Regulation and the EU crisis

The current spat between the UK and France over whose economy is in worse shape is like two people, one with both arms broken and the other with both legs broken, arguing about who is in better condition to play a game of tennis. All they are achieving is to focus attention on the fact that both of them are not in a fit condition. In doing so, to mix metaphors, they are both placing each other further into the firing line. As it is, the firing line is already broadening:

Bank of America Corp., Goldman Sachs Group Inc. and Citigroup Inc. had their credit grades cut by Fitch Ratings as the impact of financial regulation and market turmoil weighed on the industry.

The lenders’ long-term issuer default ratings were cut one level to A from A+, Fitch said yesterday in a statement. Barclays Plc, based in London, Credit Suisse Group AG, Deutsche Bank AG and BNP Paribas SA also had their grades lowered.

[and] Credit ratings of the world’s biggest lenders have come under pressure amid weak economic growth and doubts about whether European regulators have done enough to end the sovereign-debt crisis. Lenders in the region must raise about 114.7 billion euros ($149 billion) in capital to help address the turmoil, the European Banking Authority said last week.

Fitch downgraded Barclays and Zurich-based Credit Suisse to A from AA-, while lowering France’s BNP Paribas and Deutsche Bank to A+ from AA-. Fitch corrected an earlier version of its statement to announce that Frankfurt-based Deutsche Bank was cut one level instead of two. Morgan Stanley’s long-term issuer default rating was affirmed at A.

And, of course, sitting underneath all of this is sovereign debt exposure. In 2008, I wrote a post which clearly lays the blame for this debacle in the right place; the banking regulators. I used a Bank of England paper on the impacts of the Basel accord framework (from the Bank for International Settlements, BIS) to highlight the problems the regulators were causing; in particular the idea that risk could be identified and codified by a group of experts. This is what I had to say about the first Basel Accord:

So here we have a determination of risk which assumes that, for example, OECD based banks are safe. We now see that this is not the case, and many of the banks in the OECD would, without government support, now be bankrupt. We also see that lending into government securities is also 'safe' but, as I have argued elsewhere in this blog, countries such as the UK are extremely unsafe at present.

So here we have the essential problem. A bunch of very smart people got together and said that they were able to determine levels of risk. Their conclusions have been shown to be wrong. In particular, OECD banks have demonstrably been shown to be, in a very large number of cases, unsound. I will reiterate this point once again - they were wrong.

Another point in the Basel I accord was that it creates a perverse incentive to lend to governments. Investing in government debt means that money is not being invested into potentially wealth creating investments in the private sector. It also virtually guarantees that government will have access to credit, regardless of whether the governments are acting responsibly or irresponsibly. Such guaranteed provision will almost certainly have been a factor in the growth in Western government / OECD debt. However, it would be impossible to prove one way or another.

 For Basel II, I had the following to say (the quote is from the BoE paper):

Another interesting feature of Basel II is that the accord put the credit rating agencies centre stage in the assessment of risk:

Under the standardised approach banks will slot assets into weighting bands according to ratings from ligible rating agencies (ie recognised by national
supervisors in accordance with specified criteria).

The BoE paper acknowledges that the rating agencies may be no better than the banks at assessing risk, but fails to acknowledge that there is a central conflict of interest - that the ratings agencies are paid for conducting the rating by the banks themselves. The importance of the poor preformance of these ratings in the current financial crisis can not be overstated. However, they were critical to the entire Basel II system:

Exposures to borrowers without a credit rating will be placed in an unrated band that will carry a 100% weight (ie 8% capital charge), but regulators are requested to review the default experience of the particular market (and individual bank) to decide whether this is sufficient. Undrawn facilities to corporates of less than one year, which currentlycarry a zero weight, will be weighted at 20%.

At the heart of all of this regulation is an unfounded belief that, somehow, there are a bunch of people with sufficient wisdom to determine risk, and therefore create a system in which risk of failure is abolished. Such a point view can only do one thing - create complacency. It creates a situation where, provided you meet the rules, you must be sound.

So here we are, years later, with banks having gorged on mountains of 'safe' sovereign debt (as a note, in some financial jurisdictions, they continued to ask banks to report based upon Basel I), and the ratings agencies playing 'catchup' with reality in their issuance of downgrades. Just to add to this wonderful array of regulation, the Basel III accords, a response to the crisis, are now about to be implemented and will require banks to hold larger capital buffers (see here for a summary from BIS). Although market pressures were already leading to banks increasing their buffers, the impact will be for banks to conserve capital to meet the new requirements with implementation of the rules in 2013. In light of the problems of 2008, this might seems like a good idea, but is closing the stable door after the horse has bolted. Or if I can stretch the metaphor, slamming the stable door shut whilst the horse is half way out of the door.

What really worries me however is the tweaking of the principles of Basel II into the overall structure of the Basel II accords (see full document here, note 1). For example, the new accord places greater emphasis on stress testing, but remember this:

When the European Banking Authority (EBA) published the results of ‘stress tests’ on 90 banks across 21 countries in the EU in July 2011, Franco-Belgian bank Dexia was given a clean bill of health. Barely three months later, however, Dexia needed a €4bn bailout package. The bank had been unable to raise the cash it needed on the financial markets, largely due to concerns about its ability to withstand losses on its €3.4bn exposure to Greece.

Also, for the external rating of assets, they seek to mitigate what they call 'cliff effects' (which I have understood to be 'falling off'), but the ratings agencies are still front and centre alongside the bank's internal risk assessment. The internal risk assessments are seen as an additional check:

Finally, the proposal will seek to reduce to the extent possible reliance by credit institutions on external credit ratings by: a) requiring that all banks' investment decisions are based not only on ratings but also on their own internal credit opinion, and b) that banks with a material number of exposures in a given portfolio develop internal ratings for that portfolio instead of relying on external ratings for the calculation of their capital requirements.

Just to add to the interest and conflicts of interest, for example Moody Analytics boasts that their systems are used by the major banks in supporting Basel I, II and III:

We also provide an integrated economic capital solution for Pillar II ICAAP requirements, as well as an internal rating framework with proprietary and customizable models and scorecards. Additionally, we also provide solutions that allow you to allocate and price risk more effectively and to integrate risk management into the business at the point of origination, increasing operational efficiency and optimizing risk and return, which will be critical in a world with higher capital requirements. Our products are complemented with comprehensive analysis and stress testing tools and expert advisory, implementation and customization services to assist you in all phases of your project.

This will be the same organisation that has, in recent times, been an exemplar of effectiveness in spotting high risk assets, as well as objectivity. For those of you unfamiliar with Moody's I pulled this story up from the WSJ to illustrate the point:

Yuri Yoshizawa, managing director of global structured credit, intends to leave the Moody's Corp. unit at the end of June, a person familiar with the situation said Friday. This person said Ms. Yoshizawa made the decision to step down. She couldn't be reached for comment.

The operation overseen by Ms. Yoshizawa was criticized as an example of what went wrong when rating firms analyzed CDOs and other mortgage-related deals before the worst of the financial crisis. Lawmakers and other critics say ratings firms like Moody's awarded their highest ratings to questionable mortgage bonds in order to win business from issuers of the bonds.

Collateralized debt obligations were among the hardest-hit investments during the crisis, causing tens of billions of dollars in losses for investors, many of whom were attracted to their high ratings.

At a Senate hearing last April, Ms. Yoshizawa was prodded about the back-and-forth between analysts and bond issuers as the analysts worked on ratings for new bonds. "There was always pressure from banks," she said, noting that the relationship could get contentious and "very abusive."

Emails between Ms. Yoshizawa and Moody's colleagues emerged during the investigation by the Financial Crisis Inquiry Commission, a panel formed to explore the causes of the crisis.

An October 2007 email showed that the firm's market share in CDOs had fallen to 94% from more than 98%. In her reply, Ms. Yoshizawa asked colleagues to "take a look at the deals we didn't rate … to double check the information and to let me know any of the 'stories.' "

Some critics cite the email as an example of pressure on Moody's analysts to win business. Ms. Yoshizawa told lawmakers last year that she couldn't recall ever removing an analyst from a transaction as it was being rated because of arm-twisting by banks, though she said future deals might be assigned to a different analyst.

So here we have the situation. Banking regulations determined that OECD sovereign debt was safe, banks gorged on the debt, and the debt was not safe. As Basel was adapted, it placed ever greater influence in the hands of ratings agencies who have a track record of being hopeless at assessing risk, have chronic conflicts of interest, and who only manage to downgrade assets at the point at which they are about to collapse (if not after they have collapsed). On top of this, the internal risk assessment looms large. It is hardly inspiring of confidence.

Most worrying is that, those who are determining policy think that this is all a good idea. Now that really does present a worrying picture.......


Note 1: I have not read the whole document (not an easy read, but interesting in places), but summaries can be found elsewhere.

Bleeding the 'Real' Economy to Support the Financial System

I am in the highly unusual position of agreeing with Krugman (or at least in part), the Nobel winning economist who writes in the New York Times. He has just recently written an op-ed on the subject of the huge profits being achieved by Goldman Sachs ($US 3.4 billion), and says the following:

The huge bonuses Goldman will soon hand out show that financial-industry highfliers are still operating under a system of heads they win, tails other people lose. If you’re a banker, and you generate big short-term profits, you get lavishly rewarded — and you don’t have to give the money back if and when those profits turn out to have been a mirage. You have every reason, then, to steer investors into taking risks they don’t understand.

And the events of the past year have skewed those incentives even more, by putting taxpayers as well as investors on the hook if things go wrong.

Inevitably, the massive bonuses that Goldman are about to distribute are a major point of the controversy. However, whilst this is all good populist material, the focus should be on a system in which the banks were bailed out in the first place. As Krugman identifies, it is a case of 'heads they win, tails other people lose'. Krugman, I recall, was in favour of 'saving' the financial system, as were many others. What we are now seeing is the result of the 'salvation' of the system. The banks that took huge bad bets are now appearing to make large profits.

Regarding Goldman Sachs as the evil in the machine, the populist mantra of the day, I will not criticise them. Provided that they act in the law, their duty is to do the best possible for their shareholders, and also their employees. Goldman Sachs are simply doing a very effective job within a framework that allows them so much leeway. They are no different from GM in holding out their hand for government support, but are simply more effective at doing so. Goldman Sachs are just a symptom, and are certainly not the cause of the problem. It is not their role that should be subject to criticism, but the government and the Federal Reserve - it is the state that is the problem. It is the state that is at the root of the appearance of the bumper profits and bonuses at Goldman Sachs.

I say 'appearing', as there are real question marks over how 'real' these profits actually are. The bailout of AIG has been linked to an indirect bailout of Goldman Sachs, for example by the bane of Goldman Matt Taibbi of Rolling Stone magazine. On top of AIG, it is not clear how much Goldman has been bailed out by the various programs that have been enacted to remove toxic assets from the balance sheets of banks, as the recipients of such bailouts is shrouded in secrecy. There are also the changes in accounting rules have allowed banks to do some extraordinary accounting tricks:

During the financial crisis, the market prices of many securities, particularly those backed by subprime home mortgages, have plunged to fractions of their original prices. That has forced banks to report hundreds of billions of dollars in losses over the last year, because some of those securities must be reported at market value each three months, with the bank showing a profit or loss based on the change.

Bankers bitterly complained that the current market prices were the result of distressed sales and that they should be allowed to ignore those prices and value the securities instead at their value in a normal market. At first FASB, pronounced FAS-bee, resisted making changes, but that changed within a few days of a Congressional hearing at which legislators from both parties demanded the board act.

This is just one example. In other words, as a result of the bailouts and the changes to the accounting rules, it is nigh on impossible to work out exactly where any real profits might lie. Quite simply, nobody but the banks themselves and the Federal Reserve, and perhaps other arms of the government, can untangle the real state of the banking system. However, it is almost certain that the sudden profitability of the banks is rooted in the various bailouts and accounting tricks. Whilst it is quite plausible that many parts of the Goldman operations are profitable, the overall genuine profitability is buried in the accounting and the bailouts. Krugman identifies the complete opacity of the situation as follows:

I won’t try to parse the competing claims about how much direct benefit Goldman received from recent financial bailouts, especially the government’s assumption of A.I.G.’s liabilities. What’s clear is that Wall Street in general, Goldman very much included, benefited hugely from the government’s provision of a financial backstop — an assurance that it will rescue major financial players whenever things go wrong.

Under such conditions, it is no wonder that so many commentators are calling 'foul' over the massive bonuses that are going to be paid out by Goldman Sachs to their employees. However, the underlying problem remains as to why all of this has taken place. Why have the changes to the accounting rules taken place, and why are toxic assets being taken off the hands of the banks, thereby transferring risk from the private sector to the state sector?

The argument has been that certain financial institutions are 'too big to fail', but the reality is that the various government measures to support the situation is entrenching the system in which the large financial institutions threaten the financial system. With each bailout, with each measure, they undermine the market forces which might discipline the banks, creating ever more public exposure to private risk taking. In doing so, they simply embolden the banks to take further risks.

As was identified at the start of the process of the bailouts, there is an inherent moral hazard in bailing out banks, in that they cannot lose. They become a one way bet, and that will, however much oversight is applied, eventually lead to complacency, and excessive risk taking. It is now apparent that, under the current system, profit is guaranteed by public institutions. The worst case scenario for the major banks is that they might have a few quarters of poor or no profits, but there is an implicit guarantee that the government will do whatever is necessary to engineer a return to profitability. There will be no more Lehmans in the future, as the new regulatory regime will never allow another major bank failure for fear of a repeat of this crisis. One way or another, the 'too big to fail' banks will be immune from any major losses.

The solution given by many, like Krugman, is more supervision and regulation. However, if a bank is 'too big to fail', with proposals for special levels of supervision as a result, it will become to be seen as the 'safest' kind of bank. If a bank is seen as 'safe', it will offset any measures such as stronger capital adequacy requirements through being able to raise finance more cheaply, and through the state guarantee will win more business, and the result will be to just get bigger, and consolidate ever more risk into a small number of institutions. The crisis has already seen a consolidation in the number of major banks, and this process is likely to continue.

The problem is that the same regulators who failed to see the risks in the current system will be responsible for regulation under any new system. Whilst they might (possibly) be able to spot the kind of risks that caused the current financial meltdown, what is to say that they will be able to spot the risks that arise in the next particular set of economic circumstances? The difference is that, next time around, it is more likely that there will be even more concentration of risk in a few major institutions, and therefore even greater system-wide risk.

If you doubt what I am saying, take a look at one of the key policy makers discussing the state of housing and the financial system pre-crisis. I found this video of pre-crisis statements by Bernanke on Reddit recently. For the many out there calling for more regulation, you will need to think about how the regulators might be able to identify risk, when the record of policymakers is so abysmal. Quite simply, the policymakers who will formulate the regulation are clowns dressed up in important titles, armed with mechanistic formulae and jargon.

Whilst all of the shenanigans continue in the financial sector, the 'real' economy in the US continues to bleed. At some point in time, it is the real economy that will have to pay the price of the salvation of the 'financial system'. Again, I find myself agreeing with Krugman:

The bottom line is that Goldman’s blowout quarter is good news for Goldman and the people who work there. It’s good news for financial superstars in general, whose paychecks are rapidly climbing back to precrisis levels. But it’s bad news for almost everyone else.

The fact is that, one way or another, the 'real' economy will eventually be paying for the profits at Goldman and the massive bonuses, and that 'real' economy is already suffering extreme pain. In the meantime, it is not apparent that the 'salvation' of the financial system has translated into salvation of the economy. For all the talk of 'green shoots', the US economy continues on a steady descent, with all the pain that means for those working in the 'real' economy.

The panic engendered when the financial crisis hit is now over. I argued against the bailouts at the time that they were taking place, at that moment of panic. I argued that the resource being poured into the banks would be needed whilst the economy restructured. I argued that the bailouts would continue on from those that were proposed at the start, and that is what has taken place. And.....every single $US that has been poured into the rescue of the financial system will one day be repaid in taxation from the 'real' economy. I argued against the bailouts on this principle.

All of this, hidden in opacity, has led to a point at which insolvent banks are now able to make a 'profit'. Exactly why has this massive bleeding of resources into insolvent banks been allowed to take place? Where exactly is the salvation of the real economy, the pot of gold at the end of the rainbow of the financial system? Like the pot of gold and the rainbow, if we just go a bit further.....we might just find the pot of gold.

In this terrible mess, the point that is forgotten is what a financial system is actually really for. It only exists to allocate accumulated capital and provision of insurances; the financial system should be a support to the real economy, by efficiently allocating capital. It is entirely unclear how pouring trillions of dollars into insolvent institutions, capital which will eventually be taken out of the 'real' economy, might facilitate this. The 'real' economy is now expensively supporting the financial system, rather than the financial system supporting the real economy. It seems that this is the exact opposite of what a financial system actually should be doing. It is simply beyond any reasonable explanation.

It is the same policymakers who are supporting the financial system at the cost of the economy who will be formulating the new regulatory framework. It is the same policymakers who failed to see the risks inherent in the financial system that will be overseeing and regulating the future risks in the financial system. It is the same policymakers who have overseen the consolidation of the banking system into fewer hands, who are engineering a system in which banks will be ever more concentrated. It is the same clowns who were responsible for the current mess in the financial system, who have engineered that insolvent institutions make profits, that will suddenly have the wisdom to create a 'safe' financial system in which major risk is banished.

It is not an encouraging prospect.

Note: The use of the term 'real' economy is a convenience, as the financial system is actually part of the real economy. As such it is used simply as a way of saying that I am referring to the provision and exchange of services and goods outside of the financial sector.

The G20 and Ongoing Delusions

A Major Error in the post - comment added on 6 April:

I have had a commentator point out a somewhat ridiculous error in the blog. I intended to write about the recent G20 communique, and instead pulled up the text from the previous communique. Thank you to Tiberius who (very politely pointed out this error).

Essentially, the error was caused by a search for the document pulling up the older version. I should have checked the dates. This is a serious error and I therefore would like to offer my apologies. My aim was to go straight to the source, rather than rely on the interpretation of others. However, checking that I have the right source is a good starting point.

I have left the post as it stands. The principle of this blog is that nothing is deleted - even if it is rather a bad mistake. I only ever add notes and comments (as in this example) and date the change. However, in light of the error, please disregard this post. Once again, please accept my apologies for an idiotic and careless mistake.

I was puzzled at some of the commentary in the other media, but their commentary makes rather more sense now.....

Cynicus Economicus

Original post follows:

As promised a post on the G20 outcome. If you have the time you may wish to read the full text of the official communique, which can be found here.

Perhaps the most striking thing about the communique is the acceptance that the nature of the financial system was such that the world developed an unsustainable imbalance. However, the way that this is phrased still fails to accurately reflect that many of the imbalances were the direct result of policies of central banks, and no mention is made of the role of the regulators in creating the financial products that were to play such a large part in the crisis. In fact, the communique offers a vague and disingenuous picture of the causes. As such I will quote the section titled 'Root Causes of the Current Crisis' and examine it in some depth:

3. During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.

4. Major underlying factors to the current situation were, among others, inconsistent and insufficiently coordinated macroeconomic policies, inadequate structural reforms, which led to unsustainable global macroeconomic outcomes. These developments, together, contributed to excesses and ultimately resulted in severe market disruption.

The best way to examine this, is to take each point, and examine how it reflects the reality. Point (1) is as follows:

'During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence.'

They describe economic growth during recent times, and this is an accurate description of the world situation. However, what they do not acknowledge is that the so called growth of the Western economies was a growth in activity form debt expansion, not a growth in wealth. In other words the growth was centred in the developing economies, and the growth in the Western economies was illusory (a post which shows how illusory that growth is can be found here).

With regards to the market participants (the major banks) seeking higher yields and taking risk, they were simply responding to two factors. One of these was the wall of money flowing into Western economies due to factors such as the low interest rates and Quantitative Easing (printing money) in Japan, the massive accumulation of petro-money in the Gulf states, and the quasi-mercantilist policies of China to achieve export growth. The problem such a wall of money might create is that, whilst the first tranches of money might be usefully used, the later tranches of money would have ever less opportunity to be invested in productive investments. The money had to go somewhere, and we can see the roots of bad lending into consumer markets. These imbalances were not the result of 'markets' but the active manipulation of the economy by governments.

If we combine this with the Basel regulatory framework (the other factor) it is possible to see the severe problems which can be firmly laid at the door of the central banks, and regulatory systems. Even the Bank of England admits that Basel I was the spur towards securitisation, and encouraged off-balance sheet activity. To this we might add that the system was responsible for the use of ratings agencies to assess products (e.g. CDOs), and the internal 'rocket scientist' calculation of risks that proved to be so wrong headed. Finally, the accords actively encouraged banks to lend to governments for the purposes of capital adequacy, thereby offering a further spur (as if any were needed) for some Western governments to borrow excessively (thereby leaving them vulnerable to the current shocks). A longer discussion of how the regulatory system helped to cause the crisis can be found here (a long post, and this is just one element of it).

In other words, whilst the banks may reasonably be cited as problematic, if not idiotic, they were in large part responding to a regulatory and macro-economic environment that was determined by government and central banks. It is always difficult to assign culpability in such cases, but there is much that can be laid at the doors of those who are behind the communique, those who now profess wisdom after the event.

Point (2) is as follows:

At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.

Whilst this appears as an acknowledgement of fault by regulators and government, it still essentially pins the blame firmly on the banks. The nearest it comes to any real acknowledgement is the mention of 'ramifications of domestic regulatory actions', but this fails to accept that the underlying problem was resultant from the combination of factors outlined in response to point (1). By appearing to accept a modicum of fault, this is simply a distraction from the depth of the problems that were created by those controlling the economic system.

Point (3) is as follows:

Major underlying factors to the current situation were, among others, inconsistent and insufficiently coordinated macroeconomic policies, inadequate structural reforms, which led to unsustainable global macroeconomic outcomes. These developments, together, contributed to excesses and ultimately resulted in severe market disruption.

This ignores the single most important factor in this economic crisis, a point that I have discussed at many points in this blog. The real underlying cause of the crisis is the doubling of the global labour force in a period of about 10 years, resultant from the increases in mobility of capital, access to technology and access to world markets (discussed in more detail here). It is simply baffling that one of the most dramatic changes in the world economy continues to be ignored -even as a potential factor.

Having misread the causes of the crisis, it is inevitable that the solutions that are proposed are going to be misdirected. On the positive side, at least the communique acknowledges the severity of the problems, but it would be impossible to do otherwise. I will go through some of the points that they are proposing:

Continue our vigorous efforts and take whatever further actions are necessary to stabilize the financial system.

This raises the simple question of what has been achieved so far? $US trillions have been poured into various bailouts, and yet there is still a dysfunctional financial system. Banks which are completely insolvent continue to absorb ever more money whilst still remaining insolvent. The latest method of hiding the insolvency is the change in the 'Mark to Market' valuation of assets, which is a way of hiding the underlying (non) value of assets. Quite simply, such policy is delusional. The latest Geithner plan for the US financial system, is just yet another case of destruction of wealth dressed up as salvation. However it might be spun, an artificial price will be set for toxic assets, and the inevitable losses will have to be 'monetised'. Such monetisation means yet more printing of money such that, one way or another, every $US will be taxed to pay to support insolvent financial institutions.

At each stage of the bailouts, there are the same promises that the latest measure will solve the problem, but each time the bailout fails another round of bailouts follow. All the time, there is talk of 'getting credit flowing again', as if the trade imbalances might be solved by endless expansion of credit.

Underlying all of this is a belief that some financial institutions are simply 'too big to fail', and this is at the heart of the problem. Governments have determined that these financial firms can never fail, and then wonder why they take outrageous risks. They have created a casino in which, if you bet on black and red comes in, it becomes an inconvenient blip in your operations. One way or another, it will eventually be back to business as usual, with every other sector of the economy paying for bank losses.

The next point is as follows:

Recognize the importance of monetary policy support, as deemed appropriate to domestic conditions.

This should win prizes for having no meaning whatsoever. What on earth might this actually mean? Does this mean that, in the past, this has not been policy? Have governments and central banks previously not recognised the importance of monetary policy support?

The point that follows this does, at least, offer something that might have a vague meaning:

Use fiscal measures to stimulate domestic demand to rapid effect, as appropriate, while maintaining a policy framework conducive to fiscal sustainability.

The key word in this is sustainability, but what might or might not be sustainable is not mentioned. For example I have, since the start of this blog, suggested that the UK government would need to turn to the IMF for funding for the very reason that the fiscal policy would not be able to be sustained in the face of economic crisis. From the Telegraph we have an article in which 'a senior cabinet minister' is talking about the necessity to go the IMF. The latest spin on this is to say that it is no longer to be seen as an act of desperation, which is perhaps one of the most audacious incidents of spin in this whole crisis. Can the US fiscal policy be sustained? The Congressional Budget Office thinks not....

I also asked in the early posts in this blog who might be able to fund the IMF as the crisis deepens. As if on cue, there is now the news that the IMF is simply going to print money to pay for activities:

At the behest of the world leaders, the IMF will increase the amount each country has in so-called Special Drawing Rights (SDR) by $250bn.

This is effectively global quantitative easing – comparable to the unprecedented measures the Bank of England carried out last month when it committed to pumping £75bn into the British economy. This is a form of printing money.

Under the IMF scheme, each country has an allocation of a shadow IMF currency – known as SDRs. This currency can be converted into useable currencies such as dollars, euros or sterling. The amount of SDRs was dramatically increased by more than ten-fold yesterday. The scheme is best regarded as a safety valve for struggling economies, and rich countries are likely to donate some of their SDR allocation to those most in need.

Is the endless fiscal expansion based upon credit, endless expansion of the money supply sustainable? What do these people think money actually is? Is it some magic thing that can create actual wealth from nothing? Does the production of money of itself make us wealthy, or does our labour make us wealthy? Endless borrowing for consumption and spending and printing of money does not create wealth - it simply destroys it.

As this is already a long post, I will not go into more detail on this, although this deserves greater consideration. Instead I will jump to the discussion of regulation. On the one hand the communique insists that regulation is a national concern, but on the other suggests that action should be taken to avoid 'regulatory arbitrage' i.e. seeking out the best regulatory environment. That these two goals are incompatible is surely obvious? They later say:

We call upon our national and regional regulators to formulate their regulations and other measures in a consistent manner. Regulators should enhance their coordination and cooperation across all segments of financial markets, including with respect to cross-border capital flows. Regulators and other relevant authorities as a matter of priority should strengthen cooperation on crisis prevention, management, and resolution.

So what they really mean is that there will be international standards. However, assuming that they can come up with a commonality of regulation, is that a good thing? The first point to mention is that the Basel frameworks had this goal, but were in fact major contributors to the crisis. There are many more passages that have similar objectives. Perhaps the absurdity of such regulatory aims can be found in these passage from the communique:

Strengthening Transparency and Accountability: We will strengthen financial market transparency, including by enhancing required disclosure on complex financial products and ensuring complete and accurate disclosure by firms of their financial conditions. Incentives should be aligned to avoid excessive risk-taking.

And:

Enhancing Sound Regulation: We pledge to strengthen our regulatory regimes, prudential oversight, and risk management, and ensure that all financial markets, products and participants are regulated or subject to oversight, as appropriate to their circumstances.

At the heart of this is the central delusion that risk can be managed and assessed. It is the idea that risk is somehow something that can be defined. This is exactly what the Basel regulatory framework sought to do. This is the Basel framework that said that essentially said that OECD banks were 'safe'. They were not. Why will the next method of assessing risk be any safer? The same people who made this error are likely to be the same people who will make the next determination of risk.

Even more disturbing is the detail. For example we have the following:

Mitigating against pro-cyclicality in regulatory policy

We can all remember talk of the 'Great Moderation', the 'New Economy', the 'post-Industrial Economy', or the infamous Gordon Brown statement of no more boom and bust. Just as the determination of what was safe was completely wrong, so was the determination of the state of the world economy and national economies. Once again, the same people who called the world economy wrong, who called the state of national economies wrongly, will be the ones that will now apparently call them right. Why should such assertions be taken seriously?

In one respect, the communique does offer a positive perspective, and this is the commitment to open trade. However, there are no mentions of what allowed the severity of the distortions of trade, such as central bank manipulations of money supply. Whilst tariff barriers are important, they pale into insignificance compared with the potential distortions in the money supply, such as those created in Japan, or the Western economies. What of Chinese mercantilism - holding down their currency to ensure export growth, and to make imports more expensive? Can a system of open trade work in a system where these distortions are allowed?

Inevitably, the communique covers a lot more detail, and I will not comment on each and every point. A summary of the communique can be seen as follows:

• An assessment of the crisis that ignores the centrality of governments and central banks in the creation of distortions - and crucially ignoring the effects of the impact of the massive input of labour and the role of this expansion in the crisis
  
• A belief that the same people who failed to see this crisis coming will see the next crisis coming
• A belief that the same regulators who set up the current system, with terrible results, will be able to regulate against another crisis
• A belief that risk can be seen in advance, even though history shows us that it can not be foreseen
• A belief that a more unified regulatory system will stop crises, when the previous attempt to do so helped create the systemic nature of the current crisis
  
• No mention of how the money supply in individual economies is one of the most central/important factor in the world trading system - just some vague illusions with no action on this central factor
  

Perhaps the central point here is that our 'betters' somehow see themselves as both omniscient and omnipotent. They are still deluding themselves that they have the wisdom and foresight to control economies through their endless tinkering. All the while they delude themselves in this way, they still fail to acknowledge their own pivotal roles in the current crisis. It is clear from the communique that they know that there are problems that they have created, but these are buried and lack any clear explanation or action. It is far easier to blame the impersonal financial system (and outside of the G20 scapegoat some big name bankers) than confront their own failings.

In the case of the Western debtor economies, if our 'betters' were to accept their role in the crisis, they would need to forgo some of their power. In particular, they would have to abandon the fiscal irresponsibility that allows them to spend the future wealth of their voters, whilst pretending that it is the government's money to spend. It would mean that they would have to abandon their endless expansion of money and credit, and face up to the underlying real wealth creation of their economies, and face the fact that their policies of borrow and spend simply can not be continued. It is a message they fear telling the voters, and so they pretend that such a system might continue.

For the creditor nations, they would need to face the fact that they have been pouring their wealth into a delusion, and that they must accept that the paper they exchanged for their wealth is of little value. That would be a very bitter pill for them to swallow.

The G20 is a whitewash, which just promises more of the same delusion that put the world economy into this mess in the first place. It is the same people with the same delusions offering more delusions. It is not a new world order, but the maintenance of a fantasy old world order. Quite simply, they propose more and more of the economic tinkering that hid the changes that took place in the world economy - the massive expansion of the world labour force. Their solution is to try to maintain the imbalances that this expansion created. Rather than accept the real redistribution of wealth that this represents, they are seeking to pretend that they can keep going on as before - just with ever more of the kind of 'control' that turned an adjustment into a crisis.

Fractional Reserve Banking - A Problem?

As promised, a post on fractional reserve banking (FRB). It is rather an odd subject, and some might think a little too much a matter of detail. However, I would encourage you to read on, as this is something that is useful to discuss in understanding the economy. It is, after all, a central part of our banking system, and also the subject of lots of debate, not to mention a favourite subject of conspiracy theorists.

I will confess that I have had to come back to this introduction, as it has turned into a very long post. However, at the end, you will see why there are some problems with what you are hearing regarding failure of regulation, and also some problems in what is being understood about the state of bank lending and the money supply. I believe that this is important, and that it is important that we all understand FRB.

I had hoped to discuss central banking, but that will have to be left for another time - which means that there is a hole in this discussion. It is a hole I will fill at a later date.

I mentioned when I discussed FRB in a recent post that I had some nagging doubts about the subject. At the time I had read several discussions of the impacts and operations, and had also seen lots of references to the subject from various conspiracy theorists. However, there seemed many interpretations so the subject remained opaque. I thought I had a good understanding, but was not sure. As such, I thought I would look a little deeper, and see if I could grasp why the different interpretations cause so much confusion, and offer my own understanding of the subject.

As what I am presenting is my own interpretation, I have put a list of some of the reading I have undertaken below, as you may want to take a look at the different arguments first hand.

A good starting point in understanding the subject is to understand where FRB came from, as this is very revealing. It actually originates with medieval money changers, whose role was assuring the quality of gold, holding gold securely and facilitation of transactions between merchants. If you believe the conspiracy theorists, they propose that these 'wicked' people would take gold deposits, then secretly and sneakily lend the deposits to other people. In doing so they profited from the money of others, and only kept a fraction of the gold deposited with them. This is, according to some thinking, a fraud in which the depositors are duped by the money changers. They claim that today such wickedness continues (see note 1).

Regardless of the conspiracy theorists, in this situation we can see the essential points of FRB. A depositor deposits gold with an intermediary, the intermediary lends out a proportion of the deposit, and keeps only a fraction of the total deposits. To this we should add that one of the key parts of the system was that, if a depositor wanted their gold, it had to be repaid on demand. As such, we have a situation where, if all the depositors ask for the return of their deposits at the same time, then the gold changer goes bust. They do not have all the gold that has been deposited....

Having heard the conspirator view, an alternative point of view is that there are some good reasons why the gold changers lent the gold deposits. I have given these as a summary below:

• The law in the medieval period was immature, such that there were cases of gold changers running off with deposits (it still happens today - of course). If only having a fraction of the deposits available, there was less that the gold changer could steal at any one moment. It was a reassurance.
  
• For the same reason (that only a fraction of the gold is available) it was more difficult for monarchs/princes to expropriate it. This was common during the medieval period, in particular during times of war.
  
• Depositors are also potential borrowers. If you have a person who is a depositor, you will get to know their business. If you know their business, you are more likely to lend to them, as they are less of a credit risk. In addition, lending to them encourages them to keep their deposits with the money-changer. A merchant would want to deposit with a gold changer who also lent, as such a person was most likely to provide credit when it was needed
  

A more commonsense argument against the idea of the money changers 'cheating' the depositors is that a medieval city was a place of limited size, with trade dominated by merchant guilds, and this makes it highly improbable that the gold changers could secretly lend their depositor money on a regular basis without people noticing. I simply can not imagine that it would be possible to cheat a narrow group of merchants in this way.

Another interesting point from history is that gold changer (from now on I will call them bankers) were sometimes regulated. In one Italian city, the bankers placed collateral with the city in order to be allowed to have a cloth with a shield on their trading table. This was an assurance to the people who deposited with the banker that he had collateral, but others could still act as a banker without such collateral. In other cases a city would have a system of limited licenses, which allowed them to only have a few bankers to monitor. This oligopoly regulation had an advantage for the 'regulators', which was that the city would be able to demand preferential credit terms for the city government as part of giving access to the city banking market.

It is interesting how absolutely clear the situation of FRB is when we look at it in the historical context. In particular, when we see the picture of the depositors giving the gold coins to the banker, and the banker then lending out those same coins to the borrower, we can see that the discussion of banks 'creating' money looks rather odd. I will quote my last discussion, to express how the money 'creation' argument is expressed.

However, the system gets a little bit weird when we think of a bank using my £100 deposit to invest it/deposit it with another bank. That bank then has an £80 deposit from the original bank, but only needs to keep £16 in reserve, leaving £64 which they can then lend. If we think about this, my deposit has allowed lending of £80 + £64, which means that they are lending more than I have deposited (£80 is lent from the original bank, and £64 from the second bank). If we add up the two sums of money available for lending, then we appear to have created money. This is the standard picture of FRB, that money is created from nothing, but I will illustrate further.

However, I went on to say the following (think of it as gold coins not £):

When I enter into bank A and deposit £100, the bank effectively writes me an IOU for the £100. The bank then takes my money and lends £80 to bank B, who writes an IOU to bank A for £80. That bank then lends £64 to a consumer, who writes an IOU to bank B. Whilst it may appear if we look at it in some respects that we are creating money, as more money has been lent than deposited, I think that this is an exaggeration of what is actually happening. In the end, the amount of credit that reaches the end user of the credit has not expanded in the way that those who are anti-FRB seem to imply. Whilst each bank appears to be creating money, the reality is that the more banks that touch the money, the less money there is available to be lent into the economy outside of the banking system.

If we think of it as pieces of gold coming out of one banker's strong box, being placed into another banker's strong box, then being lent to a final borrower, it is very clear that no money is actually 'created'. It is just pieces of gold being moved from one bank to another, but each time the gold moves, there is a note on the balance sheet. The point here is that recording money does not mean the creation of money. I am genuinely puzzled that so many economists seem to have fail to see it this way. A quick reading of the history of FRB makes this obvious, but I thought it was self-evident before this.

Now, having established that FRB does not 'create' money, there are some complications that I will come to later.

Before I deal with anything else, what of the issue of us all being 'dupes'. This is the idea that somehow we are all unaware that the banks are going out lending our money without our knowledge. In the modern world, because of deposit guarantees by governments, we have come to a point where we do not (normally) worry about such issues. However, what if we took the guarantees away? Would we all be 'duped' into depositing at such risk?

The reality is that, even without government guarantees, it is difficult to make the case that depositors are being duped. If this was the case then, in the time when there were no guarantees (e.g. pre-1930s USA), what would have stopped a person from publicising that everyone is being duped and offering a 100% reserve bank. If we all wanted 100% reserves, then someone would have offered a fee based 100% reserve deposit system. In effect, they would corner the banking market. The reality is that, before government guarantees, all depositors would know that the banks lent money, or why else would the banks be in business?

There still remains the idea that it is somehow 'wrong' that a bank can take £100, promise to return the money on demand, and yet still lend £90 of that money. The idea is that this is a fraud. They do not have the right to lend that money, as it must be available for immediate return. This is a common idea amongst Austrian economists, and the link takes you to the relevant section. The interesting point here is that there is a mixing of the role of central banks, and the role of FRB in general. More of that another time....

In the meantime, to answer the question of whether it is wrong to lend the deposits, I will return to discussion in my post on banking regulation (I did not realise it was so long until I looked again today). I discussed an example of an individual with £10,000 to invest. He could put the money in a bank, he could buy shares in the company that he works for, or he could invest the money in his sister's business. In all cases, ignoring government guarantees, he would be in a situation where the capital has gone out of his hands and where he might at some point not be able to withdraw his money. In the case of the bank, there is the possibility of a bank run, in the case of the shares his company share price might be volatile and fall, and in the case of his sisters business (a restaurant) the money might be tied up in equipment.

In all cases he has risked his money, and in all case he is in a position where he might not have immediate access to all of his money. In this example, I would like to highlight the case of his investing in his sister's business. Would we say that his sister is acting fraudulently by taking his money and not being able to return it on demand? I think few would say such a thing.

However, when it comes to banks, they do make this promise. This is the problem, not the FRB system. It is the promise that is the only problem, but there is also an element of self-delusion. If we invest money, then we are surely living a delusion if we think that it is not at risk. When we deposit money with a bank, they will invest that money, and will therefore risk the money. It is no different to our investing with our brother/sister/uncle, who may lose all of our money if their business fails. The only difference is that we choose to allow another fallible individual to invest the money rather than us. If you really want to understand this, I can only suggest that you go through my post on bank reform and money.

Quite simply, the idea that a bank can be regulated such that it will not lose your money is delusional. I address how to manage this in the bank post, so will not repeat it here.

At this point, it might be worth recapping with some key points:

1. FRB does not 'create' money, however attractive and clever the arguments to the contrary. Think of the strong-boxes and gold as you read the arguments
2. There is nothing wrong with lending depositors money, provided that you are explicit that there is some kind of risk to their deposit
3. It is not possible to invest and gain a return on money without risk
   

For the moment, I would like to return to the example of the person investing £10,000 in his sister's restaurant. Having made the investment, let's imagine that a year later he needs his money back. He goes to his sister, but she does not have the cash available in the business, as she has used her revenue to expand the business. However, she calls her accountant, and asks the accountant to value her business, and provide her brother with the report. Her brother owns a share in the business, and this is given as having a value of £15,000. The brother takes the report to a bank, and asks to borrow £9,000 and offers his share of the business as security. The bank agrees to the loan, and the brother draws down and spends the money in the form of bank notes. The brother writes an IOU.

Have we created money here? The business has £15,000 of equity that he has borrowed against, and the bank has given £9,000 as money in the form of credit. Yesterday the money in the business did not exist, today it does not exist, but there is an entry in an accountants book of £15,000, and an actual £9,000 in physical banknotes circulating in the wider economy. The £15,000 in a book is only notional money, 'perhaps' money, but £9,000 in bank notes has appeared because of it. The money supply measured in the economy appears to have increased. Where has it come from?

In this case, the money is coming from a depositor somewhere. For the sake of simplicity, we will imagine the bank only has one depositor However, the money has been committed to the loan. On the one hand, a person who is a depositor has put £10,000 in their account and the money remains in that account. Nothing is debited from that account. On the other hand, the bank gives the brother £9000, and records that the brother now owes the bank £9000. If you look at the bank it appears that the £9000 has never left it, as it is recorded as still being in the account of the depositor. It looks like there is £10,000 in the bank, and an additional £9000 in the economy. The money supply appears to have increased.

The reality is that it is loaned out, in this case with the notional security of a share in the business. This is the 'fraud'. The bank just hopes that the depositor does not ask for more than £1000 before the payment is made.

If the depositor was to ask for £2000, then the bank would be insolvent, even though it has a very good prospect of returning the full £10,000 to the depositor in the long term. If the depositor asks for £2000, this is a bank run.

As another thought, what happens if the bank refuses to loan the brother the £9000? They do not think the restaurant business is a good business at the moment, and therefore do not accept the accountants figures. In this case, the deposit in the bank sits unused. In this case, there is still £10,000 in the depositor's account, but no £9000 in the wider economy. The money supply has not increased.

All of this looks very reasonable, right up to the point where you think about the movement of the gold coins. When we think about this, we can see that, outside of the banks books, the amount of money has not changed. There is no more money, even though it is recorded that there is. The reality is that, money is not appearing and disappearing, it is just a question of whether the money is utilised or not utilised for lending, and the rest is just book keeping entries.

What is the key difference to the wider economy in these situations? If you believe some pictures, there has been a contraction in the money supply in the second case, and an expansion in the first. However, in both cases the real amount of money available in the economy is the same. It appears that this causes some confusion. People are mixing up book keeping with the actual money. We know that there is no more money, or the bank would be able to lend the money and be able to return the depositor's money.

I will give another example, which is about what counts as money.

In this case, I am going to lend money to my friend Fred. He needs to borrow £10. I give him the money in return for an IOU (I would obviously not ask for an IOU in real life). The same day another friend, David, comes to me also asking to borrow £10. However, I have no money left. The friend has a problem that he pays petrol money to George for a lift in his car to work, and the George will not trust that he will pay later.

I then offer Fred the IOU and sign at the bottom that I am giving the IOU to him. David takes this to George, and presents it to him as payment. George knows me and knows I fulfill my promises, and knows Fred (who wrote the IOU), and trusts that he will pay me. He accepts the IOU and gives David his lift into work.

Have we just created money? Have we just added £10 to the money supply, or even £20? After all, George has just accepted the IOU as payment for a service. I have accepted the IOU as a future payment. The IOU looks and performs exactly as money does. Even more odd is, what happens when Fred pays me, and I pay off the IOU? George rips up the IOU. Have we destroyed money?

How about if, in a different scenario, George knows Fred and also knows that he works in the building industry. George also knows that the building industry is in a slump, so doubts that Fred will be able to pay. He therefore does not accept the IOU. How does this fit with money creation? Have we just shrunk the economy? Does the non-creation of money mean that the money supply has shrunk, or not grown?

The point that I am hoping that I am making here is that the notion of what counts as money is very flexible. This is important in the consideration of FRB, as one of the big questions that is important in the consideration of FRB is what actually counts as a reserve. Furthermore, at what point does something become money? In the case of the IOU for example, does it only become money when it is accepted by George, or is it money anyway? Is it money when it is in my hand, before Fred returns the £10?

This is not an abstract debate, but is at the heart of why there is disagreement over whether FRB is a good or bad thing - a key part of the debate is the definition of what money is....

On the one hand the 'Austrian School' says that it is 'a present good' not a form of credit and therefore a bank becomes like a warehouse, whereas the Keynesians define it as a 'future good'. I am not sure that either perspective is actually very useful, and they also do not account for how ordinary people view money. In my post on banking reform, I offered this definition of money, which I hope will make sense:

In other words, money is a contract for the provision of x amounts of goods and/or services. It allows us not to have to go through life making lots of impossibly complex contracts, between all of the specialisms in which we participate, which would be quite impossible and inefficient to manage. Quite simply, it is better that we use an intermediary that offers the same contractual commitment. In order for this to work, the contract implicitly must have the same value tomorrow as it does today.

You may want to read the full explanation here, if this does not make sense to you. Under this definition, the IOU is money, as there is an underlying contract and it can be used as a unit of exchange. However, it is not very useful as it can only be exchanged in the future, and it is necessary to know that Fred is a builder and that he works in the building industry before we accept or do not accept the value of the contract.

This is important, as what is held as a reserve in a fractional banking system depends on how we look at money. For example, a government bond looks remarkably like an IOU type of money. We need to know a lot of detail about the state of the government in order to know whether the government is likely to be able to honour the underlying contract. The same goes for many financial instruments...they are all IOUs that are money, but with a necessity that we have an understanding of the underlying condition of the issuer of the IOU. In this respect, for all but specialists (and they also struggle with understanding the value of the underlying contract), such money is not much use to ordinary people.

It should be mentioned here that the perception of ordinary people is important in defining money. All money is a collective belief that x will provide y, and any money that does not provide such a belief may be money, but is money of little use. As in the case of the IOU, it only becomes useful if we think Fred will actually get work to support the value of the IOU.

On the other hand, if the money is backed by a fixed specie of a commodity, such as gold, then we know that, whatever happens, we can exchange our money for x amount of something. The contract is explicit and clear to everyone. What this means is not that we have produced price stability, or come to a formula for perfect economics, but rather that we have given money a point of reference that we can all understand. You do not need to be an expert to understand that, if you really want, you can swap x units of currency for x units of gold. Again, you should read my full discussion if you have outstanding questions.

It is here that we come to one of the problems of modern FRB. The problem is that new banking regulations have seen playing around with what can be effectively counted as a reserve. In particular the Basel Committee, which was formed by central bank governors from the G10 countries, established two regulatory frameworks for banks, called Basel I and Basel II. Basel I was drafted in 1988, and has been widely implemented such that it is the key regulation that has been in place in recent years, and Basel II was drafted in 2004 and has therefore been adopted as the de facto modern regulatory standard for OECD banks.

The first accord is one in which they introduced miniminum reserve requirement of 8%, and then delineated these reserves into two different types (tier 1 and tier 2) with 4% required from each tier. For example, in tier 1 we do have the familiar and comforting cash reserves, which means actual money on hand to pay to depositors and capital paid for by the sale of bank equity. However, in tier 2 we start to move further away from our familiar notions of money, and start to include items such as subordinated debt, which is a kind of debt issued by the banks where the debt is at the bottom of the heap in payout (meaning the lender comes at the bottom of any claims in the event of bankruptcy). Already, we are starting to move away from our gold into the strong box, and gold out of the strong box model, as we are doing the something similar to replacing the gold with silver.

On top of this, we also have a problem in the way that the reserve requirements are calculated. Instead of the flat rate of 8% being applied evenly, meaning for every loan, there must be an 8% reserve, Basel I added a system of weighting to different types of lending, such that only certain kinds of loans required the full 8%. This makes the 8% figure entirely notional.

Examples of the weightings can be found below:

• Sovereign debt held in domestic currency, all OECD debt, and all claims on OECD governments - 0%
• Bank debt created by banks within the OECD, loans guaranteed by OECD governments, Short term non-OECD bank debt - 20%
• Residential mortgages - 50%
• Most other loans - 100%

What we have here is a situation in which the amount that needs to be held in reserve has changed to a variable amount, and that does mean a change in the money supply. In particular, as banks alter the shape of their portfolio, it is possible that the amount of money that is really available outside of the banking system will actually change. Furthermore, under these rules, we have a system in which it is possible to lend to governments with no need to hold reserves. They are given no risk whatsover. If we think back to the history of banking, going back to the medieval period, we had a situation in which governments would grant banking privelages in exchange for preferential terms. It all looks painfully familiar.....

Above all else, it is possible for banks to lend to government with no reserves whatsoever. This means that, in principle, a bank can loan to their government without any deposits whatsoever. This is blatant encouragement to lend to the government and it might be considered that it is no coincidence that the debt of many OECD governments continue to grow at a shocking pace. You may be unsuprised to find that the provision of this facility was not changed in Basel II, though the mechanism has changed...

Another interesting aspect of this new method of reserve calculation was that it saw OECD banks as being nearly risk free, and mortgages as relatively low risk. This is very interesting, as what we have is a group of experts who think that they know what future risks are. We can now see how completely wrong the regulators actually were, as many OECD banks are effectively bankrupt, and I would argue that the same applies to some governments (though this has yet to be proved unlike the banks). The most disturbing part of this is that the regulators implemented the rules to create a stable banking system, but it has resulted in the current chronic instability.

However, this miscalculation of risk was not the only damaging part of this new framework. The framework also led to the development of many of the instruments of the destruction of the banking system that we see today. I have detailed in the post on banking reform how the Bank of England accepts that Basel I led to the development of securitisation, and it is also detailed in a paper by Balin (2008).

Securitisation was a very handy way of being able to keep a low risk weighting whilst actually holding relatively risky debt. Another result of Basel I was that banks 'hid' their risks through 'off balance sheet' entities such as subsidiaries, which allowed them to maintain an appearance of having a low risk status whilst taking significant risks. As such, I will repeat this, just so everyone is clear on this. Basel I led directly to the boom in securitisation and off-balance sheet vehicles that has since destroyed the banking system.

Now we come to Basel II which attempted to rectify the faults of Basel I, and we will see that many of the changes encouraged the current crisis. A positive point was that they sought to stop the off-balance sheet chicanery. However, they also set up a system in which 'approved' ratings agencies would determine the risk weighting of the different kinds of loans.

Welcome to the world of AAA- rated CDOs carrying a 0% risk weighting, meaning that no reserves were needed whatsover for the risk in these instruments! I will not go into all of the details of the various weighting methods for different type of debts, as I am sure that you can grasp the idea that an AAA- CDO having a 0% risk weighting might well have been an incentive for the creation and expansion of such instruments of destruction, and that any system that allows this is problematic. Essentially, the problem is that the ratings agencies had no incentive to rate the risk accurately, as the people issuing the instruments paid, and they also were often incapable of understanding what they were rating.

However, this is not the only problem that was built into Basel II. They also devised a way of monitoring credit risk that encouraged the banks to measure their own credit risks. With the approval of regulators they were encouraged to model the risk on their own loan books, which is where another instrument of destruction was born - the 'rocket scientist' risk models. These were the risks models that predicted that the financial crisis could not happen. These gave them the confidence that all was well, and have rightly been subjected to lots of justified criticism ever since.

In addition to credit risk, we can add calculations for market risk (the now infamous Value at Risk models) and operational risk. I will not detail these as they the problems again were rooted in how the risks were modelled. What we are left with is a new method of calculation of reserves which still retains the 8% starting point, but equally turns this into a notional figure. The calculation is below:

Reserves = 0.08 * risk weighted assets + operational risk reserves + market risk reserves

There were other elements to Basel II such as a widening of the scope for regulatory oversight and other measures but, as in the case of the oversight, it seems that the basic problem is that the regulators were as clueless as the banks themselves in calculating and seeing risk. Their poor performance was no more than a reflection of the poor performance of the ratings agencies.

From this brief discussion, there are several key points that need to be made. The first of these is that FRB does not, of itself, lead to money creation. A change in the actual structure of reserves that are held can, however, change the money supply. If the portfolio of a bank includes lending to government, for example, they are left with more cash to lend to other sectors. In addition, if we think of the strong box of gold, the money supply can be altered by a decision not to lend the money. The money is still there, but not playing an 'active' role in the economy. However, this does not happen in practice.

The theory goes that, as banks become worried, they will stop lending and money will become 'inactive' in the economy. However, the reality is that the money does not become inactive, but instead will go into government bonds, or other 'safe' instruments. What happens is that the government gets yet more finance, and the banks still appear to have lending capacity because the lending makes no impact on their reserves. Remember, loans to AAA rated governments have 0% weighting as they are 'risk free', and therefore make no impact on reserve requirements. It therefore appears that banks are lending less as the lending to government makes no impact on their reserves.

We therefore have a situation at the moment where the banks are apparently 'hoarding' money. However, the more borrowing that governments undertake, the more the banks will lend. All the while, their reserve position is unchanged, giving the impression that they are not lending. Meanwhile the government suggests that the banks are hoarding, and they should therefore increase the money supply to encourage them to lend. The reality is that the money is pouring into government coffers, but that does not mean that the money supply is being reduced. As I have discussed in other posts, the government is merely a buffer to getting the new money into the 'real world' money supply. The government provides capital to the banks, then the banks lend to the government.

The government can not spend immediately, as it takes a while to allocate the money to projects. However, the created money has added to the money supply. It is just that it will take time before it appears in the wider economy. The key point here is that banks never leave money sitting on deposit doing nothing, except in the very, very short term. At present they are not lending into the wider economy as before, such that their reserve position suggests that they are reducing the amount of money in the economy by 'sitting' on deposits. However, they are not sitting on the deposits but moving money into government debt.

In addition to this, money is flowing out of the countries to return money according to demands of depositors overseas. Again, money is not disappearing but ending up in overseas reserves. This money might be 'inactive', but I can not be sure. Are the overseas depositors 'sitting' on the money? Again, I am not sure. However, I am sure that these demands for returns of deposits will represent an outflow of money from many economies, in particular the UK economy. In the case of the US, for the moment, the deposits are still flowing into funding of government debt. How long that can last is the big question....

Since I have been writing this blog I have relied on my sense of logic and rationality as a guide to what I write. I will freely confess that fractional reserve banking has been a great challenge. The challenge was that the explanations just did not make sense, clever as they may have appeared. In particular, it is a subject which many economists have given considerable thought to - but I can not help thinking that they have missed the point, in particular with the view of 'money creation'. I have offered a point of view that suggestst that they have misunderstood what they are seeing, and that they have mixed up balance sheet entries with money that actually reaches the economy. This is a long way from conventional economic theory.

(As such, keeping in mind the strong box holding gold, I recommend reading the references that I have provided, so that you can make up your own minds)

There is no doubt that the regulation of the banking system has made a situation in which the money available in the economy has changed, but this is about regulation, not FRB. The ability for the regulatory system to work has been built in government guarantees of the banking system, which has allowed us, as individuals, to pretend that the banks do not risk our money. After all....if all goes wrong the government will step in and save the banks....

We are now in the process of doing this - stepping in and saving the banks. The trouble is that, it is not the government saving the banks, it is us. This is the lie that governments keep telling us - that they are saving the banks and the financial system. I describe why this is a lie in detail in my last post.

The regulators - who are bankers, economists and politicians - have set up a system in which our banks were supposed to be free of risk, but instead created a system of systemic risk. We are all now paying the price of the wisdom of the regulators and 'experts'. It is all of us that are paying for the misguided regulation, but still there are calls that the same regulators that made the mess do more.....re-regulation is the mantra, but this call is driven by the same people that have taken our economies to destruction....

Even now, in the midst of the crisis, how many people understand how the reserve requirements actually work, and how these encouraged the problems? I would suggest - very, very few. In such circumstances it is easy to redirect blame on the banks, on 'greedy bankers', but they have just foolishly responded to the incentives and limitations imposed by regulation. We hear considerable chatter about deregulation as the cause of the crisis, but it was actually the regulation, and the distortions of behaviour resultant from the regulation, that caused the crisis.

We can add in to this mix, that many economists have failed to connect the real world with banking balance sheets. FRB appears to be a perfect example, where economists look at balance sheets, rather than the money that flows to real people and business in the economy.

My intention when starting this post was also to discuss the role of central banks in FRB, but I am afraid that this will have to be delayed for the moment, as this post is already far longer than I intended. In particular, the central banks do create money, and also have some significant impacts on the role of FRB. Their role in the economy, as I will discuss at another time, is entirely negative. In a later post I will discuss the central banks, and will refute the conspiracy theorists, whilst pointing out the problems with central banks.

Note 1: Apologies for a long post, but there was no way to get the message over without some kind of detail. As always, comments are welcome. In particular, as I am contradicting so much economic theory I welcome economists to comment (no equations, please, just clear explanations).

Samples of Reading...

Balin, J (2008), Basel I Basel II, and Emerging Markets: A Nontechnical Analysis

Block, W & Garschina, KM 1996, 'Hayek, business cycles and fractional reserve banking: Continuing the de-homogenization process', The Review of Austrian Economics, vol. 9, no. 1, pp. 77-94

Bordo, MD 1990, 'The Lender of Last Resort: Alternative Views and Historical Experience', Economic Review, vol. 47, no. 2, pp. 18–29.

Bordo, MD & Redish, A, 'Why Did the Bank of Canada Emerge in 1935?'

Carlos, DA 1985, 'GOOD-BYE FINANCIAL REPRESSION, HELLO FINANCIAL CRASH', Journal of Development Economics, vol. 19, pp. 1-24.

Cochran, JP, Call, ST & Glahe, FR 1999, 'Credit creation or financial intermediation?: Fractional-reserve banking in a growing economy', Quarterly Journal of Austrian Economics, vol. 2, no. 3, pp. 53-64.

de Soto, JH 1995, 'A critical analysis of central banks and fractional-reserve free banking from the Austrian school perspective', The Review of Austrian Economics, vol. 8, no. 2, pp. 25-38.

de Soto, JH 1998, 'A critical note on fractional-reserve free banking', Quarterly Journal of Austrian Economics, vol. 1, no. 4, pp. 25-49.

Klein, B 1974, 'The Competitive Supply of Money', Journal of Money, Credit and Banking, vol. 6, no. 4, pp. 423-53.

Phillips, RJ & Jerome Levy Economics, I 1995, Narrow Banking Reconsidered: The Functional Approach to Financial Reform, Bard College, Jerome Levy Economics Institute.

Rajan, RG, Center for Research in Security, P & University of, C 1998, 'The Past and Future of Commercial Banking Viewed through an Incomplete Contract Lens', Journal of Money, Credit & Banking, vol. 30, no. 3.

Selgin, G 1994, 'On Ensuring the Acceptability of a New Fiat Money', JOURNAL OF MONEY CREDIT AND BANKING, vol. 26, pp. 808-.

Selgin, G 2000, 'Should We Let Banks Create Money?' INDEPENDENT REVIEW-OAKLAND-, vol. 5, no. 1, pp. 93-100.

Selgin, GA & White, LH 1987, 'THE EVOLUTION OF A FREE BANKING SYSTEM', Economic Inquiry, vol. 25, no. 3, pp. 439-57.

Tobin, J 1964, 'Commercial Banks as Creators of" money"'.

There are plenty more references. I have also skipped the conspiracy theorist references, as you can find these easily online. Some references are also a little incomplete, which I will admit is resultant from being a little tired (a poor excuse). However, you should be able to find them.

Note 1: I have never seen any anti-semitism explicitly expressed in any of the conspiracy theories, but there does sometimes appear to be a sub-text running underneath. I have no reason for sensitivity to such issues, approached the conspiracy theory with an open mind, but could not help but notice this. Still, nothing is explicit, so it could be that there is no such intention and I have imagined this. I am not sure why I would though....

Banking Regulation - Buyer Beware

This post on bank and financial regulation has been under consideration for a long time. The reason why it has taken so long is that I was allowing myself to become confused, in much the same way most people become confused over these issues. The cause of this confusion is that we all seem to forget what the financial and banking system is, and what it does.

The reason I am now able to write this post is that I have had a very good comment posted on 'Financial Crisis - A Brief Review', in which the author offers an argument that deregulation caused the current financial crisis. The argument that was presented helped me to focus in on what matters, which is to ask what banks are for, and how the financial system operates. In particular, the argument that the Financial Services Modernization Act of 199, in conjunction with a fiat money system, was fingered as the guilty party (I am simplifying, so I suggest reading the original comment). The comment also pointed me to the Ludwig von Mises Institute for an article in support of the argument. The reason why the comment and this article allowed me to finally write this post was that I was preparing all kinds of complex counter arguments, including a long discussion on the Basel Accords, when I realised that I too was missing the point. Whilst I cover these issues, I am now not so concerned with these details, but more concerned with basic principles.

I was forgetting what the banking system was for, and what money is for. It is only if we remember this that we can start to think of how the system can operate effectively. If we keep these basics in mind, it will become apparent that much of the banking regulation is trying to achieve the impossible, the removal of risk. It also becomes apparent that the system of money is built on foundations of sand.

The logical starting point for reform would be the issue of what money actually is. It is not some magic substance that has a picture of a famous dead person on it, or the picture of the queen, but something which has a purpose in the exchange of goods. Lets imagine, for example, that a sofa shop owner is in need of milk for his family, and that the milk requirement is one cows worth of milk production per day. He believes that one cow's worth of milk production for the lifespan of the cow is worth one sofa in his shop.

Now, in the real world, it may be the case that I do not have a cow to provide the milk to the sofa shop owner, or a farm, or anything else which the sofa shop owner wants. However, for the sake of ease, we will say that I am in the business of providing consultancy to farmers, advising them on best practice in milking. As such, I can sell my advice for milk. My own milk requirements are very small, so I do not need all of the milk that the farmer provides in return for my advice. When I want to buy the sofa, I could therefore write a contract that, instead of providing one cow lifespan worth of milk to me in return for my services, the farmer instead directs that same milk to the sofa shop owner. As such, I am now in the position to make an exchange for the sofa, and can take it home.

As such, money is an intermediary, which allows us to not have to go through this complex process to make an exchange for a sofa. In order for money to operate in this role, so that I do not have to set up lots of contracts, the person in the shop must believe that the intermediary that I provide (money) = one cow's worth of milk over the lifespan of the cow. In other words, the shop owner would expect that the money I provide will be able to purchase milk in the quantity of one cow's production (a) over the number of days the cow will live (b). When I enter the shop without a cow or a cast iron milk supply contract, I must provide the shop owner with something which guarantees that I will provide the shop owner with a x b worth of milk, over a period of several years. In effect, that is what I am exchanging for the sofa.

In other words, money is a contract for the provision of x amounts of goods and/or services. It allows us not to have to go through life making lots of impossibly complex contracts, between all of the specialisms in which we participate, which would be quite impossible and inefficient to manage. Quite simply, it is better that we use an intermediary that offers the same contractual commitment. In order for this to work, the contract implicitly must have the same value tomorrow as it does today. When I hand over money for in exchange for the sofa, the sofa shop owner is going to get a bad deal if, in three years time, he finds that he is only able to purchase three quarters of a cow's milk production. It is for this reason that inflation is bad. It is, in effect, a breach of a contract. Whenever inflation occurs, we lose some element of our belief in money to honour the contracts between one another. I have chosen the milk production example to illustrate this point, as it is very important in the consideration of money.

To illustrate this point, I recently had a comment on a post regarding hyper-inflation and whether it is a good time to buy a house at such a time. My answer was as follows:

I have read about hyper-inflation in principle, but here is a good question of the process in practice. The first thing is that, during hyper inflation, the value of cash is destroyed. At the same time the cash price of assets rise, although their real value may not change. At its most basic, what I am trying to say is that, if a pint of milk has the same value as a loaf of bread, whilst the cash value of these may change, the relationship of the value, one to another, does not necessarily change. So it is with housing. If a house is worth 100,000 pints of milk today, all other things being equal, it will be worth 100,000 bottles of milk tomorrow. However, the value of housing was over-inflated, such that all things are not equal. As such, whilst the cash price of a house may rise, the value of that asset will presumably continue to decline relative to other assets.

Within this reply, we have a problem when we think about money. Within this scenario we have a situation where the value of one thing versus another is unstable. In the case of of the house, today it might be worth 1oo,ooo pints of milk but the next day it may only be worth 99,000. Alternatively, if there is a sudden expansion in the dairy industry, it may be that the house will be worth 110,000 the next day, as there is an oversupply of milk into the market, thereby reducing the value of milk relative to other items. This can happen to any particular product, commodity or service - and that includes gold.

If we take the value of gold, it might be that the demand for gold drops, due to a change in society where gold becomes associated with 'bling', thereby reducing the demand for gold for personal decorative use. In such a situation, there will be an oversupply of gold relative to the demand for gold, and the value in exchange of gold will drop relative to other items. The problem that I am illustrating is that nothing has a fixed and enduring value in exchange relative to other things.

Now we come to the situation of money today. As many readers will be aware, the gold standard was abandoned many years ago. The gold standard was a situation in which each unit of currency could, in principle, be exchanged for a fixed amount of gold. Today, there is no such backing, such that money has no contractual guarantee. I would therefore like to return to my milk and sofa example.

When I enter the sofa shop, bearing a fistful of bank notes, I am offering the sofa shop owner something that he believes to be a contract, but which actually is not a contract at all. If we say that there is a situation of high inflation, or hyper inflation, then there is no recourse for our sofa shop owner. I might give him £2000 which today looks like it will pay for a cow's lifetime supply of milk, but which will in three years time not be able to be used to purchase even one day's supply of milk. There is no contractual commitment in what I had handed him. None whatsoever.

How does the situation differ under the gold standard? I have already pointed out that the value in exchange of gold varies relative to other goods and services. As such, I could go into the shop and purchase the £2000 sofa in exchange for money which can be converted into x amount of gold. If there is a massive expansion in gold production, or gold was less desirable for the 'bling' factor, then it may also be the case that the gold in three years time would be insufficient to buy the milk that was required by the sofa shop owner.

In such a situation, it becomes apparent that money, in all forms, is a fundamentally flawed concept. I will commit the sin here of quoting Wikipedia, but they offer an excellent summary of what money is supposed to be:

"Money is a matter of functions four, a medium, a measure, a standard, a store."

In all cases it is very easy to achieve the first three, but the last point is the one that causes the problem. In all cases it is impossible to guarantee the last item, even with gold. If it is a store, it must be accepted that it is potentially a leaky one. In other words, whatever is used as the standard unit of exchange, it carries with it risk that the value in exchange today and tomorrow might not be the same.

We are therefore in the tricky position of having to make some choices. On the one hand, we could abandon the concept of money altogether, which would mean endless complexity in arranging reciprocal contracts between endless numbers of individuals. On the other hand we have to use something as an intermediary in exchange whose value is subject to change. The former option is simply impractical, and the latter is unsatisfactory. However, the options are just these.

From this perspective, it is apparent that there is a necessity for money, but that money needs to still retain a contractual value. Under the present system of fiat money, there is quite literally no contract whatsoever, and the value of money in exchange rests in its entirety on the delusion that there is an underlying contract. Such a system has huge risk, because if ever there comes a point where individuals demand that the contract they believe to be there is fulfilled, they will find that there is nothing there at all. It is the current situation in the Western world that there is a huge amount of money issued, that this money has been used to purchase goods and services from other countries, but there is very little that the money can actually be exchanged for. This is seen in the imbalance in trade between the East and the West (ignoring cases like Germany).

In other words, if the countries that have provided the goods and services try to exchange the money issued in the West for goods and services, they will find insufficient goods and services available for the money to purchase. We have, for example, used the money issued to buy plasma TVs from China and can not offer any good or service in return for those purchases. We have used an item in the exchange which is not actually backed up with any contractual commitment to reciprocate with anything. We are in a situation where, if the perception of the underlying contract is tested, it will be found that it does not exist. At that point, the belief in the value of money will quite literally disappear. This is the risk that has been taken.

It is at this point that we return to the very imperfect gold standard. If all currency issued is backed by gold, then there is an explicit contract. If you do not wish to use the money in exchange for any goods or services, then you have the option of exchanging the currency for a fixed amount of a commodity. Whilst there is a risk that the value of that commodity might fall in relation to its value in exchange with other commodities, goods or services, it will always have some value in exchange. It guarantees that money will always have some value. Gold is used because it has, throughout history, has a relatively high value in relation to many other commodities. However, any commodity has the same function and the question of which commodity just becomes a question of relative historical value stability, and practical questions of how it can be stored/used/transferred etc.

In short, money must have an underlying contractual commitment, or it becomes subject to losing its meaning. Whether that contract is an exchange for gold, or any other commodity, the important point is that the contract is fixed. In this way our sofa shop owner knows that, whatever happens, he will always be able to buy at least some milk with his money, even if he is unable to buy as much milk as he originally expected. It is very imperfect, but it is better than the option of being able to buy no milk at all, which is possible under a system of fiat money.

It is at this point we now need to turn to the broader issue of banking and financial regulation. Although I have not expressed any preference for which commodity might be used as a backing for money, I will stick with the gold standard as being the method of contractual commitment.

The first question that is raised is who might issue money. My answer is very simple. Anyone at all. That means you, or I, or the person next door can issue money. It is, in any case, what we do all the time. If we remember that money is an intermediary in exchange, we start to see that, for example, when we offer to do something for another person in exchange for something else, we are effectively issuing money, in some cases the unit of currency is a verbal promise, in others a contract written to say that we will do something. In both the case of the contract and the promise, they are both units of exchange.

For the purposes of the wider economy, in ensuring that exchange is efficient and effective, it is important that there are monetary units that are widely accepted. It is only in ensuring that this objective is achieved that there should be any regulation of money. Whilst anyone can issue money (though I suspect few would accept notes backed by nothing where there is a gold standard alternative), there is a regulatory role in ensuring that there is available a particular form of money that is contractually tied to gold. As such there is a regulatory role in the issuing of this money. That role is to fix the rate of exchange, ensure that it is never changed, and to ensure that money that is so fixed can be identified as such.

As such, any individual, or institution, can issue gold backed money, provided that they can demonstrate that they have the gold available to meet the standard, and that the gold is secured against sale. The role of government in such a system is to monitor the institutions that are issuing the money to ensure that they have sufficient gold, and the printing of the money in a consistent format with the issuing institution's name printed on the money. The government might also issue currency, but only if it is also backed with sufficient gold to meet the standard. The institutions that can issue money according to the gold standard would have a special designation as deposit banks. All money within these banks would be contractually guaranteed to be able to be converted into gold (or at least nearly all of it, as an allowance would be needed to allow the banks to acquire the gold as deposits rise). As these banks would not be investing money, they would need to charge a fee for the deposits.

In addition to deposit banks, there would also be an alternative, and relatively unregulated banking system, where the banks would be designated as 'speculative' banks. It is here that we come to the difficult subject of regulation. Before we continue, it is worth reviewing the two basic purposes of banks.

The first purpose of banks is as a place to store money in a relatively safe place. The deposit banks serve this purpose, and therefore there must always be deposit banks available to individuals and businesses, even if the government must step in and offer this service (the least preferable option). The second role of banks is as a conduit for investment. This is best explained by thinking of an individual who has £10,000 saved from their salary. They have several options of what to do with this money. On the one hand, they might put it into a deposit bank, which will only guarantee that, at any time in the future, that money will be able to be exchanged for a fixed amount of gold. Alternatively, they may wish to use that money for speculative investment.

The investor has several choices on how to invest that money. On the one hand, the investor has a sister who is planning to open a restaurant. She is looking within the family for investment capital. Being her brother, he knows her well, she has explained her plans, and he must therefore make a judgement on whether this is a good investment. On the other hand, he might invest the money in the company which he works for, as the company is offering shares in the company to employees in order to raise money for the development of a new product. He knows the company well, he knows the details of the plans for the new product, and can therefore reasonably judge whether it is a good investment. His final option is to outsource the investment decision to an institution specialising in investments - a speculative bank.

In all three cases there is a common factor. In all three cases he must risk some, or all, of the value of his money. In all cases, the money will be invested in projects where, if he wants the money to be returned, there is no guarantee that it will be immediately available, or whether it will ever be returned at all. All three cases are identical in this respect, and no amount of regulation will ever change this basic reality. It is here that we come to the fundamental problem of modern regulation. It is aimed at removing the risk from investment, the risk that money will not be returned to investors. It is really very simple, as soon as a person/institution wishes to gain interest on their capital, they take a risk with that capital. The only way for interest to be accrued is through investment, and all investment is speculative and inherently risky. To try to regulate risk away is therefore an impossibility, but this is the purpose behind much of the regulation.

Regulation of risk is not possible, but regulation of provision of information about risk can be regulated. If we take a look at the Basel banking accords, they do not seek to regulate information but are seeking to regulate risk. A very good discussion of the Basel accords can be found here at the Bank of England website, and I will use it as the basis of discussion. In particular, the date of the paper is 2001, and the paper therefore details the thinking of regulatory institutions pre-credit crisis. The introduction to the piece starts as follows:

The 1988 Basel Accord was a major milestone in the history of bank regulation, setting capital standards for most significant banks worldwide—it has now been adopted by more than 100 countries. After two years of deliberation, the Basel Committee on Banking Supervision has set out far-reaching proposals for revising the original Accord to align the minimum capital requirements more closely with the actual risks faced by banks.

The important point in this paragraph comes in the last sentence. This is the problem that is inherent in all regulation, that there is an objective standard of assessment of risk that can be discovered and codified. The thinking behind regulation is best summarised again in the BoE paper:

One issue when deciding on the capital requirements for
each probability-of-default band is the appropriate
solvency standard that regulators should be targeting for
minimum capital.(5) This needs to balance prudence
with efficiency. Banks are regulated to protect
depositors (because of information asymmetries and the
social consequences of loss of savings) but just as
importantly to protect the financial system. This reflects
their central role in the economy. Because of their
position in the payments system and lending to small
and medium-sized businesses and retail customers, the
cost of banking crises can be very high. Bank of
England research,(6) which examines 43 crises worldwide
over the last 25 years, indicates that economic activity
forgone during the length of a banking crisis can
amount to between 15% and 20% of annual GDP.

So here we have expressed very clearly. Bank regulation is to protect depositors. What the statement does not do is explicitly state is protect them from what. What they mean when they say protect depositors is that the intention is to protect depositors from losing their money. Such an objective is impossible, as all investment carries risk, including complete loss of all capital. The only way to protect depositors is through the provision of a deposit bank (as detailed before) and even that carries the risk that the value of gold might be subject to change. The other problem highlighted is information asymmetry between depositors and the banks. Rather than address this problem, regulation seeks to address the impossible - the elimination of risk for depositors.

The answer to this perceived problem, was Basel I. This is described in the BoE paper as follows:

The 1988 Accord represented a revolutionary approach
to setting bank capital—an agreement among the
Basel Committee member countries that their
internationally active banks would at a minimum carry
capital equivalent to 8% of risk-weighted assets (with
the Committee setting broad classes of risk weights).
The agreement was made against a background of
concerns about a decline in capital held by banks,
exacerbated by the expansion of off balance sheet
activity, and worries that banks from some jurisdictions
were seeking a short-term competitive advantage in
some markets by maintaining too low a level of
capital.
The introduction of the Accord seems to have led to
some rebuilding of capital by the banks in the G10, but
over time the broad nature of the risk categories created
strains.(2) The Accord differentiates between exposures
using general categories based on the type of loan—
exposures to sovereigns (split into OECD and
non-OECD), exposures to banks (split into OECD and
non-OECD, with the latter split into less than one year
and more than one year), retail mortgages, and other
private sector exposures. Little allowance is made for
collateral beyond cash, government securities and bank
guarantees.

So here we have a determination of risk which assumes that, for example, OECD based banks are safe. We now see that this is not the case, and many of the banks in the OECD would, without government support, now be bankrupt. We also see that lending into government securities is also 'safe' but, as I have argued elsewhere in this blog, countries such as the UK are extremely unsafe at present.

So here we have the essential problem. A bunch of very smart people got together and said that they were able to determine levels of risk. Their conclusions have been shown to be wrong. In particular, OECD banks have demonstrably been shown to be, in a very large number of cases, unsound. I will reiterate this point once again - they were wrong.

Another point in the Basel I accord was that it creates a perverse incentive to lend to governments. Investing in government debt means that money is not being invested into potentially wealth creating investments in the private sector. It also virtually guarantees that government will have access to credit, regardless of whether the governments are acting responsibly or irresponsibly. Such guaranteed provision will almost certainly have been a factor in the growth in Western government / OECD debt. However, it would be impossible to prove one way or another.

So now we come to the Basel II accord. Once again, I will quote from the BoE paper. It makes interesting reading.

The broad categories reflected the state
of systems in banks at that time. But during the
1990s, banks started to develop more sophisticated
systems to differentiate between the riskiness of various
parts of the portfolio to improve pricing and the
allocation of economic capital. These systems
highlighted the discrepancy between required capital
and economic capital for some exposures, creating an
incentive to sell some loans. The chart below sets out a
risk measure, the value at risk (VaR) over a one-year period,(1)
for portfolios of exposures in each rating
category, and shows that for loans to all borrowers down
to BBB the Basel minimum requirements of 8% capital
(of which 4% is equity) would probably be higher than
the equity capital that a bank would chose to hold.

This disincentive for banks to hold prime-quality loans
was probably one of the factors behind the securitisation
boom in the United States. By March 1998, outstanding
non-mortgage securitisations by the ten largest US bank
holding companies amounted to around $200 billion
(more than 25% of these banks’ loans).(2) Banks outside
the United States were also increasingly turning to
securitisation to adjust their portfolios. The ability of
banks to choose how much risk they wished to carry
against a particular quantum of regulatory capital
threatened to undermine the objective of an
international capital floor. Another concern about the
Accord was that the limited recognition of risk reduction
through collateral or credit derivatives would discourage
banks from taking advantage of these techniques and
more generally impair the development of markets.

I have highlighted two sections with italics, which stand as two examples which will illustrate contradictory points. In the first section, the securitisation boom is seen to be as a result of Basel I. This was to lead to many of the problems we have seen today. The second point was actually a positive point for Basel 1, which was that it was limiting the growth of credit derivatives, which are creating ongoing problems for the banking system today, but this was seen as a negative by the BoE. Basel II sought to rectify this 'failing'. In both cases, the regulation had distorting effects on the structure of markets, and in one case a positive outcome is seen as a negative. The regulators simply can not make accurate assesment of risk.

Another interesting feature of Basel II is that the accord put the credit rating agencies centre stage in the assessment of risk:

Under the standardised approach banks will slot
assets into weighting bands according to ratings from
eligible rating agencies (ie recognised by national
supervisors in accordance with specified criteria).

The BoE paper acknowledges that the rating agencies may be no better than the banks at assessing risk, but fails to acknowledge that there is a central conflict of interest - that the ratings agencies are paid for conducting the rating by the banks themselves. The importance of the poor preformance of these ratings in the current financial crisis can not be overstated. However, they were critical to the entire Basel II system:

Exposures to borrowers without a credit rating will be
placed in an unrated band that will carry a 100%
weight (ie 8% capital charge), but regulators are
requested to review the default experience of the
particular market (and individual bank) to decide
whether this is sufficient. Undrawn facilities to
corporates of less than one year, which currently
carry a zero weight, will be weighted at 20%.

At the heart of all of this regulation is an unfounded belief that, somehow, there are a bunch of people with sufficient wisdom to determine risk, and therefore create a system in which risk of failure is abolished. Such a point view can only do one thing - create complacency. It creates a situation where, provided you meet the rules, you must be sound. However, the institutions then game the rules, and seek ways to best exploit the rules. The only solution to this is ever more rules, and ever more complexity, and within that complexity the institutions will just find new ways to subvert the rules. Above all else, however, is the simple fact that it is not possible to remove risk from investments, and that risk must be an accepted part of any system, including risk of bankruptcy.

I started the post mentioning a commentator's very good and interesting argument that deregulation caused the problems. It is a good basis to discuss the idea that deregulation was the problem. One of the points made was as follows:

But, at any rate, since Basel II was not even published until June 2004, and not implemented in the US until the years after 2005 (well after the housing bubble began), how could it be a major cause of the current crisis?
Of course, Basel I (which was published in 1988 and implemented in most Western countries in 1992) could have played a role. But in the absence of the three factors discussed above (the Financial Services Modernization Act, the Commodity Futures Modernization Act of 2000, and the real estate bubble), how could Basel I have caused this on its own?

I would not suggest that Basel 1 caused the problem by itself, but rather was a contributory factor, and this can be seen in the BoE paper. The reason for the housing bubble was actually the result of a flood of capital into western markets (resultant from the shift in the world economy) with insufficient good investment opportunities to soak up the capital. Once the sound investments were gone, then there was little choice but to invest in ever more risky investments. This was compounded by the state entities of Freddie Mac and Fannie Mae having an unfair advantage in the provision of lending into prime mortgages, leaving less investment opportunities for the genuinely commercial banks. As for Basel II, it may not have caused the problems, but it certainly exacerbated the problems. In particular, putting the ratings agencies centre stage was problematic, as well as the structure for internal risk assessment.

The author of the comment, in a second comment, quotes the following:

Paulson convinced the SEC Commissioners to exempt the investment banks from maintaining reserves to cover losses on investments. The exemption granted by the SEC allowed the investment banks to leverage financial instruments beyond any bounds of prudence. In place of time-proven standards of prudence, computer models engineered by hot shots determined acceptable risk. As one result Bear Stearns, for example, pushed its leverage ratio to 33 to 1. For every one dollar in equity, the investment bank had $33 of debt!”

I would argue that this is just an example of the problem of regulation. The SEC legitimised all of this. Without such legitimacy, without the approval of a regulatory body, would this kind of practice have been so readily accepted? It is at the very heart of my argument - regulation and regulators encourage complacency. The commentator also mentioned the role of regulatory arbitrage, with the UK offering a laxer regulatory regime as a way of attracting more banking business to the UK. It is yet another example of how regulation can create distortions in the market place. The UK claimed that its 'soft touch' regulation was both sound and more efficient but, as with the US system, it was neither sound or efficient. It is possible to therefore suggest that every regulatory regime should meet the same standards of regulation, but we then encounter the Basel approach, where the risk assessment regime of both of the accords have now been shown to be wrong.

They were wrong, but conferred a false sense of security/legitimacy in the activities of the banks, much as the SEC did in the example given above.

What of the Financial Services Modernization Act, the Commodity Futures Modernization Act of 2000? These are fingered as the guilty in the cause of the financial crisis. However, I would suggest that, for example, the legal structure of financial institutions is not an issue of concern. The structure of financial instruments is not an issue of concern. As you may be gathering, the real issue of concern is the nature of the oversight of the activities of the institutions.

As the BoE suggests, there is an asymmetry of information. When I gave the example of the person investing the £10,000 I pointed to two examples in which the investor had good knowledge about the potential investments (his sister and his company). In these cases information was not a problem, but even with good information the risk remained. The problem of information arose with the speculative bank. How can an investor make an assessment of an institution as complex as a bank in the assessment of risk. How can he know what an SIV or CDO actually are. It is here that we have the assymetry of information.

Before continuing, a quick question. Should the investment of our investor's money in his sister's restaurant be subject to regulation? Just as putting money in a speculative bank risks the life savings of our investor, so does investment in his sister's new business. Regulation is there to protect the investments of depositors, but why would that protection not apply to investment in his sister's new business. In both cases, if the investment of that money goes wrong, then he loses his savings. For some reason, when the word 'bank' is mentioned, confusion arises. We MUST protect the savings of individuals invested in banks, but not if an individual invests in other ways. Why? In both cases the individual might lose all their money, so investing in his sister's business should be regulated, if regulation is to be meaningful and consistent.

For example, if the government guarantees money invested through a bank, why would it not do the same if the business of the sister of our investor goes bankrupt. In both cases the money was used for investment, in both cases our investor lost his savings. Where is the difference? As I said, mention of the word 'bank' seems to change everything, but I can see no rational explanation of why this should be the case. An investment is an investment, whatever the conduit.

The classic picture conjured up in defence of the regulation is that of a little old lady losing her life savings. My answer to this is the deposit banks. If, however, the little old lady wishes to venture outside the relative safety of a deposit bank, then she must accept that she moves into risk, including risk to all of her capital. However, the problem is just the same for all investors, and conjuring up images of little old ladies is just an emotive argument. A 30 year old man with a family to support will also be hurt badly if he loses all of his savings.

So how can this problem be overcome, the problem that when we invest money, we are subject to great risks? The answer is that the problem can never be overcome, but can be mitigated with information. In particular, the nature and source of the information needs to be regulated.

As such, the most important piece of regulation would be to actually make it illegal for banks, or any other financial institution, to pay for any kind of rating on their overall financial status, or the status of any of their products. It is obvious really, but the users of the ratings need to pay for the ratings if their interests are to be represented. As long as the banks pay for their own ratings, their is a fundamental conflict of interest.

The other regulation is even more straightforward. All of the speculative banks need to call themselves by this title, as a constant reminder of their nature. Whenever an account is opened, a standard form will state that they make no guarantee of the return of any cash deposited in their care, and that the person opening the account must declare that they accept the conditions. In addition, on a daily basis, they would be regulated to publish their daily (gold standard) cash reserves available for immediate withdrawl as % of deposits, as well as a monthly rolling statement of % change upwards and downwards. These would be audited on a random basis, with massive fines for any attempt to massage/distort the figures. The figures would be published on their websites and, where a bank has branches, published in the all of the branches in a predetermined format.

The aim of such a measure is to remove the complacent belief that any investment is safe. It is to remind individuals and business that they should take care over where they place their money. It is a climate of fear, and one which will encourage people to pay for services which critically scrutinise the state of the banks. A climate of fear sounds unpleasant, but it is the only discipline that will ensure that investors and depositors have a care for the use of their money. In addition, there is the security of the deposit banks, which will always be an option if the fear of the unregulated sector is too great for any individual. The deposit banks offer greater security than the existing banking system. In addition, other banks will take intermediate risk positions, maintaining relatively high cash reserves, but at the cost of smaller returns on money invested. This is the nature of all investment - the trade off between risks and returns. In a deposit bank, almost no risk and no returns.

At the heart of this argument, I keep on returning to risk, and the impossibility of the removal of risk. Even a deposit bank, backed by gold has risk. Any regulation that suggests that it removes risk is a delusion, and this has been demonstrated in this financial crisis. What was safe is now unsafe, and the regulators have been found to be wrong.

As such, my proposed reform does nothing to remove risk, or to attempt to mitigate risk. The aim of the system is simply to make the nature of the risk more transparent. Despite this, little old ladies, and 30 year old family men, will lose their savings. However, if that little old lady were to lose her money through investing in her grand daughter's business, no one would call for regulation of the granddaughter's business or ask that she not be allowed to ask her grandmother for investment.

As I said at the start, banks just serve two purposes. A relatively safe place to leave your money, or as a conduit for the risky business of investment. I have proposed a return to the gold standard, not because I believe that it is risk free, but because it provides for an alternative that offers people a certain contractual guarantee, albeit a guarantee with a limitation that the value of that guarantee is variable. It allows for deposit banks to offer a fairly low risk, but nevertheless a risk. It also supports the value of money, through offering an explicit contract. The value of that contract may vary, but the contract remains regardless of any change of circumstance.

I am not sure that I have done this subject full justice, but hope that, at least, it presents a challenge to the belief that banks must be regulated. There is a lot more detail that I would like to discuss, but time is (as ever) too short and I have other comitments that I need to attend to. I am also sure that there will be faults in my thinking, so I look forward to the astute readers of this blog pointing out the problems.

Note 1: I have not responded to the many posts over the last few days, as this has been a bit of a long and demanding post. As ever, I will try to catch up, though the backlog seems to get bigger by the day.

Note 2: I have reread the post, and apologies that it is a bit clunky in places. I hope that it is clear enough.