Sometimes everything comes together in unintended ways. That has happened to me this week. I…
Today I have been reading all the documentation surrounding the proposals issued by the Bank of International Settlements to reform the regulatory system for international banking. These considerations then took me to an interesting paper from Deutsche Bank where they refute (albeit unintentionally) much of the media hysteria about exploding government bond yields and bond markets “closing governments down” because their deficits are “ballooning out of control”. In fact, the DB Report shows categorically that within the new regulatory framework that the BIS (and hence the Australian Prudential Regulation Authority will introduce), there is scope for larger budget deficits. In terms of the state of the Australian labour market and the very slow growth that the world economy will experience in the coming years, a further stimulus package is necessary. The DB Report implies that the bond markets would welcome it. Curious?
Typically the financial market commentators all run a similar line. But there are times when the game becomes clearer – when self-interest actually discloses things that the popular media do not care to report. When these disclosures are made you get a picture into the true nature of the monetary system and the way the government operates within it and impacts on the non-government sector.
Special Pleading Classic One
One classic instance of this type of event occurred in Australia in 2002. At that time, the thinning of the federal bond market was a topic of discussion during the Review of the Commonwealth Government Securities Market.
At that time, the federal government had been running budget surpluses since 1996 and economic growth was only maintained by the massive buildup in household debt which kept consumption expenditure afloat. It was an unsustainable growth strategy because the private sector cannot increasingly accumulate debt.
The stock adjustments arising from the surpluses saw the outstanding stock of federal government debt fall dramatically as the government systematically undermined private wealth holdings. As this was occurring, the key financial market players who had been vehemently demanding the conservative government retrench the welfare state, public fiscal exit plans and introduce widespread deregulation (the cries never really change to they) started to realise that the thinning bond markets were not in the best interests.
The Review was announced after the industry had lobbied the federal government relentlessly to salvage their own corner of corporate welfare.
You can read the Treasury Discussion Paper along with all the public submissions, including that produced by The Centre of Full Employment and Equity (written by myself and Warren Mosler) if you are interested.
In our Submission, we addressed several claims made in the Treasury Discussion Paper, which was released to accompany the review. We also addressed the claims made by the Sydney Futures Exchange that by eliminating the CGS market the government would “deny superannuants an A$ denominated (default) risk free investment for their retirement planning at a time of an ageing population and in a mandatory superannuation environment.”
We noted that what is not often understood is that Commonwealth Government Securities (CGS) are in fact government annuities. That is, guaranteed income streams.
We also wondered whether the “free market” lobby that were making these points (about superannuation losing out) really wanted the private sector to have access to government annuities rather than be directing real investment via privately-issued corporate debt, as an example
The point is also applicable to claims that CGS facilitate portfolio diversification. Why would Australians want to provide government annuities to private profit-seeking investors? This clearly interferes with the investment function of private markets.
We argued that direct government payments be limited to the support of private sector agents when failures in private markets jeopardise real sector output (employment) and price stability. Later in the Report we detailed that this support should be largely confined to providing employment guarantees and that government endeavour be focused on the provision of first-class education, health, aged care and other activities which unambiguously advance public purpose.
In this context, we also demanded a comparison of this method of retirement subsidy against more direct methods involving more generous public health and welfare provision and pension support. No such comparison was ever forthcoming from the government or its private sector puppeteers who were both rushing to increase the surpluses and had actively promoted the reduction of welfare benefits that were being received by the disadvantaged Australians and wide scale deregulation and privatisation.
The financial markets had been leading voices at the time (and still) demanding the government cut its deficit and get the “public debt-monkey” off the back of the economy. The neo-liberal government fell into line and started to run massive surpluses (even though unemployment and underemployment was very high) and regularly announced how it was retiring the public debt.
It was truly ironical while the government was acting according to the wishes of the financial sector – once it became obvious that the “corporate welfare” part of the deal was threatened – the very same financial players sought reassurances from government that a minimum volume of public debt would be issued each year even though (in their own words) it was not required to fund any deficits – there were surpluses after all at the time.
It was incredible really that these characters who kept the line that debt is used to fund deficits – suddenly (but subtly) shifted their line demanding more debt even though there was in their own logic no need for it. The public never really were party to the debate – it was rather technical – and so they never really were exposed to the double-standards operating.
The whole Review and the subsequent decisions highlighted the hypocrisy of the “debt-monkey lobby”. It became clear to those in the know that the actual agenda operating was that the financial organisations (banks etc) wanted to get rid of all government support (welfare) unless it impinged on their own ability to live the high-life. Then it was fine.
In our Submission, we argued that the roles identified by IMF, Australian Treasury and the Sydney Futures Exchange among others for the government bond market are not justifiable on public good grounds. They were classic examples of special pleading by an industry sector for public assistance in the form of risk-free government bonds for investors as well as opportunities for trading profits, commissions, management fees, and consulting service and research fees.
Furthermore, and ironically, their arguments are inconsistent with rhetoric forthcoming from the same financial sector interests in general about the urgency for less government intervention, more privatisation, more welfare cutbacks, and the deregulation of markets in general, including various utilities and labour markets.
Specifically, government price level intervention into private markets is typically challenged by economists on efficiency grounds. What is not widely understood is that government bonds issuance is a form of government price level intervention in interest rate markets. The burden of proof falls on those arguing in favour of government bonds issuance to show that the market in question is incapable of viable operation without government intervention and will, unassisted, produce outcomes detrimental to the macro priorities of full employment and price stability. No such arguments have ever been convincingly presented.
We also noted a larger irony in the entire discussion – as all parties to the debate, including the Treasury omitted discussion of the primary role of government bonds in the context of a flexible exchange rate system – that is, to support the term structure of interest rates rather than to fund government expenditure. This omission subsequently undermined much of the validity of the arguments advanced.
Today … another classic case
I thought about this again today when I read a report published last Monday (February 22, 2010) from Deutsche Bank – Bond Supply – implications for Bank Liquid Asset Portfolios – thanks to The Age economics writer Peter Martin for the link.
The DB document (from its Sydney branch) notes that:
We think it very likely that the 2010 Budget will project a much lower peak in gross Commonwealth debt than was the case in the mid-year economic and fiscal outlook. While good news for the Government, a lower peak and the likely intent by the Government to start repaying this debt as soon as it can has implications for the proposed reforms to bank liquidity arrangements.
First, they are noting that our misanthropic federal government (at least when it comes to the unemployed) is talking big about getting the deficit back into surplus as soon as possible and reducing the debt burden we are allegedly leaving to our grandchildren. They have devised some ridiculous formulas (fiscal rules) that they will implement to achieve these aims.
The Government will never learn it seems. A return to the pursuit of surpluses will ultimately be self-defeating. For all practical purposes any fiscal strategy ultimately results in a fiscal deficit as unsustainable private deficits unwind. But these deficits will be associated with a much weaker economy than would have been the case if appropriate levels of net government spending had have been maintained.
The Government rehearses the conservative logic that by running budget surpluses they are “saving” and these “resources” are then able to be used by the private sector. The government sees a virtue in retiring net government debt. But a government surplus is an equal reduction in non-government net income and net financial assets.
This net income and resulting net financial assets serve as the “equity” that supports the private sector’s credit structure. By removing this net income and net financial assets, government budget surpluses undermine the credit structure, which ultimately readjusts to its reduced equity base as Hyman Minsky showed in his writings in the 1980s.
The economy will only sustain high levels of output after the government realises deficits sufficiently large to restore necessary income and equity to support an expanding private sector credit structure.
Further, the Government does not require budget surpluses to retire debt. The government can retire debt at any time it wants by using the RBA’s support rate rather than public debt for interest rate support when it net spends.
Additionally, the RBA always has the open option to purchase and thereby retire remaining public debt outstanding. Again, this simply exchanges one private sector asset, public debt, for another, RBA member bank balances.
While net taxation revenue will also retire debt, we repeat that this will ultimately not reduce cumulative government deficit spending and therefore in the long term not retire debt.
It is fare better to let market forces determine the level of government deficit spending. A fixed-wage Job Guarantee policy can attenuate any tendency towards financial instability and provide the “switch” between private and public sector employment over the business cycle, as well as provide an anchor effect to the price level.
I have always found it ironic that during a time of heightened appreciation of market forces, the option to let market forces determine the size of the fiscal deficit has not been open to discussion. But in saying that I do not find it surprising, as the presumed fixed exchange rate assumptions and restrictions take precedence.
Second, what about these “proposed reforms to bank liquidity arrangements”? Before I look at them we need some background.
Basel I and II
The Bank of International Settlements (BIS) convened the so-called Basel Committee on Banking Regulations and Supervisory Practices (known initially as the Cooke Committee) in 1974 in reaction to the growing international financial instability. The initial concern was to provide a level playing field in international banking. But declining capital levels would also come to the fore.
They sought to develop a common minimum standard of capital adequacy that all international banks should maintain. They wanted to ensure stability of the international financial system but allow the banks freedom to determine their own portfolio choices and allow competition.
As the potential for major international bank failure grew as risk levels were rising, the Basel Committee on Banking Supervision which at that time comprised central banks and supervisory authorities of 10 countries met in 1987. The work culminated in the Basel Capital Agreement published in July 1988 (which was called Basel I).
The methodology defined a “minimum” amount of capital that banks should retain – the minimum risk-based capital adequacy. You can read up on the details HERE
Several amendments have been made to the original accord.
The new approach to regulation no longer prescribed the asset composition of the banks’ balance sheets. Earlier approaches forced banks to hold certain types of assets (government bonds) in strict proportions. This system of regulation was ineffective because the banks were continually innovating and taking business “off the balance sheet”. For example, banks started to own finance companies which were not subject to regulation.
The Basel I approach, however, still gave banks a wide freedom to lend. But banks with high risk lending strategies were “forced” to hold a relatively high proportion of shareholder equity.
Sticking points were how to define capital (which was essential if they were going to impose capital adequacy.
Capital plays a very different role in the bank than it does in the corporation.
In the latter case, capital facilitates the transfer of ownership of assets, profits, etc to shareholders. Capital is also a means of raising funds through share issues. So that rising debt/equity ratios will usually push the cost of debt up and force the firm to resort to equity for further expansion.
But banks can have virtually unlimited leverage and the amount of debt a bank can raise depends more on its perceived safety than its debt/equity ratio. For a bank, the liability side does not exist purely to fund the activities of the bank. It is a part of the activities of the bank. They can (in theory) borrow whatever they need as part of their normal activities of intermediation.
An essential role of bank capital is to act as a buffer against losses. It is the last line of defence against losses.
Basel I defined a two-tiered capital classification:
- Tier 1 (Core Capital) – are funds permanently dedicated to the solvency of the company. They constitute the highest quality capital. They allow the bank to keep operating despite suffering some losses. It includes – Paid-up ordinary shares; Non-repayable share premium account; General reserves; Retained earnings; Non-cumulative irredeemable preference shares; Minority interests in subsidiaries.
- Tier 2 (Supplementary Capital) – is a less primary or reliable form of protection. Rather than being supplied by shareholders it is the product of the bank’s activities. It cannot be as easily converted into liquid funds. It includes – General provision for doubtful debts; Asset revaluation reserves; etc
They then defined the risk-weighed assets in the following way:
|Asset Type(s)||Weight (%)|
|Currency, gold, short-term (< 12 months) federal government bonds, Balances with the central bank||0|
|All other government bonds, claims on OECD governments, local currency claims on non-OECD governments||10|
|LGS and semi-government securities of non-commercial bodies (foreign and domestic), claims on banks (excluding long-term claims on non-OECD banks)||20|
|Loans secured by residential mortgage (for loan-to-valuation ratio is less than 80%)||50|
|Claims on non-commercial public enterprises, claims on corporations and NBFIs, housing loans (loan-to-valuation ratio > 80 per cent)||100|
Then the capital adequacy requirements were expressed in terms of a:
minimum capital ratio = Core Capital plus Supplementary Capital divided by Risk-weighted assets
The ratio of capital to risk-weighted assets had to be at least 8 per cent. Core capital had to be at least 4 per cent. This minimum applies to the bank and the consolidated group, except insurance company and funds management subsidiary operations.
The 1996 amendments introduced market risk. Market risk arises when there are price changes in debt instruments, equity, commodities and forex exposures. A bank’s market risk exposure is determined both by the volatility of the underlying risk factors and the sensitivity of the bank’s portfolio to movements in those risk factors.
Banks face market risk from a full range of positions held in their portfolios but the capital standards focus on the market risks arising from the bank’s trading activities. Thus market risk is considered to be a component of the trading activity and because the positions are marked to market each day they are more visible.
The substitution of the banks’ internal risk management systems for broad, uniform regulatory measures of risk exposure is said to lead to capital structures which more closely reflect individual bank’s true risk exposure. This refers to the use of an internal models approach.
The new guidelines also include qualitative standards. Any bank must be able to demonstrate that it has a sound risk management system. The risk estimates must be closely integrated with the risk management process.
Banks must keep credit control units separate from the units that generate the market risk exposure. The experience of Barings PLC contributed to this requirement. They must conduct independent reviews.
Basel I was not very effective for many reasons, including:
- There was only a partial differentiation of credit risk – the 4 categories in the table above.
- The 8 per cent capital ratio was static and didn’t reflect changing market circumstances (rising risk).
- There was zero recognition of the term-structure of credit risk – that is, they did not incorporate the “maturity of a credit exposure”.
- They did not properly recognise portfolio diversification effects.
There were other problems and this led to the 2007 Basel II Capital Accord. You can read all the changes introduced by Basel II HERE. Essentially it added “operational risk” (losses arising from human error or management failure) and defines new ways of calculating credit risk. New approaches to assessing these risk exposures were recommended.
The problem with the Basel framework is that it gave banks an incentive to underestimate credit risk. The banks are allowed under the framework to use their own models of risk assessment to reduce the required capital and increase returns. Part of those returns are the fabulously large bonuses that are now common in private banking.
It is clear the managers failed to allocate adequate capital as the risk exposure of their banks was increasing rapidly in the lead up to the crisis. It is clear that a system of self-regulation and the ability to under report risk failed.
Latest Basel developments
In December 2009, by way of reflection on the current crisis, the BIS issued a new paper – International framework for liquidity risk measurement, standards and monitoring – which proposes further changes to the international regulatory environment for banks.
This is the document that the DB Report I referred to above is talking about.
The BIS Discussion Paper notes at the outset that:
Throughout the global financial crisis which began in mid-2007, many banks struggled to maintain adequate liquidity. Unprecedented levels of liquidity support were required from central banks in order to sustain the financial system and even with such extensive support a number of banks failed, were forced into mergers or required resolution. These circumstances and events were preceded by several years of ample liquidity in the financial system, during which liquidity risk and its management did not receive the same level of scrutiny and priority as other risk areas. The crisis illustrated how quickly and severely liquidity risks can crystallise and certain sources of funding can evaporate, compounding concerns related to the valuation of assets and capital adequacy.
They say that a given a “key characteristic of the financial crisis was the inaccurate and ineffective management of liquidity risk” regulative changes have to be made to “for banks to improve their liquidity risk management and control their liquidity risk exposures”.
One of the changes to the Basel framework proposed in this document is the introduction of better liquidity risk supervision. In that context, they propose some new standards, one of which is the introduction of a Liquidity Coverage Ratio, which will represent “minimum levels of liquidity for internationally active banks”.
The BIS say that:
The liquidity coverage ratio identifies the amount of unencumbered, high quality liquid assets an institution holds that can be used to offset the net cash outflows it would encounter under an acute short-term stress scenario specified by supervisors. The specified scenario entails both institution-specific and systemic shocks built upon actual circumstances experienced in the global financial crisis.
You can see that the regulatory environment is shifting back towards asset composition – a focus which was abandoned when capital adequacy became the main regulative approach.
In the proposals, the BIS discuss what constitutes a reasonable definition of liquidity for these purposes. High quality assets would include cash, sovereign debt, non-central government public sector entities and a number of Supras (but conditionally specified).
These assets would have to comprise more than 50 per cent of the overall required stock.
The Australian Prudential Regulation Authority (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.”
In December, following the BIS publication, APRA released a discussion paper. You can read their detailed responses to the Basel proposals HERE.
Essentially, the main issue here is the definition of liquid assets. APRA considers that:
liquid assets should be high quality assets that can be readily sold or used as collateral in private markets, even when those markets are under stress … sovereign bonds will be the assets that most clearly satisfy these criteria.
Why does all this matter?
Back to the DB Report
The DB Report argues that the proposed BIS changes which APRA will oversee in Australia are being:
… developed against a backdrop of significant government bond issuance. Thus it envisages government debt forming a substantial portion of liquid assets. In the Australian context, this will not be possible – a point that will be emphasised by another significant downward revision to the projections of government debt in the May Budget.
Commenting on the implications of the proposals in the new BIS report, DB says:
In particular, it means that the stock of commonwealth and semi-government debt will almost certainly be insufficient for bank liquidity purposes. It is inevitable, in our view, that Supra and agency debt will be included in the pool of high quality assets as a consequence. But even this will not provide a large enough pool of liquid assets for the banks … unless the liquidity buffer is kept relatively small.
So what does that mean? Several things.
Bond yields are not affected by volume
First, the DB Report argues that:
… the prospect of less debt has much implication for the level of Australian bond yields. After all, to be consistent with our view that increased supply would not pressure rates upward we have to think that a smaller peak in supply will not push rates lower.
I wonder why News Limited and all the other right-wing lacky media outlets didn’t give this opinion (from one of the large investment banks) any exposure?
The reason is simple it would not have suited the uninformed hysteria that they pump out each day about yields exploding and bond markets refusing to fund government deficits.
The fact is that bond yields have barely moved over the course of the public debt build-up. Consider the following graph.
The first graph shows the weighted on Australian government Treasury note issues since March 9, 2009 to February 18, 2010. The data is from the Australian Office of Financial Management. The modest rise in yields has followed the movement in the RBAs target interest rate which was pushed up in late 2009.
There has also been a huge demand for the public debt in Australia. Consider the following graph which shows the time covered or bid-to-cover ratio which is just the the $ volume of the bids received to the total $ volumes desired. So if the government wanted to place $20 million of debt and there were bids of $40 million in the markets then the bid-to-cover ratio would be 2. Some people claim that this provides a signal of market appetite for debt.
Please read my blog – D for debt bomb; D for drivel … – for more discussion on this point.
First, the use of the ratio assumes it matters. It doesn’t because the Australian Government is not revenue-constrained so it could just abandon the auction system whenever it wanted to if the ratio fell to 0.00001.
Second, it is highly interpretative as to what the ratio signals. It certainly signals strength of demand but how strong becomes an emotional/ideological/political matter. Even if you believed that the government was financing its net spending by borrowing, then a bid-to-cover ratio of one would be fine – enough lenders to cover the issue. Some commentators think that 2 is a magic line below which disaster is imminent. There is no basis at all for that.
There is also no basis in the statement that a ratio above 3 is successful and by implication a ratio below 3 is unsuccessful. After all, anything above 1 tells you that some investors do not get their desired portfolio. That sounds like a failure to me.
The data is again provided by the Australian Office of Financial Management. Remember a ratio of 1 means that there is enough demand to match the issuance intentions of the government.
Not enough public debt
Further, DB is worried that if the federal government returns to surplus then the bond supply into the markets will dry up.
In this context they do some calculations based on estimated trends in budget parameters. They say:
If we assume for illustration purposes that a bank’s liquidity reserves needs to be 10% of assets, then the current Australian banking ‘system’ would need to hold a stock of around $200 billion in liquid assets. Even in a few years time the total stock of outstanding ACGB and Semi-government debt is unlikely to be much more than $300 billion … Hence under the Basel liquidity proposals the bank will need to own at least a third of the ACGB and Semi market within a few years – which implies a potentially significant maturity mismatch given that much of this debt is long-term.
While they go onto to discuss other related issues like the need for a “covered bond market” and Supra and AAA-rated agency debt to be included in the defintion of liquid assets for regulatory purposes the point and implications are clear.
While this case is not of the same ilk as the special pleading in the first vignette that presented above (from 2002), the points are clear. As new regulatory rules are introduced by prudential authorities, the demand for liquid assets by banks will rise. The demand is already high and not even close to exhaustion (see data above).
But these liquidity rules will expand the scope for debt issuance without invoking any unfavourable reaction from bond markets.
It also means that if the government wants to maintain the voluntary constraints that it imposes on itself to match all net spending $-for-$ with debt issuance into the private markets, it can also start issuing short-term Treasury notes (at lower yields) and reduce the long-term debt is issues. That would overcome the bankers’ concerns about maturity mismatch.
But the preferable solution is for the government not to issue any debt at all and just pay interest on reserves (preferably close to zero) which would satisfy the liquidity requirements of the proposed new regime.
While the banks would not want this option (because they enjoy the guaranteed public handout – income from the interest payments) it would be preferable from a societal perspective because the whole machinery of bond issuance could be abandoned – with the real resources freed (labour etc) to perform socially useful tasks.
As an aside, some people think the interest payments are not an income to the non-government sector in the sense that the tender price is usually discounted to incorporate the yield. That doesn’t alter anything other than the accounting entries. The non-government sector still enjoys a guaranteed return on the funds they put into the bond purchases.
Once again insights into how things actually work out there in real world land often come from odd sources and are usually disclosed when self-interest forces the discussion to get away from the hype and hysteria and instead focus on reality.
The DB Report, in my view, clearly is an example of that even though that was not their actual motive. They were lobbying for lower liquidity requirements and a broader spectrum of assets to be included in the definition.
But you can equally conclude that as the banking sector grows the appetite for more public debt would be substantial and yields would not be impacted by this growth in demand.
What this means is that under given the voluntary constraints that the federal government imposes on itself to match all net spending $-for-$ with debt issuance into the private markets, there will be considerably larger scope for the bond markets to absorb the public debt under the guidelines proposed by the BIS without pushing up yields.
That insight alone knocks the debt hysteria on the head.
Further, the budget deficit should expand until there is full employment. Given the spending preferences of the non-government sector, the effective and desirable limit on net public spending is reached when capacity is being fully utilised.
At present, we are a long way from that point. So a third stimulus should be implemented in the May Budget which will also ease the concerns of the bond markets who will welcome the extra high quality liquid assets in the face of new banking rules coming out of Basel III.
I also find it interesting that the popular media just ignores this sort of report but instead continually promote discussion papers and statements that present the hysterical side of the debate.
Finally, this is another example of “if only the public knew what the real story was – they would react and vote differently”.
That is enough for today!