Cleaning up the mess

In my post on the anatomy of a bank run, I suggested that the rule should be "provide central bank liquidity support to everything, taxpayer support to nothing". This is because in a bank run/liquidity crisis, it isn't realistically possible to distinguish between those institutions that are suffering from a disastrous shortage of liquidity and those that are actually insolvent. Financial institutions that are both liquid and solvent prior to the crisis can quickly become illiquid as markets freeze and they are unable to borrow to meet commitments, then insolvent as asset prices collapse due to fire sales in the desperate search for cash in the absence of market funding. Stopping the run is the top priority, and that means providing liquidity. Since insolvency is difficult to distinguish from illiquidity when markets have frozen and asset prices are in freefall, Bagehot's Dictum cannot apply. Central banks should simply supply unlimited liquidity to anything and everything until the run stops. And they should do it early. Leaving it until asset prices are collapsing is too late.

We should not need direct government intervention in the form of guarantees, loans and equity stakes to stop bank runs. But when the run stops - and if central banks provide enough support, it will - then what remains will be the most almighty mess. This is where governments come in. It is not their job to stop the run. But it is their job to clear up afterwards.

The aftermath of a major bank run/market panic resembles the end of a battle. The floor is littered with bodies. Some are dead and need to be disposed of. Others are still alive, but mortally wounded. Still others are seriously wounded but could recover with appropriate treatment. And there may be a lucky few that appear to have escaped virtually unscathed - but they may have unsuspected internal bleeding that causes them to collapse later on.

Sorting out the dead from the alive, despatching the nearly dead and administering field surgery to those with some hope of surviving is dirty work. And governments are abysmal at it. They keep alive the mortally wounded, fail to do necessary surgery on the injured and - most bizarrely of all - resurrect the dead. All too often the result is a population of zombies. And as anyone who has watched Night of the Living Dead knows, zombies are high maintenance. They drain the life out of the economy living creatures with their seemingly insatiable appetite for human - well, in this case we can say "activity". Or "money", upon which much productive activity depends. When financial institutions are badly damaged they soak up money like sponges, draining the real economy to keep themselves alive while giving nothing back. Actually, so do damaged corporations if they get the chance. It isn't just financial institutions that can be seriously damaged by a financial crisis. Japan's zombie corporate sector was propped up for years by its equally zombie banks. And the US bailed out General Motors in 2008.

Anyway, the point is that the mess left after a financial crisis seriously needs cleaning up so it doesn't cause long-term damage to the economy. This post is an attempt to put together a blueprint for what should be done.

The first thing to note is that worthy though this appears to be, introducing layer upon layer of regulation and intrusive supervision in the hope of completely preventing financial crises is not realistic. There will always be financial crises. Indeed it could be argued that periodic financial crises are necessary in a well-functioning financial system. If we consider the financial system as a living thing - after all it is a system created from the actions of living things, so it might be expected to behave much like a living thing itself - periodic expansion and contraction of credit can be regarded as the financial system "breathing". Attempting to prevent this squeezes risk-taking out of the system, and risk-taking by financial institutions is essential to the economy - that is how investment capital is provided to businesses, enabling them to grow. If financial institutions are prevented from taking any risk at all, the result is slow economic death. Suffocate them with regulation and supervision, and you turn them into zombies.

This is not to say that regulation and supervision is not necessary: but we do have to consider how much is "enough". We don't want to turn bankers into box-tickers, so busy complying with a myriad rules that their real job of risk analysis and management is neglected. An over-regulated bank is either useless (because it can take no risks) or dangerous (because it doesn't understand the risks it takes). I would be the first to agree that there was insufficient regulation and supervision prior to the 2008 crisis: but I think we are now in danger of going too far the other way, coming up with piles and piles of new regulations but not actually addressing the real issue - which is how we manage, rather than prevent, financial crises.

If we accept that financial crises are inevitable, the question is firstly, what do we need to protect from the worst effects of financial crisis, and how should we do this? And secondly,  how do we go about cleaning up the mess? Or better, can we minimise the amount of mess that financial crises create, while still allowing them to happen?

Much of the mess arising from financial crises is caused by the interconnectedness of the financial system. A bank run such as happened in 2008 is only possible because of the extensive interconnections between banks, shadow banks and corporations. So there have been suggestions that interconnectedness should be reduced. But this is idiotic. It is that very interconnectedness that makes the financial system vibrant and dynamic, enabling it - when working well - to support the wider economy.

pando-trembling-giant (2)Financial institutions are like aspens: they appear separate, but in fact they are all part of one single organism. Cut an aspen off from the rest and it will wither and die. Reduce the interconnectedness of the financial system and you reduce its effectiveness as a monetary transmission mechanism to the wider economy. The question should not be how to reduce the interconnectedness of the financial system, but what parts of it do we wish to protect from the effects of a bank run/market panic, and how should we go about this?

As a general rule, it is the parts of the financial system that circulate money that must be protected at all costs. These are the payments network (including transaction accounts), the interbank funding network and the central bank itself. Once these are protected, commercial financial institutions can and should be allowed to fail, as I shall explain.

In a modern developed economy the payments network is the lifeblood of the economy. If it breaks down even for a few hours, the economy comes to a shuddering halt, causing untold damage to households and businesses. In a bank run, payments systems come under considerable strain, simply because of the very large and unstable flows of funds that go through them as deposits are withdrawn. But perhaps more importantly, the payments network is dependent on the banks that administer it remaining upright. When RBS failed in the UK the payments network nearly went down with it. We have to make it possible for a clearing bank to fail without bringing down the payments network. The heart of "too big to fail" is "can't let the payments network fail".

I am personally in favour of detaching payments systems from commercial banks. I don't have a problem with payments systems themselves being privately owned and administered, but they should not be dependent on banks. There should be a common payments gateway utility, available to all banks but not owned by them or dependent on them.

But isolating the payments network is not enough. If a clearing bank fails, a lot of people lose access to transaction accounts. The payments network may still be working, but those people can't make or receive payments. Deposit insurance, certainly in Europe, does not pay out fast enough to protect those people. They need emergency lines of credit, either at other banks or as a last resort at the central bank. When there is a financial crisis, businesses and households need a lender of last resort so that we don't have to keep dead banks alive.

I don't see a problem with central banks providing this facility. There is no reason why liquidity support should only be available to financial institutions: if other businesses and households are distressed as a consequence of financial system problems, the central bank should provide them with liquidity too. It's all about maintaining the flow of funds around the economy.

This brings me to the final part of the "plumbing" that must not be allowed to fail - and that is the funding mechanism for financial institutions, both banks and non-banks. This is the heart of my argument that in a crisis central banks should provide liquidity to everything. When financial institutions can't fund themselves they fail in a disorderly fashion, causing asset price collapse and widespread insolvencies. Central banks can prevent this by maintaining the flow of funds around the financial system even at the height of a widespread bank run.

In fact financial institutions fail all the time, but they don't normally cause a crisis despite being critically interconnected with others. Like aspens, they can die without harming the whole plant. They are quickly and easily resolved, either by being wound up and their assets distributed, or by being taken over by other institutions. But in a financial crisis the extent of failures may be much greater and the whole plant is under stress - hence the need for the central bank to support the "root", and for the central bank itself to have the backing of its government. My statement "taxpayer support to nothing" actually meant "nothing except the central bank". Yes, I know that central banks can continue to provide liquidity indefinitely even if they are technically insolvent. But markets don't necessarily believe that, and financial crises are essentially failures of market confidence. If asset prices fall so low that the central bank's solvency is at risk, an explicit commitment from government to recapitalise it if necessary may be needed to prevent further market panic.

So if the plumbing - the "root" - of the financial system is isolated so it cannot fail in a crisis, can individual components be allowed to fail in a crisis as well as under more normal circumstances? And if so, how do we go about this? In a crisis, takeovers may not be possible or desirable - some terrible mistakes have been made with forced takeovers. But that doesn't mean windups aren't. Just as dead aspens are a source of nutrients to live ones, so the assets of dead banks can help to revitalise living ones.

So we survey the battlefield after the run has stopped. The first priority is to identify which financial institutions are actually dead. This is not as easy as it sounds. When the place is flooded with liquidity, banks may look alive when they are actually dead. Liquidity can also disguise mortal wounds, in much the same way as blood transfusions can prolong life when there is undiscovered internal bleeding due to catastrophic damage to vital organs. One of the biggest problems in Cyprus was that the Eurosystem had provided liquidity to Laiki bank for far too long and almost certainly in breach of its own rules: Bagehot must have been turning in his grave. There is no real doubt that Laiki was rendered insolvent by the Greek debt restructuring in March 2012. But it was not allowed to die for another year. By keeping it alive, the Eurosystem increased the indebtedness of the Cypriot banking system - a debt which had to be made good by increased haircuts on large deposits at Bank of Cyprus. And it also made the eventual windup of Laiki bank more traumatic, because people believed that it would be bailed out. It would have been better if it had been allowed to fail a year before.

Regulators need to be able to recognise when a financial institution is actually dying or dead. It is kinder to cut off liquidity support sooner rather than later. We need the equivalent of a Liverpool Care Pathway for financial institutions, so we don't prolong life unnecessarily and expensively. Regulators should examine the accounts of all financial institutions that remain dependent on liquidity support after a bank run has stopped or other catastrophic failure been resolved, and close down any that are unable to bring their capital levels up to minimum standards. A bank that cannot raise even minimum levels of capital isn't worth saving, however long it has been in existence. There is no room for sentimentality on a battlefield.

But what about banks and financial institutions that are wounded but viable? Should they be simply allowed to continue as before? Well, no. If they are wounded they need treatment, possibly including radical surgery. A damaged bank is damaging to the economy, which itself is also damaged by the crisis. We cannot afford the time for banks to heal themselves, and if left to their own devices they may never do the necessary surgery at all. So once again it is up to regulators to determine "treatment plans" for banks and financial institutions that are receiving liquidity support but meet minimum capital requirements. This might simply be a question of imposing conditions, such as requiring them to raise more capital or retain earnings until capital levels are restored. Or it might require more radical action such as stripping out portfolios of toxic assets and disposing of them, perhaps by means of a state-backed "bad bank". This needs to be done quickly. The approach taken by the UK, whereby damaged banks retained large amounts of toxic assets on their balance sheets and unwound them over a period of years, was very damaging to the economy. Damaged banks don't lend productively to the economy - they are not in a position to take on more risk since their balance sheets are already very risky. RBS, Lloyds/HBOS, HSBC, Barclays, Nationwide and - we now know - the Co-Op (or rather, Britannia Building Society) all should have had their toxic assets stripped. Had this been done in 2008/9, the UK economy might now be in a very different shape.

But how do we prevent financial crises being so catastrophic anyway? Key to this is of course my suggestion that central banks should provide liquidity support to EVERYTHING - not just banks,shadow banks and other financial institutions, but if necessary businesses and households too. This maintains the flow of funds in the economy and prevents serious damage due to liquidity failures in various sectors. But looking beyond that, we should seek to prevent widespread die-off among our aspens. After all, if a plant loses a lot of its top growth it is weakened and less productive.

The key to this is capital. I'm sorry, but it is. The fact is that the more highly leveraged a financial institution is, the more likely it is to fail in a financial crisis. I've already said elsewhere that I think a leverage ratio should be used in conjunction with a risk-weighted capital ratio to determine minimum capital levels. I'm actually in favour of two capital requirements - an absolute minimum below which a financial institution would simply be closed down, and a "standard" level below which a financial institution would be regarded as in "special measures" (as the Parliamentary Commission on Banking Standards put it). Financial institutions whose capital is below the "standard" would be banned from issuing dividends and bonuses until capital levels were restored, and could be encouraged to raise capital by other means such as rights issues. There is considerable debate at the moment about how much capital banks should have, ranging from Matthew Klein's idea that all lending should be backed by capital not debt, Miles Kimball's suggestion of 30-50% equity to total assets, Anat Admati's minimum 25-30% equity to total assets (she recently said she would prefer 40%), to the IMF's recent suggestion that all of that is overkill and a figure of 9% equity to total assets would be enough. Clearly there is room for considerable debate, but at least everyone is agreed on one thing - the paper-thin ratios of the past cannot be allowed again. I would venture to suggest that maybe the IMF's figure could be used as my "minimum" below which an institution would simply be closed down, and a "standard" figure could be much higher. I would also suggest that both the "standard" and "minimum" figures would need to be determined according to the needs of the supporting economy: for example, both would need to be higher in a small economy with a large financial sector (such as the UK) than in a large economy with a relatively smaller financial sector (such as the US).

And finally. Even with unlimited liquidity and higher levels of capital, it is still conceivable that there could be a financial crisis that leaves virtually all of a country's banking sector in "special measures" - weakened and with limited lending capacity. Stripping bad assets out and forcing banks to increase capital helps to minimise this effect, but there could still be a need for direct reflation of the economy, bypassing the damaged institutions. Central bank liquidity support to households and businesses may have to morph into government financing of households and businesses. In the UK we are heading fast down that road: the Government is already providing funding to businesses via a range of different initiatives (although there are huge problems getting this funding to the businesses that need it, not least because Government is useless at communicating), and now some households are receiving help too through the Help to Buy scheme. The problem is that once Government starts offering direct assistance to businesses and households, it is very difficult to withdraw it once banks are restored to health. I can't help feeling that if Government had fixed the banks as I suggest four years ago, much of this direct support of businesses and households would not have been necessary.

Related links:

Anatomy of a bank run - Coppola Comment
Mortgages are dangerous beasts - Coppola Comment
What Glass-Steagall 2 gets wrong: Everything - Matthew Klein (Bloomberg)
The bankers' new clothes - Anat Admati & Martin Hellwig
Anat Admati, Martin Hellwig & John Cochrane on Bank Capital Requirements - Confessions of a Supply-Side Liberal
How much capital should banks have? - Lev Ratnovski, IMF (Vox)
Changing banking for good - Parliamentary Commission on Banking Standards (pdf)
Night of the Living Dead - YouTube (video)
Pando, the single largest living organism on earth - Amusing Planet

I am indebted to Heidi Moore for the "aspens" idea.


  1. “Provide central bank liquidity support to everything, taxpayer support to nothing". A sleight of hand, I suggest. If a CB creates money out of thin air and gives or lends it banks, it could just as easily have given or loaned it to ordinary householders, i.e. taxpayers. Or to put it in economics jargon, everything has an opportunity cost. I.e. the cost of the above printing is in effect born by ordinary citizens / taxpayers.

    Most taxpayers have tumbled to the fact that they've been fleeced so as support banks. And for anyone who wants the full details on that point, I recommend Mark Blyth's book, "Austerity - the hsitory of a dangerous idea".

    “introducing layer upon layer of regulation and intrusive supervision in the hope of completely preventing financial crises is not realistic.” There is actually a phenomenally simple way of stopping bank runs, and all without any need for complicated regulation. In fact I can spell it out in nine words: make it illegal for banks to issue runnable liabilities.

    That is, if the only liabilities that banks have are shares or quasi-shares, then there is no reason for a run. Or to put that in the words of George Selgin, “for a balance sheet without debt liabilities, insolvency is ruled out”. That’s from the passage of his book “Theory of Free Banking” where he sets up his ideal hypothetical banking system. The book is free online.

    1. Hi Ralph,

      You're in Matthew Klein's camp - 100% equity backing for all lending. I did discuss this in the post. Personally I think it's overkill.

      I've read Selgin's book and heard him speak. He's impressive about the liabilities side but much weaker on lending. I don't really agree with him, but then I don't agree with Austrian economics much so that's not surprising.

    2. Frances,

      You say “I am personally in favour of detaching payments systems from commercial banks.” So am I. Or to be exact, I think that entities which administer payments systems should be separate from lending entities - (whether either of them are called “banks” is immaterial.)

      But you then say “But isolating the payments network is not enough. If a clearing bank fails, a lot of people lose access to transaction accounts.” Why? If the “transaction account” entities are separate from the lending entities, then the failure of a lending entity won’t be a problem for the “transaction account” or “payment system” entity, seems to me.

      I agree that I’m in the Matthew Klein camp, and that that puts me at odds with the IMF author’s claim that high equity levels are “overkill” as you put it. Plus I agree that there is “room for considerable debate” there. I’d put it differently: I think that equity level question is the CRUCIAL question in this debate.

    3. I suspect I just asked a silly question there: namely why would failure of lending entities impinge on transaction entities. Your answer (the one you set out in a previous post) is presumably that the large amount of money swilling around when everyone runs from lending entities causes chaos in transaction entities.

    4. Ralph,

      If all assets are 100% equity backed, where do the deposits go? Are we going to set up banks that lend nothing and hoard deposits?

      I also hope you realize that bank runs are as much a problem for the asset side as they are for the liability side. And that save for short-term funding and deposits, the majority of liabilites are not immediately redeemable or "runnable" as you put it.

    5. 100% Equity backed will simply never work out because it does not provide for the right risk/reward metrics

    6. That will lead to a collapse of current system. Also, many bank asset (i.e. loans) are reypothecation over and over in the system and there just isn't enough equity to back all these lending even if all the bank credits are converted into equity.

      There are about £2T M4/Broadmoney and RBS balance sheet alone is about £1.4T and the entire banking sector's balance sheet is about £10T+ (foreign asset included).

      A ponzi scheme cannot stop obviously.

  2. For every financial analyst who doesn't see much common ground with the Austrians, there's an Austrian who fails to see how centrally planned economies (and now financial markets) can possibly work. I suspect these alternate poles can and will never be reconciled.

  3. Why does Central Bank solvency matter? Surely a CB cannot go bankrupt in the same way that a private company can?

    1. There is a huge debate among the economics profession about whether central bank solvency matters. My view is that whether central banks are solvent matters not at all if their goverments stand behind them. But a central bank whose government refuses to back it (or is unable to because of an extremely weak fiscal position) is in deep trouble, because it is effectively then no different from the private institutions that it is mandated to support.

    2. Hi Frances, Obviously BoE can always repay a £ based debt. It is just numbers in the CHAPS payment system.

      Just imagine if BoE cancelled all the QEed bonds (and hence make a 'loss' on them) - will it cease to operate? Obviously not, it is just another day although then the price level will begin to rise to absorb the 'free cash flow'.

      Its constrained is when the people reject the currency although the threshold is pretty HIGH as the government demands payment of taxes in the currency.

    3. To add to cancel the QE bond bit... it is not as if BIS (or PRA or the Treasury) will come knocking on BoE's door telling them to leave the building.

  4. A few comments:

    1. The "zombie banks" in Japan (actually the phrase was coined in the S&L debate) didn't behave in quite this way. Before this crisis, a "zombie" bank meant one that had negative economic value of the equity and therefore no incentive to do anything other than gamble for redemption - ie, the problem with zombie institutions was that they made too many high-risk loans and acquisitions, not too few. I also strongly disagree that the concept of a "zombie company" in the nonfinancial sector really makes any sense at all and have never seen a really convincing definition of what might constitute one. Capital isn't "tied up" in companies that are less profitable than some arbitrary standard (any more than it's "held" by banks), and there is no process whereby the bankruptcy of a Northern tinbasher during a recession creates a vibrant new startup in Shoreditch, let alone one which employs more people.

    2. The lending drought in the UK after the crisis wasn't really caused by balance sheet overhang - it was caused by policy. The UK banks, from about 2010 onward, actually had pretty good balance sheets by a) the standards prevailing before the crisis and b) the standards implemented in Basel 3, given the transition arrangements. But the FSA/PRA decided to accelerate the enforcement of the standards, out of some belief that the problem was urgent. Then in 2012/13, after the banks had achieved the standards, they invented a new leverage ratio standard (significantly more conservative than the Basel one) and accelerated the implementation of that too. Nobody has ever really explained why this act of pro-cyclical capital regulation was carried out, or how it might be thought to be consistent with the FPC's remit to carry out countercyclical policy.

    3. Totally agree that any bank which hasn't got a private sector funding model hasn't got a business, but would think that nationalisation and/or recapitalisation-by-bail-in is a better solution than closing it down in most cases. In general, winding up a bank is a really expensive and nasty process that should always be avoided.

    1. Oh yes. The Basel III thing should have been in forced at 2003, not 2010/11/12/13.

      As for lending, just exactly what percentage of the household, private equity, developers will remain solvent at say a 4% base rate and a prime lending rate of say 6 - 7% (2-3% bank margin) ?

  5. continuing, like the verbose loon I am ...

    4. I think Laiki is about the only case I can think of where the "bayonet-the-wounded" approach to dealing with economically insolvent institutions was the better approach, because in general, banking problems get better if given time, not worse. As I say, the UK isn't such an example, because their capital shortage was policy-created. Also, we need to think about the dynamic effects on bank runs and stability - if the early windup process became the norm, then you would expect to see a lot more bank runs.

    5. As Paul Tucker pointed out in his speech recently, your two thresholds of "action" and "closedown" correspond quite well to low- and high- trigger CoCo instruments, so it is possible to build a "second chance" at each level into the capital structure. I really don't understand why people like Anat Admati and Robert Jenkins are so hostile to CoCo and they seem to make really weak arguments that are just based on a dislike of (not really very) complicated securities.

    6. Your point on central bank support of everything is really important and a lot of the banking reformers should take it much more seriously. At the heart of it, the key point is Duncan Watts' central point from network theory - that it's more or less impossible to build a useful network which doesn't have a "giant component". I really worry that a lot of reformers are going to end up creating a massive shadow-banking industry that they will pretend has nothing to do with them when it catastrophically blows up.

    7. One point about requiring very high equity backing for lenders (particularly 100%!) is that it suffers from the "zombie banks can't lend" problem to very very great extent. If you wipe out a load of the equity of a system structured along those lines, you've damaged the capacity to fund a recovery much more than you would if the system had some flexibility in its use of leverage. As far as I can tell, Matthew Klein and Admati & Hellwig make an assumption that more equity can always be raised from the capital markets, but as someone who has actually been involved in trying to get rights issues away for a bank that has just declared massive losses, I think that the comparatively small amounts that were done in 2009-10 were the absolute chilly limit of what could have been achieved.

    1. Dan,

      Great comments.

      1) The "zombie" definition has changed, I think. Zombie banks may take excessive risks, or they may take no risks at all. Either way they are useless and damaging to the economy.

      Regarding corporations - if you think back to the glorious 1970s, part of the problem was companies which could not compete internationally being propped up by public money in order to preserve jobs (remember British Leyland?). While that is a laudable aim, it isn't economically helpful in the longer term. I would call those companies zombies, personally.

      2) King was openly in favour of "narrow banking", which is 100% backing of deposits by safe assets. This was rejected by the Vickers committee in favour of ring-fencing and increased capital. I suspect King pushed higher capital requirements hard as a "next best" option having failed to get what he really wanted. That certainly seems to be Vince Cable's view, with his recent comments about "capital Taliban".

      3), 4) I agree that temporary nationalisation may at times be a better option windup. But we should not rule out winding up a large bank. I don't like the idea that dead banks must be resurrected. The hard fact of commercial life is that wrecked companies die. If we always rescue them, we diminish their commercial status and turn them into quasi-state organisations. That is true both of financial and non-financial companies.

      5) I don't have a problem with CoCos provided that the legal circumstances under which they convert to equity are clear. I wrote a post recently in which I argued that making legal provision for bailing in unsecured creditors, as the European Bank Resolution Directive will do, in effect creates much larger capital buffers in banks because it turns large deposits and senior bonds into subordinated debt.

      6) I'm glad we agree about central bank support for everything. Really that is the key message of this series of three posts. Providing liquidity support to some but not others in a crisis just makes the crisis worse and causes more damage to the economy. I don't think enough people are talking about this - they are concentrating too much on capital.

      7) The battle between "max capital" and "min capital" proponents will run for quite a while, I think. There are pros and cons to both arguments. In suggesting two capital requirements I was trying to find a compromise position. I do think it would be better if banks had more shareholders' funds, but as you say raising it is not necessarily that easy, especially in the aftermath of a crisis when no-one wants to invest in damaged banks. Actually mutuals have an even bigger problem since they can't easily raise equity in the capital markets due to their ownership structure. I think that's why Nationwide has been given longer to meet the enhanced capital requirements than the banks.

  6. Certainly the recent complaints that the capital requirement of 3% is to harsh seem unfounded.

    I think one was of looking at the bank security issue is that credit is now so ubiquitous that collateral prices are created by the credit system that they are supposed to be supporting, and so collateral no longer performs its role of being something of value independant of the loan transaction. When the collateral is actually required in a credit crisis the colateral evaporates along with the credit.
    So how about making evaluations of collateral more reallistic.

  7. How can you differentiate the Central Bank from the taxpayer? For each dollar created by a CB, the rest of the dollars are worth proportionately less. This is a tax, plain and simple. I'm not saying there aren't times when that is appropriate - there are. But you cannot pretend that a CB supporting banks is somehow not impacting the taxpayer. It's a clever illusion.

    1. That's incorrect, I'm afraid. Increasing the amount of money does not necessarily change its value. It depends on the demand for money.

      The definition of a liquidity crisis is excessive demand for cash (hence fire sales of assets to obtain cash). Therefore central banks' cash creation in a crisis cannot itself devalue the currency. However, the exchange rate may fall if investors reject the currency because of the crisis.

      The fiscal backstop for central banks is required because they will be accepting as collateral assets whose price may fall rapidly.

  8. It’s not impossible to distinguish insolvency from illiquidity, even in a crisis, but it takes some hard work and, most important, the political and ideological will. No bank will show up as insolvent if you allow it to risk-weight its own assets and the same time those control the data are in danger of losing their jobs, bonuses, and stock. But to carry your aspen analogy forward, an orderly rapid resolution process is vital to stop the rot from spreading. A simple, objective debt to equity ratio is probably the most practical choice for regulation: cross this line, and it’s game over, no exceptions, no matter how “systemic” you say you are.

    1. A debt to equity ratio is really not "simple" or "objective" and anyone who thinks it is probably ought to wait a bit before taking over the reins of regulation. The numbers you see on the balance sheet are, every bit as much as the risk-weighted numbers and for the same reasons, the product of an awful lot of subjective judgement and assumptions.

  9. I think we can date the death of the current market paradigm of intermediated credit to October 2008.

    The problem now is nothing whatever to do with the solvency or liquidity of credit intermediaries and everything to do with the fact that an increasing - due to austerity and automation - majority of individuals are illiquid, insolvent or both.

    There's nothing new about this: the toxic combination of compound interest and private property in land has always, for thousands of years, had this effect of wealth concentration.

    There are solutions which might conceivably work after a fashion.

    On the monetary side there's social credit (C H Douglas) which is essentially a continuing helicopter drop.

    On the fiscal side, there's levies on privileged property rights eg levies on land rentals; on non-renewable resources; on limited liability; and on IP, the proceeds of which could be distributed as citizens' dividends.

    Of course, privileged turkeys do not enact Christmas or even permit such financial pornography to be discussed in the mainstream media.

    But all is not lost, because my view is that in a world of direct instant connections, public sector credit intermediation is as obsolescent as private sector credit intermediation.

    Based around 'people-centric' (ie mobile) devices, I think we will see - initially in the developing world - a new generation of mobile finance.

    Firstly, Peer to Peer mobile credit solutions (not the lending of existing money, but quasi-VISA systems owned in common between sellers and buyers).

    Secondly, direct 'Peer to Asset' mobile investment - using the prepay instruments which make debt and derivatives obsolete - in energy and location rental value.

    We will see these mobile credit and mobile investment solutions begin to emerge within the next year or so, I think, because it is actually in banks' interests to migrate to a role as service providers because to do so is 'capital lite'.

    It was the capital efficiency of financial dis-intermedaition which drove the mis-selling of market risk in index funds and ETFs etc by investment banks to 'muppet' investors.

    A prepay instrument is essentially an ETF with units redeemable in the underlying, and it represents an 'adjacent possible' which is already commonplace in wholesale markets and will shortly begin to emerge in retail markets.

    The outcome of a new generation of mobile finance will be 'qualitative easing' through a re-basing of credit, and a debt/equity swap on a global scale - it's just that it won't be the iniquitous absolute ownership form of equity we are used to, but the form of credit which pre-dates the 300 year aberration of modern finance capital which has come to an end.

    1. @ChrisJ,

      Are you sure the HMRC/Treasury/State (the 'rent seeker' with arm force) will allow that ?

  10. I was a little puzzled by the comment about the difficulty of distinguishing between illiquid and insolvent Banks, since Bagehot is careful to cover that. He writes:

    " If it is known that the Bank of England is freely advancing on what in ordinary times is reckoned a good security—on what is then commonly pledged and easily convertible—the alarm of the solvent merchants and bankers will be stayed."

    I think the key phrase here is "what in ordinary times is reckoned a good security".

    In other words, Bagehot is saying something like "Don't worry about the marketability of security X right now, because right now is, almost by definition, an unusual situation. instead think about whether security X would be a good security in *normal* times".

    Bagehot is saying that you can't tell illiquid from insolvent right now, so don't try. Just ask if the Bank which needs support owns securities that would be good in normal times, which is when the support would need to be paid back.

    And of course we saw that in 2007-2012. MBA paper that was unsaleable in 2008-9 recovered a lot of its value by 2011-12. If we had asked what it was worth in 2007-8 we would have made a lot of illiquid Banks insolvent by refusing them support. But by asking what MBS paper would be worth in normal times, we kept them liquid.

    1. Yes, fair enough. Someone else pointed that out too. It's nice to know that I'm on the same page as Bagehot really!

      The result is of course that central banks in a crisis have to take a lot of balance sheet risk, so the fiscal backstop is essential. But I'd rather have a fiscal backstop for the central bank and nothing else than indiscriminate government support for financial and non-financial institutions.

    2. "MBA paper that was unsaleable in 2008-9 recovered a lot of its value by 2011-12"

      The question to be asked is whether the recovered value will again be forced down because the security backing the paper could fall in value if the Fed pulls the plug. We noticed that in May and June. By propping up the value of the asset artificially we are not able to ascertain the true value of the paper. The problem with underlying securities now is that its value is propped up by the Fed (aka atlas). The idea holding the whole thing up is that when the Fed pulls the prop, the growth will be able to provide the prop. The problem with this is the mispricing of risk and elevated asset price-- the Fed does not (may be cannot) allow the value of asset (and thus the paper) to be downgraded as it will make the institution holding the paper to become insolvent.

    3. Once the state starts supporting anything it is difficult to stop. That's as true of assets as it is of workers. But it's not a reason not to do it. What has to be done is to set limits and endure the screams.

      I don't accept that protecting the Fed's balance sheet is a valid reason for providing exceptional support to assets long-term. It's a crisis measure only and to my mind we have overdone it: QE1 was a good timely response to a horrible situation, but QE2 and especially QE3 were unnecessary and unhelpful. I've written about this elsewhere.

    4. I ask myself these questions...

      Can the Fed taper QE without a market fit? UNLIKELY. They are scared stiff.
      Is the increase in 10-Y yield a trend of rising interest? LIKELY.
      How is the Fed going to extricate itself without a fall in the asset prices?
      If asset prices go down are we back to 2008?

      I really do not know the answers. Unfortunately I think neither does the Fed know.

      Unless this circle of [Crisis-->Fed Intervention-->Create Bubble-->Remove Punch bowl-->Crisis] is stopped your asset does not reflect true value. Its price depends on the stage of Fed Intervention. This is unlikely to happen without a significant correction without intervention.

  11. Dear xxx, no I will not led you a monkey till next payday. Wonga rates for de wronga ppl!!!

  12. This comment has been removed by the author.

    1. The CB would accept collateral even if the market price was falling. That's why it needs the fiscal backstop.

      You are joking about "lending to build factories" not causing bubbles, aren't you? Commercial property was a MUCH bigger problem in the financial crisis than residential. And have you looked at commercial property in Spain and Ireland? Whopping bubble that has now burst.

      King does come out with some strange ideas sometimes.

  13. Wouldn't the CB still accept colteral if the drop in colateral prices was seen as temporary. For example you said that even treasuries go down in a crisis but I can't see the CB refusing to accept a 1 million pound treasury as colteral for a temporary 1 million pound loan whatever the market price was.

    How about discouraging banks from blowing bubbles in the first place. Some lending causes the asset price to inflate other lending does not. The mortgage credit market has caused house price bubbles in thepast but lending to build factories that creates products of the same value of the new deposits does not create bubbles.
    In fact a few years ago Mervyn King floated the suggestion that it could be beneficial for there to be a separate interest rate for mortgages , then nothing more was said.

    1. On second thoughts I don't think that analysis of the mortgage market is right. Prices might go up as interest rates go down but I doubt that they would go above the capitalized rental value even at zero interest rate.

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  15. Dear Frances Coppola,
    I found your blog via the FT's Alphaville, where I had the opportunity of listing to your very interesting talk with Prof. Admati in an "AlphaChat". I've been reading up on banking and finance but I'm basically a macro-economist by profession. From what I read, I have the impression that there are two very material factors that tend to push bank management to borrow instead of raising equity to finance the asset side of their balance sheet: One, bank management is paid a wage, but remuneration is also often in the form of stock options. These would lose value in the case of capital increases, which dilute existing equity. Two, financing investment through borrowing frequently allows for the expensing of interest payments, i.e., deducting interest payments on debt from tax liabilities. This thus allows a bank to reduce its tax wedge and increase retained earnings, ceteris paribus. Is this view correct? Do you see this as a source of banks' preference for borrowing over raising equity in funding their activity?
    Thanks very much,
    Patrick Van Brusselen, Brussels, Belgium

  16. Hmm is anyone else encountering problems with the images on this blog loading?
    I'm trying to determine if its a problem on my end or if it's the blog.
    Any feed-back would be greatly appreciated.

    my web blog; citifinancialservicing


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