The financial system rests on quicksand

[globaleconomicollaps]

http://www.ft.com/intl/cms/s/0/826e5...44feabdc0.html

August 29, 2012 8:24 pm
The financial system rests on quicksand

By John Gapper
Illustration on the unsuccessful financial market regulation reforms pushed by the US Securities and Exchange commission by Ingramm Pinn©Ingram Pinn

If anything is calculated to cause despair about the prospects of making the financial system safer, it is the failure of the Securities and Exchange Commission to tame the $2.6tn US money market fund industry. Mary Schapiro, the SEC chairman, has tried her best but she was stymied last week.

The stakes are so high that reform now needs to be taken out of the hands of the SEC’s commissioners, who have shown themselves to be fatally susceptible to industry lobbying, and led by the US Treasury and Federal Reserve. Failing that, international regulators should limit the dependence of banks on these shaky foundations.


What are the chances of the other US authorities succeeding where the SEC has failed? Sadly limited, given the poisonous climate in Washington, acrimony over the Dodd-Frank Act and the presidential election. These form dispiriting obstacles to reform of the shadow banking system, of which money market funds form one of the oldest parts.

Reform of money market funds ought to be an open-and-shut case, given the events of 2008. The first evidence of the distress triggered by the Lehman Brothers collapse was when the Reserve Primary fund “broke the buck” because it held $785m of Lehman securities. That led to a rapid run on its deposits and official intervention to stop other funds toppling.

As Ms Schapiro observed in June, “we do not know what the full consequences of an unchecked run on money market funds would have been”, but it is safe to say: not good. The funds, established in the 1970s as competitors to banks, have become one of the primary short-term funding mechanisms of both US and European banks.

The rivals rely on each other in potentially unstable ways. The US Treasury estimates that 105 money market funds with total assets of $1tn could fail in the same way as Reserve Primary if any of their top 20 counterparties defaulted. The latter include many European banks – 30 per cent of the assets of money market prime funds are European bank debt.

In other words, the danger of another cascading crisis, with fragile banks being drained of funding, remains. The old-fashioned bank run, with depositors lining up outside banks to withdraw cash, has been updated to corporate treasurers wiring money from money market funds at any hint of trouble.

The structure of the funds makes them especially prone to a run. They are used by treasurers and investors to park their short-term cash, confident that their deposits will not lose value. Paul Tucker, a deputy governor of the Bank of England, has called them “narrow banks, in mutual-fund clothing”.

These funds started after regulators capped the interest rates banks could offer depositors. The mutual fund structure evaded these limits and offered investors higher returns at fairly low risk since funds were supposed only to invest in short-maturity and high-quality assets.

They grew rapidly, to a peak of $3.8tn in 2008, after the SEC decided in 1983 to let them fix their net asset values at $1 a share by dropping mark-to-market accounting. They could offer a bank-like guarantee to depositors that their cash would be repaid in full, with interest.

Defaults or downgrades of assets sometimes threatened to make funds “break the buck” – to be unable to maintain the $1 fixed value and have to go into run-off. But, except for one minor case, the investment companies that sponsored them stepped in to support them.

The 2008 failure exposed the key weakness. If a parent cannot, or will not support a troubled fund, its investors have an incentive to take their money out quickly, igniting a panic that can easily spread. “It is like a banking system without capital. I cannot see why [a run] will not happen again,” says Gary Gorton of Yale University.

Ms Schapiro wants to impose a safeguard by offering funds a choice. They could either become more like investment funds by allowing their net asset values to float, or more like banks by raising a buffer of capital. They might also limit redemptions of cash in times of panic.

Neither option seems unreasonable to me – neither would eliminate any possible problem, merely make it less likely – but the industry responded with overblown rhetoric about being persecuted. “All of these reforms are designed to eradicate money market funds as we know them,” complained Christopher Donahue, president of Federated Investors.

The funds, which were bailed out in the crisis by the Treasury guaranteeing their net asset values and financing banks to buy their commercial paper, claim – Goldman Sachs-like – not to have asked to be rescued. They were essentially the bystanders to a financial panic elsewhere, they insist.

This rewriting of history was enough to swing the votes of three SEC commissioners and block Ms Schapiro’s effort, with the excuse that more time has to be devoted to research. The only hope lies with the Financial Stability Oversight Council, the Treasury-chaired committee of regulators set up by Dodd-Frank to oversee systemic risks.

Several Fed governors have argued the case for money market fund reform, so we shall discover whether the FSOC is merely a distinguished talking shop or will override the SEC. If it does not act, Mr Tucker says supervisors should limit the amount of short-term funding that European and international banks can get from “flighty sources” such as money market funds.

After the Libor scandal, in which Mr Tucker played a role, it would be a fine way to inflame transatlantic financial tensions. Absent the right action in the US, however, it would also be a good idea.

[cobben]

Re: The financial system rests on quicksand

30 per cent of the assets of money market prime funds are European bank debt.

If this is true, I'm beginning to think Armstrong might be right about things accelerating out of control two years ahead of schedule.


And weird is not the half of it, is the NY Fed putting out a warning of what might be coming down the pipeline if things start to blow up?

If Interest Rates Go Negative . . . Or, Be Careful What You Wish For

. . .

Certified checks, which are liabilities of the certifying banks rather than individual depositors, might become a popular means of payment, as well as an attractive store of value, because they can be made payable to order and can be endorsed to subsequent payees. Commercial banks might find their liabilities shifting from deposits (on which they charge interest) to certified checks outstanding (where assessing interest charges could be more challenging). If bank liabilities shifted from deposits to certified checks to a significant degree, banks might be less willing to extend loans, because certified checks are likely to be less stable than deposits as a source of funding.

As interest rates go more negative, market participants will have increasing incentives to make payments quickly and to receive payments in forms that can be collected slowly. This is exactly the opposite of what happened when short-term interest rates skyrocketed in the late 1970s: people then wanted to delay making payments as long as possible and to collect payments as quickly as possible. Some corporations chose to write checks on remote banks (to delay collection as long as possible), and consumers learned to cash checks quickly, even if that meant more trips to the bank, and to demand direct deposits. However, if interest rates go negative, the incentives reverse: people receiving payments will prefer checks (which can be held back from collection) to electronic transfers. Such a reversal could impose novel burdens on payment systems that have evolved in an environment of positive interest rates.


Conclusion
The take-away from this post is that if interest rates go negative, we may see an epochal outburst of socially unproductive—even if individually beneficial—financial innovation. Financial service providers are likely to find their products and services being used in volumes and ways not previously anticipated, and regulators may find that private sector responses to negative interest rates have spawned new risks that are not fully priced by market participants.

[mmr]

Re: The financial system rests on quicksand

Before last summer's iteration of the European crisis, the 30% European asset concentration figure was approximately correct. Now the assets are more heavily concentrated in short-term Treasuries and agency debt and short-term loans to Japanese, Canadian, Australian, and domestic US banks.

[jk]

Re: The financial system rests on quicksand

Conclusion
The take-away from this post is that if interest rates go negative, we may see an epochal outburst of socially unproductive—even if individually beneficial—financial innovation.

unlike the era we've been living through?

[globaleconomicollaps]

Re: The financial system rests on quicksand

Before last summer's iteration of the European crisis, the 30% European asset concentration figure was approximately correct. Now the assets are more heavily concentrated in short-term Treasuries and agency debt and short-term loans to Japanese, Canadian, Australian, and domestic US banks.

humm... got a link?

[globaleconomicollaps]

Re: The financial system rests on quicksand

http://libertystreeteconomics.newyor...-wish-for.html

If Interest Rates Go Negative . . . Or, Be Careful What You Wish For
Kenneth Garbade and Jamie McAndrews

The United States has slid into eight recessions in the last fifty years. Each time, the Federal Reserve sought to revive economic activity by reducing interest rates (see chart below). However, since the end of the last recession in June 2009, the economy has continued to sputter even though short-term rates have remained near zero. The weak recovery has led some commentators to suggest that the Fed should push short-term rates even lower—below zero—so that borrowers receive, and creditors pay, interest.





One way to push short-term rates negative would be to charge interest on excess bank reserves. The interest rate paid by the Fed on excess reserves, the so-called IOER, is a benchmark for a wide variety of short-term rates, including rates on Treasury bills, commercial paper, and interbank loans. If the Fed pushes the IOER below zero, other rates are likely to follow.

Without taking a position on either the merits of negative interest rates or the Fed's statutory authority to fix the IOER below zero, this post examines some of the possible consequences. We suggest that significantly negative rates—that is, rates below -50 basis points—may spawn a variety of financial innovations, such as special-purpose banks and the use of certified bank checks in large-value transactions, and novel preferences, such as a preference for making early and/or excess payments to creditworthy counterparties and a preference for receiving payments in forms that facilitate deferred collection. Such responses should be expected in a market-based economy but may nevertheless present new problems for financial service providers (when their products and services are used in ways not previously anticipated) and for regulators (if novel private sector behavior leads to new types of systemic risk). This post supplements an earlier post in Liberty Street Economics that reviewed possible disruptions that could result from zero interest rates.


Cash and Cash-like Products
The usual rejoinder to a proposal for negative interest rates is that negative rates are impossible; market participants will simply choose to hold cash. But cash is not a realistic alternative for corporations and state and local governments, or for wealthy individuals. The largest denomination bill available today is the $100 bill. It would take ten thousand such bills to make $1 million. Ten thousand bills take up a lot of space, are costly to transport, and present significant security problems. Nevertheless, if rates go negative, the U.S. Treasury Department’s Bureau of Engraving and Printing will likely be called upon to print a lot more currency as individuals and small businesses substitute cash for at least some of their bank balances.

If rates go negative, we should also expect to see financial innovations that emulate cash in more convenient forms. One obvious candidate is a special-purpose bank that offers conventional checking accounts (for a fee) and pledges to hold no asset other than cash (which it immobilizes in a very large vault). Checks written on accounts in a special-purpose bank would be tantamount to negotiable warehouse receipts on the bank’s cash. Special-purpose banks would probably not be viable for small accounts or if interest rates are only slightly below zero, say -25 or -50 basis points (because break-even account fees are likely to be larger), but might start to become attractive if rates go much lower.


Early Payments, Excess Payments, and Deferred Collections
Beyond cash and special-purpose banks, a variety of interest-avoidance strategies might emerge in connection with payments and collections. For example, a taxpayer might choose to make large excess payments on her quarterly estimated federal income tax filings, with the idea of recovering the excess payments the following April. Similarly, a credit card holder might choose to make a large advance payment and then run down his balance with subsequent expenditures, reversing the usual practice of making purchases first and payments later.

We might also see some relatively simple avoidance strategies in connection with conventional payments. If I receive a check from the federal government, or some other creditworthy enterprise, I might choose to put the check in a drawer for a few months rather than deposit it in a bank (which charges interest). In fact, I might even go to my bank and withdraw funds in the form of a certified check made payable to myself, and then put that check in a drawer.

Certified checks, which are liabilities of the certifying banks rather than individual depositors, might become a popular means of payment, as well as an attractive store of value, because they can be made payable to order and can be endorsed to subsequent payees. Commercial banks might find their liabilities shifting from deposits (on which they charge interest) to certified checks outstanding (where assessing interest charges could be more challenging). If bank liabilities shifted from deposits to certified checks to a significant degree, banks might be less willing to extend loans, because certified checks are likely to be less stable than deposits as a source of funding.

As interest rates go more negative, market participants will have increasing incentives to make payments quickly and to receive payments in forms that can be collected slowly. This is exactly the opposite of what happened when short-term interest rates skyrocketed in the late 1970s: people then wanted to delay making payments as long as possible and to collect payments as quickly as possible. Some corporations chose to write checks on remote banks (to delay collection as long as possible), and consumers learned to cash checks quickly, even if that meant more trips to the bank, and to demand direct deposits. However, if interest rates go negative, the incentives reverse: people receiving payments will prefer checks (which can be held back from collection) to electronic transfers. Such a reversal could impose novel burdens on payment systems that have evolved in an environment of positive interest rates.


Conclusion
The take-away from this post is that if interest rates go negative, we may see an epochal outburst of socially unproductive—even if individually beneficial—financial innovation. Financial service providers are likely to find their products and services being used in volumes and ways not previously anticipated, and regulators may find that private sector responses to negative interest rates have spawned new risks that are not fully priced by market participants.


Disclaimer
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

[mmr]

Re: The financial system rests on quicksand

http://www.ici.org/viewpoints/view_1...rope_data_june

[astonas]

Re: The financial system rests on quicksand

http://www.ici.org/viewpoints/view_1...rope_data_june

Thanks, mmr. That's very helpful information!

[cobben]

Re: The financial system rests on quicksand

Conclusion
The take-away from this post is that if interest rates go negative, we may see an epochal outburst of socially unproductive—even if individually beneficial—financial innovation.

unlike the era we've been living through?

heh-heh!

Remember, this is the NY Fed speaking, they probably mean "socially unproductive" for the banks.

[cobben]

Re: The financial system rests on quicksand

If this is true, I'm beginning to think Armstrong might be right about things accelerating out of control two years ahead of schedule.


And weird is not the half of it, is the NY Fed putting out a warning of what might be coming down the pipeline if things start to blow up?

If Interest Rates Go Negative . . . Or, Be Careful What You Wish For

Negative interest rates = time has negative value.

correlation = causality, or co-incidental?

Human action under ultra-low interest rates

. . .

Another way of examining this is the following: The zero interest rate indicates that time is free. And as anything that is free is wasted, time will also be wasted. Therefore, the equity of a firm, which is the equivalent of a call option on the assets of a firm, will become very cheap in terms of the debt of the company, as the debt does not grow with time because no interest is due on it (this only holds true, if the company is profitable, as a friend pointed to us). Arbitraging for this distortion in relative value, lifts the price of stocks, and to make this process sustainable in time, central banks need to keep throwing liquidity to the system, until they no longer can….

Now, if savings leave the matrix “system”, we will see in the long run an important de-leveraging, as the credit multiplier becomes less and less powerful. With more assets outside the system, the pricing mechanism becomes less efficient, since there are fewer signals to market participants. Capital markets disappear, specialization decreases, economies of scale are threatened. With more assets outside the system, productivity plunges and with it, unemployment skyrockets in rigid (unionized) labour markets (characteristic of developed economies). As developed economies, with high stock of capital, rely on economies of scale, this fundamental transformation has enormous damaging potential.

The flight from the system brings more financial repression as a logic reaction. In those nations with established coercive savings plans pension plans , politicians set their eyes on these virgin pools of capital, to force a bid to their liabilities (i.e. sovereign debt). This process eventually spirals, since the financial repression aimed to prevent market participants from protecting their inter-temporal exchange decisions, grows exponentially and brings about precisely the opposite outcome: A complete defence of savings, now fully thrown into an informal economy.

At this point, something has to be said about wealth transfer, because not every market participant is able to re-allocate his/her investments and re-direct his/her savings from the system to the informal world. Those who cannot save enough, those employed in firms and trapped in pension plans, will see their assets evaporate. If the harm is too significant, it may even be a cause for them to leave their condition as employees and become self-employed. This is the landmark of underdeveloped economies: A huge mass of self-employed, undercapitalized citizens in an informal system. The informality prevents them from accessing credit, which enhances their undercapitalization.

Finally, we ask that you note one last thing: As productivity, employment and production decrease, even a steady and low rate of inflation has the potential to morph into hyperinflation. It’s only a matter of time, and it occurs once the capital markets (including the futures markets) vanish, when the only reason to demand currency is for transactional purposes, when the demand of currency to settle debts is only marginal.

Martin Sibileau

[Chris Coles]

Re: The financial system rests on quicksand

Perhaps one of you here can tell me if my own analysis is correct. As I see it:

The Bank of England is in the process of becoming the “Prudential Authority” within the United Kingdom. And by that meaning; that it will also become responsible for the shadow banking system as well.

What most do not understand is that the shadow banking system is in fact what we once called the savings institutions; particularly the insurance companies. So an associated implication is that these “others” were also taking advantage of the “blind eye” of the authorities’, (apparent, sic!, lack of understanding of the entire workings of the financial system), to openly act as though they were themselves banks to “Leverage” their inputs. So we are NOT dealing with a banking crisis; we are dealing with a systematic creation of almost unbelievable volumes of what one might call “Vapourware” (grossly leveraged income), by institutions totally OUTSIDE of the banking system.

Again, I believe that Mervyn King has been very conservative with the proposal that the leverage was fifty, when I have read of examples where others thought it might have reached several hundred or more, and then, to make matters much worse, re-distributing the leveraged paper amongst themselves.

Let me give you an example. Think; if you wanted to open a business, you must be able to supply sufficient assets, equity capital, to underpin your trade and then, you can only trade to the limit of those assets. So how did the many “Hedge Funds” come up with their sometimes hundreds of billions? Where did the money come from? I say it came from a friend saying to another, Hey George, why not open a Hedge Fund and I will send you billions for which all I will ask for in return is, say, 5% return, and with the software I am going to also send you, (also of course for a small consideration), you can deal electronically via a computer on the “Markets” and make at least 12% return. (And of course, also, as a hedge fund, you too can lend to others……..). Pass it on George….

So George does not have any real capital; instead, he has a friend who will also benefit by being able to offload his “LEVERAGED” paper to another that will not ask too many questions of how he got started…….. That is how we suddenly have so many hedge funds trading on computers and earning so much money….. except that it is entirely money that is vapourware; perhaps as little as one three hundredth of a Euro/dollar for each supposed Euro/dollar…. …

Now we can see why the authorities have been so reluctant to widen the discussion; it leads to the recognition that this is not just a banking crisis, it is the entire financial system that is broken. Imagine being faced with many loose bricks in the walls of your home and knowing that if you pull any single one of them out, the whole house might fall down. What do you do? ….. you try and forget and just carry on living there in the hope that nothing will happen that brings the house down around you.

Sooner or later, we must have a leader that has the courage to face the facts and acts accordingly. All we can and must do is keep the facts out in the open so that they are not swept under the house carpet.

[gwynedd1]

Re: The financial system rests on quicksand

We are all not Monetarists now...or shouldn't be.

[mmr]

Re: The financial system rests on quicksand

Alternatively, the money market funds may just attempt to put themselves out of business -

Money market funds look to pass on losses

Investors in the €1.1tn European money market fund industry are facing losses as big managers prepare to pass on the impact of negative short-term interest rates.

...with interest rates on short-term French and German government debt in negative territory as investors scurry for safety, most money market funds now offer no yield to new investors. The European Central Bank last month said it could start charging banks to hold their cash overnight, which means bank deposit rates may also turn negative.

“We are looking at various options, some of which may require changes to the fund prospectus and articles of association, that would allow us to continue operating during periods of negative yields,” said Jonathan Curry, global chief investment officer for HSBC Global Asset Management’s liquidity funds, which includes a €7bn European money market fund.

“If investors want to continue using a money-market fund if market yields are negative, they will need to accept the market is charging for investment options that target preservation of capital.”...

According to people in the industry options include reducing the number of shares investors’ hold in the fund to reflect negative income.

The Institutional Money Market Funds Association, a London-based industry body, said asset managers could also levy fees outside the fund structure to reflect negative yields without reducing the net asset value...