Does QE mean money printing?

Although the debate on the effects of QE on the economy and whether QE is deflationary or inflationary has (at least in my mind) been settled, there seems to exist a rather going "concern" on whether the buying of government bonds from the Central Bank equals money printing. Whether it does or it does not have separated people into two camps: those who believe that too much QE can lead to hyperinflation and those who believe that it will cause nothing of this kind.

But first things first: QE, although usually defined as the purchase (by the Central Bank) of government bonds in the possession of commercial banks. Yet, there is also an additional point: the one where the Fed purchases new bond issues. To see why this points holds see the following breakdown:

As it is obvious from the above, the only major change in the categories is the increase in foreign demand for US debt and the increase in the Fed's share of debt. Essentially, as many have argued before, when QE is initiated, collateral in the form of government bonds becomes more scarce in the economy. This is supposed to make the banks focus their funds elsewhere, meaning an increase in lending. These operations are usually conducted by the Fed either at the expiration and the re-introduction of a bond or by direct "investment" in the markets.

The point to be made here is that if the bonds are purchased from the pile of existing bonds then QE is nothing but an asset swap: cash is exchanged with bonds (both at zero risk for the bank). This does not mean an increase of the money supply whatsoever. Yet, if the government decides to issue additional bonds (remember the whole "raising the debt ceiling" debate?) then the Fed is essentially creating new money by purchasing some of them.

Remember that in order for newly printed money to enter the market it has to either be channeled through government spending or by throwing these amount off a helicopter. (If we choose the former then Monetarism and Keynesianism are essentially saying the same thing.) Thus, if the Fed purchases bonds from new issues, then it is essentially creating new money to enter the market via the government spending channel. Here, we are talking about money which did not exist before. Again, if it was a bond rollover then we would be talking about an accounting increase in cash and a decrease in government bonds (both on the asset side of the balance sheet) which have no effect on the money supply. If the money is lent, then we have an indirect increase in the outstanding amount of money in the economy, via the money multiplier, yet, this is not money printing. It is printing only if the Fed purchases new bond issues.

Now suppose that the Fed buys some new bond issues. Should we experience hyperinflation? The answer is no and not because increasing the money supply does not mean an increase in inflation. It is simply because of timing. Since the money base (M0) is just about 1/3 of the broad money in the economy (MZM) the effects of a rise in M0 just offset the decrease in MZM due to deleveraging. This is the major reason why the money supply in the US has been increasing over the last year despite the decrease in loans. It is just now, that the increase in bank lending has returned to its "normal" growth rate, that QE has began tapering.

Is QE a panacea? Obviously not. As already said, it may cause short-term asset bubbles and disinflation as a result of increased investment in the stock market. Still, those are just short-term effects and compared to the contrary (in the case of the US, a huge depression). In addition, just like fiscal stimulus, it can only be implemented when times are bad. In booms, QE and fiscal stimuli can cause private investment "crowding out" thus forestalling growth and creating additional inflation. In booms, the latter two tend to cause more damage than good. The two camps referred to at the beginning of this article can both be right but at different times: when times are good, QE can cause high inflations. When times are bad, it does not.

Overall, QE remains a good idea, despite its short-term side effects. The big question of whether the ECB will be able to apply something like it in the Eurozone remains to be answered.

New Year's Change of Mind: Was the Cyprus Haircut more equal than we think?

2013's most startling development was probably the Cyprus deposit haircut, an unprecedented event which caused numerous reactions around the world. In March, the Eurogroup came up with Plan A, i.e. to haircut all existing depositors, regardless of institution or the amount of money in their accounts, at a flat rate of 6.75%; a decision which the Cypriot Parliament rejected. After 2 long weeks of bank "holidays" and intense negotiations, the plan changed to the dissolution of Laiki Bank and the haircut of all deposits above 100,000 euros in the Bank of Cyprus (the final amount of the unsecured deposit haircut was 47.5% as agreed in late July).

My reaction to the first plan was that it was unfair: a person with €10,000 in his bank account would suffer more than a person with €10 million in his after a 6.75% cut. The second plan still seemed unfair but had the advantage that depositors in other banks would not be hurt and that the "little guy" would remain an unscathed. Obviously, the "big boys" still get hurt, which means less investment and less growth, equaling more unemployment. Yet, there is actually much more good in this than was first considered.

First of all, the ones which got hurt more in the crisis were not CEO's or other businessmen; it was paid employees. Have a look at the following table compiled by the Economic Policy Institute:

As the reader may observe, in 2011-2012 average worker compensation shrunk by 1.6% while average CEO compensation increased by more than 14% during the same time-frame. What this indicates is that high-income earners do not get hurt by much during a recession. The average paid employee does. The simple reason is that the worker goes out first and the businessman continues to operate; most importantly it is the latter who makes the decision not the former. Even when a recession begins to fade out the businessman can exploit the situation and earn much more than before since wages are much stickier than profits (as also seen in the 2013 results of US firms).

The trouble with Plan A, i.e. the haircut on both secured and unsecured deposits is that the former (i.e. secured depositors) are more prone to the use of their wealth than the latter. As Simon Kuznets has shown back in the early 50's, the higher the income, the less percentage of your income you spend (for a discussion of austerity and income see this). This means that most of the money a low- or middle-income worker earns will end up back in the economy in the form of consumption. On the contrary, the money a high-income person earns are employed differently: if you take away from him, his consumption will not be reduced by as much for the simple reason that he will just save less. Since the economy is mainly driven by consumption (it comprises of the largest part of GDP) if it decreases, GDP will also be decreased.

A question which may arise concerns the banks' ability to lend if we experience dis-savings. The thing is that it will not matter by that much. Remember that if one spends, another will pocket the proceeds, thus the money ends up in the bank anyhow, i.e. the bank will not lose any funds. Second, even though the bank has less deposits now, it has much greater equity which allows it to lend out more funds to boost the economy either directly or indirectly.

This is what has happened in Cyprus since March: those with big, unsecured deposits, found themselves at a loss. Recent IMF estimations, after the second examination of the island's program development, showed that private consumption has fallen by just 2.8% year-to-year, much less than the severe contraction in Greece or other periphery countries, even though the unemployment rate has reached 17% (the 3rd highest in the Eurozone). Since private consumption has not fallen by much, GDP contraction was less than expected. Most importantly, what the less-than-expected decrease in consumption means is that Cyprus has a better chance of experiencing growth faster than other countries is recession; since demand does not fall, employers have less incentives to fire people and businessmen have greater incentives to invest.

There is a caveat in this though: the haircut exacerbated the already declining confidence in the banking sector, meaning that individuals prefer to keep their money under the proverbial (in this case even literal) mattress than deposit it. This can be easily seen in the data, with total deposits following a downwards trend since March, forcing the banks to request liquidity from the ECB. Yet, as the IMF points out, this exit of deposits appears to have reached its peak, with the overall amount in the system stabilizing in October. NPL's are still a major cause of headache in the island, yet an increase in consumption, in addition to the banks' increased ability of issuing of new loans due to higher equity ratios means that better days are ahead.

Summing up, the haircut on unsecured deposits is much more equal than first considered. It hurts those with larger wealth, who spend much less of their income (as a percentage) than those who are on the other side of the spectrum. This means that consumption is less affected by the haircut than by austerity measures: compare Greece and the succession of harsh austerity measures and tax hikes imposed which resulted in a 5-year depression to Cyprus where the haircut was accompanied by mild austerity measures (mostly in 2011 and 2012, with a few ones in 2013). The difference is extraordinary. Yet, as mentioned before, the haircut's caveat is the exacerbation of the already fragile trust towards the banking system, which is the cause of decreased liquidity; yet, if the ECB can ascertain that it will live up to the task of providing "whatever it takes" to the banks, it might be that the haircut is not a terrible idea at all.

Foreign Currency Loans in Europe: Slovenia

A policy usually followed by many banks, especially those in countries belonging to the emerging or developing group, is lending on a foreign currency. This practice has been extremely popular during the 2000's, where in Europe developing countries witnessed foreign currency loans in excess of 50% of total loans (see graph below). The practice does not just take place in  developing countries; borrowers in countries with a relatively stable currency or one which is appreciating pursue such strategies in order to minimize the amount of funds they have to return in terms of local currency.

Source: Foreign Currency Loans and Systemic Risk in Europe

Interestingly, most Central Banks appear to be approving of such behaviour since foreign currency loans are usually a strong growth driver. According to a recent paper, Turkey witnessed a significant increase in growth since forex loans expanded, although restrictions (which were later eased) on household loans were imposed in 2009. Economic theory, and more specifically the currency substitution view, states that high inflation drives high forex lending as people mistrust their domestic currency. Conversely, as inflation falls and domestic currency appreciates, demand for loans is reduced (see graph below). The rationale behind this idea is simple: if domestic currency rises, then I have to pay less in terms of domestic currency than I have borrowed. If, for example, I got a $1 million loan and the rate with my domestic currency currency was 2 units I would get 2 million units of domestic currency. If domestic currency rose to 1.5 unit per $1, then I would have to repay just 1.5 million units of domestic currency. The more stable the currency is, the less the probability that an appreciation will cause the value of the loan to fall, thus the incentive for foreign borrowing is reduced. In addition, this type of strategy works well for both the lender and the borrower.

A more interesting question is why high inflation leads to higher foreign currency borrowing. The reason is that as people see the value of their currency reduced by tremendous inflationary pressures, they tend to switch to something more stable, in most cases the US dollar. This was something evident in other cases of hyperinflations where the domestic currency was discarded by the residents and something else was used in transactions. Yet, what the theory cannot explain is why people choose to borrow in foreign currency when borrowing in domestic currency is something they could have done to reduce the value of their loans. The only possible explanation from my point of view is that when people see a very high rate of inflation (although not as high as to discard the currency) , they expect it will fall sooner or later so they decide to gamble with foreign currencies to win the difference. Such a practice would have been extremely successful had it been followed in Turkey since the late 1990's or early 2000.

What one should note here is the dangers such practices pose for the banks themselves: if the currency depreciates significantly, they are in grave danger of never seeing their loans repaid. Thus, it is essential for the banks to hedge their foreign currency loans if they wish to minimize the exchange rate risk; risk arises from the banks' unwillingness to do so. In the Fed article cited above, Yesin calculates something very interesting: the foreign currency mismatch index, which is a measure of net unhedged foreign liabilities (foreign liabilities minus foreign assets minus loans in foreign currency) over total assets. This indicates the indirect exchange rate risk that banks assume when they lend to unhedged borrowers as derived from the probability of a joint failure of households and nonfinancial corporations to service their foreign currency loans as a result of a foreign currency appreciation (or domestic currency depreciation). The results presented are quite interesting:

As we can see, most of the non-EZ countries have a significant exposure to foreign exchange risk. Interestingly, if these countries face a currency depreciation, and bank need to be bailed out, the excess funds needed to bail the country out will further depreciate the currency; this will mean that the cost of repaying the funds will be further increased, thus promoting more failures and bad debts. Nevertheless, given that most of these countries are not yet caught up in the recessionary spiral the whole of the EZ has been in (with the exception of Croatia which is the only case which needs to be further examined), the probability of such a thing occurring is low. 

Slovenia on the other hand is a very different story. With recent developments stating that Slovenia is one of the most likely candidate for the next EU bail-out, given the similarities the country poses with Cyprus, and the fact that it has been in recession for at least the last year, it is interesting to note that a depreciation of the euro could deeply impact the country and have severe consequences for the country's already wounded banks. The problem with Slovenia lies not just with the euro depreciating but with other currencies appreciating as well. Slovenia's bank have given out many loans in Swiss Francs over the past 5 years; if the CHF appreciates more than the euro does then consequences could be devastating for households and corporations which borrowed in the currency. While 4% of total assets may not appear to be much, for banks which are heavily depended on regulatory requirements to lend even a change of 1% could wreck havoc; especially if we are talking about a bank with very low capital requirements.

It is not that banks can be destroyed with a 1% loss. It is that banks with trust issues cannot sustain the consequences of such actions: people lose confidence in the banks, they withdraw money thus reducing liquidity; their fear causes consumption to fall, which means that investment also falls. These, in addition to higher unemployment, make non-performing loans increase, which brings banks a step closer to collapsing.

Is this as bad as it sounds? Unfortunately, I cannot predict the future paths of neither the CHF nor the Euro. The Euro has been appreciating with regards to the CHF over the past year, yet, given the instability of the region, large movements in both currencies cannot be discarded. This puts Slovenia's banks at the mercy of both currency speculators and the ECB; unfortunately for the country they cannot distinguish which represents the lesser evil. As Slovenia sees its growth potential reduced it would be a good time to impose restrictions on the banks' lending on foreign currency, either by forcing hedging or by restricting further lending in other currencies in general.

Skeptics might say that it would put too much emphasis on the euro and the success of the Eurozone. This might be true, but whether we like it or not this is our domestic currency and it is probably the best hedge ailing banks like the ones in Slovenia can do at the moment.

Is the Interest Rate Inflationary?

This is a post I probably shouldn't write given the previous two ones on banking (here and here). It is, nevertheless a question, or more often, a "conclusion" I usually get when when a discussion on inflation arises. As most people have developed a somewhat irrational, deeply rooted fear of inflation perhaps instilled by the extreme rates of the 1980's, anything that appears it might assist in an increase in inflation scares them deeply. It is a reaction which runs deep in human psyche: if the extreme hurts us, then we do not even accept an infinitesimal quantity out of fear of escalation. Even so, truth is that the interest rate paid on loans is anything but inflationary. Allow me to demonstrate:

Suppose we have an economy where a bank has 60 units of currency in cash (not deposits, this is a very simplistic model). At a given time 0, a worker borrows the 50 units and builds a lemonade stand to sell his homemade lemonade from lemons he gathers at home (making his cost, other than personal labour, 0 units of currency). Lemonade is the only good for human consumption sold in this simple economy. The worker uses the proceeds from the stand to repay the loan; given that the bank wants to make a profit from the loan, it charges the worker an additional 10 units. If the loan duration is 10 years, then the total amount to be paid would be 60 units, or 6 units per year. Thus, the bank is making a profit of 1 units per year, while the worker is forced to pay half a unit per year as the cost of borrowing. 

At first, this might appear as unsustainable: how is the worker ever going to earn 6 units per year in such an economy? This most straightforward of questions, represents one of the parts of economics most people fail to see; the inability to comprehend the full circle of money, results in incomplete models and flawed understanding. The better question here is what the worker does with the money he borrows. If he could just build the stand and equipment on his own what would the point of borrowing be? He could just chop wood on his own, manufacture the screws, the nails and the hammers needed, create the juicer and cups he would need and make some boxes to keep his lemons in and have no need for extra money, just extra time. Yet, our worker cannot do all that; more so, he does not have to do all that because he purchase them and that is why he is borrowing the money.

The worker, goes to the manufacturer's shop, where, using the 50 units he just borrowed, he buys everything he needs and goes down the road to set up his shop. Although the manufacturer can create all these goods and sell them, does produce any lemonade; either because she does not have the time, the expertise, the raw material or even because she is just bored to do so since she can simply purchase it with the 50 units of currency she just got from selling her merchandise. She thus breaks the total amount to 10 annual purchases of 5 units' worth of lemonade.

Let's now consider the bank: the bank currently has 10 available units, expects to get an additional 6 every year. Yet how does the bank consume? The answer is rather simple if one considers all that exists in a bank branch. It has to pay for its employees, rent, electricity, office supplies and other equipment. For simplicity, we assume here that the bank only has to pay an employee, with a salary of 1 unit per year, with the employee spending the money in the only available good for consumption in the economy, i.e. lemonade.

The transactions for each of the 4 involved in the economy in year 1 looks like this (total money means total money available for spending):

In year 2, the same chain of  even would again unfold:

Finally, at year 10, the balances would become:

Note that here, the amount of money in the economy, as stated at the beginning, is not customers' deposits. If they were, the reader will remember from here, that when a new loan is issued, money in the economy is increased and from here, that when that loan is repaid the amount of money is reduced back to its original levels, until the amount is again re-lent. In this model, where the bank just lends out cash, money is not reduced with debt repayment, yet although the interest rate appears to create money out of thin air, all it does is in essence re-distribute money in the economy.

When a loan is repaid, the bank's income is the spread (i.e. the difference) between the deposits and loans interest rates. This money is nevertheless not withheld from the economy: they are either paid as salaries and wages to employees, or spent for equipment, rents, etc. These are all included in the bank's costs one might suggest. True, but even if we use just net profit as a measure, money is almost never left sitting idly in a safe-box. The part employed as retained earnings is used to facilitate expansions, upgrades and other stuff which will make the bank more competitive in the future. This is nothing else but consumption, albeit under a different name. Even if retained earnings are not used for consumption and are just put in marketable securities, it really makes no difference, since even marketable securities are a form of consumption (they are, in essence, a short-term loan). How about the rest of the money? Well, we shouldn't forget about dividends right? Banks pay dividends to their shareholders who are able to employ that money as they please, meaning either spending or investing it. When interest is charged, nothing leaves the economy as many would like to believe; it is just distributed differently, just like when you and I decide to spend or save.

An increase in the money supply and thus in inflation, occurs only when new loans are issued and not when the repayment means that the borrower will have give back more money (in nominal terms always) than he borrowed. The conclusion is that money does not really stay in a bank's box when the latter charges interest and receives its profit: it is mere re-distribution. Obviously, whether this re-distribution is the optimal from the society's point of view is something completely different and certainly beyond the scope of this article.

Note: The same situation would also hold if the bank was lending customer deposits, yet the amount repaid would have to be re-lent at the same time to keep money supply stable. This does not mean that the interest rate would have any different function: it would again be just a re-distribution of funds.

Contagion, Capital Controls and Too Big To Fail: Outcomes of the Cyprus agreement

Corralito Protests in Buenos Aires

Just when I thought that nothing more would have to be said about the Cyprus experiment, a literature over capital controls, whether Cyprus should leave the Eurozone and if potential contagion is something to be feared in the future arose. Economists have been evaluating every one of the aforementioned issues and just as they always do, they could not agree on anything.

Capital controls have been in Cyprus for four days now and apart from the mess at the banks as a result of the 12-day "holiday" no significant flight of capital occurred (and no bank run, to the delight of everyone, even journalists). Although the ECB does not publish real-time Target2 balances, it appears that the capital controls have done their job (if one excludes the stupid decision to close down all banks and leave branches in Russia and Romania open). Probably every article online condones the measures taken by the Cypriot government, yet, some of them agree that there was no other option. Fellow blogger Protesilaos Stavrou commented that if controls persist even after the first tranche is paid by the Troika, then the whole programme was a fiasco; a statement I partially agree with.

Abolishing capital controls cannot happen over a day. The strict regulations applicable now should be transformed to more lax ones over time, with the aim of completely abolishing them until the end of the year (at the very extreme). Why the end of the year? Simply because anything that lasts more than 9 months should be considered as permanent no matter what the authorities may claim. Receiving the first tranche from the Troika does not really mean anything unless the ECB is willing to increase the ELA funding for the Cypriot banks, whose reputation has sunk over course of this deal. If €10 or €20bn of deposits exit the island will the ECB be ready to accommodate the lack of liquidity? 

Many compare Cyprus with Iceland. I beg to differ. First of all, Iceland was not part of the Euro-Area, which means that it had to create its own liquidity. If the ECB agrees to provide ELA funding for the Cypriot banks which may need it (so far only the Bank of Cyprus appears to be in need), then Cyprus can abolish the controls (again, over time) without any more harm to its reputation or economy. In addition, Cyprus banks only account for 10% of GDP and the economy receives a strong boost of foreign money in the form of the 2.5 million tourists who visit the island every year; not be rude to Iceland but we have to admit that their tourism is much less than that. Even without that amount of tourism, Iceland, having imposed capital controls for about 5 years now, exhibited a 3.1% growth in GDP in 2011 with an unemployment rate of less than 5% in mid-2012. Thus, although most economists discern capital controls they have really benefited the country's economic performance. Having capital controls is not bad per se; it's how long you keep them and how harsh they are that makes the difference.

Let's move on to contagion issues. A New York Times article stated that the Bank of Cyprus is no bigger than Indy Mac Bankcorp, a savings and loans institution in the US, which failed five years ago and needed a bail-out. The author misses a little detail though: the US has a GDP of $15 trillion while Cyprus's is about 1,000 times lower. Thus, Indy Mac was approximately 0.0018% of GDP (it had $27bn in assets), while the Bank of Cyprus is approximately 1.5 times as big as the Cypriot GDP. The difference between the two was that Indy Mac was NOT too big to fail. As stated before, there would be no severe contagion in any monetary terms from Laiki bank failing. Neither Bank of Cyprus for that matter. What made the two banks systemic was there strong presence in Greece. After selling that for the cheaper price they could get, they now pose no danger to the European economy (bad move for the Cypriots). 

What makes a difference though, are the psychological effects this issue has had. The banking union, planned for 2014, now appears to be a vague dream; no predictability of institutions exists in any form. If someone thinks that the situation is not so bad and people still trust their banks then why should Wolfgang Schauble have to tell us that the savings in euro are safe? Ordinary citizens have no other viable option in the EU but to place their savings in a bank account. Yet, the less-than-100k accounts do not amount to much. For example, in Laiki bank, only €4bn out of a total of  €20bn will be saved, i.e. 80% of deposits belong to large depositors. These are the people who have the ability and knowledge to transfer funds from one country to another at the click of a button. It is, unfortunately or not, the big depositors that the EU has to reassure to the small ones. In addition, it is not just depositors that have to be persuaded. It is also emerging economies or other countries who use the euro as a reserve currency. The Economist observes that countries in the developing world are drastically reducing their reserves in the Euro, with reserves being at their lowest in a decade. The Euro is as strong as its weakest link and we do not even know who that link is.

Uncertainty is running wild in the Union, as the Eurogroup does not appear to understand the decisions it is making. Another outcome of the Cyprus experiment is that a brand new Too-Big-To-Fail bank has emerged in Greece. Pireaus Bank, after securing €16.2bn of loans at the ridiculously low price of €524 million, has become probably the largest bank in Greece controlling 28% of loans and 27% of deposits. With no agenda on being pessimistic isn't market concentration in the banking industry a big issue, especially in an economy in recession? Time will tell. Yet, it now appears that Greece is being dominated by 3-4 banks, which is almost never good for competition and always never good for the economy if they face trouble. If the Eurogroup decided to reduce the Cypriot banking sector the EU average by making one bank default and make the other less systemic why isn't it doing the same in Greece? Oh, I forgot: we are only looking for solutions AFTER the problem has hit us over the head with a baseball bat. 

This is has been a great week for euro-skeptics. A Euro-exit appears to be less distant know that ever before. The question is who will take the first step. The outcome of Italy's elections will dominate the Euro-Area over the next few weeks, while all of us will keep an eye in France, whose fiscal deficit was still very high in 2012. If the austerity cycle resumes then we are all in big trouble; especially Germany.

A Review of the Legislation Passed in Cyprus

Source. www.philenews.com

Although I unfortunately could not get my hands on the actual bill proposed and passed at the Cypriot Parliament yesterday, a description of the measures is the following:

1. Creation of a National Solidarity Fund whose purpose is the funding or financial support of banking institutions, assisting and supporting their recapitalization or promote and contribute to the Republic's funding. The Fund's income will be derived from natural gas revenues or bonds or other securities the Fund will issue and sell.

2. Power to the Minister of Finance or the Central Bank Governor to impose restrictive measures in banking transactions in case of emergency. These measures up to now are (the provision for the increase of these measures exists in the legislation):

• Maximum amount of monthly withdrawal €10,000
• Term Deposits are forbidden from premature ending
• Obligatory renewal of all term deposits ending over the next period (unspecified)
• Restriction in the creation of new banking accounts
• Current accounts to be transformed into notice accounts
• No-cash transactions to be limited
• Cashing of cheques and interbank transactions to be limited
• Limitation of the public's transactions with the banks

3. Division of Laiki (Popular) Bank to a good bank/bad bank scheme. All depositors who possess up to €100,000 in the bank will be insured. The percentage of the uninsured deposits to be lost is yet to be formally announced. Good assets and liabilities from Laiki Bank will be merged with the ones of the Bank of Cyprus PLC (the island's largest banking institution). A liquidator will be assigned in order to collect non-performing loans by Laiki.

All other laws passed yesterday by the Cyprus Parliament were Amendments to previous legislation, giving more power to the Central Bank to monitor, obtain information and intervene in banking institutions with the purpose of promoting recovery plans, providing for the creation of an integrated recovery framework and increasing early intervention measures.

Banks, Audits and Ratings

Most of the readers who are watching the current developments in economics and banking have surely seen the case of Deutsche Bank and Banca Monte dei Paschi di Siena SpA. For those who did not what the German bank did was to create a complex derivative which was able to hide all the losses its Italian counterpart had, with the latter placing a losing bet on Italy's government bonds (for further details, Bloomberg has an excellent article on the subject). 

The point to be made in this article is beyond the complex derivatives world where many of the sold products cannot be understood even by those who created them. It is about the role of banks in modern societies and the much more important role of auditors and rating agencies who supposedly examine these accounts thoroughly to provide investors with their opinion on the subject.

Auditors have long been in my mind (or maybe in everyone's mind) as the people who oversee whether a company is doing it's job correctly in informing investors and the general public over its financial position and the dangers it might face in the future. Yet, as many have stated over time, there seems to be a great conflict of interest: auditing firms get paid by the people whom they audit. So the situation presented to them is similar to the following example: company X is paying you a substantial amount of money every year to tell everyone else in the world if its practices are correct and whether they should be fine in investing with it. Yet, if investors do not put their money with company X as a result of your operations, then the company will seek another auditor and you will not get any money. Morally there should be no problem: you do your work and be honest on whether the company has a solid financial position or not. Yet, as most things in real life, it is not just black or white. What happens if that company is very large, probably your best client, have a long professional relationship with it and is one of the major sources of income for you? If you disclose the truth you lose a very large income which you were most likely going to have for the rest of that company's life. If you do not then you may face consequences. Not so easy is it?

The accounting cycle. Source: Wikimedia Commons. Author: Club-oracle

Yet, it should be. Remember the failed energy giant Enron? Well Arthur Andersen, the firm who performed the audits for Enron was shut down after the scandal. What is more, the Andersen's auditors were not even allowed to work in the industry again. Now do tell me if that happened every time when auditors did their work bad, how many auditors would we have? Either very few behaving well or many behaving well. Given the workings of the supply and demand forces I think the latter is much more probable than the former. Yet, as people do not get punished for their wrongdoings much of this is continued. Had the auditors who reviewed the Greek banks' accounts in 2008-2009 posed any thoughts on the quality of their loans or their financial positions? How about Spanish, Italian or Cypriot banks? Had the auditors done their job correctly in Germany or not? 

One may argue that the banks' financial accounts are more complex than any other company's. Maybe that is so. Yet, as the student's expertise rises should the examiner's expertise rise as well? If these people are not really experts in their fields (i.e. bank auditing) what business do they have reviewing balance sheets?

A similar point of view arises when one looks at the ratings agencies. Over the past few years many have questioned both the legitimacy and the trust people should have on ratings agencies (for a detailed post on the subject I refer you to Protesilaos's post here). Yet, nations and individual companies watch them eagerly as the opinion of Moody's, Fitch, and Standard&Poor's shapes the markets in most (if not all) countries of the world. They are considered independent and yet their source of income is derived mainly through the same channels as the auditors: the company who wishes the agency to rate a product (or the whole company) pays them a significant fee to do so.

Although many might argue that they are indeed honest with their prediction on sovereign nations over the past couple of years (at least in Europe) I would remind the reader of the sub-prime debt fiasco. While these collateralized products should have been graded as poor investments they had been awarded an AAA status, the highest obtainable in their scales. Maybe they could not have seen what would happen. Or maybe knowing that if they impose harsh ratings they would be losing clients to the other two each decided to be lenient with their ratings. Very lenient if you consider the chaos that occurred in 2008...

What can we do about this then? Should we use more and more experts to oversee that banks are doing their best not to "cheat" investors? Should we impose stricter rules on auditors and rating agencies and the problem will immediately be solved? The answer is actually much simpler than most people believe: regulations which would forbid banking institutions from using derivatives other than for currency and interest rate hedging (the reason is that currency hedging has good reasoning behind it as it protects the bank from severe changes in the exchange rates. Similarly for the interest rate hedging) would solve the problem much better and much faster than anything else. If banks are not allowed to invest in complex derivatives or buy loans from other banks then this would both make the banks' and the auditors' work easier. In addition it would have the advantage of the banks being less prone to bubbles and busts. Which would mean that less government support (i.e. tax-payers money) will be needed to bail them out.

What should happen is that banking institutions should be completely independent of all investing activities other than the ones described above. The banking industry should make a return to the traditional commercial bank model instead of the do-it-all one it is currently practicing. Sure, profits will be reduced. Still the world would be a much better place. Banks have outgrown most of their home nations. Even in Germany, Deutsche Bank's assets are about 2/3 of the German GDP. You may only imagine what happens when other banks are added. Deutsche was one of the main orchestrators of the 2008 financial crisis by issuing tremendous amounts of collateralized debt obligations and selling them to investors. It is claimed that they have failed to acknowledge a up to $12bn of paper losses in their $130 billion portfolio of leveraged trades. You may imagine the assistance needed when if this bank ever needs assistance. Yet no actions of forbidding it from trading and forcing it to stick to its commercial activities has been taken...

We can only safeguard ourselves and our banks by making them less prone to collapse. That can be easily made by forbidding them to engage in investing activities, imposing harsher penalties to misbehaving auditors and ratings agencies. Still, nothing has been done. Let's hope that legislators decide to take some action and refrain from the "this time it's different" notions...

Bank Bailouts: The Correct Way

Some time ago, a book I read stated that the very nature of capitalism was to allow firms to die without any consequences to the system. The author wondered why the same thing isn't possible with banking institutions. That author was Nassim Nicolas Taleb and the book was titled Black Swan. (However, I wouldn't really recommend the book) Although at first I thought the author was right, after considering it I realized that the banks are not at all like any other firm.

If tomorrow Google were to file for bankruptcy, the consequences would be a lack of a good search engine and thousands of Google employees left without a job (and you wouldn't be reading this!). Otherwise, no harm would be done to the ordinary person. Now imagine what would happen if one of the major banks were to collapse: millions of people would suddenly be worried of being left with little or no money (although a country guarantees approximately 100,000 euros of deposits by each person in each bank). In the end, people would get their savings back (expect the persons which had amassed millions who will only get 100,000), however, the whole procedure would be traumatic to the ones who were unlucky enough to get caught in it. Nevertheless, such a procedure is preferred to the cost of pumping a bank with new money every now and then just to sustain it.

Thus, the question becomes: When should banking institutions be rescued? The answer is simple, although it may be tricky to define at times: When they are solvent, largely problem-free and have faced trouble only as a result of an unpredictable event to which they bore minimal or no responsibility. This, for example, would be the case with most EU banks which suffered great losses from the Greek haircut (although there were other banks which had overextended credit over the years).

If a banking institution is thought to be worthy of rescue then the course of action should be by directly providing liquidity to them. This would mean that governments, Central Banks or (preferably) an institution like the ESM, should provide liquidity to the banks; with the latter issuing new shares with voting rights, committing to repurchase them at an amount obtained after accounting for a fixed interest rate, and agreeing that the institution's participation in the bank's equity capital would be reduced each year, thus making sure that the stream of payments from the bank to the state would be continuous. Even if government (or Central Bank) intervention in banking institutions is not considered a good thing, it is much better than merely purchasing preferred shares, as the very recent Barclay's example indicates. By agreeing to pay interest on the amount given to them and repurchasing those shares at fixed intervals, it is assured that the taxpayers' money is not just thrown down a bottomless pit, making the banks more careful in their future investments and gradually reducing government intervention within them.

Following this, the distressed bank should implement some austerity measures, either by cutting down salaries or other benefits or, better, by reducing its activities both at domestic as well as at an international level. Needless to say, the bank's heads at the time of government intervention should be replaced. The bank could spin-off some of its operations if they are profitable, however, this should be done in a way that the new company is an independent one and not with the bank still controlling a substantial interest in it. Likewise, the spin-off should not be sold to another bank as this would increase the other bank's risk of becoming too-big-to-fail.

In the case of the bank becoming insolvent, problem-ridden with issues which are not due to unexpected events (e.g. management issues, poor lending decisions, etc) then it should be let collapse just like any other ordinary firm. If the bank has some operations which are profitable and well-functioning, then these should be spun-off, or sold to another company, even though selling them to another bank should be avoided for reasons of the other bank becoming extremely large. What the reader may inquire is what if the second bank is already too big? What difference would it make if the profitable operation is sold to them? First of all, a new spin-off will require more employees (think of new management, trainees, secretaries, even cleaners) than if it is sold to another company where existing economies of scale would take over. This would have a positive effect on unemployment especially since other bank's employees are expected to be laid off as a result of the collapse. Then, even the acquiring bank is already too big, in what scenario would the government (or another institution) be spending less for stabilization: saving a 100 billion bank or a 105 billion bank? And remember that's billion...

Under the current scheme, most banks are either classified as too big to fail or too little to have any exposure. Take the UK for example where only 5 independent large banks exist, with the government having interest in two of them. What should have been done was to reduce the level of activities of the Royal Bank of Scotland and Lloyds Banking Group to levels where such intervention would be easier in the future, also allowing the creation of more banking institutions, which would promote a competitive environment instead of an oligopolistic one.