BASEL III: The Deflationary Symbiotic Alliance Between Governments and Banking Sector. Thought of the Day 139.0

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The Bank for International Settlements (BIS) is steering the banks to deal with government debt, since the governments have been running large deficits to deal with the catastrophe of BASEL 2-inspired mortgaged-backed securities collapse. The deficits are ranged anywhere between 3 to 7 per cent of the GDP, and in cases even higher. These deficits were being used to create a floor under growth by stimulating the economy and bailing out financial institutions that got carried away by the wholesale funding of real estate. And this is precisely what BASEL 2 promulgated, i.e. encouraging financial institutions to hold mortgage-backed securities for investments.

In comes the BASEL 3 rules that implore than banks must be in compliance with these regulations. But, who gets to decide these regulations? Actually, banks do, since they then come on board for discussions with the governments, and such negotiations are catered to bail banks out with government deficits in order to oil the engine of economic growth. The logic here underlines the fact that governments can continue to find a godown of sorts for their deficits, while the banks can buy government debt without any capital commitment and make a good spread without the risk, thus serving the interests of the both parties involved mutually. Moreover, for the government, the process is political, as no government would find it acceptable to be objective in its viewership of letting a bubble deflate, because any process of deleveraging would cause the banks to offset their lending orgy, which is detrimental to the engineered economic growth. Importantly, without these deficits, the financial system could go down the deflationary spiral, which might turn out to be a difficult proposition to recover if there isn’t any complicity in rhyme and reason accorded to this particular dysfunctional and symbiotic relationship. So, whats the implication of all this? The more government debt banks hold, the less overall capital they need. And who says so? BASEL 3.

But, the mesh just seems to be building up here. In the same way that banks engineered counterfeit AAA-backed securities that were in fact an improbable financial hoax, how can countries that have government debt/GDP ratio to the tune of 90 – 120 per cent get a Standard&Poor’s ratings of a double-A? They have these ratings because they belong to a apical club that gives their members exclusive rights to a high rating even if they are irresponsible with their issuing of debts. Well, is that this simple? Yes and no. Yes, as is above, and no is merely clothing itself in a bit of an economic jargon, in that these are the countries where the government debt can be held without any capital against it. In other words, if a debt cannot be held, it cannot be issued, and that is the reason why countries are striving for issuing debts that have a zero weighting.

Let us take snippets across gradations of BASEL 1, 2 and 3. In BASEL 1, the unintended consequences were that banks were all buying equity in cross-owned companies. When the unwinding happened, equity just fell apart, since any beginning of a financial crisis is tailored to smash bank equities to begin with. Thats the first wound to rationality. In BASEL 2, banks were told to hold as much AAA-rated paper as they wanted with no capital against it. What happened if these ratings were downgraded? It would trigger a tsunami cutting through pension and insurance schemes to begin with forcing them to sell their papers and pile up huge losses meant to absorbed by capital, which doesn’t exist against these papers. So whatever gets sold is politically cushioned and buffered for by the governments, for the risks cannot be afforded to get any more denser as that explosion would sound the catastrophic death knell for the economy. BASEL 3 doesn’t really help, even if it mandated to hold a concentrated portfolio of government debt without any capital against it, for absorption of losses in case of a crisis hitting would have to exhumed through government bail-outs in scenarios where government debts are a century plus. So, are the banks in-stability, or given to more instability via BASEL 3?  The incentives to ever more hold government securities increase bank exposure to sovereign bonds, adding to existing exposure of government securities via repurchase transactions, investments and trading inventories. A ratings downgrade results in a fall in value of bonds triggering losses. Banks would then face calls for additional collateral, which would drain liquidity, and which would then require additional capital as way of compensation. where would this capital come in from, if not for the governments to source it? One way out would be recapitalization through government debt. On the other hand, the markets are required to hedge against the large holdings of government securities and so short stocks, currencies and insurance companies are all made to stare in the face of volatility that rips through them, of which the net resultant is falling liquidity. So, this vicious cycle would continue to cycle its way through any downgrades. And thats why the deflationary symbiotic alliance between the governments and banking sector isn’t anything more than high-fatigue tolerance….

Negative Interest Rates? huh!

Many months ago, Bank of Japan (BoJ) introduced a Quantitative and Qualitative Monetary Easing (QQME) with Negative Interest Rates. Whats the logic behind this other than maybe reducing reserves to induce banks into lending more? Tricky and audacious at the same time. The seven-pager document (hereCaution: pdf) isn’t a rigmarole, but the underlying logic sure is a Rube Goldberg machinic one, and that too in the face of impeccable liquidity management at the operational level at the Bank, where near zero-interest rates amidst growing fiscal deficits were carefully held. When Japan initiated its Quantitative Easing (QE) in the early 2000s, the rationale was to flood banks with enough liquidity to promote private lending leaving them with humongous stocks of reserves and scarcely a risk of liquidity shortage. this was achieved by buying excess amount of Government bonds than would be required to set the interest rate to zero. But, this stimulating package only accomplished a moderate success rate on the performance scale, to say the least. The banks are not reserve constrained in their lending, and thus the only rationale behind the stimulus as a result of negative interest rates would be investment and consumer durable were motivated enough to borrow at lower interest rates that the asset swap (bonds for reserves) generated.

 According to the official communique, QQME with a negative interest rate would achieve the price stability target of 2% at the earliest; Adopt a three-tier-system to map-out outstanding balance of each financial institution’s current account at the bank; Introduce Money Market Operations (MMO) (Caution: pdf) to swell the monetary base by ¥80 trillion annually, and thus go in for more Quantitative Easing; and Adopt a Qualitative Easing goal by exchanging a broad range of public and private assets for reserves. In line with Point 3 on Page 3 of the document linked to above, it is maintained that the BoJ will lower the short-end of the yield curve by slashing its exposit rate on current accounts into negative territory and will exert further downward pressure on interest rates across the entire yield curve, in combination with large-scale purchases of Japanese Government Bonds. This is where Negative Interest Rate (NIR) find itself defined: Imposing tax on banks for holding reserves above certain limits with the BoJ. The logic cuts across smoothly here, for banks will not show readiness to borrow from each other at higher rates, and implying subsequent pushing of longer-maturity rates down. The dressing up logic, however is to address global volatility in markets with a double-edged sword of imposing public tax on private sector to promote exhilarating inflation. With a moderate success the first time QE was taken up, what guarantees bad implications for earnings of financial institutions slipping into the negative territory? In response, BoJ claimed, “overcoming deflation as soon as possible and exiting from the low-interest rate environment lasting for two decades is essential for improving the business conditions for the financial industry.”
Helter-Skelter midstream!!! But, there are more layers to peel to get centric. Okay, what is the three-tier-system about?
Tier-1: pays a +ve 0.1% on Basic Balance covering existing reserves traced on the system from previous QQME.
Tier-2: The Macro-“Add-on” Balance receiving a zero interest, and helping maintain required reserves held by financial institutions subject to Reserve Requirement system.
Tier-3: Policy-Rate Balance with a -ve 0.1%, with provisions of new reserves entering the system, with a tax of 0.1% on the bargain. This is where Tier-3 gets muddled. The logic is to swell reserves notwithstanding the fact that bank lending reserve constrained.
According to Bank of International Settlements’ Unconventional Monetary Policies: an appraisal (here; warning: .pdf file), such unconventional monetary policies are distinguished by central banks actively using its balance sheet to affect directly market prices and conditions beyond a short-term, typically overnight interest rate, and referring to such policies as “balance sheet policies” rather than “interest-rate policies”. Hereby, they obliterate insights understood in the Keynesian period by taking recourse to a decoupling principle via which the central banks remunerates bank reserves relative to the policy rate. Quoting in full,

..key feature of balance sheet policies is that they can be entirely decoupled rom the level of interest rates. Technically, all that is needed is for the central bank to have sufficient instruments at its disposal to neutralise the impact that these policies have on interest rates on any induced expansion of bank reserves. Generally, central banks are in such a position or can gain the necessary means. this “Decoupling Principle” also implies exiting from the current very low, or zero interest rate policies can be done independently of balance sheet policies. 

The principle is congruent with Modern Monetary Theory, or MMT in short, where Central Bank can sell Government debt in order to adjust the quantity of reserves to bring about desired short-term interest rate; or remunerate execs reserve holdings at the policy rate setting the opportunity cost of holding reserves for banks to zero. This then delinks the interest-rate level set by the central bank severing any relation between swelled-up reserves and interest rates. The BIS paper sums this up,

In particular, changes in reserves associated with unconventional monetary policies do not in and of themselves loosen significantly the constraint on bank lending…The preceding discussion casts doubt on two oft-heard propositions concerning the implications of specialness of bank reserves. first, an expansion of bank reserves endows banks with additional resources to extend loans, adding power to balance sheet policy. Second, there is something uniquely inflationary about bank reserves financing. 

This falls in line with MMT’s basis premise that banks reserves are not required to make loans and there is no monetary multiplier mechanism at work. BIS paper then starts hammering the nail in the coffin by invoking the ghosts of past Japanese experiments with QE,

A striking illustration of the tenuous link between excess reserves and bank lending is the experience during the Bank of Japan’s Quantitative Easing policy from 2001-06. Despite significant expansion in excess reserve balances, and the associated increase in base money, during the zero-interest rate policy, lending in the Japanese banking system did not increase robustly.

Japanese banks are not expanding credit as a result of unwillingness to make loans or a lack of reserves. Instead, the reason for slow credit is that businesses have sufficient capital stock to satisfy the demands of a very weak consumption sector and hence do not feel the need to borrow.
Negative interest rates will not alter that, since perhaps holding on to cash as a liquidity measure to transcend time as uncertainty is the future DOES.