If you are new to this blog, you are invited to read first “The Largest Heist in History” which was accepted as evidence and published by the British Parliament, House of Commons, Treasury Committee.

"It is typically characterised by strong, compelling, logic. I loosely use the term 'pyramid selling' to describe the activities of the City but you explain in crystal clear terms why this is so." commented Dr Vincent Cable MP to the author.

This blog demonstrates that:

- the financial system was turned into a pyramid scheme in a technical, legal sense (not just proverbial);

- the current crisis was easily predictable (without any benefit of hindsight) by any competent financier, i.e. with rudimentary knowledge of mathematics, hence avoidable.

It is up to readers to draw their own conclusions. Whether this crisis is a result of a conspiracy to defraud taxpayers, or a massive negligence, or it is just a misfortune, or maybe a Swedish count, Axel Oxenstierna, was right when he said to his son in the 17th century: "Do you not know, my son, with how little wisdom the world is governed?".

Sunday, 21 March 2010

From bail-in to bail-out: letter to The Economist


On 28 January 2010 The Economist published a guest article authored by Messrs Paul Calello, the head of Credit Suisse' investment bank, and Wilson Ervin, its former chief risk officer, who proposed a new process for resolving failing banks, "From bail-in to bail-out".

On 3 February 2010 the author of this blog sent the following letter to the Editor of The Economist. The reader are invited to draw their own conclusions why it was not published.

===

To the Editor of The Economist

Sir

The "bail-in" proposed by Paul Calello and Wilson Ervin "bail-in" "From bail-out to bail-in" fails to address the real reason for the banks' liquidity crunch: that the loan to deposit ratio was greater than 100%, creating rapid growth via the money multiplier (which every economics student studies as the process of "deposit creation"). This makes a liquidity risk a certainty, a probabilistic inevitability. When the banking system's exploding liabilities outstripped their ability to get hold of cash, central banks stepped in, in effect printing money to restore banks' liquidity through quantitative easing.

The Calello-Ervin proposal does not deal with this. It does not state at what level the money multiplier would be sustainable and how to keep it below that limit. Instead, it spreads the liquidity risk among shareholders and creditors of different financial institutions, meaning that the next (and inevitable) credit crunch will be more severe and still more widespread than the one at the end of 2008.

An analogy would be a tank in which gas pressure is growing at an uncontrolled rate. Making the tank stronger only delays the inevitable (and much larger) explosion.

In short, "innovative" risk management mechanisms such as the Calello-Ervin proposal cause more harm than good, rather as credit-default swaps have done.

Yours sincerely

Greg Pytel

23 comments:

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    ReplyDelete
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  2. Perhaps they haven't published because: 1) your reference to loan to deposit ratio is far too cryptic in the letter (I know you explain it more fully elsewhere but did you include that in your letter?); 2) if they did get your point, maybe its because they don't agree with your reasoning?

    For example, why do you think the bail-in idea conflicts with the principle that loan creation should never exceed 100% of deposits? By wiping out shareholders and moving some bondholders further down the capital structure, it exposes the mismatch between the liability and asset (loans) side of the balance sheet and is ultimately deflationary - it forces the bank to shrink the asset side of the B/S, hence putting downward pressure on the loan to deposit ratio.

    To an extent, this is already happening in the banking sector as evinced by negative net lending over the past year. Banks are rushing to reduce the loan to deposit ratio having been forced to recognise the fragility of the liability side of their B/Ss.

    You should be applauding this idea as it provides a framework to enforce loan to deposit restraint for those banks that overstretch and by implication, for the whole banking sector.

    ReplyDelete
  3. pablo9999, thanks for reading my blog:

    1. I take your point but the letters to the Editor of The Economist are practically limited to 200 - 300 words. So please advise me on a practical solution?

    2. Indeed it is an old communist tradition to publish only views that your agree with. So maybe this is not that surprising.

    3. For clarity I never stated that bail-in idea "conflicts with with the principle that loan creation should never exceed 100% of deposits". Indeed it does not in principle. I simply stated that "Calello-Ervin proposal does not deal with it". So no disagreement between us on this point. However I am not minded to agree with a practical side of your analysis. Not that I see anything wrong in theory but in practice the banks are not prepared to reduce their loan to deposit ratio. Therefore it would not be a downward pressure on loan to deposit ratio but a license to create an even bigger bubble that would blow up more spectacularly. But this is really a matter of opinion.

    Please spread a link to my blog if you think it merits it.

    Best

    Greg

    ReplyDelete
  4. pablo9999,

    I think you may enjoy an article "why banks are still not lending?" - http://gregpytel.blogspot.com/2009/08/why-banks-are-still-not-lending.html

    Best

    Greg

    ReplyDelete
  5. Thanks for your reply, Greg.

    2) So the editors of the Economist are communists for not publishing your letter! Please tell me that you are joking!?

    3) I quote your letter: "Instead, it spreads the liquidity risk among shareholders and creditors of different financial institutions, meaning that the next (and inevitable) credit crunch will be more severe and still more widespread than the one at the end of 2008. An analogy would be a tank in which gas pressure is growing at an uncontrolled rate. Making the tank stronger only delays the inevitable (and much larger) explosion."

    So you're saying the bail-in principle does not conflict in principle with sub-100% loan to deposit ratios but you ARE saying that it will exacerbate stress in the financial system to the point it explodes? And further, you are saying that this is because it spreads liquidity risk?!

    Spreading liquidity risk is generally a good thing (concentrated liquidity risk a bad thing a la Lehmans) and yet you think it adds to the problem here. Whilst I admire your sense of iconoclasm, if you’re going to turn a commonly accepted principle on its head, it requires further explanation.

    I’ve given you a pretty cogent argument as to how and why the Calello-Ervin proposal restrains loan to deposit ratios and hence DOES address “the real reason for the banks’ liquidity crunch” as you put it. You disagree because “banks are not prepared to reduce their loan to deposit ratio”. But you’ve missed the point, “it FORCES the bank to shrink the asset side of the B/S, hence putting downward pressure on the loan to deposit ratio.” It doesn't matter what the banks are PREPARED to do because there is NO CHOICE for the banks. That’s why it works as a mechanism.

    Furthermore, and it doesn't really matter as far as the argument for Calello-Ervin goes, but I think you’re wrong about bank intent wrt loan to deposit ratios. You even seem to be wilfully ignoring yourself (or at least Peston) on this point. Last time I quote you (I hope) "Not that I see anything wrong in theory but in practice the banks are not prepared to reduce their loan to deposit ratio." This is a common theme for you and yet how does it tally with the Peston quote in your blog of 8 August 09: "Take Royal Bank of Scotland. Today, its chief executive has set a target to reduce its ratio of loans to deposits from 156% to around 100% by 2013."

    This implies huge negative net lending over the stated period and at that run rate, zero loans to deposits by the turn of the next decade. If you don’t want to believe what the banker’s saying (fair enough) then look at the empirical evidence of the past year. For example take UK negative net lending to UK business between Jan 09 and Feb 10 - it has fallen by £25bn (and by £6.5bn in January 2010). This trend is being repeated across the Western Economies. Do you know how often we have had a year's worth on negative net lending in the last 100yrs? And have you consider the effect of negative net lending to deposit ratios?

    Based on their action (if not their words too) the new bank managements (such as Hester at RBS) get the point on loan to deposit ratios. That’s why they are taking unprecedented steps in net lending (i.e. negative). If we could back this up with regulatory mechanisms such as Calello-Ervin’s, then in future it might be possible to avoid the need to take such drastic steps to reduce loan to deposit ratios (because they will be held sensibly below 100% - a point I think we DO agree on).

    ReplyDelete
  6. pablo9999, thanks.

    2) Whether the Editor of The Economist is a communist or not is a question for him. However you should not be carried away with my comment: I imply that a "Besserwisser", communist or otherwise, treats the views he does not agree with in a similar manner. At least he ignores them.

    3) It is a matter of opinion. From my own research (that included a CEO of the top world bank), it is clear that the banks are not planning to remove their practice of lending with loan to deposit ratio below 100% (if they did they would have softly, implicitly admitted that they were doing something wrong. (Therefore the fact that they reduced LTD ratio for now does not matter at all in the longer term: they keep on building a pyramid.) Even LTD at 100% or not much below it (below 100% it is a rule of thumb, not a strict science, down to 90%) is a sheer madness that will blow up the financial system again. Although technically it is not a pyramid. So for that reason I stand by my comment.

    Incidentally spreading liquidity risk is not necessarily generally a good thing. For example if LTD is above 100% than liquidity risk is 100% in a finite time (as I proved on my blog: http://gregpytel.blogspot.com/2009/09/loan-to-deposit-ratio-and-banks_02.html). Therefore if you spread liquidity risk in the best way you will end up building the largest possible financial pyramid which will collapse, as liquidity risk is 100% in a finite time. It will be just much larger than it would have been otherwise.

    There is an easy way to avoid liquidity risk: just print cash, like Zimbabwe. The costs of it will be a high inflation (like in Zimbabwe). If you employ Calello-Ervin approach, the effect is the same. However people rather than getting worthless banknotes they get worthless share certificates. Callelo-Ervin way or another, you will never beat mathematical laws of complexity. If you end up building a massive pyramid then you will have to find a way to balance it: either by printing cash or issuing additional shares under Calello-Ervin system. The net effect will be the same. However the latter one will simply look better. In the same way as the pundits do not compare the current crisis to Albanian pyramids of 1996 - 1997, they do not want to compare the solution to Robert Mugabe financial strategy. But this what it has to be in reality.

    Best

    Greg

    ReplyDelete
  7. pablo9999, you wrote: "So you're saying the bail-in principle does not conflict in principle with sub-100% loan to deposit ratios but you ARE saying that it will exacerbate stress in the financial system to the point it explodes? And further, you are saying that this is because it spreads liquidity risk?!"

    I repeat: "bail-in principle does not conflict in principle with sub-100% loan to deposit ratios". Basically you can use Calello-Ervin principle when you have LTD below 100%. What's the problem (in principle)? It does not imply that I would agree with it however (but this is yet another matter).

    Calello-Ervin method, combined with lending with LTD above 100%, will help to build an even bigger pyramid. But as a pyramid is bound to collapse the damage will be even bigger. So basically it is a combination that makes the system more lethal than at present.

    Best

    Greg

    ReplyDelete
  8. 2) I’M not the one getting carried away :)

    3) Why is it a matter of opinion? It is not my OPINION that the banks are reducing the loan to deposit ratio, it is a FACT that they are. What kind of research fails to take into account the most obvious and verifiable empirical evidence available, namely the massive contraction in net lending since the end of 2008? Your opinion-based research is entirely at odds with the verifiable evidence.

    Printing cash to prop up the banks is a Bernanke/King/Brown solution. Calello-Ervin are NOT suggesting printing cash, quite the opposite in fact – they are suggesting that in a liquidity event at a financial institution, equity holders are wiped out while a proportion of bondholders are forced down the capital structure into equity.

    “However people rather than getting worthless banknotes they get worthless share certificates.” Its not just any old person being plugged with equity, specifically its bondholders of said bank getting share certificates. If they turn out to worthless then that’s tough on those bondholders who were foolish enough remain invested in a bank that recklessly overlent its way into a liquidity crises.

    Rather than increase broad money, this actually reduces it (i.e. is deflationary). As I explained before, it also reduces the liability side of the bank’s B/S, which in turn restricts its ability to grow the asset side (i.e. increase lending). They are suggesting that those who show sufficient bad judgement in investing (through bonds or equities) in a financial institution that recklessly overlends its way into a liquidity crisis, pay for that poor judgement. Bank investors pay the price, not savers and not taxpayers (unless of course those savers or taxpayers happened to own bonds or shares in that particular bank).

    ReplyDelete
  9. pablo9999,

    The fact is that banks are reducing loan to deposit ratio but not below 100%. And this is what matters. For example, ask Mr John Varley, the CEO of Barclays: he will tell you just this. In practice it does not matter whether banks are lending with LTD 300%, 150% or 110%. It is a matter of time, indeed short time, before they will blow up the system. And if Calello-Ervin method is allowed the blow-up will be just bigger.

    Calello-Ervin does not suggest printing cash. That's true. But their action amounts to the same effect. Basically you cannot simply plug liquidity hole with nothing: you have to reduce money multiplier. And whichever way you do it the effect will be the same.

    You wrote: "Its not just any old person being plugged with equity" - I think this is naive. A lot of pension funds will be affected by Calello-Ervin system, hence quite a few old folk.

    I agree that this decreases broad money and the liability side of the bank's B/S. The problem is that it puts a pressure on those owning this equity: can they go to Tesco and do a weekly shopping with it? I guess not, so it is not worth that much.

    If someone (be it institution) getting this extra equity (according to Calello-Ervin system) wants to sell it (cash it) can he get the nominal amount of cash for it immediately? If the answer is "yes", then the whole process is not necessary. If the answer is "no", then this is a toxic waste (i.e. worth as much as Zimdollars).

    Best

    Greg

    ReplyDelete
  10. "you cannot simply plug liquidity hole with nothing" - you've missed the point again Greg...the liquidity hole exists on the liability side of the bank's B/S...Calello-Ervin's proposal is a pre-agreed framework for removing this liquidity hole by forcing bond (liability) holders down the capital structure into equity. Liquidity crises arise where asset/liability mismatches become too wide for the market to bear. Under C-E, the market will have clear sight that the mismatch will be removed in an orderly and pre-agreed fashion, hence no liquidity crisis.

    "You wrote: "Its not just any old person being plugged with equity" - I think this is naive. A lot of pension funds will be affected by Calello-Ervin system, hence quite a few old folk."

    :) you've misunderstood me here...I'm not introducing OAPs into the debate. When I said "any old" I mean anybody. C-E's solution lays the price of dealing with the bank's problems with those specific investors who backed it.

    ReplyDelete
  11. pablo9999, I think you are missing the point. You wrote: “Calello-Ervin's proposal is a pre-agreed framework for removing this liquidity hole by forcing bond (liability) holders down the capital structure into equity.”

    So can you explain what would the value of this “equity” if the creditors wanted to sell them immediately? Please advise.

    My view is:

    - if it was as much as nominal value of the liability then the exercise is pointless;

    - if it is less then it is a toxic waste (and if anyone is forced to accept it is a fraud: cash is the only legal tender that might be legally forced upon you in discharge of any liability unless there was an agreement to the otherwise)

    I am introducing OAP’s into debate. Accepting Calello-Ervin proposal carries a massive risk of writing off massive chunks of pension funds.

    No doubt Calello-Ervin proposal would grately improve banks B/S. But practically this would a right of banks to organise for themselves a stimulus package at the costs of creditors. (If creditors agreed to that beforehand that's fine: this would be the risk when they took when they gave credit. If they did not it is a fraud: an act of plain theft.)

    Basically you seem to oppose my views, but your arguments simply confirm them.

    Best

    Greg

    ReplyDelete
  12. "if it is less then it is a toxic waste (and if anyone is forced to accept it is a fraud: cash is the only legal tender that might be legally forced upon you in discharge of any liability unless there was an agreement to the otherwise)"

    Well that's the whole point. C-E are proposing a solution that makes bank debt-for-equity swaps part of the pre-agreed regulatory framework. Bondholders are paid to take bank credit risk. When they invest in a bank that runs into liquidity crisis why shouldn't they expect to take a loss? Are you arguing otherwise?!? I have absolutely no doubt that all investment institutions who invest in bank bonds expect to take losses when they make bad investment decisions. At least under C-E's solution losses will be limited to those funds that took risk in those banks that over-reached.

    "No doubt Calello-Ervin proposal would grately improve banks B/S. But practically this would a right of banks to organise for themselves a stimulus package at the costs of creditors. (If creditors agreed to that beforehand that's fine: this would be the risk when they took when they gave credit. If they did not it is a fraud: an act of plain theft.)"

    As opposed to using taxpayer funds to cover bank bailouts?
    Undoubtedly C-E's proposals would require the support of the investment community but given that the latter have enjoyed the benefit of govt bailout funding (which has propped up their existing investment in banks - particularly bonds) they are not really in a position to object to a govt-led backing of C-E's proposals.

    ReplyDelete
  13. pablo9999,

    OK, I think we agree. But we have to give people a choice: if you and your business accepts to be treated in C-E proposed way fine. Good on you! I do not and i want CASH. If governments cannot assure that I will not be keeping my CASH in commercial banks but only in state owned banks (ultimately in BoE).

    C-E proposal is a licence for banks to organise stimulus packages for themselves in any scale without even government approval. In such case I would not put a penny into such banking system. If you do, it will be your choice.

    Best

    Greg

    ReplyDelete
  14. no Greg, we don't agree..

    "I do not and i want CASH. If governments cannot assure that I will not be keeping my CASH in commercial banks but only in state owned banks (ultimately in BoE)."

    Bonds are NOT cash. C-E do NOT advocate restructuring CASH holders. CASH holders retain their right to demand CASH (and enjoy greater protection of their deposits under C-E).

    "C-E proposal is a licence for banks to organise stimulus packages for themselves in any scale without even government approval."

    No. C-E merely provides a pre-agreed means of dealing with bank liquidity issues that limits their impact to those investors who have invested with that bank.

    ReplyDelete
  15. pablo9999, bonds are liability in cash at the time of maturity. (I have no knowledge of bonds - apart from convertible ones - that do not carry, ultimately, cash liability.)

    If C-E proposal was not imposed retrospectively then that's fine. If it is retrospective it is a crime. But what's new about it: anyone can get into convertible bond deal now?

    Best

    Greg

    ReplyDelete
  16. most (not all i.e. payment in kind bonds, some convertibles and other structures for example) bonds do pay cash on redemption but that is NOT the same as saying they are CASH....

    bond defaults by banks lead directly to collapse...investors know this, C-E know this, that's why their proposal focuses on dealing with that by pre-agreeing a conversion into a combination of sub debt and equity for a proportion of bondholders (who know that they will only get back cents in the dollar on debt in a bank collapse anyway)...

    The C-E proposal would not work without the agreement of bond investors. C-E are suggesting it is in bondholders interests to pre-agree a framework so everyone knows the rules before we end up with the mess that is a bank bail-OUT. They're argument is don't bail out (with taxpayer money creating moral hazard), BAIL-In those investors who already have skin in the game.

    In sum, its a decent, constructive proposal on improving the current state of regultory approach to bank failure.

    ReplyDelete
  17. pablo9999, you wrote: "bonds do pay cash on redemption but that is NOT the same as saying they are CASH". So it is "delayed" CASH. Whatever. The cash comes at some agreed point on the other end.

    Nothing is currently stopping investors to enter voluntarily into agreements of a type of C-E proposal. If I agreed with your take on C-E proposal, it is trivial on (college student level) and it is simply surprising that The Economist wasted the entire page for it.

    Best


    Greg

    ReplyDelete
  18. No it is not delayed CASH. CASH only arises on redemption if and when the bond issuer meets that redemption. If it were delayed cash, there would be no risk spread attached. This is high school level basic.

    "Nothing is currently stopping investors to enter voluntarily into agreements of a type of C-E proposal."

    No but now who's being naive? All participants need to be subject to the same framework to make it a workable solution to future liquidity crises. Govts need to endorse this kind of framework to reduce the burden on taxpayers in future bail-outs.

    ReplyDelete
  19. pablo9999, delayed "cash" carries risk as delay in itself is a risk factor. This is below high school level basic: it is kid asking for a sweet as its dad says "later". Even a five years old intuitively understands that there is a risk of "later" becoming "never".

    You have to make up your mind:

    - is C-E system voluntarily agreed arrangement in which there is nothing new as it exists NOW,

    - or is it something imposed (what do you mean by "endorse"?) by the governments retrospectively in which case it is a crime.

    - or if you make it a general compulsory framework (but not retrospective) then you will see a lot of investors not putting their money into such framework or charging higher interest to account for additional risk.

    You really have to be clear how you envisage C-E system being introduced. As either:

    - there is nothing new about it

    - or it is a retrospective criminal action

    - or it sets out new arrangement making the system inherently more risk for the investors (at very least the interest on such bonds will be higher to account for such risk). In this case it is anti-liberal kind of communist approach of centrally directed economy.

    ReplyDelete
  20. pablo9999, who ever said that "all participants" have to enter into the same type of contracts regarding the risk (which is what C-E system impose)? This really stinks with a communist approach to economy. I really do not like it. I believe that markets should be free. And if someone builds a pyramid scheme (like it is the crisis) then should be prosecuted. Setting up financial pyramid support structures is nonsensical and bound for failure. This crisis is not a result of the lack of regulations, but a result of criminal actions.

    All such proposals as C-E seem try to cover up the criminal pyramid aspects of the current financial system, rather than setting prosecutors in order to get these guys sorted like Madoff.

    ReplyDelete
  21. "delayed "cash" carries risk as delay in itself is a risk factor. This is below high school level basic: it is kid asking for a sweet as its dad says "later". Even a five years old intuitively understands that there is a risk of "later" becoming "never"."

    This is errant nonsense. Bonds are not "delayed" cash - there is no such term. Bonds are clearly distinguishable from cash by definition and it is absurd to argue otherwise.

    "You have to make up your mind:"

    Although you seem to be struggling with the concept, there is no confusion on my part. The C-E proposal is clearly a regulatory framework. As such it has to be adhered to by all market partipants. It would be useless and unfair if it applied to some and not others. It is not a retrospective change in terms & conditions of the bonds themselves, it is a framework for an orderly workout in a default scenario.

    "or if you make it a general compulsory framework (but not retrospective) then you will see a lot of investors not putting their money into such framework or charging higher interest to account for additional risk."

    You really don't get it do you? Investors have been bailed out by govt intervention through explicit and implied govt guarantees of bank debt. Were it not for this action, investors in bank debt would have been utterly annihilated. It is now up to the govt to say this can and will not happen again and here is the framework to ensure that it does not. Investors have to realise that investing in banks is not a zero risk business. Moral hazard must be removed from the system. In all probability, bank access to future funding and the cost of this funding will be higher but then it should be. That will limit reckless loan growth in the future and ensure sensible loan to deposit ratios.

    "This really stinks with a communist approach to economy. I really do not like it. I believe that markets should be free."

    So, in your view, regulating the financial system is akin to communism? Are you saying banks should not be regulated?

    ReplyDelete
  22. C'mon pablo9999, of course, there is a concept of "delayed" cash. Accounts receivable is another one.

    You seem to be struggling trying to be novel and liberal where there is nothing novel or liberal.

    I would not definitely be a part of market as proposed by C-E: I would put my money elsewhere (and so would I advise my clients).

    Yes, this kind of primitive regulations based on C-E system stinks heavily with communism from its ailing times of late Brezhnev.

    The key is:
    - the banks must not be too big to fail;
    - government must not bail out banks
    unless these two simple rules of a free market are adhered to proposals like C-E can only make things worse. And if they are C-E ideas are pointless.

    ReplyDelete