Global Central Bank Focus
Paul McCulley | February 2009
Saving Capitalistic Banking From Itself
Click here for
Paul McCulley's biography.
At its core, capitalism is all about risk taking. One form of risk
taking is leverage.
Indeed, without leverage, capitalism could not
prosper. Usually, we think of this imperative in terms of
entrepreneurs
being able to lever their equity so as to grow. And
indeed, this is the case.
But more elementally, economies –
both capitalist and socialist –
require leverage because savers for very logical reasons do not want
to have one
hundred percent of their stock of wealth in equity
investments. Rather, they logically want a portion of their portfolios
in
a fixed-commitment instrument that is senior to equity.
And savers want some portion of that fixed-commitment allocation
in
literal money, defined as a government-guaranteed obligation that
always trades at par. If you have any doubt about
this, put your hands
into your pockets and you will find just such an instrument. It’s
called currency, a zero-interest,
perpetual liability of the Federal
Reserve, itself a levered entity, capitalized by its
Congressionally-legislated monopoly
over the creation of money.
As a practical matter, of course, you don’t hold all of your
always-trades-at-par
liquidity in currency. You most likely have a
demand deposit, also known as a checking account, as well as shares in
a
money market mutual fund, which is putatively supposed to always
trade “at the buck.” You probably also have
some longer-dated bank
deposits, such as certificates of deposits, or CDs, which don’t
necessarily trade at par
in real time, but are guaranteed to do so at
maturity.
The Nature of Fractional Reserve Banking
The public’s
demand for at-par liquidity inherently creates the raw
material for leverage in the economy. Indeed, from time immemorial,
fractional
reserve banking has been built on the simple proposition
that the public’s collective ex ante demand for at-par liquidity
is
greater than the public’s collective ex post demand for such
liquidity.
Accordingly, the genius of banking1,
if you want to call it that, has
always been simple: A bank can take more risk on the asset side of its
balance sheet
than the liability side can notionally support, because
a goodly portion of the liability side, notably deposits, is de
facto
of perpetual maturity, although it is de jure of finite maturity, as
short as one day in the case of demand deposits.
Thus,
the business of banking is inherently about maturity and credit
quality transformation: banks can hold assets that are
longer and
riskier than their liabilities, because their deposit liabilities are
sticky. Depositors sleep well knowing
that they can always get their
money at par, but because they do, they don’t actually ask for their
money, affording
bankers the opportunity to redeploy that money into
longer, riskier, higher-yielding assets that don’t have to trade
at
par.
Enter the Government
A key reason that depositors sleep well at night is the fact that
since 1913
here in the United States, banks have had access to the
Federal Reserve’s discount window, where assets can be posted
for
loans to redeem flighty depositors. A second sleep-well governmental
safety net was introduced in 1933: deposit
insurance, in which the
federal government insures that deposits – up to a limit – will always
trade at
par, regardless of how foolish bankers may be on the other
side of their balance sheets.
Thus, the genius of modern
day banking, again if you want to call it
that, has always been about exploiting the positive spread between the
public’s
ex ante and ex post demand for liquidity at par, in the
context of levering the two safety nets – the central bank’s
discount
window and deposit insurance underwritten by taxpayers – which provide
comfort to depositors that they
can always get their money at par,
even if their bankers are foolish lenders and investors.
Yes, I know that sounds
harsh. But it really is how the banking world
works. In turn, banks can be very profitable enterprises, because the
yield
on their risky assets is greater than the yield on their
less-risky liabilities. And that net interest margin can be
particularly
sweet when recomputed as a return on equity, given that
banks are very levered institutions (recall, banks must hold only
8%
of liabilities in the form of Tier 1 capital).
Put differently, equity investors in banks can lose only 8% of
a
bank’s footings, but they earn the net interest margin on 100% of
those footings, so long as they don’t
make so many dodgy loans and
investments, destroying capital, that the providers of the two
government safety nets cut
them off.
Thus, it has always been somewhat of an oxymoron, at least to me, to
think of banks as strictly private
sector enterprises. To be sure,
they have private shareholders. And, yes, those shareholders get all
the upside of the
net interest margin intrinsic to the alchemy of
maturity and risk transformation. But the whole enterprise itself
depends
on the governmental safety nets. That’s why banks are
regulated.
Conceptually, as is the case in socialist
countries, banks could be –
and usually are – simply owned by the government, the ultimate form of
regulation.
Such an arrangement has the benefit of the taxpayer
sharing in the upside, not just the downside. Such an arrangement also
has
the cost of putting the government in the lending and investing
business, with little regard for the pursuit of profit,
picking
winners and losers on the basis of political clout.
Thus, capitalist economies usually want their banking
systems owned by
the private sector, where loans and investments are made on commercial
terms, in the pursuit of profit.
But also in the context of prudential
regulation, so as to minimize the downside to taxpayers of the moral
hazard inherent
in the two safety nets for depositors.
The Mae West Doctrine
But as is the wont of capitalists, they love levering
the sovereign’s
safety nets with minimal prudential regulation. This does not make
them immoral, merely capitalists.
And over the last decade or so, the
way for bankers to maximally lever the inherent banking model has been
to become
non-bank bankers, or as I dubbed them a couple years ago,
shadow bankers.
The way to do this has been to run levered-up
lending and investment
institutions – be they investment banks, conduits, structured
investment vehicles, hedge
funds, et al – by raising funding in the
non-deposit markets, notably: unsecured debt, especially interbank
borrowings
and commercial paper; and secured borrowings, notably
reverse repo and asset-backed commercial paper. And usually –
but not
always! – such shadow banks relied on conventional banks with access
to the central bank’s discount
window as backstop liquidity providers.
Structured accordingly, without explicit access or use of the
government’s
safety nets, shadow banks essentially avoided regulation,
notably on the amount of leverage they could use, the size of
their
liquidity buffers and the type of lending and investing they could do.
To be sure, Shadow Banking needed some
seal of approval, so that
providers of short-dated funding could convince themselves that their
claims were de facto
“just as good” as deposits at banks with access
to the government’s liquidity safety nets. Conveniently,
the rating
agencies, paid by the shadow bankers, stood at the ready to provide
such seals of approval.
And it
was all grand while ever-larger application of leverage put
upward pressure on asset prices. There is nothing like a bull
market
to make geniuses out of levered dunces. Call it the Mae West Doctrine,
where if a little fun is good and more
is better, then way too much is
just about right.
Also call it the Forward Minsky Journey,2 where stability begets
ever
riskier debt arrangements, until they have produced a bubble in asset
prices. And then the bubble bursts, in something
called a Minsky
Moment, followed by a Reverse Minsky Journey, characterized by
ever-tighter terms and conditions on
the availability of credit,
inducing asset price deflation and its fellow traveler, debt price
deflation.
This
dynamic is inherently self-feeding, begetting the Paradox of
Deleveraging,3 where private sector bankers – conventional
bankers and
shadow bankers alike – all move to the offer side of both asset
markets and bank capital markets,
trying to reduce their leverage
ratios by selling assets and paying off debt, and/or issuing more
equity. But by definition,
if everybody tries to do it at the same
time, as has been the case over the last 18 months or so, it simply
can’t
be done.
What is needed is for the government to take the other side of the
trade, effectively becoming the bid
side, (1) buying assets, (2)
guaranteeing assets, (3) providing cheap funding for assets, and (4)
buying bank equity
securities (of both conventional banks and shadow
banks that are permitted to become conventional banks after the fact).
Government
Goes All In4
And indeed, all four of these techniques have been put into play since
the fateful decision to let Lehman
Brothers fall into disorderly
bankruptcy. Put more bluntly, the hybrid character of banking – always
a joint venture
between private capital and governmental liquidity
safety nets – is morphing more and more towards government-sponsored
banking.
Yes, I know that is harsh, but sometimes the truth is harsh.
Capitalism and banking may not be divorced, but certainly
are engaged
in some form of trial separation.
The Treasury, the FDIC and the Fed – the big three – are
caught in the
middle, serving both as mediators as well as deep pockets to the
estranged parties. It’s not wholesale
nationalization. And it’s not
likely to become that. But only because the big three are committed to
doing whatever
it takes to prevent that outcome. Along the way, the
big three would also like – need! – to restart the engines
of credit
creation, so as to pull the economy out of its gaping hole of
insufficient aggregate demand for goods and
services, also known as a
recession.
Will it work? Judging from the markets’ collective reaction to
Treasury
Secretary Geithner’s announcement last week of the new
administration triage plans, there is room for doubt. I do
not,
however, take one-week swings in the markets as indicative as to where
this game will end. And a key reason is
actually the special powers of
the Fed and the FDIC, which can lever the taxpayer monies that
Congress provides for
the Treasury.
As evidenced in recent months, the Fed has two incredibly powerful tools:
* Section
13(3) of the Federal Reserve Act of 1932, which permits
the Fed, upon declaration of “unusual and exigent circumstances”
to
lend to anybody against collateral it deems adequate, and
* Total freedom to expand its balance
sheet, essentially creating
liabilities against itself that trade at par – also called printing
money –
so long as the Fed is willing to surrender control over the
Fed funds rate, letting it trade at zero, or thereabouts.
The
Fed has used both of these tools vigorously in recent months,
expanding its lending programs mightily, to both conventional
banks
and shadow banks (i.e., investment banks who have re-chartered as
banks, as well as primary dealers), while also
doubling the size of
its balance sheet, as it let the Fed funds rate fall to effectively
zero.
The FDIC also
has an incredibly powerful tool: the so-called Systemic
Risk Exception under the FDIC Improvement Act of 1991, which allows
the
FDIC to forgo using the “lowest cost” solution to dealing with
troubled banks if using such a solution “would
have serious adverse
effects on economic conditions or financial stability” and if
bypassing the least cost method
would “avoid or mitigate such adverse
effects.”
It’s actually not an easy clause for the FDIC
to invoke, unlike
Section 13(3) for the Fed, which can be invoked simply by a
supermajority of the Board of Governors.
For the FDIC, the Systemic
Risk Exception must be deemed necessary by two-thirds of both the
Board of Directors of the
FDIC and the Fed’s Board of Governors, as
well as by the Secretary of the Treasury, who must first consult and
get
agreement from the President of the United States.
But where there is a will, there is a way, and the FDIC is now living
firmly
in the land of the Systemic Risk Exception, legally allowed to
guarantee unsecured debt of banks as well as to put itself
at risk in
guaranteeing banks’ dodgy assets.
Bottom Line
The United States government now has both the
tools and the will to
save the private banking system, and more importantly, the real
economy, from its own debt-deflationary
pathologies. Not that it will
be easy. But it can be done, notwithstanding the catcalls that greeted
Secretary Geithner
last week.
And the essential game plan is clear: use the power of the Fed, the
FDIC and the Treasury to create government-sponsored
shadow banks,
such as the Term Asset-Backed Securities Lending Facility (the TALF)
and the Public-Private Investment
Fund (the P-PIF).
The formula? Take a small dollop of the Treasury’s free-to-spend
taxpayer money (there is
still $350 billion left) to serve as the
equity in a government sponsored shadow bank, and then lever the
daylights
out of it with loans from the Federal Reserve, funded with
the printing press. That’s the formula for the TALF, to
provide
leverage, with no recourse after a haircut, to restart the
securitization markets.
The same formula applies
for the P-PIF, with the addition of FDIC stop
out loss protection for dodgy bank assets that private sector players
might
buy. With such goodies, such players, it is hoped, will be able
to pay a sufficiently high price for those assets to avoid
bankrupting
the seller bank.
Unfortunately, Secretary Geithner hasn’t laid out the precise
parameters of
how to mix these three ingredients, which is driving the
markets up the wall. But make no mistake, these are the ingredients,
along
with continued direct capital infusions into banks where
necessary.
Uncle Sam has the ability to substitute itself
– not himself or
herself! – for the broken conventional bank system, levering up and
risking up as the conventional
banking system does the exact opposite.
Yes, there will be subsidies involved, sometimes huge ones. And yes,
the
process will seem arbitrary and capricious at times, reeking of
inequities. Such is the nature of government rescue schemes
for broken
banking systems, while maintaining them as privately owned.
You might not like it. I don’t like
it, because regulators should
never have let bankers, both conventional bankers and shadow bankers,
run amok. But they
did.
So it’s now time to hold the nose and do what must be done, however
stinky it smells, not because it’s
pleasant but because it is
necessary.
Only with the full force of the sovereign’s balance sheet can the
Paradox
of Deleveraging be broken.
Paul McCulley
Managing Director
February 16, 2009
mcculley@pimco.com
