“Safe” assets can be risky – check your assumptions

Anyone moderately familiar with crypto assets is no doubt aware that the Terra stablecoin has been experiencing problems with its algorithmic smart contract controlled peg mechanism. There are lots of lessons here I am but I think Matt Levine flags one of the more interesting ones in his “Money Stuff” column (13 May 2022).

Safe assets are much riskier than risky ones.

Matt goes on to expand on why this is so …

This is I think the deep lesson of the 2008 financial crisis, and crypto loves re-learning the lessons of traditional finance. Systemic risks live in safe assets. Equity-like assets — tech stocks, Luna, Bitcoin — are risky, and everyone knows they’re risky, and everyone accepts the risk. If your stocks or Bitcoin go down by 20% you are sad, but you are not that surprised. And so most people arrange their lives in such a way that, if their stocks or Bitcoin go down by 20%, they are not ruined.

On the other hand safe assets — AAA mortgage securities, bank deposits, stablecoins — are not supposed to be risky, and people rely on them being worth what they say they’re worth, and when people lose even a little bit of confidence in them they crack completely. Bitcoin is valuable at $50,000 and somewhat less valuable at $40,000. A stablecoin is valuable at $1.00 and worthless at $0.98. If it hits $0.98 it might as well go to zero. And now it might!

The takeaway for me is to once again highlight the way in which supposedly safe, “no questions need be asked”, assets can sometimes be worse than assets we know are risky due to the potential for them to quickly flip into something for which there is no liquidity, just a path to increasingly large price falls. This is a theme that I regularly hammer (so apologies if you are tired of it) but still for me one of the more important principles in finance (right up there with “no free lunch”).

Tony – From the Outside

Stablecoin regulation

The question of whether, or alternatively how, stablecoins should be regulated is getting a lot of attention at the moment. My bias (and yes maybe I am just too institutionalised after four decades in banking) is that regulation is probably desirable for anything that functions as a form of money. We can also observe that some stablecoin issuers seem to be engaging pro actively with the question of how best to do this. There is of course a much wider debate about the regulation of digital assets but this post will confine itself to the questions associated with the rise of a new generation of money like digital instruments which are collectively referred to as stablecoins.

My last post linked to a useful summary that Bennett Tomlin published laying out what is currently playing out in the USA on the stablecoin regulation front. Tomlin concluded that the future of stablecoins appeared to lie in some form of bank like regulation. J.P. Koning has also collated a nice summary of the range of regulatory strategies adopted by stablecoin issuers to date.

Dan Awrey proposes another model for stablecoin regulation

Against that background, a paper titled “Bad Money” by Dan Awrey (Law Professor at Cornell Law School) offers another perspective. One of the chief virtues of his paper (refer Section III.B) is that it offers a comprehensive overview of the existing state regulatory framework that governs the operation of many of the stablecoins operating as “Money Service Businesses” (MSB). The way forward is up for debate but I think that Awrey offers a convincing case for why the state based regulatory model is not part of the solution.

This survey of state MSB laws paints a bleak picture. MSBs do not benefit from the robust prudential regulation, deposit guarantee schemes, lender of last resort facilities, or special resolution regimes enjoyed by conventional deposit-taking banks. Nor are they subject to the same type of tight investment restrictions or favorable regulatory or accounting treatment as MMFs. Most importantly, the regulatory frameworks to which these institutions actually are subject are extremely heterogeneous and often fail to provide customers with a fundamentally credible promise to hold, transfer, or return customer funds on demand.

Awrey, Dan, Bad Money (February 5, 202o). 106.1 Cornell Law Review 1 (2020); Cornell Legal Studies Research Paper No 20-38
Awrey also rejects the banking regulation model …

… PayPal, Libra, and the new breed of aspiring monetary institutions simply do not look like banks. MSBs are essentially financial intermediaries: aggregating funds from their customers and then using these funds to make investments. They do not “create” money in the same way that banks do when they extend loans to their customers; nor is there compelling evidence to suggest that their portfolios are concentrated in the type of longer term, risky, and illiquid loans that have historically been the staple of conventional deposit-taking banks

… and looks to Money Market Funds (MMFs) as the right starting point for a MSB regulatory framework that could encompass stablecoins

So what existing financial institutions, if any, do these new monetary institutions actually resemble? The answer is MMFs. While MSBs technically do not qualify as MMFs, they nevertheless share a number of important institutional and functional similarities. As a preliminary matter, both MSBs and MMFs issue monetary liabilities: accepting funds from customers in exchange for a contractual promise to return these funds at a fixed value on demand. Both MSBs and MMFs then use the proceeds raised through the issuance of these monetary liabilities to invest in a range of financial instruments. This combination of monetary and intermediation functions exposes MSBs and MMFs to the same fundamental risk: that any material decrease in the market value of their investment portfolios will expose them to potential liquidity problems, that these liquidity problems will escalate into more fundamental bank-ruptcy problems, and that—faced with bankruptcy—they will be unable to honor their contractual commitments. Finally, in terms of mitigating this risk, neither MSBs nor MMFs have ex ante access to the lender of last resort facilities, deposit guarantee schemes, or special resolution regimes available to conventional deposit-taking banks.

In theory, therefore, the regulatory framework that currently governs MMFs might provide us with some useful insights into how better regulation can transform the monetary liabilities of MSBs into good money.

Awrey’s preferred model is to restructure the OCC to create three distinct categories of financial institution

The first category would remain conventional deposit-taking banks. The second category—let’s call them monetary institutions—would include firms such as PayPal that issued monetary liabilities but did not otherwise “create” money and were prohibited from investing in longer-term, risky, or illiquid loans or other financial instruments. Conversely, the third category—lending institutions—would be permitted to make loans and invest in risky financial instruments but expressly prohibited from financing these investments through the issuance of monetary liabilities

Stablecoins would fall under the second category (Monetary Institutions) in his proposed tripartite licensing regime and the regulations to be applied to them would be based on the regulatory model currently applied to Money Market Funds (MMF).

Awrey, Dan, Bad Money (February 5, 2020). 106.1 Cornell Law Review 1 (2020); Cornell Legal Studies Research Paper No 20-38
What does Awrey’s paper contribute to the stablecoin regulation debate?
  • Awrey frames the case for stablecoin regulation around the experience of the Free Banking Era
  • This is not new in itself (see Gorton for example) but, rather than framing this as a lawless Wild West which is the conventional narrative, Awrey highlights the fact that these so called “free banks” were in fact subject to State government regulations
  • The problem with the Free Banking model, in his analysis, is that differences in the State based regulations created differences in the credit worthiness of the bank notes issued under the different approaches which impacted the value of the notes (this is not the only factor but it is the most relevant one for the purposes of the lessons to be applied to stablecoin regulation)

Finally, the value of bank notes depended on the strength of the regulatory frameworks that governed note issuing banks. Notes issued by banks in New York, or that were members of the Suffolk Banking system, for example, tended to change hands closer to face value than those of banks located in states where the regulatory regimes offered noteholders lower levels of protection against issuer default. Even amongst free banking states, the value of bank notes could differ on the basis of subtle but important differences between the relevant requirements to post government bonds as security against the issuance of notes bank notes.

  • If we want stablecoins to reliably exchange at par value to their underlying fiat currency then he argues we need a national system of regulation applying robust and consistent requirements to all issuers of stablecoin arrangements
  • Awrey then discusses the ways in which regulation currently “enhances the credibility of the monetary liabilities issued by banks and MMFs to set up a discussion of how the credibility of the monetary promises of the new breed of monetary institutions might similarly be enhanced
  • He proposes that the OCC be made accountable for regulating these “monetary institutions” (a term that includes other payment service providers like PayPal) but that the regulations be based on those applied to MMFs other than simply bringing them under the OCC’s existing banking regulations
  • The paper is long (90 pages including appendices) but hopefully the summary above captures the essence of it – for me the key takeaways were to:
    • Firstly to understand the problems with the existing state based MSB regulations that currently seem to be the default regulatory arrangement for a US based stablecoin issuer
    • Secondly the issues he raises (legitimate I think) with pursuing the bank regulation based model that some issuers have turned to
    • Finally, the idea that a MMF based regulatory model is another approach we should be considering
I will wrap up with Awrey’s conclusion …

Money is, always and everywhere, a legal phenomenon. This is not to suggest that money is only a legal phenomenon. Yet it is impossible to deny that the law plays a myriad of important and often poorly understood roles that either enhance or undercut the credibility of the promises that we call money. In the case of banks and MMFs, the law goes to great lengths to transform their monetary liabilities into good money. In the case of proprietary P2P payment platforms, stablecoin issuers, and other aspiring monetary institutions, the anti-quated, fragmented, and heterogenous regulatory frameworks that currently, or might in future, govern them do far, far less to support the credibility of their commitments. This state of affairs—with good money increasingly circulating alongside bad—poses significant dangers for the customers of these new monetary institutions. In time, it may also undermine the in-tegrity and stability of the wider financial system. Together, these dangers provide a compelling rationale for adopting a new approach to the regulation of private money: one that strengthens and harmonizes the regulatory frameworks governing monetary institutions and supports the development of a more level competitive playing field. 

Tony – From the Outside

Too much information

This post is possibly (ok probably) a bit technical but touches on what I think is an important issue in understanding how the financial system operates. The conventional wisdom as I understand it is that markets thrive on information. I think that is true in some cases but it may not be necessarily true for all markets. If the conventional wisdom is wrong then there are important areas of market and bank regulation that probably need to be reconsidered.

I have written on this topic before in relation to papers by Gary Gorton and Bengt Holmstrom. These papers developed an analytical argument in favour of certain assets (or markets) being “information insensitive”. That argument makes intuitive sense to me and I have used these arguments in a couple of previous posts; one titled “Why banks are different” and another titled “Deposit insurance and moral hazard“.

I hope to eventually do a longer piece where I can bring all these ideas together but the purpose today is simply to flag an interesting post (and associated paper) I came across that offers some empirical evidence in favour of the thesis. The post is titled “(When) Does Transparency Reduce Liquidity” and you can find the paper of the same name here.

This extract from the blog post I think captures the key ideas:

“To sum up, our findings can be grouped under two headings. The first is that more information in financial markets is not always beneficial. It can reduce rather than increase trading and liquidity.

The second is that one size does not fit all in terms of gauging the impact of transparency on liquidity. For the safest of the MBS securities, the impact of transparency is negligible, while for the riskiest, transparency enhances liquidity. It is in the broad middle of the risk spectrum that liquidity is negatively impacted.

Our findings ought to be of interest to regulators on both sides of the Atlantic. In order to promote transparency and to bolster market discipline, supervisors have imposed various loan-level requirements in both Europe and the United States. The assumption seems to be that more transparency is always a good thing.

In such a climate, there has been insufficient investigation or understanding of the effects, including the negative effects, of such requirements on MBS market liquidity. Our work, we believe, begins to put this right.

“(When) Does Transparency Reduce Liquidity?” by Professors Karthik Balakrishnan at Rice University, Aytekin Ertan at London Business School, and Yun Lee at Singapore Management University and London Business School. Posted on “The CLS Blue Sky Blog” October 30 2019

Summing up

If this thesis is correct (i.e. that there are certain types of funding that should be “information insensitive” by design and that it is a mistake to apply to money markets the lessons and logic of stock markets) then this has implications for:

  • thinking about the way that bank capital structure should be designed,
  • questions like deposit preference and deposit insurance, and
  • how we reconcile the need to impose market discipline on banks while ensuring that their liquidity is not adversely impacted.

I have not as yet managed to integrate all of these ideas into something worth sharing but the post referenced above and the associated paper are definitely worth reading if you are engaged with the same questions. If you think I am missing something then please let me know.

Tony

Deposit insurance and moral hazard

Depositors tend to be a protected species

It is generally agreed that bank deposits have a privileged position in the financial system. There are exceptions to the rule such as NZ which, not only eschews deposit insurance, but also the practice of granting deposits a preferred (or super senior) claim on the assets of the bank. NZ also has a unique approach to bank resolution which clearly includes imposing losses on bank deposits as part of the recapitalisation process. Deposit insurance is under review in NZ but it is less clear if that review contemplates revisiting the question of deposit preference.

The more common practice is for deposits to rank at, or near, the top of the queue in their claim on the assets of the issuing bank. This preferred claim is often supported by some form of limited deposit insurance (increasingly so post the Global Financial Crisis of 2008). An assessment of the full benefit has to consider the cost of providing the payment infrastructure that bank depositors require but the issuing bank benefits from the capacity to raise funds at relatively low interest rates. The capacity to raise funding in the form of deposits also tends to mean that the issuing banks will be heavily regulated which adds another layer of cost.


The question is whether depositors should be protected

I am aware of two main arguments for protecting depositors:

  • One is to protect the savings of financially unsophisticated individuals and small businesses.
  • The other major benefit relates to the short-term, on-demand, nature of deposits that makes them convenient for settling transactions but can also lead to a ‘bank run’.

The fact is that retail depositors are simply not well equipped to evaluate the solvency and liquidity of a bank. Given that even the professionals can fail to detect problems in banks, it is not clear why people who will tend to lie at the unsophisticated end of the spectrum should be expected to do any better. However, the unsophisticated investor argument by itself is probably not sufficient. We allow these individuals to invest in the shares of banks and other risky investments so what is special about deposits.

The more fundamental issue is that, by virtue of the way in which they function as a form of money, bank deposits should not be analysed as “investments”. To function as money the par value of bank deposits must be unquestioned and effectively a matter of faith or trust. Deposit insurance and deposit preference are the tools we use to underwrite the safety and liquidity of bank deposits and this is essential if bank deposits are to function as money. We know the economy needs money to facilitate economic activity so if bank deposits don’t perform this function then you need something else that does. Whatever the alternative form of money decided on, you are still left with the core issue of how to make it safe and liquid.

Quote
“The capacity of a financial instrument like a bank deposit 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”

Gary Gorton and George Pennacchi “Financial Intermediaries and Liquidity Creation”

I recognise that fintech solutions are increasingly offering alternative payment mechanisms that offer some of the functions of money but to date these still ultimately rely on a bank with a settlement account at the central bank to function. This post on Alphaville is worth reading if you are interested in this area of financial innovation. The short version is that fintechs have not been able to create new money in the way banks do but this might be changing.

But what about moral hazard?

There is an argument that depositors should not be a protected class because insulation from risk creates moral hazard.

While government deposit insurance has proven very successful in protecting banks from runs, it does so at a cost because it leads to moral hazard (Santos, 2000, p. 8). By offering a guarantee that depositors are not subject to loss, the provider of deposit insurance bears the risk that they would otherwise have borne.

According to Dr Sam Wylie (2009, p. 7) from the Melbourne Business School:

“The Government eliminates the adverse selection problem of depositors by insuring them against default by the bank. In doing so the Government creates a moral hazard problem for itself. The deposit insurance gives banks an incentive to make higher risk loans that have commensurately higher interest payments. Why?, because they are then betting with taxpayer’s money. If the riskier loans are repaid the owners of the bank get the benefit. If not, and the bank’s assets cannot cover liabilities, then the Government must make up the shortfall”

Reconciling Prudential Regulation with Competition, Pegasus Economics, May 2019 (p17)

A financial system that creates moral hazard is clearly undesirable but, for the reasons set out above, it is less clear to me that bank depositors are the right set of stakeholders to take on the responsibility of imposing market discipline on banks. There is a very real problem here but requiring depositors to take on this task is not the answer.

The paper by Gorton and Pennacchi that I referred to above notes that there is a variety of ways to make bank deposits liquid (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. This of course is what deposit insurance and giving deposits a preferred claim in the bank loss hierarchy does. Combining deposit insurance with a preferred claim on a bank’s assets also means that the government can underwrite deposit insurance with very little risk of loss.

It is also important I think to recognise that deposit preference moves the risk to other parts of the balance sheet that are arguably better suited to the task of exercising market discipline. The quote above from Pegasus Economics focussed on deposit insurance and I think has a fair point if the effect is simply to move risk from depositors to the government. That is part of the reason why I think that deposit preference, combined with how the deposit insurance is funded, are also key elements of the answer.

Designing a banking system that addresses the role of bank deposits as the primary form of money without the moral hazard problem

I have argued that the discussion of moral hazard is much more productive when the risk of failure is directed at stakeholders who have the expertise to monitor bank balance sheets, the capacity to absorb the risk and who are compensated for undertaking this responsibility. If depositors are not well suited to the market discipline task then who should bear the responsibility?

  • Senior unsecured debt
  • Non preferred senior debt (Tier 3 capital?)
  • Subordinated debt (i.e. Tier 2 capital)
  • Additional Tier 1 (AT1)
  • Common Equity Tier 1 (CET1)

There is a tension between liquidity and risk. Any security that is risky may be liquid during normal market conditions but this “liquidity” cannot be relied on under adverse conditions. Senior debt can in principle be a risky asset but most big banks will also aim to be able to issue senior debt on the best terms they can achieve to maximise liquidity. In practice, this means that big banks will probably aim for a Long Term Senior Debt Rating that is safely above the “investment grade” threshold. Investment grade ratings offer not just the capacity top issue at relatively low credit spreads but also, and possibly more importantly, access to a deeper and more reliable pool of funding.

Cheaper funding is nice to have but reliable access to funding is a life and death issue for banks when they have to continually roll over maturing debt to keep the wheels of their business turning. This is also the space where banks can access the pools of really long term funding that are essential to meet the liquidity and long term funding requirements that have been introduced under Basel III.

The best source of market discipline probably lies in the space between senior debt and common equity

I imagine that not every one will agree with me on this but I do not see common equity as a great source of market discipline on banks. Common equity is clearly a risky asset but the fact that shareholders benefit from taking risk is also a reason why they are inclined to give greater weight to the upside than to the downside when considering risk reward choices. As a consequence, I am not a fan of the “big equity” approach to bank capital requirements.

In my view, the best place to look for market discipline and the control of moral hazard in banking lies in securities that fill the gap between senior unsecured debt and common equity; i.e. non-preferred senior debt, subordinated debt and Additional Tier 1. I also see value in having multiple layers of loss absorption as opposed to one big homogeneous layer of loss absorption. This is partly because it can be more cost effective to find different groups of investors with different risk appetites. Possibly more important is that multiple layers offer both the banks and supervisors more flexibility in the size and impact of the way these instruments are used to recapitalise the bank.

Summing up …

I have held off putting this post up because I wanted the time to think through the issues and ensure (to the best of my ability) that I was not missing something. There remains the very real possibility that I am still missing something. That said, I do believe that understanding the role that bank deposits play as the primary form of money is fundamental to any complete discussion of the questions of deposit insurance, deposit preference and moral hazard in banking.

Tony

“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