But this is impossible under modern monetary theory!

Or perhaps we should revise that to a “this is impossible under a deeply deluded understanding of modern monetary theory”. For there’s a certain segment of the populace who insist that banks just make up money out of thin air. So, therefore, this can never happen:

Ordinary Greeks rushed to withdraw cash from ATMs in the early hours of Saturday morning. Greece’s Alpha Bank stopped all online transactions according to its website on Friday night.

If banks do just create money ab nihilo then this cannot possibly happen. There is no possibility of a bank ever running out of money, is there? But this is happening. Therefore it cannot be true that banks do indeed just create money out of nothing.

The confusion comes from the way in which credit is created: this is indeed done by the banking system in a fractional reserve banking system. You or I go to borrow money and the money we borrow is indeed simply created, as a ledger transaction, by that bank at that time. So, to some that seems the end of the matter. But at 4 or 4.30 that afternoon, that bank has to balance its books. It must have sufficient deposits to fund all of its loans, and if it does not through its branches it must go out into the more general market and solicit some more deposits. So, that effortless creation of money only lasts until that daily point at which it must balance the books.

And, of course, the same occurs in reverse when people are reducing their deposits at said bank. It must either claw back the loans it has made (something that takes time) or it must collect more deposits from the wholesale system or it must deny people the right to extract their deposits. Because, once a day at least, those books must balance.

In a world where banks effortlessly print or make as much money as they wish banks runs cannot happen. We are seeing a bank run: therefore banks cannot effortlessly print or make all the money they wish. Monetary theory’s just great but even that has to be checked against reality occasionally.

Why the Bank of England should end its stress tests: ‘No Stress’ in a nutshell

In December last year the Bank of England reported the results of its first set of annual stress tests of the capital adequacy of the UK banking system. Its message was reassuring: our banks are safe.

Don’t believe a word of it. The banking system is actually highly vulnerable and the stress tests merely hide that fact. Indeed, they even make the banking system less safe than it already is, by pressuring banks to take hidden risks that the risk models cannot see. 

The stress tests are flawed in three distinct ways. 

The first is methodological. The tests are based on one scenario and cannot possibly give us confidence the system is safe against all the other possible scenarios they did not consider. They are based on a ‘risk-weighted’ asset metric that is unreliable because it is dependent on gameable risk models that under-estimate banks’ risks – and the system incentivizes banks to game the models to get lower capital requirements and thence higher distributions of false profits. They create systemic instability by pressuring banks to use the same models that are blind to the same risks. They lack credibility because even if the central bank thinks there are major banking problems, it cannot publicly admit to them – to do so would undermine confidence and lead to questions about its own past competence in rebuilding the banking system. The results then have all the credibility of a rigged election. 

Even if we ignore these problems, the stress tests are fatally flawed because they use a very low ‘pass’ standard, a 4.5 percent minimum ratio of capital to risk-weighted assets. This minimum is well below those coming through under Basel III. Had the Bank carried out a test using these latter minima, the banking system would have failed the test: same exercise, higher safety standard, opposite result. 

The Bank also failed to carry out any tests based on a minimum ratio of capital to leverage – a test that would have been more reliable because it is much less dependent on unreliable risk models. Even the most undemanding such test – one based on a minimum leverage ratio of only 3% – would have revealed that the banking system was very weak. The Bank’s failure to apply this latter test is all the more puzzling because the Bank expects UK banks to meet this minimum standard. Thus, the Bank asks us to believe the banking system is sound, despite the fact that a 3 percent leverage ratio test based on what it currently expects from banks and based on its own stress scenario would have suggested otherwise. One might add that many experts recommend a minimum leverage ratio of 15 percent, five times larger than the leverage test that the Bank did not conduct, or at least report. You can imagine the results. 

One can only speculate why the Bank did not report the results of these alternative tests, but one thing is sure: the comforting headlines last December would have been rather different had they done so. 

Overseas experience also indicates that stress tests are useless as indicators of bank vulnerability and can go catastrophically awry. Recent stress tests failed to notice the impending collapse, not just of one but of three national banking systems: Iceland in 2008, Ireland in 2010 and Cyprus in 2013, all of which collapsed shortly after being signed off as safe by regulatory stress tests. The European stress tests missed the latter two collapses, but also have a history of being captured by powerful banks and the Euro elite – and of using very unstressful stress scenarios to produce loss projections that turned out to be dramatically short of subsequently realized losses. 

The most recent European stress tests would appear to be no exception: the ECB party line was that all was well in the European core despite problems in the fringe countries, but these were dismissed on publication by a variety of experts who pointed out that it was the big French and German banks that were most vulnerable. However, the European stress tests overlooked their vulnerability because they used ‘risk-weighted’ asset measures that were blind to their main risks instead of leverage measures that would have revealed them – the same mistakes that were made by the Bank of England. 

Stress tests operate like a radar that cannot see any hazards. We wouldn’t dream of sending out a ship or plane reliant on a radar that didn’t work. We really shouldn’t do that with our banking system either: the Bank of England should abort its stress testing program forthwith. 

Kevin Dowd is the author of the Adam Smith Institute’s most recent report ‘No Stress’, which is available here.

The seriously fascinating opening to a European Union report

We find ourselves near helpless with laughter at this opening to the latest European Union report. It’s the one about how the eurozone should be deeper, have a common treasury and so on. And it opens with this:

The euro is a successful and stable currency. It is shared
by 19 EU Member States and more than 330 million
citizens. It has provided its members with price stability
and shielded them against external instability. Despite
the recent crisis, it remains the second most important
currency in the world, with a share of almost a quarter
of global foreign exchange reserves, and with almost
sixty countries and territories around the world either
directly or indirectly pegging their currency to it.

Europe is emerging from the worst financial and
economic crisis in seven decades.

At least one of us around here is known to be deeply eurosceptic, but even given that isn’t this just the most delightful piece of political prose?

For there’s not a single economist who wouldn’t add a “therefore” to the beginning of that second paragraph. Yes, the recession was not caused by the euro itself, but the existence of the euro most certainly made it worse than it would otherwise have been. As that same single currency made the boom beforehand even more frenzied. And then the actual monetary policies followed made matters even worse: the ECB was still raising interest rates when unemployment was soaring past 20% and more in some countries.

We can’t help thinking that, well, observe the following:

This report has been prepared by the President of the
European Commission, in close cooperation with the
President of the Euro Summit, the President of the
Eurogroup, the President of the European Central Bank,
and the President of the European Parliament.

This report reflects the personal deliberations and
discussions of the five Presidents.

Five presidents might be four or more too many for an organisation but leave that aside. But do we really desire the governance of an entire continent to be in the hands of those who could violate Poe’s Law so grievously?

New report: No Stress – The flaws in the Bank of England’s stress testing programme

In 2014, the Bank of England commenced a stress testing programme in an effort to test the capital adequacy of major UK-based banks. It concluded that its results demonstrated the resilience of the banking system. No Stress, a report from the Adam Smith Institute, suggests that we should be extremely sceptical of the Bank’s conclusions.

The report is by Kevin Dowd—Senior Fellow of the Adam Smith Institute, professor of finance and economics at Durham University, and author of three books, ten book chapters, and dozens of journal articles on risk modelling—who presents a powerful and rigorous indictment of the Bank’s stress testing programme.

Dowd makes the case that the stress tests are significantly methodologically flawed and worse than useless, giving policymakers unreliable information about the strength of the UK banking system, providing false risk comfort, and creating systemic instability by forcing banks to converge towards the Bank of England’s models.

The Bank of England (BoE) uses just one stress test scenario, which attempts to predict what would happen in the event of a major recession to the UK’s major banks: Barclay’s, the Co-op, HSBC, Lloyds, Nationwide, RBS, Standard Chartered and Santander. Using just one scenario is extremely limited – an economic downturn can take many forms, and a combination of unemployment, inflation and negative economic growth that was substantially different to the Bank’s scenario could hit the banks in a completely different way. The BoE can say that the banks are safe under its scenario, but not that they are safe in general.

The BoE’s use of risk-weightings, as opposed to leverage ratios favoured by many international authorities, to calculate banks’ assets is extremely questionable. These risk-weightings are easy to game by banks, giving a rosier picture of their health than alternative measures would show. This also distorts the bank’s investment strategy.

The BoE’s approach forces a standardisation of banks’ risk models, effectively putting all the British banks’ eggs into one basket. By misleadingly reporting that the financial sector is safe, the BoE’s stress test has provided false risk comfort to politicians and consumers.

For these reasons and more, Dowd concludes that we should end regulatory risk modelling and re-establish strong bank governance systems that make decision-makers personally liable for the risks they take. The report is available to download here. (more…)

There’s a lot of ruin in a nation

But ruin is not something in infinite supply in any nation:

From Monday, customers who held Zimbabwean dollar accounts before March 2009 can approach their banks to convert their balance into US dollars, the governor of the Reserve Bank of Zimbabwe, John Mangudya, said in a statement.

Zimbabweans have until September to turn in their old banknotes, which some people sell as souvenirs to tourists.

Bank accounts with balances of up to 175 quadrillion Zimbabwean dollars will be paid $5. Those with balances above 175 quadrillion dollars will be paid at an exchange rate of $1 for 35 quadrillion Zimbabwean dollars.

The highest – and last – banknote to be printed by the bank in 2008 was 100tn Zimbabwean dollars. It was not enough to ride a public bus to work for a week.

The bank said customers who still had stashes of old Zimbabwean notes could walk into any bank and get $1 for every 250tn they hold. That means a holder of a 100tn banknote will get 40 cents.

At some point simply running the printing presses does run into real problems. Our favourite little story from this whole disastrous episode comes from the final end days of the printed currency. Normally, currency printing is a very profitable occupation. Bit of paper, the price of some ink, and a banknote that is worth whatever the government says it is is created. Right at the end there it’s said that the final decision to stop printing was taken because….no one would accept a bank note of any denomination at all, or any number of them, in return for supplying the ink with which to print the banknotes.

There have been hyperinflations before and it’s a near certainty that it will happen again, somewhere. But this is the only example we know of where seigniorage was ridden all the way down to the bottom, to the bitter end.