Banks might be forced to buy government bonds …

The G-20 leader’s summit in the US at the moment will consider new banking regulations. In September 2008, the Basel Committee Banking Supervision (BCBS), via its Working Group on Liquidity released its revised principles for liquidity risk management and supervision. This week, the Australian Prudential Regulation Authority (APRA), which oversees the financial system released a consultation paper which incorporated the revised BCBS principles. It has created a mini-uproar because it has proposals which will force the banks to hold increased volumes of government debt. But overall, while the impost on banks will be modest they are unnecessary. Once again, modern monetary theory provides different and cleaner insights into banking.

The Australian Financial Review carried a story (September 22, 2009) with the headline Banks face being forced to buy up government debt. I cannot link you to the article because AFR charge per view. That strategy won’t help them though because their circulation is declining fast. In 2007, the AFR has a circulation of 88,264 (Source: Australian Press Council. Its current circulation is 81,845 and it has fallen 8.4 per cent in the last quarter. It is thought to be a victim of the corporate cost cutting in response to the economic crisis.

The AFR article reported the new discussion paper put out by the Australian Prudential Regulation Authority (APRA) which it took to mean that:

Banks could be forced to buy up billions of dollars of federal and state bonds under new rules designed to ensure they are in a strong position to weather any future financial crisis … [the] … consultation paper includes a proposal that would require banks to increase their holdings of government-issued bonds because international regulators have decided sovereign bonds are the most reliable source of liquidity, The Australian Financial Review reported.

APRA is the prudential regulator of the financial services industry. It oversees banks, credit unions, building societies, general insurance and reinsurance companies, life insurance, friendly societies, and most members of the superannuation industry.

You can download the APRA consultation paper from HERE

So what does the APRA paper actually say and what does it tell you about the understanding of policy makers about the opportunities available to a government in a modern monetary economy?

To understand what this is about we have to go back to square one. The Basel Committee Banking Supervision (BCBS):

… provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. It seeks to do so by exchanging information on national supervisory issues, approaches and techniques, with a view to promoting common understanding. At times, the Committee uses this common understanding to develop guidelines and supervisory standards in areas where they are considered desirable. In this regard, the Committee is best known for its international standards on capital adequacy; the Core Principles for Effective Banking Supervision; and the Concordat on cross-border banking supervision.

So it operates within the Bank of International Settlements (the central bank of the central banks) ambit to maintain capital adequacy across the banking sector.

The BCSB convenes has seven working groups spread across Risk Management and Modelling, Research Liquidity, Definition of Capital and Capital Monitoring Group, Trading Book and Cross-border Bank Resolution.

In September 2008, the Working Group on Liquidity “issued Principles for Sound Liquidity Risk Management and Supervision, the global standards for liquidity risk management and supervision.”

You can view the Principles HERE or download the Full Text.

The BCSB’s Liquidity Principle says that:

Liquidity is the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses. The fundamental role of banks in the maturity transformation of short-term deposits into long-term loans makes banks inherently vulnerable to liquidity risk, both of an institution-specific nature and that which affects markets as a whole. Virtually every financial transaction or commitment has implications for a bank’s liquidity. Effective liquidity risk management helps ensure a bank’s ability to meet cash flow obligations, which are uncertain as they are affected by external events and other agents’ behaviour. Liquidity risk management is of paramount importance because a liquidity shortfall at a single institution can have system-wide repercussions. Financial market developments in the past decade have increased the complexity of liquidity risk and its management.

The BCSB consider that the current crisis has challenged our notions of liquidity in the financial markets where easy low cost credit turned into what the BCBS says was an evaporation of liquidity which has persisted for a lengthy period to date.

Within this scenario, they argue that it was only government intervention (via the central banks) that supported both the ongoing “functioning of money markets and, in a few cases, individual institutions.”

The BCBS claims that:

… many banks had failed to take account of a number of basic principles of liquidity risk management when liquidity was plentiful. Many of the most exposed banks did not have an adequate framework that satisfactorily accounted for the liquidity risks posed by individual products and business lines, and therefore incentives at the business level were misaligned with the overall risk tolerance of the bank. Many banks had not considered the amount of liquidity they might need to satisfy contingent obligations, either contractual or non-contractual, as they viewed funding of these obligations to be highly unlikely. Many firms viewed severe and prolonged liquidity disruptions as implausible and did not conduct stress tests that factored in the possibility of market wide strain or the severity or duration of the disruptions. Contingency funding plans (CFPs) were not always appropriately linked to stress test results and sometimes failed to take account of the potential closure of some funding sources.

To overcome these perceived problems, the Basel Committee recommended among other things that banks have detailed guidance on “the maintenance of an adequate level of liquidity, including through a cushion of liquid assets”. They consider that holdings of sovereign debt to be an ideal liquidity buffer.

Relatedly, the G-20 summit in the US will allegedly “endorse action on liquidity rules as part of wider reforms to the global financial system covering limits on executive salaries and caps on bank capital.” The rules to be endorsed are the BCBS Principles issued in September 2008 and currently under further review by the working groups.

The IMF has also issued its latest World Economic Outlook which advocates that governments should not withdraw their support to the economy in general or the banking system in particular in the immediate future.

In the Consultion paper, APRA note that its principles do not fully comply with the new principles issued by the BCBS (particularly the current Prudential Standard APS 210 Liquidity). The first question they address in this context is the definition of a liquid asset for stress-testing purposes. On Page 16 of the consultation paper under liquidity, APRA says:

During the long period of benign conditions prior to the global financial crisis, APRA observed an inclination for ADIs …. [Bill notes: Authorised deposit-taking institution] … to lower the quality of liquid asset buffers in a search for return, with little apparent loss of marketability. More recently, the working definition of a liquid asset seems to have become any asset which is eligible collateral with a central bank, regardless of the extent to which acceptance of such collateral could be considered an extraordinary central bank response to the crisis.

They go on to argue that the “international consensus amongst prudential supervisors is that liquid assets should be high quality assets that can be readily sold or used as collateral in private markets, even when those markets may be under stress. As a backstop to the robustness of the liquid asset buffer, liquid assets should also be eligible central bank collateral for normal market operations.”

They consider this defintion should be incorporated into APS Principle 210 and that:

In most currencies, sovereign bonds will be the assets that most clearly satisfy these criteria.

But implementing this rule will be a problem in Australia. Why? Because the previous federal government ran increasing budget surpluses and ran down the stock of outstanding government bonds. As a consequence, the APRA consider that:

… it may be the case that the AUD-denominated stock of assets satisfying APRA’s proposed liquid asset definition is insufficient for the aggregate need of ADIs. If so, APRA will consider permitting some limited portion of the liquid asset buffer to comprise assets that are Reserve Bank of Australia (RBA) eligible collateral for normal market operations as the sole criterion.

The Consultation paper then proposes that the banking industry suggest other AUD-denominated assets that would also satisfy this definition.

The AFR article reported that “banking representatives will meet with APRA … to discuss the new liquidity rules amid concerns about the impact on their profits of shifting into government securities.”

Consistent with their role speaking on behalf of a highly profitable and now government-guaranteed oligopoly (the four banks), the Australian Bankers Association was reported as saying that Australia should not be bound by “world practice”.

They were reported in the AFT as saying:

“Ultimately. APRA must come up with a regime which is suitable for Australia and use discretion when justified.

So special pleading is already being refined to meet this perceived threat.

Some of the more extreme reaction reported has been that this gives the federal government “carte blanche” to go further into debt to fund wasteful spending programs although they will clothe the spending binge within a claim that they are enforcing this rule to help stablise the banks.

The neo-liberal line is that by forcing the banks to invest in sovereign debt, the taxpayers get screwed. One iten I read (no link – it is too stupid) reinforced the notion that “the money will find its way into equally unprofitable investments such as bridges, schools and roads”.

But the sensible discussion is focused on the reduction in bank profits that would occur. In 2008-09, banks held $3,430 million worth of Commonwealth Government securities compared to total assets of $2,591.08 billion. So less than 1 per cent (0.74 per cent).

The AFR article says that the reason the banks think this will cut profits is that they would “have to hold liquid assets to tide them over a four-week crisis with no new outside funding while meeting expected withdrawals from depositors”. At present they are expected to meet only a week-long crisis.

The profit hit comes because the liquid assets generate lower returns.

One commentator quoted by the AFR article says that the banks will have to increase their “holdings of government securities from $19 billion now to $120 billion by the end of next year” which will allegedly drive up the price of government bonds. The $19 billion refers to federal and state debt.

Coming from a modern monetary perspective, the underlying view that the banks require a stock of liquidity to satisfy prudential standards reflects a misunderstanding of where regulation should be focused. The BCBS Principles all think that it is the liability side of banking that requires strict supervision. The reality is that supervision should not be focused on the liability side of the bank system.

In that context, however, the proposal that banks be forced to hold a certain volume of government securities amounts to a small bank tax. In Australia, given that thebig four banks are making increasing profits and gaining market share under the wing of the government deposit guarantee without any requirements being imposed on them in return, a small bank tax will not interfere in their operations at all.

But consistent with what I wrote in the blog – Operational design arising from modern monetary theory – a thorough understanding of the operations of the banking system accompanied by the practice whereby the central bank lends unsecured at the target rate of interest to the member banks however much they require would eliminate the need for these principles.

It would also eliminate the industry of parasitic consultants and advisors who the banks turn to to guide them through the legislative and supervisory laybyrinth.

But moreover, given that I would not issue government debt in the first place, the principle would have no place in my supervisory framework.

Further, if you have a secure system of bank insurance in place, then regulation should focus on the asset and capital side of the banks. So the sort of issues that should be at the core of the new regulation system are to determine which assets banks will be allowed to hold and which institutions are able to purchase government insurance based on how they advance the goals of the government which to a modern monetary theorist always start with the advancement of social welfare and public purpose.

One reform necessary in Australia is to implement a system of bank insurance.

More another day on how to supervise banks.