Banks – 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

Progress in fast payment systems

As we contemplate new forms of money (both Central Bank Digital Currencies and new forms of private money like stablecoins), JP Koning makes the case that the modern payment systems available in the conventional financial system have improved more than is often appreciated …

The speeding up of modern payments is a great success story. Let me tell you a bit about it.To begin with, central banks and other public clearinghouses have spent the last 15-or-so years blanketing the globe with real-time retail payments systems. Europe has TIPS, UK has Faster Payments, India has IMPS, Sweden has BiR, Singapore FAST. There must be at least thirty or forty of these real-time retail payments system by now.

The speed of these new platforms get passed on to the public by banks and fintechs, which are themselves connected to these core systems.

That is not to say they are perfect but it is helpful to properly understand what has been done already in order to better understand what the new forms truely offer.

You can read his post here ..

http://jpkoning.blogspot.com/2021/07/those-70s-ach-payments.html

Tony – From the Outside

Taming wildcat stablecoins …

… is the title of an interesting paper by Gary Gorton and Jeffrey Zhang which argues that:

Cryptocurrency, or stablecoins to be more precise, can be viewed as the latest variation in a long history of privately produced money
The experience of the United States during the Free Banking Era of the 19th century suggests that ” … privately produced monies are not an effective medium of exchange because they are not always accepted at par and are subject to bank runs”
Stablecoins are not as yet a systemic issue but could be, so policymakers need to adjust the regulatory framework now to be ready as these new forms of private money grow and and potentially evolve into something that can’t be ignored
Policy responses include regulating stablecoin issuers as banks and issuing a central bank digital currency

So what?

I am not convinced that a central bank digital currency is the solution. I can see a case for greater regulation of stablecoins but you need to be clear about exactly what type of stablecoin requires a policy response. Gorton and Zhang distinguish three categories …

The first includes cryptocurrencies that are not backed by anything, like Bitcoin. We call these “fiat cryptocurrencies.” Their defining feature is that they have no intrinsic value. Second, there are specialized “utility coins,” like the JPMorgan coin that is limited to internal use with large clients. Finally, there are “stablecoins,” which aspire to be used as a form of private money and so are allegedly backed one-for-one with government fiat currency (e.g., U.S. dollars)

I am yet to see a completely satisfactory taxonomy of stablecoins but at a minimum I would break the third category down further to distinguish the ways in which the peg is maintained. The (relatively few?) stablecoins that actually hold high quality USD assets on a 1:1 basis are different from those which hold material amounts of commercial paper in their reserve asset pool and different again from those which employ algorithmic protocols to maintain the peg.

However, you do not necessarily have to agree with their taxonomy, assessments or policy suggestions to get value from the paper – three things I found useful and interesting:

The “no-questions-asked ” principle for anything that functions or aims to function as money
Some technical insights into the economic and legal properties of stablecoins and stablecoin issuers
Lessons to be learned from history, in particular the Free Banking Era of the 19th century

The “no-questions-asked” principle.

Money is conventionally defined in terms of three properties; a store of value, a unit of account and a medium of exchange. Gorton and Zhang argue that “The property that’s most obvious, yet not explicitly presented, is that money also must satisfy the no-questions-asked (“NQA”) principle, which requires the money be accepted in a transaction without due diligence on its value“. They freely admit that they have borrowed this idea from Bengt Holmstrom though I think he actually uses the term “information insensitive” as opposed to the more colloquial NQA principle.

Previous posts on this blog have looked at both Holmstrom’s paper and other work that Gorton has co-authored on the optimal level of information that different types of bank stakeholders require. If I understood Holmstrom correctly, he seemed to extend his thesis on the value of being able to trade on an “information insensitive” basis to argue that “opacity” in the debt market is something to be embraced rather than eliminated. I struggle with embracing opacity in this way but that in no way diminishes the validity of the distinction he draws between the relative value of information in debt and equity markets and its impact on liquidity.

Gorton and Zhang emphasise the importance of deposit insurance in underwriting confidence in and the liquidity of bank deposits as the primary form of private money. I think that is true in the sense that most bank deposit holders do not understand the mechanics of the preferred claim they have on the assets of the bank they have lent to but it seems to me that over-collateralisation is equally as important in underwriting the economics of bank deposits.

If I have not lost you at this point, you can explore this question further via this link to a post I did titled “Bank deposits – turning unsecured loans to highly leveraged companies into (mostly) risk free assets – an Australian perspective“. From my perspective, the idea that any form of money has to be designed to be “information insensitive” or NQA rings very true.

Insights drawn from a technical analysis of stablecoins and stablecoin issuers.

The paper delves in a reasonable amount of detail into the technicalities of whether stablecoins are economically or legally equivalent to demand deposits and the related question of whether stablecoin issuers might be considered to be banks. The distinction between the economic and the legal status is I think especially useful for understanding how banking regulators might engage with the stablecoin challenge.

The over arching point is that stablecoins that look and function like bank demand deposits should face equivalent levels of regulation. That does not necessarily mean exactly the same set of rules but something functionally equivalent.

One practical outcome of this analysis that I had not considered previously is that they deem Tether to be based on an “equity contract” relationship with its users whereas the other stablecoins they analyse are “debt contracts” (see below). The link between Tether and a money market fund and the risk of “breaking the buck” has been widely canvassed but I had not previously seen the issue framed in these legal terms.

This technical analysis is summarised in two tables (Table 2: Stablecoins and their Contracts as of June 30, 2021 and Table 3: Stablecoins, Redemptions, and Fiat Money as of June 30. 2021) that offer a useful reference point for understanding the mechanics and details of some of the major stablecoins issued to date. In addition, the appendix to the paper offers links to the sources used in the tables.

Lessons to be learned from history

It may have been repeated to the point of cliche but the idea that “those who cannot remember the past are condemned to repeat it” (George Santayana generally gets the credit for this but variations are attributed to Edmund Burke and Sir Winston Churchill) resonates strongly with me. The general argument proposed by Gorton and Zhang is that lots of the ideas being tried out in stablecoin design and DeFi are variations on general principles that were similarly employed in the lightly regulated Free Banking Era but found wanting.

Even if you disagree with the conclusions they draw, the general principle of using economic history to explore what can be learned and what mistakes to avoid remains a useful discipline for any practitioner of the dark arts of banking and money creation.

Summing up in the authors’ own words

The paper is long (41 pages excluding the Appendix) but I will wrap up this post with an extract that gives you the essence of their argument in their own words.

Tony – From the Outside

Conclusion
The more things change, the more they stay the same. It is still the case that regulation is being outpaced by innovation—thereby creating an uneven playing field—as it is easier and cheaper for more technologically advanced firms to offer similar products and services.
In this case, it is also true that the problems associated with privately produced money are the same as they were one hundred and fifty years ago. We stress three points from our review of history. First, the use of private bank notes was a failure because they did not satisfy the NQA principle. Second, the U.S. government took control of the monetary system under the National Bank Act and subsequent legislation in order to eliminate the private bank note system in favor of a uniform currency—namely, national bank notes. Third, runs on demand deposits only ended with deposit insurance in 1934.
Currently, it does not appear that stablecoins are used as money. But, as stablecoins evolve further, the stablecoin world will look increasingly like an unregulated version of the Free Banking Era—a world of wildcat banking. During the Free Banking Era, private bank monies circulated at time-varying discounts based on geography and the perceived risk of the issuing bank. Stablecoin prices are independent of geography but not independent of the perceived risk of their backing assets. If they succeed in differentiating themselves from fiat cryptocurrencies and become used as money, then they will likely trade at time-varying discounts as well. Policymakers have a couple of ways to address this development, and they better get going.

Who gets the money?

Matt Levine’s “Money Stuff” column (23 April 2020) has some interesting observations commenting on which bank customers received the money the U.S. government made available under its Paycheck Protection Program. The column’s headline focus is developments in the oil market, which is worth reading in its own right, but the bank commentary is further down under the subheading “PPP”.

You can find the column here but there are a couple of extracts below that give you the basic thrust of his comments …

The U.S. government is distributing free money to small businesses so that they can stay afloat, and keep paying workers, during the coronavirus shutdown. It is doing this through the Paycheck Protection Program, in which banks lend the money to small businesses, and then the government (the U.S. Small Business Administration) pays back the loans if the businesses use the money for payroll. This is, broadly speaking, sensible. I once wrote about it:

It is a public-private partnership that plays to each side’s strengths. Banks are, precisely, in the business of vetting applications from local restaurants, examining their financial records and deciding how much money they need. The government, meanwhile, is best equipped to generate magical quantities of money. The banks do something recognizably bank-like—market and underwrite small-business loans—and the government transforms them into magical free money.
Matt Levine, Bloomberg “Money Stuff” column, 23 April 2020

Matt goes on to offer his perspective on the strengths of the program, some of the practical issues of execution but also its potential unintended outcomes

That’s the idea. But if you are enlisting banks to run your program, you are going to get … banks. Like, the banks are going to behave in recognizably bank-like ways while they are doing the bank-like job of handing out the loans. Some of that will be good: You want the banks to check that the small businesses exist and aren’t stealing the money and so forth. Some of it will be good-ish, or debatable: You want the banks to check that the documents are all in order and that the loans match the businesses’ actual financial needs, but you don’t want them to spend so much time checking that the businesses never get their money.
And some of it will be … not exactly bad, necessarily, but at least unrelated to the goals of the program.

I don’t have any insight on whether these big American banks are guilty as charged, or indeed guilty at all. Matt is I think open minded and simply presenting the facts but it is something worth watching as the COVID 19 crisis plays out. As a general observation, I feel like the Australian banks have for the most part made extra (if not extraordinary) efforts to do the right thing by both their customers and the community at large. I am of course a (now semi retired) banker so that colours my observation but, as an ongoing bank shareholder, I expect to be feeling some of the impact of the forbearance in upcoming dividend payments and see that as part of the price of investing in banks.

Tony (From the Outside)

Whatever it takes

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

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

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

Interesting times

Tony

Banks may be asked to absorb more than their contractual share of the economic fallout of the Coronavirus

We have already seen signs that the Australian banks recognise that they need to absorb some of the fallout from the economic impact of the Coronavirus. This commentator writing out of the UK makes an interesting argument on how much extra cost banks and landlords should volunteer to absorb.

Richard Murphy on tax, accounting and political economy
— Read on www.taxresearch.org.uk/Blog/2020/03/04/banks-and-landlords-have-to-pick-up-the-costs-of-the-epidemic-to-come-if-the-the-economy-is-to-have-a-chance-of-surviving/

I am not saying banks should not do this but two themes to reflect on:

1) This can be seen as part of the price of rebuilding trust with the community

2) it reinforces the cyclicality of the risk that bank shareholders are required to absorb which then speaks to what is a fair “Through the Cycle” ROE for that risk

I have long struggled with the “banks are a simple utility ” argument and this reinforces my belief that you need a higher ROE to compensate for this risk

Tony

The rise of digital money

Given the central role that money plays in our economy, understanding how the rise of digital money will play out is becoming increasingly important. There is a lot being written on this topic but today’s post is simply intended to flag a paper titled “The Rise of Digital Money” that is one of the more useful pieces of analysis that I have come across. The paper is not overly long (20 pages) but the authors (Tobias Adrian and Tommaso Mancini-Griffoli) have also published a short summary of the paper here on the VOX website maintained by the Centre for Economic Policy Research.

Part of the problem with thinking about the rise of digital money is being clear about how to classify the various forms. The authors offer the following framework that they refer to as a Money Tree.

Adrian, T, and T Mancini-Griffoli (2019), “The rise of digital currency”, IMF Fintech Note 19/01.

This taxonomy identifies four key features that distinguish the various types of money (physical and digital):

Type – is it a “claim” or an “object”?
Value – is it the “unit of account” employed in the financial system, a fixed value in that unit of account, or a variable value?
Backstop – if there is a fixed value redemption, is that value “backstopped” by the government or does it rely solely on private mechanisms to support the fixed exchange rate?
Technology – centralised or decentralised?

Using this framework, the authors discuss the rise of stablecoins

“Adoption of new forms of money will depend on their attractiveness as a store of value and means of payment. Cash fares well on the first count, and bank deposits on both. So why hold stablecoins? Why are stablecoins taking off? Why did USD Coin recently launch in 85 countries,¹ Facebook invest heavily in Libra, and centralised variants of the stablecoin business model become so widespread? Consider that 90% of Kenyans over the age of 14 use M-Pesa and the value of Alipay and WeChat Pay transactions in China surpasses that of Visa and Mastercard worldwide combined.
The question is all the more intriguing as stablecoins are not an especially stable store of value. As discussed, they are a claim on a private institution whose viability could prevent it from honouring its pledge to redeem coins at face value. Stablecoin providers must generate trust through the prudent and transparent management of safe and liquid assets, as well as sound legal structures. In a way, this class of stablecoins is akin to constant net asset value funds which can break the buck – i.e. pay out less than their face value – as we found out during the global financial crisis.
However, the strength of stablecoins is their attractiveness as a means of payment. Low costs, global reach, and speed are all huge potential benefits. Also, stablecoins could allow seamless payments of blockchain-based assets and can be embedded into digital applications by an active developer community given their open architecture, as opposed to the proprietary legacy systems of banks.
And, in many countries, stablecoins may be issued by firms benefitting from greater public trust than banks. Several of these advantages exist even when compared to cutting-edge payment solutions offered by banks called fast-payments.²
But the real enticement comes from the networks that promise to make transacting as easy as using social media. Economists beware: payments are not the mere act of extinguishing a debt. They are a fundamentally social experience tying people together. Stablecoins are better integrated into our digital lives and designed by firms that live and breathe user-centric design.
And they may be issued by large technology firms that already benefit from enormous global user bases over which new payment services could spread like wildfire. Network effects – the gains to a new user growing exponentially with the number of users – can be staggering. Take WhatsApp, for instance, which grew to nearly 2 billion users in ten years without any advertisement, based only on word of mouth!”
“The rise of digital currency”, Tobias Adrian, Tommaso Mancini-Griffoli 09 September 2019 – Vox CEPR Policy Portal

The authors then list the risks associated with the rise of stablecoins:

The potential disintermediation of banks
The rise of new monopolies
The threat to weak currencies
The potential to offer new opportunities for money laundering and terrorist financing
Loss of “seignorage” revenue
Consumer protection and financial stability

These risks are not dealt with in much detail. The potential disintermediation of banks gets the most attention (the 20 page paper explores 3 scenarios for how the disintermediation risk might play out).

The authors conclude with a discussion of what role central banks play in the rise of digital currency. They note that many central banks are exploring the desirability of stepping into the game and developing a Central Bank Digital Currency (CBDC) but do not attempt to address the broader question of whether the overall idea of a CBDC is a good one. They do however explore how central banks could work with stablecoin providers to develop a “synthetic” form of central bank digital currency by requiring the “coins” to be backed with central bank reserves.

This is effectively bringing the disrupters into the fold by turning them into a “narrow bank”. Izabella Kaminska (FT Alphaville) has also written an article on the same issue here that is engagingly titled “Why dealing with fintechs is a bit like dealing with pirates”.

The merits of narrow banking lie outside the scope of this post but it a topic with a very rich history (search on the term “Chicago Plan”) and one that has received renewed support in the wake of the GFC. Mervyn King (who headed the Bank of England during the GFC), for example, is one prominent advocate.

Hopefully you found this useful, if not my summary then at least the links to some articles that have helped me think through some of the issues.

Tony

“The Origin of Financial Crises” by George Cooper

There are a lot of books on the topic of financial crises but this one, written in 2008, stand the test of time. At the very least, it offers a useful introduction to Minsky’s Financial Instability Hypothesis. There is also an interesting discussion of the alternative approaches adopted by central banks to the problem of financial stability.

George Cooper argues that our financial system is inherently unstable and that this tendency is accentuated by a combination of factors

The belief that market forces will tend to produce optimal allocations of capital, and
Monetary policy that seeks to smooth (and ideally eliminate) business cycle fluctuations in economic activity

Cooper draws heavily on Hyman Minsky’s Financial Instability Hypothesis (FIH) which he argues offers much better insight into the operation of the financial system than the the Efficient Market Hypothesis (EMH) which tended to be the more influential driver of economic policy in the years preceding the Global Financial Crisis.

Cooper uses these competing theories to explore what makes prices within financial markets move. The EMH maintains that the forces of supply and demand will cause markets to move towards equilibrium and hence that we must look to external forces to understand unexpected shocks and crises. Minsky’s FIH, in contrast, argues that financial markets can be driven by internal forces into cycles of credit expansion and asset inflation followed by credit contraction and asset deflation.

Cooper identifies the following ways in which financial systems can become unstable

Markets characterised by supply constraints tend to experience price inflation which for a period of time can drive further increases in demand
Monetary policy which is oriented towards mitigating (and in some cases pre-empting) economic downturns can also amplify market instability (i.e. the Greenspan put makes the market less resilient in the long run)
Credit creation by private sector banks contributes to money supply growth; this in turn can facilitate growth in demand but there is no mechanism that automatically makes this growth consistent with the economy’s sustainable growth path

The point about some asset markets being prone to instability is particularly pertinent for banks that focus on residential property lending. Classical economic theory holds that increased prices should lead to increased supply and reduced demand but this simple equilibrium model does not necessarily work for property markets. Property buyers more often reason that they need to meet the market because it will only get more expensive if they wait. Many of them will have already seen this happen and regret not meeting the market price previously as they contemplate paying more to get a property that is not as nice as ones they underbid on. The capacity of home builders to respond to the price signal is frequently constrained by a myriad of factors and there is a long lead time when they do respond.

The argument Cooper makes rings very true for Australia and is very similar to the one that Adair Turner made in his book titled ”Between debt and the devil”. Cooper’s (and Minsky’s) argument that the pursuit of stability is not a desirable objective and that the system benefits from a modest amount of stress is similar to the argument made by Nassim Taleb in “Antifragility”.

Cooper also discusses the different philosophies that central banks bring to the challenge of managing financial stability. The dominant view is one that focuses on the risk that sees the management of inflation risk as a dominant concern while placing greater trust in the capacity of the market to self correct any instability. The European Central Bank, in contrast, seems to have placed less faith in the market and perhaps been closer to Minsky.

Some quotes from the book will give a sense of the ideas being discussed:

“Through its role in asset price cycles and profit generation, credit formation (borrowing money for either consumption or investment) lies at the heart of the financial market’s fundamental instability”.

“Hyman Minsky said that “stability creates instability” referring to our tendency to build up an unsustainable stock of debt in times of plenty only for that debt to then destroy the times of plenty”

“For a system as inherently unstable as the financial markets, we should not seek to achieve perfect stability; arguably it is this objective that has led to today’s problems. A more sustainable strategy would involve permitting, and at times encouraging, greater short-term cyclicality, using smaller, more-frequent downturns to purge the system of excesses”

“Credit creation is the foundation of the wealth-generation process; it is also the cause of financial instability. We should not let the merits of the former blind us to the risks of the latter.”

I have made some more detailed notes on the book here.

Tony

Canada innovates in the capital buffer space

The Canadian prudential regulator (OFSI) has made an interesting contribution to the capital buffer space via its introduction of a Domestic Stability Buffer (DSB).

Key features of the Domestic Stability Buffer:

Applies only to Domestic Systemically Important Banks (D-SIB) and intended to cover a range of systemic vulnerabilities not captured by the Pillar 1 requirement
Vulnerabilities currently included in the buffer include (i) Canadian consumer indebtedness; (ii) asset imbalances in the Canadian market and (iii) Canadian institutional indebtedness
Replaces a previously undisclosed Pillar 2 loading associated with this class of risks (individual banks may still be required to hold a Pillar 2 buffer for idiosyncratic risks)
Initially set at 1.5% of Total RWA and will be in the range of 0 to 2.5%
Reviewed semi annually (June and December); with the option to change more frequently in exceptional circumstances
Increases phased in while decreases take effect immediately

Implications for capital planning:

DSB supplements the Pillar 1 buffers (Capital Conservation Buffer, D-SIB surcharge and the Countercyclical Buffer)
Consequently, the DSB will not result in banks being subject to the automatic constraints on capital distributions that are applied by the Pillar 1 buffers
Banks will be required to disclose that the buffer has been breached and the OFSI will require a remediation plan to restore the buffer

What is interesting:

The OFSI argues that translating the existing Pillar 2 requirement into an explicit buffer offers greater transparency which in turn “… will support banks’ ability to use this capital buffer in times of stress by increasing the market’s understanding of the purpose of the buffer and how it should be used”
I buy the OFSI rationale for why an explicit buffer with a clear narrative is a more usable capital tool than an undisclosed Pillar 2 requirement with the same underlying rationale
The OFSI retains a separate Countercyclical Buffer but this Domestic Stability Buffer seems similar but not identical in its over-riding purpose (to me at least) to the approach that the Bank of England (BoE) has adopted for managing the Countercyclical Buffer.
A distinguishing feature of both the BoE and OFSI approaches is linking the buffer to a simple, coherent narrative that makes the buffer more usable by virtue of creating clear expectations of the conditions under which the buffer can be used.

Bottom line is that I see useful features in both the BoE and OFSI approach to dealing with the inherent cyclicality of banking. I don’t see either of the proposals doing much to mitigate the cyclicality of banking but I do see them offering more potential for managing the consequences of that cyclicality. Both approaches seem to me to offer material improvements over the Countercyclical Buffer as originally conceived by the BCBS.

It will be interesting to see if APRA chooses to adapt elements of this counter cyclical approach to bank capital requirements.

If I am missing something, please let me know …

From the Outside

The financial cycle and macroeconomics: What have we learnt? BIS Working Paper

Claudio Borio at the BIS wrote an interesting paper exploring the “financial cycle”. This post seeks to summarise the key points of the paper and draw out some implications for bank stress testing (the original paper can be found here). The paper was published in December 2012, so its discussion of the implications for macroeconomic modelling may be dated but I believe it continues to have some useful insights for the challenges banks face in dealing with adverse economic conditions and the boundary between risk and uncertainty.

Key observations Borio makes regarding the Financial Cycle

The concept of a “business cycle”, in the sense of there being a regular occurrence of peaks and troughs in business activity, is widely known but the concept of a “financial cycle” is a distinct variation on this theme that is possibly less well understood. Borio states that there is no consensus definition but he uses the term to

“denote self-reinforcing interactions between perceptions of value and risk, attitudes towards risk and financing constraints, which translate into booms followed by busts. These interactions can amplify economic fluctuations and possibly lead to serious financial distress and economic disruption”.

This definition is closely related to the concept of “procyclicality” in the financial system and should not be confused with a generic description of cycles in economic activity and asset prices. Borio does not use these words but I have seen the term “balance sheet recession” employed to describe much the same phenomenon as Borio’s financial cycle.

Borio identifies five features that describe the Financial Cycle

It is best captured by the joint behaviour of credit and property prices – these variables tend to closely co-vary, especially at low frequencies, reflecting the importance of credit in the financing of construction and the purchase of property.
It is much longer, and has a much larger amplitude, than the traditional business cycle – the business cycle involves frequencies from 1 to 8 years whereas the average length of the financial cycle is longer; Borio cites a cycle length of 16 years in a study of seven industrialised economies and I have seen other studies indicating a longer cycle (with more severe impacts).
It is closely associated with systemic banking crises which tend to occur close to its peak.
It permits the identification of the risks of future financial crises in real time and with a good lead – Borio states that the most promising leading indicators of financial crises are based on simultaneous positive deviations of the ratio of private sector credit-to-GDP and asset prices, especially property prices, from historical norms.
And it is highly dependent of the financial, monetary and real-economy policy regimes in place (e.g. financial liberalisation under Basel II, monetary policy focussed primarily on inflation targeting and globalisation in the real economy).

Macro economic modelling

Borio also argues that the conventional models used to analyse the economy are deficient because they do not capture the dynamics of the financial cycle. These extracts capture the main points of his critique:

“The notion… of financial booms followed by busts, actually predates the much more common and influential one of the business cycle …. But for most of the postwar period it fell out of favour. It featured, more or less prominently, only in the accounts of economists outside the mainstream (eg, Minsky (1982) and Kindleberger (2000)). Indeed, financial factors in general progressively disappeared from macroeconomists’ radar screen. Finance came to be seen effectively as a veil – a factor that, as a first approximation, could be ignored when seeking to understand business fluctuations … And when included at all, it would at most enhance the persistence of the impact of economic shocks that buffet the economy, delaying slightly its natural return to the steady state …”

“Economists are now trying hard to incorporate financial factors into standard macroeconomic models. However, the prevailing, in fact almost exclusive, strategy is a conservative one. It is to graft additional so-called financial “frictions” on otherwise fully well behaved equilibrium macroeconomic models, built on real-business-cycle foundations and augmented with nominal rigidities. The approach is firmly anchored in the New Keynesian Dynamic Stochastic General Equilibrium (DSGE) paradigm.”

“The purpose of this essay is to summarise what we think we have learnt about the financial cycle over the last ten years or so in order to identify the most promising way forward…. The main thesis is that …it is simply not possible to understand business fluctuations and their policy challenges without understanding the financial cycle”

There is an interesting discussion of the public policy (i.e. prudential, fiscal, monetary) associated with recognising the role of the financial cycle but I will focus on what implications this may have for bank management in general and stress testing in particular.

Insights and questions we can derive from the paper

The observation that financial crises are based on simultaneous positive deviations of the ratio of private sector credit-to-GDP and asset prices, especially property prices, from historical norms covers much the same ground as the Basel Committee’s Countercyclical Capital Buffer (CCyB) and is something banks would already monitor as part of the ICAAP. The interesting question the paper poses for me is the extent to which stress testing (and ICAAP) should focus on a “financial cycle” style disruption as opposed to a business cycle event. Even more interesting is the question of whether the higher severity of the financial cycle is simply an exogenous random variable or an endogenous factor that can be attributed to excessive credit growth.

I think this matters because it has implications for how banks calibrate their overall risk appetite. The severity of the downturns employed in stress testing has in my experience gradually increased over successive iterations. My recollection is that this has partly been a response to prudential stress tests which were more severe in some respects than might have been determined internally. In the absence of any objective absolute measure of what was severe, it probably made sense to turn up the dial on severity in places to align as far as possible the internal benchmark scenarios with prudential benchmarks such as the “Common Scenario” APRA employs.

At the risk of a gross over simplification, I think that banks started the stress testing process looking at both moderate downturns (e.g. 7-10 year frequency and relatively short duration) and severe recessions (say a 25 year cycle though still relatively short duration downturn). Bank supervisors in contrast have tended to focus more on severe recession and financial cycle style severity scenarios with more extended durations. Banks’s have progressively shifted their attention to scenarios that are more closely aligned to the severe recession assumed by supervisors in part because moderate recessions tend to be fairly manageable from a capital management perspective.

Why does the distinction between the business cycle and the financial cycle matter?

Business cycle fluctuations (in stress testing terms a “moderate recession”) are arguably an inherent feature of the economy that occur largely independently of the business strategy and risk appetite choices that banks make. However, Borio’s analysis suggests that the decisions that banks make (in particular the rate of growth in credit relative to growth in GDP and the extent to which the extension of bank credit contributes to inflated asset values) do contribute to the risk (i.e. probability, severity and duration) of a severe financial cycle style recession.

Borio’s analysis also offers a way of thinking about the nature of the recovery from a recession. A moderate business cycle style recession is typically assumed to be short with a relatively quick recovery whereas financial cycle style recessions typically persist for some time. The more drawn out recovery from a financial cycle style recession can be explained by the need for borrowers to deleverage and repair their balance sheets as part of the process of addressing the structural imbalances that caused the downturn.

If the observations above are true, then they suggest a few things to consider:

should banks explore a more dynamic approach to risk appetite limits that incorporated the metrics identified by Borio (and also used in the calibration of the CCyB) so that the level of risk they are willing to take adjusts for where they believe they are in the state of the cycle (and which kind of cycle we are in)
how should banks think about these more severe financial cycle losses? Their measure of Expected Loss should clearly incorporate the losses expected from business cycle style moderate recessions occurring once every 7-10 years but it is less clear that the kinds of more severe and drawn out losses expected under a Severe Recession or Financial Cycle downturn should be part of Expected Loss.

A more dynamic approach to risk appetite get us into some interesting game theory puzzles because a decision by one bank to pull back on risk appetite potentially allows competitors to benefit by writing more business and potentially doubly benefiting to the extent that the decision to pull back makes it safer for competitors to write the business without fear of a severe recession (in technical economist speak we have a “collective action” problem). This was similar to the problem APRA faced when it decided to impose “speed limits” on certain types of lending in 2017. The Royal Commission was not especially sympathetic to the strategic bind banks face but I suspect that APRA understand the problem.

How do shareholders think about these business and financial cycle losses? Some investors will adopt a “risk on-risk off” approach in which they attempt to predict the downturn and trade in and out based on that view, other “buy and hold” investors (especially retail) may be unable or unwilling to adopt a trading approach.

The dependence of the financial cycle on the fiscal and monetary policy regimes in place and changes in the real-economy also has potential implications for how banks think about the risk of adverse scenarios playing out. Many of the factors that Borio argues have contributed to the financial cycle (i.e. financial liberalisation under Basel II, monetary policy focussed primarily on inflation targeting and globalisation in the real economy) are reversing (regulation of banks is much more restrictive, monetary policy appears to have recognised the limitations of a narrow inflation target focus and the pace of globalisation appears to be slowing in response to a growing concern that its benefits are not shared equitably). I am not sure exactly what these changes mean other than to recognise that they should in principle have some impact. At a minimum it seems that the pace of credit expansion might be slower in the coming decades than it has in the past 30 years.

All in all, I find myself regularly revisiting this paper, referring to it or employing the distinction between the business and financial cycle. I would recommend it to anyone interested in bank capital management.