Carney: Central Planning = Good

PrefBlog’s Department of Thesis Title Suggestions has another offering for aspiring MAs and MBAs: is the period of market ascendence over? I suggest that it is arguable that the fall of the Soviet Union in 1990 brought with it a period of free-market ascendency: behind every political and regulatory decision was the knowledge that central planning doesn’t work.

However, the Panic of 2007 has brought with it the knowledge that free markets don’t work either, and 1990 is ancient history, of no relevance to today’s perceptive and hard-nosed bureaucrats. So the pendulum is swinging and the pendulum never swings half way.

In his role as a leading proponent of central planning, Bank of Canada Governor Mark Carney gave a speech today titled The Economic Consequences of the Reforms:

Consider the jaded attitudes of the bank CEO who recounted: ―My daughter called me from school one day, and said, ‗Dad, what‘s a financial crisis?‘ And, without trying to be funny, I said, ‗This type of thing happens every five to seven years.‘‖

Footnote: J. Dimon, Chairman and CEO, JP Morgan Chase & Company, in testimony to the U.S. Financial Crisis Inquiry Commission, 13 January 2010

Possibly the most intelligent remark in the whole speech, but it was set up as straw man.

Should we be content with a dreary cycle of upheaval?

Such resignation would be costly. Even after heroic efforts to limit its impact on the real economy, the global financial crisis left a legacy of foregone output, lost jobs, and enormous fiscal deficits. As is typically the case, much of the cost has been borne by countries, businesses, and individuals who did not directly contribute to the fiasco.

This is true to a certain extent. Society is comprised of networks of relationships, some productive, others being a waste of time (do you believe that institutional bond salesmen are prized by employers because of their keen insight into the market and their uncanny ability to discern budding trends in the market? Ha-ha! They have a book of clients who will call them when the client wants to trade, that’s all). Humans form these networks with little more intelligence than an ant-hill; we only survive because recessions come along every now and then to sweep away at least a portion of the unproductive networks, leaving its participants to get new jobs, move, change their lifestyle and basically try again to form links to other networks that may, one hopes, be productive.

A financial crisis is larger than a normal recession, as Carmen M. Reinhart & Kenneth S. Rogoff have written. This has two effects – first, the number of inefficient networks that are swept away simultaneously is larger, and secondly a number of effiicient networks gets caught up in the frenzy and are swept away as well (they’re dependent upon the availability of credit. Trade finance took a beating during the crisis, for instance).

So yeah, financial crises are bad. But the most expensive North American bail-out has been GM (and is continuing to be GM, since they are being restored to health with the aid of electric car subsidies in addition to their usual welfare cheques) and GM was most certainly not an efficient network. The financial crisis was the trigger, not the cause.

Thus, we cannot blame all the pain on faceless bankers; much of it would have occurred anyway.

Carney claims:

By using securitization to diversify the funding sources and reduce credit risks, banks created new exposures. The severing of the relationship between originator and risk holder lowered underwriting and monitoring standards.

There is some doubt about this. The FRBB notes:

The evolving landscape of mortgage lending is also relevant to an ongoing debate in the literature about the direction of causality between reduced underwriting standards and higher house prices. Did lax lending standards shift out the demand curve for new homes and raise house prices, or did higher house prices reduce the chance of future loan losses, thereby encouraging lenders to relax their standards? Economists will debate this issue for some time.

It appears that this inconvenient debate will occur behind closed doors, as far as Carney is concerned.

Carney goes on to state:

In addition, the transfer of risk itself was frequently incomplete, with banks retaining large quantities of supposedly risk-free leveraged super senior tranches of structured products.

This is a clear failure of regulation, but we won’t won’t hear any discussion of this point, either.

These exposures were compounded by the rapid expansion of banks into over-the-counter derivative products. In essence, banks wrote a series of large out-of-the-money options in markets such as those for credit default swaps. As credit standards deteriorated, the tail risks embedded in these strategies became fatter. With pricing and risk management lagging reality, there was a widespread misallocation of capital.

footnote: See A. Haldane, ―The Contribution of the Financial Sector—Miracle or Mirage?‖ Speech delivered at the Future of Finance Conference, London, 14 July 2010.

An interesting viewpoint, since writing a CDS is the same thing as buying a bond, but without the funding risk. I’ll have to check out that reference sometime.

The shortcomings of regulation were similarly exposed. The shadow banking system was not supported, regulated, or monitored in the same fashion as the conventional banking system, despite the fact they were of equal size on the eve of the crisis.

There were also major flaws in the regulation and supervision of banks themselves. Basel II fed procyclicalities, underestimated risks, and permitted excess leverage. Gallingly, on the day before each went under, every bank that failed (or was saved by the state) reported capital that exceeded the Basel II standard by a wide margin.

So part of the problem was that not enough of the system was badly regulated?

In particular, keeping markets continuously open requires policies and infrastructure that reinforce the private generation of liquidity in normal times and facilitate central bank support in times of crisis. The cornerstone is clearing and settlement processes with risk-reducing elements, particularly central clearing counterparties or ―CCPs‖ for repos and OTC derivatives. Properly risk-proofed CCPs act as firewalls against the propagation of default shocks across major market participants. Through centralised clearing, authorities can also require the use of through-the-cycle margins, which would reduce liquidity spirals and their contribution to boom-bust cycles.(footnote)

The second G-20 imperative is to create a system that can withstand the failure of any single financial institution. From Bear Stearns to Hypo Real Estate to Lehman Brothers, markets failed that test.

Footnote: Market resiliency can also be improved through better and more-readily available information. This reduces information asymmetry, facilitates the valuation process and, hence, supports market efficiency and stability. In this regard, priorities are an expansion of the use of trade repositories for OTC derivatives markets and substantial enhancements to continuous disclosure standards for securitization.

This part is breathtaking. In the first paragraph, Carney extolls the virtues of setting up centralized single points of failure; in the second, he decries the system of having single points of failure. I have not seen this contradiction addressed in a scholarly and robust manner; the attitude seems to be that single points of failure are not important as long as they don’t fail; and they won’t fail because they’re new and will be supervised.

It is, however, the footnote that is egregious in either its ignorance or its intellectual dishonesty – one of the two. It has been shown time and time again that increased public information reduces dealer capital allocation, making the market more shallow and brittle (eg, see PrefBlog posts regarding TRACE. Additionally, see the work on what happened when the TSX started making level 2 quotes available back in 1993 or whenever it was. I feel quite certain that, somewhere, there is some investigation on what Bloomberg terminals did to the Eurobond market in the late eighties, but I’ve never seen any.)

Today, after a series of extraordinary, but necessary, measures to keep the system functioning, we are awash in moral hazard. If left unchecked, this will distort private behaviour and inflate public costs.

So, as part of the campaign to eliminate moral hazard, we’re going to have central clearinghouses? So it won’t matter if Bank of America does a $50-billion dollar deal with the Bank of Downtown Beanville, as long as it’s centrally cleared? And this will reduce moral hazard?

There’s another internal contradiction here, but I don’t think it will be discussed any time soon.

Another promising avenue is to embed contingent capital features into debt and preferred shares issued by financial institutions. Contingent capital is a security that converts to capital when a financial institution is in serious trouble, thereby replenishing capital without the use of taxpayer funds. Contingent conversions could be embedded in all future new issues of senior unsecured debt and subordinated securities to create a broader bail-in approach. Its presence would also discipline management, since common shareholders would be incented to act prudently to avoid having their stakes diluted by conversion. Overall, the Bank of Canada believes that contingent capital can reduce moral hazard and increase the efficiency of bank capital structures. We correspondingly welcome the Basel Committee‘s recent public consultation paper on this topic.

Carney’s proposed inclusion of senior debt as a form of contingent capital has been discussed in the post Carney: Ban the bond!. As has been often discussed on PrefBlog, this is simply a mechanism whereby bureaucrats can be given the power of bankruptcy courts, with none of those inconvenient creditors’ rights and committees to worry about. Just like the GM bail-out!

He then reprises the BoC paper on the effects of increased bank capitalization on mortgage rates, which has been discussed in the post BIS Assesses Effects of Increasing Bank Capitalization among others.

First, banks are assumed to fully pass on the costs of higher capital and liquidity requirements to borrowers rather than reducing their current returns on shareholders‘ equity or operating expenses, such as compensation, to adjust to the new rules.

Consider the alternative. If banks were to reduce personnel expenses by only 10 per cent (equal to a 5 per cent reduction in operating expenses), they could lower spreads by an amount that would completely offset the impact of a 2-percentage-point increase in capital requirements.

Second, higher capital and liquidity requirements are assumed to have a permanent effect on lending spreads, and hence on the level of economic output. No allowance is made for the possibility that households and firms may find cheaper alternative sources of financing.

The second point is critical. It seems quite definite that this will happen – if bank mortgages go up 25-50bp in the absence of other changes, then mortgage brokers will do a booming business. But he wants to regulate shadow-banks, too. And it will mean that shadow banks (or unregulated shadow-shadow-banks) will skim the cream off the market, leaving the banks with lower credit quality.

There has been nowhere near enough work done on the knock-on effect of these changes.

However, there are a variety of other potential benefits from higher capital and liquidity standards and the broader range of G-20 reforms.
First, the variability of economic cycles should be reduced by a host of macroprudential measures. Analysis by the Bank of Canada and the Basel group suggests a modest dampening in output volatility can be achieved from the Basel III proposals, as higher capital and liquidity allow banks to smooth the supply of credit over the cycle. For instance, a 2-percentage-point rise in capital ratios lowers the standard deviation of output by about 3 per cent.

So it would seem that we’re going to have another Great Moderation, except that this time irrational exuberance will not occur and we’ll live in the Land of Milk and Honey forever. Well, it’s a nice dream.

Greater competition commonly leads to more innovative and diverse strategies, which would further promote resiliency of the system. Greater competition and safer banks may also contribute to lower expected return on equity (ROE) for financial institutions. This, in turn, could help offset the costs and increase the net benefits discussed earlier.

These gains from competition could be considerable. The financial services sector earns a 50 per cent higher return on equity than the economy-wide average. If greater competition leads to a one-percentage-point decline in the ROE (through a decline in spreads), the estimated cost from a one-percentage point increase in capital would be completely offset.

Do all you bank equity investors hear this properly? What will the desired 1% decline in ROE do to your portfolio?

This was, quite frankly, a very scary speech.

2 Responses to “Carney: Central Planning = Good”

  1. […] PrefBlog Canadian Preferred Shares – Data and Discussion « Carney: Central Planning = Good […]

  2. […] my post reporting Carney’s last speech, I noted: These exposures were compounded by the rapid expansion of banks into over-the-counter […]

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