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Why the banks are winning from coronavirus

Published by Anonymous (not verified) on Tue, 05/01/2021 - 6:17pm in

Government-backed small business loans may have kept many small businesses going in the last year, but they've also been great news for the UK's banks, who have been profiting handsomely from them. In this video I explain how.


2020 hindsight: what can supervisors learn from the collapse of Barings Bank 25 years on?

Published by Anonymous (not verified) on Wed, 09/12/2020 - 8:00pm in

Ben Dubow

This year marks 25 years since the failure of Barings Bank. On Sunday 26 February 1995, the 200-year old merchant bank blew up thanks to derivatives trading, which it believed was both risk-free and highly profitable. It was neither of these things. The firm’s star trader was illicitly pursuing a strategy akin to ‘picking up pennies in front of a steam-roller‘. The steamroller arrived in the form the Kobe earthquake. The star trader’s losses ballooned and he doubled up on his bets, unsuccessfully. Barings went bankrupt. The episode captured the public imagination, and helped lead to the creation of a new regulator in the UK. 

The world has moved on since then. Banks, supervisors and policymakers around the world drew lessons in wake of Barings, and have drawn many more lessons from the global financial crisis. These lessons are now helping supervisors through the economic turmoil of a global pandemic. So why should supervisors know the story of this small bank’s failure, which took place in a different world over two and a half decades ago? Because, as the Parliamentary Commission on Banking Standards pointed out, historical awareness can help avoid the mistakes of the past. “Supervisors [should] have a good understanding of the causes of past financial crises so that lessons can be learnt from them,” the Commission recommended.

Now, Barings did not precipitate a financial crisis. Uncertain as to what the impact of a bankruptcy would be, over a fraught final weekend, the Bank of England worked on plans to avoid one.  In the final hours, the Bank of England’s Court of Directors discussed the ‘systemic’ risks should those plans not succeed. They did not succeed, but when markets opened the next day, turmoil was limited. The bank was not big enough to impact the financial system: its balance sheet ranked 32nd among UK banks. However, some of the weaknesses seen at Barings have also shown themselves at systemically important firms. And had Baring’s failure occurred alongside other fear-inducing events, perhaps it might have tipped markets over into panic. So the story is worth knowing and these are some of the morals for supervisors present and future, in the UK and elsewhere.

Firstly, Baring’s collapse reminds supervisors to be wary of complex, new and incredibly profitable businesses, especially when conducted far from head office. In the late 1980’s competition became tougher in the City of London. After Big Bang in 1986, larger foreign firms expanded their London presence and acquired most of the old British merchant banks. More competition put Barings’ profitability under pressure and the bank began to take more risk. Seeking lucrative growth opportunities, Barings rapidly expanded its Asian securities business. In 1992, among its new ventures, Barings sent Nick Leeson to Singapore to start a derivatives trading business. Leeson’s authorised business was arbitraging small price differences between futures contracts trading on the Singapore exchange and the near-identical contracts trading in Tokyo. This business went on to become a huge success, apparently generating 10% of the entire group’s profits for 1994. 

In reality, Leeson was running an unauthorised business, secretly selling options — a one way bet that markets would remain stable. Markets moved by more than Leeson expected and the strategy lost money. Leeson hid the losses, which, in the end, reached £827 million — twice the firm’s capital. Ironically, Barings may be the only bank to have illustrated twice the dangers of growing complex, far-flung businesses: in 1890 Barings was bailed out after an ill-fated move into Argentinian infrastructure finance.

Barings’ collapse also bears out the need for good controls. The idea that one man’s crime single-handedly broke a bank is far from the truth. In reality, Leeson’s activities were enabled by a litany of horrendous control failings, laid out in detail in a report by the Board of Banking Supervision (BoBS). The problems begin with the fact that management entrusted the monitoring of Leeson’s trading activities to Leeson himself. When the Baring’s Internal Auditors found out, they ordered this to stop. The management of the Singapore office said it had stopped. It had not. No one ever checked.

Management and oversight of Leeson was light touch and ambiguous. The BoBS report forensically dissects the evidence on who actually managed Leeson, with all involved denying it was them. Meanwhile, an understanding of derivatives was lacking among the heirs to 200 years of tradition who ran Barings. Management in London did not question why Leeson’s supposedly profitable trading required increasing amounts of cash to be sent to Singapore: £221 million by the end of 1994 growing to £742 million by the end. But it can be career-limiting to question a rain maker too closely, and hence the most ‘profitable’ parts of a firm may be the least well controlled.

Poor controls at the regulator played their part, too. Barings was granted a waiver by the Bank of England, which removed the limit on the amount of cash Barings Bank in London was able to send to its securities trading business in Singapore. This waiver was precedent-setting: no securities trading business had received such a waiver before. Yet the waiver did not go to a committee of senior management for scrutiny as it would today. Barings reminds supervisors why this needs to be so, and why we cannot give firms the benefit of the doubt when granting formal concessions.

Barings also reminds supervisors that, until you can trust a firm’s risk management and controls, you cannot trust its numbers. The problems at Barings were not at all apparent in the firm’s all-important capital, leverage and liquidity ratios. According to the Bank of England’s Historical Banking Returns Database, Baring’s prudential ratios were higher than peers’. But these numbers did not reflect Leeson’s hidden trades. Regulatory data cannot always be taken at face value. If a firm’s risk management and financial controls are poor, it will be a case of ‘rubbish in, rubbish out’.

A final reminder is that, when failings are widespread, the root cause surely lies at the top. Baring’s Board would not have met the expectations of today’s investors or bank supervisors. The Board lacked a Chief Risk Officer or Chief Financial Officer or truly independent Non-Executive Directors experienced in commercial banking, much less derivatives trading. The Senior Managers Regime, established after the financial crisis, gives supervisors many more powers to address good governance than existed back then. Barings collapse serves as an example of why those powers are important.

Ben Dubow works in the Prudential Regulation Authority’s International Banks Directorate.

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Comments will only appear once approved by a moderator, and are only published where a full name is supplied. Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.

How to find £50 billion

Published by Anonymous (not verified) on Sat, 05/12/2020 - 8:00pm in

This post began life as a Twitter thread. It builds on a post made here, yesterday. Some added charts and links have been included.


As some will have noted, there were a lot of reports yesterday on the fact that £50 billion of banks notes are missing in the UK economy. This got me thinking. And as a result I have to suggest that finding that £50 billion of cash would not be hard. Here’s how to do it.

As the Public Accounts Committee of the House of Commons has noted, around £50 billion of banknotes in issue have no explained use. In other words, they do not appear to be used for regular cash transactions. What their alternative use might be is not known.

Some could be in the possession of tourists, who have not bothered to exchange them on leaving the country. But the amounts involved would be small.

A bigger sum might be cash savings under the proverbial mattress. This is entirely plausible. It is possible that some of this will be related to benefit fraud: the amount of savings a person has can have a significant impact on their ability to claim a number of benefits.

There is no doubt that a significant part of this money Is used within the shadow economy. That can cover activity where tax is evaded, of course. But it also includes drug dealing and many forms of human trafficking and abuse.

No one is finding it easy to come up with an innocent explanation for the missing money. I cannot.

The Public Account Committee has suggested that the Bank of England is indifferent to this issue, even though in it acknowledges that the value of notes in issue is way in excess of those that appear to be required to meet the needs for regular cash payments within our economy.

The question then arises is whether anything can be done about this, and the obvious answer is that this is an issue that could be quite easily addressed if the willpower to do so existed. The way to address it is actually remarkably easy.

To address the issue what has to be done is that at short notice it is announced that all the UK’s main denomination banknotes (£5, £10, £20 and £50) are to be replaced. No more than a couple of weeks notice should be given.

The change over period from the old to the new notes must be very short. A maximum period of a month should be allowed, but if possible, a shorter period of perhaps no more than two weeks should be provided.

It would then be the case that within a period of four weeks, at most, most literally the entirety of UK notes in issue would cease to be legal tender, and be replaced.

It’s a fact that designing and introducing new banknotes is normally a very time-consuming, and lengthy, process. But, this exercise does not actually require the design of new banknotes. All that needs to happen is that the colours of existing banknotes be swapped.

So, for example, the brown used for the £10 note, could now be used for the £5 note. The blue from the £5 note could be used for the £20 note. And so on. That is all that is required. The designs need not change: just the colour must.

And yes, I know that will create issues for some colourblind people, But I am not sure that in this case that is a major impediment to progress, although I would, of course, be willing to hear objection.

During the four-week transition period old notes could, of course, be spent. Replacement new notes, with a total value of about one-third of the sum previously in issue, could then be injected into the economy. Because that’s all we apparently need.

At the end of the four week period, or any time during it, a person could present old notes and ask for new ones. But in the case of any sum in excess of £200 the person making the deposit would be required to identify themselves.

The usual money laundering rules for proof of identity would apply e.g. a passport, driving license or an equivalent range of documentation would be required to swap notes. Without proof new notes could not be obtained once the transition was over.

In addition, any request for an exchange of notes in excess of £500 would require that the money first of all be paid into a bank account. This money would then become traceable.

The bank through which cash deposits were made should be required to seek explanation from the depositor as to the source of the money. A very low threshold for suspicious transaction reports should be applied. HMRC should have the power to freeze deposits, instantly.

Five things would immediately happen. First, the vast majority of this £50 million would either be found, or it would cease to be in use and cease to be legal tender, and therefore cease to be available for criminal or fraudulent purposes.

Second, this cash would now have identifiable ownership. Of course some will be disguised, but the power for HMRC to freeze accounts and investigate funds must be used: this is a one off chance to freeze the shadow economy. The tax take will increase.

Third, criminal trading will become harder to undertake. This will be a massive benefit to society.

Fourth, by eliminating cheating we will have a fairer, more equal society and one in which honest small businesses will have a better chance of flourishing because they will not be undermined by dishonest ones.

Fifth, it could be argued that the national debt is reduced, although that is very much open to question for reasons I will publish soon.

How much would it cost? The National Audit Office happened to publish a survey on the cost of producing currency during the course of 2020. They estimated there are 4.5 billion notes in issue.

This chart shows the use of banknotes over time:

They also indicated the cost of printing notes was about 7p on average. Only one-third of notes will be replaced. That implies a cost of £105 million to replace the necessary banknotes. Banks might also need to be paid for the additional work involved.

The benefits of reissuing all notes should massively outweigh the costs though, most especially if a significant number of investigators are employed to pursue data and collect tax owing and pursue criminal enquiries.

And let’s also be clear, even if no cash was recovered (it’s possible, although unlikely) significant criminal activity would have been discouraged. It’s a win either way.

So will the social benefits outweigh the costs? I think so. I look forward to the argument from the politician who says otherwise.

The Bank of England balance sheet

Published by Anonymous (not verified) on Fri, 04/12/2020 - 10:51pm in


Banking, Economics

There are moments when it is wise to think a reconsideration is appropriate. My suggestion for perpetual debt did not go down well yesterday. But it did create invaluable debate.  Even 100-year debt was not seen as a zinger. But long term debt at near enough zero per cent as a way of locking in rates on money seemed to be acceptable.

Let's be clear what money I am talking about. It is the central reserve account balances held by the UK's banks and building societies with the Bank of England. These balances are described by the Bank of England as follows:

We are the UK’s central bank. Our balance sheet is special for one key reason – the nature of our liabilities. Central bank money, whether in the form of banknotes or central bank ‘reserves’ (deposits held with us by financial institutions), provides the ultimate means of settlement for all sterling payments in the economy.

This gives our balance sheet a central role in supporting monetary and financial stability.

These balances are, then, money par excellence. And those who claim that they are broad money are wrong - the Bank of England says so.  In this context, note this from a speech from Monetary Policy Committee member Gertjan Vlieghe in April this year:

Narrow money goes up with every QE issue. That is because QE creates central bank reserve accounts. And they are narrow money.  This is reflected in this representation of what is claimed to be the Bank of England balance sheet from the same speech:

I say 'claimed to be' for a reason: no such balance sheet is ever actually published because this consolidates the Asset Purchase Facility (APF)  notionally is run by the Bank of England and which actually legally owns the repurchased gilts into the Bank of England accounts but for actual accounting purposes that cannot be done as the APF is under the control of HM Treasury: although technically a subsidiary of the Bank of England its accounts are not consolidated for this reason. The above is then a Bank of England / Treasury balance sheet, but the point remains the same. As QE rises, so too (near enough, but not precisely) do central bank reserve accounts with the UK's banks and building societies increase.

For those confused by this, and who wonder what they do with this 'money', please remember what money is: it is simply a debt. There is no physical moving of assets here. And remember that no money is reused in banking. Bank money is simply a record of a debt. The APF has bought gilts from banks using money created out of thin air for that purpose by the Bank of England and that debt remains outstanding to the banks. There has been nothing to redeem it. At present there is about £800bn still, in effect owing, to be cancelled either by tax or new debt sales by HM Treasury, which is all that these balances of central bank money can effectively be used for.

In the meantime, those balances sit as deposits on commercial bank balance sheets. This is from the same speech byGertjan Vlieghe:

In 2006 for every pound of central bank money (broadly cash back then, because central bank reserve accounts were out of fashion then and banks extended each other credit, which they no longer do) there were roughly £30 of commercial loans. This is where the claim that private banks make the vast majority of money came from.

By April 2020 that ratio was £5 of bank loan for every pound of central bank money. That ratio will now have fallen again: there has been £200 billion more of QE since then.

So, let's be clear about three things.

First, private banks do not lend their central bank reserve balances on. They create new money when they lend.

Second, there would appear to be more central bank reserve balances than are needed for normal purposes at present (but the March 2020 market freeze was a warning shot on the need to have sums available to ensure liquidity between commercial banks; that was why £200 billion of QE was created then).

Third, if there are, on a day to day basis excess central bank reserves, and that seems to be the case given this loan to narrow money ratio, then the question that I ask about what can be done to manage this issue when the Bank of England thinks it necessary to control rates by paying interest on these balances does seem a fair one.

So, let me retreat from perpetuals. I know when I am beaten (even if part of narrow money is, of course, zero rate perpetuals - because that is what notes are).

And let's talk no more than 100 years. Just to put this in context the Debt Management Office suggests current debt profile is as follows:

There is already long-dated debt, as will be noted

But what we have in the case of the relationship between the Bank of England and banks with regard to central bank reserves is something different. The banks have an asset that they did not choose to acquire, but had little choice but have imposed upon them in their role as intermediaries. And as is apparent, this asset is not, as such used in their business except for the purposes of inter-bank settlement, as the Bank of England has noted.

So the question to ask is can the risk to the Bank of England on interest cost be hedged? That is what my video yesterday was effectively asking. My suggestion remains that it can be.  First, that is by recognising that these balances are narrow and not broad money. Second, it is by recognising that whilst narrow money is important its use is limited. And third, it can be by accepting that the amount of that narrow money that need be in issue with a variable interest rate need not be the full value of the balances now held. I am not sure that any of these suggestions should be that contentious.

So what to do? Let's stick with the need for some of these central reserves to continue as now. And let's then suggest that a form of long term debt that is tradeable between the holders of these balances and the Bank of England alone is an alternative for the remaining balances.  In other words, it remains a means of settlement. It remains narrow money, in effect. That is only possible with a very long redemption date. And let's suggest that a fixed rate is appropriate on this money. The average cost of government debt right now is 0.3%, which if it was used for these excess balances would add an immaterial £1.6 billion at most to the cost of serving the national debt, and provide banks with a rational reason to opt into such issues now.

Is that viable? I stress, I am exploring ideas. And I think this restructuring of what looks to be an unsustainable balance sheet as to form, but nonetheless necessary balance sheet as to function is necessary and that is why I am exploring this.


Where has all the money gone?

Published by Anonymous (not verified) on Fri, 04/12/2020 - 7:09pm in

Do you remember that very poor joke from Liam Byrne about the UK having run out of money? It cost Labour dear.

But now the Public Accounts Committee has noticed that money is disappearing in the UK. As they have observed in a report issued this morning, no one knows where UK notes and coin are and what they are being used for:

In a report published today, Friday 4th December 2020, the Public Accounts Committee says oversight of the production and distribution of notes and coins is “unclear” and “fragmented” across responsible authorities, who have been “behind the curve” in ensuring access to cash for consumers and businesses, and are failing to understand or act on the clear dangers of hardship if the UK continues its “precipitous” move towards a cashless society.

Their concern about an enforced move to a cashless society is real:

The reduction in the number of facilities from which to obtain cash, and in the number of businesses that will accept cash, can have a negative impact on the lives of many people, including those in some rural areas, vulnerable and digitally excluded people. Responsibilities are spread across HM Treasury, the Financial Conduct Authority, the Payment Systems Regulator and the Bank of England but no one body is in overall charge of making sure that people and businesses have access to cash.

I think that issue needs to be addressed but think this more significant:

Conversely, demand for sterling notes has steadily increased, but the Bank of England does not “appear to have a convincing reason for why the demand for notes keeps increasing” or any real understanding of where approximately £50 billion of issued sterling notes are, or being used for: only that this increasing demand for cash notes in the face of their declining use is “a trend being seen with other major currencies”.

They add:

The Bank estimates that 20%-24% of issued notes are used or held for cash transactions. This leaves about £50 billion worth of issued bank notes that may be being used overseas for transactions or savings, or held in the UK as unreported household savings or for use in the shadow economy. The Bank of England doesn’t know. There are implications for public policy and the public purse if a material proportion of the large volume of banknotes whose whereabouts or use are unknown are being used for illegal purposes.

As Meg Hiller MP noted:

“£50 billion of sterling notes - or about three quarters of this precious and dwindling supply - is stashed somewhere but the Bank of England doesn’t know where, who by or what for – and doesn’t seem very curious. It needs to be more concerned about where the missing £50 billion is. Depending where it is and what it’s being used for, that amount of money could have material implications for public policy and the public purse.  The Bank needs to get a better handle on the national currency it controls.”

I agree. As I do with these recommendations:

The Bank of England seems to lack curiosity about the huge volume of notes not used or held for day-to-day transactions. The Bank estimates that 20%-24% of issued notes are used or held for cash transactions. This leaves about £50 billion worth of issued bank notes whose whereabouts or use is unknown. These notes may be being used overseas for transactions or savings, or held in the UK as unreported household savings or for use in the shadow economy. The Bank does not have any real understanding of what these notes are being used for though says that it is a trend being seen with other major currencies. During the COVID-19 pandemic there was a significant increase in the value of notes in circulation, which the Bank thinks is probably explained by people being more inclined to hoard cash in case they need it. There are implications for public policy and the public purse if a material proportion of the large volume of banknotes whose whereabouts or use are unknown are being used for illegal purposes.

Recommendation: The Bank, working with other public authorities such as HMRC, should take action to improve its understanding of the factors that are driving the increase in demand for notes, and also who is holding the approximately £50 billion worth of notes.

The Bank of England’s stock of notes seems high and it is not clear to us how the Bank decides upon what is an appropriate stock level. The Bank holds stocks of notes well above its own policies for minimum levels of stocks. For example, at the end of July 2020, it held contingency stocks with a value of £30.4 billion, against its minimum guidance levels of £15.6 billion. We recognise that the Bank would not wish to risk running out of notes. However, we do not understand the Bank’s rationale for holding such high levels of stocks. The Bank does accept that it needs to improve the transparency with which it takes decisions on printing notes.

Recommendation: The Bank should ensure that it properly records and evidences the judgements it makes about printing notes and its stock levels so that it can be properly held to account for the decisions it makes.

The shadow economy remains a real threat to the UK’s ability to deliver fiscal stability. It undermines honest businesses. It creates cultures of mistrust. It harms social cohesion. All of those are big issues. The Bank of England needs to take them seriously.

As if to prove there are credible politicians in the U.K., the Public Accounts Committee has done good work here. I welcome it’s findings and recommendations. The Bank of England must be required to act.

Does Scotland needs its own central bank after independence?

Published by Anonymous (not verified) on Thu, 03/12/2020 - 6:28pm in

The discussion that was organised by the Scottish Currency Group that addressed this issue last Sunday has now been issued as a YouTube video:

Those participating in the discussion overwhelmingly supported the idea.

How to solve the long term interest issue

Published by Anonymous (not verified) on Thu, 03/12/2020 - 5:48pm in

There is concern that bank base rate increases will impact the cost of central bank reserve accounts which have effectively replaced around £800 billion of government debt. But that need not be a problem. In this video I explain how to address this issue, and solve it forever.

Trying to run Scotland without its own currency would be like a person trying to be a carpenter without having a saw

Published by Anonymous (not verified) on Mon, 30/11/2020 - 7:10pm in

I took part in a debate on the need for a Scottish Central Reserve Bank yesterday. This was run as a parallel event to the SNP conference, featuring resolutions that the SNP conference organisers had declined for debate by their membership. The event was run by Tim Rideout and the Scottish Currency Group.

I made a few notes in advance, just to concentrate my thinking. They focussed on why Scotland had to have its own currency if it was to manage its own affairs via a central reserve bank. Those notes said:

Why Scotland has to have its own currency

It’s essential to manage the economy. A country without its own currency cannot:

A) Control the interest rate, for reasons B and C

B) Provide central bank reserve accounts for its banks - meaning that a key economic sector is effectively beyond its control - and these accounts are essential for controlling short term interest rates

C) Do QE, which is essential for controlling long term interest rates

D) Advance money into the banking system to prevent banking meltdown as has been required twice in the last 12 years in the UK

E) Integrate monetary and fiscal policy - as most economists now think to be essential.

They're all a bit shorthand, I admit, but also fit fairly into recent threads on QE and related issues.

The overall point is simple though: without its own currency Scotland would not have control if its interest rate policies, would not have control of any crisis hitting it, and would not be able to integrate monetary and fiscal policies, with the latter being fundamentally undermined as a result.

As I summarised it during discussion:

Trying to run Scotland without its own currency would be like a person trying to be a carpenter without having a saw.

I could have added:

And nor can a carpenter borrow a saw, because they need it all the time and will never be able to give it back. So too with the currency.

It baffles me that this debate is required, but the SNP insists that it is by refusing to consider a Scottish currency. It’s a big mistake on their part.

QE and funding the Green New Deal

Published by Anonymous (not verified) on Sat, 28/11/2020 - 10:24pm in

The post that follows started, as a number now do, as a Twitter thread. That’s because their reach is much bigger than this blog. Some threads have reached 250,000 people. But that does not reduce its relevance here.


I’ve tweeted more about quantitative easing than I really thought to be decent of late. However the questions still keep coming, so here is another QE thread, on the use of QE funds and (especially) the link to the Green New Deal....

The question I have been asked is does it matter what QE money is spent on, and the honest answer is ‘it’s complicated’. But, maybe not so so complicated if it’s understand that QE came in three stages, each of which is quite different.

Stage 1 QE lasted from 2009 until 2016, when the last round of this stage took place in the UK. The aim at this stage was simple. As always, new money was created by the Bank of England, and mainly government bonds (gilts) were bought. That’s what QE does, in essence.

Stage 1 QE had the aim of removing gilts from the market. The idea was that money would go as a result go into riskier assets, and new investment. It didn’t. It went into speculation. But interest rates were kept low. And banks got new money, and that protected them from failure.

In Stage 1 QE the government also in effect got funds to cover its deficit. But to be clear, QE did not fund the government’s spending in this period. That was never the intention, and never what happened. Stage 1 (and 2) QE moped up the debt that spending had already created.

That QE only mops up debt is not surprising. As modern monetary theory makes clear, all government spending starts with money creation. And then the overdraft this, in effect, creates is cleared by tax receipts or debt. But the debt never comes first. So it never funds the spend.

Stage 2 QE emerged in 2020. Unlike Stage 1 the aim was not to redirect where the City put their money. The aim was to make sure that financial markets were not going to be overwhelmed by having to buy the large number of new gilts that would otherwise be on sale. It’s worked.

Stage 2 QE has other aims as well. Keeping interest rates low was still necessary. And protecting banks from stress in financial turmoil remained a priority, and key in March 2020. But primarily this was a debt funding exercise. And the spend still came first.

I’m not sure I can stress this enough: Stages 1 and 2 QE do not fund government spending. The government can do that any time it wants. It has its own bank. But because it thinks it has to clear its overdraft with the Bank of England it has to issue debt.

The only reason for Stages 1 and 2 QE is debt management, and not to fund spending. Stage 1 QE aimed to make government debt less attractive by lowering interest rates, to supposedly force money elsewhere. Stage 2 provides a buyer for the debt the market may not want right now.

It is only what I call Stage 3 QE that might change the use of QE money. I developed this idea in 2010. It was called Green Quantitative Easing back then. Jeremy Corbyn called it People’s QE. John McDonnell,was scared of it. It’s quite different to Stage 1 & 2 QE.

In Stage 3 QE a government owned investment bank seeks to secure funding to transform an economy. The aim is to deliver a Green New Deal, and everything that goes with it. I stress this could be done by conventional government spending. Plus Stage 2 QE. But Stage 3 QE is better.

Stage 3 is about much more than QE though. It recognises that vast amounts of saving is wasted right now. The stock market and land speculation are just Ponzi schemes that don’t deliver added value new jobs. Cash sits uselessly in bank accounts. Savings need to work.

Stage 3 QE works alongside a transformation of savings. State subsidies to savings - that drive the Ponzi scheme arrangements we have - need to change. So pensions funds, to get tax relief, must save 25% of their new contributions in investments that create new green employment.

The Stage 3 QE job creating investments in green jobs can be in the private sector, of course. They need not be in the UK. After all, this is a global issue. But the point is the only real useful long term investments we have now are in the green economy - so it needs to happen.

Stage 3 QE also requires that ISA savings be changed. £70bn a year goes into ISAs. Some is reinvestment, but it’s still a massive sum. And all that money needs to go into guaranteed green savings bonds issued by a National Investment Bank where it could fund the Green New Deal.

Do what I have said to reform tax on savings and all the money required to fund a Green New Deal may be found. We may not need Stage 3 QE for this purpose at all. But what if the need for reform is bigger than the capacity of savings to fund? Then Stage 3 QE can kick in.

To make Stage 3 QE work the National Investment Bank issues bonds and then the Bak of England acquires them in the usual QE way — effectively making money available for green investment. Now, for the first time, QE might be linked to an actual spend.

The link between the spend by the National Investment Bank and QE is always going to be at a distance though. The Bank of England is still playing its role of mopping up debt in this Stage 3 approach to QE. It does not control the spend. It does not manage it. It just buys debt.

It’s really important to say this. QE, whether in Stages 1, 2 or 3, never gives the Bank of England control of spending. That always stays wholly under the control of the government in Stages 1 and 2, and the government owned National Investment Bank in Stage 3.

In conclusion, QE does not fund or direct spending. It is a way of managing debt. That’s it. But we do need ways of managing debt right now. And QE - which meets international requirements and lets the Bank of England indirectly fund the government - is critical right now.

Separating deposit-taking from investment banking: new evidence on an old question

Published by Anonymous (not verified) on Fri, 27/11/2020 - 8:00pm in


Banking, mortgages

Matthieu Chavaz and David Elliott

On 16 June 1933, as the nationwide banking crisis was reaching a new peak, freshly elected US President Franklin D. Roosevelt put his signature at the bottom of a 37-page document: the Glass-Steagall Act. Eight decades later, the debate still rages on: should retail and investment banking be separated, as Glass-Steagall required? In a recent paper, we shed new light on the consequences of this type of regulation by examining the recent UK ‘ring-fencing’ legislation. We show that ring-fencing has an important impact on banking groups’ funding structures, and find that this incentivises banks to rebalance their activities towards retail mortgage lending and away from capital markets, with important knock-on effects for competition and risk-taking across the wider banking system.

How does ring-fencing affect bank behaviour?

Ring-fencing came into effect at the start of 2019. The regulation requires large UK banking groups to separate their core retail banking services from their investment banking activities, in order to protect UK retail banking from shocks originating elsewhere. Unlike Glass-Steagall, ring-fencing allows banking groups to continue to run both retail and investment banks. To do so, however, these groups must house their retail deposit-taking business in a subsidiary (the ‘ring-fenced bank,’ or RFB) that is separate from the entity housing their investment banking operations (the ‘non-ring-fenced bank’, or NRFB) — as illustrated in Figure 1. As we show in the paper, this requirement implies a substantial change in the extent to which different assets across the group are funded by retail deposits. Relative to the funding mix before the reform, the retail funding share of assets that can be placed in the RFB (such as mortgages) increases by around 18 percentage points on average. Meanwhile, the retail funding share of assets housed in the NRFB (mainly wholesale and investment banking) decreases by around 45 percentage points on average.

Figure 1: Stylised balance sheet of a banking group affected by ring-fencing

The left panel illustrates the balance sheet of a fictional banking group before ring-fencing. The right panel shows how the balance sheet might change after ring-fencing. Note that, in reality, most banking groups have a much wider range of assets and liabilities than those illustrated here.

In order to understand how this change affects banks’ behaviour, we use loan-level data for the UK mortgage market and the global syndicated lending market, and analyse the lending behaviour of banking groups over the years between ring-fencing legislation being passed (2013) and implemented (2019). To isolate the impact of ring-fencing from other developments, we compare the behaviour of banking groups who face a large change in funding structure as a result of ring-fencing to those who are unaffected, or for whom the change is more modest. In addition, we compare how the behaviour of the same bank differs between loans that will sit on the balance sheet for several months or years after ring-fencing implementation (and should therefore be affected by the change in funding structure) to loans that mature before 2019 (and are therefore unlikely to be affected by the restructuring). We only aim to estimate the impact of the change in funding structure on bank lending behaviour, and do not analyse other potential impacts of ring-fencing, for example relating to compliance costs.

Our results indicate that ring-fencing encourages UK banks subject to the reform to rebalance their activities towards retail lending and away from capital markets. Specifically, banks whose funding structures are more affected by the reform reduce the interest rates they charge on domestic mortgages, leading to an increase in the quantity of their mortgage lending. Meanwhile, they reduce their provision of syndicated credit lines and underwriting services to large corporates. This rebalancing is consistent with the idea that deposit funding provides certain advantages to banks — for example, because households place a high value on the liquidity of deposits, or because of deposit insurance — and that redirecting these benefits towards consumer lending leads to a reduction in the cost of consumer credit.

When we compare the effects of ring-fencing across different mortgage products, we find that the reduction in interest rates is larger for mortgages with maturities over two years, consistent with the idea that the funding stability of retail deposits allows banks to engage in maturity transformation. In contrast, we find no evidence that the reduction in rates is larger for higher LTV mortgages, despite the fact that the cost of retail deposits is relatively insensitive to the riskiness of the bank.

What are the effects on the wider market?

Ring-fencing requirements only apply to the largest UK banks. These banks hold large market shares in the mortgage market, suggesting the potential for spillover effects on their smaller competitors. Indeed, we find that, by offering cheaper mortgages, large banks more affected by the reform gain market share, leading to an increase in mortgage market concentration. Smaller banks respond by increasing the riskiness of their lending. Specifically, in those products and geographical areas where the large banks grow more, smaller banks tend to reduce the rates on high LTV (>90%) mortgages, and increase the share of these loans in their lending portfolios.

What does this tell us about recent developments in the UK mortgage market?

Two trends in the UK mortgage market that have attracted the attention of policymakers in recent years are falls in interest rates and increases in high-LTV lending by smaller lenders. We can use our results to estimate the role of ring-fencing in contributing to these trends.

Our results suggest that the reduction in the price of large banks’ mortgages caused by ring-fencing can explain around 10% of the overall decline in mortgage spreads observed between 2013 and 2019. In line with the Bank’s December 2019 Financial Stability Report, ring-fencing has therefore contributed to the ‘price war’ in UK mortgages, without being the main driver.

Meanwhile, our estimates indicate that the indirect effect of ring-fencing on small banks can explain around 30% of the increase in high LTV mortgages in small banks’ lending portfolios between 2013 and 2019. Again, therefore, ring-fencing appears to be one of several potential drivers of this development.

What are the broader policy implications?

By redirecting the benefits of deposit funding to retail credit markets, ring-fencing reduces the cost of credit for consumers. The cheaper credit is not concentrated in the higher-risk segment of the mortgage market, limiting financial stability concerns related to rising household indebtedness. The expansion of consumer credit is mirrored by a reduction in lending to large corporates. While the net welfare effects of this rebalancing are uncertain, we find that the reduction in corporate credit is mainly focused on lending to foreign borrowers, who are less likely to be reliant on relationships with UK banks.

Our results also suggest more ambiguous impacts on the retail credit market over the longer term. First, ring-fencing appears to lead to more concentrated markets. The increased market power of large banks could lead to more expensive credit and reduced quality of service over the longer-term; alternatively, increased concentration might simply reflect less efficient banks leaving the market. Second, the increased retail focus by large UK banks could reduce their exposure to international shocks; but by encouraging smaller banks to take more risk, ring-fencing might increase their vulnerability to shocks.

Matthieu Chavaz works in the Bank’s Monetary and Financial Conditions Division and David Elliott works at Imperial College London.

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