The Idea of Restraining Banks



In 2008 the fractionally reserved banking system almost collapsed and tax payers the world over were tasked – quite involuntarily – with rescuing the banks. It was reasoned that unless that were done, the world would basically stop turning (in reality, when corporations go bankrupt, their ownership changes; banks have gone bankrupt throughout history, and evidently, economic progress has not been impeded by this).

One would think that after such a near-death experience it would have been a good time to question the entire organizational principles of the existing banking cartel, in the way Ron Paul has for instance done in the US. However, such a questioning was avoided, as the political establishment has no intention whatsoever to return to sound money or to allow free competition in banking. Moreover, the institution of central banking, the main reason for the enormous amplitudes boom-bust cycles nowadays attain, is not be questioned by anyone. Too great are the profits and short term political advantages derived from it; it is one of the most ingenious and insidious ways ever thought up to 'boil the frog slowly' and rob him of the fruits of his labor without him noticing.

In addition, after decades of propaganda, there are a great many actual and would-be social engineers who fervently believe that this essentially socialist central planning institution is 'necessary' to 'plan the economy', which would otherwise fall prey to 'market anarchy'. If one looks around the internet, there is no shortage of 'better plans' proposed by scores of armchair planners; plans which they believe the central banks should pursue (most revolve around the 'best way' of inflating the supply of credit and money).

Instead of questioning and reforming the system as such, a number of bones were thrown in the general direction of an irate electorate. In the US for instance, the Frank-Dodd monstrosity was born, a regulatory tome the size of several of the telephone books of yore. Its content will neither increase the safety of depositors, nor prevent future bubbles from emerging and collapsing. Even if one has no inkling of the theoretical questions that are relevant to this problem, one already knows this to be the case, since a new bubble is underway at this very moment.

Furthermore, Dodd-Frank has in its attempt to provide more 'security', achieved the exact opposite by ensuring that the 'too big to fail' banks have become even bigger. The new regulations have thrown countless new obstacles in the way of competition, making it easier for the oligopoly of the biggest players to plod on, insolvent as it is. We are today further away from free banking than ever.

We should add here that from the point of view of the banks, flagrant overtrading of their capital makes a lot of sense. After all, they earn large profits while things are going well, and should a bubble burst, they can rest assured of being rescued via the backstop provided by the central bank. A monopoly issuer of money able to create money in theoretically infinite amounts can indeed rescue even completely insolvent institutions. The costs are then evenly distributed among all users of its currency, and usually don't become apparent right away. Without a doubt very few people in Japan would have expected back in the early 1990s that decades of economic stagnation were about to ensue. And even now, in hindsight, it is very difficult to apportion blame, especially for the average citizen who has no time to delve into the arcana of modern-day monetary policy.

The Holy Grail of Credit Expansion



One of the bones thrown to the electorate was the idea that banks should increase their capital to such an extent that they would be less likely to fail, and also to ensure that they could indeed be allowed to fail if (or rather, when) push came to shove next time around. This idea also had the support of the political establishment, at least initially, as politicians were deeply embarrassed by the tax-payer financed rescue of banks. Not only that, but the sovereign debt crisis in Europe showed that even though the State can normally obtain credit in very large amounts without a hitch due to the fact that it can dispose of the property and income of its citizens almost at will, there is in fact a limit to this debt expansion.

The idea that one might have to consider bailing out even more banks at some point in the future was viewed with a certain dread. And so Basel III – a considerable tightening of bank capital rules – was initially held to be an effective instrument to make the system more stable.

In the meantime though, many politicians have realized that if one forces fractionally reserved banks to set aside more capital to 'cover' their exposure, a reverse leverage effect comes into force. They are by necessity forced to either obtain new capital in sufficient amounts in the marketplace – something their shareholders don't want, as they have in many cases already seen a substantial dilution of their ownership stakes – or by shedding assets. Shedding assets means that said assets will be repriced. Not only that, it also means that credit expansion will come to a halt.

It has however become a shibboleth of modern-day economic thought, at least at the policy-making level, that no economic growth is possible without credit expansion. In addition to that it is of course feared that if the banks are forced to increase their capital, the weaker among them will once again be exposed. After their conditions have been swept under the rug so successfully in recent years one is reluctant to allow that to happen. In this context, one only need to recall the case of DEXIA – a mere three months before it went bankrupt, the European Banking Authority had declared it the 'best capitalized bank in Europe'. No-one wants more 'DEXIA' cases to emerge, although they have a nasty habit of emerging anyway (see the Monte Dei Paschi case for a recent example).

As a result of the above, combined with intensive lobbying by the banks themselves, the new Basel rules have come under attack from many sides. It is a good bet that they will be watered down ever more. Already their introduction has been 'temporarily' postponed. The eventual outcome will probably be that nothing much will actually change.

Denmark's Protest



The latest protests have been lodged by Denmark, where a simmering banking crisis has been underway for some time as a result of a real estate bubble that is in the process of deflating. The Danish real estate and mortgage credit bubble was for a variety of reasons one of the biggest in Europe. In Denmark a combination of ultra-low interest rates imposed by the central bank and a lack of alternative investment outlets have combined to make the bubble especially egregious. The reason why investment alternatives in Denmark are so scant is that the country is a socialist paradise of quite Orwellian dimensions (here is an expatriate calling it a 'slave state', here is a Danish citizen putting the alleged 'successes' of its socialist model into proper perspective).

As such, it offers little incentive to entrepreneurs to engage in wealth-creating activities. The wheeling and dealing of the border-less world of finance no doubt exerts considerable attraction in such a country. The end result of all this is that Denmark now has the biggest amount of mortgage debt outstanding relative to the size of its population as well as economic output anywhere in the world.



Naturally the idea that its banks could be forced to increase their capital in order to conform with the new Basel rules doesn't sit well with Denmark's authorities. The arguments forwarded by the Danish authorities are also interesting from a more general point of view, since one of the points at issue are the types of securities that can henceforth be used as 'safe capital'. Below are a few excerpts of a recent Bloomberg article on the topic with our comments interspersed.

Bloomberg reports:





“Denmark is ready to do for its two- centuries-old mortgage system what European Central Bank President Mario Draghi has done for the euro: whatever it takes. Danish Economy Minister Margrethe Vestager says the government is “disappointed” its demands were overlooked by Basel bank regulators last month as the nation lobbies to ensure its home-finance model isn’t wiped out by proposed liquidity rules. “That’s a key issue for us,” Vestager said in an interview in Copenhagen. Denmark is fighting for a mortgage system that “has endured any stress test that you can come up with,” she said.”

(emphasis added)

Unfortunately this doesn't sound very credible. 'Stress tests' are by now well known for their uncanny ability to fall short of reality. Given the sheer size of the outstanding mortgage debt in Denmark, it seems not very likely that really all possible adverse scenarios have been tested if the outcome of the tests was as benign as Mrs. Verstager suggests.

Recall that back in 2007, former treasury secretary Hank Paulson asserted that the US banking system was 'the safest and soundest he had ever seen in his lifetime'. Even as late as July 2008 he kept repeating that the US banking system was 'safe and sound, in spite of the problems in mortgage credit'. One of the arguments he forwarded at the time is quite interesting in this context. He said that: “…..about 99 percent of the 8,500 U.S. banks, holding about 99 percent of bank assets, fell into the highest category of capitalization, a measure of financial health.”

In short, such assertions regarding the 'financial health' of banks are utterly meaningless. The fact remains that a fractionally reserved banking system is at all times teetering on the edge of insolvency – that is in its very nature. Bloomberg continues:





“By echoing Draghi’s July pledge to use every tool at his disposal to protect the euro, Vestager is sending a clear warning to international regulators that Denmark won’t rest until its demands are met. At stake is the nation’s $600 billion mortgage-bond market, the world’s biggest, relative to the size of the population. “Danish housing finance is extremely cheap, stable and trustworthy,” Vestager said. “We’ll do whatever it takes to guard it.”





We very much believe Mrs. Vertager when she says that the Danish housing finance is 'cheap' – that is precisely why it is in trouble. Whether it is 'stable and trustworthy' as well is a matter of opinion and even if it is stable at the current point in time, this is certainly not an immutable condition in light of the size of the bubble. The Bloomberg article continues:





“Banks in AAA rated Denmark meet their liquidity needs by holding the covered bonds, which are backed by home loans. The Basel Committee on Banking Supervision wants to limit use of the securities, even though they’re rated higher than more than half the nations in the euro area. Instead, Basel would make lenders more reliant on government debt. Denmark, which doesn’t have a seat on the 27-member Basel Committee, argues the group is ignoring the lessons of the debt crisis. Thanks to its fiscal restraint, Denmark’s public debt burden is about half the euro area’s average, meaning there aren’t enough sovereign bonds to fill the liquidity shortfall the Basel rules would create. Nykredit A/S, Europe’s biggest issuer of covered bonds backed by mortgages, estimates the gap is 200 billion kroner ($36 billion). “The recent Basel announcement still focuses very much on the issuer and not on the objective characteristics,” Vestager said in the Feb. 7 interview. The rules assail a “very old and well-working mortgage system,” she said. Implementing the so-called Basel III liquidity rules would force Danish banks to sell off mortgage bonds, drive up home finance costs and send tremors through the whole economy, according to Steen Bocian, head of economic research at Danske Bank A/S, Denmark’s largest lender.”

(emphasis added)

First of all, the issue we mentioned further above, namely that the selling of assets that tighter capital rules will require is feared because it will pressure the prices of these assets is explicitly mentioned here. However, it seems quite absurd that the Basel rules require banks to hold more government bonds – that is an example of 'financial repression' in action, and it seems especially pernicious in view of the sovereign debt crisis.

In that sense the Danish authorities are certainly correct to question these requirements. As to the fact that Denmark's sovereign debt is very small – that is no doubt a good thing, but we have already seen that it is meaningless when crisis strikes, since as a rule, both tax revenues will fall and government spending will soar. One remark on covered bonds: they are superior to other mortgage securitizations insofar as the banks issuing them remain liable. We suspect however that this makes little difference in the event of a major bubble – the risks posed by the bubble are not significantly diminished on account of this feature.

Bloomberg further:





“Danish mortgage bonds, which made it through the Napoleonic wars without any defaults even as Denmark’s government went bankrupt in 1813, need to be given the same liquidity status as sovereign debt, the government in Copenhagen argues. Yet Basel isn’t the only group to question the safety of the bonds. Moody’s Investors Service argues the spread of adjustable-rate mortgage bonds, which now make up about half the market, has created a refinancing risk because bonds as short as a year are used to fund 20-year mortgages. The industry counters that any change in borrowing rates is passed on to the borrower, while the issuer only bears a far more remote risk of default. The central bank has also urged issuers to consider phasing out interest-only mortgages amid concern the loans fanned imbalances that culminated in Denmark’s housing bubble, which burst in 2008. Since their peak a year earlier, house prices have slumped more than 20 percent, sending the nation into a recession.”

(emphasis added)

That Denmark's mortgage bond market 'survived even the Napoleonic wars' seems quite immaterial in view of how big it has become. In the early 19th century, mortgage bonds probably represented a mere fraction of the total outstanding debt and had definitely not grown into the massive debtberg they represent today.

Moody's is quite correct in doubting the safety of adjustable rate mortgage bonds given the maturity mismatches it discusses in the context of refinancing. The banking industry pretends that because the risk is with the borrower, issuers have far less risk; this strikes us as a rationalization. After all, if borrowers become unable to pay, their creditors will face losses as well. Given that house prices are already declining, these losses would likely become a much bigger problem than is currently assumed. Should interest rates rise, the problem would definitely become acute very quickly (currently Denmark's interest rates are among he lowest in the world).

In fact, as Claus Vistessen of Variant Perception pointed out to us recently, a further stabilization of the euro area's periphery should probably be feared by Denmark, as it would likely lead to a cessation of capital inflows, which in turn would tend to push interest rates up.

Basel to be Ignored



As Bloomberg informs us in the final paragraphs of the article, Denmark's authorities have already told their banks to simply 'ignore Basel'.





“Though global central bank chiefs, meeting last month in Basel, Switzerland, agreed to some concessions, including extending the deadline to meet the rules to 2019 from 2015, Denmark’s pleas were ignored. “We thought a lesson was learned with the recent experience with the bonds issued by states,” Vestager said. The European Commission is working on legislation to implement the Basel recommendations, and agreed last year to submit assets to a series of tests to determine liquidity, rather than basing assumptions on an asset’s class. Top ranked benchmark Danish mortgage securities are, on average, as liquid as the nation’s government debt, even in periods of market stress, the central bank said in a Nov. 22 working paper. The study confirmed a 2010 finding. Denmark’s financial regulator has already told banks to ignore the Basel rules. The decision shows Denmark won’t impose rules on its banks it expects will harm the industry and the economy. Vestager says she’d rather assume that Basel and the commission in Brussels will accommodate Denmark’s demands. “We think it will work out,” she said. “As long as we can agree on the fact that it’s objective criteria rather than the issuer, then there is space for us as well.”

(emphasis added)

So the implementation of the new Basel 'straitjacket' is already postponed to 2019. In 2019, it may well be that new reasons will be found for further postponement. Mrs. Verstager continues to have a very good point about state debt and its presumed safety. It seems rather blatantly obvious that forcing banks to hold more government securities is not the result of altruistic deliberations regarding increasing the security of depositors (and ultimately, tax payers).

Studies on the stability of Denmark's mortgage backed securities in 'times of market stress' will likely have to be rethought once Denmark-specific market stress increases due to the teetering housing bubble.

Lastly, banks in Denmark are evidently free to ignore the new Basel rules anyway. With regard to the Basel rules, there is in principle nothing wrong with demanding that banks should hold more capital. If we had a free banking system, such interference would not be necessary. The fact is though that we do not have a free banking system, but one that has become hopelessly overleveraged and intertwined with the State. In a free market for money and banking, the market would no doubt cater to depositors who want to avoid the risk of being exposed to fractionally reserved banks.

Moreover, there should anyway be a strict legal differentiation between deposit banking and loan banking: fractional reserves for demand deposits are a kind of legalized fraud, one that infringes not only on the property rights of depositors, but also on those of other market participants. This is so because credit expansion enabled by fractional reserves is the root cause of the boom-bust cycle. It harms therefore everyone in society – which in turn means that we all have the right to denounce the practice. In a court of law, one would refer to this as the 'legal standing' of plaintiffs.

As things stand however, depositors can today hardly avoid being exposed to fractionally reserved banks, unless they keep their money under a mattress. In that sense, rules that force banks to hold more capital are a second-best solution. However, it remains to our mind highly contentious what form such capital should take. Considering the recent upheaval in sovereign debt markets and the fact that most of the modern-day welfare/warfare states would have to declare themselves instantly insolvent if their accounting were to include their unfunded liabilities, the Basel rules declaring government bonds as a 'safe' form of bank capital seem utterly absurd.

House prices in Denmark: this huge bubble in prices has been enabled by a mortgage bond market that has grown to a size that is dwarfing every other economic yardstick describing Denmark's economy. Allegedly the huge mountain of debt supporting this egregious asset price inflation is 'safe and trustworthy'. So say Denmark's financial regulators – chart via: thebubblebubble.com.

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