Bank Balance Sheets Are the Ancient Black Ocean
It’s very easy to personalize the failures of the last decade as the sins of one man. In that way, Ben Bernanke has done himself no favors. He has remained resolute in his stance, to the point of irrationality. Despite committing some of the worst mistakes, to hear him tell it there was nothing that could have been done differently, and what was done was successful. Yet, time and again his own words defy that very notion.
Everyone remembers “subprime is contained” and for all the right reasons, too. It betrayed his ignorance as well as conceit, an overconfidence that at that moment was totally unearned as it was untested. You could argue in his favor that given his position and the lingering myths surrounding it he had no other choice but to project nothing short of full confidence even if he didn’t privately really have it himself. But in doing so it had more of the qualities of Captain Smith going down with the Titanic than J. P. Morgan stepping in to save the US from another depression in 1907.
Perhaps Bernanke’s worst pronouncement came several months later. Practically no one remembers an otherwise nondescript press release issued on July 20, 2007. The world had been moving toward Basel 2 in fits and starts, an uneven implementation made messy by the very nature of the thing under scrutiny. On that date nearly a decade ago, US authorities finally reached a general understanding about how adoption would proceed in this country.
It was, as usual, no easy challenge on any side, not the least of which due to the regulatory structure. There were no less than four primary agencies responsible with often overlapping areas of concentration. There was the Federal Reserve Board of Governors, the Office of Comptroller of the Currency, the Office of Thrift Supervision, as well as the Federal Deposit Insurance Corporation. The debate among the agencies is its own topic worth full dissertation, but that will have to be for some other day or for someone else more politically predisposed.
Having reached a practical outline, Dr. Bernanke adopted his usual self-assured posture:
“I’m pleased that Governor Kroszner and the policymakers representing the other banking agencies have reached a consensus, one that will pave the way for implementation of a modern, risk-sensitive capital standard to protect the safety and soundness of our large, complex, internationally active banks.”
Three weeks later, the large, complex, internationally active monetary system blew apart for good, that which was the subject of this very statement even if those who wrote it didn’t realize it. Even Basel proponents argue that it would not have achieved anything close to what Bernanke proposed, for that is why almost immediately after the crisis Basel 2.5 and then Basel 3 rules were constructed. Worse, however, the Europeans had adopted Basel 2 several years before and their banking system performed farther from ideal than anyone else’s; indeed, it was the very epicenter of the whole crisis, and in “dollars” no less.
The intention here is not pile on an easy target, to further demonize Ben Bernanke as thoroughly as he might deserve it, but to use him as the prime example for in general terms what has gone consistently wrong. The crisis begun more than ten years ago has not yet finished, besides the considerable effort to extinguish it. Those have all failed and for these very reasons; its very nature remains almost completely misunderstood by the people who were once believed capable of almost perfection. The contrast is so striking and offensive to conventional sensibility that it is so often simply dismissed out of hand; how could the heir to the “maestro” be on the wrong end of everything, not just in the panic events starting in 2007 but right on through to his last major acts in QE3 and QE4?
Dutch economist Nout Wellink is President of De Nederlansche Bank, a member of the Governing Council of the ECB, a former Director on the Board of the Bank for International Settlements, and Chairman of the Basel Committee for Bank Supervision. Writing in September 2009, the man more inside of banking regulation than perhaps any other human who has ever lived wrote:
“The financial crisis is without precedent in this generation and likewise so has been the official sector response. In formulating responses to the financial crisis, it is necessary to address both the near term challenges related to the weakening economic and financial situation and the long term regulatory structure issues. The two are linked and it is important to manage carefully the transition from current measures to a more sustainable long term framework.”
Is it possible to write out a more damning assessment? The combination of modern bank regulations plus long sought central bank “flexibility” was supposed to make these bank panics wholly impossible. And that is what each and every one of them believed beforehand, too. All of the best DSGE, GARCH, ARCH, etc., models calculated that something like 2008 was specifically impossible. It was not so much a tragedy as travesty.
The whole point of Basel regulations is on the one hand much of the reason why it all went so wrong, while on the other hand correct in at least attempting to address what was and remains really at issue. It seems like such a simple thing, yet for all that has been done over the last several decades nothing has really come close to achieving it. The proof is all around us right now, the huge hole in the global economy blown through by the impossible panic of 2008 and then beyond every single prediction no recovery at all from it. There is as yet no answer to what should be the most basic question; what are banks actually up to?
Having observed monetary officials from all around the world very closely all through this time, I am hard pressed to believe that any one of them has ever attempted to read through a full bank balance sheet, notes and all. This is not really a charge against them so much as an impeachment of their system, one that as in the person of Bernanke matches arrogance with ignorance, the most dangerous combination in the human arsenal. What banks produce for public consumption are by and large worthless pages. The accounting rules governing corporate good practice are ill-suited for the task, and it shows.
There is relatively more information in the “notes” to the bank statements, which isn’t really saying much. The published balance sheet is itself more misleading than anything, which gets us back to the Basel rules. Capital adequacy has been the major feature of them from the very start, but the various capital ratios told us absolutely nothing about actual risk of each enterprise, and therefore the systemic dangers grown out of them.
In mid-March 2008, US Treasury Secretary Hank Paulson is reported to have telephoned Bear Stearns CEO Alan Schwartz, telling him bluntly, “Alan, you’re in the government’s hands now. The only other option is bankruptcy.” This despite the fact that the bank reported in April 2008 within the multitude of pages comprising its final quarterly 10-Q:
“At February 29, 2008, Bear Stearns, BSSC, BSIL, BSIT, BSB and BSBTC were in compliance with their respective regulatory capital requirements. Certain other subsidiaries are subject to various securities regulations and capital adequacy requirements promulgated by the regulatory and exchange authorities of the countries in which they operate. At February 29, 2008, these other subsidiaries were in compliance with their applicable local capital adequacy requirements.”
The firm was in full compliance and though it has been placed for posterity in the category of bank, Bear Stearns was not really one. It’s a classification difference that used to matter, though it doesn’t appear as if it did enough for either these non-banks or the regulators allegedly watching over them.
On September 25, 2008, the Inspector General of the Securities and Exchange Commission, H. David Cox, prepared for that agency’s Chairman the results of an audit conducted on the matter of Bear Stearns. Cox writes in the dry, banal tone of bureaucracy:
“The Commission stated that Bear Steams' unprecedented collapse was due to a liquidity crisis caused by a lack of confidence. Chairman Christopher Cox described Bear Steams as a well-capitalized and apparently fully liquid major investment bank that experienced a crisis of confidence, denying it not only unsecured financing, but short-term secured financing, even when the collateral consisted of agency securities with a market value in excess of the funds to be borrowed.”
It is the dirty secret that exposes the last half century, including not just the Great “Inflation” but also the Great “Moderation” with it. All the focus with regard to banking shifted almost exclusively to bank assets. Basel regulations were predicated on using the asset side as a prism to filter out good banks versus bad banks, the very idea floated all along that in this line of thinking explained the almost regular occurrence of bank panics throughout the 19th century and on into the 20th. Unable to distinguish the good from bad, the solvent from the reckless, the public would indiscriminately withdraw money from everyone leading to a general run and in almost every case economic depression.
But here in the 21st century we find an event (as well as others) of an alarmingly similar nature without the public’s involvement much at all. An otherwise “good” bank was put out of business, realizing in almost every statistical data set that matters the proverbial last straw for the global system. Money is a bank liability, and try as they did to make it about assets and their very narrow relationship to capital, the 2008 event, begun in 2007 with subprime, was always, always about the liability side; the money side. Policymakers, regulators, and so the public had no idea what was going on; they were all completely baffled, and sadly for all of us they still are.
We call it liquidity but in truth it is that way because the term “money” just doesn’t seem to fit. The whole concept has become so fungible that, as Alan Greenspan explained internally in June 2000, even those whose specific task it is have trouble defining it. This is not a new challenge, of course, which is one reason why the global regulatory regime shifted to the asset side in the first place. Being no longer able to define money, it was simply believed they wouldn’t have to by focusing on what banks did with funding no matter how it was obtained or, more importantly, in what format and form.
There were any number of warnings as to the imprudence of this approach, including, ironically, the S&L crisis which in many ways was attributable to the modern liability side construction of what were supposed to be traditional banks. In 1997, LTCM was practically a dress rehearsal of 2007, the perfect opportunity to witness up close the large, complex, internationally active monetary system moving past its formative stage into fully embraced adulthood. Recency bias instead prevailed largely on the strength of a cult of personality, that of the enlightened, nearly omniscient central banker.
We now have a regime adopting Basel 3 rules meant to address the shortcomings somehow only revealed in the hindsight of Basel 2. Liquidity coverage ratios are supposed to be reassuring in the same way that capital ratios were in July 2007. And yet, bank accounting and reporting is the same today as it was then. We have no better idea what they are doing now, funding and otherwise, than on the day the whole thing failed. How can that be?
At the risk of being immodest, my own experience in this regard is nonetheless instructive. I have through the expense of a great amount of time and effort been able to translate some of these official bank reports into useful information, without any aid whatsoever from the official sector that remains steadfastly attached to the same approach and philosophy. If the goal is transparency, being able to tell good from bad, then it has completely failed on several levels.
On an individual basis, the panic of 2008 showed that very well. More problematic for the longer run is this continued inability to define the whole nature of global money and how it actually works. Because the aspects that truly matter (not bank reserves) are the things that are off in the notes of bank reports there isn’t really an easy method for compiling let alone quantifying. Shared interpretation is exceedingly difficult if not almost impossible, especially for the unfamiliar. For my own purposes, I have used gross notional derivatives as one proxy for both individual bank behavior (not exposure) as well as an aggregated view of the whole system.
Bank reserves are simply assumed to be a monetary substitute for all bank liabilities, the overly simplistic reaction of monetary policymakers stunned by it all. It dismisses the intricate texture and interlocking behavior of various forms that at various times exhibit themselves currency-like characteristics (repo collateral, for one example, referring back to the SEC Inspector General Report).
As the level of bank reserves exploded in four successive QE’s, no one seems to have lingered too long on the question of why if bank reserves were a sufficient liability substitute there had to be four successive QE’s. Quite against the rise in that one form of liability, others were instead shrinking, derivatives in particular. Even though in the form of gross notional values the measure is heavily weighted toward interest rate swaps, that is still a constructive view on bank behavior as well as a decent proxy on monetary sufficiency derived from it.
The numbers are astounding, as I have chronicled many times before. Despite “reflation” in later 2016, banks are still reducing their derivative footprints and still to an unnerving degree. According to the Office of Comptroller of the Currency (OCC), total gross notionals among US commercial banks and bank holding companies was in Q1 2016 $192.9 trillion. At the end of Q4, it was $165.2 trillion, down nearly 7% in each the third and fourth quarters despite significant improvement in sentiment and otherwise. In the third quarter of 2014, the start of this “rising dollar” period, gross notionals summed to $239.3 trillion, meaning they have contracted by almost a third during it.
Perhaps more amazing and relevant to our woeful economic condition is the distribution of them by individual firm. The domestic banking system is populated by really only four major derivatives dealers: JP Morgan, Citigroup, Goldman Sachs, and Bank of America. JPM was at one point in a class by itself, which makes a lot of sense when you consider that bank’s place in the dealer system (and why it was involved directly in every major failure and near-failure of 2007 and 2008). But Morgan’s derivative book, this off-balance sheet proxy for more comprehensive unmeasurable behavior, peaked long ago in the third quarter of 2007 (the one containing both July 20 as well as August 9). At $91.7 trillion then, the latest OCC report shows the bank with just $47.5 trillion for Q4 2016.
The other three dealers have produced similar results in proportion if not the timing of them. Bank of America, for example, kept adding to its derivatives after 2008 but only until 2011, Q3 to be precise. There was the absorption of Merrill Lynch to consider, but the overall trajectory of its book was nevertheless established anyway, but only until the 2011 crisis was in full swing; another “liquidity” event of jumbled and indefinable monetary characteristics despite by then almost $2 trillion in additional bank reserves. The scale of BofA’s retreat is likewise truly remarkable, from a peak in 2011 of $55.1 trillion to the latest report totaling just $21.1 trillion.
For Citigroup and Goldman Sachs, they were adding to their positions through both 2008 and 2011 only to abruptly reverse unsurprisingly in Q3 2014. As to the latter, the continued rise was far more restrained. Citigroup, at least by OCC’s count, was in the post-crisis era nakedly aggressive. From a low of $29.6 trillion in Q1 2009 when it was receiving the bulk of its government assistance, the largest for any US bank, by Q3 2014 Citi had managed to overtake JPM, registering $70.2 trillion.
That’s a problem for several reasons, including those of accounting. If you go to Citi’s 10-Q for Q3 2014, under derivatives, again found only in the Notes accompanying the reports, the bank shows $61.5 trillion as “Trading Derivatives”, an additional $165 billion as “Management Hedges”, and $275 billion classified under “Hedging Instruments.” Or about $8.6 trillion less than what the OCC derives (pun intended) from call reports filed by the very same bank.
I’m guessing that the reported total to the regulator is the more accurate figure, at least depending on how we define “accurate.” I also have no doubt that Citi would object to that contention, claiming in its defense that its statements filed with the SEC are full and faithful, which is almost certainly true. It can be both numbers simultaneously because bank reporting and accounting is effectively medieval, developed for a world that hasn’t existed in majority for half a century. For all that has happened, we really don’t know what these banks are doing (and, as I often further contend, they often don’t know themselves).
We are left to generalize and translate on an ad hoc basis, starting out in the dark and experimenting with interpretation. At least, however, in experimenting that way it develops a more robust paradigm that the official rules never, ever achieve, based as they are on pure assumption and too often fantasy.
Though we can’t know for sure the size of Citi’s derivative book, or any of the others, we can be reasonably sure that since Q3 2014 it has retreated with astonishing speed. Using again the OCC numbers, from a peak of $70 trillion to but $43.9 trillion in just over two years. Goldman has done the same, though again on the way down far less enthusiastically just as on the way up.
Some proponents of the post-crisis regulatory updates attribute these results to prudence injected by the latest broad set of them, including Basel 3. But this one sample completely refutes that interpretation, for each bank chose retreat at a different time; again, JPM in 2008; BofA in 2011; Goldman and Citi in 2014. Regulations cannot be the common theme, though what is is clearly “dollars.” All three years are notable primarily for sharp often drastic changes in “liquidity.” Each of the four banks, as well as individual foreign eurodollar banks not included in the OCC cohort, arrived at the same conclusion with regard to their behavior after a variable number of monetary proofs (meaning some are, or used to be, more stubborn than the others).
Before 2007, all banks were expanding rapidly but after 2008 only a few, and after 2011 one less before finally after 2014 none. Stripped of risk-taking bank balance sheet behavior the global economy is ratcheted downward, each time suffering the strain and then conspicuously failing to recover from it. The current economy is so far proving it for a third time, for though it is better this year compared to last there is “somehow” no symmetry or momentum over a year beyond the downturn’s trough. Liquidity preferences still rule all over the world, “reflation” sentiment or not.
Humans have been living beside the ocean for as long as there have been humans, yet we know surprisingly little about what is down there underneath the waves. The analogy applied in the context of bank activities is apt, though at least in terms of oceanography some scientists are curious and able enough to attempt discovery and be quite successful at it. In monetary economics, there is nothing. You would think that people like Bernanke would have developed a burning passion to demand real answers after being embarrassed by how it all went wrong, why they are more the subject of scorn and derision than their self-assigned profile in courage. Nope. They prefer instead to remain unconscious so long as it keeps them in the business. Bank balance sheets are the ancient black ocean, with sea monsters ominously lurking in the vast shadows and hidden reaches.
