Fat Chance

As a boy I attended an agricultural Secondary School, that is it specialised in agriculture (it is strange grounding for becoming an economist, I know). We had a teacher who would tell a wayward boy, “You’re taking a fat chance”. The reckless economic experiments to avoid the consequences of decades of money creation and monetary policy abuse are similarly taking a fat chance.

The same teacher gathered a number of older boys together at the request of a local farmer. He proposed to the school an educational real life opportunity to prune his orchard. The older boys (no child labour here) had to complete a course in pruning and do a practical evaluation in the school’s own orchard. The group of budding arborists were taken to the farmer’s orchard to fulfil the contract. Each boy was allocated a row of peach trees to prune. Each row had about 50 trees in it. Each boy was paid per tree pruned. It was a good workable system and the pruners were clicking.

Then the cheating started. The bullies quickly worked out that a row would randomly contain smaller trees easy to prune, average trees and other monstrous trees growing wild which could take hours to prune. They then formed a group, we called them the “Group of Rocks”, for they gathered rocks and set forth to mark all the small trees in the orchard with a rock in the first fork of the tree. Soon work was subdivided into all the small trees for the Group of Rocks, while the rest of the group had to content with normal and monstrous trees.

The rest of the group went to Mr Fat Chance and complained but he did not wish to disturb the status quo as the Group of Rocks was also the group normally considered “leaders”.

The next day only half of the remaining group of boys reported for pruning. The Group of Rocks were in full force. On the third day it was only the Group of Rocks who reported for duty. It now became clear that they would have to do all the work and the rock marking system collapsed. This did not please them so on the forth day nobody reported for duty.

The educational objectives of the school and the farmer all came to nothing. The farmer hired professionals and the school went back to teaching only in the classroom. I would have had an entirely different story to tell had the Group of Rocks failed in their bid to control the allocation of the pruning purse.

Macro evaluations and micro events are interchangeable. The economic playing field is now dominated by the “too big to fail”, the Government Supported Entity, the Public Private Partnership, organised labour and the Siamese twin of Government and Central Bank. This Group of Rocks has control over the national purse in the national interest. They get to allocate the national purse to themselves at the expense of all others. They do not have to suffer the discipline of market principles. The harsh reality of penalty for mistakes and reward for getting it right does not apply to them. They get the personal reward when the going is good and the public purse when the going gets rough. They live and operate on favour and the public purse; rather than live or die by the merits of the market.

Zimbabwe did the same. They printed money and handed it to their Group of Rocks. Ruthless Central Bank activity was combined with ruthless and determined Central Government policies. In the end we see that the Group of Rocks in Zimbabwe owns everything. Everything of hardly anything. Zimbabwe recently reported 94% unemployment so the printing presses were engaged in the national interest, not so? The printing presses averted unemployment in Zimbabwe, not so? The entrepreneurial incentive has been removed from the economy. The risk reward relationships of economic activity have been perverted.

There is a simple but profound lesson in the Group of Rocks. People will labour willingly and with enthusiasm while assuming the risks of randomness in a system based on merit. Is this not a principle inherent to the “American Dream”?

Favouritism and control over the public purse will enslave those outside the inner circle. Debt is but a result of this enslavement. Favouritism destroys the co-operative specialisation inherent to free markets, destroys initiative and encourages unemployment. Thus a belief in bailouts for the Group of Rocks; so called stimulations funded by monetary theft of the savings of the rest; and an explosion of the Sovereign debt funded from the printing press will not save the economy, nor is it in the national interest or international interest.

The printing press is the route to depression, unemployment and social unrest. This is the road to Zimbabwe. The debate about a deflationary depression or a hyperinflationary depression is of interest to those with a desire to protect their savings but let’s not forget that a depression is a horrible economic event. Yet, a deflationary depression is preferable to a hyperinflationary depression. A suitably determined Central Bank and Central Government can convert a deflationary depression into a hyperinflationary depression. Still the actual problem of a depression has not been attended to. Inflation or hyperinflation is not a remedy for a depression or unemployment. Fear not the deflation, or inflation, or even hyperinflation for these are merely symptoms of the control over the national purse. Fear depression for it does not care which flavour of flation accompanies it.

Free market principles where merit allocates the national purse in a fair rule of law system will restore the economic structural imbalances. This option does not suit the Group of Rocks and no prizes for guessing who gets to decide.

I find it incredible and disturbing that access to debt to be created with public debt is offered and praised as a solution for overindulgence in debt. Debt consumption is simply spending the future today and at some stage there is just no future left to discount to today. Does anyone really believe that the Group of Rocks will forgive the debt? The Group of Rocks will shackle you with debt and collect your labour or your assets, you choose.

Thus the economic world travels the road to Zimbabwe which on the economic roadmap is on the other side of Japan. Distances are measured in unemployment. To those with an unholy faith in printing presses I say; “Fat Chance” and prepare myself for the economic and social consequences of a printing press global economy.


Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
22 February 2009


© Sarel Oberholster


Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

Capital Risk Weightings for Crash Test Dummies

Illustration to ring-a-ring-a-roses in Kate Greenaway’s Mother Goose, taken from the Project Gutenberg version project gutenberg: www.gutenberg.org/wiki/Main_Page in the public domain.


Children cling to their blankies and you cannot part them with the Disney printed fluffy blanket even when dirt, food and unspeakable things disguise Eeyore’s picture for all but the tail. Sometimes I think economists have a blanky relationship with reserve and fractional banking.

The fact is reserve banking hardly features in debt formation decisions. It was fundamentally and decisively replaced with a system of Capital Risk Weightings as introduced in Basel I and refined in Basel II. The Bank for International Settlements is very aware of risk in international settlements and the name of the money game has always been to receive settlement (or to get it back if you’ve lent it out). Capital Risk Weightings is a magnificent distributor of debt yet when you mention Basel II or Capital Risk Weightings, economists seems to prefer the blanky. The reality is that reserve requirements are so easy to meet, banks run out of capital long before they have problems with reserve requirements.

It can get complicated but let’s discover the basics of Capital Risk Weightings through Sarel’s Bucket-shop Bank Inc (SBBI for all your Debt needs).

I convince family and friends to hand over their savings say $100,000 and I issue ordinary shares of $1 to each of them (100,000 shares in total). Time to go shopping.

Office Furniture $30,000
Computer Equipment $60,000
Office equipment and Counters $20,000
Stocks of Consumables $10,000

Oops, I spent too much. No problem, I’ll just borrow $20,000 and I’m ready for business.

Here then is the Balance Sheet of:

Sarel’s Bucket-shop Bank Inc





Having only tier 1 capital is totally inefficient. I can get some tier 2 capital by issuing long term bonds (normally 5 years or longer) and I need an equal amount of tier 2 capital. So let’s go ahead and issue long term bonds for $100,000.

Now I need some Central Government Bonds and treasuries to manage my liquidity access so I buy $100,000’s worth of Government Bonds, which thankfully has a Capital Risk Weighting of 0% and have no impact on my qualifying capital. You noticed off cause that we could run an infinite Ring a Ring o’ Roses here borrowing from the Central Bank and lending to the Central Government with absolutely no limitations other than that dictated by the Central Bank. Until we all fall down, that is.

My new dressed up and ready to go Balance Sheet looks as follows:


Sarel’s Bucket-shop Bank Inc



We are now in the banking business. First question, how much can I lend out (we’ll worry about the liquidity a little later)? The Basel II Concordat would generally require a 4% tier 1 primary share capital requirement against the Capital Risk Weighting. (Allocations of Capital Risk Weightings may differ for different countries and split at 8% primary capital and 4% secondary for up to 12% total capital allocations but the calculation method will remain the same.) The tier 2/3 requirements can range from another 4% to 8% but let’s just work with 4% tier 1 and 4% tier 2.

Here is the Capital Risk Weightings table.


Data Source: Bank of International Settlements.

One more risk weighting which is important, Qualifying Residential Mortgage Bonds at 35%.

Now to answer the question, “How much can we lend out?” The math is not complicated.

1. AAA to AA : No limit - as much as we can get in liquidity.

2. A+ to A- : Step one is to calculate the capital co-efficient, easy 8% times 20% and it is equal to 1,6% (0.08*0.20). We have $200,000 in qualifying Capital so we just need to divide $200,000 by 1.6% to tell us that we can lend out = $12,500,000-00. That is a tidy sum of money. Let’s check the calculation. We need to hold 1.6% in qualifying capital against out lending activity. Thus $12,500,000-00 times 1.6% is equal to $200,000 and we’re all filled up with lending. Say we can lend out the money at 4% and get deposits at 2.5%; then we can make 1.5% gross profit on $12,500,000-00. That will give us $187,500-00 pa in gross profit for a Gross Return on Shareholders Capital of 187,5% ($187,500/$100,000).

3. The next best capital allocation lending to engage in would be Qualifying Residential Property. Here goes: 0.08*0.35 = 0.028 (2.8%). Now $200,000 divided by 0.028 = $7,142,857-14. We need to get a better profit margin than A+ to A- lending so let’s say we get deposits at 2.5% and do mortgage lending at 5.5%. That’s a 3% Gross profit margin for a gross profit of $214,285-71 (7,142,857-14*0.03) and Gross Return on Shareholder’s Capital of 214.29%. We can obviously now calculate at which level of lending rate we will prefer A+ to A- lending above Mortgage lending.

There is no need to continue the math as the principles have been demonstrated. Let’s say we’ve decided to concentrate on Mortgage Lending. We convince depositors to give us the $7,142,857-14 and we pay 2,5% interest pa. They have deposit insurance, no risk and should not have any problem to give us the money (not so?).

Our impromptu bank is a good little business at this stage.


Sarel’s Bucket-shop Bank Inc




We are certainly not maximising our efficient use of capital. Thus the next business decision is to do an Asset Backed Securitisation. We take $5,000,000 of mortgages, securitise them and sell them off to investors for an immediate $400,000 trading profit. Fantastic, we now have an additional $400,000 in tier 1 capital and we have also released precious capital held against $5mil mortgage bonds. Time to maximise business activity by lending everything we can to build a much bigger Residential Mortgage portfolio.

Say we use the $400,000 to buy Government Bonds again. We must issue another $400,000 to get tier 2 Capital, again we buy Government Bonds with it. I’ve done all the calculations and our bank now looks like this:


Sarel’s Bucket-shop Bank Inc



Can this be for real, you may ask? Certainly, it was exactly how the game was played for every turn of the asset cycle from portfolio, to securitisation, to sell off produced immediate executive bonuses and the tills were ringing, ka-ching.

We are now a bank with $36.7mil in assets and doing very well. Unfortunately we get a Global Financial Crisis. Liquidity is not a problem (access to liquidity is so easy we do not have to overly concern ourselves with any reserving requirements that the Central Bank may impose on us). We just securitise the $35.7mil Qualifying Mortgages and do repurchase agreements with the Central Bank. The real problems are:

1. We can no longer get deposits to grow.

2. We get bad debts exceeding our gross margin of 3%.

3. We basically have only $500,000 of capital for a 1.4% capital protection against the $35.7mil mortgage loans. In banking talk, we cannot survive more than 4.4% bad debts on a Gross basis (3%%+1.4% and it is a lot less on a net basis – we have to live and get our bonuses).

4. What are we going to do when house prices drop by 50% and “home owners” hand in their keys? Half of the 35.7mil is $17.9 mil against only $500,000 in capital. We have a serious collateral problem not only on our books but also in all the securitisations that we have sold off.

5. We are actually impossibly beyond redemption.


Sadly here is where Sarel’s Bucket-shop Bank Inc kicks the bucket (RIP).

I hope that this simplified essay on Basel II based debt allocation will convince more economists to study the Basel Accords for applied modern banking practices and the interaction with Central Banks. Combine Capital Risk Weightings, easy access to liquidity, deposit insurance (explicit or implied) and securitisation for a turbo charged debt distribution channel far superior to any text book description of fractional banking and reserve requirements.

The role of Central Banks in facilitating unlimited liquidity provision to the banking sector has permanently changed the banking landscape into debt driven activity with deposit taking having been relegated to an afterthought. The fixation of deposit driven banking theories simply no longer apply and it is time to retire the blanky.



Sarel Oberholster
BCom (Cum Laude) CAIB(SA)
14 February 2009

© Sarel Oberholster

Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

Fractional Banking is a Mirage

Some economists call for 100% reserve requirements of demand deposits. Reserving requirements and the money multiplier are often discussed at the same time.

The economic theory in support of increased reserving requirements and fractional banking is the theory of banks as creators of money.

The essence of this theory holds that:-

1. bank credit is accepted as money, and
2. customer deposits can be leveraged to create money.

Perhaps one should differentiate between “bank deposits” and “customer deposits”. The premise is that a bank can give a debtor a credit limit and the debtor can utilise the “credit” as if it is money.

The theory is normally simplified in the Monopoly bank with a 20% reserve requirement as follows:-





The model is static so a new deposit originating outside the construct must be introduced to facilitate the money creation process. This external source could be the activity of a Central Bank but is simply defined as an external source. The absence of a defined source allows the model to be built on fiction and is a logical quickstep required to make this theory work.

Introducing 100 units of deposit from an external source would allow the Monopoly Bank to use the new deposit for reserving requirements and “create” credit for 400 units. The new Balance sheet would be as follows:-





The 20% reserve requirement can be tested at 1500 x 0.2 = 300 units and the model is stable again.

This theory is generally taught as true but with criticism. It is actually fatally flawed and incorrect. The fatally flawed components are disguised in the undefined external source. Even more relevant is the time between the introduction of the External Deposit and the re-balancing of the Monopoly Bank’s balance sheet. The most important omission is that a production channel is accessed in this period.

The Source of all Deposits

There are two sources of deposits:

1. Savings which originates form a production surplus. Such “Savings” are available for a specific time period which can be for an hour, a day, a week a month, ten years or any such period in accordance with the specific needs of the Saver. Thus a person receiving wages on Friday afternoon may allocate his or her wage income over the next 7 days towards consumption yet a portion will enter the pool of savings and an ever diminishing portion will be available as “Savings” for the next 7 days. Note that the wage was earned in the production process. The “Savings” is 100% supported through production.
2. Unfunded monetary credits originating from “an external source”. Unfunded monetary credits are not “backed” by a production input to the economy and as such are imposters pretending to be savings.

Testing the Fractional Banking Model against the origin of deposits.

The receipt of the 100 units of External Deposit by the Central bank as a reserve requirement may have been sterilised at the Central Bank. Let’s make it so for the sake of simplicity but it is not a prerequisite requirement. Monopoly Bank granted credits of 400 units but such credits did not simply go from the recipient of the credit straight back to the Monopoly bank. No, the recipients used the credits for a purpose, to pay taxes (government spending), to buy consumables (consumer spending) or for investment (investment spending).

The 400 units of money entered the economy and the recipients received economic value for the credits. Economic value in the form of production value. Let’s proceed with a short cycle and state that the producers deposit the proceeds with Monopoly Bank.

The fact is that the 400 new units of deposit originating from the bank credits are backed by a production process. This is an absolute truth. To borrow on one hand and re-deposit on the other would only be possible under arbitrage conditions and can never fulfil any role in general economic theory. The application of the 400 units will cause malinvestment and misallocation of resources as it was made possible by a supply of unfunded monetary credit. The external origin of unfunded monetary credits is the malaise, not the banking sector when it performs its functions as expected.

It is therefore not valid or true to claim that the Monopoly Bank had created money. The Monopoly Bank did anticipate the receipt of savings backed by a production process. How was this possible? Again the model is silent. It could only happen if the Monopoly Bank could obtain a “loan” from an external source to fund the process until such time as the 400 units returned from the production process. Such a loan could have no other nature than that of an unfunded monetary credit.

Interventionism
The fractional banking model is incorrect and economically dishonest by omission. It requires two very specific monetary interventions to facilitate debt formation. A pre-existing much more menacing intervention is reserving.

Economists seldom realise that the very act of reserving is a severe intervention. It acts against the interests of the very economic participants it pretends to favour, the Saver. Any form of reserving requires that a portion of legitimate Savings must be removed from the economy, logic enmeshed in true Keynesian tradition. Savings sterilised is the only Savings not available to the economy in the normal course and robs the Saver of potential rent.

The interventions in the relationship between the Borrower and the Bank should receive the criticism of the libertarian economist. Similarly should the interventions in the relationship between the Saver and the Bank be criticised. Proposals to sterilise the Savings in the economy through reserving should not be confused with sterilisation of money creation from nothing. The one is a result of a production process in the economy, the other comes from nothing.

A 100% reserving requirement would entirely remove any rent that the Saver could earn, limit available savings and severely damage the economy.

The problem of money creation must be addressed at the intervention where it happens and not be exacerbated by punishing the Saver, the Bank, the Borrower and the economy. Each of these entities is a legitimate participant to the market and entitled to pursue its own best interests in true libertarian fashion.

The collection of short term savings in demand accounts is still legitimate savings. A discretionary subjective judgement regarding “demand deposits” should not take the place of a functional intent, that is, the bank must at all times comply with such demands of fail as a bank. Such is the nature of free market economics.

It is a fundamental function of banks to manage the pool of all deposits to achieve a transformation of funding time preferences inherent to the management of a dynamic deposit pool. Any deposit pool will have a predictable and stable component which can be utilised across the yield curve to provide much needed term funding. A 100% reserving requirement would destroy this market function of banks, invite the inevitable intervention spiral, impose an economic cost on unsuspecting economic participants, distort the much maligned savings market even further and starve the economy of the largest pool of savings available.

The interventionism of reserve requirements is similar to all other interventions and will generate the usual outcome of unintended consequences.


2 February 2009

Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .