The Fractal Character Of the Current Bank Run

Clearly the Federal Reserve disappointed global markets with its unoriginal update of Operation Twist. Those expectations of a third round of unbridled quantitative easing (QE) and intentional dollar destruction were unrealistic to begin with given the ongoing destruction in interbank lending markets. The current constraining influence of those past episodes of QE, taking too many U.S. treasury bills off the auctions and thus removing vital interbank collateral, made any attempt at another QE potentially fatal to the larger financial system.

If nothing else, the Federal Reserve under Ben Bernanke, divided as it has become, will be rigidly consistent in its prime directive of saving the financial system before all else. Partly this ingrained institutional impulse comes from its birth in 1913 as a mechanism to enforce money elasticity, meaning its primal task is and has always been to save the banking system, but the Fed also exhibits a rather unhealthy and exhaustive fixation on what it perceives to be the mistakes of monetary policy during the Great Depression.

There is no shortage of literature that assigns a great deal of causation of the 1930's collapse to the banking system's collapse, and the consequent reduction in the stock of money - the seminal work of Milton Friedman and Anna Schwartz. The stock of money has to be maintained, as current policymakers understand, lest the insipid effects of deflation begin to create the vicious and negative feedback loop of true depression.

However, even Friedman and Schwartz's work was partially incomplete since the size of the decline in the stock of money was far outpaced by the overall destruction in production (output), national income and prices. Whatever impacts the decline in the stock of money fostered, there had to be secondary impacts outside of simply creating deflationary price conditions.

Chairman Bernanke himself put forward in June 1983 his own explanation of these possible secondary reverberations:

"The basic premise is that, because markets for financial claims are incomplete, intermediation between some classes of borrowers and lenders requires nontrivial market-making and information gathering services. The disruptions of 1930-33 (as I shall try to show) reduced the effectiveness of the financial sector as a whole in performing these services. As the real costs of intermediation increased, some borrowers (especially households, farmers, and small firms) found credit to be expensive and difficult to obtain. The effects of this credit squeeze on aggregate demand helped convert the severe but not unprecedented downturn of 1929-30 into a protracted depression."

I believe there is a tremendous amount of insight here into the real world's intersection with credit intermediation. The failure of so many banking concerns destroyed, irrevocably, information that could have been very useful in alleviating the suffocating credit conditions of that period. Once a bank was closed, all its knowledge of local customers and idiosyncratic estimations of individual creditworthiness were permanently lost to the larger world.

If we believe intermediation to be most useful and vital because of this information gathering and analysis, essentially Mr. Bernanke profoundly describes a unique kind of negative productivity of the remaining subset of financial firms. In this way the negative shock of declining money stock and credit availability is amplified into a systemic underperformance of these most basic intermediation abilities.

With that in mind, I cannot help but wonder about a parallel process of negative productivity in intermediation today. Since the crisis in 2008, regulatory authorities throughout the world have taken a dim view of unbridled securitizations, and rightfully so. As a consequence of these negative perceptions of securitization on the whole, regulatory measures (especially FAS 166 & 167 in the U.S.) have been enacted or enforced to curb the practice, but instead have completely shut down almost the entire securitization pipeline (with the exception of the only GSE left relatively untouched, GNMA).

No doubt the lack of viable securitization models has contributed to the absence of credit production and scaling after 2008, but could it also be amplifying these effects in the negative productivity manner Mr. Bernanke described? No doubt some crucial lending information has been lost as the banking system has had to undo what took a few decades to construct. The entire marginal method of credit intermediation has been forcefully changed and I don't think it should be understated as to how much of an effect that is likely having on overall intermediation itself.

The prime example is interbank intermediation. As much as I personally believe that the geometric growth of interbank lending has been decidedly negative, especially how the banking system has become so marginally dependent on it in the first place, it cannot simply be undone so quickly without placing artificial constraints on the entire financial system. Eurodollars, Fed funds and repo have introduced an entirely new set of methodologies and logistics that have allowed the system to take off as it has. The repo market itself owes its primacy in interbank funding to securitization and its creation of security collateral.

In the blink of an eye in 2008 all that methodology descended into utter chaos. The information content of interbank intermediation was destroyed by reality in many cases, and by regulation in the remaining. It is tempting to simply dismiss this since the functioning of this model was flawed at its core, but it would be careless to disregard the fact that banks developed relationships and operational functionalities with each other along the lines of collateralized lending under those old terms.

In the stark light of post-crisis interbank lending, all those terms have been re-evaluated, and in many cases lost, into the abyss of securitization disfavor. Here again Mr. Bernanke's observations prove useful in that peripheral players in the interbank market now find themselves in the same desperate role of individual and small business borrowers in the early 1930's. In other words, banks that had come to depend on access to interbank funding are finding themselves now completely shut out because the collateral relationships (and the information content of those relationships) within that market have broken down.

Interbank intermediation is not providing enough information content dispersal to be useful and productive to a large enough cohort of banks (particularly of European origin and exposure) in order to properly foster the unfortunately vital role of interbank credit production and exchange. Another way of saying this, closer to Mr. Bernanke's own interpretation, is that overall interbank collateralized lending has become far more expensive than is denoted by traditional interest rate indications.

The implications here are even more profound than the rather straightforward extrapolation of a breakdown in interbank credit into a full-blown banking crisis. In terms of overall monetary policy and even our understanding of the governing dynamics of humans and money, the behavior of interbank money in 2011 in relation to cash money in the 1930's suggests an element of self-similarity between these two distinct types of money.

Without getting too much involved in a discussion of multi-fractal geometry, self-similarity is essentially a recurring pattern across multiple scales. If we think of the different classifications of money being our relevant scale here, then the parallel process of negative productivity of intermediation within both classes of money (and across time) is exactly the replication of pattern at different scales we would find in fractal systems. Given this possible exhibition of self-similarity, then the applications of random walk statistical descriptions and policies are wholly inappropriate.

Self-similar properties are particularly important as they relate to complex systems approaching, or in, critical states. For the banking system after 2008, the Fed's monetary "fixes" in the form of both versions of QE appeared, under the framework of random walk statistical evaluations, to have "fixed" the financial system. But if the element of self-similarity is at all valid, then the apparent financial functioning was nothing more than the illusion of a critical state system forming only a temporary equilibrium.

In this important regard, the practices of conventional monetary policy, and even conventional investment, are untenable to the critical state. This is precisely the point of the "Minsky Moment", where a system appears to be stable, but, remaining in a state of criticality, the longer the system appears stable the larger and more destructive the potential disaster.

For markets based on random walk statistical principles, this can be devastating since hedges will all be incompletely calculated and executed as true risks, properly defined outside of the random walk, are wholly and terribly underestimated. In terms of the investment world, this leads to institutional managers panicking when what they believed to be fully hedged positions are proved to be acutely ineffective by market actions thought impossible or exceedingly rare. So any market disruption is forcibly worse because of the adherence to randomness at a time when there is absolutely nothing random about the system.

In a far more troubling turn, these elements of self-similarity are being replicated across even more parameters and orders. Another important observation Mr. Bernanke made with regard to intermediation of the Great Depression was:

"However, in the 1930s, declining output and falling prices (which increased real debt burdens) led to widespread financial distress among borrowers, lessening their capacity to pledge collateral or to otherwise retain significant equity interests in their proposed investments. Borrowers' cash flows and liquidity were also impaired, which likewise increased the risks to lenders. Overall, the decline in the financial health of potential borrowers during the Depression decade further impeded the efficient allocation of credit. "

Again, this quote can equally apply to interbank credit today as to individual or business credit then. Our current banking crisis is succinctly summed up by the above quote as it relates to the breakdown of the perceptions of the ability to post and retain quality and unencumbered collateral. But it can equally apply to the abilities of nations to conduct their own ends of intermediation.

What we see now, particularly as represented by the problems PIIGS governments are having securing necessary credit to fund chronic structural deficits, is exactly what we saw in the Great Depression as it related to the fundamental breakdown in overall intermediation. Not only does this add to the weight of evidence of self-similarity at wider and different scales, it also adds to the idea of the complex financial system bouncing along within the confines of criticality - but never leaving that state.

As much as the Fed and other central banks are trying to avoid the mistakes they perceive were made eighty years ago, they seem to be captured by the same results of different orders. The explanation and implications could be far more profound than just a complex system refusing or unable to exit criticality. In my opinion there is little doubt that the single element of constraint on the financial system within criticality is monetary policy itself.

Beyond the mathematical ideology of a supposedly random world, there is a concurrent belief in the neutrality of money at longer time scales. In other words, monetary policymakers believe that monetary policies have no direct effects on the real economic world beyond the short-term. They can influence prices and money supply, but not real world income and output over the long haul (thus the economy largely moves in its own direction, i.e., potential).

In that same 1983 paper, Mr. Bernanke described the modern puzzle that monetarists have with the financial system's effects on the real world:

"One problem is that there is no theory of monetary effects on the real economy that can explain protracted nonneutrality"

The tragedy of that belief is that it is so easily seen to be false in the thousands and thousands of vacant condos lining the shores of Florida's beaches (and in far too many locations beyond). Not all economic activity is created equal. Economic flow predicated on the price action of assets is wholly dissimilar to economic flow based on the solid and stable income of long-term employment. The former can lead to massive misallocations and waste of scarce resources, as the housing bubble so amply showed. The monetary forces of malinvestment are all too real, and in the real world where resources are scarce and businesses are subject to real conditions of sustainable profitability, artificial economic flow due to protracted nonneutrality can be very damaging to the real, long-term prospects of real production, output, income, etc.

In terms of the financial system, adherence to the idea of long-term neutrality has created a system where its entire health is completely dependent on monetary policy being always and everywhere correct. It is simply an extension of the central bank system of controlling interest rates through Fed funds (and thereby LIBOR and repo). The interbank market grew out of the central banking theoretical constructs of how a centrally planned system should function. In one final insult of further self-similarity, the global banking system itself is a pattern of central banks at an outward, larger scale.

The monetary belief against protracted nonneutrality is incorporated within the very bedrock assumptions of global finance. So Wall Street can grow as large as it wants (as can its behemoth European cousins on their eurodollar diet), enter as many different types of financial markets or forms as it wants, and largely dominate the economy out of this mistaken view that said economy will operate as it can and should wholly and completely independent of policy effects on all forms of money. If Wall Street's size and composition has no long-term bearing on the larger economy and the real world, it can then take on any size and composition. Without considering protracted nonneutrality, there are no theoretical constraints to credit growth.

Therein lies the paradox of the modern monetary age. The more the Fed tries to fix the banking system, the more it constrains it within a state of criticality. And owing largely to the myth of protracted nonneutrality, the critical state banking system keeps the real economy in an equally self-similar critical state. Even something as relatively innocuous as the interbank money markets can place amplified strain on the larger role of total intermediation in the real economy. Just as the negative productivity in intermediation of the Great Depression led to a larger economic shock than otherwise would have formed, our current entangled system's episode of negative productivity ensures continuing dysfunction far and wide, within finance and, devastatingly, the real world.