The Platypus blues

I’ve been smitten with the Platypus Blues by Ms Luci Ellis, the erstwhile RBA Head of the Financial Stability Department. Her speech last week has received commentary on MB from H&H and Rumplestatskin but I think it needs some special detailed attention due to the extraordinary opinions expressed and how its left me feeling.

Critiquing Ms Ellis’s speech is certainly an appropriate follow up to my previous post outlining the power of practitioners to understand systems for risk management and gaming as opposed to the uselessness of market economists high level predictions. As background, I’d simply point out that Ms Ellis as with all RBA Heads of Departments, the Deputy Governor and Governor have never worked in the private sector in their professional lives. The Platypus speech would seem to highlight a number of policy misconceptions that this lack of experience causes.

The speech is long but I’ll do my best to point out important inconsistencies, inaccuracies and perhaps some bouquets. Ms Ellis:

Indeed, credit booms are very often part of the story in the lead-up to a period of financial instability. We published that assessment in the March and September Reviews. In the wake of that, we have sometimes been asked: how fast is too fast? Do we have a target for credit growth? Or for the ratio of credit to GDP? Or, perhaps, for housing and other asset prices? I can tell you quite plainly that we do not have numerical targets for any of these things. A target for credit growth, or any of these other variables, is not analogous to the RBA’s inflation target……….The distinction is simply that price stability is about inflation. So it can be defined as keeping inflation at an acceptably low rate. Financial stability is harder to define, but in essence it is about avoiding episodes when the financial system significantly harms the real economy.

My interpretation of this series of statements is that a fundamental flaw is at the heart of the RBA’s view of financial stability management. The RBA has specific targets for inflation and that is the single price (including assets) stability tool but has no targets or model parameters to govern financial stability. A big mistake not just of policy but market knowledge but lets move on. Ms Ellis:

At the Reserve Bank, and at most of our counterparts overseas, financial stability analysis includes looking at those macro ratios, but we don’t stop there. We look at the structure of balance sheets, both of financial institutions and the non-financial sectors that are their customers. Distributions matter a great deal as well. It is rarely the median borrower that causes the trouble. So we also analyse detailed micro data.

OK, a bouquet for this statement, detailed micro analysis is necessary but detailed frameworks with disclosed parameters can be built from micro systems to provide meaning to any analysis. If provided in the same way as the RBA Statistics, such would provide a framework for specialist and public debate and a discouragement for gaming. Is this what Ms Ellis meant? Let’s move on. Ms Ellis

Some people think that looking for risks to financial stability is about hunting out the ‘black swans’ that could blindside you…….It’s an important point about the limits of models, and about the need to make systems robust to unexpected events. But I don’t think that, taken literally, it’s a constructive way to conduct financial stability policy. The whole point about black swans is that you can’t look for them. You can’t imagine scenarios that are by definition unimaginable.

Hmmm, this is an overly simple summary of Mr Taleb’s book. My reading of the book’s theme is that black swan events are common despite popular opinion. It is the exact causes may be unforeseen and are rare, the occurrence of the event is not. But let’s see what is Ms Ellis’s alternative:

And the test I would apply is inspired by another member of Australia’s weird and wonderful fauna – the platypus. You see, when Europeans first saw a black swan, it would have been a surprise, but I doubt it rocked their world. There are plenty of other cases where the same species of animal is a different colour in different regions. But the platypus is strange. It is a mammal, but it has a duck’s bill; it is the only mammal with venomous spurs; it lays eggs; and it is a monotreme…………..It’s that sense of disbelief, of incredulity, that something is too ridiculous to be true, and yet it is true: that feeling is telling you something. When you have that feeling, you are having what I have come to describe as a Platypus Moment. And it is that moment, that feeling, we should be alert to.

This is inconsistent with an assertion that the RBA conducts micro analysis. As all Australians, I love the platypus but Ms Ellis’s analogy is unhelpful. The RBA’s test on identifying risks to financial stability is that when you see something so unusual, so unlike anything that you’ve seen before but if you have this funny feeling that it may be true, then that’s an event to take notice of. That may very well be the case but that’s not how systems are created which cause financial instability nor even the event that may be the tipping point. Platypus events are the symptoms not cause. Maybe the readers can understand why I have the Platypus Blues. Can Ms Ellis redeem herself?

To give a personal example, some years ago I experienced a Platypus Moment when I first read about vendor-financed down payment assistance charities in the United States………To give a personal example, some years ago I experienced a Platypus Moment when I first read about vendor-financed down payment assistance charities in the United States.Home-building companies would donate money to charities that in turn gave money to first-home buyers to fund their deposits. Usually these charities were quite local, so the builder that funded them often got the money back by inflating the sale price of the house. Unsurprisingly, US government housing agencies have found that borrowers who had received this kind of assistance were three times more likely to default on their mortgage as those who had not (Montgomery 2008).

Whilst I would strongly suggest that this Platypus was a symptom of lending processes which were supported by the US government, how is this different to the Australian FHOG especially the boost after 2008? If your looking at a financial stability risk or Platypus moment, how can the RBA go past the Australian government boosting FHOG, in concert with the RBA significantly lowering interest rates and the banks lending at those low interest rates to over stressed borrowers? It may be great sport to point out the failings in the US or other parts of the world, but its negligent of the RBA to not look into its own backyard. I’m singing the Platypus Blues! Ms Ellis:

…good example of rent-seeking. The textbooks define rent-seeking, roughly speaking, as manipulating the economic and social environment to benefit yourself without adding any real economic value to the world. In fact, because the act of rent-seeking absorbs time, energy and resources, it actually reduces human welfare. Often, but not always, rent-seekers try to persuade the government to bestow some favour on them……….Rent-seekers thrive in complex, opaque markets. A perfect example was the structured credit boom in the years before the crisis. In all the controversy about mark-to-model and the difficulties of pricing these securities, it is often forgotten that it matters whose model the security is being modelled with. Those kinds of informational advantages can be quite lucrative.

A bouquet for the first half of the above quote. Rent-seeking is my personal vendetta and is addressed often on MB. However, the gross irony of not drawing attention to the systemic risks of FHOG as I describe above makes me wonder what form of self justifying logic is going on here?

However, the second half demonstrates Ms Ellis’s lack of knowledge of the debt capital markets and credit rating opinions. Rent seekers do thrive on opaque markets. But how has that been able to thrive around the globe primarily in securitisation markets and more recently government backed bonds? In the full knowledge that credit ratings are opinions and by nature must be opaque, governments globally embedded in legislation for fund managers, banks and other financial institutions the use of these opinions in investment decisions and capital weighting. Can anyone think of a more structured environment for rent seeking to occur? BTW, not much has changed and the rent seeking continues. Ms Ellis:

The second key behaviour we watch for is risk-taking. In fact, the goal of financial stability policy is sometimes defined as reducing systemic risk: the risk of a disruptive financial crisis. I should emphasise that the objective here is not to eliminate all risk. Most social and economic progress comes from somebody being willing to take a risk – on a new idea, a new product, a new way of doing things.

This statement is a great narrative for the section on risk-taking, but what’s it backed up with? Ms Ellis:

Inappropriately relaxed perceptions about risk therefore led to inappropriately lax lending standards. Lenders didn’t worry if the borrower could afford the loan, or if that undocumented income really existed. Housing prices were rising rapidly. So lenders assumed that a borrower in trouble could always sell, or refinance with another lender.

I struggled to find much in this section worth commenting on but the above is worthy for what was not said or referred to. Ms Ellis again was referring to the US. Why not look in our own backyard? I am well aware that at the moment, reported arrears on Australian mortgages are low by international comparison but we are only now moving into a period of house price decline.  A great many mortgagors in Australia are battling extreme adversity to pay mortgages. From personal experience in the finance industry, originating mortgages and managing risk as well as knowledge of many friends, I can state categorically that many borrowers are underqualified and over stressed in the mortgages they’ve been granted by banks. Rising prices is the only thing that has saved the mortgagors.

The issue for the RBA is that detailed borrower information (ie micro analysis) is available from banks if the regulators ensure that it is provided. But on Ms Ellis’ definition, the Platypus Moment for the RBA will be when it all blows up. Yet sadly, the information and indicators were there all the time. I just keep singing the Platypus Blues. Ms Ellis:

…in the face of rent-seeking, risk-taking and other challenges to financial stability, we need to be able to respond in the right way……….The right response, in fact, has several preconditions and from there can take several forms. The first precondition is the background of the macro policy framework. Avoidance of damaging credit cycles starts with management of the business cycle.

So Australian bank’s huge borrowings from offshore circa, $700Bn, when we maintain a current account deficit which the mining FutureBoom! cannot and never will repay is managing the credit cycle? In my view, the Australian housing market cannot sustain current pricing without continued support and growth from offshore lenders. Internal resources will not suffice. In the current global environment of deleveraging this is no Platypus it’s a duck and quacks exactly like one. Ms Ellis:

The second precondition is the regulatory and institutional framework. Regulators must have the powers, the mandate, the resources and – importantly – the culture to make them able and willing to respond appropriately to a threat to financial stability. Even more important, they must be able and willing to intervene early……….A good Australian example comes from the 2004–2005 period. A system-wide stress test revealed that mortgage insurers needed more capital to be resilient to a major downturn in the housing market, should one occur. So APRA raised these firms’ capital requirements. The stress test and the fallout from the early 2000s housing boom also revealed that some newer mortgage loan products were riskier than others. So APRA raised risk weights on those loans. It has retained that tougher treatment even after adopting the Basel II standard.

These statements are only partly true. Whilst there were changes in capital requirements for mortgage insurers and banks, it had more to do with the arbitrage which existed before the change. Prior to the significant changes in regulation, the bank’s received capital relief from a mortgage insured loan greater than the amount of capital the mortgage insurers were required to carry by regulation and by the credit rating agencies. This resulted in the mortgage boom of the first half of the last decade. With low capital requirements not being a break on credit growth for mortgages, the boom would have gone the Platypus.

However, since 2007 the major banks have been able to use advanced Basel II methodologies to calculate capital, very low capital requirements have been maintained for 80% of the market and the credit boom was reinvigorated. The major banks hold less than 2% capital against residential mortgages and the mortgage insurers about 0.75% against their risk. How and why is this is no Platypus? A final comment from Ms Ellis:

Focusing on risks and behaviours is the key to that communication, not numerical targets or forecasts. For if we succeed in preventing crises, whether through communication or some other response, then any prediction of a crisis will not occur. It would be a self-negating prophecy, one that would make it harder to repeat the success later on.

I agree but its rhetoric, a statement of the obvious conclusion that we need to manage people, organizations and risks and not just numbers. But its trite to ignore real and available information. Regulation is about creating an infrastructure in which business can operate without posing systemic risks and not a set of do and don’t rules and where businesses can succeed and fail. Allowing Australia’s major banks to be TBTF and rely on taxpayer supported does not fit this paradigm. Transparency of risks and information to the risk holders is key to maintaining systems which are difficult to game. Its not the RBA’s or APRA’s role to maintain a policy stance of identifying the Platypus. But maybe its mine to keep singing the Platypus Blues.

Comments

  1. So Australian bank’s huge borrowings from offshore circa, $700Bn, when we maintain a current account deficit which the mining FutureBoom! cannot and never will repay is managing the credit cycle?

    +1

    ps. Do you reckon you could re-work this with the Luci Ellis quotes in boxes? …would make the layout visually easier

  2. It may be your role to identify the animal; but it’s sure going to be the Government and the RBA that keeps feeding it.

  3. Nice piece as always Deep T. So do you disagree with using debt targets (credit growth, debt to GDP ratios etc) in the RBA decision framework Deep T? From a laymans point of view, it seems the western world is in trobule becuase credit was too cheap for too long. Would we have avoided the worst of the GFC/credit crunch if reserve banks had leaned against accelerating private credit levels as well as inflation?

    • HnH/DE/other’s idea of the ABS including mortgage repayments in CPI has always sounded like the simplest solution to this.

    • Good question Q. Short answer is No I don’t disagree with RBA using debt targets….But

      For a long time I’ve thought that the reason most traditional economic analysis says that private debt does not matter, is that there is an underlying assumption that borrowers have been assessed properly for the ability to repay and that lenders manage their lending risks properly. So the thinking is that the private sector will only lend to a level that the economy can sustain but its the repayability of government debt that we have to worry about. This is clearly born out in the popular rhetoric of Australia’s debt position.
      However, with most of the private sector debt on TBTF banks which have implied government guarantees, I think its negligent to ignore private debt levels. This distortion of who’s accountable for the risk, can and has meant that there are large numbers of underqualified borrowers.

      There has been a massive transfer of public debt to private hands which as shown in Ireland can transfer back very quickly.

      So if the RBA has debt targets it should accompanied by micro analysis of the risk inherent in the private sector borrowing. However, I’d say its a pretty good indicator that when private sector borrowing is at levels that we see in Australia and elsewhere there’s a lot of risk. If that risk is born by the taxpayer than the debt amy as well be on the governments balance sheet.

    • Excellent article!

      The speech has a superficial charm but at its core displays the continuing shortcomings in RBA thinking.

      As many have pointed out those shortcoming are related to its continued belief in idea that the level of credit in an economy itself is not something they need to worry about.

      Simply put, we humans are not as clever as the assumptions embedded in the RBA’s economic theories.

      Needless to say those assumptions were also embedded in Wall Streets model that came unstuck in the GFC.

      Accordingly, to the RBA and Ms Ellis rent seekers and financial market platypus thrive on cheap credit and relaxed regulations yet the RBA do not accept that numeric parameters relevant to credit may be useful in determining the price of the credit that is sooooo tasty to a platypus.

      An alternative approach is straightforward.

      1. Stop yanking the interest rate lever – Let supply and demand determine interest rates.

      2. Only if inflation is too high use interest rates to bring it under control.

      3. When inflation is low interest rates should not be used as steroids to ‘stimulate growth’ or as a reward for low inflation.

      Often a lack of growth is the sign of an economy adjusting to previous mal-investment eg; a housing ponzi scheme creaking.

      4. When inflation is low – the key objective should be sustainable levels of domestic saving and outstanding credit levels (public and private)

      To lessen dependence/vulnerability to cheap money policies by foreign central banks /governments we should ensure an adequate level of domestic saving.

      To encourage a sufficient level of domestic savings an interest floor may be required.

      Personally, I think 5% is about right but many people would argue 6 – 7% is closer to the mark.

      Earning any less than $5,000 before tax on savings of $100,000 is unlikely to encourage savings (other than when fear grips the population).

      The RBA clearly subscribe to the theory that debt in the hands of rational homo economicus is a perfectly safe tool and leads to the economic promised land. One man’s debt is another man’s credit etc.

      In theory they are correct but in practice we are not the clever chimps their models confidently imagine.

      The events of the last few years have demonstrated that this confidence is unwarranted. Even the great brains on wall street could not make sensible judgments on how much debt was appropriate. The idea that emotional humans make the right rational decisions when it comes to debt is not what our credit card companies know to be true.

      We (particularly the great brains of finance) need trainer wheels to limit our ability to blow ourselves up with credit.

      Thus it is entirely appropriate that the amount of debt outstanding in the economy is kept within limits where it is unlikely to blow up the banking system.

      As to the size and shape of the trainer wheels I will leave that to others to calculate but limiting private debt and government debt each to 50% of GDP would seem to be more than a generous allowance for the Master of the Universe to play with.

      The RBA doesn’t need to lean against the winds of an asset bubble but it should lean against the winds of a credit bubble.

      • Pjh007, I can only but thank you for such a detailed and well thought throuh Reply. I dont agree with all the detail but certainly the spirit

        • I greatly appreciate the hard work done by you and the other regular MB contributors of columns (and also comments) to create an intelligent alternative forum for public debate of current economic issues.

          In the absence of serious debate of policy by our superannuated student politicians the public must do what it can to contribute directly to the formulation of policy within the public sector.

          • Pfh If I might offer (again) some thoughts as to the ‘required’ interest rate. I am now talking LONG TERM and a LONG TERM POLICY IDEA. A change from the world as it now is towards a more desirable structure such as you outline will necessarily cause dislocation. Anyway here goes (sorry to bore some people)
            Firstly I agree with your 5% idea. However we ought be talking REAL and AFTER-TAX rates.
            So first it depends on what is the REAL rate of increase in prices of goods etc however for the moment let’s assume it is 4%
            If this is to be a real rate then we require (after-tax) a rate of 9.4%. Let’s take the average marginal tax rate to be about 35% so our final interest rate required would be 14.4%

            Now most contributors here might jump all over me and suggest this rate would destroy the economy. Yes it would destroy all the wasteful practices and indulgences we now award ourselves one form and another. However what it does demonstrate is how far we are away from a long term sustainable system.

  4. “In the current global environment of deleveraging this is no Platypus it’s a duck and quacks exactly like one.”

    I love it.

  5. Diogenes the CynicMEMBER

    Basel II is a joke. “The banks hold less than 2% against residential mortgages….”

    There is the problem. Not a platypus but an elephant trumpeting in the room. So when our house prices fall 10,20 dare I suggest 40-50% what happens to our banks? Those mortgage insurers will be bust long before that.

  6. “…since 2007 the major banks have been able to use advanced Basel II methodologies to calculate capital,”

    Sadly much of the “gaming” concerns the elaboration of these so called methodologies ( of risk assessment) where the commercial bank elaborates a model of particular economic behaviour which is then willingly accepted by the regulators . CDOs were allowed to flourish because the now much discredited VaR model said they were OK .

    • +1. The underlying requirements of the Basel II advanced methodologies are fatally flawed.

      By that I mean that if the majority of lenders by size, ie Australia, follow the requirements and use an IRB Approach to determine risk weighted assets the system will fail or need to be rescued.

      I’ll post in more detail on this in the future

  7. Just found an old IMF link “The Nordic banking crisis from an international perspective. It clarifies why there is panic in the air in 2011.
    http://www.imf.org/external/np/speeches/2002/091102.htm

    From the speech in the link above:

    “One of the lessons of this is that countries need to think through the type of resolution framework that they would need in times of crisis; pre-planning is invaluable. To produce the hose while the house is burning, is a lot more difficult compared to having prepared the hose in advance, and then just turn on the fire hydrant when the fire starts.”

  8. El Zorro Dorado

    Congratulations to Ms Ellis for the fine elucidation of the Platypus Moment. It’s nomenclature is in the spirit of the Bernanke Put, but I guess it identifies gradations of black swans. We should be wary of ordinary Black Swans ….but scared when the platypus sidles up from beneath the waves.

    Now Ms Ellis looks at the macro ratios and analyzes the micro data assiduously, and it’s good to know the team is on top of things, even if it’s after the fact, and looking in on from the sidelines,and possibly outside parameters….

    Precisely when does the RBA get that fine vibration in its loins to signify that the earth has moved substantially enough?

    Is it before ‘it’ blows up from just a normal black swan? Is it an inkling that the shop is crawling with desperate and dastardly rent-seekers? Is it when a nagging notion arises, that some of its own “stabilizing” policies just might make things worse for those out there trying to make a living? Is it perhaps when there is an awakening –deep in the dark waters — that the fundamental role of the RBA is to preside over and conceal the consistent and surreptitious degradation of our purchasing power…all in the name of financial stability and imaginary, illusionary wealth gains?

    • I think the electrolocation abilities of the platypus are similar to what the RBA uses to pick up the fine vibrations emitted by a white shoe wearing rent seeker.

      Who needs numerical parameters when you can feel it in your nose!

      http://en.wikipedia.org/wiki/Platypus

      Platypus (Ornithorhynchus anatinus)

      Monotremes (for the other species, see Echidna) are the only mammals known to have a sense of electroreception: they locate their prey in part by detecting electric fields generated by muscular contractions. The platypus’ electroreception is the most sensitive of any monotreme.[30][31]

      The platypus feeds by neither sight nor smell,[34] closing its eyes, ears, and nose each time it dives.[35] Rather, when it digs in the bottom of streams with its bill, its electroreceptors detect tiny electrical currents generated by muscular contractions of its prey, so enabling it to distinguish between animate and inanimate objects, which continuously stimulate its mechanoreceptors.[31]

      Experiments have shown the platypus will even react to an “artificial shrimp” if a small electrical current is passed through it.[36]

  9. A second year course in logic will clarify the use of Black Swan etc as its misuse is really frustrating. Luci Ellis says: “You see, when Europeans first saw a black swan, it would have been a surprise, but I doubt it rocked their world.”

    Err, yes it did, it really rocked their world because they had believed with their epistemology that all creatures they knew were fixed ie white swans.

    So in logic we build arguments from premises in syllogisms to establish valid arguments. The syllogism of white swans concerns individual observations that swans are white, therefore to universal statements that all swans are white. A black swan is not possible in a logical and epistemological world constructed in this way.

    Hence in financial markets black swan events are not accidents, they are inconceivable and logically impossible.

    So, for Luci Ellis to refer to the swan and the platypus in such a way shows she has no idea of the logical meaning of this argument, how it used and what it means in her own task, and therefore, her elaboration based on that fallacious discussion is invalid.

  10. Great post DT..
    .
    How about this for a platypus moment – Received this email from Run Properties (yep, that’s the name of the REA)
    .
    Free money vanishingfast

    First home buyers in NSW who want a gift of up to $17,990 have only 11 weeks left to claim their prize.

    The State Government’s short-term stamp duty exemption for properties under $500,000 ends on December 31.

    RUN Property CEO Rob Farmer said first home buyers were jumping into the market to take advantage of the offer.

    “It’s free money from the Governmentand with interest rates on hold this is a small window of opportunity for first home buyers,” Mr Farmer said.

    “Our sales teams in Sydney are being flooded with inquiries as demand is suddenly more than supply, so anyone thinking of selling in the next 12 months should consider taking advantage of this.”

    Under the Government’s deal, first home buyers who pay less than $500,000 will pay no stamp duty, with discounts calculated on a sliding scale between $500,000 and $600,000 – but the offer ends on December 31.

    From January 1, 2012, the concession will apply only to new homes.

  11. Thanks for the critique DT.

    If I am not interpreting it wrong, by your counts banks (give or take, almost all of them), are truly 50X levered, and not the traditional 10X times figure slothed around based on 9% Tier 1 ratios.

    If that is in fact the case, it serves to remember Lehman was 35X levered at its height. It collapsed as repo market turned its back on it, due to dodgy collateral whose value was called into question(RMB’s, CDO’s etc.). But our banks are no indifferent to this besides for the fact that collateral underpinning their funding (from asset side) is a more illiquid version of the same ie Residential Home Prices. If I have not gone off the radar up until now, we can be safe to assume that the same assumption underlies our being different meme ‘House Prices never fall’.

    What the bonks at Martin place fail to realise is the cult embedded in a generation that has based their whole lifestyles and retirement plans around this. So they wouldn’t need magnificent falls as their US peers to bring about the damage.Stagnation shall be enough to show the cracks in the system. And we are experiencing that now. Time will take its toll.

  12. Another ‘Purr moment’ ,meets ‘Ace’s in Spades’..with just
    about all the ‘Animals on the Farm’…
    Well Done Deep T.,Cheers MB..JR

    • In Moderation,I could say..
      Another ‘Financial Stability ,break
      Down’,well cleared,and met by alot of Ace comments,in-mentioning alot of native species,Cheers JR
      …to
      Sir-pass beyond the wiki ‘Animal farm’ ref
      Or-well..sorryboutthat..