Wednesday, October 28, 2009

What is a bank run

The standard model of bank runs, as detailed in the Diamond-Dybvig Model is a situation where long term assets are back by short term liabilities. If the short term liabilities are withdrawn, then the bank cannot liquidate assets on the long side fast enough, and some short term liabilities holders will not be paid back. This means that a bank run can start at any moment, for any reason.

The Diamond-Dybvig model, however, is constructed on a gold-standard model of banking where institutions were reserve constrained, and thus does not apply to banking today. I have no issues with the model, just as I have no issues with carburetor design. It just isn't applicable when talking about fuel injected vehicles.

So, in the days of FDIC, reserve accounts, and fiat currency, what is a bank run?

1) When depositors take out their money, the bank debits its liability account, and also debits its reserve account. Let's say that the deposits are being transferred straight to another bank so we don't have to worry about inventory issues with physical cash. That other bank credits its deposit and liability accounts.

2) The first bank now has a lower reserve position, and it may be so low that the bank cannot make its reserve requirements. No worries, it can borrow the excess reserve it needs on the overnight interbank market -- but only if other banks are willing to make the loan. This then, is a "modern" bank run. A bank is below its reserve requirement, and other banks are not willing to lend them their excess reserves overnight.

3) The bank short on reserves can always go to the discount window and borrow directly from the Fed. The Fed, howerever, has asset requirements it demands for collateral, and the bank may or may not have those assets.

4) If the bank cannot borrow at the overnight market, nor at the discount window, then functionally it is reserve constrained. It can no longer operate as a bank.

Three interesting observations:

1) The Fed's mechanism for setting the FFR, a number which it could simply declare by fiat the way McDonalds prices its hamburgers, is susceptible to credit risk. If this looks like a broken design to you, it should, because it's terrible.

2) Over the past 12 months, the Fed has taken on ever crummier assets as collateral to lend against at the discount window. If you're asking yourself "why is the Fed asking for collateral at all, as Treasury money is the ultimate backstop anyway?" you are asking yourself an excellent question. This collateralized lending is terrible as well.

3) Note how a bank operationally is only constrained by the Fed's rules for collateral at the discount window, and capital requirements. If the Fed chose to lend uncollateralized, and simply ignored capital requirements, then a bank could operate UNIMPAIRED even if it had massive negative reserves ("liquidity constrained") and massive negative equity ("insolvent"). When someone assets that the Govt could not let Goldman et. al go under, simply say that the Fed could lend unsecured (as it ended up doing anyway) and ignore capital requirements (as it ended up doing anyway) and bank operations would be unimpaired, but the capital structure would be maintained. You can keep a bank running, but let the equity investors "go under" without any problems.

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Saturday, October 24, 2009

Even Yves doesn't quite get capital requirements

Yves Smith has been doing a great job on Naked Capitalism. I hope her book does well. But even someone with her background exhibits the same cognitive capture as everyone else when it comes to public/private finances and balance sheets.
We have now seen a lot of activity shift from banks to capital markets. And thanks to a host of factors (barriers to entry like high minimum scale, network effects, deregulation which made it easier for firms to span product and geographic markets) we now have capital markets dominated by a very small number of players. And these players are too big to fail by virtue of their ROLE, not simply their size.... Now you could in theory go back to having much more on balance sheet intermediation (finance speak for “dial the clock back 35 years and have banks keep pretty much all their loans”). Conceptually, that is a tidy solution, but it has a massive flaw: it would take a simply enormous amount of equity to provide enough equity to all those banks with their vastly bigger balance sheets. We’re having enough trouble recapitalizing the banking system we have.
The massive flaw in Yves conception is that we already need exactly that same enormous amount of equity already.

Look at Govt/Non-Govt balance sheets, you see this:

1) The Govt deficit precisely equals the sum of all Non-Govt equity.
2) Non-Govt entities build assets and liabilities on top of this equity cushion, banks by extending credit, and non-banks by taking on debt.
3) Non-Govt entities need to service that debt out of income for it to be sustainable. They can manage by taking on ever more credit (credit bubble) but eventually, the debt needs to serviced by income.
4) A credit bubble pops when the Non-Govt sector realizes it has taken on liabilities far in excess for them to be able to service out of income, and start to either pay down, or write off, that debt. At the same time, they try to increase their equity.
5) Unless the Govt runs larger deficits, the Non-Govt sector cannot increase its net equity.

Securitization let banks evade their entire purpose: 1) credit analysis constrained by 2) capital requirements. Volker is exactly correct, the Govt shoulder-focused the industry on its core public purpose. If the banks are undercapitalized to shoulder the credit they've extended, it means that the private sector is undercapitalized to shoulder the credit it has taken on.

The solution to private sector recapitalization is simple, and it does not involve Obama lending the banks money (which does not recapitalize them) and telling them to lend it to non-bank non-Govt sector entities (which does not recapitalize them either).

Friday, October 23, 2009

Returning to Prarie

A remarkable story of Detroit's decline. With pictures!

What's best is that music and cars are as important as ever -- this ruin was pure bad management.

Thursday, October 22, 2009

And now for something completely different

Just because I find these wonderful.

Tuesday, October 20, 2009

Willem Buiter has no clue

Willem Buiter is a bad writer, and does not know how commercial or central banks operate, or how Government and non-Government balance sheets interrelate. That does not preclude him from being a Professor, writing in the Financial Times, and being well respected. I strongly recommend this post by Mosler where he goes through the inanity in Buiter's recent column. You should also read the comment section that tries to rationalize the muddled mess that is "quantitative easing".

Warren phrased one insight about how the public/private partnership that is the banking industry very well:
Govt capitalization of banking is nothing more than regulatory forbearance. Bank capital is about how much private capital gets lost before govt takes losses. In the US, having the Treasury buy bank equity simply shifts the loss, once private equity is lost, from the FDIC to the Treasury, which funds the FDIC in the first place.
This is entirely correct, and obvious if you think about the last 12 months clearly.

Banks are banks because they have reserve accounts at the Fed, which free them from being reserve constrained in their lending. This is unlike us non-banks, who are definitely reserve constrained when we make loans. So long as a bank has a reserve account, it makes no difference how much capital they have on the equity line of their liability column, just so long as regulators don't care either. So a bank can write down all its bad loans and run through its equity, falling below its capital requirements, and keep making loans if it has a reserve account. If regulators don't care, then what does it matter?

One error in Warren's point, in the US, the Govt recapitalizes banks and takes losses BEFORE private capital does. Honestly: if you are in school, whatever career ideas you are entertaining, just drop them to work in Finance. If you are out of school, it is not too late for a career change. Just sit outside Goldman Sach's offices on Broad Street until they let you in.

Wednesday, October 14, 2009

I have been defeated

I tried to have Arnold Kling consider -- not buy, but at least consider -- post-Keynesianism (or Modern Monetary Theory if you prefer) over at EconLog, and have totally failed. So, I surrender!

My approach was certainly very flawed, but then so has been everyone's who is pushing this idea. It's interesting to see what memes catch on, what don't, and how unconnected that is with their factual merit. After all, PK/MMT is as wonky as the monetary nonsense Scott Sumner spouts and Sumner has been extremely successful by contrast.

Heck -- even the Austrians have done well by contrast. They at least have a lock on the libertarian market. In the past I would say that finding anyone less successful than the Austrians or libertarians would be a futile exercise.

Here's a great comparison piece between PK/MMT and what you get in your Greg Mankiw text books: Studying macroeconomics – an exercise in deception

This is the way the world ends

I cannot imagine a more cutting line than this regarding Google's new "wave" email program:
Indeed, Wave is so packed with features of marginal utility it's easy to forget it was invented by Google. Here was a company that once prided itself on simplicity; Wave is so bloated it could have come from Microsoft.
Ouch! It's impossible to predict how the next successful tech company will start, but they all end the same way.

Watching the demo video, btw., gave me flashbacks to Lotus Notes. Yes, a Google product has now been compared to Lotus Notes and Microsoft.

Thursday, October 01, 2009

Salute to Steve McIntyre

In the days of the Royal Society, scientists were hobbyists, pursuing their own whims, pushed to Truth by group norms and the standards of their peers. There was plenty of nonsense then, too (Isaac Newton was an Alchemist) but a small group of individuals, with modest means, got a lot of Science done.

Fast forward to 2009, where science is now big non-business. The nexus between Federal Agencies and science is tight, and scientists produce the results they are paid to produce. Both "Good Calories, Bad Calories" and this expose from Steve McIntyre fit exactly with my own experience in the most prestigeous laboratories on the planet. Don't believe anything you read in the NYTimes.

My favorite quote:
In a novel this refusal would have been put down to a deep and deadly conspiracy. What it really concealed was the slipshod data handling, tiny samples, the loss of essential metadata and the careless merging of datasets on which the earlier conclusions were based.
Yup, but they forgot to mention how politically, the wrong answer has become blasphemy. And we think we've moved on from Galileo Galilei's day.