We don’t want economic growth

We don’t want economic growth https://stumblingandmumbling.typepad.com/stumbling_and_mumbling/2020/01/we-dont-want-economic-growth.html

I think there is a lot of truth in this blog post

– subject to achieving a reasonable minimum, people do seem to care more about relative position than absolute wealth

– the creative destruction associated with growth is good for the herd but the individuals who lose their jobs and can’t find a place in the new economic order are obviously not so keen on the process

– conventional economic policy advice government receives does not really engage with these questions

Relevant extract from the blog copied below

There are, for my purposes, two things are going on here.

One is that what matters for well-being is not so much absolute income as our income relative (pdf) to our peers: if we are doing better than them, we’re happy and if we are doing worse, we’re miserable. Andrew Clark and Andrew Oswald have found that happiness depends more upon relative (pdf) income than absolute income, whilst Christopher Boyce and colleagues have found that it is a person’s position in the income ranking (pdf) that matters for their well-being, not their absolute income**.

If it is relative income we care about, then stagnation shouldn’t trouble us. We have as much chance of getting ahead of our peers when GDP is flatlining as we do when it is growing.

Also, though, economic growth is associated with some things many of us don’t like – with the creative destruction than runs down some industries and areas. As Banerjee and Duflo show in Good Economics for Hard Times, the economy is “sticky”: people do not or cannot adjust to such disruption. Hence Anand Menon’s heckler’s point: “that’s your bloody GDP. Not ours.” A stagnant economy in which zombie firms preserve jobs and in which we face less threat from foreign competition or new technology is perfectly tolerable for many – and better than the tumultuous, threatening growth of the 80s and 90s.

Book recommendations

Doing book recommendations seems to be very on trend. That said, I am a sucker for the “here are my favourite books” tag so here are some of the books I read this year that I can recommend.

“Scale: The Universal Laws of Life and Death in Organisms, Cities and Companies”, by Geoffrey West

The Value of Everything: Making and Taking in the Global Economy”, by Marianna Mazzucato

“The Economist’s Hour: How the False Prophets of Free Markets Fractured Our Society” by Binyamin Appelbaum

“Scale” identifies some universal scaling laws that apply in and across a range of domains, the nature and origin of these systematic scaling laws, how they are all interrelated, and how they lead to a deep and broad understanding of many aspects of life and ultimately to the challenge of global sustainability. The ways in which companies are subject to similar scaling laws to those observed in biological organisms was especially interesting for me but this is just one of a range of topics covered to draw out intriguing insights.

“The Value of Everything” has a particular view on the role of government that you may, or may not, agree with. However even the skeptics who don’t accept her overall thesis would benefit from the primer the writer offers on the different theories of value that have held sway over the formulation of public policy.

Finally, “The Economist’s Hour”. I am only half way through this book but it offered new insights for me on the role of economists and economic theory in driving some pretty fundamental changes in the society we live in.


Capital geeks take note – the IRB scaling factor strikes again


Another reminder on the importance of paying attention to the detail courtesy of a story that I picked up reading Matt Levine’s “Money Stuff” column on Bloomberg.

This extract from Matt’s column captures the essential facts:

Here, from Johannes Borgen, is a great little story about bank capital. Yesterday Coventry Building Society, a U.K. bank, announced “a correction to its calculation of risk weighted assets” that will lower its common equity Tier 1 capital ratio from 34.2% to 32.6%. That’s still well over regulatory requirements, so this is not a big deal. But the way Coventry messed up is funny:

“The Society uses Internal Ratings Based (“IRB”) models to calculate its Risk Weighted Assets (“RWAs”) and is seeking to update these models to ensure compliance with upcoming Basel III  reforms. During the process of transitioning models, the Society has identified an omission in connection with its historic calculation of its RWAs. Specifically, the necessary 6% scalar was not applied to the core IRB model outputs. The core IRB models themselves are not impacted.”

For banks that use Internal Ratings Based models, the way the Basel capital rules work is that you apply a complicated formula to calculate the risk weights of your assets, and then at the end of the formula you multiply everything by 1.06. That’s kind of weird. (The Basel capital regime for banks using IRB models “applies a scaling factor in order to broadly maintain the aggregate level of minimum capital requirements, while also providing incentives to adopt the more advanced risk-sensitive approaches.”) It’s weird enough that in the “upcoming Basel III reforms” regulators plan to get rid of it: The 1.06 multiplier is a kludge, and if you measure your risk-weighted assets a bit more accurately and conservatively, you shouldn’t have to multiply them by 1.06 at the end. 

Matt Levine, “Money Stuff”, Bloomberg

For anyone new to this game who wants to dig a bit deeper into how the advanced capital requirements are calculated, the Explanatory Note published by the BCBS in July 2005 is still a good place to start. I published a note on that paper on my blog here. The RBNZ also produced a useful note on how they used the IRB function in the portfolio modelling work they used to support their recent changes to NZ capital requirements.

It should be noted however that none of these documents discuss the 6% scaling factor. I open to alternative perspectives on this but my recollection is that the 6% scaling factor was introduced post July 2005 in one of the multiple recalibration exercises the BCBS employed to ensure that the IRB function did not reduce capital requirements too much relative to the status quo operating under Basel I. It is effectively a “fudge” factor designed to produce a number the BCBS was comfortable with (at that time).


APRA announces that it will consider a non-zero default level for the counter cyclical capital buffer

The Australian Prudential Regulation Authority (APRA) announced today that it had decided to keep the countercyclical capital buffer (CCyB) for authorised deposit-taking institutions (ADIs) on hold at zero per cent. What was really interesting however is that the information paper also flagged the likelihood of a non-zero default level in the future.

Here is the relevant extract from the APRA media release:

…. the information paper notes that APRA is also giving consideration to introducing a non-zero default level for the CCyB as part of its broader reforms to the ADI capital framework.

APRA Chair Wayne Byres said: “Given current conditions, and the financial strength built up within the banking sector, a zero counter-cyclical buffer remains appropriate.

“However, setting the countercyclical capital buffer’s default position at a non-zero level as part of the ‘unquestionably strong’ framework would not only preserve the resilience of the banking sector, but also provide more flexibility to adjust the buffer in response to material changes in financial stability risks. This is something APRA will consult on as part of the next stage of the capital reforms currently underway.

“Importantly, this would be considered within the capital targets previously announced – it does not reflect any intention to further raise minimum capital requirements.”

“APRA flags setting the countercyclical capital buffer at non-zero level”, APRA media announcement, 11 December 2019

I have argued the case for a non-zero default setting on this buffer in a long form note I published on my blog here, and published some shorter posts on the countercyclical capital buffer here, here and here). One important caveat is is that incorporating a non-zero default for the CCyB does not necessarily means that a bank needs to hold more capital. It is likely to be sufficient to simply partition a set amount of the existing capital surplus. In this regard, it is interesting that APRA has explicitly linked this potential change to the review it it initiated in the August 2018 Discussion Paper on “Improving the transparency, comparability and flexibility of the ADI capital framework”.

I covered that discussion paper in some depth here but one of the options discussed in this paper (“Capital ratio adjustments”) involves APRA modifying the calculation of regulatory capital ratios to utilise more internationally harmonised definitions of capital and Risk Weighted Assets.

Summing up, I would rate this as a positive development but we need to watch how the policy development process plays out.


The value of having more capital

The debate around the value of having higher capital requirements requires that we understand exactly what the extra capital does and how it reduces the impact of financial crises. Anyone interested in this topic will I think find this post on the Croaking Cassandra blog worth reading. The author is commenting specifically on the recent policy decision by the RBNZ to increase capital requirements but his post can be read as a more general exploration of some of the reasons why a banking system can experience substantial losses and in particular the impact of poor lending practices.

Having established this point , the author then makes the obvious (to me at least) point that capital can help protect bank creditors and ensure that banks can absorb losses and continue to operate but the capital itself cannot do anything to eliminate the costs to the economy of the poor lending itself that created the losses. The capital will help ensure that the impact of the initial losses is not compounded by a freezing up of bank lending but it will not eliminate the adverse GDP impacts of the poor lending that had to be written down or off. That I believe is an important distinction that is often ignored in the bank capital debate.

“Higher bank capital might stop the eventual realisation of the losses falling directly on bank creditors and depositors (that redistributive effect, see above) but it won’t stop the losses themselves (on the bad projects that were funded), it won’t stop those particular markets seizing up and demand no longer being there (no one much wanted to build any more new offices in late 1980s Wellington after the scale of the incipient glut became apparent), it won’t stop people across the economy (lenders, borrowers etc) having to stop and reassess how they think the economy works, their view on what might really be viable projects and so. And they won’t stop the realisation of wealth losses – the wealth that was thought to be there has gone, the only question is who now actually bears the losses.”

The post concludes with a consideration of what the best response should be.

If it really is sustained periods of greatly diminished lending standards that lead to most of the eventual costs the Bank is worrying about, it might be better for the Bank to be focusing more of its energy on understanding bank lending standards and how they are changing, and on understanding and drawing attention to important distortions in the policy or regulatory system that may be misleading borrowers and lenders alike, and so on. I’m not that optimistic that bank regulators can really make that much difference – for various reasons (including their own personal incentives) it is hard to imagine even the best central banks being that influential with governments, or being paid much heed by banks (let alone borrowers and investors not reliant on local credit). But really high capital ratios have a substantial cost to the economy and it just obvious that they are particularly potent as an instrument to limit the sorts of (overstated) costs the Bank worries about. Other big policy distortions, messing up incentives, making it harder to lend or borrow well, might just be one of the messy facts of life. High capital ratios will always appeal to central bankers – when your only tool is a hammer, all problems tend to be interpreted as nails – but they are costly for the economy and whatever gains (beyond the merely redistributive) they offer seem, from experience, likely to be slight.

And what we do need when things go badly wrong, and a whole of reassessment is taking place, is a robustly counter-cyclical monetary policy. The worst costs of serious economic shocks and misperceptions crystallised are around sustained unemployment for the individuals affected. Neither monetary or bank regulatory policy can do much about potential GDP growth or productivity, and they can’t prevent real wealth losses when bad choices have been made in the past, but they can do a great deal to alleviate the adverse cyclical consequences, to keep unemployment as low as possible, consistent with price stability, and deviations from that (unobservable point) as short as possible.

You may not agree with his analysis but the post is worth reading


On olive branches and olive trees

On olive branches and olive trees

On olive branches and olive trees

— Read on capitalissues.co/2019/12/05/on-olive-branches-and-olive-trees/

I have commented on the RBNZ capital proposals before but have not got around to a thorough reading of the decision the RBNZ released today. In the interim, I can point you to a good summary on this blog.

The short version is that the RBNZ does appear to have taken on board some of the feedback they received.


Mortgage Risk Weights – revisited

I post on a range of topics in banking but residential mortgage risk weights is one that seems to generate the most attention. I first posted on the topic back in Sep 2018 and have revisited the topic a few times (Dec 2018, June 2019#1, June 2019#2, and Nov 2019) .

The posts have tended to generate a reasonable number of views but limited direct engagement with the arguments I have advanced. Persistence pays off however because the last post did get some specific and very useful feedback on the points I had raised to argue that the difference in capital requirements between IRB and Standardised Banks was not as big as it was claimed to be.

My posts were a response to the discussion of this topic I observed in the financial press which just focussed on the nominal difference in the risk weights (i.e. 25% versus 39%) without any of the qualifications. I identified 5 problems with the simplistic comparison cited in the popular press and by some regulators:

  • Problem 1 – Capital adequacy ratios differ
  • Problem 2 – You have to include capital deductions
  • Problem 3 – The standardised risk weights for residential mortgages seems set to change
  • Problem 4 – The risk of a mortgage depends on the portfolio not the individual loan
  • Problem 5 – You have to include the capital required for Interest Rate Risk in the Banking Book

With the benefit of hindsight and the feedback I have received, I would concede that I have probably paid insufficient attention to the disparity between risk weights (RW) at the higher quality end of the mortgage risk spectrum. IRB banks can be seen to writing a substantial share of their loan book at very low RWs (circa 6%) whereas the best case scenario for standardised banks is a 20% RW. The IRB banks are constrained by the requirement that their average RW should be at least 25% and I thought that this RW Floor was sufficient to just focus on the comparison of average RW. I also thought that the revisions to the standardised approach that introduced the 20% RW might make more of a difference. Now I am not so sure. I need to do a bit more work to resolve the question so for the moment I just want to go on record with this being an issue that needs more thought than I have given it to date.

Regarding the other 4 issues that I identified in my first post, I stand by them for the most part. That does not mean I am right of course but I will briefly recap on my arguments, some of the push back that I have received and areas where we may have to just agree to disagree.

Target capital adequacy ratios differ materially. The big IRB banks are targeting CET1 ratios based on the 10.5% Unquestionably Strong Benchmark and will typically have a bit of a buffer over that threshold. Smaller banks like Bendigo and Suncorp appear to operate with much lower CET1 targets (8.5 to 9.0%). This does not completely offset the nominal RW difference (25 versus 39%) but it is material (circa 20% difference) in my opinion so it seem fair to me that the discussion include this fact. I have to say that not all of my correspondents accepted this argument so it seems that we will have to agree to disagree.

You have to include capital deductions. In particular, the IRB banks are required to hold CET1 capital for the shortfall between their loan loss provision and a regulatory capital value called “Regulatory Expected Loss”. There did not appear to be a great awareness of this requirement and a tendency to dismiss it but my understanding is that it can increase the effective capital requirement by 10-12% which corresponds to an effective IRB RW closer to 28% than 25%.

The risk of a mortgage depends on the overall portfolio not the individual loan. My point here has been that small banks will typically be less diversified than big banks and so that justifies a difference in the capital requirements. I have come to recognise that the difference in portfolio risk may be accentuated to the extent that capital requirements applied to standardised banks impede their ability to capture a fair share of the higher quality end of the residential mortgage book. So I think my core point stands but there is more work to do here to fully understand this aspect of the residential mortgage capital requirements. In particular, I would love get more insight into how APRA thought about this issue when it was calibrating the IRB and standardised capital requirements. If they have spelled out their position somewhere, I have not been able to locate it.

You have to include the capital required for Interest Rate Risk in the Banking Book (IRRBB). I did not attempt to quantify how significant this was but simply argued that it was a requirement that IRB banks faced that standardised banks did not and hence it did reduce the benefit of lower RW. The push back I received was that the IRRBB capital requirement was solely a function of IRB banks “punting” their capital and hence completely unrelated to their residential mortgage loans. I doubt that I will resolve this question here and I do concede that the way in which banks choose to invest their capital has an impact on the size of the IRRBB capital requirement. That said, a bank has to hold capital to underwrite the risk in its residential mortgage book and, all other thinks being equal, an IRB bank has to hold more capital for the IRRBB requirement flowing from the capital that it invests on behalf of the residential mortgage book. So it still seems intuitively reasonable to me to make the connection. Other people clearly disagree so we may have to agree to disagree on this aspect.

Summing up, I had never intended to say that there was no difference in capital requirements. My point was simply that the difference is not as big as is claimed and I was yet to see any analysis that considered all of the issues relevant to properly understand what the net difference in capital requirements is. The issue of how to achieve a more level playing field between IRB and Standardised Banks is of course about much more than differences in capital requirements but it is an important question and one that should be based on a firmer set of facts that a simplistic comparison of the 39% standardised versus 25% IRB RW that is regularly thrown around in the discussion of this question.

I hope I have given a fair representation here of the counter arguments people have raised against my original thesis but apologies in advance if I have not. My understanding of the issues has definitely been improved by the challenges posted on the blog so thanks to everyone who took the time to engage.