Friday, 30 November 2012

Do UK Banks Need More Capital?

Yes.  The Bank of England’s November 2012 Financial Stability Report has made the case for UK banks to shore up their levels of capital, perhaps to the tune of up to £20-50bn according to the FT.  Three arguments seem to have made: (i) banks may have to pay fines because of “misbehaviour”;  (ii) provisions for expected losses need to be made and (iii) risk weights may not be appropriate, in the sense that the weights applied may under predict risk.  Rather predictably commercial banks have complained about the new requirements arguing that they want more certainty about capital targets.  I am not quite sure that financial institutions, whose basic role is to price payoffs in uncertain future states of nature and allow people to write contracts for smoothing consumption and investment decisions over those uncertain futures, should be calling for certainty otherwise their very rationale seems to me to disappear in a puff of full information.

But more importantly, in a recent talk, I drew upon a chart published in the June 2012 Financial Stability Report (see below, p 6), that showed a pleasing movements towards some reduction in funding costs for more well capitalised banks.  That the market might now be thought to be punishing more risky banks – measured by their level of capital – means that market scrutiny of bank balance sheets may be starting to re-enforce plans for macro-prudential instruments.   So rather than an unwanted deadweight loss, or simple compliance with regulatory demands, there may be direct market benefit for financial institutions that move to more sensible levels of capital.     

One clear reason why the risk held by bank might be under-reported is that under European convention, sovereign bonds are given a zero risk weight in any calculation of risk-weighted assets.  This means that commercial banks do not have to hold any capital against these assets but which nevertheless, in reality, do carry significant risk.   This means that there is a fundamental shortfall in capital held in proportion both to the quantity and actual risk of sovereign debt. 

In fact, I examined the capital shortfall of the banking system in two ways.  Firstly, using the Eurozone Stress tests of late 2011 (Source: EBA, Eurostat, European Commission and Reuters Breaking Views), I examined the losses of all EMU and non-EMU banks in the EU from a 50% haircut (debt forgiveness, essentially) in Greek and also all Portuguese, Italian, Irish, Greek and Spanish Debt under scenarios for a 7% or 10% capital ratio target.  The capital shortfall in the case of only a 50% Greek haircut and a 10% capital target was some Euro348bn, for the UK alone this was a shortfall of Euro72bn.   Obviously some of the required adjustments may have already been made in the last year but such a calculation may not deal with further losses induced in the system, as banks may incur losses to other parties under a generalised haircut.  (These results are reported in The Euro in Danger.)  Secondly, and more recently, I then looked at the loss in terms of GDP from a 75% haircut on Greek debt and 30% on Ireland, Italy, Portugal and Spain.  With the same 10% capital target, we get a shortfall of Euro75bn in the UK, which rises to Euro221bn if the capital target is 15%.  Now while I think it is unlikely that increasing bank capital to extraordinarily high levels will be necessary or sufficient and much work remains to work out what of the optimal amount for each bank and in the system as a whole, this simple calculation seems to imply that the risk of continuing problems in the Euro Area would seem sufficient to justify the extra call for capital of this magnitude. 

Tuesday, 27 November 2012

Fiscal Multiplier and Bank Dividers

Fiscal multipliers are pretty hard to estimate as they tend not to be particularly stable.  Which is another way of saying that the impact on output of a given change in fiscal policy – which we can define as the planned path of government expenditures and tax receipts over some appropriate planning horizon - depends on a very large number of factors for which it is nearly impossible to condition.   A non-exhaustive list for fiscal policy might include the extent to which the fiscal expansion is expected, credible, temporary or financed by changes in spending or taxes, as well as the debt instruments issued.  The estimated response of the economy will depend how firms, households and banks respond to the changes in fiscal policy but also may be complicated by the response of these same agents to the same shock to which fiscal policy is responding.  The responses of other policy makers such as central bank responses to any fiscal policy and that of other fiscal authorities, particularly in a monetary union, will further complicate any attempts to estimate a clean partial. 

I illustrated some of these issues in a talk to St Catherine’s Political Economy seminar last month.  One early piece of evidence was simply a Table of recent estimates of the multiplier for the UK.  The estimates from these sources give a wide variety depending also on the way in which the fiscal stance is changed.  The outlier in these estimate are those recently derived by the IMF in the October 2012 WEO (Box 1.1), who used the negative residual (where actual output turns out to be below the forecast) of output forecasts from 2010-11 to find some correlation between the timing of fiscal consolidation and the continuing underperformance of the economy.   It turns out though that although the IMF paper tries to apply many controls, they do control for the impact of household and bank deleveraging.
Actually, all kinds of other factors may have led to such an undershoot.  Let me illustrate one.  In this model, “Reserves, liquidity and money:an assessment of balance sheet policies”, in which firms produce monopolistically competitive goods with sticky output prices, optimising households who are credit-constrained by the extent to which banks lend to them in return for collateral in an economy which is driven over the long run by productivity.  This economy can be stabilised by monetary policy changing interest rates or operating open market operations but fiscal policy also has a role by altering the supply of bonds held by the private sector, which act as collateral.  In this model we can alter the size of the government debt by increasing expenditure relative to taxes and trace the impact on output under three scenarios:  (i) a fiscal expansion when policy rates also rise and when banks increase their lending; (ii) a fiscal expansion when policy rates do not rise and the banks increase their lending and (iii) a fiscal expansion when policy rates do not rise and when banks start to delever and contract their level of activity as part of a consolidation. 

The set of impulse responses above are illustrative but show (look at the top left impulse response) that under scenario i) we see a multiplier of around 0.2, under (ii) it is around 0.5 and under (iii) it is around 0.1.  The “fiscal multiplier” in a monetary economy, where banks set the level of broad money depends not only on the policy response.  But also the impact on other interest rates – the external finance premium or bond rates.  And most importantly of all, how the banking sector responds to the state of economy that has led to the need for a fiscal expansion.  This simple calibration shows that cautious banks, or deleveraging banks, who increase the level of monitoring work they undertake and hence hold back on creating new loans can per se offset the impact of any fiscal expansion.   The key therefore, as we have known for some time, is to fix the banking system.  The problem is that the fix also requires deleveraging and consolidation.

Monday, 5 November 2012

Prediction markets and Obama Vs Romney

Four years, I posted a blog on the Iowa Electronic MarketsUS Presidential Election Market.  (For more explanation of the market go to this page.)  For much of time from his nomination in August 2008, it looked very clear from the winner-take-all market that President Obama was going to beat Senator McCain.  Recall that from early September 2008, when the winner take-all market was trading at nearly 50:50, President Obama’s star started an ascendency of such strength that by the date of the 2008 election on 4th November, the market was trading 90:10 in favour of Obama.   This means that it cost 90 cents to place a bet that the Democrats would poll the majority of votes cast, which would return $1 if this transpired and $0 if not.  To coin a phrase: this time is different (to some extent!). 
In 2012, a similar divergence in the winner-take-all (WTA, the upper chart) market started this summer and continued until late-September when by close of trade on 27 September, WTA had 82:18 for President Obama.  But rather than continuing to cascade towards Obama the prediction market went back to 58:42 by 24th October: the US public seemed to waver and Mitt Romney built up considerable momentum.  In the last week of October, much was therefore made of an election that was going to be too close to call - which seems to be even more so the case if you look at the Vote Share market (VS, the lower chart).  
But since Hurricane (Cyclone) Sandy the prices in the WTA market have gone back to favour Obama and on Sunday close 4th November and we stood at 72:28 in favour of the incumbent.  It seems that Iowa prediction markets are calling it for the President Obama, or at least that he will get the majority of the popular vote.  Unfortunately prediction markets have not taken off in the way that I had hoped a few years ago and the Iowa markets are still far from deep and liquid with a maximum bet of $500.  But the ability for market participants to trade assets in a manner to capture the probability of different states of the future remains of great use.  At the very least to someone over here in the UK, who cannot follow every turn in the US news - and yet from this market, I get a clean probability on a daily basis.  At the least we should probably ignore opinion polls and place a bit more weight on the implied probabilities from markets in which people place real money on their views.  A surprise may, of course, await us but at least we do not have very long to wait.