Thursday, 30 October 2014

The mistake made by Martin Wolf and bank regulators.

Summary: Their basic mistake is that they think that upping bank capital requirements involves costs. It doesn’t: as the Modigliani Miller theory explains, changing the way a bank is funded (e.g. changing the mix of capital versus depositors versus bond-holders, etc) has NO EFFECT ON the cost of funding a bank.

It is now widely recognised that that amount of bank capital was too low prior to the recent crisis, and after millions of hours of haggling those capital requirements are being raised a small amount.
Of course banks have resisted that change with a variety of totally dishonest and not even desperately clever arguments. I wouldn’t expect bankster / criminals and psychotics to do otherwise.
However, regulators and several household name economics commentators like Martin Wolf have been happy to concede that banks DO HAVE SOME SORT OF POINT. That is, they’ve gone along to some extent with the idea that increasing capital requirements comes at a price. Thus we supposedly cannot go wild and impose a 50% or 75+% capital requirement. For example Martin Wolf advocates 25%, which is way above the percentage advocated by Vickers, Dodd-Frank, etc.
However he says, “I accept that leverage of 33 to one, as now officially proposed, is frighteningly high. But I cannot see why the right answer should be no leverage at all. An intermediary that can never fail is surely also far too safe.”
Well the simple answer to that is that if it costs nothing to make something totally fail safe, why not do that? I.e. the CRUCIAL QUESTION is whether raised capital requirements cost anything.
Here’s why they don’t.

Deposits versus capital.
Take two hypothetical banks: one is funded ENTIRELY BY shares, and the other ENTIRELY BY depositors.  But in other respects the banks are the same: in particular, the risks stemming from the type of loans they grant are the same. It follows that the REWARD that both depositors and shareholders will want for covering that risk will be the same.
Ergo the cost of funding the two banks is the same!!
Ergo it makes no difference what the mix of capital and deposits is that funds a bank: the cost of covering relevant risks is the same!
Which is pretty much a re-statement of the Modigliani Miller theory.

Deposits, bonds and wholesale money markets.
Having rather suggested above that there are only two ways of funding a bank, capital and deposits, there are of course other ways: e.g. bonds and loans from wholesale money markets. However, the latter are essentially deposits of a sort. Indeed loans from wholesale money markets sometimes have to be repaid in one or two weeks, which makes them the same as retail term accounts where one or two week’s notice of withdrawal is required.
The word “deposit” will be used in a loose sense from now on: it covers conventional retail deposits and bonds and loans from the wholesale money market.

 The real world.
Of course in the real world, shareholders demand a higher return than depositors but that’s for the simple reason that depositors enjoy a cast iron guarantee provided to a greater or lesser extent by taxpayers that deposits are safe, whereas, while bank shareholders are subsidised TO SOME EXTENT by taxpayers, the “cast ironess” of the subsidy / guarantee is not the same. E.G. in the UK during the recent crisis bank shareholders took a hair-cut. Depositors did not.
In short, FOR A FAIR COMPARISON between the costs of funding a bank via shares and via deposits the comparison must be done on a strictly “no subsidy of any sort is available” assumption. And on that assumption, to repeat, there is no difference between the cost of funding a bank via capital as opposed to via deposits.

There is however an important difference between the two scenarios. The difference comes where it suddenly turns out that incompetent loans have been made (as occurred with many banks at the start of the recent crisis).
In the case of a bank funded just by deposits, ANY FALL in the value of the bank’s assets (i.e. the loans it has made) means the bank is technically insolvent. And if faith in the bank vanishes, a run starts, and the bank is ACTUALLY INSOLVENT.
Alternatively, if the bank is funded about 3% by capital and about 97% by deposits as was common prior to the recent crisis, then assets have to fall at least 3% before the bank becomes technically insolvent. But that’s frankly not much different the scenario just above where ANY FALL in asset prices means technical insolvency.
In contrast, where a bank is funded just by capital / shares, asset values can fall 50%, even 75% (which is practically unheard of) and the bank still isn't insolvent! All that happens is that the value of the shares fall to about 50% or 75% of initial value. In that sense, the bank cannot fail.
Now in what sense is Martin Wolf right to say such a bank is “too safe”? Exactly what is wrong with that fail safe characteristic? Absolutely nothing!
To rephrase that, where a bank is funded just by deposits and it makes disastrous loans, the bank collapses. In contrast, where it is funded just by shares / capital, it soldiers on.
The “fund by deposits” option doesn’t have a leg to stand on!

Full reserve.
And what do you know? A system in which lending entities are funded just by shares is what full reserve banking involves (at least that’s what Laurence Kotlikoff’s version of full reserve consists of). As to deposits, they are of course needed for day to day transactions, but under full reserve, that is done with accounts which are totally safe and involve no lending: those accounts are backed by central bank issued money, i.e. base money.

Modigliani Miller.
Of course MM has been criticised. But the criticisms are feeble. See this paper of mine, section 1.4 under the heading “Flawed Criticisms of Modigliani Miller.” Also Sir John Vickers devotes several paragraphs to MM in a paper published in 2012 (well after the Vickers commission final report) and suggests a few possible weaknesses in MM, but does not seriously question it.


P.S. (same day):  Another reason why bank capital may well cost more than deposits at the moment is that bank shareholders in the US have recently had to pay around $100bn in fines for crimes they didn’t commit: that’s Libor manipulation, laundering Mexican drug money, etc. (Yes that’s billion, not million) The actual perpetrators of those crimes (specific bank employees and executives) have got off Scott free. No doubt something similar applies in the UK and elsewhere.

If people with red cars have to pay the speeding and parking fines incurred by owners of blue and green cars, then the cost of running a red car will be higher than the cost of running a blue or green car. But that’s not a valid or fair comparison of the costs of running red, blue and green cars, is it? (Sorry about the change in font size there, if you see one: this blogging system goes mad sometimes.)

Saturday, 25 October 2014

Positive Money should study MMT more before commenting on it.

There are two not very clued up paragraphs at the end of this article by Positive Money. I’ve reproduced them below (in green) with comments by me interspersed (in black).
As regards MMT, an additional reason for their intransigence..”
What “intransigence”? MMTers for the most part do no positively OPPOSE the aims of PM. They just aren’t particularly interested. Economics is a big subject. MMT takes an interest in one or two narrow parts of that subject. PM likewise. No harm in that.
Models of public-private sector balances were originally devised for spotting imbalances.[10] In MMT, however, the meaning of imbalances is re-interpreted and includes a tendency to fuse fiscal with monetary functions.
Well PM also advocates “fusing” monetary and fiscal policy!! That is, PM advocates that when stimulus is needed, the state should simply print more base money and spend it (and/or cut taxes). MMTers if anything agree rather than DISAGREE with that!!
MMT contends that sovereign debt poses no problem because it equals private fortunes (strangely enough, not asking whose).
MMTers have never said that government can go mad and run up ever expanding and ludicrously large amounts of debt. If any government were to do that, interest rates would rise too far. What MMTers do say is that as long as the private sector is happy to hold debt at a relatively low interest rate, there is no harm in expanding the debt. And the rise in debt over the last few years has certainly not lead to any big rise in interest rates. Indeed rates are currently at a record low.
Warren Mosler, a leading MMTer, takes that a bit further and advocates that government should aim for a permanent zero rate of interest on the debt, which comes the same thing as saying that the only liability issued by the government / central bank machine should be base money. Milton Friedman also advocated that idea, and I agree with it.

Moreover, government expenditure (public-sector expenditure) is identified with sovereign-money creation, while private payments to the public sector (taxes) are reinterpreted as the deletion of sovereign money, analogous to paying back credit to banks.If public debt and public expenditure equal sovereign-money creation, and if a sovereign government allegedly can create as much of it as it deems decent, then it seems to follow that a sovereign government is always solvent and need not default. Deficit spending and sovereign debt thus appear to be monetarily and financially irrelevant and economically only beneficial, while monetary reform, again, appears to be irrelevant and unnecessary.
The statement that a monetarily sovereign government (that’s one that issues its own currency) needn’t ever default is correct. If it issues too much base / sovereign money and/or debt, the result will be excess inflation and/or an excessive rise in interest rates. But such a government needn’t ever default.
The idea that MMTers claim that deficit spending can only ever be beneficial is pure nonsense. The average fifteen year old who has never studied economics knows that Robert Mugabe printed and spend far too much (i.e. ran an excessive deficit) with the result being rampant inflation. However, MMTers DO CLAIM that deficits over the last 5 years or so have been deficient which has led to an unnecessary amount of austerity.
As to the idea that MMTers think that monetary reform is irrelevant and unnecessary, to repeat, that is not a point which many MMTers specifically make. To repeat, monetary reform is just one of the many areas of economics that MMTers do not take much interest in. Likewise (to repeat) there are many areas of economics which Positive Money takes no interest in.

Thursday, 23 October 2014

Banks can be rescued without taxpayers being hit?

The Bank of England seems to claim that is possible. I say it’s a mathematical impossibility under the existing system and given a bad enough bank failure. More details are as follows.
The Bank of England has just published a paper entitled “The Bank of England’s Approach to Resolution” which says in the foreword that “The Bank seeks to ensure that firms — whether large or small — can fail without causing the type of disruption that the United Kingdom experienced in the recent financial crisis, and without exposing taxpayers to loss.”
And on p.8 they say one of their aims is to
“…protect depositors and investors covered by relevant compensation schemes..”
On p.13 they say:
“The bank insolvency procedure involves putting the whole
bank into an insolvency process designed to allow for rapid
payment of deposits protected by the FSCS (up to the limit of
I’ve only skimmed through this BoE paper, so I may be doing them an injustice, but I’m baffled by their claim that no recourse will ever be needed to taxpayer money.
Let’s assume a bank is funded by depositors, bond-holders and shareholders in the ratio D, B, S. 
D, B and S sum to 100% of the banks assets / liabilities.
If the bank’s assets fall to D% of book value, then shareholders and bond-holders are wiped out and the bank can be rescued without recourse to taxpayer’s money. But if the assets fall to LESS than D%, and depositors are going to be fully protected, then there is no way depositors can be saved without recourse to taxpayers’ money.
At least that’s the case in the UK where depositor protection is funded by taxpayers (as I understand it). In contrast, in the US, those who deposit at SMALL BANKS are protected by the Federal Deposit Insurance Corporation, with insurance premiums being paid by banks.
As to LARGE BANKS in the US, they are protected by taxpayers. Those large banks like to argue that the recent bail out cost taxpayers nothing because all bail out money has been repaid. However it is questionable whether those banks were charged a realistic rate of interest for bail out money, and whether the collateral they offered in exchange was “first class” (as recommended by Walter Bagehot) or whether it was nearer the “junk” end of the scale.
So how do we prevent all taxpayer support for banks? Well it’s easy: full reserve banking.
Under full reserve, at least as set out by Laurence Kotlikoff, entities that lend, or the subsidiaries of banks that lend as opposed to accepting deposits, are funded just by shareholders, or creditors who are in effect shareholders. So given catastrophic failure (e.g. when bank assets fall to say just 10% of book value) all that happens is that those shares fall to about 10% of book value.
And there’s no need to close down the bank!
What more do you want?