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Thursday, August 19, 2010

More Detail on the Proposed BOE Act - Part Nine

Note: This is the ninth part of a series filling in details of the Proposed Bank of England Act on which I posted seven articles here from July 31st to August 3rd. Bill Totten

Ensuring Stability In Banking

The banking system under this reform would be significantly more stable than the current banking system, by reducing the sources of instability, and making the inflows and outflows of money from the bank's lending business much more predictable.

Sources of Instability Under the Current Banking System

Instability under the current banking system comes from a variety of sources:

1. Every loan that the banking system makes creates more deposits, and consequently funds more loans. As a result, as people's financial situation gets worse and they take on more debt, the overall availability of loans increases. This creates a 'positive feedback loop' - as we get further and further into debt, banks become increasingly willing to offer us more debt. This develops into high levels of personal and household debt, which eventually become impossible to repay. This in turn triggers a wave of defaults, such as seen in the sub-prime mortgage market in America, which in turn triggers a domino effect throughout the economy. This means that the loans that banks originally expected to be repaid are no longer likely to be repaid, creating a huge shortfall in their income and potentially bankrupting them. In short, the design of the current banking system makes it fundamentally prone to collapse.

2. The majority of the bank's customers can demand repayment at any time from any accounts that do not have maturity dates or notice periods. This could result in the bank being required to pay back huge sums of money in a short period of time, making the bank effectively insolvent. The banks try to guard against this by keeping back reserves, but they continually walk a knife-edge between keeping reserves high enough to cover the maximum likely net withdrawals, and keeping them as low as possible in order to free money up for making further loans (to maximise profits).

Stability in the Post-Reform Banking System

The post-reform situation is much more stable. The stability arises from the fact that the funds a bank uses to make loans are now 'locked in' - customers can no longer demand them back whenever they choose. As a result, the bank knows:

1. What it will need to repay to customers who have made investments, and when.

2. What it will receive from borrowers making repayments on their loans, and when.

Money withdrawn from Transaction Accounts doesn't affect the bank in any way, as the money is stored in full at the Bank of England, and therefore doesn't need to be 'found' from anywhere when it has to be repaid.

Since all the investment funds that will be used by the bank come from Investment Accounts, and every Investment Account has a defined repayment date (or a maturity date), the amounts that the bank will need to repay on any one day will be statistically many times more predictable than under the current system.

For Investment Accounts with Maturity Dates, a bank will know the exact amount that must be repaid on any particular date, and will also know, from experience, what percentage of customers with maturing accounts will ask for the investment to be rolled over for another period (in other words, what percentage of accounts will not need to be repaid on the maturity date).

With regards to minimum notice periods, a bank will know the statistical likelihood of an account being redeemed within the next 'x' days, and so will be able to forecast the payments that will come due on any particular day for up to six to twelve months into the future. In addition, because a bank has, on its 'loans-made' side, a collection of contracts with specified monthly repayment dates and amount, it knows almost exactly how much money it will receive on any particular date up to six months in the future (allowing for a small degree of variation due to defaults and late payments).

Consequently, the bank's computer systems will be able to easily calculate how much money should be required on any particular day up to two years into the future. If it identifies any potential cashflow problems (such as a large number of Investment Accounts maturing in a short period of time and insufficient income from loan repayments to cover them all) the bank can rein back loan making activity until it has built up a buffer to cover the upcoming shortfall. On the other hand, if the cashflow forecasts identify a period when repayments from existing borrowers are in excess of the amounts required to repay Investment Account holders, it can increase loan making activity to ensure that it does not end up with a swelling Investment Pool Account full of 'idle' funds.

Sources of Uncertainty in the Post-Reform Banking System

There are three sources of uncertainty in the post-reform banking system. The first source relates to the bank's 'in-comings', and the other two relate to the bank's potential outgoings:

1. The risk of default by borrowers. However, it should be remembered that the risk of defaults will be significantly lower throughout the entire financial system after the reform

2. The risk of a mass redemption of Early Redemption Options - there is the potential for a small scale 'run on the bank' if Investment Account holders all exercise their Early Redemption Options at the same time. For a discussion of these risks, and why we consider them to be minimal, see the Appendix on Early Redemption Options, which discusses Early Redemption Options in detail:

There is a small source of potential instability here, but this instability is many times less than the instability that is inherent in the existing system.

3. Uncertainty about the likely use of minimum notice periods. At any one point in time, there may be billions of pounds of liabilities subject to short-term minimum notice periods. For example, imagine that a particular bank has GBP 10 billion in Investment Accounts that are subject to a thirty-day minimum notice period. In an extreme case, if a rumour spread that that bank had made some bad investments, and all these account holders exercised their minimum notice period, the bank may be required to repay GBP 10 billion in thirty days from now. Again, while this is still a source of instability, it is both less likely to occur than under the current system, and if it does occur, the total impact on the bank would be far less.

The Lower Level of Systemic Risk:

We believe that the risk of any bank or all banks suffering a 'cashflow crisis' is significantly lower post-reform than under the existing banking system, for the following reasons:

1. Unlike the present day banking system, the post-reform banking system is counter-cyclical, rather than pro-cyclical. This means that the banking system will not create debt-fuelled booms that soon turn into economic crashes, causing a wave of defaults. Consequently, each bank's loan portfolio is likely to be far safer than under the current system.

2. The economy will be generally more benign. Without regular banking-fuelled boom and bust cycles, recessions will be less frequent and less severe. If a million people are no longer thrown out of employment every few years, then fewer people will run into financial difficulties, and therefore fewer borrowers will be forced to default.

3. Because the bank has limited funds for making loans (and because each loan does not create new deposits), the incentive for loan-making departments shifts from lending as much as possible, to finding good quality borrowers to lend to. As a result, the banks are less likely to lend to bad-risk borrowers, and consequently the overall quality of a bank's loan portfolio should be higher, making defaults less likely.

Provision for Emergencies

We have made provisions for the situation where a bank does not have sufficient funds in the investment pool to re-pay maturing Investment Accounts.

In this situation, the Bank of England has the discretion to make an emergency loan to the bank in question. This loan must always be used to re-credit the maturing Investment Account - it can not be used to fund new loans.

This may sound a little like the taxpayer-funded bailouts that we have seen over the last few years. In reality, it is completely different - the emergency loan will consist of nothing more than numbers added to a computer system; in other words, it will be newly-created money, and will not cost the taxpayers anything. The borrowing bank will need to repay the loan in full, out of its future income. If the bank needs to borrow significant amounts, then it is unlikely to earn a profit for a number of years. However, as the bank repays the loan, this newly created money will be 'destroyed' again, ensuring that the emergency loan has no long-term effect on the money supply. This emergency loan will merely provide some liquidity for the individual bank in unusual cash-flow circumstances.

Note that this emergency loan should only be provided to meet a short-term liquidity problem - for example, if a recession had caused a larger withdrawal from short-term Investment Accounts than normal. In deciding whether to support the bank with such an emergency loan, the Bank of England should look closely at the bank's loan portfolio and future income. If this is purely a short-term cash-flow problem (that is, loan repayments are out of synch with maturing Investment Accounts), the loan portfolio is healthy, and it's clear that the bank will soon be able to repay the emergency loan, then the emergency loan should be made. However, if the cash-flow problem arises because the bank's loan portfolio is 'toxic' and a large proportion of borrowers are defaulting, it may be unlikely the Bank of England's emergency loan will be repaid. In this case, the Bank of England would probably choose to initiate 'wind-down' procedures for the bank in question.

Penalising Banks for Poor 'Cash-Flow' Management

The Bank of England or the banking regulator can - and should - penalise banks that have to seek emergency funding. There are a number of ways that they could attempt to do this:

1. By charging a punitive rate of interest on the emergency loan (reducing the bank's future profits)

2. By charging a monetary fine

3. By launching an in-depth investigation into the bank by the banking regulator

4. By any other method that the banking regulator believes will prevent further transgressions by the bank in question or any other bank in the industry.

Rather than a bank in trouble representing a huge financial burden on the taxpayer, under our proposed reform it could actually be an opportunity for the state to profit in real and absolute terms.

No Bailouts of Bad Banks

The provisions above mean that the Bank of England would have the power to lend money to a bank in order to prevent it suffering a temporary cash-flow crisis, and that doing so would have absolutely no financial cost to the taxpayer.

However, we are keen that this should not be seen as state support for banks that are fundamentally unsound. We should not see governments supporting 'toxic banks' in the way that we have seen over the last three years.

If a bank is judged to be badly managed or have made bad investments across the board, meaning that all holders of Investment Accounts are likely to lose money, then the bank in question should be wound down, broken up and sold off to either healthier banks or debt collection firms. (Note that by 'debt collection firms', we are referring to companies that would buy - at a discount - the legal contracts between the bank and its borrowers, and collect repayments over a period of time, according to the payment terms in the individual contracts. No borrower would be requested to repay the loan earlier than originally agreed).

In the post-reform system, winding down a bank would be far easier and cheaper than under the existing system, for the following reasons:

1. The funds placed in Transaction Accounts are 100% safe, held separately from the bank's investments in the bank's Customer Funds Account at the Bank of England.

2. The taxpayer and government has no exposure or responsibility whatsoever for the funds owed to holders of Investment Accounts. The Investment Account holders would become creditors of the liquidated bank, and insolvency law would govern whether and by how much they are repaid their original investment.

Bill Totten


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