Why the real economy needs a prudential authority too

Isabella Kaminska (FT Alphaville) offers an interesting perspective on ways in which prudential initiatives in the areas of capital, liquidity and bail-in that have strengthened the banking sector post GFC might be applied to the “real economy”.

The global financial crisis taught us that laissez-faire finance, when left to its own devices, tends to encourage extreme fragility by under capitalising the system for efficiency’s sake and making it far more systemically interdependent.

Pre-2008, banks operated on the thinnest of capital layers while taking extreme liquidity risk due to the presumption that wholesale liquidity markets would always be open and available to them. It was in this way that they saved on capital and liquidity costs and increased their return on equity.  

Regulatory responses to the crisis understandably focused on boosting resilience by hiking capital buffers, liquidity ratios and also by introducing new types of loss absorbing structures. While it’s still too early to claim regulatory efforts were a definitive success, it does seem by and large the measures have worked to stymie a greater financial crisis this time around.

But what the 2008 crisis response may have overlooked is that bolstering banks to protect the economy means very little if the underlying real economy remains as thinly spread and interconnected as the financial sector always used to be.

The assessment that these banking initiatives “means very little” is possibly overstating the case.  The problems we are facing today would be an order of magnitude greater if the banking system was not able to plays its part in the solution.

The core point, however, I think is absolutely on the money, the focus on efficiency comes at the expense of resilience. More importantly, a free market system, populated by economic agents pursuing their own interests shaped by a focus on relatively short term time horizons, does not seem to be well adapted for dealing with this problem on its own. The lessons prudential regulators learned about the limits of efficient markets and market discipline also apply in the real world.

Isabella looks at the way prudential capital and liquidity requirements operate in banking and draws analogies in the real economy. With respect to liquidity, she notes for example,

“… the just-in-time supply chain system can be viewed as the real economy’s version of a fractional reserve system, with reserves substitutable for inventories.  

Meanwhile, the real economy’s presumption that additional inventories can be sourced from third party wholesale suppliers at a price as and when demand dictates, is equivalent to the banking sector’s presumption that liquidity can always be sourced from wholesale markets.

Though there is obviously one important difference.

Unlike the banking sector, the real economy has no lender of last resort that can magically conjure up more intensive care beds or toilet paper at the stroke of a keyboard when runs on such resources manifest unexpectedly.  

So what are our options? Companies could increase their inventories (analogous to holding more liquid assets) or build excess capacity (analogous to building up a capital buffer) but it is very difficult for companies acting independently to do this if their competitors choose the short term cost efficient play and undercut them on price. The Prisoner’s Dilemma trumps market discipline and playing the long game.

Isabella frames the problem as follows:

short-term supply shortages can only be responded to with real world manufacturing capability, which itself is constrained by physical availability To that extent crisis responses can only really take two forms: 1) immediate investment in the build-up of new manufacturing capacity that can address the specific system shortages or, 2) the temporary reallocation of existing resources (with some adaptation cost) to new production purposes.

The problem with the first option is that it is not necessarily time efficient. Not every country has the capability to build two new hospitals from scratch in just 10 days. Nor the capacity to create unexpected supply just-in-time to deal with the problem.

New investment may not be economically optimal either. What happens to those hospitals when the crisis abates? Do they stand empty and idle? Do they get repurposed? Who will fund their maintenance and upkeep if they go unused? And at what cost to other vital services and goods?

Isabella’s proposal …

That leaves the reallocation of existing assets as the only sensible and economically efficient mitigatory response to surge-demand related crises like pandemic flu. But it’s clear that on that front we can be smarter about how we anticipate and prepare for such reallocation shocks. An obvious thing to do is to take a leaf out of banking regulators’ books, especially with regards to bail-inable capital, capital ratios and liquidity profiles.

Isabella offers two examples to illustrate her argument; one is power companies and the other is the health system.

She notes that power utilities manage demand-surge or supply-shock risk with interruptible contracts to industrial clients. She argues that these contracts equate to a type of bail-inable capital buffer, since the contracts allow utilities to temporarily suspend services to clients (at their cost) if and when critical needs are triggered elsewhere and supplies must be diverted.

I think she has a good point about the value of real options but I am less sure that bail-in is the right analogy. Bail-in is a permanent adjustment to the capital structure in which debt is converted to equity or written off. Preferably the former in order to maintain the loss hierarchy that would otherwise apply in liquidation. A contract that enables a temporary adjustment to expenses is a valuable option but not really a bail-in style option.

What she is identifying in this power utility example is more a company buying real options from its customers that reduces operating leverage by enabling the company to reduce the supply of service when it becomes expensive to supply. Companies that have high operating leverage have high fixed costs versus revenue and will, all other things being equal, tend to need to run more conservative financial leverage than companies with low operating leverage. So reduced operating leverage is a substitute for needing to hold more capital.

Isabella then explores the ways in which the liquidity, capital and bail-in analogies might be applied in healthcare. I can quibble with some of the analogies she draws to prudential capital and liquidity requirements. As an example of a capital requirement being applied to health care she proposes that …

“… governments could mandate makers of non-perishable emergency goods (such as medicines, toilet paper, face masks, hand sanitiser) to always keep two-weeks’ worth of additional supply on hand. And companies could also be mandated to maintain some share of total supply chain production capability entirely domestically, making them more resilient to globalised shocks”

 Two weeks supply looks more like a liquidity buffer than a capital buffer but that does not make the ideas any the less worth considering as a way of making the real economy more resilient. The banking system had its crisis during the GFC and the real economy is being tested this time around. There are arguments about whether the changes to banking went far enough but it is clearly a lot better placed to play its part in this crisis than it was in the last. The question Isabella poses is what kinds of structural change will be required to make the real economy more resilient in the face of the next crisis.

Another example of FT Alphaville being a reliable source of ideas and information to help you think more deeply about the world.

Tony (From the Outside)

“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