Banking

Back to 1693
By Martin Hutchinson

The eurozone crisis, which could have been defused initially by allowing Greece to depart the euro, has now taken on a much more serious aspect. If, as seems possible, Italy, Spain and even France lose the confidence of the international debt markets and are forced to write down debt, then government debt of prime countries will no longer be considered a risk-free asset. That will take markets back beyond the traumas of the 20th century, beyond the relatively serene 19th century, beyond even the institution-forming 18th century.

It will undo the 1751 triumph of the forgotten financier Samson Gideon in forming the immortal Consols, will undo the sterling if self-serving 1721 work of Sir Robert Walpole in preventing the South Sea crash from destroying the British government bond market as the Mississippi crash did the French one, and will even undo the 1694 foundation of British credit, the formation of the Bank of England. Life for government bond dealers will revert to a primitive Hobbesian state of nature, nasty, brutish and short. But will the rest of us suffer, except in the short term?

Based on the bond market as we have known it over the last century or two, only Greece was bound to default. Its problem was not so much its starting ratio of debt to gross domestic product (GDP), but the fact that its GDP was over-inflated, being based on hopelessly unrealistic living standards for the Greek people.

Once the Greeks were paid at a level at which the country's economy would balance - no more than US$15,000 or so in GDP per capita compared to 2008's overinflated $32,000 - Greek GDP would be halved, and its debt/GDP ratio doubled to a level approaching 300%. That would have been beyond the highest levels ever successfully reduced without default - 250% of GDP by Britain after 1815 and again after 1945. Since Greece is a notoriously undisciplined society, with poor tax enforcement and an open economy whose citizens keep much of their wealth abroad, a Greek default was and is inevitable in the best of circumstances.

The same is not, however, true of Italy and Spain. Italy's competitiveness has declined by about 20% against Germany's in the last decade. However its debt level is only 120% of GDP, or say 150% of GDP if Italy's living standards and GDP declined by the necessary 20%. Since its budget deficit under the competent management of Silvio Berlusconi's finance minister Giulio Tremonti was only about 3-4% of GDP, Italy's position by the standards of the last two centuries is perfectly manageable without default being more than a distant threat.

Similarly Spain has a budget deficit of around 7% of GDP, and a housing finance sector that is a mass of bad debts, with house prices still to descend to market-clearing levels, but its official debt is only 61% of GDP, and its economically odious Zapatero government is on the way out.

The level of market panic about Italian and Spanish debt indicates that the comforting parameters of 19th and 20th century sovereign debt finance no longer hold. The principal reason for this is the determination by the eurozone authorities to break the rules by which debt markets have traditionally been governed. Instead of allowing Greece to default or rescuing it completely, they arranged an inadequate debt-financed bailout that simply postponed Greece's inevitable exit from the euro and increased its debt. Then they arranged a "voluntary" writedown of Greek private sector debt, which was subordinated in repayment to the monstrous institutional and government debt created by the bailout.

When the Greek government attempted to get referendum or electoral support for the "reforms" imposed by the eurozone authorities, the authorities replaced the Greek government with a eurozone stooge, without democratic legitimacy. Eurozone authorities repeated this stooge imposition process with the long-lasting and economically capable Italian government of Silvio Berlusconi, who they regarded as euro-skeptic and excessively devoted to free market and low-tax principles. Berlusconi was replaced with a government dominated by europhiles and the left, which had been decisively defeated in the previous election.

Finally, and most damagingly, the euro-zone authorities prevented the modest $3.5 billion of Greek credit default swaps (CDS) from paying out, thus drastically devaluing the CDS of Italy, Spain and France, whose volume is of the order of $40 billion each. They have thus called the entire CDS market into question, at least for sovereign names, and have badly shaken the security of international contracts. By doing this, according to Gillian Tett of the Financial Times, they removed the protection that Deutsche Bank, for example, thought it had obtained this year by buying CDS on $7 billion of its $8 billion Italian exposure.

Investors in PIIGS (Portugal, Ireland, Italy, Greece and Spain) debt thus now face the reality that they have been subordinated arbitrarily to the international and eurozone institutions. Their ability to protect themselves by CDS purchase has been removed. The security of their debt contracts themselves has been called into question.

Finally, investors' protection against coups and revolutions, that monetary and fiscal policy were being set by democratically elected governments acceptable to their people, has been removed by the imposition of governments wholly lacking in democratic legitimacy. If those governments impose policies that the populace finds intolerable, as is very likely, there is now far more chance of outright popular revolt or coup d'etat, since ordinary democratic change has been blocked.

In short, the protections given to government debt progressively in the last three centuries have been removed. The rationale for the Basel committee rating government debt at zero in banks' risk calculations has been exposed for the fraud it always was. Since government levels of taxation are close to the Laffer Curve yield peak in most countries, the protection given to investors by the taxing power has also been rendered nugatory.

Investors are no longer in the position of investors in the solid, well-managed government debt of Walpole and Lord Liverpool, in which the phrase "as solid as the Bank of England" made British debt sell at the finest international rates. Instead, they are in the position of the goldsmiths lending to Charles II, charging 10% for their money and liable to be ruined at any point by a Great Stop of the Exchequer, like that of 1672.

I have written before in some detail about the likely effect on the global economy of the removal of government debt markets. In general, it should improve financial availability for the private sector, while starving profligate governments of the means to implement "Keynesian" stimulus and other wasteful policies. Thus it may well improve economic performance in the long run, certainly compared to the anemic growth and high unemployment suffered in most countries since 2009.

Needless to say, however, the 2010s will be a grim decade, because the transitional and wealth effects of eliminating the government debt markets that have formed the centerpiece of the last three centuries will be enormous - a Reinhart/Rogoff depression of spectacular severity.

However, there is another effect of transporting the world financial system back to 1693 - the year before the Bank of England was established. The European Central Bank will be bankrupt because of its holdings of worthless PIIGS debt, and it is most unlikely that German taxpayers will consent to recapitalize an institution that has failed so badly, after first eliminating their beloved deutschemark. The Bank of England, the Federal Reserve and the Bank of Japan will also be legally insolvent, since in their policies of quantitative easing they have acquired gigantic quantities of assets that will drop catastrophically in price once interest rates rise.

The Fed, for example, is leveraged 60-to-1, and it was recently calculated that a rise in long-term interest rates of only 40 basis points would be sufficient to wipe out its capital. Needless to say, a rise of 4-5% in long-term interest rates, back to a historically normal level 2-3% above the true level of inflation, would put a hole in the Fed's balance sheet that in current stringent budgetary conditions would be politically impossible for the US Treasury to fill.

Thus if a debt default in the eurozone spread even partially to the over-indebted economies of Britain, Japan and the United States, not only will government bond markets be wiped out, but central banks in their current form will disappear also.

Thus if a debt default in the eurozone spread even partially to the over-indebted economies of Britain, Japan and the United States, not only will government bond markets be wiped out, but central banks in their current form will disappear also.

In the long term, this should also prove a blessing. My colleague and co-author, Kevin Dowd, has been trying for some years to persuade me that the ideal monetary system is not only a gold standard, but one entirely without a central bank. I had always resisted this, believing in the positive qualities of the privately owned Bank of England of the 1797 Old Lady of Threadneedle Street Gillray cartoon, the 1844 Bank Charter Act and the elegant inter-war Montagu Norman, the hero who removed the 1929-31 Labour government by omitting to tell that bunch of economic illiterates that leaving the gold standard was an available option.

However, lovers of central banks cannot deny that the Fed bears a substantial share of the responsibility for creating the Great Depression and an even greater share of the responsibility for creating the 2008 crash and the period of grindingly high unemployment that has followed. Thus the existence of a central bank is no longer a battle won and lost in 1694, but must be considered to have become a live question.

If government debt markets across Europe collapse and central banks worldwide are rendered insolvent, the fiat currencies of the world are no longer likely to command enough public confidence to be workable. Like successive generations of Argentine pesos and Ecuadorian sucres, they will have to be junked. Further, since there is unlikely to be a figure like Weimar Germany's Gustav Stresemann, able to create a new and workable fiat "rentenmark" out of a mythical monetization of land values, a return to a gold standard will be not only inevitable but irresistible, since it will have been imposed on the ruins of the current system by the global private sector.

With a gold standard, and central banks in ruins, a truly free banking system will also be inevitable. Most large existing banks will have failed along with their central banks, with no more money for bailouts and their regulatory institutions thoroughly discredited.

The new central bank-less gold standard banking system that arises from the ashes of the old will be perfectly workable, as in 18th century Scotland, 19th century Canada and the United States between 1837 and 1862. It will permit only minimal government, but will allow the private sector, particularly the small-scale private sector, to flourish as never before.

As after 1945, from the chaos of monetary ruin will emerge a new global economy that is stronger and healthier, provides better living standards for its citizens and imposes far fewer taxes, scams and state-aided rip-offs on their wealth than does the current system.

But the intervening decade is certainly not going to be easy or pleasant.

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The Bear's Lair: Systemic risk is worse now than in 2008

June 16, 2014 posted by Martin Hutchinson

Since the crash of 2008, huge attention has been paid by regulators to systemic risk, the risk that some event will cause the crash of the entire banking system, not just of an individual bank. Tens of thousands of pages of financial regulations have been written, and almost as many thousands of speeches have been bloviated, about how we now understand the dangers of “too big to fail” and therefore a crash such as occurred in 2008 can never happen again.
Needless to say this is nonsense; systemic risk is worse now than it was in 2008. What's more, the next crash will almost certainly be considerably nastier than the last one.

The main issue addressed by legislation has been “too big to fail,” the idea that some banks are so large that their failure would cause a catastrophic economic collapse and hence they must be propped up by taxpayers. It will not surprise you to learn that I don't regard this as the central problem.

Most of the risks in the banking system today are present in a wide range of institutions, all of which are highly interconnected and getting more so. Hence a failure in a medium-sized institution, if sufficiently connected to the system as a whole, could well have systemic implications. At the same time, pretty well all banks use similar (and spurious) risk-management systems, while leverage—both open and more dangerously hidden—is high throughout the system. Foolish monetary policy is foolish for all, and if a technological disaster occurs, it is likely to affect software used by a substantial faction of the banking system as a whole. There are a number of good reasons to break up the banking behemoths, but breaking them up on its own would not solve the systemic risk problem.

Systemic risk has been exacerbated by modern finance for a number of reasons. The system's interconnectedness is one such reason, because of the cat's cradle of derivatives contracts totaling some $710 trillion nominal amount (per BIS figures for December 2013) that stretch between different institutions worldwide.

Some of these contracts such as the $584 trillion of interest-rate swaps are not especially risky (except to the extent that traders have been gambling egregiously on the market's direction). However, other derivatives, such as the $21 trillion of credit-default swaps (CDS) and options thereon, have potential risk almost as great as their nominal amount. What's more, there are $25 trillion of “unallocated” contracts. My sleep is highly troubled by the thought of 150% of U.S. Gross Domestic Product (GDP) in contracts which the regulators can't define!

The problem is made worse by the illiquidity of many of these instruments. Any kind of exotic derivative with a long-term maturity is likely to trade very seldom indeed once the initial flush of creation has worn off. These risks have been alleviated by trading standard contracts on exchanges. But even if banks' risk management were good, failure of a major counterparty or, heaven help us, of an exchange, would cause systemic havoc because of its interconnectedness.

Another systemic risk worsened by modern finance is that of inadequate risk management. This has in no way been improved by the 2008 crash. More than three years after the crash (and nearly two years after Kevin Dowd and I had anatomized its risk management failures in “Alchemists of Loss”), J.P. Morgan was still using a variation on Value-at-Risk to manage its index CDS positions in the London Whale disaster. Morgan survived that one, but there seems no reason from a risk-management perspective why the Whale's loss should not have been $100 billion just as easily as $2 billion—which Morgan would not have survived. Regulators have done nothing to solve this problem. Indeed, the new Basel III rules continue to allow the largest banks to design their own risk-management systems, surely a recipe for disaster.

You may feel that risk management, at least, is a problem exacerbated by the size of the too-big-to-fail banks. However, this is not entirely so. Each bank will commit its own trading disasters, so that a reversion to smaller banks would equally revert to smaller but more frequent trading disasters, surely an improvement (and the London Whale's successors would be less likely to get megalomania and attempt to control an entire market). On the other hand, if the market as a whole does things not contemplated by the risk-management system—Goldman Sachs' David Viniar's “25-standard deviation moves, several days in a row” as in 2007—then since all banks use risk-management systems with similar flaws, they are all likely to break down at once, producing systemic collapse. As I shall explain below, I expect the next market collapse to take place in pretty well all assets simultaneously, with nowhere to hide. Hence a collapse in the global banking system's risk management, affecting most assets, will cause losses to pretty well all significant banks. No amount of regulation will sort that one out.

Modern finance has also made systemic risk worse through its incomprehensibility, opacity and speed. Neither the traders nor the “quants” designing new second- and third-order derivative contracts have any idea how those contracts would behave in a crisis, because they have existed through at most one crisis, and their behavior is both leveraged to and separated from the behavior of the underlying asset or pool of assets. Banks do not know their counterparties' risks, so cannot assess the solidity of the institution with which they are dealing. And in “fast-trading” areas, computers carry out trading algorithms at blistering speed, thus producing unexpected “flash crashes” in which liquidity disappears and prices jump uncontrollably.

The opacity of banks' operations is made worse by “mark-to-market” accounting, which foolishly causes banks to report large profits as their operations deteriorate, the credit quality of their liabilities deteriorates and their value of those liabilities declines. This makes the banks' actual operating results in a downturn wholly incomprehensible to investors.

The leverage problem has not gone away, in spite of all the attempts since 2008 to control it. Furthermore, much of the financial system's risk has been sidelined into non-bank institutions such as money-market funds, securitization vehicles, asset backed commercial paper vehicles and, especially, mortgage REITs, which have grown enormously since 2008. These vehicles are less regulated than banks themselves, and where the regulators have tried to control them, they have got it wrong. For example, huge efforts have been made, backed by the banking lobby, to mess up the money market fund industry, which has only ever had one loss, and that for less than 1% of the value of the fund. Conversely, the gigantic interest-rate risks of the mortgage REITs, which buy long-term mortgages and finance themselves in the repurchase market, are quite uncontrolled and a major danger to the system.

Let us not forget the role of technology, a substantial and growing contributor to systemic risk. The large banks these days develop very little software of their own, relying instead on packages both large and small from outside suppliers. The “Heartbleed” bug of April 2014 showed that even tiny programs such OpenSSL, universally used, can be attacked in ways very difficult to defend against, and that bring vulnerability to the bank's entire system. A malicious hacker somewhere in the vast and expanding Russo-Chinese sphere of influence, or even a domestic teenager, could at any time produce a bug that slipped through the protective systems common to most banks, damaging or even bringing down the system as a whole.

However, the greatest contributor to systemic risk, and the reason why it is worse today than in 2008, is monetary policy. It had been over-expansive since 1995, causing a mortgage finance boom in 2002-06 which was anomalous in that less prosperous areas and poorer people received more new mortgage finance than the rich ones. However, its encouragement to leverage has never been so great as in the period since 2009. Consequently, asset prices have risen worldwide and leverage both open and, more importantly, hidden has correspondingly increased.

In general, very low interest rates encourage risk-taking. Monetary policy makers fantasize that this will produce more entrepreneurs in garages. Actually, banks won't lend to entrepreneurs, so it simply produces more fast-buck artists in sharp suits. The result is more risk. When monetary policy is so extreme for so long, it results in more systemic risk. It's as simple as that.

Precisely what form the crash will take, and when it will come, is still not clear. It's possible that it will be highly inflationary. If the $2.7 trillion of excess reserves in the U.S. banking system starts getting lent out, the inflationary kick will be very rapid indeed. However it's also possible the mountain of malinvestment resulting from the last five years' foolish monetary policy will collapse of its own weight without inflation taking off. Either way, the banking system crash that accompanies the downturn will be more unpleasant than the last one, because the asset price decline that causes it will not simply be confined to housing, but will be more or less universal.

After that, systemic risk may be very much reduced—mostly because we won't have much of a banking system left!

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