Sunday, 24 February 2013

The New Model Bank

In all my years of analysing systems there is one line you hear over and over again.

"That's how we've always done it"

The implication is always that there no possibility it could be done any other way. The assumptions are unchallengeable, the procedures unalterable and the reasoning unquestionable.

Then I come along and I question, challenge and where necessary alter things.

So let's do that with a bank - starting at the very beginning.

Banking is fundamentally a very simple spread operation. You charge more for your assets than you pay on your liabilities. Hence the old 3-6-3 line 'pay 3%, charge 6% and be on the golf course by 3pm'.

So we'll start with those principles for the initial model.

I'm going to build this model within the Sterling Monetary Framework - since that is the one that I'm familiar with and interested in. I want this model to be one that could run as an actual bank in the UK.

The Funding for Lending data page shows the lending size of regulated institutions in the UK. The newly formed Metro Bank is the smallest, holding £78m of lending. So operating at that sort of size it should therefore be possible to obtain regulatory authorisation, a Reserve Account and access to the Discount Window Facility at the Bank of England.

There is no Cash Ratio Deposit requirements for institutions under £500m of liabilities so the capital adequacy ratio is going to be, if I've read the Basel runes correctly, about 8-9%. So £100m of lending is going to require a minimum carrying equity of about £8m. (As a comparison Metro Bank has raised about £120m of equity to set up its operations).

Now as we know on the margins loans create deposits, but as the excellent JKH post shows within the current framework you still have to manage your liabilities mostly within the private sector.

However there is one point that post overlooks - which is that the liability always exists while the loan does. All that happens is that the person that the bank is liable to changes. An example will hopefully demonstrate what I mean.

So initially after you create the loan the balance sheet looks like:

Lending Bank Transactional Bank
Assets Liabilities Assets Liabilities
CB Reserves £0 Deposit £100

Loan £100
CB Reserves £0 Deposit £0

then the Lending Bank loan customer pays somebody at the Transactional Bank and you get:

Lending Bank Transactional Bank
Assets Liabilities Assets Liabilities

Deposit £0

Loan £100 CB Reserves £100 CB Reserves £100 Deposit £100


Then given that Transactional Bank gets just the bank rate of interest from the CB Reserves it will try and lend them out, and, importantly, the only taker will be Lending Bank (let's assume for simplicity this is the only loan in the clearing period we're analysing). So you then get.

Lending Bank Transactional Bank
Assets Liabilities Assets Liabilities
CB Reserves £0 Deposit £0 Inter Bank Reserves £100
Loan £100 Inter Bank Deposit £100 CB Reserves £0 Deposit £100

So the net result of the decision by the initial borrower to pay somebody at Transactional Bank is to force Transactional Bank to become the replacement depositor in Lending Bank. (That's 'force' in the sense of maximising income from the excess reserves).

That gives us the first cut of a new model for a Lending Bank - outsource the expense of managing retail deposits to Transactional Bank and just use the overnight market permanently to cover off the mortgage loans made. The interest rate hedge is that the loans made are simply charged at a percentage above the overnight rate.

Currently the best tracker on offer is priced at 1.88% above. Running that through the model with an average expected loss ratio (which is generally less than 0.5% of the outstanding book on these types of loans) seems to show a reasonable return on equity. The costs of running this loan model will be very low - particularly if you push the loan origination out via the brokers so that origination costs scale with turnover. You then get paid for your underwriting talent.

By creating the loan in an entity with a reserve account you pretty much force the system to loan you the matching deposit for as long as the loan exists. Therefore it doesn't seem to make any sense to pay a time premium for longer term money.

So would this work? Thoughts welcome.

25 comments:

Ramanan said...

"By creating the loan in an entity with a reserve account you pretty much force the system to loan you the matching deposit for as long as the loan exists. Therefore it doesn't seem to make any sense to pay a time premium for longer term money."

This is completely against the principles of banking.

Take the crisis scenario of the present. You are assuming that a bank that loses deposits will always find a lender bank with lots of CB reserves to lend it. It is not what has happened during the crisis. Just because a bank has more CB reserves won't lend it out because there is a credit risk associated with the lending.

I think implicit in your assumptions is that the banks with less reserves will *always always* be able to fund itself at the central bank otherwise.

Unfortunately it isn't so simple either. The bank losing reserves is limited by the amount of collateral it has and hence limited in how much it can borrow from the central bank.

It is true that central banks have relaxed collateral standards during the crisis but you can't take it to extreme.

More generally, a bank funding everything overnight is left with a huge risk of

i)paying higher interest on rolling over liabilities should interest rates rise and if credit risk rise.

ii)being unable to do so.

Even in the case where banks have liabilities to pay off at different maturities, they have run into problems. Simplifying it to say "fund everything overnight" makes no sense at all.

Tom Hickey said...

Ramanan, in the US the Fed is providing huge extra liquidity in terms of excess reserves and a very low FFR, and I get the impression that this is intentionally encouraging banks to fund overnight in order to increase the spread so that they can recapitalize. It would seem that under the circumstances the reason banks would be reluctant to take this opportunity being offered them would be due to regulator attitude. But the attitude seems to be encouraging rather than discouraging.

Ramanan said...

Tom,

Yes in crisis times central banks do provide liquidity.

In the US, the central bank has done away with most bank rescues and the excess reserves created in the banking system is the result of QE. These are not the result of heavy borrowing by banks from the Fed.

This has nothing to do with whether banks wish to fund short term or not.

But the idea of banks funding everything overnight is bizarre. If a bank is unable to borrow at the money market, it will require the central bank's discount window. However if it fails to provide collateral, it will have to pay fines and if this is repeated often, its license will be withdrawn.

A bank typically has less marketable assets which can be used as collateral or for sale for its liquidity purposes. So if all its liabilities have maturity of 1-day, it may face issues in borrowing large quantities if these funds leave the bank.

You cannot assume that it will find lenders at a large scale especially given the experience of this crisis.

Игры рынка said...

2 words: Northern Rock.

Ralph Musgrave said...

My reaction is similar to Ramanan’s, though I’d put it this way: Northern Rock tried the “rely on wholesale money markets” idea, and look what happened.

Wholesale money is attractive in that the rate paid for it may be less than what banks have to pay retail depositors. Plus for a bank, there is less administrative cost in borrowing a million than borrowing a thousand (per pound/dollar borrowed).

But retail depositors are very reluctant to switch banks. I.e. they are a captive source of funds for banks. Wholesale depositors a fickle.

Ralph Musgrave said...

Игры рынка beat me to it with the phrase "Northern Rock" by a few seconds. Rotter. I actually plonked by above comment on this site before noticing his comment.

Neil Wilson said...

Northern Rock was insolvent. This bank is not insolvent and is running a very sensible and rational lending policy.

It's important here to separate insolvent banks (who have burnt out their capital buffer by bad lending) from the standard issue of illiquidity.



Neil Wilson said...

"Wholesale depositors a fickle."

This is not wholesale depositors.

This is inter bank lending - from other entities with reserve accounts at the BoE.

The only other thing those entities can do with the money is deposit it with the central bank.

Nobody else will want it as a matter of construction.

stone said...

Neil, Northern Rock became insolvent not because its loans to customers were bad but because it ended up having to pay high interest to the Bank of England when it ended up relying on the discount window because interbank lending dried up in 2007. The Northern Rock intention was to make mortgages lending at say 5% and fund that with short term money wholesale funds at 3%. It ended up funding using the discount window at say 6% or whatever it was. The banks hated the Bank of England for having a punitive discount window interest rate BUT the Bagehot principle was that the discount window rate needs to be punative.

Игры рынка said...

How do you define solvency? What if assets are perfectly solvent but your nominal liabilities are much higher? What if nothing happened with your 30y mortgages but interest rates simply increased?

What you are proposing is no rocket science. But you are building a theoretical model for a absolutely rational world with no information uncertainty. Forget it. Noone will seriously discuss it. When a bank run starts noone cares about such niceties as temporal illiquidity.

It is one thing to invent everything neoliberal which has no connection to the real world and which gets completely ignored by any real world business. And it is completely another thing to blame real world for not understanding what they do. And they are plenty of people in the industry who do understand what they do. It is also important to challenge assumptions, and I personally do it every day, but it is also important not to overshoot.

Neil Wilson said...

Hi R,

Thanks for stopping by and commenting. Your thoughts are very much appreciated and your concerns are very real indeed.

However I am going to push back here. Not because what you say isn't reasonable, but to explore the edges a bit more.

"Just because a bank has more CB reserves won't lend it out because there is a credit risk associated with the lending. "

In which case the lender of last resort has to step in to deal with the temporary, and remember irrational, liquidity issue.

That is sort of the point of a lender of last resort.

This bank is not insolvent. It's lending is sound, its delinquency rate is solid and it has a good equity buffer. Let's say it makes those rates publicly accessible at all times.

So in reality if another bank - which can assess these risks much better than anybody else - won't lend otherwise useless assets to the bank on the shortest possible terms, why would anybody else?

If the inter bank lending system freezes up then the inter bank rate starts to drift upwards and away from the central bank policy rate - requiring that the central bank intervene to prevent a systemic collapse. They have no choice.

"The bank losing reserves is limited by the amount of collateral it has and hence limited in how much it can borrow from the central bank. "

If the central bank takes that approach then in an irrational illiquid scenario the central bank will lose control of its policy rate because all the reserves are on deposit at the central bank.

"Even in the case where banks have liabilities to pay off at different maturities, they have run into problems"

I would argue that is always the case unless the deposit and the loan are maturity matched. Where you have any mismatch whatsoever some deposits will be due to rollover before a loan disappears.

"This is completely against the principles of banking. "

I would argue it is entirely in keeping with the principles of banking - which currently is to maturity transform.

There's probably another post in this, but remember here that we're talking about borrowing otherwise useless reserves from the other 40 odd reserve account holders.

There is nothing else they can do with the money other than lend it to the central bank (ie leave it on deposit there).

"paying higher interest on rolling over liabilities should interest rates rise and if credit risk rise. "

Given that the loans are linked to this, this is simply passed through to the customers. The loans here are a spread on the overnight.

What is more interesting is whether the bank refusing to lend the reserves actually needs them for itself. Could that be covering up some loss on its own asset sheet.


Neil Wilson said...

"What if nothing happened with your 30y mortgages but interest rates simply increased?"

If you look above you'll notice that the loans issued are linked to the interest rate. So the interest rate risk is passed through.

If the rate on the liabilities goes up so does the charge on the assets. That's not unusual here in the UK where we have 'tracker' mortgages.

"How do you define solvency? "

The equity buffer hasn't been burnt off against bad loans.

" It is also important to challenge assumptions, and I personally do it every day, but it is also important not to overshoot."

It's very important to overshoot. The fact that it is annoying you is precisely what I'm trying to achieve. I want to shake the foundations and see what is there.

When you question a deeply held belief it always generates a certain amount of anger initially.

And I also get the line 'no one will take you seriously' a lot as well. That again is a symptom of hitting a core belief.

I'm not bothered about upsetting the Very Serious People. I'm interested in bashing the model around to see what will work.

The only silly question is the one left unasked.

So rather than saying it won't work, how about suggesting what the minimum change required would be to make it work?

Игры рынка said...

"So rather than saying it won't work, how about suggesting what the minimum change required would be to make it work?"

Sorry, Neil. I am doing ALM strategy in a reasonably big european bank. I know enough of stuff about loans creating deposits and banks still needing funding. I know pretty well how interbank market operates. But it is not about challenging assumptions here. Simply because interbank market exists for settlement purposes and not for funding purposes. You cannot come with a completely external idea of interbank funding into a framework which was not create for such purposes. If you do, you get Northern Rocks until it is over.

Lender of last resort cares about the whole market and not so much about individual banks. This is how todays system functions. If you follow Mosler's proposal about unlimited CB funding then it might work. But you also have to realize that interest rates on liabilities carry out an important non-bank economic function which you cannot just sweep aside.

Neil Wilson said...

Hi stone,

Thanks for taking the trouble to comment it is appreciated.

"The Northern Rock intention was to make mortgages lending at say 5% and fund that with short term money wholesale funds at 3%."

In which case their model is different from mine. Mine passes interest rate risk through to the borrowers.

Whatever the liabilities cost, the assets then cost that plus the margin.

So they track.

If necessary you could make the loans track the discount window rate. Would that be a rational adjustment to the model?

" BUT the Bagehot principle was that the discount window rate needs to be punative."

And time has probably showed that to be a very bad idea, since it makes a bad problem worse when there is a systemic issue.

If you want to bring the spread between the base rate and the inter bank rate down, the central bank has to lend in the middle area with less of a haircut.

Northern rock is one of those cases where there was a variety of causes to its destruction.. Whether it was the bad 'liar' loans that destroyed the bank, inappropriate action from a lender of last resort with flat feet or an overambitious model will no doubt be the subject of many a PhD.

Neil Wilson said...

Hi,

Thanks for coming back. I appreciate the input of somebody in the know here.

Forgive me if the questions appear naive. I'm trying to understand where the tension points are here in the model structure.

"Lender of last resort cares about the whole market and not so much about individual banks. "

Yes. But what I'm trying to get here is how much leverage an individual bank can harness by pushing at the systemic features of the settlement system.

And that fundamental feature is that if you create a loan, you create an amount of excess reserves that can only reasonably be lent back to you *or* deposited at the central bank.

What can you do with that structure to competitively reduce your cost of funding?

Is there a market for interbank settlement or is it done on point-to-point agreements between the reserve account holders?

Игры рынка said...

It is important to remember that interest rate risk exists. There is no way to hide it or eliminate it. Banks can outsource it to clients, which was a big trend in the recent past, or they can try to handle it internally. Obviously, banks are generally better equipped to handle it instead of individual borrowers. You can have a look at the working paper No 339 from BoE, among others, on this topic. You will see that already in their simple model default risk of borrowers is much more sensitive to interest rates than to credit factors like unemployment rate.

There is also a regulatory risk limit (Basel2) on interest rate risk. In reality banks go pretty long ways to arbitrage this limit and I think that regulators know about this but such are the rules of the game. Btw the whole interest rate risk framework was introduced after the S&L crisis in the USA. So it is, as some people say, the market reality.

To your question, there is no really any tension in the system as such. The system is indifferent but we, people/market, define the breaking points. When it breaks down is pretty much like defining when some bubble will burst. Your model is perfectly fine but it is just too theoretical and relies on too heavy assumptions about the real world.

While central banks care about the liquidity of the system, until recently they were generally agnostic with regards to individual bank practices. Basel 3 with its liquidity rules is going to change it. But it is still upto individual banks to define their liquidity risk and interest rate risk appetite with the given framework.

Competitive banking, as we have it and as JKH constantly emphasizes esp. with references to Mosler's proposals, has very important features. For once, we cannot just ignore the non-bank economy of which bank balance sheets are just a mirror. By declaring some part of bank balance sheets as irrelevant (e.g. structure of liabilities) we by definition declare the mirror part of non-bank balance sheets as irrelevant as well.

Finally I am personally very much against liquidity rules of Basel 3. I think they are utterly stupid with potentially very harsh and unintended consequences. But banks proved to be extremely lousy in managing their liquidity risk and there is probably no other way to force a new culture onto banks unless with a stick.

Ramanan said...

Neil,

I understand the lender of the last resort argument which is typically used to highlight the reverse causality.

However, you cannot take it to extreme.

The game will not run if all banks don't play the game. If a single bank tries to fund everything overnight in the money markets and use the central bank as a backstop, it will frequently need to use the discount window and will run out of collateral and a lot of fine will be imposed on it.

The risk is not just the whole money market freezing. The risk is the lending to one particular bank freezing.

Neil Wilson said...

"The game will not run if all banks don't play the game."

But will it run if you play a slightly different game?

What I'm looking at here is a system where the Lending Bank is separated from the Transactional Bank and they are linked via the clearing system.

The Transactional Bank is in the business of managing retail deposits, etc and making money from that, but lends via inter bank in big chunks.

Whereas the Lending Bank lends retail and covers via inter bank.

I'm looking to see if there is any outsource separation economies between the different functions - so you have Lending Banks sourcing from several Transactional Banks and vice versa.

The idea I have in my head is the usual 'get paid for underwriting' lending bank that you see in the MMT literature combined with the separation of lending and transaction management that you see in the Positive Money literature.

stone said...

Neil, the Mosler plan plan was to allow banks unlimited zero interest loans at the discount window BUT banks were ONLY allowed to make unsecured loans. So mortgages were not allowed. Your plan seems to be to allow unlimited discount window borrowing for secured loans. I think the Mosler plan only makes any kind of sense because of the unsecured loans only rule. Under your system credit fueled asset bubbles would go bonkers. House prices would get pushed up and up and up.

Игры рынка said...

Neil, your transaction bank will buy government bonds with surplus deposits. Same money - less risk.

Neil Wilson said...

That's not what I'm getting at stone.

I'm operating within the existing structure and seeing what elements from the other ideas can be brought to play within the current regulatory framework.

It's very much about not changing the system. It's about pushing the current system in slightly different directions to see what falls out.

Is there any benefit from separation, amalgamation, going shorter, going longer, etc.

Neil Wilson said...

"Neil, your transaction bank will buy government bonds with surplus deposits. Same money - less risk."

But they would then get the reserves straight back as the government spent the money and forced deposit creation.

Government doesn't keep a huge chunk of bank reserves in the Treasury account. It's only a float.

The existing excess float of reserves from QE shows that the banks can't get rid of all of them for government bonds.

Игры рынка said...

Neil, sure, but it is a central bank problem. The system is perfectly closed whatever way you look. Neither deposits nor reserves can leave it but one is exchangeable into another and central bank is there to ensure it. Plus to care about its interest rate policy.

Simon Reynolds said...

Hi Neil,

Great post, as usual. Thanks for promoting MMT ideas.

Not totally related, but can you help with the following?

I'm not an economist, but I'm trying to understand how macroeconomics really works. I try to follow discussions in the blogosphere on the causes and consequences of the global financial crisis.

As I understand them (I don't understand all of their ideas) economists like Randall Wray, Bill Mitchell, Scott Fullwiler, Cullen Roche and co seem to have much more coherent ideas about macroeconomics than any orthodox economist I've read.

I know that the job guarantee idea causes division, but I'm not knowledgable enough to understand the implications of the differences betweem MMT and Monetary Realism. Where do you stand on the MMT / Monetary Realism split? Is it that important when looking for an overview of the core ideas about how macroeconomies work?

Neil Wilson said...

MR just uses MMT and removes the Job Guarantee. They believe in an unemployment buffer and that fighting for jobs is important to keep you strong and healthy.

It's a bit like not having universal healthcare keeps you strong and healthy.

So I see it as a very classic United States Republican political viewpoint - to the right of Warren's more Democratic position.

Both of these are to the right of the standard UK political position.

I'm just a simple engineer. I fix problems in the messy old real world using whatever the simplest thing that will work is.

To me if there isn't enough work paying enough income to eliminate poverty then you create enough work paying enough income to eliminate poverty and take it from there.

I see no reason that people should fear for the future. It's just not British.