How to control the banksters

The banking system is broken, propped up by every day taxpayers for the benefit of a few, mainly in the FIRE sector. Mortgage loans are the cancer that’s eaten away whatever financial stability Australia had previously. Our own politicians might smell that something is rotten with MegaBank, but how many realise that their careers and future taxes will pay for the bonuses and excesses of the Banksters once the system needs rescuing?

A broken banking system needs fixing but is it by wholesale replacement or strategic repairs? Whilst there is no doubt in my mind that MegaBank needs reform, there are perhaps changes that can be made under current oversight that would force the whole system to reform itself. The key is how banks calculate and fund core Tier 1 capital (ie ordinary shares).

Tier 1 capital is important because banks can’t create it, they must raise it from external sources. As we all should know by now banks create money when they lend or out of nothing. Whilst personally I did not think it necessary, there is a scientific paper on the issue that proves this point. Tier 1 capital cannot be manufactured by banks like their lending creates money.

Just think of a simple system that has one bank (MegaBank). MegaBank lends $100 on a mortgage to A who buys a house for $100 from B. B deposits the funds with Megabank. Under the above mentioned paper, money is created out of nothing. However, they’ve left out the next step. Megabank must raise Tier 1 capital as well as a “protection” against loss. For MegaBank today that’s an especially small amount of about $2 on the $100 loan. MegaBank issues shares to Z super fund for the $2. Z withdraws $2 from MegaBank to subscribe for shares. So the situation is that Megabank created net funds from debt of $98 ($100 – $2) and raised $2 from shares to fund the $100 loan.

Raising Tier 1 capital is problematic for banks as this can reduce return on Tier 1 equity (ROE). The more Tier 1 capital to be raised on a loan the bigger and more probable reduction in ROE. ROE also drives Bankster’s bonuses. This is the reason that MegaBank repeatedly misrepresents its capital as representing unquestionably strong when any reasonable analysis would tell you they are just average. Although It now appears that our global regulators have woken up that small amounts of Tier 1 capital per loan creates excessive lending and asset bubbles and are changing the rules.

The banking world awaits the finalisation of the now termed Basil IV. The most controversial point outstanding and yet to be agreed is a floor on the discount to the standard method of calculating bank capital requirements or risk weighted assets. The floor is to be imposed on those banks using internal risk based (“IRB”) models. Regulators in Europe and the USA are in some disagreement but it does seem that they’ll settle on a discount floor of 25%. or 30%.

Setting such a floor will have significant implications for MegaBank that now use the IRB method to determine risk weight on assets especially as it effects residential mortgages. Whilst the floor is likely to result in risk weights increasing at the margin and across the board, the failure of Basel IV for the Australian taxpayer is that it does not go far enough in determining appropriate risk weights for residential mortgages on the books of MegaBank.

To start with, the standard risk weights for residential mortgages are grossly inadequate and simplistic. The following graphs represent the risk weights on a standard mortgage with and without Lender’s Mortgage Insurance (“LMI”). For the capital requirement the risk weight is multiplied by 8%.

Whilst Basel IV can be applauded for setting a floor on the discount to the standard weights and for increasing the strength of MegaBank and cushioning the financial system against any future requirement for government support it does not go anywhere near far enough in identifying loans that should require even higher risk weights than the standard.

There are aspects of residential mortgages that significantly affect the risk and are not considered by the standard method. The standard method only considers LVR as in the bands above, or defines a non-standard loan as one in which the income of the borrower is not fully verified. There are other factors that should be considered in the risk weight and capital calculations.

To nominate the most important mortgage factors, not formally accounted for in the standard method in determining risk weights; varying periods of interest only, investment loans, new high rise apartments and high risk regions. Even if APRA, behind the scenes, is requiring larger risk weights for these factors that is just not good enough. If Basel IV sets a floor for IRB banks, ie MegaBank, based on a discount to the standard weights then the standard weights must consider all significant factors to guard against gaming.

More controversial though are macro factors and bank specific factors that also should be considered to both protect against system risk and to increase competition for the benefit of consumers. High order systems are created from basic and understandable components but that does not mean you can understand the high order system by just analysing the underlying components.

Understanding the destructive power of a cyclone does not come from analysing water, air and heat. It’s also not possible to understand the mortgage loan market and inherent risk by analysing every dollar lent. External factors brewed with other mortgage factors can create a high order system risk that is destructive and unstoppable like the cyclone. What about the following?

“Size of the Mortgage book relative to household incomes” must be a very important consideration and a clear indicator of systemic risk. Australia appears regularly in the top 3 on this metric with The Netherlands and Denmark. As both these countries have tax deductibility of mortgage interest, on an after tax basis Australia would be a clear winner. The RBA recognises the risk, so where’s the risk weight.

“Concentration in the banking book” is a factor that APRA should consider under Basel II requirements in setting or agreeing risk weights. The concentration of residential mortgages on the books of MegaBank is extreme by international standards as is the size of the book relative to the size of the market. Yet there is no specific weight for this factor imposed by APRA.

“Asset (house) prices” where they are at inflated levels relative to measures such as GDP should be considered in determining risk weights and, therefore, the level of bank capital. Inflated house prices do not necessarily mean that those prices will collapse but it does mean that if prices do drop significantly loses on mortgages will be much greater and therefore represent a greater risk to a bank’s balance sheet.

“Funding from international sources” needs to be identified as a specific risk factor that must be incorporated into risk weights. International sourced loans represent an additional risk to the total Australian banking system from APRA’s liability management regime. If international lenders withdraw funds from the Australian system, this capital flight would only be managed by banks sourcing funds from the Reserve Bank and, therefore, represents a risk to the Australian taxpayer that must be considered when determining risk weights.

So how can the above factors be considered in capital calculations?

The thing about risk is that combining risks on top of each other doesn’t create a linear probability, rather its exponential. I do like the equation y = (1+x)^n. Applying the right variables and we create the following curve:

That looks to me like the shape of a curve that could represent the risk inherent in the Australian mortgage market as we pile mortgage risks on system risks to greater and greater heights. It, therefore, can be used to determine MegaBank and all bank’s risk weights and Tier 1 capital requirements.

As an example of what’s possible, if we set Y to equal the multiplier to the standard risk weight, X to be sum of the mortgage risks and n to be the sum of the system risks we can perhaps create an algorithm that will provide us with a system and bank protecting negative feedback loop.

Let’s set the standard at 1 and incremental risk increase of 20% for each of the interest only, investment, high rise and regional risk increases. In addition, we can set the incremental risk increase of 30% for each system risk of the very large size of the mortgage book, concentration of residential mortgages, inflated asset prices and international borrowings. Our algorithm produces the following risk curve.

Logically these risk curves can be dialled up and down and adjusted for additional risks and circumstances.

Whilst our algorithm will produce a myriad of combinations, in my example and at the extreme of all mortgage and system risks outlined herein being at play, the following graph represents the adjustments to the standard bank capital requirements.

My example produces very large capital requirements as it should be for such an extreme example of added risk factors. My purpose, however, is to demonstrate that a capital requirement system for residential mortgages that is consistent, detailed and covers all reasonable loan and system risks is easily created. With modern technology a central system could assess every mortgage application and every mortgage loan in Australia with risk assessments specific for every bank and provide an instant risk weight for a mortgage on parameters set by APRA. It could be built for less than 1% of MegaBank’s annual IT budget. That’s a cheap strategic repair to the current system.

The key to controlling the Bankster’s risk taking and gaming of the system is to capture what they are doing before loans are written and capital requirements set relative to the total risk factors both mortgage loan and system factors.

The banking system can’t blow asset bubbles with rising requirements to access Tier 1 capital rather than the theoretical perpetual debt and money bubble machine that currently exists and requires little to no capital for unlimited growth. Until of course the borrowers default.

That’s how you do macroprudential.

At the beginning I alluded that perhaps there was system fix. Unfortunately it’s too late for Australia, we are too far in and are cooked. Next time around hopefully.

Comments

  1. Thanks DeepT as usual it’s worth reading and rereading everything that you share.
    My feeling is that it all comes down to the simple fact that bank risks raise and fall counter cyclically. It would be nice if our banks were adequately capitalized (tier 1 capital etc) but I get the feeling that banks would just resort to moving their loans off-the-books as was the case in 2007 in the US with the “invention” of non-insurance derivatives (CTS, CTO’s .. etc) complex hybrids and the Securitization of Special Purpose Entities (SPE). From a risk analysis perspective Derivatives are not Insurance because no one in the system has adequate reserves of anything but self minted paper, yet they appear to be Insurance when viewed from a Bank accounting perspective.

    It does seem that me that the best solution to this problem is to build a financial system that suffers from regular disruptions which absolutely destroy those banks that like to play fast and loose. This way the banks become the guardians of the financial system rather then the exploiters of any weakness in the system that we define to regulate them.

    • It is a travesty that the “bailout” concept which is now “assumed” to be the standard practice every time a crisis comes along, is not conditional on restructuring of the banks bailed out, including dismissal of the top 3 levels of executives, a ban on them ever serving in finance-sector roles again for life, and confiscation of their superannuation funds. I bet if there were “conditions” like this, the entire sector would suddenly start to display some responsibility, foresight and discipline.

      There should have been a complete clean-out of Wall Street in 2008, and quite possibly US voters thought Barack Obama the man to act tough with Wall St. Sadly, Obama was unexceptional among Democrat Candidates in that his funding and backing from Wall St made him, not the Republican, “Wall Street’s Candidate”. But lefty voters seem to never grasp these realities.

      • But that would require regulation Phil. So we can’t have that.
        Much better to leave things to market forces.
        ie. government gets non-voting stock and job creators get to keep their jobs and salaries. Because market forces.

      • @Sweeper Re: leave it to market forces
        I agree but to be effective these market corrections need to be regular (within recent memory, I’d say no less than every 5 years, and it needs to be left to the market to find solutions. Governments stepping into the breach is what emboldens these banks during the up-cycle, up cycles that last 25 years are what allow the punters to forget just how fundamentally fragile lenders are when the economy turns south.
        Look no further then Genworth LMI for the most cynical up-cycle managed company on the planet, They claim to be a traditional Insurance but have laughable reserves in many ways they’re worse than the AAA rated Securitized paper floated in 2002-2006.
        Nope regular unconstrained dips is all that can control banksters.

      • truthisfashionable

        I’m sure I’m not the only one who can see our second tier of banks (which is increasing rapidly in count) could easily take over were these bloated behemoth’s we call the big four to fail.

        Sure there would be some initial issues as everything transitioned across, nothing a new gov entity/bank couldn’t solve in an interim period. The savings to the country compared to a bailout would be significant.

      • The other option to consider is to explicitly remove all tax-payer support. That way the onus would fall on the banks to win the trust of customers (and deposits). The competition would naturally extend to greater balance sheet transparency and various other (risk mitigation) mechanisms to draw in customers. Those banks that didn’t join the race to be ‘best’ would naturally fail as deposits would simply drain away to the better institutions.

        Alas, there is more chance of Elon Musk settling Mars than this happening.

  2. Excellent essay, Deep T.

    One of the narratives we hear all the time is that “rampant deregulation” is responsible for the world’s system tipping into crisis from the 2000’s on. But it seems obvious that the problem is that the regulations that do exist and are assumed to proof the system, do no such thing. And the existence of regulations, and the assumptions about them, leads to everyone giving no thought to risk – because we pay regulators to think about that, don’t we?

    The world is being ruined by incompetence, which most of the time is being ruthlessly exploited by the 0.1% who are the almost the only ones who understand stuff. The poachers are geniuses and the gamekeepers are mostly vain, conceited, Walter Mitty types whose career-advancing skills are inversely proportional to their actual competence – of course some of them are outright corrupt stooges but this depends on the most of their colleagues being too dim to see through them.

    The same applies to the urban planners who play a crucial role in the rigging of the whole system since the 1980’s – saving the planet means wrecking the economy, but none of them see that. None of them even see one single economics principle of cause and effect between their Plans, and the perverse outcomes which to them, are always because of some factor that was in “coincidence” with the timing of their Plans. Of course the 0.1% have been the sugar-daddies to the “save the planet” and the conservation and anti-sprawl activists all along.

    • Good grief Phil….

      Born at the OTC clearly articulated the risk factors and was summarily dismissed by the Chicago boys, because of rational agent models and claims about experienced people not shooting their feet off. This is made manifold by revolving door factors and the de-funding and de-toothing of any relevant agency which might nip problems in the bud or prosecute malfeasance.

      You have a sociopolitical problem that has been festering since neoliberalism became dominate and all you can add is regulation did it…. sigh…

      disheveled… this is the market as envisioned, externalizing failure is not a bug, but feature for some..

  3. All that needs to be done is limit the credit the banks are allowed to lend to an individual to 3 X their income. Any more than that is slavery.

    • The Penske FileMEMBER

      I like this idea as it is simple. Of course low doc lending breaks it down. NCCP regulated home loans would work but commercial and private transactions just can’t be regulated.

    • They did this in Ireland (3-4x income max) but problem is, it worked in the short term, but the market is back to madness and I’m not sure if this has been relaxed again?

  4. how to fix banksters?
    let them self-regulate themselves

    BTW. Under Rudd”s Labor government we had Minister for Finance and Deregulation .

  5. Well that pretty well summs the situation. just again to mention the drivers for this outcome
    greed and the induced belief that punters could become wealthy through speculation, where their wealth has been pinned against a misrepresented asset value, and the accomodating nature of the financial market and the equities
    market where the asset resides as an entry in a ledger, which at least for an equities market the value of which is visible on a daily basis and the instrument can be disposed of in a trading day when required, with no remorse.
    this joint is going to be like the titanic, it will sink sooooo deep it will take years just to find the wreck.
    A fair value for the ASX is 4500. WW

  6. To hell with that. Freeze rents, all a New York, and Fed-State Gov’t offer to buy out existing investor properties at a 5% premium to market. THINK MINIMUM EFFORT MAXIMUM RESULT, PLEASE MB. State Govt already owns / buys homes as do the Feds via Defence, so there is no ‘freak out we are changing something factor’

  7. Since I am not a bankster and have not followed in detail how they operate this article is a bit too deep for my sleep deprived mind (or what is left of it at this late stage of my life).

    Being a simple person I like simple solutions. Here is what I propose

    1. First simple step is get back to a separation of banking into commercial and household savings arms like we used to have. Savings bank money should to be used solely for personal loans and housing loans. Funds deposited into the commercial arm of the banks (at higher commercial rates) should be used solely for what has traditionally been considered commercial activities, with none of it being allowed to be used for residential property development or on existing housing.

    2. Second simple step is to not allow any financial institution to use foreign sourced borrowed funds for on-lending in Australia for any real estate activity, both commercial real estate and residential real estate (both new developments and existing properties). The main reason for this is that real estate is not a tradeable good and therefore does not generate foreign exchange sourced income to repay the overseas sourced loans and interest payments thereon. There are other reasons but this is the key one for me.

    3. A third innovation is to require the lending institutions to only lend money for real estate to Australian citizens or those with PR and not to overseas citizens who want to invest in Australian real estate, whether for new or existing housing stock, and obviously not for real estate in other countries.

    4. Possibly set a requirement that lending institutions hold a fixed percentage of their loans rather than have them securitised in order to make them own their loans, thereby removing the moral hazard associated with lending

    5. Let the commercial arms of banks fail, ie no bailouts.

    6. Limit the activities of foreign owned banks to the commercial field and make it a requirement that none of their funds are locally sourced – if its all from overseas they would then not be involved in our real estate sector and have to focus on actually providing funds for commercial development, which is why we opened up our banking sector to foreigners.

    In essence these measures would make the finance sector more like utilities and eliminate the need for taxpayer subsidisation and guarantees.

  8. Great post …. the more people understand the iniquities of our current system the closer we’ll come to a sea-change.

    However, where several observers fall down is blaming the problems on regulation (or lack of) as well as basic human qualities as ‘greed’. Seriously? How do you solve greed.

    No, the problem is the system — fiat money to be specific. It’s like locking a bunch of children in a lolly store for a week but telling them they cannot, under any circumstances eat any of the lollies. On discovering on Day 1 that some lollies are missing, the proprietors decide to implement a suite of ‘regulations’ to prevent further disappearance of lollies. When these don’t work, a committee of advisors recommend ‘even more regulations’ and when those don’t work, the same clowns clamour for even more. And so on, ad infinitum. All along, the solution is very simple: remove the children from the lolly shop.

    That’s fiat money for you right there, aided and abetted by a Central Bank that can print all the money the ‘system’ needs at a fixed price. How on earth anyone is even remotely surprised when real estate (and a host of other assets) goes through the roof after the money-supply explodes into the blue yonder under this system is beyond me.