Wednesday, April 22, 2009

Mixed up policy responses and liquidity preference

I frequently get emails suggesting that governments should force banks to lend and that would solve the recession.  I tend to agree but it would be difficult – and the government actions to date have exacerbated the lack of lending.

As it is, there is little to no balance sheet growth at any major bank in America and aggregate bank lending is falling.  Excess cash at the Federal Reserve is building up fast.  The economy is still sour (and getting more so) and bank credit losses are continuing to rise.  

Meanwhile banks sit on cash.  

Bank of America (for recent and topical example) is carrying $173 billion in cash and cash equivalents – a number which immunises them against many but not all ills and is about $140 billion higher than normal.

This excess cash inhibits BofA profitability by maybe 5-7 billion per annum (pre-tax).  They don’t really want that profit drain – but – in a telling comment – they thought it was worth it to have that negative carry because the cost to running short of liquidity was too high.  

The excess cash across the entire banking system probably exceeds a trillion dollars.  If only it could be spent – then we would have the stimulus we need.  

Alas – that is what is meant by being at the zero constraint of monetary policy.  We have banks with a seemingly endless liquidity preference.  It is not that there is no demand for loans (though demand is much ameliorated).  Banks are rapidly tightening lending criteria too and indeed some banks are just not lending to new customers.

Now lending standards needed to tighten.  2006 was insane.  But early 2009 is also insane– and if it were a perfect world lending would have moderated much slower so as to displace maybe 200 thousand workers per month.  (The economy can usually generate new jobs that fast.)  Indeed the whole idea of stimulus is to slow the rate of job loss in the economy down to a level where normal functioning of the labour market can deal with it.

That is not where we are.  We have an extraordinarily rapid change in liquidity preference for banks, an extraordinary tightening of standards and an extraordinary recession.  

Now some people are into forcing the banks to lend.  Willem Buiter (who is often clever and sometimes wrong) suggests confiscating banks that will not lend.  Useless as tits on a bull he says.

That would be fine if he did not want to confiscate marginally insolvent banks too.  A bank that is stretched for capital or liquidity would usually preserve both by restricting lending.  You restrict lending so as not to be confiscated – except in Willem Buiter’s world where you lend to avoid being confiscated.  

Now I thought that the confiscation of Washington Mutual was perhaps the single most destructive government action of this cycle.  That was a minority view – and remains one.  Felix Salmon thinks I am alone – but a paper from the New York Fed makes it clear that the confiscation of WaMu very rapidly increased the liquidity preference of mainstream banks and hence spread the crisis from the Wall Street Banks to Main Street.  

The lesson of Washington Mutual – learned hard – was that you could have adequate capital but a minor run and be confiscated.  The only way to cope was to have massive excess liquidity.  

And so we are in an unusual liquidity trap.  In the Japanese liquidity trap the general populace had massive excess cash savings.  The liquidity preference was the preference of the legendary Mrs Watanabe who liked sitting – in cash – on three years of Mr Watanabe’s salary.  

In America the liquidity preference belongs to banks.  Mr and Mrs Middle America are not swimming in cash.  Indeed all the evidence suggests that they are over-indebted.  It’s the banks that are swimming in cash.  And it is the bank’s excess demand for liquidity that makes monetary policy ineffective.

Now Paul Krugman has argued that it doesn’t really matter why we are at the zero bound in monetary policy – but I think it does.  If we are at the zero bound because Mrs Watanabe wants to save to excess then we should target Mrs Watanabe.  If we are at the zero bound because Bank of America is scared of arbitrary government action (as evidenced in the confiscation of WaMu) then we should address Bank of America’s concern.

The first way to address Bank of America’s concern is for Sheila Bair to fall on her sword.  She should resign because – through confiscating Washington Mutual – she spread the crisis to Main Street.  But regular readers should know I have a very low opinion of her and will not be surprised by that comment.

But I have a second proposal.  It is floated for discussion only as it is obviously risky.  The idea is that the bank capital adequacy requirements be dropped a couple of percentage points – but only if their genuine third party loans fully owned on the balance sheet are growing by more than say five percent per annum.


mark ii said...

surely the common sense way of dealing with this is to require the banks to pay interest on their 'excess cash'...

tweek the interest rate and soon they'll be sending money out the door

John Hempton said...

What - are you suggesting the Federal Reserve should take interest rates NEGATIVE - by forcing the banks to pay interest (to them presumably) on their excess cash?

I would love to know the legal mechanism...

But yes - your suggestion is that we should remove the zero bound by having negative interest rates on cash.

We could also remove the zero bound by inducing inflationary expectations. But that works better with Mrs Watanabe.

Mrs. Watanabe said...

I would be surprised if banks started lending anytime soon. A major reason why banks had been lending to any idiot who wanted to borrow was that they could buy a swap from AIG for the protection.

I hate debt anyway, so no tears from me. Debt is the porn equivalent of money.

Rod said...

There is, of course, a simple if impracticle answer to the question of whether to force banks to lend. Fast forward 10 years and look at what happened to the Chinese banks that have recently obeyed the central command to open the floodgates.

I find it hard to believe any solution that assumes banks have suddenly become irrational and unresponsive to financial incentives (which is assumed by solutions that use threats etc). I find it easier to believe that there is nothing that all these banks would rather do than lend money at current rates (as evidenced by any bank not under current threat of stress test etc). So are we not back to the problem (discussed at length on these pages) how to remove the threat of liquidity driven insolvency?

John Hempton said...

The lending in 2006 was insane.

But the management of the banks were not irrational. They were responding to the incentives that they were given.

The incentive was to keep the balance sheet ticking over or the CEO would be out of a job.

The lack of lending now is equally insane. But the management are responding to the incentives given.

Keep liquid. Keep alive. Overdo above. Or you will be confiscated and out of a job.

Both incentives are NOT THE RIGHT INCENTIVES. But they are the incentives we have.

Hubert said...

Brilliant idea John!

Although I think WaMu shocked bondholders more than management, the flexible capital ratio might solve a lot.
It would be totally approriate here in Germany.
Bank lending here has reached insane restrictions on Mittelstand companies with unrealistic covenants. So either you stop borrowing (hardly a possibility) or you sign covenants that gives the banks a licence to steal your company whenever you experience some stress in your P&L (= probably when your auditor brings in 2009 results). Owners just hope that banks have other things to do and won´t go as far.

I would have thought that giving banks gov money should come with a string attached that they ought not to be allowed to shrink their company loan book. But your idea is much better.

gaius marius said...

mr hempton -- i'm not sure why excess reserves must be a function of bank liquidity preference. i don't doubt that there's some truth to this. but anecdotal evidence is also that banks are snapping up high-yielding securitized debt at low prices -- it seems they are ready to employ cash situationally.

as you say, american households are debt swamped. but does it follow that they are not driving liquidity preference because they are not liquid?

indeed it seems to me that most banks would love to lend to good household credit -- they need to earn on fat spreads, after all, to get out of their mess. but it also seems that good household credits have in aggregate sharply revised opinions of debt in light of new understandings and situations (eg employment). so they are paying down debt and saving. the households still approaching banks for loans are, it seems, the desperate -- exactly those to whom the banks now cannot lend.

this distribution of credit quality and loan demand means, i think, that it is essentially lack of quality loan demand driving excess reserves -- as noted above, banks can no longer insure against making awful credits and so don't, but good credits are paying down on net.

Anonymous said...

So you think the trillion in cash sitting idle on banks' balance sheets is not needed to handle more write downs?

John Hempton said...

Anon's last comment is nonsensical.

A bank lends money out.

The liquidity goes down RIGHT THEN.

The write off the loan does not change liquidity. Not one drop. But it does change solvency.

The excess liquidity on the balance sheet is completely irrelevant when handling write downs.


Dilip said...

As the very first commenter pointed out, negative interests seem like another option. Greg Mankiw has a post on this today:

Advant Guard said...

The CEO of U.S. Bancorp said in the earning conference calls that business that are creditworthy are no longer interested in borrowing. Should we create a government program to force business to debase their balance sheets by borrowing money they don't need until economic recovery happens?

Anonymous said...

I like your blog. your insights are brilliant. maybe rose colored glasses at times, but nonetheless brilliant. I am curious re. your vendetta for Sheila Bair. just how much did you lose on WM. P.S. I believe you are correct that they prob could have withstood the run.

Don said...

OK. I agree that WaMu was a mistake. But Figure 2 still supports my contention that Lehman started the crisis. You can only interpret the WaMu seizure within a context of a Calling Run having begun. However, I believe that the government should have intervened to save WaMu, given its circumstances. Or, at the very least, given WaMu more time. This still supports my view that government intervention was expected and depended upon. I don't know if you agree.

Absent Lehman and a Calling Run, I don't think WaMu would have been seized. However, remember, you're for consolidation. I'm not.

Don the libertarian Democrat

John Hempton said...

I lost less than 1% of my wealth on WaMu.

I however had a few other preferreds and lost about 4% of my wealth (thus far) on them.

I just think WaMu was a really bad decision. Incompetent and dangerous.


Joyce said...

RE I just think WaMu was a really bad decision. Incompetent and dangerous.

I agree John...and getting rid of Sheila Bair would be the first step in improving consumer confidence...

People rise to their level of incompetence and Bair is surely at hers.

How they can be thinking of handing her responsibility for more, is mind boggling...This woman created more problems than she has ever solved, and selling WAMU for pennies on the dollar was a huge mistake...and I do hope it bites her, hard...

Get the facts on just how bad her judgement was....

Anonymous said...

Why not a one off 5% wealth tax on everyone's cash holdings and liquid assets?

It would get people spending much quicker than cash chucked out of helicopters.

Aaron Krowne said...

I think the real problem is that $170 billion in reserves is actually quite appropriate for positions that stretch into the trillions. 10% reserve requirement, and all. What's that you say -- an anachronism?? A barbarous relic??

I don't know. I think perhaps it was the $30B level of reserves that was unnatural.

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