Thursday, December 17, 2009 122 Comments

Expiring liquidity facilities: bad plan, Stan

The Fed, ensuring a busy quarter ahead, tells us:
In light of ongoing improvements in the functioning of financial markets, the committee and the board of governors anticipate that most of the Federal Reserve’s special liquidity facilities will expire on Feb. 1, 2010, consistent with the Federal Reserve’s announcement of June 25, 2009. These facilities include the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility and the Term Securities Lending Facility.
Thankfully, this date for a fully-loaded round of financial Russian roulette comes with a caveat:
The Federal Reserve is prepared to modify these plans if necessary to support financial stability and economic growth.
Ya think?

I am not, of course, any kind of financial analyst. My comments do not constitute investment advice, never have, and never will. But sometimes a nigga just got to step up to the plate, get his hand on tha mic and lay down some chronic prophecy. I predict: serious financial disturbances will occur on or before February 1, 2010. Or soon thereafter.

(And if you want to know more: consult my big nigga, Professor Sethi of Ba - I mean, Columbia. He gots to get his mind off all them little ladies. Plus he says he got some kind of model and shit. Sound like a stone-col' OG PhD nigga to me.)

Okay, stop laughing. I also have a serious - ie, verifiable - prediction. I predict that before the end of 2010, probably well before the end of 2010, possibly even before the beginning of 2010, the Fed will be forced to renew these facilities or others like them. In other words, I predict that its attempt to kick the liquidity junk will not succeed. In the end, I believe all these "temporary" facilities will become substantively permanent - just like the original LF, deposit insurance.

Please bear in mind that this is a guess, rather than a deduction, and is based on assumptions about rational crowd behavior that may simply turn out to be false. If they are false, it is not my explanation of maturity transformation which is false; it is just these assumptions, ie, the belief that humans are even remotely distinguishable from remote-controlled sheep. Certainly if they were remote-controlled sheep, I would expect no crisis.

With this caveat of my own, let me put it this way: the Fed simply does not understand maturity transformation. It thinks it can just take these collapsed markets, which it suspended by guaranteeing, and turn them back on again. And they'll just work. This could be described as the therapeutic theory of financial cryonics. If Alcor could freeze your brain and then warm it up, this would be a tremendous achievement. It would not cure your brain tumor, though.

The Fed can freeze the money market, then thaw it back out. An achievement - though hardly unprecedented. Let's look for a second at how it did this.

What are these temporary liquidity facilities? A "liquidity facility" is simply an open-ended guarantee that the Fed (or some other authorized authority) will issue an arbitrary number of dollars to buy an arbitrary number of goods at a fixed price.

In principle this exact mechanism could be used to fix the price of corn. Or at least, to support it. Although the Fed would wind up owning a lot of corn. What's neat, though, is a trick that can be played in the securities markets. Through the miracle of loan guarantees, an issuer of currency X can be used to support the price of any debt, ie, promise of future payment. So long as every principle of good accounting is disregarded, these contingent liabilities can easily be omitted from the sovereign balance sheet.

To fix prices, the sovereign just issues an invisible, parallel, derivative security which is invisibly bundled with the security whose price is to be fixed. (Or at least, supported - I'm not sure whether infinite dollars can be used to suppress dollar prices, though perhaps some trick can be played. It's always easier to intervene prices upward than downward. Downward you are rationing; upward, you are just taxing.)

Thus, consider the case of FDIC deposit "insurance." When you make a "deposit," ie a zero-term loan continuously renewed, to a "bank," ie a vampire whorehouse with AIDS, in return you receive not one but two notional securities. For every green dollar you deposit, you receive two dollar-sized instruments: the bank's promise to repay you on demand (call it a yellow dollar), and FDIC's promise to pay you if the bank can't (call it a blue dollar - precisely, a credit-default swap.)

Taped together, the yellow and blue dollars make green. Your loan to the bank is risk-free. And indeed these instruments have to be taped together. Because if you could separate the two, and create separate markets in which yellow and blue dollars traded separately - coeds, what would happen? We'll return to this question in a moment.

All the liquidity facilities mentioned in the press release are of this class. Your "yellow dollar" in the case of the money-market funds, for instance, is a dollar which is "in" a money-market fund. In reality, this yellow dollar is a zero-term debt (promise to pay on demand) by a financial intermediary, which is backed by "commercial paper," which is a meaningless word for short-term loans issued by large corporations. These corporations are typically performing maturity transformation in the sense Minsky describes - that is, their financial structure has been designed so that they have to roll over their loans, rather than repay them from cash flow.

What the Fed is doing, when it terminates these liquidity facilities, is canceling its "blue dollars" - ie, its loan guarantees. Each blue dollar is marked: "not good after February 1, 2010." My prediction boils down to the prediction that these securities will not in reality be canceled. Rather, I believe they will ultimately remain good.

Bureaucratically, however, turning around on this plan - and effectively admitting that these once-temporary programs have become permanent - represents a significant defeat for the Fed. Therefore, the Fed will have to suffer some pain before admitting this defeat. Thus, I expect market turbulence.

This time around, the market should be pretty sure the Fed will not actually let the money market fail. It was pretty sure of that in 2008, or at least it should have been. But it still had to test the Fed's intangible commitment to provide liquidity insurance to the money market and the shadow banking system. Once that commitment is withdrawn, it must be tested afresh.

(Those who can predict this turbulence accurately, as always, can make money off it. But this is an exceptionally nontrivial task - you can't go to Ameritrade and click to short "yellow dollars." Since my prediction is that any crisis will be ended by the Fed restoring or extending its facilities, no persistent change in any price is implied. I'm sure it is possible to make money off a correct prediction of turbulence - if you know the prediction is correct, which I don't. But it can be done only by capable and well-trained professionals.)

Again, the backstops will hold. The blue dollars will survive. But after February 1, 2010, they go from being formal guarantees to informal ones - just the same position they held before 2008. Note that the actual financial condition of the banking industry, ie its actual balance sheet, has not particularly improved since 2008.

Therefore, the market will have to test the strength and reality of these backstops. It will do so through that phenomenon we have learned to know well and love, here at UR, the "liquidity" (or more correctly, maturity-transformation) crisis. More broadly, the entire wave of temporary powers that were the original fruit of the first wave of the crisis is expiring, dissipating, and vaporizing, as emergency powers do in Washington. It is being sucked up by bureaucracies on all sides, restoring the normal Beltway equilibrium of general administrative paralysis.

In a political context where the administration is weak, the Fed is weak, its chairman is awaiting confirmation, and Congress is actively on the rampage - how easy is it for the Fed to make this U-turn? I suspect the market will want to find out, especially at a time when the first sovereign default crises of the New Depression (Greece, etc) appear imminent.

One of the serious problems here is that, while the guys at the Fed may not be geniuses, they are not dumb, either. They are, in fact, perfectly competent economists. And they know perfectly well that this whole blue-dollar scheme is a botch, because they have read their Hayek and know that it's a bad idea to conceal a price signal. In this case, the price of yellow dollars.

Or prices, of course, because the price of a yellow dollar depends on the financial condition of the issuing bank. If the bank is solvent, the yellow dollar is worth $1 - ie, one green dollar. If the bank is insolvent, the yellow dollar is worth whatever it can recover of the assets. Which could be nothing, in extremis, in which case the corresponding blue dollar is worth $1.

Back in 2008, when everyone was pretending there was no such thing as a blue dollar, there was something that looked like a free market for yellow dollars. Unfortunately, this market had to be frozen. It started sending a signal that no one wanted to hear: that the banks were insolvent. In money-market terms, the yellow dollar "broke the buck."

Formal blue dollars, via the LFs, were hastily issued. As we've seen, the blue-and-yellow dollar trades as a green dollar, period. In fact, this is the problem with blue-and-yellow dollars, in the long term, and why the instinct to terminate the LFs and return to a free market is quite sound. Yes, by all means: Washington should get out of the banking business. Canceling the blue dollars on February 1, 2010 is not, I believe, an effective way for it to do so.

With blue dollars, the solvency signal as well as the liquidity signal is laundered. The bank (or corporation, etc) can borrow money from actors who will bear no loss if it fails. In the medium term, this is a recipe for a lot of bad loans. In the long term, this is a recipe for turning the country into the Soviet Union: a land in which all loans are government loans. Command economics replaces financial sanity as the grounds for evaluating capital investments. Frankly, in the present state of the real-estate market, we are already most of the way there.

When Washington cancels the blue dollars - the loan guarantees of the various LFs - it turns the market for yellow dollars back on. Now, note that this market, when it was frozen, was in the throes of a maturity-transformation crisis. What would a rational actor do when the market is turned back on? Redeem his yellow dollars for good, old-fashioned green dollars - while he can still get the official 1:1 exchange rate. Once enough people follow, the rate will no longer be 1:1. And so on. The bank run begins all over again.

We can see this easily by solving the thought-experiment I posed earlier: split the yellow and blue dollars. If holders of yellow dollars can be granted free blue dollars - loan guarantees, credit-default swaps, call them what you like - these securities, presently virtual, can be made tangible. Tangible, they can be made negotiable. In principle, each of these steps is a Pareto optimization.

But look what happens when you have two separate markets! The bank run exhibits reflexivity - in the absence of artificial stabilization, unprotected maturity transformation is like a pencil standing on its point. However precisely it is positioned, the pencil's state can at best be described as a stable disequilibrium. It can be held standing either by a solid support (the liquidity facilities), or by duct tape (opacity, inefficiency, irrationality, etc).

When the blue dollars were created, the pencil (really more like a telephone pole) was falling over. The market for yellow-only dollars was frozen in this position. Turn it back on, and what happens? With the solid support gone - what duct tape could hold up this market, now? Anything equivalent to a yellow-dollar market (for instance, actual CDS on banks) is a perfect feedback signal, and should instantly revert to collapse mode.

Just like a falling pencil, a bank run is reflexive - the farther the yellow-dollar price falls under $1, the greater the force pushing it down. If the Fed does not intervene at all, all the banks fail, and so do all the corporations which issued short-term paper for internal maturity transformation. Of course this will never be allowed to happen, because it conflicts with the Fed's mission, and so on. However, this U-turn cannot be not certain until it happens.

This logic predicts another wave of the crisis. If it is correct, a second tsunami could hit at any time - even tomorrow morning. Again, UR does not provide financial advice. All I'm saying is: make sure you are safe from this great, churning, angry wall of water. Don't panic, though!

It's interesting to note the effect of these tsunamis on the gold-dollar exchange rate. If you put a chart of the gold price next to a chart of UR posts which mention gold, you will see immediately that the latter cause the former to drop sharply in the short term, but rise smoothly in the long. Of course, I have no conceivable explanation for this pattern, which I'm sure is just a coincidence. However, I do have some observations regarding liquidity crises and gold.

Broadly, over the last few years, gold builds up a pool of money correlated with "risk assets" which represent anti-dollar bets. When there is any hint of a liquidity crisis in the dollar world, we see a "shortage of dollars" ("shortage of money" is a 19th-century term for "liquidity crisis"), implying a kind of deflationary suction which tends to raise the price of dollars in everything.

Including, for instance, gold. When gold has been going up for a while it always accumulates a population of momentum traders who, not having read UR and not understanding monetary formation, are weak hands. A shock takes the frothy air out of the top of the bubble. Further down, though, gold buyers are notoriously strong hands - quite committed to their decision to bail on paper and head for real metal.

And in the longer term, what the market sees is that the Fed cannot, because of its economic mission, tolerate any sustained deflationary pressure within the dollar economy. (For example, if the Fed canceled all its liquidity programs, we'd be back to the five-cent hotdog, if anyone had any hotdogs - in short, Mad Max Beyond Thunderdome, with Norman Rockwell prices.) Thus, in the longer term, the general instability, stagnation and incontinence of the dollar system is revealed, driving savers to the emerging hard currency outside it.

(The effect of a maturity crisis in the dollar on the dollar-gold exchange rate should not be confused with the effect of a maturity crisis in gold, which (due to the presumed fractional-reserve structure of the futures markets and other bullion-banking institutions) I still believe is possible. Bullion banks, the "commercial" traders on Comex and other exchanges, have issued quite a large number of short-term liabilities in gold and silver. Presumably these traders do not expose themselves directly to price fluctuations - so these liabilities must be backed by other positions, almost certainly not allocated bullion, almost certainly in gold and silver. There is not enough bullion on the exchanges for it to be pure bullion. It cannot consist entirely of mining hedges, ie long-term promises of gold and silver - because the positions fluctuate too widely. So there must be something else, and I wonder what the hell it is. My guess: synthetic baskets of mining stocks. Regardless, unprotected maturity transformation is a dangerous game for lender and borrower alike, and no one should be playing it.)

122 Comments:

Blogger TGGP said...

This is mere pedantry, but I'm pretty sure what Mencius calls "stable equilibrium" is what's called "unstable equilibrium" in high school physics. A system not in equilibrium or tending toward it (the Lachmann/Shackle view of the economy) is moving and possibly accelerating. A pencil standing on its tip is in equilibrium: all forces balance and it remains in position. The equilibrium is merely unstable, if disturbed it will move away from its old position and lack the tendency to return. A ball at the bottom of a bowl is in a stable equilibrium. A "stable disequilibrium" would be something like a periodic process.

I recall at Overcoming Bias a while back (the post might now have been moved to Less Wrong) a way to bet on volatility rather than a specific direction was discussed. It was something like betting on both extreme highs and lows.

Charles Calomiris, also of Columbia, participated in an interesting edition of EconTalk discussing financial crises that focused heavily on deposit insurance. His view is that in the absence of such insurance, banking has been stable. The U.S had some "panics" due to our practice of unit banking and seasonal fluctuations in the cotton market (which made it seem like the Federal Reserve was an improvement), but Canada was spared those problems. He didn't declare himself to be a free-banker, but that sounded like what many of them have said. They have a number of historical examples that they claim support free-banking as an optimal system. According to Selgin there have been no 100% reserve "warehouse banks" since the late middle ages, but perhaps he's less familiar with Galapagos (and anyway, shouldn't safety deposit boxes substitute?). Your comparison of maturity transformation to English seems off then, since there have been plenty of other languages coexisting with it not only in the late middle ages but up to this day.

December 17, 2009 at 6:55 PM  
Anonymous zanon said...

Mencius: Your model of banking is wrong. Banks do not borrow short to lend long. Therefore, they do not MT. Therefore, your MT analysis is not applicable.

Money market funds DO MT by the way. So your analysis is applicable there.

Of all the idiot ideas swirling around, getting rid of FDIC really does have to be one of the worst. Glad it will never happen, although its current implementation leaves a great deal to be desired. You are correct though, it is not "insurance".

TGGP: Calomiris has no clue what he is talking about.

December 17, 2009 at 10:46 PM  
Anonymous Walter said...

Ignore "zanon."

He's a frequent commenter at that delusional monetary crank Warren Mosler's blog. zanon has nothing interesting, intelligent, or original to say. He just apes that retard Mosler.

zanon has no idea what he's talking about.

December 18, 2009 at 12:33 AM  
Anonymous Steve Johnson said...

I recall at Overcoming Bias a while back (the post might now have been moved to Less Wrong) a way to bet on volatility rather than a specific direction was discussed. It was something like betting on both extreme highs and lows.

Long volatility (i.e., betting that volatility will increase, and you are buying it cheap to sell back dear): go long on a straddle (long call / put at the same strike on the same underlying) or a strangle (long call / put at different strikes on the same underlying)

Short volatility: go short on a straddle or strangle.

Long straddle or strangle has potentially unlimited profit with the potential losses limited to the option premiums.

Short straddle or strangle has a maximum profit of the option premiums. Losses are potentially unlimited as the underlying moves away from the price at the time of the writing of the option contracts.

The VIX is a measure of the volatility of the S&P 500 and has derivatives markets. You can go long or short on general market volatility by buying calls or puts on the VIX (respectively) or selling puts or calls (respectively) on the VIX.

December 18, 2009 at 1:57 AM  
Anonymous Devin Finbarr said...

Zanon-

Moldbug was talking specifically about the "shadow banking" sector, aka CP issuers and money market funds, when he says that MT caused the crisis. He understands that normal banks operate very differently. His problem with normal banks is that they are basically equivalent to the government making all loans, which is too soviet for his tastes.

December 18, 2009 at 7:16 AM  
Anonymous zanon said...

Devin: In my post I did say that money market funds have this problem. I must have missed the part where he talks about how reserve accounts solve this problem. The Diamond Dgybvy model he talks about does NOT make this distinction, although it claims to talk about regular banks. Same thing with almost all discussion on this topic.

And while Mencius prides himself on accepting reality as it is, he clins to his delusions with regards to money.

Note that the best way to kill the CP/MM market is to make FDIC *unlimited*! This has not been an Austrian theme, nor one for economists like Calomiris. ("100% reserve" is clear signal they have no idea what they are talking about).

Given what money is, and how it works, it makes most sense to move *all* private section credit creation to regular banks and run them properly. Running this properly is a good, Reactionary principle.

Walter: Mosler is a strange fish, but he is correct in this. Austrian economics is not applicable to fiat monetary systems.

Nothing wrong with learning something and sharing that with others.

December 18, 2009 at 7:38 AM  
Anonymous Anonymous said...

Please explain this poor foreigner this little piece of US sociology: what is the point in 2010 of a all-woman's college? I was amazed by this Barnard-Columbia stuff.

December 18, 2009 at 9:21 AM  
Anonymous Anonymous said...

Jews in prison.

December 18, 2009 at 10:08 AM  
Anonymous Dravic said...

Please explain this poor foreigner this little piece of US sociology: what is the point in 2010 of a all-woman's college? I was amazed by this Barnard-Columbia stuff.

Vaginal research logistics.

December 18, 2009 at 11:02 AM  
Anonymous Michael S. said...

Zanon is right. As a bank owner, when I read economists writing about banking, I'm always impressed by their apparent lack of acquaintance with real-world commercial banking practice.

Maturity transformation is not evident in comparing the typical bank's loan portfolio with its deposits. In my experience, considerable effort is devoted to balancing deposit maturities with loan maturities. I wish I could show you the regular analyses we make of both at my bank.

Where I believe maturity transformation takes place, in some sense, is in the investment portfolio of a bank. There, one may find 30-year bonds, clearly a longer term than any time deposit. However, investments are ordinarily available for sale at any time to satisfy the need for liquidity.

At the crux of the collapse in late 2008 was that many investments, such as those in mortgage-backed securities (some of which had been given AAA or AA ratings by the agencies), were not in fact liquid. No one knew what value to assign to them.

Commercial banking was not the nexus of the collapse. It was in non-bank mortgage lending. To the extent commercial banks participated, it was as a consequence rather than as a cause.

The broke-ness of FDIC is purely theoretical at this point, because all its losses to date have been paid out of the fund it has raised by charging premiums on insured deposits. Aggregate net losses of all ~8000 FDIC insured institutions for the last four reported quarters (from the 4th quarter 2008 through the 3rd quarter 2009) were $19.9 billion. Compare that figure with the $82.1 billion loss of Fannie Mae, and the $38 billion loss of Freddie Mac during the same four quarters, and you'll see what is, to quote W.C. Fields, "the Senegambian in the fuel supply."

December 18, 2009 at 12:51 PM  
Anonymous Alex said...

"There is not enough bullion on the exchanges for it to be pure bullion"

Bullion is not held on the COMEX itself but many exchange accredited warehouses distributed within a 150 mile radius of NYC. To the extent paper short positions are not guaranteed by this physical gold, they are guaranteed by central banks, who lend gold to banks and other financial shorts via the OTC gold repo market, which positions are considered collateral for exchange positions.

Anon@9:21, the barnard/Columbia thing is simply win win; it's easier for the girls to emerge with a Columbia degree, and the guys benefit from the greatest b/g ratio in the ivies.

December 18, 2009 at 1:53 PM  
Anonymous Michael S. said...

Further as to 'reserves': this is a term that covers a multitude of sins, but the most frequent use of it in everyday banking practice is with reference to what are called loan loss reserves. The loan loss reserve account is made up of funds that are set aside out of a bank's income to cover any losses on loans. The percentage reserved varies depending upon the type of loan, e.g., a loan against cash-based collateral like a CD will be reserved at a lower rate than one collateralized by real estate, which will in turn be reserved at a lower rate than an unsecured loan.

Let's suppose our bank has picked up $100 million in new deposits and has to decide what to do with the money. It may lend it, and, if it does, let's say a loss reserve averaging 2% is set aside. That's a $2 million charge to earnings - right now.

On the other hand, under both US and international (Basle accords) regulations, if the money is invested in bank-qualified securities, NO loss reserve is required to be charged against earnings on the amount purchased.

If you are a bank executive - particularly in a publicly-traded bank with shareholders that hang on the estimates of this quarter's earnings like maggots on road-kill - which would you do? Would you try to lend the money to your borrowing customers, carefully underwriting each loan with the intent of holding it to maturity, and for your reward take a hit of $2 million against current profits? Or would you invest it in that nice AAA rated Fannie Mae preferred stock?

This is but one example of how the financial collapse of 2008 was caused, not by too little regulation or too much regulation, but rather by boneheaded regulation that gave perverse incentives, and regulation that we may well suspect was purposely written by politicians to channel money into uses they favored. We have after all observed Nobelist Joseph Stiglitz to write in 2002 that there was essentially no possibility of loss from the GSEs Fannie & Freddie. We have heard Barney Frank say he thought it was appropriate to 'roll the dice' on subsidized housing. They came up snake-eyes.

December 18, 2009 at 1:59 PM  
Anonymous Leonard said...

Michael S., I assume your bank does offer demand deposits, and you do not keep 100% reserves? There is maturity transformation.

Can you give us some sort of breakdown of your bank's situation, in regard to the total amount of deposits and reserves as versus loans and investments?

December 18, 2009 at 2:00 PM  
Anonymous Guy said...

While I agree with the economic argument, I'm not sure about the political. It doesn't seem like it would be a very big deal for the Fed to come out and say, "The economy is not ready, we're going to extend the life of these programs a for a while more." For one, they didn't actually promise to close them out, they only "anticipated" that they would expire. Two, it doesn't seem like people are making a big deal out of this (searching for
*fed liquidity facilities* in Google news doesn't turn up much), so there probably won't be much pressure on them to follow through. And finally, after all the trillions that have been spent to stop this crisis, extending these programs seems like a peccadillo in comparison. So I personally expect that if the turbulence does start to get bad at all, the Fed will just extend the life of these programs and it won't be a big deal.

Michael S,

How could it even be possible to match deposit maturities with loan maturities? As Moldbug said, demand deposits are effectively 0-term loans continuously rolled over. Their maturity is always right now! The only way you can match the maturity of a demand deposit is to hold cash.

I assume that what you do is consider the maturities of your demand deposits to be when you expect the depositor to stop rolling over (i.e. withdraw). Then you match the expected withdrawal times with the maturities of the loans. This qualifies as maturity transformation! I would assume that all maturity transformers balance their maturities in that way, but you have actually match your actual maturities in order to not be a maturity transformer.

And on the FDIC, again as Moldbug has pointed out, imagine what would happen if they weren't implicitly backed by an infinite printing press! Mass withdrawal of yellow dollars.

December 18, 2009 at 2:00 PM  
Anonymous Alex said...

http://www.kitco.com/lease.chart.html

here, the kitco lease rates, showing that short dated gold is on loan for negative money. This tells us that there is possibly more physical bullion available than financial buyers want coming into their possession. IE, they will loan it to financial shorts at a loss, rather than pay storage and insurance.

December 18, 2009 at 2:15 PM  
Blogger nazgulnarsil said...

Michael S and winterspeak are the only people who let me feel like I'm not crazy.

December 18, 2009 at 2:47 PM  
Anonymous Anonymous said...

How Likely Is Hyperinflation?

By Peter Bernholz

Tuesday, December 15, 2009
Have central bank and government reactions to the crisis created a large danger for the future?

During the past several months, concerns have risen that the expansionary policies of the U.S. government and the Federal Reserve System
to counter the present crisis are creating the danger of a substantial future inflation. Some speak even of a hyperinflation, that is, of a rate of
inflation exceeding 50 percent per month. People believing in the latter scenario base their concerns on results I presented in
Monetary Regimes and Inflation: History, Economic and Political Relationships, which shows that all hyperinflations were caused by
huge government deficits. By analyzing many historical examples, I illustrated how hyperinflations resulted whenever 40 percent or more of
government expenditures were financed by money creation. Since it is expected that about 42 percent of U.S. expenditures will be financed
by credits this year, some fear the emergence of hyperinflation in the United States. Consequently we face the interesting question of whether a very high U.S. inflation with a corresponding fall of exchange rates has to be expected.

http://www.american.com/archive/2009/december-2009/how-likely-is-hyperinflation

December 18, 2009 at 4:58 PM  
Anonymous zanon said...

Michael:

The "reserves" I'm talking about are reserves kept at reserve accounts at the Federal Reserve, as required by "fractional reserve banking" (FRB).

Loan loss reserves is capital set aside for loans going bad (as you say).

Making this distinction clear is CRITICALLY IMPORTANT in this discussion. People believe that bank lending is reserve (FRB) constrained when it is capital constrained.

So, to avoid this confusion, could you call loss reserves something like "loan loss setasides"? Otherwise there really is no hope.

LEANARD: Banks post the reserves they need in their reserve accounts at the Fed as per regulation. if they end the day long (or short) reserves, the lend (or borrow) on the overnight market until they are back in compliance.

You're talking about capital requirements, which is how many liabilities the bank can pile onto its equity base. The max is set by Govt also.

Since banks do not lend out reserves, the quantity of reserves tells you nothing about inflation.

December 18, 2009 at 5:25 PM  
Blogger Bron said...

Alex,

Those lease rates are derivations from LBMA forward rates and LIBOR and as such subject to some margin of error, especially when LIBOR is close to zero. It is a purely theoretical rate.

I can guarantee you no one is offering to pay the Perth Mint to borrow gold!

December 19, 2009 at 5:47 AM  
Anonymous Walden said...

zanon,

I've heard quite a few people champion Mosler, winterspeak, and others for having realistic views on monetary and macro economics. They've described these views as "post-Keynesian."

I'm not familiar with any of these views, just with the standard neoclassical views along with some Austrian views thrown in.

I'd like to learn more though - any good resources or good places to start? It all seems a bit cryptic to me.

December 19, 2009 at 9:58 AM  
Blogger Alex said...

Bron, the lease rate is a real rate based on a real sale and repurchase of thousands of tons of gold. The forward curve in gold (LBMA or COMEX) is in large part a function of it and not the converse. There is a sales group on any metals/fx trading desk given to central bank clients who lease gold on a short term window to support short sales in physical bullion. In what way is this not a real rate, or a real lease?

I would agree that actual leases are likely to fall as storage dynamics push the yield negative.

& they wouldn't be offering to pay the Perth mint but the reserve bank of australia see eg

http://www.rba.gov.au/publications/annual-reports/rba/2009/html/ops-fin-mkts.html

December 19, 2009 at 11:15 AM  
Anonymous Michael said...

Zanon, I know that reserves of Federal Reserve member banks are held in the FRB. That is really not relevant, because a great many banks are not FRB members. State-chartered commercial banks, savings banks, and Federally-chartered savings-and-loans are not required to be FRB members. There are more institutions belonging to these classes than there are nationally chartered commercial banks, which are required to be FRB members. The principal benefits of FRB membership were at-par clearance of checks and the ability to use the Fed's discount window. As both have long been extended to non-members, there is little reason now to get a national charter. This is a point I do not remember being brought up when I took a money & banking economics class as a university student 40 years ago, and I knew, from what I learnt through casual conversation with my father, that it was the case even then. There has long been a vast disconnection between what academic economists teach and what is true in the real world.

Of course lending capacity is capital-based, and the matter at issue in the recent troubles is - what ratio of capital to assets shall be required? A commercial bank is now considered adequately capitalized if it has 8% Tier 1 capital. The GSEs were operating, under the regulatory authority of their own special agency, with less than 1%. Again, the Senegambian in the fuel supply.

December 19, 2009 at 12:20 PM  
Anonymous Michael S. said...

Guy, a bank has assets of cash on hand and due from banks, investments (theoretically available for sale at any time), loans, and its physical properties. Its liabilities consist of demand deposits, time deposits, and capital.

A bank's demand deposits are typically balanced against its cash on hand and due from banks and its investments. Its loans are balanced against time deposits. A bank is never completely 'loaned up,' i.e., its loans make some fraction of its total deposits. The art is to manage this percentage so as to keep a sufficient amount liquid to meet any call for funds by demand depositors.

So, as I said, if there is maturity transformation at all it is in the investment portfolio and not in the loan portfolio. We might have 30-year bonds in the investment portfolio but with the understanding they are available at any time for sale. What happens if we can't sell them, or if marking them to market causes a huge loss? This is what happened to commercial banks that held large investments in mortgage-backed securities. The Federal government has stood behind the debt securities of Fannie and Freddie; if it had not, the collapse would have been much more protracted and severe. However, holders of Fannie's and Freddie's preferred stocks (which were bank-qualified) and of private mortgage-backed securities are out of luck.

We also need to understand the role of capital. Capital amounts to a sort of perpetual deposit; that's why it is on the liability side of the balance sheet. Unlike demand or time deposits, capital cannot be withdrawn. Shares of stock which represent it can only be sold, for whatever the market will bear, to a willing buyer. If a bank is properly capitalized, it has a sufficient liquidity cushion - a capital reserve, if you will - to meet any demand from its depositors.

Partial-reserve banking existed long before central banks or anything we might properly call bank regulation. There were Medicis and Fuggers centuries before the first central bank, the Bank of England, was created. It is worth noting that both the Medici and Fugger banks eventually failed, and they did so because they were insufficiently capitalized; but by that time, their owners had moved onward and upward in the world. Determining what is proper capitalization has always been a matter of trial and error. It was before there were central banks and has remained so since they came into existence. I think it must always be, because economics is at bottom a reflection of mass psychology. We must remember that 'credit' derives from the Latin 'credere,' i.e., to believe. The word credit is thus cousin-german to the word 'creed,' i.e., a statement of faith. We extend credit because we have faith in a borrower's ability to repay. Whether any given creditor's faith has been well-founded makes the difference for him between success and failure.

December 19, 2009 at 12:45 PM  
Blogger Mansoor H. Khan said...

Why not give all depositors a choice:

1) a 100% reserve account with no credit risk and high monthly fee (money warehouse account). The money in these accounts would simply end up at the FED (non-lendable and secure, with no credit risk).

2) a non-100% reserve account (today's type of FRB accounts) with possibly interest earning and low fee.

Once this choice is given remove deposit insurance (which is a lie backstopped by the printing press).

Safe Storage of Electronic Money -- 100% Reserve Digital Cash

The (usually) transparent process of inter-bank lending works so well that most of the time we don't even think about it. This process has largely weaned the public away from physical paper money. Note that most money (about 90%) now exists only as entries on bank ledgers, backed by loans (debt). Also, note that possessing physical paper dollars is like having equity in the economic output of the United States of America, and has no credit risk associated to it. Physical paper money is not anyone's liability.
Bank deposit money, on the other hand, does have credit risk associated to it. That risk consists of the liability of the bank in which the deposit resides. Strangely enough, most of the time the credit risk of bank deposit money is lower than the theft and physical-loss risk of physical paper money.
That is why we use bank deposit money more than physical money. Through this (normally) transparent process of inter-bank lending, the banking system acts like a huge clearinghouse (essentially a giant ledger) which clears payments between its customers without the physical transfer of cash, and keeps track of who has how much money. Most money in the world economy is not physical (paper cash or gold) but logical (ledger entries).
To summarize: physical paper money is equity. Bank deposit money is backed by debt (actually that's not 100% true--reserves at the federal reserve system are also equity, essentially an electronic version of physical paper cash).
That difference -- that physical paper money = equity in the nation's economy, and that a bank deposit = debt (a bank obligation) causes great confusion.

We have become very comfortable with bank deposit money, without thinking much about the credit risk we are taking. Bank failures, when they happen, create confusion and chaos because the vast majority of businesses and individuals use checking accounts for convenience (they can write checks rather than handling physical paper cash) and they don't really think much about the credit risk that is normally associated with keeping their money (their most liquid capital) in a bank in a checking account. In fact, in most cases users of checking accounts do not want to take a credit risk. But in the current banking system there are no alternatives.
Is There a Better Way?
Consider the banking industry's contribution to society. The banking industry provides three major services to the public:
1. It provides a "safe" place to hold the public's most liquid assets (cash).
2. It acts like a giant clearinghouse (settling checks without physical paper cash transfer).
3. It is a source of loan money (banks evaluate the credit worthiness of borrowers). Think of "credit worthiness evaluation" as a service to society. If bankers do a poor job at evaluating credit worthiness they will end up mis-allocating economic resources.
What I am asserting is that it is possible to have a banking system where a customer would get benefits 1 and 2 described above without taking a credit risk, if banks gave people a choice between a regular account and a special "100% reserve account."

--continued in next comment

December 19, 2009 at 3:14 PM  
Blogger Mansoor H. Khan said...

Why not give all depositors a choice:

1) a 100% reserve account with no credit risk and high monthly fee (money warehouse account). The money in these accounts would simply end up at the FED (non-lendable and secure, with no credit risk).

2) a non-100% reserve account (today's type of FRB accounts) with possibly interest earning and low fee.

Once this choice is given remove deposit insurance (which is a lie backstopped by the printing press).

Safe Storage of Electronic Money -- 100% Reserve Digital Cash

The (usually) transparent process of inter-bank lending works so well that most of the time we don't even think about it. This process has largely weaned the public away from physical paper money. Note that most money (about 90%) now exists only as entries on bank ledgers, backed by loans (debt). Also, note that possessing physical paper dollars is like having equity in the economic output of the United States of America, and has no credit risk associated to it. Physical paper money is not anyone's liability.
Bank deposit money, on the other hand, does have credit risk associated to it. That risk consists of the liability of the bank in which the deposit resides. Strangely enough, most of the time the credit risk of bank deposit money is lower than the theft and physical-loss risk of physical paper money.
That is why we use bank deposit money more than physical money. Through this (normally) transparent process of inter-bank lending, the banking system acts like a huge clearinghouse (essentially a giant ledger) which clears payments between its customers without the physical transfer of cash, and keeps track of who has how much money. Most money in the world economy is not physical (paper cash or gold) but logical (ledger entries).
To summarize: physical paper money is equity. Bank deposit money is backed by debt (actually that's not 100% true--reserves at the federal reserve system are also equity, essentially an electronic version of physical paper cash).
That difference -- that physical paper money = equity in the nation's economy, and that a bank deposit = debt (a bank obligation) causes great confusion.

We have become very comfortable with bank deposit money, without thinking much about the credit risk we are taking. Bank failures, when they happen, create confusion and chaos because the vast majority of businesses and individuals use checking accounts for convenience (they can write checks rather than handling physical paper cash) and they don't really think much about the credit risk that is normally associated with keeping their money (their most liquid capital) in a bank in a checking account. In fact, in most cases users of checking accounts do not want to take a credit risk. But in the current banking system there are no alternatives.
Is There a Better Way?
Consider the banking industry's contribution to society. The banking industry provides three major services to the public:
1. It provides a "safe" place to hold the public's most liquid assets (cash).
2. It acts like a giant clearinghouse (settling checks without physical paper cash transfer).
3. It is a source of loan money (banks evaluate the credit worthiness of borrowers). Think of "credit worthiness evaluation" as a service to society. If bankers do a poor job at evaluating credit worthiness they will end up mis-allocating economic resources.
What I am asserting is that it is possible to have a banking system where a customer would get benefits 1 and 2 described above without taking a credit risk, if banks gave people a choice between a regular account and a special "100% reserve account."

-- continued on next comment

December 19, 2009 at 3:15 PM  
Blogger Mansoor H. Khan said...

These special accounts, which are not available to the public today, would have no credit risk. The money in such accounts would not be lendable. There would still be fraud risk, of course. A bank desperate for cash might be tempted to "dip" into the reserves allocated to their 100% reserve accounts. Of course we would make such "dipping" illegal. The 100% accounts would be the electronic equivalent of storing physical paper bills in a safe deposit box at the bank. The total reserves of a bank would be "safely electronically stored" at a central bank (much like reserves at the FED).
I know that Misesians and libertarians and ZH readers don't like central banks and are very suspicious of them. It seems to me that electronic version of physical paper cash (i.e., digital cash) is the next natural step. Much like airline tickets are now mostly issued as e-tickets and not as negotiable paper tickets. By its nature "digital cash" would have to be stored on some central bank on a computer hard-disk (i.e, an electronic ledger) and it would also contain the owner's identifying information (i.e., the bank account number). Such "digitial cash" would NOT be debt money (as are bank deposits today) but would be "equity" money (like physical paper cash). Ofcourse we could go a step further and back-up the "digital cash" with gold reserves in the vault (but I am NOT proposing that we do this). I am trying to understand the Misesian and libertrarian distaste for a central bank. By the way I want a central bank as a safe repository of electronic money only and nothing more. I don't think a central bank should try to influence interest rates or lend money like the current FED.
Such accounts would have no credit risk (like physical paper cash) but would have the benefit of being used in electronic transactions and be accessible by personal checks. Of course, a 100% reserve account would not earn interest but would most likely have monthly maintenance fees associated to it (similar to a safe deposit box; it would also be very much like the reserve accounts that banks have with the Fed).
Such accounts, if widely used, would lessen the impact of bank failures on the economy in terms of a contraction of the money supply, chaos and confusion--but would not completely eliminate them.


Lending involves business risks (credit risks). If a customer were to choose a non-100% reserve account then he would be subject to losing his money. This would force the public to do some homework before handing money over to a bank (in essence, customers would need to consider banks' credit ratings, quality of management, etc.).
Of course, in this type of setup, a non-100% reserve account would probably have to pay a higher interest rate than the fractional reserve accounts do today. In fact if the public had a choice of 100% reserve accounts, there would be no need to impose legal reserve requirements on non-100% reserve accounts. There would be a clear separation between accounts that have a credit risk and accounts that don't. The accounts with credit risk would need to set their interest rates high enough to attract depositors.

December 19, 2009 at 3:17 PM  
Anonymous Guy said...

Michael S,

I'm sort of confused. It sounds like you're saying that you match the maturity of your loans with the maturity of your time deposits completely. Meaning, for every dollar you owe to a time depositor at time T, you are owed a dollar at time T (or sooner) by a loanee, or you have a dollar in cash. Is that correct? Like you said, I don't know much about real world banking, but that still is hard to believe. I've never heard of 30-year CD's, but I have heard of 30-year mortgages, so I don't see how you can be matching your maturities 100%.

Also, why is it meaningful to say that the loan portfolio is maturity matched and the investment portfolio is not? If it's all on one balance sheet, then either the balance sheet is maturity matched or it's not. Of course you can divide the balance sheet up any way you wish. You can group your investments with your time deposits and then say that your investments are maturity matched. But the only thing that matters is whether the balance sheet as a whole is maturity matched.

December 19, 2009 at 6:00 PM  
Anonymous zanon said...

Walden: I don't know. I started at Mosler and winterspeak. Mosler has a bunch of "required readings" on his site. Maybe you can start there. Winterspeak is easier to read, but it's hard to find anything. Post Keynesians are crazy, but they know how banks work!

Michael: The reason I stress keeping reserves straight is that people think bank lending is reserve constrained when in fact, as you say, it is capital constrained. So you get all this nonsense about fractional reserve banking being this fraud, and no awareness about how credit extension creates reserves. The operational details you add about how some banks are not Fed Reserve members is interested are interesting, and as you say, at this point moot. I guess that operational design did not work out either.

People think that banks actually take deposits and lend them out (at a multiple) as loans. They do not realize that banks make loans, and the borrow at the overnight interbank market as necessary to meet reserve requirements. The loans, of course, creating reserves.

December 19, 2009 at 9:14 PM  
Anonymous Walden said...

zanon,

Thanks. Yeah I guess I'll start with Mosler's required readings. I just started reading Winterspeak recently, and I like his stuff so far. It's concise and to the point, but his archives are organized pretty badly so it's hard to navigate his posts on post-Keynesian econ and try to get firm handle on the major points.

BTW, I wonder what Mencius thinks about post-Keynesianism. Anybody know if he's ever mentioned it before or know his thoughts on it?

December 19, 2009 at 9:25 PM  
Anonymous zanon said...

Walden: I can't speak for Mencius, but I would guess he would say Mosler is an inflationist. That is technically accurate, but it would be more reasonable to call PKs anti-deflationist.

December 19, 2009 at 10:33 PM  
Anonymous josh said...

walden,

He is not a fan.

December 20, 2009 at 5:42 AM  
Anonymous josh said...

sorry, the link.

http://unqualified-reservations.blogspot.com/2009/01/gentle-introduction-to-unqualified_22.html

December 20, 2009 at 5:44 AM  
Anonymous Michael S. said...

Guy, commercial banks don't hold 30-year mortgages. That is a business in which Fan & Fred were and are big.

If a commercial bank makes any mortgages to hold in its own portfolio, they typically are 5-year mortgages, amortizing on a 30-year schedule, with balloon payments at the end of the term. This permits adjustment of the rate every five years, and the amount of five-year loans is - yes indeed - typically balanced against the amount of five-year and longer term CDs.

What you don't seem to be understanding about the role of a bank's investment portfolio is that, even if it consists of long-term securities (e.g., 30-year bonds) they are presumed to be available for sale at any time in a liquid market. Thus it is ordinarily appropriate to have the total of cash on hand & due from banks, plus investments, on the asset side, set off a roughly corresponding total of demand deposits on the liability side. Capiscite?

Bank liquidity crises occur when the presumed marketability of investments ceases to exist. So it was in 1929 and so it was in 2008.

December 20, 2009 at 7:14 PM  
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December 20, 2009 at 9:09 PM  
Anonymous Guy said...

Yes, I think I understand it now, thanks.

December 20, 2009 at 9:42 PM  
Anonymous zanon said...

Michael S:

The point that post-keynesians have to make about the banking system is that lending is capital constrained, not reserve constrained.

Therefore, changing the quantity of reserves in the banking system (as Bernanke has done) change interest rates (down to zero) but do not spur lending as that is driven by capital and demand from credit worthy borrowers.

By reserves, I mean the reserves posted at the Fed as per regulatory requirements, traded on the interbank market, and if needed, borrowed from the discount window. Not "set aside" reserves in case a loan goes bad.

Yes?

December 20, 2009 at 10:38 PM  
Anonymous Cal said...

The point that post-keynesians have to make about the banking system is that lending is capital constrained, not reserve constrained.

What are you referring to by "capital" here? Do you mean that theoretically lending is constrained by all the capital in the entire economy, rather than quantity of reserves held at a particular bank or banks?

Are the PKs claiming something along the lines of: the banks are basically agents of the State, the State has total command of the fiat currency which is managed and created through the banks and other facilities, the fiat currency naturally can be and is used to buy/sell goods/services in the real economy, therefore theoretically lending through the banks is ultimately limited to the amount of capital in the entire economy (since the fiat currency it wields can theoretically command real goods/services)?

December 20, 2009 at 11:49 PM  
Anonymous Pals said...

"What you don't seem to be understanding about the role of a bank's investment portfolio is that, even if it consists of long-term securities (e.g., 30-year bonds) they are presumed to be available for sale at any time in a liquid market."

Michael, what you don't seem to understand is Maturity Transformation. If you have to rely on selling these things to meet depositors, and on there being a liquid market, then you're doing MT. The reason, as even mainstream Keynesian Minsky would tell you, is that this becomes profitable for you, and for others and so they indulge in it more and more and more, until it becomes too over-leveraged, and someone comes to ask for their money and selling the paper on the market doesn't fetch the needed price. Hence the "liquidity crisis".

Relying on "liquidity" to meet obligation is a self-defeating strategy. The more it succeeds, the more inevitable its eventual demise into a liquidity crisis. A non-MT bank never faces this problem.

December 21, 2009 at 2:36 AM  
Anonymous zanon said...

Cal: Neither. I'm referring to the legal requirement that a bank can only have assets (receivables) up to a certain % multiple of their equity (another balance sheet entry). This is a legal requirement, and is sometimes even enforced.

December 21, 2009 at 8:26 AM  
Anonymous Michael S. said...

Pals, I did not say there was no maturity transformation. I said that if maturity transformation took place, it was in the investments rather than in the loans. So just where do we disagree?

MM is fond of quoting old references, and (in general) I like them and find much in them to be insightful. However, Bagehot's "Lombard Street" formulation of maturity transformation, viz., that banks borrow short and lend long, is not an adequate summary of the problem as it occurs in modern commercial banking. Let us recall, first of all, that one principal function of banks in the nineteenth century was the issuance of bank notes. This has completely disappeared. The modern distinction between time and demand deposits is an artefact of twentieth-century bank regulation. The amortizing mortgage is another. These and many other changes have taken place. Banking today is not at all like what it was in Bagehot's day.

If we want to understand the how and why of the present economic circumstances, we must understand the way in which commercial banking participated in them. It is simple minded to suggest that they came about because banks borrowed short and lent long.

Funds management in commercial banks tries to balance the maturities of deposits against loans, and (in my observation) does so successfully. The problem does not lie in loans being for longer terms than deposits. It lies in the faulty presumption that available-for-sale investments (of whatever term) will in fact be saleable when the demand for liquidity arises.

The mortgage lending business is not a major part of commercial banking. To start with, over 50% of the residential real estate mortages in the U.S. are held by Fannie Mae, Freddie Mac, or the FHA, or have been bundled by them into mortgage-backed securities. A substantial non-bank private mortgage industry also developed outside the constraints of commercial bank and thrift regulation (e.g., Countrywide Financial). Capital requirements and other aspects of regulatory supervision for the GSEs and the private non-bank mortgage industry were looser than bank regulations, because these non-bank operations did not take deposits from the public. Neither did the GSEs make direct loans. They bought them from mortgage originators. The funds used to buy these loans were raised by the sale of securities.

Commercial banks were among the purchasers of those securities, which regulations gave them a clear incentive to prefer as assets over direct loans (as I have already pointed out). Therefore, to the extent there is any maturity transformation in commercial banking it is what has entered into their investment portfolios through these long-term securities, rather than through long-term loans (which commercial banks don't normally make). The fault of the securities, though, is not their long terms (or the long terms of the mortgages with which they are collateralized). It is instead, first, that their underlying collateral was unsound, and second, that when this unsoundness became apparent, the liquid market for them collapsed. Ergo sunt lacrimae rerum.

The comparatively minor and derivative role of commercial banking in the inflation and subsequent burst of the real estate bubble can be seen in the loss data I have already quoted for Fannie, Freddie, and FDIC-insured banks and thrifts. In the past four quarters, Fannie & Freddie together lost $120.1 billion, all directly chargeable to the taxpayer. Aggregate losses for the more than 8000 FDIC-insured institutions were $19.9 billion, about 16% of what the two GSEs lost all by themselves. Of course, many commercial banks have remained profitable throughout this period because they had no part in the mortgage-backed securities debacle.

December 21, 2009 at 11:22 AM  
Anonymous Michael S. said...

Zanon, the 'reserves' represented by a FRB member bank's stock ownership in the Fed will be found on the asset side of its balance sheet, in its investment portfolio. The same may be said of the required stock purchase made by banks & thrifts that borrow from the Federal Home Loan Banks.

What these assets really represent is something akin to the old sort of arrangement in which a bank customer who had a credit line was required to keep a 'compensating balance' on deposit. Thus, if you (say) has a $100,000 credit line but were required to keep a $10,000 compensating balance, all that meant was that your real credit line was $90,000. Since non-member institutions now have access to the discount window the relevance of FRB stock ownership is no longer very significant.

The FRB stock held by a FRB member bank represents the historic successor to specie (gold bullion and coin) held by a commercial bank as a partial reserve against that bank's private bank notes. This system was supplanted by one in which commercial banks holding national charters could place bonds on deposit with the U.S. Treasury, and were entitled thereby to issue "national bank notes" up to 90% of the bonds' value. There was a brief period between the creation of the FRB and the onset of the Great Depression when these national bank notes circulated alongside Federal Reserve notes, U.S. notes, and gold and silver certificates, but the issuance of national bank notes ended in 1935, and with it, the ability of any commercial bank directly to create money.

The lending capacity of a bank is today a function of its capital (i.e., capital paid in by stockholders, plus surplus, undivided earnings, and certain other monies). There are several ways to categorize capital but the most common is Tier I capital. A bank is considered well capitalized if it has a Tier I capital to assets ratio of 8% or greater.

December 21, 2009 at 11:48 AM  
Anonymous zanon said...

Michael S: I very much like the points you made about how banks today are very different from banks in the past. Fiat regimes are very different from convertible/bullion etc. regimes.

Let me be crystal clear with you to make sure we're on the same page re: reserves. Here is my understanding of how loans and reserves work in a bank that has a reserve account:

1. creditworthy customer asks for a loan
2. bank has sufficient capital to make loan.
3. bank makes loan to customer by crediting a receivable account and debiting a reserve account.
4. deposit gets deposited somewhere, which credits a deposit account and debits a reserve account
5. if loan and deposit are made at the same institution, the reserve debit and reserve credit cancel out, no change.
6. if loan and desposit made at different institutions, then the short institution borrows what it needs from the long institution overnight in overnight interbank lending market.
7. if system as a whole is short of deposits, it goes to discount window.

Would you agree?

December 21, 2009 at 1:24 PM  
Anonymous Michael S. said...

Zanon: When a bank makes a loan to a customer, the bookkeeping entry reflecting the transaction moves the amount in question from cash on hand & due from banks to the loan portfolio. This is simply a transfer of funds from one asset account to another. It does not affect the footing.

If the customer spends the cash or does not, at any rate, redeposit it in the same bank, this is the only immediate effect the loan has. As time passes, the bank accrues interest on its books, and as the loan is paid down, both the principal and interest thus paid move from loans receivable and interest receivable back to cash on hand & due from banks. The interest is reflected as it accrues as gross earnings on the P&L statement, from which expenses of operation are deducted to arrive at net earnings.

If the customer should deposit some of the proceeds of his loan in an account at the same bank that made the loan, that increases deposits on the liability side of the bank's balance sheet and creates an offsetting increase on the asset side in the cash on hand & due from banks account. Footings on both sides are increased by the amount deposited. They will both be diminished as the customer draws checks or cash out of his deposit account.

If the customer deposits the proceeds of his loan at another bank, that bank creates a deposit account on its liability side and adds to the total of cash & due from banks on its asset side.

The "& due from banks" portion of the account title of cash & due from banks reflects the amount of money that is at some point in transit between a bank and the institutions on which checks have been drawn that are deposited in it. In other words, if you give me a check for $100 on Monday, I deposit it in my bank that same day, and it does not clear your bank till Wednesday, that $100 is due from your bank to mine until it clears. Once it clears it is, properly speaking, cash on hand.

The ability of any given bank to make loans is conditioned first on its having sufficient deposits, and the capacity to maintain both, on its having adequate capital to maintain the proper ratios. Liquidity is assured by having sufficient deposits on its liability side, and sufficient funds on the asset side as cash or as available-for-sale investments. Funds are sufficient when they are enough to meet immediate demands from depositors and then some. The 'then some' is an important function of bank capital.

If a bank does not have sufficient liquidity, it can "buy fed funds" from banks that have surplus liquidity and want to make a bit of interest on it by "selling fed funds." A bank that buys fed funds is basically acquiring a type of liability akin to a short-term deposit, and one that sells fed funds acquiring an asset akin to a short-term loan. This is normally done in preference to going to the discount window, which is done as a last resort.

The 'multiplier' that determines how much money can be created by lending is thus really founded on the amount of capital the regulatory agencies deem appropriate for a lender to have, rather than on the 'reserves' about which economics textbooks speak.

The FRB's ability to affect the money supply is not exercised in practice by raising or lowering reserve requirements but rather by setting the discount rate. You may well recall the days of Regulation Q, which used to set the maximum interest rate a bank or savings-and-loan association could pay on time deposits, and state usury laws, which set the maximum interest rate a lender could charge borrowers. These have gone the way of Nineveh and Tyre, and the FRB's ability to move the discount rate up or down serves as an effective price control both on the cost and on the price of funds. Banks can, or at least try, to make money on the spread between the two. As long as there is a spread, within due bounds it does not matter what the rates are.

December 21, 2009 at 3:05 PM  
Anonymous Michael S. said...

(continued)

The salient point to make is that the development of a large non-bank financial sector, and the phenomenon of disintermediation (the flight of retail customers from customary financial intermediaries such as banks & thrifts) have allowed a large pool of credit to come into existence outside the purview of the FRB, FDIC, Comptroller of the Currency, and state banking regulators. The real-estate bubble resulted from this effective creation of money and could not have happened without the connivance of politicians.

To propose that the remedy for what has happened is to destroy and replace commercial banking with some creation of abstruse theory is like suggesting that the remedy for a flooded basement is to raze the house to its foundations instead of fixing the leaky plumbing. It recommends a drastic treatment for a malady that the prescriber has not understood.

December 21, 2009 at 3:15 PM  
Anonymous zanon said...

Michael S: Your description of bank lending, then, is different from the post-keynesians. And they pride themselves on being the only people to get this right, so probably someone is in error. In particular, you say:

"The ability of any given bank to make loans is conditioned first on its having sufficient deposits, and the capacity to maintain both, on its having adequate capital to maintain the proper ratios."

I am with you 100% re capital. There is a disagreement re: deposits.

What you're saying is that if a credit worthy customer came into your bank (which has a reserve account), asked for a loan, and you had capital (but were short deposits) you would turn them down? Really? Would you have them wait and see if you might be able to drum up some deposits so you could make this profitable loan?

PKs would say that the bank would just make the loan, whatever its reserve position happened to be at that moment. Then, they would borrow what reserves they needed overnight for regulatory compliance either at the discount window, or, more likely, at the overnight interbank lending market.

In this model, deposits (and reserves) place no limit on bank lending (capital of course, does). Moreover, the money to "fund" loans comes from banks inflating both sides of their balance sheets (asset and liability) and NOT from debiting one asset to credit another.

Later on in your post you talk about how the multiplier is really about capital, not reserves, which I agree with and which agrees with what I say above. I cannot get that to agree with what YOU say earlier in your post, when you talk about "deposits" being a limit.

December 21, 2009 at 3:44 PM  
Anonymous Michael S. said...

Zanon: further on 'banks that have a reserve account' - do I understand you to meanby this, FRB member banks?

I think there may be some confusion here between the clearing role of the Federal Reserve System and its role as the holder of member banks' reserves in the form of FRB stock.

All banks clear the checks drawn on other banks that have been deposited with them either through correspondents or through the Fed. There has been at-par clearance of checks drawn on non-member banks for perhaps 50 years. They all have accounts to clear through the Fed, and use them except when clearance through a correspondent is more convenient. The role of correspondent banks is much less important in this process than it used to be.

In either case it is facilitated by the maintenance of a demand deposit account, whether with the correspondent or with the Fed. If A's bank is not a direct correspondent of B's, and A issues B a check, or B issues A a check, when the check is deposited in one or another of their respective accounts, the depositary bank will add its endorsement and forward the check to its correspondent or to the Fed for deposit in its account. The correspondent or the Fed will then collect the check from the drawer's bank by charging that bank's account, and the drawer's bank will charge its customer's account.

The amounts kept in these clearing accounts by the banks are reflected as assets in their respective cash on hand & due from banks accounts. They must be sufficient to prevent overdraft. These assets are part of a bank's ordinary working capital, just as the cash in a retailer's till is part of his working capital.

Such clearing accounts are distinct from the FRB stock held by an FRB member bank, which has to be viewed as more in the line of a long-term investment, and is not readily available for sale. This stock is, properly speaking, the 'reserve' of the econ textbooks. As I've earlier noted, there's little benefit to FRB membership today, since at-par clearing through the Fed and access to the discount window no longer require it (even stock brokers and money market funds can now use the discount window!). The major remaining benefit of a national charter, and accompanying FRB membership, is that it gives a bank the ability to branch across state lines. I suppose that if the FRB stock ownership requirement were structured properly, it might force bigger banks to operate with capital sufficient better to guard against their risk of failure, they being 'too big to fail.' Of course this isn't the case - cf. Citi!

December 21, 2009 at 3:48 PM  
Anonymous Michael S. said...

Zanon - obviously there must be a source of funds for lending. If not a deposit, what? You can buy deposits - there is a big market in brokered CDs. You can borrow from the Federal Home Loan Bank in order to make residential mortgages. A loan from the FHLB shows up on the liability side under a different heading, but it's functionally the same thing.

No bank will make a loan on which it cannot make money, no matter how sound the borrower's credit. If a bank does not have sources of funds at sufficiently low cost that it can make loans at a sufficient interest rate to yield a profitable spread, it's better off not to make loands.

It is amusing to read in the press how the politicians wish banks would make more loans, when in fact our problem is that there is almost no loan demand, and it's very hard right now to find enough profitable vehicles in which to put the funds depositors have placed with banks. This is a product of the extremely low level at which interest rates have been maintained by the FRB. What are you getting on passbook savings at your bank right now? Do you wonder why?

December 21, 2009 at 3:57 PM  
Anonymous zanon said...

Michael S: When I said "banks that have a reserve account" I merely meant banks that had access to the discount window. I wanted to distinguish it from the shadow banking system, although these days the line is not clear.

"obviously there must be a source of funds for lending. If not a deposit, what?"

This is where you and the PKs split company. I'm not sure how functionally involved you were with this part of your banks operations, but I've spoke with people who did this and they tie in with what the PKs say.

The PKs say there is no source of funds for lending. The banks just expand both sides of their balance sheets, creating the money out of nothing. The credit a receivable (asset) and a deposit (liability). If the receivable and deposit are at the same bank, then that's it. If they are different banks, each borrows or lends what it has to through the overnight interbank market to meet reserve requirements.

So, the causality runs like this:
The loan CREATES the deposit (subject to capital requirements and creditworthy borrower demand)

The bank then borrows (or lends) the reserves it needs to overnight via the interbank market to make its regulatory requirement. If the sector is short reserves, it borrows them from the discount window.

I've gone through the operational mechanics and accounting of this and it seems sound.

December 21, 2009 at 4:55 PM  
Anonymous zanon said...

Michael S: You and I totally agree that the low levels of lending are a demand problem. The people who need money cannot pay it back! Lending is pro-cyclical, Obama does not need to understand this.

I am getting ZIRP on my passbook savings because the Fed has set interest rates at zero. Fed can set FFR wherever it wants.

December 21, 2009 at 4:58 PM  
Blogger JR said...

You're talking about capital requirements, which is how many liabilities the bank can pile onto its equity base. The max is set by Govt also.

Since banks do not lend out reserves, the quantity of reserves tells you nothing about inflation.


Isn't/hasn't the FED been monetizing debt to remove risky assets from bank balance sheets to improve bank capital ratios. Does this not show up as excess reserves?

December 22, 2009 at 11:24 AM  
Anonymous Transhuman said...

Mencius Moldbug will be debating Robin Hanson about futarchy at the Foresight Conference 2010 on Saturday, January 16, 2010. Tickets are available at Ticketmaster, and the debate will be live on pay-per-view on HBO.

December 22, 2009 at 11:34 AM  
Anonymous zanon said...

JR: In a fiat currency world, the Fed always "monetizes debt". You need to debit a reserve account, and credit a Treasury account to buy a Treasury. When the Treasury matures, you reserves the transaction. This is another one of those things that really hasn't translated well.

The Fed has essentially begun to lend unsecured to banks by accepting whatever garbage as collateral for reserves. Since its' Govt money on the other end if a bank goes bust, this actually seems like common sense.

Yes, it would show up as excess reserves if they weren't drained by issuing Treasuries (see above)

December 22, 2009 at 1:41 PM  
Anonymous Michael S. said...

JR - you should look at a bank's balance sheet some time. You can get your bank's call report on the internet. You will not find the kind of 'reserves' on it that economists talk about. You will find loan loss reserves, and reserves against certain contingent liabilities where they may exist, etc.

Zanon, I think I see what you mean about deposits, though in practice the circumstance you are describing very seldom occurs. The reason is that typically a bank is never completely 'loaned up,' i.e., its loans are some fraction of its deposits and it has room to make additional loans without needing additional deposits. I do not think my bank has ever been more than 80% loaned up since it was founded in 1914.

Being completely loaned up is a banking condition comparable to that of an hotel with no vacancy. In either case, the business cannot lend/rent to any new customer because its extant resources are entirely occupied. Where the hotel would have to build new rooms, the bank has to buy new deposits (i.e., brokered CDs), borrow from other banks, go to the FHLB, or as a last resort to the Fed's discount window. One way or another, it is acquiring new liabilities to match the new assets (loans), and its ability to do both is dependent on its having adequate capital to support them.

What is deadly to a bank is for enough of its assets to turn bad that the amount that must be written off exceeds loan loss reserves, at which point capital takes the entire brunt of the loss. Let us suppose we have a bank with $100 million in assets and $9 million in capital. It is well capitalized. However, let's suppose $3 million in loans must be written off beyond available loan loss reserves. Although this amount is only 3% of assets, it is 33% of capital, and now the bank has $6 million in capital. It is no longer going to be considered well capitalized; its FDIC premiums rise, regulatory supervision becomes more onerous, and it is now in some trouble. Let's say another $2 million in loans go non-accrual, or (more likely) the big block of Fannie Mae preferred stock in the investment portfolio turns out to be worthless. Next thing the FDIC is there on Friday afternoon, and come Monday there will be a new sign in front of the building.

December 22, 2009 at 3:57 PM  
Anonymous zanon said...

Michael S:

OK -- we are getting closer. Let me ask you this -- is being "loaned up" a function of capital, or reserves (fractional reserve banking) requirements?

The capital requirement case is very clear. SIVs and other off balance sheet vehicles that were not, along with awful corrupt regulations, enabled banks to be more than "loaned up" in the boom.

With reserve requirements, borrowing from other banks, overnight, IS the interbank market, and it is how the FFR is set.

I totally see how a bank may prefer not to do it, as it drives up the cost of capital and hence decreases ROE. Nevertheless, so far I have not found anything that says that reserves constrain lending, and we are in total agreement about how capital constrains lending.

Maybe you have not thought about this at a system level before. Based on our discussion, do you see (capital willing) how lending CREATES the deposits that then "fund" that lending? Either directly or indirectly.

December 22, 2009 at 4:53 PM  
Anonymous zanon said...

Michael S: Just to stress the point about being "loaned up".

Suppose you had a brand new bank, freshly capitalized, with no loans or deposits on its books.

Are you saying that it would be UNABLE to make a loan until it took in some deposits? Certainly it has plenty of capital!

Maybe making the loan would be a bad idea, it should focus on deposits first as they would reduce CoC etc. But the question here is whether this new bank, with no deposits, can make the loan.

PKs say absolutely.

Moreover, if that loan was deposited at that same bank, then you'd have no net change in the reserve account, a receivable, and a deposit (liability) with the loan CREATING the deposit.

December 22, 2009 at 9:34 PM  
Anonymous Guy said...

Michael S,

Your explanation of real world banking is very helpful - these are the details they leave out of econ textbooks and Wikipedia articles, and they're good to know.

What is kind of surprising to me is that banks are strict about matching their maturities on their loans, but not their investments. I mean, what's the point? If you really want to mismatch maturities, then it should be easy to do it across the whole balance sheet. Simply securitize your loans so that they're marketable, and you're good to go. All of your assets can be used in maturity transformation. It's a mystery to me that banks don't do this already.

Also, why do you think a maturity matched banking system would destroy commercial banking as we know it? If banks already match maturities in their loan portfolio, all they would have to do is extend that prudence to their investment portfolio. Nearly all of the important functions of banks would remain.

Finally, you say (referring to mortgage backed securities) "their underlying collateral was unsound, and second, that when this unsoundness became apparent, the liquid market for them collapsed." You may already agree with this, but I want to point it out anyways: the reason that the liquid market for the MBS's collapsed was because the demand for them came from maturity transformation.

In a normal, non-MT market, if an MBS is discovered to be unsound, all that should happen is that the security takes a one-time haircut. This is because the market demand for future dollars has not changed; the only thing that has changed is the amount of future dollars a given MBS can be expected to yield.

However, MT demand is different. MT demand is channeled from people who don't actually want to hold on to long term securities. Whereas the security has a term of 30 years, they only desire to invest for 3 months. They are willing to do this because they are confident that in 3 months they (or the institution they've invested with) can sell it.

This means that in an MT market, an individual's demand for a security is not merely contingent on his own personal valuation of the stream of future dollars it represents, but also the market's valuation. Because, he must be confident that in 3 months he will be able to sell the security on the market at a good price.

In other words, MT is a coordination game that only works if everyone is MTing together. Once a security takes a decent sized haircut, it becomes harder to coordinate knowing that, not only did the price just fall, but everyone else just saw it fall. The security loses some reputation, which is important to MT demanders. Thus, the security loses even more value to them, further depressing the price. Eventually, once the price falls far enough, the security is denominated as "frozen" or "toxic," and it becomes impossible to coordinate around. MT demand disappears.

Nothing like this can happen without MT. If an investor is holding on to a 30-year security because he actually wants a 30-year security, then it makes no difference to him what the market thinks of it. If the price goes down some, he might imagine that investors are losing confidence in the security, and that soon it's price will crash. But so what? He plans on holding to maturity. If the security is ever revealed to be "unsound", and the price falls further than the haircut that is necessary to account for the newly discovered unsoundness, then his demand for the security actually goes up, since he is now getting a better price.

Again, you might already agree with this. But I have seen people claim that this crisis was caused solely by unsound loans, and that MT had nothing to do with it. I think that without MT, there's no way this crisis could have been this deep or protracted.

December 22, 2009 at 10:27 PM  
Anonymous Michael S. said...

Being completely loaned up happens when the percentage of deposits represented by loans is 100%.

A de novo bank, freshly capitalized, will attract both depositors and borrowers, though not necessarily in proportion. A typical strategy of a de novo bank to deal with this is to buy deposits (brokered CDs) so it can make loans. There is more risk in this than in obtaining deposits the normal way, because brokered CDs are not stable deposits ("core deposits"). Because of this, the regulatory capital requirements for de novo banks are considerably higher than those for established banks.

It is also possible to take long-term loans from the FHLB to make mortgages, but there is usually not enough spread in this to make it profitable as a main source of funds. The same is true of trying to lure depositors away from other banks by offering higher rates on time deposits. If this is combined with an effort to lure borrowers with lower rates on loans, it's a sure recipe for losing money. Several de novo banks have failed for this very reason in my bank's market area.

In a de novo bank with mainly brokered deposits I suppose the circumstance could arise in which the withdrawal of a big CD could lead to the appearance that the bank was (say) 105% loaned up, i.e., was in the position of having effectively part of its capital tied up in loans. However, the operator of the bank would quickly move to buy offsetting deposits or borrow from other banks, and the position would be quite transitory.

December 23, 2009 at 10:11 AM  
Blogger Игры рынка said...

everyone who is interested in MMT (or post-Keynesean) go to http://bilbo.economicoutlook.net/blog

easy reading and frequent posts

December 23, 2009 at 10:46 AM  
Anonymous Michael S. said...

The reason that the market for mortgage-backed securities collapsed was not that they represented a maturity transformation. It was that a good many of the mortgages represented by the securities were no longer accruing.

A credit is only good as long as the debtor is servicing his debt. Think of credit cards as an example. Nothing in the retail credit market is as short-term as credit card debt. It's nominally a 30-day (approximately) extension of credit; many people pay off the whole balance every month. Others let a portion roll over from month to month as a revolving charge account. On a bank's or other creditor's book, these obligations show at face value until a debtor misses his payments; then they might be watch-listed and if no resumption of payments is forthcoming, become non-accrual assets for the creditor, who has to write them down and take a loss to reserves at that point.

The same thing that is true of these very short-term credits is true of a residential mortgage. What keeps it at face value on the lender's books is that it is being serviced. Other assumptions about the borrowers creditworthiness are as at the time the credit was extended. Even if his circumstances have changed dramatically there is no way for the creditor to know until the debtor stops servicing his debt.

The collapse of mortgage-backed securities, and with it, residential real estate values, began in 2007. You will recall that the Fed lowered interest rates in 2001 following the 9/11 attacks, in response to fears of recession. Many borrowers in ensuing months took adavantage of the low rates then available to buy houses using 5-year mortgages on a 30-year amortization schedule, with balloon payments at the end of the term which would normally have been re-financed with another 5-year mortgage at whatever the current rate was at the time of refinancing.

By 2007, the FRB had raised the discount rate by something like 350 basis points from its 2001 low. This caught up with customers who had bought houses in 2002 at mortgage rates blow 4%. When they came to re-finance for the second 5-year term, they found that prevailing rates were at about 7%. As you will see if you do the arithmetic, the first five years of a 30-year amortization schedule do very little to pay down principal. Further, re-financing the remaining principal at a rate 350 basis points higher than what prevailed for the first five-year term will more than double the monthly payment.

What makes a house affordable or not to the typical buyer is not its price (which determines the principal of the mortgage), but rather the monthly payment. By mid-2007 many householders found they could no longer afford the monthly payment at the re-financed rates. Those people put their houses on the market. Soon there were more houses for sale than there were willing buyers at their asking prices, so prices began to fall. This in turn undermined the collateral value on which loans had been made.

We must understand that under the market-dominant regime of Fannie Mae and Freddie Mac, a "qualifying loan" (i.e., qualified to be purchased by Fan or Fred) was any loan up to $417,000, with maximum loan-to-value of 97%. Thus many borrowers had bought houses in the low to high-middle price range with no more than 3% down payments. Their equity in these houses was quickly destroyed by falling real estate values. They were effectively in the same position as people who had bought stocks on margin were in October 1929.

As mortgage borrowers walked away from houses, service on those mortgages stopped, and hence the income stream of mortgage-backed securities. The market for the latter then essentially ceased to exist for a period because there was no way to know the value of the underlying assets.

.

December 23, 2009 at 10:51 AM  
Anonymous Michael S. said...

(continued) Maturity transformation is not the explanation of this bubble and burst any more than it was of similar episodes in the past. Liquidity crises can arise with very-short term credits (the 'call money' used to purchase stocks on margin), as in 1929 or 1907, or with long-term credits, as in 2008. Behind all these bubbles was a rise in the prices of the assets financed, due to loose monetary policy, and behind all of their bursts, a shift towards tighter monetary policy.

Interventionist government monetary and fiscal policies have been advocated for decades as tools to even the peaks and valleys of the business cycle, which theorists used to blame on the inflexibility of the gold standard and the periodic withdrawals of liquidity it occasioned in correction of trade imbalances. I think the argument can be made, on the basis of recent experience, that the interventions have instead reduced the frequency of the cycle at the expense of increasing its amplitude.

The collapse of 2008 took place in the secondary mortgage market, which originated in 1938 by the Federal government's creation of Fannie Mae, and which has been dominated continuously since then by government-sponsored entities. Let us place the blame where it belongs.

December 23, 2009 at 11:04 AM  
Blogger Игры рынка said...

Michael S is partialy right about how banks operate with regard to MT. Zanon has a lot of light on reserves.

Let me try as well and I start with reserves. Today is the end of the year and most banks should have plans for the next year. When you do such a plan you start with goals. For simplicity lets say your goal is to increase assets by 10%. This goal is approved by the Board and then pushed down to business units for execution. NOWHERE, and I repeat, NOWHERE it is discussed whether there will be enough deposits to satisfy this 10% growth.

Lets go to another side. You are a credit officer sitting in the retail (or wholesale) office in the middle of nowhere. Suddenly a nice customer pops up and he wants a loan. NOONE, and I repeat, NOONE is going to call ALM department or Treasury (or whoever is responsible) in the head office and ask whether the bank has enough deposits at that point of time. The officer simply grants this loan.

So the issue with reserves/deposits/loans is clear.

Lets turn to MT and why Michael S is partially right. Banking by definition makes money from structural contribution. In a normal speak this stuff describes the steepness of yield curve. If maturities on balance sheet match 100% then bank is a simple aggregation business and it is questionable whether it makes sense. So maturities do NOT match and it is not only about liquidity portfolio but the whole BS. However, it also does not mean that there is a 100% mismatch. Each bank finds its own balance between ON funding and term deposit funding and it is part of business model.

There is also the topic of Transfer Pricing with F in front of it (standing for Funds). Any bank (or company for the same sake) with more than one office has a transfer pricing system by which it can steer particular time buckets of both sides of its balance sheet. In our bank it is discussed monthly and the reason is volatility. Previously we did it quarterly with very little changes

December 23, 2009 at 11:12 AM  
Anonymous Michael S. said...

I have sat in many bank board meetings and I do not recall discussing how to raise deposits. That's never been something we've had to worry about; as I said earlier, I don't think my bank has ever been more than 80% loaned up. In recent months we have seen more deposits flow into our bank (the so-cslled 'flight to quality') and it has been hard to stay more than about 72-73% loaned up.

I have no insight from personal experience into how someone who was close to being 100% loaned up might think about the problem. I have witnessed other institutions try to deal with this problem. There used to be a savings-and loan in our market whose CEO decided to offer a CD interest rate 100 basis points higher than anyone else in the area. He raised a lot of expensive deposits, for which he then had to pay by making high-interest, hence riskier, loans. His S&L went bust and the remnant of it is now owned by one of the big nationwide banks.

December 23, 2009 at 12:58 PM  
Anonymous zanon said...

Michael S:

OK, so you and the post-Keynesians disagree. PK's would say that a brand new bank need not get any deposits, via brokered CDs or anything else, in order to make loans. They say the bank can just make the loan even if it has zero deposits.

Thank you for shedding light on the fact that banks do try to balance maturities, at least to some degree.

btw. glad we agree on awfulness of brokered deposit business.

December 23, 2009 at 12:58 PM  
Blogger Игры рынка said...

1. Liquidity portfolio is there to satisfy deposit creation as well as deposit withdrawal.

2. You might say that being 80% loaned-up is efficient. Others might say it is not and even more - it is very expensive. It depends on your business model and market. If deposits run at 10% pa, would you still be 80% loaned-up or you would try to increase it?

3. Loans and deposits are correlated and this is given. But correlation does not mean causation. And it also does not tell us what comes first.

December 23, 2009 at 1:45 PM  
Blogger Игры рынка said...

and btw the same principles of money apply internationally which is the reason I skipped all brokered deposits and FRB institution discussions. I mean all those points are irrelevant :)

December 23, 2009 at 1:48 PM  
Anonymous zanon said...

Игры рынка said...

" 3. Loans and deposits are correlated and this is given. But correlation does not mean causation. And it also does not tell us what comes first."

Exactly.

Michael S (and most people) say causation goes deposits -> loans.

PKs say it goes loans -> deposits

December 23, 2009 at 2:01 PM  
Anonymous Michael S. said...

Zanon, I agree with our Russian interlocutor on his point 3. Deposits and loans are correlated, but causation does not proceed necessarily in one direction or the other. If we make loans and need deposits to cover them, we get the deposits. If we have deposits, we need to make some loans in order to pay for the deposits. Banks need to have both. A bank may create some deposits by its lending activity, but the nature of loans is that they are used for some purpose by the borrower that takes the money out of the bank. No one borrows money just to deposit in in an account at the lending bank! So, some deposits have to come in the door or be brought in it at some point.

A lending officer is not, of course, going to have authority to lend so much money that when a customer comes in the door and wants a loan, it will necessitate his calling to see if there are sufficient deposits to make it. Their sufficiency will be made sure by his superiors. If his loan is too big for him or any internal management to approve, it will go to the discount committee of the Board which will be quite aware of how loaned up the bank is, as well as of all sorts of other criteria that will determine whether the loan can be made. At some point a loan request runs into the bank's legal lending limit (the maximum amount a bank is permitted by regulators to lend to any given customer). Well before this level is reached, judgment on the credit will be up to people who are quite aware of whether or not there is money enough to fund it.

Of course how loaned up your bank is depends on your business model and market. It also depends on what allows you to sleep at night. As to the question of whether being 80% loaned up is efficient in a market where the cost of money is 10%, my recollection of the Jimmy Carter years (when inflation was high and interest tried to be higher) is that our bank was less loaned up then than it is now. It was a great time for banks to sell fed funds and do other short-term investing, and very tough for the long-term borrower.

December 23, 2009 at 2:33 PM  
Anonymous zanon said...

Michael S:

Russian? I thought it was Greek!

It's fine for you and the PKs to disagree. I'm just pointing out that you are.

PKs will say that the quantity of deposits IN NO WAY, EVER limits the ability of a bank to create a loan. Capital requirements certainly do (as we agree).

At a Macro level, across banking as a sector, this is certainly true because of how the overnight interbank lending market connects reserves.

At a Micro level, at individual banks, I can see how a bank might turn to other sources before turning to the overnight interbank market. I think this is what you're talking about when you say "get the deposits". For example, you might make a loan, and then decide to sell a CD to get some deposits. But you don't have to. You could, if you wanted, just borrow what you needed from some other bank on the interbank market.

Therefore, according to the PK argument, since getting deposits is always an option, but never a requirement, the causality runs loans -> deposits. And bank lending is never deposit or reserve constrained, always credit and capital constrained.

December 23, 2009 at 3:01 PM  
Blogger Игры рынка said...

lol. I am neither. Just happen to speak Russian.

Michael S:
"No one borrows money just to deposit in in an account at the lending bank!"

Let me put it this way:
No one collects money just to pay depositor some interest

Since you agreed that in real life the Board decides on loan growth and never discusses the availability of deposits we could technically close the whole discussion. The rest is just fantasy of fractional reserve system proponents like Bernanke who never spent a single day in real business.

Deposits are no driver or constraint on loan growth. However if you want you can always have more deposits than actual loans. We all know that cash is a valid asset class. Finally, each bank keeps some collateral buffer at the central bank (from its liquidity portfolio). And should it run low on deposits at the end of the day/reporting period, it can simply buy ON deposits from CB.

Very interesting discussion!

December 23, 2009 at 3:47 PM  
Anonymous zanon said...

Игры рынка

LOL! Well said.

I don't know what's more ridiculous. Obama/Bernanke whining about why banks aren't lending out all their reserves, or Austrians arguing that our current system is bad because it maturity mismatches by lending out short term deposits to fund long term loans.

UR is about seeing things as they are. A pity that does not seem to include accounting.

December 23, 2009 at 3:55 PM  
Anonymous Michael S. said...

Zanon -

If our fellow conversationalist here is not Russian, his name is at least in the Cyrillic alphabet. Perhaps he is a Bulgar or a Serb. If it were Greek, I'd know how to read it; as it is, all I can do is to recognize it.

I suggest the reason a bank would not go to the overnight interbank market to fund a loan is precisely to avoid what Bagehot said was typical banking practice - lending long and borrowing short. A bank wants to balance - not, perhaps, perfectly, but certainly approximately - the duration of its loan portfolio with the duration of its deposits. Every banker I know would shy instinctively from funding a loan that might be of several months' or years' term with overnight borrowings such as fed funds. They are used just to plug holes in the balance sheet, and then only for a short while.

Considered as a system it may appear that bank loans appear to lead to deposits rather than the other way around. At the level of any given bank in the system, this is hardly the case. Furthermore, deposits do not simply materialize ex nihilo; they have to come from somewhere. Capital is the constraint on how much of either loans or deposits a bank may have, but the constraint - the capital-to-assets ratio has not been uniformly applied.

And so we come back to the point I've tried to make earlier, which is that non-bank financial institutions - the two most important being de facto operations of government, Fannie Mae and Freddie Mac - were created for the express purpose of carrying out bank-like functions with a fraction of the capital that would have been necessary had they legally been banks, and were given privileged access to investment funds based on ratings they did not deserve. Their extremely leveraged positions pumped money into the housing market, inflating the prices of residential real estate. The process fed upon itself as higher real estate prices permitted more credit to be extended against collateral that now appeared to be worth more. Was this money creation? If so, where is the money now? Où sont les neiges d'antan?

December 23, 2009 at 3:57 PM  
Blogger Игры рынка said...

Michael S.

This document from BIS is a nice read in its entirety but please go first to page 27 and read a couple of paragraphs and please note that they talk from perspective of central banks

http://www.bis.org/publ/work292.pdf?noframes=1

December 23, 2009 at 4:08 PM  
Anonymous zanon said...

Michael S:

I agree with your characterization of Fannie and Freddie.

I disagree with your statement that deposits aren't create ex nihilo, coincident with loan creation. Private sector balance sheets can and do expand and contract.

I understand and accept your point about banks preferring to avoid the overnight market, and now understand the mechanisms they have to do that.

Игры рынка: page 27 gets it right, thank Gods!

December 23, 2009 at 4:22 PM  
Blogger nazgulnarsil said...

I'm not really clear on the whole "buying deposits" thing.....you buy a liability? to yourself?

did this get explained and I just missed it in the multiple text walls? (suggest a ctrl-f phrase).

much thanks.

December 24, 2009 at 3:26 AM  
Blogger Игры рынка said...

you have to pay for deposits, correct? it is called interest. so buying deposits is a question of price. higher price means more despots.

December 24, 2009 at 7:33 AM  
Anonymous Michael S. said...

Well and good, but if deposits aren't necessary then why do banks work so hard to attract them? Not only is there interest-rate competition for deposits (constrained by the need for a profitable interest rate margin), but also a great deal is done to accommodate depositors with services they want. If loans were all that was important to a bank's business, why (for example) do we find ATMs in so many places? ATMs do nothing for the borrowing customer. They are accommodations for the depositor. Why were debit cards introduced? They, too, are accommodations for depositors, making it easier for them to use their demand deposit accounts. Credit cards, which create loans, had already been in existence for years before debit cards. If lending were the only important activity of a bank, one should suppose there was no raison-d'etre for the debit card. Bankers show by their behavior that they think (at least) that deposits are essential to their business.

December 24, 2009 at 11:09 AM  
Anonymous zanon said...

Michael S: You already know the answer to this.

No one is saying deposits aren't important. We're just pointing out that lending is not deposit constrained (banks do not lend out deposits), it is capital constrained.

Therefore, in regards to the post, banks don't really maturity mismatch the way Mencius (and Austrians in general) think. The shadow financial system is a different business, of course.

In regards to deposits, as you yourself pointed out, they are the cheapest liability a bank can get (I think) -- certainly cheaper and preferable to borrowing overnight at interbank market. Since bank lending is capital constrained, return on equity ends up being function of cost of capital for the bank, as it drives the spread.

I am sure this is something you have discussed often at your bank meetings.

December 24, 2009 at 12:17 PM  
Blogger Игры рынка said...

Are you talking about retail deposits? It is part of business model. Retail deposits require retail branches, ATMs, debit and credit cards and so on. However they are a cheap, reliable and predictable source of funding. More than this, retail customers are very good customers, they have loyalty, their children get this loyalty, they buy a lot of cross-products, insurance, pension funds, term savings etc. So it is a complex thing why banks go for retail customers. But in no way they have to. There are plenty of banks without any somehow significant retail presence.

In crisis like this retail banks experienced a lot inflows and had few problems with outflows. However many wholesale banks became history. On the other hand retail banks are typically very slow and suffer from low profitability. There is obviously no right or wrong strategy.

December 24, 2009 at 12:26 PM  
Anonymous zanon said...

Игры рынка:

I think Michael S was asking about deposits more generally, wholesale or retail.

His question is, why not go for zero deposit bank which just makes loans, and funds then by borrowing at interbank market.

My answer was: it is possible, but not good for profits

December 24, 2009 at 12:47 PM  
Anonymous Michael S. said...

Zanon, I think we are agreed that the constraint on lending is capital, not deposits. However to say that lending is not deposit-constrained does not mean that deposits are unnecessary. For every asset (cash, loan, investment, or physical property)a bank owns, it must have a corresponding liability. In the typical bank the greater part of those liabilities are deposits. In fact it is the acceptance of deposits from businesses and individuals that distinguishes banks from non-bank/"shadow banking" financial operations (whether GSEs like Fannie and Freddie or private-sector like Countrywide Financial). The latter were exempted from the capital requirements of commercial banking on the pretext that they did not accept such deposits, but raised funds for their lending activities by other means. For the same reason, capital requirements were less stringent for investment banking, which neither accepted deposits nor engaged in commercial lending.

I mention ATMs and debit cards simply because they are well known examples of ways in which banks try to attract and accommodate depositors - just about everyone in the civilised world is, after all, a retail banking customer of some sort. Of course there are commercial banks that do not seek such customers. J.P. Morgan, before it merged with Chase Manhattan, was such an example. But as a commercial bank, it still sought deposits. Deposits seem to me to be a defining characteristic of commercial banking.

December 24, 2009 at 1:00 PM  
Blogger Игры рынка said...

Deposits is just one side of banking business and it is not required. If we ask on the street why type of business banks are in then "providing loans" will be high on the list and "collecting deposits" will be low if at all on the list.

In any case I think it is irrelevant how banks fund their assets and apart from some basic stress tests even regulators are not that much interested (though it appears to change now). Compare this to the attention paid to asset.

December 24, 2009 at 2:10 PM  
Anonymous zanon said...

Michael S: The reason I harp on about deposits not being necessary is because:
1) it is a correct fact; and
2) it puts in end to the "maturity mismatch" nonsense Austrians such as Mencius Moldbug go on and on and on about.

A bank can take on other liabilities different than deposits if it chooses (and you agree). If you wish to erase the line between "necessary" and "a really good idea" you are welcome to do so. This means you will remain confused about how the finance system actually works, and worse, will continue to get sucked into unproductive arguments with Austrians.

The former is actually no great handicap, but the latter is a terrible Fate that I wish on no one. Certainly not someone as pleasant as yourself.

You cannot make any progress with Austrians until you point out that banks do not lend out deposits, and the causality in fact goes from loans -> deposits.

I think we are done. Thank you for opening my eyes to the variety of liabilities a bank has access to, and would reach before BEFORE going to the interbank market.

December 24, 2009 at 2:16 PM  
Blogger nazgulnarsil said...

Игры рынка thank you! duh, i'm an idiot.

December 25, 2009 at 1:08 AM  
Blogger Matt Franko said...

Zanon/Michael et al:

If a group put together a small bank with say $15m in capital, could the bank immediately proceed to acquire $150M of GSE preferred yielding 6% (assuming it existed), bringing back $9M annually to the investors group (60% gross yield on original investment). Then just run the bank's lending and deposit services as a "breakeven" segmented operation, ie just for the purposes of getting the "free leverage" afforded to you by being a bank?? Or would deposits have to be taken in first? Resp,

December 26, 2009 at 6:01 AM  
Anonymous Michael S. said...

Zanon - of course, commercial or retail deposits are not the only sources of funding available to a bank. I suppose to be precise, one should say that in order to engage in banking one must acquire liabilities (not only, or necessarily, deposits) in order to fund assets. Whether the liabilities are deposits or some other source of funding makes no difference in itself; what is important is that they cost less in interest paid and expense of service than the assets (loans or investments) yield in income. If there is not a positive interest margin, there's no point in doing it.

Matt Franko, this is also a sort of answer to your question. If what you propose were to be successful, some source of funding at less cost than the expected income stream would be the first necessity.

Under U.S. law, you wouldn't need a commercial bank charter to do what you propose if you did not intend to get funding for the purpose by taking deposits from businesses and individuals. That is why (for example) the GSEs and their feeders, such as Countrywide, to operate without such charters, outside the purview of commercial bank regulation.

There are, however, many advantages to having legal ability to act as a commercial bank. Wal-Mart, for example, has long sought a way to take the profits from bank credit card sales away from the banks it uses to service them, by getting its own charter and making this operation a profit rather than a cost center. It is a textbook example of a large business seeking vertical integration. So far (to my knowledge) this has been beaten back by lobbying from the commercial banking industry which really does not like the idea of Wal-Mart offering retail banking services at every one of its stores.

December 26, 2009 at 1:20 PM  
Blogger Matt Franko said...

Michael,
Thanks, what I am driving at is that if you didnt have a banking license, you would have to borrow the $135M additional funds to buy the $150M of GSE preferred, and pay interest, killing your yield. (ala Countrywide)

If you put together a group of say 30 investors, with $500k each, for $15M capital, then organized a bank, could you not just go acquire $150M in GSE preferrred by crediting the bank accounts of the preferred share sellers that you bought them off of? with no interest owed to anyone else because the bank license gives you the abilty to just credit a bank account out of thin air? This (6% Preferred yield) would result in $9M gross revenues to your bank before taking in any deposits or making any loans. The rest of the endeavor (loans & deposits) would just become a "breakeven" exercise with managed risk so as not to "kill the golden goose"? Or again am I missing thae fact that some other deposits must be raised before bank assets can be acquired? Resp,

December 26, 2009 at 4:37 PM  
Anonymous zann said...

Good Gods Michael S. You seem to not have read a word I have written.

"I suppose to be precise, one should say that in order to engage in banking one must acquire liabilities (not only, or necessarily, deposits) in order to fund assets."

No no no no no. And 100 times no. Unless by liabilities you mean "equity".

I will not go into further detail as it is a waste of time. i hope your bank is citibank or some other such too big to fail institution that can withstand ignorance about how it operates.

Better yet, you and Matt Franko can go into business together. Or you can become a univerity professor or an Austrian, two other avocations where basic understanding of operational reality is not required.

December 27, 2009 at 8:31 PM  
Anonymous Michael S. said...

Zanon, you apparently were not aware on which side of the balance sheet equity appears when you made your last post. Be this as it may, in practice commercial banks (except for those in statu nascendi) never have solely equity on the liability side. Indeed, many in recent months have operated with effectively no equity, until the FDIC came calling.

I will reiterate that a defining characteristic of commercial banks under U.S. law is their acceptance of deposits from their customers. That is a point that distinguishes them from non-bank financials such as the GSEs or Countrywide. Deposits are part of the usual and customary business of commercial banks. Do you really dispute this?

My family have been principal stockholders in our nearly 100 year old bank for over 50 years, and I think I have a pretty good idea how it works. We've never had an unprofitable year. Practice and theory are, of course, two different things.

December 27, 2009 at 9:27 PM  
Blogger Игры рынка said...

Guys, you take it too serious. Nobody disputes that deposits are important. However the fact that they are written into law does not mean that it defines banking per se. It just happens that once an institution starts taking deposits it acquires a put option from the government and all associated costs (though the price of this option is way in-the-money but that is another issue).

The dispute here was not about deposits (at least to my understanding) but about the process, i.e. whether it is from A to B, from B to A or completely independent. Personally I am for the last option as I do not see any real causality between A and B. The relationship between A and B depends solely on banks management and not business requirements. And Countrywide etc. showed just that.

The reason banks go for deposits is that it is a cheap, stable and predictable funding; deposits can build loyalty; and then banks cross-sell other products.

The argument that only because deposits are written into fabrics of law and existing regulation does not mean that in reality the process mentioned above is from A to B.

December 27, 2009 at 11:55 PM  
Blogger Игры рынка said...

I many times mentioned here that it is upto each bank to decide on its business model. The way Michael S. does his business is a very prudent one and in fact we should be all very happy about it because it is the way banking was done long before internet was invented. If everybody did it this way we would not be in a situation we find ourselves now. His "put option" is much closer to fair value than the one of Citigroup. So I can not understand why and how one can blame him for doing what he does and the way he does. My full respect to him if in doing so he can make shareholders happy.

The problem of current situation comes from complete rubbish statements like this

"... conducting the nation's monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices"

And the fact that monetary authorities have clue about fiat money system, stability of prices, and full employment is really scary. This is the single most important reason why we have what we have because none of what they have declared is achievable through monetary policy. They can only hope to achieve that but hope is a bad management tool

December 28, 2009 at 3:05 AM  
Blogger Matt Franko said...

Zanon,
To be clear, would you propose, if we started a brand new bank ($15M capital) the following series of events could occur, in exact order:

We get our regulatory approval on Monday.
Tuesday we immediately proceed to purshase $150M (10x leverage) of financial assets.
Wednesday we would fund our first loan to our first loan customer.
Thursday we would have no customers (play golf!).
Friday we would accept our first deposit from our first deposit customer...

December 28, 2009 at 4:38 AM  
Blogger Игры рынка said...

Matt Franko, your efforts to try to invent a situation to prove or disprove something just tell here that you have no idea about bank operations.

How about this sequence happening on day 1 of your new bank:
1. you put $15m and get license
2. you go and purchase $15m of bonds
3. you repo these bonds and get $15m minus haircut of ON deposits
4. you go and purchase more of the same bonds
5. you repo new bonds again and get more ON deposits.
6 - to infinity: keep on doing the same (does it sound like fractional reserve system)

And now try to answer the following questions:
Is there a loan?
Is there a deposit from a customer?
Is there a capital requirement?
Is there a reserve requirement

December 28, 2009 at 5:54 AM  
Blogger Matt Franko said...

Hp, No special knowledge claimed on my part. Trying to understand.

My answers to your questions based on my (limited) understanding:
Loan? No.
Customer Deposit? No.
Capital Requirement? Yes.
Reserve Requirement? Yes.

December 28, 2009 at 11:30 AM  
Anonymous Michael S. said...

Our Russian-named correspondent seems right to me: making loans and taking deposits, in the ongoing business of a bank, take place independently of each other. If there is an insufficiency of funds to cover loans in a way that will meet regulatory requirements, one buys fed funds to plug the hole.

Zanon and Matt F. seem in their own distinct ways to be asking which comes first, loans or deposits, which - in terms of continuing operations - is like asking whether the chicken or the egg comes first.

I have never had experience with owning/running a de novo bank, which is about the only circumstance in which the question could arise in practice. I suppose if I were, my first concern would be to generate some income to pay ongoing expenses. Banks of course make money by lending or from investment. So, one would probably be in the position of lending some of one's capital first and then trying to replace it with some other cheaper source of funding. The regulatory capital requirements of de novo banks are higher than those of established banks exactly because such banks have ongoing expenses right from the start, but do not have income. In this respect they are like any other start-up business. We find that it takes a few years to make a new branch into a profitable operation, and the same would be true in spades for a de novo bank.

However, lending or investing solely one's own capital is not banking. There are certainly businesses that engage in such activity, ranging from pawn shops to large privately operated funds. However, it does not seem to me that a bank, properly so called, would continue to operate in this fashion for very long after opening its doors. What is really at issue in this discussion is, how do we define banking, and what distinguishes it from other types of financial business?

December 28, 2009 at 11:40 AM  
Blogger Matt Franko said...

Michael, thanks for your responses here. and I appreciate the engagement of all here.

What I have been led to believe, and PLEASE correct me if you feel I am way off base, is that banks can directly authorize the crediting of a bank account sort of "out of thin air" so to speak.

For instance: Your bank A approves a loan application for an auto. You put the loan agreement in the file cabinet (this is your new asset ie the loan agreement) and then go on your computer system and direct the Fed to credit the reserve account of the car dealer (who banks with another bank B)across town who sold your customer the car when that dealer deposits the check drawn on your bank A into his bank account at bank B. All you are doing is self certifying that your bank A will still posses the appropriate regulatory capital ratios even with this new loan at your bank A . Your required reserves at your bank A are not affected at all since there was no depository balances affected at your bank A. However, bank B reserve requirements are affected because bank B received a new deposit from the proceeds of the loan into the car dealers account.

If what I am saying above is accurate, it does not look to me like your bank A has to "source" the funds from anywhere. This would be the key difference between George Bailey's "Building & Loan" which lended a % of deposits and your commercial bank A that is not reserve constrained.

Resp,

December 28, 2009 at 1:11 PM  
Anonymous Michael S. said...

Matt F.,the difference between a 'building-and-loan' or mutual savings-and-loan association (now almost an extinct species, I think) and a commercial bank is that a mutual savings-and-loan has no stockholders. There is no account on the liability side of its balance sheet for capital stock. What there is (or was) is an account called 'surplus,' which represents the amount of money left over from interest paid by borrowers on their loans after the 'dividends' (interest) have been paid to the depositors/mutual owners of the association.

This money in theory belongs to the depositors, but if a depositor were to withdraw his funds from the institution during its ongoing business life, he would not get any of it. Again, in theory, were the S&L to close, each depositor would get his pro-rata share of the surplus, as of the last business day.

What happened in practice during the S&L crisis some years ago was that these surplus accounts suffered a financial version of the tragedy of the commons. Because there was no clearly identified class of owners who had a reason to be attentive to it (like the stockholders of a commercial bank), savings-and-loans tended to fall into the hands of their managements and of a few big depositors, typically housing developers. The housing developers would borrow funds from their captive S&Ls to begin a development, then as they sold houses would direct the buyers to those S&Ls for financing, paying down their development loans with the proceeds. This worked as long as strict regulation of interest rates and of the business ambit of S&Ls was in place. S&Ls also enjoyed an advantage over commercial banks in the interest rates they could pay depositors, under the former "Reg Q." They were the fair-haired children of populist politicians, long before those pols discovered the potential of Fannie Mae and Freddie Mac.

This all began to fall apart once interest-rate regulation was abandoned and the lending authority of S&Ls was extended from residential mortgages to all sorts of loans previously the province of commercial banks. S&L managements did not have the experience to know what were good loans and what were not, and they had no stockholders looking to them for continued earnings. Soon the 'surplus' accounts were depleted. The (then) FSLIC ended up taking most of them over and trying to arrange mergers, rather as FDIC is now doing with failed banks. Ultimately the FSLIC was collapsed into the FDIC and most mutual S&Ls ended up either merging with commercial banks or becoming stock S&Ls. There is now not much distinction between an S&L and a commercial bank, except in vestiges such as the "Federal" charter held by an S&L as opposed to the "National" or "State" charter held by a commercial bank.

I'll repeat here a commercial banker's joke about S&Ls, told me by my father years ago:

A fabulously rich Saudi prince had three young sons, one 8, one 5, and one 3. The prince asked each one what present he would like for his birthday.

The eight-year old said he wanted an airplane. So dad gave him a 747, complete with crew and tricked out with every possible luxury. The five-year old wanted a boat, so dad gave him the QE2. The three-year old wanted a Mickey Mouse outfit. And what did his dad give him? A savings-and-loan association.

December 28, 2009 at 2:51 PM  
Blogger Игры рынка said...

Michael S., issue here is much broader than just a distinguishing feature or two of banking. It is clear that the idea that central banks control quantity of money is simply wrong (but heavily sold to the public). Once you acknowledge it you can start thinking about banking system as a whole and not just some institutions. For instance, you can rid of FDIC and big chunk of Fed by providing any amount of money to the banking sector subject to available eligible collateral. For this task you do not need central bank and government can easily run it (as ultimate issuer of money). By doing this you completely eradicate the issue of bank runs. Instead you put central bank and FDIC resources into the analysis of the asset side of BS of banking system and collateral eligibility and evaluation rules. This should also serve as an incentive for banks to create proper collateral rather than some phony assets which 6 months later will be offloaded onto heads of some poor souls. Banking will become damn boring like it used to be but also very prudent. In the process I am sure a lot of resources will be freed up for more productive use in more productive areas of economy

How does it sound?

ps. In general I am not sure that private banking has any justification to exist (versus public banks) given all headaches it creates. Once you strip-off ALM/treasury function from the bank what is left is a simple excel sheet where one records all assets and calculates cash-flows ;)

December 28, 2009 at 11:44 PM  
Anonymous zanon said...

Игры рынка:

Michael S fails even to distinguish a feature or two of banking. If you don't understand how loans create deposits, you don't understand balance sheets, and it is game over.

I also disagree with your ideas to get rid of FDIC, and to lend to banks collateralized.

The liability side of the balance sheet is obviously no place for market discipline. FDIC should be unlimited (this killing money market accounts which are an abomination) and Fed should lend unsecured to all banks, thus eliminating the kind of bank run that brought down Lehman.

I do not see any meaningful distinction between Central Bank and Govt, so maybe this is what you mean -- move all CB functions into the Govt formally? I would say that unless CB gets the first clue over how its financial system works, it does not matter when they are the 3 inches from Govt they are currently, or the 0.5 inch they will be if they are formally absorbed. If Geither, Summers, etc. are in charge, it will run in the same crap way.

We are in agreement about focusing on quality of asset side of balance sheet, though. Some easy ways to improve this of course. Nothing will happen under Obama administration.

Next few years will be very bad.

December 29, 2009 at 7:46 AM  
Anonymous Michael S. said...

Zanon, of course I understand that when a bank makes a loan to a customer, the money's first stop is generally in a depositary account at the lending bank. But it doesn't stay there very long, so from the point of view of the individual bank the creation of deposits by loans is a very transitory phenomenon. My comments here have been about how an individual bank operates in practice, as opposed to the theoretical operation of a national or the global banking system. If anyone has failed to make a distinction it is
perhaps you who have failed to make this one.

I also suggest it is appropriate to distinguish between commercial banking as it is actually carried out under the regulatory purview of U.S. government agencies, and "banking" as it is portrayed by news reporters and editorial writers - who tend to confuse the distinct functions of commercial banks, GSEs, non-bank financial companies, investment houses, etc., and the different regulatory frameworks under which they respectively operate. Their performance this time is of a piece with what they did during the S&L crisis to which I referred, when they failed to point out that commercial banks were almost unscathed by the troubles that beset S&Ls - for the structural reasons I described in my previous comment.

The financial sector of the U.S. economy is and has long been substantially shaped by regulation. Its difficulties, and the lopsided way in which they affect some parts of it as opposed to others, are the results of differences in the way that the different parts of it are regulated; some much less prudently than others. This circumstance is is turn largely the result of politics. There could be nothing more disingenuous than to blame the collapse on 'market failure,' as many politicians want to do. They resemble saboteurs who, having thrown a spanner in the works, proudly proclaim that something was wrong with the design and they had always told us so.

December 29, 2009 at 11:06 AM  
Anonymous zanon said...

Michael S: Please take a look one hill farther than you are for how loans create deposits. As you say, a deposit in the credit extending organization is transitory, but what does it transit to? Clearly it is deposits at other deposit taking institutions. When Austrians (which was the entire point of the original post) say that banks "lend out deposits" they were talking at a system level, not making a point about how one individual bank operates or does not operate, although they will gladly make completely the wrong point about individual banks as well. You continue to encourage them to make this wrong point because your own perspective does not look one hill farther -- fine. Your fate can be to argue with austrians. although you still seem too nice for such a thing to befall you.

it is 100% obvious to me that banking is not a private sector industry, so your "market failure" comments must be directed elsewhere.

December 29, 2009 at 11:26 AM  
Blogger Alex said...

Many thanks Michael for your clear and cogent posts here. Do you perchance have a blog?

December 30, 2009 at 4:23 AM  
Blogger notgreat said...

i think zanon is getting at the topic of this paper:

http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/

see specifically "The Data versus the Money Multiplier Model".

however, i have to disagree with zanon's characterization of the Austrian school's position. they argue against credit expansion which is unbacked by savings in general, not just "maturity transformation".

December 30, 2009 at 2:45 PM  
Blogger jimbo said...

I think Micheal S. is hitting on something that is at the crux of whatever dispute he and Zanon are having: looking at the operations of a single bank doesn't necessarily tell you a whole lot of about the operations of the banking system as a whole.

From the point of view of a single bank, it seems like they get these things called "deposits" from some people and loan them out to other people. Savvy bankers like Micheal S. know that they don't have to wait around for deposits to come to them (they can just buy them from another bank, or from the Fed), but the basic logic seems to be the same as me taking a fiver out of my pocket and lending it to my brother-in-law.

But from the point of view of the banking system as a whole, what is indisputably correct is that those "deposits" are just the accounting records of other bank's loans. The extension of a loan creates both a liability and an offsetting asset at the same time. The fact that this asset most often ends up on the balance sheet of another institution tends to hide this fact from the people involved in the transaction.

December 31, 2009 at 10:37 AM  
Anonymous Michael S. said...

Of course the proceeds of a loan to a customer of one bank can and will end up either as cash in circulation or as a deposit of another customer in another bank. My points were always with respect to the operation of an individual bank, which cannot expect to create deposits solely by its own lending activity.

Further, the notion that system-wide bank deposits are solely the creation of bank lending is not tenable. Some money finds its way into bank deposits without having any obvious provenance from bank lending activity. There are many non-borrowing bank customers and users of cash. They trade with each other and as a result bank deposits are made that do not originate from bank loans. Finally, the principal means of money creation in a fiat currency economy is direct issuance by government - the central bank being operationally a department of government, however it may formally be structured.

The error - one might even call it a delusion - of many people who have studied economics, or who call themselves economists - is that the neat mathematical expressions in economics textbooks or econometric modelling have the same accuracy and repeatability that the mathematically-expressed formulae of (say) optics or electricity do. This delusion leads its votaries into the belief (for example) that manipulating the discount rate is a handy tool for adjusting the money supply, and that all sorts of economic distress can be forestalled by its use. In fact, because the institutions now engaged in the extension of credit are so numerous, so differently organized and regulated, that the tool has become at once unwieldy and unpredictable in its effect.

The analogy that occurs to me, because of recent experience this winter, is to trying to steer a car on an icy road. What seems a small movement of the steering wheel can result in a substantial oversteer, and if one is going too fast, will result in loss of control and an ensuing wreck.

The basic unsoundness of much mortgage credit was the icy road, while fluctuation in the discount rate over a range of what? 400 basis point? was the Fed's oversteering. No wonder the old jalopy has ploughed into the ditch!

Politicians and bureaucrats would like us to think that they use economic policy to mitigate the severity of the trade cycle, when in fact they much more often succeed in aggravating it.

December 31, 2009 at 12:42 PM  
Anonymous zanon said...

JIMBO: You are exactly correct. And this is why the causation is loans -> deposits, not the commonly believed despots -> loans.

Michael S: The post was not about a single bank, nor is the operation of a single bank that interesting. I understand that it is your background, but you need to think one hill farther.

You do a good job of identifying the other source of private sector deposits. In fact, this other source you describe is the ONLY source of NET private sector savings, as banks are formally part of private sector, and thus their balance sheet expansion cannot have any net impact on that sector.

We are 100% agreed on the cluelessness of economists. When Treasury and Fed have no idea how banking system works, it is as winterspeak says, monkeys with scalpels.

Notgreat: Good, you are on right track. Now please explain to me what is "credit expansion which is backed by savings". Please do this with balance sheet entries. This is something I have seen no Austrian do, and it is because you see how nonsensical Austrian position is once you actually bother to do accounting correctly.

December 31, 2009 at 3:45 PM  
Blogger notgreat said...

zanon: the best austrian reference i can think of which actually does the balance sheet accounting is "Mystery of Banking" by Rothbard.

i loaned my copy out, but i'm pretty sure that he starts there with a "de novo" bank, as michael s. puts it, and proceeds to explore what happens as loans are created & deposits come in. he looks at things both from an individual-bank and a system-wide level.

you say that austrian economics is not applicable to fiat money systems. which specific parts of austrian economics aren't applicable? there are parts of austrian economics which assume nothing about the form of the monetary system, so their validity is orthogonal to whether money is fiat or commodity or something else.

December 31, 2009 at 4:20 PM  
Anonymous zanon said...

notgreat: Thank you for the pointer. If I can find it on Google Books I will check it out.

Every account I have seen so far of Austrian banking, of which this moldbug post is typical example, has at its core two tenants, both of which are false.

1. banks lend out deposits
2. the maturity mismatching in 1 is very bad.

In fiat reality:

1. banks do not lend out deposits
2. is moot

December 31, 2009 at 5:55 PM  
Anonymous Devin Finbarr said...

Zanon-

As we discussed before, the money markets and commercial paper markets do maturity mismatch. And the worst of this crisis was when the money markets broke the buck and CP froze. Thus maturity mismatching is still very relevant. Moldbug is very clearly talking about the money markets/shadow banking sector when we analyzes the current crisis: "We are now in a position to understand the crisis as a whole. What happened is that a shadow banking system appeared, which performed maturity transformation without formal FDIC backing."

Thus Moldbug's analysis is still very relevant.

It is true that 99% of Austrians get this wrong, they still think maturity mismatching in the regular banking sector is the true problem (which it's not). But Moldbug gets it right.

January 1, 2010 at 10:26 PM  
Anonymous zanon said...

notgreat: I actually found the Rothbard t-tables. The system he is describing ceased to exist in 1930s, so has no relevance to today. But he actually made OK points regarding that now obsolete technology.

Devin: Come off it. In his post, Moldbug talks about FDIC. FDIC is not part of shadow banking system, it is part of regular banking system.

If you understand how actual real banking system operates, then the problem with the shadow banking system is not that it maturity mismatches, it is THAT IT EXISTS AT ALL.

We have perfectly good solution that does not maturity match and appropriately has private sector directing capital investment. It is implemented like rubbish by people who have no idea what they are doing, and therefore performs rubbish.

You are saying "maybe we can clean rubbish to make it less stinky". The obvious, correct, engineering solution (that Moldbug is so fond of in the realm of democracy) is simply to clean up rubbish and get rid of it. It is ironic that in case of finance, Moldbug turns out to be a moderate Republican!

There is simple solution to get rid of corporate paper and MM funds. Can you guess what it is? If you understand banking it is plain as day.

Happy New Year everyone!

January 1, 2010 at 11:46 PM  
Anonymous Devin Finbarr said...

Zanon-

He mentions FDIC in order to explain that FDIC backed banks are not subject to maturity transformation related bank runs, which is what the PK's believe too.

We have perfectly good solution that does not maturity match and appropriately has private sector directing capital investment. It is implemented like rubbish by people who have no idea what they are doing, and therefore performs rubbish.

I assume your talking about the traditional banks (members of the FDIC and Fed Reserve System)? The problem is that this is not an example of "private sector directing capital". Because these banks are backed ultimately by the government, the government must set the regulations that determine what is a valid loan. Thus you get very top down, managerial style capitalism which results in cheap loans to build cookie cutter developments and expensive loans for mom and pop businesses. Worse, these lending regulations are easily influenced by politics, which results in corrupting the lending regulations.
The fact that the reserve system banks perform like garbage is inherent to the design.

January 4, 2010 at 5:52 PM  
Anonymous zanon said...

Devin: Please. Once again, I urge you to look beyond a single hill, if you are able.

In our democracy, everything is necessarily politicized. People also make mistakes. These are boring points, especially to UR readers, of which I assume you are one.

"Because these banks are backed ultimately by the government, the government must set the regulations that determine what is a valid loan"

A "valid loan" is one that gets paid back. Govt regulation has nothing to do with what a "valid loan" is, and in fact, pushes invalid loans far too often.

You will note that Mencius spills acres of ink on what is unimportant problem for banking system, and trivial to solve problem for shadow banking system, this red herring called Maturity Mismatch.

You will note he writes nothing about the asset side of the equation, which is the important side. Typical Austrian.

January 5, 2010 at 10:54 AM  
Anonymous Michael S. said...

So far as I am able to tell, the 'shadow banking system' (if by that is meant Fannie & Freddie, and private-sector issuers of mortgage-backed securities) did not engage in maturity transformation. If one issues 30-year bonds to fund the purchase of 30-year mortgages, which are then used to collateralize the bonds, there is no maturity transformation.

MBS issuers did not suffer runs, as they are commonly understood. When you buy a bond, you can't get your money back from the issuer till the end of its term. The only way you can get your money out is by selling the bond to some willing buyer. When there are no willing buyers, then you have trouble!

Maturity transformation is an elaborate and wrong explanation for a problem that is much more simply and correctly explained. The collapse of the market in MBSs took place because the mortgages with which they were collateralized were bad. The collateral of the mortgages was inadequate and its value was often fraudulently inflated. The borrowers had insufficient or non-existent means of repayment. The securities were unrealistically rated AAA or AA and so were bought by institutional investors, including commercial banks, in the unfounded belief that they were sound and that there would always be a liquid market for them.

What we experienced as a result was a liquidity crisis. Liquidity crises can involve either long-term debt, like MBSs, or very short-term debt, like the 'call money' used to finance the purchase of stocks on margin in the run-up to the crash of 1929. Whether long- or short-term, the issuers of the credits in question lost their shirts when the underlying collateral turned out not to be worth what they thought it was.

Both in 1929 and in 2008, the liquidity crises took place because of the vagaries of central banking - in either case, a long period of inflation brought on by lax monetary policy, followed by a deflation in consequence of tightening.

Bernard Baruch, who sold out his stock positions shortly before the crash of 1929, was reportedly asked how he foresaw what was coming, and responded that when he began to hear stock tips from shoeshine boys, he knew it was time to get out of the stock market. One might say, in parallel fashion, that when cable TV shows like "Flip This House" began to appear, telling middle-class people they could speculate profitably in residential real estate using borrowed funds, it was time to get out of the housing market.

January 5, 2010 at 11:23 AM  
Anonymous zanon said...

Michael S:

Thank you. You are entirely correct here. The only episode that remotely might look like maturity mismatch problem (if you squint) is Lehman.

The Fed solved this by relaxing the collateral it accepts at discount window. It took them forever to do this, and while a step in the right direction, it is still fundamentally wrong architecture and therefore best considered a strategic failure.

January 5, 2010 at 12:11 PM  
Anonymous Devin Finbarr said...

Zanon-

Let me try and focus the discussion a little bit:

What in your mind is the core problem with financial system? What would you do to fix/reform the banking system? (Of course in any discussion of hypothetical policies, perspective matters a lot. A policy that would work if you personally are running the show might be a disaster if implemented by our current Congress. So that me know the perspective from which you are making the recommendation, ie, hypothetical absolute monarch or hypothetical advisor to Obama )

January 5, 2010 at 5:22 PM  
Anonymous Devin Finbarr said...

Michael S-

There are a number of ways maturity transformation occurred in the shadow banking system. The worst case was in the money market funds. These funds promised their holders that their shares were backed by short term paper. But in reality, through very complicated contracts and schemes, the shares were backed by 30 year mortgages.

So either a bank or a lender like Countrywide makes a loan, then the loans get securitized and sent through a CDO CP Put provider, or some other maturity transformation scheme, and it ends up in a money market fund as 90-day commercial paper.

When Reserve Prime broke the buck, there was a run/near run on the money market funds. In a bank run, even good loans, loans that will almost certainly pay off, drop dramatically in their present price. Thus even though the loans backing the money market funds were in many cases good loans, had the Fed not stepped in, money market funds would have returned pennies on the dollar. But the Fed stepped in and back stopped the funds, stopping the bank run in its tracks.

If you are feeling masochistic and want to go into the gory details of tranches and SIV's and CDO's you can read "The Panic of 2007":
http://www.kc.frb.org/publicat/sympos/2008/gorton.08.04.08.pdf

Megan McArdle had a pretty good explanation too (although I disagree with her conclusion that money markets are a necessary evil):
http://meganmcardle.theatlantic.com/archives/2008/09/how_close_was_the_financial_sy.php

You can get a shorter version from Jeff Lacker of the Richmond Federal Reserve Bank:
http://bigpicture.typepad.com/comments/2008/06/lacker-the-fed.html

Lacker writes: "For example, asset-backed commercial paper, which grew very rapidly between 2003 and the first half of 2007, allowed money funds and other investors to place short-term, liquid funds in securities backed by mortgages and other longer term instruments. More broadly, many structured finance arrangements involve maturity transformation. Repurchase agreements also provide a means for investors to make very short term (overnight) investments backed by longer term securities, as does such specialized instruments as Auction Rate Securities."

Another form of maturity mismatching that happened in the Shadow Banking sector is that corporations would fund long term projects (5 - 10 year projects) with very short term commercial paper.

I believe you are correct that the collapse of Fannie Mae was not do to maturity transformation, their problem was loans that could not be re-payed.

January 5, 2010 at 5:34 PM  
Anonymous zanon said...

Devin Finbar:

Your question about the nature of the financial system, and therefore how to reform it, are not narrowing the question at all. It is broadening it.

Your current understanding of the system is extremely primitive and incorrect. You demonstrate this with your list of posts, all of which were written by people who do not understand financial system and make incorrect statements about reserves, lending, and capital. The fact that two are associated with Fed should make you very afraid -- they are monkeys with scalpels. Megan, a mere blogger, is monkey with crayon and I don't care.

If I tell you how to fix financial system, you will not understand my answer because you do not understand financial system.

And you cannot understand financial system because you have this bad ideas in your head that mean nothing correct can enter.

If Michael S cannot look beyond next hill, you cannot look beyond your own nose. To say that the problem with money market account is that it they maturity mismatch is like saying the problem in a plane crashing is gravity. Yes, kind of, but it misses the point especially if you set about trying to cure gravity to reduce plane crashes.

As I said at January 1, 2010 11:46 PM, "there is simple solution to problem of corporate paper and MM funds. Can you guess what it is?"

THIS is focusing the subject. If you understand banking answer is obvious.

If you get it right, then I will continue. Until them, you will have to continue your education on your own. I already told you step 1.

January 5, 2010 at 10:08 PM  
Anonymous Michael S. said...

As for my alleged failure to look beyond the next hill, let's remember the history of this discussion. It has been the persisten bee in MM's bonnet that banks routinely engage in maturity transformation, borrowing short and lending long, because Bagehot said it was so in "Lombard Street." My answer to this was that in general, this is not the practice of modern commercial banks, and that good funds management in fact attempts to offset loans with time deposits of comparable term. Maturity transformation in their loan portfolios is something that commercial banks strive to avoid, and was not in any event the cause of the 2008 collapse.

We then got involved in a digression about bank deposits and their ultimate source. All I observed was that at the level of the individual commercial bank, deposits are not and cannot be generated solely by the bank's lending activity. Bankers therefore are, and have to be, concerned about how they fund their loans.

This implies nothing in particular about the system-wide sources of bank deposits or the ways in which money is created. I never said it did.

Even so, the typical economics textbook gives a distorted impression of how the system works. The reasons for this are that most such books reflect a time when commercial banks still had a much larger market share within the financial sector than they do now, and they fail to take account of the development of non-bank/"shadow bank" financial operations, or of the magnitude of the GSEs. This leads to an inaccurate representation of the effectiveness of central banking as an instrument of policy. In particular, textbook economics does not tell us how different government agencies (including GSEs) work at cross purposes to each other, producing not the dream of an orderly planned economy but rather the nightmare of blind incompetence and outright corruption that we have actually experienced.

Finally, loans and investments are two different things. Money market funds do not make loans to borrowing customers which they then hold to maturity. That is a way in which they differ from commercial banks. Such funds invest in securities for which there is, in theory, always a liquid market. The nominal terms of their investments (or, for that matter, of the AFS investments of commercial banks) therefore matter not at all, as long as the market is liquid. It will only cease to be liquid when the securities are perceived as not being worth what they were previously thought to be - and this is true whether the securities in question are short- or long-term debt, equities, whatever. Maturity transformation has nothing to do with this, and is a decoy notion that distracts us from discerning the real reasons for the collapse.

January 6, 2010 at 2:34 PM  
Anonymous zanon said...

Michael S:

"All I observed was that at the level of the individual commercial bank, deposits are not and cannot be generated solely by the bank's lending activity."

yes, this is the hill that you cannot see beyond, the single bank operating in isolation.

at system level, lending is one of two ways that deposits are created. But this requires you to see over first hill. It is not a large jump, I am surprised you have not made it. You seem like a good, perceptive guy.

I am sure you know what the second method of private sector deposit creation is. Don't mention it on this site though, it will blow their Austrian minds.

"This leads to an inaccurate representation of the effectiveness of central banking as an instrument of policy"

Central banking is completely ineffectual as monetary policy is almost entirely impotent at all times. This is not a function of size of commercial banking vs. shadow banking system. It is function of what reserves actually are, and how they actually operate. Since you do not look at interbank market, only at isolated bank, this may also be hard for you to see.

Still, you are much closer to truth than Devin who has two layers of misinformation to dig himself out of. I have higher hopes for you.

It is so interesting to me how banking system, which is actually quite simple, is so completely befuddling to people, and quality of information out there so bad. You explain and explain, but nothing happens.

January 6, 2010 at 4:20 PM  
Anonymous Devin Finbarr said...

Zanon-

The links I referenced were not about banks but about money markets, which was the question we were discussing. The authors of the posts (especially Megan) do not understand banking nor do they understand most of the financial system, but their specific points about maturity mismatching in the money markets and shadow banking sector were correct. You claimed that the shadow banking sector did not have a maturity mismatching problem, which means you do not correctly understand a $6 trillion+ sector of the financial sector that was ground zero for this current crisis.

To say that the problem with money market account is that it they maturity mismatch is like saying the problem in a plane crashing is gravity.

No, it's like saying the engineering of the plane was fundamentally flawed. Fix the engineering.

"there is simple solution to problem of corporate paper and MM funds. Can you guess what it is?"

Well, I can come up with possible solutions, but I wouldn't call them simple.

The quick hack to the MM and corporate paper funds is what the Fed is already doing with its special lending facilities.

A more permanent hack is to extend deposit insurance up to unlimited amounts, and then fold the money markets into the regular banking sector. But I wouldn't call this a simple operation as money markets have an entirely different structure than banks and hold very different types of paper on their books.

But this still doesn't fix the problem of creating responsible lending. In the short term regulations can be tightened, in the long term a way needs to be figured out to get the private sector and those lending the money to have more skin in the game. Also not a simple task.

I've read a lot of post-Keynesian material. I've read all of Mosler's required readings, plus lots from Winterspeak, JKH, RebelEconomist, and others. The PK's raise a lot of good points (reserves don't matter at a system level, banks have a license to create money, the national debt is nonsensical, quantitative easing doesn't work, etc.) But I think they miss a lot in their analysis. For example, in Mosler's seven deadly frauds piece, I agree with his critiques of the simplistic views, but ultimately disagree with him because of different arguments than the arguments that he debunks. I don't think that Mosler's plan is terrible. It would almost certainly be an improvement on our current system. But I wouldn't call it "simple". His plan that I just linked to raises a whole new set of questions and potential problems. Can you think of some?

January 6, 2010 at 6:17 PM  
Anonymous Devin Finbarr said...

Michael S.

such funds invest in securities for which there is, in theory, always a liquid market. The nominal terms of their investments (or, for that matter, of the AFS investments of commercial banks) therefore matter not at all, as long as the market is liquid. It will only cease to be liquid when the securities are perceived as not being worth what they were previously thought to be - and this is true whether the securities in question are short- or long-term debt, equities, whatever.

A "liquidity" crisis in the modern sense IS a maturity transformation crisis.

The nominal terms of the investments backing the security matter a tremendous amount. Let's say the backing investments were all notes promising $1.01 in 30-days. And let's say that solvency fears spark a run on the money market (perhaps 5% of loans had defaulted). Lots of people rush to get their money out. The money market will try and sell its securities, but this will flood the market driving down the price of 30-day dollars to far below a dollar. But if the backing investments actually had a term of 30-days, then the fund can simply wait 30-days, redeem the note, and pay off the people withdrawing. People will still be out 5% due to defaults, but they'll still get $.95 cents on the dollar.

Now let's imagine that the securities backing the money market fund were backed by 30 year loans. Again, there is a solvency crisis, again people rush to get their money out. The money market tries to sell its securities, but again this floods the market. The price of 30-year dollars falls. But this time, the person withdrawing cannot wait for the loan to mature, the only way of getting any money is for the fund to sell of the security to someone else. But who will buy it? The security will be sold at far less than $.95 on the dollar.

Worse, the "crisis" price is almost the accurate price, ie the price reflecting the demand for 30 year money. In the pre-crisis state, lot's of people intending to buy a 30-day dollar were actually buying a 30-year dollar. This increased demand for the 30 year dollar. In the post crisis state, people realize they were holding 30 year dollars and try and sell them for current dollars. The only demand left for 30 year dollars are people actually intending to hold the securities for 30 years. Demand for 30 year money tanks, and the maturity mismatchers lose a ton of money.

The problem is not liquidity, it's supply and demand. The banks would have no problem selling the securities at a price the market actually demands them at, they just aren't willing to take the losses, so they create the orwellian terminology of a "liquidity" crisis.

January 6, 2010 at 6:46 PM  
Anonymous zanon said...

Devin:

Good, you got the answer right.

But I don't know what you mean by "simple". Everything you mention in your response is technically very simple. It involves financial technology that has been around for decades. It is no iPhone or Google, it is just some regulations that existed a generation ago.

It would be unpopular with bankers, and therefore the politicians they own. But academics would oppose it because they have no idea what they are talking about. This complexity has nothing to do with the solution, and everything to do with the fact that our political system, as Mencius says, is "incurably insane".

Sadly, the Austrian nonsense that keeps being brought up simply makes matters worse.

You say banks should have more "skin in the game". I agree. Then you say this is complicated, but this is nonsense. Again, this has very old technology, simple solution.

The problems I see with the solution have to do with industry, academic, and political resistance out of idiocy, pride, and greed. But this is problem of system, not problem of solution.

You say you read PK stuff, yet you seem to not understand it as you stick with ridiculous Austrian view.

Liquidity crises comes for interbank market seizing up (Lehman). This is because interbank market is designed like rubbish, and Fed eventually fixed it in kludgey way. Solvency crises comes from banks failing capital requirements through bad loans eroding capital base (as Michael S says). But if CB lends directly unsecured (as it always should) and waives capital requirements (as is its perogative), then there can be no liquidity crises and insolvent banks can continue to operate unimpaired. Crises is completely unnecessary if regulators had the first clue of what they were doing. Maturity mismatch has nothing to do with it. Your target, like all Austrians, is one the wrong side of balance sheet.

January 6, 2010 at 10:46 PM  
Anonymous Anonymous said...

Devin, during the recent crisis, demand for "30 year money" didn't tank - in fact the value of 30 year sovereign debt rose sharply throughout 2008, most sharply following the collapse of Lehman. It would seem obvious that duration as such is not the defining risk characteristic of bad bank investments.

January 8, 2010 at 2:43 AM  

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