BoE stress tests: all you need to know

The Bank of England has released the results of its latest round of its annual banking stress tests and its semi-annual financial stability report this morning. Used to measure the resilience of a bank’s balance sheet in adverse scenarios, the stress tests measured the impact of a severe slowdown in Chinese growth, a global recession […]

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Draghi: Eurozone will decline without vital productivity growth

It’s productivity, stupid. European Central Bank president Mario Draghi has become the latest major policymaker to warn of the long-term economic damage posed by chronically low productivity growth, as he urged eurozone governments to take action to lift growth and stoke innovation. Speaking in Madrid on Wednesday, Mr Draghi noted that productivity rises in the […]

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Asia markets tentative ahead of Opec meeting

Wednesday 2.30am GMT Overview Markets across Asia were treading cautiously on Wednesday, following mild overnight gains for Wall Street, a weakening of the US dollar and as investors turned their attention to a meeting between Opec members later today. What to watch Oil prices are in focus ahead of Wednesday’s Opec meeting in Vienna. The […]

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Banks, Financial

RBS emerges as biggest failure in tough UK bank stress tests

Royal Bank of Scotland has emerged as the biggest failure in the UK’s annual stress tests, forcing the state-controlled lender to present regulators with a new plan to bolster its capital position by at least £2bn. Barclays and Standard Chartered also failed to meet some of their minimum hurdles in the toughest stress scenario ever […]

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Barclays: life in the old dog yet

Barclays, a former basket case of British banking, is beginning to look inspiringly mediocre. The bank has failed Bank of England stress tests less resoundingly than Royal Bank of Scotland. Investors believe its assets are worth only 10 per cent less than their book value, judging from the share price. Although Barclays’s legal team have […]

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Categorized | Banks

Central banks as last-gasp pawnbrokers

Posted on May 31, 2016

James Ferguson cartoon©James Ferguson

Will there be another huge financial crisis? As Hamlet said of the fall of a sparrow: “If it be now, ’tis not to come. If it be not to come, it will be now. If it be not now, yet it will come — the readiness is all.” So it is with banks. They are designed to fall. So fall they surely will.

A recent book explores not only this reality but also a radical and original solution. What makes attention to this suggestion even more justified is that its author was at the heart of the monetary establishment before and during the crisis. He is Lord Mervyn King, former governor of the Bank of England. His book is called The End of Alchemy

    The title is appropriate: alchemy lies at the heart of the financial system; moreover, banking was, like alchemy, a medieval idea, but one we have not as yet discarded. We must, argues Lord King, now do so.

    As Lord King remarks, the alchemy is “the belief that money kept in banks can be taken out whenever depositors ask for it”. This is a confidence trick in two senses: it works if, and only if, confidence is strong; and it is fraudulent. Financial institutions make promises that, in likely states of the world, they cannot keep. In good times, this is a lucrative business. In bad times, the authorities have to come to the rescue. It is little wonder, then, that financial institutions have become so large and pay so well.

    Consider any large bank. It will have a wide range of long-term and risky assets on its books, mortgages and corporate loans prominent among them. It will finance these with deposits (supposedly redeemable on demand), short-term loans and longer-term loans. Perhaps 5 per cent will be financed by equity.

    What happens if lenders decide banks might not be solvent? If they are depositors or short-term lenders, they can demand their money back immediately. Without aid from the central bank, the only institution able to create money without limit, banks will fail to meet that demand. Since a generalised collapse would be economically devastating, needed support is forthcoming. Over time, this reality has created a “Red Queen’s race”: governments try to make finance safer and finance exploits the support to make itself riskier.

    Broadly speaking, two radical solutions are on offer. One is to force banks to fund themselves with far more equity. The other is to make banks match liquid liabilities with liquid and safe assets. The 100 per cent reserve requirements of the
    “Chicago plan”, proposed during the Great Depression, is such a scheme. If liquid, safe liabilities finance liquid, safe assets — and risk-bearing, illiquid liabilities finance illiquid, unsafe assets — alchemy disappears. Finance would be safe. Unfortunately, the end of alchemy would also end much risk-taking in the system.

    Lord King offers a novel alternative. Central banks would still act as lenders of last resort. But they would no longer be forced to lend against virtually any asset, since that very possibility must create moral hazard. Instead, they would agree the terms on which they would lend against assets in a crisis, including relevant haircuts, in advance. The size of these haircuts would be a “tax on alchemy”. They would be set at tough levels and could not be altered in a crisis. The central bank would have become a “pawnbroker for all seasons”.

    The value of liquid assets would then be known. They would consist of re­serves at the central bank plus the ag­reed collateral value of any other assets. In the long run, argues Lord King, liquid assets, so defined, should match an institution’s liquid liabilities, defined as loans of a year’s maturity or less.

    This scheme has several advantages. First, it recognises that only the central bank can create needed liquidity in a crisis. Second, it offers a path to a world without alchemy. Third, it offers an option between the status quo and the extreme of 100 per cent reserve banking. Fourth, it eliminates moral hazard, since the penalty on obtaining liquidity would be defined in advance. Fifth, it exploits today’s circumstances, including the reserves created by quantitative easing and the infrastructure created by central banks to assess and manage collateral. Sixth, regulation could then be reduced to just two rules: a higher maximum leverage ratio (of at most 10 to one) and the rule that the pledgeable value of assets at the central bank must exceed the value of liquid liabilities.

    Martin Wolf

    The self-inflicted dangers of the EU referendum

    British Prime Minister David Cameron delivers a speech at a Stronger In campaign event in his Witney constituency in central England on May 14, 2016. Prime Minister David Cameron on Saturday stepped up his campaign for Britain to remain in the EU, warning that exiting the bloc would cost Britain billions of pounds in investment. / AFP PHOTO / POOL / EDDIE KEOGHEDDIE KEOGH/AFP/Getty Images

    Cameron might soon be known as the man who left the UK in far-from-splendid isolation

    In spring 2015, the value of the collateral of UK banks at the BoE was £314bn and of bank reserves was £317bn. This makes total liquid assets of £631bn. That is to be compared with deposits of £1.82tn. Over time, this gulf could be eliminated. The BoE should make existing reserves permanent. It could raise reserves by further permanent increases in the monetary base. Finally, it could agree the pledgeable value of more assets.

    This is a radical and interesting set of proposals. If the proposed rule were in effect, the only people with an interest in “running” from a bank would be long-term lenders and shareholders. But if share prices did crash and long-term loans dried up, management would be under the right sort of pressure. It would also give time to resolve the financial position of institutions in difficulty. If equity were insufficient, then these losses would fall on longer-term creditors in a predefined order.

    This scheme has drawbacks. Pledge­able values would have to vary with economic conditions, which could create a degree of stress. But it is a valiant attempt to discipline a financial system that makes promises it cannot keep. At the very least, the cost of making those promises would be made predictable and transparent. Alchemy would be less lucrative; banks would be better capitalised; and runs by short-term creditors should cease. These ideas deserve open-minded consideration.