Tag Archives: Liquidity

Macroeconomic Effects of Bank Solvency vs. Liquidity

In a CEPR discussion paper, Òscar Jordà, Björn Richter, Moritz Schularick, and Alan M. Taylor suggest that higher bank capital ratios help stabilize the financial system ex post but not ex ante, and that illiquidity breeds fragility.

Abstract of their paper:

Higher capital ratios are unlikely to prevent a financial crisis. This is empirically true both for the entire history of advanced economies between 1870 and 2013 and for the post-WW2 period, and holds both within and between countries. We reach this startling conclusion using newly collected data on the liability side of banks’ balance sheets in 17 countries. A solvency indicator, the capital ratio has no value as a crisis predictor; but we find that liquidity indicators such as the loan-to-deposit ratio and the share of non-deposit funding do signal financial fragility, although they add little predictive power relative to that of credit growth on the asset side of the balance sheet. However, higher capital buffers have social benefits in terms of macro-stability: recoveries from financial crisis recessions are much quicker with higher bank capital.

Money, Banking, and Dreams

In another excellent post on Moneyness, J P Koning likens the monetary system to the plot in the movie Inception, featuring

a dream piled on a dream piled on a dream piled on a dream.

Koning explains that

[l]ike Inception, our monetary system is a layer upon a layer upon a layer. Anyone who withdraws cash at an ATM is ‘kicking’ back into the underlying central bank layer from the banking layer; depositing cash is like sedating oneself back into the overlying banking layer.

Monetary history a story of how these layers have evolved over time. The original bottom layer was comprised of gold and silver coins. On top this base, banks erected the banknote layer; bits of paper which could be redeemed with gold coin. The next layer to develop was the deposit layer; non-tangible book entries that could be transferred by order from one person to another.

The foundation layer has changed over time:

One of the defining themes of modern monetary history has been the death of the original foundation layer; precious metals. … as central banks chased private banks from the banknote layer … and then gradually severed the banknote layer from the gold layer. By 1971, … [b]anknotes issued by the central bank had become the foundation layer. The trend towards a cashless world is a repeat of this script, except instead of the gold layer being slowly removed it is the banknote layer.

Fintech improves the efficiency of the layer arrangement and its connections. It also adds new layers: For instance, some payments made via mobile phone effectively transfer claims on deposits. And it may circumvent layers:

In U.K., the Bank of England is considering allowing fintech companies to bypass the banking layer by offering them direct access to the bottom-most central banking layer.

In contrast, a krypto currency like bitcoin establishes a new foundation layer, on which new layers may be built:

Even now there is talk of a new layer being developed on top of the original bitcoin foundation, the Lightning network. The idea here is that the majority of payments will occur in the Lightning layer with final settlement occurring some time later in the slower Bitcoin layer.

I fully agree with this characterization. In addition to the theme emphasized by Koning—adding layers—I would also stress the theme of untying higher-level layers from lower ones: Central bank money typically is no longer backed by gold; deposits typically are not fully backed by notes; and mobile phone credits may no longer be backed by deposits. The process of untying layers relies on social conventions and trust, and it is fragile. Important questions concern the cost of such fragility, and its necessity. Fragility is not necessary when the social cost of liquidity provision at the foundation layer is negligible.

Collateral Values in ECB Operations

In the NZZ, Kjell Nyborg questions whether the collateral values of the securities the ECB accepts in monetary policy operations reflect market values. He argues that the valuation is discretionary and politicized.

Meine Analyse macht deutlich, dass der Besicherungsrahmen in der Euro-Zone in unterschiedlicher Ausprägung unter all diesen Problemen leidet. Das öffentliche Verzeichnis der zulässigen notenbankfähigen Sicherheiten enthält 30 000 bis 40 000 verschiedene Wertpapiere, von Staatsanleihen bis hin zu unbesicherten Bankanleihen und forderungsbesicherten Wertpapieren (Asset-Backed Securities). Die überwiegende Mehrheit dieser Wertpapiere hat keinen Marktpreis. Ungefähr ein Drittel all dieser Sicherheiten wird in nichtregulierten Märkten gehandelt. Zudem können Banken nichtmarktfähige Anlagen und Wertpapiere mit «privaten Ratings» verwenden, die nicht im öffentlichen Verzeichnis sind. Daher basieren die Werte der Sicherheiten mehrheitlich auf Modell- statt auf Marktpreisen. Interessanterweise ziehen Banken es vor, Sicherheiten zu benutzen, bei denen häufiger theoretische Preise verwendet werden. Generell tendiert die Besicherungspolitik der Euro-Zone zu risikoreichen und illiquiden Sicherheiten. Die untergeordnete Rolle des Marktes sieht man auch an der Häufigkeit, mit welcher die Sicherheitsabschläge für die Repo-Geschäfte des Euro-Systems aktualisiert werden: Dies geschieht lediglich alle drei bis vier Jahre.

Im Kern des Geldsystems in der Euro-Zone gibt es somit wenig Spielraum für Marktkräfte oder Marktdisziplin. Insgesamt kann die Besicherungspolitik des Euro-Systems als expansiv beschrieben werden. Die Liste notenbankfähiger Sicherheiten ist äusserst umfangreich und oft auf die «Bedürfnisse» von Banken in verschiedenen Ländern zugeschnitten. Sicherheiten können, zum Beispiel, durch Staatsgarantien aufgewertet werden. … Weil es im Kern des Euro-Geldsystems an Marktkräften und Marktdisziplin fehlt, entsteht ein Vakuum, das von anderen Kräften, wie Rating-Agenturen und der Politik, aufgefüllt wird.

… Ich dokumentiere, dass DBRS eine ausschlaggebende Rolle innehatte, indem sie über eine lange Zeit hinweg Italien und Spanien ein Rating von A– und Portugal ein solches von BBB– gab. Das hob den Wert der in diesen Ländern begebenen Sicherheiten um ungefähr bis 200 Mrd. € an und kann als unterstützende Massnahme für indirekte Bail-outs interpretiert werden.

Im Dezember 2011 und Februar 2012 hat die EZB eine ihrer wichtigsten geldpolitischen Massnahmen vor dem Beginn des Quantitative Easing implementiert. … Um aus dieser Möglichkeit Vorteil zu schlagen, hat die italienische Regierung gleichzeitig eine präzedenzlose Anzahl von Garantien für Bankanleihen mit niedrigem oder gar keinem Rating gesprochen. Damit erhöhte sie deren Besicherungswert. Darüber hinaus hat die EZB mehr als 10 000 unbesicherte, auf nichtregulierten Märkten gehandelte Bankanleihen der öffentlichen Liste notenbankfähiger Sicherheiten hinzugefügt, obwohl der aggregierte Wert notenbankfähiger Sicherheiten die Nachfrage von Banken nach Zentralbankgeld schon bei weitem überstieg.

Seignorage and Cantillon Effects in India

On Alt-M, Larry White discusses three aspects of the Indian “demonetization” experiment.

The transition from old notes blocks “honest” currency transactions, reduces income, and harms the poor who don’t have access to alternative means of payment. Because not all old notes will be redeemed, the transition into new notes will generate seignorage revenue for the government on the order of USD 40 billion, according to White’s estimates. Not all groups or industries get access to the new notes at the same time; this changes the terms of trade (Cantillon effects).

Pawn Shops, Information Insensitivity, and Debt-on-Debt

In a BIS working paper (January 2015), Bengt Holmstrom summarizes some of the implications of the research on information insensitive debt. He cautions against moves to increase transparency in debt markets and defends the shadow banking system. He explains why opacity and information insensitivity are valuable and argues that debt-on-debt arrangements are (privately) optimal.

It all started with pawn shops:

The beauty lies in the fact that collateralised lending obviates the need to discover the exact price of the collateral. …

Today’s repo markets … are close cousins of pawn brokering with similar risks for the parties involved. … the buyer of the asset (the lender) bears the risk that the seller (the borrower) will not have the money to repurchase the asset and just like the pawnbroker, has to sell the asset in the market instead. The seller bears the risk that the buyer of the asset may have rehypothecated (reused) the posted collateral and cannot deliver it back on the termination date. … the risk that a pawnbroker may sell or lose the pawn was a big issue in ancient times and could explain why the Chinese pawnbrokers were Buddhist monks. …

People often assume that liquidity requires transparency, but this is a misunderstanding. What is required for liquidity is symmetric information about the payoff of the security that is being traded so that adverse selection does not impair the market. …

… stock markets are in almost all respects different from money markets …: risk-sharing versus liquidity provision, price discovery versus no price discovery, information-sensitive versus insensitive, transparent versus opaque, large versus small investments in information, anonymous versus bilateral, small unit trades versus large unit trades. … money markets operate under much greater urgency than stock markets. There is generally very little to lose if one stays out of the stock market for a day or longer. This is one reason the volume of trade is very volatile in stock markets. In money markets the volume of trade is very stable, because it could be disastrous if, for instance, overnight debt would not be rolled over each day. …

… debt-on-debt is optimal … . It is optimal to buy debt as collateral to insure against liquidity shocks tomorrow and it is optimal to issue debt against that collateral tomorrow. In fact, repeating the process over time is optimal, too, so debt is in a very robust sense the best possible collateral. This provides a strong reason for using debt as collateral in the shadow banking system. …

Panics always involve debt. Panics happen when information insensitive debt (or banks) turns into information-sensitive debt.

Should the Fed Reduce the Size of its Balance Sheet?

On his blog, Ben Bernanke discusses the merits of the Fed’s strategy to slowly reduce the size of its balance sheet to pre crisis levels. Bernanke (with reference to a paper by Robin Greenwood, Samuel Hanson and Jeremy Stein) suggests that this strategy should be reconsidered:

First, the large balance sheet provides lots of safe and liquid assets for financial markets. This might strengthen financial stability. (DN: In my view, there are also reasons to expect the opposite.)

Second, a larger balance sheet can help improve the workings of the monetary transmission mechanism, in particular if non-banks can deposit funds at the Fed. Currently, the Fed accepts funds from private-sector institutional lenders such as money market funds, through the overnight reverse repurchase program (RRP). (DN: I agree. As I have argued elsewhere, access to central bank balance sheets should be broadened.)

Third, with a large balance sheet and thus, large bank reserve holdings to start with, it could be easier to avoid “stigma” in the next financial crisis when banks need to borrow cash from the Fed but prefer not to in order not to signal weakness. (DN: Like the first, this third argument emphasizes banks’ needs. In my view, monetary policy should not emphasize these needs too much because it is far from clear whether bank incentives are sufficiently aligned with the interests of society at large.)

Bernanke also discusses the reasons why the Fed does want to reduce the balance sheet size.

First, in a financial panic, programs like the RRP could result in market participants depositing more and more funds at the Fed until the interbank market would be drained of liquidity. But these programs could be capped.

Second, a large balance sheet increases the risk of large fiscal losses for the Fed and thus, the public sector. Losses could trigger a legislative response and undermine the Fed’s policy independence. But these risks could be kept in check if the Fed invested in government paper that constitutes a close substitute to cash, such as three year government debt. (DN: But why, then, shouldn’t financial market participants hold three year government debt rather than reserves at the Fed? Because cash is much more liquid than government debt … But what does this mean?)

“Elektronisches Notenbankgeld ja, Vollgeld nein (Reserves for All, But no Sovereign Money),” NZZ, 2016

Neue Zürcher Zeitung, June 16, 2016. PDF, HTML. Ökonomenstimme, June 17, 2016. HTML.

  • Vollgeld seems attractive because it decouples the supply of money from intermediation. By enabling everyone to use legal tender for electronic payments, electronic base money would satisfy a need.
  • Vollgeld would prevent bank runs, at least partly; render deposit insurance unnecessary and reduce moral hazard; could help stabilize the credit cycle; and would redistribute seignorage to the central bank.
  • But these objectives can be obtained with less intrusive means.
  • Moreover, a Vollgeld system would be hard to enforce. Banks and their clients would establish new means of payment to circumvent the regulation. And in times of crisis, the central bank would feel obliged to provide liquidity assistance and bail outs.
  • The central problem is not that private money is used for transactions; it rather is that the money’s users rely on the central bank to guarantee the substitutability of private money and base money. In a democracy, the central bank cannot credibly let large parts of the payment system go under.
  • A sudden, forceful change of regime does not offer a credible way out of this trap.
  • But letting the general public access central bank reserves without abolishing private money from one day to the other may open a path towards a new arrangement where the public learns to distinguish between private and base money and where only the latter is publicly guaranteed.

Commitment Against Alchemy?

In the FT, Martin Wolf discusses Mervyn King’s proposal to make the central bank a “pawnbroker for all seasons” as laid out in King’s recent book “The End of Alchemy.”

Lord King offers a novel alternative. Central banks would still act as lenders of last resort. But they would no longer be forced to lend against virtually any asset, since that very possibility must create moral hazard. Instead, they would agree the terms on which they would lend against assets in a crisis, including relevant haircuts, in advance. The size of these haircuts would be a “tax on alchemy”. They would be set at tough levels and could not be altered in a crisis. The central bank would have become a “pawnbroker for all seasons”.

The key part of this quote is “could not be altered in a crisis.” Central banks and governments have always found it very difficult to commit not to support systemically (or politically) important players ex post. This problem lies at the heart of many problems in the financial system and elsewhere. By assuming that central banks could commit under the proposed arrangement, the proposal abstracts from a key friction.

Mervyn King on Narrow Banking and Liquidity Insurance

In the FT, John Plender reviews Mervyn King’s “The End of Alchemy: Money, Banking and the Future of the Global Economy.” King diagnoses two problems underlying the crisis. First,

Interest rates today, he says, are too high to permit rapid growth of demand in the short run but too low to be consistent with a proper balance between spending and saving in the long run. The disequilibrium persists, as does a misallocation of capital to unproductive investments.

The second problem relates to the financial system and

the alchemy that runs through the financial system, whereby governments pretend that paper money can be turned into gold on demand and banks pretend that the short-term deposits used to finance long-term investments can be returned whenever depositors want their money back. …

King argues that Bagehot’s famous dictum on central bank crisis management — lend freely on good collateral at penalty rates — is out of date because bank balance sheets today are much larger and have fewer liquid assets than in the 19th century. Central banks are thus condemned in a crisis to take bad collateral in the shape of risky, illiquid assets on which they will lend only a proportion of the value, known as a haircut.

King suggests this lender of last resort role should be replaced by … a pawnbroker for all seasons. In effect, he offers an elegant refinement of the concept of “narrow banking”, which seeks to ensure that all deposits are covered by safe, liquid assets. In his system, banks would decide how much of their asset base to lodge in advance at the central bank to be available for use as collateral. For each asset, the central bank would calculate a haircut to decide how much to lend against it. Together with banks’ cash reserves at the central bank, this collateral would be required to exceed total deposits and short-term borrowings.

This central bankerly pawnbroking would facilitate the supply of liquidity, or emergency money, within a framework that eliminates the incentive for bank runs. It amounts to a form of insurance whereby the central bank can lend in a crisis on terms already agreed and paid for upfront …

The system would displace what King regards as a flawed risk-weighted capital regime ill-suited to addressing radical uncertainty. Today’s liquidity regulation would also become redundant. But banks would still need an equity buffer, with King seeing an equity base of 10 per cent of total assets as “a good start”, against the 3-5 per cent common today.

The current shortfall of fully liquid assets against deposits — the alchemical gap — could be eliminated progressively over 20 years, during which time the expectation would grow that banks would no longer be bailed out. The system would apply to all financial intermediaries …

Update: The Economist‘s reviewer writes:

… Lord King wants banks to buy “liquidity insurance”. In normal times banks would pledge collateral to the central bank, which would agree to lend a certain amount against it, if necessary. Banks would thus know in advance precisely how much help they could get in the event of a meltdown, making them behave responsibly when times were good.

Stable Inflation Expectations

In an Atlanta Fed blog post, Nikolay Gospodinov, Paula Tkac, and Bin We explain research suggesting that inflation expectations are stable, in spite of the rather dramatic drop in five-year/five-year forward TIPS breakeven inflation. They conclude:

To summarize, our analysis suggests that (1) long-run inflation expectations remain stable and anchored, (2) the seemingly large correlation of market-implied inflation compensation with oil prices arises mainly from the dynamics of the TIPS liquidity premium, and (3) long-run market- and survey-based inflation expectations are remarkably close in terms of level and dynamics over time.

Arguments in Favor of ELA to Greece

Martin Hellwig argues in the Handelsblatt that the ECB should not cut Emergency Liquidity Assistance (ELA) to the Greek central bank. He makes the following points:

  • In 2010, the ECB pressured Ireland to guarantee bank liabilities (vis-a-vis other European banks) by threatening to cut ELA. Such blackmailing is inconsistent with the ECB’s task to safeguard cash and payment systems.
  • The same applies to Greece now. As lender of last resort, the ECB should provide funding to Greek banks even (or exactly) when they don’t have access to markets, as long as they are solvent. In principle, the banks may use central bank funding for whatever purpose they see fit; right now, however, the ECB has put restrictions on Greek banks’ purchases of Greek government bonds.
  • Are the Greek banks solvent? There are certainly liquidity problems, due to heavy withdrawals triggered by fears that the Greek government may convert Euro into Drachma denominated deposits. Solvency problems are only very recent, due to the economic malaise.

At this point Hellwig stops arguing based on the European treaties.

  • Instead, he suggests that the solvency rule could be waived in situations like currently in Greece or in Germany in 1931.
  • He concedes that a freezing of ELA could be considered a precautionary measure against Grexit—an event that is not anticipated in the European treaties.
  • But it could also be considered a measure that forces Greece into economic turmoil; the Greek banks into insolvency; and Greece out of the Euro area against its will.

“Vollgeld, Liquidität und Stabilität (100% Money, Liquidity and Stability),” NZZ, 2014

Neue Zürcher Zeitung, May 12, 2014. PDF. Extended version in Ökonomenstimme, May 13, 2014. HTML.

  • A 100% money regime reduces the risk of credit bubbles, but requires more and better fine-tuning by the central bank.
  • Central banks can already implement higher reserve requirements. If the fact that they don’t reflects policy failure, then the 100% money proposal risks handing more power to one source of the problem.
  • A 100% money regime increases financial stability, at least temporarily, but it forces banks to find new sources of funding and lowers the interest rate for depositors, which is fine.
  • If lender of last resort support by the central bank occurs at too low interest rates then seignorage revenues are privatised and costs socialised under the current regime. Moving to a 100% money regime would help but so would simple Pigouvian taxation.
  • How can a 100% money regime be enforced if market participants end up coordinating to use other securities than deposits as means of payment?
  • More stable deposits in a 100% money regime do not imply a more stable banking system unless other regulation is imposed that completely prevents “maturity transformation.”
  • Aggregate liquidity cannot be created out of nothing, with or without deposit insurance.
  • Societies have to take a stand on whether they want to guarantee broader monetary aggregates than base money. If so, the cost of the guarantee should be privatised. Problems arise if societies pretend not to provide such guarantees but central banks nevertheless feel obliged to step in ex post and market participants are aware of that fact ex ante; bad, self-fulfilling equilibria are the consequence.
  • Commitment on the part of policy makers is key; it requires independent central bankers and regulators.