We live in a old men's economy. "the old model rewards banks for encouraging investment — for the purpose of avoiding scarcity of goods in the future — by extending credit today."
But in old men's economy. "in order to make profits under a negative carry regime, banks (and other institutions) have to pull investment funding, encourage disinvestment, hoard money rather than lend it, and try to induce an artificial scarcity of goods in the future."
The negative carry universe
Posted by Izabella Kaminska on Jul 04 16:16.
This is a follow-up to our post on “ base money confusion“, which incorporates some of the ideas we’ve raised in our “ beyond scarcity” series.
Let’s assume a few truths (we’re sure they’ll be up for debate, but here goes anyway):
- Only the central bank can control the amount of base money (inclusive of excess reserves).
- Base money is what’s left over after all assets and liabilities cancel out. It is, in other words, the system’s tangible equity. Or the equity of the system.
- Base money, however, does not constrain banks’ ability to create credit.
- Central banks are mandated to support banks which are illiquid but not insolvent.
- If a bank’s short term liabilities outnumber its short-term liquid assets, it is possible but not definite that a bank is insolvent.
- A bank’s tangible common equity determines its solvency.
- If a bank’s tangible equity appears temporarily eroded because of an inability to liquidate longer-term assets quickly enough, it can borrow from the central bank to bridge that gap.
- When a central bank creates base money to help bridge that gap, it effectively dilutes base money (tangible equity) outstanding. This is why such measures are only supposed to be temporary.
- If the bank cannot recapitalise itself with the help of central bank “liquidity” it should theoretically be deemed insolvent, since supplying more base money would only dilute the system’s base money further; providing advantage to one bank over the others.
This is where we are now.
The only difference is that it wasn’t just one bank that needed liquidity. It was pretty much all banks uniformly.
When there is a uniform liquidity crunch it results in higher interbank rates (cue Liebor madness), since banks compete with each other ever more aggressively for funding.
In 2008 banks started competing with each other exactly in this way. The reason for this was because some of their longer term assets had suffered an impairment shock, which had frozen up the markets for these assets. Even if many of the assets were not intrinsically worthless, they could no longer be liquidated without compromising tangible common equity, nor could they be pledged as collateral for short-term liquidity.
Tangible common equity is determined by what’s left over after you deduct liabilities (such as deposits) against a bank’s assets (such as loans). As assets become impaired or sold below value, tangible equity is increasingly threatened (since liabilities remain the same).
To suppress rates from blowing out and turning a liquidity crisis into a solvency crisis the authorities stepped in an unprecedented fashion.
The hope was that this was a system-wide liquidity crisis not a system-wide insolvency crisis. Provided the central bank could tide banks over with liquidity in the short-term — by providing a reasonable bid for assets which nobody else wanted or was prepared to fund against — banks could smooth out losses over a number of quarters, rather than take them all at once, then reset into a profitable lending pattern which would eventually bolster tangible equity again. In banking more time to smooth out losses equals a better chance to avoid insolvency.
Unprecedented central bank intervention
From a base money point of view, an extended period of assistance was justified because the system had been hit pretty much uniformly. So even if the system’s tangible base money equity was diluted as a result of the central bank’s balance sheet expansion, it benefited all banks pretty much equally.
Unfortunately it soon transpired that liquidity was not enough to bridge the short-term funding gap. Banks also needed to be recapitalised in order to stay solvent.
Again, this was justified because it was hoped that upon recapitalisation and with liquidity support banks could soon reset and become profitable again, being able to support themselves.
Yet, this failed to happen.
More QE was attempted on the belief that the system still needed more liquidity.
Yet this too failed to help. If anything the dilution of the system’s base tangible equity crowded out the remaining safe collateral markets utilized by the shadow banking industry, which had no recourse to positive interest at the central bank, something which threatened to turn rates negative. In other words, base money dilution was in excess of what was needed to cover the system’s short-term liabilities. QE2 supported banks, but only at the cost of shadow banks and other investment agencies (such as GSEs) which were not protected from negative interest rates in the same way banks were.
This is ultimately because base money creation came at the cost of making previously liquid Treasury markets less liquid, at the same time as making them more scarce. With too much liquidity (rather than too little) investors began to compete with each other for safe stores of value at the cost of principal and thus tangible equity once again. Banks which had recourse to interest bearing deposit facilities at the central bank, meanwhile, were incentivised to take the wrong sorts of risks — risks which had little to do with lending — in a bid to up interest returns.
It was thus decided that the system didn’t need more liquidity, what it needed was more time for banks to become profitable. Hence operation twist was dispatched to flip the curve back into positive carry mode for banks.
And this is where we truly are now.
The battle is no longer about liquidity but about preventing the negative carry universe from impairing bank profitability forever. Indeed, unless a positive carry is re-established banks will never be able to support themselves, for they will never be able to make money according to the old model.
That’s because the old model rewards banks for encouraging investment — for the purpose of avoiding scarcity of goods in the future — by extending credit today. It rewards them for taking a risk on investments that might fail to overcome scarcity in the future. It does not, however, reward them for taking the opposite risk: that investments may lead to the production of too many goods.
This is why negative net interest income is now the primary problem of the system.
It’s a phenomenon we’ve called time depreciation of money. Bill Gross has referred to it as the “paranormal” banking model. Peter Stella, meanwhile, has written about the model’s primary symptom: the negative money multiplier effect.
Indeed, in order to make profits under a negative carry regime, banks (and other institutions) have to pull investment funding, encourage disinvestment, hoard money rather than lend it, and try to induce an artificial scarcity of goods in the future.
All of which, at best, transforms the banking industry into a global pariah and, at worst, make it completely irrelevant for the modern age.
Negative rates, of course, could just make the problem worse.
No wonder central banks are doing everything they can to maintain a positive carry. |
