Commentaries

What banks can learn from hedge funds

Should the banking industry look more like the hedge fund sector? That’s the surprising suggestion made last week by two Bank of England officials.

In a fascinating paper, Piergiorgio Alessandri and Andrew Haldane explore the level of public support given to banks in the crisis and the problem of institutions that are too big too fail. Their main point is that if this issue is not addressed it will lead to new crises and even bigger bailouts in the future – a state of affairs they describe as a “doom loop”.

But the most eye-catching passage is a suggestion that banks have a lot to learn from hedge funds:

It may be coincidence that the structure of the hedge fund sector emerged in the absence of state regulation and state support. It may be coincidence that the majority of hedge funds operate as partnerships with unlimited liability. It may be coincidence that, despite their moniker of “highly-leveraged institutions”, most hedge funds today operate with leverage less than a tenth that of the largest global banks. Or perhaps it might be that the structure of this sector delivered greater systemic robustness than could be achieved through prudential regulation. If so, that is an important lesson for other parts of the financial system.

This is quite a change of heart. Until a few years ago, regulators viewed hedge funds as the main threat to financial stability. These fears have proved unfounded. Though plenty of hedge funds have blown up – or turned out to be massive frauds – none has so far threatened to drag down the system.

Some things that currently take place in banks are probably better suited to hedge fund structures. Proprietary trading is a prime candidate. There is also a strong case to be made for private partnerships. Would investment banks have grown so large if they were owned by partners who were exposed to any losses?

Even so, it seems fanciful to suggest that the hedge fund model is better. Banks fund themselves by taking retail deposits that customers believe to be safe. That precisely the reason they are so heavily regulated. Hedge funds raise money from institutional investors and wealthy individuals who – in theory at least – realise they could lose it all. Without deposit insurance, the failure of a bank can spark a loss of confidence across the industry. The failure of a hedge fund is less likely to have systemic consequences.

Volatile volatility

I was struck by the phrase “volatility itself has been volatile” in the FT article this morning. It pretty much sums up both the confusion and concerns in the market about whether risky assets are at an inflection point or taking a breather before embarking on another leg up.

The central bank meetings this week certainly aren’t helping, but the FOMC, the ECB or the BOE aren’t likely to do anything that’s going to signal a shift in policy. FOMC should keep the phrase “extended period,” while ECB isn’t likely to given any new insights on the euro or interest rates. The BOE could add more fuel to its quantatitive easing program, but that would hardly be earth-shattering news given its losing streak on growth.

There is the U.S. employment report later in the week, but no one is expecting a turnaround there either. In fact, most have their eyes on the magic 10, as in 10% unemployment that seems simply inevitable given the lousy job market.

Still, the VIX – the fear gauge that measures equity market volatility – is, well, looking pretty volatile.

Chart below.

Do banks really need to hoard liquidity?

That’s the provocative question posed by Willem Buiter. His latest, characteristically lengthy, blog post tackles the regulatory vogue for forcing banks to hold much greater reserves of liquid assets – in practice, government bonds.

Buiter’s missive follows new rules from Britain’s Financial Services Authority, which will force banks to increase their reserves of government bonds by more than a third. The rules have been met with predictable bleating from the industry, which accuses the regulator of undermining Britain’s competitiveness and promoting the fragmentation of the global financial system. Another concern is the FSA’s handling of the transition.

Buiter’s objections are more fundamental. He’s not convinced banks should be preparing to deal with a seizure in the markets. That, he argues, is the job of central banks:

It may be possible for private banks to hold enough liquid assets (government debt, effectively) on their balance sheets to survive even a major liquidity crunch without recourse to the central bank.  But that would be socially inefficient.  Banks are meant to intermediate short liabilities into long-term assets, and frequently into long-term illiquid assets.  It’s what their raison d’être is.

By contrast, Buiter says: “Providing liquidity is what God made central banks for.”

It’s an argument which deserves to be explored further, though it does raise some practical concerns.

The first is whether central banks are able to prop up individual lenders without making matters worse. After all, the run on Northern Rock started after  the Bank of England announced it was providing support to the mortgage bank. The Bank of England has since installed a permanent discount window similar to the one used by the Federal Reserve. But it remains to be seen whether banks will dare use it once markets have returned to normal.

So that’s why the Bank buys all that government debt

I’ve found the answer to the monetary puzzle de nos jours. The ritual of the UK Treasury’s DMO issuing new government debt one day, only to have the Bank of England buy similar amounts of almost identical stock the next, has puzzled me ever since Quantatitive Easing began.

How much simpler it would be for the Treasury to borrow directly from the Bank – the modern equivalent of running the printing press faster – to pay the government’s bills.

It turns out that the Maastricht treaty (Article 104(1)) expressly forbids European governments from borrowing directly from the central bank. The prohibition was drafted during a period when inflation seemed endemic, requiring strict controls to prevent monetary incontinence among European Union governments.

So QE is a mechanism to circumvent the rules. Perhaps you knew that already. The traders in gilt-edged stock, many of whom are not natural europhiles, should raise their Roederer Crystal to the treaty, as they laugh all the way to the (taxpayer-supported) bank.

David Blanchflower, the man who knew too much

Goodhart’s Law states that if you rely on a single measure to set economic policy, it will mislead you. Charles Goodhart coined it in 1975 when he was senior adviser to the Bank of England it was targetting growth in the money supply. It’s taken longer for the law to apply to the Bank’s targetting of inflation through interest rates set by the Monetary Policy Committee, but it’s arrived now.

The MPC’s brief is simple; the committee must set Bank Rate at a level to keep inflation, measured by the Consumer Price Index, as close to 2 percent as it can. The acceptable range is one per cent either side. By and large, helped by a decade when the cost of goods was constantly falling, it had managed to do what it’s supposed to do. Today’s decision to leave Bank Rate at the nominal level fof 0.5 percent reinforces the expectation that the CPI will stay inside its range.

Unfortunately, it’s all gone horribly wrong, and David Blanchflower, who served for three years until May 2009, is savage in his criticism of his fellow-members. Writing in the New Statesman, he accuses them of being victims of  “group think”, under “the old iron fist” of Mervyn King, the governor of the Bank of England. Starting in October 2007, Blanchflower voted for lower interest rates every month until Bank Rate finally hit 0.5 percent in March this year. He was frequently alone.

With hindsight, he has every right to his told-you-so, but it’s worth recalling how different conditions were two years ago.  When he first voted for a cut, the CPI was just over the 2 percent target, and clearly headed upwards. Experience of previous inflationary surges in the UK economy suggested (at least) that if the genie of expectations gets out of the bottle, putting it back is a long and painful process, and the MPC’s projections looked ominous.

They were right. The CPI rose to a peak of 5.2 percent in September 2008. Even now, after the worst recession for at least half a century, this measure of inflation is only slightly below the 2 percent target.

Blanchflower may be crowing, but he first voted for a rate cut in March 2007, at the peak (as we can now see) of the house price boom. Had the committee agreed with him, there would have either been a final frenzy of buyers acquiring property they could not afford, or a gut-wrenching U-turn as the MPC (unanimously) raised rates two months later.

Today, he believes that the risk of a long-lasting recession is not over. He castigates the “feeble six” members of the MPC who disagreed with King’s proposal to raise the ceiling on the amount of stock the Bank plans to buy in. Yet the efficacy of this policy of Quantitative Easing is far from proven. The bizarre spectacle of a UK Treasury, desperate for money, spewing out new stock in vast quantities one day only for the Bank to buy almost identical stocks the next, defies common sense.

Deleveraging in action, Bank of England edition

Ever since branches started forming outside Northern Rock branches two years ago, British consumers have been told they have way too much debt. They finally appear to be paying attention. Bank of England data released today shows net lending to individuals fell by £600m between June and July. Nothing surprising there, you might say. Surely it’s only normal that people are paying back their debts. Except that this is the first drop since the Bank started recording monthly data back in 1993. Or, as the Bank’s statisticians put it:

Total net lending to individuals fell by £0.6 billion in July, showing a net repayment for the first time in the series.

For most of the past two years, the net lending figures have been falling. But they had not turned negative, until now. The question is whether this is a one-month blip or the beginning of a trend. Certainly, the drop in mortgage lending is at odds with other recent figures. Also in July, according to the British Bankers Association, the number of mortgage applications that have been approved rose to their highest level for a year and a half. The question is whether those new borrowers will compensate for the people who have decided it is high time they paid off some debt. Watch this space.

Bank of England gets creative

The Bank of England’s changes to the eligible collateral for repo operations announced yesterday contained a curious quirk: the Bank will now accept covered bonds backed by loans to small and medium sized enterprises.

Covered bonds are a kind of secured bank debt, backed by loans or mortgages. If the bank can’t repay the debt, bondholders can liquidate the collateral to get their money back.

Why are the Bank’s new rules interesting? For the simple reason that, to my knowledge, there is no such thing as an SME covered bond — yet.

What is the bank playing at? Clearly UK lenders are under pressure to boost lending to small companies; allowing them to pledge SME loans as collateral may help open up a new funding channel and get some funds flowing to UK businesses. Perhaps it knows that some banks are getting ready to launch the first such deals and wants to give them every chance of succeeding.

SME covered bonds won’t help borrowers that much on their own, since covered bonds are guaranteed by the issuer and don’t allow banks to free up any capital for new lending. That’s why we also need the securitisation market to get back on its feet too. (In a securitisation the bank sells assets or transfers their economic risk, allowing it to recycle capital and make new loans).

Back to the future for debt panel proposal

Anything that saves time and money in the restructuring of debt sounds like a good idea — particularly given there are likely to be a lot more bad loans that will need sorting out in the coming months and years. 

London bankers working in this area have begun pushing an idea to by-pass the courts in the restructuring of billions of pounds worth of debts.

Like many of the ideas currently being kicked around on regulation — and sorting out the mess left by the financial crisis – it seems to be a case of back-to-the-future. The idea is apparently for the establishment of a panel with echoes of the informal London Approach operated by the Bank of England before the Financial Services Authority (FSA) took over the regulation of banks.

Reuters restructuring correspondent Tom Freke has got details from his sources who are pushing the restructuring panel as an alternative to British government proposals to make UK insolvency rules more like the U.S. Chapter 11 process.

This explanation of the London Approach comes from the British Bankers’ Association:

The Bank of England’s role has been to advocate a spirit of constructive international cooperation and, when asked, to act as an independent mediator concerning any fundamental inter-lender disagreement. There is no formal arbitration process. It encourages all lenders to adopt a reasonable and supportive attitude towards companies experiencing financial difficulty to which they have been willing lenders in the first place.

The basic concept is a moratorium or ‘standstill’ outside a statutory process whereby lenders agree (for a period) not to take any individual action nor to improve their positions relative to each other in terms of repayment or by way of security. This allows time to gather information, assess viability and evaluate options, with a view to implementing an agreed strategy and, if appropriate, restructuring. Loss-sharing arrangements will be included in the standstill documentation

Is it time at last for a big exit?

Of its myriad stimulus programs, the Federal Reserve’s purchase of US Treasurys could be one of the first significant ones to expire as scheduled. The Fed could say as much when policy makers meet next week for their regularly scheduled two-day meeting.

The Bank of England could steal the Fed’s thunder by being first, though. The Bank could decide as early as tomorrow to halt its program that has hoovered up 125 billion pounds of debt with money hot off the printing presses. NYT says it’s a toss-up on whether it will end the program.

The programs have already lost their pop in the markets, but the symbolism of pulling out is huge and could provide clues into how well the financial markets can be weaned off government funds.

Throwing money from helicopters, Bank version

A bit late, I know, but this page is well worth a look if you haven’t seen it. If you thought there was a difference between the Bank of England’s sophisticated programme of Quantative Easing and throwing fivers out of a helicopter to a grateful populace, this diagram should convince you that they are much the same thing.

Pedants may point out that we’re not getting the dosh directly, and they’d be right, but when the government can print the money to dish out as benefits to the one-third of UK households which are now dependent on them, the difference is academic.

On the other hand, perhaps the whole QE charade merely reflects the shortage of helicopters, since our only two serviceable ones are in Afganistan.

Hat tip to Jim Leaviss at Bond Vigilantes.