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Weekend reflections

January 16th, 2009

It’s time once again for weekend reflections, which makes space for longer than usual comments on any topic. As always, civilised discussion and no coarse language.

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  1. Will
    January 16th, 2009 at 19:07 | #1

    Dear all

    I’m not clear on the protocol for promoting your own ideas in forums like this, and my apologies if it is inappropriate. But I am a long term reader of the blog and would be very grateful for any comments from other readers on a suggested approach to what is now becoming one of the most pressing issues of the global financial crisis, countering the extreme procyclicality in bank lending.

    My view is that giving more and more capital to banks is not going to work in the short to medium term because banks’ management will, rationally, hoard it to try to maintain or rebuild their capital ratios in a deteriorating economic environment. Today, unlike in a normal environment, there is absolutely no incentive for bank management to trade the certain immediate decline in capital ratios from making new loans against the possible long term increase in capital ratios as those loans are repaid and profits generated on them.

    The current response to this, at least in the UK and France, is for governments to (try to) explicitly direct banks to continue lending. Obviously banks will resist such directions as against their interests, and the question of how this can be reconciled with the conflicting objective of maintaining bank solvency and market confidence in banks in the short term has not, and I fear cannot, be addressed.

    The decline of this debate into name calling (one leading journal in my field editorialized for banks to “Grow up and start lending”) and moralizing (“it is in the interests of society for banks to lend”), contrary to all we know about game theory, is an extremely bad sign.

    By contrast my proposal focuses purely on incentives, and I think that it is possible to match up the genuine incentives of all parties in a way that does encourage responsible (as opposed to bubble-driven) new bank lending.

    Of course it would require a genuine change in the way bank lending is done, and I am surprised (although maybe I shouldn’t be) at how few proposals for genuine change in the obviously flawed structure of the bank lending model have yet emerged.

    Again, any thoughts would be extremely welcome. The paper is here..

    http://www.bus.qut.edu.au/faculty/schools/economics/documents/discussionPapers/2008/239WilliamWild28OCT08.pdf

    Cheers
    Will

  2. Ian Gould
    January 16th, 2009 at 20:00 | #2

    “The current response to this, at least in the UK and France, is for governments to (try to) explicitly direct banks to continue lending. Obviously banks will resist such directions as against their interests, and the question of how this can be reconciled with the conflicting objective of maintaining bank solvency and market confidence in banks in the short term has not, and I fear cannot, be addressed.”

    Wil, the obvious way to do this would seem to be for governments to agree to purchase new loans once they were made.

  3. Will
    January 16th, 2009 at 20:05 | #3

    Ian

    I think there are two problems with governments simply buying the loans. First, their capacity to keep buying banking system assets. Second, moral hazard. Banks originating the loans would not be bearing the credit and liquidity risks on them. This was one of the root causes of the sub-prime, securitization problem in the first place.

    Thanks
    Will

  4. Ernestine Gross
    January 16th, 2009 at 20:26 | #4

    Will,

    I’ve read your paper once and I’d like a little time to reflect on it. There is one question I have at present. At what price would a bank issue preference shares to a borrower? I assume your model (involving a new type of stapled securities) is intended for the whole sale debt market.

    Regards
    Ernestine Gross

  5. Will
    January 16th, 2009 at 20:45 | #5

    Ernestine

    Thanks for your interest and you are right, it probably is best as a wholesale lending product. My field is project finance, and I think it would work pretty well there because the SPV borrower is explicitly and transparently created and capitalized to meet the requirements of the lenders.

    In terms of pricing, the fundamental thing is the amount subscribed by the borrower. Let’s say a borrower was after a $100 loan, and the bank had a 10% Tier 1 Capital requirement. The borrower would subscribe $10 to the new preference shares. How many preference shares that represented may not be so important.

    There is obviously a lot more to it; for example the preference shares should really be structured to be Core Tier 1 Capital not Innovative Tier 1 Capital. This may require an option to convert them to ordinary shares (but with a redemption option for the bank to avoid possible dilution), which would impact on the actual number issued and the price at which each would be issued. But that doesn’t change the basic idea and it was easier not to confuse the paper with such detail.

    Cheers
    Will

  6. Ernestine Gross
    January 16th, 2009 at 22:09 | #6

    Will,

    I fully agree with you that bank lending is pro-cyclical (and worse) and this is a problem – indeed, together with changing risk preferences this is what drives Minski’s financial market instability hypothesis (discontinuities). I also agree with you that there is an incentive-compatibility problem, which cannot be solved by moralising and name calling (or a strong belief in the effectiveness of motivational talk to generate ‘confidence’). You try to address this incentive-compatibility problem within the current institutional arrangements. I don’t see the simplifications in your models as a problem – quite the contrary.

    Your reply to my question fully answers my question.

    Reflecting aloud, the effect of your proposal is on the debt/equity structure of the borrower such that the regulatory given capital structure requirement (capital adequacy ratio) of the bank is fulfilled (true?) Assuming true, this means that you link the regulatory requirement on banks to the rest of the economy (true?) Not a bad idea. This would give the regulatory authority a further policy instrument (changing the capital structure requirement of banks to influence debt/equity ratios economy).

    Your model is written in rates of return, which is quite common in Finance. The parameter values for your model 1 would not be the same as for model 2, if implemented, except by chance.

    Personally, I prefer models written in prices (values) rather than rates of return. IMO, the latter approach makes it easier to deal with detailed questions,including those you raised.

    (I am not a specialist in the practice of project finance but I do know that the aim is to align the objective of the bank (default risk free lending) with the debt/equity structure for a project, given its cash flows.)

    There is at least one G.E. model which assumes that investors in equity invest in debt proportionately (I’d like to check my memory before I name the model). When reading this model I took it that this was a simplifying assumption -perhaps there is more to it then what I thought at the time.

    Perhaps a tough test for your proposal is to ask: Would it prevent a Madoff?

  7. observa
    January 17th, 2009 at 09:39 | #7

    Will proposes-
    “The concept itself is relatively simple; a borrower’s equity-holders would effectively
    contribute new Tier 1 capital to a bank to enable it to undertake new lending, and
    the new structure developed in this paper would ensure that this capital is applied
    exclusively to support new lending to that particular borrower.”

    Isn’t that simply saying that all bank lending should be secured over physical assets? Gold bugs might point out that’s not even necessary if it’s gold that being lent out.(or some quantitative paper claims on actual physical quantities of gold held in trust by the central bank perhaps)In the case of such gold lending and borrowing, the individual bank is merely a facilitator of the transaction, taking an administrative cut, without the capacity to create more paper gold. The same applies if an individual bank has access to foreign central bank gold. The problem really arises when many central banks are relying on a plethora of individual banks to determine the fiat money supply via the fractional reserve system and the difficulty they have in assessing how reliable and tangible that is from time to time.

    If fiat money is not rooted in some commodity value like gold then perhaps it needs to be rooted in something else of value. To my mind that means security over physical assets if it’s not to be intangible income streams or equity in Madoff Securities Ltd. Essentially that leaves the money supply to be backed by mortgages over real property and goods up to worst case historical fire sale levels. Not much room for revolving credit for consumption there, unless non bank lenders want to stake their homes or cash savings on such money making ventures. Licenced banks charged with care and oversight of underlying money supply might be able to lend consumers nothing for a new plasma, 40% of the value of a new car, or 60% of Valuer Generals valuation of a home, but the rest will have to come from personal savings, Aunty Ednas purse or some other venturesome capitalist’s savings. Might work better than the current scheme in the absence of anything solid like gold. It might even lift that fire sale security level in the long run.

  8. Will
    January 17th, 2009 at 18:47 | #8

    Observa

    I’m sorry but it wasn’t intended to say anything about security over physical assets, gold or the fiat money system. Its think it might be all far simpler than you, and maybe Ernestine in relation to her very last comments about GE models, are thinking.

    The banks’ balance sheet structures would be exactly the same as currently, comprising loan assets on one side and liabilities and capital on the other. The proposal is simply that the owners of firms might be highly motivated to provide the banks with new capital, and thus enable them to write new loans to those firms and grow their balance sheets, in this environment where arm’s length investors have no motivation and governments are finding it increasingly difficult to do so. In other words, rather than paying other people to provide the banks with new permanent capital to support growth in their loan portfolios, borrowing firms (or rather their owners) simply do it themselves.

    The paper then observes that there are other positive consequences that flow from it, including the possible introduction of a negative feedback loop to aggressive bank lending in economic upcycle.

    Cheers
    Will

  9. Ernestine Gross
    January 17th, 2009 at 20:23 | #9

    Will,

    My comment is totally independent of Observer’s point.

    One question you may not be able to avoid is: Under what conditions would it be conceivable to get investors in equity, issued by non-bank firms, to invest in preference shares, issued by the bank, in order to get a loan from the bank for the firms in which they are prepared to invest equity? Why is a bank necessary if investors in (buyers of) financial securities could buy shares and bonds, in fixed proportions, issued by a non-bank firm (and regulators stipulating industry specific debt/equity ratios)? Your current solution is to have a regulatory rule to enforce your model 2. What are the consequences?

    (To the best of my knowledge, one way to approach a problem of the type you deal with is to first find a G.E. solution and then find a mechanism to implement it to overcome incentive compatibility problems.)

  10. Will
    January 18th, 2009 at 02:25 | #10

    Ernestine

    Sorry, I wasn’t suggesting that your comments had anything to do with Observa’s. Its perhaps that I am not an economist and so I thought you might have been reading a bit more into it than was there when you linked it to GE, which I don’t understand and certainly didn’t contemplate.

    But I do now understand a little better what you are saying. I would in fact argue that it is most efficient for owners of firms to be the investors in the permanent capital of their firm’s lending banks because, by eliminating the capital charge on loans to their firms, they are making a certain saving, which can be discounted at the risk free rate.

    On the other hand, an arm’s length investor investor in bank capital has to be compensated for uncertainty in their return. In other words, the capital charge on a normal has to reflect a substantial premium over the risk free rate, which cost then has to be borne by the borrowing firm and thus its owners.

    Does this make sense? And I do thank you very much for taking the time to think about this.

    Cheers
    Will

  11. Kien
    January 18th, 2009 at 14:19 | #11

    Here is another suggestion for stimulating private sector investment/consumption, inspired by a throw-away comment in Paul Krugman’s recent letter to the President-elect (at http://www.rollingstone.com/politics/story/25456948/what_obama_must_do/print) that the Fed may end up issuing Visa cards. Why not? Why not issue every American a Visa card with a (say) $50,000 credit limit at 0% interest rate, except that:

    (a) the credit expires if it is not used within 1 year; and

    (b) any amount owing is repayable only if the borrower’s taxable income exceeds (say) $100,000.

    It’s like the student loan scheme that we have in Australia, except that the loan can be used to fund any expenditure.

    Interest on the credit card could be tied to the Fed funds rate. When the economy recovers, the Fed could pull cash back in by offering to write off (say) 20% of outstanding debt that is repaid within a specified offer period.

  12. observa
    January 18th, 2009 at 19:38 | #12

    “The proposal is simply that the owners of firms might be highly motivated to provide the banks with new capital, and thus enable them to write new loans to those firms and grow their balance sheets, in this environment where arm’s length investors have no motivation and governments are finding it increasingly difficult to do so.”

    Will, I think the really big picture answer is, if that’s where you want to go then you wouldn’t want to start from here and that’s a universal policy-maker’s paradigm now. Nevertheless it’s important to understand how it is we got here and you’re on the right track, albeit I’d suggest you’re busy treating symptoms rather than the disease.(you might like to think about the history of water pricing in that regard)

    There’s no shortage of capital at present, just a shortage of investment opportunities at those artificially inflated prices and manipulated low rates of return. In that environment savings naturally retreat to Govt guaranteed safe havens with obvious fallout. As for believing in printing money and giving it to people and institutions who haven’t earned it to spend our way out of this mire, that’s simply Zimbabwean trillionaire dreaming at its extreme. The dreamers seem to have the floor though, which is why I’m part hedging in gold, part hedging in those Govt guaranteed bank deposits. I don’t think I’m alone there which seems to be confounding those who still have unerring faith that it’s consumption that drives economic wellbeing. (by all means fling me the readies, but spare me the fallacy of composition junk).

  13. Ernestine Gross
    January 18th, 2009 at 21:02 | #13

    Will, your paper contains your email address. Would it be o.k. if I send further comments to your email address – I don’t wish to overuse our host’s blogsite. I also would like to send you a paper and get your comments.
    Ernestine

  14. January 18th, 2009 at 21:35 | #14

    Cross-posted from OLO forum “Bush’s democracy of hypocrisy”:

    … I urge everyone to check this brilliant BrassCheck TV broadcast at:

    http://www.brasschecktv.com/page/253.html

    … and then afterwards visit:

    http://www.newbushcoins.com/

    … and order a set of ‘coins’ (fridge magnets really) for US$9.98 + postage and handling, particularly if you happen to live in North America.

    Celebrating the age of Bush

    The commemorative coin set

    You’ve probably seen the ads for commemorative coins celebrating Obama’s election.

    But what about soon to be former president George W. Bush?

    Celebrate the president who gave so much (irony alert)

    If you need a laugh, this will provide it.

    Details:

    http://www.brasschecktv.com/page/253.html

    - Brasscheck

    P.S. Please share Brasscheck TV e-mails and
    videos with friends and colleagues.

    That’s how we grow. Thanks.

  15. Will
    January 18th, 2009 at 23:41 | #15

    Ernestine

    That would be great. Speak with you soon.

    Observa

    If you think that the rationale for banks as asset transformers and creators of liquidity is flawed, and I am not suggesting that is an unreasonable view, then you are right, I am trying to treat the symptom. But I am starting from the practical position where we all agree that continuing to have banks is a good thing. One thing I maybe don’t agree with you is that there is no shortage of capital today, by which I mean patient, long-term capital – everyone seems to demand that they can invest in anything and have perfect liquidity, and hence today no one is willing to invest for fear of having to mark-to-market next month.

    Thanks to you both.

    Cheers
    Will

  16. Will
    January 21st, 2009 at 21:27 | #16

    Apologies but this is definitely my final unsolicited post on the idea raised above.

    The feedback I have has been positive, in terms of the concept, but I think it has found little traction (as far as I am aware) because it is difficult to identify who would initiate and implement such a scheme. To this end, and given current events on the banking markets, I have developed a simple strategy in which government could lead and provide an important intermediation function. I have distilled it into a couple of short paragraphs, as follows.

    With respect to each bank under its regulation, the government could create and own a vehicle called, say, a Capital Investment Trust (CIT). The bank could then negotiate to provide loans to firms in exchange for those firms investing amounts, equal to the Tier 1 regulatory capital requirement on those loans, in the CIT. The CIT would in turn invest those amounts in appropriate risk-free Treasury Bills, and each firm would receive an ongoing return equal to its pro-rata share of the return on those Treasury bills.

    The CIT would simultaneously provide the bank with a permanent facility (Capital Reserve Facility) under which it could, at any time and at its option, draw up to the full amount of the funds invested in the CIT. In return for the drawings, which would be met by the CIT through redemption of the Treasury bills, the bank would issue the CIT with new ordinary shares. The number of shares issued would be equal to the amount drawn divided by the then current share price. The CIT would distribute those shares to the firms who invested in the CIT on a pro-rata basis. Those firms would continue to receive their pro-rata share of the return on any remaining Treasury bills held by the CIT. And new firms could subsequently invest further amounts in the CIT in exchange for new loans, allowing the scheme to continue indefinitely.

    The national regulator would accept the undrawn Capital Reserve Facility as Core Tier 1 capital for the bank, so it would never be intended that the facility be utilized except in a final bank liquidation scenario.

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