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Liquidity, Bank Capital and Market Reform

by ARGeezer Sun Sep 4th, 2011 at 01:12:09 PM EST

Liquidity has almost been given a bad name by all of the officials who have claimed that the problem with the economy from 2008 to today is lack of liquidity. Critics have vociferously asserted that the bigger problem is solvency. Given the price history of US residential real estate since 2008 and the size of the class of US RMBS financial assets from 2002 to 2006 the solvency of institutions holding these RMBSs certainly seems questionable. But looked as on its own merits, as opposed to the camouflage uses to which it has been put, liquidity is an important and neglected factor in our financial markets.

London Banker has a new post on this subject: Liquidity, Liquidity, Bank Capital and Market Reform. After all, there was a time when central banks were not the chief source of liquidity and it would seem desirable to find a way to return to that situation, especially seeing that re-inflating the bubble doesn't seem to be working so well. His post consists of a series of comments from a friend's e-mail, shown here in orange, to which London Banker responds.  

Central bankers and securities regulators lost sight of liquidity over the past decade or two in permitting reforms which compromised the health of the financial system. Thanks to the Greenspan and Bernanke puts, and to surplus recycling by Asian economies, many took liquidity - like oxygen - for granted. Like oxygen, you only realise how critical liquidity is when its absence becomes noticeable.

Now that bank regulators have rediscovered liquidity as an essential attribute of healthy banks and healthy markets, it is important to reinforce some key qualities.

   Liquidity means you can generate cash from a physical asset or paper claim.

If you can't exchange the asset for a major currency to meet a sudden funding need, then the asset shouldn't be permitted as regulatory capital. Basel II and Basel III have generated hundreds of pages around credit scoring and asset type while ignoring the fact that most of what banks are attributing as capital cannot be turned into cash on demand.


But, effectively, the criteria came to be having a AAA rating on the asset. But that was like Kansas before the tornado of 2008. The tornado exposed the fraud of the AAA ratings and "We ain't in Kansas anymore!"



Liquidity can be gained by sale or repo of an asset, preferably in a transparent market. Where no market exists or the market has become illiquid, then liquidity must be gained through a central bank.

Virtually all RMBS markets failed under stress in 2008 and 2009, with failures spreading to other asset classes as investors grew wary of dealer spreads and perceived shallow dealer commitment levels. As the scope of funding problems grew, illiquidity spread to sovereign debt for troubled countries such as Greece and Portugal. Few OTC asset markets have recovered sufficient liquidity for dealing in size.

When the public markets will not price an asset in size without a large spread, then the central banks become the market makers of last resort. Without central bank repo of illiquid RMBS and sovereign debt, virtually every major bank in the OECD would have failed.

Because they now have the role of market maker of last resort, central banks should become much more active in ensuring that any asset permitted to be classed as capital by a bank can be liquidated on demand in a public market. Rather than leaving market structure to the investment banks and their tame securities regulators, the central banks should be driving forward reforms to ensure that capital assets are issued in fungible series, in size, and traded in transparent exchange markets with committed market makers.

This will require a major policy reversal on exchange regulation. Securities regulators have been under pressure for several decades to liberalise OTC markets, permit fragmentation to off-exchange trading systems, and turn a blind eye to issuance of securities in small, idiosyncratic offerings that will never liquidly trade except back through the offering investment banks. The quality assurance and market conduct functions of exchanges have been eroded following demutualisation, and exchanges now are run for profit of their highly concentrated owners rather than in the public interest.

Markets are at the heart of successful civilisations. Markets require quality norms, information publication, and price transparency to operate effectively. Regulators and investors allowed credit ratings to substitute for exchange listing rules and reporting requirements during the liquidity boom. Ratings were gamed by the banks until they were meaningless. We should now be forcing assets back onto exchanges and force the exchanges to regulate quality and information norms in the public interest. If this requires re-mutualising the exchanges, or public ownership of exchanges, then that should be on the agenda. Letting the exchanges be run by the thugs who gamed the markets and the rating agencies isn't healthy.

"Regulatory forbearance" via "extend and pretend" and refusal to prosecute fraud on the pretext that it would further damage the markets are not healthy either. But regardless of the implausibility of an appropriate governmental response to this situation it is still useful to have a clear set of requirements for properly functioning financial markets.

Display:
The whole damn point of having a central bank is to make sure that liquidity is never a problem for your financial system.

You cannot eliminate solvency risk by regulatory fiat, but by using the discount window you can eliminate liquidity risk altogether. And you should. Demanding that banks source their liquidity in a private market will either make your interest rate policy completely impotent or simply add an unnecessary complication to what is mathematically indistinguishable from sourcing it at the discount window. Except that funding directly at the discount window gives the CB a number of useful regulatory tools that it can bring to bear against wayward banks. Those go away when you intermediate the central bank provided liquidity in an interbank market.

The problem with the rating agencies is not that they allowed trash to become liquid. It is that they provided the SEC with an excuse to not do its job, and lawmakers with an excuse to prevent the SEC from doing its job.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sun Sep 4th, 2011 at 02:00:12 PM EST
Then you should be quite pleased with the current situation, excepting the fact that not all central banks seem to understand their function. While I would prefer that we get back to a situation where banks could safely lend to one another because they had some degree of confidence in each other's balance sheets -- provided this is accomplished by writing down existing debt to current market values and cleaning up the mess.

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sun Sep 4th, 2011 at 02:28:34 PM EST
[ Parent ]
Then you should be quite pleased with the current situation,

Not at all. There's too much garbage being posted as collateral at the various discount windows. Central banks are not supposed to accept garbage as discount window collateral. They are supposed to tell their financial regulators that bank so-and-so tried to post garbage at the discount window, so it might be a good idea to sic some forensic accountants on bank so-and-so.

But the fact that central banks are rediscounting garbage and financial regulators are colluding with Ponzi scams does not prove that financial regulators or discount window operations are bad ideas. It proves that it is a bad idea to allow your financial regulator and central bank to get into bed with crooks. In the same way Katrina did not prove that FEMA is a bad idea - it proved that it is a bad idea to let FEMA be run by halfwits and Republicans (but I repeat myself).

While I would prefer that we get back to a situation where banks could safely lend to one another because they had some degree of confidence in each other's balance sheets

Indeed. But that is not a liquidity problem. And even when they are sufficiently confident to lend to each other, there is no particularly compelling reason that they should lend to each other rather than fund at the discount window (and rather a lot of compelling reasons to want to bind them to the discount window where the CB can monitor their balance sheets in real time rather than just when Shit Blows Up).

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sun Sep 4th, 2011 at 03:16:09 PM EST
[ Parent ]
To be clear, I think the system you described would be excellent, but the only thing that seems less likely than governments reforming the financial sector is that they would do it via the method you describe - unless they were confident that the central banks would continue to serve the financial sector at the expense of all other sectors much as they are doing today they wouldn't even try. Though perhaps we might see movement in the direction you describe in the US for small, systemically unimportant banks, which, likewise, would do nothing to solve the problem.

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sun Sep 4th, 2011 at 04:37:11 PM EST
[ Parent ]
I would prefer that we get back to a situation where banks could safely lend to one another because they had some degree of confidence in each other's balance sheets

The really sad part is that 3 or 4 years ago we were commenting that "banks looked at their own balance sheet, saw ShitPile™ and wondered about the other banks' balance sheets" was the best explanation for the interbank liquidity problems. 3 to 4 years ago. And very little progress has been made on that front since you're still wishing that it were not so today.

Economics is politics by other means

by Migeru (migeru at eurotrib dot com) on Sun Sep 4th, 2011 at 04:18:22 PM EST
[ Parent ]
Yeah, we prefer to live with zombies than to write down the debt of politically important people. Beginning to look like this will be The Decade of the Living Dead Financial Institutions.

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sun Sep 4th, 2011 at 04:40:35 PM EST
[ Parent ]
Yeah, we prefer to live with zombies than to write down the debt of politically important people.

Bingo.

As usual, this is not an economic problem - it's a failure of democracy problem with obvious economic effects.

by ThatBritGuy (thatbritguy (at) googlemail.com) on Sun Sep 4th, 2011 at 04:57:33 PM EST
[ Parent ]
About three years ago... Trying to understand the current financial situation
This is how I understand the current financial situation. Correct me if I am wrong. As I understand it the financial markets are right now somethink like:

  • Company A owns company D billions, that debt is insured by company B.
  • Company B owns company C billions, that debt is insured by company A.
  • Company C owns company A billions, that debt is insured by company D.
  • Company D owns company B billions, that debt is insured by company C.

Suddenly everyone has realised that no one has the billions. Oh, and they do not either know exactly how the others debt/insurance situation looks.

what we can know is that constructive, multinational solutions for the good of the people - and against the wishes of the banks, the greed-is-good think tanks, and others who stand to loose - is very unlikely. Thus trade and production will slow down untill it gets so bad that new solutions look worthwhile.

Please correct me if I am wrong, because if I am right and nothing is done I would say we are looking at a 1930ies depression scenario globally.

Looks like I was right.

Sweden's finest (and perhaps only) collaborative, leftist e-newspaper Synapze.se

by A swedish kind of death on Mon Sep 5th, 2011 at 07:13:01 AM EST
[ Parent ]
I recall saying back then, tho' not in your diary, if each of the companies can make the interest payments the mutual debt isn't a problem UNTIL the companies have to roll-over the debt.  Since a large part of the money received from roll-over goes to returning the principal on the previous debt issue ... a touchy situation arises.

Three things can happen:

  1.  They can't roll over the debt.  They go bankrupt.  And the cascade effect causes another Great Depression.

  2.  The various Central Banks loan the money to the Major Money Market banks in their respective countries, this money is lent to the companies to pay each other, and the can is kicked down the road.

  3.  The various Central Banks loan the money directly to the companies, bypassing the MMM banks.  One nice thing here is the companies would be paying interest directly to the Central Bank and, potentially, indirectly to the government.  Still kicking the can down the road but the can would land farther.


She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre
by ATinNM on Mon Sep 5th, 2011 at 11:18:49 AM EST
[ Parent ]
The cascade effect in (a) causes a financial crisis, serious enough to lead to a Depression. Whether it causes a Depression depends on the actions of the fiscal authorities.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.
by BruceMcF (agila61 at netscape dot net) on Tue Sep 6th, 2011 at 12:15:34 PM EST
[ Parent ]
Willem Buiter's Maverecon: After subverting bank insolvency, our leaders are now about to make a mess of liquidity (October 6, 2009)
Unless there is a major change of direction among global economic and financial officialdom, we are at risk of ending up with a world in which liquidity provision is privatised and insolvency risk for banks is socialised.  This would be the exact opposite of what makes sense: solvency is (or should be) a private good and liquidity is (or should be) a public good.

...

Following the confirmation of the already widespread suspicion that large banks and other complex financial institutions were deemed too big, to complex, too interconnected, too international or too politically connected to fail, the (large-scale) financial sector in the overdeveloped world is now characterised by the soft-budget constraint pathology identified by Kornai. Profits go to shareholders, top managements and other insiders.  Losses are socialised.   What should be the private good of capital and resources devoted to enhance the solvency of private financial enterprises, is now publicly provided - and over-supplied.

...

The unnecessary and undesirable private provision of the public good of liquidity

Unlike solvency, which is or should be a private good that has been provided publicly and socially inefficiently by the state, liquidity, which can be provided or hoarded privately, is a public good that ought not to be provided privately but by the central bank.  In the UK, the FSA has announced measures requiring UK banks to hold significantly more liquidity.  Currently, banks and building societies in the UK hold about £280 bn worth of cash and government bonds from countries deemed to be solvent (yes there are some left, apparently).  The FSA wants this liquidity buffer to be increased by at least one third, and possibly by more.  In addition, reliance on wholesale market funding will have to be cut by at least 20 percent: deposits good, wholesale funding bad.  There is a grace period - so as not to depress bank lending even more, these bigger liquidity buffers will only have to be achieved when the economy recovers.

...

The authorities should not waste their limited organisational capital to force banks to provide inefficiently the public good of liquidity when confidence and trust are low.  They should instead focus on ways of enforcing hard budget constraints on banks - to confront them with the realities of insolvency in a way that separates shareholders, unsecured creditors, boards and managers from their investments while leaving the bank as a functioning organisation capable of continued intermediation.

Why isn't this man a Central Banker?

Economics is politics by other means
by Migeru (migeru at eurotrib dot com) on Sun Sep 4th, 2011 at 03:25:14 PM EST
[ Parent ]
Because he writes stuff like "confront them with the realities of insolvency in a way that separates shareholders, unsecured creditors, boards and managers from their investments."

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sun Sep 4th, 2011 at 03:31:38 PM EST
[ Parent ]
No, no! That would never do! The man is clearly a dangerous radical.

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sun Sep 4th, 2011 at 04:44:15 PM EST
[ Parent ]
"He was an external member of the monetary policy committee of the Bank of England from 1997 till 2000. "

Wind power
by Jerome a Paris (etg@eurotrib.com) on Tue Sep 6th, 2011 at 12:44:27 PM EST
[ Parent ]
We've got liquidity running out of our ears.

What we don't have is a functioning micro-economy that can take advantage of it, at the interest rate the finance sector needs to cover their thirty years of nutburger loans, idiotic "investments," and obscene Return on Capital to which they have become accustomed.

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Sun Sep 4th, 2011 at 02:40:41 PM EST
I.e., a shortage of credit worthy borrowers, a surfeit of zombie banks with "excess reserves" and underwater balance sheets - a combination made possible by "extend and pretend", governments and regulators that are afraid to even hint at reforming the system and paralyzed political processes that are incapable of taking the necessary fiscal measures for the same reasons governments won't reform the financial system.

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sun Sep 4th, 2011 at 02:50:16 PM EST
[ Parent ]
What the article seems to be pointing out is that solid glass cast to look like water ain't liquid - except in the sense of its extreme viscosity. Or - you can't put irredeemable assets down as capital.

You can't be me, I'm taken
by Sven Triloqvist on Sun Sep 4th, 2011 at 03:21:04 PM EST
[ Parent ]
But that conclusion does not follow from its premise. There is nothing wrong with putting illiquid assets down as capital, as long as the asset is viable on a hold-to-maturity basis.

Demanding that all, or a substantial fraction of, bank assets must be liquid is effectively a demand that banks must engage in securitisation. Which is, shall we say, not the most productive demand one could possibly make of one's banks.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sun Sep 4th, 2011 at 03:24:35 PM EST
[ Parent ]
But then do you allow that banks should hold regulatory required reserves and that these should, in fact, be liquid, as described in the post by London Banker?

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sun Sep 4th, 2011 at 04:47:18 PM EST
[ Parent ]
Regulatory reserves, obviously. But they are liquid by definition and in any event not a constraint on a solvent bank. And if the bank is insolvent then the only advantage of it having liquid assets is that it expedites bankruptcy proceedings.

Regulatory capital, OTOH, should not have to be liquid.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sun Sep 4th, 2011 at 08:05:15 PM EST
[ Parent ]
What has been happening in Ireland, recently?  Don't hear much about their financial situation following the crisis.  Except for this.

"Beware of the man who does not talk, and the dog that does not bark." Cheyenne
by maracatu on Sun Sep 4th, 2011 at 03:09:39 PM EST
GDP starting to grow (artificially, due to multinational profits which will be repatriated).

GNP still shrinking, but I suspect that GNP + shadow GNP is flatlining or growing - the black economy has been growing quickly over the last couple of years as governments have brought themselves into disrepute and the feeling that not paying taxes isn't all that unacceptable given what the banks and politicians got up to.

Official unemployment at 14% or so. How many of those are actually working in the black economy is difficult to say.

Domestic growth going to remain problematic as government continues to slash spending (shrinking its revenue base, naturally).

Bad mortgage debt is an ongoing problem. Not sure how that's going to be worked out - it's probably going to be a mix of write offs and restructuring. Repossessions on the necessary scale probably aren't politically possible.

Lots of the middle and upper working class unemployed have reasonable size redundancy payments to fall back on. When those start running out you may start seeing trouble: if the domestic economy doesn't pick up properly inside about 18 months, things will get exciting.

I should make this a diary.

by Colman (colman at eurotrib.com) on Sun Sep 4th, 2011 at 03:25:34 PM EST
[ Parent ]
I posted the following over at LondonBanker's place, but thought I'd give it a whirl here as well:

[LondonBanker's] central contention seems to be that it is desirable to demand that any security held on a bank balance sheet as regulatory capital must be liquid. This is a wholly superfluous requirement that will not enhance financial stability and do nothing to prevent crises like the present.

In a modern central banking system, any solvent, legally managed bank is able, under all non-crisis conditions, to access unlimited liquidity from the interbank market, at an overnight rate fixed by the central bank.

If a crisis causes the interbank market to break down, there can, ultimately, be three explanations:

  1. The overwhelming majority of the banks usually able to access the interbank market have a solvency problem.

  2. A substantial number of banks has solvency issues, and the market participants do not know which banks are solvent and which are not.

  3. There is no substantial solvency problem and the interbank market participants are just being silly.

In the last case, demanding that bank assets are liquid does nothing for you that the central bank cannot do better at the discount window.

In the former two cases, the liquidity of bank assets does nothing to resolve the crisis that your financial regulator cannot do better by sending its forensic accountants into the books of the insolvent (or suspected to be insolvent) banks, to wipe out the bad assets. Once your financial regulator has painted a reality-based picture of the asset side of the insolvent bank's balance sheet, you decapitate the two or three topmost echelons of its management and wipe out the shareholders and however many of the bondholders you have to in order to restore solvency.

The bank can then be recapitalised by issuing common stock to the sovereign, issuing common stock into the private money markets, or subjecting the (now most junior) next tranche of bondholders to a forcible debt to equity swap.

If the bank's senior creditors included pension funds, important industrial concerns or other institutions that are of strategic importance to the country, but which are not covered by depositor insurance, the sovereign can then bail them out on a case-by-case basis (and should then revise its definition of "insured deposits" so it more accurately reflects the actual contingent liabilities of the sovereign in the event of a bank failure).

The insolvent bank is now solvent and under new management, and there is no further liquidity problem that the discount window cannot solve better than the private money markets.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sun Sep 4th, 2011 at 03:20:12 PM EST
the liquidity of bank assets does nothing to resolve the crisis that your financial regulator cannot do better by sending its forensic accountants into the books of the insolvent (or suspected to be insolvent) banks, to wipe out the bad assets.

But central banks have not done as you describe. Instead we get "stress tests" which are little more than fraudulent public relations for the banks by the central bank/treasury and/or regulators. It seems to me that the approach you are advocating absolves the banks of the need to have any liquidity to meet unexpected contingencies. In that case the failure to perform of any significant loan makes them insolvent.

I can see the value of the central bank providing liquidity to allow the member bank time to dispose of longer term assets. Perhaps we could move in that direction if accompanied by massive claw-back provisions for management and an effective solution to the massive agency problem now on offer. Else you are encouraging bank management to be ever more aggressive with their investments knowing that they can keep bonuses while losses will be socialized.

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sun Sep 4th, 2011 at 05:06:38 PM EST
[ Parent ]
But central banks have not done as you describe. Instead we get "stress tests" which are little more than fraudulent public relations for the banks by the central bank/treasury and/or regulators.

Indeed. But that is a solvency problem (or rather a political problem), not a liquidity problem. Enacting portfolio requirements that further discriminate against illiquid assets will not solve that problem.

It seems to me that the approach you are advocating absolves the banks of the need to have any liquidity to meet unexpected contingencies.

No, but it does absolve the bank of the need to obtain that liquidity from the money markets. On the other hand, it imposes more stringent checks on the bank's solvency. Which is what matters when you're targeting an overnight rate (or, for that matter, the risk-free rate of any other maturity).

In that case the failure to perform of any significant loan makes them insolvent.

No. Solvency is a function of the difference between their assets and liabilities. Liquidity is a function of the term structure of your assets and liabilities. One of the nice things about being the central bank of a floating fiat currency is that you can use the discount window to ensure that the term structure of your banking system's liabilities matches the term structure of its assets, thus removing financial sector liquidity risk altogether. But this does not in any way improve solvency. Liquidity enables you to hold your loans to maturity, but a dud loan is still a dud loan when it matures so holding to maturity doesn't do anything for your solvency.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sun Sep 4th, 2011 at 08:49:40 PM EST
[ Parent ]
I suspect that much of any difference between us boils down to terminology or jargon.

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sun Sep 4th, 2011 at 09:13:26 PM EST
[ Parent ]
Solvency crisis: the assets aren't really assets, or the liabilities are more than are entered into the books, or both.

Liquidity crisis: assets cannot be turned into cash quickly enough to meet need for cash to meet liabilities as they fall due.

An assets entered into the books with a value of €10 that is really worth €0.10 that can be turned into €0.10 at a moment's notice is perfectly liquid ~ the institution that has enough millions of assets like that on their balance sheet backing a substantial amount of non-equity assets is in trouble, sooner or later.

One way to postpone the trouble is to pretend that the assets have their book value, "but just not right now", which is how solvency crises get masked as liquidity crises. But if the problem is not the speed that the assets can be turned into cash, but the amount of cash they are ever likely to be turned into, that's a solvency crisis when you scratch underneath the lies being told.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Tue Sep 6th, 2011 at 12:22:51 PM EST
[ Parent ]
... prevent a solvency crisis is:

Before a major €1b obligation falls due, Bank A has €10b of assets on the books, worth €5b, €1b are in rock solid liquid prudential capital reserves that can be liquidated €1b.

The liquid "capital" reserves are used to meet the obligation. Now the bank has €9b on the books worth €4b.

Or the bank borrows short term from the central bank to meet the obligation. Now the bank has converted its obligation just fallen due for one about to fall due in a few months ... and in a month or three, it will still have €5b in assets pretending to be worth €10b.

Insisting that an insolvent commercial bank have adequate liquid reserves is like insisting that someone with appendicitis needs to eat well and exercise regularly. Good, prudent advice, sure, but unlikely to prevent a ruptured appendix when it is already swollen.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Tue Sep 6th, 2011 at 12:44:00 PM EST
[ Parent ]
I found this in London Banker's previous post: Basel Accords: "Tissue paper over a mountain range" His complaint against Basel II is that it made all members of various classes of debt equal:

The principal flaw was the uniform weighting of assets:
  • zero weight for OECD government debt and all other government debt with less than one year maturity;
  • 20 percent weight for debt of OECD banks;
  • 50 percent weight for mortgage debt.

The problem with this approach is that it has led to bank insolvency:

Basel Capital Accords did promote global competition, and so the concentration of global banking into a very few global banks by punishing smaller banks with higher capital requirements. And to that extent, the plan worked to favour Wall Street and the City. The plan also worked in favour of the Italians, who could issue copious government debt to capitalise their banks at the zero risk weighting and flog that debt to American, British and German banks who carried it at zero risk too.

But as the American, British and German banks were relieved of the onerous responsibility for due diligence, they took sillier and sillier risks. For example, they bought lots of Italian government bonds. They spread the emergent model of securitisation far past any productive reinvestment of capital to the point of wasting each nation's decades of accumulated wealth to finance excess consumption. They bought ratings from willing rating agencies to justify more and more leverage with less and less capital. They used derivatives to make their balance sheets and accounting impenetrable and misleading, and then got governments to adopt the same techniques in the public sector to support increasing government debt. And all the time the bias of Basel made them more and more powerful.

Basel II cemented big banks' control of both regulators and markets. They could use ratings to justify investments in structured products that seemed to have no economic rationale for either investors or intermediaries, but were magically profitable for everyone in theory. They could use internal models to book profits now and defer losses indefinitely, so ensuring wonderful bonus growth. Ah, glory days!

It is all starting to unravel now. Despite a commitment to Basel III - to be implemented far in the future - I doubt Basel II will last much longer. This week saw Portugese and Irish government bonds downrated to junk. Even the mighty US Treasury is on creditwatch for downrating given the rising risk of default.

Junk rating means risk. Recognition of an asset as capital implies that it can be priced in a liquid market when cash is required. When sovereign debt is junk rated and only good for collateral at the ECB or Fed, then it should not be eligible for bank capital. And so, zero weighting of these bonds as bank capital assets is no longer defensible. The banks holding Irish and Portugese debt as zero weighted for regulatory capital will have to supplement their capital at a time when bond markets are already dysfunctional and becoming downright illiquid for new issues. Huge maturity mismatch and refinancing overhangs were already threatening banks over the next few years, and now it will be much, much worse.

So now we have "cash for trash" at the central bank's discount window before we even get to mortgage debt. I think what he is searching for is a way to deal with the situation that has arisen where the Bund is the benchmark and many other Euro-zone government debt instruments have to be severely discounted against the Bund. Yet, per Basel II they still can be carried at zero discount as regulatory capital by banks. I read this post about a month ago but didn't get around to posting anything based on it.


As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sun Sep 4th, 2011 at 09:46:58 PM EST
[ Parent ]
But the Basel rules would not have been improved by the demand that the securities in question were liquid. Dud quasi-sovereign €-Mark bonds were perfectly liquid right up until they weren't. There wasn't a period of steadily deteriorating liquidity - or at least not a nearly long enough one to dispose of the bonds that were turning illiquid at anything above firesale prices.

The Basel rules are garbage because they don't distinguish between holdings in your own currency freely issued by your own sovereign, versus holdings in other currencies (which carry currency risk and possibly default risk) or in your currency but from a non-sovereign entity (which carry default risk). Again, this is a solvency problem, not a liquidity problem.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Mon Sep 5th, 2011 at 04:53:01 AM EST
[ Parent ]
I can see the validity of your argument - even while not liking the answer. :-/  The central bank is a better solution to the liquidity issue, especially if they are properly doing their job and effectively using the view this gives them into the condition of the member banks balance sheets. This should also improve the overall solvency of the banks. The problems involve the if and the should. The only thing I can see that would really improve the situation is more transparency into the member bank's balance sheets by the central bank combined with a will to use it. Had we had those desiderata we would not be in the situation we find ourselves. There is certainly no reason to mourn the passing of Basel II, but the damage it wrought remains with us and the problem remains political.  

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Mon Sep 5th, 2011 at 10:52:58 AM EST
[ Parent ]
Basel II hasn't passed, it has been "upgraded" with Basel III and its liquidity buffers and what-not.

Elsewhere in this thread I link to a maverecon post on liquidity and solvency where Willem Buiter criticises the British regulators for suggesting in 2009 the very kinds of liquidity buffers that became part of Basel III in 2010.

Liquidity buffers are simply a black hole for central bank liquidity. Currently the massive liquidity injections are resulting in huge "excess reserves" which don't circulate. The problem is solvency, not liquidity, and demanding that all assets be liquid, as JakeS points out, begs the question. When solvency is in doubt and the market is not liquid the only agent that can ensure the liquidity of assets in the market is the Central Bank through Market-Maker of Last Resort action or good old-fashioned discounting of more or less liquid assets. The fact that the ECB balks at discounting or purchasing illiquid assets only exacerbates market illiquidity. The Central Bank should't look to the market for guidance on either liquidity or solvency - if that's all it does, it becomes an entirely superfluous institution.

Economics is politics by other means

by Migeru (migeru at eurotrib dot com) on Mon Sep 5th, 2011 at 11:17:58 AM EST
[ Parent ]
And we're off to La-La Land rev. III.

Given the short-term thinking of most banks, their demand for unrealistic Return on Capital, the fact their Balance Sheets are loaded with "non-preforming¹" debt, and everybody correctly expecting economic "slow-down²" ...

Doesn't matter how much liquidity a bank has squirreled away, there's nothing to invest in.  

¹ Non-preforming defined as "they can whistle for their money"

² Slow-down here defined as "micro-economic activity circling around the old toilet bowl" for the next umpty-ump years

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Mon Sep 5th, 2011 at 11:31:03 AM EST
[ Parent ]
If there were anything "profitable", by their definition, in which to invest there would not be "excess reserves" or the massive retained earnings showing up as cash on the books of profitable corporations. Perhaps central banks could freeze the excess reserves in conjunction with sane fiscal policy by the government consisting of needed infrastructure paid out of newly created money or, in and even more fanciful world, out of that portion of excess reserves that was due to governmental largess, including profits from levitating the stock market and other interest rate arbitrage schemes on offer since 2008. In the USA the TBTFs were given almost free money that they could use for investing in US treasuries, etc. Through 2010 that was >3% on significant amounts of money. ZIRP has now even come to the TBTFs, but there are limits on how thoroughly one can screw the majority of the population in a failed attempt to save your buddies.

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Mon Sep 5th, 2011 at 01:18:24 PM EST
[ Parent ]
The central banks could stop remunerating excess reserves, for instance.

Economics is politics by other means
by Migeru (migeru at eurotrib dot com) on Mon Sep 5th, 2011 at 02:19:07 PM EST
[ Parent ]
Or even charge for holding them.

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Mon Sep 5th, 2011 at 03:13:41 PM EST
[ Parent ]
More Maverecon: Negative interest rates: when are they coming to a central bank near you? (May 7, 2009)

Economics is politics by other means
by Migeru (migeru at eurotrib dot com) on Mon Sep 5th, 2011 at 03:24:25 PM EST
[ Parent ]
My half-baked, possibly half-witted, suggestion:

Have the Central Bank lend money directly to the Real Economy economic actors and collect the interest directly and pass it through to the government instead of working through the Money Market Banks.

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Mon Sep 5th, 2011 at 02:27:25 PM EST
[ Parent ]
That's what the European Investment Bank is for...

Economics is politics by other means
by Migeru (migeru at eurotrib dot com) on Mon Sep 5th, 2011 at 03:29:05 PM EST
[ Parent ]
Current policy constitutes fighting a liquidity trap with liquidity. If there is any improvement it will not be due to the liquidity provisions.

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Mon Sep 5th, 2011 at 03:22:50 PM EST
[ Parent ]
The central bank is a better solution to the liquidity issue, especially if they are properly doing their job and effectively using the view this gives them into the condition of the member banks balance sheets. This should also improve the overall solvency of the banks. The problems involve the if and the should.

Central banking is a political function. A crooked central banker is every bit as damaging to your economy (and, potentially, your democracy) as a crooked president or prime minister.

But the lesson here is not that you should not trust central banks to do central banking. The lesson is that you should not hire crooks to run your central bank.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Mon Sep 5th, 2011 at 05:05:12 PM EST
[ Parent ]
The lesson so many need to learn is that crooks are, in effect, what we have had for decades - certainly in the USA.

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Mon Sep 5th, 2011 at 07:15:23 PM EST
[ Parent ]
I like the idea of swapping debt to equity. If I had the time it'd be a nice exercise to see just how large a part of banks balance sheets is unsecured debt. Anyone know off the top of their head this number or a report (which must exist somewhere)???
by crankykarsten (cranky (where?) gmx dot organisation) on Tue Sep 6th, 2011 at 08:41:11 AM EST
[ Parent ]
I like the idea of swapping debt to equity.

That's not a novel idea. It's called bankruptcy, and has been on the books of most advanced economies since at least the mid-19th century.

That it is viewed as an innovative solution in this day and age is a little depressing.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Sep 6th, 2011 at 09:15:26 AM EST
[ Parent ]
well, if there is a swap a bankruptcy can be avoided, but yes, the idea is indeed nothing new.

However, apart from a few "fringe" websites in the last three years I have practically never heard calls for a large scale restructuring using debt-equity swaps.

I think it would be a good solution for banks balance sheets. However, I have not been able to grasp how a debt-equity swap would work on a sovereign balance sheet. Come to think of it, all sovereign debt is essentially equity, isn't it?

by crankykarsten (cranky (where?) gmx dot organisation) on Tue Sep 6th, 2011 at 09:34:41 AM EST
[ Parent ]
well, if there is a swap a bankruptcy can be avoided,

Bankruptcy, forced debt to equity conversion; po-tay-to, po-tah-to.

What you avoid (and what it is normally in the public interest to avoid) is liquidation. Which is not quite the same thing.

However, apart from a few "fringe" websites in the last three years I have practically never heard calls for a large scale restructuring using debt-equity swaps.

You may have and not realised it. The Americans call it "Ch. 11 bankruptcy," after the relevant section of their bankruptcy code. (And as opposed to Ch. 7 bankruptcy, which involves liquidation.)

However, I have not been able to grasp how a debt-equity swap would work on a sovereign balance sheet.

Well, you could index the bonds to GDP, like Iceland did.

Come to think of it, all sovereign debt is essentially equity, isn't it?

Arguably yes. Arguably no. Most firms that issue equity cannot send armed goons to your house to take away your stuff.

A sovereign bond is a form of money, and like all sovereign monetary instruments it is neither properly debt nor properly equity.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Sep 6th, 2011 at 09:47:45 AM EST
[ Parent ]
You may have and not realised it. The Americans call it "Ch. 11 bankruptcy," after the relevant section of their bankruptcy code. (And as opposed to Ch. 7 bankruptcy, which involves liquidation.)

The generic term is "special resolution regime".

Economics is politics by other means

by Migeru (migeru at eurotrib dot com) on Tue Sep 6th, 2011 at 10:08:00 AM EST
[ Parent ]
"Restructuring" is also frequently used. I guess it is supposed to sound less scary than "default" or "go whistle for your money."

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Sep 6th, 2011 at 01:58:08 PM EST
[ Parent ]
It raises the hope that it will be someone else who has to go whistle for their money.

That question of who gets to go whistle for their money is, of course, to some degree responsible for the recoil from bank receivership in the US part of the Panic of 2008, until the big banks had been bailed out enough so that they could buy out medium sized and smaller banks taken into receivership. Receivership normally means that most of the depositors are not told to whistle for their money, but many of the creditors are.

Indeed, given that everything that can be done to resolve the crisis without inconveniencing the very wealthy has been done, as a matter of selection the rest of what needs to be done to resolve the crisis will inconvenience the wealthy.

What ought to have been done in the US from the outset was to take the "too big to be allowed to fail" banks into receivership, sort through the account liabilities that needed to be honored for economic stability, sort through the assets for enough to back those account liabilities, and set up a "good bank", with assets topped up in return for public preferred stock if need be, releasing the rest of the mess to go through ordinary bankruptcy proceedings.

But that would have left far too many of the wealthiest, including the wealthiest among those working at the bank, getting the short end of the stick. The fact that they had earned the short end of the stick was neither here nor there, nor was what could have been the tremendous political appeal of seeing rich banksters get perp-walked after the receivers had gone through their books, when it came to public policy in a thoroughly corrupt political system.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Tue Sep 6th, 2011 at 02:27:42 PM EST
[ Parent ]
will have to look into that Iceland solution, sounds interesting...

BTW, great link to the Koo Video, thanks!

by crankykarsten (cranky (where?) gmx dot organisation) on Tue Sep 6th, 2011 at 10:39:37 AM EST
[ Parent ]
I like the idea of swapping debt to equity.

I would like ANY discussion in the public sphere of how to write down obviously bogus debt instruments to a realistic value. Since 2008 it has seemed that the very discussion of this need in public has been taboo amongst The Serious People. My concern is that this will remain the case until it doesn't, and then it will change in some disastrous manner that only a few insiders from a few countries have discussed amongst themselves, that change will quickly prove disastrous and the authors of the "plan" will wail: "How could we have known?" while privately congratulating themselves on having fobbed most of the ill consequences off on others.

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Tue Sep 6th, 2011 at 11:44:57 AM EST
[ Parent ]
..as capital cannot be turned into cash on demand.

Is this all? There is very simple solkution to this "problem:" Lower the price of that f*** asset.

by kjr63 on Wed Sep 7th, 2011 at 09:22:20 AM EST
The preferred solution is to repo the asset, often at a discount rate that is a bit hopeful. The bank gets high powered money from the central bank and both can pretend that the asset is not impaired, or not too badly. "It'l come back - some fine someday." True, this is only a temporary solution, but it can be repeated. To sell the asset at a significant discount is to recognize the loss, which might also call into question the true value of other assets on your books and on the books of other banks. Repo is the heart of "extend and pretend", at least as I understand it.

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Sep 7th, 2011 at 10:03:03 AM EST
[ Parent ]
Not so.

The heart of "extend and pretend" is the SEC and FDIC not doing their jobs.

Granted, the Fed is allowing the SEC and FDIC to not do their jobs. But realistically speaking, the Fed can't force the SEC and FDIC to do their jobs. It can only present the SEC and FDIC with the choice between doing their jobs or letting the interbank market freeze solid. And since the interbank market is the Fed's problem, not the FDIC's or the SEC's, that's not a particularly sharp sort of stick to wave around.

Sorta like how China can't force the US to run a sustainable industrial policy, it can only force the US to choose between economic collapse and a sustainable industrial policy. And given that a US collapse would hurt China more than an unsustainable US industrial policy, that is not a decision that China is particularly keen on forcing the Americans to make.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Wed Sep 7th, 2011 at 04:20:59 PM EST
[ Parent ]
I am reminded of the Aristotelian hierarchy of causes.

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Sep 7th, 2011 at 09:57:20 PM EST
[ Parent ]
Still better is to make the tax payer buy them on credit. Bank gets the interest, investor liquidity, tax payer junk. All are happy, especially the tax payer, when the politicians celebrate that they saved the world..
by kjr63 on Thu Sep 8th, 2011 at 07:50:13 AM EST
[ Parent ]
Naturally this means "irresposible" behaviour of governments and they should be afterwards punished for indebtness. So that public domain can be privatised and sold again on credit, so that banks get more interest etc..
by kjr63 on Thu Sep 8th, 2011 at 07:54:19 AM EST
[ Parent ]
"often at a discount rate that is hopeful"

"and both can pretend that the asset is not impaired, or not too badly"

... is both institutions maintaining the pretense that the commercial bank is solvent ... when it is not.

Which is to say that the problem is a solvency crisis. If the asset is not impaired, but simply less liquid than the liabilities at hand, there is nothing wrong with the central bank engaging in direct lending using repo operations. Eventually the sound asset reaches liquidity ~ as it matures at the very least ~ and the series of rolled over repo's tthat was used to meet the liability is finally resolved.

Or was stated more clearly up above, liquidity is a public good which can be provided publicly, if there is a shortage of private liquidity, with no problem.

As it stands, the US Fed is filling up its balance sheet with bad debt, and since no major central reserve bank has pursued the "let's own a pile of chickenshit" before, we don't really know how that plays out.

Eventually there has to be a limit lurking in there  ~ in the end the debt assets will mature to reveal there is no there, there ~ and since the heart of the policy of pretending that a solvency crisis is a liquidity crisis is being unwilling to resolve the root causes of the solvency crisis, we can predict with some confidence that the banking sector will continue piling up insolvency and then the Fed taking the bad debt over until we find out what happens when a Central Reserve Bank has "too much bad debt.

Unless we bite the bullet first and resolve the solvency crisis.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Thu Sep 8th, 2011 at 11:48:28 AM EST
[ Parent ]


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