Wednesday, 7 May 2014

The Impact of Flight to Quality on Bank Lending

John Cochrane's paper on run-free banking, which I mentioned in my last post, includes a section discussing why financial crises have real effects.  It's an important question.  Understanding why a fall in the value of securities or a bank run might lead to a reduction in output should shape how we think about financial regulation.[1]

One of the main features of the recent crisis was the flight to quality, in which investors sought to sell privately issued asset-backed securities in favour of government paper.  The simple story here then might be that the fall in demand for private paper reduces the price and raised the yield. This raised the cost of borrowing for new borrowers wanting to access this market.  Faced with this higher effective interest rate, private agents looked to defer spending.

It's a reasonable story and no doubt has an element of truth.  However, I think it misses some important features of the way things work in practice.

Much of the flight to quality of the recent crisis involved short-term investors refusing to take private long-term securities as collateral for short term investment.  This had two important implications for banks.  First, banks were effectively underwriting the liquidity of these securities, so that when the collateral based funding dried up, the banks had to take them onto their balance sheet.  Secondly, the problems with financing the securities caused holders to try to offload them leading to big falls in the market value.  Many banks were heavily exposed to this and took significant losses, eating into their capital base.

So banks suffered a fall in capital at the same time as they were being forced to increase their holdings of assets.  Banks were also having to reassign positions from the trading book to the banking book, due to the increasing illiquidity of those positions, putting further pressure on capital.

In the short run, capital represents an important constraint on bank lending.  In theory, it should be just a question of price.  If the bank needs more capital to lend, it simply charges the borrower the amount needed to cover the cost of the additional capital.  In practice, capital is not something that can be turned on like a tap.  Banks normally rely heavily on retained earnings to provide capital growth.  Although they can do equity issues if needed, capital is inherently long term and paying a high long term price may not be appropriate to deal with a shorter term problem.  So one implication to the flight to quality was a big reduction in bank lending capacity.

Another issue is that a willingness to hold loans at a particular price is not indicative of a willingness to advance new loans at that price.  Banks may be prepared to hang on to distressed loans, rather than sell them at the prevailing market price, because they expect the effective return at that price to outweigh realised losses.  This implies that were they to make new loans at a comparable rate, the profit on the good loans would cover the expected level of defaults. 

However, simply because a strategy might appear to be profitable does not mean a bank will want to pursue it.  Banks may be concerned that undertaking what is apparently riskier lending will cause concern with the shareholders, even if such a tactic could be very profitable.  Things like strategy and focus play an important role in shaping behaviour, not just profit maximisation.  Of course, this may leave the market open to new lenders who are prepared to run higher loss levels, but it can take a long time for this to happen.

The point about factors such as these is that the flight to quality is not just about an increase in the rate at which the private sector can borrow.  In fact, for many people, it means that they can no longer borrow at any price.  The fall in lending played an important role in transmitting the effects of the financial crisis to the real economy, but the quantity response needs to be analysed independently of the price response.  

[1] The analysis here is not intended to be the same as Cochrane's, nor to necessarily contradict what he is saying.


  1. I like to think of bank loan quality in the following way:

    Begin with a bank-with-no-money.

    Then government decides to issue a block of green federal reserve notes in exchange for work performed and materials traded.

    This block of notes soon comes to rest in the bank-with-no-money as deposits. (Now the bank DOES have money!).

    This bank can lend these notes to others. The lending of these notes creates additional deposits. With a limit that the bank can not lend more notes than it has, the maximum initial loan the bank can make is a loan of the size of the initial government block of notes. A loan of this size will result in total deposits of two times the original government issue.

    Now we can relate quantity and quality. Assuming that government issued the notes using borrowed money, the QUANTITY of loans has doubled. The QUALITY of loans has divided between government loans and private loans so the AVERAGE QUALITY of loans has declined.

    This process can continue, made easier with multiple banks. Having made the initial doubling of government notes, banks can again double the DEPOSITS by making additional loans. After this second doubling, the QUANTITY of loans is four times the original government issue. The AVERAGE QUALITY of loans has decreased further as the ratio of government to private loans is now 1:3.

    This dilution of AVERAGE QUALITY can continue until it becomes to be perceived as a problem. That can take a long time.

    1. Roger Sparks, what then do you make of historical examples of informal private IOUs being widely used as money? Have you seen JP Koning's post:

      Basically credit money can (and has in the past) come into being without any connection to central bank money.

    2. Roger Sparks, I've been mulling over what you wrote in my head. Do you think that your "average quality" idea is really any more helpful than thinking about it in terms of capital adequacy and liquidity risk?

      I totally agree with you that a monetary system with no risk free assets (eg nothing like treasury bonds or federal reserve notes or bank reserves or gold) would be more awkward but I'm not sure that it doesn't have some historical precedence. I thought that in ancient agricultural communities throughout Europe, tally sticks were used as a monetary system with the final means of settlement being a share of an agricultural harvest. So people traded all sorts of goods and services throughout the year with the unit of exchange not being any sort of central bank money (it was before central banks) or coin but rather being a share of the harvest.

  2. John Hussman has written that in his opinion the free fall stage of worsening financial crisis was stemmed when the regulators stopped basing regulation on mark to market valuations of securities held by financial institutions,
    "Rather, the crisis ended – and in hindsight, ended precisely – on March 16, 2009, when the Financial Accounting Standards Board abandoned mark-to-market rules, in response to Congressional pressure by the House Committee on Financial Services on March 12, 2009. The decision by the FASB gave banks “significant judgment” in the values that they assigned to assets. With that discretion, banks could use cash-flow models (“mark-to-model”) or other methods (“mark-to-unicorn”)."

    Does that fit in with your point that the main problem was that banks were suffering from not having enough capital to satisfy regulators and so were retrenching?

  3. Jeremy Grantham has said that he thinks that problems with the financial sector had much less influence on the 2008 collapse than people make out. His idea is that the real problem was the high commodity prices in 2008 and that is what really caused the problems. The financial sector woes were just a sideshow.

    "the price of oil quadrupled and the price of other commodities, such as metals and food, tripled from 2002-2008. Every time that had happened before, like 1974 and 1979 in the two oil crisis, it was followed by global recession. That alone should have been enough to cause a recession. Add that to the housing bust and you don't need to create any space to explain why we had a recession and a slow recovery. I remain open to persuasion that debt is that big a deal. We have had it foisted upon us that the general idea that finance is so incredibly important that, if a corner bank goes bust, the whole of civilisation grinds to a halt. It's enormously helpful to the banking system to have believed such nonsense, but I think that's what it is."

  4. stone,

    Yes - Hussman's point is in line with what I'm saying. It wasn't quite my point that bank capital was the main issue although I think it was a significant part of the picture. I do think that the key mechanism by which the problems in the financial sector had real effects was through the sharp reduction in credit provison and I also think that this has to be looke at as a quantity response - not just a price response. It is not adequate to say the cost of borrowing went up - in fact, for many potential borrowers, debt became completely unavailable at any price. Bank capital positions had a lot to do with that, but the fact that many investors refused to fund certain ABS - at any price - also had a big impact.

    On Grantham, I would also agree that the rise in commodity prices was one of the key factors that brought about the end of the Great Moderation and led to everything unwinding. But I wouldn't say the financial sector was a sideshow, because what happened there definitely made things a lot worse.

  5. stone,

    You are certainly correct that there have been many non-government methods of payment over the centuries. Some of them have been extensive and enduring but I think only government sponsored methods of payment have endured for longer periods of time.

    Nick was writing about quality of money and quantity. Generally, government money is considered as the most reliable with private money falling behind. The repeated deposit based lending (like I used in the examples) effectively converts government based money into privately sponsored money, while, at the same time, expanding the money supply and presumably the average price of all items. Without further government injections of money, the ratio of government money to private loan based deposits would approach 0:1. At the 0:1 ratio, the money system would effectively have converted back to a private based system.

    Based on my reading of the data, in both the 2001 and 2007-8 recessions, the ratio of government to private based deposits DID approach 0:1. I do not know if that was just a observable fact or a meaningful cause of financial problems. The first event was a recession that was rap;idly overcome.

  6. Great set of posts (this one and the Neo-Fisherites).
    (Declining) financial assets often have a "jump" quality due to: loan covenants, ratings downgrades, the "market for lemons" problem, change in market liquidity, momentum etc. As you noted, "conventional" economic analysis, doesn't really take this into account.