Shadow Banking Sound Worse Than It Actually Is

Over at The Economist there is a piece that suggest that imposing higher capital requirements on banks could “push people into the arms of shadow banks”, who do not face the same level of regulation as banks. (H/T Tyler Cowen).

I don’t like the phrase “shadow banks”. It takes a good idea – risk being managed by those better able to manage it – and repackages it as an evil, nasty finance sector conspiracy.

With respect to competition in finance lowering the liquidity premium and leading to higher leverage to maintain shareholder returns, that’s not a big deal. Barriers to entry in banking are reasonably high – but barriers to entry for potential shadow banking activity are higher because you are entering into a world that has a far shorter timeframe than prudential regulation can reasonably deal with. Some repo loans could be less than 24 hours. Some money market funds could have 200 counterparties to monitor.

The irony of it all is that even banks subject to Basel capital and liquidity requirements will engage in “shadow bank-like” activity. Overnight repo lending is a prime example of this. If you kept up with the literature you’d be aware that banks have greatly increased the complexity of their collateral security agreements to offset higher counterparty default risk – they’re regulating themselves reasonably well thank you very much people who know nothing about shadow banking activity.

I believe that there are macroeconomic consequences of higher levels of regulation – less credit is granted, and because entrepreneurial trial and error includes a lot of error, the less projects that get started, the less likelihood that we’ll move out of the silent recovery into recovering the completely wasteful puritan deleveraging of the past few years.

As long as shadow bank credit losses are borne by shareholders and there are no more bailouts, there’s nothing wrong with it. In fact, given that banks seem only interested in propping up real estate prices instead of performing their function as a utility and lending for productive activity, the sooner New Zealand’s own shadow bank sector – finance companies – gets back up and running in a big way, the sooner housing affordability dreams will be realised and the sooner the silent recovery will turn into the boom we need so desperately to get low marginal product workers back into employment and out of part-time / casual purgatory.

There Needs To Be More Discussion On Basel III Instead Of House Prices

Housing is topical. Housing is easy for a journalist with a BA in Media Studies to understand. Housing articles drive traffic for online ad impressions and listing revenue. But are high LVR restrictions really the answer to perceived problems with house prices?

Basel III capital and liquidity requirements are not topical, but when it comes to financial stability they are pretty much the global tool that is so much better than market specific intervention despite the fact that imposing higher loss reserves on certain types of lending can have supply side impacts because a lot of growth can only occur because there are capital costs that have to be financed by a bank.

The Reserve Bank response to submissions I wrote about yesterday is an example of why market specific (house prices are in a b*****! we must act now!) interventions with a good goal like improving financial stability and lowering systemic risk through avoiding a lot of mortgage writedowns if house prices ever fall and high LVR borrowers have negative equity, are not necessarily a good idea.

This sort of regulation is “good” in the sense that the RBNZ really cares about financial stability now it has some fancy new macro-prudential kung fu to implement. It isn’t good in that there is barely any discussion of basic supply and demand factors affecting house prices, particularly in Auckland.

But anyway the focus on housing is really crazy in light of how massive Basel III capital and liquidity requirements are in terms of changes to bank lending processes and risk management processes.

It’s like worrying about rules for adding a conservatory to your house when the global building authority has issued a mandate saying “you have to use office tower strength reinforced concrete with earthquake shock absorbers for your residential foundations”.

My dream is that one day more people will be as passionate about supply side effects flowing through from higher capital and liquidity requirements before even thinking about the enhanced (negative) supply side effects high LVR restrictions could have.

Remember all of those finance companies? They were providing the risk capital that built most of the apartment buildings and subdivisions to get to a point where New Zealand still doesn’t have enough apartments and houses on decent sections.

Now, banks can’t lend like some of their more aggressive property lending teams did pre-2008 and the second tier finance sector has restricted itself to “sure thing” deals. The other alternative is hedge funds looking for extremely high rates of return for short term loans that won’t ever be capitalised.

Why oh why can’t we have a better media? This stuff isn’t hard to get your head around. It’s just a basic supply and demand story. Supply of housing is restricted both by lower credit availability and by council and environment court red tape. Add in a demand curve shift to the right from immigration and this could have been an ECON101 essay question.

Why John Key Will Take Graeme Wheeler’s Independence Away

An independent central bank is better than a government micro-managed central bank.

If you disagree, have a read of the interesting things National Prime Minister Robert Muldoon did with wage and price controls.

Furthermore, the global financial crisis shows what happens when central bankers fold under pressure from politicians and big banks to “do something” in the form of quantitative easing.

Yes, many central bankers desperately wanted to bail out the global financial system, but a good number warned that no good would come of it, and they’ve been proven correct.

A jobless recovery around the world made easier because artificially low interest rates make borrowing for capital investment easier and thus replacing labour with robots is simply a profit maximising strategy for corporations.

Last year I was writing about how the Labour-Greens-NZ First troika could prove disastrous for the independence of the Reserve Bank of New Zealand.

But I clearly forgot that John Key is an interventionist just as much as Helen Clark ever was. It’s just that he intervenes in different areas of policy.

The issue of housing affordability is on track to become an election issue. If young couples can’t buy houses they are less likely to have kids, which means the demographic ponzi scheme paying for unproductive oldies to stay alive collapses forthwith.

They’re not special though, and don’t deserve special treatment like the first home subsidy – a perversion of Kiwisaver as a retirement savings scheme if there ever was one.

But on the other side of that same coin they don’t deserve another slap down in the form of higher loan-to-value restrictions.

This is because banks are unlikely to grant such loans – which run the risk of negative equity if house prices fall – to low income households.

In the aftermath of Basel III and other risk management changes in the banking sector, loan quality matters a lot more than it did before 2008.

If the Reserve Bank does want to put a speed limit on housing, they are completely ignoring the supply and demand story around housing services.

In fact, they are basically saying that static efficiency (one price for housing! no price changes! a price rise is not a signal but an indication of a bubble!) beats dynamic efficiency.

What they’re also doing is missing the wood from the trees – the reason house prices are going up so quickly is because it’s not only hard to build a house, it’s almost impossible to obtain financing for property development.

And what they’re also doing is forgetting that a lot of house deposits come from parents and grandparents.

Young people in aggregate suck at choosing profitable careers and saving – economic outpatient care is probably the key driver of the Auckland housing market.

How does this work? Well, if two sets of parents chip in tens of thousands of dollars each to the pittance scraped up by Jack & Jill then suddenly a mortgage can be approved.

John Key will foil the Reserve Bank Governor Graeme Wheeler on this issue because he knows that despite an independent central bank being an inherently good thing, his 3rd term in government is simply more important.


Where Will Property Developers Obtain Capital From?

The news that the directors of Lombard Finance received from the Court of Appeal home detention sentences substituted for the community work and reparation sentences they received in the High Court was greeted with much whinging about finance companies in general.

But with the collapse of the finance company sector, and of lending to risky property development projects in general, where will property developers obtain capital from? It sure won’t come from the big banks and it is ridiculous to expect NZ private investors to organise funding schemes organically.

In his weekly overviews, Tony Alexander has pointed out that some developers are raising finance in China for projects in Auckland. This is an interesting development, particularly when it is harder for regulators to keep track of overseas promotion of New Zealand investment schemes than if they stick to our shores.

While foreign capital is obviously essential to any supply side response to a housing shortage in Auckland, we cannot ignore the role that altered bank preferences because of Basel III have on the risk takers in property development.

Many property developers have left the industry with their tail between their legs because their last big project – which funnily enough would generally have contributed somewhat to an increased supply of housing in Auckland – failed at the peak of the global financial crisis for reasons more to do with banks reducing their risk profile as opposed to holding out for the rebound that has occurred since.

Finance companies filled an important role by taking on a lot of high risk projects that banks could easily finance – except for the fact that a new property development, because of past oversight mistakes and wet behind the ears lending managers, is unlikely to pass a credit risk committee with new capital and liquidity requirements imposed by fiat around the globe.

I disagree with Shamubeel Eaqub that we can’t build far more houses than we currently do. Much of the blame for the “shortage” of skilled construction labour is that those who used to employ them had the plug pulled by risk averse bankers right when continued work through the global financial crisis would have seen an additional 50,000 or more housing units constructed from 2008 to 2013.

Developers with strong balance sheets (read: a handful) will be able to complete projects and will earn reasonable margins if they can avoid delays and lock in labour on medium term contracts.

They are ably assisted in their profit maximisation by the demise of the second tier lending sector because their traditional competition – those oft criticised property developers – have more chance of an Official Assignee court case than a resource consent hearing on a new subdivision.

There is a market opportunity, already realised by the Manson family of Auckland with their New Zealand Mortgage & Securities, for mezzanine finance in New Zealand that is more in tune with the reality of construction sector projects. It’s risky business – but it’s risk taking that will drive the economic recovery and lead construction back to where it needs to be to match domestic migration to Auckland and population growth in general.

When Technocrats Strike (Bank Of International Settlements Basel III Edition)

Over at TVHE, Matt writes about the BIS arguing that structural adjustments and balance sheet restructuring should be imposed on the world without any democratic input. He makes it clear that there has to be some democratic input into these processes. I argue that the BIS has already won a cold war against risky lending with Basel III.

The Bank of International Settlements is a technocratic institution based in Basel, Switzerland. Alongside providing a lot of good stuff in the form of supervising global payments systems and coming up with some very good global settlement policy, it has also produced one of the most complicated pieces of technocrat policy since Bretton-Woods.

That would be Basel III – a series of capital and liquidity requirements for all banks around the world. Check your local bank’s Key Disclosure Statement – you’ll find a lot of footnotes stating how they’re transitioning towards Basel III compliance and some banks are even raising additional capital so that their Tier 1 capital ratio is higher than it needs to be “just in case”.

These capital and liquidity requirements are obviously a good idea in the aftermath of the global financial crisis. Investment banks like Lehman Brothers and Bear Stearns over-extended themselves on mortgage-backed securities and when they marked their positions to market, they essentially were worthless.

The US Treasury, using AIG Financial Products as a conduit, paid out the credit default swaps on all of these sub-prime CDOs at 100 cents on the dollar. This transferred hundreds of billions of dollars from US taxpayers to Wall Street banks.

In essence, Basel III is a technocratic series of rules and committee based supervision (seriously) that aims to avoid a repeat of 2008. The theory goes that if banks have to hold more capital and make fewer risky loans, then the financial system will be more stable and there’ll be no need for big bank bailouts.

The BIS has essentially changed the way every single bank abiding by or transitioning to Basel III does business. Why? Because different types of loans require different levels of reserves held against them in case of default. Different types of equity offer different levels of capital the bank can use in calculating its compliance with Basel III.

This means that, without any democratic input, the BIS and everyone participating in the Basel III process has already imposed massive structural adjustments on how capital is allocated in literally every single country! The technocrats have already changed how every single bank in the world prepares its financial statements and manages its balance sheet! If that isn’t a technocratic imposition without reference to democratic processes I don’t know what is.

Why are banks happy to lend on houses but not to small businesses? Because they need higher loss reserves for business lending. Ergo, you can borrow a $1 million for a house but borrowing $1 million for a development to increase housing supply is almost impossible unless you already have $1 million in net assets as security, rendering the whole point of participating in the bank lending market moot and the likelihood of any economic recovery relying on credit negligible.

What does this have to do with Basel III? Well, with quantitative easing injecting enormous amounts of liquidity into the financial system at the same time that higher capital requirements and liquidity constraints have been imposed on banks and financial institutions, it simply makes more sense to keep stuff on your balance sheet in assets that enable you to count them as Tier 1 capital under Basel III rules. That is why financial institutions have returned to profitability so quickly.

Thus, in the pursuit of financial stability, the Basel III process has also made it less likely that loans will be granted to the risky activities that will bring the Western economies back into growth mode. There is a trade-off between financial stability and credit being allocated towards risky activities like business startups and property development.

Remember, when private sector demand for credit is down, and banks need to raise enormous amounts of capital to meet Basel III requirements, how focused will they be on performing their role as a capital allocation utility i.e. the reason they’re given banking licenses? How focused can you be on business development in property lending when you made big mistakes in the last boom and now have a whole plethora of new rules around who you can lend money to?

It’s almost as if the technocrats did not believe that there were any tradeoffs in pursuing policy that, funnily enough, I think the average person in the street would wholeheartedly approve of. Regulation has consequences. We should be very concerned that the Reserve Bank wants to increase its level of “macro-prudential supervision” through loan-to-value restrictions.

Bank Stress Testing And Open Bank Resolution

Bank stress testing is an interesting thing to think about. The goal is to model what would happen to bank income statements and balance sheets in the wake of “shocks” like house prices returning to realistic levels or people realising that paying debt back just gives executives bonuses and less disposable income for cool stuff.

The Reserve Bank’s latest Financial Stability Report includes some discussion of recent bank stress tests done in collaboration with the Reserve Bank of Australia.

The impaired asset expense estimations even when the “shocks” happen are extremely low. An impaired asset expense is recognising on an income statement that you’re unlikely to have a loan repaid.

This flows through to whether the bank makes a profit or loss. If they make a loss, they have to raise additional capital in order to retain high Tier 1 capital ratios under Basel III requirements.

There is $35 billion in wholesale funding that banks have to rollover to replace over the next 3 years. With the euro-zone crisis still nowhere near being resolved, and the LIBOR scandal, will there even be a functioning wholesale money market in 3 years?

To say that there will be is arrogant in the extreme. Just look at how quickly the overnight lending markets evaporated after Lehman Brothers. We have no idea what could trigger another freeze. What if Greece exits suddenly and the charade that the euro-zone still has some semblance of solvency evaporates?

The RBNZ and RBA worked with the banks’ own models in order to conduct stress tests. They do not say whether they adjusted the banks’ figures to reflect the incentive they have to under-report substantial losses they would incur if certain shocks happened.

There is also not much discussion on whether impaired asset expenses peaking at 2% is realistic at all. This is odd. Why? Because if a major shock happens and New Zealand goes into a deep recession, we have no way of telling how the dominos will fall.

What I mean by this is that we can’t say what will cause different businesses to make shutdown decisions in the wake of a deep recession. Some business owners might fear the worst, layoff their employees promptly and suddenly an extra 30-40 mortgages start falling behind.

What happens if impaired asset expense ratios go above 2%? And if banks aren’t able to raise capital either domestically or on the wholesale money markets?

They become insolvent. Their capital ratios fall below their Basel III requirements. There is a risk that no capital injection can be arranged and so we turn to the proposed Open Bank Resolution strategy.

While I won’t go into detail about how the Open Bank Resolution process will work, I will make one comment : what if the initial losses are far greater than what the Reserve Bank has considered in building their model?

Banks actually have a major incentive, if the government is going to guarantee solvency support of the unfrozen portion of their assets, to make hay while the sun shines.

Paying bank executives 7-figures salaries in gratitude for shifting potential taxpayer liabilities into the tens of billions of dollars, when there is no recourse for clawing back excessive compensation and excess returns that have been clawed off the table, is folly in the extreme.

We cannot tell what the actual level of losses will be. We cannot tell what the actual impaired asset expense will be if a major bank collapses a year or so after a deep recession.

This means that the most honest value of government solvency support to a bank admitted to the Open Bank Resolution scheme is $X billion to $XX billion.

Furthermore, if the RBNZ takes over an insolvent bank, are there measures in place to insure futures contracts are rolled over to avoid cash settlement? What if a $10 billion notional US Treasury position isn’t rolled over? Do term depositors or taxpayers stump up for that?

If I was employed by the RBNZ I would be actively “war gaming” things outside the model. What if the Australian government, for political reasons, doesn’t want its super funds to eat the losses of an insolvent big bank? What if the Australian High Commissioner takes a trip to the Beehive and tells Bill English that the New Zealand government will eat the losses in partnership with the Australian government?

Bank stress testing based on the numbers is better than no bank stress testing at all. But there needs to be some clear thinking about what “outside the model” potential hurdles might need to be overcome.