The Credit Cycle

I finally have my kitchen back, and now can devote more time to writing and consulting. I am still pushing another project, so my output here will probably be limited. I have taken another look at my bank primer project, and realised that I have too much content — I will need to trim back the theoretical wrangling texts that I previously wrote. With today’s article, I think I have covered most of the content I want to be in the book, although I might stick in some cursory analysis of a few different banks’ balance sheets. For example, I might compare some teeny-tiny American bank versus larger European or Canadian banks as a way of indicating the dispersal of what “banks” are. This article has only been lightly edited.

If the economy was in a stable equilibrium dominated by agents forecasting their cash flows out to infinity, defaults would be a random process – defaults would occur, but without a pattern to them. Default risk would be an insurable risk (i.e., could be managed by actuarial calculations like life insurance). However, the existence and popularity of the term “business cycle” indicates that the flows of commerce are cycle – and defaults follow the business cycle. During an expansion, banks do face a persistent relatively low level of defaults and delinquent loans, which does accord with being a random, insurable risk. The problem is recessions – which see a spike in defaults. Although it is possible for there to be a recession without a default spike (as discussed below), the “interesting” recessions are the ones with default spikes. The “really interesting” recessions are the ones where the banking system itself joins in on the default trend.

Primer: Introduction To Credit Spreads

After a hiatus resulting from various disturbances, I am back with another book manuscript section. I just reworked this section, and hopefully did not introduce major issues into it. However, I wanted to get this out before next week. Right now, my main concern in life is getting my kitchen sink back.

This section introduces credit spreads from a bond pricing perspective. Looking at bonds is not completely inappropriate, as banks do hold bonds in their liquidity portfolio. The illiquid loans on bank balance sheets can be analysed in the same way, albeit bankers might use different terminology.

Wholesale Payments Systems and Bank Reserves

Status update. I had to take an unplanned trip, while at the same time starting a new consulting project. I focussed on the project before I left, and I now have some time to do some writing while away from home. This is the latest instalment of my draft manuscript, which is a brief discussion of wholesale payments systems. I might beef up the discussions further. International payments is another variant topic, but I may shy away from opening that can of worms.

Wholesale payments systems are the glue that ties the banking system together. These systems allow banks to make monetary transfers to each other – either on their own account, or on the behalf of clients – quickly and more importantly, safely. The payments system allows bank clients to transfer money electronically to one another without worrying about the exact mechanism for the transfer.

Bank Credit Risk Management

This article is an unedited draft section from my banking manuscript. It finishes off the chapter on risk management.

The focus of this book is on how bank lending and liquidity flows interact with the wider economy. So long as credit losses remain at acceptable levels, they do not interrupt those flows. Given that the focus is elsewhere, this section will just offer a high-level perspective on how banks manage credit risk, without attempting to discuss what strategies individual banks use to analyse credit risk. Although this section will mainly refer to lending decisions, liquidity provision to capital markets participants also requires credit risk analysis.

Primer: Bankruptcy

This article is a draft section from my banking manuscript. It fits into a chapter on bank risk management. This article is an introduction to basic bankruptcy procedures, which needs to be understood before worrying about how banks manage the risk of their customers defaulting. This version of the section includes some text about bank resolution procedures that was previously published (but modified here).

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.

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.

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.

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.

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.

Self-Funding And Deposit Hoarding

Once again, this is an unedited draft of a section that would go into my banking manuscript. It follows onto the previous example.

In the extended example of how new bank loans are self-funding when we look at the entire financial system (including bond markets), one might attempt to critique it based on the idea that the depositors that are the recipients of spending that is financed by new bank loans (which creates deposits that are transferred) might hoard the deposits — preventing re-circulation back to the bank that extended the loans. (Alternatively, recipient banks might hoard reserves.) Such criticisms might seem plausible since the example uses convenient numbers to make life easier for the writer/reader — what happens if behaviour is different?

Bank Self-Funding Example

This is a potential section for my banking manuscript. It probably needs some diagrams, but I do not want to spend too much time on them if they end up not being used.

One way to get a better handle on the mechanics of the overall banking system is to work through an example that includes some of the important features we want to capture, but avoiding extraneous details. The example I am using has the following features.

Banks, Intermediation, And Pass-Throughs

This is a topic that is of interest for my book on banking. It may overlap some existing texts written some time ago (which is creating a future editing problem). Note that I refer to “this book” which should be read as “previous articles scattered around on my Substack.”

A somewhat arcane point of debate is whether banks are “(financial) intermediaries” or not. The reason why this is supposed to matter is whether banks exist to match savers or borrowers, or whether they “create saving.” From my perspective, the problem is the term “intermediary” as it is too vague, and should be replaced by the somewhat less common term “pass-through entity.” This is yet another example of how heterodox/orthodox economic debates have drifted into terminology disputes over decades. I will first explain the debate as I see it, then touch on the debate as framed by others.

Asset Allocation And Banking

Note: This article would hopefully be worked into my banking manuscript. I think it overlaps other article(s), but I wanted to see how this line of argument looks. Needless to say, I have no put the articles into a single document…

One of the difficulties with understanding banking is that one needs to use relatively complex macro models to see how the formal banking system interacts with the non-bank financial system. Analysis based on looking at the motivations of a single bank or based on models where only the formal banking system exists will be misleading. Stock-flow consistent (SFC) models are one of the few attempts at such a modelling framework.

The Central Bank And Government Finance

This article continues the sequence of articles on central banks as banks. This article was as brief as possible since it overlapped my book Understanding Government Finance (available for sale cheaply at online bookstores, and I emphasise that it would be an amazing Christmas present for friends and/or enemies (depending on what you think of my writing)). I might need to expand upon the less obvious points herein if this text does get into my book manuscript.

Central banking largely evolved the way it did due to the exigencies of wartime finance. The central government needs control over its financial operations in wartime, and any attempts to interfere by the private sector would be viewed as akin to sabotage. For a free-floating sovereign (and currency pegs are typically broken during major wars), the system guarantees that the financial flows will continue to flow.

Central Bank Balance Sheets

This article continues my series of articles on central banks as banks.

Central bank balance sheets (in the modern era, at least) are relatively simple. There is a split between banks with a currency peg and those without. After that, the key point to keep in mind that the minimum size of the central bank balance sheet is not under the control of the central bank — other actors create a minimal demand for their liabilities. The only freedom of action for central bankers is growing beyond the minimum, which they did not do before the days of Quantitative Easing (QE). The article finishes off with a discussion of consolidation.

This text overlaps material found in my book Understanding Government Finance.

Central Bank Banking Basics

This article continues the plan outlined in the previous article “Central Banks as Banks.” As I described therein, this is projected to become a chapter within my banking primer. I am not going to describe private banking — as that is the job of other chapters — but I will cover the issues of inter-bank transactions. This article is about fundamentals that we normally do not think about.

As the name suggests, central banks are at the centre of the banking system. The objective of a well-run banking system is that you do not have to worry about how it works. So long as everything under the hood is operating, you do not need to enquire how the money gets from one account to another. By not worrying about those details, we tend to only focus on the flashy bits of central banking (e.g., trying to hit an inflation target) instead of the banking system regulation part.

Central Banks As Banks

My plan is to write a draft what should become a chapter for my banking book. The inflation manuscript is in good shape (but way behind schedule), but there’s nothing I can publish from it (other than reposting the edited version of articles posted earlier). This article is somewhat lightweight — it might turn into the introductory section, which I normally just keep as a summary of the chapter contents. The advantage of putting this summary out is that it sort-of explains why I might cover some digressions in the first articles.

Central banks, as the name suggests, are in fact banks. This rather straightforward perspective was lost in the decades after World War II, when central bankers bought into mainstream thinking and they thought of themselves as “benevolent central planners.” Instead of worrying about mundane distractions like credit risks within the system, the researchers were running around pretending they were 1960s control systems engineers optimally determining the trade off between growth and inflation. Of course, this neglect of banking led to the rather awkward Financial Crisis in 2008, where central bankers suddenly had to get a handle on banking risks once again. Since then, central bankers have been quite vigilant about banking risks — at least the ones that are similar to the last crisis.

Another Bank Bites The Dust

First Republic Bank was forced into a take over by J.P. Morgan Chase, and was yet another Californian victim of bad banking risk management. My bias was that First Republic was not large enough to worry about, so I cannot offer any insights into the event. My main complaint is that this appears to be another bank that blew itself up with interest rate risk, which makes my life of writing a banking primer more difficult. I had always made allowances for bad bank risk management in the United States, but I had underestimated how large an incompetent bank can get.

Other than for the unfortunate owners of securities issued by First Republic (and apparently wealthy people in San Francisco who wanted overly generous mortgages), the demise of this bank is not a big deal by itself for the macroeconomy. Instead, the issue is whether there are still other weak links in the banking system? I am not in a position to have a strong opinion on that question, but it would be a question worth looking in to. My bias is to not pay too much attention to interest rate risk — credit risk is the killer for financial systems. Although I am seeing people pointing to commercial real estate risk, I do not think I could point to a time in recent decades where somebody was not worried about credit risks in commercial real estate.

The usual worry is that the Fed hikes until something breaks — which is exactly how I describe previous cycles.1 Since the current bank failures were due to interest rate risk, we can blame them on Fed action. The question is whether these are enough to derail the economy? Although the Monetarist-inclined are worried about M2, my concern is credit growth (since Fed balance sheet shenanigans are forcing reallocations of financial assets which do not have much economic impact). One measure of credit that I like — commercial & industrial (bank) loans outstanding (above) — has rolled over.

As can be seen in the chart, C&I loans rolling over only tended to happen in recessions. However, we did see a lack of growth in the mid-2010s without a recession (circled episode), so I would be cautious about panicking.

I am not in the forecasting business, and do not want to be calling for recessions every six months. Although there are certainly negative vibes, one can still argue that they are consistent with a “soft patch,” which is a part of lengthy modern business cycles. You pays your money, and you takes your chances.

1

There is a survivorship bias in that observation. It could be explained by (1) business cycles being typically ended by financial fiascos, and (2) the Fed tending to hike rates until the expansion ends, with (1) and (2) being independent.

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(c) Brian Romanchuk 2023

QE/QT And Deposits

Things seem to be calming down in financial markets, which could be interpreted in one of two ways. The benign interpretation is that a few weak banks failed, but the rest of the financial system is in decent shape. The paranoid interpretation is that crises occur in stages, with pauses between the key failures. So far, I lean towards the benign interpretation — there are some areas of weakness, but not a lot of visible credit failures in the real economy. Things will deteriorate as the cycle ages, but such is the fate of capitalist finance.

I just wanted to comment on bank deposits, which has been attracting some attention. My initial reaction is that we should expect some reversal in deposit growth as the Fed reverses its balance sheet growth. However, the figure above was not exactly what I expected.