Monday, 27 February 2012

Spot the difference

The UK's Bank of England is on a splurge. It is spending newly-created money like it is going out of fashion. It is buying up the UK's own gilt-edged securities, which it is putting safely in a vault with the intention of selling them again sometime, maybe, if the mice haven't eaten them first. The institutional investors it buys those gilts from then go and spend that money, or they put it in a bank deposit account, or something. Anyway, one way or another that money finds its way into bank deposit accounts, simply because all money at some point comes to rest in a bank deposit account......So banks have higher deposit balances. Does that mean they lend more? No, it doesn't. Deposits don't belong to them - they are debt. What banks need is capital (because regulators insist they need it), and they haven't got enough of that. So although they are awash with deposits, they aren't lending, because lending uses capital. UPDATE - And because, as Ann Pettifor points out in the comments on this post, their chances of getting loans repaid are diminishing by the day. Result, a lot of money sloshing around in the banking system doing very little, and a lot of government debt sitting in the central bank doing nothing.

Now let's look at Europe. In December, the Euroean Central Bank (ECB) created 489 bln new euros and lent it out as cheap three-year loans to European banks - the Long-Term Repo Operation (LTRO). The banks didn't get it for nothing, of course - central banks won't lend anyone anything unless they have collateral. And in the olden days (i.e. prior to sovereign debt crisis), that collateral had to be pretty darn good - triple-A rated government securities, that sort of thing. But those are becoming increasingly hard to come by and very expensive, which is putting them out of reach of cash-strapped banks. So these days the ECB will accept almost anything as collateral against its lending - junk Greek bonds, rubbish commercial loans, toxic mortgages, you name it. UPDATE 28th Feb - Now everything EXCEPT junk Greek bonds. Defaulted bonds are too much even for the ECB to swallow! *** Further update 26th March - But NEW Greek bonds are fine, even though they are trading at much the same sort of yield as the old ones. Where's the Genie, I want to know?

But, you say, LTRO is lending, whereas QE is asset purchase. Obviously they are different, aren't they?

Well, not very. In fact the difference is vanishingly small.  In the financial world, lending and sale/purchase transactions are pretty much the same thing. For those unfamiliar with the financial jargon, let me explain how a "Repo" works.

A "repo" is a Repurchase Agreement. You sell the bank the contents of your attic for far more than they are worth, and you enter into an agreement with the bank that in three years' time you will buy back your attic contents for even more than they will be worth by then. In the meantime the bank can do what it likes with the contents of your attic - flog 'em to someone else, hold a boot sale, that sort of thing. Provided that it can obtain something that looks and smells exactly like the contents of your attic when you come to repurchase them, you need never know what has happened to them in the meantime.  The practice of "selling on" or "re-pledging" assets provided as "collateral" for a repurchase agreement or secured loan is known as rehypothecation.

So when people talk about "collateral" in relation to repos, it is not quite what we normally mean by that. After all, if you pawn your watch for a month, you don't give the pawnbroker the right to sell on that watch to someone else for that month, do you? But that's what happens with repurchase agreements and other forms of "collateralised lending" in the financial world. The assets aren't "pledged", they are effectively sold.

Now, because you have a legal commitment to repurchase your aunty's fur coat (complete with mothballs) after a specified period of time, a repurchase agreement is normally treated as a loan rather than a sales transaction. But this is questionable because of the treatment of collateral that I described above, and there have been several examples of repurchase agreements being accounted for as sales, of which the most notorious was Lehman Repo 105. The advantage from the bank's point of view of accounting for a repo as a sales transaction is that when combined with rehypothecation it does not expand the bank's balance sheet. It is just a purchase of securities which are then sold on, not a term loan, so the proceeds go to profit & loss and there is no impact on the balance sheet. And the future purchase and sale - well, that's in the future, innit? Although arguably it should at least be accounted for as an accrual.... Anyway, the Repo 105 scam enabled Lehman to hide its future financing needs and overstated its real income. It was a major contributor to Lehman's failure. And it looks as if MF Global has been doing something remarkably similar.

I'm sure by now you have worked out why this post is called "spot the difference". The UK's BoE is explicitly buying assets, with no repurchase date, for newly-created money. The ECB is also explicitly buying assets for newly-created money - but it will sell them back after three years. It's the same thing, really, isn't it?

Well, not quite. It's all a question of what flavour of fudge you like. You see, the Bank of England doesn't like taking on credit risk, and because banks in the UK are unpopular it doesn't want to be seen to be funding banks directly. But it doesn't have any qualms about buying its own government debt. So it limits its purchases to very safe triple-A rated sterling-denominated UK Government securities, which as the UK has rather a lot of debt are not too difficult to come by - nothing like as difficult as euro-denominated European government triple-A rated securities. And it buys those securities from institutional investors rather than banks. The money finds its way into banks, of course, as I described above. But it is an indirect flow.

Conversely, the ECB doesn't like buying government debt in the secondary market - German disapproval of this practice is palpable. But it is very happy to lend to banks. It regards itself as responsible for maintaining the liquidity of the banking system, and it is also helpfully (egged on by Sarkozy) providing an indirect way of funding governments. You see, the LTRO money was used to some extent by COMMERCIAL banks to buy up their governments' debt. That got the ECB nicely off the hook while still bailing out debt-distressed countries. It massively increased the balance sheet risk of the commercial banks concerned, of course, especially in Italy - but as long as the ECB keeps providing money, they will stay afloat and so will their sovereigns.  The snag is that to participate in LTRO they have to provide collateral, but unless they participate in LTRO they are really quite likely to go bust, as European banks are generally in pretty poor shape. Which is why the ECB will accept just about any old rubbish as collateral these days.

The next LTRO is on 29th February, and this time there is a twist. The money will be distributed via national central banks. European banks this time will go to their own central banks, who will create brand-new euros and dish them out in return for any old junk. This will leverage up national central banks instead of the ECB. This is A Good Thing, because it means that when the European banks can't repay the money in three years' time and the assets turn out to be worthless, it is the taxpayers of the banks' OWN countries that will get hit for the inevitable bailouts - not the Germans (who provide most of the capital to the ECB).

So the LTRO is a disguised bailout of both banks and sovereigns. And it is the biggest can-kicking exercise in history. It provides huge amounts of money to distressed banks that are poorly capitalised and over-leveraged, on the back of junk collateral and with absolutely no certainty that these banks will be able to repay the money anyway. And there are still NO moves to do anything about European banks' desperate lack of capital and appallingly risky balance sheets. I think I know EXACTLY when - and where - the next major banking crisis will be, don't you?

So those of you who think the UK is taking huge economic risks with its QE programme, just take a look across the channel. The UK's monetary policy looks like a model of prudence compared with Europe's.  And all of this to avoid directly bailing out countries or forcing Germany to support weaker Eurozone members. It is total madness.


  1. Not only is it total madness, it's the repetition of the same old behaviour that bust the West's economies back in 2007/8.
    The only genuine recovery possible is valuable securities in the form of commodities or precious metals. Ergo living within means. Now that doesn't run a cycle convenient for the façade of electoral gain. So democracy has to be sacrificed in order to keep this ponzi viscous circle turning.

  2. Frances, Thanks for this. I do not agree that 'lending needs capital'. Private banks create credit as easily (and in unregulated ways) as the central bank. That is, they enter numbers into a computer, demand collateral and a promise to repay at a certain rate of interest. The loan is then deposited as bank money in the account of the borrower.

    The reason that banks are not lending is because they have massive and growing liabilities and losses....for each loan they have made (which has become a deposit in a bank) they expect repayment...And with rising unemployment, bankruptcies etc...repayments look less likely. That is why they are not lending; their balance sheets look very, very bad....

    1. Yes,that's a fair point, Ann. Banks only "need" capital for lending to the extent that regulators enforce that need. Strictly, they could run on close to 100% debt/equity - and indeed many banks did so prior to 2008.

      Certainly their balance sheets are a mess, and I agree that even without increased capital requirements that is a sufficient explanation for the growing credit crunch in Europe and the poor lending figures in the UK.