Reality No Longer Has a Seat At the Banking Table
There is little debate about the need to recapitalize European banks that have yet to fully disclose or mark their obviously troubled sovereign exposures. In fact, it is all but certain that those same banks are at least a hundred billion euros short in their capital accounts (and likely a multiple of that). Since the modern banking system is based on the idea of capital buffers rather than actual, physical cash (or gold), the accounting of capital stands as the basis for the entire system.
These projected capital shortfalls typically leave only a couple of options for the banks most affected: sell assets (hopefully near par or for a gain) or go to the market to raise equity. European bank stocks have not had the best year, so that is the most unattractive option from the system's perspective. European entities have signaled a willingness to sell assets, but with bond prices behaving worse than bank stocks the losses are really too much for weakened capital accounts to bear.
Where does that leave a system with a universally recognized shortfall in the fundamental basis of all fractional lending? To change the methodology of accounting for the riskiness of their asset books - an accounting trick to strengthen capital ratios without having to actually strengthen capital ratios.
Both Reuters and Bloomberg reported that European banks are actively engaging in "risk-weighted asset optimization". In other words, banks are recalculating exactly how risky their assets might be (by "updating" the assumptions in their "proficient" random walk statistical calculations) so that their projected risk-weighted asset total declines. Since the capital ratios that govern bank operations are defined as total risk-weighted assets divided by Tier 1 equity capital, reducing the "risk" part of the numerator makes the capital ratios look far better.
The impetus for this refiguring (which only seems to go in one direction - you would think if this was a real process there would at least be a chance that risk-weightings could actually rise given the lack of nuance about the direction of risk in every credit market, including the supposedly risk-free sovereign class) comes from the Basel rules that assign different weightings to different classes of assets. Basel II gives banks latitude in "modeling" the potential riskiness of each specific asset since banks long ago successfully argued that it was inappropriate to assign broad weightings and definitions to idiosyncratic assets.
So instead of selling stock into a bad market or engaging in asset fire-sales (concrete expressions of a "bad" bank), banks will simply refigure themselves to be far less risky, thereby increasing their capital ratios, "fixing" the problem without much fuss. Reality no longer has a seat at the banking table since it is a demonstrable fact that banks are holding far riskier assets than they estimated only a few months ago (just ask MF Global), especially since default risk is not the only concern.
To what purpose do capital ratios serve if they are to be so easily discarded by the farce of one-way "risk-weighted asset optimization"? A capital-based system makes some sense on a basic level since the primary goal is to place a first-loss "tranche" in front of the more senior levels of the liability structure. If first-loss equity capital is sufficient, depositors and bondholders can be reasonably assured that a bank can absorb large losses and still be able to repay them in whole (this is also the principal guiding the securitization process).
So it is in the bank's best interest to ensure that the "thickness" of the equity tranche is maximized (for both a bank and a securitization structure). However, since it is perceptions of thickness that matter, believable means to achieving equity buffers are far more effective. Contrast that need with a bank on a physical fractional standard where the amount of cash in a vault is the governing limitation. Under the cash standard the bank would be out of business once the cash dwindled, regardless of whether there were any actual losses incurred. Again perceptions matter here, but it is more about cash on hand and less about actual losses. So it seems like there has been a positive evolution as actual losses are now the impetus for "runs", not just fear of a lack of available physical cash. The capital-based framework systemically sorts "bad" banks from "good".
But as we see all too plainly today, there is no real answer when a large proportion of the banking cohort cannot be counted as "good" banks. In fact, the capital ratio scheme has already completed part of its job by pointing out which banks are in fact "bad" banks. Where the system seems to be failing is in how to deal with those problem institutions since there is no shortage of less-than-believable "solutions" to the equity capital buffer problem.
If regulators endorse, as they appear to be doing, the fantasy of risk-weighted asset optimization accounting, then the capital ratio-standard of banking is entirely insufficient to do the full job it was designed for. This is nothing more than moral hazard in different clothing.
At some point, the banking system is supposed to advance the idea of intermediation in the real economy. Since long-term economic health is utterly dependent on money being efficiently allocated to "good" ideas and projects (those that have the best prospects for long-term stability and sustainability), it follows that banks that accumulate large losses are economically inefficient. "Bad" banks are doing nothing more than assigning and allocating credit to "bad" ideas, so the economy is actually far worse off if they continue to exist. It makes no sense to allow inefficiently allocating banks to stay in business since they produce a negative productivity of credit money.
Under less stressed systemic circumstances, the capital ratio failure of "bad" institutions would likely lead to the orderly bankruptcy of the credit producer in question - with the full approval and assistance of regulators. The system is simply ill-equipped, however, for a mass of failures (defined by the size of institutions) at the same time. In other words, the equity capital system is not all that much better than the physical system since both inadequately deal with systemic pressures (though in opposite directions). That means that the capital limitations from the preceding stage of the systemic event, the credit buildup, is not at all effective at limiting the ability of the system to build and maintain negative productivity of money and credit. The equity standard allows a large accumulation of "bad" banks, in direct contrast to its stated purpose.
The supposed superiority of the equity capital system led the banking system to fully believe it had discovered a better understanding of risk, and therefore could accumulate far more risk than a physical system. This unwarranted expectation meant extending fractional lending out to extremes. At the same time, these accumulations of risk were advanced into the real economic system through perverted prices and incentives.
The belief in progress or evolution of the banking system went hand-in-hand with technological progress. Computing power has created the ability to mathematically model complex systems, seemingly adding an elegant element of real control over both the systems and the ability to predict problems. So in reality, the move to the equity-based banking system was concurrent to the technological advancement in mathematical mapping. The qualitative understanding of the system as it existed in past years was willingly swapped for the new quantitative modeling of modern finance.
As we have seen in numerous painful examples since 2007, there was a huge hidden cost in making this change. Mathematical modeling is not yet anywhere near sophisticated enough to handle the real world. The dependence on historical data series introduces recency bias, while the fundamental building block of random walk statistics is a simplistic short cut that leaves out real world complications and relationships. The mathematical system is long on hubris and far too short on common sense. But the math is supposed to be an objective arbiter of economic control, so it has great appeal to political sensibilities.
The entire banking system as it had existed since the Great Depression was dismantled on this premise of solid, objective quantitative control. Demonstrating this conceit fully, the repeal of the Glass Steagall Act was being debated during the collapse of Long-Term Capital Management (LTCM) in late 1998, yet there was no pause to that repeal process which came to fruition in late 1999. A year later David Li birthed the Gaussian copula function, and the marketplace for securitizations exploded in an environment of the unlimited cash of deregulated credit production and an over-accommodative accounting-based restraint.
Financial innovation, untethered to physical cash, exploded as new and better ways to manage the perceptions of equity and fractional lending were uncovered, largely through calculating complexity. This system logically leads to a single-minded purpose of expanding that equity calculation by any and all means necessary. Under the physical-based system, success in intermediation meant actual cash flowing back into the bank from good loans and investments. The equity capital calculation, on the other hand, creates a proactive incentive to find more innovative ways to express financial success, even if that success is far from assured.
The trade that brought down MF Global a few weeks ago, for example, was a repo-to-maturity transaction. The company bought sovereign PIIGS debt, funded those purchases by a term repo with the intent on earning a spread between the low repo cost of funds and the relatively high interest coupons of the troubled sovereigns.
The accounting conventions as they were/are currently construed allowed MF Global to account for this carry trade as a sale, thereby removing any liability from the balance sheet (making this an off-balance sheet transaction). Worse than that, the company capitalized this expected spread return and booked a profit at the inception of the trade. The assets that brought the company down into bankruptcy were already included in the company's retained earnings, and thus the capital buffer, as it tried to convince counterparties that its capital levels were more than adequate; an almost comical element of circular logic that unsurprisingly did nothing to avoid MF Global's final fate (perceptions matter).
The ability to create and manage the level of credit in any economic system is no different than the operation of the printing press. Credit money in today's economy is functionally no different than physical cash in previous generations (you can take nothing more than your credit card to the store and take home goods). The question of risk-weighted asset optimization, repo-to-maturity, LTCM and the rest is about who should control that ability to create virtual money or money from nothing (a related discussion is whether there should even be any ability to create money from nothing). The banks want your complicity and trust, but continually demonstrate they are not worthy of it. Using mathematics to model expected transactions is not the same as objectively advancing the economic interests of society as a whole.
The real economy pays a high cost for the mismanagement of credit and money. Since money does exhibit protracted nonneutrality, the real economy can and does suffer the drastically negative effects of the diminishing productivity of money. Not only are scarce resources wasted, but real productive activities also languish behind the rising tide of speculation that plentiful money always leads to. In the larger system of incentives, the unconstrained banking system is hindered by the real economy since the real economy requires time and patience to achieve success. A banking system that prefers repo-to-maturity capitalization is not one marked by patience, so it is little wonder that the devotion to short-term profits through any means dominates financial firms.
Since credit production and virtual money printing contain very dangerous potential, the limitations on those abilities are a vital check on economic power. History is replete with examples of these dangers, including the bubbles of the very recent past, yet there is no retreat from the goal of unlimited credit. Being able to pervert basic economic functions, especially the natural balance between speculation and capital investment, should make constraining the banking system (with its single-minded goal of maximum risk) the fundamental task of any central bank.
The equity limitations of the current system are unfit for that task simply because it features ephemeral restrictions that are easily disregarded in favor of accounting innovation and both implied and explicit moral hazard. There is no political will to enforce these soft limitations, and the pliable notion of bank equity lacks any strength since it is so easily manipulated in the dark calculations of financial black box math. As such, the amount of economic power left unchecked in the hands of the banking system is an affront to economic (and therefore political) freedom.
The physical cash system, while still nominally controlled by a central bank, at least allowed the public an opportunity to withdraw (both literally and figuratively) from the system, thus checking the banking system's ability to maximize fractional lending and systemic risk. It was a hard, unambiguous check on the system's credit/money powers - one that could easily circumvent central banks unwilling to fulfill their societal role by siding with maximum fractional lending.
Since regulators are unwilling to reduce the economic power of the banking system (indeed, they are all too willing to enhance it since they believe credit is a powerful tool in their own control of the economy), we are left with a stark choice of a debt-based, subservient economic system that is ruled on the very flawed whims and obvious conflicts of mathematical notions of risk and rational expectation calculations, or to find an alternative that seeks to actually limit the process of credit production's intrusion into what should be a free market. Essentially, this is a choice of how we define "money".
Money is supposed to be a tool that enhances the process of the free exchange of goods and services. In other words, the willingness and ability to exchange precedes the notion of money. The modern, central bank-controlled system of fractional credit believes in the opposite mode of economic exchange. It seeks to create money from nothing in order to create demand for exchange. Money, for current iterations of central banks, precedes exchange demand. In this backwards case, it is no wonder that money seeks almost exclusively to acquire more money since true productive activities are nothing more than incidental.
The predicate exchange of goods and services in the traditionally free market, however, looks upon the acquisition of money in a far different way. The ultimate goal here is to use money to grow and/or attain true wealth: real productive capacity. With true wealth as the ultimate measurement of success, the entire economic system is enhanced by that desire. The chase of real wealth requires broadening participation through both labor and capital (physical), with money in a properly subservient role, to be successful. This ultimately means that the goals of the system and its disparate participants are in direct alignment.
The monetarist system seeks, in the end, to simply acquire money from someone else through means that do not require broadening participation - positive impacts in the real economy are, again, incidental. In fact, the negative productivity of money in the current speculatively imbalanced system actually reduces the ability of the economy to broaden participation. Monetarism is a zero sum game, at best. The lack of economic progress in this current recovery is directly linked to this continual advancement of flawed money and the related do-or-die maintenance of the current monetary system.
Constraining this power will ultimately mean a system of checks and balances, including an exogenous limitation to credit production. It should also mean an increase in financial competition, since competition is itself a check on the concentration of power.
That means the Fed's primary goal should have nothing to do with managing interest rates (which allows banks to create credit without limitation) or regulating meaningless equity accounting. The Fed especially needs to relinquish any role as nominal head of the current cartel of bank credit. Instead, our central bank might be better construed as a financial Federal Trade Commission, an agency designed to make sure that financial firms never concentrate enough to form a cartel or monopoly, instead preserving the primary role of the real economy over the financial economy through scarcity.
There is too much power in the ability to create money. The banking system, their central bank partners and ineffective regulators have conclusively demonstrated that they are not to be trusted with the virtual printing press.
Not only have we seen the financial economy overgrow the real economy, bringing forth destructive bubbles and ongoing economic disaster, we have also seen the unseemly lengths the current system will go to preserve all this control. Risk-weighted asset optimization may be legal, but in the spirit of what equity capital is supposed to accomplish it is as much a fraud as outright theft.
If an organization is that close to violating its equity constraint that it would resort to such mismanagement, then the job that constraint was designed to do should be finished by putting the firm, and its inability to advance the real economy by making good and productive loans, out of our misery.
