Monthly Archives: September 2016

Bank resolution in the Banking Union

First, here is a piece of text from the preamble (67) of the Bank Recovery and Resolution Directive (BRRD):

“An effective resolution regime should minimise the costs of the resolution of a failing institution borne by the taxpayers. It should ensure that systemic institutions can be resolved without jeopardising financial stability. The bail-in tool achieves that objective by ensuring that shareholders and creditors of the failing institution suffer appropriate losses and bear an appropriate part of the costs arising from the failure of the institution. The bail-in tool will therefore give shareholders and creditors of institutions a stronger incentive to monitor the health of an institution during normal circumstances and meets the Financial Stability Board recommendation that statutory debt-write down and conversion powers be included in a framework for resolution, as an additional option in conjunction with other resolution tools.”

What’s at stake?

Given the recent market turbulence in some of the large banks in Europe, I thought it might be useful to go through the steps how bank resolution works today in Europe and more specifically in the Banking Union (BU).  There is a rather thick pile of new european legislation and therefore, in order to avoid misunderstandings, some facts might be in order, so here we go.

The Banking Union institutions

First of all, Banking Union in Europe consists of the following three pillars:

-Single Supervisory Mechanism (SSM)

-Single Resolution Mechanism (SRM)

-Single Rule Book

SSM, i.e.  ECB together with the national supervisors take care of the daily supervision of banks. This includes, but is not limited to, capital adequacy monitoring, liquidity adequacy monitoring, credit risk, market risk, operational risk and the like. ECB is the central prudential supervisor in the BU and it directly supervises the large banks in the BU.

SRM consists of the Single Resolution Board and national resolution authorities. SRB prepares the resolution plans and decides on the resolution process, including on the use of the Single Resolution Fund (SRF) and on the use of the bail-in tool.

Single Rule Book includes most importantly the capital requirements directive (CRDIV), capital requirements regulation (CRR) and the bank recovery and resolution directive (BRRD). These rules are EU law, with regulations directly binding.

How resolution is triggered and carried out?

First of all, it should be noted that the SRB has the task to prepare resolution plans for large banks in Europe. This means that once the resolution commences,  the SRB  follows the pre-agreed resolution plan. The resolution plan includes the intended resolution actions and tools that are planned to be used, including the bail-in tool.

Now let’s assume a large, internationally active bank based in the BU goes into trouble (for example unexpectedly large losses). The regulation establishing the SRM provides the following procedure:

First, the conditions for resolution require that the entity is failing, or is likely to fail (~equity is non-positive) and resolution action is needed. ECB is responsible for making this assessment (there are exceptions). The Single Resolution Board will then take the decision to put the institution in resolution.

When resolution commences, the SRB will decide e.g. on the applicable resolution tools and determine on the use of the Single Resolution Fund (SRF). If the fund is to be used, European Commission will have to assess whether the use of the fund is in line with the state aid rules.

If a bank is to be resolved, first an independent valuation of its assets and liabilities must be made. After the valuation, a conversion/write down of capital instruments takes place. Thereafter the resolution might involve an asset separation, sale of business, bridge bank establishment and the use of the bail-in tool.

The Single Resolution Fund

The Single Resolution Fund is owned by the SRB. The target size of the Fund is 55 billion euros. Banks in the BU contribute annually to the fund to raise the money needed. The fund can be used in extraordinary circumstances.

The Single Resolution Fund (banks will provide the funds by paying ex-ante contributions) can take part in the financing of the resolution action according to the following rules:

1.Within the resolution scheme, when applying the resolution tools to entities referred to in Article 2, the Board may use the Fund only to the extent necessary to ensure the effective application of the resolution tools for the following purposes:

(a) to guarantee the assets or the liabilities of the institution under resolution, its subsidiaries, a bridge institution or an asset management vehicle;

(b) to make loans to the institution under resolution, its subsidiaries, a bridge institution or an asset management vehicle;

(c) to purchase assets of the institution under resolution;

(d) to make contributions to a bridge institution and an asset management vehicle;

(e) to pay compensation to shareholders or creditors if, following an evaluation pursuant to Article 20(5) they have incurred greater losses that they would have incurred, following a valuation pursuant to Article 20(16), in a winding up under normal insolvency proceedings;

(f) to make a contribution to the institution under resolution in lieu of the write-down or conversion of liabilities of certain creditors, when the bail-in tool is applied and the decision is made to exclude certain creditors from the scope of bail-in in accordance with Article 27(5);

(g) to take any combination of the actions referred to in points (a) to (f).

No more bail-outs !

The process I’ve described above ideally means that banks are not be bailed out by the tax payer anymore. First of all, the philosophy is that banks should hold sufficient amount of bail-inable debt (MREL) on their balance sheet in order to be able to convert /write down the debt if a bank suffers huge losses and its equity is wiped out. Even if the SRB would decide to use the Fund to inject capital in a bank, the money is collected from the banking sector. One should also note that the Fund can only be used after a sufficient amount of debt has been written down/converted into equity (8 % of the balance sheet).

What is the role of the central banks ?

Given that problems related to solvency are dealt with the SRB, the only role for the ECB and the national central banks is to provide extraordinary emergency liquidity assistance (ELA) to the solvent bridge institutions or to the new resolved institutions.

Is Deutsche Bank in trouble?

Legally speaking, this is to be assessed by the ECB. Given the current market valuations of insurance contracts for the subordinated debt (5y sub CDS) , the market is clearly pricing an element of increased risk there (in terms of bail-in). Given the systemic role of DB, not least through its huge derivatives book, I can only hope that the ECB and the SRB do what the EU legislation is requiring from them.

 

What is good economics and what are its triumphs?

I read an interesting piece of critique yesterday by Paul Romer. The core of his critique is that modern macroeconomics (~Dynamic Stochastic General Equilibrium models) has drifted during the past 30 years or so into a form of Post-Real Models, like in theoretical physics, where one has M-theories, string theories and so forth. In essence, mathematical consistency and structure with little touch with reality I suppose. I have to say that as a practising professional economist, I must agree with Dr. Romer. Modern macroeconomics most likely does more bad than good in terms of understanding how the economic machine works. I do understand the need for microfoundations, but given that most DSGE-models do not cater for bank leverage, financial markets and credit/leverage cycles in general, I do not see any intellectual interest in these models currently. Moreover, modelling banks as mere intermediaries is plain wrong. Reading Irving Fisher, Friedrich Hayek, Knut Wicksell, Joseph Schumpeter and J.M. Keynes is far more useful (and rewarding).

Economics and the scientific method

Nevertheless, I do not accept the position of dismissing economics altogether. Economics is a set of ideas. Even though economics is not a natural science, economics, should, in my opinion follow the scientific method, i.e. the method of doing economics should follow the rules of:

  1. Characterising the phenomenon
  2. Formulating hypotheses
  3. Making predictions
  4. Experimenting –falsification and verification
  5. Evaluation and making improvements

Most likely the main problem with DSGE -models and modern macroeconomics is with the first step. A model of an economy should not be based on a simple  linear optimal control problem with stochastic shocks. One should model the economy more like some artificial economies are modelled in computer games (Simcity, Civilization, Democracy). Physicists model complex phenomena using for example the Ising model, why  not to bring this paradigm into economics as well? Optimal control is a good tool for controlling ICBM-missiles, but not so much for complex, human economies. If the model does not work and is ontologically unrealistic, I don’t see the benefits of having microfoundations.

What is good economics ?

There are a lot of good theories and models in economics. The following list is a list based on my experience, on what is important.

  1. Economic efficiency

Given that resources are scarce, economics has quite nice formalisations for using resources efficiently. Usually we have the following vector program, where one needs to solve:

max (f_1(\vec{x}),f_2(\vec{x}),f_3(\vec{x}),f_4(\vec{x}),..)

s.t.  \vec{x}\in X

The objective vector could represent a set of utilities for individuals in a society, or profits for a firm, or a utility function for a central bank. What is important that efficient use of resources comes through a (convex) optimisation program. Pareto efficient solutions can be desciribed for partially ordered sets. Of course one of the triumphs in welfare economics are the theorems that codify the invisible hand of Adam Smith: competetive market allocation is Pareto-optimal (conditions cannot be improved for some, without affecting negatively others). Kenneth Arrow and Gerard Debreu were the pioneers in these issues.

2. Public choice

Economic methodology married with political science. Assuming voters, bureaucrats and politicians to be selfish utility maximisers, one can  deduce interesting things. My favourite is the median voter theorem, which basically says that the median voter preferences are represented  by a majority rule.

3. Economics and social welfare -veil of ignorance

This is close to ethics and moral philosophy, especially Rawlsian moral theory but maybe surprisingly economics has something to offer for social welfare theory as well. One of the most interesting results is by John Harsanyi (1955), which says that under some mild assumptions, social welfare is a weighted sum of individuals’ expected utility. Expected utility was by the way developed by the genius John von Neumann. The veil of ignorance -concept was as well originally developed by Harsanyi well before John Rawls.

4. Cournot competition and game theory

Cournot competition (1838) is an equilibrium concept (Nash equilibrium), where two firms choose optimal levels of production in a strategic setting, where individual firms have market power. Firms have what is so called “best response functions” and the intersection of these curves define the equilibrium. Very intuitive, and profound. Again, while John von Neumann was not busy discovering quantum mechanics and the first computer, he developed game theory further as well. Minimax theorem and of course later John Nash’s equilibrium theorems are important.

4. Portfolio theory

Choosing an optimal allocation for an investment portfolio. Harry Markowitz saw the light and formulated it as a quadratic program. One has the covariance matrix of stock returns C, the return vector R, risk parameter lambda and the weights w. The program is simply:

max \vec{w}^TC\vec{w}-\lambda \vec{w}\cdot \vec{R}

subject to \sum w_i=1

5. CAPM

Capital asset pricing model is kind of funny, because it seems trivial (as a projection in the Hilbert space) but it can be deduced also from utility maximisation. What CAPM says is that there is a price of risk, which can be calculated based on the covariance with the market risk.

E[R-R_0]=\beta E[R_M-R_0]

 

6. Options pricing and the risk neutral probability measure

Heat flow and financial derivates benefit from the same underlying structure, which is the  continuous Brownian motion that models white noise in the continuum limit, Black & Scholes (1973) realised that using the Ito lemma and Fourier transforms, one could derive excplicit pricing formulae for European options, stemming from the following parabolic PDE:

 

\frac{\partial V}{\partial t}+\frac{1}{2}\sigma^2 S^2\frac{\partial^2 V}{\partial S^2}+rS\frac{\partial V}{\partial S}-rv=0

 

The link between the heat equation and BS equation comes from the fact that the generator of the stochastic process in stock markets and diffusion processes is a second order Partial differential operator.

The risk neutral probability measure is an imagined probability measure that equates the price of an asset with the expectation of its present value payoff. In this way, all the assets can be priced using only expectations.

7. Covered interest rate parity

The determination of exchange rates in relation to interest differentials is of course interesting, at least for traders. So here we have it

 

\frac{F_i}{S_j}=\frac{1+i_i}{1+i_j}

 

In other words, the ratio of forward FX rate to spot FX rate is the ratio of the interest rates in the respective currencies.

8. Comparative advantage (international trade)

‘Focus on where you’re good at’ -David Ricardo

9. The Trilemma (international finance)

It is impossible to have the following things at the same time: fixed exchange rates, free capital mobility and an independent monetary policy.

10. Tragedy of the commons

We have an incentive to defect, when we have common property –>private property.

This is the list. As you can see, no DSGE models.

Euro area monetary policy and its discontents

What is at stake?

The monetary situation in the Euro area is still rather fragile and  the main indicator (medium-term market implied inflation expectations) points to the direction where additional monetary easing is definitely required. When the ECB governing council assembles tomorrow and on Thursday to decide on the rates and on the monetary policy stance in general, the members of the council will face a thorny choice between various self-conflicting options.

Scene setter

First of all, it should be noted that making policy decisions is very delicate in the current situation, given all the political and legal constraints inherent in the Euro area constellation. However, if we focus on the main objective, i.e. keeping inflation expectations firmly anchored (close to 2 per cent, in the medium term), the data is rather disappointing. The market implied expectation for the 5 y inflation in the medium term has drifted downwards for some time now. The current number is well below 1,3 %. The figure below illustrates this very clearly. This number is surely one of the main market indicators that the ECB watches keenly.

sg2016090631274

Fig. 1. 5y5 Inflation swap forward -implied inflation

Despite of the current extended asset purchase programme (QE), it seems that the monetary policy channel is still somewhat impaired, as significant expansion of the Eurosystem consolidated balance sheet has not lead to a substantial increase in bank lending in the Euro area. This impairment ultimately affects inflation negatively, at least if we assume that inflation depends somehow positively on the money in circulation (cash and bank deposits).Remember, MV=PY.

sg2016090631887

Fig. 2. Eurosystem balance sheet (ECB +national central banks)

Again, we must remember that QE does not automatically increase the amount of “real” money, because the stock of bank deposits (firms’ and peoples’ money) does not automatically change due to QE. QE does however increase excess reserves by crediting commercial banks’ central bank checking accounts, and flattens the yield curve.This should encourage lending and borrowing. There is also the FX/currency channel, which boosts exports, to some extent.

sg2016090632234

Fig. 3. Euro area money supply (M3) -annual growth rate, SA

One might say that in the Euro area we have an impaired bank lending channel, as new bank lending is still rather sluggish. For me this seems to be effectively a demand side problem and should be tackled with fiscal measures. However, given that we do not live in a sovereign money and/or fiscal union, the ECB must act, and it should act sooner than later.

Policy instruments

So, what are the main options and obstacles? As the eurosystem is buying a large amount of government bonds each month (almost 80 bn eur a month), the price level of bonds has increased to the extent that a large portion of sovereign bonds in Euro area have negative yields. This does not need to be a problem, as long as the instruments yield on average more than -0,4% (central bank deposit rate). This will guarantee a positive net interest income for the national central banks.

So, as long as the net interest income is positive (on average), negative yields are not of any major concern for the Eurosystem as a whole. For banks, the ultra-low interest rate environment is toxic, as most of the loan books are tied to euribors, and the deposit rates are not. So the price of lowering the central bank deposit rate is basically to worsen bank profitability (and to punish savers in general). Given the low levels of capital in some parts of the banking system, low profitability might be a problem in terms of financial stability. However, it might be so that a 10-25 bps further cut in the deposit rate is realistic, given that the other options are even more difficult.

It might be nevertheless argued, that the negative rate does not really boost lending, because we might have reached the limits of the effect of interest rates on investment decisions and banks will charge positive rates from loan customers anyway.

Given that the low yields are a de facto constraint, what else could be done in order to expand the QE programme? Well, one can always target longer maturities, whenever possible. Also, one can target more credit risk. This is technically easy, but politically hard. Technically speaking, if one would like to expand the QE programme, to say 100 bn a month, which I think is needed, one could easily do so by buying solely for example Italian government bonds. However, this would mean deviating from the capital key pro rata -approach and thus would be a (larger) step towards a fiscal union, at least that’s how it would look like in many countries. Politically not likely.

The final and the most radical option would be to launch an all-out equities and/or junk bond purchasing programme. The eurosystem could start buying very risky assets with high yield. I think this is off the table, as is helicopter money, at least for now.

To sum up on the options

  1. Lower the deposit rate by for example 25 bps to -0,65 % (and the repo rate and the rate on marginal lending facility accordingly, in order to keep the interest rate corridor tight). This would lower the market rates further across the yield curve.
  2. Relax the issue limit and/or capital key. This would mean that the Eurosystem could acquire a bond issue in its entirety and target individual Member States. Politically delicate, not likely.
  3. Extend the QE programme to equities and/or junk bonds as the BoJ has done. This would most likely be rather controversial and would inflate the equity market further still.

Given the legal and political challenges, my bet would be that there will be a further cut in the interest corridor. This might be accompanied with some bond buying below the -0,4 % limit, as long as the overall profitability of the Eurosystem is positive. Alleviating from the capital key creates more political strain and tension, compared to the benefits of QE.

Has monetary policy reached its limits?

Nevertheless, I think that in the Euro area, monetary policy has reached its limits, more or less. Bank profitability and capital issues constrain further rate cuts and alleviating from the capital key could be politically toxic. So what is left is little. Structural reforms are necessary, but in this case, we need most likely more support from the fiscal side. Given the pathological current account surplus of Germany, it seems clear that the external value of the Euro is too weak for Germany. The accumalating huge net international investment position due to persistent current account surpluses should be tackled by the European commission and the Council, using the six-pack provisions. The other options for fiscal stimulus are basically left with some boosted form of the Juncker plan, and/or boosting the EIB lending volume. One could envisage a role for the ESM as well, at least in theory.