Saturday 12 March 2016

Mervy King’s bizarre arguments against very high bank capital ratios.


Mervyn King, former governor of the Bank of England, has just published a book entitled “The End of Alchemy…”.

In Ch 7 of the book he argues against the idea that the bank industry should be split in two, one half (funded just by shares) doing lending, and the other half of which accepts deposits, but which cannot lend (except to government or the central bank). Under that arrangement the first half cannot go insolvent (though King doesn’t seem to have worked that out, as is shown below). As to the second half, that’s as safe as it is possible to get in this world. (Incidentally, King sometimes refers to the lending half as “wide banks”).

That arrangement obviously involves a capital ratio of 100% for the lending half. But some of the arguments for and against that arrangement also apply to capital ratios that are high, but not up to the 100% level. For example Martin Wolf and Anat Admati advocate a 25% or so ratio, while Miles Kimball (economics professor at the University of Michigan) advocates 50%

King’s first objection to very high capital ratios comes in the paragraph starting “So why hasn’t the idea been implemented?” That first objection actually comes in two parts. First King says “Banks will lobby hard against such a reform.”


Yes I bet they will. Doubtless they also lobby against controls on laundering Mexican drug money. But any such lobbying is a total and complete irrelevance: the only important question is whether much higher bank capital ratios (or curtailing the laundering of Mexican drug money) is in the best interests of the country as a whole.

Second, and also part of his first objection, King says the transition to very high capital ratios “…could be disruptive, forcing a costly reorganisation of the structure and balance sheet of existing institutions.” Well the simple answer to that is that the existence of high upfront costs is not an argument against ANYTHING, whether it’s demolishing an office block and re-building it, or anything else. The only important question is whether benefits outweigh costs in the long run, a point which I’d imagine 95% of taxi drivers understand.

Moreover, it’s debatable as to whether the latter transition really would be costly. Milton Friedman’s view was that it WOULDN’T. As he put it in his book A Program for Monetary Stability, “There is no technical problem in achieving a transition from our present system to 100% reserves easily, fairly speedily and without any serious repercussions on financial or economic markets.”

Well the above pair of objections to higher capital ratios aren’t too clever are they? I’d expect an intelligent school leaver to see the flaw in King’s arguments there.


Intermediation.

King’s second objection to narrow banking has to do with intermediation, and answering it would take too long. So I’ll skip that in this article. I’ve actually dealt with all relevant points in earlier articles.


Bank insolvency.

King’s third objection does not consist of one single clear point. Rather it’s a collection of different points.

The opening sentences of this third objection are just below. But first I’d better explain that King’s phrase “radical uncertainty” which appears in the passage below refers to big problems that suddenly appear from nowhere, like the 2007/8 bank crisis: so called “black swan” events.

Anyway, his third objection starts…

“Third, and most important of all, radical uncertainty means that it is impossible for the market to provide insurance against all possible contingencies, and one role of governments is to provide catastrophic insurance when something wholly unexpected happens. Ending alchemy does not in itself eliminate large fluctuations in spending and production.”

(By “alchemy”, King means (roughly speaking) “borrow short and lend long”. I’ve put his definition of the word at the end below. As you’ll see, his “alchemy” is a strange concept. But “borrow short and lend long” is the best translation into normal English I can think of.)

Well it’s true, as King says, that curtailing borrow short and lend long, or implementing very high capital ratios will not of itself eliminate “fluctuations in spending and production”.  The advocates of very high capital ratios have never claimed they do. But the latter changes do make banks more stable.

King’s criticism is like criticising cars because while they transport people in comfort and at quite a speed, they only carry about four people and don’t go as fast as airliners. Cars (and this may be news to King) are a big improvement on horses and carriages. That’s an achievement.

Moving on, King then makes various points which I could criticise, but I’ll concentrate on his worst mistake which is that he quite clearly does not understand that wide banks cannot go insolvent, nor does he understand the basic money creation process which private banks engage in.

He says, “Ensuring that money creation is restored to government through the requirement for narrow banks to back all deposits with government securities does stop the possibility that runs on the banking and shadow banking sectors will transmit shocks at rapid speed right across the financial sector, as happened to such devastating effect in 2008. But the risk from unexpected events is then focused on the prices of assets held directly by households and businesses and on the solvency of wide banks.”

Now hang on. As King himself rightly points out, wide banks (the half of the industry which lends to mortgagors, businesses, etc) are funded just by equity. That being the case, how is it possible for them to go insolvent? Insolvency means not being able to pay creditors when debts are due for settlement. But a bank funded just by equity doesn’t owe anything to anyone!

Of course it’s theoretically possible that a bank becomes indebted to TRADE CREDITORS (e.g. those who supply it with electricity, paper, computers etc) and that the loans the bank has made are so hopeless that there is no cash available from those loans when they’re due for repayment. But nothing like that has ever happened in the banking world far as I know. That degree of failure would be far worse than occurred with Lehmans or Northern Rock.

The next passage which indicates that King basically does not understand wide banks reads, “Although wide banks cannot create money in the form of deposits, they can still borrow short and lend long.”

Complete nonsense. It’s the very fact of a bank borrowing short and lending (long or short) that results in money creation. That is, if a bank accepts a deposits totaling £X and lends that on, then borrowers have £X to play around with, and depositors still see a total of £X (credit balance) on their bank statements. £X has been turned into £2X. In contrast, if a bank borrows long (e.g. depositors cannot get access to their money without say 3 or 6 months notice) that so called money is not counted as money in most jurisdictions. So no money multiplication takes place.

As King himself correctly pointed out a few paragraphs earlier, a wide bank is one funded just by equity, i.e. not funded by short term debt. As he put it…

“If deposits must be backed with safe government securities, then it follows logically that all other assets, essentially risky loans to the private sector, must be financed by issuing equity or long-term debt, which would absorb any losses arising from those risky assets.”


Conclusion.

Mervyn King was head of one of the world’s leading central banks for a decade or so. You have to wonder whether he was up to the job to judge by his book. If you want to know why the 2007/8 bank crisis erupted, perhaps you now have part of the answer.


King’s definition of “alchemy”.

His definition runs as follows (and if you find it a mouthful, so do I).

“By alchemy I mean the belief that all paper money can be turned into an intrinsically valuable commodity, such as gold, on demand and that money kept in banks can be taken out whenever depositors ask for it. The truth is that money, in all forms, depends on trust in its issuer. Confidence in paper money rests on the ability and willingness of governments not to abuse their power to print money. Bank deposits are backed by long-term risky loans that cannot quickly be converted into money. For centuries, alchemy has been the basis of our system of money and banking. As this book shows, we can end the alchemy without losing the enormous benefits that money and banking contribute to a capitalist economy.”

Were you somewhat bamboozled by that definition? I was.

For example, where are these people who apparently think that “all paper money can be turned into an intrinsically valuable commodity, such as gold, on demand and that money kept in banks can be taken out whenever depositors ask for it”?

Anyone with a grain of common sense knows that if the entire population tried to withdraw their stock of money from banks and turn it into gold or anything else “intrinsically valuable”, the result would be chaos. For a start, every bank would immediately go insolvent and we’d have rampant inflation!



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P.S. 19th March 2016.   There is another none too flattering review of Mervy King’s book (by Joseph Huber) here.
 
P.S. 29th March 2016.  As distinct from my above article which deals with just one chapter of King's book, there was a long letter in the Financial Times recently which criticised the BASIC IDEA in King's book. (Letter title: "Banking system sometimes needs a does of radical uncertainty.")




4 comments:

  1. I haven't read King's book, but I broadly agree with your reactions.It seems that King is very close to advocating full reserve narrow banks, but somehow he loses the plot in a tangle of words.

    Here are a few point on your article.
    1. As you note, Friedman's view was that "a transition from our present system to 100% reserves" could be achieved "easily, fairly speedily and without any serious repercussions". This relates to a zero loan/full reserve requirement for NARROW (transaction) banks. This does not imply a 100% capital ratio for WIDE (investment/loan making) banks. Regarding the latter, as you have previously noted, Friedman thought these could be financed by a combination of equities and debentures.
    2. King says “Although wide banks cannot create money in the form of deposits, they can still borrow short and lend long.” Presumably he simply means that wide banks can borrow at shortER terms than the loans which they make. If so, your comments "Complete nonsense. ..." do not apply.
    3. A 100% equity capital requirement for wide banks would indeed remove virtually all danger of them going bust. But why not let wide banks have loan capital and risk going bust if the shareholders and the bondholder investors wish to take the risks. Its not obvious that 100% equity for wide banks would lead to a better mix of investments in the real economy.

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    Replies
    1. 1. Fair point. I was using the words equity and "share" in a very broad sense: to include debentures or bonds where (when the worst comes to the worst) investors can lose all their money: as distinct from deposits, where savers are absolutely guaranteed not to lose out. Should have made that clear.

      2. King actually contradicts himself. He says wide banks are funded by equity or long term debt (as I point out above), but then says that those banks can “borrow short”.

      3. My answer is that letting wide banks be funded partially by bonds that can’t be bailed in just opens up the possibility of insolvency, and that means disruption, plus that disruption achieves nothing, not even for shareholders or bond-holders. Reason is thus.

      Assume (to keep things simple) that the value of a bank’s shares are strictly related to the value of its assets, and those assets fall to the point where shareholders are wiped out and there are only enough assets to pay bond-holders Xp in the £. If those bonds can be bailed in, then bond-holders get Xp in the £. Alternatively, if the bonds are “non-bail-inable” and the banks goes insolvent, then after the assets have been sold, bond-holders will again get Xp in the £. Obviously I’m ignoring the costs of the bail in process and the insolvency process for the sake of simplicity.

      Conclusion: bonds that can’t be bailed in achieve nothing apart from dislocation of the Lehman variety.

      Furthermore, the whole bail in process is fraught with problems. E.g. come and crisis, and in the heat of the moment, bond-holders with political connections my use their connections to escape hair cuts. Indeed, as I understand it, bond-holders with political connections in Europe managed to do that in the recent crisis.

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  2. Alchemy;

    "the medieval forerunner of chemistry, based on the supposed transformation of matter. It was concerned particularly with attempts to convert base metals into gold or to find a universal elixir."

    King's deinition is rather dated one for a start,but I supppose when he was an apprentice central banker he filled out ledger books with a quill and ink.

    Paper money??...really?We do not use paper money much now thanks to electronic banking.It was not paper money that caused the last crisis.The state had to print alot of what used to be paper money to get us out of the problem.So that isn't the problem.

    So half of is defintion is redundant.Getting to the second bit it hardly improves.What he should have said is the commercial banks have turned state backed money,(that which was once backed by gold but is now backed by something much more valuable; the labours of an entire nation) into commercially issued money that carries the same trust and authority as if it was in fact state money.
    This is in effect the same as turning privately created money (that is created out of nothing) into(what was once)gold.

    Ok its not catchy,but it fits the definition of alchemy far better.

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  3. I have finally finished the book.Large parts of it I agree with, the rest as you say is odd.To criticise the cost/disruption of implementing full reserve banking is a cop out I agree.No one likes new rules,eg many did not want to be forced to wear saftey belts,but they save lives.

    Besides if these Masters of the Universe at our banks are so clever and make so much profit(based on the bonuses they awarded theselves)this cost will be a mere blip.

    Things that are worth looking at in this book;

    Gross market value of derivatives is around one half of assets of the largest top 20 banks in the world.i.e equal to all lending to households and businesses.A lot of these will be basically insurance and based on various triggers.What is allowed as an asset seems to be a problem for me here.

    Mutuals that converted to banks after 1990 all failed in the crisis.


    Leverage is a better measure of a banks risk than capital ratios.(a rule of thumb)
    eg Northern Rock had best RWA's in the UK in 2007, yet went bankrupt 3 months later.

    Regulation has become "extraordinarily complex",not many people understand them.He uses the 15 minute rule used by one bank,if you cannot pitch the idea to a group of peers in 15 minutes the idea is binned.As he says, "complexity is inefficient".

    Finally and this is the most important one for me;

    It is hard to step in and "impede" growth is asset prices,(since this is not a current concern of central banks)It is anentirley different thing though to step in and provide liquidity in a crisis ....which is basically what he proposes in his book.So we are left with a position where he does not see role for controlling asset prices,which is odd as I would say that is what inflation is.Only house prices and share prices, that caused much of the problems, are not in the basket of inflation measures.

    This is the biggest obstacle we have to changing the current system.No one belonging to the establishment wants to interfere in what they see as a free market,even if that free market is not good for the the economy as a whole.

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