Have central banks become debt black holes?

In an interesting post on Golem XIV, the ECB swallowed the market, the argument was presented that the central banks have piled on so much debt that they have effectively made it impossible for the financial market based on private funding to re-emerge.

While I agree with the author's conclusion that there is a barrier to the financial markets being taken off of central bank life support, I disagree that the barrier is the debt on the central bank balance sheets.

The reason that the financial markets are still on life support was the decision at the beginning of the bank solvency led financial crisis to adopt the Japanese model for handling the crisis.

Under the Japanese model, banks hid on and off their balance sheets the true extent of their losses and only recognize losses to the extent that they generate earnings in excess of banker bonuses, shareholder dividends and de minimum increases in book capital.

All banks know that every other bank is hiding losses.  This is why the interbank loan market froze at the outset of the financial crisis and why it refroze as the Eurozone sovereign debt crisis gained momentum.

The response by the central banks has been to step in and provide the liquidity that the interbank lending market would provide.  In doing so, the central banks have taken collateral for their loans.

The central bank programs are reversible if, and only if, policymakers and financial regulators adopt the Swedish model for handling the crisis and require banks to provide ultra transparency.

It is only when every bank is able to access the current asset, liability and off balance sheet exposures of every other bank on an on-going basis that each bank can independently assess the risk of each of its competitors and determine the amount and price of any loan to these competitors.

The problem is this. The Central banks have chosen to lend to insolvent private banks and to the nations that already bankrupted themselves trying to bail out their unbailable banks. 

In an attempt to make their lunacy seem sensible, the central banks assured everyone that they would only accept as collateral for the money they were lending out, the best assets the banks possessed. So the best of the insolvent banks’ assets were sucked in and cheap central bank loans flooded out.  

The central banks said that ‘now the banks were stabilized’ they hoped the banks would lend to the market and to each other thus allowing the broader economy and the banks themselves to be funded ‘by the market’. 

Neither happened. Why? Well the banks continued not to trust the quality of the assets they were offering each other as collateral. Not entirely surprising since the banks had already pledged the best of them to the central banks. Without trust-able assets as collateral – no loans. 

So the banks were forced back to the ECB and the Fed for more loans. Of course they had already pledged their best assets. So began the gradual but inexorable loosening of criteria for what the ECB would accept as collateral. At first it was only AAA rated. Then it was bonds from ailing nations. Then it was anything that came to hand.   

Which made the ‘market’, AKA other banks, even less keen on accepting as collateral whatever was left. And so on round and round. We have long since reached the point where the central banks like the ECB, either directly or washed first through a national bank such as The bank of Greece or Spain, has begun to accept almost anything as collateral. 

When I say washed what I mean is the national bank in Spain or Greece or Ireland may accept some asset which is thoroughly sub-prime in return for a sovereign bond. That bond is then acceptable to the ECB as collateral because it is a Sovereign bond, which as we all know are AAA rated, for sure, for sure never going to default. 

However the more sub-prime, stinky, slimy paper the national banks are stuffed with, the more the sovereign debt is backed by a national bank which resembles a sewer of rotting rubbish, a nation in the grip of austerity and a contracting economy. 

Whatever pretty prime-time fictions you get hosed with each evening, this is the reality that dare not be reported. And we all know it. Ireland is in recession, Spain’s economy is contracting and so is Portugal’s. That is why ‘the market’ keeps hiking the interest it insists upon for lending to National banks.  

The result is that the private banks have already pledged anything good they had. They will not therefore lend to each other because they know none of them has any assets left which are worth anything. Thus they are forced to go back to the ECB and Fed for more money and those institutions are forced to take even more ropey assets in return for issuing even more loans.  Each time round, each new QE and new lot of money, sucks in more bad assets and makes any possiblity of private funding even more remote. 

The Central banks have swallowed the market. All debt and debtors are being drawn into ever tighter orbit. None will escape.

While the author has clearly described a reinforcing spiral where the banks become ever more dependent on the central banks, the description ignores the simple fact that when making a loan, the first question to ask is will the borrower pay it back.

In the absence of ultra transparency, banks do not know which of their competitors can or cannot repay a loan.  The interbank lending market is frozen because banks don't know which banks can repay a loan.

Provide ultra transparency and the dependency on the central bank is ended.

Now you might object that I have simply missed the point of the official policy. Certainly the National banks and the Central Banks have removed huge amounts of the toxic loan/assets from the private banks… and this we are assured is a good thing. 

This is called ‘cleaning up’ the banks. The rubbish is removed and in its place ‘good’ national and central bank bonds are put in their place, giving the private banks lots of good assets. And it does sound possibly OK when you hear it put that way and don’t think too hard about it. 

But we have to remember a couple of things. 

First the bad assets have not ‘gone’. They still exist. They are still money which was lent out, which itself was often borrowed and thus has to be repaid, but which is not now bringing in any profit. Those losses are still warm and moistly rotting, just doing it in National and Central bank vaults now. 

The author makes a very important point that the losses still exist.

However, pledging an asset that contains the loss to a central bank does not transfer the loss to the central bank.  The borrowing bank is still on the hook for the loss.  It is expected that the borrowing bank will repay the loan in full and get the asset containing the loss back.

Second, for all that the banks do now have sovereign and Central bank bonds to pledge, they are still, all of them, coming back to the ECB and the Fed for more QE easy money loans. This is because even though the banks have used that QE money to speculate on commodities and currencies to try to make a fast and out-sized profit – still chasing high risk and return – they still have huge liabilities (money they owe) not being paid for from income which is  not coming in from yet more bad assets which are nevertheless still  being held at imaginary values so as to make the assets side of the balance sheet look like it might balance out those liabilities....  

One of the reasons that ultra transparency is needed is so the market can exert discipline on the bankers and stop them from gambling on redemption.  The experience of the US Savings & Loans was that in the absence of ultra transparency, bankers gambled on redemption, lost and dramatically increased the cost to the taxpayers.

My main point is that the banks, despite 4 years of never-quite-materializing recovery, still need loans from the central banks and still need to pledge assets to get them. How many more assets do they have? Probably many hundreds of billions. But they are increasingly awful.... 

The question is why do the banks need to pledge increasing amounts of assets to the central bank?

Because market participants are becoming increasingly unwilling to fund the banks!

This takes several forms.  First, there is the frozen interbank lending market.  Second, there is the unsecured bank debt market which also froze due to a lack of ultra transparency and an inability to determine which banks can repay their debt.  As loans from both of these frozen markets mature, they must be repaid... hence a need for central bank funding.

The third form of market participant unwillingness to fund the banks is the on-going bank run in Ireland, Greece, Spain, Portugal and Italy.  As deposits flow out, banks turn to the central banks for funding.

Please note, all three ways that market participants show their unwillingness to fund the banks are addressable and reversible if the banks were required to provide ultra transparency.