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Christopher Mahoney
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I spent eight years at Bank of America in New York (1978-86) covering Wall Street, then moved to Moody's Investors Service where I worked for 22 years, covering banks, sovereigns and corporates. I chaired the Credit Policy Committee for four years. I retired in 2007 as vice chairman. PLEASE... More
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  • The Intellectual Fallacy Of Central Bank Financial Strength

    There is an article in this month's ECB Bulletin titled "Central bank balance sheet expansion and financial strength in crisis times: the case of the Eurosystem". It is an extraordinary display of cant, nonsense and false assertions; in fact, it is almost Orwellian, as in 1984. Please wade through the following excerpts, and then I will comment:

    "The implementation of monetary policy is inevitably associated with financial risk because it involves the provision of central bank money against assets or collateral from private agents. If a central bank is perceived to be taking excessive risk, its credibility and the public's perception of its ability to deliver on its mandate may be affected.

    "Both in normal and in crisis times, central banks must preserve their financial strength, which means that they must always have sufficient financial resources available over time to conduct monetary policy in an independent manner, and hence deliver their policy objectives in all circumstances. What matters in ensuring the credibility of the central bank is its financial strength across time.

    "The ECB treaty prohibits monetary financing. These provisions preclude the monetising of sovereign debt. Through promoting price stability in the long term, these provisions indirectly contribute to the financial health of the Eurosystem's balance sheet.

    "The central bank's stand-alone financial strength reinforces credibility in its capacity to always deliver on its mandate while avoiding exposure to political pressures. This helps to anchor expectations among the general public and financial market participants that the central bank is in a position to effectively deliver on its mandate and that its monetary policy decisions will not be unduly constrained by concerns about financial resources."

    --ECB Monthly Bulletin, September 2013

    Let's parse these words. Note that the tone is didactic, from "on high", as opposed to scientific. No evidence is adduced in support of the following four palpably false hypotheses:

    1. To maintain confidence and credibility, central banks must maintain a high level of standalone financial strength.

    2. Central banks must always have sufficient financial resources available over time to conduct monetary policy in an independent manner, and hence deliver their policy objectives in all circumstances.

    3. The ECB's unwillingness to engage in QE ("monetary financing") contributes to the financial health of the Eurosystem's balance sheet.

    4. The ECB's standalone financial strength helps to anchor expectations that monetary policy will not be constrained by concerns about financial resources.

    In a nutshell: A principal policy objective of a fiat money central bank should be its standalone financial strength.

    Where did this shibboleth come from? Please name the economist, in any country. This bogus platitude can be found in no economics textbook written since the end of the gold standard. It was pulled out of thin air, and what I have called "Commercial Bank Thought", the earnest belief system of those who think that because they understand commercial banking, they must be experts at central banking. One can work for a commercial bank for decades and never learn anything about monetary policy--in fact the correlation is negative. Commercial banking is about making and collecting loans. Central banking is about delivering growth with moderate inflation. Those two Venn Diagrams don't touch. Commercial banks (private sector, profit-seeking enterprises) inadvertently, unintentionally and unknowingly act as vectors of central bank policy.

    Now, I will concede that when the Fed is asked to lend dollars to foreign central banks, it must consider their ability to pay the dollars back. But normally, central banks don't borrow from each other. It's a tangential activity. What central banks actually do is manage the money supply by adding or withdrawing liquidity from the banking system. That means either buying bonds with newly printed currency, or selling bonds from portfolio.

    The only actors who have credit exposure to the central bank are commercial banks who keep their liquidity reserves there. Do they worry about the Fed's standalone financial strength? No. Here's the crucial point: the reason why JP Morgan does not have a team of analysts running the numbers on the NY Fed (where it has a lot of money on deposit) is because the NY Fed prints dollars. The NY Fed can't run out of dollars.

    Now let's turn to other holders of dollar claims, such as the People's Bank of China. Does the PBoC have analysts studying the Fed's balance sheet? No, because the PBoC knows that the Fed prints dollars just as it prints RMB. There is no credit risk associated with its claims on the Fed. (The Treasury, yes, but the Fed, no.)

    Bogus hypothesis: "Central banks must always have sufficient financial resources available over time to conduct monetary policy." What does this mean? When it comes to buying things, they print money, so that is not a constraint. Now they do have to sell assets from time to time to mop up liquidity. What if they run out of bonds to sell? Then they can sell their own bonds. Not only does a fiat money central bank not require capital, it doesn't require assets, since it can issue its own bonds.

    Bogus hypothesis: "The ECB's unwillingness to engage in QE contributes to the financial health of the Eurosystem's balance sheet." What the ECB is saying is that, because it won't buy Club Med government bonds, it is maintaining the euro's credibility by protecting it from Club Med government credit risk. The euro is backed by good Nordic assets, not dodgy Latin assets. The credibility of the euro is supported by the market's confidence that the ECB can survive a collapse of Southern Europe. Indeed, the credibility of the euro may require the collapse of Southern Europe, which is a small price to pay for credibility.

    I recently suggested that Draghi is a hired gun. His employment contract specifies price stability, and that's what he's delivering. I have also said that Draghi has a secret contempt for the corrupt and profligate Italian political class, and that he hopes that Italy can be reformed by austerity and deflation. Maybe, who knows? He doesn't talk to me. But I would like to think that Draghi is a man of integrity and charity, and not merely a mercenary of the Bundesbank.

    So I ask myself: Did Draghi read this article, or was it written by the Bundesbank and shoved into the Bulletin? Why did he allow it to be published, when he knows that it is utter nonsense?

    At some point, when X+1 millions of Europeans are out of work, I would hope that Draghi will have the courage to be the St. Thomas Moore to Jens Weidmann's King Henry VIII and say: "I can no longer support your policies. I will do what I see fit, and it will be up to you to try to stop me".

    Tags: ecb, euro, eurozone
    Sep 16 11:46 AM | Link | Comment!
  • The Bundesbank's Target2 Exposure Is Manageable

    AEP at the Telegraph has a thought-provoking column about the implications of eurozone exit for the Bundesbank's (BB) balance sheet. The concern is that, when the peripheral central banks leave the eurozone, they will default on their outstanding balances to the Eurosystem, which are called Target2 Balances. The big Target2 debtors are the Bank of Italy and the Bank of Spain. The ECB has compensated for the withdrawal of deposits from the Club Med banks by extending ~700B* of credit to the peripheral central banks, financed mainly by the BB.

     

    An illustrative example: Barclay's risk committee decides move to its euro clearing accounts from Santander to Deutsche (or from its Madrid branch to its Frankfurt branch). Santander borrows the money it owes to Barclay's from the Bank of Spain, which in turn borrows from the BB. The BB then sells securities (Bunds) to German banks to fund its new loan to the Bank of Spain. Two weeks later, Spain exits the eurozone, redenominates all of its financial liabilities into New Pesetas (including Target2 and its own bonds), and the Bank of Spain defaults on its loans from the BB. This makes the BB insolvent (on whose balance sheet these loans are booked), thus requiring a bailout from the hapless German taxpayer**. That's the "crisis scenario".

    But I don't think that the situation is really so dire. First of all, I believe that the BB's exposure is to the eurosystem as a whole, and not to the Bank of Spain. So the default causes a solvency problem for the ESCB, not the BB. The ESCB is rendered insolvent, and would require a bailout from its owners (mainly, Germany). Minor difference, but a difference.

    [Nomenclature alert: The ECB = the Federal Reserve Board; the European System of Central Banks = the Federal Reserve System; the Bundesbank = the NY Fed, which has the bulk of the system's assets and liabilities on its balance sheet. Neither the FRB nor the ECB has a balance sheet. They are the boards of directors for their systems, which are made up of regional central banks. Most of the business conducted by the FRB and the ECB is handled by their "lead" banks, the NY Fed and the Bundesbank. The terms "the Fed" and "the ECB" are merely shorthand for the Eurosystem and the Federal Reserve System, banking groups with centralized governance but regional operating entities. The US system has the advantage that its regional central banks are not creatures of the 50 states, and not subject to local political influence. Bill Dudley (NYSEARCA:NYF) does not confer with Andrew Cuomo (NYS) on monetary policy.]

    Furthermore, there is no need for a bailout of the ESCB or the BB. A bailout would be required if the eurosystem was on the dollar standard or the gold standard; in other words, if its liabilities were denominated in a currency that it can't print. But the ECB prints euros, at no cost to anyone. A printing press doesn't need capital because it prints its own money. The ECB would not require a bailout from anyone other than its own printing press. The eurozone's money supply would not be affected, because the eurosystem's assets have no impact on the monetary aggregates (money is claim on the banking system, not an asset of the central bank). It would be very different if the ECB were on gold, but it's on Monopoly Money. If you or I were to xerox a euro note, it would be worthless. If the ECB does, it's money. Photocopied euros are not legal tender. Printed euros are legal tender.

    While it is true that the eurozone as a consolidated entity would "lose" the amount of money defaulted upon by Spain, it would have no economic, monetary or fiscal impact.

    Take a look at the dollar zone: Imagine that Texas announced that it planned to secede, resulting in a global run on Texas banks. That would require the Dallas Fed to fund the banks by borrowing from the system (i.e., the NY Fed). Then, when Texas does secede from the US, it redenominates into its own domestic currency and defaults on its liabilities to the system. The Fed would lose the amount lent to the Dallas Fed, which would appear on the balance sheet of the NY Fed, as an accounting entry and nothing more. (I'm making the simplifying assumption that Texas nationalizes the Dallas Fed, and that its only members are Texas banks.) No one would worry about the solvency of the NY Fed, or of the FRB. The remaining reserve banks can still print dollars, and the ex-Texas money supply would be unaffected. (The status in the US of currency printed by the Dallas Fed would be problematic, as it would be in the case of Spain. Know your bank notes!)

    This discussion harks back to prior conversations about the meaninglessness of central bank solvency, and the option of central bank debt forgiveness as a way of reducing government debt. The difference is that, instead of forgiveness on a planned and orderly basis, the default method would be a fait accompli, but otherwise similar.

    I have undoubtedly made a technical error or two in my analysis, but I doubt that they would change my overall conclusion, which is that Target2 balances don't matter in economic, financial or fiscal terms.

    However, T2 balances are a valid index of the market's assessment of redenomination risk, as the BIS has pointed out***.

    ___________________________________________________

    *http://www.eurocrisismonitor.com/index.htm

    **http://www.cesifo-group.de/de/ifoHome/publications/working-papers/CESifoWP/CESifoWPdetails?wp_id=19094645

    ***http://www.bis.org/publ/work393.pdf

     

    Sep 15 3:33 PM | Link | Comment!
  • Spain Is The Next Lehman

    "Where's the next Lehman?"

    --lead article in this week's Economist

    "We still view the Spanish banking system as weak given the ongoing deterioration in asset quality, and further capital injections will probably be required. It is also becoming more likely that any future capital injections would be achieved by bailing in bank creditors - particularly junior creditors - before resorting to the ESM support package."

    --Moody's credit opinion for Spain

    My answer to the Economist's question is: Spain is the next Lehman. The ECB's upcoming Asset Quality Review (this winter) will reveal a number of insolvent banks that will require recapitalization. Moody's already rates seven Spanish banks below investment grade . Now financing the recapitalizations shouldn't pose a problem, because Spain still has a 50B euro credit line from the ESM. The ESM gives Spain the money, and they use it to recap the bad banks. Problem solved.

    The problem would be solved were it not for the eurozone's new "No Bailout Principle", which requires "bailing in" creditors prior to the disbursement of ESM funds. In other words, the banks must default before they can be recapitalized.

    It is conceivable that such a bail-in could be conducted in such a way that depositors, counterparties and interbank lenders would be protected. If so, it would be very helpful if the Troika could make such an announcement now, rather than waiting for the inevitable funding crisis this winter.

    If no such reassurances are given, rational actors will further reduce their exposure to weak Spanish banks. Presumably this funding could be replaced with funds from the ECB, but that is not a path to viability.

    I would add that the Spanish government's rating is teetering on the brink of junk status. It is now rated Baa3/Negative Outlook. Moody's observes: "We would consider downgrading Spain in the event of an inability to implement the fiscal and structural reforms that are aimed at stabilising its debt burden, and/or in the event of a loss of access to private markets."

    Tags: spain, lehman, ecb
    Sep 10 5:33 PM | Link | Comment!
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