I don’t have a solid economic model of different types of zero interest rate policies. I guess the number of instances historically doesn’t give us enough material to get a classification. But this is worth stating.
Zero in Japan looks very different from how zero in America looks right now.
How Japan looks
One of the first posts on my blog was about 77 Bank. 77 is a typical mid sized Japanese regional bank. It has vast excess deposits. It has plenty of liquidity – but almost nobody to lend it to. Competition to attract worthy borrowers is intense – and is led by prices. Loans are typically made on less than 50bps of margin.
The banks are bizarrely unprofitable. At 12 times leverage and a spread after costs of about a third of a percent the return on equity – before tax and provisions – is about four percent.
Businesses – at least ones with any claim to be credit worthy – have no trouble borrowing at all in Japan.
There is however a problem with these low spreads – a very big problem. Japanese banks are vulnerable to very low levels of credit losses. A loss rate of a third of one percent wipes out profit. A loss rate of 2 percent sustained over a couple of years would wipe out half the capital.
Summary: Japan has zero rates and the banks can’t make a spread because they have no willing borrowers. The banks have no liquidity problems – but they have a capital problem whenever losses rise to merely low levels from extremely low levels. The reason banks stopped lending was that there were insufficient willing borrowers.
The broken bank in Japan is a “zombie” (living dead). It has insufficient capital and not enough spread to rebuild capital over even a decade. It has enough liquidity to limp on for many years. However it often is attracted to riskier loans in a vain effort to find some spread – and it is prone to blow ups. For a long time Nishi Nippon City bank looked like that.
Note that Japan is now facing credit losses of a couple of percent - and that is high enough to cause widespread devastation to the low-spread Japanese banking system.
How the US looks
Most US banks have spreads after costs well above two percent of assets. Wells Fargo for a long time has had an interest spread above five percent. Spreads are still that high or higher.
In the good times background loss rates were one percent or more. Indeed there were plenty of businesses in the US which worked fine with three percent background loss rates (much car lending for instance).
There is no shortage of willing borrowers. Indeed there are plenty of worthwhile projects at the moment that have a hard time being funded because the banks don’t have any money available. Banks can’t fund themselves as the market for senior bank funding has shut down. The reason banks have stopped lending is that there are insufficient people willing to provide funds to banks. In plan parlance banks don’t lend because they can’t borrow.
It is trite – but the key difference is between a current account deficit country and a current account surplus country.
The deficit country has to borrow from abroad. Banks intermediate the deficit and the banks are subject to hot money flows.
Being subject to hot money flows the banks are subject to runs – very big and destructive runs.
The banks in those countries fail fast. Japanese banks by contrast remain as zombies (living dead) with insufficient capital but enough liquidity to last decades.
In current account deficit countries nationalisation or part nationalisation is a common end-game for a financial crisis.
Lots of people talk about Sweden (or better Norway) because they did their nationalisation well. But another example is Korea – where the bank blew themselves up too – and were critically dependent on (Japanese) money which became rapidly unavailable.
I know how these things look. I don’t have a decent model grounded in facts-on-the-ground.
I am surprised at the tone of the WSJ story about Japanese regional banks needing a bailout. They don’t need it from a liquidity perspective – they need it from a capital perspective. The WSJ story does not make this clear.
In America and the UK the banks have (serious) liquidity problems. I am not sure they have capital problems. Indeed my view is that there is no capital problem in the system – but the banks individually might have issues. The reason there is no capital problem in the system is that the underlying pre-tax pre-provision profitability is about 400 billion per annum.
Am I right that the system has adequate capital?
This view looks really controversial. It is just assumed – more or less by all pundits – that the banks are insolvent. Krugman’s latest piece on zombie banks is just one of many.
But the pre-crisis net tangible capital of the US banks was about 1.4 trillion. About 500 billion has been raised or defaulted since the crisis began. So call it 1.9 trillion. The pre-tax, pre-provision profitability has added another 400 billion per year to the pool – so we are at 2.3 trillion or more. A few hundred billion of the losses are borne outside the banking system.
If total losses get to the 3 trillion numbers that Roubini talks about. the system will get to neutral capital in two years and be fully recapitalised in five. If those numbers are right this is not a capital problem – it’s a liquidity problem.
The problem is serious though – and nationalisation may be the right prescription. It appears – as a matter of fact – to be the end game in countries which have current account deficits and banking crises (see Korea, Sweden, Norway). I am just not sure how to do it right – and when people (like Krugman) borrow the expression “zombie banks” from Japan I think they are substituting words for clear thinking.
I guess the thinking is hard though. If I thought all this stuff through clearly enough I would have that Nobel Prize in economics. Alas I did my last academic economics twenty years ago.