BoE's Posen attacks banks for failing to do their job

The Telegraph reports that Mr. Posen, a member of the Bank of England's Monetary Policy Committee, is accusing banks of not doing their jobs and instead being "reluctant, risk-adverse jerks".

Regular readers are not surprised by this characterization of bankers as this blog has described on several occasions why they are behaving the way they are.  A brief recap:

• Leading up to the beginning of the financial crisis on August 7, 2007, banks were not originating loans with the intent to hold them on their balance sheet, but instead to distribute these loans to investors through structured finance securities.  This is a very important point because the riskiness of the loans that banks might want to hold on their balance sheet to maturity could be considerably different from the riskiness of loans that investors might want exposure to.

• Since the financial crisis began, banks have not been required to recognize all of their losses.  This is very important because it leaves banks guessing as to the value of the borrower's collateral [for example, this blog previously documented that banks are reluctant to lend against real estate because the price keeps falling].  Imagine for a second going into a loan committee meeting and trying to explain why a bank should grant a mortgage when the bank has two other mortgages on the same block that are not performing.

• Since the financial crisis began, financial regulators have been pursuing a strategy of requiring banks to raise their Tier I capital ratio.  As predicted on this blog, banks are having difficulty selling equity because investors cannot assess the risk of the bank.  The result of having their access to the capital markets cutoff is that banks are electing to shrink their balance sheet and increase their income through fees they charge.

Perhaps the performance of bankers would be dramatically different if financial regulators would pursue policies, like requiring ultra transparency, that address the underlying cause of the on-going financial crisis.

Imagine for a second what would happen if investors had current information on an observable event basis for the collateral backing structured finance securities.  Suddenly, these securities could be valued.  With the ability to value comes primary market demand for additional securities.  With primary market demand comes banks originating loans to distribute....

Mr Posen, a member of the Bank's nine-strong Monetary Policy Committee, added that banks were making "excuses" for their failure to lend to small businesses, suggesting the real reason might be that they are "reluctant, risk-averse jerks". 

Speaking to Sky News, he said: "We, the British taxpayer, but also the British government as a regulator, is not getting value for money because the role of banks ... is to provide credit for growth of the real economy in the UK and they are not doing the job. 

"We've got to change the competitive pressures on them, change the rules on them so they're forced to do the job right." 

Official figures show that small businesses repaid 6.1pc of their outstanding debts to the banks over the past year as the cost of borrowing became more expensive. Mr Posen claimed that the decline in borrowing by small businesses was not due to lack of demand, as the banks have claimed, but to the higher cost. 

"When banks say it's all about no demand [for loans], that's crazy," he told BBC Radio's Wake up to Money. "Fees, prices and spreads on loans going to small businesses are going up, and normally prices don't go up when demand is falling." 

He added that banks were using new capital and gearing requirements as an excuse to limit lending. "They are not being forced to build up capital and cut back their balance sheets as much as they claim... It's an excuse, it's not a reality," he said. 

To explain their behaviour, he wondered whether bankers were "reluctant, risk-averse jerks" or if there was a more fundamental problem. 

He claimed banks were choosing to roll over loans to big businesses rather than make new loans to smaller firms and stressed that the problem was particularly acute in the UK due to the lack of alternative funding for small businesses. He urged the Government to press ahead quickly with its credit easing programme to get £20bn into the sector.

Is Ed Milibrand's posturing setting the stage for requiring banks to adopt ultra transparency?

Philip Aldrick wrote an interesting column in the Telegraph in which he discussed how opposition to crony capitalism is picking up strength.  Specifically, he discussed what he felt were better ways to address issues like banker bonuses than the successful brute force methods being adopted by Mr. Milibrand.

What is important to note about Mr. Milibrand's efforts is they are setting the stage for real reform of the banks.

Mr. Aldrick argues for 'putting capitalism back in the heart of capitalism', but then suggests a number of solutions that are easily gamed and don't put capitalism back in the heart of capitalism.

Regular readers know that putting capitalism back in the heart of capitalism requires replacing opacity with transparency.

For the invisibile hand of the market to work properly buyers must have access to all the useful, relevant information in an appropriate, timely manner on what they are buying.  For banks, this information comes in the form of ultra transparency under which they disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

Opacity allows bankers to make big bonuses by taking bets where the market cannot adjust the cost of the bank's funds to reflect the true riskiness of the bets.

Ultra transparency links the cost of the bank's funds to the riskiness of the bank.

Fresh from his victories on Stephen Hester’s bonus (Pyrrhic) and Fred Goodwin’s knighthood, Ed Miliband is back banging the “responsible capitalism” drum.... 

Capitalism has been rigged for far too long. Bankers were somehow excluded from the rules that the rest of us followed. Reform is needed that will put “capitalism back into the heart of capitalism”, as the Bank of England’s deputy Governor Paul Tucker succinctly put it. 

His boss, Sir Mervyn King, the Bank’s Governor, picked up the same theme last month. “Those who have suffered most have been those who accepted the disciplines of a market economy only to find that others were excused that discipline because they were ‘too important to fail’,” he said in words that clearly struck a chord with Miliband. 

Reforming capitalism will be the lasting legacy of the crisis.... 

What is needed is a change in the rules....

Contrary to reactionary sentiment, regulatory reform does not mean the end of free market capitalism. There are already rules in place. Lots of them. As Adam Smith made clear, markets need to be backed up by the rule of law. And many of those rules already have huge influence over behaviour.... 

Changing the rules again will just rearrange the free market, not kill it. 

And when it comes to bankers’ pay, far more intelligent people than me – mostly at the Bank – have come up with a bunch of good ideas. 

To start with, the way performance is measured should be overhauled. One compelling idea is to base it on return on assets rather than return on equity, as currently. Imagine buying a £100,000 house with a £10,000 deposit. If the price of the house rises to £110,000, you have doubled your deposit – your equity. That’s a 100pc return, but the asset has risen just 10pc. 

The debt multiplied what skill there was in picking the property tenfold. 

Debt works in the same way for bankers, where a 100pc return guarantees a bonus 10 times larger than a 10pc return. But there is one big difference. If the house price falls, you lose. If a banker’s investment falls, all they may lose is their bonus that year. Return on assets is a far superior measure of skill, and so a better way to measure rewards....

Of course, this assumes that bankers are not smart enough to figure out how to receive the same bonus using Return on Assets.

And then there is Miliband’s beloved issue of accountability. Shareholders currently don’t rein in the amount paid out in bonuses because the awards are presented as a done deal. Bonuses are qualified as “expenses” not distributions, such as dividends. If they were reclassified, then shareholders might be able to vote on the share of distribution....

Actually, without transparency there is no true accountability.  Transparency is needed so that the market properly prices the bank's securities to reflect the risks being taken by the bank.

Keen to ditch the anti-business mantle, Miliband does say: “Nobody begrudges exceptional rewards for exceptional performance. That is how capitalism should work.” He is right. Really good bankers, under the proposals above, could still be paid obscene amounts. But they would have to be really, really good, and most would get peanuts. 

Bankers should be well compensated if they can generate superior risk adjusted returns in a transparent environment.

If he is serious about fixing capitalism’s social ills he should propose some detailed changes to the rules that govern it, and then move out of the way. Given the right incentives, the free market would put responsibility back into capitalism all on its own.

Thank you Mr. Aldrick for inviting Ed Milibrand to propose that banks be required to provide ultra transparency.

Confirmation that risk remains in banking system even as banks show higher Tier I capital ratios

Bloomberg ran an article which confirms that while EU banks are taking significant steps to boost their Tier I capital ratio, the bad debt remains on their balance sheets.  Some of the bad debt is known, but like structured finance securities that are no longer marked to market, some of the bad debt is hidden.

Now why exactly should higher capital requirements cause the interbank loan market to unfreeze (every bank knows what it is hiding in the way of bad debt) or cause the unsecured bank debt market to unfreeze (investors still can't assess the risk of the banks because they do not have the information required to know what each bank's bad debt exposure is)?

European banks have almost doubled the amount of loans they are trying to sell to 2.5 trillion euros ($3.3 trillion) in the past year as they seek to cut balance sheets....

“Banks have continued to develop their deleverage strategies, and have become more transparent in communicating these to the market,” Richard Thompson, a partner at London- based PwC, said in today’s report. “Over the past year PwC has seen an increasing volume of non-core loan portfolio transactions, a trend that is expected to continue.” Last year the figure was estimated to be 1.3 trillion euros, PwC said. 

While the total amount of bad loans on European banks’ balance sheets has remained stable at about 518 billion euros in the past year, in countries such as Spain, Greece and Italy balances have been increasing, offsetting reductions in Germany and Ireland, PwC said.

Banks tighten loan terms amid property-price fears

The Irish Independent ran an article on banks tightening loan terms that could have appeared in any EU country or the US and been equally valid.

As this blog has repeatedly pointed out, it is very difficult for banks to lend money when they see the value of the collateral that would secure their loan declining.

In addition, the effect of banks tightening loan terms exacerbates the impact on credit availability caused by the frozen structured finance market.

With the structured finance market unavailable, banks have to hold onto the mortgages they originate.  With the financial regulators pushing for higher capital ratios, banks have an incentive to limit their loan portfolios.  Combining long term credit risk with limited capacity naturally leads to a focus on only highly qualified borrowers.

BANKS are making it harder for people to get mortgages because they believe house prices will keep falling and fear the economy will continue to slow down. 

The lenders are imposing tougher conditions before they will grant mortgages, a Central Bank survey on lending has found. 

Regulators said banks would continue to turn down applications for mortgages despite the Government boosting the tax reliefs it will pay new buyers this year, and banks claiming to be willing to lend. 

Although banks have cut the interest rates they charge on mortgages, at the same time they are demanding larger deposits, the Central Bank said. 

But it is not just a reluctance to lend that is keeping the property market in a price-fall spiral. Demand for home loans weakened in the last three months of last year due to economic uncertainty. 

House prices have fallen by half since the peak of the property bubble in 2007, with an international study last month concluding that prices in Ireland were now among the most affordable in the world. 

But the Central Bank survey found that lenders were being put off by the likelihood that prices would keep falling and have responded to this by making it harder to get approved for a mortgage. 

"The tightening of credit standards in respect of mortgage lending was attributed to less favourable expectations regarding economic activity, along with diminished prospects for the housing market," the survey stated. 

Hopes of an uplift in the property market have been dashed by a comment in the survey that "credit standards are expected to tighten on loans to households with loan demand anticipated to remain unchanged".

The availability of finance was the biggest stumbling block for the property market, the Royal Society of Chartered Surveyors Ireland (RSCSI), whose members include estate agents, said in a report this week. 

A lack of banking funding means up to a quarter of house purchases are now made by cash buyers. 

The RSCSI said: "On the residential side, only those in secure roles either in the public service or from high-profile, international firms are being offered mortgages, despite claims to the contrary from the banks themselves."...

A spokesman for the Irish Banking Federation said banks were engaged in prudent lending to prudent borrowers.

Spain unveils plan to clean-up bad real estate loans in banking system

The Spanish government unveiled its plan for cleaning-up the bad real estate loans in the banking system.

According to articles from Reuters, the NY Times and the Wall Street Journal, the centerpiece of the plan is the requirement that the banks set aside an addition 50 billion euros against the 176 billion euros of bad debt in the banking system.

The primary source of funding for this provision is future bank earnings.  Specifically, bank earnings for the twelve months following the provision.

If these earnings are not sufficient, banks are urged to merge and apply the savings from the merger to fund the provision.  Banks that merge will be able to apply earnings for the next two years to paying for the provision.

If earnings for the next two years prove fails to fund the provision, then the Spanish government is willing to lend money to the banks by purchasing so-called CoCo securities.  These securities convert into equity based on the performance of the banks.

Regular readers will have noticed how closely this plan resembles this blog's blueprint for saving the financial system.

• Spain's plan and the blueprint require banks to recognize their losses today.

• Spain's plan and the blueprint require banks to rebuild their book capital through retention of future earnings.

• Spain's plan and the blueprint keep banks with a viable franchise open and close banks that are unable to generate the future earnings to rebuild their book capital.

There are two major difference between Spain's plan and the blueprint.

• The blueprint requires that banks provide ultra transparency and disclose to the market on an on-going basis their current asset, liability and off-balance sheet exposure details.  This disclosure is necessary so that market participants can confirm that the banks have in fact fully addressed all their losses.  More importantly, it allows the market to exert discipline to ensure that bank management does not try to gamble on redemption while rebuilding book capital.

• The blueprint also does not put a limit on how long the banks have to rebuild their book capital through retention of future earnings.  As a practical matter, I don't think that the Spanish government is going to enforce a 12 or 24 month timeframe for rebuilding capital for any bank with a viable franchise.

From Reuters,

Spain's banks must raise 50 billion euros ($65.86 billion) in extra funds to compensate for foreclosed properties and bad loans to housebuilders festering on their balance sheets, under new rules revealed on Thursday. 

The centre-right government gave newly-merged banks and banks planning tie-ups extra time, two years to write down deteriorating assets by setting aside provisions. Other banks will get one year. 

"The Spanish banking system will emerge from this process stronger, with fewer but more solid banks, meaning that Spanish lenders will be among the healthiest in the European Union," the Economy Ministry said in a statement. 

Spain's battered banks have cut back on lending to families and small businesses in a country desperately in need of credit as it continues to battle the euro zone debt crisis and heads into a second recession in four years. 

By cleaning the banks' balance sheets of worthless property assets, hammered in a property crash four years ago, the new government hopes to rekindle investors faith in Spanish banks -- allowing them to borrow on the international money markets and start lending at home again.
The banks have been largely shut out of interbank markets ever since the Greek bail-out in early 2010.

Requiring ultra transparency would really help here, but this is something that the banks should do voluntarily themselves.  After all, ultra transparency is the sign of a bank that can stand on its own two feet.

Banks must make a specific provision from results totalling about 25 billion euros across the entire sector, Economy Minister Luis de Guindos said in a news conference. 

In addition, banks must put aside capital equal to 20 percent of the book value of undeveloped lots and 15 percent of the book value of unfinished developments. That will amount to around 15 billion euros for all the banks and can come from profit, capital hikes or convertible bonds. 

For performing real estate loans, banks must make a generic provision of 7 percent, taken against results, to total around 10 billion euros. Previously banks were not required to make any provisions for those loans. 

The government will lend to banks that struggle to meet the new requirements through convertible shares. If a bank fails to pay back the loan during this time, the state will take it over..... 

Provisions against losses will now rise to between 35 percent and 80 percent, depending on the type of asset or loan. 

Banks looking to merge to meet the new requirements must present their plans before May 30 of this year.

Senior Italian Regulator says that higher bank capital requirements risk making situation worse

According to a Reuters' article, the head of Italy's bourse regulator voice his concern over higher bank capital requirements and observed that they risk damaging investor confidence.

So now damaging investor confidence can be added to igniting a credit crunch on the list of reasons why higher bank capital requirements in the absence of ultra transparency is a bad policy.

Further bank capital increase requested by the European Banking Authority (EBA) risk denting investor confidence, Giuseppe Vegas, head of Italy's bourse regulator Consob said on Thursday. 

"At the moment, the prospect of further, strongly dilutive capital increases risks not only making raising new capital difficult but creating a climate of mistrust among investors which, in the last analysis, could compromise the attractiveness of our shareholder system," he told a Senate hearing. 

He said there was a need to consider extending the deadlines for EBA's capital requirements, which force banks to strongly bolster their capital reserves.

Pesky question of how banks value securities takes center stage

Once again, the question of how banks value their exposures has taken center stage.  This time, the valuation issue came up due to a lawsuit against four Credit Suisse traders who are accused of manipulating the valuation of structured finance securities.

Regular readers know that one of the primary reasons your humble blogger has been advocating ultra transparency is that it ends this activity.

When market participants can see a bank's current asset, liability and off-balance sheet exposure details, they can independently value these exposures.  After all, setting prices is what markets are good at.

Ultra transparency also allows market participants to call attention to any exposure where there is a considerable discrepancy between their independent value and the bank's value.

The Wall Street Journal ran an article that highlights how without ultra transparency market participants do not know if a bank is solvent (the market value of its assets exceeds the book value of its liabilities).

Allegations that several former Credit Suisse Group AG employees misstated bond values revive a thorny question for investors: whether to trust the valuations companies assign their riskiest, most-illiquid assets....

The case spotlights the valuation questions that have dogged banks and securities firms since the start of the financial crisis. 

The puzzle of whether financial institutions properly acknowledged losses on their investments wasn't made any simpler when accounting-rule makers, pressured by Congress, in 2009 gave banks and other companies more leeway in valuing less-liquid assets. 

Without ultra transparency, there is no way for market participants to know whether banks have recognized all of their losses or whether there are massive amounts of losses still hiding on and off balance sheet.

This is the reason that market participants do not trust banks.

The Credit Suisse case comes as a new set of accounting rules that took effect at the start of 2012 will force companies to disclose more about the methods and assumptions they use in valuing exotic securities. 

The new disclosures wouldn't have prevented the sort of improprieties that allegedly occurred at Credit Suisse, experts say. But they may act as a check on companies, by giving investors a chance to see what assumptions are made in valuation models. 

"The fact that they have to report this will make management think," said Ravi Jagannathan, a finance professor at Northwestern University.

Compare and contrast the new rules with ultra transparency.  Ultra transparency will prevent this sort of impropriety as market participants will be quick to notice.

The new rules are a one-off solution.  It requires market participants to review the assumptions for all the bank's valuation models and figure out which ones might be driving a mis-statement in the valuation of securities.  Then, market participants are left without knowing the size of the exposure of the bank.  Exactly how is this going to lead to market discipline?

The new rules, enacted last May by U.S. and international accounting-rule makers, deal with how companies value their assets at "fair value," which is the market value or the closest approximation of it. The rules will require companies to make some new disclosures about the ways they determine fair value for their "Level 3" securities—the ones companies value using their own estimates and models. 

For instance, for securities backed by home mortgages, companies will have to disclose what assumptions they are using for mortgage prepayment rates, the probability of default and the severity of losses. 

Companies also will have to describe how sensitive their valuations are to any changes in the estimates and models they use. And for any items that companies must disclose the fair value but aren't required to carry at fair value on the balance sheet—such as bank loans—the companies must specify whether the items fall into Level 3 or would be classified as Levels 1 or 2, which are more-liquid assets that companies value using market prices or other "observable" information. 

The new disclosures will start showing up in companies' first-quarter reports.

Despite shrinking in size, Irish banks still dependent on ECB funding

An Independent article reports that deposits in Irish banks are stabilizing.

This stabilization confirms one of the critical assumptions underlying the blueprint for saving the financial system.  The assumption is that there is a core level of deposits in each bank that are not sensitive to the solvency of the bank, but rather are sensitive to the explicit and implied deposit guarantee.

This core level of deposits together with unlimited borrowing from the central bank ensures that a bank can continue in operation indefinitely regardless of whether it is solvent (market value of its assets exceeds the book value of its liabilities) or not.

BAILED-out banks gained almost a billion euro of ordinary Irish deposits at the expense of foreign lenders in December, new figures reveal. 

The boost marks the first time the 'covered' banks' deposit performance has been significantly better than that of other lenders with retail operations here. 

But analysts last night stressed that the overall state of bailed out banks' deposits could best be described as "stable" and that there was no evidence vast sums were flowing into the Irish banks. 

The latest data shows our bailed-out institutions saw their overall deposits drop by €29bn in 2011, leaving the banks with €154.5bn of customers' cash on their books.... 

"Deposits aren't flowing in but they have stabilised," Davy's financial analyst Emer Lyons said last night, adding that Irish banks were "still paying very attractive rates".

 In a note issued to clients, Goodbody's pointed out that the latest Central Bank dispatches included the "surprise" information that Irish banks had not increased their reliance on European Central Bank funding despite taking three-year money from the ECB in December....

Goodbody's suggested that Irish banks might have extended existing one-year ECB loans to three years rather than drawing brand new money. 

"Clearly, deleveraging, as well as stability in deposits is resulting in a lower (albeit still-high) dependence on central bank funding," the note added.

Bill Gross takes on Fed's zero interest rate policy

In his February 2012 Investment Outlook, Bill Gross examines the critical assumptions behind the Fed's zero interest rate policy and finds they do not hold and as a result the policy is doing more harm than good.

Regular readers know that over the last year this blog has run several posts on this topic that came to the same conclusion (see here, here, and here).  In fact, the similarities between his Investment Outlook and this blog's posts in looking at the critical assumptions behind the Fed's zero interest rate policy suggest that he too is a regular reader.

• Recent central bank behavior, including that of the U.S. Fed, provides assurances that short and intermediate yields will not change, and therefore bond prices are not likely threatened on the downside.
• Most short to intermediate Treasury yields are dangerously close to the zero-bound which imply limited potential room, if any, for price appreciation.
• We can’t put $100 trillion of credit in a system-wide mattress, but we can move in that direction by delevering and refusing to extend maturities and duration....

The transition from a levering, asset-inflating secular economy to a post bubble delevering era may be as difficult for one to imagine as our departure into the hereafter....

Yet the imagination and management of the transition ushers forth a plethora of disparate policy solutions.... 

Fed Chairman Ben Bernanke ... preannounced an awareness of the deleterious side effects of quantitative easing several years ago in a significant speech at Jackson Hole. Ever since, he has been open and honest about the drawbacks of a zero interest rate policy, but has plowed ahead and unleashed his “QE bowser” into the wild with the understanding that the negative consequences of not doing so would be far worse. 

Actually, it his belief that the negative consequences of not doing so would be far worse.

Walter Bagehot, the man who wrote the book on modern central banking, would say that this belief is not true and that the negative consequences far exceed the benefit.  Mr. Bagehot said that rates should not drop below 2% and John Maynard Keynes deferred to his judgement.

My goal in this Investment Outlook is not to pick a “doggie bone” with the Chairman. He is makin’ it up as he goes along in order to softly delever a credit-based financial system which became egregiously overlevered and assumed far too much risk long before his watch began. 

Like Mr. Gross, I do not want to step into the Bagehot/Bernanke debate.

This blog has consistently focused on the alternative to the Fed attempting to address over-leverage in the financial system through monetary policy.  The alternative is to have the banks function as a safety valve between the excesses in the financial system and the real economy.

Banks can act as a circuit breaker by absorbing the losses on the excesses in the financial system today and restoring their book capital through future retained earnings.

My intent really is to alert you, the reader, to the significant costs that may be ahead for a global economy and financial marketplace still functioning under the assumption that cheap and abundant central bank credit is always a positive dynamic. When interest rates approach the zero bound they may transition from historically stimulative to potentially destimulative/regressive influences. 

Much like the laws of physics change from the world of Newtonian large objects to the world of quantum Einsteinian dynamics, so too might low interest rates at the zero-bound reorient previously held models that justified the stimulative effects of lower and lower yields on asset prices and the real economy. 

It is instructive to mention that this is not necessarily PIMCO’s view alone. Chairman Bernanke and Fed staff members have been sniffin’ this trail like the good hound dogs they are for some time now. In addition, Credit Suisse, in their “2012 Global Outlook,” devoted considerable pages to specifics of zero-based money with commonsensical historical comparisons to Japan over the past decade or so. The following pages of this Outlook will do the same.  

At the heart of the theory, however, is that zero-bound interest rates do not always and necessarily force investors to take more risk by purchasing stocks or real estate, to cite the classic central bank thesis.  

First of all, when rational or irrational fear persuades an investor to be more concerned about the return of her money than on her money then liquidity can be trapped in a mattress, a bank account or a five basis point Treasury bill. But that commonsensical observation is well known to Fed policymakers, economic historians and certainly citizens on Main Street.  

What perhaps is not so often recognized is that liquidity can be trapped by the “price” of credit, in addition to its “risk.” 

Capitalism depends on risk-taking in several forms. Developers, homeowners, entrepreneurs of all shapes and sizes epitomize the riskiness of business building via equity and credit risk extension. 

But modern capitalism is dependent as well on maturity extension in credit markets. 

No venture, aside from one financed with 100% owners’ capital, could survive on credit or loans that matured or were callable overnight. Buildings, utilities and homes require 20- and 30-year loan commitments to smooth and justify their returns. Because this is so, lenders require a yield premium, expressed as a positively sloped yield curve, to make the extended loan. 

A flat yield curve, in contrast, is a disincentive for lenders to lend unless there is sufficient downside room for yields to fall and provide bond market capital gains. This nominal or even real interest rate “margin” is why prior cyclical periods of curve flatness or even inversion have been successfully followed by economic expansions. Intermediate and long rates – even though flat and equal to a short-term policy rate – have had room to fall, and credit therefore has not been trapped by “price.” 

When all yields approach the zero-bound, however, as in Japan for the past 10 years, and now in the U.S. and selected “clean dirty shirt” sovereigns, then the dynamics may change. Money can become less liquid and frozen by “price” in addition to the classic liquidity trap explained by “risk.”  

Even if nodding in agreement, an observer might immediately comment that today’s yield curve is anything but flat and that might be true. Most short to intermediate Treasury yields, however, are dangerously close to the zero-bound which imply little if any room to fall: no margin, no air underneath those bond yields and therefore limited, if any, price appreciation. 

What incentive does a bank have to buy two-year Treasuries at 20 basis points when they can park overnight reserves with the Fed at 25? What incentives do investment managers or even individual investors have to take price risk with a five-, 10- or 30-year Treasury when there are multiples of downside price risk compared to appreciation? At 75 basis points, a five-year Treasury can only rationally appreciate by two more points, but theoretically can go down by an unlimited amount.  

Duration risk and flatness at the zero-bound, to make the simple point, can freeze and trap liquidity by convincing investors to hold cash as opposed to extend credit.  

Where else can one go, however? We can’t put $100 trillion of credit in a system-wide mattress, can we? Of course not, but we can move in that direction by delevering and refusing to extend maturities and duration. 

Recent central bank behavior, including that of the U.S. Fed, provides assurances that short and intermediate yields will not change, and therefore bond prices are not likely threatened on the downside. Still, zero-bound money may kill as opposed to create credit. 

Developed economies where these low yields reside may suffer accordingly. It may as well, induce inflationary distortions that give a rise to commodities and gold as store of value alternatives when there is little value left in paper. 

Where does credit go when it dies? It goes back to where it came from. It delevers, it slows and inhibits economic growth, and it turns economic theory upside down, ultimately challenging the wisdom of policymakers. 

We’ll all be making this up as we go along for what may seem like an eternity. A 30-50 year virtuous cycle of credit expansion which has produced outsize paranormal returns for financial assets – bonds, stocks, real estate and commodities alike – is now delevering because of excessive “risk” and the “price” of money at the zero-bound. We are witnessing the death of abundance and the borning of austerity, for what may be a long, long time.

Banking in a market economy

The Bank of England's Paul Tucker has written an interesting paper on banking in a market economy.  In it, he neatly summarizes how banking and capital markets have merged over the last 3 decades.

A generation or so ago, we could have relied upon separate regimes for banking and for securities markets. In that far-off world, banks extended and held illiquid loans, overseen by
banking supervisors. And, in a largely separate universe, securities regulators policed the integrity of individual transactions and offerings on public exchanges served by specialist intermediaries. 

The growth of private markets – over-the-counter, derivatives, securitisation – and of banks as intermediaries in capital markets has changed all that, as the 2007–09 crisis cruelly exposed. 

The revolution, whether we like it or not, has been the fusion of banking and capital markets. 

Even the most limited forms of commercial banking involve hedging of customer business in interest-rate and foreign-exchange markets. Wholesale loans to medium-sized and large companies, loans that are syndicated and traded, lie in the intersection of commercial and investment banking. 

The solutions to the problems of global finance have to cover securities markets as well
as banking.

I would ask that you re-read his summary as it highlights several critical issues.

• Securities regulators have historically deferred to the primacy of bank regulators for all bank related matters.
• Banking and capital markets have fused; and 
• Solutions have to cover both the securities market and banking.

These observations give rise to a question:  where in all of the new regulations enacted since the start of the financial crisis on August 9, 2007 is the solution that a securities regulator would naturally adopt?

Since the Great Depression, capital markets in the US and Europe have been based on the philosophy of disclosure.  Specifically, the idea that market participants must have access to all the useful, relevant information in an appropriate, timely manner.  Securities regulators were given the responsibility for making sure this occurs.

Given this responsibility, how would securities regulators have fulfilled their responsibility that banks disclose all their useful, relevant information if banking supervisors did not exist?

Would the securities regulators have adopted the same disclosure that we have now that the Bank of England's Andy Haldane says leaves banks resembling 'black boxes'?

Or, would the securities regulators have adopted ultra transparency and required banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details?

There is reason to believe that securities regulators would have adopted ultra transparency because this is the information that bank supervisors have access to and use so that they can oversee banks.