Brookings: Topics - Banking

A Theoretical Framework for Kenya's Central Bank Macroeconometric Model

Maureen Were, Anne W. Kamau, Moses M. Sichei and Moses Kiptui — Fri, 17 May 2013 10:29:00 -0400

INTRODUCTION

This paper presents the theoretical framework for the Central Bank of Kenya (CBK) macroeconometric model. In addition, it highlights the theoretical base for the model’s main behavioral equations. The justification for the model relates to its usefulness in aiding the policymaking process at the CBK. It is expected that the model will support the Monetary Policy Committee (MPC) and Research Department in further understanding how the economy works through the complex interactions of various economic agents. The conduct of monetary policy requires fairly accurate analyses and forecasts backed up by sound economic theory and a rationale ensuring that effective monetary policy is formulated and implemented. In this regard, the model will provide consistent short-term forecasts of key macroeconomic variables such as economic growth and inflation. In addition, the model will be helpful in evaluating the impact of various shocks and policies on the economy. The MPC may also use the model as an instrument to help in structuring its communication with the public on the rationale behind its decisions.

This paper is organized as follows. The rest of Section 1 discusses the type of macro model developed, Section 2 presents the model’s logical and theoretical framework and illustrates the linkages between the monetary submodel and the other blocks of the model, Section 3 discusses the theoretical foundations of the model’s behavioral equations, and Section 4 concludes.

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Authors

Maureen Were
Anne W. Kamau
Moses M. Sichei
Moses Kiptui

Image Source: © Antony Njuguna / Reuters

Banking Has to Become Boring Again

Lex Rieffel — Mon, 29 Apr 2013 17:39:00 -0400

Editor's Note: Lex Rieffel responds to John Dizard's opinion piece, "Tobin tax will only benefit shady fixers,” in a Letter to the Editor.

Sir, John Dizard makes the classic argument against the European financial transaction tax (Tobin tax) due to go into effect at the beginning of 2014, cleverly linking it to the fresh warning from the Institute of International Finance about the “Balkanisation” of the global economy (“Tobin tax will reinforce position of banks it seeks to challenge”, April 20). But Mr Dizard focuses on the short-term impact and misses the larger context.

While US banks are likely to benefit in the short term, past experience suggests that their eager financial engineers and clever lawyers will invent a new set of instruments that in due course trigger another financial crisis.

The point is that ordinary citizens around the world will not be able to sleep soundly until banking once again becomes boring. Given the choice between Balkanisation and more taxpayer-funded bailouts, isn’t Balkanisation the more rational option?

The argument that financial sector freedom is necessary for economic growth rests on an assumption that gross domestic product growth is the solution for all problems. Surely we have seen enough in the past few decades to question this assumption.

If the solution instead is smart investment, both by the public sector and the private sector, then bankers are among the last we would want deciding which investments to finance.

Banks are backward-looking intermediaries, inclined to invest in the last good idea. That is actually a more useful function than the alternative, which is rushing like lemmings over a cliff.

Authors

Lex Rieffel

Publication: Financial Times

Image Source: © Fabrizio Bensch / Reuters

Currency Wars: This Time, Is It for Real?

Jacques Mistral — Wed, 10 Apr 2013 14:03:00 -0400

In his presidential campaign in 1928, Herbert Hoover promised to help impoverished farmers by increasing tariffs on agricultural products; after the election, he also asked Congress to reduce tariffs on industrial goods. In April 1929, well before Black Thursday, U.S. Representative Reed Smoot, a Republican from Utah, introduced a bill that passed the House in May. The bill increased agricultural and industrial tariffs at levels that had not been seen for a century. This was a relatively benign beginning of what would become one of the most tragic policy measures of the 1930s. Within a few months of the bill being passed in the Senate as the Smoot-Hawley Tariff Act, other countries in response raised their own trade barriers, which started a vicious circle of contracting world trade flows and economic activity, and rising unemployment from 1930 to 1933.

There are three main lessons from the policies mentioned above:

“Beggar-my-neighbor” policies are bad.
Bad policies can have tragic consequences.
Beware of benign measures that can ignite uncontrollable chain reactions.

Indeed, these lessons have been in every policymakers’ mind since the Lehmann Brothers failure. In fact, the creation of the G-20 was a spectacular effort by the major economies of the world to cooperatively answer the challenges raised by the most severe financial crisis since the 1930s. The G-20 coordinated the management of strong macroeconomic policies, including huge deficits and easy monetary policies. These were bold decisions but not radical, and those who condemned government intervention have been rebutted by the urgency of these measures. And it is now widely acknowledged that these unconventional measures successfully avoided the transformation of the Great Recession into another Great Depression.

In the U.S., the recovery is at best shaky, unemployment is artificially reduced by the growing number of discouraged workers who have stopped looking for work, and the median income is dramatically lagging.

Today, there are reasons of hope that have been eloquently described by Roger Altman [1]: it can be argued that in the U.S., and to a lesser degree in Europe, the crisis has inspired significant reforms that have pushed the economy closer to a sound and sustainable growth trajectory. However others rightfull so object that enormous challenges are still facing the populations and their respective governments. The price paid for curing the damages of the global financial crisis is extremely high everywhere. In the U.S., the recovery is at best shaky, unemployment is artificially reduced by the growing number of discouraged workers who have stopped looking for work, and the median income is dramatically lagging. In Europe, austerity is the name of the game in every country except Germany and despair is growing among the populace. Japan has been stuck for two decades in deflation. Many citizens around the world feel that the efforts have gone too far, yet the benefits and retribution have benefitted too few. Electoral frustrations are on the rise as demonstrated in Italy where Mario Monti’s wise policies have been followed by the success of the Five Stars Movement of Beppe Grillo. Italy turning ungovernable is a bad sign for democracies. Could we see a comeback of desperate national policy experiments like the ones that democracies were progressively pushed to adopt after facing insurmountable difficulties in the early 1930s?

Now, a really radical policy experiment is already taking shape in Japan with the introduction of what has been named “Abenomics” after the name of the newly-elected prime minister, Shinzo Abe. It has taken only one election and one nomination at the head of the Bank of Japan to really revolutionize monetary policy. This revolution can be qualified in two ways, one benign, one threatening.

There is first reason to rejoice. After two decades of failed policies, it’s finally good to see bold politicians ready to do whatever it takes to extract Japan from its deflationary trap. Should Mr. Abe succeed, he would unclench the domestic brakes to economic growth, which deflation has so lengthily opposed: declining prices in effect are discouraging consumption (goods will be better and cheaper tomorrow, why spend now?) and investment (facing massive excess capacity of production and weak final demand, why invest now?). The new mission of the governor of the Bank of Japan is to raise inflationary expectations to 2 percent, which would make Japan converge with the world average inflationary trend and monetary policy. Demand would restart and Japan would contribute to an improved global economic outlook. This is the view that the IMF chief recently endorsed. As expected, Mr. Kuroda last week unveiled a much more aggressive package of quantitative easing than what we have previously witnessed, with a view to double the monetary base. Japan’s central bank will buy more long-term government bonds, pushing private investors to invest more in risky assets. Since the election, the Nikkei has risen 34 percent. Different polls and surveys suggest that the public is positively reacting to Mr. Abe’s promises.

Is success already underway? That would be good news for Japan and for the world. But it is clearly too soon to celebrate because this virtuous circle can simply fail to happen. No central bank until now has ever tried to raise inflationary expectations and no one knows if this can turn to be a practical and manageable reality. Inflationary expectations could also easily turn out of control. Before exercising traction on the economy, they could impose higher interest rates that would have devastating consequences for the Japanese Treasury in the management of a huge public debt (more than twice the size of the GDP). But there is something worse than the risk of Abenomics having poor or adverse domestic consequences.

The other side of Abenomics is currency management, a much less propitious theme for a government to communicate in the weeks leading up to the IMF Spring Meetings in Washington. This aspect of the policy is not only bold, it’s actually radical. As a candidate, Mr. Abe made extremely clear that he was willing to help the manufacturing sector by depreciating the yen and that monetary policy would be designed with this goal in mind. Remember that Japan, despite all its woes, remains a formidable exporter with an external surplus close to ¥650 billion in February (approximately $6.5 billion). As my fellow economists at Brookings have recently shown [2], the Japanese bilateral surplus with the U.S., which is $23 billion according to reported trade statistics, would dramatically increase by 60 percent and reach $36 billion if measured in added-value terms. Mr. Abe’s message was well received by investors who quickly after the election started to short the yen. As a result, the yen has slumped 21.5 percent in the past five months— the worst (or the best?) performance among the currencies of the developed economies. Following last week’s announcement that the Bank of Japan was really acting to debase monetary policy, the yen weakened beyond 99 yen per dollar and dropped against 15 major currencies.

A weakening yen also poses challenges for China, complicating the China’s strategy to reach its 8 percent target growth for this year; it could also trigger huge capital flows into China destabilizing the delicate control of financial stability

This is where Mr. Abe and Mr. Smoot cross ways: both are local politicians inspired by the difficulties facing their countries; both are willing to use every available policy tool to soften these difficulties; neither is willing to shock the global economy, which has never been the case when arguing in favor of protectionism or competitive devaluations. But these measures are nonetheless radical because they have the potential to ignite uncontrollable chain reactions. South Korea for one already declared itself very concerned by this aggressive policy, which is totally understandable. For instance, when Toyota and Sony take some advantage of Abe’s policy, the ones that would likely be first to suffer are Hyundai and Samsung. South Korea has vital interests at stake and, over In the last five months, it has been struggling with a pernicious appreciation of its currency. A weakening yen also poses challenges for China, complicating the China’s strategy to reach its 8 percent target growth for this year; it could also trigger huge capital flows into China destabilizing the delicate control of financial stability; SAFE, the financial institution that manages China’s huge official reserves, last week published its yearly report for 2012. Commenting on the global environment, the report emphasized that “a yen’s depreciation can’t solve Japan’s structural problem, … [but] could turn out of control and trigger a suspicion about its sustainability,… and finally have dangerous spill-over-effects”[3]. Chinese officials at the Boao Forum also expressed similar concerns.

We still don’t know the end. Hope is that we could see the positive interpretation of a bold Japanese policy experiment contributing to a better functioning world economy. Experience should nonetheless make us cautious. What the movement by the Bank of Japan does is to increase an already huge excess liquidity, inundating global markets. In addition, the Japanese government has added a dangerous touch of currency manipulation. Both aspects should be alerts for the IMF rather than too quickly fuel the artificial satisfaction of promises regarding higher inflationary expectations and increased domestic demand. In the end, competitive devaluations always prove inefficient and dangerous because they inevitably provoke reactions and retaliations. “Currency wars” have made headlines from time to time in the recent years but these were skirmishes. This time it could be for real, and this should be a major concern for the United States. It is a great thing that Japan recently expressed interest in joining the Trans-Pacific Partnership, but these are words with long delayed potential results. A more constructive and immediate task is to continue the cooperative global approach of exchange rate policies and to strongly discourage any temptation of national radical policy experiments. This should be a central issue next week during the IMF Spring Meetings in Washington.

[1] Roger C. Altman: “The Fall and Rise of the West”, Foreign Affairs, January-February 2013

[2] Kemal Dervis, Joshua Meltzer and Karim Foda: “Value-Added Trade and its Implications for International Trade Policy”, Brookings Opinion, April 2, 2013

[3] http://www.safe.gov.cn/resources/image/076044004f1fb34a9da59ff675a23beb/1365377817854.pdf?MOD=AJPERES&name=2012年中国国际收支报告.pdf

Authors

Jacques Mistral

Image Source: © Issei Kato / Reuters

Excessive Bank Equity Rules Would Slow the Economy

Douglas J. Elliott — Tue, 09 Apr 2013 00:00:00 -0400

There are serious proposals to force banks to fund themselves with considerably less debt and far more money from their shareholders. This would protect the rest of us, by leaving more of the risk with shareholders and reducing the potential need for taxpayer bailouts. However, there is a trade-off for the greater safety; loans would become more expensive and the economy would slow.

The added safety is well worth the cost when raising equity levels from the risky pre-crisis levels to those being mandated by global regulators under the “Basel III” rules. It might be good to go somewhat further, but not to the extreme levels advocated by some. My fear is that drastic actions may be taken in this area because some argue that it would be economically costless to do so. This idea is wrong in the real world, even if it makes sense under very specific theoretical conditions. There is only space in this column for a high-level discussion of this complex topic. Please see my recent paper on bank capital requirements for a somewhat more detailed explanation.

US banks currently fund about 5% of their assets with money from their common shareholders (“common equity,” one part of the safety buffers known as “capital”), with the rest coming from depositors, bondholders, and a few other sources. This is more than double the pre-crisis levels and is only modestly below the Basel III requirements. Some have called for increasing the level to as much as 30%, a drastic change that would be costly for the economy.

At first blush, it seems obvious that selling stock to investors who want returns of 10-15% a year would increase a bank’s costs, and therefore its loan rates, as compared to borrowing from bondholders or depositors who charge far lower rates. However, the economists Modigliani and Miller won the Nobel Prize in part for showing that, under idealized conditions, it does not matter what proportion of a firm’s funding comes from equity rather than debt. Adding more equity makes a firm less risky and reduces the cost of each unit of equity or debt by an amount that exactly offsets the switch to an otherwise more expensive mix of funding.

This fundamental theory of finance is the core reason some theorists and their followers argue that there is no economic cost to forcing banks to fund themselves much more through common stock. However, there are at least 6 differences between the real world and the idealized conditions necessary for Modigliani-Miller to hold. Taken together, these imply substantial societal costs to mandating extreme levels of equity.

Tax advantages for debt. Modigliani and Miller ignored corporate taxes in their initial work. In reality, interest payments on debt and deposits are tax deductible, while dividends to shareholders are not, creating a major incentive for banks and other firms to fund with debt. Miller later showed that tax advantages at the investor level for owning stock could work in the opposite direction, and would fully eliminate the corporate tax effect under very specific conditions that are not met in the US tax system. The actual offset in the US is perhaps a 50% reduction, maybe less, still leaving taxes as a big factor. This does mean tax collections would be higher, so the net effect on economic growth would depend on what was done with the extra money.

Many advocates of extreme levels of equity call for the abolition of interest deductibility. The same relative effect could be achieved by giving banks a tax deduction on their dividends, as Belgium does. For better or worse, neither of these things is likely to happen, so bank funding costs would go up and some or all of this would be passed on to borrowers. Advocates of extreme capital ratios should offer their proposed back-up plans if interest deductibility is not abolished.

Deposit guarantees and other backstops. Bank deposits are guaranteed up to certain limits, and some argue that federal policies provide protection to uninsured deposits and bank debt through implicit guarantees. Guarantees of debt and deposits block the key mechanism of Modigliani-Miller, since there is little reason for funders with guarantees to lower what they charge as banks become safer. A perfect risk-based pricing system for guarantees would offset the behavioral effect, but we do not have this in practice and are unlikely to achieve it, for both political and technical reasons.

Issuance costs. Modigliani-Miller ignores the transactional costs of raising funding. In practice, the direct issuance costs for equity are much higher than for debt or deposits, although still not huge in the grand scheme of things. More importantly, investors insist on a significant price discount if a firm wants to sell them stock, out of a fear that management knows of reasons why the share price should be lower and therefore is seizing an opportunity to “sell high.” Modigliani-Miller ignores both effects. Recognizing this, some advocates of very high equity levels are willing to allow banks to meet the requirements very gradually through retaining all profits, in exchange for a ban on dividends and share buybacks. This largely eliminates the problem of issuance costs, but would create major market distortions that would potentially last for decades, as some banks would build up their equity levels faster than others and therefore operate with a different, and more expensive, cost structure. There could also be substantial disincentives to increase lending, if doing so would require equity issuance to avoid lowering the equity ratios. If there are no such requirements to maintain equity ratios, then there would be the opposite incentive to increase lending sharply to restore the bank’s lower preferred equity ratios, undoing the effect of setting higher requirements.

Skepticism by investors. Many investors and equity analysts have made clear their skepticism that adding equity increases bank safety as much as the theory says it would. Actions by managements or mistakes by regulators could counteract the positive effects, at least partially. Banks are always going to be “black boxes” to some extent, so there may be a limit to how much investors are willing to drop their required return. Nor is there clear historical evidence to refute the concerns about a partial offset due to investor skepticism. As long as significant numbers of investors are skeptical, the price of equity and debt will not go down to the extent that Modigliani-Miller assumes as banks raise more equity. This will put pressure on financial institutions to avoid operating with the higher equity levels.

Shadow banking. The higher costs that would be imposed on banks because of these real world issues would create strong market pressure to move business out of the highly regulated banking system into various forms of shadow banking. Dodd-Frank has given regulators some powers to deal with shadow banking, but nothing like the authority that would be needed to counteract this level of market pressure. In practice, fully counteracting this pressure may be impossible without rigid government controls that would harm the economy in themselves. Few, if any, analysts believe we would be better off with a massive shift of banking activity into shadow banks. A financial system that relied primarily on shadow banking would be much more vulnerable to crises that would shake the wider economy.

Transition issues. As already noted, there are a host of issues of how to get from here to there without damaging a still fragile economy.

In sum, higher equity levels at banks increase the safety of our financial system in important ways, but we should not overshoot, as there are real costs that we must balance against the benefits.

Authors

Douglas J. Elliott

Publication: Real Clear Markets

Image Source: © Keith Bedford / Reuters

Cyprus as Another Euro-Solution

Jacques Mistral — Wed, 27 Mar 2013 12:00:00 -0400

After 10 hectic days, Cypriots will return to economic life. The price, however, is an inevitable and costly adjustment plan. But contrary to many predictions, the eurozone and the Cypriot government have been able to find a solution in less than 10 days. Moreover, the eurozone has avoided yet another financial hurdle that, despite its small size, was described as having the potential to start another acute phase of the euro crisis.

The management of the eurozone crisis over the last three years has proven to be extremely tortuous. It remains so, and this episode will certainly not be the last. However, observers might also point to how the management by congressional leaders of the U.S. fiscal and deficit problems reveals similar political complexities. Could both be the inevitable result of a democratic, diverse, continental political constituency?

What people need to understand about the eurozone is its continuous willingness to ensure the future of the euro, and its (until now) proven capacity to find compromises despite diverging national interests.

Cyprus has been recognized for months as a ticking bomb within the eurozone, mixing a hypertrophied banking system (that produced jobs and wealth for Cypriots) with huge Russian deposits and suspected money laundering.

Cyprus has been recognized for months as a ticking bomb within the eurozone, mixing a hypertrophied banking system (that produced jobs and wealth for Cypriots) with huge Russian deposits and suspected money laundering. It seems that this had become Cyprus’s most important comparative advantage. The fight against money laundering is supposed to be a great cause of the OECD countries, and it is surprising to note that this aspect did not receive appropriate weight when commenting on the unconventional tools used by the troika to design its plan. The Cypriot banking system is not like the average banking system of Southern Europe. It is a case in itself and deserves a solution of its own.

The “success story” of Cyprus was destroyed by the haircut on Greek bonds; Cypriot banks hold massive amounts of Greek bonds on behalf of their foreign clients. Incidentally, this says a lot about the prowess of this supposed “international financial center” and the awareness of its clients. For many reasons, mostly the country’s democratic process, the active search for a solution to problems in Cyprus had been postponed for months until Saturday, March 16, when an agreement was reached between the newly-elected president of Cyprus, the eurozone governments, and the troika. On that date, every old prejudice about the mismanagement of the eurozone crisis, that had been shelved for the last year, suddenly resurfaced with a new torrent: of criticisms (an ill-conceived plan); of denunciations (a crisis of stupidity); of rejection (Europe is for people, not for Germany); of financial horrors (inevitable propagation of the Cypriot bank run); and finally of doomed forecasts (be alert, the breakup is coming).

Yet one week later, it is interesting to visit the control room and watch the radar screens:

The agreement? Better designed and operational as of Monday, March 25;
Bank runs propagation? No sign (even in the London branches of the two Cypriot banks);
European periphery bond market? A definitely strong first quarter;
Stock markets? Stable;
Exchange markets? Stable.

However, we should not consider this summary to mean that this new episode in the eurozone saga has been more efficiently managed than the previous ones. Definitely not!

Two examples among many explain why this is not the case. First, the idea to tax every bank account whatever its amount was not a product of “German stupidity” but reflects a demand from the Cypriot president, who was willing to preserve the image of the island as a financial center; as if the confidence of dirty money could be a sustainable comparative advantage for Cyprus! The stupefying thing is that the other euro governments accepted this clause even though it was financially dangerous and certain to be rejected by the populace and its representatives. In following the relief produced by the substance of the new agreement, the Dutch finance minister and chairman of the Eurogroup announced that the Cypriot treatment was great news because it showed that bank depositors may be expected to contribute to future bailout packages. However this is explosive and potentially as damaging as the PSI initiative adopted at Deauville. There was immediate backtracking but this reminds us that the whole process remains fragile. All this being properly considered, we should examine the ongoing euro crisis along a different narrative.

And after having described the situation in Cyprus as potential chaos in the waiting, experts now explain the absence of collateral effects by referring to the July 2012 famous commitment of Mario Draghi.

What the above mentioned facts demonstrate is that markets and people outside of Cyprus adopted (at least until the Dutch minister’s proclamation) a much calmer view than specialized commentators. And after having described the situation in Cyprus as potential chaos in the waiting, experts now explain the absence of collateral effects by referring to the July 2012 famous commitment of Mario Draghi. This is at best an excuse for not exploring other explanations and at worst a superstition for placing too much power in his mouth. Rather, two broader facts should be emphasized:

First, looking outside the eurozone, the euro has remained as attractive an international currency as before all the vicissitudes of the sovereign debt crisis despite all the aggressiveness on part of the international financial press. The exchange rate with the dollar constantly remained close to 1.3— a rate which reveals an over-valuation of the euro; such stability is surprising given all the daily announcements of its forthcoming collapse. This fact, which has never received proper attention, at the very least proves that the euro has always remained as attractive as the dollar. After all the drama we have gone through, there was little chance that the Cypriot episode will change this global perception of the euro.
Second, within the eurozone, there is an underestimated willingness to stick to the euro as the currency of the European continent. Austerity measures are never popular and governments that adopt them have been punished in Greece, Spain, France and Italy. Nevertheless, this is the natural product of democracy, and when it comes to the explicit question— “do you prefer to stay in the eurozone, with its mechanisms and constraints, or move on your own?”— the popular answer everywhere has been “we stay”. This is what popular votes have proven in Ireland, Greece and Spain, as well as in Germany where local elections have regularly promoted euro-friendly candidates.

So what can we conclude from the recent crisis in Cyprus? The first conclusion is that Cyprus will pay a high price for exiting a dramatic situation and securing access to eurozone support; no other feasible deal was better than that one at that particular moment. Second, we have witnessed once again the willingness of the eurozone to stay the course, and its ability to design imperfect but feasible compromises, which is not so bad when compared to what’s going on in Washington. In brief, this is another Euro-solution. However, Cyprus is certainly not the last challenge confronting the governments and people of the eurozone. In that sense, the most problematic lesson from this chaotic week is not financial but political. The future of Europe more and more lies in the hands of Germany and there is no place here for accusing the Germans of egoism. Financially speaking, they have moved forward at every step during the last three years and they are the ones that repeatedly take the biggest risks. There is no question that Germany has a prominent voice and that it defends its financial security before entering into an agreement. This is what should have been expected and this is what we have seen with what happened in Cyprus. Looking forward, the bigger problem facing the eurozone is the urgent need to design a macroeconomic policy that will spur a return to growth for the region. On this issue, there is still no visible Euro-solution and that could prove to be the biggest risk facing Europe.

Authors

Jacques Mistral

Is Russian Peter Being Used to Pay the Cypriot's Paul?

Bessma Momani — Thu, 21 Mar 2013 13:46:00 -0400

Cyprus, a small island of one million people, has very large banks. In fact, the banks have the wealth of eight times the entire Cypriot economy.

Obviously, this doesn’t add up and that’s because Cyprus has become an offshore financial centre, offering a haven for money transfers, money laundering, and Internet banks. Foreigners from Russia, worth nearly €20 billion, have been attracted to these lax rules in setting up bank accounts that accompany low corporate tax rates.

Not surprisingly, 40 percent of all Cypriot bank deposits are foreign owned making them an easy target to raise funds. But there’s another reason that the Cypriot government has chosen this route. The perception of European Union (EU) countries is that some of these Russian depositors may be shady characters linked to either criminal activity or government cronies that deposited corrupt funds.

Few democratic EU creditors, particularly the Germans who face an upcoming election, want to bail out Cypriot banks to safeguard Russian assets.

Few democratic EU creditors, particularly the Germans who face an upcoming election, want to bail out Cypriot banks to safeguard Russian assets. Not especially when the EU already has a less than friendly relationship to strongman Putin, who played musical chairs with his now prime minister and who unabashedly supports the despised Syrian regime.

The troika creditors, the EU, the International Monetary Fund and the European Central Bank, will only give Cyprus money needed to recapitalize its distressed banks if it can reduce their overall debt burden to 60 percent of GDP and raise €5.8 billion. There are few state assets or valuables that can be used to raise the funds needed.

Usually, governments have forced its own creditors, like those holding government bonds, to take a “hair cut” by then returning less on the interest or principal that was promised. Raising taxes on citizens to generate government income has been another common route taken in previous EU bailout. But with such a small population, this isn’t an easy way to raise the necessary funds.

The Cypriot plan would have required all depositors to forgo nearly seven to 10 percent of their deposits toward the government debt write-down.

This levy presents a first of its kind in managing the contemporary EU debt crisis; in 1990, Italy had a similar bank tax but the amount was less painful at 0.06 percent. The Cypriot plan would have required all depositors to forgo nearly seven to 10 percent of their deposits toward the government debt write-down. This measure would face a number of potential legal contentions, as the EU passed a 2008 depositors insurance law that guaranteed up to €100,000 in each bank account.

This is why the Cypriot legislature, sitting for only a month, rejected the plan and may reconsider the universal application of the government levy and instead apply this only to those accounts over €100,000. Protecting these smaller mainly domestic depositors, this might then raise the percentage on large, presumably foreign, depositors to even 15 percent. No wonder Russian President Putin said this was “unfair, unprofessional and dangerous.”

For the first time, the small island of Cyprus, with less than two percent of the European economy, might be shifting the burden or passing the buck on to Russia. Wealth and international politics at play...

Authors

Bessma Momani

Publication: CIGI

Image Source: © John Kolesidis / Reuters

If Europe Doesn't Stand Up After Cyprus

Carlo Bastasin — Wed, 20 Mar 2013 00:00:00 -0400

Editor's note: This article was originally published in Italian by Il Sole 24 Ore.

Like what happens to less intelligent creatures, there was also a sudden disavowel of paternityin the Cypriot mess. No one in Europe admits responsibility for the project of forced confiscation on all bank deposits, also the more modest ones. A proposal that, while necessary, will not survive to its temerity and is putting in danger the stability of the Euro area. On the other hand, the confusion about responsibilities is due to the unbalanced decision-making mechanism that has characterized the last years of the European crisis.

Facing an emergency, Berlin sets the political priorities; the Eurogroup decides the least tricky technical solution for the governments; the heads of state communicate the decisions to their citizens, attributing the responsibility to Brussels; finally the EU commission and the European Central Bank execute orders, at times sanctioning countries and almost always taking the blame.

The anti-European short circuit is assured because the level at which decisions are made is never at the level where democratic choice happens. In fact, the problems arise when a National Parliament meets, as happened yesterday in Cyprus. The citizens circle the Parliament and the parties accuse Brussels or Berlin, also hiding the national responsibilities.

Contrary to what is said, for example, the confiscation of Cypriot deposits is a national fiscal measure. It does not violate the insurance of balanced bank accounts in the EU, that spring into action when a bank fails. It is a tax that will be discussed at the European level and that is conditional on European support, but will be done at the national level. However, in a certain confusion of roles and in a certain mess of solutions it was easy for the government and the Cypriot Parliament to turn it down like an error committed entirely by others.

Clarifying to citizens the allocation of responsibilities between Cyprus and countries in the Euro area is difficult because the transparency of the European decision-making process is really poor: there exist no memos of the Eurogroup meetings, whose last leader was chosen because he was not very garrulous; the heads of government then agreed bilaterally over telephone; above all a true public confrontation does not exist, but there are 17 members and 17 borders.

The only common thing is the confusion of blame that, if it was not tragic, would be funny. Try to follow the thread: on Sunday, all accused the German minister Wolfgang Schaublre for the proposal of forced withdrawal. Schauble however claims that he is opposed, with the IMF, to withdraw on small Cypriot money savers. Berlin, in fact, unloads the responsibility on the government of Nicosia, that (for fear of a bank run) did not want high withdrawal on the rich. But it accuses also the EU Commission and the German member of the ECB, Joerg Asmussen, who had observed that a bank run was already happening and that they needed to freeze accounts. Cypriot president Anastasiades retorts that he was blackmailed by Berlin and by the ECB, which would have cut funds that keep the country's banks alive. The Commision denies having defined the proposal and finally the ECB denies directly and categorically: the blame is on the political negotiations held in Brussels. All the institutions, however - IMF, EU, ECB - are together on having had to put a limit of 10 billion on the assistance to Nicosia. Officially to not bring Cypriot public debt to over 140% of the GDP, but in reality to appease crediting governments and to limit their expenditure. Are you lost? You have reason to be.

But we are still far from having unraveled the tangle. Behind the negotiation with Cyprus, there are in fact others that are more complex. The most important regards relations with Russia which leads with around 20-25 billion Euros deposited in Cyprus, one of the most obscure financial markets in Europe. To not touch the small Cypriot depositors, there is a need to withdraw 15-16% of big deposits. But Moscow had just loaned 2.6 billion to Nicosia, which now, pushed by European partners, they have to withhold like a tax on Russian deposits.

The European relationship with Russia is based on big interests and huge suspicions. Berlin first wants to impose on Cyprus the closure of financial channels with Moscow. It is a negotation of such implications from having to be leader of leaders of government or of ministers abroad rather than financial ones. But Europe has no real common foreign policy, least of all in the Euro area. The result is that Cyprus will end up asking Moscow for help. Hypothetically, it could end by depending on Russia so much that it detaches from the Euro area, opening the gate to the first devastating exit of a country from the Euro. Yet a European political initiative was possible: a battle against off-shore finance would collect the consensus of the vast majority of European citizens and would be difficult for Cypriots, facing European support, defending the abuses of their banks. As is seen, whether in foreign policy or in institutional assets, denouncing the lack of European political unity is anything other than an appeal to abstract principles of a dated Europeanism. However the Cypriot crisis shows also that the will of Europeans to help themselves in exchange for common policy (for example the fight against money laundering) is exhausted and weak bringing into doubt also the solidarity that will be indispensable to constitute a bank union. That is the project with which is necessary to avoid, like in Cyprus, a banking crisis sinking a country. A project on which depends the survival of the Euro.

It is estimated that Cyprus has until June to choose to form a tie with Moscow or fail. A somewhat long time that may keep the Euro area in check and may also coerce it brutally to change its strategy one more time.

Authors

Carlo Bastasin

Publication: Il Sole 24 Ore

Image Source: © John Kolesidis / Reuters

Higher Bank Capital Requirements Would Come at a Price

Douglas J. Elliott — Wed, 20 Feb 2013 10:26:00 -0500

A dangerous misconception appears to be taking root in the public debate about bank safety. A belief is growing that banks could be made much safer, at essentially no economic cost, by requiring shareholders to supply far more of the funding for banks with correspondingly less coming from debtholders and depositors. In fact, there would be significant economic costs, so there needs to be a debate centered on an examination of the trade-offs. Personally, I agree with the majority of analysts and policymakers that the costs would outweigh the benefits, but my key point here is that we need a debate on the trade-offs, wherever we come out on them.

The arguments start with a sound theoretical base, but important caveats and practical problems are dropped from the discussion somewhere in the transmission chain from the more careful academic studies to the popular discourse. This matters, because many of the simplistic proposals being aired would reduce lending and make what remains substantially more expensive. The recent severe recession is a reminder of how much damage a credit crunch can do, so we ought not to inflict one on ourselves voluntarily.

The proposals call for much greater levels of bank capital, mostly in the form of “shareholder equity”, which comes from the sale of common shares to investors in combination with bank profits that accumulate over time. Currently, common shareholders supply roughly 5% of the funding for most banks, while the proposals often call for increasing this up to 30%. A key attraction is that proponents frequently argue that this increase in capital is costless or nearly so, when measured properly.

I will argue that this is untrue, unless one assumes some major changes to law and public policy that are very unlikely to occur. Even if they do, there would remain quite difficult transition issues and a more permanent problem that the change would likely cause a massive shift of lending to less regulated sectors, reducing the benefits of the change, potentially to the point of making the financial system less stable in the aggregate, not more.

Once one accepts that there will be significant economic costs to sharply higher capital requirements, then a useful debate can take place about the right level of capital, given the trade-offs, and how best to achieve it. In fact, this is the debate that much of the policymaking and academic community has been involved in for some years, and to which I have contributed. My central point is that it is important not to be sidetracked by arguments that there is no real cost to the added capital.

The remainder of this paper will discuss the issues at a fairly high level, both because of space limitations and to ensure the key points are understandable for a non-specialist. For those wishing more explanation, I have included a list of my more detailed papers on this topic under References in the back. This includes a primer on bank capital, for those new to the topic.

Before beginning the substantive explanation, let me explain my background. I was a financial institutions investment banker for almost two decades, (until 2008), primarily at J.P. Morgan, which might appear to some to potentially bias me in favor of the banks. However, I have been a strong supporter of the core of the Dodd-Frank reforms and of the Basel III global agreement on bank capital and liquidity requirements, as well as other reforms, which many in my former industry lobbied against quite strongly. I have done very extensive analyses of the economic costs and benefits of higher capital requirements, including as the co-author of a year-long study for the IMF on this topic and as sole author of an earlier series of papers for a task force put together by the Pew Charitable Trusts and additional papers since.

The core of agreement

As noted, there is a sound theoretical basis for the argument that, under certain conditions, high levels of capital at a firm do not raise financing costs. Modigliani and Miller demonstrated this more than 50 years ago and both went on to win Nobel Prizes in Economics, in part for this critical insight. They found that, under idealized conditions, moving to higher levels of funding in the form of common stock, and therefore lower levels of debt, would leave the total cost of funding unchanged. Common stock (also referred to as “common equity” or sometimes “equity”) should always be more expensive than debt, because debt has greater legal protections, particularly the right to be paid off in bankruptcy prior to shareholders receiving payments. So, it might seem at first blush that more equity and less debt should raise the total cost. However, Modigliani and Miller showed that the cost of each unit of equity and each unit of debt would drop by an amount that exactly offset the additional cost from having more units of equity and fewer of debt. The price per unit drops because both equity and debt become safer, and therefore more attractive, when a firm has more equity to protect it from financial shocks and thereby avoid bankruptcy.

No one of note seriously argues with this overall point anymore, under the idealized conditions assumed in the analysis. The issue becomes the extent to which these idealized conditions hold true in the real world and what the implications are of divergences from it.

The first area of disagreement: tax effects

In the U.S. and most of the advanced economies, interest payments on debt are tax-deductible while dividend payments on common stock are not. This is partially offset by lower tax rates for capital gains on the sale of stock by investors, but the net tax effect remains substantially more favorable to debt than to equity. Adding tax effects based on U.S. law to the Modigliani-Miller framework results in an altered finding – the total after-tax cost of financing a company is lower with higher levels of debt and lower levels of equity. This is a major reason that banks fund with much more debt and deposits than equity.

Proponents of much higher bank capital requirements generally argue that this differential tax treatment is a policy distortion that should be eliminated. My impression is that most economists agree with this position, although the issue seems to me more complicated than it is often presented, even from a theoretical point of view. (Does it really make sense for a bank to have no tax benefit related to its main expense, funding itself, while being taxed on the interest it receives from making loans and owning bonds?)

Regardless of the theoretical conclusions, it behooves advocates of sharply higher bank capital to make clear what their policy conclusions would be if the tax law were not changed, since this outcome is highly unlikely. This question is too often sidestepped or downplayed.

Advocates do make the sound argument that higher tax bills for banks would not represent money being burned, but would be available for other public uses and therefore represents a private cost and not a public one. However, this would still have the effect of pushing banks to raise credit pricing and/or reduce credit availability, unless the higher tax revenue is returned to the banks or used to subsidize borrowing. That is, the tax regime for banks could be altered to lower their tax rate or in some other manner offset the higher tax bill resulting from holding more equity and less debt. (Belgium gives a tax advantage to bank issuance of common stock in order to achieve this objective.) Alternatively, borrowers could be granted a government subsidy to offset the higher costs banks would charge.

Absent these changes, we should acknowledge that credit would become pricier and potentially less available. This represents an economic cost that then has to be weighed against the societal benefits of greater financial stability and the gains from whatever is done with the additional tax revenue. The trade-off might be worth it, but it is a trade-off and needs to be analyzed as such.

The second area of disagreement: government guarantees

Another factor not present in the Modigliani-Miller model is that bank debt and deposits often receive explicit or implicit government guarantees that are not fully offset by insurance premiums. The most obvious example is the FDIC’s guarantee of a large portion of bank deposits. The FDIC charges premium rates set by Congress, which partially offset the economic advantage. However, the aggregate premiums do not fully offset the benefits and, equally importantly, the degree of risk-sensitivity of the premiums is fairly low. Put simply, many bank depositors treat their deposits as if they were government-guaranteed and completely safe. Therefore, they do not charge more for deposits with riskier banks and less for safer ones, as Modigliani-Miller assumes for debt. The FDIC premiums do vary modestly with risk, but not enough to substitute for the market pricing that would occur without government guarantees.

Similarly, most observers believe that investors in bank debt assume that their risk is lowered by the potential for a government rescue if the financial markets start to fall apart. They do not necessarily believe that an idiosyncratic problem at a single bank, no matter how large, will cause a rescue. However, their biggest risk is that we have a repeat of the recent financial crisis, when wide swathes of the financial system were put at risk. In such circumstance, there remains a belief that government help would be available to at least some extent. This, too, reduces the responsiveness of interest rates on bank debt to differing levels of risk. The level of risk of bank equity is much less influenced by guarantees, since it is observable that governments are willing for shareholders to lose a high percentage of their investments in banks, sometimes all.

Taken together, these explicit and implicit guarantees make bank debt and deposits cheaper and less responsive to changes in risk, thereby incentivizing banks to fund less with equity and more with these other sources.

Advocates of higher capital correctly point out that these subsidies represent policy distortions and ought to be done away with, or their price passed through to banks to eliminate the economic distortion. Dodd-Frank does go some ways to accomplish this, but it clearly does not eliminate the issue. Therefore, forcing banks to move away from cheap debt towards expensive equity would raise their costs, with some or all of that passed through to borrowers. Higher capital levels would make banks intrinsically safer, which would itself reduce the benefit of any remaining guarantees, but the advantage would not be eliminated.

It might be worth forcing higher capital levels and either accepting higher credit costs and lower availability or providing subsidies to offset the effect. My point is simply that there are actual trade-offs at play here, a fact often ignored or denied by advocates of very high capital ratios.

Third area of disagreement: efficiency of capital-raising

Modigliani-Miller assumes a frictionless financial system, in which there is effectively no transaction cost for raising funds and in which equity and debt markets price securities perfectly. In reality, there are transaction costs, although these tend not to be major in the grand scheme of things for stocks that are already publicly traded. (Initial public offerings have quite significant transaction costs, but additional sales after that are considerably cheaper. Banks are generally publicly traded already and therefore IPO costs will seldom arise.)

The bigger issue is that stock offerings normally come at a discount. This is observable in the market and there are also theoretical reasons to expect it. The key theoretical explanation is probably the one related to what economists refer to “asymmetric information.” Put simply, company managements know their firm’s situation better than anyone on the outside. If they are willing for their company to sell shares, then it is unlikely that they view the shares as underpriced by the market and they may even think the stock price is currently higher than warranted. This is particularly concerning, since managements tend to have an excessively optimistic view of the prospects of the businesses they run. So, if they think the stock price is reasonable or even too high, then the shares are unlikely to be a bargain. Recognizing this problem, investors normally demand a discount to protect them from the real possibility that they would otherwise be overpaying for the shares. (The same issue theoretically applies with debt issuance, but the practical effect is far smaller, for a variety of reasons[1].)

In addition, markets are not always fully efficient, with money ready to shift at a moment’s notice to the investment with the best risk/return tradeoff available. For example, a key market for bank stocks consists of dedicated funds that have developed the expertise to invest in that specialized area. There is a limit to the funds they have available for investment at any given time. Therefore, stock offerings also come at a discount out of the need to lure sufficient money in the limited time in which the offering is operational.

Some of the factors that create a need for a discount are of less significance when small amounts are raised than when larger offerings are undertaken. The informational asymmetry problem is also lessened in circumstances where managements are not given a choice, such as when operating under a government mandate.

Advocates of sharply higher capital requirements generally argue that each of the above issues are of minor importance, especially when spread out over the many years in which the bank will use the equity raised. They also sometimes argue that the informational asymmetry problem can be effectively eliminated by simply requiring banks to raise the capital, so that investors will see that it does not reflect managements’ views on stock prices. However, unless the government is willing to require that certain absolute amounts are raised, the more likely approach is to set minimum capital levels in relation to the size of the bank. In that case, bank managements could choose to shrink, in order to lower or eliminate their need to sell stock or hold back on dividend payments or share repurchases. Thus, investors would still see the choice as essentially voluntary.

Forcing an absolute level of capital may be a viable choice for regulators in the short-term, but it would become micromanagement of the banks in the medium- to long-term, by foreclosing the ability to modify business plans in a way that would reduce capital requirements.

The fourth area of disagreement: market perceptions of the safety benefits of capital

Modigliani-Miller relies on markets to correctly perceive the change in relative safety that results from adding more equity to the funding mix. However, there is a chance that markets will be too skeptical in this regard, in which case equity and debt costs will not fall as they should and total funding costs will go up more than would be required by the other factors described above. Higher funding costs would then be passed on to borrowers in whole or part.

Why might markets be too skeptical? First, markets may assume that banks will be able to “game” the system. If managements would prefer to target a lower ratio of capital to risk, they may be able to find ways to take on additional risk that are not reflected in the formulas used to determine required capital levels. At the extreme, they might be able to hold the effective capital to risk ratio constant, producing no net gain in safety. Second, and related, markets may fear that managements will take stupid risks in an attempt to keep profits up in the face of the cost pressures produced by the factors described earlier.

The “black box” nature of banks is a related problem. Investors must rely on the quality of lending, securities, and derivatives transactions that are difficult to understand from the outside. There is likely to be a limit as to how safe investors are willing to assume banks will be, at least in the proposed range of capital requirements. This may change in the long-term, if banks end up proving themselves to be very safe.

It also must be recognized that much of the empirical work in this area shows a weaker relationship between capital ratios and overall risk levels than theory suggests. There are many reasons for the inability to prove the stronger case, including real difficulties in measuring the true level of risk being taken. Nonetheless, one can understand why markets may be somewhat skeptical of something on which academics assure them of the truth, but have not conclusively proven with empirical evidence.

Assuming, as I do, that the academics are fundamentally right on this, the markets should adjust appropriately in the long run. However, the transitional problems discussed next could be considerably exacerbated for some years by the market’s need to see proof of the increased safety. In addition, problems from gaming the risk levels would not go away over time, unless regulators find better methods to catch such actions, which may not be possible. On the positive side, to the extent that banks find intelligent ways to increase expected profits while taking higher risk the result may be equivalent to regulators imposing a lower than anticipated capital ratio, which would also mean lesser effects on credit.

The fifth area of disagreement: transitional effects

Proponents of sharply higher bank capital often downplay the difficulty of the transition from our current rules to the proposed new standards. However, there are real dangers that would need to be addressed. If the transition is too short, a substantial number of banks may have to sell a considerable amount of stock to maintain their current lending levels, much less to accommodate increasing credit demand. However, raising bank equity is unlikely to look very attractive for some years, because of a combination of: the continuing effects of the financial crisis, including major litigation and regulatory risks; the ever-increasing capital requirements as a result of adopting the proposed changes; and the problems that markets can have in absorbing large offerings in a sector in a limited time period. If there is any room for discretion, many banks are likely to cut back on credit provision to avoid having to raise some or all of the new capital. If there is not room for discretion, it will mean that the government has essentially imposed credit quotas on individual banks, which seems unlikely and probably economically damaging.

If banks do cut back on credit provision, then either the economy is likely to be slowed down, or less regulated entities will pick up the lending slack, bringing up other risks that will be covered in the next section.

Previous sections mentioned some other issues that would be harder in the near and medium-term than in the long run and there are likely to be others as well.

The sixth area of disagreement: the growth of “shadow banking”

There is a danger in focusing solely on the highly regulated financial sector. Extremely high capital requirements may drive banking activity into institutions or financial arrangements that are not regulated as strongly, often referred to somewhat pejoratively as “shadow banks.” There are many ways in which “shadow banking” can occur, and different authors have different definitions. A quite incomplete list of the mechanisms and institutions includes: Structured Investment Vehicles (SIVs), repurchase agreements (repos), money market funds, finance companies, and some forms of securitizations and derivatives.

There is near universal agreement after the financial crisis that the shadow banking sector is potentially capable of creating massive problems and triggering a future crisis. Therefore, there is much discussion of how to control those institutions and types of transactions. However, the truth is that we are far from completely figuring out how to make this happen and it is unlikely that there will be an approach clever enough to provide the same level of systemic protection in regard to shadow banks as there will be for highly regulated entities. There are some types of institutions that are so much like banks that it is conceivable that they will end up with capital requirements quite similar to banks, such as finance companies, but there will always be room for activity to move still further away from arrangements that look like traditional banks.

Let me give just one example of the type of difficulty that could arise in trying to regulate shadow banking on a basis similar to standard banking. If banks, and everything that looks bank-like, have very high capital requirements, then there will be a strong incentive for major industrial and retail firms to provide credit directly to their customers and suppliers. They could simply provide credit directly, to the extent this is allowed by the new regulations without triggering treatment as a bank. Beyond that, it is well known that there are many different ways to provide supplier and customer financing without making a formal loan. For example, one could pay a supplier up-front for a shipment of goods that will not be provided for some time in the future. If that is regulated away by treating it as a loan, then it will likely still be possible in many cases to buy a year’s worth of goods in advance, with a refund mechanism if the buyer ends up wanting to take less than the agreed level. This would economically be equivalent to an informal intent to purchase goods, combined with a loan to the supplier. Regulators would have to dive deep into the regulation of the business practices of non-banks in order to avoid all the potential permutations and it is impossible to imagine that happening in the U.S.

On the other side of the ledger, these companies would find themselves borrowing large sums in order to fund the supplier and customer loans. There will be a strong temptation to do this primarily in the short-term money markets, such as the commercial paper market, since this is almost always the cheapest source of funding on average over time. Policymakers and analysts generally are concerned about the funding side as the primary source of risk to the financial system from shadow banks. After all, if an industrial company wants to loan out funds that it has obtained from shareholders or long-term bond investors, why should regulators worry? On the other hand, a “bank run” could result if short-term money markets freeze, resulting in contagion effects across the financial system. There is a great deal of truth to this, although I would suggest that a future financial system with a much larger role for lending from huge businesses to small ones could produce its own form of crisis and resulting credit crunch, if large losses started to result from making big volumes of bad loans over some future period of extended prosperity.

Current market conditions would limit how much leverage could be taken on by big industrial firms and how much of that could be short-term in nature, since wholesale markets are skittish after the debacle of the financial crisis. However, feasible risk levels could rise very substantially as memories fade.

There are many disadvantages to allowing shadow banking to supplant traditional banking as the main source of lending to small and medium-sized enterprises and, perhaps even families. (Lending to big corporations in the U.S. has already largely moved out of the hands of the banks, except for contingent lending, such as letters of credit or revolving loans or lines of credit.) The lenders would be subject to much less supervision and regulation and their activities would be less well understood by the monetary authorities and by regulators. They might also undertake lending activity with less knowledge and experience of how to do so safely. This would be a particular problem in the near to medium term, as the expertise is being acquired.

How big might the trade-offs be?

The primary intent of this paper is to underline the fact that there are trade-offs between higher capital and goals such as economic growth. It would require a much longer paper to quantify the trade-offs, as I have done in part in the papers listed below.

However, it is easy to demonstrate that the level of costs is significant enough to require serious investigation. The first-order effect of increasing the ratio of common equity to total assets for banks from 5% to 30% would clearly be very high. Assume that the annual cost of bank equity is 5 percentage points higher than the after-tax cost of bank deposits and debt. (There are arguments for a higher figure or for a lower one. This is just an example in the middle of the range.)

If one quarter of the funding for their assets (30% minus 5%) shifts to the more expensive funding source, then, all else equal, banks would have to earn about 1.25 percentage points more, after-tax, on their total assets. This would translate into a need to collect nearly two percentage points more on their loans and other assets, all else equal, since the interest collected would be taxable. A two percentage point increase in credit pricing would have huge economic effects.

The good news is that this first-order effect would be offset by increased tax revenues, greater financial safety, a squeeze on bank cost, shifts of business away from the banks, and other factors. The debate needs to be about this set of trade-offs, rather than the false debate about why a seemingly costless approach to bank safety is being stifled by the power of the banks and those who do their bidding.

References

Elliott, Douglas, “A Primer on Bank Capital,” The Brookings Institution, (Washington: The Brookings Institution), January 2010, http://www.brookings.edu/~/media/Files/rc/papers/2010/0129_capital_elliott/0129_capital_primer_elliott.pdf

Elliott, Douglas, Suzanne Salloy, and Andre Oliviera Santos, “Assessing the Cost of Financial Regulation,” IMF Working Paper 233, September 2012, available at http://www.imf.org/external/pubs/ft/wp/2012/wp12233.pdf

Elliott, Douglas, “Quantifying the effects of lending increased capital requirements,” (Washington: The Brookings Institution), September 2009, http://www.brookings.edu/papers/2009/0924_capital_elliott.aspx

Elliott, Douglas, “A Further Exploration of Bank Capital Requirements: Effects of Competition from Other Financial Sectors and Effects of Size of Bank or Borrower and of Loan Type,” (Washington: The Brookings Institution), January 2010, http://www.brookings.edu/~/media/Files/rc/papers/2010/0129_capital_elliott/0129_capital_requirements_elliott.pdf

[1] The deposit portion of “debt” is often guaranteed and therefore insensitive to the future prospects of the bank. The rest of the debt is insensitive to all variations in future performance in the range of outcomes that avoid bankruptcy. Stockholders, on the other hand, care greatly about whether they earn a zero or negative return or a strongly positive one. Knowing a bank is “safe” may effectively be enough for a bondholder, but is not nearly enough information for a stock investor.

Authors

Douglas J. Elliott

Image Source: © Brendan McDermid / Reuters

Obama's SOTU Should Promote a Continued Path to Financial Reform

Michael Barr — Tue, 12 Feb 2013 11:10:00 -0500

In tonight's State of the Union, President Obama should take the opportunity to remind the country of the need to stay on the path of financial reform. A collective amnesia appears to be descending on Washington-and on major financial capitals around the world-about the causes and consequences of the financial crisis. The financial crisis of 2008 crushed the American economy, cost millions of Americans their jobs and their homes, shuttered American businesses, and wiped out family savings. We're still suffering from those effects.

The President's financial reform law, enacted in 2010 against massive opposition from Wall Street and most Republicans, laid a firm foundation for a more resilient financial sector, one that works for American families, instead of exposing us all to needless risk and cost.

A new Consumer Financial Protection Bureau has been built from scratch. New rules governing derivatives transactions have largely been proposed. A resolution authority and improvements to supervision have been put in place. The largest firms have to hold a lot more equity capital. The U.S. financial system is more resilient than it was four years ago.

But nearly three years later, there's still much work to do to turn that law into reality.

And the financial sector did not leave the battlefield after their defeats in 2010. Far from it. The brutal fight over financial reform wages on, and there is a serious risk that financial sector lobbying and lawsuits will further weaken the resolve for reform. Aggressive lawsuits are being used to try to unseat the consumer bureau director, block shareholder rights, roll back protections against abuse in the derivatives market, and slow down reform. Many Republicans in Congress have blocked nominees to key posts or used the appropriations process to undermine enforcement of financial laws.

To be clear: the financial system is safer, consumers and investors better protected, and taxpayers more insulated, than they were four years ago-by a lot. But that is not enough.

In the next four years, it will be critical to stay on the path of reform.

Authors

Michael Barr

Publication: Real Clear Markets

Image Source: © Chip East / Reuters

National Suspicions Undermine Global Financial Cooperation

Douglas J. Elliott — Tue, 22 Jan 2013 15:45:00 -0500

Mistrust and narrow conceptions of short-term national interests are undermining the global cooperation necessary to repair the damage of the financial crisis and build the safe and efficient financial sector that we need going forward. Increasingly interconnected national economies need financial institutions and markets that efficiently cross borders as well. Further, the many links that already exist in global finance require cooperation on financial regulations to avoid a race to the bottom or dangerous gaps that encourage risky behavior.

The terrible global financial crisis of 2007-9, and the ensuing "Great Recession," concentrated the minds of national leaders on the need for cooperation. Several G-20 summits of the leaders of the world's big economic powers focused on setting global rules, in particular by mandating that the Basel Committee on Banking Supervision and the Financial Stability Board build new and improved global rulebooks. Recognizing the need for reform, and knowing that the most powerful leaders in the world were watching, these international organizations moved swiftly to reach agreement, despite the daunting complexity of the task. In particular, the Basel Committee designed the "Basel III" rules to ensure that major banks have enough capital and liquidity to operate safely. These rules are big improvements on the earlier Basel and Basel II accords that had governed banks in the run-up to the financial crisis.

Unfortunately, mistrust and narrow national fears are eroding cooperation. The Basel Committee is increasingly divided into two camps, each suspicious of the other. The US, the UK, and some others are pushing hard to ensure that short-term concerns do not lead the standards to be whittled down too far. Germany, France, Japan and their allies appear more concerned about avoiding any actions that will make life much harder for their banks in the midst of the Euro Crisis and Japan's continuing stagnation. Within these camps, most countries are also maneuvering to protect their own particular national interests, often conceived in a narrow and short-term way. No country has a monopoly of virtue here and there are genuine issues about how to balance long-term and short-term goals while also accommodating true differences in national economic and financial structures. It's time to step back from the antagonism and mistrust and work harder to find a common ground that will get us through the short-term while building a better global financial system that will aid all of us.

The same problems of creeping mistrust are evident in Europe as well. Back in the summer, European leaders took a bold and necessary step forward by agreeing to build a true "banking union" across Europe, or at least the Eurozone. They did this in part because integrated supervision and support for banks was long overdue, given the amount of cross-border banking that already occurs in Europe. Mostly, though, they did it because the financial markets had concluded that using national guarantees for national banking systems in Europe was pouring fuel on the fire of the Euro Crisis. Spain was the example du jour. The need for the Spanish government to rescue its banking system made the government's debt load higher and more burdensome. Meanwhile, the plummeting value of existing Spanish debt, and the rising interest rates on new borrowings, were inflicting severe damage on the banks, leading to a vicious circle. Bringing banks together across Europe into a system with Europe-wide safety nets would break this link. Keeping the new system safe also calls for Europe-wide oversight of the banks, to ensure that lax supervision in a troubled country does not unfairly cost taxpayers across Europe.

So far, so good. However, fear about the Euro Crisis has diminished. As a result, true banking union is being delayed, watered down, and splintered, at least in comparison with the original grand statements. The bold, high-level promises were always going to be constrained by the realities of implementation, but this has gone further than I had hoped. In particular, Germany and the other fiscally strong Eurozone nations are dragging their feet about anything that might cost money, especially in the run-up to this fall's German elections.

At this point, a pessimistic reading is that the part of the banking union proposal that was supposed to break the link between the safety of governments and the safety of their banks will not happen for at least a couple of years and may not truly ever be implemented fully. Even the "easy" part, agreeing on overall supervision of Eurozone banks by the European Central Bank, is at risk of meaning considerably less than it should, at least for a few more years. Giving the ECB the ultimate supervisory power can mean a lot of different things and Germany and some others are pushing to weaken the ECB's mandate, at least in practice. Germany wants to protect its politically connected system of savings banks and cooperative banks from real European oversight.

In Europe, and in the wider world, it is critical that leaders recognize that the gains from cross-border cooperation in finance are large and the risks from playing games to protect narrow national interests are also big. It's time to get serious again, across the board. Complacency is dangerous with the job of reform still so far from finished.

Authors

Douglas J. Elliott

Publication: Real Clear Markets

Image Source: © Kai Pfaffenbach / Reuters

Finish the Job of Financial Reform

Michael Barr — Thu, 27 Dec 2012 11:20:00 -0500

When President Obama came into office four years ago, the financial crisis had just thrown the U.S. economy over a cliff. The financial stability plan that the President and Treasury Secretary Geithner launched worked: the financial panic ended and the economy began to grow again. With the announcement earlier this month of AIG’s repayment of taxpayer funds, TARP and other federal investments are 90 percent repaid, and net costs of the federal intervention in the financial sector overall are expected to approximate zero. That is a remarkable achievement.

At the same time, the Administration put forward a financial reform plan, eventually enacted as the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, to make the financial system more resilient, and to protect taxpayers and the broader economy in the future. The Act brings shadow banking into the daylight; regulates the largest firms regardless of their corporate form; establishes a resolution authority to wind down financial firms in a financial panic; sets new rules of the road for financial derivatives; puts in place the tools to reduce systemic risk across the market; sets out important investor protections; and establishes a new Consumer Financial Protection Bureau to look out for the interests of households.

Regulators have been working hard over the last two and a half years to implement these reforms. A new Consumer Financial Protection Bureau has been built from scratch. New rules governing derivatives transactions have largely been proposed. The resolution authority and many new approaches to supervision have been put in place. The U.S. financial system is more resilient than it was four years ago.

While much progress has been made, a combination of financial sector lobbying and aggressive lawsuits, congressional appropriations cuts and moves to delay or block nominees, and interagency wrangling, has slowed rule making.

Now is the time to finish the job of financial reform.

The Financial Stability Oversight Council needs to bite the bullet and designate systemically important firms for heightened supervision. The Fed needs to finalize its rules for tough new oversight, including limits on counterparty credit exposures and on the relative size of liabilities held by the largest firms; and it must also urgently speed up reforms to repo markets. The CFTC and the SEC need to finalize derivatives rules, and push for LIBOR reform. Regulators need to put in place a firm Volcker rule on proprietary trading. And markets need clarity and a coordinated approach to the risk retention rule for securitizations (“qualified residential mortgages”), ability-to-pay rule (“qualified mortgages”), and the practices of Fannie Mae and Freddie Mac for loans they will guarantee (let alone legislation to determine the ultimate fate of the government-sponsored enterprises).

At the SEC, a Commission deadlock has blocked the outgoing Chairman’s proposed reform of Money Market Funds, which faced a devastating run in the financial crisis, stemmed only by a massive taxpayer guarantee of the entire sector. If the SEC is unable to reach a consensus on how to proceed, the FSOC and the banking regulators will need to step in with an admittedly second-best set of steps to make MMFs less susceptible to runs, and the rest of the financial system less vulnerable to contagion from such runs.

Beyond MMFs and derivatives, the SEC faces critical regulatory policy challenges on investor protection, market structure, high frequency trading, exchange-traded funds, JOBS Act implementation, and a host of other issues. And its embattled enforcement division still has a long way to go, working with the Department of Justice, in rebuilding the public’s trust that our financial markets are being adequately policed for unlawful conduct.

Globally, new capital and liquidity rules have been proposed; the Europeans are making progress on derivatives reforms, supervision and new resolution authorities; and U.S. and global regulators have made progress on mechanisms to coordinate action on all these topics. Yet much still remains in flux, and there remains the danger that the next financial crisis, like the last, will occur when there are still no globally coordinated mechanisms for regulation or crisis management.

To be clear: the financial system is safer, consumers and investors better protected, and taxpayers more insulated, than they were four years ago—by a lot. But that is not enough. In the next four years, it will be critical to stay on the path of reform.

Authors

Michael Barr

Image Source: © Molly Riley / Reuters

Should Central Banks Target Employment?

Kemal Derviş — Wed, 19 Dec 2012 16:29:00 -0500

On December 12, US Federal Reserve Chairman Ben Bernanke announced that the Fed will keep interest rates at close to zero until the unemployment rate falls to 6.5%, provided inflation expectations remain subdued. While the Fed’s governing statutes, unlike those of the European Central Bank, explicitly include a mandate to support employment, the announcement marked the first time that the Fed tied its interest-rate policy to a numerical employment target. It is a welcome breakthrough, and one that should be emulated by others – not least the ECB.

Central banks’ statutes differ in terms of the objectives that they set for monetary policy. All include price stability. Many add a reference to general economic conditions, including growth and employment or financial stability. Some give the central bank the authority to set an inflation target unilaterally; others stipulate coordination with the government in setting the target.

There is no recent example, however, of a major central bank setting a numerical employment target. This should change, as the size of the employment challenge facing the advanced economies becomes more apparent. Weak labor markets, low inflation, and debt overhang suggest that a fundamental re-ordering of priorities is in order. In Japan, Shinzo Abe, the incoming prime minister, is signaling the same set of concerns, although he seems to be proposing a “minimum” inflation target for the Bank of Japan, rather than a link to growth or employment.

The spread of global value-chains that integrate hundreds of millions of developing-country workers into the global economy, as well as new labor-saving technologies, imply little chance of cost-push wage inflation. Likewise, the market for long-term bonds indicates extremely low inflation expectations (of course, interest rates are higher in cases of perceived sovereign default or re-denomination risk, such as in Southern Europe, but that has nothing to do with inflation). Moreover, the deleveraging underway since the 2008 financial implosion could be easier if inflation were moderately higher for a few years, a debate the International Monetary Fund encouraged a year ago.

Together with these considerations, policymakers should take into account the tremendous human and economic costs of high unemployment, ranging from the millions of shattered lives, skills erosion, and disappearance of opportunities for an entire generation, to the dead-weight loss of idle human resources. Is the failure to ensure that millions of young people acquire the skills required to participate in the economy not as great a liability for a society as a large stock of public debt?

Nowhere is this reordering of priorities more needed than in the eurozone. Yet, strangely, it is the Fed, not the ECB, that has set an unemployment target. The US unemployment rate has declined to around 7.7% and the current-account deficit is close to $500 billion, while eurozone unemployment is at a record high, near 12%, and the current account shows a surplus approaching $100 billion.

If the ECB’s inflation target were 3%, rather than close to but below 2%, and Germany, with the world’s largest current-account surplus, encouraged 6% wage growth and tolerated 4% inflation – implying modest real-wage growth in excess of expected productivity gains – the eurozone adjustment process would become less politically and economically costly. Indeed, the policy calculus in Northern Europe greatly underestimates the economic losses due to the disruptions imposed on the South by excessive austerity and wage deflation. The resulting high levels of youth unemployment, health problems, and idle production capacity also all have a substantial impact on demand for imports from the North.

Contrary to conventional wisdom, the ECB’s legal mandate would allow such a re-ordering of priorities, as, with reference to the ECB, the Treaty on the Functioning of the European Union states that “The primary (emphasis added) objective of the European System of Central Banks…shall be to maintain price stability,” and there is another part of the Treaty dealing with general eurozone economic policies that emphasizes employment. This would seem not to preclude a temporary complementary employment objective for the ECB at a time of exceptional challenge.

Moreover, the ECB has the authority to set the eurozone-wide inflation target, and could set it higher for two or three years, without any treaty violation. The real problem is the current political attitude in Germany. Somehow, the memory of hyperinflation in the early 1920’s seems scarier than that of massive unemployment in the early 1930’s, although it was the latter that fueled the rise of Nazism. Maybe the upcoming German elections will allow progressive forces to clarify what is at stake for Germany and Europe – indeed, the entire world.

In a more global context, none of this is to dismiss the longer-term dangers of inflation. In most countries, at most times, inflation should be kept very low – and central banks should anchor inflation expectations with a stable long-term target, although the alternative of targeting nominal GDP deserves to be discussed.

Moreover, monetary policy cannot be a long-term substitute for structural reforms and sustainable budgets. Long periods of zero real interest rates carry the danger of asset bubbles, misallocation of resources, and unintended effects on income inequality, as recent history – not least in the US and Japan – demonstrates.

For the coming 2-3 years, however, particularly in Europe, the need for deleveraging, the costs of widespread joblessness, and the risk of social collapse make the kind of temporary unemployment target announced by the Fed highly desirable.

Authors

Kemal Derviş

Publication: Project Syndicate

Structuring the Financial Industry to Enhance Economic Growth and Stability

Tue, 04 Dec 2012 08:30:00 -0500

Event Information

December 4, 2012
8:30 AM - 2:30 PM EST

Falk Auditorium
Brookings Institution
1775 Massachusetts Avenue NW
Washington, DC 20036

In light of the financial crisis and ensuing severe recession, Western governments are in the process of sharply transforming the laws and regulations for banks and other financial institutions. Yet, recent scandals and problems at major banks have given new life to calls for major structural changes beyond Dodd-Frank, Basel III and other banking reforms, including a return to Glass-Steagall’s restrictions on activities at banking groups or breaking up the largest banks. Any such changes would have significant implications for economic growth and stability, given the central role of finance in lubricating the gears of the economy.

On December 4, the Economic Studies program at Brookings held a conference to review the social purposes of finance, the current structure of the financial industry, and various reform proposals. Federal Reserve Board Governor Daniel Tarullo delivered the keynote address, along with presentations by Brookings Senior Fellows Martin Baily and Donald Kohn.

Read a summary of the event by Douglas Elliott »

Video

Transcript

Transcript (.pdf)

Event Materials

Bank Hackers Deny They’re Agents of Iran

Noah Shachtman — Tue, 27 Nov 2012 00:00:00 -0500

A slew of American officials have blamed Iran for attacks on the servers of Bank of America, Well Fargo, HSBC, and other western banks. But the hackers taking credit for the sophisticated distributed denial-of-service strikes say that’s all wrong; they claim they hit the financial institutions because they were pissed off about “The Innocence of Muslims,” the infamous viral video making fun of the Prophet Muhammad. Tehran didn’t have a thing to do with it.

“We are not dependent on any government. We merely wanted to protest against the insulting movie,” people claiming to be part of the Izz ad-Din al-Qassam Cyber Fighters tell the Flashpoint Partners research group in an interview (.pdf).

There’s no telling if the denial is legitimate — or if the people being interviewed are behind the bank attacks at all. But the interviewees are dead on when they say that ”there are some ones who want to portray this action [the bank hacks] as political.” Shortly after the U.S. Defense Secretary talked about the bank jobs, unnamed American officials began whispering that they were the work of Iran.

The bank attacks this fall weren’t typical DDOS operations, which merely seek to overload servers with junk traffic. For one, they generated up to 100 gigabits per second of data — 10 to 20 times more than what it usually takes to knock a site offline. The attackers overwhelmed routers, servers, and server applications all at once; typical DDOSers target just one. They specifically targeted the banks’ Domain Name Server architecture, which translates website names (“cash.com”) into numerical internet-protocol addresses. And their traffic largely came from legitimate IP address, making it tough for the banks to filter. The websites for PNC Bank, Wells Fargo, Bank of America, and other institutions buckled in quick succession; customers had trouble transferring funds and paying bills online.

Prolexic, a company that specializes in stopping these sorts of attacks, blamed a toolkit called “itsoknoproblembro” for the DDOS assaults. The Cyber Fighters took responsibility as each site went down. But some security researchers believed the attacks to be so sophisticated, they could’ve only been pulled off with government help. ”This isn’t consistent with what hacktivists are capable of,” Michael Smith, a security specialist at Akamai, said in September.

Pretty soon, American politicians starting blaming one government in particular: the one in Tehran. ”I think this was done by Iran and the Quds Force, which has its own developing cyber-attack capacity,” Sen. Joe Lieberman told C-Span around the same time. “And I believe it was in response to the increasingly strong economic sanctions that the United States and our European allies have put on Iranian financial institutions.” The press began to speculate that the bank attacks were in some way a payback for the U.S.-led campaign of online sabotage against Iran’s nuclear program.

In October, Defense Secretary Leon Panetta raised the stakes further, warning of a cyber strike “as destructive as the terrorist attack of 9/11.” He then presented as harbingers of the coming catastrophe an attack on the Saudi energy company ARAMCO — as well as the DDOSes on the banks. “While this kind of tactic isn’t new, the scale and speed was unprecedented,” he added.

In the following day, anonymous U.S. officials told reporters that Iran was behind both attacks, without sharing details about why they thought this was so.

The al-Qassam group says that’s baloney, claiming that they’re merely “volunteer hackers which share the beliefs about [the] insulting video and [the] protest against it.”

When Flashpoint asked if the organization was “supported or funded by any government,” the group’s representatives simple answered: “Nope.”

There’s no guaranteeing the group is telling the truth, of course. Nor is there any assurance that the people who spoke with Flashpoint are really from the al-Qassam organization. The interviewees even claim that some statements previously attributed to the group are false. That’s one of the tricky things about cyber security. While the systems for tracing an attack back to a particular computer are much improved, there are often lingering questions about who’s really behind the hack.

Authors

Noah Shachtman

Publication: Danger Room (Wired)

Key Issues on European Banking Union: Trade-Offs and Some Recommendations

Douglas J. Elliott — Wed, 14 Nov 2012 14:51:00 -0500

OVERVIEW

European leaders have committed to moving toward a banking union, in which bank regulation and supervision, deposit guarantees, and the handling of troubled banks will be integrated across at least the euro area and possibly across the wider European Union. This is quite positive for two reasons. Most immediately, it will help solve the euro crisis by weakening the link between debt-burdened governments and troubled banks, where each side has added to the woes of the other. In the longer run, it will make the “single market” in European banking substantially more effective.

Unfortunately, it is much easier to endorse the concept of a banking union than it is to design and implement one. Banks are central to the European financial system, supplying about three quarters of all credit, and are therefore critical to the functioning of the wider economy in Europe. Their supervision is not just a technical issue; it requires many subjective judgments that have serious implications for credit provision, economic growth and jobs. Choices about how much credit banks provide, and to whom, strongly affect the relative performance of national economies and individual businesses and families. Not surprisingly, national governments have been extremely reluctant to give up control over more than €30 trillion of bank assets and are doing so now only because of the severity of the euro crisis. Designing integrated bank supervision will require fighting out how power will be divided among various European institutions and national authorities.

Nor is it the case that we know the right answers and have merely to summon the political will to push them through. Financial regulation is a balancing act, requiring judgments about the relative importance of many things, including:

Dealing with the short-term euro crisis versus long-term improvement of the “single market” in financial services in the EU.
The trade-off of economic growth and financial safety. It is well established that many safety margins in banking carry with them an economic cost2.
The efficiency of supervisory centralization versus the benefits of local knowledge.
The efficiency of a single regulator versus the benefits of multiple specialized regulators, such as for consumer protection or specialized financial institutions like savings banks.
Supervisory independence from political interference versus accountability.

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Download the full paper

Authors

Douglas J. Elliott

It’s Time to Take the ‘E’ Out of ‘LIE-BOR’

Michael Barr — Thu, 18 Oct 2012 10:53:00 -0400

Barclays has been fined, the British have issued their report, and now everything can go on as usual with the London Interbank Offer Rate (“LIBOR”), right?

I don’t think so.

The investigation into rate-fixing by Barclays revealed a widespread culture of pervasive, deceitful conduct in the setting of the most important private sector benchmark for over $300 trillion in derivative contracts and $10 trillion in adjustable-rate loans. It is highly unlikely that Barclays was the only major bank engaging in this conduct, and public investigations and private lawsuits are likely to reveal further misconduct in the months ahead.

The basic structure for the setting of LIBOR is fundamentally flawed. It permits banks with obvious conflicts of interest to skew the LIBOR rate in order to benefit their own firm. Barclays, for example, was alleged to have attempted to manipulate LIBOR to benefit its traders and to hide its growing costs of borrowing in the financial crisis. Barclays also is alleged to have attempted to manipulate LIBOR in collusion with other firms. These actions apparently occurred during both quiescent markets and turbulent ones.

As it currently stands, LIBOR is not a market interest rate. It provides the illusion of market rates that are relied upon by everyone from sophisticated derivative traders to ordinary mortgage borrowers, but the rate itself is pure fiction. Banks submit a rate at which they supposedly could borrow, but there’s no requirement that the rates submitted be based on actual transactions. A handful of banks can collude to manipulate the rate.

In normal times, the rate is not needed, as U.S. dollar LIBOR tracks (with a regular additional cost reflecting credit and liquidity risks of private borrowing) the risk-free rate of Federal funds and Treasury bills. In abnormal times—such as the financial crisis peak in the fall of 2008—no one can count on the fact that it tracks anyone’s true cost of funds. And if it did track someone’s true cost of funds, it could hardly be said to track the costs of funds of any particular institution facing (or not facing) liquidity or solvency strains, even among the “elite” group setting the rate.

But what about reform? Didn’t the British authorities just fix the problem?

No.

The “Wheatley Report” issued last month is definitely better than the status quo. It echoes a series of reform proposals first put out by the New York Federal Reserve Bank in 2008—making LIBOR less subject to manipulation and auditing submissions. This is all for the good. If we have to keep LIBOR, making it subject to greater scrutiny is definitely preferable to the status quo.

But at this point, it is not enough. LIBOR, as one prominent political cartoon called it, is really “LIE-BOR,” and continued reliance on it rightly undermines trust in the financial system. As Mervyn King, Governor of the Bank of England put it, LIBOR represents “the rate at which banks do not lend to each other.”

What should we do going forward?

There are four potential paths:

First, reform LIBOR, along the lines of the Wheatley Report. Better than the status quo, but if you ask me, I wouldn’t trust it. The incentives for manipulation are too strong, and regulators are never going to be able to keep up with the foul play. The regulatory apparatus required to enforce the reforms are likely to make LIBOR less risk-sensitive and more litigation-averse, which undermines the point of the reform.

Second, reform LIBOR, along the lines recently suggested by Commodity Futures Trading Commission Chair Gary Gensler. Much better: banks would rely on actual transactions (lagged by a day) instead of made-up claims about borrowing costs. But the market for actual, unsecured interbank lending is currently thin, and likely to get thinner, as both the Dodd-Frank Act’s interbank credit limit and the Basel III’s liquidity requirements will penalize such transactions.

Third, reform LIBOR, by requiring banks to “commit” to a LIBOR rate, as suggested in a thoughtful article by Professors Abrantes-Metz and Evans, even if the transactions do not take place, on the grounds that reducing the incentive to lie involves committing firms to borrow or lend at the quoted rates, and one should be concerned about making sure there’s a LIBOR rate in place even during periods of market stress when few actual transactions are likely to occur. But committing to borrower or lend at a certain rate is not likely to have much bite when you need it—during a financial panic—because other sources of borrowing, including from the central bank, or from private sources on a secured basis, will often trump the option of unsecured borrowing at the quoted rate. And the benefits from misstating LIBOR to gain on trading positions may swamp the costs of borrowing (or lending) some amount at the committed rate even if the firm is forced to do so.

Fourth, reform LIBOR by replacing it with an actual, traded, transparent rate in a liquid market. For example, U.S. $ LIBOR could be based on the Overnight Index Swap (OIS) rate (based on Federal funds) or Treasury-bill rate, plus a fixed spread.

At the end of the day, and acknowledging the costs, I’m with option four.

While the change will not be easy, it is time to abandon the fiction of “market” rate setting by quotes from the largest banks. Using OIS or Treasury bills as the index rate would permit parties to hedge interest-rate risk, as LIBOR was intended. Parties that want to hedge bank credit and liquidity risk can do so with other instruments, although these instruments too have their own difficulties.

To be sure, there are costs to this approach: transition costs to moving away from a widely used market convention to a new system; the risks of market fragmentation and lower liquidity if market participants do not readily settle on a new contract rate; and the ongoing cost of having a rate that may diverge from actual bank credit and liquidity conditions, especially in a severe financial crisis.

But LIBOR apparently never actually reflected these market conditions. The supposed gains of having a rate that reflects interbank credit risk is belied by actual market practice and is unlikely to be fixed by other reforms.

The financial sector is suffering from a deficit of trust. That lack of trust has been earned. To build a more resilient financial system, we need to start with the basics: trust in the financial system will be restored when it acts honestly.

And one key measure of that will be when the financial system bases contracts on actual, observable, transparent market transactions.

Authors

Michael Barr

Publication: Yahoo! Finance

Back to the Brink for the Eurozone?

Kemal Derviş — Wed, 10 Oct 2012 11:55:00 -0400

When European Central Bank President Mario Draghi announced in late July that the ECB would “do whatever it takes” to prevent so-called “re-denomination risk” (the threat that some countries might be forced to give up the euro and reintroduce their own currencies), Spanish and Italian sovereign-bond yields fell immediately. Then, in early September, the ECB’s Council of Governors endorsed Draghi’s vow, further calming markets.

The tide of crisis, it seemed, had begun to turn, particularly after the German Constitutional Court upheld the European Stability Mechanism, Europe’s bailout fund. Despite the ECB’s imposition of conditionality on beneficiaries of its “potentially unlimited” bond purchases, financial markets across Europe and the United States staged a major rally.

It seems, however, that the euphoria was short-lived. Yields on Spanish and Italian government bonds have been inching up again, and equity investors’ mood is souring. So, what went wrong?

When I welcomed Mario Draghi’s strong statement in August, I argued that the ECB’s new “outright monetary transactions” program needed to be complemented by progress toward a more integrated eurozone, with a fiscal authority, a banking union, and some form of debt mutualization. The OMT program’s success, I argued, presupposed a decisive change in the macroeconomic policy mix throughout the eurozone.

There has been some progress, albeit slow, toward agreement on the institutional architecture of a more integrated eurozone. The necessity of a banking union is now more generally accepted, and there is a move to augment the European budget with funds that could be deployed with policy or project conditionality, in addition to ESM resources. (Germany and its northern European allies, however, insist that this be an alternative to some form of debt mutualization, rather than a complement to it.)

The ESM, supported by the ECB, could become a European version of the International Monetary Fund, and the new funds in the European budget could become, with support from the European Investment Bank, Europe’s World Bank. All of this will take time, but there is some movement in the right direction.

Where there has been virtually no progress at all is in the recalibration of the macroeconomic policy mix. The prevailing strategy in Europe remains simply to force internal devaluation on the southern countries, with excessive austerity aimed at causing severe wage and price deflation. While some internal devaluation is being achieved, it is producing so much economic and social dislocation – and, increasingly, political upheaval – that there is no supply response, despite the accompanying structural reforms.

Indeed, the deflationary spiral, particularly in Greece and Spain, is causing output to contract so rapidly that further spending cuts and tax increases are not reducing budget deficits and public debt relative to GDP. And Europe’s preferred solution – more austerity – is merely causing fiscal targets to recede faster. As a result, markets have again started to measure GDP to include some probability of currency re-denomination, causing debt ratios to look much worse than those based on the certainty of continued euro membership.

While all of this is happening in Europe’s south, most of the northern countries are running current-account surpluses. Germany’s surplus, at $216 billion, is now larger than China’s – and the world’s largest in absolute terms. Together with the surpluses of Austria, the Netherlands, and most non-eurozone northern countries – namely, Switzerland, Sweden, Denmark, and Norway – northern Europe has run a current-account surplus of $511 billion over the last 12 months. That is larger than the Chinese surplus has ever been – and scary because it subtracts net demand from the rest of Europe and the world economy.

Inflicting excessive austerity on the southern European countries while limiting their exports by restricting effective demand in the north is like administering an overdose to a patient while withholding oxygen. The political and economic success of southern Europe’s much-needed structural reforms requires the proper dose and timing of budgetary medicine and buoyant demand in the north.

The northern countries argue that permitting wage growth and boosting domestic demand would reduce their competitiveness and trade surplus. But that misses the entire point: surplus countries must contribute no less than deficit countries to global and regional rebalancing, because the world economy cannot export to outer space. This argument was always emphasized when the Chinese surplus was deemed excessive, but it is virtually ignored when it comes to northern Europe.

If conservative politicians and economists in Europe’s north continue to insist on the wrong overall macroeconomic policy mix in Europe, they could yet bring about the end of the eurozone, and, with it, the end of the European project of peace and integration as we have known it for decades. This is not to argue against the need for vigorous structural and competitiveness-enhancing reforms in the south; it is to give those reforms a chance to succeed.

Authors

Kemal Derviş

Publication: Project Syndicate