Monday, 29 February 2016

Cocos and bank capital: a belated explainer

A few weeks ago, in a piece about Deutsche Bank's recent difficulties, I commented about its use of so-called "coco bonds" - contingent convertible bonds. I had over-simplified my description, and was promptly taken to task for doing so by @creditmacro on Twitter. He provided me with a detailed explanation of what coco bonds are and how they work. This piece draws heavily on his input. All of the quotations are from him unless otherwise stated. His full write-up can be found in Related Reading at the foot of this post. 
I'm also indebted to Martien Lubberink for pointing me to the capital structure diagram. 

In the aftermath of the financial crisis, regulators around the world recognised that banks were insufficiently capitalised. The proportion of equity (shareholders' funds) on the liability side of their balance sheets was distressingly low, which exposed their creditors - whose claims make up the rest of the bank's liabilities - to the risk of losses in the event of an asset price collapse such as happened in the autumn of 2008 after the fall of Lehman Brothers. Not only was common equity deficient, but the various forms of junior debt (preference shares and subordinated debt) that should have protected senior creditors including depositors proved inadequate to the task. Clearly, banks needed more, and better, capital.

The Basel Committee on Banking Supervision issued a set of proposals (Basel III) that called on national authorities to improve the quantity and quality of bank capital. These were transposed into EU law via the Capital Requirements Directive IV (CRD IV) and Capital Requirement Regulation (CRR).

As a result of the European regulations, bank capital structures have become somewhat complex, as this graphic from the European Commission shows:

Note that this is a layered or "tiered" structure. CRD IV requires banks to have permanent capital of at least 8% of risk weighted assets (RWA): in the diagram, this is the bottom three tiers. Of these, common equity (CET1) is the largest, at a minimum of 4.5% of RWA, though most banks now have far higher levels, many in double digits. Above that is Additional Tier 1 capital (AT1), and Tier 2 - subordinated debt and preference shares, broadly speaking - forms the remainder of the permanent capital. The tiers above that are variable and discretionary capital buffers.

As its name implies, CET1 is made up of shareholders' funds (issued shares and retained earnings). But it is AT1 and Tier 2 that interest us. Some Coco bonds are Tier 2 instruments, but most are AT1, sitting above CET1 but below Tier 2 in the bank's capital structure. They are deeply subordinated, and are therefore risky investments. They are now so dominant in AT1 capital that they are usually known as AT1 in market trading.

AT1 bonds are hybrid instruments, with characteristics of both debt and equity. Officially, they are classed as debt, which means their coupon payments are tax deductible: they are thus a cheaper way of boosting capital ratios than rights issues. But they are designed to absorb losses ahead of senior and subordinated debt. There are four broad types of AT1 bond, all of which impose losses on investors when a bank's CET1 capital falls to a predetermined trigger level, though they do so in different ways:

  1. Equity convertible. Around 40% of the market
  2. Temporary write down/up: if capital falls below the trigger level the bonds' par level is reduced - for example from 100 down to 85 - until capital moves back above the trigger level. This is around 50% of the market. (Deutsche Bank's “cocos” are this type)
  3. Permanent write down: in the example above, the bonds' par value would be permanently reduced from 100 to 85. Around 5% of market
  4. Write-off.  Around 5% of market
But the predetermined CET1  trigger is itself complex and variable:
...initially we had “low trigger” bonds (5.125% trigger) which were lower risk for investors, but we have moved towards  “high trigger” structures becoming standard (~7% trigger).  This part can add to the complexity of AT1 through the bank legal structures of Group and Holding Companies where in some cases AT1 bonds have dual triggers across the legal entities.
High-trigger bonds can suffer losses ahead of both lower-trigger AT1s and equity holders, This potentially undermines pari passu principles and cuts against normal capital structure hierarchy, in which equity holders take first loss.

It's not just the par value of AT1 bonds that is variable. Coupon payments can be, too. To qualify as AT1, coco bonds must be issued as perpetual instruments with discretionary coupon payments - which means coupon payments can be cancelled at any time for any reason. AT1 bonds typically offer interest rates of 6-7%, which in today's low interest rate environment appear attractive compared to senior unsecured or subordinated bonds. But unlike traditional (Tier 2) subordinated debt, AT1 issuers can choose not to pay a coupon, and the investor has no recourse. This is why Deutsche Bank was at pains to reassure investors that it had sufficient payment margin to cover AT1 coupon payments for the next two years.

Perpetual they may be, but AT1 bonds are callable. Usually, therefore, the market prices them as if they will be called at the next call date. But there is uncertainty around this: when the market view of the probability of a call declines, as it is doing at the moment, duration and credit risk increases and the market price of the bonds falls. For market wonks, this is a more technical explanation:
Finally it’s worth touching on negative convexity which is prominent in AT1 markets right now. Negative convexity affects callable bonds and occurs when the market starts to price in the expectation that they will not be called at their next call date.  If we take an AT1 with 5 year call and we think it’s no longer going to be called in 2021 and at best 2026, then we need to reprice the bond to take into account the added duration and risk.  In most cases as interest rates fall the ability of the issuer to refinance the debt at a lower price and call the outstanding bond increases but.. you may ask.. we are seeing interest rates fall now, so why are AT1 showing signs of negative convexity?  In this instance it’s the credit risk part of refinancing that is increasing at a faster pace and the worry that the current back end spread (the level that the coupon resets at post initial call date) will be lower than the refinancing cost of issuing a new bond - hence uneconomical to do so and may therefore be blocked by the regulator.
This last threat is real. It's worth remembering that the only reason AT1 bonds exist at all is the demand of regulators for higher bank capital levels. They are, first and foremost, regulatory capital instruments. Regulators can, and do, dictate how banks should use them.

They are, however, attractive to investors looking for yield. They can also be profitable for traders, and as such highly liquid:
AT1s come in 750-1.5bn deal sizes, trade in minimum amounts of 200k and tend to come with call structures varying across 5, 7, 10 year parts of the curve. The bonds trade in cash price, unlike the bulk of credit markets which trade in spread, and tend to work on 50 cents bid offer.  As such, AT1 are a lucrative product to trade across bid-offer and they quickly became a favourite among the Street trading desks willing to provide high levels of liquidity where 10 to 25 million bids or offers were the norm at peak times.
Consequently, the AT1 market is increasing in size. In July 2014, the European Securities Markets Association (ESMA) reported that total issuance was 60bn Euros and expected to grow fast. But as these bonds are generally rated well below investment grade, some of the largest institutional investors such as pension funds cannot invest in them, and those who can are liable to dump them at the drop of a hat:
The bulk of AT1 market however is High Yield rated and as such attracts “tourist” money both from corporate Investment Grade funds and from High Yield funds.  And this is one of the issues with the AT1 market... it’s an off benchmark asset class with a small dedicated buyer base. When times are good, AT1 is everyone’s best friend... when times are bad, index based investors drop their off benchmark overweights and return to benchmark weightings to avoid further underperformance.
This tends to make the market price volatile. Stable capital, these are not. And this obviously poses something of a problem for banks using them to shore up their capital ratios.

But there is an even bigger problem. Because of their complexity, there is real concern that these instruments are easily mispriced. ESMA discussed the pricing problems back in July 2014:
To correctly value the instruments one needs to evaluate the probability of activating the trigger, the extent and probability of any losses upon trigger conversion (not only from write-downs but also from unfavourably timed conversion to equity) and (for AT1 CoCos) the likelihood of cancellation of coupons. These risks may be highly challenging to model. Though certain risk factors are transparent, e.g., trigger level, coupon frequency, leverage, credit spread of the issuer, and rating of instrument, if any, other factors are discretionary or difficult to estimate, e.g. individual regulatory requirements relating to the capital buffer, the issuers’ future capital position, issuers’ behaviour in relation to coupon payments on AT1 CoCos, and any risks of contagion. A comprehensive appreciation of the value of the instrument also needs to consider the underlying loss absorption mechanism and whether the CoCo is a perpetual note with discretionary coupons (AT1 CoCos) or has a stated maturity and fixed coupons (T2 CoCos). Importantly, as one descends down the capital structure to sub-investment grade where the majority of CoCos sit, the level of precision in estimating value when compared to more highly rated instruments, deteriorates. ESMA believes that this analysis can only take place within the skill and resource set of knowledgeble institutional investors.
Basically, don't dabble in these things unless you know what you're doing.

And don't assume you will make any money from them, either. There doesn't as yet appear to be a satisfactory hedging strategy for them: credit default swaps don't cover AT1s, and hedging with equity is both expensive and of unclear effectiveness, especially for AT1s that don't convert to equity. With all the risks and uncertainties, 6-7% coupon doesn't look that great, really:
In summary you’re looking at an average of 6-7% coupon at issuance for the lowest ranked debt in a bank’s capital structure with risks of failure to pay coupons, extended duration and principal being written down or wiped out completely. 
It is a matter of some concern that the European regulators - and the large European banks - seem to be placing so many of their eggs in the AT1 basket. It may simply be early days, and these instruments will become more stable as the market matures. But I suspect a large part of the problem is that no-one knows how they would behave in a crisis. And until this has been tested in reality, the AT1 Coco bonds will continue to be everyone's favourite football.

Related reading:

Cocos & AT1s - what, who and where? Credit & Macro
Capital requirements - CRDIV/CRR - FAQs - European Commission
Potential risks associated with investing in contingent convertible instruments - ESMA

Sunday, 28 February 2016

HSBC: the Don Giovanni of banks?

HSBC's results were bad. But they could get a whole lot worse. The list of lawsuits they are facing resembles Don Giovanni's catalogue of conquests, as eloquently explained by his accomplice Leporello. Don Giovanni was, of course, eventually sent to hell as retribution for his crimes. Will HSBC, too, be consigned to fire and brimstone? Somehow I doubt it...

My Forbes piece on HSBC's catalogue of lawsuits is here.

And if you like Mozart, Leporello's "catalogue aria" is here. The Italian words and English translation are here.

Monday, 22 February 2016

Don't blame the boomers

From Joe Sarling's blog comes this a lovely chart showing housing affordability by cohort since 1955:

As can be seen, the current generation of young people - Generation Y - faces paying a far higher proportion of their incomes in mortgages or rent than any previous cohort. This does not, of course, take into account the considerable price difference between London and everywhere else: if London were excluded, I suspect their position would not look quite so dire. Nonetheless, this chart is distinctly worrying. Such a high proportion of income spent on housing costs is not remotely sustainable.

But that is not what interested me about this chart. What is far more interesting is who really benefited from the increase in house prices since 1960. Contrary to popular opinion, it's not the baby boomers. It's the cohorts immediately before and immediately after them - Generation X, and (above all) the inter-war generation. Yes, those poor old people who grew up in the Depression and lived through World War II have benefited more from house price appreciation than anyone else. Considerably better, actually.

To be sure, many of the inter-war generation did not own property - at least to start with. The period from 1955-1970 was a period of enormous social housebuilding:

(chart from A Right To Build, Alastair Parvin)

The "cradle to grave" support that the post-war governments (of both colours) offered included a commitment to provide housing to whoever wanted it. So a whole generation grew up believing that they simply had to put down their name on a council waiting list and they would in due course get a house or a flat. To rent, of course. But they could rent it for life. And many of these houses and flats were substantial properties suitable for bringing up quite large families.

It's perhaps not widely known that - unlike the US - the UK did not have a baby boom in the 1950s. The UK's post-war baby boom was in two phases: those born immediately after the war (1946-50), and a second group born in Harold MacMillan's "you've never had it so good" period in the early 1960s. So Joe's chart is rather misleading, bringing together as it does two separate cohorts. I wonder exactly what he means by "baby boomers".

Anyway, the later cohort of "baby boomers" are the children of the inter-war generation. And I am one of them. The inter-war generation, encouraged by the easy availability of social housing and - for those who wanted to buy - low house prices, had large families. My father could afford the mortgage on a three-bedroom house with a garage, in the suburbs of London, on his modest salary as an insurance clerk. His wife, my mother, did not need to work. Which was just as well, as I am the eldest of four and my youngest brother is only five years younger than me. She had her work cut out.

Then came the inflation of the 1970s, and the first of several house price corrections, the Secondary Banking Crisis of 1973-5. The first group of baby boomers - those born after the war - were caught by this. House prices for the first cohort of baby boomers were significantly less affordable than they were for the inter-war generation. But for older people with higher incomes, smaller mortgages and significant equity, they were comfortable. My parents sold their three-bedroom semi for £14,500 in 1976, replacing it with a dilapidated six-bedroom Victorian house for the princely sum of £16,000. It needed work, of course, but the total expenditure on it was probably of the order of £20,000. It was still manageable on my father's salary alone.

But the 1980s destroyed all that.

There was another house price correction in the recession of the early 1980s. But this was followed by an enormous house price bubble. Fuelled by an overheating economy (the "Lawson boom") caused by over-easy monetary policy, and fiscal changes such as the ending of double mortgage interest rate tax relief for couples (signalled a year before it was implemented), house prices shot up. The inter-war generation who had rented social housing were allowed to buy their council properties through the Right to Buy programme. This also pushed up house prices, as the council properties were sold to their occupants at below market prices and then sold on by those occupants in order to turn a quick profit. Easy lending, too, helped feed the frenzy: 100% mortgages made their first appearance at that time, while mis-sold endowment policies enabled people to take on interest-only mortgages in the mistaken belief that an attached life insurance policy would pay the principal at maturity. Twenty years later, this came back to haunt them, as thousands of these policies proved to be worth far less than the mortgages they were supposed to pay off.

For the second cohort of baby boomers, together with those born in the 1950s, this house price boom was a disaster. Not only had the price of houses risen considerably, interest rates were sky-high. The Bank of England's base rate - to which most UK mortgages were tied - was in double digits for much of the 1980s, and by 1990 it was at nearly 15%. Of course older people were paying these rates too, but their mortgages were significantly smaller. The hit to their disposable income was far less. And social housing was no longer an option. The council houses had mostly been sold, and only those who met "need" criteria would qualify for social housing.

By 1988 I was earning more than my father, and I was single with no children. I wanted to buy my own property. But I could not afford a house like the one I grew up in, let alone the 6-bedroom Victorian house into which we had moved in 1976. So I left the suburbs of London, and moved somewhere cheaper. I thought that as my income rose, I would be able to return after say five years. That was twenty-eight years ago.  Beckenham is still home, but - to misquote Robert Louis Stevenson - home is no more home to me. I know now that I will never return to the place where I was born.

I bought my first house in 1988, when I was 28 - the same age at which my father bought the house I grew up in. But buying in 1988 was disastrous. It was the peak of the boom. Lacking a deposit, I had bought my house with a 100% endowment mortgage. A year later, prices crashed. I spent the next seven years in negative equity, unable to move and paying huge amounts in interest on a mortgage whose principal did not reduce (because the tied endowment policy meant it was interest-only).

Joe's chart shows how bad the 1990s housing crash was. It wiped out the net worth of the 1960s baby boomers who bought property in the late 1980s. Because so many of us were in negative equity, we ended up in a worse wealth position than those ten years younger than us - Generation X.

Generation X entered the market when housing affordability was at levels not seen since the 1950s. They bought at the bottom, and then benefited from the record-breaking rise in house prices that peaked in 2006. And though they lost some value in the 2007-8 crash, the house price collapse was nowhere near as deep as that in the 1990s. Generation X have fared well from rising house prices.

But the inter-war generation have fared the best of all. Yes, they lived through the inflation of the 1970s and the high interest rates of the 1980s. But their mortgages were largely paid off by the 1990s, so they were never in negative equity. And despite the crashes of the 1970s, 1990 and 2007-8, overall the period from 1955-2016 has seen a simply enormous rise in house prices. Those who owned property throughout that period have done very well indeed. In 1999, my parents sold the aforementioned six-bedroom Victorian house in Beckenham for £200,000, and bought a three-bedroom bungalow outside London for cash. That bungalow too is now worth considerably more than when they bought it. Even now, the inter-war generation continue to benefit from rising house prices.

So please don't blame the "baby boomers" for the house price appreciation that has made property unaffordable for large numbers of today's young people, They are neither the cause of it nor the principal beneficiaries.

UPDATE. Neal Hudson has produced an amended version of Joe's chart which adds a baseline affordability taking into account mortgage interest rates.  I've embedded it as a tweet so that Neal's comment is visible.
Makes my point even more strongly, I think. And answers some of the comments on this post.

Friday, 19 February 2016

The problem with words

Ah, those pesky words. They do not mean what we think they do. And sometimes we say one thing, but people think we mean another. 

And so it is that David Glasner, in a beautifully crafted takedown of my previous post, has managed to miss my point entirely.

I did, in fact, read carefully all of David's quotation from Ralph Hawtrey, though I did not quote all of it. Hawtrey's point is that what appeared to be destructive competitive devaluation as countries left the gold standard was in fact beneficial loosening of domestic monetary policy. His fishing fleet did indeed all come safely into harbour, eventually.

This was also my point, and the reason why I highlighted Hawtrey's gold standard thinking. Hawtrey understood that in a gold standard system, loosening domestic monetary policy must involve deliberate devaluation versus gold. Indeed in any fixed currency peg system, monetary loosening requires explicit devaluation versus the commodity or foreign currency to which the currency is pegged. As David notes, the problem is distinguishing between devaluation to raise domestic AD (which as a side effect also improves the balance of trade), and devaluation specifically to seize export advantage. It is surprisingly difficult to draw this distinction in practice: the reality is that those earlier into harbour do fare better than the late arrivals, which gives the impression of beggar-my-neighbour policy even if that is not what is intended.

But in a floating rate system, devaluation is a consequence of monetary loosening, not a cause of it. So deliberate devaluation in a floating-rate system would be beggar-my-neighbour policy, even if the stated purpose was domestic AD support. Central banks use weasel words.

However, under either system, there is no sense in which "competitive" can ever be an accurate description of devaluation arising from domestically-focused monetary policy. So Hawtrey was not in fact advocating competitive devaluation at all. His point was that the apparent "competition" was illusory.

My critique of David therefore rested on his apparent advocacy of competitive devaluation, in contradiction of Hawtrey's argument. But David says that was illusory too. Words, again.

The problem with words was brought forcibly home to me in Giles Wilkes' reaction to my post. My final paragraph includes the following sentence:
Of course, if the world were to reintroduce some kind of common currency standard such as gold, we might be able to return to exchange rate targeting as a policy response. 
Giles thought this meant that I was advocating returning to the gold standard. Dear me, no. That is the last thing I would suggest. But reading it back, I can see how my words could be interpreted in that way. What I meant, of course, was this (which you will find in the comments):
I see absolutely no benefit in returning to a gold standard, or to any managed exchange rate system. Some countries do better with a pegged or managed exchange rate, but that is a local decision. But many do better with a free float: for example, the Russian central bank has given a textbook demonstration of the benefits of abandoning a fixed peg for a free float, which others should learn from. I think there might be some value in having an international medium of account (similar to Keynes's bancor), but it should be a floating rate system.
Is it clear now? The sentence Giles took exception to is sarcastic (hence the reference to Mars in the next sentence). As is this phrase that David quotes:
If the US eased monetary policy in order to devalue the dollar support nominal GDP, the relative prices of imports and exports would rebalance - to the detriment of those countries attempting to export to the US.
This is a reference to deliberate devaluation in a supposedly floating-rate system, described as domestic AD support but in fact aimed at creating a trade surplus. Hence the strikethrough. I do not think the US has done this, actually. But I am fairly sure the ECB has.

But beggar-my-neighbour competitive devaluation is not the only form of destructive exchange rate policy, nor even the worst. On Twitter, Iron Economist pointed out that deliberately propping up a currency is every bit as common as deliberately devaluing it. Here, for example, is Winston Churchill, in 1925, justifying a catastrophic decision to return to the gold standard at the pre-WW1 parity on grounds of imperial supremacy:
Thus over the wide area of the British Empire and over a very wide and important area of the world there has been established at once one uniform standard of value to which all international transactions are related and can be referred. That standard may, of course, vary in itself from time to time, but the position of all the countries related to it will vary together, like ships in a harbour whose gangways are joined and who rise and fall together with the tide. I believe that the establishment of this great area of common arrangement will facilitate the revival of international trade and of inter-Imperial trade. Such a revival and such a foundation is important to all countries and to no country is it more important than to this Island, whose population is larger than its agriculture or its industry can sustain, which is the centre of a wide Empire, and which, in spite of all its burdens, has still retained, if not the primacy, at any rate the central position, in the financial systems of the world. 
(quoted in Tony Norfield's book "The City")

Interestingly, Churchill's description of the ships in the harbour all rising together with the tide is the same analogy as Hawtrey used. Yet he was arguing for a strong currency policy, whereas Hawtrey was arguing for devaluation. Metaphors are profligate.

Churchill's decision was roundly criticised by John Maynard Keynes in a pamphlet entitled "The economic consequences of Mr. Churchill", in which Keynes rightly ignored Churchill's imperialist agenda and focused on the domestic effects of a seriously overvalued pound sterling. But this is not the only example of disastrously strong sterling policy. As I showed in this post, the UK is a serial offender, though it has (fortunately) allowed the pound to float freely since its departure from the ERM in 1992. Not that it is alone. Many countries have played the strong currency game, usually with unfortunate consequences. The latest player is China, which has backed away from floating the onshore yuan and is currently holding it at too high a level. I fear this will not end well.

It was, of course, destructive STRONG currency policy of this kind that Hawtrey was really criticising. Many Western countries clung to the gold standard in the teeth of the Depression, to the detriment of their domestic economies and the welfare of their citizens. As countries were, one by one, forced to abandon the gold standard, their currencies devalued, making matters even worse for those still desperately holding on. Consequently, those that left the gold standard early, such as the UK, fared far better than those that remained on it for longer, such as the USA. This has been brilliantly documented by Barry Eichengreen in his book "Golden Fetters".

Anyway, my sincere apologies to David for misunderstanding his point. But perhaps he will acknowledge that he has also misunderstood mine. Deliberate devaluation for competitive purposes is destructive. And words are slippery things.

UPDATE. Andrew Lainton looks at the accounting-identity violation inherent in competitive devaluation. It is not possible for all countries to run a trade surplus: if all try to, then the result is a significant contraction in global trade. And even with trade contraction, someone, somewhere has to run a substantial trade deficit if most of the world is competing for export advantage. That is what I meant when, in my previous post, I said the world is once again trying to cast the USA in the role of consumer-of-last-resort. We do not yet trade with Mars.


Tuesday, 16 February 2016

Competitive devaluation is not a free lunch

It's not often I disagree with David Glasner. Or, for that matter, with Ralph Hawtrey. But I fear I have to take issue with both of them over competitive devaluation. "Bring it on", says David. No, please don't. It's a terrible idea.

Hawtrey's pictorial explanation of why competitive devaluation is a good idea seems both charming and plausible:
This competitive depreciation is an entirely imaginary danger. The benefit that a country derives from the depreciation of its currency is in the rise of its price level relative to its wage level, and does not depend on its competitive advantage. If other countries depreciate their currencies, its competitive advantage is destroyed, but the advantage of the price level remains both to it and to them. They in turn may carry the depreciation further, and gain a competitive advantage. But this race in depreciation reaches a natural limit when the fall in wages and in the prices of manufactured goods in terms of gold has gone so far in all the countries concerned as to regain the normal relation with the prices of primary products. When that occurs, the depression is over, and industry is everywhere remunerative and fully employed. Any countries that lag behind in the race will suffer from unemployment in their manufacturing industry. But the remedy lies in their own hands; all they have to do is to depreciate their currencies to the extent necessary to make the price level remunerative to their industry. Their tardiness does not benefit their competitors, once these latter are employed up to capacity. Indeed, if the countries that hang back are an important part of the world’s economic system, the result must be to leave the disparity of price levels partly uncorrected, with undesirable consequences to everybody. . . .
The picture of an endless competition in currency depreciation is completely misleading. The race of depreciation is towards a definite goal; it is a competitive return to equilibrium. The situation is like that of a fishing fleet threatened with a storm; no harm is done if their return to a harbor of refuge is “competitive.” Let them race; the sooner they get there the better.
The highlight "in terms of gold" is mine, because it is the key to why Glasner is wrong. Hawtrey was right in his time, but his thinking does not apply now. We do not value today's currencies in terms of gold. We value them in terms of each other. And in such a system, competitive devaluation is by definition beggar-my-neighbour.

Let me explain. Hawtrey defines currency values in relation to gold, and advertises the benefit of devaluing in relation to gold. The fact that gold is the standard means there is no direct relationship between my currency and yours. I may devalue my currency relative to gold, but you do not have to: my currency will be worth less compared to yours, but if the medium of account is gold, this does not matter since yours will still be worth the same amount in terms of gold. Assuming that the world price of gold remains stable, devaluation therefore principally affects the DOMESTIC price level.  As Hawtrey says, there may additionally be some external competitive advantage, but this is not the principal effect and it does not really matter if other countries also devalue. It is adjusting the relationship of domestic wages and prices in terms of gold that matters, since this eventually forces down the price of finished goods and therefore supports domestic demand.

Conversely, in a floating fiat currency system such as we have now, if I devalue my currency relative to yours, your currency rises relative to mine. There may be a domestic inflationary effect due to import price rises, but we do not value domestic wages or the prices of finished goods in terms of other currencies, so there can be no relative adjustment of wages to prices such as Hawtrey envisages. Devaluing the currency DOES NOT support domestic demand in a floating fiat currency system. It only rebalances the external position by making imports relatively more expensive and exports relatively cheaper.

This difference is crucial. In a gold standard system, devaluing the currency is a monetary adjustment to support domestic demand. In a floating fiat currency system, it is an external adjustment to improve competitiveness relative to other countries.

But so what, you say? What is wrong with countries competing on terms of trade?

This graph, from Gavyn Davies in the FT, shows what happens to the "last fishing boat into harbour"(to use Hawtry's analogy):

(The 20% dollar appreciation has already happened, by the way: the US$ REER has risen that much in the last 18 months or so.)

Yes, that is a 1% deflationary shock and a 3% or more decline in the contribution of net exports to GDP. As Gavyn explains:
The negative impact of the rising dollar on the level of GDP, relative to the baseline, is surprisingly large and persistent, with a cumulative impact of around 3 percentage points after three years. About half of this effect arrives in the first four quarters after the dollar rise, with the rest coming later.
Importantly, the impact of the higher exchange rate does not reverse itself, at least in the time horizon of this simulation – it is a permanent hit to the level of GDP, assuming that monetary policy is not eased in the meantime. 
And he goes on to explain what the effect on (real) GDP would be:
According to the model, the annual growth rate should have dropped by about 0.5-1.0 per cent by now, and this effect should increase somewhat further by the end of this year. 
Doesn't sound much like a "free lunch" to me.

But of course this assumes that the US does not ease monetary policy further. Suppose that it does?

The hit to net exports shown on the above graph is caused by imports becoming relatively cheaper and exports relatively more expensive as other countries devalue. If the US eased monetary policy in order to devalue the dollar support nominal GDP, the relative prices of imports and exports would rebalance - to the detriment of those countries attempting to export to the US. They have three choices: they respond with further devaluation of their own currencies to support exports, they impose import tariffs to support their own balance of trade, or they accept the deflationary shock themselves. The first is the feared "competitive devaluation" - exporting deflation to other countries through manipulation of the currency; the second, if widely practised, results in a general contraction of global trade, to everyone's detriment; and you would think that no government would willingly accept the third. However, the Fed has permitted passive monetary tightening over the last eighteen months, and in December 2015 embarked on active monetary tightening in the form of interest rate rises. Davies questions the rationale for this, given the extraordinary rise in the dollar REER and the growing evidence that the US economy is weakening. I share his concern.

Hawtrey's "fishing fleet" analogy only applies when there is some kind of buffer that will absorb the deflationary shock. In his day, that was the gold price. These days, it is whichever country has the tightest monetary policy, which at the moment is the US. Though this could change once the Fed realises the world is once again casting the US in the role of consumer-of-last-resort - after all, this didn't end too well last time, did it? Central banks are passing deflation around the world like a hot potato.

Of course, if the world were to reintroduce some kind of common currency standard such as gold, we might be able to return to exchange rate targeting as a policy response. Alternatively, we could trade with Mars. But failing either of those, deliberately manipulating the exchange rate is destructive. In today's floating fiat currency system, there is no such thing as a "free lunch".

Related reading

The trade effect of negative interest rates
Japan's negative rates: the China connection
Let's all play QE - Pieria

Image is of Craster Harbour in Northumberland, UK. Photographed by me in April 2015.

Monday, 15 February 2016

Negative rates and bank profitability

Banks are complaining. "Negative interest rates hurt our margins," they moan. Here's Commerzbank, for example, in its recent results announcement (my emphasis):
Mittelstandsbank attained a solid result in a challenging market environment. The operating profit declined in the 2015 financial year to EUR 1,062 million (2014: EUR 1,224 million), yet remains at a high level. The fourth quarter accounted for EUR 212 million (Q4 2014: EUR 251 million). The full year revenues before loan loss provisions declined to EUR 2.7 billion (2014: EUR 2.9 billion). This development is due in particular to the downturn in deposit transactions, which was driven by the negative level of interest rates on the market as well as the depreciation of a shareholding.
 And here is Danske Bank's CFO Heinrik Ramlau-Hansen, quoted in Bloomberg:
“There are considerable costs associated with negative rates. In 2015 alone, narrowing deposit margins resulted in a cost of more than 2 billion kroner ($302 million)".
Many will not be sympathetic to this. "If they don't want to pay negative rates on deposits at the central bank", goes the popular thinking, "they should lend the money out".

Indeed, individual banks can avoid paying negative rates on excess reserves. They can discourage customers from making deposits; they can choose to hold reserves in the form of physical cash; or they can increase new lending (not refinancing), since the balance sheet result of new lending is replacement of reserves with loan assets.*

But of course the reserves do not disappear from the system. They simply move to another bank, which then incurs the tax. The banking system AS A WHOLE cannot avoid negative rates on reserves. The reserves are in the system, so someone has to pay the negative rate. If banks increase lending to avoid the negative rate, the velocity of reserves increases. It's rather like a game of pass-the-parcel.

Now of course it is not quite that simple. In monetary systems that have required reserves calculated as a proportion of eligible deposits, increasing lending increases the proportion of total reserves that are "required", and thus reduces the proportion of total reserves on which the negative rate is payable. This is true in both the US and the Eurozone. So in these systems, increasing lending IS a way of reducing the impact of negative rates. The ECB says that since negative deposit rates were introduced there has been some increase in lending. Is this due to negative rates, or due to QE, or due to general improvement in loan demand as the economy improves, or due to restored banks loosening credit criteria? We do not know. Perhaps it is all of them.

It seems reasonable to suppose that negative interest rates might increase loan demand. Negative interest rates on reserves put downwards pressure on benchmark rates and thus on bank lending rates, attracting those who would otherwise be priced out of borrowing. But typically those are riskier borrowers. We have just spent eight years forcing banks to reduce their balance sheet risk. Do we really want to force banks to lend to riskier borrowers? Of course, tight underwriting standards could be used to deny those people or businesses loans: but doesn't that rather defeat the purpose of negative rates? It's something of a double bind.

It's also worth remembering that risky assets tie up bank capital. It is not clear that the return from lending to riskier borrowers in a very low-rate environment outweighs the cost of capital required to support them. If it does not, then banks will choose to bear the negative rate rather than increase lending. They might even raise interest rates to borrowers to cover the cost, or pass the negative rate on to certain groups of depositors.

That said, there is a wider market effect of negative policy rates that could benefit banks. Negative policy rates (deposit and funding) depress the short end of the money market yield curve. All short-term rates respond to this, so we would expect most demand deposits to carry a negative rate, along with short-term risk-free securities. The steepening of the curve should improve the margins of all financial institutions that make money from maturity transformation. For banks this is an encouragement to lend longer-term, offsetting the margin squeeze at the short end of the curve. And when the central bank is actively depressing longer-term rates with QE, negative rates could actually protect bank margins by preventing the curve from flattening.

There is a second protective effect for banks, too, pointed out by Bloomberg in the piece cited above:
Fewer customers default on their loans when borrowing costs sink, and that means banks suffer fewer impairments. After writing down 853 million kroner in the fourth quarter of 2014, Danske wrote back 139 million kroner in the final three months of 2015. For all of last year, impairments were just 57 million kroner, compared with 2.79 billion kroner in 2014.
Downwards pressure on interest rates acts as a form of forbearance. But again, we have to consider whether this is what we really want. Do we want banks lending to high-risk borrowers at artificially low interest rates, and reducing provisioning against existing risky loans? What would happen when we raise interest rates again?

But the banks insist that despite all this, their margins are squeezed. And the reason appears to be their own reluctance to pass on negative rates to depositors. Indeed, the Bloomberg piece headlines with "Negative rates costing billions won't hurt clients, says Danske". And it finishes with this:
"Negative rates clearly create a pressure on net interest income for the banking sector, and Swedish banks are not an exception,” according to Uldis Cerps, the agency’s executive director for banks. 
That said, Swedish banks are “better positioned” because of their “good profitability,” Cerps said. That “increases their capacity to absorb further NII reduction.”
So at present, the expectation is that banks will absorb the cost of negative rates. There really is a margin squeeze. Clearly, only stronger, better-capitalised banks will be able to afford this, and they will offer more attractive rates both to depositors and borrowers. For customers, this margin squeeze looks attractive. But for banks, it looks like a cut-throat competitive spiral in which only the strongest - or those with the strongest government backing - will survive.

It also raises serious questions about the relationship of banks to the wider economy. Negative rates are effectively a tax on deposits, and as such are intrinsically contractionary. They are a form of financial repression. As long as banks choose to absorb that tax themselves, those who pay that tax will effectively be bank shareholders and employees. But if banks choose to pass that tax on, it will be savers and borrowers who pay the tax. Would the increased economic activity that negative interest rates may generate be sufficient to offset the effect of this tax?

Alternatively, if we think of negative rates as a monetary operation rather than a tax, we can say that the central bank drains back a small proportion of the reserves it adds to the system through QE. This is monetary tightening. Again, would the increased economic activity generated by negative rates be sufficient to offset this effect?

I do not know. And I do not think anyone else does either. But one thing seems clear. How negative rates would work in practice is no clearer than how QE works in practice. They are experimental, and their effects are complex. Hydraulic monetarist arguments ("if you can get rates low enough the economy will rebound") are simplistic.

I suspect that the principal effect of negative interest rates (especially in combination with QE) will not be to increase bank lending but to depress the exchange rate. And when everyone is depressing the exchange rate, there is an unpleasant race to the bottom and global trade grinds to a halt. We have played this scene before. It did not end well last time. Why do we think this time is different?

Related reading

The strange world of negative interest rates
The liquidity trap heralds fundamental change
Bank profits, negative rates and evidence - FT Alphaville
It was the financial crisis that stopped banks lending, not interest on excess reserves - Forbes
(and see the exchange of comments with Dr. George Selgin
Banks don't lend out reserves - Forbes

Image from Getty Images. 

* Yes, I know banks create deposits when they lend. But for the purposes of this post I have conflated the two steps of lending, which are loan & deposit creation followed by loan drawdown. After step 1, there is indeed a new deposit which balances a new loan asset. But after step 2, the new deposit has disappeared along with an equivalent amount of reserves (asset), leaving only the loan asset.

Friday, 5 February 2016

The trade effect of negative interest rates

Yesterday, HSBC prepared the ground for imposing negative rates on business depositors. This is an excerpt from HSBC's letter announcing the necessary change to the Terms & Conditions of HSBC business accounts:

Now, this requires some explanation. Firstly, the change applies only to BUSINESS accounts. Retail depositors are unaffected. Secondly, it applies only to currency accounts, not sterling accounts. And thirdly, despite HSBC's mention of "negative rates set by central banks including the European Central Bank", the relevant "policy or reference rate" at present is still positive everywhere except Sweden, where the policy rate is currently -0.35%.

Central banks set several interest rates, of which only one is the so-called "policy rate". The policy rate is usually the rate at which the central bank will lend to banks against good collateral: it is the benchmark not only for the interbank lending rates (Libor, Euribor and their relatives), but also for retail and wholesale bank lending rates: for example, in the UK, standard variable mortgage rates (SVRs) are typically priced as base rate plus margin. 

For the US, the "policy rate" is the Fed Funds Rate. For the UK, it is "bank rate" or "base rate". And for the ECB, it is the "main refinancing operations" (MRO) rate.  The rate that HSBC refers to in its letter is the MRO rate. In effect, it is saying that if the MRO rate falls below zero, it may impose a negative rate on Euro deposit accounts held by UK business customers. 

The MRO rate falling below zero is not as unlikely as it sounds. Currently, the Fed Funds target rate is 0.5%, as is the Bank of England's base rate: the Fed raised rates in December 2015, and the Bank of England has just decided to leave the base rate on hold. But the ECB has been progressively cutting interest rates since 2011. As this chart from the ECB shows, the ECB's deposit rate has been negative since June 2014 (this is the "negative rate" that people talk about), though it was recently reduced further. But more importantly, the MRO rate is only just above zero, at 0.05%:

The ECB is widely expected to cut interest rates further because of continued poor economic performance and very low inflation in the Eurozone. Dropping the MRO rate below zero is no doubt one of the options being considered.  

So what is the impact on banks of a negative refinancing rate? Clearly, since policy rates are benchmarks for bank lending rates, it forces down the price of new lending. Currently, banks like HSBC have resisted the temptation to cut deposit rates below zero in response to the ECB's negative deposit rate, because they have been able to maintain their net interest margins by keeping lending rates up. But downwards pressure on benchmark lending rates would squeeze their margins. So HSBC is giving notice that if the ECB pushes the MRO rate below zero, the cost to them of reducing the price of new lending in Euros may be passed on to businesses in the form of a negative interest rate on Euro deposits. 

But hang on. HSBC is a British bank, and the letter has been sent to UK business customers, most of whom have sterling accounts. And these days, foreign currency payments can be made directly to sterling accounts with the bank managing the currency exchange. So who would this affect? 

It would affect any business which is doing sufficient business with the Eurozone to justify having a Euro account. Particularly, businesses which are both exporting to and importing from the Eurozone, perhaps importing raw materials and parts and exporting finished goods. A negative MRO rate would, in effect, be a tax on UK businesses doing business with the Eurozone.

Now it could be argued that if a UK business faces the equivalent of a withholding tax on sales to the Eurozone, this would benefit Eurozone businesses. But if HSBC can apply this tax to its UK clients, so too can Eurozone banks to their Eurozone customers. So I wouldn't bet on this effect, personally. 

It does, however, seem possible that businesses - both Eurozone and foreign - might push the cost on to customers by raising the price of goods and services. This would help bring Eurozone inflation back towards its target. But raising inflation by deliberately increasing business costs is contractionary: it would do absolutely nothing for the Eurozone's chronic demand deficiency. And businesses might choose to absorb the cost by putting downwards pressure on wages and - if possible - supplier prices, by cutting investment and even by laying off staff. They might also reduce dividends to shareholders. Given this, is hard to see how a negative MRO rate would constitute "expansionary policy".

I've argued before that negative rates are not expansionary. At that time, I hadn't thought about the trade effects. But looking at the trade effects now just confirms my view. Negative policy rates would make the Eurozone's economic performance worse. Don't go there. 

Related reading:

Monday, 1 February 2016

What they really want

As Henry Tapper puts it, today is WASPI day. Today is the day that "Women Against State Pension Inequality" get the Westminster debate for which they have campaigned.

Eh, wait? Wasn't there a debate on this back in early January?

Yes, there was. It was a backbench motion proposed by the SNP MP Mhairi Black. It called on the government to re-examine the acceleration of the equalisation of women's and men's pension ages in the 2011 Pensions Act, which added up to 18 months to the state pension age of some women born in the 1950s:
That this House, while welcoming the equalisation of the state pension age, is concerned that the acceleration of that equalisation directly discriminates against women born on or after 6 April 1951, leaving women with only a few years to make alternative arrangements, adversely affecting their retirement plans and causing undue hardship; regrets that the Government has failed to address a lifetime of low pay and inequality faced by many women; and calls on the Government to immediately introduce transitional arrangements for those women negatively affected by that equalisation.
The motion was carried by 158 votes to zero, a remarkable achievement for Black, the youngest MP in the House of Commons. But the Government is not bound to take any notice of it, and so far has declined to do so.

And it wasn't what WASPI wanted anyway. They are not really interested in the 2011 change. Their aim is much larger: payment in lieu of pension at 60 for all women born between April 1951 and December 1959 whose pension age has risen as a consequence of the 1995 and 2011 Pension Acts. This is why they continued to drum up support for their petition even after Mhairi Black's motion was carried unanimously.

On Monday last week, in an interview on BBC2's Victoria Derbyshire show, one of the WASPI women, Wendy Eachus, made a heartfelt case for the state pension to be paid from her 60th birthday.  She described how her dream of stopping work and visiting her family in Australia and Canada had been shattered. In her words: "I wanted to do some travelling and enjoy life a bit while I'm still fit enough to do so".

The following day, Simon Read, in the Independent, wrote a sensible piece particularly highlighting the plight of women affected by the 2011 change and women born 1951-3 who will not qualify for the new State Pension. He featured Wendy's interview.

But there's a problem. Wendy Eachus was born in 1956. She is not one of those affected by the 2011 change. And when she reaches her state pension age in 2022, she will receive the new State Pension. Simon Read's piece is not about her. It just shows how confused the whole subject is that a good journalist like Simon Read managed to miss this.

By choosing Wendy Eachus to front this interview, WASPI shot themselves in the foot. They inadvertently revealed their real aim on mainstream media. No more could they pretend that this was about "fair transitional arrangements" for those caught by the 2011 change. No, it is all about the 1995 equalisation of mens' and womens' pension ages, which affects younger women more than older ones. Wendy herself made it clear that she wants the pension at 60 to which she believes she is entitled.

In her briefing to today's debate, the Pensions Minister, Ros Altmann, summarises the WASPI demand thus:
The Debate is about the WASPI petition, claiming to call for ‘transitional arrangements’ for 1950s women whose state pension age has increased from age 60. These so-called ‘transitional arrangements’ actually call for all 1950s women to be paid their state pension from age 60. They are effectively and unequivocally asking Government to reverse the women’s pension age changes of the 1995 Pensions Act not just the 2011 Pension Act. This would give thousands of pounds to each of these women. 
It is fair to say that this aim is not clearly expressed in the petition, which simply calls for "fair transitional arrangements" for women born in the 1950s:

But it is pretty clearly stated on their Facebook page:

More importantly, it was explicitly stated by Anne Keen, one of the co-founders, in her verbal evidence to the Work and Pensions Committee:
"Basically, what we are asking – and we feel this is a very fair ask – is for the Government to put all women in their 50s born on or after 6 April 1951 and affected by the state pension age in exactly the same position they would have been in had they been born on or before 5 April 1950.  …all our lives we expected to receive our pension when we were 60...Although there was not a written contract as such there was a psychological contract."
Ros Altmann appears to be correct. Putting all 1950s women into the financial position that they would have been in had they been able to claim their state pension on their 60th birthday, as women born prior to 5 April 1950 did, is equivalent to rolling back the state pension rises in the 1995 and 2011 Pension Acts.

But WASPI have repeatedly denied that this is the correct interpretation. They claim to support equalisation of womens' and mens' pension ages. They insist that the issue is inadequate notice, and that the demand is for "fair transitional arrangements", not repeal of the 1995 and 2011 Pension Acts. And they've convinced a lot of people. Over 135,000 have signed the petition.

The 1995 Act included transitional arrangements. It delayed the start of the equalisation by 15 years so that women had adequate time to prepare. And it provided for women's pension age then to be raised gradually over the course of 10 years, from 2010-20. All women born prior to April 1950 would retire on their 60th birthdays, but for those born from April 1950 to March 1955 the SPA would rise by one month in two. All women born from April 1955 onwards would retire at 65.

The 2011 Act accelerated the 1995 change for women born 1953-4, and added an extra year for those born September 1954 onwards. They will now retire at 66, not 65. Wendy Eachus was sent a letter about this change. The trouble was, she didn't know about the 1995 change, because DWP communication was - to put it mildly - inconsistent. So to her, this letter told her not about a 1-year increase, but about a 6-year one.

The DWP says that "all women were written to". This is now true for 1950s women, though not yet for younger ones: most women born in the 1960s and 70s, whose pension age was 60 when they started work, still have not been written to about the rises. But the DWP's statement misses the WASPI point about notice. Receiving a letter telling you that your state pension age has effectively risen by six years when you are less than two years from the state pension age that you expected is a terrible shock, and for some women will have caused financial as well as emotional distress. It is unfair to blame women for DWP communication cock-ups.

WASPI argue that the 1995 transitional arrangement was "unfair" because it was not properly communicated.  In response to this, WASPI are demanding not the repeal of the 1995 Act, but the elimination of the transitional arrangements put in place in 1995 and amended in 2011. Would this create "fair transitional arrangements"?

If the WASPI demand were met in full, all 1950s-born women would in effect receive their pensions as if entitled to them on their 60th birthday. No doubt they would regard this as "fair". But women born in 1960 would not receive them until their 66th birthday. So a woman born on 31st December 1959 would receive the equivalent of six years' more state pension than her classmate born 1st January 1960.

The original transitional arrangements were designed to prevent severe cliff edges like this: even the 2011 acceleration did not create anything as sharp as this. The cliff edge that the WASPI demand would create if met in full is clearly shown on this chart from Suzy Allbright:

The truth is that the WASPI demand is not for "fair transitional arrangements". It is for NO transitional arrangements. And it is grossly unfair to women born in early 1960, who would not only receive six years' less pension than their classmates but would have to pay higher NICs and taxes to fund the extra payments to their peers. So WASPI want to stiff their younger sisters. Nice.

What about the WASPI claim that they support equalisation of state pension ages? Indeed they do - for the same group of slightly younger women. Under the WASPI plan, a woman born 1st January 1960 would receive her state pension at the same age as her male classmate born the same day. But a woman born 31st December 1959 would effectively receive her state pension SIX YEARS earlier than a man born the same day. So WASPI support equalisation, but for their younger sisters, not for themselves.

As Ros Altmann puts it in her briefing to the debate today, "They call their campaign ‘Women Against State Pension Inequality’, but its demands could perhaps be more accurately described as ‘Women Advocating State Pension Inequality’ ".

It is abundantly clear that rolling back state pension entitlements cannot happen, not least because it is horrendously expensive. The estimated cost of effectively restoring state pension at 60 for 3.7m women born in the 1950s exceeds £100bn, and could be double that if EU equality law means that the same payments have to be made to 1950s-born men as well. However angry women are about lack of notice, it is very hard to see how such indiscriminate payments irrespective of need and regardless of the cost to younger women and men can possibly be justified.

But that does not mean that the needs of those who face hardship because of these changes should be forgotten. Few people would disagree that the DWP should act to relieve distress caused by their communication failures. The question is what form that relief should take. Personally I think this should take the form of adjustments to working-age benefits - for example, removing jobsearch conditionality and sanctions for women and men over 60 who are claiming JSA and ESA, and relaxing the taper so that they can keep more of their savings.

When the WASPI campaign fails, as it inevitably must, it is important that this debate keeps going.

UPDATE. Since there seems to be quite a lot of confusion about the effects of the 1995 change and the 2011 acceleration, I am posting here a handy guide to retirement ages, courtesy of Ros Altmann.

Please note that I will not provide links to the WASPI petition or any WASPI source material. I will also remove any such links added in the comments. 

Related reading:

The angry WASPIs

Here I stand, I can do no other