Mervyn King, Governor of the Bank of England, is correct in linking the reckless lending by banks and other financial institutions that, together with the matching reckless borrowing, lay at the roots of the current financial crisis, to remuneration structures that rewarded extreme risk taking on poorly designed financial products. The diagnosis is fine. What to do about it is less obvious. These remuneration packages did not fall to earth from the moon. They are the result of a distorted economic environment. The key distortions, unfortunately, cannot be remedied, because they have highly desirable consequences as well as the dysfunctional ones highlighted by the crisis. Let’s consider some of them:
Tim Young makes three interesting comments on my blog on the Bank of England’s Special Liquidity Scheme:
(1) The Treasury bills involved are of nine months original maturity, not one year.
(2) In the event that the borrower defaults, the public sector gets stuck with a loss if the value of the collateral is less than the value of the t-bill loan, even if the issuer of the securities posted as collateral does not default. Presumably this is much more probable than a simultaneous default, especially if the borrower is widely known to be a holder of such securities.
(3) US mortgages are not in general non-recourse.
The Olympic games have become a joke. A bad joke. It is time to put the event out of its misery. There was about a 1500 year gap between the last of the Olympic Games in Ancient Greece, and the first of the Games in the new Olympic era. Let’s have another 1500 years without Olympics. Then we can see again. There are three arguments that support this recommendation.
On my way to Gatwick Airport to participate in a conference in Riga (Latvia) on economic challenges faced by the Baltic countries, I noticed a sign post for the village of Pratts Bottom. It reminded me of why I love living in this country. I am sure I really could find Little Whinging in Surrey if I looked long enough.
This naturally brings us to the question as to whether the Bank of England subsidises the banks through its newly created Special Liquidity Scheme (SLS). The scheme is a swap of one-year maturity Treasury Bills for illiquid mortgage-backed securities, covered bonds (Pfandbriefe), and asset-backed securities backed by credit card receivables. Let’s refer to this collection of bank assets as MBS (for mortgage-backed securities).
The actual baby turns out not to be too different from the one expected. The Bank of England is now wholeheartedly committed to acting as market marker of last resort for systemically important securities for which the markets have become illiquid, not to say defunct, since the start of the crisis in August 2007.
The market maker of last resort provides market liquidity in the transactions-based model of financial capitalism the same way the lender of last resort provides funding liquidity to banks in the relationships-based model of financial capitalism. The same institution, the central bank, can play both roles. All real-world versions of financial capitalism are convex combinations of the transactions-based model and the relationship-based model. The relative weight on the transactions-based model is highest in the US and the UK. Anne Sibert and I called for the Bank of England and other central banks to act as market makers of last resort on August 12, 2007, when the crisis had barely hatched from the wind egg of the financial bubble of 2003-2006.
The Bank of England and HM Treasury are likely to announce a package to take some illiquid assets off the banks’ balance sheets. It is hoped that this measure will (a) encourage the banks to engage in more mortgage lending to homeowners and (b) will help unfreeze the markets for residential mortgage backed securities (RMBS) that have been dead since last August. The amount involved is rumoured to be about £50 billion, an amount equal to just under half the net home lending in the UK last year, and probably close to the amount of net home lending we will see in 2008 (even with the injection of Treasuries that will be announced).
The failures of the western financial models
The worst outcome of the current financial crisis would be a return to the status quo ante that produced the pathologies, anomalies and contradictions that are its root causes.
I believe that the Western model of financial capitalism – a convex combination of relationships-based financial capitalism and transactions-based financial capitalism – has, in its most recent manifestations (those developed since the great liberalisations of the 1980s), managed to enhance the worst features of these two ideal-types and to suppress the best. This period has been characterised by a steady increase in the relative dominance of the transactions-based financial capitalism model in the overall financial arrangements of the world, most spectacularly in the US, the UK, and such smaller countries like New Zealand and Iceland, somewhat less in most of continental Europe and elsewhere.
In today’s Daily Telegraph there is a column of mine that proposes turning the Debt Management Office of the United Kingdom, a branch of HM Treasury, into a full-fledged Sovereign Portfolio Management Office or Sovereign Wealth Management Office.
The purpose is to kill two birds with one stone: (1) to get the state to invest in residential mortgage backed securities (RMBS) to unclog that market and restore access of first-time buyers to mortgage financing; (2) to get the state to issue more index-linked long-term debt and other useful instruments, like longevity bonds (bonds whose coupon or interest rate is tied to the survival rates /life expectancy of particular age cohorts). Longevity bonds index-linked to the CPI or to average earnings would be especially useful for pension funds and other institutional investors that are short longevity risk.
When I hear or read the words ‘off-balance-sheet financing’ or ‘special purpose vehicle’, warning lights begin to flash and I grab for my obfuscatometer. Off-balance-sheet financing is any form of funding that avoids placing the owners’ equity, liabilities or assets on the balance sheet of a firm or other legal entity. The most common way to achieve this is by placing those items on some other entity’s balance sheet. A standard approach is to create a special purpose vehicle (SPV) and place assets and liabilities on its balance sheet. An SPV is a firm or other legal entity established to perform some narrowly-defined or temporary purpose.
There are circumstances (possibly as many as one percent of the reported occurrences of SPVs), where such entities are created to achieve true efficiency gains. For instance, creating a separate legal entity for certain activities may better align incentives for risk-sharing or may avoid conflict of interest. The overwhelming majority of SPVs are, however, created for nefarious and/or dishonest purposes: evading or avoiding regulation (and associated financial burdens and constraints or reporting obligations); tax avoidance or tax evasion; accounting shenanigans, including the circumvention of ceilings on the budget deficit or debt of public entities; and hiding assets or liabilities from scrutiny by interested parties. These often clever schemes are always economically equivalent to a much more straightforward on-balance-sheet arrangement.
The Institute of International Finance, an organisation representing many of the world’s largest banks and other financial companies, has issued a pretty frank mea culpa for the litany of errors of omission and commission perpetrated by its members during the financial boom that turned to bust in August 2007. The Interim Report of the IIF Committee om Market Best Practice states a large number of home truths and makes a host of useful suggestions about risk management, liquidity managements, compensation of senior bankers and superstars, over-reliance on formal quantitative models etc.
The tone of the report is one of “We know we screwed up, but now we’ve learnt our lesson (really we have!!) and we’ll never do it again; so there is no need to regulate us more severely and intrusively”.