in the central bank’s ability to pursue its inflation objective possibly reflects a simpler time when the inflation problem was deemed solved but the paper is still my goto frame of reference when I am trying to understand how the banking system creates money.

If you want to dive a bit deeper into this particular branch of the dark arts, some researchers working at the US Federal Reserve recently published a short note titled “Understanding Bank Deposit Growth during the COVID-19 Pandemic” that documents work undertaken to try to better understand the rapid and sustained growth in aggregate bank deposits between 2020 and 2021. Frances Coppola also published an interesting post on her blog that argues that banks not only create money when they lend but also when they spend it. You can find the original post by Frances here and my take on it here.

A special shout out to anyone who has read this far. My friends and family think I spend too much time thinking about this stuff so it is nice to know that I am not alone.

Tony – From the Outside

Stablecoin business models – I need a dollar

There has been a lot written on stablecoins in the wake of Terra’s crash. Matt Levine has been a reliable source of insight (definitely worth subscribing to his “Money Stuff” newsletter) but I am also following Izabella Kaminska via her new venture (The Blind Spot).

Maybe I am just inexplicably drawn to anything that seeks to explain crypto in Tradfi terms but I think this joint post by Izabella and Frances Coppola poses the right question by exploring the extent to which stablecoin issuers will always struggle to reconcile the safety of their peg promise to the token holders with the need to make a return. The full post is behind a paywall but this link takes you to a short extract that Izabella has made more broadly available.

Their key point is that financial security is costly so your business model needs an angle to make a return … to date the angles (or financial innovations) are mostly stuff that Tradfi has already explored. There is no free lunch.

If it’s financially secure, it’s usually not profitable

So, what was the impetus for issuers like Kwon to focus on these innovations? For the most part, it was probably the realisation that conventional stablecoins – due to their similarities with narrow banks – are exceedingly low-margin businesses. In a lot of cases, they may even be unprofitable.

This is because managing other people’s money prudently and in a way that always protects capital is actually really hard. Even if those assets are fully reserved, some sort of outperformance has to be generated to cover the administration costs. The safest way to do that is to charge fees, but this hinders competitiveness in the market since it generates a de facto negative interest rate. Another option is cross-selling some other service to the captured user base, like loan products. But this gets into bank-like activity.

The bigger temptation, therefore, at least in the first instance, is to invest the funds in your care into far riskier assets (with far greater potential upside) than those you are openly tracking.

But history shows that full-reserve or “narrow” banks eventually become fractional-reserve banks or disappear.

“Putting the Terra stablecoins debacle into Tradfi context”, Frances Coppola and Izabella Kaminska, The Blind Spot

Tony – From the Outside

SWIFT …

… has been in the news lately.

This link takes you to a blog I follow written by Patrick McKenzie that offers a payment expert’s perspective on what SWIFT is, together with Patrick’s personal view on what the sanctions are intended to achieve.

This short extract covers Patrick’s assessment of the objective of the sanctions

The intent of this policy has been described variously in various places. In my personal opinion, I think the best articulation of the strategy is “We are attempting to convey enormous displeasure while sanctioning some banks which are believed to be close to politically exposed Russians, while not making it impossible for Russian firms generally to transact internationally nor sparking a humanitarian crisis either inside or outside of Russia.”

One of the key insights is that SWIFT manages the messaging that accompanies international payments and facilities their processing, not the transfers of money per se. The sanctions do not make it impossible to transact with Russia, they mostly make it operationally very difficult and not really worth the effort, especially at scale. Especially if you are a regulated bank who cares about your long term relationship with your regulator.

Another nuance that does not always come through in the newspaper reporting of the sanctions is the extent to which the compliance functions in banks are under pressure to interpret and anticipate the intent of the regulatory sanctions

Many commentators confuse the actual effects of severing particular banks from SWIFT with what they perceive as the policy goal motivating it. More important than either is, in my opinion, what it communicates about commander’s intent to the policy arms who are responsible for enforcing it.

Specifically, it communicates that Something Has Changed and that Russian institutional money, specifically “oligarch” money, is now tainted, and not in the benignly ignored fashion it has been for most of the last few decades.

Where there is some doubt or ambiguity, banks are likely to err on the side of caution.

Patrick’s post is worth reading if you are interested in this particular aspect of SWIFT and his blog worth following if you are interested in payments more generally.

Tony – From the Outside

The elasticity of credit

One of the arguments for buying Bitcoin is that, in contrast to fiat currencies that are at mercy of the Central Bank money printer, its value is underpinned by the fixed and immutable supply of coins built into the code. Some cryptocurrencies take this a step further by engineering a systematic burning of their coin.

I worry about inflation as much as the next person, perhaps more so since I am old enough to have actually lived in an inflationary time. I think a fixed or shrinking supply is great for an asset class but it is less obvious that it is a desirable feature of a money system.

Crypto true believers have probably stopped reading at this point but to understand why a fixed supply might be problematic I can recommend a short speech by Claudio Borio. The speech dates back to 2018 but I think it continues to offer a useful perspective on the value of an elastic money supply alongside broader comments about the nature of money and its role in the economy.

Borio was at the time the Head of the BIS Monetary and Economic Department but the views expressed were his personal perspective covering points that he believed to be well known and generally accepted, alongside others more speculative and controversial.

I did a post back in March 2019 that offers an overview of the speech but recently encountered a post by J.W. Mason which reminded me how useful and insightful it was.

The specific insight I want to focus on here is the extent to which a well functioning monetary system relies on the capacity of credit extended in the system to expand and contract in response to both short term settlement demands and the longer term demands driven by economic growth.

One of the major challenges with the insight Borio offers is that most of us find the idea that money is really just a highly developed form of debt to be deeply unsatisfying if not outright scary. Borio explicitly highlights “the risk of overestimating the distinction between credit (debt) and money” arguing that “…we can think of money as an especially trustworthy type of debt”

Put differently, we can think of money as an especially trustworthy type of debt. In the case of bank deposits, trust is supported by central bank liquidity, including as lender of last resort, by the regulatory and supervisory framework and varieties of deposit insurance; in that of central bank reserves and cash, by the sovereign’s power to tax; and in both cases, by legal arrangements, way beyond legal tender laws, and enshrined in market practice.

Borio: Page 9

I did a post here that explains in more detail an Australian perspective on the process by which unsecured loans to highly leveraged companies (aka “bank deposits”) are transformed into (mostly) risk free assets that represent the bulk of what we use as money.

Borio outlines how the central banks’ elastic supply of the means of payment is essential to ensure that (i) transactions are settled in the interbank market and (ii) the interest rate is controlled …

“To smooth out interbank settlement, the provision of central bank credit is key. The need for an elastic supply to settle transactions is most visible in the huge amounts of intraday credit central banks supply to support real-time gross settlement systems – a key way of managing risks in those systems (Borio (1995)).”

Borio: Page 5

… but also recognises the problem with too much elasticity

While the elasticity of money creation oils the wheels of the payment system on a day to day basis, it can be problematic over long run scenarios where too much elasticity can lead to financial instability. Some degree of elasticity is important to keep the wheels of the economy turning but too much can be a problem because the marginal credit growth starts to be used for less productive or outright speculative investment.

This is a big topic which means there is a risk that I am missing something. That said, the value of an elastic supply of credit looks to me like a key insight to understanding how a well functioning monetary system should be designed.

The speech covers a lot more ground than this and is well worth reading together with the post by J.W. Mason I referenced above which steps through the insights. Don’t just take my word for it, Mason introduces his assessment with the statement that he was “…not sure when I last saw such a high density of insight-per-word in a discussion of money and finance, let alone in a speech by a central banker”.

Tony – From the Outside