Monday, August 15, 2016

Central Bank Follies - QE, Negative Interest Rates and Regulatory Capital

This post is long.  It is a compilation of posts on each topic. I'll get to the bottom line up front.
  • Quantitative Easing (QE) keeps banks liquid, but does little else for the broad economy. If anything, it incentivises banks to buy government bonds (and soon to be high grade corporates) rather than focus on core lending activity.  
  • Sub-normal and now negative interest rates distort asset prices.  Investors are crowded out of low-risk assets and crowded in to higher risk assets, all the while reducing their reward / risk ratio.
  • Faced with compressed interest rate spreads banks resort to broad based fees. This is a regressive tax on people and businesses who can least afford it and have little or no alternative.
  • Continual rounds of QE and interest rate cuts undermine the economy by transmitting negativity and pessimism.  If people and businesses are continually afraid of the next looming financial crises they are more likely to reduce spending and reduce investment.
  • Increased drive on the part of central banks to raise banking capital adequacy ratios reduces the overall capital available for banks to lend encourages banks to lend to an increasingly narrow segment of businesses and consumers, ironically, those who need credit least.
  • Risk weighting capital toward collateralised and secured loans forces banks to focus on the credit backstop rather than credit fundamental. Any smart lender should put the ability and willingness of a borrower to pay ahead of the collateral the lender offers.  Collateral is merely a backstop and when projects fail, the collateral is often a poor backstop at best.
  • Reduction in risk taking by banks must be accompanied by support and encouragement for the emergence of alternative lenders - i.e. the P2P lending industry ( sorry if that's a self-interested view, but even if I weren't a P2P lender and if I didn't run a P2P lending fund I'd still feel the same....really!).
Now for the Meat and Potatoes

I'm not a macro economist by training, so take what I say here with a grain of salt.  Still, you don't have to be a rocket scientist to realise that something is wrong in Frankfurt, Washington, Tokyo and London.
They say the road to hell is paved with good intentions.  Central bankers in fact have good intentions.  They see themselves as the guardians of the stability and security of our financial system and in this respect they are not far from the truth.

Mark Carney, governor of the Bank of England, recently remarked that monetary policy has certain limitations.  Central banks can help economies cope with economic shocks that disrupt the financial system.  By adopting sound monetary policies Central Banks create the foundation that underpins money as a medium of exchange.

So why is it that central bankers around the world seem to be continuously inventing new tools and techniques to jump start the world's economies?  Is it possible that we've reached the point where the doctors are over-medicating the patient?

Is it not possible that in their rush to help central banks are now doing more harm than good?  Have we reached the point where monetary policy is producing absurd and perverse outcomes?

It's harder to be the player than the fan, but the more I look at the direction central bank policy around the world has taken, the more I fear the policy ship has gone dangerously off course.

The trends I find most worrying are zero and sub-zero interest rates, the constant effort to push liquidity into the financial markets and the obsession with bank capital requirements.  Let's take them one at a time.

The Obsession with Bank Capital

We are nearly a decade after the onset of the sub-prime mortgage sector that is commonly looked upon as the trigger for one of the world's greatest banking crises since the Great Depression of the 1930s.

Policy makers around the world had little choice but to bailout the banking system. The bailouts meant firstly that banks received infusions of fresh capital. Secondly the inherent riskiness of banking generally was subjected to intense scrutiny.  The conclusion of policy makers was that banks should be significantly deleveraged.  Third, the overall riskiness of bank lending came into question and the inescapable answer was that banks should redefine the way they look at risk so that going forward they make less risky loans.

Of course, with more capital and less leverage banks are much more resilient in the face of loan losses.  But at the same time the emphasis on reducing the perceived riskiness of bank lending actually undermines efforts to reignite global economic growth.

The relentless focus on bank capital has has changed the character of bank lending and in ways detrimental to the global economic recovery.  Risk weighted capital requirements set out by regulators force banks to emphasise relatively low interest rate secured loans in their product mix at the expense of higher interest rate unsecured loans.  Also what's changed is loan to value rates.  Regulations and capital requirements have reduced the amount of bank lending available on a project by project basis.

In principle there is nothing wrong with a lender preferring to make one type of loan over another.  But systematically, in their rush to improve the stated financial condition of the banking sector central banks have given banks incentives to turn a blind eye to credit worthy projects and left wide swatches of the economy underfunded and underleveraged. Ironically, the losers are companies that operate in some of the world's fastest growing and most profitable sectors. Let's look at some examples before we move on.

The software, retail, engineering and design sectors share one thing in common.  Mostly they are asset poor and hence collateral poor.  They require capital to fund inventory and labor for a period until they receive full value for the goods and services they sell.  The faster the sales growth, the more capital they need.  When sales turn down the cycle works in reverse.  They reduce inventory and labor purchases so working capital needs decline and for a period of time they become highly cash generative.  They may be strong companies, well run, highly cash generative.  Yet systematically their access to bank capital is constrained.  The result is that many companies are less profitable than they could be and many banks leave profitable lending opportunities on the table.

Many SME's fall into the same credit trap.  SME's are the back bone of the global economy.  SME's are owned by small groups of private shareholders, often families.  They live from their businesses, so they draw income, leaving little in the way of retained earnings.  We can see many examples of highly credit worthy, cash generating businesses whose access to bank lending is constrained only because bank lending models focus on balance sheet metrics rather than cash generation.  The result again is that many SME's are capital constrained and underfunded and banks leave profit opportunities on the table.

Ironically, many SME's fail not because they have bad businesses, but because they don't have the working capital to meet demands of growth nor the working capital to whether cyclical fluctuations.  But for access to more credit when they most need it, otherwise good businesses with good prospects are forced to shutter their doors.  Who suffers?  Their trade creditors, many of whom may depend on bank financing and their owners, many of whom are the retail mortgage customers banks so happily accept.

So when business turns down the so-called safe mortgage backed loans central bankers seem to relish turn unexpectedly bad. The banking sector can whether the storm, perhaps.  But the real economy, where real people put real bread on their tables each day, is far from secure.

I'll leave the topic of bank capital and and secured lending with one more thought.  Collateral and credit quality don't go hand in hand.  We can find many examples of asset rich companies whose cash flows dry up either because business turned down or the project just didn't work out.  When this happens banks are stuck with assets that are not working, not productive and worth not nearly as much as they would be otherwise.

The Myth of Quantitative Easing

The purpose of quantitative easing is to enable the financial sector to withstand the impact of economic downturn by ensuring banks have ample liquidity to service their creditors.  Let's not forget that banks are creditors far more than equity holders.  They live and die from their ability to borrow money.

Quantitative easing means the Central Banks put cheap money into the hands of banks.  In exchange they pledge or give securities to the Central Banks, depending on whether the Central Bank is buying the security outright or just lending money to the banks.

It's not practical for banks to transfer loans made to borrowers to the Central Bank, so banks instead give government bonds, and now corporate bonds to the Central Bank.  Really all that is happening is a transfer of the balance sheet from the banking sector to the Central Bank.

Banks might make more loans with all the cash they get from the Central Bank except for the fact the Central Bank demands banks have more capital and demands banks put constraints on the types of loans they make.  I've yet to see hard evidence that quantitative easing translates into real growth in bank lending.
Much of the benefit from quantitative easing in terms of liquidity to lend is offset by the loss of lending capital brought about by the relentless drive to shore up bank capital bases and shift risk weighted capital toward collateral based lending.

There's another distortion brought about by quantitative easing in the form of the impact on bank profitability.  Banks used to make money by borrowing from depositors and lending out to borrowers.  Banks made money obviously by making good loans first and foremost.  Second, when loans turned sour, banks protected their investment by actually helping their borrowers through a difficult time if that was what was called for.  Regulation around non-performing loans and the implication off non-performing loans on bank balance sheets has changed this dynamic.  Banks are far less willing and far less able to restructure loans, either proactively or reactively.

So how do banks make money now?  First, they make only the so-called safe, collateralised, low risk loans.  Interest spread compression drives a big hole through bank profitability, especially when banks are blessed with all the brick and mortar and legacy infrastructure.

Faced with the double whammy of interest spread compression and overall loan volume banks charge depositors and borrowers higher fixed fees.  Depositors bear an increasingly big fee burden for the fact they have no choice but to keep their money in the banking system.  They pay transaction fees, account fees, overdraft fees, and any other fee banks can dream up.  Inevitably the people that are burdened with those fees are the people who can least afford to pay those fees.  Bigger customers get fee discounts.  Bigger customers don't go overdrawn. Bigger customers transact larger amounts of money so fees are minimal in comparison to their transaction size.

The second way banks make money is by investing in assets they can readily sell to the Central Banks.  Many of the losses from the Greek debt crisis were avoided within the banking sector because the Central Bank and the European Investment Fund became the last resort buyer of all that Greek debt.  The ECB balance sheet is awash with Italian, Spanish, Portugese debt and French debt.  This is not because Italy, Spain, Portugal and France are bad countries, but rather because it just so happens their is more of their debt available for the ECB to buy than say Czech or Slovak or even German debt.

Without challenging their skills and knowledge as a central banker, is it not ironic the most recent ECB presidents were from Italy and France, two of the European countries with the highest amount of government debt outstanding relative to GDP?

Whether it's Washington, Tokyo, London or Frankfurt the story is the same.  The banking sector's profitability is inexctricably tied to its ability to buy government bonds and sell them or pledge them to the central bank.

We are coming to the end of this rope.  Interest rates on most government debt in Europe is near zero or sub-zero.  Think about that!  It cost an investor money to loan buy government debt.  The ECB is losing money every time it buys another Bund.  Who is on the other side of that transaction?  The man in the street?  The average ordinary citizen?  A hedge fund?

Look again.  The other side of that transaction is filled with banks that survived because they were too big to fail so the taxpayers bailed them out.  The other side of that transaction is filled with banks under marching orders to build or rebuild their equity bases.  The other side of that transaction is filled with banks that make more and more money charging fees rather than making as many loans to as many good borrowers as they can find, collateral or no collateral.

So where do we go next?  Many central banks are running out of government debt to buy.  So now they start with corporate debt.  Of course, the corporate debt they buy will be only investment grade rated, at least for now.  This is nothing short of a transfer of wealth from the high yield borrowers to the investment grade borrowers.  Again, another swath of the economy is left wanting while banks service an increasingly narrow segment of the economy.

What's really worrisome is that when economies turn down investment grade debt often becomes high yield or junk debt.  Corporates have gone bankrupt simply because rating changes collapsed their capital structures.  Enron was investment grade debt until....Lehman was A rated until...AIG was A rated until....And yet, central bankers around that world have brought us to the point where all this A rated paper will find its way to the central bank balance sheet and long before the wheels come off.

The inescapable conclusion here is that QE does far less for the economy than central bankers tell us it will do.  Furthermore, QE is fundamentally distorting risk and capital market pricing.

Negative Interest Rates - The Ultimate Perversion

We've reached the realm of absurdity.  Negative interest rates means savers get penalised and borrowers get paid.  Yet that is what is happening.  Bank fees are a form of negative interest rates  Banks charge their depositors for opening and maintaining bank accounts.  Who pays this tax?  The smallest savers of course!  The people who can least afford this cost.  Yet this is where the world has come to.

When I was growing up many many moons ago interest rates were double digits and banks faced regulations capping the interest rate they could pay for deposits.  Banks were tripping over themselves to get depositors.  Practically every month my parents got a toaster or a clock, a microwave oven or any other kind of appliance simply because they took a maturing certificate of deposit and moved it from one bank to another.  If you walked into a bank to open a deposit you were greeted as if you'd just gave life to the dead.
Today?  You open an account and the first thing you are presented with is all of the money you will pay to the bank who is borrowing your money so that it can buy government bonds that yield next to nothing and place them with the central bank.

The ECB was the first Central Bank to setup this distortion.  Tokyo followed suit.  London and Washington wonder if they are next and say they hope not.  Yet if things keep going the way they are going, we will see negative rates in the US and the UK.

The second distortion created by sub-normal and negative rates is the price of risk.  Faced with essentially a worthless risk-free asset class investors extend inevitably into more riskier instruments than they might otherwise.  As the hunt for yield feeds on itself yield curves compress.  Investors move further out into commodities and equities and the relationship between volatility, return and yield unravels.  Projects that might otherwise offer high returns that reflect their genuine risk offer returns that hide the true inherent riskiness.  This leads to sub-par investment returns in the medium term and is effectively a tax on the economy.

What of the equity markets?  They continue to hit all time highs.  But this too is an illusion at best.  Asset prices are driven by money supply.  In a world of quantitative easing and sub-normal central risk, money supply increases, forcing asset prices higher.  When interest rates start their inevitable march to higher level inflated asset prices will of course collapse.

The Conundrum of Low Inflation

Central banks point to low inflation and low GDP growth and say that as a consequence monetary policy will remain relatively loose.   The argument they put forth is that by lowering interest rates they will encourage businesses to borrow and generate savings for existing borrowers.

The benefit of interest saved, they argue, will be plowed back into the economy in the form of either further investment or consumption.

What central bankers seem to forget is that borrowing for business and consumer mortgage is more like a step function than a question of 0.25%.  The base rate can be zero or 1 or 2 or even 5 and so long as there are profitable projects, business will borrow.  Of course there comes a point where the marginal increase in borrowing rates results in a sharp fall-off in borrowing.  Call that the elasticity of demand for borrowing.
The second issue central bankers don't often recognise is the impact of their actions on consumer and business confidence in the economy.  We are trained to think that hikes in interest rates occur because the economy is strong and perhaps at risk of overheating, and declines in interest rates occur because the economy is getting worse.

The paradox is that the more central bankers lower rates, the more they transmit pessimism and distorted asset prices into the economy. Central bankers - if you are listening - here is the message:
  • Business want to borrow and often pay in excess of 10% even when base rates are zero!
  • The lower rates go, the more pessimism there is in the economy, the more frightened business become, the more risk averse banks become.
  • Low interest rates compress bank earnings and force them to charge higher fees, which is a regressive tax on consumers and businesses.
  • The small extra savings consumers and businesses make when rates go down doesn't get pumped back into spending and investment, especially when the savings occur amid bearish economy outlook and the negative signal of a rate cut.
  • The appetite of consumers and businesses to spend and invest at any given moment or any given short interval in time is finite. It is, in fact, a step function driven by the lifespan of the acquired asset and purchasing power. The interest cost, if any, attached to the purchase is marginal.
The Take Aways

Years from now economists will look back and marvel at the tendency of central bankers to over-medicate in the wake of the financial crises that began in 2008.  In fact, they will blame central bank policy for delaying the recovery.  Why?
  • The obsession with bank capital requirements has reduced the overall level of capital available for lending.
  • The obsession with bank capital requirements and the concept of risk weighting loans skews bank lending to a narrow segment of businesses and consumers.
  • The window of opportunity is to expand capital availability by encouraging the development of alternative P2P lenders.  Governments around the world should be doing everything they can to encourage and foster the development of P2P lending as an asset class.  Britain does this successfully, and this is one reason why the British economy was doing relatively well prior to the idiocy of Brexit.
  • Quantitative easing furthers distortions in asset prices.  Natural investor for safe, long term, fixed rate assets are crowded out of safe assets and crowded into risky assets by  the ever expanding balance sheet of the central bank.  When that bubble burst, the results will be ugly.
  • Quantitative easing It doesn't necessarily increase the appetite of banks to lend.  In fact, it gives the banks overweighted incentive to invest in only those assets they can sell or pledge to the central bank.
  • Interest rate cuts have only marginal impact on real economic activity.  In fact, each successive encourages businesses and consumers to delay purchase decisions, either out of fear that things will get or worse or out of the expectation that interest rates will fall further.
  • Interest rate cuts encourage lenders to look for floating rate rather than fixed rate loans.  The lack of supply of long term fixed rate loans means when interest rates begin to rise wealth is transferred from borrower to lender or in the case of banks - from borrower to equity holder of a large borrower.
  • If central banks want to encourage economic growth then they need to lead a return to normalcy with a signal of confidence.  They need to start raising interest rates.  This will start a virtuous cycle of increasing bank profitability  and give savers more incentive and more confidence to invest.
  • An environment of rising rates will encourage businesses to invest.  First they will be encouraged by the optimism and confidence of the central bank.  Second, amid expectations that rates will continue rising they will want to capture the benefit of low interest rates.  Finally, rising interest rates will feed into rising output prices, which will in turn generate increased profitability and therefore higher government tax revenues.  Rising output prices and risking profitability will encourage hiring and raise labor prices, which obviously will help consumers.
  • Rising interest rates will reduce the banks' incentive to rely on fee income and therefore remove essentially a regressive tax.
Bottom line:  For years central banks have been over-medicating.  Improved bank capital adequacy must be accompanied by the robust development of alternative lending solutions that are not constrained by need for collateral but focus instead on fundamental credit worthiness - willingness and ability to pay.  The trend toward lower interest rates clearly is unsustainable. Quantitative easing is creating asset bubbles and further exacerbating distortion of bank incentive to make real loans rather than buy securities. The longer this goes on, the harder it will be for all of us.
Michael Sonenshine is CEO of Symfonie Capital.  He runs the Symfonie Angel Fund,  the Symfonie P2P Lending Fund and the SymCredit P2P lending platform.  For more info contact

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