Electrification Will Not Prevent Future Crises

'' When the RBS failed, my predecessor Alistair Darling felt he had no option but to bail the entire thing out...Not just RBS on the high street, but the trading positions in Asia, the mortgage books in sub-prime America, the property punts in Dubai...I want to make sure that the next time a chancellor faces that decision, they have a choice. To keep the bank branches going, the cash machines operating, while letting the investment arm fail.'' George Osborne, Feb 4^th 2013.

George Osborne chose JP Morgan’s international processing centre to announce his proposal to ‘electrify’ the ringfence between retail and investment arms of UK banks, giving government a reserve power to split a bank should the fence be breached. Amidst the brouhaha that followed, it is perhaps worth asking whether separation resolves many of the problems which led to the crisis anyway.

Osborne’s announcement itself was more political pantomime than theatre, overwrought with cheap symbolism and reliant upon audience participation. The backdrop bore the JP Morgan logo portraying Osborne as the brave hero, the very epitome of a man fearless of audience and setting, prepared to deliver his devastating message mano-a-mano with the bankers in the heart of their territory. The speech drew predictable ‘boos’ from the yahoos in the stage-boxes as the BBA trawled out the usual line that this would mean less lending to businesses and a diminished role for London as a financial centre; points made with such monotony that one has to wonder whether Anthony Browne has a draw string on his back.

The shock and disbelief of the industry are of course staged, but essential to the overall act. The banks need to look like they’re feeling some pain so that the British public avert their vindictive gaze, satisfied that revenge has been exacted. Similarly Osborne needs a setting which projects his own strength but doesn’t risk public embarrassment, which is why this speech took place in the polite back office lagoon of Bournemouth, not Canary Wharf among sharks who are likely to bite; all vital as the economy teeters on the brink of austerity-fuelled decline. But behind this performance, the pre and post Vickers process has been lobbied heavily by the banking industry. Key industry actors would have been aware of Osborne’s intentions. Some may even have had a role in shaping the parameters and smoothing out the rough edges (note Osborne’s speech only says government will have ‘the power’ to separate, not that it ‘will’ separate – ominous if we remember how large corporations may use their political power and influence to avoid being split). When the amendments were announced, not an eyebrow was raised on the markets: the share price of Barclays and RBS dropped only modestly and in line with the index, suggesting that much of this was anticipated anyway.

But this all raises a bigger question. Let’s suppose we had Glass Steagall not Vickers’ fence, would we be safe from another crash? My opinion is probably not.

The causes of the crisis were/are manifold: the scale of banking liabilities relative to national GDPs; the interconnectedness of banking institutions that accompany that scaling up; the complexity of many innovations which connect these institutions and thus produce system fragility; and the opacity of the accounting information which produces uncertainty at times of stress. Central to all of these problems is the over-supply of credit. The problems of the 2000s can all to a greater or lesser extent be thought of as what happens when banks discover that they can a) lend money against a secured asset without first having to take deposits and b) discover that they can readily produce or access assets against which they can borrow. That is a circuit; the cogs and wheels of the bubble machine.

Modern Monetary Theory (MMT) has something to say here. MMT implies that banks don’t gamble with existing deposits, rather they make loans (assets) first and in doing so create deposits (liabilities) as the sum lent is credited to the borrower’s current account (this is the double entry balance sheet accounting identity). Banks then finance those deposits (or liabilities) crucially after the loans have been issued (the cashflow accounting identity). During the boom years they were able to do this relatively simply through central bank reserves or the short term markets, securing their loan with their newly acquired asset. But as the crisis bit, asset quality (or perhaps more accurately the perception of asset quality) deteriorated: the AAA mortgage backed securities, the Southern European sovereign bonds, etc that had been accepted as collateral by private lenders, all of a sudden lost that particular property. The story of the crisis therefore is really a story about the shortage of good, rehypothecatable collateral and the inability of banks to finance their liabilities while their asset position deteriorates. This is why the ECB and other central banks are working so hard to reignite the interbank market by accepting more and more dross from bank balance sheets as collateral for loans in the absence of willing private counterparties, or swapping them for ‘good’ assets which are. Central banks have in no small way become ‘rehypothecators of last resort’.

From this perspective, it doesn’t really matter if investment and retail banking operations are separate. The national and global economy relies on its investment banks just as much as its retail banks. The modern economy needs institutions that finance larger businesses, arrange M&A activities, underwrite share issues and develop hedging products for multinationals. These functions will always need to be propped up by the State if the institutions that perform those functions begin to teeter. The fundamental problem therefore is not the presence or absence of a retail arm, but the scale of the liabilities and the interconnectedness of those investment banks as the speculative activities are bundled in with their more ‘functional’ activities.

The separation of wholesale and retail may have worked in the 1930s, but it is inadequate now. It matters little whether the investment banking arm of a universal bank buys mortgages off its in-house retail arm or the retail arm of another universal bank. The macro/systemic effects are the same when scale and interconnectedness come into play. Here at CRESC Towers we are reminded of Moliere’s quip that nearly all men die of their remedies and not of their illnesses. One can’t help feeling that Osborne’s pantomime toughness and unwillingness to tackle this primary problem of scale and interconnectedness at the wholesale level, may just provide the diversion that banks need to continue business as usual.

Stanley

Singh And Stella on Collateral

A recent paper by Manmohan Singh and Peter Stella for the IMF Research Department (blogged version here) makes an interesting contribution to begin by questioning the money multiplier – one of the key concepts concerning how central banks are supposed to work.

Traditionally, they point out, “credit and money are [considered] counterparts to each other on different sides of the balance sheet”: banks create credit backed by the ‘base money’ which they hold as currency or deposits with the central bank. The money multiplier is the ratio of total monetary liabilities in the economy (the loans extended by the banking system) divided by the monetary base. With bank notes removed from the equation leaving only the ‘liquid reserves’ which banks have deposited with the central bank, the adjusted money multiplier is considered to provide a measure of the performance (or risk) of the commercial banking system in providing credit to the economy.

Through their ability to create or withdraw these reserves of base money by buying and selling financial assets from commercial banks (known as ‘open market operations’) the central banks are commonly considered to control a ‘transmission mechanism’ which determines the money multiplier. To increase the supply of money in the economy, the central bank can buy financial assets from commercial banks in exchange for liquid central bank deposits, which should provide the basis for increased lending both between commercial banks and into the wider non financial economy (the exact quantity of which should be predictable through algebra): QE has essentially been this carried out on a vast scale, and it is why many financial commentators assert that the measures will inevitably create hyperinflation. 

The paper challenges these notions, firstly by pointing out the by now well known fact that in the decades leading up to the financial crisis, the total amount of credit in the US economy increased far faster than the creation of new central bank deposits (see figure 2). Why? Only commercial banks can hold deposits at the central bank, but as the authors point out over the past 30 years the shadow banking system “has accounted for almost the entire growth in US financial deepening”. How? Though the use of liquid assets to be used in collateralized borrowing: highly rated securities can be used again and again as collateral for the creation of new loans in a process called re-hypothecation, and the increased use of securitization created a range of new alternative liquid assets to be used by the shadow banking system to create loans.

Distinctions need to be made between different types of collateral. On the one hand there is high quality collateral in the form of bonds issued by solvent sovereign governments, which can be used in credit creation almost anywhere. Other kinds of securities can be used as collateral under normal market conditions (and their use grew enormously in the run up to 2008) but they lose their utility in this regard in a downturn when markets begin to doubt their value. This happened most spectacularly with securitized housing market assets, resulting in a system wide liquidity crisis as interbank lending seized up.

The real fulcrum of liquidity creation, they argue, is to be found in the market practices relating to judgements of which assets are ‘acceptable collateral’ rather than with the central bank officials executing conventional monetary policy. Since the crisis, this has been reflected in two phenomena. Firstly, there has been intense demand for safe assets to use as collateral – hence the low price of UK and US government borrowing despite their indebtedness. Secondly, despite the unprecedented creation of new reserves at the Fed, there has been no corresponding increase in inflation (see table 1).

 

Since the crisis, chains of re-pledging have shortened from 3 steps in 2007 to 2.4 at the end of 2010, while the total volumes of re-pledged collateral have fallen from $10 trillion in 2007 to $5.8 trillion at the end of 2010. The actions taken by central banks in expanding their balance sheets has not, the authors suggest, been sufficient to make up for these losses: conventional QE substituted central bank deposits for high quality collateral that would have been re-pledged for collateralized borrowing, meaning that QE had nothing like the lubricating effect on the financial system that would have been anticipated under a conventional money multiplier view.

The banks’ liquidity crisis continues and, as the authors note

Unless there is some rebound in the pledgeable collateral market (by either an increase in ‘source’ collateral, or its velocity or re-use rate), the likely asymmetry in the demand and supply of good collateral may entail some difficult choices for the markets and the regulators.

Difficult choices such as whether a return to pre-crisis levels of global liquidity is even possible, let alone desirable.

Monetary policy is in uncharted territory and, they argue, as assumptions about the relative importance of the transmission mechanism against the role of collateral are revised, swapping bad for good collateral may now become a routine activity of central banks. This carries with it questions of risk and accountability which make the independence of central banks from democratic accountability seem more problematic than ever.