Currency in Question

Fiat money is being questioned

All of the uses of fiat money are currently being called into question in one way or another.  For example, economists long since discarded the notion of currency as a reliable measuring stick for a great many purposes.  They have developed alternatives such as constant dollar value, trade adjusted value of the currency, and, of course, the ECONOMIST’s “big Mac index.”

The contradiction between enumerating “store of wealth” as a function of the currency, while using deflated or constant dollar values when measuring across time, does not seem to bother economists.  But it is not just the store of wealth role of money that is being questioned.  The alternative measures listed above imply that its role as a medium of exchange between countries is in question.

The ability to retain conflicting views on the same subject is not unusual.  Interestingly enough, it often surfaces in connection with efforts to defend a fiat money.    For example, an article in the WALL STREET JOURNAL entitled “A Golden Solution forEurope's Sovereign-Debt Crisis,” pointed out that many sovereigns in southern Europe could reduce their borrowing costs by securing the loans with their gold reserves.  The whole issue arises as a part of the effort to defend a fiat currency, the euro. 

So, essentially, the article points out, the euro could be defended by having it abandoned for some purposes of a currency: for borrowing costs to be lower for gold-backed debt versus debt backed by the sovereign government, buyers of the bonds have to believe the wealth preserving value of the gold is better than the wealth-preserving value of the sovereign backed fiat currency.  Part of this is a questioning of the trustworthiness of the sovereign, but there is undoubtedly also an element of distrust of fiat currency.

The issue was raised in connection with southern European countries with large amounts of debt and large gold reserves.  So, undoubtedly the focus was on the trustworthiness of the countries.  But it would be naïve to assume that the distrust does not reflect upon the currency.  Basically, it reflects a belief that there is some probability that no entity will step in and honor the value of the currency implied by the debt.  In that respect, it is the currency that is in question.  Further, while the article focuses on southern European countries, the same issue has been raised in connection with other countries not in the Euro Zone.  At its extreme, entities are forced to issue bonds in a foreign country’s currency. The issue has receded in the background now that the European Central Bank seems to be indicating that it will step in to honor the debt.

In the example of the southern European countries, the proposal would result in one currency being used to pay taxes within the sovereigns, and a second currency, gold, being used to secure debt.  Further, since a substantial portion of that debt is held by other sovereigns or their proxies, the banks, it would move the medium of exchange between sovereigns toward gold rather than the fiat currency.  Put differently, barter between sovereigns would be carried out in gold if it involves a transfer across time.

Europe is not alone in experiencing a questioning of the role of fiat currency.  The WALL STREET JOURNAL on August 29, 2012 had an opinion piece entitled “The Gold Standard Goes Mainstream.”  It pointed out that the major political party in the US was calling for a Gold Commission.  Now, as we all know, government commissions often are nothing more than a showcase for politicians who like to hear themselves talk.  But it is worth noting that the topic they are talking about is the abandonment of fiat currency.

The opinion piece tries to make some sense of this.  Those readers interested in their interpretation of this should review the opinion piece.  However, an obvious interpretation of the very existence of the opinion piece is that a substantial number of people in the US are fed up with the failings of fiat currencies and looking for alternatives.

More direct and broad-brush questioning of the medium of exchange currently in use was advanced by Stephanie Pomboy, founder of MacroMavens, in an interview in BARONS (July 21, 2012).  The article was entitled “Coming: The End of Fiat Money” which leaves little doubt about the major focus of her comments.

She also makes it quite explicit by stating: “I don't see it in the next 12 months. I think a five-year time horizon is very, very realistic. I envision a gold-backed currency system. We are going back to hard money, rather than a fiat system where debtors can silently default by inflating their debts away.”

One does not need to go so far as to depend on a forecast.  The first time the statement was made by Pomboy, gold was trading in the 1570's.  Subsequently, the price in terms of fiat money has gone up.  Since gold has very little value other than as a medium of exchange and store of wealth, that price change reflects a decrease in the role of fiat money as a medium of exchange and store of wealth.  Of those functions, Pomboy’s focus is on investing as is reflected in her statement, “I would own gold [and] companies tied to mining.”

Further, one doesn't have to adopt Pomboy’s conclusion that gold will become the substitute for fiat money.  She could be totally wrong regarding gold.  Her comments reflect the growing trend toward questioning fiat currencies regardless of whether gold is a viable substitute.

Pomboy could well turn out to be partially right.  Fiat money may cease to function as a store of wealth and be replaced by gold or some other mechanism.  However, as discussed in a previous posting, “When a Currency Is Working, It Isn't Questioned,” the “store of wealth” role of a currency may be the least important of the three functions that economists often cited.  Further, it should be clear that the Hedged Economist believes that the only true store of wealth is the acquisition of something that produces wealth in the future.  No money in existence or ever conceived fills that role.

The examples above harken back to a past time when gold served as a currency.  One doesn't have to be a gold bug to question fiat currencies.  In fact, one can just question how fiat currencies are being managed without advocating an alternative to fiat currencies.  That is exactly what was reported in the WALL STREET JOURNAL on December 23, 2012.  The article was entitled “Global CurrencyTensions Rise: Japan's Abe Calls on Central Bank to Resist Easing Moves by U.S.and Europe.”

Although the title makes reference to Japan’s complaint about how fiat currencies are being managed, it references a number of other similar complaints and actions.  In fact, the general theme of the article is best summarized by a quote. It is from a presentation by Mr. King, a UK official.  He commented:  “I do think 2013 could be a challenging year in which we will, in fact, see a number of countries trying to push down their exchange rates. That does lead to concerns.”  He went on to say: “The policies pursued by countries for domestic purposes are leading to tension collectively.”

Such complaints are not new to international relations.  However, what does seem to be new is that a significant number of countries are acting upon their concern.  Further, their actions sometimes involve the use of a non-fiat asset as an alternative to fiat money for reserves.  US citizens, because it became a political issue, are well aware that China manages its exchange rate.  It has been an object of global criticism for its efforts to hold down the value of its currency.  China's purchases of reserves of commodities have become an important determinant of world prices and are closely followed by commodity investors.

But now a number of countries long committed to allowing the value of their currency to be determined by the market feel it is necessary to intervene.  They include Switzerland, Israel and South Korea, along with others like Brazil that do not have as long history of commitment to fiat money for actual trade. Policy makers in Australia also are under increasing pressure to fight the rise of the Australian dollar.  An article published on January 8, 2013 highlighted how unusual the current situation is by the very title of the article: “Button-Down Central Bank Bets It All.”  It went to some lengths to describe how unusual the behavior of the Central Bank of Switzerland has been. 

One should also note that governments’ use of gold as a part of its reserves has been rising.  In fact, there are observers who attribute a substantial portion of the rise in the price of gold to the efforts of governments to expand their gold reserves.  In a curious twist, if that is true, the governments' efforts are probably contributing to the demise of fiat currency.  It is highly likely that the rise in the price of gold calls attention to the failures of fiat currencies.

These currency disputes are currently within the bounds of just being tension.  One is free to attach their own level of significance to the fact that the tension is surfacing in the form of disputes about fiat money.  But it is hard not to believe that if enough countries are dissatisfied with the existing fiat currency system, an alternative will be found.  That alternative may be another fiat money, but that is not guaranteed.

On a totally different front, Barron's cover on December 31, 2012 highlighted an article entitled “The End of Cash?” In this article, it is the use of fiat currency as a medium of exchange that is questioned.  The article points out that “fewer and fewer Americans use cash to make purchases large and small…” The article explains that “while cash in circulation is growing, it is becoming increasingly marginalized for retail transactions. This year, greenbacks will account for an estimated 29% of U.S. retail payments, according to McKinsey & Co., down from 36% a decade ago.”

As the article explains.  “Having already vanquished checks, the two big payment networks, Visa (V) and MasterCard (MA), are even more focused on displacing cash.”  The article also points out that there are: “A wave of relative upstarts … beginning to garner attention, particularly as so-called digital wallets take hold. The eBay (EBAY) unit PayPal, Google (GOOG) Wallet, and Square are all plays on the digital wallet, essentially a locker of personal-payment data stored either in the cloud or on smartphones. The wireless carriers are also fighting to get into the game by controlling the secure chips that are becoming common in smartphones.”  Discover and American Express also compete to replace currency as the medium of exchange.

However, all of these competitors use currency as the measure of value.  The Hedged Economist would contend that as long as the fiat currency is used to measure value, these substitutes do not constitute a challenge to the fiat currency.  Thus, since the role of currency as a measure of value is not questioned, the article’s implications are indirect. 

A logical question is: How this differs from checks as a substitute for dollar bills, or for that matter, how is it different from the decision to issue a dollar coin rather than a paper dollar?  If one wants to understand how this relates to currency, it is necessary to go beyond just the methods being used to pay for transactions.  One has to look at the ways the transactions are being financed.

Keep in mind that many brokerage firms, including Fidelity and Schwab, offer credit cards linked to brokerage accounts.  In essence, the transaction is financed, not off of future income, but off of capital in the form of income-earning assets.  While still denominated in dollars, the transaction is secured not by gold or the government's guarantee, but by an income-producing capital investment.  Further, remember that the accounts the credit cards are linked to may allow margin borrowing.  This certainly represents something very close to the equivalent of the banking system’s fractional reserves.

Granted, the relationship between currency and these new forms of paying for transactions is indirect, but, basically, people are issuing their own currencies through the use of their brokerage account linked credit cards.  It bears a striking resemblance to the development of fractional reserves currency by individuals.  Fractional reserve banking was the original source for fiat currencies.  One should never forget that the first dollar bills, pound sterling, etc. were issued not by governments but by individual banks. 

A more direct challenge to fiat currency is appearing on the Internet.  The Hedged Economist recently received an inquiry about a clear effort to develop a new fiat currency.  The inquiry related to Coinbase.  Coinbase issues Bitcoin which is a new digital currency that is being used all over the world. 

It is interesting, although it has some of the markings of an affinity-based Ponzi scheme.  Despite that, it is worth close observation because it makes for very easy barter. As the ECONOMIST article referenced in the previous postings points out, "The origin of money is a response to barter costs, in which the best money is that which minimizes the costs of trade."  The person who forwarded the inquiry was told that about $25M USD is traded a day, and personally knows of several business that accept it.  So, to the tune of $25M USD, Bitcoin is serving as money.

Interestingly, Bitcoin's challenge to currency also includes an element focused on the role of currency as a store of wealth.  That challenge as a store of wealth is introduced by the fact that they have pre-announced how much additional currency will be issued.  To those familiar with the relationship between the value of money and the supply of money, that represents a definite challenge.  Coinbase will be issuing a pre-announced dollar value of the Bitcoins.  If their rate of issuance is less than the Central Bank’s rate of issuance, the dollar value of each Bitcoin could increase.  If that is done without impeding its role as a medium of exchange, it could become a very appealing currency.

Nothing in this posting or the previous two (“When a Currency Is Working, It Isn't Questioned” and “Currency and the Role of Government”) represent an endorsement of the positions noted.  Regarding gold, The Hedged Economist’s perspective has been the subject of a number of postings.  Hopefully, this posting is clear regarding other substitutes for fiat currency that it references.

Any discussion of the future role of fiat currency contains a forecast.  As has been discussed in The Hedged Economist, forecasts are always scenario-based.  What is significant about the questioning of fiat currency discussed in this posting is that it reflects the fact that a large number of people can see a variety of scenarios under which fiat currency will lose its luster.  The sheer fact that so many observers can see so many different scenarios under which fiat currency is called into question is in-and-of itself significant.  Thus, even without a full scenario it is possible to determine some characteristics of how our fiat currency system will change.  That will be the subject of the next posting.

 

 

Currency and the Role of Government

An irrelevant issue.

It is interesting, but totally irrelevant, that the ECONOMIST magazine (“On the Origin of Specie,” Aug 18th 2012) delves into a long-standing debate in economics.  That debate is the issue raised in the title of this blog: what is the role of government in the process of establishing a currency?  The government's role regarding currency has an impact upon whether the different roles of money can be retained by one commodity regardless of whether that commodity is a slip of paper or a physical good.

The ECONOMIST discussion is made irrelevant by the application of totally circular reasoning.  The article states: “The evidence suggests that only “informal” monies can spring up purely privately.” But, the article's definition of informal money seems to be that it is not endorsed by the government.  The net effect is that the article says nothing relevant to the discussion of the role of government in creating a viable currency.

In fact, the author goes on to point out that “informal money can exist on the grandest scale.”  It uses the example of the dollar’s position as the world’s reserve currency as an example of a currency being adopted informally.  By using that particular example, the article illustrates the irrelevance of their definition of formal money.  A government endorsement does nothing but meet their criteria for formal money.  That endorsement is totally irrelevant to whether something functions as a currency.  All of the functions of currency are totally unrelated to whether it is “formal” currency.  Such circular logic in order to reach the conclusion that government has a role in defining the currency is unfortunate.

Many of those who argue that currency requires, or is dependent upon, government will at the same time point out the advantages to the government of having a central role.  One of the advantages is the ability to capture seigniorage (the difference between the value of the currency and the cost of the inputs).  That, however, represents the introduction of inefficiency, a cost to using currency.  Further, there is no particular reason why only government could capture that seigniorage.

The historical evidence is that government is no more reliable as the benefactor of that seigniorage than private entities.  In fact, a number of the examples that are often used to illustrate the role of government in establishing a currency could equally well be used to illustrate governments’ tendency to abuse seigniorage.

The argument often also recognizes why governments get involved in the development of a currency.  It allows governments considerable efficiency in taxing economic activity confiscating resources produced by the private sector.  If those who argue that government has an essential role in defining the currency would look closely at history, they would realize that often the definition of the currency is dependent upon the definition of how one can pay taxes.  So, the argument that government has an essential role in establishing a currency is reduced to an argument that governments can define how they will take resources from the private economy.  That is true, but proves nothing.

Viewed from that perspective, it isn't surprising that often those who favor a major role for government in the regulation of society also believe that government has an inherent role in defining currency.  By contrast, those who would see the government's role reduced are inclined toward allowing the market to define the medium of exchange.  One of the great dangers to strong central government is that a substantial portion of the population will facilitate trade by barter and start holding their wealth in a form that is hard to tax.  That makes it much harder for the government to confiscate a portion of the increased value generated by trade.

The ECONOMIST article is interesting in that it points out that a currency can end up functioning both as an informal, some would say freely chosen, medium of exchange, while also existing as a formal, government-endorsed, medium of exchange.  The example often given is that a country's currency can also become a freely chosen international reserve currency.  That has been true throughout history and was true of gold, silver, the British pound and now the US dollar. 

What is dependent upon government involvement is how quickly a currency can cease to be a viable medium of exchange and store of wealth.  Governments change their method of taking resources much slower than the private sector can shift to a new currency.  That follows automatically from the fact that governments are always responding to the medium of exchange.  It also can leave the government collecting money that is less and less useful as a method of commandeering resources. 

One only needs to recognize that economists developed a number of “laws” to explain how currencies function when more than one medium of exchange was in existence.  If there was a formal mechanism for stating that this is the currency, the issue of how multiple mediums of exchange function would never have existed.

The issue of the government's role would be irrelevant.  There is, however, no reason to believe that “bad money drives good money out of circulation” could not equally apply to where money circulates.  One currency could be of no use other than to pay taxes, while another is used primarily for trade.  That separation in the roles of currency is exactly what happens and is described in connection with international reserve currencies.  In most countries the native currency will be a medium for paying taxes, while that function is totally missing in the international reserve currency function. 

More generally, alternative methods of facilitating barter can coexist quite comfortably alongside of formal money without the tax-paying role of money being undermined.  There have always been methods of exchange other than formal monetary transactions.   Similarly, it is not the money itself that produces in the future.  Money is just a method by which current resources are channeled into something that produces in the future. 

Economists often brush over the third role of money: “it must be a unit of account, a useful measuring-stick.”  They just assume that it follows from the first two.  Yet, in some respects it is the most telling.  If people start calculating their wealth using something other than the currency or start thinking of prices in terms other than the currency, the role of money is clearly in question.  That questioning will be the topic of the next posting.

When a Currency Is Working, It Isn't Questioned.

Definitions matter

Economists are fond of defining money by enumerating its uses.  The ECONOMIST Magazine had an article on the topic.  It first reviewed the standard definition:

“Money fulfills three main functions. First, it must be a medium of exchange, easily traded for goods and services. Second, it must be a store of value, so that it can be saved and used for consumption in the future. Third, it must be a unit of account, a useful measuring-stick. Lots of things can do these jobs. Tea, salt and cattle have all been used as money.”

Economists do a substantial disservice to the public's understanding of the role of money by enumerating its potential uses as if they were all equally important.  As is discussed below, there are important caveats to the notion that money is a store of wealth.  If money is not channeled into something that produces in the future, there is no wealth in the future. 

ECONOMIST magazine goes on to describe the function of money as reducing the cost of barter (“On the Origin of Specie,” Aug 18th 2012).  The emphasis on reduced cost of barter has the advantage of automatically explaining the benefit of having a well-functioning currency.  There is tremendous benefit to society from making barter (trade) less costly.  It introduces tremendous efficiencies into the economy.  Reduced costs of exchange allow the same resources to produce more benefits to society.

Considerable controversy about monetary policy and the government's role can arise from placing different emphasis on “store of wealth” verses “media of exchange.” That can be seen immediately from the fact that inflation is inherently an issue "across time."  So, it relates only to the role of money as a store of wealth.  If one places a high value on the role of money as a medium of exchange and a low value on the role as a store of wealth, one’s policy conclusions will be different from those of somebody who inverts those priorities.

The focus on making barter efficient can lend perspective to this often contentious debate.  The role of money as a store of wealth can be viewed as making barter more efficient.  However, in the case of "store of wealth" the barter is across time.  Essentially, the store of wealth function of money relates to only a subset of the broader category of medium of exchange. 

Monetary theorists do not seem to realize that the issue of whether the different roles of money can be separated is more important than the emphasis on specific aspects of the role of money.  Clearly, they can be separated for prolonged periods of time.  Further, there is a distinct possibility that too much emphasis upon the role for money as a store of wealth is counterproductive.  Wealth can never be produced by money.  It is always produced by the effective deployment of resources to produce in the future. 

If a substantial portion of the population does not know how to use current resources to produce in the future, money may have a default role as a store of wealth.  When money fills that default role as a store of wealth, it becomes a mechanism by which society can transfer current productive effort into the future, but for that to happen the money must be entrusted to someone who can effectively use it to produce in the future.  In that respect, the size of the financial service industry, or at least its importance, is inversely related to the portion of the population who know how to productively employ resources.  If few people know what to do with money other than spend it, they need a large financial service sector to channel resources into future production.

Differences in the emphasis placed on the various functions of money are often assumed to relate primarily to one's balance sheet.  Specifically, the role as a store of wealth is far more important to those with wealth.  Those with debt, on the other hand, do not want money to function well as a store of wealth.  They benefit from a depreciating currency. But they will care whether it is an effective means of exchange. 

A strong argument can be made for the position that the wealth is not the cause for the attitude about the importance of money as a store of wealth.  Both the wealth and the belief that money should serve as a store of wealth reflect an individual's preference for income in the future rather than immediate consumption.  The inverse is also true.  Those who think the exchange value of money (i.e., the ability to spend it) is most important probably are those most anxious to spend it now.

It never seems to occur to people that what applies to the individual may also apply to the entire society.  A society that is wealthy and producing wealth may lean toward a stable currency, while a society in decline where wealth and income are falling favors a currency that is declining in value along with their income and wealth.  What is not clear is the direction of causality.  Does a society with growing income and wealth want a stable currency?  Or, does a stable currency produce rising income and wealth within a society?

Basel Negotiators Actually Have Their Heads Screwed On

They are focusing on the right issue

Readers of The Hedged Economist are aware that this blog is hardly a fan of those developing the Basel banking regulations.  Yet, it does appear that they actually understand what the risks to banks are.  On January 7, 2013, the WALL STREET JOURNAL had an interesting article on the status of the Basel negotiations.  It appeared under the title “Rules for Lenders Relaxed: Regulators Agreeto Ease Requirements for Meeting Guideline on Liquidity.”

It is interesting that the reporter discussing the regulations presented the changes as “Global banking regulators watered down a key element of their plan for creating a safer financial system, giving ground to banks…”  Perhaps, the reporter was a former sportscaster and does not understand that financial regulations have financial implications.  This is not a game where one side wins the other side loses.  Either side could win or lose with disastrous results.  The purpose of the regulation is the results they achieve, not the game itself.  The article goes on to explain that the regulators made the changes in response to the fact that banks “argued the rules were unworkable and financially risky [emphasis added].” 

As will be explained below, on key issues the article is wrong about the rules being watered down.  The article discusses Basel regulators decisions on the most important issue: liquidity.  Unfortunately, the article treats, liquidity, as if it were posted to a scoreboard.  What is overlooked is that the very definition of liquidity is what was being negotiated.  Viewed from that perspective, the changes may represent a strengthening of regulations.

As was discussed in “It's a Wonderful Life’ OnRegulatory Policy: The Real Risk,” the maturity mismatch characteristic of banking is unavoidable.  Their liabilities are short run while their assets are long run.  The classic example is that deposits can be pulled without advanced notice, but the banks’ loans cannot be called immediately.  Consequently, the greatest risk to banks is that they will not have the liquidity to meet withdrawals.

Where the article goes astray is in its assessment of what produces liquidity.  For example, it reports that “The liquidity rule requires banks to be holding enough liquid assets—originally limited mostly to cash and government bonds—to be able to withstand an intense 30-day liquidity crisis similar to what occurred in fall 2008.”  Under mark-to-market accounting, the value of government bonds can drop as much or more than many other assets.  US investors only have to remember what happened to government bondholders during the 70s and early 80s when government bond holders got crushes.  Europeans, on the other hand, have a more recent example in Greek bonds.

Liquidity is not just being able to sell an asset: it also involves not taking a bath or losing one’s shirt when the asset is sold.  An asset is only liquid if one can get a decent price for it.  To ensure that they would have some assets that were retaining their value, banks lobbied for the inclusion of a large number of “high quality liquid assets.”  Their contention was that it should include a diverse array of assets: “everything from blue-chip stocks to mortgage-backed bonds to stashes of gold.”  It took the European debt crisis, which has seen some governments' bonds become junk-rated and illiquid, to convince the Basel Committee that a diversified portfolio provided liquidity better than a portfolio concentrated on a single set of investments.

It is easy to understand why it took the European financial crisis to impress upon the Basel Committee the simple fact that a diversified portfolio is liquid.  One only has to look at how this rather commonsense change in their focus is being reported to realize that they suffer from broad media and public lack of appreciation of investment fundamentals.  Keep in mind this article was taken from the financial press.  One would hope the financial reporters would have a better understanding of investment fundamentals. Still, one has to wonder why the Basel Committee did not immediately recognize the legitimacy of the banks’ arguments. 

More than once The Hedged Economist has commented on the excessive dependence on theoretical models of portfolio performance characteristic of the Basel regulations.  Perhaps, the Basel Committee has problems applying their quantitative rigor to more than one asset at a time.  But clearly, a diversified portfolio will, under most circumstances, including a financial crisis, provide more liquidity than a concentrated portfolio. 

Interestingly, what is totally missing from the discussion of liquidity is hedging.  As discussed in a previous posting (“It's a Wonderful Life’ On Regulatory Policy:Focus”), hedging is an important way banks address the maturity mismatch inherent in their business.  What is curious about the absence of reference to hedging is that the OCC is well aware of the role of hedging.  As was pointed out in the previous posting, the former Chief Counsel for the OCC identified the “whale trade” as a likely hedge and a routine aspect of banking.

Given that the Basel III regulations rely heavily on quantitative measurement of risk associated with various investments, one is surprised that they would not extend that analysis to include hedging strategies.  Those familiar with The Hedged Economist probably noted a high degree of skepticism about the quantitative measurement of risk and hedges.  But, the techniques are necessary at bank, and they are extremely effective when applied with the appropriate level of skepticism about the quantitative measurements.

The thought of the Basel Committee looking at hedging strategies is a little bit scary.  The problems with the quantitative methods they use include that they assume a determinant variability of asset prices, and what is even scarier is that they often assume constant variability of asset prices.  The models assume that there is always a market.  Therefore, when addressing liquidity, the assumption of constant variability implies something close to constant liquidity.  Thus, there is a risk that their quantitative methods will assume away the problem regulators should be addressing.  They have not developed models that predict market discontinuities (i.e., interruptions in liquidity).

The article goes on to report other changes that were made.  While the folly of how the article addresses the source of liquidity is apparent, the balance of the coverage does address serious questions about the extent of liquidity banks should be required to hold.  But note that it is the extent of liquidity that is now the focus not the source of liquidity.  No change in the intended amount of liquidity would have any significance if the definition of what is liquid was wrong.  Consequently, while “watered down” may seem more justifiable with respect to the amount of liquidity, it's a quite hollow description without first defining liquidity.

The article uses as an example of the amount of liquidity required.  It states: “the original rule stated that banks needed to assume that, in a theoretical 30-day crisis, they would see 5% of their retail deposits vanish. The banking industry argued that was unrealistically harsh. Sunday's [January 5^th] rule lowers the level to 3%. And instead of assuming that corporate clients would draw down their credit lines by 100% in a crisis, the figure has been changed to 30%, a shift that significantly lowers the amount of liquid assets banks need to have on hand.”  One can draw his or her own conclusions about which scenarios are more realistic for a financial crisis in the 21st century, but, clearly “watered down” is an accurate reflection of the changes in the amount of liquidity.

One has to congratulate the Basel Committee for addressing the right issue.

“It's a Wonderful Life” On Regulatory Policy: Crimes Verses Mistakes

Ignoring theft

The third deficiency of the current regulatory focus presents less of a systemic risk to the financial system, but clearly creates a substantial risk of the different type.  One can hardly consider regulations just if they overlook stealing. 

Perhaps the policy wonks should come up with the simple regulation that overrides all their other regulation and states simply “no other regulation implies a right to take other people's money.”  It is when until uncle Billy loses a deposit, in other words until money disappears, that regulators and law-enforcement become involved.  In “It's a Wonderful Life” misappropriation of the depositors’ funds is among the most serious charges Potter levels at George when Potter really wants to be nasty. How refreshing!

The media, bank regulators, the judicial system, and policy wonks all seem to be totally unable to distinguish between out-and-out theft and perfectly honest activities.  For example, on Christmas eve day, the same day the WALL STREET JOURNAL reported the investigation into Regions Financial, the paper had an article entitled “MF Global Trustees Cut 'Gordian Knot.”  This second article reported on the current status of efforts of the courts in relation to MF Global”s bankruptcy. It was an amazing juxtaposition of a complete failure of our legal system and the waste of our regulatory system.

Recall that the banks are not being accused of taking depositors’ money: what has been in question is how they were investing it for the depositors.  Regulators are focusing on issues such as: Whether investments were prudent, were reserves adequate for the types of investments being made, and did banks adequately disclose their investment activity?  Those are important issues but pale compared to ensuring that no one is just stealing the money.

The situation at MF Global is totally different from that of the regulatory focus.  As the article reports: “In the months after the bankruptcy, trustees estimated that about $1.6 billion in customer money had been moved from its proper place in MF Global's final days.”  It's incredible that no one explicitly states the money was stolen from customers’ accounts.  These were not funds deposited with MF Global for use by other than the owners.

One should note this is very different from the example of Prime Reserve, a mutual fund that broke the buck.  In that case, the funds were at all times invested within the mutual fund for the benefit of mutual fund owners.  In the case of MF Global, funds from depositors were pledged, (i.e., loaned), and the proceeds used for the benefit not of the depositors but of MF Global.  In short, they took the depositors money and used it for their own benefit.  It is the possibility that a similar event occurred at Bailey Building and Loan that brings the law into play in “It's a Wonderful Life.”

MF Globel involves a violation of depositors’ intent as well as a phenomenal demonstration of dishonesty on the part of MF Global’s management.  It is a regulatory disgrace that this could be done.  So, one would suspect that given the emphasis on reforming our financial system there would be severe penalties for those involved and a serious effort to ensure that such regulatory loopholes are eliminated.  Instead, as reported in the WALL STREET JOURNAL article, the result is an agreement that “signaled a new détente over how money from the eighth-largest U.S. bankruptcy should be distributed and whether creditors or former customers of the company's brokerage operations should take precedence.”

“Regulators and plaintiffs' lawyers also are looking into MF Global's bankruptcy. Plaintiffs' lawyers have sued Mr. Corzine and other former executives of the firm, hoping they could win funds to compensate MF Global customers.”  One is forced to ask:  Why in the world is it necessary for customers to sue in order to get their money?  Common sense would suggest that one of the primary purposes of financial regulation should be to ensure that people do not steal other people's money.  Instead our regulators set up a framework that allows them to pursue trivial issues while ignoring what was clearly intended as a misappropriation of funds.

It isn't any wonder that there is active opposition to regulation?  Regulators have no one but themselves to blame for it.  They are not focusing on institutions that represent the greatest risk.  In addition, they seem to be more interested in pursuing witch-hunts, then protecting individuals from dishonest behavior.  The Hedged Economist considers this nonsensical behavior on the part of regulators extremely unfortunate.  A healthy regulatory environment would go a long way toward producing a more stable financial system and one that the public could trust.

“It's a Wonderful Life” On Regulatory Policy: The Real Risk

Not addressing systemic risk

Focusing on the wrong institutions may lead regulators and policy analysts to ignore the greatest risk to banks.  This second failing of regulatory and policy focus has serious implications beyond just the resources they are wasting.  Bank runs represent the source of the greatest risk that arises from the maturity mismatch.  They are far more serious systemically than any bank’s trades.  It is, after all, a bank run that threatens Bailey Building and Loan.  George tries to explain that to customers of Bailey Building and Loan.

Perhaps both policy discussions and regulatory initiatives should focus on the maturity mismatch.  Put simply, it is the greatest risk in banking and is far more likely to result in a financial crisis than any particular bank’s investment.  US policy wonks and regulators seem to have outsourced the entire issue to those negotiating the Basel III rules. 

Regulators and policy analysts should be trying to figure out how to assist banks in hedging the maturity mismatch.  US regulators seem to be doing exactly the opposite.  Remember, ultimately, it is only the ability to produce cash that saves Bailey Building and Loan.

Once one focuses on the real issue of the liquidity squeezes that create financial crises, TARP is neither the only nor the most important government program implemented during the financial crisis.  The government's Transaction Account Guarantee (TAG) as the name implies involved guaranteeing deposits.   As anyone at all familiar with American banking regulation knows, the FDIC guarantee of deposits was a primary response to bank runs during the depression.  What was different about the Transaction Account Guarantee program was it guaranteed all deposits rather than those below a limit.

A WALL STREET JOURNAL article published the day after Christmas discussed deposit guarantees. It focused on one of the issues deposit guarantees implemented during the financial crisis created.  As the article's title, “Small Banks to Depositors: Trust Us: Dec.31 Expiration of FDIC's Unlimited Guarantee Drives a Scramble to AllayCustomers' Concerns,” implies, runs remain a problem for small banks.  In fact, the primary argument that small banks make for continuing the guarantees is that they cannot compete for deposits without the guarantees.  They fear that if the guarantees are ended, they will experience runs as depositors shift their money to larger banks.

The article clearly demonstrated that maturity mismatches characteristic of banks are still the major systemic risk.  That risk is most immediate and threatening not at large banks but among small banks.  Instead of addressing that risk directly, regulators are off tilting at windmills.  Hedging and even proprietary trading do not create maturity mismatches.  In fact, when done appropriately they mitigate the risk introduced by maturity mismatches.

Probably nothing illustrates the confusion better than how one of the small banks is trying to encourage depositors not to withdraw their deposits.  The article quotes Keith Costello, chief executive of Broward Bank of Commerce. "We are telling our customers that we have a loan portfolio that has no nonperforming loans, which is a very clear statement that our bank is very solvent, very safe and very secure."  

Under mark-to-market accounting, what matters is not whether the loan is performing or not.  Market value and liquidity are what determines the solvency of an organization.  Performing loans do not necessarily meet the liquidity requirements that can be created by a run.  When a run occurs, performing loans may have to be sold at distressed prices in order to meet emergency liquidity requirements.

The systemic risk that this creates was highlighted in a WALL STREET JOURNAL article on December 30, 2012 (“Gauging the Guidance That ModelsGive the Fed”).  The article describes how the Fed uses various models of the economy and the financial system to predict the future course of the economy.  Those predictions are then used to determine what the appropriate Fed policy is.

It goes on to note the limitations of the model with the following quote: “But here is the problem: The models are deeply flawed. They failed to foresee the financial crisis in 2008 and have tended to overestimate the strength of the economy for several years.”  The article is not being at all alarmist.  As it notes, “Of course, no model or human can perfectly predict the future.” 

The problem is not that the models are less than perfect.  From the perspective of regulatory policy, the problem arises from the sources of the gaps in how they read and project the economy.   “One of the biggest is that they have ignored the nuances of the financial system—one of the primary channels through which Fed policy works.”  This is a pretty explicit statement that their models are not a useful tool in directing regulatory policy, and that their models do not reflect the risks that can arise from misguided regulation.

It goes on to make those risks rather explicit.  “The models have formulas that predict how many pennies an investor will spend for every $1 increase in his stock-market portfolio or how much less banks might lend if interest rates go up half a percentage point. But they haven't predicted the vulnerability of banks to a financial panic or how that vulnerability affects the broader economy [emphasis added].”  In short, a principal Fed policy tool provides the Fed with information that has a big blind spot.  That blind spot relates to the greatest source of systemic risk arising from the financial system.  One can call that risk bank runs, liquidity squeezes, financial markets freezes or financial panics.  They should be the primary focus of regulation.

“It's a Wonderful Life” On Regulatory Policy: Focus

Focusing on the wrong organizations

Let's start with the waste inherent in focusing on the wrong institutions.  The WALL STREET JOURNAL had an article entitled “Probe of Big Bank Widens: SEC, Others ExaminingWhether Regions Financial Improperly Classified Bad Loans” As it reports, “Federal agencies are examining allegations that Regions Financial Corp. (RF) improperly classified loans that went bad during the financial crisis, according to depositions filed as part of a civil lawsuit against the large southeastern U.S. bank.”

One shouldn't misinterpret the focus of these comments.  As pointed out in the last posting (“It's a Wonderful Life’ is truly a gift that doesn't stop giving”), the accounting practices of financial institutions present a serious problem to investors.  As the WALL STREET JOURNAL article puts it, “transparency of accounting decisions at major banks became a major concern for investors...”  There is nothing wrong with that statement.  Also, this posting does not imply any judgment about Region’s accounting practices.  The issue is whether the resources could be used in other ways that would provide greater benefit. One does not need to judge Region’s accounting to see some policy folly. 

What is curious and shows a short sightedness of much of our policy is the timeframe the article seeks to establish for the need for transparency.  They go on to say that the concern arises as “questions on the subject continue to bubble as financial firms' crisis-related cases wind their way through the courts,” and the article treats the issue of transparency as if it only relates to practices that occurred “during the financial crisis.”  As any investor knows, that is pure hogwash.

The problem is that it is not just the reporter who gets this wrong.  Consider the reported origins of the investigation.  The article reports “The Regions depositions emerged as part of a lawsuit brought in 2010 by two pension funds that own Regions stock. The funds allege that Regions hid problems by moving loans out of nonaccrual status, which means interest payments were overdue and collection of the principal unlikely. Rising nonaccruals typically force banks to increase reserves for loan losses, a move that eats into profits. A lawyer for the funds declined to comment.”

Is it any wonder that “a lawyer for the funds declined to comment?”  Pensions have a fiduciary responsibility, and one has to wonder where was the pension manager’s due diligence if they only noticed accounting irregularities during the financial crisis.  If accounting irregularities were there, they didn't start with the financial crisis.  Further, it seems to me that an objective analysis of the practices used to establish reserves would not flag pensions as particularly good judges.  For the lawyer to have commented might have presented a real case of the pot calling the kettle black. 

As the article reports, the investigation reflects a “widening U.S. scrutiny of the lender as regulators and federal investigators step up their surveillance of the methods banks use to classify loans or reserve for losses.”  What policy wonk or bureaucrat came up with the notion that bank reserves at large regional banks are the highest priority for scrutiny?  Although not the purview of bank regulators, from a policy perspective, it would make more sense to focus on pension funds, especially public sector pension funds.  Many pensions, especially those in the public sector, have been deceiving pensioners regarding reserves for years.  It would have been nice if the article had reported whether there was any evidence that pensions’ lawsuit reflects an effort by the pensions to compensate for previous failures in the pension funds’ reserve policies.

Focusing just on banks, large regional banks hardly seem to be highest priority.  One should recall from previous postings that TARP repayments would indicate that it was smaller banks, not large regionals, that proved to be insolvent during the financial crisis.  So, based upon the TARP experience, when the issue is solvency, the bank regulators may be focusing on the wrong banks.

The folly of the regulatory practice was illustrated again in another article on December 27, 2012 in a WALL STREET JOURNAL article entitled “Whale' Capsized Banks' Rule Effort."  It focused on the J.P. Morgan Chase (JPM) trade that resulted in extensive press coverage.  The first thing to note is that the J.P. Morgan Chase trade involved significantly less money than the article on TARP indicates that smaller banks have cost the federal government.  Second, it should be noted that the J.P. Morgan Chase trade cost the bank profitability, but cost the federal government nothing.  That outcome appears, at least to this analyst, to be totally appropriate.

The more important point that many of those framing policy do not seem to understand was highlighted by Julie Williams, The Chief Counsel for the OCC at the time.  As she put it, “such trades were likely part of the bank's regular course of business….  They were likely hedges….”  If that is true, then much of a critique of the trade, and citing it as justification for the Volcker-rule is totally misguided. 

It is unfortunate that many people reach the conclusion that the fact that traders lost money “demonstrated the risks posed by proprietary trading at large banks.”  Quite to the contrary, the conclusion that people are reaching demonstrates, not risk to the bank, but naivety on the part of the person reaching the conclusion.  Put simply, not every trade is designed to make money.  The people who think they have to make money on every trade are incredibly naïve.  They seem to totally lack any understanding of the purpose of a hedge or the reality of investing.  Unfortunately such nonsense seems to be guiding many of the people formulating policy.

As the article points out, portfolio hedging is often designed to protect against losses across an entire portfolio.  J.P. Morgan Chase’s loss on the “whale trade” may have allowed it to hold other investments that resulted in a much greater profit.  The first obligation of anybody who wants to reach a policy conclusion from the “whale trade” is to show that it was not intended to hedge other portfolio risks.  That is far more difficult than just determining J.P. Morgan Chase’s aggregate profitability or loss during the quarter.  There is no reason to assume that J.P. Morgan Chase was not hedging other investments that will yield a return in another period.   Maturity mismatches are extremely common in banking.

It is possible that the loss represented a miscalculation of the extent or timing of the hedge.  It is important to keep in mind that when a bank’s investments are not hedged, also involves a maturity mismatch.  So, a miscalculation on timing, or even on the extent of the hedge, may have been less damaging to the bank than if it had left its investments unhedged. 

Regulators seem to be chasing headlines in stead of trying to facilitate a functioning financial system.