JACKSON HOLE IN ONE?

FT's Krishna Guha writes on the meeting of central bankers (except Mervyn King) at their regular Jackson Hole, Wyoming, gettogether, "As central bankers from around the world queued on the terrace of Jackson Lake Lodge at the weekend to gaze at the stars above the Teton mountains through almost Nasa-sized telescopes, they must have wished they had as much clarity on the economic horizons they usually scan as they did on the constellations above... though they are now confident that the world has avoided an economic black hole." - a very non-Roubiniesque comment? I offer a vision photographed when the crisis was in meltdown in August 2007by Tyler Nordgren who captured this lunar eclipse sequence from his campsite in Grand Teton National Park on August 29. He took an exposure of the moon every 10 minutes until it disappeared and the sun lit up the mountains with alpenglow. I can do no better than to begin with krishna's text, "That is not an easy idea to sell to politicians, voters – or even regulators. After all, as Turner points out, world without a reliable compass is frightening, exhausting and time-consuming to navigate. “For the regulators of the world, once you have accepted that you don’t have an intellectual framework of “more market is always better” you’re in a much more worrying space, because you don’t have an intellectual system to refer each of your decisions.” And it remains crucially clear whether Turner will ever be able to actually turn any of his rhetoric into policies, given the scale of backlash that his comments will undoubtedly spark from the banking world. But I, for one, reckon he is to be applauded, for at least trying to think the unthinkable again - and move away from a crude reliance on creeds. The only question now whether other regulators will follow, not just in Europe, but, above all, in the US, where so many of the free-market dogmas first sprung to life?"
Free market may or may not be fairly described as "dogma" even if for many it is undoubtedly no better than this. The British alone running a trade deficit for free trade reasons for most of the 19th century that made the country rapaciously interested in finding gold to pay its creditors, is probably the better starting place for earmarking the origin of this 'dogma'. The USA was doing similar for most of the 20th century and there can be little doubt that while extreme imbalances in world trade led to the Credit Crunch (and other negative blips and major downturns from time to time) this also generated much that has been positive, if as in everything neither all negatives nor all positives. What now seems indubitable is the new central role for central banks who must now address problems with more empicism less dogmatic theory, more Keynesianism less Monetarism, more prudential macro- finance & macro-economics less micro-finance & supply-side theory; is Quantitative Easing supply-side finance or merely clearing the decks (debt restructuring) preparatory to massive issues of government bonds and ultimately replacing private indebtedness poorly collateralized (that grew to 3 times GDP in many countries when public sector debt stuck at half of GDP) with public debt (fully collateralized) that can profit for the taxpayer from interbank wholesale funding when private finance dried up (Credit Crunch)? Global finance appears to most peoplemore avant-garde puzzling abstractions than Cubist paintings seemed a century ago. Krishna reports, "Instead, much of the talk in the formal seminars and during the hikes in the lower slopes of the Tetons – although, ahead of his renomination on Tuesday as Fed chairman, Ben Bernanke opted to go (horse) riding instead – revolved around the lessons of the crisis for the future of central banking. Unease was widespread that even when the last asset they have had to purchase has been refinanced or sold off and the last unorthodox bank loan cleared, it would not be possible to go back to the pre-crisis status quo."
Well, indeed not for 5-6 years, by which time we might only be a year or two before the next set of global cyclical downturns? Macro-economics should now dominate in central bank analysis and prognosis, as it should do so too in banks' governing bankers thinking much thoroughly and ethically about their role in the global economy? "Central banking is going to change – in all cases, though more for some central banks than others – as policymakers seek to live up to elevated, and in some cases newly formalised, responsibilities for financial stability. It will become a broader, messier and more complex business, with objectives that may appear at times to be in conflict, new tools that are as yet largely untested and – at least at the margin – possible changes to the operation of monetary policy as well." As, central banks, especially the ECB, now realise it is not their remit and ideas only that have to change, but also undo how now discredited ideas are hard-wired into their constitutions; they need constitutional change?
Krishna says, "Although no one at Jackson Hole put it in such terms, there was a time when the life of a central banker was relatively straightforward, if not exactly easy. The job was to ensure economic stability by managing inflation, the monster that had ravaged the world economy in the 1970s. Most central bankers and academic economists were confident they knew how to do this: through some variant of inflation targeting, pioneered 20 years ago by the Reserve Bank of New Zealand and adopted by many others including the Bank of England. The Fed operates a de facto inflation targeting regime, which Mr Bernanke pushed to make more explicit, and academics claimed that even authorities such as the European Central Bank that deny being inflation targeters were so in practice. Implement such a regime successfully, the thinking went, and a central bank would not only achieve low and stable inflation but in doing so would ensure economic stability and the optimal platform for growth and prosperity. For a while it seemed to work. The 'great moderation' ensued – an era of low and stable inflation accompanied by long expansions and short and shallow recessions. But the credit crisis put paid to the idea that inflation targeting – at least as often practised, with a focus on consumer prices and a short policy horizon – was enough to ensure stability and growth." This was rather like finding a way through the thicket without worrying overmuch about what was living and what was dead wood, so long as general confidence was maintained about getting through. Now, the onus on central banks is to be far more comprehensive about the totality of economics + finance and to take fuller responsibility for systemic problems, which means being able to issue instructions that banks have to formally take full notice of and be made responsible for taking necessary actions - and that in turn means central banks no longer issuing complex double-sided advice like brokers, but actually issuing firm orders to banks to stop doing X and do more of Y etc.
Krishna reflects the Jackson Hole discussion, by reporting ""It is a good time to review the prevailing philosophy in the light of the current crisis," Masaaki Shirakawa, governor of the Bank of Japan, told his peers at the Jackson Hole conference. He said central banking before the crisis rested on three assumptions of "pre-established harmony", all of which now appear flawed. The first of these was that "macroeconomic stability can be achieved by monetary policy which pursues low and stable inflation" and that "price stability and financial stability are complementary". The other assumptions were that the authorities needed simply to keep an eye on individual financial groups rather than consider risks in a system-wide context, and that liquidity would be continuous in wholesale funding markets.
Inflation targeting did not fail, at least in the eyes of most central bankers, and it will continue to be the cornerstone for most. But policymakers now know that managing the outlook for consumer prices over horizons of a few years is insufficient to ensure financial and economic stability. "There is an emerging consensus that price stability does not guarantee financial stability and is in fact often associated with excess credit growth and emerging asset bubbles," said Mark Carney, governor of the Bank of Canada, which operates an inflation targeting regime.
Low inflation and moderate interest rates feed investor confidence and over time reduce conventional measures of financial risk, spurring financial groups to take on more leverage and fund longer-term investments with short-term funds. The crisis shows how disastrously that can end."
What is being rethought is the idea that the macro-economy can be tracked and deemed ok by merely tracking some very broad indicators such as prices, stability and consumer confidence. Indeed, this was not unlike risk management by score-card; if the lid continues to fit the refuse bin we need not worry about the mess of waste inside it. Confidence was always a lunatic indicator centrally revered by banks. Commercial and consumer confidence was really a reflection of how easy they perceived it is to get bank credit i.e. banks lent more the more borrowers perceived it was easy to get loans - totally circular perception. Central bankers agree on a first line of defence against instability is tougher regulation of financial institutions, to make it harder to load up on debt funding mismatches in good times – caps on leverage plus new "macroprudential" powers to limit risk-taking system-wide. Jaime Caruana, head of BIS, said at Jackson Hole that these powers could come in two forms: tools to curtail concentrations of risk in the financial system, and policies that tighten requirements during an economic upswing, mitigating the extent to which risk-taking builds during booms. This all presumes a cyclical awareness and predictive modeling that central banks do not have, neither do governments. Central banks and government are not allowed to forecast downturns publicly. In economies with global banks, the regulators are also limited in the orders they can issue based on national economic concerns - and who other than the UN has global economic models, not the IMF or World Bank or BIS?
Krishna comments, "Like most of his peers, Mr Bernanke sees these macroprudential powers as providing the most promising way to ensure stability, in large part because they can be targeted at specific financial excesses. Awarding such powers to central banks is proving controversial, though, with Congress balking at proposals to make the Fed America's systemic risk regulator. While politicians mostly worry about the concentration of power in the central bank, some experts also worry that deploying macroprudential tools – for instance in a way that slowed the flow of funds to subprime borrowers – could drag the (central) bank into political controversy. Mervyn King, governor of the Bank of England... warned in June against placing the Bank in a situation where it had a formal mandate for financial stability but not the tools with which to achieve it. That would leave it "in a position rather like that of a church whose congregation attends weddings and burials but ignores the sermons in between"."The lack of models for analysis and lack of integrated finance sector data into macroeconomic models problem is alluded to by krishna, "But even if they win these powers, central banks know little about how to calibrate these tools or how they will interact with interest rates. On how to manage matters monetary, the core issue remains whether central banks should "lean against the wind" by running a tighter policy during asset and credit booms even if this means undershooting an inflation target for a couple of years – a debate that the crisis has revived with a vengeance." This raises a phenomenally big question, that of attempted or desirability of trying to banish by pre-empting cyclical events, and whether the emphasis has to be on equipping banks with sufficient capital reserve to ride out downturns - thereby acting anti-cyclically alongside fiscally-keynesian governments? Recessions easily wipe out 90% of bank reserves (at Basel Accord levels) and the current crisis is doubling this normal expectation. The implication could be that banks have to double their capital reserves, which of course would be an enormous motivation to push a great deal more of assets growth off balance sheet? Central banks have a lot of partial theories, but have failed to try to integrate them into a total system view - globally it is a bit like having to figure out how sunspots impact all of the earth's and humankind's infrastructure - less about pre-emption and prescription and more about understanding the interdependancies of our economic systems. I offer this interesting graphic, which I hasten to say is not a macro-economic or macro-financial model, but interesting none the less. Jean-Claude Trichet, president of the ECB, told the Jackson Hole symposium that the traditional objections to leaning against the wind are harder to sustain. As Krishna reports, "He said the ECB in effect leans against rising asset prices already – through its two-pillar approach that takes into account monetary and credit aggregates. "I trust that our own monetary policy concept is approximately this idea – that we should incorporate in a rules-based framework this leaning against the wind," Mr Trichet added. Some other central banks – including the Bank of Canada – put some direct weight on asset values by targeting a consumer price index that includes house prices. The Fed focuses on an index that includes a proxy for rent but not prices and has always rejected leaning against the wind on asset price. Although Mr Bernanke (who did not address the issue at Jackson Hole) has said he is open to reviewing the arguments, particularly if credit bubbles are involved, his instinct is that it is almost always better to use more targeted instruments to deal with credit excesses. Yet there may be common ground over the need to take a longer-term perspective on inflation. The ECB has always emphasised its focus on the medium term and Mr Bernanke has long argued in favour of a "flexible" form of inflation targeting that seeks to hit the spot over the medium term – as opposed to the formal two-year horizon at the Bank of England. In principle, this allows a central bank to set interest rates at a level that it thinks will result in inflation undershooting in two years' time, in order to reduce the likelihood of a bigger miss further down the line when a bubble may burst. That is hard to pull off in practice, because it is very difficult to forecast inflation many years out and virtually impossible to predict whether a bubble will burst soon on its own (in which case the central bank should be lowering rates, not raising them). Still, in at least one respect it may be easier than before for central bankers to exploit whatever flexibility there is in their legal inflation targeting regimes." There will always be at least two very different ways of seeing the same shapes. Krishna expresses this with, "...But in the aftermath of the crisis, the cost of not curtailing financial imbalances – even in a world of moderate inflation – is plain for all to see, even if how best to curb them remains rather more blurry a reality than the view of the stars through a high-powered telescope against the dark Wyoming sky."

TT (TOBIN TAX)?

Gillian Tett, who recently presented and debated her new book at the Edinburgh Book Festival this week and who then participated at the Prospero conference where Lord Turner raised the prospect of TT. Gillian weighs in to the question too of “Does the world need a global Tobin tax? (see previous blog) that she finds is buzzing around London’s financial circles this week. She says, “the really interesting thing about Turner’s suggestion is the wider intellectual impetus behind it. For as the FSA chairman surveys the financial crisis, he is increasingly convinced that Western policymakers are at a crucial intellectual water-shed”… (saying) “the whole efficient market theory, Washington consensus, free market deregulation system…” (that it) was so dominant that it was somewhat like a “religion”. This gave rise to “regulatory capture through the intellectual zeitgeist”, enabling the banking lobby to swell in size and power. But now, he says, there has been “a very fundamental shock to the ‘efficient market hypothesis’ which has been in the DNA of the FSA and securities and banking regulators through-out the world.” Hence “the idea of that more complete markets were good and more liquid markets are definitionally good” is no longer trusted. “[This crisis] requires a very major reconstruct of the global financial regulatory system, [not] a minor adjustment.” John McFall MP, Chairman of the House of Common finance committee says TT is "impractrical" and possibly there speaks the voice of Gordon Brown too on this question? But the moral imperative behind this issue is not so easily gainsaid. Gillian rightly sees the possibility here of “…mere political posturing. The FSA, after all, has faced criticism for failing to get tougher in curbing banking bonuses, and if also fending off proposals to put it under the Bank of England.” To this I can add that the FSA was (with the SEC) entirely duplicitous over short-selling curbs, stock-lending, and calls for enquiries into misleading statements to shareholders attendant on capital-raisings in 2008, and to which longer term could be added indifference to quality of markets, markets per se, systemic risks, and failed to make the case for more resources to do the job they are statutorily obliged and expected to do. Both FSA and SEC, if not many other national regulators, are severely under-resourced, but also have been suspected of conflicts of interest in being as ruthless and authoritative as circumstances demand (see blogs passim).
Gillian says, “Turner’s comments are a striking sign of the times. And they raise a crucial question: namely what type of intellectual framework should Western regulators now use, if their prior bible – or compass – has now turned out to be so flawed? Sadly, Turner does not offer any pat answers. He has a long list of ideas he thinks that politicians and regulators should debate. Aside from the Tobin tax, he would like to consider more curbs on financial innovation, and a review of market dominance and pricing activity in the wholesale finance sector. But those ideas are not really a manifesto; instead, he stresses that regulators are “still trying to work out” what to do “after a fairly complete train wreck of a predominant theory of economics and finance.”” Gillian sees here a moral compass question on a global scale, which is of course fascinating since, as we all sort of know, even if money is morally-neutral, global finance surely is not even if global financiers are like arms-traders infamous for taking the moral low-ground of saying if I don’t do the deal all that happens is someone else does; “I was only following (buy/sell) orders”. This is reminiscent to me of Jonathan Swift’s Tale of a Tub written in the wake of South Sea Bubble, where he makes a naïve but morally-driven fool of himself in seeking to promote global solutions to the book of common prayer etc. (for which read the FSA’s Prudential Sourcebook), doomed to failure for the infinity of distractions into dead-ends amid acres of turpitudinous apologia. Gillian echoes that reminiscence, “No doubt, that agnostic stance will infuriate some (or confirm the impression that regulators are toothless). But that may be the wrong response. After all, the real problem with finance in the past few decades is not simply that policymakers and investors were using flawed economic and financial theories, but using them in such a blind way that they often disengaged their brains.”
To repeat my own refrain – the problem is that while we may have theories, but we lack comprehensive macro-economic-financial models in which to validate and test the theories, and by we I mean everyone including governments and central banks. At the book festival Prof. James Lovelock (90, and booked on Virgin Voyager) yesterday was making a similar point about “Global Heating”. He said Gaia (the term he invented for a self-adjusting global system) does not move in linear ways, and yet governments will sponsor computer models but not fund people to go out in ships and gather the data we need to validate the model-theories. Hence, our long-term forecasts are no better than short-term weather-forecasting. We will spend billions at CERN to find elusive bosons in neutron collisions to try and prove the standard theory of cosmology, but all oceanic research ships have been retired! Similarly, in credit crunch, we entertain policy-theories, but are not undertaking fundamental research to gather the data we need to answer the questions raised by what some describe as financial weapons of mass destruction.
Gillian says, “Bodies such as the FSA, for example, were so wedded to ideas of market efficiency that they only intervened when there was a clear case of market failure. Similarly, investors were so obsessed with narrow, short-term definitions of shareholder value, that they – like regulators – often appeared to be acting on auto-pilot. However, the unpleasant truth is that there is never going to be any complete intellectual system to explain how financial systems ‘should’ work.” Gillian concludes, "That is not an easy idea to sell to politicians, voters – or even regulators. After all, as Turner points out, world without a reliable compass is frightening, exhausting and time-consuming to navigate. “For the regulators of the world, once you have accepted that you don’t have an intellectual framework of “more market is always better” you’re in a much more worrying space, because you don’t have an intellectual system to refer each of your decisions.” And it remains crucially clear whether Turner will ever be able to actually turn any of his rhetoric into policies, given the scale of backlash that his comments will undoubtedly spark from the banking world. But I, for one, reckon he is to be applauded, for at least trying to think the unthinkable again - and move away from a crude reliance on creeds. The only question now whether other regulators will follow, not just in Europe, but, above all, in the US, where so many of the free-market dogmas first sprung to life?" Unlike Gillian Tett, I am confident, or at least hopeful, that a fairly complete intellectual system cannot be constructed is not true - it's my job, and not above my pay-grade; even Prof. Lovelock remains hopeful about Global Warming despite his realistic expectation that because Global Heating has progressed so far we are in for an inevitably terrifying time that he compares to WWII? In my view we can empirically determine how financial systems work, and do so at least as well as IPCC predicts global warming, and how macro-finance relates to the so-called “real macro-economy” globally; the ideas and most of the data exists and merely need the sponsorship to be brought together into useful analysis. But, I do not believe in the desirability or our capability to banish asset bubbles as critics of Bernanke suggest when they blame him and Greenspan for loose monetary policy leading to bubbles. We are in the 33rd credit & economic set of cycles since the 1850s, and I confidently expect many more in this century alone. And here I agree also with Gillian when she writes, “…ideologies are always rooted in shifting power structures and struggles. And just as the old intellectual model proved imperfect, any new ‘theory’ that might yet replace it – with or without a Tobin tax – will have limitations too. What is needed now, in other words, is not so much a new ‘creed’ or magic-wand policies, but policy makers, politicians, investors and bankers who are willing to engage their brains, and keep remaking policy, as the world evolves.”This brings us on to what are central bankers thinking at Jackson Hole? (next blog)

BUBBLE & TAX (squeak!)

One of my Summer breakfast specials is bubble & squeak. Adair Turner (head of FSA) threw into the political frying pan (of our credit crunch dog’s breakfast) the idea of Tobin Tax, a sizzler conceived in 1972 by Prof. Jimmy Tobin at Princeton to reduce exchange rate volatility. 1972 was 17 years before the first BIS survey data of world FX markets collected triennially over 2-3 weeks that remains today only way we know roughly how much FX trading there is). In case you don’t know, there is roughly $3.5tn in daily FX transactions, $1tn a day in money markets, $0.5tn per day in bonds, and $0.25tn per day equities trading world-wide (total turnover divided by 2+ to get a single-counted value of transactions). These are my figures only, for the egregious fact is no-one knows exactly as none of the major wholesale markets are entirely “on exchange”; FX & MM not at all, bonds only slightly, equities mostly, but not entirely. They do not have to report. BIS surveys FX periodically (in Springtime every 3 years) but not MM or Bonds?
For a tax on wholesale financial market transactions to work at all, requires all the taxable transactions to be undertaken within regulated exchanges. Free market liberalism has resisted this for over a century and continues to do so. Now, in policy debates dragged up from muddy ocean depths by the Credit Crunch, it has been stated by many decision-takers that credit markets should be brought “on exchange”, but progress is stymied and slow. What underpins this is the question of quality of price discovery, quality of markets, long ago kicked into the long grass when stock exchanges became private corporations able to denationalize by merging across borders and pursue global relevance, and when any number of competitor systems were allowed, and when cost of transactions became more the competitive focus than quality. In arguable fact, ever since Tobin Tax, the world’s wholesale markets pursued a directly opposite goal of cheaper easier trading.
Therefore Tobin’s idea was only ever a theory proposition – it never had a snowball’s chance. His idea was also structural; to tax financial exuberance of the first world to fund a transfer of money to the third world. Well, the one benefit of Credit Crunch and asset bubbles was surely to deliver unexpectedly prolonged high growth for third world exporting countries, for which they may be ever grateful.
Tobin Tax (TT), as an idea was raised many times in the ‘80s and ‘90s when folks could not understand how it is that financial markets can apparently trade the equivalent of world GDP every 6-8 weeks, and that’s before we consider the same again in nominal value of derivatives trading, which is at least mostly on-exchange? In theory, TT might discourage speculation by making currency trading more costly, but that would only ever have been a first-order effect, most likely dissipated as the tax is passed on. FT reporting on this posited the theory that the volume of destabilizing short-term capital flows would decrease, leading to greater exchange rate stabili. But, of course, there is as yet no global tax authority to impose global taxes on global financial transactions, no monitoring, no formal reporting, global or otherwise, and no academic or other theory to explain how must is genuine need to trade and how much is speculation; old data suggests roughly a 20%/80% split before we consider market-makers who merely churn the market. TT is a speculation tax, but FX is a zero-sum game. Therefore, the global tax has to be on turnover, not profit.
And anyway, which currency should all be measured in, and at what moments in time. When FX margin spreads go to the 4th to 6th decimal places, how many decimal places further on should the tax be exerted, and could trading systems accounting be trusted to measure that? Even if a tax on FX turnover was say 0.05% or 5bp at both ends of the deal the result is $one trillion or more than the total GDP of the African continent. To be complete about this TT should apply to all derivatives and to MM, Bonds and equities, in which case the tax would equate to the total GDP of China plus India. Sounds great, but a global tax on this scale would undoubtedly reduce the volume traded enormously - and derivative or other measn found to emulate or track without actual cash-market trading i.e. the tax would be avoided and evaded!
So why is the clever Adair Turner suggesting this as an alternative to “swollen” financial sector paying excessive salaries grown too big for society. He says debate on bankers’ bonuses is a “populist diversion” and more drastic measures are needed to cut the financial sector down to size.
He adds that FSA should “be very, very wary of seeing the competitiveness of London as a major aim”, claiming the city’s financial sector has become a destabilising factor in the British economy. Mayor Boris Johnson discounts this as an aberration view that Lord Turner should rethink since the Mayor wants London’s wonderful competitiveness to emerge even stronger from the crisis!
Turner’s question is actually sensible and legalistic. It is against EU law for the UK to support its financial sector for competitiveness gains. It is not really, as FT surmises, that “Britain is becoming increasingly sceptical about the perceived advantages of being a leading financial centre”. Lord Turner’s suggestion that a “Tobin tax” is a reproach to the debate over bankers’ bonuses (BB) is something of a blind. BB we can all do something about, however problematic. TT is another matter entirely! The question of BB is linked to London as a financial centre insofar as BB is defended as being competitively necessary on the grounds that there would be a business flight to centres where BB would not suffer any capping. This is baloney in my view, for reasons I shall not enumerate here, not this time, save to say that bonus earners are 1. not nearly so valuable as is pretended and 2) they don’t all want to go live in tax-havens, or they’d all have done so long ago.
Lord Turner is sensibly worried too about a return to “business as usual” (mentality and/or actuality) in the banking sector, suggesting that new taxes may be necessary to curb excessive profits and pay in the financial sector. Indeed, correct, but this has a complex aspect, which is that bankers do not know their value or their riskiness other than what they can get away with. They are as star-gazing as those who cannot explain how it is that the world’s income appears to be traded ever couple of months, who cannot understand where all this niagra of finance money flow comes grom and goes to and how it is they have a pool ticket to swim in such deep fast flowing waters.
None of the academic instituites, governments or central banks have macro-economic macro-financial models to answer this question either. Despite our computer-data rich world the truth is that for almost everyone, including bankers, today’s science on the matter remains somewhere in the medieval world of astrology; it is definitely not astro-physics. Most bonus-bankers are clear about one thing, they prefer it that way, to be priests of voodoo-finance, not economists!

POLITICAL ECONOMIC BRINKMANSHIP

After a sojourn to reflect and refocus on developments, what are the questions that dominate the political ether? The question I hear most often socially: "is the government (US or UK) doing the right thing?" My answer is a confident YES. Then I say "but both US and UK governments are failing to paint a clear picture of what they are doing and precisely why!"
see also: http://lloydsbankgroup.blogspot.com/)
Republicans in the USA and Conservatives in the UK are successfully twisting the issues to make recession and banking crisis appear domestic political failures. This is most telling for the UK's Labour government with a general election due in less than a year from now. But it has to be clear to intelligent observers that the UK's position is only to be expected and remains prudentially sensible as a proportionate set of responses to the crisis. PM Gordon Brown has maintained a stance that in effect says "trust me (us) to do the right thing to get us out of this crisis." The general public, at least the political chattering class, wants detailed explanations, not abstract assurances. The Conservative Opposition, echoed by the Liberals, have in the media created the axiomatic assumption that "public finances are in a mess." There is tremendous anger about banks and bankers, but the effect of ya-boo politics has been to divert anxious blame onto the government. Reading UK media the impression is gained that the UK's public finances and national debt must be the world's worst, if even no-one is quite sure what precisely defines concepts like 'finances in a mess'. Note the example of the following table. This reviews the financial debt of countries relative to GDP. There is a misnomer in the 3rd column (private sector debt) which is really household debt only as may be surmised in any case from column 7 of total bank assets (total loan gross exposures, not domestic only) given that public sector element is typically about half ratio to GDP with a few exceptions. There is a concerted forgetting that UK private sector gross debt over the past decade grew from 3 times public sector debt to 6 times public sector debt (3 times GDP) while, until the crisis broke, public sector debt held steady and fell slightly. Now the general public are being daily made anxious about the government fiscal deficit and medium term prospect of tax rate rises, most recently by the NIESR report on the economy, which fails to take account of the feedback effects of saving the financial sector. see the following: http://www.niesr.ac.uk/pdf/210709_225037.pdf
The NIESR has adapted the average recovery for previous recessions to state that incomes will not recover to the pre-crisis level (in real terms before unemployment rose and GDP experienced negative quarterly growth) until after 6 years. This is merely the average peak-to-peak period but has been exaggerated in the media as if a damning indictment of someone or something, similarly that GDP rates forecast are worse than the last published government figures (March Budget)? Yet, in fact there is nothing shocking or surprising about this. What is surprising is the NIESR's assumption that with a lower pound growth recovery will be export-led i.e. a total reversal of the credit boom growth previously! This assumption is conditional on whether government efforts to persuade or force banks to maintain or even increase lending will be effective, especially via the public sector owned banks. A very similar view would apply in the USA. What seems remarkably gauche about this outlook is that both UK and USA remain magnets for other countries foreign exchange surpluses. There is an improvement in growth expected for both insofar as the external account trade deficits will narrow as export-surpluses countries trade surpluses shrink, but this is not a recipe for halting unemployment rises. That depends on fiscal boosts and the banks cushioning the shrinkage of credit (deleveraging by banks to thereby most easily restore their capital ratios and by borrowers, especially households, cutting back their spending). Only restoring some credit boom effect and regaining confidence will slow and halt the domino, knock-on, rippling, or however anyone wants to describe it, negative vortex of beggar-my-neighbour impacts through the economy and all economies.
The banks have not woken up and smelled the coffee of their collective responsibility for economic recovery alongside government; they continue to live with pre-crisis mindsets, witness their inability and extreme unwillingness anyway, to tackle the bonus-culture. Government (UK and USA) have also not spelled out clearly enough what the banks are obliged by government to do to help both themselves and the economy. Lloyds Banking Group, for example, has improved its capital ratio to over 14% but mainly by reducing its risk weighted assets (loans) by nearly 40%, of which half was gained by an asset for BoE cheque swap with the Bank of England! The remaining half of the deleveraging is largely by retiring loans and not rolling them over. The effect of this alone in the case of but one bank has a 1% negative ratio to GDP and a GDP impact of possible minus 0.5%. Compounded by deleveraging by other major banks and we have a negative pro-cyclicality effect, precisely what banking regulation Basel II is most concerned to identify and avoid! Is the government forecasting or that of NIESR or any other model supposed to have predicted this? Governments created something of a cleft stick here, on the one hand wanting to see their financial interventions repaid soonest and on the other seeking assurances that the banks would maintain substantially more than minimum regulatory capital reserves and also maintain lending at pre-crisis levels. These objectives if not sensibly timed become mutually exclusive!
It is not hard therefore to conclude that what is less important right now is what caused the crisis and more important is what are the banks doing today? They are making the recession deeper. Bankers have an ready culprit they can blame for causing pro-cyclicality, the Basel II capital adequacy regulations, which ironically were designed with the objjective of addressing precisely this problem!
The banks still look at the underlying economy as exogenous to their business performance, not as something intrinsic that they can directly effect. They have as yet not embraced and understood Basel II Pillar II stress testing and economic scenario analysis and the central banks, government, and economic institutes like NIESR are not offering guidance and tools for how to analyse better the role of banks in the economy!
The banks are currently in a period of retrenchment, recoiling like scalded cats in the face of public sarcasm, and therefore unable to take responsibility alongside government in concerted efforts to redeem the economy. The public debate continues to confuse symptoms and underlying disease. The banking crisis may have had viral-like causes that transmitted throughout the whole financial system, but the public, led by politicians, media and pundits, continue to primarily blame all major banks as if they are individually guilty or heinous excessive risk-taking, even though the collective guilt is also obvious. Some pundits say we should have let individual banks fail absolutely as if diseased parts of the body-financial could be cut out to let the healthy parts prosper. This is myopic at best and ego-mania at worst, every cloud has silver linings for some whether short-sellers or doom-monger talking-heads.
Of course, what is it I'm saying here other than we need more comprehensive clarity delivered to the general public. How easy is that? Not easy at all. Opinions like politics are a market-place. After 2 years of the most intensive news coverage given to any crisis including war coverage, is the general public more attuned to detailed technicalities of what is happening and why, and what is being done, and what should be done, than before? Where can the public plant its feet and say this is real?
Timothy Geithner recently visited Alistair Darling but they failed to use the meeting adequately. They, both of their governments administration, need each other to validate each other's fiscal responses to the recession and financial interventions to salve the banking crisis. But, it is clear they don't quite get that. No one trusts bankers and only reluctantly trust economists. Politicians are generally mistrusted. Therefore this only leaves the inter-governmental sphere where mutual validation and confidence may be gained. My perception is that there is considerable confidence at this level, but it is not being communicated. In part this is because it lacks the tools for the job to analyse policy interventions sufficiently to know the timing of when to expect the positive benefits of policy measures to become apparent, by which I mean both finance sector interventions and budget fiscal deficits. The US and the UK are in recessions that are 6 and 4 quarters ahead of others, and consequently their fiscal deficits are higher and broadly in agreement. Politicians are sensibly wary of creating hostages to fortune, however, in making economic projections of qhen their actions should have positive results. This was a similar problem for central banks when trying to issue warnings ahead of the credit crunch, too wishy-washy elegantly shredded into lumpy bit kind of advice, with on the one hand and on the other etc. If there is one experience to be warned about I gained working in banks and as an economist is that too many people in key risk management positions are more risk adverse about their own careers than capable of setting this aside to state clearly what they believe. That said, it is doubtful that any major bank's board had it received cogent and accurate advice in say 2006 or early 2007 mapping out precisely what was about to hit them, would not have had 'shot' the bringer of bad tidings, at best had him or her dragged off to the funny farm. Economics is for various reasons, including bonus culture ones, something that most top bankers resist like the plague, whether qualified in banking or as is equally commonplace not educated about the totality of banking at all. Economics is sobering and not what inebriates can tolerate if given the choice? Perhaps polticians and central banks should take a leaf out of how wartime leaders such as Roosevelt and Churchill dealt with matters of public information and military command when they recognised that confidence mattered most combined with well-judged honesty in appealing to all to do their utmost in these difficult challenging times, etc? The recession and financial crisis is not a place for simply saying "I am your leader so trust me!" Time for more political courage, to step up and say that to the best of our judgment this is what we believe and deliver confidence-boosting expectations and take the political risk. The opposition political parties similarly need to be seen to stop playing party politics on the issue of getting out of recession and the credit crunch crisis. There are plenty of other matters they can be sarcastic about. Obama attempted in the US to gain a bi-partisan approach on the crises. he only half succeeded. In Europe, it seems to me that bi-partisanship has not even been proposed as a necessary or useful way forward! In the UK, Labour is pinning its hopes on being seen to have steered the economy through the recession. That has no precedents as a political strategy that I can recall. Better would be to simply go for honest statesmanship in the interests of what works best to restore public confidence in what it is that politicians are supposed to do best and most responsibly?
Geithner stated on 13th July that there is a good chance that the U.S. and other leading economies will start growing again over the next two quarters, but there are still significant risks to the outlook. This chimes with UK views (Government and NIESR) that there will be positive GDP growth in 4th quarter 2009. Essentially, this is based on narrowing of the external account and past recessions given that UK and US have both now reached the end of previous average recession periods, with one overlooked aspect that is that UK recovery tends to occur 2 quarters after the US, hence do not expect UK positive GDP before next year! Furthermore, both the official assurances of UK and US governments have been made without analysis of the cycle impacts of what the banks are doing. Their respective national economic models lack that depth; they cannot model for the details of the financial sector statistics within their GDP forecasting models!
Geithner said, "In my view there are still significant risks and challenges ahead," Geithner said when asked if he was concerned about the possibility of a double-dip recession. The issue is less double-dip in my view than simply 'double' given that the financial crisis is doubling the depth of what would have been a more normal to-be-expected recession. He said the world's major economies were largely in agreement on the steps that needed to be taken to boost economic activity. Yes indeed, but hard to guess that from statements by politicians except when speaking under the G8 and G20 umbrella. "I think we have remarkably strong consensus in place on core elements," Geithner said. This is not strictly true on the face of data, but is as good as it gets. He was speaking after talks with UK's Alistair Darling as part of a trip that will take in the Middle East and Paris. Geithner and Darling said leaders of industrialised nations would discuss the measures they are taking when the G20 meets in Pittsburgh in September. This is a critical month for the USA when its annual government budget ends and a new one has to be announced and voted through Congress. The number of state interventions in the banking crisis has slowed compared to last year. Everyone is treading water waiting to see what happens to banks balances by the end of the second quarter to then gauge what the US especially will decide it needs as a fiscal boost after September and in off-budget fiat (money market) interventions and command economy edicts to the banks. By then we should also have the measure of Quantitative Easing plus government bond auctions and we will probably be in the maelstrom of another nervous stcok market fall. Geithner will seek to reassure Gulf Arab states this week that U.S. dollar assets they hold in large quantities remain a strong investment. This is bolstered by scare stories about the Euro trillions of toxic debt in the Eurozone. On the one hand a strengthened dollar and weaker Euro should add to containment on oil prices on top of fall in demand, on the other hand there is a strong motive by foreign investors to anticipate another dip in US equity and asset values. A recent decline in Saudi foreign assets shows the purchase of U.S. Treasuries by Washington's Gulf allies, five having currencies pegged to the dollar, at levels seen in the past decades should no longer be taken for granted. This reflects narrowing of the US external account, hoiwever, and is not worrisome since the US, like the UK, now want their government bond new issues to be bought by domestic buyers, principally by the banks. The banks may foolishly insist on quid pro quo: "we'll buy your debt if you lessen the pressure on us to maintain lending levels and let us deleverage further!" Negative growth pro-cyclicality by banks has some way yet to run. If we take our best bets on this from past recessions, expect the banks to continue shrinking their household and corporate loan books at least up to the 3rd quarter of 2010!

Edinburgh economist predicts toxic debt boon

From Sunday Times business section, 10 May, 2009, page 1
"Robert McDowell says UK Treasury will finance recapitalisations and pay off many budget deficits through troubled banks" by Ian Fraser
The UK government should comfortably claw back at least half of forecast budget deficits in 2010-12 because of higher-than-expected returns from its ownership of shares in troubled banks and profits from bank bailouts, according to an Edinburgh-based economist.
Robert McDowell, a banking economist and risk-management consultant, said: “The UK and US Treasuries are charging substantial fees and exerting 25-30% haircuts, leaving themselves with more than adequate headroom to generate substantial medium-term profit which, I calculate, will finance both their bank recapitalisations and pay off half of medium-term government budget deficits, thus relieving taxpayers of the risk of sharply higher future tax rates.”
The British and American Treasuries have been criticised for their programmes to purchase billions of pounds of “toxic” and“legacy assets” from the banks, including impaired mortgage-backed securities, collateralised debt obligations, credit card bonds and student loans.
However, McDowell, who advises governments as well as banks, said such criticism is unjustified. He believes that, while asset-backed securities were arguably the cause of the credit crunch, they are also going to play a part in bringing it to an end.
McDowell said the UK government’s support for the banking sector, including the special liquidity scheme and the asset protection scheme, will generate a net profit of about £185 billion, and possibly more than £200 billion, “which is a substantial three-year gain from off-budget financing worth about £900 billion currently”. He said £200 billion would eradicate 45% of future budget deficits.
To this I add: The 2009 Budget authorises the bank of England to engage in up to £150 billions in Quantitative Easing, which means buying in outstanding gilts (government bonds) early. No-one has questioned where the financing originates to buy back the gilts. It has to come from net balance between assets and liabilies on the Bank of England's balance sheet. last time I looked the BoE balance sheet was £500bn, considerably more than the IMF which is seeking to grow to that level and equivalent to that of the Bank of International Settlements. Not all of the nearly £600bn assets being bought in by the BoE have yet transacted and its quantitative easing programme is somewhere in the £25-50bn range so far. I view the £150bn authorisation as an indicator of the net profit medium term that the government expects roughly to generate from its investment in saving the banks including majority ownership under UKFI Ltd.
BoE said it would spend a further £50bn of newly-created money to buy bonds. Note that the ECB has so far expanded its balance sheet much less than the BoE despite being responsible for a much bigger eceonomic areas. It has pledged to buy €60bn (£53.4bn) of covered euro bonds though the size of its asset purchase scheme is still small in comparison to those operated by the Federal Reserve or BoE with HM Treasury. This is something of an indictment of the Euro Area system whereby all the money market liquidity windows of the 16 constitutent central banks are vested and centralised in the ECB. It has a board of 16 central banks' representatives plus 6 ECB'ocrats, but among the central bankers are 9 economists and this bodes well for its gathering responsiveness. ECB President Jean-Claude Trichet said the bank would buy covered bonds, typically backed by mortgages, but did not rule out other purchases, which may let the ECB buy government bonds, although this has by political convention about fairness been resisted so far. The ECB will double the maximum term of its loans to banks to 12 months and loosen the rules on the assets which can be used as collateral to lessen the financial strain throughout the eurozone. 12 months is however much shorter than the 3 years offered by the BoE and similar medium term support from the US Treasury and Federal Reserve.
Details of the Bank of England's Special Liquidity Scheme (21.4.08) and its successor Asset Protection Scheme and Asset Purchase facility (19.01.09) - both organised by BoE as 'agent for HM Treasury and the Debt Management Office) do not have to be revealed until October 2009, and at the government's discretion not even then. This is according to the 2009 Banking Act (http://www.opsi.gov.uk/acts/acts2009/pdf/ukpga_20090001_en.pdf). What we do know is the following asset swaps for treasury bills and Bank of England cheques, where the bank assets are securitised as asset banked bonds and purchased as collateral for up to three years for: SLS - £245bn assets pledged as collateral, swapped for £185bn in treasury bills, with a roughly 3% fee. The assets are securitised as bonds paying about 3% above LIBOR, averaging say 5% net after the coupon on the T-bills over 3 years = £6bn + £28bn.
The difference between the assets pledged and the T-bills they were swapped for provides backing for the £37bn of preference shares bought from Lloyds TSB, HBoS and RBS paying 9% (subject to the banks' profitability). We can assume they will pay and average of 6% over 3 years = £7bn.
The APS scheme has we know taken in £325bn and £245bn from RBS and LBG plus another £15bn in exchange for Bank of England cheques left as deposits with the Bank of England, for a £22.1bn fee paid partly in preference shares and converted into common stock, and 2% insurance, plus very importantly, the banks agree to make no tax claim for losses for "several years!" (see http://www.hm-treasury.gov.uk/statement_chx_260209.htm)
It is not possible to gauge the exact value of all this, but investment in bank shares of £37bn plus £34.6bn (£71.6bn) and becoming worth more. (see p.59 of Budget Report http://www.hm-treasury.gov.uk/d/Budget2009/bud09_completereport_2520.pdf).
These shareholdings were paid for off-budget i.e. not at taxpayers' expense. This plus about £30bn a year on average over 3 years in coupons and dividends i.e. £150-200bn say over 3 years, but can become considerably more.
There is also the BoE's Asset Purchase Facility. "Following a request from the MPC, the Chancellor authorised the Bank of England to use the APF for monetary policy purposes and increased the total scale of the fund to £150 billion, up to £50 billion of which could be used for private sector asset purchases. Asset purchases since then have been financed by the issuance of central bank reserves at the Bank of England". (page 60, Budget Report)
'Central Bank Reserves' means BoE cheques as per the Asset Protection Scheme. This has the advantage that the recipients cannot sell the payment they receive and must keep this as a financial reserve. It avoid issuing treasury bills that could be sold and may be represented at unexpected times rather than simply rolled over.
Thus from these schemes the government should gain a net profit of about £185bn, and very possibly over £200bn, which is a substantial 3 year gain from off-budget financing worth about £900bn currently. If part or all of this is used in the Quantitative Easing scheme for buying in £75bn of government bonds and then up to £150bn in total, and I judge there could be another £50bn, this is about half of the government's likely Budget Deficit of £175bn deficit in 2009, then say £160bn and £125bn in 2010 and 2011 respectively.
Given that long term interbank funding that UK banks require to finance their funding gaps remains very hard to get from private sources, we can expect the Bank of England to add several £100bn more to the Asset Protection Scheme during the remainder of this year, which would mean we can be even more confident that there will be a £200bn three-year gain or more, sufficient to cover half of government budget deficits. The agreements with the banks will also ensure about £50bn in new lending into the economy by the banks.
Chancellor Darling in his Budget report 2009 highlights in red on p.25, "Reflecting the principle of transparency, the fiscal forecasts include a provisional estimate for the high end of a range for the net impact of unrealised losses on financial sector interventions, equal to 3½ per cent of GDP." The budget deficit is about 12.4% ratio to GDP for 2009/10, then 11.9% and 9.1% in the next two years. The Chancellor is therefore indicating that a substantial part the deficit is required, at least roughly half most probably,assuming a 4:1 multiplier, to compensate the economy for the banks' and possibly may not be needed if the government's financial sector interventions pay-off.
In the case of the ECB there is now tacit admission that the policy of leaving interest rates relatively high and quietly talking down the prospect of quantitative easing has been abandoned.
There remains considerable fear and uncertainty about how the chips will fall. The BoE's MPC recently stated: “The world economy remains in deep recession. Output has continued to contract and international trade has fallen precipitously. The global banking and financial system remains fragile despite further significant intervention by the authorities.”
The BoE's QE has prompted a sudden jump in the price of government bonds, or gilts. Though this may not be sufficient to close the gap so that the BoE will not still be buying the higher coupon outstanding gilts cheaply on the secondary market. It will no doubt use other banks to do the buying for it. we can see this in that despite the higher QE, the benchmark bond yield remains above the level it was before QE was announced and began.

STRESS TESTS TO CLIMB UP OUT OF CRUNCH CRISIS RECESSION?

Bank stocks have been rising well internationally. Wednesday (yesterday) was especially good for US financial stocks as investors expressed relief the capital shortfalls identified by the government’s “stress tests” at large banks such as Citigroup and Bank of America were not as big as feared.
The bank rally occurred as news of the capital needs of the 19 banks involved in the tests leaked out during the day, ahead of the official release of the results on Thursday.
Citi, BofA and Morgan Stanley were among the big names that will have to raise equity following the completion of the tests, while JPMorgan Chase, Goldman Sachs and American Express are among those that will not need additional capital, people familiar with the situation said.
Citi and BofA emerged as the banks with the biggest capital shortfalls, with Citi’s equity needs projected to be more than $50bn and BofA requiring about $34bn in fresh equity.
However, BofA’s capital deficit is more pressing because Citi has already agreed to bolster its balance sheet by converting preferred shares owned by the government and other investors and selling non-core businesses.
People close to the situation expect Citi to have to raise no more than $6bn through the expansion of its planned conversion of preferred shares – less than the $10bn-plus the market had feared. The move could decrease the government’s stake in Citi, which was expected to be 36 per cent to about 33 per cent.
New equity ratio rule
US banks will be required to hold enough equity to ensure that they would still have a common equity ratio of at least 4% of risk-weighted assets at the end of 2010 even if the adverse scenario set out in bank stress tests were to materialise, the authorities said on Wednesday 6th May. I suggest that they should consier applying an equivalent of the Dutch National Bank’s Liquidity directive.
Banks are required to report on a consolidated level on their liquidity position to the DNB monthly, on the basis of the liquidity supervision directive. The liquidity directive seeks to ensure that banks are in a position to cope with an acute short term liquidity shortage under the assumption that banks would remain solvent. In principle, the DNB liquidity directive covers all direct domestic and foreign establishments (subsidiaries/branches), including majority participations. The regulatory report also takes into consideration the liquidity effects of derivatives and the potential drawings under committed facilities.
The directive places emphasis on the short term in testing the liquidity position over a period of up to one month with a separate test of the liquidity position in the first week. For observation purposes, several additional maturity bands are included in the liquidity report (one to three months, three to six months, six months to one year and beyond one year).
Available liquidity must always exceed required liquidity. Available liquidity and required liquidity are calculated by applying weighting factors to the relevant on- and off-balance sheet items, i.e. irrevocable commitments. The liquidity test includes all currencies. Compliance reports concerning liquidity requirements of foreign subsidiaries are submitted to the appropriate foreign regulatory authorities as required. At a consolidated level, and in every country in which a bank operates, the banking group must adhere to the liquidity standards imposed by the applicable regulatory authorities.
The use of a common equity ratio – even if as a benchmark rather than a formal future standard – is a departure from normal bank regulation. It is intended to ensure that banks have good quality capital, providing permanent capacity to absorb losses and flexibility over cash distributions.
The US authorities also said that the 19 biggest US banks will also be required to hold enough overall tier one capital to ensure that they would still have tier one capital equal to at least 6% ratio to RWA. This allows their reserve capital to operate as a cushion that can depress by half.
Banks will have 30 days to present a plan to meet the demands identified by regulators. They will also be required to outline steps they will take to “address weakness, where appropriate” in their own processes for capital planning. They are tasked to outline how they will, over time, repay existing government capital injections (e.g. in payment or in preferred shares) and reduce reliance on debt issued under a government-guaranteed programme. Up to 10 of the 19 banks are likely to need fresh equity, according to various unnamed sources. Morgan Stanley is said to need $1.5bn in new equity, as a result of its buying a majority stake in Citi’s Smith Barney brokerage.
Tim Geithner, the US Treasury Secretary, said last night on PBS: “I think the results will be, on balance, reassuring.” Investors concur, with shares in BofA, Citi and Wells Fargo – expected to need $10bn-plus in new equity – rising by over 15%.
The tests aim to ensure that even in an adverse economic scenarios, such as obviously the current crisis, banks can retain tier one capital of at least 6% of risk-weighted assets RWA – loans and other exposures less collateral, with both the assets and liabilities risk-weighted and risk-graded) and tangible common equity of at least 4% at the end of 2010 (when economic recovery should be 1 year old). Each bank told to raise additional equity has until June 8 to present a plan to regulators explaining how it intends to do so. The concern here is to have clarity in time for planning the administration’s budget for budget year starting 1 October. This is required even though further government financing will be off-budget via Federal Reserve balance sheet of T-bills, and only on-budget if requiring longer term Treasury Bond issues.
These banks will also be required to remedy any “weaknesses” (governance, systems, data quality, reporting process, risk management controls, and risk mitigation measures) in their internal capital planning (liquidity risk management) and to outline how they eventually intend to buyt hemselves out of government-sponsored aid.
The revelation that BofA needs about $34bn in extra capital will increase pressure on Ken Lewis, its embattled chief executive. The banks and the regulators declined to comment to news sources such as FT or Reuters or were unavailable.
The stress tests overseen by the FDIC involved more than 150 senior bank supervisors, analysts and economists being interrogated (subject to Geneva Convention or Basel Accord Rules) in the top 19 US banks about their likely losses in the event of a deeper-than-expected recession. This is somewhat complicated and relieved by FASB relaxaion of fair value mark-to-market valuations that takes the illiquid temporary turbulence effects out of market pricing. It is also helped that 3 month LIBOR has fallen to its lowest level since the ‘80s even if longer term funding from private sources remains a desert.
Following the policy (announced February 10) these banks were asked to estimate their short term future losses against capital to meet those losses, under adverse conditions that reflect a view of current conditions shaded on the relatively more benign side of the possible range of outcomes, as defined by the FDIC.
The teams of bank supervisors – specialising in specific types of assets, bank earnings capacity and reserves – then evaluated the banks’ submissions and asked for further information. They tested banks’ projections against independent benchmarks of their own tailored to the portfolio mixes of each bank. The problem here is that the authorities do not have complete macoeconomic models with sufficient financial sector detail to produce and adequatelyrobust and complete benchmark. It is easier to benchmark the banking sector to the economy than to directly correlate any one bank to the economy. The latter is almost impossible. The problem therefore is that whatever macro-prudential and macro-economic modelling the supervisors have to check with is not availabl to the banks themselves. There is, of course, considerable scope for judgement in these matters, but the all tolled the liklihood of the banks assessments agreeing directly with that pre-calculated by the supervisor team is zero! Hence, there will be considerable interative toing and froing between supervisor team and the bank. It may take until end of June to reach consensus agreement.
Taking into account likely losses, operating earnings (repeatable and one-offs) and own-capital reserves, the supervisors make a judgment about on whether each bank requires additional capital to guard against the risks represented by the stress test, with particular concern for whether that capital may be obtained from private sources or must be sought from the Federal Reserve, US Treasury, FDIC, and/or Congress and the White House.
There was both an overall tier-one capital test (which virtually every bank met easily) and a common equity test (which identified the need for many banks to hold economic-capital cushions against wider market and economy risks).
Supervisors did at least tell the banks about their assessment headline terms shortly in advance of visits, i.e. only last week – giving them a few days to crunch through their spreadsheets and challenge the findings. One immense difficulty of all this is that spreadsheets are not powerful enough to turn the handle on all of banks books and do not facilitate audit-trail drill-downs. We are dealing with macro- views top-down applying credit risk, market risk and liquidity risk assessments of large portfolios, large asset classes, where the magins for error greatly exceed the margins that the supervisors ant to have precision on i.e. increments of 0.25% of ratio to RWA or 0.125% of assets. Liquidity funding covers typically 30% of assets (the funding gap) and this is a larger ‘call’ on authorities financial resource than incremental top-up to Tier capital.
With assets of say $30tn of which $20tn are less than AAA, the funding gap is say $6-9tn that will require most of it rolling over perhaps within 6 months. Federal Reserve, US Treasury and FDIC balance sheets probably already have secured half of the requirement. The government is anxious not to let the banks deleverage to satisfy the remainder, and yet reluctant to be seen delivering yet more support in the $1+ trillion region, which would severely damage confidence just when the recession is hopefully in its last 2 quarters. The FDIC had also said in advance that relaining TARP and other sources of $150bn should be more than enough to see out this year. Hence, there is concern to keep the outcome of new funding requirement to below this, hence too Geithner’s plan to leverage the hedge funds into this role by offering them cheap loans to buy toxic assets. The hedge funds know they have political leverage here despite their general unpopularity (only a few notches adrift of the mistrust of the banks, except that at least bank shares are currently rising). This leverage resulted in their generous ‘exit’ clauses should they sometime down the track doubt their ability to make double-digit returns from buying up to $500bn of the banks ‘impaired’ assets.
Bankers say the authorities were willing to update their assessments in the light of changes to asset portfolios from the fourth quarter to the first quarter (reflecting FASB dispensation), but refused to put much weight on very strong first-quarter operating earnings when reaching their judgment on future revenues (which neatly agrees with maket sentiment that at first welcomed the record profits before recognising that these were mainly accounting changes and one-off gains).
Today’s announcement will in effect put banks into one of four categories: those (if any) that need extra tier-one capital; those that need to increase their equity buffer; those that have an adequate capital buffer under the stress test standard; and those that have surplus capital and could be eligible to repay bail-out funds subject to further conditions.
Nouriel Roubini and others, who with the credit ratings agencies, share one outlook in common, which is that there are no penalties just now for being excessively gloomy, advocates in good populist manner the dstruction of some banks to allows others to flourish in their place, a kind of fast-forward Darwinianism. Roubini complains that the tests have no precise insolvency threshold. In my view this is only sensible. Insolvency for banks is not a fixed moment in time event and there are at least six different ways of assessing insolvency. And, in any case, when government stands behind the banks, more so when it owns them, the normal regulatory and insolvency critieria no longer apply as before! Quoting the IMF estimates of losses, which actually added nothing we did not know already, Roubini reiterates that since losses have doubled in six months, the stress test results cannot “be credibly interpreted as a sign of bank health”. My response is, no of course not; these are not yet healthy patients. That is not the issue. The question is have they died or are the vital signs good enough, with evidence of at least near-normal brain-function not to turn off the life support?
Roubini is like a camp-doctor. These banks are cripples, let’s top them if they need “extra capital have, in fact, failed. As a result, these institutions will not be able to raise outside capital and will immediately require government help. Once again, the question will be how the near-insolvent banks can be kept afloat, to avoid systemic risk. But the question we really should be asking is: why keep insolvent banks afloat? We believe there is no convincing answer; we should instead find ways to manage the systemic risk of bank failures.” Good luck to that as a policy prescription: the complexity is mind-boggling.
Like a Eugenicist, Roubini says simply, “Trillions of dollars have been thrown at the system, just so that we can avoid the natural process of creative destruction that would take down these institutions’ creditors. Why shouldn’t the creditors bear the losses?”
He cites as counter-arguments, the “Lehman factor” and counterparty risk, the fear of being on the other side of a transaction with a failed bank”. But this includes the fact that Government is now a major counterparty and cannot risk the banks going under and all those T-bills being presented suddenly for redemption payments. Perhaps mindful of that, he suggests “a new insolvency regime for systemically important financial institutions is passed on a fast-track basis by Congress. Problem nearly solved.” Fast-tracking anything through Congress is an operational risk. I see the problem also that instead of allowing the vacuum of major failed banks to be filled by those with unreconstructed ethics, the government and regulators should continue with supporting the troubled banks in order to clean them up and ensure the country has better, ethically sounder banking. This is economically as important as anything else for the long term. Roubini has a fond belief that there is sufficient spring in the rest of the financial markets for them to rebound even if those big banks fall over. This I very much doubt. I judge that the interconnectedness of financial institutions is far far more complex a network than Roubini realises. Finance is not a competitive market mainly. The banks chased alpha unrealistically, fooling themselves into believing they are their on performance drivers. The difference in performance among banks is minor. The major factors are the economy, nationally and globally. I think Roubini should abandon a micro-theory view and get back to macro-economics.
The stress-tests, from which bankers have to learn this is how they must manage in the future, concern managing through the vicious circle between economic and financial weakness plaguing the economy, paving the way for a reliable recovery. Once that is achieved then other tinkering, Shumpeterian perhaps, is open to debate, not before.
Just now the focus is on narrowing the information gap between what bankers think banks are worth and what investors think banks are worth, they hope to enable many banks to raise the equity they need from the private market. Banks must clean up their balance sheets to attract more equity but not at the expense of the underlying economy.
Officials privately agree that the stress test is not a worst-case assessment but they argue that by intervening relatively early by the standards of past crises they can help ensure such an outcome does not materialise. The assessments are, however, based on a banker’s rather than an economist’s analysis of losses and that is their gross realism failing. They should though avoid the accountant’s snapshot view of solvency by allowing banks to value assets held to maturity at higher than current market prices, and gives them credit for their ability to earn their way back to health over time, taking account of time to generate debt recoveries.
The Federal Reserve tries to narrow the gap between the banker’s view and the economist’s view (two disttinctly different cultures) by taking a broad view of risks and a more forward-looking assessment of loan losses and recoveries. If the strategy succeeds in restoring confidence and drawing in additional equity, it should result in a decline in risk spreads on bank debt, reducing their funding costs and encouraging them to be more aggressive in lending to households and businesses. This correlates well with UK policy that has exceeded even the total support for banks of the rest of the EU. The other OECD countries will be under pressure to follow suit with publishing stress tests of their own. The EU is seeking stress tests on 47 banks, now reduced to the top 25. But these are late. This is because everyone under-estimated the difficulties of assessing scenarios and building models across so many national economies, and the lack of models appropriate to doing this work at a pan-EU level as well as individual country levels.

Banks, Bonds, and Bond Traders

It is fair comment that a feature of investment banks and governments has long been one of incestuous mutuality or let's call it conspiratorial cooperation, from the very earliest times of loan-financing the King's Treasury as an alternative to tax-hike shocks to pay for wars or any other large investments. There is too a long history of the dangers of being a government creditor before governments became more mindful of parliaments, of laws and social responsibilities to manage better the economic impacts of government finance especially when leveraged by political democracy and economic theories that inculcated those responsibilities.
We are going through a special period when governments have been digging deep into the artistry of off-balance sheet financing via central banks treasury bills to bail out the technical insolvencies of banks. Despite this massive lender of last resort help, today there is a plethora of investment analysts notes circulating with undisguised sarcasm and cynicism about government finances. Even I am amazed at how shamelessly the financial markets can turn to savage governments that are doing so much to buy them survival time through the credit crunch and recession!
Some of this is knee-jerk mindless politicking. How easy to blame governments for the so-called 'mess in which public finances are in', on the one hand decrying historically high government deficit spending while on the other complaining about the threat of higher taxation such as the UK's new 50% higher tax rate for those earning above a quarter of a million and similar higher taxation in the US. What would it be costing those who complain if the governments stuck to balanced budget targets regardless of the underlying recession? There is a cry on many sides for government spending to be cut and tax rates to be lower. We entered the crisis with historically low direct taxes (income and corporation taxes).
Some others decry the 'crowding out' effect of governments mopping up savings by issuing a few trillion of government bonds on top of the trillions of bills issued as swaps for impaired and semi-illiquid assets held by banks to reduce their writedowns and nominal losses, to protect their capital and ensure they can retain basic solvency. Given the highest credit rating of government bonds, however, crowding out is offset by the boost to economic growth compared to what it would otherwise have been (i.e. the money is not lost to the economy, but generates multiplier effects by how it is redistributed) and the Treasury bonds help leverage bank lending and have a very high collateral value to support further investment credit. Productive investment is made more by those who borrow than by those with surplus savings. Hence, the 'crowding out' view should be replaced by a 'crowding in' theory of government borrowing. There is not a simple correlation between money supply statistics and government borrowing, certainly not one that can persuade me of the simple axioms of classic monetarist precepts. But, the reality for clear-thinking economists is that lower government spending would not help the economy anyway, not the 'real economy' so-called; it would today just make the whole of the 'economic cake' smaller and postpone recovery, possibly propelling the world's leading economies into Depression (up to a decade possibly of zero, negative or low growth as Japan in the '90s, or longer, as applied economists know, The Great Depression of 1873-1896).
I can only characterise fiscal consrvatives and 'small government is better government' pundits as blinkered, unable or unwilling to see and take responsibility for the big picture! Adam Smith's 'invisible hand' hypothetical and subjective proposition was not that everyone's selfishness should be as narrowly and individually focused as possible to produce the maximum inadvertent public economic and charitable benefits. That would be patently absurdist, since it can only be obviously true that extreme selfishness would undermine national economic integrity, and similarly at the global level; income and wealth is ultimately a social product, dependent on the quality and integrity of the total system, not of each part acting independently.
The famous national debt clock in New York shows the gross debt figure, but over a third of this is are obligations between arms of government, not tradable Treasury bonds, much of which in my view should be made tradable and sold into the secondary bond market and the proceeds used to finance social programs and a large part of the budget deficit without thereby increasing the gross national debt. The internal government part of the national debt is shown by the gap between red and blue lines. In other OECD countries this debt that is internal to government is typically about 20-25% of gross national debts.
Except for the USA in recent years unless we look only at its publicly held debt which has remained fairly constant, many governments held the line in maintaining a fairly constant gross debt ratio over the last decade, the private sectors, banks, businesses and households more than doubled their debt ratios to GDP in credit-boom high trade deficit countries. But, without that the trade-surplus countries could not have maintained their growth. Indeed, it was a boon to many emerging markets. But now we see export-led economies recessing faster than deficit-led economies. An exception to prove the rule is the Bush strategy from 2001 onwards when government tax cuts and cuts in social programs, with Adam Smith's 'invisible hand' in mind as prescribed by monetary conservatists, helped secure recovery but in a severely unbalanced way that proved to be relatively 'jobless' compared to more conventional fiscal recoveries.
The private sector should not complain now when the public sector has to do substantial borrowing now. And it is very likely, anyhow, that government deficits and debt ratios may fall as ratios to GDP sooner and faster over the medium term (3-5 years) than private sector balances, especially as it turns out that much of the financing bail-out of banks proves to be profitable for taxpayers - even if taxpayer money is scarcely involved in the bail-outs. I know it is hard for taxpayers to understand that their money is not what the government is playing with in its liquidity windows and treasury bills for bank asset swaps. They readily confuse government budget deficits with bank bailouts. The two things are not the same. Government budget deficits are almost entirely fiscal responses merely to recover economic growth, not to recapitalise or restructure the banks directly.
Had governments been less prudential over the past 20 years and done more to rein in asset bubbles, property, credit markets, including most importantly the banking bubble where banks stocks grew to dominate a quarter of stock markets and nearly half of quoted compnaies' profits, then the crisis today would be less severe.
Many commentators are now talking of the Treasury Bubble as the next bubble after
the dot-com, housing, mortgages, commercial real estate, private equity, and hedge fund bubbles. This is nonsense. We can see clearly that when government takes on the liabilities of the banking sector that there is a massive net reduction in credit insurance; the government credit risk spread goes up a few tens of basis points, but private sector and banks credit risk spreads fall by hundreds of basis points.
Commentators are happily getting on their high horses about investors chasing long-term Treasury prices to loftier and loftier levels only now to find this bubble too is leaking air fast like previously emerging markets, commodity prices and oil last year, and so on. This is not the same. The demand for government paper has utility and necessity; it is not just a speculative bubble.
Long bond futures fluctuate. They may have fallen 20bp — from 143 mid-December to 123 yesterday and yield on the benchmark 10-year Treasury Note from 2.06% to 3.11% — up 51% with technical levels all over the place, but this is just to be expected camera-shake.
There is also some staking out the market in advance of the large government auctions expected monthly this year. It is not a case of too much supply and not enough demand driving prices lower, at least not anywhere except at the long end simply because at first sight very long term paper seems unnatractive at current historically low coupon rates. This does not mean that the current volumes of government borrowing are more than the markets can willingly even hungrily absorb. All that is happening is that government is testing the outer limits before settling on the optimumally cheapest maturities they can get away with.
UK and US Treasuries are also buying in their own bonds, so-called Quantitative Easing, which just looks to me like restructuring their cost of money and reducing the availability of older higher coupon paper by a significant amount to focus buyers who need government paper on new issues. The Fed said at a policy meeting weeks ago that it would buy back up to $300bn, and it didn't alter that target at last Wednesday's gathering.
Critics lambast UK and US treasuries for buying or swapping illiquid and impaired RMBS and CMBS, toxic CDOs, credit card bonds, student loans — to loan money against anything and everything! This is much exaggerated. The Treasuries are charging substantial fees and exerting 25-30% haircuts, leaving themselves with more than adequate headroom to generate substantial medium term profit that I calculate will both finance recapitalisations of banks and pay off half of medium term government budget deficits thus relieving taxpayers of the risk of sharply higher future tax rates. Personally I'd like to see these haircuts translated into lower mortgage debt for sub-prime and other troubled mortgagees.
Some analysts fear all this is dragging down the US dollar, but that correction is welcome and to be expected anyway. However, there is the usual panic reaction too that the U.S. Treasury is borrowing and spending the country into oblivion! That is just absurd doom-mongering when this accusation had been better aimed at the private sector. Last week US Treasury sold a record $26bn in 7-year notes (reasonable), $35bn 5-year notes, $40bn 2-year notes, to be followed this next week by $71bn in longer-term debt. This all seems very sensible to me. Total net borrowing needs for the second quarter are now $361bn. But, given this is for the current budget year ending September 30 the timing is quite responsible, even if massively up from the only $13bn this time last year and double the previous estimate of $165bn.
The rumours are that the US Treasury will sell 30-year bonds every month, and start auctioning 50-year bonds! In the UK long term government bond yields always fall because there is sizeable Life and Pension fund demand. This may now be the case too in the US? The issuance is needed to fund the fiscal-deficit projected to hit at least $1.75tn in 2009 and $1.2tn in fiscal 2010. The importance can be seen in the composition of foreign holders of US government paper. The high issuance is good news for the economy as the only leverage getting the economy out of the hole it is in, but there is scarcely a news source or market commentary that says so. Negative sensationalism to rattle the cages of investors and persuade them into panic buying of gold or CFDs or Treasury bills and avoid long term bonds. But no investors except those with decades long term liabilities should be buying 30-50 year bonds anyway!
For more on this see my Obamanomics blogspot. (click to via profile)