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Tuesday, July 2, 2024

Primer: Currency Risks For Banks

Yet another unedited section from my banking primer manuscript. My feeling is that this section is packing in too much information, and might be trimmed. The technical appendix may be too technical, but I will look at that later.

Although the major banks have global operations and currency trading is a massive financial market, this book largely ignores the complications created by banks operating in multiple currencies. The first reason is that the author has no useful experience in that area. The second is that currency risk is not a significant source of risk for well-managed banks. If a sensible bank is operating in two currencies, it is best understood as two banks operating in one currency, with one bank acting as parent. (From a regulatory perspective, the fact that the home base is in a different jurisdiction matters, but this text is not delving deep enough into details for that to be a concern.)

Currency risk is defined as the risk of generating losses based on changes to the exchange rate between two currencies (i.e., the price of a currency in terms of another). Currency risk is not the risk associated with a bank relying on transferring funding from one currency to another. This cross-currency financing risk was a major factor in the 2008 Financial Crisis, but it is not “currency risk” as it understood from a risk management perspective. This distinction matters because there is considerable folklore about banks running currency risks, and the people spreading that folklore make the mistake of treating the cross-currency financing risk as being a currency risk.

Friday, June 28, 2024

Primer: Bank Interest Rate Risk

Interest rate risk refers to the potential for losses due to the movement of the risk-free curve, which is largely driven by the central bank policy rate and its expected future path. One might also use a yield curve based on the main banking reference floating rate used in the jurisdiction. When LIBOR was the reference rate, the curve would be derived from LIBOR fixes, short-term interest rate futures and LIBOR swaps. This curve traded relatively close to the governmental yield curve (e.g., U.S. Treasurys), but there was a spread between them. Regardless of which curve is used, changes in the spread between those high-quality curves is dominated by the changes in the level of either curve.

Tuesday, June 25, 2024

Primer: Bank Liquidity Risk

This article is an unedited draft from my banking primer manuscript. It probably needs more work, but I will not be able to look at again for awhile.

One of the main economic functions of banks is providing liquidity to other actors – i.e., ensuring that clients can get funding on short notice. Banks are only able to do this by themselves carefully managing liquidity risk. Although the central bank can bail out the banking system if something goes horribly wrong, the expectation is that private banks should manage liquidity risk on their own.

Wednesday, June 12, 2024

Random Observations

My writing plans were disturbed (bike got a flat tire…), and so I am stuck with a placeholder article. I had been working on a section for my banking manuscript, but I want to look it over before posting a draft.

North American Monetary Policy Developments

The Bank of Canada (BoC) cut the target for the overnight rate to 4.75% on June 5th. They feel that policy is restrictive, and they stated that “our confidence that inflation will continue to move closer to the 2% target has increased over recent months.”

Tuesday, June 4, 2024

Balance Sheets Of Financial Firms

This article is an unedited draft of a section that would go into the introductory chapter of my banking manuscript. It is somewhat of a placeholder, and I may want to add more information (e.g., have a table that is an actual balance sheet). Given the nuisance value of setting up tables, I will not worry about that until much closer to publication.

This section is an introduction to what balance sheets are, with an emphasis on financial firms. It will also cover some of the jargon used in this text. If the reader is completely unfamiliar with accounting, it may be necessary to supplement this material with other primers. The focus on this text is the economic principles of banking, and not the highly specialised accounting used in the industry.

Tuesday, May 28, 2024

"Inflation Means Prices Are Higher Than They Used to Be"

One of the advantages of being very slow to finish off my inflation manuscript is that I can add content as things pop up. This section is an edited draft that was added in response to a recent Felix Salmon article.

One argument that came up as I was finishing this manuscript is that there has been a linguistic drift in the word “inflation.” In the article “’Inflation Doesn’t Mean What is Used To,” Felix Salmon argued that in popular usage, the meaning of “inflation” has drifted to mean: “[A]m I paying higher prices for things than I used to?”

Although Salmon’s article (correctly) predicted that economists’ responses to this suggestion would be negative, he argues that they are out of touch with the common usage of the term. Since this book intends to properly explain the concept of inflation, there is no way I could use such a definition, since it has obvious shortcomings. (As he noted, prices could be falling, but this would qualify as “inflation” so long as prices were lower at some previous point in time.)

If we rely on what prices are stuck in people’s memory, the results can be dubious, since the comparison points are arbitrary. My personal example is when I visited the United Kingdom in 2022 and compared the prices of chocolate bars to the price in the department vending machine in 1992 (22 pence, or 23 pence for the premium bars). (That price stuck since I used to feed my 1p and 2p coins into the vending machine to get rid of them.) The fact that prices were indeed lower 30 years previous is not providing much information about current trends in the U.K. economy.

Although I have doubts that this new usage would get traction – any serious economist or financial market commentator is not going to use it – there are a few arguments that seem reasonable.

1.      Salmon highlights that the use of the change of the price level over one year is arbitrary. However, using the one-year percentage change has major advantages over alternative time frames (discussed below). People write “inflation” or “inflation rate” instead of “annual inflation rate” because it is less wordy.

2.      Most people in developed countries at present do not have a good grasp of what the overall inflation rate is, and mainly look at the level of prices of a handful of goods (gasoline, groceries). They will then compare current prices to some conveniently lower price that occurred some time in the past. However, I would argue that is a side effect of the low inflation regime – back in the 1970s, people had a much stronger grasp of inflation since they dealt with increasing inflation rates over a multi-year period. The fact that people apparently paid money to a website that claimed that inflation was “really” several percent higher than official statistics is a sign that many people do not have a good idea what the inflation rate is.

3.      Although not noted in the article, people’s perceptions of inflation seem to be partly driven by the editorial agenda of the business press. It is not entirely an accident that the Republican-leaning business press got extremely excited about inflation during the presidential term of a Democratic President.

The preference for the annual rate of change of inflation is easily explained. The first is that it eliminates seasonal effects. The second is it easy to calculate – how many people would know how to properly calculate the annualised rate of inflation over periods other than one year? The final reason is that the one-year rate of change seems to capture changes in economic trends. Annualising 3-month percentage changes creates massive swings in the inflation rate that are misleading (particularly with data that has seasonal adjustment problems or even unadjusted). A two-year annualised inflation rate (or longer) might be useful for historical analyses (what happened over a certain period?) but moves too slowly to capture changes in economic trends. Although it is not clear that a 12-month window is “optimal,” it is the easiest one to understand. (Why would you look at the annualised percentage change over 9 months?)

Although it is safe to say that the popular perception of inflation is quite often at odds with official inflation, it seems unlikely that changing the definition of inflation would help matters.


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(c) Brian Romanchuk 2024

Wednesday, May 22, 2024

Self-Funding And Financial System Fragmentation

This is an unedited draft for my projected banking manuscript. It might be an idea to embed some of this content into earlier articles that discussed the self-funding nature of the banking system. Although I planned to do a different article first, I decided to add this discussion in response to some reader feedback.

When discussing the self-funding nature of the banking system, the risk is that my arguments may suggest to some readers that a bank can make whatever loans it wishes without ever worrying about funding. I was conscious of this comprehension risk when setting out my examples — I tried to emphasise the practical limits of what the bank can do. However, readers might skip over the numbers, or might just see out-of-context quotations of what I write. Rather than bury everything I previously wrote under a layer of waffle, I want to break out the concerns herein into a stand-alone discussion.