Recent Posts

Sunday, June 4, 2017

Primer: Funding Versus Credit Risk

The act of lending involves two fundamental operations: extending financing (funding) ans taking credit risk. These two roles are typically thought of together, which obscures what is happening. By decoupling these concepts, we can better understand the effects of debt issuance. If we can eliminate credit risk, the circular nature of financial flows means that the only limitations on debt issuance are real resource constraints. This understanding helps us better understand the behaviour of economic models (why they depart from real-world behaviour), governmental finance, and banking.

Financial Engineering

Financial engineering has a deservedly bad reputation as a result of sell-side financial engineers devising toxic securities to dump on their clients. However, on the buy side, a lot of "financial engineering" consists of breaking apart traded instruments into their fundamental risk factors. Knowing what risks you are running is the key to good portfolio management.

In this article, I discuss credit financial instruments of all types, including some that might not be thought of as "financial," such as accounts receivable. However, the remarks are not really applicable to equities.

The following factors are the main ones that determine the "fundamental" value of a credit instrument  (although we may need to add some to get an expected market price). I am listing them all for completeness; only the first two are discussed in the rest of the article.
  • Funding (or financing). The need to transfer "money" (or assets of some sort) to the borrower.
  • Credit risk. Will the borrower pay back the borrowing?
  • Term (maturity). 
  • Interest rate risk. This can be tied to the maturity (fixed coupon), but not always (floating rate notes).
  • Optionality. Can either party have the right modify the structure of payments?
Once again, the latter three factors are critical for pricing instruments, but they can be viewed as secondary to the act of lending.

In order to do such a decomposition, we need instruments to be able to isolate these risks. We can separate the funding/credit risk components by using a credit guarantee or credit default swap (CDS). A bond owner can hedge out the credit risk of a bond by "buying protection" in the CDS market (albeit by gaining a credit risk exposure to the swap counterparty). Meanwhile, seller of CDS protection ended up with the credit risk associated with the loan, but without extending any financing,

My argument is that the first two terms are quite different, but common usage of "financing" causes people to blur the two together. One method to deal with this would be to invent a new term for the act of extending money without worrying about credit risk, but I will stick with "financing/funding" as that is already the phrasing used by many (most?) authors.

Modelling Perspective

Embedding credit analysis within a mathematical economic model is difficult, but funding poses no problems. It is therefore easy to set up models with behaviour that is hard to interpret if we lump together funding and credit.

We can use the Python sfc_models stock-flow consistent (SFC) modelling framework to create an example. It currently is only emulating models from the Godley and Lavoie's Monetary Economics, but the equation structure is slightly different, and it is easy to illustrate the limited constraints on funding if there is no credit risk.

Within sfc_models, each sector has a net financial holding variable, denoted F. Imagine that a non-government entity issues debt, but otherwise undertakes no transactions in an accounting period, the variable F associated with that sector would not change. Instead, it will grow its balance sheet: it would increase the stock of financial liabilities (it increased its debt), and it will invest the proceeds into other financial assets. For the sake of simplicity, label this other financial asset "short-term paper," which is issued by a number of issuers (think of a money market mutual fund).

Where does the funding come from? If all entities in the model issue liabilities that do not have credit risk, there is nothing to distinguish them within portfolios. If all liabilities are short-term instruments, they are all indistinguishable from "money" or "treasury bills." As a result, other entity would increase their holdings of the issuing entity's new debt, and there would have been a reshuffling of other entities' portfolios that would allow the issuer to increase its holdings of "short-term paper." (The simplest case is one other entity reallocating from "short-term paper" into the newly issued debt.)

In summary:
  • The target entity issues $X of new debt; it ends up $X in new financial assets ("short-term paper"). Balance sheet $X larger.
  • Other entities exchange $X of "short-term paper" for $X of new debt. Balance sheets have same size, just with an allocation change.
Since there are no worries about credit risk, there is no financial reason for there to be any limit to this process. Entities could issue arbitrarily large amounts of debt, and the proceeds invested in the arbitrarily large issuance of liabilities issued by other entities. Since such a result appears nonsensical, the modeller has to impose behavioural rules that limit debt issuance. For example, debt issuance is typically tied to consumption or investing (in real assets). Production capacity constraints exist (although not in the simpler SFC models!), and so arbitrarily large nominal debt flows cannot be matched by arbitrarily large flows of real goods and services. In other words, the increased nominal flows would likely just represent inflation.

The exact mechanism of the transfer is deliberately shrouded in mystery. The sfc_models framework follows the aggregation methodology of standard stock-flow consistent models, and all transactions are assumed to clear simultaneously at the end of the accounting period. We cannot trace the individual transactions, rather all we see is the new portfolio configurations (and flows) at the end of the period. This is somewhat akin to the notion of equilibrium in mainstream economics, which is briefly touched upon this survey paper by Michalis Nikiforos and Gennaro Zezza. Ramanan has a longer discussion of how equilibrium fits in within the post-Keynesian approach. I would note that the notion of (short-run) equilibrium as used here is a well-defined mathematical concept, unlike the ambiguous ideas used in mainstream mathematics.*

This situation is distinct from what might happen in an agent-based model, which theoretically might track all transactions. In such a case, we would explicitly model how debt is funded, and it may be that the developer of the model will put into place behavioural limits on how much debt can be funded.

My argument is that adding such arbitrary limits on debt issuance is perhaps misleading; the private sector will arrange its affairs in such a way so as to eliminate funding constraints. Instead, the real limit is on the willingness to take credit risk. A business cycle is largely defined by the increased willingness of the private sector to take credit risk -- allowing debt issuance to expand -- until that willingness disappears (the financial crisis that has terminated every expansion in recent decades). This should sound roughly familiar; it is just a restatement of Minsky's Financial Instability Hypothesis.

The rest of this article discusses how to translate these observations on mathematical models toward the real world. In my view, the apparent ability of mathematical models to allow unlimited debt expansion is not a deficiency of the model (as a result of the violation of the common sense idea of "loanable funds" limiting debt issuance). Instead, it is the difficulty of modelling credit risk, which is the true brake on debt growth.

Why is Credit Risk Hard to Model?

It is perhaps not obvious why credit risk is hard to model within a macroeconomic model. The reason is that mathematical models follow rules, whereas credit risk often revolves around people and firms not following rules.

We have to remember that a mathematical model is just a statement about sets, and elements of sets. There are no mathematical elves that live inside the model, running production functions, trading, and lending to each other.

Lending decisions are often based on instinct, but they generally credit ratio guidelines, which could be modeled. In the real world, both sides of the transaction will scour business plans and accounting data to determine whether such guidelines are met. Lenders have to factor in the possibility that borrowers are delusional, or lying through their teeth. As a result, the financial sector has an active role in the decision-making process.

In a mathematical model, such negotiation is not going to be easy to represent (outside of an agent-based model, or game-theoretic models that abstract away from the rest of of the economy). The aggregate position of the borrowing sector is presumably known, as are the lending standards. Therefore, the natural set up is to set up a borrowing capacity function, and a willingness to borrow to function. The "decision" within the model is based on those functions, and thus it appears that only the borrowing sector is behind the decision, and the financial sector is entirely passive. (Since this is the natural implementation, I am not a fan of the heterodox complaint about the absence of the financial sectors in models; its role can be implicitly buried in the borrowing behaviour od the real economy sectors.)

In summary, the credit risk component of a macro model is most likely going to look unrealistic.

Not Just Banks

The ability of banks to expand their balance sheets is well known; loans create deposits. There is considerable mysticism about this ability, and the belief that makes them special. (I discuss this topic in "Are Banks Special: Yes and No." As the title suggests, banks do have some privileges, but this can be overstated.)

Non-bank finance also allows the private sector to expand their balance sheets. Firms can issue commercial paper, and invest the proceeds in the commercial paper market. So long as the issuers are willing to hold eachother's commercial paper, this process can continue indefinitely. Certainly, banks are involved in the payments mechanism, but there is no need for any borrowing from banks that is observed at the close of the day. If banks somehow became a bottleneck for the system, arrangements would be made to bypass those constraints.

We are not even confined to the financial sector. Firms routinely sell goods and services on a credit basis: accounts receivable and payable. The seller effectively extends funding in the form of goods or services provided to the buyer; since the seller had to previously finance the inventory that was sold.

Trade finance is an important component of capitalism, even if it gets less attention than banking in popular analysis. Vendor financing was a critical component of the technology bubble, and is often sneered at. However, rediscounting receivables was one of the drivers of the development of the money markets. Merchant banks rediscounted receivables, and this gave the instruments enough credibility to be traded in the money markets.

Furthermore, there is an intense economic force behind vendor financing. By extending financing, you make sales, and thus profit. If regulation clamped down on financing -- such as is suggested by full reserve banking -- commerce would grind to a halt. With apologies to Frank Herbert -- the credit must flow. As a result, attempts to protect the sanctity of "money" -- such as gold backing, or full reserves -- will be bypassed to grease the wheels of commerce. The drive for profit and incomes creates a political coalition that dooms attempts to restrict private credit creation too tightly.

The problem with vendor financing is that the seller needs to correctly judge the creditworthiness of buyer. (This was a key problem in the tech bubble.) There is an incentive for businesses to find a way of outsourcing that credit analysis. Historically, general stores had to keep track of the tabs that they extended to their regular customers, and the determination of the size of the tab was a role that only trusted persons could make. (The fact that publicans acted as financial intermediaries when the Irish banking system was shuttered by a labour dispute in the 1970s is an example of the credit expertise in the real economy -- discussed in this book review.) Credit card companies have taken over the role of credit assessment for retailers, and so it is possible to have junior employees acting as cashiers. In other segments of the economy, intermediaries spring up to fulfil that role (such as receivables factoring, or trade finance companies). For large fixed investments, the bond market exists to absorb the credit risk that is too concentrated for even the banking system.

The fact that financing forms will adjust to allow credit to be advanced explains why I believe that the "equilibrium" description of financing in mathematical models are relatively close to the truth. The system will evolve so that if there is some entity that is willing to take on the credit risk of the borrower, so there will be a way of matching the supply and demand.

The willingness of someone to underwrite the credit risk of a borrower is thus one constraint on borrowing. The other constraint is real: trade finance can only be advanced against existing goods and services. If we attempt to advance more paper claims against resources than there are resources available, inflation would result.

This analysis implies that arguments suggesting various policies are needed to raise savings rates to fund investment are bunkum. There is no need to raise the volume of savings; borrowing is inherently self-financing. The role of the financial sector -- if it is functioning properly -- is to assess credit risks. The only advantage of new financing forms is that they may be able to undertake credit risk that banks naturally shun. Stories about entrepreneurs needing to save to build their business (or people hoarding coconuts on desert islands to "invest") miss the point: they needed to save to invest since no one was willing to lend them money. Since most new businesses fail, there is not a huge lineup of firms to extend such financing. However, existing firms have a track record, and financing is normally available for viable ones.

The Role of Banks

The importance of money creation by banks is overstated. By itself, money creation is a financing operation, and financing itself is not an issue. Instead, the role of banks in credit analysis is what matters. Banks have an inside view of depostors' liquidity position, which is of great value in credit analysis. They also are diversified lenders, which naturally reduces their risk. By contrast, the fate of specialist lenders depends upon a narrow group of clients, who are therefore exposed to sectoral downturns.

The evolution of banks towards the originate-to-distribute model is an abdication of the fundamental responsibilities of banks. As a result, they have lost the technical competence to execute their core business functions properly, which sadly is a feature of many large corporations.

What Happened in Canada

The explosion of Canadian household debt after the disastrous decision by the CMHC to underwrite the credit risk of risk borrowers is very easy to understand from this point of view. They took away the credit risk eliminating the true constraint on borrowing. As one might expect, borrowing accelerated. The only limit on borrowing was finding new buyers that could pass the exceedingly easy barriers against borrowing too much money, not really financing. (Arguably, the Canada Mortgage Bonds were created to allow the necessary intermediation, which would have been difficult if the mortgages remained on the bank balance sheets. The institutional structure of Canada ensures that wealth leaks into non-bank finance -- for example, pension funds -- and it would have been necessary for the banks to increase their already large bond borrowing programmes to recirculate the funding from the shadow banks to the mortgage positions.)

Offering credit guarantees looks like a way to implement government policy "for free," which is attractive in an environment where politicians have a primitive ideological fear of government debt. However, such guarantees eliminate the constraint on credit growth for that class of borrower, and so it is necessary to think whether unchecked growth of a certain type of debt will be a good idea.

Central Governments

A central government (that controls its central bank, and borrows in its own free-floating currency) is essentially free of the risk of involuntary default. (To what extent that claim is controversial, I discuss it at greater length in Understanding Government Finance.)

Therefore, such governments are free of the credit risk aspect of borrowing, and they are thus only engaged in a financing operation. Meanwhile, there are no financial constraints on such an operation, as I discussed earlier. Since government money always trades at par, liability issuance by the government is matched by rising non-government financial asset holdings (often called a circular flow). The only constraint on government borrowing is the real constraint: there has to be someone willing to sell real goods or services (or work) for the nominal dollar amount offered by the government.

As a result, economic models that allow for arbitrarily large amounts of government borrowing appear to be closer to real world behaviour.

Keen observers of Modern Monetary Theory (MMT) would note that I used the dreaded word "financing" with respect to government spending. They do not like to use that word with respect to government debt issuance. They have realistic political concerns about the misuse of words to frame debates. For example, Bill Mitchell discusses the role of language in a recent article on the language used in World Bank publications:
The shift from systemic failure to individual choice – from a lack of jobs to transactional choice – from responsibility to aid all citizens to governance and oversight of ‘taxpayer funds’ – from the responsibility of government under international treaties to provide enough jobs to contract brokering and surveillance – from full employment to full employability – reflected the neo-liberal dominance of public policy.
And the shift in language was an intrinsic part of this policy shift. Of this abandonment of full employment. Of this jettisoning of responsibility.
That is when I became interested in the way language and framing works.
With respect to government borrowing, MMT authors are very keen to differentiate the central government from other borrowers. This is in opposition to hypocritical rambling about "magical money trees" (as discussed by Neil Wilson here). As a result, I have some sympathy for this view. However, they are effectively lumping the act of financing with the act of credit transfer (like everyone else), which I view as awkward. "Financing" or "funding" appear to be the best technical terms for the act of transferring money, without worrying about the transfer of credit risk. Until such a term is established, a discussion similar to the one here is going to be awkward.

Concluding Remarks

We need to decouple the act of funding from the act of taking credit risk. Credit risk and real resource constraints are the true limits on borrowing; trying to find magic debt-to-GDP ratios is a doomed quest.

Footnote:

* The notion of "long-run equilibrium": that there are steady-state ratios towards which variables converge is somewhat harder to define without adding classifications of variables within models if the economy is growing. Different classes of variables will exhibit different growth rates (for example, real growth rates versus nominal), and so badly selected ratios will not converge towards any value, even in a "steady state." These classifications are not in place in the sfc_models framework, and so a formal definition is hard to implement.

(c) Brian Romanchuk 2017

19 comments:

  1. Financial engineers (so-called) cannot do swap contracts to reduce systemic risk -- so swaps just create a system based on musical chairs -- when the music stops someone will default on a cash flow obligation and the write-off of financial assets will be allocated to some units.

    The stock-flow norms are ratios of flows to stocks that agents use to manage their business models. Credit and funding are linked by the nature of the balance sheets, income statements, and the changing parameters in the stock-flow norms. The process markets use to adjust stock-flow norms must be built into the model in order to get a debt default event with some basis in agent-based reality.

    ReplyDelete
  2. The banking system is confusing to me. Would you agree that in a fiat money system where the central bank promised to provide liquidity and was determined to keep the payments system functioning, that the funding constraint for banks with access to the central bank is greatly reduced? Especially compared to the funding constraint on non-bank credit suppliers?

    ReplyDelete
    Replies
    1. The central bank liquidity backstop explains why banks are safer than non-banks, and why non-bank finance has to be backstopped by banks (since they have the central bank behind them). We have discovered after centuries of practice that we need such a liquidity backstop, and why something full reserve banking will not work. (Full reserve banking proponents want to believe that the private sector will not figure out to replicate the economic functions of formal banks if the lending capacity of formal banks are deliberately crippled.)

      These backstops are needed because we cannot seperate credit and funding risk in the private sector. A run on the liquidity position of an entity is normally associated with a drop in the credit quality of that entity. In other words, the "liquidity constraint" only appears after the credit worries surface. (During the financial crisis, the withdrawal of liquidity may have appeared indiscriminate, but there were highly legitimate credit risks hanging over a lot of entities. You had no way to identify who were safe borrowers.)

      During an expansion, credit concerns are isolated, and means are found to match lenders to borrowers. This means that there is effectively no funding (liquidity) constraint.

      Delete
    2. The reason for my question is that I have significant confusion about the role of deposits in the banking process. In my undergrad years, I accepted what is the prevailing view of economists about banks- that they take deposits (very short term loans) and on-lend them in longer term loans to their borrowers at a higher interest rate and that is basically how they make their profits. Of course this was complicated a bit by the money multiplier proposition, but banks were primarily intermediators between savers and borrowers.

      After my exposure to MMT (apparently I'm highly susceptible), I completely rejected what I was taught in school about banks and the money multiplier and intermediation. But this in turn leads to some questions. For instance, Why do banks take deposits if MMT is correct about how banks create money? Most banks, but not all banks, seem quite happy to do so. Why would they do so if they were not a source of cheap funding?

      Scott Sumner recently posted a couple of articles about the moral hazard created by FDIC deposit insurance. http://econlog.econlib.org/archives/2017/06/american_bankin.html and http://www.themoneyillusion.com/?p=32036 I think there is plenty of moral hazard in banking but that he is wrong about this as being the source of it. Too big to fail and access to the liquidity function of the Fed are both far more important sources of moral hazard in my view. I was going to comment about that over there, but I have recently been chastised about not knowing what I am writing about (by Bill Mitchell, no less , in the post you link to) so remained silent. In the future, I have decided that most of my comments will be in the form of questions.

      So what do you think is the best way to understand the role of customer deposits in the banking system? How do banks that do not take deposits manage to exist?

      Delete
    3. Deposits are a cheap source of funding, so they are attractive. Furthermore, they are far stickier than internet folklore would suggest. By the time there is a bank run at the retail level, the wholesale funding has dried up. (The only exceptions might be in recent fiascos in the euro area, where political decisions drove the runs, and the wholesale investors did not get a lead on retail.)

      Furthermore, you have natural cross-selling opportunities with your depositors. You are more likely to borrow from the bank you deposit with, get a credit card with them, etc.

      As a bank, it is expensive building a retail network. But that is the cost of entry to get the attractive funding and customer base. However, it is possible to build your business by relying on wholesale funding; it's just a riskier strategy. (Northern Rock was a recent poster child for the failure of that strategy.)

      Although that explains the attractiveness of deposits, I do not know whether that answers your question. The question of money creation is somewhat divorced from that. You also need to distinguish between the behaviour of the aggregate system, and the point of view of an individual bank. The system is uncontrained, but an individual firm has to watch its liquidity position.

      I am unsure if there are what banks you are referring to that do not take deposits. Historically, such things would be "investment banks" or "merchant banks," that would rely on wholesale funding. For example, specialty bond dealers funded themselves by issuing some bonds, but mainly relying on borrowing against their securities portfolio. They would rely on backup credit lines with banks that could borrow at the discount window. (In Stabilizing an Unstable Economy, Minsky described how the Chemical Bank of New York (name from memory) acted as the emergency back up for (bond dealers/commercial paper). Yes, I've forgotten the details; I may have mentioned this elsewhere.) In any event, those "banks" were not really in the same line of business at the deposit-taking banks; unfortunately, de-regulation erased the distinctions between the various types of financial firms.

      Complaints about moral hazard created by deposit insurance are not serious; you have to be somewhat unaware of how financial systems work in practice to get excited about it. Yes, there is a cost - you need to regulate banks properly. That was the mistake our neoliberal regulators made, not moral hazard. Libertarians live in a fantasy world where everything can be rules-based, and we do not need regulators to make decisions. That theory was tested to destruction going into 2008.

      Delete
    4. I had been relying on this info from a friend who told me he worked for successful bank that didn't take deposits until recently. I called him up and he confirmed that and that while his bank made loans to customers, it relied on the wholesale market for funding and did not have access to the Fed discount window, and that the loans it made were processed through other banks in wire transfers rather than by issuing a check payable through an account at his bank. So maybe that institution did not meet the criteria for being a 'true bank'. In 2009 his institution purchased a bank that that accepted CD accounts only and continues to operate this way. He said the reason for the purchase was the cheaper source of funding as well as access to the Fed. Is this the distinction between a real bank and a 'shadow bank'?

      Either way, is not 'money created' through the loan process? Even if his 'bank' relied on commercial banks for funding its own loans that his bank underwrote themselves? Presumably, this was profitable through the different credit worthiness of the bank itself and the firms it was lending to?

      Delete
    5. Oh, and his 'bank' was leveraged far less than most commercial banks and way less than some investment banks. He said something like 3 times, as opposed to 10 or so for commercial banks and up to 30 for investment banks. Not sure if that is an important distinction.

      Delete
    6. What type of borrowers did they have? If they were businesses, I think they would have been called something like a "merchant bank." I should have written "depository institution" instead of "true bank," but when most people go on about "banks", they mean "depository institution." In Canada, the specialty finance firms were largely steamrolled by the big Schedule 1 banks, and so I am not too familiar with them, other than from historical discussion. The other types of "banks" - merchant banks, investment banks - are not involved in the standard "money multiplier" discussion.

      There would not have been narrow money created by the lending process, but they would have issued short-term liabilities (either via securitisation or rediscounting) which may have made their way into a broad money definition. Since the definition of "money" is arbitrary, all that really matters is that they are presumably issuing short-term liabilities to fund positions in short-term assets, and that is economically equivalent to what banks do.

      Of course, if they funded themselves by borrowing from a bank, that operation would create narrow money.

      Delete
    7. When you say they are presumably issuing short term liabilities to fund positions in short term assets I am losing you. The standard theory was that banks issued short term liabilities (deposits) to fund longer term assets (loans)?

      My understanding of the process which the bank my friend works at was that they would make a loan to something they decided was credit worthy. That loan was now an asset for them that they could use as a type of collateral to borrow against, which they would do when they found the next credit worthy person to loan to, and so on. I was appalled the first time I heard this business model because it seemed so risky. But that was in 2005 or 2006 before my MMT exposure and before the US financial crisis. Apparently, his bank did good underwriting and weathered that crisis despite the risks.

      Delete
  3. A bank needs to force a flow of reserves in its favor to the extent necessary to clear net interbank payments. This is why banks need to develop sources of funding. When the bank develops a source of funds reserves are either conserved (an interbank payment is avoided) or increase temporarily. When net payments clear reserves flow back out to the banking sector. Banks keep reserves to a minimum so bank assets and liabilities expand on a flow of reserves that does not necessarily increase the stock of reserves in the aggregate banking system.

    Moral hazard in banking is caused primarily by agency problems - executives who are authorized "agents" acting on behalf of shareholders can reap rewards via pay incentives and shift risk to others including public authorities their own shareholders. Shareholders are not really empowered to discipline CEOs, Boards of Directors, and pay incentive experts. Warren Buffet says compensation advisory firms can all be called "Ratchet, Ratchet, and Ratchet" implying that they enable Boards to justifying ratcheting up compensation packages of CEOs. Some ways to reduce agency hazard is to improve rules for shareholder supervision, improve bank regulation policies, and improve bank regulation practices.

    Agency problems may be amplified by the presence of FDIC insurance which otherwise has a legitimate role insuring a class of depositors from a loss of savings in bank failures.

    ReplyDelete
    Replies
    1. Joe Leote, several days ago you provided a link to the interviews conducted by the investigators of the causes of the financial crisis appointed by Congress. I want to thank you for that. The interview with Warren Buffet was very interesting. Also very good were Dean Baker and Bill Black. There are hundreds of hours of these interviews with all sorts that might be connected to the meltdown- commercial bankers, investment bankers, AIG executives, regulators, people from ratings agencies, economists and more. Fascinating stuff that I have managed to spend too much time listening to :)
      The link is https://fcic.law.stanford.edu/resource/interviews#H

      Delete
    2. Listen to the interview with Viral Acharya if interested in the credit and funding connections between banks (depository institutions) and shadow banks during the global financial crisis. The basic idea is that banks had many off-balance sheet liabilities that came onto the balance sheet during the crisis. The bank sector did not allocate enough capital, under the Basel capital regulations, to cover its off-balance sheet risk.

      To better understand deposit insurance schemes and so-called capital regulations I use this four page paper as a simplified model of the interaction between bank balance sheets and income statements:

      https://www.richmondfed.org/~/media/richmondfedorg/publications/research/economic_brief/2012/pdf/eb_12-03.pdf

      The loan loss reserve, shown as a contra-asset, is not to be confused with reserves at the central bank, listed as cash in this paper. If the example bank did not use loan loss reserve accounting then it would simply total loans = $64,000, Equity = $8,000, and Total Assets = Liabilities and Equity = $101,000. So we see that the loan loss reserve is a set-aside of equity.

      When the aggregate bank system pays deposit insurance premiums it effectively accumulates a loan loss reserve at the insurance institution. This means if a bank or banking system cannot self-insure it will not necessarily be able to insure deposits by moving the aggregate loan-loss reserve to a DIC.

      Basel capital requirements are supposed to relate to the credit quality in the loans and other financial assets in a bank portfolio -- the risk of loan-loss is supposed to be managed via capital regulations.

      If the actual loan-loss is sufficiently large then it wipes out the insurance cushions in the loan-loss reserves (equity set aside to absorb the first loss), it wipes out equity owners, and next it wipes out unsecured depositors and other lenders to the bank or bank sector. The anticipation of this write-off makes it harder for banks or shadow banks to raise equity or keep deposits - this is the rollover risk tied to credit quality in the asset portfolios.

      The crisis shows that banks had off-balance sheet liabilities to non-banks, without sufficient risk cushions, and the federal government had off-balance sheet liabilities to banks and non-banks, since the expansion of the Fed/Treasury balance sheets (both effectively agencies of the federal government) is the only way to keep cash flowing in an economy imploding from poor credit, capital, and loan-loss risk management in the financial markets.

      Delete
  4. "A bank needs to force a flow of reserves in its favor to the extent necessary to clear net interbank payments."

    No it doesn't.

    The net position at the central bank - excluding government payments - is zero at the end of the day. The central bank's target is to step out of the clearing loop at the end of every day.

    Banks lend to each other to clear payments. If they don't then payments fail. A central bank is there to reduce the collateral requirements of the payment system, to act as a clearing house for interbank lending and to sit in the middle between two banks that don't trust each other.

    Reserves are a red herring in pretty much all cases. They are lubricant, not fuel and have no control function whatsoever.

    ReplyDelete
  5. Neil writes, "No it doesn't."

    Hyman Minsky, in Stabilizing an Unstable Economy, says that every unit is like a bank: to hold its position in long term assets it must force a cash flow in its favor to make current payments. Every unit holds position-making instruments that are used to make payments or can be sold in liquid markets to raise funds to make current payments. Any unit that can rollover and develop liabilities to force a cash flow in its favor to make current payments resembles a bank in that regard.

    Minsky says that a banker has an incentive to increase the balance sheet as part of the profit motive and the desire to get rich running a bank. In the United States reserves are the means of clearing payment among banks, agencies of federal government, and government sponsored enterprises. Reserves did not earn interest prior to late 2008. Minsky says banks develop reserve-economizing liabilities to minimize reserves and grow the balance sheets in the aggregate bank sector.

    "Banks lend to each other to clear payments. If they don't then payments fail." This is true in some states of the world and at the margin in a system where the central bank keeps the aggregate bank a little short on "free" or "excess" reserves. Then at the end of the day some banks are forced to borrow from each other and to go to the discount window of the central bank to cover their reserve overdraft. But it does not eliminate the custom of forcing a flow of reserves to clear net payments by dealing with other non-bank units in the economy according to my understanding.

    ReplyDelete
  6. "As a result, economic models that allow for arbitrarily large amounts of government borrowing appear to be closer to real world behaviour."

    While arbitrarily large amounts of government borrowing seem possible, the effects of those large amounts are not yet well explained (in my view). To say that they cause "inflation" seems to be a broad-brush euphemism.

    I would suggest that we (amateur macro-economist) consider the micro-economic scenario of a merchant who issues gift-certificates in payment of work performed. It seems to me to be a micro-economic model of exactly how government can create money in conjunction with Central Bank operations.

    Something to think about. Obviously there are differences that need bridging with scale and ownership arguments.

    I find the parallels very compelling.

    ReplyDelete
  7. 'models follow rules, whereas credit risk often revolves around people and firms not following rules'. That is a rather profound statement. Apart from your very interesting discussion of model-ability, If they are not following rules, what are they following?

    ReplyDelete
    Replies
    1. What I have in mind are things like accounting fraud. They know that they are not creditworthy borrowers, but hope to fool the banks into lending them money (so they can run off with it). That sort of dynamic is going to be hard to work into a macro model, and one would wonder why you would. But this sort of thing cannot be ignored in the real world, and so from a perspective of "realism" you need both sides of the transaction.

      Delete
    2. OK, I thought you might be referring to Keynes' notion of 'conventional opinion' which Minsky uses to account for changing appetites for credit risk in his (in)stability cycle. That also might be a little hard to model.

      Delete

Note: Posts may be moderated, and there may be a considerable delay before they appear.

Although I welcome people who disagree with me, please be civil.

Please note that my spam comment filter appears to dislike long "anonymous" posts. I get no warning about this, and only go through my "spambox" infrequently. The best bet it to keep comments short, and if you think the spam filter struck, let me know with a short comment.