Saturday, 16 July 2011

Flannel and ostriches

Yesterday the European Banking Authority (EBA) published the results of its "stress tests" on European banks. The full report is here for those with time on their hands!

The "stress tests" were designed to test the ability of European banks to withstand economic problems such as recession. Losses arising from difficult economic conditions should be absorbed by shareholders' equity (common stock) and retained earnings - what is known as "Core Tier 1 capital" (see my blog explaining this, Reserve Confusion). 

Banks have historically held very little Core Tier 1 (CT1) capital, so in the financial crisis they had little ability to absorb losses, and taxpayers were forced to provide funds to many banks to prevent creditors (bond holders and retail depositors) losing their money.  Financial regulators around the world have since required banks to hold a higher percentage of risk capital, particularly CT1, against risk weighted assets. The European stress tests demonstrated that only 8 European banks have less than 5% CT1 against risk weighted assets and a further 16 have less than 6%.  Out of  90 banks tested, that isn't too bad, is it?

Actually it's flannel. The Basel committee recently recommended that internationally-active banks should have CT1 of 7% of risk weighted assets, and systemically-important banks should hold an additional 2.5%.  Now, not all of the banks tested are internationally active - the Spanish Cajas, for example, are domestic banks. But a lot are, and some are systemically important. So the EU test has actually set a low bar for CT1 and applied it equally to all banks, whatever their size and significance.  Reuters produced a useful little calculator yesterday which shows how many banks fail if the capital requirement is raised to higher levels. Apart from being great fun to play with, this calculator shows - worryingly - that if the EU had used the base Basel requirement of 7%, 41 banks would have failed. And at 8% 53 banks fail.  Highest on the list - i.e. needing to raise the most actual capital in monetary terms - are some banks that without question are systemically important, such as RBS, Deutsche Bank and Societe Generale. There isn't a snowball's chance in hell that they will meet the enhanced Basel requirement of 9.5% CT1 in any reasonable timeframe.

That's bad enough. But the EU test is also structurally inadequate. It ignores the biggest risk to European banks at the moment - the risk that there will be sovereign debt default in more than one country. Yes, the tests show that overall the European banking system can withstand Greek default, although Greek banks would fail.  But withstanding default by Ireland, Portugal and maybe Spain and Italy too - on only 6-7% CT1, which is what most EU banks have? I don't think so. 

Pity the EU taxpayers, especially German ones. The main thing the stress tests have proven is that if there is a string of defaults, they will have to stump up. And that will be inevitably followed by recession and austerity in the whole EU, not just the countries defaulting.

The structural inadequacy of the EU test, and the low capital requirement, arise from the fact that at the moment no EU leader is prepared to admit that multiple sovereign default is even a serious risk, let alone likely to happen soon.  I am reminded of the last line of Flanders & Swann's The Ostrich: "Here in this nuclear testing ground/ Is no place to bury your head!".  Let's hope the EU leaders get their heads out of the sand and come up with a sensible plan for dealing with excessive debt burdens in peripheral countries before the Eurozone blows up in their faces.

Sunday, 10 July 2011

Trust in danger

Hot on the heels of Johann Hari's exposure as a plagiarist - and comments from many that "he's not the only one" - comes the disorderly demise of the News of The World amid allegations of phone hacking. And again, comments from many that "they're not the only ones".

Think back a few years. Do you remember the MPs expenses scandal? The initial belief from Conservatives that "it wasn't any of us" only to discover that yes, it was some of them as well? Suddenly policitians could not be trusted with the nation's finances. Corruption was exposed.

Now look at the financial crisis of 2008. I know I keep singing this tune, but what was exposed was excessive risk-taking and fraud in retail banking. Traditional, safe retail banks suddenly could not be trusted with our money. Admittedly considerable attempts have been made to blame investment banking for the crisis, because that's always been a bit dodgy, hasn't it? But the reality, that people know in their hearts, is that high street banks are not trustworthy.

The three professions of journalist, politician and banker all depend upon trust. Investigative journalists need to be believable or no-one will take their output seriously, and they need to be trustworthy or no-one will tell them anything. Politicians depend on trust for their mandate to govern - once the trust of voters is broken, the next election is lost. And banks need people to lend them their money, trusting that the banks will look after it properly.

Not only do these professions depend on trust, people need to be able to trust them. The media hold immense power over opinion and can massively influence behaviour simply by presenting researched facts and coherent opinion. Even if those facts are wrong people still believe them if they have been reported in a quality newspaper - as I discovered when I corrected the Guardian over the reporting of Barclays 2009 results.  As a nation we need to be able to trust that the people we elect to represent us in the Mother of Parliaments, and by extension the people we appoint to govern us, will act fairly, honourably and in our best interests. And as individuals we need to trust that our financial institutions will treat our money with respect and honour their obligations to us.

We have in the last few years had our trust in all three professions shattered. And we are deeply shocked. Confidence in the electoral process, in party politics and in government is at an all-time low. Politicians are seen as looking after their own interests and those of their rich friends, rather than the interests of the people they serve. Bankers are seen as ripping us off to make huge amounts in bonuses: these days, even used car salesmen and estate agents are regarded as more trustworthy than bankers.  And journalists are seen as amoral sensationalists, who will stoop to the lowest depths to spin a story and if necessary fabricate it, caring not at all about the cost to the lives and reputations of the people involved.

Isolated instances of bad (even criminal) behaviour by a member of a profession don't cause this deep-seated malaise. Dr. Harold Shipman, the worst serial killer in UK history, was able to kill so many people because his profession as a GP meant that people trusted him. But his conviction for murder didn't destroy people's trust in the medical profession. Similarly, the few examples there have been of teachers prosecuted for child abuse haven't resulted in huge numbers of people refusing to trust teachers with their children - but a much larger number of child abuse cases among Roman Catholic priests has resulted in a massive loss of trust in the priesthood.  Even if they are not paedophiles, priests are treated as if they might be.

So if journalists, politicians and bankers now are not trusted it is not because of individual bad behaviour by the likes of Johann Hari, Elliott Morley and Fred Goodwin. It is because there have, over a period of time, been sufficient examples of immoral or criminal behaviour by members of these professions to make people suspect that such behaviour is not exceptional but is the norm.

Loss of trust in such powerful professions is terrible. All three have really important roles to play in our society, though the power they wield has gone to their heads and they seem to have forgotten that their first priority is to serve the people of the country with honesty and integrity. All three are now discovering that they have no future without the trust of the people they serve.

And now it appears that the police, too, are part of the general malaise. Senior police officers have routinely failed to investigate possible criminal activity by newspapers and banks in the interests of "maintaining good relationships".  Cover-ups are the order of the day. Yes, Sir Paul Stephenson has done the decent thing and resigned - but Mark Reckless's blog today points out that he has got out just in time to avoid the dirt hitting him: in 2009 he failed to investigate major News of the World phone hacking allegations properly.  And Yates, of course, is still hanging on in there. Trust in the police - already undermined in some sectors of society by heavy-handed police tactics in UK Uncut marches - is sliding downhill at a rate of knots.

What can members of these professions do to regain our trust? What can be done to shift the public perception that there is a cosy elite who rub each other's backs? Cameron's statement that "we're all in it together" looks more like "they're all in it together".

I don't have any easy answers. Honesty and transparency would help, though that looks like it's in short supply these days.  But public servants - which is what all these people are, even those who ostensibly work for commercial organisations - must recognise that their first duty is to the people of the country. Behaviour that hurts ordinary people in the interests of selling more newspapers, making more money or getting more votes is unacceptable. Those who are shown to be indulging in such behaviour should be called to account.

Wednesday, 6 July 2011

Pulling off the plaster

On my blogpost "There's no more money" I stated that one reason for the Bank of England's QE programme was to stave off deflation. There has been one comment in response:

                                                "Why is deflation bad?"

It's an amazing question.

My immediate reaction was "well, obviously it is".  And then I thought, "well, actually it's not obvious at all, and I don't know the answer".  So I did some research to find out what economists say about whether deflation is a good or bad thing.  I found Krugman's article on this, and several others as well. As I expected, Krugman's article was accurate in description but uniformly negative in opinion about deflation. But the others were more balanced. And one, ElliotWave, pointed out that deflation was not bad unless you were unprepared for it.

Now, according to ElliotWave's description, the UK is pretty unprepared for a period of deflation.  Households, businesses and government are all carrying exceptionally high levels of debt. Government debt is heading for 70% of GDP. Individual debt is over 100% of GDP. And corporate debt is higher still.  But deflation seems to be what everyone wants.  The Government is putting in place measures designed to reduce the rate at which government debt is growing, which generally reduce the amount of money available, to households in particular.  Banks are not lending anything like the amounts they were prior to the financial crisis. And individuals and businesses are choosing to pay down debt rather than spend money. All of this adds up to a severe and rapid contraction. Deflation is not just a risk, it is inevitable.

But my questioner wants to know whether deflation is a bad thing. And after reading all those articles and papers, I don't know any more than I did before, except that this is another subject on which economists don't agree. But of one thing I am certain. Whether deflation is a bad thing depends on the circumstances. And in the present economic circumstances I don't think it is a bad thing at all.  I think it is essential.  The only debate should be over how fast the economy should deflate.

Let me explain my thinking. 

The prosperity of the ten years to the financial crash in 2008 was built upon a credit bubble, not on real economic growth. There was no sound economic foundation to this prosperity.  In effect, the UK was living beyond its means. As a consequence of this, many businesses and individuals are carrying historically unprecedented and unsustainable levels of debt. This debt is now much more expensive than it was a few years back, and tighter lending conditions mean refinancing it is no longer an option for most people and businesses. The only other option is to reduce it, and that is what people and businesses are doing.

Debt reduction causes shrinkage in the money supply, which increases the value of monetary units and therefore tends to reduce prices. This is deflation. Under normal circumstances this shrinkage would be offset by expansion in the money supply due to new bank lending.  But at present the banks aren't lending at anything like the levels required to offset private sector debt repayment. Nor should they be. After all, the private sector wants to reduce its debt, not take on more.  So deflation is necessary if the private sector debt burden is to be reduced - unless, of course, the reduction in private sector debt is offset by increases in public debt.

Officially, we don't have deflation as such at the moment - we have inflation, mainly due to a VAT increase coupled with rising world prices for fuel and food prices.  But the pattern of behaviour in the domestic economy is definitely deflationary. House prices, which have been inflated due to the credit bubble, are falling, and the retail sector is turning in awful results.  People and businesses are reducing their spending across the board, and rising prices in some sectors are simply encouraging people to make even deeper cuts. Were this not the case, external factors would mean that inflation might well be quite a bit higher than it is at present.

Government policy so far has ignored the drive to deleveraging in the private sector and concentrated on controlling public sector spending while stimulating the economy in various ways to promote growth. These measures include a failed attempt at demand stimulus through  quantitative easing; corporate tax reduction; measures to improve lending to businesses, both through the banks and directly from government; light-touch regulation of tax avoidance measures such as offshoring. All of these are bound to be ineffective if the private sector prefers to pay its debts and sit on its cash, which is what is happening. Near-zero economic growth is here to stay while the private sector isn't spending.

The question is, do we really need to push for economic growth at the moment? Or should we accept that the UK economy is rebalancing itself, deflating the unsustainable credit bubble and returning to a more stable, if smaller, base? If we interfere with this so as to slow down the rate of contraction or delay its effects - for example by encouraging more bank lending to businesses, or increasing debt-financed public spending - do we make the necessary adjustment easier to bear, or do we simply turn an excruciating but mercifully short adjustment into a long-drawn-out agony?

I don't know the answer to this. But I know how I prefer to take off sticking plaster.

Monday, 4 July 2011

Sausage factories

I'm aware that most of my posts so far have talked mainly about the way the UK retail banking system works and its role in the financial crisis of 2008. It has not escaped my notice that the US retail banking system is very different, but I must admit that until a recent twitter conversation with Cate Long I hadn't realised just HOW different it is. In particular, the US mortgage market operates in a fundamentally different way from the mortgage market in any other country - and that very different model was at the heart of the financial crisis not only in the US but throughout the Western world.

I'm also aware that some of my blogs get quite technical and they aren't always jargon-free. And the way the US mortgage market works is complex and hard to get your head round without illustration. So I thought I would describe it in terms of something much more familiar. I'm going to talk about sausages.

Imagine there are a hundred small farms all producing various varieties of meat - chicken, lamb, beef, pork.  They sell some of their meat locally, but most of it is bought up by two huge processing plants.  These processing plants dump all the meat, irrespective of its type, into huge vats, where it is boned, skinned and minced.  It is then processed into sausages, which are packed up and sold on to domestic supermarkets and exporters.  The exporters repackage the sausages under their own labels, taking some of them apart and creating new sausage-based products such as tins of baked beans with sausages in, tinned sausage stews and frozen sausage pies.  Many of these repackaged sausages are exported, particularly to the UK and European countries where sausages and sausage-based products are popular because they are cheap and tasty.

Sounds like a really good, sound international industry, doesn't it? What could go wrong? 

The meat that is produced is of course inspected by meat inspectors to make sure it is fit for human consumption before it is sold.  And in the past the standards were high and quite a lot of meat didn't pass the test.  This annoyed the farmers, because they couldn't get rich from farming, and it annoyed the factories, because they couldn't get enough meat to satisfy their international customers.

One day an enterprising farmer had a moan at the meat inspector about the meat standards and the fact that so much of his meat was only fit for pet food. To his surprise he discovered that the meat inspector agreed with him. So between them they came up with a scheme whereby some of the meat that should be condemned would actually be marked as "fit for human consumption" and sold at the higher price.  Not all of it, of course - too much and questions would be asked.  But enough to give a nice little boost to farm profits. The meat inspector got a cut of the proceeds, of course. 

The farmer told his (equally frustrated) farmer friends about his friendly meat inspector. And the meat inspector told those of his colleagues he knew held similar views to him on the stupidity of meat standards. And before long, several farms were working with helpful meat inspectors to pass on some meat as "fit for human consumption" when it should have been condemned. 

Well, the inevitable happened, of course. There was a massive outbreak of E Coli, initially in the UK and then in the US and various European countries. Hundreds died, and thousands more were very ill. Hospitals were unable to cope with the influx of sick people, and nurses and doctors worked around the clock but were still unable to treat everyone. Stocks of medicines ran out.  Businesses lost money and many went bankrupt because so many of the workforce were ill. Governments declared national emergencies and asked unaffected countries for financial and medical assistance. It was a major global disasater. But no-one could work out where it had come from.

The obvious culprits initially seemed to be the export firms.  After all, they were doing major repackaging and reprocessing operations: maybe some of their practices were a bit dodgy. And investigations discovered that that was indeed the case.  Some of the export firms were adding potentially lethal substances to their products to make them look more attractive to housewives. And consumer watchdogs, noticing the pretty packaging, attractive colour and pleasant smell, were giving them top-notch approval ratings, which encouraged more consumers to buy the products.  But if that was the only cause, how come people in the US were dropping like flies when all they had bought was sausages?

All the way down the line, companies involved in meat reprocessing were going bust. People just weren't buying sausages and sausage-related products any more. The export market collapsed. It was a major disaster for the industry. So the government stepped in to provide financial support to these companies so that they could find alternative suppliers and rebuild their shattered reputations. The largest amount of support went to the two giant factories.

Government investigators soon realised that although the export companies were making matters worse by their use of toxic substances in reprocessed products, they weren't the source of the E Coli outbreak. So they looked at the two sausage factories. Everything looked alright there - the factories were clean and hygiene standards were good. So they started to look at the farms themselves. And it soon became apparent that all was not well. Some of these farms had poor hygiene and animal welfare standards, others had untreated TB in cattle and there was an outbreak of swine fever in one area.  All of these should have reduced or stopped the sales of meat from those farms - but it hadn't. Eventually, after much snooping and undercover work, the investigators started to expose the collusion of some farmers and meat inspectors. Prosecutions followed, of course.  Interestingly, in the course of one of those prosecutions it emerged that both the factories had known about the public health risk and turned a blind eye.....they were only too happy to have the additional meat so they could produce more sausages.

The underlying problem was, of course, fraud.  But had the meat that should have been condemned only been sold in local markets and not passed on to the factories, there would have been small local outbreaks of E Coli which would have been easily contained and the culprits identified and prosecuted quickly.  Because it was sold on to the factories, which mixed it up with good quality meat and repackaged it, it went EVERYWHERE. Every sausage produced by the sausage factories was potentially a public health risk. And there were millions of them, and they were sold all round the world. So what started as a small-scale scam by a few disgruntled farmers and unscrupulous meat inspectors became a global public health disaster. It took years for the economies of the countries affected to recover. And the people who lost loved ones, or who were scarred by their illness, will never recover.

It's a horrible story, isn't it? Fortunately it has not happened. Or has it? Try substituting "mortgage" for "meat", "RMBS" for "sausage" and "financial" for "public health" in the above tale and see what happens.....

There is no more money!

Yesterday I had a conversation with several people who believed that the purpose of Quantitative Easing (QE) in the UK and the US was to provide cash to banks so that they could lend more.  They called it "printing money" and insisted that it would cause inflation and therefore lead to interest rate rises, which is a bad thing, of course, isn't it?

They have missed the point completely.

QE is an interest rate management tool.  Nominal interest rates (base lending rates) in both the US and UK have been nearly zero for a long time now.  Low interest rates would normally encourage spending - which is needed to stimulate economies - but both these economies were in such a poor state after the financial crisis and ensuing deep recession that near-zero rates made little difference and there was a serious risk of deflation. It was not possible to cut nominal rates further as this would make them negative, which would mean central banks were paying commercial banks to borrow money.  However, real interest rates in the form of bond yields needed to fall further to encourage financial divestment and spending.

Both the Fed and the Bank of England therefore initiated asset purchase programmes. They bought up corporate bonds and equities, along with their own debt instruments, in return for short-dated Treasury Bills. These Treasury Bills were new issues (i.e. invented money) - which is where the accusation of "printing money" comes from.

The effect of these asset purchases was to reduce the supply of corporate and government bonds and equities in the financial marketplace, which raised their prices and depressed bond interest rates (yields). That's what QE was supposed to do - and it did work to some extent. Real interest rates did indeed fall and deflation has (so far) been avoided.

There was a secondary effect, which was to increase the amount of liquidity in the financial system. Treasury Bills have to be intermediated into currency by banks, so all purchases of assets under the QE programme resulted in increases in bank deposits at least on a short-term basis.  In effect, financial institutions sold long-term investments for cash, and temporarily parked that cash at commercial banks, increasing their cash reserves. Now banks could indeed have lent this out to commercial borrowers - if they wanted to. But they didn't have to, and the evidence is that all they did was lend it to each other or (mainly) back to the central banks.  So QE did NOTHING to encourage bank lending. Nor was it intended to. The Bank of England itself says that although the extra cash reserves could be lent out, banks might not choose to do that when they are trying to repair their balance sheets. Contrary to popular belief, QE does not increase bank capital - and it is capital that banks need if they are to lend more.

My friends also thought that QE inflated commercial banks' balance sheets with extra cash reserves paid for by the taxpayer. This is nonsense. Firstly, the new issues of Treasury Bills were NOT paid for by the taxpayer - they were simply created "from thin air" by crediting recipient deposit accounts.  Secondly, the newly-created Treasury Bills were then used to buy an equivalent quantity of longer-dated financial assets, mostly from institutional investors rather than banks. So if there has been an influx of cash reserves in commercial bank balance sheets, it is because institutional investors have chosen to park their money there rather than spending it on other investments. Since banks generally are not increasing their lending portfolios, the increased deposit balances would be offset by a reduction in other forms of bank borrowing, so would not make any difference at all to the size of bank balance sheets. Bank balance sheets are no bigger than they were before. The only banks that DO have bigger balance sheets as a consequence of QE are, of course, the Fed and the Bank of England, who now hold large stocks of corporate bonds, equities and government bonds.  These will be sold in due course once the economy improves.

And now to the inflation question.

My friends believed that the newly-issued money actually made its way into circulation, increasing the amount of money in the economy and therefore debasing its value, which causes inflation.  This again is nonsense. The only way money can get into the economy is through bank lending and corporate bond issuance, and as I have already noted, banks weren't lending (and still aren't) and businesses are not investing. Even if they were, part of the reason for the poor performance of both US and UK economies is people and businesses in the private sector paying off debt, which reduces the amount of money in circulation. So although QE did increase the cash reserves available to banks, there is no evidence that much of it got into the real economy, and whatever did reach the real economy simply offset the money being destroyed by deleveraging. There is NO more money in the economy as a result of QE.

However, they were right about QE causing inflation. That was the purpose of the QE programme. A small amount of inflation is necessary in a healthy economy: zero inflation indicates stagnation, and negative inflation is deflation. Near-zero inflation rates in a demand-depressed economy are very bad news because they can signal the start of a deflationary spiral.  In the UK the Government sets an inflation target and the Bank of England is responsible for taking the measures necessary to keep inflation around that target. Dropping too far below the target is just as bad as exceeding it. So the purpose of QE was to raise the inflation rate to around the Government's target by stimulating demand in the economy. 

And yes, this should then lead to interest rate rises. Near-zero interest rates over the long term are indicative of an economy in very bad shape - as Japan's experience shows. A healthy economy not only needs some inflation, it needs positive interest rates. QE was intended to raise inflation by stimulating demand so that nominal interest rates could be increased to a more normal level. 

So yes, QE would increase inflation, and this should eventually lead to interest rate rises. However, it doesn't seem to have been very effective, at least in the UK. Inflation is now well above the government's target, but interest rates are still near-zero and there is a serious demand slump in the domestic economy.  Now if the inflation in the economy were due to QE, demand would have improved, wouldn't it? So it can't be due to that. In fact the inflation we are now seeing is due to external factors, especially high global prices for essential commodities and oil, coupled with consumption tax increases.

In fact QE has been a spectacular failure. And my friends were right about one thing - the lack of bank lending is the reason why it hasn't worked. QE requires banks to be lending normally and businesses to be investing normally in order for the additional liquidity to find its way into the real economy, which is where the demand stimulus is needed. But they aren't, and no amount of extra cash will persuade them to do so if they don't want to.

So the prevailing beliefs about QE, peddled by journalists who don't know anything and don't bother to do their research properly, are totally, utterly and completely wrong. Unfortunately a lot of people believe them. Which is why I wrote this blog. SOMEONE has to explain how it really works!