Monday, July 17, 2017

Mervyn King’s “The End of Alchemy” – The Beginning of new Banking Regulation?

In 2016, Mervyn King has written a great book about money, banking, and the future of the global economy. In my view, the book is at least 20 years ahead of its time. What Mervyn King proposes to make the financial system crisis resistant is both simple and completely intuitive. But it’s probably too easy to be adopted today. The complexity of financial regulation is too much of a crowded place for consultants, auditors, middle managers, and regulators to be left desert…




The financial crisis is the result of a saving / spending disequilibrium.

If the economy had grown after the crisis at the same rate as the number of books written about it, then we would have been back at full employment some while ago.” If King writes this in his introduction, the obvious question is: Why do you add another one?

The reason is that King is convinced that the 2008/09 financial crisis is not about the failure of some overambitious bankers but the failure of the financial system as a whole:

The 2008/09 financial crisis actually starts in 1989, when the Berlin wall fell and the free market doctrine was going global: King explains how China, India, and the countries of the former Soviet Union started producing and exporting cheaper consumer goods for the developed world. Over time, this lead to an imbalance between the developed and the developing world:

  • The developing world was exporting and saving but not consuming.
  • The developed world was borrowing and spending but not saving.

However, the developed world borrowed less than what the developing world wanted to invest, thus leading to ever lower interest rates which accelerated the vicious circle. At one point in time, the borrowers could no more reimburse and the house of cards collapsed.


What is financial alchemy?

At the heart of King’s book is his concept of financial alchemy – the idea that money equals physical goods such as gold and other precious metals. The alchemy consists of the belief that banks take everyone’s deposits short term (because we can claim the same amount of money back at any point in time) and invest it long-term without any risk for the depositor. Indeed, this is only true if you trust the system (investors, bankers, central bankers, etc. - basically everyone who participates in the financial system) and your trust holds true. In practice, Mervyn King writes, financial alchemy simply doesn’t work.

But why? The reason is that risk diversification doesn’t work. The idea that our short-term deposits are safe although the bank invests them long-term is based on the idea that the bank can diversify the risk of its investments. Mervyn King says that diversification cannot contain risk: There are, indeed, economic crisis events when everybody moves in the same direction, thus making risk diversification meaningless.


Uncertainty – radical uncertainty – is the spice of life.”

But what are these economic crisis events all about? King tries to come closer to a meaningful explanation using the concept of radical uncertainty.

Probability forecasting is everywhere in finance: Mathematicians take data sets from the past and derive probabilities for future scenarios. King writes that this is ok for managing risk. Risk is exactly that – the nature of a future outcome that can be defined precisely and, based on past experience, can be assigned some probability of the outcome occurring.

However, probability forecasting cannot handle uncertainty. The latter describes situations where you don’t know the outcome and, therefore, neither the probabilities of them occurring.


How to avoid financial alchemy?

Given the problem of maturity and risk transformation, how can we make bank deposits safe? The author gives four possible solutions:

  • Suspend the withdrawal of deposits in times of economic crises: This seems impossible. Beyond the panic that would spread around the population, how would people pay for their transactions?
  • Government guarantee for bank deposits: This is where we are today, at least implicitly. But this is not ideal because it virtually subsidizes the banks and creates problems of moral hazard.
  • Revoke the possibility for banks to create limited liability companies: This would mean we go back a few centuries and abandon capitalism. But who would then want to run a bank?
  • The central banks replaces lost deposits with official loans to banks: This is what Mervyn King suggests. In such system, he calls central banks the pawnbroker for all seasons (PFAS).


LOLR vs. PFAS – Does it make a difference?

Today, in times of financial crisis, central banks are “lenders of last resort” (LOLR). They lend to failed banks if nobody else does any more – not to save any individual bank but to save the financial system as a whole.

Apart from taxpayers’ sentiment of injustice (“We pay for bankers who got high bonuses in the past for lousy work!”) LOLR involves two problems:

  • Providing emergency liquidity to a bank increases people’s incentive for a bank run.
  • Banks may be reluctant to accept central bank liquidity because of the implied stigma.
  • As LOLR, a central bank should provide liquidity; it should not, however, solve an underlying solvency problem. If it did the latter, it would actually help individual financial institutions and not the whole system and that is not what taxpayer money should be used for. But can anyone draw a sharp front-line between liquidity and solvency?

Acting as a pawnbroker for all seasons (PFAS), the central bank’s role in a financial crisis changes:

  • A PFAS is different from a LOLR in that the PFAS plans in advance for lending a specific amount of liquidity to any bank in crisis against a specific nature and amount of collateral that the bank provides.
  • The central bank doesn’t protect the financial system by protecting a specific bank. It protects the deposits directly, not because they are held with such or such bank but because they are backed by either cash or a guaranteed contingent claim on its reserves. This, obviously, requires that banks are obliged to hold a specific amount of cash or collateral to back deposits at any time.

Mervyn King suggests implementing the PFAS system over a period of 10 to 20 years and describes the following concrete functioning:

  • Each bank decides how much and which collateral it wants to provide to the central bank in case of a liquidity crisis.
  • The central bank examines such assets upfront and decides on the applicable haircuts (i.e. How much will this asset be worth during a crisis?)
  • The sum of these assets determines the maximum amount that a bank can lend.
  • The financial regulator determines the bank’s total effective liquid liabilities, i.e. the bank’s total demand deposits and short-term unsecured debt (up to, say, one year).
  • The total effective liquid assets should exceed the total effective liquid liabilities. This rule constitutes a form of mandatory insurance against a banking crisis.


Minimum Capital Requirements, Risk Weighted Assets, Leverage Ratio, Liquidity Ratio – Do we still need all this?

In Mervyn King’s world of banking and finance, the answer is no. The central banking committing upfront to lend at all times against predefined assets makes all these things unnecessary. A pity for all the regulators, consultants, and compliance staff but what a fantastic win over bureaucracy!

But would it really be easier to determine asset haircuts for PFAS than to determine risk weighted assets? The author says that “the possibility to calibrate risk weights is an illusion [because of the presence of radical uncertainty].” I would say more or less the same about the asset haircuts. If you cannot figure out the riskiness of an asset because you don’t know anything about the future events that will trigger a crisis, how can you possibly know what an asset will be worth in such crisis? But still, the beauty of King’s system is that the central bank engages upfront to lend instead of hypocritically denying the necessity for a LOLR if such and such financial ratio is met.

Mervyn King’s book is excellent. If you are interested in the banking and finance world, you should definitely read it!





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Mervyn King – The End of Alchemy – 2016

Wednesday, July 5, 2017

Corporate Banking – How to turn around unprofitable clients

Compliance, minimum capital requirements and their reporting, technology,… Basically all hot topics in banking today cost money and don’t generate revenue. How can banks then remain profitable?

Bain & Company has looked at this question and, on May 16, 2017, published a short paper on the topic: The main message is to shift management attention from cost cutting and operational efficiency in back offices to managing corporate client profitability.


The bank’s corporate client portfolio

Bain writes that a typical corporate client portfolio looks like this:

  • 20 % generate economic profits (In addition, 5 % of this 20 % or 1 % of the total portfolio actually generate most value).
  • 50 % generate moderate value or just break even.
  • 30 % fall below the threshold for economic profit (In addition, 3% of this 30 % or 1 % of the total portfolio actually have the most negative impact).

The numbers seem pretty devastating to me. After all, should banks’ employees be motivated and fully client focused if 30 % of the latter destroys value and 50 % hardly generates any profit?

So what to do? There are basically two ways to tackle the problem:

  • You focus on the profitable customers and get rid of the rest.
  • You keep the rest and focus your attention on increasing their profitability.

Bain chooses the second alternative. That makes sense: Can you imagine a bank firing a substantial portion of its customers while maintaining a good brand in the general public and the economic / political sphere? Besides, increasing clients’ profitability seems to require more consulting services as well…


How to manage corporate client profitability?

There are three basic steps:

  • Step 1: Which clients are (not) profitable?
  • Step 2: How to serve unprofitable clients in a different way?
  • Step 3: Move ultimately unprofitable clients off the book

The main problem of the first step is cost allocation data. If a bank’s IT system cannot track costs and clients properly, you cannot determine customer profitability either.

Bain suggests Return on RWA (RoRWA) as the main profitability indicator. Typically between 2-3 %, RoRWA is expected to increase with future higher interest rates. The message of this indicator is pretty simple: “Let’s get way from pure revenue growth towards profitable revenue!”

Turning to step 2, Bain says that the main cause for low profitability is a high RWA (typically through lending – Denominator up) without getting ancillary high margin business such as transaction banking, risk management, and advisory services in return (Numerator flat).

To avoid step 3, the bank needs to show low profit customers that it tracks client profitability individually and that the client needs to provide ancillary, more profitable, business to the bank.

Ideally, the above analysis is carried out over the entire life cycle of a client relationship, i.e.:

  • Onboarding: You should only spend money on new clients if they have the potential of being profitable.
  • Deal pricing: Deal pricing decisions must link the deal profitability as such to promised ancillary business. In other words, exceptionally low pricing can only be granted if compensated through other, more profitable business.
  • Profitability management over the entire business cycle of a client. This means, if the client earns a lot, the bank should earn a lot and vice versa.


There is one thing I find bizarre in all this discussion: Shouldn’t the prices for an unprofitable banking business simply rise to make it profitable again instead of cross-subsidizing it? Once again, markets don’t seem to work here…


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