Financial crisis

Error message

Deprecated function: The each() function is deprecated. This message will be suppressed on further calls in _menu_load_objects() (line 579 of /var/www/drupal-7.x/includes/menu.inc).

Britain was not "nearly bust" in March

Published by Anonymous (not verified) on Wed, 24/06/2020 - 2:49am in

"Britain nearly went bust in March, says Bank of England", reads a headline in the Guardian. In similar vein, the Telegraph's Business section reports "UK finances were close to collapse, says Governor":Eh, what? The Governor of the Bank of England says the UK nearly turned into Venezuela? Well, that's what the Telegraph seems to think: 

The Bank of England was forced to save the Government from potential financial collapse as markets seized up at the height of the coronavirus crisis, Governor Andrew Bailey has said. In his most explicit comments yet on the country's precarious position in mid-March, Mr Bailey said 'serious disorder' broke out after panicking investors sold UK government bonds in a desperate hunt for cash. It left Britain at risk of failing to auction off the gilts needed to fund crucial spending - and Threadneedle Street had to pump £200bn into markets to restore a semblance of order.

Reading this, you would think that the UK government's emergency gilt issues had triggered a sterling market meltdown, wouldn't you? If this is indeed what happened, then the Bank of England has strayed far beyond its mandate and compromised its independence. Why on earth the Governor would voluntarily admit this surely requires some explanation. After all, if it is true, it could cost him his job. The source for the Telegraph's extraordinary claim is this 51-minute podcast from Sky News, in which Sky's economics editor Ed Conway and former Chancellor Sajid Javid grill the Governor on his handling of monetary policy during the coronavirus crisis. The particular part of the interview that has raised eyebrows is in this clip, which I have transcribed here:

Bailey: We basically had a pretty near meltdown of some of the core financial markets….I got to Wednesday afternoon, and the markets team came down here, and you know it’s not good when they turn up en masse, and you know it’s not good when they say “we’ve got to talk”, and it wasn’t good. We were in a state of borderline disorderly, I mean it was disorderly in the sense that when you looked at the volatility in what was core markets, I mean core exchange rates, core government bond markets, we were seeing things that were pretty unprecedented certainly in recent times, and we were facing serious disorder.

Conway: How scary was that? What would have happened if the Bank hadn’t stepped in?

Bailey: “Oh I think the prospects would have been very bad. We would have had a situation in which in the worst element the Government would have struggled to fund itself in the short run”. 

So no, the market meltdown was not triggered by high government spending. The market meltdown was because of investors panicking about Covid. It did, however, threaten to cause a government debt crisis.

Or - did it? Government struggling to fund itself "in the short run" simply means that it might have needed to pay out money before it could raise it. Normally it would cover short-term cash needs by issuing Treasury bills, which are short-dated, highly liquid bonds with very low interest rates. But when markets are malfunctioning, it can't do this. And high-interest gilts or pandemic bonds would take time to issue. So it could potentially find itself short of ready cash for urgent spending. However, as I have explained before, not being able to raise immediate funds for an urgent purchase is not insolvency, it is illiquidity. Relieving temporary illiquidity is what central banks do, and have done since the time of Bagehot. Historically they have done so not only for banks, but also for governments. And in the UK, the Bank of England still bears this responsibliity. The Ways and Means overdraft (which was extended in April) is the living evidence of the Bank of England's role as liquidity provider of last resort for the UK Government. But it is simply a working capital overdraft, such as any solvent business would have. Using this overdraft in no way implies that the Government is "insolvent", "bust", "bankrupt" or any of the other inflammatory headlines that journalists like to use. And nor does it mean the Bank of England is financing government deficit spending on anything other than a very short-term basis. It simply smooths out cash flow. Conway's assertion that the Government was "within a whisker of insolvency" is total nonsense, as is the Guardian's claim that "Britain nearly went bust in March". The Government was not shut out of markets long-term, as an insolvent sovereign would be. It had short-term cash flow problems solely because markets were malfunctioning.  Indeed, in another part of the interview Bailey said exactly this (my emphasis):

Conway: At the time you were nervous about government not being able to finance itself. 

Bailey: Yes, because of market instability.

Bailey went on to explain that the reason why the Bank intervened was not because the Government was having funding difficulties, but because market instability was driving up interest rates across the entire economy, and indeed across the whole world:

How would this have played out if we hadn’t taken the action that we and other central banks took? I think you would have seen a risk premium enter into interest rates, I think markets would have priced in a risk premium, and it could have been quite substantial given the degree of instability we were seeing. That would have raised the effective borrowing cost throughout the economy. In terms of the Bank of England's objectives, that would have made it harder for us to achieve our objectives, both in terms of inflation and in terms of economic stability.

The market meltdown was weakening central banks' hold on interest rates. They had to act, not to protect government finances but to prevent monetary conditions from tightening sharply, potentially triggering a dangerous debt deflationary spiral. The first responsibility of central banks in this crisis has been to prevent an exogenous shock to the real economy from triggering a financial crisis that would amplify the shock and significantly deepen the inevitable recession. That's what the exceptional interventions by central banks, including the Bank of England, since March have been all about. 
Bailey observed that although the UK Government was the largest borrower in the sterling market, it was far from the only one. Big corporations were borrowing enormous amounts, both in the market and from banks. Interest rates were rising on their bonds as well as government bonds. So the fact that the Government was the largest borrower was "actually largely irrelevant to that argument about a risk premium and an increase in the effective rate of interest."Bailey said that the £200bn of QE announced by the Bank of England the day after his crisis meeting with the markets team was to provide emergency liquidity to the whole market.  By injecting very large amounts of liquidity into the market, the Bank of England aimed to slake investors' thirst for cash and stop the fire sales that were driving up interest rates. And it succeeded. As a by-product of this action, the UK Government regained access to short-term market funding. But Bailey insists that ensuring the Government could fund itself was not the primary target. Regaining control of interest rates was. 
The market meltdown in March also affected banks. It's a measure of how far we have come since 2008 that Conway & Co made nothing of the fact that the Bank of England had to provide emergency liquidity support to banks. Keeping banks afloat when markets are melting down is all in a day's work for a central bank, these days. Nothing to look at at all. But if a central bank provides emergency liquidity support to a government struggling to raise short-term cash when markets are melting down, that means the government is bust, the central bank is captive and the country is Venezuela? How utterly absurd. 
I found the interviewers' constant focus on government financing a serious distraction from what was an important story about the Bank's vital responsibility for ensuring the smooth operation of financial markets. When financial markets melt down as they did in 2008, the whole world suffers. Central banks saw the same thing happening again in March 2020, and acted to stop it. And their action was extremely effective. It seemed to me that this was the story Bailey really wanted to tell, but the interviewers were intent on pushing him towards the issue of monetary financing and the Bank's independence. Sajid Javid, in particular, seemed to want Bailey to paint the Chancellor's handling of the crisis as irresponsible and profligate. Which genius at Sky News thought it was a good idea for the Chancellor who was forced out of his job without ever producing a Budget to discuss the performance of his successor with the Governor of the Bank of England?
Finally, it is extremely unfortunate that none of the media reports highlighted Bailey's strong endorsement of the Government's exceptional measures to support people through this crisis:

It's entirely necessary that the state has to step in at this point. In a shock of this nature, you can't leave it to individual citizens to find their way through it, "well, good luck" sort of thing. The state has to assert its role at this point, which it did. It wasn't easy, but it did it. 

Fiscal policy is pre-eminent. The Bank of England's job is to ensure the smooth functioning of markets and keep the economy as stable as possible so that the Government can support people through this crisis. And that is what it is doing - successfully. This, not "Britain nearly went bust", is what should be on the front page of every newspaper. 
Related reading:
Pandemic economics and the role of central banksThe End of Britain?

Robert Solow on 'Why Economies Grow'

Published by Anonymous (not verified) on Sun, 10/05/2020 - 9:32pm in

As a follow-up and companion piece to my previous post, I decided to publish a transcription of a lecture on economic growth by Robert Solow that I transcribed originally as an aid for friends and colleagues who were studying economics. Although the lecture was given by Prof. Solow a few years ago during the height of the financial crisis, it contains loads of timeless insights, some of which is useful to be reminded of in the current situation, as discussions about the output gap resume in the next few years (see chart).

However, it's extremely important to keep in mind that in our current predicament as a result of covid potential GDP will also likely take a huge hit, as businesses and employees require some catching up in terms of business practices (misaligned with changing consumer preferences) and job training (due to skills entropy from employees being on furlough), to name only a few aspects that are likely to be impacted. In many ways, the post-covid period will bring us back to the type of economic analysis that used to occur a long time ago when natural catastrophes had significant and frequent impacts on economies' productive capacities.

The video of the lecture is included down below, though the sound quality is very bad, which is why I recommend reading the transcription instead (and you'll get through the transcript much faster by reading it).

Key insights are highlighted in bold font. Enjoy!

The business of this course is the long run. What are the sources of economic growth in the national economy or in the larger economy? Where does growth come from? And the policy implication – well, not implication, but policy question – is ‘How do you get an economy to grow rapidly and to have that growth widely shared in the nation?’
But there is a problem – it is a problem that appeared in the slides that Prof Newstone showed. It is a problem about getting there from here. So I’m going to start by talking a little bit about right now – this is not going to be the usual stuff about the financial crisis and all that – I have something else in mind.

There is something very odd about our economic situation in the US today. I read just recently an estimate from the Federal Reserve that about $7 trillion worth of wealth has been destroyed in the last year or year in a half (in 2008-2009). The country, so to speak, is $7 trillion poorer than it was.

When I wasn’t having a conversation with Cathy in the car, I was trying to divide 7 trillion by 300 million--the population of the US--in my head. It comes to about $23,000 for every man, woman and child in the country. Some, of course, have lost more, some have lost less.

What I want to point out is how strange that is: $7 trillion of wealth has gone down the drain but the productive capacity of the US economy – the capacity of our system to produce goods and service for its people – hasn’t diminished at all. In fact, it is undoubtedly higher than it was a year ago or 18 months ago: the labour force is a couple percent larger, the skills and education and training of the population is certainly not deteriorating and have probably gained. The net investment in capital has been positive – it’s been declining – but has been positive.

So we have a bigger stock of productive capital in the economy now than we did a year ago or 18 months ago. So the productive capacity of this economy is bigger than it was, despite of this $7 trillion of disappearance of wealth. If you are thinking of buying the US economy as a gift for your boyfriend or girlfriend, it would be worth just as much as it was worth – you know, like a used car – it would be worth just about as much as it was worth a year ago.

So in that sense we haven’t lost anything at all. But, of course, the point is we are in a recession. It is one year old according to pundits. And according to other pundits, or the same pundits, it’ll continue for at least until the second half of this year and maybe beyond. And the point is we are not using the productive capacity that we have.

You saw the unemployment numbers that Professor Newstone showed you. It is a lot harder to measure excess capacity in industry than it is to measure unemployment, but there are such figures, and they show an increase in unused capacity. So we have this machine for producing the goods and services for the population and we are not making full use of it. And that under-use of economic capacity, of productive capacity will go on for a long time. Even if the economy turns up in the second half of this year we will undoubtedly finish 2010 still with some slack in the economy because the slack disappears only gradually. 

So if you are interested – now, this is the point, this is why I started this way – if we are thinking about the long run growth of the economy (which means the long run growth of its capacity to produce), it’s not a separate but it’s an analytically slightly different problem to make sure that that capacity is used.

As long as we are not using all of the capacity that we have, the economy and the decision-makers in the economy are not likely to be motivated to do the things that increase potential output, that increase the productive capacity very rapidly.

So the short-run order of business – policy business – for us and every other rich country in Europe or Asia right now is to close that gap or narrow that gap between productive capacity and actual output, which means fundamentally trying to increase the demand for goods and services. And to do that in a way that at least doesn’t create obstacles to the long-run growth of the economy once the gap is closed, and maybe does some things that will help it.

So, imagine it is now January 2011 and the American economy and the economies of the other rich countries – developed countries of the world – are prospering reasonably well, are using their capacity, have closed that gap. Then the question is: What makes them grow? What economic activities that take place have the effect of increasing the capacity of the economy to produce useful goods and services? 

Now, you won’t be surprised – in fact, I’m staring at this monitor here and it says: so what determines the rate of economic growth in the economy? And that’s the question that I want to come to now, and it becomes relevant after we have done the short run task of closing that gap. There isn’t any one word or two word answer to that question. 

And I should make it explicit that I am thinking now about what determines the rate of economic growth in a rich economy, in an advanced industrial economy. I am not thinking about developing economies where the answers are related but the answers are somewhat different.

And the truth is that for an advanced economy the answers to that question – what are the sources of growth of national output, of productive capacity – are really the usual suspects. They are things we have known about now for quite a long time. And basically, what matters is what you might describe as investment in a very broad sense. I have to emphasize “in a very broad sense”.

What increases the productive of an economy like ours is investment in physical capital, in machinery, in computers and all the rest of that, investment in what economists call human capital, meaning skills and capacities of workers and people who work in the economy, and investment in new technology.

And here there is a slight difference between the US and even most of the countries in Europe. Not quite across the board but in most branches of industry the US is the technological leader. The gap was very big at the end of the Second World War and has closed considerably. But still, if you look at sector by sector, with some exceptions, the US is the technological leader.

Other countries of the world, that were even fairly rich countries have the luxury of being able to acquire technology by innovation, essentially by adopting, using what is already known. This country (i.e., the US) is in the position of having – so to speak – to invent its own future.

So basically, if we are looking now at the US, the things we have to look after in order to have a successful fairly high rate of growth (we can talk about the equity issues later) are a high rate of savings and investment in plant and equipment. I’d rather have the saving done here than abroad so that, in effect, the capital equipment that is built by investment in this country is owned in this country, and the returns to it stay in this country. It’s not necessary but it’s probably desirable. 

We need an extraordinary amount of emphasis – and we’ll talk more about this later – on investment in human capital, on producing the labour force that has the skills that are necessary to successfully operate that plant and equipment. And that is especially important because a country like this also has to invest in new technology. There is no place it can copy from – it has to in most cases create it itself.

Now, when I say new technology, the phrase tends to have a “high tech” air about it. But I don’t mean it that way.  New technology needn’t be high tech. It turns out that – in many ways – the most important contributors to productivity in the US over the last decade or two have been the application of information technology to wholesale trade, retail trade and financial services.

In fact, there are studies trying to understand why the major, big European economies, Germany, France, UK and Italy have lagged behind the US in productivity terms, general productivity terms. And the common answer seems to be that they have been slow to adapt the information technology to the service sectors. In manufacturing, there is very little gap, if any. But the gap is in the service sectors. 

So, this is extremely important. And I want to emphasize it, even at the risk of some repetition. One of the standard, valid, almost universal generalizations about the way people behave economically is that technically the income elasticity of the demand for services is high. All over the world, as incomes rise, personal incomes rise, people want to spend, [and] choose to spend a larger fraction of that income on services rather than goods. And you can understand why that should be so.

So this means that most of the rapidly growing advanced economies grow more rapidly in the service-producing sectors than in the goods-producing sector. There are exceptions to that. A country like Germany – to a lesser extent Japan, or formally Japan, not so much anymore – has a strong bias toward trying to make its living from simply exporting high quality manufactured goods. You notice I said exporting because the population of Germany, like the population of anywhere else, wants to consume services as it gets rich, not goods.

So those are the things, the essentially important things that a country like the US needs to do to generate long-run growth of productive capacity. 

I should say, in terms of policy, that you should beware of any universal advice like “well, the market will take care of that”. You know, if the alternative to the free-market economy is some kind of central planning, there is no question to where the advantage lies. But there is absolutely no evidence in the historical record of the advanced economies that zero regulation or weak regulation of industry is somehow conducive to rapid growth, or that minimal involvement of the government in the economy is conducive to rapid growth.

The functions of the government in terms of long run growth are just what you would deduce from what I have already said: promoting research and development, providing incentives for investment when they are lacking, taking care of education, and looking after mobility. By the way, it is probably also true that a country – there is less evidence for this generalization, but it’s probably also true – that business cycle instability is bad for economic growth.

For countries that are given to wide fluctuations like the ones we were looking at a few minutes ago, that’s not helpful for long-run growth because it adds to uncertainty. The likelihood of broad fluctuations adds to uncertainty is bad for all forward looking activities, like investment, like mobility, like education.

I wanted to say one more thing about the issue of mobility. When I say mobility, I mean industrial mobility and occupational mobility. In a rapidly growing, technologically-based economy, people have to change the nature of their jobs frequently and capital has to flow freely from obsolescent industries to new industries.

It is very important when you come in this course to talk about issues of equity. I think it is very important to find ways so that the burdens that are associated with necessary mobility don’t fall on workers and other people who are ill-equipped to prepare them [for that eventuality].

Dislocation and sometimes dislocation is probably an inevitable part of fast, mainly technologically-based growth. But it is the task of economic policy to find ways of combining that with income security, up to now, where it’s mostly below the median for incomes.

Ten things to know about CMHC’s Insured Mortgage Purchase Program

Published by Anonymous (not verified) on Tue, 07/04/2020 - 5:42am in

In March 2020, the Trudeau government launched a new version of the Insured Mortgage Purchase Program (IMPP). According to CMHC’s website: “Under this program, the government will purchase up to $50 billion of insured mortgage pools through CMHC.”

Here are 10 things to know:

1. Canada Mortgage and Housing Corporation (CMHC) is a federally-owned crown corporation. Many of us know CMHC as the federal agency that works with provincial and territorial governments to assist some low and moderate income households with rental housing. Likewise, some of us know CMHC as the lead federal agency on Canada’s National Housing Strategy (geared mostly to renters).

2. CMHC has been acting as a publicly-owned insurance company for residential mortgages since 1954. Indeed, in addition to assisting some renter households, CMHC also offers to insure mortgages with high loan-to-value ratios.[1] In other words, it tells the banks and other financial institutions: “If you are willing to provide a mortgage to this prospective homeowner, we’ll make sure you don’t incur any losses if they ever end up in default.”

3. The Superintendent of Financial Institutions (OSFI) regulates the banks to make sure they don’t engage in overly risky activity. Banks (and other financial institutions) sometimes like to get aggressive in their lending, so OSFI says they can’t make mortgage loans with less than a 20% down payment unless the mortgage is insured. CMHC provides such mortgage insurance, and premiums are paid by qualifying homeowners.

4. Most of Canada’s formal financial institutions are currently eligible to have their mortgages insured by CMHC.[2] Indeed, CMHC’s insurance program is not available to all lenders, but it does apply to all major mortgage issuers.[3] Mortgages that do not have CMHC insurance include mortgages with larger down payments and mortgages issued by some of Canada’s newer mortgage lenders.

5. Without CMHC’s insurance program (or equivalent) prospective homeowners would typically need at least a 20% down payment in order to purchase a home.[4] That would make it more challenging for many Canadians to buy a home for the first time. So without this insurance program in place, rental vacancy rates in Canada would likely be even lower than they are today (and this would be bad news for renters and prospective renters).

6. If an approved lender (namely, a bank, trust company, or credit union) makes a mortgage loan, CMHC will issue an insurance policy on that mortgage. The down payment can be anywhere from 5% to 20% of the value of the home. And if there’s a default, CMHC pays the bank. With this insurance program, a mortgage with a high loan-to-value ratio all of a sudden becomes a very good investment for the bank—that is, what once looked like a high-risk loan is now a low-risk loan. CMHC insurance therefore makes mortgage lending attractive for banks.

7. Homeowners then have to pay the premiums. For a loan-to-value ratio up to 80%, the premium is 2.4%. For a loan-to-value ratio between 80.1% and 90%, the premium is 3.1%. And for a loan-to-value ratio of between 90.1% and 95%, the premium is 4%. That’s the premium paid by qualifying homeowners, as a lump sum, when they take out the mortgage. Premiums go to CMHC’s publicly-owned insurance program. CMHC takes the premiums and invests them in stocks and bonds. When the time comes to cover claims on insurance, they can use the pool they built up to pay the claims.

8. With our looming recession, some homeowners will likely default on their mortgages. Knowing this, banks and other lenders have been looking at the state of all their loans (in fact, they must do so according to federal regulations).[5] And they need to be setting aside reserves against those possible defaults. Some banks are starting to think about calling in (i.e., cancelling) their loans and/or not issuing new loans. To avert such a crisis—known as a liquidity crisis—the Government of Canada is essentially injecting money into the financial system so that banks and other lenders don’t have to call in loans and stop issuing new loans (which would make matters worse for Canada’s economy). The Government of Canada is giving CMHC money to buy existing mortgages (all of which are insured by CMHC, and are therefore safe for the government to buy). When banks sell these mortgages to CMHC, banks get cash in return, which they can use to then make new loans (including new mortgage loans).

9. With the recently-announced IMPP, CMHC is offering to bulk purchase insured loans. CMHC effectively becomes a bulk purchaser of insured loans, bundled as mortgage-backed securities. CMHC has offered to buy back as many as financial institutions want to sell to them, up to the $50 billion threshold (an amount that has since been expanded to $150 billion). Homeowners will see no difference in the day-to-day. Once each mortgage term ends (they’re typically five-year term mortgages) homeowners will have to renew their mortgages with lenders.

10. A buy-back on this scale has only taken place once before. As is noted elsewhere: “Between fall 2008 and the end of 2010, CMHC purchased $69 billion of mortgages” via a previous iteration of this same program, in the immediate aftermath of the 2008-09 world financial crisis.

In sum. With the IMPP, the Government of Canada has likely helped prevent a financial crisis, which would have made our looming recession even worse. (For a concise overview of Canada’s housing finance system, see Chapter 4 of the Canadian Housing Observer 2014.)

I wish to thank the following individuals for assistance with this blog post: George Fallis, Susan Falvo, Marc Lee, David Macdonald, Marc-André Pigeon, David Pringle, Saul Schwartz, John Smithin, Tsur Somerville and two anonymous sources. Any errors are mine.

[1] A few caveats are in order here. First, CMHC also insures mortgages in rural areas that have low loan-to-value ratios (otherwise, the lender might refuse to issue a mortgage). Second, there are two other insurers of residential mortgages in Canada, in addition to CMHC. They are Genworth and AIG.

[2] And also by Genworth and AIG.

[3] Any lender or mortgage broker can apply to be an NHA-Approved Lender, and must then comply with CMHC underwriting standards—and if they don’t, they risk losing the approved lender status.

[4] Alternatively, they might provide another guarantee for the lender.

[5] OSFI sets requirements for reserves, based on risk-weighting criteria.

Ten things to know about CMHC’s Insured Mortgage Purchase Program

Published by Anonymous (not verified) on Tue, 07/04/2020 - 5:42am in

In March 2020, the Trudeau government launched a new version of the Insured Mortgage Purchase Program (IMPP). According to CMHC’s website: “Under this program, the government will purchase up to $50 billion of insured mortgage pools through CMHC.”

Here are 10 things to know:

1. Canada Mortgage and Housing Corporation (CMHC) is a federally-owned crown corporation. Many of us know CMHC as the federal agency that works with provincial and territorial governments to assist some low and moderate income households with rental housing. Likewise, some of us know CMHC as the lead federal agency on Canada’s National Housing Strategy (geared mostly to renters).

2. CMHC has been acting as a publicly-owned insurance company for residential mortgages since 1954. Indeed, in addition to assisting some renter households, CMHC also offers to insure mortgages with high loan-to-value ratios.[1] In other words, it tells the banks and other financial institutions: “If you are willing to provide a mortgage to this prospective homeowner, we’ll make sure you don’t incur any losses if they ever end up in default.”

3. The Superintendent of Financial Institutions (OSFI) regulates the banks to make sure they don’t engage in overly risky activity. Banks (and other financial institutions) sometimes like to get aggressive in their lending, so OSFI says they can’t make mortgage loans with less than a 20% down payment unless the mortgage is insured. CMHC provides such mortgage insurance, and premiums are paid by qualifying homeowners.

4. Most of Canada’s formal financial institutions are currently eligible to have their mortgages insured by CMHC.[2] Indeed, CMHC’s insurance program is not available to all lenders, but it does apply to all major mortgage issuers.[3] Mortgages that do not have CMHC insurance include mortgages with larger down payments and mortgages issued by some of Canada’s newer mortgage lenders.

5. Without CMHC’s insurance program (or equivalent) prospective homeowners would typically need at least a 20% down payment in order to purchase a home.[4] That would make it more challenging for many Canadians to buy a home for the first time. So without this insurance program in place, rental vacancy rates in Canada would likely be even lower than they are today (and this would be bad news for renters and prospective renters).

6. If an approved lender (namely, a bank, trust company, or credit union) makes a mortgage loan, CMHC will issue an insurance policy on that mortgage. The down payment can be anywhere from 5% to 20% of the value of the home. And if there’s a default, CMHC pays the bank. With this insurance program, a mortgage with a high loan-to-value ratio all of a sudden becomes a very good investment for the bank—that is, what once looked like a high-risk loan is now a low-risk loan. CMHC insurance therefore makes mortgage lending attractive for banks.

7. Homeowners then have to pay the premiums. For a loan-to-value ratio up to 80%, the premium is 2.4%. For a loan-to-value ratio between 80.1% and 90%, the premium is 3.1%. And for a loan-to-value ratio of between 90.1% and 95%, the premium is 4%. That’s the premium paid by qualifying homeowners, as a lump sum, when they take out the mortgage. Premiums go to CMHC’s publicly-owned insurance program. CMHC takes the premiums and invests them in stocks and bonds. When the time comes to cover claims on insurance, they can use the pool they built up to pay the claims.

8. With our looming recession, some homeowners will likely default on their mortgages. Knowing this, banks and other lenders have been looking at the state of all their loans (in fact, they must do so according to federal regulations).[5] And they need to be setting aside reserves against those possible defaults. Some banks are starting to think about calling in (i.e., cancelling) their loans and/or not issuing new loans. To avert such a crisis—known as a liquidity crisis—the Government of Canada is essentially injecting money into the financial system so that banks and other lenders don’t have to call in loans and stop issuing new loans (which would make matters worse for Canada’s economy). The Government of Canada is giving CMHC money to buy existing mortgages (all of which are insured by CMHC, and are therefore safe for the government to buy). When banks sell these mortgages to CMHC, banks get cash in return, which they can use to then make new loans (including new mortgage loans).

9. With the recently-announced IMPP, CMHC is offering to bulk purchase insured loans. CMHC effectively becomes a bulk purchaser of insured loans, bundled as mortgage-backed securities. CMHC has offered to buy back as many as financial institutions want to sell to them, up to the $50 billion threshold (an amount that has since been expanded to $150 billion). Homeowners will see no difference in the day-to-day. Once each mortgage term ends (they’re typically five-year term mortgages) homeowners will have to renew their mortgages with lenders.

10. A buy-back on this scale has only taken place once before. As is noted elsewhere: “Between fall 2008 and the end of 2010, CMHC purchased $69 billion of mortgages” via a previous iteration of this same program, in the immediate aftermath of the 2008-09 world financial crisis.

In sum. With the IMPP, the Government of Canada has likely helped prevent a financial crisis, which would have made our looming recession even worse. (For a concise overview of Canada’s housing finance system, see Chapter 4 of the Canadian Housing Observer 2014.)

I wish to thank the following individuals for assistance with this blog post: George Fallis, Susan Falvo, Marc Lee, David Macdonald, Marc-André Pigeon, David Pringle, Saul Schwartz, John Smithin, Tsur Somerville and two anonymous sources. Any errors are mine.

[1] A few caveats are in order here. First, CMHC also insures mortgages in rural areas that have low loan-to-value ratios (otherwise, the lender might refuse to issue a mortgage). Second, there are two other insurers of residential mortgages in Canada, in addition to CMHC. They are Genworth and AIG.

[2] And also by Genworth and AIG.

[3] Any lender or mortgage broker can apply to be an NHA-Approved Lender, and must then comply with CMHC underwriting standards—and if they don’t, they risk losing the approved lender status.

[4] Alternatively, they might provide another guarantee for the lender.

[5] OSFI sets requirements for reserves, based on risk-weighting criteria.

A few ambitious points on fighting the crisis

Published by Anonymous (not verified) on Sat, 21/03/2020 - 5:14am in

We are facing two crises at once, health and economic, that are related in very important ways. The covid-19 epidemic has done major damage around the world, but it’s highlighting some serious structural problems with the US social model that better-run countries are not so afflicted by. We are plagued by a deep economic polarization complicated by minimal social protections; severely diminished state capacity, with eroded institutional structures and extremely debased quality of personnel at the highest levels; years of underinvestment in basic infrastructure, both broadly and in health care particularly; and decades of neoliberal policies that have shaped a common sense based on competitive individualism, with little sense of social solidarity. That’s the longer-term context in which we face the acute crisis of this disease—which is almost certainly a portent of what we’ll face as the climate crisis worsens.

To recover from this, we need to do many things, both short- and long-term. To deal with the health crisis, we obviously need testing kits and a rapid mobilization to build hospitals, ICUs, and ventilators. It will take state action to do that properly; The Market will never do it on its own. It may not be socialism, but if we do it well, it will legitimate a public sector badly in need of legitimation. If China can build hospitals in ten days, there’s no reason we can’t. It’s nice Trump is deploying a couple of navy hospital ships but that’s barely a start.

But I’ll leave more detailed plans for the health emergency to people who know the field. My expertise is in politics, economics, and finance, and I want to make several points about that.

The financial crisis is real and potentially devastating. There are some people on the left who doubt the wisdom of saving the banking system, but to let it collapse would be to repeat the mistakes of 1929–1932, when a cascade of thousands of bank failures magnified a downturn into a Great Depression. Actions like the Federal Reserve’s repos and securities purchases are a bare minimum to prevent a replay of the slide into depression 90 years ago. It’s important to point out that all these trillions are not taxpayer money—it’s money created out of thin air by the Fed. That’s not a financing strategy for all time—it can’t fund Medicare for All or a Green New Deal. That will take real resources. But it’s essential in this moment of crisis.

But I share the frustration with how the Fed is spending trillions in an effort to restore the status quo before this latest crisis. That’s what happened in the 2008–2009 crisis: extraordinary measures were undertaken, but that left the long-term causes of that crisis, like income polarization and unregulated financial buccaneering, unaddressed. Stronger measures are called for this time, for example. Here are some ideas.

• Nationalize several of the largest banks—and unlike the nationalizations in Sweden in the 1990s and the UK a decade ago, they should not be undertaken with the idea of returning them to private ownership as quickly as possible, after the government eats the losses. They should be run on entirely different principles. Shareholders will whine, but without a state-led rescue, the value of their stock would fall close to 0 anyway.

• At the same time, severely rein in with an eye to abolishing, the shadow banking sector of private equity (PE) and hedge funds. PE has saddled companies with crippling levels of debt, which enrich their investors but put them at great risk of failure even in relatively good times. (A subset of PE, venture capital, can play a more constructive economic role, but it’s quite small: there was less than $10 billion in early-stage financing from the sector last year.) And hedge funds do little but destabilize markets. The goal should be to turn finance into something like a utility.

• There’s no reason the nationalized banks couldn’t be run to finance, for example, the Green New Deal (GND). Some of the GND will have to be financed with traditional tax- and bond-financed public spending, but there’s no reason these socialized banks couldn’t participate.

• Along with the nationalized banks, we should create something on the model of the Reconstruction Finance Corporation, to finance the GND. It would be a publicly capitalized bank that would evaluate and fund projects like clean energy generation and new models of food production.

• This would be a propitious time to nationalize the oil and gas sector, undertaken with the idea of putting them out of business. We must move as quickly as possible to stop the use of fossil fuels, and as long as these entities exist, the political and economic obstacles to that necessity are nearly impossible to overcome. Because the price of oil has fallen so dramatically, the value of the major carbon producers has cratered. The five biggest US-based oil companies (Exxon Mobil, Chevron, ConocoPhillips, Phillips 66, and Valero) have a combined market capitalization of under $350 billion, which is equal to about an eighth of JPMorgan Chase’s total assets and less than 2% of GDP. Again, shareholders will whine, but as the financial world wakes up to the inevitability of carbon’s obsolescence, the value of their investments will tend towards 0 anyway.

• Unlike earlier crises from the last few decades, this one is not centered in the financial sector. It’s in what Wall Street like to call the “real sector,” the world of production and labor most people live in. While finance will suffer serious losses in a sharp downturn, the goal of policy should be to prevent catastrophic failure. It will be unable to provide even the modest stimulus quantitative easing did during and just after the 2008 crisis. A real sector crisis requires a much more fiscally centered approach.

• The federal government must provide people with income support as they lose their jobs. It’s distressing that Republicans like Trump and Romney are talking about sending every American a check for $1,000 while House Speaker Nancy Pelosi shot down a similar suggestion from former Obama economic adviser Jason Furman days earlier. This is a bare minimum. Why not $2,000? Unemployment insurance must be expanded (and a lot, as I show here), as must Medicaid, to take care of people who are about to lose their employer-provided health insurance.

• We also need to invest in the physical and social infrastructure of this country. For decades, civilian public investment net of depreciation has hovered just above 0, meaning that we’re doing little better than replacing things as they decay. This economic statistic can easily be confirmed just by walking around anywhere in the US outside our richest neighborhoods. We need massive investment in public infrastructure on the model of the New Deal, both to fight the slump and to make this country habitable for the bottom 80–90% of the population. That infrastructure investment must not simply be more of the same. It needs to be part of a conversion of an economy based on exploitation of workers and nature into something humane and sustainable.

• We also need to get now-unemployed auto workers back to work but building vehicles that don’t threaten life on earth. A model to think about was the proposal to transform a plant in Ontario GM closed into something more earth- and worker-friendly.

• Longer term, never has the need for Medicare for All been so clear. And the reason for that isn’t only the need of freeing people from the anxiety of not being able to pay for essential care, but also because there is little in the way of planning for the distribution of health care resources beyond what The Market demands. A major part of the reason the US is so unprepared to handle the coronavirus crisis is that hospitals are built and outfitted according to where the money is, not where the needs are. Hospitals in rural areas are broke and closing, and recently a hospital in Philadelphia that served a largely poor clientele was closed because it stood on land that developers would prefer to turn into condos. The pharmaceutical industry, which has for decades been turning publicly funded basic research into private profit based on its own priorities and not human need, must be wrestled to the ground.

This is a terrifying moment, with sickness, death, and imminent destitution haunting all of us. Things could get very ugly. But it’s also an opportunity to emerge from this crisis a better country. The ideas I’ve listed here are fanciful under the current political order. But we have to think big to challenge that order. Over the last few decades, neoliberalism has encouraged a consciousness of self-reliance. We need to articulate a vision of solidarity and mutual care. Millions of lives depend on that.

Thanks to Jerry Epstein, Leo Panitch, Bob Pollin, and especially Sam Gindin for helpful comments on this little effort.

All you need is cash

Published by Anonymous (not verified) on Tue, 18/02/2020 - 8:00pm in

Andreas Joseph, Christiane Kneer, Neeltje van Horen and Jumana Saleheen

Financial crises affect firm growth not only in the short-run, but even more so in the long-run. Some firms permanently gain while others lose and cash is a crucial asset to have when the credit cycle turns. As we show in a new Staff Working Paper, having cash at hand allows firms to continue to invest during the crisis while industry rivals without cash have to divest. This gives cash-rich firms an important competitive edge that not only benefits them during the crisis but that gives them an advantage that lasts way beyond the crisis years.

But first, how are cash holdings – a firm’s deposit to asset ratio – actually distributed across sectors and firms? Figure 1 provides some insight. It looks at cash holdings just prior to the crisis, but these patterns have not changed much over time. Each dot represents an industry in the UK and shows how much cash firms in that industry have on average (horizontal axis) and how much these holdings vary within that industry (vertical axis). A striking fact stands out. Firms’ cash holdings not only differ greatly across but also within narrowly defined industries. This means that at any given moment in time some firms in an industry will have lots of cash at hand while others only very little.

Figure 1: Variations in cash holdings by industry (2006)

Notes: This figure plots the correlation between mean and standard deviation of the cash holdings of UK firms at the 4-digit industry level. Cash holdings are defined as deposits over total assets and measured in 2006.

Well, does this matter? Maybe not. When the economy is doing well firms’ cash holdings do not make much of a difference. This is roughly demonstrated in the top panel of Figure 2. Here we first rank firms in each industry according to the size of their cash holdings compared to other firms in that industry in the year 2000. Red means little cash compared to one’s industry rivals while green means lots of cash. Next, we track investment for these firms over time, i.e. the growth of their fixed assets, such as buildings, machines, office equipment, patents etc. Hardly any relationship between firms’ cash holdings and their investment between 2001 and 2007 exists: both cash-rich and cash-poor firms invested during this period. We now repeat this exercise, but measure cash in 2006 instead. That is, we rank firms according to the size of their cash holdings relative to their rivals just prior to the start of the global financial crisis. The picture changes dramatically as seen in the bottom panel of Figure 2. While firms with cash continued to invest throughout the crisis, cash-poor firms were shrinking their fixed assets. Perhaps more surprisingly, this divergence in investment behaviour became even more pronounced during the recovery period. Cash thus seems a crucial asset to have when the credit cycle turns.

Figure 2: Investment high vs low cash firms: pre-crisis and crisis period

Notes: These figures plot the average fixed asset growth for firms in each percentile of relative cash within the 90 percent interquartile range. In panel A average fixed asset growth is tracked over the period 2001-2007 and in panel B over the period 2007-2014. Fixed asset growth is defined as the log difference between 2001 and year 2001+j (pre-crisis period) and between 2007 and 2007+j (crisis period). Relative cash is calculated by subtracting from the firm’s cash holdings its industry mean and dividing the difference by the industry standard deviation and is measured in 2000 for the
pre-crisis period (panel A) and in 2006 for the crisis period (panel B). Industry mean and standard deviation are determined at 4-digit level.

Why does cash matter?

Keeping cash idle might be expensive during normal times, but when a financial crisis hits having cash at hand can positively affect firm investment for several reasons. First, cash provides a firm with an internal source of funds when earnings decline and it becomes more difficult to borrow from banks. Second, cash preserves its value when asset prices drop and can serve as high-quality collateral that a firm can pledge to raise external funds. Third, a firm with cash does not have to increase its cash holdings for precautionary reasons and can use its funds for investment instead.

Thus, firms with ample cash at hand can more easily continue to operate, replace fixed assets that have depreciated and even seize profitable investment opportunities when they come along despite the crisis. Their cash-starved rivals by contrast have to forgo investment opportunities, may be forced to shrink their fixed assets and may even struggle to survive. As a result, an investment gap between cash-rich and cash-poor firms opens up.

This brings about a shift in competition dynamics. As cash-rich firms grow their fixed assets their productive capacity expands. At the same time the productive capacity of cash-poor firms shrinks. During the recovery phase when demand returns and credit conditions improve, cash-rich firms have thus more capacity to meet this demand and can subsequently reinvest their earnings, increasing their capacity further. Cash-poor firms, on the other hand, have difficulties catching up with their cash-rich rivals and see their positions weaken further. As a result, the investment gap between cash-rich and cash-poor firms that opens up during a crisis period is amplified during the recovery period. This explains the growing divergence between “green” and “red” firms as observed in the bottom panel of Figure 2.

Who needs cash most?

While Figure 2 shows some very striking patterns, it is important to make sure that these differences are caused by differences in pre-crisis cash holdings and not by other factors. This is especially important as consumers reacted strongly to the crisis and were buying less products. In our analysis we therefore control for a large number of firm characteristics that might also explain how much a firm can invest when the credit cycle turns, as well as for economic conditions in the region where the firm is located and changes in demand and productivity affecting each industry. Even after accounting for all this, we find a strong cash effect.   

In numbers, cash-rich firms grew their fixed assets with 4 percentage points more between 2007 and 2009 – the depth of the crisis – compared to their cash-starved industry rivals. By 2014 this number had tripled to 12 percentage points – a big difference. This effect was present both for firms whose cash holdings fluctuated a lot over time and for firms whose cash holdings were very stable. The cash-effect was unique to the crisis and post-crisis recovery period and was not present in the tranquil period that preceded the global financial crisis. This suggests that the tightening of credit conditions played an important role in driving the cash- effect.

So who benefits most? Not surprisingly, it’s the young and small firms. During a financial crisis banks are more likely to cut lending to young and small firms. Having access to cash should thus be especially advantageous for these firms. Indeed, we find that a young firm (a business that is less than 10 years old) with cash invested 15 percentage points more over the period 2007-2014 than a young firm without cash and a small firm with cash 19 percentage points more than a small firm without cash.

As an illustrative example, let’s compare two hypothetical small coffee shops somewhere in the UK with different cash holdings before the start of the crisis. Let’s say that both have equipment, such as coffee machines, grinders, furniture, computers etc., worth £100,000. Using our estimates, the coffee shop with high levels of cash will, by 2014, have grown its equipment to the value of roughly £110,000, while the cash-poor shop’s equipment will only be worth just over £90,000. In other words, the cash-rich business owner could replace its coffee machines with the latest models and even buy and extra machine and expand the business. The other one instead had to scale down and keep old machines running for longer. Which one would you more likely go to for your morning latte? Very likely, the first one.

Indeed, we find that cash-rich firms, especially the young and small ones, were able to capture market share from their cash-poor rivals during the crisis and even more so during the recovery phase. And these firms were also able to generate greater profits over time. When you have more and better coffee machines, you are able to serve more customers and can poach them from your competitors.

To conclude

A financial crisis not only impacts firms in the short-run, but also in the long-run as some firms permanently gain while others permanently lose. Having cash at the onset of a crisis gives a firm an important competitive edge during the crisis that it can further exploit during the recovery phase. A liquid balance sheet when the credit cycle turns is thus an important determinant of firms’ long-term growth after a crisis – and a factor largely neglected by economists and policy makers.

Andreas Joseph works in the Bank’s Advanced Analytics Division, Christiane Kneer works in the Bank’s Financial Stability Strategy and Risk Division, Neeltje van Horen works in the Bank’s Research Hub and Jumana Saleheen works at the CRU Group.

If you want to get in touch, please email us at bankunderground@bankofengland.co.uk or leave a comment below.

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.

Possible pitfalls of a 1-in-X approach to financial stability

Published by Anonymous (not verified) on Thu, 06/02/2020 - 8:00pm in

Adam Brinley Codd and Andrew Gimber

Meteorologists and insurers talk about the “1-in-100 year storm”. Should regulators do the same for financial crises? In this post, we argue that false confidence in people’s ability to calculate probabilities of rare events might end up worsening the crises regulators are trying to prevent.

Sir Paul Tucker recently said he thought the public would want regulators to make sure financial crises like the one in 2008–2009 happened less than once every 75 years. And an approach called GDP (or growth) at risk – which has featured prominently in the IMF’s financial stability assessments since October 2017 – typically focuses on the 5th percentile, i.e. a 1-in-20 bad outcome for GDP growth, as a way of measuring downside economic risks.

Framing risks in terms of 1-in-X outcomes might be helpful as a communication tool, but it comes with risks of its own. That’s because unwarranted faith in the odds of rare events can set the stage for far worse outcomes. No matter how hard we try, we cannot accurately quantify the chances of rare events. The reasons can be summed up in two parts: can’t know and don’t know.

Can’t know

Putting odds on future events is inherently difficult. It’s obvious that we can’t know what will happen – nobody can predict the future. But we can’t even know everything that might happen. All we can be sure of is that there are things that will happen in the future that we cannot even conceive of today. And since there are possible future events that we can’t even list out, we can’t assign probabilities to them. This simple fact also means our estimates of the chances of events we can list out are likely to be wrong: a person who has never experienced snow will overestimate the chances of rain on a very cold day.

Even if we can imagine the event, it can be a fool’s errand to try to predict its impact. History is full of examples of discoveries and inventions whose impact was barely conceivable. Heinrich Hertz famously said his discovery of radio waves was “of no use whatsoever”. Even if a few visions of the future end up looking eerily prescient (such as E. M. Forster’s 1909 short story that foreshadowed the darker side of the internet age), most will probably be as wide of the mark as predictions of robot barbers or nuclear-powered vacuum cleaners.

The relevance for financial regulators is that financial crises are rare and unexpected events.  Despite regulators’ efforts to make banks more resilient and reduce the chance of a crisis, the risk will never be eliminated. And although most people know a financial crisis when they see one, when stability does break down the trigger is likely to be something that very few people had identified or expected.

Don’t know

Even if we know what can happen, outside of casino games and lotteries it is nearly impossible to get the odds of things happening right. And the less likely an event is, the harder it becomes to say exactly how unlikely it is. Human behaviour is notoriously difficult to predict, especially under extreme circumstances.

Even if we forget about trying to work out the chances of specific events, and instead look at aggregate metrics like GDP growth or oil prices, we still can’t do this with much accuracy. The more you aggregate, the less data you have. To get precise estimates of the severity of rare events, you need lots of data points. Yet we only have reliable annual GDP growth figures for 100 years (100 data points), and reliable quarterly GDP growth figures for 40 years (160 data points).

Even where we have lots of data, it is still hard to work out the odds of extreme events. Often, our estimates can be very sensitive to individual data points in our sample.

In the 31 years to August 2001, there were 109 fatal terrorist attacks in the US. If US antiterrorism authorities focused on the 95th percentile, they would be focused on attacks that killed 3 people. Extend the sample window forward by one month, to include 9/11, and the 95th percentile jumps to 13 deaths – still a tiny fraction of the actual number of deaths on that awful day.

We know that our estimates will always be uncertain, but does this matter if they are the best we can do? Surely it’s better than having no estimates at all?

The land of black swans

Things don’t immediately go wrong when people estimate the odds of unlikely events. They go wrong when people place unwarranted faith – or undue emphasis – on those estimates. Doing this leaves them poorly prepared for events which they erroneously thought were too unlikely to worry about – one of Nicholas Taleb’s infamous black swans – which sets the stage for far worse outcomes.

The invention of the Black–Scholes option pricing model in the 1970s led to a boom in the sale of so-called portfolio insurance. This aimed to limit downside risk by buying put options, or automatically shorting index futures when the stock market fell. The Black–Scholes model, it was thought, allowed broker-dealers to accurately price these options and to hedge them with offsetting trades. However, the model’s assumptions on return distributions and arbitrage conditions proved wrong. On Black Monday in 1987, the Dow Jones Industrial Average fell by 22.6% – an event the Black–Scholes model implied was very nearly impossible. The SEC report into the crash found a significant role for the fire-sale dynamics unleashed by portfolio insurance. Similar dynamics seem to have been at play in the Japanese “VaR shock” episode in 2003, when a spike in volatility induced banks using value-at-risk models to sell off Japanese government bonds at the same time. Without widespread reliance on the Black–Scholes and VaR models, it seems unlikely that there would have been the same degree of correlated selling in these episodes.

False comfort from pricing models estimated on past data struck again during the subprime mortgage crisis. In August 2007, Goldman Sachs’ then CFO was quoted as saying “We were seeing things that were 25-standard deviation moves, several days in a row” – about as likely as winning the lottery dozens of times, week after week.

Macroprudential policymakers around the world are starting to look at a framework called GDP at risk (also known as growth at risk) to help them gauge the tail risks to the economy. It’s not designed to identify specific near-term risks such as bank failures or cyber attacks. But it’s one useful way of thinking about the dangers posed to future prosperity by rapid credit growth and other variables that have historically been associated with crises. GDP at risk provides a way of adding up those vulnerabilities and tracking their evolution over time.

Still, policymakers should take little comfort from any particular estimate of the 5% tail of the GDP growth distribution – all this says is that, according to the model, there’s a 1-in-20 chance of GDP growth being that bad or worse. Even if the past were a reliable guide to the future, we just don’t have enough historical data to get a precise estimate of how much worse things are likely to be beyond that point.

Where does this leave us?

In search of true, but imperfect, knowledge

The odds people calculate are themselves highly uncertain. But what can be done about this meta-uncertainty?

Policymakers could avoid talking about probabilities altogether. Instead of a 1-in-X event, the Bank of England’s Annual Cyclical Scenario is described as a “coherent ‘tail risk’ scenario”.

Policymakers could avoid some of the cognitive biases that afflict people’s thinking about low-probability events, by rephrasing low-probability events in terms of less extreme numbers. A “100-year” flood has a 1% chance of happening in any given year, but anyone who lives into their 70s is more likely than not to see one in their lifetime.

Policymakers could  be vocal about the fact that there are worse outcomes beyond the 1-in-X point of the distribution. Although it’s subject to the same “can’t know” and “don’t know” problems, expected shortfall estimates the average bad outcome in a 1-in-X tail of the distribution, rather than the least-bad one. And policymakers can supplement risk assessments based on limited historical data with additional “extreme but plausible” scenarios, as happens for stress testing of central counterparties.

Policymakers should learn as much as they can from past events and do the best they can to assess the risk environment with the available historical data. But there are limits to how reliably they can estimate the chances of an extreme event. Nobody can know all the possible future events that policymakers should be concerned about. Even with a narrow focus on the things that can be measured, there isn’t much data with which to estimate the tails of the distribution – the unlikely but potentially disastrous events that macroprudential authorities are supposed to deal with.

Adam Brinley Codd works in the Bank’s Stress Testing Strategy Division and Andrew Gimber works in the Bank’s Macroprudential Strategy and Support Division.

If you want to get in touch, please email us at bankunderground@bankofengland.co.uk or leave a comment below.

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.

European banks and the global banking glut

Published by Anonymous (not verified) on Sat, 08/06/2019 - 6:50am in


In a lecture presented at the 2011 IMF Annual Research Conference, Hyun Song Shin of Princeton University argued that the driver of the 2007-8 financial crisis was not a global saving glut so much as a global banking glut. He highlighted the role of the European banks in inflating the credit bubble that abruptly burst at the height of the crisis, causing a string of failures of banks and other financial institutions, and economic distress around the globe. European banks borrowed large amounts of US dollars through the money markets and invested them in US asset-backed securities via the US's shadow banking system. In effect, they acted as if they were US banks, but in Europe and therefore beyond the reach of US bank regulation. This diagram shows how it worked (the “border” is the residency border beyond which US bank regulation has no traction):

But it is not the model itself so much as Shin's remarks about the role of European regulation after the introduction of the Euro that interest me:

Why was it Europe that saw such rapid increases in banking capacity, and why did European (and not US) banks expand intermediation between US borrowers and savers? Two likely elements of the answer to both questions is the regulatory environment in Europe and the advent of the euro. The European Union was the jurisdiction that embraced the spirit of the Basel II regulations most enthusiastically, while the rapid growth of cross-border banking within the eurozone after the advent of the euro in 1999 provided fertile conditions for rapid growth of the European banking sector.

The permissive bank risk management practices epitomized in the Basel II proposals were already widely practised within Europe as banks became more adept at circumventing the spirit of the initial 1988 Basel I Accord. Basel II was subsequently codified most thoroughly in the European Union through the EU’s Capital Adequacy Directive (CAD). In contrast, US regulators have been more ambivalent toward Basel II, and chose to maintain relatively more stringent regulations (at least, in the formal re gulated banking sector) such as the cap on bank leverage.

So there we have it. Forget Asian savers, the yen carry trade, Wall Street excesses. The 2007-8 financial crisis was all the fault of European policy makers and regulators.

There is no doubt that the Eurodollar market played a sizeable role in the financial crisis. In this paper, Dong & McCauley of BIS show how the flows of dollars across the Atlantic changed from 1999 to 2007. These graphics show the four types of Eurodollar transaction: pure offshore transactions, round-tripping across the Atlantic, US investment in Europe, European investment in the US:





The pure offshore transaction is the most common type of Eurodollar transaction. But during the period 1999-2007, there was a considerable increase in the second type, round-tripping across the Atlantic. These transactions can be driven by regulatory arbitrage:

If domestic deposits attract reserve requirements or incur deposit insurance premiums or pay yields that are capped by interest rate regulation, then depositors willing to hold a deposit in a Caribbean or London branch of a familiar bank can avoid such costs or regulations and receive a higher yield.

This appears to support Shin's argument that lax regulation in Europe attracted inflows of funds from the US. But Dong & McCauley also give an alternative explanation:

Round-tripping can also involve important credit intermediation in which a non-US bank puts its capital at risk. In the 2000s, as we shall see below, European banks attracted dollar funding from risk-averse US residents in order to finance holdings of ultimately risky US asset-backed securities at what seemed to be attractive spreads.

This is not regulatory arbitrage, it is interest rate arbitrage. Money market funds would lend to European banks because they could get better rates than from US banks. But why were European banks offering higher rates on US deposits than US banks?

The first reason could be the low interest rate environment in the US in the early 2000s. The Fed Funds rate was several percentage points below both the UK base rate and the ECB's refi rate, a difference that was not entirely lost in the exchange rates. European banks might therefore be expected to offer better US dollar rates on deposits than US banks. But we know that banks in Europe also borrowed and lent huge amounts of Euro and sterling at this time, feeding real estate bubbles in the UK, Ireland and Spain and sovereign debt bubbles in Greece and Italy. If covered interest rate parity only weakly held during this time, low US rates might have encouraged European banks to fund themselves in US dollars for lending in Euro and Sterling. But this wouldn't explain the increase in round-tripping.

The second reason, according to Shin, is the introduction of the Euro. The single currency removed exchange rate risk in cross-border lending between Eurozone countries, which undoubtedly encouraged large Eurozone banks to lend excessively to both the private and public sectors in Eurozone periphery countries. The Eurozone crisis can indeed be partly laid at the door of the single currency, for this and other reasons. But it is difficult to see why the introduction of the Euro would have encouraged European banks to load up with US securities. They could do so even without the Euro: the UK is not a member of the Euro, but the UK banks were among the most significant contributors to the Eurodollar lending glut.

To my mind the most likely explanation is the US's securitization engine. US banks, whose lending Shin correctly notes was limited by a leverage ratio, did not keep loans on their balance sheets. They sold them, and used the proceeds to fund further lending. Northern Rock and HBOS in the UK used similar “lend-securitize-fund” models. While the securitization engine was working well, as it was in the early 2000s, banks that used this model did not have an enormous need for wholesale funds. Most of their lending was funded by the proceeds from securitizations. They would therefore be unlikely to offer good rates to US money market funds. It was not until the securitization engine started to slow in 2006 that banks using this model started to need larger amounts of US dollar funding and rates started to rise.

So US banks unloaded their loans into warehouses for securitization and sale. And once they left the balance sheets of regulated banks, they were outside US regulatory jurisdiction, as Shin's diagram shows. There was effectively no regulation of the process of securitization and sale. Investment banks created exotic products from packages of warehoused loans, obtained high credit ratings for them from captive ratings agencies, and sold them into the global capital markets, where they were snapped up by – among others – European banks.

Shin rightly notes that the European banks were not subject to the US's leverage ratio. Instead, they had Basel II's capital ratio. And because these exotic securities were routinely rated AAA, their effect on European banks' capital requirements was negligible. They could load up to the skies with these things with virtually no capital allocation. In this, Shin is correct. Had European banks been subject to a leverage ratio, they would not have been able to load up on toxic US credit derivatives, and the course of history might have been very different.

But I think it is unfair to lay the responsibility for the growth of the US dollar “banking glut” solely at the door of European regulations. After all, it was the tight regulation of US banks that forced them to sell their loans. It would be more accurate to say that the combination of a leverage ratio in the US and a capital ratio in Europe caused the creation of what we might describe as a “pump”. US banks were looking for a marketplace into which to sell loans that they couldn't keep on their balance sheets, while European banks were looking to buy safe assets that had minimum capital requirements and gave good returns. The industry that grew up to service both sides was the unregulated “shadow” banking industry. The incentives for this industry to misprice risk are clear.

And there is another dimension to this that Shin does not discuss. His diagram suggests that “US households” were the suppliers of funding to both US banks and – via money market funds – to the European banks. But where did these US households get their money? After all, US wages have been stagnating for two decades.

The answer is not, as Bernanke would have it, Asian savers. It is far more toxic. Shin's diagram is a “loanable funds” model, where banks take in deposits and loan a proportion of them out. But that is not how lending works. The reality is far more complex. In the next two paragraphs, if you get confused, remember this: “Loans create deposits, and deposits fund loans”.

The US banks created new deposits when they lent against property. Those deposits transferred to the sellers of property, who put that money into money market funds which then lent the money on to European banks. Meanwhile, the US banks sold their loans to the shadow banking industry, which in turn sold the securities created from those loans to European banks. So in effect, the US banks provided the European banks with the funds to buy their securities.

But there was also a credit creation process going on at the European end. Banks don't just create money when they lend – they create money when they buy securities, too. After all, it is only another form of lending. That money found its way back through the shadow conduits to the US banks, which used it to fund their loans. So the European banks also provided the US banks with funding for lending. There was in fact a two-way flow of funding. No wonder leverage increased so so much and so quickly.

It is those flows of funds that dried up in the financial crisis. We could say that the “pump” failed. When the heart stops beating, the patient quickly dies.....

So what should we learn from this?

Neither US nor European banks thought they were “taking excessive risks”. On the contrary, both sides were looking for safety. US banks were prudently removing loans from their balance sheets in order to remain within their Basel 1 leverage constraints. And European banks were prudently looking for safe assets that gave good returns. Not only that, but the shadow institutions that pumped the lending and the funding from the US to Europe and back again also thought they were acting prudently. After all, the securities were backed by the US property market, which had not suffered a major fall since the 1930s. And the US dollar deposits were backed by the US government.

The story of the financial crisis is a story of the failure of safe assets. That is why it was so traumatic. People expect to take losses on risky investments. They don't expect to take losses on safe ones. Yet we are still trying to make the financial system “safer” and encourage investors to invest in “safe” assets. When will we learn that the safest investment is a risky one, and the most dangerous investments are those that are believed to be completely safe?

And it is also a warning of the consequences of regulatory arbitrage. The fact that the US and European banks had different regulatory regimes created a golden opportunity for unregulated institutions to exploit, with catastrophic consequences. Yet the US, the UK and the EU are still devising their own systems of regulation with scant regard for international consistency. When will we learn that an international industry requires international regulation?

Related reading:

Financial hurricanes
Financial hurricanes - lecture given for Brave New Europe in Berlin, February 2019 (Youtube video)
On risk and safety
The illusion of safety

This post originally appeared on Pieria in October 2014. The header image is from the original Pieria post. 

The housing bubble that never burst, and other fairy tales

Published by Anonymous (not verified) on Fri, 14/07/2017 - 7:00am in

Co-written by Kate Tucker. This article is the second part of my “State of the Housing Bubble” series, which began with Housing bubble is now official, commence arse-covering (panic)!. It is a long form article, so I put some Read more

The post The housing bubble that never burst, and other fairy tales appeared first on Rational Radical.

The Left should celebrate Brexit: UK just kicked Neoliberalism in the nuts

Published by Anonymous (not verified) on Fri, 24/06/2016 - 8:38pm in

It is a sad and ironic indictment on the state of the global Left and the progressive agenda, that the very compelling reasons to support a Brexit have been lost amongst the rightful consternation with the racist views and actions … Read more

The post The Left should celebrate Brexit: UK just kicked Neoliberalism in the nuts appeared first on Rational Radical.