Wednesday, 30 July 2014

Strange things are happening in Hungary's banking sector

Continuing my Forbes series on the mysteries of banking in Eastern Europe:
The Hungarian banking system has been a thorn in the Hungarian government’s side for quite some time. A large proportion of it is foreign-owned, which makes it more likely that there would be outflows of capital and restriction of essential lending activity in a crisis. And, of course, it’s more difficult to coerce foreign-owned banks into doing things that the government wants, such as cheap lending to favored borrowers and buying up government debt
Not only are many of its banks foreign-owned, they lend foreign currencies too. A high proportion of Hungarian mortgages are in euros or Swiss francs. Banks extended foreign-currency mortgages to Hungarian households at a time when the exchange rate to forints was favorable. But since then the international value of the forint has fallen, mainly due to a sustained period of monetary easing by the Hungarian central bank. This has improved economic conditions but left Hungarian households struggling to pay their foreign-currency mortgages.
So what are the Hungarian authorities doing about this? Find out here.

Related reading:

The trouble with Hungary.....

Potential for crisis aftershocks at Eastern European banks - Neil Buckley, FT

English: Hungarian National Bank, Budapest Mag...

Hungarian National Bank. (Wikimedia)

Tuesday, 29 July 2014

The not-so-pure retail bank

I've decided I don't like Lloyds Banking Group*. It presents itself as this pure retail bank that would never behave in such a dastardly manner as the universal banks with their greedy rapacious investment banking arms. But the reality is far different.

LBG has just been fined a total of £218m jointly by the FCA and American regulators for rigging benchmark rates including Libor. That is the crime for which the Barclays' chief Bob Diamond lost his job. But we're all used to hearing about Libor fines now: LBG is the seventh bank to be fined (and there are more to come). The seven banks fined so far, with the amounts, are as follows (chart courtesy of the Wall Street Journal):


OK, so LBG's fine doesn't look that bad, does it? It's the smallest fine of any of the big banks. But in this case the size of the total fine is not a good indicator of the seriousness of the offence. To find out what is really going on, we need to break it down.

The fine is made up of three components - £105m from the FCA, $105m from the US's CTFC and a further $86m from the US Department of Justice. The American fines ares substantially lower than those imposed on other banks, reflecting LBG's lower level of overseas activity. But the FCA's fine is considerably higher than that imposed on any other British bank for benchmark rate rigging: at £105m (after 30% discount for "pleading guilty") it is the same as that issued to Rabobank. Only UBS has been fined more by the FCA for benchmark rate rigging.

Why is the FCA's fine so high? The clue lies in this letter to the Chairman of LBG from the Governor of the Bank of England:
The Financial Conduct Authority has made the Bank aware of enforcement action which it is taking against Lloyds Bank plc and Bank of Scotland plc (the Firms) in relation to manipulation of LIBOR and of submissions to the BBA GBP Repo Rate (the Repo Rate) during the period from January 2009 to June 2009. In respect of the manipulation of the Repo Rate, we understand that the motive was to reduce fees payable to the Bank under the Special Liquidity Scheme (SLS), for which the level of fees was dependent on the Repo Rate.

Such manipulation is highly reprehensible, clearly unlawful and may amount to criminal conduct on the part of the individuals involved. It reduced not only the amount of fees payable by the Firms but also the fees payable by other firms using the SLS. The Bank's calculations show that the total reduction in fees received by the Bank may have been as high as £7.76 million. 
So LBG was not only rigging Libor, it was rigging another rate too - the Repo Rate, used to price the cost of borrowing under the Special Liquidity Scheme during the financial crisis.

The Special Liquidity Scheme was put in place by the Bank of England to support distressed banks struggling to obtain market funding - of which HBOS was a prime example. Indeed according to Jill Treanor in the Guardian, LBG was one of the largest beneficiaries of this scheme. It enabled banks to exchange illiquid mortgage assets at the Bank of England for highly liquid UK Treasury bills, which these banks could then use as quality collateral against which to obtain funding in the repo markets. Banks were charged fees for this service in order to bring the cost of such borrowing close to commercial (unsecured) norms. The size of the fee was determined by the spread between 3-month Libor and the 3-month Repo Rate, subject to a 20 bps minimum: a narrower spread meant a lower payment, and vice versa.  

Clearly failing to understand that the SLS was preserving their jobs, traders routinely overstated the Repo Rate to narrow the spread to Libor and therefore reduce the fees payable to the Bank of England. The Guardian trenchantly describes this as "biting the hand that feeds them". This example of an interchange between two traders (quoted by the FCA in the Final Notice) shows how the scam worked:

Lloyds Trader A: The only thing is, I like it, we try and push it, we put Page 10 of 27
a higher rate when obviously we…

BoS Manager A: Well do you want me to put 102 for the 3’s?

Lloyds Trader A: Yeah do 102. It is just that we try and give a higher rate when we do the SLS obviously, so therefore we get a bit better yield on the book, are you with me?

And it is this, not the rigging of Libor, that explains the high fine. Two-thirds of the fine is for defrauding the Bank of England, and by extension (since the Bank is wholly owned by Her Majesty's Government) taxpayers. In addition, LBG has had to refund the £7.76m the Bank of England says it should have received. Furthermore, as the Governor's letter indicates, criminal prosecutions of the individuals involved may follow: the Serious Fraud Office says its investigation is "ongoing". No other British bank has openly defrauded taxpayers in this way. Not even RBS. So much for the wonderful retail bank culture. LBG is toxic through and through.

And that extends into Libor rigging. The FCA speaks of a "poor culture" on the money market desks responsible for obtaining short-term funding for lending (as retail banks, neither Lloyds TSB nor HBOS relied on trading for income, and nor does the enlarged LBG). We now know why they rigged the Repo Rate. But why did they manipulate Libor?

In the case of HBOS, the answer is clear. HBOS deliberately gave low submissions to the Libor panel in the last few weeks before its failure, in order to make itself look better than it actually was. This remark from a senior manager at HBOS (quoted in the CTFC's press release) is telling:
As a bank we are extremely careful about the rates we pay in different markets for different types of funds as paying too much risks not only causing a re-pricing of all short term borrowing but, more importantly in this climate,may give the impression of HBOS being a desperate borrower and so lead to a general withdrawal of wholesale lines...
HBOS certainly wasn't the only bank doing this at the time. Indeed as markets froze and real funding rates headed for the skies, it is likely that all Libor submissions were understated at this time. HBOS's behaviour is reprehensible, but understandable.

But both HBOS and Lloyds TSB also allowed their traders to manipulate Libor submissions to suit their trading positions. We perhaps might expect traders in investment banks to behave like this, and management to turn a blind eye - after all, their profits depend it. That's why investment banks need watertight controls around Libor submissions and the like, and why the absence of those controls is a sackable offence for executive management, as Bob Diamond discovered. But why on earth would retail banks allow their traders - whose job is funding and hedging, not market making - to behave like this?

It's clear from the traders' messages that traders were manipulating Libor submissions to suit their own positions, not to benefit the bank as a whole. And the traders' messages indicate that they knew perfectly well that what they were doing was market manipulation, but they thought they could get away with it - after all, everyone was doing it. But they were more like naughty children than adults - the Famous Five with swear words. I am reminded of the password for Harry Potter's map - "I solemnly swear that I am up to no good".

But this doesn't excuse senior management, any more than parents are excused for turning a blind eye to their children playing truant and causing mayhem in the local park. It was the job of executive management to set and enforce the standards of behaviour across the bank. And it seems they manifestly failed to do so. The FCA suggests that this was a sin of omission rather than commission:
The Authority does not conclude that either Lloyds Bank or Bank of Scotland as firms engaged in deliberate misconduct. Nevertheless, the improper actions of many Lloyds Bank and Bank of Scotland employees involved in the misconduct were at least reckless and frequently deliberate. The Firms, because of a poor culture on their Money Market Desks and weak systems and controls, failed to prevent the deliberate, reckless and frequently blatant actions of a number of their employees.
Nor is this the first such sin. LBG/HBOS has previously been fined SIX times for conduct offences, all but one since the financial crisis. Here's the FCA's list:
  • In September 2003, the Authority imposed a penalty of £1.9 million on Lloyds TSB Bank plc (now known as Lloyds Bank plc) for systems and controls breaches in relation to its conduct in selling high income bonds between October 2000 and July 2001
  • In May 2011, the Authority imposed a penalty of £5 million (£3.5 million after the 30% discount for settling at stage 1) on Bank of Scotland for breaches of Principle 3 and Principle 6 between July 2007 and October 2009 relating to its handling of complaints relating to retail investments
  • In March 2012, the Authority imposed a public censure on Bank of Scotland for breaches of Principle 3 between January 2006 and December 2008 relating to the management and control of its corporate lending. 
  •  In October 2012, the Authority imposed a penalty of £6 million (£4.2 million after the 30% discount for settling at stage 1) on Bank of Scotland plc for breaches of Principle 3 in relation to incorrect mortgage terms and conditions that it gave to standard variable rate customers
  • In February 2013, the Authority imposed a penalty of £6,164,327 (£4,315,000 after the 30% discount for settling at stage 1) on Lloyds TSB Bank plc, Lloyds TSB Scotland plc and Bank of Scotland plc for breaches of Principle 3 (and DISP 1.4.1R(5)) between May 2011 and March 2012 relating to their failures to pay redress promptly to PPI complainants
  • In December 2013, the Authority imposed a penalty of £35,048,500 (£28,038,800 after the 20% discount for settling at stage 2) on Lloyds TSB Bank plc and Bank of Scotland plc for their breaches of Principle 3 between 1 January 2010 and 31 March 2012 relating to serious failings in the systems and controls governing the financial incentives that they gave to sales staff.
And the FCA adds, in relation to this latest censure:
The failure of the Firms to establish and maintain adequate systems and controls in the above cases is not wholly similar to this case and, with the exception of the March 2012 Final Notice, the cases do not relate to the wholesale banking businesses of the Firms. However, all six previous matters highlight the inadequacies of the Firms (both members of Lloyds Banking Group plc) in implementing adequate systems and controls for their different business areas. 
In short, this is yet another example of long-standing management failure at LBG and HBOS. This latest censure of course relates to behaviour from 2006-2009, and the executive team then in place has long since departed. The SFO's criminal investigation may extend to them, but as the FCA concludes that the offences were individual rather than systemic it seems unlikely that any of the former executive team will face prosecution in this case.

But the last two fines were for serious failures of customer service that happened on the watch of the CURRENT team. The last was so sickening that I felt it warranted the Board's resignation. Why are they still in place, I want to know?

Related reading:

Final Notice, Lloyds and Bank of Scotland - Financial Conduct Authority

Governor's letter to Lord Blackwell - Bank of England

Response to Governor's letter from Lord Blackwell - Lloyds Banking Group

Of obseen Libor manipulation - FT Alphaville (rubbery jubbery)

*I should declare here that I do have a personal grievance with LBG. Obviously I'm not going to disclose details, as it is a personal financial matter, but suffice it to say that I experienced a level of customer "service" that was so bad I reported them to the Financial Ombudsman.

Saturday, 26 July 2014

The EU should beware of Russian interest in Balkan banks.

Especially when it is disguised.

My latest post at Forbes takes a jaundiced look at who is in the race to acquire Hypo Alpe Adria's network of Balkan banks. I'm not usually much of a conspiracy theorist, but this is the Balkans, after all - the far-fetched is mundane in that part of the world. There is something very shady going on, and I reckon the Russians are behind it.

Read about it here.

Oh, and in case the Balkans look like a black hole to you, here's a map (courtesy of Wikipedia).

Friday, 25 July 2014

No, it's not party time yet

It seems the UK is something of a poster child for economic recovery. The ONS reports that GDP has grown by 0.8% in Q2 and by 3.1% since Q2 2013. This is a pretty solid performance. And it's an important milestone, too: the UK's GDP is now back to its pre-crisis peak.

And the UK has become one of the few bright spots in the IMF's generally gloomy forecast for world growth. Upgrading the UK's growth forecast to 3.2% by the end of the year, the IMF said that the UK would maintain its position as one of the world's fastest-growing economies.

Predictably, the Coalition government and its supporters claimed this as success. George Osborne tweeted that the IMF's upgrade showed his economic plans were working:

And Matthew Holehouse,  political correspondent of The Telegraph, describes the IMF's upgrade as "a vindication of George Osborne's economic plan".

This frankly is stretching things WAY too far. This chart from Ben Chu of the Independent places the UK's economic performance in its G7 context:

How on earth is the second slowest recovery in the G7 "vindication" of George Osborne's policies? And it's not just because the UK had a very deep recession, either. Japan - yes, you know, that country we like to think is in an eternal slump - had a deeper contraction but has recovered faster despite the tsunami and Fukushima disaster. And Germany, whose contraction was nearly as deep as the UK's, exceeded its 2008 GDP peak in Q1 2011.

In fact this chart shows clearly the derailing of the UK's recovery in 2010 just after the Coalition came to power. Note that this is BEFORE the Eurozone crisis hit in 2011: the Eurozone crisis must have affected the UK economy, but it isn't a sufficient explanation. I've also argued that high energy prices explain quite a bit of the evident slowdown from late 2010 onwards. But it is hard not to conclude, as Simon Wren-Lewis and others do, that fiscal austerity delayed the UK's recovery. Far from a vindication of the Coalition's policies, the fact that the UK is only just back to its 2008 peak after four years of Osbornomics is quite an indictment. Whatever the reason, Osborne has actually presided over the slowest recovery since the Second World War:

And it is also far too soon to celebrate recovery. There is still a long way to go: wages are still falling in real terms, business investment is still weak and the UK's external position is poor. GDP may be back to its pre-crisis peak, but GDP per capita is still some distance below (thanks to FT Alphaville for this chart):

Best keep the lid on the bubbly for a bit longer.

Related reading:

Britain's long, weird recovery in 13 charts - FT Alphaville

The stocks and the flows

There have been calls for interest rate rises to discourage risky new lending. But the Resolution Foundation shows that it is the stock of existing debt that is the real problem. Household debt still stands at over 90% of GDP, and many of these households already have difficulty paying their mortgages: there is a real risk that raising interest rates would make their debts unaffordable, forcing them into default and the economy into recession. The Resolution Foundation has important recommendations for policy makers to reduce the risks of interest rate rises. But they don't go quite far enough....

Find out more here. (Pieria)

Wednesday, 23 July 2014

QE is fiscal policy

A new paper by Johnston and Pugh of the legal department of the University of Sheffield discusses the legality and the effectiveness of QE and its relatives, including the ECB's OMT "whatever it takes" promise.

The background to this is the German Constitutional Court's ruling that OMT amounts to monetary financing of government deficits and is therefore unlawful. Although the European Court of Justice is still to give its judgment in this matter - and is widely expected to dissent - the ECB is evidently doing its best to avoid outright QE, quite possibly because of questions over its legitimacy. The ECB has stated that in its opinion QE is legal, but then it said that about OMT too. The truth is that it is by no means clear that QE is legal in the Eurozone.

So the University of Sheffield's legal eagles have had a good look at the legality of both OMT and QE with respect to the Lisbon Treaty. And they concur with the German Constitutional Court. OMT does indeed amount to monetary financing of governments. So does QE. Both are therefore illegal under Article 123 of the Lisbon Treaty.

Article 123 of the Lisbon Treaty reads thus:

1. Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.

2. Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the European Central Bank as private credit institutions.

The UK has a specific restriction on the applicability of Paragraph 1 to allow it to continue to use the Treasury's existing "ways and means" overdraft facility at the Bank of England:

10. Notwithstanding Article 123 of the Treaty on the Functioning of the European Union and Article 21.1 of the Statute, the Government of the United Kingdom may maintain its ‘ways and means' facility with the Bank of England if and so long as the United Kingdom does not adopt the euro.

But in the view of Johnston & Pugh this does not exclude the UK from the GENERAL prohibition of monetary financing of fiscal deficits in Article 123. The "ways and means" overdraft was last used in 2008 at the height of the financial crisis: that borrowing has since been repaid and the UK has no current plans to use this overdraft facility. The question is therefore whether the Bank of England's QE programme has breached the prohibition of monetary financing to which the UK is subject as a signatory to the Lisbon Treaty. The Sheffield researchers think it has.

The reasons are not straightforward. Central bank purchases of own-government debt in the capital markets are not prohibited under the Lisbon treaty. Indeed they cannot be, because that would prohibit the main mechanism that EU central banks have historically used to control inflation, namely open market operations (sales & purchases of government debt) to maintain interest rates at a target level. This mechanism is currently in abeyance because of the presence of excess reserves in the banking system, but that does not mean it will never be used again in the future. QE also involves secondary market purchases of government debt. It is therefore easy to see QE as simply open market operations on a much larger scale. But the researchers argue that this is a misunderstanding of the nature and purpose of QE.

When government debt is purchased in a QE programme, the purpose is to control the market price of that debt. From the time that QE is announced until it is ended, the central bank effectively sets a floor on the price of government debt. This applies in both limited QE programmes, such as the Bank of England's, and unlimited, such as those in the US, Japan and Switzerland.

Forcing governments to fund themselves in the capital markets rather than obtaining funding from the central bank is supposed to ensure fiscal discipline. If governments over-spend, the thinking goes, capital markets will push up the cost of borrowing, forcing them to cut back spending and/or raise taxes. But if the central bank sets the price of government debt and stands ready to buy it in unlimited quantities, there is no discipline on the government. It can issue as much debt as it likes in the certain knowledge that there will always be a buyer. There cannot be a "buyer's strike" causing the price of debt to crash and yields to spike, as happened in Greece.

And this applies whether or not the central bank is actively purchasing securities. OMT has never been used - but its effect has been to force down yields on Italian and Spanish bonds, allowing their governments to maintain high debt/dgp levels without fear of default. There is no question but that the ECB did this to preserve the Euro. But it has undoubtedly also benefited the governments of those countries.

This is why the authors argue that QE is monetary financing of government deficits even though purchases are made from investors and banks, not directly from governments. QE amounts to an unlimited central bank credit facility. It is not the prohibition of government purchases that would be breached in an ECB QE programme, it is the prohibition of overdrafts and credit lines to governments.

And this raises a further issue. There has been huge debate about exactly how QE reflates the economy, though none of the explanations offered by economists and central banks have been conclusive: it has been claimed that QE influences the economy through portfolio effects (but substituting one safe asset for another doesn't have any effect on aggregate demand), suppression of the term premium (but it's probably very low anyway), increased liquidity in financial markets (doubtful, because QE contributes to collateral scarcity), increased bank lending (bank lending has been stagnant or falling), increased corporate investment (share buy-backs due to low borrowing costs are not investment). Most people agree that QE does support asset prices in a crisis, but its effectiveness as a long-term economic stimulus is questionable.

But the implication of Johnston & Pugh's work is that we have fundamentally misjudged the nature of QE. It has monetary effects, yes, but it is in reality a fiscal tool. It uses the central bank's ability to control market prices to enable governments to borrow and spend. This is why QE only works when the fiscal stance is expansionary. When the fiscal stance is contractionary - as it has been in most developed countries to varying degrees since 2010 - QE is ineffective.

Regarding QE as an enabler for fiscal expansion may explain a puzzle. Japan has by far the highest debt/gdp in the world, but it has very low borrowing costs. This can partly be explained by the fact that the Japanese are diligent savers, and much of their savings is held in the form of government debt: it could also perhaps be explained by the fact that investors are creatures of habit, retreating into traditional safe havens such as Japanese yen and JGBs when things get rough. But Japan has also been doing QE for far longer than any other country. Could the central bank's historical willingness to intervene in markets to control the price of Japanese debt be the reason why the JGB yield remains so low despite very high debt/gdp and poor economic growth?

But QE is also highly regressive. Doing fiscal expansion by the back door in this way virtually ensures that the money created does not go where it would have the most effect - it goes to those who least need it. The biggest beneficiaries of QE programmes are the rich, the value of whose assets rises when central banks intervene in this way - not just because the price of government debt rises, but because the price of other assets rises too due to substitution effects and the "reach for yield".

When government uses the central bank's suppression of bond yields as an opportunity to lock in low borrowing rates for the future and fund a fiscal expansion programme, then QE can be highly effective. But when governments fail to take advantage of central bank price control, QE can only benefit the economy through monetary channels which are both morally dubious and of questionable effectiveness. And when governments use QE as a cover for ill-considered fiscal austerity, QE actually transfers wealth from the poor to the rich. The weak monetary effects of QE might offset this effect to some extent, but the idea that QE can entirely negate the harmful effects of fiscal tightening in an economic downturn is not supported by the evidence. "Monetary offset" is a very nasty joke.

Johnston & Pugh's conclusion is damning:
In this paper, we have seen that, whilst QE can be argued to amount in substance to monetary finance, it is likely that the courts would not rule it unlawful. However, if a central bank did not offer justifications couched in monetary policy terms, there would be a much more serious risk of the intervention falling foul of Art 123 TFEU. The law’s emphasis on justifications and deference to central banks may not be surprising, but it does mean that there is scope for monetary finance so long as nobody admits that that is what is happening. It also means that arguably, monetary policy is outside the rule of law. It would be better for everybody if the debate was more open. 
So QE and OMT are illegal under EU treaties, but for political reasons no-one will ever admit that. This is the reason for the entirely artificial separation of monetary and fiscal policy, the monetary justifications for QE, the pretence that central banks are independent, and the charade of "fiscal discipline". The central bank must monetize debt, because the alternative is sovereign debt default and collapse of the currency: but if the central bank loses credibility, the currency is junk.

There is an elaborate charade whose sole objective is preserving the central bank's credibility. When central banks are monetizing government debt, it is the electorate, not the market, that controls the fiscal authority's propensity to borrow and spend. But if an elected government blatantly uses central bank debt monetization as an excuse for high borrowing and spending, the credibility of the central bank is toast. So everyone has to pretend that QE and its relatives don't fund the government, and politicians and voters have to be persuaded that restricting government's ability to borrow and spend is in their interests. The inflation monster is routinely invoked to terrify electorates into voting for austerity-minded politicians, and if that isn't enough, then the bond vigilantes and public debt bogeymen are called in too. And it works: not only have voters across Europe apparently been convinced that fiscal austerity is necessary even when it is clearly harming their economies, they have also been convinced that elected governments can't be trusted to manage public finances responsibly and must be restrained by unelected, unaccountable bureaucrats with their own political agendas. What an appalling erosion of democracy.

But debt monetization should not have to be a back-door exercise. In their concluding paragraphs, Johnston & Pugh call for an open debate about carefully considered outright monetization to end the disastrous austerity/debt deflation/higher debt/more austerity spiral in the Eurozone:
We have serious doubts about the efficacy of QE as a means to reflating the economy in the aftermath of a debt deflation.....Increased fiscal spending by governments would be more likely to be effective, but is currently ruled out by a belief that governments must pursue austerity in order for their countries to escape the crisis. We agree with Adair Turner that the time has come for a meaningful discussion about whether monetary finance offers a better way out of the current economic malaise, and if so, what form that monetary finance should take.
I have considerable sympathy for their argument, certainly for the depressed Eurozone periphery countries. Outright monetization is prohibited because of the fear of Weimar-style hyperinflation: but as I've explained before, hyperinflation is always and everywhere a consequence of political chaos and loss of trust. Provided that central bank credibility is maintained throughout, outright monetization of excessive legacy government debt burdens does not have to mean hyperinflation. There is still a need for fiscal discipline and structural reform going forward to ensure that debt, once relieved, does not build up again. But a one-off monetization of the debt burdens of the Eurozone periphery would do much to help Europe out of its seemingly endless slump.

Related reading:

Sacred cows and the demand for money
QE myths and the Expectations Fairy
Inflation, deflation and QE
Slaying the inflation monster
Rethinking the monetization taboo - Adair Turner
Have central banks been breaking the law? - Telegraph

Monday, 21 July 2014

The not-so-new (but very uncertain) neutral

My latest post at Pieria considers the likely future path of interest rates and central bank reaction functions. History shows that central banks delay raising interest rates for too long after a recession, then panic and raise them too much, causing another one. Will they do this again? Probably....

Read the whole post here.

FOMC meeting. Photo credit: Wikipedia