Category Archives: economics

Account Keeping

I have been digging through some family archives and came across an old bank passbook belonging to my great grandfather, William Booth. He lived in Perthville in the central west of NSW. His account was with the Bank of New South Wales, Bathurst branch.


Pasted inside the front cover is a statement of the account keeping fees. I was born after decimalisation, so 5/- was not immediately meaningful to me. It turns out that the semi-annual fee is five shillings. To complicate matters further, the first transaction in the passbook is dated 1903, so these are British shillings. Australia did not introduce its own currency until 1910.

Passbook fees

Having worked out that much, I was interested to compare 1903 account keeping fees to account keeping fees today. So, the next step was to convert five 1903 British shillings into present day Australian dollars. The website Measuring Worth comes in handy for this purpose. The site’s banner features the following quote from Adam Smith’s The Wealth of Nations (1776).

The real price of every thing, what every thing really costs to the man who wants to acquire it, is the toil and trouble of acquiring it… But though labour be the real measure of the exchangeable value of all commodities, it is not that by which their value is commonly estimated… Every commodity, besides, is more frequently exchanged for, and thereby compared with, other commodities than with labour.

With that in mind, it provides a range of present day values for five 1903 shillings. Well, almost present day: their data series extend to 2011, so in 2011 terms five shillings is worth any one of the following

£22.00 using the retail price index
£26.00 using the GDP deflator
£86.80 using the average earnings
£134.00 using the per capita GDP
£200.00 using the share of GDP


Back in the day of William Booth, account keeping involved someone manually reconciling three columns of pounds, shillings and pence. These days the process is computer-assisted, so a retail price adjustment may be more appropriate than average earnings or any of the other measures.With UK inflation running at 2.6% over 2012, I can tweak £22.00 to £22.57. Using the current exchange rate, that amounts to A$33.33. Strictly speaking, even though Australia used British pounds in 1903, I should use an Australian retail index, but as Measuring Worth only has US, UK, Japanese and Chinese conversions at the moment, I will stick with the British approach.

So, Mr Booth was paying just over $5 per month in service fees for his banking. The Bank of New South Wales has since become Westpac. According to the Westpac website, the monthly service fee for the “Westpac Choice” transaction account is $5. Fees at other banks would be very similar. So, perhaps surprisingly, account keeping fees seem to have changed very little over the last 110 years!

Westpac fees

Given the level of automation in banking today, it would be reasonable to expect that fees would be lower than they are today. Certainly if the five shillings were adjusted based on average wages, the cost of Mr Booth’s account keeping would be more like $20 per month. Not only that, like every other bank, Westpac also offers a basic account option with zero account keeping fees. I am sure that would not have been an option in 1903.

Prisoner of Speed

A favourite podcast of mine is known in our household as “Danny’s podcast” in honour of the friend who first put me on to it. The podcast is better known as Radiolab and last week’s episode turned on the theme of Speed. After answering the question, what is the fastest sense, attention turned to high-frequency trading. As the Radiolab hosts are more comfortable with science than finance, they turned for assistance to David Kestenbaum from the Planet Money podcast.

In a past Mule post, I expressed reservations about the merits of high-frequency trading. Just last year, there was talk in the European parliament of enforcing a delay on electronic trading. Some critics argue that high-frequency trading creates instability in financial markets and may have been to blame for the “flash crash” of 2010.

One of the more intriguing aspects of high-frequency trading was brought out in the podcast during an interview with a technologist from the US trading firm Tradeworx. Bemoaning the cost of constantly competing to allow faster and faster trading (millions of dollars are being thrown at shaving milliseconds from the time to send trades to an exchange), he said that high-frequency traders were caught in a prisoner’s dilemma.

The prisoner’s dilemma is a staple of the study of the branch of mathematics known as “game theory“, which seeks to analyse strategic decision-making. Here is a quick overview for anyone unfamiliar with it.

Two criminals are arrested and taken to separate cells to ensure they cannot communicate with one another. The police have enough evidence to send each man to jail for one year. With a confession the police could get a conviction on a more serious charge. So, the police point out to each prisoner that cooperation will help reduce their sentence. If neither prisoner confesses, both will face one year in prison. If one testifies against his partner in crime, he will go free while the partner will get three years in prison on the main charge. But, if they both confess, that cooperation is not worth as much and both will be sentenced to two years in jail.

So, what should each prisoner do? No matter what the other prisoner does, confessing will improve their outcome, either from one year to none if the other does not confess, or from three years to two if the other does confess. So, the only rational thing to do is to confess. If both prisoners follow this logic, they will both get two years. And yet, if they had both kept quiet, it would have only been one year each, which would be better for both of them. The problem is that the “global optimum” is hard to obtain because there is too much of a risk for each prisoner that the other will defect.

The same is true for the high-frequency traders. While it might be cheaper for all of them to call a truce and freeze their technology at its current state, there would always be the risk that one firm breaks the truce and gains an edge. So, they all continue to compete in the speed race.

But the prisoner’s dilemma applies to more players than just the trading firms themselves.

If one of the major exchanges, such as the NASDAQ tried to stop the speed race, then it may well find itself losing business to any other exchange which continued to facilitate faster trading. An exchange without trading does not last long.

Governments too face the dilemma. There is already intense competition between exchanges operating in different countries and no government would want to lose the kudos and, more importantly, revenue that comes with playing host to a major financial centre. Would the UK government, for example, want to put London at a disadvantage to Europe or the US? Unlikely.

The German government is now delaying plans to curb high-frequency trading, in order to “clarify technical details”. I suspect that this will turn out to be a rather long delay.


Where is the money coming from?

PalmTreeIt has been quite some time since I wrote about the mechanics of money, but today I am at it again. The catalyst is not, as some might expect, the recent discussions about the possibility of the US Treasury minting a trillion dollar coin, but rather a recent discussion I had with a banker about deposits on a small tropical island.

While deposit levels at banks in Australia are below upcoming regulatory minimums, leading to intense competition in the pricing of term deposits, the banker I spoke to was facing the opposite problem in the small nation of Paradise Island (not its real name).

As he told the story, despite offering rather unattractive interest rates on deposits, deposit balances had continued to grow. Worse, demand for loans was weak and so the bank was forced to keep growing balances on deposit with the island nation’s central bank. Since banks like to diversify their investments, this situation was not ideal. Ordinarily, he said, deposits would build up as exporters took in payments for their goods, but periodically these balances would be swept out again as they remitted their profits to offshore parent companies. This did not seem to be happening any more. Exactly why these deposits were growing was a mystery and, short of closing the doors of all their branches, he did not really know how to stop these balances from growing.

With years of reading Bill Mitchell under my belt, I knew that the way to think about this question was to take a macro perspective rather than thinking from the perspective of one bank.

The first thing I focused on was the balances with the central bank. A popular misconception is that banks can choose between holding deposits with the central bank or lending the money to their customers. In fact they cannot. The central bank itself only has two types of “customer”: banks and the government. You and I cannot walk into the central bank and open up an account. This means that the only thing that can happen with central bank balances is that they move around from one bank to another or to and fro between the government and banks.

Imagine for a moment that the bank arranges a $100,000 loan for me to buy a nice little shack on one of Paradise Island’s beaches. If the shack vendor banks with my bank, then our bank will see both its loans and its deposits increase by $100,000. On the other hand, if the  vendor banks elsewhere, my bank will have to transfer $100,000 to the vendor’s bank. This is done by moving money between the banks’ respective  accounts with the central bank. So, in this case, my bank has an increase in its loans of $100,000 and a decrease of $100,000 in its deposits with the central bank. But that central bank deposit has not left the system (and it has not gone to me). Rather, it has moved from one bank to another.

While there will be movements in central bank balances in this fashion from one bank to another in the normal course of business transactions, balances will tend to average out to reflect each bank’s market share. So, my banker friend is unlikely to be alone in seeing deposits with the central bank growing. Indeed, looking at the aggregate bank balances with the Paradise Island central bank, it becomes evident that there is a systematic trend.

Deposit BalancesAggregate Balances with the Central Bank

So how does this happen? The most likely explanation is that the balances are coming from the government. As the government spends money, behind the scenes there will be money moving from the government’s account at the central bank to the accounts of commercial banks. This can happen if the government is running a deficit, spending more money than it is receiving. But that is not the case here. In fact, Paradise Island has been running a surplus of late.

A bit more digging through the national accounts reveals the answer. Paradise Island receives aid from larger developed nations and the  government has been spending most, but not all of this aid. The twist is that this aid has come in the form of foreign currency, which the government then deposits with the central bank in return for local currency balances which it is then able to spend. As a result, the central bank’s foreign asset balances have also been steadily growing. The similarity of these two charts is no coincidence: the two sides of a balance sheets must balance and the growth in the central bank’s assets directly mirrors the growth in their liabilities, in the form of commercial bank deposits. This is an example of what is known as “grossing up the balance sheet”.

Foreign Assets

 Foreign Assets of the Central Bank

So the growth in bank deposit balances with the central bank has nothing to do with Paradise Islanders hoarding money or choosing not to remit their profits offshore. Instead it is the direct result of the government spending its aid money. If the local banks want to have less of their money tied up in deposits with the central bank, rather than pointlessly trying to incentivise their customers to borrow or place their deposits elsewhere, they should consider encouraging the central bank to sell some of their foreign assets, reversing the grossing up of the balance sheet.

For me the most interesting aspect of this discussion is the fact that even if you can see exactly what is going on inside your own institution, it can be difficult to understand the workings of the system as a whole.


HandshakeDuring the week I attended a farewell function for a retiring colleague. The turnout was impressive, a sign of deep respect earned over a career at the bank spanning more than forty years. In the speeches, a recurring theme was trust.

The primary business of a bank is lending money, which exposes the bank to credit risk, the risk that a borrower will be unable to repay the loan. On more than one occasion, our retiring colleague had turned down a loan based on prior bad experiences with the prospective borrower. Why would you lend money to someone who has lied in the past? Learning from past betrayals of trust proved time and again to be a wise risk management strategy.

In Trust: The Social Virtues and The Creation of Prosperity, Francis Fukuyama argues that trust has played a crucial role in the development of capitalism. While some point to the role of the rule of law for enforcing contracts in enabling business, Fukuyama emphasises that legal recourse only serves as a last resort. More important is the simple confidence of a handshake: the confidence that those you do business with will live up to their end of the bargain. Those societies which developed mechanisms for extending trust beyond small networks of families and friends were rewarded with greater economic success.

If trust is important for business, it is particularly so for banking. But, scanning the financial headlines over the last few months shows a banking system apparently intent on destroying society’s trust in banks and bankers.

Serious Fraud Office investigating the rigging of LIBOR rates

Barclays is just the first bank to be fined for allowing traders to manipulate the LIBOR interest rate benchmark. The scandal cost chief executive Bob Diamond his job and this story will be back in the headlines as the findings extend to other banks and civil cases unfold.

HSBC accused of providing a conduit for “drug kingpins and rogue nations” 

Before a US Senate hearing, HSBC’s head of compliance faced charges that the bank had acted as knowing banker to Mexican drug cartels. He acknowledged that “there have been some significant areas of failure” and resigned his position there and then.

Standard Chartered alleged to have “schemed” with Iran to launder money

The BBC article in the link above is coy in its language. The New York Department of Financial Services is a little less so. Page 5 of their report quotes a Standard Chartered executive as saying, “You f—ing Americans. Who are you to tell us, the rest of the world, that we‟re not going to deal with Iranians?”

The front page of the Economist epitomises where this has led.


The worldwide reputation of bankers is at its lowest point, in my lifetime at least. The result will be new and more stringent regulation and more intrusive oversight of banks by regulators. This outcome will be well-deserved as banks have proved themselves unworthy of the trust of their communities. However, it is also likely to keep borrowing costs and transaction fees high as banks struggle to deliver shareholder returns while covering the costs of new regulatory requirements. So, it will not just be banks bearing the cost of their misdeeds.

Trust is hard to earn and, once lost, harder to recover. Every bank around the world should be thinking very hard right now about how to restore trust in banks.


Shadow Banking

The Financial Services Authority (FSA) is the banking and financial services regulator in the UK. For now at least.

Back in 2010, the Chancellor of the Exchequer (the equivalent of the Treasury in Australian terms) announced plans to scrap the FSA in response to a failure during the financial crisis of the 10 year old “tri-partite system”. This tri-partite system split responsibility for national financial stability management between the Treasury, the Bank of England and the FSA. The government is now working on shifting  responsibility back from the FSA to the Bank of England, a process which will establish three new regulatory bodies: the Financial Policy Committee (FPC), the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA). More three-letter initialisations and, dare I say it, a new tri-partite system?

Until this process is complete, the FSA continues about its business. The chairman of the FSA is Lord Adair Turner, Baron of Ecchinswell. Turner is also a member of the steering committee of the G20 Financial Stability Board (FSB). In March this year, he spoke at the London CASS business school on the topic of “shadow banking” and its role in the financial crisis.

Shadow banking, a term coined by Paul McCulley in the early days of the crisis, refers to a diverse range of entities such as “structured investment vehicles” (SIVs), hedge funds and money-market funds which have evolved to provide some very similar functions to banks, while not being subject to the same regulatory controls. A nightmare scenario for any bank is a “run”, when too many people try to withdraw their deposits at the same time. Shadow banks can also fall victim to runs. These runs may not be very obvious outside the financial markets, there are no queues of angry depositors on the streets, but they can be just as dangerous and runs on shadow banks were in fact a major factor underlying the global financial crisis. For this reason, regulators like Turner and the FSB are not only focused on strengthening controls on banks, but on better understanding shadow banks and, if possible, subjecting them to regulation to reduce the chances of future financial crises.

So what is it that shadow banks do? To answer that, I’ll first go back to the basics of banking. Although banks have evolved to provide many other products and services, the essence of banking is taking deposits and providing loans. The diagram below illustrates the flow of capital from an investor to a bank and from a bank to a borrower. Having given the bank some money, the investor now has a financial asset in the form of a deposit (and the deposit is a liability from the bank’s point of view). Likewise, the loan now represents a financial asset for the bank (and a liability from the borrower’s point of view). So the bank acts as intermediary between savers and borrowers. In doing so, however, banks act as more than a simple broker matching borrowers and lenders. Most bank lending also involves maturity transformation. More colloquially, this is known as lending long and borrowing short.

Bank Capital Flows

The typical depositor wants their money to be readily available in an at call transaction account. Some may be tempted by higher interest rates to put money in term deposits, usually no longer than 6 months to maturity. On the other hand, most borrowers do not want their loans due and payable too quickly. Home buyers borrow in the expectation that their earnings over coming years will allow them to pay interest and principal on their loans. Likewise, companies making capital expenditure, building factories, buying equipment or acquiring other businesses borrow in the expectation that the revenue generated by their expanded business capability will allow them to repay their loans. In both cases, the term of the loans must match the timeframes over which earnings are generated.

Some lenders will be prepared to make longer term investments, some borrowers may be able to repay more quickly, but overall there is a mismatch in maturity preferences of lenders and borrowers. Banks are in the business of bridging this gap in preferences. In the ordinary course of events, they can allow depositors to withdraw funds before loans are due to be repaid, making use of funds from other depositors, borrowing from other banks or, in need, borrowing from the central bank. But if too many borrowers withdraw at the same time and the bank is unable to meet those demands, then the bank can fail. This is known as liquidity risk, and has become an enormous focus of regulators, risk managers and rating agencies around the world in the wake of the global financial crisis.

While the financial crisis certainly highlighted the dangers of liquidity risk for commercial and investment banks such as Northern Rock and Lehman Brothers, it was outside the traditional banking sector that the greatest liquidity problems arose, particularly as a result of securitisation.

Securitisation is a form of structured finance that predates the financial crisis by many years. Essentially it involves setting up a trust (or similar legal entity) which provides loans that become the assets of the trust (often referred to as a “pool” of loans). The funds to provide these loans are obtained by selling a special kind of bond to investors, known as asset-backed securities (ABS). Principal and interest flowing from the loan pool is collected by the trust and periodically passed through to investors.

ABS capital flows

The most common form of securities bundles up pools of home loans, in which case they are referred to as residential mortgage-backed securities (RMBS).

Unlike bank-lending, there is essentially no maturity transformation involved in financing by means of ABS. Investors cannot withdraw their money early from the trust, they have to wait until it is repaid by borrowers. The only other option for an investor wanting to “liquidate” their investment (i.e. turn it back into cash) is to find another investor to sell their securities to.
The problem with ABS is the overall mismatch of maturity preferences between borrowers and lenders. Without getting into the business of maturity transformation, there was always going to be a limit on how large the market for ABS could become. Faced with a problem like this, it was only a matter of time before innovative financiers came up with a solution. One such solution was asset-backed commercial paper (ABCP). This involves adding another step in the chain, often referred to as a “conduit”. The conduit was simply another legal entity which would buy ABS, funding the purchase by issuing short-dated securities known as asset-backed commercial paper.
ABCP capital flow

Just like a bank, the conduit is exposed to liquidity risk. Before the crisis, this risk was considered fairly low. After all, the assets of the conduit were readily trade-able securities. Most of the time the conduit could repay investors simply by issuing new ABCP to other investors but, in the unlikely event that no such investors could be found, it could simply sell the ABS. In some cases, investors were provided with additional assurance of repayment in the form of “liquidity backstops” provided by banks, essentially a guarantee that the bank would step in to repay investors in need (although these commitments were not always very clearly disclosed to bank shareholders). This whole arrangement was considered highly satisfactory and conduits typically received the highest possible rating from credit rating agencies.

Unfortunately, liquidity risk is a real risk as the world eventually discovered. Once the US mortgage market started to get into trouble in 2007, investors around the world began, quite reasonably, to be rather reluctant to invest in RMBS and other ABS. Prices on these securities began to fall. Managers of large-scale cash investment funds, until then enthusiastic buyers of ABCP, decided that more traditional cash investments were more attractive. The conduits were forced to sell ABS at precisely the time when prices were falling. Their selling pushed prices down further in a vicious cycle, a perfect illustration of the close relationship between funding liquidity risk (the risk of not being able to repay obligations) and market liquidity risk (the risk of being unable to sell financial assets at anything other than a painfully low price). As a result, some conduits were rescued by the banks backing them (“taking them back on balance sheet”), while others collapsed.

The problems of ABCP were just one example of non-bank liquidity failures during the financial crisis. Others include the venerable US money market fund, the Reserve Fund “breaking the buck” or Australian non-bank lender RAMS finding itself unable to continue funding itself by means of “extendible commercial paper” (ECP).

ABCP conduits, money-market funds, non-bank mortgage lenders along with many other non-bank financiers that make up the shadow banking sector had well and truly entered the business of maturity transformation and are all exposed to significant liquidity risk as a result. There are many linkages between banks and these shadow banks, whether through commitments such as liquidity backstops, direct lending or even partial or complete ownership. Regulators are concerned that too much risk in the shadow banking sector means too much risk for banks and too much risk for the financial system as a whole.

One strategy for regulators is to enforce a cordon sanitaire around banks, protecting them from shadow banks. But many, including Lord Turner, worry that is not enough to protect our global financial system with its complex interconnections from damage when shadow banks fail. Ideally they would like to regulate shadow banks as well, preventing them from running too much liquidity risk. But this is not an easy task. As the name suggests, it is not easy to see what is going on in the world of shadow banks, even for well-informed financial regulators.

Goodhart’s Law

Another post and another Law, but this time no mathematics is involved.

Imagine you are running a team of salespeople and, as a highly motivated manager, you are working on strategies to improve the performance of your team. After a close study of your team’s client call reports you realise that the high performers in the team consistently meet with their clients more frequently than the poor performers. Eureka! You now have a plan: you set targets for the number of times your team should meet with clients each week. Bonuses will depend upon performance against these targets. Confident that your new client call metric is highly correlated with sales performance, is objective and easily measurable, you sit back and wait.

Six months later, it is time to review the results. Initially you are pleased to discover that a number of your poor performers have achieved very good scores relative to your new targets. Most of the high performers have done well also, although you are a little disappointed that your best salesperson came nowhere near the “stretch target” you set. You then begin to review the sales results and find them very puzzling: despite the high number of client meetings, the results for most of your poor performers are worse than ever. Not only that, your top salesperson has had a record quarter. After you have worked out whether you can wriggle out of the commitment you made to link bonuses to your new metric, you would do well to reflect on the fact that you have fallen victim to Goodhart’s Law.

According to Goodhart’s Law, the very act of targeting a proxy (client meetings) to drive a desired outcome (sales performance) undermines the relationship between the proxy and the target. In the client meeting example, the relationship clearly broke down because your team immediately realised it was straightforward to “game” the metric, recording many meetings without actually doing a better job of selling. Your highest performer was probably too busy doing a good job to waste their clients’ time with unnecessary meetings.

The Law was first described in 1975 by Charles Goodhart in a paper delivered to the Reserve Bank of Australia. It had been observed that there was a close relationship between money supply and interest rates and, on this basis, the Bank of England began to target money supply levels by setting short-term interest rates. Almost immediately, the relationship between interest rates and money supply broke down. While the reason for the breakdown was loosening of controls on bank lending rather than salespeople gaming targets, the label “Goodhart’s Law” caught on.

Along with its close relatives Campbell’s Law and the Lucas Critique, Goodhart’s Law has been used to explain a broad range of phenomena, far removed from its origins in monetary policy. In 18th century Britain, a crude form of poll tax was levied based on the number of windows on every house. The idea was that the number of windows would be correlated with the number of people living in the house. It did not take long for householders to begin bricking up their windows. A more apocryphal example is the tale of the Soviet-era nail factory. Once central planners set targets for the weight of nail output, artful factory managers met their target by making just one nail, but an enormous and very heavy nail.

Much like the Law of Unintended Consequences, of which it is a special case, Goodhart’s Law is one of those phenomena that, once you learn about it, you cannot help seeing it at work everywhere.

Bitcoin revisited

Just over a year ago, I wrote about the digital “crypto-currency” Bitcoin. It has been an eventful year for Bitcoin.

Designed to provide a secure yet anonymous, decentralised means for making payments online, the first Bitcoins were virtually minted in 2009. By early 2011, Bitcoin had begun to attract attention. Various sites, including the not-for-profit champion of rights online, the Electronic Frontier Foundation (EFF), began accepting Bitcoins as payment. But when Gawker reported that Bitcoins could be used to buy drugs on “underground” website Silk Road, interest in the currency exploded and within a few days, the price of Bitcoins soared to almost $30.

This kind of attention was unwelcome for some, and shortly afterwards EFF announced that they would no longer be accepting Bitcoins, fearing that this would be construed as an endorsement of the now controversial currency. Around the same time, the first major theft of Bitcoins was reported and the Bitcoin exchange rate fell sharply.

Bitcoin price history

Bitcoin Exchange Rate

More recently, another high-profile theft has caused ructions in the Bitcoin economy, prompting e-payments provider and PayPal competitor, Paxum, to abandon the Bitcoin experiment, which in turn forced one of the larger Bitcoin “exchanges” to shut down. The anonymity of Bitcoin is a design feature, but it also makes it almost impossible to trace thieves once they have their virtual hands on Bitcoins.

How much damage this does to the fledgling currency remains to be seen, but it certainly makes for a volatile currency. The free-floating Australian dollar is a reasonably volatile real-world currency but, as is evident in the chart below, Bitcoin volatility is an order of magnitude higher. That in itself is reason enough for any online business to think twice about accepting Bitcoins.

Bitcoin volatilityRolling 30 day volatility (annualised)

Whatever its future, Bitcoin is a fascinating experiment and, even if it does not survive, digital currencies of one form or another are surely here to stay.

Data sources: Bitcoin charts, Bloomberg.

More spreads

To provide a bit more context for the French government bond spreads discussed in the last post, the chart below shows the 5-year spreads to German bonds for a few more European countries.

All SpreadsWith spreads over 4300 basis points (43%), the chart is dominated by Greece, so here is the chart again with Greece removed.

Spreads without GreeceAs you can see in both charts, while French spreads are certainly heading north, they have a long way to go.

For those who have spotted the break in the line for Ireland, my data source seems to be missing 2010 data. I am looking into that and will update the casts if I plug the gaps.

Data source: Bloomberg.

French spreads

Changes of leadership in both Greece and Italy were initially well-received by markets, but investors are getting nervous again. Attention is shifting to France, and French government bonds seem to be on the nose. The chart below shows the “spread” between French and German 5-year government bonds. Measured in basis points (1/100th of 1%), the spread is the difference between the yields on the respective bonds and it has now reached 183 basis points.

Given that yields on 5-year government bonds are only 0.95%, that is a big difference. Investors are demanding almost double the rate of interest on a French bond offered by a German bond if they are to take on the risk that France is not able to repay its debt in 5 years’ time.

Unlike France, the United Kingdom is lucky enough to have its own currency and the spread between UK and German government bonds is only 10 basis points. More on that in a future post.

Data source: Bloomberg.



The oldest bank in the world

Yes I am back. I know it has been a while. What can I say? I have been quite busy!

One of the things taking up my time during the week was preparing for and then giving a talk for the Q-Group on operational risk capital modelling. It sounds arcane, I know, but there was one exciting part: I had the opportunity to try out the simulated laser pointer that you can create by pressing your finger on the screen of the iPad during a Keynote presentation.

Since regulators expect banks to use their capital models to quantify 1 in 1,000 year losses, I slipped a reference in my presentation to the Italian bank Monte dei Paschi di Siena which, having been founded in 1472, is a mere 539 years old. The somewhat oblique point was that no-one should take these models too seriously.

Monte dei Paschi

Monte dei Paschi di Siena

It was an ironic twist that evening that this was headline on the front page of the Wall Street Journal website:

Siena Headline (II)

It seems that Monte dei Paschi di Siena was one of a number of banks suffering as a result of the European sovereign debt crisis and it makes an interesting case study of the challenges of the business of banking.

Back in the original days of the global financial crisis, the banks that got into the most trouble were the ones with significant exposure to “toxic assets” (US mortgages, mortgage-backed securities and their ilk). Once people started to worry about these toxic assets, the problem was that no-one really knew how much exposure any given bank had to these assets and so no-one wanted to lend to anyone else. Since many banks (including Australian banks) rely on wholesale debt markets (i.e. they borrow money from big institutional investors around the world like pension funds), this became a problem for everyone.

Back then you might have thought that a regional bank like Monte dei Paschi di Siena would be fairly immune to what was going on, but it got off to a bad start in the crisis by acquiring another bank, Banca Antonveneta in 2007. In retrospect (and even at the time in the eyes of some analysts), it paid too much and over-extended itself at the wrong time. Within a couple of years, its capital buffers had become so thin that it was forced to turn to the Italian government for a capital injection and also cut its dividend payments right back in an attempt to rebuild. This was painful for Siena because, in a peculiarity of Italian banking, the majority shareholder of Monte dei Paschi di Siena is a charitable foundation, originally established in the 1990s for the express purpose of acquiring the bank when banks across the country were being privatised. This foundation makes donations to all sorts of public groups across the city of Siena and, with the dividend cut, the donations stopped too.

To make matters worse, the bank is a large holder of Italian government bonds, which have not been performing particularly well of late. With a capital base of €7.1 billion (figure as at April 2011), it held €32.5 billion (figure as at December 2010) in Italian government bonds and so any decline in value of Italian government bonds put pressure on the bank’s capital. In mid-2011, in the face of the European debt crisis, the bank decided it needed to further bolster its capital position. But the foundation did not want to lose its majority share-holding, so the foundation turned to JPMorgan and Goldman Sachs (aka the vampire squid) to borrow money to buy new shares issued by the bank. Unfortunately the loans were secured by shares and as the share price continued to fall, the foundation had to hand over more shares to its lenders. If things do not improve, the foundation is likely to be forced to sell more shares, ultimately losing its majority stake in the bank. The foundation, which once made around €250 million a year in donations to the city, is not looking likely to be able to contribute nearly as much to the public good in the future.

Will this venerable bank be the first to survive for 1,000 years? It has not failed yet, but the immediate future still looks rather shaky.