Banks Look Safer with Deposits
bloomberg.com
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In order to offload the risk of these loans, the original lender is packaging them up together. Then they can sell ownership of the consolidated loans to other financial institutions. The original lender is only required to retain around 10% of the consolidated loans.
Needless to say, the institution originating the loan ends up disconnected from the risk once it is sold to other financial institutions. At least they're insured, right?
In many cases, isn't this already the case with the largest consumer loans (mortgages)? If the buyer understands the risks of the consolidated loans, what's the beef? If the bank is hiding the risks, that's another issue - I agree.
I think the point is that this creates a lot of incentive for the bank to hide the risks that they wouldn't otherwise have. Perhaps more importantly, it doesn't incentive them to prioritize things that might help them measure the risk better, so those sorts of improvements never get made and it just deteriorates over time.
From a buyer's perspective, they receive the due diligence that the originator provided. There are various risk models put in place with that information, but they are also "insured".
These are the same fundamentals that led to the 2008 crisis. Giving loans to people who weren't actually qualified. Miscalculating the risk, intentionally or not. Buyers ok with the risk, assuming the insurance would come through in the worst case.
If there is an event, or a series of events, that cause these loan takes to become insolvent, say losing jobs with no hope of getting a new one (truck drivers being replaced with self-driving trucks?), that would cause large amount of loan defaults...
That part may be the only redeemable part of this process.
Because, hey...let's package these into collateral debt obligations, and then hey...let's engineer these CDOs with tranches of various credit quality as rated by rating organizations not understanding what they are rating and afraid of asking for more information because their profit is based on volume of these ratings and not quality, and hey...let's create a second CDO based on the lowest rated tranche of the first CDO, and boom, that low credit score is magically now a AAA, and why not create tranches of this second CDO too. Then, let's create a market out of this with a way to short the CDOs, and let's call this new instrument something ridiculous as Credit Default Swap. No one is ever going to need those, because everybody in the financial industry believes the underlying assumptions that 1) the real-estate prices will forever go up, 2) and there is no chance that more than 4% of sub-prime mortgages are going to default. Seeing that this makes a lot of sense, let's make a trillion dollars worth of these and we don't have to put them on the balance sheet because they are AAA rated, safe as the US Treasury bonds, and so why not get leveraged 40 to 1 on these. Oh wait, that's already been tried.
Banks do not lend their deposits. (That's what a fund does.) Banks create deposit money when they make a loan, and statistically multiplex asset cash against deposits to manage transfers of money within the banking system. Repayment of loans then removes the created deposit money from the system.
Meanwhile, you can lever your "low risk" loan income 10x so that 1-3% marginal yield looks like 10-30% profit. Hard to give up that crack pipe!
Reserves don't actually play a roll in loss management, bad loans have to be written off against loss provisions and/or profits - liability/equity accounts. Basel 3 has put mandatory limits on how much loss provisions/capital has to be held, but it hasn't solved the fundamental problem with the interaction with the money supply.
Discussion of the issue is often fraught with accusations of conspiracy theory. Austrian economists (widely regarded as kooky by the establishment) have a bunch of books related to these issues perhaps the best of which is Rothbard.
_0 https://mises.org/library/mystery-banking _1 http://www.bundesbank.de/download/bildung/geld_sec2/geld2_ge... _2 http://www.bankofengland.co.uk/publications/Documents/quarte... _3 https://www.youtube.com/watch?v=CvRAqR2pAgw
Our banking system is founded on a lie.
I suggest a valid alternative is the truth. If someone gives you their money and it's your job to store it safely you should to that. For 100% of that money. Not 10% of it.
As for the 100% retention idea it is like complaining that a car isn't a faster horse. There may be some fringe cases when the horse is better but most of the time the primary use was going fast across paved roads.
To be a good steward involves investment - just any asset sitting stored is a waste of value and will not even preserve it against inflation. It is the red queen's race.
My money is not the bank's asset. Neither is the stuff I put in a storage unit at public storage.
Imagine if they were loaning out your stuff while you were away.
If I choose to invest my money that's my right. It's not your right to choose how I invest my money.
Going faster isn't a reason why it should be OK to steal people's money when you're saying you're keeping it safe.
Lies like this brought down the entire world economy. Wars were started. Lives were lost. But you suggest it's better except when it's not?
I don't agree.
Austrians say they use praxeology. They approach economic problems through deduction. This should make some of their theories falsifiable. After all, if you can't find evidence for the notion of opportunity cost, then it can't be a valid concept.
I think that the problem with Austrian economics is that relying on praxeology and deduction is like doing theoretical physics - you make assumptions, do logic based on those assumptions and see if it fits the real world. It can work, but it's slow.
A theory involving math is only better than the alternative if it is also correct. Theories can be falsifiable if they don't have math either.
For example, I might have a theory that water always flows downhill. Then I am confronted with a pump, and my theory is now falsified. Fitting a mathematical model involving gravitational constants and laminar flows will be a better theory because it fits the observations very well.
A theory that I have porridge for breakfast in a way that can be modeled with an iid normal distribution is a terrible theory, because if I find out about it I'll start playing with my breakfast just to spite the modeler. The inclusion of a precise mathematical model just paints a bigger target for me to hit. Economics is much more in that vein of things - the people being modeled can respond to the models themselves.
The mainstream economics theories are all going to be based on non-mathematical assumptions that link reality to a math-y model. Those assumptions are the weak point of economics. We can trust the academics to get the math right once they've finished making assumptions.
Again, it is easy and often valid to criticize the methodologies associated with mainstream econ, but the question is whether one can offer a demonstrably superior alternative. You have not done that here.
That isn't the only question. There is also a question "is there something here that we can model?". There is no requirement to provide a better model if the existing model is inaccurate enough.
I've never actually seen an economic model that uses maths beyond accounting balances or basic calculus/timeseries so I'm certainly not qualified to critique them - whatever they are.
But the Austrain critiques seem to be something like that if you blow a credit bubble then manipulating accounting identities isn't enough to avoid having to pay back the credit at some point and taking an economic fall where the credit gave you a boost. That is a falsifiable position. The Americans and others are running a big experiment that has so far provided potentially falsifying evidence. They can still be proven wrong even though they havn't published an equation, so their theories are obviously falsifiable.
We disagree here. I think this notion is what allows people to arbitrarily dismiss theories that they personally don't like.
As the other commenter mentioned: they lend out more money than the depositors gave them. It works roughly along these lines: depositors give the bank $10 million. The bank can now make loans worth $100 million (or some such number depending on the type of debt). They're creating money "out of thin air".
Neffy probably knows more about how it actually works, but what I described is the basic principle of fractional reserve banking.
The 'fractional reserve banking' model is just wrong. (That there are no real reserve requirements in places like Canada or the UK, should really tell people this).
In reality it works like this. Loans create deposits. So you lend $10 million and end up with $10 million of loans and $10 million of deposits. The regulator then says you have insufficient capital, so you issue equity or bonds to the tune of $1 million and convince 10% of your depositors to swap their deposits (that you created) for that equity/bond by setting an appropriate interest rate on it.
Rinse and repeat until you run out of people to lend to at a price they are prepared to pay.
Neither deposits, nor equity have a quantity control function. It's all about the price, not the quantity.
In other words the amount of money in the system floats at the current price of money.
That is factually wrong. You have significant capital requirement both in term of RWA or Leverage Exposure (the latter is more likely to be binding for mortgages), particularly in the UK which along with Switzerland gold pleated every international (BIS, EU) regulations.
Banks cannot extend their balance sheet indefinitely, and if you look at UK banks, they significantly deleveraged since the financial crisis, as they adapted to new regulations.
In fact these capital requirements, along with increased liquidity requirement are probably why the multiplier effect considerably reduced after the crisis.
Same with liquidity which is just increased amounts of loans to the central bank (government) in the form of government bonds. Collateral uplift can give you that.
All these just add to the cost of the bank, which changes the price and that reduces the number of people taking the loans. But the fact remains that the quantity floats at the current price of money. Liquidity and capital requirements just change the current price of money.
I think this is an oversimplification to the point where it is misleading.
Banks can't literally create money like this. What happens is that if a bank has $10m in deposits, they have $10m to loan out, but not more. In practice, they are limited by how much they can loan out by the fractional reserve. If that limit is 10%, then this bank can loan out $9m, so there is now $19m in existence.
If you follow this out to the limit, you get $100m with $10m of initial deposits and a fractional reserve of 10%, but a bank can't just multiply its money by 100%/10% and loan out that much money.
So let's say a bank has $10m deposits. You're right: they will lend out $10 million, most of that in mortgages, a bit in business loans, a tiny bit in personal loans. Mortgages come with the condition that you don't get the money, you get to write a checque (or do a bank transfer), verified by an official like a notary public. Now you might notice ... so wait ... they lend you money that you can only deposit into another bank account (and then very likely stays in that bank account) ?
So that means they can pull this: $10 million in deposits. They lend out $10 million, $9.5 ends up into accounts in that same bank and become deposits. So now they have $9.5 million in new deposits and $10 million in assets (money people owe them). Plus an additional $1 million in interests. Because there's only 5 banks where money can be kept, they're pretty much guaranteed, once above a certain size, to keep or exchange 1:1 deposits created from loans in their bank.
So now they lend out the new deposits ... and of course also the assets. So now they lend out a further $21.5 million. Next step is a further ~$40 million. In most of the world laws specify that they can only multiply ~50 times this way (Australia being a very notable exception).
So with $10 million in source deposits a bank would lend out a little less than half a billion $.
Obviously in practice it's 100 times more complex than described above. For example, banks will usually sell a good part of those assets, like loans, and then take that as a profit, and pay it out to shareholders. This changes their risk profile in positive ways. There's business loans which mostly (the larger amounts at least) work like mortgages but not entirely. There's international transactions, ...
The thing to remember is: large amounts of money simply don't "really exist". Starting at maybe $100 million it is simply not possible to "have" that amount of money. Something else is happening, some financial construction is involved.
What OP copypastaed is word-for-word from a monologue in the movie.
Maybe another movie?
Until they start hedging their exposure in some more or less creative way.
I'm just an armchair analyst, but I'd love to know what the people buying these loan packages know. Because it doesn't seem low risk to me.
And their incentive is the same as an audit company, it is an existential threat.
Sharp suites and clever talk only won't impress anyone anymore.
The business model is the same; big failures are still common (e.g. the recent case of Oi SA); the same Big Three still control the market; "no meaningful reform of the credit-rating agencies has been undertaken" (Paul Volcker).
> And their incentive is the same as an audit company, it is an existential threat.
What existential threat? Which relevant (and this mostly means the Big Three, which "issued 97%–98% of all credit ratings in the United States and roughly 95% worldwide") rating agency has went bankrupt or even faced a major threat to its dominance?
Someone's buying it, so the banks are making the sausage again. Such is life.
There is a lot of overall sense in having retailers focus on retailing, and leave the high finance stuff to underwriters, like insurance.
The problems is that the laissez faire market dynamics degenerate at this point, Retailers get too good at retailing, selling people bad deals that could land them in trouble later. Underwriters focus on securitization, which is ultimately a sister to the money-creation process (like "fractional reserve" banking).
Pretty much any solution is clunky. You can try to force "originators" to hold risk, but this limits scale. You can regulate underwriting rules (affordability & doc checking standards, for instance). You can regulate underwriting, but the high finance sector is (a) good at influencing regulators and (b) good at finding ways around regulations.
|regulating for risk is a tricky business. You end up trying to regulate away risk, which is impossible.
Regulators need a way to run some sort of "bug bounty" program for loopholes. If the government could crowdsource their limited resources in the right direction maybe they wouldn't be perpetually 5+ years behind.
Because of depositor insurance and pension fund insurance, risks are not treated as real risks. People know their lack of consideration of risk will be bailed out.
Make two kinds of banks. One very simple and safe with no incentives for risk taking. Another that is unregulated and you are risking your money. Those who don't want to deal with risk can put their money in the former and earn a safe return.
And that could be achieved by limiting a bank to writing mortgages, only loaning the first 60% of the 5-year moving average of a house's price. Require 20% down and let higher risk lender's lend the rest. Such a bank should also get paid back first.
This safe bank would not resell its mortgages and managers would never earn bonuses for a higher rate of return. Don't even offer checking accounts, just savings accounts. Don't have branches.
Keep the books completely open to the depositors 24/7.
Would you bother with your seat belt if the doctor would completely heal you, regardless of the cost, without any direct cost to you?
Of course, the reality is we do have to pay for every bailout. As taxpayers.
Or, rather, some day our children will.
Unless, of course, where you put your money is on you. Then there'd be real interest in banking with low risk.
Human intelligence is distributed and responsibility should be as well. Concentrate the power and people take advantage and then weasel out of responsibility, leaving others to suffer the consequences.
The well connected get their risks socialized, because they are "too big to fail". The same story is repeated over and over again.
People who take the risks should get both the losses and the benefits. It's called "skin in the game".
i'm not sure about this plan, i'll just say i prefer credit unions myself.
Of course I would.
In other words, people do indeed take greater risk with their money if the interest rate is higher. And expect to earn less if the investment is very safe.
The only long period of sustained banking stability was the period with the strongest regulatory system.
I just prefer to give people of choice of what kind of institution they want to trust. And bail out none of them, a regulation of what government is allowed to do.
The job of the banks is to lend capital to firms and households for the capital development of the economy. So you just make any loan or activity outside that remit unenforceable for regulated banks.
Banking should be boring, particularly if there is an expectation the taxpayer is on the hook in extremis.
A. Bond market liquidity, especially in places where negative interest rates have been adopted [1][2].
B. In times of crisis, bail-ins can still happen [3].
These two issues go hand-in-hand and will probably cause a lot of trouble in the financial system going forward.
[1] https://www.armstrongeconomics.com/world-news/central-banks/...
[2] https://www.armstrongeconomics.com/products_services/socrate...
bail-in's don't burden public coffers and would target disdain at the 1 company that was overlevered, instead of politicians
are you referring to the safety of your deposits? because that is different than causing trouble for the financial system
People saved to buy an apartment towards the end of the Soviet Union. When the Soviet Union collapsed they could barely afford a car for the saved money.
in 2008-2010 the FDIC got on the phone and brokered sales of smaller banks to large banks, specifically because they needed to do their part to stave off disaster with their thin credit line. Congress didn't ask them to do this, they just got on the phone because they had live capitalization ratio data.
so it isn't clear that there is really any near term issue that money injectors can't manage, AT LEAST FROM the things you mentioned. I could think of other things but I'll leave you to come up with the succinct argument
EDIT: The key distinction I'm trying to make is the difference between solvency (debt repayment ability) and liquidity (in a market, the bid-ask spread or whether you can actually transact).
Why do you think there is a problem when the ECB can hold bonds till maturity? Central banks have an infinite time horizon, they are upgraded sovereign wealth funds. The issuers themselves can just rollover and create new bonds when their old bonds are reaching maturity, if they haven't paid them all off yet. This is commonplace. If they fail at having enough revenue or getting investor appetite for a new issuance then they default.
There are criticisms possible about central bank behavior, but as far as stability to the financial system what problem do you think there is? Central banks haven't been in the habit of actually unwinding their portfolios into an illiquid market, and their large bond holdings can just be repaid by the issuer.
My understanding is that there are few or no private bids for bonds at current interest levels. As you probably know the ECB recently announced an end to QE. Rolling over debt at an interest rate set by the private market is not sustainable. So, the ECB is somewhat trapped. They either renew QE or expose themselves to very high servicing costs set by private buyers.
Hopefully that's clear as mud? Maybe I m missing something.
The issuers roll over debt at their own discretion. The ECB only has the risk of some issuers defaulting before those issuers pay the ECB back in whole, and to offset that risk the ECB limited the universe of eligible assets to as low as a BBB rating. I think it is merely embarrassing for an institution that uses public money to experience defaults, but it is accountable to no one and it creates that public money. It is more like a human-productivity futures contract.
And yes, if the ECB really feels at risk then it can lower the target interest rate deeper negative, and issuers will issue new debt at even more attractive rates since the money is free. Yes, this is your renew QE scenario.
The ECB is not trapped, the private wealth is.
Sure, it is a monetary policy twilight zone, but I think the market tolerance and financial market outcome is not as dire as is often reported. The worries are hyperinflation, but this is a currency term that would be called dilution in other asset classes. Managed dilution of a currency-share is what they are doing. The other worry is balance sheet unwinding, but central banks don't need to do that and can completely distort the market so that their position is profitable anyway (further dilution lowering interest rates so that the issuer can rollover debt instead of defaulting). The last worry is market intolerance to that currency's monetary policy, but the whole world is doing this right now there is nowhere for private money to go except crypto and art.
https://www.frbservices.org/resources/central-bank/faq/exces...
For: https://www.nbcnews.com/business/business-news/more-7-millio...
Against: https://www.bloomberg.com/opinion/articles/2019-02-20/subpri...
The thing about the housing crisis was that it dropped asset prices and really pinched consumers. Failures in other areas like auto loans will likely pinch holders of the CDOs but only make it slightly harder to get a car loan. The transaction amounts are relatively low compared to housing.
That said - corporate debt is in the trillions and if your favorite Fortune 500 goes belly up a bunch of jobs go with it. Not to mention the overall equity losses to those holding index funds.
That said... my long term bearishness has not really been super well paid off haha. My hypotheses ain’t worth the bits they’re stored on.
Also, people don't go buying more cars for speculative investment.
Don't allow reselling mortgages and managers never earn bonuses for a higher rate of return. Don't even offer checking accounts, just savings accounts. Don't have branches.
Would we even need deposit insurance for such a bank?
PS: Banning companies from raising cash by selling off assets makes them LESS safe and robust to failure, not more. Do I really need to spell out why?
> if it ONLY wrote mortgages
> Don't allow reselling mortgages
If a bank only write mortgages and can't sell them what else do you expect them to sell? The office chairs?
My purpose there was to keep government or off budget government entity or corporation from buying any mortgages.
I have no problem with selling an asset, as long as government is not subsidizing bad practices by assigning an unrealistic value to something that is fraught with risk.
Selling a mortgage to private investors is not a problem.
If you did make the interest rate attractive enough to get folks whose job is shopping for the best interest rate, you’re in for serious bad news any time the bank falls behind competitively risked interest rates. It will see massive outflow of deposits, be unable to pay them, and have to liquidate its mortgages, potentially at a severe discount (they’re illiquid by nature, right, and may have declined in fundamental value due to e.g. interest rate changes in the interim).
Now your bank is failing and, as soon as you do the responsible think and report insolvency or inability to satisfy withdraws, instant bank run.
When a bank fails, the owners would lose their investment. But the assets of the bank, its loans, could be put into a public corporation and shares distributed to the depositors in proportion to their deposit.
Then depositors could sell and get 80 cents on the dollar or whatever. Or the depositors can wait awhile and sell when the markets recover. They might even make more than the interest they were promised.
Such mortgages are fundamentally sound, so for most people the sensible thing is to wait. They can also sell some and keep most to get through their own short term cash flow needs.
Of course, this is not a product for today's environment, as all depositors face zero risk of losing their principal.
People pay more for safer cars. Why wouldn't they give up some interest for a safer account?
the nature of consumer banking is that the nitty-gritty grindy bits of real finance - overnight and term repos, daily settlements, credit risk and value adjustments - are abstracted away (for a fee) from the typical user who doesn't really want to care about these things, even if it will do them a lot of good to at least consider these effects.
Complexity makes systems brittle and exploitable. Also, most of the complexity adds no value. For example, do we still need debt? Wouldn't it be better for a company to just create and sell shares if they wanted to raise funding?
In a healthy economic environment, loaning money doesn't make any sense. When you make a loan, you limit your upside potential but you're still exposed to the full downside risk (e.g. if the debtor goes bankrupt). The only real use case for debt is to create speculative bubbles... You manipulate markets to inflate asset prices so that people need to borrow more money so that the interest payment on the loan taken for that asset is more profitable than any real investment return that the asset could have generated organically.
>> a business might not want to hand over ownership
In terms of not wanting to hand over control; a business could achieve this by issuing non-voting shares. In terms of actual ownership, I don't think it makes sense for an economic entity to give or loan money to a venture unless they understand or at least believe in the venture - Ownership is the best way to demonstrate that belief.
Debt may be a way to commoditize the funding process but this doesn't make sense begin with - Money loaned by bankers on the basis of broad statistical probabilities cannot outperform money invested by investors on the basis of deep understanding of the market and business domain.
If the economy ran more on debt, we'd end up with fewer well informed investors and more poorly informed bankers. The economy would be much less efficient.
Given how healthy the economy is right now, and how low interest rates are right now, the market clearly disagrees
The economy that we have today is the result of a decade of artificial manipulation by government entities - There is little real value behind the growth. All the numbers look bigger but they're more brittle than ever.
Your last paragraph, though, is completely at odds with basic financial and economic theory. Loans make mathematical sense because you don't make just one of them; you aggregate capital and take calculated risks on a broad variety of prospects. Many of them are low-risk (e.g. loans backed by substantial assets), others are high-risk, and you adjust the interest charged so that to take on high-risk investments you must be compensated with high interest rates. Maybe you take the full downside on one or two investments (e.g. you invest in two outright frauds), but if you have fifty other loans that offset those losses by paying high rates of interest, then you still make a profit.
Also to your point in the second paragraph: equity is a bad tradeoff in many cases. If I'm starting a business that I expect to be hugely profitable, but I need $100,000 in startup costs, would I rather give up a big chunk of my company and pay out dividends for decades (or in perpetuity), or borrow the money and pay it back with a comparably small amount of interest quickly?