Quote of the Day: Monetary Policy Cannot Solve All Economic Problems That May Ail Our Economies; What happens When The Fed Stops Distorting Prices?

The authority of monetary policymakers to intervene in financial markets has come to be accepted and expected. Whether the purpose is to change the relative price of various assets, such as long vs. short dated Treasuries, or to alter the allocation of credit, such as Treasuries vs. mortgage-backed securities, the result has been a much more interventionist central bank. The belief is, of course, that central bankers know enough to control relative asset prices with sufficient precision and that the transmission mechanisms and consequences are sufficiently predictable that policymakers can better control real economic growth and employment, and now, financial stability.

I find this a dubious proposition at best. For central banks to act as if these conditions exist suggests to the public that monetary policy has great ability to fine tune economic outcomes. That means monetary policy makers may well be accepting more responsibility for managing economic outcomes than they, in fact, can deliver. This is a recipe for failure and can undermine the public’s trust and confidence in the central bank. So maybe a little more humility on the part of central bankers and the public regarding what they monetary policy can accomplish is in order and a little less intervening just because it can, or has the power or authority, may be prudent. Monetary policy simply cannot solve all economic problems that may ail our economies.

(bold added)

This quote is from Charles Plosser former President, Federal Reserve Bank of Philadelphia and former Dean, Graduate School of Business Administration, University of Rochester as interviewed by the Money and Banking blog

More juicy quotes (bold mine)

As I mentioned, no regulatory authority anywhere in the world, no central bank no financial supervisory agency, saw the crisis coming. What makes us think we will spot the next one? Whenever it arises it will surely come from somewhere the authorities were not looking.

We face a number of challenges. First we have the problem of defining financial stability. I know of no good definition. Without a definition how do we know if we have succeeded? How do we know if we have over compensated and reduced risks too much without some metric that tells us of the trade-offs? Implicit in the Dodd-Frank legislation is the view that if only we could write enough rules and prohibitions on the financial sector we could solve the problem. I believe this is a bit like the dog chasing its tail, and equally futile.

Second we should acknowledge that stability risks can move around. Where regulators look, those risks are unlikely to be found. The challenge is figuring out where they will show up next. Financial markets are adept at packaging and repackaging risks in forms that the market will buy. There is nothing inherently wrong with this except regulators will always be behind the market developments.

Finally, the central bank should be particularly vigilant in not artificially encouraging financial imbalances or stability risks through its monetary policy actions. Unfortunately, this may bring financial stability and the goals of monetary policy into stark conflict. There is an ongoing and important debate on this issue. That is, should monetary policy be used to address financial stability risks or not; what if it’s a source of the risks?

Today the stated goal of the interventions undertaken by the Fed such as the asset purchases or the maturity extension program have been intended to encourage risking-taking and alter the portfolio balances of economic agents. If successful, these actions distort market prices. One stability risk worth considering is: What happens when the Fed stops distorting prices?

Wow! Ambiguity in the definition of financial stability, stability risk in a state of perpetual flux (or also policy or political response as 'fighting the last war' or dealing with past rather then present evolving problems) and most importantly, treating symptoms while encouraging the disease (financial imbalances) seem as an implied rebuke on central banking's "macroprudential policies" and the Basel Standard!

Phisix 7,800: Peso Smashed, January Remittance Growth Rates Plunges, Short Term Treasury Yields Spike!

And as man cannot bear to be without the miraculous, he will create new miracles of his own for himself, and will worship deeds of sorcery and witchcraft, though he might be a hundred times over a rebel, heretic and infidel ― Fyodor Dostoyevsky, The Brothers Karamazov

In this issue:

Phisix 7,800: Peso Smashed, January Remittance Growth Rates Plunges, Short Term Treasury Yields Spike!

-US Dollar’s Domino Effect: Philippine Peso and Malaysian Ringgit Smoked!

-OFW Remittances: Growth Rates Crash in January! Structural Headwinds Compounded by Event Risks

-Short-Term Philippine Treasury Yields Spike as Yields Flatten! Basel Standards are No Guarantee of Adequate Risk Measurement

-Capital Flight from Local Elites? Asian Currencies and CDS Spreads Show Why This Time Won’t Be Different

-Sweden Cuts Rate Announces QE as BIS and OECD Warns on Low Interest Rates!

Phisix 7,800: Peso Smashed, January Remittance Growth Rates Plunges, Short Term Treasury Yields Spike!

Marking the close occurred in a stunning 4 out of the 5 trading days this week!

It’s just horrifying to see how the Philippine stock market has transmogrified into a broken system characterized by mass hysteria and rampant manipulation!

US Dollar’s Domino Effect: Philippine Peso and Malaysian Ringgit Smoked!

In noting of the Philippine pesos’ outperformance, last week I asked, “For now, the Philippine peso now takes on the leadership but for how long?”

The currency markets appeared to have answered my question.

Although the US Federal Reserve’s FOMC dropped the word “patient” from their recent policy meeting, a “surprisingly downbeat outlook” and Fed Chairwoman Ms. Janet Yellen’s implied assurances of stretching an interest rate hike via “doesn’t mean we are going to be impatient” sent the US dollar tumbling. The US dollar even experienced a flash crash! (see right window). Growing accounts of real time flash crashes represents another sign how fragile and vulnerable the current financial markets have been.

Compounding the US dollar’s plight has been reports that the Chinese government’s central bank, the PBOC, massively intervened in support of her currency, the yuan.

So these factors—the Fed’s dovish stance and PBOC intervention—sent Asian currencies rallying hard (see right also see JP Morgan Bloomberg’s Asian Currency Index ADXY). The same factors have likewise accommodated a risk ON environment.

Yet the Philippine peso and the Malaysian ringgit defied the general regional sentiment. Against the US dollar, the peso plummeted 1.19% while the ringgit has been once again crushed, down by 1.3%. 

This week’s meltdown has not only erased the gains of the year, but has dragged down the peso to a year to date loss of .2%. Current momentum suggests that the USD-peso may break the 45 levels soon (see right)

Meanwhile, the ringgit’s sustained losses have brought the USD MYR pair to the peak of 2008! (see left)

Aside from the US dollar’s relative strength over most currencies, there are likely internal factors that have led to the pesos’ decline.

OFW Remittances: Growth Rates Crash in January! Structural Headwinds Compounded by Event Risks

This week the BSP came out with a report on personal and cash remittances for the month of January. 

Strikingly, personal and cash remittances inched up by ONLY .2% and .5% respectively! This marks the second below 2% growth rate in 3 months!

January’s growth rate crash represents the worst level since January 2009!

Yet the trends of the rate of growth of personal and cash remittances have been on a downhill as noted above.

It would be facile to blame seasonality for this. I can also add the Dodd-Frank ACT 1073 remittance-transfer as potential obstacle to remittance flows as previously discussed.

But a showcase of the January activities since 1990 reinforce the downside trend of growth rates in remittance flows. As one would note from the left graph, since 1998, remittance growth rates have been on a steady decline.

It would appear that the law of compounding and diminishing returns likewise affects remittance trends. Nominal remittance levels have reached size and scale where growth rates have become incremental.

Yet January’s nominal remittance trend may have even broken its long term trend.

While seasonality and Dodd Frank may have contributed, they are likely to be secondary (epiphenomena) or aggravating factors. But January activities show that seasonal dynamic appear as minor events.

And current conditions like crashing oil prices may have likely been another more significant contributing cause too. As I warned last December[1]

And yet how will the blowing up of the Middle East bubble extrapolate to Philippine OFW remittances? More than half or about 56% of OFWs according to the Philippine Overseas Employment Administration (POEA) have been deployed to this region. Will OFWs (and their employers) be immune from an economic or financial crisis? This isn’t 2008 where the epicenter of the crisis was in the US, hence remittances had been spared from retrenchment. For this crisis, there will be multiple hotbeds. The ongoing crashes in oil-commodity spectrum have already been showing the way.

So the above suggests that the structural declining trend in remittance growth rates seems as being reinforced by secondary causes such as oil prices and possibly the Dodd-Frank statute.

What is the implication of the remittance slowdown?

Well, as I wrote this week[2]:

This partly explains the ongoing pressures in retail activities and the weakening of the consumer household activities (HFCE) as revealed by the 4Q 2014 GDP data provided by the government, as explained here.

The rising account of store vacancies at shopping malls appear as real world (not statistical) symptoms of this.

Yet ironically, the supply side (housing, shopping malls, hotel and related industries) continues to project consumer trends as perpetually headed to the sky for them to borrow and build with ferocity. For instance, the daughter of the Philippines' richest tycoon anchors her firm's expansion projects largely on remittances as posted here

The end result from the widely divergent expectations and activities will be a huge or massive excess capacity mostly financed by debt!

And yet the sellside industry, expects earnings growth rate for the Phisix in 2015 to be at the mid teens. If current trends continue, then they will not only miss by a mile or by an ocean but by a galaxy!

And whatever strength by the peso, or its outperformance in the region, will be further exposed if such trends continue.

Is it a wonder why the BSP chief adamantly insists of deflationary risks in his latest speeches?

Short-Term Philippine Treasury Yields Spike as Yields Flatten! Basel Standards are No Guarantee of Adequate Risk Measurement

There could have been another factor to last week’s peso meltdown. 

Yes symptoms of funding pressures have reappeared in the Philippine treasury markets. Short term rates have massively spiked to return to December levels! That’s just two months after the Philippine government raised $2 billion overseas. The $2 billion loans may have helped temporarily improve February Gross International Reserves now at $81.3 billion.

Yet to apply the BSP chief’s splendid advice to journalists (whom I previously quoted[3]):

Economic numbers rarely tell the complete story when taken at face value. Therefore, a responsible journalist who seeks to offer readers a fuller appreciation of the information will examine the figures within a broader context or against an array of other relevant indicators.

So even if the BSP declares that the Philippine banking system as having “adequate capital levels against risks” for commercial and universal bank and for rural and coop banks, “figures within a broader context or against an array of other relevant indicators” in the prism of the treasury markets suggests that the alleged diminished risk outlook has been inconsistent or incompatible. Said differently, what statistics say and what the treasury markets have signaled have diverged.

Further, the obsession towards statistical or quant models as measures of risks as to declare the system safe has been vastly misplaced. 

Proposed changes at the Basel standards or ‘Basel IV’ have already been raising a hubbub at the international banking world.

An officer from the American Bankers Association exposes on the flaws of the Basel standards (as excerpted by Euromoney)[4]. [bold mine]

"As Basel III was an admission that Basel II got things wrong, Basel IV is a clear recognition that there is much that is wrong with Basel III," he says. "Yet the folks at Basel have not yet looked in the mirror and asked whether what is mostly wrong might be happening in Basel, that the simple concept of Basel I, to have some basic global capital standards, has been lost in an effort to over-engineer and micromanage at the global level the fine details of capital standards."

Yet why have some bankers been pushing back on Basel Committee on Banking Supervision’s (BCBS) proposals?

BCBS wants to end the practice of risk-weighting lenders’ exposures by reference to external credit ratings and instead suggests using measures such as capital adequacy and asset-quality metrics on exposures to other banks, for example. For corporates, the BCBS argues a given borrower’s revenue and leverage should determine credit risk weights rather than ratings, with the latter typically discriminating between industries and local-accounting standards. 

Bankers see plenty of problems. Since this way of risk-weighting exposure to other banks is determined by common tangible equity ratios and the non-performing assets ratio, it does not adequately take into account divergent liquidity and business-risk profiles, nor differences in supervisory processes under Pillar 2 of the Basel regime, says a senior regulatory adviser to the CEO of a large European universal bank.

The adviser adds: "Credit rating agencies look at a multitude of factors and these metrics are always richer, incorporating thorough timely reviews, and engagement with counterparties and agencies. You can also never empirically replace these qualitative assessments. 

The answer to the push back; because there is no uniformity in the risk profile of each loan portfolio.

To repeat “You can also never empirically replace these qualitative assessments”. Hmmm

Doesn’t this resonate with what I wrote back in October 2014[5]?

Because the BSP doesn’t really know of the viability or credit worthiness of each of the loans that have been extended throughout the system. And this lack of knowledge is what they admit as “uncertainty” and thus the warning “risks that could challenge… financial stability pressures from repricing of credit; sharp downward adjustments in prices of real and financial assets; and, capital flow volatility”.

They have practically NO idea what happens when there will be a “repricing of credit” and or how intense and scalable will “sharp downward adjustments in prices” and or how volatile capital flow will be.

Even bankers and regulators see Basel standards as inadequate measures of risk. So the citation of accounting metrics or statistics does nothing to uphold the supposed soundness of the system.

Going back to the Philippine treasury markets, the spike in short term yields has once again steepened the yield curve flattening dynamics.

Such flattening dynamic posits for an implied tightening of the liquidity environment as banks has less incentives to lend in an economy that has become increasingly dependent on debt.

Again considering that the Philippine treasury markets have been tightly held or controlled by the Philippine government and their banking sector vassals, those short term yield spikes signify as signs of growing fissures in the system.

And could the peso selloff have been also prompted by increasing concerns over risks build up despite the government and media’s attempt to whitewash them?

Capital Flight from Local Elites? Asian Currencies and CDS Spreads Show Why This Time Won’t Be Different

Two more items.

Has the local elites been seeking refuge away from the peso and domestic equities?

The BSP’s Balance of Payment report[6] says that in 4Q 2014 and in the entire 2014, the financial accounts registered net outflows.

I quote below the BSP’s explanation per category and put an emphasis on the activities of residents

4Q Direct investments (bold added): The direct investments account yielded higher net outflows of US$977 million in Q4 2014, more than double the net outflows of US$471 million in Q4 2013. Residents’ net acquisition of financial assets of US$2.4 billion exceeded their net incurrence of liabilities (foreign direct investments in the Philippines or FDI) of US$1.4 billion. This developed as equity capital placement abroad by resident non-banks surged to US$1.7 billion from US$226 million.

4Q Portfolio investment holdings: The portfolio investments account posted net outflows of US$1.2 billion in Q4 2014, 7.5 percent higher than the net outflows in Q4 2013. This development was reflective of the prevailing volatility in financial markets amid lingering uncertainty over the global growth prospects. Residents’ net acquisition of financial assets amounted to US$930 million, a reversal of the US$81 net disposal of financial assets in Q4 last year on account of net placements by domestic deposit-taking corporations (US$777 million) and the central bank (US$171 million) in debt securities issued by non-residents.

4Q Other investment accounts: The other investment account recorded net outflows amounting to US$2.3 billion in Q4 2014, more than five times the US$426 million registered in the comparable quarter last year. Net outflows stemmed mainly from higher net acquisition of financial assets which reached US$4 billion from US$1.2 billion in Q4 2013, due largely to higher residents’ deposit placements (US$2.7 billion) and net lending (US$1.4 billion) abroad.

The same Balance of Payment report for 2014 reveals the same dynamics.

Direct investments: The direct investment account reversed to net outflows of US$789 million from net inflows of US$90 million a year ago. This developed on account of the 91.7 percent rise in residents’ net acquisition of financial assets to US$7 billion from US$3.6 billion due to resident corporations’ net placements in both equity capital (US$2.9 billion) and debt instruments (US$4 billion) abroad.

Portfolio Investments: Portfolio investment account recorded net outflows of US$2.5 billion during the period, a reversal of last year’s net inflows of US$1 billion. This was due to residents’ net acquisition of financial assets of US$2.5 billion, from a net disposal of assets amounting to US$638 million combined with non-residents’ net withdrawal of investments amounting to US$3 million, a reversal from the net placements of US$363 million in 2013.

Other accounts: The net outflows in the other investment account doubled to US$6.9 billion from US$3.4 billion in 2013 on account of increased net placements in currency and deposits abroad by resident banks and non-bank corporations, amounting to US$2.7 billion and US$1.4 billion, respectively), and to higher resident banks’ net lending of US$2.7 billion.

Have domestic elites been bullish on the outside, but bearish in the inside? Have they been engaged in ‘do as I say, but not as I do’? So why the seeming outgrowth in capital exodus?

Finally, a lot of people from the formal sector have come to believe that the Philippines have become invincible to exogenous factors as to price domestic financial assets to perfection.

This week’s peso activity shows why this won’t be true, and add to this the above, the cost of insuring government debt via ASEAN 5 year CDS spread from Deutsche Bank.

While so far the Philippines has outperformed, the seeming near synchronized movements of CDS spreads shows of the relevance of the region’s influence.

The above only shows that this time won’t be different.

Sweden Cuts Rate Announces QE as BIS and OECD Warns on Low Interest Rates!

As I have been saying, central banks have aggressively embarked on crisis resolution measures even as global stock markets have run amuck.

The Swedish central bank cut rates into negative territory last week, as well as, announced the Swedish version of QE. 

From the New York Times[7]:

The executive board of the Swedish Riksbank said that it had cut its main rate target by 0.15 percentage point to minus 0.25 percent, and that it would buy government bonds valued at 30 billion kronor, or about $3.5 billion, over the next few months.

The bank said in a statement that it saw signs “that inflation has bottomed out and is beginning to rise,” but that the strength of the currency “risks breaking this trend.” The measures on Wednesday were intended “to support the upturn in inflation,” said the Riksbank, which signaled its “readiness to do more at short notice.”

The actions of the Swedish Riksbank marks the seventh rate cut by global central banks for the month of March and 25th for the year based on the tabulation of the CentralBankRates.com. This has been a count for rate cuts alone and excludes other non interest rate actions.

Central banks seem as in a panic mode in the face of abruptly falling economic indicators as financial markets party! 

It is as if we exist in two different worlds

Yet when the crisis emerges, global central banks would have little or no ammunition left to mount rescues as they have been desperately frontloading them.

Yet in a follow up to their September call, the OECD once again issues a brief warning on low interest rates[8].

“Lower oil prices and widespread monetary easing have brought the world economy to a turning point, with the potential for the acceleration of growth that has been needed in many countries,” said OECD Chief Economist Catherine L. Mann. “There is no room for complacency, however, as excessive reliance on monetary policy alone is building-up financial risks, while not yet reviving business investment. A more balanced policy approach is needed, making full use of fiscal and structural reforms, as well as monetary policy, to ensure sustainable growth and public finances over the longer term.”

The Bank for International Settlements has been consistently, persistently determined to warn of a risk buildup since 2014.

In the media briefing for the BIS Quarterly Review[9], Mr Claudio Borio, Head of the Monetary & Economic Department, goes on the record to caution the world from current set of policies. (bold mine)

In the process, central banks have shown that the so-called zero lower bound on interest rates is quite porous. Negative policy rates at the short end, coupled in some cases with large-scale asset purchases at the longer end, have pushed both term premia and nominal yields firmly and farther into negative territory. If this unprecedented journey continues, technical, economic, legal and even political boundaries may well be tested. The consequences should be watched closely, as the repercussions are bound to be significant, on the financial system and beyond.

The unforeseen technical, economic, legal and even political boundaries repercussions from inflationism reminds me of this majestic quote from the high priest of inflationism[10] (bold mine)

Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security but [also] at confidence in the equity of the existing distribution of wealth.

Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become "profiteers," who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.

How so very relevant such quote have been today.

Has central banks implicitly functioned as communist Trojan horses whose policies could have been engineered to destroy the residual capitalist structure of the world?

---

[1]See Phisix: The October Syndrome is Back! Philippine Casinos as the Causa Proxima? December 15, 2014

[2] See Wow, Philippine Remittance January Growth Rates Collapse to Near Zero or Post 2009 Crisis Levels! March 17, 2015

[3] See Phisix 7,800: Record Phisix as the BSP Continues with Deflation Spiel! March 9, 2015

[4] Euro Money Bank regulation: ‘Basel IV’ sparks banker fury March 2015

[5] See Phisix: 7,400 is not the Technical Hurdle, the BSP Governor Is October 6, 2014

[6] Bangko Sentral ng Pilipinas Q4 2014 BOP Position Yields US$574 Million Surplus; Full-Year 2014 Registers US$2.9 Billion Deficit March 20, 2014

[7] New York Times Sweden Cuts Key Interest Rate to Minus 0.25% March 18, 2015

[8] OECD Newsroom Low oil prices and monetary easing triggering modest acceleration of global recovery March 18, 2015

[9] Mr Claudio Borio BIS Quarterly Review March 2015 - media briefing BIS.org

[10] John Maynard Keynes The Economic Consequences of the Peace 1919. pp. 235-248. PBS.org

Quote of the Day: Credit Allocation Determined by World’s Bank Regulators

The financial crisis served to differentiate two types of investments–the ones that get bailed out and the ones that don’t. Investors naturally have a preference for the former. That means big banks can get cheap credit. And what does Basel tell them they can do with their cheap credit? Buy government bonds.

So what we have had over the past ten years is a massive exercise in credit allocation by the world’s bank regulators. They offer explicit and implicit guarantees to banks that invest in assets officially designated as low risk, and now they are shocked, shocked to find capital pouring into exactly those assets.

This is from economist, author and professor Arnold Kling on his blog.

Indian Banks Reduce Exposure on US Banks

More signs of anxiety in the global financial markets: Indian banks reportedly reduced deposits with US Banks

From Financial Chronicle (mydigitalfc.com)

India banks’ deposits with US banks dipped in June, reflecting heightened risk aversion. This showed up in a fall in custodial liabilities of American banks to counterparties in India, which shrank by over $2 billion in June.

According to the US treasury data released, custodial liabilities of American banks payable in US dollars in June was $13.059 billion. A year ago, the holdings were $15.288 billion.

The custodial liabilities included foreign currency deposits by Indian banks in American banks. Indian banks hold dollar deposits with US counterparts for settlement of international liabilities.

Andhra Bank currency trader Vikas Babu said, “There is some risk aversion on US banks. So, banks have shifted to short-term US treasuries for less than one year for liquidity purposes.”

The shift to US treasuries, however, was not necessarily driven by interest earnings. Short-term holdings in US treasuries earned barely 0.5 per cent. Correspondent account balances, that are technically current accounts, earned zero interest. But the shift was partly on account of the fact that foreign institution balances in US banks are not covered by the US federal deposit insurance company (FDIC). FDIC provides insurance cover for bank deposits only to US entities and residents.

The shift to US treasuries was also apparent from a steep $9.5 billion rise in holdings to $50.8 billion by Indian institutions, including the RBI. The increase in holdings was despite compression in India’s external reserves by $26.5 billion in June from the corresponding period of the previous year.

Aside from possible concerns over the health of the US banking sector, the shift to short term securities could also mean that Indian banks may be expecting a spike in US interest rates, perhaps in anticipation of another round of asset purchases by the US Federal Reserve.

Also Indian banks may be under pressure from the recent economic slowdown. Indian banks have been required to raise 1.75 trillion capital by 2018 in order to comply with Basel III capital adequacy standards (yahoo)

Will Gold be a Part of Basel Capital Standard Regulations?

At the Mineweb.com, Ross Norman CEO of Sharps Pixley thinks that chances are getting better for gold to take a role in the banking system’s capital standard regulations.

Mr. Norman writes,

Banking capital adequacy ratios, once the domain of banking specialists are set to become centre stage for the gold market as well as the wider economy. In response to the global banking crisis the rules are to be tightened in terms of the assets that banks must hold and this is potentially going to very much favour gold. The Basel Committee for Bank Supervision (or BCBS) as part of the BIS are arguably the highest authority in banking supervision and it is their role to define capital requirements through the forthcoming Basel III rules.

In short, they are meeting to consider making gold a Tier 1 asset for commercial banks with 100% weighting rather than a Tier 3 asset with just a 50% risk weighting as it does today. At the same time they are set to increase the amount of capital banks must set aside as well. A double win potentially.

Hitherto banks have been much dis-incentivised to hold gold while being encouraged to hold arguably riskier assets such as equity capital, currencies and debt instruments, none of which have fared too well in the crisis. With this potential change in capital adequacy requirements. bank purchases of gold would drive up its value relative to other high quality qualifying assets, increasing its desirability for regulatory purposes further. This should result in gold being re-priced to bring it on a par with all other high quality assets.

While this should be good news, gold isn’t structurally compatible with the current form of political institutions (welfare-warfare state-central banking and privileged bankers) highly dependent on inflationism.

Since the Basel standards have in itself been fundamentally flawed, like in the past, governments and their adherents will only use gold as scapegoat for any future crisis. But who knows.

Nevertheless, the above serves as added indications where gold will likely play a greater role in the global economy, perhaps as money.

Quote of the Day: The Volcker Rule is a Bad Idea

what the Volcker Rule does is drive banking from the private sector and toward the government sector. Thus, this rule, rather than limiting credit, simply pushes banks to use funds to invest in and provide more liquidity for the government sector.

If credit is to be created by the Fed, I would rather have those funds directed to the private sector, or see banks blow themselves up with synthetic instruments, than have the funds directed toward more investments in the government sector, which will do nothing but allow the state to grow. Thus, the Volcker Rule is a bad idea.

That’s from Austrian economist Bob Wenzel.

Like the Basel regulations, banks are being directed by statute to channel private sector savings to finance the government than to the private sector.

This legislation seems to be a component of the unholy grand scheme of financial repression—the plunder of private sector’s resources for the use of politicians through the banking system. [yeah and politicians and their sycophants have the effrontery to call out on “inequality” when much of the private sector resources have already been absorbed by them.]

And this is why banks end up in cohabitation with governments, as well as, why central banks have been there to provide a backstop on them when private sector resources have been squeezed dry.

Corruption is indeed rooted on arbitrary and repressive laws.

$6 Trillion worth of Fake US bonds Seized by Italian Police

From Reuters

Italian police said on Friday they had seized about $6 trillion worth of fake U.S. Treasury bonds and other securities in Switzerland, and arrested eight Italians accused of international fraud and other financial crimes.

The operation, co-ordinated by prosecutors from the southern Italian city of Potenza, was carried out by Italian, Swiss and U.S. authorities after a year-long investigation, an Italian police source said.

It began as a investigation into mafia loan-sharking, but gradually expanded as prosecutors used telephone and computer intercepts to unearth evidence of illegal activity surrounding Treasury bonds.

The fake securities, worth more than a third of U.S. national debt, were seized in January from a Swiss trust company where they were held in three large trunks.

The U.S. Embassy in Rome thanked the Italian authorities and said the forgeries were "an attempt to defraud several Swiss banks". It said U.S. experts had helped to identify the bonds as fakes.

Eventually these alleged 'genuine' government or treasury bonds will be exposed for what they are. They will be defaulted upon either directly or indirectly through massive inflation. In addition, “risk free” by edict (Basel Accord) is a myth.

How Capital Regulations Contributed to the Current Crisis

At the Wall Street Journal, American Enterprise Institute’s Peter J. Wallison explains how capital regulations are partly responsible for the current mess (bold emphasis mine)

Basel is the Swiss city where the world's bank supervisors regularly meet to consider and establish these rules. Among other things, the rules define how capital should be calculated and how much capital internationally active banks are required to hold.

First decreed in 1988 and refined several times since then, the Basel rules require commercial banks to hold a specified amount of capital against certain kinds of assets. Under a voluntary agreement with the Securities and Exchange Commission, the largest U.S investment banks were also subject to the form of Basel capital rules that existed in 2008. Under these rules, banks and investment banks were required to hold 8% capital against corporate loans, 4% against mortgages and 1.6% against mortgage-backed securities. Capital is primarily equity, like common shares.

Although these rules are intended to match capital requirements with the risk associated with each of these asset types, the match is very rough. Thus, financial institutions subject to the rules had substantially lower capital requirements for holding mortgage-backed securities than for holding corporate debt, even though we now know that the risks of MBS were greater, in some cases, than loans to companies. In other words, the U.S. financial crisis was made substantially worse because banks and other financial institutions were encouraged by the Basel rules to hold the very assets—mortgage-backed securities—that collapsed in value when the U.S. housing bubble deflated in 2007.

Today's European crisis illustrates the problem even more dramatically. Under the Basel rules, sovereign debt—even the debt of countries with weak economies such as Greece and Italy—is accorded a zero risk-weight. Holding sovereign debt provides banks with interest-earning investments that do not require them to raise any additional capital.

Accordingly, when banks in Europe and elsewhere were pressured by supervisors to raise their capital positions, many chose to sell other assets and increase their commitments to sovereign debt, especially the debt of weak governments offering high yields. If one of those countries should now default, a common shock like what happened in the U.S. in 2008 could well follow. But this time the European banks will be the ones most affected.

In the U.S. and Europe, governments and bank supervisors are reluctant to acknowledge that their political decisions—such as mandating a zero risk-weight for all sovereign debt, or favoring mortgages and mortgage-backed securities over corporate debt—have created the conditions for common shocks.

I have explained here and here how Basel capital standard regulations does not address the root of the crisis—fiat money and central banking—and will continue to churn out rules premised on political goals, knee jerk responses to current predicaments (time inconsistent rules) and incomplete knowledge.

A manifestation of the institutional distortions as consequence to regulations which advances political goals can be noted at the last paragraph where US and European governments and bank supervisors are “reluctant to acknowledge that their political decisions”, which have not only “created conditions for common shocks”, but has existed to fund the welfare state and the priorities of political leaders in boosting homeownership ownership which benefited or rewarded the politically privileged banks immensely.

Capital regulation rules will continue to deal with the superficial problems of the banking system which implies that banking crises will continue to haunt us or won’t be going away anytime soon despite all model based capital ratio adjustments. It's been this way since the closing of the gold window or the Nixon shock (see above chart from the World Bank)

Global Banking Regulators to Force Banks to Hold More Liquid Assets

From the Reuters,

Global banking regulators will press ahead with the first worldwide effort to force banks to hold more liquid assets, the chairman of the Basel Committee on Banking Supervision said in an interview with the Financial Times on Monday.

Stefan Ingves, who also heads the Swedish central bank, said the Basel group plans to put uniform implementation of the Basel III reforms at the top of its agenda.

The measures, which will also force banks to cut back on short-term funding, have come under scrutiny from some of the 27 member countries who say the rule changes could damage the broader economy.

The reforms, which were agreed to by the member states, will force banks to hold more top-quality capital against unexpected losses, but there are rising concerns that some countries will not stick to the agreement.

Bank capital standards will continue to put pressure on the markets as I explain here and here. More liquid assets will not stop the consequent crisis from central banking induced bubble cycles. In fact, this could worsen it.

By forcing banks to hold more liquid assets, which will likely come in the form of government debt, this compels banks to finance financially strained governments. So productive capital will be channeled to preserve the privileges of the political and the banking class at the expense of the economy, which signifies a form of financial repression.

Central bank based bank capital regulations are essentially aimed at the preservation of the unsustainable banking system-central banking-welfare-warfare state political economy.

Why Capital Standard Regulations Will Fail (Part 2)

In my earlier post, I presented one of the three major arguments on why capital regulation standards won’t live up on its expected role to curb systemic failures.

regulators think that the action of bankers can be restrained by virtue of fiat. They are delusional. They forget that as humans, regulator-banker relationship will be subject to various conflict of interests relationships such as the agency problems, time consistency dilemma, regulatory arbitrage and regulatory capture aspects.

In reality, more politicization of the banking-central banking amplifies systemic fragility.

In a recent paper Cato’s Kevin Dowd, Martin Hutchinson, Simon Ashby, and Jimi M. Hinchliffe writes, (bold emphasis mine)

In this paper, we provide a reassessment of the Basel regime and focus on its most ambitious feature: the principle of “risk-based regulation.” The Basel system suffers from three fundamental weaknesses: first, financial risk modeling provides the flimsiest basis for any system of regulatory capital requirements. The second weakness consists of the incentives it creates for regulatory arbitrage. The third weakness is regulatory capture.

The Basel regime is powerless against the endemic incentives to excessive risk taking that permeate the modern financial system, particularly those associated with government-subsidized risk taking. The financial system can be fixed, but it requires radical reform, including the abolition of central banking and deposit insurance, the repudiation of “too big to fail,” and reforms to extend the personal liability of key decision makers—in effect, reverting back to
a system similar to that which existed a century ago.

The Basel system provides a textbook example of the dangers of regulatory empire building and regulatory capture, and the underlying problem it addresses—how to strengthen the banking system—can only be solved by restoring appropriate incentives for those involved.

So the Cato study essentially echoes my insights.

For me, ‘regulatory empire building’ signifies as the conventional political process that has been designed to promote and sustain a welfare-warfare state. The welfare-warfare state depends on the de facto fiat paper money platform that basically operates on a central banking-banking industry cartel, which funnels much of the funds from the private sector to the political class (financial repression).

The Basel system essentially institutionalizes such operating framework. Capital standard regulations applied to the global banking system which assigns government bonds as ‘risk free’, which requires banks to finance government spending by holding sovereign liabilities into their balance sheets, has been backfiring on the back of unsustainable economics of the welfare-warfare state. Economics cannot be dictated by fiat or by legislation.

The financial system can indeed be fixed, but I think, it will take a a major systemic collapse for the political incentives to change.

In the meantime, politicians around the world will invariably resort to various band-aid, kool aid and ‘extend and pretend’ measures in response to any emergent problems. This will continue to accrue strains into the fragile incumbent operating system.

Let me repeat, politicization of the banking and financial industry will amplify, and not reduce, systemic fragility.

Genuine reforms must be directed towards empowering the markets over politics.

Why Capital Standard Regulations Will Fail

Global regulators have been arguing over the kind of regulations required for crisis prevention.

From Bloomberg,

Capital standards designed to fortify the global financial system are eroding as European officials, beset by a debt crisis, rewrite the regulations and U.S. rulemaking stalls.

The 27 member-states of the Basel Committee on Banking Supervision fought over the new regime, known as Basel III, for more than a year before agreeing in December to require banks to bolster capital and reduce reliance on borrowing. Now, as they put the standards into effect in their own countries, European Union lawmakers are revising definitions of capital, while the U.S. is struggling to reconcile the Basel mandates with financial reforms imposed by the Dodd-Frank Act.

“The game on the ground has changed in Europe and the U.S.,” said V. Gerard Comizio, a former Treasury Department lawyer who is now a senior partner at Paul Hastings Janofsky & Walker LLP in Washington. “The realists in Europe realized that their banks cannot raise the capital they’d need to comply. U.S. banks have reversed course and are more assertively fighting against it. The future of Basel III looks less certain now than it did when it was agreed to.”

The Basel committee revised its capital standards and outlined new rules on liquidity and leverage after the 2008 crisis exposed the vulnerability of the banking system. Credit markets froze following the collapse of Lehman Brothers Holdings Inc., sending the world economy into its first recession since World War II. Basel III was meant to create “a much stronger banking and financial system that is much more resilient to financial crises,” said Mario Draghi, who will take over as president of the European Central Bank in November.

Not Binding

Basel standards aren’t binding, so each country needs to write its own rules putting the agreed-upon principles into effect. The European Commission proposed regulations to parliament last month that would translate Basel III into law. A majority of EU governments also must endorse them. U.S. regulators led by the Federal Reserve have to come up with their own version, though they don’t need legislative approval.

The proposed EU rules, submitted by financial services commissioner Michel Barnier, omitted a ratio designed to improve banks’ cash positions, deferred decision on a rule to limit borrowing, revised capital definitions and extended some compliance dates. In the U.S., regulators are stymied because the 2010 Dodd-Frank Act bars the use in banking rules of credit ratings, which Basel III relies on to determine risk.

First, regulators have been squabbling over proposed elixirs, when in reality they are arguing about treatments to the symptom rather than the disease itself.

All these web of proposed regulations, on top of existing maze, won’t stop the banking financed boom bust cycle. This is because the current central banking based monetary system has been engineered for bubbles.

As the great Murray N. Rothbard wrote

for it is the establishment of central banking that makes long-term bank credit expansion possible, since the expansion of Central Bank notes provides added cash reserves for the entire banking system and permits all the commercial banks to expand their credit together. Central banking works like a cozy compulsory bank cartel to expand the banks' liabilities; and the banks are now able to expand on a larger base of cash in the form of central bank notes as well as gold.

Two, regulators think that the action of bankers can be restrained by virtue of fiat. They are delusional. They forget that as humans, regulator-banker relationship will be subject to various conflict of interests relationships such as the agency problems, time consistency dilemma, regulatory arbitrage and regulatory capture aspects.

In reality, more politicization of the banking-central banking amplifies systemic fragility.

Yet amidst the publicized noble intentions, we can’t discount that the implicit desire by regulators for these laws have been to expand control over the marketplace and to protect the interests of certain groups (regulatory favored groups).

Three, as shown above opposing interests leads to conflicting design of regulations.

In a world of complexity, centralization is bound for failure.

Let me add that while many see capital adequacy laws as one way of restraining bubbles, such perspective do not account for the unseen or unintended consequences.

Expanding capital adequacy regulations or laws can have lethal effects on the economy: they destroy money.

As Professor Steve Hanke explains, (bold emphasis mine)

The oracles have erupted in cheers at the increased capital-asset ratios. They assert that more capital has made the banks stronger and safer. While at first glance that might strike one as a reasonable conclusion, it is not the end of the story.

For a bank, its assets (cash, loans and securities) must equal its liabilities (capital, bonds and liabilities which the bank owes to its shareholders and customers). In most countries, the bulk of a bank’s liabilities (roughly 90%) are deposits. Since deposits can be used to make payments, they are “money.” Accordingly, most bank liabilities are money.

To increase their capital-asset ratios, banks can either boost capital or shrink assets. If banks shrink their assets, their deposit liabilities will decline. In consequence, money balances will be destroyed. So, paradoxically, the drive to deleverage banks and to shrink their balance sheets, in the name of making banks safer, destroys money balances. This, in turn, dents company liquidity and asset prices. It also reduces spending relative to where it would have been without higher capital-asset ratios.

The other way to increase a bank’s capital-asset ratio is by raising new capital. This, too, destroys money. When an investor purchases newly-issued bank equity, the investor exchanges funds from a bank deposit for new shares. This reduces deposit liabilities in the banking system and wipes out money.

By pushing banks to increase their capital-asset ratios to allegedly make banks stronger, the oracles have made their economies (and perhaps their banks) weaker.

Prof. Tim Congdon convincingly demonstrates in Central Banking in a Free Society that the ratcheting up of banks’ capital-asset ratios ratchets down the growth in broad measures of the money supply. And, since money dominates, it follows that economic growth will take a hit, if banks are forced to increase their capital-asset ratios.

Professor Hanke goes to show how these regulations have impacted the Eurozone which has resulted to declining money supplies that has led to the recent market turbulence. Read the rest here

To add, adherence to math or algorithm based models has been one of the principal weakness of such regulations, writes Philip Maymin, (bold emphasis mine)

One might think that the ideal regulations would be those that find the right numbers for these portfolios, not too small and not too large—the Goldilocks of risk.

Surprisingly enough, it is not possible. It turns out that no algorithm for calculating the required risk capital for given portfolios results in lower systemic risk.

In Maymin and Maymin (2010), we prove why this is so, both mathematically and empirically. First, the math. Imagine that there are 1,000 securities whose returns are each independently distributed according to the standard bell curve of a normal distribution. Simulate five years of monthly returns for each security, and then calculate the volatility that each one actually realized. Because there are only sixty data points for each security, some securities will appear to have a little higher volatility than they truly do, and some will appear to have a little less. Out of the one thousand securities, how many would you guess exhibit less than 80 percent of their true volatility?

The answer is ten, and we show this with a formula in the paper. If we make the situation more realistic by relaxing the assumption about normality, the problem is exacerbated, and the ten securities with the lowest realized volatilities would deviate even further from their true volatility.

We also show empirically that the securities with historically low volatility tended to have almost twice as much subsequent risk, while those with historically high volatility tended to have almost half as much subsequent risk. For both the riskiest and least risky securities, therefore, historical risk is a statistical illusion.

Here's where the problem of objective regulations comes in. To see it, consider the perspective of a bank deciding what to invest in. It can invest in any of the 1,000 securities, but if it invests in the special ten that exhibit less than 80 percent of their true volatility, it will have to put up one-fifth less capital than otherwise. At least to some extent, those ten securities will be more favored than the others. What's worse, every bank will favor the same ten securities because the objective regulations are the same for everyone.

If those securities continue to rise, then no problem will be apparent. But if they should fall, then, suddenly, all banks will need to liquidate the exact same positions at a time when those positions are falling anyway. This sets the stage for systemic failure. Consider sub-prime mortgages as an illustration. These assets appeared to be historically low-risk and were, therefore, regulatorily favored. Banks invested more in them than they perhaps should have. For a while, as real estate prices continued their ascent, no problems surfaced. But once the market turned, banks began experiencing more losses on their sub-prime mortgage holdings than their regulatorily-mandated risk calculations had planned for. Banks needed to raise capital quickly and began doing two things: selling the sub-prime mortgages, dropping the prices even lower; and selling other assets. Because the banks all acted nearly simultaneously, and all in the same direction, the impact on the markets was both broad and deep, and systemic collapse became a real threat.

Bottom line: whack-a-mole stop-gap regulations meant to preserve the current fragile, broken and unsustainable paper money system founded on the cartelized system of welfare government-central banking-politically privileged "Too big to fail" banks will ultimately fail.

Paper money will return to its intrinsic value-ZERO.