Wednesday, February 29, 2012

Standard Chartered's Peter Sands identifies systemic risk

In discussing his bank's financial results, a Telegraph article reports that Peter Sands observed
that he was worried that international regulators were fixated on preventing another collapse like Lehman Brothers and not looking at the risks created by the expansion of central bank balance sheets.
Please re-read the highlighted text because Mr. Sands has identified the largest systemic risk in the financial system.

Just like structured finance securities and bank balance sheets are 'black boxes', so too is a central bank's balance sheet.

While a central bank can always fund its balance sheet by printing more money, there is a risk from the expansion in the central bank balance sheets that the public loses confidence.

As Morgan Stanley said (hat tip Zero Hedge):

What happens when the public loses confidence in central bank liabilities? 
A: A run on the fiat money systemIn response to the seismic shift in private sector risk-aversion the financial crisis brought about, central banks have deployed their balance sheets to cushion the blow to the economy.
Actually, the private sector is no longer willing to buy opaque products including structured finance securities and bank liabilities that are not guaranteed.

The central banks are using their balance sheet to fill this hole.

Should the central banks want to stop using their balance sheets, they should require the end of opacity in the financial system.
They have done so by taking the unwanted risk off the private sector balance sheet and replacing it with safe as well as liquid assets: central banks’ own liabilities
This is, in essence, a confidence trick. It works for as long as the private sector is willing to hold these liabilities – i.e., for as long as they are considered safe, which in turn depends on them being considered safe by everyone else. 
A central bank will, of course, never default on its liabilities – they can, after all, create unlimited amounts of it. 
But the ‘safety’ property also depends on whether this asset is seen as a store of value, i.e., likely to maintain its real value – its value in terms of goods and services. 
So, while there is no technical limit to the expansion of central bank balance sheets, there is a limit nonetheless: the public’s confidence in the real value of such liabilities – and government liabilities more generally. The more such liabilities are created, the more we approach this point. 
How would such a loss of confidence unfold?  
If the supply of central bank liabilities – call it ‘liquidity’ – exceeds the public’s liquidity preference, then the latter will seek to substitute away from it. The public will then buy goods and real assets. The result is self-fulfilling inflation – inflation will rise essentially because the public has lost confidence in the ability of central bank liabilities to maintain their real value. 
 We are probably very far from such an outcome – far enough that it can be considered a tail risk. Yet, the risk in question is nothing less than a wholesale run on the fiat money system.


Noni Mausa said...

"The public will then buy goods and real assets..."

But what sorts of real goods? Suppose I make median wage (for the moment) and have a choice of putting my extra money in the bank, or buying goods and assets. If I don't trust the central banks then I probably don't (or shouldn't) trust government bonds and other investments, insured or not. Gold -- well really, what good is gold to me as a little person, when converting it back to liquidity is also under a pile of controls, and might not be feasible at the moment I need the cash? Ditto for gems and art and antiques - their value is not easily realized, and depends on a population of interested buyers somewhere down the timeline. The losses between the buying price and the selling price can be huge.

Property? Real estate isn't going anywhere, that's true, and the things that can degrade or destroy it are not common. But even if paid in cash and owned outright, property still requires property tax payments. In this sense, it is never fully owned, plus it shares the liquidity problems of art and gems, and isn't portable and is often not divisible either.

Or, is the wary consumer driven, willy nilly, to a carpe diem lifestyle? An apple, whether Granny Smith or iPad, is a real asset, but its keeping qualities are limited. Various tools and furnishings might be good investments, but as a median wage American I can't be sure how long my job will endure. Where does a homeless person keep his tool-and-die set and his oak dining room suite?

No, it actually looks like the safest investment for a person who doubts the good faith of the banks, his employer, the job market, and his government might actually be cash money in a jam jar, buried in the woods somewhere. Cash also loses its value, but seems a good balance between the illiquidity of art and property and the dubious reliability of bonds and stocks.

Am I being too paranoid here? Having seen my relatives successively lose their own jobs, savings, pensions and properties, I can't tell anymore. I plan to go buy a corncob pipe and sit in the porch rocker, thinking about it.


Richard said...


Thanks for the insightful comment. You have focused on a very interesting question: what to do if there is a run on the fiat money system.

In his shareholder letter, Warren Buffett suggested that income producing property was better than gold.

Yes, both are illiquid. However, even if there is a run on the fiat money system, the income producing property should still produce income (just in a new currency).

Mr. Buffett focused on farm land although I suspect that timberland would be a pretty good choice too.

Noni Mausa said...

Thanks -- although as a median wage earner I probably don't have a lot of leverage in the farm and timber sectors. I might be able to put away $4-10,000 a year, that is, not have to spend it for essentials.

Perhaps something like a farming co-op?


Richard said...

At this point, we are heading into specific investment advice as oppose to relaying a relevant public argument made by Mr. Buffett.

Since I am not an investment advisor, I think you can appreciate why I won't offer more specific investment advice.

selebi51 said...

Standard Chartered do not heed own advice. Standard Chartered promote high risk / dangerous investmnts