Monday, 6 April 2015

Let’s ban bank bonds.

One of the basic activities of banks under the existing system is to (1) accept money from depositors and bond holders, (2) invest or lend on that money, and (3) promise to return to depositors and bond holders the exact sum borrowed from them.

That promise is basically FRAUDULENT, and for the simple reason that loans and investments go wrong from time to time. I.e. the above promise is no different to borrowing money off a friend, second, promising to return the money, while third, putting the money on a horse. In contrast, if you tell your friend what your’re doing and agree to share profits and losses, then that’s honest. That’s non-fraudulent. And in that case, your friend has effectively bought a share in your horse betting business.

It could be said against the above point that if the proportion of a bank’s funding that comes from shares (its “capital ratio”) is much higher than currently obtains (e.g. if the ratio was raised to the 30% or so advocated by Martin Wolf and Anat Admati) then the chances of the bank going bust are remote, thus there’d be no harm in letting banks be funded partially by bonds.

Well the first answer to that is that there have been cases of small banks going bust in the US where it has turned out that the bank’s assets have dropped by much more than 30% as compared to book value.

Second, if funding via bonds was cheaper than funding via shares, that might be an argument for allowing bank bonds. However, funding via bonds just isn't cheaper.

Modigliani Miller.

Of course, many people THINK that funding via bonds is cheaper because the return demanded by bond holders is less than the return demanded by shareholders. But that difference simply reflects the fact that in the event of problems, shareholders take a hair-cut before bond holders.

The reality, as pointed out by Modigliani and Miller is that the cost of funding a bank or indeed any corporation is determined by the risks it runs – in the case of a bank, whether it specialises for example in NINJA mortgages or standard mortgages. And those risks are TOTALLY UNAFFECTED by the way the corporation is funded.

In short, having a bank funded 100% by shares rather than say 50% by shares and 50% by bonds will have NO EFFECT on the cost of funding.

Incidentally, the Modigliani Miller theory HAS BEEN criticised, but the criticisms are pretty feeble. See under the heading “Flawed criticisms of Modigliani Miller” (p.15) here.

What exactly is a bond?

A bond is a promise by a bank or any other corporation to repay sums borrowed from bond holders on some due date. And if the corporation CANNOT pay on the due date, the corporation undertakes to declare itself insolvent with bond holders getting less than 100 cents in the dollar after insolvency proceedings are complete.

But what exactly is achieved by that arrangement as compared to funding a corporation via shares? The answer is “exactly and precisely nothing because bond holders end up getting exactly the same as had they bought shares instead of bonds”. At least that’s true given a perfectly reasonable simplifying assumption, as follows.

Suppose a corporation is funded 50% by shares and 50% by bonds. And let’s assume the value of shares and bonds is strictly related to the value of the corporation’s assets. Of course in the real world, the value of shares and bonds is also influenced by the market’s view of the corporation’s prospects. But that’s what might be called a “wild card”: it can result in the value of shares and bonds being ABOVE OR BELOW a valuation based just on the value of the above assets.

So let’s ignore “prospects” and concentrate on assets.

If the value of the assets of the above “50:50” corporation falls to 50% of book value, then shareholders are wiped out, while bonds will still be worth their book value. And if the value of assets falls to say 25% of book value, then bond holders will get half their money back (50 cents in the dollar) after insolvency proceedings are complete.

But suppose instead that the corporation is funded 50% by ordinary shares and 50% by preference shares. And suppose, again, that asset values fall to 25% of book value. As above, ordinary shareholders are wiped out, while preference shareholders find that half their stake in the corporation has been wiped out: if you like, their stake is worth 50 cents in the dollar. And that’s exactly the same outcome as had those preference shareholders bought bonds instead.

The only difference is that in the bond scenario, the corporation is closed down, while in the preference share scenario, the corporation soldiers on, which is a slightly better outcome.

To summarise, what do bonds achieve? Absolutely nothing! They’re a farce!

A bond is essentially a promise by a firm to close down, i.e. to blow its brains out, if it cannot repay bondholders on the due date. And that is a fatuous promise.

However, I believe in free markets, and if some corporation really wants to blow its brains out should it not be able to repay bondholders, then I think on balance that it should be allowed to. However I wouldn’t strongly disagree with anyone who argued that promises to blow one’s brains out or burn one’s house down should be banned.

But whatever the truth of the latter point, banks are different to other corporations. As has been graphically illustrated over the last five years or so, the failure of large banks has serious systemic consequences: e.g. five years of excess unemployment. Thus I suggest bank bonds might as well be banned. That’s a nice simple rule, and there’s much to be said for simple rules, assuming all else is approximately equal.

Bail in bonds.

Another option is to allow bonds, but to bail them in when problems arise.

However, there are a few problems there. First, anything that gives preference to those with inside information is undesirable, e.g. it enables insiders to flee before others. Second, “bailinable” or “haircuttable” bonds come to the same thing as preference shares. Third, the idea that bank regulators actually know when a bank is in trouble is a joke, if past performance of regulators is any guide.

So why don’t we just cut the cr*p and ban bank bonds? Those wanting to fund banks would buy ordinary or preference shares instead, and the latter two come to the same thing as bonds. Plus that ban would mean that regulators (whose competence is in any case very questionable) needn’t get involved.


  1. Disregarding deposit insurance, the main argument here against bank bonds (fraud) also applies to bank deposits!
    "So why don’t we just cut the cr*p and ban bank bonds?" and also bank deposits?
    So why don’t we just cut the cr*p and ban fractional reserve banking?

    However, I suspect that the accusation of "fraud" in your second paragraph is largely inappropriate. Most bank depositors and investors in bonds, especially since 2008, are well aware that there are risks, and that these risks are substantially mitigated by deposit insurance and government bailouts of too-big-to-fail banks.

    So, the argument against fractional reserve banking on the grounds of fraud is weak.
    But there is still a strong case against fractional reserve banking (i.e. in favour of full reserve banking) on the grounds of financial stability and avoidance of "hidden" subsidies to banks.

    1. You’re right: my “fraud” accusation in the case bond holders is going too far. That is, bond holders are relatively clued up and know what they are doing. However, the accusation is valid in the case of ordinary households and small firms. In the 1930s (before deposit insurance) millions of households in the US saw the sums they had put into allegedly safe bank accounts vanish into thin air.

      Re deposit insurance, where that is funded by taxpayers (as it is in the UK) that amounts to a subsidy of banks, and I agree: that misallocates resources. That cannot be justified.

      As to where deposit insurance is self-funding (as with FDIC in the US), the flaw with that is that while FDIC can cover small banks, as it does in the US, the sums required to rescue a series of large banks are so huge that in practice only the state can come up with the necessary sums of money. And even there, sundry states have been near bankrupted recently because of that.

      IN THEORY it might be possible to make that state organised bank insurance commercially viable. But the reality, as the recent crisis demonstrated, is that politicians just fall for the temptation of offering bankers sweet-heart deals (in exchange for wads of dollar bills in brown envelopes).

      So Adam Levitin was right when he said at the start of his paper that “Banking is based on two fundamentally irreconcilable functions: safekeeping of deposits and relending of deposits.” See:
      Conclusion: entities / banks which lend should be funded just by shares, which is what full reserve consists of.


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