Money, Credit, and Crises: Understanding the Modern Banking System [1 ed.] 9783030643836, 9783030643843

Table of contents :
Preface
Contents
List of Figures
List of Tables
Part I A History of Banking
1 A Brief History of Money and Credit
Introducing Coins
Banking in the Middle Ages
Merchant Banking
The Rise of Public Banks
Goldsmith Banks and the Bank of England
References
2 Banking in the Twentieth Century
The Great Depression
The Global Depression
Introducing Deposit Insurance
Bretton Woods
The Secondary Banking Crisis in the UK
References
Part II How Banking Works
3 Money and Inflation
Hyperinflations
No Inflation Means No Growth
References
4 Money and Banking
The Money Multiplier
Deposits and Liquidity
References
5 Banking and the Economy
Lending and the External Sector
Stock Market Lending
The Feedback Loop Again
Monetary Policy and Lending
References
6 Investment Banking
Facilitators of Third-Party Credit
Derivatives
Securities Lending
Repos and Reverse Repos
Brokers and Dealers
References
7 Banking in Crisis
Non-performing Loans and Bank Balance Sheets
Provisioning
NPLs: From Banks to the Economy
Insolvency
Too Big to Fail
The Bail-In
References
8 Financial Instability
International Instability: Cyprus
Financial Instability in Japan
Stabilizing the Unstable
References
Part III Modern Banking
9 Securitization
The Beginnings
Mortgage-Backed Securities
Collateralized Mortgage Obligation
Reducing CMO and SPV Risks
Expanding Securitization
Credit Card Securitizations
Client Riskiness Types: Alt-A
Asset-Backed Securities
Synthetic Securitization
A Generic Overview
References
10 Shadow Banking
Collateralized Debt Obligations
Asset-Backed Commercial Paper
Defining Shadow Banking
The Importance of Shadow Banking
References
11 Modern Crisis-Dealing Practices
Quantitative Easing
Quantitative Easing and Money Supply
Quantitative Easing and Inflation
Quantitative Easing and Bank Lending
QE and Bank Lending in the Euro Area
Quantitative Easing and Private Investment
Quantitative Easing, Bond Yields, and Monetary Financing
Selling Back Securities: The Tapering
Easing in the EU and Japan
QE: A Conclusion
Negative Interest Rates
References
12 Epilogue: The Future
Cashless Societies
Digital Banks and E-Money
Cryptocurrencies
Afterword
References
References
Index

Citation preview

Money, Credit, and Crises

Understanding the Modern Banking System

Nektarios Michail

Money, Credit, and Crises

Nektarios Michail

Money, Credit, and Crises Understanding the Modern Banking System

Nektarios Michail Central Bank of Cyprus Nicosia, Cyprus

ISBN 978-3-030-64383-6 ISBN 978-3-030-64384-3 https://doi.org/10.1007/978-3-030-64384-3

(eBook)

© The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Palgrave Macmillan imprint is published by the registered company Springer Nature Switzerland AG The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland

Preface

This book started off about three years ago, in an effort to fully grasp what went on with the world at the time. The first topic I had aimed to examine was the efficiency of quantitative easing policies, now Chapter 11 of this book. In the process of finding out as much as I could about the topic, I realized that there was a lack of easy-to-read material. While academic studies, blog posts, and speeches, are aplenty, there is no simple man’s guide to what this policy was all about. So I decided to create one. In the process of this creation, I realized that an article on its own would have been pointless. How could I refer to the economics of the banking sector if there was no explanation about them before? In order to understand how quantitative easing works, one needs to understand how the world of banking works. This led to another issue: how could one appreciate the world of banking at this point in time, without looking at all the other policies which shaped it, such as deposit insurance? Nonetheless, to look at them one would have to go back in time and elaborate on what went on during that period that caused such a paradigm shift in policy. After all of this, and many other similar thoughts and realizations, the quantitative easing chapter ended up second to last, enriched with other policy measures assumed in the last ten years. While writing, I have always aimed to keep things as simple as possible. I find no reason for unnecessary complexity, especially if ideas, notions, and policies can be explained on the basis of a few basic principles. That said, the reader of this book should rest assured that just everyday knowledge about

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Preface

banking should be enough to go through it without any issue. I have assumed that the reader has only a very basic understanding of what the banking sector is and I have (hopefully) proceeded with explaining most notions as simply and thoroughly as possible. In my mind, this book is aimed at anyone who wishes to better understand a sector which is usually riddled with mystery given that most people tend to focus on just a few parts of it. It was one of the promises I made that the focus would have been on the forest and not on the trees. As such, I have refrained from too narrowly focusing on the particulars (other than explaining their workings and effects that is) and have instead offered the big picture regarding the sector. I hope that the book will provide you with much insights and expand your knowledge on how banks work in the current environment. Naturally, over the course of writing this book, there have been many people who have helped me in clearing my thoughts, provided me with more knowledge on the topic, or supported me along the way. My editor, Tula Weis has been extremely supporting and patient with my delays, and so have Lucy Kidwell and Balaji Varadharaju from Palgrave Macmillan and Springer Nature respectively. I would like to thank Christos Savva and Demetris Koursaros for the interesting discussions and support they have offered me since my doctoral years. Furthermore, I would like to thank the research team at the Central Bank of Cyprus, namely, George Kyriacou, Pany Karamanou, George Thucydides, Ioanna Evangelou, Charis Charalambous, Angelos Roussos, Maria Mithilou, and particularly Lena Cleanthous and Christiana Aristodemou. Many thanks go Agorasti Patronidou, whose help in drafting Chapter 10 (Financial Instability) has been invaluable. I owe a great deal of gratitude to Christos Vassis for meticulously going through the whole book and providing insightful comments and suggestions. Naturally, family support has been paramount throughout these years. Naturally, all remaining errors are my own. Limassol, Cyprus August 2020

Nektarios Michail

Contents

Part I

A History of Banking

1

A Brief History of Money and Credit Introducing Coins Banking in the Middle Ages Merchant Banking The Rise of Public Banks Goldsmith Banks and the Bank of England References

3 7 8 12 15 19 24

2

Banking in the Twentieth Century The Great Depression The Global Depression Introducing Deposit Insurance Bretton Woods The Secondary Banking Crisis in the UK References

27 31 43 46 47 51 56

Part II 3

How Banking Works

Money and Inflation Hyperinflations

61 66

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Contents

No Inflation Means No Growth References

69 74

4

Money and Banking The Money Multiplier Deposits and Liquidity References

77 82 85 90

5

Banking and the Economy Lending and the External Sector Stock Market Lending The Feedback Loop Again Monetary Policy and Lending References

91 95 97 98 100 103

6

Investment Banking Facilitators of Third-Party Credit Derivatives Securities Lending Repos and Reverse Repos Brokers and Dealers References

105 106 107 109 110 111 113

7

Banking in Crisis Non-performing Loans and Bank Balance Sheets Provisioning NPLs: From Banks to the Economy Insolvency Too Big to Fail The Bail-In References

115 117 122 124 126 128 132 134

8

Financial Instability International Instability: Cyprus Financial Instability in Japan Stabilizing the Unstable References

137 144 146 149 153

Contents

Part III

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Modern Banking

9

Securitization The Beginnings Mortgage-Backed Securities Collateralized Mortgage Obligation Reducing CMO and SPV Risks Expanding Securitization Credit Card Securitizations Client Riskiness Types: Alt-A Asset-Backed Securities Synthetic Securitization A Generic Overview References

157 159 161 165 167 171 172 173 174 177 178 181

10

Shadow Banking Collateralized Debt Obligations Asset-Backed Commercial Paper Defining Shadow Banking The Importance of Shadow Banking References

183 184 185 190 193 197

11

Modern Crisis-Dealing Practices Quantitative Easing Quantitative Easing and Money Supply Quantitative Easing and Inflation Quantitative Easing and Bank Lending QE and Bank Lending in the Euro Area Quantitative Easing and Private Investment Quantitative Easing, Bond Yields, and Monetary Financing Selling Back Securities: The Tapering Easing in the EU and Japan QE: A Conclusion Negative Interest Rates References

199 199 201 203 204 209 211 213 216 218 219 219 225

12

Epilogue: The Future Cashless Societies Digital Banks and E-Money

227 227 229

x

Contents

Cryptocurrencies Afterword References

231 232 234

References

235

Index

247

List of Figures

Fig. 2.1 Fig. 2.2 Fig. 2.3 Fig. 2.4 Fig. 3.1 Fig. 3.2 Fig. 3.3 Fig. 3.4 Fig. 4.1 Fig. 4.2 Fig. 4.3 Fig. 4.4 Fig. 4.5 Fig. 5.1 Fig. 5.2 Fig. 5.3 Fig. 6.1 Fig. 7.1 Fig. 7.2 Fig. 7.3 Fig. 7.4

Bank loans on securities (billions of USD) US Discount rate (%) Gold held in the Treasury and Federal Reserve Banks ($ millions, time period: January 1926–January 1934) Federal Budget Balance (% of GNP) Inflation rate for the US (%) Supply, demand, and price determination US inflation and money printing US inflation and capacity utilization US (real) currency in circulation per capita ($) The loan creation process in the bank balance sheet Bank’s balance sheet after the withdrawal of a loan An illustration of the purchase of bonds by the banking sector Loans annual growth and the funds rate in the US since 1970 Case-Shiller National Home Price Index Monetary Interest Paid (Billion, $) Bank lending growth and Current Account Balance in Australia Broker/dealer assets as % of total banking assets Bank balance sheet when a loan is granted Bank balance sheet after the loan is withdrawn Bank balance sheet when half the loan is repaid Bank balance sheet with NPL

33 35 37 38 62 63 67 68 78 79 80 81 87 93 93 96 112 117 118 119 120

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List of Figures

Fig. 7.5 Fig. 7.6 Fig. 7.7 Fig. 7.8 Fig. 7.9 Fig. 8.1 Fig. 8.2 Fig. 8.3 Fig. 8.4 Fig. 8.5 Fig. 8.6

Fig. 8.7 Fig. 8.8 Fig. 8.9 Fig. 8.10 Fig. 8.11 Fig. 8.12 Fig. 9.1 Fig. 9.2 Fig. 9.3 Fig. 9.4 Fig. 9.5 Fig. 9.6 Fig. 10.1 Fig. 10.2 Fig. 10.3 Fig. 10.4 Fig. 11.1 Fig. 11.2 Fig. 11.3 Fig. 11.4 Fig. 11.5 Fig. 11.6 Fig. 11.7 Fig. 11.8 Fig. 11.9 Fig. 11.10 Fig. 11.11

Bank balance sheet with bank capital Balance sheet with bank capital and bad loans Using capital to cover bad loans Bank balance sheet with provisioning Bank failures in the US Phase 1, economic boom (hedge lending) Phase 2, economic bust (Ponzi lending) ABS security issuance and real estate growth Mortgage debt payments as a percent of disposable income Mortgage debt outstanding (billion, $) Net percentage of banks reporting tightening standards (The figure indicates lending standards for large firms. The picture is similar for small and medium firms) US private debt-to-GDP ratio Unemployment and house price index Property prices change Real interest rates (Japan) Japanese GDP growth Domestic credit to private sector growth Bank balance sheet changes during securitization Banks’ borrowing from the Fed’s Discount Window ($, billions) Securitization flow chart Conduit balance sheet Securitization process Cumulative flow to securitized mortgage bonds in the US (billions, $) MMMF total financial assets (Billions, $) Two-tier structure Conduit balance sheets after securitization The shadow banking system Evolution of M1 money stock (Billions, $) Reserve balances at all federal banks (Billions, $) US inflation excluding energy and food (y/y, %) Flow of credit (Billions, $) Difference of loan prime rate and 3-month deposit rate (%) Net percentage of banks’ reporting increased willingness to make consumer instalment loans in the US Net percentage of domestic banks reporting stronger demand for commercial and industrial loans in the US Loans as a share of total assets Excess reserves and bond holdings as a share of total assets Gross private investment (Billions, $) Government investment (Billions)

120 121 122 123 127 139 139 140 140 141

142 143 145 146 147 147 148 162 164 167 167 170 171 186 188 189 192 202 202 203 204 205 205 207 209 210 211 212

Fig. 11.12 Fig. 11.13 Fig. 11.14 Fig. 11.15 Fig. 11.16 Fig. 12.1

List of Figures

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10-year bond yield (%) Federal government debt and interest payments (Billions, $) University of Michigan consumer confidence index Bank prime lending rate Bank net interest margins Currency in circulation per person, deflated ($)

214 214 215 217 221 228

List of Tables

Table 9.1 Table 9.2 Table 10.1

Examples of securitized assets excluding MBS, CARs, and CARDs Sample deal attachment and detachment levels Shadow banking

175 178 193

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Part I A History of Banking

1 A Brief History of Money and Credit

What is money? Despite our daily use of it, it is not often that we ponder what makes something money, especially in the modern era where we take the prevalence of paper or digital money as granted. Throughout history, there have been different uses of various forms of money, and in each step in money’s advance, people have reshaped the way they do their commercial transactions and have introduced new distinctions.1 In the broadest sense, in order for something to be considered as money, it needs to serve four functions: (a) being a medium of exchange, (b) an overall standard, (c) a measure of value, and (d) a store of wealth.2 Being a medium of exchange means that money has the ability of facilitating transactions, so long as it is accepted by all the parties involved. In this sense, practically everything can be used as money: pieces of paper with a stamp on it, cigarettes, iron, copper, and as has been the norm until the early twentieth century, gold. This brings up interesting complications: suppose John owes Paul 5 chickens, then John can potentially repay his debt by providing 20 pieces of fruit. This simple example suggests that even intangibles like trust and creditworthiness can be employed as a means of transaction; in fact, they have been, and still are in use throughout the world. The above example also introduces the idea of credit: it could be the case that Paul’s chickens have not hatched yet, or that John’s trees did not bear any fruits at that time of the year. As such, what would matter is that both parties in this transaction believe that the other is trustworthy to repay them back at some future period of time. While unexpected situations beyond their

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 N. Michail, Money, Credit, and Crises, https://doi.org/10.1007/978-3-030-64384-3_1

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control may prevent the repayment of this debt (e.g. bad weather for the trees, or a pack of foxes attacking the chickens), the idea in the back of head of the person initiating the transaction is that the receiver of the goods can be trusted to repay the favour at some future period of time. In this case, “money” is essentially synonymous to “credit”: John agrees to repay Paul at some future period of time, with this agreement being equivalent to the means of transaction. Thus, credit, appears to have been the first type of “money”, with the obvious benefit of requiring little, if any, proof for the transaction. As anthropological evidence has also shown, in periods when reading and writing was not something the broader public used, a promise to repay was as good a proof as any other.3 However, the exchange of goods simply on credit terms has plenty of drawbacks, with the most important one laying in the lack of guarantee that what we have exchanged will be compensated for. It is one thing to assume that people from a small village or a small society, whom we have known for all of our lives, will be good in their promise to repay us for what we have provided, and a totally different thing to assume the same for a complete stranger. As you may have guessed, this presents serious impediments on trade, especially with foreigners or even out-of-towners. Thus, as inter-city and inter-nation trade increased, the need for something other than just a promise was required. This made bartering, i.e. the exchange of one type of good with another take the place of credit. Bartering persisted for centuries. As Adam Smith notes back in 1776, “The armour of Diomede, says Homer, cost only nine oxen; but that of Glaucus cost a hundred oxen. Salt is said to be the common instrument of commerce and exchanges in Abyssinia; a species of shells in some parts of the coast of India; dried cod at Newfoundland; tobacco in Virginia; sugar in some of our West India colonies; hides or dressed leather in some other countries; and there is at this day a village in Scotland, where it is not uncommon, I am told, for a workman to carry nails instead of money to the baker’s shop or the ale-house”.4 Barter also allows us to understand what the second function of money suggests: money has to serve as a standard of (deferred)5 payment of debt. Simply put, this function suggests that if Paul agrees to receive 20 pieces of fruit in a month’s time then the value of this agreement cannot change through time—20 oranges will always be 20 oranges. The third function of money also holds in this case: anything can be expressed in terms of oranges, be it a house, a chicken, or anything else one would wish to trade. Bartering also comes with its own inconveniences. First and foremost, there is the inconvenience of searching for someone who will both accept what you have and you will also be able to use his production. A builder may

1 A Brief History of Money and Credit

5

build a house for Paul and may not need chickens as he also has his own production of poultry. In order to get the builder to build him a house, Paul would have to enter another agreement with John to exchange chicken for fruit and then provide the fruit to the builder. This would mean a combination of the two types of money (credit and barter), and it would also imply an extension of the trustworthiness required between the two parties (Paul and the builder). This would be necessary as the transaction requires the inclusion of an additional party (i.e. John), who needs to be accepted by the original parties (Paul and the builder). This is not the only limitation when it comes to credit and bartering. The man who wants to purchase fruit may have nothing but cattle to exchange for it, but the sale of the whole ox may be required as it cannot be broken down to pieces.6 The fact that fruits are perishable while an ox can live for a longer period of time makes the potential of such a transaction more difficult for the ox owner. Naturally, a way around this would be to exchange the ox for a number of fruits which could be spread out through time (i.e. two pieces of fruit per day for a year), if both the buyer and the seller were located close to each other. Still, this would have been very difficult in the case of a wandering merchant and a local fruit producer. To avoid the above issues, a type of money which would also meet the fourth function, i.e. being a store of wealth (value), needed to be introduced, while the other three functions are also met. For something to be used as a store of wealth means that it can last for a significant amount of time, an ability that, e.g. fruit or cattle does not have. Furthermore, this would also imply that it would need to maintain its ability to be exchanged with other things, with at least some degree of certainty, which implies that people would be willing to accept it. This can happen in two ways: first, by having a sovereign guarantee it, and second, by it being universally accepted as a means of transaction, without requiring state approval. The two characteristics can, naturally be interconnected: for example, a sovereign guarantee almost always makes the item a universally accepted means of transaction, at least within the jurisdiction of that specific nation. Printed (or minted) money is the most suitable example: a country’s government and banks are obliged by law to accept the country’s sovereign currency, a subject we will delve into soon. The second characteristic can exist without the first being fulfilled, though. For example, gold serves as a universal holder of value irrespective of the fact that most governments do not guarantee transactions with it (more on that in Chapter 6). Other precious metals (or in some cases, precious rocks) also

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fulfil this requirement, however, for the sake of illustration, will stick to gold for the rest of this analysis. Gold has a distinct characteristic that makes it quite the exemplary means of transaction: it serves practically no other purpose. To illustrate the significance of this consider an alternative scenario in which copper was employed both as a means of transaction as well as for industrial purposes. This means that the value of copper would be different depending on the person willing to obtain it: it would be worth X to an industrialist who could convert it to electricity cables, Y to the person seeking to mix it with other metals to get a better alloy, and Z to someone who simply employs it as a means of transaction. If the value of, say X was greater than Y and Z, then most likely all values of copper would converge to that, hence depriving industrialists of its use in an alloy. Even worse, if Z was greater, for some reason, then both industrialists would not be able to manufacture.7 Hence, the absence of any use for gold (other than for purely cosmetic purposes and currently for some minor industrial applications) is sufficient to make it an excellent means of exchange. This ability has made gold the ultimate means of transaction since very early in the history of mankind. Furthermore, gold and other precious metals have the natural advantage of not being oxidized and are thus able to be also used as a store of wealth. Finally, Gold and other metals can be broken down to smaller pieces, hence facilitating even the tiniest of transactions. In Babylonia, around 2300 BCE, when trade for citizens outside the city was finally allowed,8 the need for a more standardized form of money emerged, making gold and silver rise to prominence. Gold and silver bullion was not particularly easy to transfer though, mostly out of fear of having them stolen. This made home storage of precious metals undesirable. Thus, around 2000 BCE,9 Babylonians placed their savings with trusted men, to whom they paid as much as one-sixtieth of the amount for the provision of that service. The famous statutes of Hammurabi addressed this topic, stating that contracts should be arranged before making the deposit. This early form of banking was further enhanced by the provision of loans from the palace and the temple, out of the wealth they already possessed. Usually, loans involved issuing seed-grain and payment was made after the harvest. Loan contracts were drawn on clay tablets, which included an agreement on interest. The House of Egibi, a family of wealthy Babylonians, was famous for its banking operations which included accepting deposits for safekeeping and financing international trade. At this point, it appears that depositors began asking for interest given that their funds were used productively and allowed the “bankers” to make a gain for the accrued interest.10

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Introducing Coins Up until this point in history, when someone referred to the use of money, they talked about the use of gold and silver bullion for transactions and storage. In other words, gold was in unprocessed form, as it was naturally encountered in the ground, or maybe with some minor modifications in order to be suitable for use. To further facilitate trade and perhaps most importantly to gain from the sale of Gold and fund other activities (e.g. wars, roads, bridges), states began to mint coins mostly made by gold and silver. The first state to introduce gold and silver coins was Lydia, around 650–600 BC,11 made by electrum, an alloy of gold and silver.12 Coin minting made that money the official legal tender of the country or city, i.e. the only currency which was allowed to be used in that specific region. Standardized money in the form of coins did not have much effect on the nascent banking industry, which was mainly limited to safekeeping, usually by the temple.13 Some lending out of these deposits also took place, with the philosopher Demosthenes commenting that more than 20% of funding for a banker’s loans came from deposits. Similarly, he also notes that a court judgement against another banker would result in losses to depositors in his bank. Furthermore, it was confirmed that bankers during that era offered a direct return to induce them to save their money with them or some sort of other services (participation in maritime loans or banking services).14 Despite the wider use of banking services, banks provided only a small fraction of the total amount of loans, with the majority of these taking place in the city of Athens.15 However, Athenian bankers were also known to keep their transactions confidential, known only to the banker and the depositor or borrower, which could have potentially undermined the importance of banks. In addition, given the lack of records on which the deposit of funds could be found meant that bankers faced no financial risk, given that the court would have to rely only on the banker’s records. Furthermore, using a banker as an intermediary to borrow money from, unlike direct lending from another person, meant that the transaction did not have to be disclosed to the public.16 The practice of deposit-taking continued in ancient Rome, while bankers were also allowed to convert foreign currency to the only legal tender in Rome thus becoming the first currency exchangers. As these people conducted their business on a long bench called “bancu”, they were soon called for the first time, bankers.17 During the Roman era, a type of public bankers were also appointed by the state to address the problem of citizens’ indebtedness by providing public funds to them.18 As in Athens, in order for a banking

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service, such as the transfer of ownership to take place, both parties needed to be physically present. The next major disruption to the money and banking status quo came with the realization that even metals (precious or not) come with their disadvantages. Using Gold necessitates that the parties involved in the transaction are able to measure the exact weight of the bullion, so that neither buyer nor seller could be cheated. This is especially true for Gold whose value is so large that even the smallest difference in weight could have a strong effect on its value. Furthermore, assaying the quality of the bullion offered is an even more tedious task: if the content of the bar is 90% and not 100% gold it would make a tremendous difference in the value. This is also why counterfeiting was relatively easy: changing the composition of a gold coin by just 5% would mean huge profits to counterfeiters, while even the smallest change to the weight would also allow them to profit by cheating both the buyer and seller.

Banking in the Middle Ages As with all previous periods in the history of money, international trade played the predominant role in the move from specie (bullion) to representative (paper) money. Paper money was introduced in China during the tenth century AD, with its roots in the merchant receipts of deposit around 600– 900 AD. These were later used in Europe, after their introduction by Marco Polo in the thirteenth century.19 The idea was similar to the previous development of promissory notes, i.e. that merchants did not want to carry the heavy copper coinage with them in large transactions and thus issued credit notes, often for a limited duration.20 Similar promissory notes often inscribed on leather, were also prominent in ancient Rome and Carthage but without any backing of the amount.21 In contrast, paper money (banknotes) were to be used widely as a means of payment, secured by the deposit in either gold or silver. While there was still no intention to move away from gold and silver, trusting that someone’s coins were not counterfeit was a difficult thing to do. Depositary institutions played an important role when it came to facilitating transactions between individuals, especially in medieval Italy. It is easy to see how paper money has important advantages, as it is easy to create and carry and many denominations can be easily crafted. Furthermore, the presence of an intermediary (the bank) removed any fears of counterfeit coins. Hence, representative (paper) money came to dominate the markets, as the

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need for larger transactions emerged. In essence, representative money was a certificate, usually in paper form, which reflected a claim to the bank for a particular amount of gold or silver.22 It was during the Middle Ages that the previous functions of a bank, namely storage and the transfer of ownership to avoid the need for counting and transferring coins from one person to another (still with physical presence required), expanded giving rise to the majority of functions still used today. Medieval bankers had developed a system which allowed them to “immobilize” the actual coin and allowing the transfer of their ownership on their books, very similar to how bank accounts operate today. It was during this period that the first written order of payment, something resembling a modern-day cheque, although at the time not transferable to a third party, appeared. Italian banks, namely in Venice, charged fees for transfer services with an additional fee charged for cash withdrawals.23 Despite this “immobilization” it was still customary that both parties involved in a transaction would have to present at the bank for the change in ownership to take place at a bank.24 After the transaction was completed, customers could withdraw the coins, transfer them to another bank in which they had an account with and even receive an overdraft and some transitory accounts to facilitate the collection of receivables. Deposit banking alleviated many of the issues associated with the issuance of gold coins: most commercial transactions in the country involved credit and deferred payment, but, with banks as an intermediary, the risk of nonpayment or the risk that the payment was counterfeit was essentially zero. Through this, banks alleviated much of the transaction risk, which was the major concern of the “credit-and-trust-to-repay” systems prior to the introduction of depositary institutions. Furthermore, deposit banks also removed much of the risk of storage and counterfeiting further allowing trade to flourish. An additional problem depositary banks helped to ease was the scarcity of money. Gold was not easily found, especially before the European escapades into Latin America and the plummeting of local wealth. This, in the absence of banking, could limit the amount of transactions that could take place in an economy. Using depositary banks did not necessitate the use of coins, as ownership could move from one person to another without the need for a physical exchange of coins. Depositary banks did not usually extend credit in the form of a loan but instead chose to usually take the form of equity participation. In many occasions, banks were forced to act as an investing partner due to the ban on usury: due to religious purposes, Christians were at the time strictly forbidden

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from charging any kind of interest on loans. 25 Bankers usually invested their own personal funds, as well as those of the bank in commercial ventures, and were not reluctant in investing the bank’s funds in their own ventures as well. As such, the distinction between the bank and the banker was vague.26 Bankers of the era were also involved in non-commercial lending, namely to princes, nobles, municipalities, etc. This captured the largest portion of the banker’s investments, given that non-commercial lending was usually secured. The way this worked was similar to a modern-day pawn shop, as bankers retained jewellery or plates as collateral. Also similar to modern-day developments, a number of failed banks during the 1500s banking crisis in Venice was found to be in possession of vast treasures of jewellery.27 Another practice which is still predominant today was first used during the medieval era: in the case that borrowers did not have collateral, they provided a promissory note co-signed by one or more substantial guarantors. If the borrower failed, the guarantors were then summoned to assume the debt burden. Forward contracts were also indirectly introduced in order to avoid the usury problem: lending to farmers was often in the form of agreeing on a price to purchase the upcoming crops. Italian banks were also heavily involved in state financing. As it was reported, around 10% to 20% of bank assets in Venice consisted of loans to the government. This was favourable for the government as well, since it enhanced its ability to command resources during crises, given that suppliers were more willing to accept payment from banks than to accept a government note for deferred payment. A similar role was assumed by the Ricci bank in Florence which operated as the de facto official bank of the Grand Duchy, setting the tone for the creation of central banks in the mid-1600s.28 States usually did not have to pay any interest given that the loan was secured by the tax or customs revenue, further supporting local governments and underlining the rapidly increasing power of banks. Medieval banks also engaged in discounting, i.e. purchasing receivables at a lower price before their due date and benefiting from the proceeds. In addition, banks also provided guarantees, in the sense that they promised to pay if their customer failed to do so. This practice was common for shipbuilders in Genoa, while banks reached the point of guaranteeing the payments of customs duties by importers in Venice. At a more extreme level, banks bought and sold the option to buy claims on public debt at an agreed rate within a pre-specified period, sometimes extending as long as eight months in advance.29 Banks of the era faced pretty much the same problems as their modern-day descendants: liquidity and risk. In essence, banks had to have enough coins

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available to meet any withdrawal demands, as well as to prepare themselves for potential losses. The situation was much more difficult though. In Burges, a dozen depositors accounted for two-thirds of all deposits, making the bank prone to liquidity issues if one of them suddenly decided to withdraw his funds.30 To address such potential sudden withdrawals, banks were usually forced to keep about 30% of their deposits as reserves and not lend them out. This was (probably) the first time “fractional reserve banking” was recorded, meaning that banks did not keep all of their liquidity at hand, but only held a percentage of customer deposits while investing the rest. Smaller banks also used to keep their money deposited in larger banks, paying a fee for that service. Given that coins were not readily at hand when needed, banks resorted to all sorts of trickery in order to avoid giving back the full amount in times of monetary tightness: working shorter hours, giving the money back in low denomination coins which took longer to count, reduce the number of transactions, and even suspend convertibility of the deposits to coins. This naturally induced what later came to be known as “bank runs”, i.e. that people rushed to banks in order to get their money before the bank was out of liquidity. Banks were also faced with issues not related to their operations. In the unstable middle ages, war was a common phenomenon and a major cause of instability in both their operations as well as the well-being of their investments. The monetary environment was also unstable given that shortages of coins were common, forcing the public to increase withdrawals and banks to run out liquidity. Given the emphasis on agricultural products, banks were also prone to weather conditions, as well as in specific times of the year, e.g. when coin was needed to purchase grain from the countryside in Florence from September to January. Deposit banks were heavily regulated by governments, mainly as they played an important role in the management of currency. As mints were usually under the control of the crown, deposit banks were unofficially acting as agents of the mint, by accepting and giving out bullion. There was also a dark side for the need for regulation, as they were suspected of purchasing bullion and selling it abroad. As gold and silver bullion was the predominant measure of the value of money, facing an outflow of bullion would mean that a state would see its currency drop in value. Note that gold coins could easily be melted and then reshaped into the currency of another state, leaving zero traces behind them. To avoid this, governments had to both closely monitor deposit banks as well as manipulate interest rates in order to offer higher deposit returns and convince depositors to keep their money within the state.

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There was also another reason for deposit banks’ regulation: the use of deposit banks as a facilitator of trade made them essential to the commercial expansion of a state. Thus, when banks failed, commerce came to a standstill. As always, bank failures brought more regulation even though their enforcement was much more difficult.31 Access to banking was restricted in most states, requiring a municipal licence or being a member of an appropriate gild. In other states, banking licences were auctioned to the highest bidder, while in other cases a council examined whether those wishing to establish a bank were suitable for the profession. In most states, bankers had to provide some sort of “surety” as a guarantee, usually in the form of real estate or through third-party guarantees. If the bank failed, the guarantors were accountable for its debts up to a predetermined amount. In Venice, after a series of bank failures, the required guarantee of 3,000 ducats was later raised to 20,000.32 The same state had a long history of asset restrictions, aiming to limit the risk exposure of deposit banks. Venice banned investment in most commodities and especially bullion, a restriction Flanders also imposed later on, while it limited investments in commercial ventures to 1.5 times the personal wealth of the banker.33 Banks in Venice were also forced to pay in cash on demand, something that bankers usually avoided due to liquidity fears.34 Despite the regulation, bank failures were often. When a bank failed, payments were immediately suspended and records seized (if the banker hadn’t already fled the city!), while the “sureties” were required to pay up. The banker’s personal property was placed in receivership and had to be sold to cover the bank’s debts, including the “sureties”. As in every other sole proprietary business, the owner’s (banker’s) liability was unlimited.35 In case the depositors could not be repaid in full, the banker could end up in jail, while in Barcelona a banker who failed to pay up within a year was liable to execution. In general, a failed banker was permanently prohibited from opening another bank, even though in Venice banks which were not insolvent but illiquid were allowed to establish a successor bank, provided that his creditors were willing to accept payment in the form of deposits in the new bank.36

Merchant Banking The need for more international trade also helped to increase the types of bank. In the eleventh century merchant banks emerged in Italy. Once large trading companies were established in Italy, they found it easier to set up permanent branches (or correspondents) in order to facilitate their

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trades. Given that they already had these branches, it was only natural that they would also engage in transferring funds for other merchants, thus becoming merchant bankers. Merchant banking was similar to modern-day bank transfer, however back in the day, physical presence was required. It was thus common for merchant bankers to have physical presence in many regions. The Peruzzi, among the largest banking houses, had offices in 15 locations and 7 countries.37 Finance usually came after a merchant had already accumulated substantial wealth via his trading activities, and was thus viewed also as a way to diversify income as well as to manage wealth. Merchant banks were usually familyowned and used their own excess capital, in addition to the loans obtained via the above-described time lag effect, to finance foreign trade in return for a share of the profits. Merchant banks were the first to exploit exchange rate differences to their profit. If, e.g. British pounds were for sale more cheaply in Paris than in Venice, bankers would sell in Venice and buy in Paris, benefiting from the difference. This strategy, called “arbitrage”, allowed the market to remain liquid and kept exchange rates at their normal levels by eliminating the periodical discrepancies.38 Merchant bankers also traded on the anticipation of fluctuations in exchange rates: if they believed that English cotton sales would be high (note that they had all the information through the facilitation of the transactions), they would buy as much sterling as they could so as to resell it later at a profit. Interest rate differences between two places were also a common source of arbitrage, as banks could borrow cheaply and lend more expensively. Naturally, while such activities helped to smooth price and exchange rate fluctuations, merchant bankers were also in the business of manipulating the market in various ways and harming other participants. The lack of technology at the time meant that a time delay existed between the merchant bank accepting funds in one place and paying them in another. This essentially meant that the merchant banker was receiving a free loan from other merchants, which could then be lent to third parties, benefiting from the time delay. 39 Merchant bankers acted as intermediaries in the deposit and loan business, similar to the previous generation of banks. Still, their ability to borrow more easily, given the time lag between accepting funds and paying them, and at cheaper rates meant that they could pass that benefit to the loan-seeker, while benefiting from the interest or exchange rate difference at the same time.

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This process made lending cheaper and more readily available than ever before: a merchant banker was able to borrow funds cheaper than any ordinary merchant and could just lend him the money, at a rate which, although higher than the bank’s cost, would also still be lower than the rate an ordinary merchant could obtain from any other source. For example, the Medici bank paid depositors between 8–10% and lent the money at 12–14% in the fifteenth century, a difference similar to modern-day banking practices. This was in contrast to the individual bankers of the past which were not so adept in obtaining much better credit terms than their ordinary merchant counterparties as that they lacked the “security” element, given the small size of their operations. The intermediary practice broke the centuries-old link between sales and credit: instead of receiving goods on credit, a merchant could purchase the goods with borrowed money, removing the lack-of-confidence barrier from trade.40 Allowing merchants to pay with borrowed money instead of credit also boosted what came to be known as the “money market”, which traded in short-term loans. The money market attracted both merchants and nonmerchants which sought to borrow for short-term purposes. Sovereigns also sought to borrow in money markets, in order to meet their short-term liquidity problems, such as when financing a fair, and merchant bankers were more than happy to oblige, given that loan was on very favourable terms for the lender.41 Short-term lending was much to the merchant bankers’ benefit, as they also borrowed for short maturities. In addition, money market lending was also a way to control the borrower, given that in order for the lender to accept an extension of the loan’s due date, the government had to satisfy them of its willingness and ability to repay. This would many times involve an agreement to pass on some government revenue to the lender. Naturally, this was not to the government’s best interests, given that it imposed higher transaction costs, as well as limiting its ability to be relatively loose with its spending policies.42 In addition to the financing of trade activities, merchant banks also traded in wool, cloth, wine, lead, and even horses; the fact that merchant banks had a presence in many markets and good information allowed them to buy low and sell high, along with many resources to exploit such investments when they occurred. Merchant banking was mostly an Italian profession, with Italian banks, starting from Champagne in the twelfth and moving to the Florentines in the fifteenth and the Genoese in the sixteenth century, ruling most of Europe. Naturally, these were high-risk investments given that they were prone to bad weather, piracy, or war, which could severely hurt individual banks.43

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The failure of the largest bank in Siena (the Gran Tavola of the Bonsigniori) in 1298 allowed the Florentine merchant bankers to take over.44 Merchant banks were more focused on liquidity than other aspects of risk management, and notoriously avoided “liquidity transformation”, i.e. borrowing short-term and lending long-term. Instead, they aimed to match the maturity of their assets with that of their liabilities, usually ranging from three months to one year. With regard to credit risk in their lending, they protected themselves by acquiring some sort of security from their borrowers. For merchant bankers, insolvency also meant the loss of their personal fortune, given that they were fully liable for any mishaps. Thus, they sought to reduce this possibility, with the Medici setting up each branch as a separate partnership, insulating the rest of the banking house from any losses that could incur. Still, reputational damage could not be avoided. Merchant banking faced various crises throughout the Middle Ages, mostly related to sovereign lending. Governments (notably in Florence and South Germany) were over-indebted and forced merchant banks to absorb a “haircut” in the value of the loans after a restructuring took place.45 Thus, while merchant banks continued to exist (and still do), they mostly refrained from sovereign lending—so did governments which now turned to other means of financing their needs.46

The Rise of Public Banks By the middle of the fifteenth century, a wave of deposit bank failures took place across Europe, attributed to the “bullion famine” which constrained the banks’ liquidity. The general deflation and slump threatened their viability and was particularly harmful in places which relied upon banks for their means of payment. Feedback loops followed as bank failures increased demand for coins and further exacerbated the shortage. As the cascade of banks collapses continued into the sixteenth century, the confidence of merchants and governments in the existing system was shaken. In Venice it was reported that out of the 103 private banks founded through the state’s life, 96 had failed.47 In response, Venice established the Banco di Rialto, in 1587, which was set up as a payments institution that did not engage in financial intermediation. In particular, it merely assumed the role of accepting deposits, allowing cash withdrawals and facilitating the transfer of deposits from one person to another. In contrast to deposit banks, it paid no interest on deposits and offered no credit facilities. Still, the banco was very successful—merchants

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even speculated on the premium paid for banco payments (agio) versus cash payments.48 In other cities, motives were not so benevolent: the Taula of Barcelona, formed in 1401, lent the collected money to the local government, allowing it to fund its debt very cheaply. The Taula was also responsible for receiving tax payments, issuing bonds, and making interest payments, a mixture of modern-day Central Bank, Ministry of Finance, and commercial bank features. Unsurprisingly, the state was not so successful in managing its debt burden, forcing the Taula to suspend payments by the 1460 s, while a reorganization in 1468 imposed a restriction on city (sovereign) lending.49 The pitfall of over-lending to the public proved minimal and public banks continued to be successful, being much less subject to failure than private banks. Furthermore, the fact that just one public bank existed meant that processing payments was done much faster, as there was no need for deposits to move between banks. By the end of the seventeenth century, most deposit banking on the European continent was in the hands of public banks.50 The Renaissance came with a new type of public banks, known as “exchange banks”, first established in Amsterdam in 1609. During that period, the Dutch were the prominent commercial force in Europe and Amsterdam, being the capital of Holland, served as the central point of trade. Given its prominence in trade, Amsterdam was soon flooded with coins from its neighbouring countries, many of which were worn and damaged. Given money’s dependence on the amount of available gold and silver, worn and damaged coins had a depreciative effect on local currency, as they decreased the availability of bullion. This phenomenon was not new, as it was also observed in the Middle Ages, but in the case of Amsterdam it resulted in reducing the value of its currency by 9%.51 This prohibited the infusion of newly minted coins into circulation, but these were instead collected, melted, and exported as bullion. In contrast, imported coins of lower quality were used instead, replacing coins with a higher nominal value. The phenomenon, later called Gresham’s Law but with references dating in the Bible, Talmud and Ancient Greece, was just a result of money, created using two different materials, forced to have the same nominal value as despite the difference in the value of the two materials.52 In essence, if the value of gold is 10 times the value of silver, then forcing a silver coin to have the same value as a gold coin would mean that it would be to someone’s best interest to purchase gold coins with silver coins and then melt them to sell them as bullion. Similarly, worn coins, which had a lower quantity of gold were used to purchase newly minted coins, thus benefiting from the difference.

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To remedy this situation, the Amsterdam Wisselbank was formed. While the bank aimed at facilitating trade, supressing usury, and have a monopoly on all trading of bullion, it was also focused on the withdrawal of abused and counterfeit coins from circulation.53 In particular, coins were taken in as deposits, but the value of these deposits was determined on the metal weight of the coins and not on their face value, creating a uniform system, and avoiding Gresham’s Law. As proof of the deposits, the bank issued credits, known as bank money. Having avoided all the issues related to counterfeiting, along with the added advantages of being much more convenient and secured by the city of Amsterdam, bank money was traded at a premium to coins, ranging from 4 to 6.25%.54 The need for coins to conduct a transaction was so diminished that actual withdrawals from the bank became a very rare occurrence. In contrast, the bank transferred money from one person to another by book entry, called a giro banking operation. The city of Amsterdam did its best to protect the Wisselbank as any bill exceeding six hundred guilders had to be paid in bank money, forcing all merchants to keep an account at the bank.55 Wisselbank was successful as the business model it followed allowed it to do so. The bank offered bank money (credit) in its books for gold and silver bullion deposited, at about 5% less than the current mint value. The depositor would get a receipt that entitled the bearer to draw the amount of bullion deposited from the bank within six months. To retrieve the bullion, a person would have to present a receipt for the bullion and the bank money equal to the book entry, as well as pay a fee representing a warehousing cost. If the time period of six months went by without the receipt presented for withdrawal, then the bank was entitled to keeping the 5% difference between the mint and bank value as fee for warehousing the deposit. Still, while the receipt was presented in order to avoid paying the fee, no actual withdrawal took place. Interestingly, the two instruments (receipt and bank money) were sold separately and thus it was often the case that a receipt was matched with different bank money than the one it originated with.56 Given the abundance of bank money in the city, deposit receipts were usually renewed every 6 months so that the depositor did not have to pay the 5% fee.57 The Wisselbank proved extremely successful, as the silver content of Dutch coins became relatively stable by 1650, with Amsterdam becoming the place where “nearly all the bills payable in Europe were drawn, remitted, or otherwise discounted and traded”.58 Similar to the previous versions of banks, the Wisselbank charged a variety of fees which made it highly profitable. In addition to the potential for a 5%

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charge and fee for warehousing gold and silver, the bank also charged account opening, transfers between accounts as well as various other charges. While at first operating like a depositor bank, Wisselbank was, by 1657, allowing individual depositors to use an overdraft facility. These were kept a secret until 1790, when word of these loans became public and the premium on bank money disappeared and fell to a 2% discount. By the end of that year, the bank admitted insolvency and was taken over by the city of Amsterdam in 1791, eventually closing in 1819.59 While not aimed at creating any sort of central bank money, but rather to enforce better minting ordinances, the Wisselbank is considered as the archetype of a central bank, given that it was the first time a public institution arranged the distribution of money. The next time a public bank shook the world was in 1661, when a bank in Sweden began to issue credit notes, which were freely transferable and backed by the promise of payment in metal.60 Motives for the creation of Stockholms Banco were, naturally, not for the greater good. The Swedish Crown wanted to control and restrict the supply of copper in order to raise its price in Amsterdam (the world’s commodity trading centre) and benefit its copper monopoly. However, copper was used to create coins, which meant that the larger and heavier the coins got, the easier it was to sell them as copper bars. Gresham’s law was also observed, as coins were also minted in silver, providing additional incentive for melting and exporting them as bullion. To avoid this, the Swedish tried to impose copper coins on as many conquered provinces as possible, albeit with little success. Stockholms Banco, a usual deposit and lending bank which had operated since 1657, was faced with an issue: a reduction in the amount of copper in newly minted coins made depositors rush to withdraw their stack. However, the bank did not have enough stock of plate money to meet demand and neither did the promise of paying an interest rate did much good. The bank’s director, Johan Palmstruch, came up with an ingenious idea to solve the problem: the bank issued notes which declared that the holder had a claim on Stockholms Banco for a specified sum of money, while the notes were to be exchanged for cash on demand.61 The real innovation was that these notes were not tied to deposits but issued at will and relied on public confidence that the Bank would redeem them on demand. The Crown Council did not object to the issuance, mostly because while the Stockholms Banco was private enterprise, half of the bank’s profits would end up in the Crown’s budget. The notes ended up being accepted in all the main commercial centres in the world, recognized and held in great esteem.

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Exuberance did not hold much. By 1663, the bank had less than 4,000 daler in cash, where a depositor had announced that he wished to withdraw 10,000. As problems accumulated, the Council proclaimed that it supported the termination of the bank’s loans in 1664, with the experiment lasting for less than three years. Palmstruch ended up in jail for over-creating notes, but the idea of a government-linked entity which would issue notes caught on and would become much more popular later.62

Goldsmith Banks and the Bank of England In the early seventeenth-century London, goldsmiths, i.e. metalworkers who specialize in working with gold and other metals, gradually began expanding their services and acted as creditors, by exchanging foreign and domestic coins, exploiting the discrepancy in the weights and values of the coins. In essence, blacksmiths would exchange coins with lesser gold weight, e.g. due to wear and tear, at the same price as a coin with more quantity, benefiting from the difference.63 As their fortunes increased, goldsmiths soon began to lend money, becoming the biggest debtors in London by 1660.64 Goldsmiths also accepted bills of exchange, i.e. a promise to repay someone at a pre-specified time and amount, before their due date, at a discount. To conduct this business, goldsmiths issued notes in the form of loans, with the bill of exchange acting as the underlying collateral. Goldsmiths often used the bearer clause, meaning that, unlike all previous bank money, this could be paid to any person and not just a specific payee. In other words, whoever presented the notes would get the money. This transformed the way banking took place: previously, if John received paper money from Jack, who had gotten it from Bank A as a receipt for his deposit, Jack was still the go-to person in the case things went south; Jack was still the debtor, not Bank A. In this case, the goldsmith paper money suggested that once John got the paper money, Jack was out of the equation and Bank A was the only debtor. As expected, this further eliminated the possibility that the debtor lacked the funds. Under the English law of the time, debt instruments had to be endorsed by the transferor. If debt instruments were not endorsed, this was considered just a sale. Thus, as bankers’ notes did not require endorsement, the transferors were no longer legally liable for the notes.65 Importantly, goldsmith notes were successful because they included a demand clause, i.e. that noteholders could demand payment from the bankers at any time, making them of indefinite duration.

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The demand clause also assisted in giving the impression that the notes were equivalent to the gold that was kept in the goldsmiths’ vaults. This notion was quick to be dissolved. The goldsmiths’ “promise to pay” relied on the fact that bankers maintained what is known as “fractional reserve”, i.e. they held a percentage of the total amount of notes in circulation, ranging from 10 to 66%. This helped to break the direct relationship between the amount of notes which circulated and the coins held in the vaults.66 In essence, the notes were transformed into paper credit: the goldsmiths were giving credit to the whole economy, in essence creating money out of thin air for the first time in history. To understand how important this is, remember that in every period prior to this, money creation was limited to the amount of specie available. In essence, bankers in any previous era did not really create any new lending if they did not hold the equivalent amount of coins in their books. For example, if the Wisselbank decided that it wanted to grant a loan and had 500 gold coins as deposits in its books, it would only grant a loan up to that amount. In contrast, goldsmith bankers could extend lending to any amount, similar to the Stockholms banco. Note that this is not a case of having reserves. In the case of the Wisselbank, if it lent out the full 500 gold coins, it would have essentially zero liquidity reserves. Still, that amount of loans could have been funded with the existing amount of coins. Goldsmiths on the other hand could potentially extend credit even if it meant that they essentially had negative liquidity reserves, i.e. they had no way to fund that loan. This was feasible simply because paper money could be created out of thin air—or out of a belief that paper was backed by the viability of the goldsmith banker. Goldsmiths’ mutual acceptance of each other’s notes, allowed for mutual indebtedness and thus further supported the system. However, creating money out of thin air is essentially meaningless if the issue is prone to bankruptcy or liquidity problems. A goldsmith’s note was as good as the trust the bearer had in the system, as well as the issuer; if goldsmith A was suspected that he would not be able to meet his paper money credit obligations, then they would deny any notes originating from him. Furthermore, holders of goldsmith A notes would start demanding specie in return for the paper money, in essence wiping him out. In this case, the monopoly over the issuance of trust would be very difficult to obtain in the case of a private individual or entity, given that these are always prone to bankruptcy. On the contrary, it is much easier to accept a body which would have the state’s approval, as the Wisselbank experience had shown. This entity would

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also have to be able to control the quantity of paper credit such that the economy is not overloaded with money and each note loses its value. Similarly, it is easy to see that controlling the amount of paper money in the economy is also beneficial for the state, given that it can increase lending to itself as it wishes, provided of course that it does not overdo it. This latter reason was the rationale for the creation of the world’s first Central Bank, not surprisingly in England, given that statesmen were dissatisfied with the goldsmith’s increasing influence as the King’s largest creditors.67 The Bank of England was created in 1694, with the purpose of acting as a banker to the government, given that it found it hard to borrow as revenues declined after the abolishment of the health tax.68 Previous attempts to borrow in order to fund wars forced the government to pay around 10% to its lenders, forcing them to resort some sort of financial engineering in order to reduce the cost. The government was quite explicit in its need for a banker and thus agreed on creating one. The “Governor and the Company of the Bank of England” corporation69 was authorized to raise £1,200,000 by subscription, with no individual subscription exceeding £20,000. The amount was to be lent wholly to the government, at a rate of 8% per annum in order to fund “the war against France”.70 The corporation was to have the privileges of a bank for 12 years, but the corporation was not authorized to borrow or owe more than their capital. Through time, the Bank of England became more established as the government’s banker, even though having gone through some difficulties at the end of the seventeenth century.71 Through its mandate, the Bank of England separated itself from traditional banking functions such as deposits and lending, and focused on becoming the state’s banker. While initially Bank of England notes were not legal tender (i.e. debtors were not forced to offer and creditors were not obliged to receive them), by 1709, it was granted a monopoly on the issuance of notes, which then became legal tender, in the city of London—its monopoly on the issuance of notes over the whole country would have to wait until 1833. Still, the innovation was there: for the first time in centuries, a government had an official banker, and notes issued by a single corporation were forced to be used as legal tender across the Kingdom. To make trading in its legal tender easier, in 1725 the Bank of England banknotes were printed, for amounts of £20 and upwards, in increments of £10—the highest denomination printed was £90. Still, it would be possible to increase each denomination by £9.99 by a bank cashier in order to reflect the actual amount of the deposit. This was done by increasing the value of the note in writing.72 As such, the Bank of England managed to displace

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goldsmith bankers, who were no longer in a position to issue their own notes, shifting power from private bankers to the public one. As the Bank of England remained stable through a variety of crises, wars, and other unfortunate events, the money it issued gained more and more of the public’s trust, allowing it to continue its job of printing it. The success of the Bank of England as the government’s banker prompted more countries to follow its lead. Napoleon created the Banque de France in 1800 in an attempt to improve war financing,73 and large family banking houses played the role of a central bank in various other European countries.74 Still, despite the central bank innovation, not all countries sought to follow the English example. For countries such as the US, it would take a crisis to force them to reconsider.

Notes 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

12.

13. 14. 15. 16. 17. 18.

19.

Zelizer (1997). Milnes (1919). This was first analysed by Jevons (1876). Graeber (2012). Smith (1950, Chapter 4, p. 26). For more on the possible distinction, see Greco (2001). Ibid., 4. This argument goes back to Samuelson (1958). Moorey (1999). Bromiley (1995). Schnegg (2004). Goldsborough, R. A Case for the World’s Oldest Coin: Lydian Lion. http://rg. ancients.info/lion/article.html. This was also supported by Herodotus (Histories, I, 94). Although electrum can be found in a natural state, in the case of the Lydian coins, electrum was man-made as the Lydians chose to carefully control the percentages of gold and silver. Gilbart (1837). Schnegg (2004) and Millett (2002). Millett, Paul. Lending and Borrowing in Ancient Athens. Cambridge University Press, 9 May 2002. Cohen (1992). Andreau (1999). This is very similar to what “bad banks” do nowadays to fix non-performing loan problems. See Labate, V. Banking in the Roman World, 17 November 2016. Goetzmann and Rouwenhorst (2005).

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20. Ebrey and Walthall (2006). 21. Jones, John Percival. 1890. Speeches of J.P. Jones: Money and Tariff, 1890–93. 22. Given that this is backed by commodities, it is also known as commodity money. 23. Ibid., 23. 24. Kohn (1999a, b). 25. Islam posed similar restrictions on lenders but Jewish newcomers, mainly in the Lombardy area, could extend high-risk loans and charge a rate of interest, see Banks, Erik. 1999. The Rise and Fall of the Merchant Banks. Kogan Page Ltd. 26. Ibid., 24. 27. Ibid., 24. 28. Ibid., 24. 29. Ibid., 24, quote from Goldthwaite (1985). 30. Ibid., 24. 31. Ibid., 24. 32. Mueller (1979). 33. de Roover (1949). 34. Mueller (1997). 35. Ibid., 34. 36. Usher (1934). 37. Abulafia (1997). 38. Ibid., 33. 39. Kohn (1999a, b). 40. Bindoff (1958). 41. Ibid., 39. 42. Ibid., 39. 43. Craig (2001). 44. Ibid., 43. 45. The decline in the profitability of the commodity trade, after a huge inflow of silver from the newly discovered Americas, was another factor which limited the merchant bankers’ activities. 46. Ibid., 39. 47. Ibid., 24. 48. Ibid., 24. 49. Ibid., 24. 50. Ibid., 24. 51. French (2006). 52. Tamari (2011). 53. Bloom ([1937] 1969). 54. Ibid., 56. 55. Ibid., 56. 56. Quinn and Roberds (2007). 57. Ibid., 4. 58. Quinn and Roberds (2005).

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59. 60. 61. 62. 63. 64. 65. 66. 67. 68. 69.

70. 71. 72. 73. 74.

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Ibid., 51. Stockholms Banco, Sveriges Riksbank. Ibid., 60. Ibid., 60. Richards (1965). Kim (2011). Ibid., 64. Ibid., 64. Wennerlind (2011, p. 103). Andreades (2013). This is the official title, still in use today, even though banknotes are issued, more fashionably, “in the name of the Governor and Compania of the Bank of England”. Ibid., 68. Ibid., 68, pp. 82–83. History of the Bank of England https://www.bankofengland.co.uk/about/his tory. Accessed 28 June 2019. Smith (2006). Teichmann (1994).

References Abulafia, D. (1997). The impact of Italian banking in the late Middle Ages and Renaissance, 1300–1500. In A. Teichova, G. K. van Hentenryk, & D. Ziegler (Eds.), Banking, trade, and industry: Europe, America, and Asia from the thirteenth to the twentieth centuries. Cambridge: Cambridge University Press. Andreades, A. M. (2013). History of the Bank of England . Routledge. Andreau, J. (1999). Banking and business in the Roman world . Cambridge: Cambridge University Press. Bindoff, S. T. (1958). The greatness of Antwerp. In G. R. Elton (Ed.), The new Cambridge modern history. Volume II the reformation. Cambridge: Cambridge University Press. Bloom, H. I. ([1937] 1969). The economic activities of the jews of Amsterdam in the seventeenth and eighteenth centuries. New York and London: Kennikat Press. Bromiley, G. W. (1995, February 13). International standard Bible encyclopedia: A-D Wm. B. Grand Rapids: Eerdmans Publishing. Cohen, E. E. (1992). Athenian economy and society: A banking perspective. Princeton, NJ: Princeton University Press. Craig, V. V. (2001). Merchant banking: Past and present. FDIC Banking Review, 14, 29.

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de Roover, R. A. (1949). Gresham on foreign exchange. Cambridge: Harvard University Press. Ebrey, P. B., & Walthall, A. (2006). East Asia: A cultural, social, and political history. Boston: Houghton Mifflin Company. French, D. (2006). The Dutch monetary environment during Tulipmania. Quarterly Journal of Austrian Economics, 9 (1). Gilbart, J. W. (1837). The history and principles of banking. London: Longman, Rees, Orme, Brown, Green and Longman. Goldthwaite, R. A. (1985). Local banking in renaissance Florence. Journal of European Economic History, 14 (1), 5–55. Graeber, D. (2012). Debt: The first 5000 years. London: Penguin. Greco, T. H. (2001). Money: Understanding and creating alternatives to legal tender. White River Junction, VT: Chelsea Green Publishing. Jevons, W. S. (1876). Money and the mechanism of exchange (Vol. 17). D. Appleton. Kim, J. (2011, October 15). How modern bank originated: The London Goldsmith-Bankers’ institutionalization of trust. Business History, 53(6), 939– 959. Kohn, M. (1999a). Early deposit banking (Dartmouth College, Department of Economics Working Paper [99-03]). Kohn, M. (1999b). Merchant banking in the medieval and early modern economy (Dartmouth College, Department of Economics Working Paper [99-05]). Millett, P. (2002, May 9). Lending and borrowing in ancient Athens. Cambridge: Cambridge University Press. Milnes, A. (1919). The economic foundations of reconstruction. London: Macdonald and Evans. Moorey, P. R. S. (1999, November 1). Ancient Mesopotamia: Materials and industries the archaeological evidence. Eisenbrauns. Mueller, R. C. (1997). The Venetian money market: Banks, panics, and the public debt 1200–1500. Baltimore: Johns Hopkins University Press. Mueller, R. C. (1979). The role of bank money in Venice, 1300–1500. Studi Veneziani n.s. III , 47–96. Quinn, S., & Roberds, W. (2005). The big problem of large bills: The Bank of Amsterdam and the origins of central banking (Federal Reserve Bank of Atlanta Working Paper 2005–16). Quinn, S., & Roberds, W. (2007). The Bank of Amsterdam and the leap to central bank money. American Economic Review, 97 (2), 262–265. Richards, R. D. (1965). The early history of banking in England . New York: Augustus M. Kelley. Samuelson, P. A. (1958, December). An exact consumption-loan model of interest with or without the social contrivance of money. The Journal of Political Economy, 66 (6), 467–482. Schnegg, K. (2004). Commerce and monetary systems in the Ancient world: Means of transmission and cultural interaction (R. Rollinger & C. Ulf, Eds.). Stuttgart: Franz Steiner Verlag.

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Smith, A. (1950 [1776]). An inquiry into the nature and causes of the wealth of nations. London: Methuen. Smith, M. S. (2006). The emergence of modern business enterprise in France, 1800– 1930 (p. 59). Cambridge, MA: Harvard University Press. Tamari, B. (2011, July). Gresham’s Law. Economics Quarterly, 115, December 1982 (revised and translated). Teichmann, G. (1994). Sal. Oppenheim jr. & Cie., Cologne. Financial History Review, 1(1), 69–78. Usher, A. P. (1934). The origins of banking: The primitive banks of deposit 1200– 1600. Economic History Review, 4, 1932–1934. Wennerlind, C. (2011). Casualties of credit—The English financial revolution 1620– 1720. Cambridge, MA: Harvard University Press. Goetzmann, W. N. & Rouwenhorst, K. G. (2005, August 1). The origins of value: The financial innovations that created modern capital markets (p. 94). Oxford: Oxford University Press. Zelizer, V. A. R. (1997). The social meaning of money. Princeton, NJ: Princeton University Press.

2 Banking in the Twentieth Century

Throughout the history of economics there have been quite a few booms, bursts, crashes, panics, and crises. To examine each and every one of them would require a book of its own and already quite a few exist on the subject.1 Beside the length of such a study, there is another reason that students of banking sector development do not really need to focus on them: not all financial crises have had an impact on the evolution of banking. This chapter overviews the banking crises which have mostly affected the workings of the banking sector and well as the different changes in regulation which resulted from them. To this end, only crises which took place in the twentieth and the twenty-first century are examined. The focus is even more limited since the crises which have affected economic thinking have mostly taken place in developed economies. While important crises have also manifested in developing economies, none of them have had any material impact on the conduct of banking. The first crisis that reformed the banking sector in the world’s leading economy, and forced the creation of a central bank, was the panic of 1907 in the US. As with most crises, a trigger, which may or may not be related to the overall economic conditions, is necessary for the whole economy to move to panic area. In the case of the 1907 panic, the trigger was F. Augustus Heinze’s attempt to corner the market for the United Copper stock on October 16, i.e. to guide the stock price where he wanted and profit from it. Heinze’s endeavour proved unsuccessful since other investors (namely those with active interests in United Copper) increased the amount of available copper causing

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a sharp drop in the share prices.2 As the public became aware of Heinze’s fall, who took his brother’s brokerage house down with him, they became worried about the solvency of banks in which Heinze and another participant in the copper fraud, C. F. Morse, held prominent positions. Fear of insolvency precipitated a series of runs on the banks. Usually, a bank would have enough money to cover for deposit outflows and as observers comment, the copper fraud may not have led to a panic in a benign economic environment. However, times were not as benign, especially in the New York market. Specifically, banks faced large seasonal variations in liquidity, a result of the outflow of capital to finance crop shipments from the Midwest to the East Coast. During that period, New York City’s money markets were left squeezed for cash. The absence of finance bills, which were contracts to extend credit in hope for profits from the exchange market, altered the flow of gold (on which all currencies were based during the time) and contributed to forming the conditions of the crisis. These bills, usually issued during the summer, prevented substantial outflows of gold from import countries and thus minimized the need for an actual shipment of gold. However, a US policy to increase gold inflows nearly caused a crisis in Great Britain from which gold was flowing out. The Bank of England retorted with an increase in its interest rate in late 1906 and threatened another increase if US finance bills were not paid upon maturity. This caused a suspension of finance bills in the US and an outflow of gold from the already squeezed market. As a result, the New York money market found itself drained of cash as the usual seasonal patterns were intensified by international gold flows. As suggested earlier, depositors feared that the speculators, which had close ties with the banks, would take the latter down with them and rushed to withdraw their money from Mercantile National in which Heinze presided. The New York Clearinghouse, a consortium of banks examined the Mercantile’s assets, deemed that it was solvent, and stated that it would support Mercantile on the condition that Heinze resigned. Morse, on the other hand, was at the board of seven other banks, two of which called for aid from the clearinghouse in response to large withdrawals. To assure the public, the clearinghouse (and the banks themselves) relieved Heinze, Morse, and some of their close associates from their duties. The clearinghouse promised to fund around $10 million to aid former Heinze banks, which further reassured depositors that the worse was over. Overall, the run on the banks did not last long. After Heinze and Morse were removed from

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bank management the run ceased. Just five days after the failure to corner the market, on October 21, the reorganization of national banks was complete.3 The bank run did not become systemic as depositors who withdrew money from Mercantile Bank redeposited them in other New York banks. However, economic conditions remained uncertain. On October 21, the National Bank of Commerce announced that it would no longer clear checks from the Knickerbocker Trust Company, which was New York’s third largest trust and had already faced depositor runs. The move of the National Bank of Commerce was interpreted as a vote of no confidence that seriously alarmed depositors both in Knickerbocker and other trusts. Trust companies were financial intermediaries which had grown rapidly in prominence at the turn of the twentieth century largely due to freer investment opportunities. While trusts were originally conservative institutions managing estates, holding securities, and taking deposits, by 1907 they were performing most of the functions of a bank except the issue of banknotes. Many large trusts specialized in underwriting securities while others wrote mortgages or invested directly in real estate, activities that were barred or limited for national banks. Their main channel of profitability was their investments in collateralized loans, i.e. risky loans to firms that could (usually) not obtain credit though national or state banks. Inherently, trusts’ assets were riskier than the assets of other financial intermediaries. However, regulation was laxer in the case of trusts. In the state of New York, trusts were required to hold just 5% of assets as currency in their vaults, in contrast to a requirement of 25% for national banks. These regulatory differentials made trusts useful to banks as well, with many of them gaining direct or indirect control in trust companies. Thus, extensive liquidation of loans by trusts threatened the assets of national banks, which, although legally distinct, were also operating in the same market. In New York, the patriarch of financiers, John Pierpont Morgan, singlehandedly arranged for funds to flow to distressed trusts, deciding which to support and which to allow to go down. Knickerbroker Trust was victim number one. Denied of Morgan’s help, as Benjamin Strong, the head of Banker’s Trust Company could not evaluate Knickerbrocker’s financial condition, the fund underwent a run for three hours on October 22, before suspending its operations just after noon, having paid $8 million in cash. The run on trusts continued, as newspaper articles cited Trust Company of America as the “sore point” of the panic. The trust faced the same issue as Knickerbrocker: on October 23, $13 million of a total of $60 million in deposits were claimed by depositors, compared to $1.5 million on the day before. Seeing that the panic would spread if more trusts were allowed to fail,

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Morgan channelled $3 million to it, with J. D. Rockefeller depositing another $10 million within Union Trust and announcing his support for Morgan. The secretary of the Treasury was also quite supportive: between October 21 and October 31 the Treasury deposited close to $38 million in New York national banks and provided $36 million in small bills to meet runs. This huge inflow to banks left the Treasury with just $5 million in working capital and prevented it from providing further support during the rest of the panic. The tightness of banks also had a major impact on the stock market: money lent for the purchase of stock was scarce. In fact, money was so scarce that even at a rate of 60% (i.e. the interest rate to be paid to the lender) no money was offered. The rate soon reached 100% on the exchange. Under the guidance of J. P. Morgan, $25 million were offered to the exchange, from which almost $19 million were borrowed during the day. Notably, a large amount of the Treasury deposits was used to support the stock exchange.4 The funds were soon depleted and another money pool was granted to the exchange, this time with clauses prohibiting margin sales (only cash sales were allowed) in order to stifle speculation. The effort to keep trusts and the market afloat left banks with tighter money and reserves. Given that United States lacked a central bank at the time, the system had no formal mechanism to increase liquidity, i.e. the supply of currency, swiftly. However, clearing house loan certificates acted as an artificial mechanism to increase the supply of available currency. This practice had already taken place in the panic of 1893 and was widely used across the country. In times of normal business, these certificates were only used by banks to clear accounts with each other and as reserve assets. During the panic, the certificates allowed banks to monetize their non-currency assets as they would substitute currency with loan certificates. As contemporary commentators observe, in many cities the actual currency paid was limited to very small amounts or denied altogether and was replaced by checks, which were “payable only through the clearinghouse”.5 The benefit, and hence the reason why the offered checks were accepted by the public was that they were secured by collateral deposited with the clearinghouse committee (albeit not currency). Furthermore, the funds were practically guaranteed by all of the associated banks, in that banks agreed to accept them at par for the stated amount. Cashier’s checks found also widespread use during the panic, however, these were also “payable at the clearinghouse”. Currency substitutes introduced in late 1907 remained in circulation until the mid of 1908 in some cases.

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The panic ended approximately three weeks after it started, however, the economic contraction it was part of lasted until June 1908. Most memorable for the role of J. P. Morgan in “saving the day”, the panic was vital in understanding the benefits of a centralized clearinghouse and an institution to act (at Bagehot’s advice) as a lender of last resort when needed.6 To address these needs, in 1913 US President Wilson signed the law for the creation of the Federal Reserve System of banks, with Benjamin Strong, the head of Banker’s Trust whose qualities even J. P. Morgan trusted, becoming the first president. The Fed was given the mandate to provide a uniform national currency that would expand and contract as needed and to serve as lender of last resort. While over time the focus of the central bank has been enhanced to include other tasks, the panic of 1907 remains in the American central banker’s mind as the crisis that fundamentally altered the financial scene during at least the next 20 years. The world remained relatively at peace after the panic of 1907, until the First World War forced huge spending expenses. The debts most developed economies came to accumulate combined with the monetary authorities’ obsession to return to the “gold standard”, i.e. to a fixed exchange rate (and overall association of money supply) with an ounce of gold, as a sign of stability, caused severe disruptions to the system.

The Great Depression The first disruption came in 1927 with the Sh¯owa financial crisis in Japan. The Sh¯owa crisis occurred after the post-WWI business boom in Japan in which many companies invested heavily in increased production capacity in what proved to be a bubble instead of solid growth. The slowdown, combined with the Great Kant¯o earthquake of 1923 which cost the lives of more than 140,000 people, caused an economic depression which led to the failures of many businesses. The government, in an effort to safeguard the economy, issued “earthquake bonds” to overextended banks via the Bank of Japan. However, when in January 1927 the government proposed to redeem the bonds, rumour spread that the banks holding them would go bust. In a manner similar to the 1907 panic, depositors rushed to get their money out resulting in a bank run in which 37 banks went bankrupt. The collapse of a large number of small banks increased the power of the zaibatsu financial conglomerates, which came to dominate Japan’s finances until WWII.

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The situation was finally solved through the imposition of a three-week bank holiday and the issuance of emergency loans by the Bank of Japan.7 The Sh¯owa crisis, despite its severe impact on Japan’s banking sector, did not become a warning sign to the rest of the world regarding the state of its affairs, mainly because the Japanese currency was pegged to the dollar and not directly to gold. The warning sign came along with a crisis just two years later and was called the Great Depression. Nothing better serves to depict a situation more than an image. In the case of the Great Depression there are three: first, Dorothea Lange’s Migrant Mother Photograph which depicts a concerned mother with two children clinging on to her, serves as a reminder of how bad an economic slump can become for the population. Second, John Steinbeck’s “Grapes of Wrath” which describes the despair of farmers moving from Oklahoma to California with hopes of finding employment, even though these soon disappear. Third, and perhaps more relevant in this context, Frank Capra’s “It’s a wonderful life” depicts what a bank run really looks like and how banks can get into situations where they lack liquidity when James Stewart’s character, a banker is faced with a crowd asking for its deposits, replies to a customer “No… You are thinking of this place all wrong. As if I had the money back in a vault. The money is not here. Your money is in Joe’s house, that’s right next to yours, and then the Kennedy house and Mrs Maklin’s house and a hundred others”. The Great Depression, which to date has served as an example as to how far the world’s economy can decline, originated in the US starting with a stock market crash on October 29, 1929. Similar to all other crises in the past (and future), the sharp decline in asset prices cause a run for money to cover the brokers’ open positions in the stock market. In 1929, the money was nowhere to be found, firstly because the crash wiped out 19.5% of the Dow Jones value in October and a further 21.5% in November. Over the two months, a cumulated loss of more than 37% of the total value of the stock market had evaporated.8 Second, and most important, bank lending to brokers, mostly associated with the securities market, doubled from 1924 to 1929 (Fig. 2.1).9 Since margin requirements were only 10% (i.e. for every dollar in deposit brokers would lend an additional nine),10 the stock market crash forced brokers to liquidate at lower prices causing further damage on the market and the banks who saw their customers lacking the funds to repay them. Hence, the drop in asset values was immediately passed on to the banks. The credit boom of the 1920s, which also increased lending other than the securities markets by more than 33% left banks more vulnerable. Overall lending had more than doubled during the “roaring 20s”. In contrast, while

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real GDP increased by an impressive 60%, the increase was much less, with the remaining change impacting prices, especially those of the stock market, which more than doubled in value during the decade.11 As with every other financial crisis, the preceding stock boom came along with the usual self-dealings and other illegal actions. The “speculative orgy” proved to be so large in later investigations, that a journalist in 1933 “begged Mr Pecora [the head of the Senate Committee on Banking and Currency] not to break so many front-page stories daily because it was physically impossible to cover them all”.12 The stock price bubble was nonetheless not hidden from public eye. In as early as March 1929, Paul Warburg, prophesized that “if orgies of speculation are permitted to spread too far, however, the ultimate collapse is certain not only to affect the speculators themselves but also to bring about a general depression involving the entire country”.13 Warburg’s warning was spot on: increased exposure of banks to asset prices, and specifically the stock market made them feel the sting at once. A vicious cycle with a feedback loop between bank failures and bank runs by depositors who feared about their savings was initiated soon. In 1929, bank suspensions increased by 32% (to 659 failures) compared to 1928, while they more than doubled in 1930, reaching 1350 failures. The losses to depositors who held their money were larger than expected due to the lack of available liquidity caused by the crash and the runs: in 1929, 33% of deposited money to failed institutions was lost, with the number dropping to 28% in 1930.14 The feedback loop, which will be described in more detail in Chapter 4, is not difficult to see: some banks failed because large losses were inflicted on them by the stock market crash. The failure of these banks led to losses on

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deposited accounts which spread fear among depositors. The latter stormed, en masse, to withdraw their deposits from other banks which had not failed until then. However, the bank runs caused liquidity shortages to these institutions which were then forced to call their loans. As borrowers did not have the money to repay at that time, banks had to suspend their operations. Under these conditions, the remaining banks were less reluctant to lend out more money to the public. Most importantly, the public is also not only unwilling to borrow but also more eager to get rid of debt, causing further disruptions in the economy. In contrast to usual economic thinking that bank loan supply increases will always find eager borrowers, this was not the case. Data from the period support this argument since demand for money was falling more rapidly than the supply of money in 1930 and 1931.15 These events caused a further drop in asset prices and further drops to the net worth of businesses. This occurs as the value of the business drops due to the fall in asset prices while the outstanding amount of its debt remains the same. The generalized problem with bank failures, unwillingness to hold debt and the reduction in the net worth of businesses results in a reduction in consumption, employment, trade, and overall output. Throughout the course of these events, the loss in confidence is large and pessimism about the future prevails. Hence, money is usually hoarded and most importantly, the price level drops significantly increasing the real value of debt. The above story, albeit somewhat differently put was first brought out by Irving Fisher in 1933. Eloquently, he named it the “Debt-Deflation Theory of the Great Depression”16 and he specifically emphasized that the cycle repeats itself: as a result of the drop in employment and output and the decrease in the price level, banks are even less willing to lend, borrowers even less willing to assume debt, and so on. Note that the Debt-Deflation theory does not suggest that all declines in the price level (i.e. deflations) are the same. Specifically, a small decline in the price level is not expected to have a significant impact as it simply reallocates wealth from debtors to creditors without damaging the economy. However, when deflation is severe, falling asset prices along with debtor bankruptcies lead to a decline in the nominal value of businesses.17 As Fisher points out, this chain of events will continue until, at some point, something happens that breaks the sequence. The Great Depression started off as a usual banking crisis, rooted in the banks’ overextension to the stock market. Usually, a banking crisis would have been contained in the sector and end within a couple of years. However, this was not the case because not only were policy actions and the overall economic foundations unhelpful, they actually worsened the recession.

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On one hand, the Federal Reserve, which was in a policy vacuum since Benjamin Strong’s untimely death in 1928, did not do much to ease the burden on borrowers: while the interest rate decreased in the last months of 1929 (Fig. 2.2), the decrease was very mild compared to the sharp crash the stock market experienced. In spite of the continued decrease in the rate until 1931, when it reached a low of 1.5%, it appears to have been very little impact on the economy. The reason is straightforward: in an environment where banks are not willing to lend and people (and businesses) are not willing to borrow, decreasing the interest rate will make very little difference to the creation of new lending. This was acknowledged by most elected officials by the time the Depression “officially” ended in 1933. In meetings of the US Congress during 1933, Representative Bacon suggested that “credit was tightened in the desire to remain as liquid as possible to meet the emergencies of runs”, while Representative Steagall commented that “The fear that grips the minds and hearts of bankers, keeping ever before them the nightmare of bank runs, makes it impossible for them to extend the credits that are indispensable to trade and commerce”.18 Data from the period provide evidence of these anecdotal suggestions. Banks’ unwillingness to lend led them to keep an amount of money in the Federal Reserve far greater than formally required: the aggregate excess reserves of the Federal Reserve member banks increased by almost a factor of 14, from $42 million in October 1929 to a peak of $584 million in January 1933. During the same period, the number of banks had dropped from 8,616 7.50 6.50 5.50 4.50 3.50 2.50 1.50 1920M01 1920M07 1921M01 1921M07 1922M01 1922M07 1923M01 1923M07 1924M01 1924M07 1925M01 1925M07 1926M01 1926M07 1927M01 1927M07 1928M01 1928M07 1929M01 1929M07 1930M01 1930M07 1931M01 1931M07 1932M01 1932M07 1933M01 1933M07 1934M01 1934M07

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to 6,816.19 Using a different point of view, excess reserves per bank increased from $4,784 to $85,680 in the four years, in a 17-fold increase. To act as the devil’s advocate, understanding that during recessions banks are unwilling to lend and people are unwilling to borrow was not part of the period’s economic knowledge, but was introduced much later by Richard Koo, under the name “balance sheet recession”.20 While there can be some justification as to the Federal Reserve’s failure of acknowledgement that the impact of interest rate reductions on the creation of new money would be minimal, there is no justification as to why the Federal Reserve did not act as the lender of last resort and pump liquidity to the economy (more on this on Chapter 9). As Milton Friedman and Anna Schwartz have argued,21 the downward trend in the economy would have been just another recession had the Federal Reserve taken decisive action. In contrast, the Federal Reserve sat idly while large public bank failures produced panic and widespread runs on local banks. The Federal Reserve, as Friedman and Schwarz argue, could have increased the quantity money in the economy and thus provide liquidity to banks and rescue them from failure. Due to the Fed’s inaction, close to 10,000 banks were suspended from 1929 to 1933.22 The reasons behind the Fed’s and the overall government’s inaction were firstly, an inherent belief in the view that markets were self-regulating and a laissez faire (let them be) attitude would have been enough for the economy to return to its feet at some point. This was based largely on Say’s law which suggests that supply creates its own demand, and to a strong adherence to Joseph Schumpeter’s ideas about “creative destruction”. While creative destruction may hold in times when only specific institutions or industries are facing difficulties, it does not provide a justification for inaction when things are going systemically (and systematically) south. Furthermore, universally generalizing the creative destruction dictum means that one is essentially making the inherently flawed assumption that all businesses matter the same for the economy, i.e. that when a firm that assists in the smooth functioning of the system fails (i.e. a bank) nothing more is expected to happen compared to when a fast food company suspends its business. As a contemporary noted “(…) bank failures paralyse the economic life of whole communities, not only through the loss of money accumulations but by the destruction of the deposit currency which is the principal medium of exchange in all business activity”.23 However, during the time of the Depression many government officials were even promoting ideas that liquidations of real estate, stocks, bonds, banks, and others, were not inherently bad and “even panic is not altogether a

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bad thing. It will purge the rottenness out of the system. (…) People will work more, live a more moral life” as President Herbert Hoover said his Treasury Secretary claimed.24 Many officials at the Federal Reserve appear to have also held a similar attitude, associated with the “real bills doctrine”. The doctrine was associated with the idea that supply and demand in money market should meet and thus should not be affected by policy. Thus, provision of additional credit by the Fed would only take place if demand from banks existed. To determine whether it should expand, the Fed looked at the supply of commercial paper and the level of excess reserves. With commercial paper markets stagnant and excess reserves on the rise, as previously examined, the Fed concluded that no new monetary initiatives were required.25 The second reason behind the Fed’s inaction was none other than the US adherence to the gold standard. The original Federal Reserve act of 1913, required a backing of 40% in gold, but by the late 1920s the Federal Reserve had already almost reached the limit of allowable money which could be backed by the gold in its possession.26 Gold holdings in fact remained relatively stable in the first year of the recession, while it increased in early 1931, reaching a peak in August (Fig. 2.3). In September 1931, Great Britain, which was also severely hit by the Great Depression chose to abandon the gold standard. Speculators, believing (correctly as it later proved) that the US would be the next to abandon gold, turned their attention to the dollar, converting their dollars to gold. The resulting outflow of gold reserves (external drain) put pressure on the US banking system (internal drain) as both international and domestic depositors withdrew cash in anticipation of further bank 4,000 3,800 3,600 3,400 3,200 3,000 2,800 1934M01

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failures.27 The sharp decline lasted until October 1931, when the Federal Reserve raised its discount rate by approximately 2 percentage points to avoid further drain. The combination of the drain and the huge rise of the discount rate during a full-fledged recession further deteriorated the situation. Recall that the value of repayments is increased if the interest rate rises, making things worse for borrowers who are already trying to repay debt. In addition, the cost of deposits increases for banks. In the words of Friedman and Schwarz, these caused a “spectacular” increase in bank failures and bank runs. Naturally, as things turned to the worst for banks, money, employment, and output followed the collapse. Official government actions were equally unhelpful during the period. Adhering to the views of his Treasury Secretary (and perhaps also his own prejudices at the time), Herbert Hoover allowed for a surplus budget during 1929–1930 (Fig. 2.4). Furthermore, while the budget was allowed to deteriorate in 1931, the deficit was just 0.50% of the Gross National Product (GNP). Reflecting these policies of surpluses, federal debt decreased in 1929 and 1930, increasing only slightly in 1931. The deficit exceeded 1% in 1932, when Hoover’s Treasury Secretary was replaced, but most of the deficit resulted from the reduction in receipts; expenditures rose only by 0.2% of GNP in 1932. Budget deficits, even during economic downturns were seen as the original sin at the time. To this end, the Hoover administration passed the Revenue Act of 1932, which raised personal and corporate income taxes and introduced a number of new direct and excise taxes, the largest peacetime tax increase in US history.28 1.0% 0.5% 0.0% -0.5% -1.0% -1.5%

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The absence of fiscal policy action remained even after Hoover’s successor, Franklin Delano Roosevelt, came to power. Ironically, Roosevelt actually criticized Hoover for fiscal irresponsibility. While fiscal spending further increased during Roosevelt’s time, the budget deficit was only 1.5% of GNP at maximum and driven mostly by increases in military spending than an effort to push the economy out of the Depression through fiscal expansion.29 Denied of both fiscal and monetary stimulus, it not surprising that the recession turned into a Depression. The Fed provided at best no material support to the banks, while in times it even made things worse for them, and consumption, a victim to the whims of the inflexibility of the gold standard and the subsequent unwillingness of fiscal authorities to increase spending, continued its free fall. As if this was not enough, Congress passed what was known as the SmootHawley Act of 1930. In particular, the act raised US tariffs on over 20,000 imported goods, which greatly assisted the reduction of global trade, as other countries retaliated with additional tariffs. The overall reduction in demand, with further assistance from the Smoot-Hawley Act, led to a contracting spiral of US trade, which reduced more than 60% in the 1930–1933 period.30 As other researchers have commented,31 trade barriers may have arisen from the desire to remain at the gold standard. Since monetary autonomy was sacrificed (remember the real bills doctrine) to have their exchange rate fixed, policymakers resorted to trade controls in order to prevent further currency depreciation. This conclusion is further strengthened by the fact that countries which were not part of the gold bloc were less inclined to impose tariffs. In general though, the Smoot-Hawley Act, while providing barriers to trade, did not cause but was a policy action which negatively impacted the US economy at the time. Efforts for recovery in the US started in 1932, when the Glass-Steagall Act gave the Federal Reserve greater latitude to provide credit to beleaguered financial institutions.32 In April 1932 when the Congress began to exert pressure on the Fed to ease monetary policy, and in particular to pursue open market purchases of securities at a large scale. While the Fed was reluctant, it did authorize substantial purchases between April and June 1932. The infusion of liquidity slowed the decline in the stock of money and brought down yields on government and corporate bonds as well as commercial paper. Most importantly, as Friedman and Schwartz note, “tapering off the decline in the stock of money and the beginning of the purchase programme were followed shortly by an equally notable change in the general economic indicator” (p. 324). However, the experiment with open market operations ended

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abruptly when Congress adjourned in July for the presidential campaign season. With Roosevelt’s win in November of 1932, the constitution-mandated lag until he officially took office in March 1933 resulted in heavy speculation regarding the incumbent’s likely policies. Roosevelt’s refusal to make definite policy, statements further increased uncertainty. As many inferred (correctly) that the president-elect would devalue the dollar or break the link with gold entirely, investors (both foreign and domestic) began to convert dollars to gold putting extra pressure to the already fragile financial system and gold reserves. Instead of getting better, things turned worse in early 1933. While bank holidays were frequent events during the Depression, the straw that broke the camel’s back occurred in Detroit, when the Governor declared a statewide banking holiday on February 14, to prevent the failure of the Union Guarding Trust Company of Detroit, Michigan, a bank with close ties to Henry Ford. Instead of preventing a panic, the Michigan bank holiday gave new meaning to the law of unintended consequences: suspending operations confirmed peoples’ fears, that banks were unsafe, and sparked a US-wide bank run. The hoarding of cash is evident in the behaviour of currency in circulation: outstanding amounts increased from $5.5 billion on February 15 to $7.25 billion in March 8, or by 32% in less than four weeks. Following Michigan, almost all of the other states declared bank holidays.33 Why the system reacted so erratically to these bank holidays is, in the words of Friedman and Schwartz (p. 330) “by no means clear”, even with the benefit of hindsight. Perhaps, as commentators suggest it was a combination of factors such as the already weakened position of banks which made them fail even in minor liquidity outflows, the public’s exacerbated demand for gold and the overall 40% gold backing for notes. However, the Gold reserves that were required by law in order to continue backing notes, would soon be depleted. By March 1, 1933 the gold outflow severely damaged reserves, reducing backing to 24%. This development forced the head of the Federal Reserve Bank of New York, George L. Harrison, to send an urgent message suggesting the declaration of a national banking holiday. The Board of the Federal Reserve banks replied with a suggestion to suspend convertibility to gold for 30 days. However, this would not stop the outflow of gold. While Harrison’s suggestion of banking holiday would settle that issue, many banks, as well as other officials, opposed any such action. The indecisiveness of officials led to further bank failures and underlined the need for action.

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Finally, on Sunday, March 5, 1933, Roosevelt, after formally succeeding Hoover on the previous day, proclaimed a four-day suspension of all banking transactions, beginning on the following date. Stock exchanges, although not mentioned in Roosevelt’s executive order, also closed. Despite the original plan, Roosevelt did not reopen the banks as planned on March 9; rather he extended the closure for three days. In contrast to earlier reactions, Americans did not react in horror but waited for his plan. On the same day (March 9), the Emergency Banking Act was passed at the Congress. The first title of the Act approved the President with tremendous powers of regulation over transactions in gold, silver, credit, and currency, including any transactions in foreign exchange. Title II of the Emergency Banking Act gave powers to restrict the operations of banks with impaired assets, while Title III allowed to evaluate whether a bank needs additional funds to operate and to provide funds to any such bank via either preferred stocks or loans secured by collateral. Most importantly, the Federal Reserve could now issue emergency currency backed by either any direct obligation of the US or any notes, drafts, bills of exchange, or bankers’ acceptances acquired under the provisions of the Act. The Fed, with its new powers, would (and did) circulate these notes, alongside normal notes, even though these were not back by gold. It could do this, because the Act provided that the new notes “shall be receivable at par in all parts of the United States… and shall be redeemable in lawful money of the United States on presentation at the United States Treasury”. Finally, Roosevelt’s 15-minute radio address to the people on Sunday, March 12, informed the public that the US Treasury would only allow sound banks to reopen on the following day. In his own words “I can assure you that it is safer to keep your money in a reopened bank than under the mattress”. Surprisingly, when banks opened the following day, depositors stood in line to return their cash. In one week, currency in circulation decreased by 4%. By the end of March, the outstanding amount of currency decreased to $6.07 billion. More than two-thirds of the cash withdrawn during the February run had returned to the banks. The fact that Roosevelt managed to ease peoples’ fears boiled down to that, in contrast to Hoover, he favoured action and not idleness. The Emergency Banking Act was proof of this: the fact that the Federal Reserve committed to supply unlimited amounts of currency to reopened banks, created a de facto setup for a 100% deposit insurance. Even though in many parts of the US news had not reached the people, Roosevelt’s plain language and friendliness on his radio address convinced many. It is not thus surprising

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that some authors claim that the end of the Depression was due to a change in expectations.34 The move off gold continued soon after bank runs had been dealt with. On April 20, Roosevelt issued a proclamation, aimed at stopping gold outflows. The proclamation prohibited exports of gold and prohibited the Treasury and financial institutions from converting currency and deposits into gold coins and ingots.35 In May 1933, the Thomas Amendment to the Agricultural Adjustment Act, aimed at helping farmers save through cheapening the dollar, granted the president broad powers over monetary policy: whenever the president desired currency expansion, the open market committee of the Federal Reserve should be authorized to purchase up to $3 billion of federal obligations (read: debt). If open market operations proved to be inadequate, the president could either have the Treasury issue up to $3 billion in bonds or reduce the gold content of the dollar by as much as 50% or accept $100 million dollars in silver.36 The amendment, in addition to giving the president power to inflate the dollar, also aimed at reducing silver holdings by the public. The above measures weakened the dollar’s link to gold. To further devalue the dollar, the Roosevelt administration authorized the Reconstruction Finance Corporation (which provided financial support to state and local governments and loans to private businesses) to purchase gold at increasing prices.37 The increase of money would increase inflation and hence assist in relieving debtors, reviving businesses, as well as making American goods cheaper abroad and discouraging imports. The culmination of Roosevelt’s efforts to reflate the economy the Gold Reserve Act passed into law in January 1934. The Act empowered the Secretary of the Treasury to require delivery at the Treasury of all gold and gold certificates (other than jewellery) held by anybody in the country in exchange for dollars.38 In addition, gold could no longer be exported. Importantly, the price of gold was set at $35, a sharp increase of 40% in relation to the old price of $20.67 per ounce.39 The easing in monetary conditions contributed significantly to the growth in M1 money supply which grew by an annual average of approximately 10% per year in the 1933–1937 period. As a result, GNP grew at an average annual rate of more than 8%, marking the end of the Depression period.40 Overall, during the 1929–1933 years, real output dropped by 26.5%, the largest contraction in the US history. By mid-1933 the unemployment rate increased to than 25.5%, compared to less than 1% until September 1929. International trade, as previously discussed, deteriorated significantly, a result of both the drop in demand and the Smoot-Hawley tariffs. Output recovered

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to 1929 levels in 1937 but it was not until WWII, and in particular 1941, that unemployment reached 1929 levels.41

The Global Depression The difference between the Great Depression and other crises of the past was that this time the crisis had a global reach. Even though it started in the US, its effects were rapidly passed on to other countries. Those which still maintained the gold standard suffered the most, as recent studies have shown.42 Australia was one of the countries which was most hardly hit by the Great Depression, with the effects of the economic crash lasting until WWII. Even before the US market crash in 1929, unemployment in Australia stood at 10%, reaching 32% in 1932. The fact that the country still relied on Great Britain which demanded that Australia met its international loans obligations to it through savage wage cuts.43 Despite suggestions by some politicians to default on overseas debt, a new government which settled in 1931 favoured deflationary instead of inflationary measures. In what came to be known as the Premier’s Plan, tough economic measures were passed in order to account for Great Britain’s suggestions.44 The Plan included a 20% slash in spending, a similar-sized cut in public and private sector wages, an increase in income and sales taxes and a reduction in interest rates. While the plan’s success is an issue of great debate among historians, recovery did eventually come in 1932, mostly driven by the departure from the gold standard in 1931 (and the subsequent currency depreciation) and aided by a slow recovery in international wheat and wool prices from 1933 onwards. Canada was probably the only country in which output was as severely affected by the Depression as the US. At the height of the Depression in 1933, real output in the country had fallen by roughly 28% and prices had declined about 15% from their 1929 levels. At the same period Canadian exports were at about one-third from their 1928 peak. Similar to the US, the Canadian government was doing nothing on the monetary front since the start of the crisis. The advance rate (similar to the discount rate) remained unchanged at 4.5% from September 1928 until October 1931. Banks became increasingly cautious about their own lending activities and were repaying their borrowings from the government so fast that advances fell to zero by the spring of 1931, compared to a peak of $112.9 million in late 1929. The monetary contraction exacerbated the economic

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downturn and contributed to the appreciation of the Canadian dollar to 0.90USD. The advance rate was reduced to 3% in October 1931 and further to 2.5% in May 1933. In the autumn of 1932, the government used moral suasion to force the banks to borrow in order to reflate the economy, depreciating the Canadian dollar to 0.80USD. The depreciation was only temporary though since Roosevelt’s actions on the gold front strengthened the Canadian dollar once again in 1933. The reduction of notes backing in gold to 25% did not have much impact either, as it was considered to as an appropriate move to counter developments in the US. For Canada, the 1930s progressed with little sign that the Depression was ending. Popular distrust with banks, high nominal rates (at 7%), and even higher real rates (at 17%), brought to the attention of the government the need for establishing a central bank. Ignoring the opposition by Canadian commercial bankers, which mainly rested on loss of profits from note-issuing privileges which would now go the central bank, the Bank of Canada started operations in March 1935. However, despite the expectations for monetary activism by the creation of the central bank, the advance rate remained the same throughout the 1930s. It was not until the outbreak of WWII, in 1939 that the Canadian economy returned to 1929 levels.45 France did not suffer as much as other countries during the period, as the Great Depression did not lead to a financial crisis, with repercussions only associated with the gold standard. Output declined by approximately 13% until 1936, which was less than half the reduction in most other countries, and approximately two-fifths of the reduction in US output. In general, in the 1930–1939 period output grew by an average rate of −0.30% annually. Employment declined by approximately 10% until 1936, when a slow recovery started.46 As with the majority of other countries, recovery started only when France departed from the gold bloc. Interestingly, France is considered, along with the US, the main drivers of the gold-associated monetary tightening in rest of the world and hence the globalism of the Great Depression. The US already held about 40–45% of the world’s gold until the mid-1920s, a result of the shifting in power during WWI. France’s holdings started to increase by mid-two countries’ holdings of gold started to increase substantially, increasing to 15% in 1929 and 20% in 1930. During the early 1930s, the US and France held approximately 60% of the world’s gold.47 The fact that both countries did not pursue expansionary monetary policies (in economic parlance, inflows of gold were sterilized) meant that the rest of the world would have to tighten its policy in order not to experience additional outflows. Tighter policy meant worsening

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the already deteriorating world economic environment. However, as France was in the enviable position of having a large amount of gold it was also in the non-enviable position of being fettered in the gold standard mentality. Its unwillingness to forgo the fixed exchange rate led it to a recessionary spiral leading up to World War II. In Germany, the onset of the Great Depression in the US produced a severe shockwave. Following the end of World War I, Germany was forced to pay war reparations amounting to 132 billion gold marks (of which only 50 billion were required to be paid). With the Dawes Plan, agreed in August 1924, Germany would begin to repay 1 billion marks in the first years, which would increase to 2.5 billion marks annually in five years. At the same time, Germany would be loaned 800 million marks, chiefly from the US and Britain. The Dawes Plan provided short-term relief to the ailing German economy. However, the financial troubles during the Great Recession made American banks withdraw their loans to German companies. This had a direct impact on German unemployment which soared to 33.7% in 1931 and 40% in 1932.48 Hoover tried to ease the situation by issuing a public statement suggesting that a one-year moratorium be put on war reparations, but with little effect. Just like everywhere else, leaving the Gold standard, along with the easing of war reparation repayments as agreed by the Young Plan in 1931 helped to ease the situation for Germany. The imposition of exchange controls to halt capital flight and give central banks room for manoeuvre also played a large part in stabilizing flows. Most importantly, Germany did heavy use of fiscal policy to solve the problem. Unemployment started its decline in 1933 and continued dropping sharply, going below 12% in 1935. While this was greeted with joy, it was not economics which pursued the German government to do the trick, but re-armament.49 A similar expansion of fiscal policy, mostly aimed at military expenditure did the trick in Japan as well. However, while the economics of fiscal expansion did the trick, it was the cause which was problematic not the means: and it would take World War II to get the world economies back to full-blown economic growth.

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Introducing Deposit Insurance In addition to the global impact of the Great Depression,50 its other most distinguishing characteristic was a large amount of bank runs. These, as previously discussed in this chapter, emanated from a fear of depositors losing their money in the case of bank failures. This fear was not unfounded but was supported by evidence that a large amount of losses was indeed inflicted upon depositors of insolvent banks. In order to overcome this fear, Roosevelt, in his radio address to the public implicitly suggested that all deposits in banks which would reopen on Monday would be safe. However, this measure would be just temporary and also be prone to future bank failures which would once again trigger bank runs. To ensure that no bank runs would occur in the future, the Banking Act of 1933 introduced a temporary plan for coverage of all deposits in full up to $2,500 for all Fed member banks. In 1934, the temporary plan was extended to cover all deposits up to $5,000, while the plan was made permanent with the Banking Act of 1935. The 1935 Act covered not only Fed member banks but also forced non-members which had average deposits of more than $1 million in 1941 to join by July 1942. In order to fund the deposits insurance plan, banks were obliged to pay 1/12 of 1% of average total deposits.51 Naturally, the flat rate across all banks, meant that depositors at riskier banks would enjoy the same protection as depositors in conservative banks, despite the formers’ larger probability of failure. As later crises have demonstrated, this issue proved to be of the utmost importance, even though this has somewhat been addressed since. However, the incentives behind the idea were as pure as they could have been: the ordinary Joe does not really understand how well or bad his bank is doing. Despite being regular customers how many regularly check banks’ financial statements in order to gauge their financial position? Furthermore, of those who do check financial statements, how many really understand what is going on with the institution they hold their life savings with? In a popular cartoon at the time of the Depression, a squirrel asked a despaired depositor “why didn’t you save some money for the future, when times were good”? with the depositor replying “I did”.52 Avoid repetition of these events, safeguard depositors, and avoid panic in times of bank failures, deposit insurance serves a great purpose. Deposit insurance was so popular that it was soon replicated by many other nations across the globe. By year-end 2013 59% of all countries had explicit deposit insurance. The number stood at 84% for high-income countries,

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and at 96% for European countries. Of the countries with deposit insurance, 88% follow a scheme similar to the ex ante one in the Banking Act of 1935, in which premiums are collected on a regular basis. While some partial funding by the government exists in some countries, the vast majority of nations operates a privately funded plan. Fear of bank failures is beneficial for deposit insurance as recent experience has shown: the number of countries which had explicit deposit insurance jumped from 84 in 2003 to 112 in 2013. Of the 28 countries which introduced it, 14 did it after the 2008 financial crisis. In addition, almost all (96%) countries with explicit deposit insurance increased the statutory coverage limit in their deposit insurance scheme. The success of the deposit insurance schemes is undeniable: excluding isolated bank runs in the late 2000s recession, which were quickly contained, no systemic bank run has taken place in countries which have employed deposit insurance policies.53

Bretton Woods The end of World War II found the Allied forces more eager to cooperate in order to create a new international monetary system. While the “need” to continue a currency’s bond with gold was still strong in the heads of most of the public (including many policymakers), most realized that the ties with gold had long been repealed. In fact, there was no effective gold standard in the majority of the western world: by the time ratio of currency to gold reserves became binding, Central Banks just reduced the percentage of gold backing.54 To this end, the United Nations Monetary and Financial Conference, which took place in July 1944 at Bretton Woods, New Hampshire, US, constructed a blueprint for the post-war international monetary system. The Bretton Woods System, as it came to be known, promoted free convertibility of currencies, at a fixed (pegged) exchange rate, which was adjustable within a 1% band. However, countries were permitted to devalue up to 10% without consultation when faced with “fundamental disequilibrium”. The dollar preserved a fixed price to gold, at $35 per ounce.55 This fixing of exchange rate was based on the premise that if the US maintained a reasonable stability of prices and costs, other countries would be impelled to follow similar polices, because of the emphasis they placed on maintaining the dollar exchange rates for their currencies. To facilitate exchange rate stability, in December 1945, the International Monetary Fund (IMF) came to life.56 In theory, the IMF would allow for the transfer of gold

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and currencies to countries in order to back current account deficits (i.e. if the country was, in general, importing more than exporting). The issue was that, since the US already controlled three quarters of the world’s gold reserves, a current account surplus would mean that the US exported more than it imported and would hence bring gold and currencies back. As a result, world reserves would fall and a US surplus was seen as undesirable.57 The issue was that the US was indeed in a surplus from 1954 to 1971. This meant that the US was also a net exporter of capital to the world, including private investment, military, travel, and foreign aid. These foreign liabilities grew so large that caused concern as to whether the fixed exchange rate with gold could be maintained. Abiding to gold standard practices, if the level of gold in the US declined then interest rates would have to rise and the contractionary monetary policy would attract inflows and gold. However, US policies at the time, and notably those aiming at full employment, made it nearly impossible for the Federal Reserve to raise interest rates. Most importantly, this would not have been a viable solution for the long-term: if payments increased as US income increased, then interest rates would have to rise until recovery from the war settled in. This, simple enough, was the major construction flaw of Bretton Woods. With a US surplus not desirable, the Bretton Woods system caused another problem: with its status as a reserve currency country, the US was able to live beyond its needs. The country could import foreign merchandise, buy foreign companies, and participate in foreign military adventures all at the same time. Many (including the French President Charles de Gaulle) thought that these “exorbitant privileges” more than outweighed the pressures on the dollar price and the official gold losses. To add to this, despite the fact that foreign countries welcomed their ability to obtain dollar reserves, fears of dollar devaluation made them uncomfortable.58 As foreign liabilities increased, a result of the capital outflows, countries had to take action in order to preserve the system. The first thing central banks did was intervene in the market for gold to stabilize its price close to $35 per ounce. To this end, the Gold Pool was created in 1961 in order to share the cost of maintaining the London price of gold at $35 an ounce, instead of depleting US gold reserves. This solution did not last for long as non-US central banks were not willing to continue to share the losses indefinitely. In fact, some of the countries even took advantage of this situation to acquire more gold reserves (e.g. France). The Gold Pool collapsed shortly after as non-US countries asked for more contractionary US monetary policy. This led to the creation of two-tier gold market in London: one for private transactions at going market prices and

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another for official transactions at $35. The price in the market for private transactions was eventually brought down to $35 as South Africa increased its gold production and sales. Troubles for the Bretton Woods system were not over though. In 1968, central banks stopped buying and selling gold at the open market, making it possible only for foreign central banks to ask the US Treasury for gold. The Bretton Woods system switched at that very instant from a fixed dollar price gold standard into a dollar standard. As a consequence, price levels of other countries in the Bretton Woods system had to move in line with the prices in the US. As the latter had been pushing towards full employment, prices were increasing and so were the prices in foreign countries.59 Currency devaluations with respect to the dollar were also hurting the system: the UK which had already devalued by 30% with respect to the dollar in 1949 devalued further in 1967. However, the US refused to devaluate its exchange rate with gold, despite the fact that prices had risen more than 2.5 times since 1929. If the price of gold had been adjusted accordingly it would stand at $52. Concern about the viability of the system increased further as the US budget deficit rose. The efforts of the Federal Reserve to stabilize inflation by increasing policy rates were not successful for long. In 1970, the recession caused a drop in interest rates, a subsequent flight of capital and foreign liabilities of the US more than doubled to $50 billion, approximately five times more than the value of gold reserves. The Federal Reserve, aiming to fight off the recession, further lowered rates. Inflation abroad soared as countries experienced a huge inflow of dollars. In 1969, Germany, which saw its inflation rate rise to 5.3% from 1.8%, allowed the German mark to float, i.e. trade freely with the dollar. As a result, the dollar depreciated 9.3% with respect to the mark. Canada was the first to follow in floating its currency in 1970, while the Netherlands did it in May 1971. Most other countries appreciated their currencies. By the end of August 1971, all major currencies excluding the French franc floated against the dollar. In the US, wage and price controls aimed at taking action against inflation pushed countries to demand more gold. The Nixon administration, fearing a run on US gold reserves, closed the gold window thus banning the exchange of dollars to gold. The “Nixon shock”, was the final nail on Bretton Woods coffin.60 The surprise was not really that Bretton Woods collapsed, but rather how it had managed to survive all these years despite inconsistent policies in relation to maintaining a fixed exchange rate. To begin with, surplus countries had no

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incentive to adjust and all the incentives in the world to accumulate gold. Second, the notion of “fundamental disequilibrium” was not really separate from short-term fluctuations which could have been more easily dealt with. Naturally, separating between the two is easier said than done. Finally and perhaps most importantly, the US took advantage of the situation to boost its economy, tying much of its foreign aid to purchases from domestic markets, restricting capital movements, and placing much more weight on domestic concerns than on the maintenance of the world monetary system.61 The Bretton Woods system, while at first it does not appear directly associated with the financial system, has the implication that a fixed exchange rate requires a stable quantity of money in the economy. Hence, it implicitly requires that money and inflation are controlled in order to retain the peg to both the currencies and gold. This naturally implies a monetary policy which is active in restraining money growth. In addition, the Bretton Woods system makes a strong economic point about how the US managed to further promote its position as the economic leader of the world after World War II. Even after the collapse of the system, the US has been enjoying the advantage of having the dollar as a reserve currency. This means that other countries are willing to accumulate dollar reserves and in fact, invest heavily in US securities (bonds, stocks, etc.) in order to maintain their (usually fixed) currencies at the going rate which allows them to enjoy their export-led growth. The US is naturally not doing the world a favour by allowing this as it uses the funds for its own growth and foreign investments help finance domestic capital formation.62 The implications for whichever country boasts the world’s reserve currency are tremendous: as in the case of Bretton Woods it can live outside its means. More importantly it means that the country whose currency is the international reserve can take others down with it in case it faces financial distress. Put more clearly, if the US gets into a recession, its imports will drop, hence countries in the export-led economies group will suffer but so will developed countries which invested in the US. In general, when the buyer gets hit the seller also hurts. However, the situation is not easily reversible, nor should investors in the reserve country (whichever that may be) worry about flights of capital from the export-led countries. It is not the interest of anyone to change the status quo. If a structural change is to come, then this would arrive slowly and start with a replacement in the preference of a reserve currency. The end of the Bretton Woods system did not really displace the order of countries in the world; it just made the official dollar exchange into an unofficial one with floating exchange rates for the major currencies. This meant the abolition of capital controls something which contributed heavily to the

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overall reach of the financial system outside the boundaries of a country’s natural borders. Most importantly, after removing the exchange of dollars to gold it has marked a new era of money creation, one which is not constrained by neither exchange rate pegs nor gold reserves.

The Secondary Banking Crisis in the UK The tale of early cases of financial instability around the world ends with the UK’s secondary banking crisis of 1973–1975. To better understand the reasons behind the crisis, which was probably the first characterized by drops in real asset prices until then in the history of twentieth century, it would be advisable to overview the macroeconomic developments of the time. Specifically, after a period of slack and rising unemployment, the thrust of economic policy from about 1971 was directed towards expansion. Part of the strategy was to make finance readily available in order to provide a stimulus to investment. In addition, the planning restrictions of the 1960s in the country, which prompted a dry-up of new projects, led to inadequate supply in the early 1970s. This was the case particularly for office space with a sharp increase in rents when they were free to be negotiated. As returns from property outperformed returns in all other sectors in the economy, credit flew to it. Secondary banks were financial institutions which, although received deposits and granted loans, were not of sufficient size or quality to be as main banking institutions. Using the words of Bank of England “Deposittaking alone does not constitute a bank. It was always (and still is) open to any company or partnership to take deposits and to on-lend them”. If the institution prospered and its reputation and market standing increased then it could eventually come to be accepted as a full member of the banking community. Despite their non-recognition, secondary banks operated in the same areas as they obtained deposits and gave out loans. At the same time, they faced fewer regulatory constrictions than “authorized” banks. Much of their business laid mainly in the fields of consumer credit and personal loans, often secured on second mortgages. In 1972, when the “authorized” banking system was discouraged from investing in property (using the rationale that loans for property developments would reduce the amount of loans available for industrial purposes), secondary banks, or “the fringe” as they came to be known, stepped up for the job.

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Unlike usual depositors, the fringe met its depository requirements from the money markets, which included institutional investors (pension funds, investment companies, etc.), industrial and commercial companies, and banks. Since there was less demand for industrial loans than expected banks found themselves with excess funds which they channelled indirectly in the booming property prices by providing liquidity to the fringe. Offering a small premium to the existing bank rates, the fringe managed to attract wholesale deposits, mainly short-term. In 1973, the economic environment took a turn for the worse. The depreciation of the sterling led the Bank of England to raise the minimum lending rate to 11.5% towards the end of July and further to 13% by the end of November. In addition, a special deposits scheme was imposed on the following month, which defined a penalty on any interest-bearing liabilities in the wholesale money markets. In essence, the more a bank lent in the money markets, the more penalty it would have to pay. Lacking cheap (or in some times, lacking in general) wholesale deposits caused severe problems to the fringe. In November 1973, London and County Securities found itself in trouble as it could not renew deposits taken through the money markets. The imposition of a freeze in business rents introduced uncertainty to the property market, further dimmed the fringe’s potential. As sophisticated investors did not wish to participate in the money markets, it became evident that a collapse of several of these depositinstitutions was eminent; panic would likely spread to the rest of the banking system both indirectly through the collapse in confidence as well as directly through the money market wholesale deposits they had offered to the fringe. To avoid such a collapse in the banking sector, the Bank of England, proving that it had learned its lesson from the Great Depression, moved quickly and decisively. By the end of December 1973, “the lifeboat” Committee (which comprised of the English and Scottish clearing banks and the Bank of England) identified all deposit-taking institutions with known or anticipated liquidity difficulties. The (authorized) bank with the closest connection with the problem fringe was appointed as the “related bank” to it. The related bank made a rapid and as thorough as possible investigation of the fringe’s affairs and reported back to the Committee. The Committee could provide support to a company which faced trouble if the following criteria were met: first, if the company was solvent at the time and was likely to remain solvent provided that it received liquidity, second, the company had “sufficient banking characteristics” and had attracted a significant level of deposits from the public, and finally, no existing shareholders could provide this liquidity. The lifeboat charged the receivers of

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liquidity with the interbank rate plus a margin of 1.5–2%. By the end of March 1974, 21 institutions were considered to require liquidity support, of which 17 were approved for support; total advances amounted to just under 400 million pounds. The collapse of property prices was fully apparent by the first half of 1974. The drop in asset prices deteriorated the assets of the companies which had already obtained liquidity. As independent depositors denied exposing themselves to further, the total amount of support committed increased sharply, reaching 1.2 billion pounds, or 40% of the capital and reserves of the English and Scottish clearing banks. Going further would compromise their own soundness and hence the Bank of England had to provide additional funds on its own. Amidst the uncertain international environment, which saw the closure of large international banks in New York, Germany, and Tel Aviv (in addition to many banks facing large losses), nervousness in the UK increased. By September 1974 total amount of support outstanding stood at close to one billion pounds and by the end of the year it was just 18 million below the 1.2 billion pound maximum. The Bank of England provided temporary extra support, with the amount reaching 1.285 billion in March 1975.63 From 1975 onwards, things became rosier for the UK. Reconstructions started to work out and the outstanding lifeboat support was reduced to virtually half of its peak. To avoid such issues from arising again, the Bank of England’s supervisory arrangements were extended and legislation was passed in 1979, which regulated the acceptance of deposits in the course of a business and enhanced the Bank of England’s ability to control institutions with deposit-taking businesses.64 The secondary banking crisis in the UK marked both end of an era and the dawn of another. The lessons of the Great Depression and the letthem-be approach, which considered financial meltdown as a normal process which took the rottenness out of the system, was officially dead. Injections of liquidity into the system were now the new norm, abiding to Bagehot’s advice. Furthermore, the overall economic and financial landscape was rapidly changing. The Nixon shock of 1971, which effectively ended any connection of gold to the dollar and the increased role of investment banks and securitizations in the 1970s and 1980s made concerns about over-lending of banks in the securities business obsolete. Stocks and bond loans, although still part of the banks’ loan portfolio; were fast decreasing in importance. The new favourite was property (both residential and commercial), gathered an increasing amount of attention in the 1980s onwards.

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Notes 1. The interested reader may refer to Kindelberger (1978), Mackay (1980), or Reinhart and Rogoff (2009). 2. Tallman and Moen (1990). 3. Sprague (1908). 4. The direct funding of the exchange with Treasury money was prohibited. However, since it was deposited in banks, the use of Treasury money was not specified before credited and was thus not illegal. 5. Piatt (1908). 6. Bordo (1998, 2007). 7. Smitka (1998) and Yamamura (1998). 8. Source: NBER macrohistory database. 9. Data source: FRED NBER Macrohistory Database, US Loans On Securities, Reporting Member Banks, Federal Reserve System 12/1919–06/1938. Accessed 22 February 2017. 10. Fortune (2000). 11. The Austrian school argues similarly that the key cause of the Depression was the expansion of the money supply in the 1920s. See Murray Rothbard, America’s Great Depression (Ludwig von Mises Institute, 2000) and Ludwig Mises, The Causes of the Economic Crisis, and Other Essays Before and After the Great Depression (Ludwig von Mises Institute). Retrieved on 23 February 2017. 12. Flood (1992). 13. Warburg (1929). 14. Source: Federal Deposit Insurance Corporation: The First Fifty Years, assessed on 23 February 2017, at https://www.fdic.gov/bank/historical/managing/ Chron/pre-fdic/. 15. Whaples (1995). 16. Fisher (1933). 17. This view has been expressed by Ben Bernanke in Bernanke (1983). 18. Congressional Record (daily edition), 73rd Congress, 1st Session (1933) as quoted in Flood, Mark D. “The great deposit insurance debate”. Review, Federal Reserve Bank of St. Louis, July/August 1992, 51–77. 19. Federal Reserve Board “Banking and Monetary Statistics: 1914–1941”, November 1943, Tables 101 and 18 respectively. Data for the number of banks are as of December 31, 1932, as no monthly data exist. Using data for June 1933, after the official end of the Depression the number of excess reserves per bank stands at $64,750 per bank. 20. Koo (2011). 21. Friedman and Schwartz (2008). 22. Most banks were not part of the Federal Reserve System at the time, resulting in what was known as the ‘dual-banking system’.

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23. Greer, Guy. “Wanted: Real Banking Reform”, Harper’s Monthly Magazine (October 1933), pp. 533–546, as quoted in Flood (1992). 24. Hoover, quoted in De Long (1990). 25. Eichengreen (1999). 26. Simmons (1936). 27. “Remarks by Governor Ben S. Bernanke At the Conference to Honor Milton Friedman”. The Federal Reserve Board, November 8, 2002. Retrieved on 24 December 2011. 28. Ibid., 25. 29. Source: NBER Macrohistory database, FRED. Accessed February 26, 2017. 30. Husted and Melvin (2013). 31. Eichengreen and Irwin (2010). 32. Closed for the holiday: The bank holiday of 1933, Federal Reserve Bank of Boston. 33. Silber (2009). 34. See, among others, Temin (1992), Temin and Wigmore (1990), and Eggertsson (2008). 35. Richardson, Gary, Alejandro Komai, and Michael Gou. “Roosevelt’s Gold Program”, Federal Reserve History. 36. David D. Webb. “Thomas Amendment”, The Encyclopedia of Oklahoma History and Culture, www.okhistory.org. Accessed 1 March 2017. 37. The RFC, created in 1932 by Hoover with the purpose of providing loans to states and banks, had some success in reducing bank failures until late August of the same year when it chose to publish the names of loan recipients. Publication of the names actually offset any beneficial actions until then. See Mason (2001) and Butkiewicz (1995). 38. The act can be found in http://www2.econ.iastate.edu/classes/econ355/choi/ 1934jan30.html. 39. Timothy Green “Central Bank Gold Reserves: An Historical perspective since 1845”, World Gold Council, November 1999. 40. Romer (1991). 41. NBER Macrohistory database. Retrieved on 2 March 2017. 42. Eichengreen and Sachs (1985). 43. The Great Depression, Australian Government, at http://www.australia.gov. au/about-australia/australian-story/great-depression. Retrieved on 28 February 2017. 44. Ted Theodore: The proto-Keynesian at Australian Government: The treasury. https://archive.treasury.gov.au/documents/1783/HTML/docshell.asp? URL=07_Theodore.htm#P235_35703. Retrieved on 1 March 2017. 45. The Depression years and the creation of the bank of Canada (1930–39) History of the Canadian Dollar. Bank of Canada. 46. Beaudry and Portier (2002). 47. Irwin (2010). Data are from Hardy, Charles Oscar. Is there enough gold? Ardent Media, 1936.

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48. “Unemployment in Nazi Germany” Spartacus International. 49. Ibid., 25. 50. A reader interested in studying the impact of the Great Depression in the world economy and in additional countries can refer to Eichengreen (1992), Eichengreen and Temin (2010), Twomey (1983), Dimsdale (2012), and den Boer (2004). 51. Ibid., 12. 52. McCutcheon, 1931, reprinted in Flood (1992). 53. Demirgüç-Kunt et al. (2014). 54. Bernstein (1984). 55. Sandra Kollen Ghizoni, “Establishment of the Bretton Woods System”, Federal Reserve History. 56. During the Bretton Woods conference, the World Bank was also created with the aim of providing financial assistance for the reconstruction after World War II, and the economic development of less developed countries. 57. Meltzer (1993). 58. Eichengreen (2004). 59. Hetzel (2013). 60. For a detailed examination of the Bretton Woods system see Solomon (1982). 61. Ibid., 57. 62. Dooley et al. (2004). 63. The secondary banking crisis and the Bank of England’s support of operations. Bank of England, 1978. 64. The Banking Act of 1979 on retrieved on 3 March 2017. http://www.legisl ation.gov.uk/ukpga/1979/37/pdfs/ukpga_19790037_en.pdf.

References Andrew, A. P. (1908). Substitutes for cash in the panic of 1907. The Quarterly Journal of Economics, 22(4), 497–516. Beaudry, P., & Portier, F. (2002). The French depression in the 1930s. Review of Economic Dynamics, 5, 73–99. Bernanke, B. S. (1983, June). Non-monetary effects of the financial crisis in the propagation of the Great Depression. The American Economic Review. The American Economic Association, 73(3), 257–276. Bernstein, E. M. (1984). Reflections on Bretton Woods. In The international monetary system: Forty years after Bretton Woods (pp. 15–20). Bordo, M. D. (1988, August). Born of a panic: Forming the fed system. The Region, Federal Reserve Bank of Minneapolis. Bordo, M. D. (2007, December). A brief history of central banks. Federal Reserve Bank of Cleveland.

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Butkiewicz, J. L. (1995). The impact of a lender of last resort during the great depression: the case of the reconstruction finance corporation. Explorations in Economic History, 32(2), 197–216. De Long, J. B. (1990). “Liquidation” cycles: Old-fashioned real business cycle theory and the Great Depression (No. w3546). National Bureau of Economic Research. Demirgüç-Kunt, A., Kane, E., & Laeven, L. (2014). Deposit insurance database (IMF Working Paper Series, No. 118). den Boer, P. (2004, July). The effects of the Great Depression on trade in Latin America. University of Groningen. Dimsdale, N. (2012). The financial crisis of 1931 and the impact of the Great Depression on the British economy. Economic History Society Annual Conference. Dooley, M. P., Folkerts-Landau, D., & Garber, P. (2004). The revived Bretton Woods system. International Journal of Finance & Economics, 9 (4), 307–313. Eggertsson, G. B. (2008). Great expectations and the end of the depression. American Economic Review, 98(4), 1476–1516. Eichengreen, B. (1992, May) The origins and nature of the Great Slump revisited. Economic History Review, XLV (2), 213–239. Eichengreen, B. (1999, March). The Keynesian revolution and the nominal revolution: Was there a paradigm shift in economic policy in the 1930s? (UC Berkeley Working Paper). Eichengreen, B. (2004). Global imbalances and the lessons from Bretton Woods. Economie Internationale, 4 (100), 39–50. Eichengreen, B., & Irwin, D.A. (2010). The slide to protectionism in the Great Depression: Who succumbed and why? The Journal of Economic History, 70 (4), 871–897. Eichengreen, B., & Sachs, J. (1985). Exchange rates and economic recovery in the 1930s. The Journal of Economic History, 45 (4), 925–946. Eichengreen, B., & Temin, P. (2010). Fetters of gold and paper. Oxford Review of Economic Policy, 26 (3), 370–384. Fisher, I. (1933). The debt-deflation theory of Great Depressions. Econometrica. The Econometric Society, 1(4), 337–357. Flood, M. D. (1992, July/August). The great deposit insurance debate (pp. 51–77). Review, Federal Reserve Bank of St. Louis. Fortune, P. (2000, September–October). Margin requirements, margin loans, and margin rates: Practice and principles—Analysis of history of margin credit regulations—Statistical data included. New England Economic Review, 3, 19–44. Friedman, M., & Schwartz, A. J. (2008). A monetary history of the United States, 1867–1960. Princeton: Princeton University Press. Hetzel, R. L. (2013, November). Overview of Bretton Woods. Federal Reserve History. Husted, S., & Melvin, M. (2013). International economics: International edition. Pearson Higher Education. Irwin, D. A. (2010). Did France cause the Great Depression? (NBER Working Paper 16350).

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Kindelberger, C. (1978). Manias, panics and crashes. New York: Basic Books. Koo, R. C. (2011). The holy grail of macroeconomics: Lessons from Japans great recession. Singapore: Wiley. Mackay, C. (1980). Extraordinary popular delusions and the madness of crowds. New York: Three Rivers Press. Mason, J. R. (2001). Do lender of last resort policies matter? The effects of reconstruction finance corporation assistance to banks during the Great Depression. Journal of Financial Services Research, 20 (1), 77–95. Meltzer, A. H. (1993, May/June). U.S. policy in the Bretton Woods era. Federal Reserve Bank of St Louis, Review, 73(3), 54–83. Reinhart, C. M., & Rogoff, K. S. (2009). This time is different: Eight centuries of financial folly. Princeton and Oxford: Princeton University Press. Romer, C. D. What ended the great depression? (No. w3829). National Bureau of Economic Research, 1991, and NBER, Macrohistory database. Retrieved 2 March 2017. Silber, W. (2009). Why did FDR’s bank holiday succeed? Federal Reserve Bank of New York Economic Policy Review. Simmons, E. C. (1936). The elasticity of the federal reserve note. The American Economic Review, 683–690. Smitka, M. (1998). The interwar economy of Japan: Colonialism, depression, and recovery, 1910–1940. New York: Routledge. Solomon, R. (1982). The international monetary system 1945–1981. New York: Harper & Row. Sprague, O. M. W. (1908). The American crisis of 1907. The Economic Journal, 18(71), 353–372. Tallman, E. W., & Moen, J. R. (1990). Lessons from the panic of 1907. Economic Review-Federal Reserve Bank of Atlanta, 75 (3), 2. Temin, P. (1992). Lessons from the Great Depression. Cambridge: MIT Press. Temin, P., & Wigmore, B. (1990, October). The end of one big deflation. Explorations in Economic History, 27, 483–502. Twomey, M. J. (1983). The 1930s depression in Latin America: A macro analysis. Explorations in Economic History, 20, 221–247. Warburg, P. M. (1929, March). A banking system adrift at sea. Bankers Magazine, pp. 569–573. Whaples, R. (1995, March). Where is there consensus among American economic historians? The results of a survey on forty propositions. Journal of Economic History, 55 (1), 150. Yamamura, K. (1998). The economic emergence of modern Japan (Vol. 1). Cambridge: Cambridge University Press.

Part II How Banking Works

3 Money and Inflation

Following their exit from the gold standard, the US faced a beast the like of which it had not encountered in the past. The inflation rate increased to more than 4% in 1971 and remained high averaging a 7.2% annual growth during the decade (Fig. 3.1). Inflation remained high until Paul Volker, the chairman of the United States central bank, the Federal Reserve, increased interest rates to record high levels. To understand what led to the decision of spiking interest rates, one would first have to understand what drives inflation. To do that, a proper definition is first required. Inflation, as often defined, is the rate at which the general level of prices (for both goods and services) changes. Note that inflation does not have to be positive; in the case of negative inflation the phenomenon is called deflation, a notion which we will take up later. Inflation matters because of its effects on the economy and the well-being of citizens. If inflation rises by 5%, this means that goods and services are, on average, 5% more expensive.1 Hence, a consumer would be able to purchase 5% less of the quantities in a basket of goods and services than he would have been able one year ago. To accommodate for this, wages would also have to increase by a similar amount. Note that the magic word here is on average. For example, consider a consumer who purchases just two goods, apples, and oranges, and splits his income equally between the two. If the price of apples increases by 10% and the price of oranges remains the same, then the inflation rate for the whole

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basket of goods would be 5%. In the case where apples increase in price by 10% and oranges decrease by 10%, then the basket’s inflation would be zero. The above example highlights two important points: first, overall inflation does not say much about price changes in individual goods and services. Second, it does not suggest that if the price of apples increases the consumer cannot substitute them by purchasing more oranges. This means that if the change in price is driven by demand, shifting from one good (apples) to another (oranges) can bring the price of apples down and hence show a negative rate of inflation in the economy. The usual question regarding inflation is whether it is bad or good. To examine this one would first have to understand what causes it. Since inflation is the change in the price level, what affects prices should determine how inflation moves. A usual supply and demand diagram (Fig. 3.2) would suggest that if supply decreases prices would rise, while if demand decreases prices consequently fall. The direction of causality is not one-way though: higher supply decreases prices, while lower prices also decrease supply. Hence, identifying what causes the change in the price level is of the outmost importance. To elaborate on the price-affecting power, we shall first examine the sources of changes in demand. Demand is usually affected by variations in purchasing power and consumer preferences. The latter cannot be easily discovered, nor is there a predictable pattern of evolution regarding their future paths hence we will not deal with them in detail. Note though that preferences can also be associated with technological progress: how many people would prefer a typewriter to a laptop in 2016? Preferences, even though not completely in line with

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technology, tend to move towards it; whatever differences remain are largely idiosyncratic and cultural in nature.2 Purchasing power appeals more to the economist. Whatever makes a society richer in monetary terms can have a positive effect on prices. One can easily see that upwards shifts in demand curve of Fig. 3.2 would imply that the price level also increases.3 Changes in demand are usually associated with changes in money: more money in the economy means more purchasing power for the people, hence prices should increase.4 As a consequence, most economists believe that whatever causes money to increase should also cause inflation to rise. This would be the case for, say, increases in bank lending which should cause inflation to rise as demand would inevitably increase, a result of the increase in the purchasing power of the borrower. There are however some exceptions: deficit spending by the government would also mean that inflation should rise5 since, as discussed in the previous chapter, it brings into the economy money which were previously unused in deposit accounts. However, the overall amount of money is unchanged: the 100 euros used to purchase bonds were moved from the deposit accounts of the bond buyers to the accounts of the government. When this money is spent, the 100 euro flow away from the government and back to the beneficiaries’ accounts, again without any change in the overall amount of the money stock. Budget surpluses, where the government spends less than it earns from taxation and other income sources, cause inflation to drop as demand

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decrease. Money remains unaltered in this case as well: the decrease in government debt suggests that money is returned to the investors. Nevertheless, this amount was obtained from other consumers and firms, who have paid their taxes to the state. Consequently, the amount of money in the economy is again unaltered since the reduction in the deposits of the private sector, defined as the difference between government spending and government income, will be offered to those who will have to redeem their bonds to cash. Consequently, the stock of money is affected by neither the amount of government spending nor by whether the government runs a surplus or a deficit. Inflation, on the other hand, is affected by both.6 Note that we do not refer to inflation expectations, which supposedly, under the rational expectations hypothesis would argue that the change in government spending would bring inflation if only it is considered to be permanent. Adherents of the rational expectations hypothesis suggest that the government cannot credibly say that an increase in spending will be permanent since it would have to repay those expenses by increasing taxes at some point in time. However, one should consider that an increase in spending would increase overall GDP and higher demand from the public sector would lead to higher investment and consumption from the private sector. This would, in turn, increase government expenses to partly cover for the cost of additional spending, without having to increase taxes or reduce spending. There are though limits to this behaviour as increases in times when the economy is booming would have less effects than when the economy is in a recession. 7 Given that a huge amount of uncertainty clouds all empirical estimations of the size of the effects of government spending, there is no way, other than in the case of an exorbitant change, to know whether the change in spending is permanent or not. In addition, at the time when a seller receives an order from the government, they do not know whether spending has increased or shifted between other goods. Even in the case where changes in government spending, especially government investment, are formally announced, contractors do not pay much attention on whether the money comes from an extension of the government budget or not, so long as they obtain the contract.8 Returning to the causes of inflation, the effect of transactions with other countries depends on the nature of the exchange. Foreign inflows and outflows of capital have a slightly more complex effect on inflation, depending on both the direction and the type of investment. A direct investment from Germany to Spain, through the purchase of a local house or factory, would directly increase both the local seller’s purchasing power (as he now owns a larger amount of funds) and the amount of money in the

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economy (since the local seller would have to deposit the funds).9 In contrast, a deposit from a German resident at a bank operating in Spain would also increase money supply, and as previously suggested would be beneficial for the bank’s liquidity position, but the extent of its impact would depend on how the bank utilizes that extra liquidity. If it employs it for lending purposes then it will affect inflation, if nevertheless chooses to retain it in its reserve position then it should not have any impact. As such, even if both types of inflows increase money supply in the economy, their effect on inflation is very distinct. The effect of imports and exports on inflation is relatively more straightforward: exports of goods and services increase the stock of money and the residents’ purchasing ability since they are traded with money from abroad. Similarly, imports of goods and services decrease money since this is used to pay people abroad. Imports could nonetheless increase imports through price increases abroad, which are transferred into the local economy. Probably the best example of such effects from imports is the price of oil. Suppose that a country is oil-dependent and imports 100% of its oil and furthermore suppose that the price of oil increases by 10% (say from 50 to 55 US dollars) during a year. As the country is oil-dependent it would have to continue to purchase oil from abroad at the new, increased price of 55 US dollars. The price increase suggests that producers in that country will see an increase in their oil costs by 10%, and an increase in their overall costs by some amount less than 10% (given that oil costs do not cover the full costs of operation), say 6%. Even though some of this cost will be absorbed internally by firms, they will also have to increase prices by some extent so as to share some of the losses with consumers. Hence, this will cause inflation to increase. Naturally, the same conclusions and argumentation would hold if the country could cover some of its needs in oil internally. The reason is that even within the country, the price of oil employed is the one globally determined. Hence, the same would hold in the case of any other item for which the price is globally determined such as natural gas, silver, copper, or cocoa. For the exporting country, inflation could also occur if the increase in the price was driven by increased world demand since the funds that would come to the country would rise.10 If the increase in price is due to a decrease in the quantity of production then the response of inflation would depend on the difference between the inflow of funds before and after the price increase. Suppose that before the change in price the country exported 500 barrels of oil and has now decided to export 400 barrels, an increase in the price level should be expected (25,000 previously earned are more than the 22,000

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earned after the price increase). Had the country exported 480 barrels after the price increase then inflation would rise (26,400 currently earned is higher than the 25,000 earned before). Additional supply factors that would affect inflation come from the hardening or easing of constraints on production, as well as the number of participants in a market. For example, suppose that a new procedure allows for a specific type of good to be produced at half the time required until now. This would mean that more goods would be produced and as such their price should decrease, thus lowering inflation. The entrance of new firms in an existing market would also have a similar effect, as more goods would be produced at a given time. Note that these effects both have their limits. It is not natural to assume that if all barriers for production of water glasses are lifted then all industries would move in to invest. There are though instances, like the case of closed professions where a governmental licence is required, that reducing barriers to entry would be beneficial. This is not a panacea though since further and further easing would only run to diminishing returns. Setting up costs and limits to how low prices can go, given other variable costs and the expected profit margin, matter more after some point. Other factors which affect the price level from the supply side also include the weather. Think for example the production of corn. If no rain drops during the year then the farmer faces an unintended and unwanted decrease of his production. While this could be somehow smoothed out by watering the plants, the effects of a hailstorm would be devastating on corn production. This could perhaps be offset by production in other parts of the world but it also depends on the level of the damage. In general, natural catastrophes can have a strong effect on the price of the affected goods, depending on the consumers’ ability to switch between goods.

Hyperinflations It is usually the case that inflation goes unnoticed by the general public since increases of 2–3% per year (or even a bit higher), would go about unnoticed most of the time, especially if these are driven by fluctuations in fruits, vegetables, or other crop-related goods. During some times, extreme cases of supply shocks can cause extreme cases of inflation (hyperinflation).11 Of these, the most notable, and also perhaps the most renowned is the one that took place

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in the Weimar republic from 1921 to 1924. To indicate how large the devaluation was, think that one gold mark went from being worth about 1 paper mark in the late 1910s to approximately 1 trillion paper marks by 1924. The detailed introspection of the Weimar republic’s hyperinflation is beyond the scope of this book.12 The causes of it though are important for understanding the potential consequences (or non-consequences) of contemporary economic policy. The usual rhetoric about hyperinflations is that an irresponsible government printed large amounts of money to pay for its expenses.13 This, however, is only partly true. While increased government expenses can have an impact on the value of money, these are not so large on their own to cause such severe effects.14 Figure 3.3 is indicative of the failure of this theory: while inflation declined markedly from 1980 onwards, money per capita increased significantly. In contrast, if we consider money as endogenous to an economy, i.e. that money is not only caused by events in the economy but also influences them, then it would be clear that a huge change in money supply could not have happened without an important event preceding it. Even in the case where a nation puts its “money printers” in hyperdrive, something must have made it do so.15 In examining the causes of the hyperinflations, the common pattern which arises is its coincidence with major political events, which resulted in major disruptions in the productive ability of the country. In Hungary (1945– 1946) the destructions it faced after it became a battleground between Russia and Germany, with 90% of its industrial capacity, and the most of its 4,500

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transportation system, destroyed.16 In most recent history, Zimbabwe (2007– 2008), after food production was almost brought to a halt, as a result of the forced seizures of commercial farms, as well as other misplaced government policies.17 The same story of supply-side issues re-emerges in the cases of Yugoslavia (1992–1994), Bosnia and Herzegovina (1992–1994), and the Weimar Republic (1922–1923),18 where production declined severely after a huge drop in capacity due to war. In essence, hyperinflations can be seen as the lack of credibility in the national currency.19 This lack of credibility is not, however, brought simply by the drop in the country’s production ability but also from a feedback loop caused by this: the exchange rate depreciates, government spending increases to finance the lack of production, imports as well as import prices rise, wages increase.20 Each of these phases reinforces the effect on currency depreciation and prices, causing further damage. It is thus not a surprise that to overcome many of these hyperinflations, a new currency was introduced. Further elaborating on the causes of hyperinflation, think of the effects the oil embargo of the 1970s on the US economy. Although the disruptions were not large enough to cause hyperinflation, the increase in inflation was most likely caused by the large drop in the capacity utilization (i.e. facilities used as a percentage of total facilities). Figure 3.4 indicates this behaviour precisely. The drop in capacity utilization (the dotted line), started in 1979 when the price of oil rose by 50% and reached it through in 1982, when the price of oil declined slightly. While increased government spending was mainly to blame for the increase in inflation, deficit spending did not decline until 1986. In 90.0

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contrast, the stabilization in the price of oil eased production capabilities and, along with the important supply-side reforms of Ronald Reagan,21 allowed for inflation to ease. The supply-side economics of Reagan also suggested that every doctrine serves a particular malaise and no panacea exists. The Keynesian ideas of deficit spending or budget surpluses would not have been particularly helpful when supply is hurt. In contrast, when the decline in capacity utilization (or any other measure of economic growth for that matter) is caused by demand changes, supply-side economics would prove less valuable. Notice the difference in the behaviour of capacity utilization and inflation during the late 2000s financial crisis: as expected when demand drops, both supply and inflation decrease. Supply-side reforms would not have proven so popular had there been no demand to sell to. We will return to this idea of a worldview which is not dominated by a particular ideology in future chapters. Thus far we have seen the causes of inflation, both when it comes to huge increases as well as when it comes in the usual post-1980 values of 1–2% annually. In the remainder of this chapter we will examine what the consequences of inflation are as well as its implications for the economy.

No Inflation Means No Growth The basic question one should ask is whether inflation is useful. Let us consider the opposite: if no inflation occurred, then money in the economy would have to be the same every period in time, as well as the government maintaining a balanced budget. We will assume, for simplicity that this is an economy without any exchange with the outer world so that no inflows or outflows exist.22 Supply would also have to be stable, given that changes in supply would also mean that inflation would change. If money in the economy is stable, and overall demand is stable then the economy’s growth rate is essentially zero. The measures economists usually employ to account for economic activity are usually based on counting the production of goods and services.23 Hence, the only way for the economy to grow would be to increase production. Production cannot grow in this economy without changing the price level. In Fig. 3.2, if the supply curve jumps to the left, meaning that production is increased, then prices would decrease as demand would remain the same as before. To put it another way, when 100 euro are required to purchase 5 oranges then the price of each orange would be 20 euro. If the production

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of oranges increases to 25 while the amount of euro in the economy remains stable at 100, then the price of oranges would naturally drop to 4. Consider this in economic parlance: overall (nominal) Gross Domestic Product before the increase in production would have been the number of oranges multiplied by their price, hence 100 euros. Real GDP would have been the amount of production, in this case, 5. Following the increase in production, nominal GDP would still be 100 euros, but real GDP would increase to 25, a fivefold increase. For this to hold, then prices would have decreased fivefold, from 20 to 4 euros per orange. Had production decreased, inflation would rise. Now imagine that, suddenly, a bank issues a new loan, thus boosting demand. Suppose the amount of money now becomes 110, while production remains stable at 5 oranges. As expected, price would now increase to 22 euros per orange. Real GDP would be unaltered at 5, but nominal GDP, reflecting the 10% increase in prices would increase by 10% to 110 euros. The above example illustrates that in order to have inflation two things must happen: (a) either supply must drop, which in addition to being unwanted as it would decrease the number of available goods for the general public it could also mean hyperinflations if it is severe, or (b) demand must rise. Hence, inflation should be viewed as a consequence of increased nominal growth. Inflation is what we have to put up with if we wish for a larger amount of goods and services available, since the only way to accomplish this is by increasing demand. Milton Friedman and the monetarist fraction comment that the difference between the growth rate of money expansion and output is what causes inflation. In this example, it is easy to see what he meant: an increase in the available money in the economy would increase prices. Nevertheless, money expansion is not the same as the increase in the available money in the economy: while deficit spending increases available money in the economy, it does not increase the overall money supply as we have seen earlier, given that private sector money are reduced to purchase government bonds.24 The above point to a “sad” conclusion for inflation-fearing economists (colloquially known as “hawks”): inflation can never be zero unless it happens that increases in supply, caused by increases in demand, exactly match. Even if this happens, then it would be perfectly coincidental and should not be expected to repeat soon. As supply usually lags demand (excluding the cases of new product developments), then it should always be the case that demand would increase in order for supply to follow. What is more important is whether inflation is stable or not. If prices are not stable, as they had not been during hyperinflation periods, then changes

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in prices affect production, with buyers and sellers unwilling to part with their goods. For example, if we know that a good will be worth 10% more by the end of the year then the merchant may not be willing to part with it. In contrast, if the change by the end of the year is expected to be 2%, then the waiting may not be worth it. This emphasis on nominal prices instead of real ones suggests that people have what has been called as money illusion by economists. This means that instead of viewing how prices of good X change relative to prices of good Y, we are simply focusing on the price changes of the former good. Nevertheless, in forward-looking behaviour one cannot help but focusing on nominal terms. Imagine a merchant trying to sell a good at a price of 10 euros. There is no way to be sure whether that good is relatively cheaper or relatively more expensive than other similar or identical ones. Even at the time of the internet where information is plenty, there is tremendous difficulty to pin-point the exact relative relationship between goods, especially given both the differences in characteristics of products and services as well as personal preferences and perceived views about the future.25 Hence, reliance on nominal prices, especially when inflation is expected not to be stable is much easier. In addition to the purchase and sale of goods and services, and perspective borrowers and lenders may be unwilling to engage in such activities if future changes in the value of their money would mean that their position would be worsened. For example, suppose that inflation is expected to be 100% for the year. A borrowed amount of 100 euros would be able to purchase 50 euros worth of goods and services, but its nominal value would still remain at 100. Hence, a person who used to have a wage of 50 euros would see his wage double to 100 euros and be able to repay the loan in half the time it would necessarily require. In contrast, if inflation was −50%, then the person’s wage would drop to 25 euros and while the nominal value of his borrowings would still be worth 100, it would take double the time to repay his loan. Overall, increases in the price level make borrowers better off as they would be able to repay their loans sooner as wages will also tend to rise. In contrast, savers are worse off since the purchasing power of their money decreases. It is thus not unexpected that during demand-driven recessions, savers are better off than borrowers since inflation drops. In general, the (relative) stability in inflation essentially implies (relative) stability in output and vice versa, even though this is not always a one-to-one relationship. This means that demand needs to be controlled since supply is usually a follower (unless in the case of new product development), and there is no way to picture a huge rise in supply without a corresponding increase in

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demand.26 The usual way economists think about this is through a productivity shock, which is exogenous to the economy. However, a productivity shock of this kind is hard to imagine: the only realistic scenario one can think of is that of a society of workers who spend some of their working hours idling and are now forced to fully commit to their jobs. This scenario is not very plausible as in most jobs (especially well-paid) people actually work more than their working hours. In addition, such a massive campaign would either mean that the boss would do nothing else but stalk his employees, meaning that most of his tasks would be left behind, or that some other person would be hired to do so. The former case is rather unenforceable while the latter, as the reader may have correctly guessed, suggests an increase in demand through the wages the new employee would be getting. Controlling demand means making investment opportunities less rosy for investors and potential borrowers riskier for banks. Central banks usually attempt this through the manipulation of interest rates to decrease both loan demand and loan supply. Nevertheless, as the next chapter will suggest this merely amounts to fine-tuning the economy and not actually affecting it.

Notes 1. Note that to begin with, inflation simply referred to monetary inflation, i.e. the change in paper currency. Nowadays, inflation is taken to mean any increase in prices. (see, Frances Coppola, Inflation is always and everywhere a political phenomenon). 2. See Michail (2020) for convergence of consumption patterns. 3. The distinction between supply and demand shocks is also be found in Bernanke and Gertler (1999) and Bernanke (2004), albeit not discussed in detail. 4. Milton Friedman was the one who popularised this idea, even though the famous quantity theory of money was developed earlier by John Stuart Mill (Principles of Political Economy, 1848) and its algebraic formulation comes from Irving Fisher (1911, The Purchasing Power of Money). Still, Friedman’s aphorism that ‘inflation is always and everywhere a monetary phenomenon’, while not always true, is very close to being a law in economics. 5. Similar arguments, however assuming that government spending directly affects money supply, can be found in Kocherlakota and Phelan (1999). Cochrane (2001) suggests that it is the value of debt to real primary surpluses that determines the price level. 6. Milton Friedman, with all his emphasis on money supply may have correctly identified this distinction as, during the period of high inflation in the 1980s,

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13. 14.

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he was quoted as saying that both ‘money supply and government spending’ need to be contained (Mallaby 2016). This idea dates back to Keynes’s General Theory in 1936, but recent studies have also confirmed such an effect (Auerbach and Gorodnichenko 2012). Despite what most economists’ model are based on, people are not always knowledgeable about the state of neither the government budget nor the inflation rate or the growth rate of GDP for that matter. They can only intuitively understand whether the economy is doing well or not. Naturally, in the case where the factory in Spain is owned by an Italian who sells it to a German the stock of money in Spain will not change. In addition, if the Spanish seller decides to send his money overseas the stock of money in Spain will be equally unaffected. Note that increased world demand could originate both from a large enough country as well as from an overall increase. In either case, the increase in demand would increase inflation but also have second round additional effects on the price level through the increase in oil prices. See also Montier (2013, February). “Hyperinflations, Hysteria, and False Memories” for another similar view on the discussion about to follow. For an excellent narrative of the period between the two world wars and the economic conditions of the time, including the Great Depression and the hyperinflation in the Weimar republic see Ahamed (2009). e.g. Tutino and Zarazaga (2014). Those who believe in rational expectations suggest that changes in government spending will have to be reversed in the future and inflation will not be affected. It is in fact ironic if those who believe in rational expectations also believe that increased government spending can have hyperinflationary effects on its own, given that these two worldviews are mutually exclusive. A similar argument is presented by Montier (2013). See also Hanke and Krus (2013) for hyperinflationary periods. Bryan Taylor, ‘The worst hyperinflation in history: Hungary’ on https://global financialdata.com. Coomer and Gstraunthaler (2011) Keynes’s Economic Consequences of Peace (1919) pretty much forecasted the events that followed in the Weimar Republic, suggesting that war reparations would make irrevocable damage to the economy. Frances Coppola, Inflation is always and everywhere a political phenomenon, Pieria, July 10, 2014. See Joan Robinson (1938, September), “The Economics of Hyperinflation,” a review of Bresciani-Turroni’s The Economics of Inflation,” Economic Journal 48. An overview of the Regan reforms is outlined in Mallaby (2016). Still, the best source for an overview of the policies implemented as well as their effects is Wikipedia: https://en.wikipedia.org/wiki/Reaganomics. What is probably the most startling evidence of Reagan’s supply side deregulation efforts came from

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Milton Friedman who showed evidence from the Federal registry (which records all new rules and regulations—not laws—that federal agencies create each year) that during the Reagan years the number of pages declined sharply. (Milton Friedman, Freedom’s Friend, Wall Street Journal , 2004). While this is not a necessary condition, if an economy trades it would have to also have a trade balance of exactly zero, so that money and demand do not change. Expenditure-based measures also exist but this is simply another way of looking at the same thing. The use of Divisia money has helped in this direction, as the divisia index assigns greater weight to those components most used in transactions. See Matthew Hancock ‘Divisia Money’ Bank of England. However, this is not a panacea since, in the digital era, government spending can be directly transferred to the beneficiary’s accounts without impacting currency in circulation. In addition, this is does not present a clear image of the total demand in the market. The latter can only be captured through nominal GDP, but this is usually employed for growth purposes not for demand ones. For example, if we believe that a good will be worth more in the future we would most likely try to increase its present price, although not to that extent. In contrast, just like the case of an oil shock or a war, there can be a drop in supply without a drop in demand.

References Ahamed, L. (2009). Lords of finance: The bankers who broke the world . London: Random House. Tutino, A., & Zarazaga, C. E. J. M. (2014). Inflation is not always and everywhere a monetary phenomenon. Dallas Fed Economic Letter, 9 (6). Auerbach, A. J., & Gorodnichenko, Y. (2012). Fiscal multipliers in recession and expansion. In Fiscal policy after the financial crisis (pp. 63–98). Chicago: University of Chicago Press. Bernanke, B. (2004). The great moderation. FRB Speech. Bernanke, B., & Gertler, M. (1999). Monetary policy and asset price volatility (NBER Working Paper 7559). Cochrane, J. H. (2001). Long-term debt and optimal policy in the fiscal theory of the price level. Econometrica, 69 (1), 69–116. Coomer, J., & Gstraunthaler, T. (2011). The hyperinflation in Zimbabwe. Quarterly Journal of Austrian Economics,14 (3), 311. Hanke, S. H., & Krus, N. E. (2013, Summer). World hyperinflations. In R. Parker & R. Whaples (Eds.), The handbook of major events in economic history. London and New York: Routledge.

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Kocherlakota, N., & Phelan, C. (1999). Explaining the fiscal theory of the price level. Federal Reserve Bank of Minneapolis. Quarterly Review-Federal Reserve Bank of Minneapolis, 23(4), 14. Mallaby, S. (2016). The man who knew: The life & times of Alan Greenspan. London and New York: Bloomsbury Publishing. Michail, N. A. (2020). Convergence of consumption patterns in the European Union. Empirical Economics, 58 (3), 979–994. Montier, J. (2013, February). Hyperinflations, hysteria and false memories (GMO White Paper).

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At the time countries were tied to the gold standard, money supply in the economy was, as already discussed, effectively controlled by the amount of gold in the economy. As the amount of gold in the economy increased, a country could increase its money stock and vice versa. Money is increased in two ways: first, the central bank, or whatever the monetary authority is named, issues new money and increases the existing stock, otherwise known as the monetary base. This is the old-fashioned “money-printing”. As expected, in the years following the “Nixon shock” currency in circulation (all paper currency and coin held by the public and the vaults of depository institutions)1 increased by much more than before. Figure 4.1, which depicts real (adjusted for inflation) currency in circulation per person in the US is revealing. Notice that after 1981, until which the average currency in circulation remained relatively stable, the amount per person more than doubled until 2008. There is however, another way to create money: through the banking sector. The most amazing thing the banking sector does, in addition to allowing funds to be used for productive purposes in the economy, is that it can increase the amount of money circulating in the economy. As practically anyone who has ever dealt with banks can understand, these institutions take deposits and give out loans. Money, in the broader view, includes both the monetary base and deposits, hence the first link between money and banks is established. Importantly, bank deposits amount to more than 90% of broad

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 N. Michail, Money, Credit, and Crises, https://doi.org/10.1007/978-3-030-64384-3_4

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money. Even more importantly, in the modern world, these bank deposits are mostly created by the banks themselves. This suggestion appears to be rather strange when someone first views it. How can banks create deposits if they are supposed to be redistributing them in the form of loans? The above is probably the most common misconception regarding commercial banking and a usual mix-up between what liquidity and money are. In the past, at the time of a loan issuance the bank was giving out a number of banknotes or it had to possess a certain amount of gold to account for the creation of new money. Nowadays, modern banks simply credit the client’s account with a bank deposit of the size of the loan, while simultaneously creating a customer obligation, i.e. the loan amount that has to be returned.2 For clarity, a graphical representation of the changes in the bank balance sheet after a new loan is created can be found in Fig. 4.2. In this simplified balance sheet, just before the loan is created the bank has assets worth 120, of which 20 is currency and the rest are reserves at the central bank. These assets are matched with deposit liabilities of the same amount. After a loan is granted, the bank simultaneously creates an asset and a liability: a new deposit liability is created with the amount of money the loan is worth and a new asset is created in the form of a loan obligation by the customer. The central bank has nothing to do with this new money creation as its balance sheet is not affected by the change. The consumer (or in general the loan-taker) faces a similar but exactly opposite change in his balance sheet: his deposits are increased by the amount of the loan, while his liabilities are at the same time also increased by the amount of the loan he has to repay.

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Fig. 4.2 The loan creation process in the bank balance sheet

This is illustration of how money is created also suggests that loan repayment decreases the amount of money in the economy. As expected from Fig. 4.2, repayment of the loan facility would return the bank’s balance to its standing in panel (1), i.e. when total deposits were 120 and not 180. This occurs for the case of money creation. What happens with liquidity is a different matter. Liquidity differs much from the case of a simple increase in money supply through loan creation. Up until now, the bank had only created the deposit and the matching loan and the consumer did nothing with it. Now consider the case where the consumer wishes to withdraw his money in order to purchase a house. In this case, the bank’s balance sheet would reduce its reserves and simultaneously reduce its deposits. This is illustrated in Fig. 4.3, where the bank reduced its reserves at the central bank in order to offer it to its customer. Note two important things: first, the bank could have also reduced its currency position, had it have enough to cover it and if the customer needed the money in cash. Second, the implicit assumption here is that the customer withdrew the money in the form of either a cheque or a transfer and hence the reserve position of the commercial bank at the central bank was reduced. Naturally, if the recipient of the amount is a customer of the same bank (or in a simplified economics exercise only one bank exists in the economy) then the amount would return to the bank and increase its deposit liabilities and reserve assets by the same amount, returning it to the Fig. 4.3, panel (3) standing. In the case that the recipient holds an account at another bank

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Fig. 4.3 Bank’s balance sheet after the withdrawal of a loan

then the other bank will increase its reserve assets at the central bank with the deposit of the amount, with a simultaneous increase to the customer’s account, hence the deposit liabilities of the third bank. In the case that the recipient takes the amount in cash, then, as we have discussed, the bank’s currency position would have been reduced by the amount withdrawn. The purpose of the above discussion is not to suggest that deposits are unimportant for banks. In contrast, they provide important liquidity which allows banks to cover their customers’ needs for withdrawals. Nevertheless, it should be remembered that deposits do not increase available funds for banks, but are essentially taken away from the economy since they are not used to purchase goods and services.3 As expected, banks do not keep their deposits as cash in their vaults. This is mainly because the amount of money available as cash is just a small fraction of the total, given that money is mostly electronic in the digital era. Other than the reserves held at the central bank, commercial banks also hold large amounts of government bonds. These holdings are reducing the amount of money in the economy since bonds are not part of neither the narrow money nor the broad money measure. However, these holdings can be readily transformed to money by selling the bonds. Purchasing government bonds is a way or re-inputting those deposits back to the economy. The money from the deposits goes to the government, which uses it for productive purposes (hopefully!)4 meaning that these return to the economy. Hence, even though the government withdraws the money from the economy by issuing bonds, the money will return to the economy

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Fig. 4.4 An illustration of the purchase of bonds by the banking sector

provided that the government spends them. Thus, in this case if 20 units of money is given to the government in return to a bond and this money is spent, then money supply will remain intact as they will return to the economy. In addition, the bank will own an IOU from the government. It is easy to see now why increased government spending increases money in the economy. What should be underlined is that regardless of whether the government borrows from a bank or a private fund or an individual, money stock in the economy is reduced. The reason is purely statistical: both deposits (if the private sector purchases the bond) as well as reserves (if the bank purchases the bond) are part of the money supply. In contrast, the purchased government bond is not.5 Figure 4.4 depicts this change in the bank’s balance sheet. The bank uses its available liquid funds, i.e. its reserves to purchase a government bond (panel 6). The bank’s balance sheet is neither increased nor decreased as it simply exchanges one form of asset with another. The stock of money is reduced nonetheless since reserves are part of the broad money definition. If, at the repayment period of the bond, the government returns the cash to its creditor then the amount of money stock returns to its earlier state (i.e. panel 5). Naturally, the above takes place if the government borrows in order to finance its deficit, or in other words if the public debt is increasing. If the government budget is balanced then this is simply a redistribution of money in the economy since government income is matched with government spending. On the contrary, if the government is running a surplus then the available money is increased since existing bonds are repaid. The effects

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from running a surplus or a deficit in the economy will be discussed later when inflation is examined.

The Money Multiplier The above clarifications provide arguments against the classical “money multiplier” case. Common understanding in economics was that if 100 units of money were deposited in a bank then the bank could lend this amount excluding what the regulator (i.e. the central bank) thought it should have as obligatory liquidity (what is called as reserve requirement). For example, if a bank is required to hold 10% of deposits for liquidity purposes (called as the reserve requirement) then the bank could lend out 90 units of that currency. Then, assuming for simplicity and without loss of generality, that only one bank exists in the economy, those 90 units would return and then the bank could lend 81 of them (90 multiplied by 90%), and so on until all that could be lent is lent. This formula suggests that the multiplier is the inverse of reserve requirement. In this example, the classical “money multiplier” would be 10 (1/0.10) and it would predict that approximately 900 units of money could be created. The idea behind the classical multiplier is that banks lend out reserves or deposits. As we have seen, this is not a valid case, since banks do not lend out either of the two.6 This brings out the important question of what the limits to this money-creating procedure are. An important determinant should, at least in principle, be the price of loans. 7 Interest rates on lending assume the role of the pricing system, i.e. higher interest rates mean that the price one would have to pay for obtaining a loan is higher. The interest rate cannot be lower than that charged by the central bank and thus the monetary authority rate serves as the floor. Naturally, if the bank is to have any profit then the interest rate it will charge its borrowers will be higher than the central bank rate, as well as the interest rate it will offer to its depositors. This spread between the bank deposit rate and the bank lending rate is known as the interest rate margin and is the key metric that will define bank profitability, always along with the level of loans. The idea behind retail bank profitability is as straightforward as the sale of any other good or service and relates to the price (interest rate margin) and the quantity (amount of loans) sold. The higher the interest rate margin or the larger the quantity of loans it has issued, the higher the bank profitability. Even more so, bank loans are expected to exist for at least a few years hence any profits will be recurring.

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At any given price (i.e. interest rate) there are some people who would be willing to assume a loan while others will not, thus marking an approximate limit to the loan creation. As such, the bank can potentially increase its interest rate margin to an extent but only by raising its loan interest rates, given that its deposit rates are very close to the central bank interest rate and thus it cannot use its discretion to set them. The loan interest rate, and subsequently the interest rate margin will depend on borrower creditworthiness, the liquidity conditions in the banking sector (see next section), and the prevailing state of the economy, but the trade-off between higher loan interest rates and less people wishing to borrow exists. Hence, while it is to the bank’s best interest to raise interest rates, this could harm the amount of loans it will be able to grant. This suggests that there exists a limit to the loan-creating procedure, still do not provide support to the argument that there is a limit as to how much lending can be matched with deposits.8 Suppose for example that a bank, in response to a customer request creates a new loan. Nevertheless, it lacks the liquidity to cover for this loan in the case the customer wishes to withdraw it. The simple solution would be to either borrow from the central bank, at the floor rate mentioned in the previous paragraph, or borrow from another bank (what is known as interbank lending) to cover for its lack of liquidity. The central bank and the third commercial bank have both the incentive and the ability to lend as this is a zero-risk investment. The increase in bank lending means that money in the economy has increased. Even if the money does not remain within the bank, it will most likely be deposited at another bank, which will see its liquidity increased. This additional liquidity will be deposited at the central bank and hence the monetary authority can lend it back to the commercial bank that originated the loan. Similarly, instead of depositing it at the central bank, the commercial bank that sees its liquidity increase can lend the money back to the loan originator. In both cases, the excess or lack of liquidity is covered. Given that money moves fast across countries and banks, it is often the case that a bank can have excess liquidity in one day and a lack of liquidity in the following day. To cover for this short-term ups and downs without disrupting the flow of credit, interbank and central bank lending is used, usually with some sort of collateral like government bonds. Consequently, the premise that there is a limit to how many deposits can be matched with loans does not appear to have any validity. In the case that no other obstacles or incentives to lending exist, interest rates are assumed to be the price of lending and hence the only determinant of quantity. Nevertheless, there are a few other determinants from the

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banks’ point of view: first, banks may not be willing to lend in the case that their return from that loan is very low, something usually associated with the spread between the cost of funding and the benefit from loan granting. This situation is more common at times when interest rates are low.9 Second, it may be that the banks view their perspective borrower not creditworthy enough to be granted a loan. In this case, the loan application is rejected but has nothing to do with neither interest rates nor the bank’s willingness to lend. Furthermore, the “interest rate as a determinant of the quantity of lending” approach ignores the fact that that there is another limit in how much money can be created by commercial banks. This limit is also imposed by regulatory practices and is commonly referred to as the capital ratio of a bank. Simply put, the banks are obligated by legislation to possess an amount of capital to serve as a buffer for any potential losses. This safeguard provides support to both the bank, when a year of negative profits takes place, as well as to the overall system as it makes banks less prone to fluctuations in the economy. For example, the European Banking Authority demands that banks have a core tier 1 ratio of 9% to fill their regulatory needs. This core tier 1 ratio is just a fancy name to suggest that the total capital of the bank (i.e. its issued equity, bonds, preferred shares) divided by its assets exceeds that ratio. Assets do not simply come into this ratio at face value: depending on where these are invested, they are assigned a risk weight. Following the Basel accords, which refer to a set of recommendations on banking regulations by 12 countries sought to provide a more explicit way of measuring risk, the risk weight of a particular loan category has been standardized.10 In particular, government bonds of high quality11 as well as cash have a risk weight of 0%, mortgage loans have a weighting of 35%, credit cards, overdrafts, and auto loans a weighting of 75%, other loans a weighting of 100% and non-performing or overdue loans from 100 to 150%.12 These weights have a strong impact on the number that will enter the denominator at the time of the estimation of the tier 1 ratio. For example, if a bank only hands out overdrafts and has an outstanding amount of 140 euros, then only 75% of that, or 105 euros will be counted with regards to the calculation of tier 1. This regulatory requirement provides a limit to the creation of money. Furthermore, the amount of money creation crucially depends on the type of loan or other investment that the bank chooses to create. For example, suppose that a bank has 100 euro worth of capital and it chooses to only grant mortgage loans. Considering that each mortgage has a 35% risk weight, on the basis of the Basel II credit risk, then to reach the capital ratio limit of 9% the bank would need to create approximately 3174 euro (100 as the

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numerator and 3174 multiplied by 35% as the denominator would yield approximately 9%—see Eq. 4.1). This is way in excess of the 1000 euro that the traditional multiplier with a 10% reserve ratio would suggest and happens because of the fact that the reserve ratio is usually not imposed by a central bank. On the other hand, if the risk weight was 120% as is the case with non-performing loans (more on NPLs later), then the amount would be limited to 740 euro in this extreme case (the same 100 numerator divided by a 740 multiplied by 120%). Money Creation and Capital Ratio Capital Ratio =

100 = 9% 3174 ∗ 35%

(4.1)

The rest of the cases lie in the neighbourhood of the Naturally, in the case where the risk weighting equals one, the 1111 euro limit would equal the amount of the 9% traditional multiplier, but with a twist: the risk-weighted limit is binding, the traditional multiplier limit is not since banks can, as already presented, borrow from other sources to cover for liquidity issues. Furthermore, in contrast to the rigid and static view of traditional multiplier, in which at 9% reserve requirement 100 euros can only become 1111 and no more, the capital adequacy multiplier accounts for changes in bank balance sheets: if capital increases then the limit increases. If capital decreases then the limit follows suit. This is naturally not something that can be easily calculated. Banks do not have just one capital ratio and as such, one could be constraining money creation while another may still have room to go. It could, for example, be the case that the Core Equity Tier 1 ratio is 5% above its regulatory minimum, but the Core Equity Tier 2 (which includes revaluation reserves, hybrid capital instruments and subordinated term debt, general loan-loss reserves, and undisclosed reserves) is very close to its minimum value. Hence, while one capital ratio could support the creation of money, another could restrict it, with no room for manoeuvre. As such, pinpointing the exact amount of potential money creation can be tricky.

Deposits and Liquidity It should again be mentioned that understanding the nature of money creation by banks and how the money multiplier should actually be estimated on the basis of the capital adequacy ratio does not diminish the role of deposits in banking. As already suggested, there is a distinct difference

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between money and liquidity. Suppose now that a bank can issue a new loan because its capital is adequate enough, but it does not possess enough liquidity to do so. This can happen in the case of a large outflow both from the bank as well as from the country itself. For example, rumours about the viability of a bank or a country in general can incentivize investors to withdraw their funds and deposit them in another jurisdiction or sovereign. A clear case of this occurred in Cyprus, in which the deposits of the nowdefunct Cyprus Popular Bank decreased from 25 billion in end-2010 to 17,8 billion by September 2012, in fear of the bank’s weakening position.13 Deposit flight can signal distress both for a bank as well as for the country itself. In distinction from what is known as a bank run where depositors rush to withdraw their funds in a short period of time,14 deposit flight is usually associated with smaller amounts leaving the bank (or country) for a larger period of time. This protracted flight leads to liquidity issues and increases interest rates as cash-starved banks start to compete in order to obtain a limited amount of funds. The amount is limited because it only increases in available lending or inflows from abroad can create new funds. Lending is itself rather “constrained” since only increased “money creation” appetite by the central bank can create new funds. However, since the central bank is not willing to suffer losses on behalf of the commercial bank, it may prove very difficult to persuade it to give out more funds. This, unless a change in the deposit flows takes place, will most likely lead to a deterioration of the commercial bank’s position with developments most likely to range from a forced sale of the bank to a competitor to forced foreclosure.15 Liquidity also has implication for the conduct of banking when it is abundant. Suppose for example that banks receive an inflow of foreign deposits, large enough to substantially increase their current liquidity position. 16 To banks, more deposits mean higher costs since interest needs to be paid on them. To absorb this cost bank has to use these deposits in a way that they are at least covering up the cost of carrying them in their balance sheets. Using them as reserves is not an efficient way since income from the central bank interest will always be less than the interest paid on deposits. Consequently, depending on the rate of interest paid on deposits banks can either purchase government bond or, more effectively for them, and perhaps more riskily for the economy, give out more loans. Depending on the amount of excess liquidity this can also create a lending boom (or bubble). The crucial part to determine where the excess funds are channelled is the level of interest rate paid on deposits and the size of the influx. For example, if interest rates on deposits are 2% and the yield on a sovereign bond currently stands at 2.2%, then banks can safely purchase bonds to cover for their costs.

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On the other hand, if interest rates on deposits are high enough not to justify an investment in sovereign bonds, or if excess liquidity is large enough, the bank would also have to hand out its liquidity in the form of loans. The bank’s actions are naturally dependent on the state of the economy as well as its willingness to assume risk: in a recession, banks view17 most investments as riskier than they would have been if the economy was growing. Furthermore, the banks do not really function in a vacuum, as people also have to be willing to assume a loan for the bank to be able to grant it. Returning to the original argument that the interest rate is the price of lending, it is now easier to see that this may not be the case. Other more important determinants, like the bank’s available liquidity or whether it has reached its regulatory limit play a more important role. Furthermore, the bank’s perception of the perspective borrower’s probability to default, or in other words how risky that loan is, also matters gravely for loan granting.18 Bear in mind though that sometimes interest rates make a difference. Figure 4.5 indicates that sometimes interest rates matter for the banking sector, but only when these are binding. The clearest evidence of such behaviour is the US in the late 1970s and early 1980s. Bank lending decreased significantly during the period as a result of the abnormally high interest rate, in an effort to counter inflation. Note that while traditional ways of viewing the response of the banking sector would expect the growth rate of lending to increase once interest rates started to drop, this was not the case. While interest rates decreased until the mid-1990s, the rate of loan growth decreased as well, even going negative during the 1990–1994 period, when interest rates were much lower than 30.0

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ever before. The same image re-emerges in the mid-to-late 1990s, with loan growth increasing while higher interest rates dominated. In a similar manner, the 2004–2007 period was marked by high growth rate of loans and higher interest rates. Explanation for this behaviour stems from the fact that central banks are (and should be) retroactive and not proactive. Given that forecasts can be wrong, it is meaningless and even harmful at times, to act on them. Thus, central banks react only after the economy has acted. This suggests that interest rates are strongly affected by the state of the economy and can act just as a cushioning factor. They are thus not a strong determinant of the quantity of lending but a rather softer one. For interest rate to actually have a strong effect, they would have to increase substantially in order to be binding. For central banks, this is better as large swings in bank lending due to changes in interest rates would be undesirable. This is why central banks often suggest that they fine-tune the economy and not completely affect it.

Notes 1. Monetary base also includes bank reserves in addition to currency in circulation. 2. Werner (2014a,b), Ryan-Collins et al. (2011), McLeay et al. (2014a,b). 3. Whether or not saving is a good idea for the economy is up for a long debate. As Keynes (1936) suggests, while saving is individually a good idea it may be a bad idea if everyone does it since it deprives the economy of a substantial amount of consumption, resulting to what has been named as the paradox of thrift. This, however, depends on the state of the economy: if an amount of income is saved when times are good then it might mitigate the effects of a recession as people will spend from their deposits. On the contrary, and as it usually happens, because people do not save much when times are good, they worry about the future and start saving when times are bad, causing an even deeper slump. Evidence of this behaviour can be seen in the United States where the savings rate was constantly falling during the Great Moderation period (1980– 2007) reaching 3% in 2007. By the end of the crisis, it had more than doubled at 6.1% and has remained above 5% until 2015. 4. It should not matter whether or not government spending is productive with regards to re-sending the money to the economy. All that matters in this case is that the money reaches the economy, regardless of whether this is done by an increase in road construction or by civil servant pay increases. The only difference is that the second way is less effective as some of the funds will most likely be saved and not spent. 5. There is a way that money in the economy remains unaltered in the case of the issuance of a new government bond. The case, as the reader may have already

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guessed, takes place when a bank creates a loan (increasing money supply) to a private sector firm or individual, and that person or entity fully invests that amount in government bonds (decreasing money supply). In this case, the increase is fully compensated by the decrease and money supply remains unchanged. If the bond is repaid, then money supply is again increased. See also Paul Sheard, “Repeat After Me: Banks Cannot And Do Not “Lend Out” Reserves” Standard and Poors, August 13, 2013. McLeay et al. (2014b). Tobin (1963). See, for example, Borio et al. (2015), or Claessens et al. (2016). Basel II: International Convergence of Capital Measurement and Capital Standards: a Revised Framework, Comprehensive Version (BCBS) (June 2006 Revision). High quality bonds are those that are considered to top ranked by the major ratings agencies. This overview is of course a simplification, as there are money subcategories of loans and advances. The interested reader can refer to ‘International Convergence of Capital Measurement and Capital Standards: A revised framework.’ Bank of International Settlements. Cyprus Popular bank annual report for 2010, 2011 and the nine months of 2012. In the US, Wachovia bank lost approximately 1% of its total deposits on a single day, 26 September 2008. Since customers wishing to leave their accounts with less than 100,000 made the withdrawals (the FDIC limit for deposit insurance), this was dubbed ‘the silent run’. See http://www.charlotteobserver.com/ news/article9016391.html. It should be remembered though, that the action of shutting down a bank is not taken only by the regulator, in this case the central bank, but is also highly political due to the associated costs. This justifies more emphasis on the financial account than the usual practice of relying on the current account as a source of potential imbalances. Borio (2016) has also made a similar suggestion. Note that as already commented in the introduction, there are no such things as ‘banks making decisions’. People working in the banking sector make the decisions, and as human beings are affected by their feeling and the external environment. For an elaboration, see Goodhart (2013).

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References Borio, C. E., Gambacorta, L., & Hofmann, B. (2015). The influence of monetary policy on bank profitability. International Finance, 20 (1), 48–63. Borio, C. E. (2016). On the centrality of the current account in international economics. Journal of International Money and Finance, 68, 266–274. Claessens, S., Coleman, N., & Donnelly, M. S. (2016). Low-for-long interest rates and net interest margins of banks in advanced foreign economies (No. 2016-04-111). Board of Governors of the Federal Reserve System (US). Goodhart, C. A. (2013). The potential instruments of monetary policy. Central Bank Review, 13, 1–15. Keynes, J. M. (2018 [1936]). The general theory of employment, interest, and money. Cham: Springer. McLeay, M., Radia, A., & Thomas, R. (2014a). Money creation in the modern economy: An introduction. Bank of England Quarterly Bulletin, 2014 (Q1), 4–13. McLeay, M., Radia, A., & Thomas, R. (2014b). Money creation in the modern economy. Bank of England Quarterly Bulletin, 2014 (Q1), 14–28. Ryan-Collins, J., Greenham, T., Werner, R., & Jackson, A. (2011). Where does money come from? A guide to the UK monetary and banking system. London, UK: New Economics Foundation. Tobin, J. (1963). Commercial banks as creators of ‘money’ (Cowles Foundation Discussion Papers No. 159). Werner, R. A. (2014a). Can banks individually create money out of nothing? — The theories and the empirical evidence. International Review of Financial Analysis, 36, 1–19. Werner, R. A. (2014b). How do banks create money, and why can other firms not do the same? An explanation for the coexistence of lending and deposit-taking. International Review of Financial Analysis, 36, 71–77.

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It is easy to see that through the combination of the factors outlined previously, the banks’ willingness to lend and the peoples’ willingness to borrow will match and create new loans. Lending has the effect of increasing peoples’ purchasing ability and hence overall demand in the economy. As suggested previously, increases in demand cause inflation to rise, hence an increase in bank lending should, indirectly, increase both inflation and demand. If that was the case then understanding and even quantifying the effects of bank lending on the economy would have been easy. However, to grasp the full array of the effects one would have to understand different aspects of lending and especially types of loans. Imagine dear reader that you work in a bank, more specifically you are the person who is in charge of accepting or rejecting loan applications. One day, John Smith comes up on you and asks whether he could obtain a loan to purchase a house. John has a stable income source (he works for the government) and you decide in favour of granting him the loan. As expected, John uses his newly acquired funds to purchase a house from a local builder. The builder/land developer, let’s call him Friedrich, has a house already finished, which he hopes to fund through the selling price (he has taken a lot of credit from raw materials providers). Naturally, Friedrich makes a profit from selling the house. Seeing that his investment paid off, Friedrich decides to build another similar house. However, since he has to repay his creditors, he lacks the total amount. Friedrich comes to you now and asks whether he could also obtain a loan. He plans to build a house and © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 N. Michail, Money, Credit, and Crises, https://doi.org/10.1007/978-3-030-64384-3_5

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he pledges it for collateral. You, given that it appears to be a valid investment since people would always like to purchase houses to live in, decide to grant him a loan, but at a higher interest rate than the one offered to John because the investment is riskier; after all, Friedrich’s line of business means a more uncertain income stream. Having obtained the loan, Friedrich comes up with an interesting idea: if there is demand for housing, why not just increase the price just a little bit to make some extra profit? After all, he knows how much John’s house has cost and how much profit he can make, thus it is easy to add a small premium to the newly build one. Hence, when Joan decides to purchase the house she would have to pay more than what John did. Joan now comes to you again to get a housing loan. Since Joan’s records show that she also has a relatively stable income (she is a local shop owner), you do not hesitate in accepting her application. You may notice the amount the house costs is higher but that is of course what the buyer and seller have agreed and you have no say in it. Friedrich makes his profit again and he repays his loan. Overall, the sale of two houses in the economy has led to the formation of two housing loans and one investment loan, as well as the repayment of the latter. This will not leave the rest of the economy unaffected though: Friedrich has employed some other people to help him build the house then these people would also have to get some compensation for their effort. The materials Friedrich used to build the house would also need to be purchased from somewhere. The people on the receiving end of Friedrich’s payments, i.e. those who supplied goods and labour, would then spend (at least some) of their new money on food, drinks, and entertainment. This would mean that, at least to some extent, Joan’s income would also increase, as a result of the new money in the economy since overall spending power has increased. Suppose now that this little experiment is done in a country of millions: in essence, people borrow money to purchase house and builders borrow money to build them.1 It is now easier to see the feedback loop between lending and housing: as long as people can borrow to finance the purchase of their house then demand will grow. If demand grows, then it is to the sellers’ best interest to increase prices. It is also to the workers’ best interest to request more wages as it also is to the raw materials suppliers’ best interest to also raise their prices. Hence, it would be easy to infer that a rise in domestic indebtedness would mean inflation increases. This, however, does not have to be limited to the usual inflation rate calculated. Remember from Chapter 3 that inflation is measured as the change in the price of a basket of goods, which, by definition cannot incorporate all types of goods and services. There still has to be an

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impact though on some types of prices: excluding the case that lending has fled the country (which is impossible since we are investing in real estate), house prices must increase.2 Take for example, the US during the 2003–2007 period: house prices increased by 34% in the 2003–2007 period (Fig. 5.1), a result of a significant increase in bank lending, gauged by the increase in the monetary interest paid (Fig. 5.2).3 Naturally, not all of the increase in demand has to be incorporated in housing prices; some of the increase in prices was absorbed by the CPI and the stock market while a part was also invested abroad.

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Is this phenomenon self-perpetuating then? Or is there a mechanism that supplies a ceiling? Unfortunately, the answer is “no” for the first question and “yes but we don’t know exactly what” for the second. Consider this: suppose that some shock in increased unemployment by say 10%, i.e. from 4.5% to approximately 5%. The increase essentially means that some of the people who were able to repay their loans will no longer have that ability. This implies that approximately 10% of that monetary interest (about 190 billion) would remain unpaid. This, at the time, was about 20% of total bank capital.4 Needless to say that some banks would have been more hurt than others. Hurting the bank would follow that you, as the loan officer, after seeing a lot of borrowers failing to repay their debts, would get stricter with new loan applications. Loan granting would become more difficult which means that builders like Friedrich would not find many buyers. As a consequence, Friedrich would also fail to repay his loans properly. If Friedrich fails then his workers and his suppliers will also be hurt. The former will become unemployed and the latter will see their incomes reduce and may have to lay off people to cover for that. This, as you can imagine, will mean that more people will be unemployed and hence will spend less. These are bad news for Joan since she will also sell fewer goods and hence she may no longer be able to pay off her mortgage. As you may have correctly guessed, in times when things go south, the only person who is unaffected will be John, the civil servant. It is now easier to see why when no-one is willing to spend, people tend to turn to the government. In general, a lending bubble stops only when some kind of shock affects the borrower’s (either housing or business) ability to repay their loans. The shock may be small but, depending on the underlying economic circumstances and the level of indebtedness, can escalate through time: for example, a small rise in unemployment can have severe effects on the economy, through a similar, but reverse, feedback loop. Notice though that the same conclusion cannot be reached in other cases where bank lending increases consumer demand. Some could argue that in the case where a new auto loan is granted, demand for automobiles increases and hence prices can be expected to rise by some extent. A similar argumentation could be found in say, increases in spending power by more credit card funding. However, this is not the case. Most goods are not the same across brands (think of the difference between one automobile and another) and, in most cases, neither are services. Hence, an increase in the popularity of say, Porsche cars, would not necessarily imply an increase in the popularity of Volkswagen

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models but it would imply that the profits of domestic sellers would rise due to the higher quantity sold. The most important distinction between real estate lending and other lending is that the former only has local supply. Simply put, if one chooses to live in London, he would not be willing to purchase a house in Frankfurt. Hence, as demand for real estate increases through the greater availability of funds from the banks, houses in London remain more or less at the same level. To be realistic, the supply of housing will also increase once house prices rise. However, the supply of housing will increase only to a certain extent, as land is limited. In contrast, automobiles can be manufactured both domestically as well as abroad and supply can increase rapidly over a fortnight. The same can happen with other types of consumer goods. What is expected to happen when demand increases is that overall spending will go up, which means that sales will also increase and subsequently so will prices. Hence, sellers will benefit from higher incomes as a result of the increase in both prices and sales. Higher incomes usually mean higher prices and higher prices lead to higher wages, hence an increase in the price of domestically produced goods is more likely to take place. Overall, an increase in lending (and especially in consumer lending) is likely to increase wages and hence make domestically produced goods less competitive in terms of prices. A reduction in price competitiveness suggests that these goods will be more expensive compared to very similar (think identical) goods manufactured abroad and hence exports will reduce. But this is not a scenario often faced by firms since the quality of higher priced goods as well as the usual shift to high-end products more than compensates for changes in prices.5 Hence the impact of banking, via increased demand, to the export side is not that strong.

Lending and the External Sector What is stronger is the effect of banking on imports. Higher demand will naturally cause imports to rise; higher lending will also have this effect. Think for example an economy which has a negative trade balance, i.e. the value of its imports is more than the value of its exports.6 In other words, more money is leaving the economy than is coming in the economy. What would happen if this situation continued for a while and the quantity of money was stable (and assuming that import prices remained the same, thus no import inflation takes place) is that overall money in the economy would reduce and deflation would take place. If, in contrast, banks lend money to the public

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then this situation can never occur since money issued would be more than money spent abroad. By offering lending to the public, banks allow for a country to experience a sustained trade deficit, without harming its economy. Furthermore, it also has beneficial effects on the economy since trade improves technology diffusion, both for developed as well as for developing economies.7 There are of course limits to this behaviour since continuous trade deficits usually cause currency depreciation and hamper competitiveness in the long-run. However, in the case of a few years’ time or even much more, having a larger trade deficit can be sustained if the deficit is not excessively large. The case of Australia is particularly revealing: the country has had sustained current account deficits since the 1980s, increasing as bank lending rose. The 2007–2008 Great Recession and subsequent reduction in lending led to an improvement in the deficit in 2009, which disappeared as banks resumed lending (Fig. 5.3).8 The avoidance of currency deterioration by Australia can be attributed to the fact that even though the deficit has been relatively large, it has been supported by an increase in bank lending and a sustained growth in real GDP. As such, while more money goes abroad, a larger amount of money and goods is produced at home. This does not preclude the possibility of adverse effects: if banks in Australia face issues which will force them to contract lending (note that even during the 2007–2008 crisis and since bank lending in the country has been increasing by more than 6% annually) then a sharp reduction in the current account balance should be expected. This conclusion does

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not hold solely for the case of Australia but can be viewed as a general statement: in the case where the banking sector faces issues, then the effect on trade from the reduction in money supply and consequently overall demand can be strong.9

Stock Market Lending Entities or processes which are mostly domestic and have less effect from outsiders tend to be more affected by changes in bank lending. As such, the stock market, even though there is some abroad participation, tends to also be closely connected to banking and be affected by it. This is mostly done through traders who are willing to bet more than they currently have in their portfolio and are offered the chance to do so as banks give them access to credit. To elaborate on this, suppose that a trader wants to purchase some shares which he believes that will rise in value very soon. The share price in this example is 50 euro and the trader has 5,000 euro in his account. If he does not use bank funding (what is called as leverage), then he can only purchase 100 shares. Now suppose that the bank is willing to allow him to purchase at a leverage of 1:50. Thus, for every euro the trader has, he will be able to purchase 50 euro worth of shares. This means that his bet suddenly increases from 100 shares to 5,000 shares. Naturally, if the share price rises the trader stands to gain a lot from leveraging. In contrast, a decrease in the price of the stock will mean that he will lose most, if not all, of his original capital (the 5,000 euro). Usually, stock market participants do not interact directly with banks. Stock brokers do that on their behalf, with banks usually assigning a line of credit to these brokers. Most brokers usually have agreements with several banks (their “liquidity providers”), they are able to provide ample credit to their customers. Brokers usually service a large number of customers, cancel out the trades internally (i.e. a trader will purchase a share and another will sell) and send the remainder bets to the exchange. To cover for their customers’ bets, funds are provided by the brokers at the exchange. In the case of price movements against a broker’s position at the exchange, additional funds will have to be deposited. Banks facilitate these transactions both through the provision of liquidity as well as satisfying the demand for withdrawals of funds. This way, investors can trade without concern about the creditworthiness of the individuals with whom they are dealing; brokers, exchanges, and banks remove this risk from the market.10

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The similarities with the case of lending are rather evident: by allowing more loans to be allocated to stock market participants, banks increase their exposure to stock market ups and downs. Since the stock market is viewed as a zero-sum game, i.e. that one man’s loss is another man’s gain, the bank is assumed to be “protected” from traders’ activities since they will cancel each other out. In addition, the bank stands to gain from the interest rate charge on these short-term loans. The zero-sum game assumption is not really valid in practice though, despite conventional thinking. Short interest (i.e. traders who bet that the stock price will decrease), usually amounts to either much more or much less than 50% of the stock.11 However, even though this may be the case most of the times, complications arise when times are turbulent. In fact, consider a rising stock market.12 In this case, traders can stand to make continuous profits if they buy and hold, or even more simply if they buy and sell at a higher price. This means that bank lending will become beneficial for the economy (or at least those who own shares), since traders will be able to repay their loans and actually earn a profit which they can consume.

The Feedback Loop Again The feedback loop between prices and lending re-emerges in this case as well: higher prices will mean more lending (since higher prices mean higher purchasing costs) and more lending will mean even higher prices as the newly created funds will be used to purchase shares. This blissful situation faces two potential threats: first that it highly depends on bank lending and thus a bank facing troubles elsewhere (e.g. in housing loans) may decide to limit new lending, forcing the stock market to run out of liquidity. To put this into perspective, think about what the market expects: a large amount of money to be used for purchasing purposes every day. If the amount of available money is reduced then the market will face more people willing to sell than people willing (able) to buy stocks. This will force the price down and from then on it depends on traders’ reactions. The second threat is that a sudden, large drop in the stock market will endanger banks’ financial position and create a downwards spiral, again depending on how severe the drop is and how traders react to it. In 1987, traders got really scared and, with the combination of “stop loss” orders caused stock market losses of more than 30% in one month.13 Unfortunately for market participants, crashes are not usually expected by most of them.

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While some can profit from unexpected drops in the value of shares,14 many will end up either bankrupt or with severe damages at the best-case scenario. In the history of the twentieth century, the first threat never really realized directly; banks never withdrew the provision of liquidity to stock market participants. This happened because firstly, it is highly profitable and they do not want to impact their bottom line, and secondly, they realize that if they withdraw credit a stock market crash is likely to follow since participants will not be able to buy shares at the current, lending-boosted, prices. There were times of course when the markets have witnessed indirect withdrawals of liquidity when banks faced problems, but these were at times when bank failure looming. Notice that if a single bank faces any issues with liquidity and decides to curb liquidity to the stock market, brokers will increase their lending from other banks. Only when all banks simultaneously pull out of the market brokers are left without any funds to operate, even though they may find other sources, e.g. money market mutual funds, who may be willing to provide liquidity. The second threat materialized more than once in the US: in 1987 (Black Monday), in 1989 (Friday the 13th mini-crash), in 1990 (recession), in 2000 (the burst of the dot-com bubble), in 2007–2008 (the financial crisis), in May 2010 (the flash crash) and in August 2015 (the stock sell-off ).15 The list may in fact be missing a few. The important part of this list that of the seven crashes, only two were caused by economic fundamentals; the remaining five were just the workings of the stock market and even though there is some consensus of what may have magnified a drop to a crash, there is no idea of what may have caused it in the first place.16 Failure to understand the causes of stock market crashes means that they are practically impossible to predict and there is no way to prepare against them. This should normally mean that every once in a while, banks should be expected to have large losses as a result of stock market crashes. Nevertheless, due to the nature of the exchanges and the fact that most dealers usually have to cover for their customers’ losses (up to the point where they do not themselves fail naturally) this does not take place very often. An examination of the US banks’ average return of equity indicates that it was negative only in 1987 and the 2008–2009 Great Recession.17 Consequently, it would take a rather large shock to the stock market in order for banks to assume a big hit. Overall, the smooth operation of the exchanges requires a smooth operation of the banking system. When the first takes a hit, some losses will most likely be absorbed by the banks, but they will not be heavily hurt unless

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the exchange faces severe damage. If banks take a hit then the exchange will certainly be damaged, as funds will no longer be able to move freely. Remember that in Chapter 4, monetary policy operations were viewed as fine-tuning of the economy. This was because interest rates are seldom increased to levels at which they will effectively be binding. Binding essentially entails the fact that interest rates will increase by that much that those interested in obtaining credit will choose not to do so after a threshold because the rate of return on their investment will no longer be larger than the cost of borrowing the funds. This should be viewed as monetary policy aiming at lowering demand for funds. The supply side of this “market” for funds are banks who are either willing to loosen lending or tighten them. Tightening does not necessarily mean that banks will increase their interest rates; this has nothing to do with the supply side. If banks are not willing to lend, then they can simply tighten lending standards by rejecting more loan applications, with the simple justification that the customer is viewed to be very risky for the bank. Indeed, there have been times when tighter “terms and conditions” have been recorded when banks did not wish to lend.18 The inability of interest rates to have an effect on supply also implies that changing them will have no impact on the risk-taking appetite of the bank. It does not matter whether interest rates are higher or lower, banks with excess liquidity and nowhere better to use will tend to lend more.19 In summary, the above suggest that it is rather difficult for monetary policy to have an impact on new lending.20 Still, the banking sector serves as the channel through which monetary policy can be transmitted to the public.

Monetary Policy and Lending Despite the many proposals and suggestions in the literature, there is just one way through which monetary policy can influence the economy and that is through the existing stock of loans. To see how this works, let’s take John, the civil servant from the previous example. John earns a stable salary and pays a stable amount of interest on his mortgage. Suppose now that the interest rate increases, because the central bank feels that the economy is over-heating. Consequently, the interest rate on John’s mortgage will also have to increase. To account for this increase, the bank will have to recalculate the amount of interest due each month, and that recalculation will result in a higher amount, since interest rates have gone up. Thus, John, whose income has not changed during this period of time, will have to devote a higher

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percentage of his income to the repayment of his mortgage. More interest paid means less money available and hence less demand in the economy. The above, as the reader has suspected, makes the assumption that John has obtained a mortgage with a variable interest rate. In addition, it also makes the assumption that the mortgage loan, as well as any other type of loan, needs to have a regular stream of payments for monetary policy to have an effect. In the case of financial products that are drawn only for rollover purposes, monetary policy will not have much effect. Still, even in the height of the crisis, these products were not that many. The example above, employed John’s mortgage to drive its point, but the same holds irrespective of the type of loan, with some minor differences. Overall, the more indebted a country or an individual is, the more effect monetary policy will have on him or the economy. A 1% change of the interest rate will be more significant if a country’s private sector has borrowings of 100 billion than if it has borrowed 10 billion. In addition, the longer the duration of the loan, the larger the effect from policy will be since the effect will be rolled over many years. The banking sector can retort to such changes in the interest rates with its only weapon: increasing availability of funds and loan granting. This can overcome the effect from increasing interest rates but has its limits since most banks would not be willing to lend to someone who is already struggling to repay his loans. Hopefully, neither will that person be willing to obtain more debt, but we have seen exceptions from sanity from both the bankers and the public dozens of times. Further to the above effects, banks also have some additional which are undoubtedly positive. First, they have facilitated transactions, with the assistance of technological advances, in ways previously thought impossible. For example, the ease that funds are currently moving along the globe is unprecedented. This has facilitated both international transactions as well as within-country exchanges of funds. In addition, banks have also provided us with a solution of exchanging cash for an item, without physically holding it, through checks and credit/debit cards, further facilitating transactions. Second, banks have also made access to credit easier by making potential borrowers know that they are usually willing to lend money out. Had banks not existed, credit would have been scarcer and economic growth would have been less.21 Third, banks have also provided a solution to safety: even though this is not usually examined as one of the benefits of banking, it is certain that the public does not have to fear about their savings anymore. Banks will always guarantee that if you place a deposit, you can get your money back at any instant you wish without having to worry about someone stealing it

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from you. Furthermore, despite of this facilitation, banks actually give us a positive return through the interest rate on deposits. A world without banks or any other beast which performs the same functions under a different name would be rather unimaginable. Banks have strong effects on the economy through various channels and ways and their impact is clear and undeniable. What matters is how much this is understood and how this understanding can be used to make the economy better off.

Notes 1. Note that the situation would have been altogether different if the building of house was made on demand as the builder would no longer need to borrow but would obtain periodic payments from the owner for his services. 2. Indeed the inflation rate was flat at about 2% for the early 21st century (see Fig. 5.1). 3. The series is constructed as the total domestic business interest paid plus household interest paid minus domestic financial businesses, so as not to double-count interest. The series used were A2062C1A027NBEA − A1100C1A027NBEA + W292RC1A027NBEA 4. Total bank capital obtained from FRED. 5. Note however that firms do not only compete in prices, even though this is the usual rhetoric in economics. They also compete in quality and other characteristics which are unaffected by inflation. For an early view of this idea see Wickham Skinner, ‘The focused factory’ Harvard Business Review May 1974. 6. For an excellent introduction to international economics, see Husted and Melvin (2013). 7. Technology diffusion can be viewed as the intake and use of new technologies from imports, which would have otherwise not been obtained in the country. Think for example the years it would have to take each country to develop automobiles on its own. For an overview of the effects of trade on technology diffusion see Comin and Mestieri (2013) 8. Source for the data is the Reserve Bank of Australia and the Australian Bureau of Statistics. 9. Indeed, Bems et al. (2010) show that 70% of the contraction in trade during the Great Recession was due to demand factors. 10. Bernanke (1990). Note that what is described above does not just hold for the stock market, but for other regulated (and some over-the-counter) markets, such as futures, options, etc. 11. Wall Street Journal’s ‘Biggest short positions’ on Tuesday December 27, 2016 records three Nasdaq stocks having a short position (as percentage of outstanding stock) more than 50%, while for the rest the percentage is much

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12. 13. 14.

15. 16.

17. 18. 19.

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lower (link: http://www.wsj.com/mdc/public/page/2_3062-nasdaqshort-highli tes.html). Constantly means that trend is upwards, not that there are no ups and down in-between. Based on the Russell 2000 Price index. The Nasdaq fell by 27% during the same period and the Wilshire 5000 by 28%. (Source: FRED). Nassim Nicolas Taleb’s and Mark Spitznagel’s investment strategy focuses on large unexpected negative events, or ‘Black Swans’, but this does not work for everyone (Taleb 2007, The Black Swan, Random House). Others such as traders in Michael Lewis’s ‘The Big Short’ have also benefited from shorting the market, but this is not reflective of most traders’ behaviour. Source: Wikipedia list of stock market crashes and bear markets. Explanations for the 1987 crash include the heavy reliance on ‘portfolio insurance’ which had huge stop loss orders placed as part of the investment strategy, while for the flash crashes Michael Lewis’s ‘The Flash Boys’ (W.W. Norton and Company, 2014) suggests that problems in algorithmic trading may have caused the crash. In the case of the dot-com, the bubble just burst after it proved that most of the companies had no fundamentals (earnings, sales, etc.) to support their growth. Source: FRED Return on Average Equity for all US Banks (Code: USROE). Geanakopolos (2009). This contradicts the ‘risk-taking channel of monetary policy” in which banks are assumed to give riskier loans when interest rates are lower. Borio and Zhu (2012). One exception is, as already suggested, the case where the interest rate is too high. When the interest rate is zero, bank maintenance and funding costs do not allow it to drop below a certain level. When interest rates are below zero, banks are punishing those with large deposits, as they cannot physically remove them, which can result on reducing bank liquidity (see chapter future). Koursaros et al. (2020).

References Bems, R., Johnson, R. C., & Yi, K.-M. (2010). Demand spillovers and the collapse of trade in the global recession. IMF Economic Review, 58, 295–326. Bernanke, B. S. (1990). Clearing and settlement during the crash. Review of Financial Studies, 3(1), 133–151. Borio, C., & Zhu, H. (2012). Capital regulation risk taking and monetary policy: A missing link in the transmission mechanism? Journal of Financial Stability, 8(4), 236–251.

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Comin, D., & Mestieri, M. (2013). Technology diffusion: Measurement, causes and consequences. In P. Aghion & S. Teven Durlauf (Eds.), Handbook of economic growth (Vol. 2B). Amsterdam: Elsevier Press. Geanakopolos, J. (2009). The leverage cycle. In D. Acemoglu, K. Rogoff, & M. Woodford (Eds.), NBER Macroeconomics Manual . Chicago: University of Chicago Press. Husted, S., & Melvin, M. (2013). International economics: International edition. Pearson Higher Education. Koursaros, D., Michail, N., & Savva, C. (2020). Tell me where to stop: Thresholds in the bank lending and output growth relationship. Empirical Economics, 1–29. Taleb, N. N. (2007). The black swan. New York: Random House.

6 Investment Banking

Friedrich, our builder/land developer from the previous chapter has been prospering. His sales have been increasing through the years and his business is becoming more profitable. To further enhance his business’s prospects, he would like to purchase new equipment and build a new office building to house employees who work in the firm’s sales and finance departments. While these people are not directly involved in building, they are very important to the smooth functioning of his firm. Furthermore, Friedrich would like to sell or rent the remaining offices to other firms for additional profit. A project of this size requires some significant funding. While having the knowledge and the associates to pull this through, Friedrich understands that the firm does not currently have the funds to cover the large cost of purchasing the land and starting construction work. As usual, he would like to obtain a loan from the bank. Still, knowledge of the fact that his earnings stream is not as smooth as John’s or Joan’s puts him into thinking. The firm’s proceeds are dominated by large inflows during some months (when a house is sold), while in others very few proceeds may come in. This may be fine when building a single house since the amount is not that large, but in a large project loan payback will constitute a large amount of monthly expenses. Fortunately for Friedrich, there is another way to borrow which may come in handy: his firm can issue a bond to raise the money. Issuing a bond means that he will have to pay interest on the money obtained at fixed intervals (e.g. quarterly or annually) and repay the amount in full when the bond is due

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(the maturity date). For example, if he chooses to borrow 10 million for 10% interest rate with a maturity of 5 years, it means that he would have to pay back 1 million per year for the coming five years plus a full repayment of 10 million at the end of the fifth year. Since his sales are rather unpredictable and he expects large inflows after the completion of the office building, issuing a bond sounds appealing.1 Moreover, he hopes that bond issuance will be able to get him a lower interest rate thus decreasing his expenses. However, Friedrich has no idea how to issue a bond. The legal and economic structure of the issue is quite complicated and most importantly it is not very easy to find investors who are willing to lend money to a firm. In addition, spending time to do all this would also mean that he would be less devoted to boosting the firm’s potential. Fortunately, there is a type of intermediary which is able to pull all of this through on Friedrich’s behalf. The intermediary is called an investment bank. Investment banks are entities which operate as intermediaries between those who wish to raise funds and those who wish to lend for investment purposes. In this aspect, investment banks are similar to banks. However, investment banks neither accept deposits nor are able to issue new loans using their cash. By having a large array of potential investors in their books, investment banks facilitate both private sector as well as government who wish to borrow funds from capital markets as well as issue shares (equity). The purchase of debt of equity upon issuance is called the primary market for securities and has traditionally been the focus of the investment banking industry.

Facilitators of Third-Party Credit To illustrate how this service works, Friedrich’s potential bond issuance serves as a good example. Once investment banks agree to assist him, Friedrich can rest assure that he will receive all the money he is asking for; these banks essentially guarantee that if investors do not purchase the whole amount of the bond investment banks will step up and cover for what remains at a pre-determined price. This service is called underwriting and is extremely valuable for fund-seekers (both private sector and government) as it significantly increases the bond’s appeal to investors. From the investor’s point of view, involving an investment bank into the deal is a sign that both the bond and the firm are at least of decent quality; no investment bank would agree to cover the amount of the bond that is not purchased by potential investors if it did not believe that its quality was at least decent.2

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If the amount the customer wishes to raise through the bond issuance is large, as is the case with most government bonds, an investment bank “syndicates” with other similar banks in order to share the risk of having to cover a specific amount. In addition to their role in equity and capital markets, investment banks also provide “leveraged loans” which are loans to already highly indebted companies to fund specific projects, such as mergers and acquisitions.3 The secondary market, where many (but not all) securities are traded after their issuance in the primary market, is another area in which investment banks provide a wide range of services. Specifically, they buy and sell financial instruments that are already issued and traded in the market, at their clients’ request. This is called “market-making services” and the clients are often described as “institutional investors”. The term incorporates all types of “asset managers” who participate in financial markets such as pension or hedge funds who manage savings on behalf of individuals as well as insurance funds who manage large cash pools from their customers’ payments to cover for other products they offer.4 Apart from the direct impact of facilitating market access to their clients, these activities also provide valuable liquidity to markets such as corporate bonds where trading is not done directly via an exchange, but investors have to contact market-makers for price quotes. The fact that the securities promoted by investment banks can be more easily traded in the market, means that the investor’s risk of selling the securities back in the market will be significantly reduced. This happens because investment banks will act as the intermediary (i.e. the market maker) in order to facilitate trading by absorbing excess buying or selling. This adds more liquidity in the market, since investors knowing that they will be able to sell a security at their will are more likely to purchase it either from the primary or the secondary market. Nevertheless, investment banks are not always willing to do this on their customers’ behalf since in stressed market conditions, volatile market prices can result in losses.5

Derivatives Investment banks also trade in derivatives with their clients. A derivative is a financial product which allows the owner to either buy or sell a specific amount at a specific rate at a specific future date. For example, a derivative may allow the purchaser to buy 1 million US Dollars, at the rate of 0.90 Euros per Dollar, six months from now. They are called derivatives because

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their value is derived from an underlying asset; in the above example, the underlying asset being the Euro to Dollar exchange rate. Despite the relative novelty of the name, derivatives have been in existence since the time of Aristotle who records that the philosopher Thales, after forecasting that the olive harvest would be good in the coming season, deposited a small deposit to reserve all the olive presses of the town for his exclusive use during the harvest season. The deal paid off since the crop was indeed spectacular, olive presses were in high demand and Thales could charge any price he wanted as a monopolist.6 As it is evident from this ancient parable, the main use of derivatives has been speculation, in one form or another. Despite the fact that they are mostly used for speculative purposes, derivatives, if properly used, can also serve as a way for firms to reduce risks from a potential change in the underlying asset. For example, consider Friedrich’s firm, which operates in the US and has agreed to purchase 10 million euros worth of goods from a supplier in Germany, with payment upon delivery in three months. If the exchange rate is now at 0.90 Euros per Dollar, a potential appreciation of the euro to, say 0.85, would mean an additional cost of 650,000 Dollars to the firm (the difference in exchanging Dollars to Euros from the 0.90 exchange rate to the 0.85 exchange rate). In contrast, a potential depreciation of the Euro (e.g. from 0.90 to 0.95) then the firm will stand to gain that amount. Suppose now that someone offered the following deal to Friedrich: for a cost of 100,000 Dollars, he can purchase a derivate which will allow the firm to exchange Euros for Dollars at the specified rate of 0.90 in three months’ time. Naturally, Friedrich should take the deal: if the euro appreciates to more than 0.89, the cost of 100,000 will be less than the loss he would incur. If the euro depreciates more than 0.91, then the gain will be more than the 100,000 he would have to pay for the purchase. In a way, a derivative is more or less like an insurance policy, when the purpose is not to speculate. For a specified loss, in this case 100,000, Friedrich is insured from losing more money due to currency fluctuations and can stand to gain more if the exchange rate moves to his favour. This type of derivative is called a forward contract; if this is traded on a centralized exchange then this is called a futures contract. There are other types of derivative contracts available: for example, options are derivative contracts which allow the owner the right (but not the obligation) to buy (call option) or sell (put option) a security, at a predetermined price, either at a specified date (European option) or at any time during the option’s life (American option). Another type of derivate is a swap contract, which allows two counterparties to exchange cash flows over a period of time, based on the value of the underlying asset. The two most popular types

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of swaps are interest rate swaps, where a fixed interest rate cash flows are exchanged with variable interest rate cash flows or vice versa, and currency swaps, where the counterparts exchange principal and/or interest payments of a type of loan (e.g. a bond) in one currency for a loan in another currency.7 Many investment bank customers seek to enter such trades because they either want some kind of insurance against future moves of the markets or because they would like to speculate in them. Investment banks provide both the access to the exchange, in the case where these derivatives are traded, or create bespoke products which suit their customer needs. Further to these, investment banks also provide ancillary services, such research and analysis aimed at informing their clients about factors which affect the movements of currencies, shares, corporate and government bond, commodities, and others.

Securities Lending The securities lending and in general the broader universe of repurchase agreements is another area in which investment banks are heavily involved. Securities lending involves the temporary transfer of financial securities, like shares or bonds, from a lender to a borrower. For example, if firm A owns shares in company X, and firm B wishes to “borrow” them then it can reach an agreement to “rent” them for some amount of time, at a fee. In such a transaction, an investment bank usually acts as the intermediary between the two firms, facilitating the transaction and benefiting from a fee at the same time. For the lender to agree to lend its shares or bonds, the borrower is expected to post some type of collateral. This takes the form of other securities (bonds, equities) or cash. In Europe, securities are mostly taken as collateral, while in the US cash is the most usual type of collateral.8 These differences can be partly attributed to variation in regulatory practices in the two regions. In order to protect the lender from potential losses, the market value of the pledged collateral is usually larger than the one of lent securities. This excess margin is usually called a “haircut” and reflects the potential variation in the market value of the collateral and the securities lent. Since market moves tend to be rapid, the collateral and lent securities are valued regularly, with the required margin adjusted accordingly. Ownership of the lent securities is transferred to the borrower but the transaction is structured such that the economic benefits associated with ownership (such as dividends in the case of stocks or coupons in the case of bonds) are paid back to the original owner. Rights of ownership associated

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with shares9 such as voting rights are surrendered when the equity is lent; in case the original owner wishes to vote, he would have to recall them. This is easily done since owners of the securities have the right to recall their securities at any time, with the reasons for recalling usually being their concern about the creditworthiness or the borrower and their desire to vote on the equities. Similarly, borrowers may also return the security at any time if they decide to do so. Investment banks are key players in securities lending and may borrow either on their behalf or on behalf of their clients, e.g. pension or hedge funds. Purchase on their behalf is usually done in order to meet customer demand and facilitate the buying and selling of securities as part of their market-making services. In contrast, purchase on behalf of their customers is done mainly because these funds wish to enter a speculative trade, specifically short-selling.10 Further to these, investment banks usually manage the whole process and re-evaluate the margin required.

Repos and Reverse Repos A repurchase agreement (commonly known as repo) on the other hand looks more like a secured loan, i.e. one backed by some type of collateral. For example, a firm which wishes to borrow cash can do so by pledging an asset, for example, a government or corporate bond, and agreeing to purchase it at a specified future date at a prearranged price. The counterparty, i.e. the entity which provides the cash, has the right to use the asset until the repurchase date. Typically, repos are used by financial institutions which aim at covering their financing need (e.g. because large outflows occurred). Repos are usually employed for short-term financing needs, with the US market relying mostly on overnight agreements. In contrast, short-dated repos (one month or less) represent about half of total outstanding value in Europe, while prior to the crisis, short-dated repos account for two-thirds of the value. The reduction reflects regulatory pressure on banks to lengthen the duration of liabilities.11 Overall, repos are similar to cash-collateralized securities lending. There are though two major differences between the two: first, repos always have an explicit agreement for a repurchase date, while this is not necessary for securities lending. This makes the latter more flexible for lenders and borrowers. Second, the purpose of the transaction also differs as securities loans are usually motivated by short-selling or trade settlement (market

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making) purposes, while the purpose of a repo is to borrow or lend cash in general. Regarding both transactions, a very important part is that in both Europe and the US, cash collateral pledged for the loan can be further rehypothecated, i.e. be used by banks for their own purposes, usually for additional lending. To this end, investment banks manage “pooled” programmes that group cash collateral from a number of owners and re-invest the cash according to region-specific regulations on rehypothecation. Specifically, in the US a limit of 140% of the customer’s debit balance exists while no such regulations exist in Europe.12 To see how the limit works, suppose a customer has $750 in pledged securities and a debit balance of $300. This means that the customer has borrowed $300 in cash, to which he has pledged an asset worth $750, with a net equity position of $450 ($750−$300). The investment bank can rehypothecate 140% of the pledged collateral, i.e. $420 (140% multiplied by $300). Naturally, the regulation was designed with the purpose of enhancing investor protection when the quality of the collateral is low and hence it is binding only when the pledged asset value is much higher than the value of cash obtained. If the value of the asset in the previous example drops by just $50, to $700 then the regulation is no longer binding as the bank will be able to lend the whole available balance of $400. Similar to the money multiplier, this regulation provides a cap to the amount of cash that can be used for rehypothecation purposes, thus it may also be called the “collateral creation multiplier”. In contrast, there is no limit to collateral creation in Europe, thus collateralized assets can be infinitely used. Accounting-wise, pledged collateral does not appear on a firm’s balance sheet, since the purpose of the balance sheet is to capture the assets and liabilities of a firm during that day. If pledged collateral appears in the balance sheet then it cannot be listed by another firm. In contrast, pledged collateral entries are shown in footnotes simultaneously by several entities.

Brokers and Dealers Investment banks have also been involved into trading in the secondary market (where secondary simply refers to any type of market other than the original issuance of the security, e.g. a stock or bond market) for their own accounts. Essentially, instead of investing on their clients’ behalf, traders used the bank’s surplus cash to speculate in high-yield securities or derivatives. This

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50.0% 45.0% 40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0%

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practice is called proprietary trading and although significantly subdued since the 2008 financial crisis due to regulatory changes,13 was very important to investment banks earlier. The wide range of investment banking services has increased both the banks’ revenues as well as their influence in financial markets. The banks’ influence is especially important to small firms that are unable to borrow without brokers’ or dealers’ intermediation. Figure 6.1 is indicative of this trend: investment banking assets as a percentage of total banking assets grew from 5% in 1980 to a peak of 43% in 2007. Following the large losses faced in the 2007–2009 crisis, assets dropped to approximately 20% of total in 2015. Of the above services provided by investment banks, the ones most related to the real economy are the facilitation of issuance of shares and bonds, the advisory role for mergers and acquisitions as well as the provision of leveraged loans to firms. In contrast, while some firms in the real economy also engage in exchange rate, equity, and interest rate derivatives, the vast majority of these services is addressed, and used by the financial sector. At the other extreme, services providing access to financial markets only adhere to the financial sector,14 of which none has acquired more notoriety than asset securitization and the products that derive from it.

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Notes 1. A bank should also be able to facilitate a loan which would only have monthly payments of interest and a large repayment at the end of the period or accept periodic large payments. However, these bullet and balloon loans respectively, did not fare well in the late-2000s financial crisis. 2. Naturally, there are exceptions to this rule as an investment bank may perceive the firm, and subsequently the bond, to be less risky than it has been originally thought to be. In addition, some investment banks (like the infamous DrexelLambert) focused entirely on issuing low-quality ‘junk’ bonds. 3. Balluck (2015). 4. Ibid., p. 7. 5. Benos and Wetherilt (2012). 6. Crawford and Sen (1996) 7. The interested reader can refer to Hull (2003) for more details about derivative contracts. 8. Dive et al. (2011). 9. Shares represent partial ownership of a firm, to the percentage the holdings amount to the total. 10. Short selling is a trading strategy in which the investor believes that the share is overvalued and expects it to fall. Hence, the investor borrows the equity and sells it, with the purpose of purchasing the back when the price drops, making a profit from the price difference. Naturally, if the price goes up the investor stands to lose from this trade. 11. Source: International Capital Market Association (ICMA) “What are the typical maturities of repos?” Retrieved 18 January 2017. 12. Singh and Aitken (2010). 13. Ibid., 3. 14. Ibid., 3, p. 10.

References Balluck, K. (2015, Q1). Investment banking: Linkages to the real economy and the financial system. Bank of England Quarterly Bulletin. Benos, E., & Wetherilt, A. (2012). The role of designated market makers in the new trading landscape. Bank of England Quarterly Bulletin, 51(4), 343–353. Crawford, G., & Sen, B. (1996). Derivatives for decision makers: Strategic management issues. New York: Wiley. Dive, M., Hodge, R., Jones, C., & Purchase, J. (2011). Developments in the global securities lending market. Bank of England Quarterly Bulletin, 51(3), 224–233.

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Hull, J. C. (2003). Options, futures, and other derivatives. Upper Saddle River, NJ: Prentice Hall. Singh, M., & Aitken, J. (2010). The (sizeable) role of rehypothecation in the shadow banking system (IMF Working Paper No. 172).

7 Banking in Crisis

As you may have guessed or if you were living in almost any part of the world over the past twenty years, as experienced in everyday life, banks do not always do well. There have been many cases, as per Chapters 1 and 2, that banks have performed bad, and were either forced to shut down, merge with another institution, or even rescued using government money. Thus, in this chapter, we will delve more into the reasons banks fail as well as to the effects this can have on the economy. As we discussed in the previous chapters, banks are in the business of fund allocation and are thus important in providing liquidity to the economy, be it to the private or the public sector. Problems in the banking sector can then only originate through its operations, and have been very stable throughout the history of banking: it can either be due to credit allocation gone badly or due to a lack of liquidity. When we say credit allocation gone badly, we essentially mean that a loan receiver is currently unable to repay its debt obligations. Naturally, in any given period of time, a small percentage of a bank’s borrowers is due to face trouble repaying its loans. However, it is to the bank’s best interests if that percentage remains small and that is why banks spend a lot of time and effort trying to estimate probabilities of default for customers and create credit scorings. At times though, it is beyond the banks’ ability to control what is happening in an economy. Take for example the case of Greece: up until October 2009, the country was enjoying a reputation of a relatively reliable borrower, when suddenly,

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the prime minister announced that its government (fiscal) deficit would be much higher than expected, and its debt burden would consequentially also increase.1 Many non-Greek banks were exposed to Greece, as they had heavily invested in the country by purchasing government bonds, back when it was considered to be creditworthy. Thus, when the Greek prime minister made his announcement, banks found themselves in a situation they had been unable to forecast. Nonetheless, the first and most usual reason for a loan to go bad is that banks chose to lend money to people who already had bad credit history. Bad credit history usually means that people had either defaulted on their loans in the past or that they were occupied in high-risk jobs and their salary was not sufficient enough to properly cover the instalment amount. This was the case in the sub-prime lending crisis, where banks chose to lend on people who had very low credit scores, (hence the term “sub-prime”) and that this resulted in significant loan defaults in the coming years. Over time, the accumulation of bad or non-performing loans, as they are more often termed, can result in significant losses for the banks. Before we move to how banks are affected by an increase in bad debts, let us start with some definitions. In most countries, the most straightforward definition of a loan that has repayment issues is when more than 90 days have elapsed since the last day of payment. Since most instalments are paid on a monthly basis, this effectively means that three months have elapsed without any payment. Once a borrower has not paid his instalment for more than 90 days then his loan will be classified as a non-performing one, in which case he will suffer penalties in the form of additional interest and other fees. Naturally, there are other types of loans which require less frequent instalment payments, such as a yearly repayment of interest and a one-off payment of the initial amount later on, similar to a bond. In such cases, the classification into the non-performing category relates more to the bank’s assessment of the borrower’s ability to repay, and to how much that has changed over time. As such, in cases like this, or in the case of a generic prudency check, where a bank can provisionally put a small portion of its portfolio in the non-performing category for the sake of preparing for a bad day, classification becomes more of an art than a precise definition. This is why banks employ a large number of analysts for this job, and why there is a heavy reliance on the future of the economy. Had banks in Greece, to use our previous example, been able to see the fiscal issue coming, then banks would have been more prepared, and less damage would be made to them and, subsequently, to the economy.

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Non-performing Loans and Bank Balance Sheets Thus, the big question is how banks are affected by these non-performing loans and why should we care. The answer is straightforward. As you can remember from the previous chapters, banks create lending and deposits at the same time. In Fig. 7.1, a new loan worth e60 was created, with a corresponding increase in deposits. The increase in deposits will not be found in the bank’s books once the loan balance is withdrawn from the bank, as it will be removed with a corresponding decrease in the banks currency (cash) by e60. This would happen regardless of whether this is a cash or a cashless transaction, given that it simply refers to the available liquidity of the bank. As the reader may infer, given that the period a loan being granted and withdrawn is short, this increase in deposits will not be usually found in the bank’s balance sheet. It is simply depicted here for illustration purposes. As soon as the loan is withdrawn, this money will enter the system as a form of “new deposits”, which will increase the total amount of total deposits in the country, but they will, at the same time, decrease the amount of deposits in the said bank (Fig. 7.2). As we also discussed before, if just one bank exists in the system, then this amount will definitely return to that specific institution. As time elapses and the loan is being repaid, the outstanding amount of the loan is reduced and replaced with an increase in the bank’s cash (currency).

Fig. 7.1 Bank balance sheet when a loan is granted

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180 160 140 120 100 80

Loans (Assets)

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Reserves (Assets)

0 Fig. 7.2 Bank balance sheet after the loan is withdrawn

At the same time, the total amount of deposits in the economy is reduced, given that the money to repay has to come from somewhere if not from the same bank, as is the assumption here. Figure 7.3 shows this situation, where bank deposits remain as they are (we assume here that the client receives the funds to repay the loan from another bank), where the amount of loans outstanding is reduced in half (e30), with the decrease reflected in a corresponding increase in currency. As such, when the loan is being repaid the bank receives the amount back and this ends up replenishing the bank’s liquidity. Hence, the bank is able to continue providing more loans given that these will return to the bank in the form of deposits or that they will be returned as the loan is getting repaid. Notice the link between the borrower and the bank here. The bank places newly created money in the system and increases the amount of deposits, however, the credibility of that money rests effectively on two factors: the bank’s ability to get its money back and the borrower’s ability to repay. Given that the former is just another way of showcasing the latter, all that is left is that the borrower needs to be able to repay for the bank to able to continue with its operations. In the opposite case the bank will be faced with an issue: it has sent out e60 of new deposits in the system but it cannot guarantee that it can actually

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180 160 140 120 100

Loans (Assets)

80 60

Reserves (Assets)

Deposits (LiabiliƟes)

40 20

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0 Fig. 7.3 Bank balance sheet when half the loan is repaid

get the money back. Thus, what happens when a loan goes into the nonperforming category? Have a look at Fig. 7.4. The borrower took a e60 loan but only able to pay out e30. The remainder is placed as a bad loan, a nonperforming one, which means that the bank now recognizes that it will not be able to receive it. What this means that the bank currently has a e30 hole in its balance sheet, meaning that if depositors come en masse to take their money away, a quarter of them will not be able to get their money back. Now, our first reaction is that e30 is a small amount of money, but just consider what would happen if someone told you that a quarter of total deposits in your country would not be honoured. Usual reaction is a rush to the banks, with people demanding their money back, similar to what happened in the Great Depression. Given that banks do not have all of their deposits siting with them at any point in time (remember it’s called fractional reserve banking), then banks would either collapse under the pressure for liquidity or the central bank would need to intervene to give them more liquidity. On the other hand, of course, banks can use their existing capital to counter these losses. In a more realistic scenario, a bank’s balance sheet would look something like Fig. 7.5, where in the liabilities’ column, bank capital would also be included. In essence, the bank’s capital would also reflect the reserves it has on its asset side, to an equivalent amount. However, once a

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140 120 100

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0 Fig. 7.4 Bank balance sheet with NPL

140 120 100

Loans (Assets) Bank Capital (Equity)

80 60 40 20

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Currency (Assets)

0 Fig. 7.5 Bank balance sheet with bank capital

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loan goes bad, the bank has to step in and use its existing reserves in order to ensure that no disruption occurs when someone wishes to take that money. In essence, the banks needs to make good on its “promise” to the remainder of the system that the money is has created in the form of a new deposit, when the loan was originally granted, is still backed by it. To do this, the bank will have to step in and replenish that bad debt (i.e. reserves) with part of its capital, in order to maintain the balance of the quantity of money demanded and supplied. Hence, when a loan turns bad, the bank will face a balance sheet that will look something like Fig. 7.6. In order to cover for the hole in its balance sheet, the bank will have to deal with this by replacing the bad loan with its capital. This would lead us to Fig. 7.7, where, as you can see, the overall bank capital has been reduced by the amount of the bad loan. Hence, total banks assets have been reduced to e90, versus e120 to begin with. The issue here is straightforward again: the bank can absorb as much losses (remember that a bad loan is a loss for the bank) as its bank capital. In fact, it can actually absorb fewer losses, given the current capital ratios. For example, if total assets were e90, and the capital ratio was 10% of total assets, the bank would have faced solvency issues if its capital fell below e9 (more on risk weights and capital ratios later). 140 120 100

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80 60

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40 20

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0 Fig. 7.6 Balance sheet with bank capital and bad loans

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40 20

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0 Fig. 7.7 Using capital to cover bad loans

Provisioning Bad loans do not usually turn bad from one day to another. There are usually signs for this, such as the borrower missing the first and second payments. In fact, there may also be other signals such as wishing to restructure a loan because they cannot afford to repay, seeking extensions, and so on. To address this, the bank usually starts using what is known as the provision for bad loans. Provisioning means that the bank starts allocating an amount from the bank’s capital to counter any potential losses it may have from the loan. In the previous example, the bank would have started provisioning for the bad loan as soon as any event that triggered its belief that it will end proper repayment took place. Hence, it would have started by, e.g. moving e10 from the loan balance to provisions, then another e5 if the situation continued, until finally the whole amount was moved to provisions and removed from the outstanding loan balance. The significance of provisions is that it allows banks not to deduct the amount directly from their capital, until what happens with the loan is fully resolved. For example, if at the end of the day the borrower agreed to pay e15 and then he was declared bankrupt, there would have been no need for the bank to deduct the full, e30 balance from its capital, as was the case between Figs. 7.6 and 7.7. This would have been the case also if the borrower

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had some sort of collateral for the loan, e.g. a car or a house. In that case, provisions would have been smaller given that the bank would repossess the item and sell it to cover as much of its losses as possible. As such, the bank’s balance sheet would have looked something like Fig. 7.8. The inclusion of a loan in provisions, while better than fully writing it off through a reduction in bank capital is not something that should be taken lightly. In contrast, bank loans for which specific provisions were made usually end up as bad loans and, after any collateral is repossessed, the remainder is written off the bank’s capital. Naturally, what we refer to here is for a specific loan. If provisioning is done collectively, i.e. if the bank expects that, say, 2% of its loans will end up as non-performing on the basis of previous history, then provisioning is generic, i.e. the 2% amount is transferred to the provisions account without signalling any specific loan. As one expects, the difference between the actual amount the bank will receive from the loan (i.e. loan after provisions are deducted) and the outstanding amount of the loan on the bank’s balance sheet, represents a loss for the bank. In normal times, this difference goes to the profit and loss account of the bank, and is deducted from any gains the bank has generated over that period. For example, if collective losses from provisioning within a year are e1,000 and total operating profit was at e1,500, then (supposing for simplicity that no other expenses were left out) net profit for the bank 140 120 100

Provision for Bad Loan Bank Capital (Equity)

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0 Fig. 7.8 Bank balance sheet with provisioning

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would have amounted to e500. In this case, the bank does not have to write off capital, given that it has generated enough income to cover for the losses. The remaining e500, i.e. the net profit, can now be either distributed as dividend, used to expand or maintain operations, or simply used to create more reserves. The latter choice would have been the soundest one, however, banks also need to have a look at both their operations as well as take care of their shareholders. Basically, while banks could allocate more of their gains to reserves, they usually need to use more of them to establish their presence and gain market share. As you can expect, bigger banks are more prone to such issues, given the extent of global competition. On the contrary, smaller banks only have to worry about a very small number of branches and customers compared to larger institutions, which usually takes much less to maintain. Hence, if properly managed, smaller banks could potentially have a better reserve position and greater resilience to bad loan shocks. More on this later on in the chapter. In general, what provisioning does is allowing the bank to spread out its potential losses over a period where they can be countered off using operating profit (see next paragraph) and hence preserve their capital. Had this not been the case, banks would have to issue more capital when a large number of losses hit them and then have excess capital when times were good. Basically, what provisioning does is allow for a better scheduling of capital issuance (or profit retention/reserve creation) by letting the bank use its operating profits to cover for any adverse effects with regard to loan granting.

NPLs: From Banks to the Economy The effects non-performing loans have on bank balance sheets spill over to the rest of the economy. The bank’s ability to lend is, as discussed before, proportional to the capital it has. If the bank’s capital base is reduced because of higher non-performing loans, then it will no longer be able to lend the same amount as it did in the past. Furthermore, if the hole is large enough, the bank may pause loan granting as it will need to withdraw liquidity from the economy in order to be able to continue operating and meet its regulatory criteria. To illustrate these criteria, an example is required. Firstly, given that risk is not uniform in all types of loans there are different risk weights assigned to different loan categories.2 To this end, the Basel Accords, which refer to a set of recommendations on banking regulations by 12 countries, sought to provide a more explicit way of measuring risk.3 In particular, in the second

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meeting of the Basel Committee on Banking Supervision, more commonly known as the Basel II accord, a standardized approach to credit risk (i.e. the risk that the counterparty will not be able to meet their debt obligations) was reached. With regard to credit risk, Basel II suggests that holding sovereign bonds of states which have a AAA rating, will be assigned a 0% risk weight, as the probability that the state will default on its risk is nearly zero. On the other hand, overdrafts, auto loans, personal finance, small business, and credit card loans all carry a risk weight of 75%. For loans with a residential real estate collateral the risk weight is 35%, while for loans with commercial real estate as collateral the risk weight is 100%. Finally, for non-performing loans, the level stands at 150% if provisions for the particular non-performing loans are less than 20%, while they reduce to 100% if provisions exceed 20%. Hence, as you can observe, higher non-performing loans can have a stronger effect on the bank’s ability to extend more credit than simple mortgages. In an example, having a e300 mortgage loan, on e60 worth of bank capital would mean that the capital ratio would stand at e300 multiplied by 35%, yielding e105. This will be the denominator, with the numerator being the total amount of bank capital, i.e. e60. This would suggest a 57.1% capital ratio (Eq. 7.1). Equation 7.1—CAPITAL RATIO Capital Ratio =

60 = 57.1% 300 ∗ 35%

If the capital requirement was 15%, then the bank would still be able to issue more loans. Now, if the loan becomes a non-performing one, then the risk weight would jump to 150%, meaning that the denominator becomes e450 instead of e105. Even though the bank’s capital did not change, and neither did it issue any more loans, the capital ratio of the bank would still shrink to 13.3%, effectively prohibiting it from granting any new loans. In fact, the bank would most likely need to get back liquidity, either from loan repayments or from issuing capital, in order to continue with its operations. If this happens, the liquidity in the economy will dry out, suggesting that some firms or individuals could face a liquidity issue. In other words, firms may not be able to operate as smoothly as in the past, given that they will not be able to get the funds they need to continue with their operations. This could have significant effect on the economy as it could lead to a downwards spiral of lower lending and higher non-performing loans (e.g. Great Depression, Japan’s lost decade, and the Great Recession) which can permanently affect the viability of the economy. For these reasons, the level

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of non-performing loans needs to be properly monitored and assessed on a regular basis from both the bank and its regulator. Naturally, despite the banks’ and the regulators best efforts, there are times when banks cannot predict a worsening of the economic environment. More so, banks may not be well prepared for a worsening hence adding to the already dire situation. In this case, banks can go out to the market for new capital; however, given the prevailing level of pessimism of the economy at the time, securing new funds is not likely. In such situations, banks battle with insolvency and can be either merged with another institution, cease their operations, or receive bailout money from the government or the central bank. An additional possibility is a bail-in, where banks are salvaged using their depositors and bondholders funds. The next section will deal with these issues.

Insolvency Insolvency occurs in the case where a bank is unable to meet its obligations to depositors and others (e.g. bond holders).4 In other words, when the bank has so many non-performing loans, or has, in general, been faced with so many losses that its existing capital is not sufficient enough to cover for them, given the capital requirements (severely undercapitalized in FDIC parlance), then it is considered as a failing institution. What happens in this case is that the national authority that guarantees lending in the country (e.g. the FDIC for the US), comes in and takes everything over. By taking over, we effectively mean that the bank is sold off to the highest bidder, i.e. another banking institution, which has agreed to purchase the available assets (usually loans), with the authority using the proceeds to settle as many of the bank’s liabilities. In most cases, authorities aim for the acquiring bank to obtain both the loans and the deposits of the failed bank, in order for the authority not to use the deposit guarantee scheme. This has been one of the most popular ways for a bank to be liquidated in the past. In the case of well-organized authority, which is what most developed economies have, a bank could close its business on Friday and reopen on Monday under the name of the acquiring bank. Naturally, the full transition would depend on the complexity of the failed bank’s structure and could take months until everything is fully integrated. Still, this would not prevent customers from conducting their business as before. There are times, of course, when the asset side of a failed institution is so bad that no buyer exists. As the FDIC shows, about 6% of bank failures from

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2000 to 2016, no buyer was available for the bank.5 If this happens, then the national authority tries to offer just the deposit accounts for sale, in the hope that the additional liquidity could lure in interested buyers. If again a buyer is not found, then what is left is that the national authority issues a check for insured deposit amount per person, and tries to help account holders to move their funds to other banks as best they can. In the words of the FDIC, “Liquidation requires the FDIC, in its capacity as receiver of the failed financial institution, to pay off insured depositors up to the current insured amount and dispose of the assets, if no acceptable bids are received. If an acceptable bid is received, all deposits or insured deposits are transferred to the acquiring institution”.6 The decision to resolve or sell a financial institution depends on the “least cost principle”, where the cost of liquidating the failing financial institution is compared to the costs of bids received from other interested institutions.7 The case for liquidation is usually selected for smaller banks or ones in which retail presence is very small, like banks with many institutional investors. Bank failures are more common than we expect, at least in the US. As data from the FDIC show, there have been around 559 bank failures from 2001 to 2020, with the most taking place during the global financial crisis period (Fig. 7.9). In particular, 297 institutions failed during 2009 and 2010, around 4% of the total number of institutions. At the moment, it appears that around 5,000 FDIC-covered institutions operate in the US, down from the almost 10,000 that existed in 2002.8 400.0

180

350.0

160 140

300.0

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250.0

100 200.0 80 150.0

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Total Assets (LeŌ Axis)

Fig. 7.9 Bank failures in the US

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In general, while bank failures are relatively common, and even though in some cases the institutions are large enough to have an impact on the economy, the role of national authorities has been critical in safeguarding the economy and depositors from further damage. At the same time, the transition of depositors from one institution to another has usually been relatively smooth, without causing any major distortion to the households and firms using the bank. Nonetheless, there are times when some financial institutions cannot be allowed to fail, because they are too large and their breakdown could have a strong effect on the functioning of the economy, while at the same time, selling them off to another big institution may not be a good idea since it would create mega-institutions with monopoly power of the sector. In those cases, it is less costly to the authorities to just extend the amount necessary to continue with their operations, usually in the form of a loan, or in exchange for an equity share. Naturally, this would happen when the bank is at a level where it would just require some additional funds to continue operating and not all hope has been lost. In such cases, the bank is named as a “systemic” institution, also colloquially known as “Too Big to Fail”.

Too Big to Fail The first bank to be seen as a “Too Big to Fail” institution was the Continental Illinois National Bank and Trust Company in the US, which failed in 1984. At the time, it was the seventh largest bank in the country, with approximately $40 billion in assets, and was the largest bank failure in US history, until the Great Recession.9 Continental Illinois had invested in risky loans, notably by purchasing loans from another bank which were given to energy-related projects, while at the same time it had invested in developing countries which experienced a debt crisis in mid-1982. When the bank’s non-performing loans surged to $2.3 billion in early 1984, rumours of the bank’s insolvency caused a bank run, with depositors withdrawing $10.8 billion from a total of $28.3 billion. As sources note, of the $28.3 billion, around $20.7 billion were not insured by the FDIC, hence the rationale behind the bank run.10 The Federal Reserve acted swiftly by allowing Continental Illinois to borrow $3.6 billion, acting as the banking system’s “lender of last resort”. The term, which dates back to William Bagehot in the 1870s, suggests that in order to stabilize the system, central banks should provide “very large loans at very high rates” where a liquidity drain appears in the system.11 Bagehot

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went a step further, and suggested what would become a policy norm in the twenty-first century, namely that central banks should lend “to merchants, to minor bankers, to ‘this and that man’, whenever the security is good”. Of course, what should be emphasized here is the “whenever the security is good”, meaning that a central bank should lend but only when the borrower can offer something of value in return, such as government bonds. In such cases, when the risk to the central bank is minimal given the value of the collateral, lending can be easily extended. The issue with Continental Illinois was that it was strongly connected with other banks. In fact, the FDIC had estimated that around 2,300 banks had invested in Continental Illinois, with nearly half of them having deposits of more than the deposit insurance level of the time ($100,000). Most importantly, 179 of those banks had amounts equal to half their equity was outstanding deposits in Continental Illinois. Put simply, if Continental Illinois went down, at least 179 more banks would immediately default, with many others also experiencing heavy losses. Thus, the failure toll would have significantly increased in the months to come, putting a strain to the overall financial system. As a result of this “systemic” fear, the FDIC went forth to announce a $1.5 billion capital infusion into the bank, just a few days after the Federal Reserve had extended a line of credit. Going even further, the FDIC announced that it would guarantee all creditors, including those with deposits of more than the deposit guarantee limit. As time went by and no buyer was found, the FDIC provided permanent assistance by purchasing $4.5 billion of bad loans from the bank. At the end of the day, all bondholders and depositors of the bank were fully protected, while stockowners lost everything. Continental Illinois continued to function under government ownership until 1991, when the government exited its stake. In 1994, Bank of America purchased the bank.12 The Continental Illinois case was the first time a large institution came close to failure. Prior to that, the average size of a liquidated bank was $65 million. As authorities feared the worst for the US banking system, they chose an option that offered them stability at the cost of having to “bail out” the bank out of the central bank’s pockets. The Continental Illinois case however, set an alarming precedent: when you get large enough, the central bank will have to bail you out. This means that banks could potentially assume more risk, under the assumption that their bondholders will not lose their whole investment and depositors will not be hurt. Obtaining an equity stake in large corporations was a theme that not only persisted by expanded in the Great Recession: the Troubled Asset Relief

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Program (TARP) was designed in such a way that banks would issue preferred stocks and the US Treasury would buy this. This would boost bank capital (as preferred shares go to the numerator in addition to bank equity) and thus allow the banks to absorb more losses. More than $200 billion was spent on supporting financial companies, with another 50–60 billion spent on non-financial institutions. While this could be viewed as a bad thing, it was nonetheless quite profitable for the US Treasury, as most banks repaid TARP money using capital raised from the issuance of equity securities. For example, the Treasury made a $12 billion profit in a $45 billion loan to Citigroup,13 while the Treasury also made a profit on the loans it gave to AIG.14 Overall, total profits from the $636 billion outflows were $121 billion, marking this as a highly lucrative investment for the US Treasury.15 While some critics have questioned whether the programme has been successful or whether banks chose to exploit it for acquisition purposes, it still remains that acting as a lender of last resort prevents the economy from experiencing a meltdown, and can add a significant amount of liquidity to the market in periods where the private initiative is not as strong. In addition to stabilizing the financial sector, it is commonly agreed that without TARP, unemployment would have been much higher.16 The only potential issue with bailing out systemic or too big to fail institutions, relates to the moral hazard issues, which means that systemic banks, knowing they are large enough to be saved, assume more risk as they have limited downside: if the risk pays off, banks will get more profit; if it doesn’t the authorities will bail them out. As such, one could argue that it would be better if no systemic institutions existed. Naturally, the administrative cost for regulating a large number of smaller banks may be larger than just a few large ones. On the other hand, the cost for financial stability may be much less than having huge institutions operating, especially when they reach a “too big to fail” status. Still, management is key in any situation: under proper management, no major surprises should be expected, especially if banks are prudent in their provisioning process and their reserve policy. What should be remembered here is that during the savings and loans crisis, when a large number of institutions went bankrupt, no rescue was made, given that none of them was large enough to cause any issues to the system. Comments regarding the banks needing economies of scale, i.e. becoming more efficient when they are larger, do not appear to hold in practice.17 In fact, evidence has shown that larger banks experience decreasing returns to scale,18 or are, at best constant.19 Other studies have found that foreign banks can be less efficient than domestic ones.20 In general, what can be taken

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from the overall contributions of the literature on the topic is that banks are not really the most efficient institutions, regardless of their size, and one of the major issues that they need to resolve is the rationalisation of bank branches.21 What really matters here is lobbying to get what you need, with banks proving that they have mastered this art better than anyone else has: from 1998 to 2011, the finance, insurance, and real estate (FIRE) sector spent $6.8 billion on federal lobbying and campaign contributions in the US.22 Since 2016, more than half a billion was spent on lobbying for the FIRE sector.23 Politicians, who do not want to lose any of those contributions, will likely continue to support the policies promoted by banks, which can go against financial stability. Please note that such politicians are not corrupt: lobbying is a legal form of offering money (“donations”) in exchange for getting listened to when they wish—in general, there are ways in which lobbying can and has helped the overall society.24 Naturally, whether lobbying means politicians will simply act on what they are asked or whether it refers only to the exchange of ideas and an opportunity to hear the other side’s view, is, of course, a topic that relates to the politician involved. Nonetheless, the whole point is whether the administrative strain of regulating a few large banks can compensate the moral hazard issue of the “too big to fail” dogma. If this is the case, then, by reduction ad absurdum, having just one large bank would be best for the economy. Of course, then we would enter other sorts of issues such as the bank interfering with politics and vice versa, leading to all sorts of corruption issues.25 Hence, while this is definitely an undesired state, the question which arises is how big can banks be without being too big to fail? The answer, as simply as possible, likely lies in the fact that the smaller banks are the less the systemic danger. While this does not mean “one town – one bank”, it does suggest that, since the criteria for being a systemic institution are well established,26 all that is left is to set a maximum size level a bank can reach. Naturally, the criteria can vary by country; however, the principle of having smaller institutions, to the extent where their monitoring does not become an administrative nightmare, can remain as one of the pillars of financial stability. What should be remembered from the above is that a bailout of banking institutions is not bad per se. At times, saving an institution can be much better than the cost of seeing the whole sector go down as interconnections between banks force huge losses to spread fast. Still, moral hazard issues are present, namely that institution which feel they have reached “too big to fail” size, can take on more risk than they would have otherwise done. This could

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potentially be resolved by placing caps on the banks’ size, or the rescuing of a bank could also take place using a different mechanism, namely the “bail in”.

The Bail-In The only case of a “bail in” of unsecured depositors took place was in Cyprus in 2013. In particular, Cyprus, a member of the European Union, was unable to use a bailout to save its banks as its existing government debt was already too high. As such, it came to an agreement with the relevant European authorities that it would conduct a “bail in”, meaning that all unsecured depositors would suffer a haircut of their deposits in order to create capital for the bank. The authorities went the other way here: instead of increasing bank capital to support the money creation extended by the banks in previous years, they sought to decrease the outstanding amount of money by decreasing deposits. At the same time, as these were turned into bank capital, the bank’s ability to support the outstanding liquidity of the economy was improved. The “bail in” is a hybrid between bailing out the bank (i.e. saving it) and allowing it to collapse (i.e. where unsecured depositors lose their money). By combining the two, there is little public sector involvement, hence resolving the moral hazard issue, while the systemic institution continue to live to fight another day. Nonetheless, other questions arise, namely, whether depositors have any way of understanding whether an institution is facing difficulties or not. This unprecedented case was met with horror as this had been the first time depositors were forced to pay for their bank’s mishaps. Ironically, there would have been much less upheaval if the authorities had decided to just close the bank down and allow for the depositors to get just a percentage of their money. What messed things up was the fact that the bank would continue to operate and hence it was “unthinkable” that depositors have to bear any losses. Still, this was not without any repercussions: the Cyprus economy, already in a recession since 2012, remained there until 2015, while nonperforming loans skyrocketed to more than 50% of loans. Nonetheless, an improvement in the overall macroeconomic situation ensued as the economy adjusted to this new situation after 2–3 years of a downturn.27 While Cyprus is the only country in which a bail-in was officially used, the topic has attracted global attention, with the Financial Stability Board issuing guidance and a number of principles for authorities to consider as they develop plans for the effective execution of bail-in resolution strategies

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for global systemically important banks.28 Nonetheless, there has thus far not been any other use of the bail-in mechanism, notably due to the absence of a major banking crisis around the world since 2009. Overall, when banks are faced with issues, which arise when capital levels plunge, authorities can either support or let them fail. In the latter case, either the bank is sold off to the highest bidder or the authority liquidates it and offers the depositors a cheque with their amount of deposits. If the authorities choose to support it, then they can either bail out the bank, i.e. grant loans and guarantees to it, or bail in the bank, i.e. using unsecured depositors’ money to capitalize it. In either case, the political cost is large, with the public not seeing either option as favourable. Hence, like medicine, prevention or early detection is key, allowing the authorities to resolve the potential issues without pursuing any such strategies.

Notes 1. Report on Greek government deficit and debt statistics. European Commission, January 2010. 2. Basel II: International Convergence of Capital Measurement and Capital Standards: a Revised Framework, Comprehensive Version (BCBS) (June 2006 Revision). 3. Basel Committee on Banking Supervision: https://www.bis.org/bcbs/. 4. https://www.fdic.gov/consumers/banking/facts/. 5. https://www.bankrate.com/banking/heres-what-happens-when-your-bank-is-liq uidated/. 6. FDIC Resolutions Handbook https://www.fdic.gov/bank/historical/reshan dbook/resolutions-handbook.pdf#nameddest=Ch2. 7. Deslandes et al. (2019). 8. Source: https://www.fdic.gov/bank/statistical/stats/2020mar/industry.pdf. 9. Haltom (2013). 10. Furlong (1984). 11. Bagehot (1873). 12. Ibid., 8. 13. U.S. exits Citigroup stake and earns $12 billion profit https://www.reuters.com/ article/us-citigroup-treasury-offering-idUSTRE6B55KP20101207. 14. Treasury Sells Final Shares of AIG Common Stock, Positive Return on Overall AIG Commitment Reaches $22.7 Billion https://www.treasury.gov/press-cen ter/press-releases/Pages/tg1796.aspx. 15. Paul Kiel and Dan Nguyen, Bailout Tracker: Tracking Every Dollar and Every Recipient, ProPublica (published April 15, 2009; updated March 19, 2020). https://projects.propublica.org/bailout/.

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16. A pool of economists was asked whether unemployment would have been higher if the measures were not implemented. The overall consensus was in agreement with that statement. https://www.igmchicago.org/surveys/bank-bai louts/. 17. Aly et al. (1990) show that branching and non-branching have the same amount of efficiency and large banks are more efficient only when it comes to the allocation of funds. 18. Miller and Noulas (1996). 19. Brissimis et al. (2010). 20. Sathye (2001). 21. Huljak et al. (2019). 22. https://www.huffpost.com/entry/auction-2012-banks-lobby-washington_n_ 1240762. 23. https://www.opensecrets.org/federal-lobbying/sectors/summary?cycle=2019& id=F. 24. Peterson and Pfitzer (2009). 25. In fact, such issues are expected to arise endogenously as Shleifer and Vishny (1994) show. 26. “Global systemically important banks: updated assessment methodology and the higher loss absorbency requirement”, Bank of International Settlements. 27. For more on the Cyprus bail in, see Michaelides and Orphanides (2016). 28. Principles on Bail-in Execution, Financial Stability Board, 21 June 2018. Accessed at: https://www.fsb.org/2018/06/principles-on-bail-in-execution-2/.

References Aly, H. Y., Grabowski, R., Pasurka, C., & Rangan, N. (1990). Technical, scale, and allocative efficiencies in US banking: An empirical investigation. The review of economics and statistics, 72(2), 211–218. Bagehot, W. (2008 [1873]). Lombard street: A description of the money market. NuVision Brissimis, S. N., Delis, M. D., & Tsionas, E. G. (2010). Technical and allocative efficiency in European banking. European Journal of Operational Research, 204 (1), 153–163. Deslandes, J., Dias, C., & Magnus, M. (2019, February). Liquidation of banks: Towards an ‘FDIC’ for the banking union? Economic governance support unit. Directorate-General for Internal Policies, PE 634.385. Furlong, F. (1984, August 31). Market responses to continental Illinois. Federal Reserve Bank of San Francisco Weekly Letter. Haltom, R. (2013, November 22). Failure of continental Illinois. Federal Reserve History.

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Huljak, I., Martin, R., & Moccero, D. (2019). The cost-efficiency and productivity growth of euro area banks (European Central Bank Working Paper Series, August, No. 2305). Michaelides, A., & Orphanides, A. (Eds.). (2016). The cyprus bail-in: Policy lessons from the cyprus economic crisis. London: World Scientific. Miller, S. M., & Noulas, A. G. (1996). The technical efficiency of large bank production. Journal of Banking & Finance, 20 (3), 495–509. Peterson, K., & Pfitzer, M. (2009, Winter). Lobbying for good. Stanford Social Innovation Review. Sathye, M. (2001). X-efficiency in Australian banking: An empirical investigation. Journal of Banking & Finance, 25 (3), 613–630. Shleifer, A., & Vishny, R. W. (1994). Politicians and firms. The Quarterly Journal of Economics, 109 (4), 995–1025.

8 Financial Instability

The Financial Instability Hypothesis (FIH) was developed by Hyman Minsky1 in the 1970s and 1980s, with the aim of answer the question of whether “it”, i.e. a Great Depression-like event, could happen again. Following up on this, a side-question was that if “it” can happen, why “it” didn’t occur in the years since World War II. Hence, the FIH focused on providing a better understanding of the causes of financial instability, mainly in sophisticated modern economies. The essence of his hypothesis lies in the argument that financial crises are inherent in the modern economic system. In periods of prolonged economic prosperity and high optimism for future prospects, financial institutions invest in riskier assets while borrowers and lenders are encouraged to be more and more reckless. This reckless behaviour makes the economic system more vulnerable, especially in the case that default materializes. Hence, the overall cycle of exuberance and prosperity of the modern, bank-based, economy makes it subject to booms and busts.2 Eventually, when distress happens, if the financial system is too highly leveraged, it is at the risk of a systemic collapse. As investors begin to realize this, they seek to reduce their exposure by selling out their existing positions. This leads to liquidity drying out and to a fall in asset prices, followed by a contraction in income and a decrease in employment. This cycle makes the economy inherently unstable, thus, this type of market failure is in need of government regulation. Naturally, the lack of proper regulation would

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warrant the need for government intervention once this worst-case scenario materializes.3 In order to understand the FIH, it is key to distinguish between three income-debt relations for economic units.4 First, hedge finance units, can fully validate their debts out of current cash flows. Second, speculative finance units can merely meet their payment commitments, by covering only interest. Third, Ponzi finance units do not have enough cash flow income to meet their debt service requirements, are thus unable to cover interest payments. As such, a Ponzi unit borrows to cover interest payments.5 When speculative and Ponzi finance dominate the economy, there is greater likelihood that “the economy is a deviation amplifying system”.6 What this suggests is that, as a result of the increase in speculation, the economy will tend to amplify the impact from any potential moves, due to the increase in lending. A simple explanation for this is that leverage tends to boost returns in both directions (negative or positive), and hence this can have the same impact on the economy. As leverage continues to rise, the deviation from the underlying economic fundamentals increases, hence the term “deviation-amplifying” system. Had only hedge units existed in such an economy, then the feedback loop would have been deviation-reducing and assist in maintaining a steady system functioning. On the other hand, a deviation amplifying feedback loop serves to change the system functioning through growth and development. Naturally, the “deviation amplifying system” is neither the starting point nor a permanent state of the economy. For Ponzi and speculative units to dominate, we first need some specific economic circumstances to take hold. Unfortunately for the prevalent economic setup, these circumstances are not very difficult to take place. In particular, the setup of instability is as follows: initially, an economy is in a phase of strong economic growth, the tranquil period, as Minsky refers to it, which however carries debts from previous cycles. In this tranquil period, there is low inflation, rising employment and a general perception of prosperity. The financial structure in a euphoric economy is dominated by hedge finance units.7 As the period of economic growth prevails, financial institutions relax the lending criteria that were considered vigilant in the past, thus they become overconfident in terms of who they lend to.8 In the same respect, other economic agents (e.g. households and corporations), also tend to assume more speculative behaviours, which fall into the second and third debtincome relations. This behaviour is boosted by the fact that, in the recent past, as a result of the persistent economic growth, investments were highly

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Fig. 8.1 Phase 1, economic boom (hedge lending)

Fig. 8.2 Phase 2, economic bust (Ponzi lending)

lucrative, and thus they expect higher profits, even from the riskiest of investments. This phenomenon, known as short memory, suggests that while agents tend to look in the past, they only look at the recent past and tend to ignore longer horizons.9 Principally, the FIH consists of two phases, related to the boom (Fig. 8.1) and the bust cycle of asset prices (Fig. 8.2). In the boom phase, asset prices, such as property prices in the case of the Great Recession (Fig. 8.3), rise, and, as a result, investors form the expectation of future price increases.10 Given that the behaviour of an economy depends on the pace of investment, the investors’ willingness to finance their projects using debt depends on the

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expectation that this investment will have high enough future cash flows to repay the loan. This increases demand for credit (Figs. 8.4 and 8.5) at a time when commercial banks are more willing to lend to borrowers as they likewise have the expectation of higher profits. Banks in the Financial Instability Hypothesis, unlike most other economic theories, are considered as profit-seeking

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institutions. In this sense, expectations become crucial when it comes to explaining asset price cycles.11 Driven by this profit-seeking (or profit maximization) behaviour, but constrained by their ability to lend to borrowers, as money is a scarce commodity and they need to adhere to their capital ratios, banks begin to slowly expand lending to hedge units. As the expectations of higher profits for firms become embedded in their behaviour, banks also follow suit. In this case, higher risk always equates with higher profits as the probability of not getting their money back is limited. This is further reinforced by the fact that many loans are collateralized by assets, whose price is also rising during the boom phase. As a result, lending to speculative and eventually Ponzi schemes becomes greater. Eventually, once over-lending to speculative and Ponzi schemes increases enough, the economy’s resilience to shocks is reduced. As such, when asset prices start falling (either endogenously because the market cannot sustain any more expansion, or exogenously due to an unexpected shock such as the coronavirus shock in 2020), lenders tighten their lending criteria (Fig. 8.6) and the market supply of loans deflates, leading to the bust phase. The drop in asset prices will lead to a rise in non-performing loans, which will hit commercial banks’ capital reserves and profits. If the crisis is severe enough, this might cause a financial system failure, as a result of bank insolvencies and the loss of liquidity. In a systematic credit boom, financial markets may not only limit lending to people but also limit

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borrowing to each other. Naturally, if an unexpected negative shock takes place during the hedge-unit financing period where banks only lend to units that can repay their debts out of their cash flows, then the impact on the economy will be smaller. A recent example is the Great Moderation period in the US, which led to the global financial crisis of 2007–2009 (Fig. 8.3). The Great Moderation refers to a period of unusually low macroeconomic volatility, i.e. suggesting stable growth rates, with very few and short-lived recessions.12 When referring to the Great Moderation, we generally point out to the years between 1986 and 2006, right before the sub-prime mortgage crisis. This lengthy economic period is characterized by low inflation, positive economic growth as well as rising of asset prices (Fig. 8.3). As a result of this period of economic exuberance, activities financed by debts increase, which in turn, raises the market price of capital assets. Given that, the behaviour of an economy largely depends on the pace of investment, the increase debt-financed investments can lead to a lending boom, with the rationale for increasing lending (falsely) supported by the previous phase, which was dominated by hedge units. The Great Recession is a recent example of the lending boom described previously. Because of the increase in the supply of credit through new loans, there is an increase of the banking system’s leverage, transforming the economy into a boom economy.13 An economy can be characterized as a

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boom economy in a period when there is rapid economic expansion measured by high GDP growth rates. This eventually leads to lower unemployment, higher inflation which is also reflected in asset prices. In the case of the Great Moderation period, this higher inflation rate was recorded in house prices, which grew by an average rate of 5.6% annually. As stated previously, the credit boom drives economic growth in the form of a short-term increase in GDP and a significant increase in asset prices. At the same time, Speculative- and Ponzi-financed activities rise, leading to an increase in the private debt-to-GDP ratio (Fig. 8.7). However, Ponzi-financed activities cannot continue operating without limit and eventually fail, either endogenously, or with the “help” of an external event. If the debt burden rises significantly, or if it is focused on particular sectors, then even small increases in bad debts can make the system extremely unstable.14 Once this moment comes (dubbed “Minsky moment” by market participants), the failure of a number of firms can decrease investments, which lowers the expected profits and thus the amount of credit that financial institutions is willing to extend. Overall, what the financial instability hypothesis tells us is that the “(…) economy endogenously generates a financial structure which is susceptible to financial crises”.15 Even when markets operate normally, it ultimately results to a credit boom that leads sooner or later to financial crises and depressions. Ironically, while the effort of central banks is to protect the economy from a potential loss of income, if a period of growth and exuberance continues

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for long, then the eventual crisis could be much stronger than ones occurring more often. Naturally, this is a conjecture which cannot be easily validated.

International Instability: Cyprus Empirical evidence of the Financial Instability Hypothesis can also be found in other countries beyond the US. For example, Cyprus’ housing bubble incident is a solid case in which the boom cycle in real estate prices, after a continuous period of growth from 1975 until 2007, led to an overwhelming increase in loans, also facilitated by the inflow of foreign deposits. During the period when Ponzi units dominated the economy and banks lent based on collateral and not based on repayment ability, non-performing loans started to grow. This was, however not properly documented in the banks’ balance sheets due to the perceived well-collateralization (i.e. because they were collateralized with real estate whose prices had been rising for more than 20 years). However, despite the potential for the boom phase to run for a long period of time, the end of foreign flows to the country after the global financial crisis led to the burst cycle of falling asset prices, deteriorating bank balance sheets and overall tighter lending conditions.16 The outcome was the worst economic burst in the history of the island during peace time, and one which culminated in the bail-in of unsecured deposits. Prior to 2008, the economy of Cyprus was in a euphoric period of economic growth and expansion characterized by low unemployment and general economic stability where house prices were continuously rising (Fig. 8.8—solid line, left axis).17 Up to 2004, when the country joined the EU, demand and supply for real assets were mainly driven by domestic residents, with only a few outside investors. As a result, house prices were relatively stable, and always in an upwards trend. Still, most lending was offered to creditworthy individuals which used mortgages to purchase their main residence. When Cyprus entered the European Union in 2004, more European foreign investors were motivated into coming in the country and investing in houses. This, in combination with the economic stability in the country, increased demand for houses and their prices kept increasing progressively.18 Investors, witnessing housing prices continually increasing, grew the expectations of more future rises in the prices. This in turn, nudged them into investing in the housing market, in order to make a profit from a future

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sale. As a result, demand increased even more and an accelerating amount of investors grew interested in the housing market, both foreign as well as local. Financial institutions, used to the culture of perpetually growing house prices, were alerted by the increased demand also grew expectations of future profits, driving them to more and more relaxed lending criteria. What is important to note is that loans were made with land as collateral, which in combination with the increased loans simplified the lending process even more. This was also aided by ample bank liquidity, as foreign capital came from abroad, attracted by the high interest rates required to support the continuous inflow of deposits. Banks felt “safer” giving out the excessive amount of loans with collateralization and investors were encouraged by the ease of taking a loan, to take more and more. This investing behaviour finally led to a lending boom that finally revealed a bubble in house market prices that eventually busted. Speculative and Ponzi units now dominated in the economy leading to the insolvency of financial institutions, with a large amount of loans becoming non-performing when house prices began to drop. This, eventually led to the bursting of the housing market bubble which, in its turn forced the banking sector into increasing its non-performing loans to the highest level in the world for a few years (as a percentage of total loans). As the market entered the bust phase, and liquidity was withheld from the market, the economy entered its largest recession period in peacetime. Banks have since been faced with huge losses and have issued new capital to support their operations a few times. At the moment, the nation’s economy appears to

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have roughly stabilized, as banks shifted their focus to funding hedge units, i.e. those with an ability to repay their loans from cash flow.

Financial Instability in Japan Empirical evidence of the Financial Instability Hypothesis can also be found in Japan, where an asset bubble period led to what is most known in the economic history of the country as the “Lost decade”, running from 1991 to 2001.19 In the years between 1986 and 1991, the country faced an asset price bubble which increased land prices by 150% (Fig. 8.9). This enormous increase, led to a balance sheet recession, driven by a collapse in land and stock prices, causing Japanese firms to become insolvent.20 The asset price bubble, most likely affected by a huge inflow of foreign capital,21 was also assisted from the relaxed economic policy followed by Japan’s Central Bank at the time. The Bank pushed the country’s policy interest rate lower during the bubble (Fig. 8.10), counter to what one would expect. The decrease in interest rates increased demand for lending which helped to further inflate the bubble. Increased demand for lending, coupled with the exorbitant rise in property prices, which made them attractive as collateral, led to Japan’s commercial banks following what is known as the “window guidance” tactic, i.e. they did not take into consideration the quality of the borrower when deciding who to lend to.22 This increase in lending, in turn, pushed investment and spending higher, which led to an average growth rate of nearly 5% in the 1985–1989 period 25.0% 20.0% 15.0% 10.0% 5.0% 0.0%

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(Fig. 8.11). This is followed by a sharp drop in 1991 and 1992 as the Nikkei, which had increased threefold from January 1986 to December 1989, went down by more than 40% in the coming two years. Land prices soon followed, starting their decline in the last quarters of 1991 and then registering a 7% decline in 1992, as real GDP declined by 0.52% in 1992. From 1993 onwards, GDP moved up and down repeatedly, with the average growth rate in the 1993–2007 period standing at 1.15%, ranging from −1.13% in 1998 to 3.10% in 1995. The banking sector was at the core of the bubble and the bust, and is most likely the reason why despite the generous spending from the Japanese government, which tripled its annual fiscal deficit from 1991 until 1995, did 8.00% 6.00% 4.00% 2.00% 0.00% -2.00% -4.00% -6.00%

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not manage to stabilize growth.23 The perceived “premature” fiscal consolidation of 1997 may have been enough to sustain growth had the banking sector been able to continue providing loans.24 Bank lending soared during the bubble period, increasing by a staggering 70% during the 1985–1991 period (Fig. 8.12). As expected, the bursting of the bubble brought trouble to loans that were mainly related to the housing/real estate sector, causing non-performing loans to increase,25 causing massive losses to the sector. This resulted to lower bank capital,26 and thus, not leaving them any room to boost lending. Notably, this took place despite two large bank recapitalization programmes by the Japanese state, after the initial estimations of the banking sector’s capital needs proved to have been very low.27 The high level of NPLs was evident until 2001, at which point they started to decline, but it was not until 2005 that they stabilised at a low, sustainable, point. As the GDP path shows, the Japanese economy began picking up, even though bank credit growth still remained subdued. Like most countries, Japan was no exception to the global financial crisis which hit just at the time when firms had managed to overcome the bubble period and adjust their balance sheets to the large amount of debt accumulated over the first crisis. It was only after 2009, when bank lending started to consistently grow again that GDP growth started to pick up again. In a similar manner with the case of the US and Cyprus, Japan is also a victim of the ongoing cycles of the modern financial system, generating 20.0% 15.0% 10.0% 5.0% 0.0% -5.0% -10.0%

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booms and busts in prices. As Minsky supported, instability seems inherent in this system, a problem that cannot be prevented, but can only be prepared for.

Stabilizing the Unstable The previous sections have painted a rather dire image of the financial sector: after all, no matter what policies or actions the central bank or government follows, there appears not to be a panacea for instability. Given that instability is inherent in a system that becomes overwhelmed with greed, a natural characteristic of an economy based on the maximization of profits, the question which arises is whether it would be possible for an economy to prepare itself for something that is simply the natural outcome of human behaviour. Naturally, changing human behaviour is out of the question, given that this appears more to be the topic of dystopian novels rather than a realistic approach. One of the main causes of instability is the private sector’s inability to regulate itself.28 As excessive risk is not usually marketed or priced, there is a difficulty to quantifying and creating an endogenous backstop for it. Even in the case where a private sector “insurance” against such events takes place, there is no way to make sure that this will be paid: the efforts of AIG to provide an insurance against the possible bankruptcy of sub-prime bonds (known as CDS—Credit Default Swaps), did not end up well as the fallout from the 2008 crisis forced the Federal Reserve to issue an $85 billion bailout package for the firm. The company’s problems emerged as claims for investors to receive their compensation for bearing the CDS soared almost four-fold, to $32 billion in just three days.29 If AIG defaulted, then the responsibility for the collateral would have been passed on to its corresponding banks, given the structure of the CDS. This would have effectively meant that the banks would be guarantors of their own products, a rather oxymoronic scenario. Hence, given the private sector’s inability to monitor itself, what is left is nothing more than the need to create a backstop to the private sector’s motives, by either providing disincentives or by simply regulating its performance. It should be remembered that financial stability is usually one of the main targets of a central bank, and thus policy actions are needed in order to diminish the externalities (i.e. job losses, recession, etc.) which could potentially be created when financial instability exists.

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Policy actions are also needed to eliminate the presence of information asymmetries that create market failures, e.g. that the lender has less information about the borrower in comparison to the information the borrower has for himself. The result of these information asymmetries can result in moral hazard issues, e.g. when the borrower accumulates excessive debt and can manipulate the bank, adverse selection, e.g. when loan costs increase and “good” borrowers do not wish to borrow at those rates again. These can endogenously lead to an unstable state of the market, which can, in turn, lead to the bust cycle. As it has been noted,30 there have been three major developments that have made instability less prominent than it had been in the first half of the twentieth century. The first has been the introduction of deposit insurance, and most importantly, that this was backed by central bank and government commitments. In the case that they did not back this, then the actual market value of the banks’ assets would have been much lower, especially in periods of distress. The presence of deposit insurance prevents this from happening, as it provides a backstop to the level of funds that can be withdrawn from the system. Remember that the level of bad loans (i.e. bank assets) is a determinant of how much liquidity has to be withdrawn from the market. If the central bank guarantees the level of deposits to a certain extent, this means that a minimum of liquidity will be ensured. The second development has been “big government”. What this means that government spending now takes up a larger part of GDP than it had in the first half of the twentieth century. In 1929, the US federal government’s share stood at around 3%, jumping to 24% by 1986. Interestingly, the share of private investment remained approximately the same, at 16%. Bigger government presence in the economy means greater stability of consumption, given that most of the spending relates to wages, social payments, and interest on debt. Naturally, a level exists after which the government can sustain its debt credibility and its overall viability, after which state bankruptcy becomes an issue (e.g. during the European Sovereign Debt crisis in early 2010). While a trade-off between financial and sovereign instability may exist, it is overall certain that the, within reason, practice of “big government”, along with deficit spending during crises can be helpful in safeguarding the economy from more severe crises. The third development has been the quick and effective interventions of central banks, which have been acting as a “lender of last resort” to the economy. The successful interventions in both the 2008 financial crisis as well as the recent coronavirus experience, in which the Federal Reserve moved to

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bail out several banking institutions as well as support the markets by guaranteeing loans, have provided invaluable support to the system. Other than the direct bailouts, the remaining measures took effect mostly through the expectations channels: it was a signal that “the Fed is there” rather than the actual usefulness of the measures.31 Nonetheless, despite the effectiveness of these measures, an important point to be made is that the effectiveness of any regulatory and intervention system will be lost over time, due to the nature of the regulations themselves. In effect, given that the existing regulations have blocked some profit opportunities, markets participants seek to innovate in order to evade those constraints. Hence, due to the innovative nature of the markets, driven by their profit-maximizing behaviour, regulatory systems are prone to breakdowns, especially once they have avoided disaster for a while (e.g. the US prior to the 2008 crisis, or Cyprus prior to the 2013 crash). As a result, any system of rules and regulations needs to be modernized at intervals to allow for the effects of innovative financial developments to be incorporated into it. A crucial aspect to grasp is the fact that financial instability is not a matter for each country to deal on its own, but a global phenomenon that requires cooperation. There are three main reasons for this: First, markets do not have borders and hence the bursting of a boom cycle in a major economy such as the US can spill over across the world, as was the case during the 2008 Great Recession when the collapse in sub-prime ABS products caused losses across the world. Second, the problem of information asymmetries is far more severe when it comes to a global aspect, as borrowers and lenders with cultural differences unite in a global market, attempting to exploit international loopholes. Third, the level of stringency of each national authority could vary, leading to banks and other financial institutions setting presence in other countries to exploit more lax regulations. A simple example is the South-East Asia crash in the 1990s, where Western financial institutions provided loans and exploited the looser regulations of the region. While financial innovations are aplenty, policymakers across the world should focus on six main areas to secure financial stability.32 First, adequate macroeconomic and structural policies are required in order to safeguard that the economy will function as smoothly as possible, while regulations should keep up with the pace of financial innovation. Second, an adequate legal framework will establish and enforce rights to commitments in cases of bankruptcy and private property legislation and stakeholder commitments in cases of failure by financial institutions.

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Third, financial markets should have accounting standards ensuring truthful and timely reporting, auditing, transparency in risk-taking and revelation of consolidated accounts achieving high level of information shared by all economic agents. Fourth, efficient and deep financial markets as they function better and therefore are more stable. Fifth, there is a need for regulations and supervision of the financial markets as liberalization raises instability. Sixth and last, monitoring the capital flows using “Tobin Taxes” discourages speculative short-term flows of capital in and out of an economy, without harming long-term flows. Overall, the Financial Instability Hypothesis can be traced in various international cases. While a boom-bust cycle is inevitable, especially if the rules and regulations of a country or region are not regularly updated to catch up with financial innovation, the extent and duration of the cycle can be minimized, along with suitable interventions by the central bank and the government. This, along with the potential global coordination of policies can prevent instability from spreading across to other countries and prevent market failures and potential global economic crisis.

Notes 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19.

Minsky (1992). Minsky (1983). Eggertson and Krugman (2012). Minsky (1983, 1992). Wray and Tymoigne (2008). Ibid., 1. Ibid., 2. Ibid., 2. Short memory can also be linked to the stock market (LeBaron 2001; Kovbasyuk and Spagnolo 2018). All US-related data were obtained from the Federal Reserve of St. Louis Database. Ibid., 2. Bernanke (2004). Ibid., 2. Koursaros et al. (2020). Ibid., 2. Michail and Thucydides (2019). Data were obtained from the Central Bank of Cyprus website. Loizou (2007, 2008, 2012). All data are from the St. Louis Federal Reserve Database and World Bank.

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20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32.

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Koo (2011a). Michail and Thucydides (2019). Werner (2005). Koo (2011b, Exhibit 11). Koo (2011b). Hoshi (2001). Herr and Miyazaki (1999). Fujii and Kawai (2012). Wyplosz (1999). McDonald and Paulson (2015). Minsky and Kaufman (2008). Kohn (2010). Wyplosz (1999).

References Bernanke, B. (2004). The great moderation. FRB Speech. Eggertsson, G. B., & Krugman, P. (2012). Debt, deleveraging, and the liquidity trap: A Fisher-Minsky-Koo approach. The Quarterly Journal of Economics, 127 (3), 1469–1513. Fujii, M., & Kawai, M. (2012). Lessons from Japan’s banking crisis–1991 to 2005. In Research handbook on international financial regulation. Cheltenham, UK and Northampton, MA: Edward Elgar. Herr, K. E., & Miyazaki, G. (1999). A proposal for the Japanese non-performing loans problem: Securitization as a solution, bankruptcy and reorganization (Professor E. Altman, Ed.). Japan, Tokyo. Hoshi, T. (2001). What happened to Japanese banks. Monetary and Economic Studies, 19 (1), 1–29. Kohn, D. L. (2010). The Federal Reserve’s Policy actions during the financial crisis and lessons. Koo, R. C. (2011a). The world in balance sheet recession: Causes, cure, and politics. Real-World Economics Review, 58(12), 19–37. Koo, R. C. (2011b). The holy grail of macroeconomics: Lessons from Japans great recession. Singapore: Wiley. Koursaros, D., Michail, N., & Savva, C. (2020). Tell me where to stop: Thresholds in the bank lending and output growth relationship. Empirical Economics, 1–29. Kovbasyuk, S., & Spagnolo, G. (2018). Memory and markets. Available at SSRN 2756540. LeBaron, B. (2001). Empirical regularities from interacting long-and short-memory investors in an agent-based stock market. IEEE Transactions on Evolutionary Computation, 5 (5), 442–455.

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Loizou, A. (2007) H π oι´oτ ητ α τ ων ξ šνων αγ oρασ τ ων. ´ Article available at http://www.aloizou.com.cy/documents/PoiotytaKsenonAgoraston.htm (in Greek). Loizou, A. (2008). H αγ oρ α´ ακιν ητ ´ ων τ ης Bρετ αν´ιας + Kυπριακ α´ ακ´ινητ α. Article available at http://www.aloizou.com.cy/documents/agoraakin itontisBretanias KypriakaAkinita.htm (in Greek). ´ oσ η. Available at http:// Loizou, A. (2012). ‘Δε´ικτ η αγ oρ ας ´ ακιν ητ ´ ων’, 5η Eκδ www.aloizou.com.cy/CyprusRealEstatePropertyIndexIssue5.pdf (in Greek). McDonald, R., & Paulson, A. (2015). AIG in hindsight. Journal of Economic Perspectives, 29 (2), 81–106. Michail, N. A., & Thucydides, G. (2019). The impact of foreign demand on cyprus house prices. Cyprus Economic Policy Review, 13(2), 48–71. Minsky, H. P. (1983). The financial instability hypothesis: An interpretation of Keynes and an alternative to ‘standard’ theory. John Maynard Keynes. Critical Assessments, pp. 282–292. Minsky, H. P. (1992). The financial instability hypothesis (The Jerome Levy Economics Institute Working Paper [74]). Minsky, H. P., & Kaufman, H. (2008). Stabilizing an unstable economy (Vol. 1). New York: McGraw-Hill. Werner, R. A. (2005). New paradigm in macroeconomics: Solving the riddle of Japanese macroeconomic performance. Basingstoke: Palgrave Macmillan. Wray, L. R., & Tymoigne, É. (2008). Macroeconomics meets Hyman P. Minsky: The financial theory of investment (Working Paper, No. 543). Levy Economics Institute of Bard College, Annandale-on-Hudson, Wyplosz, C. (1999). International financial instability. Global Public Goods: International Cooperation in the 21st Century, pp. 152–189.

Part III Modern Banking

9 Securitization

Suppose that you are the bank that has granted Friedrich’s, John’s, and Joan’s loan. As we have seen in Chapter 4, while money is not necessary when a bank issues loans, liquidity is highly important when the loans are withdrawn. We also know that banks make a gain from the interest rate differential between the amount of interest they charge for loans and the amount of interest they pay to depositors. This spread (called the interest rate margin) is stable over time and depends usually on factors such as available liquidity and the state of the economy, as well as the perceived risk of the borrower. Hence, in order for a bank to make more profit, two options are available: either to increase lending and keep the interest rate margin as it is, or start giving loans to less creditworthy individuals or firms. Naturally, the second option is much riskier; hence, it would be best to avoid it. On the other hand, the bank cannot really increase its loans forever. It is limited by the amount of risk it can bear, i.e. its capital requirements, as well as the amount of funds (i.e. deposits) it has available. Now, one day, Karl comes to your bank and asks for a loan. Karl is a usual middle-class employee and he just wants a normal amount of lending to build his house—nothing excessive, and you are certain that he will be able to repay it as it is just a small fraction of his income. Granting the loan is a no brainer, but there is just one issue: the bank is already at its capital requirements maximum and you cannot extend any more lending. There really must be a way around this otherwise you are forever bound to be at your legal limits.

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Enter your friendly neighbourhood investment banker, let’s call him Robert. He comes all shiny in his grey business suit and offers you a new deal that could help you overcome this capital ratio issue, called securitization. What is that you ask? He insists it is a very simple process and one that will allow you to circumvent all these legal issues. The general idea, as Robert puts it, goes as follows: you have many loans that you have granted over the years and, like a proper financial institution, you monitor and follow them through, making sure that they are making proper repayments. These loans, put together, represent an overall loan portfolio. The loans belong to different individuals hence there is very little risk that these people will all face financial trouble at the same time. In addition, you have is a large number of loans and thus, what you would call idiosyncratic risk, i.e. the risk of a few individuals not repaying, will have minimal impact on the overall pool of loans. This is the same as car insurance: a few people will have accidents in one year, but the probability of all insured cars being involved in an accident over a year is nearly zero. Hence, the probability of a large loss on the overall loan portfolio should be very small. Naturally, this falls back to the idea that none of these people exhibit correlated behaviours, meaning that if one person goes bankrupt others will not follow. While this is true of car insurance (the probability of someone being involved in a car accident here and this affecting someone’s driving behaviour 100 kilometers away is minimal), this does not hold for the economy: a country-wide recession could affect people who have never met or even engaged in any type of business together. Still, Robert says that you shouldn’t worry about this. It doesn’t happen every day, after all. While the inevitable crash happened in 2008, this was nowhere to be seen back in the 1980s or 1990s. Hence, securitization became a popular tool for banks. Effectively, banks bundled their loan portfolios together and sold them off. By doing so, they got rid of all those loans from their balance sheets and they were thus once again able to lend again. While this may appear like they sold e10 million of loans to grant another e10 million to different people, this was not the case. In fact here’s where things got interesting: instead of just selling out the loans, they sold it off to another entity, called an SPV (more on that later), which was also controlled by the bank. The SPV then issued a bond and linked the payments of the bond to the loan portfolio. Let’s put this simply: your bank would sell Friedrich’s loan to the SPV. Suppose that the loan was worth e100,000, with an 8% interest and a 20year maturity period. What the SPV did was that it issued a e100,000 bond, with a 20-year maturity, but with less than 8% interest, say 7%. This was a

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win–win situation for the bank: it freed its balance sheet from the loans, thus allowing it to grant more loans, while at the same time it also gained from the interest rate differential between the loan and the bond. In addition, the bank also charged a servicing fee, i.e. a cost to keep up with a loan, something that it would have done in any case. Interestingly, investors were also very happy because the interest rates from these loan-backed bonds were higher than the rest, and they did not usually face any issues with repayment (until they did in 2008—more on that later). The idea of securitization was simple, yet powerful: banks could get rid of their loans and free up their balance sheets, at least until the change in regulations in the US in 2010,1 so that they could lend out more, they got more cash for their troubles via the sale of loans, and benefited from the interest rate differential and the servicing fee. This was quite appealing as banks sought to maximize their earnings, and as long as the borrowers were creditworthy. Naturally, as banks run out of creditworthy people, they decided to keep on lending to those who could not really pay back the loans. This was enough to lead to a cycle of excess lending, based on previous good results, the very first part leading to the financial instability cycle and the inevitable collapse of 2008. In 2008, securitization played a major role, especially in the US, but with spillovers all over the world as pension funds and banks had invested in such loan-backed bonds. Naturally, while securitization appeared to be the culprit, it was nothing but the scapegoat: the real problem was, once again, overlending and over-confidence by banks that they made the right choices and that nothing could go wrong. Nonetheless, securitization was the instrument that made all this exorbitant increase in lending take place. Regardless of the amount of complexity and financial innovation that took place in designing the various securitized products below, the basic ideas were the above. In effect, securitization means bundling together a portfolio of loans, making a bond, and then selling off the bond to investors. As discussed, this benefited the bank by reducing its risk-weighted assets (i.e. loans) so that it could grant more loans. In addition, the bank gained from the interest rate spread and the servicing fee making it an overall excellent profit opportunity for it.

The Beginnings The industry of securitization was first born in 1970 in the US, when the Government National Mortgage Association (GNMA or “Ginnie Mae”), a government-owned entity, bundled government-guaranteed residential home

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mortgages into a security (a bond).2 It had probably been the first time in the history of the twentieth century that a government-sponsored organization created innovative financial products. While investors had traded whole loans or unsecuritized mortgages for some time before that, securitization marked the first time that both the principal and interest payments were passed through to investors.3 Prior to the introduction of the Mortgage-Backed Security, the whole-loan market, including the buying and selling of mortgages was relatively illiquid. As in the case of other securities, illiquidity presents a risk to those investors since they may be unable to find buyers if they wish to sell their portfolio. Furthermore, holding loans meant that interest rate increases could drive the lender’s cost higher than his income from the loan, i.e. the bank would stand to have a higher cost of funding compared to its income from lending. As if these were not enough issues, trading of loans was relatively costly as it meant a bundle of details and paperwork. The introduction of the mortgage pass-through, changed the status quo by combining similar (in terms of maturity, interest rate and quality) loans into pools and then selling direct ownership of this portfolio of loans to investors.4 More specifically, the portfolio is placed in a trust and certificates of ownership are sold to investors while the loan originator (i.e. the bank) continues to service the portfolio and collects interest and principal. These, after the deduction of a service fee, are passed on to investors. Since the loans in the portfolio were backed by government-guaranteed mortgages, investors faced essentially no default risk. Importantly, since the ownership of the mortgage does not lie with the originator (the bank) these do not appear on the originator’s financial statements. The pass-through security (and the MBS) revolutionized the secondary mortgage market making it more attractive to both investors and lenders. In contrast to the illiquid market structure of the previous decades, investors now had a liquid instrument and lenders (banks) had the option to move any interest rate risk associated with mortgages off their balance sheets and furthermore increase their liquidity. After the successful introduction of the pass-through security by Ginnie Mae, its example was soon followed by the Federal Home Loan Mortgage Corporation (Freddie Mac), an indirect agency of the US federal government, which introduced a similar pass-through security in 1971. The security was called “participation certificate” (PC) and was backed by portfolios of uninsured (compared to the Ginnie Mae insured ones) and privately insured mortgage loans. Monthly interest payments and full repayment of principal

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were guaranteed by Freddie Mac, but the timing of the principal payments was not.

Mortgage-Backed Securities Ten years later, in 1981, the Federal National Mortgage Association (Fannie Mae), a private corporation chartered by the federal government entity, similar to Freddie Mac, introduced the name that came to cover all types of mortgage pass-throughs: the Mortgage-Backed Security (MBS). While maintaining all the aspects of the PC and the Ginnie Mae pass-through, like the pooling of similar loans and the subsequent sale of the portfolio ownership, the MBS did not however guarantee monthly interest payments and the full repayment of principal. Similar to the PC the timing of payments was also not guaranteed. The MBS was more of an investment in the traditional sense: the investor stood to lose his stake (or at least some of it) if things went south. This feature would soon motivate private banks to issue their own private Mortgage-Backed Securities. The introduction of the Mortgage-Backed Security was not, at least initially, pursued with the goal of generating more profits but was backed by a mandate to increase home ownership across the US. In fact, that was the overall point of the Ginnie, Fannie, and Freddy creation. As a commentator put it “The collapse of the national housing market in the wake of the Great Depression [1929-1933] discouraged private lenders from investing in home loans. Fannie Mae was established in order to provide local banks with federal money to finance home mortgages in an attempt to raise levels of home ownership and the availability of affordable housing ”.5 In the beginning, Fannie Mae included both Fannie and Ginnie, but was split in 1968 in order to form the two institutions. Ginnie, which is housed within the government, provides guarantees only for securities backed by loans insured by government agencies. In contrast, Fannie Mae was authorized to purchase conventional mortgages in 1970. Freddie Mac was established in the same year, with the same charter as Fannie: to expand the secondary market for mortgages. Abiding with their charter, the Government-Sponsored Entities (GSEs) sought to provide local banks with federal money with which they would finance home mortgages. To do so without having access to the federal budget, they bought loans from the banks in exchange for cash, in order to provide them new mortgages with more liquidity. The explicit guarantee of the US government for Ginnie issues made the bonds risk-free; in the case of Freddie and Fannie, investors believed that these had at least the

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implicit guarantee of the government. Even though it was not specifically stated (Freddie and Fannie underlined the fact that their certificates were not guaranteed by the US government) this belief allowed both entities to save billion in borrowing costs. Banks were more than happy to part with their loans for several reasons. First, and perhaps most important, loan sales means less leveraged balance sheets and more free capital for further investment (i.e. lending). This means that banks have lower capital requirements which allows them to create more lending more easily. For example, if a bank sees its capital drop close to the regulatory minimum, it can choose to sell some loans. After the sale, having less risky assets and the same capital means that the ratio would rise, instantly making it a less risky bank and most likely increasing its attractiveness to investors. Second, the pass-through of mortgage securities allows banks to reduce the maturity gap between their assets and their liabilities. Since the bank sells a pool of long-term mortgages the change in ownership means that these are removed from its books, an action which shortens the average maturity of its assets. However, the bank continues to service these loans and collects the fees. In combination with the first reason which shows that less capital is now required for regulatory purposes, this reduction in the outstanding loans of the bank, along with the collection of the fee from servicing the sold portfolio, suggests that return on capital will be increased. To graphically illustrate how the first two reasons affect banks, Fig. 9.1 indicates the change in their balance sheet after a loan sale. Specifically, prior Before loan securitization (1)

After loan securitization (2)

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Fig. 9.1 Bank balance sheet changes during securitization

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to the sale of a loan portfolio, total loans amounted to 60 million. Assuming for simplicity a risk weight of 100% (this simplification does not impact the overall conclusion of the example) and a minimum capital ratio of 9%, the bank would have to hold capital of 5.4 million. Assuming that each loan generates 4% of its value in income then the bank’s return on capital would be 44% (60 × 0.04/14.4).6 In addition, the bank’s liquidity ratio (i.e. its liquid assets as a percentage of total liabilities) currently stands at 66.7% (120/180). Following the securitization process, a sale of a portfolio of 40 millions worth of loans was made. The sale resulted in an equivalent increase in cash. Re-evaluating the above ratios suggests that the bank is now required to have just 1.8 million in capital, freeing 3.6 million for lending purposes. Assuming that the bank retains a servicing fee of 1% on the loans sold, the return on capital has now grown to 66.7%. In addition, the bank’s liquidity ratio has increased to 88.9%. Thus, by selling a portfolio of loans, not only has the bank reduced its overall capital requirements but has boosted its ratios, making it a more attractive investment and creating more value for existing shareholders. There are also additional justifications as to why banks choose to securitize: a third reason is that banks are protected from interest rate risk. In 1986, for example, 62% of all mortgages held by Savings & Loans associations (S&L, banks that specialize in accepting savings deposits and making mortgages and other loans) in the US were fixed-rate loans.7 In contrast, 65% of time and savings deposits matured in a year or less. Having long-term fixed mortgages meant that an increase in interest rates would result in losses. The disparity between loan and deposit maturities has decreased significantly in recent years, with the use of adjustable or floating rates, which fluctuate along with the prevailing interest rates. However, the prevalence of fixed-rate mortgages in the 1980s assisted in increasing the popularity of MBSs. Finally, securitization also provides banks (or other firms which engage in securitization) with a relatively inexpensive source of funds. Since lots of loans are bundled together, their risk is perceived to be much less than if they were individually sold. The reason is because the relation of one loan with another (correlation) is assumed to be zero, or at least close to it. The assumption underlying this near-zero correlation is that if John defaults on his mortgage, Joan will most likely not be affected. This allows banks to sell the bonds at a lower interest rate compared to what it would normally have to offer to depositors, in order to obtain the same funds. The same holds for private firms, which can benefit from a substantial decrease in the interest rate paid, just from bundling their receivables and selling them as a bond.

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A natural question here is why banks don’t borrow funds from the Central Bank. As suggested in Chapter 3, banks can borrow money from the Central Bank to cover their open positions (i.e. their lack of liquidity) at the cost of the predetermined interest rate set by policymakers. This interest rate is higher than the available interbank rates (e.g. Libor or Euribor) but is nevertheless lower than the bond interest rate. Still, lending from the Central Bank is very little, excluding times of trouble (Fig. 9.2). This behaviour is justifiable since banks need to show that they have exhausted all private sector sources before asking from the Central Bank to provide them with credit. The rationale behind this is that if banks need to go to the Central Bank for every liquidity need they have, the Central Bank may end up providing more liquidity to the system than it would like to do in the first place. From the banks’ point of view, this means that if no-one else from the private sector is willing to lend to you then you are not perceived as a safe investment and nobody but the Central Bank is willing to lend you funds. Hence, from the banks’ point of view borrowing from the Central Bank signifies weakness or riskiness. In essence, the bank is stigmatized.8 To avoid the stigma, banks tend to stay away from Central Bank borrowing, until no other alternative is available. The banks’ efforts to avoid the stigma of borrowing from the Central Bank are of economic sense, since institutions which have borrowed from the Federal Reserve record an increase in borrowing costs by 32 basis points (i.e. 0.32%). In order not to borrow from the Federal Reserve and avoid the extra 32 basis on top of borrowing, banks were willing to pay a premium of 44 basis points. This premium reached 132 basis points during the peak of 1,400 1,200 1,000 800 600 400 200 1959 1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

0

Fig. 9.2 Banks’ borrowing from the Fed’s Discount Window ($, billions)

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the recent financial crisis. These estimates have been even larger in the early 2000s.9 To address this unwillingness to borrow from the Central Bank, even during the crisis, the Federal Reserve created the Term Auction Facility (TAF), which provides loans to banking institutions which are “judged to be in generally sound financial condition (…) and are expected to remain so over the terms of the TAF loans”. The definition of “sound financial condition” alleviates the problem of the bank being seen as one which faces financial difficulties and consequently the bank avoids being stigmatized. Indeed, data suggest that TAF was much more successful than simple Discount Window lending. However, the risk of being overused for funding excess lending remains.10

Collateralized Mortgage Obligation While the introduction of MBS was revolutionary in itself, its structure was too volatile and was heavily influenced by mortgage prepayments. This risk of prepayment is essentially the difference between the expected (specified) payback date of the bond and the actual date that enough mortgagors refinance (e.g. when interest rates are falling) or repay their mortgage and hence their loan no longer exists. Since privately insured mortgages were repaid (or refinanced) more often than Ginnie-insured ones, the average life of a private MBS was seven to nine years.11 This uncertainty, lowered demand for the MBS, since investors might have to reinvest their money with a lower return at some unexpected time. To address this, Freddie Mac issued a bond which is known as the CMO (collateralized mortgage obligation). The main difference of the CMO from Fannie Mae MBS was that it had several different payment features, which aimed at lowering prepayment risk. Specifically, the Freddie CMO was divided into three maturity classes (also called tranches, a French word for slice), with each class receiving semi-annual interest payments. Class 1 bondholders received the first instalments of principal payments and any prepayments until their bonds were paid off. Class 2 bondholders received principal payments and prepayments before Class 3 bondholders received any principal payments. The Freddie CMO structure was structured such that Class 1, 2, and 2 bonds were repaid within 5, 12, and 20 years from the offering date.12 This structure makes the bondholders more certain about the duration of their securities, with more risk being attributed to higher term-life. In the Freddie CMO, Class 3 received a higher interest rate than Class 2, which

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in turn received a higher interest rate than Class 1. The large reduction in uncertainty resulting from this separation of rights on the bond led to a large increase in the popularity of securitized products, causing investors who might have otherwise avoided entering the mortgage market (such as funds which only invest in low-risk products) to be attracted to it. Following the Freddie innovation, the private sector further enhanced it as in recent years CMOs have included more than 50 tranches.13 Still, the intuitive distinction into three levels exists: highly ranked tranches, which are more protected by others are called “senior”, tranches which are subordinate to senior tranches but still receive some protection are called “junior” or “mezzanine” and the remaining tranches, which have no claim on collateral until all obligations to all other tranches are met, are called residual classes. The introduction of the CMO has also been pivotal in the development of another important innovation in modern banking: that of the investment conduit. Recall that the Ginnie pass-through and the Freddie MBS constituted pass-through securities: the ownership of the mortgages portfolio was passed on to the investor (who was also taxed as the owner of this pool). However, in the case of the Freddie CMO the ownership of the bond was not passed through. In contrast, the bond was a pay-through meaning that only the cash flows from the mortgages were dedicated to servicing the bonds, while the mortgage pool remained as assets in the books of the issuer. The fact that ownership of the pool of loans remained with the originating institution posed the problem of bankruptcy risk: in the case that the loan originator (i.e. the bank) failed for whatever reason, it would also have to default on the bonds. To avoid this risk, the conduit (which is also known as the Special-Purpose Vehicle (SPV) or a master trust), is designed in a way as to be bankruptcy-remote.14 This design has the additional benefit that the SPV is treated and rated only based on the quality of the assets (i.e. the pool of purchased loans) it holds and not on the quality of the loan originator. Furthermore, it also allows for the bank to remove the assets from its balance sheet and enjoy the benefits discussed earlier. The flow of assets and funds associated with the setup of an SPV is illustrated in Fig. 9.3 (first and second row, respectively). The conduit has the purchased pool of mortgages as assets, while the issued Mortgage-Backed Security would lie its liabilities. Note that the SPV does not really need to have anything else in its assets since it serves primary as the holder of the mortgage pool, while the loans themselves are still serviced by the originator (bank). Conveniently, the purchase of the mortgage pool is funded by the proceeds from the issue of the bond, hence no prior funding of the SPV is required. Figure 9.4 indicates the simple conduit balance sheet.

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Fig. 9.3 Securitization flow chart

180 160 140 120 100 80

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Mortgage Bond (LiabiliƟes)

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Fig. 9.4 Conduit balance sheet

Reducing CMO and SPV Risks For the SPV, of the utmost importance is the ability to sell the newly created bonds to investors. To this end, the SPV would have to address several risks. As discussed in the previous paragraph, it is pivotal for the conduit to be bankruptcy-remote. In addition, the bond would be sliced in different tranches which would bear different riskiness such as the Freddie CMO. Although these steps eliminate the risk of bonds failing if the originating bank

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faces problems, as well as assigning different risk across different tranches and prevent prepayments, they do not have anything to say about the quality of the underlying collateral. The issue of the underlying collateral is easily handled though, through the careful and prudent selection of assets (mortgages) for inclusion in the pool. In addition, the bonds are usually over-collateralized meaning that more assets (mortgages) are included in the pool than required for the bond to be issued. The extra collateral is kept as security against potential mortgage defaults which could reduce cash flow, and is evaluated at fixed intervals. In the case the value of the collateral drops, new collateral must be added to it. For example, suppose an analysis by a rating agency indicates that in order for the pool to receive an “AAA” rating it would need a 40% credit enhancement. This means that at least 40% more assets than the value of the bonds need to exist. For example, if the pool was worth 200 euros, then the originator could only issue 120 euros’ worth of “AAA” securities. If the pool performed poorly and 30% losses on the portfolio occurred, lowering the portfolio to 140, there would still be room for additional losses without hurting the bondholders.15 Furthermore, two additional credit enhancements are often employed. First, the excess spread, defined as the interest payments and other fees received on the assets minus the interest payments made on the bond, is usually the first line of defence and is tapped before any other type of credit support is used. Note that the service fee is not deducted from the estimation of the excess spread.16 To clarify how the excess spread is used, imagine that a portfolio, on which 100 euros worth of bonds were issued, generated 10 euros of income, of which 7 were handed to the bondholders. Hence, the originator will earn an excess spread amounting to 3 euros per year, which are usually retained in an account (but are also sometimes returned to the originator). Suppose that losses on the portfolio have driven income from the pool to reduce to 8. Since this is still higher than the amount due, it would mean that the bonds would be serviced normally.17 In a similar manner, the second enhancement is a cash reserve account. This can be either a specified amount of cash which is retained in an account to absorb any losses or, capturing any excess cash flow (such as from the excess spread) until a cash reserve has been built up to a predetermined amount. If the account is used, e.g. if in the example above, income from the pool reduced to 6 euros per year and the additional 1 euro is provided by the reserve account, any excess cash flow in the future can be retained until the cash reserve reaches a certain level amount. Further to these, the deal may

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also have performance-related triggers, which require additional cash flows to be withheld if the quality of the underlying asset deteriorates.18 Complementary to the above enhancements (over-collateralization, excess spread, cash reserves, division into tranches, and a bankruptcy-remote design for the SPV) firms also bundle insurance against losses in the portfolio (also called a wrap19 ) is also purchased from a top-rated third-party insurance company, to further safeguard the investors’ interests. Foreign exchange and interest rate swaps can also be used to improve the overall risk profile of the security. Other enhancements include the provision of a liquidity line or a letter of credit to the SPV, allowing the facility to borrow cash if needed. This type of credit support is considered to be provided by the originator. In contrast, there is also another form of credit support (retained by the originator), in which the originator retained the most subordinated tranche because it is too expensive to compensate investors for the assumed risk. Here, the originator does not usually provide a cash reserve or set aside excess cash flow. Note that regardless of whether credit support is provided or retained the originator maintains most of the economic risk associated with the transaction. The originator also retains most of the benefit from the transaction because if the pool of assets behaves as it should and the credit support is not used, it gains all the excess cash flow. The increase in bond safety has two significant effects and two substantial benefits: first, safer bonds mean that more investors will be attracted to them and thus more bond sales can be achieved. Second, ratings agencies also appreciate this improvement in safety and thus provide more beneficial overviews. In the world of investment, better ratings usually mean lower yields (interest rates) for the seller. Lower yields imply that the cost of servicing the bond (the interest amount payable each year) declines significantly which suggests an increase in the overall excess spread. Hence, both the probability of things going as planned (remember that lower rates mean greater excess spread) and the potential for future gain increase with lower interest rates. If all goes well, asset securitization is a win–win situation for bondholders and the originator. Yet, the latter stands to gain more from the deal. It is easy to see now why rating agencies are a big part of the securitization process. These agencies help design the tranche structure of the SPV (remember the over-collaterization example earlier), to accommodate different risk preferences and provide a rating indicative of the overall quality (risk) of the pool of assets. This rating is necessary for investors who need someone to do their due-diligence for them. While some investors may also be forced by law to hold just investment-grade securities, i.e. mostly senior

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and perhaps some mezzanine tranches, and hence the rating is even more important. As to any bond issue, an underwriter is required. Underwriter duties are usually assumed by an investment bank although in some cases brokers and banks can also take up this role. In addition to their role of selling the securities to either public offerings or private placements, underwriters (investment banks) are also very involved in setting up the SPV, structuring of the transaction, and, in direct contact with the rating agencies, arrange the tranche design as well any credit enhancements needed. Similar to usual cash-offer practices, underwriters purchase the bonds at a discount and then proceed to sell them to other investors. In addition to structuring and selling the products, underwriters also provide liquidity support in the credit market through their market-making services. While in the early history of securitization originators sought underwriters to create pass-through securities for them, it is now not uncommon for underwriters to seek out originators for securitization purposes. Summing up, securitization procedure for MBS can be found in Fig. 9.5. The originator connects with the SPV (the issuer), and if the originator does not service the assets itself, it is also connected to a servicing firm. The SPV is connected with the rating agency and the underwriter (who are both connected together) to structure the deal. In some deals, a trustee firm is also required to manage the SPV (trust) and to represent the rights of investors. The trustee usually collects the receivables and makes the payments to the bondholders.

Fig. 9.5 Securitization process

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Expanding Securitization Despite the relative complexity of the procedure, mortgage securitization proved very popular: in their peak, $690 billion’s worth of securitized mortgage bonds were issued in a single year (2005) in the US. Overall, the total cumulative issuance doubled from 2004 to 2007, an indication of the popularity of the securitized product in the US (Fig. 9.6). The success of MBS was enough for the originators (and the underwriters) to look for additional assets which could be bundled and sold to investors. The requirements for a suitable pool of assets were not that prohibiting after all. First, the pool needs to be of sufficiently large and homogeneous volume in order to facilitate statistical analysis. For the same reason, a stable history of rates, defaults, delinquencies, prepayments, etc., needs to exist. Of the utmost importance is diversification within the pool of assets. Mortgages are considered to be sufficiently diversified since their recipients are both geographically and socio-economically diverse. Finally, the lender’s (originator) needs to have quality standards which can be evaluated by rating agencies and the assets need to transferable. In essence, the assets need to be of enough quality to support a high credit rating without the backing of the originator.20 Naturally, when looking for an alternative it is usual to search for things which are very similar to what you are trying to imitate: hence, loans for mobile homes fit the needs and were bundled by Ginnie Mae in September 1985. However, the private sector started to gain the lead in bundling; in 3,000 2,500 2,000 1,500 1,000 500

Fig. 9.6 Cumulative flow to securitized mortgage bonds in the US (billions, $)

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January 1985, automobile loans were first packaged and sold as securities. Similar to the original pass-throughs, the interest and principal of the underlying auto loans were passed to the security holders. These auto loan-backed securities were known as certificates of automobile receivables, or CARs.21 Despite the similarities with mortgage loans, CARs had the disadvantage that they required more monitoring. Since the collateral, the car, is not stationary it does not contain its value as well as a house. In contrast to the MBS for which no insurance was taken for the pool when first issued, the increased risk associated with auto loans dictated it. Hence, to protect against losses, each of the auto loans carried its own insurance while the pool of auto loans was further insured by a private insurer. The innovation of auto securitization did not rest just in the underlying asset. Importantly, it was the first time that a private firm (which provided financial services to auto dealers) securitized a new type of loan. Investment banks were again very helpful to this transaction: Salomon Brothers was the underwriter who developed and issued the bond for a private placement. In March of the same year, Salomon Brothers repeated the trick and was pivotal in the first public offering of a security backed by automobile loans. To avoid the Federal Reserve’s suggestion that the loans should remain on the bank’s balance sheet, a trust was set up to hold the underlying assets so that the bank could be relieved, making the overall structure of the CAR issue more similar to the one of mortgage bonds (similar to Fig. 9.5).

Credit Card Securitizations Following auto loans securitization, credit card receivables have also taken the securitization path in April 1986. The first “certificates of amortizing revolving debts” or CARDs as they came to be known, were issued in April 1986 and had a stated maturity of five years. Salomon Brothers was again the underwriter. Due to the higher risk associated with credit card payments, the originator (Bank One) was forced to credit enhance the pool: it established a reserve fund equal to twice the size of the historical default rate on credit card debt and also retained 30 per cent of the credit card pool. The first CARDs securitization also introduced another financial innovation: the bondholders would only receive interest payment for the first 18 months, with principal payments made during this period used to purchase additional receivables. After the 18 months had elapsed, investors would also receive principal payments. The distinction between principal and interest would be further strengthened in a few months’ time, when

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Fannie Mae issued the first stripped MBS security in July 1986 to create principal-only (PO) and interest-only (IO) bonds.22 A PO security is one which receives some or all of the principal component of payments on underlying debt obligations, but none of the interest component. In this case, the amount to be received is known (since it equals the amount of the issued loan), but the timing is unknown. In contrast, the IO security receives some or all of the interest component of payments on the underlying pool of debt obligations but none of the principal component. The distinction between IO and PO allures investors for different purposes, especially depending on their future views about interest rates: if rates increase, the value of the PO decreases while the value of IO increases. Likewise, if rates decrease PO increase in value and IO decrease. The reason is that PO depends on the “present” value of future payments to obtain this value and future cash flows have to be adjusted for the cost of having invested elsewhere, e.g. in a bank. Hence, higher interest rates mean that the same future cash flow in the future will be worth less. In the case of IO higher rates mean that mortgages are not likely to be prepaid (as the interest rate of a refinancing would be higher than the existing) and in addition, more interest amount is due, hence their values would rise. The characteristics of IO securities made them appealing to investors wishing to hedge their risks while POs were served mostly investors who sought more risk than traditional MBS securities. Due to their higher risk, IOs and POs are usually sold at a large discount to their value.23

Client Riskiness Types: Alt-A Naturally, not all bank customers have the same characteristics. Some have more stable income (e.g. John), others need large investment and face uncertain timing of their payoffs (e.g. Friedrich) and others have uncertain income flows because their sales fluctuate over the year(s) (e.g. Joan). For the bank, as to any other investor, higher fluctuations mean higher risk. To compensate for this, investors require a higher return (i.e. interest rate) on their investments, in order to grant the money. One could not really classify Joan as a bad investment: her shop generated income, but was prone to the whims of the public and a victim to fashion trends. Usual bank practices would assign Joan to the “Alt-A” category, in which the borrower is unable to provide complete documentation of her assets or the amount (or source) of his income. The category is naturally not only associated with incomplete documentation. Other characteristics such

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as a loan-to-value ratio (i.e. value of the loan divided by the value of the house) more than 80%, without any insurance on the amount, a higher than normal debt-to-income ratio, etc. Banks would many times lend to borrowers in the Alt-A category, as higher return would at times compensate for the higher risk. Hence, bundling and securitizing a pool of Alt-A products, in the usual MBS way, was also good business for the banks. The fact that investors required about 2% additional interest rate for the bonds made them more attractive securities for those wishing to invest in fixed income structured products.24 Another type of loans which have been used for securitization purposes are commercial loans, which are pooled together to form what is known as the Commercial Mortgage-Backed Security (CMBS). The natural difference between these and residential loans is that, in the US, they carry less prepayment risk as they do not allow for unrestricted prepayments by the borrowers. In Europe there is less prepayment protection. Similar to residential MBS (RMBS), the typical CMBS returns principal to investors incrementally during its life, unlike a government or corporate bond which pays interest and provides a lump-sum amount at its expiry. In this case, a servicer also exists, however, due to the higher costs of monitoring the loans the fees to the servicer consume nearly all of the difference between the interest rate on mortgages and the interest rate of the security. The most notable difference between RMBS and CMBS is that in the latter case, no deal is made without first finding the buyers for the junior (i.e. non-investment grade) bond classes. These buyers first examine the proposed pool of loans and may take out loans they deem to be very risky. This provides an additional layer of protection for senior buyers, particularly because the junior class buyers tend to be real estate experts. Naturally the holders of the junior class require a much higher return on investment for the extra work they put in.25

Asset-Backed Securities The financial innovation securitized bonds brought with them as well as their investment appeal made the products very popular. The quest for assets to securitize moved beyond mortgages, credit cards and auto loans, as well as banks in general. Soon, non-financial firms that had some assets to bundle also started joining the game. Securitized assets came to include most receivables a company may have had (Table 9.1).26 Since banks usually have a

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Table 9.1 Examples of securitized assets excluding MBS, CARs, and CARDs Aircraft leases Manufactured housing contracts Automobile leases Railcar leases Boat loans Real estate Trade receivables

Recreational vehicle loans Dealer floorplan loans Royalty streams Equipment leases Student loans Truck loans Marine shipping container leases

wider array of receivables than other private sector firms, they kept the lion’s share of the securitization pie. The finance jargon divided securitized products into two large categories: the first included only “prime” mortgage loan securitizations (MBS) and “Alt-A” mortgage bonds. All other assets were included in the second, more general category, and received the title asset-backed securities (ABS). All types of assets in Table 9.1, as well as CAR and CARD products seen earlier, can be viewed as ABS products, with the type of “asset backing” defined in the name of the product. For example, an automobile lease ABS structure would include only those assets in its pool. The ABS category also includes a product which, although may have mortgages in the pool of assets, does not qualify as an MBS. The reason is that these loans represent an even riskier strand of bank customers than Alt-A ones. These are people whose credit history has not been that good: they have either defaulted on past credit obligations, have had (or still have) nonperforming loans (i.e. they have missed more than 90 days of payments), or make payments which are less than the instalment amount. Similar to Alt-A customers, this category also has high loan-to-value (LTV) ratios, may have taken a second mortgage on their houses or have drawn lines of credit secured by their homes.27 These bank customers are commonly referred to as “sub-prime” or, more eloquently, customers with “home equity loans (HEL)”. Since these were not really “prime” mortgage loans, HELs would usually be classified as ABS products. One reason banks would lend to sub-prime borrowers is because entities like Fannie Mae were charged with performing a “special assistance function” to promote home ownership among families that might not otherwise have been able to purchase homes. This assistance was similar to a subsidy to provide mortgage loans with low-interest rates through certain Fannie programmes. In essence, the US government (remember that Fannie is fully owned by the state) would bridge the difference between the amount paid by Fannie to purchase the low-interest rate loans from the originators (banks) and the amount received when Fannie bundled and sold the bonds

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to investors at a discount. Another reason for lending to sub-prime borrowers was that, especially in the 1980s and 1990s, some savings and loans banks would lend money based on the strength of the collateral and not based on the borrower’s ability to repay or their credit history. Probably the most important reason for the rise of sub-prime lending was securitization itself. In the 1990s securitized products became more widespread and the easy access of banks to funding through these products, allows many new players to enter the sub-prime lending business. The competition for sub-prime lending was so large fierce that some companies began to use questionable accounting tactics to inflate profits. In 1999–2000, two-thirds of the major sub-prime mortgage lenders were either bankrupt or bought out while in financial distress. In the following years, lenders’ access to cheap funding through securitization pushed lending to sub-prime borrowers to higher grounds. Banks introduced interest-only loans, which allowed the borrower to repay just the interest amount due for some years, using some sort of “teaser rate”. With sub-prime securitization increasing (in 2003, HEL ABS accounted for approximately 25% of all outstanding ABS), banks were more than willing to grant new loans to riskier customers. Similar to traditional MBS, HEL ABS are enhanced both by seniorsubordinated tranches and time tranching. The two enhancements allow for a specification of the riskiness and the duration of each “slice” of the bond, similar to the Fannie pay-through MBS. Again similar to MBS, HEL ABS also use excess spread to cover for current period losses. However, in the case of HEL ABS any unused excess spread is used to pay down the principal balance of senior certificates, in what is called “accelerated amortization” or “turboing”. This repayment creates a mismatch between the amount of the pool and the amount held in securities. The difference, as in usual MBS credit enhancements is called over-collateralization. The percentage of over-collateralization has to be maintained throughout the security’s duration. Some HEL ABS issuers go as far as securitizing the residual interests (i.e. the most subordinated class) in their HEL deals. These securitizations are called NIM (net interest margin) deals, because the excess spread is in essence the interest on mortgages net of the interest on the securities. In order for them to obtain the interest due, excess spread would have to be positive and the specified amount of over-collateralization has to be met. NIMs can get either all excess spread, unused OC at the termination of the deal, prepayment penalties or cash flows specifically designed to enhance the NIM. Note that even though HEL ABS are the riskiest of securitized products, NIMs represent the riskiest part of the whole deal.28

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Synthetic Securitization The final product to be overviewed in this chapter is “synthetic” securitization. In contrast to a usual securitization, a synthetic deal involves the removal of the credit risk associated with a pool of mortgages by means of credit derivatives instead of a “true sale” of assets to an SPV. Specifically, the originator retains ownership (i.e. the assets remain on the originator’s books) as well as the economic benefit of the assets while the credit risk is transferred to investors.29 To make such a transaction feasible, a credit derivative known as the credit default swap (CDS) is necessary. The CDS is a contract between two parties in which one buys credit protection (swaps) from the other. A CDS is similar to purchasing an insurance policy which covers for credit risk. Credit risk mainly covers bankruptcy or default of the underlying reference entity (e.g. bond, pool of assets, firm, state) on its financial obligations. In particular, suppose that X (the buyer) agrees to pay Y (the seller) a periodic fee during the term of a contract regarding protection from a credit event of company Z. The fee is paid in specified intervals (e.g. quarterly) on a predetermined rate (e.g. Libor). After the deal is completed, if company Z faces issues then Y is obligated to pay X the amount specified in the contract.30 In the case of a synthetic MBS (either residential or commercial), the deal can be either unfunded, funded, or partially funded. In the case of an unfunded synthetic MBS, a CDS is used to transfer credit risk from the mortgage pool to a swap counterparty. No bond is issued and usually no SPV is involved. The investor (the swap counterparty) receives the CDS premium and in return agrees that he will pay out on any losses incurred by the originator on the pool of assets. In the case of funded synthetic MBS structure, an SPV is set up, which issued tranched bonds. These are referenced to the credit performance and risk exposure of the portfolio of assets, just like a usual MBS. The proceeds of the notes (excess spread) are then either invested in eligible collateral such as government bonds or passed on to either the originator or a third party. In the first case, this is known as a collateralized funded synthetic MBS while in the second as uncollateralized. In partially funded deals, the bond issue is combined with a CDS that transfers a portion of the pool of assets to investors. Synthetic deals introduce what is known as attachment and detachment points. The attachment point specifies the level of losses—specified in percentage terms—after which a bond class will face its first loss. The detachment point for a tranche specifies the level of losses after which the class

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Table 9.2 Sample deal attachment and detachment levels Class Super senior Class A Class B Class C Total

Amount ($ millions) 800 50 50 100 1,000

% of deal

Subordination

Attachment and detachment level (%)

80.0

20.0

20–100

5.0 5.0 10.0 100.0

15.0 10.0 0.0

15–20 10–15 0–10

is completely wiped out. In the sample deal of Table 9.2, Class B with an attachment point of 10% and detachment point of 15%, will be unaffected until losses reach $100 million (since the overall reference portfolio is worth $1,000). After that amount, each additional dollar of losses for the portfolio will equal a dollar of losses for tranche B. If losses on the portfolio exceed $150 million (the detachment point), the tranche is wiped out. This holds irrespective of whether the deal is funded or unfunded, with the difference that the Super Senior class would belong to the investors issuing the CDO.

A Generic Overview In the course of this chapter, the reader has been exposed to various types of securitized products.31 Due to this diversity of products and structures, securitization has not yet been granted a formal definition. After viewing the range of these products, it makes intuitive sense to define securitization through the characteristics of the procedure, namely the issuance of debt and related securities which will be repaid through the pooling of some (financial) assets and the delinking of the credit risk of the collateral asset pool from the credit risk of the originator. While this is a quite general definition, including additional characteristics in it would limit its scope. For example, the inclusion of credit support can leave out products which were not credit-enhanced for one reason or another (e.g. the early Ginnie pass-throughs). Similarly, including tranching in the definition will leave out products that do not use this technique (e.g. asset-backed commercial paper—see Chapter 10), while the use of an SPV would also exclude some synthetic products. To this end, while the definition is rather broad and vague, it allows for capturing the whole universe of securitization, at least for the current period. Future products may naturally render it obsolete.

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The popularity of securitized products has grown significantly over time, and despite the 2007–2009 recession, private sector MBS still account for more than a fifth of the total outstanding US bond market debt which stands at $40 trillion. ABS issues account for less than this, at approximately 3.5% of the total market, but still in excess of one trillion dollars. Combining private sector MBS, ABS, and agency MBS accounts for approximately a third of total outstanding bond debt in the US economy.32 The sheer amount of securitized bonds outstanding has allowed many more participants in the financial and real markets to be involved in banking sector-related assets and has given rise to what has been known as the “shadow banking system”.

Notes 1. Creating an understanding of Special Purpose Vehicles, PriceWaterhouseCoopers, December 2011. Accessed at: https://www.pwc.com/gx/en/bankingcapital-markets/publications/assets/pdf/next-chapter-creating-understandingof-spvs.pdf. 2. Segoviano et al. (2013). 3. Statement of Cameron L. Cowan on behalf of the American Securitization Forum at the “Hearing on protecting homeowner: preventing abusive lending while preserving access to credit”, November 5, 2003. 4. Pavel (1986). 5. Alford, Rob. “History News Network | What Are the Origins of Freddie Mac and Fannie Mae?”. Hnn.us. Retrieved January 19, 2017. 6. For simplicity, the assumption of no interest payable on deposits was made. Altering the assumption simply makes the same point, albeit with slightly more complex calculations. 7. The change from fixed-rate loans to adjustable rate loans did not hamper the incentives for securitization. In contrast, products like ARMs (Adjustable Rate Mortgages) were soon designed. 8. Furfine (2003). 9. Armantier et al. (2015) and Erhan and Demiralp (2010). 10. Similar arguments can be found in Wall (2016). 11. Ibid., 3. 12. Ibid., 3. 13. Statement of Cameron L. Cowan on behalf of the American Securitization Forum at the “Hearing on protecting homeowner: preventing abusive lending while preserving access to credit”, November 5, 2003. 14. Bankruptcy-remoteness does not, however, mean that the conduit cannot be owned by the bank. It simply means that its operations are unrelated to those of the bank and will not be impacted in case the bank faces issues.

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15. Standard & Poor’s “Credit FAQ: The Basics of Credit Enhancements in Securitizations”, June 24, 2008. 16. In particular, the service fee is first deducted and then added back onto the equation. 17. Some authors refer to excess spread as “credit enhancing interest-only strip”, however there is no distinction between the two. See for example, Chen et al. (2008). This should not be confused with interest-only and principal-only bonds, a separate category of MBS which will be discussed in more detail below. 18. “Demystifying Securitization for Unsecured Investors” Moody’s Special Comment, January 2003. 19. Cetorelli and Peristiani (2012). 20. Ian H. Giddy “The Securitization Process”, Stern School of Business, New York University. 21. Ibid., 3. 22. Kenneth G Lore, “Mortgage-Backed Securities—Developments and Trends in the Secondary Mortgage Market”, West Group, 1999. 23. “The benefits of investing in mortgage IOs” UBS US Fixed Income, October 22, 2014. 24. For a full exploration into Alt-A loans see “A journey to the Alt-A Zone”, Nomura Fixed Income Research, June 3, 2003. 25. “Synthetic CMBS Primer”, Nomura Fixed Income Research, September 5, 2006. 26. “Demystifying Securitization for Unsecured Investors” Moody’s Special Comment, January 2003. 27. Lines of credit are similar to credit cards as they provide an available amount for withdrawal, based on some predetermined amount. Like credit cards, they are considered revolving since the amount is not the same given withdrawals and repayments. 28. For more information on ABS see “Home Equity ABS Basics” Nomura Fixed Income Research, November 1, 2004, and on NIMs Wolf, J. “Net interest margin securitizations: understanding the risks” Moody’s special report, June 7, 2000. 29. Appendix B, Fabozzi et al. (2007). 30. Credit Default Swap (CDS) Primer, Nomura Fixed Income Research, May 12, 2004. 31. For a more detailed view of securitization see Fabozzi et al. (2007) or Fabozzi (2001). 32. Source: SIMFA. Data as of January 2017.

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References Armantier, O., Ghysels, E., Sarkar, A., & Shrader, J. (2015). Discount window stigma during the 2007–2008 financial crisis. Journal of Financial Economics, 118(2), 317–335. Cetorelli, N., & Peristiani, S. (2012, July) The role of banks in asset securitization. FRBNY Economic Policy Review. Chen, W., Liu, C.-C., & Ryan, S. G. (2008). Characteristics of securitizations that determine issuers’ retention of the risks of the securitized assets. Accounting Review, 83, 1181–1215. Erhan, A., & Demiralp, S. (2010). Discount window borrowing after 2003: The explicit reduction in implicit costs. Journal of Banking & Finance, 34 (4), 825– 833. Fabozzi, F. J. (Ed.). (2001). Investing in asset-backed securities (Vol. 75). Hoboken, NJ: Wiley. Fabozzi, F. J., Davis, H. A., & Choudhry, M. (2007). Introduction to structured finance (Vol. 148). Hoboken, NJ: Wiley. Furfine, C. (2003). Standing facilities and interbank borrowing: Evidence from the federal reserve’s new discount window. International Finance, 6 (3), 329–347. Pavel, C. (1986, July/August). “Securitization,” economic perspectives. Federal Reserve Bank of Chicago, pp. 16–31. Segoviano, M., Jones, B., Lindner, P., & Blankenheim, J. (2013). Securitization: Lessons learned and the road ahead (IMF Working Papers, 255). Wall, L. D. (2016, June). TAF: The cure-all for stigma? Notes from the Vault, Federal Reserve Bank of Atlanta.

10 Shadow Banking

The innovative nature of securitization and the comparatively higher returns of structured products made more and more investors willing to participate in such deals. With the private sector not losing any time to create even more arcane products to exploit the popularity of securitization. Aimed at exploiting the power of securitization to spread credit risk in the economy, these products significantly increased the interconnectedness between the banking system and the entities linked to it through securitizations and other funding schemes. The entities, details of which this chapter will elaborate upon, have come to collectively be called as “the shadow banking system”.1 To understand how these entities have been linked to the banking system, it is first essential to examine the products which allowed them to do so. Naturally, the primary link between banking and other entities is securitization itself. To begin with, the SPV, which holds the pool of assets is tied with the originator (the bank) through lines of credit and/or loans. Hence, while the bank may be “relieved” of the assets it has sold to the SPV, and even though the SPV is bankruptcy-remote, the bank is still affected by the performance of the pool of assets. Next, remember that many securitized products are insured. The insurance company, is known as a financial guarantor, which is a type of monoline insurance company. The term “monoline” was coined in 1989 when the State of New York restricted the type of risk insurers could take on to only one business line; in this case, the business line is the insurance of third-party debt. In the securitization case, the insurance company unconditionally guarantees

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the timely payment of principal and interest if the issuer of the debt is unable to meet its financial obligations.2 In the finance parlance insurances “wrap” their rating around the bonds, making them safer. Hence, in the case that the pool of assets underperforms, the insurance company would be liable to compensate investors for their losses. In the case of severe underperformance or default, the monoliner stands to lose more. In a similar manner, issuers of CDS are also closely affected by the performance of a structured security. If the product triggers the credit event then the issuer has to make good for the insurance it has provided. Since issuers of CDS range from commercial banks, to insurance companies (not just monoliners), life and health insurance providers, and hedge funds3 the range of involved entities is considerably large. Finally, investors, while in not direct involvement in the process, are naturally heavily influenced by the well-being of the pool of assets. Investors in MBS and ABS include investment companies, banks, insurance companies, asset management, government entities (remember Ginnie Mae is government-owned), corporations, mutual funds, and pension funds.4 The large array of investors has further dispersed the impact of securitized products across the majority of the financial system as well as some realms of the real economy.

Collateralized Debt Obligations New products, which were based on securitized products, also emerged. The most notable example has been what is known as collateralized debt obligation or a CDO. A CDO follows the usual securitization structure in that it issues a bond with some underlying financial assets to cover for it. However, instead of having a pool of mortgage loans as assets, a CDO arrangement invests in a portfolio of corporate bonds or loans. In the former case, it is called a collateralized bond obligation (CBO) and in the latter case it is called a collateralized loan obligation (CLO). In essence, a CLO is similar to an MBS with the difference that the CLO is backed by corporate loans instead of mortgages, while a CBO uses corporate bonds as the underlying asset. Other CDOs invest in previously securitized products such as ABS or MBS: these are called structured finance CDOs or SF-CDOs. CLOs and SF-CDOs have accounted for more than 80% of outstanding CDOs since 2006.5 There have traditionally been only two reasons motivating the construction of a CDO. The first is that a bank wishes to remove assets from its balance sheet and creates a CDO to transfer the assets to it. This has been called a

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“balance sheet CDO”. The second is the reason is mainly related to investment incentives. Since the interest rate received from the investment portfolio the CDO owns is larger than the interest rate paid on the securities it issues (bonds), there is room for profit. This profit would usually go to equity (or residual) investors, but a portion of it would also go to the manager (the role of which is usually assumed by an investment bank) as a performance-based fee. In addition, since investment banks earn money based on the amount of assets they manage, increasing assets under management increases their income. This form represents more than 90% of total CDO issuance and is known as an “arbitrage CDO”.6 CDOs also come in other types: if the repayment of the issued bonds is based on the income received from the portfolio assets then this is called a “cash flow CDO”. On the other hand, if the repayment is based on sales of these portfolio assets then the deal is called a “market value CDO”. Similar to MBS, synthetic CDOs in which the deal is in the form of a CDS contract between the investor and the deal also appeared. Finally, CDOs-Squared also appeared in the market, in which a usual CDO is created but the underlying assets represent stakes (tranches) in other already issued CDOs.7 Since their introduction in the early 1990s, CDOs have become increasingly popular, accounting for about half of all outstanding ABS each year in the 2006–2016 period.8 It is easy to see how CDOs have increased investors’ connections to the banking system. Investment products like CDOs invest either directly (balance sheet CDOs) or indirectly in bank-created assets and in addition also create further exposure to insurance companies (or other CDS counterparts) to these assets. Finally, CDOs-squared have further increased connections by, in essence, reinvesting funds in the original CDOs.

Asset-Backed Commercial Paper Another financial product which stems from the innovation of asset securitization is asset-backed commercial paper (ABCP). Similar to its predecessor, the simple Commercial Paper (CP) issuance, ABCP represents the issuance of a short-term (less than 270 days) promissory note for a specific amount and with maturity on a specific date. The only difference between CP and ABCP is that the former is unsecured while the latter has specific assets attached to it as collateral. The CP market has a long history, dating back to the nineteenth century in which non-financial sectors of the economy (e.g. utilities and transportation companies) borrowed money from wealthy individuals, other business and

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financial institutions by issuing this type of promissory note. In the twentieth century, increased demand for durable goods boosted purchases on credit and hence financial CP dominated non-financial issuance. Nevertheless, the real growth in CP came in the 1970s when Money Market Mutual Funds (MMMFs) indirectly allowed small investors to access the CP market.9 MMMFs are open-ended mutual funds, meaning that their shares are publicly traded and anyone can purchase and sell them at will. These funds invest in high-quality, short-term debt instruments such as commercial paper, treasury bills, and repurchase agreements. Using the interest earned from these short-term loans, MMMFs pay dividends which aim at maintaining a stable net asset value (NAV) of $1 per share.10 Since their inception, MMMFs have been widely regarded as being as safe as bank deposits (and perhaps even more liquid), yet providing a higher yield. This perceived safety has at times been challenged with MMMFs at times “breaking the buck”, i.e. incurring losses which made them trade below the $1 NAV. This had been very rare, occurring only three times in the 37 years prior to the 2007–2008 financial crisis. These rare events (excluding the crisis) did not do much to hamper MMMF reputation: the stability of the funds has made them extremely popular in recent years (Fig. 10.1), accounting for about 40% of all investment company assets. Individual (or “retail”) investors invest in MMMFs for several reasons, most importantly because they wish to “hold cash” temporarily, either for their own personal reasons or because they want to take a defensive position in anticipation of declining equity markets. Through this abundance of funds, MMMFs have become important players in the commercial paper and repo markets, providing cash to banks, broker/dealers, insurance companies, 3,500 3,000 2,500 2,000 1,500 1,000 500

Fig. 10.1

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and other investment funds. In recent years, MMMFs have come to own about 40% of total outstanding paper (both ABCP and CP), more than 20% of all repurchase agreement and more than 40% of total short-term agency MBS.11 As already suggested, commercial paper is a short term, unsecured note issued by a business, which aims at financing current transactions including meeting payroll obligations and funding assets such as receivables and inventories. Despite being allowed a maturity of up to 270 days, approximately 60% of outstanding CP have a maturity of one to four days. This is done primarily to minimize interest expense since shorter duration means less risk and hence less interest rate paid. Since it represents a cheap funding solution many issuers usually roll over CP, meaning that they issue new paper to cover maturing paper.12 Some firms, which are not rated highly enough may not find adequate demand when selling their CP directly in the market (directly placed) and thus they choose to do so with the help of CP dealer (dealer placed). The CP market has allowed the advancement of many captive finance firms. Captive finance firms are those who are completely owned by another company (e.g. an automobile company) and provides credit to customers for purchasing products of that company. For example, an automobile manufacturer can create a captive finance firm to finance customers’ purchases (in the automotive finance industry, captive finance firms account for about a third of total loans).13 Similarly, a retail supermarket can also create a captive finance arm to promote purchases based on credit. The captive firm finances these purchases by issuing commercial paper and repays them by following up on customer repayments. In general, the structure of CPs is fairly simple; in contrast, ABCP is more complicated. At first, similar to securitization, commercial paper is issued by a conduit to fund the purchase of assets. However, while in the case of MBS and ABS products the underlying assets are known to investors, the ABCP conduit is an opaque entity whose assets are unknown to investors. For this reason, interest rates on ABCP are higher than those on traditional CP.14 ABCP programmes are usually sponsored (i.e. created) by financial institutions or large corporations. In the latter case, the reason for the ABCP creation is to finance the sponsor’s own assets. If the sponsor is a financial institution, it is usually aimed at providing financing alternatives to its clients. In other words, the financial institution creates the ABCP so that its clients can move their assets to it. In addition, an ABCP can be created in order to move the sponsor’s assets off its balance sheet.

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Depending on the sponsor’s role in referring the assets to be financed through the programme as well as the purpose of funding, there are three common structures of ABCP programmes. The first is known as the “single seller” programme in which the sponsor is the sole originator of the financed assets. In this case, the ABCP conduit can be viewed as an alternative source of funding for the sponsor’s business activities. The second programme structure is referred to as “multiseller”, with the sponsor usually being a financial institution seeking to provide financing alternatives to its clients. The multi-seller structure provides the opportunity to purchase assets from different sellers. The third programme is known as “securities backed” where the sponsor is a financial institution seeking arbitrage opportunities or capital relief associated with moving assets off balance sheet. This structure invests in various securities, including rated MBS, ABS, and other corporate securities. The sponsor does not own the conduit (instead equity is issued), but it usually retains a financial stake in it by either providing credit enhancement, liquidity support, or both. Liquidity support often takes the form of loan or asset purchase facilities. These facilities provide alternative sources of funding to cover for maturing CP in the case the conduit cannot issue new CP, something known as rollover risk. Credit enhancement usually takes the form of overcollateralization, third-party guarantee, loan facilities, subordinated debt, letters of credit, guarantees, or any forms other acceptable to rating agencies.15 Excluding purchases of rated securities and direct lending, for the ABCP to purchase assets from interested sellers, an additional step to the securitization process is required. Here, the asset first needs to be transferred (sold) to an SPV (which is often called the transferor) and then the SPV signs off the rights and interests in the assets to the conduit (Fig. 10.2). This “two-tier” structure is designed to isolate the asset from the seller’s balance sheet in the event of a bankruptcy. Over the years, ABCP grew increasingly popular: in the US, outstanding ABCP rose from $600 billion in 2001 to $1 trillion in 2007, dropping to $200 billion following the crisis. The reasons behind the rapid increase in ABCP from the 1990s onwards have been similar to those of other

Fig. 10.2

Two-tier structure

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securitization products. Banking institutions (mainly broker/dealers), saw opportunities to increase their fees from potential participants, many of which were firms which had preferred to borrow from the CP market instead of banks. Capital requirements also made banks more eager to dispose assets, through the securitization procedures they came to master in the previous decade. As markets were becoming more knowledgeable about securitized products they were more willing to invest in them. In addition, ABCP programmes would allow brokers to bring smaller firms to the market for CP, which they had been unable to do in the past due to their size.16 As a result, commercial paper issued by financial firms increased while non-financial CP declined. Figure 10.3 presents the conduit’s balance sheet after the sale of liabilities and the purchase of assets. In general, the major difference between an ABCP structure and a CDO structure is that the former issues short-term liabilities (commercial paper) while the latter issues longer-dated liabilities. In other terms, both the reasons for the initial setup of the conduits as well as the investment universe ABCPs and CDOs function is very similar. Securitization activities as well as ABCP and CDO issuance created large cash proceeds for originators, in addition to the additional fees they receive as servicers or as management fees for assets under management. The proceeds have been traditionally channelled to three areas: treasury securities, debt reduction, and to originate new assets. Since the originator is usually exposed to the economic risk of securitization (i.e. it retains the lowest-rated tranche in securitizations or provides credit and liquidity enhancements in the case ABCP Conduit (1)

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of ABCPs and CDOs) the first can be considered as passive actions which aim at maintaining the same risk profile. In the case of debt reductions, the senior bondholders who get repaid are better off since they receive the securitization proceeds; the remaining senior bondholders are worse off since there less assets exist to cover for any losses. Hence, the overall risk profile of the originator is worsened. Originating new loans does not have clear-cut effects on the risk perception of the originator. On one hand, increasing assets (no matter how low-risk they may be) means that the overall riskiness of the firm has increased since it also retains economic risks in the securitized products. On the other hand, if the loans are not very risky then the secured bondholders will have more assets to cover for any potential losses. In the case the SPV is consolidated, the firm will have more debt for more assets, hopefully with a one-to-one increase in both. If the SPV is not consolidated then an increase in assets will actually lower the debt-to-assets ratio to the amount prior to securitization. Naturally, the increase in securitized products has increased the interconnectedness of the banking sector with the other sectors of the economy. With many firms having already been involved in the securitization process, the introduction of CDO and ABCP structures further enhanced the banking sector’s reach in the economy. In the wake of the crisis, Paul McCulley dubbed “the whole alphabet soup of levered up non-bank investment conduits, vehicles and structures” as “the shadow banking system”.17

Defining Shadow Banking Shadow banking does not really have a proper definition, other than the commonly accepted notion that the entities which comprise it must be outside (or very loosely linked to) the traditional system of regulated depository institutions. The activities of shadow banking, as observers comment,18 are similar to those of the traditional banking sector. However, a closer look reveals that this is only limited to maturity transformation, in the sense that short term, liquid liabilities are used to obtain longer-term, less-liquid assets. The most important task of the traditional banking sector, i.e. the creation of money, is not part of the services that shadow banking provides. What shadow banking does is to facilitate money creation through the provision of funding to the traditional banking sector. Drawing for the above, shadow banking can be broadly viewed as the “(unregulated) activities of non-bank entities which facilitate the provision of credit to the economy”. The major source of this facilitation is mostly done

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via increasing available funds for commercial banks. This bank funding can be either direct or indirect. For example, when an MMMF or an investment bank makes a repurchase agreement with a bank, the investor provides direct funding. On the contrary, the purchase of an MBS bond does not directly provide funding to a bank since the SPV is bankruptcy-remote and independent. Thus, the SPV, while providing funding directly to the bank, does it through the funds of someone (the investors) who does not engage in direct contact with the bank. Another good example of the separation between direct and indirect funding can be found in the case of CP and ABCP: in the first case, the MMMF directly funds the bank. On the opposite, an ABCP funds the bank through investors’ money but the latter does not interact with the bank at all since all they see is the investment conduit. In either case, both transactions will be classified as part of “shadow banking”. Other activities of these entities, although they may not be conducted with the traditional banking system, can also be considered as shadow banking since they will indirectly affect their ability to provide liquidity to traditional banks. For example, the actions of entities which do not provide direct funding to the banking system, but facilitate its provision (e.g. insurance companies) should also be included in the definition of shadow banking.19 Some functions of traditional banking can also be viewed as part of the shadow banking system, albeit indirectly. For example, the assignment of credit lines to SPVs, CDOs, and other shadow entities does not provide funding to commercial banks themselves, but facilitates the issuance of financial products. Other provisions such as loans to these entities can also be considered as part of shadow banking. Figure 10.4 provides a schematic overview of the linkages between shadow banking and traditional banking functions. While ultimately everything moves down the line to investors (and upwards towards loan takers), linkages in the system move in both directions: while the SPV brings funding back to the banking system, the banking system is also linked to the SPV through liquidity provision such as loans and lines of credit. Similarly, banks are also connected to insurance companies and other entities in both ways. The schematic representation of the shadow banking also includes captive finance companies which obtain funding largely (but not exclusively) from MMMFs. These firms also facilitate the creation of credit by allowing borrowers to purchase, e.g. automobiles from their mother company. Since this lending increases overall credit in the economy but is not formally regulated it is also considered as a part of shadow banking. Nevertheless, it should

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Fig. 10.4

The shadow banking system

be remembered that captive finance companies do not create money but simply provide “store credit”, funded through MMMFs. While the schematic representation presents an overview of the linkages between entities it is beneficial to directly specify the types of entities which currently comprise the shadow banking system, as well as their specific type and activity. Table 10.1 presents this (naturally non-all-encompassing) breakdown with a further distinction as to whether the activity provides any type of funding to the commercial banking sector. For example, money market participants include MMMFs and other various categories of money market funds such as cash funds, securities lenders, and so on. These money market firms are active participants in the repo, ABCP, CP, swaps, and securitization markets. Of these, swap, CP, and repo activities provide direct funding to commercial banking while the rest facilitate the provision of indirect funding. In contrast, captive finance firms do not provide any type of funding to the commercial banking sector but increase overall credit in the economy. Drawing from the discussion made in this and the previous chapter on securitization, one can safely comment that the shadow banking system is a quite complicated structure, with activities not being at times as transparent as one would hope so. The natural question which has thus far remained unanswered is why does the shadow banking matter this gravely as to take up so much of our time? The answer to this question needs to be divided into

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Shadow banking

Entity

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Funding

Money Market Participant

MMMFs, Cash Funds, Enhanced Cash Funds, Ultra-short bond Funds, Securities Lenders, etc.

Insurance Companies Monoline Insurance

Insurance Companies

Repo ABCP RMBS/CMBS/ABS Swap Agreements CP CDS sold

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Financial Guarantees on individual loans CDS on CDOs CDS on securitized bonds (credit enhancement) SPV Management SPV Creation Securitization Underwriting Commercial Paper Derivatives ABCP Creation Captive Finance Securitization ABCP

Direct

Credit to consumers

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Credit lines to shadow system.

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Bilateral repos, Securities lending.

Either

Investment Banks

ABCP

Captive Finance Firms Credit Institutions

Investment Funds

Monoline Insurance

Broker/Dealers

Single-seller conduits, Multi-seller conduits, Hybrid conduits, Repo conduits, Securities arbitrage conduits, etc. Auto loans, credit cards, etc. Traditional financial system (local and foreign banks) Hedge Funds, Pension Funds

Indirect Indirect

Indirect Indirect Indirect Direct Direct Indirect N/A Indirect

two parts: first, how does the commercial banking sector affect the shadow banking sector and vice versa and second, how do both impact the economy.

The Importance of Shadow Banking The answer to the first part lies in the interchanges between the two banking systems. The largest part of the shadow banking system’s activities is that of

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providing funding to the commercial banking system either directly or indirectly. Increased funding means that banks have more available cash than before, suggesting that they will have to invest them one way or another. Note that if the cash remains idle there is no actual cost for the bank since they are not paying interest on these assets, hence there is less incentive for banks to invest them in high-yielding assets. Earlier in this chapter, three potential ways of investing this money (shortterm government bonds, paying down debt, new loan issuance), with the respective effects on the overall risk of the bank. However, when it comes to returns, new loan issuance poses a higher potential than the other two. When the emphasis is to increase returns and not to lower the overall riskiness/exposure of the bank then issuing new loans clearly dominates all other options. Note that seeking customers to issue new loans is not always the prevailing strategy for banks, nor is the incentive to dispose the newly acquired funding as large as in the case of deposit funding. Depending on the bank’s perception of the macroeconomic environment as well as the regulatory requirements and the available opportunities at the time, its priorities may change accordingly. Consequently, while the shadow banking’s major role is to create new funding for commercial banks, the impact on lending depends on the banks’ incentives at the time. In addition to increasing available funding for commercial banks, parts of the shadow banking system (namely MMMFs) have increased the availability of (cash) collateral in the economy. In general, an increase in cash availability increases the volume of financial transactions. Note that to borrow cash for collateral posting, a firm will usually have an open position (there is no reason to borrow cash at a cost just have it laying around). The increase in available collateral means that the price of borrowing will decrease as firms will be able to borrow at a lower cost, with more upside from the derivative transaction they will engage. Hence, more collateral creates an incentive for more transactions similar to the way more available funding creates an incentive for higher lending. The importance of cash for collateralization purposes is huge: in collateral for derivatives, cash is king, with 84% of collateral received or delivered being in this form.20 The five-fold increase in collateral usage has been dominant in the tripling of the notional amount of outstanding derivatives during the 1998–2006 period.21 Cash is important not only because it can be used for collateral but because it can be reused (rehypothecated) in other transactions. For example, as discussed earlier, cash collateral for repos can be reused in other repo transactions, similar to the money multiplier notion. To a (much)

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lesser degree, securitized bonds can also be used as underlying collateral in repurchase agreements or derivative securities. The first part of the question regarding the significance of the shadow banking system lies mostly in the increase in the availability of funding and cash collateral. Through these functions, both the commercial and the shadow systems find themselves in the position to increase the volume of their transactions at will. Nevertheless, the outcome does not lie solely on the incentive to increase profits but on the perceived riskiness of their counterpart be it an individual or a business. Moving to the second part of the question, the real economy can benefit from the shadow banking system through the availability of more cash for non-financial CP, as well as more derivative options to hedge their operations. Securitization can, at some times, allow people with relatively risky profile (e.g. Alt-A clients) to obtain loans they would have otherwise been refused. The most important role of the shadow banking system is that it spreads the risk associated with the commercial banking sector away from their originators. Banks still retain a large part of the economic risk associated with loan transactions but securitization helps in spreading part of this risk to investors willing to participate. The risk does not just remain with investors, even though these are the ultimate “beneficiary”: insurance companies, investment banks, MMMFs, and other shadow banking entities are part of an enlarged system which ultimately boils down to how well the commercial banks do their jobs. Unlike diversification in finance (and securitization), which helps in alleviating risk associated with a specific investment by investing in more than one instrument, the shadow banking system does not reduce risk. It simply spreads it around, increasing interconnectedness between banks (remember that banks are also large customers in the securitized products market), and more importantly between the commercial banking system and the real economy. Most of the times, commercial banks do their jobs well enough and profits run from the banking sector to the real economy. During those periods, everybody is happy and the exposure to the banking sector is the thing which increases their profits. There are some other times though when banks are not doing so well: large problems in their operations spring up to their balance sheets and from there to securitized bonds and the people who purchased them. The question now comes to whether the periods in which banks are not doing well arise often enough and are severe enough to matter for the economy.

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Notes 1. McCulley (2007). 2. Schich (2008) and A. M. Best Methodology “Rating monoline financial guarantors in the public finance sector”, August 16, 2016. 3. Hedge funds are a type of investment fund which caters only to certain accredited investors. Stakes in hedge funds cannot be offered or sold to the public, avoiding direct regulatory oversight. Mutual funds are investment funds which pool money from many investors, each owning a share in the fund, to purchase securities. In contrast to hedge funds, mutual funds are open-ended, i.e. the stake in the fund can be sold to the general public on a daily basis. Other investment funds include private equity funds (which invest in equity securities and debt in operating companies that are not publicly traded on a stock exchange) and pension funds which manage private pension schemes. 4. “Demystifying securitization for unsecured investors” Moody’s Investors Service, January 2003. 5. Source: SIMFA. Data as of January 2017. 6. “CDOs in Plain English: A summer intern’s letter home” Nomura Fixed Income Research, September 13, 2004. 7. “The Bespoke” Nomura Fixed Income Research, November 17, 2004 and “CDOs-Squared Demystified” Nomura Fixed Income Research, February 4, 2005. 8. Source: SIMFA. Data as of January 2017. 9. MMMFs are also known as “money market funds” or “money funds”. 10. Murphy (2009). 11. Ibid., 10. 12. Anderson and Gascon (2009). 13. Experian—State of the Automotive Finance Market. Data for 2014. 14. “ABCP 2008 year in review and 2009 outlook” Structured Finance: Special Report, Moody’s Investors Service, February 10, 2009. 15. Fitch Ratings “Asset-Backed Commercial Paper Explained” Structured Finance, November 8, 2001. 16. Post (1992) 17. Ibid., 1. 18. Bernanke (2012) and Pozsar et al. (2013). 19. Other definitions (e.g. Pozsar et al. 2013) emphasize on regulation or on whether the liability resides on the financial institution’s balance sheet to pinpoint the actions which merit inclusion in shadow banking. Others (Claessens and Ratnovski 2014) have suggested that the need to have an official backstop, i.e. a form of guarantee, either from the public or the private sector, is what should be used for a definition of the shadow banking. However, this definition is more in line with securitization rather than funding operations. For example,

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while most securitized products do need some type of enhancement, monoline insurances do not require any such backstops. 20. Source: International Swaps and Derivatives Association (ISDA) “Collateral use for OTC derivatives”, October 2009. 21. Source: SIMFA. Date: January 5, 2017 and BIS and ISDA through Gary Gorton (2010).

References Anderson, R. G., & Gascon, C. S. (2009). The commercial paper market, the fed, and the 2007–2009 financial crisis. Federal Reserve Bank of St. Louis Review, 91(6), 589–612. Claessens, S., & Ratnovski, L. (2014). What is shadow banking? (IMF Working Paper 2014/25). Gorton, G. B. (2010). Slapped by the invisible hand: The panic of 2007 . New York: Oxford University Press. McCulley, P. (2007, September). Teton reflections. PIMCO Global Central Bank Focus. Murphy, E. (Ed.). (2009, June 30). Money market fund reform. Securities and Exchange Commission: Proposed rules, Securities and Exchange Commission, pp. Release No. IC–28807; File No. S7–11–09. Post, M. (1992, December). The evolution of the US commercial paper market since 1980. Federal Reserve Bulletin, 78(12), 880–891. Pozsar, Z., Tobias, A., Ashcraft, A. B., & Boesky, H. (2013, December). Shadow banking. FRBNY Economic Policy Review. Schich, S. (2008). Challenges related to financial guarantee insurance. OECD Journal: Financial Market Trends, 2008(1), 81–113.

11 Modern Crisis-Dealing Practices

In the twentieth century, financial crises had been mainly dealt with the usual interest rate adjustments by central banks. However, as central banks have aimed to resolve crises faster, they have gotten more creative and added new tools to their arsenal. One of the most popular tools is quantitative easing, or QE, which has become increasingly popular since the 2008–2009 Great Recession.

Quantitative Easing The term “quantitative easing” was first introduced by Richard Werner in a newspaper article back in 1995.1 At the time, Werner was pointing out that Japan’s economic recovery required an increase in the “quantity of credit creation” by the overall banking system. Since the expression “credit creation” could probably appear obscure in to the readers, the term was redefined as “quantitative monetary easing” or, for shortness, “quantitative easing”.2 Initially, Werner had other plans for his term, mainly direct involvement of the central bank to the private sector, such as direct purchases of nonperforming assets from private banks, direct lending to companies and the government, and purchases of debt and equity instruments. His other suggestions included direct funding of government expenses through standard loans from private banks and directly targeting the quantity of credit creation by

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the overall banking system through the relaxation of capital requirements and other practices. To the cognoscenti, objections start to stir up, as these do not even appear to be close to what the term “quantitative easing” has come to involve. A few years after Werner’s proposal, the Bank of Japan3 chose to use this expression to refer to a different policy: that of reserve targeting. This policy essentially means that a central bank takes commercial banks’ assets away from them and gives them cash in return. This is what QE has come to stand for, with the most popular explanation being that quantitative easing refers to any type of policy where a central bank buys government bonds or other financial assets (most usually other types of bonds, such as corporate or mortgage-backed) in order to inject money into the economy, with the ultimate target being the expansion of economic activity. Through the purchase of government and other types of bonds, the central bank hopes to get some of these assets from commercial banks (given that they tend to place their excess cash in such securities) and give them cash, in exchange. The theory is that banks will seek to lend out these newly acquired cash to eager loan seekers. The rationale behind such a suggestion is that it is more costly for banks hold more cash, instead of lending them out to the public. By costly, we mean that banks earn less by keeping their cash at a central bank (these are what is commonly known as bank reserves) or by investing them in bonds, given that the large-scale increase in bond purchases would have definitely had a negative impact on their yield. As such, the assumption goes, it is instead better for the banks to lend them out. Another, implicit assumption, is that banks had a need for more liquidity and this was the reason they did not engage in loan granting to begin with. As we will later see, both these assumptions are not so well-founded. Quantitative easing, after being implemented by the Bank of Japan, has also been employed by the US Federal Reserve (in 3 rounds), the Bank of England, the Swedish central bank, the Swiss National Bank, and the European Central Bank. One would guess that since so many central banks have followed this advice, proof of its success would be overwhelming. Unfortunately, this is not the case: it is in fact rather difficult to find studies which examine whether quantitative easing (QE) has had an impact on output and prices, with most focusing on the direct impact asset purchasing has on bond yields.4 Quantitative Easing, like most of the policy-based responses during the financial crisis, has been based on a monetarist point of view,5 a worldview which considers that controlling money supply can assist in easing recessions and slowing down booms. This monetarist view has been put together with

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the one of people who diagnosed that the US was at the time facing a liquidity trap, a situation where the short-term interest rate has reached a level beyond which it cannot fall and thus monetary policy is ineffective.6 This has been dubbed as the zero lower bound (ZLB), namely under the premise that the policy rate and all subsequent interest rates cannot drop below zero.7 Modern views on monetary policy suggest that, given that policy is inefficient in a liquidity trap, what should matter at the ZLB is the management of expectations.8 Overall, QE was supposedly the tool to deal with all of these issues, however, as already suggested, most studies have dealt with how QE impacts interest rates,9 which is what QE is supposed to affect in the first place, by increasing demand for those assets. In order to provide more insights into how QE works, we proceed somewhat differently: the rest of this chapter focuses on providing a framework regarding the effects and rationale of QE, based on the insights from the chapters on money, inflation, and banking. To do so the implementation of three rounds of easing in 2008 in the US as well as subsequent actions in the European Union are examined.10

Quantitative Easing and Money Supply Quantitative Easing, by definition, increases money supply. Consider QE1, in which the Fed announced the purchase of $600 billion of agency bonds during the December 2008–March 2010 period. Comparing Fed assets in 2008Q3 to those in 2010Q1, these more than doubled from $1.2 trillion to $2.3 trillion. A balance sheet expansion should obviously have a counterpart. In this case, the counterparts were those institutions or individuals that held agency bonds at that point in time. Consequently, the conversion of their bond holdings to cash holdings, after the Fed’s purchase also meant that the outstanding amount of cash in the economy, measured by the M1 definitions of money stock had to increase (Fig. 11.1). The case is very evident in the subcategories of demand and savings deposits, which increased by approximately 26% and 22%, respectively (or $95 and $878 billion) during the QE1 phase. Even though reductions were observed in other categories which comprise the M2 definition, the overall increase reached $569 billion during the period. The same occurred for bank excess reserves, which can be viewed as the banks’ deposits in the economy, other than the regulatory minimum ones, and also increase the outstanding stock of money (Fig. 11.2).

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The rationale is simple: the Fed has effectively switched debt securities with newly created cash. Given that the former does not constitute part of the money stock definition, it was not included in M1 (or M2). By changing it to cash it is, by definition, included in the money stock, with the same holding irrespective of whether the bonds purchased are sovereign, agency, or corporate. Of course, it should not mean that an increase in QE by, say, 1 billion would mean an equivalent increase in money supply since parts of this amount could be reinvested or could belong to investors abroad. Still, overall, QE, by definition, means an increase in the money supply given that it replaces items not included in the money stock with items which are included in it.

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Quantitative Easing and Inflation To begin with, remember that inflation is affected by supply and demand factors. These factors, do have to change in order for inflation to move from its previous level. However, focusing on Fig. 11.3, which removes the impact of oil and food prices (which remember that are internationally determined and thus account for supply factors given that they are not related with the US economy), inflation remained relatively stable until the third quarter of 2008. The absence of an increase in inflation during a recession (in contrast with the 1980’s one), suggests that the recession is demand-driven and not caused by supply factors. Demand factors mean that inflation will drop during the recession (as was the case in 2009) while the supply side will be affected through this drop. As we would expect, to increase demand we would have to increase money in the market. Notice the difference however between the availability of money and the money in the economy. In the first case, the availability of money in the economy increased but overall money in the economy did not increase. In fact, for bank reserve balances to increase it would mean that an amount of liquidity remained unused, compared to earlier times. Hence monetary conditions in fact tightened, despite the increase in the overall money supply. Unfortunately for economists, there currently exists no metric to pin-point this change in the availability of money.11 To that extent, one can only view the amount of new lending in the economy, which decreased significantly during the recession period (Fig. 11.4). Nevertheless, the absence of a direct 3.0 2.5 2.0 1.5 1.0 0.5

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metric should not limit economic thought,12 as intuition allows to understand that the excess liquidity of banks should be placed at the availability of loan seekers, or similarly, loan seekers should be actively interested in obtaining those funds in order for the availability of funds and consequently for the inflation rate to increase. However, this did not happen in 2009 and the answer lies in the following section.

Quantitative Easing and Bank Lending To answer this question, we would first have to examine whether the factors affecting the supply of loans. To this end, and as we have already discussed in the previous chapter the most important factors are the interest rate margin (i.e. the difference between the interest rate charged for loans and that paid for deposits)13 and perspective borrower’s probability of default (PD). To have an effect on bank lending, QE would need to have an effect on either of the two factors. If neither is altered by easing then bank behaviour should also not be affected. The negative numbers in Fig. 11.4 indicate that net bank lending (i.e. excluding interest capitalization) was declining until 2011Q2.14 Examining the factors affecting bank lending suggests that the bank interest rate spread between the loan rate charged and the deposit rate paid was reduced significantly (Fig. 11.5) during the recession. The drop was mainly caused by the sharp decline in the policy rate that took the bank prime rate down with it. Deposit rates did not respond so quickly and hence banks found themselves in a worsening position at least in late 2008 and

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early 2009. Nevertheless, the spread re-coupled in late 2009 supporting the fact that banks should have had an incentive to lend. What weighed more however appears to have been the banks’ perception of the potential borrower’s probability of default. This, in essence, stands for how possible it is for the bank not to get its money back. If the bank believes that the probability of not being repaid is high enough, then it will most likely not lend out the money. Figure 11.6 illustrates this phenomenon through the banks’ own eyes, by utilizing data from the Senior Loan Officer Opinion Survey. As these suggest, the net percentage of banks that reported an increased willingness to lend 40.0 30.0 20.0 10.0 0.0 -10.0 -20.0 -30.0 -40.0 -50.0 2016Q1

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(i.e. the banks willing to lend minus the banks willing to lend over the total number of banks in the survey) was below zero since the third quarter of 2007 and grew positive only after 2010. The negative levels reached are themselves quite impressive: the banks which were unwilling to lend were approximately 4 times the ones willing to part with their funds. Thus, it is not a surprise that their newly created cash (which replaced agency or government bonds), were deposited in the Fed in the form of excess reserves. This brings up a very interesting point which relates to the multiplier concept discussed in Chapter 4: as we suggested earlier, the money multiplier is limited not by the reserve requirements imposed by central banks, but from the capital requirements. This has some powerful implications for monetary policy. As is well known, during periods of financial distress, the economy’s probability of default increases. As such, banks (correctly) see lending to individuals as riskier than any other investing activity on their behalf, such as purchasing bonds or depositing with the central bank. The issue here is not that lending is risky per se but that lending is riskier than before, given that the economy is in a recession, while at the same time banks are faced with an increasing number of non-performing loans that threaten their capital ratios. Put yourself in the bank’s position: if you knew that your capital ratios are just barely above the legal minimum, would you lend or would you wait for the recession to calm down and get something back from your bad loans so that your capital ratios improve? Before answering, think also how bad of a signal it would be for a bank to increase lending and then announce that it has a capital hole and it needs to raise more money from investors. Banks, who are already going through a harsh time, do not want to bring any more attention to them unless they really need to. Hence, it is much easier for them to withhold lending, or at least ration it, instead of risking their capital positions. Finally, while we often see banks as rigid, faceless institutions, they are in fact run by people, who themselves have feelings, and like the rest of us, are prone to over- and under-reactions. Hence, it is often the case that if they get scared enough to feel that something bad might happen (such as during a financial crisis) then they may overreact and limit lending to a large extent. This overreaction is similar to the one observed in the boom phase of the Financial Instability Hypothesis, where banks overreact to the ongoing economic growth period and increase their lending to speculative and Ponzi units. In addition to banks’ unwillingness to lend, the public was also not very keen to get new lending either: the vast majority of banks recorded a decrease in the level of demand for commercial and industrial loans (Fig. 11.7).15 This

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is in accordance with what Richard Koo16 has dubbed as a balance sheet recession: in contrast with a usual recession, a balance sheet one is characterized by the fact that a large portion of the private sector is trying to minimize its debt. This reaction is quite understandable given that borrowers, seeing their incomes drop, will aim to limit their expenses. Given that one of the major expenses a household has is its mortgage, then it only makes sense to aim for limiting that. Still, in accordance to the Keynes’ paradox of thrift, if one household limits spending, then this is fine. If all households do the same, then aggregate demand drops and the economy is hurt.17 Explaining this in more detail, when a debt-financed bubble collapses then, as expected, asset prices also collapse. Nevertheless, the existing liabilities remain meaning that the private sector’s balance sheet is in the red. To get out of this mess, firms are forced to repair their balance sheets. This can be done in either of two ways: either by increasing savings (which can only be done with cost reductions) or by paying down debt (either through existing deposits, i.e. decreasing money or by generating new profits which can be rather difficult during recessions). In either of the two cases, aggregate demand is reduced, as we have already seen in the second question regarding inflation. The simple deductive conclusion from this situation is that the private sector, busy in repaying loans, is not really interested in obtaining new lending. Furthermore, this helps in explaining why banks felt that their perspective borrowers, with damaged balance sheets, would not be good loan candidates. To further explain what is meant by a balance sheet recession, a simple example is required: remember Friedrich the builder from Chapter 5? Now

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imagine if Friedrich had managed to obtain a loan of 1 million to build a mansion which he thought he would sell for 1.2 million. After Friedrich completed its building, demand collapsed taking house prices down with it. The nice builder who tried to make profit from real estate has now been left with a mansion worth less than the original value of the loan (say 900 thousand). As such, Friedrich is left with negative equity, i.e. after the selling the house he would still owe the bank about 100 thousand. As you may well imagine, neither is Friedrich willing to get a new loan, nor is the bank eager to give one out to him. An interesting complication of balance sheet recessions is that conventional monetary policy, i.e. the manipulation of interest rates, does no longer work like it used to in other types of recessions. The reason is that people do not have any incentive to get new loans now, no matter how cheap the cost of borrowing is. Similarly, neither are banks willing to lend to people with negative equity since this will most likely end up in a loss.18 What is even more important is that as households seek to deleverage (i.e. decrease the amount of loans they have), monetary policy becomes even less effective. Put it this way: if total lending in an economy is $100 billion, then a 1% interest rate cut would amount to savings of around $1 billion from households. Even if households moved some of that amount to their savings account, then the economy would still benefit. Now, if households are focused on deleveraging and total lending was reduced to $90 billion, then the amount of savings would be reduced to $900 million. Furthermore, it is more likely that households would use that amount for further deleveraging, hence depriving the economy from a substantial boost. If you consider that this mechanism may not be strong enough, let’s see an example: bank loans in the US stood at $7 trillion just a month after the Lehman crisis in September 2008, when the world finally understood what was imminent. In the following year, total loans dropped to $6.5 trillion. At the same time, the Federal Reserve policy rate dropped by around 1%. This meant that around $5 billion were lost due to this reduction in loans, while at the same time the remaining $65 billion of gains were likely used for repayments. Even ignoring the potential effects from people trying to fix their balance sheets, it is not that the environment for loan seekers improved: the bank prime interest rate did not budge since the first quarter of 2009 after the policy rate was set to zero. In fact, even after three rounds of easing, the bank rate remained flat until the first interest rate hike in late 2015. Finally, as already discussed in Chapter 3, banks do not loan out of their reserves, but instead create money “out of thin air” during the loan process.

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The provision of additional cash helps only in creating more liquidity which in normal times can promote riskier lending. If the Federal Reserve was actively looking for a way to make sure that banks had enough liquidity to provide loans, a simpler solution would have been increasing the availability of Fed credit to banks in the case of loan granting. This would ensure the continuation of the normal operations of banking without having to exchange their bond holding with cash. In essence, this option would allow for less spending by the Federal Reserve (again it should be mentioned that this is not taxpayer money but is instead a money-printing process) and much less intervention in the market for any type of bonds.

QE and Bank Lending in the Euro Area It is interesting to see that this also holds in the euro area. As Fig. 11.8 shows, lending to the private sector, as a percentage of total assets, has not increased since 2010. This suggests that banks prioritize their capital requirements, despite successive rounds of QE, negative interest rates (more on this in a few pages), and other incentive measures such as the European Central Bank providing cheap liquidity to banks to give loans to the private sector (commonly known as LTROs—Longer-Term Refinancing Operations or TLTROs—Targeted Longer-Term Refinancing Operations). In fact, banks appear to have been still unwilling to extent credit to the private sector, at least to the extent policymakers believe they should have. On the other hand, they have found it more profitable to increase interbank lending, perhaps 60.0% 55.0% 50.0% 45.0% 40.0% 35.0% 2010Jan 2010May 2010Sep 2011Jan 2011May 2011Sep 2012Jan 2012May 2012Sep 2013Jan 2013May 2013Sep 2014Jan 2014May 2014Sep 2015Jan 2015May 2015Sep 2016Jan 2016May 2016Sep 2017Jan 2017May 2017Sep 2018Jan 2018May 2018Sep 2019Jan 2019May 2019Sep 2020Jan

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also exploiting interest rate differentials between countries, while at the same time making sure that such lending is short term and to a well-respected institution. Similar to the US banks, European banks have put most of their additional funds into excess reserves, with each phase of quantitative easing in the region (Fig. 11.8). In 2012, a jump in reserves was observed, due to an increase in the ECB’s reserve requirements in July of that year.19 As the banking system adjusted to the new requirements, reserves moved down again, back to long term, near-zero, levels prevalent in the economy prior to 2012, but resumed their upwards trend after the first phase of QE, which started in 2015. During that period, excess reserves moved from around 1% to more than 8% in September 2018 when QE ended. Exactly one year later, in September 2019, QE was reinitiated and excess reserves picked up again. Effectively, Fig. 11.9 simply confirms what Fig. 11.8 shows, i.e. that banks will not engage in excess lending despite having surplus liquidity if they consider it risky, or if it will hurt their capital needs. Finally, despite the heavy rate of asset purchases, banks keep holding around 10% of their assets in government bonds (Fig. 11.9), suggesting again that quantitative easing does have an impact on their perception of risk. In fact, from March 2015 until March 2017, when the ECB’s QE programme was in full speed, with purchases at e60 billion per month until March 2016 and e80 billion per month until March 2017, bond holding decreased by just 2.2% of total assets, all of which appear to have gone into excess reserves.20 Overall, QE does not affect bank lending as, during a financial crisis, people are less willing to borrow and banks are not eager to lend due to 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 2010Jan 2010May 2010Sep 2011Jan 2011May 2011Sep 2012Jan 2012May 2012Sep 2013Jan 2013May 2013Sep 2014Jan 2014May 2014Sep 2015Jan 2015May 2015Sep 2016Jan 2016May 2016Sep 2017Jan 2017May 2017Sep 2018Jan 2018May 2018Sep 2019Jan 2019May 2019Sep 2020Jan

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increased worries about the borrowers’ probability to default and the potential effect this could have on their capital ratios. Furthermore, banks do not lend from reserves and thus a simple extension of the availability of Fed credit to banks for loan granting would have done the same thing, albeit more simply and without pumping the economy with cash. As a commentator has put it “the ECB experience has been roughly comparable to the Fed’s experience: Much monetary creation and much expansion of the balance sheet and monetary base producing comparatively little credit expansion”.21

Quantitative Easing and Private Investment Had QE boosted investment, then Fig. 11.10 would have been very different. Instead of observing the large drop in 2008–2009, the trough of which coincided with the implementation of QE1, investment should have picked up much earlier. In fact, the trough of Fig. 11.10 coincides with the drop in bank credit observed in Fig. 11.5. After that point, investment saw an upwards trend. The increase in investment does not coincide with the behaviour of net bank lending. If QE was to have some effect on this then one could claim that a possible explanation it has had some delayed effects on investment, perhaps through the confidence channel. Nevertheless, there has to be some source of funding in order to increase investment. The story does not appear to match the data: Foreign Direct Investment (FDI) decreased during the period22 and bank lending growth was negative until 2010q4. Thus, there 3,300 3,100 2,900 2,700 2,500 2,300 2,100 1,900 1,700

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are only two ways this could take place: either firms used existing deposits, which is contradictory with what the deposits data show for the US,23 or firms took advantage of the lower wages of the 2009–2013 period to boost investment activity. The drop in wages is both in line with the Phoenix Miracle view of credit-less recoveries, as well as the balance sheet recession notion presented previously.24 The latter provides a rationale to the view that firms wishing to improve their balance sheets would have to cut back at their expenses and repay their loans. The former (Phoenix) suggests that wage decreases would allow for additional funds to be used for investment purposes. In both cases, the decrease in wages is required for the improvement of the firm’s position. It is also necessary for the reinstitution of growth and does not stem from any policy actions.25 An additional explanation for the path of investment lies in the oldfashioned Keynesian idea of increased government spending. In fact, the increase in government consumption and investment (Fig. 11.11) has been important in reducing the effects of the slump and promoting growth prospects. Specifically, government consumption and investment increased by more than 7% in 2008, followed by a 3% and 2% increase, respectively, in 2009. Government investment stabilized in 2010 while government consumption increased by a further 3%, after which it stabilized. The moral of the story is simple: while the reduction of interest rates to near-zero levels in 2008 and the subsequent rounds of monetary easing would have been helpful in any other recession, they will not amount to much during a financial crisis, simply because the dynamics relate to supply-side 680.0

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problems (i.e. the banks) and not a lack of demand for lending. In addition, if households are over-indebted and seek to deleverage, monetary policy will be even less effective, as the situation will more resemble a balance sheet recession. On the other hand, more emphasis should be placed on governmentrelated policies which aborted further deterioration of the economy by not allowing demand to drop any further. In fact, in many quarters during the recession government had the only positive contribution to growth. Without the 45% increase in the US government debt ceiling by the Congress from 2007 to 2010, the recession would have been even worse for the country.

Quantitative Easing, Bond Yields, and Monetary Financing Taking all of the above into consideration, there is no direct channel through which quantitative easing could have had an effect on the economy.26 The policymaker actions which had a direct effect on the economy were confined to the increase in government investment and consumption, i.e. they were originated by fiscal and not by monetary policy. The role of the drop in wages was also important, however, this was not the outcome of the actions of either the Federal Reserve or the US government but a natural outcome of any recession. Nevertheless, QE did have a significant impact: as already discussed, QE programmes aim to reduce interest rates through the purchase bonds (Fig. 11.12), either public or private ones. If John owns a government bond and the Fed purchases the bond from him, then a change in ownership, via increasing the price of the bond and lowering the costs of borrowing for the government, occurs. In this case, the government benefits from exchanging higher interest rate bonds with lower interest rate bonds, which reduce the amount of interest due. In fact, the US government reduced the amount of interest paid by 3.5% in 2008 and a further 9% in 2009, while debt increased by 10% and 18%, respectively (Fig. 11.13).27 While, naturally, the drop in interest paid can also be attributed to the interest rate reductions, totalling around 3.5% in 2008, the strong impact in 2009 suggests that a large part is attributed to QE. This allows the government to use the extra fiscal space to allocate more money in the economy without jeopardizing its fiscal deficit (remember that the interest saved would have also gone to the private sector, but it would most likely take the form of savings, which are not part of the active money in the economy).

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Further to the above effects, the impact is even greater if the programme mandate allows the Fed to purchase newly created bonds, which only happens when the stock of government debt is allowed to increase. In this case, QE purchases are in fact assisting the government to obtain financing much cheaper as the interest rate on its bonds is reduced and can be viewed as direct monetary financing. Again, in order for this to be viewed as monetary financing, the stock of government debt must be increasing. Coupled with fiscal austerity or unwillingness to exploit the fiscal space created with the reduction in interest expenses (such most countries in the European Union and Japan) means that QE will not have any direct effects

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on the economy. In this case there is only one channel: confidence. Confidence, or as eloquently put “the management of expectations”,28 was greatly affected by the Fed’s announcement of policy actions. Figure 11.14 suggests that confidence increased just a quarter after the announcement of the QE programme. The increase continued until 2010 and was relatively stable until the end of the second period of quantitative easing. The effects of QE on confidence also provide a rationale for a timely implementation of policy actions: confidence nearly halved from 2007Q1 to 2008Q4 and immediately bounced after its announcement. Had it not been implemented, confidence would have most likely continued its free fall. However, the picture is also illustrative for another purpose: even though confidence peaks up, there is no direct effect on the economy. It is as if someone has felt better right after a serious illness: while they would like to go out and play football, not only do they feel weak but are also still afraid of the illness they have been through as it is very clear in their minds. This experience, more resembling a trauma, can last for a while. While in the Great Recession the swift actions of the government have made the economy recover faster, it took the US about 30 years to bring interest rates up to 4% after the Great Depression of 1929.29 In addition, the absence of government policies and the continuous effort for balance sheet improvements led to what Irving Fisher dubbed as the “debt-deflation” vicious cycle, where a decrease in prices caused by willingness to reduce borrowing results in increasing the real value of borrowing, making it even harder to repay.30 Some QE programmes have also targeted private sector bonds. However these actions do not appear to do anything other than pumping money into firms which should have done their risk management much better. Increasing

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private sector liquidity does not entail that investment of consumption will increase, since people seldom consume much out of deposits.31 In addition, given the uncertain environment, it is more likely that the newly acquired cash will either be invest in low-risk stocks or low-risk bonds. In either case, this will not do much for the economy unless companies issue new shares and use the funds for investment purposes. Given that low-risk firms are very unlikely to do this as they already have enough cash laying around, it does not follow that investment will certainly benefit from the purchase of private sector bonds. To sum up this section, QE affects the economy by lowering interest rates for government bonds, but, in a financial crisis, this reaches the economy only if the government exploits the drop in interest rates by increasing spending. The greater the increase in spending, the larger the effect from quantitative easing.

Selling Back Securities: The Tapering Many market participants fear that if the Federal Reserve reduces the amount of bond purchases (“taper” the QE programme in Fed parlance), stops purchases altogether, or, even worse, starts unloading the bonds carried on its balance sheet it will wreak havoc to the economy. This appears to be the usual rhetoric of Cassandras, despite the fact that QE did not really have any direct impact on the economy. As the economy was only affected through the increase in government spending, and this appears to have rather stabilized since 2011, then the worst for the real economy appears to have already been gone. There, of course, remains the effect that QE has on interest rates, mainly the bond market. This, as much of the existing literature has found, appears to have been rather strong. However, it does not follow that the effect would reverse by the same amount if the Fed stops purchasing bonds. In fact, the Fed began to taper, i.e. reduce the amount of purchased bonds, in December 2013.32 In Fig. 11.13, one can notice the effect on the 10-year Treasury: it increased by a non-remarkable 0.07 percentage points (or 7 basis points), from 2013Q4 to 2014Q1. From then onwards, the downwards trend continued. The fear that markets would collapse once the Federal Reserve tapered appears rather unfounded: the markets have simply shrugged off the stop in bond purchases. Unless the Fed simply drops all of its holdings in the market, then no major movement is expected.

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While the fear of tapering appears unsound, does the unloading of these bonds pose a potential threat to the system? The answer is that, as with all things, it depends on the timing. Suppose that the Fed had decided to drop off its bond holding back in 2010, at the time when the recovery was still weak: most likely the effect would have caused bond yields to rise, similar to what an increase in the policy rate would have caused. In fact, the reason behind the use of QE in the first place was that the interest rate, the usual way of fine-tuning the economy, reached zero and could not go further down. The behaviour of banks is in accordance to the above argumentation. After the interest rate determined by the Federal Reserve reached zero in December 2008, the bank prime interest rate, i.e. the rate charged for business loans reached its floor, at about 3% and remained there despite heavy asset purchasing (Fig. 11.15). Remember that banks also have their costs: wages, rents, interest rates on deposits. These make up a floor on interest rates beyond which rates cannot really drop. In reality, the Fed should be in no hurry to dispose the bonds since the central bank is not bounded by any timing constraints or by the desire to make profits. Instead, the wisest thing for the Fed would be to wait until the economy is booming again and then dispose the bonds, in addition to manipulating the interest rate. This would be more beneficial to the target the Fed is trying to reach, that is cooling off the economy by increasing bank interest rates. Even if the Fed can wait until the economy booms again, there is no certainty that selling the bonds would cool off the economy. Just like easing did not really have an impact on bank lending because it did not affect banks’ 9.00 8.00 7.00 6.00 5.00 4.00 3.00

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willingness to borrow, unloading the securities should not be expected to have an effect on lending the way the policy rate fine-tunes the economy. The Fed may end up suppressing bond yields upon the sale of its stock of securities which could cause more money to flood into the bond markets and cool off stock prices but this is not expected to have any effect on the real economy. QE tapering, as well as the disposal of the securities held by the Fed, is not expected to have an effect on the real economy even though it will have an impact on bond yields. The only way for it to have an impact is if the Fed chooses to sell the bonds during a recession or otherwise turbulent period, or does so by unloading the magnitude of its balance sheet at one specific moment in time. The bigger question is what the Fed can do about all these assets, as well as how effective this policy is. Would simple and straightforward monetary financing have been more to the point and much more efficient? Naturally, this is a question that deserves much policy (and political) consideration, given the long-term implications it could have on the conduct of monetary policy as well as the future of central banking. As such, it goes beyond the scope of this book.33

Easing in the EU and Japan The responses to the previous questions have suggested that QE measures have no direct impact on the economy other than the lowering of bond yields. If governments exploit this fact to boost aggregate demand by spending more, then QE can have some indirect effects on the economy. As suggested earlier, quantitative easing measures do not have an effect on the economy on their own, but rely on the government stepping up on deficit spending. However, while European countries and Japan had put forth QE measures, they had, at the same time have promoted fiscal austerity measures. Austerity means that government spending reduces and as the previous questions have demonstrated, this effectively cut off the only “direct” channel of transmission. To further strengthen the point, it has been also recorded that the only time Japan’s easing programmes were succeeding, even for a short period of time, were during a phase of expansionary fiscal spending.34 As has been explained before, the absence of fiscal enlargement prohibits the use of lower bond yields for the improvement of the economy and simply allows for the expectations channel to be affected by asset purchases.35 Even worse, fiscal

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austerity also takes its toll on expectations, not allowing for the smooth transition of the effects.36 Overall, the answer here is simply that central banks have over-estimated the ability of QE to impact the economy without any cooperative fiscal expansion.

QE: A Conclusion Applying the intuition of the previous chapters, quantitative easing policies do not appear to have a direct impact on the economy. In contrast, government spending is required to reinvigorate growth. Asset purchases do however have an impact through two channels of transmission: (i) confidence and (ii) lowering the cost of lending for the government. The first does not have a direct impact on the economy but can be positive after some periods. The second has the most important effect, by lowering interest paid by the government and, if the programme allows for a direct purchase of newly issued bonds, it can also be viewed as monetary financing. If this is coupled with fiscal enlargement then aggregate demand is increased; if not then it is simply a sit-and-wait policy expecting the lowering of interest rates to do its job. Austerity is the worst of both worlds since it both lowers aggregate demand and does not allow the government to take advantage of lower yields as well as reduces confidence in the economy. To top this, if austerity measures are not front-loaded (i.e. if austerity is implemented in stages) the effect on confidence will be even more prolonged. In essence, quantitative easing is nothing more but the modernization of Keynesian policies of increased government spending during downturns, albeit with the assistance of the Central Bank to lower financing costs. This is the reason why the QE measures in Europe and Japan have not been successful: the lack of fiscal space only limits the impact of these measures to confidence effects. Even though these are very important in the economy, they do not appear to have the ability to boost inflation or output in the short-run.

Negative Interest Rates The imposition of negative interest rates has been promoted as “indispensable” by policymakers, but notably this comment was made by the Swiss National Bank Governor, who, most of all, wanted to prevent the Swiss Franc

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from rising any further.37 Nonetheless, the first country to impose negative interest rates was Denmark, back in 2012, with a policy which lasted for two years and then a reimposition just a few months later, for another two years. The popularity of negative interest rates has risen through time, with Japan, Sweden, Switzerland, and the European Central Bank having imposed negative rates since then.38 The rationale behind the move to negative policy rates was driven largely by a need to increase inflation, which remained at low levels for too long, and boost the economy through increases in bank lending to the private sector. In most cases, the lowering of interest rates came in addition to large-scale asset purchase programmes (read QE), which had been in existence since monetary authorities hit the zero lower bound (ZLB). By setting negative interest rates, policymakers envisaged that banks with excess liquidity would channel it to loan funding, instead of keeping it in the form of reserves, as it would now actually have a cost. For example, if the deposit policy rate is at −0.25%, then it means that a bank would have to pay the central bank for each day it keeps money at it. Despite the appeal such a thought may have, when authorities on banking such as Charles Goodhart advocated the move to negative interest rates (on excess reserves) as a complement to quantitative easing, he realized that the impact these could have on banks’ behaviour would be very limited. In his own words “But it is not a game changer. This is because neither IOER [interest on excess reserves], nor QE, directly affects the main factors restricting bank lending to the private sector (…)”.39 These factors are primarily related to bank concerns over their perspective borrowers’ probability of default, and, to a lesser extent, their returns targets (namely Return on Equity—RoE), meaning that they would like to charge higher interest rates for assuming the specific risk. Specifically, for the case of RoE, the spread over a bank’s marginal funding cost has to be large enough to generate a return that meets that bank’s target RoE. In order to boost bank lending growth, interest rates would have to increase interest rate margins (IRMs) to induce banks to facilitate lending. However, this was not the case. As a report from the Swiss National Bank notes,40 “Remarkably, domestically focused banks’ average interest rate margins on outstanding claims stabilised at a low level in 2015, after a seven-year downward trend. This occurred despite liability margins slipping further into negative territory (…)” This stabilization can also be found in Sweden and Denmark (Fig. 11.16).41 Intuitively, the policy would also make sense from the demand side of banking: lower interest rates should encourage households and businesses to

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borrow and spend more as they reduce borrowing costs. Nonetheless, the fact that this is a tool mostly aimed at the demand and not the supply side of bank lending means that it is not enough for borrowers to seek more lending; lenders must also be willing to provide them with funds. As studies have shown, banks do not adjust loan terms because of negative policy rates.42 Basically, it is much easier to pass on the cost to consumers and firms, given that they have no alternative. This was already done in the case of large firms, with consumers receiving just zero interest on their deposits in most countries. Despite the belief that depositors could move their funds away from a bank and keep it under the proverbial mattress, this can only happen in the case when the amount is minimal. How could a single individual keep his life savings safe? As burglars have admitted, the safest place to keep your money is at the bank. That said, it is also evident that negative interest rates have a stronger impact on net depositors, and benefit net borrowers. If your assets are greater than your liabilities, then you will be penalized by paying negative interest. Even if you do not end up paying for your deposits, the interest rate received on them will be zero. The rationale is again that you would have to spend this in order to boost the economy. Nonetheless, as we have also seen before, the

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economy is a circle: if one spends another has to receive. Hence, the amount being charged will also remain stable. Furthermore, with negative rates and a constant search for income to cover their operating expenses, if policy rates remain for a long period of time, the riskiness of investments that banks choose to lend to will increase, this time supported by policy. This can be viewed via the fact that bank interest rate margins have not decreased as expected. While negative interest rates have essentially eliminated the perception of the zero lower bound, their practical benefits are still unclear and suggests that the manipulation of interest rates may not be able to influence banks’ lending behaviour.43 Hence, while negative interest rates may appear to have some intuitive appeal, the practice of banking does not appear to support their conclusions. That said, it would perhaps be best if policy focused on allowing banks to function as they best can in the prevailing economic environment and not aim to squeeze small changes in lending. In fact, negative interest rates appear to have become a popular item in the countries when QE did not have an impact, namely due to the fact that fiscal policy was not allowed any space. Hence, as local perceptions did not allow for the proper functioning of QE, negative rates tried to push the private sector into a lending craze, risking at the same time the creation of a real estate bubble.44 In contrast with QE, in which securities can just be held at the central bank’s balance sheet without causing any issues in the functioning of the markets, if negative rates persist for long, a policy-inflated lending boom, along with all the consequences this could have, may take place. As banks experience more and more years of economic growth, then they start lending to riskier projects, as well as focusing their lending in specific sectors. The most difficult part of negative interest rates is their gradual removal, given that the timing needs to be correct, in order to send messages of prosperity to the markets and not panic them. At the same time, it is quite difficult to see how policymakers will be able to sustain them once retail clients are included in the list of those who have to pay for their deposits. Overall, there has been no evidence about the success of negative interest rates. Still, some countries appear to be convinced that they work. While they may be useful in sustaining a depressed exchange rate, such as the case of Switzerland, there is zero proof that it can otherwise support the workings of an economy and boost lending. This, as already discussed, lies in the fact that the policy rate is aimed at the demand side of lending (consumers and firms) and not the supply side (banks).

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Notes 1. Werner, R. A. (1995). How to create a recovery through “Quantitative Monetary Easing”. The Nihon Keizai Shinbun (Nikkei), 2 September 1995 (morning edition), p. 26. 2. Lyonnet and Werner (2012). Lessons from the Bank of England on “quantitative easing” and other “unconventional”monetary policies. International Review of Financial Analysis, 25, 94–105. 3. “Monetary Policy under Zero Interest Rate: Viewpoints of Central Bank Economists”, Bank of Japan Monetary and Economic Studies, February 2001. 4. Exceptions include Lyonnet and Werner (2012), Gros et al. (2015), and Gros (2015). 5. Nelson (2013). 6. For a more detailed definition of a liquidity trap see Eggertsson (2008). 7. Notice that the zero lower bound (ZLB) does not necessarily mean that interest rates have to be at precisely zero but could be at a point beyond which they cannot fall. This bound can reflect cost of deposits, a risk premium, and other bank costs. 8. Eggertsson and Woodford (2004). 9. See inter alia, Krishnamurthy and Vissing-Jorgensen (2011), Christensen and Rudebusch (2012), and Falagiarda (2014). 10. The source of all figures is the FRED database. Shaded areas indicate the three QE phases. 11. A simple metric would be the deduction of the monetary base (currency in circulation and bank reserves) from the M1 money stock, which includes the most volatile components of money. From 1984 until 2008, its level remained relatively stable, until the surge in reserves in the fourth quarter of 2008, forcing it to go negative and remain there since. 12. Allowing things which cannot be measured to limit understanding would amount to Hayek’s pretence of knowledge. 13. Goodhart (2013) differentiates between the return on equity (RoE) and the banks’ funding costs. The distinction is not necessary as bank interest rate margins cover for both. Goodhart also identifies that QE does not have an effect on bank lending. “This is because neither IOER [interest on excess reserves], nor QE, directly affects the main factors restricting bank lending to the private sector (…)” (page 11). 14. Flow of funds are also more significant in the case of phoenix miracles (see below). Biggs et al. (2009). 15. Using the FRED Senior Loan Officer Opinion Survey data, the same picture also emerges for smaller businesses. 16. Koo (2011a, b) and Koo (2016). For the first-time introduction of the term see Cantor and Wenninger (1993). 17. Keynes (1936).

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18. The net effect from quantitative easing was also found to be very small in the case of Japan. See Bowman et al. (2015). 19. Todd (2013). 20. https://europe.pimco.com/en-eu/resources/smartcharts?chart=ECB-Quantitat ive-Easing-QE-Timeline. 21. Ibid., 19. 22. See FRED series ROWFDIQ027S, https://fred.stlouisfed.org/series/ROWFDI Q027S. Accessed November 7, 2016. 23. Deposits, All Commercial Banks (DPSACBW027SBOG). Accessed August 10, 2020. 24. Calvo et al. (2006). 25. The only actions which could have an impact on wages would have been persisting union deals or collective agreements; protection of such deals during recessions could have disastrous effects as it would not allow for wages to drop as much as required for the country to regain competitiveness. The increasing trend of wages in Japan until the late 1990s and their slow reduction in the 2000s has also contributed significantly to country’s lost decade. 26. See Michail et al. (2020). 27. Naturally, this reduction in interest rates cannot be solely attributed to quantitative easing but also to the reduction of the Federal Reserve interest rate to zero. However, there is evidence that at least some part of this reduction was the result of QE measures. See for example, Gambacorta et al. (2014) and Joyce et al. (2010). 28. Eggertsson and Woodford (2004) are the usual modern reference however this goes back to Keynes’s General Theory (1936) 29. Koo (2011b) 30. Fisher (1933). 31. Poterba (2000). 32. https://www.federalreserve.gov/newsevents/press/monetary/20131218a.htm. 33. Ibid., 26. 34. Koo (2011b). 35. Boyer (2012), Calcagno (2012), and Konzelmann et al. (2016). 36. Beetsma et al. (2015) and Michail et al. (2018). 37. Thomas Jordan, Governor of the Swiss National Bank, as quoted in Bloomberg “SNB negative rates are right for now despite risks, Jordan says”, October 24, 2016. 38. The analysis below mostly follows Michail (2019) as well as Bech and Malkhozov (2016). 39. Goodhart (2013). 40. Swiss National Bank (2016), Financial Stability Report (page 5). 41. Data from the European Central Bank, Statistical Data Warehouse 42. Heider et al. (2020).

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43. Goodhart (2013), Blanchard et al. (2010), and Michail et al. (2016). 44. https://www.housers.com/blog/en/european-central-bank-alerts-housing-bub ble-risk-8-countries-spain-considered-healthy/.

References Bech, M., & Malkhozov, A. (2016, March). How have central banks implemented negative interest rates. BIS Quarterly Review. Beetsma, R., Cimadomo, J., Furtuna, O., & Giuliodori, M. (2015). The confidence effects of fiscal consolidations. Economic Policy, 30 (83), 439–489. Biggs, M., Mayer, T., & Pick, A. (2009). Credit and economic recovery. (DNB Working Paper No. 218). Amsterdam: Netherlands Central Bank. Blanchard, O., Dell’Ariccia, G., & Mauro, P. (2010). Rethinking macroeconomic policy. Journal of Money Credit and Banking, 42, 199–215. Bowman, D., Cai, F., Davies, S., & Kamin, S. (2015). Quantitative easing and bank lending: Evidence from Japan. Journal of International Money and Finance, 57, 15–30. Boyer, R. (2012). The four fallacies of contemporary austerity policies: The lost Keynesian legacy. Cambridge Journal of Economics, 36 (1), 283–312. Calcagno, A. (2012). Can austerity work? Review of Keynesian Economics, 1, 24–36. Calvo, G. A., Izquierdo, A., & Talvi, E. (2006). Phoenix miracles in emerging markets: Recovering without credit from systemic financial crises (No. w12101). National Bureau of Economic Research. Cantor, R., & Wenninger, J. (1993). Perspective on the credit slowdown. Federal Reserve Bank of New York. Christensen, J. H., & Rudebusch, G. D. (2012). The response of interest rates to US and UK quantitative easing. The Economic Journal, 122(564), F385–F414. Eggertsson, G. B. (2008). Liquidity trap. In S. N. Durlauf & E. Blume (Eds.), The new Palgrave dictionary of economics. London: Palgrave Macmillan. Eggertsson, G. B., & Woodford, M. (2004). Policy options in a liquidity trap. The American Economic Review, 94 (2), 76–79. Falagiarda, M. (2014). Evaluating quantitative easing: A DSGE approach. International Journal of Monetary Economics and Finance, 7 (4), 302–327. Fisher, I. (1933). The debt-deflation theory of Great Depressions. Econometrica: the Econometric Society, 1(4), 337–357. Gambacorta, L., Hofmann, B., & Peersman, G. (2014). The effectiveness of unconventional monetary policy at the zero lower bound: A cross-country analysis. Journal of Money, Credit and Banking, 46 (4), 615–642. Goodhart, C. A. (2013). The potential instruments of monetary policy. Central Bank Review, 13, 1–15. Gros, D. (2015, June 12). The QE placebo. CEPS Commentary.

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Gros, D., Alcidi, C., & De Groen, W. P. (2015). Lessons from quantitative easing: Much ado about so little? CEPS Policy Brief (330). Heider, F., Saidi, F., & Schepens, G. (2020). Life below zero: Bank lending under negative policy rates. Review of Financial Studies, 32(10), 3728–3761. Joyce, M., Lasaosa, A., Stevens, I., & Tong, M. (2010). The financial market impact of quantitative easing (Bank of England Working Paper 393). Keynes, J. M. (2018 [1936]). The general theory of employment, interest, and money. Cham: Springer. Konzelmann, S., Gray, M., & Donald, B. (2016). Assessing austerity. Cambridge Journal of Economics, 38(4), 1–22. Koo, R. C. (2011a). The holy grail of macroeconomics: Lessons from Japans great recession. Singapore: Wiley. Koo, R. C. (2011b). The world in balance sheet recession: Causes, cure, and politics. Real-World Economics Review, 58(12), 19–37. Koo, R. C. (2016, February 2). Authorities and markets continue to ignore real economy and act on textbook assumptions. Nomura Research Group Publication. Krishnamurthy, A., & Vissing-Jorgensen, A. (2011). The effects of quantitative easing on interest rates: Channels and implications for policy. Brookings Papers on Economic Activity, 2011(Fall), 215–265. Lyonnet, V., & Werner, R. (2012). Lessons from the Bank of England on ‘quantitative easing’ and other ‘unconventional’ monetary policies. International Review of Financial Analysis, 25, 94–105. Michail, N. A. (2019). What if they had not Gone Negative? A counterfactual assessment of the impact from negative interest rates. Oxford Bulletin of Economics and Statistics, 81(1), 1–19. Michail, N. A., Koursaros, D., & Savva, C. S. (2016). The lack of persistence of interest rate changes on banks’ lending and risk taking behaviour. Bulletin of Economic Research, forthcoming. https://doi.org/10.1111/boer.12273. Michail, N. A., Koursaros, D., & Savva, C. S. (2018). The effects of fiscal policy on business confidence. Economics and Business Letters, 7 (2), 76–83. Michail, N. A., Koursaros, D., & Savva, C. S. (2020). Did quantitative easing have an impact? Evidence from the US (Working Paper Series). Central Bank of Cyprus. Nelson, E. (2013). Friedman’s monetary economics in practice. Journal of International Money and Finance, 38, 59–83. Poterba, J. M. (2000). Stock market wealth and consumption. The Journal of Economic Perspectives, 14 (2), 99–118. Todd, W. F. (2013). The problem of excess reserves, then and now (Levy Economics Institute of Bard College Working Paper 763).

12 Epilogue: The Future

Previous chapters have provided a detailed overview of how the banking system functions. Regardless of the country or the state of the economy, the banking system has the particular effects discussed, with regards to how it impacts the economy, money, inflation, and how crises can hurt jobs and general economic development. This chapter will not bore you with a recap of what has already been said. On the other hand, it will focus on how future developments can potentially affect the banking sector.

Cashless Societies The rationale for cashless societies stems from a view where cash represents the ultimate evil: it is via the use of cash that people tend to tax evade, receive proceeds made by illegal activities, and otherwise keep their transactions hidden by the eye of the law. As some of its advocates have suggested, there is now no need for cash anymore.1 The fact is that we have been living in an increasingly cashless world. With the rise of payments via the internet, wire and bank transfers, and credit cards, the use of hard money appears to have been reduced significantly. As a recent study by the US Federal Reserve shows,2 the value of non-cash transactions rose by more than 24% from 2012 to 2018. E-commerce has been the leading source for non-cash transactions, with around 63% of the total.

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It is only reasonable to expect that as e-trade continues to expand, the share will continue to rise, and so will non-cash transactions. At the same time, cash does not appear to be losing its appeal: in the US, cash withdrawals were actually up by 15% in 2018 compared to 2012. Still, the number is dwarfed by comparison to non-cash transactions (0.9% in 2012 and 0.8% in 2018), even though this number simply refers to new cash withdrawn and not the cash that is actually circulating in the economy. In an effort to gauge the latter, Fig. 12.1 shows that per person currency in circulation in the US, in real terms. As it appears, the value has actually increased over time, however, most likely due to the aggressive expansionary policy measures pursued by the Federal Reserve (see Chapter 11), as the increase is evident from 2009 onwards. This is also in accordance with the outstanding amount of notes issued, as their numbers grew by more than 30% per denomination from 2009 to 2019, with $100 bills more than doubling.3 In general, there does not yet appear to be any support for a movement towards a cashless society. While the number of cash transactions are hard to measure, given the fact that money provides the ultimate source of privacy, as the two parties of the transaction remain anonymous.4 As some commentators have argued, it could be the case that money is increasingly important in a digital world, where identity theft is ever-present, and other issues relating 2,400.0 2,200.0 2,000.0 1,800.0 1,600.0 1,400.0 1,200.0

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to anonymity (not always related to shady deals), data breaches, and hacking are also part of the everyday concern for users.5 Effectively, as recent experience has shown,6 the use of digital money versus hard cash has just replaced one problem with another. In the past, people were afraid that their cash might be stolen; currently, the biggest worry is that if security is breached, not only their cash but also their private information will only be out in public. Given that large-scale hacks occur every now and then,7 one cannot really argue in favour of digital money being safer than cash. The only thing that usually holds in digital theft is that no physical harm would happen to the victim. Overall, what the above suggests is that, while a rise in cashless payments is observed, there has been no real evidence of moving away from cash. More so, it appears that cash still plays an important role in society, as some US states have actually banned cashless stores. While the future is likely to bring a less frequent use of cash, given the increasing rate of e-commerce and digital payments due to their logistical ease (no need to carry a suitcase of cash), cash is very likely to remain important for everyday transactions. On the other hand, a very likely scenario is one where the use of large denomination bills will likely be ruled out at some point (the European Union has already stopped printing e500 bills),8 given that these are the ones usually employed for shady purposes. Other than this, and the inevitable rise in digital payments, there appears to be no proof, at this point of time, that we are increasingly moving towards a cashless society.

Digital Banks and E-Money It was once said that innovations in banking stopped after the discovery of the ATM. This was mostly true until the digital world came to be an everyday part of our lives. After that, banks started to innovate once again, by offering internet access to our accounts, the ability to make transfers without physically visiting the branch, paying bills, and so on. In recent days, further innovation has been the advent of digital-only banks, which have very limited, if any, physical presence. Digital banks have effectively proceeded with pushing money-holding to its logical limits: if money is just numbers on a screen and most transactions are done electronically, what is the need for a bank to have a physical presence? Why not just exist digitally, and focus on conducting transactions faster and with smaller customer fees? This is what many startup banks across the world have considered and are thus operating in a digital-only version.

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Truth be told, while the ability to create an account using just a mobile application is very appealing, most of these banks currently operate more in the sense of payment systems rather than actual banks. At the moment, digital banks offer just small amounts of loans to their clients, an expected strategy given the fact that these entities would be faced with much higher risk if they extended credit e.g. a house purchase. Nonetheless, given that these banks are regulated by the proper authorities means that these services can be extended in the near future. It could soon be the case that an application for a mortgage loan could be sent and approved within minutes, fast-tracking the whole process. Still, issues of trust remain: not all consumers, despite how tech-savvy or progressive they are, would trust a bank they cannot see. This is the reason why even though digital banks have taken up a portion of the existing banks’ clients, mostly by advertising their low-cost transaction services, the likelihood of displacing existing banks is very small. That said, it is highly likely that a hybrid case will evolve in the near future: as more and more traditional banks realize that there is no need for maintaining many branches, a turn to digitalization will ultimately take place. Traditional banks will now focus on developing their digital applications, which will be competing those of existing digital banks. At the same time, they will maintain a small number of branches which will be focused on providing loans, as well as for deposit and withdrawal purposes. Given that the latter can also take place using just an ATM, it is likely that existing branches will be replaced with just a machine to take in cash and cheques, as well as allowing for more intra-client transactions such as transfers. What should be mentioned here is that despite banks becoming increasingly more digital, the points raised about the banking sector in the previous chapters still hold. Regardless of whether money is in print or digital form, banks still continue to provide liquidity to the economy by creating new loans, and banks still face the same challenges they did when they were just brick-and-mortar in the 1930s. Overall, despite the rise in digital presence, a loan continues to be a loan and a deposit is a deposit regardless of its form. While innovations and ways to move around the legislative boundaries will always exist, the core of the banking sector will remain the same. With regards to e-money, while thus far no major developments have publicized, other than China’s trial of its new digital currency, it also appears that this will play a large role in everyday life over the next years. Effectively, e-money (or digital currency) does not make much of a difference to the everyday user: it makes zero difference if you pay your local vendor with edollars, dollars from your regular account, or cash. In fact, one of the main

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principles of e-money (or Central Bank Digital Currency—CBDC) is that it will not compromise monetary or financial stability and it will coexisting and complement existing forms of money.9 What distinguishes e-money from normal money is its convertibility: while one can withdraw her cash from a bank and keep it under the proverbial mattress, e-money is not readily convertible to cash. This provides a paradigm shift with regards to trust in a currency, a similar one to the Nixon shock, as described in Chapter 2. Back in the 1970s, the convertibility of the dollar to gold was suspended, meaning that fiat currencies were simply based on trust that the country will continue to exist and that no hyperinflations will take place. Since then, one could just see the money in the form of banknotes. The change to e-money effectively means that we trust the system literally blindly, meaning that we do not have to hold cash to believe that this is a currency. All it takes are some ones and zeros in computer code. Nonetheless, this is not expected to make much of a difference: as already discussed, money kept in a bank account are almost never physical, and with the absence of banks with a major physical presence, why not make money exist only in their digital form. The answer is straightforward as this is where cashless societies are moving into; e-money and digital banks are just the epitome of those long-term developments.

Cryptocurrencies Cryptocurrencies came out as a reaction to a lack of trust in the banking system after the Great Recession. In an effort to decentralize currency, a person named Satoshi Nakamoto published a white paper which heralded the creation of Bitcoin, a currency with a supply maximum, designed in a way to serve as a faster means of transaction compared to existing currencies.10 Bitcoin’s main appeal was not just the speed of transactions, but mostly the promise of privacy. This is because the attributes required to conduct a Bitcoin transaction, such as addresses, private and public keys, are all read in text strings, such as a public address, which are not in any direct way linked to the user’s personal identity.11 Nonetheless, there have been data breach issues, where user data have been stolen, again similar to the issues any digital-only currency or bank would face. At the moment, Bitcoin and its descendant cryptocurrencies have gained a footing in the investment world, although many people are actually using it as a means of transaction. The only issue with Bitcoin is its price behaves

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quite erratically as it does not depend on any fundamentals but is driven solely by demand. Furthermore, the fact that Bitcoin, and cryptocurrencies in general, is not backed by any state, nor does it have any legislation behind it to enforce its acceptance within some borders, makes it even more vulnerable to fluctuations. Hence, while it has a few merits as a means of transactions, namely its safety, speed, and anonymity, the large fluctuations in value make it a rather risky store of value. The popularity of Bitcoin has also pushed other creators of coins to pursue different ways, such as the introduction of stablecoins. Stablecoins basically have the speed of transaction and anonymity benefits of Bitcoin, but also have the advantage that they are linked to a particular currency, or group of currencies as a way to ensure price stability.12 For example, Tether, a stablecoin, is backed by US dollars and has a stable value of $1 for each USDT token. While the idea may appear appealing, there is in fact something exactly like this already out in the market. It’s fast, anonymous, and its value does not fluctuate much. In fact, it has been around for ages: it’s called cash. The fuss about Bitcoin and other types of cryptocurrencies has been mostly based on the fact that it is beyond the control of governments or any other authorities. Yet, this benefit comes with its own inherent disadvantage: nobody will guarantee any amount of money if Bitcoin crashes, or if the Bitcoin “bank” collapses. Hence, given the lack of a “deposit insurance” scheme for cryptocurrency holders, their value will mostly remain as a means of transactions and not as a store of value. Naturally, there are cases, mostly of the shady type, where people may choose to keep their money in cryptos for a longer period of time, ignoring the fluctuations. Finally, for cryptocurrencies to be used as a means of transaction it would necessitate a large enough market for them. Thus, if enough people choose a cryptocurrency to transfer funds then more will be attracted to it. On the other hand, if less choose to do so, the case might be that holders are unable to exchange their funds with dollars or euros, with the effect being similar to a bank run where the currency rapidly loses much of its value.

Afterword New developments in the banking sector will not change the underlying nature of the industry. Always relying on credit, and always seeking some sort of money to begin with, banks will supply the economy with liquidity while they will keep an amount of loans as their capital to maintain their credibility to the system. Naturally, while capital rules and regulations evolve and

12 Epilogue: The Future

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expand, the level at which they are binding will also depend on the period of time. At this time, no future development appears to be substantial to change the way banking has been doing its business over the course of more than two millennia. Over time, this has been a story of innovation, adaptation to new environments, credit and lending, over-exposures, crashes, crises, and instability. The tale is not going to end and the cycle will continue as economic life goes on. One sad truth of life is that wisdom is seldom passed on to the new generation. As Richard Koo has observed, and as Gabriel Garcia Marques has eloquently (yet implicitly) explored in his masterpiece “One Hundred Years of Solitude”, the next large crisis is likely to be generations away, given that those of us who learned the lesson in the Great Recession will not make the same mistake again soon. The next bubble and burst will happen in a time where we are no longer here to remember such past episodes. While the possibility of a banking crisis will never be ruled out, and one can, with certainty predict, that another crisis will take place at some point, there is still room to blunt its effects and duration, by understanding how the banking system works. This is what the current book has aimed at doing: providing a short overview of history along with a view of how the system works, so that future generations find the task of exploring the past an easier one than it currently is. I hope I have (at least partly) succeeded at this.

Notes 1. Rogoff (2015). 2. The 2019 Federal Reserve Payments Study. Accessed at https://www.federa lreserve.gov/paymentsystems/2019-December-The-Federal-Reserve-PaymentsStudy.htm. 3. Currency in Circulation: Volume https://www.federalreserve.gov/paymentsy stems/coin_currcircvolume.htm. 4. Kahn et al. (2005). 5. Ibid., 4. 6. https://www.marketwatch.com/story/visa-warns-drivers-to-watch-out-for-con cerning-trend-of-hacked-gas-pumps-2019-12-17. 7. https://www.microbilt.com/news/article/15-million-credit-accounts-hacked. 8. https://www.ecb.europa.eu/press/pr/date/2016/html/pr160504.en.html. 9. Central bank digital currencies: foundational principles and core features. Joint report by The Bank of Canada, European Central Bank, Bank of Japan, Sveriges

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Riksbank, Swiss National Bank, Bank of England, Board of Governors of the Federal Reserve and Bank for International Settlements. 10. Bitcoin: A Peer-to-Peer Electronic Cash System, Satoshi Nakamoto, 2008. 11. https://bitcoinmagazine.com/what-is-bitcoin/is-bitcoin-anonymous. 12. https://masterthecrypto.com/guide-to-stablecoin-types-of-stablecoins/.

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Index

A

Alt-A 173–175, 180, 195 Ancient Greece 16 Asset-backed commercial paper (ABCP) 178, 185, 187–193 conduit 187, 188 Asset-backed security (ABS) 151, 175, 176, 179, 180, 184, 185, 187, 188, 193 Athenian banking 7

B

Bagehot’s dictum 31, 53 Bail-in 126, 132, 133, 144 Balance sheet 123 bank 78, 79, 81, 85, 117, 119, 123, 144, 172, 222 bank capital 119, 121 changes 78, 85 currency 78 deposits 78, 144 loan granting 124, 211 loan repayment 79

loans 78, 79, 117, 121, 123, 124, 158, 159, 162, 163, 166, 172, 207, 208, 212 loan withdrawal 79 money creation 78 non-performing 117, 124, 144 provisions 123 Balance sheet recession 36, 146, 207, 212, 213 Bank failure 12, 15, 33, 34, 36, 38, 40, 46, 47, 55, 99, 126–128 Banking, fractional reserve 11, 20, 119 Bank lending standards 100 Bank of England 21, 22, 24, 28, 51–53, 56, 74, 200, 223, 234 Bank run 11, 29, 31–35, 38, 40, 42, 46, 47, 86, 128, 232 Banks Central Bank borrowing 164 deposits 6, 7, 9, 11, 12, 15–18, 21, 32, 34, 38, 46, 51, 52, 54, 77–80, 82, 83, 85, 86, 89, 101, 103, 106, 117,

© The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 N. Michail, Money, Credit, and Crises, https://doi.org/10.1007/978-3-030-64384-3

247

248

Index

118, 126, 129, 132, 186, 201, 217, 223, 224 house prices 93, 95, 145, 208 interest rates 11, 61, 83, 84, 86–88, 100, 101, 103, 145, 173, 175, 209, 212, 217, 219–223 liquidity 10–12, 14, 15, 20, 28, 30, 32–34, 36, 40, 52, 53, 65, 78–80, 82, 83, 85, 99, 115, 117–119, 125, 127, 128, 132, 141, 145, 163, 164, 191, 200 supply 34, 232 Bretton Woods 47–50, 56

C

Cashless society 228, 229 Central Bank 10, 16, 18, 21, 22, 27, 30, 31, 44, 45, 47–49, 55, 61, 72, 77–80, 82, 83, 85, 86, 88, 89, 100, 119, 126, 128, 129, 143, 146, 149, 150, 152, 164, 165, 199, 200, 206, 209, 217, 219, 220, 222–224, 231, 233 Coins 7–11, 15–20, 22, 42, 232 Collateralized bond obligation (CBO) 184 Collateralized debt obligation (CDO) arbitrage 185 balance sheet 185 cash flow 185 squared 185 structured finance 184 synthetic 185 Collateralized loan obligation (CLO) 184 Collateralized mortgage obligation 165 Commercial paper (CP) 37, 39, 185–189, 191–193, 195 Continental Illinois 128, 129

Credit default swap (CDS) 149, 177, 180, 184, 185, 193 Cryptocurrencies 231, 232 Currency in circulation 40, 41, 74, 77, 88, 223, 228

D

Dawes Plan 45 Deficit spending 63, 68–70, 150, 218 Deposit insurance 41, 46, 47, 89, 129, 150, 232 Banking Act of 1933 46 introduction 150 Deposits 6–8 account 11, 18, 34, 63, 78, 80, 127 liquidity 11, 32–34, 52, 53, 79, 80, 82, 83, 85, 86, 97, 103, 117, 118, 127, 145, 150, 157, 216, 220, 230 money creation 20, 78, 79, 85, 86, 132 outflow 11, 28 Depression Great Australia 43 bank failures 46 Canada 43, 44, 55 France 44 Germany 45 United Kingdom 53 Derivative contract 113 options 108 Digital banks 229–231

E

Electronic money (e-money) 229–231 Emergency Banking Act 41 Excess reserves 35–37, 54, 201, 206, 210, 220, 223

Index F

FDIC 126–129 Federal Reserve 31, 35–42, 48, 49, 54–56, 61, 128, 129, 149, 150, 152, 164, 165, 172, 200, 208, 209, 213, 216, 217, 224, 227, 228, 233, 234 Term Auction Facility (TAF) 165 Feedback loop 15, 33, 68, 92, 94, 98, 138 Financial instability Cyprus 144 hedge 138, 142 Japan 146 phases 206 Ponzi 138 2008 financial crisis 47, 112, 150, 186, 143 US 151, 159 Financial stability 130, 131, 149, 151, 231 government 42, 150 lender of last resort 36, 128, 130, 150 Fiscal deficit 147, 213 Fiscal policy 39, 45, 222 Foreign inflows and outflows 64 Friedman, Milton 36, 38–40, 54, 70, 72, 74

G

Glass-Steagall Act 39 Gold 3, 5–9, 11, 16–20, 22, 28, 31, 32, 37, 39–42, 44, 45, 47–51, 67, 77, 78 backing 37, 40, 44, 47 Nixon shock 49, 53, 77, 231 outflow 28, 37, 40, 42 standard 31, 37, 39, 43–45, 47–49, 61, 77 Gold Pool 48 Goldsmith banks 19, 20, 22

249

Goodhart, Charles 89, 220, 223–225 Gresham’s Law 16–18

H

Haircut 15, 109, 132 Heinze, Augustus 27, 28 Hyperinflation 67, 68, 70, 231 Hungary 67 Weimar 67, 73 Zimbabwe 68

I

Inflation 1970s 49, 68, 87 exports 65 growth 61, 69, 70, 142 imports 65, 95 money printing 67 oil 65, 68, 69, 203 stability 71 wages 43, 49, 61, 71 Inflation expectations 64 Insolvency 15, 18, 28, 126, 128, 141, 145 liquidation 141 Interest rates 13, 18, 28, 30, 35, 36, 38, 43, 48, 49, 61, 72, 82–84, 86–88, 92, 98, 100– 103, 106, 109, 112, 146, 157, 159, 160, 163–166, 169, 173–175, 185, 187, 199, 201, 204, 208, 210, 213–217, 219–224 consumption 174 International Monetary Fund (IMF) 47 Investment banks brokerage 111, 170 derivatives 107, 109, 111, 112 proprietary trading 112 securities lending 109, 110 third party credit 13

250

Index

K

Koo, Richard 36, 54, 153, 207, 223, 224, 233

L

Lending current account 96 demand 63, 91, 94, 97, 110, 145, 146, 206, 213, 221, 222 deposits 7, 18, 21, 82, 117 external sector 95 feedback loop 92, 98 interest rate 35, 82, 83, 87, 88, 146, 157, 160, 204, 208, 210, 220, 222 interest rate spread 30, 35, 82–84, 87, 88, 146, 157, 204, 208, 210, 220 monetary policy 100, 208, 213 risk 7, 15, 83, 222 securities 15, 32, 53, 109, 110, 176, 188, 192, 193, 218 stock market 32, 97, 99 supply 221 Leverage 97, 137, 138, 142 Loan, obligation 43, 78

banking 5, 8, 17–19, 28, 30, 38, 52, 77, 95, 116, 161, 164, 176, 185, 190, 201, 221, 229, 231 creation 20, 36, 51, 78, 79, 84–86, 132, 190 increase 19, 36, 42, 63, 65, 70, 77, 79, 81, 83, 118, 201–203 multiplier 82, 85, 111, 194, 206 Money and inflation 50, 61 Money market funds 192, 196 Monoline insurance 183, 193, 197 Morgan, John Pierpont 29–31

N

Negative interest rates 209, 219–222 effectiveness 219 Nixon shock 49, 53, 77, 231 Non-performing loans 22, 85, 117, 124, 125, 128, 132, 141, 145, 148, 175, 206 capital 123, 124, 126, 141, 206 capital requirements 125, 189, 206 economy 116, 124, 132, 144, 145, 190, 206 provisions 116, 123, 125

M

Medieval banks 9, 10 Merchant banks 12–15, 23 Minsky, Hyman 137, 138, 149, 152, 153 Monetarist 70, 200 Monetary base 77, 88, 211, 223 Monetary policy 39, 42, 44, 48, 50, 100, 101, 201, 206, 208, 213, 218 interest rates 48, 100, 201, 208 operations 100 unconventional 223 Money

P

Panic, 1907 27, 31 Paper money 8, 19–21 Probability of default (PD) 204, 205, 220 Public banks 7, 16, 18, 36 Public debt 10, 81 Purchasing power 62–64, 71

Q

Quantitative easing bank lending 204

Index

effectiveness 201 euro area 209 excess reserves 210, 220 inflation 203 investment 211 monetary financing 213 money supply 201 tapering 218

R

Ratings 89, 125, 168–171, 184, 188 Recession, Great 45, 96, 99, 102, 125, 128, 129, 139, 142, 151, 199, 215, 231, 233 Repos (Repurchase agreement) 110, 193, 194 re-hypothecation 194 Reverse Repos (Repurchase agreement) 110 Roman banking 7 Roosevelt, Franklin Delano 39–42, 44, 46

251

Federal Home Loan Mortgage Corporation (FHMC) 160 Federal National Mortgage Association (FNMA) 161 Government National Mortgage Association (GNMA) 159 Mortgage-Backed Security (MBS) 166 pass-through mortgage 170, 178 rating agencies 169 Special Purpose Vehicle (entity/conduit) 179 sub-prime (home equity) 176 synthetic 177 tranche 169, 189 underwriting 193 Shadow banking 179, 183, 190–196 entities 191–193, 195 importance 193 Sh¯owa financial crisis 31 Smoot-Hawley Act 39 Stockholms Banco 18, 20, 24 Sub-prime 116, 151, 175, 176 Supply and demand 37, 62, 72, 203

S

Savings rate 88 Schwartz, Anna 36, 39, 40, 54 Secondary banking crisis 51, 53, 56 Securitization Alt-A 174 asset-backed securities (ABS) 174, 175, 179, 184 automobiles 175 bank balance sheet 163 bank funding 159, 163 collateralized mortgage obligation 165 Commercial Mortgage-Backed Security (CMBS) 174 credit card 172, 174 credit enhancement 193 example 175 excess spread 169, 176

T

Too Big to Fail 128, 130, 131 Tranching 176, 178 Troubled Asset Relief Program (TARP) 130 V

Venice 9, 10, 12, 13, 15 Volker, Paul 61 W

Wisselbank 17, 18, 20 Z

Zero lower bound (ZLB) 201, 220, 222, 223