There are said to be two ways that money is ‘created’; by central banks and by normal banks. Arguably the two are the same and the only difference is the customer. Whereas a central bank caters primarily for a Government as ‘lender of last resort’ a normal bank caters for its individual private customers demands for loans.
Despite the recent creation of money by central banks under the guise of quantitative easing (QE) by far the larger amount of money creation is still and has always been done by ‘normal banks’. It is estimated that in everyday issuance of loans and mortgages the ‘normal banks’ like HBOS, Barclays etc create upward of 95% of all the money supply.
Bearing this in mind, the last week has seen some interesting debate and a significant move. Since the financial collapse of 2007-8 much debate has centred around QE, but as the US Federal Reserve ‘tapered’ it’s quantitative easing programme in December by $10bn per month to ‘just’ $75bn per month the debate is now moving.
Both the US Fed and the Bank of England have targeted unemployment, which appears to be falling in both countries (bearing in mind that US statistics are highly unrepresentative of true unemployment number – fewer people are claiming unemployment benefits so less people are counted as ‘unemployed’, but fewer people are actually working). It may therefore be safe to assume that the QE debate is no longer centre stage in the West – though how the Fed and BoE unwind their (loss making) balance sheets remains to be seen – and of course Japan is ploughing ahead regardless.
Although bond yields have risen in both countries, the apparent return of growth to the economies has diminished the governments demand for money from its bankers and refocused the debate to private demand via the banking system. The last week has seen several suggestions of reform: from Conservative MP Douglas Carswell’s critique of the credit driven boom / bust cycle and ‘two tier’ depositor system, to Ed Miliband’s more authoritarian interventionist suggestion of a market share cap on bank expansion. Miliband’s solution would require the breaking up of the ‘big five’ banks which currently supply a reported 85% of UK private banking demand.
Interestingly both Carswell and Miliband see the need for more competition in the domestic market, but while Carswell aims to deal with the infamous ‘fractional’ nature of the banking establishment, Milliband merely hopes more competition may solve this problem.
I shall discuss both these ideas in later articles but let us first discuss what has already happened and why it is important.
Last Sunday, the Group of Governors and Heads of Supervision (GHOS), a sub committee of the Basel Committee of Banking Supervision, effectively tore up the Basel lll accord which required banks to hold up to 6% of capital and an extra 2.5% “mandatory capital conservation buffer” during periods of high credit growth. Last Sunday the committee revised the rules to net 3% ratios including derivatives.
In all the jargon that they use to mislead the ordinary person, with ‘gross this’ and ‘net that’, nobody can deny that this represents a significant easing of banking leverage rules; Basel lll RIP. As the Central Banks in the US and UK look to ease back their money creation programmes, the other banks are given licence to create more money.
Of course, another reason why this perhaps must be done is the coming European Central Bank (ECB) ‘stress test’ of eurozone banks. Coming after the last ‘stress tests’ by the European Banking Authority, which announced that the garden was a rosy as could be only to see the Spanish banking system having to be bailed out to the tune of 100bn euros, the ECB is keen to restore confidence. Lowering the capital reserve ratios requirements via the GHOS will certainly make it easier for eurozone banks to pass the ECB’s ‘tests’.
At the very least it may save the ECB having to implement another ‘Long Term Refinancing Operation’ (LTRO) – the eurozone equivalent to QE – but you have only to look at Deutsche Bank derivative exposure to see the instability inherent in the system. No doubt the Deutsche Bank exposure is no longer below the 3% ratio, so all is ‘fine’.
One might ask why this matters? Well, we know it matters because the financial system went tits up (to use a technical phrase) in 2007-8 precisely because of cheap credit in the US mortgage system; the so called sub-prime mortgage market. When borrowing is cheap people borrow more than they perhaps should, and are apt to spend it on things they otherwise would not buy; new cars, TVs, holidays, houses etc.
For a while this looks like recovery as consumer spending rises – but it debt based recovery. If interest rates rise – and in the UK and US bond yields nearly doubled last year – then the people that borrowed so cheaply cannot to repay their loans and the banks are left with a ton of bad debt. We have seen it before, naturally – in 2007-8.
The answer provided by our Central Banks, Governments and Banking Committees has been to apply an overdose of the same medicine that caused the ailment. Osborne’s ‘Help to Buy’ scheme encourages bank lending and may end in bank debt. The questions that Carswell and Milliband this week sought to answer is “How much should banks lend at any given time, and what security should they hold to cover loans that may go bad?”.
In Part 2 I shall examine the Milliband idea and discuss a position the Party could and should take.