7/11/17: 800 years of bond markets cycles

An interesting new working Paper from the BofE, titled “Eight centuries of the risk-free rate: bond market reversals from the Venetians to the ‘VaR shock’” (Bank of England, Staff Working Paper No. 686, October 2017) by Paul Schmelzing looks at new data for “the annual risk-free rate in both nominal  nd real terms going back to the 13th century.”

Such a long horizon allows the author to establish and define the existence of the long term “bond bull market”

Specifically, the author shows “that the global risk-free rate in July 2016 reached its lowest nominal level ever recorded. The current bond bull market in US Treasuries which originated in 1981 is currently the third longest on record, and the second most intense.”

And plotting real debt bull markets (shaded):

Finally, the extent of the current bond bull market (since 1981) relative to previous historical bull markets is reflected also in the extent of yield compression (annualized) that has been achieved during each bull market cycle:

While the rest of the paper goes through three specific case studies of bull markets corrections, it is the first section - the one based on historical long-term data series - that poses the starkest evidence of just how exceptional (and thus risk-loaded) the current markets environment is. Looking at historic averages, and potential for historical mean reversion for yields, the current yield on U.S. 10 year paper will have to double, effectively increasing long-term risk exposure to widening fiscal deficits by the tune of 2.5-2.75 percent of GDP. The cost of carrying this level of indebtedness, when yields run 1.5-1.7 times the upper envelope of the potential rate of economic growth is a function of simple arithmetic. Currently, this arithmetic suggests that the U.S. will either have to figure out how to live with above 5% annual deficits and ballooning debt, or how to live within its own means.

21/9/17: Another reminder: Financial Crises are becoming more frequent & more disruptive

As recently noted by Holger Zschaepitz @Schuldensuehner, new research from Deutsche Bank shows that "Post Bretton Woods (1971-) system vulnerable to crises. Frequency of Financial Crises increased since then. Growth of finance encouraged trend".

Of course, readers of this blog would have known as much by now.  Almost 2.5 years ago I wrote about research by Claudio Borio of BIS on the same topic (see http://trueeconomics.blogspot.com/2015/05/8515-bis-on-build-up-of-financial.html) and Borio's findings are linked to his own earlier work on excess financial elasticity hypothesis (see http://trueeconomics.blogspot.com/2011/11/07112011-dont-blame-johnny-foreigner.html).

So while the DB 'research' simply replicates the findings of others who paved the way, it does present a nice picture of the amplified nature of financial crises in recent decades, both in terms of timing/frequency and in terms of impact.

3/1/17: Dead or Dying... A Requiem for the Traditional Banking Model

Earlier today, I briefly posted on Twitter my thoughts about the evolving nature of traditional banking. Here, let me elaborate on these.

The truth about the traditional banking model: it is dead. Ok, to be temporally current, it is dying. Six reasons why.

1) Banks can’t price risk in lending - we know as much since the revelations of 2007-2008. If they cannot do so, banks-based funding model for investment is a metronome ticking off a crisis-to-boom cyclicality. That policymakers (and thus regulators) cannot comprehend this is not the proposition we should care to worry about. Instead, the real concern should be why are equity and direct lending - the other forms of funding - not taking over. The answer is complex. Informational asymmetries abound, making it virtually impossible to develop retail (broad) markets for both (excluding listed equity). Tax preferences for debt is another part of the fallacious equation. Habits / status quo biases in allocating funds is the third. Inertia in the markets, with legacy lenders being at scale, while challengers being below the scale. Protectionism (regulatory and policy) favours banks over other forms of lending and finance. And more. But these factors are only insurmountable today. As they are being eroded, direct financing will gain at the expense of banks.

The side question is why the banks are no longer able to price risks in lending, having been relatively decent about doing so in previous centuries? The answer is complex. Firstly, banks are legacy institutions that have knowledge, models, memory and intellectual infrastructure that traces back to the industrial age. Time moved on, but banks did not move on as rapidly. Hence, today's firms are distinct from Coasean transaction cost minimisers. Instead, today's firms are much more complex entities, dealing with radically faster pace of innovation and disruption, with higher markets volatility and, crucially, trading in the environment that is more about uncertainty than risk (Knightian world). Here, risk pricing and risk management are not as closely aligned with risk modeling as in the age of industrial enterprises. Guess what: if firms are existing in a different world from the one inhabited by the banks, so are people working for these firms (aka banks' retail customers). Secondly, banks' own funding and operations models have become extremely complex (see on this below), which means that even simple loan transaction, such as a mortgage, is now interwoven into a web of risky contracts, e.g. securitisation, and involves multiple risky counterparties. Thirdly, demographic changes have meant changes in risk regulation environment (increased emphasis on consumer protection, bankruptcy reforms, data security, transparency, etc) all of which compound the uncertainty mentioned above. And so on...

2) Banks can’t provide security for depositors - we know, courtesy of pari passu clauses that treat depositors equivalently with risk investors. The deposits guarantee schemes are fig leaf decorations. For two reasons. One: they are exogenous to banks, and as such should not be used to give banks a market advantage. Of course, they are being used as such. Two: they are only as good as the sovereign guarantors’ willingness / ability to cover them. Does anyone, looking at the advancement of the cashless society in which the state is about to renew on its own promissory fiat at least across anonymity and extreme risk hedging functions of cash, really thinks the guarantees are irrevocable? That they cannot be diluted? If the answer is no, then that’s the beginning of an end for the traditional deposits-gathering, but bonds-funded banking hybrids.

More fundamentally, consider corporate governance structure of a traditional bank. Board and executives preside (more often, executives preside over the board due to information asymmetries and agency problems). Shareholders are given asymmetric voting rights (activist institutional shareholders are treated above ordinary retail shareholders). Bondholders have direct access to C-suite and even Board members that no other player gets. And the funders of the bank, the depositors? Why, they have no say in the bank. Not even a pro forma one. This asymmetry of power is not accidental. It is an outrun of the centuries of corporate evolution, driven by pursuit of higher returns on equity. But, roots aside, it certainly means that depositors are not the key client of the bank's executive. If they were, they would be put to the top of the corporate governance pyramid.

Still think that the bank is here to protect your deposits?

3) Banks can’t provide efficient platforms for transactions - we know, courtesy of #FinTech solutions. Banks charge excessive fees for simple transactions, such as currency exchanges, cross border payments, debt cards, some forms of regular utility payments, etc. They charge to issue you access to your money and to renew access when it deteriorates or is lost. They charge for all the things that many FinTech platforms do not charge for. And they provide highly restricted (i.e. costly) platform migration options (switching banks, for example). Some FinTech platforms now offer seamless, low cost migration options, e.g. aggregators and some new tech-enabled banks, e.g. KNAB. Anecdotal evidence to bear: two of my banks on two sides of the Atlantic can’t compete on fees and time-to-execute lags with a small firm doing my forex conversions that is literally 10 times cheaper than the lower cost bank and 5 days faster in delivering the service.

If you want an analogy: banking sector today is what music industry was just at the moment of iTunes launch.

4) Banks can’t escape maturity mismatch and other systemic risks - we know, courtesy of banks' reliance on interbank lending and securitisation. The core model of deposits being transformed into loans is hard enough to manage from the maturity mismatch perspective. But when one augments it with leveraged interbank funding and securitisation, we end up with 2007-2008 crisis. This is not an accident, but a logical corollary of the banking business model that requires increasing degrees of leverage to achieve higher returns on equity. Risks inherent in lending out of deposits are compounded by risks relating to lending out of borrowed funds, and both are correlated with risks arising from securitising payments on loans. The system is inherently unstable because second order effects (shutdown of securitised paper markets) on core business funding dominate the risk of an outright bank run by the punters. Worse, competitive re-positioning of the financial institutions is now running into the dense swamp of new risks, e.g. cybercrime and ICT-related systems risks (see more on this here: http://trueeconomics.blogspot.com/2017/01/2116-financial-digital-disruptors-and.html). No amount of macro- or micro-prudential risk management can address these effects. Most certainly not from the crowd of regulators and supervisors who are themselves lagging behind the already laggardly traditional banking curve.

As an aside, consider current demographic trends. As older generations draw down their deposits, younger generation is not accumulating the same amounts of cash as their predecessors were. The deposits base is shrinking, just at the time as transactions volumes are rising, just as weak income growth induces greater attention to transactions fees. Worse, as more and more younger workers find themselves in the contingent workforce or in entrepreneurship or part time work, their incomes become more volatile. This means they hold greater proportion of their overall shrinking savings in precuationary accounts (mental accounting applies). These savings are not termed deposits, but on-demand deposits, enhancing maturity mismatch risks.

5) Banks can’t provide advice to their clients worth paying for - we know this, thanks to the glut of alternative advice providers, and passive and active management venues. And thanks to the fact that banks have been aggressively ‘repairing margins’ by cutting back on customer services, which apparently does not damage their performance. Has anyone ever heard of cutting a value-adding line of business without adversely impacting value-added or margin? Nope, me neither. So banks doing away with advice-focused branches is just that - a self-acknowledgement that their advice is not worth paying for.

Worse, think of what has been happening in asset management sector. Fee-based advice is down. Fee-based investment funds (e.g. hedge funds) are shrinking violets. But all of these players bundle fees with performance-based metrics. And here we have a bunch of useless advice providers (banks) who supposed to charge fees for providing no performance-linked anchors?

6) Banks can’t keep up with the pace of innovation. How do we know that? Banks are already attempting to converge to FinTech platforms (automatisation of front and back office services, online banking, e-payments, etc,). Except they neither have technical capabilities to do so, nor integration room to achieve it without destroying own legacy systems and business, nor can their investors-required ROE sustain such a conversion. Beyond this, banking sector has one of the lowest employee mobility rates this side of civil service. Can you get innovation-driven talent into an institution where corporate culture is based on being a 'lifer'? Using Nassim Taleb's term, bankers are the 'IBM men' of today. Innovation-driven companies have none of these. For a good reason, not worth discussing here.


So WHAT function can banks carry out? Other than use private money to sustain superficial demand for overpriced Government debt and fuel bubbles in assets?

It is a rhetorical question. Banks, of course, are not going to disappear overnight. Like the combustion engine is not going to. But banks’ Tesla moment is already upon us. Today, banks, like the car companies pursuing Tesla, are throwing scarce resources at replicating FinTech. Most of the time they fail, put their tails between their legs and go shopping for FinTech start ups. Next, they will fail to integrate the start ups they bought into. After that, we will see banks consolidation moment, as the bigger ones start squeezing the smaller ones in pursuing shrinking market for their fees-laden services. And they will be running into other financial sector players, with deeper pockets and more sustainable (in the medium term) business models moving into their space - insurance companies and pension funds will start offering utility banking services to vertically integrate their customers. Along this path, banks' equity capital will be shrinking, which means their non-equity capital (costly CoCos and PE etc) will have to rise. Which means their ROEs will shrink some more.

Banking, as we know it, is dying. Banks, as we know them, will either vanish or mutate. If you are investing in banking stocks, make sure you are positioned for an efficient exit, make certain the bank you are investing in has the firepower to survive that mutation, and be confident in your valuation of that bank post-mutation. Otherwise, enjoy mindless gambling.

2/1/2015: Monetary Policy and Property Bubbles

Returning again to the issue of lender/funder liability in triggering asset price bubbles (see more on this here: http://trueeconomics.blogspot.ie/2015/01/112015-share-liability-debtor-and-lender.html), CEPR Discussion Paper "Betting the House" (see
http://www.cepr.org/active/publications/discussion_papers/dp.php?dpno=10305) by Òscar Jordà, Moritz Schularick, Alan M. Taylor asks a question if there is "a link between loose monetary conditions, credit growth, house price booms, and financial instability?"

The authors look into "the role of interest rates and credit in driving house price booms and busts with data spanning 140 years of modern economic history in the advanced economies. We exploit the implications of the macroeconomic policy trilemma to identify exogenous variation in monetary conditions: countries with fixed exchange regimes often see fluctuations in short-term interest rates unrelated to home economic conditions."

Do note: Ireland and the rest of euro periphery are the prime examples of this specific case.

The authors find that "…loose monetary conditions lead to booms in real estate lending and house prices bubbles; these, in turn, materially heighten the risk of financial crises. Both effects have become stronger in the postwar era."

So let's give the ECB a call… 

12/2/2014: Jobless Recoveries post-Financial Crises: Solutions Menu?

Next few posts will be touching on some interesting new research papers in economics and finance… in no particular order. Please note, no endorsement or peer review analysis from me here.

To start with: NBER WP 19683 (http://www.nber.org/papers/w19683) by Calvo, G., Coricelli, F. and Ottonello, P. "JOBLESS RECOVERIES DURING FINANCIAL CRISES: IS INFLATION THE WAY OUT?" from November 2013.

The paper discusses 3  traditional policy tools to mitigate jobless recoveries during financial crises: 

• inflation
• real devaluation of the currency, and  
• credit-recovery policies. 

The nominal exchange rate devaluation tool not being available to the euro area economies independently of the ECB, we have by now heard a lot about inflation (the need for). At the same time, real devaluation tool includes fabled European cost-competitiveness measures. 

Here's the pre-cursor to the paper: "The slow rate of employment growth relative to that of output is a sticking point in the recovery from the financial crisis episode that started in 2008 in the US and Europe (a phenomenon labeled “jobless recovery”). The issue is a particularly burning one in Europe where some observers claim that problem economies (like Greece, Italy, Ireland, Spain, and Portugal) would be better off abandoning the euro and gaining competitiveness through steep devaluation. This would be a momentous decision for Europe and the rest of the world because, among other things, it may set off an era of competitive devaluation and tariff war."

Hypotheticals aside, the study starts by "digging more deeply into the relationship between inflation and jobless recovery, also considering the possible role of real currency depreciation and resource reallocation (between tradables and non-tradables)."

As authors note: "This discussion is particularly relevant for countries that, being in the Eurozone, cannot follow a nominal currency depreciation policy to mitigate high unemployment rates 

(e.g. Greece, Italy, Ireland, Spain, and Portugal)."

First finding is that there is "some evidence suggesting that large inflationary spikes (not a higher inflation plateau) help employment recovery. Even in high-inflation episodes, inflation typically returns to its pre-crisis levels…" so the effects of the induced inflation wear out quasi-automatically.

Second finding is that "(independent of inflation) financial crises are associated with real currency depreciation (i.e., the rise in the real exchange rate) from output peak to recovery. This shows that the relative price of non-tradables fails to recover along with output even if the real wage does not fall, as is the case in low-inflation financial crisis episodes. This implies that, contrary to widespread views, nominal currency depreciation may eliminate joblessness only if it generates enough inflation to create a contraction in real wages; real currency depreciation or sector reallocation might not be sufficient to avoid jobless recovery if all sectors are subject to binding credit 

constraints that put labor at a disadvantage with respect to capital." In other words, there goes Argentina's fabled hope for recovery via devaluations.

Third finding extends the second one to the case closer to euro area peripherals: "Similarly, for countries with fixed exchange rates, “internal” or fiscal devaluations during financial crises are likely to work more through reductions in labor costs than changes in relative prices and sectoral reallocation obtained through taxes and subsidies affecting differentially tradable and non-tradable sectors." In other words, internal devaluations work, and they work via cost competitiveness gains and exporting sector repricing relative to domestic.

Tricky thing, though: "However, neither nominal nor real wage flexibility can avoid the adverse effects of financial crises on labor markets, as wage flexibility determines the distribution of the burden of the adjustment between employment and real wages, but does not relieve the burden from wage earners." which means that a jobless recovery is more likely under internal devaluation scenario.

Fourth finding: "Our findings highlight the difficulty in simultaneously preventing jobless and wageless recoveries, and suggest that if the goal is to avoid jobless recovery, the first line of action should be an attempt to relax credit constraints." Oops… but credit constraints are not being relaxed in the case of collapsed financial systems and debt overhang-impacted households in the likes of Ireland.

More on this: "Only direct credit policies that tackle the root of the problem seem to be able to help unemployment and wages simultaneously. …common sense suggests the following conjectures. In advanced economies, quantitative easing operations, especially if they involve the purchase of “toxic” assets, can have an effect on increasing firms’ collateral and relaxing credit constraints that affect employment recovery." But, of course, in Ireland these measures failed to trigger such outcomes - Nama has been set up for two years now and credit restart is still missing. May be one might consider the fact that targeting of bad assets purchases is needed? May be buying up wasteful real estate assets was not a good idea and instead we should have pursued purchases and restructuring of mortgages? Sort of what Iceland (partially and with caveats) did?

Overall, tough conclusions all around. 

2/1/2014: Risk, Regulation, Financial Crises: A Panacea Worse than the Disease?

An interesting - both challenging and revealing - piece on 'preventing the future crisis' via http://www.pionline.com/article/20131223/PRINT/312239993/preventing-the-next-financial-crisis-requires-regulatory-changes.

Few points worth commenting on:

Per article: "…Record investment management industry profits as well as record market highs belie the fact we remain truly exposed to complex financial products and services not yet fully restrained since the crisis of 2008." As a logical conclusion to this, of the "three things in particular should concern all of us who are stakeholders in the finance industry as we move into the new year" the first one is:

"…complacency that another crisis can't happen because we have fixed the gaps in regulation."

So far nothing to argue with. Financial innovation (aka a path of increasing complexity) remains the main source of margins uplift in the industry. As long as that is the case, we are going to have less transparency, lower capacity to price risks and, as the result, greater fragility of the system, especially with respect to tail events.

"Nothing could be further from reality and the list of unfinished regulatory business is long. " And the article rolls on with a brief list of reforms and changes yet to take place. Alas, desired or not, these changes are hardly going to bring about any significant change in the way the sector operates. The irony is: the article warns against complacency and then complacently assumes (or even postulates - take your pick) that implementing the list of regulations and reforms supplied will resolve the problem of 'gaps in regulation'.

Really? Now, wait a second. We have a problem of 2 parts:
Part 1: complexity of system is high.
Part 2: complexity of regulation lagging complexity of system.

Matching Part 1 to Part 2 by raising complexity of regulation can only address the problem of risk buildup if and only if Part 1 is independent of Part 2. Otherwise, rising complexity in 2 can lead to rising complexity in 1 and a race in complexity.

Still with me? That is a major problem of the financial system as we know it since at least 19th century. The problem is that rising complexity of regulation is driving financial innovation probably as much as the need for higher margins. The race to match Part 1 and Part 2 above is a loss-making game for regulators, and thus, for economies at large.

If that is at least partially true, the argument should not be about regulations that are yet to be implemented, but rather about which regulations can help reducing complexity (and increase risk management effectiveness) in both Parts 1 and 2. We are still missing that argument, having departed firmly on the path of reasoning that suggests that higher complexity of regulation = higher system ability to absorb shocks. More dangerously, we are seemingly traveling along the line of logic that suggests that higher complexity of regulation = higher ability of system to 'prevent' shocks.


The article goes on to list another major source of risk: "investment management industry overconfidence that it is back in control". Specifically, "We in the industry perceive ourselves as having rectified our inability to see building counterparty, leverage and liquidity risks, masked through Federal Reserve policy by the unorthodox government support of financial markets and the nearly 10,000-point move in the Dow Jones industrial average since the financial crisis."

In reality, "Systemic risks are still building, undetected. Transparency is not increasing and the unwillingness or inability to remove government support in the markets is unprecedented."

Guess what? If you assume that more regulation + more complex regulation = better risk management, you are going to become complacent and you are going to get a false sense of security, control. This brings us back to the first point above.


And now to the non-point point number 3: "Finally, we in the investment management profession seem totally nonchalant about the current state of our existing regulatory system. It is alarmingly outdated, under-resourced and no match for the complexity of markets in the 21st century. To be clear, we are not talking about the new regulations addressing the crisis, rather the basic requirements of our present regulatory structure."

Back to point one above, then, again…


The reason I am commenting on this article is precisely because it embodies the very poor logical reasoning that is leading us to structure regulatory responses to the crisis in such a way that it will assure the emergence of a new crisis. But the real kicker is not that. The real kicker is that the very belief that regulatory system based on matching complexity of regulated services can ever be calibrated well-enough to assure stability of the system is a belief suffering from gross over-extension of faith.

A constant race to increase complexity of the system will lead to system collapse. 

16/1/2013: Some charts on US unemployment: Financial Crises v Recessions

Two absolutely fascinating charts showing just how different is the current Great Recession from the previous recessions and how the financial crises disruptions are much longer lasting structural in nature when it comes to unemployment than traditional recessions.

(Source: http://oregoneconomicanalysis.wordpress.com/2012/09/24/checking-in-on-financial-crises-recoveries/ )

First, financial crises:

And now, run-of-the-mill recessions:

And financial crises duration in terms of unemployment levels:

The above charts should really be a wake up call to the European 'leaders' still pretending that the recovery is only a matter of short time stroll through deficits reductions.

Here is a link to an excellent presentation (from April 2012, albeit) by the US Treasury on the crisis responses to-date, showing the complexity and the sheer magnitude of these responses. To anyone familiar with the EU response to the crisis - these amount at best to 1/10th of the scale/scope of the US responses.

Here's a telling comparative:

It is also telling to read the level of realism in the US Treasury's presentation as to the problems remaining in the economy that is virtually unparalleled with the reports from the EU and some National Governments (e.g. Ireland).