It is with no feelings of joy that we republish this article, first posted on 8 February 2010
Guest contributor Anita Acavalos, daughter of Advisory Board member Andreas Acavalos, explains the political and economic predicament in Greece.
In recent years, Greece has found itself at the centre of international news and public debate, albeit for reasons that are hardly worth bragging about. Soaring budget deficits coupled with the unreliable statistics provided by the government mean there is no financial newspaper out there without at least one piece on Greece’s fiscal profligacy.
Although at first glance the situation Greece faces may seem as simply the result of gross incompetence on behalf of the government, a closer assessment of the country’s social structure and people’s deep-rooted political beliefs will show that this outcome could not have been avoided even if more skill was involved in the country’s economic and financial management.
The population has a deep-rooted suspicion of and disrespect for business and private initiative and there is a widespread belief that “big money” is earned by exploitation of the poor or underhand dealings and reflects no display of virtue or merit. Thus people feel that they are entitled to manipulate the system in a way that enables them to use the wealth of others as it is a widely held belief that there is nothing immoral about milking the rich. In fact, the money the rich seem to have access to is the cause of much discontent among people of all social backgrounds, from farmers to students. The reason for this is that the government for decades has run continuous campaigns promising people that it has not only the will but also the ABILITY to solve their problems and has established a system of patronages and hand-outs to this end.
Anything can be done in Greece provided someone has political connections, from securing a job to navigating the complexities of the Greek bureaucracy. The government routinely promises handouts to farmers after harsh winters and free education to all; every time there is a display of discontent they rush to appease the people by offering them more “solutions.” What they neglect to say is that these solutions cost money. Now that the money has run out, nobody can reason with an angry mob.
A closer examination of Greek universities can be used as a good illustration of why and HOW the government has driven itself to a crossroad where running the country into even deeper debt is the only politically feasible path to follow. University education is free. However, classroom attendance is appalling and there are students in their late twenties that still have not passed classes they attended in their first year. Moreover, these universities are almost entirely run by party-political youth groups which, like the country’s politicians, claim to have solutions to all problems affecting students. To make matters worse, these groups often include a minority of opportunists who are not interested in academia at all but are simply there to use universities as political platforms, usually ones promoting views against the wealthy and the capitalist system as a whole even though they have no intellectual background or understanding of the capitalist structure.
This problem is exacerbated by the fact that there is no genuine free market opposition. In Greece, right wing political parties also favour statist solutions but theirs are criticised as favouring big business. The mere idea that the government should be reduced in size and not try to have its hand in everything is completely inconceivable for Greek politicians of all parties. The government promises their people a better life in exchange for votes so when it fails to deliver, the people naturally think they have the right or even the obligation to start riots to ‘punish’ them for failing to do what they have promised.
Moreover, looking at election results it is not hard to observe that certain regions are “green” supporting PASOK and others “blue” supporting Nea Dimokratia. Those regions consistently support certain political parties in every election due to the widespread system of patronages that has been created. By supporting PASOK in years where Nea Dimokratia wins you can collect on your support when inevitably after a few election periods PASOK will be elected and vice versa. Not only are there widely established regional patronage networks but there are strong political families that use their clout to promise support and benefits to friends in exchange for their support in election years.
Moreover, in line with conventional political theory on patronage networks, in regions that are liable to sway either way politicians have a built in incentive to promise the constituents more than everyone else. The result is almost like a race for the person able to promise more, and thus the system seems by its very nature to weed out politicians that tell people the honest and unpalatable truth or disapprove of handouts. This has led people to think that if they are in a miserable situation it is because the government is not trying hard enough to satisfy their needs or is favouring someone else instead of them. When the farmers protest it is not just because they want more money, it is because they are convinced (sometimes even rightly so) that the reason why they are being denied handouts is that they have been given to someone else instead. It is the combination, therefore, of endless government pandering and patronages that has led to the population’s irresponsible attitude towards money and public finance. They believe that the government having the power to legislate need not be prudent, and when the government says it needs to cut back, they point to the rich and expect the government to tax them more heavily or blame the capitalist system for their woes.
After a meeting in Brussels, current Prime Minister George Papandreou said:
Salaried workers will not pay for this situation: we will not proceed with wage freezes or cuts. We did not come to power to tear down the social state.
It is not out of the kindness of his heart that he initially did not want to impose a pay freeze. It was because doing so would mean that the country may never escape the ensuing state of chaos and anarchy that would inevitably occur. Eventually he did come to the realisation that in the absence of pay freezes he would have to plunge the country into even further debt and increase taxes and had to impose it anyway causing much discontent. Does it not seem silly that he is still trying to persuade the people that they will not pay for this situation when the enormous debts that will inevitably ensue will mean that taxes will have to increase in perpetuity until even our children’s children will be paying for this? This minor glitch does not matter, though, because nobody can reason with a mob that is fighting for handouts they believe are rightfully theirs.
Greece is the perfect example of a country where the government attempted to create a utopia in which it serves as the all-providing overlord offering people amazing job prospects, free health care and education, personal security and public order, and has failed miserably to provide on any of these. In the place of this promised utopian mansion lies a small shack built at an exorbitant cost to the taxpayer, leaking from every nook and cranny due to insufficient funds, which demands ever higher maintenance costs just to keep it from collapsing altogether. The architects of this shack, in a desperate attempt to repair what is left are borrowing all the money they can from their neighbours, even at exorbitant costs promising that this time they will be prudent. All that is left for the people living inside this leaking shack is to protest for all the promises that the government failed to fulfil; but, sadly for the government, promises will neither pay its debts nor appease the angry mob any longer. Greece has lost any credibility it had within the EU as it has achieved notoriety for the way government accountants seem to be cooking up numbers they present to EU officials.
Dismal as the situation may appear, there still is hope. The Greeks many times have shown that it is in the face of dire need that they tend to bond together as a society and rise to the occasion. Family ties and social cohesion are still strong and have cushioned people from the problems caused by government profligacy. For years, the appalling situation in schools has led families to make huge sacrifices in order to raise money for their children’s private tuition or send them to universities abroad whenever possible. This is why foreign universities, especially in the UK, are full of very prominent and hard working Greek students. Moreover, private (as opposed to public) levels of indebtedness, although on the rise, are still lower than many other European countries.
However, although societal bonding and private prudence will help people deal with the consequences of the current crisis, its resolution will only come about if Greek people learn to listen to the ugly truths that sometimes have to be said. They need to be able to listen to statesmen that are being honest with them instead of politicians trying to appease them in a desperate plea to get votes. The time for radical, painful, wrenching reform is NOW.
There are no magic wands, no bail-outs, no quick and easy fixes. The choice is between doing what it takes to put our house in order ourselves, or watching it collapse around us. This can only come about if Prime Minister George Papandreou uses the guts he has displayed in the past when his political stature and authority had been challenged and channels them towards making the changes the country so desperately needs. Only if he emerges as a truly inspired statesman who will choose the difficult as opposed to the populist solution will Greece be up again and on a path towards prosperity. He needs to display a willingness to clean up the mess made after years of bad government and get society to a point where they are willing to accept hard economic truths. One can only hope…
Via Bank plans to cap risky mortgages – Telegraph:
Mortgage lending would be “capped” to stop borrowers taking out risky loans under radical Bank of England plans to prevent a repeat of the credit crisis, a senior official has disclosed.
But why did borrowers wish to borrow so much, so riskily? And why did lenders wish to lend so much, at such risk?
In the first place, credit has been too cheap for too long. Low interest rates are bound to encourage people to borrow more and save less. Therefore, people saved less and borrowed more. This was the result of the Bank of England’s decisions.
House prices kept rising because people kept borrowing and pumping money into housing. Housing was excluded from the Bank’s measure of inflation, so rates stayed low.
The appearance of inevitable and uninterrupted house price rises gave the impression that we were in a new era within which the old rules did not apply: borrowing caps could be raised to excessively risky levels and borrowers could rely on price increases to deal with the capital.
Lenders used models which fundamentally understated risk. For example, markets do not behave within the Gaussian or “normal” distribution: extreme events happen more often than a normal distribution predicts. Furthermore, the risk of mortgage default correlates across similar mortgages when the economic environment changes. Still, the models said risks were lower than they were, so more credit could be extended.
Since the lenders were neither, on the whole, mutuals or partnerships with open-ended liabilities and since the employees making the decisions shared only in the upside, there was insufficient motivation to manage to the true level of risk.
Moreover, securitisation of mortgage pools and so forth palmed off the risk onto hapless investors who probably trusted the risk models and the market environment created by excessively cheap credit. And, “Hey, look at the returns!” The personal touch was missing from the relationships between borrowers, ultimate lenders and intermediaries, further corrupting the system.
Of course when the pantomime ended, the taxpayer was forced to pick up the bill. And still bonuses were paid in bailed-out banks!
Now, having created the boom with cheap credit and moral hazard, the Bank plans, not to fix the root problems, but to pile intervention upon intervention…
There is much else to be said, for which I recommend The Alchemists of Loss and Money, Bank Credit, and Economic Cycles. However, on the face of it, the Bank’s present proposals merely extend the infantilisation of the financial services sector.
Later this week, I will indicate ten serious plans for financial reform.
I see the panel of economic experts that is the acting industry have latched onto the Tobin tax, now re-branded the ‘Robin Hood Tax’. Never mind that Robin Hood fought against unjust taxes by tyrants: the modern day bogey man is the banker.
Now funny thing is, I do agree with a lot of the sentiment expressed by the morally indignant of Primrose Hill.
Yes, the financial world has grown out of all proportion to the real world
Yes, the rewards for participation in this job seem ludicrously high
Yes, bankers have been bailed out by tax payers and are now furiously spinning the wheels of casino capitalism faster than ever before.
Yes, we should do something about it.
But. Not this.
Firstly, why financial markets are important. The good that these things do is provide a price on the future. They allow us all to insure ourselves against the unknown, whether that be a fixed rate mortgage to buy your house, or a bond issue that allows a company to grow.
Financial markets provide sellers for the shares you want to buy, insurers for risks you want to avoid and lenders when you need to borrow.
Attack the market, and you attack its ability to do this job efficiently. The price will be paid by you.
It is said that the market will absorb the Tobin/Hood/Luvvie tax. Anyone who says this clearly underestimates the ability of a bank to pass on its increased costs. You will either pay directly by higher fees, or indirectly, as the cost of everyday things get more expensive.
And more expensive they will be as the Luvvie tax will infect its way through the whole system. At every stage of production, financial markets are used to quantify and reduce costs. Commodity futures allow manufacturers to fix input costs, freight derivatives allow shippers to control cash flow, forward foreign exchange allows import/export companies to insure against wild market swings, credit insurance allow insurance against default and so on and on.
But surely a tiny transactional tax would pass unnoticed? Well, it may seem tiny, but to many market participants this Luvvie tax will be huge. What people fail to understand is that a regular and competitive price in many instruments come from institutions that are prepared to turn over huge volumes in order to make a net margin often much smaller than the Luvvie tax. In one fell swoop, you make a huge proportion of this trading unprofitable, therefore you take away the ability of the market to provide a price. It’s always the way of ill thought out taxes: unintended consequences. Some arbitrary decision is made, and a myriad of economic activity suddenly becomes futile.
So what? Who needs them? Well, you do. Every time you want to invest in your pension, you will (indirectly) need to buy a bond or some shares. Where do you think the seller comes from? Charity? No, it is the myriad of active traders that act as the buffer between ‘real’ buyers and sellers of these things.
In the end, you will pay by being poorer as a pensioner, by paying more interest on your mortgage and by generally being gouged more by the banks.
And so, we turn to the banks. The true villain of the piece.
The problem with financial markets is that banks are allowed to actively participate in this trading game. It would be less problematic if banks used the markets merely to reduce their risks, but this is not what they do. They see markets as a lucrative opportunity to enhance their profits, and they seize it with both hands.
Why is this bad? Because they punt their customer’s demand deposits. They take the money set aside to pay your gas bill, multiply it up tenfold, then wade onto the casino floor. What allows them to do this with some level of (misplaced) confidence is the myriad of legislative favours, monopoly rights, tax payer protection and political pressure arrayed to support them.
Here at the Cobden Centre, we’ve bleated on time and time again about how fractional reserve banking conjures money out of thin air, but it is worth repeating. You deposit £100 of notes and coin in your current account, and this becomes the property of the bank to do with as they wish. You sign it over to the bank, who lend most of it out. £100 of cash, becomes £197 of purchasing power. Whomever gets £97 loan, deposits it at their bank, and the same happens again and again.
Are you happy that the £100 you think is being safely held aside for your weekly food shopping is being used to fund £1000 of credit default swaps? I thought not.
At the end of the day, what consenting adults do in the privacy of their own bedrooms is of no concern to you. What hedge funds do with their willing clients’ money does not concern anyone but the investor. What pure trading companies do with their retained capital is of no worry to you.
The problem is the banks. An the best way to put a stop to their nefarious influence is not by taxing them and innocent parties. Not by robbing pension funds. Not by forcing you to pay higher fees to manage your financial affairs (as you surely will). No, they way to deal with the problem that banking has become is simple:
Free markets built on the bedrock of honest money.
- Huerta de Soto, Money, Bank Credit and Economic Cycles
- Baxendale, A day of reckoning: how to end the banking crisis now
- What is wrong with banking, part 1: the legal nature of banking contracts
- Frank Whitson Fetter, Development of British Monetary Orthodoxy 1797 – 1875
- F. A. Hayek, Denationalisation of Money: The Argument Refined
- Gordon Kerr, How To Destroy the British Banking System and Bailing out the Banks – Glaring Evidence of Moral Hazard
- James Tyler, My Journey to Austrianism via the City, Money is not working and How to avoid future encounters with financial meltdown
- Irving Fisher, 100% Money, 1935
Drawing on the work of Nobel Laureates in economics from three traditions, plus numerous other distinguished scholars, Cobden Centre Chairman, economist and successful entrepreneur Toby Baxendale presents an informal introduction to our proposal for honest money and the benefits consequent on the reform. See also our precis of Irving Fisher’s 100% Money.
- The average overhang of credit to money of all banks in the United Kingdom is 34 x to its reserves i.e. its actual money base.
- If more than one person in 34 walks into all banks simultaneously to withdraw their deposits, there will be a system wide bank run and a mass liquidity event with systematic default and insolvency.
- We saw the start of this with Northern Rock in the summer of 2007.
- We attempt to paper over the cracks and restore confidence in the banking system still today – with little success.
Sterling Liquid Assets (BoE FSR, Jun 2009)
A practical, politically-acceptable proposal
Our proposal is, as Irving Fisher wrote, “The opposite of radical”:
- Require 100% cash reserves to be held against all demand deposits; there can never be a crisis if a bank always holds 100% cash against all its demand deposits.
- Parliament can do this with one Act.
A similar Act took place in 1844. The Bank Charter Act or “Peel’s Act” established a 100% reserve requirement for bank notes that were issued claiming to be redeemable in gold. The reality was that there were 23 notes in issue for every one unit of gold at the time, creating instability, “panic” and general economic chaos. Not a too dissimilar situation from today where we have 34 claims on money to one unit of money. Politicians in the 19th century did not see the creation of unbacked credit through accounting entries as a problem, since it was only done on a very small scale. The problem then was rampant note issue (claims to real money) well over and above the monetary base, as this was the preferred method the bankers used at the time.
It is often forgotten but when you place £1m in a savings account (in cash) in say the Royal Bank of Scotland, which has no legal reserve requirement, they then lend £970k (in credit) , keeping on average 3% of cash back in reserves, to an entrepreneur in say HSBC, who then deposits that money in HSBC. We now have one claim to the original £1m and one claim to the £970k. The money supply has moved from £1m to £1.97m – just like magic! This is credit expansion.
The reality is that across all the banks in the United Kingdom licensed by the Bank of England, we have for every £1 of money (in cash), £34 in claims to money (credit)!
Peel’s problem was the over issue of notes to gold: our problem is the over issue of credit to money.
Continue reading “A day of reckoning: how to end the banking crisis now”
Via The Guardian, City minister campaigns to protect taxpayer from bank failures:
City minister Lord Myners today stepped up the government’s campaign to ensure taxpayers will never again need to bail out banks by urging delegates to a Downing Street seminar to hammer out ways to transfer the risk of bank failures away from the public sector.
At the start of the meeting with academics, country officials from the G7, international and UK policymakers, Myners said: “There is clearly a strong rationale to charge for the externality caused by the financial sector and financial institutions should shoulder the responsibilities for losses they may face”.
“Numerous innovative ideas including contingent capital and systemic risk levies have recently emerged to increase the resilience of the financial system globally and to ensure that the costs of any future failures primarily fall to banks and bank investors rather than taxpayers,” Myners said.
Well, yes indeed: businesses should certainly shoulder their own risks.
However, rather than raising a levy on the systemic risk, the law should remove it: bank deposits should be subject to sound property rights and contract law.
Today, we publish our brief guide to money and banking.
The Guide comprises:
- Four charts showing how Baxendale and Evans’ measure of the money supply correlates to economic activity whereas the Bank of England’s measures do not,
- How wealth is created,
- What is and is not money,
- What is wrong with the mechanistic Quantity Theory of Money,
- The role of the interest rate in the business cycle,
- How banking has become socialised through legal privilege and taxpayer guarantee,
- The shape of the debate on money and banking.
Financial engineer Gordon Kerr explains how to destroy the British banking system through the use of derivatives which take advantage of the regulatory system, then sets out four measures to solve the problem.
Nine years ago I worked as a structuring engineer in a three-man team within the investment banking unit of a major British bank. One of us was very bright. He stunned me one day with an idea as to how we could:
- Produce immediate (but illusory) substantial profits for our bank, thus ensuring that we would enjoy generous personal remuneration;
- Generate ‘virtual’ share capital to boost our bank’s capital reserves;
- Leave the actual investment risk exposure and profit expectation of our bank almost exactly the same after the transaction as before it.
Was this idea the kind of rocket science derivative engineering that justifies master of the universe labels for the three of us who designed and implemented it? No: it was extremely simple. Here’s how it worked. We transmuted some loan assets into a derivative transaction for regulatory purposes, whilst leaving the actual loan arrangements unaltered.
Continue reading “How To Destroy the British Banking System –- Regulatory Arbitrage via ‘Pig on Pork’ Derivatives.”
The following is the text of an address by Gordon Kerr, a Cobden Centre Advisory Board Member, to the Brussels Group at the European Parliament on 13th January 2010.
By Invitation of Syed Kamall MEP, Christofer Fjellner MEP and Alexander Graf Lambsdorff MEP. Meeting chaired by Shane Frith.
Syed Kamall, Shane Frith, ladies and gentlemen, thank you for inviting me here to address you today.
May I provide a few words by way of brief personal background. I have spent the bulk of my 25 year banking career as a structuring engineer.
I played a minor role in wrecking the British banking system by designing and implementing synthetic capital structures – these are mechanisms for banks to produce, as if by magic, additional capital in their accounts which does not in reality exist.
This artificial capital was and remains a product of inconsistent regulatory capital rules that applied to different categories of banking activities.
By way of example: multi billion portfolios of insured loans were flipped from the funded regulatory regime (8% capital ratio) to the derivatives regime (1/16th of this – 0.5%) merely by wrapping them up in credit default swaps.
I will seek to persuade you today of my view that there exists a simple and perhaps Europe-wide cure to the banking crisis. Make a simple legal change.
Simply stipulate that funds deposited under demand deposit contracts with banks belong to the depositor and must be backed by cash or a near cash asset (such as Government bonds).
This proposal would not freeze the banking system. On the contrary, it would revitalise it by ensuring that there could never in future be a run on banks. This proposal would enable free markets to flourish, and would remove the banks from taxpayer dependency.
The European Parliament has this power. Let me invite you to consider using it.
2. Why is this step necessary?
Let me frame the regulatory options very clearly. The number of truly different ways of regulating the banking industry is two. The only alternative to the 100% collateralised demand deposit regulatory structure is the Fractional Reserve system. This is the present system.
Under fractional reserve regulation banks are required to maintain a minimum say 8% “fraction” of their exposures as capital.
Since the bulk of European banks are shareholder owned rather than mutuals or government owned, market forces virtually compel them to push Fractional Reserve regulation to the limit.
No bank CEO could keep his job if he was not fully leveraged in supposedly stable market conditions.
Furthermore, capital is expensive to raise. Under the present system market forces result in the emergence of methods of inflating what I would regard as a fair measure of bank capital such that it appears greater than it actually is.
If the proposal now made is ignored then I fear we will have failed to learn anything from the 2008 collapse.
The alternative is simply to patch the banks back together under a supposedly strengthened Fractional Reserving set of regulations. However, FR in any form is almost certain to lead to another boom bust cycle.
In the initial phase banks will generate large profits as they again inflate the money supply, driving asset prices up which in circular fashion will boost lending once again as the collateral values of the assets justify greater and greater loans. This will give the appearance of economic growth but, like the boom that preceded the present bust, it will merely be storing up more problems for present and future taxpayers.
Contrast the sincere and genuine concern shown here in this Parliament for the interests of future generations in the context of our climate change concerns with the scant regard for their financial interests demonstrated by our continued tolerance of ineffective banking regulation.
3. A few words on the critical importance of demand deposit contracts.
Why has the UK Government, and others, bailed out banks? Of all the stakeholders in banks, which category of stakeholder was deemed so important that such previously unimagined sums needed to be spent to protect its interests?
Borrowers’ interests did not justify the bailout; their loans would be treated as an asset in liquidation and sold to the highest bidder;
Shareholders – surely this is the class of stakeholder least deserving of any taxpayer rescue funds.
Lenders – mainly other banks and institutions. This class does not merit state protection, they knew the risks and took them. Likewise derivative counterparties; this class is in exactly the same category as lenders, the only difference being the technical point that most derivative exposures are unfunded as opposed to funded. The widely quoted credit default swap market illustrates the maturity and professionalism with which both these categories of stakeholder assume credit exposure to banks.
The key stakeholder whose interests could not be sacrificed must be DEPOSITORS. Why are depositors’ interests considered so important and deserving? I think the answer to this question must be that depositors mistakenly believed back in October 2008, and even since then, that funds they deposit in a bank belong to them. That is a serious mistake. In case any of you are in any doubt there is no legal difference in any European jurisdiction of which I am aware between a deposit contract and a loan contract. Both are loans to the bank and a deposit contract is a loan that can be called back by the lender supposedly on demand.
But few UK citizens are aware of this point. A recent UK survey found that 70% of the sample surveyed believe that depositors own the money they put in a bank, just as the client of a law firm owns the funds he leaves in a solicitor’s Client account in the UK. How would you feel if you went to collect your funds from your solicitor and were told “ I’m sorry, I’ve just lost all your money by speculating it without your permission in an attempt to boost my profits? ” Yet this is how we approve of banks treating our demand deposits under fractional-reserve banking rules.
The proposal now submitted would prevent future crashes and would recognize the critical importance of demand depositors by stipulating that ownership of demand deposit funds remained with the depositors, not the banks.
Market forces would ensure that banks worthy of surviving the present crisis would clean up their business models and render their balance sheets transparent. They would seek to grow and profit by persuading depositors to convert some deposits to loans.
4. Replies to Possible Objections
Various objections have been set out:
- Banks would fail to be able to provide loans. Response: Bank lending would only be curtailed to the extent that they could not provide loans not backed by savings willingly lent to banks. Some of the projects presently being financed would not succeed in obtaining credit in such an environment. This is surely no bad thing since it is precisely these marginally viable transactions that form the tipping point of each successive banking crisis. Only 3% of the UK Bank’s liabilities are demand deposits.
- Interest rates would rise and economic development be held back. Response: The absence of bank crises would eliminate the massive squandering of capital goods which accompanies severe recessions, and there is no reason to suppose that the interest rate would be any higher in such a system than the market rate implied in today’s environment. Again, the matching up of saved funds with loaned funds should prevent the inception of non- viable projects saving the system from the crashes which always lead to a freezing up of bank lending.
- A 100% reserve requirement would inhibit the contractual freedom of the parties. Response: On the contrary, the proposal represents the natural application of traditional property law principles to a monetary deposit contract.
- Economic growth is not possible without a certain amount of credit expansion and inflation. Response: May I quote De Soto “ The slight, gradual and continuous deflation (in the sense of a rise in the purchasing power of the monetary unit) would actively foster sustained, harmonious economic development”.
At the point of collapse the Royal Bank of Scotland had leveraged itself so severely that it had lent out each pound sterling sitting in so called demand deposit accounts 66 times.
Even the most prominent defenders of fractional-reserve banking recognize that the establishment of a 100% reserve requirement would put an end to banking crises.
Simon Johnson, former Chief Economist of the IMF said in May 09 “The Finance industry has effectively captured our Government…recovery will fail unless we break this financial oligarchy”
You have the power to prevent any recurrence of these banking crises and to free governments and taxpayers from the finance industry. I urge you to use it, change the legal status of demand deposit contracts as proposed – provide that such funds remain 100% cash backed and remain the property of depositors.
Ladies and Gentlemen, thank you.
January 13th 2010
Those unfamiliar with the fine detail of derivatives pricing, regulatory capital, and accounting may have been surprised by Warren Buffet’s 2002 observation that derivatives are “the financial weapons of mass destruction”.
Further evidence of the great sage’s wisdom emerges in the Dec 8th edition of The Times. Neel Kashkari, the 35 year old banker picked by US Treasury Secretary Hank Paulson to “design” the US bailout called TARP (Troubled Asset Relief Plan) admits how the figure $700 billion was arrived at:
We have $11 trillion residential mortgages, $3 trillion commercial mortgages. Total $14 trillion. Five per cent of that is $700 billion. A nice round number.
This detail is revealing. 5% is the flip side of 95%. What is the significance of this? 95% is the magic number which has driven the enormous growth of the unfunded derivatives market. The term ‘unfunded’ is important, since the regulators had always felt comfortable in designing rules for funded assets (commonly known as loans). That task was deemed relatively easy and banks have been required to allocate 8% of capital reserves to back up their loan books.
However, unfunded exposures under swaps, forwards, options and so forth collectively known as “derivative” transactions were more difficult to analyse and control. As a result, the derivatives industry had boomed since its inception in the early 1980’s primarily on the back of remarkably generous regulatory and accounting treatment. The starting point for regulatory capital is 0.5% of “exposure”, or 1/16th of the base requirement for funded assets. For long term transactions this 0.5% figure may be augmented by the addition of reserved profit.
I must admit that this expression – reserving the profit – always struck me as the wrong way around. How would the government’s regulator of water companies react if the water industry sought to prepare new balance sheets showing today’s capital base substantially increased by the reservation of future years’ profits, then reduced back to a still inflated figure by the deduction of a portion of this reserve “for conservatism”?
Encouraged by the banks’ own pricing experts, the regulators have accepted the use of historical data analysis as the basis of the rules they established to measure the capital requirement for any risk position on a bank’s derivative book.
The mapping of these historic data observations on bell shaped normal distribution charts is at the root of accounting and regulatory capital rules for derivatives, none of which have been changed as a result of the collapse of the banking system. These charts drive pricing models and internal risk controls. Bank traders use the models to place a value on each such exposure, generally ignoring outcomes that would be outside two standard deviations from the historical norm. ‘Two standard deviations’ simply expressed, covers 95% of the outcomes.
Although regulators require investment grade banks to capitalise for risk measured beyond the 95th percentile, the 95% test is applied extensively as a ‘practical’ benchmark. If a deal ‘works’ at 95% it is generally done. If it continues to satisfy this test year after year, relevant time based portions of the profit ‘reserved’ (ie not taken into profit and loss account at inception) will be recognised.
This use of these charts always struck me as questionable on two counts:
a) Excessive reliance on historical outcomes as a predictor of the future;
b) The confirmation bias present in the mapping of the data.
Traders and transaction specialists both outnumber and are paid far more than their internal and external regulators. The internal regulators control profits and bonuses. Put simply, if the pricing or capital cost outcome of the model inputs does not fit the price on offer for the trade, the data can be re-analysed and mapped again more conveniently. This point is of particular note in ‘exotic’ derivatives territory; transactions whose subject matter is less commonly priced in the money, bond, or commodity markets. Examples such as weather, human mortality, or corporate credit defaults come to mind.
Even senior bankers unfamiliar with minutiae of derivatives calculations are aware of the significance of the 95% benchmark. So here we see the intuitive appeal of Kashkari’s sizing of the US TARP bailout – he filled the 5% confidence gap.
Sean Corrigan of Diapason Commodities Management packs more sound applied economics into this report than ever: Toby Baxendale provides a commentary. This is a great Christmas read for us all: download the report here.
On the Errors of GDP Accounting
- For the USA economy, Corrigan shows the utter futility of using the conventional GDP measure. The same applies for any of the OECD countries who use the same measure.
- Business spending in 2006 in the USA was $31 trillion vs a GDP of $13.4 trillion.
- Businesses were spending $4.30 for every $1 spend on personal consumption.
- Policy makers from around the world, if any of you are reading this article, please take note of the significance of this fact!
- This focuses on something that all Austrian economists know: the desire by the mainstream economists is not to double-count. In the end, they do not count much at all!
- As a catering fish monger myself, I buy fish off farms, boats and auctions around the world. I cut and prepare the fish and send it to my customers, the hotels and restaurants of the UK. Yet none of my spending exists in the GDP figures! My wealth and that of my suppliers does not exist as far as the authorities are concerned. I only wish that I could get the tax man to take this view like his economist colleagues in the Revenue Department!
- I had this discussion with a member of the MPC some months ago: how if my salmon was bought at the fish farm for £1 per kg and we put a £1 mark-up on after cutting it up and the end user put a £1 mark up on, it is double counting as far as he was concerned. He reasoned that to count all of the stages of production when it only finally gets sold for £3 would be an overstatement as the price of the inputs is in the final price of £3. They miss out the significance that I and my supplier have our profit to the spend in the wider economy after we have spent our companies’ resources on continuing investment and consumption. This is all real activity! This is the danger of having statisticians running the economy.
- All that matters, we are told, is that GDP is composed of 70% of final consumption expenditure. In reality, the final consumption element is more like a quarter of real GDP, once the production sector is included.
- As I have always said, the health of the production sector is driven by its ability to invest in replacement capital to make more efficient production techniques, to supply more goods and services to people at better prices and with better service levels. This is the essence of entrepreneurship, the essence of wealth creation and the essence of the recovery: magic tricks perpetrated by the economic witch doctors, who wish to pursue a policy of QE or similar, will only consume capital and not replace it with some better means of production.
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