Just Banking Presentation
Apr21
on April 21, 2012
at 8:52 am
I’m just unwinding back at my hotel after this 23 day, 4 country, 7 city trip; an exhausting but worthwhile experience (made all the more challenging by either Heathrow or Qantas losing my bag for 8 days on my arrival!).
The Just Banking conference organised by the Friends of the Earth Scotland was a fitting finale. I won’t write too much about it here–I’m too tired–but I’m sure Beth and friends will do a good write-up. For now, here is a screen recording of my presentation and the Powerpoint slides; later we’ll add the video as well.
Even if you assume 100% retention, under the operating model the deposit created goes into creating the next loan. Although it starts to get complicated when you start looking at term structure and reserve capital etc. So you need to assume those things away as well…
@Dannyb2b
“The RBA rekons there is a RRR though so I dont know.”
On the contrary, from the RBA website:
“… Moreover, unlike central banks in a number of other countries, the Bank imposes no reserve requirements.”
Mikeh 1980
Very interesting.
The RRR works it’s way via prescriptions of ratios of different tier capital.
http://en.wikipedia.org/wiki/Capital_requirement
However strictly speaking Australia does not have a reserve requirement:
http://en.wikipedia.org/wiki/Reserve_requirement
The capital requirements works in a similar way. Instead of holding notes and coins, banks hold other liquid forms of assets.
Additionally loan portfolios must be funded by similar maturity funding. This is part of a liquidity management framework, which is scrutinised by the regulator on an ongoing basis. So the picture of loan portfolio funded purely by the at call deposits or the ‘friendly’ cb via the ON rate is not consistent with imposed regulation. If banks did this they would have been bankrupt a long time ago.
The ON facility is used to balance out any short term cashflows liquidity requirements. It’s mainly used to settle trading accounts if necessary, which have unpredictable cashflows. Banks will attempt to get slightly longer tenor liquidity for short term liquidity management. This is mainly done via the interbank cash market (BBSW, LIBOR etc.) before accessing the ON facility. So for example a bank would prefer to fund 1 week cash instead of rolling over ON 7 times, so they are willing to pay a slightly higher interest rate. This is how the ON rate (RBA cash rate to be clear) anchors down the yield curve. Longer term loan portolios and especially home loans are funded by issuing long term bank paper. And because long term bank paper is not the most liquid source of funding, especially not in the wholesale amounts required by banks, the long term funding is done well ahead of time. That does not mean that some of the at call deposits don’t end up as home loans, and maybe in a very simple world where all we had is loans and deposits and 1 bank, you can say banks create deposits out of thin air. It does not apply in the world we live in.
Back in the world of theoretical bliss… Say instead of 1 bank creating deposits via loans, you have 2 banks creating deposits via loans. So now the deposits created by bank A and bank B go into 1 pool of avalaible deposits which both bank A and B must compete for, via interest rates or other means (service, facility, ATM infrastructure, etc.). Very quickly you go from the cosy world of frictionless money creation, to some sort of interplay between 2 banks to compete for available deposits while maintaining a margin between deposits and loan rates. This would be 1 step closer to reality with about 1000 steps to go.
@Danny2b
Providing a bank is solvent the charging of interest has net zero effect on aggregate demand as the money is repent either within the bank (i,.e to employ the staff) or through expenditure of profits. There is no interest rate leak – common fallacy of many pamphlet bashing out ‘monetary reformers formally known as monetary cranks’.
Of course if money is kept in idle balances anywhere that can lead to ‘credit deadlock’ but that is an issue of confidence not interest rates per se – besides interest rates are at historic lows and idle balances at historic highs, so no clear correlation – its an issue of demand and confidence not a mistake in bank plumbing.
The real problem is the time lags between lending of money from banks and the investment of firms, leading to overcapacity, bankrupcy and the building up of bad debt
Stephen Kinsella my favorite economist (sorry Steve close second) together with Antoine Godin has recently published a simulation study on this showing how the solvency of firms interacts with the creditworthiness of banks to drive a leverage cycle where bad debts in banks build up to unsustainable levels
http://www.ssrn.com/abstract=1973500
“Providing a bank is solvent the charging of interest has net zero effect on aggregate demand as the money is repent either within the bank (i,.e to employ the staff) or through expenditure of profits. There is no interest rate leak – common fallacy of many pamphlet bashing out ‘monetary reformers formally known as monetary cranks’”
yes alainton
all roads lead to owners or bank equity.
“Providing a bank is solvent the charging of interest has net zero effect on aggregate demand as the money is repent either within the bank (i,.e to employ the staff) or through expenditure of profits.”
Not necessarily true that. Banks can hoard as well – hence the massive holdings of central bank and Treasury assets.
There is no law requiring a bank to distribute its profits. In fact with capital ratios it is often better that it retain them to drive the leverage cycle higher
Since the Wallis restructure of Australian financial regulation (1997), RBA has no role in bank regulation (unlike overseas central banks). RBA does not regulate leverage (or reserve requirements); it is APRA which does. Don’t believe what you read without proper investigation and understanding.
Reserves at RBA, which are negligible relative to bank balance sheet, does not determine leverage, it is net asset or equity. Banks are required to have about 10 per cent liquid assets to bank deposits and about 10 per cent net equity relative to loans for solvency. Explore the APRA website to learn.
Alainton
“Providing a bank is solvent the charging of interest has net zero effect on aggregate demand as the money is repent either within the bank (i,.e to employ the staff) or through expenditure of profits.”
Providing the interest income is spent then you get the same aggregate demand. The change is that the banks determine what will be the aggregate demand instead of entities across the overall economy. An imbalance if you will.A redistribution of purchasing power from the overall economy to the banks. This effect helps to create an economy dominated by the financial sector. But the banks may also not respend and just hoard money.
“Of course if money is kept in idle balances anywhere that can lead to ‘credit deadlock’ but that is an issue of confidence not interest rates per se – besides interest rates are at historic lows and idle balances at historic highs, so no clear correlation – its an issue of demand and confidence not a mistake in bank plumbing.”
Confidence is destroyed by the banks through the consequences of their imbalanced lending activites which is causing them and other actors to hoard money or leave it within the banking system. Credit deadlock is a huge problem when all money is originated as credit. But if the CB deals directly with the public in a non debt based system then the deadlock can be sidestepped a circuitbreaker if you will. Banks wont drive business cycles when they feel confident and send everything downwards when they decide to stop lending.
“Stephen Kinsella my favorite economist (sorry Steve close second) together with Antoine Godin has recently published a simulation study on this showing how the solvency of firms interacts with the creditworthiness of banks to drive a leverage cycle where bad debts in banks build up to unsustainable levels”
That insolvency tendency couldn’t have anything to do with the enforced cost accounting conventions which make firms have to chase insufficient demand vis a vie prices would it?
“Not necessarily true that. Banks can hoard as well – hence the massive holdings of central bank and Treasury assets”
this is just a liquidity swap within the banking system neilw,
no net increase in the net worth position of non bank entities
no effect on aggregate demand .
@Lyonwiss
My original comment in this thread was whether the need for Australian banks to borrow offshore was due to a capital constraint (since there is no reserve constraint). Do you have any thoughts?
Mikeh 1980
There could also be other non economic reasons for the seemingly excesive offshore borrowing. Im not sure specifically but there may be political motives of some sort.
Remember most of the Aussie banking system is only four banks. Look at the financial statements of the big four and you will find that all the voting at shareholder meetings can be accounted for by the four biggest shareholders. HSBC, JPM, and I cant remember the other 2. Therefore the Aussie banks could be acting in some subsidiary function to other global banks. Just a thought.
@ Mikeh1980 April 25, 2012 at 1:13 pm
Banks lend long (eg mortgages) borrow short (eg deposits). The long assets and short liabilities are two sides of their balance sheets. But banks have to continually roll over their short-term liabilities because they mature! This is the so-called funding problem. If there are not enough domestic bank bills and deposits (by banks’ lenders), then they have to seek funding off-shore.
Bank lending (when properly regulated) is always capital constrained, i.e. there is always an upper limit to leverage allowed by the capital (or equity) they hold. A typical major Australian bank has $25B capital to issue about $250B worth of long-term loans, about half of them mortgages. It has to continually borrow from the market up to $250B! The GFC is mainly about no private sector (other banks or investors) wanting to lend to the banks even in the short-term, because suspected insolvency.
So much for economists’ view of banks creating money “out of thin air”.
“this is just a liquidity swap within the banking system neilw,”
Not when accompanied by deleveraging (money destruction). The income from central bank and government assets becomes what the increasing bank equity is seeking – rather than being used to back loans (for which there is no aggregate increase in demand, so that can’t happen).
Consider the situation where there is such lack of demand for loans that the bank is run off. What does the bank end up holding to cover its equity?
Liquidity swaps are an entirely different thing which admittedly use the same assets.
“Bank lending (when properly regulated) is always capital constrained, i.e. there is always an upper limit to leverage allowed by the capital (or equity) they hold. ”
Which can also be created out of thin air based on the price.
Bank lends money based on current equity. That is laundered by the system via several transactions and ends up in the hands of a third party who then subscribes for a bank’s investment bond issue.
Hey Presto more capital to drive the next round of leverage expansion.
Capital is always available based on price. There is not a fixed quantity of capital.
“The GFC is mainly about no private sector (other banks or investors) wanting to lend to the banks even in the short-term, because suspected insolvency.”
Which is why they have a lender of last resort, so its never really a problem.
The GFC was really about *capital* which the banks were also increasingly borrowing short…
I think that a careful analysis of this will show that the quantity theory of money and the velocity of its “circulation” is really just another piece of shattered and still too little examined piece of economic orthodoxy.
http://social-credit.blogspot.com/2010/03/alberta-post-war-reconstruction.html
All of the articles on the following page are also relative.
http://social-credit.blogspot.com/
@neilw
I acknowledged the idle balances issue in the next para. However I agree with contra Mahanish on the liquidity swap issue.
You raise an interesting point
‘Capital is always available based on price. There is not a fixed quantity of capital’
But is there a fallacy of composition here.
Imagine if every bank all at once tried to raise capital through loans from elsewhere in the system. From what banks? It would push interest rates up. In balance sheet terms the amount banks borrow from other banks must match the amount other banks are prepared to lend. If there is a mismatch the interbank rate will rise or fall. And there is no ‘hey its an asset and can be created out of thin air’ argument as even if all banks could do this the money to repay the loans and interest must come from other bank balances and net to zero+interest over term. Of course these loans must be backed by collatoral so equity to banks net can only be decreased if there is an increased pledge of capital to banks to create an expansion of the capital base of banks. This is similar to Tobins arguments on structural constraints to portfolios.
The argument im making is is similar to MMT but with a twist.
Banks can net only expand credit in the economy by shifting capital from the non bank private sector – but the withdrawl of investment will drive the downside of the credit cycle through contracting the real economy (Kaleckis/Hilferdings argument) as the credit expansion drives the upside through increasing aggregate demand (Hawtrys argument). The only way then to expand the whole of the private sector – such as in a balance sheet recession such as now, is to create debt free state money and introduce it to the economy through public spending which increases demand (Wrays argument). There is no fixed quantity of capital but the economy can only expand net overall in the long term by the amount that money is created to expand productive capital (Fishers argument), so it is anticipated future capital not current capital that sets a cap on growth.
Im wondering if there is a simplified accounting way -short of a full SFC model- to look at this – perhaps a social accounting matrix of two banks and two representative customers – with T accounts modelled between them. Of course such a matrix could not deal with term structure but it would help.
“Imagine if every bank all at once tried to raise capital through loans from elsewhere in the system.”
They did. What happens is that the returns from the banks have to go up to attract the capital required to continue the loan expansion that provides the capital.
It’s exactly the same asset price bubble – but in bank capital. It got shorter in maturity to reduce the rate required to obtain it and the banks got into more and more leverage games to try and justify the dividend rate on the investment capital. And you get lobbying to reduce the regulatory capital ratios
And that continues until the bubble goes pop and then boom.
It’s not the interest rate that goes up. It’s the required return on bank capital – which can be achieved by reducing the time element while keeping the rate static.
You have to be very careful with your balance sheets to separate what is bank capital/equity and what is happening to support that on the asset side, from the normal process of liquidity in banking which is assets and other liabilities balancing out. The bank really only cares about the transfer to and from equity. That’s why they do the rest of the leverage stuff.
This is where the actual pyramid hierarchy helps the model – with the private banks clearing from the central bank (which may then clear via a supra-central bank) that then guarantees all those bank’s cashflow. It’s much easier to see what is going off with a pyramid.
@ NeilW April 25, 2012 at 5:46 pm
You need to differentiate between what regulation is designed to do, what regulation fails to do, but deisgned to do and what regulation fails to do, but never designed to do. Understanding the difference is very important to any proposed solution.
@ NeilW April 25, 2012 at 5:52 pm
You said: “Which is why they have a lender of last resort, so its never really a problem.” Yes, that was a short-term solution in liquidity provision as envisaged by Walter Bagehot, years ago and is what was intended. But it is not a long-term solution to prevent insolvency, which is not what was intended, but now perverted. You need to understand the difference.
Neil
I dont think were necessarily saying different things if banks have a high elasiticity of capital expansion through finacialisation – then there is less pressure to raise interest rates. Then they can sell ‘assets’ on to boost their equity position and reduce their risk. A lot of cdos were bought by the non banking sector – in 2007 Citibank had 40% sales to hedge funds, 50% to asset managers and 10% to banks. This supports the storey that banks were selling high risk loans and sucking in investment funds from the non bank sector to boost capital to fund even more high risk loans.
You tell a storey where capitalists are price makers on the financial assets that they bought from banks and able to secure increased returns, and banks price takers because they need the capital.
Whats missing from this storey is why rates of profit, and extent of accumulation, in each sector was different generating the capital transfer. Physical Asset prices must be the driver, I dont buy the global savings gut idea.
What would happen if you model free banking without central banks? Central banks try to set the price of new money by controlling intrest rates. But since central banks are central planning they will most likely set the price ie the interest level wrong at times. Artificial low interest rates would then cause future financial crisis by financing assest price bubbles mostly in housing but also in other assest classes such as stocks.
That’s what I do model Christian–when I have a flexible interest rate. It makes little difference. It’s much like thinking that we can know now the price of carbon that will stop Greenland melting.