Lazear on Dodd-Frank and Capital

Ed Lazear has a nice WSJ oped, "How not to prevent the next financial meltdown." (Also available here via Hoover.) The main points will not be new to readers of this blog, or my much longer essay but the piece is admirable for putting the basic points so clearly and concisely.

The core problem of focusing on institutions not activities:

The theory behind so-called systemically important financial institutions, or SIFIs, is fundamentally flawed. Financial crises are pathologies of an entire system, not of a few key firms. Reducing the likelihood of another panic requires treating the system as a whole, which will provide greater safety than having the government micromanage a number of private companies.

A crisis is a run:

The risks to a system are most pronounced when financial institutions borrow heavily to finance investments. If the value of the assets falls or becomes highly uncertain, creditors—who include depositors—will rush to pull out their money. The institution fails when it is unable to find a new source of funds to meet these obligations.

Nay, a crisis is a systemic run:

A bank’s inability to pay off its creditors can be transmitted to others. The mechanism can be direct: The debtor bank defaults, and its creditors cannot repay their creditors, etc. But the mechanism can be indirect. The suspicion that similar assets held by other institutions are subject to the same downward pressure can start a run at even an unrelated financial institution.

Ok, a minor disagreement here: The dominoes theory -- I fail, I don't pay you, you fail, you don't pay Joe, Joe fails, etc. -- is popular and enshrined in much Dodd-Frank rule making. It simply did not happen. Our financial crises are simultaneous runs, not failure dominoes. I fail, your investors see that and worry you might not pay them back, so they run, and so on. Companies do understand counterparty risk! And even small equity buffers multiply -- For a domino to go from A to E, A's losses must exceed all the combined equity of A, B, C, D, and E. Domino models tend to have large single counterparty exposures and no equity.  But, this is an oped, and it's a story widely told, so I can't blame Lazear for passing it on as a possibility.

The stability of equity:

consider the contrast between the 2008 financial crisis and the dot-com crash in the late 1990s and early 2000s.

The bursting of the dot-com bubble and subsequent failure of many Internet-based companies had serious repercussions for investors, but not for the financial sector. That’s because the failed firms were financed primarily through equity, not borrowed money. Investors took big losses when the value of tech companies fell precipitously. But there were no runs.

Floating-value liabilities also are run-proof:

Mutual funds are similar. Many are large and hold assets that may be risky, but they don’t fail when the value of their assets falls. The liabilities move one-for-one with the value of the assets because the fund does not promise to pay off any fixed amount to its investors. There is no reason for a run: Getting money out first serves no purpose to investors nor does withdrawal of funds cause significant distress. The fund simply sells the assets at the market price and returns that amount to investors.

Mortgage backed securities are fine -- if held long-only in investor's portfolios. It's funding MBS by rolling over overnight debt that causes problems.

The bottom line: equity financed investment and narrowly backed deposits

These factors suggest that instead of trying to divine which firms are systemically important, banks should be required to get a larger share of the funds they invest by selling stock. Bank investment funded by equity avoids the danger of a run: If the value of a bank’s assets falls, so too does the value of its liabilities. There is no advantage in getting to the bank before others do.

deposits—the checking and saving accounts that are bank liabilities—should be invested only in short-maturity secure assets, like Treasury bills.

Good news: These views seem to be taking hold. The people who run the regulatory agencies are pretty smart, they do listen, and they understand better than we do just how unworkable the plan is for them to make sure no big highly levered bank ever loses money again:

The Federal Reserve seems to be wising up, and may require higher equity capital for the SIFIs and place less emphasis on regulation

Additionally, the international Financial Stability Board announced on July 31 that it would set aside work on designating funds or asset managers as systemically important to focus instead on whether their activities or products were systemically important.

The last point is especially important. There has been a little noticed effort underway to designate asset managers as "systemically important." Asset managers buy and sell stocks on your behalf. There is no fixed value promise and no run here. But there is a chorus that worries the asset managers might all sell, herd, or otherwise act with behavioral biases and they need to be regulated as SIFI. If you understand that a crisis is a run, and that the government should not try to prevent any asset from ever losing value, you see this is not such a great idea.

Greece and Banking, the oped

Source: Wall Street Journal; Getty Images

A Wall Street Journal Oped with Andy Atkeson, summarizing many points already made on this blog. This was published August 5, so today I'm allowed to post it in its entirety. You've probably seen it already, but this blog is in part an archive. If not, here is the whole thing, with my preferred first paragraph.
Local pdf here.

Greece's Ills [and, more importantly, the Euro's] Require a Banking Fix 

Greece suffered a run on its banks, closing them on June 29. Payments froze and the economy was paralyzed. Greek banks reopened on July 20 with the help of the European Central Bank. But many restrictions, including those on cash withdrawals and international money transfers, remain. The crash in the Greek stock market when it reopened Aug. 3 reminds us that Greece’s economy and financial system are still in awful shape. 


Greece’s banking crisis revealed the main structural problem of the eurozone: A currency union must isolate banks from sovereign debt. To fix this central structural problem, Europe must open its nation-based banking system, recognize that sovereign debt is risky and stop letting countries use national banks to fund national deficits.

If Detroit, Puerto Rico or even Illinois defaults on its debts, there is no run on the banks. Why? Because nobody dreams that defaulting U.S. states or cities must secede from the dollar zone and invent a new currency. Also, U.S. state and city governments cannot force state or local banks to lend them money, and cannot grab or redenominate deposits. Americans can easily put money in federally chartered, nationally diversified banks that are immune from state and local government defaults.

Depositors in the eurozone don’t share this privilege. A Greek cannot, without a foreign address, put money in a bank insulated from the Greek government and its politics. When Greece’s banks fail, international banks can’t step in to offer safe banking services independently of the Greek government.

European bank regulations encourage banks to invest heavily in their own country’s bonds, even when they have lousy ratings. The flawed banking architecture of Europe’s currency union pretends that sovereign default will never happen. Wise Europeans have known about these flaws for years, but the system was never fixed because it allows indebted countries to finance large debts.

This is the euro’s central fault. A currency union must treat sovereign default just like corporate or household default: Defaulters do not leave the currency union, and banks must treat sovereign debt cautiously. When Europeans can put their money into well-diversified pan-European banks, protected from interference from national governments, inevitable sovereign defaults will not spark runs, or destroy local banks and economies. And government bailouts will be far less tempting.

That is the long-term fix, but how does the eurozone get out of its current mess? The ECB’s latest Greek bailout deal is focused on long-run structural reforms, asset sales, budget targets and illusory tax increases. It might at best revive growth in a year or so.

But without well-functioning banks, Greece’s economy will collapse long before such growth arrives. To revive the banks and the economy, Greeks must know their money is safe, now and in the future. So safe that Greeks put money back in the banks, pay debts and seamlessly make payments—with no chance of a euro exit, tightened capital controls that impede international payments or depositor “bail-ins,” a polite word for the government grabbing deposits.

The United States offers a precedent. The U.S. economy ground to a standstill in the banking panic of 1933. The administration of Franklin D. Roosevelt closed America’s banks with a national banking holiday to stem the bank run. It then took immediate steps to restore confidence with the clear promises of the Emergency Banking Act of 1933 to resolve insolvent banks, promises backed up by the remarkable rhetoric of FDR’s first fireside chat and the intact borrowing power of the federal government. When banks reopened, Americans lined up to redeposit their money. In the 1980s, the U.S. deregulated banks to allow extensive branch and interstate banking, further isolating local banks from local troubles.

Europe is headed toward bailing out both the Greek government and Greece’s struggling banks. Instead, Europe should resolve and recapitalize the banks alone, put them under private European ownership and control, and insulate them from further Greek government interference. Then Europe can let Greece default, if need be, without another bank run.

Then move on to Italian and Spanish banks, which are similarly larded up with government debts and are threatening the euro. These banks can still be defused slowly, selling their government debts, without huge bailouts.

Europe needs well-diversified, pan-European banks, which must treat low-grade government debt just as gingerly as they treat low-grade corporate debt. Call it a banking union, or, better, open banking. The Greek tragedy can serve to revive the long-dormant but necessary completion of Europe’s admirable common-currency project.

Too much debt, part II

"China to flood economy with cash" reads today's WSJ headline. When you read the article, however, you find it's not quite true. China to flood economy with debt is more accurate.

The expected move to free up more funds for lending—by reducing the deposits banks must hold in reserve—is directly aimed at countering the effects of a weaker currency,

The People’s Bank of China’s latest planned move, which could come before the end of this month or early next month, would involve a half-percentage-point reduction in banks’ reserve-requirement ratio, potentially releasing 678 billion yuan ($106.2 billion) in funds for banks to make loans.

I had hoped the world learned this lesson in the financial crisis. Equity is great. When things go bad, shareholders lose value by prices falling, but they cannot run and the firm cannot fail if it does not pay equity holders.

Financial crises are always and everywhere about debt, especially short term debt. Lending more, encouraging more bank leverage, reducing reserves and margin requirements, means that when the downturn comes a needless wave of runs and defaults follows.

Inevitably, it seems, another downturn will come, another set of books will have been found to have been cooked, and then we will find out who lent too much money to whom. US investment banks, 2008, strike one. Greece, 2010, strike 2. China, 2015, strike 3? Do we no longer bother closing the barn doors even after the horse leaves?

This story should also give one pause about the wisdom of "macro-prudential" policy, by which wise central bankers are supposed to presciently open and close the spigots of leverage to manage asset prices.

Europa hat die Banken missbraucht

An editorial in Süddeutche Zeitung, on Greece, banks and the Euro, summarizing some recent blog posts.

I don't speak German, so I don't know how the translation went, but it sounds great to me:

Die jüngste Griechenland-Krise rückt das größte Strukturproblem des Euro in den Vordergrund: Unter dem Dach einer gemeinsamen Währung müssen Staaten genauso wie Firmen pleitegehen können. Banken müssen international offen sein, sie dürfen nicht vollgepackt sein mit den Schuldtiteln lokaler Regierungen. So war der Euro ursprünglich konzipiert. Leider haben Europas Politiker die erste Prämisse vergessen und sind zur zweiten gar nicht erst vorgedrungen. Jetzt ist es Zeit, beides in Angriff zu nehmen.... 

The English version:

Greek Lessons for a Healthy Euro

The most recent Greek crisis brings to the foreground the main structural problem of the euro: Under a common currency sovereigns must default just like corporations default. And banks must be open internationally, not stuffed with local governments’ debts.

This is how the euro was initially conceived. Alas, europe’s leaders forgot about the first and never got around to the second. It’s time to fix both.



If Volkswagen defaults on its debts and goes bankrupt, nobody dreams that it therefore has to leave the euro zone and start paying its workers in Volkswagen marks. In a currency union, governments cannot print their way out of trouble, so they are just like companies.

When Greece got in to trouble, the first bailout went to the German and French banks who had bought lots of Greek debt. Those debts were all transferred to official holders, meaning, indirectly the German taxpayer.

Why, with the 2008 financial crisis already in the rear view mirror, were European banks — too big to fail, apparently — allowed to load up on Greek debt, to the point that they had to be bailed out? Why did europe’s bank regulators let banks hold sovereign debt as a risk free asset?

The problem has only gotten worse. Greek banks are stuffed with Greek government debt. That’s why there was a run. Greeks, knowing their banks will fail if the government defaults, rush to get money out. They have stopped paying their mortgages, as they have stopped paying taxes, and stopped paying each other. The economy is plummeting. Even with the banks now supposedly open, capital controls remain in place so Greeks cannot pay for imports. And savvy Greeks know there is still a chance of Grexit, deal failure, depositor “bail-ins,” and tightened capital controls. They would be fools to put money back in banks.

A modern economy cannot function without banks. Greece will not restart its economy, restart its tax collections, and restart any hope of paying its debts without completely open and trustworthy banks.

Banking across Europe should be open, and divorced from local government debt. A Greek should be able to put his or her euros in a pan-european bank, whose assets are diversified across Europe and will not even hiccup if Greece’s government defaults. A Greek business should be able to borrow from the same bank, whose deposits come from all over Europe. If a Greek bank fails, any European bank should be able to come in and operate it the next morning. And the Greek government should have no right to grab deposits, force banks to buy its debts, or change the currency of those deposits.

If this had been the case, there would have been no run. The Greek economy would not have collapsed. And then Europe could have been a lot tougher with the Greek government about repayment.

This is how the United States works. When states and cities in the U.S. default — such as Detroit, Puerto Rico, or, possibly Illinois — there is no run on the banks, and banks do not fail or close. Why? Because nobody dreams that defaulting states or cities must secede from the dollar zone and invent a new currency.  State and city governments cannot force state banks to lend them money, and cannot grab or redenominate deposits. Americans can easily put money in Federally chartered, nationally diversified banks that are immune from state  and local government defaults.

As a result, when one of our state governments gets in fiscal trouble, nobody thinks they need to rush to their bank to get their money out, there is no “contagion,” and much less pressure for bailouts.

This was how the euro was supposed to be set up. Many economists have been warning about it for years. But governments like to use their banks as piggy banks, and it never happened.

Greece is not the end. Italian and Spanish banks are just as loaded up with their governments’ debts, and just as prone to a run. There is time to de-fuse this bomb slowly, but that time will run out.

Sovereign default without exit and open banking are the key requirements for the european currency union. A currency union does not need “fiscal union.” The US did not bail out the city of Detroit, or states when they failed. A currency union does not require similar economies. Panama uses the US dollar. A currency union does not need countries to have similar cultures, values, economic development, or productivity. A currency union does not need political union.  Europe used gold as the common currency for centuries, centuries when Kings defaulted frequently.

Many people say that small countries need their own currencies, so they can artfully devalue. But a century’s worth of devaluations and inflations did not produce a Greek growth miracle. There is no exchange rate at which Greece’s government workers will start exporting Porsches to Stuttgart.  Rather, it was binding themselves to the euro that produced a boom, only sadly wasted.

Greece off the euro will be a disaster. Drachmas will surely not be convertible, so Greece will end up like Cuba or Venezuela, with government workers and pensioners paid in worthless local currency, and everyone who can get paper euros operating on a cash basis.  No efficient large businesses can work in such an economy.  Greece’s only hope is to liberalize its economy, open to Europe, grow strongly, and pay back its debts.

The euro is a great and worthy project, and a necessary precursor to healthy open economies in small countries of a globalized world. It’s time to finish building it as originally conceived, not turn it into a bailout union.

Mr. Cochrane is a Senior Fellow of the Hoover Institution at Stanford University.

Greenspan for Capital

Alan Greenspan joins the high-capital banking club, in an intriguing FT editorial

If average bank capital in 2008 had been, say, 20 or even 30 per cent of assets (instead of the recent levels of 10 to 11 per cent), serial debt default contagion would arguably never have been triggered. Had Bear Stearns and Lehman Brothers continued as capital-conscious partnerships, a paradigm under which both thrived, they would probably still be in business. The objection to a capital requirement of 20 per cent or more, even when phased in over a series of years, is that it will suppress bank earnings and lending. History, however, suggests otherwise.

20 to 30 percent used to be the sort of thing one could not say in public without being branded some sort of nut.

Alan also echoes the main point. Banks need lots of regulators micromanaging their investment decisions, because taxpayers pick up the bag for their too-high debts. Banks with lots of capital do not need asset micro-regulation:

...An important collateral pay-off for higher equity in the years ahead could be a significant reduction in bank supervision and regulation.

Lawmakers and regulators, given elevated capital buffers, need to be far less concerned about the quality of the banks’ loan and securities portfolios since any losses would be absorbed by shareholders, not taxpayers. This would enable the Dodd-Frank Act on financial regulation of 2010 to be shelved, ending its potential to distort the markets — a potential seen in the recent decline in market liquidity and flexibility.

A double bravo.

However, to be honest, I have to nitpick a bit on what seems like the right answer for some of the wrong reasons.


Alan seems to argue that the rate of return to equity is independent of leverage:

Banks compete for equity capital against all other businesses....

In the wake of banking crises over the decades, rates of return on bank equity dipped but soon returned to their narrow range. ...

What makes the stability of banks’ rate of return since 1870 especially striking is the fact that the ratio of equity capital to assets was undergoing a significant contraction followed by a modest recovery. Bank equity as a percentage of assets, for example, declined from 36 per cent in 1870 to 7 per cent in 1950..Since then, the ratio has drifted up to today’s 11 per cent. 

So if history is any guide, a gradual rise in regulatory capital requirements as a percentage of assets (in the context of a continued stable rate of return on equity capital) will not suppress phased-in earnings..

There is an exam question in here: what seems wrong? Answer: Competition for equity capital should drive the risk adjusted rate of return for bank equity to be the same as for other businesses. If banks issue more capital, the raw rate of return to equity should decline. So should the variability (beta, risk) of that return. (Other things held constant, which may well be why the historical record is muddy.)

In fact, Alan seems precisely to be making the banks' argument. They claim that the return on equity capital is independent of leverage. They have to pay (say) 10% to shareholders, but only 1% to debt holders, so debt is a cheaper source of financing. Banks claim that forcing them to issue more expensive capital will force them to raise loan rates and strangle lending. Which, curiously, Alan seems to be endorsing. Though he starts with

The objection to a capital requirement of 20 per cent or more, even when phased in over a series of years, is that it will suppress bank earnings and lending. History, however, suggests otherwise.

He follows up with

...bank net income as a percentage of assets will be competitively pressed higher, as it has been in the past, just enough to offset the costs of higher equity requirements. Loan-to-deposit interest rate spreads will widen and/or non-interest earnings will increase.

Ok, so earnings may not be affected, but a rise in loan-to-deposit spreads is exactly what the banks are warning of, and it's hard to see how that would not "suppress bank lending."

All this only happens if investors demand the same return to equity no matter what leverage, and competition then forces banks to deliver that return. This proposition is precisely what advocates (such as myself) or more capital deny. Investors are not that dumb, they demand a competitive risk adjusted rate of return. More capitalized banks will deliver lower rates of return -- and equally lower risk. Bank "stock" will look very much like long term bonds and become the cornerstone of safe portfolios. So we get all of Greenspan's benefits and none of the downside.

Of course, this is just an editorial. He may have meant "risk adjusted" return, and was trying to simplify language.

A Capital Fed Ruling

The Fed just released it's latest missive to the big banks, and the answer is capital, lots more capital.

Three cheers for the Fed.

They are increasingly understanding that no matter how much they try to micromanage asset decisions, it's impossible to regulate away risk from the top. And "liquidity" will vanish the minute it's needed. Joke version -- liquidity standards are like requiring everyone on an airplane to carry a thousand bucks, so they can buy a parachute if the engines blow up. Just who will be buying "liquid" assets in the next crash?

So,  just raise capital, lots more capital, and slowly let the rest fade away.

A minor complaint: The Fed did it right but said it  wrong.

..under the rule, a firm that is identified as a global systemically important bank holding company, or GSIB, will have to hold additional capital...

No, capital is not "held." Capital is issued. Capital is a source of funds, not a use of funds. Capital is not reserves.  Please all, stop using the word "hold" for capital.

"A key purpose of the capital surcharge is to require the firms themselves to bear the costs that their failure would impose on others," Chair Janet L. Yellen said. "In practice, this final rule will confront these firms with a choice: they must either hold substantially more capital, reducing the likelihood that they will fail, or else they must shrink their systemic footprint, reducing the harm that their failure would do to our financial system. Either outcome would enhance financial stability."

Issuing (not holding!) more capital does not make firms "bear costs." Firms never bear costs. They pass costs on to customers, workers, shareholders, or (especially for banks!) the government.  The slight argument for higher "costs" is that equity gets to leverage with less subsidized too-big-to-fail debt; that's not a cost, that's a reduction in subsidy. If (if) the cost of equity capital is high by some MM failure, then equity receives higher returns and borrowers pay higher costs. This is a surprising quote. Ms. Yellen is usually accurate in such matters.

But that's a minor complaint. I'd rather they raise capital and explain it wrong rather than the other way around. And of course, I'd rather they keep going. I'm also a skeptic that big banks are "systemic" and little banks are not, and thus should be allowed to continue with sky high leverage. But we'll get there.

Update:

A reader asks why I'm so persnickety about language. In this case, it's important. I think everyone recognizes that more capital leads to more financial stability. When an equity-financed bank loses money, share prices decline, but there are no failures or freezes. However, if you think capital is "held," and it "costly," then you think that banks shifting to issuing equity or retaining dividends to obtain funds has a cost to the economy, and regulators should require as little capital as possible. If you recognize that capital is issued, does not tie up funds, does not reduce the amount available for lending, then your mind is open to obtaining financial stability with lots and lots more capital.

Greece again

I read this morning's news of a deal -- we'll see how long it lasts -- with interest. Here's a video exchange with Rick Santelli on the subject on CNBC (I can't seem to get the embed to work, so you have to click the link.)

My main thought: what about the banks? The minute Greece reopens its banks, it's a fair bet that every person in Greece will immediately head to the bank and get every cent out. The banks' assets are largely Greek loans, which many aren't paying -- why pay a mortgage to a bank that's already closed and will probably be out of business soon anyway -- and Greek government debt; mostly Treasury bills that only roll over because banks hold them. They can't sell either, so the banks will instantly be out of cash.

The deal reported in today's papers really barely mentions that problem. But that is the problem of the hour.


Greece is basically off the euro now. Being in the euro does not mean that restaurants take euros. Being in the eurozone means that banks use euros, that you can take euros out and arrange international transfers using euros.

The economy is paralyzed. The main thing a deal needs is a way to reopen banks in a matter of days. Privatization and labor laws are fine, but that generates growth a year from now at best. And raising taxes? They must be kidding.

I've read with interest some proposals that the EU take over the banks. The EU takes on the bad assets, gives or sells the rest to large international banks, and these operate under EU rules -- not Greek regulators; they can't buy any Greek debt, and Greece can't tax them.  It's expensive, yes, but it's basically as shoot-the-hostage approach. A functioning economy would help Greek finances. And then the EU can let the Greek government default if it wishes.  Saving the banks might be a lot cheaper than saving the Greek government and the banks.

There are two original sins in the euro, neither having to do with fiscal union. The first is that each country has its own banks, and each government uses its banks as piggybanks to stuff with government debt. European bank regulators and Basel regulations treat sovereign debt as risk free. Then, if the government defaults, the whole banking system is dragged down with it. The second is the endlessly repeated fallacy that government default means the country must change the units of its currency. If Chicago defaults on its debts, nobody thinks it must introduce a new currency, or that Chicago's banks will fail.

A currency union needs a banking union, or at least banks that are not stuffed with government debt. A currency union needs to let sovereigns default without changing currencies or paralyzing the banking and payments system. A currency union needs a banking union.

Can Greece Leave?

Is Grexit even possible?

It strikes me that the best Greece can do with a Drachma is to create a two-currency system, sort of like Cuba or Venezuela, or at best Argentina; countries whose politics the Greek government seems to admire, and whose economies its may soon resemble.

If the government brings back the Drachma  as a way to pay pensions, government salaries, and bank accounts, Euros will still circulate in Greece.

18% of Greek GDP is tourism. That number may be understated -- I don't know if it includes tourist spending at restaurants, stores, transport, and other places that mix tourists and locals. Tourists will spend Euros, not Drachmas. So hotels, gas stations, restaurants, grocery stores, clothes stores, airlines, car rentals, etc. will likely still gladly take euros and euro credit cards, and from locals as well as tourists.

I looked up Greek GDP at the OECD.  Of 157 billion euros value added, agriculture is a tiny 6, industry 18, of which manufacturing 13.  However, services are 130, 80% of the total.  Here, the big items are  "distribution, trade, repairs, transportation accommodation and food" 41, real estate activities 34, and public administration 39.   Exports and imports are each about 60 out of 180 billion euros.

Now, anyone exporting -- 60 out of 157 -- has access to euros and likely invoice in euros thank you very much. Anyone importing will need to get their hands on those euros.

(Interestingly most exports are services, most imports are goods. I can't get a handle on what services Greece exports, and thus whether devaluation would make much difference.)

The 41 billion of "distribution, trade, repairs, transportation accommodation and food" services will surely take euros as above, to convenience the tourist trade.  I can't fathom how 34 billion euros are real estate services -- not construction -- so I can't guess really if that is euros or Drachmas.  The 39 billion of public administration gets Drachmas.

So, the Drachmaized Greece that I see is not the cleanly devalued newly competitive powerhouse that some on the left seem to envision.  Instead I see a two-currency economy. Pensioners and government workers and anyone unlucky enough to still have a Greek bank account get Drachmas. Hotel owners, restaurant owners, and exporters get euros, above or under the table.

In this scenario, I can't imagine a freely convertible currency. Will the government really give 100 Drachmas to someone who used to get 100 Euros, with an exchange rate below half? The point of not cutting salaries was political. So we are almost sure to see capital controls, exchange controls, and a fictional overvalued exchange rate, so Greece can pretend to pay pensioners and government workers.

It's not a pretty thought. Sticking with the euro seems a far better option, just like sticking with the meter.

Greece vs Puerto Rico and what's "systemic."

How is a Greek default different from a Puerto Rican default?

Answer: because Puerto Rico doesn't have its own banking system. It can't shut down banks. Banks in Puerto Rico are not loaded up on Puerto Rico debt, so depositors are not in danger if the state government defaults.

Puerto Rico, like Greece, uses a common currency. But there is no question of PRexit, that people wake up one morning and their dollar bank accounts are suddenly PR Peso bank accounts. So they have no reason to run and get cash out.

Banks in New York are also not loaded up on Puerto Rico debt. US bank regulators haven't said that those banks can pretend Puerto Rico debt is risk free.

If a Puerto Rican bank fails, any large US bank can quickly take it over and keep it running.

A Puerto Rican government default will be a mess. Just like the default of a large business in Puerto Rico. But it will not mean a bank run, crisis, and economic paralysis.

So here is a big lesson of the Greek debacle: In a currency union, sovereign debt must be able to default, without shutting down the banks, just as corporations default. Banks must not be loaded up on their country's sovereign debt. Bank regulation must treat sovereign default just like corporate default. It can happen, and banks must diversified and capitalized to survive it.  Banks must be free to operate across borders.  A common currency needs a firm commitment that it will not be abandoned.

In financial regulation, the big debate rages over what is "systemic,"  with the latest absurd idea to extend that designation to equity asset managers. (More later.) All that discussion starts with statements that  sovereign debt or anything backed by sovereign debt or sovereign guarantees is safe and per se not "systemic." Sovereign debt still counts as risk free in almost all banking regulation.

Greece should reinforce the lesson: Sovereign debt is a prime source of "systemic" danger. That is especially true of small governments in a currency union. A government is just a highly leveraged financial institution and insurance company.

Wrong answers:

- Fiscal union. The US is not necessarily going to bail out Puerto Rico. Or Illinois. Or their creditors. People keep saying a currency union needs fiscal union, but it is not so.

- National deposit insurance is really not central either. The banks operating in Puerto Rico are not in danger, so they don't need deposit insurance protection.

Update: A colleague pointed me to this excellent article on banks holding their own sovereign debt by Lucrezia Reichlin and Luis Garicano.

Last Greek thoughts

A few salient points that don't seem to be on the top of the outpouring of Greece commentary.

1. Greece seems to be coming to a standstill.  Kerin Hope at FT  (HT Marginal Revolution):

... many [Greeks] have simply stopped making payments altogether, virtually freezing economic activity.

Tax revenues for May, for example, fell €1bn short of the budget target, with so many Greek citizens balking at filing returns. 

The government, itself, has contributed to the chain of non-payment by freezing payments due to suppliers. That has had a knock-on effect, stifling the small businesses that dominate the economy and building up a mountain of arrears that will take months, if not years, to settle.

“Business-to-business payments have almost been paused,” one Athens businessman says. “They are just rolling over postdated cheques.”

 Around 70 per cent of restructured mortgage loans aren’t being serviced because people think foreclosures will only be applied to big villa owners,” one banker said.

2.  If a Greek goes to the ATM and takes out a load of cash, where does that cash come from? The answer is, basically, that the Greek central bank prints up the cash. Then, the Greek central bank owes the amount to the ECB. The ECB treats this as a loan, with the Greek central bank taking the credit risk. If the Greek government defaults, the Greek central bank is supposed to make the ECB good on all the ECB's lending to Greece.  It's pretty clear what that promise is worth.

Some observations on what these stories mean.

1.  The argument is not about "lending" to Greece, i.e. covering this year's primary surplus. The argument is whether the IMF, ECB, and rest of Europe will lend Greece money to... pay back the IMF, ECB, and the rest of Europe. This is a roll over negotiation, not a lending negotiation.

The loans were not intended to be paid back now. The loans were intended to go on for decades. But with conditions. The negotiation is about enforcing or modifying the conditions for a roll-over.

Rolling over short term debt with periodic reviews is a nice incentive mechanism. Foreign policy should try it.

2. The latest proposed agreement includes sharp increases in tax rates.  Now? Are you kidding?

Source: theguardian.com

I am reminded of the story of a town, that had a bridge, that had a 50 mph speed limit. A drunk driver, going 85, caused  horrific crash. The town lowered the speed limit to 25.

What Greece needs is to get going again. That is, to persuade anyone that this is a good country to start a business, invest, hire people, and so forth.  In particular, if Greece is to pay back debts, it has to become an export-oriented growth economy, and run trade surpluses Higher VAT, higher corporate taxes, and higher taxes on successful entrepreneurs are hardly the way to go about attracting investment.

I think of taxes in terms of incentives. Keynesians look at aggregate demand. Either way, raising tax rates, now, in an economy where nobody is paying much of anything because they see the big explosion ahead seems destined, pragmatically, to raise no revenue. And, incidentally and humanely, to further crater the economy.

Despite cuts, the Greek government is still spending north of 50% of GDP. If you want to get primary surpluses, that seems the place to cut.

But with an economy at a standstill, major structural reform (like, go back and put back in the structural reforms that Syriza scuttled on arrival) seems like a more promising short-term set of conditions. And we'll see you on the next big roll-over.

3. Rolling over post-dated checks is a fascinating story to a monetary economist. Money is created when needed, apparently.

4. The bank run, or "jog." Remember, the big Greek bailout already happened. Private investors, largely European banks, who held Greek government debt got to sell their debt to government and IMF. Bailouts are creditor bailouts.

One way of viewing the current slow motion crisis is an invitation for ordinary Greeks to join these investors. Take euros out of the bank. The government default will happen, possibly with bank closures, capital controls, currency exit, and expropriation. But lending to Greek banks is now bailed out, with the losses sent to Europe via the ECB, just as German bank's lending to Greek banks was bailed out in the first round. Too clever, maybe, but that is the effect.

Too clever, really, to describe the situation. It only works if the government actually does exit, and soon. Getting money out of the banks and then defaulting is one thing. But a frozen economy can't go on long.

I repeat: the run and non-payment, freezing the economy, happen largely because people see capital controls, bank account expropriation, grand all-around default (your mortgage might get redenominated to Drachmas too, and forgiven once the bank goes under, so why pay now) and Grexit in the future.  The simplest way to stop the run and economic cratering would be a solid commitment from both sides that government default will not mean Grexit,  capital controls, etc.

5. Without the banks, this would all be simple. Greece could default, stay in the Euro (unilaterally if need be) and Euro zone. One government defaulting on debts to other governments is not a crisis.
All along though, the involvement of the Greek banking system makes it much harder.

Greece has 11 million people, $242 billion GDP and 51,000 square miles. That's as many people as Ohio, the GDP and land area of Louisiana. Why does Greece need its own banking system in a common currency and free market zone?

Think how much easier this would all be if Europe had gotten around to integrating its banking system. In any city in the US, the major banks are all national. If California defaults on state bonds, your Chase bank account is safe, and not because of Federal deposit insurance. Because the bank has no exposure to California bonds.

Imagine if Greeks deposited money in a local branch of a large pan-European bank, backed by assets spread throughout Europe. Imagine if Greeks borrowed money from the same bank, funded by deposits spread throughout Europe. Imagine if, when a remaining Greek bank defaults, the European equivalent of Chase could sweep in, and take over loans and deposits seamlessly. A default by the Greek government on its bonds would be inconsequential to Greek banking.

Why not? Well, such banks would not hold vast amounts of Greek government debt. Such banks would not have Greek ownership, or be controlled by the Greek regulatory system. Such banks would not be available targets of Greek capital controls, or a currency change.

Greece needs an independent, national, banking system about as much as Ohio or Louisiana need independent, state banking systems.

6. And currency. Many economists keep saying how wonderful it is for tiny countries to have their own monetary policy, so they can devalue their way out of crises like these. They advocate "capital controls" (English translation: expropriation of savings). That's how Argentina, say, is such a success story. We may be about to see.

Bank at the Fed

"Segregated Balance Accounts" is a nice new paper by Rodney Garratt, Antoine Martin, James McAndrews, and Ed Nosal.

Currently, large depositors, especially companies, have a problem. If they put money in banks, deposit insurance is limited. So, they use money market funds, overnight repo, and other very short-term overnight debt instead to park cash. If you've got $10 million in cash, these are safer than banks. But they're prone to runs, which cause little financial hiccups like fall 2008.

But there is a way to have completely run-free interest-paying money, not needing any taxpayer guarantee: Let people and companies invest in interest-paying reserves at the Fed. Or, allow narrow deposit-taking: deposits channeled 100% to reserves at the Fed.

(I'm being persnickety about language. I don't like the words "narrow banking." I like "narrow deposit-taking" and "equity-financed banking," to be clear that banking can stay as big as it wants.)

That's essentially what Segregated Balance Accounts are. A big depositor gives money to a bank, the bank invests it in reserves. If the bank goes under, the depositor immediately gets the reserves, which just need to be transferred to another bank. This gets around the pesky limitation that the Fed is not supposed to take deposits from people and institutions that aren't legally banks.

...the funds deposited in an SBA would be fully segregated from the other assets of the bank and, in particular, from the bank's Master Account. In addition, only the lender of the funds could initiate a transfer out of an SBA; consequently, the borrowing bank could not use the reserves that fund an SBA for any purpose other than paying back the lender. ...The bank receives the IOER rate for all balances held in an SBA. The interest rate that the bank pays the lender of the funds deposited in an SBA would be negotiated between the bank and the lender

The reverse repo program achieves the same thing, but many at the Fed seem to regard it with suspicion.

Why is this such a good idea? First, from my perspective, it opens the door to narrow banking; to government provided run-proof electronic money.

Second, emphasized in the paper, SBAs could help "pass through" interest rate rises. Suppose the Fed wants interest rates to be 5%  It starts paying banks 5% on reserves.  Banks will probably start demanding 5% or more on loans, since they can get 5% from the Fed. But banks may not compete on deposits, merrily taking our money at 0% and investing at 5%.  Large institutional investors, who can invest in money market funds, aren't going to sit still for that however, so they SBA accounts should very quickly reflect interest on reserves. In turn, that will put upward pressure on short-term commercial paper, Treasury, and other markets, and provide competition for deposits.

I learned an interesting legality. Are the SBA accounts really run free, exempt from bankruptcy proceedings? Not totally

Under the FDI Act, and subject to certain exceptions that are not applicable here, creditors of a DI [Depository Institution] that is in FDIC receivership are prohibited from exercising their right or power to terminate, accelerate, or declare a default under any contract with the DI, or to obtain possession or control of any property of the DI, without the consent of the receiver during the 90-day period beginning on the date of the appointment of the receiver. For purposes of this paper, it is assumed that the FDIC would act quickly to permit lenders to gain access to SBAs that collateralize their loans. However, this treatment has not been approved by the FDIC, and the decision by the FDIC on treatment of an SBA account in resolution could affect the willingness of firms to participate in these accounts.

That's all putting it mildly. It could also affect the willingness of firms not to run at the first hint of trouble, which is the whole point. Evidently, the FDIC needs to carve exemption from bankruptcy in stone.

A few quibbles

The near elimination of credit risk, which is the hallmark of SBAs, would level the playing field so that all banks could borrow in the overnight money market on equal footing..

Well, not really. Sure, they can borrow on equal footing so long as they put the results right in to the Fed. They cannot borrow for other purposes, like to lend it out to you and me, on equal footing.

The paper also echoes the worry that firms might run to these programs in a crisis

One concern is that SBA take-up could be too large. .. in times of intense stress, which may be characterized by a flight to quality, flows into SBAs could produce a scarcity of reserves that banks use to meet reserve requirements and could also cause (temporary) dislocations in funding markets for nonbank entities.  

I beat up on this view in discussing the overnight RRP program here, so I won't make the same points again. It still makes no sense to me. Flows into SBAs have to come from somewhere; and we're $3 trillion dollars away from required reserves anyway. And will be even further away once this program goes in.

Update: In fact, when you dig in to the paper, it pretty much concludes that these "financial stability" arguments are not important. From p 18

Recently, market observers and policy makers have expressed concerns that uncapped ON RRPs could exacerbate flight-to-quality flows, by providing a risk-free alternative to bank deposits, thereby causing a removal of much needed liquidity from the financial system.  For these reasons, an aggregate cap on the amount that can be invested at the ON RRP facility has been imposed and an auction pricing mechanism has been introduced to ration ON RRPs in the event that bids exceed
the aggregate cap. 

A similar concern could arise with SBAs. During a crisis, SBAs might be seen by lenders as an attractive near risk-free investment. However, a "surge" into SBAs i.e., an increased supply of funds by lenders for SBA collateral arrangements, would be accommodated by counterbalancing price movements.... an increase in the federal funds rate, as usable reserve become scarce. Further, because SBAs are supplied competitively, their rate would not adjust, since the rate is "competitively tied" to the IOER rate. The result would be an increase in the spread between the federal funds rate and the rate paid on SBA balances, which would help to arrest the surge and mitigate potential dislocations in funding markets. 

Additional factors could limit the ability of investors to suddenly place large sums of money into loans secured by SBAs. ...

I think there are deeper conceptual problems with the whole argument that offering SBAs, ON RRPs, or floating-rate Treasuries contributes to a run by offering a safe alternative, but in the end we are agreeing just for slightly different reasons.

Reserves for all! Via money funds and overnight RRP, or via narrow deposits at banks. Or, via fixed-value floating-rate Treasuries. Let the run-proof financial system begin to emerge.

Now, if the Fed would only say "and, by the way, any bank that puts all of its deposits in SBAs, and finances all of its lending with equity capital, will be exempt from all the Dodd-Frank regulation and stress tests, because it is obviously completely un-systemic."

McAndrews on negative nominal rates

Jamie McAndrews of the New York Fed has a thoughtful and clear speech on negative nominal rates and the benefits of currency. (Some previous posts on the subject here  here and here.)

A few high points:

1. Needed: anonymous electronic transactions.

Many (not all) negative interest rate proposals call for the elimination of currency. Currency is dying anyway due to the great advantages of electronic transactions. I bemoaned the loss of privacy and political freedom when the NSA, the IRS, and pretty soon Twitter and the Chinese Department of Hacking have a record of everything you've ever bought or sold. Jamie brings up another important point:

The anonymity afforded by currency transactions prevents a buyer from suffering from any actions taken after the transactions that could exploit the knowledge gained by the seller of the buyer’s identity. For example, identity theft, or theft of credit or debit card information, is avoided through the use of currency. This is an economic benefit that is distinct from valuing privacy from a civil liberties point of view. If currency cannot be used in transactions, buyers are at a disadvantage, and many otherwise beneficial transactions (not related to buyers seeking to engage in tax evasion or otherwise illicit activity) would not take place.

Anonymity has value in many transactions. Anonymity equals finality.

It's not hard to have anonymous electronic transactions. Stored value cards could work well as electronic cash. If regulators allowed it, it would be simple enough to set up a money market fund that allows anonymous investing. Regulators don't allow it.

2. Hysterisis of institutions and the lesson of the 70s


There are fixed costs in setting up many institutions that adapt to negative nominal rates. For example, the option to hold currency:

.. Often, the costs of holding currency securely, by having a safety deposit box or a vault, are fixed costs. Once one has a vault, or has rented a safety deposit box, the costs of storing additional currency in it, up to its capacity, is nil. This suggests that there is a dynamic element to the economics of avoiding negative interest rates: the longer the negative rates are expected to persist, and the lower they are, the more favorable are the returns to investing in a vault. Once the vault investment has been made, maintaining negative rates would likely become more difficult.

An even more far-reaching change that many have suggested would be the creation of a new institution to handle and store currency on behalf of others; this could dramatically reduce the costs of holding currency...

Jamie adds to the clever ways to synthesize zero rate investments, and a cost I hadn't thought of

For example, suppose that one holds a credit card under existing U.S. rules: one can withdraw funds from an account that is earning a negative rate, and pay one’s debt to the credit card company in advance of when it is due, earning a zero return during the prepayment period....

... if one were to receive a check from the U.S. government for a tax refund, one could simply put it in a safe place and earn zero interest on it during the time the check remained undeposited...

...leaving the check undeposited, much like the hoarding of currency, is a negative outcome for society. ... This may impose unexpected costs on the check writer, triggering unplanned overdrafts and associated charges...

...having talented individuals looking for these opportunities is a dead-weight loss to society. We would rather have them use their talents for more socially productive purposes.

We went through this once before. In the 1970s, pricing and financial institutions were set up with small positive interest rates in mind. It took a period of prolonged inflation to induce people to spend all the fixed costs to adapt to high interest rates, including widespread indexation, money market funds, interest-paying checking accounts, and so forth. In turn, the easing of these "frictions," quickly removed the hoped-for benefits of inflation. For example, prices and wages were sticky when there was less inflation. Turn on inflation, and once people put the effort in to index contracts, price and wage stickiness fade, and inflation has much less output and employment effect.

So, the same sorts of legal and financial investments that allowed an economy to adapt to high nominal interest rates can also allow it to adapt to negative interest rates -- at large cost, in time and effort, in rewriting contracts, and in foregoing many advantages of currency. But are we sure the benefits will not disappear at the same time?

3. Financial institutions and negative rates

The health of banks and many other financial institutions depends on earning a spread between what the institutions earn on their assets and what they pay on their liabilities. Negative rates can squeeze bank profits.

and a lot of non-banks too. There is a plausible channel here that negative nominal rates hurt a large swath of financial institutions -- at least until they rewrite all their contracts and persuade all their clients to accept negative rates. This is a channel by which lowering rates could hurt economic activity.

By the way, I learned that those negative rates aren't so negative,

..the central banks that have negative policy rates offer zero rates on many of their deposits from banks, imposing negative rates on the “marginal” deposits. In this way, commercial banks can, in general, charge their retail depositors deposit rates of zero and earn zero at the central bank on at least a large portion of their reserve holdings.

4. Speaking of cause and effect signs...

..people could infer [from a negative interest rate] that the central bank itself has low expectations for inflation and is lowering nominal rates into negative territory as a way to “ratify” the low expected inflation environment. Such an inference would complicate the central bank’s effort to achieve its objective because it could encourage and entrench the public’s expectations for deflation. That could complicate the potential exit from the negative rate regime

Maybe with abundant excess reserves, the Fisher equation is stable -- and that lowering nominal rates will cause inflation to decline. Jamie isn't quite ready to burn at the heretic's stake on this issue, but you can see him edging closer to the fire.

Gdefault needs not Grexit

The little grumpy cartoon usually represents me pounding my coffee down in agreement as the WSJ exposes some idiocy. Last week, alas, I spilled my grumpy coffee in disagreement with a little part of its otherwise excellent  "The case for letting Greece go."

Thursday marks another deadline in Greece’s struggle to avoid default, as a €450 million payment to the International Monetary Fund comes due. Athens says it will meet this obligation, but sooner or later Prime Minister Alexis Tsipras and his government will miss a payment to someone if it doesn’t agree with creditors on a new bailout. An exit from the euro would then be a real possibility.

Please can we stop passing along this canard -- that Greece defaulting on some of its bonds means that Greece must must change currencies. Greece no more needs to leave the euro zone than it needs to leave the meter zone and recalibrate all its rulers, or than it needs to leave the UTC+2 zone and reset all its clocks to Athens time. When large companies default, they do not need to leave the dollar zone. When cities and even US states default they do not need to leave the dollar zone. A common currency means that sovereigns default just like large financial companies. (Yes, a bit of humor in the last one.)


Sure we can have an argument about whether it would be a good idea. The first 147 devaluations and currency confiscations didn't produce Singapore on the Mediterranean, but maybe the 148th will do the trick. The canard is the logical necessity of Grexit.

This is a particularly dangerous canard too. Greece is undergoing a slow motion bank run. Greeks are wisely taking their euros out of Greek banks and either holding cash or taking it abroad. So, how to Greek banks give them euros without selling all their assets -- loans and Greek government bonds? Answer, they get the money from the Greek central bank, which gets the euros from the ECB. The ECB is getting antsy about funding not just Greek government debt, but the whole Greek banking system.

Sooner or later Greeks will translate all this central banker speak about "capital controls" "liquidity management" and so forth to "there is a good chance that tomorrow morning your bank account will be frozen or converted to Drachmas." Then the run of all time starts and the whole thing unravels.

How do you stop that from happening? By shouting from the rooftops that the currency remains the euro, no matter if the government defaults on its loans to the IMF. At least we can shout from the rooftops that changing currencies is a separate decision, and that stiffing the IMF does not imply the logical necessity of grabbing Greek bank accounts.

To be sure the article gets much right. It's main thesis: Letting Greece default might be the right thing to do

But if Athens won’t implement reforms that would return Greece to growth and sustainable finances, allowing the country to leave would be the least bad outcome.

And if the WSJ understood that "allowing the country to default" is not the same thing as "allowing the country to leave" the case is even stronger. (Though who does this "allowing" is a bit muddy. One more subject-less sentence infects the forlorn English language of policy-speak)

No one should cheer a Greek exit, which would be a disaster for the Greeks.

Yes. Yet another reason to separate sovereign default from a change of monetary units.

Greece’s main contagion threat now would be if it is bailed out again without reform. 

This is the article's central point, and a good one. In financial as in foreign policy, people take important lessons from discovering that threats are empty.

The strongest argument against allowing Greece to leave the euro is that it would dent the bloc’s appearance of permanence, making the euro more like a currency peg that members could leave at will.

Exactly. And if we would all go back to the original Instruction Manual For the Euro, that says sovereign default can happen, just like corporate default, and does not require a change of currency, that permanence would be all the more assured.

Duffie and Stein on Libor

Darrell Duffie and Jeremy Stein have a nice paper, "Reforming LIBOR and Other Financial-Market Benchmarks" I learned some important lessons from the paper and discussion.

Libor is the "London interbank offering rate." If you have a floating rate mortgage, it is likely based on Libor plus a percentage.

In its current form, LIBOR is determined each day (or “fixed”), not based on actual transactions between banks but rather on a poll of a group of panel banks, each of which is asked to make a judgmental estimate of the rate at which it could borrow.

As soon as money changes hands, there is an incentive to, er, shade reports in the direction that benefits the trading desk.

Revelations of widespread manipulation of LIBOR and other benchmarks, including those for foreign exchange rates and some commodity prices, have threatened the integrity of these benchmarks.. 

or report a rate that makes your bank look better (lower rate) than it really is:

During the financial crisis of 2007-2009...Some banks did not wish to appear to be less creditworthy than others... The rates reported by each of the panel of banks polled to produce LIBOR were quickly published, alongside the name of the reporting bank, for all to see. As a result, there arose at some banks a practice of... understating true borrowing costs when submitting to a LIBOR poll. 

An important point as we get in to security design mode:

many of the documented cases of LIBOR manipulation...involved only very small rate distortions, with the guilty parties often misstating their borrowing costs by just one or two basis points. 

OK, what to do? Rather obviously, publishing the individual bank quotes and not just the average is not a good idea, and I gather will end.

In Darrell and Jeremy's view, we really need two indices for the two separate purposes of Libor.

Libor is used as an index for banks who issue adjustable rate mortgages. For that use, an index of bank borrowing costs is appropriate. But bank borrowing from each other has dried up considerably. Interbank borrowing is really no longer a marginal source of funds. And the market is so small these days that a transactions-based index would be unreliable -- and also open to manipulation.

They suggest an index based on a larger set of securities more representative of actual borrowing costs,

LIBOR ... fixing must be broadened so as to be based on unsecured bank borrowings from all wholesale sources—not just other banks, but non-bank investors in bank commercial paper and large-denomination CDs.

There is an important (very stylized, and likely inaccurate) story here. Why do we have indices anyway?  In the old days, you went to the bank to borrow money. It was like going to a car dealer in the 1950s. Each bank might quote you a price, but you don't really have a good idea if you're getting a good deal without a lot of shopping. In this environment, you can't really have variable rate loans where the bank just announces a new rate.

A better system: The bank quotes you "prime" rate plus some percentage points. But what's "prime?" Well, at least you know it's the basis for the bank's lending to all its other customers. If they say "prime went up you have to pay a higher rate on the loan" you know they're doing the same to all their customers, not just you. That makes variable rate loans more possible and reduces haggling and shopping.

Better yet: The dealer shows you his invoice (the real one, not the phoney one at car dealers!) That's the Libor idea. It's an index of the rates banks pay for funding at the margin. So if Libor goes up, it's much more transparent that the bank is just passing costs on to you.

Don't banks like the obscure system to charge higher profits? Well, not necessarily, which is another important lesson. Haggling over each item and dealing with customers who feel like they're in the 1950s Chevy showroom from "Tin Men" turns out to be less profitable than running a large volume transparent Car-Max operation.

So far so good, but now a second lesson comes to the fore. Libor, as constructed, was a lot better than "prime" announced by each bank. But once markets and contracts settle on Libor, it's awfully hard to move to something better yet.

This gives a role for policy, as Jeremy and Darrell point out, in setting standards, or moving markets to another focal point. We can all use feet or meters, miles or kilometers, dollars or euros.

Being a popular interest rate index, Libor was the natural choice for interest rate derivatives. For example, a swap is a contract in which I promise to pay you $x dollars per year, and you pay me a floating rate. What's a good floating rate... Well, the banks are all using Libor, let's use that!

So now we are in this puzzling point that a huge amount of money changes hands based on a tiny market.

...Unfortunately, there are surprisingly few actual loan transactions between banks that could be used to fix most of the IBORs...

At the commonly-used three-month tenor, transactions in the underlying market for unsecured bank funding are roughly on the order of a billion dollars on a typical day, while the volume of gross notional outstanding in the swap market that references LIBOR at this tenor is on the order of $100 trillion, or 100,000 times larger. [See Table 1 and Table 2.]

And Libor really isn't the right index here. Most derivatives traders are interested in hedging the overall level of rates. They don't mostly care about the bank credit spreads. If treasury rates go down but bank rates go up, because people get scared about banks as in 2008, these traders want an index that goes down.

...IBORs have been heavily used in contracts whose purpose is to transfer risk related to general market-wide interest rates. These “rates trading” applications are not specifically tied to the borrowing costs of banks. It is a self-reinforcing choice by market participants, however, to trade in more liquid high-volume markets, all else equal. In part through an accident of history, this desire to belong to the high liquidity club has led to a massive agglomeration of trade based on the IBOR benchmarks.

So, Darrell and Jeremy propose a second, transactions-based index to be used for derivatives contracts. They have a brilliant idea. Currently, most derivatives are based on three month rates. So, in January 1, we look at the rate for borrowing and lending from January 1 to March 31, and settle derivatives. But there is very little volume in three month rates. Instead, watch the general collateral overnight rate, which has tremendous volume, and pay off contracts on March 31, based on the average of the one-day rates in the quarter.

They have a lot of useful thought on implementation and transition, of course.

Run Free Video

This is a talk I gave at the joint Mercatus/Cato "After Dodd-Frank" conference last spring.  It's based on Toward a Run-Free Financial System.

Pennacchi on Narrow Banking

I stumbled across this nice article, "Narrow Banking" by George Pennacchi. The first part has a informative capsule history of U.S. banking.

George defines a spectrum of "narrow" banks. For example he includes prime money market funds -- borrow money, promise fixed value instant withdrawal, buy Greek bank commercial paper. But that is "narrower" than traditional lending, as the assets are short term and usually marketable.

Some interesting tidbits:

Prior to the twentieth century, British and American commercial banks lent almost exclusively for short maturities. Primarily, loans financed working capital and provided trade credit for borrowers who were expected to obtain cash for repayment in the near future

Therefore,

... the typical structure of these early banks contrasts with the modern view of banks, according to which the received wisdom is that “[t]he principal function of a bank is that of maturity transformation---coming from the fact that lenders prefer deposits to be of a shorter maturity than borrowers, who typically require loans for longer periods” (Noeth & Sengupta 2011, p.8)....maturity transformation was often considered a violation of prudent banking.

On the nature of assets:

Following the US Civil War, many banks ... invested in commercial paper... With the establishment of the Federal Reserve System in 1913, commercial paper became especially desired because it was eligible collateral for borrowing from the Fed’s Discount Window. According to Foulke (1931), prior to the 1930s, banks and trust companies held more than 99% of commercial paper....In contrast, banks today hold very little commercial paper

so "bank" then = "prime money market fund" today -- but, after 1913, with discount window liquidity support. Some disintermediation makes a lot of sense. In 1830, you could not hope to sell commerical paper in 10 milliseconds on an electronic exchange, so the "liquidity creation" by banks was more necessary.  The struggles the SEC is having with prime funds today has deep roots.

Credit lines:

One credit service of banks that is ubiquitous today but was completely absent from banks in the nineteenth and early-twentieth centuries was the loan commitment. In recent years, more than 70% of business lending was from loan-commitment drawdowns.

This was an especially interesting issue in the crisis. Chari,  Christiano, and Kehoe noticed bank lending going up in fall 2008. Lending freeze, what lending freeze?  Scharfstein and Ivashina argued increased lending was mostly companies grabbing cash promised under existing lines of credit.

Prior to the 1930s, banks often had long-term relationships with particular borrowers: Banks would lend repeatedly for short terms to the same borrower....During the financial panic period of 1857--1858, the [Black River] Bank’s number of borrowers declined by nearly 75%,..early banks made virtually no formal loan commitments.

so rolling over loans without commitment is a way to preserve the option not to lend in a crisis. Perhaps Fed liquidity support is what changed rolling over to promising to do so.

Narrow deposit creation and the viability of equity-backed banking:

...[the] Louisiana Banking Act of 1842. ...required a bank to hold specie (gold) and bills of exchange and promissory notes maturing in 90 days or less in amounts at least equal to its deposits and notes issued. Moreover, the ratio of specie to the total of deposits plus notes had to be at least one-third. The bank could make loans with maturities greater than 90 days, such as mortgages, and hold real estate and other fixed assets but they must be funded with equity capital, not deposits or notes.

Hammond (1957, p.683) states, “The available evidence is that the system operated with distinguished success…Although the banks of New Orleans were well known throughout the country for their strength and integrity, the law governing them was not generally emulated.” Sumner (1896, pp. 387, 389) is more enthusiastic, calling the act “the most remarkable law to regulate banks, which was produced in this period, in any State…"

We seem doomed to constantly reinvent the steam engine, then to forget how it worked.

In summary, prior to the early-twentieth century, many US banks functioned similarly to narrow banks by holding primarily short-maturity assets to match their short maturity liabilities. Despite the several episodes of banking panics, it may be argued that panics occurred primarily at banks that deviated from the narrow-banking ideal. 

A new kind of moral hazard:

A more important response to the 1907 panic was the establishment in 1913 of a government lender of last resort and central bank in the form of the Federal Reserve System. Access to the Fed’s Discount Window made it less costly for banks to hold longer-term and more illiquid loans. Indeed, Friedman & Schwartz (1963) argue that the Fed’s existence changed banks’ behavior in ways that led to more bank failures during the early 1930s. Banks shifted to higher credit-risk loans and felt less need to lend to each other during times of stress because that was now considered the Fed’s responsibility (which the Fed failed to perform adequately).

...bank capital-asset ratios were trending downward since the 1840s (when they were over 50%), but the decline accelerated following the founding of the Fed and the FDIC. The capital ratio then stabilized in the range of 6%–8% starting in the early 1940s

and half of that at the start of the financial crisis in 2007.

As with other proposed bank reforms, recommendations for narrow banks appear most frequently following major financial crises. With the exception of the Louisiana Banking Act of 1842, and possibly the U.S. Postal Savings System, proposals involving narrow banks have not been implemented.

Well, not yet!

The rest of the paper has a nice summary of narrow banking proposals, and theoretical analysis.

Regulation and competition

From taxis to banks, regulation is quickly captured to stifle competition. Only it's usually polite not to say it out loud. Today's WSJ has a lovely little piece, Regulation is Good for Goldman confirming the former and violating the latter pattern.

the Goldman Sachs CEO explained how higher regulatory costs are crushing the competition.

“More intense regulatory and technology requirements have raised the barriers to entry higher than at any other time in modern history,” said Mr. Blankfein. “This is an expensive business to be in, if you don’t have the market share in scale...

he said his bank is “prepared to have this relationship with our regulators”—and the regulators are prepared to have a deep relationship with Goldman—“for a long time.”

.. it is unusual to see a financial CEO like Mr. Blankfein state the effect so candidly. Goldman can afford to hire battalions of lawyers and lobbyists to commune with regulators... As ever, powerful government mainly helps the powerful.

I have met several people who started financial companies in the pre-Dodd-Frank era. They all say there is no way they could start their businesses now. Working out of the garage, you can't afford a multi-million dollar compliance department.

Run-Free Funds Expand

Louise Bowman at Euromoney reports

Fidelity Investments has announced plans to convert up to $125 billion-worth of prime US money market funds (MMFs) into government-only funds –

Meaning, funds that invest only in government securities.

...a move that is a direct consequence of the new SEC regulations covering this business that were announced in July.

...From October next year, MMFs must hold at least 99.5% of total portfolio assets in cash or government securities and repos collateralized by such instruments to be exempt from new regulations imposing fees and gates on such funds in times of stress. The rules are designed to slow deposit runs and reduce systemic risk

In case you missed it, in the financial crisis the Reserve Fund, which held a lot of Lehman debt, suffered a run, and too big to fail quickly expanded to money market funds.

What are they invested in now?

Of the $125 billion in the three Fidelity funds, only 22% is currently invested in government fund-eligible assets, according to BAML. That means $97 billion (78%) now invested in CDs, CP, non-government repo and other instruments will need to be rolled into government holdings. Of this, $9 billion is bank CP, $2 billion non-financial CP and $15 billion non-government repo....less than 10% of the $97 billion in short-term unsecured bank paper held by the three Fidelity funds marked for conversion was issued by US institutions.

This is, in my view, great news. Money market funds were promising complete safety -- you can take your money out at any time -- and lending it, unsecured and uninsured, to banks. Not just too big to fail American banks, but (say) Greek banks.

I thought this would be more of a challenge. You can always promise greater yields during good times and hope for a bailout in bad. Or, each investor hopes to get out ahead of the others. Apparently not,

"Many investors have told us that they want access to money market mutual funds with a stable NAV that will not be subject to liquidity fees or redemption gates," stated Fidelity when news of the conversion became public. 

Though to some extent that's because the temptation is low right now.

With credit spreads on non-government funds as low as they are, the returns are simply not attractive enough versus government funds ... 

Louise worries that this spread will rise.  

The expectation is that...unsecured funding costs for the banks will rise. This has particularly serious implications for non-US banks, as they are far greater users of this market than their US counterparts, which have ready access to cheap deposits.

It will. It should. But paragraph 1 should inform paragraph 2. A higher rate will induce people to take the risk and hold commercial paper directly, or suffer the indignities of the fees and gates in return for higher yields. Supply does equal demand!

Like the other Squam Lakers, I think that floating values are a better solution for non-government funds. But I like emergence of run-free, treasury-backed money market funds!

(This is "narrow banking" but I try not to use that word. The point is not to "narrow" banking. Using that word reinforced the fallacy that the size of credit creation must contract. The point is that risky investments should have floating-value or run-free liabilities, and fixed-value liabilities should be backed by government securities. For more, "Toward a run-free financial system")