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Where is my swap line? And will the diffusion of financial power Balkanize the global response to a broadening crisis?

by Brad Setser
October 18, 2008

Some emerging market central banks have noticed that they – unlike the Bank of Japan, Bank of England, Swiss National Bank and the European Central Bank – don’t have access to unlimited dollar credit through reciprocal swap lines with the Federal Reserve.

Peter Garnham of the FT, drawing on Derek Halpenny of Tokyo-Mitsubishi UFJ, observes:

Analysts say the unlimited dollar currency swaps set up between the Federal Reserve and central banks have helped bring stability to currencies through alleviating institutions desire to purchase dollars in the spot market to satisfy overnight funding requirements. “In contrast, the lack of currency swaps put into place between the Federal Reserve and emerging market central banks has likely helped to exacerbate the pick up in emerging market currency volatility” says Derek Halpenny, at the Bank of Tokyo Mitsubishi UFJ.

Think of Korea. There is “a shortage of dollars in the Korean banking system” – and Korean banks (and the Korean government) are scrambling to obtain them. That is likely adding to the pressure on the Won.

For all the talk about how the G-7 has lost relevance, in a lot of ways the recent crisis has reinforced the G-7’s importance. Banks in G-7 countries that borrowed in dollars have access to unlimited dollar financing from their central banks – dollar financing that comes from the fact that the main G-7 central banks have access to large swap lines with the Fed.

Banks in emerging market countries have no such luck.

Korea is a highly developed emerging economy. In a lot of ways it already has emerged. But it isn’t part of the G-7 (or G-10) and doesn’t have a swap line with the Fed that allows the Bank of Korea to borrow dollars from the Fed by posting won as collateral. That means that it has to rely on its foreign currency reserves – and its government’s capacity to borrow dollars in the market – to support its banks. Unless, of course, Korea could draw on a set of East Asian swap lines, and effectively borrow from Japan and China.

The old global architecture for responding to financial crises had, in my view, two essential components:

First, the major countries themselves were responsible for acting as the lender of last resort (and the bail-outer of last resort) to their own domestic financial system. Since the advanced economies banks’ had liabilities denominated in their own countries’ currency (US bank deposits are in dollars, British deposits are in pounds, and so on) this wasn’t hard.

And emerging economies had to turn to the IMF (sometimes reinforced with “second line” financing from the G-7) for dollar (or DM or pound or Euro) financing – whether to help meet their government’s own financing need, to help the emerging economies’ central bank provide a “hard currency” lender of last resort to its domestic financial system or to provide the emerging economy more foreign currency reserves to backstop its currency.

And since emerging market governments often borrowed in dollars or euros rather than their own currencies – and since many emerging market savers held dollar or euro denominated domestic deposits – emerging economies often had a need for significant financing.

This financing though was never unconditional – and was never unlimited. The $35b the IMF lent to Brazil in 2002 and the $20-25b the IMF lent to Turkey in 00-01 seemed big at the time, but it now seems small.

That architecture has been extended in one key way in the crisis:

European and Japanese banks facing difficulties refinancing their dollar liabilities now have (indirect) access to the Fed. The availability of $450b in credit from the Fed allowed European central banks to lend dollars to their banks without dipping into their (comparatively modest) reserves.

Emerging market central banks generally haven’t been as lucky. Their ability to lend dollars to their own banks is still limited by their own holdings of dollar reserves, their ability to borrow reserves from the IMF in exchange for IMF policy conditionality and their ability to borrow dollars from other emerging market economies with spare dollar reserves.

I am still trying to figure out how important a change this is – and to assess whether this new architecture makes sense for a global financial system that has changed fundamentally in some ways but not in others.

At one level, the stark divide between banks regulated by a the G-10 countries — which now have access to the Fed as a lender of last resort, albeit indirectly — and the banks regulated by the rest of the world seems a bit anachronistic. The center of the world economy won’t always be in the US and Europe.

On another level, a higher level of cooperation is possible among countries with broadly similar political systems than among more diverse group of countries with different political and economic systems. Similar forms of government, broadly similar (though changing) conceptions of the state’s role in the economy and a standing political alliance* facilitate the kind of cooperation among G-10 central banks that we have seen recently. Korea could presumably be drawn into the club without changing its basic character – Korea is a US ally and a democracy. Iceland could too, if it patches up its relationship with the UK – though the risk that Iceland’s government now has more debt than it can pay makes accepting Icelandic collateral in exchange for dollars a bit more of a problem.

Adding emerging economies with different economic and political systems from the G-7 countries into the “swap line” club might fundamentally change its character. Among other things, the US and Europe basically agree that their currencies should float against each other — and that they should regulate (or, until recently, not regulate) their financial systems in fairly similar ways.

There is another key difference between European banks’ need for dollars and many emerging markets’ need for dollars. European banks need dollars to finance their holdings of US mortgages and other US securities. If they didn’t have access to dollar financing, they would either have to borrow euros and buy dollars – pushing the dollar up (and hurting US exporters) or they would have to dump their US assets (hurting US banks holding similar assets). By lending to European central banks who then lent to their own banks, the US kept some European banks from being forced sellers of risky US assets – and in the process putting pressure on US banks. The US wasn’t acting entirely altruistically.

Emerging market banking systems by contrast often need dollar financing not to support their portfolios of US assets but to support their domestic dollar lending.

And it is now clear that a broad range of emerging economies do need access to the international banking system to continue the kind of breakneck growth that they have experienced recently — and have been caught up in the recent “deleveraging” of the global financial system. The FT’s Garnham again:

Analysts said emerging market currencies were being hit as foreign investors pulled money out of developing regions, driven by liquidity pressures from the credit crisis. “There seems little now that the authorities can do to reverse the process of deleveraging that is taking place with financial institutions all contracting their balance sheets at the same time,” said Derek Halpenny, at Bank of Tokyo-Mitsubishi.

Hungary is scrambling for euros.

Ukraine’s government is scrambling for dollars and euros – both to back its currency and to cover the maturing foreign currency borrowing of its banks.

Pakistan’s government needs dollars.

Korean banks are scrambling for dollars.

As are Russian banks. And Kazakh banks. And Emirati banks.

In many of the oil exporters, the government was building up foreign currency assets (reserves, sovereign wealth funds) while the private sector (including many firms with close ties to the government) were big borrowers from the international banking system. In the Emirates there is an added complication: Abu Dhabi was the emirate building up its external assets, while Dubai was the emirate doing the most borrowing.

But across the emerging world, external bank loans have dried up – creating a scramble for foreign currency liquidity.

And emerging markets (and Iceland) are looking for help from a range of sources. Their own central banks’ reserves (Korea, Russia, the Emirates) – or the foreign assets of their sovereign fund (Russia, China, Qatar, Kuwait, perhaps Abu Dhabi).*** The IMF, which is clearly back in business. European central banks (Hungary borrowed 5 billion euros from the ECB, the Nordics swap line with Iceland — which was recently tapped for euro 400 million). Russia (if it lends to Iceland).

Or China. Pakistan was certainly hoping that China would offer an alternative to the IMF; China though does not currently seem to be willing to hand Pakistan a sum that is equal to a couple of days of its reserve accumulation … .

This frantic activity suggests another potential change to the global architecture for responding to crises: the IMF no longer necessarily has a monopoly on hard currency crisis lending to the emerging world. It is now one player among many.

That is a fundamentally a reflection of the increased reserves of many large emerging economies.

China clearly has more dollars than in needs to maintain its own financial stability, which means that it is an alternative source of dollar financing. Russia may be too – though the large dollar and euro liabilities of Russian banks and firms implies that its own need for reserves could be quite large. It isn’t in as comfortable a position as China.

The diffusion of pools for dollar liquidity available to lend to troubled emerging economies seems at least to me to pose a fundamental issue for the G-7 countries that traditionally have been able to essentially decide on how the IMF’s funds are used among themselves: does the diffusion of financial power a major effort to bring the big emerging powers into the IMF’s fold – and thus to restore a de facto IMF monopoly on large-scale crisis lending? Or would the cost of any “deal” that would lead that countries like China and Russia and Saudi Arabia (which already has a large IMF quota) channel their lending through the IMF prohibitive?

The right answer isn’t clear to me. On one hand, granting the new players significantly more votes might make it next to impossible to build consensus in the IMF – and even a generous increase in the voting weights of key emerging economies might not be enough to convince them to channel their “crisis” lending through the IMF. China might not want to give up on bilateral lending in exchange for say 15% of the IMF’s voting shares. On the other hand, China hasn’t been keen to throw its reserves around over the past few weeks – preferring the safety of Treasuries to Agencies (or a dollar deposit in Pakistan’s central bank) – and might prefer conditional IMF lending to the risk of losing its funds …

For now it seems to me that the crisis likely has increased the gap between the G-7 (and G-10) countries and the rest of the world in a couple of key ways. Inside G-7 land, US banks could lend in euros (and European banks lend in dollars) secure that they had access to a lender of last resort – and the G-7 countries would still be in a position to offer hard currency loans to their “out-of-area” friends through the IMF. Outside G-7 land, countries would rely primarily on their own foreign currency reserves to cover the foreign currency liabilities of their banks – and potentially could use their own reserves to finance their crisis lending to other troubled countries.**

In some ways, that is a world where the gap between the G-7 countries and the rest would gets larger not smaller …

* Switzerland is an exception; it stands outside the “Western’ alliance but has access to the swap lines. But the Swiss have long been a big part of central bank cooperation – Basle and all.
** This leaves aside a key issue, namely the fact that countries outside the G-7 provide enormous quantities of unconditional dollar financing to the US through the buildup of their reserves. That reserve growth is partially a function of the need for countries outside the G-7 world of reciprocal swap lines to hold a lot more foreign currency – but it is also a function of these countries ongoing policy of pegging their currency to the dollar at an undervalued level. It also ignores the debate over whether sovereign funds investments in the US and European banks should be considered private investments for profit, or part of the global policy response to the crisis.
*** SWF Radar has been invaluable in tracking the use of sovereign funds to support domestic banking systems; many of my links are drawn from there.

70 Comments

  • Posted by Chidambaram

    Brad,
    WSJ reports CIC’s to increase their stake in Blackstone to 12.% from 9.9%., buying the shares on the open market.
    Also QIA is reported to have invested $8.83b in Credit Suisse Group last Thursday.
    Looks like SWFs investing in US and other banking stocks is a result of these stocks having fallen quite a lot recently.
    Best regards,
    Chidambaram

  • Posted by glory

    like you would’ve thought that BWII would have broken down by now, but no! instead it’s mutated into its more virulent form :P

  • Posted by glory

    Crisis Inspires a Grand Plan in Japan: “urging the government to inject some of its abundant cash into troubled U.S. and European banks, in return for equity, and to purchase distressed corporate assets at fire-sale prices.”

  • Posted by black swan

    A logical reason for not lending outside of the G-7, would be the fear that the money would not be paid back. Yet, since the Fed has dumped $213 billion ($50B/Bear Stearns, $138B/Lehman collapse and $25B/bailout bill) into JP Morgan, an IB with somewhere around $100 trillion in derivative exposure, fear of loan defaults must have little to do with the Fed’s insular lending practices.

  • Posted by bsetser

    Chidambaram — Credit Suisse isn’t a US bank, nor is Blackstone. I don’t fully understand the CIC’s investment in blackstone, but it isn’t a big sum in any real sense: $3b bought the CIC 10% of blackstone a while back, now they can probably get another 2-3% for a couple hundred million. QIA has been all over the map with its investments — but it clearly is the most risk seeking SWF right now. It took a big position in Barclays this spring (after the other SWFs decided to sit out after taking big losses on earlier investments), and it recently look a sizeable position in CS and the Qatari banking system (which it recapped with $4-5b). it now must have an impressive concentration in financials. it also presumably has taken large losses on its UK real estate investments.

    black swan — fair point. there is a case to be made that the fed (like most americans) overestimates emerging market risk and underestimates the risk associated with lending to highly leveraged us financial institutions.

  • Posted by moldbug

    It’s a pretty serious regulatory mistake for a country to allow its banks to engage in fractional-reserve banking / maturity transformation in foreign currencies, when they don’t have a lender of last resort who can create the currency for free. Doh! It really shouldn’t take an Austrian to inform anyone of this basic fact.

    Of course, in the 19th century, weakly protected MT was done with gold on a pretty regular basis. And the corresponding crashes were extremely dramatic. For many years it was the boast of the Bank of England that 10% rates would “draw gold out of the ground.” Eventually when credit expansion got too great, this turned out not to be true. Iceland, etc, are feeling the pain of a similar event – these EMs are to dollars and/or euros much as Europe and America were to gold in 1931-33.

    I knew about the Eastern European SFr mortgages, but I certainly didn’t know there was that much dollar debt issuance in countries like Korea. Debt denominated in foreign currencies should be issued only in exceptional circumstances – eg, by a trading company whose revenue is in that same currency. Whatever BWIII turns out to be, I suspect this will be one of its lessons. Random homeowners and FX carry trades don’t mix.

  • Posted by Steve Waldman

    Brad — Great essay, as always. I don’t exactly understand the rules by which some countries get unlimited access to US financing, while others do not, but it seems to be creating (or revealing) an implicit politically/financially integrated block. It’s not just G-7, right? There’s Denmark, Norway, Sweden, Australia… Does anyone know whether Korea has asked and been rebuffed? Presumably that’s the case with Iceland.

    I’ve been trying to think through the balance of payments / NIIP implications of these currency swaps. At first blush, they’re symmetrical — we lend dollars, they lend Euro or Francs or whatever in identical amounts. But at second blush, that doesn’t seem quite right. They borrow, because they need the dollars. The Fed has nothing to do with its Swiss Francs, and presumably lends its cache right back to the SNB. In other words, it seems to me that these swaps amount to a capital flow from the US to the swapees, offsetting some of our NIIP. The dollars lent are then paid to holders of dollar-claims against local banks. If those claimants are Americans, there is no net flow, funds flow from the US and back to the US. But if those claimants are locals, the net flow “sticks”.

    Plus, the collapse in the value of US assets that precipitated the crisis seems like an extravagant case of the phenomenon you once called “dark antimatter”. Presumably US claims on European assets are struggling too, but Americans probably don’t hold that many worthless Euro CDOs.

    Together, this has me wondering whether recent events will suddenly, oddly, make a big dent in America’s negative NIIP.

    The dollar’s recent strength would be a countervailing force, but I don’t have a good sense of the relative quantities. Will the diminished dollar value of of US claims on Europe offset the effect of America’s new claims and the devaluation Europe’s US-mortgage portfolio? The scale of the swap arrangements, several hundred billion dollars, represents a significant fraction of our ~2T NIIP, no?

    It’s a strange thing, but for so long the imbalances of BWII seemed like America’s problem. What seems to be emerging is that the US and its traditional allies are so financially integrated that the balance sheet of the union matters more than the balance sheet of the US or Eurozone separately. The recent dollar strength is like the Eurozone and other floating allies belatedly suffering their share of the weakness of the larger bloc to which they belong.

    Am I missing something, getting something wrong?

    (I’m sorry for the long comment. No one does NIIP stuff as well as you, and I wanted your thoughts.)

  • Posted by black swan

    The misdirection of Fed capital is astounding. Our municipalities, state governments and public pension plans are imploding because of the inability to float municipal bonds. While there is little trust within the banking system, there is even less trust, since the monolines have been discredited, in what were once construed to be some of the safest investment vehicles around, the muni bonds. Without municipal bonds to fund our cities and counties, there will be waves of public layoffs, and that will change what is perceived to be a recession, into a depression.

    The solution is so simple. Instead of having the Fed/Treasury insure the new senior debt of the nine banking institutions that sheltered the architects of our present worldwide solvency crisis, have them insure muni bonds. Instead of pouring trillions of dollars into opaque, level 3 asset laden, investment banks, and into what is theoretically supposed to be a top down solution (that gets stuck at the top) for the liquidity jam, pour that money into Federal municipal bond gaurantees. This would insure that many public jobs would be saved, and projects, that could actually add US taxpayers to public and private employment rolls, would be built. It would also give the American investor a tax free investment vehicle with Federal Government indemnification. It is a bottom up solution that could bring hundreds of billions of dollars off of the sidelines and directly into the economy.

    I believe the Treasury is not talking about doing anything like this, because the Treasury is Goldman Sachs (Paulson, Kashkari, Wilson and Forst). There isn’t a modicum of evidence to suggest that any of the Treasury’s ‘fixes’ are done to benefit the US taxpayer. In fact, there is little doubt that the contrapositive of this is being proven every day. The media treat Paulson and Buffett like heroes, when what they represent are self-centered, self-serving forces of perpetual greed and economic destruction. Our Government has rigged it so that they have unlimited power. Why should they lend to municipalities, let alone developing nations. With all the wealth these characters have amassed, what could be more fun for them but to create even more distressed assets to plunder?

  • Posted by Don the libertarian Democrat

    “Smith’s colleague, Tu Packard, said that the problem is that in the hierarchy of lending risk, emerging markets countries fall at the bottom: “There’s only a limited amount of capital globally, and the big demand elsewhere is crowding out emerging markets.”

    http://www.washingtonpost.com/wp-dyn/content/article/2008/10/17/AR2008101702964_2.html?hpid=topnews

    Here’s the oddity, following up on an earlier point. It seems the crisis began at the center, and yet the periphery is left out of the guarantees or opportunities you mention. What’s wrong with this picture?

  • Posted by k

    Let me put out a “political incorrect” statement,

    You know why Koreans don’t get their dollar swaps from the Fed? Because they’re YELLOW-SKINNED people.

    (No, Japanese are the “Europeans of the Asians”, at least they regard themselves as such, though they are ridiculed to no less degree behind their back among the “western” club.)

    So President Lee Myung-bak, a former big “honcho” from Hyundai, a lifelong pro-business, pro-America, pro “west” business executive, who rushed to sign the first Free Trade Agreement with the US among Asia countries earlier this year(http://en.wikipedia.org/wiki/U.S.-Korea_Free_Trade_Agreement), pushed imported American beef down the throats of Korean people despite fierce domestic resistance, was shown the door when he came to beg for lifeline supporting dollar.

    I am shocked!

    Maybe he should read more Noam Chomsky, less Tom Friedman.

  • Posted by black swan

    Could it be that Ben Bernanke really is a student of the Great Depression, and that his major trading partner swap policy is proof that he has learned a lesson from the failures of the Smoot-Hartley Act some 78 years ago? For this to be true, it would be necessary to believe that Geithner and Paulson allow Bernanke to have any decision making power.

    The Smoot-Hartley Act would have been the antithesis of today’s major trading partner cooperation. Under the act the US erected trade barriers that blocked the exports of its European trading partners. The European governments returned the favor by erecting tariffs, against the US, of their own. The US effectively killed its own foreign trade which had helped to make it the greatest creditor nation in the world.

    Today, the US is the greatest debtor nation in the world, and may be cooperating extensively with its major economic partners to prevent the possibility of retaliation for having dumped worthless CDOs or CLOs on them. The Chinese are already demanding restitution, and have been able to put teeth in those demands by putting an abrupt end to agency buying. It is, of course, the investment banks who were largely responsible dumping the toxic waste, so maybe Paulson, trying to prove he is not another Mellon, is a willing participant in what may be Bernanke’s plan. Why bother assuage the emerging market countries, when even in aggregate, they do not have the power of the major economic powers?

  • Posted by Jehu

    black swan Says: “Could it be that Ben Bernanke really is a student of the Great Depression”

    Could it be that this is the number one mistaken assumption regarding the current crisis: that avoiding a new depression is the task of the moment?

    Perhaps more success could be gained by realizing this is a deflation of the sixty year old bubble built ON TOP of the Great Depression.

    As such, everything Mr. Bernanke knows about depression fighting is of no use in these circumstances.

  • Posted by JKH

    Steve/Brad,

    For what it’s worth, my interpretation of currency swaps and NIIP:

    In short, there is no effect on NIIP.

    The Fed “exports” dollars via the currency swap. This is a capital outflow.

    Foreign central banks lend swapped dollars to foreign commercial banks. The latter have dollar clearing accounts with the Fed – either directly in the case of multinationals with a US presence, or indirectly through “correspondent” US banks in (e.g.) New York. Either of these relationships is the default banking conduit for a capital inflow to the US. These accounts in turn clear with the Fed, increasing domestic reserves at the Fed as a result of the original receipt of swapped dollars.

    Alternatively, one can construct higher order asset-liability examples generating the required clearing flows. E.g. – the foreign bank uses the dollars to repay dollar interbank borrowing from a US bank. Thus, a capital outflow (the swap) finances the repayment of a prior outflow. The repayment is a capital inflow.

    And a capital inflow is ensured, regardless of the domicile of the first repaid overseas dollar liability. If one follows the full chain reaction of actual dollar payments, it is impossible to construct an example where a capital inflow to the US isn’t forced at some stage of the chain. Double entry book keeping at the global level forces the economics. The default clearing case is as described in the preceding paragraph. In this sense, the exported dollars can’t just disappear.

    Currency swaps are included in “other assets” on the Fed balance sheet. The offsetting Fed liability is an increase in bank reserves. The Fed may sterilize any unwanted increase in reserves using its usual domestic arsenal (which now includes Treasury bill financing and increased Treasury deposits at the Fed, as well as the payment of interest on reserves).

    There are two additional capital flows – at least effectively – associated with each currency swap. These are the round trip “flows” in the collateral currency. It’s not clear how the collateral is invested. It may just be a return deposit with the foreign central bank. The collateral flows don’t appear as separate items on the Fed balance sheet, since they are embedded within the corresponding dollar accounting items. I don’t know if they are included more explicitly in the international balance sheet accounting, but they would seem to have the substance of back to back international flows.

    Finally, there is an alternative macro perspective on the question. NIIP changes require either net current account flows or international balance sheet valuation changes. There is no net CA change here, at least not directly. And there is no change in balance sheet value because the currency swap is hedged (the tail end of the swap is contracted at a pre-agreed exchange rate). So there is no direct NIIP effect.

    There may be an extraneous knock-on effect on CA and NIIP due to the economic effect of lending activity. But this is quite independent and separate from the operational effect of the swap. In the same way, the effect of exchange rate changes on the rest of the largely non-hedged international balance sheet would have a significant effect on NIIP, but would be unrelated to these currency swaps.

  • Posted by bsetser

    K — one of the themes of my essay is that the line (which seems to be G-10 v the rest, and thus sweeps in Japan and Australia along with Switzerland and Sweden and somehow Denmark also made it in despite not being part of the G-10) doesn’t make much sense. i would say it is more an anachronism than racism, but it does reinforce what might be termed “old” financial boundaries.

    And i am not sure it makes sense from the narrow self-interest of the US. Korea’s produces goods that overlap with both those produced in the US (cars, chips) and in China (electronics, ships, cars, etc) — so won weakness/ a korean slump will tend make korean goods more competitive with US goods (cutting into US exports/ adding to detroit’s troubles) and reduce china’s willingness to allow the RMB to continue to appreciate.

    black swan — the washington post has a good article about the unintended consequences of each stage of the government’s response to the crisis driving the next stage of its response; if states/ localities cannot borrow b/c banks and the agencies are guaranteed and they are not, the us will have to guarantee their borrowing as well. the contingent liabilities keep growing.

  • Posted by bsetser

    Steve — I agree with JKH’s analysis of the BoP effects of a swap. in the first instance, they increase both the United States and Europe’s foreign assets and foreign liabilities in a symmetrical way. If the dollars (an f. asset of Europe, a liability of the US) that the ECB borrows from the Fed are lent to a European bank that repays debt it owes to a US money market fund, it works out that the increase in the Fed’s lending to the world substitutes for a fall in private US lending to the world, so there is no net impact.

    As for the impact of this on the NIIP, I would argue that the biggest impact won’t come on the debt side — though the losses on european (especially swiss thanks to UBS!) holdings of US debt will be significant. Rather the big impact will be on the equity side — and with global markets generally doing worse than the us markets (and the dollar rallying) i suspect the NIIP will deteriorate significantly, as the valuation gains that offset the rise in the stock of debt will go away.

  • Posted by gillies

    black swan : “I believe the Treasury is not talking about doing anything like this, because the Treasury is Goldman Sachs (Paulson, Kashkari, Wilson and Forst). There isn’t a modicum of evidence to suggest that any of the Treasury’s ‘fixes’ are done to benefit the US taxpayer.”

    the $255 000 in campaign contributions made by goldman sachs sounds generous, but the $700 billion so called bailout beats it by a ratio of 2 750 000 : to 1.

    of course, there may be no relation between these two numbers . . .

  • Posted by glory

    there’s a mastercard parody commercial in there somewhere i suspect :P + re: goldman, corzine (among others) is waiting in the wings! …should obama fail; of course, he’d be going in with an enormous amount of goodwill

  • Posted by ReformerRay

    Emerging countries as a whole have been exporting more than importing ever since the Aisan financial crisis. They can borrow from each other. China may want to use this opportunity to develop closer ties with other developing nations.

  • Posted by ReformerRay

    Black Swan rightly criticizes the Paulson emphasis only on banks. Municipal bond markets need help along with the commercial paper markets.

    Maybe direct intervention in these markets should replace funding banks.

  • Posted by Twofish

    Sometimes you can figure out why something it by just taking a walk…

    For example, you take the number 6 train to Grand Central Station and walk north on Park Avenue. As you do so you walk past the headquarters of Barclays, HSBC, JP Morgan, UBS, and Deutsche Bank before ending up at the headquarters of Citigroup. You don’t pass any Korean or Japanese banks (although if you take a short detour you end up at a tiny building which is the headquarters of Bank of China).

    This nicely explains who gets bailed out and who doesn’t.

    One other thing that is interesting is that if you walk inside the buildings, youo really don’t see that many Japanese or Koreans. Lot’s of Chinese and Russians.

  • Posted by NJ

    Brad,

    Indian reserves dipped more than 10% since march.

    http://www.indianexpress.com/news/Forex-kitty-depleting–falls–35-7-bn-since-March/375127

    Is the FX reserve addition (aka US debt financing) in trouble now ?

  • Posted by black swan

    Gillies, I’m not aware of what the $255,000 number you quote represents. I do know, however, that Goldman Sachs has been Obamba’s number one campaign contributor over the last 5 years, having given him in excess of $700,000. I don’t know what GS has given to McCain or other members of Congress, but the original Paulson Plan, which was presented to the SEC in 2000, and then, again, successfully in 2004, called for unlimited leverage instead of the formally mandated 12-1 ratio. Paulson’s Harvard alum buddy, Christopher Cox, was certainly pulling for him, but it would have taken more grease than just Chris to get this debacle through.

    Goldman Sachs takes a bi-partisan approach in its money and influence peddling. After all, it was Bush’s Chief of Staff and former Goldman Sachs executive director, Josh Bolton, that landed Paulson his Treasury Secretary job. Once Paulson took the job, the doors opened at the Treasury and the NY Fed for the following Goldman Sachs directors: Paulson, Kahskari, Jeffrey, Jester, Shafran, Wilson, Forst, Steel, Friedman, Dudley, Corrigan, Liddy, and Johnson. That has turned out to be a large enough number of Goldman Sachs directors to transform the Fed and the Treasury into a taxpayer funded GS hedge fund.

  • Posted by Twofish

    black swan: The solution is so simple. Instead of having the Fed/Treasury insure the new senior debt of the nine banking institutions that sheltered the architects of our present worldwide solvency crisis, have them insure muni bonds.

    Not so simple. If you insure municipal bonds, but don’t insure the banks, then you don’t have anyone to underwrite the issuance of the bonds. What typically happens when a municipality wants to float an municipal bond is that they go to a syndicate of investment banks that buy the bond, and then the bank takes the bond and sells them on the credit markets. If you insure the bonds, but the banks aren’t willing to underwrite them beause they have no cash, then it’s pretty useless, since you have no mechanism to sell the bonds.

    black swan: I believe the Treasury is not talking about doing anything like this, because the Treasury is Goldman Sachs (Paulson, Kashkari, Wilson and Forst).

    Precisely. They know the securities markets well enough to know that some things just won’t work. This is a big problem that I’m not sure how to deal with. Anyone that really understands the market is heavily involved in it and is going to have connections, left and right, and hence conflicts of interest. Anyone with no conflicts of interest probably doesn’t have the experience needed to do the job. Another problem is that if you need someone to do a job quickly, you find someone you know and trust, but this tends to squeeze out competent people that you don’t know, and the people who Paulson trusts are precisely the people that a lot of voters *don’t* trust.

    I’m not that worried about Goldman-Sachs taking over the world, since if Goldman-Sachs starts acting out of line, the other big investment banks will start screaming. Of course, then there is the valid question of what you do when the big investment banks collectively act out of line.

    black swan: There isn’t a modicum of evidence to suggest that any of the Treasury’s ‘fixes’ are done to benefit the US taxpayer.

    We’ll see in a year. Goldman-Sachs is making one of those “bet the firm” bets that they are famous for. If three years from now, the economy is in great shape, and you point to the voter that Goldman-Sachs is in control of the Treasury Department. They may react with “Great!!! We need more people from Goldman-Sachs running the world. I want my kids to work for Goldman-Sachs. God bless Goldman-Sachs” If three years from now, the economy is in a depression, then Congress is going to hold lots of hearings on cronyism and people will be demanding human sacrifices.

    The first case may sound odd, but there is precedent for something like this. At the start of the Great Depression, a small group of people figured out that they that could run the world by putting key people in charge of the economic infrastructure of the United States, and if did it competently that they would amass more power and wealth than anyone could dream of, and they could do it in a way that the general population would actively support their efforts. These people were in charge of running Harvard, Yale, Princeton, MIT, Stanford, University of Chicago, etc.

  • Posted by k

    Twofish,

    “One other thing that is interesting is that if you walk inside the buildings, you really don’t see that many Japanese or Koreans. Lot’s of Chinese and Russians.”

    And if you read the bios of executive committee of these grand institutions, they’re 95% white male, of which half are Europeans and the rest are Americans. You can throw in some occasional Indians. No Chinese, Russian, Japanese or Korean. And last time check, all power rests with executive committee. No?

  • Posted by Twofish

    black swan: That has turned out to be a large enough number of Goldman Sachs directors to transform the Fed and the Treasury into a taxpayer funded GS hedge fund.

    It was Goldman-Sachs that invented the term “long term greed” and it’s pretty clear to me that they do have a devious plan to take over the world, and it’s obvious what they plan is and what it is not. What they plan isn’t is to the take over the Treasury Department and loot it. The trouble with that plan is that it really doesn’t get you that much money and power, and after you get a mere several hundred billion dollars, which is pocket change for these people. Also, people tend to figure out that they’ve been looted, at which point they do nasty things to you.

    No, the real devious plan here is to put Goldman-Sachs alumni in key positions of power, and have then act competently and ethically in ways that cause the US economy to grow. It this plan succeeds, then GS is looking at returns of tens of trillions of dollars over the next century and control and influence over the the major governments and financial institutions of the world into the 22nd century. The amount of wealth and power that Goldman-Sachs will end up with if they turn out to be competent is staggering. It’s big. Harvard big.

    I don’t think of Goldman-Sachs as an investment bank so much as a cult that does investment banking. I’ve found that you can usually tell within five minutes whether the person you are talking to works for GS or has worked for GS in the past.

  • Posted by black swan

    Twofish, I believe that if the Federal Government was insuring muni bonds instead of senior notes, there would be no shortage of bond underwriters. This is not about a cash problem, it is about a trust problem. Government indemnification would take care of the trust problem. The cash would come from investors, like me, who are stuck in short-term, low interest Treasuries.

    I totally disagree with your three year window of success for Goldman Sachs. Everything these guys do is for short term gain. Without Government bailouts, these IBs are toast. I’m guessing that fixers like Blankfein and Cohn know this and are looking for one more $70 million dollar payday, before the doors are shut. I’m only sorry they are not prison doors.

  • Posted by Twofish

    k: And if you read the bios of executive committee of these grand institutions, they’re 95% white male, of which half are Europeans and the rest are Americans. You can throw in some occasional Indians. No Chinese, Russian, Japanese or Korean.

    Looking at senior management is like looking at a distant galaxy. You are looking back in time at what entry level hiring practices were in the early 1970′s, whereas the influx of Chinese and Russians didn’t happen in the 1990′s. What you need to look is how things change over time, and Chinese, Russians and Indians that I’ve seen have positions that are at their level of seniority.

    Finance is a good place for advancement since the powers that be don’t care what your skin color, religion, or sexual orientation is, as long as you can make money for them. They’d much rather have you in the power structure working for them than outside working against them. The major investment banks in the US after all were started by German Jews.

    This is one reason that Wall Street tends be uncomfortable with the Republican social agenda since investment banks tend to be extremely gay-friendly places.

    However, this does get at one of the other agenda items on the Chinese governments, to do list. China wants global corporations. China is not going to get these global corporations by taking over Citigroup. However, given about twenty or thirty years, China could get lots of power by turning CCB, ICBC, and BOC into global financial institutions that can compete with Citigroup, Bank of America, and JP Morgan Chase.

    One thing that is interesting here is how recent events have greatly tightened the linkages between the banks and national governments.

    k: And last time check, all power rests with executive committee. No?

    No. Finance is much too complex and ever changing to have a centralized power structure. You have to push decision making down to very low levels because otherwise decisions don’t get made. The management committee is in charge of strategic direction, but they means that 1) they need people at other levels to handle tactical decision making and 2) they need good information from the lower levels to be able to make strategic decisions.

  • Posted by Twofish

    black swan: Twofish, I believe that if the Federal Government was insuring muni bonds instead of senior notes, there would be no shortage of bond underwriters.

    Just to clarify, bond underwriter is a specific job. Someone who underwrites a bond is acting as a wholesaler.

    In order to underwrite a bond issue, you need billions of dollars in cash, and also people that will return your phone calls when you try to sell them the latest bond issue. If I called up a pension fund out of the blue and asked them to give me $100 million to buy this new bond offering, they’d hang up on me.

    black swan: The cash would come from investors, like me, who are stuck in short-term, low interest Treasuries.

    You have a chicken and egg problem. You can’t give the cash until there is a bond issue, but the bond can’t be issued until there is cash. So you need someone with lots and lots of cash to break the chicken and egg problem. Enter the investment bank.

    The problem with the financial system is that lots of stuff seems to happen by magic which means that people lose track of the details. You call up your broker and buy a bond. Magic. Who does your broker call?

    black swan: I totally disagree with your three year window of success for Goldman Sachs. Everything these guys do is for short term gain.

    *Nothing* Goldman-Sachs does is for short term gain. If you are in a competing investment bank, you find yourself constantly fighting with Goldman-Sachs and you do not want to underestimate them. Right now, the fear by competing IB’s is that Goldman-Sachs will dominate Treasury and the Fed and that they will get squeezed out, which is the only reason you are hearing about this.

    black swan: I’m guessing that fixers like Blankfein and Cohn know this and are looking for one more $70 million dollar payday, before the doors are shut. I’m only sorry they are not prison doors.

    Seventy million dollars is *NOTHING* to these people. If Blankefein or Cohn wanted $70 million dollars then they could get it within 15 minutes by making a phone call. They aren’t playing at that level. They think in terms of billions or trillions. Their goal is not to shut the doors, but keep the doors open, and get at some of the tens of trillions that are available there.

    Once you reach a certain level, money becomes unimportant. What motivates people at that level is not money. It’s power and glory.

  • Posted by JKH

    Moldbug,

    You make an important point about relative intensities of maturity transformation risk across different modes of banking. Banks in general tend to have internal policies that mitigate “maturity transformation” risk. Such policies include minimum limits on liquid asset levels, maximum limits on maturity mismatches by sub-period projection, and maximum limits on deposit counterparty risk. Each of these mitigates maturity transformation exposures otherwise left unchecked.

    Banks and their exposures can be categorized according to the risk that is naturally present in their business models as well as the effectiveness with which they manage the risk. The typical commercial bank has a domestic retail deposit base. This is the least risky source of funding from a qualitative point of view in the sense of maturity transformation exposure. This retail funding base is typically supplemented with domestic wholesale funding in order to fill in remaining required funding for the full asset base. Wholesale funding is considered to be more at risk than retail funding in the sense of maturity transformation. Wholesale funding risk is further accentuated for commercial banks that own investment banks (universal banks). Finally, commercial or universal banks that operate in foreign currencies tend to require wholesale funding in order to do so. As you point out in the European case, this type of maturity transformation adds yet another level of MT risk.

    But the riskiest maturity transformers have been stand-alone (no more) investment banks. And it is no coincidence that these institutions with the riskiest liquidity profiles had the least effective risk management infrastructure to deal with it. They thought themselves too immune to fail. Bear Stearns went down because of this. And Merrill was driven into the arms of Bank of America due to the cushioning effect of BoA’s retail deposit base (cum CDIC insurance) on the maturity transformation risk profile of Merrill as a stand-alone investment bank.

  • Posted by LB

    this is a fascinating discussion…thank you to all the contributors so far.

    just read this yesterday from Jean Baudrillard in his book Impossible Exchange.

    thought it might have some relevance across the many various tangents that have grown from this topic (and the topics from which this topic is a tangent):

    “The illusion of the economic sphere lies in its having aspired to ground a principle of reality and rationality on the forgetting of this ultimate reality of impossible exchange (that it ultimately cannot be exchanged for itself). Now, that principle is valid only within an artificially bounded sphere. Outside that sphere lies radical uncertainty. And it is this exiled, foreclosed uncertainty which haunts systems and generates the economic illusion. It is this failure to understand this which leads systems into incoherence, hypertrophy and, in some sense, leads them to destroy themselves. For it is from the inside, by overreaching themselves, that systems make bonfires of their own postulates, and fall into ruins.

    To put it another way: has there ever been any ‘economy’, in the sense of an organization of value that is stably coherent and has a universal purpose and meaning?”

    J.B. goes on to answer this question is in his distinct ideosyncratic way, but i have chosen to keep it open-ended for each of us to ponder in our own.

    cheers

  • Posted by Cedric Regula

    Twofish:”Once you reach a certain level, money becomes unimportant. What motivates people at that level is not money. It’s power and glory.”

    I certainly learned back in the late ’80s that we shouldn’t be in awe of all investment bankers. The company I worked for was taken over by a group that eventually became a division of Lehman.

    They took us over by doing an LBO, financed with 16% junk bonds, which shows just how important it is for them to facilitate these transactions with all the money they have.

    However, this group seemed to be be lacking in the superhuman IQs we come come to know and respect from investment bankers like GS(Ref:Cramer). We were a very profitable company, but were taken over because we happened to be in an out of favor industry, and our stock price only commanded a PE of 8.
    That’s what happens when you are a smaller manufacturer of defense components and the Cold War ends.

    We would have still been ok, but the rocket scientists that bought us ran the company into the ground. They needed to consolidate and sell off facilities to make their biz plan work(the one they put together before buying us and attempting to learn a little about the biz) and needed to find cash in our real estate holdings, bonuses, and salaries. So eventually everyone that mattered found another job, and the company sort of disappeared.

    But I’m sure the superhumans at GS wouldn’t make the same mistake with America, once we turn it over to them.

    But here’s an interesting article to read where an anonymous investment banker is interviewed and demonstrates the mental workings of the uber class.

    PS. I’ve been looking around for nude posters of investment bankers, to complement my Greenspan collection. Are they selling these yet?

  • Posted by LB

    cedric: “and needed to find cash in our real estate holdings, bonuses, and salaries.”

    this reminds me of our conversation a couple weeks back about the ultimate collateral of the MBS’s: the real estate value of ‘America the Beautiful’.

    (in addition to the cash provided by the taxpayer)

    of course, there is also the most intangible of intangible assets: goodwill. beyond even the full faith and credit of the USGov lies something even more intangible on the USA’s books.

    what is the value of the American Dream?
    is it enough to cover the debt incurred?

    p.s.
    here’s one to add to your collection (and it’s free as long as you have a printer).

    http://tinyurl.com/55cnsc

  • Posted by bsetser

    JKH — It is interesting that both the US i-banks and the european commercial banks got into serious trouble with the “maturity transformation” business — presumably for similar reasons: both needed wholesale or market financing. I suspect both are now heavily reliant on the Fed for financing — with the european banks drawing on the fed via the swap lines through their “home” central bank.

    i suspect those EM banking systems that were big borrowers in dollars from the rest of the world are next in line — i.e. Korea, Kazakhstan, Russia and Dubai (and maybe others). In most cases, the government will use its is reserves/ foreign assets to make up for a lack of external financing.

    one request: rather than turning this into a discussion of Goldman (or government, per the NYT today) Sachs, could the discussion be focused on the global architecture for crisis response/ the G-7 (or G–10) v the rest divide when it comes to access to dollar swaps and what it means. thanks!

  • Posted by LB

    brad: “In most cases, the government will use its is reserves/ foreign assets to make up for a lack of external financing.”

    you mean the USGov yes? if so, it seems that that would be the logical next step in its quest to quash uncertainty, both economic & geopolitical, given that Paulson’s attempt to draw a line in the sand with Lehman was what was opened Pandora’s box in the first place.

    perhaps, this is implicitly the only solution available to the US at this point? for it may have already gone beyond the point of no return and the only way is go further into the fiat abyss.

    The US will become not only the ‘global policeman’ but also the ‘global investment bank’.

    of course, the implicit exchange in this bargain is that if and when the USGov ever defaults, then the USGov can cash in this ‘goodwill’ and ask (on bended knee) for a global forgiveness of US debt.

    p.s.
    you might want to consider adding Pakistan to your list, especially if the election tips to Obama/Biden.

  • Posted by bsetser

    I was actually thinking about the Russian government, the korean government and the emirati government (really abu dhabi) not the USG. the USG is financing its intervention by borrowing in $, not by using its existing assets. all three governments have large accumulated stocks of reserves/ foreign assets that could offset an external deleveraging by their private sectors.

    you are right that Pakistan is at huge risk, as it lacks any stock of fx reserves. it will have to rely on borrowing from other other governments/ the IMF. I need to look at the basic BoP data for pakistan tho to understand better the sources of the pressure on its reserves/ the ruppee. I wasn’t aware that it had been a big borrower from int. banks but i haven’t been paying close attention either.

    Ukraine also has large external debts in its banking sector/ limited reserves and is turning to the imf.

    in effect, those countries that cannot draw on the fed for $ via the swaps either have to go to the IMF or use their own resources (reserves) — unless there is evidence that those EMs with spare reserves are willing to lend to other EMs that are short of reserves outside of the context of an IMF program.

  • Posted by MMcC

    bsetser: “could the discussion be focused on the global architecture for crisis response/ the G-7 (or G–10) v the rest divide when it comes to access to dollar swaps and what it means. thanks!”

    Locally, the betting (albeit with not much conviction – there’s at least some chance China will try to sit the problem out entirely) is that China will explore dollar assistance to local trouble spots bilaterally, and that the upcoming ASEAN+ meeting will be more window dressing (and opportunities for backroom deals) than creating or organizing a concerted response. It’s not clear to me (and it appears not be clear to anyone else talking about this in China) what China stands to gain from backing a multilateral local approach than it does from making the same deals bilaterally. That said, a lot of the skepticism about multilateralist approaches in ASEAN (or ASEAN+) stems from skepticism about ASEAN itself, which colours most people’s predictions (mine included, I have to admit.)

  • Posted by gordon

    “Well, this letter gives M. le Comte de Monte Cristo unlimited credit on our house.”

    “And what is there that requires explaining in that simple fact, may I ask, M. le Baron?”

    “Merely the term unlimited…”

  • Posted by moldbug

    JKH,

    You make an important point about relative intensities of maturity transformation risk across different modes of banking. Banks in general tend to have internal policies that mitigate “maturity transformation” risk. Such policies include minimum limits on liquid asset levels, maximum limits on maturity mismatches by sub-period projection, and maximum limits on deposit counterparty risk. Each of these mitigates maturity transformation exposures otherwise left unchecked.

    Obviously, your understanding of risk-modeling procedures in modern financial institutions is to mine as an elephant is to a flea.

    However, at the forest level, one thing is obvious about these models: they were based on Gaussian distributions of historical rollover probability. They were not based on the game theory of a bank run, or as I would say a maturity crisis.

    Taleb in his latest book goes on and on and on on the danger of assuming Gaussian distributions. The point is accurate, of course. And in this case it is especially egregious, because Taleb’s argument is just that until you discover Australia, you can’t really know that there are no black swans in the world.

    In the case of bank runs, maturity crises, liquidity crunches, or whatever you want to call them, Australia has been mapped up and down. The black swans are banded and have research identifiers. The Diamond-Dybvig model is not an obscure Austrian invention – it is a well-known part of the mainstream econ literature.

    Here is an example of the fallacy:

    The typical commercial bank has a domestic retail deposit base. This is the least risky source of funding from a qualitative point of view in the sense of maturity transformation exposure.

    And why is it the least risky source of MT funding? Because the rollover propensities of retail depositors are historically well-known, and the Central Limit Theorem applies to a T. If you simply model transaction history, the probability of all the bank’s customers showing up on the same day to empty their accounts is roughly the probability of Mars crashing into Jupiter.

    Except, as we do know, bank runs happen. Moreover, if banks were not FDIC insured, they would happen instantly. MZM = (10 * M0) cannot be explained in any other way.

    So the deposit base is un-risky, but in a different way: it has excellent, if informal (I refer to FDIC’s protection from Fed/Treasury, not banks’ protection from FDIC) protection. FDIC insured deposits are un-risky for the same reason that Treasuries are un-risky. The liability is bundled with an informal CDS from Fed.

    But I assume (please correct me if I’m wrong) that the MT risk models are coded to think of a deposit base as safe because of retail withdrawal history, not because of informal credit-default swaps issued by the political sector. As we’ve seen, the result is right, but the reasoning is completely wrong.

    This illustrates something of the smoke-and-mirrors quality of modern risk modeling, whose primary customer is not – as one might expect – the shareholder concerned with the safety of his capital, or the lender with the risk of his loan, but the regulator who will bail out those and only those who played the game by the book.

    At least in theory. Said theory strikes me as in need of updating.

  • Posted by moldbug

    bsetser,

    What’s especially interesting is the developing line between countries that can afford to bail out their own banks, and countries that can’t. In other words: which countries, when this all plays out, will have retained their financial sovereignty? Barring spectacular, Hjalmar-Schacht-like tricks, clearly not Iceland.

    Some calculations on this sensitive subject might be rather interesting…

  • Posted by Twofish

    One curious part is how things are moving past pure financial considerations into foreign policy ones. In deciding whether or not Pakistan gets aid or not, the non-financial considerations are likely to be far, far more important than the financial ones. The consequences of a banking crisis in Pakistan are quite scary. Also, I suspect that if Korea were near a default, that pretty quick either China or the United States would hand it a life preserver. Brazil on the other hand….

    The other fault line is what countries have banks with massive dollar liabilities and which one’s don’t. Chinese bank liabilities are mostly in RMB, and Japanese bank liabilities are mostly in Yen. I’m curious what Russian liabilities are in. Rubles or dollars. One consequence of this is that if you have banks that have liabilities denominated in local currencies, then if there is a run to the dollar then this stabilizes things if you have large dollar foreign exchange reserves.

    Personally, I think it’s a good thing to have multiple interests and multiple sources of funding. If you channel all crisis funding through the IMF, then that becomes a single point of failure and whatever economic philosophy the IMF staff have because the only way to run an economy. If you have multiple sources of funding then there and backup mechanisms.

    bsetser: On another level, a higher level of cooperation is possible among countries with broadly similar political systems than among more diverse group of countries with different political and economic systems.

    I don’t think that this is really the case. Also one thing that gets forgotten is that the various countries involved have very different economic systems. The economic systems of the United States, Britain, France, Japan, and Germany are *very* different from each other. The fact that people spend their thing trying to figure out how to make the systems interoperate and that it’s in no ones political interest to scream about the differences, means that most people aren’t that aware of how different the economic systems are.

    Also, I do think that this episode may mark the end of US efforts to impose democratic systems on Saudi Arabia, Russia, and China. I do suspect that we are moving to a situation in which the Russia, Chinese and Saudi governments are considered governments with objectionable policies (sort of the way that Europeans view the death penalty in the United States) rather than an ideological adversary that must be changed at all costs.

  • Posted by Twofish

    Also, I’ve heard whispers that Dubai was in trouble and got bailed out by the Saudis. One possible consequence of this episode is that the world might end up divided along “civilizational lines.” In which the Saudis become the lender of last resort for the Islamic world, China and Japan are the lenders of last resort for East Asia, and the United States is the lender of last resort for Atlantic states.

  • Posted by black swan

    “What’s especially interesting is the developing line between countries that can afford to bail out their own banks, and countries that can’t. In other words: which countries, when this all plays out, will have retained their financial sovereignty? Barring spectacular, Hjalmar-Schacht-like tricks, clearly not Iceland.”

    Surpise, surprise, Brad. It appears the S.Korea has the abililty to bail itself out,

    http://www.cnbc.com/id/27274488

    where Switzerland’s ability to do the same is suspect. Is Switzerland, with its banks that are purported to hold a third of the world’s private wealth deposits, on its way to becoming another Iceland? It appears that the Swiss have lost control of their short term interest rates, or why the emergency euro swap action?

    http://www.guardian.co.uk/business/feedarticle/7876896

  • Posted by JKH

    Moldbug,

    My knowledge of the subject is slightly dated, but with some traction from a practitioner perspective. I’d agree with virtually everything you’ve stated. Some additional comments:

    I haven’t read Black Swan but am roughly familiar with the idea. My suspicion is that after nearly 20 years of attacking the problem with Gaussian distributions, those risk managers who are still standing will now proceed to repeat the error by attempting the same objective with finely tuned fat tailed distribution modelling, probably with the same outcome.

    My experience is that intelligent bank CEOs exist. They asked questions about Black Swan events before Taleb ever thought of the idea. Taleb’s thinking is in large part a violent reaction to an excess of precision quantification in risk management.

    I’m not sure that Gaussian modelling ever made much of an inroad into the maturity transformation problem per se. Most of it was applied at least initially to investment bank “market risks” rather than commercial bank liquidity risk. The MT risk mitigation techniques I referred to were quite frankly more back of the envelope in coming up with “the number” for risk limits. This may have been due to the natural priority and diversion of quantitative precision to investment banking markets, but it also resulted from the relative amorphous nature of the liquidity hedging problem. And it may have taken into account the futility of modelling things so precisely while in search of probabilities with orders of magnitude similar to that of the Mars/Jupiter collision problem. This was implicit acknowledgement of a black swan problem.

    I assume black swans can’t be perfectly hedged. If so, then one deals with them by attempting first to conceive of them, and then to respond with risk mitigation, selecting from feasible alternative strategies. Taken to the limit, the only way to hedge the black swan is to hedge all risk by taking no risk, withdrawing from banking entirely. The Diamond-Dybvig model seems to describe the logical reality, but I doubt that it prescribes “the number” in the sense of liquidity risk limits of the type I referred to, in the context of a competitive maturity transformation environment. So I think the intelligent CEO was thinking realistically about the optimal imperfect hedge for the liquidity black swan, given the constraints of a non-fetal mission statement within a competitive environment that was structurally skewed to MT risk.

    I also think the intelligent CEO was quite aware of the importance of FDIC type insurance, particularly in relation to a stable retail deposit base. Remember that such insurance had a capped and domestic exposure limit in normal times. This has much to do with the ranking of suggested MT risk modes. Importantly, large wholesale amounts and foreign currency amounts were not insured. Also, the ranking of foreign currency as the highest commercial bank MT risk reflects the reasonable expectation that foreign currency depositors may be less familiar with a domestic institution, and that LLR backstop financing does not apply in normal times to foreign currency financing. This latter point reinforces why the Fed’s aggressive currency swap arrangement with European central banks is so stunning.

  • Posted by a

    Twofish – your admiration of GS knows no bounds and is nauseating. Three times in the last 15 years GS has gone to the wall and had to be rescued, the first time by the Japanese, the last two times by the U.S. government. Considered as an IB or as a hedge fund, it is atrociously badly run.

    “Seventy million dollars is *NOTHING* to these people. If Blankefein or Cohn wanted $70 million dollars then they could get it within 15 minutes by making a phone call. They aren’t playing at that level. They think in terms of billions or trillions. Their goal is not to shut the doors, but keep the doors open, and get at some of the tens of trillions that are available there.”

    Riiiight. They make think in terms of trillions, but still they need the odd billion here and there to keep in business so they can dream of the trillions.

    The U.S. government has invested 10 billion into GS, at ridiculously bad terms. GS bonus pool for this year is now north of 10 billion. Does that disgust you? Probably not.

  • Posted by Twofish

    a: Considered as an IB or as a hedge fund, it is atrociously badly run.

    Name four that are better.

  • Posted by Twofish

    a: Twofish – your admiration of GS knows no bounds and is nauseating.

    It’s part of the love-hate relationship most of Wall Street has with them.

    It’s because I’ve seen knife fights with GS, and they end up winning. Maybe they don’t deserve to win. Maybe they bend, break, change the rules. Maybe they don’t fight fair. Whatever. The point is that they end up winning, and you don’t want to underestimate them. If you want to fight GS and win, you have to start by respecting them even if you hate them and think that they are evil bastards that deserve to get their teeth kicked in, because if you don’t respect and at some level admire them, you will lose and lose badly.

  • Posted by Steve Waldman

    Brad ‘n JKH — It’s taken a while, but I think you have me convinced. Fundamentally, a loan can’t be an outflow, because a claim of ownership remains with the lender. Neither a loan from SNB to the Fed, nor from the Fed to SNP is a flow, so the combination cannot be a flow. Absent valuation changes (including defaults), NIIP can only be moved by an exchange of current goods for financial claims or by outright transfers. Any zero NPV financial transaction is just a claim-for-claim swap. (In the very stylized way I’m now thinking about things, even interest payments only matter due to “valuation changes”, as fair loans would yield for the borrower a tradable return that exactly offsets the interest — failure to invest the loan proceeds well in FX yielding projects would represent a kind of investment loss, a valuation change.)

    In the end, any NIIP effect would be second-order, if for example CBs purchased dollar assets from banks, which then invested in dollar assets that might perform well or poorly. The swaps might lead to portfolio shifts that alter effect of future valuation changes, but a fair, hedged financial transaction can’t direcly lead to NIIP changes.

    (I don’t think the swaps can be entirely hedged though. Changes in FX values and prevailing interest rates would lead to mark-to-market gains or losses, as entering into an offsetting swap on the original terms would no longer be a zero NPV affair. So the swaps might be NIIP neutral directionally, but increase future NIIP volatility, a very little bit.)

    Anyway, sorry for being a bit slow and muddled in thinking this out.

  • Posted by LB

    sorry brad, should have confirmed your comment before going off on a wild & crazy tangent.

    nonetheless, perhaps the Pandora’s box analogy still is valid.

    2fish makes a very astute statement that “things are moving past pure financial considerations into foreign policy ones”.

    how does one model risk in such an environment?

    “but the regulator who will bail out those and only those who played the game by the book.” (moldbug)

    and perhaps in consultation with their counterparts in the state department when dealing with foreign banking institutions.

    maybe this is why ms. rice attended the G7 meeting? if so, then the ‘book’ has just gotten to be the size of ‘war & peace’.

    i realize that this is an economics blog, however what is becoming more apparent by the day is that economics and geopolitics are fusing themselves at the hip (not that they weren’t before, but now the crisis has forced them to drop their pants so there is no more illusion).

    this is a critical point to consider when attempt to understand the new global architecture, methinks.

    p.s. looks like china beat the US to the punch in helping pakistan –

    http://tinyurl.com/5lcf8o

    p.p.s. another wacky thought, but with an approx. $80B surplus, would it be that surprising to see iraq get into the friendly lender fray if the crisis deepens in the Middle East, either on its own accord or as a US proxy?

    btw, the iraqi stock market rose over 40% last month and is up 25% for the year (hat tip NY Post). and guess what, the iraqi central bank is charging 16% for loans.

    moldbug, wonder if they’re practicing misean-style MT?

  • Posted by Cedric Regula

    Twofish:”It’s because I’ve seen knife fights with GS, and they end up winning. Maybe they don’t deserve to win. Maybe they bend, break, change the rules. Maybe they don’t fight fair. Whatever. The point is that they end up winning, and you don’t want to underestimate them. If you want to fight GS and win, you have to start by respecting them even if you hate them and think that they are evil bastards that deserve to get their teeth kicked in, because if you don’t respect and at some level admire them, you will lose and lose badly.”

    Quite a hilarious view of the world.

    I can’t help having this vision of low six figure income administrators at the Pentagon, CIA, FBI and NSA finally figuring out that this will all cost them budget money, loss of power, and handicap their ability to meet their public charters of national defense, intellegence, security and law enforcement.

    Not a popular crowd to cheer for nowadays either, but I think they will find a way to make the Jets and Sharks buy their own silverware and put a very small ring fence around the knifefight.

    And there are rumblings worldwide that foreign powers are not really interested in participating in investment banking drama, and I do believe there are more than 9 people in the world that are knowledgeable enough about the problem to regulate it from an international body that may be more buffered from political corruption.

    But in the meantime here’s a little PR piece indicating that $70B of the $700B bailout may already be slated for banking bonuses this year.

    http://www.guardian.co.uk/business/2008/oct/17/executivesalaries-banking

  • Posted by LB

    p.s. moldbug, i was playing loose with the term ‘regulator’ in the post above, using it to mean the Treasury Dept. as a whole to illustrate the shotgun marriage between Treasury & State, though i should have said intl. banking institutions (incl. JPM, Citi, et al) instead of foreign.

    steve: “So the swaps might be NIIP neutral directionally, but increase future NIIP volatility, a very little bit.”

    i was thinking that before as well steve. a very little bit assumes that both currencies remain relatively stable, yes? perhaps this is partly why the s.koreans have yet to receive any swap assistance (the won is too volatile)?

  • Posted by a

    Twofish – Surely you realize that part of the GS operation manual is to have its former employees, now working in the Federal government, to give it any advantage possible. It is systematic, and it is looting. So I don’t find your view of GS (which seems to deny the looting) very coherent.

  • Posted by JKH

    Steve/Brad/LB,

    “So the swaps might be NIIP neutral directionally, but increase future NIIP volatility, a very little bit.”

    This is true, probably.

    During the life of the swap, mark to market volatility would register directly as NIIP changes, provided that the relevant risk component (s) are captured as mark to market accounting in NIIP accounting. Not all market risk is marked to market in NIIP accounting. Some is marked; some remains at book. For example, Brad is the expert on this in the more significant and important areas of bonds and equities.

    More substantively, and regardless of the accounting treatment in NIIP or elsewhere, the cumulative effect of mark to market volatility on such a currency swap will be zero by the time the swap matures. Market value converges to book value at that point.

    NIIP is therefore cumulatively unchanged by the time the maturity or rollover date is reached.

    At that point, the historic volatilities observed are only an exercise in speculation on the opportunity cost of the original choice of market timing.

  • Posted by a

    Twofish : “Name four that are better.”

    Almost any hedge fund that’s still standing. In fifteen years GS almost went backrupt 3 times. Any hedge fund with that record would be bust now.

  • Posted by Pallj

    In the six years since the privatization of the main Icelandic banks, cheap credit is what allowed them to “blossom” and cheap credit also turned out to be their downfall.

    While they were state owned they were strictly regulated by the central bank. But since then their growth was exponential and no lender of last resort anywhere in sight. The central bank along with the rest of Iceland’s real economy are totally mismatched to their big behinds that urgently needed a chair for parking purposes, because the music had stopped. You can say this was simply bound to happen, because all good things come to an end at some point.
    There is no mystery to it. Big banks cannot be propped up by small economies.

    I am more confused about the American rescue packet, which in theory rescues the big European players as well. Intuitively I can’t figure out where the 700 billion actually come from? Under which mattress were they hidden? How come they hadn’t been spent on Iraq or something?

    I’m also confused about how the banks are going to start lending each other again. Supposing the 700b goes some way towards helping banks avoid defaulting en masse on their cheap credit loans, but is that enough to start the music playing again? Will these banks automatically start lending other banks money again, just because they have narrowly escaped ruin?

    It just seems like this crisis is not simply a crisis of confidence, but also a collapse of the illusion that there was tons of money in the system, when there wasn’t.

    Won’t it be inevitable that the big SWFs will have to become very involved in fueling the big engine. I just don’t see how the US can finance a full tank of gas without using the Xerox machine…

  • Posted by gillies

    “It just seems like this crisis is not simply a crisis of confidence, but also a collapse of the illusion that there was tons of money in the system, when there wasn’t.”

    yes, a collapse of the illusion that exponentially growing debt could be repackaged and classified as securities.

  • Posted by gillies

    fractional reserve debunking.

  • Posted by Twofish

    Cedric: I can’t help having this vision of low six figure income administrators at the Pentagon, CIA, FBI and NSA finally figuring out that this will all cost them budget money, loss of power, and handicap their ability to meet their public charters of national defense, intelligence, security and law enforcement.

    The nice thing about being in business and finance is that you can figure out ways of paying off the people that need to be paid off and taking a cut for yourself. You can do this if you generate wealth.

    There are three sources of power. Ideas, money, and guns. Ideas beat money. Money beats guns. The money lenders and businessman have often (and sometimes with good reason) been hated and resented, and there is this common fantasy if the utopia that would result if we just shoot the bankers. Sometimes, it has happened, but the results have never been utopian.

    Cedric: And there are rumblings worldwide that foreign powers are not really interested in participating in investment banking drama.

    No. Everyone is interesting in participated in the investment banking drama, they just want it on terms that they control. It’s pretty impossible to call yourself a world power without your own set of banks. Part of the military-economic complex.

    Cedric: I do believe there are more than 9 people in the world that are knowledgeable enough about the problem to regulate it from an international body that may be more buffered from political corruption.

    Anything that buffers an organization from political corruption also buffers it from political accountability. Some of the worst economic abuses in the recent times have been done by supposedly apolitical organizations like the IMF and the World Bank. The IMF and World Bank have traditionally leaned far, far too heavily toward international banks and far, far too heavily against third world farmers. It’s because there are too many bankers at IMF board meetings and not enough third world farmers.

    It’s not that bankers are evil, but if that power corrupts, and if you have a small inbred group of people in charge of something whether they are bankers, peasants, politicians, lamas, priests or taxicab drivers, you are going to have a mess because power corrupts everyone.

    Cedric: But in the meantime here’s a little PR piece indicating that $70B of the $700B bailout may already be slated for banking bonuses this year.

    A typical investment bank has about 10,000 to 20,000 employees, and the pay pattern is to have most of the pay in bonus, and they are going to be very lean this year.

  • Posted by Twofish

    Pallj: I am more confused about the American rescue packet, which in theory rescues the big European players as well. Intuitively I can’t figure out where the 700 billion actually come from?

    That depends on who gets elected.

    If Obama gets elected, then most of the bailout will be paid for by an increase in taxes on people making over $250,000/year, with stimulus packages given to people making less. Personally I think its a great idea since the rich have benefited disproportionately from the past few years of under-regulation, and so they should pay for it.

    If McCain gets elected, then he plans a tax cut and so obviously this bailout will be paid by the magic and wishful thinking money fairy that Republican presidents since Reagan have been invoking.

  • Posted by Scott

    It seems that it might be in the US’s interest not to support domestic dollar lending in the emerging markets, as the “breakneck” growth was driven by exports to the US and is not sustainable.

  • Posted by Pallj

    OK, so Obama suggests future taxes should do the trick, while McCain doesn’t think that sounds too good. But in the meantime it’s the tooth fairy that Obama wants to borrow the money from, and McCain wants to take it of, right?

  • Posted by Judy Yeo

    The situation has kinda calmed down after the Koreans rebooted their system over the weekend, the main issue with the tone fo your piece seems to be that alck of an overarching central “superman fgiure” means that all is close to descending into some form of anarchy? Is that only from the viewpoint of someone who has , for the longest time last century, been superman or the viewpoint of someone who’s in the “rest of the world” category that has been viewed as needing instruction, guidance and rescuing? Apologies if that was too sarky but sometimes the neo-imperialist tone is too much of a bait.

  • Posted by LB

    judy,
    thanks for the douse of cold water at the end of the current proceedings.
    i personally found it quite refreshing.

  • Posted by moldbug

    JKH,

    In a nutshell, yes – MT risk is not amenable to modeling. You either do MT or you don’t. The goal of risk mitigation is to prevent an accident in which your bank alone blows up, not to guard against a systemic crisis requiring an LLR.

    “Giving up on banking” is a bit of an overstatement, perhaps. It is certainly possible to imagine banking in a zero-MT environment – structuring maturity-balanced assets and liabilitie. But, in a market which contains an LLR, zero-MT banking is not economically competitive. This is the usual vicious cycle of moral hazard. Moreover, the maturity mismatches on the collective balance sheet of the Western financial system are so gigantic that restructuring them as maturity-matched positions would demand an intervention of Napoleonic proportions.

    Keynes may have said it best with his “sound banker” quote. “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he’s ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him.” “No one,” in this case, meaning the government. Moral hazard is endemic to the very nature of the Anglo-American banking system. It’s no surprise that the business cycle – a better name might be “banking cycle” – characteristic of this system has continued even into the 21st century.

  • Posted by a

    Cedric: But in the meantime here’s a little PR piece indicating that $70B of the $700B bailout may already be slated for banking bonuses this year.

    Twofish: A typical investment bank has about 10,000 to 20,000 employees, and the pay pattern is to have most of the pay in bonus, and they are going to be very lean this year.

    Salaries in banking are already high. “Very lean” is, I guess, a reflection of someone who works on Wall Street, who thinks getting 50% of last year’s record bonuses is equivalent to – like – poverty.

  • Posted by a

    I stand corrected. Bloomberg has an article out this morning that says that GS is planning to pay out *two thirds* of last year’s record bonuses. A lean year indeed.

  • Posted by JKH

    Moldbug,

    The “giving up on banking” notion related to the necessity of withdrawing from all risk taking (not just MT risk) in order to hedge black swan risk. I realize from your posts and comments that a zero-MT environment is quite conceivable, at least in theory, while still permitting other risk taking.

    The Keynes quote is excellent, as is normal with Keynes, although Chuck Prince continued to dance and didn’t exactly escape blame for being conventionally reckless.

    The other Keynes quote that captures perfectly the pandemic risk management disease goes something like:

    “Better to be approximately right than precisely wrong.”

  • Posted by Twofish

    GS is paying 2/3′s of last years bonuses. Lehman Europe is paying zero of last years bonuses.

    a: Salaries in banking are already high. “Very lean” is, I guess, a reflection of someone who works on Wall Street, who thinks getting 50% of last year’s record bonuses is equivalent to – like – poverty.

    Last year was not a record year. 2005/2006 were record years. Most people in a investment bank don’t make enough money to be affected by Obama’s tax increases. It’s not poverty, but the reality of the situation is that most people in an IB aren’t making the type of money that “Joe the Plumber” supposedly makes (but doesn’t). The salaries in an investment bank are *extremely* skewed, with a few people making huge amounts of money, and most people making not huge money, which is one reason that you have more sympathy for social redistributionist policies among people in Wall Street than you otherwise would expect.

    Investment bankers aren’t going to be facing poverty, but some of the people who depend on the 48% marginal tax rates that you see in New York City are going to get hit. For people working in IB’s, 48% of the bonus goes to public schools, parks, public transit, free clinics, social workers etc. etc. etc. so the people who do deal with poverty in NYC are quite worried since their funding is about to disappear. You go back to the 1970′s and look at the pictures of drug-infested, crime-infested, graffiti-filled slums. They don’t exist anymore. In NYC, trickle done does work because of the high tax rates.

    The real frightening thing is for someone with a physics or engineering Ph.D., banking the *ONLY* industry in the United States that can give you *ANY* hope of getting into the upper class. If you work in another other industry, you end up hitting the glass ceiling and you end up working for MBA’s and finance people that are generally clueless. You can start your own startup company in Silicon Valley, but most CEO’s in Silicon Valley end up working for the VC’s and bankers that run the company, who are sometimes clueless.

    That stinks, but that’s the way that it is. If you hate the system and it disgusts you, that’s great. I’m trying to give you the information you need to change it. Poverty doesn’t really bother me that much. I wouldn’t mind teaching community college for one fourth the salary that I’m making. However, what does make me angry is the lack of power. If you don’t have money, you don’t have power, and if you don’t have power, then other people are going to be making decisions about your life, and that is unacceptable to me.

    I’m not defending the system, I’m just describing it. However for a lot of scientists and engineers, Wall Street has given career options and opportunities that don’t exist anywhere else in the United States.

  • Posted by Twofish

    JKH: I realize from your posts and comments that a zero-MT environment is quite conceivable, at least in theory, while still permitting other risk taking.

    I don’t think that it is really. There are so many ways of doing maturity transformation that if banks don’t do it, someone else will.

  • Posted by RebelEconomist

    Moldbug,

    If MT is such a problem, then why don’t banks simply pass on the problem to their customers by saying to each “the bank reserves the right to limit withdrawals to x per day during times of excessive demand”? Assuming that MT has some efficiency advantages, it seems a shame to throw the whole thing out because of a risk that materialises once every few decades.

  • Posted by JKH

    Twofish,

    I take your point. I suspect that in order for a zero-MT environment to be conceivable in theory, it would have to be prohibited by government in the defined local environment (e.g. all private financial institutions). Otherwise, MT is too natural a banking risk to be relinquished voluntarily by any normally dancing CEO.

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