Deposit insurance

I recently flagged a post by Patrick McKenzie on the mechanics of the humble bank deposit. Patrick has followed that with another equally interesting discussion of deposit insurance. The post is written as a high level primer and so it does not offer any insights to anyone already familiar with the topic.

The main thing that grabbed my attention was Patrick’s emphasis on the “information insensitive” nature of bank deposits. This to my mind is a fundamental concept in analysing bank deposits but gets way less attention that I think it deserves. It is particularly important when you are looking at the question of the extent to which deposit insurance promotes moral hazard.

So it was good to see someone else promoting the importance of this concept. On the other hand, his discussion of the information insensitivity of deposits does not give as much attention to the role of “deposit preference” as I think it deserves. It is always possible of course that I have this wrong but, for me at least, the preferred claim that many jurisdictions afford bank deposits is a key part of understanding why bank deposits can be information insensitive” without necessarily creating moral hazard.

If you are interested to dig deeper ….

  • Matt Levine did a good post on the overall question of how finance uses tranching to turn a pool of risky assets into a mix of safe and risky claims on those assets where he described this as “A main move in finance” (see here for my summary of the column if you don’t have access to his column)
  • There is also a page on my website where I discuss the arguments for protecting depositors (the “why”), another where I attempt to dig a bit deeper into the technical aspects of bank deposit protection (the “how”), and this post offering an Australian perspective on the process of how bank deposits (a loan to highly leveraged company) get turned into mostly risk free assets in the hands of bank depositors.

Tony – From the Outside

The alchemy of deposits

Patrick McKenzie dropped an interesting post on the seemingly humble but actually quite awesome deposit. You can find my (Australian focussed) perspective on the mechanics of bank deposits here but who could resist learning more about “…the terrible majesty of the humble bank deposit”.

The perspective Patrick offers is not necessarily new for anyone who understands banking but a lot of this is probably not well understood by the broader public actually using bank deposits. His post is short and worth reading if only for the “pink slime” analogy.

His first point is that “deposits are money”

The actual core feature of deposits is that you can transfer them to other people to effect payments. Big deal, you might think. You can also transfer cows, sea shells, Bitcoin, an IOU from a friend, or bonds issued by Google to effect payments. But deposits are treated as money by just about everyone who matters in the economy, including (pointedly) the state. Economists can wax lyrical about what “treated as money” means, but the non-specialist gloss is probably just as useful: anything is money if substantially everyone looking at the money both agrees that it is money and agrees at the exchange rate for it. This is sometimes referred to as the “no questions asked” property; money is the Schelling point for value transfers that all parties to a transaction are already at.

This is so fundamental a feature of deposits that, in developed nations, we don’t remember that it isn’t automatic

His second point is that bank deposits are “heavily engineered structured products pretending to be simple”.

From the consumer’s perspective, deposits are “my money,” functionally riskless. This rounds to correct. From the bank’s perspective, deposits are part of the capital stack of the bank, allowing it to engage in a variety of risky businesses. This rounds to correct. The reconciliation between this polymorphism is a feat of financial and social engineering. A bank packages up its various risky businesses—chiefly making loans, but many banks have other functions in addition to the risks associated with any operating business—puts them in a blender, reduces them to a homogenous mix, and then pours that risk mix over a defined waterfall.

The simplest model for that waterfall is, in order of increasing risk: deposits, bonds, preferred equity, and common equit

The “pink slime” analogy referenced above is a colourful way of saying that deposits benefit from having a claim on a diversified pool of assets, the “homogeneous mix” in the extract above. Equally important however is the fact that deposits have a super senior claim on that diversified pool as outlined in the waterfall analogy.

Patrick has packed quite a few nice turns of phrase into his post but one of my favourites addresses the pervasive misuse of the term “deposit”

The fintech industry has not covered itself in glory here. Sometimes firms misclaim a product to be a deposit where it is not. Sometimes they actually institutionally misunderstand the nature of the product they have created. One would hope that that never happens, but … smart people are doomed to continue discovering that just because a deposit is a complex structured product involving a bank which has a stable dollar value, not every complex structured product involving a bank which appears to have a stable dollar value is actually a deposit

To repeat “…just because a deposit is a complex structured product involving a bank which has a stable dollar value, not every complex structured product involving a bank which appears to have a stable dollar value is actually a deposit”

Patrick uses the recent example of Voyager as a case in point. I don’t think it is being pedantic to argue that a “crypto bank” is an oxymoron but I don’t hold out much hope that the term will go away any time soon. A “bank” is arguably a highly regulated institution by definition and the crypto versions to date are either not regulated or subject to a less onerous form of regulation.

This is Patrick’s take on Voyager

Voyager, a publicly traded company, marketed a deposit-adjacent product to users, paying a generous interest rate. Then a cascading series of events in crypto, outside the scope of this essay, blew up a series of firms, including one which had taken out a loan of hundreds of millions of dollars from Voyager. Suddenly, the information-insensitivity of Voyagers not-deposits was pierced, the pink slime appears both undermixed and undercooked, and customers now need to follow a bankruptcy proceeding closely. … When something which was believed to be a deposit is discovered to not actually be a deposit, infrastructure around it breaks catastrophically. Matt Levine has an excellent extended discussion about how Voyager discovered that attaching the ACH payment rail to their deposit-adjacent product became a huge risk once they went under.)

As regular readers will know, I am a big fan of Matt Levine so I endorse Patrick’s recommendation to read Matt’s accounts of what is going on in the crypto world. There is one aspect of Patrick’s post however that I struggled with and that is his account of bank deposits as a cheap source of funding

Why fund the risks of a bank with deposits, as opposed to funding them entirely with bonds and equity (and of course, revenue), like almost all businesses do? From the bank’s perspective, this is simple: deposits are very inexpensive funding sources, and the capability to raise them is the one of the main structural advantages banks have vis-a-vis all other firms in the economy. 

He is correct of course in the sense that the nominal interest rate on bank deposits is quite low, commensurate with their low risk. Two observations however,

Firstly, the true cost of a bank deposit has to take account of the cost of running all the infrastructure that facilities creating a diversified pool of assets and operating the payment rails that allow deposits to effect payments.

The second is that the super senior preferred claim that bank deposits have on the waterfall makes the other parts of the bank liability stack more risky. I know that the “bail-out” or “Too Big To Fail” have traditionally created a subsidy. However, banks are now required to hold both a lot more capital and to issue “bail-in” instruments that should in principle mean that this subsidy is much reduced if not eliminated. If the other parts of the bank liability stack are not pricing in these changes then the really interesting question is why not.

So there is a lot more to this than what Patrick has written (and he has promised further instalments) but I can still recommend his post as a useful (and entertaining) read for anyone seeking a better understanding of this particular corner of the banking universe.

Tony – From the Outside

Matt Levine on stuff that gets lost in translation

I have been referencing Matt Levine a lot lately. No apologies, his Money Stuff column is a regular source of insight and entertainment for banking and finance tragics such as myself and I recommend it. His latest column (behind a paywall but you can access a limited number of articles for free I think) includes a discussion of the way in which the DeFi industry has created analogues of conventional banking concepts like “deposits” but with twists that are not always obvious or indeed intuitive to the user/customer.

We have talked a lot recently about how crypto has recreated the pre-2008 financial system, and is now having its own 2008 financial crisis. But this is an important difference. Traditional finance is in large part in the business of creating safe assets: You take stuff with some risk (mortgages, bank loans, whatever), you package them in a diversified and tranched way, you issue senior claims against them, and people treat those claims as so safe that they don’t have to worry about them. Money in a bank account simply is money; you don’t have to analyze your bank’s financial statements before opening a checking account.

Matt Levine “Money Stuff” column 28 June 2022 – Crypto depositors

How banks can create safe assets is a topic that I have looked at a number of times but this post is my most complete attempt to describe the process that Matt outlines above. To me at least, this is a pretty fundamental part of understanding how finance works and Matt also did a good post on the topic that I discussed here.

One of the key points is that the tranching of liabilities also creates a division of labour (and indeed of expertise and inclination) …

There is a sort of division of labor here: Ordinary people can put their money into safe places without thinking too hard about it; smart careful investors can buy equity claims on banks or other financial institutions to try to make a profit. But the careless ordinary people have priority over the smart careful people. The smart careful heavily involved people don’t get paid unless the careless ordinary people get paid first. This is a matter of law and banking regulation and the structuring of traditional finance. There are, of course, various possible problems; in 2008 it turned out that some of this information-insensitive debt was built on bad foundations and wasn’t safe. But the basic mechanics of seniority mostly work pretty well.

The DeFi industry argues that they want to change the ways that traditional finance operates for the benefit of users but it also expects those users to be motivated and engaged in understanding the details of the new way of doing things. A problem is that some users (maybe “many users”?) might be assuming that some of the rules that protect depositors (and indeed creditors more generally) in the conventional financial system would naturally be replicated in the alternative financial system being created.

Back to Matt …

The reason people put their money in actual banks is that we live in a society and there are rules that protect bank deposits, and also everyone is so used to this society and those rules that they don’t think about them. Most bank depositors do not know much about bank capital and liquidity requirements, because they don’t have to; that is the point of those requirements.

The problem according to Matt is ….

Broadly speaking crypto banking (and quasi-banking) is like banking in the state of nature, with no clear rules about seniority and depositor protection. But it attracts money because people are used to regular banking. When they see a thing that looks like a bank deposit, but for crypto, they think it will work like a bank deposit. It doesn’t always.

This feels like a problem to me. As the industry becomes more regulated I would expect to see the issues of seniority and deposit protection/preference more clearly spelled out. For the time being it does seem to be very much caveat emptor and don’t assume anything.

Tony – From the Outside

“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

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:

  1. The “no-questions-asked ” principle for anything that functions or aims to function as money
  2. Some technical insights into the economic and legal properties of stablecoins and stablecoin issuers
  3. 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. 

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

Is the financial system as resilient as policymakers say?

This is the question that Sir Paul Tucker poses in a BIS Working Paper titled “Is the financial system sufficiently resilient: a research programme and policy agenda” (BIS WP790) and answers in the negative. Tucker’s current role as Chair of the Systemic Risk Council and his experience as Deputy Governor at the Bank of England from 2009 to 2013 suggests that, whether you agree or disagree, it is worth reading what he has to say.

Tucker is quick to acknowledge that his assessment is “… intended to jolt the reader” and recognises that he risks “… overstating weaknesses given the huge improvements in the regulatory regime since 2007/08”. The paper sets out why Tucker believes the financial system is not as resilient as claimed, together with his proposed research and policy agenda for achieving a financial system that is sufficiently resilient.

Some of what he writes is familiar ground but three themes I found especially interesting were:

  1. The extent to which recourse by monetary policy to very low interest rates exposes the financial system to a cyclically higher level of systemic risk that should be factored into the resilience target;
  2. The need to formulate what Tucker refers to as a “Money Credit Constitution” ; and
  3. The idea of using “information insensitivity” for certain agreed “safe assets” as the target state of resilience for the system.

Financial stability is of course one of those topics that only true die hard bank capital tragics delve into. The Global Financial Crisis (GFC) demonstrated, however, that financial stability and the resilience of the banking system is also one of those topics that impacts every day life if the technocrats get it wrong. I have made some more detailed notes on the paper here for the technically inclined while this post will attempt (and likely fail) to make the issues raised accessible for those who don’t want to read BIS working papers.

Of the three themes listed above, “information insensitivity” is the one that I would call out in particular. It is admittedly a bit clunky as a catch phrase but I do believe it is worth investing the time to understand what it means and what it implies for how the financial system should be regulated and supervised. I have touched on the concept in a couple of previous posts (here, here, and here) and, as I worked through this post, I also found some interesting overlaps with the idea introduced by the Australian Financial System Inquiry that systemically important banks should be required to be “unquestionably strong”.

How resilient is the financial system?

Tucker’s assessment is that Basel III has made the financial system a lot safer than it was but less resilient than claimed. This is because the original calibration of the higher capital requirements under Basel III did not allow for the way in which any subsequent reduction in interest rates means that monetary policy has less scope to help mitigate economic downturns. All other things being equal, any future stress will have a larger impact on the financial system because monetary policy will have less capacity to stimulate the economy.

We could quibble over details:

  • The extent to which the capital requirements have been increased by higher Risk Weights applied to exposures (Tucker is more concerned with the extent to which capital requirements get weakened over time in response to industry lobbying)
  • Why is this not captured in stress testing?
  • The way in which cyclical buffers could (and arguably should) be used to offset this inherent cyclical risk in the financial system.

But his bigger point sounds intuitively right, all other things being equal, low interest rates mean that central banks will have much less scope to stimulate the economy via monetary policy. It follows that the financial system is systemically riskier at this point in time than historical experience with economic downturns might suggest.

How should we respond (in principle)?

One response is common equity and lots of it. That is what is advocated by some academic commentators , influential former central bankers such as Adair Turner and Mervyn King, and most recently by the RBNZ (with respect to the quantum and the form of capital.

Tucker argues that the increased equity requirements agreed under Basel III are necessary, but not sufficient. His point here is broader than the need to allow for changes in monetary policy discussed above. His concern is what does it take to achieve the desired level of resilience in a financial system that has fractional reserve banking at its core.

”Maintaining a resilient system cannot sanely rely on crushing the probability of distress via prophylactic regulation and supervision: a strategy that confronts the Gods in its technocratic arrogance. Instead, low barriers to entry, credible resolution regimes and crisis-management tools must combine to ensure that the system can keep going through distress. That is different from arguing that equity requirements (E) can be relaxed if resolution plans become sufficiently credible. Rather, it amounts to saying that E would need to be much higher than now if resolution is not credible.”

“Is the Financial system sufficiently resilient: a research programme and policy agenda” BIS WP 790, p 23

That is Tucker’s personal view expressed in the conclusion to the paper but he also advocates that unelected technicians need to frame the question [of target resilience] in a digestible way for politicians and public debate“. It is especially important that the non-technical people understand the extent to which there may be trade-offs in the choice of how resilient the financial system should be. Is there, for example, a trade-off between resilience and the dynamism of the financial system that drives its capacity to support innovation, competition and growth? Do the resource misallocations associated with credit and property price booms damage the long run growth of the economy? And so on …

Turner offers a first pass at how this problem might be presented to a non-technical audience:

Staying with crisp oversimplification, I think the problem can be put as follows:

• Economists and policymakers do not know much about this. Models and empirics are needed.

• Plausibly, as BIS research suggests, credit and property price booms lead resource misallocation booms? Does that damage long-run growth?

• Even if it does, might those effects be offset by net benefits from greater entrepreneurship during booms?

• Would tough resilience policies constrain capital markets in ways that impede the allocation of resources to risky projects and so growth?

If there is a long-run trade off, then where people are averse to boom-bust ‘cycles’, resilience will be higher and growth lower. By contrast, jurisdictions that care more about growth and dynamism will err on the side of setting the resilience standard too low.

BIS WP790, Page 5

He acknowledges there are no easy answers but asking the right questions is obviously a good place to start.

A “Money-Credit Constitution”

In addition to helping frame the broader parameters of the problem for public debate, central bankers also need to decide what their roles and responsibilities in the financial system should be. Enter the idea of a Money-Credit Constitution (MCC). I have to confess that this was a new bit of jargon for me and I had to do a bit of research to be sure that I knew what Tucker means by it. The concept digs down into the technical aspects of central banking but it also highlights the extent to which unelected technocrats have been delegated a great deal of power by the electorate. I interpret Tucker’s use of the term “constitution”as an allusion to the need for the terms on which this power is exercised to be defined and more broadly understood.

A Money-Credit Constitution defined:

“By that I mean rules of the game for both banking and central banking designed to ensure broad monetary stability, understood as having two components: stability in the value of central bank money in terms of goods and services, and also stability of private-banking-system deposit money in terms of central bank money.”

Chapter 1: How can central banks deliver credible commitment and be “Emergency Institutions”? by John Tucker in “Central Bank Governance and Oversight Reform, edited by Cochrane and Taylor (2016)

The jargon initially obscured the idea (for me at least) but some practical examples helped clarify what he was getting at. Tucker defines the 19th and early 20th century MCC as comprising; the Gold Standard, reserve requirements for private banks and the Lender of Last Resort (LOLR) function provided by the central bank. The rules of the game (or MCC) have of course evolved over time. In the two to three decades preceding the 2008 GFC, the rules of the game incorporated central bank independence, inflation targeting and a belief in market efficiency/discipline. Key elements of that consensus were found to be woefully inadequate and we are in the process of building a new set of rules.

Tucker proposes that a MCC that is fit for the purpose of achieving an efficient and resilient financial system should have five key components:

– a target for inflation (or some other nominal magnitude);

– a requirement for banking intermediaries to hold reserves (or assets readily exchanged for reserves) that increases with a firm’s leverage and/or the degree of liquidity mismatch between its assets and liabilities;

– a liquidity-reinsurance regime for fundamentally solvent banking intermediaries;

– a resolution regime for bankrupt banks and other financial firms; and

– constraints on how far the central bank is free to pursue its mandate and structure its balance sheet, given that a monetary authority by definition has latent fiscal capabilities.

BIS WP, Page 9

In one sense, the chosen resilience strategy for the financial system is simply determined by the combination of the capital and liquidity requirements imposed on private banks. We are using the term capital here in its broadest sense to incorporate not just common equity but also the various forms of hybrid equity and subordinated debt that can be converted into equity without disrupting the financial system.

But Tucker argues that there is a bigger question of strategy that must be addressed; that is

“whether to place the regime’s weight on regulatory requirements that impose intrinsic resilience on bank balance sheets or on credible crisis management that delivers safety ex post. It is a choice with very different implications for transparency.”

BIS WP 790; Page 11

Two alternative strategies for achieving a target state of financial system resilience

Strategy 1: Crisis prevention (or mitigation at least)

The first strategy is essentially an extension of what we have already been doing for some time; a combination of capital and liquidity requirements that limits the risk of financial crisis to some pre-determined acceptable level.

“… authorities set a regulatory minimum they think will be adequate in most circumstances and supervise intermediaries to check whether they are exposed to outsized risks.

BIS WP 790, Page 11

Capital and liquidity requirements were increased under Basel III but there was nothing fundamentally new in this part of the Basel III package. Tucker argues that the standard of resilience adopted should be explicit rather than implicit but he still doubts that this strategy is robust. His primary concern seems to be the risk that the standard of resilience is gradually diluted by a series of small concessions that only the technocrats understand.

How did we know that firms are really satisfying the standard: is it enough that they say so? And how do we know that the authorities themselves have not quietly diluted or abandoned the standard?”

BIS WP 790; Page 11

Tucker has ideas for how this risk of regulatory capture might be controlled:

  each year central bank staff (not policymakers) should publish a complete statement of all relaxations and tightenings of regulatory and supervisory policy (including in stress testing models, rules, idiosyncratic requirements, and so on)

  the integrity of such assessments should be subject to external audit of some kind (possibly by the central auditor for the state).

BIS WP 790, Page 12

but this is still a second best approach in his assessment; he argues that we can do better and the idea of making certain assets “informationally insensitive” is the organising principle driving the alternative strategies he lays out.

Strategy 2: Making assets informationally insensitive via crisis-management regimes

Tucker identifies two approaches to crisis management both based around the objective of ensuring that the value of certain agreed liabilities, issued by a defined and pre-determined set of financial intermediaries, is insensitive to information about the financial condition of these intermediaries:

Strategy 2a: Integrate LOLR with liquidity policy.

Central bankers, as the suppliers of emergency liquidity assistance, could make short term liabilities informationally insensitive by requiring banks to hold reserves or eligible collateral against all runnable liabilities. Banks would be required to cover “x”% of short term liabilities with reserves and/or eligible collateral. The key policy choices then become

  • The definition of which short term liabilities drive the liquidity requirement;
  • The instruments that would be eligible collateral for liquidity assistance; and
  • The level of haircuts set by central banks against eligible collateral

What Tucker is outlining here is a variation on a proposal that Mervyn King set out in his book “The End of Alchemy” which I covered in a previous post. These haircuts operate broadly analogously to the existing risk-weighted equity requirements. Given the focus on emergency requirements, they would be based on stress testing and incorporate systemic risk surcharges.

Tucker is not however completely convinced by this approach:

“… a policy of completely covering short-term labilities with central bank-eligible assets would leave uninsured short-term liabilities safe only when a bank was sound. They would not be safe when a bank was fundamentally unsound.

That is because central banks should not (and in many jurisdictions cannot legally) lend to banks that have negative net assets (since LOLR assistance would allow some short-term creditors to escape whole at the expense of equally ranked longer-term creditors). This is the MCC’s financial-stability counterpart to the “no monetary financing” precept for price stability.

Since only insured-deposit liabilities, not covered but uninsured liabilities, are then safe ex post, uninsured liability holders have incentives to run before the shutters come down, making their claims information sensitive after all.

More generally, the lower E, the more frequently banks will fail when the central bank is, perforce, on the sidelines. This would appear to take us back, then, to the regulation and supervision of capital adequacy, but in a way that helps to keep our minds on delivering safety ex post and so information insensitivity ex ante.”

BIS WP 790, Page 14

Strategy 2b: Resolution policy – Making operational liabilities informationally insensitive via structure

Tucker argues that the objective of resolution policy can be interpreted as making the operational liabilities of banks, dealers and other intermediaries “informationally insensitive”. He defines “operational liabilities” as “… those liabilities that are intrinsically bound to the provision of a service (eg large deposit balances, derivative transactions) or the receipt of a service (eg trade creditors) rather than liabilities that reflect a purely risk-based financial investment by the creditor and a source of funding/leverage for the bank or dealer”

Tucker proposes that this separation of operational liabilities from purely financial liabilities can be “… made feasible through a combination of bail-in powers for the authorities and, crucially, restructuring large and complex financial groups to have pure holding companies that issue the bonds to be bailed-in” (emphasis added).

Tucker sets out his argument for structural subordination as follows.

“…provided that the ailing operating companies (opcos) can be recapitalised through a conversion of debt issued to holdco …., the opcos never default and so do not go into a bankruptcy or resolution process. While there might be run once the cause of the distress is revealed, the central bank can lend to the recapitalised opco …

This turns on creditors and counterparties of opcos caring only about the sufficiency of the bonds issued to the holdco; they do not especially care about any subsequent resolution of the holding company. That is not achieved, however, where the bonds to be bailed in … are not structurally subordinated. In that respect, some major jurisdictions seem to have fallen short:

  Many European countries have opted not to adopt structural subordination, but instead have gone for statutory subordination (eg Germany) or contractual subordination (eg France).

  In consequence, a failing opco will go into resolution

  This entails uncertainty for opco liability holders given the risk of legal challenge etc

  Therefore, opco liabilities under those regimes will not be as informationally insensitive as would have been possible.

BIS WP 790, Page 15

While structural subordination is Tucker’s preferred approach, his main point is that the solution adopted should render operational liabilities informationally insensitive:

“….the choice between structural, statutory and contractual subordination should be seen not narrowly in terms of simply being able to write down and/or convert deeply subordinated debt into equity, but rather more broadly in terms of rendering the liabilities of operating intermediaries informationally insensitive. The information that investors and creditors need is not the minutiae of the banking business but the corporate finance structure that enables resolution without opcos formally defaulting or going into a resolution process themselves

BIS WP 790 , Pages 15-16

If jurisdictions choose to stick with contractual or statutory subordination, Tucker proposes that they need to pay close attention to the creditor hierarchy, especially where the resolution process is constrained by the requirement that no creditor should be worse off than would have been the case in bankruptcy. Any areas of ambiguity should be clarified ex ante and, if necessary, the granularity of the creditor hierarchy expanded to ensure that the treatment of creditors in resolution is what is fair, expected and intended.

Tucker sums up the policy implications of this part of his paper as follows ...

“The policy conclusion of this part of the discussion, then, is that in order to deliver information insensitivity for some of the liabilities of operating banks and dealers, policymakers should:

a) move towards requiring that all short-term liabilities be covered by assets eligible at the central bank; and, given that that alone cannot banish bankruptcy,

b) be more prescriptive about corporate structures and creditor hierarchies since they matter hugely in bankruptcy and resolution.”

BIS WP 790, Page 16

Summing up …

  • Tucker positions his paper as “… a plea to policymakers to work with researchers to re-examine whether enough has been done to make the financial system resilient“.
  • His position is that “… the financial system is much more resilient than before the crisis but … less resilient than claimed by policymakers”
  • Tucker’s assessment “… is partly due to shifts in the macroeconomic environment” which reduce the capacity of monetary and fiscal policy stimulus but also an in principle view that “maintaining a resilient system cannot sanely rely on crushing the probability of distress via prophylactic regulation and supervision: a strategy that confronts the Gods in its technocratic arrogance“.
  • Tucker argues that the desired degree of resilience is more likely to be found in a combination of “… low barriers to entry, credible resolution regimes and crisis management tools …[that] … ensure the system can keep going through distress”.
  • Tucker also advocates putting the central insights of some theoretical work on “informational insensitivity” to practical use in the following way:
    • move towards requiring all banking-type intermediaries to cover all short-term liabilities with assets eligible for discount at the Window
    • insist upon structural subordination of bailinable bonds so that the liabilities of operating subsidiaries are more nearly informationally insensitive
    • be more prescriptive about the permitted creditor hierarchy of operating intermediaries
    • establish frameworks for overseeing and regulating collateralised money market, with more active use made of setting minimum haircut requirements to ensure that widely used money market instruments are safe in nearly all circumstancesarticulating restrictive principles for market-maker of last resort operations
  • Given the massive costs (economic, social, cultural) associated with financial crises, err on the side of maintaining resilience
  • To the extent that financial resilience continues to rely on the regulation and supervision of capital adequacy, ensure transparency regarding the target level of resilience and the extent to which discretionary policy actions impact that level of resilience

I am deeply touched if you actually read this far. The topic of crisis management and resolution capability is irredeemably technical but also important to get right.

Tony