Category: Banks & Interest Rates

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China: Uncertain foundations – FT.com

Simon Rabinovitch at FT writes:

Shadow banking is flourishing in China, helping to make non-bank institutions as big a source of credit as banks themselves since July – something that has never happened before. Chinese bankers, leading rating agencies and the International Monetary Fund have all warned about risks from the surge in loosely regulated lending, with some even pointing to parallels with developed economies before the global financial crisis. But the Chinese government itself has taken a permissive stance.

Highly regulated banks restricted lending to property developers following concerns over a real estate bubble. But regulators turned a blind eye to unregulated shadow lenders who borrow short — normally no more than 3 months — and lend long. They may believe this will sustain economic growth while protecting banks from risky lending. The thinly capitalized sector, however, is at risk from defaults and a consequent liquidity crisis which could spread to the banking sector.

via Uncertain foundations – FT.com.

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IMF: Australia's banks need more capital

The IMF identifies risks to Australia’s banking system:

  • Residential mortgages are banks’ single largest asset, and a combination of high household debt and elevated house prices increases the risk in this portfolio.
  • Banks rely on funding from outside the country, and with the crisis in Europe and the global economy suffering, these funding sources are volatile.
  • Four major banks dominate the banking system, and they share many similarities that can be a cause of risk spreading from one to another in the event of a crisis.

……The four major banks are systemically important which means difficulties in any one of them would have severe repercussions for the financial system and the economy. A higher minimum capital requirement would provide a bigger cushion against potential losses.

Capital ratios may under-state capital requirements through risk-weighting assets. Past performance is not always a good predictor of the future. I prefer FDIC director Thomas Hoenig’s unweighted comparison of tangible assets to tangible equity.

via IMF Survey: Australia’s Banks Sturdy, Closely Connected.

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The “Export Price Norm” saved Australia from the Great Recession « The Market Monetarist

The Market Monetarist writes how a combination of luck and good policy saved Australia from recession.

Milton Friedman once said never to underestimate the importance of luck of nations. I believe that is very true and I think the same goes for central banks. Some nations came through the shock in 2008-9 much better than other nations and obviously better policy and particularly better monetary policy played a key role. However, luck certainly also played a role…..

via The “Export Price Norm” saved Australia from the Great Recession « The Market Monetarist.

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Shadow Banking Grows to $67 Trillion Industry, Regulators Say – Bloomberg

Ben Moshinsky and Jim Brunsden write:

The size [$67 trillion] of the shadow banking system, which includes the activities of money market funds, monoline insurers and off- balance sheet investment vehicles, “can create systemic risks” and “amplify market reactions when market liquidity is scarce,” the Financial Stability Board said in a report, which utilized more data than last year’s probe into the sector……

via Shadow Banking Grows to $67 Trillion Industry, Regulators Say – Bloomberg.

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The Foolproof Way

In his 2003 paper Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others Lars E.O. Svensson describes his Foolproof Way of escaping from a liquidity trap — experienced by countries such as Japan, and lately the US, when central bank interest rates are close to zero.

The Foolproof Way consequently consists of announcing and implementing three measures: 1) an upward-sloping price-level target path, starting above the current price level by a price gap to undo; 2) a depreciation and a crawling peg of the currency; and 3) an exit strategy in the form of the abandonment of the peg in favor of inflation or price-level targeting when the price-level target path has been reached.
As discussed in the previous subsection, a currency depreciation and a crawling peg is unique in providing the central bank with a concrete action that demonstrates the central bank’s commitment to a higher future price level, establishes credibility for the peg, induces private-sector expectations of a higher future price level, and stimulates the economy by reducing the real interest rate. As argued, via a depreciation and a crawling peg with a rate of appreciation approximately equal to the average foreign interest rate, the central bank can actually implement approximately the optimal way to escape from a liquidity trap and strike the optimal balance between current stimulus of the economy and the future price level. Furthermore, as discussed, the exchange rate is unique in providing a relatively direct measure of the private-sector expectations of the future price level.

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The Liquidity Trap

In his 2003 paper Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others Lars E.O. Svensson describes the liquidity trap experienced by countries such as Japan and lately the US, when central bank interest rates are close to zero percent.

If the nominal interest rate is initially low, which it is when inflation and expected future inflation are low, the central bank does not have much room to lower the interest rate further. But with deflation and expectations of deflation, even a nominal interest rate of zero percent can result in a substantially positive real interest rate that is higher than the level required to stimulate the economy out of recession and deflation. Nominal interest rates cannot fall below zero, since potential lenders would then hold cash rather than lend at negative interest rates. This is the socalled “zero lower bound for interest rates.”
In particular, conventional monetary policy seems unable to provide sufficient stimulus to the economy and address recession and deflation once the zero lower bound for interest rates has been reached. The problem is that the economy is then satiated with liquidity and the private sector is effectively indifferent between holding zero-interest-rate Treasury bills and money. In this situation, standard open-market operations by the central bank to expand the monetary base by buying Treasury bills lead the private sector to hold fewer Treasury bills and more money – but this has no effect on prices and quantities in the economy. When this “liquidity trap” occurs, expanding liquidity (the monetary base) beyond the satiation point has no effect. If a combination of a liquidity trap and deflation causes the real interest rate to remain too high, the economy may sink further into a prolonged recession and deflation.

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Fed monetary policy

I read this excerpt from a speech by Ben Bernanke in September (courtesy of Cullen Roche):

The tools we have involve effecting financial asset prices. Those are the tools of monetary policy. There are a number of different channels. Mortgage rates, other interest rates, corporate bond rates. Also the prices of various assets. For example, the prices of homes. To the extent that the prices of homes begin to rise, consumers will feel wealthier, they’ll begin to feel more disposed to spend. If home prices are rising they may feel more may be more willing to buy home because they think they’ll make a better return on that purchase. So house prices is one vehicle. Stock prices – many people own stocks directly or indirectly. The issue here is whether improving asset prices will make people more willing to spend. One of the main concerns that firms have is that there is not enough demand… if people feel their financial position is better… they’ll be more likely to spend, and that’s going to provide the demand firms need in order to be willing to hire and to invest.

It stopped me in my tracks. Here is why:

  1. The Fed Chairman avoids stating the obvious: there is only one aim of monetary policy: to increase or decrease the amount of debt in the economy. Their tools are designed to encourage people to borrow more — or occasionally less, when the results of their earlier policy materialize.
  2. Raising prices to increase demand? Raising home prices is unlikely to clear inventories of unsold homes or stimulate the construction industry.
  3. What Bernanke is referring to is known as the “wealth effect” — raising asset prices by lowering interest rates stimulates spending. The “wealth illusion” would be a more appropriate name.
  4. Rising asset prices make people more willing to spend. He is 100% correct here. But he fails to mention the resulting asset bubble that follows. Low interest rates and rising prices feed speculation….. which lead to higher prices and more speculation….. which lead to a self-reinforcing spiral.

Economics is not a hard science like engineering or physics, where one can accurately gauge outcomes. It is a soft science, like psychology, and many practitioners with competing theories as to how to treat the patient. With spectacular failure rates. Theory after theory is consigned to the waste basket as we struggle to understand the human condition.

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Back to Basics: A Better Alternative to Basel Capital Rules | Thomas M. Hoenig

FDIC Director Thomas Hoenig calls for a simple capital ratio of Tangible Equity/Tangible Assets instead of the complex measures proposed by Basel III. Using Tier 1 capital measured according to Basel III standards overstates tangible equity capital by about 40 percent and using risk-weighted assets makes capital adequacy ratios even more subjective.

Prior to the founding of the Federal Reserve System in 1913 and the Federal Deposit Insurance Corporation in 1933, bank equity levels were primarily market driven. In this period the U.S. banking industry’s ratio of tangible equity to assets ranged between 13 and 16 percent, regardless of bank size……..

[Basel capital standards] led to a systematic decline in bank capital levels. Between 1999 and 2007, for example, the industry’s tangible equity to tangible asset ratio declined from 5.2 percent to 3.8 percent, and for the 10 largest banking firms it was only 2.8 percent in 2007. More incredible still is the fact that these 10 largest firms’ total risk-based capital ratio remained relatively high at around 11 percent, achieved by shrinking assets using ever more favorable risk weights to adjust the regulatory balance sheet.

via FDIC: Speeches & Testimony – 9/14/2012.

Hat tip to Barry Ritholz.

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Richard Fisher | Politicians need to get their act together

Texas Fed President, Richard Fisher believes fiscal authorities need to get their act together. “There is a limit to what we can do. We can’t have a Buzz Lightyear monetary policy: to infinity and beyond.”

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Fisher’s frustration with Washington is hard to miss:

“We have to completely reboot tax policy. We need to completely reboot spending policy……..This is all about job creation…..We have to build confidence in the business community, who are the job creators. And until we give them some clarity, they are just going to hold back. If we have temporary fixes to the fiscal cliff this just pushes out the envelope of indecision…… Just get the job done. Give the business community and those who employ people — the private sector — a sense of direction and confidence. Right now they know nothing. They don’t know what their taxes are going to be. They don’t know what spending patterns are going to be. They don’t know what the costs of these massive regulatory initiatives are going to be…. No business can plan right now…..”

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