Saturday, 30 March 2013

A failure of compassion

The deed has been done. A deal has been struck to wind up Laiki Bank and restructure the Bank of Cyprus. Deposits of less than 100,000 Euros are protected from loss, as are deposits at other banks. Deposits of over 100,000 Euros are frozen and will be seized in part or whole to pay the debts that Laiki Bank and Bank of Cyprus cannot pay - including the money lent to Laiki Bank by the ECB to keep it going even though it was obviously insolvent.

So Cypriot taxpayers and small savers are off the hook. Popular belief has it that those who will pay are rich Russian oligarchs, who are probably criminals and tax evaders and therefore deserve what is coming to them. Tax campaigners claim that as Cyprus was a tax haven, the destruction of its banking sector is only just and fair. Small savers across Europe breathe a sigh of relief at the news that their deposits are safe. Larger depositors cling to the Eurogroup's assurance that Cyprus is a "special case" and this will never happen anywhere else - despite Dijsselboem's  incautious remarks about the Cyprus deal forming a basis for other bailouts.

None of this is true. There is no justice in the Cyprus deal. Everyone in Cyprus, and many people in other countries, will pay - for what is in fact a sovereign bailout.

Let me explain. I noted in a previous post that the Cyprus government could not afford to pay deposit insurance claims in the failed banks. To do so would have raised their sovereign debt/GDP ratio to an estimated 145%. The IMF regards this as unsustainable, so would not have contributed to the 10bn Euros bailout fund, which would have left the Euro area governments funding all of it. Clearly the Eurogroup wants all the IMF funds it can get, so the burden doesn't fall too heavily on Euro area countries many of whom are already in difficulties themselves. So a solution that forced the IMF to withdraw would be unwelcome. The first proposed solution involved partial failure to honour deposit insurance. This was rejected by the Cypriot parliament - foolishly, as I shall explain shortly. But also fortunately, since if it had been accepted it could have sparked bank runs across Europe. The final deal ensures that deposit insurance can be fully honoured without raising sovereign debt/GDP to unsustainable levels.

But note who is responsible for the payment of this deposit insurance. It is a SOVEREIGN responsibility. Yes, banks pay a levy for it - but if the claims exceed the amount paid in by banks, the sovereign then meets depositor insurance claims from general taxation. In that way it is like other "pay-as-you-go" sovereign liabilities such as pensions and social security. National Insurance in the UK is a good example of a supposed "insurance fund" that doesn't exist in reality: people "pay in", but the money is spent on existing obligations and any future claim they make has to be met from future contributions by others. That's how deposit insurance works too, at least for large claims.

So this is a SOVEREIGN bailout. Large deposits have been raided to pay the deposit insurance on smaller deposits that the sovereign could not afford to pay. It is correct to describe the large deposits seizure as taxation. It is absolutely incorrect to suggest, as some have, that it establishes an order for creditor payouts in the event of a bank failure. There has been no change in preference order: large deposits still rank pari passu with smaller deposits and with senior bonds. What this has done is establish a precedent for a sovereign to seize large bank deposits to enable it to meet its obligations.

So why is this unjust? Why was the Cypriot government foolish to reject the original proposal? Isn't it only fair that the rich should pay?

I would be the first to agree that those with the broadest shoulders should bear the largest burden. But that isn't what is going to happen. The large deposits that have been frozen don't just belong to rich Russians. They also belong to Cypriot businesses - who needed that money to pay wages and suppliers. They belong to Cypriot households - who saved that money to buy houses and pay for their children to go to university. They belong to charities, and educational foundations such as the University of Cyprus. They belong to UK citizens who have retired to the sun. They belong to hard-working Russian businesses and households who placed their money in those banks because of fear of expropriation of those funds by their own corrupt and predatory government. They belong to anyone, anywhere, who thought that Cypriot banks offered a better deal on interest rates than their own banks. The fallout across Europe will be considerable. A lot of people stand to lose a lot of money, and most of it isn't "laundered" as some people have claimed. If there was criminal money in Cyprus banks - and there may well have been - most of it probably left long before the crisis hit and is now safely stashed away in Malta, or Latvia, or Cayman. As always with catastrophes of this order, the burden falls on those who can't escape - ordinary hard-working families and businesses.

And that's why the Cypriot parliament was foolish to turn down the original bailout proposal. It was actually the best deal for small depositors. Yes, they would have lost some money. But now they will lose their jobs, their businesses, their livelihoods. Businesses whose liquid assets are frozen will go bankrupt. Shops will close - particularly those whose main business lines were aimed at Russian visitors. Households will be forced to cut back spending. People - especially the young - will struggle to get even basic jobs. Nor will the banking sector be able to provide much in the way of financial support for hard-pressed businesses.  The windup of Laiki Bank leaves a very large hole in Cyprus's banking sector, and the restructured Bank of Cyprus will be in no condition to lend for some time to come - if it survives at all. For the truth is that this is only the first bailout. As we saw with Greece, one bailout leads to another as GDP collapses. And make no mistake, Cyprus's GDP is going to collapse. Massively.

As we know from the financial crisis, the failure of a large part of a country's banking sector is devastating for its economy. And Cyprus is already in recession due to fiscal consolidation and a nasty downturn in the manufacturing and construction sectors. The economic disaster facing Cyprus is of a similar order to the collapse of former Iron Curtain economies after the breakup of the Soviet Union. Latvia's GDP fell by 20% in 1990-91. Some analysts estimate the fall in Cyprus's GDP as a direct consequence of this deal at -10% this year and maybe another -8% in 2014. It could well be more. And the burden of such a disaster will fall most heavily on the ordinary people of Cyprus. The raid on large deposits will actually be paid for by the small depositors it was intended to protect.

So should we feel sorry for Cypriots? Well, not everyone thinks so. In a conversation yesterday, an anti-poverty campaigner expressed a view that as Cypriots are not poor compared to say people in Malawi, what happens to them doesn't really matter and we should be addressing the needs of the REAL poor in other parts of the world. To me this misses the point. Ordinary Cypriots whose lives will be devastated by the forthcoming economic collapse are the "real poor" in exactly the same way as the poor in sub-saharan Africa. The causes of their poverty are the same: corruption, greed and selfishness among the rich and powerful, paid for by the (relatively) poor and powerless. It is merely a matter of degree.

But I am even more disturbed by the attitude of tax justice campaigners, rejoicing at the closure of a tax haven. They approve of the demolition of the Cypriot financial industry, and look forward to the same treatment for Malta, Luxembourg, the Netherlands and Ireland. The effect on the lives of ordinary people in these countries apparently concerns them not at all: some even suggest that as Cypriots have benefited from inflows of hot money, they should now pay for living off the proceeds of crime. I am horrified by such a failure of compassion. There have been calls for Cyprus to have "transitional relief" as it struggles to reorient its economy away from financial services. To their credit, the Troika recognised that Cyprus's economy is in deep trouble and announced in their press conference that they would send in a "task force" to help restructure the economy to generate jobs and growth. But will it provide financial support? I doubt it. Compassion is in short supply in the Euro area.

The view in some circles that Cyprus deserves what is coming to it is not lost on Cypriots themselves. And they are anxious to set the record straight. As one man put it in an email to me:
"We are not idiots. We know that we are to blame. We, the people and our corrupt politicians. But to be treated like this……! you do not murder a family if a kid is misbehaving.  Whole generations of Cypriots, their lives and future have been destroyed......"
So those who feel strongly about justice and poverty, think again. Ordinary Cypriots are not to blame for this crisis, but they are the ones who will pay. They deserve our compassion and our support.

Related links:

Sowing the wind - Coppola Comment
Sham guarantee - Coppola Comment
The broken Euro - Coppola Comment

Tuesday, 26 March 2013

Cyprus banks and UK deposits

I'm writing this brief explanation for those who are unsure about the status of deposits held in UK outposts of Cypriot banks, and to confirm the situation for people with deposits in Cypriot banks in Cyprus itself.

Bank of Cyprus UK
Bank of Cyprus UK is a UK-incorporated bank regulated by the FSA. It is a separate legal entity from its  Cypriot parent and has its own capital, which is ring fenced to make it unavailable for raiding to bail out its parent. Deposits in the Bank of Cyprus UK are insured under the UK's Financial Services Compensation Scheme. Since the UK is a member of the European Union, the UK's scheme is consistent with the European Union's rules for deposit guarantee schemes. Deposits in the Bank of Cyprus UK are therefore insured up to a limit of £85,000, and any claim would be made against the UK scheme.

As the Bank of Cyprus UK is a UK bank, the terms of the restructuring ordered for its parent, the Bank of Cyprus, do not apply. All deposits in the Bank of Cyprus UK are therefore safe from confiscation by the Cypriot government, regardless of their size. Deposits in the Bank of Cyprus UK are not frozen and there are no restrictions on withdrawals.

Laiki Bank UK
Unfortunately for UK depositors, Laiki Bank UK is not a separate entity. It is a branch of Laiki Bank (Cyprus). Deposits in Laiki Bank UK are insured under the Cyprus deposit guarantee scheme. Because Cyprus is a member of the European Union, the Cyprus scheme is consistent with the European Union's rules for deposit guarantee schemes. Deposits in Laiki Bank UK are therefore insured up to a limit of 100,000 Euros at the prevailing exchange rate. Any claim for compensation would be made in the first instance against the UK Financial Services Compensation Scheme. It would be the responsibility of the UK Government then to seek reimbursement from the Cyprus scheme.

However, the terms of the winding-up order for Laiki Bank DO apply to deposits in Laiki Bank UK. Deposits of less than 100,000 Euros will be transferred to the Bank of Cyprus (or possibly Bank of Cyprus UK - it is unclear at present) as part of the closure procedures for Laiki Bank. Deposits above that amount are frozen and depositors should expect to lose a substantial proportion of the excess above 100,000 Euros, possibly as much as 100%. No compensation will be available for this loss.

Accounts held by UK depositors in Bank of Cyprus
Deposits of less than 100,000 Euros in Bank of Cyprus will be untouched. Larger deposits are frozen and will eventually be subject to a haircut. The size of the haircut is currently unknown but it is thought likely to be of the order of 40%. Compensation will not be available for this loss.

Accounts held by UK depositors in Laiki Bank (Cyprus)
Deposits of less than 100,000 Euros in Laiki Bank will be transferred in their entirety to the Bank of Cyprus. Larger deposits are frozen: they will in due course be placed in a new state-owned entity and written off in part or in full against Laiki Bank's bad assets. Holders of deposits in excess of 100,000 Euros should expect to lose a large part, up to 100%, of the excess amount (the initial 100,000 Euros is protected). Compensation will not be available for this loss.

Other Cypriot banks, and Cyprus branches and subsidiaries of overseas banks.
No other bank is involved in the bailout at present. Deposits of any size in other Cypriot banks and in Cyprus branches and subsidiaries of overseas banks will be unaffected by the proposed haircut.

Bank opening
Laiki Bank (Cyprus) is now permanently closed and will be wound up. All other banks in Cyprus are closed until Thursday 28th March at the earliest. When they open there will be strict limits on withdrawals, payments and transfers from all Cypriot banks. There will also be limits on the convertibility of Cyprus Euros to other currencies and limits on the amount of money that may be transferred out of the country.

The Bank of Cyprus UK has remained open throughout the crisis. As a UK bank, it has no reason to close. There will be no restrictions on withdrawals, payments or transfers to or from Bank of Cyprus UK except to/from its Cyprus parent and other Cyprus banks.

Laiki Bank UK was open until last Friday, but is now permanently closed and will be wound up with Laiki Bank (Cyprus). It seems likely that Laiki Bank UK was one of the conduits through which money left Cyprus during the extended bank holiday.

Non-Cypriot banks
I'm including information here on the status of Bank of Ireland UK and Santander UK to reassure those who are worried that these may be affected by problems with their parent banks in, respectively, Ireland and Spain. Like Bank of Cyprus UK, Bank of Ireland UK and Santander UK are separately-capitalised subsidiaries of their parents. They are UK-iincorporated banks that are regulated by the FSA, and the UK's Financial Services Compensation Scheme applies to deposits of under £85,000 in these banks as in all other UK-incorporated banks. Were Ireland or Spain to find themselves in a similar situation to Cyprus, these UK subsidiaries would be excluded from any depositor haircut or levy and from forcible winding-up. 

And finally - the UK. Since the Global Financial Crisis, the entire direction of regulation in the UK has been to make banks safer. They are being required to have more capital, more liquid assets, a higher ratio of deposits to loans and generally to reduce balance sheet risks. As the stated aim of the UK government is to reduce or eliminate the need for taxpayer bailout, it is not possible to state that all deposits are 100% safe: only smaller deposits that are subject to Financial Services Compensation Scheme insurance can be regarded as completely safe from loss or confiscation. However, improved capitalisation of UK banks and the presence of convertible bonds in their capital structures make it far less likely that a contribution would be required from large depositors in the case of a UK bank failure than is the case in Cyprus, where banks are poorly capitalised and have few bonds. The recapitalisation of UK banks will continue for some time to come. 

Sunday, 24 March 2013

The broken Euro

Imagine you live in a prosperous country, with a lovely climate, beautiful beaches, blue seas. But there's something funny about this country. It doesn't have a functioning banking system.

You can put money into your bank, but you can't get it out again. At least you can, through ATMs, but only in very small amounts.

If you have money on deposit, you can't take the money out and close the account. And if it's a time deposit, when it reaches the end of its life, you can't have the money to spend. You have to roll it over into a new deposit.

You can't cash a cheque in a high street bank. You can't pay bills in a high street bank, either. And no high street bank is lending any money, so if you want a loan, forget it. In fact high street banks are not much use.

Your employer pays you in cash, because there are no electronic payments. Which is just as well, really, because you need cash. There are no automated payments such as direct debits, so you pay all your household bills in cash. Credit and debit cards are no longer accepted anywhere, so you buy all your shopping and petrol for your car with cash. You can't make phone or internet purchases.

If you have more than one account, you can't transfer money between your accounts. If only one of your accounts has ATM access, once that account is empty, you are stuck with no money.

You can't go on holiday abroad because you can't take any money out of the country. Your employer won't send you abroad on business, either, because you might not come back.....

All the local shopkeepers will only accept cash, not cheques. That's because they have to pay suppliers in cash, and once you put money in a bank, you can't get it out again.....But all small businesses are having a very hard time. Shops are closing, businesses going bust, people losing their jobs. You're not sure how much longer you will keep yours. You've taken a pay cut already, even though it means you struggle to pay your mortgage.

It would really help if lots of tourists would visit your beautiful sunny country. But the place is deserted. Tourists are unwilling to come here's very cheap, but they can only bring cash with them and whatever they bring must stay here - and if they run out of cash they can't get any more.

This is Cyprus. Or rather, it will be - next week. When full capital controls are imposed. When Cyprus is ring-fenced from the Euro area and its membership of the European Union is effectively suspended.

I am not being dramatic. The above is a description of the effects of the capital control bill forced through the Cypriot parliament this weekend. From Tuesday, Cyprus becomes a black hole in the Eurozone: any money that goes into it stays there, and no money can leave......From a safe distance, it will appear frozen in time, a small cash-based economy, isolated from the rest of the EU. While inside, invisible to all except those who actually go there - or live there - its social fabric is torn apart as its economy collapses. Note the final clause in the capital control bill:
Any other measure which the Finance Minister or the Governor of Cyprus Central Bank see necessary for reasons of public order and safety
So as people's livelihoods are destroyed and their standard of living crashes, other measures may be introduced to ensure that they can't take matters into their own hands.

The IMF acknowledged in a paper a few months ago that capital controls can be helpful in crisis-hit economies. In Cyprus's case, the immediate need for capital controls is to choke off bank runs when the banks reopen after the extended bank holiday. The trouble is that bank runs are not necessarily acute. As we have seen in other countries, notably Greece and Spain, bank runs can be silent and extended. Even in Cyprus, deposit flight started some time before the attempted depositor haircut last week that forced closure of the banks. It is difficult to see how, with a wrecked financial system and collapsing economy, capital controls can be lifted at all without setting off bank runs. As things are set to get much worse, probably including bank failure and sovereign default in the not too distant future, capital controls are likely to remain in place for a long time. Despite the IMF's insistence that capital controls should be short-term, recent use of them has been anything but: Iceland has now had "temporary" capital controls for five years, and Argentina for ten (although that is probably for political reasons). Dismantling capital controls is not easy.

But the Cyprus capital controls differ fundamentally from those imposed in the Iceland banking crisis. Iceland is a sovereign state with its own currency. Cyprus is a member of a currency union - the Euro. And capital controls make a complete nonsense of currency union.

Once full capital controls are imposed, a Euro in Cyprus will no longer be the same as a Euro anywhere else in the Euro area. It cannot leave the island. The Cyprus Euro will in effect be a new domestic currency. The imposition of capital controls in Cyprus is therefore the end of the single currency in its present form. As this image shows, the single currency will have a bit missing - a bleeding chunk torn from its edge:

Yes, the Eurogroup will claim that it is "business as usual" in the Euro area. Draghi will continue to claim that the Euro is "irreversible". Eurostat will continue to produce statistics for E17 and E27 including Cyprus. But the reality will be that the Euro will be broken in two. There will be the Cyprus Euro, and the "mainland" Euro (if we can call it that).

One of the interesting effects of capital controls is that the Cyprus Euro would be likely to depreciate against the mainland Euro - a de facto floating exchange rate. This might help to protect the Cypriot economy from the worst of the coming economic collapse. The ECB would of course enforce convertibility at par for any Euros that did manage to get in or out of the island, but as this traffic should be small, the purchasing power of the Cypriot Euro within Cyprus itself would be far more important. Cyprus would in effect have gained control of its own currency without the costs and risks of redenomination.

But this is not as good as it sounds. There would be likely to be serious shortages of Euros in Cyprus once capital controls were in place. Currently the Cypriot central bank cannot print Euros: the Euros in circulation in Cyprus are printed in France and the Netherlands on behalf of the Cypriot central bank and transported to Cyprus. These Euros are printed in accordance with the ECB's rules, which operate strict proportionality in relation to the size of the economy and overall Euro area money supply, but Cyprus's need for cash will be much greater when there are no alternative methods of payment. I can't see the ECB being particularly keen on expanding the physical money supply in Cyprus because of Cypriot capital controls.

Because of this, I would expect to see alternative currencies starting to circulate in the Republic of Cyprus. The obvious candidates are sterling, because of the large UK expatriate community and military presence; and Turkish lira, because of the presence of the (unrecognised) Northern Republic on the island of Cyprus.*
And because of the ban on electronic transactions in Euros, I would not be surprised to see e-currencies and mobile money becoming popular: they would be an effective way of avoiding capital controls. It is unclear exactly how the Government and central bank would respond to this, but remember that final clause in the capital controls bill: is a ban on private use and holdings of alternative currencies beyond the bounds of possibility? Or would they simply accept (gratefully) that use of alternative currencies relieves the pressure on the Cyprus Euro, enabling more economic activity than would otherwise be possible? Much depends, I suspect, on the pressure on public finances caused by the now inevitable economic collapse. Declining tax take might encourage  a desperate government to enforce use of the Euro, despite shortages, to help ensure that taxes can be collected. Using alternative currencies is of course a standard way of avoiding tax. Personally I think this would be a mistake: repressing alternative currencies would depress economic activity and slow down recovery. But as the Troika would be overseeing Cyprus's public finances and enforcing the agreed austerity measures (and probably harsher ones too, once the debt/GDP ratio started to rise due to economic collapse), counterproductive repression of alternative currencies to increase short-term tax take seems likely.

The fact that the ECB will still control the purse strings, and the Troika will still oversee public finances, may eventually make the shortage of Euros and the lack of control of monetary policy intolerable. If this were to happen, then Cyprus should formally break free. The fact that it cannot print Euros means that it would then have to redenominate, probably into Cyprus pounds at one-to-one par value with the Cyprus Euro. This is not a step to be undertaken lightly, though: it would mean that Cyprus's public debt would then be denominated in a foreign currency. Some form of currency peg, perhaps to sterling, would in my view be necessary to prevent collapse of the new currency and disorderly debt default. I'm not at all sure this route should be followed yet. It may be that the fragmentation of the Euro caused by capital controls will give Cyprus sufficient protection to enable it to recover from this awful mess - if the Troika's hamfistedness doesn't scupper the whole thing anyway.

So the nature of the Euro will be fundamentally changed by Cyprus's capital controls. The single currency will exist in name only: the reality will be fragmentation. But it is not just the single currency that will be compromised. The isolation of Cyprus is clearly in breach of the founding principles of the European Union. It is unclear whether the capital controls are legal: Article 63 says they are not, but Article 65 1b and 2 suggests they may be. I leave that to the lawyers: I am more interested in the principles. The European Union was founded on "four freedoms": free movement of goods, free movement of services, free movement of capital and free movement of people. Capital controls are direct prevention of free movement of capital. In fact it is worse than that, because strict capital controls also severely curtail free movement of goods and services and free movement of people - the other founding principles. Will other countries want to trade with Cyprus, if it is difficult to get money out of the island? How can anything other than subsistence-level trade within the island operate, if payments can only be made in cash? How can people move in and out of Cyprus, if they can't take any money with them? Indeed, how can any of these freedoms be said to operate in a country with capital controls as tight as those now signed into law in Cyprus? In effect, Cyprus is no longer a full member of the European Union.

And this sets a dangerous precedent. The Troika's mishandling of the Greek crisis and the ensuing contagion to Cyprus has fundamentally weakened the European project. If it can bully one state into imposing capital controls in clear breach of the principles of the European Union, and in so doing destroy the integrity of the single currency, then it can do it to others. And this is on top of the damage already caused by the disastrous attempt to impose losses on small depositors in Cyprus, and the imposition of highly damaging "deficit reduction" programmes against the will of the people in a number of states including Cyprus. The Troika has already demonstrated that it will sacrifice democracy in the cause of the European project. But now it shows that it will sacrifice the very principles of that project to maintain the sham of unity. How much longer before the whole thing unravels?

Related links:
Cyprus, capital controls - The Prodigal Greek (Yiannis Mouzakis)
Capital controls in Cyprus: the end of Target2? - Guntram Wolff, Bruegel
Cyprus: The operation was a success, shame the patient died - Pawel Morski
Sowing the wind - Coppola Comment
The liberalization and management of capital flows - IMF
The Icelandic financial crisis - Wikipedia
Internal market - Wikipedia
TMM Thoughts on Cyprotoxins - Macro Man
Analysis: "Lex Cyprus" will set precedents for closer EU union - Paul Taylor (Reuters)
Will Germany turn Europe into Latin America? - Christopher T. Mahoney

and once again, a strong plug for FT Alphaville's excellent Cyprus Coverage.

"Broken Euro" image courtesy of George Mitakides

* Turkey has already expressed an interest in reopening negotiations with a view to achieving recognition of the Northern Republic, apparently in return for allowing the Cypriot government to exploit the natural resources in the southern part of the island and offshore waters. This is an interesting and rather disturbing development: at present the Republic of Cyprus appears to be ignoring Turkey's offer (and associated warning), but that may change if the EU freezes them out and they are faced with economic collapse.

Wednesday, 20 March 2013

Sham guarantee

So you think small bank deposits are guaranteed, do you? That they are perfectly "safe"? Read what follows, and think again. 

The Eurogroup President's statement on Cyprus included the following commitment (my emphasis):
"The Eurogroup continues to be of the view that small depositors should be treated differently from large depositors and reaffirms the importance of fully guaranteeing deposits below EUR 100.000".
Ok, so that's the standard line on deposit insurance. Small deposits, including current accounts, are safe from loss because they are 100% guaranteed by government.

Here's the President of Cyprus on the subject (again, my emphasis):
The State would be obliged to compensate depositors in response to the obligation regarding guaranteed deposits. The capital required in such a case would amount to about 30 billion euros, which the State would be unable to pay.
Indeed it would not. After all, the reason for the proposed depositor haircut is that the Cypriot government can't afford to borrow even 7 billion euros, let alone 30 billion. Actually the Cypriot government can't borrow at all, really. Its credit rating was cut to junk quite some time ago and the only buyers for its debt now are the same banks that are threatening to implode if they aren't recapitalised.

Tim Worstall thinks that deposit insurance payouts are the responsibility of central banks. No they aren't, at least not in the Euro area. They are the responsibility of member state governments. And the ECB is not going to create money to meet the obligations of member state governments - even when those obligations are mandated by European Union directives, as is the case with deposit insurance. Nor could the Cypriot central bank create the money, either. Euro area member state central banks are subject to the ECB and can only issue money in accordance with its rules and under its supervision. At present it is by no means clear whether the Cypriot central bank will be allowed to continue creating money to fund the Cypriot banks under the Emergency Liquidity Assistance (ELA) scheme: the disastrous "burn the depositors" scheme was agreed in response to an ECB threat to withdraw funding, and although the ECB appears to have backed off from this at the moment, there are still no guarantees that it won't follow through on its threat at some point. Hell would freeze over before the ECB gave permission to the Cyprus central bank to create money to compensate depositors on behalf of the Cyprus government.

So the Cyprus national government can't borrow to meet depositor claims, and it can't print money to meet their claims either. And it has insufficient tax income even to meet current spending obligations, never mind insurance claims. This is not looking good for depositors, is it?

Well, I suppose it could sell some assets. Or, even better, the banks could, so that the Government didn't have to meet depositor claims. The President had something to say about this too (once more, my emphasis):
A proportionate amount corresponding to the deposits of thousands of depositors for deposits over 100.000 Euro, would be led to a vicious cycle of asset liquidation, and these depositors would suffer losses of over 60%Such an uncontrolled situation would push the whole banking system into collapse with all the attendant consequences.Thousands of small and medium enterprises, and other businesses would be driven to bankruptcy due to their inability to trade.
Oh. So liquidation of bank assets wouldn't raise anywhere near enough to meet depositor claims, and would wreck the entire economy. Why on earth are these banks still allowed to trade? However, Cyprus is a rich country - isn't it? At least, according to "genauer" in a comment on FT Alphaville:
Cyprus is very rich. Lots of drilling rights, lots of private wealth to be taxed.Just not as immediate cash on hand.
That the sacred TFEU rights of the (poor) Euro taxpayers should be violated, to smoother rich tax havens, is hilarious.
Well, this is not quite what it seems. Taxing private wealth is not as easy as it sounds, especially when most of that wealth is in your financial centre (which is being trashed anyway). Large deposits made by rich foreign oligarchs and multinational corporations to reduce tax liability in other places tend to evaporate like the morning mist when you attempt to tax them. And drilling rights? There appear to be deposits of oil and gas in that part of the Aegean, to which Cyprus claims rights. But it is by no means clear to what extent those deposits are realistically exploitable, nor whether Cyprus really can lay claim to them. Turkey thinks otherwise, and has already made it clear that it will not tolerate any attempt by Cyprus to exploit those deposits. (Turkey of course not only claims those deposits, it claims Cyprus itself.) Egypt also disputes Cyprus's claim.

So not only does Cyprus not have liquid assets, it may not actually have exploitable assets at all. It has some ports that could be privatised - the IMF is keen on that idea. And it has two British naval bases. It could auction those off, perhaps? Well, only if the UK Government agreed, which might be tricky. And I'm not sure how the possibility of Russia or China buying these strategically-important bases would be regarded by the US, which is watching the Cyprus affair from across the Pond with some concern. 

The experience of Greece shows that forced sales of state assets to meet government obligations is fraught with difficulties, can be extremely slow and may not raise the expected funds anyway. And the precarious political position of Cyprus, at the gateway of the Middle Eastern melting pot and partly occupied by Turkey, doesn't bode particularly well for foreign investors.

So Cyprus can't borrow, can't print, can't obtain enough money from liquidating bank assets and may not be able to raise enough money from sales of state assets to meet depositor claims. Depositor insurance doesn't look like it's worth much, does it?

But - this is an EU deposit insurance scheme. Surely the EU would step in to ensure that depositors were compensated under the terms of its scheme?

Dream on. Germany has made it clear that a common deposit insurance scheme is simply not up for discussion. No way are German taxpayers going to fund the claims of Cypriot depositors. As "genaeur" puts it:
the national bank guarantees are to be paid nationally,as everywhere else.
And this is the heart of the matter. The Eurogroup's "full guarantee of deposits below E100K" is unfunded and therefore untenable. The Cypriot government cannot afford the deposit insurance to which it is committed under the EU Directive, and other states won't help. Cypriot deposits are not guaranteed and it is positively evil of the Eurogroup to give depositors the impression that they are.

The proposed deposit haircut of 6.75% for deposits under 100,000 Euros looks harsh and unfair. And indeed it is. But not because deposits were ever "safe". Compared with the alternative - bank failure, sovereign insolvency and unrecoverable loss of most of their money - this was a good deal for small depositors. And it may still be improved. 

What is harsh and unfair is that depositors have been led to believe that small deposits were guaranteed, when the supposed "guarantee" is not worth the paper it is written on. In the Eurozone, deposit insurance is only as good as the ability of the sovereign to honour it. If the sovereign cannot honour it, it is worthless. And that is the situation not only in Cyprus, but also in Greece, Portugal, Ireland and possibly Spain. None of these sovereigns could borrow, print or otherwise raise the money to meet claims under the EU's deposit insurance scheme. 

It is time that depositors were told the truth. The lack of a common deposit insurance scheme in the Eurozone means that deposit insurance is a luxury available only to those countries that can afford it - which are also the countries that least need it. Everywhere else, it is a sham. 

Related links:

Sowing the wind - Coppola Comment
Gas in Cyprus - how much of a guarantee? - Nick Butler, FT (paywall)
Cyprus bailout: Welcome to another Great Depression - Tim Worstall, Forbes (annoying video ads)
Doubts over Cyprus gas bonanza - Guardian
Cyprus, Fight Club & Capital Controls - Pawel Morski. Read his previous two posts on this, too. 
EU single market: deposit guarantee schemes - European Commission
Privatization of Greek assets runs behind schedule - NPR
Wanted: EU banking union as Cyprus kills off deposit insurance dream - Euromoney

Plus the entire FT Alphaville series on Cyprus, which is brilliant.

Saturday, 16 March 2013

Sowing the wind

The terms of Cyprus's bank bailout have shocked the world. For the first time, small bank depositors will take a hit.

Small depositors have long been regarded as sacrosanct. Although in theory they rank alongside bondholders and large depositors in the queue for funds, in practice they have always been protected - usually by taxpayers.  There is a widespread belief that because small deposits are insured in nearly every developed nation, therefore they should not take losses when banks are bailed out instead of being allowed to fail. Depositors losing money when banks are kept afloat, when they would have escaped unscathed if the banks failed, seems both unfair and illogical.

Hence the reason for the "shock and awe" response to the Cyprus bailout terms. A 6.75% one-off "stability levy" will be imposed on deposits covered by deposit insurance (under 100,000 Euros). The levy on larger deposits will be 9.99% - not a great difference, really, and much less than might have been expected: after all, depositors could lose 100% of deposit value above 100,000 Euros. Additionally, there will be higher withholding taxes on interest. These penalties will be applied to all deposits, including those in well-managed banks that don't require bailout.

The description of this as a "tax" or levy is a bit of a fudge. Under what type of taxation scheme are people provided with shares to compensate them for the taxes they have paid? But that is what is happening here. Depositors will be provided with bank shares to the value of their losses. They are being "bailed in" in the same way as junior bond holders: a percentage of their deposits are being converted to equity. The money taken from the depositors will go to the sovereign to compensate it for the cost of bailing out the banks. At the end of the process, the sovereign will be left with a manageable amount of debt, and the banks will be owned by their depositors and junior bondholders. In effect they will have become mutuals.

When I explain it like that, it doesn't sound so bad, does it? The problem for depositors is twofold, really:
  • their liquid assets (cash deposits) will have been replaced with illiquid ones (shares in banks that currently have little market value)
  • they are forced to take the risk that the future value of those banks will not compensate them for the money surrendered to the sovereign.
So depositors have an immediate liquidity problem, and the possibility of future real losses. They are not suffering a real immediate loss of capital at all. The sovereign is providing them with shares to the value of their losses. Yes, I know those shares look like duds, but there is no market for them so it is impossible to obtain a real market price. The sovereign is valuing the shares as it sees fit. It remains to be seen whether the sovereign's valuation is correct. I have considerable doubts about this, but that is for reasons that have nothing to do with the current bailout and everything to do with the real economic issues in Cyprus and the utterly inept and counterproductive measures being taken to deal with them.

Plenty of people have questioned why small depositors had to be hit at all. The German financial minister, Wolfgang Schäuble, who appears to have masterminded the bailout plan, wanted large depositors to take a much larger hit so that small depositors could be protected. The IMF took a similar view. It seems that the Cypriot government did not agree. There is considerable speculation as to why the Cypriot government preferred to see small depositors hit. To me it seems most likely that it has to do with the Cypriot government's wish to avoid upsetting Russia, given Nicosia's hope that Russia will contribute to the bailout by softening the terms of its existing sovereign loan, and the considerable amount of money (some of it undoubtedly dirty) from Russian oligarchs that is held in Cypriot banks. But it is also possible that Nicosia is still hoping to maintain its foothold in the international tax haven network. Even with the 2.5% increase imposed as part of this bailout, corporation tax is a very competitive 12.5%, and the Cypriot government has encouraged growth of the financial sector by attracting deposits from overseas investors.  Frankly I think this is pie in the sky. A 10% loss may be all in a day's work for corrupt depositors, but that doesn't mean they will continue to deposit funds in a country that imposes losses like that when there are others that don't. The large depositor haircut is a mortal blow to Cyprus's ambitions to be an international financial centre - and that has serious implications for its economy. 

Cyprus's economy is dwarfed by its financial sector, whose total assets are 8 times its GDP. It's uncannily like Ireland without the property bubble but with a much larger neighbour and trading partner in a horrible mess. And like Ireland, the sovereign cannot afford to bail out its banks. A taxpayer bailout like that done in Ireland would leave the sovereign with estimated debt of 145% of GDP. The IMF considers this unsustainable, and under its own rules would therefore be unable to contribute to the bailout fund. As the Eurogroup is expecting the IMF to contribute, clearly a taxpayer bailout of Cyprus banks would be out of the question, unless it was immediately followed by Greek-style PSI restructuring of sovereign debt. No-one wants to go there....

Except that they will go there, eventually. Although I have explained above why this is perhaps not such a terrible deal for depositors as it seems, that is not how they will see it. The run on Cypriot banks started as soon as the deal was made public. Cyprus was forced to introduce temporary restrictions on the movement of capital to prevent depositors removing their funds to avoid the levy. And although this choked off an immediate acute bank run prior to the levy being imposed, I do not think depositors will want to keep funds in banks any more. After all, it's not very long since the Cypriot President announced that there would be no deposit if the Government can break that promise, why should depositors believe the description of this levy as a "one-off"?  Large depositors will eschew Cyprus in favour of non-Eurozone countries such as Latvia. Small depositors will withdraw funds in cash and stuff their mattresses, or they might buy gold.  In fact there has been a slow run on Cypriot banks for some time now, as international depositors withdrew funds due to bailout fears: I expect this run to increase to a flood once banks re-open after the bank holiday. 

The effect of large and small depositors removing funds on that scale will be a brutal economic downturn as the money supply collapses. In particular, the dominant financial sector will suffer a severe contraction, putting thousands of jobs at risk and paralysing lending to Cypriot households and businesses. And that is IN ADDITION to the estimated 4.5% economic contraction that is already happening due to austerity measures imposed on Cyprus in 2012 to reduce its fiscal deficit, and the further measures required in this bailout. "Deep recession" is already forecast for Cyprus. A major bank run will be economically catastrophic. And the effect of that economic disaster will be to increase both the fiscal deficit and the public debt as a proportion of GDP. After all, even if the government doesn't increase borrowing, a collapse in GDP immediately raises the debt burden to unsustainable proportions, spooking investors and causing unaffordable rises in yields on sovereign debt. 

Cypriot banks may or may not become insolvent. They will become completely dependent on central bank funding, of course, just like their Greek counterparts. But a second bank bailout is not a complete certainty. What in my view is a racing certainty is a SOVEREIGN bailout due to GDP collapse some time in the next two years. This bailout may have averted the immediate risk of disorderly default and Euro exit, but economically it is completely insane. And it is dangerous, not just for Cyprus but for other countries too.

For the fact is that deposit insurance everywhere in the EU has now been undermined. The precedent has been set for insured depositors to suffer losses in order to protect Russian oligarchs and reckless banks. If the Eurogroup can impose this on Cyprus, it can do so elsewhere too. Yes, Olli Rehn says they have no current plans to do so, and insists that the Cyprus bailout is unique. But haven't we heard this before? Wasn't the Greek bailout "unique", and the Irish bailout, and the Portuguese bailout, and the Spanish bailout? It is only "unique" until the next domino falls. I would not be surprised now to see bank runs across the entire Eurozone periphery, and perhaps in other EU countries too. 

They have sown the wind

UPDATE: It appears that Cyprus came very close to actual default. This tweet from Yiannis Mouzakis shows that the ECB was preparing for collapse of Cyprus's two main banks:
The timing of this is exquisite and it is hard not to conclude, as Mouzakis does, that it was done to put pressure on the Cypriot government in order to obtain a deal at any price, regardless of the consequences for the Cypriot economy and for its people. If that is true then it exposes the European Union for what it is rapidly becoming - a nascent totalitarian state. 

UPDATE 2 - The FT confirms the ECB's role in forcing through the deal. It says the ECB threatened to stop providing liquidity to Laiki, Cyprus's second-biggest bank, which would have caused an immediate disorderly collapse. I have written previously about the ECB's disgraceful behaviour. This is the worst example yet. 

Related links:

Statement by the Eurogroup
Statement by the President of Cyprus
Cyprus's savers bear brunt of unexpected bailout - Reuters
Bailout terms prompt run on Cyprus banks - Al Jazeera English
Shock in Cyprus as bailout brings bank account haircut - Ekathimerini
EU's Rehn says Cypriot haircut on deposits will not be repeated elsewhere - Ekathimerini
Eurozone targets Cyprus bailout deal this month - News Tribe (Mar 5th)
First memorandum deal makes a second memorandum almost a certainty - Alex Apostolaides
Cyprus: A Brutal Lesson in Realpolitik - Pawel Morski
Unfair, short-sighted and self-defeating - The Economist
Cyprus bailout: A suboptimal and unjust agreement of the Eurogroup - Protestilaos Stavrou
Why Cyprus's rescue matters to us - Peston (BBC)
A stupid idea whose time had come - FT Alphaville


ECB presses Cyprus to impose bank levy - FT
A central bank crisis - Coppola Comment

Thursday, 14 March 2013

Risk versus safety, bank reform edition

The Parliamentary Commission on Banking Standards has produced its second interim report. Predictably, the media homed in on its proposal to include provision in primary legislation for full separation of retail from investment banking across the entire UK banking industry if ring-fencing turned out to be a dud. Not that that would mean much - the only UK bank that still has a major investment banking arm is Barclays, and even that is being scaled down in favour of renewed emphasis on retail banking. In fact the way things are going, by the time the ring-fencing scheme is implemented it will resemble a plan to repair the door on an empty stable. The horses will have long since become Tesco burgers. Yawn.

But the report is actually far more interesting if you ignore ring fencing and look at the rest of it. It affords an extraordinary snapshot of the conflicting agendas of Government and Parliament at the moment. Government is in a hole, largely of its own making: the economy is stagnating, inflation is rising and the prospects of a Conservative victory in the 2015 election are getting slimmer by the day. The Chancellor's strategy for "getting the economy moving" rests almost entirely on increasing the amount of private sector borrowing in the economy - from households, mostly in the form of new mortgages (though there is growing use of payday loans too), and from businesses. This despite the considerable evidence that households remain over-indebted and the squeeze on real incomes is depressing discretionary spending, with significant consequences for domestic business. Lack of sales remains the number 1 concern of UK industry, particularly small & medium-size companies (SMEs). However, the popular perception is that "banks aren't lending" not because people don't want to borrow but because banks won't lend to reasonable risks. In vain do the banks - and the Bank of England - argue that the main obstacles to lending are a lack of creditworthy borrowers and subdued demand for loans: in vain do businesses argue that the main obstacles to their borrowing are lack of investment opportunities and subdued domestic and global demand. No, banks must lend. The Government's deficit reduction strategy (and their election campaign) depends on it.

But the Parliamentary Commission has a different agenda. Its objective is reform of the UK banking system to make it "safer" - or, more accurately, to reduce the risk that taxpayers will have to bail out depositors due to bank failures. The entire report focuses on measures to improve safety: nowhere does it recognise the Government's desire for banks to increase risk lending. So there appears to be a fundamental mismatch between the objectives of the Commission and the Government's current focus. The Commission wants banks to be "safer": the Government wants them to take more risks. It seems unlikely that this impasse can be resolved to mutual satisfaction unless both sides are prepared to compromise. And so far there are no signs of compromise. The Commission adamantly refuses to accept the Government's watering-down of some of its earlier recommendations: the Government rewrites some of the Commission's proposals in order to make it easier to dismiss them. The headline finding of the Commission was "More work needed". It's not just more work that is needed. It is agreement on the fundamental aims of the entire exercise.

The Commission is equally uncompromising when addressing the question of bank capital requirements. And actually its recommendations on this subject are both more interesting and more useful than the media-friendly ring fencing scheme. The Commission proposes early adoption of a leverage ratio as a backstop to the Tier 1 capital ratio, and recommends increasing the leverage ratio from Basel III's 3% to 4% in line with the higher capital ratios for both ring-fenced and investment banks already agreed.

The background to this is the mess that successive Basel committees have managed to make of capital adequacy regulations. Basel I's belt-and-braces approach was at least comprehensible, though there were some bizarre effects such as 50% weighting of domestic mortgages across the board regardless of the loan-to-value ratio (LTV) or the creditworthiness of the borrower. Basel II, in attempting to resolve some of these anomalies, vastly increased the complexity of the risk calculations, forcing regulators to allow banks to develop and use their own risk weighting models for more complex instruments. Among the banks allowed to use their own risk weighting models were HBOS and RBS. Need I say more?

Basel III has tightened up on capital adequacy, leverage and liquidity ratios, though the Commission is proposing even tougher requirements. But it has failed to resolve the question of complexity and still provides opportunities for banks to game the system, not least because it still allows banks to use their own models in some circumstances. Unsurprisingly, the Commission is unimpressed. In its view Tier 1 capital ratios calculated according to Basel III risk weighting rules can be fudged in many of the same ways as the Basel II ratios were. So the Commission wants another measure which does away with the suspect risk weightings and simply looks at the ratio of shareholders' funds to total assets - the "leverage ratio". To be fair, the Basel committee is proposing to introduce such a measure.....but not any time soon. The Commission wants it now. And it also wants the Bank of England to be responsible for reviewing how risk weightings are calculated. Somehow I get the impression that the Commission doesn't trust the Basel committee. Or banks.

Using a measure of total leverage as a backstop to the capital ratio seems eminently sensible to me. After all, the risk of any asset is at best a subjective measure, and it is subject to change without notice. Prime mortgages become sub-prime when unemployment rises and property prices fall. Sovereign debt becomes high-risk when fundamentals in the countries concerned (or a poorly constructed political experiment) give cause for alarm. The ability of supposedly "safer" assets such as mortgages suddenly to turn toxic is in my view a reason NOT to have a lower leverage ratio for building societies. In a property market collapse, building societies are as much at risk as banks.

Risk weightings cannot easily adapt to sudden changes in asset risk due to economic shocks, and banks do not like to admit that their assets are riskier than they appear so are reluctant to recalculate weightings in the light of changed circumstances. Therefore Tier 1 capital ratios can give a misleading impression of strength. The relationship of the risk-weighted capital ratio and the leverage ratio is itself a key indicator: increasing divergence between the two should be a cause for alarm. Although so should convergence.....after all, we don't want banks having nothing but high-risk assets on their books. Regulators should take a view as to the appropriate distance between leverage and capital ratios - as indeed the Commission is doing.

Higher capital ratios, a new leverage ratio, ring-fencing and separate capitalisation of retail operations.....all of these are supposed to protect taxpayers from bailouts. And the Commission is suggesting other measures too: depositor preference (where insured depositors rank ahead of unsecured bondholders in the queue for payouts after insolvency), greater use of instruments such as contingent convertibles (CoCos) that can be converted from debt to equity under distressed circumstances, a voluntary insurance scheme for deposits in excess of £85,000. None of these measures would prevent banks suffering serious losses and in some circumstances becoming insolvent: the bulkheads simply won't go all the way up to the deck. But what they may do is make banks easier to resolve and reduce the likelihood of depositor losses and taxpayer bailout. They won't stop the ship sinking, but there should be more lifeboats.

However, all this emphasis on safety comes at a price. Safe banks are risk-averse. They will only lend to good risks. The effect of higher capital ratios is to encourage banks to reduce asset risk - for example by requiring more and better collateral, and lending only to the best credit risks. And depositors like this. They do not want banks "taking risks with their money". They want banks to lend prudently. This conflicts with the needs of SMEs: lending to SMEs is about as risky as it gets, because most SME's are asset-light and cash flow is always uncertain. And it also conflicts with the desire of savers for good rates of interest. Lending only to the best risks does not make for good returns on savings. Savers may be protected from acute losses, but they won't make money on their savings. If savers want good interest rates, banks need to be able to take risks - and that means that savers (or rather taxpayers) must accept some risk of loss.

Protecting savers (or rather taxpayers) at all costs inevitably means reduced lending to SMEs unless unweighted capital levels are much higher. But more fundamentally, even a bank lending only from its own capital, or lending only to to the best risks, is not "safe". There is no such thing as a "safe asset", and therefore no such thing as a "safe bank". All lending is intrinsically risky, however it is funded and whatever collateral is pledged against it. The path to safety in asset portfolios lies in active management of risk, not in its avoidance. That applies to banks just as much as investors.

Even if risk weightings were not suspect, there would still be a fundamental problem with relying on them to define the safety of assets and, by extension, of the banks that hold them. Capital ratios based on risk weighted assets encourage banks not to manage risk but to avoid it. Just as reliance on agency credit ratings encouraged investors not to bother to manage risks properly, so defining "risk" by means of risk weightings encourages banks to rely on regulatory definitions of risk instead of understanding the nature of assets and actively managing risks themselves.Lending decisions start to be driven by their effect on capital, rather than by the balance of risks in the asset portfolio: no surprise that banks seeking yield would try to "game" the risk weightings to enable them to take more risk without appearing to do so. I would rather have a bank that was accepting higher risks and managing them properly, than a bank that was seeking out higher yields on apparently "low risk" assets. That's how banks ended up exposed to periphery sovereign debt. It was never "low risk", but the risk weightings masked its true riskiness. Capital ratios are no panacea. We rely on them at our peril. The leverage ratio is perhaps less easily fudged, and has the advantage that it does not discourage risk lending. But it too is no substitute for professional asset portfolio management by banks.

Real safety will not come from tougher regulations. And it certainly won't come from a ring fence imposed far too late to make any real difference. All these measures will do is decrease risk lending by the regulated sector and drive riskier enterprises, and savers looking for better returns, towards unregulated forms of financial intermediation. Real safety comes from professional risk management and commitment to customer service on the part of the banks themselves. Until these are established throughout the banking industry - retail banks as much as investment banks - there can be no real safety.

Related links:

Banking reform: towards the right structure - Parliamentary Commission on Banking Standards
Osborne should accept commission on banking standards' advice - Nils Pratley, Guardian
Supermarket banking - Coppola Comment
The illusion of safety - Coppola Comment
On risk and safety - Coppola Comment
A really scary story - Coppola Comment

Friday, 8 March 2013

The legacy systems problem

A comment I made on BBC 5Live's Wake Up To Money programme has attracted quite a bit of attention. It's quoted in the BBC's report about RBS's recent IT failure:
"We just have a lot of legacy systems out there," said Frances Coppola, a former RBS employee and an independent banking analyst.
"Some of those systems haven't been replaced for a long time," she said.
And my colleague on the programme added the following:
"The bank has given too much priority to grand schemes and acquisitions, rather than running a day-to-day bank," said Alastair Winter, chief economist at Daniel Stewart Securities.
Both of these remarks need further explanation, and to do so I need to talk about what I actually did in banking. I am usually described as a "former banker", but that isn't entirely true. I worked in systems. I started as an IT analyst/programmer, moved on into IT project management, then crossed the fence into the business (doing an MBA in the process) and became a business analyst and project manager working on joint business/IT projects. So when I talk about bank IT systems, I'm not making it up. I really do know what they are like. I worked on them.

Admittedly, I left banking ten years ago, and systems have changed in that time - considerably. But the principal areas of development have been in front-end applications (customer interface) and in settlement processing and payments. The core systems, that run the basic banking processes, have not been upgraded. That's why despite the massive increase in processing power and storage capacity in modern IT technologies, banks like RBS are still running massive traditional mainframe computers. Their software won't run on anything else. I suppose it keeps IBM in business, but it is not what we might expect for a modern real-time, mission critical banking system.

The existence of ancient "legacy" systems within the modern banking systems architecture is not necessarily to do with lack of investment, as Alastair Winter suggested, though fast growth and acquisitions complicate IT architectures and can make systems vulnerable. I shall return to the likely effect of RBS's aggressive expansion strategy shortly. But the real problem is the size, complexity and criticality of these old systems - plus the fact that many of them are written in progamming languages that are not widely used now, so there are skills shortages among IT staff. Many of these systems are also poorly documented (comments in code were something of a rarity when these systems were written) and their functions are poorly understood. Replacing them without affecting functionality is therefore not an easy task. Even replacing a single program can have adverse effects if the program is not properly understood, as I discovered when my team replaced a start-of-day batch program in a systems upgrade on one occasion: the old program was complex and poorly documented, we (perhaps inevitably) failed to understand exactly what it did and we therefore subtly changed its functionality without realising it. Fortunately the changes we made didn't cause major problems, and it wasn't a major retail banking system anyway. But imagine that, scaled up to an entire suite of retail banking applications running millions of bank accounts, with trillions of transactions going through every day? No wonder banks have shied away from replacing these systems. The risks, and the associated costs, are terrifying.

However, there is another reason why banks have avoided replacing legacy systems. Banks are driven by the need to make profits, and profits don't come from upgrading basic infrastructure. No, they come from new business lines, risky mergers and applications, swanky front-office applications to support fancy new products. Infrastructure is boring and the cost of replacing it is a hit to short-term profits. Therefore banks do whatever they can to avoid expensive replacement of legacy systems. Keeping the things running, patching them up and circumventing them if necessary is the order of the day. Banks that are expanding very rapidly are particularly prone to develop a patchwork of unintegrated and incompatible systems, because every time they acquire a new business they also acquire the systems that support it and they seldom allow the time to integrate these before moving on to the next expansion opportunity. I saw this happening very clearly during my time at UBS, and I have no doubt that RBS was doing the same during its fast expansion in the run-up to its failure in 2008. Piecemeal, incompatible systems are a risk, but banks don't worry about that when the business opportunities are good.

It would be nice to think that if banks that are expanding won't invest in new core systems, maybe damaged banks that are trying to reduce their risks might do so. Sadly that isn't true either. Core system replacement is very expensive, and damaged banks are trying to reduce costs as well as risks. Very expensive IT infrastructure projects simply aren't acceptable to management or staff when their jobs are on the line. So since 2008, despite their supposed commitment to reducing risk, banks such as RBS still haven't addressed the legacy system problem. They've reduced their balance sheet risk, but not their operational risk.

But as I noted above, bank IT systems have developed enormously in the last couple of decades despite the existence of old systems. That is because to avoid replacing legacy systems banks have adopted a practice known as "wrapping". This approach was recommended by consultancies as a lower-cost and perhaps more importantly, lower-risk approach to improving banking system functionality. Basically you treat your legacy system as a "black box" which remains untouched at the core of your system: around it you create a "shell" of additional applications that provide your customer interface, your straight-through settlement processing, your point-of-sale functionality and your real-time updates (yes, this functionality can be added even if the "black box" is a batch system). This is akin to the way in which off-the-shelf package applications are typically customised, but it is of course on a much larger scale.

The "wrapping" approach has been all too successful. Customers now expect real-time banking services twenty-four hours a day: in fact the entire economy has come to depend on them. But the core banking systems still do not support this. The functionality to support real-time banking services is in the shell. So as far as customers are concerned, the shell applications ARE the banking system. The balances that we see on our internet banking screens ARE our real balances, to us - but not to the bank. To the bank, the real balances are in the core system, which is invisible to customers and is probably updated in overnight batch processing, not in real time as customers think. There is divergence between how financial information appears to customers and how it appear to the banks themselves. And this opens up the possibility of system errors causing data corruption, with a serious impact on customers. Just to give an example of what MIGHT happen, suppose that a customer deposits cash into their account. That cash shows up immediately in their balance in the customer-facing applications - online banking screens, telephone services, branch information points. And they can use it for payments. But the core system doesn't apply that cash to the balance, or the payments made using that cash, until the overnight process. If that process fails, or the customer application doesn't transfer the information correctly, the result could be an imbalance between what the customer thinks they have in their account and what the bank says they do.

Over time, the "shell" of additional applications becomes ever larger and more complex, and customers come to rely on it more and more. And because the core uses old technology, and the shell applications are much newer, there are problems with technological compatibility and connectivity. That increases the risk of failures. The more fragmented your systems architecture, and the more it relies upon stable interconnections between different technologies, the riskier it becomes. Efforts have been made to reduce risks, of course - to improve the stability of connections, and to provide "fail-safe" backups for critical components - but in the end the "pasta rule" still applies: the more your systems architecture looks like spaghetti, the higher risk it will be.

So the problem for banks is the balance of risk: the risk of replacing a critical legacy system and it all going horribly wrong (and costing a fortune) versus the risk of increasing instability in an ever-more-complex systems architecture founded on diverse technologies. It's rather like the risk of a major operation (which could result in death but might lead to full recovery) versus medical treatment to control symptoms - you get iller but you don't die, at least not for a while. But eventually the operation becomes necessary. The question is whether IT systems in banks have reached the point where radical surgery is the only option.

This is not simply a question for banks to consider. It is a matter for political consideration. The economy as a whole has become critically dependent on the real-time performance of bank systems. If the payments network goes down because of the failure of one component - a large banking system - the entire economy stops working. The RBS system was only out for 3 hours, but in that time people couldn't make debit card payments, they couldn't get cash, automated payments weren't made, wages weren't paid into accounts. Just imagine what would have happened if it had gone down for days - as nearly happened in 2008. Those who think that RBS should have been allowed to fail do not understand how damaging that would have been to ordinary people and businesses. Even twenty years ago, the damage from a three-hour outage in the late evening would not have been so extensive.

The increasing fragility of banking systems poses a real risk to the economy as a whole. Unless this is addressed, we run the risk of a major systems failure in one or more banks at some point. The two RBS failures are warnings. Banks and politicians need to address this problem before there is a real disaster.

Wednesday, 6 March 2013

The fatally flawed FLS

The first results from the UK's Funding for Lending scheme have been released. As widely predicted, it has been a flop. Of the large banks who signed up for the scheme, only one - Barclays - has increased lending. The others - Royal Bank of Scotland (RBS), Lloyds Banking Group (LBG) and Santander - have all reduced net lending. To be fair to LBG and Santander, they have only done exactly what early in 2012 they said they would do, namely reduce retail lending, particularly mortgages. But that is exactly what the Funding for Lending scheme was supposed to prevent.

The origins of the Funding for Lending scheme lie in the Eurozone crisis. Roll back the clock to mid-2012, and we see a picture of tight credit conditions for customers, particularly higher-risk homebuyers and small businesses. In its first Financial Stability Report in June 2012, the Financial Policy Committee (FPC) attributed the difficult credit conditions to rising funding costs for banks: as banks' funding costs rose due to fears about Eurozone instability and contagion to UK banks, they passed those higher costs on to borrowers, raising interest rates and thereby reducing demand for loans. This was supported by SME representatives, who complained about high interest rates. It seems the excess liquidity created by QE wasn't enough to encourage lending. More was needed.

Initially, the Bank of England used an emergency liquidity scheme called the Extended Collateral Term Repo (ECTR) facility, which allowed banks to pledge a wide range of loans and securities in return for cash. This scheme ran for four months, June-September 2012. It was then effectively replaced by the Funding for Lending scheme, although it remains in place as an occasional emergency funding scheme to supplement the Bank of England's Discount Window Facility (DWF) and operational lending facility.

The Funding for Lending (FLS) scheme is subtly different from the ECTR. It accepts the same wide range of collateral, but instead of dishing out cash, it lends banks 9-month sterling Treasury bills. Banks can then use these as high-quality collateral in the funding markets, which should reduce their cost of funding to somewhere close to the policy rate (currently 0.5%). This is really a variant of the DWF, which lends gilts against a wide range of collateral for the same purpose.  The difference is that T-bills have shorter maturities, so carry lower interest rates (typically 0.3-0.4%) and need to be rolled over sooner.

Where the FLS differs wildly from the DWF and the ECTR is in the obligations it places on borrowers. FLS borrowing incurs a fee, which increases if borrowers reduce their lending to non-banks (corporates and households). The way the fee works is somewhat complicated, but the Bank of England has helpfully released some worked examples so we can all understand it. The useful example in relation to LBG, RBS and Santander is the third one, which shows that a bank that reduces its lending substantially during the reference period (July-December 2012), as all three have, will pay 1.25% over the standard 0.25% fee on all its borrowings under the scheme. That is quite a hefty hike.

But it obviously wasn't hefty enough to deter banks from borrowing money under the scheme then deliberately reducing lending to meet operational targets. And doing some basic calculations quickly shows that the 1.25% hike actually isn't necessarily that much of a deterrent. Assuming the high-quality collateral allowed them to borrow from the funding markets at 0.5%, the initial cost of FLS funding on the base stock of lending was 0.75%. That is a very considerable reduction on the prevailing funding spreads at the time, as this chart from the June 2012 Financial Stability Report shows:

So for the last 6 months, these banks have benefited from much reduced funding costs for their EXISTING operations. Now they will have to pay an additional 1.25% for that funding: but even then it is only 2%, which is still less than other forms of funding at the start of the FLS scheme.  It is particularly telling that the banks that have participated in the scheme but failed to increase their lending are generally regarded as weak by the markets. LBG and RBS would have been facing much higher funding costs than those in the chart. I have no doubt that these banks did the number crunching just as I have, and realised that it was in their interests to participate in the scheme even though they had no intention of increasing net lending any time soon.

However, developments since the FLS was introduced have rather changed things. For a number of reasons, of which in my view by far the most important is the calm in the Eurozone following the ECB's announcement of OMT (although the FLS scheme itself is also a factor), market funding costs for UK banks have fallen considerably over the last 6 months.

There is now little difference between market funding costs for well-regarded banks and the FLS scheme. (Not that LBG is a well-regarded bank - but that's another story!)

Both LBG and RBS claim, in their respective 2012 results, that they expect to lend more FLS-funded mortgages in 2013. And the Bank of England echo this in the February inflation report, claiming that the FLS scheme "takes time" to get going. I am unconvinced.

Don't misunderstand me. I have no doubt that RBS and LBG do indeed intend to lend more at some point. But it won't be because of the FLS scheme. They will lend more when they have reduced their balance sheets to a size compatible with meeting regulatory capital requirements without diluting shareholders' equity (remembering that a lot of that equity in both cases belongs to the state). And - more importantly - when households and businesses are showing better risk profiles. Banks only lend when the risk-return profile is right for them. Throwing money at them, whether excess reserves via QE or cheap market funding via collateral enhancement (which is what FLS is), DOES NOT MAKE THEM LEND.

The fundamental flaw in FLS is that it assumes that corporates and households both want to borrow more and can afford to do so. Neither is true. Corporates have been paying off debt at a considerable pace, and according to the Bank of England's February inflation report, many have large cash balances that they are not investing. Large corporations have also been taking on debt, but much of that has been to refinance existing debt obligations at lower rates or to buy back equity. Household deleveraging currently seems to have slowed down, but that doesn't mean they want to take on more debt: real incomes are falling due to wage restriction, consumption tax rises, benefit cuts and inflation in essential goods, so many have stopped paying off debt because they cannot afford the repayments, not because they don't want to pay it off - and those people cannot take on more debt. And many others don't want to take on debt. Borrowing to fund consumption is definitely out of fashion.

There are of course still households and corporations who do want to borrow. But by and large these are the riskiest ones - first-time-buyers and new small businesses. And they don't want to pay the sort of rates that banks want to charge. The FLS scheme could indeed help these, and there is just a chance that it may still do so: although the fall in market funding costs discourages banks from borrowing any more from the scheme, it may make the penalties for reducing lending rather expensive for those who have already borrowed from the scheme (though there is provision for banks to pay back these loans early). But neither category can provide the UK economy with the major boost it desperately needs. After all, if first-time buyers buy houses, they may spend less into the economy - unless they were previously renting, in which case the effect is most likely a wash. And the failure rate for new small businesses in an economic slump is frightening.  If the Chancellor was hoping that the FLS would kickstart the UK economy, he is doomed to disappointment.

There is no way that policies designed to increase the indebtedness of households and corporates can succeed. The private debt overhang in the UK economy is crippling; households' debt levels are frighteningly high, and although corporates have been deleveraging there is no real evidence that they have any intention of borrowing to invest in growth-making opportunities: caution is the name of the game at the moment.  And structural problems in the labour market are depressing demand. The IMF noted on a recent blog post that private debt levels across Europe, including the UK, are a considerable drag on growth, and suggests measures rather different from those currently favoured by the Coalition government (my emphasis):
Given the downdraft on consumption and investment, fiscal policy should emphasize long-term measures to raise primary balances and/or cyclically adjusted balances—as opposed to headline deficit targets. Structural measures on the supply side (labor and product market reforms) are crucial to offsetting some of the output cost of depressed demand. We also need to take a second look at whether the legal framework supports timely workouts of household debt.
So a much slower pace of fiscal adjustment, structural supply-side reform, and debt relief for households. As has already been suggested by a very large number of people, from respected economists to yours truly. Welcome aboard, Madame Lagarde.

The FLS is just another example of the Chancellor messing around with money instead of addressing the real issues. And because it depends on increasing household and corporate indebtedness when the private sector is already weighed down by debt, it isn't going to solve anything. Like the rest of the Government's economic policies, it is built on a false premise. It is fatally flawed.