Monday, 4 February 2013

The deadly quest for safety

Last week I attended a conference on Shadow Banking at Cass Business School. One of the things that struck me in the course of the two days was the disconnect between those who perceive the shadow banking system simply as a deconstructed banking system that we don't yet fully understand, and those who see it as the primary means by which money is hidden from view for the purposes of avoiding taxation. In his excellent presentation on tax havens, Ronen Palan commented that separation of fiscal and monetary policy meant that central banks didn't concern themselves with the social effects of shadow banking. In his words, they didn't "join the dots". This post is my attempt to join the dots. 

Much attention has recently been focused on the shortage of safe assets in the financial system. There have been proposals for creation of a larger supply of safe assets through issuance of more government debt (Gorton, BIS) or changing the tenor of government debt from long- to short-term (Pozsar), since the shadow banking system uses short-term government debt as collateral. There have been suggestions (Singh) that the problem is not so much a shortage of safe assets as reduced velocity of collateral due to safe asset hoarding. There have also been many suggestions that the financial system should create more of its own safe assets and stop expecting government to backstop it all the time. And there is evidence that the financial system is already finding ways of circumventing tighter collateral rules through collateral transformation services, thus undermining the direction of regulation particularly of riskier activities such as OTC derivatives trading.

But so far, as far as I can see, no-one is asking why the financial system needs safe assets in such quantities. What exactly is the driver behind such a desire for safety?

It is unfair to blame regulation alone for the increased demand for safe assets. All regulation has done is sharpen an existing need. Nor is it fair to say that the increased demand is solely due to risk aversion following the 2007/8 financial crisis. Investors were seeking safety as a primary objective long before that. In fact one of the key factors in the financial crisis was the failure of safe assets. Residential mortgage-backed securities, widely used in the shadow banking system as safe assets to back cash deposits, suddenly became unsafe as the extent of subprime defaults emerged: when BNP Paribas announced that it could not price mortgage-backed commercial paper following the failure of the Bear Sterns hedge funds in August 2007, institutional investors pulled their deposits and the ABCP funding market collapsed. Similarly, in 2008 the fall of Bear Sterns itself and later of Lehman caused runs on tri-party repo, a supposedly safe collateralised form of funding. Safety, it seems, was critical, and when safety was removed, so was the money.

This is vital to an understanding not only of the 2007/8 financial crisis, but of the shadow banking system and financial crises in general. It is often stated that the cause of the credit bubble and subsequent crash was "search for yield" - lots of hot money flowing around the world seeking a return. That is true, but it is not the whole story. The first, and most important thing, that the hot money flows were seeking was SAFETY. Investors were looking first of all to avoid loss. The search for yield was secondary. 

Avoiding loss is the key driver of all depository activity, whether in the regulated banking system or outside it.  Investors making cash deposits do not expect to take losses. This is as true of cash-rich corporations and high net worth individuals as it is of small retail depositors. The problem is that large deposits in the regulated banking system are not insured. So large-scale depositors look for liquid investments outside the regulated banking system that carry some form of guarantee or safe collateral backing. Short-term government debt is the best, but prior to the financial crisis property-backed private label assets were also regarded as good collateral. When those failed in the financial crisis, that left a crippling shortage of safe collateral. The temporary lifting of the FDIC insurance limit mitigated this by enabling insured bank deposit accounts to be used by wholesale depositors. But that limit has now been reimposed, and yet there still is no sufficient replacement for the private-label safe assets lost in the financial crisis and the sovereign ones lost in the Eurozone crisis. 

The question is whether avoiding loss is a reasonable expectation for a wholesale depositor - or indeed for a retail one - and more importantly, whether governments should be expected to make good all losses suffered by depositors. Deposit insurance schemes explicitly commit government to making good the losses of small depositors. Some people suggest that only transaction accounts should receive such a guarantee, and that other small retail deposits should not be guaranteed: but deposit insurance helps to prevent retail depositor panics and bank runs, and there may also be good social reasons for protecting small savers from loss. But wholesale depositors are perhaps a different matter.

Typical losses suffered by depositors are default (where the depository institution is unable to return their money) and capital erosion due to negative real interest rates (where inflation is higher than the nominal rate of interest on the deposit). For retail depositors, the first of these is mitigated through deposit insurance and the second may be mitigated by indexed rates. Similarly, for wholesale depositors the first of these is mitigated through investing in safe assets and the second by investing in index-linked assets. But there is a third type of loss that both retail and wholesale depositors seek to avoid, and that is taxation. Retail depositors avoid taxation by putting funds into pensions and other forms of tax-free saving such as the UK's ISAs.* The equivalent for wholesale depositors is taking funds offshore and/or transforming them into assets that are more lightly taxed. That is what the shadow banking system does. 

At present there is considerable concern around the world about tax avoidance. There are calls for closure of tax loopholes, elimination of tax avoidance schemes and clampdown on tax havens. This is driven by considerable public anger about what is seen as "unfair" behaviour by large corporations and rich individuals. The tax avoidance about which there is so much anger is perfectly legal and arises as a direct consequence of liberal tax regimes, open borders and free movement of capital. The question is therefore one of morality: is it "right" for wealthy individuals and large corporations to seek to avoid tax by perfectly legal means?

Tax campaigners have a point: wholesale depositors using the shadow banking system to avoid taxes while taking advantage of government guarantees on debt are looking to have their cake and eat it. But from the point of view of the wholesale depositors, avoiding taxes is perfectly reasonable. Retail depositors, after all, are able to save free of tax: why should not wholesale depositors? And since tax havens provide a legal means for them to do so, why should they not use them? I've outlined some practical reasons why governments might wish to offer retail depositors more loss protection than wholesale ones, but the moral case for this is still to be made, and until it is, in my view it is wrong to regard wholesale depositors as "immoral" for seeking the same loss protection as retail depositors. 

So wholesale depositors seek to deprive government (legally) of tax income. But, by investing in government debt they are returning money to government even if they are not paying tax - money that can be productively used for investment in the real economy. Admittedly government has to pay interest on that debt, but that's the only cost, and it could be very low or even zero. So what is the problem? Why is tax avoidance such an issue, if government debt is the vehicle in which the "hidden" deposits are primarily invested? Surely an alternative to the difficult job of chasing tax avoiders all around the world would be simply for governments to issue more debt and encourage those tax avoiders to buy it? Admittedly, if government spent the money it raised from so much additional debt it would risk inflation, but it could always raise interest rates and/or increase taxes to choke it off. What's not to like?

Sadly this strategy falls foul of the problem I identified in my post "When governments become banks" and discussed further in "Safe assets and Triffin's dilemma". How do government assets remain safe? In the eyes of investors, government assets only remain safe if they can be guaranteed to be repaid in the future - which means, ideally, holding cash backing for them (risk-free) and/or running fiscal surpluses sufficient to meet all future debt service and refinancing obligations. Running persistent fiscal surpluses, unless accompanied by trade surpluses, destroys the private sector's ability to save, eventually wrecking both investment in the real economy and ordinary people's security. And cash backing for government debt prevents money raised through debt issuance from being invested productively in the economy. The consequence of large wholesale depositors' desire for safety is therefore progressive impoverishment of smaller depositors and indeed of the whole economy. This could be offset by taxation of wholesale deposits, but not if those wholesale deposits have been hidden somewhere they cannot be taxed. 

Alternatively, government could simply ignore investors' demands for debt to be kept safe, and do whatever is necessary to meet the needs of their economies. After all, as I've pointed out before, sovereign currency-issuing governments don't actually have to issue debt at all. They do so in order to make it possible for the private sector to save in something other than currency. If large wholesale depositors abuse that facility, governments can simply refuse to make it available to them. But the problem is that issuing large amounts of debt without considering the effect on price and interest rates potentially impedes the ability of the government (via its central bank) to control inflation

Really we need to reframe the whole issue. A sovereign currency-issuing government does not require debt in order to fund spending, and it does not require taxation either. Debt is a savings scheme. And taxation is a means of mopping up the excess of government spending over production, thus reducing the risk of inflation - the same job as interest rates do on the monetary policy side. The real issue is investment, not taxation. 

It is unreasonable of wholesale depositors to withhold risky investment in potentially productive activities themselves AND refuse to allow government to do so. If private investors will not take risks, and the government cannot for fear of upsetting private investors, the economy is doomed to stagnation. So it seems to me that wholesale depositors have three choices: 
  • They can allow governments to meet their need for safe assets, but accept that governments will use the money raised from the additional debt to invest productively in the economy. 
  • They can invest their deposits productively themselves, taking risks in order to generate economic growth to the benefit of everyone including themselves - and perhaps governments might offer some tax incentives for this. 
  • They can allow government to invest productively on their behalf using money they return to government through taxation. 
Or some combination of all three, of course. And on its side, government needs to consider the extent of loss protection it can or should reasonably offer to both wholesale and retail depositors. Current direction of policy appears to discriminate against wholesale depositors in favour of retail, while keeping the back door open for wholesale depositors to find less obvious ways of obtaining similar protection. 

It is not acceptable for wholesale depositors to dictate terms to governments regarding the conduct of economic policy while withholding essential investment and expecting the sovereign to compensate them for losses. Nor is it necessary or desirable for government to encourage hoarding of unproductive assets by offering sovereign loss-protection insurance of one kind or another to all investors. For there to be a growing and productive society, someone has to take risks - and if the private sector will not, they should either be slapped in the face as Beckworth suggests, or government should take the risks instead. The quest for safety ultimately leads to economic death. 


* Note that the existence of non-bank tax-free savings schemes for small depositors causes  disintermediation, since ordinary retail bank and building society (thrift) deposits aren't eligible for tax relief. The consequences of this for the safety and stability of bank lending are not widely discussed. 

Related links:

Global Safe Assets - Gourinchas & Jeanne (BIS)
The return of negative repo rates - FT Alphaville (for disussion of taxation)
Resolving the safe asset shortage problem - Macro and Other Markets Musings
Collateral transformation - Alloway (Markit)

13 comments:

  1. The first, and most important thing, that the hot money flows were seeking was SAFETY. Investors were looking first of all to avoid loss

    We think of the period up to mid 2007 as being one of calm and stability; why were they so jumpy?

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    1. Depositors look to avoid losses even in calm periods.

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  2. " Some people suggest that only transaction accounts should receive such a guarantee, and that other small retail deposits should not be guaranteed: but deposit insurance helps to prevent retail depositor panics and bank runs, and there may also be good social reasons for protecting small savers from loss. "

    The UK banking system managed to get by without deposit insurance until the EEC forced it on the Thatcher government (1979). There is no need for a retail bank run scenario if the central bank is doing its job of lender of last resort. When they refuse to even acknowledge that it is their role to be LOLR, such as the King BoE, that is when something like the Northern Rock debacle occurs. Especially when a BBC journalist (Peston) announces the bank have run out of money. The CB should certainly not be a LOLR to an insolvent bank, so the deposit insurance is a nice subsidy by taxpayers to those who deposit funds in insolvent banks. Therefore, the deposit insurance is not going to prevent the bank being illiquid if the central bank does its job. The DI is only really offering anything if the bank is in fact bankrupt. It would be quite rational for depositors to panic and engage in a bank run if the bank is insolvent. There are a number of reasons why that is the rational thing to do. You do not know how long the government will take to pay the DI compensation. You do not know whether everyone else is going to panic so you panic and the whole thing becomes a self-fulfilling prophecy.

    It is quite possible that deposit insurance does more harm than good. Depositors get lazy and do not give much thought to the safety of where they deposit money. The depositors laziness fails to put on a check on the banks and as a consequence they amplify risk.

    " I've outlined some practical reasons why governments might wish to offer retail depositors more loss protection than wholesale ones, but the moral case for this is still to be made, and until it is, in my view it is wrong to regard wholesale depositors as "immoral" for seeking the same loss protection as retail depositors. "

    The best argument that is usually made is retail depositors are considered unsophisticated lenders. Other lenders to a bank are supposedly more sophisticated, professional and should understand risk better that the secretary of the local bowling club.

    This is off topic although some parts are relevant. I don't know if you have ever read this essay by Tim Congdon from a few years ago.
    http://www.iea.org.uk/sites/default/files/publications/files/upldbook450pdf.pdf

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    1. Hi Richard,

      Thanks. Actually I'm with you on the limited use of deposit insurance in choking off bank runs, hence my use of the term "helps to....". Depositors are more concerned about liquidity - they aren't going to wait for a bank to fail then claim their money back, they will take it out before it fails. I agree that an adequate LOLR is a much more effective preventative for bank runs. As you say, the UK existed for a very long time with no deposit insurance and no bank runs.

      King's inept handling of the Northern Rock liquidity crisis surely has to go down as one of the worst examples of central banker incompetence in history. I really don't know how he kept his job. He nearly didn't.

      The naivety of retail depositors may be a practical reason for insuring them against loss, but it is not a moral one. My point is that "morality" is being used to justify taking a harder line with wholesale depositors than retail ones, but I have yet to see a convincing moral argument for discriminating against wholesale depositors.

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  3. "Really we need to reframe the whole issue. A sovereign currency-issuing government does not require debt in order to fund spending, and it does not require taxation either. Debt is a savings scheme. And taxation is a means of mopping up the excess of government spending over production, thus reducing the risk of inflation - the same job as interest rates do on the monetary policy side"

    Blimey Frances I knew you were sort of sympathetic to MMT but thats smack you in the face head on MMT. Thats 2 of us in NW Kent then lol.

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  4. Great post, Frances. I think the UK has the same system we do, where part of the draw of Gilts (US Treasury Securites) is that they are risk-free. Some have suggested that going with Interest on Reserves along with removing the FDIC cap would pretty much blow away the "debt" myth, neutralizing the debt hand-wringers in the process. I can see the moral question posed above, should we do away with bonds entirely, but have a look at these banking proposals for the US:

    http://moslereconomics.com/wp-content/pdfs/Proposals.pdf

    As Warren would say, the Financial Sector is a LOT more trouble than it's worth.

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  5. There is no need to scratch heads about the MORAL case for insuring large wholesale deposits. Pure economics answers the point, as follows.

    Bank accounts where the relevant sums are not loaned on or invested by the relevant bank involve virtually no risk, ergo government might as well insure those. Little taxpayer exposure is involved, regardless of whether the deposits are large wholesale ones or small retail ones.

    In contrast, if deposit insurance is offered for accounts where the relevant money IS LOAND ON, that’s a subsidy of commerce. And that amounts to an misallocation of resources. So that form of deposit insurance should be outlawed. And if government acts as lender of last resort for those sort of accounts, that’s also a subsidy, i.e. a misallocation of resources. That misallocation occurs (again) regardless of whether the deposits are large or small.

    And wouldn’t you know it, the latter arrangement is inherent to full reserve banking.



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  6. In my view, of the three choices shown, I prefer a combination of the following:

    1. All demand deposits in Banks are to be swept into the Bank's demand deposit account at the Central Bank, who invests them in Treasury Demand Deposit Bonds paying 2.5%. The bank keeps 0.5%, remitting 2% to the depositor.

    2. All savings deposits in Banks are to be swept into the Bank's savings deposit account at the Central Bank, who invests them in Treasury Savings Bonds paying 5.5%. The bank keeps 0.5%, remitting 5% to the depositor.

    3. All loans made by a bank, are made from bank capital.
    4. Banks may syndicate loans to no one other than the Federal Development Bank specializing in that type of loan, under terms and conditions specified for that loan class. For example: Bank A can make a $24 million loan to Solar Generating Company for construction of a solar electricity generating plant, syndicating 90% of the loan to the Federal Renewable Energy Development Bank at 1% interest, under the FRED's terms for such loans, which permit Bank A to receive 5% interest on it's capital, for a combined rate of 1.2% offered the borrower.
    5. High wealth individuals desiring larger returns, must invest in corporate/business bonds and shares, taking on risk.
    6. Treasury Bonds are offered to one and all at 0.5% interest for 10 years, which means risk free is available, but essentially yields nothing. Treasury Bills with 90 day duration yield 0%, same as cash. Treasury Bonds with 30 year duration yield 1%

    7. Only the purchase of shares/bonds newly issued by businesses is tax exempt. Sale of such assets for the first time in the secondary market is taxed at 1%. Subsequent sales are taxed at 5%. All shares/bonds expire worthless 50 years after they are first sold in the secondary market. This provision is for the express purpose of fostering investment into businesses, rather than into speculation.

    INDY

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    1. Re 3, I agree that loans made by banks should only come from bank creditors who take a hit when those loans go wrong.

      But there’s a problem with No.2 and the 5%: it’s that many governments (e.g. US and UK) are currently paying a lot less than 5% for money they borrow. So if that idea was implemented, why would anyone buy normal government debt? Everyone would go for the much more generous and equally safe 5%.

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  7. The constant multiplication money not only reduces its value but creates a situation in which there isn't enough business left in the world to produce expected returns of investment.

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  8. Frances says, “But so far, as far as I can see, no-one is asking why the financial system needs safe assets in such quantities. What exactly is the driver behind such a desire for safety?”

    Agreed. I’m equally baffled.

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  9. What is money? What are deposits? The velocity of collateral is no different than the velocity of bank deposits. The unregulated, prudential reserve, money creating, E-D banking system (not ECB system) has used collateral since the early 60's to expand new money & credit.

    The Fed is now behind the curve. It must immediately raise the remuneration rate to stop a train wreck. Money growth is too fast to sustain without causing rapid inflation.

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  10. domenica tropeano12 April 2013 at 18:40

    hi frances, I find your post very interesting.

    ReplyDelete