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!
Resource:
Mervyn
King – The End of Alchemy – 2016
