Saturday, 1 October 2016

"Financial contagion"

There have been lots of explanations offered for why a fall in land prices affects the wider economy, which is like the tail wagging the dog. It is ultimately the health of the economy which dictates land rents, which adjusted for interest rates dictate land prices.

Some people talk vaguely about "the wealth effect" or "animal spirits" or "financial contagion" in the vaguest sense, in which there is some truth but those are very simplistic and superficial concepts.

The way I understand it, it is a simple mechanical thing that follows automatically from the way banks work. It illustrates the old adage that "If you owe the bank £10,000 it's your problem, if you owe the bank £1 million, it's the bank's problem."

As we know, an average UK bank's assets are 80% loans on land and 20% short term loans, overdraft facilities, HP agreements, credit cards etc. The bulk of their liabilities are customer deposits.

When the land price/credit bubble finally pops, as it does every 18 years or so, people will want to withdraw money from the riskiest bank, i.e. the one whose assets are 99% loans on land and which has been handing out the highest loan-to-value mortgages e.g. Northern Rock. People withdraw money from NR and short of stashing notes under the bed, all they do is swap a deposit with NR for a deposit with a safer bank or with the government e.g. NS&I.

Duly panicked, depositors with the second wobbliest bank will want to withdraw their money on the assumption that it will pop next. That bank of course can't call in much of the 90% of its loans that are on land any faster than the underlying loans and interest are going to be repaid; the borrowers simply can't pay any faster. The banks don't want to do mass foreclosures on land which is falling in value because that would be a vicious spiral, so where do they get the money from to repay the depositors who want to withdraw?

The only ways they can get money back quickly are (a) cancelling people's overdrafts or (b) stopping their credit cards and demanding repayment in full (or not making any more personal loans).

a) I look at dozens of balance sheets every week when I'm doing tax returns, and it is quite normal for a business to finance its entire stock of goods with an overdraft. That stock of goods has a turnover period of a few weeks or months, so the bank can get its money back as quickly as the goods can be sold. By doing this, the bank has bitten the hand that feeds. When those goods have been sold and the overdraft repaid, the business will find it difficult to stay in business because it can't finance more purchases. Some will survive by scaling down, others will go under.

b) If people stop spending on credit cards/personal loans, clearly there will be less spending on goods and services for several months until all the debts are cleared and people have saved up for what they otherwise would have bought with a personal loan.

Put (a) and (b) together, we see that the productive economy is being sacrificed on the altar of the land price/credit bubble. These two effects reinforce each other of course; once a business has had its overdraft cancelled and demand for its output is falling, it will find it hard to refinance with another bank; there are knock-on effects on its suppliers. So people lose their jobs, there is less spending and less demand etc etc.

TBH reminded me by email about the most extreme example of this, being Royal Bank of Scotland's infamous Global Restructuring Group.
Is there a simple fix?

Obviously, the best answer is always shift taxes from production to land values, as a second best, the answer must surely be to segregate banks into two types:

a) hmm, let's call them "Building societies" who lend only on land and whose depositors face strict withdrawal limits i.e. they can't withdraw any faster than borrowers are paying in, so a "deposit" with such a bank is more like an annuity. Mortgages and deposits are denominated in "land pounds" which of course do not exist so can only be repaid with "real pounds" or "government pounds ". So even if their depositors all panic, the building society is allowed to pu a temporary stop on withdrawals, and

b) ordinary commercial banks who are only allowed to lend short term to businesses to finance working capital and fixed assets; to grant overdrafts, issue credit cards and make personal loans etc. These are "real pounds" and deposits are only accepted in "real pounds" or "government pounds". Depositors, collectively, know that they can withdraw all their deposits within a few months without there being a bank run; and they know that the bank is insulated from land price speculation, so they probably wouldn't all want to withdraw anyway.

[Neither type of bank would get any sort of taxpayer-underwritten deposit guarantee. If people want maximum security, there will of course be a third type of quasi-bank which is the government itself, which creates/prints "government pounds" by spending (or paying out deposits) and destroys/unprints money by collecting taxes (or taking deposits). Whether it collect taxes in government pounds, land pounds or real pounds does not seem to matter for these purposes.

People will only be able to deposit "real pounds" or "government pounds" (but not "land pounds") with National Savings and Investments, which would be made a lot more modern and like a normal bank.]

Lending between banks and building societies would be strictly verboten, of course.  So we break the link between useful banking (oiling the wheels of the economy, putting deposits to profitable use) and dangerous banking (land price speculation). This surely makes far more sense than some arbitrary and meaningless split into "retail banks" and "investment banks".

Rather perversely, there is an inverse relationship between the savings rate (i.e. deposits) and house price increases, so actually, during such a period, the banks should have more money from depositors to lend to the productive economy, but somehow it doesn't work like that. I suppose because once the land/credit bust has infected the real economy, banks are just too cautious and stick all the money into government bonds or something.
I cheerfully admit that this might all be old hat and a widely accepted explanation in some circles (not that I've ever read it anywhere). Possibly I have missed the point and there is a better explanation, so I'm open to suggestions, but AFAIC, it is as simple as that.


Lola said...

Back to the future? That's broadly what did happen pre about 1986. Most mortgage origination was carried out by building societies with banks only doing specialist stuff - like self cert or mortgages to self employed customers where they could 'read the statements' of said customer.

Mark Wadsworth said...

L, yes, most of YPP policies are back to the future. You just pick a point in time when things worked and use that as a template.

As to "specialist mortgage lenders" that's absolutely fine, but for these purposes they are in category (a) and must be strictly separated from category (b).

Bayard said...

Yes, I got my first mortgage in 1986 and I remember it being something new that you went to a bank for a mortgage.

Dinero said...

Talking of balance sheets and banks , assets and liabilities. How is the value to the bank, of the interest from loans, recorded on the balance sheet.

Mark Wadsworth said...

B that is when the rot set in.

D, you'd better do a quick bookkeeping course. Income is recorded in the P&L together with expenses and at the end of the year, the profit/loss is added to/subtracted from shareholders funds (as a balancing figure to reflect change in net assets).

Random said...

Several of the proposals to narrow banking propose to restrict bank lending far further than is necessary or socially sensible - putting up the cost of lending far too high. We need to restrict lending just to capital development - new projects and perhaps automation - and to make it really cheap and without some One True Path Soloman like public bank.

"ordinary commercial banks who are only allowed to lend short term to businesses to finance working capital and fixed assets; to grant overdrafts, issue credit cards and make personal loans etc. Depositors, collectively, know that they can withdraw all their deposits within a few months without there being a bank run; and they know that the bank is insulated from land price speculation, so they probably wouldn't all want to withdraw anyway."

This is getting close to the MMT solution. Under MMT banking policy the central bank lends to the entrepreneur basically on demand.

Banks that want access to the BoE get an unlimited cost free overdraft at the Bank of England. 0% funding costs. In return they must drop all the side businesses and just do capital development lending on an uncollateralised basis - probably in the form of simple overdrafts. In other words they become an agency businesses delivering state money to those that require it.

Loans that do not meet criteria set for capital development from *those* banks with access to the BoE become unenforceable. If banks make unsuitable or shit loans they go bust.

Finally, we need a mutual transaction system. There are lots of ways of designing a mutual transaction system. But at its core is one concept - that transactions operate on the balance sheet of the central bank, not the individual banks. So you would have a Transaction Department at the Bank of England (alongside the Issue and Banking Departments) and current and savings account ultimately represent liabilities on that balance sheet.

The functional aspects are less important - existing bank accounts could be held in trust by the current banks, run as separate subsidiaries companies and a myriad of different other options. But the key point is that the operational entity is acting as agent and the legal ownership and responsibility is always at the central bank. That makes anything recorded in the transaction system exactly the same as holding cash. You have a receipt for liabilities at the central bank.

However that makes the individual banks short of deposits and balancing liabilites. The replacement on the individual bank's balance sheets is of course an overdraft from the central bank - as I mentioned before. Existing banks would then have to get the match funding to free themselves from the central bank lending restrictions, conform to requirements or just enter run-off. To have interest on deposits in a private system there has to be income from somewhere else to pay that interest. Therefore in this system it becomes a line item of government spending - likely via interest bearing accounts for individuals at National Savings. Paying interest on deposits in this way is then really just the same as paying coupons on Gilts. Gilts, of course, would cease to be issued under any rational government.

Any lending businesses that doesn't want to take the oath, then has to fully fund their lending on a maturity matched basis Zopa style. No deposit insurance, no access to the Bank of England, and losses absorbed by those doing the lending. This then becomes the fate of the shadow banking system - the building societies and money funds.

Mark Wadsworth said...

R, I agree with some of those suggestions and heartily disagree with others, but it's all drifting off the topic a bit, which was "Why do falls in house prices drag down the economy? Is there an easy fix?"

Random said...

Right. And even if they did "drag down the economy" just cut taxes. Jeez.