The Banking Business…Note Quote

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Why is lending indispensable to banking? This not-so new question has garnered a lot of steam, especially in the wake of 2007-08 crisis. In India, however, this question has become quite a staple of CSOs purportedly carrying out research and analysis in what has, albeit wrongly, begun to be considered offshoots of neoliberal policies of capitalism favoring cronyism on one hand, and marginalizing priority sector focus by nationalized banks on the other. Though, it is a bit far-fetched to call this analysis mushrooming on artificially-tilled grounds, it nevertheless isn’t justified for the leaps such analyses assume don’t exist. The purpose of this piece is precisely to demystify and be a correctional to such erroneous thoughts feeding activism. 

The idea is to launch from the importance of lending practices to banking, and why if such practices weren’t the norm, banking as a business would falter. Monetary and financial systems are creations of double entry-accounting, in that, when banks lend, the process is a creation of a matrix/(ces) of new assets and new liabilities. Monetary system is a counterfactual, which is a bookkeeping mechanism for the intermediation of real economic activity giving a semblance of reality to finance capitalism in substance and form. Let us say, a bank A lends to a borrower. By this process, a new asset and a new liability is created for A, in that, there is a debit under bank assets, and a simultaneous credit on the borrower’s account. These accounting entries enhance bank’s and borrower’s  respective categories, making it operationally different from opening bank accounts marked by deposits. The bank now has an asset equal to the amount of the loan and a liability equal to the deposit. Put a bit more differently, bank A writes a cheque or draft for the borrower, thus debiting the borrower’s loan account and crediting a payment liability account. Now, this borrower decides to deposit this cheque/draft at a different bank B, which sees the balance sheet of B grow by the same amount, with a payment due asset and a deposit liability. This is what is a bit complicated and referred to as matrix/(ces) at the beginning of this paragraph. The obvious complication is due to a duplication of balance sheet across the banks A and B, which clearly stands in need of urgent resolution. This duplication is categorized under the accounting principle of ‘Float’, and is the primary requisite for resolving duplicity. Float is the amount of time it takes for money to move from one account to another. The time period is significant because it’s as if the funds are in two places at once. The money is still in the cheque writer’s account, and the cheque recipient may have deposited funds to their bank as well. The resolution is reached when the bank B clears the cheque/draft and receives a reserve balance credit in exchange, at which point the bank A sheds both reserve balances and its payment liability. Now, what has happened is that the systemic balance sheet has grown by the amount of the original loan and deposit, even if these are domiciles in two different banks A and B. In other words, B’s balance sheet has an increased deposits and reserves, while A’s balance sheet temporarily unchanged due to loan issued offset reserves decline. It needs to be noted that here a reserve requirement is created in addition to a capital requirement, the former with the creation of a deposit, while the latter with the creation of a loan, implying that loans create capital requirement, whereas deposits create reserve requirement.  Pari Passu, bank A will seek to borrow new funding from money markets and bank B could lend funds into these markets. This is a natural reaction to the fluctuating reserve distribution created at banks A and B. This course of normalization of reserve fluctuations is a basic function of commercial bank reserve management. Though, this is a typical case involving just two banks, a meshwork of different banks, their counterparties, are involved in such transactions that define present-day banking scenario, thus highlighting complexity referred to earlier. 

Now, there is something called the Cash Reserve Ratio (CRR), whereby banks in India (and elsewhere as well) are required to hold a certain proportion of their deposits in the form of cash. However, these banks don’t hold these as cash with themselves for they deposit such cash (also known as currency chests) with the Reserve Bank of India (RBI). For example, if the bank’s deposits increase by Rs. 100, and if the CRR is 4% (this is the present CRR stipulated by the RBI), then the banks will have to hold Rs. 4 with the RBI, and the bank will be able to use only Rs. 96 for investments and lending, or credit purpose. Therefore, higher the CRR, lower is the amount that banks will be able to use for lending and investment. CRR is a tool used by the RBI to control liquidity in the banking system. Now, if the bank A lends out Rs. 100, it incurs a reserve requirement of Rs. 4, or in other words, for every Rs. 100 loan, there is a simultaneous reserve requirement of Rs. 4 created in the form of reserve liability. But, there is a further ingredient to this banking complexity in the form of Tier-1 and Tier-2 capital as laid down by BASEL Accords, to which India is a signatory. Under the accord, bank’s capital consists of tier-1 and tier-2 capital, where tier-1 is bank’s core capital, while tier-2 is supplementary, and the sum of these two is bank’s total capital. This is a crucial component and is considered highly significant by regulators (like the RBI, for instance), for the capital ratio is used to determine and rank bank’s capital adequacy. tier-1 capital consists of shareholders’ equity and retained earnings, and gives a measure of when the bank must absorb losses without ceasing business operations. BASEL-3 has capped the minimum tier-1 capital ratio at 6%, which is calculated by dividing bank’s tier-1 capital by its total risk-based assets. Tier-2 capital includes revaluation reserves, hybrid capital instruments and subordinated term debt, general loan-loss revenues, and undisclosed reserves. tier-2 capital is supplementary since it is less reliable than tier-1 capital. According to BASEL-3, the minimum total capital ratio is 8%, which indicates the minimum tier-2 capital ratio at 2%, as opposed to 6% for the tier-1 capital ratio. Going by these norms, a well capitalized bank in India must have a 8% combined tier-1 and tier-2 capital ratio, meaning that for every Rs. 100 bank loan, a simultaneous regulatory capital liability of Rs. 8 of tier-1/tier-2 is generated. Further, if a Rs. 100 loan has created a Rs. 100 deposit, it has actually created an asset of Rs. 100 for the bank, while at the same time a liability of Rs. 112, which is the sum of deposits and required reserves and capital. On the face of it, this looks like a losing deal for the bank. But, there is more than meets the eye here. 

Assume bank A lends Mr. Amit Modi Rs. 100, by crediting Mr. Modi’s deposit account held at A with Rs. 100. Two new liabilities are immediately created that need urgent addressing, viz. reserve and capital requirement. One way to raise Rs. 8 of required capital, bank A sells shares, or raise equity-like debt or retain earnings. The other way is to attach an origination fee of 10% (sorry for the excessively high figure here, but for sake of brevity, let’s keep it at 10%). This 10% origination fee helps maintain retained earnings and assist satisfying capital requirements. Now, what is happening here might look unique, but is the key to any banking business of lending, i.e. the bank A is meeting its capital requirement by discounting a deposit it created of its own loan, and thereby reducing its liability without actually reducing its asset. To put it differently, bank A extracts a 10% fee from Rs. 100 it loans, thus depositing an actual sum of only Rs. 90. With this, A’s reserve requirement decrease by Rs. 3.6 (remember 4% is the CRR). This in turn means that the loan of Rs. 100 made by A actually creates liabilities worth Rs. Rs. 108.4 (4-3.6 = 0.4 + 8). The RBI, which imposes the reserve requirement will follow up new deposit creation with a systemic injection sufficient to accommodate the requirement of bank B that has issued the deposit. And this new requirement is what is termed the targeted asset for the bank. It will fund this asset in the normal course of its asset-liability management process, just as it would any other asset. At the margin, the bank actually has to compete for funding that will draw new reserve balances into its position with the RBI. This action of course is commingled with numerous other such transactions that occur in the normal course of reserve management. The sequence includes a time lag between the creation of the deposit and the activation of the corresponding reserve requirement against that deposit. A bank in theory can temporarily be at rest in terms of balance sheet growth, and still be experiencing continuous shifting in the mix of asset and liability types, including shifting of deposits. Part of this deposit shifting is inherent in a private sector banking system that fosters competition for deposit funding. The birth of a demand deposit in particular is separate from retaining it through competition. Moreover, the fork in the road that was taken in order to construct a private sector banking system implies that the RBI is not a mere slush fund that provides unlimited funding to the banking system.  

The originating accounting entries in the above case are simple, a loan asset and a deposit liability. But this is only the start of the story. Commercial bank ‘asset-liability management’ functions oversee the comprehensive flow of funds in and out of individual banks. They control exposure to the basic banking risks of liquidity and interest rate sensitivity. Somewhat separately, but still connected within an overarching risk management framework, banks manage credit risk by linking line lending functions directly to the process of internal risk assessment and capital allocation. Banks require capital, especially equity capital, to take risk, and to take credit risk in particular. Interest rate risk and interest margin management are critical aspects of bank asset-liability management. The asset-liability management function provides pricing guidance for deposit products and related funding costs for lending operations. This function helps coordinate the operations of the left and the right hand sides of the balance sheet. For example, a central bank interest rate change becomes a cost of funds signal that transmits to commercial bank balance sheets as a marginal pricing influence. The asset-liability management function is the commercial bank coordination function for this transmission process, as the pricing signal ripples out to various balance sheet categories. Loan and deposit pricing is directly affected because the cost of funds that anchors all pricing in finance has been changed. In other cases, a change in the term structure of market interest rates requires similar coordination of commercial bank pricing implications. And this reset in pricing has implications for commercial bank approaches to strategies and targets for the compositional mix of assets and liabilities. The life of deposits is more dynamic than their birth or death. Deposits move around the banking system as banks compete to retain or attract them. Deposits also change form. Demand deposits can convert to term deposits, as banks seek a supply of longer duration funding for asset-liability matching purposes. And they can convert to new debt or equity securities issued by a particular bank, as buyers of these instruments draw down their deposits to pay for them. All of these changes happen across different banks, which can lead to temporary imbalances in the nominal matching of assets and liabilities, which in turn requires active management of the reserve account level, with appropriate liquidity management responses through money market operations in the short term, or longer term strategic adjustment in approaches to loan and deposit market share. The key idea here is that banks compete for deposits that currently exist in the system, including deposits that can be withdrawn on demand, or at maturity in the case of term deposits. And this competition extends more comprehensively to other liability forms such as debt, as well as to the asset side of the balance sheet through market share strategies for various lending categories. All of this balance sheet flux occurs across different banks, and requires that individual banks actively manage their balance sheets to ensure that assets are appropriately and efficiently funded with liabilities and equity. The ultimate purpose of reserve management is not reserve positioning per se. The end goal is balance sheets are in balance. The reserve system records the effect of this balance sheet activity. And even if loan books remain temporarily unchanged, all manner of other banking system assets and liabilities may be in motion. This includes securities portfolios, deposits, debt liabilities, and the status of the common equity and retained earnings account. And of course, loan books don’t remain unchanged for very long, in which case the loan/deposit growth dynamic comes directly into play on a recurring basis. 

Commercial banks’ ability to create money is constrained by capital. When a bank creates a new loan, with an associated new deposit, the bank’s balance sheet size increases, and the proportion of the balance sheet that is made up of equity (shareholders’ funds, as opposed to customer deposits, which are debt, not equity) decreases. If the bank lends so much that its equity slice approaches zero, as happened in some banks prior to the financial crisis, even a very small fall in asset prices is enough to render it insolvent. Regulatory capital requirements are intended to ensure that banks never reach such a fragile position. In contrast, central banks’ ability to create money is constrained by the willingness of their government to back them, and the ability of that government to tax the population. In practice, most central bank money these days is asset-backed, since central banks create new money when they buy assets in open market operations or Quantitative Easing, and when they lend to banks. However, in theory a central bank could literally spirit money from thin air without asset purchases or lending to banks. This is Milton Friedman’s famous helicopter drop. The central bank would become technically insolvent as a result, but provided the government is able to tax the population, that wouldn’t matter. The ability of the government to tax the population depends on the credibility of the government and the productive capacity of the economy. Hyperinflation can occur when the supply side of the economy collapses, rendering the population unable and/or unwilling to pay taxes. It can also occur when people distrust a government and its central bank so much that they refuse to use the currency that the central bank creates. Distrust can come about because people think the government is corrupt and/or irresponsible, or because they think that the government is going to fall and the money it creates will become worthless. But nowhere in the genesis of hyperinflation does central bank insolvency feature….

 

Conjuncted: Bank Recapitalization – Some Scattered Thoughts on Efficacies.

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In response to this article by Joe.

Some scattered thoughts could be found here.

With demonetization, banks got a surplus liquidity to the tune of Rs. 4 trillion which was largely responsible for call rates becoming tepid. However, there was no commensurate demand for credit as most corporates with a good credit rating managed to raise funds in the bond market at much lower yields. The result was that banks ended up investing most of this liquidity in government securities resulting in the Statutory Liquidity Ratio (SLR) bond holdings of banks exceeding the minimum requirement by up to 700 basis points. This combination of a surfeit of liquidity and weak credit demand can be used to design a recapitalization bond to address the capital problem. Since the banks are anyways sitting on surplus liquidity and investing in G-Secs, recapitalization bonds can be used to convert the bank liquidity to actually recapitalize the banks. Firstly, the government of India, through the RBI, will issue Recapitalization Bonds. Banks, who are sitting on surplus liquidity, will use their resources to invest in these recapitalization bonds. With the funds raised by the government through the issue of recapitalization bonds, the government will infuse capital into the stressed banks. This way, the surplus liquidity of the banks will be used more effectively and in the process the banks will also be better capitalized and now become capable of expanding their asset books as well as negotiating with stressed clients for haircuts. Recapitalization bonds are nothing new and have been used by the RBI in the past. In fact, the former RBI governor, Dr. Y V Reddy, continues to be one of the major proponents of recapitalization bonds in the current juncture. More so, considering that the capital adequacy ratio of Indian banks could dip as low as 11% by March 2018 if the macroeconomic conditions worsen, the motivation for going in for recap bonds has no logical counters. As I have often said this in many a fora, when banks talk numbers, transparency and accountability the way it is perceived isn’t how it is perceived by them, and moreover this argument gets diluted a bit in the wake of demonetization, which has still been haunted by lack of credit demand. As far as the NPAs are concerned, these were lying dormant and thanks to RBI’s AQR, these would not even have surfaced if let be made decisions about by the banks’ free hands. So, RBI’s intervention was a must to recognize NPAs rather than the political will of merely considering them as stressed assets. The real problem with recap bonds lie in the fact that the earlier such exercise in the 90s has still resulted in bonds maturing, and unless, these bonds are made tradable, these would be confined to further immaturities.

Financial Fragility in the Margins. Thought of the Day 114.0

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If micro-economic crisis is caused by the draining of liquidity from an individual company (or household), macro-economic crisis or instability, in the sense of a reduction in the level of activity in the economy as a whole, is usually associated with an involuntary outflow of funds from companies (or households) as a whole. Macro-economic instability is a ‘real’ economic phenomenon, rather than a monetary contrivance, the sense in which it is used, for example, by the International Monetary Fund to mean price inflation in the non-financial economy. Neo-classical economics has a methodological predilection for attributing all changes in economic activity to relative price changes, specifically the price changes that undoubtedly accompany economic fluctuations. But there is sufficient evidence to indicate that falls in economic activity follow outflows of liquidity from the industrial and commercial company sector. Such outflows then lead to the deflation of economic activity that is the signal feature of economic recession and depression.

Let us start with a consideration of how vulnerable financial futures market themselves are to illiquidity, since this would indicate whether the firms operating in the market are ever likely to need to realize claims elsewhere in order to meet their liabilities to the market. Paradoxically, the very high level of intra-broker trading is a safety mechanism for the market, since it raises the velocity of circulation of whatever liquidity there is in the market: traders with liabilities outside the market are much more likely to have claims against other traders to set against those claims. This may be illustrated by considering the most extreme case of a futures market dominated by intra-broker trading, namely a market in which there are only two dealers who buy and sell financial futures contracts only between each other as rentiers, in other words for a profit which may include their premium or commission. On the expiry date of the contracts, conventionally set at three-monthly intervals in actual financial futures markets, some of these contracts will be profitable, some will be loss-making. Margin trading, however, requires all the profitable contracts to be fully paid up in order for their profit to be realized. The trader whose contracts are on balance profitable therefore cannot realize his profits until he has paid up his contracts with the other broker. The other broker will return the money in paying up his contracts, leaving only his losses to be raised by an inflow of money. Thus the only net inflow of money that is required is the amount of profit (or loss) made by the traders. However, an accommodating gross inflow is needed in the first instance in order to make the initial margin payments and settle contracts so that the net profit or loss may be realized.

The existence of more traders, and the system for avoiding counterparty risk commonly found in most futures market, whereby contracts are made with a central clearing house, introduce sequencing complications which may cause problems: having a central clearing house avoids the possibility that one trader’s default will cause other traders to default on their obligations. But it also denies traders the facility of giving each other credit, and thereby reduces the velocity of circulation of whatever liquidity is in the market. Having to pay all obligations in full to the central clearing house increases the money (or gross inflow) that broking firms and investors have to put into the market as margin payments or on settlement days. This increases the risk that a firm with large net liabilities in the financial futures market will be obliged to realize assets in other markets to meet those liabilities. In this way, the integrity of the market is protected by increasing the effective obligations of all traders, at the expense of potentially unsettling claims on other markets.

This risk is enhanced by the trading of rentiers, or banks and entrepreneurs operating as rentiers, hedging their futures contracts in other financial markets. However, while such incidents generate considerable excitement around the markets at the time of their occurrence, there is little evidence that they could cause involuntary outflows from the corporate sector on such a scale as to produce recession in the real economy. This is because financial futures are still used by few industrial and commercial companies, and their demand for financial derivatives instruments is limited by the relative expense of these instruments and their own exposure to changes in financial parameters (which may more easily be accommodated by holding appropriate stocks of liquid assets, i.e., liquidity preference). Therefore, the future of financial futures depends largely on the interest in them of the contemporary rentiers in pension, insurance and various other forms of investment funds. Their interest, in turn, depends on how those funds approach their ‘maturity’.

However, the decline of pension fund surpluses poses important problems for the main securities markets of the world where insurance and pension funds are now the dominant investors, as well as for more peripheral markets like emerging markets, venture capital and financial futures. A contraction in the net cash inflow of investment funds will be reflected in a reduction in the funds that they are investing, and a greater need to realize assets when a change in investment strategy is undertaken. In the main securities markets of the world, a reduction in the ‘new money’ that pension and insurance funds are putting into those securities markets will slow down the rate of growth of the prices in those markets. How such a fall in the institutions’ net cash inflow will affect the more marginal markets, such as emerging markets, venture capital and financial futures, depends on how institutional portfolios are managed in the period of declining net contributions inflows.

In general, investment managers in their own firms, or as employees of merchant or investment banks, compete to manage institutions’ funds. Such competition is likely to increase as investment funds approach ‘maturity’, i.e., as their cash outflows to investors, pensioners or insurance policyholders, rises faster than their cash inflow from contributions and premiums, so that there are less additional funds to be managed. In principle, this should not affect financial futures markets, in the first instance, since, as argued above, the short-term nature of their instruments and the large proportion in their business of intra-market trade makes them much less dependent on institutional cash inflows. However, this does not mean that they would be unaffected by changes in the portfolio preferences of investment funds in response to lower returns from the main securities markets. Such lower returns make financial investments like financial futures, venture capital and emerging markets, which are more marginal because they are so hazardous, more attractive to normally conservative fund managers. Investment funds typically put out sections of portfolios to specialist fund managers who are awarded contracts to manage a section according to the soundness of their reputation and the returns that they have made hitherto in portfolios under their management. A specialist fund manager reporting high, but not abnormal, profits in a fund devoted to financial futures, is likely to attract correspondingly more funds to manage when returns are lower in the main markets’ securities, even if other investors in financial futures experienced large losses. In this way, the maturing of investment funds could cause an increased inflow of rentier funds into financial futures markets.

An inflow of funds into a financial market entails an increase in liabilities to the rentiers outside the market supplying those funds. Even if profits made in the market as a whole also increase, so too will losses. While brokers commonly seek to hedge their positions within the futures market, rentiers have much greater possibilities of hedging their contracts in another market, where they have assets. An inflow into futures markets means that on any settlement day there will therefore be larger net outstanding claims against individual banks or investment funds in respect of their financial derivatives contracts. With margin trading, much larger gross financial inflows into financial futures markets will be required to settle maturing contracts. Some proportion of this will require the sale of securities in other markets. But if liquidity in integrated cash markets for securities is reduced by declining net inflows into pension funds, a failure to meet settlement obligations in futures markets is the alternative to forced liquidation of other assets. In this way futures markets will become more fragile.

Moreover, because of the hazardous nature of financial futures, high returns for an individual firm are difficult to sustain. Disappointment is more likely to be followed by the transfer of funds to management in some other peripheral market that shows a temporary high profit. While this should not affect capacity utilization in the futures market, because of intra-market trade, it is likely to cause much more volatile trading, and an increase in the pace at which new instruments are introduced (to attract investors) and fall into disuse. Pension funds whose returns fall below those required to meet future liabilities because of such instability would normally be required to obtain additional contributions from employers and employees. The resulting drain on the liquidity of the companies affected would cause a reduction in their fixed capital investment. This would be a plausible mechanism for transmitting fragility in the financial system into full-scale decline in the real economy.

The proliferation of financial futures markets has only had been marginally successful in substituting futures contracts for Keynesian liquidity preference as a means of accommodating uncertainty. A closer look at the agents in those markets and their market mechanisms indicates that the price system in them is flawed and trading hazardous risks in them adds to uncertainty rather than reducing it. The hedging of financial futures contracts in other financial markets means that the resulting forced liquidations elsewhere in the financial system are a real source of financial instability that is likely to worsen as slower growth in stock markets makes speculative financial investments appear more attractive. Capital-adequacy regulations are unlikely to reduce such instability, and may even increase it by increasing the capital committed to trading in financial futures. Such regulations can also create an atmosphere of financial security around these markets that may increase unstable speculative flows of liquidity into the markets. For the economy as a whole, the real problems are posed by the involvement of non-financial companies in financial futures markets. With the exception of a few spectacular scandals, non-financial companies have been wary of using financial futures, and it is important that they should continue to limit their interest in financial futures markets. Industrial and commercial companies, which generate their own liquidity through trade and production and hence have more limited financial assets to realize in order to meet financial futures liabilities in times of distress, are more vulnerable to unexpected outflows of liquidity in proportion to their increased exposure to financial markets. The liquidity which they need to set aside to meet such unexpected liabilities inevitably means a reduced commitment to investment in fixed capital and new technology.

Banking and Lending/Investment. How Monetary Policy Becomes Decisive? Some Branching Rumination.

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Among the most notoriously pernicious effects of asset price inflation is that it offers speculators the prospect of gain in excess of the costs of borrowing the money to buy the asset whose price is being inflated. This is how many unstable Ponzi financing structures begin. There are usually strict regulations to prevent or limit banks’ direct investment in financial instruments without any assured residual liquidity, such as equity or common stocks. However, it is less easy to prevent banks from lending to speculative investors, who then use the proceeds of their loans to buy securities or to limit lending secured on financial assets. As long as asset markets are being inflated, such credit expansions also conceal from banks, their shareholders and their regulators the disintermediation that occurs when the banks’ best borrowers, governments and large companies, use bills and company paper instead of bank loans for their short-term financing. As long as the boom proceeds, banks can enjoy the delusion that they can replace the business of governments and large companies with good lending secured on stocks.

In addition to undermining the solvency of the banking system, and distracting commerce and industry with the possibilities of lucrative corporate restructuring, capital market inflation also tends to make monetary policy ineffective. Monetary policy is principally the fixing of reserve requirements, buying and selling short-term paper or bills in the money or inter-bank markets, buying and selling government bonds and fixing short-term interest rates. As noted in the previous section, with capital market inflation there has been a proliferation of short-term financial assets traded in the money markets, as large companies and banks find it cheaper to issue their own paper than to borrow for banks. This disintermediation has extended the range of short-term liquid assets which banks may hold. As a result of this it is no longer possible for central banks, in countries experiencing capital market inflation, to control the overall amount of credit available in the economy: attempts to squeeze the liquidity of banks in order to limit their credit advances by, say, open market operations (selling government bonds) are frustrated by the ease with which banks may restore their liquidity by selling bonds or their holdings of short-term paper or bills. In this situation central banks have been forced to reduce the scope of their monetary policy to the setting of short-term interest rates.

Economists have long believed that monetary policy is effective in controlling price inflation in the economy at large, as opposed to inflation of securities prices. Various rationalizations have been advanced for this efficacy of monetary policy. For the most part they suppose some automatic causal connection between changes in the quantity of money in circulation and changes in prices, although the Austrian School of Economists (here, here, here, and here) tended on occasion to see the connection as being between changes in the rate of interest and changes in prices.

Whatever effect changes in the rate of interest may have on the aggregate of money circulating in the economy, the effect of such changes on prices has to be through the way in which an increase or decrease in the rate of interest causes alterations in expenditure in the economy. Businesses and households are usually hard-headed enough to decide their expenditure and financial commitments in the light of their nominal revenues and cash outflows, which may form their expectations, rather than in accordance with their expectations or optimizing calculations. If the same amount of money continues to be spent in the economy, then there is no effective reason for the business-people setting prices to vary prices. Only if expenditure in markets is rising or falling would retailers and industrialists consider increasing or decreasing prices. Because price expectations are observable directly with difficulty, they may explain everything in general and therefore lack precision in explaining anything in particular. Notwithstanding their effects on all sorts of expectations, interest rate changes affect inflation directly through their effects on expenditure.

The principal expenditure effects of changes in interest rates occur among net debtors in the economy, i.e., economic units whose financial liabilities exceed their financial assets. This is in contrast to net creditors, whose financial assets exceed their liabilities, and who are usually wealthy enough not to have their spending influenced by changes in interest rates. If they do not have sufficient liquid savings out of which to pay the increase in their debt service payments, then net debtors have their expenditure squeezed by having to devote more of their income to debt service payments. The principal net debtors are governments, households with mortgages and companies with large bank loans.

With or without capital market inflation, higher interest rates have never constrained government spending because of the ease with which governments may issue debt. In the case of indebted companies, the degree to which their expenditure is constrained by higher interest rates depends on their degree of indebtedness, the available facilities for additional financing and the liquidity of their assets. As a consequence of capital market inflation, larger companies reduce their borrowing from banks because it becomes cheaper and more convenient to raise even short- term finance in the booming securities markets. This then makes the expenditure of even indebted companies less immediately affected by changes in bank interest rates, because general changes in interest rates cannot affect the rate of discount or interest paid on securities already issued. Increases in short-term interest rates to reduce general price inflation can then be easily evaded by companies financing themselves by issuing longer-term securities, whose interest rates tend to be more stable. Furthermore, with capital market inflation, companies are more likely to be over-capitalized and have excessive financial liabilities, against which companies tend to hold a larger stock of more liquid assets. As inflated financial markets have become more unstable, this has further increased the liquidity preference of large companies. This excess liquidity enables the companies enjoying it to gain higher interest income to offset the higher cost of their borrowing and to maintain their planned spending. Larger companies, with access to capital markets, can afford to issue securities to replenish their liquid reserves.

If capital market inflation reduces the effectiveness of monetary policy against product price inflation, because of the reduced borrowing of companies and the ability of booming asset markets to absorb large quantities of bank credit, interest rate increases have appeared effective in puncturing asset market bubbles in general and capital market inflations in particular. Whether interest rate rises actually can effect an end to capital market inflation depends on how such rises actually affect the capital market. In asset markets, as with anti-inflationary policy in the rest of the economy, such increases are effective when they squeeze the liquidity of indebted economic units by increasing the outflow of cash needed to service debt payments and by discouraging further speculative borrowing. However, they can only be effective in this way if the credit being used to inflate the capital market is short term or is at variable rates of interest determined by the short-term rate.

Keynes’s speculative demand for money is the liquidity preference or demand for short-term securities of rentiers in relation to the yield on long-term securities. Keynes’s speculative motive is ‘a continuous response to gradual changes in the rate of interest’ in which, as interest rates along the whole maturity spectrum decline, there is a shift in rentiers’ portfolio preference toward more liquid assets. Keynes clearly equated a rise in equity (common stock) prices with just such a fall in interest rates. With falling interest rates, the increasing preference of rentiers for short-term financial assets could keep the capital market from excessive inflation.

But the relationship between rates of interest, capital market inflation and liquidity preference is somewhat more complicated. In reality, investors hold liquid assets not only for liquidity, which gives them the option to buy higher-yielding longer-term stocks when their prices fall, but also for yield. This marginalizes Keynes’s speculative motive for liquidity. The motive was based on Keynes’s distinction between what he called ‘speculation’ (investment for capital gain) and ‘enterprise’ (investment long term for income). In our times, the modern rentier is the fund manager investing long term on behalf of pension and insurance funds and competing for returns against other funds managers. An inflow into the capital markets in excess of the financing requirements of firms and governments results in rising prices and turnover of stock. This higher turnover means greater liquidity so that, as long as the capital market is being inflated, the speculative motive for liquidity is more easily satisfied in the market for long-term securities.

Furthermore, capital market inflation adds a premium of expected inflation, or prospective capital gain, to the yield on long-term financial instruments. Hence when the yield decreases, due to an increase in the securities’ market or actual price, the prospective capital gain will not fall in the face of this capital appreciation, but may even increase if it is large or abrupt. Rising short-term interest rates will therefore fail to induce a shift in the liquidity preference of rentiers towards short-term instruments until the central bank pushes these rates of interest above the sum of the prospective capital gain and the market yield on long-term stocks. Only at this point will there be a shift in investors’ preferences, causing capital market inflation to cease, or bursting an asset bubble.

This suggests a new financial instability hypothesis, albeit one that is more modest and more limited in scope and consequence than Minsky’s Financial Instability Hypothesis. During an economic boom, capital market inflation adds a premium of expected capital gain to the market yield on long-term stocks. As long as this yield plus the expected capital gain exceed the rate of interest on short-term securities set by the central bank’s monetary policy, rising short-term interest rates will have no effect on the inflow of funds into the capital market and, if this inflow is greater than the financing requirements of firms and governments, the resulting capital market inflation. Only when the short-term rate of interest exceeds the threshold set by the sum of the prospective capital gain and the yield on long-term stocks will there be a shift in rentiers’ preferences. The increase in liquidity preference will reduce the inflow of funds into the capital market. As the rise in stock prices moderates, the prospective capital gain gets smaller, and may even become negative. The rentiers’ liquidity preference increases further and eventually the stock market crashes, or ceases to be active in stocks of longer maturities.

At this point, the minimal or negative prospective capital gain makes equity or common stocks unattractive to rentiers at any positive yield, until the rate of interest on short-term securities falls below the sum of the prospective capital gain and the market yield on those stocks. When the short-term rate of interest does fall below this threshold, the resulting reduction in rentiers’ liquidity preference revives the capital market. Thus, in between the bursting of speculative bubbles and the resurrection of a dormant capital market, monetary policy has little effect on capital market inflation. Hence it is a poor regulator for ‘squeezing out inflationary expectations’ in the capital market.

Conjuncted: Banking – The Collu(i)sion of Housing and Stock Markets

bank-customers-1929-stock-market-crash

There are two main aspects we are to look at here as regards banking. The first aspect is the link between banking and houses. In most countries, lending of money is done on basis of property, especially houses. As collateral for the mortgage, often houses are used. If the value of the house increases, more money can be borrowed from the banks and more money can be injected into society. More investments are generally good for a country. It is therefore of prime importance for a country to keep the house prices high.

The way this is done, is by facilitating borrowing of money, for instance by fiscal stimulation. Most countries have a tax break on mortgages. This, while the effect for the house buyers of these tax breaks is absolutely zero. That is because the price of a house is determined on the market by supply and demand. If neither the supply nor the demand is changing, the price will be fixed by ‘what people can afford’. Imagine there are 100 houses for sale and 100 buyers. Imagine the price on the market will wind up being 100000 Rupees, with a mortgage payment (3% interest rate) being 3 thousand Rupees per year, exactly what people can afford. Now imagine that government makes a tax break for buyers stipulating that they get 50% of the mortgage payment back from the state in a way of fiscal refund. Suddenly, the buyers can afford 6 thousand Rupees per year and the price on the market of the house will rise to 200 thousand Rupees. The net effect for the buyer is zero. Yet, the price of the house has doubled, and this is a very good incentive for the economy. This is the reason why nearly all governments have tax breaks for home owners.

Yet, another way of driving the price of houses up is by reducing the supply. Socialist countries made it a strong point on their agenda that having a home is a human right. They try to build houses for everybody. And this causes the destruction of the economy. Since the supply of houses is so high that the value drops too much, the possibility of investment based on borrowing money with the house as collateral is severely reduced and a collapse of economy is unavoidable. Technically speaking, it is of extreme simplicity to build a house to everybody. Even a villa or a palace. Yet, implementing this idea will imply a recession in economy, since modern economies are based on house prices. It is better to cut off the supply (destroy houses) to help the economy.

The next item of banking is the stock holders. It is often said that the stock market is the axis-of-evil of a capitalist society. Indeed, the stock owners will get the profit of the capital, and the piling up of money will eventually be at the stock owners. However, it is not so that the stock owners are the evil people that care only about money. It is principally the managers that are the culprits. Mostly bank managers.

To give you an example. Imagine I have 2% of each of the three banks, State Bank, Best Bank and Credit Bank. Now imagine that the other 98% of the stock of each bank is placed at the other two banks. State Bank is thus 49% owner of Best Bank, and 49% owner of Credit Bank. In turn, State Bank is owned for 49% by Best Bank and for 49% by Credit Bank. The thing is that I am the full 100% owner of all three banks. As an example, I own directly 2% of State Bank. But I also own 2% of two banks that each own 49% of this bank. And I own 2% of banks that own 49% of banks that own 49% of State Bank. This series adds to 100%. I am the full 100% owner of State Bank. And the same applies to Best Bank and Credit Bank. This is easy to see, since there do not exist other stock owners of the three banks. These banks are fully mine. However, if I go to a stockholders meeting, I will be outvoted on all subjects. Especially on the subject of financial reward for the manager. If today the 10-million-Rupees salary of Arundhati Bhatti of State Bank is discussed, it will get 98% of the votes, namely those of Gautum Ambani representing Best Bank and Mukesh Adani of Credit Bank. They vote in favor, because next week is the stockholders meeting of their banks. This game only ends when Mukesh Adani will be angry with Arundhati Bhatti.

This structure, placing stock at each other’s company is a form of bypassing the stock holders

– the owners – and allow for plundering of a company.

There is a side effect which is as beneficial as the one above. Often, the general manager’s salary is based on a bonus-system; the better a bank performs, the higher the salary of the manager. This high performance can easily be bogus. Imagine the above three banks. The profit it distributed over the shareholders in the form of dividend. Imagine now that each bank makes 2 million profit on normal business operations. Each bank can easily emit 100 million profit in dividend without loss! For example, State Bank distributes 100 million: 2 million to me, 49 million to Best Bank and 49 million to Credit Bank. From these two banks it also gets 49 million Rupees each. Thus, the total flux of money is only 2 million Rupees.

Shareholders often use as a rule-of thumb a target share price of 20 times the dividend. This because that implies a 5% ROI and slightly better than putting the money at a bank (which anyway invests it in that company, gets 5%, and gives you 3%). However, the dividend can be highly misleading. 2 million profit is made, 100 million dividend is paid. Each bank uses this trick. The general managers can present beautiful data and get a fat bonus.

The only thing stopping this game is taxing. What if government decides to put 25% tax on dividend? Suddenly a bank has to pay 25 million where it made only 2 million real profit. The three banks claimed to have made 300 million profit in total, while they factually only made 6 million; the rest came from passing money around to each other. They have to pay 75 million dividend tax. How will they manage?! That is why government gives banks normally a tax break on dividend (except for small stockholders like me). Governments that like to see high profits, since it also fabricates high GDP and thus guarantees low interest rates on their state loans.

Actually, even without taxing, how will they manage to continue presenting nice data in a year where no profit is made on banking activity?

How Permanent Income Hypothesis/Buffer Stock Model of Milton Friedman Got Nailed?

Milton Friedman and his gang at Chicago, including the ‘boys’ that went back and put their ‘free market’ wrecking ball through Chile under the butcher Pinochet, have really left a mess of confusion and lies behind in the hallowed halls of the academy, which in the 1970s seeped out, like slime, into the central banks and the treasury departments of the world. The overall intent of the literature they developed was to force governments to abandon so-called fiscal activism (the discretionary use of government spending and taxation policy to fine-tune total spending so as to achieve full employment), and, instead, empower central banks to disregard mass unemployment and fight inflation first. Wow!, Billy, these aren’t the usual contretemps and are wittily vitriolic. Several strands of their work – the Monetarist claim that aggregate policy should be reduced to a focus on the central bank controlling the money supply to control inflation (the market would deliver the rest (high employment and economic growth, etc); the promotion of a ‘natural rate of unemployment’ such that governments who tried to reduce the unemployment rate would only accelerate inflation; and the so-called Permanent Income Hypothesis (households ignored short-term movements in income when determining consumption spending), and others – were woven together to form a anti-government phalanx. Later, absurd notions such as rational expectations and real business cycles were added to the litany of Monetarist myths, which indoctrinated graduate students (who became policy makers) even further in the cause. Over time, his damaging legacy has been eroded by researchers and empirical facts but like all tight Groupthink communities the inner sanctum remain faithful and so the research findings haven’t permeated into major shifts in the academy. It will come – but these paradigm shifts take time.

Recently, another of Milton’s legacy bit the dust, thanks to a couple of Harvard economists, Peter Ganong and Pascal Noel, who with their paper “How does unemployment affect consumer spending?” smashed to smithereens the idea that households would not take consumption decisions with discretion, which the Chicagoan held to be a pivot of his active fiscal policy. Time traveling back to John Maynard Keynes, who outlined in his 1936 The General Theory of Employment, Interest and Money a view that household consumption was dependent on disposable income, and, that in times of economic downturn, the government could stimulate employment and income growth using fiscal policy, which would boost consumption.

In Chapter 3 The Principle of Effective Demand, Keynes wrote:

When employment increases, aggregate real income is increased. The psychology of the community is such that when aggregate real income is increased aggregate consumption is increased, but not by so much as income …

The relationship between the community’s income and what it can be expected to spend on consumption, designated by D1, will depend on the psychological characteristic of the community, which we shall call its propensity to consume. That is to say, consumption will depend on the level of aggregate income and, therefore, on the level of employment N, except when there is some change in the propensity to consume.

Keynes later (in Chapter 6 The Definition of Income, Saving and Investment) considered factors that might influence the decision to consume and talked about “how much windfall gain or loss he is making on capital account”.

He elaborated further in Chapter 8 The Propensity to Consume … and wrote:

The amount that the community spends on consumption obviously depends (i) partly on the amount of its income, (ii) partly on the other objective attendant circumstances, and (iii) partly on the subjective needs and the psychological propensities and habits of the individuals composing it and the principles on which the income is divided between them (which may suffer modification as output is increased).

And concluded that:

1. An increase in the real wage (and hence real income at each employment level) will “change in the same proportion”.

2. A rise in the difference between income and net income will influence consumption spending.

3. “Windfall changes in capital-values not allowed for in calculating net income. These are of much more importance in modifying the propensity to consume, since they will bear no stable or regular relationship to the amount of income.” So, wealth changes will impact positively on consumption (up and down).

Later, as he was reflecting in Chapter 24 on the “Social Philosophy towards which the General Theory might lead” he wrote:

… therefore, the enlargement of the functions of government, involved in the task of adjusting to one another the propensity to consume and the inducement to invest, would seem to a nineteenth-century publicist or to a contemporary American financier to be a terrific encroachment on individualism, I defend it, on the contrary, both as the only practicable means of avoiding the destruction of existing economic forms in their entirety and as the condition of the successful functioning of individual initiative.

For if effective demand is deficient, not only is the public scandal of wasted resources intolerable, but the individual enterpriser who seeks to bring these resources into action is operating with the odds loaded against him …

It was thus clear – that active fiscal policy was the “only practicable means of avoiding the destruction” of recession brought about by shifts in consumption and/or investment. That view dominated macroeconomics for several decades.

Then in 1957, Milton Friedman advocated the idea of Permanent income hypothesis. The central idea of the permanent-income hypothesis, proposed by Milton Friedman in 1957, is simple: people base consumption on what they consider their “normal” income. In doing this, they attempt to maintain a fairly constant standard of living even though their incomes may vary considerably from month to month or from year to year. As a result, increases and decreases in income that people see as temporary have little effect on their consumption spending. The idea behind the permanent-income hypothesis is that consumption depends on what people expect to earn over a considerable period of time. As in the life-cycle hypothesis, people smooth out fluctuations in income so that they save during periods of unusually high income and dissave during periods of unusually low income. Thus, a pre-med student should have a higher level of consumption than a graduate student in history if both have the same current income. The pre-med student looks ahead to a much higher future income, and consumes accordingly.Both the permanent-income and life-cycle hypotheses loosen the relationship between consumption and income so that an exogenous change in investment may not have a constant multiplier effect. This is more clearly seen in the permanent-income hypothesis, which suggests that people will try to decide whether or not a change of income is temporary. If they decide that it is, it has a small effect on their spending. Only when they become convinced that it is permanent will consumption change by a sizable amount. As is the case with all economic theory, this theory does not describe any particular household, but only what happens on the average.The life-cycle hypothesis introduced assets into the consumption function, and thereby gave a role to the stock market. A rise in stock prices increases wealth and thus should increase consumption while a fall should reduce consumption. Hence, financial markets matter for consumption as well as for investment. The permanent-income hypothesis introduces lags into the consumption function. An increase in income should not immediately increase consumption spending by very much, but with time it should have a greater and greater effect. Behavior that introduces a lag into the relationship between income and consumption will generate the sort of momentum that business-cycle theories saw. A change in spending changes income, but people only slowly adjust to it. As they do, their extra spending changes income further. An initial increase in spending tends to have effects that take a long time to completely unfold. The existence of lags also makes government attempts to control the economy more difficult. A change of policy does not have its full effect immediately, but only gradually. By the time it has its full effect, the problem that it was designed to attack may have disappeared. Finally, though the life-cycle and permanent-income hypotheses have greatly increased our understanding of consumption behavior, data from the economy does not always fit theory as well as it should, which means they do not provide a complete explanation for consumption behavior.

The idea of a propensity to consume, which had been formalised in textbooks as the Marginal propensity to consume (MPC) – which described the extra consumption that would follow a $ of extra disposable income, was thrown out by Friedman.

The MPC concept – that households consume only a proportion of each extra $1 in disposable income received – formed the basis of the expenditure multiplier. Accordingly, if government deficit spending of, say $100 million, was introduced into a recessed economy, firms would respond by increasing output and incomes by that same amount $100 million. But the extra incomes paid out ($100 m) would stimulate ‘induced consumption’ spending equal to the MPC times $100m. If the MPC was, say, 0.80 (meaning 80 cents of each extra dollar received as disposable income would be spent) then the ‘second-round’ effect of the stimulus would be an additional $80 million in consumption spending (assuming that disposable and total income were the same – that is, assuming away the tax effect for simplicity). In turn, firms would respond and produce an additional $80 million in output and incomes, which would then create further induced consumption effects. Each additional increment, smaller than the last, because the MPC of 0.80 would mean some of the extra disposable income was being lost to saving. But it was argued that the higher the MPC, the greater the overall impact of the stimulus would be. Instead, Friedman claimed that consumption was not driven by current income (or changes in it) but, rather by expected permanent income.

Permanent income becomes an unobservable concept driven by expectations. It also leads to claims that households smooth out their consumption over their lifetimes even though current incomes can fluctuate. So when individuals are facing major declines in their current income – perhaps due to unemployment – they can borrow short-term to maintain the smooth pattern of spending and pay the credit back later, when their current income is in excess of some average expectation.

The idea led to a torrent of articles mostly mathematical in origin trying to formalise the notion of a permanent income. They were all the same – GIGO – garbage in, garbage out. An exercise in mathematical chess although in search of the wrong solution. But Friedman was not one to embrace interdependence. In the ‘free market’ tradition, all decision makers were rational and independent who sought to maximise their lifetime utility. Accordingly, they would borrow when young (to have more consumption than their current income would permit) and save over their lifetimes to compensate when they were old and without incomes. Consumption was strictly determined by this notion of a lifetime income.

Only some major event that altered that projection would lead to changes in consumption.

The Permanent Income Hypothesis is still a core component of the major DSGE macro models that central banks and other forecasting agencies deploy to make statements about the effectiveness of fiscal and monetary policy.

So it matters whether it is a valid theory or not. It is not just one of those academic contests that stoke or deflate egos but have very little consequence for the well-being of the people in general. The empirical world hasn’t been kind to Friedman across all his theories. But the Permanent Income Hypothesis, in particular, hasn’t done well in explaining the dynamics of consumption spending.

Getting back to the paper mentioned in the beginning, it finds deployment of a rich dataset arguing to point where the permanent income hypothesis of Friedman is nailed to the coffin. If the permanent income hypothesis was a good framework for understanding what happens to the consumption patterns of this cohort then we would expect a lot of smoothing going on and relatively stable consumption.

Individuals, according to Friedman, are meant to engage in “self-insurance” to insure against calamity like unemployment. The evidence is that they do not.

The researchers reject what they call the “buffer stock model” (which is a version of the permanent income hypothesis).

They find:

1. “Spending drops sharply at the onset of unemployment, and this drop is better explained by liquidity constraints than by a drop in permanent income or a drop in work-related expenses.”

2. “We find that spending on nondurable goods and services drops by $160 (6%) over the course of two months.”

3. “Consistent with liquidity constraints, we show that states with lower UI benefits have a larger drop in spending at onset.” In other words, the fiscal stimulus coming from the unemployment benefits attenuates the loss of earned income somewhat.

4. “As UI benefit exhaustion approaches, families who remain unemployed barely cut spending, but then cut spending by 11% in the month after benefits are exhausted.”

5. As it turns out the “When benefits are exhausted, the average family loses about $1,000 of monthly income … In the same month, spending drops by $260 (11%).”

6. They compare the “path of spending during unemployment in the data to three benchmark models and find that the buffer stock model fits better than a permanent income model or a hand-to-mouth model.”

The buffer stock model assumes that families smooth their consumption after an income shock by liquidating previous assets – “a key prediction of buffer stock models is that agents accumulate precautionary savings to self-insure against income risk.”

The researchers find that the:

the buffer stock model has two major failures – it predicts substantially more asset holdings at onset and it predicts that spending should be much smoother at benefit exhaustion.

us_pih_study_2016

7. Finally, the researchers found “that families do relatively little self-insurance when unemployed as spending is quite sensitive to current monthly income.” Families “do not prepare for benefit exhaustion”.

The Scourge of Ratings Agencies

This is from the archives written over two days in August and September this year and meant as part of the weekly digest for PFPAC (FB).
Some days back, a friend, asked a question on Ratings Agencies (RAs hereafter), and if there is anything viable or subsequently pliable of these? So, this is a delving into the world of RAs, with a due note of caution that the piece is liable to technical morass. I don’t think I can help emaciate that, and so readers not too glued to technicalities can happily “skip” this. Another caveat here is the number of loose ends rooting and branching out to nowhere, or rather everywhere, for, the political of the neoliberal is an all-encompassing compass far larger than adherence to revolutionary struggles of the peripherals, and rooted in nodal points and events that bring such thoughts to fruition in the first place. RAs’ political economy ties in perfectly with the neoliberal and financialisation of capital in stitching these loose ends. So, it is time to go back to man is the political animal (Reasoning) of Aristotle from the present-day cow is the political animal of scores and scores (Pun intended!)….
Lets begin with indemnities, the technical parlance for insurance, wind and wade through probabilities and reach a designated ‘credit police‘, for this is where historical roots of RAs lie. Edmund Halley (Yes, the same astronomer giant credited with the eponymously-named comet!) in 1693 is credited with publishing the first-ever mortality tables based on the parish records for the Polish-German town of Breslau showing a mortality rate of 1 in 30 every year. These figures corroborated to a setting aside of a thirtieth of a company towards life insurance and annuities, whereby anyone investing in to this fraction by a company would be a policyholder, a member of the population subject to patterns of death and disease, and measured, averaged and thus risk-managed. Below is the original table that Halley came out with.
halley_life_table_1693
Now, if an insurance company brought together a large enough pool of policyholders, individual uncertainty was almost magically eliminated, so long as the actuary did his math correctly. The math isn’t really subjected to individual vagaries, but culminates in an objective reality, an often debated and nuanced extreme of statistical probability theory based on data analysis. So far, so good. But, how does this augur with banking and finance?  Analogising the death-disease parametric of insurance with bankruptcy and default of banking and finance, there is a relationship of equivalence to be drawn here. Just like insurance is subject to probability over long periods of time, a bank with a loan portfolio is played upon equivalently by probability over long periods of time, and both of these draw parallels in alleviating anxieties, or eliminating risks.
Jumping over from insurance. There is a catch here. Actuaries could potentially be instrumental in reducing risks or anxieties through their mathematical genius, but would that mean a trade-off with risk assessments, or due diligence as the latter is gaining currency? As in the case of insurers, who would require a bonafide ‘health certificate’ before bestowing policies, banks too would require such certification (at least ideally that is how it is supposed to work). Enter “Credit Police“. As Nicholas Dunbar in his The Devil’s Derivatives says of them: these might be the credit officers at a bank or, more ubiquitously, a credit ratings agency paid by the borrower to provide them with “health certificate”. Instead of an actuary counting deaths, lenders can turn to a RA to count defaults and crunch the numbers.
This brings us to the definition of RAs: Rating agencies, or credit rating agencies, evaluate the creditworthiness of organisations that issue debt in public markets.  This includes the debts of corporations, nonprofit organisations, and governments, as well as “securitised assets” – which are assets that are bundled together and sold as a security to investors.  Rating agencies assign a letter grade to each bond, which represents an opinion as to the likelihood that the organisation will be able to repay both the principal and interest as they become due.
The first ratings agent (credit police) in the world is often considered to be a financial journalist, who went by the name John Moody, whose interests in the American railroads in the earliest part of the 1900s led him analytically to opining on uncertainty on bonds, wherein all it required was scouring public records in determining what was really owned and how was it being performed. But, there seemed to be a parallel action in the form of Henry Poor’s firm that had been doing something similar fifty years before Moody sprang on to the scene. But, what really distinguished Moody from Poor and made the former a credit police was categorising the companies into creditworthiness. These categories is what is almost followed universally even today, and were alphabetically-based. 3 As (Triple A) was the elitist of these categories with a credit standing to the mighty USA itself. This was followed by 2 A (Double A), 1 A or just A (Single A), and B (similar sub-divisions), C (similar sub-divisions) and finally D, or Default. But, Moody drew another distinction, viz. Bonds above Ba rating were called investment grade, whereas below Ba were termed speculative grade. It is to be noted that investment graded-Bonds have a minimal risk of default, whereas speculative grade issue or issuer ratings are all ratings below BB+ or Ba+ included, down to CC-. Speculative grade or sub-investment grade issues can be considered “less vulnerable in the short run but face major uncertainties and exposures to adverse business, financial and economic conditions” (BB) or “subject to substantial credit risk” (Ba), to “a marked shortcoming has materialised” or ’typically in default’ (C). Speculative grade ratings are also called junk bonds. Moving on, what Moody did was sort sheep from the goats, in that, he promulgated investment grades as having a less chance of defaulting compared to speculative ones, and sold his bond ratings via a subscription newsletter winning trust through his analysis.
So, how does statistics/probability that tames uncertainty also quantify and qualify the loss? Dunbar makes a compelling argument. A portfolio of bonds of a particular grade would need to pay an annual spread higher than that of a risk-free cash investment, to compensate for the average default rate for bonds. In the same way that life insurance premiums vary according to the age of the policyholder, there is a credit spread for a particular rating of a bond – so, for example, bonds rated Baa by Moody’s should pay about a quarter of a percentage (Caution: pdf) in additional interest to make up for expected defaults over time.  If you make it your business to lend money to a large number of Baa-rated companies, then on average, over time, your business will theoretically break even – as long as you charge these companies at least a quarter of a percent more a year than the loan rate enjoyed by the Government. Investment grade companies re happy to pay this premium in return for borrowing money, and the spread earned on corporate bonds or loans is typically a multiple of the statistical default loss rate. Such actuarial approaches work if investments are not given up on prematurely. Moreover, default rates could fluctuate year-to-year even under the consideration of the stability of long-term average, but helps in riding out a recession by waiting for the good loans in your portfolio balancing out the losses over time. This is where RAs get political, for the actuarial approach set forth by them is through the cycle to describe their ratings, to legitimise their analysis, to reassure the implication  that their actuarial approaches were recession-proof.
This political toning isn’t really a theoretic, as journeying back into history has ample attributions to elevating RAs in tune with their stellar reputations to a sinecure by US regulators. Forwarding by six decades, the integrity of these RAs twisted from charging investors to charging issuers. As the value of the rating agencies derives from their reputation for independent credit analysis and reporting, the issuer-pay model poses definite problems for independence, at least in appearance, starting with the questions of partiality. The perception of such potential conflicts of interest may partly explain why S&P did not choose to follow Moody’s and extend its issuer-pay model to corporate bond issuers in 1970. At the time of Moody’s announcement, S&P declared, “the income from the publications that carry our ratings and the expansion of our commercial paper rating activity enable us to provide corporate bond ratings without charge at this time”. Moody’s and S&P’s ability to successfully implement an issuer-pay model reflects their market power and reputational capital. However, when the SEC (US Securities and Exchange Commission) recognized Moody’s and S&P as Nationally Recognized Statistical Ratings Organizations in 1975, this directly increased the regulatory use of credit ratings and gave the two agencies enormous power and prestige. Very likely, this designation also made the issuer-pay model sustainable. Although many technological and economic factors led to the switch from investor-pay to issuer-pay fees for credit ratings three decades ago, the question of whether this revenue model is associated with actual conflicts of interest remains an empirical one. Recent rating down- grades for bonds rated Aaa prior to the financial crisis have led some to speculate that the issuer-pay model has weakened rating agencies’ due diligence and led to poor quality ratings. Both Congress and the SEC have considered ways to change the issuer-pay model. Although the newly passed Dodd–Frank Wall Street Reform and ConsumerProtection Act does not address the issuer-pay model, it requires the Government Accountability Office to prepare a study of alternative ways of compensating rating agencies. It also asks the SEC to adopt new rules concerning the conflicts of interest that arise from rating agencies’ sale and marketing practices.

In light of the above controversy, rating agencies contend that their concerns for reputation discourage them from engaging in any short-term opportunistic behavior. Indeed, Moody’s claims, ‘‘We are in the integrity business’’, and S&P takes it one step further, claiming, ‘‘Our reputation is our business’’ The SEC concurs: “The ongoing value of a rating organization’s business is wholly dependent on continued investor confidence in the credibility and reliability of its ratings, and no single fee or group of fees could be important enough.”…….

 

But, what of countries? How are they given sovereign ratings and why should they even matter? Countries are issued sovereign credit ratings. This rating analyzes the general creditworthiness of a country or foreign government. Sovereign credit ratings take into account the overall economic conditions of a country including the volume of foreign, public and private investment, capital market transparency and foreign currency reserves. Sovereign ratings also assess political conditions such as overall political stability and the level of economic stability a country will maintain during times of political transition. Institutional investors rely on sovereign ratings to qualify and quantify the general investment atmosphere of a particular country. The sovereign rating is often the prerequisite information institutional investors use to determine if they will further consider specific companies, industries and classes of securities issued in a specific country. More governments with greater default risk and more companies domiciled in riskier host countries are borrowing in international bond markets. Although foreign government officials generally cooperate with the agencies, rating assignments that are lower than anticipated often prompt issuers to question the consistency and rationale of sovereign ratings. How clear are the criteria underlying sovereign ratings? Moreover, how much of an impact do ratings have on borrowing costs for sovereigns?

 

Ratings Agency is a company that specialises in evaluating a company’s or government’s ability to repay debts, which in a technical jargon is creditworthiness. Although, they mainly give ratings to debt instruments like corporate and sovereign bonds, they could also be involved in doing something similar to commercial loans. These agencies are sustained by charging fees from corporations or governments and selling their analysis to public at large. Although credit rating agencies are private firms, their role in financial regulatory frameworks has expanded since the 1970s – especially as a result of an international agreement to assess bank portfolios based on the risk of their assets and set capital requirements accordingly. This so-called Basel II Accord sought to add nuance to regulatory standards. A key justification for the incorporation of rating agencies’ credit assessments was the belief that they offered a more sophisticated approach to measuring credit risk than did the simpler regulatory practice of basing capital requirements on a fixed percentage of total assets – the approach in the earlier Basel I Accord, which allowed for much less differentiation.
Prior to the era of project financing, debt financing by banks was the mainstay of funding, where the onus of assessing the risks associated with credit lay ultimately with the funders/lenders, i.e. the banks themselves. But, one of the bridges that linked debt financing to project financing was the instrument of bonds, whose meteoric rise has been coterminous with RAs’ density of indispensability. When any prospective bond buyer assesses the risks involved with  transacting bonds, she would rely on the analysis provided by these RAs. So, if one looks keenly into this logic of transactions, it becomes quite sensible to derive the fact that corporations would indeed want to be rated according to their aspirations to stay on in the business. But, when Governments take this leap, it is a slight misnomer to feel it that way common-sensical. But, alas! no, governments become part of the process of ratings simply by way of fact that many of these sovereign entities raise money on capital markets.
A borrower’s economic outlook is taken into consideration by performing industry studies to assess how a particular industry would evolve and how profitable a company will be in future. It is then culled with borrower’s management. For instance, a country with massive debts and a government that is unlikely to take actions to reduce them would attract a lower rating. Now, why is this important is by ascribing to the fact that it affects expressivities of investment climate by fluctuating between borrowing costs. For example, pension funds are often allowed to hold bonds rated at investment grade. A lowering in a na insurer’s rating can thus have an enormous effect if pension funds have to sell those assets. Interestingly, while the talks are on about Basel III, it is the Basel II framework that dictates how banks can use data from RAs to determine how risky loans would be, and thus outline the amount of reserves a bank has to hold against those loans. But, the obvious question being begged here would be: do these RAs never fail? The answer is exactly not as affirmative as it should be. Enron, for instance was never rated to default, but only after a true picture of its financial state emerged, was it lowered. Enron was a giant corporation, and probably didn’t have the domino impact that a country, or a group of countries would have had if these RAs went berserk with their determination. Since, for a country, the loss is gargantuan, as it is likely aggravated by directly impacting investors’ confidence resulting in an immediate pull out of the region.
The postcrisis debate over the role of credit rating agencies in financial regulation has focused primarily on issues such as conflict of interest and adequacy of performance. Among the questions are how the rating agencies assign ratings, what they rate, and whether ratings fueled the precrisis lending boom and resulting asset bubbles and provoked an opposite and pernicious effect after the crisis. These are valid concerns, but they also underscore how credit rating agencies have become an essential part of the financial system – “hardwired” if you will, in such a way that they take the place of due diligence rather than supplement informed decision making. This hardwiring results, in part, from the investment strategies of banks, investment funds, and other private entities. Primarily, though, it stems from credit rating agencies’ institutionalized role in public policy activities – chiefly in banking regulation, but also in areas such as determination of the eligibility of collateral in central bank operations and investment decisions of publicly controlled or operated funds, such as pension funds. The use of agency ratings in financial regulation amounts both to privatization of the regulatory process – inherently a government responsibility – and to abdication by government of one of its key duties in order to obtain purported benefits such as lower regulation costs and greater efficiency and nuance. So, was really is the issue here or what really is the problematic?
1. Credit rating agencies aim to maximize profits and shareholder value. Although they have a powerful incentive to provide trustworthy information, they do not have the same mandate as a regulatory agency charged with providing information in the interest of the public. When the private motive and the public imperative are not fully compatible, there is potential for conflict and confusion. One or both may suffer. If the public imperative suffers, it undermines the credibility of the regulatory process.
2. Even if a rating agency enjoys an excellent track record, the credibility of the regulatory process risks erosion because ratings are inherently fallible; they depend on judgments. In the marketplace, if a credit rating agency crosses a threshold of unreliability, it will lose customers and eventually fail. However, if it is part of the regulatory framework, its mistakes may have severe implications, and even if a poor performer can eventually be removed, how can a credit rating agency fail as long as it is part of the regulatory framework? Who will be liable if the agency’s opinions result in distortions – especially if financial institutions end up holding too little capital?
3. Rating changes move markets, affecting the value of assets and thus capital requirements. They also affect whether those assets can be used as collateral. This is not inherently bad (indeed such changes are intended to affect assessments of riskiness and asset prices), but a change may cause sudden destabilization, unnecessarily raise volatility, and/or lead to overshooting of the asset’s value, particularly in the event of a downgrade. Ratings changes, then, can cause regulation-induced crises. Moreover, the due diligence of investors whose decisions are tied to ratings (for example, certain pension funds) is diminished or even overridden because of the overwhelming importance of credit ratings.
4. Credit rating agencies have long enjoyed considerable influence over market movements because of the faith placed in them by those who demand their services. The enshrinement of their role in regulation multiplies their potential power. It further distorts competition in an industry that has oligopolistic tendencies, because consumers benefit not only by being able to compare different asset classes under one rating system but also by not having to decipher the methodologies of numerous credit rating agencies.
But, then is a reform possible? And if yes, in what direction?
 
a. Regulatory enhancement: This would involve modifying existing rules, but keeping credit rating agencies in essentially the same regulatory role. Regulations could be tighter. For example, authorities might require rating agencies to be more open about how they operate. The way they are remunerated might also be changed to resolve conflicts of interest. Fees might be regulated. Governments could establish more effective evaluation and accreditation processes for rating agencies and their methodologies and enhance quality control. Investor boards could be established to request credit ratings, which would keep clients and rating agencies separate. Regulators could acknowledge fallibility and establish acceptable levels of accuracy, although this would raise questions about recourse or compensation when inaccuracy occurs. An alternative might be to regulate private credit rating agencies so extensively that they would become essentially public utilities. This approach would substantially reduce conflict of interest and would cost much less than establishing a new public credit rating agency. It would also raise important questions about how to select a rating agency. Would prospective borrowers be compelled to use a particular agency? Would agencies be asked to volunteer? Would there be a competitive selection process.
 
b. The public solution: One or more of the private credit rating agencies could be brought under public control, or all private agencies could be excluded from regulatory activity and replaced by a new public agency. The new agency would follow a transparent and approved rating methodology. It would be paid to cover its operating costs, but instead of profit maximization, provision of accurate information to optimize the regulatory process would be its main objective. Setting up such an agency may be beyond the ability of individual countries and could lead to other problems, such as regulatory protectionism. At the same time launching such an agency at the supranational level would be complicated, requiring international cooperation and considerable good faith. The public solution would resolve certain conflict of interest problems, but arguably would generate new ones with respect to the rating of sovereigns, which would be rating themselves or being rated by an entity they own (wholly or partially). Moreover, a public agency would have to establish credibility and independence from political influence and prove itself a reliable source. It would be costly because it would involve establishment of one or more new institutions. It would also not be immune to problems such as regulatory capture, fallibility of ratings, failures of timeliness, moral hazard, and political repercussions emanating from its decisions. Existing rating agencies would likely suffer a drop in business.
 
c. Return to simpler capital rules: The role of rating agencies could also be eliminated and regulators could return to a few simple and predetermined capital requirements for borrowers. What is lost in nuance and sophistication would be offset by greater simplicity, and therefore transparency. It would also be more predictable and easier for regulators to apply and monitor. A return to static ratios would eliminate errors in judgment arising from ratings changes, although determination of the ratios would be a significant point of contention. Without private rating agencies’ conflicts of interest, transparency and predictability would improve. Greater simplicity would also likely reduce the potential for market participants to evade regulations. However, the simplified capital rules could increase the cost of raising funds and make it harder for some entities to do so, which would curtail financial activity and could impair economic growth. Moreover, because the simpler rules would not differentiate among risks, they could create a perverse incentive for banks to lend more to riskier entities, thus increasing the likelihood of future financial crises. So a simple-rules approach would have to be monitored carefully and implemented in conjunction with other regulatory tools and indicators. Its relative simplicity and lack of institutions render it the cheapest proposal for governments to implement. From a political point of view, any return to simple rules could suggest the failure of the Basel II approach, which supported risk-based capital charges.
 
d. Market-linked capital charges: This approach would turn to the market to determine the level of capital an institution must hold to support an asset. Instead of a credit rating, the market price would be used to gauge the asset’s risk profile. In essence, the amount of capital required to hold a fixed-income security would be related to its yield. The capital required for a security would rise in proportion to its spread over a designated benchmark: the market would determine the risk. Such an approach would remove credit rating agencies from regulation while retaining a sophisticated, transparent, and market-friendly process. Indeed, because market determinations change frequently, capital adjustments could be made more often in a more gradual and nuanced fashion than the credit rating agencies’ grade changes, which often lead to sudden, destabilizing movements. But this approach requires deep and liquid markets and might have to be supplemented with minimum and maximum capital charges – turning it into a variant of the simple capital rules option. Additional safeguards during periods of market crisis would require regulators to intervene when prices cross certain thresholds and diverge significantly from underlying values. The market could serve as a guide to regulators, without removing them from the regulatory process – as happens when they rely on credit rating agencies. But there is the potential for manipulation, especially when liquidity is constrained or an asset is traded infrequently and therefore susceptible to volatile movements.
But, who bells the cat after all? Governments have worked to introduce tighter regulation after the Enron collapse in 2001, a case of massive fraud that the rating agencies did not signal. Governments themselves are affected by the ratings they receive from the agencies they regulate. Some suggest this opens up the opportunity for a conflict of interest.The frameworks for bank ratings have become more transparent. When rating government finances, the agencies argue that they are balanced and impartial. Downgrading a country’s rating inevitably puts an agency in the firing line, but this doesn’t mean they are necessarily wrong to do so. No one can predict the future, and it gets really murky on the financial scene. Credit ratings are assessed by modelling risk of default, not by predicting the unforeseeable. Experience, combined with rigorous procedures, can finely tune risk modelling and increase its reliability, but, ultimately, investors act at their own risk and according to their own judgment. However, credit ratings have the potential for significant social, economic and political fall out. Governments are shaken if their ratings drop. The cost of borrowing rises, interest rates may be affected, and it has an impact on the value of a nation’s currency. Many are asking for more transparency in how the agencies evaluate banks and whether this high impact public service should remain in the hands of private operators.
The drawbacks and costs of each option must be weighed against expected benefits—which must be identified and, where possible, quantified. In some ways, it is a case of pick your poison because there will always be risks associated with regulation, and those who are regulated will always find creative ways to evade or subvert rules not to their liking. Any reform of credit rating agencies must be part of a broader revamping of regulation, because many regulatory failings were identified in the aftermath of the 2008 global financial crisis. Moreover, the transition costs of moving to a new system must be examined carefully, because they will surely be considerable. Cost, however, should not become an excuse for inaction – which would perpetuate government failure and erode the credibility of financial regulation. That could jeopardize the health of the financial sector and the economy – both nationally and globally. There is need to strengthen the accuracy of credit ratings agencies and thus reduce systemic risks, which could be brought about by a regulatory authority required to rate them in terms of their performance; such regulatory bodies facilitating the ability of investors to hold RAs accountable in civil lawsuits for inflated to deflated credit ratings safeguarding against the reckless conduct of these RAs; ensuring that RAs institute internal controls and ratings methodologies; and most importantly, these regulatory bodies ensuring that RAs give higher risks to financial instruments whose performance cannot be reliably predicted due to their novelty or complexity, or that rely on assets from parties with a record of issuing poor quality assets. Until then, we are subject to thee vagaries and accompanying cause-effects.