The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Wednesday, June 29, 2011

Joye vs. McCrann round XXXVI: Does the RBA subsidise banks?

As is his reflexive predisposition, my old sparring partner, Terry McCrann, thumps me a few times in his News Ltd column today on the question of the RBA's liquidity facilities. I am quite sure I am right and Terry is wrong on this subject (notwithstanding my respect for Terry and belief he is the best rates commentator in media land). Anywho, we have exchanged some emails about this, and I thought I would share my latest response...
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Hi Terry, as I suggested earlier, you seem to misunderstand my point, so I will make it clearer:

1/In the *absence of* the taxpayer liquidity support, some banks would likely be trading insolvent;

2/ Ipso facto, in the presence of the liquidity support, there is no insolvency question (I take this as bleedingly obvious);

3/ The question I am interested in is whether these institutions would be insolvent in the counterfactual of no liquidity support, and the balance-of-probabilities (if not certainty) answer is emphatically yes;

4/ You are quite wrong on the question of the subsidy. As I explain in my article by directly quoting Dr Debelle, the RBA (taxpayers) provide banks with *below market* interest rates--Dr Debelle makes this very explicit and repeats the point several times--so there is, by definition, a taxpayer subsidy;

5/ The RBA does not deny this. Indeed, this is precisely why the RBA is proposing a "new charge" for its liquidity facilities, which has not existed before;

6/ The point about liquidity being a public good, which Gans/Joye first argued in Australia in 2008 (Nick Gruen has made similar points), is a technical observation that you can have 'market failures' whereby information asymmetries (eg, “I don’t know exactly what arrears/risks my counterparty bank has on its balance-sheet and will not, therefore, lend to it”) can lead to the evaporation of liquidity. On this basis, there is a role, as Gans/Joye argued at some length, for governments to step-in and supply temporary liquidity support to the system, which is exactly what the RBA does. This problem is exacerbated by the banking business model, which is predicated on inherent asset-liability mismatches, which makes banks vulnerable to insolvency/liquidity risks;

7/ The essential message I was seeking to deliver is summarised in the final two paras of my Business Spectator piece today;

8/ I would also suggest you read this section from the 2008 Gans/Joye paper (enclosed below).


The Public Goods of Liquidity and Price Discovery

The central tenet of this proposal is that a basic level of liquidity in key economic markets is a ‘public good’. The policy imperative here is reinforced by the fact that severe market dislocations, such as the credit crunch that we are presently observing, are becoming increasingly common and more quickly transmitted in today’s highly networked world. The presence and apparent regularity of these extreme events is consistent with recent academic innovations in the so-called ‘behavioural finance’ and ‘extreme value theory’ literatures.

In standard finance theory, academics, and the commercial practitioners that follow their prescriptions, have all too often made the erroneous assumption (for analytical purposes) that asset returns are ‘normally distributed’ (ie, virtually never subject to events like the 1987 stock market crash or the 2001 tech wreck) and that financial markets are ‘frictionless’—ie, investors always benefit from perfect liquidity and price-discovery. These are, by way of example, some of the essential assumptions underpinning the ‘Capital Asset Pricing Model’ (CAPM), which is widely used around the world by investors and their advisors. Up until recently, the assumption of perfect liquidity and return normality were condition precedents in almost all financial models used by financial market participants.

In the real world, however, investors are finding that they are increasingly faced with periods of profound illiquidity, extremely poor price discovery, and, in certain cases, complete market failure. In the financial market history of the last two decades, there are numerous examples of this illiquidity problem and governments acting to remedy it. In 1998 the massive hedge fund LTCM confronted severe illiquidity when the Russian government defaulted on its debt obligations, losing some US$4.6 billion in less than four months (LTCM was also hit by a sudden convergence in the ‘correlations’ of all of the assets it held, which it had previously assumed to be uncorrelated and hence well-diversified). Of course, at that time the US Fed acted to facilitate a bail-out of LTCM by a consortium of investment banks.

In the past eight months, major institutions around the world have been subject to the specter of extreme illiquidity in the market for many of their debt securities, which has in turn made price discovery near impossible (ie, how do you value assets for which there are virtually no prices, and when prices do exist almost all participants—including the regulators and government—agree that they represent dramatic deviations from any understanding of fair market value).

One of the primary problems here is that academics, practitioners, and regulators are discovering that financial markets are not always ‘efficient’ in the sense that was popularized by University of Chicago financial economists such as Eugene much macroeconomic analysis of the last half century.

More recently, though, pioneering academics such as Kahneman and Tversky34 —the former of whom received the Nobel Prize in 2002— and Richard Thaler have applied principles from psychology, sociology and anthropology to document that in practice people behave in a manner that can deviate strikingly from the equilibrium predictions of the efficient markets hypothesis (and rational expectations in particular).

This makes intuitive sense if we cast our minds back through history and consider the speculative fads and crashes of the Dutch tulip mania, the emergence of junk bonds in the early 1980s, the related 1987 stock market crash, the late 1990s tech craze and the inexorable tech wreck of 2001. Over the last 20 years a large body of evidence has built up illustrating that humans are fallible and subject to a wide range of biases, including irrational loss-aversion, framing, use of heuristic rules of thumb, hindsight biases, and cognitive dissonance (ie, avoiding information that conflicts with our assumptions).

Many authors, such as Barberis, Shleifer, and Vishny35 and Daniel, Hirshleifer, and Subrahmanyam36 have demonstrated that there can be major mispricings, non-rational decision making, and return anomalies in financial markets due to these behavioural biases. In particular, the tendency of humans to identify fictitious ‘patterns’ in otherwise random return sequences, and for us to be consistently ‘over-confident’ in our assessment of our own forecasting abilities, can result in significant market over- and under-reactions in asset price returns (eg, consider the tech boom and subsequent crash). Behavioural economists have also found evidence of the anecdotally well-known market phenomenon of ‘herding’ and ‘groupthink’ whereby strongly anomalous market-wide effects can materialise where there is collective fear and greed (again consider the wild and seemingly irrational—at least judging by the actions of central banks—swings in the risk appetites of global debt investors before and after the US sub-prime crisis).

It is now accepted by many economists that these behavioural biases that plague human decision-making under uncertainty can cause extreme asset price bubbles and subsequent crashes. In parallel with these innovations in the field of behavioural finance, academics have also started to accept that capital market returns are not ‘normally distributed’, but rather characterized by ‘fat-tails.’37 The presence of these fait-tails or so-called ‘black swans’ in asset returns, which suggests that extreme events (such as the 1987 crash or the current credit crunch) can occur with far greater regularity than the predictions of a ‘normal’ distribution, is also consistent with the tendency of investors to irrationally herd in one positive or negative direction, which can perpetuate clusterings of extremely positive or negative outcomes, such as that which we are observing today.

For better or worse, it would appear that recent regulatory changes that require institutions to ‘mark-to-market’ securities that they would previously hold to ‘term’ sometimes serves to further exacerbate these liquidity crises and entrench the associated market failures (since these institutions are forced to report losses and raise equity to supplement their capital on the basis of inaccurate prices that are an artifact of irrational investor risk-aversion and the consequent unwillingness to trade).

In the presence of highly uncertain prices, institutions are reluctant to lend to one another as they do not have sufficient visibility on the value of the collateral that they will use as security. This propagates potentially enormous problems for the financial system at large as transactions that were previously considered to be nearly risk-free are subject to perceptions of ‘counterparty risk’. This is precisely what happened with Bear Stearns, which on 10 March 2008 reportedly still had US$17 billion in cash. A few days later, the leading US investment bank Goldman Sachs announced to the world that it would no longer serve as a counterparty in Bear Stearns’ transactions. Goldman’s actions shattered confidence in Bear Stearns’ ability to service its obligations and meant that it could no longer raise any short-term debt funding to underwrite its working capital requirements. Once again, the Fed was forced to step in and inject liquidity into a market that had failed: in particular, the Fed took Bear Stearns’ otherwise illiquid and unpriceable assets as security and lent JP Morgan the US$30 billion that it needed to buy Bear Stearns.

In 2005 paper, economists Cifuentes, Ferrucci and Hyun Song Shin,38 argue:

"When the market’s demand for illiquid assets is less than perfectly elastic, sales by distressed institutions depress the market prices of such assets. Marking to market of the asset book can induce a further round of endogenously generated sales of assets, depressing prices further and inducing further sales. Contagious failures can result from small shocks… At times of market turbulence the remedial actions prescribed by these regulations may have perverse effects on systemic stability. Forced sales of assets may feed back on market volatility and produce a downward spiral in asset prices, which in turn may affect adversely other financial institutions…In this way, the combination of mark-to-market accounting and solvency constraints has the potential to induce an endogenous response that far outweighs the initial shock."

It should be clear that market failures and the absence of price discovery suggest that the provision of a minimum level of liquidity can be construed as a ‘public good’. While in practice it is hard for any good to unconditionally satisfy the two key conditions of a public good—namely ‘non-rivalness’ and ‘non-excludability’—many come close to approximating them (eg, the light from a lighthouse, clean air, and market infrastructures). It is well known that markets can fail to produce sufficient quantities of such goods, which is referred to as the ‘public good problem’. As a technical aside, there may be an argument that market liquidity is ‘rival’ but ‘non-excludable’, in which case it may be more appropriately classified as a ‘common pool resource’. In any event, you have similar problems to those found with public goods, albeit that in this case they are known as the ‘tragedy of the commons’.

The argument that market liquidity has public good characteristics is an increasingly well-understood feature of the academic literature. Schwartz and Francioni39 note that a number of different ‘exchange goods’ have public good qualities. They nominate ‘price discovery’ in financial markets, wherein transaction prices are like the beam from a lighthouse. The quality of these prices in turn relies on the effectiveness of the market’s infrastructure, systems, procedures and protocols, which takes the bids and offers and transforms them into market-clearing trades that give rise to prices. Price discovery is also dependent on how the exchange discharges its self-regulatory obligations. Schwartz and Francioni assert that an exchange’s self-regulatory obligations and the provision of supplementary liquidity are other examples of ‘exchangeproduced’ public goods.

Along similar lines, Holmstr√∂m and Tirole40 address the question of whether “the state has a role in creating liquidity and regulating it either through adjustments in the stock of government securities or by other means?” They conclude that when there are liquidity shocks and “aggregate uncertainty” the private sector “…cannot satisfy its own liquidity needs. The government can improve welfare by issuing bonds that commit future consumer income…The government should manage debt so that liquidity is loosened (the value of bonds is high) when the aggregate liquidity shock is high and is tightened when the liquidity shock is low. The paper thus suggests a rationale both for government-supplied liquidity and for its active management.”

The provision of supplementary liquidity and price stabilisation services by a government agency, such as we are seeing today with the RBA (on a limited basis that only ADIs can, in practice, benefit from), the US Fed, the Bank of England, the CHMC in Canada, or, perhaps in the future, AussiMac, is clearly consistent with the supply of the public goods of liquidity and price discovery. In short, these interventions are needed because the production of sufficient liquidity and accurate price discovery are not forthcoming in a pure market environment that is gripped for considerable periods of time by irrational investor behaviour—that is, by the complete closure of otherwise incredibly low-risk markets, such as the market for primary AAA Australian mortgage-backed securities. Importantly, the supply of liquidity and price discovery by these government agencies conveys non-rival and non-excludable benefits to all market participants.
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