Monday, 29 April 2013

Turning back the clock? The future of retail banking

In my last post, I commented that there is a fundamental problem with retail bank profitability about which regulators unwisely appear totally unconcerned. Various people have suggested that I am therefore calling for looser regulation. That is a misunderstanding. The issue runs far deeper. Really it calls into question the future of banking as we know it. 

Many people would like to return to a supposed “golden age” of banking, when banks were small and local and bank managers were respected pillars of the community with real power to make lending decisions. And I understand their nostalgia. In some ways they are right. We need to restore trust in banking. But should we - or could we - turn back the clock?

Retail banking began to change in the 1960s with the advent of non-bank lenders and development of money markets.  The UK’s banking cartel was ended in 1971 to level the playing field for banks and non-banks, encouraging competition to give a better deal for customers.  The lifting of exchange controls in 1979 forced banks to compete for deposits with the Eurodollar market. The breakup of the building societies’ cartel in 1983 and relaxation of restrictions on savings banks to allow them to offer a full range of banking services increased the competitive environment for retail banks and reduced their profitability.

In response to this, retail banks started to cross-sell products such as endowment mortgages and pensions early in the 1980s. After Big Bang this expanded considerably when they bought up non-banks that traditionally had provided these products. Despite this, retail banks’ profitability continued to decline, forcing them to seek better returns by gaining market share. They introduced free current account banking and other incentives to attract retail customers. Conversion of building societies into banks from 1988 onwards enabled retail banks to buy up their smaller competitors, and deregulation of merchant banking and the stock market enabled them to acquire ready-made investment banking arms. The age of universal banks had arrived.

Retail banking’s low profitability also forced change from within. The old retail banking model was popular with customers but expensive to run. And keeping back office processing in the branches prevented banks from benefiting from economies of scale and computer technology. So banks centralised their back–office processing in specialised centres with giant computers. Stripping out back-office processing from the branches allowed them to reduce staffing levels and give more focus to product sales.

A new view of retail banking was developing. As deregulation removed the boundaries between different types of financial product, banks saw themselves as “one-stop shops” where customers would come for ALL their financial needs. For retail banks this was a lifeline. Their core retail offering of deposits, payments and vanilla lending was only marginally profitable. But if they could use deposit and current account balances to fund more profitable activities, then it was worth attracting deposits and current accounts. And even more importantly, even if they couldn’t make any money out of core retail banking, they could cross-sell other products to their customer base. Suddenly retail customers became very desirable, particularly at the low- to middle- income level where people traditionally were paid in cash and had little borrowing. They represented an enormous sales opportunity, not just for retail banking products but for far more lucrative things such as endowment mortgages, pensions and insurance.

Bank staff didn’t understand these products, but they were given aggressive sales targets for them with penalties for under-performance.  Mis-selling started from the moment that banks diversified into added-value products. The scale of mis-selling across the range of added-value retail financial products has driven people away from banks: few people now would buy insurance from their high street bank. Even trust in core retail banking products has been eroded by what is seen as appalling behaviour by some commercial banks. Investment banking has borne the brunt of people’s anger, and it has suffered a severe contraction, with thousands of job losses. But the large universal banks are far from popular – hence the rise of movements such as Move Your Money, which encourage people to move deposits and current accounts to smaller banks and non-banks such as building societies and credit unions.

The overlay of profitable added-value activities is being stripped away from retail banking, leaving an increasingly unprofitable core. .Very low interest rates are destroying bank margins, while regulation forcing them to maintain higher levels of capital and liquid assets raises their costs. Branch use is declining as customers turn to automated payments and online and telephone banking. As the use of cash declines, transactions through payments systems are at an all-time high, which is a cost to the banks but not currently to their customers. There is growing competition from non-banks for traditional retail lending products, especially online where lending decisions based on credit scores can be made in a matter of minutes.  Legislation is planned to force banks to limit the use of deposit balances to supporting retail lending, not higher value investment banking activities.  And regulators are determined to limit the range of products that banks can sell. To me this does not look like a viable business model. Somehow, retail banks have to make some money.

I foresee a number of ways in which they might improve their profitability for the future.

Free current account banking will end.  Banks are already introducing accounts with monthly fees.  There may be fee-based current accounts similar to mobile phone contracts, setting limits on the volume and types of payments that can be made for a given monthly fee: perhaps there might be a “pay-as-you-go” option for low-volume payments users.

The mass market in banking is going online. Competition in the online marketplace is intense, but online banking does not have the overheads of high street branches, so for many banks, a move to the online market place may signal a return to profitability.

Branch banking is set to change radically. Some banks in Ireland have already closed all their branches, and in the UK hundreds of branches have already closed and many more closures are planned. It seems unlikely that there will continue to be “high street” branches as we know them. However, there will still be a need for local banking to support the elderly, the low-paid and small businesses. So the future for branch banking may be part-time cashier outlets in local shops, and small local banks offering fee-based personalised services.

More radically still, the big banks may find their dominance challenged. Large retailers are creating their own banks: Marks & Spencer is now offering current accounts, and other retailers are bound to follow suit. 

There can be no return to the banking of the past. Even the supermarket-style high street bank branches to which we have become accustomed are doomed. But diversity in finance is set to increase, and that is surely a good thing for both banks and customers. 

Related links: 

The profitability problem - Coppola Comment

Sunday, 28 April 2013

The profitability problem

The Co-Operative bank has pulled out of its proposed purchase of Lloyds branches, citing the bad economy and tougher regulatory requirements for banks. Various people have suggested that this said more about the Co-Op itself than anything else: "bad economy and tough regulation" easily translates into "business is weak and we are short of capital". Indeed they are. In February this year, the Co-Op shamefacedly admitted to a £1bn black hole in their capital. But Robert Peston points out that the Verde branches would actually be better capitalised than the Co-Op's own, and the deal would therefore have improved their overall capitalisation. So what is going on?

The regulatory environment for banks is indeed tough and becoming tougher. The Prudential Regulatory Authority is determined to clamp down on risky activities and force banks to protect themselves and the financial system from failure through increased capital buffers and liquidity reserves. And the Financial Conduct Authority is imposing tighter supervision of larger banks, and serious restriction on products and funding strategies that it considers to be not in customers' best interests - which include many of retail banks' more profitable activities. Nowhere does the need to make profits feature in the terms of reference of either regulator. They don't seem remotely interested in ensuring that commercial banks can be profitable.

Yet both should be. An unprofitable bank is a risky bank. And an unprofitable bank is unlikely to give good value to customers.

Firstly, the risks. These centre around the ability of banks to absorb losses. Banks are at risk of insolvency if the value of their assets falls - for example through a spate of bankruptcies among borrowers. They are also at risk of running out of money if depositors decide to remove their funds, although this can be mitigated by an effective central bank acting as lender of last resort provided that the banks in question have sufficient acceptable collateral. The risk of running out of money is therefore mitigated by banks holding high-quality liquid assets such as government bonds. And the risk of insolvency is mitigated by capital.

Contrary to popular opinion, capital is not "cash". Nor is it deposits, or any other sort of debt. It is shareholders' funds - what in other companies would be called "equity". Just to remind you (I know I've written about this before), banks can raise capital in three ways:
  • directly from shareholders by means of new shares (rights issues). Shareholders are unlikely to want to buy more shares in banks that are already offering a poor return on their existing shareholdings.
  • by retaining earnings (profits) instead of dishing them out to shareholders as dividends, employees as increased wages and/or customers as reduced prices. This of course requires them to be making profits.
  • by reducing the overall size of their asset base, either by reducing the risk profile of the assets or by selling them. Put bluntly, this means limiting lending to better risks, selling off parts of their business, and reducing the amount of lending they do.
If a bank is not profitable, it cannot give any sort of decent return to its shareholders, it cannot build up capital, and it is unable to undertake the sort of risk lending - particularly to businesses - that really benefits the economy. It is highly risk averse and reluctant to lend except against very good collateral and/or at high rates. And if it is chronically short of capital and regulators are unyielding, it will slowly break itself up, or it may seek a buyer. Its focus is on self-protection and damage limitation rather than on developing a vibrant and well-diversified lending portfolio. In short, it is a zombie.

Having a banking system made up of the living dead is an incredibly unhealthy state of affairs for the economy. I am personally of the opinion that a large part of the UK's stagnation is caused by the fact that two of its five big banks are badly damaged (RBS and LBG), one more is undergoing major restructuring (Barclays), and a fourth (HSBC) has suffered serious reputational damage due to criminal activities in one of its overseas operations. RBS and LBG are currently making losses, and Barclays is generating a return on equity that is well below its cost of capital. This is not sustainable. These banks simply are not in a fit condition to support the economy.

Nor can they give good value to customers. I've worked for a bank that wasn't making any money. In 1989, Midland Bank declared a full-year loss following writedowns of its holdings of Latin American debt and a ridiculous mistake on money market positions. The following year it managed to scrape together £11m, a dismal return for the UK's fourth largest bank. Midland was desperate to make money: it had very little capital and a huge portfolio of dodgy loans. So it took stupid risks - hence the position error. And it cut costs. Particularly staff costs. It embarked on a programme of redundancies and restructuring across its entire business. No-one knew where the axe would fall next. It became a demoralising place to work, not only for staff but for the managers whose job it was to make redundancies and if possible encourage people to leave before being made redundant - after all redundancy is a cost....

Staff who are worried about their jobs don't generally give good service to customers. And it is unreasonable to expect them to do so. Their first priority is their families. It's not that they become any less competent, but they become preoccupied with their own concerns and see little point in going out of their way for customers when they do not know how much longer they will be around to serve them anyway. I don't know what it's like to work for Barclays at the moment, but I imagine the situation must be pretty grim: the bank is making job cuts across the board and restructuring large parts of the business. There was recently a serious shakeout of senior management, and in my experience that is nearly always followed by weeding-out of the people perceived as being "followers" of the senior managers who have lost their jobs. Barclays is busy re-educating all its staff in its new "core values", which include a commitment to customer service - but how effective will this be when staff are worried about their own futures? The job market in financial services is very difficult at the moment.

Yet the FCA makes no mention at all of the critical need for banks to take care of their staff. They seem to think that good customer service can come through intrusive (and expensive) supervision coupled with strict limits on the types of business banks can do. No it can't. Banks are people businesses. If the staff aren't happy, neither will the customers be.

Nor can a bank that is desperate to improve the returns to its shareholders give good value to customers. This is a fundamental conflict of interest: customers want low prices, but shareholders want profits. Reading the Barclays' strategic review announcement from February 2013, it is (to me at any rate) very clear where their focus is:
"Based on the results of its strategic review, Barclays is today making several commitments. Barclays seeks to:
Financial commitments
  • Deliver a return on equity for the Group in excess of the Group cost of equity in 2015, which we have assumed will remain at the current 11.5% level;
  • In 2013, reduce headcount by at least 3,700 across the Group, including 1,800 in the Corporate & Investment Bank and 1,900 in Europe Retail and Business Banking. This is expected to result in a restructuring charge of close to £500m in Q1 2013;
  • Reduce the Group’s total cost base by £1.7bn to £16.8bn in 2015, including interim cost estimates of £18.5bn and £17.5bn in 2013 and 2014 respectively. This excludes ‘one-time’ costs to achieve the strategic plan of £1bn in 2013, £1bn in 2014 and £0.7bn in 2015, delivering a Group cost to income ratio in the mid 50s in 2015;
  • Target Risk Weighted Assets (RWAs) of £440bn by the end of 2015, after mitigating the estimated impact of CRD IV (£81bn) through legacy asset and other RWA reductions (£75bn), enabling RWA investment in selected areas;
  • Report a transitional Common Equity Tier 1 ratio above its target ratio of 10.5% in 2015; and
  • From 2014, accelerate our progressive dividend policy, targeting a payout ratio of 30% over time."
Barclays' adjusted return on equity in the quarterly results just announced was 7.6%. Admittedly this did reflect restructuring costs, but I struggle to see how they will achieve a return on equity in excess of 11.5% within two years while ALSO giving customers good service and value for money. And the cost-cutting targets are extremely challenging. The FCA should be looking at the viability of these financial targets in relation to the new regulatory focus on customer value.

Which brings me neatly back to the Co-Op. You see, the Co-Op is a mutual. It is owned by its customers. Here is the Co-Op's statement explaining the reasons for withdrawing from the Lloyds deal (my emphasis):
"The Co-operative Group announces that it has withdrawn from the process currently being run by Lloyds Banking Group for the disposal of branch assets (“Verde”) after The Co-operative Group and The Co-operative Bank plc Boards decided that it was not in the best interests of the Group’s members to proceed further at this time. This decision reflects the impact of the current economic environment, the worsened outlook for economic growth and the increasing regulatory requirements on the financial services sector in general."
Taking on the Verde business would have made the Co-Op Bank the fifth largest retail bank in the UK. It would have been subject to tighter regulation, higher capital and liquidity requirements and more intrusive supervision - all of it in a difficult economic environment. This was not in the best interests of its customers.

And therein lies the problem. The tougher regulatory environment for banks is supposed to reduce the risks to taxpayers and improve value for customers. But in a stagnating economy where profitable lending opportunities are hard to come by, banks are already struggling to make money. Tougher regulation increases their costs and circumscribes their earning opportunities. As Noble Cause put it on twitter:
Such severe limitation perversely may mean that risks to taxpayers actually increase and value for customers declines. The approach to regulation needs to be rethought. Banks must be able to to take reasonable risks in order to make money. An unprofitable banking sector is in no-one's interests.

Related links:

Co-Op Bank's £1bn black hole - This Is Money
Will the Co-Op pull out of banking? - Robert Peston, BBC
Cyprus and the financing of banks - Coppola Comment
Approach to banking supervision - Prudential Regulation Authority
FCA Risk Outlook 2013 - Financial Conduct Authority
Barclays Announces Senior Management Changes - Barclays
Strategic Review Announcement February 2013 - Barclays

Sunday, 21 April 2013

The real meaning of Fitch's downgrade

The credit ratings agency Fitch has downgraded the UK's sovereign debt by one notch to AA+ from AAA.

This was not unexpected: the UK has been on "negative watch" for some time and was downgraded by Moody's not long ago. However, the terms of the downgrade are distinctly odd.

Firstly, let's remind ourselves what the purpose of a credit rating is. For sovereign debt, it is supposed to give investors an indication of the risk of loss due to default. Therefore it will assess the conduct of fiscal and monetary policy in the country concerned in the light of key macroeconomic indicators. Neither the indicators themselves, such as the projected path of GDP, interest rates and debt/GDP, nor the economic policies alone are a sufficient indicator of default risk. Both are needed to give a reasonable assessment of the likelihood of sovereign default and/or debt restructuring.

Credit ratings are NOT intended to give a general indication of the health of an economy. Nor are they intended to indicate risk of indirect losses due to inflation or low interest rates.

So the downgrade indicates that the UK is considered slightly more likely to default on its debt than countries such as Canada and Norway that still have AAA ratings.

The justification for this is the UK's weak economic performance, which despite government's best efforts to contain public borrowing is creating a rising debt trajectory - now expected to peak at over 100% of GDP - and large fiscal and current account deficits. Fitch correctly notes that the rising proportion of debt/GDP increases the financial fragility of the UK economy, making it less resilient to economic shocks.

That seems reasonable, doesn't it? Except that Fitch then goes on to undermine the entire justification for this downgrade by pointing out that there is virtually zero chance of a "self-fulfilling fiscal financing crisis" because of the UK's status as a reserve currency issuer and the Bank of England's willingness to "intervene in the government debt market" (i.e. buy sovereign debt). If there is virtually zero chance of a fiscal financing crisis, then there is virtually zero chance of debt default. In which case, what exactly is the point of this downgrade?

Fitch implies that, rather than allowing the UK to default on its debt, the Bank of England would monetise it. Now, the risk from monetisation is inflation. But a credit rating does not assess the risk of losses due to inflation. It is supposed to assess the default risk. If, as Fitch suggests, the Bank of England would as a last resort monetise debt, there is ZERO risk of default.

It is worth pointing out at this point that Fitch's implication that as a last resort the Bank of England would monetise debt ignores the fact that the UK is a member of the EU, and monetary financing of government is explicitly forbidden under the Lisbon Treaty. Whether or not the UK's debt does indeed have an increased risk of default therefore depends on the UK's commitment to the EU. The current government is perhaps a little wobbly on that: it may well be that, as a last resort, it would break the Lisbon treaty to prevent debt default. In which case there is still zero risk of default, though there might be considerable political and economic instability from such a course of action. However, if the UK chose to abide by its treaty commitments (not to mention its self-imposed limits on the extent of sovereign debt purchases by the central bank), then there would be some risk of default as large-scale monetisation of debt would not be an option.

But there is a more fundamental issue here. Fitch notes that the UK's public debt is denominated exclusively in domestic currency. A sovereign currency-issuing government should never default on its domestic-currency sovereign debt obligations, since it can always create money to settle them. Debt default for a sovereign currency issuer is a therefore a POLITICAL decision, not an economic one. Fitch's downgrade amounts to a vote of no confidence in the Cameron government, and particularly in the Chancellorship of George Osborne. And the timing of the announcement is exquisite, coming as it does at the end of a week which saw bad labour market figures, criticism from the IMF of the Chancellor's economic strategy, and the exposure of fundamental flaws in an economic theory frequently used to justify  aggressive deficit reduction measures.

For this reason, illogical though it seems, the Fitch downgrade should be taken seriously. The Government does not give the impression of being competent. Frequent U-turns on changes to taxes and benefits, poorly thought-out reforms of entitlement programmes, lack of coherent investment strategy, propping of an overblown housing market, failure to tackle bank reform, undermining of expansive monetary policy with ill-considered fiscal tightening.....none of these look like the actions of a Government that has the faintest idea what to do with a stagnant economy and damaged financial system. What is worrying is there is little evidence that the Opposition's ideas are any more coherent. Only today the Labour party outlined changes to the unemployment benefits system that would leave people in debt when they found a job: it was billed as "putting 'insurance' back into National Insurance", but I've never heard of an insurance system that forced people to repay money paid out under the scheme.

The biggest risk to the UK economy, and therefore to the safety of UK sovereign debt, is the clowns running our political system. Heaven help Mark Carney. He has a simply horrible job to do.

Related links:

Fitch downgrades United Kingdom to AA+ , Outlook Stable - Fitch Ratings (press release)
Moody's downgrades UK's government bond rating to Aa1 from Aaa: outlook now stable - Moody's (press release)
UK unemployment rises to 2.56m - BBC
A Bad Week for UK's Osborne - CNBC
Reframing Reinhart & Rogoff - Coppola Comment
Labour plans student-style "salary loans" for the unemployed - Guardian

Friday, 19 April 2013

Reframing Reinhart & Rogoff

The economics world is aghast. Two distinguished economists, Carmen Reinhart & Kenneth Rogoff, have been shown to have produced shoddy work.

I don't propose to comment on the details of the case. Suffice it to say that Reinhart & Rogoff were wounded by a paper that showed that their data was flawed. They defended themselves, and were also defended by numerous economists around the world who argued that although the data might be flawed, the economic analysis justified their conclusions. But the next day, the Rortybomb blog delivered the killer punch. Econometric analysis by Arindrajit Dube demonstrated that even with good data, the economic analysis was flawed and the conclusions unjustifiable. High public debt cannot reliably be shown to cause low growth. But low growth can reasonably reliably be shown to cause high public debt.

This is a no-brainer, actually. There are two reasons for this.

Firstly, public debt is normally quoted in relation to GDP. This is a ratio. Debt/GDP can rise either because debt increases at a faster rate than GDP, or because GDP falls faster than debt does. So when an economy is in recession, public debt INEVITABLY rises as a proportion of GDP, not because the nominal amount is increasing (though it probably is, as I shall explain shortly) but simply because GDP is shrinking. Severe and prolonged recession can make the debt/GDP ratio look simply terrible.

Secondly, in a recession public spending tends to increase. This is because of what economists term "automatic stabilisers", which replace some of the normal functions of the private sector when the private sector is retrenching. For example, unemployment benefits maintain basic incomes for the unemployed while they look for jobs, supporting demand in the economy and preventing serious hardship. In a recession, people tend to lose their jobs, so unemployment rises and with it the benefits bill. At the same time, tax revenue falls because GDP is falling. Therefore, in a recession public borrowing must increase because the gap between public spending and tax revenue increases (the fiscal deficit, roughly). The only way it can fail to increase is if public spending is drastically cut and/or taxes increased, interfering with the action of automatic stabilisers and crushing demand in the economy. I will return to this shortly.

So in a recession, assuming no direct action is taken to prevent it, the debt/GDP ratio naturally increases. Therefore the assumption should be that, unless shown otherwise, poor growth causes high debt, not the other way round. I am astounded that so many people have inferred the opposite from Reinhart & Rogoff's paper, and even more astounded that until Dube, no-one appears to have done any serious econometric analysis to confirm the direction of causation. Dube's econometrics are pretty basic. As Jonathan Portes commented on Twitter, why on earth didn't Reinhart & Rogoff do them in the first place?

The problem is is that people who worry about debt/GDP ratios see the ratio rising as GDP falls, and start to panic. And Reinhart & Rogoff's flawed analysis encourages them to do so. This has led to calls for restraint of fiscal deficits and debt-cutting programmes when economies are in deep recession. Many of the worst examples of severe and counterproductive fiscal austerity have been "justified" on grounds of public debt/GDP close to the Reinhart & Rogoff "tipping point" of 90%. That tipping point has now been shown to be completely arbitrary. Many people could be justifiably angry at the damage that has been done through misguided fiscal policy done on the basis of Reinhart & Rogoff's work. Not that they were the only ones, of course. Other economists have much to answer for too - Alesina, for example, with his notion of "expansionary fiscal contraction" which has been shown to be a very rare breed indeed.

However, I did say that I was reframing this debate. And that is what I shall now do. You see, Reinhart & Rogoff completely missed the point. Even if their analysis was right, even if the data were reliable, it would still be unhelpful. They are looking at the wrong metrics.

Debt/GDP is a pretty confusing metric, since it compares a stock and a flow. It would be more meaningful to compare fiscal deficit/GDP. But even that is not ideal, since GDP measures activity in the economy, not government income, and the government income figure is netted with spending to give the deficit. The reality is that governments do not have to pay all their debt off in one year - in fact most governments pay off little or no debt. What they have to do is service the debt. And their ability to service the debt is governed by two things: 1) the interest rates prevailing on outstanding debt stock and on new issues during that period: 2) revenue from taxation and other income.

In a recession, government income reduces as GDP falls. And as I've already noted, the nominal amount of debt tends to increase in recession due to automatic stabilisers. Therefore, in a recession, governments may have problems servicing debt unless interest rates also fall. Which in most cases they do, forced down by the actions of central banks. But note that this has nothing whatsoever to do with the debt/GDP ratio. Interest is paid on the nominal amount. And if interest rates are high enough, a debt/GDP ratio well below 90% could be unsustainable. Or, of course, if tax revenue is too low. High GDP does not necessarily imply large tax revenues - that depends on the design of tax policy and the effectiveness of collection.

For example, what we saw in the Eurozone periphery in 2010 was interest rates rising in recession-hit countries where the debt/GDP ratio was seen as unsustainable. Rising to the point where even if the country were not experiencing a massive GDP contraction and catastrophic fall in tax income, the debt would be impossible to service.

Every single one of the Eurozone sovereign bailouts has been to enable countries to SERVICE their debt, not pay it off. The IMF always comes out with some guff about "putting public debt on a sustainable path", but this is never achieved through the bailout itself. Absent some form of default or debt restructuring, the only way to reduce the nominal amount of public debt is by running a sustained fiscal surplus. And as I've already noted, reducing the nominal amount of public debt doesn't necessarily improve the debt/GDP ratio: in fact if running a fiscal surplus results in poor economic performance - which is distinctly possible, since fiscal surpluses extract money from the private sector in excess of the amount actually needed to meet current public spending commitments - the debt/GDP ratio could worsen even when the nominal amount of debt is reducing. I admit this would be unusual, but it is definitely possible. And this brings me to the severe fiscal austerity programmes that have been introduced in many countries with the intention of achieving fiscal surplus and therefore reducing nominal debt over the medium term.

Fiscal austerity tends to cause economic contraction. This again is something of a no-brainer: the more money you extract from the private sector through higher taxes and/or spending cuts, the less money the private sector will have for spending and investment. The IMF's paper on debt reduction during fiscal consolidation suggested that debt/GDP would actually rise during the first few years of fiscal consolidation. And they caution against targeting debt/GDP as a measure of the success of fiscal consolidation programmes. They comment that targeting debt/GDP means that as the target will inevitably be missed in the first few years, there will be political pressure to tighten policy even more, causing further economic contraction and driving the economy into a deflationary spiral. And they observe that permanent damage can be done to economies that suffer repeated fiscal tightening in the name of reducing debt/GDP. Yet this is exactly what is being done in a number of Eurozone countries. No wonder the Eurozone is in recession, parts of it deeply so.

So not only is debt/GDP a flawed metric, it is also dangerous when used as a policy target, and unhelpful as an indicator of a government's current ability to service its debt. However, it does serve one useful purpose - and interestingly this is not often mentioned. Just as the debt/equity ratio gives a useful indication of a company's financial fragility, so the debt/GDP ratio indicates the sensitivity of a economy to economic shocks. Countries with high debt/GDP ratios are more likely to have trouble servicing their debts when GDP falls and more likely to find it necessary to raise taxes and/or cut other spending.  And it is fair to say that nervous investors are not too happy about high debt/GDP ratios either - partly, it has to be said, because of Reinhart & Rogoff's work - so yields tend to rise with the debt/GDP ratio provided there isn't somewhere else in the world in a worse mess. At the moment there are lots of places in a mess, so debt/GDP is not a reliable indicator of investor attitude to risk. Having a functioning central bank seems to be much more important.

Debt/GDP is also sometimes suggested as an indicator of interest rate risk, but I disagree with this. As I said earlier, interest is paid on the nominal amount. It would be far better to do sensitivity analysis to identify the likely effect on government finances of changes in interest rates.

But of course the metric you use to measure debt is completely irrelevant anyway when you remember that government debt is not what you think it is. So the real problem with Reinhart & Rogoff, and indeed the mainstream economic view of debt, is that worries about the size of the stock of debt (nominal or debt/GDP) are largely unfounded when a plentiful supply of safe assets is essential to the smooth running of the monetary system. And it is completely illogical for governments to impose severe austerity to reduce fiscal deficits while encouraging central banks to purchase safe assets and create unlimited bank reserves. All this does is create imbalances and weird distortions in the monetary system: the two actions cancel each other out and the result, as we are seeing, is stagnation. When will we understand the real role of public debt in our fiat currency system?


Does High Public Debt Consistently Stifle Economic Growth? Herndon, Ash & Pollin
On Reinhart & Rogoff - Ritwik Priya
Reinhart-Rogoff recrunch the numbers - Chris Cook, FT (paywall)
Reinhart-Rogoff and Growth in a Time Before Debt: Arindrajit Dube at Rortybomb
Reinhart & Rogoff's scary red line - Azizonomics
The Challenge of Debt Reduction during Fiscal Consolidation - Eyraud & Weber, IMF (pdf)
Still missing the point on Reinhart-Rogoff - Pragmatic Capitalism
Revisiting the evidence on expansionary fiscal austerity - voxeu
Government debt is not what you think it is - Coppola Comment
When governments become banks - Coppola Comment

Wednesday, 10 April 2013

Bankers behaving badly

"The entire culture in bank executive management is one of irresponsibility. They play fast and loose with other people’s money, then wriggle out of accepting the consequences.  While people with this attitude remain in place at the top of banks, there will be no real change in culture.  And until the prevailing culture in banks changes, there can be no real change in banking."

My analysis of the bad behaviour of bank executive management across the entire UK banking industry can be read here:

Bankers behaving badly - Frances Coppola at

Monday, 8 April 2013

The extent of evil

This post is an attempt to piece together my thoughts on the role of what we might call "wrong", or "bad", human behaviour - not just things that are actually called "crime" and subject to civic penalties, but things that though not necessarily illegal, cause harm.

Someone suggested to me recently that tax avoidance should be "stamped out". He wanted such severe controls on economic behaviour by firms and individuals that avoiding tax became impossible: among other things he wanted strict capital controls so that money could not flow out of the country into tax havens, and severe penalties for tax avoidant behaviour. I have used the term "avoidance" here deliberately: the narrower term "evasion" applies to practices that are actually illegal, but my correspondent was not referring to those. He meant any activity that deprived government of what he considered its rightful income.

At the opposite extreme are a number of people who have suggested to me that taxation is theft and therefore inherently wrong. To them, money that they have earned or inherited is rightfully theirs, and government should defend their title to it rather than deprive them of it. Avoiding tax is a legitimate defensive response to a predatory government that seeks to take their property from them by force.

Both of these positions claim the moral high ground: each claims that the position of the other is "wrong" and the behaviour that the other supports is "bad". This is a logical impossibility. They can't both be right.

The sheer impossibility of reconciling such opposed positions leads society to impose laws, which may be arbitrary. I've had numerous arguments with people who argue that there is no need for government to impose laws, because the only laws needed are natural ones which can be self-policed. Natural laws, apparently, are the right to own property and the right not to suffer violence (in all its forms, including non-physical coercion). Well, we all might agree with this....but a look at nature gives the lie to the idea that these are in any respect "natural" laws. The "natural" law - the law of the jungle, if you like - is that my right to property is limited by my ability to defend that property from predators, including others of my own species. When something comes along that is bigger and stronger than I am, I must relinquish my property, either voluntarily (to avoid damage) or through violent coercion which may result in my injury or death. How I obtained that property is of no consequence: however hard I worked for it, it is not "mine". And the definition of "property" in jungle law is in direct contrast to our modern social mores. "Habeas corpus" does not apply in the jungle, at least not to females or young: in most mammalian species, males fight over the right to "own" females, and many males kill young that are not sired by them.

Much of the behaviour that we consider "wrong" among human beings actually stems from the fact that we are mammals and we naturally behave much like other species of mammal - seizing and defending territory, fighting for ownership of food and females, attacking people who get in our way or have something that we want. We could construct society on this basis, and in fact when government fails, that is how society tends to organise itself: leaders appear who are big and strong enough to defend property, and others attach themselves to those leaders in a subservient role in return for protection. Subservience may involve submitting to violent and (to our eyes) abusive practices: the "right to rape" is a common attribute of warlords.

But our modern "civilised" societies are constructed differently, and our rules of behaviour explicitly forbid behaviour that is apparently completely natural. The Ten Commandments, upon which law is based not only in Western societies but also in Islamic countries, specifically forbid murder, taking property from others (theft, adultery*) and encouraging others to kill or take property from someone ("bearing false witness"). Even the natural DESIRE to take from others is forbidden ("you shall not covet"). Property rights are indeed very important: our society hangs together through respect for the property rights of others, including their right to control their own body, and when this respect fails, the very fabric of society is damaged. But property rights are not in any way "natural", and violating them is only "wrong" because we agree, as a society, that it is wrong. And under some circumstances, we suspend our own rules. Killing in war is an acceptable form of murder: war itself is usually an attempt to take territory from others or regain territory previously lost to others. War is a fundamental violation of property rights.

Societies justify the suspension of property rights in war by demonising the opposing side. They become "less than human": myths circulate claiming that they indulge in all manner of vile behaviour that we - the "morally right" - would never dream of doing, would we? But we would, of course. In fact when we win, we do. The losers in war are often excluded from normal social rules long after the war itself is over: not only do they lose their external property, they lose their right to personal integrity. Slavery, often with associated abuse, is the traditional fate of a defeated people, but it is - like war - a fundamental violation of property rights.

But it is not just in war that people can be demonised. Distressed societies typically find minority groups to blame for their woes, and behaviour towards these groups can resemble that towards the losers in war. Hatred of particular minorities is whipped up by circulating myths about them that appear to show that they violate social rules. And that hatred can spill over to those who attempt to dispel those myths. Societies are not tolerant of people who challenge prevalent beliefs. Speaking the truth is a dangerous pastime.

In fact I am struck by how dangerous human societies are. Homo sapiens (in its social form) is the most lethal predator ever to walk the Earth. We are capable of wreaking destruction across large swathes of the planet: other species are justifiably frightened of us and we destroy ecological habitats whereever we go. We are even dangerous to ourselves. And yet.....we are capable of behaving differently. We can act in accordance with our instincts, or we can act differently. It is our choice. Our social and moral "values" are founded on the idea that we will generally choose NOT to act destructively, and our laws exist to protect society from people who choose to act destructively. At least that's the idea.

The problem is that we are blind to our own behaviour. We are quick to notice when others are acting in destructive ways, but not so quick to identify the same behaviour in ourselves. And at times we choose to ignore or override our ability to choose alternative courses of action. I recently watched the final programme in the documentary series "All watched over by machines of loving grace". I was struck by the way in which the definition of "human as machine" was used to justify acting on instinct rather than choice. The argument was that we are pre-programmed to act in a certain way and are not able to make meaningful choices about our own behaviour: the freedom to choose is an illusion because our behaviour is ALWAYS driven by instinct. This unbelievably depressing idea was reflected in the dark nature of the documentary: even choices that appeared good, and were done from the best of motives, only made matters worse. The implication was that there was no point in trying to do good, so we might as well just act out our basic instincts. Like Elphaba in "Wicked", we are justified in crying out "No good deed will I attempt to do again!"

But the "humans are machines" idea is merely the "humans are animals" argument dressed in a different fabric. And the "humans are animals" argument has long been used to justify all manner of bad behaviour: "I couldn't help it", "It's only natural", "I was acting on instinct".....All of these are excuses. "Human machine" is just as destructive a concept as "human animal". Both are a denial of humanity.

Humans are certainly capable of destructive behaviour. But as I noted above, we are also capable of choosing NOT to behave destructively. So we can "help it", it may be "only natural" but that doesn't make it right, "instinct" does not imply suspension of rational thought. All of us are tempted to do things that would deeply hurt others: all of us at times act out our desires in destructive ways. That doesn't mean that we should stop trying to make better choices: on the contrary, experiencing the consequences of our bad decisions creates an opportunity to learn what better choices would be, so that we don't make the same mistake again. At the social level, the desire of some to do good will sometimes be overwhelmed by the bad behaviour of others. But to abandon all attempts to "do good" because it's pointless is the policy of despair.

Which brings me back to the fundamental question that I posed (indirectly) at the start of this post. How do we decide what is "good"? I have no easy answers: society has struggled with this problem for all of time. Indeed it is in attempting to answer this question definitively that we make our worst errors. When we define some form of behaviour as "right" and everything else as wrong, we open the door to demonisation and dehumanisation of those who don't agree with us. The consequences can be terrible. Attempting to ensure that everyone obeys all the rules all the time is as destructive as having no rules at all. In fact a look at human history suggests that it may even be worse. The worst mass murders in history have been in totalitarian states which forcibly imposed arbitary rules and demonised those who did not, or could not, comply.

The desire to act in a way that does not harm others and is not destructive of the environment must come from within - it cannot be imposed from above. Social rules only work when the majority of people choose to obey them: if a majority choose NOT to obey a rule, it cannot be enforced without brutality. For example, the Catholic Church's ban on artificial methods of contraception is unenforceable: the majority of Catholics do not agree with it and the Church has no means of enforcing it. Even where there are severe penalties for breaking a particular rule, people still break it: murder still exists even when the penalty is death or life imprisonment. It is necessary to protect society from those who would break its rules, and society does try to persuade those who don't agree with the rules to conform, though I am wary of this - Huxley's Brave New World and Orwell's 1984 both paint horrible pictures of forcible "re-education" of people who disagree with rules. But imposition of rules always involves coercion and may involve violence. Completely "stamping out" what we regard as bad behaviour is impossible without behaving even worse ourselves.

And "stamping out" bad behaviour can be bad for those doing the stamping, too. Wherever there is productive economic activity, there is also crime. When we devote too much energy to preventing the crime, we also kill the economic activity associated with it - and we are actually the poorer for it. More fundamentally, when we kill or imprison those who disagree with us, we close down all debate, depriving us of an important brake on our own behaviour and a means of learning from our mistakes. There must be room within any society for disagreement over its rules: social rules need to change over time, and it is through engagement in debate that beliefs are challenged, prevailing orthodoxies changed and rules updated.

Evil is a natural characteristic of human beings, and the propensity to do evil - even unintentionally - extends throughout society. We fight it not by "stamping it out" when we see it in others, but first and foremost by critically examining our own motives and choosing behaviour that we believe to be right. The standards suggested by the major religions are a guide, though in my view they should not be blindly followed: much wrong has been done in the name of doing right according to religious standards....But in the end, our own consciences are our best guide, and our capacity for rational thought is our best defence against the extent of evil.

Related links:

Two takes on the Tyranny of Democracy - Coppola Comment
All Watched Over by Machines of Loving Grace: The Monkey in the Machine and the Machine in the Monkey - BBC (video)
Brave New World - Aldous Huxley (book - free to read)
No good deed - Wicked (video)
A voyage to Arcturus - Lindsay (synopsis)
On the callousness of the American right - Coppola Comment

* In a society in which women are regarded as the property of men, adultery is a form of theft and the penalties are always severe. In Western societies we no longer regard women as the property of men, so the definition of adultery has changed - we would now regard it as a breach of contract. But adultery remains a socially harmful behaviour: the consequences for children, in particular, can be severe. Marital breakdown is the single biggest cause of child poverty in Western societies.

Saturday, 6 April 2013

Something's rotten in retail banking

The Parliamentary Commission on Banking Standards has released its report into the fall of HBOS. And it is damning. It paints a picture of HBOS as probably the worst-run bank in the UK - a poster child for how not to run a bank. Management incompetence and self-delusion, a highly aggressive and ill-thought-out expansion strategy, totally inadequate risk management and a culture that rewarded excessive risk-taking and silenced those who sought to raise concerns. It could hardly be worse.

More importantly, the findings for the first time brought to light the fundamental misunderstandings of the problems in banking that have persisted, and even been encouraged, since the financial crisis. I have felt like a lonely voice pointing out that HBOS, Northern Rock and the other UK banks that failed, with the sole exception of RBS, were RETAIL banks, and that neither ring fencing nor reform of investment banking was going to deal with the problems. But it seems that in the case of HBOS, the Committee agrees (their emphasis):
"As Sir Charles Dunstone, non Executive Director of HBOS 2001-08, observed, if HBOS had survived as an independent entity in the form it took in 2008, it would almost all fall within the proposed ring-fence. HBOS had no culture of investment banking; if anything, its dominant culture was that of retail banking and retail financial services more widely, areas from which its senior management were largely drawn. Whatever may explain the problems of other banks, the downfall of HBOS was not the result of cultural contamination by investment banking. This was a traditional bank failure pure and simple. It was a case of a bank pursuing traditional banking activities and pursuing them badly."
 And they go on to point out the limitations of structural reform:
Structural reform of the banking industry does not diminish the need for appropriate management and supervision of traditional banking activities.
HBOS was a traditional retail bank doing secured and unsecured lending to households and businesses. It did not have any proprietary trading activities at the time of its failure (these were closed down in 2005). It was active in financial markets only for the purposes of funding, not market-making. It did not have an "investment banking arm". It did, however, have a Treasury division, which lost £7bn on credit derivatives. Many people are confused about this: how can a Treasury division that is only concerned with funding lose so much?

Funding was a critical issue for HBOS.  It expanded its loan books far faster than it could acquire stable sources of funding, such as customer deposits, to fund them: By the time of its failure its funding gap was £111bn. In the years before the financial crisis it diversified its funding vehicles into the new credit derivatives, issuing an astonishing £13bn of RMBS in 2003 alone. This seemed like a reasonable thing to do: after all, they were  mortgage-backed, had AAA credit ratings and were widely traded. For an over-leveraged retail bank looking to diversify its funding sources, using these things looked sensible. It turned out to be anything but.

So lesson no.1 for today is: just because a bank is only doing retail lending doesn't mean it isn't using securities and derivatives. But a bank that is only doing retail lending is less likely than an investment bank to have the expertise to manage the risks in such investments. The Treasury division lost money because of its naivety as an investor. And this raises questions again about the direction of structural reform. If a bank is prevented from acting as an investment manager, either on its own account or on behalf of clients, how can it attract and retain the skills to manage the investments it needs to make for the purposes of funding? One of the trenchant remarks made by the Committee about HBOS's appalling risk management was "portfolio management was a distant dream". No wonder they lost so much. They hadn't a clue what they were doing.

Since then, retail banks have been improving their stable funding sources. Loan to deposit ratios have been narrowing and there is much less use of wholesale funding. But this brings me to lesson no. 2. I have been writing recently about Cyprus. Cypriot banks were funded almost entirely with deposits: they had little senior debt and not much equity. Consequently, when they failed due to over-aggressive expansion and risky lending, customer deposits had to be raided to bail them out. Increasing the proportion of customer deposits in a bank's liabilities base DOES NOT MAKE IT SAFER. It makes its funding more stable - because wholesale funding markets lend shorter-term and are more prone to runs than retail deposits - but it is no substitute for a prudent capital structure with sizeable layers of both capital and convertible debt. Like Anat Admati, I am unimpressed with banks' arguments that capital is too expensive. Banks have a responsibility to their customers. Putting customer deposits at unnecessary risk because of an inappropriate capital structure and inadequate risk and portfolio management is simply unacceptable. Lesson no. 2 for today is that ANY form of asset expansion funded entirely with debt puts customers' money at risk. Questions should be asked by regulators when any bank shows signs of embarking on such a strategy.

In fact the Committee's observation that HBOS's expansion strategy was "asset-led" was at the heart of the matter. The big problem with banks - especially retail banks - is the conflict of interest between their savers and their borrowers. Savers expect their money to be looked after: borrowers expect banks to take risk. Lesson no. 3 for today is therefore that it is the job of banks to accept AND MANAGE risks. It is unacceptable for banks to accept risks when they do not have the expertise to manage them adequately, as was particularly the case in HBOS's Corporate Lending division. Excellence in risk management across all areas of the business is the heart of banking: it is not an optional extra and should not be sidelined in the way it was at HBOS. When risk management in the financial industry fails, so does the industry.

There is a core competence problem in retail banking in relation to the management of customer funds. Retail banks see customers' savings as "funding" and both loans and deposits as "products". Staff are there to sell products, not to invest people's money. This to my mind is a fundamental misunderstanding of the nature of retail banking. Retail banks are fund managers: their job is to invest the savings of ordinary people productively for a return.* They need to develop skills in investment management. And more importantly, they need to develop a culture of respect for customers and their money. That, it seems, was completely missing at HBOS. And not just at HBOS: the Salz report into Barclays highlighted the aggressive sales culture and emphasis on short-term financial performance. Retail bank staff - often poorly paid and with large amounts of their remuneration stemming from commission on product sales - had enormous incentives for mis-selling, reinforced by aggressive sales targets. Professional management of customers' money was completely lost in the drive to sell products.

So the final lesson for today is that there needs to be a fundamental rethink of the nature of retail banking and the core skills required. Professional investment management and risk management skills need to be at the heart of retail banking just as much as other areas of the financial industry. And this change must come from within. Regulators may be able to curb the worst excesses, but they cannot fix the underlying cultural problems. Retail banks must stop "selling" and start "serving". Until they do, there will continue to be major failures in retail banking.

Related links:

An accident waiting to happen - findings of the Parliamentary Commission on Banking Standards re HBOS
Papering over the rot - Coppola Comment
Why do we never learn? - Coppola Comment
Faith in Grampian contributes to fall of Bent - Ian Fraser
A failure of compassion - Coppola Comment
Cyprus and the financing of banks - Coppola Comment
Supermarket banking - Coppola Comment
Risk versus safety, bank reform edition - Coppola Comment
Fallacies, Irrelevant Facts and Myths in the discussion of capital regulation - Anat Admati (pdf)
Salz Review - an independent review of Barclays' business practices - Anthony Salz (pdf)

* Yes, I know deposit creation through fractional reserve lending muddies the waters. But one person's loan is another person's deposit: loans become savings. Banks have a responsibility to manage the deposits they create through lending.

Thursday, 4 April 2013

Cyprus and the financing of banks

The final deal agreed to restructure the Bank of Cyprus involves the bail-in of senior bond holders and large depositors (over 100,000 Euros). What this means is that in return for the seizure of some of their money, bond holders and depositors will be provided with shares in the resolved banks. They will become part-owners of the bank.

From the point of view of small depositors, this looks rather good. It ensures that their deposits are protected not only now, but in the future. I pointed out in a previous post that small deposits are only protected to the extent that their sovereign can afford them (or to the limit of the amount that can be raised from other banks): but if large deposits and senior bonds can be bailed-in, deposit insurance should always  be affordable - shouldn't it? That is, of course, assuming there are any. I shall return to that shortly.

The Bank of England's Financial Policy Committee has recommended recently that banks should have more capital. Contrary to popular opinion, capital is not "cash" - it is shareholders' funds. It is the difference between the bank's debt and its assets. And borrowing - of any kind, including from the central bank - is NOT "capital", except under certain circumstances that I shall explain. When banks have insufficient capital, they usually have three ways of creating more:

- they can issue more shares. In the first instance the share offer would normally go to existing shareholders - what we call a "rights issue".

Bank shareholders are now somewhat wary of rights issues. RBS famously did a rights issue in April 2008 to shore up its damaged balance sheet after the ABN AMRO acquisition. It failed less than 6 months later, and shareholders are now proceeding with legal action against RBS. Rights issues by damaged and undercapitalised banks would not be popular. And rights issues by partly-nationalised banks are a demand for more taxpayer money.

- they can retain earnings. This means that instead of dishing out profits to shareholders in the form of dividends or employees in the form of bonuses, they keep them. But that of course assumes that they are making profits at all. Not all banks are. And banks that are under pressure to recapitalise by retaining earnings don't necessarily give customers a good deal. They need to maintain a wide spread between interest earned on lending and interest paid on deposits, so borrowers are charged a lot and savers are paid little. We have seen widening credit spreads ever since the financial crisis.

- they can sell off or wind down portfolios of risky assets which need more capital. Or they can shrink their balance sheets, reducing both assets and debt, by selling off bits of themselves - for example, RBS's sale of the Direct Line insurance company.

This requires some explanation. Bank capital requirements as set by regulators currently use what we call "risk weighted assets", which are a way of assessing the relative risk of different types of asset. Without going into details, the effect of risk weighting is to require banks to have more shareholders' funds if their balance sheets are riskier. But the calculation of risk weightings is something of a black art, so there are numerous opportunities for banks to game the weightings and pass assets off as less risky than they actually are. Additionally, assets become riskier under certain circumstances: for example, prime mortgages become sub-prime as house values fall and interest rates rise. A large fall in house prices resulting in a lot of home owners having negative equity in their properties can render mortgage lenders insolvent due to the increased capital requirements for what are then in effect unsecured loans.

So clearly, if banks are short of capital, it is in their interests to reduce riskier lending. Unfortunately this tends to be the lending that governments like them to do - loans to small businesses, loans to first-time house buyers. Hence Mervyn King's directive that banks should increase capital "in ways that don't harm lending". I am struggling to see how this is possible. In the short-term, lending must either be more expensive (because of the need to retain earnings) or scarcer - or both. In the long-term, of course, increased capital enables banks to lend more to higher risks without putting depositors' money at risk. So a drive to recapitalise banks involves short-term pain for long-term gain.

Except in Cyprus. And possibly in the rest of the Eurozone too. Because the deal that has now been struck turns senior bonds and deposits over 100,000 Euros into contingent capital. Contingent capital is debt (bonds and deposits) that can be converted into equity (shareholders' funds). The UK's ICB has recommended that banks should, in addition to equity, hold a substantial amount of contingent convertible debt to provide additional protection to depositors in the event of a bank failure. There has been much discussion about bonuses being paid in the form of "CoCos" (contingent convertible bonds), and in Europe there have been some ideas about changing the legal status of senior bonds so that they can be bailed-in (converted to equity) if necessary. But no-one has ever suggested that deposits could be bailed in - until now. Suddenly the game has changed.

If this deal is used as a model for bank resolution in other countries as well, it means that Eurozone banks have suddenly acquired the means of recapitalisation in distress. But it carries much larger implications than that.

Firstly, it means that the only real deposits in banks are insured ones. All other placings are contingent shareholdings. That includes the liquid assets of businesses - used to pay suppliers and employees - and large amounts of funds in transit, for example during house purchase. People and businesses will have to think carefully about how they move large amounts of funds around in future, if they can be seized without warning and converted to illiquid equity.

Secondly, it means that the only real creditor of banks is the government. Deposit insurance is paid for by banks but is a government directive, and as we saw in the financial crisis, when the funding for deposit insurance is insufficient, governments step in to top it up with taxpayers' funds. In Cyprus, the top-up has been provided not by taxpayers but by bailing-in large depositors. A preference order has indeed been established for the resolution of banks, but it's not what might be expected: the order is shareholders, contingent capital holders (junior AND SENIOR debt holders and large depositors), government. Insured depositors are effectively creditors of government, not banks. But insured depositors are still at risk if there is insufficient contingent capital to bail out government AND government is so highly indebted that it cannot borrow more to make small depositors whole. They are last in the preference order, but that doesn't mean they are safe from a government default.

Could this happen? Well, yes, I think it could. Bailing-in senior debt and large deposits this time came out of the blue, giving little time for them to escape - although figures show that a large amount of money was withdrawn from Cyprus banks prior to the deal. But now the precedent has been set, and Dijsselboem made his incautious remarks about this possibly being a model for future bailouts (he was silenced of course, but the damage had been done), who is going to place large deposits in Eurozone banks, except at much higher interest rates? And who is going to buy senior bonds, except at a deep discount? By bailing-in large deposits and senior bonds in this manner - contrary to existing terms & conditions, and with very little warning - the Eurozone leadership may have ensured that banks end up more thinly capitalised, and with far higher funding costs. This places small depositors at greater risk - especially in countries where sovereigns are already highly indebted and suffering from reduced tax take due to falling GDP.

It also carries serious consequences for lending. In the Eurozone periphery, interest rates to households and businesses there are already much higher than they are in the core, and lending is scarcer. This can only get worse as banks are forced to raise interest rates to attract large deposits and buyers for senior bonds. And these countries are already in recession: investment is falling and GDP collapsing. If the credit crunch intensifies due to rising interest rates to borrowers, it will make an already bad situation much worse.

Even in Cyprus, the bailout does not look like a good deal: small depositors may have been rescued, but they will pay with their jobs and their livelihoods. But the economic collapse there was going to happen anyway.  What is much more worrying is the effect on the Eurozone periphery. If large depositors and senior bondholders take fright because of this deal - which seems highly likely - the economic effects could be disastrous.

Related links

Sham guarantee - Coppola Comment
A failure of compassion - Coppola Comment
Dijsselboem, do remember that careless talk costs lives.... - FT Alphaville
and the rest of the excellent (and now very extensive) FT Alphaville "A Cypriot Precedent" series
Still crunching - The Economist