Felix Salmon

Why banks shouldn’t trade

Felix Salmon
Oct 9, 2012 17:14 UTC

Mark Gongloff has found a new IMF working paper, by Arnoud Boot and Lev Ratnovski, which basically comes to the conclusion that banks shouldn’t be trading in financial markets. This is a conclusion others have come to as well, of course — most prominently, the Volcker Rule in the US and the Vickers Report in the UK both attempt to legislate such things, on the grounds that it’s simply not just for banks to engage in risky trading activities, safe in the knowledge that if they blow up they’ll end up getting bailed out by the government.

The IMF paper, by contrast, takes a different approach. It just looks at the way that banks work, under a few simplified assumptions. Let’s say, for instance, that banking — lending money to steady customers — is a profitable business to be in. And let’s say that a large part of what banks do is to offer credit lines. At any given point in time, the bank will have a large number of undrawn credit lines outstanding. And so it’s easy to see how the bank would be tempted to take that money, before it’s drawn down by the customer, and use it to make some short-term profits in the markets. If your trading book is closed out every day, then as soon as your customer asks for the money, you can provide it. And in the meantime, you’ve made a bit more money.

Even if trading is less profitable than banking, then, it still makes sense to trade — as a use for surplus cash which might be waiting to get put to good use.

On top of that, trading is a way of giving excess risk-adjusted returns to shareholders. Let’s stay in the world where banking is steadily profitable — if you hold on to your loans to maturity, and develop healthy relationships with a diversified group of customers, then you’ll end up with a valuable long-term franchise, where shareholders take a certain amount of risk and get a commensurate return. Meanwhile, the bank itself borrows cheaply in the wholesale market, just because it’s so safe.

Once again, at the margin, it makes sense to put a little money into trading. The bank’s cost of funds is low, for one thing. And for another thing, the risks of trading are asymmetrical. If it works, the shareholders make money. But if it fails, the losses can be so huge that the whole institution blows up — which means that not only do shareholders lose money, but so do bondholders. This, weirdly, is a good thing from the shareholders’ point of view, because it means they don’t need to bear the full cost of trading blowups. And just about any bet, if you don’t have to bear the full potential downside, thereby becomes much more attractive.

So banks therefore have two big reasons to move into trading: the paper calls the first one “time inconsistency”, and the second one “risk shifting”. The problem is that both of them make only a limited amount of sense at the margin, in small doses. In large doses, the benefit goes away — as we can see by the fact that trader-heavy investment banks nearly always trade on the stock market at very low multiples of earnings or of book value. (Even mighty Goldman Sachs, these days, is trading at less than its book value.) But the problem is the inexorable logic of marginal thinking: wherever a bank might be, a tiny bit more trading is perceived to be a good thing rather than a bad thing. And so the amount of money the bank trades just goes ever upwards, long past the point at which it’s actually a good idea.

The IMF paper does a good job of listing the consequences. UBS. Barings. Citi. Bear Stearns. Lehman Brothers. Merrill Lynch. Washington Mutual. Wachovia. Even JP Morgan, with its infamous Whale trade. Not all of them were commercial banks, but all of them got far too exposed to tradable market instruments, and suffered enormous damage as a result.

The problem here, as I see it, is that it’s pretty much impossible for banks not to be exposed to tradable market instruments. Call it the curse of the credit default swap: ever since JP Morgan invented the synthetic CDO, bank risk managers have been able to mark their credit portfolios to market, and to hedge those portfolios using derivatives.

I should take this opportunity to plug, not for the first time, Nick Dunbar’s wonderful book about the financial crisis, The Devil’s Derivatives. It is very rich on many levels, but one of the things that Dunbar does in his book is give the best explanation I’ve ever read for why it’s incredibly dangerous when banks start marking their portfolios to market.

Once again, the logic is invidious: if no bank marks its credit portfolio to market, and then one bank comes along and starts doing exactly that, the one bank which is marking to market is likely to have a significant advantage over everybody else. And so one bank moves to a mark-to-market system, and then the other banks have to follow suit to remain competitive, and the result is that everybody ends up in a state where they’d all be better off if none of them did it.

According to Gongloff, the IMF paper says that banks “should be allowed to hedge their bets” with “small trading positions”. But hedging is trading — as we saw, most clearly, at JP Morgan’s Chief Investment Office. And trading is just as dangerous when it’s done for hedging purposes as it is when it’s done for absolute-return purposes.

In an ideal world, then, banks simply wouldn’t be allowed to trade at all. What’s more, in that world the banks would quite possibly make more money than they’re making right now. But you’d need globally-coordinated regulation to get there, and it’s simply not going to happen. Which is why trading blow-ups are here to stay — and regulators are always going to be on the back foot when it comes to trying to prevent them.


BTW, you probably also ought to read “How Basel 2.5 beached the London whale”
http://www.risk.net/digital_assets/5926/ jpm.pdf

I thought this was the money quotes:
“There is a danger that banks shift from controlling risk to controlling RWAs. They are not the same thing. It’s a logical response to new regulation, but it’s not prudent risk management,” says Alistair McLeod, head of portfolio analytics at Barclays in London. “If you have an environment where return on capital is a principal, perhaps even the main driver of profitability, which is definitely what we are moving towards, then the motivations and priorities of an individual trading desk don’t necessarily result in an optimal risk management strategy for the whole of the house. If you pursue a strategy that controls or limits a specific risk target,
and you can do that independently of the impact that strategy has on other risk measures, or the principles of common sense risk management, then that creates a huge problem.”

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How prepaid debit is displacing checking accounts

Felix Salmon
Oct 8, 2012 18:17 UTC

Prepaid debit cards just keep on getting better — ever closer, that is, to the holy grail of essentially replicating the free checking account of yore. Checking was never actually free, of course: it was basically a bait-and-switch, where people thought that they were getting free checking but then got hit with huge unexpected fees when they could least afford them.

But when hidden overdraft fees and the like were made illegal, and bank fees started becoming increasingly salient and obvious, the search for a checking-account replacement began. And there are two big ones: credit unions, on the one hand, and prepaid debit cards, on the other.

I’ve been a bit disappointed in the way that credit unions in general have responded to the new world of banking. As far as I can tell, most of them have been subdued and cautious when it comes to trying to poach customers from the big banks. And many of them actually opposed the Dodd-Frank law which did so much to protect consumers and to prevent banks from running up hidden fees.

For instance, Patrick Adams, the CEO of St Louis Community Credit Union, was a vocal opponent of the Durbin Amendment, laying out a parade of horribles that he was sure would come to pass were the amendment to be signed into law:

Here’s another surefire lock of a bet. You will be more frustrated than ever. Your costs at the bank will be up. Your costs at the retailer will be up. You will be confused as to which retailers accept your debit card and which ones don’t. You will have no clue what the minimums and maximums of your debit card activity will be because there will be no consistency among retailers. As a result, you will carry more cash and more checks.

I took his “surefire lock of a bet”, and eventually we agreed to settle it in July 2012, once the new law had been in force for a year. Adams sent me a grudging email in August, saying that although he would “pay the $100 to your credit union in the name of helping a fellow credit union do the good works of our industry”, he had also learned that he “will never again be lured into sharing information with someone I thought was an interested party from a credit union perspective to only have it placed as a topic for a blogger”.

The point here is that in many cases — see also my article about Missouri Credit Union — credit unions look and feel very much like banks, with the similarities far outweighing the differences. And so while credit unions are nearly always a better deal than banks, they’re generally not being nearly as aggressive as I would like in terms of trying to be a much better deal.

Meanwhile, prepaid debit cards have been improving enormously. Once upon a time they were nearly all rip-offs; now, they’ve reached the point at which they can start to be a real checking-account alternative, without the fees and the kind of haterage which almost all of us feel towards our bank at some point.

bluebird-chart_129940301332156543_293x483.pngThe latest card to hit the market is the Bluebird, from American Express and Walmart. The fee schedule, on the left, is very impressive, starting with the first line, a $0 monthly fee. American Express has had no-monthly-fee debit cards in the past, but nothing with the kind of distribution clout offered by Walmart.

On top of that, if you use this card as a checking-account replacement, then ATM withdrawals are free within the reasonably extensive MoneyPass network. In order to qualify for that, you need to sign up for some kind of direct debit, which is easy to set up from most employers, Social Security, and the like. We’ve seen this incentive to use direct debit in the past: Suze Orman’s Approved Card has pretty much the same thing, for instance. But it costs $3 a month — and, crucially, it’s expensive to reload if you try to put money on it through means other than some kind of bank transfer.

The Bluebird card, by contrast, can be reloaded with cash at any Walmart: pay for your groceries and put any money you have left over right onto your card. And the Bluebird card offers something else pretty revolutionary as well — you can even deposit checks into your account, for free, using mobile check deposit.

Being able to deposit money into your account for free is a key feature of checking accounts which prepaid debit cards have historically had a very difficult time replicating. This is one area where banks have a clear advantage over other prepaid debit-card providers. If you have a debit card from Chase or US Bank, for instance, then you can deposit money into your account at any of their branches or ATMs. But the bank cards have their own limitations: Chase doesn’t offer bill-pay, for instance, while US Bank doesn’t offer check deposit.

Interestingly, the loophole which is making all these prepaid cards possible is exactly the same as the loophole which prevents Chase from offering bill-pay. The Durbin Amendment to Dodd-Frank forced interchange fees on debit cards to come down substantially, while carving out an exception for prepaid cards. So Durbin allowed the prepaid industry to keep on growing — but because Chase is a big bank, it’s not allowed to offer bill-pay on its prepaid card, since at that point it would fall foul of the rules about the interchange fees charged by big banks on their checking-account debit cards.

One interesting thing about prepaid cards is that they’re easy to start up — and, by the same token, they’re easy to drop. People tend to use a single card for no more than a few months at a time — in stark contrast to the many years that they use a checking account. Especially if you’re moving from job to job, it’s as easy to just get a new prepaid card, most of the time, as it is to set up direct debit onto your old one.

Which helps explain why Green Dot shares are down almost 20% today. Green Dot used to be the exclusive provider of prepaid cards at Walmart; no longer. And given the choice, it makes very little sense to choose one of Green Dot’s cards over the Bluebird: the only real disadvantage that Bluebird has is that it’s an Amex card, which means that it isn’t accepted in as many places as Visa and Mastercard.

So expect to see Bluebird make some serious inroads with respect to the Green Dot user base — and expect, too, that Bluebird users are going to be less likely to graduate to a checking account than Green Dot users were. While most checking accounts offer a lot of things which you couldn’t get with a Green Dot debit card, that list is much smaller once you’ve got a Bluebird card.

The number of unbanked households in the US is rising — it’s now at 8.6% of all households, up 0.6 percentage points in the past two years alone. As prepaid debit cards become ever cheaper and more attractive alternatives to checking accounts, and as online startups introduce their own checking-account alternatives, that number is only going to increase.

But the economics here are interesting. I’ve spoken to a number of prepaid debit card issuers, including Chase Liquid and Suze Orman, and they all swear that there’s simply no way they can even break even unless they charge a monthly fee. But now Bluebird has joined Simple in giving out cards where pretty much everything is free, there’s no monthly fee, and you even have access to things like mobile check deposit which are still rare in checking accounts.

And what that says to me is that it’s going to be very difficult to compete as a pure prepaid-debit play, going forwards. American Express and Simple don’t need their debit-card arms to be profitable on a month-to-month basis: they’ve got their eyes on bigger prizes. That’s good for consumers, but it’s likely to mean that the universe of prepaid offerings is going to shrink. If you can’t offer something for free, or very close to free, then increasingly you might as well just not bother.


Online banks like Charles Schwab, Etrade, Ally, and ING are the future, not credit unions or pre-paid debit. They really have no fees, and are super convenient. A true consumer win. I’m disappointed that “Move Your Money” focus on credit unions and the like.

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Who is to blame for Ina Drew’s downfall?

Felix Salmon
Oct 3, 2012 15:47 UTC

Susan Dominus has a big 7,500-word NYT Magazine feature on the rise and fall of Ina Drew, featuring a couple of bland quotes from Jamie Dimon but nothing — nothing on the record, at least — from Drew herself. (We’re told explicitly about four different people who declined to comment when approached by Dominus, including “London Whale” Bruno Iksil and his boss Achilles Macris; Drew is not one of the four.)

The story, as Dominus presents it, is a tragic one. Drew was a highly competent and highly successful trader, who used her deep knowledge of the markets to stay one step ahead of the quants and the rocket scientists who coveted her job. But then she decided that she needed a group of quants and rocket scientists herself, and after she came back from her year-long battle with Lyme disease, which kept her out of the office for most of 2010, she never really regained full control or understanding of what the London office was getting up to.

Dominus actually puts forward two subtly different narratives of what went wrong. The first is that the quants ultimately managed to snow her — that in her final months at JP Morgan, Drew basically didn’t know what was going on in London, and was out of her depth:

At some point in December of last year, a former executive from the group says, Drew checked in with Macris and Martin-Artajo about the position while the two men were in New York. They answered, but the executive, who understood the trade, remembers thinking that they did not give as full an answer as they could have. “I think they glossed over details to the point where Ina knew the product, the size they were trading, but she did not know what the true P.& L.” — profit and loss — “impact could possibly be in a stressful scenario,” he said. She was asking the right questions, he said, but did not seem to be picking up on what was not being said…

By the second week in May, the stress had taken a toll. A colleague saw Drew walking around the executive floor, her mascara smeared. A slight tremor in her hand left over from her illness seemed worse, a physical symbol of her emotional state. Although she still came to work dressed impeccably, she had lost weight and looked somber, almost shut down. The week that the bank decided to make a public disclosure, 20 senior people gathered in a meeting room on the 47th floor. Everyone went around the room and spoke about what they had found out and what still needed to be learned. After about 45 minutes, with the meeting drawing to a close, Drew, uncharacteristically, still had not said a word. Finally, John Hogan, the chief risk officer for the bank, asked: “Does anyone need anything? Need some help?” Drew raised her hand. “I need help,” she said. It was a white flag.

But there’s a second narrative, too — which is that the trades were actually not completely stupid, that they could actually have worked out OK in the end, and that it wasn’t the markets so much as “complicated, interlocking human dynamics” which ultimately did Drew in:

Maybe Drew still believes — as Macris does, according to people at the bank — that the position could have worked out given enough time. Maybe if she had asked the right questions sooner, her traders would have been forced to clarify or she would have sensed danger before it went out of control. Many systems failed and perhaps, too, her judgment.

Drew was someone known for her grasp of the big picture, for internalizing historical trends and economic cycles to the point where her gut instincts were almost always right. She was also someone known for having a personal touch. But in this instance, she seemed incapable of grasping the complicated, interlocking human dynamics that can’t be measured by reassuring models — the idea that a position could be leaked, that the press might bear down, that the regulatory environment could compound all those problems.

This narrative is much less believable. For one thing, pretty much all positions work out “given enough time”. But markets are all about timing. This argument sounds suspiciously similar to the testimony of Joe Cassano to the Financial Crisis Inquiry Commission: hey, if you hadn’t forced me to unwind my positions, my positions would have ended up making money! It’s a pretty silly argument from anybody who’s been in the market for more than about five minutes, and it’s especially silly were it to come from someone like Drew who has been a trader for decades.

And more generally, the whole point of being a trader with gut instincts, rather than a quant staring at computer models, is that you’re reacting to the whole world — the real, messy world, where hedge funds will leak your positions to the WSJ and Bloomberg, and where regulators don’t like nasty surprises — rather than just to the easily-tractable numbers in a VaR model.

With hindsight, it’s clear that Ina Drew was in some ways a human version of one of those clever financial strategies which works until it doesn’t. She was by all accounts an excellent manager with incredibly loyal staff — except when she set up the London office of the CIO, which managed the lion’s share of her billions, and which didn’t respect her at all. As a trader, Drew was extremely attuned to the vicissitudes of the markets — at least until she took her leave of absence, after which her fabled spidey-sense seems to have deserted her.

What’s missing from Dominus’s story is any indication of whether or how Drew was actually managed. Over her years at Chemical Bank, as it slowly transformed and grew into today’s JPMorgan Chase, Drew amassed ever-increasing quantities of money and power. Eventually, as Dominus says, she “had direct control over more money than most players on Wall Street — on the level of the top asset managers in the country, including BlackRock and Pimco”. The trader had become an asset manager, and in a very real sense she was competing with the rest of the bank: before anybody at JPMorgan could lend out a single dollar, they essentially had to persuade Jamie Dimon that the risk-adjusted returns from doing so would exceed the returns which he could get by just giving that dollar to Ina.

Drew was very good at managing and investing the money she was given, and the reward for that skill was that she got given ever-greater amounts of money — over $350 billion, in the end. But at that point, her job had changed both qualitatively and quantitatively from the job she had proven herself good at. Qualitatively, much less of her job involved trading rates in New York, and much more of it involved highly-complex derivatives trades in London, something she was never particularly comfortable with. And quantitatively, running $350 billion is both a blessing and a curse. On the one hand, you can “whale” on the market and push your counterparties around, much like a poker player with a monster stack. On the other hand, if you ever do get forced to unwind your position, you’re toast.

The big difference between Drew and pretty much everybody else on Wall Street is that she never needed to unwind anything: during the crisis, when everybody else was panicking and deleveraging, her positions only grew. In many ways, she was one of the biggest recipients of everybody else’s forced unwinds. But then, when the tables were turned, she proved to be just as human as everybody else.

One man, more than anybody else, had the job of looking at that $350 billion pot of money and wondering whether it was simply too big. And there’s no indication that Jamie Dimon ever did that. Bank clients, borrowers: they had position limits. But Ina Drew never did: she would happily accept all the money Dimon funneled her way. In a weird way, she wasn’t just Dimon’s employee, she was also his counterparty: she was the person with whom he would entrust JP Morgan’s balance sheet when he had nothing better to do with it. And it doesn’t seem that anybody at JP Morgan was worried about that particular counterparty risk — not even when Drew was out of the office for a year, and especially not when she returned to increasingly fractious internal politics.

If there’s a villain in this story, then, it’s not Iksil or Macris or anybody in London: it’s Dimon. The buck stops with him, and yet he’s somehow emerged largely unscathed, with a stock price back in pre-Whale territory and a glossy double-page Annie Leibovitz portrait in Vanity Fair. Dimon’s ego has only grown since the whale crisis: “Honestly, I don’t care what second-guessers say in life,” he tells Dominus. “If anyone in the company knew, they should have said something.”

The question, of course, is whether Dimon would have listened. Dimon needed his own spidey-sense: he needed to be able to tell the difference between vicious internal politics and back-stabbing, on the one hand, and genuine reports of risk-management failures, on the other. When it came to the CIO, he couldn’t do that. And it’s far from clear that he’s learned his lesson.


Smart post. I’m still not quite getting why the $6b hiccup was such a big deal, given the $350b pot. Trading, a two percent loss is not a good day at all, but not the end of the world. Until it is, I guess.

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JP Morgan’s depositors needn’t worry about its gambles

Felix Salmon
Sep 24, 2012 16:27 UTC

Bill Cohan declares, today, that the money JP Morgan lost in its infamous “London Whale” trades actually belonged to depositors. He’s wrong about that.

Here’s Cohan’s argument:

To my mind, the money that Iksil lost was depositors’ money. Iksil worked for the CIO, where depositors’ money is invested until it is lent out. The trade lost almost $6 billion in cash, which we know is real because hedge funds such as Saba Capital, run by wunderkind Boaz Weinstein, and Blue Mountain Capital staked out the other side of Iksil’s trade and made a fortune. How could there be any confusion that the money Iksil lost came from the bank’s depositors?

This is just silly. If you deposit money at a bank, you’re lending that money to the bank. Bank deposits count as liabilities on the bank’s balance sheet: they’re money that the bank owes to its depositors. And like all other debt, bank deposits are a contractual arrangement: the bank borrows your money — and agrees to repay it — on certain terms. Often, those terms include an effective call option: the depositor can ask for her money back at any time.

Once money is borrowed, the borrower can do with it as she wishes. If JP Morgan borrows money from depositors and then gambles it in London, then any profits it makes on those gambles are profits of JP Morgan — and any losses it makes on those gambles are losses of JP Morgan. The bank’s obligations to depositors are unchanged.

I believe that JP Morgan shouldn’t be allowed to gamble its excess deposits in London like this, and in that sense I’m not that far removed from Cohan: it does matter where the bank is getting its billions. JP Morgan has lots of excess deposits just because it’s too big to fail and is therefore a place where most companies and rich individuals want to deposit their money: they know the bank is safe and that they’ll be able to get it back whenever they want it.

But just because the money came from depositors doesn’t mean that it belongs to depositors. Depositors have no particular claim to that money in particular; they have their own place in the pecking order when it comes to seniority, but there’s no pool of JP Morgan funds that depositors have some kind of privileged access to. So long as JP Morgan remains solvent, the money belongs to JP Morgan, and depositors just have claims on the bank.

Cohan then says that depositors only avoided losing money because JP Morgan was lucky enough to avoid a bank run. But again that’s silly: if depositors did end up losing money because of a bank run (and I doubt they would, but that’s a separate issue), then the cause would be the bank run, not some losses in London. Banks are always at risk of a run, and there’s no reason at all to believe that the London Whale losses changed that probability at all.

Cohan also says, unhelpfully, that “taking money out of depositors’ accounts is exactly what banks do”. But of course this isn’t true at all. A bank account is just that — an accounting of how much money the bank owes the depositor (or, if it’s in negative territory, how much money the customer owes the bank). The bank can take money out of depositors’ accounts by charging that depositor those fast-rising fees. When that happens, the amount of money the bank owes the depositor goes down. But it can’t take money out of depositors’ accounts by lending that money to someone else, or even by gambling it in London, since those activities don’t have any effect on the amount the bank owes the depositor.

If you borrow money from a bank, you owe that money back to the bank however well or badly you invest it. The same is true of the money that the bank borrows from you. Cohan is trying to gin up controversy where there is none: his headline reads “Exactly Whose Money Did the London Whale Lose?”, and he simply refuses to accept the simple fact — patiently explained to him by JP Morgan spokesman Joe Evangelisti — that the answer is “JP Morgan shareholders’”. Instead, he goes all faux-naive:

Evangelisti said depositors lost nothing and, in fact, the CIO account has an embedded $10 billion unrealized gain. This leaves me feeling a little like the casino executive in “Ocean’s Eleven” who, upon realizing the casino’s vault had just been robbed of close to $163 million, incredulously asks Andy Garcia’s casino-owner character: “I don’t understand. What happened to all that money?”

This really isn’t hard to understand. The CIO account is huge — on the order of $360 billion. It goes up, and it goes down. When it goes up, JP Morgan treats those gains as profits for the benefit of shareholders. When it goes down, the losses are borne by the shareholders as well. Overall, the account has gone up, but during a few fateful quarters it went down, and as a result shareholders lost money in those quarters. No one’s denying that there were losses. But it’s just not true to say that depositors suffered any losses, because they didn’t.

The United States has a two-tier system of deposit insurance. There’s the formal insurance provided by the FDIC, which covers deposits up to $250,000. And then there’s the informal too-big-to-fail insurance: the fact that JP Morgan is so big that the government would always step in before any of its depositors had to suffer losses. This system has served America well. And there’s really no good reason to scare people into thinking that their money is being gambled away in London, when in reality it’s perfectly safe. It’s the shareholders, not the depositors, who need to keep an eye on such things.


I am with streeteye.

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Should banks get to deduct their interest costs?

Felix Salmon
Sep 21, 2012 13:08 UTC

I’m delighted to welcome Jesse Eisinger to the ranks of people who think it’s high time that we abolished — or, at the very least, significantly curtailed — the tax deductibility of interest. Paul Volcker was an early member; the CBO has been making the case for a while; and Treasury has been very explicitly in favor since February.

The last time I wrote this idea up, I quoted Dan Primack, who suggested that 65% of corporate debt interest should be tax deductible, along with 100% of interest at companies with less than $20 million in revenues. To which I added: “(And, presumably, banks, too.)”

But Jesse isn’t making that presumption: he thinks that even banks — especially banks — should be hit by such a change.

What isn’t well appreciated is how much the debt deduction helps the banks. The first way is direct: Banking is a highly leveraged industry. Banks use more debt than equity to finance their activities. The tax break makes the debt cheaper and encourages banks, at the margin, to gorge on more.

This is absolutely true. And I completely agree with Anat Admati, and many others, that banks should have less debt and more equity. But, I’m not convinced that fiddling around with the deductibility of interest is the right way to go for banks. For everybody else, yes. As Treasury points out, if a company finances new investment with equity, the effective marginal tax rate on that investment is 37% — while if the investment is financed with debt, the tax rate is minus 60%. A difference of 97 percentage points.

Think about it this way: if you borrow money on your credit card, you pay off the interest with your after-tax income. That’s as it should be: no one’s seriously suggesting that you should be able to use pre-tax dollars to pay for the interest on the greetings card you bought last month. But for banks, as for all companies, the deductibility of debt makes a huge difference.

It’s worth spelling this out. To make it simple, let’s use an old-fashioned 3-6-3 banker: he takes money in at 3%, lends it out at 6%, and hits the golf course by 3 o’clock. And let’s say that the bank just acts as the intermediary between depositors and lenders.

So Fred has $1,000 on deposit, and Brenda has a $1,000 one-year loan. When that year is up, Fred’s deposit has grown to $1,030, while Brenda has repaid a total of $1,060. The difference — the profit to the bank, which the banker has to pay tax on — is $30.

Now let’s say the bank was financed 50% by debt, and 50% by equity. It still lends Brenda $1,000, but it takes just $500 from Fred, and uses its own money — prior years’ accumulated income, perhaps — to find the other $500 to lend to Brenda. At the end of the year, it has still earned $60 from Brenda, but this time it has paid Fred only $15 in interest. Which means that the bank’s profit has risen to $45.

And of course if the bank was financed wholly by equity — if it had no deposits or liabilities of any sort — then it would make a profit of the full $60 on Brenda’s loan.

So why don’t bankers use lots of equity and very little debt, if they like profit so much? Because of the power of leverage. Take that $1,000, lend it to Brenda, and you make $60. But what if you take that same $1,000 and make ten loans instead? Each loan would comprise $100 of your own money, and $900 which you’ve borrowed from Fred. On each of those loans, you take in $60 from Brenda, and pay out $27 to Fred in interest, for a total profit to yourself of $33.

And if you make $33 ten times over, that’s $330, which is a lot more attractive than a mere $60.

Right now, nothing in the tax code changes this fundamental mathematics at all. Let’s say the bank has a corporate income tax rate of 30%. Then the $60 of income on one loan becomes a post-tax income of $42, while the $330 of income on ten loans becomes a post-tax income of $231.

But what happens if you abolish the tax-deductibility of interest? Then things change dramatically. In the single-loan case, the bank doesn’t make any interest payments to depositors: Fred’s not in the picture at all. And so the pre-tax profit remains at $60, and the post-tax profit remains at $42.

But in the ten-loan case, the $330 is the difference between $600 in revenue and $270 in the cost of interest paid out to depositors. If you can’t deduct that $270 in interest, then you have to pay tax not on the $330, but rather on the $600. Which means your tax bill goes up to $180, and your post-tax income falls from $231 to $150.

Now $150 is still larger than $42. But the multiplier effect is shrinking. With tax-deductible interest, issuing ten loans got you 5.5 times the profit that you saw when you were making one loan. Without tax-deductible interest, you’re still taking ten times the risk, but your final profit is only 3.6 times what you would make by just issuing a single loan directly.

So, should we abolish or severely curtail the tax deductibility of interest even for banks? Would that be a good way of giving them a little bit of incentive, at the margin, to cut down on excessive leverage?

I’m not convinced. The way to cut down on leverage, it seems to me, is to cut down on leverage. That’s what Basel III is for, not the tax code. For banks, money is their raw material: it comes in, gets transformed, and goes out, every working day. And for any business, profit is what you’re left with after paying for your raw materials. I can absolutely get on board with making it more attractive for a widget maker to invest in its raw materials using equity rather than debt. But when debt is your raw material, I’m not sure.

Certainly any such move would make checking and savings accounts more expensive for consumers. Remember that while a bank account from the consumer’s perspective is a handy place to keep your money, from the bank’s perspective it’s a funding source — the depositor is lending money to the bank, which then turns around and lends it on to someone else. If the bank had to pay income tax on all of the interest paid to depositors, that would surely cause quite a lot of harm to the whole depository ecosystem.

That said, there are aspects of the idea that I like. It would encourage banks to make real loans to real people, at real margins, rather than engaging in clever financial shenanigans where the profit is a tiny sliver compared to the cost of funds. (Or, to put it another way, it would encourage JP Morgan to move less money to the Chief Investment Office rocket scientists in London, and move more money to its branches for personal and small-business loans.) And in general, as I’ve said many times, our entire society needs to deleverage and move to more of an equity-based funding model.

But let’s not start by engaging the banks in a thermonuclear regulator war when we don’t really have any idea what the unintended consequences might be. There’s an enormous amount of good to be done just by abolishing or reducing the tax-deductibility of debt in the commercial sphere; so let’s begin there. If that works well, then maybe we can think about moving on to banks in some way.


So, deposits/bonds are debt, debt is leverage, and leverage is way of creating financial assets out of thin air.

What happens when those financial assets stop growing, or actually decrease? Negative global financial effects; lower growth (vs. leverage-fueled 1990-2000s)

What would be the total required new equity if 30% of all bank leverage was replaced by equity?

Calamity (or at least so from the top of the developed world).

“So, you get what we had here this week, which is the way [we] wants it. Well, [we] gets it.”

I don’t have another solution, and agree with Felix’s goal and most of his thought process, but I don’t see how you could regulatorily de-preference debt and move towards more equity, unless over a timeframe that makes the Basel process look speedy.

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Why we can’t simplify bank regulation

Felix Salmon
Sep 14, 2012 17:04 UTC

Is simplicity the new new thing? The front page of the new issue of Global Risk Regulator — the trade mag for central bankers around the world — features an excellent article by David Keefe about Sheila Bair, Andrew Haldane, and calls for a “return to simplicity”. Bair tells Keefe that “we’re drowning in complexity”:

“The public is tired of rules they don’t understand,” she said, adding: “We should be simplifying the rules, we should be simplifying the institutions for which the rules are made, but it’s going in the opposite direction.” …

Bair said she was in “wholehearted agreement” with Haldane’s attack on the complexity of regulation.

“Regulation”, in this context, means one very specific thing: Basel III, the new code governing the world’s banks. No one is advocating that it be abolished: it’s clearly much more robust than its predecessor, Basel II.

But if Basel II was horribly complicated, Basel III is much more complex still — and, as I and others have been saying for the past couple of years, that’s a real problem. Ken Rogoff puts it well:

As finance has become more complicated, regulators have tried to keep up by adopting ever more complicated rules. It is an arms race that underfunded government agencies have no chance to win.

More recently, bankers themselves have started saying the same thing: yesterday, for instance, Sallie Krawcheck said that the complexity of financial institutions “makes you weep blood out of your eyes”.

So perhaps there’s a consensus emerging that regulation needs to be simplified, trusting heuristics more while spending less time and effort complying with thousands of pages of highly-detailed rules. What matters is not whether financial institutions dot every i and cross every t, so much as whether they are behaving in a safe and sensible manner. After all, one of the main reasons that we haven’t seen any high-profile criminal convictions of bankers for their roles in the financial crisis is just that their compliance officers were generally very good at staying within the letter of the law. Which didn’t really help the system as a whole one bit.

But there are lots of very good reasons why even if we are reaching a consensus on this, that doesn’t mean there’s much if any chance of some new simple system ever actually coming into place.

For one thing, the window of opportunity has closed. In the immediate wake of the financial crisis, regulators found agreement that they should get tough: that had never happened before, and it’s likely that it will never happen again. Even in the Basel III negotiation process, national regulators tended to push hardest for regulations which would be felt the most by banks in other countries, rather than their own. But at least everybody was in the vague vicinity of the same page. Without another major crisis, no one feels any real urgency to implement yet another round of major regulatory change, especially before Basel III has even been implemented. And without that sense of urgency, nothing is going to happen.

And more generally, there’s a ratchet system at play here. It’s easy to make a simple system complex; it’s pretty much impossible to make a complex system simple. All of us live in a world of contracts and lawyers — and the financial system much more than most. Financial regulation will become simpler the day that contracts become shorter and easier to understand, which is to say, never.

How has the financial-services sector managed to make an ever-greater proportion of total profits over time? By extracting rents from complexity. As a result, any attempt to radically simplify anything in the sector is going to run straight into unified and vehement opposition from pretty much every bank and financial-services company in the world. (Note that Sallie Krawcheck, like Sandy Weill, only started criticizing bank complexity after she left the industry.)

So while banks opposed Basel III, at least they got increased complexity out of it, which means that the barriers to entry in the industry were raised. Which is good for them, and bad for the rest of us. Why did Simple, for instance, take so long to launch? Because it’s very, very difficult to create anything simple in today’s banking system. Complexity is here to stay, whether the likes of Bair and Haldane and Krawcheck like it or not. And with complexity comes hidden risks. Which means we’ll never be as safe as any of these people would like.



And the last thirty years of so called ‘deregulation’ has driven the degree of complexity; see Dodd Frank, and THIS:

http://www.macrobusiness.com.au/2012/09/ death-by-financial-rules/

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How many U-turns can a bank fit inside a loophole?

Felix Salmon
Aug 9, 2012 14:42 UTC

The NYT has two excellent articles about the Standard Chartered affair today. Read this one first, about the law which may or may not have been broken; and then move on to this one, about the reaction to the case in London.

Up until 2008, the US law governing banking transactions with Iran fell short, shall we say, from what you might expect from a perfect model piece of legislation. Banks in New York couldn’t do such business — unless the money just came in to the US and then immediately left again — but even then there were lots of rules surrounding disclosures and the like which tended to slow such business down. The big argument in this case is not whether the transactions took place, but rather whether Standard Chartered illegally circumvented the disclosure rules, by stripping lots of information from the transactions before they reached New York.

In other words, this whole thing is a fight over the size of a loophole. Standard Chartered defends its actions on the grounds, in the NYT’s words, that they “fell squarely within that loophole” — while Benjamin Lawsky sees the loophole as being much smaller, and the StanChart transactions as falling outside it.

Viewed from across the pond, all of this seems a little bit silly. London has always been a more freewheeling and international banking center than New York; moving money around the world is what London banks do. And so the English are seeing a war on London here:

John Mann, perhaps the most strident critic of Britain’s banking culture in Parliament, said in an interview on Wednesday that the Standard Chartered allegations reflected an anti-Britain bias by American regulators, who he said were trying to bolster Wall Street at the expense of the City of London.

This is silly; I’m quite sure that Lawksy doesn’t have some kind of hidden agenda to boost the fortunes of Goldman Sachs or BofA. But the US rules are definitely written in a world where the US can and will advance its own geopolitical agenda by imposing regulations on domestic institutions, as well as foreign institutions with a US presence. And since it’s impossible to be an international bank without having a US presence, the US geopolitical agenda ends up being imposed on every major bank in the world.

The London view of things is different: it sees itself more a global financial center, rather than a UK city, and historically has tried to be as welcoming as it can be to foreign institutions and capital flows. Hence the now-famous quote from an English StanChart executive, complaining about where the “fucking Americans” get off telling the rest of world what they can and can’t do when it comes to Iran.

What’s more, while London regulation is principles-based, US regulations are rules-based — which means that if Standard Chartered could find a way of moving money around the world while remaining within the four corners of the law, it would happily do so. There’s very little doubt that StanChart’s actions violated the spirit of the law; Lawsky’s assertion is that they violated the letter of the law, as well. But that remains to be seen. In London, and in general, StanChart would generally avoid taking refuge in loopholes like this. But New York is different, and in New York, StanChart played by different rules.

So while Lawsky’s suit isn’t a matter of bolstering Wall Street at the expense of the City, it is a matter of trying to impose the US (and, indeed, NY) vision of finance on every global financial institution. When it comes to things like capital adequacy, regulators around the world have interminable meetings in boring cities to try and build a global framework they can all agree on. When it comes to things like money transfers, however, every country has different rules, and the US has no compunction in declaring that, say, all flows in and out of Iran are money laundering and/or terrorist finance unless proven otherwise.

Up until now, US bank regulators have taken a relatively sanguine view of such matters. They understand that New York is an international financial center, and so long as banks are making a good-faith effort to stay within the letter of the law, they’re often given the benefit of the doubt. Some might call that regulatory capture; others might simply see New York regulators triangulating towards international norms.

Lawsky, on the other hand, clearly doesn’t care a whit for international norms or the global nature of finance. He sees behavior which on its face involves trading with Iranians and making hundreds of millions of dollars in profit from activities no US bank would want to touch. He has every right to go after StanChart, which has a major New York presence. And he also — crucially — has the right to take away StanChart’s banking license here, which would basically kill the bank entirely. What he sees as the moral high ground looks to Londoners very much like judicial bullying.

The US tightened up its loophole in 2008, and when it did so, StanChart’s U-turns came to an end: they thought they were within the loophole, and when that loophole went away, they stopped what they were doing. In other words, we’ve already had the US action which put an end to StanChart’s behavior: in fact, we had it four years ago. What extra purpose is served in going so aggressively after StanChart now? That’s the question that London is asking; I’d be interested to hear Lawsky’s answer.


@FS – you might care to re-examine the wisdom of your ascribing benign intentions to StanChart’s management after you closely consider this -

http://www.reuters.com/article/2012/08/1 0/us-standardchartered-iran-privilege-id USBRE8791AT20120810?feedType=RSS&feedNam e=topNews

IMO the documents cited in the article establish a strong ‘prima facie’ case of the bank knowingly engaging in transactions which it understood to be highly likely to be in violation of US law. Equally gag-inducing is the apparent blatant complicity of the bank’s attorneys in the planning and execution and concealment of the improper activity. This is unambiguously out-of-bounds – and every lawyer knows it. The traditional attorney-client privilege has no application to such a matter – just ‘cause your partner in crime is a lawyer doesn’t get your conspiratorial conversations any special legal status.

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Dennis Kelleher, Libor, and high-frequency trading

Felix Salmon
Aug 8, 2012 06:03 UTC

Dennis Kelleher of Better Markets has responded to my post in which I said, inter alia, that he was wrong about high-frequency trading. He, of course, says that I’m wrong — indeed, that I’m “over the top and just plain wrong in many ways”, and that the post is “self-discrediting”. Blogfight! So, fair warning: this post is my response to his response to my post; if you’re not into that kind of thing I fully understand, and you’re probably much more grown-up than either of us. Anyway.

First, Felix totally overlooks the fact that some of the biggest banks in the world knowingly committed multiple very serious crimes by rigging the Libor rate.

It’s true I didn’t dwell on this, because it really wasn’t the subject of my post. My point was that whenever something scandalous or unacceptable happens in the financial markets, it’s not enough that the activity is scandalous or unacceptable: the financial press also feels the need to demonstrate that the little guy was being ripped off somehow. Even if he wasn’t. In this case, I’m perfectly happy to agree with Kelleher that rigging Libor was a very serious crime.

Kelleher accuses me of ignoring other things, too, like the difference between the two separate parts of the Libor-rigging scandal. Again, yes, I didn’t mention that. I also didn’t mention Standard Chartered, or HSBC money-laundering, or, for that matter, the Olympics badminton scandal. Kelleher has made it his life’s work to rail against such things, so maybe he feels that I should mention them in every post I write. But I can hardly be wrong about something if I didn’t even mention it.

He does, however, say that I’m “dead wrong that no one was harmed by the banks rigging the Libor rate”. This is a bit of a nasty accusation, because if I’d said that no one was harmed by the Libor rigging, then indeed he would be quite right to call me wrong. But I never said anything like that. He also says that I don’t understand interest-rate swaps, and proceeds to give a perfectly accurate explanation of how they work. And again, his explanation doesn’t contradict anything I said. But I do think he misses my point, so let me try again.

Kelleher uses an example of a municipality which has entered into an interest rate swap and is paying a fixed rate while receiving a floating rate linked to Libor. Such swaps are designed to protect borrowers from rising interest rates; the flipside of the deal is that if rates fall, then the borrower will end up losing money. And as it happened, rates fell, and the borrowers ended up losing money.

Now here’s the thing: the municipalities didn’t insist on linking the interest-rate swap to Libor because their borrowing costs are particularly bank-like. They just used Libor because it was the market standard, a proxy for interest rates more generally. The Libor scandal — and, yes, it is a scandal — is that the banks ended up printing a rate for Libor which was closer to prevailing interest rates than it should have been. Because Libor is tied to the interest rate on unsecured bank debt, it can actually rise when interest rates are falling, if the credit spread on bank debt rises fast enough. From the point of view of borrowers engaging in interest-rate swaps, that’s a bug, not a feature. What they want is a simple proxy for interest rates; they don’t want a proxy for interest-rates-plus-financial-sector-credit-spreads.

So Kelleher is right, in a narrow sense, when he says that if you were receiving floating-rate interest payments linked to Libor, then you got less money than you should have got. Because according to the contract, your payments should have included that extra bank-credit-spread component, on top of the interest-rate component. But my point is that no one ever entered into an interest-rate swap because they were making a bet on bank credit spreads rising. As a result, the losses here are losses of windfall, unexpected revenues. And of course there are just as many borrowers who entered into floating-to-fixed interest-rate swaps: they ended up winning just as much as the fixed-to-floating borrowers ended up losing.

It’s worth taking a step backwards here. In the grand scheme of things, borrowers gained rather than lost from the Libor manipulation, because it meant that they paid less interest on floating-rate debt. The real losers here are investors who bought floating-rate debt, and who should have been paid more than they were. My point is that if you’ve found someone claiming to have lost money as a result of the Libor manipulation, and they’re a borrower rather than an investor, you’re pretty much scraping the barrel. The Libor scandal is scandalous for many reasons, first and foremost that it involved banks lying in order to manipulate a hugely important interest rate. You don’t need to show borrowers losing money in order for there to be a scandal here: there would be a huge scandal even if no borrowers lost any money at all.

Kelleher then moves on to the main subject of my post, which was high-frequency trading. I said he was wrong when he said on a TV show we were on that shops like Knight rip off small investors. He replies:

Mr. Kelleher distinguished between high speed trading (really high speed market making) and predatory high frequency trading (HFT). Maybe not the most precise way to talk about these activities, but not too far off the mark for a general audience. It was the later practice not the former that Mr. Kelleher said rips off small investors, frequently referred to in the market as dumb money. (Not mentioned was that, because shops like Knight pay for order flow from retail brokers and pick off what they want, there are fewer natural buyers and sellers in the market and only professional or toxic retail flow actually gets to the market.)

OK, let’s make a distinction between high-speed market-making, on the one hand, and HFT, on the other. If you’re making that distinction, then Knight absolutely falls into the former category: it’s one of the helpful market-makers, rather than one of the predatory algobots. This part of the show hasn’t made it onto the internet, but I can assure you that Kelleher never explained that his distinction, at the margin, actually makes Knight look better rather than worse.

But in any case, the high-frequency algobots don’t rip off small investors, because the two never come into contact with each other. If a small investor puts in a stock trade, it ends up being filled by Knight, or one of the other high-speed market-makers. The algobots are whale-hunting: they’re looking for big orders from institutional investors, which they can game and front-run and otherwise prey upon. If small investors ever found themselves naked in the open oceans of the markets, the same thing might happen to them, but they don’t: they’re protected from those waters by companies like Knight, which will give them exactly what they want at the national best bid/offer price.

You’d think that Kelleher, having made the distinction, would be happy that small investors don’t end up being picked off by predators, but he’s not: he reckons that because they’re not out in the open ocean, that means “there are fewer natural buyers and sellers in the market”. Well, you can’t have it both ways. And frankly if retail investors did return to the market, it wouldn’t help matters: there wouldn’t be more volume or more liquidity or any visible positive effect.

So why did Kelleher even make his distinction in the first place? Just so that he could then come out and say that “HFT is a liquidity taker, not a liquidity provider”. In order to say that, he needs to exclude high-speed market-makers like Knight, who clearly do provide liquidity to retail investors. When I said that high-frequency shops provide liquidity to the market, I was very much talking about Knight, and I can assure Kelleher that everybody who was watching TV on Monday night thought that he was talking about Knight as well. After all, it’s Knight that’s in the news right now.

Finally, Kelleher pushes back against my “anti-regulation stance”, which is quite hilarious; he also informs his readers that “Felix also sees HFT as nothing but a force for good.” Maybe he didn’t see my post on Monday, where I talked about how HFT is “quite literally out of control”. I concluded that post by saying that “the potential cost is huge; the short-term benefits are minuscule. Let’s give HFT the funeral it deserves.” So obviously I don’t consider HFT to be “nothing but a force for good”.

The fact is, however, that I don’t need to go back to Monday’s post to demonstrate my anti-HFT bona fides. In the very post that Kelleher’s responding to, I write this:

I do think that the amount of HFT we’re seeing today is excessive, and I do think that we’ve created a large-scale, highly-complex system which is out of anybody’s control and therefore extremely dangerous.

Kelleher, then, is a man who, immediately after reading those words, can turn around and describe me as someone who sees HFT as nothing but a force for good. It’s very hard to know how to respond to such a person, but I guess that does at least explain why he thinks I said so many things I never said. He might think he’s responding to me, but in fact he’s just creating a straw man and putting my name on it. Which, frankly, is a little bit annoying.


This and other topics that are relevant for speed traders and institutional investors will be discussed at High-Frequency Trading Leaders Forum 2013 London, next Thursday March 21.

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The danger of repo

Felix Salmon
Aug 6, 2012 14:28 UTC

Remember how there’s a very good chance that Treasury’s new floating-rate notes are going to be linked to some kind of repo benchmark? Well, here’s another reason that’s a bad idea: the repo market is shrinking fast, at least in Europe — and if it can shrink in Europe, it can do so in the US, as well.

What’s more, we want the repo market to shrink. Gillian Tett, in her latest column, explains that as rules about collateral tighten up, they create what Manmohan Singh calls a “second deleveraging”. But weirdly, Tett thinks that an increased focus and reliance on the repo markets is a good thing in the long term: “a financial system in which transactions are secured on assets is likely to be a healthier system than one which is largely – or patchily – unsecured,” she says, “particularly if that collateral is valued in a regular, disciplined basis”.

This is exactly wrong. Repos are a form of informationally-insensitive asset: they epitomize the paradoxical and ultimately destructive desire on the part of people with money to lend out money but to take no credit risk while doing so. Informationally-insensitive assets are a bad idea in general, for reasons which are probably familiar at this point to most readers of this blog: they breed complacency, tail risk, and deluded, magical thinking. But repos are a particularly bad species of the genus, because they are a direct replacement for old-fashioned unsecured credit.

Lending money in return for interest on that money is a form of investing: one entity, with money to spare, invests that money in a venture which can put it to good use and profit from it. If all goes according to plan, both win. The borrower might be poor but has ideas, and the ability to make money in the future; the investor makes such profits possible.

When you move from a credit-based system to a repo-based system, however, all that changes. At that point, future profitability isn’t enough to get you cash: instead, you need to be rich already, and you need to be able to hypothecate your existing assets to some lender. If we’re talking about the banking system, here, we’re talking about a world in which banks simply cease to trust each other at all, and the answer to all interbank credit questions is “no”. The only way for banks to lend to each other is to either go through some central counterparty, hub-and-spoke style, or else to retreat to the world of repo, where banking prowess counts for nothing and all that matters is collateral quality.

The implications of such a world are already being seen: Tett says that “collateral arbitrage” has now become a profit center at some banks. Far from trying to lend out money to creditworthy borrowers, banks are beginning to make money by gaming inconsistent repo rules. No good can come of this.

And in times of crisis, a reliance on repo markets makes all banks incredibly fragile, and vastly increases the risk to taxpayers should a bank fail. Once upon a time, banks had equity, they had debt, and then they had deposits. If a bank failed, the bank’s equity would be wiped out first, and then its debt. The depositors were senior, which meant there was relatively little chance that the FDIC would have to bail them out.

Now, however, bank debts are shrinking, replaced with repo operations. As a result, when a bank fails, the equity gets wiped out first — and then there’s no cushion any more before the depositors start losing money and need to be bailed out. The rest of the finance world is senior to depositors: they have repo collateral, which makes them secured creditors, and secured creditors are senior to unsecured creditors, even when the unsecured creditors are just mom-and-pop depositors.

The more that the world of finance relies upon repo, the less it relies upon relationships and trust and underwriting and all the other ties which bind. The financial sector can’t afford those ties to be severed: the cost of breaking them, in terms of foregone growth and profit, is far too great. But we seem to be doing exactly that.

Update: See also Carolyn Sissoko, from February,  a great post. h/t Waldman.


Re “bill of exchange”, two quite different ideas are being conflated here. A bill of exchange is not a “secured loan” because it is not a loan of any type whatsoever; it is a payment instrument, consisting of instructions to a third-party bank to pay the bearer (or a named party.) The modern American will be more familiar with a “bill of exchange” as a “check.”

Bills of exchange are substitutes for currency and were widely used in 19th century America because the private currencies issued by its myriad banks were not accepted or were heavily discounted in locations far removed from the issuer.

It is true that bills of exchange were often paired with financing, because the people who wanted to make such payments did not possess the means to pay on their own account. The loans were separate transactions, though, ans as noted by realist50 were secured by the goods they financed.

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