'No More Banks' Is the Worthwhile Goal

Story Stream
recent articles

This week marked the fifth anniversary of Dodd-Frank, the omnibus regulatory response to the last financial event. The law still has supporters, of course, but its praises are quite thin and scattered. Critical scrutiny, by contrast, is in no short supply. The reason for that varies as much as its reach, as after five years many of the important "rules" remain to be finalized or even written. In trying to answer every financial irregularity about 2008, Dodd-Frank has become, or intended to become, a part of nearly everything.

The reason for that is relatively straightforward even if still obscured by focusing on complexity; regulators don't understand banking. The law treats a bank as if it were an institution clawed out from the 1940's movie It's A Wonderful Life, unfrozen and reanimated full of simple depositors and the kinds of characters that could not imagine hundreds of trillions in interest rate swaps (or even hundreds of trillions, for that matter). That is why the Volcker Rule is contentious, as it "seems" proprietary trading doesn't fit the mold yet it "somehow" makes sense if only in snapshots of disorder.

Only recently has bond liquidity become something of an ongoing topic, a few years late for all that it would matter. In discussing what is really a dangerous incongruence, commentary will often turn to Dodd-Frank as if it were the sole factor; it is but only in what can be tangibly applied to an almost exclusively hidden and dark system. If Dodd-Frank is at least partially responsible for the systemic decay it is because there are no more banks.

According to the Competitive Enterprise Institute, the FDIC approved, on average, 170 new banks per year before July 2010; since Dodd-Frank regulators have approved exactly one, total. That fact by itself affords no judgments, as it isn't perfectly clear that, in a vacuum, more banks make a better system - in fact, given serial asset bubble circumstances, I would argue vehemently that less banks is far more a worthwhile goal. But we do not exist in a vacuum and the opportunity to reform in that direction has been now completely lost as each and every official effort around the world has gone into maintaining the same financialism that existed before the crisis. Therefore, "no new banks" is a huge problem.

It is not often that these more inherent flaws can be so easily quantified, but the attention on systemic liquidity has produced an almost plethora of numerical anecdotes on the subject. In Bloomberg last week, for example, RBS was quoted as calculating bond liquidity now as some 90% below (in Europe) what it was in 2006 for "credit markets" (the article was not more specific about geography or segment). The trend in liquidity long predates Dodd-Frank, though this is not to say that the law hasn't had these claimed negative effects.

And these implications are, and almost certainly at some point will be, dire:

"‘Without enough strong liquidity, it's hard to execute bond trades in sufficient size or price to move portfolio risk around quickly or cheaply,' he said [Mike Parsons, head of U.K. fund sales at JPMorgan Asset Management in London]. ‘The bigger the position, the harder it is to find enough liquidity to sell it or buy it.'"

With conditions relatively benign and position concentration already a problem, it takes very little imagination to understand what that means for even slightly less benign circumstances; let alone when the entire herd tries to turn.

"NN Investment Partners said it seeks to manage difficult trading conditions by diversifying positions and capping trade size. The Netherlands-based asset manager avoids owning large concentrations of a single bond and uses derivatives such as credit-default swaps or futures that are easier to buy and sell, said Hans van Zwol, a portfolio manager.
"'We really want to stay away from positions we can't get out of,' he said."

As prudent as that suggestion sounds, "stay away from positions we can't get out of", sheer numbers in bond funds alone more than suggest that isn't a widely shared investment theme. While immediately the reference to credit default swaps will conjure up mostly forgotten images of AIG, Bear Stearns and "toxic waste" more broadly, the reason for that is inherent in the financialism that provides the basis for what banking has become. These derivatives are not just needless inventions of a greedy Wall Street, they are every bit as much actual and viable currency as the quaint notions of physical dollar bills that govern the "financial reform" set about half a decade ago.

The wholesale banking system, of which the eurodollar standard is one expression or form, has been called shadow banking rightly because it is dark and unseen by the vast majority. Because of that, there is little appreciation for exactly how it all works and why. Again, this would be almost a moot point if official and legitimate intent (the people's) were set upon dismantling the abomination, but they aren't; they are trying, desperately at times, to rebuild and restore it. That means, in practical terms, not ignoring what made it appear to work in the pre-crisis era, which include all manner of "distasteful" elements such as credit default swaps.

In cosmology, there is a concept called "dark matter" (as well as dark energy). It cannot be seen but we know it is there as it actually accounts for most of the matter in the universe. The universe would not exist as it does nor would it work as it does with this "stuff" that cannot, as yet, be proven or really described. In wholesale finance, bank balance sheet factors, traded and chained liabilities of all kinds, function equivalently to dark matter; a sort of "dark leverage" that cannot be quantified by conventional means, yet it is there, immense and essential. Without it, the whole works fall apart (as "they" are now just starting to take account with finally, belatedly recognizing systemic liquidity).

To understand and appreciate the concept you really have to understand and appreciate that the dollar is no more. The conventional date of death is usually stated as August 15, 1971, when Nixon "closed the gold window", ushering in the age of fiat, but the transition began long before that. The dollar was becoming the "dollar" as early as the 1950's, though there is no way to pinpoint the exact transformation. That Nixon was "forced" to default was just the last step, the conclusive proof that the former and traditional dollar had already been made untenable (at least as far as the US government was not willing to abide by financial and market discipline any longer).

For a time after August 1971, nobody really knew what would follow; it was almost a Wild West of currency. There was the Smithsonian Agreement which tried to impose some common standards, but it was short-lived. Then, suddenly, there were no longer any questions as if the "dollar" just started to be what it was (almost as if, staying within the cosmology analogy, it were a singularity). Some people hold to the convention that the rise of the petrodollar was responsible and came to be what the reserve currency system is even now, and that is partially true but far too incomplete to appreciate the evolution. The petrodollar presupposes that there are physical amounts of currency circulating from the US to oil producers to banks in London, forming the basis of an international currency regime. The truth is that while that framework is correct, it assumes the wrong order or even that the "petro" part is at all necessary.

Under the traditional banking arrangement people or businesses deposit something, a physical quantity, at a bank which then lends out in a fractional ownership situation. That is what Dodd-Frank largely conceives and still forms the basis of most common perceptions about banks. In that arrangement, the bank is noteworthy for a supply of credit and debt but is mostly relegated to a background role of safe-keeping property. It was only by entangling money into finance, out of property, that this arrangement changed.

Under the traditional gold standard, central banks engaged in swaps (especially in the 1920's, relevant to the 1929 crash and beyond) and other forms of financial bypasses, but by and large banking was that act of custody and accounting. Money was moved from one account to another, often a physical vault, which meant, again, property. If a bank failed, property remained property, disentangled from the idiosyncrasies of whatever financial factors led to the bankruptcy. Individual banks were no more important than the corner grocer; it was the cluster of failures that was always the issue.

That meant that authorities longed to treat banking as a whole rather than its individual and disaggregate parts - that is, after all, the entire point of "currency elasticity" from the ground up. To socialize banking meant that money itself had to be similarly socialized, away from individual property rights, and the transitions in the 1950's and 1960's accomplished it. What came out of that age was the eurodollar, at first received hostilely by the Federal Reserve and Treasury. But by the 1970's, it was embraced as the great answer (as it had already been embraced by foreign central banks wishing to source "dollars" without having the actual trouble of finding them).

Foreign trade would no longer be financed by physical money or physical anything. Bank balance sheet ledgers were the "source", and they were entirely pliable and far more easily coerced. The reason the petrodollar nomenclature is incomplete is because what replaced the Bretton Woods gold exchange standard was not a London-based pool of physical Federal Reserve Notes attained via the oil trade deficit, but rather a credit-based system of no physical anything anywhere. Eurodollars are created by eurodollar banks without any official backing, save one; the regulatory treatment of eurodollar liabilities as equivalent (or nearly so, as it was until 1990) and substitutes for US banks from their foreign subs.

Without focusing too much on the logistics and operational mechanics of that, in general the difference is astounding. In a true, hard money system it is money itself that is vital, with the banks as at most a secondary tool; in this new credit-based currency system it is the bank and its balance sheet that has attained supremacy.

The effect of technology and regulatory evolution in the 1980's and 1990's was to expand the ways in which bank balance sheets could themselves expand. As I have detailed before, that has meant in many circumstances, especially applicable today, math-as-money. The general ability to transform calculations is typically expressed in derivatives trading; moving one or more elements of "risk" via liability (and corresponding asset) transactions. This is dark leverage.

Leverage in its most basic and customary form is easy to grasp. Even traversing one step toward dark leverage, it still holds at least some of the basics. For example, a repo trade itself is one form of quasi-leverage. Depending upon the haircut, you put down a piece and borrow the rest. If you get a 2% haircut on a UST trade, that means you put in 2% of your own money and borrow 98% of the proceeds (which is done simultaneously, so long as your account and the repo custodian's balance by the end of the trading session). That is 50-to-1 leverage from your side, but from the perspective of the other side, the "lender", it is murkier. The cash owner will, in the course of regular business, also make concurrent use of securities to fund other, internal operations which has the effect of reducing funding costs and even increasing "capital" efficiency in other areas. Thus, leverage is extracted upon both sides of a repo trade, especially in high churns of rehypothecation.

The further into the wholesale, eurodollar rabbit hole you progress, the less it all makes straightforward sense; the more dark this dark leverage becomes. There was a hedge fund that operated in the midst of the "golden age" (an ironic term to be used this way) of the eurodollar standard called Primus Guarantee, Ltd. The founder and CEO was Tom Jasper, who in the 1980's was responsible, in good part, for derivatives as they are now, creating and leading ISDA.

Primus Guarantee at the end of 2005 ran a reported balance sheet of just $673 million. On the liability side, there was only $200 million in debt and $361 million in "equity" (of which $265 million was additional paid-in-capital). That visible balance sheet supported $13.5 billion in credit default swaps written on 535 single-name entities. The fund had cash and liquid investments of just $629 million of which to pay out any claims, which were judged to be minimal given that most of these single names were AAA-rated (and banks).

Those credit default swaps were used as hedges against financial positions taken by financial firms all throughout the wholesale system; hedges and risk management processes that undoubtedly allowed, via math, those counterparties to greatly expand their own leverage ratios in practice to a degree that cannot be calculated. A firm wanting to buy, say, $250 million in corporate credit positions as a basis was able to buy significantly more when the position was hedged with offsetting "protection" written by Primus. That was the basis for the explosion in subprime structures and "products", as without "protection" it would all have been calculated as too risky and too "inefficient" in terms of the modern sense of capital. It was all really based on this risk transformation, the traded liability of risk absorption done via derivative transaction; premised on something that isn't even contained on any balance sheet.

How much leverage is there in the chains of liabilities I just described? Really, what is even the leverage in all that? Primus gave out a claim which afforded counterparties essentially bigger numbers; no cash, just fuzzy transactions that don't conform to traditional ideas about even balance sheets.

This has been an argument in bank regulations itself for some time, as there isn't a clear way to describe massive derivative positions. Too often that becomes entangled in the numbers, which has the effect of misdirecting attention toward something that is entirely unhelpful. For example, at the end of 2008 when Bank of America "absorbed" Merrill Lynch its combined derivative book contained a reported (don't get me started on what might be going on in between reporting periods) $64.5 trillion in total gross notional interest rate swaps. Most people are stopped right there, glued to the $64.5 trillion despite the fact that the number itself holds very little meaning. Reported gross notionals are unimaginably huge, but they do not mean individual dollars or even "dollars."

These numbers are not one-to-one translatable into currency, instead offering only a relative measure of dark leverage capacity. If you want to find the panic in 2008, really find it, look no further than the changes in gross notionals for credit default swaps then. The Office of the Comptroller of the Currency (OCC) reports that in the third quarter of 2007 total gross notional credit derivatives, of which CDS are the main part, totaled $15.4 trillion. The OCC does not give specifics about asset classes (how much was tied to ABX or subprime? Nobody will ever know and in the end it really doesn't matter) but what is important is that gross figure was up from $12.9 trillion at the end of Q2 2007, and only $1.2 trillion at the start of 2004!

At the end of Q1 2008, total gross credit derivatives had grown, but only to $16.4 trillion as the spread of dark leverage had come almost to a grinding halt. Again, the trillions is not quantitatively the measure of leverage but only a means for comparison of what that might practically be. By the end of Q2 2008, after Bear had hit its wall, gross notionals had actually declined to $15.5 trillion which meant that dark leverage was not widely available at the moment it was needed the most - the panic was on, only smoldering in wait of a rush of oxygen (selling).

While the OCC only measures domestic "exposure", the Bank for International Settlements (BIS) estimates gross notional for all major banking; thus incorporating foreign elements and banks of the whole eurodollar system. Their figures show it worse than the OCC, which matches what actually happened in 2007 and 2008 - it was largely a foreign affair, centered in London along the geographical "dollar" divide.

Understanding that dark leverage component to the panic in 2008 and understanding that it is bank balance sheet construction that actually replaced the gold standard, you can begin to appreciate why liquidity and financial order are "unexpectedly" in such short supply now. While credit default swaps were the first order of dark leverage during the housing mania and then the panic, interest rate swaps have become seemingly the primary balance sheet control factor thereafter. All the data from individual banks, with only a few exceptions, and the aggregate estimates of the BIS and OCC show that IR swap capacity is falling - and rapidly since the "dollar" started to rise just over a year ago.

Whereas BofAML had $64.5 trillion in IR swaps gross at the start of 2009, the bank only reports $36 trillion as of Q1 2015. All of that decline came after the middle of 2011, which matches what we see in both the BIS and OCC figures. That suggests that the eurodollar standard was, in fact, starting to be rebuilt until it stumbled upon the euro crisis (which was, and is, as much a renewed "dollar" crisis). There was hope in that initial burst after the panic, but it has all reversed irretrievably, despite two more QE's and the ECB's constant attention, in the years since. The dark leverage reverses, which means banking reverses and no longer provides the same amount of resource support, by far, that it did at the outset of panic nearly eight years ago.

As noted above, that wouldn't be such a problem if the orientation of finance and regulation were set upon dismantling the wholesale system in full or in good part. The dealer network that provided all this "liquidity" and dark leverage is a shell of what it used to be, replaced in what was intended to be temporary by central bank balance sheets that are even more inefficient and irresponsive to immediate needs. In other words, the dealers exited starting in 2007 and it was central banks that ultimately filled that void; but only after it was all over (always behind the curve, not the least of which is due to this very discussion about misunderstanding the very basic nature of the modern bank). There is nothing waiting with which to take their place, though some have posited that money market funds will be the central vehicle.

That might be the case (a big "if") but that does not account for dark leverage and chained liability transformation capabilities. Liquidity is multi-dimensional and money funds only form one part of one dimension - what passes for cash these days. If liquidity, and really systemic capacity, is dangerously low, then it is the unseen dearth of dark leverage.

As I have said and written since October 15, we note this deficiency mostly outside the domestic experience. Brazil, Russia, China, etc., can all attest to "dollar" problems, and quite severe disorder as a result. October 15 here in the US should have been a resounding alarm, but instead it is swept away as some computer-trading effect lasting only 12 minutes by all the authorities and agencies (including the Treasury, Federal Reserve Board and FRBNY) that have vested interests in looking the other way and proclaiming only "resiliency" and successful rebuilding.

It is human nature to see in the past what might come in the future, and I have wondered along those lines of late. From an eerie, concerning and very unnatural repeating repo rate to other concerning factors beyond what I have catalogued here, I often cast attention toward history rhyming. Everyone is looking out for the next "Lehman moment" and while I am sure there hasn't been one and there is likely not to be another one in that form, the concept is almost certainly to repeat. In that respect, might October 15 have been the next August 2007? Might January 15 been the repeat of Bear Stearns? The Swiss franc upset was perhaps more dangerous and damaging than Bear Stearns ever was, beyond even the fact that gross notional derivatives have crashed in the past few quarters at an even faster rate than early 2008.

If this were just a minor recurrence reset by some fundamental reassurance since then, those lingering doubts would fade with history. But everything about the "dollar" since the really October 15 has gotten appreciably worse; copper crashed to a new cycle low yesterday, as crude prices have returned to the $40's. The Brazilian real almost smashed 2.30 to the dollar, gold is cycling down also to new multi-year lows and the treasury curve is once more acting like it did between October 15 and January 15 (and many, many more indications along those lines).

Maybe, in the end, this will all amount to an uneven transition from what once was to whatever will eventually take its place. That much is certain, in that there can no longer be banking as it was prior to 2007 and that the "dollar" isn't really viable beyond its current central bank basis. On the other hand, the events of the past year, six months in particular, may also be another warning.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

Show commentsHide Comments

Related Articles