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Tuesday, May 12, 2009


hempton on current accounts and zombie banking

john hempton recently posted a two-part series -- here and here -- which saw exposure on talking points memo. in them he articulated the case of a typical japanese regional bank called 77 bank, using it as an example to illustrate why american banks are not in real danger of becoming zombie banks.

This bank seems to be very good at taking deposits – but can’t seem to lend money.

This is typical in regional Japan. It is also a problem – because when interest rates are (effectively) zero the value of a deposit franchise is also effectively zero.

So – guess what. It sits there – just sits – with huge yen securities (yields of about 50bps) doing nothing much. ...

Now in a land where the banks are awash in funding the marginal cost of funds is pretty close to zero. Welcome to Japan.

But American banks are not awash in funding – and given the profligacy (especially historic) of the American consumer – not to mention tax cut funded Iraq wars and the like – the US financial system is almost always going to be an importer of spondulicks. That might change in twenty five years – but it is not changing now.

Because American banks – at the margin – are simply not awash in funding the marginal funding will be expensive – whereas in Japan the marginal funding is cheap.

And because of that loans will be expensive. They will always cost at least a few percent (whereas in Japan you can often get mortgage funding for less than one percent). ...

Banks in America have – at least by Japanese standards – very fat margins
. Wells Fargo has the fattest margins of pretty well any major bank in the world (which is why Warren Buffett likes it so much). I have previously written about the large and increasing revenue of Bank of America here (and other places).

The high levels of revenue are what is recapitalising the American banking system. It is why the American system will muddle through and be right again within a couple of years.* Whereas the low revenue in Japan (resulting in 3% returns on equity in fully capitalised banks without credit losses) means that recapitalisation takes decades.

this would be extremely positive news for the american banking system, but i questioned the comparison in the comments.

for what it's worth, i think a more appropriate comparison would be to the 77 bank of 1991. i have a sneaking suspicion that 77 bank was then also a mirror image of the current 77 bank, but i'd love to be disabused of that notion.

hempton kindly disabused me in a third post, and along the way made an important point by reiterating part of an earlier famous post regarding eastern europe.

First observation: banks intermediate the current account deficit

· Countries that run big current account deficits have banks with loan to deposit ratios above 130. (See Australia or New Zealand for examples.)

· Countries that run big current account surpluses have loan to deposit ratios of 70 or less. (See my post on 77 Bank for an example.)

· Another way of saying this is that banks in current account deficit countries are generally reliant on wholesale funding. [It’s the crisis in wholesale funding that is causing the problems in American banks now.]

that is to say, opposing the case of 77 bank and japanese banks generally in both 1990 and 2008, american banks have a far higher loan-to-deposit ratio. and this is a function of the current account of each country -- japan having been a major current account surplus nation, america being a massive current account deficit nation. the result is that, while japanese banks were and are awash with deposit funding, american banks are heavily reliant on wholesale funding -- funding whose ultimate source is in fact the imported savings bases of other countries like china and japan.

richard koo has made an extremely effective case illustrating that japan avoided, despite suffering a massive balance sheet recession beginning with the asset shock of 1990, a terrible depression resulting from a collapse of credit by using the government treasury to incur public deficits, borrowing excess savings out of the japanese banking system. these funds were then spent as fiscal stimulus, providing macroeconomic support to incomes, deposits and GDP at a time when the private sector set about repairing its balance sheet by moving into an aggregate fiscal surplus and reducing its borrowing dramatically. this, over time, had the effect of refinancing japan's titanic corporate debt bubble onto the government balance sheet while preventing an far greater collapse of incomes and assets than was actually experienced as a result of a devastating paradox of thrift.

hempton here illustrates with 77 bank that japanese banks already had excess funding in 1990 as a result of the current account surpluses run by 'japan, inc.' -- but also that, consistent with koo's explanation, private loans diminished and excess funding grew over the duration of the crisis, with a far greater percentage of the bank's investment portfolio consisting of japanese government bonds or JGBs.

but it is the implications for the american experience going forward that are most interesting. koo has divided banking crises into four types by distinguishing between two kinds of banking crisis and two background conditions of demand for funds. the most severe manner of crisis (type IV) is a systemic banking crisis against a background of low loan demand -- which is what we very likely face today. koo's recommendation under this circumstance is a slow disposal of non-performing loans and capital injections from the government. this is because, koo argues, banks will face an inability to reloan funds at reasonable spreads as excess savings pile up in the banking system and lenders compete to farm out funds to a much diminished pool of borrowers, and this in turn will destroy their ability to make money and recapitalize by earnings. this is exactly what transpired in japan, where banks have taken the better part of two decades and a series of capital injections to recover.

hempton, however, is arguing that this crisis will look more like a type III scenario resolution -- where fat spreads persist and allow the banks to recapitalize out of earnings -- and this because the united states, being a large current account deficit nation, is faced with having to import relatively expensive marginal funding for the forseeable future thanks to a deposit base too small to support its credits. even in a 'savings glutted' world, this figures to keep the marginal cost of funding high relative to the average cost of funding -- the very definition of a fat spread.

i've followed with a comment appended to this third post.

sustainable fat spreads are really good news for the american banking system from the credit crunch/zombie perspective, and more or less obviate the need of permanent large capital transfers to lenders as long as guarantees remain in place. but i wonder what the longer-run effect on the borrowers is?

clark is on the right track w/r/t me -- i've heard richard koo talk on the topic of collapsed private sector loan demand post-asset-shock, with the government needing to pull excess funds out of the banks as they accumulate, using fiscal stimulus to re-employ the funds and keep money circulating (and therefore sustain incomes and GDP as the private sector moves to surplus), breaking the paradox of thrift and effectively refinancing the private sector debt bubble onto the public balance sheet over the course of years.

the united states obviously fits the bill of a mirror-image big current account deficit country with underfunded banks. but with the global collapse of trade flows we're also seeing the twin deficits narrow pretty considerably. do you find it credible to think that american banks will witness a migration to narrower trade deficits and therefore better funding profiles as households slow consumption and set about repairing balance sheets?

given the balance sheet shock many of us are faced with, i have to imagine banks will be seeing net negative private sector loan demand for some time -- well after they've finished repairing. on the fed's bank data i think they already are seeing it -- nearly all activity seems to be refinancing while household credit outstanding is contracting. this would appear to aggravate the 'savings glut' problem. it also implies they'll be accumulating, if not japanese-level excess funds, significantly lower loan:deposit ratios provided that there isn't a deflationary crash in monetary aggregates to decimate deposits. (government willingness to support monetary aggregates with deficit spending/fiscal stimulus looks important in that light.) given that some funding will still have to be imported, i wonder if the fact that marginal interest rates are unable to decline to near-zero doesn't also serve to accelerate the household deleveraging.

if i read you right, what you're saying is that if the american administration -- on the koo model -- attempts to sustain systemic cash flows and GDP by countering persistent private deleveraging with public leveraging, it may not find excess reserves laying about on bank balance sheets to soak up with treasuries (as was the case in japan). if cash comes into US banks and isn't reloaned for lack of private loan demand, those banks would instead have the imperative to scale down their balance sheet by paying down expensive wholesale funding, in accordance with the shrinking current account deficit that the funding is ultimately derived from.

that issue, it seems to me, is currently being mitigated by near-zero-cost public financing of the banks -- which only replaces the wholesale borrower, with the treasury stepping in the place of the banks to import funding. it wouldn't be until the current account balance effectively zeroed that excess funds would start to pile up in american banks, if and when that happens, and true zombie banking kickstarted.

while it bodes well for the credit crunch, this all sounds a pretty grim longer-run economic proposition. am i getting that straight?

in other words, while fat spreads are good for resolving the credit crisis in the banking system, this is a superficial problem that obscures a larger and more intractible one -- the loss of loan demand. healthy banks are of little use if the private sector is reducing liabilities and demonstrates no appetite for new borrowing.

moreover, if the government's effort to sustain monetary aggregates and GDP is predicated on borrowing excess funds out of the banks -- but excess funds are being directed by the banks to pay down wholesale funding in line with the contraction of the current account deficit -- what recourse has the government to sustain aggregate demand? this is a particularly salient point with global trade crashing and -- in a timely posting by calculated risk -- the american current account deficit going right along with it.

i'll here append any response from hempton.

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Diane Sawyer on GMA told the nation that the recession's over!

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This is a great dialogue, thanks for posting on it! I had been puzzled by Hempton's post and almost chimed in but was glad to see you did instead.

I'm not clear on how his arguments support his conclusion. For me I think it comes down to two questions:

1. A key argument of Hempton's appears to be that the marginal cost of funding will always be relatively expensive when it has to be imported via a current account deficit... But why is that the case??? Whoever holds those dollars ultimately has to choose some dollar-denominated investment, so they should only be able to choose among US bank/asset choices at low US rates. (If they sell the dollars to someone else the new person faces the same choice).

2. I think you are right to question Hempton's assumption that our current account deficit won't shrink or disappear... but if it does, I don't understand why it should matter with respect to marginal cost of bank funds? That just means those dollars are in American hands now instead of foreigners, but they still participate in dollar-denominated funding/asset options.

I've come to realize recently that I must have a different (possibly flawed?) view of international flows than conventional wisdom. But it seems Steve Keen may share a similar view, if I understand him correctly. See his comment here as of April 28th, 2009 at 2:05 pm:

"...Capturing international trade and financial flows between nations is therefore important, but second order to getting the overall framework right.

One important feature of this is getting causation right, and in my modelling–and the work of Minsky and the general monetary Post Keynesian perspective, to which I am a contributor–the financial causation goes from loans to deposits: loans create deposits, rather than the “deposits create loans” perspective of standard (empirically falsified) monetary analysis.

On this topic, conventional wisdom blames the high savings rate of Chinese and Japanese consumers for the American debt bubble. The Chinese & Japanese saved a lot, it had to be invested somewhere, so the Yanks borrowed it and yadda yadda.

From my perspective, the causation works the other way. Yanks took out enormous debt, and spent the debt-generated money largely on Chinese and Japanese goods, thus enabling the money to end up in Chinese and Japanese bank accounts while the USA accumulated the debt.

It’s the “barter” model of the world that infests the minds of neoclassical and Austrian economists. In a barter world, you can only be loaned what someone else has not already consumed–so savings are needed for investment. But in the credit world in which we actually live, a bank can give you a loan and create money (and debt) instantly without needing goods to back it beforehand. This simple reality is ingrained in Post Keynesian economics now, but still foreign to other schools of thought."
Am I correct to think that this discrepancy in explanations of how capital flows work might be relevant to my two questions, and do you disagree with it?

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Mr. Koo of the Nomura Research Institute in the March 2008 Business Week rejected the idea of fat spreads to solvency, "That's not possible today, because there is not enough demand to play the fat spread game in the US. Companies and consumers are already too indebted to be willing to take on more debt. That is why capital injection is necessary."

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I am feeling less healthy than I should for this level debate. I would like to continue though - so I will get up to it.


Roughly current account deficit countries with banking troubles go BANG and current acccount surplus countries with banking trouble go fizz.

We know what a sustainable situation looks like - its an economy where savings are about 5 percentage points higher and the economy shifts 5 percentage points out of domestic industries and into export and import competing industries.

5 points is probably 5 points of the labour market or say 7 million workers.

The macro problem is how do you get there from here?

I will follow up later...


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he did, joec, and that's consistent with other comments i've heard him make regarding the current situation in the US.

but then again, i've read his most recent book, and his discussion of current account balance concentrates on the role of globalization in facilitating destabilizing international flows. without rereading it, i don't recall a discussion of wholesale funding or how the differences in bank funding might alter outcomes.

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feel better, john. thanks for taking the time.

Roughly current account deficit countries with banking troubles go BANG and current acccount surplus countries with banking trouble go fizz.
that would seem consistent with the banks of past example rushing pell-mell to minimize expensive portion of their liability side, and not being so compelled in the case of cheap deposits.

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A key argument of Hempton's appears to be that the marginal cost of funding will always be relatively expensive when it has to be imported via a current account deficit... But why is that the case???

hbl, i think the answer must be "expensive in relation to what?"

deposits are cheap funding and remain so even in japan because the expense rate for the bank is less than either the yield of investments (JGBs, for example) or the accrual rate of loans, net some expenses (including FDIC insurance, which helps keep the deposit expense rate so low).

wholesale funding, however, must be priced for a different order of risk -- particularly now -- and that rate can be volatile with plenty of roll risk for the borrowing bank thanks to a massive duration mismatch (wholesale funding being largely short-term). witness, as example, the recent travails of LIBOR! :)

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Diane Sawyer on GMA told the nation that the recession's over

WHEW! i'm glad that's over, ccd. now i can put this down and get back to watching the cubs. :)

oh... wait.

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