Setting the Price of Money

During normal times central banks typically vary the price of money to achieve their monetary stability objectives. The most common instruments of choice are interest rates and exchange rates.

Setting interest rates

In countries where the exchange rate is free to find its own market level, the relevant price of money is the interest rate. However, the financial system comprises many different interest rates that are often determined by commercial decisions not by the central bank. So, for the sake of credibility, central banks need to choose a price, an interest rate, that they can actually control.

In the Fed’s case the target interest rate of choice is the federal funds rate – an overnight borrowing rate agreed by an exclusive club of key market players. Since the fed funds market is populated by only authorised entities, the borrowing that takes place can be unsecured, without the need for collateral. Moreover, since what is being borrowed and lent are reserves (US$ deposits at the Fed) the Fed itself can effectively steer the rate into whatever target range it chooses.

The Fed’s control principally stems from its monopoly control over the supply of reserves which it can squeeze and expand through open market operations (purchases and sales of securities by the New York Fed, usually via repo, in exchange for central bank deposits). In normal times, reserves are relatively scarce so fine-tuning the fed funds rate is relatively straightforward. However, although the GFC happened many years ago, its legacy lives on. In particular it changed the fed funds market in significant respects.

First, the fed funds market has shrunk markedly since the GFC – a mirror image of the huge rise in reserves. Around a decade ago the volume of reserves borrowed was over $250bn. However, borrowing collapsed by the end of the 2008 falling below $60bn by end 2015. Borrowing is currently in a $80bn-$100bn range. This contraction reflects the huge amount of excess reserves that were built up after three huge rounds of QE – reducing the need for most eligible entities (the notable exception being foreign banks) to borrow.

Second, the existence of such large reserves combined with an institutional wrinkle, has required new central bank tools to control the key fed funds rate. The wrinkle in question is that the Federal Home Loan Banks (FHLBs) are allowed to participate in the fed funds market but are not eligible to receive interest on excess reserves. Not only does this mean that FHLBs are, by far, the main supplier of fed funds but also has contributed to the spectacle of the effective fed funds rate falling below the so-called “floor” interest rate – the interest rate on excess reserves (IOER).

As well as exploring the mechanics of interest rate setting another key objective of this Session 12 segment is to reinforce understanding of balance sheet truths about commercial bank reserves. In particular, you will be able to avoid common pitfalls and illusions, such as,

  • “large reserves prove that banks are hoarding liquidity rather than supporting lending”
  • “negative interest rates boost credit supply”
  • “reserves are deposits not lent out to households and non-bank companies”

Still puzzling as to why these statements are, at best, misleading? Maybe it’s a good time to review this, this and this.

Setting exchange rates

So far we have focussed on the interest rate price of money. But central banks can also try to manipulate exchange rates. What they cannot do – unless, unusually, they can limit cross-border capital flows – is to juggle both at the same time. The reason is the famous impossible trinity.

If you want to moderate a strong exchange rate, maybe because it’s killing your export industry, then you will probably need to cut interest rates. But cutting interest rates could add to inflation problems – making exports more expensive for global customers. Getting a dream combination of interest and exchange rates is not easily achievable. Unless your economy is in a perfect sweet spot you either tweak interest rates and let the currency take the strain (a floating exchange rate regime) or you choreograph the exchange rate and let interest rates find their own level (a managed exchange rate regime).

Managing the currency does not necessarily mean that it is fixed for all time or that, like Ecuador and some others, you do not even have a domestic currency. Indeed, there is nothing that stops a country flip-flopping between interest rate management and exchange rate management (China and Switzerland often do this). The point about the impossible trinity is that you cannot do both simultaneously.

Why would some countries choose to fix their exchange rates rather than interest rates?  Usually this because of an understandable fear of floating. Leaving currencies to their own devices – especially in a world of hot, fickle capital flows – can be especially damaging for countries that are both highly dependent on trade and whose credibility (their criminal risk record) is in question (that is, the bulk of emerging and developing countries). Floating can get economies into big trouble.

We already know that, at a domestic level, the financial system is prone to amplify trends. In other words finance is procyclical – a small boom quickly morphs into a large boom and vice versa. At the global level, the same overshooting problem clearly exists. When in fashion, emerging markets attract huge waves of global capital, pushing up their exchange rates and setting the seeds of an export-led recession and reckless borrowing in (temporarily depreciating) US dollars. When the narrative turns sour, foreign capital exits as quickly as it arrived. The domestic currency buckles, US$-denominated debt breaks companies and the banks. It does not look pretty.

But the undoubted dangers of floating does not mean that fixing your exchange rate is an easy choice, Far from it. Fixing the exchange rate is a huge commitment that, if broken, can unleash severe and lasting damage on an economy. Some countries can survive failures in fixed exchange rate regimes (UK’s White Wednesday, for example). But, even in Britain’s case, the ERM car crash did huge damage to the government’s reputation. More generally, failing to stick with a fixed currency regime can be much more devastating – leading to substantial, prolonged losses of output and jobs. In extreme cases, such as the 2001 collapse of Argentina’s peg versus the US$, it can lead to street riots and undignified political exits.

The bottom line is that pegging your currency does not guarantee stability. The peg will be of a nominal exchange rate, not the real exchange rate – and it is the latter, of course, that really matters for your country’s competitiveness. Changing the peg will undermine confidence and leave permanent scars on credibility – economic and political. Mistakes can be costly and long-lived. Successful currency pegs typically only occur if sacrifices are willing to be made in terms of deep-rooted, probably painful, social and economic reforms. But if countries have the appetite for such reforms then why be fazed by the rugged landscape of floating?

Are there lesson here for Europe’s EMU? It is hard to argue that the region is an optimum currency area. The ragbag of countries that currently make up the Eurozone contains very different structural characteristics that cannot be readily straitjacketed by single currency rules. Some have likened EMU to the gold standard, drawing unnerving parallels with the path to the inter-war chaos of the 1930s. Maybe that is a bit too pessimistic; we shall see.

14 Nov 2018

Central Banks

Central banks are…er…banks.

Like their commercial counterparts they have balance sheets. Loans and other assets are funded by customer deposits and freshly minted money (of top-notch quality). More often than not, they have capital – though with leverage that would make a hedge fund blush. Moreover, central banks do market-based stuff: repos, reverse repos, securities, collateral. They are seriously looking at cryptocurrencies, blockchain, cybersecurity and other 21st century FinTech. If pressed they will push the legal envelope harder than any of their commercial brethren would dare. Innovation in a tight spot? Well, just take a peek at some of the amazing feats they got up to during the GFC once interest rates got zeroed out. And could we call them “shadowy”? Oh yes, more of that later!

But central banks differ from commercial banks in key respects. Often, though not always, they are embedded in the State – with all its legal and tax protections. They are endowed with a social purpose: not for them the grubby world of profits, rather the nobility of social well-being and high moral values. And their customers are typically a clubby lot – major bank-holding companies, the government and other central banks.

Central banks were relatively rare at the beginning of the 20th century but now most countries have one. It was in 17th century Europe where powerful nations, with big military and trade ambitions, first recognised the benefits of centralised finance. Waging war and holding on to super-rich trade routes did not come cheap. The aristocracy could ,of course, follow the traditional path of confiscating assets taxation. But monarchs learned the hard way that too much tax-and-grab led to severe headaches.

In the 18th century, the newly formed United States of America was initially hesitant about creating a central bank. Several Founding Fathers, notably Jefferson, were wary of centralising power in the hands of “Eastern money”. Hamilton – the first US Treasury Secretary (who has now reinvented himself as a hip-hop superstar) – had a different vision. He argued that, without a central bank, the fledgling country would struggle to move forward; especially as its finances were in tatters after the War of Independence. Experiments with a Bank of the United States followed but, President Andrew Jackson – often compared with Donald Trump – killed the project off in 1836. It was to be another 70 years or so before the concept was to be considered again.

The Federal Reserve System – which exists to this day – did not come into existence until just before the First World War (the Federal Reserve Act of 1913). The institution was born out of the hugely damaging 1907 Panic – a crisis that had several parallels with the GFC a century later. It was the last straw after many decades of financial instability in the so-called Free Banking era.

The involvement of central banks in financing war efforts continued well into the 20th century. Indeed, there are hugely controversial accounts of how certain central banks, including the “ultra-shadowyBIS, were in cahoots with the Nazis. As for the contribution of central banks in dealing with global financial crises, their record in the 1920s onward was horrendous, as superbly chronicled in Liquat Ahamed‘s Pulitzer prize-winning The Lords of Finance.

The ECB is a relatively new kid on the central banking block, emerging in 1998 just before the launch of the euro, Europe’s newish single currency. The ECB is unusual in that its legal supranational status provides it with significant powers and independence. Again, as with the Fed and other central banks, controversy has surrounded the organisation since its inception – not least during the spats that unfolded during the EU’s sovereign debt crisis, reliving ugly WW2 memories.

Despite multiple issues, central banks did a better job in the GFC than in the Depression perhaps reflecting the greater detachment from political interference. New Zealand was the first country to grant its central bank independence in 1989 since when many countries have followed. A benign delegation by politicians? More often a device for deflecting attacks by volatile international capital. The decision of a British Labour government to set the Old Lady free surprised markets. But it was a canny quick fix to establish credibility. In any case, the small print – which few noticed – contained override clauses should the “national interest” require it.

The GFC has reignited criticisms of central banks, if only because of their dismal failure to anticipate the crash. For sure, once fired up, they did a better job than their counterparts in the 1930s. But serious problems emerged when legal powers were stretched to extend liquidity to troubled institutions. Many parts of society felt “cheated” by the persistence of ultra-low interest rates and the huge feather-bed that was provided for errant bankers. And new powers provided to central banks, in the interests of ensuring financial stability, have further exacerbated worries that unelected technocrats are getting too big for their boots.

As interest rates climb, and banks begin reaping increasingly large gains on their bloated reserves, the complaints will only get louder. Whether central banks can hold onto what independence and credibility they retain, is increasingly a moot issue. Central bankers will need all their artful powers of communication to contain the criticism. Main Street has yet to make its peace with Wall Street.

6 Nov 2018

Shadow Banking

The term “shadow banking” conveys a sense of darkness and illegality. However, that is not an accurate description of what is 21st century market-based banking. “Shadow banking” has become a popular description for credit intermediation outside the regulated banking system but, in many ways, it is highly misleading. Since the GFC, regulators are keenly watching what is going on in this sector of finance – the shadows that we know about, pretty much always on the right side of the law, have powerful spotlights pointing at them. The trick, however, is knowing where to point the spotlight and being able to figure out the significance of what is revealed.

In session 10 we shall examine the essence of market-based banking which combines both securitisation and collateral management. Conceptually, we already know how to “securitise” cash flows – we did that back in Session 5 by applying PDV/DCF techniques to, for example, regular mortgage payments. Now we look at actual examples and track the history of mortgage-backed securities (MBS) since the 1970s. Specifically, we look at the rise of Fannie Mae and Freddie Mac. Together with Ginnie Mae, these government-backed agencies dominate US housing finance and comprise at least 60% of US shadow banking.

Although Fannie and Freddie got into trouble, requiring both to be formally “adopted” by the Government (the official term is “conservatorship“), the main problem area in the GFC swirled around so-called “private-label” MBS. These were securities generated by loans that did not meet the relatively high standards of Fannie and Freddie. Such loans feeding into the private sector machine were either large, lacked key documentation or were dependent on borrowers with poor credit history (the infamous sub-prime sector). Another key problem was the excess complexity of structured mortgage-backed securities. These were securities that involved slicing and dicing; apparently creating AAA credits out of mish-mashes of cash flows. Blinded by poor science and tainted by misaligned incentives, it was not long before the alchemy was caught out.

Policymakers have clearly been chastened by the GFC but the enthusiasm for securitisation and shadow banking remains intact. Rightly so, such activities have the potential to improve access to finance – encouraging growth and better living standards. But there is still an enormous amount of work to do to acquire information and understanding of what is going on in a rapidly evolving sector. Even on relatively narrow definitions, shadow banking is probably already larger than it was at the time of the GFC. Regulators are trying hard to keep pace but they are always going to be hard pressed to identify where the problem areas are. Back in the early 2000s, asset-backed commercial paper was the darling of the shadow funding sector. But that form of private sector money has long fallen out of fashion. Do we know where to look now? China’s huge shadow banking sector, Facebook, Google, Amazon, private equity, leveraged loans, maybe insurance companies, CCPs?

The problem in pinning down future financial risk arguably has parallels in international military conflicts. When former US Secretary of Defense, Donald Rumsfeld, was briefing journalists in 2002 on the flaky evidence linking Iraq to weapons of mass destruction he provided this epic quote:

…as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones

31 Oct 2018

Capital Punishment

We learnt in Session 7 that banks – for all their power and swagger – are not that profitable, especially on RoA measures.

Now combine that with a key message from Session 5 – high returns are unlikely if you are not prepared to take risk. Low risk, low returns. No pain, no gain.

But here’s a paradox. Banks give us low returns but they are decidedly not “safe”. In bad times, they are risk on steroids, as was evident in the GFC.  So how do they get away with it?

Of course the answer was addressed in Session 1. Money and banking are society’s beating heart and breathing lungs. The modern world cannot function without finance. Love it or hate it, we have to live with it.

Little wonder, then, that State involvement in, and support for, finance is huge. Partly that is to temper any abuse of monopoly power. It also acknowledges that a well functioning finance system delivers essential social benefits. We do not expect governments to make huge profits out of policing and national defence. Why should we expect banks to do any better in delivering utility money, credit and payments services? 

Session 7 revealed another twist. Well meaning safety nets for the banks can generate moral hazard – making banks riskier than warranted. As citizens we want protection from financial catastrophes. But do our efforts, through all those explicit (and implicit) public subsidies make catastrophes more likely? This dilemma is nothing new. Roosevelt was well aware of the problem when deposit guarantees were introduced in the 1930s. The trick is getting the right balance through smart social contract design.  

So what shall we focus on next? Our review of commercial banking has frequently underlined the critical importance of liquidity and capital. Do not default, do not go bust. In the upcoming session we shall not say much more about liquidity (the Bear Stearns episode spoke volumes about the havoc that illiquidity can wreak and we have space later on in the course to talk more on improving liquidity positions). Rather, for now, our attention will focus on capital risk.

We touched on this topic before in Session 6, noting that broken promises are not the only means by which vital capital is eroded. To fix ideas, we shall consider three major sources of capital risk:

  • operational risk … especially cyber risk but also covering litigation costs, rogue traders, etc
  • credit risk … the chances of defaults and poor recovery rates and what can be done in the way of protection
  • market risk … the problems arising from interest rate and currency volatility when balance sheets are not “properly” balanced. This leads us into gap & duration analysis and the wonderful world of derivatives, hedging and speculation.

With so many risks to capital it is easy to lose sight of the big picture. This is where Value at Risk (VaR) models, stress tests and market-based metrics such as SRISK come in useful. Then again, with any modelling exercises, you need to avoid the danger of “garbage in, garbage out”. So we take the opportunity to unpick some accounting methods and assumptions that could lead us astray (contingencies, netting and marking-to-market).

Tracking back to credit risk, we already know that it poses major headaches for banks. Tackling credit risk requires lots of information-gathering efforts, smart contract design and, above all, ample capital buffers. So, you might be wondering, why don’t banks do what the rest of world does when faced with risk (falling ill, house burning down, smartphone screen cracking)? Specifically, why don’t banks just get insured?

Good idea… and one that several banks came up with in the 1990s. However, only one persevered with the concept, JP Morgan, who developed the so-called Credit Default Swap in 1994 – primarily as a tool for controlling risk, so persuading regulators that less capital buffers would be required.

The full story has been expertly written up by Gillian Tett in Fool’s Gold. The book provides an excellent perspective on the Great Financial Crisis and touches on a number of themes we are covering in our course:

  • Europe’s significant participation in the development of credit derivatives and associated issuing vehicles
  • how the Greenspan Fed was persuaded by the powerful Wall Street lobbying machine to view credit derivatives as a rationale for light-touch regulation in the new millennium (an approach that was also backed by New Labour, under PM Tony Blair)
  • the transformation of credit default swaps into a means of speculation, so lifting global systemic risk to dizzying heights
  • how stodgy, risk averse, institutions (AIG, Deutsche Bank) got infected by the hype; hubris and nemesis following in quick succession

Tett notes that, by 2006, as US house prices turned and underlying sub-prime problems burst into view, some (but not all) Wall Street players and regulators were getting cold feet. But, by then, the genie was out of the bottle; bulls and bears were battling it out, adding to the trading frenzy. The CDO (collateralised debt obligation) machine was in full gear and speculators pounced on the new “doom” indices that could be tracked and traded in huge amounts. 

Complex derivatives combined with misaligned incentives, a toxic mix: the rest is GFC history.

18 Oct 2018

Many Unhappy Returns

Banks have always operated in dangerous conditions. As we discovered in Session 5, risk is all around us. And toughest of all, we face radical uncertainty. You don’t know what you don’t know. The Medicis in Renaissance Italy knew a thing or two about risk as well as the symbiotic links between money, banking and power. Certainly they understood that being small was not beautiful. For diversification reasons alone, you need to spread your wings, and spread them far.

But even the savvy of the Medicis did not prevent their demise as the 16th century approached. Italy’s domination of European finance ended, showing that even financial behemoths can come badly unstuck. It was a lesson echoed many times in the centuries that followed, not least our own.

Through the 20th century, megatrends such as globalisation, deregulation and financial innovation contributed to a huge expansion of banking activity, traditional and “shadow”. Financial knowhow accelerated with the help of rocket science and whizzy new derivative products. All-powerful, all-knowing Masters (and Mistresses) of the Universe were strutting the streets of London and New York.

After the dotcom “blip” Wall Street attention moved to the most important tangible asset on the planet, property. Surely, with all that sophistication and mathiness the world of finance could do a great rebuilding job for Joe Public. The democratisation of capital reaching out to impoverished borrowers. Sub-primers who, hitherto, could only dream of ever buying their own home. The politicians salivated, the money wheels turned. This was Nirvana. 

Of course, with the benefit of hindsight it was a horrible example of pride before a fall; hubris followed by nemesis. As the GFC dust settled, serious failures of judgement – business and ethical – came to light.

And yet, despite all that risk – exogenous and endogenous, we learn in Session 7 that the returns offered to investors (both before and after adjusting for leverage) appear pathetically low. In looking at measures of profitability we need some more tools: RoE, RoA, NIM. We discover that RoE is a particularly popular metric but very misleading for the unwary. A key takeaway is that business performance, especially in banking, is not simply about returns. The risks taken to achieve those returns are critical. For that reason we shall also look at asset quality metrics such as non-performing loan ratios, charge-off rates and the so-called Texas Ratio. Equity market signals also provide useful insights – we pay special regard to price-book ratios as a way of tracking market confidence in banks’ business models. 

On a more optimistic note, efforts have been made since the GFC to improve some of the key fundamentals – notably more liquidity and more (and better) capital. However, it is worth maintaining a broad historical perspective. For sure, banks are doing a better job than they were 10 years ago. But, in comparison with the liquidity and capital reserves held 50-150 years ago, the record looks far less impressive.

In the UK, for example, the liquid assets ratio was around 10 times larger in the 1960s than it is now. Also median leverage ratios were much higher.

As for the US, a similar pattern emerges. For example, the FDIC’s Thomas Hoenig webpage contains information on the US leverage ratio since the 1860s (the chart below). In a later session, we assess the adequacy of the current global reform program (Basel III). That program seeks a few percentage points more on capital ratios, amongst many other reforms.

Brave new world? Or just lamentably unambitious? When critics like Admati & Hellwig and the Minneapolis Fed chief are calling out for far higher leverage ratios, in the 20-30% range, you can hopefully now appreciate where they are coming from.

12 Oct 2018

US leverage ratio

Liquidity & Capital Watch

Session 6 will reiterate the now familiar twin mantras: do not default, do not go bust. And we repeat a banker’s to-do list that involves gathering more information, diversifying, smart contract design, keen risk pricing together with plenty of capital and liquidity buffers.

Around a decade ago, the global financial system went into meltdown. What seemed so shocking at the time was that, despite the apparent sophistication and smartness of modern banking, the financial system proved tragically fragile and vulnerable.  In 2011 a senior Chinese central banker reportedly said to Lord King (former governor of the Bank of England) 

“We in China have learnt a great deal from the West about how competition and a market economy support industrialisation and create higher living standards. We want to emulate that… But I don’t think you’ve quite got the hang of money and banking yet.”

The GFC was partly bad luck but, in finance, as in many walks of life, you make your own luck. Risk is typically endogenous not exogenous.

We shall learn that the property reversal from 2005 onwards was the GFC trigger, but the problems went much deeper

  • excessive leverage
  • poor liquidity management
  • reduced lending standards
  • misinformation & misaligned incentives
  • flawed rocket science
  • regulatory weaknesses
  • limited legal powers to resolve failing banks
  • contagious networks
  • doom loops (positive feedback mechanisms)

If you have not done so already, I recommend dipping into The Economist’s survey of past financial crises or the wonderful book by Rogoff & Reinhart, This Time Is Different: Eight Centuries of Financial Follies. As the FT’s Martin Wolf has commented, “This Time Is Different” are the four most dangerous words in finance.

You will notice that many of the GFC problems we list are common features in many past crises. The narratives vary but the underlying themes are remarkably similar.  So why do we keep making the same mistakes, over and over? Human foibles – greed and fear – play their part. Certainly, the ancient Greeks warned about hubris and nemesis, and yet many centuries later, the trap is still catching the unwary.

On the theme of human irrationality, the 2017 winner of the Nobel Prize in Economics, Richard Thaler has broadened our understanding. He makes a brief appearance in the following Big Short clip, with Selena Gomez, to describe one particular GFC folly (the synthetic CDO). Enjoy – and don’t skip the awesome interplay with the CDO manager; believe me, these sort of people really do exist!

4 Oct 2018

Risk Is All Around Us

We now take a big step forward in our money and banking journey. “Safe” is in short supply; even if attained, “safe” can disappoint.

Debt instruments, even if issued by top quality credits such as the US government, can suddenly lose value if the interest rate environment goes sour (the Fed unexpectedly tightens by raising the fed funds target, for instance). And if you have to liquidate that asset sooner than planned, then that loss will have to be crystallised, maybe a large amount if you are sitting on long-dated bonds. It’s one manifestation of what we call market risk (there are other types we shall look at later on in the course).

Knowing that in advance means that, before buying, investors will want higher yields the longer the maturity of the US government’s debt (both to cover for likely Fed tightening and for the anguish of living with such risks). Indeed, the US Treasury yield curve illustrates exactly that upward-sloping phenomenon.

Market risk is also present in the equity market. Recall that with equity there are no promises in the first place and that, with a high probability, prices will display roller-coaster features at times (specific, maybe even market, risk on steroids).

With debt, there are legally-binding promises but that does not mean that the borrower always delivers. Bonds can be unnervingly surprising at times! It’s what we call credit risk. We shall look at a number of examples by examining yield spreads against “gold-plated” US and German government paper. Banks, companies, even governments themselves can wobble – in terms of perception if not reality.

Managing risk is an important task, not just for banking professionals, but in our own daily lives. So we shall introduce concepts such as diversification (including hedging), together with supporting quantitative tools, notably covariances and correlations. We put theory into practice with a portfolio visualizer site. Other (free) tools you might find interesting include Fin Wiz and Sector SPDRs.

27 Sep 2018

Shadow Money

We have already learnt that money can take on many shapes and sizes. At any one time several monies can happily co-exist, even within a single jurisdiction. For most advanced economies, especially the US, top-quality money – the best that money can buy – is issued by the State (either coins, typically minted by the Government or bills and electronic deposits issued by the central bank). Such money is ultra-safe since it is directly supported by the promise of the State. If you can’t trust that promise then what hope is there?

However, we have also discovered that top-quality money is in relatively short supply. Most money, even as conventionally defined, is issued by the private sector – in the form of commercial bank deposits. These deposits are not quite as safe as high-powered money (aka the monetary base) especially if balances exceed the FDIC guarantee limit. However, for the many retail customers who are under the $250k limit, bank deposits are effectively a State promise and so, rationally, can be considered safe.

But for wholesale customers, such as cash-rich companies, there are risks in holding large pools of commercial bank deposits for which there is little compensation. US Treasury bills and bonds offer safe havens but, again, supply is insufficient to match demand and the yields on offer are skimpy.

This is the primary reason why shadow money – and the banking apparatus that supports it – is, and always has been, so large. The private creation of money-like instruments to supplement commercial bank deposits and government debt is legal, useful and huge. Across the three main sectors we focus on – commercial paper, money market mutual funds (MMMFs) and repos (repurchase agreements) – we shall find thriving multi-trillion dollar industries. Of course, the GFC dented shadow business, but it was not a killer blow. 

Needless to say, private shadow money is not as safe as the monetary base. When the economy is in good shape shadow money is regarded as good as conventional money, arguably better since it offers higher interest rates. However, as brutally demonstrated during the GFC, the presumption of safety can be shattered in bad times leaving a sad pile of broken promises. Little wonder then that huge chunks of financial activity – built on “safe” quicksand – quickly tumbled into crisis. 

In our introduction to shadow money we spend extra time talking about repurchase agreements (aka repos). One angle we shall probably not have time for is how, against the spirit – if not the letter – of accounting law, repos can be used to “window-dress” balance sheets; to make them look less leveraged than they really are.

Needless to say, Lehman Brothers provides a great example of what repos should NOT be used for – to mislead regulators, trading counterparties and investors. But they were used for that purpose, and Lehman’s sleight of hand was roundly condemned when the post-mortem took place. You can read the story here and here. This “loophole” was reportedly closed although suspicions often resurface about new forms of chicanery.

Our session on shadow money will also cover bonds – longer-term promises. Strictly speaking, bonds are not money – you cannot buy your weekly groceries with bonds. But a few agile moments with a smartphone could readily turn bonds into “cash” (market liquidity) or act as collateral for borrowing “cash” (funding liquidity). Bonds can reasonably be viewed as quasi-money and certainly play a leading role in the shadow money and banking world. 

In dealing with money market instruments and bonds we need some technical expertise in calculating interest rates and yields. Along the way we learn about

  • the inverse relationship between asset prices and yields
  • the heightened price sensitivity of assets as duration (maturity, length of borrowing) increases
  • that a safe asset (the promise is kept) is not necessarily a risk-free asset; market risk can be especially painful for holders of long-term promises 

We shall use discounted cash flow (present value) methods to price credible promises. A key insight here is that a promised cash flow can be viewed as an income earning asset. That promise could start off as an OTC loan but it could also readily spawn the creation of an exchange-traded security. Mortgages provide an excellent example.  

This, and our following session on risk, are amongst the most technical of the course. However, while some of the material is tricky, please persevere with it. The lessons learnt will be invaluable – not just for this course but for navigating your personal financial future!

22 Sep 2018

Money, Banking & Alchemy

In our preliminary discussions about banks and balance sheets we shall learn something new about money. Trust remains central, not least our trust, as bank customers, that electronic deposits are safe. And yet you may well feel that something fishy is going on. Banks appear to create money out of nothing. In a sense, because balance sheets balance, deposits (money) – liabilities of a commercial bank – are backed by assets, notably the loans that commercial banks make. But then those loans can be risky and banks are often locked into contracts that mean they cannot necessarily call in those loans at a moment’s notice. In contrast depositors can shift or withdraw their deposits very quickly. Deposits are meant to be safe and liquid. Loans are typically much less safe and illiquid. It makes money and banking seem like a form of medieval alchemy: a magical transformation of base metals into gold.

Well, you are right to feel uncomfortable. Money and banking is a form of alchemy except textbooks like to give it more “scientific” descriptions such as risk and maturity transformation. In fact, the former Governor of the Bank of England, Mervyn King, has written a book on the issue called “The End of Alchemy: Money, Banking and the Future of the Global Economy“. It is an excellent book and I highly recommend it. Your textbook authors, Cecchetti and Schoenholtz, also give the book high praise in their blog article, Making Banking Safe.

15 Sep 2018

Money Matters

Our introductory session on money highlights a number of points, including

  • money as symbolic of civilisation: the dominance of voluntary, commercial exchange over violence; the emergence of respect for the rule of law and property rights
  • the State (democratic or autocratic) has always played a huge role in supporting the “moneyness” of money
  • money is typically an IOU (though there are exceptions) and so fundamentally depends on trust

By way of illustration, a little-known ceremony in London – dating back to the 13th century – takes place each year. So, in addition to taking a look at the above video, check out the following references if you’re still not convinced that money is steeped in history and politics.

History of the Trial of the Pyx Royal Mint website
Have you ever seen a £1,000 coin? BBC News, 1 Feb 2017
Sampling Inspection and Quality Control: The Trial of the Pyx University of Wisconsin, Feb 1976

Needless to say, the lecture will cover more contemporary examples of how the State uses money and its supporting infrastructure not just to achieve core objectives such as financial and monetary stability but also to help enforce the law and pursue foreign policy.

Money comes in many shapes and sizes: physical or digital, privately or publicly issued; widely or narrowly available; and with transfer systems that can be centralised (“traceable” bank deposits) or decentralised (“anonymous” peer-to-peer bitcoins). Textbooks generally focus on money that is an asset for the holder with a corresponding liability somewhere else in the system (a central bank if it is dollar bills or a commercial bank if it is an electronic bank deposit).

However, popular interest – but not participation – is currently engaged by new, disruptive, quasi-money. Bitcoins, like many of their cryptocurrency rivals and other commodity-style moneys, are not the liability of anyone else. It can all get rather confusing. As such, I highly recommend you read a recently published article from the BIS (Bank for International Settlements) which contains some illuminating “flower” visualisations.

Money Flower: Taxonomy
Money Flower: Taxonomy
Money Flower: Examples
Money Flower: Examples

The article also discusses

  • issues that central banks need to consider, should they decide to introduce their own cryptocurrencies
  • some key technical drawbacks with the blockchain system (which is just one type of distributed ledger technology)


Like any product, money has its price. Indeed we shall unveil four prices to choose from. One is the exchange rate and we shall take the opportunity to review currency markets and how not to get confused by foreign exchange quotations. As we look at the grand historical sweep of global currencies over millennia we shall see once more that power, politics and money are inextricably linked.

8 Sep 2018